We believe that our facilities are adequate for our present needs in all material respects.
Net income was $155.1 million in 2016, compared to $331.5 million in 2015. In 2016, net income was adversely affected by lower operating income driven by unfavorable development on prior years’ loss and loss adjustment expense (“LAE”) reserves, partially offset by lower catastrophe and current accident year losses. (See discussion below). Additionally, net income was adversely affected by prepayment charges of $56.0 million, net of tax, which we paid in the second quarter in connection with the redemption of $380.0 million in higher coupon debt following our issuance of $375.0 million of 4.50% senior debentures.
We are continuing efforts to improve our underwriting results in both our Commercial and Personal Lines, through rate increases and improvements to our mix of business. At Chaucer, we continued to experience significant competitive pressure on rates in 2016, which is expected to persist in 2017. In response to these challenging market conditions, we actively manage Chaucer’s underwriting portfolio, using our expertise, distinctive underwriting capabilities and market knowledge to target specific attractive underwriting opportunities.
We believe our 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. The small commercial and middle market businesses are 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, distinctive products, franchise value through limited distribution, and industry segmentation. Growth in our specialty lines continues to be an important part of our strategy.
We believe these efforts have driven, and will continue to drive, improvement in our overall mix of business and our underwriting profitability. Commercial Lines net premiums written grew by 3.5% in 2016, driven by both our core commercial and specialty businesses. This growth is primarily due to rate and exposure increases, strong retention and targeted new business expansion.
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). Approximately 83% of our policies in force are account business. We are focused on making investments that help maintain profitability, build a distinctive position in the market, help diversify us geographically from our largest historical core states of Michigan, Massachusetts and New York, and provide us with profitable growth opportunities.
Net premiums written grew by 5.2% in 2016, primarily due to increased rates in both the homeowners and personal automobile lines, as well as improved new business trends and higher retention. Underwriting results improved in 2016, as compared to 2015, primarily due to lower catastrophe losses and improved current accident year loss performance, partially offset by unfavorable development on prior years’ loss reserves and higher expenses. We continue to seek rate increases that keep pace with underlying loss cost trends, subject to regulatory and competitive considerations.
Chaucer deploys specialist underwriters in over 30 major insurance and reinsurance classes, including marine and aviation, property, energy, casualty and other coverages. We obtain business through Lloyd’s, the leading international insurance and reinsurance market, which provides us with access to specialist business in over 200 countries and territories worldwide through its international licenses, brand reputation and strong security rating. Our underwriting strength, diverse portfolio and Lloyd’s membership underpin our ability to actively manage the scale, composition and profitable development of this business.
Primary business operations include insurance products and services currently provided through four operating segments. Our domestic operating segments are Commercial Lines, Personal Lines, and Other. Our international operating segment is Chaucer. Commercial Lines includes commercial multiple peril, commercial automobile, workers’ compensation and other commercial coverages, such as inland marine, specialty program business, management and professional liability, surety and specialty property. Personal Lines includes personal automobile, homeowners and other personal coverages. Chaucer includes marine and aviation, property, energy, casualty and other coverages (which includes international liability, specialist liability coverages, and syndicate participations) and, prior to June 30, 2015, U.K. motor. Effective June 30, 2015, we transferred our U.K. motor business to an unaffiliated U.K.-based insurance provider. Accordingly, results from the Chaucer segment no longer include this business subsequent to June 30, 2015. Included in the “Other” segment are Opus Investment Management, Inc., which markets investment management services to institutions, pension funds and other organizations; earnings on holding company assets; and, a discontinued voluntary pools business. We present the separate financial information of each segment consistent with the manner in which our chief operating decision maker evaluates results in deciding how to allocate resources and in assessing performance.
Consolidated net income was $155.1 million in 2016, compared to $331.5 million in 2015. The decrease of $176.4 million is primarily due to lower operating income of $95.6 million, principally from $105.4 million of unfavorable development on prior years’ loss reserves, or approximately 2% of total net reserves (including development on catastrophe losses), partially offset by lower catastrophe losses and current accident year losses. Consolidated net income for the year ended December 31, 2016 also included net losses from the repayment of debt of $57.4 million, net of tax, compared to $15.7 million, net of tax, for the year ended December 31, 2015. Additionally, the year ended December 31, 2015, included after-tax gains of $40.6 million from the disposal of the U.K. motor business.
Operating income before interest expense and income taxes was $322.8 million for the year ended December 31, 2016, compared to $466.1 million for the year ended December 31, 2015, a decrease of $143.3 million. This decrease was primarily due to higher unfavorable prior years’ loss reserve development, partially offset by lower catastrophe and current accident year losses. Unfavorable development on prior years’ loss reserves was $140.3 million for the year ended December 31, 2016, compared to favorable development of $94.3 million for the year ended December 31, 2015, a change of $234.6 million. Catastrophe-related activity for the year ended December 31, 2016 was $125.1 million, compared to $181.3 million for the year ended December 31, 2015, a decrease of $56.2 million. Lower current accident year losses in our domestic segment were partially offset by higher losses in our Chaucer segment.
Operating income before interest expense and income taxes was $466.1 million for the year ended December 31, 2015, compared to $406.8 million for the year ended December 31, 2014, an increase of $59.3 million. This increase was due primarily to lower catastrophe losses, a lower expense ratio and higher net investment income, partially offset by higher large loss activity in the Chaucer segment and lower favorable development on prior years’ loss reserves.
Favorable development on prior years’ loss reserves was $94.3 million for the year ended December 31, 2015, compared to $99.1 million for the year ended December 31, 2014, a decrease of $4.8 million.
Most of Chaucer’s transactions are denominated in the currencies that we use to settle transactions with Lloyd’s, specifically the U.S. Dollar, the U.K. Pound Sterling (“GBP”) and the Canadian Dollar. These are Chaucer’s functional currencies under U.S. GAAP. A portion of Chaucer’s transactions and its assets and liabilities are denominated in other currencies, such as the Euro, the Swiss Franc, the Australian Dollar and the Japanese Yen. Changes in the value of these currencies versus the functional currencies, particularly versus the GBP, cause transactional gains and losses during each reporting period. During 2016, the GBP weakened meaningfully against most currencies. We believe that this was due, in large part, to the effect of the U.K’s referendum vote to discontinue its membership in the European Union (“Brexit Referendum”). In contrast, during 2015 and 2014, the GBP strengthened against most currencies. The following table summarizes the total effect of Chaucer’s foreign exchange transactional gains and losses on comprehensive income:
During 2016, foreign exchange losses reduced pre-tax operating income by approximately $22.0 million compared to foreign exchange gains on pre-tax operating income of approximately $11.7 million and $4.3 million in 2015 and 2014, respectively. This was due primarily to the revaluation of loss and LAE reserves in various currencies, particularly the Euro, the Australian Dollar and the Japanese Yen, partially offset by the revaluation of investments in overseas deposits and cash. In addition, during 2016, pre-tax unrealized foreign exchange gains from Euro-denominated investment securities were $8.3 million, which was reflected as an increase to accumulated other comprehensive income. During 2015 and 2014 the pre-tax unrealized foreign exchange impact from Euro-denominated investment securities was a loss of $1.2 million and $4.7 million, respectively.
The following table summarizes GAAP underwriting results for the Commercial Lines, Personal Lines, Chaucer and Other segments and reconciles it to operating income (loss) before interest expense and income taxes.
Commercial Lines current accident year underwriting profit, excluding catastrophes, was $171.1 million for the year ended December 31, 2016, compared to $121.2 million for the year ended December 31, 2015. This $49.9 million improvement was primarily due to improved current accident year loss performance, primarily due to property coverages in our commercial multiple peril and inland marine lines, premium growth and lower expenses.
Net premiums written in the personal automobile line of business for the year ended December 31, 2016 were $953.6 million, compared to $900.0 million for the year ended December 31, 2015, an increase of $53.6 million. This increase was primarily due to rate increases, as well as an increase in policies in force of 1.4%. Net premiums written in the homeowners line of business for the year ended December 31, 2016 were $529.7 million, compared to $507.4 million for the year ended December 31, 2015, an increase of $22.3 million. This is attributable to rate increases, as well as an increase in policies in force of 1.8%.
Personal Lines underwriting profit for the year ended December 31, 2016 was $103.8 million, compared to $72.0 million for the year ended December 31, 2015, an improvement of $31.8 million. Catastrophe losses for the year ended December 31, 2016 were $47.0 million, compared to $75.8 million for the year ended December 31, 2015, a decrease of $28.8 million. Unfavorable development on prior years’ loss reserves for the year ended December 31, 2016 was $4.3 million, compared to favorable prior year development of $19.7 million for the year ended December 31, 2015, a decline of $24.0 million.
Personal Lines current accident year underwriting profit, excluding catastrophes, was $155.1 million in the year ended December 31, 2016, compared to $128.1 million for the year ended December 31, 2015. This $27.0 million increase was primarily a result of lower weather-related property losses, primarily in our homeowners line of business, as well as rate increases.
Chaucer’s net premiums written were $816.1 million for the year ended December 31, 2016, compared to $889.3 million for the year ended December 31, 2015. This decline of $73.2 million was primarily due to a planned increase in ceded reinsurance premiums as we manage our overall underwriting risk given the challenging market conditions, as well as from lower premium volumes in our energy line where underwriting conditions continued to reflect the effects of low oil prices, and in our aviation line, partially offset by growth in our marine and casualty lines.
We continue to experience significant competition across the international insurance industry. Current pricing conditions in all markets continue to be affected by high industry capacity and competition, and a continued absence of major losses in our markets. There can be no assurance that we will be able to maintain adequate rates in light of economic conditions in our markets. Additionally, because of the inherently volatile nature of losses in many of our product lines, we may continue to experience large losses or an elevated level of losses from these or other product lines.
Other operating losses were $18.3 million for the year ended December 31, 2016, compared to $10.2 million for the year ended December 31, 2015, an increase of $8.1 million primarily due to unfavorable prior year reserve development in our run-off voluntary pools business.
Commercial Lines underwriting loss for the year ended December 31, 2015 was $12.7 million, compared to $8.3 million for the year ended December 31, 2014, a decline of $4.4 million. Unfavorable development on prior years’ loss reserves for the year ended December 31, 2015 was $45.2 million, compared to $9.2 million for the year ended December 31, 2014, an increase of $36.0 million. Catastrophe-related losses increased slightly for the year ended December 31 2015 at $88.7 million, compared to $87.8 million for the year ended December 31, 2014. Unfavorable prior year development was due to higher than expected losses in other commercial lines of $53.7 million, which includes our AIX program business. This was principally driven by losses in accident years 2013 and prior, primarily from programs which have since been terminated and from higher than expected losses in our general liability lines, partially offset by favorable development in our commercial umbrella and healthcare lines, also included in other commercial lines. We also experienced unfavorable prior year development in our commercial automobile line of $23.4 million. These items were partially offset by favorable prior year development in our workers’ compensation line of $46.9 million.
Commercial Lines current accident year underwriting profit, excluding catastrophes, was $121.2 million for the year ended December 31, 2015, compared to $88.7 million for the year ended December 31, 2014. This $32.5 million improvement was primarily due to growth in earned premium, underwriting expense efficiencies, and improved loss performance in all major lines of business that resulted from our pricing and underwriting actions.
Net premiums written in the personal automobile line of business for the year ended December 31, 2015 were $900.0 million compared to $884.1 million for the year ended December 31, 2014, an increase of $15.9 million. This increase was primarily due to rate increases, partially offset by a decline in policies in force of 3.2%. Net premiums written in the homeowners line of business for the year ended December 31, 2015 were $507.4 million, compared to $499.0 million for the year ended December 31, 2014, an increase of $8.4 million. This is attributable to rate increases which offset a decline in policies in force of 1.9%.
Personal Lines underwriting profit for the year ended December 31, 2015 was $72.0 million, compared to $22.1 million for the year ended December 31, 2014, an improvement of $49.9 million. Catastrophe losses for the year ended December 31, 2015 were $75.8 million, compared to $106.4 million for the year ended December 31, 2014, a decrease of $30.6 million. Favorable development on prior years’ loss reserves for the year ended December 31, 2015 was $19.7 million, compared to $5.1 million for the year ended December 31, 2014, an increase of $14.6 million, primarily from the homeowners line.
Chaucer’s underwriting profit for the year ended December 31, 2015 was $131.5 million, compared to $122.5 million for the year ended December 31, 2014, an increase of $9.0 million. This increase is primarily due to higher favorable development on prior years’ loss reserves, lower catastrophe losses and lower expenses, partially offset by higher large loss activity in the energy line. Favorable development on prior years’ loss reserves for the year ended December 31, 2015 was $120.1 million, compared to $104.6 million for the year ended December 31, 2014, an increase of $15.5 million. Catastrophe losses for the year ended December 31, 2015 were $16.8 million, compared to $28.8 million for the year ended December 31, 2014, a decrease of $12.0 million.
Other operating losses were $10.2 million for the year ended December 31, 2015, compared to $9.7 million for the year ended December 31, 2014, an increase of $0.5 million.
We regularly review our loss reserves using a variety of industry accepted analytical techniques. We update the loss reserves as historical loss experience develops, additional claims are reported and resolved and new information becomes available. Net changes in loss reserves are reflected in operating results in the period in which the reserves are changed.
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 52% of our aggregate net loss reserves at December 31, 2016 were for IBNR losses and loss expenses.
We regularly update our reserve estimates as new information becomes available and additional events occur which may impact the resolution of unsettled claims. Reserve adjustments are reflected in the results of operations as adjustments to losses and LAE. Often, these adjustments are recognized in periods subsequent to the period in which the underlying policy was written and the loss event occurred. When these types of subsequent adjustments affect prior years, they are described separately as “prior year reserve development”. Such development can be either favorable or unfavorable to our financial results and may vary by line of business. As discussed below, estimated loss and LAE reserves for claims occurring in prior years developed unfavorably by $140.3 million for the year ended December 31, 2016, and developed favorably by $94.3 million, and $99.1 million for the years ended December 31, 2015, and 2014, respectively. Additionally, our estimated loss and LAE reserves for catastrophe claims occurring in prior years developed favorably by $34.9 million, $21.8 million and $18.3 million for the years ended December 31, 2016, 2015 and 2014, respectively. However, there can be no assurance that current loss and LAE reserves will be sufficient.
We regularly review our reserving techniques, our overall reserving position and our reinsurance. Based on (i) our review of historical data, legislative enactments, judicial decisions, legal developments in impositions of damages and policy coverage, political attitudes and trends in general economic conditions, (ii) our review of per claim information, (iii) our historical loss experience and that of the industry, (iv) the nature of policies written by us, and (v) our internal estimates of required reserves, we believe that adequate provision has been made for loss reserves. However, establishment of appropriate reserves is an inherently uncertain process, and there can be no certainty that current established reserves will prove adequate in light of subsequent actual experience. A significant change to the estimated reserves could have a material impact on our results of operations and financial position. An increase or decrease in reserve estimates would result in a corresponding decrease or increase in financial results. For example, each one percentage point change in the aggregate loss and LAE ratio resulting from a change in reserve estimation is currently projected to have an approximate $46 million impact on operating income, based on 2016 full year premiums.
Most of our indirect business from discontinued voluntary and involuntary pools is long-tailed casualty reinsurance. Reserve estimates for this business are therefore subject to the variability caused by extended loss emergence periods. The estimation of loss reserves for this business is further complicated by delays between the time the claim is reported to the ceding insurer and when it is reported by the ceding insurer to the pool manager and then to us, and by our dependence on the quality and consistency of the loss reporting by the ceding company and actuarial estimates by the pool manager.
A review of loss reserves for each of the classes of business which we write is conducted regularly, generally quarterly. This review process takes into consideration a variety of trends that impact the ultimate settlement of claims. Where appropriate, the review includes a review of overall payment patterns and the emergence of paid and reported losses relative to expectations.
For most classes of shorter-tailed business in our Commercial and Personal Lines segments, the emergence of paid and incurred losses generally exhibits a relatively stable pattern of loss development from one accident year to the next. Thus, for these classes, the loss development factor method is generally appropriate. For many of the classes of shorter-tailed business in our Chaucer segment, the emergence of paid and incurred losses may exhibit a relatively volatile pattern of loss development from one accident year to the next. In certain cases where there is a relatively low level of reliability placed on the available paid and incurred loss data, expected loss methods or adjusted loss methods are considered appropriate for the most recent accident year.
The estimation of claims and claims expense reserves for catastrophes also comprises estimates of losses from reported claims and IBNR, primarily for damage to property. In general, our estimates for catastrophe reserves are determined on an event basis by considering various sources of available information, including specific loss estimates reported to us based on claim adjuster inspections, overall industry loss estimates, and our internal data regarding exposures related to the geographical location of the event. However, depending on the nature of the catastrophe, the estimation process can be further complicated by other impediments. For example, for hurricanes and other severe wind storms, complications often include the inability of insureds to promptly report losses, delays in the ability of claims adjusting staff to inspect losses, difficulties in determining whether losses are covered by our homeowners policy (generally for damage caused by wind or wind driven rain) or are specifically excluded from coverage caused by flood, and challenges in estimating additional living expenses, assessing the impact of demand surge, exposure to mold damage, and the effects of numerous other considerations. Another example is the complication of estimating the cost of business interruption coverage on commercial lines policies. Estimates for catastrophes which occur at or near the end of a financial reporting period may be even less reliable since we will have less claims data available and little time to complete our estimation process. In such situations, we may adapt our practices to accommodate the circumstances.
Personal and Commercial Automobile Bodily Injury - reserves recorded for bodily injury on U.S. voluntary business were $595.8 million as of December 31, 2016. A key assumption for bodily injury is the inflation rate underlying the estimated reserve. A five point change (e.g., 4% changed to 9% or -1%) in the embedded inflation rate would have changed total reserves by approximately $53 million, either positive or negative, respectively, at December 31, 2016.
Monoline and Multiple Peril General Liability - reserves recorded for monoline and multiple peril general liability on U.S. voluntary business were $672.0 million as of December 31, 2016. A key assumption for monoline and multiple peril general liability is the implied adequacy of the underlying case reserves. A ten point change in case adequacy (e.g., 10% deficiency changed to 0% or 20% deficiency) would have changed total reserves by approximately $63 million, either positive or negative, at December 31, 2016.
Trade Credit Coverages - Chaucer has experienced losses in its trade credit coverages within the marine line primarily attributable to the worldwide drop in commodity prices in 2016. Claims reserves for these losses as of December 31, 2016 were $21 million. If Chaucer were to experience another 10 individual claims, at the same average cost of the 28 notified to date, and were to not make any subrogation type recoveries (on existing or the new claims) then this would have increased total reserves by approximately $21 million at December 31, 2016.
Within other commercial lines in the table above, general liability is comprised of both monoline general liability and certain management and professional liability coverages, and other lines is primarily comprised of lawyers professional liability, fidelity, marine, miscellaneous property, and healthcare lines. Loss and LAE reserve development in our Other Segment is related to our run-off voluntary assumed reinsurance pools business. Also included in the above table, primarily in other lines, are $61.0 million, $57.7 million and $60.6 million of asbestos and environmental reserves as of December 31, 2016, 2015 and 2014, respectively. Included in the Chaucer segment in the above table are $117.0 million, $166.0 million and $203.3 million of reserves as of December 31, 2016, 2015 and 2014, respectively, related to Chaucer’s financial and professional liability lines written in 2008 and prior periods.
As a result of our 2016 fourth quarter reserve review of domestic lines of business, as discussed further below, carried domestic reserves for prior accident years, excluding catastrophes, were increased by $174.1 million in the fourth quarter, of which $161.5 million related to Commercial Lines. The majority of this adjustment is attributed to our long-tailed commercial liability coverages, including our AIX program business. In general, higher than expected loss and LAE emergence in 2016 led us to adjust our reserve assumptions in our fourth quarter reserve review and place greater weight on the adverse severity trends experienced in the most recent calendar years.
In 2016, net unfavorable loss and LAE development was $140.3 million, primarily as a result of net unfavorable development of $223.0 million for Commercial Lines, partially offset by favorable development of $95.3 million for Chaucer. The net unfavorable Commercial Lines development primarily resulted from higher than expected losses in other commercial lines of $168.0 million, which includes the AIX program business. This was primarily driven by AIX programs and business classes which have since been terminated or substantially revised, general liability coverages in accident years 2012 through 2015, and surety bonds in accident years 2012 through 2015. We also experienced higher than expected losses within the commercial multiple peril line of $74.2 million for accident years 2012 through 2015 and the commercial automobile line of $27.5 million in accident years 2012 through 2014, both primarily within liability coverages. Partially offsetting the unfavorable development was lower than expected losses of $46.7 million within the workers’ compensation line, primarily related to accident years 2013 through 2015, and, to a lesser extent, our commercial umbrella line related to accident year 2015.
In 2015, net favorable loss and LAE development was $94.3 million, primarily as a result of favorable development of $120.1 million for Chaucer, partially offset by net unfavorable development of $45.2 million for Commercial Lines. As a result of our year-end 2015 reserve review of domestic commercial and personal lines of business, carried reserves were adjusted among several of these lines of business, impacting the prior year development by line, although these adjustments had no impact on aggregate domestic carried reserves.
As a result of our fourth quarter reserve review, we recognized unfavorable prior year reserve development of $174.1 million for our domestic business excluding catastrophes, largely driven by adverse emergence in most Commercial Lines liability coverages reflecting worsening trends in the number and nature of high severity losses and higher than anticipated legal defense costs. We reacted to this adverse emergence by updating our assumptions about loss severity, loss development patterns, expected loss ratios and loss adjustment expenses for the most recent accident years, placing greater weight on the adverse severity trends experienced in the most recent calendar years. The adverse development in our AIX program business was primarily due to the general liability and commercial automobile liability coverages in the 2011 through 2014 accident years. Additionally, we recognized adverse development in our general liability and commercial multiple peril coverages primarily in accident years 2012 through 2015, contract surety business primarily related to the 2012 through 2015 accident years, and commercial automobile line primarily related to liability coverages for accident years 2012 through 2014. These increases in Commercial Lines reserves were partially offset by favorable development in our workers’ compensation line, primarily in the 2013 through 2015 accident years and, to a lesser extent, our commercial umbrella coverage in the 2015 accident year. The adverse prior year reserve development for personal lines was primarily due to higher than expected losses in our bodily injury coverage in accident years 2013 through 2015. The adverse prior year development for our Other segment was due to our run-off voluntary assumed reinsurance pools business. The reserve increase was based on an updated third-party actuarial study received in the fourth quarter for the Excess and Casualty Reinsurance Association (“ECRA”) pool that primarily consists of asbestos and environmental exposures.
Although we attempt to limit our exposures to asbestos and environmental damage liability through specific policy exclusions, we have been and may continue to be subject to claims related to these exposures. Ending loss and LAE reserves for all direct business written by our property and casualty companies related to asbestos and environmental damage liability were $9.9 million, $9.5 million and $10.1 million, net of reinsurance of $19.9 million, $20.5 million, and $21.4 million for the years ended December 31, 2016, 2015 and 2014, respectively.
Activity for our asbestos and environmental reserves was not significant to our 2016, 2015 or 2014 financial results. In recent years, average asbestos and environmental payments have declined modestly. As a result of our historical direct underwriting mix of Commercial Lines policies toward smaller and middle market risks, past asbestos and environmental damage liability loss experience has remained minimal in relation to our total loss and LAE incurred experience.
Catastrophe reinsurance serves to protect us, as the ceding insurer, from significant losses arising from a single event including, among others, hurricanes, tornadoes and other windstorms, earthquakes, hail, severe winter weather, fire, explosions, and terrorism. Although we believe our catastrophe reinsurance program, including our retention and co-participation amounts for 2017, are appropriate given our surplus level and the current reinsurance pricing environment, there can be no assurance that our reinsurance program will provide coverage levels that will prove adequate should we experience losses from one significant or several large catastrophes during 2017. Additionally, as a result of the current economic environment, as well as losses incurred by reinsurers in the past several years, the availability and pricing of appropriate reinsurance programs may be adversely affected in future renewal periods. We may not be able to pass these costs on to policyholders in the form of higher premiums or assessments.
Total cash and investments increased $439.9 million, or 5.3%, for the year ended December 31, 2016 primarily due to positive operational cashflows and market value appreciation, partially offset by funding various financing activities, including stock repurchases and debt repayments.
The increase in net unrealized gains on fixed maturities was primarily due to narrower corporate credit spreads in 2016.
Based on ratings by the National Association of Insurance Commissioners (“NAIC”), approximately 94% of the fixed maturity portfolio consisted of investment grade securities at December 31, 2016 and December 31, 2015. The quality of our fixed maturity portfolio remains strong based on ratings, capital structure position, support through guarantees, underlying security, issuer diversification and yield curve position.
Our investment portfolio primarily consists of fixed maturity securities whose fair value is susceptible to market risk, specifically interest rate changes. Duration is a measurement used to quantify our inherent interest rate risk and analyze invested assets relative to our reserve liabilities.
Our fixed maturity portfolio remains well laddered with a weighted average duration of 4.5 years, which is within our target range of 1 to 2 times the duration of our insurance liabilities.
Our fixed maturity and equity securities are classified as available-for-sale and are carried at fair value. Financial instruments whose value was determined using significant management judgment or estimation constituted less than 1% of the total assets we measured at fair value. See also Note 5 - “Fair Value” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
Other investments consisted primarily of participations in commercial mortgage loan obligations, investments in private equity limited partnerships and overseas deposits. Commercial mortgage loan participations represent our interest in commercial mortgage loans originated by a third-party. We share, on a pro-rata basis, in all related cash flows of the underlying mortgage loans, which are investment-grade quality and diversified by geographic area and property type. Our investments in limited partnerships include interests in middle market private credit, mezzanine and buyout funds. Overseas deposits are foreign and U.S. dollar-denominated investments maintained in overseas funds and managed exclusively by Lloyd’s. These funds are required in order to protect policyholders in overseas markets and enable Chaucer to operate in those markets. Access to those funds is restricted, and we have no control over the investment strategy.
The following table provides information about our fixed maturities and equity securities that were in an unrealized loss position including the length of time the securities have been in an unrealized loss position. See also Note 3 - “Investments” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
Gross unrealized losses on fixed maturities and equity securities decreased $39.5 million compared to December 31, 2015, primarily attributable to narrower credit spreads. At December 31, 2016, gross unrealized losses consisted primarily of $49.0 million of corporate fixed maturities, $13.6 million of residential mortgage-backed securities and $9.2 million on municipal securities.
The carrying values of fixed maturity securities on non-accrual status at December 31, 2016 and 2015 were not material. The effects of non-accruals compared with amounts that would have been recognized in accordance with the original terms of the fixed maturities, were reductions in net investment income of $1.1 million, $0.8 million and $2.1 million for the years ended December 31, 2016, 2015 and 2014, respectively. Any defaults in the fixed maturities portfolio in future periods may negatively affect investment income.
Our investment portfolio and shareholders’ equity can be significantly impacted by changes in market values of our securities. Market volatility could increase and defaults on fixed income securities could occur. As a result, we could incur additional realized and unrealized losses in future periods, which could have a material adverse impact on our results of operations and/or financial position.
Monetary policies in the developed economies, particularly in the United States, Europe and Japan, are supportive of moderate economic growth, while fiscal policies are more divergent and subject to change. Major central banks continue to closely monitor developments in global financial markets and the outlook for growth and are committed to adjust monetary policy as required to provide liquidity funding, support growth and achieve inflation targets. In the United States, the Federal Reserve (the “Fed”) increased its target for the federal funds rate by 0.25% in December and raised its range to 0.50% to 0.75%. The Fed expects that labor market conditions will strengthen further and inflation will rise to 2 percent over the medium term. The Fed has communicated that the timing and size of future adjustments to the federal funds rate will depend on the realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. Based on the Fed’s December 2016 economic projections, the federal funds target rate may be increased by 0.25% two or three times during 2017. While the Fed believes near-term risks to the economic outlook appear roughly balanced, they continue to closely monitor inflation indicators and global economic and financial developments.
While the United States has reduced its extraordinary measures and begun to tighten monetary policy, other major central banks continue with their stimulus policies as they seek higher growth and confront inflation and inflation expectations running below target. The removal, modification or suggestion of changes in these policies could have an adverse effect on prevailing market interest rates and on issuers’ level of business activity or liquidity, increasing the probability of future defaults. Fundamental conditions in the corporate sector generally remain sound. Operating conditions for metals and mining and oil and gas producers remain challenged, but improvement in supply/demand fundamentals has recently provided greater stability. 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, other than those previously cited, 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.
Operations are subject to risk resulting from interest rate fluctuations, which may adversely impact the valuation of the investment portfolio. In a rising interest rate environment, the value of the fixed maturity sector, which comprises 84% of our investment portfolio, may decline as a result of decreases in the fair value of the securities. Our intent is to hold securities to maturity and recover the decline in valuation as prices accrete to par. However, our intent may change prior to maturity due to changes in the financial markets, our analysis of an issuer’s credit metrics and prospects, or as a result of changes in cash flow needs. Interest rate fluctuations may also reduce net investment income and as a result, profitability. The portfolio may realize lower yields and therefore lower net investment income on securities because the securities with prepayment and call features may prepay at a different rate than originally projected. Also, funds may not be available to invest at higher interest rates.
The following table illustrates the estimated impact on the fair value of our fixed maturity portfolio at December 31, 2016 and 2015 of hypothetical changes in prevailing interest rates, defined as changes in interest rates on U.S. Treasury debt. It does not reflect changes in credit spreads, liquidity spreads and other factors that affect the value of securities. Since changes in prevailing interest rates are often accompanied by changes in these other factors, the reader should not assume that an actual change in interest rates would result in the values illustrated.
Our equity securities portfolio is exposed to equity price risk arising from potential volatility in equity market prices. Portfolio characteristics are analyzed regularly and price risk is actively managed through a variety of techniques. A hypothetical increase or decrease of 10% in the market price of our equity securities would have resulted in an increase or decrease in the fair value of the equity securities portfolio of approximately $58 million at December 31, 2016 and 2015, respectively.
We are subject to the tax laws and regulations of the U.S. and foreign countries in which we operate. We file a consolidated U.S. federal income tax return that includes the holding company and its U.S. subsidiaries. Generally, taxes are accrued at the U.S. statutory tax rate of 35% for income from the U.S. operations. Our primary non-U.S. jurisdiction is in the U.K. In July 2013, the U.K. statutory tax rate decreased from 23% to 21% effective April 1, 2014 and from 21% to 20% effective April 1, 2015. In November 2015, the U.K. statutory tax rate decreased from 20% to 19% effective April 1, 2017 and from 19% to 18% effective April 1, 2020 respectively. A further decrease in the U.K. tax rate was enacted in September 2016 to reduce the U.K. statutory rate from 19% to 17% rather than to the previously enacted rate of 18%, effective April 1, 2020. We accrue taxes on certain non-U.S. income that is subject to U.S. tax at the U.S. tax rate. Foreign tax credits, where available, are utilized to offset U.S. tax as permitted. Certain of our non-U.S. income is not subject to U.S. tax until repatriated. Foreign taxes on this non-U.S. income are accrued at the local foreign rate and do not have an accrual for U.S. deferred taxes since these earnings are intended to be indefinitely reinvested overseas.
The provision for income taxes from continuing operations was an expense of $36.2 million, $108.6 million and $95.7 million in 2016, 2015 and 2014, respectively. These amounts resulted in consolidated effective tax rates of 18.8%, 24.7% and 25.3% on pre-tax income for 2016, 2015 and 2014, respectively. These provisions reflect benefits related to tax planning strategies implemented in prior years of $20.7 million, $13.3 million and $16.2 million in 2016, 2015 and 2014, respectively. The provision for 2015 reflects a $15.6 million tax savings, net of a $1.7 million provision for uncertain tax positions, on the transfer of the U.K. motor business. The transfer of the U.K. motor business was structured as a tax-free reorganization exempt from current U.S. and U.K. taxation under the business exemption and substantial shareholdings exemption rules, respectively. Since the proceeds from this transaction are expected to be indefinitely reinvested overseas, U.S. taxes have not been recognized. The provision for 2014 also included a benefit related to the reduction of a valuation allowance of $2.9 million, and a $6.9 million benefit related to foreign exchange loss deductions on our 2013 and 2014 U.S. tax returns. Absent these benefits, the provision for income taxes for 2016, 2015, and 2014 would have been expenses of $56.9 million, or 29.6%, $137.5 million, or 31.3%, and $121.7 million, or 32.2%, respectively. The decrease in the 2016 effective tax rate is primarily due to lower underwriting income. The decrease in the 2015 effective tax rate is primarily due to an increase in our recognition of foreign tax credits for taxes paid in certain foreign jurisdictions.
Included in our deferred tax net asset as of December 31, 2016 are assets of $72.3 million related to alternative minimum tax (“AMT”) credit carryforwards and $22.3 million related to foreign tax credit carryforwards. We may utilize these credits to offset future taxable income. The result of their utilization will be a lower current tax rate offset by a higher deferred tax provision, and also lower cash expenditures for federal income taxes during the utilization period. There is no expiration on AMT credit carryforwards, and our foreign tax credit carryforwards will expire in 2026. It is our opinion that there will be sufficient future U.S. and U.K. taxable income to utilize these tax credit carryforwards. Our estimate of the amount and likely realization of tax credit carryforwards may change over time.
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 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 $20.7 million, $13.3 million and $16.2 million attributable to non-operating income, are recognized as part of our income from continuing operations during 2016, 2015 and 2014, respectively. The remaining amount of $57.5 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.
Reinsurance recoverables recorded on insurance losses ceded under reinsurance contracts are subject to judgments and uncertainties similar to those involved in estimating gross loss reserves, as disclosed above. In addition to these uncertainties, our reinsurance recoverables may prove uncollectible if the reinsurers are unable or unwilling to perform under the reinsurance contracts. In establishing our reinsurance allowance for amounts deemed uncollectible, we evaluate the financial condition of our reinsurers and monitor concentration of credit risk arising from our exposure to individual reinsurers. To determine if an allowance is necessary, we consider, among other factors, published financial information, reports from rating agencies, payment history, collateral held and our legal right to offset balances recoverable against balances we may owe. Our reinsurance allowance for doubtful accounts is subject to uncertainty and volatility due to the time lag involved in collecting amounts recoverable from reinsurers. Over the period of time that losses occur, reinsurers are billed and amounts are ultimately collected, economic conditions, as well as the operational and financial performance of particular reinsurers, may change, and these changes may affect the reinsurers’ willingness and ability to meet their contractual obligation to us. It is also difficult to fully evaluate the impact of major catastrophic events on the financial stability of reinsurers, as well as the access to capital that reinsurers may have when such events occur. The ceding of insurance does not legally discharge us from our primary liability for the full amount of the policies, and we will be required to pay the loss and bear collection risk even if the reinsurers fail to meet their obligations under the reinsurance contracts.
Two significant assumptions used in the determination of benefit plan obligations and expenses that are dependent on market factors, which have been subject to a greater level of volatility over the past few years, are the discount rate and the return on plan asset assumptions. The discount rate enables us to state expected future cash flows as a present value on the measurement date. We also use this discount rate in the determination of our pre-tax pension expense or benefit. A lower discount rate increases the present value of benefit obligations and increases pension expense. We determined our discount rate for the domestic and Chaucer plans utilizing independent yield curves which provide for a portfolio of high quality bonds that are expected to match the cash flows of our pension plans. Bond information used in the yield curve included only those rated Aa or better as of December 31, 2016 and 2015, respectively, and had been rated by at least two well-known rating agencies. The following provides the discount rates for our qualified pension plan and Chaucer plan for the periods indicated.
To determine the expected long-term return on plan assets, we generally consider historical mean returns by asset class for passive indexed strategies, as well as current and expected asset allocations, and adjust for certain factors that we believe will have an impact on future returns. Actual returns on plan assets in any given year seldom result in the achievement of the expected rate of return on assets. Actual returns on plan assets in excess of these expected returns will generally reduce our net actuarial losses (or increase actuarial gains) that are reflected in the accumulated other comprehensive income balance in shareholders’ equity, whereas actual returns on plan assets that are less than expected returns will generally increase our net actuarial losses (or decrease actuarial gains) that are reflected in accumulated other comprehensive income. These gains or losses are amortized into expense in future years. The U.S. qualified plan held assets consisting of approximately 85% fixed maturities and 15% equities at December 31, 2016. The composition of Chaucer’s plan assets are approximately 55% equities, 35% fixed maturities, and 10% real estate funds at December 31, 2016.
The increase in returns for the U.S. plan reflects long-term expectations for improvements, including increased interest rates, in the fixed maturities market in general.
When an OTTI of a fixed maturity security occurs, and we intend to sell or more likely than not will be required to sell the investment before recovery of its amortized cost basis, the amortized cost of the security is reduced to its fair value, with a corresponding charge to earnings, which reduces net income and earnings per share. If we do not intend to sell the fixed maturity investment or more likely than not will not be required to sell it, we separate the OTTI into the amount we estimate represents the credit loss and the amount related to all other factors. The amount of the estimated loss attributable to credit is recognized in earnings, which reduces net income and earnings per share. The amount of the estimated OTTI that is non-credit related is recognized in other comprehensive income, net of applicable taxes.
We estimate the amount of the OTTI that relates to credit by comparing the amortized cost of the fixed maturity security with the net present value of the fixed maturity security’s projected future cash flows, discounted at the effective interest rate implicit in the investment prior to impairment. The non-credit portion of the impairment is equal to the difference between the fair value and the net present value of the fixed maturity security at the impairment measurement date.
Deferred tax assets and liabilities primarily result from temporary differences between the amounts recorded in our consolidated financial statements and the tax basis of our assets and liabilities and loss and tax credit carryforwards. These temporary differences are measured at the balance sheet date using enacted tax rates expected to apply to taxable income in the years the temporary differences are expected to reverse.
The following are the components of our deferred tax assets and liabilities as of December 31, 2016. There were no valuation allowances required as of December 31, 2016.
We have $72.3 million of alternative minimum tax credit carryforwards and $22.3 million of foreign tax credit carryforwards. The alternative minimum tax credit carryforwards have no expiration date and may be used to offset regular federal income taxes due from future income. The foreign tax credit carryforwards will expire beginning in 2026 and may be used to offset federal income taxes due from future foreign-sourced income. In addition, we have operating loss carryforwards from our Chaucer segment, which have no expiration date. Based on our projection of future economic conditions, taxable income, reversals of existing taxable temporary liabilities, and our strategic tax planning strategies, we believe that these tax credit carryforwards and operating loss carryforwards will be fully realized.
Dividend payments to the holding company by Chaucer are regulated by U.K. law. Dividends from Chaucer are dependent on dividends from its subsidiaries. Annual dividend payments from Chaucer are limited to retained earnings that are not restricted by capital and other requirements for business at Lloyd’s. Also, Chaucer must provide advance notice to the U.K.’s Prudential Regulation Authority (“PRA”) of certain proposed dividends or other payments from PRA regulated entities. Chaucer paid $79.5 million, $61.3 million and $68.7 million in dividends during 2016, 2015 and 2014, respectively, to the holding company.
Net cash provided by operating activities was $737.6 million during 2016, as compared to $438.4 million in 2015 and $564.7 million in 2014. The $299.2 million increase in 2016 compared to 2015 was primarily due to lower reinsurance payments in 2016 as compared to 2015. In 2015, reinsurance payments were made in connection with the disposal of the U.K. motor business that did not recur in 2016. Also contributing to the increase in cash were lower claims payments during 2016. These increases were partially offset by slightly lower premium collections during 2016. The $126.3 million change in 2015 compared to 2014 was primarily due to higher federal income tax payments resulting from increased earnings, an increase in reinsurance payments, primarily due to the aforementioned disposal of the U.K. motor business, and slightly lower premium collections during 2015. These decreases were partially offset by lower claims payments.
Dividends to common shareholders are subject to quarterly board approval and declaration. During 2016, as declared by the Board, we paid three quarterly dividends of $0.46 per share and one quarterly dividend of $0.50 per share to our shareholders totaling $80.4 million. We believe that our holding company assets are sufficient to provide for future shareholder dividends should the Board of Directors declare them.
Our Board of Directors has authorized aggregate repurchases of our common stock of up to $900 million. Under the repurchase authorizations, the Company may repurchase, from time to time, common shares in amounts, at prices and at such times as the Company deems appropriate, subject to market conditions and other considerations. Repurchases may be executed using open market purchases, privately negotiated transactions, accelerated repurchase programs or other transactions. We are not required to purchase any specific number of shares or to make purchases by any certain date under this program. During 2016, we repurchased approximately 1.3 million shares of our common stock at a cost of $105.6 million.
On April 8, 2016, we issued $375.0 million aggregate principal amount of 4.50% senior unsecured debentures due April 15, 2026. Net proceeds of the debt issuance were $370.7 million. The net proceeds were used, together with cash on hand, to redeem outstanding 7.50% senior notes due March 1, 2020 and 6.375% senior notes due June 15, 2021, resulting in a pre-tax loss of $86.1 million, related primarily to the required “make-whole” provision in these issuances. During the fourth quarter of 2016, we also repurchased senior debentures with a net carrying value of $11.9 million at a cost of $14.1 million, resulting in a loss of $2.2 million. During 2015, we repurchased senior debentures with a net carrying value of $90.2 million at a cost of $114.3 million, resulting in a loss of $24.1 million. Additional information related to all borrowings is in Note 6 - “Debt and Credit Arrangements” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
At December 31, 2016, we were in compliance with the covenants of our debt and credit agreements.
Financing obligations generally include repayment of our senior debentures, subordinated debentures, borrowings from the FHLBB, and operating 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, 2016 and operating lease payments reflect expected cash payments based upon lease terms. 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.
Reflects the minimum amount expected to be contributed to the Chaucer plan based upon results of its triennial funding review, expected to be completed in 2017, and the plan’s current funded status. We do not expect to make any significant contributions to our U.S. qualified plan in order to meet our minimum funding requirements for the next several years and therefore no contributions to that plan are included in this schedule. However, additional contributions may be required in the future to both plans based on the level of pension assets and liabilities in future periods.
Non-qualified defined benefit pension and postretirement benefit obligations reflect estimated payments to be made through plan year 2026 for pension, postretirement and postemployment benefits, although it is likely that payments will be made beyond 2026. Estimates of these payments and the payment patterns are based upon historical experience.
We currently do not have any material off-balance sheet arrangements that are reasonably likely to have an effect on our financial position, revenues, expenses, results of operations, liquidity, capital expenditures, or capital resources.
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of The Hanover Insurance Group, Inc. and its subsidiaries at December 31, 2016 and December 31, 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
Net investment income includes interest, dividends and income from limited partnership interests and overseas deposits. 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 are accounted for using the retrospective method. The adjustment to yields for all other prepayable fixed maturities are 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.
The Company shares certain insurance risks it has underwritten, through the use of reinsurance contracts, with various insurance entities. Reinsurance accounting is followed for ceded transactions when the risk transfer provisions of ASC 944, Financial Services - Insurance (“ASC 944”), have been met. As a result, when the Company experiences loss or claims events that are subject to a reinsurance contract, reinsurance recoverables are recorded. The amount of the reinsurance recoverable can vary based on the terms of the reinsurance contract, the size of the individual loss or claim, or the aggregate amount of all losses or claims in a particular line or book of business or an aggregate amount associated with a particular accident year. The valuation of losses or claims recoverable depends on whether the underlying loss or claim is a reported loss or claim, or an incurred but not reported loss. For reported losses and claims, the Company values reinsurance recoverables at the time the underlying loss or claim is recognized, in accordance with contract terms. For incurred but not reported losses, the Company estimates the amount of reinsurance recoverables based on the terms of the reinsurance contracts and historical reinsurance recovery information and applies that information to the gross loss reserve. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured business and the balance is disclosed separately in the financial statements. However, the ultimate amount of the reinsurance recoverable is not known until all losses and claims are settled. Allowances are established for amounts deemed uncollectible and reinsurance recoverables are recorded net of these allowances. The Company evaluates the financial condition of its reinsurers and monitors concentration risk to minimize its exposure to significant credit losses from individual reinsurers.
Insurance premiums written are generally recorded at the policy inception and are primarily earned on a pro-rata basis over the terms of the policies for all products. Premiums written include estimates, primarily in the Chaucer segment, that are derived from multiple sources, which include the historical experience of the underlying business, similar businesses and available industry information. These estimates are regularly reviewed and updated, and any resulting adjustments are included in the current year’s results. Unearned premium reserves represent the portion of premiums written that relates to the unexpired terms of the underlying in-force insurance policies and reinsurance contracts. Premium receivables reflect the unpaid balance of premium written as of the balance sheet date. Premium receivables are generally short-term in nature and are reported net of an allowance for estimated uncollectible premium accounts. The Company reviews its receivables for collectability at the balance sheet date. The allowance for uncollectible accounts was not material as of December 31, 2016 and 2015. Ceded premiums are charged to income over the applicable term of the various reinsurance contracts with third-party reinsurers. Reinsurance reinstatement premiums, when required, are recognized in the same period as the loss event that gave rise to the reinstatement premiums. Losses and related expenses are matched with premiums, resulting in their recognition over the lives of the contracts. This matching is accomplished through estimated and unpaid losses and amortization of deferred acquisition costs.
The Company is subject to the tax laws and regulations of the U.S. and foreign countries in which it operates. The Company files a consolidated U.S. federal income tax return that includes the holding company and its U.S. subsidiaries. Generally, taxes are accrued at the U.S. statutory tax rate of 35% for income from the U.S. operations. The Company’s primary non-U.S. jurisdiction is the United Kingdom (“U.K.”). In July 2013, the U.K. statutory rate decreased from 23% to 21% effective April 1, 2014 and from 21% to 20% effective April 1, 2015. In November 2015, the U.K. statutory tax rate decreased from 20% to 19% effective April 1, 2017 and from 19% to 18% effective April 1, 2020. A further decrease was enacted in September 2016 to reduce the U.K. statutory rate from 19% to 17%, instead of the 18%, effective April 1, 2020. The Company accrues taxes on certain non-U.S. income that is subject to U.S. tax at the U.S. tax rate. Foreign tax credits, where available, are utilized to offset U.S. tax as permitted. Certain non-U.S. income of the Company is not subject to U.S. tax until repatriated. Foreign taxes on this non-U.S. income are accrued at the local foreign rate and do not have an accrual for U.S. deferred taxes since these earnings are intended to be indefinitely reinvested overseas.
Earnings per share (“EPS”) for the years ended December 31, 2016, 2015 and 2014 is based on a weighted average of the number of shares outstanding during each year. Basic and diluted EPS is computed by dividing income available to common stockholders by the weighted average number of shares outstanding for the period. The weighted average shares outstanding used to calculate basic EPS differ from the weighted average shares outstanding used in the calculation of diluted EPS due to the effect of dilutive employee stock options, nonvested stock grants and other contingently issuable shares. If the effect of such items is antidilutive, the weighted average shares outstanding used to calculate diluted EPS are equal to those used to calculate basic EPS.
The Company manages its exposure to foreign currency risk primarily by matching assets and liabilities denominated in the same currency. To the extent that assets and liabilities in foreign currencies are not matched, the Company is exposed to foreign currency risk. For functional currencies, the related exchange rate fluctuations are reflected in other comprehensive income (loss). The Company translated Chaucer’s balance sheet at December 31, 2016 and 2015 from GBP to U.S. dollars using a conversion rate of 1.23 and 1.47, respectively. The Company recognized $22.3 million in foreign currency transaction losses in the Consolidated Statements of Income during the year ended December 31, 2016, and $8.5 million and $3.3 million in foreign currency transaction gains for the years ended December 31, 2015 and 2014, respectively. These amounts include realized losses of Euro denominated securities of $0.7 million, $3.4 million, and $1.3 million in 2016, 2015, and 2014, respectively.
In April 2014, the FASB issued ASC Update No. 2014-08, (Topic 205 and Topic 360) Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. This ASC update modifies the definition of discontinued operations by limiting discontinued operations reporting to disposals of components of an entity that represent strategic shifts that have (or will have) a major effect on an entity’s operations and financial results. Also, this update requires additional financial statement disclosures about discontinued operations, as well as disposals of an individually significant component of an entity that do not qualify for discontinued operations presentation. This ASC update was effective for all disposals (or classifications as held for sale) of components of an entity that occurred within annual and interim periods beginning on or after December 15, 2014 and for all businesses that, on acquisition, were classified as held for sale that also occurred within interim and annual periods beginning on or after December 15, 2014. The Company implemented this guidance effective January 1, 2015. The effect of implementing this guidance was not material to the Company’s financial position or results of operations.
In January 2017, the FASB issued ASC Update No. 2017-04, (Topic 350) Intangibles - Goodwill and Other: Simplifying the Test for Goodwill Impairment. This guidance eliminates step 2 from the goodwill impairment test. Instead, an entity should perform its goodwill impairment test by comparing the fair value of the reporting unit with its carrying amount, including any applicable income tax effects, and recognize an impairment for the amount by which the carrying amount exceeds the reporting units fair value. However, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. The updated guidance is effective for annual or interim goodwill impairment tests performed in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company does not expect the adoption of ASC Update No. 2017-04 to have a material impact on its financial position or results of operations.
In June 2016, the FASB issued ASC Update No. 2016-13, (Topic 326) Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments. This ASC update introduces new guidance for the accounting for credit losses on financial instruments within its scope. A new model, referred to as the current expected credit losses model, requires an entity to determine credit-related impairment losses for financial instruments held at amortized cost and to estimate these expected credit losses over the life of an exposure (or pool of exposures). The estimate of expected credit losses should consider both historical and current information, reasonable and supportable forecasts, as well as estimates of prepayments. The estimated credit losses and subsequent adjustment to such loss estimates, will be recorded through an allowance account which is deducted from the amortized cost of the financial instrument, with the offset recorded in current earnings. ASC No. 2016-13 also modifies the impairment model for available-for-sale debt securities. The new model will require an estimate of expected credit losses only when the fair value is below the amortized cost of the asset, thus the length of time the fair value of an available-for-sale debt security has been below the amortized cost will no longer affect the determination of whether a credit loss exists. In addition, credit losses on available-for-sale debt securities will be limited to the difference between the security’s amortized cost basis and its fair value. The updated guidance is effective for interim and annual periods beginning after December 15, 2019. Early adoption is permitted for periods beginning after December 15, 2018. The Company is evaluating the impact of the adoption of ASC Update No. 2016-13 on its financial position and results of operations.
In March 2016, the FASB issued ASC Update No. 2016-09, (Topic 718) Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting. This ASC update requires all excess tax benefits and tax deficiencies to be recognized as income tax expense or benefit in the income statement, and be treated as discreet items in the reporting period in which they occur. Additionally, excess tax benefits will be classified with other income tax cash flows as an operating activity and cash paid by an employer when directly withholding shares for tax withholding purposes will be classified as a financing activity. Awards that are used to settle employee tax liabilities will be allowed to qualify for equity classification for withholdings up to the maximum statutory tax rates in applicable jurisdictions. Regarding forfeitures, a company can make an entity-wide accounting policy election to either continue estimating the number of awards that are expected to vest or account for forfeitures when they occur. The updated guidance is effective for interim and annual periods beginning after December 15, 2016. The Company will adopt this standard effective January 1, 2017 and will retain its current forfeiture policy of accruing the compensation cost based on the number of awards that are expected to vest. The effect this guidance will have on the Company’s results of operations is dependent on the future tax benefits or deficiencies that are recognized related to stock-based compensations awards, and could be material in any one quarterly or annual period. The adoption of this guidance is not expected to result in any cumulative effect adjustments and will not have a material impact on the liquidity of the Company.
In January 2016, the FASB issued ASC Update No. 2016-01, (Subtopic 825-10) Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities. This ASC update requires unconsolidated equity investments to be measured at fair value with changes in the fair value recognized in net income, except for those accounted for under the equity method. This update eliminates the cost method for equity investments without readily determinable fair values and replaces with other methods, including the use of Net Asset Value (“NAV”). Additionally, when a public entity is required to measure fair value for disclosure purposes and holds financial instruments measured at amortized cost, the updated guidance requires these instruments to be measured using exit price. It also requires financial assets and financial liabilities to be presented separately in the notes to the financial statements, grouped by measurement category and form of financial asset. The updated guidance is effective for annual periods beginning after December 15, 2017. The Company will adopt the guidance effective January 1, 2018 through a cumulative effect adjustment to retained earnings. The adoption is not expected to have a material impact on the Company’s financial position. The impact to the Company is expected to be increased volatility in net income beginning in 2018; the magnitude of such volatility will depend on the composition of the Company’s investment portfolio in the future and changes in the fair value of the Company’s investments.
The Company’s former life insurance businesses include indemnity obligations for which it established reserves.
The Company participates in a security lending program for the purpose of enhancing income. Securities on loan to various counterparties had a fair value of $29.9 million and $36.2 million at December 31, 2016 and 2015, respectively, and were fully collateralized by cash. The fair value of the loaned securities is monitored on a daily basis, and the collateral is maintained at a level of at least 102% of the fair value of the loaned securities. Securities lending collateral is recorded by the Company in cash and cash equivalents, with an offsetting liability included in expenses and taxes payable.
At December 31, 2016 and 2015, fixed maturities with fair values of $251.6 million and $217.4 million, respectively, and amortized cost of $238.5 million and $206.5 million, respectively, were on deposit with various state and governmental authorities.
In accordance with Lloyd’s operating guidelines, the Company deposits funds at Lloyd’s to support underwriting operations. These funds are available only to fund claim obligations. At December 31, 2016 and 2015, fixed maturities with a fair value of $491.2 million and $440.6 million, respectively, and cash of $6.3 million and $7.0 million, respectively, were on deposit with Lloyd’s.
The following tables provide information about the Company’s fixed maturities and equity securities that were in an unrealized loss position at December 31, 2016 and 2015 including the length of time the securities have been in an unrealized loss position:
The Company’s mortgage participations were $297.6 million and $200.9 million at December 31, 2016 and 2015, 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 were comprised of the following property types and geographic locations.
At December 31, 2016, scheduled maturities of mortgage participations were as follows: due in 2017 - $0.5 million; 2020 - $10.0 million; 2021 - $50.0 million and thereafter - $237.1 million. There were no scheduled loan maturities in 2018 or 2019. Actual maturities could differ from contractual maturities because borrowers may have the right to prepay obligations with or without prepayment penalties and loans may be refinanced. During 2016, the Company did not refinance any loans based on terms that differed from current market rates.
At December 31, 2016, the Company had no concentration of investments in a single investee that exceeded 10% of shareholders’ equity except for fixed maturities invested in Federal Home Loan Mortgage Corp. (“FHLMC”) and mortgage participations with a highly rated single third-party. At December 31, 2016, the Company held FHLMC with fair value of $542.2 million and mortgage participations with a carrying value of $295.9 million. At December 31, 2015, the Company had no concentration of investments in a single investee that exceeds 10% of shareholders’ equity except for fixed maturities invested in FHLMC and Federal National Mortgage Association (“FNMA”). At December 31, 2015, the Company held FHLMC and FNMA with fair values of $467.9 million and $298.1 million, respectively.
Included in the net realized investment gains (losses) were OTTI of investment securities recognized in earnings totaling $27.9 million, $26.8 million and $5.5 million in 2016, 2015 and 2014, respectively.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments and have not changed since last year.
Other investments primarily include mortgage participations, overseas trust funds required in connection with the Company’s Lloyd’s business and cost basis limited partnerships. Fair values of mortgage participations and other mortgage loans are estimated by discounting the contractual cash flows using the rates at which similar loans would be made to borrowers with comparable credit ratings and are reported as Level 3. Fair values of overseas trust funds are provided by the investment manager based on quoted prices for similar instruments in active markets and are reported as Level 2. The fair values of cost basis limited partnerships are based on the net asset value provided by the general partner and recent financial information and are excluded from the fair value hierarchy.
The fair value of debt is estimated based on quoted market prices for identical or similar issuances. If a quoted market price is not available, fair values are estimated using discounted cash flows that are based on current interest rates and yield curves for debt issuances with maturities and credit risks consistent with the debt being valued. Debt is reported as Level 2.
The Company has processes designed to ensure that the values received from its third-party pricing service are accurately recorded, that the data inputs and valuation techniques utilized are appropriate and consistently applied and that the assumptions are reasonable and consistent with the objective of determining fair value. The Company performs a review of the fair value hierarchy classifications and of prices received from its pricing service on a quarterly basis. The Company reviews the pricing services’ policies describing its methodology, processes, practices and inputs, including various financial models used to value securities. Also, the Company reviews the portfolio pricing, including a process for which securities with changes in prices that exceed a defined threshold are verified to independent sources, if available. If upon review, the Company is not satisfied with the validity of a given price, a pricing challenge would be submitted to the pricing service along with supporting documentation for its review. The Company does not adjust quotes or prices obtained from the pricing service unless the pricing service agrees with the Company’s challenge. During 2016 and 2015, the Company did not adjust any prices received from its pricing service.
Investments measured at fair value using net asset value based on an ownership interest in partners’ capital have not been included in the tables above. The fair values of these investments were $94.1 million and $59.9 million as of December 31, 2016 and 2015, respectively, which were approximately 1% of total investment assets.
The following table provides quantitative information about the significant unobservable inputs used by the Company in the fair value measurements of Level 3 assets. Where discounted cash flows were used in the valuation of fixed maturities, the internally-developed discount rate was adjusted by the significant unobservable inputs shown in the table. Valuations of $0.6 million for securities based on broker quotes for which there was a lack of transparency as to inputs used to develop the valuations have been excluded.
On April 8, 2016, the Company issued $375.0 million aggregate principal amount of 4.50% senior unsecured debentures due April 15, 2026. Net proceeds from the issuance were $370.7 million. On May 21, 2016, the proceeds, together with cash on hand, were used to redeem the outstanding 7.50% senior notes due March 1, 2020 and the 6.375% senior notes due June 15, 2021. The redemption of these notes resulted in a pre-tax loss of $86.1 million.
The Company also held 7.625% senior unsecured debentures that were issued on October 16, 1995 with a par value of $200.0 million. As of December 31, 2016 and 2015, the remaining 7.625% senior debentures have a par value of $62.6 million and $74.6 million, respectively, and mature on October 15, 2025.
The Company also held $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 $59.7 million as of December 31, 2016 and 2015 and pay cumulative dividends semi-annually at 8.207%.
In 2009, Hanover Insurance received a $125.0 million FHLBB advance through its membership in the FHLBB. This collateralized advance bears interest at a fixed rate of 5.50% per annum over a twenty-year term. As collateral to FHLBB, the Company pledged government agency securities with a fair value of $201.8 million and $176.0 million, for the aggregate borrowings of $125.0 million as of December 31, 2016 and December 31, 2015, respectively. The fair value of the collateral pledged must be maintained at certain specified levels of the borrowed amount, which can vary depending on the type of assets pledged. If the fair value of this collateral declines below these specified levels, the Company would be required to pledge additional collateral or repay outstanding borrowings. The Company is permitted to voluntarily repay the outstanding borrowings at any time, subject to a repayment fee. As a requirement of membership in the FHLBB, the Company maintains a certain level of investment in FHLBB stock. Total holdings of FHLBB stock were $9.8 million and $8.9 million at December 31, 2016 and 2015, respectively.
The Company’s deferred tax asset as of December 31, 2016 included assets of $72.3 million related to alternative minimum tax credit carryforwards and $22.3 million related to foreign tax credit carryforwards. The alternative minimum tax credit carryforwards have no expiration date, and the foreign tax credit carryforwards will expire beginning in 2026. The Company has utilized in 2016 and may continue to utilize the credits to offset regular federal income taxes due from future income, and although the Company believes that these assets are fully recoverable, there can be no certainty that future events will not affect their recoverability. The Company believes, based on objective evidence, it is more likely than not that the remaining deferred tax assets will be realized.
Although most of the Company’s non-U.S. income is subject to U.S. federal income tax, certain of its non-U.S. income is not subject to U.S. federal income tax until repatriated. Foreign taxes on this non-U.S. income are accrued at the local foreign tax rate, as opposed to the higher U.S. statutory tax rate, since these earnings currently are expected to be indefinitely reinvested overseas. This assumption could change, as a result of a sale of the subsidiaries, the receipt of dividends from the subsidiaries, a change in management’s intentions, or as a result of various other events. The Company has not made a provision for U.S. taxes on $23.5 million, $69.8 million and $23.3 million of non-U.S. income for 2016, 2015 and 2014, respectively. However, in the future, if such earnings were distributed to the Company, taxes of $43.4 million would be payable on the accumulated undistributed earnings and would be reflected in the tax provision for the year in which these earnings are no longer intended to be indefinitely reinvested overseas, assuming all foreign tax credits are realized.
There are no tax positions at December 31, 2016, 2015 and 2014 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.
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, 2016, based on current estimates of plan liabilities and other assumptions, the projected benefit obligation of the qualified defined benefit pension plan exceeds plan assets by approximately $54 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. For the U.S. defined benefit plans, an increase in the expected return on plan assets for 2016 to 5.25% reflects long-term expectations for improvements, including increased interest rates, in the fixed maturities market in general. For the Chaucer plan, the expected rate of return on plan assets was 5.45%, for both the years ended December 31, 2016 and 2015. The Company reviews and updates, at least annually, its expected return on plan assets based on changes in the actual assets held by the plans and market conditions.
During 2016, the Chaucer plan was closed to future salary accruals, which eliminated any remaining benefits to be accumulated in future periods, and resulted in a $2.4 million curtailment gain. An equal and offsetting expense was included in recognized net actuarial losses in the above table.
During 2014, the Company announced a program to offer voluntary lump-sum pension payout options to eligible former employees that, if accepted, would settle the Company’s obligation to them. The program provided participants with a one-time choice of electing to receive a lump-sum settlement of their remaining pension benefit. As part of this voluntary lump-sum program, the Company settled $55.1 million of its pension obligations with an equal amount paid from plan assets. As a result, the Company recorded settlement losses of $10.8 million, reflecting the accelerated recognition of unamortized losses in the plan proportionate to the obligation that was settled. These settlement charges were recorded in other operating expenses with a corresponding balance sheet reduction in accumulated other comprehensive income. Additionally, the Company terminated another of its small qualified plans, accelerating the recognition of unamortized losses of $1.3 million.
The benefit payments are based on the same assumptions used to measure the Company’s benefit obligations at the end of 2016. Benefit payments related to the U.S. qualified plan and the Chaucer plan will be made from plan assets held in trusts and not included with Company assets, whereas those payments related to the non-qualified plan will be provided for by the Company. Expected benefits related to the Chaucer pension plan were converted to U.S. dollars at an exchange rate of 1.23.
In addition to the defined benefit plans, THG provides a defined contribution 401(k) plan for its U.S. employees, whereby the Company matches employee elective 401(k) contributions, up to a maximum of 6% of eligible compensation in 2016, 2015, and 2014. The Company’s expense for this matching provision was $21.4 million, $20.1 million and $19.9 million for 2016, 2015 and 2014, respectively. In addition to this matching provision, the Company can elect to make an annual contribution to employees’ accounts. Additional contributions amounted to $2.0 million and $2.1 million for the 2015 and 2014 plan years, respectively.
In addition to the Company’s pension plans, the Company also has postretirement medical benefits that it provides to former agents and retirees and their dependents, and a limited number of full-time employees. The plans, which are funded by the Company through either a Health Reimbursement Arrangement (“HRA”) or directly, provide access to benefits including hospital and major medical, with certain limits, and have varying co-payments and deductibles, depending on the plan. Generally, employees who were actively employed on December 31, 1995 became eligible with at least 15 years of service after the age of 40. Effective January 1, 1996, the Company revised these benefits so as to establish limits on future benefit payments to beneficiaries of retired participants and to restrict eligibility to then current employees. In 2009, the Company changed the postretirement medical benefits, only as they relate to current employees who still qualified for participation in the plan under the above formula. For these participants, the plan provided for only post age 65 benefits. In 2015, the Company amended the plan to only provide this benefit to those participants who retire before January 1, 2018, further limiting the number of current employees who are eligible to participate in this plan. The population of agents receiving postretirement benefits was frozen as of December 31, 2002, when the Company ceased its distribution of proprietary life and annuity products. This plan is unfunded.
The benefit payments are based on the same assumptions used to measure the Company’s benefit obligation at the end of 2016 and reflect benefits attributable to estimated future service.
Employers are required to measure the funded status of their plans as of the date of their year-end statement of financial position. As such, the Company has utilized a measurement date of December 31, 2016 and 2015, to determine its postretirement benefit obligations, consistent with the date of its Consolidated Balance Sheets. Weighted average discount rate assumptions used to determine postretirement benefit obligations and periodic postretirement costs are as follows:
A one-percentage point change in assumed health care cost trend rates in each year would have an immaterial effect on net periodic benefit cost during 2016 and accumulated postretirement benefit obligation at December 31, 2016.
Compensation cost for the years ended December 31, 2016, 2015, and 2014 totaled $12.0 million, $12.3 million and $15.1 million, respectively. Related tax benefits were $4.2 million, $4.3 million and $5.3 million, respectively.
The excess tax expense realized from options exercised for the years ended December 31, 2016, 2015 and 2014 was $5.6 million, $9.7 million, and $5.9 million, respectively. The aggregate intrinsic value at December 31, 2016 for shares outstanding and shares exercisable was $31.2 million and $16.5 million, respectively. At December 31, 2016, the weighted average remaining contractual life for shares outstanding and shares exercisable was 8.1 years and 6.5 years, respectively. Additional information about employee options outstanding and exercisable at December 31, 2016 is included in the following table:
The fair value of shares that vested during the years ended December 31, 2016 and 2015 was $26.8 million and $20.4 million, respectively. As of December 31, 2016, the Company had unrecognized compensation expense of $5.0 million related to unvested stock options that is expected to be recognized over a weighted average period of 1.6 years.
In 2016, 2015 and 2014, the Company granted market-based awards totaling 87,213, 80,738, and 56,625, respectively, to certain members of senior management, which are included in the table above as performance and market-based restricted stock activity. The vesting of these stock units is based on the relative total shareholder return (“TSR”) of the Company. This metric is generally based on relative TSR for a three year period as compared to a group of Property and Casualty peer companies. The fair value of market based awards was estimated at the date of grant using a valuation model. These units have the potential to range from 0% to 150% of the shares disclosed. Included in the amount granted above in 2016 were 30,453 shares related to market-based awards that achieved a payout in excess of 100%. Also included in the amounts granted above for the performance-based restricted stock units were 1,949 shares related to awards that a performance metric in excess of 100% was achieved. All of these awards vested in 2016.
In 2016, performance and market-based stock units of 2,268 and 30,134 were included as granted due to completion levels in excess of 100% for units granted in 2014 and 2013, respectively. The weighted average grant date fair value of these awards was $57.00 and $41.77, respectively. In 2015, performance and market-based stock units of 3,125 and 36,875 were included as granted due to completion levels in excess of 100% for units granted in 2013 and 2012, respectively. The weighted average grant date fair value of these awards was $42.44 and $36.47, respectively. In 2014, performance and market-based stock units of 2,888 were included as granted due to completion levels in excess of 100% for units granted in 2012. The weighted average grant date fair value of these awards was $43.31.
The individual law of all states, including New Hampshire and Michigan, where Hanover Insurance and Citizens are domiciled, respectively, restrict the payment of dividends to stockholders by insurers. These laws affect the dividend paying ability of Hanover Insurance and Citizens.
Pursuant to New Hampshire’s statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the New Hampshire Insurance Commissioner, is limited to 10% of such insurer’s statutory policyholder surplus as of the preceding December 31. Hanover Insurance declared dividends to its parent totaling $218.8 million in 2016. No dividends were declared by Hanover Insurance in 2015 or 2014. Hanover Insurance cannot declare a further dividend to its parent without prior approval until April 2017, at which time the maximum dividend payable without prior approval would be $216.8 million.
Dividend payments from Chaucer to its parent are regulated by U.K. law. Dividends from Chaucer are dependent on dividends from its subsidiaries. Annual dividend payments from Chaucer are limited to retained earnings that are not restricted by capital and other requirements for business at Lloyd’s. Also, Chaucer must provide advance notice to the U.K.’s Prudential Regulation Authority (“PRA”) of certain proposed dividends or other payments from PRA regulated entities. Dividend payments to THG from Chaucer entities totaled $79.5 million, $61.3 million and $68.7 million in 2016, 2015 and 2014, respectively.
The Company reports interest expense related to debt separately from the earnings of its operating segments. This consists of interest on the Company’s senior debentures, subordinated debentures, collateralized borrowings with the Federal Home Loan Bank of Boston, and letter of credit facility. 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 investment gains and 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 and operating income should not be construed as a substitute for net income.
The decrease in ceded reinsurance premiums from 2015 to 2016 is primarily due to the above mentioned non-recurring U.K. motor activity in 2015, partially offset by a planned increase in Chaucer’s ceded reinsurance premiums as the Company continues to manage its overall underwriting risk.
The increase in ceded losses and LAE from 2015 to 2016 is primarily due to the aforementioned increase in Chaucer’s reinsurance purchases in 2016 and due to a higher level of ceded large loss activity in certain Chaucer and domestic lines in 2016. These increases in ceded losses and LAE were partially offset by the above mentioned non-recurring U.K. motor activity in 2015.
As a result of continuing trends in the Company’s business, reserves including catastrophes have been re-estimated for all prior accident years and were increased by $105.4 million in 2016 in comparison to decreases of $116.1 million and $117.4 million in 2015 and 2014, respectively. As a result of the Company’s 2016 fourth quarter reserve review of domestic lines of business, as discussed further below, carried reserves for prior accident years for domestic lines excluding catastrophes were increased by $174.1 million in the fourth quarter, of which $161.5 million related to Commercial Lines. The majority of this adjustment is attributed to long-tailed commercial liability coverages, including AIX program business. In general, higher than expected loss and LAE emergence in 2016 led the Company to adjust its reserve assumptions in its year-end reserve review and place greater weight on the adverse large loss and severity trends experienced in the most recent calendar years.
In 2016, net unfavorable loss and LAE development was $105.4 million, primarily as a result of net unfavorable development of $219.3 million for Commercial Lines, partially offset by favorable development of $132.8 million for Chaucer. The net unfavorable Commercial Lines development primarily resulted from higher than expected losses in other commercial lines of $169.7 million, which includes the AIX program business. This was primarily driven by AIX programs and business classes which have since been terminated or substantially revised, general liability coverages in accident years 2012 through 2015, and surety bonds in accident years 2012 through 2015. The Company also experienced higher than expected losses within the commercial multiple peril lines of $68.8 million for accident years 2012 through 2015 and commercial automobile of $27.5 million in accident years 2012 through 2014, both primarily within liability coverages. Partially offsetting the unfavorable development was lower than expected losses of $46.7 million within the workers’ compensation line, primarily related to accident years 2013 through 2015, and, to a lesser extent, the commercial umbrella line primarily related to the 2015 accident year.
Chaucer’s favorable development during 2016 was primarily the result of lower than expected losses in the property line of $45.6 million, primarily in the 2013 through 2015 accident years, the energy line of $31.9 million, primarily in the 2013 through 2015 accident years, and in the marine and aviation lines of $27.4 million, primarily in the 2008, 2009, 2014 and 2015 accident years. Additionally, Chaucer experienced lower than expected losses within casualty and other lines, specifically the specialist and international liability lines, of $15.3 million, primarily in the 2014 and prior accident years. Partially offsetting Chaucer’s favorable development was the unfavorable impact of foreign exchange rate movements on prior years’ loss reserves.
Chaucer’s favorable development was primarily the result of lower than expected losses in the property line of $43.8 million, primarily in the 2011 through 2014 accident years, the energy line of $42.1 million, primarily in the 2012 through 2014 accident years, and in the marine and aviation lines of $34.2 million, primarily in the 2010, 2012 and 2013 accident years. Additionally, Chaucer experienced lower than expected losses within casualty and other lines, specifically the specialist and international liability lines, of $22.7 million primarily in the 2008, 2011 and 2013 accident years. Chaucer’s favorable development was also partially attributable to the favorable impact of foreign exchange rate movements on prior years’ loss reserves.
In 2014, net favorable loss and LAE development was $117.4 million, primarily as a result of favorable development of $127.8 million for Chaucer, partially offset by net unfavorable development of $14.1 million for Commercial Lines. Chaucer’s favorable development was primarily the result of lower than expected losses in the marine and aviation lines of $47.4 million, primarily in the 2011 through 2013 accident years. Additionally, Chaucer experienced lower than expected losses within the property line of $30.6 million, primarily in the 2010 through 2013 accident years, and in casualty and other lines, specifically the specialty liability line of $21.4 million, primarily in the 2010 and 2013 accident years. Chaucer’s favorable development was also partially attributable to the favorable impact of foreign exchange rate movements on prior years’ loss reserves.
As a result of the fourth quarter reserve review, the Company recognized unfavorable prior year reserve development of $174.1 million for the domestic business, excluding catastrophes, largely driven by adverse emergence in most Commercial Lines liability coverages reflecting worsening trends in the number and nature of high severity losses and higher than anticipated legal defense costs. The Company reacted to this adverse emergence by updating assumptions about loss severity, loss development patterns, expected loss ratios and loss adjustment expenses for the most recent accident years, placing greater weight on the adverse severity trends experienced in the most recent calendar years. The adverse development in the AIX program business was primarily due to the general liability and commercial automobile liability coverages in the 2011 through 2014 accident years. Additionally, the Company recognized adverse development in general liability and commercial multiple peril coverages primarily in accident years 2012 through 2015, contract surety business primarily related to the 2012 through 2015 accident years, and the commercial automobile line, primarily related to liability coverages for accident years 2012 through 2014. These increases in Commercial Lines reserves were partially offset by favorable development in the workers’ compensation line, primarily in the 2013 through 2015 accident years and, to a lesser extent, commercial umbrella coverage in the 2015 accident year. The adverse prior year reserve development for Personal Lines was primarily due to higher than expected losses in bodily injury coverage in accident years 2013 through 2015. The adverse prior year development for the Other segment was due to run-off voluntary assumed reinsurance pools business. The reserve increase was based on an updated third-party actuarial study received in the fourth quarter for a pool that primarily consists of asbestos and environmental exposures.
Within total Commercial Lines and other, other lines is primarily comprised of general liability, including voluntary pools, umbrella, professional and management liability, marine, surety, and healthcare lines. Chaucer core lines includes marine and aviation, energy, property and casualty lines, primarily consisting of international liability and specialist liability coverages. Chaucer reinsured and run-off lines include financial and professional liability lines written in 2008 and prior and U.K. motor business, which was transferred through a 100 percent reinsurance contract as of June 30, 2015. Included in the above table, primarily in other lines, are $61.0 million and $57.7 million of gross asbestos and environmental reserves as of December 31, 2016 and 2015, respectively.
For the domestic lines, incurred claim count information presented represents claim frequency by individual claimant and measures the frequency of direct claim settlements that have resulted in or are expected to result in claim payments. Claim count information is presented in a manner consistent with that used in the quarterly loss reserving process. A single claim event, particularly in automobile lines, may result in multiple individual claimants and, therefore, multiple claim counts. Incurred claim counts are comprised of outstanding claims and those that are closed with a loss payment and exclude those that are closed without a loss payment. A single claim event may result in multiple claims closed with a payment when a claim is subsequently reopened with further payment. In this case, a reopened claim payment is counted as an incremental claim settlement. Claim count information is not available for direct and assumed participations in various involuntary pools and residual market mechanisms, which represent approximately 5% or less of the total gross earned premium and gross incurred claims for the lines presented. Incurred claim counts are also not adjusted for the effect of claims ceded as part of reinsurance programs, although the incurred losses and cumulative paid losses presented in the following tables are presented net of reinsurance ceded.
Chaucer incurred losses and ALAE and paid losses and ALAE that are denominated in foreign currencies are converted to U.S. dollars as of December 31, 2016, the most recent balance sheet date, for all years presented.
The incurred and cumulative paid losses and ALAE, IBNR and reported claim counts retroactively includes the 6 month period that pre-dates the acquisition of Chaucer on July 1, 2011. Additionally, during 2011 Chaucer experienced an elevated level of high severity catastrophe events. For example, three such events, the February 2011 New Zealand earthquake, March 2011 Japanese tsunami and October 2011 Thailand floods totaled approximately $125 million of incurred losses, and each event was in excess of $30 million. Chaucer experienced no catastrophe events in excess of $30 million from 2012 through 2016.
The Company’s U.S. insurance subsidiaries are required to file annual statements with state regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis), as codified by the National Association of Insurance Commissioners. Permitted statutory accounting practices encompass all accounting practices that are not prescribed; such practices differ from state to state, may differ from company to company within a state, and may change in the future. The Company’s U.S. insurance subsidiaries did not have any permitted practices as of or for the years ended December 31, 2016, 2015 and 2014.
Statutory capital and surplus differs from shareholders’ equity reported in accordance with generally accepted accounting principles primarily because under the statutory basis of accounting, deferred acquisition costs are expensed when incurred and the recognition of deferred tax assets is based on different recoverability assumptions.
The minimum statutory capital and surplus necessary to satisfy the Company’s regulatory requirements was $442.0 million, $378.5 million and $374.6 million, which equals the Authorized Control Level at December 31, 2016, 2015 and 2014, respectively.
Due to the use of weighted average shares outstanding when calculating earnings per common share, the sum of the quarterly per common share data may not equal the per common share data for the year.