We also own office space located at 645 W. Grand River, Howell, Michigan, with approximately 110,000 square feet, a three-building complex located at 808 North Highlander Way, Howell, Michigan, with approximately 178,000 square feet, where various business operations are conducted, and office space located at Thanet Way, Whitstable, United Kingdom, with approximately 40,000 square feet, where we operate our U.K. motor line of business.
Our business operations consist of four operating segments: Commercial Lines, Personal Lines, Chaucer and Other Property and Casualty.
Our segment income excluding taxes and interest of $72.5 million in 2011, includes $32.3 million of segment income generated by Chaucer. Our pre-tax segment earnings declined in 2011, principally due to an unprecedented level of weather-related events that affected the property and casualty industry. Pre-tax catastrophe losses were $361.6 million during 2011, of which $49.5 million related to our Chaucer segment. During 2010, pre-tax catastrophe losses were $160.3 million. Our 2011 catastrophe losses were principally the result of winter storms, tornado, hail and windstorm activity in both the Midwest and the Northeast in the first half of the year, Hurricane Irene and floods in Thailand and Denmark during the second half of 2011. A decrease of $43.3 million in favorable development on prior years’ loss and loss adjustment expense (“LAE”) reserves, primarily from Commercial and Personal lines, also contributed to the overall decline in segment results from the prior year. Segment income for our Commercial, Personal, and Other Property and Casualty lines, excluding catastrophes and development, was $284.5 million in 2011, compared to $276.9 million in 2010, reflecting growth in earned premium and the resulting positive effect on our expense ratio, and what we believe is an improved mix of business, partially offset by increased non-catastrophe weather-related losses.
Written premiums in Personal Lines in 2011 were comparable to 2010. Underwriting results, excluding catastrophes, improved slightly in 2011, as compared to 2010. Lower operating expenses in 2011 were partially offset by less favorable current accident year results driven by non-catastrophe weather-related losses. Similar to our strategy in Commercial Lines, we are seeking additional rate increases in our property lines (homeowners coverage) as a result of the recent catastrophe and non-catastrophe weather-related losses that the industry experienced. In addition, continued increases in premium are expected in our target growth states as we seek to improve profitability and diversify from our existing core states.
Overall, we believe that the strength and depth of our underwriting teams, the broad diversity of our underwriting portfolio and our membership in the Lloyd’s platform, together underpin our ability to manage both the scale and composition of our business. Moreover, these strengths, combined with our continued active management of our portfolio and the opportunities that we expect to arise across the majority of our markets, provide a strong basis for the profitable development of the Chaucer business.
We report interest expense related to our debt separately from the earnings of our operating segments. Our debt consists of senior debentures, junior debentures, subordinated notes, advances under our collateralized borrowing program with the Federal Home Loan Bank of Boston (“FHLBB”), and capital securities.
Catastrophe losses and prior year reserve development are significant components in understanding and assessing the financial performance of our business. Management reviews and evaluates catastrophes and prior year reserve development separate from the other components of earnings. Catastrophes and prior-year reserve development are not predictable as to timing or the amount that will affect the results of our operations and have affected our results in the past few years. Management believes that providing certain financial metrics and trends excluding the effects of catastrophes and prior year reserve development helps investors to understand the variability in periodic earnings and to evaluate the underlying performance of our operations.
The following table reflects segment income as determined in accordance with GAAP and a reconciliation of total segment income to consolidated net income.
Net premiums written grew by $545.4 million for the year ended December 31, 2011, compared to the year ended December 31, 2010, and net premiums earned grew by $757.6 million. Chaucer accounted for $428.8 million of net premiums written and $506.3 million of net premiums earned for the year ended December 31, 2011. The balance of the growth in net premiums written is attributable to Commercial Lines. A significant portion of the increase in net premiums earned in Commercial Lines is a result of the growth in net premiums written in 2010 following the OneBeacon renewal rights transaction, as well as growth in our AIX program business and in various niche and segmented businesses.
The following table summarizes GAAP underwriting results for the Commercial Lines, Personal Lines, Chaucer and Other Property and Casualty segments and reconciles it to segment income. Results for Chaucer reflect the period from July 1, 2011 to December 31, 2011.
Commercial Lines underwriting loss, excluding catastrophe and prior year loss and LAE reserve development, for the year ended December 31, 2011, was $7.6 million, compared to $20.5 million for the year ended December 31, 2010. This $12.9 million improvement resulted from growth in earned premium and the resulting positive effect on our expense ratio, and from what we believe to be an improved mix of business. Partially offsetting the effect of this growth were higher non-catastrophe weather-related losses and LAE, and higher losses in our surety business. The higher level of earned premiums primarily resulted from our 2010 OneBeacon transaction, from growth in our AIX program business, and from other growth initiatives.
Personal Lines underwriting loss for the year ended December 31, 2011 was $73.0 million, compared to a profit of $1.6 million for the year ended December 31, 2010, a decrease of $74.6 million. This decrease is due to higher weather-related losses and LAE, including catastrophes, and to decreased favorable development on prior years loss and LAE reserves, partially offset by lower operating expenses. Catastrophe losses were $163.7 million for the year ended December 31, 2011, including significant winter storms, tornado, hail and windstorm activity in the first half of the year and Hurricane Irene during the third quarter, compared to $98.7 million for the year ended December 31, 2010, an increase of $65.0 million. Favorable development on prior years’ loss and LAE reserves was $33.0 million for the year ended December 31, 2011, compared to $48.8 million for the year ended December 31, 2010, a decrease of $15.8 million. Included in 2010 results was $2.3 million of favorable LAE development, principally related to a change in the cost factors used for establishing unallocated LAE reserves.
in Michigan, which is our largest state. Our rate actions have adversely affected our ability to increase our policies in force and new business, particularly in our core states and in Florida. There is no assurance that we will be able to maintain our current level of production or maintain or increase rates in light of the highly competitive environment. We may also implement various rate, underwriting, and other actions to create capacity for growing partner agent account business, reduce our property concentrations, and with a view to increasing our longer-term profitability. Such events may affect our ability to grow.
We currently expect to achieve rate increases for a majority of Chaucer lines in 2012. Recent natural catastrophe losses, particularly those affecting the U.S., New Zealand, Japan and Thailand, are triggering rate increases in the majority of catastrophe-exposed territories. We also expect to see terms and conditions improve in our energy portfolio as markets respond to losses in 2011. We expect our casualty and aviation accounts to remain challenging, with over-capacity affecting pricing. In our U.K. motor account, which has experienced significant price increases since 2010, we expect more modest rate increases in 2012, although we anticipate these will exceed claims inflation. There can be no assurance that we will be able to maintain or increase our rates in light of economic and regulatory conditions in our markets.
Other Property and Casualty segment loss for the year ended December 31, 2011 was $0.5 million, compared to a profit of $3.5 million for the year ended December 31, 2010. The $4.0 million decrease is primarily due to lower net investment income and less favorable development in our run-off voluntary pools.
Favorable development on prior years’ loss and LAE reserves for the year ended December 31, 2010 was $61.5 million, compared to $104.1 million for the year ended December 31, 2009, a decrease of $42.6 million. This change was primarily related to our surety bonds, workers’ compensation, and commercial multiple peril lines. Included in the current year results was $7.5 million of favorable LAE development, principally related to a change in the cost factors used for establishing unallocated LAE reserves. LAE in 2009 includes a benefit of $18.0 million, including $14.4 million associated with prior accident years, related to a change in our unallocated loss adjustment expense reserving methodology.
Personal Lines net premiums written for the year ended December 31, 2010 was $1,462.9 million, compared to $1,472.2 million for the year ended December 31, 2009, a decrease of $9.3 million. The most significant factor contributing to lower net premiums written is our continued focus on driving profit improvement in our core states, resulting in lower new business activity. Policies in force in our core states decreased 7% in 2010. This was largely offset by our efforts to diversify our Personal Lines business into targeted growth states. Policies in force in our target growth states increased 4% in 2010.
Personal Lines underwriting profit for the year ended December 31, 2010 was $1.6 million, compared to a loss of $43.6 million for the year ended December 31, 2009, an increase of $45.2 million. This increase was primarily due to more favorable current accident year loss results, principally resulting from benign loss trends, which we attribute to improved non-catastrophe weather, and improvement in our mix of business, shifting to a greater proportion of whole account business, continued rate increases in both personal automobile and homeowners lines, and to lower expenses. These were partially offset by increased catastrophe losses due to several severe hail, wind, and thunderstorm events. Catastrophe losses were $98.7 million for the year ended December 31, 2010, compared to $70.3 million for the year ended December 31, 2009, an increase of $28.4 million.
Personal Lines underwriting profit, excluding prior year loss and LAE reserve development and catastrophes, was $51.5 million for the year ended December 31, 2010, compared to a loss of $12.7 million for the year ended December 31, 2009, an increase of $64.2 million. This increase was primarily due to more favorable current accident year loss results, principally resulting from lower frequency of losses, which we attribute to improved non-catastrophe weather and benign loss trends. Additionally, we experienced an improvement in our mix of business, shifting to a greater proportion of whole account business, as well as continued rate increases in both the personal automobile and homeowners lines. Also, underwriting and other operating expenses decreased, primarily due to lower pension costs, the favorable resolution of a loss contingency and to lower technology costs.
Other Property and Casualty segment income for the year ended December 31, 2010 was $3.5 million, compared to $4.0 million for the year ended December 31, 2009. The $0.5 million decrease is primarily due to lower favorable development in our run-off voluntary pools, partially offset by lower pension costs in 2010.
We determine the amount of our loss reserves based on an estimation process that is very complex and uses information from both company specific and industry data, as well as general economic and other information. The estimation process is a combination of objective and subjective information, the blending of which requires significant professional judgment. There are various assumptions required, including future trends in frequency and severity of claims, operational changes in claim handling, and trends related to general economic and social conditions. Informed subjective estimates and judgments as to our ultimate exposure to losses are an integral component of our loss reserve estimation process.
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, 2011 were $3.8 billion. Therefore, a relatively small percentage change in the estimate of net loss reserves would have a material effect on our results of operations.
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 $103.3 million, $111.1 million, and $155.3 million for the years ended December 31, 2011, 2010, and 2009, respectively. However, we have experienced unfavorable development in prior years and there can be no absolute assurance that current loss and LAE reserves will be sufficient.
a longer tail on average than the our traditional U.S. business, contains a substantial book of U.K. motor property damage, worldwide property insurance and reinsurance business, including certain high excess property layers, marine property, aviation property and energy property business which has relatively short development patterns. For these property coverages, claims are generally reported and settled shortly after the loss occurs because the claims relate to tangible property and are more likely to be discovered shortly after the loss occurs and property losses are often more easily valued. Consequently, the estimation of loss reserves for these classes is generally less complex. However, this is less true for our Chaucer reinsurance business and high excess property layers where there is often a longer period of time between the date a claim is incurred and the date the claim is reported compared with our direct insurance operations. Therefore, the risk of delayed recognition of loss reserve development is higher for our assumed reinsurance and high excess property layers than for our direct insurance lines.
While we estimate that a majority of our written premium is in what we would characterize as shorter tailed classes of business, most of our loss reserves relate to longer tail liability classes of business. Long-tailed classes include commercial liability, automobile liability, workers’ compensation and other types of third party coverage. Chaucer business longer tailed lines include aviation liability, marine liability, energy liability, nuclear liability, U.K. motor medical and liability, international liability, specialist liability, and financial institutions and professional liability. For many liability claims, significant periods of time, ranging up to several years or more, may elapse between the occurrence of the loss, the discovery and reporting of the loss to us and the settlement of the claim. As a result, loss experience in the more recent accident years for long-tailed liability coverage has limited statistical credibility because a relatively small proportion of losses in these accident years are reported claims and an even smaller proportion are paid losses. An accident year is the calendar year in which a loss is incurred. Liability claims are also more susceptible to litigation and can be significantly affected by changing contract interpretations, the legal environment and the risk and expense of protracted litigation. Consequently, the estimation of loss reserves for these coverages is more complex and typically subject to a higher degree of variability compared to short-tail coverages.
The loss reserve estimation process relies on the basic assumption that past experience, adjusted for the effects of current developments and likely trends, is an appropriate basis for predicting future outcomes. As part of this process, we use a variety of analytical methods that consider experience, trends and other relevant factors. Within the comprehensive loss reserving process, standard actuarial methods which include: (1) loss development factor methods; (2) expected loss methods (Bornheutter-Ferguson); and (3) adjusted loss methods (Berquist-Sherman), are given due consideration. These methods are described below:
Bornheutter-Ferguson methods utilize the product of the expected ultimate losses times the proportion of ultimate losses estimated to be unreported or unpaid (to calculate IBNR directly). The expected ultimate losses are based upon current estimates of ultimate losses from prior accident years, adjusted to reflect expected earned premium, current rating, claims cost levels and changes in business mix. The expected losses, and corresponding loss ratios, are a critical component of Bornheutter-Ferguson methodologies and provide a general reasonability guide.
For most classes of shorter tailed business in our Commercial and Personal Lines segments, the emergence of paid and incurred losses generally exhibits a relatively stable pattern of loss development from one accident year to the next. Thus, for these classes, the loss development factor method is generally appropriate. For many of the classes of shorter tailed business in our Chaucer segment, the emergence of paid and incurred losses may exhibit a relatively volatile pattern of loss development from one accident year to the next. In certain cases where there is a relatively low level of reliability placed on the available paid and incurred loss data, expected loss methods or adjusted loss methods are considered appropriate for the most recent accident year.
The Chaucer segment contains run-off business comprised of liability lines, notably financial institutions and professional liability business written by Lloyd’s Syndicate 4000. 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 Syndicate 4000 business written in 2008.
Monoline and Multi-Peril General Liability - reserves recorded for general liability on voluntary business were $275.2 million as of December 31, 2011. A key assumption for general liability is the implied adequacy of the underlying case reserves. A ten point change in case adequacy (e.g. 10% deficiency changed to 0% or 20% deficiency) would have changed estimated IBNR by approximately $19 million, either positive or negative, at December 31, 2011.
Chaucer new classes of business- an increase in the ultimate loss ratios on new classes of business (energy, engineering and international liability classes) by 5%, 10%, and 15% in the 2009 and prior, 2010, and 2011 years of account, respectively, would have increased estimated IBNR by approximately $65 million at December 31, 2011.
The following table provides a reconciliation of the gross beginning and ending reserve for unpaid losses and loss adjustment expenses (including Chaucer with respect to the six month period ended December 31, 2011).
Loss and LAE reserves for claims occurring in prior years developed favorably by $103.3 million, $111.1 million and $155.3 million during the years ended December 31, 2011, 2010 and 2009, respectively. These amounts for 2011 include favorable loss and LAE reserve development of $34.7 million and $33.0 million, for the full year for Commercial Lines and Personal Lines, respectively, and $35.5 million for Chaucer for the six months ended December 31, 2011. The primary drivers of reserve development for the year ended December 31, 2011 were as follows:
Lower than expected losses within our personal automobile line, primarily related to bodily injury coverage in the 2008 through 2010 accident years.
Within our other commercial lines, our commercial umbrella line related to the 2007 through 2009 accident years contributed to the favorable development, partially offset by unfavorable development in our surety line, primarily related to the 2009 accident year.
In addition, the 2010 amount includes $9.8 million of favorable development resulting from a change in the cost factors used for establishing unallocated loss adjustment expense reserves.
The primary drivers for reserve development during the year ended December 31, 2009 were as follows:
Lower than expected losses within the personal automobile line, primarily related to bodily injury coverage in the 2005 through 2008 accident years.
Lower than expected losses within the workers’ compensation line, primarily in the 2000 through 2008 accident years.
Lower than expected losses within the commercial multiple peril line, primarily in the 2005 through 2007 accident years.
In addition, in 2009, we changed our unallocated loss adjustment expense reserving methodology from that based on cash payments to that based on unit costs, which resulted in a $20.0 million benefit, of which $16.0 million related to prior years. We believe that the methodology based on unit costs is more representative of our future costs of settling our existing claims.
reserves, resulting in a decrease of $0.1 million. During 2010, we reduced our asbestos and environmental reserves by $1.2 million due to several small settlements. In recent years, average asbestos and environmental payments have declined modestly. As a result of the declining payments, our estimate of asbestos and environmental liability reserves was lowered, resulting in favorable reserve development of $7.1 million during the year ended December 31, 2009.
In addition, we have established gross loss and LAE reserves for assumed reinsurance pool business with asbestos and environmental damage liability of $31.1 million, $33.9 million and $45.6 million at December 31, 2011, 2010 and 2009, respectively. These reserves relate to pools in which we have terminated our participation; however, we continue to be subject to claims related to years in which we were a participant. Results of operations from these pools are included in our Other Property and Casualty segment. The $11.7 million decrease in these reserves during 2010 was primarily due to a large claim settlement within these pools. A significant part of our pool reserves relates to our participation in the Excess and Casualty Reinsurance Association (“ECRA”) voluntary pool from 1950 to 1982. In 1982, the pool was dissolved and since that time, the business has been in run-off. Our percentage of the total pool liabilities varied from 1% to 6% during these years. Our participation in this pool has resulted in average paid losses of approximately $2 million annually over the past ten years.
During 2011, our net unrealized gains on fixed maturities increased $76.9 million, or 38.6%, to a net unrealized gain of $276.0 million at December 31, 2011, compared to $199.1 million at December 31, 2010.
Amortized cost and fair value by rating category were as follows:
Our sovereign debt totals $89.3 million, or 1.2% of the total portfolio, and is limited to the highly rated countries of the U.K., Germany, France and Denmark. We have no sovereign debt of lower rated countries such as Greece, Portugal, Ireland, Italy and Spain. Our supranational and foreign agency exposure totals $116.5 million, or 1.5% of the total portfolio, and primarily consists of debt securities from the highly rated countries of Germany, Netherlands and Norway. Exposure to European banks, excluding those that are based in the U.K., totals $123.5 million, or 1.6% of investment assets. Also, we hold money market funds totaling $258.9 million, or 3.4% of the total portfolio, which are comprised of a well-diversified portfolio of short-term debt securities of predominately large financial institutions domiciled in highly rated countries. The remainder of our European non-sovereign debt exposure, excluding the U.K., is $293.9 million, which represents 3.9% of the portfolio. Generally, these securities are high quality, large cap multi-national companies that are well diversified by sector, country and issuer.
The table above represents all European countries in which we have exposure. We determined country exposures based on the country of domicile for the ultimate parent company of the various issuers we hold; however, in light of the economic and financial inter-relatedness and dependencies that exist among European countries and related financial systems, economic turmoil in one country could trigger a contagion effect on other countries. We believe the quality of our European credit exposure remains sound based on ratings and issuer strength, position in the capital structure, support through guarantees and partial government ownership by highly rated countries, diversity and quality of non-financial issuers and blend of industry exposures, and yield curve position. We believe that we do not have meaningful indirect exposures in our portfolio or invest in credit derivatives.
We manage our country exposure using fundamental analysis coupled with relative value considerations. Investment decisions are based on the combination of a top-down macroeconomic perspective and bottom-up credit security analysis. We monitor political and economic developments; progress toward attainment of growth and budget targets; developments related to policy, reform and regulatory initiatives from European officials; progress toward funding objectives, including the availability and cost of funding; outlook for credit ratings; ability of banks to meet increased regulatory capital standards, operate in a weakened macroeconomic environment, and maintain adequate liquidity and sufficient access to capital to meet funding requirements; and contagion throughout the financial system as evidenced by increased costs for interbank funding, lower prices for stocks and corporate bonds, as well as the availability of capital.
We actively manage our current holdings and seek securities with the best combination of credit strength and valuation. As we invest new capital, we have a defensive bias based on the uncertainty regarding the strength and duration of economic recovery, downside risks as a result of the European debt crisis and our belief that volatility will remain high based on these challenges. Accordingly, some areas of our focus include providers of essential services or products best positioned to navigate the period of weak growth; industrials with greater international exposure, either locally or via exports, particularly to the developing world, which we view more favorably based on higher growth assumptions for emerging market economies; and financial institutions best positioned regarding asset quality, liquidity and capital adequacy.
Overall economic growth remains weak throughout the European region and is expected to have a dampening effect on earnings growth and credit quality for some time. Volatility remains high and European sovereign risk premiums are elevated, although down from peak levels. Many attribute the decline in risk premiums to the apparent success of the European Central Bank’s Long-Term Refinancing Operations (“LTRO”) since it created enough demand to lower short-term government bond yields in 2012. LTRO is designed to support banks by reducing systemic risk and thereby bank and sovereign funding. Also in 2012, several sovereign debt ratings were downgraded by Standard & Poor’s and Fitch, which had limited impact on sovereign yields since the bulk of these actions were anticipated by investors. Moody’s is assessing all European bank ratings in light of the challenges they face as a result of the crisis and expects negative rating actions on the banks most affected by the crisis, with many bank ratings likely to be placed on review for downgrade during the first quarter 2012. We do not anticipate that any such developments will have a material effect on our financial condition, results of operations or liquidity.
For the year ended December 31, 2011, we recognized in earnings $6.9 million of other-than-temporary impairments (“OTTI”) on fixed maturity and equity securities. OTTI on debt securities was $5.5 million, primarily on below investment grade corporate and municipal bonds that we intend to sell. Additionally, we recognized OTTI of $0.9 million related to estimated credit losses on residential mortgage-backed securities. We also recognized OTTI on a common stock of $1.4 million. For the year ended December 31, 2010, we recognized $13.9 million of OTTI on fixed maturities, certain low-income housing tax credit limited partnerships (“LIHTC”) and equity securities in earnings, of which $4.4 million related to LIHTC partnerships, $4.3 million was estimated credit losses on debt securities, $3.3 million related to debt securities classified as intend to sell and $1.9 million related to common stocks. For the year ended December 31, 2009, we recognized OTTI of $32.9 million in earnings, which principally included losses on below investment grade corporate bonds in the industrial sector we intended to sell of $21.2 million and $9.5 million from perpetual preferred securities, primarily in the financial sector.
The following table provides information about our fixed maturities and equity securities that are in an unrealized loss position. (See also Note 3 “Investments” on pages 99 to 102 of the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K).
The carrying values of defaulted fixed maturity securities on non-accrual status at December 31, 2011 and 2010 were not material. The effects of non-accruals compared with amounts that would have been recognized in accordance with the original terms of the fixed maturities, were reductions in net investment income of $2.3 million for both years ended December 31, 2011 and 2010. Any defaults in the fixed maturities portfolio in future periods may negatively affect investment income.
Our investment portfolio and shareholders’ equity can be significantly impacted by changes in market values of our securities. As the U.S. and global financial markets and economies remain unstable, market volatility could increase and defaults on fixed income securities could occur. As a result, we could incur additional realized and unrealized losses in future periods, which could have a material adverse impact on our results of operations and/or financial position.
We maintain an overall risk management strategy that can incorporate the use of derivative instruments to manage significant unplanned fluctuations in earnings caused by foreign currency and interest rate volatility.
Net realized gains on investments were $28.1 million, $29.7 million, and $1.4 million for 2011, 2010, and 2009, respectively. Net realized gains in 2011 are primarily due to $27.7 million of gains recognized from the sale of fixed maturities and equity securities and $6.1 million of gains on foreign currency hedges, partially offset by $6.9 million of other-than-temporary impairments from fixed maturities and equity securities. Net realized gains in 2010 are due to $43.6 million of gains recognized, primarily from the sale of fixed maturities and equity securities, partially offset by $13.9 million of other-than-temporary impairments from fixed maturities, low-income housing tax partnerships and equity securities. Net realized investment gains in 2009 resulted from $34.3 million of gains recognized principally from the sale of fixed maturities, partially offset by $32.9 million of other-than-temporary impairments from both fixed maturities and equity securities.
In connection with the acquisition of Chaucer, we entered into a foreign exchange forward contract, which was settled in July 2011 at a loss of $11.3 million. See “Investments” on pages 59 to 64 of this Form 10-K. The loss on the contract was offset by the lower U.S. dollars required to meet the GBP based purchase price, which resulted in a $6.4 million gain on foreign exchange. Additional decreases in the exchange rate occurred subsequent to payment of cash proceeds on July 14, 2011. Gains of $0.3 million were recognized related to the loan notes that are due in GBP to certain former shareholders of Chaucer common stock for the year ended December 31, 2011. We will be subject to fluctuations in the currency until such loan notes have been paid.
Discontinued operations consist of: (i) Discontinued First Allmerica Financial Life Insurance Company (“FAFLIC”) Business, including both the loss associated with the sale of FAFLIC on January 2, 2009 and the loss or income resulting from its prior business operations; (ii) Discontinued Operations of our Variable Life Insurance and Annuity Business in 2005; and (iii) Discontinued Accident and Health Business.
On January 2, 2009, we sold our remaining life insurance subsidiary, FAFLIC, to Commonwealth Annuity and Life Insurance Company (“Commonwealth Annuity”), a subsidiary of The Goldman Sachs Group, Inc, (“Goldman Sachs”). Previously, on December 30, 2005, we sold our variable life insurance and annuity business to Goldman Sachs, including the reinsurance of 100% of the variable business of FAFLIC. We agreed to indemnify Commonwealth Annuity and Goldman Sachs for certain litigation, regulatory matters and other liabilities relating to the pre-closing activities of the businesses that were sold. As of December 31, 2011, our total gross liability related to these guarantees was $3.8 million. We regularly review and update this liability for legal and regulatory matter indemnities. Although we believe our current estimate for this liability is appropriate, there can be no assurance that these estimates will not materially increase in the future. Adjustments to this reserve are recorded in our results in the period in which they are determined.
Our overall investment strategy is intended to balance investment income with credit and duration risk while maintaining sufficient liquidity and the opportunity for capital growth. The asset allocation process takes into consideration the types of business written 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, 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, as well as undervalued securities in the credit markets balanced by strong relative value characteristics. 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, property types and geographic locations. In addition, we currently carry debt which is subject to interest rate risk, which was issued at fixed interest rates between 5.50% and 8.207%. Current market conditions do not allow for us to invest assets at similar rates of return; therefore, our earnings on a similar level of assets are not sufficient to cover our 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. At December 31, 2011, 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 $25 million. A hypothetical 10% increase or decrease at December 31, 2010 would have resulted in an increase or decrease in the fair value of the equity securities portfolio of $13 million.
We are subject to the tax laws and regulations of the U.S. and foreign countries in which we operate. We file a consolidated U.S. federal income tax return that includes the holding company and its U.S. subsidiaries. Generally, taxes are accrued at the U.S. statutory tax rate of 35% for income from the U.S. operations. Our primary non-U.S. jurisdiction is the U.K. with a 26% rate. The U.K. statutory rate decreases from 26% to 25% effective April 1, 2012. We accrue taxes on certain non-U.S. income, which is subject to U.S. tax as a result of being owned by a U.S. shareholder at the U.S. rate. Foreign tax credits, where available, are utilized to offset U.S. tax as permitted. Certain of our non-U.S. income is not subject to U.S. tax until repatriated. Foreign taxes on this non-U.S. income are accrued at the local foreign rate and do not have an accrual for U.S. deferred taxes since these earnings are intended to be permanently reinvested overseas.
As of December 31, 2011, we have a deferred tax asset of $112.2 million of alternative minimum tax (“AMT”) credit carryforwards. We expect to utilize these tax credits during the next four to five years. The result of their utilization will be a lower current tax rate offset by a higher deferred tax provision, and also lower cash expenditures for federal income taxes during the utilization period. Once the minimum tax credits have been fully utilized, we expect our current tax rate to be closer to the statutory rate of 35%. Although there is no expiration on AMT credit carryforwards, we cannot be certain that we will utilize them as quickly as our expectations.
During 2011, we reduced the valuation allowance related to our deferred tax asset by $55.6 million, from $91.5 million to $35.9 million. There were four principal components to this reduction. First, we decreased the valuation allowance by $29.0 million as a result of the transactions described above which utilized our capital loss carryforwards. Second, we decreased the valuation allowance by $21.9 million on certain unrealized losses as a result of unrealized appreciation in our investment portfolio. This decrease was reflected as an increase in accumulated other comprehensive income. Third, as a result of $28.1 million in net realized gains during 2011, we decreased the valuation allowance by $7.5 million as an increase to income from continuing operations, since these gains utilized our capital loss carryforwards. Fourth, in the 2010 U.S. federal income tax return, we were able to utilize an additional $7.6 million of capital loss carryforwards that expired in 2010.
As such, we increased the valuation allowance by $2.6 million with an equal and offsetting increase to the related deferred tax asset. The remaining increase of $0.2 million was attributable to other items reflected as expense from discontinued operations.
In 2010, we reduced the valuation allowance related to our deferred tax asset by a total of $104.1 million, from $195.6 million to $91.5 million. There were four principal components to this reduction. First, we reduced the valuation allowance by $66.2 million as a result of the transactions described above which utilized our capital loss carryforwards. Second, we increased the valuation allowance by $20.3 million for certain tax basis unrealized losses which we did not believe we could utilize. This increase was reflected as a decrease in accumulated other comprehensive income. Third, $135.5 million of our capital loss carryforwards expired in 2010. As a result, we released the $47.4 million of the valuation allowance attributable to these expirations with an equal and offsetting reduction in the related deferred tax asset. Fourth, as a result of $29.7 million in net realized capital gains, we decreased our valuation allowance by $9.7 million as an increase to income from continuing operations since these gains utilized our capital loss carryforwards. The remaining $1.1 million decrease was attributable to other items reflected as income from discontinued operations.
During 2009, we reduced the valuation allowance related to our deferred tax asset by $152.6 million, from $348.2 million to $195.6 million. There were two principal components to this reduction. First, we reversed, through other comprehensive income, the $118.4 million valuation allowance that we had recognized at December 31, 2008 associated with the tax benefit related to the net unrealized depreciation in our investment portfolio at that time. During 2009, appreciation in the portfolio changed the nature of the tax attribute from that of an asset to that of a liability, and thus, there was no longer a need for that portion of the valuation allowance. Second, as a result of the aforementioned transactions, we reversed $28.4 million of the valuation allowance as an adjustment to other comprehensive income and $6.0 million of the valuation allowance as an adjustment to income from continuing operations. The remaining $0.2 million net increase in our valuation allowance was attributable to other items, and reflected as a $0.9 million increase in income from continuing operations and a $1.1 million decrease in income from discontinued operations.
Reinsurance recoverables recorded on insurance losses ceded under reinsurance contracts are subject to judgments and uncertainties similar to those involved in estimating gross loss reserves, as disclosed above. In addition to these uncertainties, our reinsurance recoverables may prove uncollectible if the reinsurers are unable or unwilling to perform under the reinsurance contracts. In establishing our reinsurance allowance for amounts deemed uncollectible, we evaluate the financial condition of our reinsurers and monitor concentration of credit risk arising from our exposure to individual reinsurers. To determine if an allowance is necessary, we consider, among other factors, published financial information, reports from rating agencies, payment history, collateral held and our legal right to offset balances recoverable against balances we may owe. Our reinsurance allowance for doubtful accounts is subject to uncertainty and volatility due to the time lag involved in collecting amounts recoverable from reinsurers. Over the period of time that losses occur, reinsurers are billed and amounts are ultimately collected, economic conditions, as well as the operational and financial performance of particular reinsurers, may change and these changes may affect the reinsurers' willingness and ability to meet their contractual obligation to us. It is also difficult to fully evaluate the impact of major catastrophic events on the financial stability of reinsurers, as well as the access to capital that reinsurers may have when such events occur. The ceding of insurance does not legally discharge us from our primary liability for the full amount of the policies, and we will be required to pay the loss and bear collection risk even if the reinsurers fail to meet their obligations under the reinsurance contracts.
As of December 31, 2011 and 2010, we determined our discount rate utilizing an independent yield curve which provides for a portfolio of high quality bonds that are expected to match the cash flows of our pension plan. Bond information used in the yield curve included only those rated Aa or better as of December 31, 2011 and 2010, respectively, and had been rated by at least two well-known rating agencies. At December 31, 2011, based upon our qualified plan liabilities and cash flows in relation to this discount curve, we decreased our discount rate to 5.125%, from 5.625% at December 31, 2010.
For the years ended December 31, 2011 and 2010, the expected rate of return on our qualified plan assets was 6.50% and 7.00%, respectively. The decrease reflects our strategy to shift investment assets from equity securities to fixed maturity investments over several years resulting in our composition of 82% fixed maturities and 18% equities at December 31, 2011, as well as declines in the fixed maturities markets in general. Actual returns of the plan investments generated approximately $58 million and $56 million of gains during 2011 and 2010, respectively, as compared to expected returns of approximately $34 million and $35 million, respectively.
Discount Rate - A 25 basis point increase in the discount rate would decrease our pension expense in 2012 by $1.9 million and decrease our projected benefit obligation by $12.7 million. A 25 basis point reduction in the discount rate would increase our pension expense by $1.9 million and increase our projected benefit obligation by $13.3 million.
Prior to 2002, our Chaucer segment provided defined benefit pension retirement benefits to certain of its employees. As of December 31, 2001, the defined benefit section of the pension plan was closed to new members. The defined benefit obligation for this plan is based on the employees’ years of service and final pensionable salary.
As of December 31, 2011 and the July 1, 2011 acquisition date, we determined our discount rate utilizing a 15 Year AA corporate bond index. At December 31, 2011, based upon our Chaucer plan liabilities and cash flows in relation to this index, we decreased our discount rate to 4.90%, from 5.50%, at the July 1, 2011 acquisition date.
For the six months ended December 31, 2011, the expected rate of return on plan assets was 7.40%. The composition of our Chaucer plan assets are 78% equities, 12% fixed maturities, and 10% real estate funds at December 31, 2011. Actual returns of the plan investments generated approximately $4.5 million of losses during the six months ended December 31, 2011.
Holding all other assumptions constant, sensitivity to changes in our key assumptions related to our Chaucer pension plan are as follows:
Expected Return on Plan Assets - A 25 basis point increase or decrease in the expected return on plan assets would decrease or increase our pension expense in 2012 by $0.1 million.
For our impairment review of asset-backed fixed maturity securities, we forecast our best estimate of the prospective future cash flows of the security to determine if we expect to recover the entire amortized cost basis of the security. Our analysis includes estimates of underlying collateral default rates based on historical and projected delinquency rates and estimates of the amount and timing of potential recovery. We consider available information relevant to the collectibility of cash flows, including information about the payment terms of the security, prepayment speeds, the financial condition of the underlying
We estimate the amount of the other-than-temporary impairment that relates to credit by comparing the amortized cost of the debt maturity security with the net present value of the debt security’s projected future cash flows, discounted at the effective interest rate implicit in the investment prior to impairment. The non-credit portion of the impairment is equal to the difference between the fair value and the net present value of the fixed maturity security at the impairment measurement date.
The following table reflects statutory surplus for our U.S. insurance subsidiaries:
Chaucer corporate members operate in the Lloyd’s market, which requires that these members deposit funds, referred to as “Funds at Lloyd’s”, to support their underwriting interests. Lloyd’s sets required capital annually for all participating syndicates based on each syndicates’ business plans, the rating and reserving environment, and discussions with regulatory and rating agencies. Although the minimum capital levels are set by Lloyd’s, it is the responsibility of Chaucer to continually monitor the risk profiles of its managed syndicates to ensure that the level of funding remains appropriate. Such capital is comprised of cash and cash equivalents, investments, undrawn letters of credit provided by various banks and other assets. At December 31, 2011, the required capital supporting our Lloyd’s business totaled $737.5 million (using the December 31, 2011 GBP to U.S. dollar conversion rate of 1.55). We have securities, assets and letters of credit pledged to Lloyd’s to satisfy these capital requirements at December 31, 2011 and expect to be able to meet these capital requirements in the future.
Net cash provided by investing activities was $182.8 million during 2011, compared to net cash used in investing activities of $98.8 million in 2010 and $174.2 million in 2009. During 2011, cash provided by investing activities primarily resulted from $756.1 million of cash and cash equivalents acquired from Chaucer. This increase was partially offset by cash paid for the Chaucer acquisition totaling $468.4 million, which included an $11.3 million payment related to a foreign currency exchange forward contract, and the investment of a portion of our Chaucer segment’s cash into fixed maturities. During 2010, cash used was primarily related to our net purchases of equity securities and fixed maturities. Additionally, cash was used in 2010 in connection with our acquisitions and renewal rights transactions. During 2009, cash was primarily used as we invested a portion of existing cash into fixed maturities and invested the proceeds from the sale of our Life Companies into fixed maturities. Additionally, in 2009, cash was used in connection with the One Beacon renewal rights agreement, which was funded, in part, by the sale of equity securities. This investing activity was partially offset by cash provided from sales of fixed maturities to fund our stock repurchase program.
Net cash provided by financing activities was $127.3 million during 2011, compared to cash used in financing activities of $8.6 million in 2010 and $130.2 million in 2009. During 2011, cash provided by financing activities primarily resulted from the issuance, on June 17, 2011, of $300.0 million of unsecured senior debentures. Cash received from the issuance of debt was partially offset by the repurchase of $86.8 million of debt, the payment of dividends to our shareholders, repayments of collateral related to our securities lending program, and repurchases of common stock. During 2010, cash used in financing activities primarily resulted from repurchases of common stock and debt, as well as the payment of dividends to our shareholders. These were substantially offset by proceeds from the issuance, on February 23, 2010, of $200.0 million unsecured senior debentures. During 2009, cash used in financing activities primarily resulted from $148.1 million net repurchases of our common stock and $37.5 million to fund annual dividends to shareholders. These uses were partially offset by $53.1 million of cash inflows from our securities lending program. Also during 2009, a $125.0 million advance received as part of the FHLBB collateralized borrowing program was offset by $125.9 million used to repurchase a portion of our corporate debt.
Dividends to common shareholders are subject to quarterly board approval and declaration. During 2011, as declared by the Board, we paid three quarterly dividends of $0.275 per share and one quarterly dividend of $0.30 per share to our shareholders. The total dividends paid to our shareholders in 2011 were $50.9 million. We believe that our holding company assets are sufficient to provide for future shareholder dividends should the Board of Directors declare them.
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 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 is essentially fully funded as of December 31, 2011. As a result, we currently expect that significant cash contributions will not be required for this plan for several years. The Chaucer pension plan is approximately $30 million underfunded as of December 31, 2011. The ultimate payment amounts for both the defined benefit plan and the Chaucer pension plan 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 and the ultimate valuation and determination of benefit obligations. Since differences between actual plan experience and our assumptions are likely, changes to our funding obligations in future periods are possible.
Over the past several years, we have issued, through two separate transactions, $500 million in senior debentures and have received advances of $163.9 million through our membership in FHLBB as part of a collateralized borrowing program. Additional information related to these borrowings is provided in Note 6 - “Debt and Credit Arrangements” on pages 110 to 111 of the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
Additionally, from time to time, we may also repurchase our debt. In 2011, we repurchased, in several transactions, $69.5 million of Junior Debentures at a cost of $72.1 million, resulting in a net loss of $2.6 million. In addition, we repurchased $4.0 million of surplus notes outstanding related to AIX, $8.0 million of capital securities related to AIX and $3.0 million of capital securities related to Professionals Direct, Inc. These repurchases are expected to reduce our pre-tax interest costs in 2012 by approximately $6 million. In 2010, we repurchased $36.5 million of our Junior Debentures at a cost of $38.5 million, resulting in a $2.0 million loss on the repurchases. In 2009, we repurchased in several transactions, including a tender offer, our mandatorily redeemable preferred securities and Senior Debentures, resulting in a gain of $34.5 million. These mandatorily redeemable securities were originally issued through AFC Capital Trust I, which was liquidated on July 30, 2009. We may decide to repurchase additional debt on an opportunistic basis.
On August 2, 2011, we entered into a $200.0 million committed syndicated credit agreement which expires in August 2015, with an option to increase the facility to $250.0 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 this agreement are unsecured and incur interest at a rate per annum equal to, at our option, a designated base rate or the three - month LIBOR plus applicable margin. The agreement provides covenants, including but not limited to, maintaining at least a certain level of consolidated equity, maximum consolidated leverage ratios, and an RBC ratio at our primary U.S. domiciled property and casualty companies. We had no borrowings under this agreement during 2011. At December 31, 2011, we were in compliance with these covenants.
In 2010, Chaucer entered into a £90.0 million Standby Letter of Credit Facility that is used to provide regulatory capital supporting Chaucer’s underwriting through two managed syndicates expiring on December 31, 2015, and provides for an annual commitment fee of 1.14 percent. The Standby Facility contains restrictive financial covenants including, but not limited to, maintaining a minimum consolidated tangible net worth and a leverage ratio of less than or equal to 35 percent for Chaucer.
On March 31, 2010, we acquired Campania Holding Company, Inc. (“Campania”) for a cash purchase price of approximately $24 million, subject to various terms and conditions. Campania specializes in insurance solutions for portions of the healthcare industry.
On December 3, 2009, we entered into a renewal rights agreement with OneBeacon. Through this agreement, we acquired access to a portion of OneBeacon’s small and middle market commercial business at renewal, including industry programs and middle market niches. This transaction included consideration of approximately $23 million, plus certain potential additional consideration estimated to total approximately $11 million, primarily representing purchased renewal rights intangible assets which are included as other assets in our Consolidated Balance Sheets. The agreement was effective for renewals beginning January 1, 2010
(1) Debt includes our senior debentures due in 2025, which pay annual interest at a rate of 7 5/8%, our senior debentures due in 2020, which pay annual interest at a rate of 7.50%, our senior debentures due in 2021, which pay annual interest at a rate of 6.375%, and our junior subordinated debentures due in 2027, which pay cumulative dividends at an annual rate of 8.207%. In addition, we have subordinated notes denominated in Euros due in 2034, which pay interest semi-annually based on the European Inter bank offer rate (Euribor), plus an agreed margin of 3.75%, and subordinated notes due in 2036, which pay interest semi-annually based on the U.S. dollar 3-month LIBOR, plus an agreed margin of 3.1%. Payments related to the principal amounts of these agreements represent contractual maturity; therefore, principal and interest associated with these obligations are reflected in the above table based upon the contractual maturity dates and current Euribor and LIBOR rates of 1.565% and 0.581%, respectively. The Company has the ability to prepay the subordinated notes, which is not reflected in the table above. The Euro denominated debt is converted from Euro to GBP at current rates and then translated to U.S. dollars based upon the December 31, 2011 exchange rate between the GBP and U.S. dollar of 1.55. In addition, we have $125.0 million of borrowings under a collateralized borrowing program with the FHLBB which pays interest monthly at a rate of 5.50% annually. Such borrowings are available for a twenty-year term or through September 25, 2029. We also have $38.9 million of borrowings under this collateralized borrowing program which pays interest monthly. Furthermore, we borrowed an additional $7.4 million under this program in January 2012. All borrowings under this program with the FHLBB pay interest at a weighted average rate of 3.88%. These borrowings have a maturity date of July 20, 2020.
(5) Investment commitments include $46.8 million related to the City Square Project, $23.6 million related to tax credits, and $17.6 million related to partnerships and other investment commitments.
Information regarding litigation and legal contingencies appears in Note 17-“Commitments and Contingencies” on pages 127 to 128 of the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K. Information related to certain regulatory and industry developments are contained in “Regulation” in Item 1 - Business included on pages 12 to 14 of this Form 10-K and in Item 1A - “Risk Factors” on pages 22 to 37 of this Form 10-K.
Catastrophe - A severe loss, resulting from natural and manmade events, including risks such as hurricane, fire, earthquake, windstorm, tornado, hailstorm, severe winter weather, explosion, terrorism, riots and other similar events.
Combined ratio, GAAP - This ratio is the GAAP equivalent of the statutory ratio that is widely used as a benchmark for determining an insurer’s underwriting performance. A ratio below 100% generally indicates profitable underwriting prior to the consideration of investment income. A combined ratio over 100% generally indicates unprofitable underwriting prior to the consideration of investment income. The combined ratio is the sum of the loss ratio, the loss adjustment expense ratio and the underwriting expense ratio.
Specialty Lines - A major component of our other commercial lines. There is no accepted industry definition of “specialty lines”, but for our purpose specialty lines consist of products such as inland and ocean marine, bond business, specialty property, professional liability, management liability and various other program businesses. When discussing net written premiums and other financial measures of our specialty businesses, we may include non-specialty premiums that are written as part of the entire account.
Supranational - An international organization, or union, whereby member states transcend national boundaries or interests to share in the decision-making and vote on issues pertaining to the wider grouping. European Investment Bank is an example of a supranational.
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of The Hanover Insurance Group, Inc. and its subsidiaries at December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2011 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
As discussed in Note 1 to the consolidated financial statements, the Company changed the manner in which it accounts for other-than-temporary impairments of debt securities in 2009.
The consolidated financial statements of The Hanover Insurance Group, Inc. (“THG” or the “Company”), include the accounts of The Hanover Insurance Company (“Hanover Insurance”) and Citizens Insurance Company of America (“Citizens”), THG’s principal U.S. domiciled property and casualty companies; and certain other insurance and non-insurance subsidiaries. In addition, effective July 1, 2011, the Company acquired Chaucer Holdings plc (“Chaucer”), a specialist underwriting group which operates through the Society and Corporation of Lloyd’s (“Lloyd’s) (See Note 2 - “Acquisitions and Discontinued Operations”. The consolidated financial statements include Chaucer’s results for the period from July 1, 2011 through December 31, 2011. These legal entities conduct their operations through several business segments as discussed in Note 13 - “Segment Information”. Additionally, the consolidated financial statements include the Company’s discontinued operations, consisting of the Company’s former life insurance businesses and its accident and health business. All intercompany accounts and transactions have been eliminated.
Fixed maturities and equity securities are classified as available-for-sale. Available-for-sale securities are carried at fair value, with the unrealized gains and losses, net of taxes, reported in accumulated other comprehensive income, a separate component of shareholders’ equity. The amortized cost of fixed maturities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in net investment income.
Fixed maturities that are delinquent are placed on non-accrual status, and thereafter interest income is recognized only when cash payments are received.
Cash and cash equivalents includes cash on hand, amounts due from banks and highly liquid debt instruments purchased with an original maturity of three months or less.
Acquisition costs consist of commissions, underwriting costs and other costs, which vary with, and are primarily related to, the production of premiums. Acquisition costs are deferred and amortized over the terms of the insurance policies.
Deferred acquisition costs (“DAC”) for each line of business are reviewed to determine if it is recoverable from future income, including investment income. If such costs are determined to be unrecoverable, they are expensed at the time of determination. Although recoverability of DAC is not assured, the Company believes it is more likely than not that all of these costs will be recovered. The amount of DAC considered recoverable, however, could be reduced in the near term if the estimates of total revenues discussed above are reduced or permanently impaired as a result of a disposition of a line of business. The amount of amortization of DAC could be revised in the near term if any of the estimates discussed above are revised.
In accordance with the provisions of ASC 350, Intangibles- Goodwill and Other, the Company carries its goodwill at amortized cost, net of impairments. Increases to goodwill are generated through acquisition and represent the excess of the cost of an acquisition over the fair value of net assets acquired, including any intangibles acquired. Goodwill is no longer amortized but rather, is reviewed for impairment. The Company recorded $6.9 million in goodwill related to the acquisition of Chaucer. Additionally, acquisitions can also produce intangible assets, which have either a definite or indefinite life. Intangible assets with definite lives are amortized over that life, whereas those intangible assets determined to have an indefinite life are reviewed at least annually for impairment.
The Company’s debt includes senior debentures, junior debentures, subordinated notes, trust preferred capital securities, and advances under the Company’s collateralized borrowing program with the Federal Home Loan Bank of Boston (“FHLBB”). The senior debentures and subordinated notes are carried at principal amount borrowed, net of unamortized discounts. The junior subordinated debentures and borrowings under the FHLBB program are carried at principal amount borrowed. Debt also includes liabilities connected to trust preferred capital securities, related to outstanding securities issued by AIX Holdings, Inc. (“AIX”) and Professionals Direct, Inc. (“PDI”). Cash distributions on such trust preferred stock are accounted for as interest expense. (See Note 6 - “Debt and Credit Arrangements”).
The Company’s reporting currency is the U.S. dollar. The functional currencies of the Company’s foreign operations are the U.K. Pounds Sterling (“GBP”), U.S. dollar, and Canadian dollar. Assets and liabilities of foreign operations are translated into the U.S. dollar using the exchange rates
The Company manages its exposure to foreign currency risk primarily by matching assets and liabilities denominated in the same currency. To the extent that assets and liabilities in foreign currencies are not matched, the Company is exposed to foreign currency risk. For functional currencies, the related exchange rate fluctuations are reflected in other comprehensive income (loss). The Company translated Chaucer’s balance sheet from GBP to U.S. dollars using the December 31, 2011 conversion rate of 1.55. The Company recognized approximately $0.7 million in foreign currency transaction gains in the Statement of Income during the period from July 1, 2011 to December 31, 2011.
requires new and clarified disclosures for fair value measurements. The guidance requires that transfers in and out of Levels 1 and 2 be disclosed separately, including a description of the reasons for such transfers. Additionally, the reconciliation of fair value measurements of Level 3 assets should separately disclose information about purchases, sales, issuance and settlements in a gross, rather than net disclosure presentation. The guidance further clarifies that fair value disclosures should be separately presented for each class of assets and liabilities and disclosures should be provided for valuation techniques and inputs for both recurring and non-recurring fair value measurements related to Level 2 and Level 3 categories. The disclosure guidance provided in the update was effective for reporting periods beginning after December 15, 2009. The Company implemented this guidance effective January 1, 2010. Implementing this guidance did not have an effect on the Company’s financial position or results of operations.
In December 2009, the FASB issued ASC Update No. 2009-16 Transfers and Servicing (Topic 860) - Accounting for Transfers of Financial Assets which codified Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets an amendment of FASB Statement No. 140. This guidance revises FASB Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Extinguishment of Liabilities a replacement of FASB Statement 125 and requires additional disclosures about transfers of financial assets, including securitization transactions, and any continuing exposure to the risks related to transferred financial assets. It also eliminates the concept of a “qualifying special-purpose entity”, changes the requirements for derecognizing financial assets, and enhances disclosure requirements. This ASC update was effective prospectively, for annual periods beginning after November 15, 2009, and interim and annual periods thereafter. The Company implemented this guidance as of January 1, 2010. The effect of implementing this guidance was not material to the Company’s financial position or results of operations.
As of April 1, 2009, the Company adopted guidance included in ASC 320, which modifies the assessment of OTTI for fixed maturity securities, as well as the method of recording and reporting OTTI. Under the new guidance, if a company intends to sell or more likely than not will be required to sell a fixed maturity security before recovery of its amortized cost basis, the amortized cost of the security is reduced to its fair value, with a corresponding charge to earnings. If a company does not intend to sell the fixed maturity security, or more likely than not will not be required to sell it, the company is required to separate the other-than-temporary impairment into the portion which represents the credit loss and the amount related to all other factors. The amount of the estimated loss attributable to credit is recognized in earnings and the amount related to non-credit factors is recognized in accumulated other comprehensive income, net of applicable taxes. A cumulative effect adjustment was recognized by the Company upon adoption of this guidance to reclassify the non-credit component of previously recognized impairments from retained earnings to accumulated other comprehensive income. The Company increased the amortized cost basis of these fixed maturity securities and recorded a cumulative effect adjustment of $33.3 million as an increase to retained earnings and reduction to accumulated other comprehensive income for the year ended December 31, 2009. (See further disclosure in Note 4 - “Investment Income and Gains and Losses”).
In June 2011, the FASB issued ASC Update No. 2011-05 (Topic 220) Presentation of Comprehensive Income (“ASC Update No. 2011-05”). This ASC update requires companies to present net income and other comprehensive income in either a single continuous statement or in two separate, but consecutive, statements of income and other comprehensive income. The option to present items of other comprehensive income in the statement of changes in equity is eliminated. In addition, an entity is required to present on the face of the financial statements reclassification adjustments from other comprehensive income to net income. This ASC update should be applied retrospectively and except for the provisions related to reclassification adjustment, is effective for interim and annual periods beginning after December 15, 2011. In December 2011, the FASB issued ASC Update 2011-12 (Topic 220) Comprehensive Income which deferred the implementation date of the reclassification adjustment guidance in ASC Update No. 2011-05. The Company expects that the implementation of the guidance related to financial statement presentation will not have a significant impact to its current financial statement presentation. The Company is evaluating the impact of presenting the reclassification adjustment to its Consolidated Statements of Income and Comprehensive Income.
The following accounting policies relate only to the Company’s discontinued operations, which are in run-off. Please refer to the above captions for policies related to assets and liabilities that were held by both the Company’s ongoing business and the discontinued business.
or claims events, or unfavorable mortality or morbidity experience that are subject to a reinsurance contract, reinsurance recoverables are recorded. The amount of the reinsurance recoverable can vary based on the terms of the reinsurance contract, the size of the individual loss or claim, or the aggregate amount of all losses or claims in a particular line or book of business. The valuation of losses or claims recoverable depends on whether the underlying loss or claim is a reported loss or claim, an incurred but not reported loss or a future policy benefit. For reported losses and claims, the Company values reinsurance recoverables at the time the underlying loss or claim is recognized, in accordance with contract terms. For incurred but not reported losses and future policy benefits, the Company estimates the amount of reinsurance recoverables based on the terms of the reinsurance contracts and historical reinsurance recovery information and applies that information to the gross loss reserve and future policy benefit estimates. The reinsurance recoverables are based on what the Company believes are reasonable estimates. However, the ultimate amount of the reinsurance recoverable is not known until all losses and claims are settled.
This transaction is expected to advance the Company’s specialty lines strategy and result in broader product and underwriting capabilities, as well as greater geographic and product diversification. The acquisition adds a presence in the Lloyd’s market, which includes access to international licenses, an excess and surplus insurance business and the ability to syndicate certain risks.
Shareholders of Chaucer received 53.3 pence for each Chaucer share, which was paid in either cash or loan notes to those shareholders who elected to receive such notes in lieu of cash. Loan notes will be paid over the next five years. The closing of the acquisition followed approval of the transaction by Chaucer shareholders on June 7, 2011, subsequent court approval in the U.K. and regulatory approvals in various jurisdictions. The following table summarizes the transaction in both GBP and U.S. dollars:
In connection with the transaction, the Company entered into a foreign exchange forward contract, which provided for an economic hedge between the agreed upon purchase price of Chaucer in GBP and currency fluctuations between the GBP and U.S. dollar prior to close. This contract effectively locked in the U.S. dollar equivalent of the purchase price to be delivered in GBP and was settled at a loss of $11.3 million during the year ended December 31, 2011. The loss on the contract was due to a decrease in the exchange rate between the GBP and U.S. dollar, but was partially offset by the lower U.S. dollars required to meet the GBP-based purchase price, resulting in a $6.4 million gain on foreign exchange during the year ended December 31, 2011. Additional decreases in the exchange rate have occurred subsequent to the payment of cash proceeds on July 14, 2011. Foreign exchange gains of $0.3 million
were recognized related to the loan notes that are due in GBP to certain former shareholders of Chaucer common stock during the year ended December 31, 2011. The Company will be subject to fluctuations in the currency until such loan notes have been paid.
This payment was funded from the THG holding company, which included approximately $300 million of proceeds from the senior unsecured notes issued on June 17, 2011. See Note 6 - “Debt and Credit Arrangements” for additional information.
Weighted average shares outstanding and per diluted share amounts in 2011 exclude common stock equivalents, since the impact of these instruments would be antidilutive.
On March 31, 2010, the Company acquired Campania Holding Company, Inc. (“Campania”) for a cash purchase price of approximately $24 million, subject to various terms and conditions. During 2011, the Company recognized an additional $4.7 million of consideration based upon the terms of the agreement. Campania specializes in insurance solutions for portions of the healthcare industry.
On December 3, 2009, the Company entered into a renewal rights agreement with OneBeacon Insurance Group, LTD. (“OneBeacon”). Through this agreement, the Company acquired access to a portion of OneBeacon’s small and middle market commercial business at renewal, including industry programs and middle market niches. This transaction included consideration of $23 million, plus additional contingent consideration which totaled $11 million, primarily representing purchased renewal rights intangible assets which are included as Other Assets in the Consolidated Balance Sheets. The agreement was effective for renewals beginning January 1, 2010.
Discontinued operations consist of: (i) Discontinued First Allmerica Financial Life Insurance Company (“FAFLIC”) Business; (ii) Discontinued Operations of the Company’s Variable Life Insurance and Annuity Business; and (iii) Discontinued Accident and Health Business.
During 1999, the Company exited its accident and health insurance business, consisting of its Employee Benefit Services business, its Affinity Group Underwriters business and its accident and health assumed reinsurance pool business. Prior to 1999, these businesses comprised substantially all of the former Corporate Risk Management Services segment. Accordingly, the operating results of the discontinued segment have been reported in accordance with Accounting Principles Board Opinion No. 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions (“APB Opinion No. 30”). On January 2, 2009, Hanover Insurance directly assumed a portion of the accident and health business; and therefore continues to apply APB Opinion No. 30 to this business. In addition, the remainder of the FAFLIC accident and health business was reinsured by Hanover Insurance in connection with the sale of FAFLIC to Commonwealth Annuity, and has been reported in accordance with ASC 205.
OTTI unrealized losses in the tables above represent OTTI recognized in accumulated other comprehensive income. This amount excludes net unrealized gains on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date of $25.1 million and $36.1 million as of December 31, 2011 and 2010, respectively.
At December 31, 2011 and 2010, fixed maturities with fair values of $103.5 million and $87.3 million, respectively, and amortized cost of $97.0 million and $84.1 million, respectively, were on deposit with various state and governmental authorities.
The Company enters into various agreements that may require its fixed maturities to be held as collateral by others. At December 31, 2011 and 2010, fixed maturities with a fair value of $212.9 million and $169.8 million, respectively, were held as collateral for collateralized borrowings and other arrangements. Of these amounts, $205.7 million and $162.7 million related to the FHLBB collateralized borrowing program at December 31, 2011 and 2010, respectively.
The Company maintains an overall risk management strategy that may incorporate the use of derivative instruments to manage significant unplanned fluctuations in earnings that may be caused by foreign currency exchange and interest rate volatility.
During 2011, Chaucer held foreign currency forward contracts utilized to mitigate changes in fair value caused by foreign currency fluctuation in converting the fair value of GBP and Euro denominated investment portfolios into their U.S. dollar denominated equivalent. During the year, the Company recognized a net gain of $6.1 million related to these instruments, reflected in net realized investment gains in the Consolidated Statements of Income. All Chaucer forward contracts were terminated in October 2011.
The following tables provide information about the Company’s fixed maturities and equity securities that are in an unrealized loss position at December 31, 2011 and 2010:
The Company employs a systematic methodology to evaluate declines in fair value below amortized cost for fixed maturity securities or cost for equity securities. In determining other-than-temporary impairments of fixed maturity and equity securities, the Company evaluates several factors and circumstances, including the issuer’s overall financial condition; the issuer’s credit and financial strength ratings; the issuer’s financial performance, including earnings trends, dividend payments and asset quality; any specific events which may influence the operations of the issuer; the general outlook for market conditions in the industry or geographic region in which the issuer operates; and the length of time and the degree to which the fair value of an issuer’s securities remains below the Company’s cost. With respect to fixed maturity investments, the Company considers any factors that might raise doubt about the issuer’s ability to pay all amounts due according to the contractual terms and whether the Company expects to recover the entire amortized cost basis of the security. With respect to equity securities, the Company considers its ability and intent to hold the investment for a period of time to allow for a recovery in value. The Company applies these factors to all securities.
At December 31, 2011, there were contractual investment commitments of up to $64.4 million, consisting primarily of the Company’s commitment to invest approximately $46.8 million in the City Square Project. In addition to these investment commitments, the Company has contractual obligations to purchase tax credits of up to $23.6 million.
The carrying value of non-income producing fixed maturities, as well as the carrying value of fixed maturity securities on non-accrual status, at December 31, 2011 and 2010 were not material. The effect of non-accruals for the years ended December 31, 2011, 2010 and 2009, compared with amounts that would have been recognized in accordance with the original terms of the fixed maturities, was a reduction in net investment income of $2.3 million, $2.3 million and $3.1 million, respectively.
Included in the net realized investment gains (losses) were other-than-temporary impairments of investment securities recognized in earnings totaling $6.9 million, $13.9 million and $32.9 million in 2011, 2010 and 2009, respectively.
Corporate bonds-the Company utilized a financial model that derives expected cash flows based on probability-of-default factors by credit rating and asset duration and loss-given-default factors based on security type. These factors are based on historical data provided by an independent third-party rating agency.
The Company follows the guidance in ASC 820 as it relates to the fair value of its financial assets and liabilities. ASC 820 provides for a standard definition of fair value to be used in new and existing pronouncements. This guidance requires disclosure of fair value information about certain financial instruments (insurance contracts, real estate, goodwill and taxes are excluded) for which it is practicable to estimate such values, whether or not these instruments are included in the balance sheet at fair value. The Company is responsible for the determination of the value of the investments carried at fair value and the supporting methodologies and assumptions. These fair values presented for certain financial instruments are estimates which, in many cases, may differ significantly from the amounts that could be realized upon immediate liquidation.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments. Except for a discussion on foreign government fixed maturities and other investments, which have been added as a result of the acquisition of Chaucer, these methods and assumptions have not changed since last year.
Residential mortgage-backed securities - estimates of prepayment speeds based upon: historical prepayment rate trends; underlying collateral interest rates; geographic concentration; vintage year; borrower credit quality characteristics; interest rate and yield curve forecasts; U.S. government support programs; tax policies; delinquency/default trends; and, in the case of non-agency collateralized mortgage obligations, severity of loss upon default and length of time to recover proceeds following default.
Asset-backed securities - overall credit quality, including assessments of the underlying collateral type such as credit card receivables, auto loan receivables, equipment lease receivables and real property lease receivables; geographic diversification; vintage year; historical collateral performance including delinquency, default and casualty trends; economic conditions influencing use rates and resale values; and contract structural support features.
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. Generally, all prices provided by the pricing service, except quoted market prices, are reported as Level 2. The Company holds certain equity securities that have been issued by privately-held entities that do not have an active market and for which the pricing service cannot provide fair values. Generally, the Company estimates fair value for these securities based on the issuer’s book value and market multiples. These securities are reported as Level 3.
Fair values are estimated by discounting the future contractual cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings.
Changes in the observability of valuation inputs may result in a reclassification of certain financial assets within the fair value hierarchy. Reclassifications between levels of the fair value hierarchy are reported as of the beginning of the period in which the reclassification occurs. As previously discussed, the Company utilizes a third party pricing service for the valuation of the majority of its fixed maturities and equity securities. The pricing service has indicated that it will only produce an estimate of fair value if there is objectively verifiable information to produce a valuation. If the pricing service discontinues pricing an investment, the Company will use observable market data to the extent it is available, but may also be required to make assumptions for market based inputs that are unavailable due to market conditions.
The following tables provide, for each hierarchy level, the Company’s assets at December 31, 2011 and 2010 that are measured at fair value on a recurring basis. Equity securities exclude FHLBB common stock of $9.4 million at December 31, 2011 and $8.6 million at December 31, 2010, which is carried at cost.
During the years ended December 31, 2011 and 2010, the Company transferred fixed maturities between Level 2 and Level 3 primarily a result of assessing the significance of unobservable inputs on the fair value measurement. There were no transfers between Level 1 and Level 2 during 2011.
On June 17, 2011, the Company issued $300 million aggregate principal amount of 6.375% senior unsecured notes due June 15, 2021. Additionally, on February 23, 2010, the Company issued $200.0 million aggregate principal amount of 7.50% senior unsecured notes due March 1, 2020. The Company also issued senior unsecured notes with a face value of $200.0 million on October 16, 1995. As of December 31, 2011 and 2010, the remaining senior debentures have a $121.6 million face value, pay interest semi-annually at a rate of 7.625% and mature on October 15, 2025. All of the Company’s senior debentures are subject to certain restrictive covenants, including limitations on the issuance or disposition of stock of restricted subsidiaries and limitations on liens. These debentures pay interest semi-annually.
In 2011, the Company repurchased in several transactions, $69.5 million of these junior debentures at a cost of $72.1 million, resulting in a net loss of $2.6 million on the repurchases. Additionally, in 2011, the Company repurchased $8.0 million and $3.0 million of the capital securities related to AIX and PDI, respectively. In 2010, the Company repurchased $36.5 million of its Junior Debentures at a cost of $38.5 million, resulting in a loss of $2.0 million on the repurchase. These debentures pay cumulative dividends semi-annually at 8.207% and mature February 3, 2027.
The Company borrowed $125.0 million in 2009 from the FHLBB. This advance bears interest at a fixed rate of 5.50% per annum over a twenty-year term. In July 2010, the Company committed to borrow an additional $46.3 million from FHLBB to finance the development of the City Square Project. See Note 3 - “Investments” for additional information. These borrowings were drawn in several increments from July 2010 to January 2012. These additional amounts mature on July 20, 2020 and carry fixed interest rates with a weighted average of 3.88%. Through December 31, 2011, the Company has borrowed $38.9 million under this arrangement. Interest associated with the $46.3 million will be capitalized through the construction phase of the City Square Project.
As collateral to FHLBB, Hanover Insurance pledged government agency securities with a fair value of $205.7 million and $162.7 million, for the aggregate borrowings of $163.9 million and $134.5 million as of December 31, 2011 and December 31, 2010, 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, Hanover Insurance would be required to pledge additional collateral or repay outstanding borrowings. Hanover Insurance is permitted to voluntarily repay the outstanding borrowings at any time, subject to a repayment fee. As a requirement of membership in the FHLBB, Hanover Insurance maintains a certain level of investment in FHLBB stock. Total purchases of FHLBB stock were $9.4 million and $8.6 million at December 31, 2011 and 2010, respectively.
Interest expense was $55.0 million in 2011, $44.3 million in 2010, and $35.5 million in 2009, and included interest related to the Company’s senior debentures, junior debentures, subordinated notes, FHLBB borrowings, capital securities and surplus notes. All interest expense is recorded in other operating expenses. At December 31, 2011, the Company was in compliance with the covenants associated with all of its debt indentures and credit arrangements.
FAFLIC in 2009. At December 31, 2011, the Company has recorded a full valuation allowance against this asset, since it is the Company’s opinion that it is more likely than not that the asset will not be realized. In addition at December 31, 2011, the Company has a deferred tax asset of $33.6 million related to U.S. net operating loss carryforwards and a deferred tax asset of $14.5 million related to foreign net operating carryforwards. The pre-tax U.S. operating loss carryforwards of $95.9 million will expire beginning in 2031. The pre-tax foreign operating loss carryforwards of $62.1 million were generated in the U.K. and have no expiration date. It is the Company’s opinion that there will be sufficient future U.S. and U.K. taxable income to utilize these loss carryforwards. The Company’s estimate of the gross amount and likely realization of loss carryforwards may change over time.
At December 31, 2011, the Company has a deferred tax asset of $112.2 million of alternative minimum tax credit carryforwards. The alternative minimum tax credit carryforwards have no expiration date. The Company may utilize the credits to offset regular federal income taxes due from future income, and although the Company believes that these assets are fully recoverable, there can be no certainty that future events will not affect their recoverability. The Company believes, based on objective evidence, the remaining deferred tax assets will be realized.
During 2010, the Company reduced its valuation allowance, for both continuing and discontinued operations, related to its deferred tax assets by $104.1 million, from $195.6 million to $91.5 million. There were four principal components to this reduction. First, the Company reduced the valuation allowance by $66.2 million as a result of the aforementioned transactions, which utilized the capital loss carryforwards. Second, the Company increased its valuation allowance by $20.3 million for certain tax basis unrealized losses which the Company does not believe it can utilize. This increase was reflected as a decrease in accumulated other comprehensive income. Third, $135.5 million of the capital loss carryforwards expired in 2010. As a result, the Company released $47.4 million of its valuation allowance attributable to these expirations with an equal and offsetting reduction in the related deferred tax asset. Fourth, as a result of $29.7 million in net realized gains during 2010, the Company decreased its valuation allowance by $9.7 million as an increase to income from continuing operations,
During 2009, the Company reduced its valuation allowance, for both continuing and discontinued operations, related to its deferred tax asset by $152.6 million, from $348.2 million to $195.6 million. There were two principal components to this reduction. First, the Company reversed through other comprehensive income, the $118.4 million valuation allowance that it had recognized at December 31, 2008 associated with the tax benefit related to the net unrealized depreciation in its investment portfolio at that time. During 2009, appreciation in the portfolio changed the nature of the tax attribute from that of an asset to that of a liability, and thus, there was no longer a need for that portion of the valuation allowance. Second, as a result of the aforementioned transactions, the Company reversed $28.4 million of the valuation allowance as an adjustment to other comprehensive income and $6.0 million of the valuation allowance as an adjustment to income from continuing operations. The remaining $0.2 million net increase in its valuation allowance was attributable to other items, and reflected as a $0.9 million increase in income from continuing operations and a $1.1 million decrease in income from discontinued operations.
There are no tax positions at December 31, 2011 for which the ultimate deductibility is highly certain, but for which there is uncertainty about the timing of such deductibility. Included in the December 31, 2010 balance is a $3.6 million receivable which was part of the aforementioned 2005 and 2006 proposed settlement.
As of January 1, 2005, the defined benefit pension plans were frozen and since that date, no further cash balance allocations have been credited to participants. Participants’ accounts are credited with interest daily, based upon the General Agreement of Trades and Tariffs (“GATT”). In addition, the grandfathered benefits for the transition group were also frozen at January 1, 2005 levels with an annual transition pension adjustment calculated at an interest rate equal to 5% per year up to 35 years of completed service, and 3% thereafter.
Prior to 2002, our Chaucer segment provided defined benefit pension retirement benefits to certain of its employees. As of December 31, 2001, the defined benefit pension plan was closed to new members. The defined benefit obligation for this plan is based on the employees’ years of service and final pensionable salary.
The expected rates of return were determined by using historical mean returns, adjusted for certain factors believed to have an impact on future returns. Specifically, for the U.S. defined benefit plans, because the allocation of assets between fixed maturities and equities has changed, as discussed in “Plan Assets” below, the historical mean return was adjusted downward slightly to reflect this asset mix. The adjusted mean returns were weighted to the plan’s expected target asset allocation at December 31, 2011, resulting in an expected rate of return on plan assets for 2011 of 6.50%. The Company reviews and updates, at least annually, its expected return on plan assets based on changes in the actual assets held by the plans.
The following table provides target allocations and actual invested asset allocations for 2011 and 2010.
Included in total plan assets of $574.7 million at December 31, 2011 were $568.8 million of invested assets carried at fair value and $5.9 million of cash and equivalents. Total plan assets at December 31, 2010 of $547.8 million included $541.7 million of invested assets carried at fair value and $6.1 million of cash and equivalents.
The following tables present for each hierarchy level the U.S. qualified defined benefit plan’s investment assets that are measured at fair value at December 31, 2011 and 2010. (Please refer to Note 5 - “Fair Value” for a description of the different levels in the Fair Value Hierarchy).
The following table presents for each hierarchy level the Chaucer defined benefit plan’s investment assets that are measured at fair value at December 31, 2011.
Securities classified as Level 2 at December 31, 2011 include pooled funds which are valued at the close of business using a third party pricing service. These values are adjusted by the fund manager to reflect outstanding dividends, taxes and investment fees and other expenses to calculate the NAV.
Real estate fund investments classified as Level 3 at December 31, 2011 are valued based upon the values of the net assets of the fund. Although the NAV is calculated daily, transactions also consider cash inflows and outflows of the fund. The price where units are transacted includes the NAV, which is adjusted for investment charges and other estimated acquisition costs such as legal fees, taxes, planning and architect fees, survey and agent fees, among others.
The Company recognizes the current net underfunded status of its plans in its Consolidated Balance Sheet. Changes in the funded status of the plans are reflected as components of accumulated other comprehensive loss or income. The components of accumulated other comprehensive loss or income are reflected as either a net actuarial gain or loss, a net prior service cost or a net transition asset. The following table reflects the benefit obligations, fair value of plan assets and funded status of the plans at December 31, 2011 and 2010. U.S. qualified and non-qualified plan amounts represent activity for the calendar year. Chaucer pension plan amounts reflect activity since the date of acquisition of July 1, 2011.
The following table reflects the total amounts recognized in accumulated other comprehensive income relating to both the U.S. defined benefit pension plan and the Chaucer pension plan as of December 31, 2011 and 2010.
The following table reflects the total estimated amount that will be amortized from accumulated other comprehensive income into net periodic pension cost in 2012:
The unrecognized net actuarial gains (losses) which exceed 10% of the greater of the projected benefit obligation or the fair value of plan assets are amortized as a component of net periodic pension cost in future years.
The benefit payments are based on the same assumptions used to measure the Company’s benefit obligations at the end of 2011. Benefit payments related to the qualified plans and the Chaucer plan will be made from plan assets, whereas those payments related to the non-qualified plans will be provided for by the Company.
In addition to the defined benefit plans, THG provides a defined contribution 401(k) plan for its U.S. employees, whereby the Company matches employee elective 401(k) contributions, up to a maximum percentage of 6% in 2011, 2010, and 2009. The Company’s expense for this matching provision was $17.8 million, $16.5 million and $14.2 million for 2011, 2010 and 2009, respectively. In addition to this matching provision, the Company can elect to make an annual contribution to employees’ accounts. There were no additional contributions in 2011 and 2010. The Company’s cost for an additional contribution in 2009 was $2.0 million.
Chaucer also provides a defined contribution plan for its employees which provides for employer provided contributions. The Company’s expense for the period from the acquisition date of July 1, 2011 through December 31, 2011 was $2.4 million.
The following table reflects the estimated amortization to be recognized in net periodic benefit cost in 2012:
The fair value of each option is estimated on the date of grant using the Black-Scholes option pricing model. For all options granted through December 31, 2011, the exercise price equaled the market price on the grant date. Compensation cost related to options is based upon the grant date fair value and expensed on a straight-line basis over the service period for each separately vesting portion of the option as if the option was, in substance, multiple awards.
Stock grants may be awarded to eligible employees at a price established by the Committee (which may be zero). Under the Plan, the Company may award shares of restricted stock, restricted stock units, as well as shares of unrestricted stock. Restricted stock grants may vest based upon performance criteria, market criteria or continued employment and be in the form of shares or units. Vesting periods are established by the Committee.
In 2011, 2010 and 2009, the Company granted performance-based restricted share units to certain employees. These share units vest after the achievement of certain corporate goals at a rate of 50% after three years and the remaining 50% after four years of continued employment. The Company also granted restricted stock units to eligible employees that generally vest at a rate of 50% after three years and the remaining 50% after 4 years of continued employment. The following table summarizes information about employee nonvested stock, restricted stock units and performance-based restricted share units.
During 2011, the Company paid three quarterly dividends of 27.5 cents ($0.275) and one quarterly dividend of 30 cents ($0.30) per share each to its shareholders, totaling $50.9 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 $69.0 million, $70.0 million and $72.0 million in 2011, 2010 and 2009, respectively. Citizens cannot pay a further dividend to its parent without prior approval until December 2012, at which time the maximum dividend payable without prior approval would be $70.2 million.
The Company’s primary business operations include insurance products and services provided through four operating segments. These operating segments are Commercial Lines, Personal Lines, Chaucer, and Other Property and Casualty. Commercial Lines includes commercial multiple peril, commercial automobile, workers’ compensation, and other commercial coverages, such as specialty program business, inland marine, surety and other bonds, professional liability and management liability. Personal Lines includes personal automobile, homeowners and other personal coverages. Chaucer includes property, marine and aviation, energy, U.K. motor, and casualty and other coverages (which includes international liability, specialist coverages, and syndicate participations). The Other Property and Casualty segment consists of: Opus Investment Management, Inc., which markets investment management services to institutions, pension funds and other organizations; earnings on holding company assets; and, a voluntary pools business which is in run-off. 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.
Summarized below is financial information with respect to the Company’s business segments. Activity for 2011 includes results of Chaucer for the period from July 1, 2011 through December 31, 2011.
The Company reviews the assets of its U.S. Companies collectively and does not allocate them between the Commercial Lines, Personal Lines and Other Property and Casualty segments.
Long-lived assets located outside the U.S. were not material for the year ended December 31, 2011. The Company does not have revenue from transactions with a single agent or broker amounting to 10 percent or more of its consolidated revenue.
Rental expenses for operating leases amounted to $21.1 million, $17.2 million and $15.4 million in 2011, 2010 and 2009, respectively. These expenses relate primarily to building leases of the Company. At December 31, 2011, future minimum rental payments under non-cancelable operating leases, were approximately $68.9 million, payable as follows: 2012 - $19.7 million; 2013 - $17.3 million; 2014 - $14.4 million; 2015 - $11.4 million and $6.1 million thereafter. It is expected that in the normal course of business, leases that expire may be renewed or replaced by leases on other property and equipment.
As a condition to conduct certain business in various states, the Company is required to participate in residual market mechanisms, facilities and pooling arrangements such as the Michigan Catastrophic Claims Association (“MCCA”). The Company is subject to concentration of risk with respect to reinsurance ceded to the MCCA. Funding for MCCA comes from assessments against automobile insurers based upon their share of insured automobiles in the state. Insurers are allowed to pass along this cost to Michigan automobile policyholders. The Company ceded to the MCCA premiums earned and losses and LAE incurred of $69.6 million and $122.6 million in 2011, $64.7 million and $135.6 million in 2010, $55.8 million and $97.7 million in 2009, respectively. MCCA, which represented 36.1% of the total reinsurance receivable balance at December 31, 2011, is the Company's only reinsurer representing at least 10% of its reinsurance assets. Reinsurance recoverables related to MCCA were $816.7 million and $752.5 million at December 31, 2011 and 2010, respectively. Because the MCCA is supported by assessments permitted by statute, and there have been no significant uncollectible balances from MCCA identified during the three years ending December 31, 2011, the Company believes that it has no significant exposure to uncollectible reinsurance balances from this entity.
The following table provides the effects of reinsurance. Activity for 2011 includes results of Chaucer from July 1, 2011 to December 31, 2011.
(2) The favorable reserve development on assumed reinsurance activity in 2009 primarily related to the Excess and Casualty Reinsurance Association (“ECRA”) and Massachusetts Commonwealth Automobile Reinsurers (“CAR”) pools.
The table below provides a reconciliation of the gross beginning and ending reserve for unpaid losses and loss adjustment expenses as follows:
As part of an ongoing process, the reserves have been re-estimated for all prior accident years and were decreased by $103.3 million, $111.1 million and $155.3 million in 2011, 2010 and 2009, respectively. For the six months ended December 31, 2011, these amounts include favorable loss and LAE reserve development of $35.5 million for Chaucer. The Chaucer favorable development was primarily the result of lower than expected losses in the energy, property and U.K. motor lines, primarily related to the 2009 and 2010 accident years. For Commercial and Personal Lines, the favorable loss and LAE reserve development during the year ended December 31, 2011 was primarily the result of lower than expected losses in the personal automobile line, primarily related to bodily injury coverage in the 2008 through 2010 accident years, the commercial multiple peril line related to the 2007 through 2010 accident years and lower than expected losses in the 2007 through 2010 accident years in the workers’ compensation line. In addition, within other commercial lines, unfavorable development in the professional liability and surety business were partially offset by favorable development in the healthcare and other commercial property lines.
On March 5, 2009, the court issued an Order granting in part and denying in part a Motion to Dismiss filed by Defendants. The court dismissed all claims for bad faith and breach of fiduciary duty and all claims for flood damages under policies with flood exclusions or asserted under Louisiana’s Valued Policy Law, but rejected the insurers’ arguments that the purported assignments from individual claimants to the state were barred by anti-assignment provisions in the insurers’ policies. On April 30, 2009, Defendants filed a Petition for Permission to Appeal to the United States Court of Appeals for the Fifth Circuit (the “Fifth Circuit”), which was granted. On July 28, 2010, the Fifth Circuit certified the anti-assignment issue to the Louisiana Supreme Court. On May 10, 2011, the Supreme Court of Louisiana issued a decision holding that the anti-assignment provisions were not violative of public policy. The court also indicated, however, that such provisions would only serve to bar post-loss assignments if they clearly and unambiguously expressed that they apply to post-loss assignments. On June 28, 2011, the Fifth Circuit remanded the case to the Federal District Court for further proceedings consistent with the Louisiana’s Supreme Court’s opinion. On September 12, 2011, the State of Louisiana filed a Motion to Remand the case to state court, which was denied by an Order dated October 28, 2011.
At this time, the Company is unable to provide a reasonable estimate of the potential range of ultimate liability. The Company is unable to determine how many policyholders have assigned claims under the Road Home program and, in any case, has no basis to estimate the amount of any differences between what the Company paid with respect to any such claim and the amount that the State of Louisiana may claim should properly have been paid under each policy.
The Company has been named a defendant in various other legal proceedings arising in the normal course of business. In addition, the Company is involved, from time to time, in examinations, investigations and proceedings by governmental and self-regulatory agencies. The potential outcome of any such action or regulatory proceedings in which the Company has been named a defendant or the subject of an inquiry or investigation, and its ultimate liability, if any, from such action or regulatory proceedings, is difficult to predict at this time. The ultimate resolutions of such proceedings are not expected to have a material effect on its financial position, although they could have a material effect on the results of operations for a particular quarter or annual period.
The Company’s U.S. insurance subsidiaries are required to file annual statements with state regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis), as codified by the National Association of Insurance Commissioners. Statutory surplus differs from shareholders’ equity reported in accordance with generally accepted accounting principles primarily because under statutory basis for accounting, policy acquisition costs are expensed when incurred, the recognition of deferred tax assets is based on different recoverability assumptions and postretirement benefit costs are based on different participant assumptions.
The following table provides statutory net income for the year ended December 31 and surplus as of December 31 for the periods indicated:
The quarterly results of operations for 2011 and 2010 are summarized below.