(2) In 2005, 2004 and 2003, long-term debt includes the mandatorily redeemable preferred securities of a subsidiary trust (Minority interest) in accordance with Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (“Statement No. 150”). Preferred dividends associated with these instruments have been reflected in interest expense, which is included in other operating expenses, in 2005, 2004 and 2003. Reclassification of prior year amounts is not permitted under Statement No. 150.
Our results of operations include the accounts of The Hanover Insurance Company (“Hanover Insurance”) and Citizens Insurance Company of America (“Citizens”), our principal property and casualty companies; and First Allmerica Financial Life Insurance Company (“FAFLIC”), our life insurance and annuity company, and certain other insurance and non-insurance subsidiaries. Our results of operations also include the accounts of Allmerica Financial Life Insurance and Annuity Company (“AFLIAC”) through December 30, 2005. On December 30, 2005, we completed the sale of AFLIAC and the reinsurance of 100% of the variable life insurance and annuity business of FAFLIC (see Significant Transaction on pages 54 and 55 of this Form 10-K for further information) to The Goldman Sachs Group, Inc. and its subsidiaries (“Goldman Sachs”). The results of AFLIAC’s variable life insurance and annuity operations that were sold are reported as discontinued operations. Hanover and Citizens are domiciled in the states of New Hampshire and Michigan, respectively, while FAFLIC is domiciled in Massachusetts.
During 2005, we continued to invest in our commercial lines business, beginning with building and maintaining our relationships with key agents in each of our territories. We are further developing our product portfolio and specialty lines expertise in our commercial lines business as we target the small and first-tier middle markets, which represents clients whose premiums are generally below $200,000. We are expanding our businessowner’s policy to accommodate a broader spectrum of risks and larger accounts. We also continue to enhance our inland marine, bond and umbrella programs, which on average are expected to offer higher margins over time and enable us to deliver a complete product portfolio to our agents and policyholders in our target market.
Property and Casualty, and Life Companies. We present the separate financial information of each segment consistent with the manner in which our chief operating decision maker evaluates results in deciding how to allocate resources and in assessing performance.
The Property and Casualty group manages its operations principally through three segments: Personal Lines, Commercial Lines and Other Property and Casualty. Personal Lines includes such property and casualty coverages as personal automobile, homeowners and other personal policies, while Commercial Lines includes such property and casualty coverages as workers’ compensation, commercial automobile, commercial multiple peril and other commercial policies. In addition, the Other Property and Casualty segment consists of: voluntary pools business in which we have not actively participated since 1995; Amgro, Inc. (“AMGRO”), our premium financing business; Opus Investment Management, Inc. (“Opus”), which markets investment management services to institutions, pension funds and other organizations; and earnings on holding company assets.
As a result of the aforementioned sale of our variable life insurance and annuity business, our Life Companies segment, which is in run-off, now consists primarily of a block of traditional life insurance products (principally the Closed Block), our guaranteed investment contract (“GIC”) business and certain group retirement products, as well as certain non-insurance subsidiaries. Assets and liabilities related to our reinsured variable life insurance and annuity business, as well as our discontinued group life and health business, including group life and health voluntary pools, are also reflected in this segment.
Our consolidated net income increased in 2004, to $125.3 million, compared to $86.9 million in 2003. The increase of $38.4 million resulted primarily from a $80.5 million improvement in our property and casualty segment income. Also contributing to the increase in net income was a $30.4 million favorable federal income tax settlement and a $20.2 million reduction in restructuring costs. These favorable items were partially offset by an after-tax charge of $57.2 million related to the implementation of SOP 03-1, and an increase in federal income tax expense of $25.7 million. Life Companies segment income also decreased $8.1 million.
The following table reflects segment income (loss) and a reconciliation to income of the total of our reportable segments’ income (loss) for each year and is determined in accordance with Statement of Accounting No. 131, Disclosures about Segments of an Enterprise and Related information, to consolidated net (loss) income.
The Property and Casualty group’s segment income decreased $84.3 million, or 42.6%, to $113.7 million for the year ended December 31, 2005, compared to $198.0 million in 2004. In 2005, we experienced significant catastrophe losses due primarily to Hurricane Katrina, and to a lesser extent, Hurricane Rita. As a result, segment income was negatively impacted by $303.9 million of catastrophe related activity, which includes $27.0 million of reinsurance reinstatement premiums resulting from Hurricane Katrina, in 2005. Catastrophe losses for the year ended December 31, 2004 were $99.3 million primarily resulting from several hurricanes in the Southeast. Excluding the impact of all catastrophe related activity, our Property and Casualty group’s segment income would have increased $120.3 million for the year ended December 31, 2005, compared to 2004. Segment income was positively affected as compared to 2004 by an increase of $65.0 million of favorable development on prior years’ loss and LAE reserves. Also positively affecting segment income was an estimated $29 million of improved current accident year underwriting results. In addition, underwriting expenses decreased $27.4 million primarily due to lower contingent commissions and a one-time reduction in expenses due to a premium tax credit associated with our participation in an involuntary pool.
Life Companies’ segment loss was $18.7 million for the year ended December 31, 2005, compared to a loss of $22.3 million during the same period in 2004. This improvement of $3.6 million was primarily the result of lower expenses due to the run-off of our continuing life business partially offset by a $4.3 million provision for a Securities and Exchange Commission (“SEC”) investigation related to market timing (see Contingencies and Regulatory Matters on pages 59 and 60 of this Form 10-K).
Segment income for the Property and Casualty group increased $80.5 million, or 68.5%, to $198.0 million for the year ended December 31, 2004, compared to $117.5 million in 2003. Segment income includes catastrophe losses of $99.3 million in 2004, compared to $59.4 million in 2003. Catastrophe losses were higher in 2004, as compared to 2003, due to four hurricanes in the Southeast. During 2003, however, we recorded a charge of $21.9 million resulting from an adverse arbitration decision related to a single large property claim within a voluntary insurance pool that we exited in 1996. Excluding this charge and the impact of the increase in catastrophe losses, segment income would have increased $98.5 million as compared to 2003. Segment income was positively affected by an estimated $112 million of improved current accident year loss performance due to net premium rate increases across all principal product lines and to a decrease in non-catastrophe claims activity primarily in
personal lines. Additionally, development on prior years’ loss and LAE reserves improved by $33.0 million, excluding the pool charge described above. These favorable items were partially offset by an increase in policy acquisition and other operating expenses of $38.1 million.
Life Companies’ segment loss was $22.3 million for the year ended December 31, 2004, compared to a segment loss of $14.2 million during the same period in 2003. This increase in loss was primarily the result of lower interest margins on GICs, primarily from higher swap contract expenses, an increase in corporate overhead costs related to the discontinued variable life insurance and annuity business, as well as lower net investment income resulting from a decline in partnership income. These were partially offset by improved results due to the continued run-off of our broker-dealer operations and from certain non-insurance subsidiaries, as well as $11.5 million of asset impairments recorded in 2003 related to our discontinued retail brokerage operations.
Net realized investment gains, net of deferred acquisition cost amortization, were $18.6 million in 2005, primarily due to $33.4 million of gains recognized from the sale of approximately $1.2 billion of fixed maturities. Partially offsetting these gains were $9.3 million of impairments, primarily related to fixed maturities and $1.0 million of losses related to the termination of certain derivative instruments. During 2004, net realized investment gains, net of deferred acquisition cost amortization, were $16.1 million, primarily due to $29.1 million of gains from the sale of $735.3 million of fixed maturities. Partially offsetting these gains were losses of $9.7 million related to the termination of certain derivative instruments and $6.3 million of impairments primarily due to fixed maturities. During 2003, net realized investment gains, net of deferred acquisition cost amortization, were $12.8 million primarily resulting from $60.9 million of gains from the sale of approximately $1.0 billion of fixed maturities. These gains were partially offset by impairments of $40.2 million, primarily related to fixed maturities.
Losses on derivative instruments were $0.3 million in 2005 as compared to gains on derivative instruments of $1.3 million in 2004 and $1.5 million in 2003. The changes in net gains on derivative instruments in 2005, 2004 and 2003 resulted from derivative activity that does not meet the requirements of hedge accounting.
In 2004, we ceased certain employee and affinity group businesses and restructured certain commercial lines operations in our Property and Casualty group and recognized $3.2 million in expenses related to this effort. In 2003, we ceased our retail operations related to our broker-dealer in our Life Companies segment. In 2005, 2004 and 2003, we recognized expenses of $2.1 million, $5.3 million and $28.7 million, respectively, primarily as a result of this restructuring effort. These restructuring costs consisted of severance and other employee-related expenses, as well as the cancellation of certain lease agreements and contracted services.
In 2005, we completed the sale of our variable life insurance and annuity business (see Significant Transaction on pages 54 and 55 of this Form 10-K for further information). In accordance with Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-lived Assets (“Statement No. 144”), we have reflected the results of our AFLIAC variable life insurance and annuity business as a discontinued operation. As such, we have restated prior year balances related to this business as discontinued operations. We recognized income of $42.7 million from the discontinued variable life insurance and annuity business in 2005, compared to $37.2 million in 2004 and $30.6 million in 2003. Also, in 2005, we recorded a loss of $444.4 million related to the aforementioned sale of our variable life insurance and annuity business (see Life Companies - Discontinued Operations on page 41 of this Form 10-K for a further discussion of this business.)
During 2004, we adopted SOP 03-1, which resulted in a charge of $57.2 million, net of taxes. The charge results from new requirements for recognizing guaranteed minimum death benefit and guaranteed minimum income benefit reserves based on various assumptions, including estimates of future market returns and expected contract persistency.
The following is our discussion and analysis of the results of operations by business segment. The segment results are presented before taxes and other items which management believes are not indicative of our core operations, including realized gains and losses.
The following table summarizes the impact of catastrophes on results for the years ended December 31, 2005, 2004 and 2003:
Segment income from our Property and Casualty group increased $80.5 million, or 68.5%, to $198.0 million for the year ended December 31, 2004, compared to $117.5 million in 2003. In 2004, catastrophe losses were $99.3 million, compared to $59.4 million in 2003. Catastrophe losses in 2004 included four significant hurricanes in the Southeast. During 2003, however, we recorded a charge of $21.9 million resulting from an adverse arbitration decision related to a single large property claim within a voluntary insurance pool. We exited this pool in 1996. Excluding this charge and the impact of the increase in catastrophe losses, segment income would have increased $98.5 million in 2004, as compared to the same period in 2003. Segment income was positively affected by an estimated $112 million of improved current accident year loss performance due to net premium rate increases across all principal product lines and a decrease in non-catastrophe claims activity primarily in personal lines. Net premium rate increases reflect rate actions, discretionary pricing adjustments, inflation and changes in exposure, net of the estimated impact of loss inflation and policy acquisition costs. Additionally, development on prior years’ loss and loss adjustment expense reserves improved $33.0 million, from $18.5 million of adverse development for the year ended December 31, 2003, excluding the pool charge described above, to $14.5 million of favorable development for the year ended December 31, 2004. These favorable items were partially offset by an increase in policy acquisition and other operating expenses of $38.1 million due to higher contingent commissions, employee-related expenses and technology costs.
We report underwriting results using GAAP. We manage investment assets for our property and casualty business based on the requirements of the entire Property and Casualty group.
Personal Lines’ net premiums written decreased $124.3 million, or 8.4%, to $1.4 billion for the year ended December 31, 2005. The decrease in net premiums written is partially due to reinsurance reinstatement premiums of $17.7 million, resulting from Hurricane Katrina. Excluding the impact of the reinsurance reinstatement premiums, Personal Lines’ net premiums written would have decreased $106.6 million, or 7.2%, for the year ended December 31, 2005. This was primarily the result of a decrease of $93.1 million, or 9.0%, in the personal automobile line, in addition to a decrease of $12.2 million, or 3.0% in the homeowners line. The decreases in the personal automobile and homeowners lines resulted primarily from 6.0% and 5.3% decreases in policies in force since December 31, 2004, respectively. Approximately three-fourths of the decline in policies in force in both lines was the result of our strategies to enhance margins by reducing policies in certain less profitable portions of our business. We have reduced exposures in Massachusetts, where the regulatory structure is challenging and where we conduct a significant amount of business. We continue to exit certain unprofitable agency relationships. We are also exiting certain employer and affinity group accounts that were unprofitable and not well aligned with our current strategy. However, policies in force also declined in other markets, most significantly in Michigan, where policies in force decreased 2.9% since December 31, 2004. We attribute this decline partly to the introduction of an insurance score-based product toward the end of 2003 that enhanced our ability to segment
risks, certain service issues which management has addressed, and rate increases on specific classes of business.
Personal Lines’ segment income increased $8.6 million to $143.2 million for the year ended December 31, 2005, compared to $134.6 million for the same period in 2004, despite significant catastrophe losses due primarily to Hurricane Katrina, and to a lesser extent, Hurricane Rita. As a result, Personal Lines’ segment income was negatively impacted by $110.7 million of catastrophe related activity, which includes $17.7 million of reinsurance reinstatement premiums resulting from Hurricane Katrina, for the year ended December 31, 2005. Catastrophe losses for the year ended December 31, 2004 were $49.8 million. In 2004, we experienced catastrophe losses due to several hurricanes in the Southeast. Excluding the impact of all catastrophe related activity, our Personal Lines’ segment income would have increased by $69.5 million in 2005 primarily due to favorable non-catastrophe loss experience and lower expenses. Segment income was positively affected by an increase of $32.0 million of favorable development on prior years’ loss and LAE reserves, to $42.4 million in 2005, from $10.4 million in 2004. Also, segment income increased due to an estimated $17 million of improved current accident year underwriting results primarily attributable to a decrease in frequency of non-catastrophe claims in both the personal automobile and homeowners lines. In addition, underwriting expenses decreased approximately $21 million, primarily from lower contingent commissions, reflecting a change in the agency commission program, from lower employee related costs and from a one-time decrease in expenses due to a premium tax credit associated with our participation in an involuntary pool.
Personal Lines’ segment income increased $100.3 million to $134.6 million for the year ended December 31, 2004. The increase in segment income is primarily attributable to an estimated $98 million of improved current accident year loss performance. The improved loss performance is attributable to the favorable effect of net premium rate increases. Also, a decrease in non-catastrophe claims activity due to lower frequency in both the personal automobile and homeowners lines favorably impacted segment income. In addition, development on prior years’ loss and LAE reserves improved $35.7 million, to $10.4 million of favorable development for the year ended December 31, 2004, compared to $25.3 million of adverse development in 2003. These favorable items were partially offset by an increase in policy acquisition and other operating expenses of $26.7 million for the year ended December 31, 2004 as compared to 2003, due to higher contingent commissions, employee-related expenses and technology costs. Additionally, catastrophe losses increased $14.2 million, to $49.8 million for the year ended December 31, 2004, compared to $35.6 million in 2003, due to four hurricanes in the Southeast.
Commercial Lines’ net premiums written increased $52.6 million, or 7.6%, to $748.7 million for the year ended December 31, 2004, primarily due to an overall increase of 6.7% in premiums on renewed policies in commercial lines business since December 31, 2003.
Commercial Lines’ segment income decreased $40.7 million to $58.0 million for the year ended December 31, 2004. The decrease in segment income is primarily attributable to an increase in catastrophe losses of $25.7 million, to $49.5 million for the year ended December 31, 2004, compared to $23.8 million for the same period in 2003. Catastrophe losses in 2004 included four significant hurricanes in the Southeast. Also contributing to the decline in segment income is the increase of $19.4 million in policy acquisition and other operating expenses for the year ended December 31, 2004 compared to 2003. Policy acquisition and other operating expenses increased due to higher contingent commissions, employee-related expenses and technology costs. Loss adjustment expenses increased approximately $15 million primarily due to higher employee-related expenses, as a result of increased catastrophe activity, and higher litigation activity. Additionally, favorable development on prior years’ loss and LAE reserves decreased $2.9 million, to $4.1 million of favorable development for the year ended December 31, 2004, compared to $7.0 million of favorable development for the same period in 2003. Partially offsetting these unfavorable items was an estimated $14 million in improved current accident year loss performance.
We determine the amount of loss and loss adjustment expense reserves (the “loss reserves”) based on an estimation process that is very complex and uses information obtained from both company specific and industry data, as well as general economic information. The estimation process is judgmental, and requires us to continuously monitor and evaluate the life cycle of claims on type-of-business and nature-of-claim bases. Using data obtained from this monitoring and assumptions about emerging trends, our actuaries develop information about the size of ultimate claims based on historical experience and other available market information. The most significant assumptions used in the actuarial estimation process, which vary by line of business, include determining the expected consistency in the frequency and severity of claims incurred but not yet reported to prior years claims, the trend in loss costs, changes in the timing of the reporting of losses from the loss date to the notification date, and expected costs to settle unpaid claims. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. On a quarterly basis, our actuaries provide to management a point estimate for each significant line of our direct business to summarize their analysis.
In establishing the appropriate loss reserve balances for any period, management carefully considers these actuarial point estimates, which are the principal bases for establishing our reserve balances, along with a qualitative evaluation of business trends, environmental changes, and numerous other factors. In general, such additional factors may include, but are not limited to, improvement or deterioration of the actuarial indications in the period, the maturity of the accident year, trends observed over the recent past such as changes in the mix of business or the impact of regulatory or litigation developments, the level of volatility within a particular line of business, and the magnitude of the difference between the actuarial indication and the recorded reserves. Regarding our indirect business from voluntary and involuntary pools, we are provided loss estimates by managers of each pool. We adopt reserve estimates for the pools that consider this information and other facts. At December 31, 2005 and 2004, total recorded reserves were 5.4% and 5.7% greater than actuarially indicated reserves, respectively.
Inflation generally increases the cost of losses covered by insurance contracts. The effect of inflation varies by product. Our property and casualty insurance premiums are established before the amount of losses and LAE and the extent to which inflation may affect such expenses are known. Consequently, we attempt, in establishing rates and reserves, to anticipate the potential impact of inflation and increasing medical costs in the projection of ultimate costs. We have experienced increasing medical costs, including those associated with personal automobile personal injury protection claims, particularly in Michigan, as well as in our workers’ compensation line in most states. This increase is reflected in our reserve estimates, but continued increases could contribute to increased losses and LAE in the future.
We regularly review our reserving techniques, our overall reserving position and our reinsurance. Based on (i) our review of historical data, legislative enactments, judicial decisions, legal developments in impositions of damages and policy coverage, political attitudes and trends in general economic conditions, (ii) our review of per claim information, (iii) our historical loss experience and that of the industry, (iv) the relatively short-term nature of most policies written by us and (v) our internal estimates of required reserves, we believe that adequate provision has been made for loss reserves. However, establishment of appropriate reserves is an inherently uncertain process and there can be no certainty that current established reserves will prove adequate in light of subsequent actual experience. A significant change to the estimated reserves could have a material impact on our results of operations and financial position. An increase or decrease in reserve estimates would result in a corresponding decrease or increase in financial results. For example, each one percentage point change in the aggregate loss and LAE ratio resulting from a change in reserve estimation is currently projected to have an approximate $22 million impact on property and casualty segment income, based on 2005 full year premiums.
The process of estimating reserves involves considerable judgment by management and is inherently uncertain. Actuarial point estimates by line of business are the primary basis for determining ultimate expected losses and LAE and the level of net reserves required; however, other factors are considered as well. In general, such additional factors may include, but are not limited to, improvement or deterioration of the actuarial indications in the period, the maturity of the accident year, trends observed over the recent past such as changes in the mix of business or the impact of regulatory or litigation developments, the level of volatility within a particular line of business, and the magnitude of the difference between the actuarial indication and the recorded reserves. The table below shows our recorded net reserves and the actuarial reserve point estimates by line of business at December 31, 2005 and 2004.
See also “Analysis of Losses and Loss Adjustment Expense Reserve Development” in Item 1 - Business on pages 11 and 12 of this Form 10-K for the period ended December 31, 2005 for guidance related to the annual development of our loss and LAE reserves.
Although we do not specifically underwrite policies that include asbestos, environmental damage and toxic tort liability, we may be required to defend such claims. The table below summarizes our business asbestos and environmental reserves (net of reinsurance and excluding pools):
Ending loss and LAE reserves for all direct business written by our property and casualty companies related to asbestos, environmental damage and toxic tort liability, included in the reserve for losses and LAE, were $24.3 million, $24.7 million and $24.9 million, respectively, net of reinsurance of $16.2 million, $16.3 million and $15.0 million in 2005, 2004 and 2003, respectively. The outstanding reserves for direct business asbestos and environmental damage have remained relatively consistent for the last three-years. As a result of our historical direct underwriting mix of commercial lines policies toward smaller and middle market risks, past asbestos, environmental damage and toxic tort liability loss experience has remained minimal in relation to our total loss and LAE incurred experience.
Our Property and Casualty group maintains a reinsurance program designed to protect against large or unusual losses and allocated LAE activity. This includes excess of loss reinsurance, proportional (quota-share) and catastrophe reinsurance. We determine the appropriate amount of reinsurance based on our evaluation of the risks accepted and analyses prepared by consultants and/or reinsurers, and on market conditions including the availability and pricing of reinsurance. Reinsurance contracts do not relieve us from our primary obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to us. We believe that the terms of our reinsurance contracts are consistent with industry practice in that they contain standard terms with respect to lines of business covered, limit and retention, arbitration and occurrence. Based on an ongoing review of our reinsurers’ financial statements, reported financial strength ratings from rating agencies and the analysis and guidance of our reinsurance intermediaries, we believe that our reinsurers are financially sound.
negatively impacted. See also “Reinsurance” in Item 1 - Business on pages 13 to 16 of this Form 10-K for further information on our reinsurance programs.
In connection with these agreements, FAFLIC will provide transition services until the earlier of eighteen months from December 30, 2005 closing or when the operations of AFLIAC, and the FAFLIC business to be reinsured, can be transferred to Goldman Sachs. This transition period is currently expected to extend into the fourth quarter of 2006. See Loss on Sale of AFLIAC Variable Life Insurance and Annuity Business on pages 41 and 42 of this Form 10-K.
(2) Other operating expenses includes interest credited to the holders of such GICs of $19.6 million, $51.8 million and $53.5 million for the years ended December 31, 2005, 2004 and 2003, respectively.
Life Companies’ Continuing Operations segment loss was $18.7 million for the year ended December 31, 2005, compared to a loss of $22.3 million during the same period in 2004. This improvement was primarily the result of lower expenses due to the run-off of our continuing life business, partially offset by a $4.3 million provision in 2005 for an SEC investigation related to market timing (see Contingencies and Regulatory Matters on pages 59 and 60 of this Form 10-K).
Life Companies’ Discontinued Operations income was $42.7 million for the year ended December 31, 2005, compared to $37.2 million during the same period in 2004. This increase was primarily due to a benefit of $10.6 million resulting from a change in prior years tax reserves in 2005. Additionally, the combined effect of decreased GMDB reserve expenses under SOP 03-1 and derivative losses associated with the GMDB hedging program, both net of DAC, was favorable by $6.3 million in 2005 as compared to 2004. These changes were partially offset by the continued run-off of our variable life insurance and annuity business that resulted in lower fees, net of both related DAC amortization and operating expenses. Also, there was a decrease in net investment income due to lower average general account assets and lower pre-tax yields on fixed maturity securities.
(3) A hedging program was implemented on August 23, 2005 to reduce the volatility in the sales price calculation from effects of equity market movements through the date of the closing.
(4) Liability for certain contractual indemnities of AFLIAC provided under the Agreement to Goldman Sachs recorded under FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (“FIN 45”).
(5) Transaction costs include investment banker, legal, vendor contract licensing and other professional fees.
(6) Included in the proceeds from Goldman Sachs is the FAFLIC variable business coinsurance ceding commission of $8.6 million. This gain will be deferred and amortized over the remaining life of the policies in accordance with Statement of Financial Accounting Standards No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts.
As of September 30, 2005, we recorded an estimated loss on sale of $474.6 million based on our estimate at that date. Our current estimate was based on actual results through the closing date of the sale and resulted in an adjustment of $30.2 million to the loss on the sale. We anticipate incurring approximately $15 million, net of taxes, of additional costs related to employee severance and retention, net costs of transitional services and operations conversion expenses in this business in 2006. In addition, although we believe our liability for certain legal indemnities is appropriate, there can be no assurance that we won’t incur additional expenses in the future.
We use derivative instruments to hedge our GIC portfolio (see Derivative Instruments on pages 45 and 46 of this Form 10-K). For floating rate GIC liabilities that are matched with fixed rate securities, we manage the interest rate risk by hedging with interest rate swap contracts designed to pay fixed and receive floating interest. In addition, some funding agreements are denominated in foreign currencies. To mitigate the effect of changes in currency exchange rates, we hedge this risk by entering into foreign exchange swap and futures contracts, as well as compound foreign currency/interest rate swap contracts to hedge our net foreign currency exposure. In 2005 and 2004, the majority of these derivative instruments qualified for “effective” hedge accounting in accordance with Statement of Financial Accounting Standards No. 133, Accounting for Derivatives and Hedging Activities (“Statement No. 133”). These hedges resulted in a $10.8 million reduction in net investment income during 2005, as compared to a $21.3 million reduction in net investment income during 2004. These reductions were offset by similar reductions in GIC interest credited during these periods. The decreased effect of derivative instruments in 2005 was due to a decrease in average outstanding GIC deposits and associated hedges. Any ineffectiveness related to these derivative instruments is recognized in other operating expenses in our Consolidated Statements of Income. Although we do not expect our hedges to become ineffective, in accordance with Statement No. 133, there can be no assurance that we will not experience losses from ineffective hedges in the future.
(1) Includes $1.6 billion of investment assets of our AFLIAC discontinued variable life insurance and annuity business at December 31, 2004.
Our fixed maturity portfolio is comprised primarily of investment grade corporate securities, tax-exempt issues of state and local governments, U.S. government and agency securities and other issues. Based on ratings by the National Association of Insurance Commissioners (“NAIC”), investment grade securities comprised 93.5% at December 31, 2005 and 94.2% at December 31, 2004 of our total fixed maturity portfolio.
In our determination of other-than-temporary impairments, we consider several factors and circumstances, including the issuer’s overall financial condition; the issuer’s credit and financial strength ratings; the issuer’s financial performance, including earnings trends, dividend payments, and asset quality; a weakening of the general market conditions in the industry or geographic region in which the issuer operates; the length of time in which the fair value of an issuer’s securities remains below our cost; and with respect to fixed maturity investments, any factors that might raise doubt about the issuer’s ability to pay all amounts due according to the contractual terms. We apply these factors to all securities. Other-than-temporary impairments are recorded as a realized loss, which serves to reduce net income and earnings per share. Temporary declines in market value are recorded as unrealized losses, which do not affect net income and earnings per share but reduce other comprehensive income. We cannot provide assurance that the other-than-temporary impairments will, in fact, be adequate to cover future losses or that we will not have substantial additional impairments in the future.
We had $74.5 million of gross unrealized losses on fixed maturities and equity securities at December 31, 2005, as compared to $28.2 million at December 31, 2004. The increase in gross unrealized losses of investment grade fixed maturity investments is primarily due to the impact of higher market interest rates, rather than a decline in the credit quality of these investments. Approximately $12.1 million of the gross unrealized losses at December 31, 2005 relate to investment grade fixed maturity obligations of the U.S. Treasury, U.S. government and agency securities, states and political subdivisions, compared to $5.5 million at December 31, 2004. At both December 31, 2005 and 2004, substantially all below investment grade securities with an unrealized loss had been rated by the NAIC, Standard & Poor’s or Moody’s.
On August 23, 2005, we implemented a new derivative program designed to economically hedge against fluctuations in the purchase price of the variable life insurance and annuity business. The purchase price was determined at the time of closing and was subject to changes in interest rate, equity market, implied equity market volatility and surrender activity. The derivatives were terminated concurrent with the sale closing on December 30, 2005. The derivatives in this program included exchange traded futures contracts, interest rate swap contracts, and strike price call options. During the year ended December 31, 2005, we recognized $27.9 million in losses, reflected in the Consolidated Statements of Income as loss on disposal of variable life insurance and annuity business. (See Life Companies - Loss on Sale of AFLIAC Variable Life Insurance and Annuity Business on pages 41 and 42 of this Form 10-K). The hedges did not qualify for hedge accounting under Statement No. 133.
We use derivative financial instruments, primarily interest rate swaps, with indices that correlate to balance sheet instruments to modify our indicated net interest sensitivity to levels that we deem appropriate. Specifically, for floating rate GIC liabilities that are matched with fixed rate securities, we manage the interest rate risk by hedging with interest rate swap contracts designed to pay fixed and receive floating interest.
The following tables for the years ended December 31, 2005 and 2004 provide information about our financial instruments used for purposes other than trading that are sensitive to changes in interest rates. The tables present principal cash flows and related weighted-average interest rates by expected maturities, unless otherwise noted below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties, or we may have the right to put or sell the obligations back to the issuers. Mortgage-backed and asset-backed securities are included in the category representing their expected maturity. Available-for-sale securities include both U.S. and foreign-denominated fixed maturities, but exclude interest rate swap contracts and foreign currency swap contracts, which are disclosed in separate tables. Foreign-denominated fixed maturities are also shown separately in the table of financial instruments subject to foreign currency risk. For liabilities that have no contractual maturity, the tables present principal cash flows and related weighted-average interest rates based on our historical experience, management’s judgment, and statistical analysis, as applicable, concerning their most likely withdrawal behaviors. Additionally, we have assumed our available-for-sale securities are similar enough to aggregate those securities for presentation purposes. Specifically, variable rate available-for-sale securities and mortgage loans comprise an immaterial portion of the portfolio and do not have a significant impact on weighted-average interest rates. Therefore, the variable rate investments are not presented separately; instead they are included in the tables at their current interest rate.
The following table for the year ended December 31, 2004 provides information about our derivative financial instruments used for purposes other than trading that are sensitive to changes in the equity market. The table presents notional amounts, number of contracts, and weighted-average contract price by index and expected maturity.
The discussion and analysis of our financial condition and results of operations are based upon the consolidated financial statements. These statements have been prepared in accordance with GAAP, which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. The following critical accounting estimates are those which we believe affect the more significant judgments and estimates used in the preparation of our financial statements. Additional information about our other significant accounting policies and estimates may be found in Note 1 - Summary of Significant Accounting Policies of the Notes to Consolidated Financial Statements included on pages 74 to 82 of this Form 10-K.
be no certainty that current established reserves will prove adequate in light of subsequent actual experience. A significant change to the estimated reserves could have a material impact on our results of operations and financial position. An increase or decrease in reserve estimates would result in a corresponding decrease or increase in financial results. For example, each one percentage point change in the loss and LAE ratio resulting from a change in reserve estimation is currently projected to have an approximate $22 million impact on property and casualty segment income, based on 2005 full year premiums.
assumption we use is the average size of the individual losses for those claims that have occurred but have not yet been recorded by us. The reinsurance recoverable is based on what we believe are reasonable estimates and is disclosed separately on the financial statements. However, the ultimate amount of the reinsurance recoverable is not known until all losses are settled.
We account for our pension plans in accordance with Statement of Financial Accounting Standards No. 87, Employers’ Accounting for Pensions (“Statement No. 87”). In order to measure the liabilities and expense associated with these plans, we must make various estimates and key assumptions, including discount rates used to value liabilities, assumed rates of return on plan assets, employee turnover rates and anticipated mortality rates. These estimates and assumptions are reviewed at least annually and are based on our historical experience, as well as current facts and circumstances. In addition, we use outside actuaries to assist in measuring the expenses and liabilities associated with this plan.
The discount rate enables us to state expected future cash flows as a present value on the measurement date. A lower discount rate increases the present value of benefit obligations and increases pension expense. We determine our discount rate utilizing the Citigroup Pension Discount Curve as of December 31, 2005. As of December 31, 2005, based upon our plan assets in relation to this discount curve, we decreased our discount rate to 5.50%, from 5.63% at December 31, 2004.
As a result of an increase in the actual return on assets in 2005, as well as demographic participant changes, partially offset by the lower 2005 year-end discount rate, we expect our pre-tax pension expense to decrease from $21.2 million in 2005 to approximately $13 million in 2006.
Discount Rate - A 25 basis point increase or reduction in discount rate would decrease or increase, respectively our pension expense in 2006 by approximately $2.5 million. This 25 basis point increase or reduction in the discount rate would also decrease or increase, respectively, our projected benefit obligation by approximately $16 million.
Expected Return on Plan Assets - A 25 basis point increase or decrease in the expected return on plan assets would decrease or increase our pension expense in 2006 by approximately $1.0 million.
On December 30, 2005, we sold all of the outstanding shares of capital stock of AFLIAC, a life insurance subsidiary representing approximately 95% of our run-off variable life insurance and annuity business, to Goldman Sachs. The transaction also includes the reinsurance of 100% of the variable business of FAFLIC. In connection with these transactions, AIT agreed to transfer certain assets and liabilities of its funds to certain Goldman Sachs Variable Insurance Trust managed funds through a fund reorganization transaction. Finally, we agreed to sell to Goldman Sachs all of the outstanding shares of capital stock of AFIMS, our investment advisory subsidiary, concurrently with the consummation of the fund reorganization transaction. The fund reorganization transaction was consummated on January 9, 2006. In connection with the sale, the Massachusetts Division of Insurance approved both a cash dividend of $48.6 million from FAFLIC, including the $8.6 million ceding commission received related to the 100% reinsurance of FAFLIC’s variable business, and the distribution of other non-insurance subsidiaries, from which the holding company received approximately $15.4 million of additional funds.
In connection with there transactions, we have made various representations, warranties and covenants to Goldman Sachs. We have agreed to indemnify Goldman Sachs for breaches of such representations, warranties and covenants. We have also agreed to indemnify Goldman Sachs for certain litigation, regulatory matters and other liabilities relating to the pre-closing activities of the business being transferred.
(1) Hanover’s Total Adjusted Capital includes $733.0 million related to its subsidiary, Citizens.
Liquidity is a measure of our ability to generate sufficient cash flows to meet the cash requirements of business operations. As a holding company, our primary ongoing source of cash is dividends from our insurance subsidiaries. However, dividend payments to us by our insurance subsidiaries are subject to limitations imposed by state regulators, such as the requirement that cash dividends be paid out of unreserved and unrestricted earned surplus. As a result of this limitation, no dividends may be paid from FAFLIC without the consent of the Massachusetts Commissioner of Insurance. Also, the payment of “extraordinary” dividends, as defined, from any of our insurance subsidiaries is restricted. In addition, we entered into an agreement with the Massachusetts Commissioner of Insurance, upon the sale of our variable life insurance and annuity business, whereby we agree to maintain FAFLIC’s RBC ratio at a minimum of 100% of the Company Action Level (on the Industry Scale).
Net cash provided by operating activities was $153.1 million and $142.4 million in 2005 and 2004, respectively, while net cash used by operating activities was $174.3 million in 2003. The $10.7 million increase in cash provided by operating activities in 2005 was primarily due to lower net loss and LAE payments in our property and casualty business, as well as to lower net payments from the general account as a result of fewer annuity contract surrenders, and our receipt in 2004 of a non-recurring federal income tax settlement of $30.4 million. These were partially offset by lower written premiums, increased payments in 2005 for contingent commissions related to 2004 business, and an increase in federal income tax payments. The $316.7 million increase in cash provided by operating activities in 2004 was primarily due to lower net loss and LAE payments in the property and casualty business. In addition, cash flows from operations improved in 2004 due to lower net payments from the general account as a result of fewer annuity contract redemptions in the Life Companies. The usage of cash for operations during 2003 primarily reflects net payments from the general account as a result of increased annuity contract withdrawals in our Life Companies segment as a result of ratings downgrades and our cessation of new sales. In addition, approximately $100 million of cash was transferred, related to the settlement of payables resulting from the sale of our universal life insurance business. We also contributed $25 million to our qualified pension plan in 2003.
Net cash provided by investing activities was $811.5 million in 2005, $41.3 million in 2004 and $354.3 million in 2003. The $770.2 million increase in cash provided by investing activities in 2005 was primarily due to net sales of fixed maturity securities, primarily resulting from the
maturity of certain long-term funding agreements in our Life Companies segment, as well as lower underwriting results in our property and casualty group. In addition, we received net proceeds from the sale of our variable life insurance and annuity business in 2005. The $313.0 million decrease in cash provided by investing activities in 2004, as compared to 2003, was primarily from net purchases of fixed maturities and other investment assets, resulting from improved underwriting results in the Property and Casualty group. Additionally, increased funding agreement withdrawals also contributed to the decline in cash provided by investing activities partially offset by lower general account annuity redemptions in the Life Companies segment. Cash provided by investing activities in 2003 also included $64.9 million of proceeds from the disposal of our company owned life insurance policy.
Net cash used in financing activities was $749.6 million and $475.3 million in 2005 and 2004, respectively, while net cash provided by financing activities was $160.2 million in 2003. Cash used in both 2005 and 2004 was primarily due to the maturity of certain long-term funding agreements in our Life Companies segment, including trust instruments supported by funding obligations and the reduction of cash held as collateral related to our securities lending program. The cash provided by financing activities in 2003 primarily reflects a net increase in collateral held related to our securities lending program, partially offset by withdrawals of trust instruments supported by funding obligations.
During 2005, we sold AFLIAC, which held $11.0 billion of assets and $10.7 billion of liabilities at December 30, 2005. Assets transferred as a part of the sale included investment assets of $1.3 billion and $123.2 million of cash. Additionally, during 2003, we transferred approximately $450 million of investment assets and $100 million of cash to settle payables related to the sale of our universal life insurance business.
At December 31, 2005, THG, as a holding company, had $333.7 million of cash and fixed maturities. As a result of the sale of our variable life insurance and annuity business, the holding company received $235.8 million of net proceeds on December 30, 2005 upon the closing of the transaction. In the first quarter of 2006, the holding Company expects additional net cash related to the sale, as well as dividends proposed in connection therewith as described above, totalling $77.1 million. An additional $46.7 million of proceeds from Goldman Sachs has been deferred and will be received over the next three years. Excluding the deferred proceeds from Goldman Sachs, the total cash proceeds at the holding company of $312.9 million was comprised of the following:
On December 28, 2005, our Board of Directors authorized a share repurchase program of up to $200 million. As of February 28, 2006, we have repurchased 1.4 million shares at an aggregate cost of $62.3 million.
We expect to continue to generate sufficient positive operating cash to meet all short-term and long-term cash requirements, including the funding of our qualified defined benefit pension plan. The combination of the current interest rate environment reflecting lower yielding fixed maturities and volatile stock market returns have caused many U.S. pension plans, including ours, to become underfunded. As a result, without pension funding relief currently being considered by Congress, we expect to make significant cash contributions to our qualified defined benefit pension plan in future years. Based upon current law, we are required to contribute $52.1 million in 2006. As the single employer of THG, the funding of these plans is the responsibility of FAFLIC. This contribution will not affect the statutory surplus of FAFLIC.
we had no commercial paper borrowings as of December 31, 2005 and we do not anticipate utilizing commercial paper in 2006. Debt ratings downgrades resulted in our non-renewal of our credit line in 2003 and continue to preclude or adversely affect the cost and availability of credit lines, commercial paper, other additional debt and equity financing.
(3) Individual contract deposit funds are reflected in the category representing their contractual maturity.
(5) Qualified pension plan funding obligations represent the amounts necessary to be contributed to the plan to satisfy minimum funding obligations in accordance with the Employee Retirement Income Security Act of 1974. Beginning in 2006, substantial contributions will be required based on the current level of pension assets and liabilities. These estimates are based on several assumptions, including but not limited to, the rate of return on plan assets, the discount rate for benefit obligations, mortality experience, and interest crediting rates. Differences between actual plan experience and our assumptions will result in changes to our future minimum funding obligations.
(6) Non-qualified pension plan benefit obligations reflect estimated payments to be made through plan year 2015 for pension, postretirement and postemployment benefits. Estimates of these payments and the payment patterns are based upon historical experience.
(11) As of December 31, 2005, FAFLIC Variable business reserves of $124.6 million, universal life insurance reserves of $1.0 million, individual health insurance reserves of $18.7 million, and certain group life and health insurance reserves of $176.0 million have been excluded because substantially all of these obligations are reinsured with other insurance companies. The related contractual obligations and cash flows are borne by the reinsurers.
On July 24, 2002, an action captioned American National Bank and Trust Company of Chicago, as Trustee f/b/o Emerald Investments Limited Partnership, and Emerald Investments Limited Partnership v. Allmerica Financial Life Insurance and Annuity Company, was commenced in the United States District Court for the Northern District of Illinois, Eastern Division. In 1999, plaintiffs purchased two variable annuity contracts with initial premiums aggregating $5 million. Plaintiffs, who AFLIAC subsequently identified as engaging in frequent transfers of significant sums between sub-accounts that in our opinion constituted “market timing”, were subject to restrictions upon such trading that AFLIAC imposed in December 2001. Plaintiffs allege that such restrictions constituted a breach of the terms of the annuity contracts. In December 2003, the court granted partial summary judgment to the plaintiffs, holding that at least certain restrictions imposed on their trading activities violated the terms of the annuity contracts. We filed a motion for reconsideration and clarification of the court’s partial summary judgment opinion, which was denied on April 8, 2004.
We continue to vigorously defend this matter, and regard plaintiffs claims for lost trading profits as being speculative and, in any case, subject to an obligation to mitigate damages. Further, in our view, these purported lost profits would not have been earned because of various actions taken by us, the investment management industry and regulators, to deter or eliminate market timing, including the implementation of “fair value” pricing.
The monetary damages sought by plaintiffs, if awarded, could have a material adverse effect on our financial position. Although AFLIAC was sold to Goldman Sachs on December 30, 2005, we have indemnified AFLIAC and Goldman Sachs with respect to this litigation. However, in our judgment, the outcome is not expected to be material to our financial position, although it could have a material effect on the results of operations for a particular quarter or annual period. The trial date for the damage phase of the litigation has not been set.
The potential outcome of other litigation or regulatory actions, or other legal proceedings in which we have been named a defendant, and our ultimate liability, if any, from such action or legal proceedings, is difficult to predict at this time. In our opinion, based on the advice of legal counsel, the ultimate resolutions of such proceedings will not have a material effect on our financial position, although they could have a material effect on the results of operations for a particular quarter or annual period.
The proposal also includes a provision which would prohibit insurance companies from using an individual’s credit history or credit score to determine insurance rates. The Commissioner of Insurance in Michigan had previously promulgated rules purporting to ban the use of any form of credit scores in the underwriting or pricing of personal lines products, but these rules were invalidated by the Circuit Court of Barry County, a ruling the Commissioner has appealed. If the Circuit Court’s decision is overturned and the proposed ban becomes effective, it would likely have a disruptive impact on the overall market as some consumers experience a decrease in premium. The proposed ban could have an adverse effect on our retention rates and new business volume, as well as possibly lowering of overall premiums as actions are taken to offset the anticipated lower retention rates and new business volumes.
In addition, the Louisiana FAIR Plan has experienced substantial losses related to Hurricane Katrina. Under the state’s Plan, we are allowed to recover our share of such losses from policyholders, subject to annual limitations. Although we have recognized an expense currently for our estimated losses from the Louisiana FAIR Plan, given the uncertainty in the marketplace in Louisiana, there can be no assurance that our estimate of this liability will be sufficient to cover our share of the FAIR Plan losses or whether we will be able to recover such costs from policyholders. Also, the availability of private homeowners insurance in the state is declining as carriers seek to exit or significantly reduce their exposure in the state. This may increase the number of insureds seeking coverage from the FAIR Plan and could result in increased losses to us through the FAIR Plan.
Finally, the Governor of Massachusetts has proposed legislation intended to reform the Massachusetts automobile insurance system. Among other items, this proposed legislation would give the Massachusetts Commissioner of Insurance the authority to create an assigned risk plan and allow for the gradual phase-in of competitively set personal automobile rates. The Governor’s reform proposal is currently being considered by the Legislature. We cannot determine how this legislation, if passed, may affect our results of operations or financial position.
The following important factors, among others, in some cases have affected and in the future could affect our actual results, and cause actual results to differ materially from historical or projected results. While any of these factors could affect our business as a whole, we have grouped certain factors by the business segment to which we believe they are most likely to apply.
We generate most of our total revenues and earnings through our property and casualty insurance subsidiaries. The results of companies in the property and casualty insurance industry historically have been subject to significant fluctuations and uncertainties. Our profitability could be affected significantly by (i) adverse catastrophe experience, severe weather or other unanticipated significant losses; (ii) adverse loss development or loss adjustment expense for events we have insured in either the current or in prior years, including risks indirectly insured through discontinued pools which are included in the Other Property and Casualty segment (our retained Life Companies business also includes discontinued pools which present similar risks); (iii) an inability to retain profitable policies in force and attract profitable policies in our Personal Lines and Commercial Lines segments; (iv) increases in costs, particularly those occurring after the time our products are priced and including construction, automobile, and medical and rehabilitation costs; (v) restrictions on insurance underwriting; (vi) industry-wide change resulting from current investigations and inquiries relating to compensation arrangements with insurance brokers and agents; and (vii) disruptions caused by the introduction of new personal lines products, such as our new multi-variate auto product, and related technology changes and new personal and commercial lines operating models.
Specifically, underwriting results and segment income could be adversely affected by changes in our net loss and LAE estimates related to hurricanes Katrina and Rita. The risks and uncertainties in our business that may affect such estimates and future performance, including the difficulties in arriving at such estimates, should be considered. Estimating losses following any major catastrophe is an inherently uncertain process, which is made more difficult by the unprecedented nature of this event. Factors that add to the complexity in this event include the legal and regulatory uncertainty, difficulty in accessing portions of the affected areas, the complexity of factors contributing to the losses, delays in claim reporting, the exacerbating circumstances of Hurricane Rita and a slower pace of recovery resulting from the extent of
damage sustained in the affected areas. As a result, there can be no assurance that our ultimate costs associated with this event will not be substantially different from these estimates. In addition, there can be no assurance that, in light of the devastation in the areas affected by Hurricane Katrina, our ability to obtain and retain policyholders will not be adversely affected.
In particular, we have provided forward looking information relating to the sale of our variable life insurance and annuity business and its effect on our results of operations and financial position. There are certain factors that could cause actual results to differ materially from those anticipated herein. These include (i) the ability to timely achieve overhead and other expense savings; (ii) the ability of THG and FAFLIC to perform the transitional services in connection with the transactions without incurring unexpected expenses and the completion of the transitional services within the projected time so that we can realize projected cost savings; (iii) the impact of contingent liabilities, including litigation and regulatory matters, assumed by THG in connection with the transaction and the impact of other indemnification obligations owed from THG to Goldman Sachs; (iv) the ability to outsource the administration of the retained FAFLIC businesses at projected rates; and (v) future statutory operating results of FAFLIC, which will affect its projected statutory adjusted capital and ability to obtain future regulatory approval for dividends.
market value of interest rate sensitive investments; (iv) failure to obtain new customers, retain existing customers or reductions in policies in force by existing customers; (v) higher service, administrative or general expense due to the need for additional advertising, marketing, administrative or management information systems expenditures; (vi) the inability to attract, or the loss or retirement of key executives or other key employees, particularly in the Life Companies segment through completion of the anticipated transition to Goldman Sachs; (vii) changes in our liquidity due to changes in asset and liability matching, including the effect of defaults of debt securities; (viii) adverse changes in the ratings obtained from independent rating agencies, such as Moody’s, Standard and Poor’s and A.M. Best (for example, written premiums in our Commercial Lines segment were adversely affected during the time that A.M. Best had Hanover Insurance and Citizens on “credit watch” shortly after hurricanes Katrina and Rita and before we provided our preliminary estimate of projected losses); (ix) failure of a reinsurer of our policies to pay its liabilities under reinsurance or coinsurance contracts or adverse effects on the cost and availability of reinsurance; (x) changes in the mix of assets comprising our investment portfolios and changes in general market conditions that may cause the market value of our investment portfolio to fluctuate; (xi) losses resulting from our participation in certain reinsurance pools, including pools in which we no longer participate but may have unquantified potential liabilities relating to asbestos and other matters, or from fronting arrangements where the reinsurer does not meet all of its reinsurance obligations; (xii) defaults or impairments of debt securities held by us; (xiii) higher employee benefit costs due to changes in market values of plan assets, interest rates and employee compensation levels; (xiv) the effects of our restructuring actions, including any resulting from our review of operational matters related to our business, including a review of our markets, products, organization, financial capabilities, agency management, regulatory environment, ancillary businesses and service processes; (xv) errors or omissions in connection with the administration of any of our products; and (xvi) interruptions in our ability to conduct business as a result of terrorist actions, catastrophes or other significant events affecting infrastructure, and delays in recovery of our operating capabilities.
Risk based capital (“RBC”) - A method of measuring the minimum amount of capital appropriate for an insurance company to support its overall business operations in consideration of its size and risk profile. The RBC ratio for regulatory purposes is calculated as total adjusted capital divided by required risk based capital. Total adjusted capital for property and casualty companies is capital and surplus. Total adjusted capital for life insurance companies is defined as capital and surplus, plus asset valuation reserve, plus 50% of dividends apportioned for payment. The Company Action Level is the first level at which regulatory involvement is specified based upon the level of capital. Regulators may take action for reasons other than triggering various RBC action levels. The various action levels are summarized as follows:
Statutory accounting principles - Recording transactions and preparing financial statements in accordance with the rules and procedures prescribed or permitted by insurance regulatory authorities including the National Association of Insurance Commissioners (“NAIC”), which in general reflect a liquidating, rather than going concern, concept of accounting.
Underwriting expenses - Expenses incurred in connection with the acquisition, pricing, and administration of a policy.
Underwriting expense ratio, GAAP - This ratio reflects underwriting expenses to earned premiums.
We have completed integrated audits of The Hanover Insurance Group, Inc.’s (formerly known as Allmerica Financial Corporation) 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005, and an audit of its 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions on the Hanover Insurance Group, Inc.’s 2005, 2004 and 2003 consolidated financial statements and on its internal control over financial reporting as of December 31, 2005, based on our audits, are presented below.
in Internal Control-Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
The consolidated financial statements of The Hanover Insurance Group, Inc. (“THG” or the “Company”), formerly known as Allmerica Financial Corporation, include the accounts of The Hanover Insurance Company (“Hanover Insurance”), Citizens Insurance Company of America (“Citizens”), First Allmerica Financial Life Insurance Company (“FAFLIC”), and certain other insurance and non-insurance subsidiaries. These legal entities conduct their operations through several business segments as discussed in Note 16. All significant intercompany accounts and transactions have been eliminated. The Company’s results of operations also include the accounts of Allmerica Financial Life Insurance and Annuity Company (“AFLIAC”) through December 30, 2005. As further described in Note 2 - Sale of Variable Life Insurance and Annuity Business, on December 30, 2005, the Company sold, as part of a stock purchase agreement, its run-off variable life insurance and annuity business. Results of operations of AFLIAC’s variable life insurance and annuity business are reported as a discontinued operation. Prior period results have been restated to reflect this business as a discontinued operation.
If the actual income from the Closed Block in any given period equals or exceeds the expected income for such period as determined at the inception of the Closed Block, the expected income would be recognized in income for that period. Further, cumulative actual Closed Block income in excess of the expected income would not inure to the shareholders and would be recorded as an additional liability for policyholder dividend obligations. This accrual for future dividends effectively limits the actual Closed Block income currently recognized in the Company’s results to the income expected to emerge from operation of the Closed Block as determined at inception.
If, over the period the policies and contracts in the Closed Block remain in force, the actual income from the Closed Block is less than the expected income, only such actual income (which could reflect a loss) would be recognized in income. If the actual income from the Closed Block in any given period is less than the expected income for that period and changes in dividend scales are inadequate to offset the negative performance in relation to the expected performance, the income inuring to shareholders of the Company will be reduced. If a policyholder dividend liability had been previously established in the Closed Block because the actual income to the relevant date had exceeded the expected income to such date, such liability would be reduced by this reduction in income (but not below zero) in any period in which the actual income for that period is less than the expected income for such period.
In accordance with the provisions of Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (“Statement No. 115”), the Company is required to classify its investments into one of three categories: held-to-maturity, available-for-sale or trading. The Company determines the appropriate classification of debt securities at the time of purchase and re-evaluates such designation as of each balance sheet date.
Mortgage loans on real estate are stated at unpaid principal balances, net of unamortized discounts and reserves. Reserves on mortgage loans are based on losses expected by the Company to be realized on transfers of mortgage loans to real estate (upon foreclosure), on the disposition or settlement of mortgage loans and on mortgage loans which the Company believes may not be collectible in full. In establishing reserves, the Company considers, among other things, the estimated fair value of the underlying collateral.
Fixed maturities and mortgage loans that are delinquent are placed on non-accrual status, and thereafter interest income is recognized only when cash payments are received.
The Company may hold financial instruments that contain “embedded” derivative instruments. The Company assesses whether the economic characteristics of the embedded derivative are clearly and closely related to the economic characteristics of the remaining component of the financial instrument, or host contract, and whether a separate instrument with the same terms as the embedded instrument would meet the definition of a derivative instrument. When it is determined that (1) the embedded derivativepossesses economic characteristics that are not clearly and closely related to the economic characteristics of the host contract, and (2) a separate instrument with the same terms would qualify as a
derivative instrument, the embedded derivative is separated from the host contract, carried at fair value, and designated as a fair value, cash flow or foreign currency hedge, or as a trading derivative instrument.
The Company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as fair value, cash flow, or foreign currency hedges to specific assets and liabilities on the balance sheet or to specific forecasted transactions. The Company also formally assesses, both at the hedge’s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. When it is determined that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, the Company discontinues hedge accounting prospectively, as discussed below.
Contractholder deposit funds and other policy liabilities include investment-related products such as guaranteed investment contracts (“GIC”), deposit administration funds and immediate participation guarantee funds and consist of deposits received from customers and investment earnings on their fund balances.
All policy liabilities and accruals are based on the various estimates discussed above. Although the adequacy of these amounts cannot be assured, the Company believes that it is more likely than not that policy liabilities and accruals will be sufficient to meet future obligations of policies in force. The amount of liabilities and accruals, however, could be revised in the near-term if the estimates discussed above are revised.
The securities embody an unconditional obligation that requires the Company to redeem the securities on a stated maturity date. In addition, these securities contain a settlement alternative that occurs as a result of a “special event.” A special event could occur if a change in laws and/or regulations or the application or interpretation of these laws and/or regulations causes the interest from these debentures to become taxable income (or non-deductible expense), or for the subsidiary trust to become deemed an “investment company” and subject to the filing requirements of Registered Investment Companies.
Deferred income taxes are generally recognized when assets and liabilities have different values for financial statement and tax reporting purposes, and for other temporary taxable and deductible differences as defined by Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (“Statement No. 109”). These differences result primarily from loss and LAE reserves, policy reserves, tax credit carryforwards, net operating and capital loss carryforwards, employee benefit plans and policy acquisition expenses. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that all or some portion of the deferred tax assets will not be realized.
In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3 (“Statement No. 154”). Statement No. 154 replaces Accounting Principles Board Opinion No. 20, Accounting Changes (“APB Opinion No. 20”), and
Statement of Financial Accounting Standards No. 3, Reporting Accounting Changes in Interim Financial Statements. This statement establishes, unless impracticable, retrospective application as the required method for all voluntary changes in accounting principle in the absence of specific transition provisions for the newly adopted accounting principle. Statement No. 154 requires companies to retrospectively apply the effect of the change to all prior periods practicable, and the financial statements for all periods presented shall be adjusted to reflect the change. Similarly, an error in the financial statements of a prior period that is discovered subsequent to their issuance shall be reported as a prior-period adjustment, and the financial statements for each period presented shall be adjusted to reflect the correction. This statement also provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and the necessary disclosures once that determination has been made. Additionally, changes in methods of depreciation, amortization or depletion of long-lived, non-financial assets must be accounted for as a change in accounting estimate.
The statement also requires certain disclosures in the period in which a change in accounting principle or correction of an error is made. Statement No. 154 is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. Adoption of this statement is not expected to have a material effect on the Company’s financial position or results of operations.
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (“Statement No. 123(R)”). This statement requires companies to measure and recognize the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value. Statement No. 123(R) replaces Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“Statement No. 123”), and supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB Opinion No. 25”). The provisions of this statement were originally effective for interim and annual periods beginning after June 15, 2005. In April 2005, the Securities and Exchange Commission adopted a rule amending the compliance dates of Statement No. 123(R). The rule allows companies to implement the standard at the beginning of their next fiscal year, rather than their next reporting period, that begins after June 15, 2005. Accordingly, the Company has adopted Statement No. 123(R) effective January 1, 2006. In accordance with APB Opinion No. 25, the Company has not previously recognized compensation expense for employee stock options in net income because the exercise price equaled the market value of the underlying common stock on the grant date. Upon adoption of Statement No. 123(R), the Company was required to expense employee stock options. The Company adopted Statement No. 123(R) using the modified prospective transition method. Under this method, the Company will recognize compensation costs for all share-based awards granted, modified or settled after January 1, 2006, as well as any awards that were granted prior to January 1, 2006 for which the requisite service period had not been provided as of the implementation date, i.e., unvested awards. Unvested awards are to be expensed consistent with the valuation used in previous disclosures of the pro-forma effect of Statement No. 123. In addition to stock options, the Company’s share-based compensation plans also include time-based restricted shares and performance based restricted share units, for which compensation cost has been recorded over the requisite service period. Therefore, upon adoption of Statement No. 123(R), the Company will experience an increase in expense related to stock options, however, the cumulative change in accounting principle adjustment is not expected to be material. Assuming the actual number of stock compensation awards granted in 2006 is consistent with the Company’s expectations, the estimated increase in pre-tax stock compensation expense related to the adoption of Statement No. 123(R) will range from $11 million to $14 million for the year ended December 31, 2006.
Earnings per share (“EPS”) for the years ended December 31, 2005, 2004 and 2003 is based on a weighted average of the number of shares outstanding during each year. Basic and diluted EPS is computed by dividing income available to common stockholders by the weighted average number of shares outstanding for the period. The weighted average shares outstanding which were utilized in the calculation of basic earnings per share differ from the weighted average shares outstanding used in the calculation of diluted earnings per share due to the effect of dilutive employee stock options and nonvested stock grants. If the effect of such stock options and grants are antidilutive, the weighted average shares outstanding utilized in the calculation of diluted earnings per share equal those utilized in the calculation of basic earnings per share.
The Company applies the provisions of APB Opinion No. 25 in accounting for its stock-based compensation plans, and thus compensation cost is not generally required to be recognized in the financial statements for the Company’s stock options issued to employees. However, costs associated with the issuance of stock options to certain agents who did not qualify as employees were recognized in 2004 and 2003. Effective January 1, 2006, the Company adopted Statement No. 123(R) as discussed in Note 1P - New Accounting Pronouncements. This statement requires, among other items, that the cost of stock options issued to employees be recognized in the financial statements.
On December 30, 2005, the Company sold all of the outstanding shares of capital stock of AFLIAC, a life insurance subsidiary representing approximately 95% of the Company’s run-off variable life insurance and annuity business to The Goldman Sachs Group, Inc. (“Goldman Sachs”). The transaction also includes the reinsurance of 100% of the variable business of FAFLIC. In connection with these transactions, Allmerica Investment Trust (“AIT”) agreed to transfer certain assets and liabilities of its funds to certain Goldman Sachs Variable Insurance Trust managed funds through a fund reorganization transaction. Finally, the Company agreed to sell to Goldman Sachs all of the outstanding shares of capital stock of Allmerica Financial Investment Management Service, Inc. (“AFIMS”), its investment advisory subsidiary, concurrently with the consummation of a fund reorganization transaction. The fund reorganization transaction was consummated on January 9, 2006.
In connection with the sale, the Massachusetts Division of Insurance approved a cash dividend of $48.6 million from FAFLIC, including the $8.6 million ceding commission received related to the reinsurance of 100% of the variable business of FAFLIC, and for the distribution of other non-insurance subsidiaries, from which the holding company received $15.4 million of additional funds.
In connection with these agreements, the Company will provide transition services until the earlier of eighteen months from the December 30, 2005 closing or when the operations of AFLIAC, and the FAFLIC business to be reinsured, can be transferred to Goldman Sachs. These services include policy and claims processing, accounting and reporting, and other administrative services. This transition period is currently expected to extend into the fourth quarter of 2006. During this period, the Company expects to earn revenues estimated at approximately $18 million related to the continuation of activities with the disposed of business by providing these administrative services, while incurring costs estimated at approximately $25 million to $30 million. These revenues and costs represent approximately 5% and 2%, respectively, of the revenues and costs generated by the disposed of business and therefore do not reflect significant continuing involvement with the business that is being disposed. Upon conclusion of this transition services agreement, there will be no continuing cash flows associated with the business that is being disposed.
(1) Total proceeds from Goldman Sachs are based on the purchase price calculated as of the December 30, 2005 closing, subject to any adjustments following the purchaser’s review of the final purchase price calculation. Proceeds from Goldman Sachs include deferred payments of $46.7 million to be received over three years.
(4) Liability for certain contractual indemnities of AFLIAC, provided under the Agreement to Goldman Sachs recorded under FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.
As of December 31, 2005, there was a net receivable from Goldman Sachs of approximately $75 million associated with the variable life insurance and annuity business, including $46.7 million that is being deferred over three years and $26.2 million related to the AFIMS business which was received in January 2006.
Statement of Financial Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities. These charges included $14.9 million related to one-time termination benefits associated with the termination of 552 employees, and $12.6 million related to contract termination fees and other costs. As of December 31, 2005, the Company had made payments of approximately $25.7 million related to this restructuring plan, of which $14.5 million related to one-time termination benefits and $11.2 million related to contract termination fees and other costs. The liability balance at December 31, 2005 was $1.8 million. The Company currently anticipates that approximately $1 million to $2 million of other costs will be recognized in 2006 related to this restructuring. The plan is substantially complete.
The Company retired $185.2 million and $78.8 million of long-term funding agreement obligations at discounts in 2004 and 2003, respectively. This resulted in a pre-tax loss of $0.2 million in 2004 and a pre-tax gain of $5.7 million in 2003, which are reported as other operating expenses in the Consolidated Statements of Income. Certain amounts related to the termination of derivative instruments used to hedge the retired funding agreements were reported in separate line items in the Consolidated Statements of Income. The net market value loss on the early termination of derivative instruments used to hedge the retired funding agreements of $7.9 million and $6.4 million were recorded as net realized investment gains in the Consolidated Statements of Income in 2004 and 2003, respectively. There were no foreign currency transaction gains on the retired foreign denominated funding agreements in 2005 and 2004. In 2003, net foreign currency transaction gains related to the retired foreign-denominated funding agreements of $3.6 million were recorded as other income in the Consolidated Statements of Income.
The Company issued variable annuity contracts with a GMDB feature. The GMDB feature provides annuity contractholders with a guarantee that the benefit received at death will be no less than a prescribed minimum amount. This amount is based on either the net deposits paid into the contract, the net deposits accumulated at a specified rate, the highest historical account value on a contract anniversary, or more typically, the greatest of these values. If the GMDB is higher than the current account value at the time of death, the Company incurs a cost equal to the difference.
There were no deferred sales inducements as of December 31, 2005 and the balance at December 31, 2004 was $72.9 million. Amortization of deferred sales inducements subsequent to the adoption of SOP 03-1 was $11.6 million and $16.8 million in 2005 and 2004, respectively. In connection with the aforementioned sale of the Company’s variable life insurance and annuity business, the $61.3 million balance of the deferred sales inducements was also expensed in 2005.
Prior to the adoption of SOP 03-1, the Company had recorded certain market value adjustments (“MVA”) to the fixed annuity products as separate account assets and separate account liabilities in the Consolidated Balance Sheets. Changes in the fair value of MVA assets were reflected in other comprehensive income in the Consolidated Balance Sheets. In addition, the Company reflected policy fees, interest spreads, realized gains and losses on investments, and changes in the liability for minimum guarantees in net income. Notwithstanding the market value adjustment feature of this product, all of the investment performance of the separate account assets related to this product does not accrue to the contractholder, and it therefore does not meet the conditions for separate account reporting under SOP 03-1.
Upon adoption of SOP 03-1, assets related to the MVA product, primarily fixed maturities, which were carried at fair value, were reclassified to the general account as available-for-sale securities. Reserves related to contract account values included in separate account liabilities were also reclassified to the Company’s general account. Changes in the fair value of these assets have continued to be reflected in other comprehensive income in the Consolidated Balance Sheets. Additionally, amounts assessed against the contractholders for mortality, administrative and other services have continued to be included in universal life and investment product policy fees, and changes in liabilities for minimum guarantees have continued to be included in policy benefits, claims, losses, and loss adjustment expenses in the Consolidated Statements of Income. Components of the interest spreads related to this product have continued to be recorded in net investment income and policy benefits, claims losses and loss adjustment expenses in the Consolidated Statements of Income. Realized investment gains and losses were recognized as incurred, consistent with prior years.
The Company had the following variable annuities with guaranteed minimum returns:
(1) The value as of December 31, 2004 included $83.6 million relating to the AFLIAC variable life insurance and annuity business that was sold December 30, 2005. The remaining balances in 2005 and 2004 relate to FAFLIC’s variable life insurance and annuity business. This business was 100% reinsured by AFLIAC on December 30, 2005, in conjunction with the sale of AFLIAC to Goldman Sachs.
(1) Account balances as of December 31, 2004 included $97.2 million of fixed maturities and $4.0 million of cash and cash equivalents relating to the AFLIAC variable life insurance and annuity business that was sold December 30, 2005. The remaining balances in 2005 and 2004 relate to FAFLIC’s variable life insurance and annuity business. This business was 100% reinsured by AFLIAC on December 30, 2005, in conjunction with the sale of AFLIAC to Goldman Sachs.
(2) Total fixed maturities include amortized cost of $1.4 billion, gross unrealized gains of $61.4 million, gross unrealized losses of $4.6 million and fair value of $1.4 billion for the AFLIAC discontinued variable life insurance and annuity business at December 31, 2004.
(3) Equity securities include amortized cost of $1.7 million, gross unrealized gains of $1.4 million and fair value of $3.1 million for the AFLIAC discontinued variable life insurance and annuity business at December 31, 2004.
Fixed maturities with an amortized cost of $80.7 million and $128.2 million were on deposit with various state and governmental authorities at December 31, 2005 and 2004, respectively. Fair values related to these securities were $81.7 million and $134.3 million at December 31, 2005 and 2004, respectively. At December 31, 2004, fixed maturities with an amortized cost of $47.5 million and a fair value of $50.7 million, were on deposit with various state and government authorities for AFLIAC. Included in those amounts at December 31, 2004, were fixed maturities with an amortized cost of $42.4 million and a fair value of $45.1 million, which were on deposit in New York under an agreement with the State of New York’s Department of Insurance related to AFLIAC’s voluntary withdrawal of its license in New York in 1994. These deposits were maintained by AFLIAC after the Company sold its variable life insurance and annuity business to Goldman Sachs on December 30, 2005.
The amortized cost and fair value by maturity periods for fixed maturities are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties, or the Company may have the right to put or sell the obligations back to the issuers. Mortgage-backed securities are included in the category representing their stated maturity.
The Company’s mortgage loans are diversified by property type and location. Mortgage loans are collateralized by the related properties and generally do not exceed 75% of the property’s value at the time of origination. No mortgage loans were originated during 2005 and 2004. The carrying values of mortgage loans, net of applicable reserves, were $99.6 million and $114.8 million at December 31, 2005 and 2004, respectively. Mortgage loans investment valuation allowances of $1.0 million and $1.5 million at December 31, 2005 and 2004, respectively, have been deducted in arriving at investment carrying values as presented in the Consolidated Balance Sheets.
At December 31, 2005 and 2004, no real estate was held in the Company’s investment portfolio.
At December 31, 2005, scheduled mortgage loan maturities were as follows: 2006 - $23.0 million; 2007 - $3.3 million; 2008 - $2.8 million; 2009 - $10.3 million; 2010 - $38.9 million and $21.3 million thereafter. Actual maturities could differ from contractual maturities because borrowers may have the right to prepay obligations with or without prepayment penalties and loans may be refinanced. During 2005, the Company did not refinance any mortgage loans based on terms that differed from current market rates.
There were no impaired loans or related reserves as of December 31, 2005 and 2004. There was no interest income received in 2005 and 2004 related to impaired loans.
each portfolio segment consistent with the return objectives, risk tolerance, liquidity, time horizon, tax and regulatory requirements of the related product or business segment. Management has a general policy of diversifying investments both within and across all portfolios. The Company monitors the credit quality of its investments and the exposure to individual markets, borrowers, industries and sectors.
By using derivative instruments, the Company is exposed to credit risk. If the counterparty fails to perform, credit risk is equal to the extent of the fair value gain (including any accrued receivable) in a derivative. The Company regularly assesses the financial strength of the counterparties and generally enters into derivative instruments with counterparties rated “A” or better by nationally recognized rating agencies. Depending on the nature of the derivative transaction, the Company maintains bilateral Collateral Standardized Arrangements (“CSA”) with each counterparty. In general, the CSA sets a minimum threshold of exposure that must be collateralized, although thresholds may vary by CSA. The Company’s counterparties held collateral, in the form of cash, bonds and U.S. Treasury notes, of $129.7 million and $94.8 million at December 31, 2005 and 2004, respectively.
The Company recognized no gains or losses in 2005 and 2004 related to ineffective cash flow hedges. However, the Company recognized a net loss of $9.0 million in 2003, representing the ineffectiveness of all cash flow hedges, related to ineffective futures
and options contracts, which are reported in fees and other income in the Consolidated Statements of Income. All components of each derivative’s gain or loss are included in the assessment of hedge effectiveness, unless otherwise noted.
As of December 31, 2005, $0.9 million of the deferred net losses on derivative instruments accumulated in other comprehensive income could be recognized in earnings during the next twelve months depending on the forward interest rate and currency rate environment. Transactions and events that are expected to occur over
the next twelve months and will necessitate reclassifying to earnings these derivatives gains (losses) include: the interest payments (receipts) on foreign denominated trust instruments supported by funding obligations and foreign securities; the possible repurchase of other funding agreements; and the anticipated reinvestment of fixed maturities. The maximum term over which the Company is hedging its exposure to the variability of future cash flows, for all forecasted transactions, excluding interest payments on variable-rate funding agreements, is twelve months.
During the fourth quarter of 2003, the Company began using exchange traded equity futures contracts to economically hedge increased GMDB reserves which could arise from declines in the equity market. In response to entering into the aforementioned Stock Purchase Agreement to sell the variable life insurance and annuity business, the Company discontinued this program on August 22, 2005. The GMDB hedges did not qualify for hedge accounting under Statement No. 133. Additionally, in 2003, the Company entered into equity-linked swap contracts which are economic hedges but do not qualify for hedge accounting under Statement No. 133. These products are linked to specific equity-linked liabilities on the balance sheet. Under the equity-linked swap contracts, the Company agrees to exchange, at specific intervals, the difference between fixed and floating rate interest amounts calculated on an agreed upon notional amount. The final payment at maturity will include the appreciation, if any, of a basket of specific equity indices.
Unrealized gains and losses on available-for-sale, other securities and derivative instruments are summarized as follows:
(2) Equity securities and other at December 31, 2005, 2004 and 2003 include after-tax net appreciation (depreciation) on other assets of $0.6 million, $1.1 million and $(2.9) million, respectively.
(2) Substantially all below investment grade securities with an unrealized loss had been rated by the NAIC, Standard & Poor’s, or Moody’s at December 31, 2005 and 2004.
(3) Includes gross unrealized losses of $4.3 million and fair value of $191.8 million of investment grade fixed maturities and gross unrealized losses of $0.3 million and fair value of $1.5 million of below investment grade fixed maturities for the Company’s discontinued variable life insurance and annuity business related to AFLIAC at December 31, 2004. There were no equity securities in an unrealized loss position for the Company’s discontinued variable life insurance and annuity business at December 31, 2004.
The Company employs a systematic methodology to evaluate declines in fair values below amortized cost for all investments. The methodology utilizes a quantitative and qualitative process ensuring that available evidence concerning the declines in fair value below amortized cost is evaluated in a disciplined manner. In determining whether a decline in fair value below amortized cost is other-than-temporary, the Company evaluates the issuer’s overall financial condition; the issuer’s credit
The payment terms of mortgage loans may from time to time be restructured or modified. There were no restructured mortgage loans at December 31, 2005 and 2004.
(1) As of December 31, 2004 the carrying value and fair value included $1,045.8 million, and $1,015.1 million, respectively, relating to the AFLIAC variable life insurance and annuity business that was sold December 30, 2005. The remaining balances in 2005 and 2004 relate to FAFLIC’s variable life insurance and annuity business.
Long-term debt as of December 31, 2005 and 2004 consisted of the following:
The Company had no commercial paper borrowings as of December 31, 2005 and does not anticipate utilizing commercial paper in 2006.
The sale of the variable life insurance and annuity business resulted in a tax loss of $491.8 million. A valuation allowance of $472.3 million was recorded against the capital loss carryforwards, as it is the Company’s opinion that it is more likely than not that this asset will not be realized. The Company believes, based on objective evidence, the remaining deferred tax assets will be realized. At December 31, 2005, the Company had net capital loss carryforwards of $24.9 million which begin to expire in 2008. The Company also had net operating loss carryforwards of $29.5 million which begin to expire in 2020. In addition, at December 31, 2005, there were available alternative minimum tax credit carryforwards, low income housing credit carryforwards and foreign tax credit carryforwards of $124.0 million, $60.2 million and $0.7 million, respectively. The alternative minimum tax credit carryforwards have no expiration date, the low income housing credit carryforwards will expire beginning in 2018 and the foreign tax credit carryforward will expire beginning in 2013.
The Company utilizes a measurement date of December 31st to determine its pension benefit obligations. Weighted-average assumptions used to determine pension benefit obligations are as follows:
The Company utilizes a target allocation strategy, focusing on creating a mix of assets to generate growth in equity, as well as managing expenses and contributions. Various factors were taken into consideration in determining the appropriate asset mix, such as census data, actuarial valuation information and capital market assumptions. The Company has determined that the optimal investment strategy is to have a target mix of 72% of its plan assets in equity securities and 28% in fixed income securities and money market funds. The target allocations and actual invested asset allocations for 2005 and 2004 for the Company’s plan assets are as follows:
The curtailment gain in 2004 is due to the aforementioned decision to freeze the defined benefit pension plans and primarily reflects the elimination of unrecognized prior service cost. The curtailment loss in 2003 of $0.7 million is the result of the Life Companies VeraVest restructuring effort in the fourth quarter of 2003 (see Note 3 - Significant Transactions on pages 83 and 84 of this Form 10-K). The curtailment loss primarily reflects the elimination of future expected years of service for those home office participants terminated as a result of the VeraVest restructuring.
On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“The Act”) was enacted. The Act provides for a prescription drug benefit under Medicare as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to the benefit provided under Medicare. The Company adopted the provisions of the Act effective July 1, 2004. The Company determined that its benefits were at least actuarially equivalent to those provided by Medicare, and therefore recognized a reduction in its accumulated postretirement benefit obligation for the transition cost of $2.9 million in 2004.
Under the Plan, options may be granted to eligible employees or agents at a price not less than the market price of the Company’s common stock on the date of grant. Option shares may be exercised subject to the terms prescribed by the Committee at the time of grant. Options granted in 2005, 2004 and 2003 vest over three years with a 25% vesting rate in the first two years and a 50% vesting rate in the final year. Options granted prior to 2002 all vest at a rate of 20% annually for five consecutive years. Options must be exercised not later than ten years from the date of grant.
The following significant assumptions were used to determine the fair value for options granted:
The following table summarizes information about employee options outstanding and exercisable at December 31, 2005:
Stock grants may be awarded to eligible employees at a price established by the Committee (which may be zero). Under the Employees’ Plan, stock grants may vest based upon performance criteria or continued employment and be in the form of shares or units. Stock grants which vest based on performance vest over a minimum one year period. Stock grants which vest based on continued employment vest at the end of a minimum of three consecutive years.
The Company recognizes compensation expense related to nonvested shares and performance based share units over the vesting period on a pro rata basis. As a result, the Company recognized $3.7 million, $1.7 million and $2.3 million of compensation cost in 2005, 2004 and 2003, respectively. The expense in 2003 reflects net benefits of $1.8 million resulting from the termination of nonvested stock grants which were previously granted to agents and other employees whose positions were eliminated in that year.
New Hampshire, Michigan and Massachusetts have enacted laws governing the payment of dividends to stockholders by insurers. New Hampshire and Michigan laws affect the dividend paying ability of Hanover Insurance and Citizens, respectively, while Massachusetts laws affect the dividend paying ability of FAFLIC. Prior to December 30, 2005, Massachusetts laws also affected AFLIAC’s ability to pay dividends to its then parent, THG.
Pursuant to New Hampshire’s statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the New Hampshire Insurance Commissioner, is limited to 10% of such insurer’s statutory policyholder surplus as of the preceding December 31. Hanover Insurance declared no dividends to its parent in 2005, 2004 or 2003. During 2006, the maximum allowable dividend and other distributions that can be paid to Hanover Insurance’s parent without prior approval of the New Hampshire Insurance Commissioner is $120.5 million.
Pursuant to Michigan’s statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the Michigan Insurance Commissioner, is limited to the greater of 10% of policyholders’ surplus as of December 31 of the immediately preceding year or the statutory net income less realized gains, for the immediately preceding calendar year. Citizens declared no dividends to its parent in 2005 or 2004, and declared dividends to its parent totaling $48.4 million in 2003. During 2006, the maximum allowable dividend and other distributions that can be paid to Citizens’ parent without prior approval of the Michigan Insurance Commissioner is $119.7 million.
Massachusetts’ statute limits the dividends a life insurer may pay in any twelve month period, without the prior permission of the Massachusetts Commissioner of Insurance, to the greater of (i) 10% of its statutory policyholder surplus as of the preceding December 31 or (ii) the individual company’s statutory net gain from operations for the preceding calendar year. In addition, under Massachusetts law, no domestic insurer may pay a dividend or make any distribution to its shareholders from other than unassigned funds unless the Commissioner has approved such dividend or distribution. Effective December 30, 2005, in connection with the closing of the sale of the Company’s run-off variable life insurance and annuity business to Goldman Sachs, the Company entered into an agreement with the Massachusetts Division of Insurance to maintain total adjusted capital levels at a minimum of 100% of FAFLIC’s Company Action Level, which was $46.1 million at December 31, 2005. This agreement replaces the previous commitment from the Company to the Division of Insurance dated December 23, 2002, whereby the Company agreed to maintain total adjusted capital levels at a minimum of 100% of AFLIAC’s Company Action Level. Total adjusted capital for life insurance companies is defined as capital and surplus, plus asset valuation reserve, plus 50% of dividends apportioned for payment. The Company Action Level is the first level in which the Massachusetts Commissioner of Insurance could mandate regulatory involvement based solely upon levels of risk based capital. There can be no assurance that FAFLIC would not require additional capital contributions from THG. FAFLIC cannot pay dividends to its parent without prior approval from the Massachusetts Commissioner of Insurance. In December 2005, FAFLIC, with permission from the Massachusetts Commissioner of Insurance, declared a $48.6 million dividend to THG. In the fourth quarters of 2004 and 2003, with permission from the Massachusetts Commissioner of Insurance, AFLIAC declared dividends of $75.0 million and $25.0 million, respectively, to its then parent, THG.
The Company’s business includes financial products and services in two major areas: Property and Casualty and Life Companies. Within these broad areas, the Company conducts business principally in four operating segments. These segments are Personal Lines, Commercial Lines, Other Property and Casualty, and Life Companies. In accordance with Statement of Financial Accounting Standards No. 131, Disclosures About Segments of an Enterprise and Related Information (“Statement No. 131”), the separate financial information of each segment is presented consistent with the way results are regularly evaluated by the chief operating decision maker in deciding how to allocate resources and in assessing performance. A summary of the Company’s reportable segments is included below.
operating segments. Corporate debt consists of the Company’s junior subordinated debentures and its senior debentures.
(2) Includes assets related to the Company’s discontinued accident and health business. Additionally, the 2004 balance includes assets related to the Company’s variable life insurance and annuity business sold on December 30, 2005.
(3) The 2005 balance reflects $64.0 million from FAFLIC and other Life Companies’ non-insurance subsidiaries to the holding company, which was paid in the first quarter of 2006. The 2004 balance reflects the $75.0 million dividend from AFLIAC to the holding company, which was paid during the first quarter of 2005.
As permitted by APB Opinion No. 30, the Consolidated Balance Sheets have not been segregated between continuing and discontinued operations. At December 31, 2005 and 2004, this discontinued group accident and health business had assets of approximately $369.9 million and $365.9 million, respectively, consisting primarily of invested assets and reinsurance recoverables, and liabilities of approximately $441.9 million and $435.8 million, respectively, consisting primarily of policy liabilities.
Rental expenses for operating leases amounted to $15.5 million, $16.4 million and $27.3 million in 2005, 2004 and 2003, respectively. Sublease income was $1.2 million and $1.5 million in 2005 and 2004, respectively. The net rental expenses relate primarily to building leases of the Company.
On December 30, 2005, FAFLIC ceded $124.6 million of its variable life insurance and annuity business pursuant to a reinsurance agreement with AFLIAC (see Note 2 - Sale of Variable Life Insurance and Annuity Business on pages 82 and 83 of this Form 10-K). Additionally, the Company has a 100% coinsurance agreement related to substantially all of its universal life insurance business. Reinsurance recoverables related to this agreement were $1.0 million and $571.0 million at December 31, 2005 and 2004, respectively. This balance represented approximately 28.2% of the Company’s reinsurance recoverables at December 31, 2004. The decline in this recoverable is related to the sale of the variable life insurance and annuity business. Although AFLIAC was sold to Goldman Sachs on December 30, 2005, THG has indemnified AFLIAC and Goldman Sachs with respect to their reinsurance recoverables related to the business ceded under this 100% coinsurance agreement.
Effective January 1, 1999, the Company entered into a whole account aggregate excess of loss reinsurance agreement, which provides coverage for the 1999 accident year for the Company’s property and casualty business. The program covered losses and allocated LAE expenses, including those incurred but not yet reported, in excess of a specified whole account loss and allocated LAE ratio. The annual coverage limit for losses and allocated LAE is $150.0 million. The Company is subject to concentration of risk with respect to this reinsurance agreement. There were no net premiums earned under this agreement during 2005, while net premiums earned under this agreement during 2004 and 2003 for accident year 1999 were $3.2 million and $9.6 million, respectively. There were no net losses and LAE ceded during 2005, while net losses and LAE ceded during 2004 and 2003 were $3.9 million and $11.8 million, respectively. The effect of this agreement on the results of operations in future periods is not currently determinable, as it will be based on future losses and allocated LAE for accident year 1999.
In addition, the Company is subject to concentration of risk with respect to reinsurance ceded to various residual market mechanisms. As a condition to the ability to conduct certain business in various states, the Company is required to participate in various residual market mechanisms and pooling arrangements which provide various insurance coverages to individuals or other entities that are otherwise unable to purchase such coverage voluntarily provided by private insurers. These market mechanisms and pooling arrangements include, among others, the Massachusetts Commonwealth Automobile Reinsurers (“CAR”) and the Michigan Catastrophic Claims Association (“MCCA”). At December 31, 2005, both CAR and MCCA represented 10% or more of the Company’s reinsurance activity. As a servicing carrier in Massachusetts, the Company cedes a significant portion of its personal and commercial automobile premiums to CAR. Net premiums earned and losses and LAE ceded to CAR in 2005, 2004 and 2003 were $53.3 million and $37.1 million, $46.6 million and $38.1 million, and $46.2 million and $61.0 million, respectively. Additionally, the Company ceded to MCCA premiums earned and losses and LAE in 2005, 2004 and 2003 of $68.9 million and $61.3 million, $60.9 million and $12.4 million, and $46.8 million and $124.2 million, respectively.
As part of an ongoing process, the reserves have been re-estimated for all prior accident years and were decreased by $79.5 million and $14.5 million in 2005 and 2004, respectively, and increased by $40.4 million in 2003.
During the year ended December 31, 2005, estimated loss reserves for claims occurring in prior years developed favorably by $65.7 million, while during the years ended December 31, 2004 and 2003, loss reserves for prior years developed unfavorably by $1.3 million and $74.5 million, respectively. The favorable loss development during the year ended December 31, 2005 is primarily the result of a decrease in personal lines claim frequency and claim severity in the 2004 accident year. In addition, the commercial multiple peril line and other
The unfavorable loss reserve development during the year ended December 31, 2003 was primarily the result of a $21.9 million charge in the Other Property and Casualty segment resulting from an adverse arbitration decision in 2003, related to a voluntary insurance pool that the Company exited in 1996. Additionally, loss reserves for the workers’ compensation line were increased by $15.7 million in 2003, primarily as a result of increasing medical and long-term attendant care costs. Loss reserve development was also affected by an increase in personal automobile claim severity related to medical settlements in Michigan. Partially offsetting these items was favorable development in the commercial multiple peril line due to improved claim frequency in the 2002 accident year.
During the years ended December 31, 2005, 2004 and 2003, estimated LAE reserves for claims occurring in prior years developed favorably by $13.8 million, $15.8 million and $34.1 million, respectively. The favorable development in 2005 is primarily attributable to the aforementioned improvement in ultimate loss activity on prior accident years which results in the decrease of ultimate loss adjustment expenses. Development in all these periods was also favorably affected by claims process improvement initiatives taken by the Company during the 1997 to 2001 calendar-year period. Since 1997, the Company has lowered claim settlement costs through increased utilization of in-house attorneys and consolidation of claim offices. As actual experience begins to establish certain trends inherent within the claim settlement process, the actuarial process recognizes these trends, resulting in favorable development. Management believes that the impact of these actions has been previously recognized and expects less
favorable LAE prior year reserve development from these process improvements. This fact is reflected in the decline in favorable LAE prior year reserve development for the year ended December 31, 2005 versus 2004.
The Company may be required to defend claims related to policies that include environmental damage and toxic tort liability. The table below summarizes direct business asbestos and environmental reserves (net of reinsurance and excluding pools):
On May 19, 2004, plaintiffs filed a Brief Statement of Damages in which, without quantifying their damage claim, they outlined a claim for (i) amounts totaling $150,000 for surrender charges imposed on the partial surrender by plaintiffs of the annuity contracts, (ii) loss of trading profits they expected over the remaining term of each annuity contract, and (iii) lost trading profits resulting from AFLIAC’s alleged refusal to process five
The monetary damages sought by plaintiffs, if awarded, could have a material adverse effect on the Company’s financial position. Although AFLIAC was sold to Goldman Sachs on December 30, 2005, the Company indemnified AFLIAC and Goldman Sachs with respect to this litigation. However, in the Company’s judgment, the outcome is not expected to be material to the Company’s financial position, although it could have a material effect on the results of operations for a particular quarter or annual period. The trial date for the damage phase of the litigation has not been set.