Segment income excluding income taxes and interest was $75.1 million in 2012 compared to $71.8 million in 2011. The increase in our pre-tax segment income in 2012 was primarily due to a $103.9 million increase in Chaucer segment income, reflecting a full year of results from operations for Chaucer compared to only six months of results in 2011, and to lower loss activity in most Chaucer product classes. The increase from our Chaucer segment was partially offset by a $96.6 million decrease in Commercial Lines segment income, which was primarily due to unfavorable development on prior years’ loss and loss adjustment expense (“LAE”) reserves and from increased catastrophe losses in 2012, primarily as a result of Superstorm Sandy. For all segments combined, pre-tax catastrophe losses, although relatively flat year over year, were at elevated levels, with catastrophe losses of $369.9 million during 2012, compared to $361.6 million for 2011. Catastrophe losses in 2012 were primarily the result of $198.1 million of pre-tax losses related to Superstorm Sandy during the fourth quarter, and from several tornadoes during the first six months of the year. Our 2011 catastrophe losses resulted principally from winter storms, tornado, hail and windstorm activity in the first half of the year, and from Hurricane Irene and floods in Thailand and Denmark during the second half of the year. During 2012, $72.6 million of favorable development related to our Chaucer segment was partially offset by $56.8 million of unfavorable development related to our domestic operations. During 2011, $67.8 million of favorable development was related to our domestic operations and $35.5 million related to our Chaucer segment.
In our Chaucer business, we deploy specialist underwriters in over 30 major insurance and reinsurance classes, including energy, marine and aviation, U.K. motor, property, and casualty and other coverages. We obtain business through Lloyd’s, the leading international insurance and reinsurance market, which provides us with access to specialist business in over 200 countries and territories worldwide through its international licenses, brand reputation and strong security rating. Together, our underwriting strength, diverse portfolio and Lloyd’s membership underpin our ability to actively manage the scale, composition and profitable development of this business.
The focus of our capital and underwriting capabilities remains in those areas where we expect rates to be more favorable, in particular, for catastrophe-exposed marine and energy risks, with emphasis away from business where rates are currently under pressure, notably casualty and aviation.
Primary business operations include insurance products and services currently provided through four operating segments. These operating segments are Commercial Lines, Personal Lines, Chaucer and Other Property and Casualty. Commercial Lines includes commercial multiple peril, commercial automobile, workers’ compensation and other commercial coverages, such as specialty program business, inland marine, management and professional liability and surety. Personal Lines includes personal automobile, homeowners and other personal coverages. Chaucer includes marine and aviation, energy, property, U.K. motor, and casualty and other coverages (which includes interna-
tional liability, specialist coverages, and syndicate participations). The Other Property and Casualty segment consists of Opus Investment Management, Inc., which markets investment management services to institutions, pension funds and other organizations; earnings on holding company assets; and, a voluntary pools business which is in run-off. 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.
We report interest expense related to our debt separately from the earnings of our operating segments. This consists of interest on our senior debentures, junior debentures, subordinated notes, collateralized borrowings with the Federal Home Loan Bank of Boston (“FHLBB”), and letter of credit facility.
Consolidated net income includes the results of our four operating segments (segment income), which we evaluate on a pre-tax basis and we exclude interest expense on debt. Segment income excludes certain other items which we
Consolidated net income was $55.9 million in 2012, compared to $36.7 million in 2011. The $19.2 million increase is primarily due to income from our Chaucer segment and lower costs in 2012 related to the Chaucer acquisition. Additionally, we recognized a $10.8 million gain from the sale of our third party administrator, Citizens Management, Inc. (“CMI”), which was completed on April 30, 2012 (see also “Discontinued Operations”). These increases were partially offset by a decrease in segment results in our domestic operations.
The following table reflects segment income and a reconciliation of total segment income to consolidated net income.
The following is our discussion and analysis of the results of operations by business segment. The segment results are presented before interest expense, taxes and other items which management believes are not indicative of our core operations, including realized gains and losses.
Segment income was $75.1 million for the year ended December 31, 2012, compared to $71.8 million for the year ended December 31, 2011, an increase in earnings of $3.3 million. This increase is primarily due to a $103.9 million increase in Chaucer segment income, reflecting a full year of earnings for Chaucer compared to only six months in 2011 and lower loss activity in most Chaucer product classes, partially offset by a $96.6 million decrease in Commercial Lines earnings. The Commercial Lines earnings decrease was primarily due to unfavorable development on prior years’ loss and loss adjustment expense (“LAE”) reserves (“prior years’ loss reserves”) and increased catastrophe losses.
Net premiums written grew by $775.0 million for the year ended December 31, 2012, compared to the year ended December 31, 2011, and net premiums earned grew by $640.5 million, in each case primarily as a result of including a full year of Chaucer’s net premiums in 2012 compared to only six months in 2011. Chaucer accounted for $561.7 million of the net premiums written increase and $460.5 million of the net premiums earned increase. The balance of the growth is primarily attributable to Commercial Lines, resulting from rate increases, strong retention and targeted new business expansion.
Net premiums written grew by $545.4 million for the year ended December 31, 2011, compared to the year ended December 31, 2010, and net premiums earned grew
by $757.6 million. Chaucer accounted for $428.8 million of net premiums written and $506.3 million of net premiums earned for the year ended December 31, 2011. The balance of the growth in net premiums written is attributable to Commercial Lines. A significant portion of the increase in net premiums earned in Commercial Lines is a result of the growth in net premiums written in 2010 following the OneBeacon renewal rights transaction, as well as growth in our AIX program business and in various niche and segmented businesses.
The following table summarizes net premiums written and loss, LAE, expense and combined ratios for the Commercial Lines, Personal Lines and Chaucer segments. Results for Chaucer Holdings plc include activity since the July 1, 2011 acquisition date. Loss and LAE, catastrophe loss and combined ratios include prior year reserve development. These items are not meaningful for our Other Property and Casualty segment.
The following table summarizes GAAP underwriting results for the Commercial Lines, Personal Lines, Chaucer and Other Property and Casualty segments and reconciles it to segment income. December 2011 results for Chaucer reflect the period from July 1, 2011 to December 31, 2011.
Net premiums written in the personal automobile line of business for the year ended December 31, 2012 were $922.7 million comparable to $910.5 million for the year ended December 31, 2011. Growth in premiums resulting primarily from rate increases were partially offset by a decline in policies in force of 2.2%, primarily as a result of fewer policies in force in Michigan, Florida, New York, Connecticut and Oklahoma. Net premiums written in the homeowners line of business increased 0.6%, resulting primarily from rate increases, partially offset by a 3.7% decline in policies in force primarily attributable to fewer policies in force in Michigan, New York and New Jersey. These declines in both our personal automobile and homeowners lines are attributed to more selective portfolio management, including attrition resulting from rate increases we have implemented despite the competitive pricing environment.
Personal Lines current accident year underwriting profit, excluding catastrophes, was $94.0 million in the year ended December 31, 2012, compared to $58.1 million for the year ended December 31, 2011. This $35.9 million increase was primarily due to lower non-catastrophe weather-related losses in our homeowners line, partially offset by the aforementioned increase in liability and personal injury protection losses in the automobile line.
After a profitable year in our international insurance business, we expect moderating rate increases in 2013. Opportunities for rate increases will likely be limited to those marine and property markets most affected by Superstorm Sandy. Current pricing conditions for energy are flat, while aviation and liability markets continue to be affected by the challenging economic environment and over capacity. U.K. motor rates decreased modestly in 2012 and are expected to continue to decline in 2013, following significant increases in 2010 and 2011. There can be no assurance that we will be able to maintain or increase our rates in light of economic and regulatory conditions in our markets.
Commercial Lines net premiums written was $1,703.1 million for the year ended December 31, 2011, compared to $1,584.8 million for the year ended December 31, 2010. This $118.3 million increase was primarily driven by growth in our specialty businesses, particularly in our AIX program business, which accounted for $57.1 million of this growth. Also benefiting the overall growth comparison in net premiums written were modest rate increases.
Commercial Lines underwriting loss, excluding catastrophe and prior year loss and LAE reserve development, for the year ended December 31, 2011, was $9.3 million, compared to $25.3 million for the year ended December 31, 2010. This $16.0 million improvement resulted from growth in earned premium and the resulting positive effect on our expense ratio, and from what we
Personal Lines underwriting profit, excluding prior year loss and LAE reserve development and catastrophes, was $58.1 million for the year ended December 31, 2011, compared to $50.8 million for the year ended December 31, 2010, an increase of $7.3 million. This increase in non-catastrophe current accident year results was primarily due to lower operating expenses and what we believe is an improved mix of business, partially offset by non-catastrophe weather-related losses.
Chaucer’s net premiums written was $428.8 million for the six months ended December 31, 2011. By line of business, Chaucer’s net premiums written were comprised of 28.4% U.K. motor, 25.0% marine and aviation, 17.0% property, 15.6% energy and 14.0% casualty and other lines. This business mix reflects our specialist underwriting strategy and active management of our portfolio.
Chaucer’s underwriting profit for the six months ended December 31, 2011 was $11.9 million. Catastrophe losses for the six months ended December 31, 2011 were $49.5 million, principally due to floods in Thailand and Denmark. Favorable development on prior years’ loss and LAE reserves for the six months ended December 31, 2011 was $35.5 million.
Chaucer’s underwriting profit, excluding prior year loss and LAE development and catastrophes, was $25.9 million in the six months ended December 31, 2011. Underwriting expenses of $181.2 million represented 35.7% of earned premium.
Management’s process for establishing loss reserves is a comprehensive process that involves input from multiple functions throughout our organization, including finance, actuarial, claims, legal, underwriting, distribution and busi-
ness operations management. The process incorporates facts currently known and the current, and in some cases, the anticipated, state of the law and coverage litigation. Based on information currently available, we believe that the aggregate loss reserves at December 31, 2012 were adequate to cover claims for losses that had occurred as of that date, including both those known to us and those yet to be reported. However, as described below, there are significant uncertainties inherent in the loss reserving process. Our estimate of the ultimate liability for losses that had occurred as of December 31, 2012 is expected to change in future periods as we obtain further information, and such changes could have a material effect on our results of operations and financial condition.
The IBNR reserve includes a provision for claims that have occurred but have not yet been reported to us, some of which may not yet be known to the insured, as well as a provision for future development on reported claims. IBNR represents a significant proportion of our total net loss reserves, particularly for long-tail liability classes. In fact, approximately 43% of our aggregate net loss reserves at December 31, 2012 were for IBNR losses and loss expenses.
Given the inherent complexity of our loss reserve estimation process and the potential variability of the assumptions used, the actual emergence of losses will vary, perhaps substantially, from the estimate of losses included in our financial statements, particularly in those instances where settlements or other claim resolutions do not occur until well into the future. Our net loss reserves at December 31, 2012 were $4.1 billion. Therefore, a relatively small percentage change in the estimate of net loss reserves would have a material effect on our results of operations.
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 in the projection of ultimate costs. For example, we have experienced increasing medical and attendant care costs, including those associated with automobile personal injury protection claims, particularly in Michigan, as well as in our workers’ compensation line in most states. Also, the U.K. motor business written by Chaucer recently has experienced high levels of claims inflation and increases in potential fraud-type claims. These increases are reflected in our current reserve estimates, but continued increases could contribute to increased losses and LAE in the future.
Short-tail classes consist principally of automobile physical damage, homeowners property, commercial property and marine business. The Chaucer business, while having a longer-tail on average than our traditional U.S. business, contains a substantial book of U.K. motor property damage, worldwide property insurance and reinsurance business, including certain high excess property layers, marine property, aviation property and energy property business which has relatively short development patterns. For these property coverages, claims are generally reported and settled shortly after the loss occurs because the claims relate to tangible property and are more likely to be discovered shortly after the loss occurs, and property losses are often more easily valued. Consequently, the estimation of loss reserves for these classes is generally less complex. However, this is less true for our Chaucer reinsurance business and high excess property layers where there is often a longer period of time between the date a claim is incurred and the date the claim is reported compared with our direct insurance operations. Therefore, the risk of delayed recognition of loss reserve development is higher for our assumed reinsurance and high excess property layers than for our direct insurance lines.
Personal and Commercial Automobile Bodily Injury - reserves recorded for bodily injury on U.S. voluntary business were $469.8 million as of December 31, 2012. A key assumption for bodily injury is the inflation rate underlying the estimated reserve. A five point change (e.g. 4% changed to 9% or - 1%) in the imbedded inflation would have changed estimated IBNR by approximately $51 million, either positive or negative, respectively, at December 31, 2012.
Personal Automobile Personal Injury Protection Medical Payment - reserves recorded for personal injury protection medical payment on U.S. voluntary business were $174.4 million as of December 31, 2012. A key assumption for this coverage is the inflation rate underlying the estimated reserve. Given the long reporting pattern for this line of business, an additional key assumption is the amount of additional development required to reach full maturity, thereby reflecting ultimate costs, as represented by the tail factor. A five point change in the imbedded inflation and a one point change to the tail factor assumption (e.g. 1.02 changed to 1.01 or 1.03) would have changed estimated IBNR by approximately $27 million, either positive or negative, at December 31, 2012.
Workers’ Compensation - reserves recorded for workers’ compensation on U.S. voluntary business were $327.1 million as of December 31, 2012. A key assumption for workers’ compensation is the inflation rate underlying the estimated reserve. Given the long reporting pattern for this line of business, an additional key assumption is the amount of additional development required to reach full maturity, thereby reflecting ultimate costs, as represented by the tail factor. A five point change in the imbedded inflation and a one point change to the tail factor assumption would have changed estimated IBNR by approximately $39 million, either positive or negative, at December 31, 2012.
Monoline and Multi-Peril General Liability - reserves recorded for general liability on U.S. voluntary business were $344.2 million as of December 31, 2012. A key assumption for general liability is the implied adequacy of the underlying case reserves. A ten point change in case adequacy (e.g. 10% deficiency changed to 0% or 20% deficiency) would have changed estimated IBNR by approximately $23 million, either positive or negative, at December 31, 2012.
Specialty Programs - reserves recorded (including allocated LAE) for the AIX Companies were $239.1 million as of December 31, 2012. A key assumption for specialty programs is the expected loss and allocated LAE ratio (“ELR”) underlying the actuarial reserve analysis. A ten point change to the ELR on AIX would have changed estimated IBNR by approximately $11 million at December 31, 2012.
New classes of business - reserves recorded for new classes of Chaucer business (primarily within energy, engineering and international liability lines) were $246.6 million as of December 31, 2012. An increase in the ultimate loss by 5%, 10%, and 15% in the 2010 and prior, 2011, and 2012 years of account, respectively, on these classes would have increased estimated IBNR by approximately $57 million at December 31, 2012.
Other commercial lines are primarily comprised of our monoline general liability, umbrella, marine, professional liability, and healthcare lines. Included in the above table, in the Chaucer segment, are $272.4 million and $302.8 million of reserves related to Chaucer’s liabilities in Syndicate 4000, consisting of financial and professional liability lines written in 2008 and prior, as of December 31, 2012 and December 31, 2011, respectively. Also included in the above table, primarily in other commercial lines, are $60.5 million, $59.8 million and $63.9 million of asbestos and environmental reserves as of December 31, 2012, 2011 and 2010, respectively.
The primary drivers for reserve development during the year ended December 31, 2010 were as follows:
It is not possible to know whether the factors that affected loss reserves in the year ended December 31, 2012 will also occur in future periods. As discussed in detail in this Form 10-K, there are inherent uncertainties in estimating reserves for losses and loss adjustment expenses and we encourage you to read this Form 10-K for more information about our reserving process and the judgments, uncertainties and risks associated therewith.
In addition, we have established gross loss and LAE reserves for assumed reinsurance pool business with asbestos and environmental damage liability of $30.3 million, $31.1 million and $33.9 million at December 31, 2012, 2011 and 2010, respectively. These reserves relate to pools in which we have terminated our participation; however, we continue to be subject to claims related to years in which we were a participant. Results of operations from these pools are included in our Other Property and Casualty segment. A significant part of our pool reserves relates to our participation in the Excess and Casualty Reinsurance Association (“ECRA”) voluntary pool from 1950 to 1982. In 1982, the pool was dissolved and since that time, the business has been in run-off. Our percentage of the total pool liabilities varied from 1% to 6% during these years. Our participation in this pool has resulted in average paid losses of approximately $2 million annually over the past ten years.
We maintain a reinsurance program designed to protect against large or unusual losses and LAE activity. We utilize a variety of reinsurance agreements that are intended to control our exposure to large property and casualty losses, stabilize earnings and protect capital resources, including facultative reinsurance, excess of loss reinsurance and catastrophe reinsurance. We determine the appropriate amount of reinsurance based upon our evaluation of the risks insured, exposure analyses prepared by consultants, our capital allocation models 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 and conditions 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 advisors, we believe that our reinsurers are financially sound.
Net investment income before taxes was $276.6 million, $258.2 million and $247.2 million for the years ended December 31, 2012, 2011 and 2010, respectively. The increase in net investment income in 2012 compared to 2011 was primarily due to the acquisition of Chaucer on July 1, 2011 and its related assets and investment income. Also, the increase resulted from our investments in dividend-yielding equity securities, various higher yielding investment grade fixed maturities and the investment of cash balances into fixed maturities, partially offset by the impact of lower new money yields. The increase in net investment income in 2011 compared to 2010 was due to the acquisition of Chaucer and its related investment income, partially offset by the impact of lower new money yields on fixed maturities. Higher dividend income from equity securities and lower investment expenses also contributed to the increase in net investment income. Average pre-tax earned yields on fixed maturities were 4.26%, 4.84% and 5.46% for the years ended December 31, 2012, 2011 and 2010, respectively. We expect average investment yields to continue to decline as new money rates remain at near-historic lows.
We also invested cash generated from operations into fixed maturities. Equity securities increased primarily from additional purchases of exchange traded funds and mutual funds. Additionally, the value of fixed maturities and equi-ties increased as a result of market value appreciation.
Our fixed maturity portfolio is comprised of corporate securities, taxable and tax-exempt municipal securities, residential mortgage-backed securities, commercial mortgage-backed securities, foreign government securities, U.S. government securities and asset-backed securities. Equity securities primarily consist of common stocks, exchange traded funds, mutual funds and non-redeemable preferred stocks.
During 2012, our net unrealized gains on fixed maturities increased $146.7 million, or 53.2%, to a net unrealized gain of $422.7 million at December 31, 2012, compared to $276.0 million at December 31, 2011.
Our European fixed maturity credit exposure at December 31, 2012 was as follows:
Our sovereign debt totaled $111.9 million, or 1.4% of investment assets as of December 31, 2012, and was limited to the highly rated country of the U.K. We had no sovereign debt of lower rated countries such as Greece, Ireland, Italy, Portugal and Spain. In addition, our supranational and foreign agency exposure totaled $177.9 million, or 2.2% of investment assets, and primarily consisted of debt securities from the highly rated countries of Germany and the Netherlands. Exposure to European banks, excluding those that are based in the U.K., totaled $102.6 million, or 1.3% of invest
ment assets. Also, we held money market funds totaling $163.0 million, or 2.0% of investment assets, which were comprised of a well-diversified portfolio of short-term debt securities of predominately large financial institutions domiciled in highly rated countries. The remainder of our European non-sovereign debt exposure, excluding the U.K., was $358.8 million, which represented 4.5% of investment assets. Generally, these securities were high quality, large cap multi-national companies that were well diversified by sector, country and issuer. Included in our non-financial exposure were credits domiciled in Spain, Ireland, Italy and Portugal totaling $57.4 million, or 0.7% of investment assets. These consisted of large market capitalization issuers that provide essential products and/or services.
Overall economic growth remains weak throughout Europe. Volatility, while currently suppressed, could increase suddenly as officials in Europe attempt to engineer a lasting solution to the debt crisis or find a way to address the twin objectives of stimulating economic growth while balancing fiscal budgets. We believe that leaders remain committed to protecting the currency union and improving financial stability. Although the timing and degree of success toward achieving sustained improvement regarding the European crisis remains highly uncertain, we do not anticipate that future developments related to our European sovereign and non-sovereign debt exposure will have a material effect on our financial condition, results of operation or liquidity.
For the year ended December 31, 2012, we recognized in earnings $7.8 million of other-than-temporary impairments (“OTTI”), of which $6.6 million related to fixed maturities and $1.2 million related to equity securities. OTTI on debt securities consisted of $4.6 million of below investment grade corporate bonds in the utilities and industrial sectors that we intended to sell and $2.0 million related to estimated credit losses, consisting of $0.9 million on municipal bonds, $0.7 million on residential mortgage-backed securities and $0.4 million on corporate bonds. For the year ended December 31, 2011, we recognized in earnings $6.9 million of OTTI on fixed maturity and equity securities. OTTI on debt securities was $5.5 million, primarily on below investment grade corporate and municipal bonds that we intended to sell. Additionally, we recognized OTTI of $0.9 million related to estimated credit losses on residential mortgage-backed securities. We also recognized OTTI on a common stock of $1.4 million. For the year ended December 31, 2010, we recognized $13.9 million of OTTI on fixed maturities, certain low-income housing tax credit limited partnerships (“LIHTC”) and equity securities in earnings, of which $4.4 million related to LIHTC partnerships, $4.3 million was estimated credit losses on debt securities, $3.3 million related to debt securities classified as intend to sell and $1.9 million related to common stocks.
The following table sets forth gross unrealized losses for fixed maturities by maturity period and for equity securities at December 31, 2012 and 2011. 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 we may have the right to put or sell the obligations back to the issuers.
The carrying values of defaulted fixed maturity securities on non-accrual status at December 31, 2012 and 2011 were not material. The effects of non-accruals compared with amounts that would have been recognized in accordance with the original terms of the fixed maturities, were reductions in net investment income of $2.5 million and $2.3 million for the years ended December 31, 2012 and 2011, respectively. Any defaults in the fixed maturities portfolio in future periods may negatively affect investment income.
Our investment portfolio and shareholders’ equity can be significantly impacted by changes in market values of our securities. As the U.S. and global financial markets and economies have not fully stabilized, market volatility could increase and defaults on fixed income securities could occur. As a result, we could incur additional realized and unrealized losses in future periods, which could have a material adverse impact on our results of operations and/or financial position.
Monetary policies in the developed economies, particularly in the U.S. and Europe, are supportive of moderate economic growth, while fiscal policies are more divergent and subject to change. The removal or modification of these policies could have an adverse effect on issuers’ level of business activity or liquidity, increasing the probability of future defaults. While we may experience defaults on fixed income securities, particularly with respect to non-investment grade securities, it is difficult to foresee which issuers, industries or markets will be affected. As a result, the value of our fixed maturity portfolio could change rapidly in ways we cannot currently anticipate and we could incur additional realized and unrealized losses in future periods.
In 2012, we realized a loss of $5.1 million on futures contracts relating to the release of tax capital loss carryforwards. Additionally, we recognized a gain of $0.7 million on a foreign currency forward used to mitigate changes in fair value caused by foreign currency fluctuation in converting U.K. pound sterling (“GBP”) denominated securities into their U.S. dollar denominated equivalent.
In May 2011, we entered into a treasury lock forward agreement to hedge the interest rate risk associated with our planned issuance of senior debt, which was completed on June 17, 2011. This hedge matured in June 2011 and resulted in a loss of $1.9 million, which was recorded in accumulated other comprehensive income and will be recognized in earnings over the term of the senior notes.
We manage investment assets for our Commercial Lines, Personal Lines, and Other Property and Casualty segments based on the requirements of our U.S. combined property and casualty companies. We allocate the investment income, expenses and realized gains and losses to our Commercial Lines, Personal Lines and Other Property and Casualty segments based on actuarial information related to the underlying businesses. We manage investment assets separately for our Chaucer segment.
In 2012, we repurchased $65.4 million of our subordinated unsecured notes related to Chaucer at a par value. These notes had a carrying value of $60.3 million, resulting in a net loss of $5.1 million on the repurchases. In addition, we repurchased $7.0 million of capital securities related to AIX Holdings, Inc. (“AIX”) at par value. In 2011, we repurchased in several transactions, $69.5 million of our Series B 8.207% Subordinated Deferrable Interest Debentures (“Junior Debentures”) at a cost of $72.1 million, resulting in a net loss of $2.6 million on the repurchases. In addition, we repurchased $8.0 million of capital securities related to AIX at a cost of $7.7 million, resulting in a gain of $0.3 million. The net loss on all debt repurchases in 2011 was $2.3 million. In 2010, we repurchased $36.5 million of these Junior Debentures at a cost of $38.5 million, resulting in a loss of $2.0 million on the repurchase.
Acquisition costs were $2.6 million and $16.4 million for 2012 and 2011, respectively, and primarily consist of advisory, legal, and accounting costs associated with the acquisition of Chaucer on July 1, 2011. See Note 2 - “Acquisitions and Discontinued Operations” of the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
The following table illustrates the estimated impact on the fair value of our investment portfolio at December 31, 2012 of hypothetical changes in prevailing interest rates, defined as changes in interest rates on U.S. Treasury debt. It does not reflect changes in credit spreads, liquidity spreads and other factors that affect the value of securities. Since changes in prevailing interest rates are often accompanied by changes in these other factors, the reader should not assume that an actual change in interest rates would result in the values illustrated.
Our overall investment strategy is intended to balance investment income with credit and duration risk while maintaining sufficient liquidity and the opportunity for capital growth. The asset allocation process takes into consideration the types of business written, the level of surplus required to support our different businesses and the risk return profiles of the underlying asset classes. We look to balance the goals of capital preservation, net investment income stability, liquidity and total return.
The following tables for the years ended December 31, 2012 and 2011 provide information about financial instruments that are sensitive to changes in interest rates. The tables present principal cash flows and related weighted-average interest rates by expected maturities. 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. Additionally, we have assumed available-for-sale securities are similar enough to aggregate those securities for presentation purposes. Specifically, variable rate available-for-sale securities 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. Debt is presented at contractual maturities, except for the FHLBB community development advances (“CDAs”) which were repaid in January 2013.
Our Chaucer segment has exposure to foreign currency risk, most notably in its insurance contracts and its invested assets. Some of its insurance contracts provide that ultimate losses may be payable in foreign currencies depending on the country of original loss. Foreign currency exchange rate risk exists to the extent that there is an increase in the exchange rate of the foreign currency in which losses are ultimately owed. Thus, our Chaucer segment attempts to manage its foreign currency risk by seeking to match its liabilities under insurance and reinsurance policies that are payable in foreign currencies with cash and investments that are denominated in such currencies. We may also utilize foreign currency forward contracts as part of our investment strategy. The principal currency creating foreign exchange risk for us is the U.K. pound sterling, and to a lesser extent, the Euro and the Canadian dollar. A hypothetical 10% reduction in the value of foreign denominated investments would be expected to produce a loss in fair value of approximately $124 million and $128 million at December 31, 2012 and 2011, respectively.
Discontinued operations primarily consist of our Discontinued Accident and Health Business and our Discontinued Third Party Administration Business, CMI.
The Discontinued Accident and Health Business had no significant financial results that impacted 2012, 2011 or 2010.
We are subject to the tax laws and regulations of the U.S. and foreign countries in which we operate. We file a consolidated U.S. federal income tax return that includes the holding company and its U.S. subsidiaries. Generally, taxes are accrued at the U.S. statutory tax rate of 35% for income from the U.S. operations. Our primary non-U.S. jurisdiction is the U.K. In July 2012, the U.K. statutory rate decreased from 26% to 24% effective April 1, 2012 and from 24% to 23% effective April 1, 2013. We accrue taxes on certain non-U.S. income that is subject to U.S. tax as a result of being owned by a U.S. shareholder at the U.S. tax rate. Foreign tax credits, where available, are utilized to offset U.S. tax as permitted. Certain of our non-U.S. income is not subject to U.S. tax until repatriated. Foreign taxes on this non-U.S. income are accrued at the local foreign rate and do not have an accrual for U.S. deferred taxes since these earnings are intended to be permanently reinvested overseas.
Our income tax provision on segment income was a benefit of $1.9 million for 2012, compared to an expense of $2.6 million for 2011 and an expense of $59.3 million in 2010. These provisions resulted in effective tax rates for segment income of (14.4)%, 15.5% and 33.3% in 2012, 2011 and 2010, respectively. The tax benefit in 2012 is primarily due to income from foreign operations not subject to U.S. tax and lower segment income. The decrease in expense for 2011 is primarily due to lower segment income.
Included in our deferred tax net asset as of December 31, 2012 are assets of $112.2 million related to alternative minimum tax (“AMT”) credit carryforwards and $14.6 million related to foreign tax credit carryforwards. We may utilize these credits to offset future taxable income. The result of their utilization will be a lower current tax rate offset by a higher deferred tax provision, and also lower cash expenditures for federal income taxes during the utilization period. There is no expiration on AMT credit carryforwards and our foreign tax credit carryforwards will expire beginning in 2021. It is our opinion that there will be sufficient future U.S. and U.K. taxable income to utilize these tax credit carryforwards. Our estimate of the gross amount and likely realization of tax credit carryforwards may change over time.
to offset this gain, and resulted in the release of $29.0 million of the valuation allowance we held against the deferred tax asset related to these capital loss carryforwards. A release of $0.2 million was reflected in income from continuing operations and the remaining amount of $28.8 million was reflected as a benefit in accumulated other comprehensive income. During 2012, we recognized $1.4 million of the $28.8 million in income from continuing operations, related to non-segment income. The remaining amount will be released into income from continuing operations in future years, as the investment securities subject to these transactions are sold or mature.
In November 2011, we reached an agreement with the IRS on our 2005 to 2006 audit cycle, resulting in a tax benefit of $2.1 million recognized as income related to our discontinued operations. The benefit is primarily due to the concession of our separate account dividends received deduction issue by the IRS Appeals Division, which resulted in the reduction of our liability for this uncertain tax position. See Note 7 - “Income Taxes” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K for additional information. Also in April 2011, we received notification that an interest refund claim filed with the Internal Revenue Service in 2009 had been accepted, resulting in a tax benefit of $0.6 million recognized in discontinued operations.
In January, July, September, and December 2010, we completed transactions which resulted in the realization, for tax purposes only, of unrealized gains in our investment portfolio of $98.4 million, $37.1 million, $31.1 million, and $120.8 million, respectively. These transactions enabled us to realize capital loss carryforwards to offset these gains, and resulted in the release of $66.2 million and $34.4 million in 2010 and 2009, respectively, of the valuation allowance we held against the deferred tax asset related to these capital loss carryforwards. The total release of $100.6 million was accounted for as an increase in income from continuing operations of $3.2 million and $6.0 million in 2010 and 2009, respectively, with the remaining $91.4 million reflected as a benefit in accumulated and other comprehensive income at December 31, 2010. During 2012 and 2011, we recognized $12.6 million and $9.5 million, respectively, of the $91.4 million in income from continuing operations, related to non-segment income. The remaining amount will be released into income from continuing operations in future years, as the investment securities subject to these transactions are sold or mature.
In 2010, we reduced the valuation allowance related to our deferred tax asset by a total of $104.1 million, from $195.6 million to $91.5 million. There were four principal components to this reduction. First, we reduced the valuation allowance by $66.2 million as a result of the aforementioned transactions which utilized our capital loss carryforwards. Second, we increased the valuation allowance by $20.3 million for certain tax basis unrealized losses which we did not believe we could utilize. This increase was reflected as a decrease in accumulated other comprehensive income. Third, $135.5 million of our capital loss carryforwards expired in 2010. As a result, we released the $47.4 million of the valuation allowance attributable to these expirations with an equal and offsetting reduction in the related deferred tax asset. Fourth, as a result of $29.7 million in net realized capital gains, we decreased our valuation allowance by $9.7 million as an increase to income from continuing operations since these gains utilized our capital loss carryforwards. The remaining $1.1 million decrease was attributable to other items reflected as income from discontinued operations.
See “Segment Results - Reserves for Losses and Loss Adjustment Expenses” in Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-K for a discussion of our critical accounting estimates for loss reserves.
We share a significant amount of insurance risk of the primary underlying contracts with various insurance entities through the use of reinsurance contracts. As a result, when we experience loss events that are subject to a reinsurance contract, reinsurance recoveries are recorded. The amount of the reinsurance recoverable can vary based on the size of the individual loss or the aggregate amount of all losses in a particular line, book of business or an aggregate amount associated with a particular accident year. The valuation of losses recoverable depends on whether the underlying loss is a reported loss, or an incurred but not reported loss. For reported losses, we value reinsurance recoverables at the time the underlying loss is recognized, in accordance with contract terms. For incurred but not reported losses, we estimate the amount of reinsurance recoverable based on the terms of the reinsurance contracts and historical reinsurance recovery information and apply that information to the gross loss reserve estimates. The most significant 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.
Expenses related to these plans are generally calculated based upon information available at the beginning of the plan year. Our pre-tax expense related to our defined benefit plans was $11.0 million and $13.0 million for 2012 and 2011, respectively. Expenses in 2012 include $1.8 million related to the Chaucer pension plan and expenses in 2011 include $0.4 million related to the Chaucer pension plan for the period of July 1, 2011 to December 31, 2011.
In 2012, actuarial losses of approximately $48 million primarily resulting from the decrease in the discount rate from the prior year were partially offset by the benefit from investment gains of approximately $24 million. The benefit from the investment gains experienced in 2011 was essentially offset by a decrease in the discount rate from the prior year. These net losses resulted in adjustments to our accumulated net actuarial losses in 2012 and 2011 of $23.7 million and $0.4 million, respectively, which are reflected as decreases to our accumulated other comprehensive income. The change in these actuarial gains and losses is amortized into earnings in future years. The adjustments to accumulated other comprehensive income from these actuarial losses occurring in 2012 and 2011 were offset by the amortization of actuarial losses from prior years of $10.8 million and $14.0 million in 2012 and 2011, respectively. Given the effect of our actual investment experience in 2012, and taking into consideration the decrease in discount rates in 2013, U.S. pension related expenses in 2013 are expected to increase slightly from 2012. Accordingly, we expect our pre-tax pension expense for the U.S. qualified defined benefit pension plan to increase from approximately $6 million in 2012 to approximately $7 million in 2013.
Holding all other assumptions constant, sensitivity to changes in our key assumptions related to our U.S. qualified defined benefit pension plan are as follows:
Discount Rate - A 25 basis point increase in the discount rate would decrease our pension expense in 2013 by $1.8 million and decrease our projected benefit obligation by $14.3 million. A 25 basis point reduction in the discount rate would increase our pension expense by $1.8 million and increase our projected benefit obligation by $14.9 million.
For the year ended December 31, 2012 and the six months ended December 31, 2011, the expected rate of return on plan assets was 7.50% and 7.40%, respectively. The composition of our Chaucer plan assets are 77% equities, 14% fixed maturities, and 9% real estate funds at December 31, 2012. Actual returns of the plan investments generated approximately $10 million of gains and $5 million of losses during the year ended December 31, 2012 and the six months ended December 31, 2011, respectively as compared to expected returns of approximately $6 million and $3 million, respectively.
Discount Rate - A 25 basis point increase in the discount rate would decrease our pension expense in 2013 by $0.2 million and decrease our projected benefit obligation by $7.3 million. A 25 basis point reduction in the discount rate would increase our pension expense by $1.5 million and increase our projected benefit obligation by $7.8 million.
We monitor corporate fixed maturity securities with unrealized losses on a quarterly basis and more frequently when necessary to identify potential credit deterioration as evidenced by ratings downgrades, unexpected price variances, and/or company or industry specific concerns. We apply consistent standards of credit analysis which includes determining whether the issuer is current on its contractual payments and we consider past events, current conditions and reasonable forecasts to evaluate whether we expect to recover the entire amortized cost basis of the security. We utilize valuation declines as a potential indicator of credit deterioration and apply additional levels of scrutiny in our
Our deferred tax assets and liabilities primarily result from temporary differences between the amounts recorded in our consolidated financial statements and the tax basis of our assets and liabilities and loss and tax credit carryforwards. These temporary differences are measured at the balance sheet date using enacted tax rates expected to apply to taxable income in the years the temporary differences are expected to reverse.
We have $112.2 million of alternative minimum tax credit carryforwards and $14.6 million of foreign tax credit carryforwards. The alternative minimum tax credit carryforwards have no expiration date and may be used to offset regular federal income taxes due from future income. The foreign tax credit carryforwards will expire beginning in 2021. In addition, we have operating loss carryforwards that relate to current year U.S. net operating loss and foreign net operating loss carryforwards from our Chaucer segment. The U.S. net operating loss carryforwards expire beginning in 2031 and the Chaucer net operating loss carryforwards have no expiration date. Based on our projection of future economic conditions, taxable income, reversals of existing taxable temporary liabilities, and our strategic tax planning strategies, we believe that these tax credit carryforwards and operating loss carryforwards will be fully realized.
The NAIC prescribes an annual calculation regarding risk based capital (“RBC”). RBC ratios for regulatory purposes, as described in the glossary, are expressed as a percentage of the capital required to be above the Authorized Control Level (the “Regulatory Scale”); however, in the insurance industry, RBC ratios are widely expressed as a percentage of the Company Action Level. The following table reflects the Company Action Level, the Authorized Control Level and RBC ratios for Hanover Insurance (which includes Citizens and other U.S. insurance subsidiaries), as of December 31, 2012 and 2011, expressed both on the Industry Scale (Total Adjusted Capital divided by the Company Action Level) and Regulatory Scale (Total Adjusted Capital divided by Authorized Control Level):
Chaucer corporate members operate in the Lloyd’s market, which requires that these members deposit funds, referred to as “Funds at Lloyd’s”, to support their underwriting interests. Lloyd’s sets required capital annually for all participating syndicates based on each syndicate’s business plans, the rating and reserving environment, and discussions with regulatory and rating agencies. Although the minimum capital levels are set by Lloyd’s, it is the responsibility of Chaucer to continually monitor the risk profiles of its managed syndicates to ensure that the level of funding remains appropriate. Such capital is comprised of
cash and cash equivalents, investments, undrawn letters of credit provided by various banks and other assets. At December 31, 2012, we are in compliance with the capital requirements. We have the following securities, assets and letters of credit pledged to Lloyd’s to satisfy these capital requirements at December 31, 2012. In 2012, the Company has decided not to renew its capital provision reinsurance treaty for the 2013 underwriting year with Flagstone Re. In accordance with the terms of the capital provision reinsurance treaty, Flagstone Re is obligated to provide funds at Lloyd’s in relation to its participation during the 2009 through 2012 underwriting years, until such time that these years close. Even without the reinsurance treaty, we expect to be able to meet these capital requirements in the future.
Dividend payments to the holding company by our Chaucer business are regulated by U.K. law. Dividends from Chaucer are dependent on dividends from its subsidiaries. Annual dividend payments from Chaucer are limited to retained earnings that are not restricted by capital and other requirements for business at Lloyd’s. Also, Chaucer must provide advance notice to the U.K.’s Financial Services Authority (“FSA”) of certain proposed dividends or other payments from FSA regulated entities. In connection with an intercompany borrowing arrangement with the holding company, interest on a $300 million note is paid by Chaucer on a quarterly basis to the holding company. This interest approximates $5.5 million quarterly and may be deferred at the election of the holding company. If deferred, the interest is added to the principal. As of December 31, 2012, Chaucer has paid $27.4 million of interest to the holding company.
Net cash used in investing activities was $562.8 million during 2012, compared to net cash provided by investing activities of $182.8 million in 2011 and net cash used in investing activities of $98.8 million in 2010. During 2012, cash used was primarily related to net purchases of fixed maturities as we invested cash from Chaucer and net investments in equity securities. Cash used to purchase investments was partially offset by cash received from the sale of a building. See Note 3 - “Investments” in the Notes
Net cash used in financing activities was $133.4 million during 2012, compared to net cash provided by financing activities of $127.3 million in 2011 and net cash used by financing activities of $8.6 million in 2010. During 2012, cash used in financing activities primarily resulted from the repurchases of $72.4 million of debt, the payment of dividends to shareholders, repurchases of our common stock and repayments of collateral held for our securities lending program, partially offset by the proceeds from the FHLBB debt borrowings. During 2011, cash provided by financing activities primarily resulted from the issuance, on June 17, 2011, of $300.0 million of unsecured senior debentures. Cash received from the issuance of debt was partially offset by the repurchases of $86.8 million of debt, the payment of dividends to our shareholders, repayments of collateral related to our securities lending program, and repurchases of common stock. During 2010, cash used in financing activities primarily resulted from repurchases of common stock and debt, as well as the payment of dividends to our shareholders. These were substantially offset by proceeds from the issuance, on February 23, 2010, of $200.0 million unsecured senior debentures.
Dividends to common shareholders are subject to quarterly board approval and declaration. During 2012, as declared by the Board, we paid three quarterly dividends of $0.30 per share and one quarterly dividend of $0.33 per share to our shareholders. The total dividends paid to our shareholders in 2012 were $55.1 million. We believe that our holding company assets are sufficient to provide for future shareholder dividends should the Board of Directors declare them.
Over the past several years, we have issued, through two separate transactions, $500 million in senior debentures and have received advances of $171.3 million through our membership in FHLBB as part of a collateralized borrowing program. In January 2013, we repaid $46.3 million of our FHLBB CDAs plus prepayment fees of $7.8 million for a total payment of $54.1 million. Additional information related to these borrowings is provided in Note 6 - “Debt and Credit Arrangements” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
Chaucer pension plan funding obligations reflect estimated payments to be made through plan year 2020 based on a payment schedule determined by the plan’s trustees. Additional contributions may be required for unfunded benefit obligations, if any, after plan year 2020 as determined by the plan’s trustees. For purposes of this table, we used the foreign currency exchange rate of 1.63 at December 31, 2012 to determine the future cash payments.
Information regarding litigation and legal contingencies appears in Note 17 - “Commitments and Contingencies” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K. Information related to certain regulatory and industry developments are contained in “Regulation” in Part 1 - Item 1 of this Form 10-K and in “Risk Factors” in Part 1 - Item 1A of this From 10-K.
Expense Ratio, GAAP - The ratio of underwriting expenses to premiums earned for a given period.
Multivariate product - An insurance product, the pricing for which is based upon the magnitude of, and correlation between, multiple rating factors. In practical application, the term refers to the foundational analytics and methods applied to the product construct. Our Connections Auto product is an example of a multivariate product.
Reinstatement premium - A pro-rata reinsurance premium that may be charged for reinstating the amount of reinsurance coverage reduced as the result of a reinsurance loss payment under a reinsurance treaty. For events that we are the insured party, the charge would decrease premiums; for events where we provide reinsurance coverage, the charge would increase premiums. For example, in 2005, this premium was required to ensure that our property catastrophe occurrence treaty, which was exhausted by Hurricane Katrina, was available again in the event of another large catastrophe loss in 2005.
Underwriting expenses - Expenses incurred in connection with the acquisition, pricing and administration of a policy.
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of The Hanover Insurance Group, Inc. and its subsidiaries at December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
As discussed in Note 1 to the consolidated financial statements, the Company changed the manner in which it accounts for deferred policy acquisition costs in 2012.
Other investments consist primarily of overseas deposits, which are investments maintained in overseas funds and managed exclusively by Lloyd’s. These funds are required in order to protect policyholders in overseas markets and enable the Company to operate in those markets. Overseas deposits are carried at fair value. Realized and unrealized gains and losses on overseas deposits, including the impact of foreign currency movements, are reflected in the income statement in the period the gain or loss was generated. Also included in other investments are investments in limited partnerships, which are accounted for by the equity method of accounting or at cost.
The Company’s debt at December 31, 2012 includes senior debentures, junior debentures, and collateralized borrowings with the Federal Home Loan Bank of Boston (“FHLBB”). The senior debentures are carried at principal amount borrowed, net of unamortized discounts. The junior subordinated debentures and borrowings under the FHLBB program are carried at principal amount borrowed (See Note 6 - “Debt and Credit Arrangements”).
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 ASC 740, Income Taxes (“ASC 740”). These temporary differences are measured at the balance sheet date using enacted tax rates expected to apply to taxable income in the years the temporary differences are expected to reverse. These differences result primarily from insurance reserves, tax credit carryforwards, deferred policy acquisition costs, loss carryforwards, and employee benefit plans.
The Company manages its exposure to foreign currency risk primarily by matching assets and liabilities denominated in the same currency. To the extent that assets and liabilities in foreign currencies are not matched, the Company is exposed to foreign currency risk. For functional currencies, the related exchange rate fluctuations are reflected in other comprehensive income (loss). The Company translated Chaucer’s balance sheet at December 31, 2012 and December 31, 2011 from GBP to U.S. dollars using a conversion rate of 1.63 and 1.55, respectively. The Company recognized approximately $6.3 million in foreign currency transaction gains in the Statement of Income during the year ended December 31, 2012. During the six months ended December 31, 2011, the Company recognized $5.1 million of foreign exchange transaction gains including the $6.4 million gain recognized on the foreign currency forward contract associated with the purchase price of Chaucer. See Note 2 - “Acquisitions and Discontinued Operations” for further information.
In May 2011, the FASB issued ASC Update No. 2011-04 (Topic 820) Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASC update results in a consistent definition of fair value and common requirements for measurement of and disclosure about fair value for both U.S. GAAP and International Financial Reporting Standards (“IFRS”). The new guidance includes changes to how and when the valuation premise of highest and best use applies, clarification on the application of blockage factors and other premiums and discounts, as well as new and revised disclosure requirements. This ASC update is effective for interim and annual periods beginning after December 15, 2011. The Company implemented this guidance as of January 1, 2012. The effect of implementing this guidance was not material to the Company’s financial position or results of operations.
In December 2010, the FASB issued ASC Update No. 2010-29 (Topic 805) Disclosure of Supplementary Pro Forma Information for Business Combinations (a consensus of the FASB Emerging Issues Task Force). This update provides clarity on the presentation of comparable pro forma financial statements for business combinations. Revenues and earnings of the combined entity should be disclosed as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. Additionally, this update requires the disclosure to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The disclosure guidance provided in this ASC update is effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. The Company implemented this guidance as of January 1, 2011. Implementing this guidance did not have an effect on the Company’s financial position or results of operations upon adoption; however, the disclosure requirements were applied to the Company’s acquisition of Chaucer. See Note 2 - “Acquisitions and Discontinued Operations” for pro forma results of operations of THG and Chaucer.
In February 2013, the FASB issued ASC Update No. 2013-02 (Topic 220) Comprehensive Income Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. This guidance requires an entity to provide information about the amounts reclassified out of accumulated other comprehensive income (“AOCI”) either on the face of the Statement of Income or in the Notes to the Consolidated Financial Statements. Significant amounts reclassified out of AOCI should be provided by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified in its entirety to net income in the same reporting period. For amounts not required to be reclassified in their entirety to net income, a cross-reference to other disclosures provided for in accordance with U.S. GAAP is required. This guidance is applicable for reporting periods beginning after December 15, 2012. The Company expects that the implementation of this guidance will not have an impact on its results of operations or financial position and will impact its disclosures only.
On July 1, 2011, the Company acquired Chaucer, a U.K. insurance business. Chaucer is a leading specialist insurance underwriting group at Lloyd’s. Chaucer underwrites business in several lines of business, including marine and aviation, energy, property, U.K. motor and casualty and other coverages (which include international liability, specialist coverages, and syndicate participations). Chaucer is headquartered in London, with a regional presence in Whitstable, England and locations in Houston, Singapore, Buenos Aires, and Copenhagen.
Shareholders of Chaucer received 53.3 pence for each Chaucer share, which was paid in either cash or loan notes to those shareholders who elected to receive such notes in lieu of cash. Loan notes can be paid, at the election of the note holder, through 2016. The closing of the acquisition followed approval of the transaction by Chaucer shareholders on June 7, 2011, subsequent court approval in the U.K. and regulatory approvals in various jurisdictions. The following table summarizes the transaction in both GBP and U.S. dollars:
Transaction costs associated with the acquisition, which included advisory, legal, and accounting costs, were expensed as incurred. Allowances for uncollectible accounts related to reinsurance recoverables were not significant at July 1, 2011.
The following unaudited pro forma information presents the combined revenues, net income (loss) and net income (loss) per share of THG and Chaucer for the years ended December 31, 2011 and 2010 with pro forma purchase accounting adjustments as if the acquisition had been consummated as of January 1, 2010. This pro forma information is not necessarily indicative of what would have occurred had the acquisition and related transactions been made on the dates indicated, or of future results of the Company. Amounts in 2011 and 2010 are converted from GBP to U.S. dollar at rates of 1.60 and 1.55, respectively.
Discontinued operations primarily consist of the Company’s Discontinued Accident and Health Business and the Company’s Discontinued Third Party Administration Business, Citizens Management, Inc. (“CMI”).
reinsured by Hanover Insurance in connection with the sale of FAFLIC to Commonwealth Annuity, and has been reported in accordance with ASC 205, Presentation of Financial Statements.
OTTI unrealized losses in the tables above represent OTTI recognized in accumulated other comprehensive income. This amount excludes net unrealized gains on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date of $20.5 million and $25.1 million as of December 31, 2012 and 2011, respectively.
In accordance with Lloyd’s operating guidelines, the Company deposits funds at Lloyd’s to support underwriting operations. At December 31, 2012 and 2011, fixed maturities with a fair value of $497 million and $372 million, respectively, and cash of $3 million and $94 million, respectively, were on deposit with Lloyd’s. These funds are available only to fund claim obligations.
The Company enters into various agreements that may require its fixed maturities to be held as collateral by others. At December 31, 2012 and 2011, fixed maturities with a fair value of $213.8 million and $212.9 million, respectively, were held as collateral for collateralized borrowings and other arrangements. Of these amounts, $200.8 million and $205.7 million related to the FHLBB collateralized borrowing program at December 31, 2012 and 2011, respectively.
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.
In May 2011, the Company entered into a treasury lock forward agreement to hedge the interest rate risk associated with the planned issuance of senior debt, which was completed on June 17, 2011. This hedge qualified as a cash flow hedge. It matured in June 2011 and resulted in a loss of $1.9 million, which was recorded in accumulated other comprehensive income and is being recognized as an expense over the term of the senior notes. All components
Equity securities and other balances at December 31, 2012, 2011 and 2010 include after-tax net appreciation on other invested assets of $2.1 million, $1.9 million and $1.8 million, respectively. Fixed maturities at December 31, 2012 and 2011 include after-tax net depreciation on derivative instruments of $1.0 million and $1.2 million, respectively.
The following tables provide information about the Company’s fixed maturities and equity securities that are in an unrealized loss position at December 31, 2012 and 2011:
The carrying value of non-income producing fixed maturities, as well as the carrying value of fixed maturity securities on non-accrual status, at December 31, 2012 and 2011 were not material. The effects of non-accruals for the years ended December 31, 2012, 2011 and 2010, compared with amounts that would have been recognized in accordance with the original terms of the fixed maturities, were reductions in net investment income of $2.5 million, $2.3 million and $2.3 million, respectively.
Included in the net realized investment gains (losses) were other-than-temporary impairments of investment securities recognized in earnings totaling $7.8 million, $6.9 million and $13.9 million in 2012, 2011 and 2010, respectively.
For 2012, total OTTI was $7.3 million. Of this amount, $7.8 million was recognized in earnings, including $0.5 million that was transferred from unrealized losses in accumulated other comprehensive income. Of the $7.8 million recorded in earnings, $5.4 million related to fixed maturity securities that the Company intends to sell, $1.2 million was estimated credit losses on fixed maturity securities and $1.2 million related to common stocks.
The methodology and significant inputs used to measure the amount of credit losses on fixed maturities in 2012, 2011 and 2010 were as follows:
The Company utilizes a third party pricing service for the valuation of the majority of its fixed maturity securities and receives one quote per security. When quoted market prices in an active market are available, they are provided by the pricing service as the fair value and such values are classified as Level 1. Since fixed maturities other than U.S. Treasury securities generally do not trade on a daily basis, the pricing service prepares estimates of fair value for those securities using pricing applications based on a market approach. Inputs into the fair value pricing common to all asset classes include: benchmark U.S. Treasury security yield curves; reported trades of identical or similar fixed
maturity securities; broker/dealer quotes of identical or similar fixed maturity securities and structural characteristics such as maturity date, coupon, mandatory principal payment dates, frequency of interest and principal payments, and optional redemption features. Inputs into the fair value applications that are unique by asset class include, but are not limited to:
Residential mortgage-backed securities - estimates of prepayment speeds based upon: historical prepayment rate trends; underlying collateral interest rates; geographic concentration; vintage year; borrower credit quality characteristics; interest rate and yield curve forecasts; government or monetary authority support programs; tax policies; delinquency/default trends; and, in the case of non-agency collateralized mortgage obligations, severity of loss upon default and length of time to recover proceeds following default.
The Company holds privately placed fixed maturity securities and certain other fixed maturity securities that do not have an active market and for which the pricing service cannot provide fair values. The Company determines fair values for these securities using either matrix pricing utilizing the market approach or broker quotes. The Company will use observable market data as inputs into the fair value applications, as discussed in the determination of Level 2 fair values, to the extent it is available, but is also required to use a certain amount of unobservable judgment due to the illiquid nature of the securities involved. Unobservable judgment reflected in the Company’s matrix model accounts for estimates of additional spread required by market participants for factors such as issue size, structural complexity, high bond coupon, long maturity term or other unique features. These matrix-priced securities are reported as Level 2 or Level 3, depending on the significance of the impact of unobservable judgment on the security’s value. Additionally, the Company may obtain non-binding broker quotes which are reported as Level 3.
Level 2. The Company holds certain equity securities that have been issued by privately-held entities that do not have an active market and for which the pricing service cannot provide fair values. Generally, the Company estimates fair value for these securities based on the issuer’s book value and market multiples. These securities are reported as Level 3 as market multiples represent significant unobservable inputs.
The fair value of debt was estimated based on quoted market prices. If a quoted market price is not available, fair values are estimated using discounted cash flows that are based on current interest rates and yield curves for debt issuances with maturities and credit risks consistent with the debt being valued. Debt is reported as Level 2.
The Company has processes designed to ensure that the values received from its third party pricing service are accurately recorded, that the data inputs and valuation techniques utilized are appropriate and consistently applied and that the assumptions are reasonable and consistent with the objective of determining fair value. The Company performs a review of the fair value hierarchy classifications and of prices received from its pricing service on a quarterly basis. The Company reviews the pricing services’ policies describing its methodology, processes, practices and inputs, including various financial models used to value securities. Also, the Company reviews the portfolio pricing, including securities with changes in prices that exceed a defined threshold are verified to independent sources, if available. If upon review, the Company is not satisfied with the validity of a given price, a pricing challenge would be submitted to the pricing service along with supporting documentation for its review. The Company does not adjust quotes or prices obtained from the pricing service unless the pricing service agrees with the Company’s challenge. During 2012 and 2011, the Company did not adjust any prices received from brokers or its pricing service.
The following table provides, for each hierarchy level, the Company’s estimated fair values of financial instruments that are not carried at fair value.
There were no Level 3 liabilities held by the Company for years ended December 31, 2012 and 2011.
Significant increases (decreases) in any of the above inputs in isolation would result in a significantly lower (higher) fair value measurement. There are no interrelationships between these inputs which might magnify or mitigate the effect of changes in unobservable inputs on the fair value measurement.
As collateral to FHLBB, Hanover Insurance pledged government agency securities with a fair value of $200.8 million and $205.7 million, for the aggregate borrowings of $171.3 million and $163.9 million as of December 31, 2012 and December 31, 2011, respectively. The amount of required collateral decreased in conjunction with the repayment of the $46.3 million of FHLBB CDAs in January 2013. The fair value of the collateral pledged must be maintained at certain specified levels of the borrowed amount, which can vary depending on the type of assets pledged. If the fair value of this collateral declines below these specified levels, Hanover Insurance would be required to pledge additional collateral or repay outstanding borrowings. Hanover Insurance is permitted to voluntarily repay the outstanding borrowings at any time, subject to a repayment fee. As a requirement of membership in the FHLBB, Hanover Insurance maintains a certain level of investment in FHLBB stock. Total holdings of FHLBB stock were $9.7 million and $9.4 million at December 31, 2012 and 2011, respectively.
Interest expense was $61.9 million in 2012, $55.0 million in 2011, and $44.3 million in 2010. At December 31, 2012, the Company was in compliance with the covenants associated with all of its debt indentures and credit arrangements.
Included in the Company’s deferred tax asset as of December 31, 2012 are assets of $58.4 million related to U.S. net operating loss carryforwards and a deferred tax asset of $16.7 million related to foreign net operating carryforwards. The pre-tax U.S. operating loss carryforwards of $166.8 million will expire beginning in 2031. The pre-tax foreign operating loss carryforwards of $70.7 million were generated in the U.K. and have no expiration date. It is the Company’s opinion that there will be sufficient future U.S. and U.K. taxable income to utilize these loss carryforwards. The Company’s estimate of the gross amount and likely realization of loss carryforwards may change over time. At December 31, 2012, the Company has fully utilized its deferred tax asset related to U.S. capital loss carryforwards.
Included in the Company’s deferred tax asset as of December 31, 2012 are assets of $112.2 million related to alternative minimum tax credit carryforwards and $14.6 million related to foreign tax credit carryforwards. The alternative minimum tax credit carryforwards have no expiration date and the foreign tax credit carryforwards will expire beginning in 2021. The Company may utilize the
credits to offset regular federal income taxes due from future income, and although the Company believes that these assets are fully recoverable, there can be no certainty that future events will not affect their recoverability. The Company believes, based on objective evidence, the remaining deferred tax assets will be realized.
During 2012, the Company released $35.9 million of its valuation allowance related to its deferred tax asset held at the beginning of the year. The release of this valuation allowance resulted from the aforementioned transaction which utilized capital loss carryforwards, unrealized appreciation in its investment portfolio, and net realized capital gains in its Consolidated Statements of Income. Accordingly, the Company recorded decreases in its valuation allowance of $25.3 million as an adjustment to accumulated other comprehensive income, $7.7 million as an adjustment to income tax expense from continuing operations, and $2.9 million in discontinued operations.
In January, July, September, and December 2010, the Company completed transactions which resulted in the realization, for tax purposes only, of unrealized gains in its investment portfolio of $98.4 million, $37.1 million, $31.1 million, and $120.8 million, respectively. These transactions enabled the Company to realize capital loss carryforwards to offset these gains, and resulted in the release of $66.2 million and $34.4 million in 2010 and 2009, respectively, of the valuation allowance it held against its deferred tax asset related to these capital loss carryforwards. The total release of $100.6 million was accounted for as an increase in income from continuing operations of $3.2 million and $6.0 million in 2010 and 2009, respectively, with the remaining $91.4 million reflected as a benefit in accumulated other comprehensive income at December 31, 2010. During 2012 and 2011, the Company recognized $12.6 million and $9.5 million, respectively, of the $91.4 million in income from continuing operations related to non-segment income. The remaining amount will be released into income from continuing operations in future years, as the investment securities subject to these transactions are sold or mature.
During 2010, the Company reduced its valuation allowance, for both continuing and discontinued operations, related to its deferred tax assets by $104.1 million, from $195.6 million to $91.5 million. There were four principal components to this reduction. First, the Company reduced the valuation allowance by $66.2 million as a result of the aforementioned transactions, which utilized the capital loss carryforwards. Second, the Company increased its valuation allowance by $20.3 million for certain tax basis unrealized
losses which the Company did not believe it could utilize. This increase was reflected as a decrease in accumulated other comprehensive income. Third, $135.5 million of the capital loss carryforwards expired in 2010. As a result, the Company released $47.4 million of its valuation allowance attributable to these expirations with an equal and offsetting reduction in the related deferred tax asset. Fourth, as a result of $29.7 million in net realized gains during 2010, the Company decreased its valuation allowance by $9.7 million as an increase to income from continuing operations, since these gains utilized the Company’s capital loss carryforwards. The remaining $1.1 million decrease was attributable to other items reflected as income from discontinued operations.
Although most of the Company’s non - U.S. income is subject to U.S. federal income tax, certain of its non-U.S. income is not subject to U.S. federal income tax until repatriated. Foreign taxes on this non - U.S. income are accrued at the local foreign tax rate, as opposed to the higher U.S. statutory tax rate, since these earnings currently are expected to be permanently reinvested overseas. This assumption could change, as a result of a sale of the subsidiaries, the receipt of dividends from the subsidiaries, a change in management’s intentions, or as a result of various other events. The Company has not made a provision for U.S. taxes on $10.0 million and $4.2 million of non-U.S. income for 2012 and 2011, respectively. However, in the future, if such earnings were distributed to the Company, taxes of $5.0 million would be payable on such undistributed earnings and would be reflected in the tax provision for the year in which these earnings are no longer intended to be permanently reinvested overseas, assuming all foreign tax credits are realized.
The Company or its subsidiaries files income tax returns in the U.S. federal jurisdiction and various state jurisdictions, as well as foreign jurisdictions. With few exceptions, the Company and its subsidiaries are no longer subject to U.S. federal income tax examinations by tax authorities for years before 2007. The IRS audits of the years 2009 and 2010 commenced in June 2012 and audits of the years 2007 and 2008 commenced in April 2010. In 2011, the Company received a RAR for the 2007 and 2008 IRS audit. The Company agreed to all proposed adjustments other than a disallowance of deduction for certain loss reserves, for which it filed a formal protest and is currently working through the IRS Appeals process. The Company believes it will ultimately prevail on this issue and accordingly has not recorded any liabilities for uncertain tax positions. The effect of the proposed disallowance of deductions for certain reserves, if sustained, only impacts the timing of such deduction and does not materially affect the Company’s financial position. The Company and its subsidiaries are still subject to U.S. state income tax examinations by tax authorities for years after 2006 and foreign examinations for years after 2009.
Weighted-average assumptions used to determine the Chaucer pension benefit obligations are as follows:
Weighted-average assumptions used to determine net periodic pension costs for the Chaucer pension plan are as follows for the year ended December 31, 2012 and the six months ended December 31, 2011:
The expected rates of return were determined by using historical mean returns, adjusted for certain factors believed to have an impact on future returns. Specifically, for the U.S. defined benefit plans, because the allocation of assets between fixed maturities and equities has changed, as discussed in “Plan Assets” below, the historical mean return was adjusted downward slightly to reflect this asset mix. The adjusted mean returns were weighted to the plan’s expected target asset allocation at December 31, 2012,
resulting in an expected rate of return on plan assets for 2012 of 6.00%. The Company reviews and updates, at least annually, its expected return on plan assets based on changes in the actual assets held by the plans.
Securities classified as Level 1 at December 31, 2012 and 2011 include actively traded mutual funds and publicly traded securities which are valued at quoted market prices. Securities classified as Level 2 at December 31, 2012 and 2011 include a separate investment account, which is invested entirely in the Vanguard Total Bond Market Index Fund, a mutual fund that in turn invests in investment grade fixed maturities, as well as a custom fund that invests in commingled pools and investment grade fixed income securities. The fair value of each of the Level 2 investments is determined daily as the Net Asset Value (“NAV”) based on the value of the underlying investments, which is determined independently by the investment manager. The daily NAV, which is not published as a quoted market price for these investments, is used as the basis for transactions. Redemption of these funds is not subject to restriction.
The investment strategy of the Chaucer defined benefit pension plan is to invest primarily in growth assets in the form of equity funds which are expected to provide a positive return that exceeds inflation over the longer term in order to protect the existing and future liabilities of the pension plan. In order to reduce volatility and diversify the portfolio, the target allocation includes an exposure to corporate bond and commercial property funds. The plan will be reviewed annually and target allocation changes will be made as appropriate. The following table provides target allocations and actual invested asset allocations for 2012 and 2011.
Real estate fund investments classified as Level 3 at December 31, 2012 and 2011 are valued based upon the values of the net assets of the fund. Although the NAV is calculated daily, transactions also consider cash inflows and outflows of the fund. The price where units are transacted includes the NAV, which is adjusted for investment charges and other estimated acquisition costs such as legal fees, taxes, planning and architect fees, survey and agent fees, among others.
(1) For the period July 1, 2011 (date of acquisition) to December 31, 2011.
On January 4, 2010, the Company made a discretionary contribution of $100.0 million to the U.S. qualified defined benefit pension plan. These funds were invested primarily in fixed income investments. With this contribution, and based upon the current estimate of liabilities and certain assumptions regarding investment return and other factors, the Company’s U.S. qualified defined benefit pension plan is underfunded by approximately $15 million. However, the Company is not required to fund its U.S. qualified benefit plan in 2013. The Company expects to contribute $3.1 million to its U.S. non-qualified pension plans to fund 2013 benefit payments, and $4.5 million to the Chaucer pension plan. At this time, no additional discretionary contributions are expected to be made to the plans during 2013 and the Company does not expect that any funds will be returned from the plans to the Company during 2013.
The benefit payments are based on the same assumptions used to measure the Company’s benefit obligations at the end of 2012. Benefit payments related to the U.S. qualified plans and the Chaucer plan will be made from plan assets, whereas those payments related to the non-qualified plans will be provided for by the Company.
In addition to the defined benefit plans, THG provides a defined contribution 401(k) plan for its U.S. employees, whereby the Company matches employee elective 401(k) contributions, up to a maximum percentage of 6% in 2012, 2011, and 2010. The Company’s expense for this matching provision was $17.9 million, $17.8 million and $16.5 million for 2012, 2011 and 2010, respectively. In addition to this matching provision, the Company can elect to make an annual contribution to employees’ accounts. There were no additional contributions in 2012, 2011, and 2010.
Cash received for options exercised for the years ended December 31, 2012, 2011 and 2010 was $2.3 million, $3.9 million and $12.1 million, respectively. The intrinsic value of options exercised for the years ended December 31, 2012, 2011 and 2010 was $1.2 million, $1.8 million and $2.6 million, respectively.
The excess tax expense realized from options exercised for the years ended December 31, 2012, 2011, and 2010 was $0.4 million, $1.5 million, and $0.1 million, respectively. The aggregate intrinsic value at December 31, 2012 for shares outstanding and shares exercisable was $8.4 million and $6.5 million, respectively. At December 31, 2012, the weighted average remaining contractual life for shares outstanding and shares exercisable was 5.0 years and 2.7 years, respectively. Additional information about employee options outstanding and exercisable at December 31, 2012 is included in the following table:
Time-based restricted stock units granted in 2012 and 2011 were significantly lower compared to 2010 due to a shift in awards granted to non-executive officers from time-based restricted stock units to time-based cash awards.
Performance based restricted stock units are based upon the achievement of the performance metric at 100%. These units have the potential to range from 0% to 133% of the shares disclosed, which varies based on grant year and individual participation level. Increases above the 100% target level are reflected as granted in the period in which performance-based stock unit goals are achieved. Decreases below the 100% target level are reflected as forfeited. In 2012, performance-based stock units of 31,750 were included as forfeited due to completion levels of less than the threshold achievement level for shares granted in 2010. The weighted average grant date fair value for these awards was $42.15. In 2011, performance-based stock units of 47,375 were included as forfeited due to completion levels of less than the threshold achievement level for shares granted in 2009. The weighted average grant date fair value for these awards was $34.19. In 2010, performance-based stock units of 11,472 were included as forfeited due to completion levels less than 100% for units granted in 2007. The weighted average grant date fair value for these awards was $48.46. Additionally, in 2010, 25,055 performance-based stock units were included as forfeited due to completion levels of less than 100% for units originally granted in 2008. The weighted average grant date fair value for these awards was $45.21.
Dividend payments from Chaucer to its parent are regulated by U.K. law. Dividends from Chaucer are dependent on dividends from its subsidiaries. Annual dividend payments from Chaucer are limited to retained earnings that are not restricted by capital and other requirements for business at Lloyd’s. Also, Chaucer must provide advance notice to the U.K.’s Financial Services Authority (“FSA”), or its successor regulator, of certain proposed dividends or other payments from FSA regulated entities. There are currently no plans to repatriate dividends from Chaucer to its parent.
The Company reports interest expense related to its debt separately from the earnings of its operating segments. This consists of interest on the Company’s senior debentures, junior debentures, subordinated notes, collateralized borrowings with the Federal Home Loan Bank of Boston, and letter of credit facility. Management evaluates the results of the aforementioned segments on a pre-tax basis and excludes interest expense on debt. Segment income (loss) excludes certain items which are included in net income (loss), such as income taxes and net realized investment gains and losses, including gains and losses from certain derivative instruments. Such gains and losses are excluded since they are determined by interest rates, financial markets and the timing of sales. Also, segment income (loss) excludes net gains and losses on disposals of businesses, discontinued operations, costs to acquire businesses, restructuring costs, extraordinary items, the cumulative effect of accounting changes and certain other items. Although the items excluded from segment income (loss) may be significant components in understanding and assessing the Company’s financial performance, management believes that the presentation of segment income (loss) enhances an investor’s understanding of the Company’s results of operations by highlighting net income (loss) attributable to the core operations of the business. However, segment income (loss) should not be construed as a substitute for net income (loss) determined in accordance with U.S. GAAP.
Prior to the acquisition of Chaucer, the Company’s revenues were generated exclusively in the U.S. Revenues attributable to foreign countries are a result of the Chaucer acquisition. The following table presents gross written premium (“GWP”) based on the location of the risk:
The worldwide and other category includes insured risks that move across multiple geographic areas, including the U.S. and U.K., due to their mobile nature or insured risks that are fixed in locations that span more than one geographic area, and risks located in a single country outside the U.S. and U.K. These contracts include, for example, marine and aviation, hull, satellite, offshore energy exploration and production risks that can move across multiple geographic areas and assumed risks where the cedant insures risks in two or more geographic zones. These risks may include U.S. and U.K. insured risks.
As a condition to conduct certain business in various states, the Company is required to participate in residual market mechanisms, facilities and pooling arrangements such as the Michigan Catastrophic Claims Association (“MCCA”). The Company is subject to concentration of risk with respect to reinsurance ceded to the MCCA. Funding for MCCA comes from assessments against automobile insurers based upon their share of insured automobiles in the state. Insurers are allowed to pass along this cost to
Michigan automobile policyholders. The Company ceded to the MCCA premiums earned and losses and LAE incurred of $74.0 million and $99.9 million in 2012, $69.6 million and $122.6 million in 2011, $64.7 million and $135.6 million in 2010, respectively. MCCA, which represented 34.5% of the total reinsurance receivable balance at December 31, 2012, is the Company’s only reinsurer representing at least 10% of its reinsurance assets. Reinsurance recoverables related to MCCA were $856.3 million and $816.7 million at December 31, 2012 and 2011, respectively. Because the MCCA is supported by assessments permitted by statute, and there have been no significant uncollectible balances from MCCA identified during the three years ending December 31, 2012, the Company believes that it has no significant exposure to uncollectible reinsurance balances from this entity.
As part of an ongoing process, the reserves have been re-estimated for all prior accident years and were decreased by $15.8 million, $103.3 million and $111.1 million in 2012, 2011 and 2010, respectively. For the year ended December 31, 2012, and the six months ended December 31, 2011, these amounts include favorable loss and LAE reserve development of $72.6 million and $35.5 million, respectively for Chaucer. The Chaucer favorable development during the year ended December 31, 2012 was primarily the result of lower than expected losses in the energy line, primarily in the 2008 through 2011 accident years, marine and aviation lines, primarily in the 2007 through 2011 accident years, casualty lines, primarily in the 2010 and 2011 accident years, and the property lines, primarily in the 2009 through 2011 accident years. For Commercial and Personal Lines, the unfavorable loss and LAE development during the year ended December 31, 2012 was primarily the result of higher than expected losses within other commercial lines, primarily in the contract surety line due to the ongoing challenging macroeconomic environment for contractors, and to a lesser extent, the AIX program business, primarily related unexpected severity in commercial automobile liability, commercial multiple peril and general liability in a limited number of programs, and from higher than expected large losses within the commercial automobile line, primarily related to liability coverage in the 2011 accident year. In addition, the Company experienced higher than expected losses within the personal automobile line, primarily related to bodily injury severity in the 2010 and 2011 accident years, and higher than expected homeowners property losses from non-catastrophe weather related activity in the 2011 accident year. Partially offsetting the unfavorable development was lower than expected losses within the commercial multiple peril line, related to the 2008 through 2011 accident years.
The $111.1 million favorable loss and LAE reserve development during the year ended December 31, 2010 is primarily the result of lower than expected losses in the personal automobile line across all coverages, primarily related to the 2009 accident year, and lower than expected losses in the workers’ compensation line, primarily related to the 2008 and 2009 accident years. In addition, lower than expected losses in the commercial multiple peril line in liability coverages, primarily related to the 2007 through 2009 accident years and in the commercial umbrella line related to the 2007 through 2009 accident years contributed to the favorable development, partially offset by unfavorable development in the surety business, primarily related to the 2009 accident year. The 2010 amount includes $9.8 million of favorable development resulting from a change in the cost factors used for establishing unallocated loss adjustment expense reserves.
Loss and LAE reserves related to asbestos and environmental damage liability, primarily in other commercial lines, were $60.5 million, $59.8 million and $63.9 million as of December 31, 2012, 2011 and 2010, respectively. Ending loss and LAE reserves for all direct business written by the Company related to asbestos and environmental damage liability, included in the reserve for losses and LAE, were $9.8 million, $10.0 million and $10.1 million, net of reinsurance of $20.4 million, $18.7 million and $19.9 million as of December 31, 2012, 2011 and 2010, respectively. As a result of the Company’s historical direct underwriting mix of Commercial Lines policies toward smaller and middle market risks, past asbestos and environmental damage liability loss experience has remained minimal in relation to the Company’s total loss and LAE incurred experience. In addition, the Company has established gross loss and LAE reserves for its run-off voluntary assumed reinsurance pool business with asbestos and environmental damage liability of $30.3 million, $31.1 million and $33.9 million at December 31, 2012, 2011 and 2010, respectively. These reserves relate to pools in which the Company has terminated its participation; however, the Company continues to be subject to claims related to years in which it was a participant. Because of the inherent uncertainty regarding the types of claims in these pools, the Company cannot provide assurance that its reserves will be sufficient.
The Company estimates its ultimate liability for asbestos, environmental and toxic tort liability claims, whether resulting from direct business, assumed reinsurance and pool business, based upon currently known facts, reasonable
assumptions where the facts are not known, current law and methodologies currently available. Although these outstanding claims are not significant, their existence gives rise to uncertainty and are discussed because of the possibility that they may become significant. The Company believes that, notwithstanding the evolution of case law expanding liability in asbestos and environmental claims, recorded reserves related to these claims are adequate. The asbestos, environmental and toxic tort liability could be revised in the near term if the estimates used in determining the liability are revised, and any such revisions could have a material adverse effect on the Company’s results of operations for a particular quarterly or annual period or its financial position.
The Plaintiff filed an Amended Complaint adding two new named plaintiffs and additional claims on December 11, 2009. In response, the Company filed a Motion to Dismiss on January 30, 2010. In addition to the pending claim challenging the calculation of lump sum distributions, the Amended Complaint included: (a) a claim that the Plan failed to calculate participants’ account balances and lump sum payments properly because interest credits were based solely upon the performance of each participant’s selection from among various hypothetical investment options (as the Plan provided) rather than crediting the greater of that performance or the 30 year Treasury rate; (b) a claim that the 2004 Plan amendment, which changed interest crediting for all participants from the performance of participant’s investment selections to the 30 year Treasury rate, reduced benefits in violation of the Employee Retirement Income Security Act of 1974 (“ERISA”) for participants who had account balances as of the amendment date by not continuing to provide them performance-based interest crediting on those balances; and (c) claims against the Company for breach of fiduciary duty and ERISA notice requirements arising from the various interest crediting and lump sum distribution matters of which Plaintiffs complain. The District Court granted the Company’s Motion to Dismiss the additional claims on statute of limitations grounds by a Memorandum Opinion dated March 31, 2011, leaving the claims substantially as set forth in the original March 12, 2007 complaint. Plaintiffs filed a Motion for Reconsideration of the District Court’s decision to dismiss the additional claims, which was denied with respect to the claims set forth in (a) and (b) above; however, the Court did allow the fiduciary duty claim regarding plaintiffs’ “whipsaw” claim to stand. On June 22, 2012, the Company and the Plan filed a Motion for Summary Judgment to dismiss the claims of one of the plaintiffs who received his lump sum distribution after December 31, 2003, on the basis that certain amendments to the Plan effective January 1, 2004 eliminated any basis for payment of an additional “whipsaw” amount to participants who received lump sum distributions after December 31, 2003. On December 13, 2012, the Court held this motion in abeyance pending a ruling on Plaintiffs’ Motion for Class Certification. Plaintiffs filed their Motion for Class Certification on January 14, 2013. On February 8, 2013, the Company and the Plan informed the Court that they did not oppose the certification of a class.
The Company’s U.S. insurance subsidiaries are required to file annual statements with state regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis), as codified by the National Association of Insurance Commissioners. Statutory capital and surplus differs from shareholders’ equity reported in accordance with generally accepted accounting principles primarily because under the statutory basis of accounting, policy acquisition costs are expensed when incurred, the recognition of deferred tax assets is based on different recoverability assumptions and postretirement benefit costs are based on different participant assumptions.
(1) Per diluted share amounts in the second and third quarters of 2011 and the fourth quarter of 2012 exclude common stock equivalents, since the impact of these instruments was antidilutive.