The executive offices of the Corporation are in Warren, New Jersey. The administrative offices of the P&C Group are located in Warren and Whitehouse Station, New Jersey. The P&C Group maintains territory, branch and service offices in major cities throughout the United States and also has offices in Canada, Europe, Australia, Latin America and Asia. Office facilities are leased with the exception of buildings in Whitehouse Station, New Jersey and Simsbury, Connecticut. Management considers its office facilities suitable and adequate for the current level of operations.
Management’s Discussion and Analysis of Financial Condition and Results of Operations addresses the financial condition of the Corporation as of December 31, 2014 compared with December 31, 2013 and the results of operations for each of the three years in the period ended December 31, 2014. This discussion should be read in conjunction with the consolidated financial statements and related notes and the other information contained in this report.
Certain statements in this document are “forward-looking statements” as that term is defined in the Private Securities Litigation Reform Act of 1995 (PSLRA). These forward-looking statements are made pursuant to the safe harbor provisions of the PSLRA and include statements regarding our loss reserve and reinsurance recoverable estimates; asbestos and toxic waste liabilities and related developments; the impact of the economy on our business; the impact of changes to our reinsurance program in 2014 and the cost of, and market for, reinsurance in 2015; the adequacy of the rates at which we renewed and wrote new business; market conditions affecting us and our competitors in 2015, including premium volume, rate trends, pricing and competition; property and casualty investment income during 2015; cash flows generated by our investments; currency rate fluctuations; the repurchase of common stock under our share repurchase program; our capital adequacy and funding of liquidity needs; the funding and timing of loss payments; and the redemption of our capital securities. Forward-looking statements frequently can be identified by words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “will,” “may,” “should,” “could,” “would,” “likely,” “estimate,” “predict,” “potential,” “continue,” or other similar expressions. Forward-looking statements are made based upon management’s current expectations and beliefs concerning trends and future developments and their potential effects on us. These statements are not guarantees of future performance. Actual results may differ materially from those suggested by forward-looking statements as a result of risks and uncertainties, which include, among others, those discussed or identified from time to time in our public filings with the Securities and Exchange Commission and those associated with:
the occurrence of terrorist attacks, including any nuclear, biological, chemical or radiological events;
the occurrence of significant weather-related or other natural or human-made disasters, particularly in locations where we have concentrations of risk or changes to our estimates (or the assessments of rating agencies and other third parties) of our potential exposure to such events;
opportunities to profitably grow our property and casualty insurance business; and
Operating income was $1.9 billion in 2014, $2.1 billion in 2013 and $1.4 billion in 2012. The lower operating income in 2014 compared with 2013 was due primarily to lower underwriting income in our property and casualty insurance business and, to a lesser extent, a decrease in property and casualty investment income. The higher operating income in 2013 compared with 2012 was due to substantially higher underwriting income in our property and casualty insurance business, offset in part by a decrease in property and casualty investment income. Management uses operating income, a non-GAAP financial measure, among other measures, to evaluate its performance because the realization of investment gains and losses in any period could be discretionary as to timing and can fluctuate significantly, which could distort the analysis of operating trends.
Underwriting results were profitable in each of the past three years, but less so in 2012. The combined loss and expense ratio was 88.3% in 2014, 86.1% in 2013 and 95.3% in 2012. The 2.2 percentage point increase in the combined loss and expense ratio in 2014 compared with 2013 was due primarily to a higher current accident year loss ratio excluding catastrophes. The 9.2 percentage point decrease in the combined loss and expense ratio in 2013 compared with 2012 was due primarily to a substantially lower impact of catastrophes and a lower current accident year loss ratio excluding catastrophes. The impact of catastrophes accounted for 3.6 percentage points of the combined ratio in 2014 compared with 3.4 percentage points in 2013 and 9.6 percentage points in 2012.
During 2014, 2013 and 2012, we experienced overall favorable development of $636 million, $712 million and $614 million, respectively, on loss reserves established as of the previous year end. In each year we experienced favorable prior year loss development in each segment of our insurance business.
Property and casualty investment income before taxes decreased by 4% in 2014 compared with 2013 and decreased by 6% in 2013 compared with 2012. Property and casualty investment income after tax decreased by 4% in 2014 and 5% in 2013 compared with the respective prior year. The decreases were primarily due to a decline in the average yield on our investment portfolio. Management uses property and casualty investment income after tax, a non-GAAP financial measure, to evaluate its investment results because it reflects the impact of any change in the proportion of tax exempt investment income to total investment income and is therefore more meaningful for analysis purposes than investment income before income tax.
Net realized investment gains before tax were $369 million ($242 million after tax) in 2014 compared with $402 million ($261 million after tax) in 2013 and $193 million ($125 million after tax) in 2012. The net realized investment gains in 2014 were primarily related to investments in limited partnerships, sales of equity securities and, to a lesser extent, sales of fixed maturities. In 2013, net realized investment gains included the recognition of a gain in connection with the business combination of an issuer in which we held equity securities and warrants. The remaining net realized gains in 2013 were primarily related to investments in limited partnerships and sales of equity securities. The net realized gains in 2012 were primarily related to sales of fixed maturities and investments in limited partnerships.
We evaluate the underwriting results of our property and casualty insurance business in the aggregate and for each of our business units.
* The change in net premiums written is not presented for this business unit since it is in runoff.
Net premiums written in the United States grew in each segment of our insurance business in 2014, with the most significant growth occurring in our personal insurance segment. Net premiums written in the United States increased to a lesser extent in our commercial insurance segment and our specialty insurance segment, of which the predominant component is our professional liability business. Growth in our personal insurance segment was attributable to higher rates upon renewal, higher insured exposures, strong retention of existing business, and new business. Growth in our commercial insurance segment and our professional liability business reflected renewal rate increases, increased retention of existing business, as well as new business.
retention of existing business, and new business. Growth in our commercial insurance segment and our professional liability business, while reflecting higher rates and strong retention, was constrained by our underwriting actions and judicious approach to new business.
Average renewal rates in 2014 and 2013 in the United States were up in both our commercial insurance segment and professional liability business compared with expiring rates, but more significantly in 2013. The amounts of coverage purchased or the insured exposures were down slightly in the United States in both of these components of our business in both 2014 and 2013 compared with the respective prior year. We continued to retain a high percentage of our existing commercial insurance and professional liability business in the United States in both years. Renewal retention levels in our commercial insurance segment were modestly higher in 2014 compared with those in 2013, which were similar to the levels in 2012. Renewal retention levels in our professional liability business were modestly higher in 2014 compared with 2013, which in turn were slightly higher than those in 2012. As portions of our business have approached rate adequacy due to pricing and underwriting actions over the past several years, the level of rate increases has moderated and we have achieved higher retention levels. The level of new business was up significantly in our commercial insurance segment in 2014 after declining slightly in 2013 compared with the respective prior year. New business in our professional liability business increased in 2014 compared with 2013, which in turn was higher than 2012.
For several years, a positive pricing environment for most of our commercial and professional liability insurance products sold in the United States has supported our efforts to increase rates in order to maintain or improve profitability in these classes of business. We expect positive pricing to continue into 2015 in the United States. However, we expect that the average rate increases we achieve in 2015 in our commercial and professional liability classes will be at lower levels than the rate increases we achieved in 2014. Portions of our business have approached rate adequacy and the competitive market for these products is expected to continue to exert downward pressure on rates. In our personal insurance business in the United States we also expect rates to increase overall in 2015, but at lower levels than those achieved in 2014. Outside the United States, weak economic conditions have placed downward pressure on the pricing environment for several years. We expect that the overall rate environment outside the United States will be similar in 2015 compared to 2014 with rates remaining near flat. During 2014, the U.S. dollar strengthened against the currencies used in many locations outside the United States in which we transact business. The effect of a stronger U.S. dollar in 2015 compared to 2014 could result in lower premiums written when foreign currency denominated premium amounts are expressed in U.S. currency. We expect that our overall net premiums written in 2015 will be slightly to modestly higher compared with 2014, assuming average foreign currency to U.S. dollar exchange rates in 2015 remain similar to 2014 year-end levels.
For property risks in the United States and Canada we purchase traditional catastrophe reinsurance, including our primary treaty, which we refer to as the North American catastrophe treaty, as well as supplemental catastrophe reinsurance that provides additional coverage for our exposures in the northeast United States. For certain exposures in the United States, we have also arranged for the purchase of multi-year, collateralized reinsurance funded through the issuance of collateralized risk-linked securities, known as catastrophe bonds. For events outside the United States, we also purchase traditional catastrophe reinsurance.
The catastrophe bond arrangements provide reinsurance coverage for specific types of losses in specific geographic locations. They are generally designed to supplement coverage provided under the North American catastrophe treaty. A $225 million catastrophe bond arrangement that we had in place expired in March 2014. We currently have three catastrophe bond arrangements in effect that expire between 2015 and 2018. We have a $250 million reinsurance arrangement that expires in March 2015 and a $270 million reinsurance arrangement that incepted in March 2014 and expires in March 2018. Both of these catastrophe bond arrangements provide coverage for our exposure to homeowners and commercial losses related to certain perils, including hurricanes, earthquakes, severe thunderstorms and winter storms in twelve states in the northeast United States and the District of Columbia. The $270 million reinsurance arrangement provides similar coverage for named storms in addition to hurricanes. We also have a $150 million reinsurance arrangement that expires in March 2016 that provides coverage for our exposure to homeowners-related hurricane and severe thunderstorm losses in eight states along the southern U.S. coastline.
For the indicated catastrophic events in the northeast United States, the combination of the North American catastrophe treaty, the supplemental catastrophe reinsurance, and the $250 million and $270 million catastrophe bond arrangements provides additional coverage of approximately 63% of losses (net of recoveries from other available reinsurance) between $1.75 billion and $3.65 billion.
Our primary property catastrophe treaty for events outside the United States, including Canada, provides coverage of approximately 75% of losses (net of recoveries from other available reinsurance) between $100 million and $350 million. For catastrophic events in Australia and Canada, additional reinsurance provides coverage of 80% of losses (net of recoveries from other available reinsurance) between $350 million and $475 million.
Our commercial property per risk treaty provides coverage for property exposures both inside and outside the United States. Depending upon the currency in which the covered insurance policy was issued, the treaty provides coverage per risk of approximately $510 million to $750 million in excess of our initial retention, which is generally between $20 million and $30 million.
As a result of lower renewal rates compared to expiring rates associated with the North American catastrophe treaty, the primary property catastrophe treaty that covers events outside the United States, the commercial property per risk treaty and the supplemental catastrophe reinsurance, as well as the lower rates associated with the $270 million catastrophe bond compared to those of the expiring bond, the overall cost of our property reinsurance program was lower in 2014 than in 2013. We do not expect the changes we made to our property reinsurance program during 2014 to have a material effect on the Corporation’s results of operations, financial condition or liquidity.
The combined loss and expense ratio (or combined ratio), expressed as a percentage, is the key measure of underwriting profitability traditionally used in the property and casualty insurance business. Management evaluates the performance of our underwriting operations and of each of our business units using, among other measures, the combined loss and expense ratio calculated in accordance with U.S. statutory accounting principles. It is the sum of the ratio of losses and loss expenses to premiums earned (loss ratio) and the ratio of statutory underwriting expenses to premiums written (expense ratio) after reducing both premium amounts by dividends to policyholders. When the combined ratio is under 100%, underwriting results are generally considered profitable; when the combined ratio is over 100%, underwriting results are generally considered unprofitable.
The only reinsurance recoverable we had from our primary catastrophe reinsurance treaties during the three year period ended December 31, 2014 was that related to Storm Sandy because there was no other individual catastrophe event for which our losses exceeded our initial retention under the treaties.
Net premiums written in our personal insurance segment, which represented 36% of our net premiums written in 2014, increased by 4% in 2014 and 5% in 2013 compared with the respective prior year. Net premiums written for the classes of business within the personal insurance segment were as follows:
respective prior year, reflecting the negative effect of foreign currency translation. Growth both inside and outside the United States in both years reflected higher renewal rates as well as increases in coverage on existing policies. Premiums for our other personal business, which includes accident and health, excess liability and yacht coverages, increased in 2014 and 2013 compared with the respective prior year, driven by growth in the accident and health and the excess liability components of this business. Growth in our accident and health business was higher in 2014 than in 2013. In both years, premiums for our accident and health business increased significantly in the United States, due primarily to new business, but decreased outside the United States. In our excess liability business, which is predominantly written in the United States, growth was also higher in 2014 than in 2013.
Our personal insurance segment produced profitable underwriting results in each of the past three years. The combined loss and expense ratios for the classes of business within the personal insurance segment were as follows:
Our personal automobile results were profitable in each of the past three years, although less so in each successive year. The 2.0 percentage point increase in the combined ratio in 2014 compared with 2013 was driven mainly by less profitable results in the United States. The 1.4 percentage point increase in the combined ratio in 2013 compared with 2012 was driven by less profitable results outside the United States. Results in all three years benefited from moderate claim frequency and favorable prior year loss development, although favorable prior year loss development was less significant in 2014.
Homeowners results were profitable in each of the past three years. The combined ratio was 6.0 percentage points higher in 2014 compared with 2013, which in turn was 11.9 percentage points lower compared with 2012. The higher combined ratio in 2014 compared with 2013 was due primarily to a higher current accident year loss ratio excluding catastrophes, driven by an increase in fire losses and non-catastrophe weather-related losses. The lower combined ratio in 2013 compared with 2012 was due in large part to a lower impact from catastrophes and, to a lesser extent, a lower current accident year loss ratio excluding catastrophes. The impact of catastrophes accounted for 8.9 percentage points of the combined loss and expense ratio for this class in 2014 compared with 11.5 percentage points in 2013 and 21.0 percentage points in 2012.
Net premiums written in our commercial insurance segment, which represented 43% of our net premiums written in 2014, increased by 2% in both 2014 and 2013 compared with the respective prior year. Net premiums written for the classes of business within the commercial insurance segment were as follows:
Growth in net premiums written in our commercial insurance segment in 2014 occurred both inside and outside the United States, while in 2013 growth was driven by an increase in net premiums written in the United States. Net premiums written outside the United States were flat in 2013 compared with 2012. Premium growth in our commercial insurance segment in both years reflected higher rates, particularly in the United States. Premium growth in 2014 also reflected an increase in new business. In both 2014 and 2013, premium growth in our commercial insurance segment was constrained by lower renewal exposure and our continued efforts to secure adequate rates on renewal business in a market that remained competitive. In 2013, premium growth in most classes of business was also limited by a market that offered only limited attractive new business opportunities. In both 2014 and 2013, the most significant growth occurred in the workers’ compensation class, reflecting high retention, new business, as well as renewal rate increases. During each of the past three years, the overall rate environment in the commercial insurance market in the United States was positive. Average renewal rates in the United States were up in both 2014 and 2013 compared with expiring rates, but the level of increase was lower in 2014 than in 2013. Increases occurred in both years in all major classes of this business. Average renewal rates outside the United States also increased compared with expiring rates in both 2014 and 2013, but the level of increase was lower than the level achieved in the United States. Retention levels of our existing policyholders both inside and outside the United States were strong in each of the past three years. The average renewal exposure was down slightly in both 2014 and 2013, both inside and outside the United States. The amount of new business increased significantly in 2014 compared with 2013, both inside and outside the United States, as a result of more opportunities to write new business at appropriate rates. The amount of new business decreased slightly in 2013 compared with 2012 in the United States, due to our focus on obtaining adequate rates in the competitive market, but increased slightly outside the United States.
Multiple peril results were profitable in each of the past three years, but more so in 2014 and 2013. The 4.3 percentage point increase in the combined ratio in 2014 compared with 2013 was due to less profitable results in the property component of this business, reflecting a higher loss ratio excluding catastrophes. The 10.4 percentage point decrease in the combined ratio in 2013 compared with 2012 was due primarily to a lower impact of catastrophes in the property component of this business. Results for the liability component were profitable in each of the past three years, benefiting in each year from favorable prior year loss development. The impact of catastrophes accounted for 4.9 percentage points of the combined loss and expense ratio for the multiple peril class in 2014 compared with 3.3 percentage points in 2013 and 10.9 percentage points in 2012.
The increase in net premiums written for our professional liability business in 2014 was driven by growth in the United States. Net premiums written outside the United States in our professional liability business decreased slightly in 2014, due to the negative effect of foreign currency translation. In 2013, net premiums written increased modestly both inside and outside the United States. Premium growth in both years included the modestly positive effect of our decision not to renew a reinsurance program, which expired July 1, 2013, that provided coverage for a portion of our professional liability business. Premium growth in our professional liability business in both years reflected our focus on profitability in the pricing of renewal policies and new business, in what has remained a competitive market place. Nevertheless, the overall rate environment was positive in both 2014 and 2013, particularly in the United States. Retention levels for this business remained strong. Retention levels in the United States were higher in 2014 compared with those in 2013 and 2012. Retention levels outside the United States were similar in 2014 and 2013 following a modest increase in 2013 compared to 2012. New business in the United States increased in both 2014 and 2013 compared with the respective prior year. New business outside the United States also increased in 2014 following a decline in 2013. The increase in new business in 2014 reflected opportunities to write suitably-priced business in select classes due to the positive pricing trends in the market over the past few years. Renewal retention levels and new business volume in 2013 and 2012 reflected the selective reduction of our exposure in some customer segments where rate levels were not attractive. Average renewal rates for our professional liability business in the United States were up in both 2014 and 2013 compared with expiring rates, but the level of increase was less in 2014 than in 2013. Rate increases occurred in most classes of this business in both years. Average renewal rates outside the United States were flat in 2014 and up slightly in 2013 compared with expiring rates. The amounts of insured exposures in the United States were down slightly in both 2014 and 2013 compared with the respective prior year. Such amounts outside the United States were down in both years, but more so in 2013.
Net premiums written for our surety business decreased in 2014 and increased in 2013 compared with the respective prior year. Premiums written in our surety business depend significantly on the extent to which our existing customers are awarded contracts to perform services. As a result, premium growth in our surety business can often vary from year to year. In 2014, net premiums written decreased both inside and outside the United States, reflecting a reduction in the volume of large premium transactions compared with 2013. Premiums written outside the United States in 2014 also reflected the negative effect of foreign currency translation. In 2013, net premiums written increased both inside and outside the United States. The growth in net premiums written outside the United States in 2013 was driven by growth in Latin America.
Our specialty insurance segment produced profitable underwriting results in each of the past three years, more so in each successive year. The combined loss and expense ratios for the classes of business within the specialty insurance segment were as follows:
Our professional liability business produced profitable results in each of the past three years, more so in each successive year. The combined loss and expense ratio for this business decreased by 7.1 and 7.4 percentage points in 2014 and 2013, respectively, compared to the respective prior year. The lower combined ratio in 2014 compared with 2013 was due to a higher amount of favorable prior year loss development and, to a lesser extent, a lower current accident year combined ratio. The lower combined ratio in 2013 compared with 2012 was due to a lower current accident year combined ratio and, to a lesser extent, a higher amount of favorable prior year loss development. The lower current accident year combined ratio in 2014 and 2013 compared with the respective prior year reflected both higher premium rates and positive underwriting actions taken to improve the profitability of this business. The current accident year combined ratio in 2012 reflected adverse loss trends in certain classes within this component of our business. The favorable prior year loss development over the past three years was driven by positive loss experience, primarily related to accident years 2010 and prior. The fiduciary liability class produced highly profitable results in each of the past three years. Results for the directors and officers liability class were also highly profitable in all three years, more so in each successive year. Results for both the fiduciary liability and directors and officers liability classes reflected favorable prior year loss development in each of the past three years. For the fidelity class, results were profitable in 2014, breakeven in 2013 and unprofitable in 2012. Results for this class include loss activity resulting from alleged third party and insured-employee criminal activity, which included several large losses in recent years. Results for the employment practices liability class were unprofitable in each of the past three years, but much less so in 2014. Results in 2013 and 2012 were adversely impacted by unfavorable prior year loss development. Employment practices liability claims have been more numerous and protracted in recent years due primarily to the lingering effect of the economic downturn and resulting unemployment levels. Our errors and omissions liability class produced unprofitable results in each of the past three years, but much less so in 2014. Results in 2013 and 2012 reflected unfavorable prior year loss development, mostly outside the United States.
Our surety business produced profitable results in each of the past three years due to favorable loss experience. The combined loss and expense ratio was 20.1 percentage points higher in 2014 compared with 2013, which in turn was 4.2 percentage points lower compared with 2012. The higher combined ratio in 2014 compared to 2013 and 2012 was due to one large loss outside the United States. Our surety business tends to be characterized by losses that are infrequent but have the potential to be highly severe. When losses occur, they are sometimes mitigated by recovery rights to the customer’s assets, contract payments, collateral and bankruptcy recoveries.
The majority of our surety obligations are intended to be performance-based guarantees. We manage our exposure by individual account and by specific bond type. We have substantial commercial and construction surety exposure for current and prior customers, including exposures related to surety bonds issued on behalf of companies that have experienced deterioration in creditworthiness since we issued bonds to them. We therefore may experience an increase in filed claims and may incur high severity losses, especially in periods of weak economic conditions. Such losses would be recognized if and when claims are filed and determined to be valid, and could have a material adverse effect on the Corporation’s results of operations.
The extent of losses from a natural catastrophe is a function of both the total amount of insured exposure in an area affected by the event and the severity of the event. We regularly assess our concentrations of risk in natural catastrophe exposed areas globally and have strategies and underwriting standards to manage these exposures through individual risk selection, subject to regulatory constraints, and through the purchase of catastrophe reinsurance coverage. We use catastrophe modeling and a risk concentration management tool to monitor and control our accumulations of potential losses in natural catastrophe exposed areas in the United States, such as California and the gulf and east coasts, as well as in natural catastrophe exposed areas in other countries. The information provided by the catastrophe modeling and the risk concentration management tool has resulted in our non-renewing or reducing our exposure on some accounts and refraining from writing others.
We will continue to manage this type of catastrophic risk by monitoring terrorism risk aggregations. If TRIA is not extended beyond its current December 31, 2020 termination date and a robust reinsurance market for terrorism risks does not develop so we can continue to mitigate our exposure to a large scale terrorism attack, we may not renew or we may reduce our exposure on some policies in some locations and we may curtail new business writing in some major U.S. cities and other geographic areas where our exposure aggregations could become unacceptable. Given the unpredictability of potential targets, the frequency and severity of potential terrorist events, and notwithstanding the measures we have taken or may take to mitigate terrorism exposure as well as the programs that governmental entities provide, however limited, to cover some of that exposure, the occurrence of a terrorist event could have a material adverse effect on the Corporation’s results of operations, financial condition or liquidity.
Unpaid losses and loss expenses, also referred to as loss reserves, are the largest liability of our property and casualty insurance subsidiaries.
Total gross loss reserves related to our insurance business decreased by $409 million in 2014, driven by significant decreases in gross case and IBNR reserves in the professional liability classes reflecting paid claim activity, favorable prior year loss development and reduced exposures. A significant decrease in gross loss reserves also occurred in the property and marine class of business, driven mainly by a decrease in case reserves, due in large part to the continuing resolution and payment of claims related to Storm Sandy. The most significant increases in gross loss reserves occurred in the workers’ compensation class, mainly due to increased exposures. Reinsurance recoverable related to our insurance business decreased by $141 million in 2014, with the largest decreases occurring in the property and marine class of business due in large part to recoveries received from reinsurers related to Storm Sandy, and in the professional liability classes of business, driven by recoveries from reinsurers.
In establishing the loss reserves of our property and casualty subsidiaries, we consider facts currently known and the present state of the law and coverage litigation. Based on all information currently available, we believe that the aggregate net loss reserves at December 31, 2014 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. It is therefore possible that management’s estimate of the ultimate liability for losses that had occurred as of December 31, 2014 may change, which could have a material effect on the Corporation’s results of operations and financial condition.
Liability claims are also more susceptible to litigation and can be significantly affected by changing contract interpretations and the legal and economic environment. Consequently, the estimation of loss reserves for these classes is more complex and typically subject to a higher degree of variability than for short tail classes. As a result, the role of judgment is much greater for these reserve estimates.
Expected loss ratio methods use loss ratios for prior accident years, adjusted to reflect our evaluation of recent loss trends, the current risk environment, changes in our book of business and changes in our pricing and underwriting, to determine the appropriate expected loss ratio for a given accident year. The expected loss ratio for each accident year is multiplied by the premiums earned for that year to calculate estimated ultimate losses.
Frequency/severity methods first project ultimate claim counts (using one or more of the other methods described above) and then multiply those counts by an estimated average claim cost to calculate estimated ultimate losses. The average claim costs are often estimated through a regression analysis of historical severity data. Generally, these methods work best for high frequency, low severity classes of business.
For certain long tail classes of business, however, anticipated loss experience is less predictable because of the small number of claims and erratic claim severity patterns. These classes include directors and officers liability, errors and omissions liability and commercial excess liability, among others. For these classes, the loss development factor methods may not produce a reliable estimate of ultimate losses in the most recent accident years since many claims either have not yet been reported to us or are only in the early stages of the settlement process. Therefore, the actuarial estimates for these accident years are based on less extrapolatory methods, such as expected loss ratio and Bornheutter-Ferguson methods. Over time, as a greater number of claims are reported and the statistical credibility of loss experience increases, loss development factor methods are given increasingly more weight.
Senior management meets with our actuaries each quarter to review the results of the latest loss reserve analysis. Based on this review, management determines the carried reserve for each class of business. In making the determination, management considers numerous factors, such as changes in actuarial indications in the period, the maturity of the accident year, trends observed over the recent past and the level of volatility within a particular class of business. In doing so, management must evaluate whether a change in the data represents credible actionable information or an anomaly. Such an assessment requires considerable judgment. Even if a change is determined to be permanent, it is not always possible to determine the extent of the change until sometime later. As a result, there can be a time lag between the emergence of a change and a determination that the change should be reflected in the carried loss reserves.
In addition, we must consider the uncertain effects of emerging or potential claims and coverage issues that arise as legal, judicial, economic and social conditions change. These issues have had, and may continue to have, a negative effect on our loss reserves by either extending coverage beyond the original underwriting intent or by increasing the number or size of claims. Examples of such issues include professional liability claims arising out of volatility in the financial markets, directors and officers liability and errors and omissions liability claims arising out of accounting and other corporate malfeasance, and exposure to claims asserted for bodily injury as a result of long term exposure to harmful products or substances. As a result of issues such as these, the uncertainties inherent in estimating ultimate claim costs on the basis of past experience have grown, further complicating the already complex loss reserving process.
The following discussion includes disclosure of possible variation from current estimates of loss reserves due to a change in certain key assumptions for particular classes of business. These impacts are estimated individually, without consideration for any correlation among such assumptions or among lines of business. Therefore, it would be inappropriate to take the amounts and add them together in an attempt to estimate volatility for our loss reserves in total. We believe that the estimated variation in reserves detailed below is a reasonable estimate of the possible variation that may occur in the future. However, if such variation did occur, it would likely occur over a period of several years and therefore its impact on the Corporation’s results of operations would occur over the same period. It is important to note, however, that there is the potential for future variation greater than the amounts discussed below.
Two of the larger components of our loss reserves relate to the professional liability classes other than fidelity and to the commercial excess liability class. The respective reported loss development patterns are key assumptions in estimating loss reserves for these classes of business, both as applied directly to more mature accident years and as applied indirectly (e.g., via Bornheutter-Ferguson methods) to less mature accident years.
Based on facts currently known and the present state of the law and coverage litigation, we believe that the loss reserves carried at December 31, 2014 for asbestos and toxic waste claims were adequate. However, given the inherent uncertainties, as well as the judicial decisions and legislative actions that have broadened the scope of coverage and expanded theories of liability in the past and the possibilities of similar interpretations in the future, it is possible that our estimate of loss reserves relating to these exposures may increase in future periods as new information becomes available and as claims develop.
New asbestos claims and new exposures on existing claims have continued despite the fact that usage of asbestos has declined since the mid-1970s. Many claimants were exposed to multiple asbestos products over an extended period of time. As a result, claim filings typically name dozens of defendants. The plaintiffs’ bar has solicited new claimants through extensive advertising and through asbestos medical screenings. A vast majority of asbestos bodily injury claims have been filed by claimants who do not show any signs of asbestos related disease. New asbestos cases are often filed in those jurisdictions with a reputation for judges and juries that are sympathetic to plaintiffs.
A number of jurisdictions have adopted venue reform that requires plaintiffs to have a connection to the jurisdiction in order to file a complaint, although in more recent years, this type of reform has slowed.
Asbestos claims against the major manufacturers, distributors or installers of asbestos products were typically presented under the products liability section of primary general liability policies as well as under excess liability policies, both of which typically had aggregate limits that capped an insurer’s exposure. In recent years, a number of asbestos claims by insureds are being presented as “non-products” claims. In these instances, claimants contend that they came into contact with asbestos at premises owned or operated by our insureds and/or were exposed to asbestos during asbestos installation at a particular location. These non-products claims are presented under the premises or operations section of primary general liability policies. Unlike products coverage, the premises or operations coverages in these older policies typically had no aggregate limits on coverage, creating potentially greater exposure. Further, in an effort to seek additional insurance coverage, some insureds with installation activities who have substantially eroded their products coverage are presenting new asbestos claims as non-products operations claims or attempting to reclassify previously settled products claims as non-products claims to restore a portion of previously exhausted products aggregate limits. It is difficult to predict whether insureds will be successful in asserting claims under non-products coverage or whether insurers will be successful in asserting additional defenses. Accordingly, the ultimate cost to insurers of the claims for coverage not subject to aggregate limits is uncertain.
In establishing our asbestos reserves, we evaluate the exposure presented by each insured. As part of this evaluation, we consider a variety of factors including: the available insurance coverage; limits and deductibles; the jurisdictions involved; the number of claimants; the disease mix exhibited by the claimants; the past settlement values of similar claims; the potential role of other insurance, particularly
underlying coverage below our excess liability policies; potential bankruptcy impact; relevant judicial interpretations; and applicable coverage defenses, including asbestos exclusions.
Our actuaries and claim personnel perform periodic analyses of our asbestos related exposures. The analyses performed in each of the past three years noted modest adverse developments mostly related to a small number of existing cases. The analyses also indicated a slower than expected decline in the number of insureds with first-time asbestos claim activity. Based on these developments, we increased our net loss reserves related to asbestos claims by $25 million in 2014, $51 million in 2013 and $28 million in 2012.
Most PRPs named to date are parties who have been generators, transporters, past or present landowners or past or present site operators. Most sites have multiple PRPs. These PRPs had proper government authorization in many instances. However, relative fault has not been a factor in establishing liability. While the volume of new claims is significantly reduced from the activity in the 1980s, PRPs continue to tender claims to insurers on newly identified hazardous waste sites. Insurance policies issued to PRPs were not intended to cover claims arising from gradual pollution. Since 1986, most policies have specifically excluded such exposures.
Our actuaries and claim personnel perform periodic analyses of our toxic waste exposures. In each of the past three years, the analyses of our toxic waste exposures indicated that some of our insureds had become responsible for the remediation of additional polluted sites and that, as cleanup standards continue to evolve as a result of technology advances, the estimated cost of remediation of certain sites had increased. Defense costs associated with some of these cases have also increased. Based on these developments, we increased our net loss reserves related to toxic waste claims by $75 million in 2014 and $55 million in both 2013 and 2012.
The overall prior year loss development by accident year was as follows:
The classes of business having the most significant impact on prior year loss development in 2014 were as follows:
We experienced favorable development of about $60 million in the aggregate in the personal and commercial property classes, with the most significant amounts related to the 2013 and 2012 accident years. The severity of late developing property claims that emerged during 2014 was lower than expected. Reserve estimates for these claims are based on an analysis of past loss experience on average over a period of years because the incidence of large property losses in any year is subject to a considerable element of fortuity. As a result, this lower emergence had only a modest effect on the determination of carried loss reserves for these classes at December 31, 2014.
We experienced favorable development of about $160 million in the aggregate in the personal and commercial liability classes. The most significant favorable development occurred in the excess liability classes, particularly in accident years 2010 and prior. There was some offsetting adverse development in other liability classes, most notably due to $106 million of incurred losses related to asbestos and toxic waste claims in older accident years. Overall, prior period liability claims were lower than expected, particularly the severity of such claims, and the effects of underwriting changes that affected these years have been more positive than expected.
We experienced favorable development of about $30 million in the surety business due to lower than expected loss emergence in recent accident years.
We experienced unfavorable development of about $60 million in the fidelity class due to higher than expected reported loss emergence, related mostly to accident years 2008 through 2010.
In Item 1 of this report, we present an analysis of our consolidated loss reserve development on a calendar year basis for each of the ten years prior to 2014. The variability in reserve development over the ten year period illustrates the uncertainty of the loss reserving process. Conditions and trends that have affected reserve development in the past will not necessarily recur in the future. It is not appropriate to extrapolate future favorable or unfavorable reserve development based on amounts experienced in prior years.
Our U.S. property and casualty insurance subsidiaries are required to file annual statements with insurance regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities. These annual statements include an analysis of loss reserves, referred to as Schedule P, that presents accident year loss development information for the nine years prior to 2014. It is our intention to post the Schedule P for our combined U.S. property and casualty insurance subsidiaries on our website as soon as it becomes available.
Property and casualty investment income before taxes decreased by 4% in 2014 compared with 2013 and decreased by 6% in 2013 compared with 2012. In 2014 and 2013, the decrease was primarily due to a decline in the average yield of our property and casualty subsidiaries’ investment portfolio, partially offset by the impact of an increase in our average invested assets. In both years, the decrease in the average yield on the investment portfolio primarily resulted from lower reinvestment yields on
securities that we purchased to replace fixed maturities that matured, were redeemed by the issuer or were sold during the year. While the property and casualty subsidiaries generated substantial operating cash flows during each of the past three years, average invested assets in the three years were impacted by substantial dividend distributions made by the property and casualty subsidiaries to Chubb during the period. As a result of the dividend distributions, our property and casualty subsidiaries held only a slightly higher amount of average invested assets in both years compared with the respective prior year.
The after-tax annualized yield on our property and casualty subsidiaries’ investment portfolio was 2.73% in 2014 compared with 2.88% in 2013 and 3.12% in 2012.
We expect that property and casualty investment income after taxes will decline in 2015 compared with 2014. The expected decline is primarily due to the decrease in the yield on our investment portfolio during 2014 as a result of investing available funds in securities with yields lower than the yields of the securities that matured or were sold in 2014. Assuming the average yield on fixed maturities available in the market in 2015 is similar to the year-end 2014 level, the decline in the yield on our investment portfolio is expected to continue in 2015 as the funds from securities that mature, are called or are redeemed are reinvested. The expected decline in property and casualty investment income after taxes in 2015 also reflects an assumption that average invested assets in 2015 will be similar to the level in 2014, based on our expectations of investable cash flows during the year. During 2014, the U.S. dollar strengthened against the major currencies in which investments we hold are denominated. If those exchange rates in 2015 remain at the same levels as at December 31, 2014, our investment income growth in 2015 would be adversely affected.
The net realized gains of equity securities and other invested assets in 2013 included $74 million and $10 million, respectively, related to the exchange of our holdings of common stock and warrants of Alterra Capital Holdings Limited for common stock of Markel Corporation and cash as a result of a business combination that took place during the second quarter of 2013.
The net realized gains of the limited partnerships reported in 2014 primarily reflected the positive performance of the global equity and high yield investment markets in the first six months of 2014 and the fourth quarter of 2013. The net realized gains of the limited partnerships reported in 2013 primarily reflected the positive performance of the global equity and high yield investment markets in the first and third quarters of 2013 and the fourth quarter of 2012. The net realized gains of the limited partnerships reported in 2012 primarily reflected the strong performance of the U.S. equity and high yield investment markets in the first and third quarters of 2012, partially offset by the negative performance of several non-U.S. equity markets, particularly in Asia, in the fourth quarter of 2011 and the global equity markets in the second quarter of 2012.
We regularly review invested assets that have a fair value less than cost to determine if an other-than-temporary decline in value has occurred. We have a monitoring process overseen by a committee of investment and accounting professionals that is responsible for identifying those securities to be specifically evaluated for a potential other-than-temporary impairment.
The determination of whether a decline in value of any investment is temporary or other than temporary requires the judgment of management. The assessment of other-than-temporary impairment of fixed maturities and equity securities is based on both quantitative criteria and qualitative
information. A number of factors are considered including, but not limited to, the length of time and the extent to which the fair value has been less than the cost, the financial condition and near term prospects of the issuer, whether the issuer is current on contractually obligated interest and principal payments, general market conditions and industry or sector specific factors. The decision to recognize a decline in the value of a security carried at fair value as other than temporary rather than temporary has no impact on shareholders’ equity.
Information related to investment securities in an unrealized loss position at December 31, 2014 and 2013 is included in Note (2)(b) of the Notes to Consolidated Financial Statements.
Capital resources provide protection for policyholders, furnish the financial strength to support the business of underwriting insurance risks and facilitate continued business growth. At December 31, 2014, the Corporation had shareholders’ equity of $16.3 billion and total debt of $3.3 billion.
On January 29, 2015, the Board of Directors authorized the repurchase of up to $1.3 billion of Chubb’s common stock. The authorization has no expiration date. We expect to complete the repurchase of shares under this authorization by the end of January 2016, subject to market conditions and other factors.
Our property and casualty operations provide liquidity in that insurance premiums are generally received months or even years before losses are paid under the policies purchased by such premiums. Cash receipts from operations, consisting of insurance premiums and investment income, provide funds to pay losses, operating expenses and dividends to Chubb. Cash receipts in excess of required cash outflows can be used to build the investment portfolio with the expectation of generating additional investment income in the future.
Chubb’s liquidity requirements primarily include the payment of dividends to shareholders and interest and principal on debt obligations. The declaration and payment of dividends to Chubb’s shareholders is at the discretion of Chubb’s Board of Directors and depends upon many factors, including our operating results, financial condition, capital requirements and any regulatory constraints.
As a holding company, Chubb’s ability to continue to pay dividends to shareholders and to satisfy its debt obligations relies on the availability of liquid assets, which is dependent in large part on the dividend paying ability of its property and casualty subsidiaries. The timing and amount of dividends paid by the property and casualty subsidiaries to Chubb may vary from year to year. In the United States, our property and casualty subsidiaries are subject to laws and regulations in the jurisdictions in which they operate that restrict the amount and timing of dividends they may pay within twelve consecutive months without the prior approval of regulatory authorities. The restrictions are generally based on net income and on certain levels of policyholders’ surplus as determined in accordance with statutory accounting principles. Dividends in excess of such thresholds are considered “extraordinary” and require prior regulatory approval.
During 2014, 2013 and 2012, the property and casualty subsidiaries paid dividends to Chubb of $2.0 billion, $1.6 billion and $1.8 billion, respectively, which were the maximum dividend distributions that these subsidiaries could have paid to Chubb during each year without prior regulatory approval.
The Corporation’s strong underwriting and investment results generated substantial positive operating cash flows of $2.2 billion, $1.7 billion and $2.3 billion in 2014, 2013 and 2012, respectively. In 2014, cash provided by operating activities increased approximately $420 million compared with 2013 primarily as a result of higher premium collections and lower tax payments. The lower tax payments in 2014 were attributable to lower taxable income compared with 2013. In 2013, cash provided by operating activities decreased approximately $570 million compared with 2012 primarily as a result of higher tax payments and higher loss payments, partially offset by modestly higher premium collections. The higher tax payments in 2013 were attributable to higher taxable income compared with 2012. The higher amount of loss payments in 2013 compared with 2012 reflected substantially higher catastrophe-related payments during the year, including payments related to Storm Sandy.
The following table provides our future payments due by period under contractual obligations as of December 31, 2014, aggregated by type of obligation.
(b) Includes agreements with vendors to purchase various goods and services such as information technology, human resources and administrative services.
Our investment portfolio primarily comprises high quality bonds, principally tax exempt securities, corporate bonds, U.S. Treasury securities and mortgage-backed securities, as well as foreign government and corporate bonds that support our operations outside the United States. The portfolio also includes equity securities, primarily publicly traded common stocks, and other invested assets, primarily private equity limited partnerships, all of which are held with the primary objective of capital appreciation.
During 2014, we increased our holdings of U.S. Treasury securities and tax exempt fixed maturities and we reduced our holdings of mortgage-backed securities and corporate bonds. During 2013 and 2012, we increased our holdings of corporate bonds and we reduced our holdings of tax exempt fixed maturities, mortgage-backed securities and private equity limited partnerships. Our objective is to achieve the appropriate mix of taxable and tax exempt securities in our portfolio to balance both investment and tax strategies. At December 31, 2014, 63% of our U.S. fixed maturity portfolio was invested in tax exempt securities compared with 62% and 65% at December 31, 2013 and December 31, 2012, respectively.
Changes in the general interest rate environment affect the returns available on new fixed maturities. While a rising interest rate environment enhances the returns available on new investments, it reduces the fair value of existing fixed maturities and thus the availability of gains on disposition. A decline in interest rates reduces the returns available on new investments but increases the fair value of existing investments, creating the opportunity for realized investment gains on disposition.
Fair values of financial instruments are determined by management using valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. Fair values are generally measured using quoted prices in active markets for identical assets or liabilities or other inputs, such as quoted prices for similar assets or liabilities, that are observable, either directly or indirectly. In those instances where observable inputs are not available, fair values are measured using unobservable inputs for the asset or liability. Unobservable inputs reflect our own assumptions about the assumptions that market participants would use in pricing the asset or liability and are developed based on the best information available in the circumstances. Fair value estimates derived from unobservable inputs are affected by the assumptions used, including the discount rates and the estimated amounts and timing of future cash flows. The derived fair value estimates cannot be substantiated by comparison to independent markets and are not necessarily indicative of the amounts that would be realized in a current market exchange.
Other inputs that are observable for the financial instrument, either directly or indirectly.
Fair values of equity securities are determined by management, utilizing quoted market prices.
At December 31, 2014 and 2013, a pricing service provided fair value amounts for approximately 99% of our fixed maturities. The prices we obtain from a pricing service and brokers generally are non-binding, but are reflective of current market transactions in the applicable financial instruments. At December 31, 2014 and 2013, we held an insignificant amount of financial instruments in our investment portfolio for which a lack of market liquidity impacted our determination of fair value.