We also own office space located in a three-building complex located at 808 North Highlander Way, Howell, Michigan, with approximately 176,000 square feet, where various business operations are conducted. Certain of our properties have been leased to unrelated third parties or are available for lease.
-MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Effective June 30, 2015, we transferred our U.K. motor business to an unaffiliated U.K.-based insurance provider. The transaction was executed through a 100 percent reinsurance arrangement for prior claim liabilities and in-force policies written by this division and the sale of two entities associated with this business. Total consideration from the sale of Chaucer subsidiaries was $64.9 million and the transaction resulted in an after-tax non-operating net gain of $40.6 million. See also “Disposal of U.K. Motor Business” in Note 2 - “Dispositions of Businesses” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
Pricing in our Commercial and Personal Lines remains favorable as we continue to respond to increased weather-related losses over recent years, as well as to the earnings impact of reduced investment income as a result of low interest rates, and other factors. We are continuing efforts to improve our underwriting results in both our Commercial and Personal Lines, through rate increases and improvements to our mix of business. At Chaucer, we continued to experience competitive pressure on rates in 2015. In response to these challenging market conditions, we continue to actively manage Chaucer’s underwriting portfolio, using our expertise, distinctive underwriting capabilities and market knowledge to target specific attractive underwriting opportunities.
We believe these efforts have driven, and will continue to drive, improvement in our overall mix of business and ultimately our underwriting profitability. Commercial Lines net premiums written grew by 5.8% in 2015, driven by both our core commercial and specialty businesses. This growth is primarily due to rate and exposure increases, increased retention and targeted new business expansion.
Chaucer deploys specialist underwriters in over 30 major insurance and reinsurance classes, including energy, marine and aviation, property, casualty and other coverages. We obtain business through Lloyd’s, the leading international insurance and reinsurance market, which provides us with access to specialist business in over 200 countries and territories worldwide through its international licenses, brand reputation and strong security rating. Our underwriting strength, diverse portfolio and Lloyd’s membership underpin our ability to actively manage the scale, composition and profitable development of this business.
Primary business operations include insurance products and services currently provided through four operating segments. Our domestic operating segments are Commercial Lines, Personal Lines, and Other. Our international operating segment is Chaucer. Commercial Lines includes commercial multiple peril, commercial automobile, workers’ compensation and other commercial coverages, such as inland marine, specialty program business, management and professional liability, surety and specialty property. Personal Lines includes personal automobile, homeowners and other personal coverages. Chaucer includes marine and aviation, property, energy, U.K. motor, and casualty and other coverages (which includes international liability, specialist liability coverages, and syndicate participations). As a result of the aforementioned transfer of our U.K. motor business, results from the Chaucer segment no longer include this business subsequent to June 30, 2015. Included in the “Other” segment are Opus Investment Management, Inc., which markets investment management services to institutions, pension funds and other organizations; earnings on holding company assets; and, a discontinued voluntary pools business. We present the separate financial information of each segment consistent with the manner in which our chief operating decision maker evaluates results in deciding how to allocate resources and in assessing performance.
Catastrophe losses and prior years’ reserve development are significant components in understanding and assessing the financial performance of our business. Management reviews and evaluates catastrophes and prior years’ reserve development separately from the other components of earnings. Catastrophes and prior years’ reserve development are not predictable as to timing or the amount that will affect the results of our operations and have affected our results in past years. Management believes that providing certain financial metrics and trends excluding the effects of catastrophes and prior years’ reserve development helps investors to understand the variability in periodic earnings and to evaluate the underlying performance of our operations.
Operating income before interest expense and income taxes was $465.6 million for the year ended December 31, 2015, compared to $406.2 million for the year ended December 31, 2014, an increase of $59.4 million. This increase was due primarily to lower catastrophe losses, a lower expense ratio and higher net investment income, partially offset by higher large loss activity in the Chaucer segment and lower favorable development on prior years’ loss reserves.
Catastrophe-related activity for the year ended December 31, 2015 was $181.3 million, compared to $223.0 million for the year ended December 31, 2014, a decrease of $41.7 million.
Our consolidated catastrophe related activity for the year ended December 31, 2014 was $223.0 million, compared to $140.0 million for the year ended December 31, 2013, an increase of $83.0 million. Excluding the impact of catastrophe related activity, operating income increased by $95.8 million. This increase was primarily due to improved current accident year results in our domestic segments.
Net premiums written grew by $257.4 million for the year ended December 31, 2014, compared to the year ended December 31, 2013, and net premiums earned grew by $259.8 million. Chaucer accounted for $113.9 million of the net premiums written increase and $183.9 million of the net premiums earned increase, primarily due to growth in the casualty and marine lines, the increase in Chaucer’s economic interests in Syndicate 1084, and the favorable impact of foreign exchange movements. Additionally, growth in our Commercial Lines resulting from rate increases, increased retention and targeted new business expansion, was partially offset by a decrease in our Personal Lines net premiums written.
Commercial Lines underwriting loss for the year ended December 31, 2015 was $12.7 million, compared to $8.3 million for the year ended December 31, 2014, a decline of $4.4 million. Unfavorable development on prior years’ loss reserves for the year ended December 31, 2015 was $45.2 million, compared to $9.2 million for the year ended December 31, 2014, an increase of $36.0 million. Catastrophe-related losses increased slightly for the year ended December 31 2015 at $88.7 million, compared to $87.8 million for the year ended December 31, 2014. Unfavorable prior year development was due to higher than expected losses in Other Commercial Lines of $53.7 million, which includes our AIX program business. This was principally driven by losses in accident years 2013 and prior, primarily from programs which have since been terminated and from higher than expected losses in our general liability lines, partially offset by favorable development in our commercial umbrella and healthcare lines, also included in Other Commercial Lines. We also experienced unfavorable prior year development in our commercial automobile line of $23.4 million. These items were partially offset by favorable prior year development in our workers’ compensation line of $46.9 million.
Net premiums written in the personal automobile line of business for the year ended December 31, 2015 were $900.0 million compared to $884.1 million for the year ended December 31, 2014, an increase of $15.9 million. This increase was primarily due to rate increases, partially offset by a decline in policies in force of 3.2%. Net premiums written in the homeowners line of business for the year ended December 31, 2015 were $507.4 million, compared to $499.0 million for the year ended December 31, 2014, an increase of $8.4 million. This is attributable to rate increases which offset a decline in policies in force of 1.9%. The decline in policies in force in the personal automobile and homeowners lines were principally attributable to a decline in new business volume and, to a lesser extent, our exposure management actions over the last 12 months.
Personal Lines current accident year underwriting profit, excluding catastrophes, was $128.1 million in the year ended December 31, 2015, compared to $123.4 million for the year ended December 31, 2014. This $4.7 million improvement was primarily a result of our ongoing pricing and underwriting actions in both lines of business, partially offset by higher large loss experience in the homeowners line, largely due to fire.
Although we have been able to obtain rate increases in our Personal Lines markets and believe that our ability to obtain these increases will continue, our ability to maintain Personal Lines net premiums written and to maintain and improve underwriting results may be affected by price competition, recent years’ weather-related losses, our exposure management actions, and regulatory and legal developments. We monitor these trends and consider them in our rate actions.
Chaucer’s net premiums written were $889.3 million for the year ended December 31, 2015, compared to $1,231.4 million for the year ended December 31, 2014. This decline of $342.1 million was primarily due to the aforementioned transfer of the U.K. motor business. Excluding the U.K. motor business, net premiums written declined by $36.1 million or 3.9%, primarily due to lower volumes in the energy, marine and property lines, partially offset by growth in the specialist liability line.
We continue to experience significant competition across the international insurance industry. Current pricing conditions in all markets continue to be affected by high industry capacity and competition, and a continued absence of major losses in our markets. There can be no assurance that we will be able to maintain adequate rates in light of economic and regulatory conditions in our markets.
Commercial Lines net premiums written were $2,155.9 million for the year ended December 31, 2014, compared to $2,007.2 million for the year ended December 31, 2013. This $148.7 million increase was primarily driven by rate increases, increased retention, and targeted new business expansion, partially offset by exposure and portfolio management actions that focus on reducing volatility from weather-related events and driving profit improvement.
Chaucer’s net premiums written were $1,231.4 million for the year ended December 31, 2014, compared to $1,117.5 million for the year ended December 31, 2013, an increase of $113.9 million, or 10.2%. This growth was principally related to the casualty line, primarily due to expanded underwriting capabilities, growth in the marine line, the aforementioned increase in Chaucer’s economic interests in Syndicate 1084, and the favorable impact of foreign exchange rate movements.
We regularly update our reserve estimates as new information becomes available and additional events occur which may impact the resolution of unsettled claims. Reserve adjustments are reflected in the results of operations as adjustments to losses and LAE. Often, these adjustments are recognized in periods subsequent to the period in which the underlying policy was written and the loss event occurred. When these types of subsequent adjustments affect prior years, they are described separately as “prior year reserve development”. Such development can be either favorable or unfavorable to our financial results and may vary by line of business. As discussed below, estimated loss and LAE reserves for claims occurring in prior years developed favorably by $94.3 million, $99.1 million, and $76.3 million for the years ended December 31, 2015, 2014, and 2013, respectively. However, we have experienced unfavorable development in prior years and there can be no assurance that current loss and LAE reserves will be sufficient.
A comprehensive review of loss reserves for each of the classes of business which we write is conducted regularly, generally quarterly. This review process takes into consideration a variety of trends that impact the ultimate settlement of claims. Where appropriate, the review includes a review of overall payment patterns and the emergence of paid and reported losses relative to expectations.
The Chaucer segment contains run-off business comprised of liability lines, notably financial institutions and professional liability busines. There is particular uncertainty around the reserve estimates in respect of business written in 2007 and 2008 which have been subject to claims arising out of the financial turmoil in that time period, particularly in the financial institutions book. These claims are unlikely to be settled for some time since they contain numerous coverage issues and in many cases involve class action lawsuits that are likely to take several years to resolve. We have utilized substantially all of our available reinsurance with respect to losses and LAE related to financial institutions business written in 2008.
For events designated as catastrophes which affect our Chaucer business segment, we initially calculate IBNR reserves using a ground up exposure by exposure analysis based on each cedant or insured. These are supported by broker supplied information, catastrophe modeling and industry event estimates. As more specific claim level data becomes available over time for each catastrophe event, these initial estimates are revised and updated by looking at the paid and incurred claim development and by considering it in comparison to previous catastrophe loss events.
The following discussion presents disclosure related to possible variation in net reserve estimates due to changes in key assumptions. This information is provided for illustrative purposes only. Many other assumptions may also lead to material reserve adjustments. If any such variations do occur, they would likely occur over a period of several years and therefore their impact on our results of operations would be recognized during the same periods. It is important to note, however, that there is the potential for future variations greater than the amounts described below and for any such variations to be recognized in a single quarterly or annual period. No consideration has been given to potential correlation or lack of correlation among key assumptions or among lines of business and coverage as described below. As a result and because there are so many other factors which affect our net reserve estimate, it would be inappropriate to take the amounts described below and simply add them together in an attempt to estimate volatility in total. While we believe these are reasonably likely scenarios, the reader should not consider the following sensitivity analysis as illustrative of a reserve range.
Workers’ Compensation - reserves recorded for workers’ compensation on U.S. voluntary business were $367.9 million as of December 31, 2015. A key assumption for workers’ compensation is the inflation rate underlying the estimated reserve. Given the long reporting pattern for this line of business, an additional key assumption is the amount of additional development required to reach full maturity, thereby reflecting ultimate costs, as represented by the tail factor. A five point change in the embedded inflation rate and a one point change to the tail factor assumption would have changed estimated IBNR by approximately $43 million, either positive or negative, at December 31, 2015.
Monoline and Multi-Peril General Liability - reserves recorded for general liability on U.S. voluntary business were $553.5 million as of December 31, 2015. A key assumption for general liability is the implied adequacy of the underlying case reserves. A ten point change in case adequacy (e.g. 10% deficiency changed to 0% or 20% deficiency) would have changed estimated IBNR by approximately $52 million, either positive or negative, at December 31, 2015.
New classes of business - claims reserves recorded for new classes of Chaucer business (primarily within international liability, U.S. casualty treaty and new lines written in overseas offices) were $231.5 million as of December 31, 2015. An increase in the ultimate loss ratio by 5%, 10% and 15% in the 2013 and prior, 2014 and 2015 years of account, respectively, on these classes would have increased estimated IBNR by approximately $39 million at December 31, 2015.
Casualty classes of business - claims reserves recorded for casualty classes of Chaucer business were $403.9 million as of December 31, 2015. An increase in the ultimate loss ratio of 2.5% across all classes and years of account would have increased estimated IBNR by approximately $36 million at December 31, 2015.
Loss and LAE reserves for claims occurring in prior years developed favorably by $94.3 million, $99.1 million and $76.3 million during the years ended December 31, 2015, 2014 and 2013, respectively. The 2015 activity by segment includes favorable development of $120.1 million for Chaucer, and $19.7 million in Personal Lines, partially offset by unfavorable development of $45.2 for Commercial Lines and Other. As a result of our year end 2015 reserve review of our domestic commercial and personal lines of business, carried reserves were adjusted between several of these lines of business impacting the prior year development by line. These adjustments had no impact on aggregate domestic carried reserves. The 2014 activity by segment includes favorable development of $104.6 million for Chaucer, and $5.1 million in Personal Lines, partially offset by unfavorable development of $10.6 million for Commercial Lines and Other. The 2013 activity by segment includes favorable development of $94.6 million for Chaucer, partially offset by unfavorable development of $13.7 million in Personal Lines and $4.6 million for Commercial Lines and Other.
within casualty and other lines, specialist and international liability lines of $21.9 million, primarily in the 2008, 2011 and 2013 accident years,
property line, primarily in the 2012 through 2014 accident years, and
Lower than expected losses within our personal automobile line, primarily related to accident year 2014.
property line of $27.3 million, primarily in the 2011 and 2012 accident years,
within casualty and other lines, specialist liability lines of $21.6 million, primarily in the 2008 accident year,
Although we attempt to limit our exposures to asbestos and environmental damage liability through specific policy exclusions, we have been and may continue to be subject to claims related to these exposures. Ending loss and LAE reserves for all direct business written by our property and casualty companies related to asbestos and environmental damage liability were $9.5 million, $10.1 million and $11.5 million, net of reinsurance of $20.5 million, $21.4 million, and $20.6 million for the years ended December 31, 2015, 2014 and 2013, respectively.
In addition, we have established gross loss and LAE reserves for assumed reinsurance pool business with asbestos and environmental damage liability of $27.7 million, $29.1 million and $29.8 million at December 31, 2015, 2014 and 2013, respectively. These reserves relate to pools in which we have terminated our participation; however, we continue to be subject to claims related to years in which we were a participant. Results of operations from these pools are included in our Other segment. A significant part of our pool reserves relates to our participation in the Excess and Casualty Reinsurance Association (“ECRA”) voluntary pool from 1950 to 1982. In 1982, the pool was dissolved and since that time, the business has been in run-off. Our percentage of the total pool liabilities varied from 1% to 6% during these years. Our participation in this pool has resulted in average paid losses of approximately $2 million annually over the past ten years.
Catastrophe reinsurance serves to protect us, as the ceding insurer, from significant losses arising from a single event including, among others, hurricanes, tornadoes and other windstorms, earthquakes, hail, severe winter weather, fire, explosions, and terrorism. Although we believe our catastrophe reinsurance program, including our retention and co-participation amounts for 2016, are appropriate given our surplus level and the current reinsurance pricing environment, there can be no assurance that our reinsurance program will provide coverage levels that will prove adequate should we experience losses from one significant or several large catastrophes during 2016. Additionally, as a result of the current economic environment, as well as losses incurred by reinsurers in the past several years, the availability and pricing of appropriate reinsurance programs may be adversely affected in future renewal periods. We may not be able to pass these costs on to policyholders in the form of higher premiums or assessments.
Total cash and investments decreased $331.4 million, or 3.8%, for the year ended December 31, 2015 primarily as a result of the transfer of the U.K. motor business, funding our debt and stock repurchases and market value depreciation, partially offset by the investment of positive operational cash flows.
The decline in net unrealized gains on fixed maturities in 2015 was primarily due to widening of credit spreads and, to a lesser extent, higher interest rates.
Equity securities primarily consist of developed market equity index exchange traded funds and income-oriented large capitalization common stocks.
Other investments consisted primarily of participations in commercial mortgage loan obligations and overseas deposits. Commercial mortgage loan participations represent our interest in commercial mortgage loans originated by a third party. We share, on a pro-rata basis, in all related cash flows of the underlying mortgage loans, which are investment-grade quality and diversified by geographic area and property type. Overseas deposits are non-U.S. and U.S. dollar-denominated investments maintained in overseas funds and managed exclusively by Lloyd’s. These funds are required in order to protect policyholders in overseas markets and enable Chaucer to operate in those markets. Access to those funds is restricted, and we have no control over the investment strategy. Also included in other investments were investments in limited partnerships.
For the years ended December 31, 2015, 2014 and 2013 we recognized in earnings $26.8 million, $5.5 million, and $6.0 million, respectively, of OTTI on debt and equity securities. In 2015, OTTI consisted of $16.0 million related to estimated credit losses on fixed maturities, $4.0 million on fixed maturities we intend to sell and $6.8 million on equity securities. OTTI in 2015 was largely related to the energy sector.
The following table provides information about our fixed maturities and equity securities that were in an unrealized loss position including the length of time the securities have been in an unrealized loss position. (See also Note 3 - “Investments” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K)
Market values of securities in the energy sector have experienced volatility in 2015 as crude oil prices have dropped substantially during the year. The amortized cost and market values of our total energy holdings at December 31, 2015 were $497.5 million and $457.7 million, respectively, or 5.5% of our total cash and investments. Within our energy holdings, certain subsectors will benefit from lower crude oil prices while others will be negatively impacted. Our holdings in subsectors which may be negatively impacted, such as oil field services and independents, total 2.1% of total cash and investments. The majority of these holdings are investment grade; however, if oil and commodity prices remain at depressed levels for an extended period of time or decline further, certain issuers and investments may come under duress.
We view gross unrealized losses on fixed maturities and equity securities as temporary since it is our assessment that these securities will recover in the near term, allowing us to realize their anticipated long-term economic value. With respect to gross unrealized losses on fixed maturities, we do not intend to sell, nor is it more likely than not we will be required to sell, such debt securities before this expected recovery of amortized cost (See also “Liquidity and Capital Resources” in Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-K). With respect to equity securities, we have the intent and ability to retain such investments for the period of time anticipated to allow for this expected recovery in fair value. Inherent in our assessment are the risks that, subsequent to the balance sheet date, market factors may differ from our expectations; the global economic recovery is less robust than we expect or reverts to recessionary trends; stress in the commodities sectors, including oil and gas and metals and mining, may persist for an extended period of time; we may decide to subsequently sell a security for unforeseen business needs; or changes in the credit assessment or equity characteristics from our original assessment may lead us to determine that a sale at the current value would maximize recovery on such investments. To the extent that there are such adverse changes, an OTTI would be recognized as a realized loss. Although unrealized losses are not reflected in the results of financial operations until they are realized or deemed “other-than-temporary”, the fair value of the underlying investment, which does reflect the unrealized loss, is reflected in our Consolidated Balance Sheets.
The following table sets forth gross unrealized losses for fixed maturities by maturity period and for equity securities at December 31, 2015 and 2014. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties, or we may have the right to put or sell the obligations back to the issuers.
The carrying values of fixed maturity securities on non-accrual status at December 31, 2015 and 2014 were not material. The effects of non-accruals compared with amounts that would have been recognized in accordance with the original terms of the fixed maturities, were reductions in net investment income of $0.8 million, $2.1 million and $2.3 million for the years ended December 31, 2015, 2014 and 2013, respectively. Any defaults in the fixed maturities portfolio in future periods may negatively affect investment income.
Monetary policies in the developed economies, particularly in the United States, Europe and Japan, are supportive of moderate economic growth, while fiscal policies are more divergent and subject to change. In the United States, the Federal Reserve (the “Fed”) increased its target for the federal funds rate by 0.25% in December and is expected to continue to provide forward guidance to keep rates relatively stable even as the economy strengthens. The Fed has communicated that the timing of interest rate increases will depend on progress toward its goals of maximum employment and 2 percent inflation, which are expected over the medium term as the labor market improves. Geopolitical risks and equity market volatility can also impact the movement of U.S. Treasury interest rates.
Effective June 30, 2015, we transferred our U.K. motor business to an unaffiliated U.K.-based insurance provider which resulted in the recognition of a $40.6 million gain, net of tax. See also “Disposal of U.K. Motor Business” in Note 2 - "Dispositions of Businesses” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
In 2015, through several transactions, we repurchased senior debentures with a net carrying value of $90.2 million at a cost of $114.3 million, resulting in a loss of $24.1 million. In 2013, through several transactions, we repurchased senior debentures with a net carrying value of $73.8 million at a cost of $93.7 million, resulting in a loss of $19.9 million. Additionally in 2013, we repaid $46.3 million of our FHLBB advances plus prepayment fees of $7.8 million for a total payment of $54.1 million. In 2012, we repurchased $65.4 million of our subordinated unsecured notes related to Chaucer at a par value. These notes had a carrying value of $60.3 million, resulting in a net loss of $5.1 million on the repurchases. In addition, we repurchased $7.0 million of capital securities related to AIX at par value.
During 2014, we provided eligible former employees with a one-time choice of electing to receive a lump-sum settlement of their remaining qualified defined pension benefit. Including this voluntary lump-sum program, we settled $55.1 million of our pension obligations with an equal amount paid from plan assets. As a result, we recorded settlement losses of $10.8 million, reflecting the accelerated recognition of unamortized losses in the plan proportionate to the obligation that was settled. Additionally, we terminated a small qualified plan which also resulted in the accelerated recognition of unamortized losses of $1.3 million.
Operations are subject to risk resulting from interest rate fluctuations which may adversely impact the valuation of the investment portfolio. In a rising interest rate environment, the value of the fixed income sector, which comprises 84% of our investment portfolio, may decline as a result of decreases in the fair value of the securities. Our intent is to hold securities to maturity and recover the decline in valuation as prices accrete to par. However, our intent may change prior to maturity due to changes in the financial markets, our analysis of an issuer’s credit metrics and prospects, or as a result of changes in cash flow needs. Interest rate fluctuations may also reduce net investment income and as a result, profitability. The portfolio may realize lower yields and therefore lower net investment income on securities because the securities with prepayment and call features may prepay at a different rate than originally projected. Also, funds may not be available to invest at higher interest rates.
The following table illustrates the estimated impact on the fair value of our fixed maturity portfolio at December 31, 2015 of hypothetical changes in prevailing interest rates, defined as changes in interest rates on U.S. Treasury debt. It does not reflect changes in credit spreads, liquidity spreads and other factors that affect the value of securities. Since changes in prevailing interest rates are often accompanied by changes in these other factors, the reader should not assume that an actual change in interest rates would result in the values illustrated.
The majority of our assets are invested in the fixed income markets. Through fundamental research and credit analysis, with a focus on value investing, our investment professionals seek to identify a portfolio of stable income-producing higher quality U.S. government, foreign government, municipal, corporate, residential and commercial mortgage-backed securities and asset-backed securities. We have a general policy of diversifying investments both within and across major investment and industrial sectors to mitigate credit and interest rate risk. We monitor the credit quality of our investments and our exposure to individual markets, borrowers, industries, sectors and, in the case of commercial mortgage-backed securities and commercial mortgage loan participations, property types and geographic locations. In addition, we currently carry debt which is subject to interest rate risk, which was issued at fixed interest rates between 5.50% and 8.207%. Current market conditions, in light of our risk tolerance, restrict our ability to invest fixed income assets at similar rates of return; therefore, earnings on a similar level of assets are not sufficient to cover current debt interest costs.
Chaucer has exposure to foreign currency risk, most notably in insurance contracts and invested assets. Some of the insurance contracts provide that ultimate losses may be payable in foreign currencies depending on the country of original loss. Foreign currency exchange rate risk exists to the extent that there is an increase in the exchange rate of the foreign currency in which losses are ultimately owed. Thus, Chaucer attempts to manage foreign currency risk by seeking to match liabilities under insurance and reinsurance policies that are payable in foreign currencies with cash and investments that are denominated in such currencies. We may also utilize foreign currency forward contracts as part of our investment strategy. The principal currency creating foreign exchange risk for us is the U.K. pound sterling, and to a lesser extent, the Euro, Canadian dollar, Australian dollar and Swiss franc. A hypothetical 10% reduction in the value of foreign denominated investments would be expected to produce a loss in fair value of approximately $59 million at December 31, 2015 and approximately $102 million at December 31, 2014.
Discontinued operations primarily consist of our former life insurance businesses which were sold prior to 2009, and our discontinued accident and health business.
Discontinued operations for the years ended December 31, 2015, 2014 and 2013 resulted in gains of $0.7 million, losses of $0.3 million and gains of $5.3 million, respectively, net of tax. The 2013 benefit, associated with the Company’s former life insurance businesses, was primarily due to an insurance settlement related to a class action lawsuit.
We are subject to the tax laws and regulations of the U.S. and foreign countries in which we operate. We file a consolidated U.S. federal income tax return that includes the holding company and its U.S. subsidiaries. Generally, taxes are accrued at the U.S. statutory tax rate of 35% for income from the U.S. operations. Our primary non-U.S. jurisdiction is the U.K. In July 2012, the U.K. statutory rate decreased from 24% to 23% effective April 1, 2013. In July 2013, the U.K. statutory rate decreased from 23% to 21% effective April 1, 2014 and from 21% to 20% effective April 1, 2015. Further decreases were enacted in November 2015 to reduce the U.K. statutory tax rate from 20% to 19% effective April 1, 2017 and from 19% to 18% effective April 1, 2020. We accrue taxes on certain non-U.S. income that is subject to U.S. tax at the U.S. tax rate. Foreign tax credits, where available, are utilized to offset U.S. tax as permitted. Certain of our non-U.S. income is not subject to U.S. tax until repatriated. Foreign taxes on this non-U.S. income are accrued at the local foreign rate and do not have an accrual for U.S. deferred taxes since these earnings are intended to be indefinitely reinvested overseas.
The provision for income taxes from continuing operations was an expense of $108.6 million, $95.7 million and $83.4 million in 2015, 2014 and 2013, respectively. These amounts resulted in consolidated effective tax rates of 24.7%, 25.3% and 25.3% on pre-tax income for 2015, 2014 and 2013, respectively. These provisions reflect benefits related to tax planning strategies implemented in prior years of $13.3 million, $16.2 million and $17.5 million in 2015, 2014 and 2013, respectively. The provision for 2015 reflects a $15.6 million tax savings, net of a $1.7 million provision for uncertain tax positions, on the sale of the U.K. motor business. The sale of the U.K. motor business was structured as a tax free reorganization and is exempt from current U.S. and U.K. taxation under the business exemption and substantial shareholdings exemption rules, respectively. Since the proceeds from this transaction are expected to be indefinitely reinvested overseas, U.S. taxes have not been recognized. The provision for 2014 also included a benefit related to the reduction of a valuation allowance of $2.9 million, and a $6.9 million benefit related to foreign exchange loss deductions on our 2013 and 2014 U.S. tax returns. Absent these benefits, the provision for income taxes for 2015, 2014, and 2013 would have been expenses of $137.5 million or 31.3%, $121.7 million, or 32.2%, and $100.9 million, or 30.7%, respectively. The decrease in the 2015 effective tax rate is primarily due to an increase in our recognition of foreign tax credits for taxes paid in certain foreign jurisdictions. The increase in the 2014 effective tax rate is primarily due to a modest decrease in the proportion of our income from foreign operations not subject to U.S. taxes and thus taxed at the lower U.K. rate.
The income tax provision on operating income was an expense of $125.5 million, $108.3 million and $100.9 million for 2015, 2014 and 2013, respectively. These provisions resulted in effective tax rates for operating income of 30.9%, 31.8% and 30.8% in 2015, 2014 and 2013, respectively. The decrease in the 2015 effective tax rate is primarily due to the aforementioned increase in our recognition of foreign tax credits. The increase in the 2014 effective tax rate is primarily due to a modest decrease in the proportion of our income from foreign operations not subject to U.S. taxes and thus taxed at the lower U.K. rate.
As of December 31, 2015 and 2014, we determined our discount rate utilizing an independent yield curve which provides for a portfolio of high quality bonds that are expected to match the cash flows of our pension plan. Bond information used in the yield curve included only those rated Aa or better as of December 31, 2015 and 2014, respectively, and had been rated by at least two well-known rating agencies. At December 31, 2015, based upon our qualified plan liabilities and cash flows in relation to this discount curve, we increased our discount rate to 4.875%, from 4.375% at December 31, 2014.
Discount Rate - A 25 basis point increase in the discount rate would decrease our pension expense in 2016 by $1.3 million and decrease our projected benefit obligation by $10.6 million. A 25 basis point reduction in the discount rate would increase our pension expense by $1.3 million and increase our projected benefit obligation by $11.0 million.
Prior to 2002, Chaucer provided defined benefit pension retirement benefits to certain of its employees. As of December 31, 2001, the defined benefit section of the pension plan was closed to new members. The defined benefit obligation for this plan is based on the employees’ years of service and final pensionable salary.
Actuarial losses in 2015 resulting from lower than expected investment gains that were experienced during the year were partially offset by a slight increase from the change in the discount rate as compared to the prior year, resulting in net actuarial losses for the Chaucer plan of approximately $3.2 million. Actuarial losses in 2014 resulting from decreases in the discount rate from the prior year were partially offset by benefits from the investment gains experienced during the year, resulting in net actuarial losses for the Chaucer plan of approximately $5.9 million. These losses are reflected as decreases to our accumulated other comprehensive income in 2015 and 2014, respectively. This balance is amortized into earnings in future periods. Given the effect of our actual investment experience in 2015, expected rates of return on investments in 2016 and taking into consideration the increase in discount rates, pension related benefits for the Chaucer plan are expected to remain consistent with a benefit of $0.9 million in 2015 and a benefit of $1.0 million in 2016 (using the December 31, 2015 GBP to U.S. dollar conversion rate of 1.47).
Holding all other assumptions constant (using the December 31, 2015 GBP to U.S. dollar conversion rate of 1.47), sensitivity to changes in our key assumptions related to our Chaucer pension plan is as follows:
Discount Rate - A 25 basis point increase in the discount rate would decrease our pension expense in 2016 by $0.1 million and decrease our projected benefit obligation by $7.2 million. A 25 basis point reduction in the discount rate would increase our pension expense by $0.7 million and increase our projected benefit obligation by $7.7 million.
Expected Return on Plan Assets - A 25 basis point increase or decrease in the expected return on plan assets would decrease or increase our pension expense in 2015 by $0.3 million.
The following are the components of our deferred tax assets and liabilities as of December 31, 2015. There were no valuation allowances required as of December 31, 2015.
The statutory capital and surplus for our U.S. insurance subsidiaries increased $135.7 million during 2015, primarily due to operating results, partially offset by an increase in unrealized losses.
The NAIC prescribes an annual calculation regarding risk based capital (“RBC”). RBC ratios for regulatory purposes, as described in the glossary, are expressed as a percentage of the capital required to be above the Authorized Control Level (the “Regulatory Scale”); however, in the insurance industry, RBC ratios are widely expressed as a percentage of the Company Action Level. The following table reflects the Company Action Level, the Authorized Control Level and RBC ratios for Hanover Insurance (which includes Citizens and other U.S. insurance subsidiaries), as of December 31, 2015 and 2014, expressed both on the Industry Scale (Total Adjusted Capital divided by the Company Action Level) and Regulatory Scale (Total Adjusted Capital divided by Authorized Control Level):
Chaucer corporate members operate in the Lloyd’s market, which requires that these members deposit funds, referred to as “Funds at Lloyd’s”, to support their underwriting interests. Lloyd’s sets required capital annually for all participating syndicates based on each syndicate’s business plans, the rating and reserving environment, and discussions with regulatory and rating agencies. Although the minimum capital levels are set by Lloyd’s, it is the responsibility of Chaucer to continually monitor the risk profiles of its managed syndicates to ensure that the level of funding remains appropriate. Such capital is comprised of investments, undrawn letters of credit provided by various banks, and cash and cash equivalents.
We have the following securities, letters of credit and cash and cash equivalents pledged to Lloyd’s to satisfy these capital requirements at December 31, 2015. In 2015, we entered into a new letter of credit facility which enables a higher level of these assets to be used to satisfy these capital requirements (see also “Liquidity and Capital Resources” below). At December 31, 2015, we are in compliance with the capital requirements and expect to be able to meet these capital requirements in the future.
Dividend payments to the holding company by Chaucer are regulated by U.K. law. Dividends from Chaucer are dependent on dividends from its subsidiaries. Annual dividend payments from Chaucer are limited to retained earnings that are not restricted by capital and other requirements for business at Lloyd’s. Also, Chaucer must provide advance notice to the U.K.’s Prudential Regulation Authority (“PRA”) of certain proposed dividends or other payments from PRA regulated entities. Chaucer paid $61.3 million, $68.7 million and $13.9 million in dividends during 2015, 2014 and 2013, respectively, to the holding company.
Net cash provided by operating activities was $438.4 million during 2015, as compared to $564.7 million in 2014 and $383.9 million in 2013. The $126.3 million change in 2015 compared to 2014 was primarily due to higher federal income tax payments resulting from increased earnings, the timing of reinsurance payments and slightly lower premium collections during 2015. These decreases were partially offset by lower claims payments. The $180.8 million change in 2014 compared to 2013 primarily resulted from increased premium collections during 2014, partially offset by a slight increase in claims payments. Additionally, in 2013 we made a payment related to the settlement of our life insurance postretirement benefit obligation which did not recur in 2014.
Net cash used in financing activities was $294.7 million during 2015, as compared to $71.7 million during 2014 and $105.5 million in 2013. During 2015, cash used in financing activities primarily resulted from repurchases of common stock, repayments of debt and dividend payments to shareholders. During 2014, cash used in financing activities primarily resulted from the payment of dividends to shareholders and the repurchase of common stock, partially offset by cash inflows related to the exercise of employee stock options. During 2013, cash used in financing activities primarily resulted from the repayment of approximately $121 million of debt, repurchases of common stock and the payment of dividends to shareholders, partially offset by the proceeds from the issuance, on March 20, 2013, of $175.0 million of unsecured subordinated debentures.
At December 31, 2015, THG, as a holding company, held approximately $129.9 million of fixed maturities and cash. We believe our holding company assets will be sufficient to meet our 2016 obligations, which consist primarily of dividends to our shareholders (as and to the extent declared), the interest on our senior and subordinated debentures, certain costs associated with benefits due to our former life employees and agents, and, to the extent required, payments related to indemnification of liabilities associated with the sale of various subsidiaries. As discussed below, we have, and opportunistically may continue to, repurchase our common stock and debt. We may decide to provide funds to the holding company for these or other opportunities through dividends or short-term intercompany lending arrangements.
In March 2013, we issued $175 million aggregate principal amount of subordinated unsecured debentures due March 30, 2053. These subordinated debentures pay interest quarterly. We may redeem these subordinated debentures in whole at any time, or in part from time to time, on or after March 30, 2018, at a redemption price equal to their principal amount plus accrued and unpaid interest.
We have a $200.0 million credit agreement which expires in November 2018, with an option to increase the facility to $300.0 million assuming no default and satisfaction of certain other conditions. The agreement also includes a $50 million sub-facility for standby letters of credit that can be used for general corporate purposes. Borrowings, if any, under the agreement are unsecured and incur interest at a rate per annum equal to, the higher of (a) the prime commercial lending rate of the administrative agent, (b) the Federal Funds Rate plus half of a percent, or (c) the one month Adjusted LIBOR plus one percent and any applicable margin. The agreement contains financial covenants including, but not limited to, maintaining at least a certain level of consolidated equity, maximum consolidated leverage ratios and requires certain of our subsidiaries to maintain a minimum RBC ratio. We had no borrowings under this agreement during 2015, 2014 and 2013.
Membership in the FHLBB provides us with access to additional liquidity based on our stock holdings and pledged collateral. At December 31, 2015, we had additional borrowing capacity of $34.9 million. There were no borrowings outstanding under this agreement at December 31, 2015; however, we have and may continue, from time to time, to borrow through this facility to provide short term liquidity.
The Facility agreement is subject to a letter of credit commission fee on outstanding letters of credit, which is payable quarterly. The Facility Agreement fee ranges from 1.125% to 1.50% per annum, depending on our credit ratings for portions that are not cash collateralized, and 0.275% per annum for portions that are cash collateralized, whereas the Prior Facility Agreement fee ranged from 1.375% to 1.75% per annum, also dependent on our credit ratings for portions that were not cash collateralized, and 0.275% per annum for portions that were cash collateralized. We may, from time to time, collateralize a portion of the outstanding letter of credit. In addition to the commission fee on the uncollateralized outstanding letter of credit, a commitment fee in respect of the unutilized commitments under the Facility Agreement is payable quarterly, and ranges from 0.394% to 0.525% per annum, depending on our credit ratings. Unutilized commitment fees for the Prior Facility Agreement were also payable quarterly, and ranged from 0.55% to 0.70% per annum, depending on our credit ratings. Chaucer is also required to pay customary agency fees. We paid $3.7 million and $4.1 million in interest costs in 2015 and 2014, respectively.
Simultaneous with the Facility Agreement, we entered into a Guaranty Agreement (the “Guaranty Agreement”) with Lloyds Bank plc, as Facility Agent and Security Agent, pursuant to which, we unconditionally guarantee the obligations of Chaucer under the Facility Agreement. The Guaranty Agreement contains certain financial covenants that require us to maintain a minimum net worth, a minimum risk-based capital ratio at our primary U.S. domiciled property and casualty companies and a maximum leverage ratio, and certain negative covenants that limit our ability, among other things, to incur or assume certain debt, grant liens on our property, merge or consolidate, dispose of assets, materially change the nature or conduct of our business and make restricted payments (except, in each case, as provided by certain exceptions). The Guaranty Agreement also contains certain customary representations and warranties. The current Guaranty Agreement contains terms and conditions substantially similar to the previous guaranty agreement we had in place with Lloyds Bank plc in connection with Chaucer’s previous Facility Agreement. The Guaranty Agreement replaced the prior guaranty agreement upon effectiveness of the Facility Agreement on October 15, 2015.
At December 31, 2015, we were in compliance with the covenants of our debt and credit agreements.
Reflects funding associated with the Chaucer plan based upon its current funded status and estimated additional funding required to support future salary increases through 2025. We do not expect to make any significant contributions to our U.S. qualified plan in order to meet our minimum funding requirements. However, additional contributions may be required in the future to both plans based on the level of pension assets and liabilities in future periods.
Non-qualified defined benefit pension and postretirement benefit obligations reflect estimated payments to be made through plan year 2025 for pension, postretirement and postemployment benefits. Estimates of these payments and the payment patterns are based upon historical experience.
Account rounding - The conversion of single policy customers to accounts with multiple policies and/or additional coverages.
Exposure management actions - Actions that focus on improving underwriting profitability and/or lessening earnings volatility by reducing our exposures and property concentrations in certain geographies and lines that are more prone to both catastrophe and non-catastrophe losses. These actions include, but are not limited to, non-renewal, rate increases, stricter underwriting standards and higher deductible utilization, agency management actions, and more selective portfolio management by modifying our business mix.
Loss ratio - The ratio of losses to premiums earned for a given period.
Risk based capital (“RBC”) - A method of measuring the minimum amount of capital appropriate for an insurance company to support its overall business operations in consideration of its size and risk profile. The RBC ratio for regulatory purposes is calculated as total adjusted capital divided by required risk based capital. Total adjusted capital for property and casualty companies is capital and surplus, adjusted for the non-tabular reserve discount applicable to our assumed discontinued accident and health insurance business. The Company Action Level is the first level at which regulatory involvement is specified based upon the level of capital.
Solvency II - European Commission-led fundamental review of the capital adequacy regime for the European insurance industry.
Written premium - The premium assessed for the entire coverage period of an insurance policy or contract without regard to how much of the premium has been earned. See also earned premium. Net written premium is written premium net of reinsurance.
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of The Hanover Insurance Group, Inc. and its subsidiaries at December 31, 2015 and December 31, 2014, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2015 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
In 2013, the Company consolidated its operations in Howell, Michigan from two buildings into one building. This resulted in a plan to relocate the employees and pursue the sale of one of the buildings. During the fourth quarter of 2014 the building was sold. In 2013, the Company recognized a loss of $4.7 million in conjunction with the plan to dispose of the building. This was included in other operating expenses in the Consolidated Statements of Income during that year.
In accordance with the provisions of ASC 350, Intangibles- Goodwill and Other (“ASC 350”), the Company carries its goodwill at cost, net of amortization prior to January 1, 2002 and net of impairments. Increases to goodwill are generated through acquisition and represent the excess of the cost of an acquisition over the fair value of net assets acquired, including any intangibles acquired. Since January 1, 2002, goodwill is no longer amortized but rather, is reviewed for impairment. Additionally, acquisitions can also produce intangible assets, which have either a definite or indefinite life. Intangible assets with definite lives are amortized over that life, whereas those intangible assets determined to have an indefinite life are reviewed at least annually for impairment.
The Company tests for the recoverability of goodwill and intangible assets with indefinite lives annually or whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. The Company recognizes impairment losses only to the extent that the carrying amounts of reporting units with goodwill exceed the fair value. The amount of the impairment loss that is recognized is determined based upon the excess of the carrying value of goodwill compared to the implied fair value of the goodwill, as determined with respect to all assets and liabilities of the reporting unit. The Company has performed its annual review of goodwill and intangible assets with indefinite lives for impairment in the fourth quarters of 2015 and 2014 with no impairments recognized. At December 31, 2015 and 2014, Chaucer held intangible assets with indefinite lives of $56.2 million and $76.5 million, respectively, which represents approximately 74% and 80% of the Company’s balance, respectively. In addition, at December 31, 2015 and 2014, goodwill held by Chaucer was $7.2 million and $5.8 million, respectively. The remaining balance relates to the U.S. Companies. The changes in the value of intangible assets with indefinite lives from December 31, 2014 were primarily the result of the disposition of the U.K. motor business on June 30, 2015.
The Company is subject to the tax laws and regulations of the U.S. and foreign countries in which it operates. The Company files a consolidated U.S. federal income tax return that includes the holding company and its U.S. subsidiaries. Generally, taxes are accrued at the U.S. statutory tax rate of 35% for income from the U.S. operations. The Company’s primary non-U.S. jurisdiction is the United Kingdom (“U.K.”). In July 2012, the U.K. statutory rate decreased from 24% to 23% effective April 1, 2013. In July 2013, the U.K. statutory rate decreased from 23% to 21% effective April 1, 2014 and from 21% to 20% effective April 1, 2015. Further decreases were enacted in November 2015 to reduce the U.K. statutory tax rate from 20% to 19% effective April 1, 2017 and from 19% to 18% effective April 1, 2020. The Company accrues taxes on certain non-U.S. income that is subject to U.S. tax at the U.S. tax rate. Foreign tax credits, where available, are utilized to offset U.S. tax as permitted. Certain non-U.S. income of the Company is not subject to U.S. tax until repatriated. Foreign taxes on this non-U.S. income are accrued at the local foreign rate and do not have an accrual for U.S. deferred taxes since these earnings are intended to be indefinitely reinvested overseas.
Deferred income taxes are generally recognized when assets and liabilities have different values for financial statement and tax reporting purposes, and for other temporary taxable and deductible differences as defined by ASC 740, Income Taxes (“ASC 740”). These temporary differences are measured at the balance sheet date using enacted tax rates expected to apply to taxable income in the years the temporary differences are expected to reverse. These differences result primarily from insurance reserves, deferred acquisition costs, tax credit carryforwards, employee benefit plans and deferred Lloyd’s underwriting income.
Earnings per share (“EPS”) for the years ended December 31, 2015, 2014 and 2013 is based on a weighted average of the number of shares outstanding during each year. Basic and diluted EPS is computed by dividing income available to common stockholders by the weighted average number of shares outstanding for the period. The weighted average shares outstanding used to calculate basic EPS differ from the weighted average shares outstanding used in the calculation of diluted EPS due to the effect of dilutive employee stock options, nonvested stock grants and other contingently issuable shares. If the effect of such items is antidilutive, the weighted average shares outstanding used to calculate diluted EPS are equal to those used to calculate basic EPS.
The Company manages its exposure to foreign currency risk primarily by matching assets and liabilities denominated in the same currency. To the extent that assets and liabilities in foreign currencies are not matched, the Company is exposed to foreign currency risk. For functional currencies, the related exchange rate fluctuations are reflected in other comprehensive income (loss). The Company translated Chaucer’s balance sheet at December 31, 2015 and 2014 from GBP to U.S. dollars using a conversion rate of 1.47 and 1.56, respectively. The Company recognized $12.3 million in foreign currency transaction gains in the Consolidated Statements of Income during the year ended December 31, 2015, and $4.2 million for both of the years ended December 31, 2014 and 2013.
In May 2015, the FASB issued ASC Update No. 2015-09, (Topic 944) Financial Services- Insurance: Disclosures about Short-Duration Contracts. This ASC update requires several additional disclosures regarding short-duration insurance contracts, including; disaggregated incurred and paid claims development information, quantitative and qualitative information about claim frequency and duration, and the sum of incurred but not reported liabilities plus expected development on reported claims included in the liability for unpaid claims and claim adjustment expenses along with a description of reserving methodologies. This information is required to be presented by accident year, for the number of years for which claims typically remain outstanding, but need not exceed 10 years. A reconciliation of the claims development disclosures to the aggregate carrying amount of the liability for unpaid claims and claim adjustment expenses, including a separate disclosure for reinsurance recoverables is also required for each period presented in the statement of financial position. In addition, this ASC requires insurance entities to disclose information about significant changes in methodologies and assumptions used to calculate the liability for unpaid claims and claim adjustment expenses, including reasons for the change and the effects on the financial statements. The updated guidance is effective for annual periods beginning after December 15, 2015, and interim periods within annual periods beginning after December 15, 2016. Early adoption is permitted. The Company does not expect the adoption of ASC Update 2015-09 to have a material impact on its financial position or results of operations, as the update is disclosure related.
Effective June 30, 2015, the Company transferred its U.K. motor business to an unaffiliated U.K.-based insurance provider. The transaction was executed through a 100 percent reinsurance arrangement for prior claim liabilities and in-force policies written by this division and the sale of two entities associated with this business. Total consideration from the sale of the Chaucer subsidiaries was $64.9 million and the transaction resulted in a net gain of $40.6 million.
Discontinued operations primarily consist of the Company’s former life insurance businesses, which were sold prior to 2009, and its discontinued accident and health business.
Our former life insurance businesses include indemnity obligations for which we have established reserves.
At December 31, 2015 and 2014, the portion of the discontinued accident and health business that was directly assumed had assets of $54.5 million and $65.2 million, respectively, consisting primarily of invested assets, and liabilities of $46.5 million and $49.7 million, respectively, consisting primarily of policy liabilities. At December 31, 2015 and 2014, the assets and liabilities of this business, as well as those of the reinsured portion of the accident and health business are classified as assets and liabilities of discontinued operations in the Consolidated Balance Sheets.
OTTI unrealized losses in the tables above represent OTTI recognized in accumulated other comprehensive income. This amount excludes net unrealized gains on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date of $1.1 million and $12.3 million as of December 31, 2015 and 2014, respectively.
At December 31, 2015 and 2014, fixed maturities with fair values of $217.4 million and $211.2 million, respectively, and amortized cost of $206.5 million and $196.4 million, respectively, were on deposit with various state and governmental authorities.
The following tables provide information about the Company’s fixed maturities and equity securities that were in an unrealized loss position at December 31, 2015 and 2014 including the length of time the securities have been in an unrealized loss position:
The Company views gross unrealized losses on fixed maturities and equity securities as being temporary since it is its assessment that these securities will recover in the near term, allowing the Company to realize the anticipated long-term economic value. The Company employs a systematic methodology to evaluate declines in fair value below amortized cost for fixed maturity securities or cost for equity securities. In determining OTTI of fixed maturity and equity securities, the Company evaluates several factors and circumstances, including the issuer’s overall financial condition; the issuer’s credit and financial strength ratings; the issuer’s financial performance, including earnings trends, dividend payments and asset quality; any specific events which may influence the operations of the issuer; the general outlook for market conditions in the industry or geographic region in which the issuer operates; and the length of time and the degree to which the fair value of an issuer’s securities remains below the Company’s cost. With respect to fixed maturity investments, the Company considers any factors that might raise doubt about the issuer’s ability to make contractual payments as they come due and whether the Company expects to recover the entire amortized cost basis of the security. With respect to equity securities, the Company considers its ability and intent to hold the investment for a period of time to allow for a recovery in value.
The Company’s mortgage participations and other mortgage loans were $200.9 million and $94.9 million at December 31, 2015 and 2014, respectively. Participating interests in commercial mortgage loans are originated and serviced by a third party. For these investments, the Company shares, on a pro-rata basis, in all related cash flows of the underlying mortgages. Mortgage participations and other mortgage loans were comprised of the following property types and geographic locations.
Included in the net realized investment gains (losses) were OTTI of investment securities recognized in earnings totaling $26.8 million, $5.5 million and $6.0 million in 2015, 2014 and 2013, respectively.
For 2015, total OTTI was $49.5 million. Of this amount, $26.8 million was recognized in earnings and the remaining $22.7 million was recorded as unrealized losses in accumulated other comprehensive income (“AOCI”). The $26.8 million of OTTI recognized in earnings relates to $16.0 million of credit impairments, $4.0 million of fixed maturity securities that the Company intended to sell and $6.8 million of equities.
There were no credit impairments in 2014. The methodology and significant inputs used to measure the amount of credit losses on fixed maturities in 2015 and 2013 were as follows:
Corporate fixed maturities - overall credit quality, including assessments of the level and variability of: economic sensitivity; liquidity; corporate financial policies; management quality; regulatory environment; competitive position; ownership; restrictive covenants; and security or collateral.
The Company holds privately placed fixed maturity securities and certain other fixed maturity securities that do not have an active market and for which the pricing service cannot provide fair values. The Company determines fair values for these securities using either matrix pricing utilizing the market approach or broker quotes. The Company will use observable market data as inputs into the fair value applications, as discussed in the determination of Level 2 fair values, to the extent it is available, but is also required to use a certain amount of unobservable judgment due to the illiquid nature of the securities involved. Unobservable judgment reflected in the Company’s matrix model accounts for estimates of additional spread required by market participants for factors such as issue size, structural complexity, high bond coupon or other unique features. These matrix-priced securities are reported as Level 2 or Level 3, depending on the significance of the impact of unobservable judgment on the security’s value. Additionally, the Company may obtain non-binding broker quotes which are reported as Level 3.
The Company utilizes a third party pricing service for the valuation of the majority of its equity securities and receives one quote for each equity security. When quoted market prices in an active market are available, they are provided by the pricing service as the fair value and such values are classified as Level 1. The Company holds certain equity securities that have been issued by privately-held entities that do not have an active market and for which the pricing service cannot provide fair values. Generally, the Company estimates fair value for these securities based on the issuer’s book value and market multiples. These securities are reported as Level 2 or Level 3 depending on the significance of the impact of unobservable judgment on the security’s value. Additionally, the Company may obtain non-binding broker quotes which are reported as Level 3.
During the years ended December 31, 2015 and 2014, the Company transferred fixed maturities between Level 2 and Level 3 primarily as a result of assessing the significance of unobservable inputs on the fair value measurement. There were no transfers between Level 1 and Level 2 during 2015 or 2014. There were no Level 3 liabilities held by the Company for years ended December 31, 2015 and 2014.
In 2013, the Company repurchased senior debentures maturing October 15, 2025, with a carrying value of $39.2 million at a cost of $50.5 million, resulting in a loss of $11.3 million. Also in 2013, the Company repurchased senior debentures maturing March 1, 2020, with a carrying value of $34.6 million at a cost of $43.2 million, resulting in a loss of $8.6 million.
As collateral to FHLBB, Hanover Insurance pledged government agency securities with a fair value of $176.0 million and $195.7 million, for the aggregate borrowings of $125.0 million as of December 31, 2015 and December 31, 2014, respectively. The fair value of the collateral pledged must be maintained at certain specified levels of the borrowed amount, which can vary depending on the type of assets pledged. If the fair value of this collateral declines below these specified levels, Hanover Insurance would be required to pledge additional collateral or repay outstanding borrowings. Hanover Insurance is permitted to voluntarily repay the outstanding borrowings at any time, subject to a repayment fee. As a requirement of membership in the FHLBB, Hanover Insurance maintains a certain level of investment in FHLBB stock. Total holdings of FHLBB stock were $8.9 million and $9.3 million at December 31, 2015 and 2014, respectively.
At December 31, 2015, the Company had a $200.0 million credit agreement which expires in November 2018. The Company had no borrowings under this agreement. Additionally, the Company had a Standby Letter of Credit Facility not to exceed £170.0 million (or $250.6 million). This Letter of Credit Facility provides regulatory capital supporting Chaucer’s underwriting activities for the 2015, 2016 and 2017 years of account and each prior open year of account. Simultaneous with this agreement, THG entered into a Guaranty Agreement with Lloyds Bank plc, as Facility Agent and Security Agent, pursuant to which, THG unconditionally guarantees the obligations of Chaucer under the Letter of Credit Facility.
The Company’s deferred tax asset as of December 31, 2015 included assets of $68.8 million related to alternative minimum tax credit carryforwards and $1.7 million related to foreign tax credit carryforwards. The alternative minimum tax credit carryforwards have no expiration date and the foreign tax credit carryforwards will expire beginning in 2022. The Company has utilized in 2015 and may continue to utilize the credits to offset regular federal income taxes due from future income, and although the Company believes that these assets are fully recoverable, there can be no certainty that future events will not affect their recoverability. The Company believes, based on objective evidence, it is more likely than not that the remaining deferred tax assets will be realized.
Included in the Company’s deferred tax asset as of December 31, 2014 was an asset of $29.1 million related to operating loss carryforwards. This operating loss carryforward was generated in the U.K. and was used to offset income generated in 2015.
In prior years, the Company completed several transactions which resulted in the realization, for tax purposes only, of unrealized gains in its investment portfolio. As a result of these transactions, the Company was able to realize capital losses carried forward and to release the valuation allowance recorded against the deferred tax asset related to these losses. The releases of valuation allowances were recorded as a benefit in accumulated other comprehensive income. Previously unrealized benefits of $13.3 million, $16.2 million and $17.5 million attributable to non-operating income, are recognized as part of income from continuing operations during 2015, 2014 and 2013, respectively. The remaining amount of $78.2 million in accumulated other comprehensive income will be released into income from continuing operations in future years, as the investment securities subject to these transactions are sold or mature.
Although most of the Company’s non - U.S. income is subject to U.S. federal income tax, certain of its non-U.S. income is not subject to U.S. federal income tax until repatriated. Foreign taxes on this non - U.S. income are accrued at the local foreign tax rate, as opposed to the higher U.S. statutory tax rate, since these earnings currently are expected to be indefinitely reinvested overseas. This assumption could change, as a result of a sale of the subsidiaries, the receipt of dividends from the subsidiaries, a change in management’s intentions, or as a result of various other events. The Company has not made a provision for U.S. taxes on $69.8 million, $23.3 million and $20.3 million of non-U.S. income for 2015, 2014 and 2013, respectively. However, in the future, if such earnings were distributed to the Company, taxes of $45.6 million would be payable on the accumulated undistributed earnings and would be reflected in the tax provision for the year in which these earnings are no longer intended to be indefinitely reinvested overseas, assuming all foreign tax credits are realized.
The Company recognizes interest and penalties related to unrecognized tax benefits in federal income tax expense. The Company had accrued interest of $0.6 million and $0.5 million as of December 31, 2015 and 2014, respectively. For the years ended December 31, 2015, 2014 and 2013 the Company recognized interest expense of $0.1 million, $0.5 million and $0.8 million, respectively. The Company has not recognized any penalties associated with unrecognized tax benefits.
In 2016, the Company is expecting to release $0.7 million of liability due to the expiration of a statute of limitations.
The Company or its subsidiaries files income tax returns in the U.S. federal jurisdiction and various state jurisdictions, as well as foreign jurisdictions. The Company and its subsidiaries are subject to U.S. federal income tax examinations by tax authorities for years after 2011, U.S. state income tax examinations for years after 2011 and foreign examinations for years after 2011.
As of January 1, 2005, the defined benefit pension plans were frozen and since that date, no further cash balance allocations have been credited to participants. Participants’ accounts are credited with interest daily, based upon the General Agreement of Trades and Tariffs rate (the 30-year Treasury Bond interest rate). In addition, the grandfathered benefits for the transition group were also frozen at January 1, 2005 levels with an annual transition pension adjustment calculated at an interest rate equal to 5% per year up to 35 years of completed service, and 3% thereafter. As of December 31, 2015, based on current estimates of plan liabilities and other assumptions, the projected benefit obligation of the qualified defined benefit pension plan exceeds plan assets by approximately $28 million.
The Company utilizes a target allocation strategy, which focuses on creating a mix of assets that will generate modest growth from equity securities while minimizing volatility in the Company’s earnings from changes in the markets and economic environment. Various factors are taken into consideration in determining the appropriate asset mix, such as census data, actuarial valuation information and capital market assumptions. During 2015 and 2014, the plan assets were invested 85% in fixed income securities and 15% in equity securities. The Company reviews and updates, at least annually, the target allocation and makes changes periodically.
The investment strategy of the Chaucer defined benefit pension plan is to invest primarily in growth assets in the form of equity funds which are expected to provide a positive return that exceeds inflation over the longer term in order to protect the existing and future liabilities of the pension plan. In order to reduce volatility and diversify the portfolio, the target allocation includes an exposure to corporate bond and commercial property funds. This allocation plan is reviewed annually and target allocation changes are made as appropriate.
Included in total plan assets of $123.5 million at December 31, 2015 were $122.9 million of invested assets carried at fair value and $0.6 million of cash and equivalents. Total plan assets at December 31, 2014 of $131.8 million included $130.3 million of invested assets carried at fair value and $1.5 million of cash and equivalents.
The following table presents for each hierarchy level the Chaucer defined benefit plan’s investment assets that are measured at fair value at December 31, 2015 and 2014.
Real estate fund investments classified as Level 3 at December 31, 2015 and 2014 are valued based upon the values of the net assets of the fund. Although the NAV is calculated daily, transactions also consider cash inflows and outflows of the fund. The price where units are transacted includes the NAV, which is adjusted for investment charges and other estimated acquisition costs such as legal fees, taxes, planning and architect fees, survey and agent fees, among others.
Contributions include $0.3 and $0.4 million of Chaucer employee contributions during 2015 and 2014, respectively. All other contributions for all plans were made by the Company.
During 2015, the Company transferred its U.K. motor business (See also “Disposal of U.K. Motor Business” in Note 2 - Dispositions). As a result of this transaction participants of the Chaucer plan who worked in this line also transferred to the unaffiliated U.K.-based insurance provider. Accordingly, they no longer are active participants of this plan and the liability was reduced resulting in a $1.8 million curtailment gain. An equal and offsetting expense was included in recognized net actuarial losses in the above table.
In accordance with ERISA guidelines, the Company is not required to fund its U.S. qualified benefit plan in 2016. The Company expects to contribute $3.2 million to its U.S. non-qualified pension plan to fund 2016 benefit payments and $0.7 million to the Chaucer pension plan. At this time, no additional discretionary contributions are expected to be made to the plans during 2016 and the Company does not expect that any funds will be returned from the plans to the Company during 2016.
The benefit payments are based on the same assumptions used to measure the Company’s benefit obligations at the end of 2015. Benefit payments related to the U.S. qualified plan and the Chaucer plan will be made from plan assets held in trusts and not included with Company assets, whereas those payments related to the non-qualified plan will be provided for by the Company. Expected benefits related to the Chaucer pension plan were converted to U.S. dollars at an exchange rate of 1.47.
The components of net periodic postretirement expense (benefit) were as follows:
The following table reflects the estimated amortization to be recognized in net periodic benefit cost in 2016:
Compensation cost for the years ended December 31, 2015, 2014, and 2013 totaled $12.3 million, $15.1 million and $12.4 million, respectively. Related tax benefits were $4.3 million, $5.3 million and $4.3 million, respectively.
Cash received for options exercised for the years ended December 31, 2015, 2014 and 2013 was $15.9 million, $10.9 million and $24.4 million, respectively. The intrinsic value of options exercised for the years ended December 31, 2015, 2014 and 2013 was $38.7 million, $10.6 million and $19.9 million, respectively.
The fair value of each option is estimated on the date of grant using the Black-Scholes option pricing model. For all options granted through December 31, 2015, the exercise price equaled the market price on the grant date. Compensation cost related to options is based upon the grant date fair value and expensed on a straight-line basis over the service period for each separately vesting portion of the option as if the option was, in substance, multiple awards.
The weighted average grant date fair value of options granted during the years ended December 31, 2015, 2014 and 2013 was $9.72, $8.96 and $7.69, respectively.
The fair value of shares that vested during the years ended December 31, 2015 and 2014 was $20.4 million and $7.8 million, respectively. As of December 31, 2015, the Company had unrecognized compensation expense of $3.7 million related to unvested stock options that is expected to be recognized over a weighted average period of 1.8 years.
The Company granted market-based restricted share units in 2015, 2014, 2013 and 2012. Share units granted in 2015, 2014 and 2013 generally vest after 3 years of continued employment and after the achievement of certain stock performance targets and share units granted in 2012 vest after the achievement of certain performance targets at a rate of 50% after 3 years and the remaining 50% after 4 years of continued employment. The Company also granted restricted stock units to eligible employees in 2015, 2014 and 2013 that generally vest after 3 years of continued employment. For those restricted stock units granted in 2012, vesting is at a rate of 50% after 3 years and the remaining 50% after 4 years of continued employment.
Included in outstanding shares at the end of 2015 were 56,500 market-based restricted stock units that were previously granted to the Company’s CEO. These units are no longer expected to vest as a result of the announcement, in 2015, of the CEO’s retirement from the Company in 2016. The Company is no longer expensing these restricted stock units.
In 2015, 2014 and 2013, the Company granted market-based awards totaling 80,738, 56,625, and 76,175, respectively, to certain members of senior management, which are included in the table above as performance and market-based restricted stock activity. The vesting of these stock units is based on the relative total shareholder return (“TSR”) of the Company. This metric is generally based on relative TSR for a three year period as compared to a Property and Casualty Index of peer companies. The fair value of market based awards was estimated at the date of grant using a valuation model. These units have the potential to range from 0% to 150% of the shares disclosed. Included in the amount granted above were 38,713 shares related to market-based awards that achieved a payout in excess of 100%, with 20,275 shares vesting in 2015 and the remaining 18,438 shares vesting in the first quarter of 2016 provided that the participant remains employed by the Company during the vesting period. Also included in the amounts granted above for the performance-based restricted stock units were 1,287 shares related to awards that a performance metric in excess of 100% was achieved. These awards vested in 2015.
Performance-based restricted stock units are based upon the achievement of the performance metric at 100%. These units have the potential to range from 0% to 200% of the shares disclosed, which varies based on grant year and individual participation level. Increases above the 100% target level are reflected as granted in the period in which performance-based stock unit goals are achieved. Decreases below the 100% target level are reflected as forfeited.
The intrinsic value of restricted stock and restricted stock units that vested during the years ended December 31, 2015, 2014 and 2013 was $4.4 million, $4.2 million and $1.8 million, respectively. The intrinsic value for performance-based restricted stock units that vested in 2015 and 2014 was $2.6 million and $0.3 million, respectively. For performance-based restricted stock units that would have vested in 2013, there was no intrinsic value since these awards were forfeited due to the aforementioned completion levels of less than threshold. Forfeitures in 2015 and 2014 related to the above mentioned market-based restricted stock units.
At December 31, 2015, the aggregate intrinsic value of restricted stock and restricted stock units was $24.6 million and the weighted average remaining contractual life was 1.0 years. The aggregate intrinsic value of performance and market-based restricted stock units was $16.0 million and the weighted average remaining contractual life was 0.8 years. As of December 31, 2015, there was $8.1 million of total unrecognized compensation cost related to unvested restricted stock units and performance and market-based restricted stock units, assuming performance and market-based restricted stock units are achieved at 100% of the performance metric. The cost is expected to be recognized over a weighted average period of 1.6 years. Compensation cost associated with restricted stock, restricted stock units and performance and market-based restricted stock units is generally calculated based upon grant date fair value, which is determined using current market prices.
The Company’s Board of Directors has authorized aggregate repurchases of the Company’s common stock of up to $900 million, including the $300 million increase in the program authorized on October 28, 2015. As of December 31, 2015, the Company has $289.2 million available for repurchases under these repurchase authorizations. Repurchases may be executed using open market purchases, privately negotiated transactions, accelerated repurchase programs or other transactions. The Company is not required to purchase any specific number of shares or to make purchases by any certain date under this program. During 2015, the Company purchased 1.6 million shares of the Company’s common stock at a cost of $127.3 million.
Pursuant to New Hampshire’s statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the New Hampshire Insurance Commissioner, is limited to 10% of such insurer’s statutory policyholder surplus as of the preceding December 31. No dividends were declared by Hanover Insurance in 2015, 2014 or 2013. During 2016, the maximum dividend payable without prior approval is $218.8 million.
Pursuant to Michigan’s statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the Michigan Insurance Commissioner, is limited to the greater of 10% of policyholders’ surplus as of December 31 of the immediately preceding year or the statutory net income less net realized gains, for the immediately preceding calendar year. Citizens declared dividends to its parent, Hanover Insurance, totaling $63.0 million, $66.0 million and $68.0 million in 2015, 2014 and 2013, respectively. During 2016, the maximum dividend payable without prior approval is $33.4 million. In December 2016, the maximum dividend payable without prior approval will increase by $63.0 million to a total amount of $96.4 million.
The following table presents the Company’s gross premiums written (“GPW”) based on the location of the risk:
Long-lived assets located outside the U.S. were not material for the years ended December 31, 2015 or 2014. The Company does not have revenue from transactions with a single agent or broker amounting to 10 percent or more of its consolidated revenue.
Rental expenses for operating leases amounted to $17.4 million, $20.4 million and $21.6 million in 2015, 2014 and 2013, respectively. These expenses relate primarily to building leases of the Company. At December 31, 2015, future minimum rental payments under non-cancelable operating leases were $57.1 million, payable as follows: 2016 - $16.4 million; 2017 - $13.9 million; 2018 - $10.9 million; 2019 - $7.9 million and 2020 and thereafter - $8.0 million. It is expected that in the normal course of business, leases that expire may be renewed or replaced by leases on other property and equipment.
The $99.1 million favorable loss and LAE reserve development during the year ended December 31, 2014 included favorable loss and LAE reserve development of $104.6 million for Chaucer. Chaucer’s favorable development during 2014 was primarily the result of lower than expected losses in the marine and aviation lines of $40.1 million, primarily in the 2011 through 2013 accident years. Additionally, Chaucer experienced lower than expected losses within casualty and other lines, specifically the specialty liability lines of $21.4 million, primarily in the 2010 and 2013 accident years and $21.5 million in the property line, primarily in the 2010 through 2013 accident years. Chaucer’s favorable development was also partially attributable to the favorable impact of foreign exchange rate movements on prior years’ loss reserves. For Commercial and Personal Lines, the unfavorable loss and LAE development during 2014 was primarily the result of higher than expected large losses within the commercial automobile coverages of $23.1 million, which includes the AIX program business, primarily related to liability coverage in the 2009 through 2012 accident years. Partially offsetting the unfavorable development was lower than expected losses within the personal automobile line, primarily related to the 2013 accident year, workers’ compensation line, primarily related to the 2007 through 2012 accident years, and commercial multiple peril line, primarily related to the 2012 and 2013 accident years.
The Company’s U.S. insurance subsidiaries are required to file annual statements with state regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis), as codified by the National Association of Insurance Commissioners. Permitted statutory accounting practices encompass all accounting practices that are not prescribed; such practices differ from state to state, may differ from company to company within a state, and may change in the future. The Company’s U.S. insurance subsidiaries did not have any permitted practices as of or for the years ended December 31, 2015, 2014 and 2013.
The minimum statutory capital and surplus necessary to satisfy the Company’s regulatory requirements was $378.5 million, $374.6 million and $354.5 million, which equals the Authorized Control Level at December 31, 2015, 2014 and 2013, respectively.