The Company leases its principal executive offices in New York, New York, as well as approximately 220 field and claim offices totaling approximately 4.2 million square feet throughout the United States under leases or subleases with third parties. The Company also leases offices in Canada, the United Kingdom, the Republic of Ireland, Brazil, India and China that house operations (primarily for Business Insurance) in those locations. The Company owns six buildings in Hartford, Connecticut, consisting of approximately 1.8 million square feet of office space. The Company also owns buildings located in other areas of Connecticut; Norcross, Georgia; St. Paul, Minnesota; and Omaha, Nebraska. The Company owns a building in London, England, which houses a portion of Business Insurance’s operations in the United Kingdom.
Net favorable prior year reserve development of $517 million ($409 million after-tax)
Repurchased 10.0 million common shares for total cost of $1.32 billion and paid $814 million of dividends to shareholders
The following discussions of the Company’s net income and segment income are presented on an after-tax basis. Discussions of the components of net income and segment income are presented on a pre-tax basis, unless otherwise noted. Discussions of earnings per common share are presented on a diluted basis.
The following table sets forth information regarding the Company’s net pre-tax realized investment gains.
Claims and claim adjustment expenses in 2018 were $18.29 billion, $824 million or 5% higher than in 2017, primarily reflecting the impacts of (i) higher business volumes, (ii) loss cost trends, (iii) higher loss estimates in the commercial automobile product line for bodily injury liability coverages in Business Insurance, (iv) lower net favorable prior year reserve development and (v) higher non-catastrophe weather-related losses and non-weather related losses in Personal Insurance, partially offset by (vi) lower catastrophe losses and (vii) a lower level of international surety losses in Bond & Specialty Insurance. Catastrophes in 2018
Claims and claim adjustment expenses in 2017 were $17.47 billion, $2.40 billion or 16% higher than in 2016, primarily reflecting the impacts of (i) significantly higher catastrophe losses, (ii) higher business volumes, (iii) loss cost trends, (iv) lower net favorable prior year reserve development, (v) higher non-catastrophe fire-related losses in Business Insurance and (vi) higher non-catastrophe weather-related losses in Personal Insurance. Catastrophe losses in 2017 primarily resulted from wildfires in California, Hurricanes Harvey, Irma and Maria, and several winter, wind and hail storms throughout the United States. Catastrophe losses in 2016 primarily resulted from Hurricane Matthew, wind and hail storms in several regions of the United States, flooding in the Southeast region of the United States, wildfires in Canada and Tennessee, and winter storms in the eastern United States.
the Company’s estimates of its ultimate losses before reinsurance and taxes exceed a pre-established dollar threshold.
The Company’s threshold for disclosing catastrophes is primarily determined at the reportable segment level. If a threshold for one segment or a combination thereof is exceeded and the other segments have losses from the same event, losses from the event are identified as catastrophe losses in the segment results and for the consolidated results of the Company. Additionally, an aggregate threshold is applied for International business across all reportable segments. The threshold for 2018 ranged from approximately $18 million to $30 million of losses before reinsurance and taxes.
Income tax expense in 2018 was $438 million, $236 million or 35% lower than in 2017, primarily reflecting the impacts of (i) the lower U.S. corporate income tax rate resulting from the TCJA and (ii) the net charge of $129 million in 2017 as part of the TCJA described above, partially offset by (iii) the $231 million increase in income before income taxes in 2018 and (iv) the $39 million reduction in income tax expense in 2017 as a result of the resolution of prior year tax matters. Income tax expense in 2017 was $674 million, $365 million or 35% lower than in 2016, primarily reflecting the impacts of (i) the $1.32 billion decrease in income before income taxes in 2017 and (ii) the $39 million reduction in income tax expense resulting from the resolution of prior year tax matters, partially offset by (iii) the net charge of $129 million as part of the TCJA described above.
The combined ratio of 97.9% in 2017 was 5.9 points higher than the combined ratio of 92.0% in 2016. The loss and loss adjustment expense ratio of 67.2% in 2017 was 6.7 points higher than the loss and loss adjustment expense ratio of 60.5% in 2016. The underwriting expense ratio of 30.7% in 2017 was 0.8 points lower than the underwriting expense ratio of 31.5% in 2016.
Catastrophe losses in 2017 and 2016 accounted for 7.6 points and 3.6 points, respectively, of the combined ratio. Net favorable prior year reserve development in 2017 and 2016 provided 2.3 points and 3.2 points of benefit, respectively, to the combined ratio. The underlying combined ratio in 2017 was 1.0 points higher than the 2016 ratio on the same basis, primarily reflecting (i) loss cost trends that modestly exceeded earned pricing in Business Insurance, (ii) higher non-catastrophe fire-related losses in Business Insurance and (iii) higher non-catastrophe weather-related losses in Personal Insurance.
Segment income in 2018 was $1.64 billion, $25 million or 2% higher than segment income of $1.61 billion in 2017. The decrease in segment income before income taxes primarily reflected the pre-tax impacts of (i) lower net favorable prior year reserve development and (ii) lower underlying underwriting margins, partially offset by (iii) lower catastrophe losses and (iv) higher net investment income. Catastrophe losses in 2018 and 2017 were $639 million and $858 million, respectively. Net favorable prior year reserve development in 2018 and 2017 was $142 million and $439 million, respectively. The lower underlying underwriting margins primarily reflected higher loss estimates in the domestic commercial automobile product line for bodily injury liability coverages. Income tax expense in 2018 was lower than in 2017, primarily reflecting the impacts of (i) the lower U.S. corporate income tax rate resulting from the TCJA and (ii) the decrease in segment income before income taxes, partially offset by (iii) the $15 million reduction in income taxes as a result of the resolution of prior year tax matters in 2017.
Factors contributing to net favorable prior year reserve development during the years ended December 31, 2018, 2017 and 2016 are discussed in more detail in note 7 of notes to the consolidated financial statements.
Amortization of deferred acquisition costs in 2018 was $2.39 billion, $102 million or 4% higher than in 2017. Amortization of deferred acquisition costs in 2017 was $2.29 billion, $65 million or 3% higher than in 2016. The increases in both 2018 and 2017 were generally consistent with the increases in earned premiums.
Income tax expense in 2018 was $259 million, $189 million or 42% lower than in 2017, primarily reflecting the impacts of (i) the lower U.S. corporate income tax rate resulting from the TCJA and (ii) the $164 million decrease in income before income taxes in 2018, partially offset by (iii) the $15 million reduction in income tax expense in 2017 resulting from the resolution of prior year tax matters. Income tax expense in 2017 was $448 million, $208 million or 32% lower than in 2016, primarily reflecting the impact of the $577 million decrease in income before income taxes in 2017 and the $15 million reduction in income tax expense resulting from the resolution of prior year tax matters.
The combined ratio of 97.8% in 2017 was 3.7 points higher than the combined ratio of 94.1% in 2016. The loss and loss adjustment expense ratio of 65.9% in 2017 was 4.2 points higher than the loss and loss adjustment expense ratio of 61.7% in 2016. The underwriting expense ratio of 31.9% in 2017 was 0.5 points lower than the underwriting expense ratio of 32.4% in 2016.
Catastrophe losses in 2017 and 2016 accounted for 6.0 points and 3.4 points of the combined ratio, respectively. Net favorable prior year reserve development provided 3.1 points of benefit to the combined ratio in both 2017 and 2016. The underlying combined ratio in 2017 was 1.1 points higher than the 2016 ratio on the same basis, primarily reflecting the impacts of (i) loss cost trends that modestly exceeded earned pricing and (ii) higher non-catastrophe fire-related losses.
Gross written premiums in 2018 and 2017 increased by 5% and 2%, respectively, over the respective prior year periods. Net written premiums in 2018 and 2017 increased by 5% and 3%, respectively, over the respective prior year amounts.
International. Net written premiums of $1.08 billion in 2018 increased by 7% over 2017, primarily driven by increases in Canada and in the Company's operations at Lloyd's. Net written premiums of $1.01 billion in 2017 increased by 6% over 2016, primarily driven by increases in the Company’s European operations, including Lloyd’s, as well as in Canada.
surety losses and (ii) higher business volumes. Income tax expense in 2018 was lower than in 2017, primarily reflecting the impacts of (i) the lower U.S. corporate income tax rate resulting from the TCJA, partially offset by (ii) the increase in segment income before income taxes and (iii) the $17 million reduction in income tax expense in 2017 as a result of the resolution of prior year tax matters.
Earned premiums in 2018 were $2.42 billion, $113 million or 5% higher than in 2017. Earned premiums in 2017 were $2.31 billion, $47 million or 2% higher than in 2016. The increase in earned premiums in both 2018 and 2017 reflected increases in net written premiums over the preceding twelve months.
The combined ratio of 69.0% in 2018 was 8.4 points lower than the combined ratio of 77.4% in 2017. The loss and loss adjustment expense ratio of 31.5% in 2018 was 7.1 points lower than the loss and loss adjustment expense ratio of 38.6% in 2017. The underwriting expense ratio of 37.5% in 2018 was 1.3 points lower than the underwriting expense ratio of 38.8% in 2017.
The combined ratio of 77.4% in 2017 was 11.7 points higher than the combined ratio of 65.7% in 2016. The loss and loss adjustment expense ratio of 38.6% in 2017 was 11.2 points higher than the loss and loss adjustment expense ratio of 27.4% in 2016. The underwriting expense ratio of 38.8% in 2017 was 0.5 points higher than the underwriting expense ratio of 38.3% in 2016.
Gross and net written premiums in 2018 both increased by 7% over 2017. Gross and net written premiums in 2017 increased by 5% and 4%, respectively, over 2016.
Segment income in 2018 was $297 million, $169 million or 132% higher than segment income of $128 million in 2017. The increase in segment income before income taxes primarily reflected the pre-tax impacts of (i) higher underlying underwriting margins, (ii) higher net favorable prior year reserve development, (iii) higher net investment income and (iv) lower catastrophe losses. Net favorable prior year reserve development in 2018 and 2017 was $109 million and $13 million, respectively. Catastrophe losses in 2018 and 2017 were $1.06 billion and $1.09 billion, respectively. The higher underlying underwriting margins primarily resulted from the impacts of (i) earned pricing that exceeded loss cost trends in Agency Automobile, partially offset by (ii) higher non-catastrophe weather-related losses and non-weather related losses in Agency Homeowners and Other. Income tax expense in 2018 was higher than in 2017, primarily reflecting the impacts of (i) the increase in segment income before income taxes and (ii) the $7 million reduction in income tax expense in 2017 as a result of the resolution of prior year tax matters, partially offset by (iii) the lower U.S. corporate income tax rate resulting from the TCJA.
Claims and claim adjustment expenses in 2018 were $7.35 billion, $301 million or 4% higher than in 2017, primarily reflecting the impacts of (i) higher business volumes, (ii) loss cost trends and (iii) higher non-catastrophe weather-related losses and non-weather related losses in Agency Homeowners and Other, partially offset by (iv) higher net favorable prior year reserve development and (v) lower catastrophe losses. Claims and claim adjustment expenses in 2017 were $7.05 billion, $1.36 billion or 24% higher than in 2016, primarily reflecting the impacts of (i) significantly higher catastrophe losses, (ii) higher business volumes, (iii) loss cost trends and (iv) higher non-catastrophe weather-related losses, partially offset by (v) net favorable prior year reserve development as compared with net unfavorable prior year reserve development in 2016.
Factors contributing to prior year reserve development during the year ended December 31, 2018 are discussed in more detail in note 7 of notes to the consolidated financial statements. Net prior year reserve development in 2017 and 2016 was not significant.
Amortization of deferred acquisition costs in 2018 was $1.54 billion, $91 million or 6% higher than in 2017. Amortization of deferred acquisition costs in 2017 was $1.45 billion, $105 million or 8% higher than in 2016. The increases in both 2018 and 2017 were generally consistent with the increases in earned premiums.
The combined ratio of 100.6% in 2018 was 2.5 points lower than the combined ratio of 103.1% in 2017. The loss and loss adjustment expense ratio of 74.1% in 2018 was 2.2 points lower than the loss and loss adjustment expense ratio of 76.3% in 2017. The underwriting expense ratio of 26.5% in 2018 was 0.3 points lower than the underwriting expense ratio of 26.8% in 2017.
The combined ratio of 103.1% in 2017 was 7.3 points higher than the combined ratio of 95.8% in 2016. The loss and loss adjustment expense ratio of 76.3% in 2017 was 8.8 points higher than the loss and loss adjustment expense ratio of 67.5% in 2016. The underwriting expense ratio of 26.8% in 2017 was 1.5 points lower than the underwriting expense ratio of 28.3% in 2016.
Catastrophe losses accounted for 11.7 points and 4.9 points of the combined ratio in 2017 and 2016, respectively. Net favorable prior year reserve development in 2017 provided 0.1 points of benefit to the loss and loss adjustment expense ratio. Net unfavorable prior year reserve development in 2016 had no impact on the loss and loss adjustment expense ratio. The underlying combined ratio in 2017 was 0.6 points higher than the 2016 ratio on the same basis, primarily reflecting the impacts of (i) higher non-catastrophe weather-related losses, (ii) the tenure impact of higher levels of new business in recent years in the Automobile product line and (iii) a higher level of automobile business relative to homeowners and other business, partially offset by (iv) the benefit of higher levels of earned premiums on the underwriting expense ratio and (v) earned pricing that modestly exceeded loss cost trends.
Personal Insurance’s domestic Agency business comprises business written through agents, brokers and other intermediaries.
Domestic Agency gross and net written premiums in 2018 were both 6% higher than in 2017.
Domestic Agency Homeowners and Other net written premiums of $4.15 billion in 2018 were 5% higher than in 2017. Business retention rates remained strong in 2018. Renewal premium changes in 2018 remained positive and were higher than in 2017. New business premiums in 2018 increased over 2017.
For its domestic Agency business, Personal Insurance had approximately 7.2 million and 6.9 million active policies at December 31, 2018 and 2017, respectively.
International net written premiums in 2018 were 9% higher than in 2017, primarily driven by growth in automobile net written premiums. International net written premiums in 2017 were 8% higher than in 2016, primarily driven by growth in automobile net written premiums and the impact of changes in foreign currency exchange rates.
For its International and Direct-to-Consumer business, Personal Insurance had approximately 900,000 and 878,000 active policies at December 31, 2018 and 2017, respectively.
The Income (loss) for Interest Expense and Other in 2018 was $44 million higher than in 2017. The Income (loss) for Interest Expense and Other in 2017 was $10 million higher than in 2016. Pre-tax interest expense in 2018, 2017 and 2016 was $352 million, $369 million and $363 million, respectively. After-tax interest expense in 2018, 2017 and 2016 was $278 million, $240 million and $236 million, respectively. The increase in after-tax interest expense in 2018 compared with 2017 primarily reflected the impact of the lower U.S. corporate income tax rate in 2018 resulting from the TCJA.
The Company believes that the property and casualty insurance industry has suffered from court decisions and other trends that have expanded insurance coverage for asbestos claims far beyond the original intent of insurers and policyholders. The Company has received and continues to receive a significant number of asbestos claims. Factors underlying these claim filings include continued intensive advertising by lawyers seeking asbestos claimants and the focus by plaintiffs on defendants who were not
traditionally primary targets of asbestos litigation. The focus on these defendants is primarily the result of the number of traditional asbestos defendants who have sought bankruptcy protection in previous years. The bankruptcy of many traditional defendants has also caused increased settlement demands against those policyholders who are not in bankruptcy but remain in the tort system. Currently, in many jurisdictions, those who allege very serious injury and who can present credible medical evidence of their injuries are receiving priority trial settings in the courts, while those who have not shown any credible disease manifestation are having their hearing dates delayed or placed on an inactive docket. Prioritizing claims involving credible evidence of injuries, along with the focus on defendants who were not traditionally primary targets of asbestos litigation, contributes to the claims and claim adjustment expense payment patterns experienced by the Company. The Company’s asbestos-related claims and claim adjustment expense experience also has been impacted by the unavailability of other insurance sources potentially available to policyholders, whether through exhaustion of policy limits or through the insolvency of other participating insurers.
The completion of these reviews and analyses in 2018, 2017 and 2016 resulted in $225 million increases in each year to the Company’s net asbestos reserves. In each year, the reserve increases were primarily driven by increases in the Company’s estimate of projected settlement and defense costs related to a broad number of policyholders in the home office and field office category. The increase in the estimate of projected settlement and defense costs resulted from payment trends that continue to be higher than previously anticipated due to the impact of the current litigation environment surrounding mesothelioma claims discussed above. Over the past decade, the property and casualty insurance industry, including the Company, has experienced net unfavorable prior year reserve development with regard to asbestos reserves, but the Company believes that over that period there has been a reduction in the volatility associated with the Company’s overall asbestos exposure as the overall asbestos environment has evolved from one dominated by exposure to significant litigation risks, particularly coverage disputes relating to policyholders in bankruptcy who were asserting that their claims were not subject to the aggregate limits contained in their policies, to an environment primarily driven by a frequency of litigation related to individuals with mesothelioma. The Company’s overall view of the current underlying asbestos environment is essentially unchanged from recent periods and there remains a high degree of uncertainty with respect to future exposure to asbestos claims.
The resolution of environmental exposures by the Company generally occurs through settlements with policyholders as opposed to claimants. Generally, the Company strives to extinguish any obligations it may have under any policy issued to the policyholder for past, present and future environmental liabilities and extinguish any pending coverage litigation dispute with the policyholder. This form of settlement is commonly referred to as a “buy-back” of policies for future environmental liability. In addition, many of the agreements have also extinguished any insurance obligation which the Company may have for other claims, including, but not limited to, asbestos and other cumulative injury claims. The Company and its policyholders may also agree to settlements which only extinguish any liability arising from known specified sites or claims. In many instances, these agreements also include indemnities and hold harmless provisions to protect the Company. The Company’s general purpose in executing these agreements is to reduce the Company’s potential environmental exposure and eliminate the risks presented by coverage litigation with the policyholder and related costs.
At December 31, 2018, approximately 94% of the net environmental reserve (approximately $314 million) was carried in a bulk reserve and included unresolved environmental claims, incurred but not reported environmental claims and the anticipated cost of coverage litigation disputes relating to these claims. The bulk reserve the Company carries is established and adjusted based upon the aggregate volume of in-process environmental claims and the Company’s experience in resolving those claims. The balance, approximately 6% of the net environmental reserve (approximately $20 million), consists of case reserves.
As a result of the processes and procedures discussed above, management believes that the reserves carried for asbestos and environmental claims are appropriately established based upon known facts, current law and management’s judgment. However, the uncertainties surrounding the final resolution of these claims continue, and it is difficult to determine the ultimate exposure for asbestos and environmental claims and related litigation. As a result, these reserves are subject to revision as new information
The Company’s invested assets at December 31, 2018 were $72.28 billion, of which 93% was invested in fixed maturity and short-term investments, 1% in equity securities, 1% in real estate investments and 5% in other investments. Because the primary purpose of the investment portfolio is to fund future claims payments, the Company employs a conservative investment philosophy. A significant majority of funds available for investment are deployed in a widely diversified portfolio of high quality, liquid, taxable U.S. government, tax-exempt U.S. municipal and taxable corporate and U.S. agency mortgage-backed bonds.
The carrying values of investments in fixed maturities classified as available for sale at December 31, 2018 and 2017 were as follows:
The following table shows the geographic distribution of the $25.76 billion of municipal bonds at December 31, 2018 that were not pre-refunded.
The following table shows the geographic distribution of the Company’s long-term fixed maturity investments in debt securities issued by foreign governments at December 31, 2018.
(2) No other country accounted for 2.5% or more of total debt securities issued by foreign governments.
The following table shows the Company’s Eurozone exposure at December 31, 2018 to all debt securities issued by foreign governments, financial companies, sovereign corporations (including sovereign banks) whose securities are backed by the respective country’s government and all other corporate securities (comprised of industrial corporations and utility companies) which could be affected if economic conditions deteriorated due to a prolonged recession.
In addition to fixed maturities noted in the foregoing table, the Company has exposure totaling $141 million to private equity limited partnerships and real estate partnerships (both of which are included in other investments in the Company’s consolidated balance sheet) whose primary investing focus is across Europe. The Company has unfunded commitments totaling $131 million to these partnerships. The Company has no non-redeemable preferred stock issued by companies in the Eurozone.
The Company meets its capital requirements to support its underwriting at Lloyd’s using a combination of trust deposits and uncollateralized letters of credit. Securities with a fair value of approximately $115 million and $37 million held by a wholly-owned subsidiary at December 31, 2018 and 2017, respectively, and $33 million held by TRV at both December 31, 2018 and 2017 were pledged into Lloyd’s trust accounts to provide a portion of the Lloyd’s capital requirements. For more information regarding the Company’s utilization of uncollateralized letters of credit, see “Liquidity and Capital Resources” herein.
Net unrealized investment losses included in shareholders’ equity at December 31, 2018 compared with net unrealized gains at December 31, 2017 reflected the impact of an increase in market interest rates in 2018. Equity securities, which include public common and non-redeemable preferred stocks, are reported at fair value with changes in fair value recognized in net income. Prior to January 1, 2018, equity securities were classified as available for sale and changes in their fair value were charged or credited directly to other comprehensive income.
At December 31, 2018 and 2017, below investment grade securities comprised 2.3% and 2.7%, respectively, of the fair value of the Company’s fixed maturity investment portfolio. Included in below investment grade securities at December 31, 2018 were securities in an unrealized loss position that, in the aggregate, had an amortized cost of $1.37 billion and a fair value of $1.29 billion, resulting in a net pre-tax unrealized investment loss of $81 million. These securities in an unrealized loss position represented approximately 2.2% of the total amortized cost and 2.0% of the fair value of the fixed maturity portfolio at December 31, 2018 and accounted for 9.5% of the total gross pre-tax unrealized investment loss in the fixed maturity portfolio at December 31, 2018.
During the year ended December 31, 2018, the Company incurred pre-tax realized losses of $18 million on the sale of fixed maturity investments having a fair value of $786 million.
The tables below set forth the probabilities that estimated losses, comprising claims and allocated claim adjustment expenses (but excluding unallocated claim adjustment expenses), from a single event occurring in a one-year timeframe will equal or exceed the indicated loss amounts (expressed in dollars, net of tax, and as a percentage of the Company’s common equity), based on the proprietary and third-party computer models utilized by the Company at December 31, 2018. For example, on the basis described below the tables, the Company estimates that there is a one percent chance that the Company’s loss from a single U.S. and Canadian hurricane in a one-year timeframe would equal or exceed $1.6 billion, or 7% of the Company’s common equity at December 31, 2018.
Moreover, the Company is exposed to the risk of material losses from other than property and workers’ compensation coverages arising out of hurricanes and earthquakes, and it is exposed to catastrophe losses from perils other than hurricanes and earthquakes, such as tornadoes and other windstorms, hail, wildfires, severe winter weather, floods, tsunamis, volcanic eruptions and other naturally-occurring events, such as solar flares, as well as acts of terrorism and cyber events.
The Company discusses how potentially changing climate conditions may present other issues for its business under “Item 1A - Risk Factors” and “Outlook.” For example, among other things:
The Company reinsures a portion of the risks it underwrites in order to control its exposure to losses. For additional discussion regarding the Company’s reinsurance coverage, see “Part I-Item 1 - Reinsurance.”
Net reinsurance recoverables at December 31, 2018 increased by $183 million over December 31, 2017, primarily reflecting the 2018 impacts of catastrophe losses and the asbestos reserve increase, partially offset by cash collections.
At December 31, 2018, the Company held $857 million of collateral in the form of letters of credit, funds and trust agreements held to fully or partially collateralize certain reinsurance recoverables.
from the European Union, a shutdown of the U.S. government, the failure by the U.S. government to raise the debt ceiling, changes to the U.S. Federal budget and further potential changes in tax laws in the United States or modification of the Affordable Care Act. The resulting changes in levels of economic activity could positively or negatively impact exposure changes at renewal and the Company’s ability to write business at acceptable rates. Additionally, changes in levels of economic activity could positively or negatively impact audit premium adjustments, policy endorsements and mid-term cancellations after policies are written. All of the foregoing, in turn, could positively or negatively impact net written premiums during the next twelve months, and because earned premiums are a function of net written premiums, earned premiums could be impacted on a lagging basis.
Underwriting Gain/Loss. The Company’s underwriting gain/loss can be significantly impacted by catastrophe losses and net favorable or unfavorable prior year reserve development, as well as underlying underwriting margins. Underlying underwriting margins can be impacted by a number of factors, including variability in non-catastrophe weather, large loss and other loss activity; changes in current period loss estimates resulting from prior period loss development; changes in business mix; changes in reinsurance coverages and/or costs; premium adjustments; and variability in expenses and assessments.
It is possible that changes in economic conditions could lead to higher or lower inflation than the Company had anticipated, which could in turn lead to an increase or decrease in the Company’s loss costs and the need to strengthen or reduce claims and claim adjustment expense reserves. These impacts of inflation on loss costs and claims and claim adjustment expense reserves could be more pronounced for those lines of business that require a relatively longer period of time to finalize and settle claims for a given accident year and, accordingly, are relatively more inflation sensitive. For a further discussion, see “Part I-Item 1A - Risk Factors-If actual claims exceed our claims and claim adjustment expense reserves, or if changes in the estimated level of claims and claim adjustment expense reserves are necessary, including as a result of, among other things, changes in the legal, regulatory and economic environments in which the Company operates, our financial results could be materially and adversely affected.”
In Business Insurance, the Company expects underlying underwriting margins during 2019 in aggregate will be higher than in 2018, and the underlying combined ratio during 2019 in aggregate will be lower than in 2018, assuming loss activity, primarily large losses, returns to lower and more normal levels, with the improvements expected to be in the second through fourth quarters of the year.
In Bond & Specialty Insurance, the Company expects underlying underwriting margins and the underlying combined ratio during 2019 in aggregate will be broadly consistent with 2018.
term securities was 4.5 (4.7 excluding short-term securities) at December 31, 2018. From time to time, the Company enters into short positions in U.S. Treasury futures contracts to manage the duration of its fixed maturity portfolio. At December 31, 2018, the Company had no open U.S. Treasury futures contracts. The Company continually evaluates its investment alternatives and mix. Currently, the majority of the Company’s investments are comprised of a widely diversified portfolio of high-quality, liquid, taxable U.S. government, tax-exempt U.S. municipal and taxable corporate and U.S. agency mortgage-backed bonds.
Net investment income is a material contributor to the Company’s results of operations. Based on the impacts of (i) slightly higher levels of fixed income investments (fixed maturity and short-term investments) and (ii) slightly higher yields on fixed income investments, the Company expects after-tax net investment income for the twelve months ending December 31, 2019 from those portfolios will be approximately $80 million to $100 million higher than the twelve months ended December 31, 2018. The impact of future market conditions on net investment income from the non-fixed maturity investment portfolio during the next twelve months is hard to predict. If general economic conditions and/or investment market conditions change during the next twelve months, the Company could experience an increase or decrease in net investment income and/or significant realized investment gains or losses (including impairments).
For further discussion of the Company’s investment portfolio, see “Investment Portfolio.” For a discussion of the risks to the Company’s business during or following a financial market disruption and risks to the Company’s investment portfolio, see the risk factors entitled “During or following a period of financial market disruption or an economic downturn, our business could be materially and adversely affected” and “Our investment portfolio is subject to credit and interest rate risk, and may suffer reduced returns or material realized or unrealized losses” included in “Part I-Item 1A - Risk Factors.” For a discussion of the risks to the Company’s investments from foreign currency exchange rate fluctuations, see the risk factor entitled “We are also subject to a number of additional risks associated with our business outside the United States” included in “Part I-Item 1A - Risk Factors” and see “Part II-
Statement of Income for the years ended December 31, 2018, 2017 and 2016
Statement of Comprehensive Income for the years ended December 31, 2018, 2017 and 2016
Statement of Changes in Shareholders’ Equity for the years ended December 31, 2018, 2017 and 2016
(1) Total other-than-temporary impairment (OTTI) losses were $(1) million, $(13) million and $(40) million for the years ended December 31, 2018, 2017 and 2016, respectively. Of total OTTI, credit losses of $(1) million, $(14) million and $(29) million for the years ended December 31, 2018, 2017 and 2016, respectively, were recognized in net realized investment gains. In addition, unrealized gains (losses) from other changes in total OTTI of $0 million, $1 million and $(11) million for the years ended December 31, 2018, 2017 and 2016, respectively, were recognized in other comprehensive income (loss) as part of changes in net unrealized gains (losses) on investment securities having credit losses recognized in the consolidated statement of income.
On August 4, 2017, the Company completed its acquisition of all issued and outstanding shares of Simply Business Holdings Ltd (Simply Business), a leading provider of small business insurance policies primarily in the United Kingdom, for a purchase price of approximately $464 million, which included the repayment of debt and other obligations of Simply Business. In addition, the Company issued 95,953 shares of restricted common stock valued at approximately $12 million to certain employees of Simply Business who were equity holders of Simply Business. Subject to the satisfaction of certain conditions, 50% of the restricted stock will vest two years from the issuance date and the remainder will vest three years from the issuance date. The Company used a portion of the net proceeds from the issuance of senior notes in May 2017 (described in more detail in note 8) and internal resources to fund this transaction.
On February 14, 2018, the FASB issued updated guidance that allows a reclassification from AOCI to retained earnings of the stranded tax effects that occurred due to the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA). The updated guidance is effective for reporting periods beginning after December 15, 2018 and is to be applied retrospectively to each period in which there are items impacted by the TCJA remaining in AOCI or at the beginning of the period of adoption. Early adoption is permitted. The Company adopted the updated guidance effective January 1, 2018 and elected to reclassify the income tax effects of the TCJA from AOCI to retained earnings as of January 1, 2018. This reclassification resulted in an increase in retained earnings of $24 million as of January 1, 2018 and a decrease in AOCI by the same amount.
In May 2014, the FASB issued updated guidance to clarify the principles for recognizing revenue. The updated guidance was effective for reporting periods beginning after December 15, 2017, and requires an entity to recognize revenue as performance obligations are met, in order to reflect the transfer of goods or services to customers in an amount that reflects the consideration the entity is entitled to receive for those goods or services. For the year ended December 31, 2018, approximately $171 million, or less than 1% of the Company's total revenues, were within the scope of this updated guidance and were generated from the services described below.
While insurance contracts are not within the scope of this updated guidance, the Company’s revenue related to certain services with no underlying insurance risk is subject to the updated guidance. These services include the following: (i) insurance-related services, such as risk management services, claims administration, loss control and risk management information services on behalf of non-insureds; (ii) servicing carrier fees for various residual market pools and associations; and (iii) administrative fees related to servicing third-party insurers’ obligations to participate in the Workers' Compensation Residual Market Plans in certain states. The revenues earned from these service contracts were not impacted by the adoption of the updated guidance. These revenues are earned as the Company completes its performance obligations, which primarily occurs on a pro rata basis over the contract service period and reported in fee income in the Company’s consolidated statement of income.
Commissions earned from on-line insurance brokerage services are also subject to this updated guidance and were also not impacted by the adoption of the updated guidance. Commissions are earned upon collection of the gross premium in accordance with the contracts and an accrual is made to recognize policy cancellations, either at the policyholder’s direction or for non-payment. Commissions are reported in other revenues in the Company's consolidated statement of income.
The Company adopted the updated guidance effective January 1, 2018. The adoption did not have an effect on the Company’s results of operations, financial position or liquidity.
Fixed maturities include bonds, notes and redeemable preferred stocks. Fixed maturities, including instruments subject to securities lending agreements, are classified as available for sale and reported at fair value, with unrealized investment gains and losses, net of income taxes, charged or credited directly to other comprehensive income.
The Company uses the equity method of accounting for investments in private equity limited partnerships, hedge funds and real estate partnerships. The partnerships and the hedge funds generally report investments on their balance sheet at fair value. The financial statements prepared by the investee are received by the Company on a lag basis, with the lag period generally dependent upon the type of underlying investments. The private equity and real estate partnerships provide financial information quarterly which is generally available to investors, including the Company, within three months following the date of the reporting period. The hedge funds provide financial information monthly, which is generally available to investors within one month following the
date of the reporting period. The Company regularly requests financial information from the partnerships prior to the receipt of the partnerships’ financial statements and records any material information obtained from these requests in its consolidated financial statements.
Investment income from fixed maturities is recognized based on the constant effective yield method which includes an adjustment for estimated principal pre-payments, if any. The effective yield used to determine amortization for fixed maturities subject to prepayment risk (e.g., asset-backed, loan-backed and structured securities) is recalculated and adjusted periodically based upon actual historical and/or projected future cash flows, which are obtained from a widely-accepted securities data provider. The adjustments to the yield for highly rated prepayable fixed maturities are accounted for using the retrospective method. The adjustments to the yield for non-highly rated prepayable fixed maturities are accounted for using the prospective method. Dividends on equity securities (including those with transfer restrictions) are recognized in income when declared. Rental income on real estate is recognized on a straight-line basis over the lease term. See the section titled: Real Estate in note 3 for further discussion. Investments in private equity limited partnerships, hedge funds, real estate partnerships and joint ventures are accounted for using the equity method of accounting, whereby the Company’s share of the investee’s earnings or losses in the fund is reported in net investment income.
Net realized investment gains and losses are included as a component of pre-tax revenues based upon specific identification of the investments sold on the trade date. Included in net realized investment gains (losses) are other-than-temporary impairment losses on invested assets other than those investments accounted for using the equity method of accounting as described in the “Investment Impairments” section that follows.
Some of the factors considered in identifying other-than-temporary impairments of fixed maturities include: (1) the extent to which the fair value has been less than amortized cost; (2) the financial condition, near-term and long-term prospects for the issuer, including the relevant industry conditions and trends, and implications of rating agency actions and offering prices; (3) the likelihood of the recoverability of principal and interest; (4) whether it is more likely than not that the Company will be required to sell the
For fixed maturity investments the Company intends to sell or for which it is more likely than not that the Company will be required to sell before an anticipated recovery in value, the full amount of the impairment is included in net realized investment gains (losses).
For structured fixed maturity securities (primarily residential and commercial mortgage-backed securities and asset-backed securities), the Company estimates the present value of the security by projecting future cash flows of the assets underlying the securitization, allocating the flows to the various tranches based on the structure of the securitization and determining the present value of the cash flows using the effective yield of the security at the date of acquisition (or the most recent implied rate used to accrete the security if the implied rate has changed as a result of a previous impairment or changes in expected cash flows). The Company incorporates levels of delinquencies, defaults and severities as well as credit attributes of the remaining assets in the securitization, along with other economic data, to arrive at its estimate of the parameters applied to the assets underlying the securitization.
The Company uses a discounted cash flow model to estimate the fair value of its reporting units. The discounted cash flow model is an income approach to valuation that is based on a detailed cash flow analysis for deriving a current fair value of reporting units and is representative of the Company’s reporting units’ current and expected future financial performance. The discount rate assumptions reflect the Company’s assessment of the risks inherent in the projected future cash flows and the Company’s weighted-average cost of capital, and are compared against available market data for reasonableness.
Also included in other liabilities is an accrual for policyholder dividends. Certain insurance contracts, primarily workers’ compensation, are participating whereby dividends are paid to policyholders in accordance with contract provisions. Net written premiums for participating dividend policies were approximately 1% of total net written premiums for each of the years ended December 31, 2018, 2017 and 2016. Policyholder dividends are accrued against earnings using best available estimates of amounts to be paid. The liability accrued for policyholder dividends totaled $72 million and $67 million at December 31, 2018 and 2017, respectively.
Compensation cost is measured based on the grant-date fair value of an award, utilizing the assumptions discussed in note 13. Compensation cost is recognized for financial reporting purposes over the period in which the employee is required to provide service in exchange for the award (generally the vesting period). In connection with certain share-based awards, participants are entitled to receive dividends during the vesting period, either in cash or dividend equivalent shares, commensurate with the dividends paid to common shareholders. Dividends and dividend equivalent shares on awards that are expected to vest are recorded in retained earnings. Dividends paid on awards that are not expected to vest as part of the Company’s forfeiture estimate are recorded as compensation expense.
Business Insurance offers a broad array of property and casualty insurance and insurance-related services to its customers, primarily in the United States, as well as in Canada, the United Kingdom, the Republic of Ireland, Brazil and throughout other parts of the world as a corporate member of Lloyd’s. Business Insurance is organized as follows:
Bond & Specialty Insurance provides surety, fidelity, management liability, professional liability, and other property and casualty coverages and related risk management services to its customers in the United States and certain specialty insurance products in Canada, the United Kingdom, the Republic of Ireland and Brazil, utilizing various degrees of financially-based underwriting approaches. The range of coverages includes performance, payment and commercial surety bonds for construction and general commercial enterprises; fidelity insurance for private companies, not-for-profit organizations and financial institutions; management liability coverages including directors’ and officers’ liability, employment practices liability, fiduciary liability and cyber risk for public corporations, private companies, not-for-profit organizations and financial institutions; professional liability
coverage for a variety of professionals including, among others, lawyers and design professionals; and in the United States only, property, workers’ compensation, auto and general liability for financial institutions.
Except as described below for certain legal entities, the Company allocates its invested assets and the related net investment income to its reportable business segments. Pre-tax net investment income is allocated based upon an investable funds concept, which takes into account liabilities (net of non-invested assets) and appropriate capital considerations for each segment. For investable funds, a benchmark investment yield is developed that reflects the estimated duration of the loss reserves’ future cash flows, the interest rate environment at the time the losses were incurred and A+ rated corporate debt instrument yields. For capital, a benchmark investment yield is developed that reflects the average yield on the total investment portfolio. The benchmark investment yields are applied to each segment’s investable funds and capital, respectively, to produce a total notional investment income by segment. The Company’s actual net investment income is allocated to each segment in proportion to the respective segment’s notional investment income to total notional investment income. There are certain legal entities within the Company that are dedicated to specific reportable business segments. The invested assets and related net investment income from these legal entities are reported in the applicable business segment and are not allocated among the other business segments.
The primary component of Interest Expense and Other was after-tax interest expense of $278 million, $240 million and $236 million in 2018, 2017 and 2016, respectively.
Pre-refunded bonds of $2.85 billion and $3.90 billion at December 31, 2018 and 2017, respectively, were bonds for which states or municipalities have established irrevocable trusts, almost exclusively comprised of U.S. Treasury securities and obligations of U.S. government and government agencies and authorities. These trusts were created to fund the payment of principal and interest due under the bonds.
At December 31, 2018 and 2017, the Company held commercial mortgage-backed securities (CMBS, including FHA project loans) of $1.22 billion and $1.17 billion, respectively, which are included in “All other corporate bonds” in the tables above. At December 31, 2018 and 2017, approximately $458 million and $475 million of these securities, respectively, or the loans backing such securities, contained guarantees by the U.S. government or a government-sponsored enterprise. The weighted average credit rating of the $759 million and $693 million of non-guaranteed securities at December 31, 2018 and 2017, respectively, was “Aaa” at both dates. The CMBS portfolio is supported by loans that are diversified across economic sectors and geographical areas. The weighted average credit rating of the CMBS portfolio was “Aaa” at both December 31, 2018 and 2017.
At December 31, 2018 and 2017, the Company had $367 million and $304 million, respectively, of securities on loan as part of a tri-party lending agreement.
At December 31, 2018 and 2017, the Company’s insurance subsidiaries had $4.23 billion and $4.41 billion, respectively, of securities on deposit at financial institutions in certain states pursuant to the respective states’ insurance regulatory requirements. Funds deposited with third parties to be used as collateral to secure various liabilities on behalf of insureds, cedants and other creditors had a fair value of $37 million and $35 million at December 31, 2018 and 2017, respectively. Other investments pledged as collateral securing outstanding letters of credit had a fair value of $1 million at both December 31, 2018 and 2017. In addition, the Company utilizes Lloyd’s trust deposits, whereby owned securities with a fair value of approximately $115 million and $37 million held by a wholly-owned subsidiary at December 31, 2018 and 2017, respectively, and $33 million held by TRV at both December 31, 2018 and 2017 were pledged into Lloyd’s trust accounts to provide a portion of the capital needed to support the Company’s obligations at Lloyd’s.
For the year ended December 31, 2018, the Company recognized $29 million of net losses on equity securities still held as of December 31, 2018.
Proceeds from sales of equity securities previously classified as available for sale were $765 million and $92 million in 2017 and 2016, respectively. Gross gains of $239 million and $17 million and gross losses of $3 million and $3 million were realized on those sales in 2017 and 2016, respectively.
Future minimum rental income on operating leases relating to the Company’s real estate properties is expected to be $101 million, $90 million, $77 million, $62 million and $39 million for 2019, 2020, 2021, 2022 and 2023, respectively, and $75 million for 2024 and thereafter.
The Company’s short-term securities consist of Aaa-rated registered money market funds, U.S. Treasury securities, high-quality commercial paper (primarily A1/P1) and high-quality corporate securities purchased within a year to their maturity with a combined average of 54 days to maturity at December 31, 2018. The amortized cost of these securities, which totaled $3.99 billion and $4.90 billion at December 31, 2018 and 2017, respectively, approximated their fair value.
Entities which do not have sufficient equity at risk to allow the entity to finance its activities without additional financial support or in which the equity investors, as a group, do not have the characteristic of a controlling financial interest are referred to as variable interest entities (VIE). A VIE is consolidated by the variable interest holder that is determined to have the controlling financial interest (primary beneficiary) as a result of having both the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance and the obligation to absorb losses or right to receive benefits from the VIE that could potentially be significant to the VIE. The Company determines whether it is the primary beneficiary of an entity subject to
consolidation based on a qualitative assessment of the VIE’s capital structure, contractual terms, nature of the VIE’s operations and purpose and the Company’s relative exposure to the related risks of the VIE on the date it becomes initially involved in the VIE. The Company reassesses its VIE determination with respect to an entity on an ongoing basis.
At December 31, 2018, the amount of gross unrealized losses for all fixed maturity investments reported at fair value for which fair value was less than 80% of amortized cost was not significant.
The following tables present the cumulative amount of and the changes during the year in credit losses on fixed maturities held at December 31, 2018 and 2017, that were recognized in the consolidated statement of income from other-than-temporary impairments (OTTI) and for which a portion of the OTTI was recognized in other comprehensive income (loss) in the consolidated balance sheet.
The Company also sells a small amount of U.S. equity index put option contracts that are settled for cash upon their expiration or when they are rolled over. Net realized investment losses related to these derivatives in 2018, 2017 and 2016 were not significant.
Level 3 - Valuations based on models where significant inputs are not observable. The unobservable inputs reflect the Company’s own assumptions about the inputs that market participants would use.
For investments that have quoted market prices in active markets, the Company uses the unadjusted quoted market prices as fair value and includes these prices in the amounts disclosed in Level 1 of the hierarchy. The Company receives the quoted market prices from third party, nationally recognized pricing services. When quoted market prices are unavailable, the Company utilizes these pricing services to determine an estimate of fair value. The fair value estimates provided from these pricing services are included in the amount disclosed in Level 2 of the hierarchy. If quoted market prices and an estimate from a pricing service are unavailable, the Company produces an estimate of fair value based on internally developed valuation techniques, which, depending on the level of observable market inputs, will render the fair value estimate as Level 2 or Level 3. The Company bases all of its estimates of fair value for assets on the bid price as it represents what a third-party market participant would be willing to pay in an arm’s length transaction.
The Company utilized a pricing service to estimate fair value measurements for approximately 99% and 98% of its fixed maturities at December 31, 2018 and 2017, respectively. The pricing service utilizes market quotations for fixed maturity securities that have quoted prices in active markets. Since fixed maturities other than U.S. Treasury securities generally do not trade on a daily basis, the pricing service prepares estimates of fair value measurements for these securities using its proprietary pricing applications, which include available relevant market information, benchmark curves, benchmarking of like securities, sector groupings and matrix pricing. Additionally, the pricing service uses an Option Adjusted Spread model to develop prepayment and interest rate scenarios.
The pricing service evaluates each asset class based on relevant market information, relevant credit information, perceived market movements and sector news. The market inputs utilized in the pricing evaluation, listed in the approximate order of priority, include: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, reference data, and industry and economic events. The extent of the use of each market input depends on the asset class
and the market conditions. Depending on the security, the priority of the use of inputs may change or some market inputs may not be relevant. For some securities, additional inputs may be necessary.
filings, operating results, balance sheet stability, growth and other business and market sector fundamentals. Due to the significant unobservable inputs in these valuations, the Company includes the total fair value estimate for all of these investments at December 31, 2018 and 2017 in the amount disclosed in Level 3.
The following tables present the level within the fair value hierarchy at which the Company’s financial assets and financial liabilities are measured on a recurring basis. An investment transferred between levels during a period is transferred at its fair value as of the beginning of that period.
The following tables present the changes in the Level 3 fair value category for the years ended December 31, 2018 and 2017.
Includes impairments on investments held at the end of the period as well as amortization on fixed maturities.
The Company had no material assets or liabilities that were measured at fair value on a non-recurring basis during the years ended December 31, 2018 and 2017.
to other insurance companies who agree to share these risks. The primary purpose of ceded reinsurance is to protect the Company, at a cost, from losses in excess of the amount it is prepared to accept and to protect the Company’s capital. Reinsurance is placed on both a quota-share and excess-of-loss basis. Ceded reinsurance arrangements do not discharge the Company as the primary insurer, except for instances where the primary policy or policies have been novated, such as in certain structured settlement agreements.
The Company utilizes a corporate catastrophe excess-of-loss reinsurance treaty with unaffiliated reinsurers to manage its exposure to losses resulting from catastrophes and to protect its capital. In addition to the coverage provided under this treaty, the Company also utilizes catastrophe bonds to protect against certain weather-related and earthquake losses in the Northeastern United States, and a Northeast catastrophe reinsurance treaty to protect against losses resulting from weather-related and earthquake catastrophes in the Northeastern United States. The Company also utilizes excess-of-loss treaties to protect against earthquake losses up to a certain threshold in Business Insurance (for certain markets) and for Personal Insurance, and several reinsurance treaties specific to its international operations.
Gross claims and claim adjustment expense reserves at December 31, 2018 increased by $1.02 billion over December 31, 2017, primarily reflecting the impacts of (i) higher volumes of insured exposures and loss cost trends for the current accident year and (ii) catastrophe losses in 2018, partially offset by the impacts of (iii) payments related to catastrophe losses incurred in 2017 and (iv) net favorable prior year reserve development. Gross claims and claim adjustment expense reserves at December 31, 2017 increased by $1.70 billion over December 31, 2016, primarily reflecting the impacts of (i) catastrophe losses in the second half of 2017 and (ii) higher volumes of insured exposures and loss cost trends for the current accident year, partially offset by the impacts of (iii) payments related to operations in runoff and (iv) net favorable prior year reserve development.
Reinsurance recoverables on unpaid losses at December 31, 2018 increased by $59 million over December 31, 2017, primarily reflecting the 2018 impacts of catastrophe losses and the asbestos reserve increase, partially offset by cash collections. Reinsurance recoverables on unpaid losses at December 31, 2017 increased by $142 million from December 31, 2016, primarily reflecting the impacts of catastrophe losses and the asbestos reserve increase in the second half of 2017, partially offset by cash collections in 2017, including the settlement of certain disputes as discussed in more detail in note 16.
Included in the claims and claim adjustment expense reserves are reserves for long-term disability and annuity claim payments, primarily arising from workers’ compensation insurance and workers’ compensation excess insurance policies, that are discounted to the present value of the estimated future payments. The discount rate used was 5% at both December 31, 2018 and 2017. Total reserves net of the discount were $2.45 billion and $2.32 billion, and the related amount of discount was $1.16 billion and $1.10
Business Insurance. Net favorable prior year reserve development in 2018 totaled $142 million, primarily driven by better than expected loss experience in the segment’s domestic operations in (i) the workers’ compensation product line for multiple accident years and (ii) the commercial property product line for recent accident years, partially offset by higher than expected loss experience in the segment's domestic operations in (iii) the general liability product line for both primary and excess coverages for multiple accident years, including a $225 million increase to asbestos reserves and a $55 million increase to environmental reserves and (iv) the commercial automobile product line for recent accident years.
Personal Insurance. Net favorable prior year reserve development in 2018 totaled $109 million, primarily driven by better than expected loss experience in the segment's domestic operations in the automobile product line for recent accident years.
Business Insurance. Net favorable prior year reserve development in 2017 totaled $439 million, primarily driven by better than expected loss experience in the segment's domestic operations in (i) the workers’ compensation product line for multiple accident years, (ii) the general liability product line (excluding an increase to asbestos and environmental reserves) for both primary and excess coverages for multiple accident years and (iii) the commercial multi-peril product line for liability coverages for multiple accident years, partially offset by (iv) a $225 million increase to asbestos reserves, (v) the impact of higher than expected loss experience in the commercial automobile product line for recent accident years and (vi) a $65 million increase to environmental reserves. The net favorable prior year reserve development in the segment’s domestic operations was partially offset by net unfavorable prior year reserve development in the segment’s international operations in Europe primarily due to the U.K. Ministry of Justice’s “Ogden” discount rate adjustment applied to lump sum bodily injury payouts.
Bond & Specialty Insurance. Net favorable prior year reserve development in 2017 totaled $140 million, primarily driven by better than expected loss experience in the segment’s domestic operations in the general liability product line for management liability coverages for multiple accident years.
Bond & Specialty Insurance. Net favorable prior year reserve development in 2016 totaled $350 million, primarily driven by better than expected loss experience in the Company’s domestic operations in (i) the fidelity and surety product line for multiple accident years and (ii) the general liability product line for management liability coverages for multiple accident years.
Personal Insurance. Net unfavorable prior year reserve development in 2016 was not significant and totaled $3 million.
Total reinsurance recoverables (on paid and unpaid losses) at December 31, 2018 were $8.37 billion.
The claim development tables that follow present, by accident year, incurred and cumulative paid claims and allocated claim adjustment expense on a historical basis. This claim development information is presented on an undiscounted, net of reinsurance basis for ten years, or the number of years for which claims incurred typically remain outstanding if less than ten years. The claim development tables also provide the historical average annual percentage payout of incurred claims by age, net of reinsurance, as supplementary information (identified as unaudited in the tables below). For Personal Insurance - International - Canada, the claim development information reflects the acquisition of The Dominion of Canada General Insurance Company (Dominion) in November 2013 on a retrospective basis (includes Dominion data for years prior to the Company’s acquisition of Dominion).
The incurred and paid amounts have been translated from the local currency to U.S. dollars using the December 31, 2018 spot rate for all years presented in the table above in order to isolate changes in foreign exchange rates from loss development.
Claims and claim adjustment expense reserves represent management’s estimate of the ultimate liability for unpaid losses and loss adjustment expenses for claims that have been reported and claims that have been incurred but not yet reported as of the balance sheet date. Claims and claim adjustment expense reserves do not represent an exact calculation of the liability, but instead represent management estimates, primarily utilizing actuarial expertise and projection methods that develop estimates for the ultimate cost of claims and claim adjustment expenses. Because the establishment of claims and claims adjustment expense reserves is an inherently uncertain process involving estimates and judgment, currently estimated claims and claim adjustment expense reserves may change. The Company reflects changes to the reserves in the results of operations in the period the estimates are changed.
The average value analysis combined with the reported claim development method assumes that average claim values are stable and predictable over time for a particular cohort of claims. It is typically limited to analysis at more granular levels, such as coverage or hazard/peril, where a more homogeneous subset of claims produce a more stable and fairly predictable average value. The reported claim development method is the same as the paid loss development method but uses changes in cumulative claim counts to produce estimates of ultimate claim counts rather than ultimate dollars. The resulting estimate of ultimate claim counts by cohort is multiplied by an average value per claim from an average value analysis to obtain estimated ultimate claims and claim adjustment expenses.
While these are the principal methods utilized, the Company’s actuaries have available to them the full range of actuarial methods developed by the casualty actuarial profession. The Company’s actuaries are also continually monitoring developments within the profession for advances in existing techniques or the creation of new techniques that might improve current and future estimates. Most actuarial methods assume that past patterns demonstrated in the data will repeat themselves in the future. For certain reserve components where this assumption may not hold, such as asbestos and environmental reserves, conventional actuarial methods are not utilized by the Company.
For purposes of the claims development tables above, claims reported for direct business are counted even if they eventually close with no loss payment, except in the case of (i) deductible business, where the claim is not counted until the case incurred claim estimate is above the deductible, and (ii) International-Canada reported claim counts where claims closed with no loss payment are not counted. Note that claims with zero claim dollars may still generate some level of claim adjustment expenses. Claim counts for assumed business are included only to the extent such counts are available. The Company generally does not receive claim count information for which the underlying claim activity is handled by others, including pools and associations. The Company does not generate claim counts for ceded business. The methods used to summarize claim counts have not changed significantly over the time periods reported in the tables above.
The Company cautions against using the summarized claim count information provided in this disclosure in attempting to project ultimate loss payouts by product line. The Company generally finds claim count data to be useful only on a more granular basis than the aggregated basis disclosed in the claim development tables above, as the risks, average values and other dynamics of the claim process can vary materially by the cause of loss and coverage within product line. For example, in Personal Automobile, the introduction of a new roadside assistance coverage feature several years ago resulted in a significant increase in claim counts with a low average claim cost. For this reason the Company varies its approach to, and in many cases the level of aggregation for, counting claims for internal analysis purposes depending on the particular granular analysis performed.
Net asbestos paid loss and loss expenses in 2018, 2017 and 2016 were $225 million, $271 million and $708 million, respectively. Net payments in 2016 included the $458 million net payment related to PPG Industries, Inc. Approximately 9%, 4% and 69% of total net paid losses in 2018, 2017 and 2016, respectively, related to policyholders with whom the Company entered into settlement agreements that limit those policyholders' ability to present future claims to the Company.
Environmental Reserves. In establishing environmental reserves, the Company evaluates the exposure presented by each policyholder and the anticipated cost of resolution, if any. These claims are mainly brought pursuant to various state or federal statutes that require a liable party to undertake or pay for environmental remediation. Liability under these statutes may be joint and several with other responsible parties. In the course of its analysis, the Company generally considers the probable liability, available coverage and relevant judicial interpretations. In addition, the Company considers the many variables presented, such as: the nature of the alleged activities of the policyholder at each site; the number of sites; the total number of potentially responsible parties at each site; the nature of the alleged environmental harm and the corresponding remedy at each site; the nature of government enforcement activities at each site; the ownership and general use of each site; the overall nature of the insurance relationship between the Company and the policyholder, including the role of any umbrella or excess insurance the Company has issued to the policyholder; the involvement of other insurers; the potential for other available coverage, including the number of years of coverage; the role, if any, of non-environmental claims or potential non-environmental claims in any resolution process; and the applicable law in each jurisdiction. The evaluation of the exposure presented by a policyholder can change as information concerning that policyholder and the many variables presented is developed. Conventional actuarial methods are not used to estimate these reserves.
Commercial Paper-The Company maintains an $800 million commercial paper program. (See “Credit Agreement” discussion that follows.) Interest rates on commercial paper issued in 2018 ranged from 1.47% to 2.37%, and in 2017 ranged from 0.65% to 1.17%.
The Company’s consolidated balance sheet includes the debt instruments acquired in a business acquisition, which were recorded at fair value as of the acquisition date. The resulting fair value adjustment is being amortized over the remaining life of the respective debt instruments using the effective-interest method. The amortization of the fair value adjustment reduced interest expense by $2 million and $1 million for the years ended December 31, 2018 and 2017, respectively.
Maturities-The amount of debt obligations, other than commercial paper, that become due in each of the next five years is as follows: 2019, $500 million; 2020, $500 million; 2021, $0; 2022, $0; and 2023, $0.
On June 4, 2018, the Company entered into a five-year, $1.0 billion revolving credit agreement with a syndicate of financial institutions, replacing its five-year, $1.0 billion credit agreement that was due to expire on June 7, 2018. Pursuant to the credit agreement covenants, the Company must maintain a minimum consolidated net worth, defined as shareholders’ equity determined in accordance with GAAP (excluding accumulated other comprehensive income (loss)) plus (a) trust preferred securities (not to exceed 15% of total capital) and (b) mandatorily convertible securities (combined with trust preferred securities, not to exceed 25% of total capital) less goodwill and other intangible assets. The threshold is adjusted downward by an amount equal to 70% of the aggregate amount of common stock repurchased by the Company after March 31, 2018, up to a maximum deduction of $1.75 billion. The threshold was $13.60 billion at December 31, 2018 and could decline to a minimum of $12.494 billion during the term of the credit agreement, subject to the Company repurchasing an additional $1.58 billion of its common stock. In addition, the credit agreement contains other customary restrictive covenants as well as certain customary events of default, including with respect to a change in control, which is defined to include the acquisition of 35% or more of the Company’s voting stock and certain changes in the composition of the Company’s board of directors. At December 31, 2018, the Company was in compliance with these covenants. Generally, the cost of borrowing under this agreement will range from LIBOR plus 75 basis points to LIBOR plus 137.5 basis points, depending on the Company’s credit ratings. At December 31, 2018, that cost would have been LIBOR plus 100 basis points, had there been any amounts outstanding under the credit agreement. In the event that LIBOR is no longer available, the credit agreement provides that the Company and the syndicate of financial institutions use commercially reasonable efforts to jointly agree upon an alternate rate of interest.
In August 2017, the Company issued 95,953 shares of restricted stock valued at approximately $12 million in connection with a business acquisition to certain employees of the acquired business, of which 92,995 shares remained outstanding and unvested at December 31, 2018. The restricted stock is subject to service conditions and as such is recognized as share-based compensation; 50% of the restricted stock will vest two years from the issuance date and the remainder will vest three years from the issuance date. The value is being recognized over the respective vesting periods and included with the share-based compensation cost of awards that are issued under the Company’s share-based incentive compensation plan (see note 13). The recipients generally have all the rights of a shareholder of the Company including the right to vote the applicable shares of common stock and to receive dividends on such shares, if and as declared by the Board of Directors. The restricted stock is held under the Company’s control with the Company’s transfer agent and will be released upon vesting.
TRV and its two non-insurance holding company subsidiaries received dividends of $2.30 billion, $2.33 billion and $3.05 billion from their U.S. insurance subsidiaries in 2018, 2017 and 2016, respectively.
For the years ended December 31, 2018, 2017 and 2016, TRV declared cash dividends per common share of $3.03, $2.83 and $2.62, respectively, and paid cash dividends of $814 million, $785 million and $757 million, respectively.
Statutory net income of the Company’s domestic and international insurance subsidiaries was $2.61 billion, $2.30 billion and $3.20 billion for the years ended December 31, 2018, 2017 and 2016, respectively. Statutory capital and surplus of the Company’s domestic and international insurance subsidiaries was $20.77 billion and $20.45 billion at December 31, 2018 and 2017, respectively.
The following table presents the changes in the Company’s accumulated other comprehensive income (AOCI) for the years ended December 31, 2018, 2017 and 2016.
Basic earnings per share was computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period. The computation of diluted earnings per share reflected the effect of potentially dilutive securities.
The Company paid income taxes of $408 million, $514 million and $892 million during the years ended December 31, 2018, 2017 and 2016, respectively. The current income tax receivable of $12 million and $65 million at December 31, 2018 and 2017, respectively, was included in other assets in the consolidated balance sheet.
During the fourth quarter of 2017, the Company recorded provisional amounts for the tax imposed on accumulated foreign earnings and partnership investments, as well as the amount due under the transition rule relating to the change in discounting of claims incurred, based on information available at December 31, 2017. In 2018, the Company made minor adjustments to the provisional
amounts for taxes related to accumulated foreign earnings based upon final earnings from its foreign operations and the proposed regulations issued by the U.S. Treasury. These minor adjustments were consistent with final regulations issued by the U.S. Treasury in January 2019. The Company also made minor adjustments to the provisional amount for taxes related to partnership investments based upon the latest available information associated with those investments (Form K-1s) that were received in 2018.
In November 2018, the U.S. Treasury issued proposed regulations which would establish the interest rate and discounting methodology to be used in determining the tax discount on claims and claim adjustment expense reserves under TCJA. The proposed regulations significantly reduce the deferred tax assets and liabilities related to the transition rule for discounting of reserves and reduced the estimated additional tax payments associated with the transition rule from $70 million to $23 million per year over the eight years beginning in 2018 as discussed above.
The Company estimated the amounts payable related to the transition rules for discounting of loss reserves using the regulations proposed by the U.S. Treasury during 2018. These amounts are subject to change once the final regulations are issued, which is expected to occur in 2019.
The following is a reconciliation of the beginning and ending amount of unrecognized tax benefits for the years ended December 31, 2018 and 2017:
Included in the balances at December 31, 2018 and 2017 were $29 million and $3 million, respectively, of unrecognized tax benefits that, if recognized, would affect the annual effective tax rate. Also included in the balances at those dates were $2 million and $3 million, respectively, of tax positions for which the ultimate deductibility is certain, but for which there is uncertainty about the timing of deductibility. The timing of such deductibility could affect the annual effective tax rate depending on the year of deduction and tax rate at the time.
The IRS has completed examinations of the Company’s U.S. income tax returns for all years through 2014. The Company does not expect any significant changes to its liability for unrecognized tax benefits during the next twelve months.
The number of shares of the Company’s common stock initially authorized for grant under the 2014 Incentive Plan was 10 million shares. In May 2017 and 2016, the Company’s shareholders authorized an additional 2.5 million and 4.4 million shares of the Company’s common stock, respectively, for grant under the 2014 Incentive Plan. The following are not counted towards the combined 16.9 million shares available and will be available for future grants under the 2014 Incentive Plan: (i) shares of common stock subject to awards that expire unexercised, that are forfeited, terminated or canceled, that are settled in cash or other forms of property, or otherwise do not result in the issuance of shares of common stock, in whole or in part; (ii) shares that are used to pay the exercise price of stock options and shares used to pay withholding taxes on awards generally; and (iii) shares purchased by the Company on the open market using cash option exercise proceeds; provided, however, that the increase in the number of shares of common stock available for grant pursuant to such market purchases shall not be greater than the number that could be repurchased at fair market value on the date of exercise of the stock option giving rise to such option proceeds. In addition, the 16.9 million shares authorized by shareholders for issuance under the 2014 Incentive Plan will be increased by any shares subject to awards under the 2004 Incentive Plan that were outstanding as of May 27, 2014 and subsequently expire, are forfeited, canceled, settled in cash or otherwise terminate without the issuance of shares.
The Company also has a compensation program for non-employee directors (the Director Compensation Program). Under the Director Compensation Program, non-employee directors’ compensation consists of an annual retainer, a deferred stock award, committee chair fees and a lead director fee. Each non-employee director may choose to receive all or a portion of his or her annual retainer, committee chair fee and lead director fee in the form of cash or deferred stock units which vest upon grant. The annual deferred stock awards vest in full one day prior to the date of the Company’s annual meeting of shareholders occurring in the year following the year of the grant date, subject to continued service. The deferred stock awards, including dividend equivalents, accumulate until distribution either in a lump sum six months after termination of service as a director or, if the director so elects, in annual installments beginning at least six months following termination of service as a director. The deferred stock units issued under the Director Compensation Program are awarded under the 2014 Incentive Plan.
On February 5, 2019, the Company, under the 2014 Incentive Plan, granted 2,051,673 stock option awards with an exercise price of $126.18 per share. The fair value attributable to the stock option awards on the date of grant was $16.65 per share.
The total fair value of shares that vested during the years ended December 31, 2018, 2017 and 2016 was $135 million, $166 million and $175 million, respectively.
Represents the current year change in estimated performance shares to reflect the attainment of performance goals for the awards that were granted in each of the years 2016 through 2018.
The following table indicates the line items in which the respective service costs and non-service costs are presented in the consolidated statement of income for the years ended December 31, 2018, 2017 and 2016.
The following table summarizes assumptions used with regard to the Company’s qualified and nonqualified domestic pension plans and the domestic postretirement benefit plans.
The discount rate assumption used to determine the benefit obligation is based on a yield-curve approach. Under this approach, individual spot rates from the yield curve of a hypothetical portfolio of high quality fixed maturity corporate bonds (rated Aa) available at the year-end valuation date, for which the timing and amount of cash outflows correspond with the timing and amount of the estimated benefit payouts of the Company’s benefit plan, are applied to expected future benefits payments in measuring the projected benefit obligation. The discount rate assumption used to determine benefit obligations disclosed above represents the weighted average of the individual spot rates.
The Company’s other postretirement benefit plans had financial assets of $12 million and $13 million at December 31, 2018 and 2017, respectively, which are measured at fair value on a recurring basis. The assets are primarily corporate bonds and short-term securities and categorized as level 2 in the fair value hierarchy.
The following table presents the estimated benefits expected to be paid by the Company’s pension and postretirement benefit plans for the next ten years (reflecting estimated future employee service).
Rent expense was $185 million, $188 million and $197 million in 2018, 2017 and 2016, respectively.
legislation. Because of these uncertainties, additional liabilities may arise for amounts in excess of the Company’s current insurance reserves. In addition, the Company’s estimate of ultimate claims and claim adjustment expenses may change. These additional liabilities or changes in estimates, or a range of either, cannot now be reasonably estimated and could result in income statement charges that could be material to the Company’s results of operations in future periods.
On August 17, 2010, in a reinsurance dispute in New York state court captioned United States Fidelity & Guaranty Company v. American Re-Insurance Company, et al., the trial court granted summary judgment for United States Fidelity and Guaranty Company (USF&G), a subsidiary of the Company, and denied summary judgment for the reinsurers. The Court of Appeals largely affirmed the entry of summary judgment, but remanded two discrete issues for trial.
On November 7, 2016, the Company agreed to a settlement with one of the three defendants then remaining in this dispute. The Company received payment under the settlement in the fourth quarter of 2016 and, as a result, recognized a $126 million pre-tax ($82 million after-tax) gain in the fourth quarter, which was included in “other revenues” in the consolidated statement of income for the year ended December 31, 2016. In connection with that settlement, the reinsurance recoverable balance related to this case was reduced from approximately $238 million to approximately $31 million in the Company’s consolidated balance sheet. At March 31, 2017, the claim related to the remaining defendants totaled $71 million, comprising the $31 million of reinsurance recoverable plus interest amounting to $40 million as of that date. The interest was treated for accounting purposes as a gain contingency in accordance with FASB Topic 450, Contingencies, and accordingly was not recognized in the Company’s consolidated financial statements.
In the ordinary course of selling businesses to third parties, the Company has agreed to indemnify purchasers for losses arising out of breaches of representations and warranties with respect to the businesses being sold, covenants and obligations of the Company and/or its subsidiaries and, in certain cases, obligations arising from certain liabilities. Such indemnification provisions generally are applicable from the closing date to the expiration of the relevant statutes of limitations, although, in some cases, there may be agreed upon term limitations or no term limitations. Certain of these contingent obligations are subject to deductibles which have to be incurred by the obligee before the Company is obligated to make payments. The maximum amount of the Company’s contingent obligation for indemnifications related to the sale of businesses that are quantifiable was $358 million at December 31, 2018, of which $2 million was recognized on the balance sheet at that date.
Total other-than-temporary impairments (OTTI) for the year ended December 31, 2016, and the amounts comprising total OTTI that were recognized in net realized investment gains (losses) and in other comprehensive income (OCI), were as follows:
Due to the use of an average number of shares for each quarter, the sum of the quarterly earnings per share may not equal the total earnings per share for the full year.