Fire and Marine and its subsidiary, St. Paul Properties, Inc., own a portfolio of income-producing properties in various locations across the United States that they have purchased for investment. Included in this portfolio are four office buildings in which we hold a 50% ownership interest located on Manhattan Island in New York, NY which collectively accounted for approximately 7% of the carrying value of the property portfolio at December 31, 2003.
This report contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements other than historical information or statements of current condition. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks” or “estimates,” or variations of such words, and similar expressions are intended to identify forward-looking statements. Examples of these forward-looking statements include statements concerning:
· market and other conditions and their effect on future premiums, pricing, revenues, earnings, cash flow and investment income;
· statements concerning the anticipated bankruptcy court approval of the Western MacArthur asbestos litigation settlement;
· statements concerning our expectations in our Health Care operation as we settle claims in a runoff environment;
· statements concerning our estimated maximum exposure in respect of a contract surety customer.
In light of the risks and uncertainties inherent in future projections, many of which are beyond our control, actual results could differ materially from those in forward-looking statements. These statements should not be regarded as a representation that anticipated events will occur or that expected objectives will be achieved. Risks and uncertainties include, but are not limited to, the following:
· our exposure to natural catastrophic events, which are unpredictable, with a frequency or severity exceeding our estimates, resulting in material losses;
· the possibility that claims cost trends that we anticipate in our businesses may not develop as we expect;
· risks relating to our continuing ability to obtain reinsurance covering catastrophe, surety and other exposures at appropriate prices and/or in sufficient amounts;
· risks relating to the collectibility of reinsurance and adequacy of reinsurance to protect us against losses;
· risks relating to actual and potential credit exposures, including to derivatives counterparties, reinsurers, and related to co-surety arrangements;
· risks and uncertainties relating to international political developments, including the possibility of warfare, and their potential effect on economic conditions;
· the effect of financial market and interest rate conditions on pension plan assumptions, asset valuations and contribution levels;
· the impact of assessments and other surcharges for guaranty funds and second-injury funds and other mandatory pooling arrangements;
· risks related to the business underwritten on our policy forms on behalf of Platinum Underwriters Holdings, Ltd. (“Platinum”) and fully reinsured to Platinum pursuant to the quota share reinsurance agreements entered into in connection with the transfer of our ongoing reinsurance operations to Platinum in 2002;
· changes in our estimate of insurance industry losses resulting from the September 11, 2001 terrorist attack;
· unfavorable developments in non-Western MacArthur related asbestos litigation (including claims that certain asbestos-related insurance policies are not subject to aggregate limits);
· in the case of a large contract surety exposure, risks relating to the implementation of the customer’s restructuring plan;
· the effects of emerging claim and coverage issues on our business, including developments relating to issues such as mold conditions, construction defects and changes in interpretation of the named insured provision with respect to the uninsured/underinsured motorist coverage in commercial automobile policies;
· the growing trend of plaintiffs targeting property-liability insurers, including us, in purported class action litigation relating to claim-handling and other practices;
· the cyclicality of the property-liability insurance industry causing fluctuations in our results;
· risks relating to our asset management business, including the risk of material reductions to assets under management from a significant rise in interest rates, declining equity markets or poor
investment performance and risks associated with failure to comply with various governmental regulations;
· our ability to retain key employees after the Proposed Merger; and
The St. Paul Companies, Inc. (“The St. Paul” or the “Company”) is incorporated as a general business corporation under the laws of the State of Minnesota. The St. Paul and its subsidiaries constitute one of the oldest insurance organizations in the United States, dating back to 1853. We are a management company principally engaged, through our subsidiaries, in providing commercial property-liability insurance products and services. We also have a presence in the asset management industry through our 79% majority ownership of Nuveen Investments, Inc. As a management company, we oversee the operations of our subsidiaries and provide them with capital, management and administrative services. Our Internet website address is stpaul.com. We make available, free of charge, on or through our website, annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. Our website address is an inactive textual reference only and the contents of the website are not part of this report.
· the adequacy of premiums charged relative to the risks assumed;
The Company’s fixed income portfolio maintains a very high credit quality with an average rating at AA+ and a relatively short duration of 3.8 years which mitigates the risks of increasing interest rates and widening credit spreads. During 2003, duration lengthened slightly, from 3.3 years.
The property-liability industry generally measures expenses as a percentage of written premiums, a component of revenue. Management uses a variety of measures, including the statutory expense ratio, to evaluate its success in controlling expenses. Expenses consist of variable components, such as taxes, fees and commissions that are calculated as a percentage of premium, and fixed components such as salaries, benefits, rent and system costs. The statutory expense ratio for the year ended December 31, 2003 was 29.1, an improvement over the comparable 2002 statutory expense ratio of 29.7. While the Company experienced increases in variable costs in the second half of 2003 as premiums grew, the statutory expense ratio declined. A significant portion of the increase in premiums was driven by price increases and not unit or policy increases, and generally did not require commensurate increases in fixed expenses to manage the business. Significant decreases in premiums written in our runoff businesses, combined with continuing expenses to manage those businesses, prevented further improvement in our consolidated expense ratio in 2003. We expect to manage our business in 2004 with a general objective of keeping expenses level, except for variable expenses that vary with premium production, such as premium taxes and commissions.
Our effective tax rate on pretax earnings was 16% in 2003, primarily reflecting the benefit of investment income from tax-exempt fixed income securities in our property-liability investment operations segment. In 2002, our income tax benefit of $73 million on pretax income of $176 million included $124 million of tax benefits associated with net realized investment losses. That $124 million reflected a $207 million benefit related to the sale of certain of our international operations and all other net realized gains and losses, and $83 million of tax expense related to the transfer of our ongoing reinsurance operations (discussed in more detail later in this discussion). In 2002, we substantially completed the refocusing of our international property-liability underwriting operations. As part of that effort, we sold certain of those operations in the fourth quarter of 2002, resulting in a net after-tax realized gain of $132 million that was predominantly comprised of the aforementioned tax benefits. The pretax impact on our results in 2002 from those sales was nominal, as significant operating losses had previously been reflected in our reported results for these operations prior to their divestiture.
The following table summarizes the sources of our consolidated revenues from continuing operations for the last three years.
2003 vs. 2002-The 6% decline in insurance premiums earned in 2003 was centered in our runoff Other segment, reflecting the impact of our decision to withdraw from lines of business included in that segment. In our ongoing property-liability underwriting segments, earned premiums of $6.71 billion were 22% higher than comparable 2002 earned premiums of $5.52 billion, due to a combination of new business, higher business retention levels and price increases. The $49 million decline in net investment income in 2003 was primarily due to a decline in investment yields on new investments, and a reduced amount of invested assets during 2003 resulting from the first-quarter payment of $747 million related to the Western MacArthur asbestos litigation settlement agreement. Asset management revenues grew 14% over 2002, driven by a significant increase in investment advisory fees resulting from a $15.6 billion increase in assets under management. Realized investment gains in 2003 were driven by sales of certain venture capital and equity holdings. The increase in Other revenues in 2003 over 2002 was largely due to foreign currency exchange gains.
Commercial Lines), and one segment comprising our runoff operations (Other). The composition of those respective segments is described in greater detail in the analysis of their results later in this discussion. The following is a summary of changes made to our segments in the first quarter of 2003.
Our consolidated net loss and loss adjustment expense reserves of $13.3 billion at December 31, 2003 and $14.8 billion at December 31, 2002 included approximately $5.6 billion and $8.0 billion, respectively, of net reserves related to our runoff segment. The payment of claims from these reserves will negatively impact our investment income in future periods as the invested assets related to these reserves decline.
For business underwritten in the United States and the United Kingdom, until October 31, 2003 Platinum had the right to underwrite specified reinsurance business on our behalf in cases where Platinum was unable to underwrite that business because it had yet to obtain necessary regulatory licenses or approval to do so, or Platinum had not yet been approved as a reinsurer by the ceding company. We entered into this agreement solely as a means to accommodate Platinum through a transition period. Any business written by Platinum on our policy forms during this transition period was fully ceded to Platinum under the quota share reinsurance agreements.
In May 2003, we purchased the right to seek renewal of several lines of insurance business previously underwritten by Kemper Insurance Companies. The initial payment for this right was recorded as an intangible asset (characterized as renewal rights) and is being amortized on an accelerated basis over four years. The portfolio of business involved in this transaction included the following lines: technology, small commercial, middle market commercial, inland and ocean marine, and architects’ and engineers’ professional liability. We did not assume any past liabilities with this purchase; however, we may be obligated to make an additional payment in June 2004 based on the amount of premium volume we ultimately renew during the twelve month period subsequent to this purchase. We believe it is unlikely that any additional payment would exceed $30 million. At December 31, 2003, we had accrued $10 million toward this additional obligation, recorded in “Other liabilities.” Our consolidated gross written premiums for the year ended December 31, 2003 included approximately $280 million attributable to business underwritten as a result of this purchase of renewal rights, the majority of which were included in our Commercial Lines segment.
In December 2002, we acquired the right to seek to renew the Professional and Financial Risk Practice business previously underwritten by Royal & SunAlliance in the United States, without assuming past liabilities. That business generated approximately $80 million in written premiums in 2003. The nominal cost of this acquisition was accounted for as an intangible asset and is being amortized over four years.
million represented goodwill and $37 million represented other intangible assets. The purchase price was funded through internally generated funds.
In addition, Nuveen Investments made strategic acquisitions in both 2002 and 2001, which are discussed in greater detail in the “Asset Management” section of this discussion.
LIFE INSURANCE-In September 2001, we completed the sale of our life insurance company, Fidelity and Guaranty Life Insurance Company and its subsidiary, Thomas Jefferson Life (together, “F&G Life”) to Old Mutual plc (“Old Mutual”), for $335 million in cash and $300 million in ordinary shares of Old Mutual. In June 2002, we sold all of the Old Mutual shares we were holding for a total net consideration of $287 million, resulting in a pretax realized loss of $13 million that was recorded as a component of discontinued operations on our statement of operations in 2002. At the time of the sale of the Old Mutual shares, there was a derivative “collar” agreement in place that would have determined any possible adjustment to the original F&G Life sale price one year after the closing date. The collar was recorded on our balance sheet as an asset and had a fair value of $12 million when we sold our Old Mutual shares. We agreed to terminate the collar at no value as part of the sale of our Old Mutual shares. That $12 million pretax loss was also included in discontinued operations on our statement of operations in 2002.
STANDARD PERSONAL INSURANCE-In 1999, we sold our standard personal insurance operations to Metropolitan Property and Casualty Insurance Company (“Metropolitan”). Metropolitan purchased Economy Fire & Casualty Company and subsidiaries (“Economy”), and the rights and interests in those non-Economy policies constituting the remainder of our standard personal insurance operations. Those rights and interests were transferred to Metropolitan by way of a reinsurance and facility agreement. We guaranteed the adequacy of Economy’s loss and loss expense reserves, and we remain liable for claims on non-Economy policies that result from losses occurring prior to the September 30, 1999 closing date. Under the reserve-related agreements, we agreed to pay for any deficiencies in those reserves and would share in any redundancies that developed by September 30, 2002. Any losses incurred by us under these agreements were reflected in discontinued operations in the period during which they were incurred. At December 31, 2002, our analysis indicated that we owed Metropolitan $13 million related to the reserve agreements, which was paid in April 2003. We have no other contingent liabilities related to this sale.
MINET-In 1997, we sold our insurance brokerage operation, Minet Holdings plc (“Minet”) to Aon Corporation. We recorded expenses in discontinued operations in each of the last three years related to the Minet sale. In 2003, we recorded expense primarily related to an adjustment to the tax provision on the sale, whereas the expenses recorded in 2002 and 2001 primarily represented additional funds due Aon pursuant to provisions of the sale agreement.
Our operations in runoff do not qualify as “discontinued operations” for accounting purposes.
The St. Paul has completed its funding obligations under the 2002 settlement agreement, consisting of payments of $235 million during the second quarter of 2002, and $747 million on January 16, 2003 (including interest). Following final confirmation of the Bankruptcy Court ruling, the escrowed funds will be released to the trust established by the plan for the payment of the MacArthur Companies’ asbestos related claims. The settlement agreement also provided for the USF&G Parties to pay $13 million (which was paid in the second quarter of 2002) and to advance certain fees and expenses incurred in connection with the settlement, bankruptcy proceedings, finalization of the Plan and efforts to achieve approval of the Plan, subject to a right of reimbursement in certain circumstances of amounts advanced. Up to $175 million of the initial $235 million payment will be paid to counsel for the MacArthur Companies, and persons holding judgments against the MacArthur Companies as of June 3, 2002 and their counsel, and the USF&G Parties will be released from claims by such holders to the extent of $110 million paid to such holders. At least $60 million from the initial payment and the $747 million paid in 2003 would be returned to us if final confirmation of the Bankruptcy Court ruling does not occur. At December 31, 2003, those payments of $807 million were recorded in both “Other Assets” and “Other Liabilities.”
The $312 million after-tax impact to our net income in 2002 was calculated as follows.
Our estimate of losses was based on a variety of actuarial techniques, coverage interpretation and claims estimation methodologies, and include an estimate of losses incurred but not reported, as well as estimated costs related to the settlement of claims. Our estimate of losses was originally based on our belief that property-liability insurance losses from the terrorist attack will total between $30 billion and $35 billion for the insurance industry. In 2003 and 2002, our estimate of ultimate losses was supplemented by our ongoing analysis of both paid and reported claims related to the attack. Our estimate of losses remains subject to significant uncertainties and may change over time as additional information becomes available.
We regularly evaluate the adequacy of our estimated net losses related to the terrorist attack, weighing all factors that may impact the total net losses we will ultimately incur. Based on the results of those regular evaluations, we changed our estimate of losses among our property-liability segments in 2003 and 2002. In addition, in 2003 we recorded a reduction of $46 million in estimated losses related to the attack. In 2002, we recorded an additional loss provision of $20 million and a $33 million reduction in our estimated provision for uncollectible reinsurance related to the attack.
* For more information regarding our contractual obligations, see Notes 10 and 16 to our consolidated financial statements included in Item 8 of this report.
We did not include claims to be paid out of our insurance reserves in the foregoing table, because of the significant uncertainty involved in trying to project payments related to those reserves into the future.
For certain catastrophic events, there is considerable uncertainty underlying the assumptions and associated estimated reserves for losses and LAE. Reserves are reviewed regularly and, as experience develops and additional information becomes known, including revised industry estimates of the magnitude of a catastrophe, the reserves are adjusted as we deem necessary.
Because many of the coverages we offer involve claims that may not ultimately be settled for many years after they are incurred, subjective judgments as to our ultimate exposure to losses are an integral and necessary component of our loss reserving process. We analyze our reserves by considering a range of estimates bounded by a high and low point, and record our best estimate within that range. We adjust reserves established in prior years as loss experience develops and new information becomes available.
In the fourth quarter of 2003, we updated our detailed actuarial analysis for both asbestos and environmental reserves pertaining to our exposure from direct policyholders and utilized these analyses in determining the adequacy of our reserve provision for the remaining unreported losses. For non-workers’ compensation asbestos claims, we supplemented this detailed analysis with an additional analysis to determine an estimate of reserves specifically for policyholders who have not as yet tendered their first asbestos claim. As a result of these studies, we increased net asbestos reserves by $77 million ($44 million in our ongoing operations and $33 million in our runoff operations) and net environmental reserves by $14 million (all in our ongoing operations). In addition, reviews of assumed and non-domestic exposures caused us to increase net asbestos reserves by $13 million and reduce net environmental reserves by $1 million (all of which was recorded in our runoff operations).
Health Care Reserves. During 2002, we concluded that the impact of settling claims in a runoff environment in our Health Care operation was causing abnormal effects on our average paid claims,
average outstanding claims, and the amount of average case reserves established for new claims - all of which are traditional statistics used by our actuaries to develop indicated ranges of expected loss. Taking these changing statistics into account, we developed varying interpretations of our data, which implied added uncertainty in our evaluation of these reserves. In the fourth quarter of 2002, we established specific tools and indicators to more explicitly monitor and validate our key assumptions supporting our Health Care reserve conclusions since our traditional statistics and reserving methods needed to be supplemented in order to provide a more meaningful analysis. The tools that were developed tracked the three primary indicators which influenced our expectations and included: a) newly reported claims, b) reserve development on known claims and c) the “redundancy ratio,” comparing the cost of resolving claims to the reserve established for that individual claim. Various actuarial techniques can be used to estimate Health Care reserves. While certain actuarial techniques could suggest a need for materially different levels of reserves, management believes the techniques it utilizes are the most appropriate under the circumstances.
For a detailed discussion about loss development related to our Health Care reserves in 2003, refer to the “Health Care” section of this discussion.
Reinsurance accounting is followed for assumed and ceded transactions when risk transfer requirements have been met. These requirements involve significant assumptions being made relating to the amount and timing of expected cash flows, as well as the interpretation of underlying contract terms. Reinsurance contracts that do not transfer significant insurance risk are considered financing transactions and are required to be accounted for as deposits.
table summarizes the total pretax gross unrealized loss recorded in our common shareholders’ equity at December 31, 2003 and 2002, by invested asset class.
At December 31, 2003, non-investment grade securities comprised less than 2% of our consolidated fixed income investment portfolio, and nonrated securities comprised less than one half of one percent of that portfolio. Included in those categories at that date were securities in an unrealized loss position that, in the aggregate, had an amortized cost of $59 million and a fair value of $56 million, resulting in a net pretax unrealized loss of $3 million. These securities represented less than 1% of the total amortized cost and fair value of the fixed income portfolio at December 31, 2003, and accounted for 6% of the total pretax unrealized loss in the fixed income portfolio. Included in those categories at December 31, 2002 were securities in an unrealized loss position that, in the aggregate, had an amortized cost of $160 million and a fair value of $140 million, resulting in a net pretax unrealized loss of $20 million. These securities represented 1% of the total amortized cost and fair value of the fixed income portfolio at Dec. 31, 2002, and accounted for 38% of the total pretax unrealized loss in the fixed income portfolio.
Fixed Income and Securities on Loan-On a monthly basis, these investments are reviewed by portfolio managers for impairment. In general, the managers focus their attention on those fixed income securities whose market value was less than 80% of their amortized cost for at least one month in the previous nine months. Factors considered in evaluating potential impairment include the following.
· the degree to which any appearance of impairment is attributable to an overall change in market conditions (e.g., interest rates) rather than changes in the individual factual circumstances and risk profile of the issuer;
· the issuer’s current financial condition and its ability to make future scheduled principal and interest payments on a timely basis;
· the independent auditors’ report on the issuer’s recent financial statements;
· relevant rating history, analysis and guidance provided by rating agencies and analysts; and
· whether the decline appears to be related to general market or industry conditions or is issuer-specific;
Publicly traded. On a monthly basis, individual public investments are analyzed for impairment by portfolio managers as well as an internal valuation committee. In general, attention is focused on those marketable (public equity) securities whose market value has been less than cost for six consecutive months. Factors considered are the same as those enumerated above for our equity investments.
Non-publicly traded Our non-publicly traded venture capital portfolio generally consists of investments in early-stage venture capital companies, historically with a holding period of four to seven years. These investments have primarily been made in the health care, software and computer services, and networking and information technologies infrastructures industries. We typically are involved with venture capital companies early in their formation, as they are developing and determining the viability of, and market demand for, their product. We generally do 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 do not generally expect them to become profitable for an even longer period of time. As such, our impairment analysis for these non-publicly traded venture capital investments differs from that performed for both our equity investment portfolio and our publicly-traded venture capital investments. With respect to our valuation of such non-publicly traded venture capital investments, on a quarterly basis, the portfolio managers as well as the internal valuation committee review and consider a variety of factors in determining the potential for loss impairment. Factors considered include the following.
· whether or not the internal valuation committee believes there is a 50% probability that the issuer will need financing within six months at a lower price than our carrying value; and
The quarterly (or monthly) valuation procedures described above are in addition to the portfolio managers’ ongoing responsibility to frequently monitor developments affecting those invested assets, paying particular attention to events that might give rise to impairment write-downs.
With respect to our venture capital portfolio, we manage our portfolio to maximize return, evaluating current market conditions and the future outlook for the entities in which we have invested. Because this portfolio primarily consists of privately-held, early-stage venture investments, events giving rise to
FASB Staff Position No. FAS 106-1-On January 12, 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS 106-1, “Accounting and Disclosure Requirements related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (“FSP 106-1”). This pronouncement provides companies with the option to make a one-time election to defer accounting for the effects of the Medicare Act referenced in its title (“the Act”). We have decided to defer accounting for the Act under FSP 106-1 and have made the required disclosures in Note 13-“Retirement Plans” to the consolidated financial statements. The final accounting guidance could require changes to previously reported information. We will monitor the FASB deliberations and account for the Act based on the pronouncement expected to be issued.
FIN 46(R)-In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” which was replaced in December 2003 (“FIN 46(R)”). FIN 46(R), along with its related interpretations, requires consolidation of all “variable interest entities” (“VIE”) by the “primary beneficiary,” as these terms are defined in FIN 46(R). We began applying the consolidation requirements for new VIEs in the first quarter of 2003. For VIEs created before January 31, 2003, the effective date of adoption was deferred until the first interim or annual period ending after December 15, 2003 (for us, the first quarter of 2004), but early and partial adoption were permitted.
We chose to partially adopt FIN 46(R) under the early adoption provisions in 2003, which resulted in us consolidating certain entities (summarized below) that we had not previously consolidated. We are still evaluating the implications of FIN 46(R) on our participation in various Lloyd’s underwriting syndicates. Upon partial adoption, we recorded a loss of $21 million (net of a deferred tax benefit of $3 million) in our consolidated statement of operations in 2003, classified as a “cumulative effect of accounting change” and representing the cumulative impact of FIN 46(R) on periods prior to the July 1, 2003 date of partial adoption.
The entities that we consolidated (or deconsolidated, with respect to the preferred securities of trusts) under our partial adoption of FIN 46(R) were as follows.
· Investment-We hold an investment in an insurance company that provides insurance coverage to markets in Baltimore and Washington D.C. Our investment includes a substantial majority of the company’s convertible preferred stock, but none of its voting common stock. As a result of our economic interest in the entity, we have the majority exposure to variability through our preferred stock ownership and a loan to the company, both of which are considered variable interests as defined in FIN 46(R). Accordingly, we began consolidating this entity in the third quarter. The carrying value of this investment at December 31, 2003 was approximately $4 million.
· Mandatorily redeemable preferred securities of trusts holding solely subordinated debentures of the company (“Preferred Securities”)-These securities had a carrying value of $897 million, and prior to September 30, 2003 were classified as a separate line on our balance sheet between liabilities and shareholders’ equity. These securities were issued by five separate trusts that were established for the sole purpose of issuing the securities to investors, and the securities were fully guaranteed by us. At September 30, 2003, we reclassified these securities to “Debt” in the liability section of our Consolidated Balance Sheet, as newly required under Statement of Financial Accounting Standards (“SFAS”) No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”, which generally required that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). In the fourth quarter of 2003, we determined that the provisions of FIN 46(R) applied to the trusts that issued these securities, and as a result we deconsolidated the trusts for financial reporting purposes. The debt we issued to these trusts, previously eliminated in the consolidation of our financial results, is now included in the “Debt” section of liabilities on our consolidated balance sheet. The net impact of de-consolidating these trusts was to increase our reported debt liabilities outstanding by $928 million and eliminate the $897 million of Preferred Securities issued by the trusts from our consolidated balance sheet. The difference between the two amounts was comprised of the $31 million combined equity interests we held in the deconsolidated trusts.
SFAS No. 142-In 2002, we implemented the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets”, which established financial accounting and reporting for acquired goodwill and other intangible assets. The statement changed prior accounting requirements relating to the method by which intangible assets with indefinite useful lives, including goodwill, are tested for impairment on an annual basis. It also required that those assets meeting the criteria for classification as intangible assets with finite useful lives be amortized to expense over those lives, while intangible assets with indefinite useful lives and goodwill are not to be amortized. As a result of implementing the provisions of this statement, we did not record any goodwill amortization expense in 2003 or 2002. In 2001, goodwill amortization expense totaled $114 million. Amortization expense associated with intangible assets totaled $31 million in 2003, compared with $18 million in 2002 and $2 million 2001.
In connection with our reclassification of certain assets previously accounted for as goodwill to other intangible assets upon our adoption of SFAS No. 142 in 2002, we established a deferred tax liability of $6 million in the second quarter of 2002. That provision was classified as a cumulative effect of accounting change effective as of January 1, 2002. In accordance with SFAS No. 142, we restated our results for the first quarter of 2002, reducing net income for that period from the reported $139 million, or $0.63 per common share (diluted) to $133 million, or $0.60 per common share (diluted).
At December 31, 2003, our goodwill and intangible assets totaled $1.07 billion, compared with $1.01 billion at December 31, 2002. Our asset management subsidiary, Nuveen Investments, Inc., accounted for the majority of the $52 million increase, primarily resulting from additional goodwill recorded at The St. Paul parent company resulting from Nuveen Investments’ repurchase of common shares from its minority shareholders. Our acquisition of the right to renew certain business from Kemper Insurance Company in 2003 also contributed to the increase in goodwill and intangible assets over 2002. In the second quarter of 2003, we completed the annual evaluation of our recorded goodwill for impairment in accordance with provisions of SFAS No. 142. That evaluation concluded that none of our goodwill was impaired. See Note 22 to the consolidated financial statements in Item 8 of this report for a schedule of goodwill and acquired intangible assets.
Of the total net written premiums and underwriting result in the foregoing table, $64 million and $(1) million, respectively, was recorded in our ongoing Specialty Commercial segment, and $3 million and $(48) million, respectively, was recorded in our runoff Other segment.
Our U.S. property-liability insurance operations comprise the majority of our business. These operations are required under applicable state insurance legislation and regulations to publicly report information on the basis of Statutory Accounting Principles (“SAP”), including net written premiums, statutory loss and loss adjustment expense ratio, and statutory underwriting expense ratio information. We provide in this report selected SAP information for all of our property-liability underwriting operations, as well as certain GAAP information for such operations. The types of SAP information included herein are common measures of the performance of a property-liability insurer, and we believe the inclusion of such information will aid investors in comparing our results with those of our peers in the industry. In addition, management uses this SAP information to monitor our financial performance. Definitions of the statutory information included herein are included in the “Definitions of Certain Statutory Accounting Terms” section of this discussion.
As described earlier in this discussion, we revised our segment reporting structure in 2003. Our ongoing operations are reported in two segments-Specialty Commercial and Commercial Lines. Those operations which are in runoff are reported in the Other segment. Premium growth of 24% in our ongoing segments in 2003 was driven by strong business retention levels, price increases, as well as new business (including premium volume resulting from our acquisition of the right to renew certain business previously
underwritten by the Kemper Insurance Companies). Both ongoing segments recorded strong premium increases in 2002 over 2001, with the most notable growth occurring in our Surety and Construction operations (primarily due to strong price increases in Construction, as well as acquisition-related premium growth in Surety), and in the Specialty category of the Specialty Commercial segment (due to significant price increases and new business volume in the majority of business centers comprising that category). Our consolidated net written premiums in 2001 included a reduction of $128 million for premiums ceded under specific reinsurance treaties described below.
The underwriting loss for our runoff segment in 2003 included a $350 million provision to strengthen prior-year loss reserves in our Health Care operation, and additional prior-year provisions totaling $260 million in certain other operations in runoff as described in more detail in the “Other” section of this discussion. In 2002, the underwriting loss for our runoff segment included a $472 million pretax loss related to the Western MacArthur asbestos litigation settlement, and significant provisions to strengthen prior-year loss reserves in certain of our operations in runoff. In 2001, the $1.87 billion underwriting loss in our runoff segment was driven by the $735 million of prior-year loss reserves in our Health Care operation, and $662 million of losses related to the terrorist attack.
Our ongoing segments’ expense ratios improved in both 2003 and 2002, reflecting the combined effect of significant premium growth in both years, as well as efficiencies realized throughout our underwriting operations as a result of our expense reduction initiatives over the last three years. The magnitude of improvement in 2002 over 2001 was mitigated somewhat by the impact of written premiums ceded for terrorism coverage. Expense reduction efforts in recent years included the consolidation of field office locations, the streamlining of our claim organization, the restructuring of several of our business segments, and the combined elimination of approximately 1,200 employee positions since our strategic initiatives announced in December 2001. As a result of those and other expense management initiatives, we were able to reduce our fixed expenses in both 2003 and 2002.
Catastrophe losses in 2002 totaled $31 million, primarily resulting from several storms across the United States throughout the year. Catastrophe losses totaled $1.27 billion in 2001, of which $941 million was due to the September 11th terrorist attack. The majority of the remaining catastrophe losses in 2001 largely resulted from of a variety of storms throughout the year in the United States and the explosion of a chemical manufacturing plant in Toulouse, France. Since catastrophe losses are not recognized until an event occurs, the occurrence of a catastrophic event can have a material impact on our results of operations during the period incurred. Subsequent changes to our estimate of catastrophic losses, based on better information, can also materially impact our results of operations during that period.
The business centers comprising this segment are designated specialty commercial operations because each provides dedicated underwriting, claim and risk control services that require specialized expertise, and each focuses exclusively on the respective customers it serves. Insurance coverage is often provided on proprietary insurance forms. This segment includes our Surety and Construction operations, our ongoing International & Lloyd’s operations and eight other specialty business centers collectively referred to as “Specialty.”
principal lines of business: Aviation, Marine, Global Property and Personal Lines. Aviation underwrites a broad spectrum of international airline, manufacturer, airport and general aviation business. Marine underwrites energy, cargo and hull coverages. Global Property underwrites property coverages worldwide. Personal Lines provides specialized accident and health coverages for international clients, including personal accident, kidnap and ransom, and payment protection insurance. Our ongoing international specialties (other than Global Accounts) are located in the United Kingdom, Canada and the Republic of Ireland, where we offer specialized insurance and risk management services to a variety of industry sectors. Our Global Accounts business center is based in the United States.
The following nine specialty business centers comprise the remainder of the Specialty Commercial segment and are collectively referred to as “Specialty” in the following table. Financial & Professional Services provides coverages for financial institutions, including property, liability, professional liability and management liability coverages for corporations and nonprofit organizations; and errors and omissions coverages for a variety of professionals such as lawyers, insurance agents and real estate agents. Technology offers a comprehensive portfolio of specialty products and services to companies involved in telecommunications, information technology, health sciences and electronics manufacturing. Umbrella/Excess & Surplus Lines provides insurance coverage in two distinct markets. The Specialty Excess and Umbrella unit focuses on umbrella and excess liability business for retail and wholesale distribution sources, where other insurance companies provide the primary coverage. The Excess & Surplus Lines unit underwrites non-admitted program and individual risk business for established wholesale distributors. The Excess and Surplus Lines Underwriting Facilities business center underwrites liability and property facilities produced by wholesalers and managing general agents. Public Sector Services markets insurance products and services to municipalities, counties, Indian Nation gaming and selected special government districts, including water and sewer utilities, and non-rail transit authorities. Discover Re provides insurance programs principally involving property, liability and workers’ compensation coverages, serving retail brokers and insureds who are committed to the alternative risk transfer market. Alternative risk transfer techniques are typically utilized by insureds who are financially able to assume a substantial portion of their own losses. Oil and Gas provides specialized property and liability products for customers involved in the exploration and production of oil and gas. Ocean Marine provides insurance coverage internationally for ocean and inland waterways traffic. Personal Catastrophe Risk underwrites personal property coverages in certain states exposed to earthquakes and hurricanes.
2003 vs. 2002-All business centers in this category contributed to the strong premium growth over 2002. Financial and Professional Services’ premium volume of $624 million in 2003 was 56% higher than comparable 2002 premiums of $400 million, driven by price increases and new business principally generated by our December 2002 acquisition of the right to seek to renew the professional and financial risk practice business of Royal and SunAlliance, and the May 2003 acquisition of the right to seek to renew architects’ and engineers’ professional liability business from Kemper Insurance Companies. Technology’s net written premiums of $426 million in 2003 grew 15% over 2002 premium volume of $372 million, primarily due to price increases and new business. Personal Catastrophe Risk premium volume of $131 million in 2003 was more than double the 2002 total of $61 million, due to a change in our reinsurance program related to this operation that resulted in less business being ceded to reinsurers. Price increases averaged 20% across the Specialty category in 2003 (excluding Discover Re and Personal Catastrophe Risk, whose premium structures differ somewhat from the remaining business centers in this category), compared with 29% in 2002.
2002 vs. 2001-The 22% increase in net written premium volume in 2002 over 2001 was driven by price increases and new business in several business centers. Virtually every business center in this segment achieved an increase in premium volume over 2001. In Financial & Professional Services, premium volume of $400 million grew 21% over 2001 due to strong price increases, particularly in the Directors and Officers line of business. Umbrella/Excess & Surplus Lines’ written premiums of $253 million were more than double comparable 2001 volume of $116 million, driven by a new commercial umbrella operation launched in 2002. Technology premiums of $372 million in 2002 were slightly higher than the 2001 total of $366 million, reflecting the effects of the economic weakness in the technology market sector.
million. Price increases, new business and strong renewal retention rates all contributed to the strong growth over 2002. New business volume was particularly strong in Canada.
The improvement in underwriting results in 2003 was concentrated in our international specialty operations, particularly in Canada and the United Kingdom. The underwriting profit at our operations at Lloyd’s was down slightly from 2002, primarily due to $24 million of prior year losses in the personal lines business unit at Lloyd’s.
2003 vs. 2002-Net written premiums generated by our Surety business center totaled $475 million in 2003, down 1% compared with premiums of $480 million in 2002. The decline was primarily due to the closing of certain field offices, the impact of underwriting actions to improve the risk profile of our book of business, and increased reinsurance costs. In our Construction operation, net written premium volume in 2003 of $759 million was 3% less than premiums of $786 million in 2002, as the impact of price increases in 2003 was offset by a reduction in new business.
In our Surety operation, we continued to experience an increase in the frequency of reported losses in 2003. Certain segments of our surety business tend to be characterized by low frequency but potentially high severity losses.
In addition to our largest exposure discussed above with respect to energy trading companies, our commercial surety business as of December 31, 2003 included seven accounts with gross pretax bond exposures greater than $100 million each, before reinsurance. The majority of these accounts have investment grade ratings, and all accounts continue to perform their bonded obligations.
Some of our contract surety business, particularly with respect to larger accounts, is written on a co-surety basis with other surety underwriters in order to manage and limit our aggregate exposure. Certain of these sureties have experienced, and may continue to experience, deterioration in their financial condition and financial strength ratings. If a loss is incurred and one of our co-sureties fails to meet its obligations
In recent months, the contractor has completed a restructuring of its finances and entered into revised credit agreements with its lenders. As part of our strategy to mitigate our ultimate exposure to this account by facilitating the contractor’s efforts to complete bonded projects, we made additional advances for which we recorded an after-tax loss, net of estimated reinsurance and co-surety participation, of approximately $13 million in the fourth quarter of 2003. In February and early March 2004, we made or committed to make additional advances for which we recorded a net after-tax loss of approximately $15 million. We have not changed our estimate of the recoverable from that established at the end of the third quarter of 2003. Any future changes in our estimate of the recoverable, whether positive or negative, will affect our results of operations. We may make further advances and, subject to our underwriting criteria, we may also decide to issue bonds for new projects undertaken by this contractor.
2002 vs. 2001-Total combined premium volume for our Surety and Construction operations increased by $293 million over 2001, primarily driven by $220 million of premium growth in Construction, where price increases averaged 30% in 2002. In the Surety business center, premium volume was $73 million higher than in 2001, primarily due to the combined $100 million contributed by St. Paul Guarantee in Canada (formerly London Guarantee), acquired in March 2002, and our acquisition in late 2001 of the right to seek to renew surety business previously underwritten by Fireman’s Fund Insurance Company (see the “Acquisitions and Divestitures” section of this discussion for further details about these acquisitions). Excluding the impact of the two acquisitions, Surety’s net premium volume in 2002 was slightly below comparable 2001 levels, reflecting the tightened underwriting standards instituted in recent years, particularly with respect to our commercial surety business, and an increase in domestic reinsurance costs in 2002.
Both business centers contributed to the $182 million deterioration in underwriting results compared with 2001. The Construction underwriting loss of $110 million was $75 million worse than the comparable 2001 loss of $35 million, driven by adverse prior-year loss development that prompted a $113 million fourth-quarter provision to strengthen loss reserves in our general liability and workers’ compensation coverages. The 2002 current accident year loss ratio for Construction, however, was much improved over the same 2001 ratio, reflecting the impact of strong underwriting initiatives, price increases and the shift to a larger-sized account profile. Approximately $93 million of Construction’s $113 million adverse prior year development was concentrated in general liability coverages. The table below allocates the general liability coverage portion of our reserve charge in 2002, by accident year, within our Construction business center.
concept of “accident year” is not meaningful to surety business. The yearly information in the following table represents the year in which we determined that an incident had occurred, which might give rise to a possible claim.
The following table summarizes key financial data for each of the last three years in the Commercial Lines segment.
In our Middle Market Commercial business center, net written premium volume of $1.61 billion was 31% higher than comparable 2002 premiums of $1.23 billion. In the Small Commercial business center, written premiums of $741 million grew 19% over 2002 premiums of $622 million. After extensive efforts in 2002 to build our capability to serve the small commercial marketplace, we turned our focus in 2003 to launching our insurance products tailored to meet the needs of this market sector. In the Property Solutions business center, 2003 premium volume of $73 million was 31% higher than 2002 premiums of $56 million, primarily due to new business volume and a reduction in the amount of business ceded to reinsurers.
The Commercial Lines’ underwriting profit of $235 million in 2003 was over 65% higher than the comparable 2002 profit of $141 million, primarily driven by strong improvement in current accident year results in each business center comprising the segment. The growth in profitability in 2003 was achieved despite a significant increase in weather-related losses in 2003 compared with 2002, primarily resulting from storms throughout the United States during the year. Results in 2003 also benefited from $30 million of favorable development on prior-year loss reserves. The 2003 underwriting profit reflects the success of our stringent underwriting principles and aggressive risk control efforts, as well as the significant impact of price increases achieved in 2002 and 2003. In addition, in 2003 we accelerated our focus on expense discipline, which resulted in an over one-point improvement in our statutory expense ratio for the year. As we continue to emphasize productivity enhancements, including increased use of automation and processing improvement initiatives, we expect further improvements in our expense ratio going forward.
2002 vs. 2001-Premium growth of 15% in 2002 was primarily due to price increases, the impacts of which were offset somewhat by a decline in business retention levels resulting from our efforts to increase profitability. We capitalized on favorable market conditions in 2002 by implementing significant price increases, rejecting new and renewal business where we could not achieve appropriate price increases, and selectively adding new business that met our pricing and underwriting criteria. Price increases across the entire segment averaged 23% in 2002. Middle Market Commercial net written premiums totaled $1.23 billion in 2002, 9% higher than 2001 premiums of $1.12 billion. Our focus in 2002 was to maximize the quality and profitability of our middle market book of business; as a result, the impact of significant rate increases was substantially offset by reductions in business retention rates and new business levels. Small Commercial premium volume of $622 million in 2002 grew 7% over 2001 premiums of $575 million. We greatly expanded our involvement in the small commercial marketplace in 2002 through the development of products to serve particular sectors of the market, and through investments in technology to enable easy access to those products by agents, brokers and insureds.
The Commercial Lines segment total underwriting profit in 2002 of $141 million was significantly improved over the 2001 underwriting loss of $153 million, which included $136 million of losses related to the September 11, 2001 terrorist attack. Current accident-year results in 2002 in all three business centers in this segment improved over 2001, with the most notable improvement occurring in Middle Market Commercial. The $158 million improvement in underwriting results from 2001 to 2002 (after excluding losses from the terrorist attack in 2001) reflected the impact of price increases and the improvement in the quality of our book of business, as well as a decline in weather-related losses. In 2001, reported results would have been significantly worse if not for the benefit of a $128 million reduction in prior-year loss reserves, of which $93 million related to certain business written prior to 1988.
This segment includes the results of the lines of business we placed in runoff in late 2001 and early 2002, including our former Health Care and Reinsurance segments, and the results of the following international operations: our runoff operations at Lloyd’s, including our participation in the insuring of the Lloyd’s Central Fund; Unionamerica, the London-based underwriting unit acquired as part of our purchase of MMI in 2000; and international operations we decided to exit at the end of 2001. We have a management team in place for these operations, seeking to ensure that our outstanding claim obligations are settled in an expeditious and economical manner. This segment also includes the results of our participation in voluntary insurance pools, as well as loss development on business underwritten prior to 1980 (prior to 1988 for business acquired in our merger with USF&G Corporation in 1998). In addition to our participation in voluntary insurance pools, this prior year business includes the majority of our environmental and asbestos liability exposures. The oversight of these exposures is the responsibility of the same management team responsible for oversight of the other components of the Other segment. Our Health Care operation historically provided a wide range of medical liability insurance products and services throughout the entire health care delivery system. Our Reinsurance operations historically underwrote treaty and facultative reinsurance for a wide variety of property and liability exposures.
The significant allocation to the three most recent incurred years is consistent with the nature of the claims-made insurance product. The average payment date on this book of reserves is approximately two years, meaning that 50% of the losses will be settled within two years. Accordingly, the change in assumptions that resulted in the $350 million charge in 2003 significantly impacted the most recent incurred years, as expected.
2002 vs. 2001-Written premiums in 2002 were generated by extended reporting endorsements and professional liability coverages underwritten primarily in the first quarter of the year prior to our non-renewal notifications becoming effective in several states. The majority of reporting endorsements underwritten in 2002 pertained to physicians’ and surgeons’ liability coverage.
The following presents a summary of trends we observed within our Health Care operation, by quarter, for the three-year period ended December 31, 2003. The discussion focuses on our Medical Malpractice line of business, since 99% of the reserve adjustments related to this business. Our Medical Malpractice business includes all medical liability coverage within our Health Care operation, and comprised approximately 93% of our total Health Care segment reserves at December 31, 2003; the remaining business included in this operation is represented by claims arising out of ancillary business (such as automobile and property coverage for our Medical Malpractice customers). There were no offsetting increases or decreases in reserves of different lines within our Health Care operation. Of the Medical Malpractice reserve adjustments recorded in 2003, approximately 17% related to 2002 incurred losses; approximately 33% to 2001 incurred losses; approximately 23% to 2000 incurred losses; approximately 4% to 1999 incurred losses; and the remainder of 23% to incurred losses in 1998 and prior years. Of the Medical Malpractice reserve adjustments recorded in 2002, approximately 88% related to
2001 incurred losses; approximately 50% to 2000 incurred losses; approximately (7)% to 1999 incurred losses; approximately 6% to 1998 incurred losses; and the remainder of (37)% to incurred losses in 1997 and prior years. Of the Medical Malpractice reserve adjustments recorded in 2001, approximately 29% related to 2000 incurred losses; approximately 30% to 1999 incurred losses; approximately 15% to 1998 incurred losses; approximately 10% to 1997 incurred losses; and the remaining 16% to incurred losses in 1996 and prior years.
The following table summarizes, for each quarter of 2003, 2002 and 2001, our ending net reserves for losses and allocated loss adjustment expenses for our Health Care segment, any prior-period reserve strengthening recorded in the quarter (all related to the Medical Malpractice portion of the segment), and the percentage such reserve strengthening represented in relation to beginning of period total loss liability.
* The insurance loss reserving process involves judgment by actuaries and management, including evaluation not only of underlying data, but also of changes in legal, economic and societal factors that are generally not quantifiable. Such application of judgment includes an analysis of trends that develop over time and which make it difficult to directly correlate specific data points (as discussed previously) with a specific reserving decision.
Following the cumulative prior-year reserve charges of $735 million in 2001, activity in the first quarter of 2002 developed according to projections. Average paid claims for the full year of 2001 for medical malpractice lines had been $117,000, including a fourth quarter average of $124,000. The phrase “average paid claims” as used herein excludes claims which were settled or closed for which no loss or loss expense was paid. In the first quarter of 2002, the average paid loss was down to $111,000. We interpreted this as a positive sign that prior year reserve charges up to this point had been adequate. The average outstanding case reserve increased slightly from $141,000 in the fourth quarter of 2001 to $144,000 in the first quarter of 2002, but this was interpreted as a relatively benign change, given inflation and the promising decrease in average payment amounts. No additional reserve action was taken.
Throughout 2002, we initiated significant changes to our Health Care claims organization and resolution process. During the third quarter of 2002, we began to see the results of executing this strategy. Specifically, case loads per adjuster had begun to decline substantially and the process for providing oversight on high exposure cases had been streamlined, enabling a more expeditious approach to our handling of these medical malpractice claims-including the establishment of stronger case reserves. We also added staff with expertise in high exposure litigation management to assist claim handlers in aggressively pursuing appropriate resolutions on a file-by-file basis. This allowed us to establish more effective resolution strategies to either resolve claims prior to going to trial or, for those claims deemed as non-meritorious, maintain an aggressive defense. We also became more selective in determining which cases are taken to trial and more willing to make use of our right to select defense counsel in those instances that we decide to litigate. This caused our ratio of defense verdicts to plaintiff verdicts to improve over prior years. We began to more effectively manage our claim disposition strategies to limit the number of catastrophic verdicts. We believe that executing this strategy increased our ability to reduce our ultimate indemnity losses.
Emergence of newly reported claims-Our Health Care book of business was put into runoff at the end of 2001 and our outstanding exposure rapidly dropped, as expected. Since the majority of coverage we offered was on a claims-made basis, and notification of the claim must be made within the policy period, the potential for unreported claims decreased significantly. We expected that the emergence of newly reported medical malpractice claims, with incurred years of 2002 or prior, would not exceed 40% of our current outstanding case reserve amount.
In 2003, we evaluated the adequacy of our previously established medical malpractice reserves in the context of the three indicators described above. The dollar amount of newly reported claims in the first quarter totaled $118 million, approximately 25% less than we anticipated in our original estimate of the required level of redundancy at year-end 2002. With regard to development on known claims, loss activity in the first quarter of 2003 was within our expectations. Case development on incurred years 2001 and prior was minimal, and case development on the 2002 incurred year totaled $39 million, within our year-end 2002 estimate of no more than 3% of development. For the first quarter of 2003, our redundancy ratio was within our expected range of between 35% and 40%.
In the second quarter of 2003, the dollar amount of newly reported claims totaled $127 million, approximately 5% higher than we anticipated in our original estimate of the required level of reserves at year-end 2002. Nevertheless, through the first half of 2003, the dollar amount of newly reported claims was approximately 12% lower than we anticipated. Loss development on known claims during the second quarter of 2003 was negative, but not as negative as we anticipated. Our actual redundancy ratio continued to improve in the second quarter of 2003; however, since newly reported claims and loss development on known claims did not improve as much as we expected in the second quarter, the required reserve redundancy had increased modestly from the previously estimated range of 35% to 40%.
In the fourth quarter of 2003, the dollar amount of newly reported claims totaled $65 million, approximately 24% better than we anticipated in our original estimate of the required level of reserves at year-end 2002. The dollar amount of newly reported claims for the year ended December 31, 2003 was approximately 10% better than our original expectation. We consider the assumptions we made at the end of 2002 for newly reported claims to be appropriate and we have made no changes to those assumptions. Loss development on known claims during the fourth quarter of 2003 was only slightly worse than anticipated. However, through all of 2003, the cumulative development was considerably worse than expected. Through the third quarter, this adverse development on known claims was offset by continued improvement on the actual redundancy ratio experienced and no adjustment had been needed. However, our actual redundancy ratio, which had continually improved during the first nine months of 2003, took an adverse turn during November and December, causing the required reserve redundancy to increase above our level of tolerance. The view that the redundancy ratio would not only fail to continue to improve, but could likely decay over time caused us to make an adjustment to the reserve levels. The new required redundancy ratio, after the $350 million of reserve strengthening recorded in the fourth quarter, is in the range of 30% to 35%.
In the years prior to 2002, our Reinsurance segment (“St. Paul Re”) generally underwrote treaty and facultative reinsurance for property, liability, ocean marine, surety, certain specialty classes of coverage, and “nontraditional” reinsurance, which provided limited traditional underwriting risk protection combined with financial risk protection. In late 2001, we announced our intention to cease underwriting certain types of reinsurance coverages and narrow our geographic presence in 2002, as described in more detail earlier in this discussion. As a result, in January 2002, St. Paul Re began focusing almost exclusively on the following types of reinsurance coverage: property catastrophe, excess-of-loss casualty, marine and traditional finite. St. Paul Re conducted its business through four business centers: North American Casualty, North American Property, International and Finite Risk. As discussed in more detail earlier in this report, in November 2002, we transferred our ongoing reinsurance operations to Platinum Underwriters Holdings, Ltd. (“Platinum”) while retaining liabilities generally for reinsurance contracts incepting prior to January 1, 2002. Reported results for our Reinsurance operation in 2003 represent premium adjustments and loss development on reinsurance business underwritten prior to the transfer of business to Platinum. Reported results for 2002 include those elements, as well as activity from the period January 1, 2002 up to the date of transfer to Platinum.
2003-The underwriting profit of $3 million in 2003 was driven by $8 million of favorable development on prior-year loss reserves related to the September 11, 2001 terrorist attack. Results in 2003 also included a $6 million underwriting loss related to the transfer of additional assets and reserves to Platinum pursuant to an adjustment mechanism as described in more detail earlier in this report.
reductions in premiums were partially offset by significant price increases on the narrowed lines of business underwritten in 2002 prior to the transfer to Platinum, and new business in the accident and health reinsurance market.
Business underwritten through our Lloyd’s syndicates, including the majority of Unionamerica’s business, is done in a subscription market, in which parties participate in portions of policies and/or groups of policies. As a result, the concepts of claim frequency and claim size trend for specific syndicates and/or shares of syndicates are neither available nor pertinent.
Lloyd’s accounted for $99 million of the underwriting loss in 2002, driven by adverse loss development on business written in prior years and poor current-year results from North American liability and reinsurance business. Unionamerica’s underwriting loss in 2002 of $60 million included $27 million of adverse prior year loss development, with the remainder reflecting current year losses related to strengthened loss assumptions related to contracts still in effect in 2002. These losses are centered in three lines of business underwritten through Lloyd’s syndicates that are now managed by Unionamerica: excess-of-loss reinsurance on U.S. medical malpractice, directors’ and officers’ liability business, and U.S. surplus lines business. All other international runoff lines of business accounted for $56 million of underwriting losses in 2002, compared with $94 million of losses in 2001. Losses in 2002 were centered in the Netherlands and Spain, whereas in 2001 losses were concentrated in health care business and construction coverages offered in the United Kingdom. The decline in these other international runoff losses in 2002 reflected the impact of our decision to withdraw from those markets.
The following table summarizes prior year reserve charges in 2002 by line of business or operation.
At December 31, 2003, approximately 96% of our fixed income portfolio, comprised of our fixed income securities, the securities on loan and short-term investments, was rated investment grade. Approximately 3% consisted of non-investment grade securities and 1% were non-rated securities.
At the end of 2003, the reported amortized cost of our fixed income portfolio was $15.6 billion, compared with $16.1 billion at the end of 2002. The decline was primarily due to our increased
We acquired our portfolio of mortgage loans in the 1998 merger with USF&G. The loans, which are collateralized by income-producing real estate, produced investment income of $6 million in 2003 and $10 million in 2002. Net pay downs and repayments of the loans totaled $19 million in 2003 and $52 million in 2002. We did not originate any new loans in either of the last two years.
EQUITIES-Our equity holdings consist of a diversified portfolio of public common stock, comprising less than 1% of total property-liability investments (at cost) at year-end 2003. In mid-2002, we began to reduce our level of equity investments. Our decision was prompted by several factors, including our opinion as to the near-term direction of equity prices, a comprehensive evaluation of our aggregate equity exposure (including venture capital and equities held by our pension fund), and our opinion as to the level of public equity investments that is appropriate for publicly held insurance companies. By the end of 2003, we had reduced our equity investments by $953 million (at cost) since year-end 2001.
The total return on our combined domestic and international equity portfolio was 32% in 2003, compared with (19.4%) in 2002 and (20.7%) in 2001. At the end of 2003, the market value of our remaining portfolio of $105 million exceeded its cost by $17 million. By comparison, at the end of 2002, the $375 million cost of our equity holdings exceeded its market value by $20 million.
OTHER INVESTMENTS-Our 14% equity ownership stake in Platinum Underwriters Holdings, Ltd., with a carrying value of $146 million and $129 million, at December 31, 2003 and 2002, respectively, is included in this category, as is a long-term interest-bearing security from a highly-rated entity, supporting a series of insurance transactions, with a carrying value of $359 million and $386 million at December 31, 2003 and 2002, respectively. The carrying value of this security is expected to continue to decline in proportion to the reduction in the amount of insurance which it supports. Also included in “Other Investments” are our warrants to purchase additional Platinum shares, which are carried at their market value ($65 million and $61 million at December 31, 2003 and 2002, respectively).
A significant amount of additional information regarding procedures employed to evaluate other than temporary impairments in the carrying value of any of our investments is contained in the Critical Accounting Policies section of this discussion.
For reported losses, we establish reserves on a “case” basis within the parameters of coverage provided in the insurance policy, surety bond or reinsurance agreement. For IBNR losses, we estimate reserves using established actuarial methods. Our case and IBNR reserve estimates consider such variables as past loss experience, changes in legislative conditions, changes in judicial interpretation of legal liability and policy coverages, and inflation. We consider not only monetary increases in the cost of what we insure, but also changes in societal factors that influence jury verdicts and case law and, in turn, claim costs.
The following table provides additional statistics on our long tail and medical malpractice exposures and is followed by discussion on known trends, events, or uncertainties that may affect our future results of operations or financial condition. We also further describe the nature of the underlying claims, including relevant information of the claimant population. For our general liability and workers’ compensation lines of business, we have reported separately our exposures to possible environmental and asbestos (“E&A”) obligations. For our non-E&A general liability, workers’ compensation, and medical malpractice coverages, we have included data only for our primary domestic insurance operations, excluding alternative risk transfer insurance products. The coverages in the table represented approximately 65% of our total net loss and loss adjustment expense reserves at December 31, 2003.
(1) The claim counts included in this table represent counts of “supplements,” which are extracted from our actuarial databases. A claim supplement is the finest level of detail recorded in our statistical systems. For example, two claimants for a single general liability bodily injury occurrence would be counted as two separate supplements. Our claim department manages claims on a policyholder basis, while the data in this table is presented on a claim count basis. For environmental and asbestos claims, a claim supplement count does not reflect the number of claimants involved on the account. For asbestos claims, supplements are generally created based on the number of policy years potentially implicated on the account. For environmental claims, supplements are generally created to track the number of sites involved on the account.
(2) The environmental and asbestos claim count information includes only losses on direct written business whereas the paid loss data on assumed business, presented separately, includes loss and
defense and cost containment expenses. Claim count data is not shown on losses assumed from other companies and/or insurance pools because we are often either covering a very small portion of any one claim, or a number of claims which are compiled together as one for reporting purposes and, therefore, such statistics would not be meaningful. Also, the costs to administer these claims do not include adjusting and other related payments.
Workers’ Compensation-Includes insurance which covers an employers’ liability for injuries, disability or death to persons in their employment, without regard to fault. The coverage provided under the workers’ compensation policies is based on state-specific schedules for wage replacement and medical payments for injured workers. While the largest portion of the workers insured under our policies generate a very low severity body of claims, a portion of our premium volume is generated in our Construction business center, where there is an increased possibility of permanent and total disability requiring lifetime payments. Although each state government can make changes in coverage, the changes happen after considerable public deliberation and very seldom will impact policies that have been sold in the past. The number of newly reported claims continued to decline in 2003, driven by an underlying decrease in our exposure to loss. Premiums have increased in the last several years due to pricing, but the actual number of exposures insured has dropped. The number of claims closed in 2003 declined due to a steadily decreasing number of reported claims in recent years. We closed roughly as many claims in 2002 as in 2001, driving the number of pending claims down.
Medical Malpractice-Includes insurance protecting a licensed health care provider or health care facility against legal liability resulting from death or injury of any person due to the insured’s misconduct, negligence, or incompetence in rendering professional services. Medical malpractice claims are volatile in nature. While a large number are closed without a loss payment, those with payments may be very large depending on the circumstances and judicial climate. Significant cost is expended in the settlement of these claims, often with favorable outcomes. Since this book of business is in runoff, the pending inventory is decreasing and will begin to distort some of the statistics. As the runoff matures, there will be fewer small claims and fewer meritless claims that can be quickly dismissed. The single largest risk in this line of business is associated with social trends in jury verdicts which is described in further detail in our Health Care segment discussion in this report. As reported in the Health Care discussion referenced above, newly reported claim counts are dropping quickly as we exit this business segment. As we execute our runoff strategy, we will continue to see a drop in the inventory of pending claims. The unusually high number of claims “reported” and “dismissed, settled or resolved” in 2001 in the foregoing table was due to the impact of the MMI integration.
Asbestos-This exposure relates to general liability and workers’ compensation coverages on policies which can be interpreted to cover asbestos-related exposures. This portion of business is defined as that which is reported as “Asbestos losses” as described in more detail in the following section of this report. Amounts are driven by a few very large claims, accompanied by a large number of very small claims or claims made with no payment. A significant portion of the cost of administering the claims is spent on those claims that are eventually settled without payment. Social, judicial, legislative and economic changes could result in future unforeseen developments and require reserve adjustments. Western MacArthur accounted for the majority of paid losses on settled claims in 2003 ($453 million) and 2002 ($173 million), as well as the majority of costs to administer in 2002 ($12 million), with the remainder relating to claims made in prior years. Approximately 32% and 25% of the pending general liability asbestos claim supplements as of December 31, 2003 and 2002, respectively, came from policyholders who tendered their first asbestos claim within three years of those respective dates. The increase in newly reported claims arise from policyholders who tendered their first claim to us within the last three years. For example, approximately 73% of the general liability claim supplements reported during 2003 came from policyholders who tendered their first claim after January 1, 2001. These claims are generally relatively small and have, to date, presented minimal exposure.
loss provisions in 2001 was driven by additional losses in our Health Care operation. That development in all three years is discussed in detail in the respective segment sections included herein.
The following table summarizes the composition of our gross and net loss and loss adjustment expense reserves, and the net unfavorable (favorable) prior-year loss development by segment as of December 31, 2003.
We continue to receive claims, including through lawsuits, alleging injury or damage from environmental pollution or seeking payment for the cost to clean up polluted sites. We also receive asbestos injury claims, including through lawsuits, arising out of coverages under general liability policies. Most of these claims arise from policies written many years ago. Significant legal issues, primarily pertaining to the scope of coverage, complicate the determination of our alleged liability for both environmental and asbestos claims. In our opinion, court decisions in certain jurisdictions have tended to broaden insurance coverage for both environmental and asbestos matters beyond the intent of the original insurance policies.
Our ultimate liability for environmental claims is difficult to estimate because of these legal issues. Insured parties have submitted claims for losses that in our view are not covered in their respective insurance policies, and the final resolution of these claims may be subject to lengthy litigation, making it difficult to estimate our potential liability. In addition, variables such as the length of time necessary to clean up a polluted site, and controversies surrounding the identity of the responsible party and the degree of remediation deemed necessary, make it difficult to estimate the total cost of an environmental claim.
Estimating our ultimate liability for asbestos claims is also very difficult. The primary factors influencing our estimate of the total cost of these claims are case law and a history of prior claim
Late in 2001, we hired a new Executive Vice President of Claims, with extensive experience with environmental and asbestos claims handling and environmental and asbestos reserves, who conducted a summary level review of our environmental and asbestos reserves. As a result of observations made in this review, we undertook more detailed actuarial and claims analyses of environmental reserves. No adjustment to reserves was made in the fourth quarter of 2001, since management did not have a sufficient basis for making an adjustment until such supplemental analyses were completed, and we believed our environmental and asbestos reserves were adequate as of December 31, 2001.
Our historical methodology (through first quarter 2002) for reviewing the adequacy of environmental and asbestos reserves utilized a survival ratio metric, which considers ending reserves in relation to calendar year paid losses. When the environmental reserve analyses were completed in the second quarter of 2002, we supplemented our survival ratio diagnostics with the detailed additional analyses referred to above, and concluded that our environmental reserves were redundant by approximately $150 million. Based on our additional analyses, we released approximately $150 million of environmental reserves in the second quarter of 2002. Had we continued to rely solely on our analysis of survival ratio, we would have recorded no adjustment to our environmental reserves through the six months ended June 30, 2002.
As a result of developments in the asbestos litigation environment generally, we determined in the first quarter of 2002 that it would be desirable to seek earlier and ultimately less costly resolutions of certain pending asbestos-related litigations. As a result, we have decided where possible to seek to resolve these matters while continuing to vigorously assert defenses in pending litigations. We are taking a similar approach to environmental litigations. As discussed in more detail earlier in this report, in the second quarter of 2002 we entered into a definitive agreement to settle asbestos claims for a total gross cost of $995 million arising from any insuring relationship we and certain of our subsidiaries may have had with MacArthur Company, Western MacArthur Company or Western Asbestos Company.
The amounts presented for paid losses in the following table as “Underwritten” include primarily exposures related to accident years after 1988 for policies which the underwriter contemplated providing environmental coverage. In addition, certain pre-1988 exposures, primarily first party losses, are included since, they too, were contemplated by the underwriter to include environmental coverage. “Not Underwritten” primarily represents exposures related to accident years 1988 and prior for policies which were not contemplated by the underwriter to include environmental coverage.
* The $150 million reduction of environmental reserves discussed previously was included in both the gross and net incurred losses for 2002.
reported separately in the above table, was a $150 million increase in asbestos reserves. Gross paid losses include the $248 million Western MacArthur payment made in June 2002.
The following table summarizes Nuveen Investments’ key financial data for the last three years.
2003 vs. 2002-Gross investment product sales in 2003 totaled a record $18.1 billion, 16% higher than 2002 product sales of $15.6 billion. Net flows (equal to the sum of sales, reinvestments and exchanges, less redemptions) were $9.4 billion in 2003, over $2 billion higher than 2002 net flows of $7.3 billion. Net flows were positive across all product lines-managed accounts, closed-end exchange-traded products and mutual funds. Investor demand in 2003 continued to be strong for municipal investments and high-quality taxable income-oriented investments. Nuveen Investments raised $5.7 billion during the year through new closed-end exchange-traded funds that blend various stock and bond investment strategies. With the rebound of equity markets and investors’ renewed interest in equity investing, Nuveen Investments’ equity sales grew 45% over 2002 to $6.4 billion. The success Nuveen Investments has achieved over the last several years in broadening its business beyond municipal securities enabled Nuveen Investments to participate in the recovery of equity markets through both positive net flows and market appreciation.
Investment advisory revenue totaled $405 million in 2003, 14% higher than 2002 revenue of $355 million. The increase in assets under management as well as the NWQ acquisition in August 2002 accounted for a portion of the higher revenues in 2003. Performance fee revenues of $34 million grew 48% over comparable 2002 fees of $23 million, due to continued strong fixed income performance at Symphony. The 15% increase in operating expenses in 2003 compared with 2002 was primarily due to the inclusion of NWQ in Nuveen Investments’ results for an entire year.
2002 vs. 2001-Gross sales of investment products of $15.6 billion in 2002 grew 10% over sales of $14.2 billion in 2001. The increase over 2001 was driven by an increase in exchange-traded fund sales. Municipal mutual fund sales and institutional managed account sales also increased over 2001. Sales of retail managed accounts declined, as the addition of NWQ value accounts was more than offset by a reduction in equity growth account sales. Defined portfolio sales also declined in 2002, due to Nuveen Investments’ decision to exit this product line in 2002. Net flows of $7.3 billion in 2002 were down 5% from comparable 2001 net flows of $7.7 billion. Net flows were positive across all product categories in 2002-managed accounts, exchange-traded funds and mutual funds. Nuveen Investments introduced 18 municipal closed-end exchange-traded funds in 2002, which, combined with municipal mutual funds and managed accounts, raised $4.8 billion in net new assets for the year. In addition, Nuveen Investments launched the first Preferred Stock closed-end exchange-traded fund in the industry, generating approximately $4 billion in new assets.
Investment advisory revenue of $355 million in 2002 grew 8% over 2001 revenues of $331 million. A full year of Symphony and the addition of NWQ accounted for approximately 6% of the increase, while exchange-traded funds and other fixed-income products drove the remainder. Revenues on exchange-traded funds grew 10% due to an increase in average assets under management as a result of both positive net flows and market appreciation. This increase was partially offset by a decline in advisory revenue related to equity growth accounts, where assets under management declined due to market depreciation and withdrawals.
SHARE REPURCHASES-Nuveen Investments repurchased common shares from minority shareholders in 2003, 2002 and 2001 for total costs of $42 million, $151 million and $172 million, respectively. No shares were repurchased from The St. Paul in those years. Our percentage ownership in Nuveen Investments grew from 78% at the end of 2000 to 79% at the end of 2003, as the share repurchases were substantially offset by Nuveen Investments’ issuance of additional shares under various stock option and incentive plans and the issuance of common shares upon the conversion of a portion of its preferred stock. As part of a new share repurchase program approved in August 2002, Nuveen Investments had authority from its board of directors to purchase up to 7.0 million shares of its common stock. At December 31, 2003, there were 4.2 million shares remaining under the new share repurchase program.
* Debt obligations and total capitalization exclude the fair value of interest rate swap agreements in each year.
(1) In 2003, we deconsolidated the five business trusts that issued mandatorily redeemable preferred securities to investors. See further information in the following discussion. In accordance with accounting rules, prior years were not restated to conform to the 2003 presentation.
COMMON EQUITY-In 2003, the 8% increase in common shareholders’ equity was driven by our net income of $661 million for the year. In 2002, our issuance of new common shares through a public offering and our net income of $218 million were the primary factors contributing to the 12% increase in common equity over year-end 2001. The following summarizes the major factors impacting our common shareholders’ equity in each of the last three years.
· Common share issuance. In July 2002, we issued 17.8 million common shares at $24.20 per share in a public offering that generated net proceeds of $413 million. The majority of proceeds were contributed as capital to our insurance underwriting subsidiaries.
· Common share repurchases. In 2003 and 2002, we made no significant repurchases of our common shares. In 2001, we repurchased and retired 13.0 million of our common shares for a total cost of $589 million, or approximately $45 per share. The share repurchases in 2001 occurred prior to September 11 and represented 6% of our total shares outstanding at the beginning of the year. The share repurchases in 2001 were financed through a combination of internally generated funds and new debt issuances.
· Unrealized appreciation of investments. The net after-tax appreciation on our fixed income investment portfolio declined by $114 million from year-end 2002, reflecting a decline in the market value of that portfolio due to an increase in market interest rates in 2003. In 2002, the net after-tax appreciation on our fixed income portfolio grew by $300 million over year-end 2001, reflecting the significant decline in interest rates during the year.
DEBT-Our consolidated debt outstanding at the end of the last three years consisted of the following components.
2003 vs. 2002 As discussed in more detail in Note 12 to the consolidated financial statements, in the fourth quarter of 2003 we concluded that the provisions of FASB Interpretation No. 46 “Consolidation of Variable Interest Entities”(as revised) (“FIN 46(R)”) applied to the five business trusts that issued mandatorily redeemable preferred securities to investors which were fully guaranteed by us. As a result, we “de-consolidated” these trusts, and now report our borrowings from these trusts as debt on our consolidated balance sheet. In years prior to 2003, the preferred securities issued by these trusts and guaranteed by us were reported in our balance sheet as a separate line item between total liabilities and shareholders’ equity, and referred to as “company-obligated mandatorily redeemable securities of trusts holding solely subordinated debentures of the company.” Prior to 2003, the debt issued by us to the trusts was eliminated in consolidation. The following is a summary of the provisions of the five business trusts, each of which was formed for the sole purpose of issuing those securities.
In the third quarter of 2003, Nuveen Investments issued $300 million of 4.22% notes due in September 2008 in a private placement. A portion of the proceeds was used to refinance existing debt and repay a $105 million loan from The St. Paul. The remainder will be used for Nuveen Investments’ general corporate purposes. During 2003, $67 million of The St. Paul’s medium-term notes matured, which were funded through a combination of internally-generated funds and the issuance of commercial paper.
INTEREST EXPENSE-Net interest expense on debt totaled $187 million in 2003, compared with $112 million in 2002. The 2003 total included $72 million of interest expense related to the debt associated with the five business trusts described above. At the end of 2003 and 2002, we were party to a number of interest rate swap agreements related to several of our debt securities outstanding. The notional amount of these swaps totaled $730 million at both dates, and their aggregate fair value was $46 million and $65 million at year-end 2003 and 2002, respectively. The fair value of the swap agreements is recorded as an asset, with a corresponding increase to reported debt. These swap agreements had the effect of reducing our interest expense by $32 million and $21 million in 2003 and 2002, respectively.
Our total distribution expense related to the preferred securities was $70 million in 2002 and $33 million in 2001. The increase in 2002 was due to the $575 million, 7.6% securities issued by St. Paul Capital Trust I in November 2001. In 2003, subsequent to the de-consolidation of these trusts, the expense related to these trusts ($72 million) was included in our total interest expense.
In September 2001, we sold our life insurance subsidiary, F&G Life, to Old Mutual plc, for $335 million in cash and 190.4 million Old Mutual ordinary shares (valued at $300 million at closing). The cash proceeds received were used for general corporate purposes. In June 2002, we sold all of the Old Mutual shares we were holding for total net proceeds of $287 million, which were also used for general corporate purposes.
CAPITAL COMMITMENTS-We made no major capital improvements during any of the last three years, and none are anticipated in 2004.
Liquidity is a measure of our ability to generate sufficient cash flows to meet the short- and long-term cash requirements of our business operations. Our underwriting operations’ short-term cash needs primarily consist of paying insurance loss and loss adjustment expenses and day-to-day operating expenses. Those needs are met through cash receipts from operations, which consist primarily of insurance premiums collected and investment income. Our investment portfolio is also a source of additional liquidity, through the sale of readily marketable fixed maturities, equity securities and short-term investments, as well as longer-term investments such as real estate and venture capital holdings. After satisfying our cash requirements, excess cash flows from these underwriting and investment activities are used to build the investment portfolio and thereby increase future investment income.
Net cash flows provided by continuing operations totaled $133 million in 2003, compared with cash provided by continuing operations of $129 million in 2002 and $884 million in 2001. Operational cash flows in 2003 were negatively impacted by the January 2003 payment of $747 million related to the Western MacArthur asbestos litigation settlement, which accounted for a significant portion of the net $1.2 billion decline in insurance reserves disclosed on our consolidated statement of cash flows for the year ended
December 31, 2003. The additional decline in insurance reserves was primarily due to loss and loss adjustment expense payments related to our other operations that were placed in runoff at the end of 2001, which included our Health Care and Reinsurance operations, as well as several of our international underwriting operations. We have ceased underwriting new business in these operations, and as expected, the payments out of previously established reserves have exceeded new loss and loss adjustment expense reserve provisions, resulting in a decline in our total reserve balance. Our cash flows from operations improved during the second half of 2003, however, reflecting the impact of price increases and continuing improvement in the quality of our book of business in our ongoing underwriting segments.
Ratings with respect to claims paying ability and financial strength are important factors in establishing the competitive position of insurance companies and will also impact the cost and availability of capital to an insurance company. We compete with other insurance companies, financial intermediaries and financial institutions on the basis of a number of factors, including the ratings assigned by internationally-recognized rating organizations. Ratings represent an important consideration in maintaining customer confidence in our ability to market insurance products. Rating organizations
· A.M. Best: Placed our financial strength and debt ratings under review with positive implications.
· S&P: Revised the CreditWatch status of our financial strength and debt ratings from positive to developing, following our announcement of the $350 million pretax charge, and subsequently revised the CreditWatch status from developing to negative, following its latest assessment of us on a stand-alone basis. It indicated that, subject to the completion of the Proposed Merger, it expects to affirm our current A+ financial strength rating and BBB+ senior unsecured debt rating, which would align the ratings with those of Travelers post-close of the Proposed Merger. It also indicated that if the Proposed Merger were not completed, it would expect to downgrade us to an A financial strength rating and a BBB senior unsecured debt rating.
· Fitch: Revised the Rating Watch status of our debt ratings from positive to evolving, following our announcement of the $350 million pretax charge, and subsequently lowered our senior unsecured debt rating from BBB+ to BBB, following its latest assessment of us on a stand-alone basis. Fitch simultaneously revised the Rating Watch status from evolving to positive and indicated its belief that it will likely upgrade our ratings upon the close of the Proposed Merger with Travelers.
Ratings are not in any way a measure of protection afforded to investors and should not be relied upon in making an investment decision.
Due to the long-term nature of obligations under our pension plans, the accounting for such plans is complex and reflects various actuarial assumptions. Management’s selection of plan assumptions, primarily the discount rate used to calculate the projected benefit obligation and the expected long-term rate of return on plan assets (“LTROR”), can have a significant impact on our resulting estimated projected benefit obligation and pension cost, and thus on our consolidated results of operations. Such plan assumptions are determined annually, subject to revision if significant events occur during the year, such as plan mergers and significant plan amendments.
Total pension cost encompasses the cost of service, interest costs based on an assumed discount rate, an expected long-term rate of return on plan assets and amortization of actuarial gains and losses, adjusted for curtailment gains or losses, if any. Actuarial gains and losses include the impact of unrecognized gains and losses that are deferred and amortized over the expected future service period of active employees. Any unrecognized gains or losses related to changes in the amount of the projected benefit obligation or plan assets resulting from experience that differs from the expected returns and from changes in assumptions are deferred. To the extent an unrecognized gain or loss exceeds 10 percent of the greater of the projected benefit obligation or the fair value of plan assets (“10 percent corridor”), the excess is recognized over the expected future service periods of active employees. At December 31, 2003, the accumulated unrecognized loss for our consolidated pension plans subject to minimum amortization approximated $305 million, which exceeded the 10 percent corridor, and will be amortized over 12 years. As a result, pension cost in 2004 is expected to include approximately $25 million of amortization. The amount of the unrecognized gain or loss that is less than the 10% corridor, and is therefore not subject to minimum amortization in 2004, was approximately $117 million at December 31, 2003.
The expected long-term rate of return on plan assets is estimated based on the plan’s actual historical return results, the expected allocation of plan assets by investment class, market conditions and other relevant factors. We evaluate only whether the actual allocation has fallen within an expected range, and we then evaluate actual asset returns in total, rather than by asset class, giving consideration to the fact that our equity investments have a higher volatility than our other investment classes, which is consistent with the market in general. The following table presents the actual allocation of plan assets in comparison with the expected allocation range, both expressed as a percentage of total plan assets, on a consolidated basis as of December 31, 2003 and for our U.S. plan only as of December 31, 2002. Our U.S. plan accounted for 95% of our consolidated pension plan assets as of December 31, 2002.
* The high level of cash at year-end 2002 resulted from a significant contribution we made to the plan in December 2002.
The following table presents our consolidated weighted average pension plan assumptions.
Because of the subjective nature of certain plan assumptions, the following table presents, for the U.S. plan only, a sensitivity analysis to hypothetical changes in the LTROR (in 50 basis point increments) and the discount rate (in 25 basis point increments) on net income for the year ended December 31, 2003. The results presented in the tables assume that only the LTROR or discount rate assumption, as applicable for each table, is changed and that all other assumptions remain constant.
It is estimated that the December 31, 2003 assumptions will result in a consolidated 2004 pension cost of approximately $15 million.
Our expected long-term rate of return for our postretirement benefits plan differs from that used for our pension plan due to differences in the funded assets (fixed maturity investments in our postretirement
benefits plan compared with various investment classes in our pension plan) used to fund certain of the related obligations.
As discussed in more detail in Note 12 to the Consolidated Financial Statements, in December 2003, the FASB issued a revised version of FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46(R)”), which again deferred the effective date for certain provisions of FIN 46(R) until the first interim or annual period beginning after December 15, 2003, which for us would be the period ended March 31, 2004. Under the partial adoption provisions of FIN 46(R), we early-adopted the consolidation and disclosure provisions of this interpretation in 2003. Our partial adoption specifically excluded the following item.
On January 12, 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS 106-1, “Accounting and Disclosure Requirements related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (“FSP 106-1”). This pronouncement provides companies with the option to make a one-time election to defer accounting for the effects of the Medicare Act referenced in its title (“the Act”). We have decided to defer accounting for the Act under FSP 106-1 and have made the required disclosures in Note 13-“Retirement Plans” to the consolidated financial statements. The final accounting guidance could require changes to previously reported information. We will monitor the FASB deliberations and account for the Act based on the pronouncement expected to be issued.
Statutory Expense Ratio (a statutory financial measure): The company uses the statutory definition of expenses in calculating expense ratios disclosed. Expenses are divided by net written premiums to arrive at the expense ratio. “Statutory” expenses differ from “GAAP” expenses primarily with regard to policy acquisition costs, which are not deferred and amortized for statutory purposes, but rather recognized as
Statutory Combined Ratio (a statutory financial measure): The sum of the statutory expense ratio and the statutory loss ratio.
Net Written Premiums(a statutory financial measure) and Net Earned Premiums (a GAAP financial measure): Net written premiums are a statutory measure of premium volume that differs from the net earned premiums reported in our GAAP statement of operations. Written premiums for a period can be reconciled to earned premiums by adding or subtracting the change in unearned premium reserves in the period.
Scope of Responsibility-Management prepares the accompanying consolidated financial statements and related information and is responsible for their integrity and objectivity. The statements were prepared in conformity with United States generally accepted accounting principles. These consolidated financial statements include amounts that are based on management’s estimates and judgments, particularly our reserves for losses and loss adjustment expenses. We believe that these statements present fairly the company’s financial position and results of operations and that the other information contained in this annual report is consistent with the consolidated financial statements.
Internal Controls-We maintain and rely on systems of internal accounting controls designed to provide reasonable assurance that assets are safeguarded and transactions are properly authorized and recorded. We continually monitor these internal accounting controls, modifying and improving them as business conditions and operations change. Our internal audit department also independently reviews and evaluates these controls. We recognize the inherent limitations in all internal control systems and believe that our systems provide an appropriate balance between the costs and benefits desired. We believe our systems of internal accounting controls provide reasonable assurance that errors or irregularities that would be material to the consolidated financial statements are prevented or detected in the normal course of business.
We have audited the accompanying consolidated balance sheets of The St. Paul Companies, Inc. and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of operations, shareholders’ equity, comprehensive income and cash flows for each of the years in the three-year period ended December 31, 2003. 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.
Consolidation-We combine our financial statements with those of our subsidiaries and present them on a consolidated basis. The consolidated financial statements do not include the results of material transactions between our subsidiaries and us or among our subsidiaries. Certain of our foreign underwriting operations’ results, and the results of certain of our investments in partnerships, are recorded on a one-month to one-quarter lag due to time constraints in obtaining and analyzing such results for inclusion in our consolidated financial statements on a current basis. In the event that significant events occur during the lag period, the impact is included in the current period results.
In the first quarter of 2003, we eliminated the one-quarter reporting lag for our operations at Lloyd’s. The effect of reporting those operations on a current basis was a $34 million reduction to our 2003 pretax income from continuing operations. During 2001, we eliminated the one-quarter reporting lag for certain of our primary underwriting operations in foreign countries. The effect of reporting those operations on a current basis was a $31 million increase to our 2001 pretax loss from continuing operations.
Indebtedness of Management-We have made loans to certain current and former executive officers for their purchase of our common stock in the open market. These are full-recourse loans, further secured by a pledge of the stock purchased with the proceeds. The loans accrue interest at the applicable federal rate for loans of such maturity. Loans to former executive officers are being repaid in accordance with agreed-upon terms. The total amount receivable under this program, included in “Other Assets”, was $1 million and $7 million on December 31, 2003 and 2002, respectively. This program was terminated effective March 20, 2002; consequently, no new loans were made after that date.
Platinum Underwriters Holdings, LTD. (“Platinum”)-See Note 19 in this report for a summary of related-party transactions with Platinum.
Reclassifications-We reclassified certain amounts in our 2002 and 2001 consolidated financial statements and notes to conform to the 2003 presentation. These reclassifications had no effect on net income, or common or preferred shareholders’ equity, as previously reported for those years.
Use of Estimates-We make estimates and assumptions that have an effect on the amounts that we report in our consolidated financial statements. Our most significant estimates are those relating to our
Insurance Losses and Loss Adjustment Expenses-Losses represent the amounts we paid or expect to pay to claimants for events that have occurred. The costs of investigating, resolving and processing these claims are known as loss adjustment expenses (“LAE”). We record these items on our statement of operations net of reinsurance, meaning that we reduce our gross losses and loss adjustment expenses incurred by the amounts we have recovered or expect to recover under reinsurance contracts.
Reinsurance-Written premiums, earned premiums and incurred insurance losses and LAE all reflect the net effects of assumed and ceded reinsurance transactions. Assumed reinsurance refers to our acceptance of certain insurance risks that other insurance companies have underwritten. Assumed reinsurance has, for the most part, been written through our St. Paul Re operation. During 2002, we transferred our ongoing business previously written through St. Paul Re to Platinum Underwriters Holdings, Ltd. See Note 19 for a more detailed discussion of this transfer. Ceded reinsurance means other insurance companies have agreed to share certain risks with us. Reinsurance accounting is followed for assumed and ceded transactions when risk transfer requirements have been met. These requirements involve significant assumptions being made related to the amount and timing of expected cash flows, as well as the interpretation of underlying contract terms.
Insurance Reserves -We establish reserves for the estimated total unpaid cost of losses and LAE, which cover events that occurred in 2003 and prior years. These reserves reflect our estimates of the total cost of claims that were reported to us (“case” reserves), but not yet paid, and the cost of claims incurred but not yet reported to us (“IBNR”). We reduce our loss reserves for estimated amounts of salvage and
Our liabilities for unpaid losses and LAE related to tabular workers’ compensation and certain assumed reinsurance coverage are discounted to the present value of estimated future payments. Prior to discounting, these liabilities totaled $875 million and $887 million at December 31, 2003 and 2002, respectively. The total discounted liability reflected on our balance sheet was $710 million and $718 million at December 31, 2003 and 2002, respectively. The liability for workers’ compensation was discounted using rates of up to 3.5%. The liability for certain assumed reinsurance coverage was discounted using rates up
to 7.5%, based on our return on invested assets or, in many cases, on yields contractually guaranteed to us on funds held by the ceding company, as permitted by the state of domicile. Tabular workers’ compensation reserves are indemnity reserves that are calculated using discounts determined with reference to actuarial tables that incorporate interest and contingencies such as mortality, remarriage, inflation or recovery from disability applied to a reasonably determinable payment stream. Reserves for medical costs associated with the work place injury and reserves for loss adjustment expenses are not discounted.
Policy Acquisition Expenses-The costs directly related to writing an insurance policy are referred to as policy acquisition expenses and consist of commissions, state premium taxes and other direct underwriting expenses. Although these expenses are incurred when we issue a policy, we defer and amortize them over the same period as the corresponding premiums are recorded as revenues. On a regular basis, we perform a recoverability analysis of the deferred policy acquisition costs in relation to the expected recognition of revenues, including anticipated investment income, and reflect adjustments, if any, as period costs. Should the analysis indicate that the acquisition costs are unrecoverable, further analyses are performed to determine if a reserve is required to provide for losses, which may exceed the related unearned premiums.
Allowance for Doubtful Accounts-Our allowance for doubtful accounts for premiums and deductibles receivable is calculated by applying an estimated bad debt percentage to an aging of receivables segmented by business unit to determine general collectibility. Specific collection issues are highlighted separately, and a comparison of prior year write-offs with year-to-date results is made to determine reasonableness. We also have an allowance for uncollectible reinsurance recoverables that is calculated based on the outstanding balances, taking into consideration the status of the reinsurer, the nature of the balance and whether or not the amount is in dispute. The establishment of our allowance for doubtful accounts involves judgment and therefore creates a degree of uncertainty as to adequacy at each reporting date.
In August 2002, Nuveen Investments purchased NWQ Investment Management Company, Inc. (“NWQ”), an asset management firm based in Los Angeles with approximately $6.9 billion of assets under management at the time of acquisition in both retail and institutional managed accounts. NWQ specializes in value-oriented equity investments with significant relationships among institutions and financial advisors serving high-net-worth investors.
In July 2001, Nuveen Investments acquired Symphony Asset Management, LLC (“Symphony”), an institutional investment manager, with approximately $4 billion in assets under management at the time of acquisition. As a result of the acquisition, Nuveen Investments’ product offerings were expanded to include managed accounts and funds designed to reduce risk through market-neutral and other strategies in several equity and fixed-income asset classes for institutional investors.
Nuveen Investments’ distribution revenues are earned as mutual fund productsare sold to the public through financial advisors, and prior to the second quarter of 2002, the sale of defined portfolios. Distribution revenues will rise and fall commensurate with the level of sales of these products. In March 2002, Nuveen Investments ceased offering defined portfolio products. Underwriting fees are earned on the initial public offering of Nuveen Investments’ exchange-traded funds.
We consolidate 100% of Nuveen Investments’ assets, liabilities, revenues and expenses, with reductions on the balance sheet and statement of operations for the minority shareholders’ proportionate interest in Nuveen Investments’ equity and earnings. Minority interest of $96 million and $80 million was recorded in other liabilities at the end of 2003 and 2002, respectively.
Fixed Income-Our fixed income portfolio is composed primarily of high-quality, intermediate-term taxable U.S. government, corporate and mortgage-backed bonds, and tax-exempt U.S. municipal bonds. Our entire fixed income investment portfolio is classified as available-for-sale. Accordingly, we carry that portfolio on our balance sheet at estimated fair value. Fair values are based on quoted market prices, where available, from a third-party pricing service. If quoted market prices are not available, fair values are estimated using values obtained from independent pricing services or a cash flow estimate is used.
Real Estate and Mortgage Loans-Our real estate investments include warehouses and office buildings and other commercial land and properties that we own directly or in which we have a partial interest through joint ventures with other investors. Our mortgage loan investments consist of fixed-rate loans collateralized by apartment, warehouse and office properties.
For direct real estate investments, we carry land at cost and buildings at cost less accumulated depreciation and valuation adjustments. We depreciate real estate assets on a straight-line basis over 40 years. Tenant improvements are amortized over the term of the corresponding lease. The accumulated depreciation of our real estate investments was $189 million and $169 million at December 31, 2003 and 2002, respectively.
We carry our mortgage loans at the unpaid principal balances less any valuation adjustments, which approximates fair value. Valuation allowances are recognized for loans with deterioration in collateral performance that is deemed other than temporary. The estimated fair value of mortgage loans was $63 million and $82 million at December 31, 2003 and 2002, respectively.
Securities on Loan-We participate in a securities lending program whereby certain securities from our fixed income portfolio are loaned to other institutions. We require collateral equal to 102 percent of the fair value of the loaned securities. We maintain full ownership rights to the securities loaned, and continue to earn interest on them. In addition, we have the ability to sell the securities while they are on loan. We have an indemnification agreement with the lending agents in the event a borrower becomes insolvent or fails to return securities. We record securities lending collateral as a liability and pay the
borrower an agreed upon interest rate. The proceeds from the collateral are invested in short-term investments and are reported on the balance sheet. We share a portion of the interest earned on these short-term investments with the lending agent. The fair value of the securities on loan is removed from fixed income securities on the balance sheet and shown as a separate investment asset.
statement of operations. Fair value for our derivatives is based on quoted market rates or models obtained from third party pricing services.
Lloyd’s solvency requirements call for certain of our funds to be held in trust in amounts sufficient to meet claims. These funds amounted to $30 million and $167 million at December 31, 2003 and 2002, respectively.
We evaluate our goodwill for impairment on an annual basis. If an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount, we will test for impairment between annual tests.
We carry office properties and equipment at depreciated cost. We depreciate these assets on a straight-line basis over the estimated useful lives of the assets. The accumulated depreciation for office properties and equipment was $517 million and $504 million at the end of 2003 and 2002, respectively.
At December 31, 2003 and 2002, respectively, we had $73 million and $69 million of unamortized internally developed computer softwarecosts. For the years ended December 31, 2003, 2002 and 2001, we recorded $18 million, $13 million and $7 million of amortization expense, respectively.
We assign functional currencies to our foreign operations, which are generally the currencies of the local operating environment. Foreign currency amounts are remeasured to the functional currency, and the resulting foreign exchange gains or losses are reflected in the statement of operations. Functional currency amounts are then translated into U.S. dollars. The unrealized gain or loss from this translation, net of tax, is recorded as a part of common shareholders’ equity. The change in unrealized foreign currency translation gain or loss during the year, net of tax, is a component of comprehensive income. Both the remeasurement and translation are calculated using current exchange rates for the balance sheets and average exchange rates for the statements of operations.
We follow the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), FASB Interpretation 44, “Accounting for Certain Transactions involving Stock Compensation (an interpretation of APB Opinion No. 25),” and other related interpretations in accounting for our stock option plans utilizing the “intrinsic value method” described in that literature. We also follow the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” for our option plans, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure; an amendment of FASB Statement No. 123”. These require pro forma net income and earnings per share information, which is calculated assuming we had accounted for our stock option plans under the “fair value method” described in those Statements.
Had we calculated compensation expense on a combined basis for our stock option grants based on the “fair value method” described in SFAS No. 123, our net income and earnings per share would have been reduced to the pro forma amounts as indicated.
* As reported net income or loss included $5 million, $8 million, and $5 million for 2003, 2002 and 2001, respectively, in stock-based compensation expenses, net of related tax benefits.
Interest and Income Taxes Paid-We paid interest on debt and distributions on redeemable preferred securities of trusts of $179 million in 2003, $167 million in 2002 and $133 million in 2001. We paid net federal income taxes of $62 million in 2003, and received refunds of $100 million in 2002 and $54 million in 2001.
Non-cash Investing and Financing Activities-In July 2002, we issued 8.9 million equity units, each having a stated amount of $50. Each equity unit included a forward purchase contract on our common stock. Related to these contracts, we established a $46 million liability, with a corresponding reduction to shareholders’ equity.
of these exposures is the responsibility of the same management team responsible for oversight of the other components of the Other segment.
In addition, in the fourth quarter of 2003, our Specialty Programs business center, previously reported in our Specialty Commercial segment, was moved to our Commercial Lines segment to more accurately reflect the manner in which this business is underwritten and managed. All data for 2002 and 2001 included in this report were restated to be consistent with the changes made to our segment reporting structure in 2003.
In accordance with provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” since Surety & Construction, International & Lloyd’s, Health Care, and Reinsurance were reported as separate segments during 2002 and are considered to be of continuing significance in analyzing the results of our operations, we continue to separately present and discuss (as appropriate) in this report information about those businesses for all years covered by this report.
Our operations in runoff do not qualify as “discontinued operations” for accounting purposes. For the year ended December 31, 2003, these runoff operations collectively accounted for $327 million, or 5%, of our net earned premiums, and generated underwriting losses totaling $762 million (an amount that does not include investment income from the assets maintained to support these operations). For the year ended December 31, 2002, these runoff operations collectively accounted for $1.98 billion, or 26%, of our net earned premiums, and generated underwriting losses totaling $874 million, an amount that included a $585 million pretax loss provision related to the Western MacArthur asbestos litigation settlement agreement. For the year ended December 31, 2001, these runoff operations collectively accounted for $2.97 billion, or 40%, of our net earned premiums, and generated underwriting losses totaling $1.87 billion, an amount that included a $735 million pretax loss provision to strengthen prior-year loss reserves in our Health Care operation and $662 million of pretax losses related to the September 11, 2001 terrorist attack.
The accounting policies of the segments are the same as those described in the summary of significant accounting policies in Note 1 of this report. We evaluate performance based on underwriting results for our property-liability insurance segments, investment income and realized gains for our investment operations, and on pretax operating results for the asset management segment. Property-liability underwriting assets are reviewed in total by management for purposes of decision-making. We do not allocate assets to these specific underwriting segments. Assets are specifically identified for our asset management segment.
The Other segment includes the results of the lines of business we placed in runoff in late 2001 and early 2002, including our former Health Care and Reinsurance segments, and the results of the following international operations: our runoff operations at Lloyd’s, including our participation in the insuring of the Lloyd’s Central Fund; Unionamerica, the London-based underwriting unit acquired as part of our purchase of MMI in 2000; and international operations we decided to exit at the end of 2001. This segment also includes the results of our participation in voluntary insurance pools, as well as loss development on business underwritten prior to 1980 (prior to 1988 for business acquired in our merger with USF&G Corporation in 1998). In addition to our participation in voluntary insurance pools, this prior year business includes the majority of our environmental and asbestos liability exposures. Our Health Care operation historically provided a wide range of medical liability insurance products and services throughout the entire health care delivery system. Our Reinsurance operations historically underwrote treaty and facultative reinsurance for a wide variety of property and liability exposures. As described in more detail in Note 19 to the consolidated financial statements herein, in November 2002 we transferred our ongoing reinsurance operations to Platinum Underwriters Holdings, Ltd.
In 2001, we sold our life insurance operations. Those operations are accounted for as discontinued operations and are not included in our segment data.
Note 18, “Restructuring and Other Charges,” describes charges we recorded during 2001 and where they are included in the foregoing tables.
In 2001, we eliminated the one-quarter reporting lag for our primary underwriting operations in foreign countries (not including our operations at Lloyd’s). As a result, our consolidated results for 2001 include their results for the fourth quarter of 2000 and all quarters of 2001. The incremental impact on our property-liability operations for the year ended December 31, 2001 of eliminating the reporting lag, which consists of the results of these operations for the three months ended December 31, 2001, was as follows.
Reclassification of Lloyd’s Commission Expenses-In 2003, we reclassified certain commission expenses related to our operations at Lloyd’s. In prior years, we determined commission expense based on premiums reported by the Lloyd’s market (net of commissions) using an estimated average commission rate. Until recently, gross premiums (prior to reduction for commissions) were not readily available from the Lloyd’s market. In 2003, we began recording actual commission expense for our Lloyd’s business. We reclassified prior period results to record actual commission expense on a basis consistent with that implemented in 2003. There was no impact to net income or shareholders’ equity as previously reported for any prior periods, because the reclassification had the impact of increasing previously reported premiums and commission expense in equal and offsetting amounts. For the year ended December 31, 2003, this reclassification had the impact of increasing both net earned premiums and policy acquisition costs by $81 million compared with what would have been recorded under our prior method of estimation. In addition, net written premiums increased by $116 million in 2003, (a portion of which was due to the elimination of the one-quarter reporting lag). For the year ended December 31, 2002, the impact was an increase to both net earned premiums and policy acquisition costs of $112 million and an increase to net written premiums of $91 million. For the year ended December 31, 2001, the impact was an increase to both net earned premiums and policy acquisition costs of $112 million and an increase to net written premiums of $132 million.
The assumed conversion of preferred stock and zero coupon notes were each anti-dilutive to our net loss per share for the year ended December 31, 2001, and therefore not included in the diluted earnings per share calculation.
Valuation of Investments-The following presents the cost, gross unrealized appreciation and depreciation, and estimated fair value of our investments in fixed income securities, equities, venture capital and securities on loan.
We continually monitor the difference between our cost and the estimated fair value of investments, which involves uncertainty as to whether declines in value are temporary in nature. If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in our common shareholders’ equity. If we believe the decline is “other than temporary,” we write down the carrying value of the investment and record a realized loss on our statement of operations. Our assessment of a decline in value includes our current judgment as to the financial position and future prospects of the entity that issued the investment security. If that judgment changes in the future, we may ultimately record a realized loss after having originally concluded that the decline in value was temporary.
At December 31, 2003 and 2002, the carrying value of our consolidated invested asset portfolio included $0.95 billion and $1.03 billion of net pretax unrealized appreciation, respectively. Included in those net amounts were gross pretax unrealized losses of $129 million and $208 million, respectively. The following tables summarize, for all securities in an unrealized loss position at December 31, 2003 and 2002, the aggregate fair value and gross unrealized loss by length of time those securities have been continuously in an unrealized loss position. The cost of these investments represented approximately 16% of our investment portfolio (at cost) at December 31, 2003. The majority of unrealized losses related to fixed income securities are issuer-specific rather than interest rate-related.
Statutory Deposits-At December 31,2003, our property-liability operation had fixed income investments with an estimated fair value of $1.13 billion on deposit with regulatory authorities as required by law.
other investments being used as collateral to secure our obligations under a series of insurance transactions.
Fixed Income by Maturity Date-The following table presents the breakdown of our fixed income securities by years to maturity. Actual maturities may differ from those stated as a result of calls and prepayments.
Net Investment Income-Following is a summary of our net investment income.
Included in gross realized losses for our fixed income portfolio in 2003, 2002 and 2001 were impairment write-downs totaling $17 million, $74 million and $77 million, respectively. Gross realized losses in our equity portfolio in 2003 and 2002 included impairment write-downs of $6 million and $26 million, respectively. No such write-downs occurred in 2001. In our venture capital portfolio, impairment write-downs totaled $143 million, $122 million and $88 million in 2003, 2002 and 2001, respectively. See Note 1 for additional information regarding our accounting policy for other-than-temporary investment impairments.
Effective January 1, 2001, we adopted the provisions of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended (“SFAS No. 133”). The statement requires the recognition of all derivatives as either assets or liabilities on the balance sheet, carried at fair value. In accordance with the statement, derivatives are specifically designated into one of three categories based on their intended use, and the applicable category dictates the accounting for each derivative. We have held the following derivatives, by category.
Fair Value Hedges-For the years ended December 31, 2003, 2002 and 2001, we have several pay-floating, receive-fixed interest rate swaps, with notional amounts totaling $730 million, $730 million and $230 million, respectively. They are designated as fair value hedges for a portion of our medium-term and senior notes, which we have entered into for the purpose of managing the effect of interest rate fluctuations on this debt. The terms of the swaps match those of the debt instruments, and the swaps are therefore considered 100% effective. The balance sheet impact for year ended December 31, 2003, was a decrease of $19 million in the fair value of the swaps and the related debt on the balance sheet, with the statement of operations impacts offsetting. The impact for the years ended December 31, 2002 and 2001 from movements in interest rates were increases of $42 million and $8 million, respectively, in the fair value of the swaps and the related debt on the balance sheet, with the statement of operations impacts offsetting.
In 2003, Nuveen Investments, in anticipation of the private placement debt issuance, entered into two treasury rate lock transactions with an aggregate notional amount of $100 million. These treasury rate locks were designated as cash-flow hedges. The treasury rate locks were settled for $1 million. We have deferred this loss in OCI as the treasury rate locks were considered highly effective in eliminating the interest rate risk on the forecasted debt issuance. Amounts accumulated in OCI will be reclassified into earnings commensurate with the recognition of the interest expense on the newly issued debt.
The accumulated changes in OCI as a result of cash flow hedges for 2003 (net of taxes) are summarized as follows.
The $955 million of “Loss reserves sold” shown in the table consist of $944 million of reserves related to our sale of Camperdown UK, Limited, and $11 million of reserves related to the sale of our insurance operations in Botswana. See Note 11 to the consolidated financial statements for further information regarding these transactions.
Health Care Exposures. At the end of 2001, we announced our intention to exit, on a global basis, all business underwritten in our Health Care operation through ceasing to write new business and the non-renewal of business upon policy expiration, in accordance with regulatory requirements. In 2001, loss activity in this operation continued to increase not only for the years 1995 through 1997, but also 1998, and early activity on claims incurred in 1999 through 2001 indicated an increase in severity for those years. Those factors led to a much different view of loss development in the Health Care operation, and resulted in a $735 million provision to increase prior-year loss reserves.
During the first three quarters of 2003 we tracked these three indicators. Newly reported claims were better than expected, reserve development on known claims was worse than expected and the redundancy ratio was better than expected. Not only was the redundancy ratio better than expected, it improved in each of the first three quarters continually offsetting any adverse reserve development on known claims. The combined impact of these three indicators offset one another, and reserve levels were deemed appropriate.
In the fourth quarter of 2003, the dollar amount of newly reported claims totaled $65 million, approximately 24% better than we anticipated in our original estimate of the required level of reserves at year-end 2002. The dollar amount of newly reported claims for the year ended December 31, 2003 was approximately 10% better than our original expectation. We consider the assumptions we made at the end of 2002 for newly reported claims to be appropriate and we have made no changes to those assumptions. Loss development on known claims during the fourth quarter of 2003 was only slightly worse than anticipated. However, through all of 2003, the cumulative development was considerably worse than expected. Through the third quarter, this adverse development on known claims was offset by continued improvement on the actual redundancy ratio experienced and no adjustment had been needed. However, our actual redundancy ratio, which had continually improved during the first nine months of 2003, took an adverse turn during November and December, causing the required reserve redundancy to increase above our level of tolerance. The view that the redundancy ratio would not only fail to continue to improve, but could likely decay over time, caused us to record a $350 million increase to reserve levels. The new required redundancy ratio after the $350 million of reserve strengthening recorded in the fourth quarter is in the range of 30% to 35% and allows for future inflationary effects.
Surety Exposures. Within our surety operations, we have exposures related to a small number of accounts which are in various stages of bankruptcy proceedings. In addition, certain other accounts have experienced deterioration in creditworthiness since we issued bonds to them. Given the current economic climate and its impact on these companies, we may experience an increase in claims and, possibly, incur high severity losses. Such losses would be recognized in the period in which the claims are filed and determined to be a valid loss under the provisions of the surety bond issued.
If the contractor were to fail to complete its bonded projects, we currently estimate that our aggregate additional loss, net of estimated collateral, reinsurance recoveries and participation by co-sureties (one of which has experienced ratings downgrades and is in runoff), would likely not exceed $75 million on an after-tax basis, assuming a 35% statutory tax rate. Given the uncertainties relating to the contractor’s business and other factors, there is no assurance that our estimate and our potential exposure will not increase.
associated with certain portions of the business sold are included in our total reserves, but the related incurred losses are excluded from continuing operations in our statements of operations for all periods presented, and included in discontinued operations. See Note 17 for a discussion of reserve guarantees we made related to this sale.
Environmental and Asbestos Reserves-Our underwriting operations continue to receive claims under policies written many years ago alleging injury or damage from environmental pollution or seeking payment for the cost to clean up polluted sites. We have also received asbestos injury claims tendered under general liability policies.
The following table summarizes the environmental and asbestos reserves reflected in our consolidated balance sheet at December 31, 2003 and 2002. Amounts in the “net” column represent gross amounts reduced by consolidated reinsurance recoverables. See Note 20 for a discussion of a significant asbestos litigation settlement agreement.
Our historical methodology (through first quarter 2002) for reviewing the adequacy of environmental and asbestos reserves utilized a survival ratio metric, which considers ending reserves in relation to calendar year paid losses. When the environmental reserve analyses were completed in the second quarter of 2002, we supplemented our survival ratio diagnostics with additional detailed analyses, and concluded that our environmental reserves were redundant by approximately $150 million. Based on our additional analyses, we released approximately $150 million of environmental reserves in the second quarter of 2002. Had we continued to rely solely on our analysis of survival ratio, we would have recorded no adjustment to our environmental reserves through the six months ended June 30, 2002.
In the second quarter of 2002, we also supplemented our survival ratio analysis of asbestos reserves with a detailed claims analysis. We determined that, excluding the impact of the Western MacArthur settlement, our asbestos reserves were adequate; however, including that impact, we determined that our asbestos reserves were inadequate. As a result, gross and net asbestos reserves were increased $150 million.
In the fourth quarter of 2003, we updated our detailed actuarial analysis for both asbestos and environmental reserves pertaining to our exposure from direct policyholders and relied more heavily on these analyses in determining the adequacy of our reserve provision for the remaining unreported losses. For non-workers’ compensation asbestos claims we supplemented this detailed analysis with an additional analysis to determine an estimate of reserves specifically for policyholders who have not as yet tendered their first asbestos claim. As a result of these studies we increased net asbestos reserves by $77 million and net environmental reserves by $14 million. In addition, reviews of assumed and non-domestic exposures caused us to increase net asbestos reserves by $13 million and reduce net environmental reserves by $1 million.
Income Tax Expense (Benefit)-Income tax expenses or benefits are recorded in various places in our consolidated financial statements. A summary of the amounts and places follows.
Our Tax Rate is Different from the Statutory Rate-Our total income tax expense (benefit) on income (loss) from continuing operations differs from the statutory rate of 35% of income from continuing operations before income taxes as shown in the following table.
Net Operating Loss (“NOL”) and Foreign Tax Credit (“FTC”) Carryforwards-For tax return purposes, as of December 31, 2003, we had NOL carryforwards that expire, if unused, in 2005-2022 and FTC carryforwards that expire, if unused, in 2005-2008. The amount and timing of realizing the benefits of NOL and FTC carryforwards depend on future taxable income and limitations imposed by tax laws. The approximate amounts of those NOLs on a regular tax basis and an alternative minimum tax (“AMT”) basis were $2.78 billion and $988 million, respectively. The approximate amounts of the FTCs both on a regular tax basis and an AMT basis were $27 million. The benefits of the NOL and FTC carryforwards have been recognized in our consolidated financial statements.
Undistributed Earnings of Subsidiaries-U.S. income taxes have not been provided on $75 million of our foreign operations’ undistributed earnings as of December 31, 2003, 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.
IRS Examinations-The Internal Revenue Service has examined our consolidated returns through 2000 and is currently examining the years 2001 through 2002. We believe that any additional taxes assessed as a result of these examinations would not materially affect our overall financial position, results of operations or liquidity.
The following summarizes our capital structure, including debt, preferred securities, and equity instruments.
As discussed in more detail in Note 12 to the consolidated financial statements, in the fourth quarter of 2003 we concluded that the provisions of FASB Interpretation No. 46 “Consolidation of Variable
· MMI Capital Trust I issued $125 million of preferred securities in 1997, the proceeds of which were used to purchase subordinated debentures issued by MMI Corporation. We assumed the liability for these debentures upon our acquisition of MMI in 2000. We make semi-annual interest payments at a rate of 7.625% on the debentures, which have a mandatory redemption date of December 15, 2027. The preferred securities in turn pay a preferred distribution of 7.625% semi-annually in arrears. In 2002, we repurchased and retired $4 million of the MMI trust preferred securities in an open market transaction.
Medium-Term Notes-The medium-term notes outstanding at December 31, 2003 bear interest rates ranging from 6.3% to 7.4%, with a weighted average rate of 6.8%. Maturities range from five to 15 years after the issuance dates. During 2003 and 2002, medium-term notes having a par value of $67 million and $49 million, respectively, matured, and payments at maturity were funded with internally generated funds.
Commercial Paper-We maintain an $800 million commercial paper program with $600 million of back-up liquidity, consisting entirely of bank credit agreements. Interest rates on commercial paper issued in 2003 ranged from 1.1% to 1.5%, in 2002 the range was 1.4% to 2.1%; and in 2001 the range was 1.1% to 6.7%.
7.875% Senior Notes-In April 2000, we issued $250 million of senior notes due April 15, 2005. Proceeds were used to repay commercial paper debt and for general corporate purposes.
Zero Coupon Convertible Notes-The zero coupon convertible notes mature in 2009, but were redeemable beginning in 1999 for an amount equal to the original issue price plus accreted original issue discount. In addition, on March 3, 1999 and March 3, 2004, the holders of the zero coupon convertible notes had/have the right to require us to purchase their notes for the price of $640.82 and $800.51, respectively, per $1,000 of principal amount due at maturity.
Interest Rate Swap Agreements-At December 31, 2003 and 2002, we were party to a number of interest rate swap agreements with a total notional amount of $730 million related to several of our outstanding debt issues. The net effect of the swaps was to reduce our interest expense in 2003 and 2002 by $32 million and $21 million, respectively. The aggregate fair values of these swap agreements at December 31, 2003 and 2002 were assets of $46 million and $65 million, respectively. The fair value of
these swap agreements is recorded on our balance sheet as an increase to other assets and a corresponding increase to debt, with the statement of operations impacts offsetting.
Interest Expense-Our net interest expense on debt was $187 million in 2003, $112 million in 2002 and $110 million in 2001. The 2003 total included interest expense on the debt related to the five preferred security trusts no longer included in our consolidated financial statements.
Maturities-The amount of debt obligations, other than commercial paper, that become due in each of the next five years is as follows: 2004, $55 million; 2005, $429 million; 2006, $59 million; 2007, $1,015 million; and 2008, $450 million.
Debt Covenant Compliance-We were in compliance with all provisions of our debt covenants as of December 31, 2003 and 2002.
Fair Value of Debt Obligations-The fair value of our commercial paper approximated its book value because of its short-term nature. The fair value of our variable rate borrowings approximated their book values due to the floating interest rates of these instruments. For our other debt, which has longer terms and fixed interest rates, our fair value estimate was based on current interest rates available on debt securities in the market that have terms similar to ours.
The preferred shareholders’ equity on our balance sheet represents the par value of preferred shares outstanding that we issued to our Stock Ownership Plan (“SOP”) Trust, less the remaining principal balance on the SOP Trust debt. The SOP Trust borrowed funds from a U.S. underwriting subsidiary to finance the purchase of the preferred shares, and we guaranteed the SOP debt.
Common Stock and Reacquired Shares-We are 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 unissued shares. The number of authorized shares of the company is 480 million.
We reacquired approximately 13 million of our common shares in 2001 for a total cost of $589 million. We reduced our capital stock account and retained earnings for the cost of these repurchases. Share repurchases in 2003 and 2002 were minimal, primarily related to stock incentive plans.
A summary of our common stock activity for the last three years is as follows.
Undesignated Shares-Our articles of incorporation allow us 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 formation of our Stock Ownership Plan.
In May 2003, we purchased the right to seek renewal of several lines of insurance business previously underwritten by Kemper Insurance Companies. The initial payment for this right was recorded as an intangible asset (characterized as renewal rights) and is being amortized on an accelerated basis over four years. The portfolio of business involved in this transaction included the following lines: technology, small commercial, middle market commercial, inland and ocean marine, and architects’ and engineers’ professional liability. We did not assume any past liabilities with this purchase; however, we will be obligated to make an additional payment in June 2004 based on the amount of premium volume we ultimately renew during the twelve month period subsequent to this purchase. We believe it is unlikely that any additional payment would exceed $30 million. At December 31, 2003, we had accrued $10 million toward this additional obligation, recorded in “Other liabilities.” Our consolidated gross written premiums for the year ended December 31, 2003 included approximately $280 million attributable to business underwritten as a result of this purchase of renewal rights, the majority of which were included in our Commercial Lines segment.
Professional and Financial Risk Practice (“ProFin”) Business-In December 2002, we purchased the right to seek renewal of the financial and professional services business previously underwritten by Royal & SunAlliance (“RSA”), without assuming past liabilities. This business represents approximately $125 million in expiring premium. The nominal cost of the acquisition was recorded as an intangible asset (characterized as renewal rights) and will be amortized on an accelerated basis over four years.
St. Paul Guarantee-In March 2002, we completed our acquisition of London Guarantee Insurance Company (now operating under the name “St. Paul Guarantee”), a Canadian specialty property-liability insurance company focused on providing surety products and management liability, bond, and professional indemnity products. The total cost of the acquisition was approximately $80 million. The preliminary allocation of this purchase price resulted in $20 million of goodwill and $37 million of other intangible assets. We recorded $13 million of the goodwill and $26 million of the intangible assets (characterized as present value of future profits) in our Surety & Construction segment, with the remaining $7 million of goodwill and $11 million of the intangible assets in our International and Lloyd’s segment. The intangible asset is being amortized on an accelerated basis over eight years. The acquisition was funded through internally generated funds.
Penco-In January 2001, we acquired the right to seek to renew a book of municipality insurance business from Penco, a program administrator for Willis North America Inc., for total consideration of $3.5 million, without assuming past liabilities. We recorded that amount as an intangible asset and are amortizing it on an accelerated basis over five years.
NWQ Investment Management Company, Inc.-In August 2002, Nuveen Investments purchased NWQ Investment Management Company, Inc. (“NWQ”), a Los Angeles-based equity management firm, with approximately $6.9 billion in assets under management at the time of acquisition. The cost of the acquisition consisted of $120 million paid at closing and up to an additional $20 million payable over five years. As of December 31, 2003, Nuveen Investments had $133 million recorded for goodwill and $19 million for the intangible asset, net of accumulated amortization, related to NWQ. The intangible asset relates to customer relationships and is being amortized over nine years.
Symphony Asset Management-In July 2001, Nuveen Investments purchased Symphony Asset Management, LLC (“Symphony”), an institutional investment manager based in San Francisco, with approximately $4 billion in assets under management at the time of acquisition. The 2001 preliminary allocation of the $208 million purchase price resulted in $151 million recorded as goodwill and $53 million recorded as other intangible assets. In 2002, Nuveen Investments made a purchase accounting adjustment due to a revision in the valuation of Symphony, which resulted in a $9 million decrease in the intangible recorded and a corresponding increase in the goodwill recorded. As of December 31, 2003, Nuveen Investments had $158 million recorded for goodwill and $39 million for net intangibles related to Symphony. The majority of the intangible assets related to customer relationships that are being amortized over approximately 20 years.
In October 2003, we sold our subsidiary, Octagon Risk Services, Inc., a claim management and consulting services company, for proceeds of approximately $30 million. We recorded a pretax gain of $5 million on the sale.
In 2002, we sold our insurance operations in Spain, Argentina and, in Mexico, all of our operations except our surety business. Proceeds from these sales totaled $29 million and we recorded a pretax gain of $4 million related to the sales.
· Municipal Trusts-We own interests in various municipal trusts that were formed for the purpose of allowing us to more flexibly generate investment income in a manner consistent with our investment objectives and tax position. As of September 30, 2003, there were 36 such trusts, which held a combined total of $450 million in municipal securities, of which eight had not been included in our consolidated financial statements prior to our adoption of FIN 46(R) because we did not hold majority ownership in them. However, we do have the majority exposure to variability for these trusts. Therefore, we consolidated these eight trusts in 2003. The combined carrying value of these trusts at December 31, 2003 was $366 million.
· Venture Capital Entities-In our venture capital investment portfolio, we have numerous investments in small- to medium-sized companies, in which we have variable interests through stock ownership and, in some cases, loans. All of these investments are held for the purpose of generating investment returns, and the companies in which we invest span a variety of business sectors, including technology, telecommunications and healthcare. As a result of our review of this portfolio, we identified three entities that we are now consolidating under the provisions of FIN 46(R). The combined carrying value of these entities at December 31, 2003 was $(5) million.
· Mandatorily redeemable preferred securities of trusts holding solely subordinated debentures of the company (“Preferred Securities”)-These securities had a carrying value of $897 million, and prior to September 30, 2003 were classified as a separate line on our balance sheet between liabilities and shareholders’ equity. These securities were issued by five separate trusts that were established for the sole purpose of issuing the securities to investors, and the securities were fully guaranteed by us. At September 30, 2003, we reclassified these securities to “Debt” in the liability section of our Consolidated Balance Sheet, as newly required under SFAS 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”, which generally required that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). In the fourth quarter of 2003, we determined that the provisions of FIN 46(R) applied to the trusts that issued these securities, and as a result we deconsolidated the trusts for financial reporting purposes. The debt we issued to these trusts, previously eliminated in the consolidation of our financial results, is now included in the “Debt” section of liabilities on our consolidated balance sheet. The net impact of de-consolidating these trusts was to increase our reported debt liabilities outstanding by $928 million and eliminate the $897 million of Preferred Securities issued by the trusts from our consolidated balance sheet. The difference between the two amounts was comprised of the $31 million combined equity interests we held in the deconsolidated trusts.
The consolidation/deconsolidation of the foregoing entities had the net impact of increasing (decreasing) the balance sheet and statement of operations’ captions by the amounts indicated in the following table.
In addition to the foregoing entities that were consolidated pursuant to FIN 46(R), we also hold significant interests in other variable interest entities for which we are not considered to be the primary beneficiary, as follows.
Defined Benefit Pension Plans-We maintain funded defined benefit pension plans for most of our employees. These plans provide benefits under three retirement benefit formulas: a traditional pension formula, a cash balance pension formula and a cash balance retiree health formula. For those employees who are in the traditional pension formula, benefits are based on years of service and the employee’s compensation while employed by the company. Pension benefits generally vest after five years of service.
The traditional pension plan and cash balance pension formulas were amended effective January 1, 2003, which reduced the projected benefit obligation by $84 million at December 31, 2002. In addition, the postretirement medical plan was amended effective January 1, 2003. As a result, postretirement life insurance coverage was eliminated for active employees, and employees who were not within five years of retirement eligibility were switched to the cash balance retiree health formula from the traditional postretirement healthcare benefit plan. These actions reduced the accumulated postretirement benefit obligation by $22 million.
Our pension plans are noncontributory. This means that employees do not pay anything into the plans. Our funding policy is to contribute amounts at least sufficient to meet the minimum funding requirements of the Employee Retirement Income Security Act that can be deducted for federal income tax purposes. This may result in no contribution being made in a particular year.
For those employees covered under the cash balance retiree health formula, we maintain a cash balance retiree health account (“health account”) to measure the amount of benefits payable to an employee. For each plan year an employee is an active participant, the health account is increased for pay credits and interest credits. Pay credits are calculated based on pensionable earnings up to the Social Security taxable wage base for the plan year and added to the health account on the first day of the next plan year. Interest credits are added at the end of each calendar quarter.
The accumulated benefit obligation for all defined benefit pension plans was $1.08 billion and $994 million at December 31, 2003 and 2002, respectively.
Weighted-average assumptions used to determine net periodic benefit cost for years ended December 31 are as follows:
A health care inflation rate of 8.00% in 2003 was assumed to remain the same in 2004, decrease one percent annually to 5% in 2007 and then remain at that level. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
Our unqualified pension plan had a pretax accumulated benefit obligation in excess of the recorded accrued pension cost totaling $6 million at December 31, 2003. As a result, we accrued an additional minimum liability of $4 million (after-tax) in the fourth quarter, with an offsetting reduction to other comprehensive income in common shareholders’ equity.
On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) was signed into law. This act introduces prescription drug coverage under Medicare for Medicare-eligible retirees beginning in 2006 as well as a federal subsidy to certain sponsors of retiree health care plans. We anticipate that the benefits we pay after 2006 will be lower as a result of the new Medicare provisions. However, the retiree medical obligations reported at December 31, 2003 do not reflect the impact of this legislation. Deferring the recognition of the new Medicare provisions’ impact is permitted by Financial Accounting Standards Board Staff Position 106-1 as a result of open questions about some of the new Medicare provisions and a lack of authoritative accounting guidance about certain matters. We chose to defer the implementation of the Act pending the issuance of final accounting guidance from the Financial Accounting Standards Board. The final accounting guidance could require changes to previously reported information. We will monitor the FASB deliberations and account for the Act based on the pronouncement expected to be issued.
To finance the preferred stock purchase for future allocation to qualified employees, the SOP (formerly the PSOP) borrowed $150 million at 9.4% from our primary U.S. underwriting subsidiary. As the principal and interest of the trust’s loan is paid, a pro rata amount of our preferred stock is released for allocation to participating employees. Each share of preferred stock pays a dividend of $11.72 annually and is currently convertible into eight shares of our common stock. Preferred stock dividends on all shares held by the trust are used to pay a portion of this SOP obligation. In addition to dividends paid to the trust, we make additional cash contributions to the SOP as necessary in order to meet the SOP’s debt obligation.
We follow the provisions of Statement of Position 76-3, “Accounting Practices for Certain Employee Stock Ownership Plans,” and related interpretations in accounting for this plan. We recorded expense of $13.8 million, $7.4 million and $0.5 million for the years 2003, 2002 and 2001, respectively.
The SOP allocated 95,246 preferred shares in 2003, 82,383 preferred shares in 2002, and 55,578 preferred shares in 2001. Unallocated preferred shares had a fair market value of $24 million and $47 million at December 31, 2003 and 2002, respectively. The remaining unallocated preferred shares at December 31, 2003 will be released for allocation annually through January 31, 2005.
We have made fixed stock option grants to certain U.S. and non-U.S.-based employees, as well as outside directors. These grants were considered “fixed” because the measurement date for determining compensation costs was fixed on the date of grant. In the past we have also made variable stock option grants to certain company executives. These were considered “variable” grants because the measurement date was contingent upon future increases in the market price of our common stock. No variable stock options are currently outstanding.
Since the exercise price of our fixed grants equals the market price of our stock on the day they are granted, there generally is no related compensation expense for financial reporting purposes. However, during 2002 and 2001, certain executives’ outstanding options became subject to accelerated vesting and an extended life, under the terms of the Senior Executive Severance Policy or employment agreements, and we recorded compensation cost of $4 million and $16 million, respectively. We have also recorded compensation expense (benefit) associated with our variable options and restricted stock awards of $7 million, $9 million and $(8) million in 2003, 2002 and 2001, respectively.
U.S.-Based Plans-Our fixed option grants for certain U.S.-based employees and outside directors give these individuals the right, once those grants are vested, to buy our stock at the market price on the day the options were granted. Fixed stock options granted under the stock incentive plan adopted by our shareholders in May 1994 (as subsequently amended and restated) become exercisable no less than one year after the date of grant and may be exercised up to ten years after grant date. Options granted under our option plan in effect prior to May 1994 may be exercised at any time up to 10 years after the grant date. At the end of 2003, approximately 8.9 million shares remained available for grant under our stock incentive plan.
Global Stock Option Plan (“GSOP”)-In the past, we had a separate fixed stock option plan for employees who were not eligible to participate in the U.S. and non-U.S. plans previously described. Options granted to eligible employees under the GSOP were contingent upon the company achieving threshold levels of profitability, and the level of profitability achieved determined the number of options granted. Generally, options granted under this plan can be exercised from three to 10 years after the grant date. Although options were granted under this plan in 2001 and 2000, the company no longer expects to issue grants under this plan.
The following table summarizes the activity for our fixed option plans for the last three years. All grants were made at the market price on the date of grant.
For our fixed option plans the following table summarizes the options exercisable at the end of the last three years and the weighted average fair value of options granted during those years:
Up to 20% of the 33.4 million shares authorized under our 1994 Stock Incentive Plan may be granted as restricted stock awards. The stock for this type of award is restricted because recipients receive the stock only upon completing a specified objective or period of employment, generally one to five years. The shares are considered issued when awarded, but the recipient does not own and cannot sell the shares during the restriction period. During the restriction period, the recipient receives compensation in an amount equivalent to the dividends paid on such shares. Up to 5.3 million shares were available for restricted stock awards at December 31, 2003.
In 2002 we implemented the Capital Accumulation Plan. Under this plan eligible employees may receive up to 25% of their annual bonus in the form of restricted stock of the company. The company provides a matching contribution of restricted stock at a 10 percent discount from the market price on the date of grant. The restricted stock is generally subject to a two-year vesting period. Participation in this program is voluntary unless an employee’s annualized base pay is greater than $100,000, is not retirement-eligible and will not become retirement-eligible within two years of the date the bonus was paid. The “performance year” to be measured is the current year, with expense being recognized over the subsequent two years. For the 2003 performance year grants, $10.2 million of expense will be recognized over the two-year vesting period, beginning in 2004. For the 2002 performance year grants, $4.4 million of expense will be recognized in 2004.
We also have a Deferred Stock Award Plan for stock awards to non-U.S. employees. Deferred stock awards are the same as restricted stock awards, except that shares granted under the deferred plan are not issued until the vesting conditions specified in the award are fulfilled. Up to 3,000 shares were available for deferred stock awards at December 31, 2003.
Please refer to Note 1 for the Pro Forma information on stock option grants based on the “fair value” method as described in SFAS No. 123.
venture capital investment subsidiaries. Additional amounts have been committed to fund new and existing investments in partnerships and certain other venture capital entities. Our future obligations as of December 31, 2003 are estimated as follows.
Letters of Credit-In the normal course of business, we enter into letters of credit as collateral, as required in certain of our operations. As of December 31, 2003, we had entered into letters of credit with an aggregate face value of $944 million.
Acquisition of Symphony-As of December 31, 2003, our asset management subsidiary, Nuveen Investments, Inc., may be required to make additional payments of up to $121 million related to their acquisition of Symphony, based on Symphony reaching specified performance and growth targets. Any future payments will be recorded as additional goodwill.
Sale of Minet-In May 1997, we completed the sale of our insurance brokerage operation, Minet, to Aon Corporation. We agreed to indemnify Aon against any future claims for professional liability and
other specified events that occurred or existed prior to the sale. We monitor our exposure under these claims on a regular basis. We believe reserves for reported claims are adequate, but we do not have information on unreported claims to estimate a range of additional liability. We purchased insurance to cover a portion of our exposure to such claims. Under the sale agreement, we also committed to pay Aon commissions representing a minimum level of annual reinsurance brokerage business through 2012. The maximum annual amount payable to Aon related to that commitment is $20 million. We also have commitments under lease agreements through 2015 for vacated space (included in our lease commitment totals above), as well as a commitment to make payments to a former Minet executive.
Sale of Camperdown UK-In December 2003, we sold our London subsidiary, Camperdown UK. As part of that sale, we have agreed 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 $203 million, and is included in the total “sales of business entities” reported below. We recorded a fair value of $24 million in “Other liabilities” for this indemnification. All other guarantees related to this sale are also included in the total “sales of business entities” reported below. At Lloyd’s, we underwrite business through a single syndicate (“Syndicate 5000”) for which we provide 100% of the capital. In 2003, Fire and Marine entered into a 100% quota share reinsurance agreement directly with Syndicate 5000 that in effect transferred Syndicate 5000’s underwriting results for the 2003 year of account to Fire and Marine.
Structured Settlements-Certain settlements of claims under workers’ compensation and other liability policies involve periodic payments to a claimant for a number of years, usually funded through the purchase of an annuity from a third party. As our primary obligation to pay has been transferred to a third party, our historical practice has been to treat all structured settlements as extinguishing our liability to the policyholder, although in some cases we remain contingently liable in the event of any defaults by the companies issuing the annuities. As of December 31, 2003, the outstanding balance of structured settlements for which we remain contingently liable was approximately $1.59 billion.
Legal Matters-In the ordinary course of conducting business, we (and certain of our subsidiaries) have been named as defendants in various lawsuits. Some of these lawsuits attempt to establish liability under insurance contracts issued by our underwriting operations, including liability under environmental protection laws and for injury caused by exposure to asbestos products. Plaintiffs in these lawsuits are seeking money damages that in some cases are substantial or extra contractual in nature or are seeking to have the court direct the activities of our operations in certain ways.
· Asbestos Settlement Agreement-On June 3, 2002, we announced that we and certain of our subsidiaries had entered into an agreement settling all existing and future claims arising from any insuring relationship of United States Fidelity and Guaranty Company, St. Paul Fire and Marine Insurance Company and their affiliates and subsidiaries, including us, with any of MacArthur Company, Western MacArthur Company, and Western Asbestos Company. In January 2004, the U.S. Bankruptcy Court for the Northern District of California issued an order approving the settlement agreement with the MacArthur Companies, and confirming the MacArthur Companies’ proposed plan of reorganization. See discussion in Note 20.
· Petrobras Oil Rig Construction-In September 2002, the United States District Court for the Southern District of New York entered a judgment in the amount of approximately $370 million to Petrobras, an energy company that is majority-owned by the government of Brazil, in a claim related to the construction of two oil rigs. One of our subsidiaries provided a portion of the surety coverage for that construction. As a result, we recorded a pretax loss of $34 million ($22 million after-tax) in 2002 in our Surety & Construction business segment. The loss recorded was net of reinsurance and previously established case reserves for this exposure, and prior to any possible recoveries related to indemnity. We continue to actively pursue an appeal of this judgment.
· Purported Class Action Shareholder Lawsuits-In the fourth quarter of 2002, several purported class action lawsuits were filed against our chief executive officer, our chief financial officer, and us. In the first quarter of 2003, the lawsuits were consolidated into a single action, which makes various allegations relating to the adequacy of our previous public disclosures and reserves relating to the Western MacArthur asbestos litigation, and seeks unspecified damages and other relief. In the fourth quarter of 2003, we agreed in principle to a settlement, which is subject to certain customary conditions and subject to court approval. If the settlement is consummated, it will result in our payment of an amount that is not material to our results of operations.
· World Trade Center Litigation-In 2002, we and certain other insurers obtained a summary judgment ruling that the World Trade Center (“WTC”) property loss on September 11, 2001 was a single occurrence. Certain insureds, including the WTC’s leaseholder, appealed that ruling, asking the court to determine that the property loss constituted two separate occurrences rather than one. In September 2003, the U.S. Circuit Court of Appeals for the Second Circuit ruled that under terms of the policy form we used to underwrite property coverage for the WTC, the terrorist attack constituted one occurrence.
Agency Loans-We have provided guarantees for certain agency loans in order to enhance the business operations and opportunities of several of the insurance agencies with which we do business. As of December 31, 2003, these loans had an aggregate outstanding balance of approximately $6 million. We have guaranteed the lending institutions that we will pay up to the entire principal amount outstanding in case of any agency defaults, plus any reasonable costs associated with the default. There are varying terms on the loans, and the guarantees are in place until the loans are paid in full.
Venture Capital-Our subsidiary, St. Paul Venture Capital VI, LLC has guaranteed third party loans in the aggregate amount of approximately $1 million. In the event that the borrower would default, St. Paul Venture Capital has guaranteed payment up to the aforementioned limits, plus any costs, fees, and expenses that the lending institution might incur in the administration of the default on the loans. These guarantees are in place until the loans are paid in full.
Platinum Transaction-In connection with the Platinum transaction, (see Note 19) we entered into a series of servicing agreements with Platinum relating to the transfer of our 2002 reinsurance business. Such agreements provide general indemnification obligations on each of the parties with respect to representations, warranties and covenants made under the terms of each of the agreements. Generally, the indemnification obligations of each party are capped at the aggregate of all fees received by each party. These indemnifications survive until the applicable statutes of limitation expire. In addition, we agreed to provide indemnification to Platinum and its subsidiaries, directors and employees for losses incurred due to inaccurate or omitted information in certain sections of the Platinum Registration Statements and Prospectuses used in connection with Platinum’s initial public offering of securities, or the Private Placement Memorandum used in connection with Platinum’s private offering of securities to Renaissance Reinsurance. We also agreed to make certain payments to the underwriters of the Platinum public offerings if Platinum fails to satisfy certain indemnification obligations to them in specified circumstances. Our obligations pursuant to these indemnities have an aggregate limit of $400 million, which amount will be reduced by any payments we make to investors in the public or private offerings. The obligation to indemnify Platinum and its subsidiaries, directors and employees expires on November 1, 2004.
Other-We have guaranteed to indemnify the holders of the mandatorily redeemable trust preferred securities in the event those trusts default. The entire amount of that obligation is included in our consolidated debt obligations.
At the time of the sale of F&G Life in 2001, we recorded a net after-tax loss of $74 million on the sale proceeds. That loss was combined with F&G Life’s results of operations prior to sale for an after-tax loss of $55 million and was included in the reported loss from discontinued operations for the year ended December 31, 2001.
Standard Personal Insurance-In 1999, we sold our standard personal insurance operations to Metropolitan Property and Casualty Insurance Company (“Metropolitan”). Metropolitan purchased Economy Fire & Casualty Company and subsidiaries (“Economy”), and the rights and interests in those non-Economy policies constituting the remainder of our standard personal insurance operations. Those rights and interests were transferred to Metropolitan by way of a reinsurance and facility agreement. We guaranteed the adequacy of Economy’s loss and loss expense reserves, and we remain liable for claims on non-Economy policies that result from losses occurring prior to the September 30, 1999 closing date. Under the reserve-related agreements, we agreed to pay for any deficiencies in those reserves and would share in any redundancies that developed by September 30, 2002. Any losses incurred by us under these agreements were reflected in discontinued operations in the period during which they were incurred. At
December 31, 2002, our analysis indicated that we owed Metropolitan $13 million related to the reserve agreements, which was paid in April 2003. We have no other contingent liabilities related to this sale.
Nonstandard Auto Insurance-Prudential purchased our nonstandard auto insurance business marketed under the Victoria Financial and Titan Auto brands for $175 million in cash (net of a $25 million dividend paid by these operations to our property-liability insurance operations prior to closing). We recorded an estimated after-tax loss of $83 million on the sale in 1999, representing the estimated excess of carrying value of these entities at closing date over proceeds to be received from the sale, plus estimated income through the disposal date. This excess primarily consisted of goodwill. We recorded an after-tax loss on disposal of $9 million in 2000, primarily representing additional losses incurred through the disposal date in May, and an additional after-tax loss on disposal of $5 million in 2001, primarily representing tax adjustments made to the sale transaction.
$4 million of equipment charges and $3 million of legal costs. The $62 million pretax charge was included in “Operating and administrative expenses” in our 2001 statement of operations; with $42 million included in “Property-liability insurance-other” and $20 million included in “Parent company, other operations and consolidating eliminations” in the table titled “Income (Loss) from Continuing Operations Before Income Taxes and Cumulative Effect of Accounting Change” in Note 3 to the consolidated financial statements.
The following presents a rollforward of activity related to this accrual.
In August 1999, we announced a cost reduction program designed to enhance our efficiency and effectiveness in a highly competitive environment. In the third quarter of 1999, we recorded a pretax charge of $60 million related to this program, including $25 million in employee-related charges related to the termination of approximately 590 employees, $33 million in occupancy-related charges and $2 million in equipment charges.
Late in the fourth quarter of 1998, we recorded a pretax restructuring charge of $34 million. The majority of the charge, $26 million, related to the termination of approximately 500 employees, primarily in our commercial insurance operations. The remaining charge of $8 million related to costs to be incurred to exit lease obligations.
We expect to be obligated under certain lease commitments for approximately six years. The following presents a rollforward of activity related to these commitments.
19 Transfer of Ongoing Reinsurance Operations to Platinum Underwriters Holdings, Ltd.
On November 1, 2002, we completed the transfer of our continuing reinsurance business (previously operating under the name “St. Paul Re”) and certain related assets, including renewal rights, to Platinum Underwriters Holdings, Ltd. (“Platinum”), a Bermuda company formed in 2002 that underwrites property and casualty reinsurance on a worldwide basis.
In conjunction with the transfer of our continuing reinsurance business to Platinum, we entered into various agreements with Platinum and its subsidiaries, including quota share reinsurance agreements by which Platinum reinsured substantially all of the reinsurance contracts entered into by St. Paul Re on or after January 1, 2002. This transfer (based on September 30, 2002 balances) included $125 million of unearned premium reserves (net of ceding commissions), $200 million of existing loss and loss adjustment expense reserves and $24 million of other reinsurance-related liabilities. The transfer of unearned premium reserves to Platinum was accounted for as prospective reinsurance, while the transfer of existing loss and loss adjustment expense reserves was accounted for as retroactive reinsurance.
The transaction resulted in a pretax gain of $29 million and an after-tax loss of $54 million in the year ended December 31, 2002. The after-tax loss was driven by the write-off of approximately $73 million in
deferred tax assets associated with previously incurred losses related to St. Paul Re’s United Kingdom-based operations, as well as approximately $10 million in taxes associated with the pretax gain.
Our investment in Platinum is included in “Other Investments.” The income from our 14% proportionate equity ownership in Platinum is included in our statement of operations as a component of “Net investment income” from the date of closing. Our warrants to purchase additional Platinum shares are carried at their market value ($65 million and $61 million at December 31, 2003 and 2002, respectively), with changes in their fair value recorded as other realized gains or losses in our statement of operations. In 2003 and 2002, we recorded net pretax realized gains of $4 million and $7 million, respectively, related to this option.
These developments at trial, coupled with general changes in the legal environment affecting the potential liability of insurers for asbestos claims, caused us to engage in more intense settlement discussions at the end of April, in May, and early June of 2002.
Subsequent to May 15, 2002, there were additional adverse developments at the trial. USF&G’s motions for nonsuit and for reconsideration of prior evidentiary rulings were denied. In light of continued adverse trial developments, the fact that jury deliberations on the first phase of the trial were expected to commence as soon as the second week of June, and in an effort to put its largest known asbestos exposure behind us, we began negotiating a single lump-sum payment settlement with the plaintiffs. Negotiations were intense and ultimately the Company achieved a comprehensive agreement on June 3, 2002, before the completion of the first phase of the jury trial. Importantly, this agreement (which was subject to bankruptcy court approval) not only settled pending claims, it also settled, with possible minor exceptions, all claims that Western MacArthur and its affiliates could possibly have against us and USF&G, including but not limited to the claims made in the pending lawsuit, for a pre-tax liability then estimated at $988 million as described below. The settlement agreement was filed as an exhibit to our Report on Form 8-K dated July 23, 2002. That document includes more detailed information about the settlement agreement.
The plan of reorganization includes an injunction in favor of The St. Paul against any direct or indirect liability for asbestos-related claims against the MacArthur Companies. Under the injunction, all current and future asbestos-related claims of the MacArthur Companies will be channeled to, and paid solely from, the trust established by the plan. The MacArthur Companies will release the USF&G Parties from any and all asbestos-related claims for personal injury, and all other claims in excess of $1 million in the aggregate, that may be asserted relating to or arising from, directly or indirectly, any alleged coverage provided by any of the USF&G Parties to any of the MacArthur Companies, including any claim for extra contractual relief.
The St. Paul has completed its funding obligations under the 2002 settlement agreement, consisting of payments of $235 million during the second quarter of 2002, and $747 million on January 16, 2003 (including interest). Following final confirmation of the Bankruptcy Court ruling, the escrowed funds will
be released to the trust established by the plan for the payment of the MacArthur Companies’ asbestos related claims. The settlement agreement also provided for the USF&G Parties to pay $13 million (which was paid in the second quarter of 2002) and to advance certain fees and expenses incurred in connection with the settlement, bankruptcy proceedings, finalization of the Plan and efforts to achieve approval of the Plan, subject to a right of reimbursement in certain circumstances of amounts advanced. Up to $175 million of the initial $235 million payment will be paid to counsel for the MacArthur Companies, and persons holding judgments against the MacArthur Companies as of June 3, 2002 and their counsel, and the USF&G Parties will be released from claims by such holders to the extent of $110 million paid to such holders. At least $60 million from the initial payment and the $747 million paid in 2003 would be returned to us if final confirmation of the bankruptcy court ruling does not occur. At December 31, 2003, those payments of $807 million were recorded in both “Other Assets” and “Other Liabilities.”
As of December 31, 2001, our estimated gross pretax losses and loss adjustment expenses incurred as a result of the terrorist attack that occurred on September 11, 2001 totaled $2.3 billion, with an estimated net pretax operating loss of $941 million. These estimated losses were based on a variety of actuarial techniques, coverage interpretation and claims estimation methodologies, and included an estimate of losses incurred but not reported, as well as estimated costs related to the settlement of claims. Our estimate of losses was originally based on our belief that property-liability insurance losses from the terrorist attack will total between $30 billion and $35 billion for the insurance industry. In 2002, our estimate of ultimate losses was supplemented by our ongoing analysis of both paid and reported claims related to the attack. Our estimate of losses remains subject to significant uncertainties and may change over time as additional information becomes available.
We regularly evaluate the adequacy of our estimated net losses related to the terrorist attack, weighing all factors that may impact the total net losses we will ultimately incur. Based on the results of those regular evaluations, we reallocated certain estimated losses among our property-liability segments in 2003 and 2002. In addition, in 2003, we recorded a $46 million reduction in estimated losses related to the attack. In 2002, we recorded an additional loss provision of $20 million and a $33 million reduction in our estimated provision for uncollectible reinsurance related to the attack.
In 2002, we and other insurers obtained a summary judgment ruling that the World Trade Center property loss was a single occurrence. Certain insureds, including the World Trade Center’s leaseholder, appealed that ruling, asking the court to determine that the property loss constituted two separate occurrences rather than one. In September 2003, the U.S Circuit Court of Appeals for the Second Circuit ruled that under terms of the policy form we used to underwrite property coverage for the World Trade Center, the terrorist attack constituted one occurrence. Additionally, through separate litigation, the aviation losses could be deemed four separate events rather than three, for purposes of insurance and reinsurance coverage. Even if the courts ultimately rule against us regarding the number of events, we believe the additional amount of estimated after-tax losses, net of reinsurance, that we would record would not be material to our results of operations.
The original estimated losses in 2001 and the adjustments recorded in 2002 and 2003 impacted our statements of operations as follows. The tax expense or benefit was calculated at the statutory rate of 35%.
The (benefit) detriment on our business segments of the estimated net pretax operating loss of $941 million recorded in 2001, the $13 million net reduction in and reallocation of losses among segments in 2002, and the $46 million reduction in losses in 2003 are shown in the following table.
In 2002, we implemented the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets,” which established financial accounting and reporting for acquired goodwill and other intangible assets. The statement changed prior accounting practice in the way intangible assets with indefinite useful lives, including goodwill, are tested for impairment on an annual basis. Generally, it also required that those assets meeting the criteria for classification as intangible assets with estimable useful lives be amortized to expense over those lives, while intangible assets with indefinite useful lives and goodwill are not to be amortized. We also reviewed the amortization method and useful lives of existing intangible assets, and adjusted as appropriate. Generally, amortization was accelerated and useful lives shortened. As a result of implementing the provisions of SFAS No. 142, we did not record any goodwill amortization expense in 2003 or 2002. For the year of 2001, our goodwill amortization expense totaled $114 million. Amortization expense associated with intangible assets totaled $31 million, $18 million and $2 million for the years ended December 31, 2003, 2002 and 2001, respectively.
The changes in the carrying value of goodwill from December 31, 2002 to December 31, 2003 sheet were as follows.
Our underwriting operations are required to file financial statements with state and foreign regulatory authorities. The accounting principles used to prepare these statutory financial statements follow prescribed or permitted accounting principles, which differ from GAAP. Prescribed statutory accounting practices include state laws, regulations and general administrative rules issued by the state of domicile as well as a variety of publications and manuals of the National Association of Insurance Commissioners (“NAIC”). Permitted statutory accounting practices encompass all accounting practices not so prescribed, but allowed by the state of domicile. Beginning in 2001, Fire and Marine was granted a permitted practice regarding the valuation of certain investments in affiliated limited liability companies, allowing it to value these investments at their audited GAAP equity. Since these investments were not required to be valued on a statutory basis, Fire and Marine is not able to determine the impact on statutory surplus.
On a statutory accounting basis, our property-liability underwriting operations’ estimated net income for 2003 was $795 million. In 2002, actual net income on a statutory accounting basis was $550 million, and in 2001, those operations’ actual net loss on a statutory accounting basis was $1.13 billion. The estimated statutory surplus (shareholder’s equity) of our property-liability underwriting operations was $5.75 billion as of December 31, 2003. The actual statutory surplus as of December 31, 2002 was $5.22 billion.
The following is an unaudited summary of our quarterly results for the last two years.
26 Impact of Accounting Pronouncements to be Adopted in the Future