The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to assist readers in understanding the consolidated results of operations and financial condition of The Hanover Insurance Group, Inc. and its subsidiaries (“THG”). Consolidated results of operations and financial condition are prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”). This discussion should be read in conjunction with the Consolidated Financial Statements and related footnotes included elsewhere herein.
Results of operations include the accounts of The Hanover Insurance Company (“Hanover Insurance”) and Citizens Insurance Company of America (“Citizens”), our principal U.S. domiciled property and casualty companies; Chaucer Holdings Limited (“Chaucer”), our United Kingdom (“U.K.”) domiciled specialist insurance underwriting group which operates through the Society and Corporation of Lloyd’s (“Lloyd’s”); and other insurance and non-insurance subsidiaries. Results of operations include our discontinued operations, consisting primarily of our accident and health and former life insurance businesses.
Operating income before interest expense and income taxes was $336.3 million in 2017 compared to $322.8 million in 2016, an increase of $13.5 million. This increase is primarily due to year-over-year changes in development on prior years’ loss and LAE reserves (“prior years’ loss reserves”). Favorable development on prior years’ loss reserves was $32.9 million in 2017, compared to unfavorable development of $140.3 million in 2016. In 2016, we recognized a reserve charge of $174.1 million following our 2016 fourth quarter reserve review. In addition, the increase in operating income before interest expense and income taxes reflects improved current accident year underwriting results and higher net investment income, partially offset by higher catastrophe losses. Pre-tax catastrophe losses were $382.6 million in 2017, compared to $125.1 million during 2016. This $257.5 million increase in catastrophe losses is primarily due to hurricanes Harvey, Irma and Maria that occurred in the third quarter of 2017, the California wildfires that occurred in the fourth quarter of 2017, and a Midwest wind event that occurred in the first quarter of 2017.
We believe our approach to the small commercial market, distinctiveness in the middle market, and continued development of specialty lines provides us with a diversified portfolio of products and delivers significant value to agents and policyholders. Each of these businesses is expected to contribute to premium growth in Commercial Lines over the next several years as we continue to pursue our core strategy of developing strong partnerships with agents, enhanced franchise value through limited distribution, distinctive products and coverages, and continued investment in industry segmentation.
We believe these efforts have driven, and will continue to drive, improvement in our overall mix of business and our underwriting profitability. Commercial Lines net premiums written grew by 4.3% in 2017, driven by both our small commercial business and the professional lines within our specialty business. This was due to rate and exposure increases, strong retention and targeted new business expansion, collectively generating growth of 4.9%, partially offset by the impact of higher reinsurance reinstatement premiums driven by large property loss activity.
quarter of 2017, the California wildfires that occurred in the fourth quarter of 2017 and a large Midwest hail event that occurred in the second quarter of 2017. The competitive nature of the Commercial Lines market requires us to be highly disciplined in our underwriting process to ensure that we write business at acceptable margins, and we continue to seek rate increases across our lines of business.
Net premiums written grew by 8.3% in 2017, primarily due to higher renewal premium driven by rate increases and improved retention, as well as new business growth. Underwriting results declined in 2017, as compared to 2016, primarily due to higher catastrophe losses, partially offset by earned premium growth. We continue to seek rate increases to meet or exceed underlying loss cost trends, subject to regulatory and competitive considerations.
Chaucer deploys specialist underwriters in over 30 major insurance and reinsurance classes, including marine, aviation and political, casualty, energy, and property coverages, written on a direct, facultative and treaty basis. 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. Our underwriting strength, diverse portfolio and Lloyd’s membership underpin our ability to actively manage the scale, composition and profitable development of this business. In addition, following the recent authorization of Chaucer Dublin, Chaucer has begun to write business through the company market, offering clients greater platform choice and flexibility and supporting Chaucer’s international development.
We report interest expense on debt separately from the earnings of our operating segments. This consists of interest on our senior debentures, subordinated debentures, collateralized borrowings with the Federal Home Loan Bank of Boston (“FHLBB”), and letter of credit facility.
Consolidated net income was $186.2 million in 2017, compared to $155.1 million in 2016, an increase of $31.1 million. Operating income was $203.8 million in 2017 compared to $184.4 million in 2016. This $19.4 million increase in operating income is primarily attributable to the year-over-year changes in development on prior years’ loss reserves. Favorable development on prior years’ loss reserves was $32.9 million in 2017 compared to unfavorable development in 2016 of $140.3 million. Additionally, 2017 benefitted from improved current accident year underwriting results and higher investment income. These increases were partially offset by a $257.5 million increase in current year catastrophe losses. The year over year comparison of consolidated net income was also affected by a $57.4 million net loss associated with the repayment of debt in 2016 that did not recur in 2017. These increases in net income were partially offset by $22.3 million of expenses related to the enactment of the Tax Cuts and Jobs Act in 2017, as well as increases of $15.8 million of after-tax losses from discontinued operations, primarily due to an increase in our long-term care pool reserves.
Consolidated net income was $155.1 million in 2016, compared to $331.5 million in 2015. The decrease of $176.4 million is primarily due to lower operating income of $95.6 million, principally from $140.3 million of unfavorable development on prior years’ loss reserves, or approximately 2% of total net reserves, partially offset by lower catastrophe losses and current accident year losses. Consolidated net income for the year ended December 31, 2016 also included net losses from the repayment of debt of $57.4 million, net of tax, compared to $15.7 million, net of tax, for the year ended December 31, 2015. Additionally, the year ended December 31, 2015, included after-tax gains of $40.6 million from the disposal of the U.K. motor business.
In addition to consolidated net income, discussed above, we assess our financial performance based upon pre-tax “operating income,” and we assess the operating performance of each of our four operating segments based upon the pre-tax operating income (loss) generated by each segment. As reflected in the table above, operating income before taxes excludes interest expense on debt and certain other items which we believe are not indicative of our core operations, such as net realized investment gains and losses. Such
Catastrophe losses and prior years’ reserve development are significant components in understanding and assessing the financial performance of our business. Management reviews and evaluates catastrophes and prior years’ reserve development separately from the other components of earnings. References to “current accident year underwriting results” exclude catastrophes and prior accident year reserve development. Catastrophes and prior years’ reserve development are not predictable as to timing or the amount that will affect the results of our operations and have an effect on each year’s operating and net income. Management believes that providing certain financial metrics and trends excluding the effects of catastrophes and prior years’ reserve development helps investors to understand the variability in periodic earnings and to evaluate the underlying performance of our operations. Discussion of catastrophe losses in this Management’s Discussion and Analysis of Financial Condition and Results of Operations includes development on prior years’ catastrophe reserves and, unless otherwise indicated, such development is excluded from discussions on prior year loss and LAE reserve development.
Operating income before interest expense and income taxes was $336.3 million for the year ended December 31, 2017, compared to $322.8 million for the year ended December 31, 2016, an increase of $13.5 million. This increase was primarily due to changes in prior years’ loss reserve development, lower current accident year losses, lower expenses and higher net investment income, partially offset by higher catastrophe losses. Favorable development on prior years’ loss reserves was $32.9 million for the year ended December 31, 2017, compared to unfavorable development of $140.3 million for the year ended December 31, 2016, a favorable change of $173.2 million, which included a reserve charge of $174.1 million following the 2016 fourth quarter reserve review. Catastrophe-related activity for the year ended December 31, 2017 was $382.6 million, compared to $125.1 million for the year ended December 31, 2016, an increase of $257.5 million.
The following table summarizes GAAP underwriting results for the Commercial Lines, Personal Lines, Chaucer and Other segments and reconciles them to operating income (loss) before interest expense and income taxes.
Commercial Lines current accident year underwriting profit, excluding catastrophes, was $173.9 million for the year ended December 31, 2017, compared to $171.1 million for the year ended December 31, 2016. This $2.8 million improvement was primarily due to lower losses in our workers’ compensation line, lower expenses and premium growth, partially offset by higher large losses and reinstatement premiums in our commercial multiple peril and inland marine lines. The impact of additional reinstatement premiums, net of ceding commissions, decreased current accident year underwriting profit by $12.0 million.
We are continuing our efforts to improve underwriting results through increased rates, pricing segmentation, specific underwriting actions and targeted new business growth. Our ability to achieve overall rate increases is affected by the current competitive pricing environment, particularly for larger middle market accounts, which may hamper our ability to grow in this portion of our business.
Chaucer’s net premiums written were $849.1 million for the year ended December 31, 2017, compared to $816.1 million for the year ended December 31, 2016, an increase of $33.0 million, or 4.0%, due to new business growth in our treaty, property and casualty lines, partially offset by a planned increase in ceded reinsurance premiums. An RITC transaction occurred in the first quarter of 2016 that had no impact on net income. The RITC transaction resulted in additional assumed premiums and loss and LAE reserves of $17.7
We continue to experience significant competition across the international insurance industry, with current pricing conditions in all markets being affected by high industry capacity and competition. Also, losses in many of our product lines are inherently volatile as the underwriting loss for the most recent year illustrates. Following recent industry losses, market prices may increase in selected classes, affecting both the lines of business we write, as well as the cost of reinsurance we purchase.
Commercial Lines underwriting loss for the year ended December 31, 2016 was $122.0 million, compared to $12.7 million for the year ended December 31, 2015, a change of $109.3 million. Unfavorable development on prior years’ loss reserves for the year ended December 31, 2016 was $223.0 million, compared to $45.2 million for the year ended December 31, 2015, an unfavorable change of $177.8 million, primarily due to higher than expected losses in other commercial lines of $168.0 million, which includes our AIX program business of $75.3 million. This was principally driven by losses in accident years 2014 and prior, primarily from programs which have since been terminated, as well as higher than expected losses in our general liability lines of $56.0 million, and higher than expected losses in surety lines of $35.3 million. We also experienced unfavorable prior year development in our commercial multiple peril line of $74.2 million and in our commercial automobile line of $27.5 million. These items were partially offset by favorable prior year development in our workers’ compensation line of $46.7 million. Catastrophe-related losses decreased for the year ended December 31, 2016 at $70.1 million, compared to $88.7 million for the year ended December 31, 2015.
Personal Lines net premiums written were $1,521.2 million for the year ended December 31, 2016, compared to $1,445.6 million for the year ended December 31, 2015, an increase of $75.6 million. This was primarily due to increased rates in both the personal automobile and homeowners lines of business, as well as improved new business trends and higher retention.
Net premiums written in the personal automobile line of business for the year ended December 31, 2016 were $953.6 million, compared to $900.0 million for the year ended December 31, 2015, an increase of $53.6 million. This increase was primarily due to rate increases, as well as an increase in policies in force of 1.4%. Net premiums written in the homeowners line of business for the year ended December 31, 2016 were $529.7 million, compared to $507.4 million for the year ended December 31, 2015, an increase of $22.3 million. This was attributable to rate increases, as well as an increase in policies in force of 1.8%.
Chaucer’s underwriting profit for the year ended December 31, 2016 was $80.3 million, compared to $131.5 million for the year ended December 31, 2015, a decrease of $51.2 million. This decrease was primarily due to higher current accident year losses, lower favorable prior year reserve development and higher expenses, partially offset by lower catastrophe losses. Favorable development on prior years’ loss reserves for the year ended December 31, 2016 was $95.3 million, compared to $120.1 million for the year ended December 31, 2015, a decrease of $24.8 million, including the effect of foreign exchange fluctuations (see “Foreign Exchange” section below for further discussion). Catastrophe losses for the year ended December 31, 2016 were $8.0 million, compared to $16.8 million for the year ended December 31, 2015, a decrease of $8.8 million.
Chaucer’s current accident year underwriting loss, excluding catastrophes, was $7.0 million in the year ended December 31, 2016, compared to an underwriting profit of $28.2 million for the year ended December 31, 2015. This $35.2 million change was primarily due to higher large losses in the marine line, including trade credit coverages related to poor market conditions and underlying commodity price-sensitive accounts, and an increased frequency of losses in our property line, partially offset by lower large losses in the energy line.
During 2017, foreign exchange losses reduced pre-tax operating income by approximately $3 million compared to a foreign exchange loss on pre-tax operating income of approximately $22 million in 2016 and a foreign exchange gain on pre-tax operating income of approximately $12 million in 2015. These items result primarily from the revaluation of loss and LAE reserves in various currencies, particularly the Euro, the Japanese Yen, the Mexican Peso and the Australian Dollar, partially offset by the revaluation of investments in overseas deposits and cash. In addition, during 2017, pre-tax unrealized foreign exchange gains from Euro-denominated investment securities were approximately $1 million, which was reflected as an increase to accumulated other comprehensive income. During 2016 and 2015 the pre-tax unrealized foreign exchange impact from Euro-denominated investment securities was a gain of $8 million and a loss of $1 million, respectively.
Management’s process for establishing loss reserves is a comprehensive process that involves input from multiple functions throughout our organization, including actuarial, finance, claims, legal, underwriting, distribution and business operations management. The process incorporates facts currently known, as well as 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, 2017 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, 2017 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 position.
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, 2017 were $5.1 billion. Therefore, a relatively small percentage change in the estimate of net loss reserves would have a material effect on our results of operations.
There is greater inherent uncertainty in estimating insurance reserves for certain types of property and casualty insurance lines, particularly liability lines, where a longer period of time may elapse before a definitive determination of ultimate liability and losses may be made. In addition, the technological, judicial, regulatory and political climates involving these types of claims are continuously evolving. There is also greater uncertainty in establishing reserves with respect to business that is new to us, particularly new business which is generated with respect to newly introduced product lines, by newly appointed agents or in geographies in which we have less experience in conducting business, such as certain new program business written by AIX, Chaucer’s U.S. casualty treaty and international liability lines, our professional liability specialty lines, our excess and surplus specialty lines, and business written in the western part of the United States. In some of these cases, there is less historical experience or knowledge and less data upon which we can rely. A combination of business that is both new to us and has longer development periods provides even greater uncertainty in estimating insurance reserves. In our management and professional liability lines, we are modestly increasing, and expect to continue to increase, our exposure to longer-tailed liability lines, including directors and officers liability, errors and omissions liability and product liability coverages. The Chaucer business acquired in 2011 contains several liability lines, of which financial institution and professional liability, U.S. casualty treaty liability, international liability and marine and energy liability, contribute the most uncertainty. Chaucer’s U.S. casualty treaty lines have grown since 2015 due to our expanded underwriting capabilities.
We regularly update our reserve estimates as new information becomes available and additional events occur which may impact the resolution of unsettled claims. Reserve adjustments are reflected in the results of operations as adjustments to losses and LAE. Often, these adjustments are recognized in periods subsequent to the period in which the underlying policy was written and the loss event occurred. When these types of subsequent adjustments affect prior years, they are described separately as “prior year reserve development”. Such development can be either favorable or unfavorable to our financial results and may vary by line of business. As discussed below, estimated loss and LAE reserves for claims occurring in prior years developed favorably by $32.9 million, unfavorably by $140.3 million, and favorably by $94.3 million for the years ended December 31, 2017, 2016, and 2015, respectively. Additionally, our estimated loss and LAE reserves for catastrophe claims occurring in prior years developed favorably by $25.5 million, $34.9 million and $21.8 million for the years ended December 31, 2017, 2016 and 2015, respectively. However, there can be no assurance that current loss and LAE reserves will be sufficient.
We regularly review our reserving techniques, our overall reserving position and our reinsurance. Based on (i) our review of historical data, legislative enactments, judicial decisions, legal developments in impositions of damages and policy coverage, political attitudes and trends in general economic conditions, (ii) our review of per claim information, (iii) our historical loss experience and that of the industry, (iv) the nature of policies written by us, and (v) our internal estimates of required reserves, we believe that adequate provision has been made for loss reserves. However, establishment of appropriate reserves is an inherently uncertain process, and there can be no certainty that current established reserves will prove adequate in light of subsequent actual experience. A significant change to the estimated reserves could have a material impact on our results of operations and financial position. An increase or decrease in reserve estimates would result in a corresponding decrease or increase in financial results. For example, each one percentage point change in the aggregate loss and LAE ratio resulting from a change in reserve estimation is currently projected to have an approximate $48 million impact on operating income, based on 2017 full year premiums.
Short-tail classes consist principally of automobile physical damage, homeowners property, commercial property and marine business. The Chaucer business, while having more longer-tail coverages than our traditional U.S. business, contains a substantial book of 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. Consequently, the estimation of loss reserves for these classes is generally less complex. However, this is less true for our Chaucer assumed 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 to us, as the reinsurer, as compared with our direct insurance operations. This delay in reporting and recognition of the extent of a loss may be greater where Chaucer is not the lead syndicate handling a claim. 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.
In addition to the methods described above, various tailored reserving methodologies are used for certain businesses. For example, for some low volume and high volatility classes of business, special reserving techniques are utilized that estimate IBNR by selecting the loss ratio that balances actual reported losses to expected reported losses as defined by the estimated underlying reporting pattern. Also, for some classes with long exposure periods (e.g., energy, construction defect, engineering and political risks), earnings patterns plus an estimated reporting lag applied to the Bornheutter-Ferguson initial expected loss ratio are used to estimate IBNR. This is done in order to reflect the changing average exposure periods by policy year (and consequently accident year).
The Chaucer segment contains run-off business comprised of liability lines, notably financial institutions and professional liability business. There is particular uncertainty around the reserve estimates in respect of business written in 2007 and 2008 which have been subject to claims arising out of the financial turmoil in that time period, particularly in the financial institutions book. These claims are unlikely to be settled for some time since they contain numerous coverage issues and in many cases involve class action lawsuits that are likely to take several years to resolve. We have utilized substantially all of our available reinsurance with respect to losses and LAE related to financial institutions business written in 2008.
Personal Automobile Personal Injury Protection Medical Payment - loss reserves recorded for personal injury protection medical payment on U.S. voluntary business were $150.0 million as of December 31, 2017. 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 embedded inflation rate and a one point change to the tail factor assumption (e.g., 1.02 changed to 1.01 or 1.03) would have changed total reserves by approximately $46 million, either positive or negative, at December 31, 2017.
Workers’ Compensation - loss reserves recorded for workers’ compensation on U.S. voluntary business were $402.6 million as of December 31, 2017. 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 embedded inflation rate and a one point change to the tail factor assumption would have changed total reserves by approximately $112 million, either positive or negative, at December 31, 2017.
Specialty Programs - loss reserves recorded for the AIX program business were $251.2 million as of December 31, 2017. Two key assumptions underlying the actuarial reserve analysis for specialty programs are the inflation rate underlying the estimated reserve for our commercial automobile liability, general liability and workers’ compensation coverages, as well as the tail factor selection for workers’ compensation. A five point change to the embedded inflation rate for the aforementioned coverages, and a one point change in the workers’ compensation tail factor on AIX program business would have changed total reserves by approximately $46 million at December 31, 2017.
Casualty classes of business - claims reserves recorded for casualty classes of Chaucer business were $557.9 million as of December 31, 2017. An increase in the ultimate loss ratio of 2.5% across all classes and years of account would have increased total reserves by approximately $47 million at December 31, 2017.
Conditions and trends that have affected reserve development in the past will not necessarily recur in the future. As discussed under “Reserving Process Overview” in the preceding section, our historical loss experience and loss development patterns are important factors in estimating loss reserves, however, they are not the only factors we evaluate to establish reserves. Additionally, due to the highly specialized nature of the Lloyd’s business, many of our business classes at Chaucer are characterized by low frequency, but potentially high severity loss events. This results in claims experience and development patterns that are less predictable and more volatile than most of our domestic Personal and Commercial lines businesses. In addition, Chaucer’s reinsurance business and high excess property layers often experience delays in claim reporting which increases the risk of delayed recognition of loss reserve development. Thus additional knowledge and understanding of the exposures and often complex underlying claims issues is required to arrive at a reliable reserve. Also, the composition of the Chaucer portfolio has changed meaningfully throughout the period since our acquisition in 2011, making historical reserve development patterns less relevant to our current business mix. Therefore, a mechanical application of standard actuarial methodologies in projecting ultimate claims could result in materially different reserves to those held. Accordingly, it is not appropriate to extrapolate future favorable or unfavorable development based on amounts experienced in prior periods.
The following table provides a summary of (favorable)/unfavorable loss and LAE reserve development, excluding catastrophes.
In 2017, net favorable loss and LAE development, excluding catastrophes, was $32.9 million, primarily as a result of favorable development of $34.1 million for Chaucer. Chaucer’s favorable development was primarily the result of lower than expected losses in the energy line of $31.0 million in accident years 2011 through 2016 and in the political line of $16.2 million in accident years 2013 through 2016, partially offset by higher than expected losses in the treaty line of $13.7 million. The higher losses in the treaty line were primarily a result of higher than expected losses in Chaucer’s U.S. casualty business in accident years 2015 and 2016.
Chaucer’s favorable development during 2016 was primarily the result of lower than expected losses in the energy line of $27.6 million, primarily in the 2013 through 2015 accident years, in the casualty line of $24.0 million, primarily in the 2014 and prior accident years, in the political line of $20.1 million, primarily in the 2008, 2009, 2014 and 2015 accident years and in the treaty line of $17.0 million, primarily in the 2013 through 2015 accidents years. Partially offsetting Chaucer’s favorable development was the unfavorable impact of foreign exchange rate movements on prior years’ loss reserves. See “Foreign Exchange” section above for further discussion.
Chaucer’s favorable development was primarily the result of lower than expected losses in the energy line of $39.9 million, primarily in the 2012 through 2014 accident years, in the treaty line of $24.9 million, primarily in accident years 2012 through 2014, in the casualty line of $21.6 million, primarily in the 2008, 2011 and 2013 accident years and in the aviation and political lines of $19.5 million, primarily in the 2010, 2012 and 2013 accident years. Chaucer’s favorable development was also partially attributable to the favorable impact of foreign exchange rate movements on prior years’ loss reserves. See “Foreign Exchange” section above for further discussion.
Although we attempt to limit our exposures to asbestos and environmental damage liability through specific policy exclusions, we have been and may continue to be subject to claims related to these exposures. Ending loss and LAE reserves for all direct business written by our property and casualty companies related to asbestos and environmental damage liability were $9.5 million, $9.9 million and $9.5 million, net of reinsurance of $20.2 million, $19.9 million, and $20.5 million for the years ended December 31, 2017, 2016 and 2015, respectively.
Activity for our asbestos and environmental reserves was not significant to our 2017, 2016 or 2015 financial results. In recent years, average asbestos and environmental payments have declined modestly. As a result of our 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 our total loss and LAE incurred experience.
In addition, we have established gross and net loss and LAE reserves for assumed reinsurance pool business with asbestos and environmental damage liability of $30.3 million, $31.2 million and $27.7 million at December 31, 2017, 2016 and 2015, 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 segment. A significant part of our pool reserves relates to our participation in the 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.
The decrease in net unrealized gains on fixed maturities was primarily due to higher interest rates, partially offset by narrower corporate credit spreads in 2017.
Our fixed maturity and equity securities are carried at fair value. Financial instruments whose value was determined using significant management judgment or estimation constituted less than 1% of the total assets we measured at fair value. See also Note 5 - “Fair Value” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
Equity securities primarily consist of U.S. income-oriented large capitalization common stocks and developed market equity index exchange-traded funds.
Other investments consisted primarily of participations in commercial mortgage loan obligations, investments in private equity limited partnerships and overseas deposits. Commercial mortgage loan participations represent our interest in commercial mortgage loans originated by a third-party. We share, on a pro-rata basis, in all related cash flows of the underlying mortgage loans, which are investment-grade quality and diversified by geographic area and property type. Our investments in limited partnerships include interests in middle market mezzanine, private equity and credit funds. Overseas deposits are foreign and U.S. dollar-denominated 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 Chaucer to operate in those markets. Access to those funds is restricted, and we have no control over the investment strategy.
Although we expect to invest new funds primarily in investment grade fixed maturities, we have invested, and expect to continue to invest, a portion of funds in common equity securities, below investment grade fixed maturities and other investment assets.
The carrying values of fixed maturity securities on non-accrual status at December 31, 2017 and 2016 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 for the years ended December 31, 2017, 2016 and 2015 were also not material. Any defaults in the fixed maturities portfolio in future periods may negatively affect investment income.
Gross unrealized losses on fixed maturities and equity securities as of December 31, 2017 were $54.3 million, a decrease of $28.7 million compared to December 31, 2016, primarily attributable to narrower credit spreads. At December 31, 2017, gross unrealized losses consisted primarily of $26.4 million of corporate fixed maturities, $11.1 million of residential mortgage-backed securities, $7.1 million on municipal securities and $5.6 million on U.S. Governments. See also Note 3 - “Investments” in the Notes to the Consolidated Financial Statements and Supplementary Data of this Form 10-K.
We view gross unrealized losses on fixed maturities as temporary since it is our assessment that these securities will recover in the near term, allowing us to realize their anticipated long-term economic value. Further, we do not intend to sell, nor is it more likely than not we will be required to sell, such debt securities before this expected recovery of amortized cost (see also “Liquidity and Capital Resources” in Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-K). Inherent in our assessment are the risks that market factors may differ from our expectations; the global economic recovery is less robust than we expect or reverts to recessionary trends; we may decide to subsequently sell a security for unforeseen business needs; or changes in the credit assessment from our original assessment may lead us to determine that a sale at the current value would maximize recovery on such investments. To the extent that there are such adverse changes, an OTTI would be recognized as a realized loss. Although unrealized losses are not reflected in the results of financial operations until they are realized or deemed “other-than-temporary”, the fair value of the underlying investment, which does reflect the unrealized loss, is reflected in our Consolidated Balance Sheets.
With respect to equity securities, we had no gross unrealized losses as of December 31, 2017. Prior to that date, we viewed gross unrealized losses on equity securities as temporary since it was our assessment that these securities would recover in the near term, allowing us to realize their long-term economic value. Beginning January 1, 2018, we will adopt ASC Update 2016-01, (Subtopic 825-10) Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU No. 2016-01”). The adoption of the ASU will reclassify the net unrealized gain on equity securities from accumulated other comprehensive income to retained earnings. Subsequently, changes in fair value on equity securities will be reported in net income. See also Note 1 - “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements included in the Financial Statements and Supplementary Data of this Form 10-K.
The following table sets forth gross unrealized losses for fixed maturities by maturity period and for equity securities at December 31, 2017 and 2016. 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.
Net income in 2017 included a $22.3 million expense related to the enactment of the Tax Cuts and Jobs Act on December 22, 2017. See also “Income Taxes” in Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 7 - “Income Taxes” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
Effective June 30, 2015, we transferred our U.K. motor business to an unaffiliated U.K.-based insurance provider, which resulted in the recognition of a $40.6 million gain, net of tax. See also “Disposal of U.K. Motor Business” in Note 2 - "Dispositions of Businesses” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
Our overall investment strategy is intended to balance investment income with credit and interest rate risk, while maintaining sufficient liquidity and the opportunity for capital growth. The asset allocation process takes into consideration the types of business written and 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 majority of our assets are invested in the fixed income markets. Through fundamental research and credit analysis, with a focus on value investing, our investment professionals seek to identify a portfolio of stable income-producing higher quality U.S. government, foreign government, municipal, corporate, residential and commercial mortgage-backed securities and asset-backed securities. We have a general policy of diversifying investments both within and across major investment and industrial sectors to mitigate credit and interest rate risk. We monitor the credit quality of our investments and our exposure to individual markets, borrowers, industries, sectors and, in the case of commercial mortgage-backed securities and commercial mortgage loan participations, property types and geographic locations. In addition, we currently carry debt that is subject to interest rate risk, which was issued at fixed interest rates between 4.50% and 8.207%. Current market conditions, in light of our risk tolerance, restrict our ability to invest fixed income assets at similar rates of return; therefore, earnings on a similar level of assets are not sufficient to cover current debt interest costs.
Our equity securities portfolio is exposed to equity price risk arising from potential volatility in equity market prices. Portfolio characteristics are analyzed regularly and price risk is actively managed through a variety of techniques. A hypothetical increase or decrease of 10% in the market price of our equity securities would have resulted in an increase or decrease in the fair value of the equity securities portfolio of approximately $58 million at both December 31, 2017 and 2016.
Chaucer has exposure to foreign currency risk, most notably in insurance contracts and invested assets. Some of the 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, Chaucer attempts to manage foreign currency risk by seeking to match 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 investment risk for us is the U.K. pound sterling, and to a lesser extent, the Canadian dollar, Euro, Australian dollar and Swiss franc. A hypothetical 10% reduction in the value of foreign denominated investments would be expected to produce a loss in fair value of approximately $57 million and $58 million at December 31, 2017 and 2016, respectively.
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 our holding company and its U.S. subsidiaries. Generally, taxes are accrued at the U.S. statutory tax rate for income from the U.S. operations. Our primary non-U.S. jurisdiction is in the U.K. In November 2015, the U.K. statutory tax rate decreased from 20% to 19% effective April 1, 2017. A further decrease in the U.K. tax rate was enacted in September 2016 to reduce the U.K. statutory rate to 17% effective April 1, 2020. We accrue taxes on certain non-U.S. income that is subject to U.S. tax at the enacted U.S. tax rate. Foreign tax credits, where available, are utilized to offset U.S. tax as permitted.
On December 22, 2017, the TCJA was enacted in the U.S. The Act substantially changed many aspects of the U.S. Tax code, including a reduction in the U.S. corporate income tax rate from 35% to 21%. While the new corporate rate is effective on January 1, 2018, we have recognized the impact of the rate change on our deferred tax balances as of the enactment date. The effect of this re-measurement of our deferred tax balances is a provision of $9.4 million, and is recorded as a component of income tax expense in continuing operations for the year ended December 31, 2017. This amount includes the revaluation of deferred taxes initially recorded through other comprehensive income and recorded through discontinued operations, such as unrealized appreciation on investments, employee benefit plan-related items, foreign currency translation adjustments and reserve adjustments for discontinued business. Deferred taxes related to the revaluation of our pension plans at December 31, 2017, as well as changes in unrealized gains and losses occurring after the Act’s enactment date, are recorded at 21% in other comprehensive income.
In addition, the Act limited various existing deductions such as executive compensation and introduced new income taxes on certain low-taxed non-U.S. income. Under the Act, the exemption from the $1 million limitation on certain executive compensation has been eliminated. As a result, we have recognized a provision of $0.2 million for the year ended December 31, 2017. Also, we may be subject to a minimum tax on certain foreign earnings effective January 1, 2018. We have elected to recognize this minimum tax in the year in which the tax arises. We do not expect that this additional tax will have a significant effect on our results of operations in most years.
The cumulative effect of the enactment of TCJA is an expense of $22.3 million for the year ended December 31, 2017, comprising the aforementioned three components. Our estimates are not based upon provisional amounts, as defined in the SEC’s Staff Accounting Bulletin No. 118. However, they are subject to change, as authoritative guidance clarifies how they are determined and recognized.
Two significant assumptions used in the determination of benefit plan obligations and expenses that are dependent on market factors, which have been subject to a greater level of volatility over the past few years, are the discount rate and the return on plan asset assumptions. The discount rate enables us to state expected future cash flows as a present value on the measurement date. We also use this discount rate in the determination of our pre-tax pension expense or benefit. A lower discount rate increases the present value of benefit obligations and increases pension expense. We determined our discount rate for the domestic and Chaucer plans utilizing independent yield curves which provide for a portfolio of high quality bonds that are expected to match the cash flows of our pension plans. Bond information used in the yield curve included only those rated Aa or better as of December 31, 2017 and 2016, respectively, and had been rated by at least two well-known rating agencies. The following provides the discount rates for our qualified pension plan and Chaucer plan for the periods indicated.
The slight decrease in return assumptions for the U.S. Plan primarily reflects an increase in expected administrative expenses in future periods. Asset returns are reflected net of administrative expenses. With respect to the Chaucer Plan, the decrease in the return assumption reflects long-term assumptions for decreased returns in the U.K. and worldwide equity markets, as well as lower returns from the fixed maturity markets in general.
The following are the components of our deferred tax assets and liabilities as of December 31, 2017.
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, 2017 and 2016, 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):
We have the following securities, letters of credit and cash and cash equivalents pledged to Lloyd’s to satisfy these capital requirements at December 31, 2017. At that date, we were in compliance with the capital requirements and expect to be able to meet these capital requirements in the future.
Dividend payments to the holding company by Chaucer 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. In addition, Chaucer must provide advance notice to the U.K.’s Prudential Regulation Authority (“PRA”) of certain proposed dividends or other payments from PRA regulated entities. No dividends were paid to the holding company by Chaucer during 2017. Dividends of $79.5 million and $61.3 million were paid by Chaucer during 2016 and 2015, respectively, to the holding company.
Net cash used in investing activities was $506.3 million during 2017, as compared to $495.4 million during 2016 and $171.5 million in 2015. During 2017, cash used in investing activities primarily related to net purchases of fixed maturities, commercial mortgage loan participations, and other investments. During 2016, cash used in investing activities primarily related to net purchases of fixed maturities, commercial mortgage loan participations, and other investments. These cash outflows were partially offset by proceeds from net sales of equity securities. During 2015, cash used in investing activities primarily related to net purchases of commercial mortgage loan participations and fixed maturities. These cash outflows were partially offset by net cash received from the disposal of the U.K. motor business.
We expect to continue to generate sufficient positive operating cash to meet all short-term and long-term cash requirements relating to current operations, including the funding of our qualified defined benefit pension plan and the Chaucer pension plan. Based upon the current estimate of liabilities and certain assumptions regarding investment returns and other factors, our qualified defined benefit pension plan and Chaucer pension plan collectively have plan liabilities in excess of plan assets of approximately $43 million. The ultimate payment amounts for our benefit plans are based on several assumptions, including but not limited to, the rate of return on plan assets, the discount rate for benefit obligations, mortality experience, interest crediting rates, inflation and the ultimate valuation and determination of benefit obligations. Since differences between actual plan experience and our assumptions are almost certain, changes both positive and negative to our current funding status and ultimately our obligations in future periods are likely.
Our Board of Directors has authorized aggregate repurchases of our common stock of up to $900 million. Under the repurchase authorizations, the Company may repurchase, from time to time, common shares in amounts, at prices and at such times as the Company deems appropriate, subject to market conditions and other considerations. Repurchases may be executed using open market purchases, privately negotiated transactions, accelerated repurchase programs or other transactions. We are not required to purchase any specific number of shares or to make purchases by any certain date under this program. During 2017, we repurchased approximately 0.4 million shares of our common stock at a cost of $37.2 million.
We have a $200.0 million credit agreement which expires in November 2018, with an option to increase the facility to $300.0 million assuming no default and satisfaction of certain other conditions. The agreement also includes a $50 million sub-facility for standby letters of credit that can be used for general corporate purposes. Borrowings, if any, under the agreement are unsecured and incur interest at a rate per annum equal to, the higher of (a) the prime commercial lending rate of the administrative agent, (b) the Federal Funds Rate plus half of a percent, or (c) the one month Adjusted LIBOR plus one percent and any applicable margin. The agreement contains financial covenants including, but not limited to, maintaining at least a certain level of consolidated equity, maximum consolidated leverage ratios and requires certain of our subsidiaries to maintain a minimum RBC ratio. We had no borrowings under this agreement during 2017, 2016 and 2015.
Simultaneous with the Facility Agreement, we entered into a Guaranty Agreement (the “Guaranty Agreement”) with Lloyds Bank plc, as Facility Agent and Security Agent, pursuant to which we unconditionally guarantee the obligations of Chaucer under the Facility Agreement. The Guaranty Agreement contains certain financial covenants that require us to maintain a minimum net worth and a maximum leverage ratio, and certain negative covenants that limit our ability, among other things, to incur or assume certain debt, grant liens on our property, merge or consolidate, dispose of assets, materially change the nature or conduct of our business and make restricted payments (except, in each case, as provided by certain exceptions). The Guaranty Agreement also contains certain customary representations and warranties. The current Guaranty Agreement contains terms and conditions substantially similar to the previous guaranty agreement we had in place with Lloyds Bank plc in connection with the Prior Facility Agreement. The Guaranty Agreement replaced the prior guaranty agreement upon effectiveness of the Facility Agreement on October 27, 2017.
Financing obligations generally include repayment of our senior debentures, subordinated debentures, borrowings from the FHLBB, and operating lease payments. The following table represents our annual payments related to the contractual principal and interest payments of these financing obligations as of December 31, 2017 and operating lease payments reflect expected cash payments based upon lease terms. In addition, we also have included our estimated payments related to our loss and LAE obligations and our current expectation of payments to be made to support the obligations of our benefit plans. The following table also includes commitments to purchase investment securities at a future date. Actual payments may differ from the contractual and/or estimated payments in the table.
We believe that strong ratings are important factors in marketing our products to our agents and customers, since rating information is broadly disseminated and generally used throughout the industry. Insurance company financial strength ratings are assigned to an insurer based upon factors deemed by the rating agencies to be relevant to policyholders and are not directed toward protection of investors. Such ratings are neither a rating of securities nor a recommendation to buy, hold or sell any security. Customers typically focus on claims-paying ratings, while creditors focus on debt ratings. Investors use both to evaluate a company’s overall financial strength.
Catastrophe loss - Loss and directly identified loss adjustment expenses from catastrophes, including development on prior years’ catastrophe loss reserves. The Insurance Services Office (“ISO”) Property Claim Services (“PCS”) defines a catastrophe loss as an event that causes $25 million or more in U.S. industry insured property losses and affects a significant number of property and casualty policyholders and insurers. In limited instances where the impact of an event extends across multiple geographic areas or time periods, but is not within the specific parameters established by PCS, the Company may determine that certain losses are better included within the same catastrophe event. In addition to those catastrophe events declared by ISO, claims management also generally includes within the definition of a “catastrophe loss”, a property loss event that causes approximately $5 million or more in Company insured losses and affects in excess of one hundred policy holders or multiple independent risks. For the international business in our Chaucer segment, management utilizes a “catastrophe loss” definition that is substantially consistent with the ISO definition framework.
Economic interest - The share of syndicate underwriting capacity supported by capital from Chaucer Holdings Limited.
Price(ing) increase or decrease (Commercial Lines and Chaucer) - Represents the average change in premium on renewed policies caused by the estimated net effect of base rate changes, discretionary pricing, inflation or changes in policy level exposure or insured risk.
Loss and Loss adjustment expense (“LAE”) ratio - The ratio of loss and loss adjustment expenses to premiums earned for a given period.
Underwriting expenses - Expenses incurred in connection with the acquisition, pricing and administration of a policy or contract, and other insurance company expenses unrelated to claims handling or investments.
We have audited the accompanying consolidated balance sheets of The Hanover Insurance Group, Inc. and its subsidiaries as of December 31, 2017 and 2016, and the related consolidated statements of income, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2017, including the related notes and financial statement schedules listed in the index appearing under Item 15(a)(2) (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Fixed maturities and equity securities are classified as available-for-sale and are carried at fair value, with unrealized gains and losses, net of taxes, reported in accumulated other comprehensive income (“AOCI”), a separate component of shareholders’ equity. The amortized cost of fixed maturities is adjusted for amortization of premiums and accretion of discounts to maturity.
Other investments consist primarily of mortgage participations, limited partnerships and overseas deposits. Mortgage participations represent interests in commercial mortgage loans originated and serviced by a third-party of which the Company shares, on a pro-rata basis, in all related cash flows of the underlying mortgage loans. Due to certain reacquisition rights retained by the third-party in the loan participation, these investments are accounted for as secured borrowings under Accounting Standards Codification (“ASC”) 860, Transfers and Servicing (“ASC 860”). Mortgage participations are stated at unpaid principal balances adjusted for deferred fees or expenses, net of reserves. Reserves on mortgages are established and are collectively evaluated based on losses expected by the Company for loans that may not be collectible in full. In establishing reserves, the Company considers, among other things, the estimated fair value of the underlying collateral.
Overseas deposits 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.
Net investment income includes interest, dividends and income from limited partnership interests and overseas deposits. Interest income is recognized based on the effective yield method which includes the amortization of premiums and accretion of discounts. The effective yield used to determine the amortization for fixed maturities subject to prepayment risk, such as mortgage-backed and asset-backed securities, is recalculated and adjusted periodically based upon actual historical and projected future cash flows. The adjustment to yields for highly rated prepayable fixed maturities is accounted for using the retrospective method. The adjustment to yields for all other prepayable fixed maturities is accounted for using the prospective method. Fixed maturities and mortgage participations that are delinquent are placed on non-accrual status, and thereafter interest income is recognized only when cash payments are received.
Insurance premiums written are generally recorded at the policy inception and are primarily earned on a pro-rata basis over the terms of the policies for all products. Premiums written include estimates, primarily in the Chaucer segment, that are derived from multiple sources, which include the historical experience of the underlying business, similar businesses and available industry information.
These estimates are regularly reviewed and updated, and any resulting adjustments are included in the current year’s results. Unearned premium reserves represent the portion of premiums written that relates to the unexpired terms of the underlying in-force insurance policies and reinsurance contracts. Premium receivables reflect the unpaid balance of premium written as of the balance sheet date. Premium receivables are generally short-term in nature and are reported net of an allowance for estimated uncollectible premium accounts. The Company reviews its receivables for collectability at the balance sheet date. The allowance for uncollectible accounts was not material as of December 31, 2017 and 2016. Ceded premiums are charged to income over the applicable term of the various reinsurance contracts with third-party reinsurers. Reinsurance reinstatement premiums, when required, are recognized in the same period as the loss event that gave rise to the reinstatement premiums. Losses and related expenses are matched with premiums, resulting in their recognition over the lives of the contracts. This matching is accomplished through estimated and unpaid losses and amortization of deferred acquisition costs.
In May 2015, the FASB issued ASC Update No. 2015-09, (Topic 944) Financial Services- Insurance: Disclosures about Short-Duration Contracts. This ASC update requires several additional disclosures regarding short-duration insurance contracts, including; disaggregated incurred and paid claims development information, quantitative and qualitative information about claim frequency and duration, and the sum of incurred but not reported liabilities plus expected development on reported claims included in the liability for unpaid claims and claim adjustment expenses along with a description of reserving methodologies. This information is required to be presented by accident year, for the number of years for which claims typically remain outstanding, but need not exceed 10 years. A reconciliation of the claims development disclosures to the aggregate carrying amount of the liability for unpaid claims and claim adjustment expenses, including a separate disclosure for reinsurance recoverables is also required for each period presented in the statement of financial position. In addition, this ASC update requires insurance entities to disclose information about significant changes in methodologies and assumptions used to calculate the liability for unpaid claims and claim adjustment expenses, including reasons for the change and the effects on the financial statements. The updated guidance is effective for annual periods beginning after December 15, 2015, and interim periods within annual periods beginning after December 15, 2016. Early adoption is permitted. The Company implemented this guidance beginning with its disclosures for the year ended December 31, 2016. The effect of implementing this guidance was not material to the Company’s financial position or results of operations, as the update is disclosure related.
In March 2017, the FASB issued ASC Update No. 2017-07, (Topic 715) Compensation - Retirement Benefits: Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. This guidance requires that an employer report in its income statement the service cost component of both net periodic pension and net periodic postretirement benefit cost in the same line item or items as other compensation costs arising from services rendered by pertinent employees during the period, and present in the income statement separately from the other components of benefit cost, if appropriate under the company’s current presentation of its income statement. Additionally, the guidance allows only the service cost component to be eligible for capitalization when applicable. The updated guidance is effective for annual and interim periods beginning after December 15, 2017, and should be applied retrospectively for the presentation of the service cost component and other components of net periodic pension cost and net periodic postretirement benefit cost in the income statement, and prospectively for the capitalization of the service cost component of net periodic cost in assets. Early adoption is permitted as of the beginning of an annual period for which financial statements have not been issued. The Company had no service cost expense for both its pension and postretirement benefit plans in 2017. The Company is not expecting to have any service cost remaining related to its pension and postretirement plans upon this guidance becoming effective, therefore the adoption of ASC Update No. 2017-07 will not have a material impact on its financial position or results of operations.
In August 2016, the FASB issued ASC Update No. 2016-15, (Topic 230) Classification of Certain Cash Receipts and Cash Payments. This ASC update provides specific guidance on the presentation of certain cash flow items where there is currently diversity in practice, including, but not limited to, debt prepayment or debt extinguishment costs, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, and distributions received from equity method investees. The updated guidance is effective for interim and annual periods beginning after December 15, 2017, and should be applied retrospectively unless impracticable. Early adoption is permitted. The adoption of ASC Update No. 2016-15 is not expected to have a significant impact on the Company’s statement of cash flows.
the lease liability will be classified as a financing activity while the interest component will be included in the operating section of the statement of cash flows. For operating leases, the asset and liability will be amortized as a single lease cost, such that the cost of the lease is allocated over the lease term, on a generally straight-line basis, with all cash flows included within operating activities in the statement of cash flows. The updated guidance is effective for interim and annual periods beginning after December 15, 2018 and is required to be implemented by applying a modified retrospective transition approach. The Company is continuing to evaluate the impact of the adoption of ASC Update No. 2016-02 on its results of operations. It is expected that assets and liabilities will increase based on the present value of remaining lease payments for leases in place at the adoption date; however, the impact is not expected to be significant to the Company’s financial position.
In January 2016, the FASB issued ASC Update No. 2016-01, (Subtopic 825-10) Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities. This ASC update requires unconsolidated equity investments to be measured at fair value with changes in the fair value recognized in net income, except for those accounted for under the equity method. This update eliminates the cost method for equity investments without readily determinable fair values, replacing it with other methods, including the use of Net Asset Value (“NAV”). Additionally, when a public entity is required to measure fair value for disclosure purposes and holds financial instruments measured at amortized cost, the updated guidance requires these instruments to be measured using exit price. It also requires financial assets and financial liabilities to be presented separately in the notes to the financial statements, grouped by measurement category and form of financial asset. The updated guidance is effective for annual periods beginning after December 15, 2017. The Company will adopt the guidance effective January 1, 2018 with a cumulative effect adjustment, reclassifying after-tax unrealized gains of $115.7 million from AOCI to retained earnings with no overall impact on the Company’s financial position. For certain limited partnership investments without readily determinable fair values, implementation of this ASC will be prospective. The impact to the Company is expected to be increased volatility in net income beginning in 2018 as changes in fair value on equity securities will be reflected in net income as a component of net realized investment gains/(losses). If the new accounting guidance had been implemented at the beginning of 2017, the Company would have recognized additional after-tax investment gains in earnings of $38.2 million for the year ended December 31, 2017.
In May 2014, the FASB issued ASC Update No. 2014-09, (Topic 606) Revenue from Contracts with Customers. This ASC was issued to clarify the principles for recognizing revenue. Insurance contracts and financial instrument transactions are not within the scope of this updated guidance, and; therefore, only an insignificant amount of the Company’s revenue is subject to this updated guidance. In August 2015, the FASB issued ASC Update No. 2015-14, (Topic 606) Revenue from Contracts with Customers, which deferred the effective date of ASC Update No. 2014-09 by one year. Accordingly, the updated guidance is effective for periods beginning after December 15, 2017 and will not have a material effect on the Company’s financial position or results of operations.
Discontinued operations for the years ended December 31, 2017, 2016 and 2015 resulted in losses of $16.8 million, losses of $1.0 million and gains of $0.7 million, respectively, net of tax. The increased losses in 2017 primarily relate to additional losses in the Company’s long-term care pool, which is included in the portion of the discontinued accident and health business that was directly assumed.
At December 31, 2017 and 2016, fixed maturities with fair values of $286.9 million and $267.7 million, respectively,were on deposit with various state governmental authorities or trustees.
Equity securities and other balances at December 31, 2017, 2016 and 2015 include after-tax net appreciation on other invested assets of $2.2 million, $2.5 million and $2.2 million, respectively.
Other investments also include interests in limited partnerships and overseas deposits of $186.4 million and $122.8 million, respectively, at December 31, 2017, and $121.3 million and $102.2 million, respectively, at December 31, 2016.
At December 31, 2017, there were contractual investment commitments of up to $173.9 million.
The carrying values of fixed maturity securities on non-accrual status at December 31, 2017 and 2016 were not material. The effects of non-accruals for the years ended December 31, 2017, 2016 and 2015, compared with amounts of net investment income that would have been recognized in accordance with the original terms of the fixed maturities were also not material.
For 2017, total OTTI was $6.2 million. Of this amount, $5.9 million was recognized in earnings and the remaining $0.3 million was recorded as unrealized losses in accumulated other comprehensive income (“AOCI”). The $5.9 million of OTTI recognized in earnings relates to $2.1 million of fixed maturity securities, $2.0 million of other invested assets and $1.8 million of equities.
The methodology and significant inputs used to measure the amount of credit losses on fixed maturities in 2017, 2016 and 2015 were as follows:
The following table provides rollforwards of the cumulative amounts related to the Company’s credit loss portion of the OTTI losses on fixed maturity securities for which the non-credit portion of the loss is included in other comprehensive income.
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 techniques 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:
The Company utilizes a third-party pricing service for the valuation of the majority of its equity securities and receives one quote for each equity 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. 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 and reports them as Level 3. Additionally, the Company may obtain non-binding broker quotes which are reported as Level 3.
The following tables provide, for each hierarchy level, the Company’s estimated fair values of financial instruments that were not carried at fair value.
During the years ended December 31, 2017 and 2016, the Company transferred fixed maturities between Level 2 and Level 3 primarily as a result of assessing the significance of unobservable inputs on the fair value measurement. During 2017, an equity security was transferred from level 3 to level 1 upon the availability of pricing from the third party pricing service. There were no transfers between Level 1 and Level 2 during 2017 or 2016. There were no Level 3 liabilities held by the Company for years ended December 31, 2017 and 2016.
The following table provides quantitative information about the significant unobservable inputs used by the Company in the fair value measurements of Level 3 assets. Where discounted cash flows were used in the valuation of fixed maturities, the internally-developed discount rate was adjusted by the significant unobservable inputs shown in the table. Valuations of $0.6 million at December 31, 2016, for securities based on broker quotes for which there was a lack of transparency as to inputs used to develop the valuations have been excluded.
The Company also held 7.625% senior unsecured debentures that were issued on October 16, 1995 with a par value of $200.0 million. The remaining 7.625% senior debentures have a par value of $62.6 million as of December 31, 2017 and 2016 and mature on October 15, 2025.
Both of the Company’s outstanding senior debentures are subject to certain restrictive covenants, including limitations on the issuance or disposition of stock of restricted subsidiaries and limitations on liens, and pay interest semi-annually.
The Company also held $175.0 million aggregate principal amount of 6.35% subordinated unsecured debentures due March 30, 2053. These debentures pay interest quarterly. The Company may redeem these debentures in whole at any time, or in part from time to time, on or after March 30, 2018, at a redemption price equal to their principal amount plus accrued and unpaid interest. In addition, the Company’s subordinated debentures maturing February 3, 2027 have a par value of $59.7 million as of December 31, 2017 and 2016 and pay cumulative dividends semi-annually at 8.207%.
In 2009, Hanover Insurance received a $125.0 million FHLBB advance through its membership in the FHLBB. This collateralized advance bears interest at a fixed rate of 5.50% per annum over a twenty-year term. As collateral to FHLBB, the Company pledged government agency securities with a fair value of $223.6 million and $201.8 million, for the aggregate borrowings of $125.0 million as of December 31, 2017 and December 31, 2016, respectively. 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, the Company would be required to pledge additional collateral or repay outstanding borrowings. The Company is permitted to voluntarily repay the outstanding borrowings at any time, subject to a repayment fee. As a requirement of membership in the FHLBB, the Company maintains a certain level of investment in FHLBB stock. Total holdings of FHLBB stock were $8.5 million and $9.8 million at December 31, 2017 and 2016, respectively.
At December 31, 2017, the Company had a $200.0 million credit agreement which expires in November 2018. The Company had no borrowings under this agreement. Additionally, the Company had a Standby Letter of Credit Facility not to exceed £220.0 million (or $297.1 million). This Letter of Credit Facility provides regulatory capital supporting Chaucer’s underwriting activities for the 2018 and 2019 years of account and each prior open year of account. Simultaneous with this agreement, THG entered into a Guaranty Agreement with Lloyds Bank plc, as Facility Agent and Security Agent, pursuant to which THG unconditionally guarantees the obligations of Chaucer under the Letter of Credit Facility.
Interest expense was $48.5 million, $54.9 million, and $60.6 million in 2017, 2016 and 2015, respectively. At December 31, 2017, the Company was in compliance with the covenants associated with all of its debt indentures and credit arrangements.
The Company’s deferred tax asset as of December 31, 2017 included assets of $23.1 million related to alternative minimum tax credit (“AMT”) carryforwards. The Company has utilized $71.5 million of its AMT credits in 2017 and may continue to utilize these credits to offset regular federal income taxes due from future income. Although the enactment of TCJA repeals the corporate alternative minimum tax effective January 1, 2018, the remaining AMT credits carried forward will continue to be utilized to offset future taxable income for tax years beginning in 2018. The Company believes it is more likely than not that the remaining deferred tax assets will be realized.
The Company or its subsidiaries file income tax returns in the U.S. federal jurisdiction and various state jurisdictions, as well as foreign jurisdictions. The Company and its subsidiaries are subject to U.S. federal and state income tax examinations and foreign examinations for years after 2013.
On December 22, 2017, the Tax Cuts and Jobs Act (“TCJA”, “U.S. Tax Reform”, or “the Act”) was enacted in the U.S. The Act substantially changed many aspects of the U.S. Tax code, including a reduction in the U.S. corporate income tax rate from 35% to 21%. While the new corporate rate is effective on January 1, 2018, the Company has recognized the impact of the rate change on its deferred tax balances as of the enactment date. The effect of this re-measurement of the Company’s deferred tax balances is a provision of $9.4 million, and is recorded as a component of income tax expense in continuing operations for the year ended December 31, 2017. This amount includes the revaluation of deferred taxes initially recorded through other comprehensive income and recorded through discontinued operations, such as unrealized appreciation on investments, employee benefit plan-related items, foreign currency translation adjustments and reserve adjustments for discontinued business. Deferred taxes related to the revaluation of the Company’s pension plans at December 31, 2017, as well as changes in unrealized gains and losses occurring after the Act’s enactment date, are recorded at 21% in other comprehensive income.
In addition, the Act limited various existing deductions such as executive compensation and introduced new income taxes on certain low-taxed non-U.S. income. Under the Act, the exemption from the $1 million limitation on certain executive compensation has been eliminated. As a result, the Company has recognized a provision of $0.2 million for the year ended December 31, 2017. Also, the Company may be subject to a minimum tax on certain foreign earnings effective January 1, 2018. The Company has elected to recognize this minimum tax in the year in which the tax arises. The Company does not expect that this additional tax will have a significant effect on the Company’s results of operations in most years.
The cumulative effect of the enactment of TCJA is an expense of $22.3 million for the year ended December 31, 2017, comprising the aforementioned three components. The Company’s estimates are not based upon provisional amounts, as defined in the SEC’s Staff Accounting Bulletin No. 118. However, they are subject to change, as authoritative guidance clarifies how they are determined and recognized.
The investment strategy of the Chaucer defined benefit pension plan is to invest primarily in growth assets in the form of equity funds that are expected to provide a positive return exceeding 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. This allocation plan is reviewed annually, and target allocation changes are made as appropriate.
The following table provides 2017 target allocations and actual invested asset allocations for 2017 and 2016.
Real estate fund investments are also 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. The following table presents the Chaucer defined benefit plan’s investment assets at December 31, 2017 and 2016.
During 2015, the Company transferred its U.K. motor business (See also “Disposal of U.K. Motor Business” in Note 2 - “Dispositions of Businesses”). As a result of this transaction, participants of the Chaucer plan who worked in this line also transferred to the unaffiliated U.K.-based insurance provider. Accordingly, they no longer are active participants of this plan and the liability was reduced resulting in a $1.8 million curtailment gain. An equal and offsetting expense was included in recognized net actuarial losses in the above table.
The following table reflects the total amounts recognized in accumulated other comprehensive income relating to both the U.S. defined benefit pension plans and the Chaucer pension plan as of December 31, 2017 and 2016.
In accordance with ERISA guidelines, the Company is not required to fund its U.S. qualified benefit plan in 2018. The Company expects to contribute $3.1 million to its U.S. non-qualified pension plans to fund 2018 benefit payments. At this time, no additional discretionary contributions are expected to be made into the U.S. plans or the Chaucer plan during 2018, and the Company does not expect that any funds will be returned from the plans to the Company during 2018.
The benefit payments are based on the same assumptions used to measure the Company’s benefit obligation at the end of 2017 and reflect benefits attributable to estimated future service.
The following table reflects the estimated amortization to be recognized in net periodic benefit cost in 2018:
On May 20, 2014, shareholders approved The Hanover Insurance Group 2014 Long-Term Incentive Plan (the “2014 Stock Plan”). With respect to new share-based award issuances, the 2014 Stock Plan replaced The Hanover Insurance Group, Inc. 2006 Long-Term Incentive Plan (the “2006 Stock Plan”) and authorized the issuance of 6,100,000 shares in a new share pool plus any shares subject to outstanding awards under the 2006 Stock Plan that may become available for reissuance as a result of the cash settlement, forfeiture, expiration or cancellation of such awards. The 2014 Stock Plan provides for the granting of the same types of awards as the 2006 Stock Plan, including stock options and stock appreciation rights (“SARS”), restricted and unrestricted stock, stock units, performance and market-based stock awards, and cash awards. In accordance with the 2014 Stock Plan, the issuance of one share of common stock in the form of an option or SAR will reduce the share pool by one share, whereas the issuance of one share of common stock for the other types of stock awards provided by the plan will reduce the pool by 3.8 shares. As of December 31, 2017, there were 4,877,576 shares available for grants under the 2014 Stock Plan.
Compensation cost for the years ended December 31, 2017, 2016, and 2015 totaled $12.3 million, $12.0 million and $12.3 million, respectively. Related tax benefits were $4.3 million, $4.2 million and $4.3 million, respectively.
Cash received for options exercised for the years ended December 31, 2017, 2016 and 2015 was $20.5 million, $15.8 million and $15.9 million, respectively. The intrinsic value of options exercised for the years ended December 31, 2017, 2016 and 2015 was $15.6 million, $21.1 million and $38.7 million, respectively.
The Company granted market-based restricted share units in 2017, 2016 and 2015. These units generally vest after 3 years of continued employment and after the achievement of certain stock performance targets. The Company also granted restricted stock units to eligible employees in 2017, 2016 and 2015 that generally vest after 3 years of continued employment.
In 2017, market-based restricted stock units of 5,881 were included as granted due to completion levels in excess of 100% for units granted in 2014. The weighted average grant date fair value of these awards was $56.45. In 2016, performance and market-based stock units of 2,268 and 30,134 were included as granted due to completion levels in excess of 100% for units granted in 2014 and 2013, respectively. The weighted average grant date fair value of these awards was $57.00 and $41.77, respectively. In 2015, performance and market-based stock units of 3,125 and 36,875 were included as granted due to completion levels in excess of 100% for units granted in 2013 and 2012, respectively. The weighted average grant date fair value of these awards was $42.44 and $36.47, respectively.
At December 31, 2017, the aggregate intrinsic value of restricted stock units was $32.5 million and the weighted average remaining contractual life was 1.3 years. The aggregate intrinsic value of performance and market-based restricted stock units was $11.2 million and the weighted average remaining contractual life was 1.5 years. As of December 31, 2017, there was $17.6 million of total unrecognized compensation cost related to unvested restricted stock units and performance and market-based restricted stock units, assuming performance and market-based restricted stock units are achieved at 100% of the performance metric. The cost is expected to be recognized over a weighted average period of 2.0 years. Compensation cost associated with restricted stock, restricted stock units and performance and market-based restricted stock units is generally calculated based upon grant date fair value, which is determined using current market prices.
Diluted earnings per share during 2017, 2016 and 2015 excludes 0.4 million, 0.6 million and 0.6 million, respectively, of common shares issuable under the Company’s stock compensation plans, because their effect would be antidilutive.
The Company’s Board of Directors has authorized aggregate repurchases of the Company’s common stock of up to $900 million. Under the repurchase authorizations, the Company may repurchase, from time to time, common shares in amounts, at prices and at such times as the Company deems appropriate, subject to market conditions and other considerations. Repurchases may be executed using open market purchases, privately negotiated transactions, accelerated repurchase programs or other transactions. The Company is not required to purchase any specific number of shares or to make purchases by any certain date under this program. As of December 31, 2017, the Company has $146.4 million available for repurchases under these repurchase authorizations. During 2017, the Company purchased 0.4 million shares of the Company’s common stock at a cost of $37.2 million.
Pursuant to Michigan’s statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the Michigan Insurance Commissioner, is limited to the greater of 10% of policyholders’ surplus as of December 31 of the immediately preceding year or the statutory net income less net realized gains, for the immediately preceding calendar year. Citizens declared dividends to its parent, Hanover Insurance, totaling $99.9 million, $70.0 million and $63.0 million in 2017, 2016 and 2015, respectively. Citizens cannot declare a further dividend to its parent without prior approval until December 2018, at which time the maximum dividend payable without approval would be $89.9 million.
The Company’s primary business operations include insurance products and services provided through four operating segments. The domestic operating segments are Commercial Lines, Personal Lines and Other, and the Company’s international operating segment is Chaucer. Commercial Lines includes commercial multiple peril, commercial automobile, workers’ compensation, and other commercial coverages, such as inland marine, specialty program business, management and professional liability, surety and specialty property. Personal Lines includes personal automobile, homeowners and other personal coverages. Chaucer includes marine, aviation and political, casualty (which includes international liability, specialist coverages, and run-off syndicate participations), energy, property, and assumed reinsurance treaty business (“treaty”). Included in the Other segment are Opus Investment Management, Inc., which markets investment management services to institutions, pension funds and other organizations; earnings on holding company assets; holding company and other expenses, including certain costs associated with retirement benefits due to the Company’s former life insurance employees and agents; and, a run-off voluntary pools business. The separate financial information is presented consistent with the way results are regularly evaluated by the chief operating decision maker in deciding how to allocate resources and in assessing performance.
Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company; consequently, allowances are established for amounts deemed uncollectible. The Company determines the appropriate amount of reinsurance based on evaluations of the risks accepted and analyses prepared by consultants and on market conditions (including the availability and pricing of reinsurance). The Company also believes that the terms of its reinsurance contracts are consistent with industry practice in that they contain standard terms with respect to lines of business covered, limit and retention, arbitration and occurrence. The Company believes that its reinsurers are financially sound, based upon an ongoing review of financial strength ratings assigned to them by rating agencies, their reputations in the reinsurance marketplace, our collections history, advice from third parties and the analysis and guidance of THG’s reinsurance advisors.
The increase in ceded losses and LAE from 2015 to 2016 is primarily due to an increase in Chaucer’s reinsurance purchases in 2016 and due to a higher level of ceded large loss activity in certain Chaucer and domestic lines in 2016. These increases in ceded losses and LAE were partially offset by the above mentioned non-recurring U.K. motor activity in 2015. The increase in ceded losses and LAE from 2016 to 2017 is primarily due to higher catastrophe loss activity in certain Chaucer lines and higher non-catastrophe large loss activity in certain domestic lines.
For Chaucer’s 2016 and 2015 U.S. casualty treaty lines, we entered into a whole account aggregate excess of loss contract. The contract covers the U.S. casualty treaty lines exposures, except specialty risks and workers’ compensation clash. This contract does not meet the risk transfer requirements of GAAP and is accounted for using the deposit accounting method. The impact of reinsurance contracts subject to deposit accounting are recognized through net investment income rather than losses. The deposit asset for this contract was approximately $76 million and $63 million as of December 31, 2017 and December 31 2016, respectively. Net investment income for this contract of approximately $8 million and $3 million was recognized for the years ended December 31, 2017 and December 31, 2016, respectively.
As a result of the 2016 fourth quarter reserve review of domestic lines of business, carried domestic reserves for prior accident years, excluding catastrophes, were increased by $174.1 million in the fourth quarter of 2016, of which $161.5 million related to Commercial Lines. The majority of this adjustment was attributed to long-tailed commercial liability coverages, including AIX program business and was largely driven by worsening trends in the number and nature of high severity losses and higher than anticipated legal defense costs. The Company reacted to this adverse emergence by updating its assumptions about loss severity, loss development patterns, expected loss ratios and loss adjustment expenses for the most recent accident years, placing greater weight on the adverse severity trends experienced in the most recent calendar years. The adverse prior year development for the Other segment was due to run-off voluntary assumed reinsurance pools business. The reserve increase was primarily based on an updated third-party actuarial study received in the fourth quarter for a pool that primarily consists of asbestos and environmental exposures.
Chaucer’s favorable development during 2016 was primarily the result of lower than expected losses in the treaty line of $39.2 million, primarily in the 2013 through 2015 accidents years, in the energy line of $31.9 million, primarily in the 2013 through 2015 accident years, in the casualty line of $24.0 million, primarily in the 2014 and prior accident years and in the political line of $21.2 million, primarily in the 2008, 2009, 2014 and 2015 accident years. Partially offsetting Chaucer’s favorable development was the unfavorable impact of foreign exchange rate movements on prior years’ loss reserves.
In 2015, net favorable loss and LAE development was $116.1 million, primarily as a result of favorable development of $153.0 million for Chaucer, partially offset by net unfavorable development of $47.2 million for Commercial Lines.
The net unfavorable Commercial Lines development primarily resulted from higher than expected losses in other commercial lines of $59.2 million. This was primarily driven by AIX programs and business classes which have since been terminated and general liability lines in accident years 2009 through 2012, partially offset by lower than expected losses in the commercial umbrella line in accident years 2012 through 2014 and in the healthcare line in accident years 2010 through 2014. The Company also experienced higher than expected losses within the commercial automobile line of $23.3 million, primarily related to liability coverage in accident years 2011 through 2013, and in the commercial multiple peril lines, primarily in accident years 2008, 2009 and 2011. Partially offsetting the unfavorable development was lower than expected losses of $46.9 million within the workers’ compensation line, primarily related to accident years 2005 through 2014, and, to a lesser extent, the commercial umbrella line related to accident years 2012 through 2014.
General liability and umbrella - occurrence is primarily comprised of our commercial monoline general liability and umbrella coverages. General liability - claims made is primarily comprised of our commercial professional and management liability lines. Within total Commercial Lines and other, other lines is primarily comprised of marine, voluntary pools, surety, fidelity and healthcare lines. Chaucer core lines includes treaty, marine, aviation and political, energy, property and casualty lines, primarily consisting of international liability and specialist liability coverages. Chaucer’s reinsured and run-off lines include financial and professional liability lines written in 2008 and prior and U.K. motor business, which was transferred through a 100 percent reinsurance contract as of June 30, 2015. Included in the above table, primarily in other lines, are $59.4 million and $61.0 million of gross asbestos and environmental reserves as of December 31, 2017 and 2016, respectively.
On March 12, 2007, a putative class action suit captioned Jennifer A. Durand v. The Hanover Insurance Group, Inc., and The Allmerica Financial Cash Balance Pension Plan, was filed in the United States District Court for the Western District of Kentucky. The named plaintiff, a former employee of the Company’s former life insurance and annuity business who received a lump sum distribution from the Company’s Cash Balance Plan (the “Plan”) at or about the time of her separation from the company, claims that she and others similarly situated did not receive the appropriate lump sum distribution because in computing the lump sum, the Company and the Plan understated the accrued benefit in the calculation. The plaintiff claims that the Plan underpaid her distributions and those of similarly situated participants by failing to pay an additional so-called “whipsaw” amount reflecting the present value of an estimate of future interest credits from the date of the lump sum distribution to each participant’s retirement age of 65 (“whipsaw claim”).
On November 2, 2017, plaintiffs filed a motion conceding that the statutory "whipsaw" claims, but not the breach of fiduciary duty or failure to meet ERISA notice requirement claims, of participants who received lump sum distributions prior to March 13, 2002 are time-barred. Consequently, on February 16, 2018, the Court entered an order limiting the claims of those participants to alleged violations of ERISA's disclosure requirements and breaches of fiduciary duty.
At this time, the Company is unable to provide a reasonable estimate of the potential range of ultimate liability if the outcome of the suit is unfavorable. The extent of potential liability, if any, will depend on the Court's ruling on the pending motion seeking to apply the statute of limitations to the claims of the sub-class of persons who received lump sum distributions between March 1, 1997 and March 12, 2002. In addition, assuming for these purposes that the plaintiffs prevail with respect to claims that benefits accrued or payable under the Plan were understated, or that the Company had a fiduciary duty to notify participants of possible claims under plaintiffs’ whipsaw theory, then there are numerous possible theories and other variables upon which any revised calculation of benefits as requested under plaintiffs’ claims could be based. Any adverse judgment in this case against the Plan would be expected to create a liability for the Plan, with resulting effects on the Plan’s assets available to pay benefits. The Company’s future required funding of the Plan could also be impacted by such a liability.
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. Permitted statutory accounting practices encompass all accounting practices that are not prescribed; such practices differ from state to state, may differ from company to company within a state, and may change in the future. The Company’s U.S. insurance subsidiaries did not have any permitted practices as of or for the years ended December 31, 2017, 2016 and 2015.
The quarterly results of operations for 2017 and 2016 are summarized below.