The Company, through its subsidiaries, owns an investment portfolio of income-producing properties and real estate funds. Included in this portfolio are four office buildings in which the Company holds a 50% ownership interest located in New York, New York, which collectively accounted for approximately 15% of the carrying value of the property portfolio at December 31, 2006.
(2) Cumulative effect of change in accounting principles, net of tax consisted of a loss of $243 million as a result of a change in accounting for goodwill and other intangible assets.
(3) Earnings per share, year-end common shares outstanding, cash dividends per share and book value per share were restated for the years prior to 2004 to reflect the impact of the merger with SPC.
(4) In August 2005, the Company completed its divestiture of Nuveen Investments, Inc., its asset management subsidiary acquired in the merger. Accordingly, the Company’s share of Nuveen Investments’ results prior to divestiture was classified as discontinued operations, along with the net after-tax loss on disposal. Prior period results were reclassified to be consistent with the 2005 presentation.
(5) In March 2002, TPC issued common stock through its Initial Public Offering (IPO). TPC issued 231 million shares of its class A common stock, representing approximately 23% of TPC’s common equity. After the IPO, Citigroup Inc. beneficially owned all of the 500 million shares of TPC’s outstanding class B common stock, each share of which was entitled to seven votes, and 269 million shares of TPC’s class A common stock, each share of which was entitled to one vote, representing at the time 94% of the combined voting power of all classes of TPC’s voting securities and 77% of the equity interest in TPC. On August 20, 2002, Citigroup made a tax-free distribution to its stockholders (the Citigroup Distribution), of a portion of its ownership interest in TPC, which, together with the shares issued in the IPO, represented more than 90% of TPC’s common equity and more than 90% of the combined voting power of TPC’s outstanding voting securities. Citigroup received a private letter ruling from the Internal Revenue Service that the Citigroup Distribution was tax-free to Citigroup, its stockholders and TPC. As part of the ruling process, Citigroup agreed to vote the shares it continued to hold of TPC following the Citigroup Distribution pro rata with the shares held by the public and to divest the remaining shares it holds within five years following the Citigroup Distribution. After the merger, this undertaking also applied to shares of Company common stock. At December 31, 2006, Citigroup held for its own account none of the Company’s outstanding common stock.
(6) Dividends per common share reflect the recapitalization effected as part of TPC’s corporate reorganization in 2002. During 2002, TPC paid dividends of $5.10 billion in the form of a note payable and $158 million in cash to Citigroup, its then sole shareholder.
The following is a discussion and analysis of the financial condition and results of operations of The St. Paul Travelers Companies, Inc. (together with its subsidiaries, the Company). On April 1, 2004, Travelers Property Casualty Corp. (TPC) merged with a subsidiary of The St. Paul Companies, Inc. (SPC), as a result of which TPC became a wholly-owned subsidiary of SPC, and SPC changed its name to The St. Paul Travelers, Inc. For accounting purposes, this transaction was accounted for as a reverse acquisition with TPC treated as the accounting acquirer. Accordingly, this transaction was accounted for as a purchase business combination, using TPC historical financial information and applying fair value estimates to the acquired assets, liabilities, and commitments of SPC as of April 1, 2004. Beginning on April 1, 2004, the results of operations and financial condition of SPC were consolidated with TPC’s. Accordingly, all financial information presented herein for the twelve months ended December 31, 2006 and 2005 reflects the consolidated accounts of SPC and TPC. The financial information presented herein for the twelve months ended December 31, 2004 reflects only the accounts of TPC for the three months ended March 31, 2004 and the consolidated accounts of SPC and TPC for the nine months ended December 31, 2004.
· Net favorable prior year reserve development of $394 million pretax ($255 million after-tax)
· Pretax net investment income of $3.52 billion ($2.71 billion after-tax)
· Total investments of $72.27 billion, up $3.98 billion from December 31, 2005; fixed maturities and short-term securities comprise 94% of total investments
Income from continuing operations in 2006 totaled $4.21 billion, or $5.91 per share diluted, compared with 2005 income from continuing operations of $2.06 billion, or $2.95 per share diluted. The $2.15 billion increase in 2006 operating results reflected a significant decline in catastrophe losses, net favorable prior
year reserve development, strong growth in investment income and higher business volume. These factors were partially offset by an increase in general and administrative expenses and a decline in fee income. Catastrophe losses in 2006 totaled $103 million, primarily resulting from several wind, rain, hail and snow storms in the United States, whereas results in 2005 included $2.19 billion of catastrophe costs, primarily resulting from Hurricanes Katrina, Rita and Wilma. Net favorable prior year reserve development of $394 million in 2006 primarily resulted from better than expected personal auto bodily injury loss experience and a decline in the frequency of non-catastrophe related losses in the Homeowners and Other line of business in the Personal Insurance segment, favorable development on 2005 catastrophe losses in Personal Insurance and continued improvement in liability and property lines of business in the Business Insurance segment. This favorable development was partially offset by unfavorable prior year reserve development primarily related to increases in reserves for asbestos, environmental and certain assumed reinsurance business, all in the Business Insurance segment. Net unfavorable prior year reserve development in 2005 of $325 million was driven by a charge to strengthen asbestos reserves, which was partially offset by other non-asbestos related net favorable prior year reserve development in all three business segments.
Income from continuing operations in 2005 totaled $2.06 billion, or $2.95 per share diluted, compared with income from continuing operations of $867 million, or $1.40 per share diluted, in 2004. The increase in income in 2005 reflected the impact of the merger, improved non-catastrophe related current year loss experience in the Company’s three reportable business segments, a decline in net unfavorable prior year reserve development and strong growth in net investment income. These factors more than offset a significant increase in the cost of catastrophes, which totaled $2.19 billion in 2005, compared with $772 million in 2004. The catastrophe losses in 2004 were primarily the result of four hurricanes that struck the southeastern United States in the third quarter. Net unfavorable prior year reserve development in 2005 totaled $325 million, compared with net unfavorable prior year reserve development of $2.39 billion in 2004. The net unfavorable prior year reserve development in 2004 was concentrated in the Business Insurance and Financial, Professional & International Insurance segments. Net unfavorable reserve development in the Business Insurance and Financial, Professional & International Insurance segments in 2004 more than offset additional income resulting from the merger and strong operating income generated by the Company’s Personal Insurance segment.
increased 4% over 2005, primarily reflecting growth in Bond & Financial Products and the absence of catastrophe-related reinstatement premiums.
Net investment income totaled $3.52 billion in 2006, an increase of $352 million, or 11%, over 2005 net investment income of $3.17 billion. The increase in 2006 was primarily the result of higher yields on short-term and long-term taxable securities, continued growth in the Company’s fixed maturity portfolio resulting from strong cash flows from operating activities and a decline in investment expenses. Also contributing to investment income growth in 2006 was the full-year impact of investment returns from the investment of $2.40 billion in proceeds from the divestiture of the Company’s equity interest in Nuveen Investments during 2005. The Company’s real estate joint venture investments, which are included in other investments, also produced strong levels of net investment income in 2006. The amortized cost of the fixed maturity portfolio at December 31, 2006 totaled $62.24 billion, $3.63 billion higher than year-end 2005. The average pretax investment yield was 4.9% in 2006 compared with 4.7% in 2005. The increase primarily reflected higher yields on taxable investments purchased in 2006 and the strong returns generated by the real estate joint venture investments.
Net investment income of $3.17 billion in 2005 grew $502 million, or 19%, over 2004, reflecting the impact of the merger, as well as an increase in invested assets over the prior twelve months, higher short-term interest rates and a decline in investment expenses. The increase in invested assets in 2005 was driven by strong cash flows from operating activities and the investment of the $2.40 billion in proceeds from the divestiture of the Company’s equity interest in Nuveen Investments. The average pretax investment yield in 2005 of 4.7% declined slightly from 4.8% in 2004, due to the maturity of higher yielding bonds and a higher proportion of tax-exempt investments. Net investment income in 2004 included $111 million from the initial public offering of one investment.
The Company allocates invested assets and the related net investment income to its reportable business segments. Pretax net investment income is allocated based upon an investable funds concept, which takes into account liabilities (net of non-invested assets) and appropriate capital considerations for
Net pretax realized investment gains in 2006 totaled $11 million, compared with net pretax realized investment gains of $17 million in 2005. The 2006 total included $49 million of net realized investment gains (net of impairment losses of $33 million) generated by the venture capital portfolio and $30 million of net realized investment gains related to U.S. Treasury futures contracts (which require a daily mark-to-market settlement and are used to shorten the duration of the Company’s fixed maturity investment portfolio). These gains were substantially offset by $33 million of net realized investment losses from the fixed maturity portfolio (including $7 million of impairment losses) and $22 million of net realized investment losses related to the Company’s holdings of stock purchase warrants of Platinum Underwriters Holdings, Ltd., a publicly-held company. In addition, the Company incurred net realized losses of $11 million related to the divestiture of two small subsidiaries.
Net pretax realized investment gains in 2005 were primarily generated from sales of venture capital investments and equity securities. In addition, the Company realized a pretax gain of $21 million from the sale of its Personal Catastrophe Risk operation and $13 million of pretax net gains related to U.S. Treasury futures contracts. Net realized investment gains in 2005 were reduced by $109 million of impairment losses, which were concentrated in the venture capital portfolio as described in more detail later in this discussion. The Company’s net pretax realized investment losses of $39 million in 2004 included impairment charges totaling $80 million. Net pretax realized investment gains (losses) in 2004 also included net losses of $44 million related to U.S. Treasury futures contracts.
Further information regarding the nature of impairment charges in each year is included in the “Investment Portfolio Management” section later in this discussion.
In Business Insurance, net written premium growth in 2006 was driven by strong increases in Target Risk Underwriting, due to significant renewal price increases for Southeastern U.S. catastrophe-prone exposures, and in Industry-Focused Underwriting, due to growth in several industry sectors served by this market. That growth was largely offset by a reduction in premium volume for operations in runoff, primarilty due to the sale of the Personal Catastrophe Risk operation in the fourth quarter of 2005. Business retention rates remained strong throughout the Business Insurance segment in 2006, and new business volume increased. In Financial, Professional & International Insurance, written premium growth in 2006 reflected strong business volume throughout the segment, and the absence of catastrophe-related reinstatement premiums. Net written premium growth in the Personal Insurance segment in 2006 reflected growth in new business volume, renewal price increases and continued strong business retention rates, partially offset by the estimated impact of transitioning to six-month policy terms in the second half of the year for a large portion of the Company’s multivariate pricing Automobile product, and an increase in ceded premiums for catastrophe reinsurance.
In the first quarter of 2005, the Company implemented changes in the timing and structure of reinsurance purchased in the Business Insurance and Financial, Professional & International Insurance segments. The changes in structure resulted in an increase in ceded premiums in 2005 when compared with 2004. The Company also made a modest adjustment to 2004 ceded written premiums to report at inception all ceded written premiums for reinsurance agreements that have minimum amounts required to be ceded. Previously, ceded written premiums for certain of these agreements were reported over the life of the
Claims and claim adjustment expenses totaled $12.24 billion in 2006, $2.68 billion less than the 2005 total of $14.93 billion. The 2006 total included $103 million of catastrophe losses and $394 million of net favorable prior year reserve development, whereas the 2005 total included $2.03 billion of catastrophe losses and $325 million of net unfavorable prior year reserve development. Catastrophe losses in 2005 primarily resulted from Hurricanes Katrina, Rita and Wilma. Net favorable prior year reserve development in 2006 was concentrated in the Personal Insurance segment, primarily reflecting better than expected loss experience in the auto bodily injury and non-catastrophe related Homeowners and Other lines of business, and a reduction in loss estimates for the 2005 hurricanes. The Business Insurance segment also experienced net favorable prior year loss experience in its ongoing operations in 2006, primarily in the commercial multi-peril, general liability, property and commercial automobile lines of business. That favorable development was partially offset by increases to asbestos and environmental reserves, which are discussed in more detail in the “Asbestos Claims and Litigation” and “Environmental Claims and Litigation” sections herein. There was also unfavorable prior year reserve development in runoff assumed reinsurance business. In 2005, the net unfavorable prior year reserve development was concentrated in the Business Insurance segment and was primarily driven by an increase to asbestos reserves, which was partially offset by other, non-asbestos related net favorable prior year reserve development in all three business segments.
In addition to the discussion in the Critical Accounting Estimates section of this report, other items specifically considered in the process of developing a uniform and consistent approach to estimating the combined company’s loss reserves after the merger included interpreting the actuarial and claim data in a
Analysis of the acquired construction reserves was completed near the end of the second quarter of 2004. Based upon the results of this analysis, the Company increased its estimate of the acquired net construction reserves by $500 million, including $400 million for construction defect and $100 million for construction wrap-up claims, and recognized this change in estimate as an income statement charge in the second quarter. There was no reinsurance associated with this charge.
Also on April 1, 2004, the Company could begin to use this detailed information to compare SPC’s assumptions, judgments and actuarial methods that were underlying the acquired reserves with its own
assumptions, judgments and actuarial methods. Similarities and differences were found to exist. Similarities included, but were not limited to, recognizing claim reserves when it was determined that contractors and commercial surety insureds were in default and thereby unable to meet their obligations, estimating initial IBNR provisions, and periodically re-evaluating, at least quarterly, the adequacy of the reserves established based on actual claims recorded and revised estimates of IBNR. Differences included judgments and methods related to determining IBNR development factors and expected salvage, among others.
Charge Related to the Financial Condition of a Specific Construction Contractor. Prior to the merger and beginning in the third quarter of 2003, SPC disclosed that a large construction contractor for which it had written several surety bonds was experiencing financial difficulty. Based upon an analysis of the financial condition of the construction contractor that was performed in the third quarter of 2003, a restructuring plan was adopted by the construction contractor, its banks, and SPC, among others, as a means to minimize estimated losses. SPC monitored the progress of the construction contractor toward meeting the requirements of the restructuring plan throughout subsequent quarters. SPC also estimated and disclosed its estimated ultimate net losses related to this exposure, beginning in the third quarter of 2003 and updated each quarter thereafter, including the effects of advances made or expected to be made to the construction contractor, applicable collateral, co-surety participations and reinsurance. The size and complexity of these particular construction contracts, coupled with the deteriorating credit quality of the construction contractor and the inherent uncertainty as to whether it would meet the obligations of the restructuring plan, resulted in a high degree of judgment in estimating potential losses.
A comprehensive analysis that began in the first quarter of 2004 was completed during the last half of the second quarter. Based upon this analysis, the Company concluded that the contractor would not be able to meet the targets set forth in its business and restructuring plans. Therefore, the Company moved from supporting the contractor’s restructuring plan to adopting a workout plan as a means to minimize estimated losses. Under the workout plan, the Company would no longer provide additional surety bonds for new projects of the construction contractor. Also as part of the workout plan, the Company was able to implement additional accounting and engineering procedures for each open project, which included using specialists to implement additional forecasting, cash management, and reporting procedures, on both a project-by-project and consolidated level. Based upon this second quarter change to a workout plan and the detailed financial analysis that was able to be performed, the Company increased its estimate of the ultimate net loss by $252 million, including $9 million of reinsurance. This estimate took into consideration paid amounts, net receivables, liquidated damages, overhead costs, additional completion costs, including costs associated with replacing the contractor, receivable discounts, current and future claims from owners and subcontractors against the contractor, and the value of collateral, among others.
The Company also commuted certain reinsurance agreements with a major reinsurer in 2004 resulting in a $113 million prior year reserve charge (in addition to a current year loss of $40 million). Commutations are a complete and final settlement with a reinsurer that results in a discharge of all obligations of the parties to the terminated reinsurance agreement.
General and administrative expenses totaled $3.46 billion in 2006, an increase of $229 million, or 7%, over the comparable 2005 total of $3.23 billion. The increase in 2006 was driven by investments made throughout the Company to support business growth and product development, costs related to the Company’s national advertising campaign and legal expenses related to investigations of various business practices by certain governmental agencies (see “Item 3 - Legal Proceedings”). These factors were partially offset by the impact of the favorable resolution of certain prior-year state tax matters, certain tax benefits, the absence of catastrophe-related state assessments and lower premium tax-related expenses.
The $284 million increase in general and administrative expenses in 2005 compared with 2004 primarily reflected the impact of the merger. In addition, the 2005 total included $43 million of state assessments related to catastrophe losses, and also reflected investments made for process re-engineering and to support business growth and product development, primarily in the Personal Insurance segment. These factors were partially offset by the benefit of expense efficiencies achieved since the completion of the merger. Included in the 2005 and 2004 totals were $112 million and $92 million, respectively, of amortization expense related to finite-lived intangible assets acquired in the merger, and a benefit of $12 million and $58 million, respectively, associated with the accretion of the fair value adjustment to claims and claim adjustment expenses and reinsurance recoverables. The 2004 total included a $62 million increase in the allowance for uncollectible amounts due from policyholders for loss-sensitive business (primarily high-deductible business). This increase resulted from applying the Company’s credit-based methodology for determining uncollectible amounts to the recoverables acquired in the merger. General and administrative expenses in 2004 also included $29 million of restructuring charges related to the merger.
of $400 million, 6.25% senior notes due June 20, 2016 and $400 million, 6.75% senior notes due June 20, 2036. The proceeds from the 2006 debt issuances were used to fund the redemption and maturity in 2006 of certain of the Company’s outstanding debt.
The Company’s effective tax rate on income from continuing operations was 26.5%, 22.8% and 7.3% in 2006, 2005 and 2004, respectively. The 2006 and 2005 effective rate reflected a higher level of pretax income associated with profitable underwriting performance. The low 2004 effective rate primarily reflected the impact of nontaxable investment income on a lower level of pretax income.
Catastrophe losses accounted for 10.3 points of the 2005 loss and loss adjustment expense ratio, compared with 4.0 points in 2004. The loss and loss adjustment expense ratio in 2005 included a 1.6 point impact of net unfavorable prior year reserve development, whereas the 2004 ratio included a 12.6 point impact of net unfavorable prior year reserve development. The 2005 loss and loss adjustment expense ratio also reflected an improvement in current accident year non-catastrophe related loss experience, compared with 2004, primarily reflecting reduced claim activity. The 1.1 point increase in the 2005 underwriting expense ratio compared with 2004 reflected the impact of reinstatement premiums, state assessments, increased commission expenses in the Personal Insurance segment and investments made for process re-engineering and to support business growth and product development, primarily in the Personal Insurance segment. These factors were partially offset by expense efficiencies realized since the completion of the merger.
GAAP carrying value of the Company’s investment in Nuveen Investments, partially offset by the Company’s share of Nuveen Investments’ net income prior to divestiture. The Company recorded a pretax gain on disposal of $345 million ($224 million after-tax) in 2005. Income from discontinued operations of $88 million in 2004 represented the Company’s share of Nuveen Investments’ net income for the year.
Operating income of $2.62 billion was $1.58 billion higher than operating income of $1.04 billion in 2005, primarily reflecting the absence of catastrophe losses, net favorable prior year reserve development, the continuation of favorable current year loss trends and a strong increase in net investment income. The Business Insurance segment incurred no catastrophe losses in 2006, whereas in 2005, the cost of catastrophes totaled $1.41 billion (including reinstatement premiums of $67 million), resulting from Hurricanes Katrina, Rita and Wilma. Net favorable prior year reserve development totaled $21 million in 2006, compared with net unfavorable prior year reserve development of $757 million in 2005 that was primarily driven by an increase in asbestos reserves. These factors were partially offset by an increase in general and administrative expenses and a decline in fee income in 2006.
Operating income of $1.04 billion in 2005 was significantly higher than operating income of $460 million in 2004, primarily due to a reduction in net unfavorable prior year reserve development, the impact of the merger and a strong increase in net investment income. These factors were partially offset by a significant increase in the cost of catastrophes in 2005. Net unfavorable prior year development totaled $757 million in 2005, compared with $2.03 billion in 2004. The 2005 total was primarily driven by a charge to increase asbestos reserves, whereas the 2004 total included $1.22 billion of charges to increase asbestos and environmental reserves, and the $500 million charge to increase construction reserves acquired in the merger, which is described in more detail in the “Consolidated Overview” section herein. The cost of catastrophes totaled $1.41 billion in 2005, compared with $532 million in 2004. Catastrophes in both years were the result of the hurricanes described in the “Consolidated Overview” section herein.
Earned premiums of $10.88 billion in 2006 decreased by $240 million, or 2%, compared with 2005, as premium increases in the majority of the segment’s ongoing operations were more than offset by the continuing decline in other runoff operations’ earned premiums, including the impact of the sale of the Personal Catastrophe Risk operation in November 2005. The Personal Catastrophe Risk operation
accounted for $111 million of earned premiums in 2005. Earned premiums in 2005 were reduced by $67 million of reinstatement premiums related to catastrophe losses.
National Accounts is the primary source of fee income due to its service businesses, which include claim and loss prevention services to large companies that choose to self-insure a portion of their insurance risks, and claims and policy management services to workers’ compensation residual market pools. The $72 million decline in fee income in 2006 resulted from lower serviced claim volume in workers’ compensation residual market pools, the impact on fee income from lower loss costs due to California workers’ compensation reforms and lower new business volume due to increased competition. In 2005, the $43 million decline in fee income compared with 2004 was primarily due to increased competition, including the loss of several large customers in the second half of 2004 and early 2005.
Claim and claim adjustment expenses in 2006 totaled $6.85 billion, down $2.51 billion from the 2005 total of $9.36 billion. The 2005 total included catastrophe losses of $1.32 billion, nearly all of which resulted from Hurricanes Katrina, Rita and Wilma, whereas the 2006 total included no catastrophe losses.
Net favorable prior year reserve development totaled $21 million in 2006. Net unfavorable prior year reserve development in 2005 was $757 million. The 2006 net favorable prior year reserve development was primarily concentrated in the commercial multi-peril, general liability, property and commercial automobile lines of business, partially offset by increases to asbestos and environmental reserves, as well as reserve strengthening for assumed reinsurance business in runoff. The commercial multi-peril and liability lines of business experienced better than anticipated loss development that was attributable to several factors, including improving legal and judicial environments, as well as enhanced risk control, underwriting and claim process initiatives. The favorable prior year reserve development in the property line of business primarily reflected less “demand surge” inflation than originally estimated for 2005 accident year non-catastrophe and catastrophe losses. “Demand surge” refers to significant short-term increases in building material and labor costs due to a sharp increase in demand for those materials and services. The commercial automobile line of business experienced better than expected loss development which was attributable to the favorable legal and judicial environments, claim handling initiatives focused on the automobile line of insurance and improvements in auto safety technology. The reserve strengthening in assumed reinsurance was primarily due to changes in projected loss development driven by an unanticipated change in the claim settlement patterns of the underlying casualty exposures. In 2005, net unfavorable prior year reserve development was driven by an increase to asbestos reserves of $830 million and reserve strengthening for environmental and assumed reinsurance, which is in runoff. Those increases were partially offset by favorable prior year reserve development from lower frequency and severity for both casualty and property-related lines of business. Drivers of the reduction in both frequency and severity were increasingly favorable legal and judicial environments, coupled with better than expected results from changes in policy provisions as well as underwriting and pricing criteria. Company initiatives
relating to claims handling, which affected claims staffing and workflows, also are believed to have contributed to the emergence of favorable severity experience in 2005.
losses and prior year reserve development improved over the 2005 ratio on the same basis, reflecting improvement in frequency and severity trends in several lines of business.
The underwriting expense ratio for 2006 was 1.7 points higher than the 2005 ratio, primarily reflecting the increases in expenses described above, and the impact of declines in fee income. A portion of fee income is accounted for as a reduction of expenses for purposes of calculating the expense ratio. Catastrophe-related reinstatement premiums of $67 million and catastrophe-related state assessments of $18 million added 0.3 points to the 2005 expense ratio.
The underwriting expense ratio in 2005 was 0.8 points higher than 2004, primarily reflecting the intentional decline in runoff operations’ earned premiums, a decline in certain ongoing operations’ earned premiums due to a lower level of written premium volume in the last half of 2004 and first half of 2005, and the 0.3 point negative impact of reinstatement premiums and catastrophe-related state assessments referred to previously. These factors were partially offset by the favorable impact of merger-related expense savings throughout the segment and personnel reductions in the Business Insurance Other sector. The 2004 underwriting expense ratio included the impact of merger-related restructuring charges and an increase in the allowance for uncollectible amounts due from policyholders.
The Business Insurance segment’s gross and net written premiums by market were as follows:
In Business Insurance Core operations, gross written premiums in 2006 were down slightly from 2005. Net written premiums in 2006, however, increased slightly over 2005. The disparity between gross and net written premium growth rates in 2006 was primarily due to a change in the structure of reinsurance coverage in the Company’s Discover Re subsidiary in National Accounts that resulted in a decline in ceded premiums. For purposes of comparison between 2006 and 2005 net written premium volume, the impact of a higher level of ceded premiums for property catastrophe reinsurance in 2006 was virtually equivalent to the impact of the $67 million of catastrophe-related reinstatement premiums in 2005. Net written premium growth in Business Insurance Core operations in 2006 was primarily concentrated in Target Risk Underwriting and Industry-Focused Underwriting, driven by continued strong business retention rates, renewal price increases and higher new business volume throughout the majority of businesses comprising these markets. The decline in National Accounts’ net written premiums primarily reflected a reduction in premiums related to favorable loss experience on business priced on a loss-sensitive basis and lower new business volume, partially offset by the decline in ceded premiums at Discover Re due to a change in the structure of reinsurance coverage. In Business Insurance Other operations, gross and net written premiums were down significantly from the comparable 2005 totals, reflecting the sale of the Personal Catastrophe Risk operation in November 2005 and the intentional non-renewal of business in the runoff operations comprising this category.
Commercial Accounts. Net written premiums of $2.38 billion in 2006 increased 2% over 2005, driven by a strong increase in business retention rates and an improvement in renewal pricing. In 2005, net written premiums of $2.33 billion grew $57 million, or 3%, over 2004 volume of $2.27 billion, reflecting the impact of the merger. However, 2005 net written premiums declined from 2004 on a pro forma combined basis, although business retention rates in this market in 2005 increased over 2004. New business volume also grew over 2004. Renewal price changes in 2005 in Commercial Accounts declined from 2004 and were in the low single digits for the year, reflecting the increased competitive market conditions.
Industry-Focused Underwriting. Net written premiums of $2.20 billion increased by 6% over 2005, driven by growth in the Construction and Oil & Gas business units. Favorable economic conditions in these industry sectors, significant increases in business retention rates and continued strong new business volume contributed to the increase in premium volume in 2006 in these two business units. The remaining three business units in this market-Technology, Agribusiness and Public Sector-all achieved lesser degrees of net written premium growth over 2005. Net written premium volume of $2.08 billion in 2005 increased 19% over the 2004 total of $1.75 billion, primarily reflecting the impact of the merger. On a pro forma combined basis, Construction’s net written premiums in 2005 declined from 2004, reflecting lower business volumes related to the process of aligning the underwriting profile of the two predecessor companies during the latter half of 2004 and the first half of 2005. Oil & Gas net written premiums in 2005 grew significantly over 2004, primarily due to the impact of the merger, strong business retention rates and higher new business volume.
Target Risk Underwriting. Net written premiums of $1.63 billion in 2006 increased by 10% over 2005, driven by strong growth in the National Property and Inland Marine business units. Significant renewal price increases, particularly for Southeastern U.S. catastrophe-prone exposures, and strong business retention rates were the primary factors accounting for net written premium growth in these two business units in 2006. The Ocean Marine business unit also contributed to net written premium growth in 2006, primarily due to a decrease in the amount of business ceded. In 2005, net written premiums of $1.48 billion were 10% higher than 2004 net written premium volume of $1.35 billion, driven by the impact of the merger. On a pro forma combined basis, however, net written premium volume in 2005 declined from 2004, primarily due to competitive market conditions for property and inland marine coverages. Ocean Marine premium volume grew significantly in 2005, driven by renewal rights transactions.
Specialized Distribution. Net written premium volume in 2006 of $1.02 billion increased 13% over 2005, primarily driven by the transfer of certain national small business insurance programs from Select Accounts to the National Programs business unit. In addition, Northland also experienced premium growth in 2006, primarily resulting from higher business retention rates and new business volume in commercial trucking, its primary line of business. In 2005, net written premium volume of $908 million grew $101 million, or 13%, over 2004 net written premiums of $807 million. The growth in 2005 was concentrated in National Programs and primarily reflected the impact of the merger and the transfer of certain program business from Commercial Accounts. On a pro forma combined basis, net written premiums in 2005 were level with 2004.
Results of the Company’s Financial, Professional & International Insurance segment were as follows:
Earned premiums in 2006 increased $124 million, or 4%, over 2005, primarily driven by growth in Bond & Financial Products. In addition, earned premiums in 2005 were reduced by $33 million of reinstatement premiums related to catastrophe losses, primarily in the Company’s operations at Lloyd’s. Earned premium volume in International and Lloyd’s in 2006 declined slightly from 2005, primarily reflecting the elimination of a one-month reporting lag at Lloyd’s in 2005 that resulted in $48 million of additional earned premiums being included in 2005 results. Also contributing to the decline in earned premiums in International and Lloyd’s in 2006 was the sale of certain classes of personal lines business at Lloyd’s in the first quarter of 2005, which had accounted for $43 million of earned premiums in 2005.
General and administrative expenses in 2006 totaled $536 million, an increase of 5% over 2005. The increase in 2006 primarily reflected the segment’s expenditures to support business growth and the segment’s share of costs associated with the Company’s national advertising campaign and legal expenses related to investigations of various business practices by certain governmental agencies. General and administrative expenses in 2005 totaled $509 million, an increase of 26% over the 2004 total of $405 million which primarily reflected the impact of the merger. The 2005 total included the impacts of a decline in commission expenses and expense efficiencies realized as a result of the merger.
The underwriting expense ratio in 2006 improved by 0.4 points compared with 2005, benefiting from the absence of catastrophe-related reinstatement premiums and increased business volume. Reinstatement premiums of $33 million increased the 2005 underwriting expense ratio by 0.4 points. In 2005, the underwriting expense ratio improved 1.3 points compared with 2004, reflecting the impact of the merger and expense efficiencies realized since the completion of the merger.
The Financial, Professional & International Insurance segment’s gross and net written premiums in 2006 increased 5% and 7%, respectively, over 2005. Growth in net written premium volume in 2006 resulted from strong construction surety volume in Bond & Financial Products, strong price increases for Southeastern U.S. catastrophe-prone exposures in the Company’s operations at Lloyd’s, strong business retention rates and new business volume in International, and the absence of catastrophe-related reinstatement premiums. The Bond & Financial Products category represents the combination of the Company’s previous Bond and Financial & Professional Services marketing groups. The elimination of a reporting lag at the Company’s operations at Lloyd’s resulted in $39 million and $31 million of additional gross and net written premium volume in 2005, respectively. In Bond & Financial Products (excluding the surety line of business, for which these are not relevant measures), business retention rates in 2006 remained strong and increased over 2005, while renewal price increases remained positive, but declined from 2005. New business volume was down from 2005. For International in 2006, business retention rates increased over 2005, renewal price changes declined slightly and new business volume increased when compared with 2005. Net written premiums in the Financial, Professional & International Insurance segment for 2005 were reduced by $33 million of catastrophe-related reinstatement premiums, primarily related to the Company’s operations at Lloyd’s.
Gross and net written premiums in 2005 increased 22% and 17%, respectively, over written premium volume in 2004. The increase in gross and net written premiums in 2005 primarily reflected the impact of the merger. Net written premiums in 2005 were reduced by the $33 million of catastrophe-related reinstatement premiums, whereas net written premiums in 2004 were reduced by $76 million of reinstatement premiums primarily related to reserving actions in Bond & Financial Products. Gross and net written premiums in 2005 declined compared with 2004 volume on a pro forma combined basis.
Operating income of $1.13 billion in 2006 was $357 million, or 46%, higher than operating income of $775 million in 2005. Results in 2006 reflected a significant decline in catastrophe losses, strong growth in business volume, continued favorable current accident year loss trends and an increase in net investment income, partially offset by an increase in general and administrative expenses. Catastrophe losses in 2006 totaled $103 million, which resulted from several wind, rain, hail and snow storms throughout the year in the United States. Results in 2005 included a cost of catastrophes of $593 million, primarily resulting from Hurricanes Katrina, Rita and Wilma. Results in both years benefited from significant net favorable prior year reserve development, which totaled $359 million in 2006 and $360 million in 2005.
Net favorable prior year reserve development in 2006 and 2005 was $359 million and $360 million, respectively. The net favorable prior year reserve development in 2006 was driven by better than expected loss experience in the auto bodily injury and non-catastrophe related Homeowners and Other lines of business, and a reduction in loss estimates for the 2005 hurricanes. In the Automobile line of business, for 2006 and 2005, the improvement was partially driven by better than expected results from changes in claim handling practices. These changes included practices which have allowed case reserves to be established more accurately earlier in the claim settlement process, thereby changing historical loss development patterns. In addition, for both years, industry and Company initiatives to fight fraud in several states led to a decrease in the total number of claims and a change in historical loss development patterns. In the Homeowners and Other line of business, favorable prior year reserve development in 2006 and 2005 was partially driven by a significant decrease in the number of claims, attributable to changes in the marketplace, including higher deductibles and fewer small-dollar claims. These changes also resulted in a change in historical loss development patterns. In addition, for 2006, non-catastrophe related Homeowners and Other loss experience was favorable due to continued evidence of a less than expected impact from “demand surge,” which refers to significant short-term increases in building material and labor costs due to a sharp increase in demand for those materials and services. Approximately $100 million of net favorable prior year reserve development in 2006 resulted from a reduction in loss estimates for catastrophes incurred in 2005, primarily due to lower than expected additional living expense losses related to Hurricane Katrina.
General and administrative expenses totaled $804 million in 2006, an increase of $139 million, or 21%, over the 2005 total of $665 million. The increase in expenses over 2005 reflected increased business volume, the segment’s continued investments to support business growth and product development, legal expenses related to investigations of various business practices by certain governmental agencies, and the segment’s share of costs associated with the Company’s national advertising campaign. The 2005 total included $25 million of catastrophe-related assessments. In 2005, general and administrative expenses were $129 million higher than the 2004 total of $536 million, primarily reflecting business growth, investments to support business growth and the catastrophe-related assessments.
The underwriting expense ratio of 28.3% in 2006 was 1.4 points higher than the 2005 expense ratio of 26.9%, primarily reflecting the impact of the increase in general and administrative expenses described above, and a slight increase in commission expenses. In 2005, reinstatement premiums related to catastrophe losses reduced earned premium volume by $21 million, and catastrophe-related assessments from various insurance pools increased taxes, licenses and fees by $25 million. These factors combined to result in a 0.5 point unfavorable impact on the Personal Insurance segment’s 2005 underwriting expense ratio.
The 2.0 point increase in the underwriting expense ratio in 2005 compared with 2004 reflected an increase in commission expenses, other insurance expenses, and taxes, licenses and fees, and the 0.5 point impact of reinstatement premiums and catastrophe-related assessments described above. The increase in commissions reflected a changing product mix and higher agent profit sharing expenses. The increase in other insurance expenses reflected the impact of process re-engineering investments and investments in personnel, technology and infrastructure to support business growth and product development.
Gross and net written premiums in 2006 increased 8% over 2005. Net written premium volume in 2006 reflected increased costs for property catastrophe coverage (which reduces net written premiums), while net written premiums in 2005 were reduced by $21 million of catastrophe-related reinstatement premiums. In the Automobile line of business, net written premium growth of 6% in 2006 over 2005 primarily reflected a strong increase in new business, partially offset by the impact of transitioning to six-month policy terms in the second half of the year for the Company’s multivariate pricing product that resulted in a lower amount of reported net written premiums in 2006. Business retention rates in the Automobile line of business remained strong and consistent with prior year rates. Renewal price changes in 2006 remained positive but were slightly below those in 2005. New business volume in 2006 was significantly higher than in 2005. The Company’s multivariate pricing product in the Automobile line of business had been introduced in 37 states and the District of Columbia by the end of 2006.
In the Homeowners and Other line of business, net written premiums in 2006 grew 10% over 2005. Business retention rates and new business volume in this line of business remained strong and increased over 2005. Renewal price changes in 2006 remained positive but declined from 2005. Net written premium volume in this line of business in 2006 also benefited from cross-selling initiatives involving the Company’s automobile multivariate pricing product.
Many coverage disputes with policyholders are only resolved through settlement agreements. Because many policyholders make exaggerated demands, it is difficult to predict the outcome of settlement negotiations. Settlements involving bankrupt policyholders may include extensive releases which are favorable to the Company but which could result in settlements for larger amounts than originally anticipated. There also may be instances where a court may not approve a proposed settlement, which may result in additional litigation and potentially less beneficial outcomes for the Company. As in the past, the Company will continue to pursue settlement opportunities.
activity. Net asbestos losses and expenses paid in 2006 were $469 million, compared with $399 million in 2005. The $70 million net increase is primarily the result of lower reinsurance billings in 2006. Approximately 50% in 2006 and 42% in 2005 of total net paid losses related to policyholders with whom the Company previously entered into settlement agreements limiting the Company’s liability. At December 31, 2006, net asbestos reserves totaled $4.05 billion, compared with $4.36 billion at December 31, 2005.
The Company recorded pre-tax asbestos reserve additions of $155 million, $830 million and $928 million in 2006, 2005 and 2004, respectively, pursuant to the completion of the Company’s annual ground-up asbestos exposure review, which included an analysis of exposure and claim payment patterns by policyholder category, as well as recent settlements, policyholder bankruptcies, judicial rulings and legislative actions. Approximately half of the $155 million 2006 pretax reserve adjustment was due to an increase in the projected defense costs for ten policyholders. Additionally, $15 million of the pretax reserve adjustment was attributable to a delay in the approval and expected payment of the previously announced settlement with PPG Industries, Inc. as part of the Pittsburgh Corning bankruptcy reorganization plan. The remainder of the reserve adjustment was primarily due to continued litigation activity against smaller, peripheral defendants. The asbestos reserve addition in 2005 resulted, in part, from higher than expected defense costs due to increased trial activity for seriously impaired plaintiffs and prolonged litigation before cases are settled or dismissed. The 2005 reserve addition also considered the January 2006 court decision voiding, on procedural grounds, the previously rendered favorable arbitration decision in the ongoing ACandS litigation (described in more detail in note 15). The asbestos reserve addition recorded in 2004 primarily resulted from an increase in litigation costs and activity surrounding peripheral defendants.
The Company has recently observed the following developments in the asbestos environment:
· a decrease in the number and volatility of asbestos-related bankruptcies; and
The policyholders with settlement agreements category includes structured agreements, coverage in place arrangements and, with respect to TPC, Wellington accounts and the settlement of the Statutory and Hawaii Actions and the Common Law Claims (for a fuller description of these matters, see “Item 3 - Legal Proceedings”) (collectively the “Direct Action Settlement”). Reserves are based on the expected payout for each policyholder under the applicable agreement. Structured agreements are arrangements under which policyholders and/or plaintiffs agree to fixed financial amounts to be paid at scheduled times. In May 2002, Pittsburgh Plate and Glass Company (PPG) and the Company, along with three dozen other insurers of PPG, agreed on key terms to settle asbestos-related coverage litigation under insurance policies issued to PPG. This settlement was to be incorporated into the Plan of Reorganization (the Plan) proposed as part of the Pittsburgh Corning (PC) bankruptcy proceeding. Pursuant to the proposed PC Plan, PC along with enumerated other companies (including PPG and Corning) were to receive protections afforded by Section 524(g) of the Bankruptcy Code from certain asbestos-related bodily injury claims. In prior years the reserves associated with this agreement were included in the structured settlement category. On December 21, 2006, the United States Bankruptcy Court for the Western District of Pennsylvania declined to confirm the Plan. Confirmation of the Plan was one of the many conditions to the May 2002 resolution with PPG. Various parties to the PC bankruptcy have filed motions for reconsideration. It is not possible to predict how or when the bankruptcy court will rule on these motions. As a result of the December 21, 2006 ruling, it is uncertain whether the terms of the May 2002 settlement will ever be fully satisfied and thus the Company has removed the reserves associated with this agreement from the structured settlement category and has made a corresponding increase in its unallocated IBNR reserve. Coverage in place arrangements represent agreements with major policyholders on specified amounts of coverage to be provided. Payment obligations may be subject to annual maximums and are only made when valid claims are presented. Wellington accounts refer to the 35 defendants that are parties to a 1985 agreement settling certain disputes concerning insurance coverage for their asbestos claims. Many of the aspects of the Wellington agreement are similar to those of coverage in place arrangements in which the parties have agreed on specific amounts of coverage and the terms under which the coverage can be accessed. As more fully described in Item 3, Legal Proceedings, TPC has entered into the Direct Action Settlement which is still subject to a number of contingencies. If those contingencies are met, then TPC will pay up to $502 million, possibly in calendar year 2007. One of the contingencies includes affirmance by all appellate courts of the orders entered by the United States Bankruptcy Court with respect to the Direct Action Settlement. It is not possible to predict how or when the appellate courts will rule on the pending appeals.
Home office, field office and other relates to policyholders for which settlement agreements have not been reached, and also includes unallocated IBNR. Policyholders are identified for home office review based upon, among other factors: aggregate ultimate expected payments in excess of a specified threshold (currently $100,000), perceived level of exposure, number of reported claims, products/completed operations and potential “non-product” exposures, size of policyholder and geographic distribution of products or services sold by the policyholder. In addition to IBNR amounts contained in the reserves for home office and field office policyholders, the Company has established a reserve for further adverse
development related to existing policyholders, new claims from policyholders reporting claims for the first time and policyholders for which there is, or may be, litigation and direct actions against the Company.
The duration of the Company’s investigation and review of these claims and the extent of time necessary to determine an appropriate estimate, if any, of the value of the claim to the Company vary
Gross paid losses in 2006 and 2005 were $189 million and $248 million, respectively. TPC entered into a significant settlement with one policyholder in 2005. TPC executed an agreement with this policyholder which resolved all past, present and future hazardous waste and pollution property damage claims, and all related past and pending bodily injury claims. In addition, TPC and this policyholder entered into a coverage-in-place agreement which addressed the handling and resolution of all future hazardous waste and pollution bodily injury claims. Under the coverage-in-place agreement, TPC has no defense obligation, and there is an overall cap with respect to any indemnity obligation that might be owed. The first two payments related to this settlement were made during 2005 and the final payment was made in the first quarter of 2006.
case with policyholders in bankruptcy where negotiations often involve a large number of claimants and other parties and require court approval to be effective. As part of its continuing analysis of asbestos reserves, which includes an annual ground-up review of asbestos policyholders, the Company continues to study the implications of these and other developments. The Company completed its most recent annual ground-up review during the third quarter of 2006. See “Part I-Item 3, Legal Proceedings.”
Because of the uncertainties set forth above, additional liabilities may arise for amounts in excess of the current related reserves. In addition, the Company’s estimate of claims and claim adjustment expenses may change. These additional liabilities or increases in estimates, or a range of either, cannot now be reasonably estimated and could result in income statement charges that could be material to the Company’s operating results in future periods.
The Company’s invested assets at December 31, 2006 totaled $72.27 billion, of which 94% was invested in fixed maturity and short-term investments, 1% in equity securities, 1% in real estate and 4% in other investments. Because the primary purpose of the investment portfolio is to fund future claims payments, the Company employs a conservative investment philosophy. The Company’s fixed maturity portfolio at December 31, 2006 totaled $62.67 billion, comprising $62.46 billion of publicly traded fixed maturities and $208 million of private fixed maturities. The weighted average quality ratings of the Company’s publicly traded fixed maturity portfolio and private fixed maturity portfolio at December 31, 2006 were AA1 and A3, respectively. Included in the fixed maturity portfolio at that date was approximately $1.78 billion of below investment grade securities. During 2006, holdings of tax-exempt securities were increased to $35.63 billion to take advantage of their relatively high credit quality and attractive after-tax yields. The average effective duration of the fixed maturity portfolio, including short-term investments, was 4.0 as of December 31, 2006 (4.3 excluding short-term investments), compared with 3.9 as of December 31, 2005 (4.3 excluding short-term investments).
The following table sets forth the Company’s combined fixed maturity investment portfolio classified by Moody’s Investors Service ratings:
The Company makes investments in collateralized mortgage obligations (CMOs) that typically have high credit quality, offer good liquidity, and are expected to provide an advantage in yield compared to U.S. Treasury securities. The Company’s investment strategy is to purchase CMO tranches which offer the most favorable return given the risks involved. One significant risk evaluated is prepayment sensitivity. While prepayment risk (either shortening or lengthening of duration) and its effect on total return cannot be fully controlled, particularly when interest rates move dramatically, the investment process generally favors securities that control this risk within expected interest rate ranges. The Company does not purchase residual interests in CMOs.
Net pretax unrealized investment gains at December 31, 2005 declined by $852 million from year-end 2004, primarily reflecting an $885 million pretax decrease in the net unrealized gain on fixed maturities that was driven by an increase in market interest rates in 2005. Partially offsetting this decrease was a $78 million increase in pretax unrealized gains on the venture capital portfolio, which reflected favorable results from several of the investments comprising this category, net of losses realized through other-than-temporary impairments.
For the year ended December 31, 2006, the Company recognized the following other-than-temporary impairments:
· $33 million in the venture capital portfolio on 16 holdings. Four of the holdings were impaired due to new financings on unfavorable terms. Six holdings experienced fundamental economic deterioration (characterized by less than expected revenues or a fundamental change in product). Four of the holdings were impaired due to the impending sale, liquidation or shutdown of the entity. Two of the holdings were public securities whose cost basis was not anticipated to be recovered over the expected holding period.
· $4 million in its real estate and other investments (excluding venture capital). The loss recorded was the result of one mortgage loan refinancing at less favorable terms.
· $25 million in the fixed maturities portfolio related to various issuers due to credit risk associated with the issuer’s deteriorated financial position.
· $5 million in the equity portfolio when it became apparent that the cost basis of those securities would not be recovered over the expected holding period.
At December 31, 2006, the Company had no fixed maturities or equity securities available for sale for which fair value was less than 80% of amortized cost or cost, respectively.
At December 31, 2006, non-investment grade securities comprised 2.9% of the Company’s fixed income investment portfolio. Included in those categories at December 31, 2006 were securities in an unrealized loss position that, in the aggregate, had an amortized cost of $599 million and a fair value of $581 million, resulting in a net pretax unrealized investment loss of $18 million. These securities in an unrealized loss position represented less than 1% of the total amortized cost and less than 1% of the fair value of the fixed income portfolio at December 31, 2006, and accounted for 4% of the total pretax unrealized investment loss in the fixed income portfolio.
The Company’s strategic objective is to enhance its position as a consistently profitable market leader and a cost-effective provider of property and casualty insurance in the United States and in selected international markets. A variety of factors continue to affect the property and casualty insurance market and the Company’s core business outlook for 2007, including competitive conditions throughout the majority of markets served by the Company’s business segments, loss cost trends, asbestos- and environmental-related developments and reinsurance and litigation costs.
The Company expects property casualty market conditions to continue to be competitive throughout 2007. Relative to 2006, within the Business Insurance segment, the Company expects renewal price changes to moderate and terms, conditions and insured values to improve for exposures susceptible to catastrophe losses, such as coastal property and oil- and gas-related exposures, while renewal price changes for non-catastrophe related exposures are expected to be subject to modest declines. Relative to 2006, within the Financial, Professional & International Insurance segment, the Company expects renewal price changes to be subject to modest declines. Also relative to 2006, within the Personal Insurance segment, the Company expects renewal price changes in the automobile and homeowners markets to remain relatively stable.
with the Securities and Exchange Commission and its $1 billion line of credit. Cash provided from these sources is used primarily for claims and claim adjustment expense payments and operating expenses. The timing and amount of catastrophe claims are inherently unpredictable. Such claims increase liquidity requirements. The timing and amount of reinsurance recoveries may be affected by reinsurer solvency and reinsurance coverage disputes. Additionally, the variability of asbestos-related claim payments, as well as the volatility of potential judgments and settlements arising out of litigation, may also result in increased liquidity requirements. It is the opinion of the Company’s management that the Company’s future liquidity needs will be adequately met from all of the above sources.
Net cash flows provided by operating activities of continuing operations totaled $4.77 billion, $3.59 billion and $5.07 billion in 2006, 2005 and 2004, respectively. Cash flows in 2006 reflected higher levels of collected premiums and net investment income, lower claim payments on catastrophe losses, as well as lower runoff claim payments. In addition, cash flows from operations in 2006 benefited from significant 2006 reinsurance recoveries related to 2005 hurricane losses, operations in runoff (primarily Gulf) and various commutation agreements. These factors were partially offset by higher interest payments and an increase in tax payments resulting from higher profitability. Cash flows in 2005 reflected an increase in loss and loss adjustment expense payments primarily related to the catastrophe losses incurred during 2005 and 2004, and an increase in tax payments resulting from higher profitability. Cash flows in 2004 included $867 million in cash proceeds received pursuant to the commutation of specific reinsurance agreements. Cash flows in 2004 also benefited from premium rate and volume increases. The Company utilized $11 million, $2.00 billion and $548 million of net operating loss (NOL) carryforwards during 2006, 2005 and 2004, respectively, thereby reducing current regular tax payments by $4 million, $698 million and $192 million, respectively.
Net cash flows provided by operating activities for all three years were negatively impacted by payments for asbestos and environmental liabilities, as well as by payments for claims related to the Company’s runoff operations.
Net cash flows used in investing activities of continuing operations totaled $3.06 billion, $5.44 billion and $4.65 billion in 2006, 2005 and 2004, respectively. Fixed maturity securities accounted for the majority of investment purchases in all three years.
The majority of funds available for investment are deployed in a widely diversified portfolio of high quality, liquid intermediate-term taxable U.S. government, corporate- and mortgage-backed bonds and tax-exempt U.S. municipal bonds. The Company closely monitors the duration of its fixed maturity investments, and investment purchases and sales are executed with the objective of having adequate funds available to satisfy the Company’s insurance and debt obligations. The Company’s management of the duration of the fixed income investment portfolio generally produces a duration that exceeds the duration of the Company’s net insurance liabilities. The average duration of fixed maturities and short-term securities was 4.0 at December 31, 2006, compared with 3.9 at December 31, 2005.
The Company also invests much smaller amounts in equity securities, venture capital, real estate, private equity limited partnerships, joint ventures, other limited partnerships and trading securities. These investment classes have the potential for higher returns but also involve varying degrees of risk, including less stable rates of return and less liquidity.
interest payments produced by the Company’s fixed income portfolio adequately fund the estimated runoff of the Company’s insurance reserves. Although this is not an exact cash flow match in each period, the substantial degree by which the market value of the fixed income portfolio exceeds the present value of the net insurance liabilities, plus the positive cash flow from newly sold policies and the large amount of high quality liquid bonds provides assurance of the Company’s ability to fund the payment of claims without having to sell illiquid assets or access credit facilities.
At December 31, 2006, total cash, short-term invested assets and other readily marketable securities aggregating $1.45 billion were held at the holding company level. The assets held at the holding company, combined with other sources of funds available, primarily additional dividends from operating subsidiaries, are considered sufficient to meet the liquidity requirements of the Company. These liquidity requirements primarily include shareholder dividends and debt service.
Net cash flows used in financing activities of continuing operations totaled $1.59 billion, $473 million and $516 million in 2006, 2005 and 2004, respectively. The 2006 total primarily reflected common share repurchases and dividends to shareholders, partially offset by proceeds from employee stock option exercises. In 2005, the total primarily reflected the repayment of debt and dividends to shareholders, which were partially offset by the issuance of common stock pursuant to the maturity of equity unit forward contracts and the issuance of debt. Dividends paid to shareholders were the primary factor in cash used in financing activities in 2004.
recorded at the merger date. A portion of the proceeds from the June 2006 debt issuances described above was used to fund this redemption.
The increase in shareholders’ equity in 2006 reflected the Company’s strong net income for the year, partially offset by the impact of common share repurchases and dividends to shareholders.
Line of Credit Agreement. The Company maintains an $800 million commercial paper program with back-up liquidity consisting of a bank credit agreement. In June 2005, the Company entered into a $1.0 billion, five-year revolving credit agreement with a syndicate of financial institutions. Pursuant to covenants in the credit agreement, the Company must maintain an excess of consolidated net worth over goodwill and other intangible assets of not less than $10 billion at all times. The Company must also maintain a ratio of total consolidated debt to the sum of total consolidated debt plus consolidated net worth of not greater than 0.40 to 1.00. In addition, the credit agreement contains other customary restrictive covenants as well as certain customary events of default, including with respect to a change in control. At December 31, 2006, the Company was in compliance with these covenants and all other covenants related to its respective debt instruments outstanding. Pursuant to the terms of the credit agreement, the Company has an option to increase the credit available under the facility, no more than once a year, up to a maximum facility amount of $1.5 billion, subject to the satisfaction of a ratings requirement and certain other conditions. There was no amount outstanding under the credit agreement as of December 31, 2006.
Shelf Registration. In December 2005, the Company filed with the Securities and Exchange Commission a shelf registration statement for the potential offering and sale of securities. The Company may offer these securities from time to time at prices and on other terms to be determined at the time of offering. During 2006, the Company issued $800 million of senior debt (as described above) under this shelf registration statement.
The following table summarizes, as of December 31, 2006, the Company’s future payments under contractual obligations and estimated claims and claims related payments. The table excludes short-term obligations and includes only liabilities at December 31, 2006 that are expected to be settled in cash.
The contractual obligations related to debt, operating leases, purchase obligations, long-term unfunded investment commitments and estimated claims and claims related payments (gross of the estimated reinsurance recoveries), at December 31, 2006 were as follows:
(1) See note 7 of the notes to the Company’s consolidated financial statements for a further discussion. Because the amounts reported in the foregoing table include principal and interest, the total long-term obligations will not agree with the amounts reported in note 7.
(4) In connection with the sale of its insurance brokerage operations, the Company committed to acquire brokerage services from the buyer through 2012. See note 15.
(6) Represents estimated timing for fulfilling unfunded commitments for investments in real estate partnerships, private equities and hedge funds.
(7) The amounts in “Claims and claim adjustment expenses” in the table above represent the estimated timing of future payments for both reported and unreported claims incurred and related claim adjustment expenses, gross of reinsurance recoverables.
The estimated future cash inflows from the Company’s reinsurance contracts that qualify for reinsurance accounting are as follows:
For business underwritten by non-U.S. operations, future cash flows related to reported and unreported claims incurred and related claim adjustment expenses were translated at the spot rate on December 31, 2006.
(8) Workers’ compensation large deductible policies provide third party coverage in which the Company typically is responsible for paying the entire loss under such policies and then seeks reimbursement from the insured for the deductible amount. “Claims from large deductible policies” represent the estimated future payment for claims and claim related expenses below the deductible amount, net of the estimated recovery of the deductible. The liability and the related deductible receivable for unpaid claims are presented in the consolidated balance sheet as “contractholder payables” and
(10) The amounts in “Reinsurance contracts accounted for as deposits” represent estimated future nominal payments for reinsurance agreements that are accounted for as deposits. Amounts payable under deposit agreements are included in “other liabilities” in the consolidated balance sheet. The amounts reported in the table are presented on a nominal basis and have not been adjusted to reflect the time value of money. Accordingly, the amounts above will differ from the Company’s balance sheet to the extent that deposit values in the balance sheet have been discounted using deposit accounting.
(11) The amounts in “Payouts from ceded funds withheld” represent estimated payments for losses and return of funds held related to certain reinsurance arrangements whereby the Company holds a portion of the premium due to the reinsurer and is allowed to pay claims from the amounts held.
The Company has entered into certain contingent obligations for guarantees related to agency loans and letters of credit, issuance of debt securities, third party loans related to venture capital investments and various indemnifications related to the sale of business entities to third parties. See note 15 to the Company’s consolidated financial statements. The Company does not expect these arrangements to have a material effect on the Company’s financial condition, changes in financial condition, revenues and expenses, results of operations, liquidity, capital expenditures or capital resources.
The process of estimating loss reserves involves a high degree of judgment and is subject to a number of variables. These variables can be affected by both internal and external events, such as changes in claims handling procedures, changes in individuals involved in the reserve estimation process, economic inflation, legal trends and legislative changes, among others. The impact of many of these items on ultimate costs for loss and loss adjustment expenses is difficult to estimate. Loss reserve estimation difficulties also differ significantly by product line due to differences in claim complexity, the volume of claims, the potential
severity of individual claims, the determination of occurrence date for a claim and reporting lags (the time between the occurrence of the policyholder event and when it is actually reported to the insurer). Informed judgment is applied throughout the process. The Company continually refines its loss reserve estimates in a regular ongoing process as historical loss experience develops and additional claims are reported and settled. The Company rigorously attempts to consider all significant facts and circumstances known at the time loss reserves are established. Due to the inherent uncertainty underlying loss reserve estimates including but not limited to the future settlement environment, final resolution of the estimated liability will be different from that anticipated at the reporting date. Therefore, actual paid losses in the future may yield a materially different amount than currently reserved-favorable or unfavorable.
A portion of the Company’s loss reserves are for asbestos and environmental claims and related litigation which totaled $4.47 billion at December 31, 2006. While the ongoing study of asbestos claims and associated liabilities and of environmental claims considers the inconsistencies of court decisions as to coverage, plaintiffs’ expanded theories of liability and the risks inherent in complex litigation and other uncertainties, in the opinion of the Company’s management, it is possible that the outcome of the continued uncertainties regarding these claims could result in liability in future periods that differs from current reserves by an amount that could be material to the Company’s future operating results. See the preceding discussion of “Asbestos Claims and Litigation” and “Environmental Claims and Litigation.”
The $1.80 billion decline in gross claim and claim adjustment expense reserves in 2006 primarily reflected payments related to prior year hurricane losses, claim and claim adjustment expense payments from runoff operations and favorable prior year reserve development, primarily in the Personal Insurance segment, partially offset by the impact of reserves acquired in the RITC transaction described in note 1.
The process for estimating the liabilities for claim and claim expenses begins with the collection and analysis of claim data. Data on individual reported claims, both current and historical, including paid amounts and individual claim adjuster estimates, are grouped by common characteristics (“components”) and evaluated by actuaries in their analyses of ultimate claim liabilities by product line. Such data is occasionally supplemented with external data as available and when appropriate. The process of analyzing reserves for a component is undertaken on a regular basis, generally quarterly, in light of continually updated information.
Most general liability policies are written on an occurrence basis. These policies are subject to substantial loss development over time as facts and circumstances change in the years following the policy issuance. The use of the occurrence form accounts for much of the reserve development in asbestos and environmental exposures, and it is also used to provide coverage for construction general liability,
including construction defect. Occurrence based forms of insurance for general liability exposures require substantial projection of various trends, including future inflation and judicial interpretations and societal litigation dynamics, among others.
For some lines, the impact of large individual claims can be material to the analysis. These lines are generally referred to as being “low frequency/high severity,” while lines without this “large claim” sensitivity are referred to as “high frequency/low severity”. Estimates of claim liabilities for low frequency/high severity lines can be sensitive to the impact of a small number of potentially large claims. As a result, the role of judgment is much greater for these reserve estimates. In contrast, high frequency/low severity lines tend to have much greater spread of estimation risk, such that the impact of individual claims are relatively minor and the range of reasonable reserve estimates is narrower and more stable.
Actuaries have to exercise a considerable degree of judgment in the evaluation of all these factors in their analysis of reserves. The human element in the application of actuarial judgment is unavoidable when
Lastly, significant structural changes to the available data, product mix or organization can also materially impact the reserve estimation process. The merger of TPC and SPC resulted in the exposure of each other’s actuaries and claim departments to different products, data histories, analysis methodologies, claim settlement experts, and more robust data when viewed on a combined basis. This impacted the range of estimates produced by the Company’s actuaries, as they reacted to new data, approaches, and sources of expertise to draw upon. It also resulted in additional levels of uncertainty, as past trends (that were a function of past products, past claim handling procedures, past claim departments, and past legal and other experts) may not repeat themselves, as those items affecting the trends change or evolve due to the merger. This also increased the potential for material variation in estimates, as experts can have differing views as to the impact of these frequently evolutionary changes. Events such as mergers increase the inherent uncertainty of reserve estimates for a period of time, until stable trends reestablish themselves within the new organization.
The principal estimation and analysis methods utilized by the Company’s actuaries are the paid development method, the case incurred development method(1), the Bornhuetter-Ferguson (BF) method, and average value analysis combined with the reported claim development method. The BF method is usually utilized for more recent accident periods, with a transition to other methods as the underlying claim data becomes more voluminous and therefore more credible. These are typically referred to as traditional actuarial methods. (See Glossary for an explanation of these methods.)
Some components of product line reserves are susceptible to relatively infrequent large claims that can materially impact the total estimate for that component. In such cases, the Company’s actuarial analysis generally isolates and analyzes separately such large claims. The reserves excluding such large claims are generally analyzed using the traditional methods described above. The reserves associated with large claims are then analyzed utilizing various methods such as:
The above is generally utilized to evaluate management’s existing estimate for prior accident periods. For the initial estimate of the current accident year, the available claim data is typically insufficient to produce a reliable indication. Hence, the initial estimate for an accident year is generally based on a loss ratio projection method which uses the earned premium for the current year multiplied by a projected loss ratio. The projected loss ratio is determined through analysis of prior experience periods using loss trend, rate level differences, mix of business changes and other known or observed factors influencing the current accident year relative to prior accident years. The exact number of prior accident years utilized varies by product line component, based on the volume of business for that component and the reliability of an individual accident year estimate.
(1) The paid and incurred development methods are sometimes also known as “link ratio” methods.
The following section details reserving considerations and common risk factors by product line. There are many additional risk factors that may impact ultimate claim costs. Each risk factor presented will have a different impact on required reserves. Also, risk factors can have offsetting or compounding effects on required reserves. For example, in workers’ compensation, the use of expensive medical procedures that result in medical cost inflation may enable workers to return to work faster, thereby lowering indemnity costs. Thus, in almost all cases, it is impossible to discretely measure the effect of a single risk factor and construct a meaningful sensitivity expectation.
Historically, the one-year change in the reserve estimate for this product line, excluding estimated asbestos and environmental amounts, over the last nine years has varied from -3% to +14% (averaging +5%) for the Company and -4% to +7% (averaging +1%) for the industry overall. The Company’s year-to-year changes are driven by and are based on observed events during the year. Because the high end of the Company’s range of historical adverse development came from certain business that has since been exited, the Company believes that the industry’s range of historical outcomes is illustrative of reasonably possible one-year changes in reserve estimates for this product line. General liability reserves (excluding asbestos and environmental) represent approximately 26% of the Company’s total loss reserves.
The Company’s change in reserve estimate for this product line, excluding estimated asbestos and environmental amounts, was +2% for 2006, +4% for 2005 and +10% for 2004. The 2006 change largely resulted from directors and officers and errors and omissions adjustments due to worse than expected large loss activity and additional information from detailed claim reviews, primarily associated with accident years 2002 and 2003. The 2005 change was the net result of numerous adjustments for various components with no individual item being a primary driver. The 2004 change was principally due to the construction defect and construction wrap-up reserving actions discussed on page 76 of this narrative.
For the more severe catastrophic events, “demand surge” inflation, which refers to significant short-term increases in building material and labor costs due to a sharp increase in demand for those materials and services
Historically, the one-year change in the reserve estimate for this product line over the last nine years has varied from -6% to +2% (averaging -3%) for the Company and -2% to +6% (averaging +2%) for the industry overall. The Company’s year-to-year changes are driven by and are based on observed events during the year. The Company believes that its range of historical outcomes is illustrative of reasonably possible one-year changes in reserve estimates for this product line. Commercial multi-peril reserves represent approximately 8% of the Company’s total loss reserves.
The Company’s change in reserve estimate for this product line was -4% for 2006, -6% for 2005 and -5% for 2004. The 2006 change was attributable to better than expected results due to, among other factors, increasingly favorable legal and judicial environments as well as enhanced risk control, underwriting and claim process initiatives. The 2005 change was the result of increasingly favorable legal and judicial environments, coupled with better than expected results from changes in policy provisions as well as underwriting and pricing criteria. The 2004 change was primarily attributable to better than expected results from changes in underwriting and pricing strategies.
Historically, the one-year change in the reserve estimate for this product line over the last nine years has varied from -7% to +9% (averaging +1%) for the Company and -1% to +9% (averaging +2%) for the industry overall. The Company’s year-to-year changes are driven by and are based on observed events during the year. The Company believes that its range of historical outcomes is illustrative of reasonably possible one-year changes in reserve estimates for this product line. Commercial automobile reserves represent approximately 7% of the Company’s total loss reserves.
Fidelity is generally considered a short tail coverage. It takes a relatively short period of time to finalize and settle fidelity claims. The volatility of fidelity reserves is generally related to the type of business of the insured, the size and complexity of the insured’s business operations, amount of policy limit
(1) These are administrative bodies that evaluate whether or not a given claim for workers’ compensation benefits is valid. Duties include the determination of whether a given injury arose out of the scope of employment, or the determination of the degree of injury where disputes exist.
and attachment point of coverage. The uncertainty surrounding reserves for small, commercial insureds is typically less than the uncertainty for large commercial or financial institutions. The high frequency, low severity nature of small commercial fidelity losses provides for stability in loss estimates whereas, the low frequency, high severity nature of losses for large insureds results in a wider range of ultimate loss outcomes. Actuarial techniques that rely on a stable pattern of loss development are generally not applicable to low frequency, high severity policies.
Unanticipated changes in risk factors can affect reserves. As an indicator of the causal effect that a change in one or more risk factors could have on reserves for fidelity and surety, a 1% increase (decrease) in incremental paid loss development for each future calendar year could result in a 1.2% increase (decrease) in loss reserves.
The Company’s change in reserve estimate for this product line was -5% for 2006, 0% for 2005 and +138% for 2004. The 2006 change was due to better than expected large loss activity. The 2004 change resulted from acquired business, including a large construction contractor loss discussed on page 77 of this narrative.
Examples of common risk factors, or perceptions thereof, that could change and, thus, affect the required personal automobile reserves (beyond those included in the general discussion section) include:
Historically, the one-year change in the reserve estimate for this product line over the last nine years has varied from -9% to +1% (averaging -4%) for the Company and -7% to 0% (averaging -3%) for the industry overall. The Company’s year-to-year changes are driven by and are based on observed events during the year. The Company believes that its range of historical outcomes is illustrative of reasonably possible one-year changes in reserve estimates for this product line. Personal automobile reserves represent approximately 4% of the Company’s total loss reserves.
The Company’s change in reserve estimate for this product line was -7% for 2006, -9% for 2005 and -6% for 2004. The decreases in 2006 and 2005 were primarily due to better than expected results from changes in claim handling practices as well as initiatives to fight fraud. The 2004 change was driven by better than expected frequency and severity, which is believed to have been principally caused by societal trends as well as fraud initiatives.
Examples of common risk factors, or perceptions thereof, that could change and, thus, affect the required homeowners reserves (beyond those included in the general reserve discussion section) include:
loss development, particularly from fewer claim counts for accident year 2003 as a result of changes in the marketplace, including higher policy deductible levels and fewer small dollar claims.
International and other includes products written by International and Lloyd’s and other products not discussed above. The principal component of “other” claim reserves is assumed reinsurance written on an excess-of-loss basis, which may include reinsurance of non-U.S. exposures, and is primarily runoff business.
Due to changes in the business mix for this line over time, the recently incurred claim liabilities are relatively short term (due to both the products and the jurisdictions involved, e.g., the Republic of Ireland and the United Kingdom), while the older liabilities include some from runoff operations that are extremely long tail (e.g., U.S. excess liabilities reinsured through the London market, and several underwriting pools in runoff). The speed of claim reporting and claim settlement is a function of the specific coverage provided, the jurisdiction, the distribution system (e.g., underwriting pool versus direct), and the proximity of the insurance sale to the insured hazard (e.g., insured and insurer located in different countries). In particular, liabilities arising from the underwriting pools in runoff may result in significant reporting lags, settlement lags and claim complexity, due to the need to coordinate with other pool members or co-insurers through a broker or lead-insurer for claim settlement purposes.
International and other reserves are generally analyzed by program/pool, country and general coverage category (e.g., U.S. Liability-excess of loss reinsurance, or General Liability-Municipalities-by country). The business is also generally split by direct versus assumed reinsurance for a given coverage/jurisdiction. Where the underlying insured hazard is outside the United States, the underlying coverages are generally similar to those described under the General Liability and Automobile discussion above, but under a different legal system. Where the underlying hazard is within the U.S., the coverage involved is typically that of General Liability, but on an excess or excess-of-loss reinsurance basis. Excess exposure requires the insured to “prove” not only claims under the policy, but also the prior payment of claims reaching up to the excess policy’s attachment point.
Unanticipated changes in risk factors can affect reserves. As an indicator of the causal effect that a change in one or more risk factors could have on reserves for International and other (excluding asbestos and environmental), a 1% increase (decrease) in incremental paid loss development for each future calendar year could result in a 1.3% increase (decrease) in loss reserves. International and other reserves (excluding asbestos and environmental) represent approximately 10% of the Company’s total loss reserves.
The Company reports its reinsurance recoverables net of an allowance for estimated uncollectible reinsurance recoverables. The allowance is based upon the Company’s ongoing review of amounts outstanding, length of collection periods, changes in reinsurer credit standing, disputes, applicable coverage defenses, and other relevant factors. Accordingly, the establishment of reinsurance recoverables and the related allowance for uncollectible reinsurance recoverables is also an inherently uncertain process involving estimates. Changes in these estimates could result in additional income statement charges. The allowance for uncollectible reinsurance at December 31, 2006 declined by $31 million from the same date in 2005.
(1) Short-term investments are primarily valued at amortized cost, which approximates fair value.
and information technologies infrastructures industries. The Company typically is involved with venture capital companies early in their formation, as they are developing and determining the viability of, and market demand for, their product. Generally, the Company does not expect these venture capital companies to record revenues in the early stages of their development, which can often take three to four years, and does not generally expect them to become profitable for an even longer period of time.
· Whether the investee’s progress has been substantially more or less than expected;
The Company’s investment portfolio includes non-publicly traded investments, such as venture capital investments (as discussed above), private equity limited partnerships, joint ventures, other limited partnerships, and certain fixed income securities. The Company uses the equity method of accounting for joint ventures, limited partnerships and certain private equity securities. Certain other private equity investments, including venture capital investments are reported at estimated fair value. These non-publicly traded securities are valued based on factors such as management judgment, recent financial information and other market data.
The following is a summary of the approximate carrying value of the Company’s non-publicly traded securities at December 31, 2006:
The Company recognizes an impairment loss when an invested asset’s value declines below cost, adjusted for accretion, amortization and previous other-than-temporary impairments (new cost basis), and the change is deemed to be other-than-temporary, or if it is determined that the Company will not be able to recover all amounts due pursuant to the issuers’ contractual obligations prior to sale or maturity. When the Company determines that an invested asset is other-than-temporarily impaired, the invested asset is written down to fair value and the amount of the impairment is included in earnings as a realized investment loss. The fair value then becomes the new cost basis of the investment and any subsequent recoveries in fair value are recognized at disposition.
Factors considered in determining whether a decline is other-than-temporary include the length of time and the extent to which fair value has been below cost, the financial condition and near-term prospects of the issuer, and the Company’s ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery.
· Determination of the status of each analyzed investment as other-than-temporary or not, with documentation of the rationale for the decision.
The Company may, from time to time, sell invested assets subsequent to the balance sheet date that were considered temporarily impaired at the balance sheet date for several reasons. For all subsequent
In August 2006, the Company announced a realignment of two of its three reportable business segments. The former Commercial and Specialty segments were realigned into the Business Insurance segment and the Financial, Professional & International Insurance segment. The Personal segment was renamed Personal Insurance. Goodwill was reallocated among the reportable business segments to align the acquired business with the appropriate reporting segment.
The impairment test, in accordance with FAS 142, is a two-step process. The first step is to identify any potential impairment using a multiple-of-earnings approach to estimate the fair value of the reporting units. The fair values of the reporting units are then compared to their carrying value, including goodwill. If the carrying amounts of the reporting units exceed their fair value, a second step is performed to measure the amount of impairment, if any. The Company’s review resulted in no impairment of goodwill for the years ended December 31, 2006 and 2005.
See note 1 of notes to the Company’s consolidated financial statements for a discussion of recently issued accounting pronouncements.
This report may contain, and management may make, certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical facts, may be forward-looking statements. Specifically, the Company may make forward-looking statements about the Company’s results of operations (including, among others, premium volume, income from continuing operations, net and operating income and return on equity), financial condition and liquidity; the sufficiency of the Company’s asbestos and other reserves (including, among others, asbestos claim payment patterns); the cost and availability of reinsurance coverage; and strategic initiatives. Such statements are subject to risks and uncertainties, many of which are difficult to predict and generally beyond the Company’s control, that could cause actual results to differ materially from those expressed in, or implied or projected by, the forward-looking information and statements.
The Company’s forward-looking statements speak only as of the date of this report or as of the date they are made, and the Company undertakes no obligation to update its forward-looking statements.
Consolidated Statement of Changes in Shareholders’ Equity for the years ended December 31, 2006, 2005 and 2004
We have audited the accompanying consolidated balance sheet of The St. Paul Travelers Companies, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statement of income, changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The St. Paul Travelers Companies, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of The St. Paul Travelers Companies, Inc. and subsidiaries internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 23, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
The consolidated financial statements include the accounts of The St. Paul Travelers Companies, Inc. (together with its subsidiaries, the Company). On April 1, 2004, Travelers Property Casualty Corp. (TPC) merged with a subsidiary of The St. Paul Companies, Inc. (SPC), as a result of which TPC became a wholly-owned subsidiary of The St. Paul Travelers Companies, Inc. For accounting purposes, this transaction was accounted for as a reverse acquisition with TPC treated as the accounting acquirer. Accordingly, this transaction was accounted for as a purchase business combination, using TPC’s historical financial information and applying fair value estimates to the acquired assets, liabilities and commitments of SPC as of April 1, 2004. Beginning on April 1, 2004, the results of operations and financial condition of SPC were consolidated with TPC’s results of operations and financial condition. Accordingly, all financial information presented herein for the twelve months ended December 31, 2006 and 2005 reflects the consolidated accounts of SPC and TPC. The financial information presented herein for the twelve months ended December 31, 2004 reflects only the accounts of TPC for the three months ended March 31, 2004 and the consolidated accounts of SPC and TPC for the nine months ended December 31, 2004.
FAS 123R, which became effective January 1, 2006, requires entities that use the fair-value method of either recognition or disclosure under FAS 123 to apply a modified version of the prospective application. Under modified prospective application, compensation cost is recognized on or after the effective date for all unvested awards, based on their grant-date fair value as calculated under FAS 123 for either recognition or pro forma disclosure purposes.
In addition, the accounting for certain grants of equity awards to individuals who are retirement-eligible on the date of grant has been clarified. FAS 123R states that an employee’s share-based award becomes vested, for expensing purposes, at the date that the employee’s right to receive or retain equity shares is no longer contingent on the satisfaction of a market, performance or service condition. Accordingly, awards granted to retirement-eligible employees are not contingent on satisfying a service condition and therefore are recognized at fair value on the date of the grant. Additionally, the period over which cost is recognized for awards granted to those who become retirement-eligible before the vesting
In September 2005, the Accounting Standards Executive Committee (AcSEC) issued Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (SOP 05-1). SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in Statement of Financial Accounting Standards No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract.
SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006, with earlier adoption encouraged. The adoption of SOP 05-1 effective January 1, 2007 did not have a material effect on the Company’s results of operations, financial condition or liquidity.
FAS 155 is effective for all financial instruments acquired, issued or subject to a remeasurement (new basis) event occurring after the beginning of an entity’s fiscal year that begins after September 15, 2006. At adoption, for contracts where the fair value option has been elected, any difference between the total carrying amount of the individual components of the existing bifurcated hybrid financial instrument and the fair value of the combined hybrid financial instrument should be recognized as a cumulative-effect adjustment to beginning retained earnings. The Company adopted FAS 155 effective January 1, 2007. Since it did not elect the fair value option, it did not have a cumulative effect upon adoption of FAS 155. The ongoing effect of adopting FAS 155 will not be material to the Company’s results of operations, financial condition or liquidity.
In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109 (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements and prescribes the recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.
Under FIN 48, evaluation of a tax position is a two-step process. The first step is to determine whether it is more-likely-than-not that a tax position will be sustained upon examination, including the resolution of any related appeals or litigation based on the technical merits of the position. The second step is to measure a tax position that meets the more-likely-than-not threshold to determine the amount of benefit to be recognized in the financial statements. A tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement.
Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent period in which the threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not criteria should be de-recognized in the first subsequent financial reporting period in which the threshold is no longer met.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (FAS 157). FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosure about fair value measurements. It applies to other pronouncements that require or permit fair value but does not require any new fair value measurements. The statement defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
FAS 157 establishes a fair value hierarchy to increase consistency and comparability in fair value measurements and disclosures. The hierarchy is based on the inputs used in valuation and gives the highest priority to quoted prices in active markets. The highest possible level should be used to measure fair value.
FAS 157 is effective for fiscal years beginning after November 15, 2007. The Company does not expect the provisions of FAS 157 to have a material effect on its results of operations, financial condition or liquidity.
FAS 159 is effective for fiscal years beginning after November 15, 2007. Upon adoption, an entity is permitted to elect the fair value option irrevocably for any existing asset or liability within the scope of the standard. The adjustment to reflect the difference between the fair value and the carrying amount would be accounted for as a cumulative-effect adjustment to retained earnings as of the date of initial adoption.
Retrospective application would not be permitted. The Company is currently evaluating the impact, if any, of FAS 159 on its results of operations, financial condition and liquidity.
Other investments include: venture capital investments, through direct ownership and limited partnerships; private equity limited partnerships; joint ventures; other limited partnerships; mortgage loans and trading securities. Certain venture capital investments that are controlled by the Company are consolidated in the Company’s financial statements. The Company uses the equity method of accounting for joint ventures, limited partnerships and certain private equity securities. Mortgage loans are carried at amortized cost. Trading securities are marked to market with the change in fair value recognized in net investment income during the current period.
Fixed maturities are valued based upon quoted market prices or dealer quotes, or if quoted market prices or dealer quotes are not available, discounted expected cash flows using market rates commensurate with the credit quality and maturity of the investment. Equity securities are valued based on quoted market prices.
Fair value is established at the time of acquisition by internal analysis or external appraisers, using discounted cash flow analyses and other acceptable techniques. The Company had no real estate held for sale at December 31, 2006 or 2005.
A mortgage loan is considered impaired when it is probable that the Company will be unable to collect principal and interest amounts due. For mortgage loans that are determined to be impaired, a reserve is established for the difference between the amortized cost and fair market value of the underlying collateral. In estimating fair value, the Company uses interest rates reflecting the current real estate financing market returns. Impaired loans were not material at December 31, 2006 and 2005.
Venture capital investments and non-publicly traded investments are reviewed quarterly for other-than-temporary impairment by the external fund manager and the Company’s portfolio managers. An impairment loss is recognized if, based on the specific facts and circumstances, it is probable that the Company will not be able to recover all of the cost of an individual holding. For a further discussion, please see the “venture capital investments” and “non-publicly traded investments” sections under the “Valuation of Investments” above.
Accrual of income is suspended on fixed maturities or mortgage loans that are in default, or on which it is likely that future payments will not be made as scheduled. Interest income on investments in default is recognized only as payment is received. Investments included in the consolidated balance sheet that were not income-producing for the preceding 12 months were not material.
Net realized investment gains and losses are included as a component of pretax revenues based upon specific identification of the investments sold on the trade date. Included in net realized investment gains (losses) are other-than-temporary impairment losses on invested assets as described above in the “Investment Impairment” section above.
Amounts recoverable from reinsurers are estimated in a manner consistent with the associated claim liability. The Company reports its reinsurance recoverables net of an allowance for estimated uncollectible
reinsurance recoverables. The allowance is based upon the Company’s ongoing review of amounts outstanding, length of collection periods, changes in reinsurer credit standing, disputes, applicable coverage defenses and other relevant factors. Amounts deemed to be uncollectible, including amounts due from known insolvent reinsurers, are written off against the allowance for estimated uncollectible reinsurance recoverables. Any subsequent collections of amounts previously written off are reported as part of claim and claim adjustment expenses. The Company evaluates and monitors the financial condition of its reinsurers under voluntary reinsurance arrangements to minimize its exposure to significant losses from reinsurer insolvencies.
A review is performed on at least an annual basis, of goodwill held by the reporting units, which are the Company’s three operating and reportable segments: Business Insurance; Financial, Professional & International Insurance; and Personal Insurance.
Claims and claim adjustment expense reserves represent estimates for both reported and unreported claims incurred and related expenses. The reserves are adjusted regularly based upon experience. Included
in the claims and claim adjustment expense reserves in the consolidated balance sheet are certain reserves discounted to the present value of estimated future payments. The liabilities for losses for some long-term disability payments under workers’ compensation insurance and workers’ compensation excess insurance, which totaled $1.98 billion and $1.92 billion at December 31, 2006 and 2005, respectively, were discounted using a rate of 5% at December 31, 2006 and 2005. Reserves related to certain fixed and determinable asbestos-related settlements, where all payment amounts and their timing are known, totaled $34 million at December 31, 2005, and were discounted using a rate of 2.6% at that date. There were no such reserves at December 31, 2006. Reserves for certain assumed reinsurance business were discounted using a rate of 7% and a range of rates from 5% to 7.5% at December 31, 2006 and 2005, respectively, and totaled $37 million and $79 million at December 31, 2006 and 2005, respectively.
Also included in other liabilities is an accrual for policyholder dividends. Certain insurance contracts, primarily workers’ compensation, are participating whereby dividends are paid to policyholders in
In February 2006, following approval by the respective managing agencies, the 2003 and prior years of account of Lloyd’s Syndicates 5000 and 779 closed through reinsurance to close (RITC) into the 2004 year of account, for which the Company is the capital provider through its 100% ownership of Lloyd’s members F&G UK Underwriters, Ltd. and Aprilgrange, Ltd. The RITC was effective January 1, 2006. The RITC resulted in the Company acquiring $538 million of net claim and claim adjustment expense reserves (net of $243 million of reinsurance recoverables), $470 million of investments, $29 million of cash and other net assets during the first quarter of 2006. There was no impact on the Company’s results of operations at the time the RITC was recorded.
The Company has an employee stock incentive compensation plan that permits grants of nonqualified stock options, incentive stock options, stock appreciation rights, restricted stock, deferred stock, stock units, performance awards and other stock-based or stock-denominated awards with respect to the Company’s common stock.
The Company may use derivative financial instruments, including interest rate swaps, equity swaps, credit derivatives, options, forward contracts and financial futures, as a means of hedging exposure to interest rate, equity price change and foreign currency risk. The Company’s insurance subsidiaries do not hold or issue derivative instruments for trading purposes. The Company recognizes all derivatives, including certain derivative instruments embedded in other contracts, as either assets or liabilities in the consolidated balance sheet and measures those instruments at fair value. Where applicable, hedge accounting is used to account for derivatives. For an instrument to qualify as a hedge, the hedge relationship must be designated and formally documented at inception, detailing the particular risk management objective and strategy for the hedge, including the item and risk that is being hedged, the derivative that is being used, and how effectiveness is being assessed. A derivative must be highly effective in accomplishing the objective of offsetting either changes in fair value or cash flows for the risk being hedged. The effectiveness of these hedging relationships is evaluated on a retrospective and prospective basis using quantitative measures of correlation. If a hedge relationship is found to be ineffective, it no longer qualifies as a hedge, and any excess gains or losses attributable to such ineffectiveness as well as subsequent changes in fair value are recognized in net realized investment gains (losses). The recognition of gains or losses on derivative instruments that have been designated and qualify as a hedge depends upon whether the derivative instrument is a fair value hedge, a cash flow hedge or a foreign currency hedge.
· Commercial Accounts serves primarily mid-sized businesses for property and casualty products, including property, general liability, commercial multi-peril, commercial auto and workers’ compensation insurance. Certain units included in Commercial Accounts prior to the realignment are now included in the Industry-Focused Underwriting, Target Risk Underwriting or Specialized Distribution groups.
· National Accounts comprises three business units. The largest provides casualty products and services to large companies, with particular emphasis on workers’ compensation, general liability and automobile liability. National Accounts also includes Discover Re, which provides property and casualty insurance products on an unbundled basis using third-party administrators for insureds who utilize programs such as collateralized deductibles, captive reinsurers and self-insurance. In addition, National Accounts includes the commercial residual market business, which primarily offers workers’ compensation products and services to the involuntary market.
· Industry-Focused Underwriting. The following business units serve targeted industries with differentiated combinations of insurance coverage, risk management, claims handling and other services:
· Construction serves a broad range of construction businesses, offering guaranteed cost products for small to mid-sized policyholders and loss sensitive programs for larger accounts. For the larger accounts, the customer and the Company work together in actively managing and controlling exposure and claims and they share risk through policy features such as deductibles or retrospective rating. Products offered include workers’ compensation, general liability and commercial auto coverages, and other risk management solutions.
· Technology serves small to mid-sized companies involved in telecommunications, information technology, medical technology and electronics manufacturing, offering a well-balanced comprehensive portfolio of products and services. These products include property, commercial auto, general liability, workers’ compensation, umbrella, internet liability, technology errors and omissions coverages and global companion products.
· Public Sector Services markets insurance products and services to public entities including municipalities, counties, Indian Nation gaming and selected special government districts such as water and sewer utilities. The policies written by this unit typically cover property, commercial auto, general liability and errors and omissions exposures.
· Oil & Gas provides specialized property and liability products and services for customers involved in the exploration and production of oil and natural gas, including operators and drilling contractors, as well as various service and supply companies and manufacturers that support upstream operations. The policies written by this business group insure drilling rigs, natural gas facilities, and production and gathering platforms, and cover risks including physical damage, liability and business interruption.
· Agribusiness serves small to medium-sized agricultural businesses, including farms, ranches, wineries and related operations, offering property and liability coverages other than workers’ compensation.
· Inland Marine provides insurance for goods in transit and movable objects for customers such as jewelers, museums, contractors and the transportation industry. Builders’ risk insurance is also offered to customers during the construction, renovation or repair of buildings and other structures.
· Excess Casualty serves small to mid-sized commercial businesses, offering mono-line umbrella and excess coverage where the Company does not write the primary casualty coverage, or where other business units within the Company prefer to outsource the underwriting of umbrella and excess business based on the expertise and/or limit capacity of Excess Casualty.
property casualty carriers that do not have in-house expertise with reinsurance, underwriting, engineering, claim handling and risk management services for this type of coverage.
· Specialized Distribution. The following business units market and underwrite their products to customers predominantly through licensed wholesale, general and program agents that manage customers’ unique insurance requirements.
· Northland provides insurance coverage for the commercial transportation industry, as well as commercial liability and package policies for small, difficult to place specialty classes of commercial business on an admitted or excess and surplus lines basis.
· National Programs offers tailored property and casualty programs on an admitted basis for customers with common risk characteristics or coverage requirements. Programs available include those for entertainment, architects and engineers, equipment rental and golf services.
· Underwriting Facilities serves small commercial businesses, offering general liability, property and commercial auto physical damage coverages on an admitted or excess and surplus lines basis.
Business Insurance also includes the Special Liability Group (which manages the Company’s asbestos and environmental liabilities); the assumed reinsurance, health care, and certain international and other runoff operations; policies written by the Company’s Gulf operation (Gulf), which was placed into runoff during the second quarter of 2004; and the Company’s Personal Catastrophe Risk operation, which was sold in November 2005. The Company’s Personal Catastrophe Risk business had been included in the Specialty segment prior to the August 2006 segment realignment. In accordance with the terms of the sale agreement, the Company retained responsibility for the pre-sale claims and claim adjustment expense reserves related to the Personal Catastrophe Risk operation and remains responsible for any changes in estimates in those reserves through a quota-share reinsurance agreement. These are collectively referred to as Business Insurance Other. The Personal Catastrophe Risk operation accounted for the majority of net written premiums in this category in 2005. In 2004, Gulf and the Personal Catastrophe Risk operation accounted for the majority of written premiums in this category.
· Bond & Financial Products provides a wide range of customers with bond and insurance products and risk management services. The range of coverages includes surety and fidelity bonds, for construction and general commercial enterprises; professional liability and management liability for public corporations, private companies and not-for-profit organizations for losses caused by the negligence or misconduct of named directors and officers; professional liability for a variety of professionals, such
as lawyers, design professionals and real estate agents for liability from errors and omissions committed in the course of professional conduct or practice; and a full range of property, auto, liability, fidelity and professional/management liability insurance for financial institutions. This business represents the fourth quarter 2006 combination of the Company’s previous Bond and Financial & Professional Services marketing groups.
In December 2006, the Company reached a definitive agreement to sell its Mexican surety subsidiary, Afianzadora Insurgentes, S.A. de C.V., which accounted for $79 million of net written premiums in 2006. The impact of this transaction will not be material to the Company’s results of operations or financial condition.
· International and Lloyd’s includes coverages marketed to and underwritten for several customer groups within the United Kingdom, Canada and the Republic of Ireland and business written as a Corporate Member at Lloyd’s. International offers specialized insurance and risk management services to several customer groups, including those in the technology, public services, and financial and professional services industry sectors. International primarily underwrites employers’ liability (similar to workers’ compensation coverage in the United States), public and product liability (the equivalent of general liability), professional indemnity (similar to professional liability coverage), motor (similar to automobile coverage in the United States) and property exposures. The Company underwrites four principal lines of business-aviation, marine, global property, and accident and special risks-through its Lloyd’s syndicate (Syndicate 5000), for which the Company provides 100% of the capital. During the second half of 2004, the Company made a decision to exit certain portions of the Lloyd’s personal lines business and, in early 2005, sold the right to renew this business as well as the operating companies that supported it.
The Personal Insurance segment writes virtually all types of property and casualty insurance covering personal risks. The primary coverages in Personal Insurance are automobile and homeowners insurance sold to individuals. These products are distributed through independent agents, sponsoring organizations such as employee and affinity groups, and joint marketing arrangements with other insurers.
In January 2007, the Company reached a definitive agreement to sell its subsidiary, Mendota Insurance Company and its wholly-owned subsidiaries, Mendakota Insurance Company and Mendota Insurance Agency, Inc. These subsidiaries primarily offered nonstandard automobile coverage and accounted for approximately $187 million of net written premium volume in 2006. The sale is not expected to be material to the Company’s results of operations or financial condition.
The cost of the Company’s catastrophe treaty program is included in the Company’s ceded premiums and is allocated among reportable business segments based on an estimate of actual market reinsurance pricing using expected losses calculated by the Company’s catastrophe model, adjusted for any experience adjustments. For Hurricane Katrina in 2005, the initial allocation of reinsurance recoverables to the segments was based upon the best estimate of segment incurred losses.
The following tables summarize the components of the Company’s revenues, operating income (loss) and total assets by reportable business segments. Financial data for prior years presented in the tables was reclassified to be consistent with the new segment structure implemented in 2006.
(1) Operating revenues for reportable business segments exclude net realized investment gains (losses) and revenues from discontinued operations. Operating income (loss) for reportable business segments equals net income excluding the after-tax impact of net realized investment gains (losses) and the after-tax impact of discontinued operations.
(1) The primary component of Interest Expense and Other is after-tax interest expense of $207 million, $186 million and $151 million in 2006, 2005 and 2004, respectively. The 2006 total also reflects a $27 million after-tax gain on the redemption of the Company’s $593 million, 7.60% subordinated debentures. See note 7.
The Company’s investment portfolio includes the fixed maturities, equity securities, and other investments acquired in the merger at their fair values as of the merger date. The fair value at acquisition became the new cost basis for these investments.
At December 31, 2006 and 2005, the Company held CMOs classified as available for sale with a fair value of $3.56 billion and $3.43 billion, respectively (excluding Commercial Mortgage-Backed Securities of $1.07 billion and $1.16 billion, respectively). Approximately 36% and 43% of the Company’s CMO holdings are guaranteed by or fully collateralized by securities issued by GNMA, FNMA or FHLMC at December 31, 2006 and 2005, respectively. In addition, the Company held $4.36 billion and $4.83 billion of GNMA, FNMA, FHLMC or FHA mortgage-backed pass-through securities classified as available for sale at December 31, 2006 and 2005, respectively. Virtually all of these securities are rated Aaa.
Proceeds from the sale of real estate investments totaled $37 million in 2005. Gross gains of $15 million were realized on those sales, and no gross losses were recognized. The Company did not sell any real estate investments in 2006 or 2004.
Future minimum rental income expected on operating leases relating to the Company’s real estate properties is $97 million, $85 million, $68 million, $53 million, $35 million, and $51 million for 2007, 2008, 2009, 2010, 2011 and 2012 and thereafter, respectively.
· Municipal Trusts-The Company owns interests in various municipal trusts that were formed for the purpose of allowing more flexibility to generate investment income in a manner consistent with the Company’s investment objectives and tax position. As of December 31, 2006 and 2005, there were 35 and 36 such trusts, respectively, which held a combined total of $391 million and $441million, respectively, in municipal securities, of which $76 million and $84 million, respectively, were owned by outside investors. The net carrying value of the trusts owned by the Company at December 31, 2006 and 2005 was $315 million and $357 million, respectively.
The Company has significant interests in the following VIEs which are not consolidated because the Company is not considered to be the primary beneficiary:
· The Company has a significant variable interest in Camperdown UK Limited, which SPC sold in December 2003. The Company’s variable interest resulted from an agreement to indemnify the purchaser in the event a specified reserve deficiency develops, a reserve-related foreign exchange impact occurs, or a foreign tax adjustment is imposed on a pre-sale reporting period. The maximum amount of this indemnification obligation is $187 million. The fair value of this obligation as of December 31, 2006 and 2005 was $65 million and $66 million, respectively. See “Guarantees” section of note 15.
The following tables summarize, for all investments in an unrealized loss position at December 31, 2006 and 2005, the aggregate fair value and gross unrealized loss by length of time those securities have been continuously in an unrealized loss position.
The Company’s consolidated financial statements reflect the effects of assumed and ceded reinsurance transactions. Assumed reinsurance refers to the acceptance of certain insurance risks that other insurance companies have underwritten. Ceded reinsurance involves transferring certain insurance risks (along with the related written and earned premiums) the Company has underwritten to other insurance companies who agree to share these risks. The primary purpose of ceded reinsurance is to protect the Company, at a cost, from volatility in excess of the amount it is prepared to accept. Reinsurance is placed on both a quota-share and excess of loss basis. Ceded reinsurance arrangements do not discharge the Company as the primary insurer, except for cases involving a novation.
The Company assumed 100% of the workers’ compensation premiums previously written by the Accident Department of its former affiliate, The Travelers Insurance Company.
Certain of the assumed reinsurance contracts that the Company has entered into with non-affiliated companies on an excess of loss basis do not transfer insurance risk. These contracts, which totaled
In 2004, the Company entered into commutation agreements with a major reinsurer, resulting in a charge of $153 million for amounts received less than the reinsurance recoverable balances of approximately $1.26 billion. In connection with the commutation, the Company also entered into a new reinsurance agreement effective April 1, 2004, that provides $300 million aggregate coverage for the 2000 accident year exposures written by SPC. Because the new agreement is for events occurring prior to the effective date of the agreement, it was considered retroactive reinsurance and the resulting $59 million gain was deferred and will be recognized in earnings as amounts are recovered from the reinsurer. Through December 31, 2006, $11 million of the deferred gain was recognized in earnings, all of which occurred in 2006. Under the terms of these agreements, the Company received net cash of approximately $867 million in 2004.
In order for a loss to be covered under the Program (subject losses), the loss must meet certain aggregate industry loss minimums that vary by Program year of amounts $100 million or less, and must be the result of an event that is certified as an act of terrorism by the U.S. Secretary of the Treasury. The original Program excluded from participation certain of the following types of insurance: Federal crop insurance, private mortgage insurance, financial guaranty insurance, medical malpractice insurance, health or life insurance, flood insurance, and reinsurance. The Terrorism Extension Act exempted from coverage certain additional types of insurance, including commercial automobile, professional liability (other than directors and officers’), surety, burglary and theft, and farm-owners multi-peril. In the case of a war declared by Congress, only workers’ compensation losses are covered by the Terrorism Act and the Terrorism Extension Act. Both Acts generally require that all commercial property casualty insurers licensed in the United States participate in the Program. Under the Program, a participating insurer is entitled to be reimbursed by the Federal Government for a percentage of subject losses, after an insurer deductible, subject to an annual cap. The Federal reimbursement percentage is 85% in 2007.
The deductible is calculated by applying the deductible percentage to the insurer’s direct earned premiums for covered lines from the calendar year immediately preceding the applicable year. The deductible under the Program was 10% for 2004, 15% for 2005, 17.5% for 2006 and will be 20% for 2007. The Company’s estimated deductible under the Program is $2.20 billion for 2007. The annual cap limits the amount of aggregate subject losses for all participating insurers to $100 billion. Once subject losses have reached the $100 billion aggregate during a program year, Congress shall determine the source of funds, if any, available for losses that exceed the $100 billion cap. The Company had no terrorism-related losses in 2006, 2005 or 2004. If the Program is not renewed for periods after January 1, 2008, the benefits of the Program will not be available to the Company, and the Company will be subject to losses from acts of terrorism subject only to the terms and provisions of applicable policies, including policies written in 2007 for which the period of coverage extends into 2008. Given the unpredictable frequency and severity of terrorism losses, as well as the limited terrorism coverage in the Company’s own reinsurance program, future losses from acts of terrorism, particularly those involving nuclear, biological, chemical or radiological events, could be material to the Company’s operating results, financial condition and/or liquidity in future periods, particularly if the Program is not extended. Regardless of whether the Terrorism Act is extended, the Company will continue to manage this type of catastrophic risk by monitoring and controlling terrorism risk aggregations to the best of its ability.
Intangible asset amortization expense is estimated to be $146 million in 2007, $126 million in 2008, $100 million in 2009, $86 million in 2010 and $69 million in 2011.
Gross claim and claim adjustment expense reserves at December 31, 2006 decreased by $1.80 billion from the same date in 2005, primarily reflecting payments related to prior year hurricane losses, claim and claim adjustment expense payments from runoff operations and favorable prior year reserve development, primarily in the Personal Insurance segment, partially offset by the impact of reserves acquired in the RITC transaction described in note 1.
The $1.75 billion decline in reinsurance recoverables in 2006 primarily reflected significant reinsurance recoveries in related to prior year hurricane losses, operations in runoff (primarily Gulf) and various commutation agreements, partially offset by the impact of reinsurance recoverables acquired in the RITC transaction described above. In 2005, the $574 million increase in reinsurance recoverables primarily resulted from recoverables related to hurricane losses incurred.
In 2006, estimated claims and claim adjustment expenses included $429 million of net favorable development for claims arising in prior years, including $394 million of net favorable prior year reserve development impacting the Company’s results of operations which excludes $62 million of accretion of discount.
changes in claim handling practices. These changes included practices which have allowed case reserves to be established more accurately earlier in the claim settlement process, thereby changing historical loss development patterns. In addition, industry and Company initiatives to fight fraud in several states led to a decrease in the total number of claims and a change in historical loss development patterns. In the Homeowners and Other line of business, favorable prior year reserve development was partially driven by a significant decrease in the number of claims, attributable to changes in the marketplace, including higher deductibles and fewer small-dollar claims. These changes also resulted in a change in historical loss development patterns. In addition, non-catastrophe Homeowners and Other loss experience was favorable due to continued evidence of a less than expected impact from “demand surge,” which refers to significant short-term increases in building material and labor costs due to a sharp increase in demand for those materials and services. Included in net favorable prior year reserve development in 2006 was a reduction in loss estimates for catastrophes incurred in 2005, primarily due to lower than expected additional living expense losses related to Hurricane Katrina.
Business Insurance. Net unfavorable prior year reserve development in 2005 was $757 million, which included the asbestos and environmental changes that are discussed in more detail in the following “Asbestos and Environmental Reserves” section, and reserve strengthening for assumed reinsurance, which is in runoff. Those increases were partially offset by favorable prior year reserve development from lower frequency and severity for both casualty and property-related lines of business. Drivers of the reduction in both frequency and severity were increasingly favorable legal and judicial environments, coupled with better than expected results from changes in policy provisions as well as underwriting and pricing criteria. Company initiatives relating to claims handling, which affected claims staffing and workflows, also are believed to have contributed to the emergence of favorable severity experience in 2005.
and fewer small-dollar claims. These changes also resulted in a change in the historical loss development patterns.
Financial, Professional & International Insurance. Net unfavorable prior year reserve development totaled $739 million in 2004, which included a $300 million charge to strengthen surety reserves, as well as a $252 million charge related to a specific construction contractor and $39 million related to the commutation of agreements with a major reinsurer. Results in 2004 also reflected a charge to increase the allowance for estimated uncollectible amounts due from a co-surety on a specific construction contractor claim.
As in prior years, the 2006 annual review considered active policyholders and litigation cases, including cases challenging the applicability of aggregate limits on asbestos claims. Developing payment trends among policyholders in the Home Office and Field Office as well as Assumed and International categories were also analyzed. The 2006 review of the Home Office and Field Office categories, which account for the vast majority of the number of policyholders, experienced an overall reduction in new claim filings as well as in gross indemnity and defense payments over prior years.
· the absence of new theories of liability or new classes of defendants.
While there remains uncertainty with respect to future exposure from asbestos claims, the Company believes that the factors noted above have led to a reduction in the overall volatility associated with its asbestos exposure.
Environmental Reserves. In establishing environmental reserves, the Company evaluates the exposure presented by each policyholder and the anticipated cost of resolution, if any. In the course of this analysis, the Company considers the probable liability, available coverage, relevant judicial interpretations and historical value of similar exposures. In addition, the Company considers the many variables presented, such as the nature of the alleged activities of the policyholder at each site; the allegations of environmental harm at each site; the number of sites; the total number of potentially responsible parties at each site; the nature of environmental harm and the corresponding remedy at each site; the nature of government enforcement activities at each site; the ownership and general use of each site; the overall nature of the insurance relationship between the Company and the policyholder, including the role of any umbrella or excess insurance the Company has issued to the policyholder; the involvement of other insurers; the potential for other available coverage, including the number of years of coverage; the role, if any, of non-environmental claims or potential non-environmental claims, in any resolution process; and the applicable law in each jurisdiction. Conventional actuarial techniques are not used to estimate these reserves.
As a result of the processes and procedures described above, management believes that the reserves carried for asbestos and environmental claims at December 31, 2006 are appropriately established based upon known facts, current law and management’s judgment. However, the uncertainties surrounding the final resolution of these claims continue, and it is difficult to determine the ultimate exposure for asbestos and environmental claims and related litigation. As a result, these reserves are subject to revision as new information becomes available and as claims develop. The continuing uncertainties include, without limitation, the risks and lack of predictability inherent in complex litigation, any impact from the bankruptcy protection sought by various asbestos producers and other asbestos defendants, a further increase or decrease in asbestos and environmental claims beyond that which is anticipated, the role of any umbrella or excess policies the Company has issued, the resolution or adjudication of some disputes pertaining to the amount of available coverage for asbestos and environmental claims in a manner inconsistent with the Company’s previous assessment of these claims, the number and outcome of direct actions against the Company and future developments pertaining to the Company’s ability to recover reinsurance for asbestos and environmental claims. In addition, the Company’s asbestos-related claims and claim adjustment expense experience has been impacted by the exhaustion or unavailability due to insolvency of other insurance sources potentially available to policyholders along with the insolvency or bankruptcy of other defendants, although the Company has noted a recent decrease in the number and volatility of asbestos-related bankruptcies. It is also not possible to predict changes in the legal and legislative environment and their impact on the future development of asbestos and environmental claims. This development will be affected by future court decisions and interpretations, as well as changes in applicable legislation, including legislation related to asbestos reform. It is also difficult to predict the ultimate outcome of large coverage disputes until settlement negotiations near completion and significant legal questions are resolved or, failing settlement, until the dispute is adjudicated. This is particularly the case with policyholders in bankruptcy where negotiations often involve a large number of claimants and other parties and require court approval to be effective. As part of its continuing analysis of asbestos reserves, which includes an annual ground-up review of asbestos policyholders, the Company continues to study the implications of these and other developments. The company completed its most recent annual ground-up review during the third quarter of 2006. See “Part I-Item 3, Legal Proceedings.”
2006 Debt Issuances-In June 2006, the Company issued $400 million aggregate principal amount of 6.25% senior unsecured notes due June 20, 2016 and $400 million aggregate principal amount of 6.75% senior unsecured notes due June 20, 2036. The notes were issued at a discount, resulting in effective interest rates of 6.30% and 6.86%, respectively. The notes pay interest semi-annually on June 20 and December 20 of each year, beginning December 20, 2006, and rank equally with all of the Company’s other senior unsecured indebtedness. Either series of senior notes is redeemable in whole or in part from time to time, at the Company’s option, prior to maturity at a redemption price equal to the greater of: 100% of the principal amount of senior notes to be redeemed; or the sum of the present values of the remaining
scheduled payments of principal and interest on the senior notes to be redeemed (exclusive of interest accrued to the date of redemption) discounted to the date of redemption on a semiannual basis (assuming a 360-day year consisting of twelve 30-day months) at the then current treasury rate plus 20 basis points for the 6.25% senior unsecured notes due June 20, 2016 and 25 basis points for the 6.75% senior unsecured notes due June 20, 2036. Net proceeds from the issuances (after original issue discount and expenses) totaled approximately $786 million.
Commercial Paper-The Company maintains an $800 million commercial paper program with $1 billion of back-up liquidity, consisting entirely of a bank credit agreement. Interest rates on commercial paper issued in 2006 ranged from 4.5% to 5.4%, and in 2005 ranged from 2.3% to 4.4%.
Senior Notes-The Company’s various senior debt issues are unsecured obligations that rank equally with one another. Interest payments are generally made semi-annually, except for the 5.01% senior notes, for which interest payments are made quarterly. The Company generally may redeem some or all of the notes prior to maturity in accordance with terms unique to each debt instrument.
The following table presents the unamortized fair value adjustment and the related effective interest rate on the SPC debt instruments acquired in the merger:
Maturities-The amount of debt obligations, other than commercial paper, that become due in each of the next five years is as follows: 2007, $1.10 billion; 2008, $552 million; 2009, $143 million; 2010, $273 million; and 2011, $2 million.
In December 2005, the Company filed with the Securities and Exchange Commission a shelf registration statement for the potential offering and sale of securities. The Company may offer these securities from time to time at prices and on other terms to be determined at the time of offering. During 2006, the Company issued senior debt with a par value of $800 million (as described above) under this shelf registration statement.
The SOP Trust may at any time convert any or all of the preferred shares into shares of the Company’s common stock at a rate of eight shares of common stock for each preferred share. The Board of Directors has reserved a sufficient number of authorized common shares to satisfy the conversion of all preferred shares issued to the SOP Trust and the redemption of preferred shares to meet employee distribution requirements. Upon the redemption of preferred shares, the Company will issue shares of common stock to the trust to fulfill the redemption obligations. See note 12. Holders of the preferred stock have a preference upon liquidation, dissolution or winding up of the Company of $100 per share.
In September 2005, the SOP was merged into the St. Paul Travelers 401(k) Savings Plan (the 401(k) Savings Plan). See note 12.
The Company is governed by the Minnesota Business Corporation Act. All authorized shares of voting common stock have no par value. Shares of common stock reacquired are considered authorized and unissued shares. The number of authorized shares of the company is 1.75 billion. The articles of incorporation allow the Company to issue five million undesignated shares. The Board of Directors may designate the type of shares and set the terms thereof. The Board designated 1,450,000 shares as Series B Convertible Preferred Stock in connection with the 401(k) Savings Plan.
On February 6, 2007, the Company, under the St. Paul Travelers Companies, Inc. 2004 Incentive Plan, granted 1,678,215 common stock awards in the form of restricted stock units, deferred stock and performance share awards to participating officers and other key employees. The restricted stock units and deferred stock awards, totaling 1,097,720 shares, generally vest in full after a three-year period from date of grant. The performance share awards, totaling 580,495 target shares, represent shares which the recipient may earn upon the Company’s attainment of certain performance goals. The performance goals are based upon the Company’s adjusted return on equity over a three-year performance period. Vesting of any performance shares is contingent upon the Company attaining the relevant performance period minimum threshold return on equity. If the performance period return on equity is below the minimum threshold, none of the shares will vest; if performance meets or exceeds the minimum performance
threshold, between 50%-160% of the performance shares will vest, depending on the actual return on equity attained. The fair value per share attributable to the common stock awards on the date of grant was $52.76.
Refer to note 11 for information regarding share-based grants made in 2006, 2005 and prior years.
On May 2, 2006, the Company’s Board of Directors authorized a program to repurchase up to $2 billion of shares of the Company’s common stock. Under this program, repurchases may be made from time to time in the open market, pursuant to pre-set trading plans meeting the requirements of Rule 10b5-1 under the Securities Exchange Act of 1934, in private transactions or otherwise. This program does not have a stated expiration date. The timing and actual number of shares to be repurchased in the future will depend on a variety of factors, including corporate and regulatory requirements, price, catastrophe losses and other market conditions. During 2006, the Company repurchased 22.8 million common shares under the program for a total cost of approximately $1.12 billion. The average cost per share repurchased in 2006 was $49.20.
(1) Activity in 2004 and 2005 was related to the Company’s minimum pension liability prior to the application of FAS 158. Activity in 2006 represented the adjustment to initially apply the provisions of FAS 158.
(2) Includes foreign currency translation adjustments, changes in the value of private equity securities, and hedging activities.
If the Company determines that any of its deferred tax assets will not result in future tax benefits, a valuation allowance must be established for the portion of these assets that are not expected to be realized. The net decreases in the valuation allowance for deferred tax assets were $16 million and $30 million at December 31, 2006 and 2005, respectively, relating in each year to foreign operations. Based upon a review of the Company’s anticipated future taxable income, and also including all other available evidence, both positive and negative, the Company’s management concluded that it is more likely than not that the net deferred tax assets will be realized.
U.S. income taxes have not been provided on $245 million of the Company’s foreign operations’ undistributed earnings as of December 31, 2006, as such earnings are intended to be permanently reinvested in those operations. Furthermore, any taxes paid to foreign governments on these earnings may be used as credits against the U.S. tax on any dividend distributions from such earnings.
In connection with the adoption of the 2004 Incentive Plan, the legacy share-based incentive compensation plans of TPC and of SPC were terminated. Outstanding grants were not affected by the termination of these plans, including the grant of reload options related to prior option grants under the legacy TPC and the legacy SPC share-based incentive compensation plans.
The 2004 Incentive Plan is the only plan pursuant to which future stock-based awards may be granted. In addition to the 35 million shares initially authorized for issuance under the 2004 Incentive Plan, the following will not be counted towards the 35 million shares available and will be available for future grants under the 2004 Incentive Plan: (i) shares of common stock subject to an award that expires unexercised, that is forfeited, terminated or canceled, that is settled in cash or other forms of property, or otherwise does not result in the issuance of shares of common stock, in whole or in part; (ii) shares that are used to pay the exercise price of stock options and shares used to pay withholding taxes on awards generally; and (iii) shares purchased by the Company on the open market using cash option exercise proceeds; provided, however, that the increase in the number of shares of common stock available for grant pursuant to such market purchases shall not be greater than the number that could be repurchased at fair market value on the date of exercise of the stock option giving rise to such option proceeds. These provisions also apply to awards granted under the legacy TPC and legacy SPC share-based incentive compensation plans that were outstanding on the effective date of the 2004 Incentive Plan, except for shares delivered to or retained in the legacy TPC Plan in connection with the withholding of taxes applicable to the exercise of outstanding options that have reload features.
Options vest over 4-year period, 25% each year on the anniversary of the grant date; or options vest over 5-year period, 20% each year on the anniversary of the grant date.
generally have a shorter expected term. The expected volatility is based on the average historical volatility of the common stock of an industry peer group of entities, due to the limited Company stock history, over the estimated option term based on the mid-month of the option grant. The expected dividend is based upon the Company’s current quarter dividend annualized and assumed to be constant over the expected option term. The risk-free interest rate for each option is the interpolated market yield for the mid-month of the option grant on a U.S. Treasury bill with a term comparable to the expected option term of the granted stock option. Shares received through option exercises under the reload program are subject to restriction on sale. A 10% discount, as measured by the estimated cost of protection, has been applied to the fair value of reload options granted to reflect these sales restrictions. The following assumptions were used in estimating the fair value of options on grant date for the year ended December 31, 2006:
A summary of stock option activity under the Company’s 2004 Incentive Plan and the legacy TPC and legacy SPC share-based incentive compensation plans as of and for the year ended December 31, 2006 is as follows:
The following table presents additional information regarding original and reload grants for the year ended December 31, 2006.
The following table presents the weighted average exercise price and weighted average grant date fair value information with respect to option awards granted in 2005 and 2004:
In connection with the merger in April 2004, the Company assumed 23 million outstanding SPC stock options, of which 4 million remained unvested and assumed approximately 240,000 of outstanding SPC restricted stock awards related to SPC equity-based compensation plans. These stock options and restricted stock awards retained the same terms and conditions that were applicable prior to the merger. At April 1, 2004, the estimated fair values of the unvested stock option awards and the restricted stock awards were $35 million and $9 million, respectively, which is being recognized as a charge to income over the remaining vesting period.
Awards of restricted stock and deferred stock are made to eligible officers and key employees pursuant to the 2004 Incentive Plan. Such awards include restricted stock grants under the Capital Accumulation Program (CAP) and Equity Awards program established pursuant to the 2004 Incentive Plan. Awards issued under CAP are in the form of restricted stock and the number of shares included in the restricted stock award is calculated at a 10% discount from the market price on the date of the award and generally vest in full after a two-year period from the date of grant. CAP has been discontinued following the issuance of CAP awards in February 2006. Other restricted stock awards issued under the Equity Awards program generally vest in full after a three-year period from the date of grant. Except under limited circumstances, during this period the stock cannot be sold or transferred by the participant, who is required to render service to the Company during the restricted period. Awards granted to non-U.S. participants are in the form of deferred stock awards. These deferred stock awards are granted at market price, generally vest after three years from the date of grant and are subject to the same conditions as the restricted stock awards except that the shares are not issued until the vesting criteria are satisfied.
Commencing with equity grants on or after January 1, 2007, the Company began to generally grant restricted stock units instead of restricted stock. A restricted stock unit represents the right to receive a share of common stock. These restricted stock unit awards will be granted at market price, will generally vest after three years from the date of grant and will be subject to the same conditions as the restricted stock awards except that the restricted stock units will not have voting rights and the common stock will not be issued until the vesting criteria are satisfied.
On October 25, 2005, the Company’s Board of Directors approved a Performance Share Awards Program pursuant to the 2004 Incentive Plan. Under the program, which became effective beginning in 2006, the Company may issue performance share awards to certain employees of the Company who hold positions of Vice President (or its equivalent) or above. The performance awards represent target shares that provide the recipient the right to earn shares of the Company’s common stock based upon the Company’s attainment of certain performance goals. The performance goals for performance awards granted in 2006 are based on the Company’s adjusted return on equity over a three-year performance period. Vesting of any performance shares is contingent upon the Company attaining the relevant performance period minimum threshold return on equity. If the performance period return on equity is below the minimum threshold, none of the shares will vest; if performance meets or exceeds the minimum performance threshold, between 50%-160% of the performance shares will vest, depending on the actual return on equity attained.
The fair value of restricted stock, deferred stock and performance shares is measured at the market price of the Company stock at date of grant.
(1) Represents awards for which the requisite service has been rendered including those that are retirement eligible. Excludes performance shares which remain subject to attainment of a performance condition.
Cash received from the exercise of employee stock options under share-based compensation plans totaled $216 million in 2006. The tax benefit realized for tax deductions from employee stock option exercises totaled $28 million for 2006.
The total accumulated benefit obligation for the Company’s defined benefit pension plans was $1.90 billion and $1.88 billion at December 31, 2006 and 2005, respectively. The Qualified Domestic Plan accounted for $1.71 billion and $1.69 billion of the total accumulated benefit obligation at December 31, 2006 and 2005, respectively, whereas the Non-Qualified and Foreign Plans accounted for $0.19 billion of the total accumulated benefit obligation at December 31, 2006 and 2005.
The following table summarizes the components of net periodic benefit cost and other amounts recognized in accumulated other changes in equity from nonowner sources related to the benefit plans for the years ended December 31, 2006, 2005 and 2004.
In choosing the expected long-term rate of return, the Company’s Pension Plan Investment Committee considered the historical returns of equity and fixed income markets in conjunction with today’s economic and financial market conditions.
As an indicator of sensitivity, increasing the assumed health care cost trend rate by 1% would have increased the accumulated postretirement benefit obligation by $29 million at December 31, 2006, and the aggregate of the service and interest cost components of net postretirement benefit expense by $2 million for the year ended December 31, 2006. Decreasing the assumed health care cost trend rate by 1% would have decreased the accumulated postretirement benefit obligation at December 31, 2006 by $28 million and the aggregate of the service and interest cost components of net postretirement benefit expense by $2 million for the year ended December 31, 2006.
Equity securities include 797,600 shares of the Company’s common stock with a market value of $43 million at December 31, 2006.
The Company’s other post-retirement benefit plan weighted-average asset allocations at December 31, 2006 and 2005 by asset category were as follows:
The Company, in September 2005, merged the Travelers 401(k) Savings Plan, the St. Paul Companies, Inc. Savings Plus Plan (SPP), and The St. Paul Companies, Inc. Stock Ownership Plan (SOP) into one new plan, the St. Paul Travelers 401(k) Savings Plan (the Savings Plan). Substantially all Company employees are eligible to participate in the Savings Plan. In 2006 and 2005, the Company matched employee contributions up to 5% of eligible pay, with a maximum annual match of $5,000 which becomes 100% vested after three years of service. The Company match contributed to accounts through 2006 was primarily in the form of the Company’s common stock. Beginning with the 2006 match that was contributed in 2007, the Company matching contribution is made in cash and invested according to the employee’s current investment elections. The Company matching contribution can be reinvested at any time into any other investment option. The expense related to this plan was $69 million and $63 million for the years ended December 31, 2006 and 2005, respectively.
All common shares and the common stock equivalent of all preferred shares held by the SOP are considered outstanding for diluted EPS computations and dividends paid on all shares are charged to retained earnings.
Rent expense was $238 million, $219 million and $207 million in 2006, 2005 and 2004, respectively.
Derivatives that are not designated or do not qualify as hedges are carried at fair value with changes in value reflected in net realized investment gains (losses). The Company has certain U.S. treasury futures
contracts and foreign currency forward contracts, which are not designated as hedges at December 31, 2006 and 2005.
The Company owns six million stock purchase warrants of Platinum Underwriters Holdings, Ltd., a publicly-held company. These warrants are not designated and do not qualify as hedges under FAS 133 and as such the mark-to-market changes in fair value are reflected in net realized investment gains (losses). In 2006 and 2005, the Company recorded a net realized investment loss of $22 million and a net realized investment gain of $7 million, respectively, related to the Company’s holdings of stock purchase warrants of Platinum Underwriters Holdings, Ltd.
At December 31, 2006 and 2005, investments in fixed maturities had a fair value, which equaled carrying value, of $62.67 billion and $58.98 billion, respectively. The fair value of investments in fixed maturities for which a quoted market price or dealer quote are not available was $547 million and $456 million at December 31, 2006 and 2005, respectively. See note 1.
The carrying values of cash, short-term securities, mortgage loans and investment income accrued approximated their fair values. See notes 1 and 3.
October 2003, ACandS commenced a lawsuit seeking to vacate the arbitration award as beyond the panel’s scope of authority (ACandS, Inc. v. Travelers Casualty and Surety Co., U.S.D.Ct. E.D. Pa.). On September 16, 2004, the district court entered an order denying ACandS’ motion to vacate the arbitration award. On January 19, 2006, the United States Court of Appeals for the Third Circuit reversed the district court’s decision and declared the arbitration award void on procedural grounds. On May 22, 2006, the United States Supreme Court denied TPC’s petition for a writ of certiorari seeking review of the Third Circuit’s decision. As a result, the matter has been remanded to district court and TPC has asked the district court to remand the arbitration to the panel that initially ruled in favor of TPC for further proceedings consistent with the Third Circuit’s decision. ACandS has opposed that request.
In the other proceeding, a related case pending before the same court and commenced in September 2000 (ACandS v. Travelers Casualty and Surety Co., U.S.D.Ct., E.D. Pa.), ACandS sought a declaration of the extent to which the asbestos bodily injury claims against ACandS are subject to occurrence limits under insurance policies issued by TPC. TPC filed a motion to dismiss this action based upon the July 31, 2003 arbitration decision described above. The district court found the dispute was moot as a result of the arbitration panel’s decision and dismissed the case. As a result of the January 19, 2006 ruling by the Third Circuit and the Supreme Court’s denial of certiorari, described in the paragraph above, this case has been reinstated.
In October 2001 and April 2002, two purported class action suits (Wise v. Travelers and Meninger v. Travelers) were filed against TPC and other insurers (not including SPC) in state court in West Virginia. These cases were subsequently consolidated into a single proceeding in the Circuit Court of Kanawha County, West Virginia. Plaintiffs allege that the insurer defendants engaged in unfair trade practices by inappropriately handling and settling asbestos claims. The plaintiffs seek to reopen large numbers of settled asbestos claims and to impose liability for damages, including punitive damages, directly on insurers. Lawsuits similar to Wise were filed in Massachusetts and Hawaii (these suits are collectively referred to as the “Statutory and Hawaii Actions”). Also, in November 2001, plaintiffs in consolidated asbestos actions pending before a mass tort panel of judges in West Virginia state court moved to amend their complaint to name TPC as a defendant, alleging that TPC and other insurers breached alleged duties to certain users of asbestos products. In March 2002, the court granted the motion to amend. Plaintiffs seek damages, including punitive damages. Lawsuits seeking similar relief and raising allegations similar to those presented in the West Virginia amended complaint are also pending in Texas state court against TPC and SPC, and in Louisiana state court against TPC (the claims asserted in these suits, together with the West Virginia suit, are collectively referred to as the “Common Law Claims”). Lawsuits seeking similar relief in Ohio have been dismissed.
All of the actions against TPC described in the preceding paragraph, other than the Hawaii Actions, had been subject to a temporary restraining order entered by the federal bankruptcy court in New York that had previously presided over and approved the reorganization in bankruptcy of TPC’s former policyholder Johns-Manville Corporation and affiliated entities. In August 2002, the bankruptcy court held a hearing on TPC’s motion for a preliminary injunction prohibiting further prosecution of the lawsuits pursuant to the reorganization plan and related orders. At the conclusion of this hearing, the court ordered the parties to mediation, appointed a mediator and continued the temporary restraining order. During
On November 19, 2003, the parties advised the bankruptcy court that a settlement of the Statutory and Hawaii Actions had been reached. This settlement includes a lump-sum payment of up to $412 million by TPC, subject to a number of significant contingencies. After continued meetings with the mediator, the parties advised the bankruptcy court on May 25, 2004 that a settlement resolving substantially all pending and similar future Common Law Claims against TPC had also been reached. This settlement requires a payment of up to $90 million by TPC, subject to a number of significant contingencies. Each of these settlements is contingent upon, among other things, an order of the bankruptcy court clarifying that all of these claims, and similar future asbestos-related claims against TPC, are barred by prior orders entered by the bankruptcy court in connection with the original Johns-Manville bankruptcy proceedings.
Four appeals were taken from the August 17, 2004 ruling. On March 29, 2006, the U.S. District Court for the Southern District of New York substantially affirmed the bankruptcy court’s orders while vacating that portion of the bankruptcy court’s orders that required all future direct actions against TPC to first be approved by the bankruptcy court before proceeding in state or federal court. Judgment was entered on March 31, 2006.
in June of 2005, has denied the insurers’ initial challenges to the pleadings. That ruling was contrary to the rulings by other courts in similar cases, and SPC and the other insurer defendants have filed a mandamus petition with the Texas Court of Appeals.
From time to time, the Company is involved in proceedings addressing disputes with its reinsurers regarding the collection of amounts due under the Company’s reinsurance agreements. These proceedings may be initiated by the Company or the reinsurers and may involve the terms of the reinsurance agreements, the coverage of particular claims, exclusions under the agreements, as well as counterclaims for rescission of the agreements. One of these disputes is the action described in the following paragraphs.
The Company’s Gulf operation brought an action on May 22, 2003, as amended on May 12, 2004, in the Supreme Court of New York, County of New York (Gulf Insurance Company v. Transatlantic Reinsurance Company, et al.), against Transatlantic Reinsurance Company (Transatlantic), XL Reinsurance America, Inc. (XL), Odyssey America Reinsurance Corporation (Odyssey), Employers Reinsurance Company (Employers) and Gerling Global Reinsurance Corporation of America (Gerling), to recover amounts due under reinsurance contracts issued to Gulf and related to Gulf’s February 2003 settlement of a coverage dispute under a vehicle residual value protection insurance policy. The reinsurers have asserted counterclaims seeking rescission of the vehicle residual value reinsurance contracts issued to Gulf and unspecified damages for breach of contract. Separate actions filed by Transatlantic and Gerling have been consolidated with the original Gulf action for pre-trial purposes.
Based on the Company’s beliefs about its legal positions in its various reinsurance recovery proceedings, the Company does not expect any of these matters will have a material adverse effect on its results of operations in a future period.
(xvi) State of Maryland Insurance Administration; (xvii) Commonwealth of Massachusetts Office of the Attorney General; (xviii) State of Minnesota Department of Commerce; (xix) State of Minnesota Office of the Attorney General; (xx) State of New Hampshire Insurance Department; (xxi) State of New York Office of the Attorney General; (xxii) State of New York Insurance Department; (xxiii) State of North Carolina Department of Insurance; (xxiv) State of Ohio Office of the Attorney General; (xxv) State of Ohio Department of Insurance; (xxvi) State of Oregon Department of Justice; (xxvii) Commonwealth of Pennsylvania Office of the Attorney General; (xxviii) State of Texas Office of the Attorney General; (xxvix) State of Texas Department of Insurance; (xxx) Commonwealth of Virginia Office of the Attorney General; (xxxi) State of Washington Office of the Insurance Commissioner; (xxxii) State of West Virginia Office of Attorney General; (xxxiii) the United States Attorney for the Southern District of New York; (xxxiv) the United States Internal Revenue Service, Department of the Treasury; and (xxxv) the United States Securities and Exchange Commission. The Company and its affiliates may receive additional subpoenas and requests for information with respect to the areas described above from other agencies or authorities.
To date, the Company has found only a few instances of conduct that were inconsistent with the Company’s employee code of conduct. The Company has responded, and will continue to respond, appropriately to any such conduct.
Except as settled as previously disclosed, the industry-wide investigations described above are ongoing, as are the Company’s efforts to cooperate with the authorities, and the various authorities could ask that additional work be performed or reach conclusions different from the Company’s. Accordingly, it would be premature to reach any conclusions as to the likely outcome of these matters.
SPC’s Sale of Minet-In May 1997, SPC completed the sale of its insurance brokerage operation, Minet, to Aon Corporation. SPC agreed to indemnify Aon against any future claims for professional liability and other specified events that occurred or existed prior to the sale. The Company assumed obligations related to this indemnification upon consummation of the merger. The Company monitors its exposure under these claims on a regular basis. The Company believes reserves for reported claims are adequate, but it does not have information on unreported claims to estimate a range of additional liability. From 1997 to 2004, SPC purchased insurance to cover a portion of its exposure to such claims. Under the sale agreement, SPC also committed to acquire a minimum level of reinsurance brokerage services from Aon through 2012. That commitment requires the Company to make a contractual payment to Aon to the extent such minimum level of service is not acquired. The maximum annual amount payable to Aon for such services and any such contractual payment related to that commitment is $20 million.
In the ordinary course of business, the Company purchases and sells securities through formerly affiliated broker-dealers. These transactions are conducted on an arm’s-length basis. Commissions are not paid for the purchase and sale of debt securities.
During the second quarter of 2004, the Company’s management approved and committed to plans to terminate and relocate certain employees and to exit certain activities. The cost of these actions has been recognized as a liability and is included in either the allocation of the purchase price or recorded as part of general and administrative expenses. The following tables summarize the Company’s costs related to these plans.
There were no significant noncash financing or investing activities during the year ended December 31, 2006.
There were no significant noncash financing or investing activities during the year ended December 31, 2004, other than the acquisition of SPC which resulted in net assets assumed of $8.76 billion (at fair value).
Intangible assets subject to amortization (excluding the Nuveen Investments’ intangible assets) were as follows: