Underwriting income has been reduced by net losses of $250.0 million ($162.5 million after-tax or $0.90 per share) in 2003, $741.1 million ($481.7 million after-tax or $2.79 per share) in 2002, $60.9 million ($39.6 million after-tax or $0.22 per share) in 2001, $31.0 million ($20.2 million after-tax or $0.11 per share) in 2000, and $46.8 million ($30.4 million after-tax or $0.18 per share) in 1999, related to asbestos and toxic waste claims.
Amounts in years prior to 2003 have been restated to reflect the accounting changes prescribed by Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51.
Management’s discussion and analysis of financial condition and results of operations addresses the financial condition of The Chubb Corporation and its subsidiaries as of December 31, 2003 compared with December 31, 2002 and the results of operations for each of the three years in the period ended December 31, 2003. This discussion should be read in conjunction with the consolidated financial statements and related notes and the other information contained in this report.
Certain statements in this report are “forward-looking statements” as that term is defined in the Private Securities Litigation Reform Act of 1995 (PSLRA). These forward-looking statements are made pursuant to the safe harbor provisions of the PSLRA and include estimates and assumptions related to economic, competitive, regulatory, judicial, legislative and other developments. These include statements relating to trends in, or representing management’s beliefs about, our future strategies, operations and financial results, as well as other statements that include words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “plan,” “should,” “will,” or other similar expressions. Forward-looking statements are made based upon management’s current expectations and beliefs concerning trends and future developments and their potential effects on us. These statements are not guarantees of future performance. Actual results may differ materially from those suggested by forward-looking statements as a result of risks and uncertainties, which include, among others, those discussed or identified from time to time in our public filings with the Securities and Exchange Commission and those associated with:
premium price increases and profitability or growth estimates overall or by lines of business or geographic area, and related expectations with respect to the timing and terms of any required regulatory approvals;
our estimates relating to ultimate asbestos liabilities and related reinsurance recoverables;
the effects of disclosures by, and investigations of, public companies relating to possible accounting irregularities, practices in the energy and securities industries and other corporate governance issues, including:
the occurrence of significant weather-related or other natural or human-made disasters;
The Corporation assumes no obligation to update any forward-looking information set forth in this report, which speak as of the date hereof.
Our underwriting results in the past three years were adversely affected by losses related to asbestos and toxic waste claims, the September 11, 2001 attack in the United States and surety losses arising from the bankruptcy of Enron Corp.
Asbestos and toxic waste losses were $250 million in 2003, $741 million in 2002 and $61 million in 2001.
During 2003, we experienced overall unfavorable development of $397 million on loss reserves established as of the previous year end, due primarily to two factors.
We strengthened asbestos loss reserves by $250 million in the fourth quarter.
We experienced unfavorable development of about $140 million in our executive protection classes, principally directors and officers liability and errors and omissions liability, as adverse loss trends in recent accident years related to corporate failures and allegations of management misconduct and accounting irregularities more than offset favorable loss experience in older accident years.
Because of substantially improved results in Chubb Europe throughout 2003, we eliminated a $40 million tax valuation allowance in the fourth quarter that was established in the fourth quarter of 2002.
Net income included realized investment gains after taxes of $55 million in 2003, $22 million in 2002 and $1 million in 2001. Decisions to sell securities are governed principally by considerations of investment opportunities and tax consequences. As a result, realized gains and losses on the sale of investments may vary significantly from period to period.
Our property and casualty business produced income before taxes of $1,133 million in 2003 compared with income of $278 million in 2002 and a loss of $53 million in 2001.
Asbestos and toxic waste losses, costs related to the September 11 attack and Enron-related surety losses and related benefits are significant components in understanding and assessing our financial performance. However, these items, which are discussed below, had a distorting effect on our results.
The following summary adjusts our reported property and casualty income or loss before taxes to exclude the impact of these items.
The profitability of the property and casualty insurance business depends on the results of both underwriting operations and investments, which we view as two distinctive operations. The underwriting functions are managed separately from the investment function. Accordingly, in assessing our performance, we evaluate underwriting results separately from investment results.
The combined loss and expense ratio, expressed as a percentage, is the key measure of underwriting profitability traditionally used in the property and casualty business. We evaluate the performance of our underwriting operations and of each of our business units using the combined loss and expense ratio calculated in accordance with statutory accounting principles. It is the sum of the ratio of losses to premiums earned (loss ratio) plus the ratio of underwriting expenses to premiums written (expense ratio) after reducing both premium amounts by dividends to policyholders. When the combined ratio is under 100%, underwriting results are generally considered profitable; when the combined ratio is over 100%, underwriting results are generally considered unprofitable.
Premium growth in 2002 and 2003 in all segments of our business was due primarily to higher rates. Premium growth was particularly strong in the commercial and specialty classes. Premium growth in our other specialty insurance business was primarily from Chubb Re, our reinsurance business that began operations in 1999.
In the wake of heavy insurance industry losses in recent years, exacerbated by the tragic event of September 11, 2001, many insurance companies sought substantial price increases, raised deductibles, reduced coverage limits or declined outright to renew coverage. In this environment, we have taken advantage of the opportunities to write new business and have retained more of our existing accounts. During 2002, we experienced substantial rate increases on business we wrote, often with more favorable policy terms and conditions. In 2003, we continued to get rate increases on much of the business we wrote, although the size of such increases decelerated throughout the year. We expect that rate increases will continue into 2004, although the size of rate increases will continue to decelerate.
Our premiums written are net of amounts ceded to reinsurers who assume a portion of the risk under the insurance policies that are subject to the reinsurance. As a result of the substantial losses incurred by reinsurers in recent years, the cost of reinsurance in the marketplace has increased significantly and reinsurance capacity for certain coverages, such as terrorism, is limited and expensive.
In 2002, we did not renew a workers’ compensation catastrophe treaty that had substantially reduced our net losses from the September 11 attack because the terms and price that were offered were uneconomical.
Our 2003 reinsurance program was similar to that in 2002. Reinsurance costs increased in line with the higher premiums on the policies reinsured. We discontinued some lower limit treaties that we believed were no longer economical and increased our participation in certain layers of the treaties renewed. Our property catastrophe treaty for events in the United States was again modified in 2003 to increase the reinsurance coverage at the top due to our increased exposure in certain catastrophe exposed areas. The program now provides coverage for individual catastrophe events of approximately 86% of losses between $150 million and $850 million, with additional coverage above $850 million that varies depending on geographic location.
Underwriting results in 2003, 2002 and 2001 were adversely affected by incurred losses of $250 million, $741 million and $61 million, respectively, related to asbestos and toxic waste claims. Underwriting results in 2001 were adversely affected by net costs of $635 million related to the September 11 attack and Enron related surety losses of $220 million. Results in 2002 and 2003 benefited from reductions in surety losses related to Enron of $88 million and $17 million, respectively.
The combined loss and expense ratio, as reported and as adjusted to exclude the effects of the asbestos and toxic waste losses, the September 11 attack and the Enron surety losses and related benefits, was as follows:
The loss ratio, as adjusted, improved in 2003 despite higher catastrophe losses, reflecting the favorable experience resulting from our disciplined underwriting standards in recent years. Losses from catastrophes other than the September 11 attack were $294 million in 2003 which represented 2.9 percentage points of the loss ratio compared with $98 million or 1.2 percentage points in 2002 and $114 million or 1.7 percentage points in 2001. Other than reinsurance recoveries related to the September 11 attack, we did not have any recoveries from our catastrophe reinsurance program during the three year period since there were no other individual catastrophes for which our losses exceeded the initial retention. Our initial retention level for each catastrophic event in the United States was
Our expense ratio decreased in 2002 and again in 2003 due in large part to premiums written growing at a substantially higher rate than overhead expenses. The improvement in 2003 was achieved despite an approximate 0.4 of a percentage point adverse impact of expensing stock options.
Asbestos and Toxic Waste Losses. In October 2002, our actuaries and claim personnel together with our outside actuarial consultants completed their periodic ground-up exposure based analysis of our asbestos related liabilities. Upon completion of the analysis and assessment of the results, we increased our net loss reserves by $625 million in the third quarter. In the fourth quarter of 2002, we reduced our previous estimate of reinsurance recoverable on potential asbestos claims, resulting in an additional increase in our net loss reserves of $75 million. Prior to the completion of the analysis, we had incurred asbestos and toxic waste net losses of $41 million in the first half of 2002 and $61 million during all of 2001.
In the fourth quarter of 2003, our actuaries and claim personnel together with our outside actuarial consultants performed a rigorous update of the 2002 ground-up analysis of our asbestos related liabilities. Upon completion of the update, we increased our net loss reserves by an additional $250 million. Our asbestos and toxic waste exposure is further discussed under “Loss Reserves.”
Enron-Related Surety Losses. Our surety losses arising from the Enron bankruptcy relate to bonds issued to various obligees in connection with Enron commitments. Although certain of these surety bonds were the subject of litigation, we recognized our maximum exposure of $220 million, net of reinsurance, in the fourth quarter of 2001. As of the end of 2002, the litigation was settled, resulting in an $88 million reduction in our surety net loss reserves. Results in 2003 benefited from a $17 million recovery from the sale of a bankruptcy claim against various Enron entities.
We estimate that our gross losses and loss expenses from the September 11 attack were about $3.2 billion. Most of the losses were from property exposure and business interruption losses. We also had significant workers’ compensation losses. Our net losses and loss expenses of $665 million were significantly lower than the gross amount due to various reinsurance agreements. Our property exposures were protected by facultative reinsurance, property per risk treaties that limited our net loss per risk, and our property catastrophe treaties. Our workers’ compensation losses were protected by a casualty catastrophe treaty and a casualty “clash” treaty that operates like a catastrophe treaty.
Certain of our reinsurers questioned our interpretation and/or application of some provisions of our property per risk reinsurance agreements with regard to the September 11 losses. The questions raised generally involved the applicable limit of reinsurance coverage available to us, the definition of what constitutes one risk, our accumulation of exposure in the various buildings destroyed or damaged and our adherence to our underwriting guidelines. During 2003, we resolved all of the questions that had been raised by our property per risk reinsurers. That resolution will result in our collecting an amount of reinsurance that confirms our estimate of net costs of $645 million related to the September 11 attack.
operations. However, we do not expect that any such change would have a material effect on the Corporation’s financial condition or liquidity.
Our personal automobile business was modestly profitable in each of the last three years. Results in each year benefited from stable loss severity.
Results for our casualty business, as adjusted, were highly profitable in 2003 and 2002 compared with unprofitable results in 2001. The improvement was due to higher rates and the culling of business where we could not attain price adequacy. In particular, the automobile component showed substantial improvement, producing highly profitable results in 2003 and 2002 compared with unprofitable results in 2001. Results for the primary liability component were profitable in all three years, improving in each succeeding year. The excess liability component produced near breakeven results in 2003 and 2002 compared with unprofitable results in 2001.
Net premiums from specialty insurance, which represent 40% of our total writings, increased by 31% in 2003 compared with a 34% increase in 2002. Premiums in 2001 included net reinsurance reinstatement premiums of $35 million related to the September 11 attack, primarily consisting of $80 million of premium revenue in our reinsurance business offset in part by costs of $40 million in our financial institutions business.
Growth in our other specialty insurance business was primarily from Chubb Re, our reinsurance assumed business. We write only treaty reinsurance, primarily casualty reinsurance. Premiums produced by Chubb Re amounted to $984 million in 2003 compared with $488 million in 2002 and $199 million in 2001, excluding the net reinstatement premium revenue of $80 million.
Our specialty insurance underwriting results, as adjusted, were near breakeven in 2003 compared with unprofitable results in 2002 and profitable results in 2001.
Executive protection results were unprofitable in 2003 and 2002 compared with profitable results in 2001. Results in 2003 and 2002 were adversely affected by directors and officers liability and errors and omissions liability claim experience, particularly from claims that have arisen due to the corporate failures and allegations of management misconduct and accounting irregularities in recent years. The improvement in 2003 was in our European operations where results in 2002 were particularly unprofitable due to deteriorating loss trends caused by an increase in litigation, often involving European companies being sued in U.S. courts for securities fraud.
Our financial institutions business produced similarly unprofitable results in 2003 and 2002. Results in 2001, as adjusted, were profitable. The fidelity component of this business was highly profitable in each of the last three years due to favorable loss experience. Results for the professional liability component were highly unprofitable in 2003 and 2002 compared with modestly unprofitable results in 2001. The deterioration was due to the same adverse directors and officers liability and errors and omissions liability claim trends experienced in our executive protection business. Financial institutions continue to be the focus of scrutiny by regulators and the plaintiffs’ bar related to investment banking and mutual fund scandals. The standard commercial business written on financial institutions produced profitable results in all three years, reflecting the rate increases and more stringent risk selection in recent years.
Our surety business tends to be characterized by infrequent but potentially high severity losses. Since the end of 2001, we have been reducing our exposure on an absolute basis and by specific bond
type. The majority of our obligations are intended to be performance-based guarantees. When losses occur, they are mitigated by the customer’s balance sheet, contract proceeds and bankruptcy recovery.
Notwithstanding our efforts to manage and reduce our surety exposure, we continue to have substantial commercial surety exposure for outstanding bonds. In that regard, we have exposures related to commercial surety bonds issued on behalf of companies that have experienced deterioration in creditworthiness, including several gas forward purchase surety bonds. We therefore may experience an increase in filed claims and may incur high severity losses. Such losses would be recorded if and when claims are filed and determined to be valid, and could have a material adverse effect on the Corporation’s results of operations and liquidity.
In particular, we have in force $520 million of gas forward purchase surety bonds with one principal, Aquila, Inc. Our exposure under these bonds will decline over the terms of the bonds, which extend until 2012. These surety bonds, which are uncollateralized, secure Aquila’s obligation to supply gas under long-term forward purchase agreements. Under the terms of these bonds, our entire obligation to pay could be triggered if Aquila failed to provide gas under its forward purchase contracts or was the subject of a bankruptcy filing. There is currently no reinsurance in place covering our exposure under these bonds. Aquila continues to perform its obligations under the related gas forward purchase agreements.
Loss reserves, which are our property and casualty subsidiaries’ largest liability, include significant amounts related to asbestos and toxic waste claims, the September 11 attack and our Enron surety exposure. The components of our loss reserves were as follows:
Loss reserves include estimates for claims that have been reported and claims that have not been reported and include estimates of all expenses associated with settling those claims. Estimates are based upon past claim experience modified for current trends as well as prevailing economic, legal and social conditions.
A reconciliation of the beginning and ending loss reserves, net of reinsurance, for the three years ended December 31, 2003 is as follows:
The favorable development in 2001 was due primarily to favorable loss experience in our commercial excess liability and executive protection coverages, offset in part by losses incurred related to asbestos and toxic waste claims.
Long-tail classes include directors and officers liability, errors and omissions liability and other executive protection coverages, commercial excess liability, and other liability classes. Most of our loss reserves relate to long tail liability classes of business. For many liability claims significant periods of time, ranging up to several years or more, may elapse between the occurrence of the loss, the reporting of the loss and the settlement of the claim. The longer the time span between the incidence of a loss and the settlement of the claim, the more the ultimate settlement amount can vary. For the long tail liability classes, a relatively small proportion of net losses in the more recent accident years are reported claims and an even smaller proportion are paid losses. Therefore, a relatively large proportion of our net losses for these classes are reserves for incurred but not reported (IBNR) losses - claims that had not yet been reported to us, some of which were not yet known to the insured, and future development on reported claims. In fact, approximately 60% of our aggregate net loss reserves at December 31, 2003 were for IBNR.
To estimate loss reserves, we use a variety of complex actuarial methods that analyze experience trends and other relevant factors. These methods generally utilize analyses of historical patterns of the development of paid and reported losses by accident year by class of business. This process relies on the basic assumption that past experience, adjusted for the effects of current developments and likely trends, is an appropriate basis for predicting future outcomes. For certain long tail classes of business where anticipated loss experience is less predictable because of the small number of claims and/or erratic claim severity patterns, estimates are based on both expected losses and actual reported losses. These classes include directors and officers liability, errors and omissions liability and commercial excess liability, among others. For these classes, we judgmentally set ultimate losses for each accident year based on our evaluation of loss trends and the current risk environment. The expected ultimate losses are adjusted as the accident years mature.
Our loss reserve review process does not calculate a range of loss reserve estimates. Using the various complex actuarial methods and different underlying assumptions, management selects the carried reserve for each class of business.
The inherent uncertainty in the process of establishing loss reserves arises from a number of factors. These factors include but are not limited to:
The plaintiffs’ bar continues to solicit new claimants through extensive advertising and through asbestos medical screenings. Litigation is then initiated even though many of the claimants do not show any signs of asbestos-related disease. Thus, new asbestos claims and new exposures on existing claims have continued unabated despite the fact that usage of asbestos has declined since the mid-1970’s. Based on published projections, we expect that we will continue receiving asbestos claims at the current rate for at least the next several years.
Our other asbestos exposures involve product and non-product liability on the part of “peripheral” defendants, including a mix of manufacturers, distributors and installers of certain products that contain asbestos in small quantities and owners of properties on which asbestos exists. Generally, these insureds are named defendants on a regional rather than a nationwide basis. As the financial resources of traditional asbestos defendants have been depleted, plaintiffs are targeting these viable peripheral parties with greater frequency and, in many cases, for larger awards.
Asbestos claims against the major manufacturers, distributors or installers of asbestos products were presented under the products liability section of primary general liability policies as well as under excess liability policies, both of which typically had aggregate limits that capped an insurer’s liability. In recent years, a number of asbestos claims by insureds are being presented as “non-products” claims, such as those by installers of asbestos products and by property owners who allegedly had asbestos on their property, under the premises or operations section of primary general liability policies. Unlike products exposures, these non-products exposures typically had no aggregate limits, creating potentially greater exposure. Further, in an effort to seek additional insurance coverage, some insureds with installation activities who have substantially eroded their products coverage are presenting new asbestos claims as non-products operations claims or attempting to reclassify previously settled products claims as non-products claims to restore a portion of previously exhausted products aggregate limits. It is difficult to predict whether insureds will be successful in asserting claims under non-products coverage or whether insurers will be successful in asserting additional defenses. Therefore, the impact of such efforts on insurers is uncertain.
In establishing our asbestos reserves, we evaluate the exposure presented by each insured. As part of this evaluation, we consider the available insurance coverage; limits and deductibles; the jurisdictions involved; past settlement values of similar claims; the potential role of other insurance, particularly underlying coverage below our excess liability policies; and applicable coverage defenses, including asbestos exclusions.
We have assumed a continuing unfavorable legal environment with no benefit from any federal asbestos reform legislation. A recent proposal, which envisioned a sizable trust funded primarily by defendants and insurers, appears highly unlikely to pass.
In the third quarter of 2002, our actuaries and claim personnel together with our outside actuarial consultants commenced their periodic ground-up exposure-based analysis of our asbestos related liabilities. As part of this analysis, they considered the following adverse trends:
access higher excess layers of insurance coverage as well as more years of coverage than previously anticipated.
Claims have been more aggressively pursued against peripheral asbestos defendants in recent years, partly in response to the bankruptcy or exhaustion of insurance coverage for many of the major traditional defendants.
Upon completion of the analysis and assessment of the results, we increased our net asbestos loss reserves by $545 million in the third quarter of 2002. Following a thorough review in the fourth quarter by our internal actuarial, claim and reinsurance personnel, we reduced our estimate of reinsurance recoverable on potential asbestos claims. As a result, our net asbestos loss reserves increased by an additional $75 million.
In the fourth quarter of 2003, our actuaries and claim personnel together with our outside actuarial consultants performed a rigorous update of their 2002 ground-up exposure-based analysis of our asbestos related liabilities. The review noted the same adverse trends observed during the 2002 analysis, particularly a further increase in estimates of the ultimate liabilities for several of our traditional asbestos defendants. In addition, the number of insureds for whom we established reserves and the average severity of claims were both higher than anticipated. Upon completion of the update, we increased our net asbestos loss reserves by $250 million.
The extent of losses from a catastrophe is a function of both the total amount of insured exposure in an area affected by the event and the severity of the event. We continually assess our concentration of underwriting exposures in catastrophe prone areas globally and develop strategies to manage this exposure through individual risk selection, subject to regulatory constraints, and through the purchase of catastrophe reinsurance. In recent years, we have invested in modeling technologies and concentration management tools that allow us to better monitor and control our accumulations of potential losses from catastrophe exposures. We maintain records showing concentrations of risk in catastrophe exposed areas such as California (earthquake and brush fires) and the gulf and east coasts of the United States (hurricanes). We also continue to explore and analyze credible scientific evidence, including the impact of global climate change, that may affect our potential exposure under insurance policies.
The effective tax rate on our investment income was 20.3% in 2003 compared with 18.2% in 2002 and 17.0% in 2001. The effective tax rate increased each year as a result of our holding a smaller proportion of our investment portfolio in tax-exempt securities.
In April 2003, the Corporation announced its intention to exit CFS’s non-insurance business and to run-off the existing financial products portfolio. Our objective is to exit this business as quickly as
possible while minimizing the potential of a large payment due to an unexpected credit event over the next few years.
In a typical portfolio credit default swap, CFS participated in the senior layer of a structure designed to replicate the performance of a portfolio of corporate securities, a portfolio of asset-backed securities or a specified pool of loans. The structure of these portfolio credit default swaps generally requires CFS to make payment to counterparties to the extent cumulative losses, related to numerous credit events, exceed a specified threshold. The risk below that threshold, referred to as subordination, is assumed by other parties with the primary risk layer sometimes retained by the buyer. The amount of subordination for each contract varies based on the credit quality of the underlying portfolio and the term to maturity of the contract. Credit events generally arise when one of the referenced entities within a portfolio becomes bankrupt, undergoes a debt restructuring or fails to make timely interest or principal payments.
Portfolio credit default swaps are derivatives and are carried in the financial statements at estimated fair value, which represents management’s best estimate of the cost to exit our positions. Most of these credit default swaps tend to be unique transactions and there is no traded market for such exposures. To estimate the fair value of the obligation in each credit default swap, we use internal valuation models that are similar to external valuation models.
The substantial loss in 2003 was due to further deterioration in the credit quality of certain referenced securities underlying the two asset-backed credit default swaps. In the first nine months of the year, the fair value of our future obligations related to these two swaps increased by $70 million. Then, in the fourth quarter, as described below, we terminated the two swaps and replaced them with a principal and interest guarantee agreement, which resulted in an additional loss of $96 million. The losses related to these two asset-backed swaps were partially offset by mark-to-market gains during the year on our corporate credit default swaps.
CFS’s aggregate exposure, or retained risk, from its in-force portfolio credit default swaps is referred to as notional amount. Notional amounts are used to express the extent of involvement in swap transactions. These amounts are used to calculate the exchange of contractual cash flows and are not necessarily representative of the potential for gain or loss. The notional amounts are not recorded on the balance sheet.
Corporate and other includes investment income earned on corporate invested assets, interest expense and other expenses not allocated to the operating subsidiaries, and the results of our real estate and other non-insurance subsidiaries. Corporate and other produced a loss before taxes of $157 million in 2003 compared with losses of $74 million and $23 million in 2002 and 2001, respectively. The increasingly higher loss in 2002 and 2003 was due to an increase in interest expense and a decrease in investment income in each of the years compared with the prior year. Interest expense increased in 2003 due to the issuance of $600 million of debt in the fourth quarter of 2002, $500 million of debt in the first quarter of 2003 and $460 million of debt in the second quarter of 2003. The higher interest expense in 2002 was due to the issuance of $600 million of debt in the fourth quarter of 2001. The decrease in investment income in 2002 and again in 2003 was due to lower average corporate invested assets resulting from the capital contributions to the property and casualty subsidiaries.
Results in 2003 included a loss at The Chubb Institute, Inc., our post secondary educational subsidiary, which provides programs primarily relating to information technology. As part of our focus on our core insurance business, we are analyzing our alternatives with respect to Chubb Institute. The effect of this loss on 2003 results was substantially offset by income from our investment in Allied World Assurance Company, Ltd.
Real estate operations resulted in a loss before taxes of $14 million in 2003 compared with losses of $6 million in 2002 and $4 million in 2001. These amounts are included in the corporate and other results. In each year, we sold selected commercial properties as well as residential properties. Real estate revenues were $72 million in 2003, $76 million in 2002 and $87 million in 2001.
We own approximately $285 million of land which we expect will be developed in the future. In addition, our real estate assets include approximately $180 million of commercial properties and land parcels under lease, of which $23 million related to a variable interest entity in which we are the primary beneficiary. We are continuing to explore the sale of certain of our remaining properties.
The recoverability of the carrying value of our real estate assets is assessed based on our ability to fully recover costs through a future revenue stream. The assumptions used reflect future improvement in demand for office space, an increase in rental rates and the ability and intent to obtain financing in order to hold and develop such remaining properties and protect our interests over the long term. Management believes that it has made adequate provisions for impairment of real estate assets. However, if the assets are not sold or developed or if leased properties do not perform as presently
contemplated, it is possible that additional impairment losses may be recognized that would have a material adverse effect on the Corporation’s results of operations.
The writedowns of fixed maturities in 2003 were primarily due to collateral deterioration of several asset-backed securities and price declines of a few corporate credits in the airline and energy sectors.
The writedowns in 2002 and 2001 were primarily due to credit deterioration and corporate failures of several issuers, particularly in the telecommunications and, to a lesser extent, energy-related industries.
required under generally accepted accounting principles to consider a relatively near term horizon when we evaluate the likelihood of realizing future tax benefits.
Capital resources and liquidity represent the overall financial strength of the Corporation and its ability to generate cash flows from its operating subsidiaries, borrow funds at competitive rates and raise new capital to meet operating and growth needs.
Capital resources provide protection for policyholders, furnish the financial strength to support the business of underwriting insurance risks and facilitate continued business growth. At December 31, 2003, the Corporation had shareholders’ equity of $8.5 billion and total debt of $2.8 billion.
In February 2003, $100 million of 6 7/8% notes were paid when due.
In March 2003, the Corporation issued $225 million of unsecured 3.95% notes due in 2008 and $275 million of unsecured 5.2% notes due in 2013. Net proceeds from the issuance of the notes were $495 million.
In June 2003, a shelf registration statement that the Corporation filed in March 2003 was declared effective by the Securities and Exchange Commission. Under the registration statement, up to $2.5 billion of various types of securities may be issued. At December 31, 2003, the Corporation had approximately $650 million remaining under the shelf registration statement.
In June 2003, the Corporation sold 15,525,000 shares of common stock. Net proceeds from the sale of the shares were $887 million. Concurrently, the Corporation issued $460 million of unsecured 2.25% senior notes due in 2008 and 18.4 million purchase contracts. The senior notes and purchase contracts were issued together in the form of 7% equity units, each of which initially represents $25 principal amount of senior notes and one purchase contract. The net proceeds from this offering were $446 million. Each purchase contract obligates the investor to purchase for $25 a variable number of shares of the Corporation’s common stock on August 16, 2006. The number of shares to be purchased will be determined based on a formula that considers the market price of our common stock immediately prior to the time of settlement in relation to the $59.50 per share sale price of our common stock at the time the equity units were offered. Upon settlement of the purchase contracts, the Corporation will receive proceeds of approximately $460 million and will issue between approximately 6,500,000 and 7,700,000 shares of common stock.
represents $25 principal amount of senior notes and one warrant. The net proceeds were $582 million. Each warrant obligates the investor to purchase for $25 a variable number of shares of the Corporation’s common stock on or before November 16, 2005. The number of shares to be purchased will be determined based on a formula that considers the market price of our common stock immediately prior to the time of settlement in relation to the $56.64 per share sale price of our common stock at the time the equity units were offered. Upon settlement of the warrants, the Corporation will receive proceeds of approximately $600 million and will issue between approximately 8,700,000 and 10,600,000 shares of common stock.
The equity units are further described in Notes (10)(a) and (20)(c) of the Notes to Consolidated Financial Statements.
The Corporation and its insurance subsidiaries are rated by major rating agencies. These ratings reflect the rating agency’s opinion of our financial strength, operating performance, strategic position and ability to meet our obligations to policyholders. Standard & Poor’s Ratings Services lowered certain of our ratings in the first quarter of 2003. Following the announcement of our fourth quarter 2003 earnings, which included charges taken to strengthen our asbestos loss reserves and to limit our exposure on the two credit default swaps written by CFS that had experienced deterioration in credit quality, Moody’s Investors Service lowered our debt ratings and changed to negative the outlook for our ratings.
The following table summarizes our property and casualty subsidiaries’ financial strength ratings from the major independent rating organizations as of March 9, 2004.
The Corporation does not have any material off-balance sheet arrangements, except as discussed in Note (16) of the Notes to Consolidated Financial Statements.
New cash from operations available for investment by the property and casualty subsidiaries was approximately $3.1 billion in 2003 compared with $1.9 billion in 2002 and $570 million in 2001. New cash available in 2003 was higher than in 2002 due to the substantial growth in premium receipts in 2003 without a commensurate increase in paid losses or operating expenses. The increase in new cash in 2002 was due to the significant growth in premium receipts while paid losses were similar in 2002 and 2001.
In addition to the cash from operations, the property and casualty subsidiaries received capital contributions from the Corporation of $800 million in the second quarter of 2003, $1 billion in the fourth quarter of 2002 and $750 million in the fourth quarter of 2001. In 2001, $250 million was used by a property and casualty subsidiary to fund the purchase of a 19% interest in Allied World Assurance Holdings, Ltd, a newly formed Bermuda-based insurer. In 2002, the interest in Allied World Assurance Holdings was transferred as a dividend from the property and casualty subsidiary to the Corporation.
The Corporation’s liquidity requirements in the past have been met by dividends from its property and casualty subsidiaries and the issuance of commercial paper and debt and equity securities. Liquidity requirements in the future will be met by these sources of funds as well as borrowings from its credit facilities.
As a holding company, the Corporation’s ability to continue to pay dividends to shareholders and to satisfy its obligations, including the payment of interest and principal on debt obligations, relies on the availability of liquid assets in the Corporation, which is dependent in large part on the dividend paying ability of its property and casualty subsidiaries. Various state insurance laws restrict the Corporation’s property and casualty subsidiaries as to the amount of dividends they may pay without the prior approval of regulatory authorities. The restrictions are generally based on net income and on certain levels of policyholders’ surplus as determined in accordance with statutory accounting practices. Dividends in excess of such thresholds are considered “extraordinary” and require prior regulatory approval. During 2003, these subsidiaries paid cash dividends to the Corporation totaling $270 million. The maximum dividend distribution that may be made by the property and casualty subsidiaries to the Corporation during 2004 without prior approval is approximately $630 million.
We believe that our strong financial position and conservative debt level provide us with the flexibility and capacity to obtain funds externally through debt or equity financings on both a short term and long term basis. However, should our ratings be downgraded, our ability to access the markets to satisfy our liquidity requirements could be adversely affected.
The Corporation has two credit agreements with a group of banks that provide for unsecured borrowings of up to $500 million in the aggregate. The $250 million short term revolving credit facility, which was to have terminated on June 27, 2003, was extended to June 24, 2004 and may be renewed or replaced. The $250 million medium term revolving credit facility terminates on June 28, 2007. On the respective termination dates for these agreements, any loans then outstanding become payable. There have been no borrowings under these agreements. Various interest rate options are available to the Corporation, all of which are based on market interest rates. The facilities are available for general corporate purposes and to support the Corporation’s commercial paper borrowing arrangement.
The main objectives in managing our investment portfolios are to maximize after-tax investment income and total investment returns while minimizing credit risks in order to provide maximum support to the insurance underwriting operations. Investment strategies are developed based on many
In 2003, we invested new cash in tax-exempt bonds and taxable bonds and, to a lesser extent, equity securities. The taxable bonds were primarily mortgage-backed securities, foreign government bonds and U.S. Treasury securities. In 2002, we invested new cash in mortgage-backed securities and, to a lesser extent, U.S. Treasury securities. In 2001, we invested new cash primarily in corporate bonds. Our objective is to achieve the appropriate mix of taxable and tax-exempt securities in our portfolio to balance both investment and tax strategies. At December 31, 2003, 51% of our fixed maturity portfolio was invested in tax-exempt bonds compared with 53% at December 31, 2002 and 59% at December 31, 2001.
The unrealized appreciation before tax of investments carried at market value, which includes fixed maturities classified as available-for-sale and equity securities, was $1,036 million, $901 million and $389 million at December 31, 2003, 2002 and 2001, respectively. Such unrealized appreciation is reflected in a separate component of other comprehensive income, net of applicable deferred income tax.
Effective January 1, 2002, the Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 may not be applied retroactively to financial statements of prior periods. Under SFAS No. 142, goodwill is no longer amortized. Goodwill amortization was approximately $20 million in 2001.
Consolidated financial statements of the Corporation at December 31, 2003 and 2002 and for each of the three years in the period ended December 31, 2003 and the report of independent auditors thereon and the Corporation’s unaudited quarterly financial data for the two-year period ended December 31, 2003 are listed in Item 15(a) of this report.