The following discussion highlights significant factors impacting the consolidated operations and financial condition of CNA Financial Corporation (CNAF) and its subsidiaries (collectively CNA or the Company). CNA is one of the largest insurance organizations in the United States and based on 2002 statutory net written premiums, is the eleventh largest property and casualty company.
During 2003, CNA conducted its operations through five operating segments: Standard Lines, Specialty Lines and CNA Re (which comprise the property and casualty segments), Group Operations and Life Operations. In addition to these five operating segments, certain other activities are reported in the Corporate and Other segment. These operating segments reflected the way CNA managed its operations and business decisions.
During 2003, CNA completed a strategic review of its operations and decided to concentrate efforts on its property and casualty business. As a result of this review, and the 2003 charges of $1,849 million after-tax ($2,845 million pretax) related to unfavorable net prior year development and a $396 million after-tax ($610 pretax) increase in the provision for reinsurance and insurance receivables, a capital plan was developed to replenish statutory capital of the
In February of 2004, CNA entered into a definitive agreement to sell its individual life insurance business to Swiss Re Life & Health America Inc. (Swiss Re) for approximately $690 million. The business sold includes term, universal and permanent life insurance policies and individual annuity products. The transaction is expected to be completed on or before March 31, 2004, subject to certain customary closing conditions and regulatory approvals. See Note T of the Consolidated Financial Statements included under Item 8 for further information.
After consideration of the increase in CCC’s statutory surplus resulting from the sale of the Group Benefits business, Loews purchased $46 million of CCC surplus notes in February of 2004, pursuant to the capital plan. In addition, the sale of CNA’s individual life business is expected to result in an addition to CCC’s statutory surplus in excess of $400 million. However, the sale of the individual life business was not consummated by February 26, 2004. As a result, Loews purchased $300 million of additional CCC surplus notes in February of 2004. Following the consummation of the individual life sale, CNA plans to seek approval from the insurance regulatory authority for the repayment of the surplus notes purchased in relation to such sale, although no assurance can be given that sale of the individual life business will be consummated or that the regulatory approval will be obtained.
The Group Operations business, individual life and annuity insurance business and CNA Re absorbed approximately $150 million of the total shared corporate overhead expenses that are allocated to all of CNA’s businesses. The Company expects that the 2004 consolidated net results will include an approximate $50 million after-tax loss for these three businesses, primarily due to these corporate overhead expenses. The 2003 expense initiative, discussed below did not contemplate the sale or exit of these businesses, and therefore the savings from this initiative will be partially offset by these expenses. The Company is evaluating its corporate expense structure and anticipates taking actions in 2004 that will reduce these expenses.
In February of 2004, CNA announced the decision to cease sales to new customers in its structured settlement and institutional markets businesses. Also, during 2003, CNA ceased sales to new customers in the individual and group long term care businesses. CNA will continue to accept new deposits and premiums only from existing customers for the institutional markets business and will service its existing commitments on all businesses in which new sales were ceased. These businesses will be managed as a run-off operation.
Throughout this MD&A, the 2003 results of operations include discussion and results for all of CNA’s businesses, including those sold or exited as described above.
The following tables provide information about CNA’s historical results of operations for the retained and sold businesses.
The following table includes the consolidated results of operations. For more detailed components of CNA’s business operations, see the segment discussions within this MD&A.
Net results decreased $1,588 million in 2003 as compared with 2002. The decline in net results was due primarily to increased unfavorable net prior year development of $1,837 million after-tax ($2,826 million pretax), a $55 million after-tax ($84 million pretax) increase in catastrophe losses, a $65 million after-tax ($100 million pretax) increase in unallocated loss adjustment expense (ULAE) reserves, and a $27 million after-tax ($42 million pretax) increase in dividend development. In addition, net results in 2003 included a $396 million after-tax ($610 million pretax) increase in the bad debt provision for insurance and reinsurance receivables, a $69 million after-tax ($104 million pretax) increase in insurance related assessments, and increased interest expense of $90 million after-tax ($137 million pretax) related to
Net unfavorable prior year development of $2,952 million, including $2,409 million of unfavorable claim and claim adjustment expense reserve development and $543 million of unfavorable premium development, was recorded in 2003. Net unfavorable prior year development of $126 million, including $35 million of unfavorable claim and claim adjustment expense reserve development and $91 million of unfavorable premium development, was recorded in 2002.
The accounting estimates discussed below are considered by management to be critical to an understanding of CNA’s Consolidated Financial Statements as their application places the most significant demands on management’s judgment. Note A of the Consolidated Financial Statements included under Item 8 should be read in conjunction with this section to assist with obtaining an understanding of the underlying accounting policies related to these estimates. Due to the inherent uncertainties involved with this type of judgment, actual results could differ significantly from estimates and have a material adverse impact on the Company’s results of operations or equity.
Insurance reserves are established for both short and long-duration insurance contracts. Short-duration contracts are primarily related to property and casualty insurance policies where the reserving process is based on actuarial estimates of the amount of loss, including amounts for known and unknown claims. Long-duration contracts typically include traditional life insurance and long term care products and are estimated using actuarial estimates about mortality and morbidity, as well as assumptions about expected investment returns. Workers compensation lifetime claim reserves and accident and health disability claim reserves are calculated using mortality and morbidity assumptions based on Company and industry experience, and are discounted at interest rates that range from 3.5% to 6.5% at December 31, 2003. The reserve for unearned premiums on property and casualty and accident and health contracts represents the portion of premiums written to the unexpired terms of coverage. The inherent risks associated with the reserving process are discussed in Reserves - Estimates and Uncertainties section below.
Invested assets are exposed to various risks, such as interest rate, market and credit risks. Due to the level of risk associated with certain invested assets and the level of uncertainty related to changes in the value of these assets, it is possible that changes in risks in the near term could have an adverse material impact on the Company’s results of operations or equity.
The Company’s reserves and deferred acquisition costs for its individual long term care product offerings are based on certain assumptions including morbidity, policy persistency and interest rates. Actual experience may differ from these assumptions. The recoverability of deferred acquisition costs and the adequacy of the reserves are contingent on actual experience related to these key assumptions and other factors including potential future premium increases and future health care cost trends. The results of operations and/or equity may be materially, adversely affected if actual experience varies significantly from these assumptions. For further information, see the Life Operations section below.
The level of Insurance Reserves maintained by the Company represents management’s best estimate, as of a particular point in time, of what the ultimate settlement and administration of claims will cost based on its assessment of facts and circumstances known at that time. Insurance Reserves are not an exact calculation of liability but instead are complex estimates that are derived by the Company, generally utilizing a variety of actuarial reserve estimation techniques, from numerous assumptions and expectations about future events, both internal and external, many of which are highly uncertain.
Given the factors described above, it is not possible to quantify precisely the ultimate exposure represented by claims and related litigation. As a result, the Company regularly reviews the adequacy of its reserves and reassesses its reserve estimates as historical loss experience develops, additional claims are reported and settled and additional information becomes available in subsequent periods.
the effects of accounting and financial reporting scandals and other major corporate governance failures, which have resulted in an increase in the number and size of claims, including director and officer and errors and omissions insurance claims;
The impact of these and other unforeseen emerging or potential claims and coverage issues is difficult to predict and could materially adversely affect the adequacy of the Company’s claim and claim adjustment expense reserves and could lead to future reserve additions. See the Segment Results sections of this MD&A for a discussion of changes in reserve estimates and the impact on the Company’s results of operations.
The Company’s experience has been that establishing reserves for casualty coverages relating to APMT claim and claim adjustment expenses is subject to uncertainties that are greater than those presented by other claims. Estimating the ultimate cost of both reported and unreported APMT claims is subject to a higher degree of variability due to a number of additional factors, including among others:
changes in the volume of asbestos and environmental pollution and mass tort claims which cannot now be anticipated;
the Company’s ability to recover reinsurance for asbestos and environmental pollution and mass tort claims.
It is also not possible to predict changes in the legal and legislative environment and the impact on the future development of APMT claims. This development will be affected by future court decisions and interpretations, as well as changes in applicable legislation. It is difficult to predict the ultimate outcome of large coverage disputes until settlement negotiations near completion and significant legal questions are resolved or, failing settlement, until the dispute is adjudicated. This is particularly the case with policyholders in bankruptcy where negotiations often involve a large number of claimants and other parties and require court approval to be effective. A further uncertainty exists as to whether a national privately financed trust to replace litigation of asbestos claims with payments to claimants from the trust will be established and approved through federal legislation, and, if established and approved, whether it will contain funding requirements in excess of the Company’s carried loss reserves.
Due to the factors described above, among others, establishing reserves for APMT claim and claim adjustment expenses is subject to uncertainties that are greater than those presented by other claims. Traditional actuarial methods and techniques employed to estimate the ultimate cost of claims for more traditional property and casualty exposures are less precise in estimating claim and claim adjustment reserves for APMT, particularly in an environment of emerging or potential claims and coverage issues that arise from industry practices and legal, judicial and social conditions. Therefore, these traditional actuarial methods and techniques are necessarily supplemented with additional estimating techniques and methodologies, many of which involve significant judgments that are required of management. Due to the inherent uncertainties in estimating reserves for APMT claim and claim adjustment expenses and the degree of variability due to, among other things, the factors described above, the Company may be required to record material changes in its claim and claim adjustment expense reserves in the future, should new information become available or other developments emerge. See the Asbestos and Environmental Pollution and Mass Tort Reserves section of this MD&A for additional information relating to APMT claims and reserves.
The ceding of insurance does not discharge the primary liability of the Company. Therefore, a credit exposure exists with respect to property and casualty and life reinsurance ceded to the extent that any reinsurer is unable to meet the obligations or to the extent that the reinsurer disputes the liabilities assumed under reinsurance agreements.
The Company has an aggregate reinsurance treaty related to the 1999 through 2001 accident years that covers substantially all of the Company’s property and casualty lines of business (the Aggregate Cover). The Aggregate Cover provides for two sections of coverage. These coverages attach at defined loss ratios for each accident year. Coverage under the first section of the Aggregate Cover, which is available for all accident years covered by the treaty, has a $500 million limit per accident year of ceded losses and an aggregate limit of $1 billion of ceded losses for the three accident years. The ceded premiums associated with the first section are a percentage of ceded losses and for each $500 million of limit the ceded premium is $230 million. The second section of the Aggregate Cover, which only relates to accident year 2001, provides additional coverage of up to $510 million of ceded losses for a maximum ceded premium of $310 million. Under the Aggregate Cover, interest charges on the funds withheld liability accrue at 8% per annum. The aggregate loss ratio for the three-year period has exceeded certain thresholds which requires additional premiums to be paid and an increase in the rate at which interest charges are accrued. This rate will increase to 8.25% per annum commencing in 2006.
The Company is required to participate in the program, but it does not cover life or health insurance products. State law limitations applying to premiums and policies for terrorism coverage are not generally affected under the program. The Act requires insurers to offer terrorism coverage through 2004. The Secretary of the Department of the Treasury has discretion to extend this offer requirement until December 31, 2005.
In connection with the IT Plan, after the write-off of impaired assets, the Company accrued $30 million of restructuring and other related charges in 2001 (the IT Plan Initial Accrual). These charges primarily
related to $29 million of workforce reductions of approximately 260 positions gross and net and $1 million of other costs.
The following table summarizes the IT Plan Initial Accrual and the activity in that accrual during 2001, 2002 and 2003.
In connection with the 2001 Plan, the Company accrued $189 million of these restructuring and other related charges (the 2001 Plan Initial Accrual). These charges include employee termination and related benefit costs, lease termination costs, impaired asset charges and other costs.
The following tables summarize the 2001 Plan Initial Accrual and the activity in that accrual during 2001, 2002 and 2003 by type of restructuring cost and by segment.
Approximately $6 million of the remaining accrual for the 2001 Plan, primarily related to lease termination costs, is expected to be paid in 2004.
Management excludes after-tax net realized investment gains or losses when analyzing the insurance operations because net realized investment gains or losses related to the Company’s available-for-sale investment portfolio are largely discretionary, except for losses related to other-than-temporary impairments, and are generally driven by economic factors that are not necessarily consistent with key drivers of underwriting performance.
Operating ratios are calculated using insurance results and are used by the insurance industry and regulators such as state departments of insurance and the National Association of Insurance Commissioners (NAIC) for financial regulation and as a basis of comparison among companies. The ratios discussed in this MD&A are calculated using GAAP financial results and include the loss and loss adjustment expense ratio (loss ratio) as well as the expense, dividend and combined ratios. The loss ratio is the percentage of net incurred claim and claim adjustment expenses to net earned premiums. The expense ratio is the percentage of underwriting and acquisition expenses, including the amortization of deferred acquisition costs, to net earned premiums. The dividend ratio is the ratio of dividends incurred to net earned premiums. The combined ratio is the sum of the loss, expense and dividend ratios.
The following discussion is of the results of operations for the Company’s operating segments.
P&C’s field structure consists of 34 branch locations across the country. Each branch provides the marketing, underwriting and risk control expertise on the entire portfolio of products. In addition, these branches provide streamlined claim services utilizing the same regional structure. The Centralized Processing Operation for small and middle-market customers, located in Maitland, Florida, handles policy processing and accounting, and also acts as a call center to optimize customer service. Also, Standard Lines, primarily through a wholly owned subsidiary, ClaimPlus, Inc., a third party administrator, began providing total risk management services relating to claim services, risk control, cost management and information services to the large commercial insurance marketplace in 2003.
Standard Lines averaged rate increases of 16%, 27% and 17% in 2003, 2002 and 2001 for the contracts that renewed during those periods. Retention rates of 72%, 68% and 76% were achieved for those contracts that were up for renewal.
The combined ratio increased 46.3 points and underwriting results decreased $1,718 million in 2003 as compared with 2002. The loss ratio increased 30.5 points due principally to the increase in unfavorable net prior year development in 2003 as compared with 2002, as discussed below, and $96 million of catastrophe losses which occurred during 2003. Catastrophe losses were $23 million in 2002. Partially offsetting these unfavorable variances was an improvement in the current net accident year loss ratio.
Approximately $495 million of unfavorable claim and allocated claim adjustment expense reserve development was recorded related to construction defect claims in 2003. Based on analyses completed during the third quarter of 2003, it became apparent that the assumptions regarding the number of claims, which were used to estimate the expected losses, were no longer appropriate. The analyses indicated that the number of claims reported was higher than expected primarily in Texas, Arizona, Nevada, Washington and Colorado. The number of claims reported in states other than California during the first six months of 2003 was almost 35% higher than the last six months of 2002. The number of claims reported during the last six months of 2002 increased by less than 10% from the first six months of 2002. In California, claims resulting from additional insured endorsements increased throughout 2003. Additional insured endorsements are regularly included on policies provided to subcontractors. The additional insured endorsement names general contractors and developers as additional insureds covered by the policy. Current California case law (Presley Homes, Inc. v. American States Insurance Company, (June 11, 2001) 90 Cal App. 4th 571, 108 Cal. Rptr. 2d 686) specifies that an individual subcontractor with an additional insured obligation has a duty to defend the additional insured in the entire action, subject to contribution or recovery later. In addition, the additional insured is allowed to choose one specific carrier to defend the entire action. These additional insured claims can remain open for a longer period of time than other construction defect claims because the additional insured defense obligation can continue until the entire case is resolved.
The unfavorable net prior year development recorded related to construction defect claims was primarily related to accident years 1999 and prior.
Approximately $98 million of unfavorable net prior year claim and allocated claim adjustment expense reserve development recorded in 2003 resulted from a program covering facilities that provide services to developmentally disabled individuals. This net prior year development was due to an increase in the size of known claims and increases in policyholder defense costs. Recent data shows the average claim increasing at an annual rate of approximately 20%. Prior data had shown average claim size to be level. Similar to the average claim size, recent data shows the average policyholder defense cost increasing at an annual rate of approximately 20%. Prior data had shown average policyholder defense cost to be level. The net prior year development recorded was primarily for accident years 2001 and prior.
Approximately $73 million of unfavorable net prior year development recorded in 2003 was the result of a commutation of all ceded reinsurance treaties with Gerling Global Group of companies (Gerling), related to accident years 1999 through 2001, including $41 million of unfavorable claim and allocated claim adjustment expense development and $32 million of unfavorable premium development. Further information regarding this commutation is provided in the Reinsurance section of this MD&A.
Unfavorable net prior year claim and allocated claim adjustment expense reserve development of approximately $40 million recorded in 2003 was related to a program covering tow truck and ambulance operators, primarily impacting the 2001 accident year. The Company had previously expected that loss ratios for this business would be similar to its middle market commercial automobile liability business. During 2002, the Company ceased writing business under this program.
Approximately $25 million of unfavorable net prior year premium development recorded in 2003 was related to a reevaluation of losses ceded to a reinsurance contract covering middle market workers compensation exposures. The reevaluation of losses led to a new estimate of the number and dollar amount of claims that would be ceded under the reinsurance contract. As a result of the reevaluation of losses, the Company recorded approximately $36 million of unfavorable claim and allocated claim adjustment expense reserve development, which was ceded under the contract. The net prior year development was recorded for accident year 2000.
segment. Unfavorable net prior year development of approximately $210 million related to small and middle market workers compensation exposures and approximately $110 million related to E&S lines was recorded in 2003. Offsetting these increases was $210 million of favorable net prior year development in the property line of business, including $79 million related to the WTC event.
The dividend ratio increased 0.9 points in 2003 as compared with 2002 due primarily to increased net prior year unfavorable dividend development. The $42 million increase in unfavorable dividend development was primarily related to workers compensation products. A review was completed in 2003 indicating dividend development that was higher than prior expectations. This development related to accident years 2002 and prior.
Net written premiums for Standard Lines increased $1,036 million in 2002 as compared with 2001. The increase in net written premiums was primarily due to decreased ceded premiums related to corporate
aggregate and other reinsurance treaties, strong rate increases, increased new business across most of Standard Lines and the absence of the change in estimate for involuntary market premium accruals recorded in 2001. The additional ceded premiums in 2001 related to corporate aggregate and other reinsurance treaties was recorded for the unfavorable net prior year development in 2001 and the WTC Event.
Net earned premiums increased $1,545 million in 2002 as compared with 2001. Net earned premiums increased as a result of the increases in net written premiums as described above and the absence of a change in estimate for retrospective premium accruals recorded in 2001.
The combined ratio decreased 46.6 points for 2002 as compared with 2001, and underwriting results improved by $1,083 million as compared with the underwriting results for the same period in 2001. The loss ratio decreased 25.4 points due primarily to decreased net prior year development and improvement in the current accident year ratio.
The discussion of the net prior year development recorded in 2002 was included in the “2003 compared with 2002” section above.
Approximately $230 million of unfavorable net prior year claim and allocated claim adjustment expense development recorded in 2001 was a result of several coverages provided to commercial entities. Reserve analyses performed during 2001 showed unexpected increases in the size of claims for several lines, including commercial automobile liability, general liability and the liability portion of commercial multiple-peril coverages. In addition, the number of commercial automobile liability claims was higher than expected and several state-specific factors resulted in higher than anticipated losses, including developments associated with commercial automobile liability coverage in Ohio and general liability coverage provided to contractors in New York. The unfavorable net prior year development was driven principally by accident years 1997 through 2000. The remaining unfavorable net prior year development affecting years prior to 1997 was driven principally by construction defect claims as described below.
The commercial automobile liability analysis indicated increased ultimate claim and claim adjustment expense across several accident years due to higher paid and reported claim and claim adjustment expense
Approximately $188 million of this amount resulted from a change in estimate in premiums related to involuntary market facilities, which had an offsetting impact on net losses and therefore had no impact on the net operating results. More than one-half of the change in estimate in premiums was attributable to accident years 1997 through 1999 with the remainder attributable to accident years prior to 1992. Accruals for ceded premiums related to reinsurance treaties other than the corporate aggregate reinsurance treaties increased $83 million due to the reserve strengthening. This increase in accruals for ceded premiums was principally recorded in accident year 2000. The remainder of the increase in premium accruals relates to the change in estimate of the amount of retrospective premium receivables as discussed above, which were principally recorded in accident years prior to 1999.
which the ratio is determined. The dividend ratio decreased 2.8 points primarily due to favorable 2002 accident year dividends.
Specialty Lines includes the following business groups: Professional Liability Insurance, CNA Global, Surety, Warranty, and CNA Guaranty and Credit.
Specialty Lines averaged rate increases of 24%, 26% and 13% in 2003, 2002 and 2001 for the contracts that renewed during these years. Retention rates of 79%, 76% and 78% were achieved for those contracts that were up for renewal.
Net loss was $17 million in 2003 as compared with $72 million in 2002. The improvement in net results was primarily due to improved current net accident year results primarily attributable to premium rate increases and increased net realized investment results. See the Investments section of this MD&A for further discussion of net investment income and net realized gains (losses). Net loss for 2002 also included a $48 million after-tax ($51 million pretax) cumulative effect of a change in accounting principle charge related to goodwill impairment. These improvements were partially offset by increased unfavorable net prior year development of $190 million after-tax ($292 million pretax), an increase in the bad debt provision for reinsurance receivables of $51 million after-tax ($79 million pretax) and increased interest expense of $4 million after-tax ($5 million pretax) related to additional cessions to the corporate aggregate reinsurance treaties.
The combined ratio increased 9.9 points and underwriting results decreased by $309 million in 2003 as compared with 2002. The loss ratio increased 7.8 points due principally to increased unfavorable net prior year development, as discussed below. Additionally, the loss ratio was negatively impacted by a $28 million increase in ULAE reserves and $49 million of current accident year losses for Surety, related to large losses in 2003, and $20 million of current accident year losses for directors and officers exposures in CNA Pro, which primarily related to recent securities class action cases related to certain mutual fund firms. These items were partially offset by the improvement in the current net accident year loss ratio and the impact of higher net earned premiums.
Unfavorable net prior year claim and allocated claim adjustment expense reserve development of approximately $75 million recorded in 2003 was related to an adverse arbitration decision in 2003 involving a single large property and business interruption loss. The decision was rendered against a voluntary insurance pool in which the Company was a participant. The loss was caused by a fire which occurred in 1995. The Company no longer participates in this pool.
Unfavorable net prior year development of approximately $180 million was recorded for CNA HealthPro in 2002 and was driven principally by medical malpractice excess products provided to hospitals and physicians and coverages provided to long term care facilities, principally national for-profit nursing homes. Approximately $100 million of the net prior year unfavorable development was related to assumed excess products and loss portfolio transfers, and was primarily driven by unexpected increases in the number of excess claims in accident years 1999 and 2000. The percentage of total claims greater than $1 million has increased by 33%, from less than 3% of all claims to more than 4% of all claims. CNA HealthPro no longer writes assumed excess products and loss portfolio transfers. Approximately $50 million of the unfavorable net prior year development was related to long term care facilities. The unfavorable net prior year development was principally recorded for accident years 1997 through 2000. The average value of claims closed during the first several months of 2002 increased by more than 50% when compared to claims closed during 2001. In response to those trends, CNA HealthPro has reduced its writings of national for-profit nursing home chains. Excess products provided to healthcare institutions and physician coverages in a limited number of states were responsible for the remaining development in CNA HealthPro. The unfavorable net prior year development on excess products provided to institutions for accident years 1996 through 1999 resulted from increases in the size of claims experienced by these institutions. Due to the increase in the size of claims, more claims were exceeding the point at which these excess products apply. The unfavorable net prior year development on physician coverages was recorded for accident years 1999 through 2001 in Oregon, California, Arizona and Nevada. The average claim size in these states has increased by 20%, driving the change in losses.
Offsetting this unfavorable net prior year development was favorable net prior year development in CNA Pro and for Enron related exposures. Programs providing professional liability coverage to accountants, lawyers and realtors primarily drove favorable net prior year development of approximately $110 million in CNA Pro. Reviews of this business completed during 2002 showed little activity for older accident years (principally prior to 1999), which reduced the need for reserves on these years. The reported losses on these programs for accident years prior to 1999 increased by approximately $5 million during 2002. This increase compared to the total reserve at the beginning of 2002 of approximately $180 million, net of reinsurance. Additionally, favorable net prior year development of $20 million was associated with the Enron settlement. The Company had established a $20 million reserve for accident year 2001 for an
A $16 million underwriting benefit was recorded for cessions to the corporate aggregate reinsurance treaties in 2002. The benefit was comprised of $55 million of ceded losses and $39 million of ceded premium for accident year 2001.
Net written premiums for Specialty Lines increased $432 million and net earned premiums increased $282 million in 2002 as compared with 2001. The increase in both net written and net earned premiums was primarily due to decreased ceded premiums related to corporate aggregate and other reinsurance treaties, strong rate increases and increased new business in most lines of business, including CNA Pro and Global. The additional ceded premiums recorded in 2001 were the result of unfavorable net prior year development and the WTC event.
Favorable net prior year development of $13 million after-tax ($20 million pretax) was recorded in 2002 in relation to the Enron exposures previously recorded as a charge of $30 million after-tax ($46 million pretax) related to the bankruptcy filing of certain Enron entities in 2001. These 2001 charges consisted of $17 million after-tax ($26 million pretax) of losses in connection with surety exposures, including advance payment obligations bonds and $13 million after-tax ($20 million pretax) of other operating expenses in connection with collateralized debt obligations, a credit enhancement product.
In addition, net results in 2001 were also adversely impacted by $12 million after-tax ($18 million pretax) of estimated losses related to the WTC event, $6 million after-tax ($9 million pretax) for restructuring and other related charges and the better alignment of premium earnings with the emergence of claims in the vehicle warranty line of business, which reduced net results in 2001.
The expense ratio decreased 9.4 points as a result of the increase in earned premium base and the 2001 write-off of unrecoverable deferred acquisition costs in the vehicle warranty line of business and lower underwriting expenses due to decreased staff levels as a result of the 2001 Plan, and other expense reduction initiatives.
During October of 2003, CNA sold most of the renewal rights for all treaty business to Folksamerica Reinsurance Company (Folksamerica), a wholly owned subsidiary of White Mountains Insurance Group, Ltd. of Hamilton, Bermuda. Concurrent with the sale, CNA announced its withdrawal from the assumed reinsurance business. CNA will manage the run-off of its retained liabilities, including unearned premium reserves. Prior to the sale, CNA Re had offered treaty, facultative, and financial reinsurance while operating primarily in the United States and select global markets.
In 2002 and prior, CNA Re’s operations had also included the business of CNA Re U.K., a United Kingdom reinsurance company. On October 31, 2002, the Company completed the sale of CNA Re U.K. to Tawa UK Limited (Tawa), a subsidiary of the Artemis Group, a diversified French-based holding company. The sale included business underwritten since inception by CNA Re U.K., except for certain risks retained by CCC. CNA Re’s U.K. subsidiaries ceased new underwriting activities in the third quarter of 2001. See the Investments section of the MD&A for further details of the sale of CNA Re U.K.
The combined ratio increased 15.6 points and underwriting results decreased $74 million in 2003 as compared with 2002. The loss ratio increased 16.8 points due principally to increased unfavorable net prior year development and increased catastrophe losses. Catastrophe losses were $29 million in 2003 for Texas tornados, Midwest rain storms, Hurricanes Isabel and Claudette, and the California wild fires. Catastrophe losses were $17 million in 2002. The expense ratio improved 1.2 points primarily due to the absence of the unfavorable expense ratio impact from CNA Re U.K. and lower acquisition expenses that were the result of a ceded profit commission payable due to the cancellation of a catastrophe reinsurance cover.
The following discusses net prior year development for CNA Re recorded in 2003.
Unfavorable net prior year claim and allocated claim adjustment expense reserve development of approximately $25 million was recorded primarily for directors and officers exposures. The unfavorable net prior year development was a result of a claims review that was completed during the second quarter of 2003. The unfavorable net prior year development was primarily due to securities class action cases related to certain known corporate malfeasance cases and investment banking firms. The unfavorable net prior year development recorded was for accident years 2000 and 2001.
The following discusses net prior year development for CNA Re recorded in 2002.
During 2002, CNA Re revised its estimate of premiums and losses related to the WTC event. In estimating CNA Re’s WTC event losses, the Company performed a treaty-by-treaty analysis of exposure. The Company’s original loss estimate was based on a number of assumptions including the loss to the industry, the loss to individual lines of business and the market share of CNA Re’s cedants. Information that became available in the first quarter of 2002 resulted in CNA Re increasing its estimate of WTC event related premiums and losses on its property facultative and property catastrophe business. The impact of increasing the estimate of gross WTC event losses by $144 million was fully offset on a net of reinsurance basis (before the impact of the CCC Cover) by higher reinstatement premiums and a
Recent concerns about reinsurance security, prompted in part by rating agency downgrades of several reinsurers’ financial strength ratings, have impacted the reinsurance marketplace. Many ceding companies are seeking provisions for the collateralization of assumed reserves in the event of a financial strength ratings downgrade or other triggers. Before exiting the reinsurance market, CNA Re had been impacted by this trend and had entered into several contracts with rating or other triggers. See the Ratings section of this MD&A for more information.
Net income was $136 million in 2002 as compared with a net loss of $669 million in 2001. The improvement in net results in 2002 was primarily due to decreased unfavorable net prior year development of $453 million after-tax ($697 million pretax) and increased net realized investment gains.
The combined ratio decreased 154.5 points in 2002 as compared with 2001, and underwriting results improved $990 million. The loss ratio decrease of 142.8 points was principally due to lower net prior year development in 2002 as compared with 2001. The 2001 unfavorable net prior year development includes a $160 million of unfavorable net prior year claim and allocated claim adjustment expense reserve development for prior underwriting year reserves for CNA Re U.K.
An analysis of assumed reinsurance business written by CNA Re showed that the paid and reported losses for recent accident years were higher than expectations, which resulted in management recording unfavorable net prior year development of approximately $690 million. Because of the long and variable reporting pattern associated with assumed reinsurance as well as uncertainty regarding possible changes in the reporting methods of the ceding companies, the carried reserves for assumed reinsurance were based mainly on the pricing assumptions until experience emerged to show that the pricing assumptions are no longer valid. The reviews completed during 2001, including analysis at the individual treaty level, showed that the pricing assumptions were no longer appropriate. The classes of business with the most significant changes included excess of loss liability, professional liability and proportional and retrocessional property. Approximately $470 million of unfavorable net prior year development was from accident years 1998 through 2000, and approximately $150 million was from accident years 1996 and 1997. The remaining $70 million of unfavorable net prior year development was attributable to accident years prior to 1996.
A $32 million underwriting benefit was recorded for the corporate aggregate reinsurance treaties in 2001, comprised of $57 million of ceded losses and $25 million of ceded premiums for accident year 1999.
Group Operations provided group health insurance and investment products and services to employers, affinity groups and other entities that purchase insurance as a group.
On December 31, 2003, CNA completed the sale of the majority of its Group Benefits business to Hartford. The business sold included group life and accident, short and long term disability and certain other products. CNA’s group long term care and specialty medical businesses were excluded from the sale. Consideration from the sale was approximately $530 million, of which $485 million was received on December 31, 2003, resulting in an after-tax realized investment loss on the sale of $130 million during 2003. See Note P of the Consolidated Financial Statements included under Item 8 for further information.
During February of 2004, CNA announced the decision to cease new sales in its institutional markets business. CNA will continue to accept new deposits and premiums only from existing customers and will service its existing commitments. This business will be managed as a run-off operation. CCC will provide credit enhancement to Continental Assurance (CAC) for certain of CAC’s investment and specialty medical products.
Group Benefits offered group long term care and specialty medical products and related services. Prior to the sale to Hartford, products had been marketed through a nationwide operation of 31 sales offices,
third-party administrators, managing general agents and insurance consultants. See Note P of the Consolidated Financial Statements included under Item 8 for further details of this transaction.
Institutional Markets and Other is a provider of annuities and investment products to pension plan sponsors and other institutional customers. The products include traditional and synthetic guaranteed investment contracts (GICs), indexed contracts, group annuities and funding agreements. CNA offers an Index 500 product, which is a guaranteed investment contract that is indexed to the performance of the Standard & Poor’s 500® (S&P 500®) Index.
Net income decreased by $96 million in 2003 as compared with 2002. The decrease in net income related primarily to increased net realized investment losses including a $130 million after-tax ($176 million pretax) loss on the sale of the Group Benefits business, the absence of net income related to the Mail Handlers Plan, including the non-recurring fee income received from First Health Group in the third quarter of 2002 and a change in the discount rate on prior year disability and life waiver of premium reserves from 6.5% to 6.0%, resulting in a $14 million after-tax ($22 million pretax) decrease in net income. The change in discount rate reflects the decreasing portfolio yield and the current investment environment. See the Investments section of this MD&A for further discussion on net investment income and net realized gains (losses). These items were partially offset by the absence of unfavorable net results
related to the variable products business which was sold to The Phoenix Companies, Inc. in the third quarter of 2002, improved operating results in the single premium group annuity product, increased favorable net prior year development related to a $7 million after-tax release of WTC event reserves, favorable results in the specialty medical line, and the impact of premium growth within Group Benefits.
Also, in February of 2004, CNA ceased new sales in its structured settlement business, but will continue to service its existing commitments. This business will be managed as a run-off operation.
Individual life primarily offers level premium term life insurance, universal life insurance and related products. Single premium immediate annuities as well as structured settlement annuities are also offered.
Net income increased by $91 million in 2003 as compared with 2002. The increase in net results related primarily to increased net realized investment gains, improvement in net results for life settlement contracts, and the absence of the cumulative effect of a change in accounting principle of $8 million recorded in 2002 relating to the write-down of impaired goodwill. Partially offsetting these items were increases in individual long term care reserves of $4 million after-tax ($7 million pretax) due to increased severity and claim frequency. The increase in reserves for individual long term care was $42 million pretax in 2003 as compared with $35 million pretax in 2002. Also partially offsetting the improvements was the write-off of capitalized software costs of $8 million pretax, lower net investment income, and severance costs of $3 million after-tax ($4 million pretax) related to the individual long term care product. See the Investments section of this MD&A for further discussion on net investment income and net realized gains (losses).
Net income decreased by $196 million in 2002 as compared with 2001. The decrease in net income related primarily to increased net realized investment losses, the cumulative effect of a change in accounting principle of $8 million after-tax recorded in 2002 relating to write-down of impaired goodwill, and a $35 million after-tax loss from discontinued operations for the sale of CNA Vida. Included in the 2001 results were $19 million after-tax ($29 million pretax) related to restructuring and other related charges and $14 million after-tax ($22 million pretax) related to the WTC event. Net results decreased due primarily to net reserve strengthening for individual long term care of $23 million after-tax ($35 million pretax), unfavorable individual long term care morbidity and increased costs related to the life settlement business in 2002. These decreases were partially offset by higher net investment income, a decrease in reinsurance charges, favorable net prior year development relating to the WTC event of $10 million after-tax ($15 million pretax) recorded in 2002 as compared with 2001.
APMT consists of the losses and expenses related to the centralized adjusting and settlement of APMT claims. See the Asbestos and Environmental Pollution and Mass Tort Reserves section on the following pages for a description of APMT reserves.
In accordance with the retroactive reinsurance agreement with Allstate, CNA shares in indemnity and must begin to reimburse Allstate for claim and allocated claim adjustment expenses if payments related to losses incurred prior to October 1, 1999 on the CNA policies transferred to Allstate exceed the claim and allocated claim adjustment expense reserves of approximately $1 billion at the date of sale. The Company’s remaining obligation valued under this loss sharing provision as of October 1, 2003 will be settled, under a time schedule established by the parties, by agreement of the parties or by an independent actuarial review of the unpaid claim liabilities as of that date. Cumulative payments of indemnity and allocated loss adjustment expenses on such policies exceeded $1 billion during the second quarter of 2003. The Company has established reserves for its estimated liability under this loss sharing arrangement.
Total revenues decreased $150 million in 2002 as compared with 2001. This decrease was due primarily to reduced revenues for CNA UniSource, due to the exit of this business, reduced net investment income and pretax realized investment gains partially offset by increased net earned premiums in group reinsurance.
Net results increased by $909 million in 2002 as compared with 2001. Net results improved in 2002 as compared with 2001 primarily due to decreased unfavorable net prior year development of $846 million after-tax ($1,301 million pretax), reduced expenses for eBusiness initiatives, improved results for group reinsurance and a $17 million after-tax ($27 million pretax) reduction in the accrual for restructuring and other related charges recorded in 2002. In addition, net results in 2001 was adversely impacted by $77 million after-tax ($119 million pretax) of restructuring and other related charges and $17 million after-tax ($27 million pretax) of estimated losses related to the WTC event for group reinsurance.
Unfavorable net prior year development of $21 million, including $23 million of net unfavorable claim and allocated claim adjustment expense reserve development and $2 million of favorable premium development, was recorded in 2002 for Corporate and Other. Unfavorable net prior year development of $1,322 million, including $1,313 million of net unfavorable claim and allocated claim adjustment expense reserve development and $9 million of unfavorable premium development, was recorded in 2001 for Corporate and Other. The gross carried claim and claim adjustment expense reserve was $4,847 million and $5,043 million at December 31, 2002 and 2001. The net carried claim and claim adjustment expense reserve was $2,002 million and $2,110 million at December 31, 2002 and 2001.
The following table provides data related to CNA’s asbestos and environmental pollution and mass tort claim and claim adjustment expense reserves.
injury actions, have ordered that so-called “unimpaired” claimants may not recover unless at some point the claimant’s condition worsens to the point of impairment.
As of December 31, 2003 and 2002, CNA carried approximately $1,767 million and $1,246 million of claim and claim adjustment expense reserves, net of reinsurance recoverables, for reported and unreported asbestos-related claims. Unfavorable asbestos-related net claim and claim adjustment expense reserve development for 2003, 2002 and 2001 amounted to $642 million, $0 and $773 million. The Company paid asbestos-related claims, net of reinsurance, of $121 million, $21 million and $171 million during the years ended December 31, 2003, 2002 and 2001.
The Company recorded $1,826 million and $642 million in unfavorable gross and net asbestos prior year development for 2003, principally due to potential losses from policies issued by CNA with high attachment points, which previous exposure analysis indicated would not be reached. As part of its review completed in the third quarter of 2003, the Company examined the claims filing trends and the projected erosion rates of underlying primary and lower excess insurance on open asbestos accounts to determine timeframes within which high excess policies issued by CNA could be reached. Elevated claims volumes, together with certain adverse court decisions affecting rapidity by which asbestos claims are paid supported the conclusion that excess policies with high attachment points previously thought not to be exposed may now potentially be exposed.
In 2001, CNA noted the continued emergence of adverse loss experience across several lines of business related to prior years. With respect to asbestos reserves, throughout 2000, and into 2001, CNA experienced significant increases in new asbestos bodily injury claims. In light of this development, CNA formed the view that payments for asbestos claims could be higher in future years than previously estimated. Moreover, in late 2000 through mid-2001, industry sources such as rating agencies and actuarial firms released analyses and studies commenting on the increase in claim volumes and other asbestos liability developments.
Also in the 2000 to 2001 time period, a number of significant asbestos defendants filed for bankruptcy, increasing the likelihood that excess layers of insurance coverage could be called upon to indemnify policyholders and creating the potential that novel legal doctrines could be employed. These developments led the Company to the conclusion that its asbestos reserves required strengthening of $773 million in 2001.
The Company has resolved a number of its large asbestos accounts by negotiating settlement agreements. Structured settlement agreements provide for payments over multiple years as set forth in each individual agreement. At December 31, 2002, CNA had four structured settlement agreements with a reserve of $118 million, net of reinsurance. Since December 31, 2002, CNA has resolved five additional asbestos accounts through structured settlement agreements. At December 31, 2003, CNA has structured settlement agreements with nine of its policyholders for which it has future payment obligations with a reserve, net of reinsurance, of $188 million related to remaining payment obligations under these
In 1985, 47 asbestos producers and their insurers, including CIC, executed the Wellington Agreement. The agreement intended to resolve all issues and litigation related to coverage for asbestos exposures. Under this agreement, signatory insurers committed scheduled policy limits and made the limits available to pay asbestos claims based upon coverage blocks designated by the policyholders in 1985, subject to extension by policyholders. CIC was a signatory insurer to the Wellington Agreement. At December 31, 2002, CNA had fulfilled its Wellington Agreement obligations as to all but five accounts and had recorded a reserve of $28 million, net of reinsurance, related to its remaining Wellington obligations. At December 31, 2003, with respect to these five remaining unpaid Wellington obligations, CNA has evaluated its exposure and the expected reinsurance recoveries under these agreements and had a recorded reserve of $23 million, net of reinsurance.
CNA has also used coverage in place agreements to resolve large asbestos exposures. Coverage in place agreements are typically agreements between CNA and its policyholders identifying the policies and the terms for payment of asbestos related liabilities. Claims payments are contingent on presentation of adequate documentation showing exposure during the policy periods and other documentation supporting the demand for claims payment. Coverage in place agreements may have annual payment caps. At December 31, 2002, the Company had estimated its exposure for its twenty-three coverage in place agreements at $66 million, net of reinsurance. As of December 31, 2003, CNA had negotiated thirty-two such agreements. Coverage in place agreements are evaluated based on claims filings trends and severities. Due to adverse claims trends described in this section, management has increased its estimate of exposure under current coverage in place agreements. The Company has evaluated these commitments and the expected reinsurance recoveries under these agreements and has recorded a reserve of $109 million, net of reinsurance, related to coverage in place agreements as of December 31, 2003.
Small accounts are defined as active accounts with $100,000 or less cumulative paid losses. At December 31, 2002, the Company had 939 small accounts with recorded reserves of $90 million, net of reinsurance. At December 31, 2003, CNA has 1,065 small accounts, approximately 84% of its total active asbestos accounts and has increased its collective reserve to $147 million, net of reinsurance, as of December 31, 2003. Small accounts are typically representative of policyholders with limited connection to asbestos. As entities which were historic targets in asbestos litigation continue to file for bankruptcy protection, plaintiffs’ attorneys are seeking other viable targets. As a result, companies with few or no previous asbestos claims are becoming targets in asbestos litigation and nevertheless must be defended by CNA under its policies. As claims filings continue to increase, costs incurred in defending small accounts are expected to increase.
The Company also evaluates its asbestos liabilities arising from its assumed reinsurance business and its participation in various pools. At December 31, 2002, CNA had recorded a $91 million reserve related to these asbestos liabilities arising from the Company’s assumed reinsurance obligations and CNA’s participation in pools, including Excess & Casualty Reinsurance Association (ECRA). At December 31, 2003, CNA has increased the reserves to $157 million, net of reinsurance, related to these liabilities.
On February 13, 2003, CNA announced it had resolved asbestos related coverage litigation and claims involving A.P. Green Industries, A.P. Green Services and Bigelow - Liptak Corporation. Under the agreement, CNA is required to pay $74 million, net of reinsurance recoveries, over a ten year period. The settlement resolves CNA’s liabilities for all pending and future asbestos claims involving A.P. Green Industries, Bigelow - Liptak Corporation and related subsidiaries, including alleged “non-products” exposures. The settlement has received initial bankruptcy court approval and CNA expects to procure confirmation of a bankruptcy plan containing an injunction to protect CNA from any future claims.
CNA has insurance coverage disputes related to asbestos bodily injury claims against Burns & Roe Enterprises, Inc. (Burns & Roe). Originally raised in litigation, now stayed, these disputes are currently part of In re: Burns & Roe Enterprises, Inc., pending in the U.S. Bankruptcy Court for the District of New Jersey, No. 00-41610. Burns & Roe provided engineering and related services in connection with construction projects. At the time of its bankruptcy filing, Burns & Roe faced approximately 11,000 claims alleging bodily injury resulting from exposure to asbestos as a result of construction projects in which Burns & Roe was involved. CNA allegedly provided primary liability coverage to Burns & Roe from 1956-1969 and 1971-1974, along with certain project-specific policies from 1964-1970.
CNA has been named in Adams v. Aetna, Inc., et al. (Circuit Court of Kanawha County, West Virginia), a purported class action against CNA and other insurers, alleging that the defendants violated West Virginia’s Unfair Trade Practices Act in handling and resolving asbestos claims against their policyholders. A direct action has also been filed in Montana (Pennock, et al. v. Maryland Casualty, et al. First Judicial District Court of Lewis & Clark County, Montana) by eight individual plaintiffs (all employees of W.R. Grace & Co. (W.R. Grace)) and their spouses against CNA, Maryland Casualty and the State of Montana. This action alleges that the carriers failed to warn of or otherwise protect W.R. Grace employees from the dangers of asbestos at a W.R. Grace vermiculite mining facility in Libby, Montana. The Montana direct action is currently stayed because of W.R. Grace’s pending bankruptcy.
CNA is vigorously defending these and other cases and believes that it has meritorious defenses to the claims asserted. However, there are numerous factual and legal issues to be resolved in connection with these claims, and it is extremely difficult to predict the outcome or ultimate financial exposure represented by these matters. Adverse developments with respect to any of these matters could have a material adverse effect on CNA’s business, insurer financial strength and debt ratings, and results of operations and/or equity.
the uncertainty as to which other insureds may be targeted in the future and the uncertainties inherent in predicting the number of future claims
the efforts by insureds to obtain coverage not subject to aggregate limits
long latency period between asbestos exposure and disease manifestation and the resulting potential for involvement of multiple policy periods for individual claims
CNA recorded $73 million in unfavorable net prior year environmental pollution development in 2003. This increase was in part due to the emergence of certain negative legal developments, including several court decisions which have reduced the effectiveness of the absolute pollution exclusion by limiting its application to traditional industrial pollution, and which have increased the scope of damages compensable under policies of insurance and the emergence of Natural Resource Damage claims under the Superfund and other federal statutes.
December 31, 2003, CNA has a structured settlement agreement with one of its policyholders for which it has future payment obligations with a recorded reserve of $12 million, net of reinsurance.
The Company categorizes active accounts as large or small accounts in the pollution area. CNA defines a large account as an active account with more than $100,000 cumulative paid losses. CNA has 144 large accounts with a collective reserve of $86 million, net of reinsurance, at December 31, 2003. The Company has made closing large accounts a significant management priority. Small accounts are defined as active accounts with $100,000 or less cumulative paid losses. CNA has 432 small accounts with a collective reserve of $53 million, net of reinsurance, at December 31, 2003.
The Company also evaluates its environmental pollution exposures arising from its assumed reinsurance and its participation in various pools, including ECRA. At December 31, 2003, CNA has a reserve of $38 million related to these liabilities.
The chart below depicts CNA’s overall pending environmental pollution accounts and associated reserves at December 31, 2003.
The Company recorded $80 million in unfavorable mass tort net prior year development in 2003, due in part to the elevated volume of silica claims. In 2003, CNA observed a marked increase in silica claims frequency in Mississippi, where plaintiff attorneys appear to have filed claims to avoid the effect of tort
reform. The most significant silica exposures identified to date include a relatively small number of accounts with significant numbers of new claims and substantial insurance limits issued by the Company. Establishing claim and claim adjustment expense reserves for silica claims is subject to uncertainties because of disputes concerning medical causation with respect to certain diseases, including lung cancer, geographical concentration of the lawsuits asserting the claims, and the large rise in the total number of claims without underlying epidemiological developments suggesting an increase in disease rates or plaintiffs. Moreover, judicial interpretations regarding application of various tort defenses, including application of various theories of joint and several liability, impede the Company’s ability to establish claim and claims adjustment expense reserves.
In 2001, CNA noted the continued emergence of adverse loss experience across several lines of business related to prior years. With respect to environmental pollution and mass tort reserves, commencing in 2000 and continuing into the first and second quarters of 2001, CNA received a number of new reported claims, some of which involved declaratory judgment actions premised on court decisions purporting to expand insurance coverage for pollution claims. In these decisions, several courts adopted rules of insurance policy interpretation which established joint and several liability for insurers consecutively on a risk during a period of alleged property damage; and in other instances adopted interpretations of the “absolute pollution exclusion,” which weakened its effectiveness in most circumstances. In addition to receiving new claims and declaratory judgment actions premised upon these unfavorable legal precedents, these court decisions also impacted CNA’s pending environmental pollution and mass tort claims and coverage litigation. During the Spring of 2001, CNA reviewed specific claims and litigation, as well as general trends, and concluded reserve strengthening in this area was necessary.
The bond segment of the investment portfolio yielded 5.1% in 2003, 6.0% in 2002 and 6.4% in 2001.
CNA classifies its fixed maturity securities (bonds and redeemable preferred stocks) and its equity securities as available-for-sale, and as such, they are carried at fair value. The amortized cost of fixed maturity securities is adjusted for amortization of premiums and accretion of discounts to maturity, which is included in net investment income. The following table provides further detail of gross realized gains and gross realized losses on fixed maturity securities and equity securities.
The largest realized losses from sales of fixed maturities and equity securities aggregated by issuer for the year ended December 31, 2003 totaled $242 million. The following table provides details of those largest realized losses aggregated by issuer including: the fair value of the securities at sales date, the amount of the loss recorded and the period of time that the security had been in an unrealized loss position prior to sale. The period of time that the security had been in an unrealized loss position prior to sale can vary due to the timing of individual security purchases. Also footnoted is a narrative providing the industry sector along with the facts and circumstances giving rise to the loss.
The Company’s general and separate account investment portfolio consists primarily of publicly traded government bonds, asset-backed securities, mortgage-backed securities, short-term investments, municipal bonds and corporate bonds.
Realized investment losses included $321 million, $890 million and $129 million of pretax impairment losses for the three years ended December 31, 2003, 2002 and 2001. The impairments were primarily the result of the continued credit deterioration on specific issuers in the bond and equity markets and the effects on such markets due to the overall slowing of the economy.
For the year ended December 31, 2002, the impairment losses recorded related primarily to corporate bonds in the communications industry sectors including $129 million related to WorldCom Inc., $74 million related to Adelphia Communication Corporation, $60 million for Charter Communications, $57 million for AT&T Canada and $53 million for Telewest PLC.
If the deterioration in these industry sectors continues in future periods and the Company continues to hold these securities, the Company is likely to have additional impairments in the future.
The Company’s non-investment grade fixed maturity securities held as of December 31, 2003 that were in an unrealized loss position had a fair value of $315 million. As discussed previously, a significant judgment in the valuation of investments is the determination of when an other-than-temporary impairment has occurred. The Company’s Impairment Committee analyzes securities placed on the watch list on at least a quarterly basis. Part of this analysis is to monitor the length of time and severity of the decline below book value of the watch list securities. The following table summarizes the fair value and gross unrealized loss of non-investment grade securities categorized by the length of time those securities have been in a continuous unrealized loss position and further categorized by the severity of the unrealized loss position in 10% increments as of December 31, 2003.
The Company regularly updates its impairment analyses and adjusts its loss as necessary. Based on these updated analyses the impairment loss was reduced by approximately $170 million after-tax in the fourth quarter of 2001, primarily because the net assets of the businesses had been significantly diminished by their operating losses, including unfavorable net prior year development recognized by CNA Re U.K. in the fourth quarter of 2001. The reduction of the impairment was included in realized investment gains/losses.
On October 31, 2002, the Company completed the sale of CNA Re U.K. to Tawa. The sale includes business underwritten since inception by CNA Re U.K., except for certain risks retained by CCC as discussed below. The purchase price was $1, subject to adjustments based primarily upon the results of operations and realized foreign currency losses of CNA Re U.K. Under the terms of the purchase price adjustment, CCC is entitled to receive $5 million from Tawa after Tawa is able to legally withdraw funds from the former CNA Re U.K. entities; at December 31, 2003, CNA has received approximately $2 million. CCC has also committed to contribute up to $5 million to the former CNA Re U.K. entities over a four-year period beginning in 2010 should the Financial Services Authority (FSA) deem those entities
to be undercapitalized. The purchase price adjustment related to foreign currency losses resulted in CNA contributing additional capital to CNA Re U.K. of $11 million. As the sale and related agreements have now been completed, the Company has finalized its impairment analysis based upon the terms of the completed transactions and reduced the impairment loss by approximately $39 million after-tax. The reduction of the impairment was included in net realized investment gains in 2002.
At December 31, 2003 and 2002, 98% and 99% of the separate account portfolio was U.S. Government agencies or was rated by S&P or Moody’s. The remaining bonds were rated by other rating agencies or Company management.
The carrying value of non-traded securities at December 31, 2003 was $270 million which represents 0.7% of the Company’s total investment portfolio. These securities were in a net unrealized gain position of $61 million at December 31, 2003. Of the non-traded securities, 48% are priced by unrelated third party sources.
The carrying value of the components of the general account short term investment portfolio is presented in the following table.
CNA invests in certain derivative financial instruments primarily to reduce its exposure to market risk (principally interest rate, equity price and foreign currency risk) and credit risk (risk of nonperformance of
Most derivatives in separate accounts are held for hedging purposes. The Company uses these derivatives to mitigate market risk by purchasing S&P 500® index futures in a notional amount equal to the contract liability relating to Life Operations’ Index 500 guaranteed investment contract product.
For the year ended December 31, 2002, net cash provided by operating activities was $1,040 million as compared with net cash used of $599 million in 2001. The improvement related primarily to federal tax refunds received in 2002 as compared to taxes paid in 2001 and decreased net payments for insurance claims.
For the year ended December 31, 2003, net cash used for investing activities was $2,133 million as compared with $1,488 million in 2002. Cash flows used for investing related principally to purchases of fixed maturity securities.
For the year ended December 31, 2002, net cash used for investing activities was $1,488 million as compared with net cash used of $205 million in 2001. Cash flows used by investing activities were related principally to increased purchases of invested assets due to positive operating cash flow and cash provided by financing activities.
Cash flows from financing activities include proceeds from the issuance of debt or equity securities, outflows for repayment of debt and outlays to reacquire equity instruments.
For the year ended December 31, 2003, net cash provided from financing activities was $386 million as compared with $432 million in 2002. For the year ended December 31, 2002, net cash provided from financing activities was $432 million as compared with $783 million in 2001.
CNA’s estimated gross pretax losses for the WTC event recorded in 2001,were $1,648 million pretax ($1,071 million after-tax). Net pretax losses before the effect of corporate aggregate reinsurance treaties were $727 million. Approximately 1%, 60% and 33% of the reinsurance recoverables on the estimated losses related to the WTC event are from companies with S&P ratings of AAA, AA or A.
A Moody’s downgrade of the CNAF senior debt rating from Baa2 to Baa3 on November 12, 2003, increased the facility fee on the three-year component of the facility from 17.5 basis points to 25.0 basis points. The applicable interest rate increased from LIBOR plus 57.5 basis points to LIBOR plus 75.0 basis points. The utilization fee remained unchanged on the three-year facility at 12.5 basis points.
On September 30, 2003, CNA Surety, a 64% owned and consolidated subsidiary of CNA, entered into a $50 million credit agreement, which consisted of a $30 million, two-year revolving credit facility and a $20 million two-year term loan, payable semi-annually at a rate of $5 million. The credit agreement is an amendment to a $65 million credit agreement, extending the revolving loan termination date from September 30, 2003 to September 30, 2005. The new revolving credit facility was fully utilized at inception.
Loews and CNAF have entered into a participation agreement, pursuant to which Loews has purchased a participation interest in one-third of the loans and commitments under the credit facility, on a dollar-for-dollar basis, up to a maximum of $25 million. Although Loews does not have rights against the contractor directly under the participation agreement, it shares recoveries and certain fees under the facility proportionally with CNAF.
In March of 2003, CNAF purchased the contractor’s outstanding bank debt for $16 million. The contractor purchased the bank debt and retired it, with $11 million of the purchase price being funded
As of December 31, 2003 and 2002, the Company had committed approximately $154 million and $141 million to future capital calls from various third-party limited partnership investments in exchange for an ownership interest in the related partnerships.
In the normal course of investing activities, CCC had committed approximately $51 million as of December 31, 2003 to future capital calls from certain of its unconsolidated affiliates in exchange for an ownership interest in such affiliates.
In addition, the Company has agreed to provide indemnification to third party purchasers for certain losses associated with sold business entities or assets that are not limited by a contractual monetary amount. As of December 31, 2003, the Company had outstanding unlimited indemnifications in connection with the sales of certain of its business entities or assets for tax liabilities arising prior to a purchaser’s ownership of an entity or asset, defects in title at the time of sale, employee claims arising prior to closing and in some cases losses arising from certain litigation and undisclosed liabilities. These indemnification agreements survive until the applicable statutes of limitation expire, or until the agreed upon contract terms expire. As of December 31, 2003, the Company has recorded approximately $16 million of liabilities related to these indemnification agreements.
A summary of the Company’s commitments as of December 31, 2003 is presented in the following table.
In connection with the approval process for aspects of the reorganization plan, the Company has agreed to undergo a state regulatory financial examination of CIC as of December 31, 2003, including a review of insurance reserves by an independent actuarial firm. CCC is also scheduled to undergo its routine state regulatory financial examination as of December 31, 2003.
Pursuant to its participation in the working group referenced above, the Company has agreed to certain time frames and informational provisions in relation to the reorganization plan. The Company has also agreed that any proceeds from the sale of any member of the CIC pool, net of transaction expenses, will be retained in CIC or one of its subsidiaries until the dividend stipulation discussed below expires.
relying on the Company’s ratings of the possibility of a rating change in the near term. Modifiers are utilized when the agencies are uncertain as to the impact of a Company action or initiative, which could prove to be material to the current rating level. Modifiers are generally used to indicate a possible change in rating within 90 days. “Outlooks” accompanied with ratings are additional modifiers used by the rating agencies to alert those parties relying on the Company’s ratings of the possibility of a rating change in the longer term. The time frame referenced in an outlook is not necessarily limited to ninety days as defined in the Credit-Watch category.
The table below reflects the various group ratings issued by A.M. Best, S&P, Moody’s and Fitch as of February 12, 2004 for the Property and Casualty and Life companies. The table also includes the ratings for CNAF’s senior debt and Continental senior debt.
All modifiers for the property & casualty companies’ insurance financial strength and holding company debt ratings as evaluated by S&P are Credit Watch with negative implications; the property & casualty companies’ financial strength and holding company debt ratings have a negative outlook from A. M. Best, Fitch and Moody’s.
S&P’s modifier to CAC’s rating is Credit Watch with negative implications; A.M. Best and Moody’s have a stable outlook while Fitch has a negative outlook on the CAC rating.
A.M. Best lowered the rating of CAC from A to A- and established a stable outlook. VFL’s rating outlook was changed from Negative to an Under Review with Developing Implications. Fitch lowered the rating of CAC from A+ to A- and kept a negative outlook. VFL’s rating outlook was changed from Negative to Rating Watch Positive. Moody’s retained their Baa1 ratings on CAC and VFL. The rating agency changed CAC’s outlook from negative to stable and placed VFL’s rating On Review for Upgrade. Standard & Poor’s did not change their A ratings on CAC and VFL, but revised VFL’s modifier to CreditWatch Developing from CreditWatch with Negative Implications.
The Company has entered into several settlement agreements and assumed reinsurance contracts that require collateralization of future payment obligations and assumed reserves if the Company’s ratings or other specific criteria fall below certain thresholds. The ratings triggers are generally more than one level below the Company’s February 12, 2004 ratings.
On November 24, 2003, CNAF sold $750 million of its participating convertible preferred stock, designated Series I (Series I Issue), to Loews. The Series I Issue has terms that make it economically equivalent to CNAF’s common stock. The preferred shares will convert into 32,327,015 shares of CNAF common stock, utilizing a conversion price per share of common stock that was based on average market prices of CNAF common stock from November 17, 2003 through November 21, 2003. The terms of the Series I Issue were approved by a special committee of independent members of CNAF’s Board of Directors. Upon conversion, Loews will own approximately 91% of CNAF’s outstanding common stock of approximately 255.9 million shares. Conversion will take place when the Company satisfies applicable stock exchange requirements.
CNA completed a common stock rights offering on September 26, 2001, successfully raising $1,006 million (40.3 million shares sold at $25 per share). Loews purchased 38.3 million shares issued in
In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51 (FIN 46). In December 2003, FASB revised FIN 46, which clarifies the application of Accounting Research Bulletin No. 51 Consolidated Financial Statements (ARB 51). As per ARB 51, a general rule for preparation of consolidated financial statements of a parent and its subsidiary is ownership by the parent, either directly or indirectly, of over fifty percent of the outstanding voting shares of a subsidiary. However, application of the majority voting interest requirement of ARB 51 to certain types of entities may not identify the party with a controlling financial interest because the controlling financial interest may be achieved through arrangements that do not involve voting interest. FIN 46 clarifies applicability of ARB 51 to entities in which the equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support. FIN 46 requires an entity to consolidate a variable interest entity (VIE) even though the entity does not, either directly or indirectly, own over fifty percent of the outstanding voting shares.
In November of 2003, the Emerging Issues Task Force (EITF) reached consensus on EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments” (EITF 03-1) that certain quantitative and qualitative disclosures are required for equity and fixed maturity securities that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The guidance requires companies to disclose the aggregate amount of
general economic and business conditions, including inflationary pressures on medical care costs, construction costs and other economic sectors that increase the severity of claims;
changes in financial markets such as fluctuations in interest rates, long-term periods of low interest rates, credit conditions and currency, commodity and stock prices;
regulatory limitations, impositions and restrictions upon the Company, including the effects of assessments and other surcharges for guaranty funds and second-injury funds and other mandatory pooling arrangements;
the impact of competitive products, policies and pricing and the competitive environment in which the Company operates, including changes in the Company’s books of business;
product and policy availability and demand and market responses, including the level of ability to obtain rate increases and decline or non-renew underpriced accounts, to achieve premium targets and profitability and to realize growth and retention estimates;
the effectiveness of current initiatives by claims management to reduce loss and expense ratio through more efficacious claims handling techniques;
weather and other natural physical events, including the severity and frequency of storms, hail, snowfall and other winter conditions, as well as of natural disasters such as hurricanes and earthquakes;
whether a national privately financed trust to replace litigation of asbestos claims with payments to claimants from the trust will be established or approved through federal legislation, or, if established and approved, whether it will contain funding requirements in excess of the Company’s established loss reserves or carried loss reserves;
The Consolidated Financial Statements include the accounts of CNA Financial Corporation (CNAF) and its controlled subsidiaries. Collectively, CNAF and its subsidiaries are referred to as CNA or the Company. CNA’s property and casualty insurance operations are primarily conducted by Continental Casualty Company (CCC) and The Continental Insurance Company (CIC). CNA’s life and group insurance operations are primarily conducted by Continental Assurance Company (CAC) and Valley Forge Life Insurance Company (VFL). CNA Group Life Assurance Company (CNAGLA) was sold to Hartford Financial Services Group, Inc. (Hartford) on December 31, 2003. For further information see Note P. Loews Corporation (Loews) owned approximately 90% of the outstanding common stock and 100% of the Series H and Series I preferred stock of CNAF as of December 31, 2003.
The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the Consolidated Financial Statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates.
In addition to the asset sales described above, and as part of the decision to focus on its property and casualty business, CNA withdrew from the assumed reinsurance business during 2003. In October of 2003, the Company entered into an agreement to sell the renewal rights for most of the treaty business of CNA Re to Folksamerica Reinsurance Company (Folksamerica). Under the terms of the transaction, Folksamerica will compensate CNA based upon the amount of premiums renewed by Folksamerica over the next two contract renewals. CNA will manage the run-off of its retained liabilities.
Premiums: Insurance premiums on property and casualty and accident and health insurance contracts are recognized in proportion to the underlying risk insured which principally is earned ratably over the duration of the policies after deductions for ceded insurance premiums. The reserve for unearned premiums on these contracts represents the portion of premiums written relating to the unexpired terms of coverage.
Claim and claim adjustment expense reserves: Claim and claim adjustment expense reserves, except reserves for structured settlements not associated with asbestos and environmental pollution and mass tort (APMT), workers compensation lifetime claims and accident and health disability claims, are not discounted and are based on 1) case basis estimates for losses reported on direct business, adjusted in the aggregate for ultimate loss expectations; 2) estimates of incurred but not reported losses; 3) estimates of losses on assumed reinsurance; 4) estimates of future expenses to be incurred in the settlement of claims; and 5) estimates of salvage and subrogation recoveries. Management considers current conditions and trends as well as past Company and industry experience in establishing these estimates. The effects of inflation, which can be significant, are implicitly considered in the reserving process and are part of the
recorded reserve balance. Ceded claim and claim adjustment expense reserves are reported as a component of reinsurance receivables in the Consolidated Balance Sheets.
Workers compensation lifetime claim reserves and accident and health disability claim reserves are calculated using mortality and morbidity assumptions based on Company and industry experience, and are discounted at interest rates that range from 3.5% to 6.5% at December 31, 2003. At December 31, 2003 and 2002, such discounted reserves totaled $2,835 million and $2,537 million, net of discount of $851 million and $974 million.
Policyholders’ funds reserves: Policyholders’ funds reserves include reserves for universal life insurance contracts and investment contracts without life contingencies. The liability for policy benefits for universal life-type contracts is equal to the balance that accrues to the benefit of policyholders, including credited interest, amounts that have been assessed to compensate the Company for services to be performed over future periods, and any amounts previously assessed against policyholders that are refundable on termination of the contract. For investment contracts, policyholder liabilities are equal to the accumulated policy account values, which consist of an accumulation of deposit payments plus credited interest, less withdrawals and amounts assessed through the end of the period.
Reinsurance contracts that do not effectively transfer the underlying economic risk of loss on policies written by the Company are recorded using the deposit method of accounting, which requires that premium paid or received by the ceding company or assuming company be accounted for as a deposit asset or liability. The Company primarily records these deposits as either reinsurance receivables or other assets for ceded recoverables and reinsurance balances payable or other liabilities for assumed liabilities. At December 31, 2003 and 2002, the Company had approximately $380 million and $618 million recorded as deposit assets and $369 million and $569 million recorded as deposit liabilities.
Income on reinsurance contracts accounted for under the deposit method is recognized using an effective yield based on the anticipated timing of payments and the remaining life of the contract. When the estimate of timing of payments changes, the effective yield is recalculated to reflect actual payments to date and the estimated timing of future payments. The deposit asset or liability is adjusted to the amount that would have existed had the new effective yield been applied since the inception of the contract. This adjustment is reflected in other revenue or other operating expense as appropriate.
Investments in life settlement contracts and related revenue recognition: The Company has purchased investments in life settlement contracts. Under a life settlement contract, CNA obtains the rights of being the owner and beneficiary to an underlying life insurance policy. The carrying value of each contract at purchase and at the end of each reporting period is equal to the cash surrender value of the policy in accordance with Financial Accounting Standards Board (FASB) Technical Bulletin 85-4 Accounting for Purchases of Life Insurance (FTB 85-4). Amounts paid to purchase these contracts that are in excess of the cash surrender value, at the date of purchase, are expensed immediately. Periodic maintenance costs, such as premiums, necessary to keep the underlying policy inforce are expensed as incurred and are included in other operating expenses. Revenue is recognized and included in other revenue in the Consolidated Statements of Operations when the life insurance policy underlying the life settlement contract matures.
CAC and VFL write investment and annuity contracts. The supporting assets and liabilities of certain of these contracts are legally segregated and reported as assets and liabilities of separate account business. CAC and VFL guarantee principal and a specified return to the contract holders on approximately 47% and 58% of the separate account business at December 31, 2003 and 2002. Substantially all assets of the separate account business are carried at fair value. Separate account liabilities are carried at contract values.
CDOs represent a credit enhancement product that is typically structured in the form of a swap. The Company has determined that this product is a derivative under SFAS 133. Changes in the estimated fair value of CDOs, like other derivative financial instruments with no hedge designation, are recorded in realized gains or losses as appropriate. The net impact of CDO’s was a loss of $1 million and $6 million for the years ended December 31, 2003 and 2002 and income of $5 million for the year ended December 31, 2001. The Company no longer issues this product.
In the normal course of business, the Company, through Group Operations, markets synthetic GICs to institutional customers. These contracts are accounted for as derivative financial instruments. Synthetic GICs are guaranteed investment contracts that simulate the performance of a traditional GIC through the use of financial instruments. A key difference between a synthetic GIC and a traditional GIC is that the contract owner owns the financial instruments underlying the synthetic GIC; whereas, the contract owner owns only the contract itself with a traditional GIC. The Company mitigates its exposure under these contracts by maintaining the ability to reset the crediting rate on a monthly/quarterly basis. This rate reset effectively passes any cash flow volatility and asset underperformance back to the contract owner.
foreign currency exchange rates. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the nature of any hedge designation thereon.
In April of 2003, the Financial Accounting Standards Board (FASB) issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (SFAS 149). SFAS 149 amends SFAS 133 for certain decisions made by the FASB as part of the Derivatives Implementation Group process and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts. SFAS 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of SFAS 149 did not have a significant impact on the results of operations or equity of the Company.
The Company generally requires collateral from its derivative investment counterparties depending on the amount of the exposure and the credit rating of the counterparty.
The Company has exposure to economic losses due to interest rate risk arising from changes in the level of, or volatility of, interest rates. The Company attempts to mitigate its exposure to interest rate risk through active portfolio management, which includes rebalancing its existing portfolios of assets and liabilities, as well as changing the characteristics of investments to be purchased or sold in the future. In addition, various derivative financial instruments are used to modify the interest rate risk exposures of certain assets and liabilities. These strategies include the use of interest rate swaps, interest rate caps and floors, options, futures, forwards and commitments to purchase securities. These instruments are generally used to lock interest rates or unrealized gains, to shorten or lengthen durations of fixed maturity securities or investment contracts, or to hedge (on an economic basis) interest rate risks associated with investments, variable rate debt and life insurance liabilities. The Company has used these types of instruments as designated hedges against specific assets or liabilities on an infrequent basis.
During 2003, the Company sold certain businesses. Accordingly, the goodwill associated with these sold businesses decreased CNA’s goodwill by $2 million in Standard Lines and $1 million in Group Operations and a reduction in CNA’s indefinite-lived intangible assets of $4 million in Group Operations. See Note P for further discussion. Additionally, a $5 million pretax impairment charge was recorded in Specialty Lines. No other impairments were identified during 2003.
Had the Company not amortized goodwill and indefinite-lived intangible assets in 2001, net loss and the related basic and diluted loss per share amounts would have been as follows:
Prior to the adoption of SFAS 142, goodwill and indefinite-lived intangible assets were amortized on a straight-line basis over the period of expected benefit, generally ranging from 15 to 30 years.
The Company has stock-based compensation plans which are detailed in Note J. The Company applies intrinsic value method by following Accounting Policy Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and related interpretations, in accounting for its stock-based compensation plan. Under the recognition and measurement principles of APB 25, no stock-based compensation cost has been recognized as the exercise price of the granted options equaled the market price of the underlying stock at the grant date.
In March of 2001, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (SFAS 140). SFAS 140 superceded SFAS No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. SFAS 140 revised the standards for accounting for
In June of 2001, the FASB issued SFAS No. 141, Business Combinations (SFAS 141). SFAS 141 requires companies to use the purchase method of accounting for business combinations initiated after June 30, 2001 and prohibits the use of the pooling-of-interests method of accounting. CNA has adopted this standard for all business combinations initiated subsequent to June 30, 2001. The initial adoption of SFAS 141 did not have a significant impact on the results of operations or equity of the Company.
In August of 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144). SFAS 144 addresses accounting and reporting for the impairment or disposal of long-lived assets. This statement supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of. Effective January 1, 2002, CNA adopted SFAS 144 for impairments of long-lived assets and for long-lived assets to be disposed of on or after January 1, 2002. The initial adoption of SFAS 144 did not have a significant impact on the results of operations or equity of the Company; however, it did impact the income statement presentation of certain operations sold in 2002.
In November of 2002, the FASB issued FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (an interpretation of FASB Statements of Financial Accounting Standards No. 5, 57, and 107 and rescission of FASB Interpretation No. 34) (FIN 45). FIN 45 clarifies the requirements of SFAS No. 5, Accounting for Contingencies (SFAS 5) relating to a guarantor’s accounting for, and disclosure of, the issuance of certain types of guarantees. FIN 45 specifies additional disclosure requirements related to guarantees, which are effective for financial periods ending after December 15, 2002. Additionally, FIN 45 outlines provisions for initial recognition and measurement of the liability incurred in providing a guarantee. These provisions are to be applied on a prospective basis to guarantees issued or modified after December 31, 2002. The initial adoption for the recognition and measurement requirements of FIN 45 did not have a significant impact on the results of operations or equity of the Company.
method of accounting for stock-based employee compensation and the effect of the method used on reported results. CNA adopted this disclosure standard in its annual and interim financial statements but did not adopt fair value accounting in 2003.
In January of 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51 (FIN 46). In December of 2003, FASB revised FIN 46, which clarifies the application of Accounting Research Bulletin No. 51 Consolidated Financial Statements (ARB 51). As per ARB 51, a general rule for preparation of consolidated financial statements of a parent and its subsidiary is ownership by the parent, either directly or indirectly, of over fifty percent of the outstanding voting shares of a subsidiary. However, application of the majority voting interest requirement of ARB 51 to certain types of entities may not identify the party with a controlling financial interest because the controlling financial interest may be achieved through arrangements that do not involve voting interest. FIN 46 clarifies applicability of ARB 51 to entities in which the equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support. FIN 46 requires an entity to consolidate a variable interest entity (VIE) even though the entity does not, either directly or indirectly, own over fifty percent of the outstanding voting shares.
In May of 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (SFAS 150). SFAS 150 establishes standards for how an issuer of financial instruments classifies and measures in its statement of financial position certain instruments with characteristics of both liabilities and equity. SFAS 150 modifies the accounting and financial statement disclosures of certain financial instruments that, under previous guidance, issuers could account for as equity. SFAS 150 affects the issuer’s accounting for three types of financial instruments that are required to be accounted for as liabilities. The Company did not have any financial instruments outstanding to which the provisions of SFAS 150 apply; therefore, the initial adoption of SFAS 150 did not have any impact on the results of operations or equity of the Company.
December 15, 2003 in these financial statements and will implement the interim disclosure requirements and annual benefit payment disclosures in all subsequent interim and annual financial statements.
In November of 2003, the EITF reached consensus on EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments” (EITF 03-1) that certain quantitative and qualitative disclosures are required for equity and fixed maturity securities that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The guidance requires companies to disclose the aggregate amount of unrealized losses and the related fair value of investments with unrealized losses for securities that have been in an unrealized loss position for less than 12 months and separately for those that have been in an unrealized loss position for over 12 months, by investment category. The Company has adopted the disclosure requirements in these financial statements.
The Company may from time to time invest in securities that may be restricted in whole or in part. As of December 31, 2003 and 2002, the Company did not hold any significant positions in investments whose sale was restricted.
Cash and securities with carrying values of approximately $2.0 billion and $1.8 billion were deposited by the Company’s insurance subsidiaries under requirements of regulatory authorities as of December 31, 2003 and 2002.
During July of 2002, the Company entered into an agreement, whereby Phoenix acquired the variable life and annuity business of VFL through a coinsurance arrangement, with modified coinsurance on the separate accounts. Securities with carrying values of approximately $492 million and $479 million
As of January 1, 2001, the Company’s collar position, which was entered into during 2000, related to its investment in Global Crossing was the only derivative position that had been designated as a hedge for accounting purposes. The nature of the transition adjustment related to this hedge was such that the $962 million unrealized gain that existed on Global Crossing when the hedge was established was preserved in accumulated other comprehensive income. During 2001, the Company’s collar position related to Global Crossing was terminated and the related stock was sold.
Fair values are disclosed for all financial instruments, for which it is practicable to estimate fair value, whether or not such values are recognized in the Consolidated Balance Sheets. Management attempts to obtain quoted market prices for these disclosures. Where quoted market prices are not available, fair values are estimated using present value or other valuation techniques. These techniques are significantly affected by management’s assumptions, including discount rates and estimates of future cash flows. Potential taxes and other transaction costs have not been considered in estimating fair values. The estimates presented herein are not necessarily indicative of the amounts that CNA would realize in a current market exchange.
The following methods and assumptions were used by CNA in estimating the fair value of financial assets and liabilities.
The carrying amount and estimated fair value of CNA’s financial instrument assets and liabilities are listed in the table below. Additional detail related to derivative financial instruments is also provided in Note C.
The fair values of notes receivable for the issuance of common stock were estimated using discounted cash flows utilizing interest rates currently offered for obligations securitized with similar collateral.
At December 31, 2003, the CNA Tax Group has a net operating loss carryforward of approximately $169 million which expires in 2023. In addition, the CNA Tax Group has an alternative minimum tax credit carryforward of approximately $99 million which can be carried forward indefinitely. It is expected that both the net operating loss carryforward and tax credit carryforward will be fully utilized.
CNA’s property and casualty insurance claim and claim adjustment expense reserves represent the estimated amounts necessary to settle all outstanding claims, including claims that are incurred but not reported (IBNR) as of the reporting date. The Company’s reserve projections are based primarily on detailed analysis of the facts in each case, CNA’s experience with similar cases and various historical development patterns. Consideration is given to such historical patterns as field reserving trends and claims settlement practices, loss payments, pending levels of unpaid claims and product mix, as well as court decisions, economic conditions and public attitudes. All of these factors can affect the estimation of claim and claim adjustment expense reserves.
Establishing claim and claim adjustment expense reserves, including claim and claim adjustment expense reserves for catastrophic events that have occurred, is an estimation process. Many factors can ultimately affect the final settlement of a claim and, therefore, the necessary reserve. Changes in the law, results of litigation, medical costs, the cost of repair materials and labor rates can all affect ultimate claim costs. In addition, time can be a critical part of reserving determinations since the longer the span between the incidence of a loss and the payment or settlement of the claim, the more variable the ultimate settlement amount can be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably estimable than long-tail claims, such as general liability and professional liability claims.
Catastrophes are an inherent risk of the property and casualty insurance business and have contributed to material period-to-period fluctuations in the Company’s results of operations and/or equity. The level of catastrophe losses experienced in any period cannot be predicted and can be material to the results of operations and/or equity of the Company.
The changes in provision for insured events of prior years (net prior year claim and claim adjustment expense reserve development) are composed of the following components. For the years ended December 31, 2003, 2002 and 2001, the unfavorable net prior year claim and claim adjustment expense reserve development was $2,409 million, $35 million and $2,464 million.
In addition to the difficulties described above, estimating the ultimate cost of both reported and unreported APMT claims is subject to a higher degree of variability due to a number of additional factors, including among others: the number and outcome of direct actions against the Company; coverage issues, including whether certain costs are covered under the policies and whether policy limits apply; allocation of liability among numerous parties, some of whom may be in bankruptcy proceedings, and in particular the application of “joint and several” liability to specific insurers on a risk; inconsistent court decisions and developing legal theories; increasingly aggressive tactics of plaintiffs’ lawyers; the risks and lack of predictability inherent in major litigation; increased filings of claims in certain states to avoid the application of tort reform statute effective dates; enactment of national federal legislation to address asbestos claims; a further increase in asbestos and environmental pollution claims which cannot now be anticipated; increase in number of mass tort claims relating to silica and silica-containing products, and the outcome of ongoing disputes as to coverage in relation to these claims; a further increase of claims and claims payment that may exhaust underlying umbrella and excess coverage at accelerated rates; and future developments pertaining to the Company’s ability to recover reinsurance for asbestos and environmental pollution claims.
Examples of unfavorable developments include decisions limiting the application of the “absolute pollution” exclusion; and decisions holding carriers liable for defense and indemnity of asbestos and pollution claims on a joint and several basis. The Company’s ultimate liability for its environmental
CNA’s property and casualty insurance subsidiaries have exposure to asbestos-related claims. Estimation of asbestos-related claim and claim adjustment expense reserves involve limitations such as inconsistency of court decisions, specific policy provisions, allocation of liability among insurers and insureds, and additional factors such as missing policies and proof of coverage. Furthermore, estimation of asbestos-related claims is difficult due to, among other reasons, the proliferation of bankruptcy proceedings and attendant uncertainties, the targeting of a broader range of businesses and entities as defendants, the uncertainty as to which other insureds may be targeted in the future and the uncertainties inherent in predicting the number of future claims.
As of December 31, 2003 and 2002, CNA carried approximately $1,767 million and $1,246 million of claim and claim adjustment expense reserves, net of reinsurance recoverables for reported and unreported asbestos-related claims. Unfavorable asbestos-related net claim and claim adjustment expense reserve development for the years ended December 31, 2003, 2002 and 2001 amounted to $642 million, $0 and $773 million. The Company paid asbestos-related claims, net of reinsurance recoveries, of $121 million, $21 million and $171 million during the years ended December 31, 2003, 2002 and 2001.
The Company recorded $1,826 million and $642 million in unfavorable gross and net prior year development for the year ended December 31, 2003 for reported and unreported asbestos-related claims, principally due to potential losses from policies issued by CNA with high attachment points, which previous exposure analysis indicated would not be reached. The Company examined the claims filing trends and the projected erosion rates of underlying primary and lower excess insurance on open asbestos accounts to determine timeframes within which high excess policies issued by CNA could be reached. Elevated claims volumes, together with certain adverse court decisions affecting rapidity by which asbestos claims are paid supported the conclusion that excess policies with high attachment points previously thought not to be exposed may now potentially be exposed.
CIC issued certain primary and excess policies to Bendix Corporation (Bendix), now part of Honeywell International, Inc. (Honeywell). Honeywell faces approximately 73,000 pending asbestos bodily injury claims resulting from alleged exposure to Bendix friction products. CIC’s primary policies allegedly covered the period from at least 1939 (when Bendix began to use asbestos in its friction products) to 1983, although the parties disagree about whether CIC’s policies provided product liability coverage before 1940 and from 1945 to 1956. CIC asserts that it owes no further material obligations to Bendix under any primary policy. Honeywell alleges that two primary policies issued by CIC covering 1969-1975 contain occurrence limits but not product liability aggregate limits for asbestos bodily injury claims. CIC has asserted, among other things, which even if Honeywell’s allegation is correct, which CNA denies, its liability is limited to a single occurrence limit per policy or per year, and in the alternative, a proper allocation of losses would substantially limit its exposure under the 1969-1975 policies to asbestos claims. These and other issues are being litigated in Continental Insurance Co., et al. v. Honeywell International Inc., No. MRS-L-1523-00 (Morris County, New Jersey).
CNA has been named in Adams v. Aetna, Inc., et al. (Circuit Court of Kanawha County, West Virginia), a purported class action against CNA and other insurers, alleging that the defendants violated West Virginia’s Unfair Trade Practices Act in handling and resolving asbestos claims against their policyholders. A direct action has also been filed in Montana (Pennock, et al. v. Maryland Casualty, et al. First Judicial District Court of Lewis & Clark County, Montana) by eight individual plaintiffs (all employees of W.R. Grace & Co. (W.R. Grace)) and their spouses against CNA, Maryland Casualty and the State of Montana. This action alleges that the carriers failed to warn of or otherwise protect W.R. Grace employees from the dangers of asbestos at a W.R. Grace vermiculite mining facility in Libby, Montana. The Montana direct action is currently stayed as to CNA because of W.R. Grace’s pending bankruptcy.
The Company recorded $80 million in unfavorable net prior year mass tort claim and claim adjustment expense development in 2003, due in part to the elevated volume of silica claims. In 2003, CNA observed a marked increase in silica claims frequency in Mississippi, where plaintiff attorneys appear to have filed claims to avoid the effect of a tort reform. The most significant silica exposures identified to date include a relatively small number of accounts with significant numbers of new claims and substantial insurance limits issued by the Company. Establishing claim and claim adjustment expense reserves for silica claims is subject to uncertainties because of disputes concerning medical causation with respect to certain diseases, including lung cancer, geographical concentration of the lawsuits asserting the claims, and the large rise in the total number of claims without underlying epidemiological developments suggesting an increase in disease rates or plaintiffs. Moreover, judicial interpretations regarding application of various tort defenses, including application of various theories of joint and several liability, impede the Company’s ability to estimate its ultimate liability for such claims.
Unfavorable net prior year development of $2,952 million, including $2,409 million of unfavorable claim and claim adjustment expense reserve development and $543 million of unfavorable premium development, was recorded in 2003. The development discussed below includes premium development due to the direct relationship of unfavorable premium development to the corporate aggregate and other reinsurance treaties.
Approximately $98 million of unfavorable net prior year claim and allocated claim adjustment expense reserve development recorded in 2003, resulted from a program covering facilities that provide services to developmentally disabled individuals. This unfavorable net prior year development was due to an increase in the size of known claims and increases in policyholder defense costs. With regard to average claim size, recent data shows the average claim increasing at an annual rate of approximately 20%. Prior data had shown average claim size to be level. Similar to the average claim size, recent data shows the average policyholder defense cost increasing at an annual rate of approximately 20%. Prior data had shown average policyholder defense cost to be level. The unfavorable net prior year claim and allocated claim adjustment expense reserve development recorded was primarily for accident years 2001 and prior.
Approximately $73 million of unfavorable net prior year development recorded in 2003 was the result of a commutation of all ceded reinsurance treaties with Gerling Global Group of companies (Gerling), related to accident years 1999 through 2001, including $41 million of unfavorable net prior year claim and allocated claim adjustment expense development and $32 million of unfavorable net prior year premium development. See Note H for further information regarding this commutation.
The following net prior year premium and claim and allocated claim adjustment expense development was recorded in the third quarter of 2003 as a result of the elimination of deficiencies and redundancies in reserve positions within the Standard Lines segment. Unfavorable net prior year development of approximately $210 million related to small and middle market workers compensation exposures and approximately $110 million related to E&S lines was recorded in 2003. Offsetting these increases was $210 million of favorable net prior year development in the property line of business, including $79 million related to WTC event.
Unfavorable net prior year claim and allocated claim adjustment expense reserve development of approximately $75 million recorded in 2003 was related to a adverse arbitration decision in 2003 involving a single large property and business interruption loss. The decision was rendered against a voluntary insurance pool in which the Company was a participant. The loss was caused by a fire which occurred in 1995. The Company no longer participates in this pool.
The following net prior year claim and allocated claim adjustment expense reserve development was recorded in 2003 as a result of the elimination of deficiencies and redundancies in reserve positions within the segment. An additional $50 million of unfavorable net prior year claim and allocated claim adjustment expense reserve development was recorded related to medical malpractice and long term care facilities. Partially offsetting this unfavorable net prior year claim and allocated claim adjustment expense reserve development was a $25 million underwriting benefit from cessions to corporate aggregate reinsurance treaties. The benefit was comprised of $56 million of ceded losses and $31 million of ceded premiums for accident years 2000 and 2001. See Note H for further discussion of the Company’s aggregate reinsurance treaties.
Unfavorable net prior year development of $149 million, including $118 million of net unfavorable claim and allocated claim adjustment expense reserve development and $31 million of unfavorable premium development, was recorded in 2003 for CNA Re. The gross and net carried claim and claim adjustment expense reserves were $2,288 million and $1,257 million at December 31, 2003. The gross and net carried claim and claim adjustment expense reserves for CNA Re were $2,264 million and $1,362 million at December 31, 2002.
The unfavorable net prior year development was primarily a result of a general change in the pattern of how losses change over time as reported by the companies that purchased reinsurance from CNA Re. Losses have continued to show large increases for accident years in the late 1990s and into 2000 and 2001. These increases are greater than the increases indicated by patterns from older accident years and have a similar effect on several lines of business. Approximately $67 million unfavorable net prior year development recorded in 2003 was related to proportional liability exposures, primarily from multi-line and umbrella treaties in accident years 1997 through 2001. Approximately $32 million of unfavorable net prior year development recorded in 2003, was related to assumed financial reinsurance for accident years 2001 and prior and approximately $24 million of unfavorable net prior year development related to professional liability exposures in accident years 2001 and prior.
CNA Re recorded an additional $15 million of unfavorable net prior year development for construction defect related exposures. Because of the unique nature of this exposure, losses have not followed expected development patterns. The continued reporting of claims in California, the increase in the number of claims from states other than California and a review of individual ceding companies’ exposure to this type of claim resulted in an increase in the estimated reserve.
Unfavorable net prior year development of $875 million, including $881 million of net unfavorable claim and allocated claim adjustment expense reserve development and $6 million of favorable premium development was recorded in 2003 for Corporate and Other. The gross and net carried claim and claim adjustment expense reserves were $7,046 million and $2,625 million at December 31, 2003. The gross and net carried claim and claim adjustment expense reserves for Corporate and Other were $4,847 million and $2,002 million at December 31, 2002.
Unfavorable net prior year development of $126 million including $35 million of unfavorable claim and claim adjustment expense reserve development and $91 million of unfavorable premium development was recorded in 2002. The development discussed below includes premium development due to the direct relationship of unfavorable premium development to the corporate aggregate and other reinsurance treaties.
Favorable net prior year development of $154 million, including $221 million of favorable claim and allocated claim adjustment expense reserve development and $67 million of unfavorable premium development, was recorded in 2002 for Standard Lines. The gross and net carried claim and claim adjustment expense reserves for Standard Lines were $12,854 million and $7,788 million at December 31, 2001.
Approximately $140 million of favorable net prior year development was attributable to participation in the Workers Compensation Reinsurance Bureau (WCRB), a reinsurance pool, and residual markets. The favorable net prior year development for WCRB was the result of information received from the WCRB that reported the results of a recent actuarial review. This information indicated that the Company’s net required reserves for accident years 1970 through 1996 were $60 million less than the carried reserves. In addition, during 2002, the Company commuted accident years 1965 through 1969 for a payment of approximately $5 million to cover carried reserves of approximately $13 million, resulting in further favorable net prior year development of $8 million. The favorable residual market net prior year development was the result of lower than expected paid loss activity during recent periods for accident years dating back to 1984. The paid losses during 2002 on prior accident years were approximately 60% of the previously expected amount.
Approximately $45 million of favorable net prior year development was recorded in property lines during 2002. The favorable net prior year development was principally from accident years 1999 through 2001, and was the result of the low number of large losses in recent years. Although property claims are generally reported relatively quickly, determining the ultimate cost of the claim can involve a significant amount of time between the occurrence of the claim and settlement.
The unfavorable net prior year development on contractors account package policies was the result of an actuarial review completed during 2002. Since this program is no longer being written, the Company
Unfavorable net prior year development of $137 million, including $68 million of unfavorable claim and allocated claim adjustment expense reserve development and $69 million of unfavorable premium development, was recorded in 2002 for Specialty Lines. The gross and net carried claim and claim adjustment expense reserves for Specialty Lines were $5,668 million and $3,461 million at December 31, 2001.
$180 million, net of reinsurance. Additionally, favorable net prior year development of $20 million was associated with the Enron settlement. The Company had established a $20 million reserve for accident year 2001 for an excess layer associated with Enron related surety losses; however the case has settled for less than the attachment point of this excess layer.
Unfavorable net prior year development was recorded as a result of an actuarial review completed during 2002 and was primarily recorded in the directors and officers, professional liability errors and omissions, and surety lines of business. Several large losses, as well as continued increases in the overall average size of claims for these lines, have resulted in higher than expected loss ratios.
Unfavorable net prior year development of $21 million, including $23 million of unfavorable claim and allocated claim adjustment expense reserve development and $2 million of favorable premium development, was recorded in 2002 for Corporate and Other. The gross and net carried claim and claim adjustment expense reserves for the Corporate and Other segment were $5,043 million and $2,110 million at December 31, 2001.
Personal insurance recorded unfavorable net prior year development of $35 million on accident years 1997 through 1999. These losses were subject to a retroactive ceded reinsurance agreement with Allstate that covers losses occurring prior to October 1, 1999. This ceded reinsurance agreement was entered into as part of the sale of the Company’s personal insurance business to Allstate. The unfavorable net prior year development was principally due to continuing policyholder defense costs associated with remaining open claims. At the end of 2002, approximately 4,800 claims remain open. It was anticipated these claims would be closed more quickly, eliminating further defense coverage costs.
Unfavorable net prior year development of $3,482 million including $2,464 million of unfavorable claim and claim adjustment expense reserve development and $1,018 million of unfavorable premium development was recorded in 2001. The development discussed below includes premium development due to the direct relationship of unfavorable premium development to the corporate aggregate and other reinsurance treaties.
A $238 million underwriting benefit was recorded for the corporate aggregate reinsurance treaties in 2001. The underwriting benefit was comprised of $443 million of ceded losses and $205 million of ceded premium for accident year 1999.
Approximately $188 million of this amount resulted from a change in estimate in premiums related to involuntary market facilities, which had an offsetting impact on net losses and therefore had no impact on the net operating results. More than one-half of the change in estimate in premiums was attributable to accident years 1997 through 1999 with the remainder attributable to accident years prior to 1992. Accruals for ceded premiums related to reinsurance treaties other than the corporate aggregate reinsurance treaties increased $83 million due to the reserve strengthening. This increase in accruals for ceded premiums was principally recorded in accident year 2000. The remainder of the decrease in premium accruals relates to the change in estimate of the amount of retrospective premium receivables as discussed above, which were principally recorded in accident years prior to 1999.
Unfavorable net prior year development of $453 million, including $415 million of unfavorable claim and allocated claim adjustment expense reserve development and $38 million of unfavorable premium development, was recorded in 2001 for Specialty Lines. The gross and net claim and claim adjustment expense reserve at December 31, 2000 for Specialty Lines were $4,813 million and $3,429 million.
Unfavorable net prior year development of $740 million, including $759 million of unfavorable claim and allocated claim adjustment expense reserve development and $19 million of favorable premium development, was recorded in 2001 for CNA Re. The gross and net claim and claim adjustment expense reserves at December 31, 2000 for CNA Re were $4,238 million and $2,735 million.
A $32 million underwriting benefit was recorded for the corporate aggregate reinsurance treaties in 2001. The underwriting benefit was comprised of $57 million of ceded losses and $25 million of ceded premium for accident year 1999.
CNA has determined that a portion of the premiums assumed under the IGI Program related to United States workers compensation “carve-out” business. Some of these premiums were received from John Hancock Financial Services, Inc. (John Hancock). CNA is aware that a number of reinsurers with workers compensation carve-out insurance exposure, including John Hancock, have disavowed their obligations under various legal theories. If one or more such companies are successful in avoiding or reducing their liabilities, then it is likely that CNA’s potential liability will also be reduced. Moreover, based on information known at this time, CNA believes it has strong grounds to successfully challenge its alleged exposure on a substantial portion of its United States workers compensation carve-out business, including all purported exposure derived from John Hancock, through legal action.
CNA has established reserves for its estimated exposure under the IGI Program, other than that derived from John Hancock, and an estimate for recoverables from retrocessionaires. CNA has not established any reserve for any exposure derived from John Hancock because, as indicated, CNA believes the contract will be rescinded.
on facts and circumstances presently known in the opinion of management an unfavorable outcome will not materially affect the equity of the Company, although results of operations may be adversely affected.
CNA is also a party to litigation and claims related to APMT cases arising in the ordinary course of business. See Note F for further discussion.
CNA assumes and cedes reinsurance to other insurers, reinsurers and members of various reinsurance pools and associations. CNA utilizes reinsurance arrangements to limit its maximum loss, provide greater diversification of risk, minimize exposures on larger risks and to exit certain lines of business. The ceding of insurance does not discharge the primary liability of the Company.
reinsurance contracts, including the corporate aggregate reinsurance treaties, require interest on additional premiums arising from ceded losses as if those premiums were payable at the inception of the contract. The amount of retroactive interest, included in the totals above, was $147 million, $10 million and $47 million in 2003, 2002 and 2001.
The Company attempts to mitigate its credit risk related to reinsurance by entering into reinsurance arrangements only with reinsurers that have credit ratings above certain levels and by obtaining substantial amounts of collateral. The primary methods of obtaining collateral are through reinsurance trusts, letters of credit and funds withheld balances. Such collateral was approximately $5,255 million and $4,754 million at December 31, 2003 and 2002.
CNA’s largest recoverables from a single reinsurer at December 31, 2003, including prepaid reinsurance premiums, were approximately $2,533 million, $2,033 million, $1,172 million, $977 million, $760 million, and $629 million from subsidiaries of The Allstate Corporation (Allstate), subsidiaries of Hannover Reinsurance (Ireland) Ltd., Hartford Life Group Insurance Company, American Reinsurance Company, European Reinsurance Company of Zurich and subsidiaries of the Berkshire Hathaway Group.
The effects of reinsurance on earned premiums and written premiums for the years ended December 31, 2003, 2002 and 2001 are shown in the following tables.
In 2001, the Company entered into a one-year aggregate reinsurance treaty related to the 2001 accident year covering substantially all property and casualty lines of business in the Continental Casualty
The Company pays a facility fee to the lenders for having funds available for loans under the three-year credit facility maturing April 30, 2004. The fee varies based on the long term debt ratings of the Company. At December 31, 2003, the facility fee on the three-year component was 25.0 basis points.
The Company pays interest on any outstanding debt/borrowings under the three-year facility based on a rate determined using the long term debt ratings of the Company. The interest rate is equal to the London Interbank Offering Rate (LIBOR) plus 75.0 basis points. Further, if the Company has outstanding loans greater than 50% of the amounts available under the three-year facility, the Company also will pay a utilization fee of 12.5 basis points on such loans. At December 31, 2003 and 2002, the weighted-average interest rate on the borrowings under the facility, including facility fees and utilization fees, was 2.3%.
A Moody’s Investors Service (Moody’s) downgrade of the CNAF senior debt rating from Baa2 to Baa3 on November 12, 2003, increased the facility fee on the three-year component of the facility from 17.5 basis points to 25.0 basis points. The applicable interest rate increased from LIBOR plus 57.5 basis points to LIBOR plus 75.0 basis points. The utilization fee remained unchanged on the three-year facility at 12.5 basis points.
Under the new credit facility agreement, CNA Surety pays a facility fee of 35.0 basis points, interest at LIBOR plus 90 basis points, and for utilization greater than 50% of the amount available to borrow an additional fee of 5.0 basis points. On the term loan, CNA Surety pays interest at LIBOR plus 62.5 basis points. At December 31, 2003, the weighted-average interest rate on the $50 million of outstanding borrowings under the credit agreement, including facility fees and utilization fees, was 2.6%. Effective January 30, 2003, CNA Surety entered into a swap agreement on the term loan portion of the agreement which uses the 3-month LIBOR to determine the swap increment. As a result, the effective interest rate on the $20 million in outstanding borrowings on the term loan was 2.76% at December 31, 2003. On the $30 million revolving credit agreement, the effective interest rate at December 31, 2003 was 2.55%.
The combined aggregate maturities for debt at December 31, 2003 are presented in the following table.
CNAF and certain subsidiaries sponsor noncontributory pension plans typically covering full-time employees age 21 or over who have completed at least one year of service. While the terms of the plans vary, benefits are generally based on years of credited service and the employee’s highest 60 consecutive months of compensation. CNA uses December 31 as the measurement date for the majority of its plans.
CNA’s funding policy is to make contributions in accordance with applicable governmental regulatory requirements. The assets of the plans are invested primarily in U.S. government securities with the balance in mortgage-backed securities, equity investments, limited partnerships and short term investments.
Weighted-average actuarial assumptions used at December 31, 2003, 2002, and 2001 to determine benefit obligations are set forth in the following table.
Weighted-average actuarial assumptions used to determine net cost for the years ended December 31, 2003, 2002 and 2001 are set forth in the following table.
Benefit expense for the Company’s savings plans was $57 million, $51 million and $53 million in 2003, 2002 and 2001.
The following table presents activity under the LTI Plan during 2003, 2002 and 2001.
The fair value of granted options was estimated at the grant date using the Black-Scholes option-pricing model. The weighted-average fair value of options granted during each of the three years ended December 31, 2003, 2002 and 2001 was $2 million, $3 million and $4 million. The following weighted-average assumptions were used for the years ended December 31, 2003, 2002 and 2001: risk free interest rate of 2.7%, 4.0%, and 4.5%; expected dividend yield of 0%; and expected option life of five years. The weighted-average assumption for the expected stock price volatility was 25.0%, 25.2% and 26.4% for the years ended December 31, 2003, 2002 and 2001.
CNA Surety has reserved shares of its common stock for issuance to directors, officers and employees of CNA Surety through incentive stock options, non-qualified stock options and stock appreciation rights under separate plans (CNA Surety Plans). The CNA Surety Plans have an aggregate number of 0.7 million shares available for which options may be granted. At December 31, 2003, approximately 1.7 million options were outstanding under these plans.
CNA occupies office facilities under lease agreements that expire at various dates. In addition, data processing, office and transportation equipment is leased under agreements that expire at various dates through 2008. Most leases contain renewal options that provide for rent increases based on prevailing market conditions. Lease expense for the years ended December 31, 2003, 2002 and 2001 was $66 million, $78 million, and $89 million. Lease and sublease revenues for the years ended December 31, 2003, 2002 and 2001 were $6 million, $9 million, and $21 million. In connection with the May of 2003 disposition of the improvements and real property located at 55 East Jackson Boulevard, Chicago, Illinois building, CCC and CAC agreed to remain liable under the two ground leases covering a portion of this property. Although the two leases expire in 2058, CCC and CAC have certain collateral, as well as certain contractual rights and remedies, in place to minimize any exposure that may arise from the new owner’s failure to comply with its obligations under the ground leases.
The table below presents the future minimum lease payments to be made under non-cancelable operating leases along with future minimum sublease receipts to be received on owned and leased properties at December 31, 2003.
CNAF has provided parent company guarantees, which expire in 2015, related to lease obligations of certain subsidiaries. Certain of those subsidiaries have been sold; however, the lease obligation
guarantees remain in effect. CNAF would be required to remit prompt payment on leases in question if the primary obligor fails to observe and perform its covenants under the lease agreements. The maximum potential amount of future payments that the Company could be required to pay under these guarantees are approximately $8 million at December 31, 2003.
In the normal course of business, CNA has obtained letters of credit in favor of various unaffiliated insurance companies, regulatory authorities and other entities. At December 31, 2003 and 2002, there were approximately $58 million and $222 million of outstanding letters of credit.
The Company has entered into a limited number of guaranteed payment contracts, primarily relating to telecommunication services, amounting to approximately $18 million. Estimated future minimum payments under these contracts are as follows: $13 million in 2004, and $5 million in 2005.
The Company has provided guarantees related to irrevocable standby letters of credit for certain of its subsidiaries. Certain of these subsidiaries have been sold; however, the irrevocable standby letter of credit guarantees remain in effect. The Company would be required to make payment on the letters of credit in question if the primary obligor drew down on these letters of credit and failed to repay such loans in accordance with the terms of the letters of credit. The maximum potential amount of future payments that CNA could be required to pay under these guarantees is approximately $30 million at December 31, 2003.
CNA has provided guarantees of the indebtedness of certain of its independent insurance producers, which expire in 2008. The Company would be required to remit prompt and complete payment when due, should the primary obligor default. In the event of default on the part of the primary obligor, the
In the course of selling business entities and assets to third parties, the Company has agreed to indemnify purchasers for losses arising out of breaches of representation and warranties with respect to the business entities or assets being sold, including, in certain cases, losses arising from undisclosed liabilities or certain named litigation. Such indemnification provisions generally survive for periods ranging from nine months following the applicable closing date to the expiration of the relevant statutes of limitation. As of December 31, 2003, the aggregate amount of quantifiable indemnification agreements in effect for sales of business entities and assets was $580 million.
On November 24, 2003, CNAF sold $750 million of its participating convertible preferred stock, designated Series I (Series I Issue), to Loews. The Series I Issue has terms that make it economically equivalent to CNAF’s common stock. The Series I Issue will convert into 32,327,015 shares of CNAF common stock, utilizing a conversion price per share of common stock that was based on average market prices of CNAF common stock from November 17, 2003 through November 21, 2003. The terms of the Series I Issue were approved by a special committee of independent members of CNAF’s Board of Directors. Upon conversion, Loews will own approximately 91% of CNAF’s outstanding common stock of approximately 255.9 million shares. Conversion will take place when the Company satisfies applicable stock exchange requirements. The proceeds from the Series I Issue were applied by CNAF to increase the statutory surplus of CNAF’s principal insurance subsidiary, CCC.
During 2002, CNAF sold $750 million of a new issue of preferred stock, designated Series H Cumulative Preferred Issue (Series H Issue), to Loews. The terms of the Series H Issue were approved by a special committee of independent members of CNAF’s Board of Directors.
CNA’s Board of Directors has approved the Share Repurchase Program to purchase, in the open market or through privately negotiated transactions, its outstanding common stock, as Company management deems appropriate. No shares of common stock were purchased during 2003 or 2002.
Dividends from CCC are subject to the insurance holding company laws of the State of Illinois, the domiciliary state of CCC. Under these laws, ordinary dividends, or dividends that do not require prior approval of the Illinois Department of Insurance (the Department), may be paid only from earned surplus, which is calculated by removing unrealized gains from unassigned surplus. As of December 31, 2003, CCC is in a negative earned surplus position. Until CCC is in a positive earned surplus position, all dividends require prior approval of the Department. In January of 2004, the Department approved extraordinary dividend capacity in the amount of approximately $312 million to be used to fund the CNAF’s 2004 debt service and principal repayment requirements.
CNA’s domestic insurance subsidiaries are subject to risk-based capital requirements. Risk-based capital is a method developed by the NAIC to determine the minimum amount of statutory capital appropriate for an insurance company to support its overall business operations in consideration of its size and risk profile. The formula for determining the amount of risk-based capital specifies various factors, weighted based on the perceived degree of risk, which are applied to certain financial balances and financial activity. The adequacy of a company’s actual capital is evaluated by a comparison to the risk-based capital results, as determined by the formula. Companies below minimum risk-based capital requirements are classified within certain levels, each of which requires specified corrective action. As of December 31, 2003 and 2002, all of CNA’s domestic insurance subsidiaries exceeded the minimum risk-based capital requirements.
As a result of the adverse 2003 charges, a capital plan was developed to replenish the statutory capital of CNA’s principal insurance subsidiaries. As a result of the sale of the Group Benefits business, Loews purchased $46 million of CCC surplus notes in February of 2004, pursuant to such commitment. In addition, the sale of CNA’s individual life business is expected to result in an addition to CCC’s statutory surplus in excess of $400 million. However, the sale of the individual life business, which is subject to
customary closing conditions and regulatory approvals, was not consummated by February 26, 2004. As a result, Loews purchased $300 million of additional CCC surplus notes in February of 2004. Following the consummation of the individual life sale, CNA plans to seek approval from the insurance regulatory authority for the repayment of the surplus notes purchased in relation to such sale, although no assurance can be given that sale of the individual life business will be consummated or that the regulatory approval will be obtained
Surplus notes issued under the capital plan will have a 20-year term, bear interest at LIBOR plus 350 basis points, reset annually, and are mandatorily prepayable in the event of certain additions to CCC’s statutory surplus from business or asset sales after the issuance of the notes. See Note T for further information.
Surplus notes are financial instruments with a stated maturity date and scheduled interest payments, issued by insurance enterprises with the approval of the insurer’s domiciliary state. All payments of interest and principal on these notes are subject to the prior approval of the Illinois Insurance Department. Surplus notes are included as surplus for statutory accounting purposes, but are classified as debt instruments under GAAP.
Surplus includes the property and casualty companies’ equity ownership of the life insurance subsidiaries in 2003, and the life and group insurance subsidiaries in 2002.
Standard Lines works with an independent agency system and network of brokers to market a broad range of property and casualty insurance products and services to small, middle-market and large businesses. The Standard Lines operating model focuses on underwriting performance, exposure based pricing, relationships with selective distribution sources and understanding customers. Standard Lines includes Property and Casualty and Excess & Surplus.
In October of 2003, CNA sold most of the renewal rights for almost all of its treaty business of CNA Re to Folksamerica, a wholly owned subsidiary of White Mountains Insurance Group, Ltd. of Hamilton, Bermuda. See Note P for further details of this transaction. Prior to the aforementioned sale, CNA Re had operated primarily in the United States and in select global markets as a reinsurer in the broker market for treaty products and in the direct market for facultative products.
Group Operations provides group life, group health insurance and investment products and services to employers, affinity groups, and other entities that purchase insurance as a group. Group Operations includes three principal business units: Group Benefits, Institutional Markets, and Federal Markets. On December 31, 2003, CNA completed the sale of the majority of its Group Benefits business to Hartford. The business sold included group life and accident, short and long term disability and certain other products. CNA’s group long term care and specialty medical businesses were excluded from the sale. Consideration from the sale was approximately $530 million, of which $485 million was received on December 31, 2003, resulting in an after-tax realized investment loss on the sale of $130 million during 2003. See Note P of the Consolidated Financial Statements included under Item 8 for further information.
During February of 2004, CNA also ceased new sales in its institutional markets business. CNA will continue to accept new deposits and premiums only from existing customers and will service its existing commitments. These businesses will be managed as a run-off operation. CCC will provide credit enhancement to Continental Assurance Company (CAC) for certain of CAC’s investment and specialty medical products.
includes term, universal and permanent life insurance policies and individual annuity products. The transaction is expected to be completed on or before March 31, 2004, subject to certain customary closing conditions and regulatory approvals. See Note T of the Consolidated Financial Statements included under Item 8 for further information.
All significant intrasegment income and expense has been eliminated. Standard Lines’ other revenues and expenses include revenues for services provided by CNA ClaimsPlus and RSKCo to other units within the Standard Lines segment that are eliminated at the consolidated level. Intrasegment revenue and expenses eliminated at the consolidated level were approximately $116 million, $130 million and $154 million for the years ended December 31, 2003, 2002 and 2001.
Approximately 3.2%, 3.5% and 4.8% of CNA’s gross written premiums were derived from outside the United States, primarily the United Kingdom, for the years ended December 31, 2003, 2002 and 2001. In 2001, the decision was made to cease new and renewal business writings in CNA Re U.K. Gross written premiums from the United Kingdom were approximately 1.8%, 1.7%, and 3.3% of CNA’s premiums for the years ended December 31, 2003, 2002 and 2001. Gross written premiums from any individual foreign country, other than the United Kingdom, were not significant.
The following table provides revenue by line of business for each reportable segment. Revenues are comprised of operating revenues and realized investment gains and losses, net of participating policyholders’ and minority interests.
During 2001, the Company incurred $62 million pretax, or $40 million after-tax, of restructuring and other related charges for the IT Plan. During 2002, $4 million pretax, or $3 million after-tax, of this accrual was reduced. No restructuring and other related charges related to the IT Plan were incurred in 2003.
During 2001, the Company incurred $189 million pretax, or $125 million after-tax, of restructuring and other related charges for the 2001 Plan. During 2002, $32 million pretax, or $21 million after-tax, of this accrual was reduced. No restructuring and other related charges related to the 2001 Plan were incurred in 2003.
As a result of this agreement, Hartford assumed assets and liabilities of $2.4 billion and $1.6 billion at December 31, 2003. The assets and liabilities of the CNA Group Benefits business sold were $2.2 billion and $1.6 billion at December 31, 2002. The revenues of the Group Benefits business were $1,204 million, $1,137 million and $1,098 million for the years ended December 31, 2003, 2002 and 2001. Net income was $52 million, $38 million and $19 million for the years ended December 31, 2003, 2002 and 2001.
Folksamerica over the next two contract renewals. The renewal rights transaction did not have a material effect on results of operations. Concurrent with the sale, CNA withdrew from the assumed reinsurance business (the CNA Re segment) and will manage the run-off of its retained liabilities.
During the second quarter of 2002, the Company sold Claims Administration Corporation and transferred the National Postal Handlers Union group benefits plan (the Mail Handlers Plan) to First Health Group Corporation. As a result of this transaction, the Company recognized a $7 million pretax realized loss on the sale of Claims Administration Corporation and $15 million of pretax non-recurring fee income, related to the transfer of the Mail Handlers Plan.
Net income from Claims Administration Corporation and Mail Handlers Plan was $5 million, including the non-recurring fee income, and $16 million for the years ended December 31, 2002 and 2001.
The Company regularly updates its impairment analyses and adjusts its loss as necessary. Based on these updated analyses the impairment loss was reduced by approximately $170 million after-tax in the fourth quarter of 2001, primarily because the net assets of the businesses had been significantly diminished by their operating losses, including adverse loss reserve development recognized by CNA Re U.K. in the fourth quarter of 2001. The reduction of the impairment was included in realized investment gains/losses.
The purchase price was $1, subject to adjustments based primarily upon the results of operations and realized foreign currency losses of CNA Re U.K. Under the terms of the purchase price adjustment, CCC is entitled to receive $5 million from Tawa after Tawa is able to legally withdraw funds from the former CNA Re U.K. entities; at December 31, 2003, CNA has received approximately $2 million. CCC has
CNA has substituted subsidiaries for the originally named subsidiaries and extended the purchase option period for the substituted subsidiaries through 2005. The Company has compensated Allstate for the postponement of its right to exercise the option due to the substitution of companies in the amount of $7 million, reducing the original payment from Allstate of $20 million to approximately $13 million. The $13 million will continue to be deferred and will not be recognized until Allstate exercises its option, at which time it will be recorded as a realized gain.
results of operations, including the loss on sale, are presented as discontinued operations in all periods presented.
affiliates were $4 million, $4 million and $6 million for the years ended December 31, 2003, 2002 and 2001.
On November 24, 2003, CNAF sold $750 million of its participating convertible preferred stock, designated Series I (Series I Issue), to Loews. The Series I Issue has terms that make it economically equivalent to CNA’s common stock. See note L for further details of this transaction.
CNA previously sponsored a stock ownership plan whereby the Company financed the purchase of Company stock by certain officers, including executive officers. Interest charged on the principal amount of these outstanding stock purchase loans is generally equivalent to the long term applicable federal rate, compounded semi-annually, in effect on the disbursement date of the loan. Loans made pursuant to the plan are generally full recourse with a ten year term and are secured by the stock purchased. The balance of the loans as of December 31, 2003 exceeds the related collateral by $36 million.
In March of 2003, CNAF purchased the contractor’s outstanding bank debt for $16 million. The contractor purchased the bank debt and retired it, with $11 million of the purchase price being funded under the new credit facility and $5 million from money loaned to the contractor by its shareholders. Under its purchase agreement with the banks, CNAF is also required to reimburse the banks for any draws upon outstanding letters of credit issued by the banks for the contractor’s benefit. Of these letters of credit, a replacement due to expire in August of 2004 remains in the amount of $3 million. Any CNAF reimbursements for draws upon the banks’ letters of credit will become obligations of the contractor to CNAF as draws upon the credit facility. As of December 31, 2003, CNAF has credit exposure of $55 million under the credit facility, net of participation by Loews, in the amount of $25 million.
The contractor has initiated a restructuring plan that is intended to reduce costs and improve cash flow, and a chief restructuring officer has been appointed to manage execution of the plan. CNAF, through its affiliate CNA Surety, intends to continue to provide surety bonds on behalf of the contractor during this restructuring period, subject to the contractor’s initial and ongoing compliance with CNA Surety’s
underwriting standards. Any losses to CNA Surety arising from bonds issued to the contractor or assumed are excluded from CNA Surety’s $40 million excess of $20 million per principal reinsurance program with unaffiliated reinsurers in place in 2002. As a result, CNA Surety retains the first $60 million of losses on bonds written with an effective date of September 30, 2002 and prior, and CCC will incur 100% of losses above that retention level. Through facultative reinsurance contracts with CCC, CNA Surety’s exposure on bonds written from October 1, 2002 through October 31, 2003 has been limited to $20 million per bond. For bonds written subsequent to November 1, 2003, CNA Surety’s exposure is limited to $14.5 million per bond subject to aggregate limit of $150 million under all facultative insurance coverage and two excess of loss treaties between CNA Surety and CCC. Both excess of loss contracts are effective January 1, 2004. The first excess of loss contract, $40 million excess of $60 million, provides CNA Surety coverage exclusively for the national contractor, while the second excess of loss contract, $50 million excess of $100 million, provides CNA Surety with coverage for the national contractor as well as other CNA Surety risks.
Effective October 1, 2002, CCC provided an excess of loss protection for new and renewal bonds for CNA Surety for each principal exposures that exceed $60 million since October 1, 2002 in two parts - a) $40 million excess of $60 million and b) $50 million excess of $100 million for CNA Surety. This excess of loss protection is necessary primarily to support new and renewal bonds for contract surety accounts with bonded backlogs or work-in-process in excess of $60 million. In consideration for the reinsurance coverage provided by the $40 million excess of $60 million contract, CNA Surety paid a quarterly premium equal to $3 million to CCC. In consideration for the reinsurance coverage provided by the $50 million excess of $100 million, the insurance subsidiaries of CNA Surety paid $6 million in premium to CCC.
Effective October 1, 2003, pending state insurance department regulatory approval, CCC entered into a $3 million excess of $12 million reinsurance contract with CNA Surety. The reinsurance premium for the coverage provided by the $3 million excess of $12 million contract is $0.3 million plus, if applicable, additional premium based on paid losses. This contract expires on December 31, 2004.
In February of 2004, CNA entered into a definitive agreement to sell its individual life insurance business to Swiss Re for approximately $690 million. The business sold includes term, universal and permanent life insurance policies and individual annuity products. CNA’s individual long term care and structured settlement businesses are excluded from the sale. Additionally, the Nashville, Tennessee insurance
The assets and liabilities of the individual life business were $6.6 billion and $5.4 billion at December 31, 2003. The revenues of the individual life business were $625 million, $652 million and $620 million for the years ended December 31, 2003, 2002 and 2001. The net income for this business was $43 million, $55 million, and $78 million for the years ended December 31, 2003, 2002 and 2001.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of CNA Financial Corporation and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note A to the consolidated financial statements, the Company changed its method of accounting for goodwill and indefinite-lived intangible assets in 2002.