Results of operations include the accounts of The Hanover Insurance Company (“Hanover Insurance”) and Citizens Insurance Company of America (“Citizens”), our principal property and casualty companies, and certain other insurance and non-insurance subsidiaries. Our results of operations also include the results of our discontinued operations, consisting primarily of our former Chaucer international business, Chaucer Holdings Limited (“Chaucer”), a United Kingdom (“U.K.”) domiciled specialist insurance underwriting group which operates through the Society and Corporation of Lloyd’s (“Lloyd’s”), and the international insurance and non-insurance subsidiaries, which collectively constituted our former Chaucer segment. On December 28, 2018, we completed the sale of Chaucer to China Reinsurance (Group) Corporation (“China Re”), and subsequently completed the sales of the Chaucer-related Irish and Australian entities on February 14, 2019 and April 10, 2019, respectively. For all periods presented, operations from Chaucer are presented as discontinued operations. Discontinued operations also include the results of our accident and health and former life insurance businesses.
Business operations consist of three operating segments: Commercial Lines, Personal Lines and Other.
Our strategy, which focuses on the independent agency distribution channel, reinforces THG’s commitment to our agency partners. It is designed to generate profitable growth by leveraging the strengths of our distribution approach, including expansion of our agency footprint in underpenetrated geographies, as warranted. As part of that strategy, we have increased our capabilities in specialty markets and investments designed to develop growth solutions for our agency distribution channel. Our goal is to grow responsibly in all of our businesses, while managing volatility.
Our account-focused approach to the small commercial market, distinctiveness in the middle market and continued development of specialty lines provides us with a diversified portfolio of products and delivers significant value to agents and policyholders. Each of these businesses is expected to contribute to premium growth in Commercial Lines over the next several years as we continue to pursue our core strategy of developing strong partnerships with agents, enhanced franchise value through limited distribution, distinctive products and coverages, and continued investment in industry segmentation.
These efforts have driven and, subject to market conditions, we believe they will continue to drive, improvement in our overall mix of business and our underwriting profitability. Commercial Lines net premiums written grew by 3.7% in 2019, primarily due to growth in our commercial multiple peril, inland marine, workers’ compensation and professional liability lines of business, partially offset by specific underwriting actions in our Hanover Programs and commercial automobiles lines.
Personal Lines focuses on partnering with high quality, value-oriented agencies that deliver consultative selling and stress the importance of account rounding (the conversion of single policy customers to accounts with multiple policies and additional coverages, to address customers’ broader objectives). Approximately 85% of our policies in force are account business. We are focused on seeking profitable growth opportunities, building a distinctive position in the market and diversifying geographically.
Catastrophe losses and prior years’ reserve development are significant components in understanding and assessing the financial performance of our business. Management reviews and evaluates catastrophes and prior years’ reserve development separately from the other components of earnings. References to “current accident year underwriting results” exclude prior accident year reserve development, and may also be presented, “excluding catastrophes”. Prior years’ reserve development and catastrophes are not predictable as to timing or the amount that will affect the results of our operations and have an effect on each year’s operating and net income. Management believes that providing certain financial metrics and trends excluding the effects of catastrophes and prior years’ reserve development helps investors to understand the variability in periodic earnings and to evaluate the underlying performance of our operations. Discussion of catastrophe losses in this Management’s Discussion and Analysis includes development on prior years’ catastrophe reserves and, unless otherwise indicated, such development is excluded from discussions of prior year loss and LAE reserve development.
The following is our discussion and analysis of the results of operations by business segment. The operating results are presented before interest expense, taxes and other items which management believes are not indicative of our core operations, including realized gains and losses, as well as unrealized gains and losses on equity securities, and the results of discontinued operations.
Operating income before interest expense and income taxes was $453.6 million for the year ended December 31, 2019, compared to $406.5 million for the year ended December 31, 2018, an increase of $47.1 million. This increase was primarily due to lower catastrophe losses, earned premium growth, lower expenses and higher net investment income, partially offset by higher current accident year large loss activity in our specialty industrial property line, personal automobile, and, to a lesser extent, our homeowners and marine lines.
Net premiums written increased by $275.7 million for the year ended December 31, 2018, compared to the year ended December 31, 2017, due to growth in both our Commercial and Personal Lines segments.
Commercial Lines net premiums written were $2,707.2 million for the year ended December 31, 2019, compared to $2,610.7 million for the year ended December 31, 2018. This $96.5 million increase was primarily driven by pricing increases and strong retention.
We have been able to obtain rate increases in our Personal Lines markets and believe that our ability to obtain increases will continue. However, our ability to maintain Personal Lines net premiums written may be affected by price competition, and regulatory and legal developments. Additionally, these factors along with weather-related loss volatility may also affect our ability to maintain and improve underwriting results. We monitor these trends and consider them in our rate actions.
Commercial Lines current accident year underwriting profit, excluding catastrophes, was $193.2 million for the year ended December 31, 2018, compared to $173.4 million for the year ended December 31, 2017. This $19.8 million improvement was primarily due to the reduction in large loss-related reinsurance reinstatement premiums, lower expenses and earned premium growth, partially offset by higher non-catastrophe current accident year losses. The reduction in reinsurance reinstatement premiums, net of ceding commissions, increased non-catastrophe current accident year underwriting profit by $21.5 million compared to the prior year. The higher non-catastrophe current accident year losses were driven by large property loss activity in our commercial multiple peril line and higher loss activity in our commercial automobile liability line, partially offset by lower loss activity in our other commercial lines.
Personal Lines underwriting profit for the year ended December 31, 2018 was $66.6 million, compared to $83.7 million for the year ended December 31, 2017, a decline of $17.1 million. Catastrophe losses for the year ended December 31, 2018 were $76.9 million, compared to $80.9 million for the year ended December 31, 2017, a decrease of $4.0 million. Unfavorable development on prior years’ loss reserves for the year ended December 31, 2018 was $33.3 million, compared to $9.4 million for the year ended December 31, 2017, an increase of $23.9 million.
Personal Lines current accident year underwriting profit, excluding catastrophes, was $176.8 million in the year ended December 31, 2018, compared to $174.0 million for the year ended December 31, 2017. This $2.8 million increase was primarily a result of earned premium growth and lower expenses, partially offset by higher non-catastrophe current accident year losses. This increase in losses was driven by higher homeowners property losses, partly due to large losses and non-catastrophe weather activity, higher personal automobile bodily injury loss severity and, to a lesser extent, higher personal automobile property losses.
The IBNR reserve includes a provision for claims that have occurred but have not yet been reported to us, some of which may not yet be known to the insured, as well as a provision for future development on reported claims. IBNR represents a significant proportion of our total net loss reserves, particularly for long-tail liability classes. In fact, approximately 49% of our aggregate net loss reserves at December 31, 2019 were for IBNR losses and loss expenses.
Some risk factors affect multiple lines of business. Examples include changes in claim handling and claim reserving practices, changes in claim settlement patterns, regulatory and legislative actions, court actions, so-called “social inflation”, timeliness of claim reporting, state mix of claimants and degree of claimant fraud. Additionally, there is also a higher degree of uncertainty due to growth in our acquired businesses, with respect to which we have less familiarity and, in some cases, limited historical claims experience. The extent of the impact of a risk factor will also vary by components within a line of business. Individual risk factors are subject to interactions with other risk factors within line of business components. Thus, risk factors can have offsetting or compounding effects on required reserves.
We are also defendants in various litigation matters, including putative class actions, which may seek punitive damages, bad faith or extra-contractual damages, legal fees and interest, or claim a broader scope of policy coverage or settlement and payment obligations than our interpretation. Resolution of these cases are often highly unpredictable and could involve material unanticipated damage awards. We have experienced, and others in the industry have reported, increased attorney involvement in claims, delayed submissions of medical and other expense claims and a trend toward higher valued settlements and litigation, all of which contribute to uncertainty regarding reserve estimates.
Our carried reserves for each line of business and coverage are determined based on the quarterly loss reserving process. In making the determination, we consider numerous quantitative and qualitative factors. Quantitative factors include changes in reserve estimates in the period, the maturity of the accident year, trends observed over the recent past, the level of volatility within a particular class of business, the estimated effects of reinsurance, including reinstatement premiums, general economic trends and other factors. Qualitative factors may include legal and regulatory developments, changes in claim handling and case reserving practices, recent entry into new markets or products, changes in underwriting practices or business mix, concerns that we do not have sufficient or quality historical reported and paid loss and LAE information with respect to a particular line or segment of our business, effects of the economy and political outlook, perceived anomalies in the historical results, evolving trends or other factors. In doing so, we must evaluate whether a change in the data represents credible actionable information or an anomaly. Such an assessment requires considerable judgment. Even if a change is determined to be apparent, it is not always possible to determine the extent of the change. As a result, there can be a time lag between the emergence of a change and a determination that the change should be partially or fully reflected in the carried loss reserves. In general, changes are made more quickly to reserves for more mature accident years and less volatile classes of business.
As stated above, numerous factors (both internal and external) contribute to the inherent uncertainty in the process of establishing loss reserves, including changes in the rate of inflation for goods and services related to insured damages (e.g., medical care, home repairs, etc.), changes in the judicial interpretation of policy provisions and settlement obligations, changes in the general attitude of juries in determining damage awards, legislative actions, such as expanding liability, coverage mandates or expanding or suspending statutes of limitations which otherwise limit the times within which claims can be made, changes in the extent of insured injuries, changes in the trend of expected frequency and/or severity of claims, changes in our book of business (e.g., change in mix due to new or modified product offerings, new or rapidly expanding geographic areas, etc.), changes in our underwriting practices and changes in claim handling procedures and/or systems. Regarding our indirect business from voluntary and involuntary pools, we are periodically provided loss estimates by managers of each pool. We adopt reserve estimates for the pools that consider this information and other facts.
In addition, we must consider the uncertain effects of emerging or potential claims and coverage issues that arise as legal, judicial, social conditions, political risks and economic conditions change. For example, claims which we consider closed may be re-opened as additional damages surface or new liability or damage theories are presented. Also, historically, we have observed more frequent and higher severity in workers’ compensation, bodily injury and other liability claims and more credit related losses (for example, in our surety business) during periods of economic uncertainty or high unemployment. These, and other issues, could have a negative effect on our loss reserves by either extending coverage beyond the original underwriting intent or by increasing the number or size of claims.
For events designated as catastrophes, we generally calculate IBNR reserves directly as a result of an estimated IBNR claim count and an estimated average claim amount for each event. Such an assessment involves a comprehensive analysis of the nature of the event, of policyholder exposures within the affected geographic area and of available claims intelligence. Depending on the nature of the event, available claims intelligence could include surveys of field claims associates within the affected geographic area, aerial photographs of the affected area, feedback from a catastrophe claims team sent into the area, as well as data on claims reported as of the financial statement date. In addition, loss emergence from similar historical events is compared to the estimated IBNR for our current catastrophe events to help assess the reasonableness of our estimates.
Personal Automobile Personal Injury Protection Medical Payment - loss reserves recorded for personal injury protection medical payment on voluntary business were $157.2 million as of December 31, 2019, of which approximately 95% relates to Michigan policies. A key assumption for this coverage is the inflation rate underlying the estimated reserve. Given the long reporting pattern for this line of business, an additional key assumption is the amount of additional development required to reach full maturity, thereby reflecting ultimate costs, as represented by the tail factor. A five point change in the embedded inflation rate and a one point change to the tail factor assumption (e.g., 2% changed to 1% or 3%) would have changed total reserves by approximately $52 million, either positive or negative, at December 31, 2019.
Workers’ Compensation - loss reserves recorded for workers’ compensation on voluntary business were $442.4 million as of December 31, 2019. A key assumption for workers’ compensation is the inflation rate underlying the estimated reserve. Given the long reporting pattern for this line of business, an additional key assumption is the amount of additional development required to reach full maturity, thereby reflecting ultimate costs, as represented by the tail factor. A five point change in the embedded inflation rate and a one point change to the tail factor assumption would have changed total reserves by approximately $129 million, either positive or negative, at December 31, 2019.
Specialty Programs - loss reserves recorded for Hanover Programs were $339.5 million as of December 31, 2019. Two key assumptions underlying the actuarial reserve analysis for specialty programs are the inflation rate underlying the estimated reserve for our commercial automobile liability, general liability and workers’ compensation coverages, as well as the tail factor selection for workers’ compensation. A five point change to the embedded inflation rate for the aforementioned coverages, and a one point change in the workers’ compensation tail factor on Hanover Programs would have changed total reserves by approximately $54 million at December 31, 2019.
“Other commercial lines - Other lines” in the table above, is primarily comprised of fidelity and crime lines of business. Loss and LAE reserves in our “Total Other Segment” relate to our run-off voluntary assumed reinsurance pools business.
The following table provides a summary of unfavorable/(favorable) loss and LAE reserve development, excluding catastrophes.
In 2018, net unfavorable loss and LAE development, excluding catastrophes, was $0.4 million. Commercial Lines favorable development of $34.1 million was primarily due to lower than expected losses of $31.0 million within the workers’ compensation line in accident years 2015 through 2017, and $25.1 million in other commercial lines, partially offset by higher than expected losses of $23.2 million in the commercial automobile line, driven by higher bodily injury severity in the 2014, 2016 and 2017 accident years. Within other commercial lines, lower than expected losses in our general liability lines, related to the 2014 through 2016 accident years, and our surety line in accident years 2015 and 2017, was partially offset by higher than expected losses in Hanover Programs, primarily in accident years 2010 through 2014. Personal Lines unfavorable development of $33.3 million was primarily due to higher than expected losses within the homeowners line in accident years 2015 through 2017, and in the personal automobile line, driven by bodily injury severity in the 2016 accident year and, to a lesser extent, the 2015 accident year. In addition, Other segment unfavorable development of $1.2 million was due to adverse loss trends in our run-off voluntary pools business which includes asbestos and environmental reserves.
In 2017, net unfavorable loss and LAE development, excluding catastrophes, was $1.2 million. Commercial Lines favorable development of $9.4 million was primarily due to lower than expected losses within the workers’ compensation line in accident years 2012 through 2016. Personal Lines unfavorable development of $9.4 million was primarily due to higher than expected losses in homeowners for accident year 2016. In addition, Other segment unfavorable development of $1.2 million was due to higher than expected losses in our run-off voluntary pools business, which includes asbestos and environmental reserves.
In addition to reserves we carry to cover exposure in our direct business, we have established gross and net loss and LAE reserves for assumed reinsurance pool business with asbestos and environmental damage liability of $29.5 million, $30.0 million and $30.3 million at December 31, 2019, 2018 and 2017, respectively. These reserves relate to pools in which we have terminated our participation; however, we continue to be subject to claims related to years in which we were a participant. Results of operations from these pools are included in our Other segment. A significant part of our pool reserves relates to our participation in the ECRA voluntary pool from 1950 to 1982. In 1982, the pool was dissolved and since that time, the business has been in run-off. Our percentage of the total pool liabilities varied from 1% to 6% during these years. Our participation in this pool has resulted in average paid losses of approximately $2 million annually over the past ten years.
See “Reinsurance” in Item 1 - Business for information on our reinsurance programs.
We held cash and investment assets diversified across several asset classes, as follows:
Investments in mortgage loan participations and limited partnerships are generally illiquid in nature.
The carrying values of fixed maturity securities on non-accrual status at December 31, 2019 and 2018 were not material. The effects of non-accruals compared with amounts that would have been recognized in accordance with the original terms of the fixed maturities for the years ended December 31, 2019, 2018 and 2017 were also not material. Any defaults in the fixed maturities portfolio in future periods may negatively affect investment income.
Gross unrealized losses on fixed maturities at December 31, 2019 were $7.6 million, a decrease of $126.6 million compared to December 31, 2018, primarily attributable to lower prevailing interest rates and tighter credit spreads. At December 31, 2019, gross unrealized losses consisted primarily of $3.9 million on corporate fixed maturities, $1.3 million on U.S. government securities and $1.2 million on municipal securities. See also Note 3 - “Investments” in the Notes to Consolidated Financial Statements.
Fundamental conditions in the corporate sector generally remain sound. While we may experience defaults on fixed income securities, particularly with respect to non-investment grade debt securities, it is difficult to foresee which issuers, industries or markets will be affected. As a result, the value of our fixed maturity portfolio could change rapidly in ways we cannot currently anticipate, and we could incur additional realized and unrealized losses in future periods.
Net realized and unrealized gains on investments were $109.4 million for 2019, compared to $50.7 million of net realized and unrealized losses for 2018 and $21.1 million of net realized gains for 2017. Net realized and unrealized gains in 2019 were primarily due to $106.5 million of appreciation in the fair value of our equity securities. Net realized and unrealized losses in 2018 were primarily due to $43.4 million of losses from the net change in fair value of equity securities that are required to be reflected in net income beginning in 2018, due to the implementation of ASU 2016-01 effective January 1, 2018. (See also Item O. “New Accounting Pronouncements” in Note 1 - “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements.) The change in the fair value of equity securities in both 2019 and 2018 resulted from prevailing market conditions. Additionally, in 2018 we recognized $4.6 million of OTTI losses and $2.7 million of losses recognized from the sale of securities, primarily fixed maturities. Net realized gains in 2017 were primarily due to $26.6 million of gains recognized from the sale of securities, primarily equities, and to a lesser extent, fixed maturities. These gains were partially offset by $5.6 million of OTTI losses.
At December 31, 2018, we had informed the FHLB of our intent to repay a $125 million FHLB note due 2029 with a coupon of 5.5%, with settlement occurring on January 2, 2019. In the fourth quarter of 2018, we recorded a non-operating charge of $20.8 million after-taxes related to the pre-payment provision. Additionally, in 2018 we repurchased subordinated debentures with a net carrying value of $9.6 million at a cost of $11.5 million, resulting in a loss of $1.9 million.
Discontinued operations include our discontinued accident and health and life businesses as well as our former Chaucer operations. In 2019, discontinued operations, in total, generated a net loss of $3.9 million, net of tax, primarily related to the long-term care pool in our discontinued accident and health business. In 2018, discontinued operations, in total, generated a gain of $152.0 million, net of tax, primarily related to the sale of the Chaucer business. In 2017, discontinued operations, in total, generated a loss of $29.9 million, net of tax, primarily related to the long-term care pool in our discontinued accident and health business and, to a lesser extent, the Chaucer business. See also “Discontinued Operations - Chaucer Business” below and Note 2 - “Discontinued Operations” in the Notes to Consolidated Financial Statements.
Contingent proceeds, as reflected in the sales and purchase agreement, may be up to $45 million and is determined based upon 2018 catastrophe losses. In 2018, our best estimate of contingent consideration was $31.7 million.
The carrying value of the Chaucer business reflects its U.S. GAAP book value at December 28, 2018, excluding $7.9 million of U.S.-related deferred tax assets that are no longer likely to be realized and therefore are reflected in the income tax expense category.
On February 14, 2019, we completed the sale of our Chaucer-related Irish entity and on April 10, 2019, we finalized the sale of the Australian entities, completing the transfer of all Chaucer-related companies. Collectively, these entities constituted the Chaucer business in 2018 and prior, whereas just the Irish and Australian entities comprised the Chaucer business reported in our results in 2019, until their respective sales to China Re. The sale of the Irish entity provided total proceeds of $28 million and resulted in a pre-tax gain of $0.4 million, with a related income tax benefit of $0.5 million. The sale of the Australian entities for total proceeds of $13 million resulted in a pre-tax gain of $1.2 million and a related income tax expense of $0.1 million.
2018 reflects the results of operations for the period in which we owned Chaucer, which concluded with the sale of the Chaucer business on December 28, 2018.
Revenues from the portion of the Chaucer business remaining after the sale of the U.K. entities in 2018 was $6.7 million during the year ended December 31, 2019. Pre-tax operating losses in this business totaled $0.5 million during the same period, whereas this business provided after-tax income of $1.6 million for the year ended December 31, 2019. Income from the Chaucer business in the year ended December 31, 2019 included a $2.0 million benefit related to a decrease in an uncertain tax position due to the expiration of the statute of limitations.
Chaucer’s net premiums earned were $850.0 million for the year ended December 31, 2018, compared to $853.0 million for the year ended December 31, 2017, a decrease of $3.0 million, or 0.4%. This was primarily due to a planned increase in the use of ceded reinsurance, as a result of current market conditions, partially offset by new business growth in the casualty line.
The provision for income taxes from continuing operations was an expense of $93.1 million, $43.5 million, and $76.8 million in 2019, 2018 and 2017, respectively. These amounts resulted in consolidated effective tax rates of 17.8%, 15.4% and 26.2% on pre-tax income for 2019, 2018 and 2017, respectively. The provisions in 2019, 2018, and 2017 reflect benefits related to tax planning strategies implemented in prior years of $14.8 million, $9.2 million, and $12.7 million, respectively. The provisions in 2019, 2018 and 2017 also included excess tax benefits related to stock-based compensation of $3.0 million, $2.3 million and $5.3 million, respectively. The provision for 2019 includes a charge of $1.2 million, which relates to the aforementioned changes in the tax law related to the 2018 sale of Chaucer. The provision for 2018 reflects a tax benefit related to prior years of $4.3 million primarily resulting from a $40.0 million contribution to our U.S. pension plan made in September 2018 and reflected as a deduction in our 2017 U.S. income tax return at the then higher statutory tax rate. Lastly, the provision for the 2017 tax year further reflects a tax benefit of $3.9 million related to the revaluation of our net deferred tax liabilities as a result of the enactment of the Tax Cuts and Jobs Act (“TCJA”, “U.S. Tax Reform” or “the Act”). See the discussion of the new tax law, “U.S. Tax Reform”, below. Absent these items, the provision for income taxes for 2019, 2018 and 2017 would have been expenses of $109.7 million, $59.3 million and $98.7 million, respectively, or 21.0% for 2019 and 2018 and 33.7% for 2017. The lower effective tax rate in 2019 and 2018 is primarily due to the aforementioned 2018 decrease in the U.S. statutory rate.
The income tax provision on operating income was an expense of $84.5 million, $69.3 million and $89.5 million for 2019, 2018 and 2017, respectively. These provisions resulted in effective tax rates for operating income of 20.3%, 19.2% and 31.7% in 2019, 2018 and 2017, respectively. The provisions for 2019, 2018 and 2017 reflect the aforementioned excess tax benefits related to stock-based compensation. In addition, the 2018 provision included the aforementioned tax benefit related to prior years of $4.3 million. Absent these items, the provision for income taxes for 2019, 2018 and 2017 would have been expenses of $87.5 million, $75.9 million and $94.8 million, or 21.0% for 2019 and 2018 and 33.6% for 2017.
The income tax provision on our former Chaucer business was an expense of $4.7 million and $21.7 million for 2018 and 2017, respectively. The provision for 2017 reflects a one-time expense of $26.2 million related to the enactment of the TCJA. This expense included a revaluation of our net deferred tax assets and the recognition of federal income tax on previously untaxed earnings from foreign operations of $13.5 million and $12.7 million, respectively. Absent these items, the provision for income tax for 2017 would have been a benefit of $4.5 million.
The 2018 income tax provision on the gain from the disposal of Chaucer business was an expense of $42.5 million. This provision includes a write off of $8.0 million of deferred tax assets primarily attributable to Lloyd’s underwriting losses.
During 2019, we recorded a decrease in our uncertain tax position of $2.0 million due to the expiration of a statute of limitations. The release of uncertain tax position was recorded as a benefit in the Chaucer discontinued business. During 2017, we recorded an increase to our uncertain tax positions of $0.9 million related to the recognition of federal income taxes on previously untaxed earnings from foreign operations. This amount is partially offset by a decrease in our uncertain tax positions of $0.6 million due to the expiration of a statute of limitation, for a net change of $0.3 million. We are subject to U.S. federal and state examinations and foreign examinations for years after 2015. There are no ongoing audits on our open tax years.
In prior years, we completed several transactions which resulted in the realization, for tax purposes only, of unrealized gains in our investment portfolio. As a result of these transactions, we were able to realize capital losses carried forward and release the valuation allowance recorded against the deferred tax asset related to those losses. The releases of valuation allowances were recorded as a benefit in accumulated other comprehensive income. Previously unrealized benefits of $14.8 million, $9.2 million and $12.7 million attributable to non-operating income, are recognized as part of our income from continuing operations during 2019, 2018 and 2017, respectively. The remaining amount of $20.8 million in accumulated other comprehensive income will be released into income from continuing operations in future years, as the investment securities subject to these transactions are sold or mature.
On December 22, 2017, the TCJA was enacted in the U.S. The Act substantially changed many aspects of the U.S. Tax Code, including reducing the U.S. corporate income tax rate from 35% to 21%. While the new corporate rate was effective on January 1, 2018, we recognized the impact of the rate change on our deferred tax balances as of the enactment date. The effect of this re-measurement of our deferred tax balances is a provision of $9.4 million for the year ended December 31, 2017. This provision is recorded as a component of income tax expense in continuing operations and within discontinued operations as a component of income from Chaucer business. A tax benefit of $4.1 million was recognized in continuing operations and an expense of $13.5 million was recognized in discontinued operations. This amount includes the revaluation of deferred taxes initially recorded through other comprehensive income and recorded through discontinued operations, such as unrealized appreciation on investments, employee benefit plan-related items, foreign currency translation adjustments and reserve adjustments for discontinued business. Deferred taxes related to the revaluation of our pension plans at December 31, 2017, as well as changes in unrealized gains and losses occurring after the Act’s enactment date, are recorded at 21% in other comprehensive income.
The Act also created a territorial tax system, which will generally allow companies to repatriate future non-U.S. sourced earnings without incurring additional U.S. taxes, by providing a 100% exemption on dividends received from certain non-U.S. subsidiaries. Although most of our non-U.S. income had been previously subject to U.S. taxes, a portion of our non-U.S. income had been indefinitely reinvested overseas and was not subject to U.S. tax until repatriated. These non-U.S. earnings are now subject to a one-time mandatory toll charge totaling $12.7 million, which is recorded within discontinued operations as a component of income tax expense related to the Chaucer business for the year ended December 31, 2017.
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements. These statements have been prepared in accordance with U.S. GAAP, which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. The following critical accounting estimates are those which we believe affect the more significant judgments and estimates used in the preparation of our financial statements. Additional information about other significant accounting policies and estimates may be found in Note 1-“Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements.
The expected return on asset assumption was 5.50% and 4.75% in 2019 and 2018, respectively. Asset returns are reflected net of administrative expenses.
Net actuarial gains related to the domestic qualified plan of $20.5 million and losses of $19.9 million were reflected as changes to accumulated other comprehensive income in 2019 and 2018, respectively. Net actuarial gains in 2019 resulted from net investment gains during the year, as well as favorable mortality experience, partially offset by the aforementioned decrease in the discount rate. Net actuarial losses in 2018 resulted primarily from investment losses experienced during the year, partially offset by increases in the discount rate. In 2019 and 2018, amortization of actuarial losses from prior years was $11.1 million and $8.6 million, respectively.
The statutory capital and surplus for our insurance subsidiaries increased $297.7 million during 2019, primarily due to approximately $340 million of income and approximately $92 million in unrealized gains on investments, net of tax, primarily offset by a $140 million dividend paid by Hanover Insurance to THG.
At December 31, 2019, THG, as a holding company, held approximately $340.7 million of fixed maturities and cash. We believe our holding company assets will be sufficient to meet our current year obligations, which we expect to consist primarily of quarterly dividends to our shareholders (as and to the extent declared), interest on our senior and subordinated debentures, certain costs associated with benefits due to our former life employees and agents, and, to the extent required, payments related to indemnification of liabilities associated with the sale of various subsidiaries. As discussed below, we have, and opportunistically may continue to, repurchase our common stock and debt. We do not expect that it will be necessary to dividend additional funds from our insurance subsidiaries in order to fund 2020 holding company obligations; however, we may decide to do so.
We expect to continue to generate sufficient positive operating cash to meet all short-term and long-term cash requirements relating to current operations, including the funding of our qualified defined benefit pension plan. During 2019, we contributed $10 million to our qualified defined benefit pension plan. We believe that this plan is essentially fully funded. The ultimate payment amounts for our benefit plan is based on several assumptions, including but not limited to, the rate of return on plan assets, the discount rate for benefit obligations, mortality experience, interest crediting rates, inflation and the ultimate valuation and determination of benefit obligations. Since differences between actual plan experience and our assumptions are almost certain, changes, both positive and negative, to our current funding status and ultimately our obligations in future periods are likely.
On April 30, 2019, we entered into a new credit agreement that provides for a five-year unsecured revolving credit facility not to exceed $200.0 million at any one time outstanding, with the option to increase the facility up to $300.0 million, (assuming no default and satisfaction of other specified conditions, including the receipt of additional lender commitments). The agreement also includes an uncommitted subfacility of $50.0 million for standby letters of credit. Borrowings, if any, under this new agreement are unsecured and incur interest at a rate per annum equal to, at our election, either (i) the greater of, (a) the prime commercial lending rate of the administrative agent, (b) the NYFRB Rate plus half a percent, or (c) the one month Adjusted LIBOR plus one percent and a margin that ranges from 0.25% to 0.625% depending on our debt rating, or (ii) Adjusted LIBOR for the applicable interest period, plus a margin that ranges from 1.25% to 1.625% depending on our debt rating. The agreement also contains certain financial covenants such as maintenance of specified levels of consolidated equity and leverage ratios, and requires that certain of our subsidiaries maintain minimum RBC ratios. Concurrent with our entry into this agreement, we voluntarily terminated our existing $200.0 million credit agreement, dated November 12, 2013. We currently have no borrowings under the new agreement and had no borrowings under the previous agreement during 2019. The LIBOR rate, upon which Adjusted LIBOR is based, is expected to be discontinued by the end of 2021. Our credit agreement permits us to agree with the Administrative Agent for the credit facility on a replacement to Adjusted LIBOR subject to the satisfaction of certain conditions.
Financing obligations generally include repayment of our senior debentures, subordinated debentures and lease payments. The following table represents our annual payments related to the contractual principal and interest payments of these financing obligations as of December 31, 2019, unless otherwise noted, and lease payments reflect expected cash payments based upon active lease terms. It is expected that in the normal course of business, leases that expire will generally be renewed or replaced by leases on similar property and equipment. In addition, we also have included our estimated payments related to our loss and LAE obligations and our current expectation of payments to be made to support the obligations of our benefit plans. The following table also includes commitments to purchase investment securities at a future date. Actual payments may differ from the contractual and/or estimated payments in the table.
Debt in the maturity in excess of 5 years category includes our senior debentures due in 2025, which pay annual interest at a rate of 7.625%, our senior debentures due in 2026, which pay annual interest at a rate of 4.50%, our subordinated debentures due in 2027, which pay cumulative dividends at an annual rate of 8.207% and our subordinated debentures due in 2053, which pay annual interest at a rate of 6.35%. Payments related to the principal amounts of these agreements represent contractual maturity; therefore, principal and interest associated with these obligations are reflected in the above table based upon the contractual maturity dates.
Catastrophe loss - Loss and directly identified loss adjustment expenses from catastrophes, including development on prior years’ catastrophe loss reserves. The Insurance Services Office (“ISO”) Property Claim Services (“PCS”) defines a catastrophe loss as an event that causes $25 million or more in insured property losses from U.S. direct writers and affects a significant number of property and casualty policyholders and insurers. In limited instances where the impact of an event extends across multiple geographic areas or time periods, but is not within the specific parameters established by PCS, THG may determine that certain losses are better included within the same catastrophe event. In addition to those catastrophe events declared by ISO, claims management also generally includes within the definition of a “catastrophe loss”, a property loss event that causes approximately $5 million or more in Company insured losses and affects in excess of one hundred policyholders.
Cede; cedent; ceding company - When a party reinsures its liability with another party, it “cedes” business and is referred to as the “cedent” or “ceding company”.
Loss reserves - Liabilities established by insurers to reflect the estimated cost of claims payments and the related expenses that the insurer will ultimately be required to pay in respect of insurance it has written. Reserves are established for losses and for LAE.
Lower (higher) expenses - Represents the period over period comparison of expenses relative to growth in earned premium. Volume driven expenses typically fluctuate commensurate with changes in premium. Accordingly, as we grow premium, these expenses increase from an absolute dollar perspective, but tend to stay proportionate compared to premium. Fixed expenses can remain constant or increase or decrease irrespective of the growth or decline in premium. When describing expenses as being “lower” or “higher” we are generally referring to changes in fixed costs relative to premium (fixed cost leverage). These “lower” or “higher” expenses correspond to a lower or higher expense ratio.
The Regulatory Action Level, which equals 150% of the Authorized Control Level, requires the insurer to submit to the commissioner of the state of domicile an RBC plan, or if applicable, a revised RBC plan. After examination or analysis, the commissioner will issue an order specifying corrective actions to be taken.
We have audited the accompanying consolidated balance sheets of The Hanover Insurance Group, Inc. and its subsidiaries (the “Company”) as of December 31, 2019 and 2018, and the related consolidated statements of income, of comprehensive income, of shareholders' equity and of cash flows for each of the three years in the period ended December 31, 2019, including the related notes and schedules of condensed financial information of the registrant, of supplementary insurance information, and of supplemental information concerning property and casualty insurance operations as of December 31, 2019 and 2018 and for each of the three years in the period ended December 31, 2019, schedule of valuation and qualifying accounts for each of the three years in the period ended December 31, 2019, and schedule of summary of investments - other than investments in related parties as of December 31, 2019 listed in the index appearing under Item 15(a)(2) (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
The consolidated financial statements of The Hanover Insurance Group, Inc. (“THG” or the “Company”), include the accounts of The Hanover Insurance Company (“Hanover Insurance”) and Citizens Insurance Company of America (“Citizens”), THG’s principal property and casualty companies; and other insurance and non-insurance subsidiaries. These legal entities conduct their operations through several business segments discussed in Note 13 - “Segment Information.” The consolidated financial statements also include the Company’s discontinued operations, consisting primarily of the Company’s former accident and health and life insurance businesses and Chaucer Holdings Limited (“Chaucer”), a specialist insurance underwriting group which operates through the Society and Corporation of Lloyd’s (“Lloyd’s”) and other international insurance and non-insurance subsidiaries. All intercompany accounts and transactions have been eliminated. On December 28, 2018, the Company completed the sale of Chaucer to China Reinsurance (Group) Corporation (“China Re”), and subsequently completed the sales of the Chaucer-related Irish and Australian entities on February 14, 2019 and April 10, 2019, respectively. Accordingly, for all prior periods presented in this Annual Report on Form 10-K, Chaucer’s accounts have been classified as discontinued operations in the Consolidated Statements of Income, and as held-for-sale in the Consolidated Balance Sheet at December 31, 2018 (See Note 2 - “Discontinued Operations”).
Fixed maturities are classified as available-for-sale and are carried at fair value, with unrealized gains and losses, net of taxes, reported in accumulated other comprehensive income (“AOCI”), a separate component of shareholders’ equity. The amortized cost of fixed maturities is adjusted for amortization of premiums and accretion of discounts to maturity.
Net investment income includes interest, dividends and income from limited partnership interests. Interest income is recognized based on the effective yield method, which includes the amortization of premiums and accretion of discounts. The effective yield used to determine the amortization for fixed maturities subject to prepayment risk, such as mortgage-backed and asset-backed securities, is recalculated and adjusted periodically based upon actual historical and projected future cash flows. The adjustment to yields for highly rated prepayable fixed maturities is accounted for using the retrospective method. The adjustment to yields for all other prepayable fixed maturities is accounted for using the prospective method. Fixed maturities and mortgage participations that are delinquent are placed on non-accrual status, and thereafter interest income is recognized only when cash payments are received.
Realized investment gains and losses on sales are reported as a component of revenues based upon specific identification of the investment assets sold. When an other-than-temporary decline in the value of a specific investment is deemed to have occurred, and a charge to earnings is required, the Company recognizes a realized investment loss. Changes in the fair value of equity securities are reported in net realized and unrealized investment gains (losses), including increases and decreases in fair value on securities that are still held and realized gains and losses on securities that have been sold.
In the normal course of business, the Company may enter into transactions involving various types of financial instruments, including debt, investments such as fixed maturities, equity securities and mortgage loans, investment and loan commitments, swap contracts, option contracts, forward contracts and futures contracts. These instruments involve credit risk and could also be subject to risk of loss due to interest rate fluctuation. The Company evaluates and monitors each financial instrument individually and, when appropriate, obtains collateral or other security to minimize losses.
The Company tests for the recoverability of goodwill and intangible assets with indefinite lives annually or whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. The Company recognizes impairment losses only to the extent that the carrying amounts of reporting units with goodwill exceed the fair value. The amount of the impairment loss that would be recognized is determined based upon the excess of the carrying value of goodwill compared to the implied fair value of the goodwill, as determined with respect to all assets and liabilities of the reporting unit. The Company has performed its annual review of goodwill and intangible assets with indefinite lives for impairment in the fourth quarters of 2019 and 2018 with no impairments recognized. At December 31, 2019 and 2018, the Company held goodwill of $178.8 million and intangible assets with indefinite lives of $15.0 million.
The Company’s debt at December 31, 2019 includes senior debentures and subordinated debentures. Debt instruments are carried at principal amount borrowed, net of any applicable unamortized discounts and issuance costs. See Note 6 - “Debt and Credit Arrangements”.
The Company’s accounting for income taxes represents its best estimate of various events and transactions.
The Company recognizes the fair value of compensation costs for all share-based payments, including employee stock options, in the financial statements. Unvested awards are generally expensed on a straight line basis, by tranche, over the vesting period of the award. The Company’s stock-based compensation plans are discussed further in Note 10 - “Stock-Based Compensation Plans.”
In March 2019, the FASB issued ASC Update No. 2019-01, Leases (Topic 842) - Codification Improvements. This ASC update modifies interim disclosure requirements related to the implementation of ASC 842. This ASC update explicitly provides an exception to certain disclosures required under ASC 250 Accounting Changes and Error Corrections. An entity should apply the amendments as of the date that it first applied ASC 842, using the same transition methodology. Consistent with the Company’s implementation of ASC 842 on January 1, 2019, the updated guidance is effective for interim and annual periods beginning after December 15, 2018. The Company implemented this guidance effective January 1, 2019 and it did not have an impact on the Company’s financial position or results of operations as the update is disclosure related.
In February 2018, the Financial Accounting Standards Board (“FASB”) issued ASC Update No. 2018-02 (Topic 220) Income Statement - Reporting Comprehensive Income: Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. This ASC update allows for a reclassification into retained earnings of the stranded tax effects in AOCI resulting from the enactment of the TCJA. Current guidance requires the effect of a change in tax laws or rates on deferred tax balances to be reported in income from continuing operations in the accounting period that includes the period of enactment, even if the related income tax effects were originally charged or credited directly to AOCI. The amount of the reclassification would include the effect of the change in the U.S. federal corporate income tax rate on the gross deferred tax amounts at the date of the enactment of the TCJA related to items in AOCI. The updated guidance is effective for interim and annual periods beginning after December 15, 2018. Early adoption is permitted. The Company early adopted this guidance effective January 1, 2018 with a cumulative effect adjustment, which reclassified $6.5 million of benefits from AOCI to retained earnings with no overall impact on the Company’s financial position.
In February 2016, the Financial Accounting Standards Board (“FASB”) issued ASC Update No. 2016-02, Leases (Topic 842) . This ASC update requires a lessee to recognize a right-of-use asset, which represents the lessee’s right to use a specified asset for the lease term, and a corresponding lease liability, which represents a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis, for all leases that extend beyond 12 months. For finance or capital leases, interest on the lease liability will be recognized separately from amortization of the right-of-use asset in the statements of income and comprehensive income. In addition, the repayment of the principal portion of the lease liability will be classified as a financing activity while the interest component will be included in the operating section of the statement of cash flows. For operating leases, the asset and liability will be amortized as a single lease cost, such that the cost of the lease is allocated over the lease term, on a generally straight-line basis, with all cash flows included within operating activities in the statement of cash flows. ASC Update No. 2016-02 requires that implementation of this guidance be through a modified retrospective transition approach. In July 2018, the FASB issued ASC Update No. 2018-11, Leases (Topic 842): Targeted Improvements, which provides entities with an additional transition method to adopt ASC Update No. 2016-02. Under this optional transition method, an entity can initially apply the new guidance at the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. The Company implemented this guidance effective January 1, 2019 using the optional transition method provided in ASC Update No. 2018-11 and elected to utilize the practical expedient package available in ASC Update 2016-02. The Company has also elected to utilize the practical expedient which allows an entity not to separate lease and nonlease components for all of its asset classes. The effect of implementing this guidance increased total assets and total liabilities each by approximately $35 million on January 1, 2019 and did not have a material effect on the results of operations.
In January 2020, the FASB issued ASC Update No. 2020-01 Investments - Equity Securities (Topic 321), Investments - Equity Method and Joint Ventures (Topic 323), and Derivatives and Hedging (Topic 815). This ASC update clarifies that an entity should consider observable transactions that require it to either apply or discontinue the equity method of accounting when using the measurement alternative under ASC 321. It also clarifies the accounting for certain forward contracts and purchased options accounted for under ASC 815. The updated guidance is effective for annual and interim periods beginning after December 15, 2020. The Company does not expect the adoption of ASC Update No. 2020-01 to have a material impact on its financial position or results of operations.
On December 28, 2018, the Company completed the sale of Chaucer to China Re and recognized a pre-tax gain on the sale of $174.4 million and an income tax expense of $42.5 million. THG paid customary transaction costs along with providing certain representations and warranties and agreeing to indemnify China Re for certain pre-sale contingent liabilities.
Initial consideration for Chaucer as determined in the sales and purchase agreement was $779 million. This amount, along with $28 million in cash proceeds received from the sale of the Irish entity on February 14, 2019, $13 million from the sale of the Australian entities on April 10, 2019, estimated contingent consideration of $31.7 million, and an $85 million pre-signing dividend from Chaucer that was received in the second quarter of 2018, resulted in expected total proceeds from the entire transaction of $936.7 million. These amounts were partially offset by $17.0 million paid to China Re to adjust the purchase price for amounts received by the Company from Chaucer prior to December 28, 2018.
Contingent proceeds, as reflected in the sales and purchase agreement, may be up to $45 million and is determined based upon 2018 catastrophe losses. In 2018 the Company’s best estimate of contingent consideration was $31.7 million.
The income tax expense represents the current tax obligation on the sale and the derecognition of deferred tax assets that are no longer likely to be realized.
Revenues from the portion of the Chaucer business remaining after the sale of the U.K. entities in 2018 was $6.7 million during the year ended December 31, 2019. Pre-tax operating losses in this business totaled $0.5 million during the same period, whereas this business provided after-tax income of $1.6 million for the year ended December 31, 2019. Income from the Chaucer business in the year ended December 31, 2019 included a $2.0 million tax benefit related to a decrease in an uncertain tax position due to the expiration of the statute of limitations.
2018 reflects the results of operations for the period in which THG owned Chaucer, which concluded with the sale of the Chaucer business on December 28, 2018.
The Company recognized $0.8 million and $1.1 million in foreign currency transaction losses in net income in 2018 and 2017, respectively.
The following table provides the effects of reinsurance related to the Chaucer business for the periods indicated.
The increase in ceded reinsurance premiums from 2017 to 2018 was primarily due to Chaucer’s planned increase in reinsurance purchases.
There were no assets or liabilities held-for-sale at December 31, 2019. Total assets and liabilities held-for-sale were $57.4 million and $22.2 million, respectively, at December 31, 2018. Assets and liabilities held-for-sale decreased during 2019 due to the aforementioned sales of the Chaucer-related Irish and Australian entities. These balances are reflected in the Consolidated Balance Sheets under the captions “Assets held-for-sale” and “Liabilities held-for-sale”, respectively.
At December 31, 2019 and 2018, the portion of the discontinued accident and health business that was directly assumed had assets of $82.4 million and $81.6 million, respectively, consisting primarily of invested assets, and liabilities of $84.4 million and $81.4 million, respectively, consisting primarily of policy liabilities. At December 31, 2019 and 2018, the assets and liabilities of this business, as well as those of the reinsured portion of the accident and health business are classified as assets and liabilities of discontinued operations in the Consolidated Balance Sheets.
The Company enters into various agreements that may require its fixed maturities to be held as collateral by others. At December 31, 2019 and 2018, fixed maturities with fair values of $94.0 million and $234.9 million, respectively, were held as collateral for the FHLB collateralized borrowing program. See Note 6 - “Debt and Credit Arrangements” for additional information related to the Company’s FHLB program.
The following tables provide information about the Company’s available-for-sale fixed maturity securities that were in an unrealized loss position at December 31, 2019 and 2018 including the length of time the securities have been in an unrealized loss position:
The Company’s mortgage participations and other mortgage loans were $441.2 million and $405.7 million at December 31, 2019 and 2018, respectively. Participating interests in commercial mortgage loans are originated and serviced by a third-party. For these investments, the Company shares, on a pro-rata basis, in all related cash flows of the underlying mortgages. Mortgage participations and other mortgage loans were comprised of the following property types and geographic locations.
Other investments also include interests in limited partnerships of $278.5 million and $235.7 million at December 31, 2019 and December 31, 2018, respectively.
The carrying values of fixed maturity securities on non-accrual status at December 31, 2019 and 2018 were not material. The effects of non-accruals for the years ended December 31, 2019, 2018 and 2017, compared with amounts of net investment income that would have been recognized in accordance with the original terms of the fixed maturities were also not material.
The following table provides pre-tax net realized and unrealized gains (losses) on equity securities from continuing operations:
Included in the net realized and unrealized investment gains (losses) were OTTI of investment securities totaling $2.0 million, $4.6 million and $5.6 million in 2019, 2018 and 2017, respectively.
For 2019, total OTTI from continuing operations was $3.8 million. Of this amount, $2.0 million, which related to fixed maturity securities, was recognized in earnings and the remaining $1.8 million was recorded as unrealized losses in AOCI.
For 2017, total OTTI from continuing operations was $5.9 million. Of this amount, $5.6 million was recognized in earnings and the remaining $0.3 million was recorded as unrealized losses in AOCI. The $5.6 million of OTTI recognized in earnings relates to $2.0 million of other invested assets, $1.8 million of fixed maturity securities and $1.8 million of equities.
The following table provides rollforwards of the cumulative amounts related to the Company’s credit loss portion of the OTTI losses on fixed maturity securities from continuing operations for which the non-credit portion of the loss is included in other comprehensive income.
Asset-backed securities - overall credit quality, including assessments of the underlying collateral type such as credit card receivables, auto loan receivables and equipment lease receivables; geographic diversification; vintage year; historical collateral performance including delinquency, default and casualty trends; economic conditions influencing use rates and resale values; and contract structural support features.
Changes in the observability of valuation inputs may result in a reclassification of certain financial assets or liabilities within the fair value hierarchy. As previously discussed, the Company utilizes a third party pricing service for the valuation of the majority of its fixed maturities and equity securities. The pricing service has indicated that it will only produce an estimate of fair value if there is objectively verifiable information to produce a valuation. If the pricing service discontinues pricing an investment, the Company will use observable market data to the extent it is available, but may also be required to make assumptions for market based inputs that are unavailable due to market conditions.
The following tables provide, for each hierarchy level, the Company’s assets that were carried at fair value on a recurring basis.
During the year ended December 31, 2019, the Company did not transfer fixed maturities between Level 2 and Level 3. During the year ended December 31, 2018 the Company transferred fixed maturities between Level 2 and Level 3 primarily as a result of assessing the significance of unobservable inputs on the fair value measurement. There were no Level 3 liabilities held by the Company for years ended December 31, 2019 and 2018.
The Company has outstanding $175.0 million aggregate principal amount of 6.35% subordinated unsecured debentures due March 30, 2053. These debentures pay interest quarterly. The Company may redeem these debentures in whole at any time, or in part from time to time, on or after March 30, 2018, at a redemption price equal to their principal amount plus accrued and unpaid interest. In addition, the Company’s subordinated debentures maturing February 3, 2027 have a par value of $50.1 million as of December 31, 2019 and 2018 and pay cumulative dividends semi-annually at 8.207%.
On January 2, 2019, the Company repaid $125.0 million of its FHLB advances that were due 2029 and had an interest rate of 5.5%, along with related prepayment fees of $26 million; such fees were recognized in 2018. Membership in FHLB provides the Company with access to additional short-term liquidity based on the level of investment in FHLB stock and pledged collateral. Total holdings of FHLB stock were $2.1 million and $8.7 million at December 31, 2019 and 2018, respectively. At December 31, 2019, the Company had pledged government agency securities with a fair value of $94.0 million as collateral for periodic short-term borrowings with the FHLB. Additionally, at December 31, 2018, the Company had pledged government agency securities with a fair value of $234.9
million in support of the $125.0 million advance that was repaid on January 2, 2019, and for periodic short-term borrowings. There were no borrowings outstanding with the FHLB at December 31, 2019 or 2018.
As noted above, on June 14, 2019, the U.S. Department of the Treasury issued regulations that change the taxation of certain non-U.S. income. These regulations apply retroactively to January 1, 2018. As a result, the Company incurred additional federal income tax of $1.2 million from the 2018 sale of Chaucer. In accordance with ASC 740, the Company has recorded a provision for this amount as a component of income tax expense in continuing operations in its Consolidated Statements of Income for the year ended December 31, 2019.
The income tax expense attributable to the consolidated results of continuing operations is different from the amount determined by multiplying income from continuing operations before income taxes by the U.S. statutory federal income tax rate of 21% in both 2019 and 2018 and 35% in 2017. The sources of the difference and the tax effects of each were as follows:
In prior years, the Company completed several transactions which resulted in, for tax purposes only, realized gains in its investment portfolio. As a result of these transactions, the Company was able to utilize capital losses carried forward and to release the valuation allowance recorded against the deferred tax asset related to these losses. The releases of valuation allowances were recorded as a benefit in accumulated other comprehensive income. Previously unrealized benefits of $14.8 million, $9.2 million and $12.7 million, are recognized as part of income from continuing operations during 2019, 2018 and 2017, respectively. The remaining amount of $20.8 million in accumulated other comprehensive income will be released into income from continuing operations in future years, as the investment securities subject to these transactions are sold or mature.
There are no tax positions at December 31, 2019, 2018 and 2017 for which the ultimate deductibility is highly certain, but for which there is uncertainty about the timing of such deductibility. Because of the impact of deferred tax accounting, other than interest and penalties, a change in the timing of deductions would not impact the annual effective tax rate.
In 2020, the Company is expecting to release $0.4 million of liability due to the expiration of a statute of limitations.
The Company or its subsidiaries file income tax returns in the U.S. federal jurisdiction and various state jurisdictions, as well as foreign jurisdictions. The Company and its subsidiaries are subject to U.S. federal and state income tax examinations and foreign examinations for years after 2015.
In addition, the Act limited various existing deductions, such as executive compensation, and introduced new income taxes on certain low-taxed non-U.S. income. Under the Act, the exemption from the $1 million limitation on certain executive compensation has been eliminated. As a result, the Company recognized a provision of $0.2 million for the year ended December 31, 2017.
The Act modified the provisions applicable to the determination of the tax basis of unpaid loss reserves. These modifications impact the payment pattern and applicable interest rate. The Act instructed the Treasury Department to provide discount factors and other guidance necessary to determine the appropriate transition adjustment. Final discount factors were released in July 2019 and the transition adjustment has been determined to total $114.5 million, resulting in a deferred tax liability of $24.0 million. This transitional amount is taken into account ratably over eight years beginning in calendar year 2018. These provisions have no overall effect on total income tax expense for the years ended December 31, 2017, 2018 and 2019.
As of January 1, 2005, the defined benefit pension plans were frozen and since that date, no further cash balance allocations have been credited to participants. Participants’ accounts are credited with interest daily, based upon the General Agreement of Trades and Tariffs rate (the 30-year Treasury Bond interest rate). In addition, the grandfathered benefits for the transition group were also frozen at January 1, 2005 levels with an annual transition pension adjustment calculated at an interest rate equal to 5% per year up to 35 years of completed service, and 3% thereafter. As of December 31, 2019, based on current estimates of plan liabilities and other assumptions, the assets of the qualified defined benefit pension plan exceeded the projected benefit obligation by approximately $15.1 million.
The expected rates of return were determined by using historical mean returns for each asset class, adjusted for certain factors believed to have an impact on future returns. These returns are generally weighted to the plan’s actual asset allocation, and are net of administrative expenses. For the qualified defined benefit plan, the 2019 expected return on plan assets of 5.50% reflects long-term expectations and increased slightly based upon long-term market expectations and expense management efforts. The Company reviews and updates, at least annually, its expected return on plan assets based on changes in the actual assets held by the plan and market conditions.
For the qualified defined benefit plan, a target allocation approach is utilized, which focuses on creating a mix of assets that will generate modest growth from equity securities while minimizing volatility from changes in the markets and economic environment. Various factors are taken into consideration in determining the appropriate asset mix, such as census data, actuarial valuation information and capital market assumptions. Target allocations are reviewed and updated at least annually. Changes are made periodically. During 2019, the target allocations changed from a mix of 85% fixed maturities and 15% equity securities to a portfolio with 90% fixed maturities and 10% equity securities.
The following table presents, for each hierarchy level, the qualified defined benefit plan’s investment assets that are measured at fair value at December 31, 2019 and 2018. Refer to Note 5 - “Fair Value” for a description of the different levels in the Fair Value Hierarchy.
Securities classified as Level 1 at December 31, 2019 and 2018 include actively traded mutual funds and publicly traded securities, which are valued at quoted market prices. Securities classified as Level 3 at December 31, 2019 and 2018 include assets held in a fixed account of an insurance company. The fair value of the investment is estimated using a comparable public market financial institution derived fair value curve that uses non-observable inputs for market liquidity and unique credit characteristics of its underlying securities.
The following table reflects the benefit obligations, fair value of plan assets and funded status of the plans at December 31, 2019 and 2018.
The accumulated benefit obligation for these plans is equal to the projected benefit obligation.
The benefit payments are based on the same assumptions used to measure the Company’s benefit obligations at the end of 2019. Benefit payments related to the qualified plan will be made from plan assets held in trust and not included with Company assets, whereas those payments related to the non-qualified plan will be provided for by the Company.
On May 20, 2014, shareholders approved The Hanover Insurance Group 2014 Long-Term Incentive Plan (the “2014 Stock Plan”). With respect to new share-based award issuances, the 2014 Stock Plan replaced The Hanover Insurance Group, Inc. 2006 Long-Term Incentive Plan (the “2006 Stock Plan”) and authorized the issuance of 6,100,000 shares in a new share pool, plus any shares subject to outstanding awards under the 2006 Stock Plan that may become available for reissuance as a result of the cash settlement, forfeiture, expiration or cancellation of such awards. The 2014 Stock Plan provides for the granting of the same types of awards as the 2006 Stock Plan, including stock options and stock appreciation rights (“SARS”), restricted and unrestricted stock, stock units, performance and market-based stock awards and cash awards. In accordance with the 2014 Stock Plan, the issuance of one share of common stock in the form of an option or SAR will reduce the share pool by one share, whereas the issuance of one share of common stock for the other types of stock awards provided by the Plan will reduce the pool by 3.8 shares. As of December 31, 2019, there were 3,614,011 shares available for grants under the 2014 Stock Plan.
Compensation cost, excluding the discontinued operations related to the Chaucer business, for the years ended December 31, 2019, 2018 and 2017 totaled $17.4 million, $14.9 million and $10.5 million, respectively. Related tax benefits were $3.7 million, $3.1 million and $3.7 million, respectively. Compensation cost attributable to the Chaucer business, net of taxes, for the year ended December 31, 2017 totaled $1.2 million and was reflected in discontinued operations.
The weighted average grant date fair value of options granted during the years ended December 31, 2019, 2018 and 2017 was $18.12 , $16.30 and $13.05, respectively.
The expected dividend yield is based on the Company’s dividend payout rate(s), in the year noted, excluding the effect of any special dividends provided. Expected volatility is based generally on the Company’s historical daily stock price volatility. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The expected term of options granted represents the period of time that options are expected to be outstanding and is derived primarily using historical exercise, forfeit and cancellation behavior, along with certain other factors expected to differ from historical data.
The fair value of shares that vested during the years ended December 31, 2019 and 2018 was $9.5 million and $9.3 million, respectively. As of December 31, 2019, the Company had unrecognized compensation expense of $2.7 million related to unvested stock options that is expected to be recognized over a weighted average period of 1.4 years.
In 2019, market-based restricted stock units of 5,820 were included as granted due to completion levels in excess of 100% for units granted in both 2016 and 2017. The weighted average grant date fair value of these awards was $75.95. In 2018, market-based restricted stock units of 3,115 were included as granted due to completion levels in excess of 100% for units granted in 2015. The weighted average grant date fair value of these awards was $70.24. In 2017, market-based restricted stock units of 5,881 were included as granted due to completion levels in excess of 100% for units granted in 2014. The weighted average grant date fair value of these awards was $56.45.
At December 31, 2019, the aggregate intrinsic value of restricted stock units was $45.8 million and the weighted average remaining contractual life was 1.3 years. The aggregate intrinsic value of performance and market-based restricted stock units was $11.8 million and the weighted average remaining contractual life was 1.2 years. As of December 31, 2019, there was $22.9 million of total unrecognized compensation cost related to unvested restricted stock units and performance and market-based restricted stock units. The cost is expected to be recognized over a weighted average period of 1.8 years. Compensation cost associated with restricted stock, restricted stock units and performance and market-based restricted stock units is generally calculated based upon grant date fair value, which is determined using current market prices.
Diluted earnings per share during 2019, 2018 and 2017 excludes 0.2 million, 0.3 million and 0.4 million, respectively, of common shares issuable under the Company’s stock compensation plans, because their effect would be antidilutive.
Pursuant to Michigan’s statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the Michigan Insurance Commissioner, is limited to the greater of 10% of policyholders’ surplus as of December 31 of the immediately preceding year or the statutory net income less net realized gains, for the immediately preceding calendar year. Citizens declared dividends to its parent, Hanover Insurance, totaling $106.0 million, $87.9 million and $99.9 million in 2019, 2018 and 2017, respectively. Citizens cannot declare a further dividend to its parent without prior approval until December 2020, at which time the maximum dividend declared payable without prior approval would be $82.1 million.
The statutes in both New Hampshire and Michigan require that prior notice to the respective Insurance Commissioner of any proposed dividend be provided and such Commissioner may, in certain circumstances, prohibit the payment of the proposed dividend.
The Company’s primary business operations include insurance products and services provided through three operating segments: Commercial Lines, Personal Lines and Other. Commercial Lines includes commercial multiple peril, commercial automobile, workers’ compensation, and other commercial coverages, such as management and professional liability, marine, Hanover Programs, specialty industrial and commercial property, monoline general liability and surety. Personal Lines includes personal automobile, homeowners and other personal coverages. Included in the Other segment are Opus Investment Management, Inc., which markets investment management services to institutions, pension funds and other organizations; earnings on holding company assets; holding company and other expenses, including certain costs associated with retirement benefits due to the Company’s former life insurance employees and agents; and, a run-off property and casualty voluntary pools business. On December 28, 2018, the Company completed the sale of Chaucer to China Re, and the sales of the Chaucer-related Irish and Australian entities were subsequently completed on February 14, 2019 and April 10, 2019, respectively. Accordingly, as of December 31, 2018, and for all prior periods, Chaucer’s results of operations are classified as Discontinued Operations in the Consolidated Statements of Income and assets and liabilities related to the Chaucer business have been classified as held-for-sale in the Consolidated Balance Sheet at December 31, 2018 (see Note 2 - “Discontinued Operations”). Certain ongoing expenses have been reclassified from Chaucer to the other three operating segments. The separate financial information is presented consistent with the way results are regularly evaluated by the chief operating decision maker in deciding how to allocate resources and in assessing performance.
Management evaluates the results of the aforementioned segments based on operating income before taxes, excluding interest expense on debt. Operating income before taxes excludes certain items which are included in net income, such as net realized and unrealized investment gains (losses). Such gains and losses are excluded since they are determined by interest rates, financial markets and the timing of sales. Also, operating income before taxes excludes net gains and losses on disposals of businesses, gains and losses related to the repayment of debt, discontinued operations, costs to acquire businesses, restructuring costs, the cumulative effect of accounting changes and certain other items. Although the items excluded from operating income before taxes may be important components in understanding and assessing the Company’s overall financial performance, management believes that the presentation of operating income before taxes enhances an investor’s understanding of the Company’s results of operations by highlighting net income attributable to the core operations of the business. However, operating income before taxes should not be construed as a substitute for income before income taxes or income from continuing operations and operating income should not be construed as a substitute for net income.
See also Note 2 - “Discontinued Operations” for a discussion on the sale of the Chaucer business.
As a condition to conduct certain business in various states, the Company is required to participate in residual market mechanisms, facilities and pooling arrangements such as the Michigan Catastrophic Claims Association (“MCCA”). The Company is subject to concentration of risk with respect to reinsurance ceded to the MCCA. Funding for MCCA comes from assessments against automobile insurers based upon their share of insured automobiles in the state. Insurers are allowed to pass along this cost to Michigan automobile policyholders. The Company ceded to the MCCA premiums earned and losses and LAE incurred of $84.3 million and $108.5 million in 2019, $70.9 million and $108.8 million in 2018, and $62.8 million and $81.4 million in 2017. The MCCA represented 56.4% of the total reinsurance receivable balance at December 31, 2019. Reinsurance recoverables related to MCCA were $1,023.7 million and $977.1 million at December 31, 2019 and 2018, respectively. Because the MCCA is supported by assessments permitted by statute, and there have been no significant uncollectible balances from MCCA identified during the three years ending December 31, 2019, the Company believes that it has no significant exposure to uncollectible reinsurance balances from this entity.
The following table provides a summary of (favorable)/unfavorable loss and LAE reserve development.
For the following net reserve components, commercial multiple peril, workers’ compensation, commercial automobile liability, general liability and umbrella - occurrence, general liability - claims made, personal automobile liability and homeowners, the Company is presenting incurred claims development tables by accident year. The commercial multiple peril, workers’ compensation, commercial automobile liability, general liability and umbrella - occurrence lines presentation includes Hanover Programs business. In each of these tables, the Company is presenting the number of years for which claims are typically outstanding, which is consistent with the period at which substantially all of the reserve development has emerged based on past history. The tables presented below include cumulative incurred loss and allocated loss adjustment expenses (“ALAE”), cumulative paid loss and ALAE and IBNR balances at December 31, 2019. IBNR includes both incurred but not reported liabilities and expected development on reported claims. In addition, cumulative incurred claim counts are presented as of December 31, 2019 and claim duration is presented in a separate table disclosing the average annual percentage payout of incurred claims by age, net of reinsurance. Claim duration is calculated as an average of paid loss and ALAE divided by incurred loss and ALAE by elapsed year. The incurred claims development tables presented are reconciled to the net carried reserves in the preceding table as of December 31, 2019.
The minimum statutory capital and surplus necessary to satisfy the Company’s regulatory requirements was $531.8 million, $518.4 million and $500.7 million, which equals the Authorized Control Level at December 31, 2019, 2018 and 2017, respectively.
The quarterly results of operations for 2019 and 2018 are summarized below.
As a result of the sale of Chaucer (see Note 2 - “Discontinued Operations”), on December 30, 2018 the Board of Directors declared a special dividend of $4.75 per share.