The executive offices of the Corporation are in Warren, New Jersey. The administrative offices of the Group are in Warren and Whitehouse Station, New Jersey. The Group maintains zone administrative and branch offices in major cities throughout the United States and also has offices in Canada, Europe, Australia, the Far East and Latin America. Office facilities are leased with the exception of buildings in Whitehouse Station and Branchburg, New Jersey and Simsbury, Connecticut. Management considers its office facilities suitable and adequate for the current level of operations.
Underwriting income has been reduced by aggregate net losses of $700.0 million ($455.0 million after-tax or $2.63 per share) recognized in the third and fourth quarters related to asbestos and toxic waste claims. Underwriting income has been increased by a reduction in net surety bond losses of $88.0 million ($57.2 million after-tax or $0.33 per share) resulting from the settlement of litigation related to Enron Corp.
Property and casualty insurance other charges includes a restructuring charge of $40.0 million ($26.0 million after-tax or $0.15 per share).
Certain statements in this document may be considered to be “forward-looking statements” as that term is defined in the Private Securities Litigation Reform Act of 1995, such as statements that include words or phrases as “will result”, “is expected to”, “will continue”, “is anticipated”, or similar expressions. Such statements are subject to certain risks, uncertainties and assumptions about our business. The factors which could cause actual results to differ materially from those suggested by any such statements include but are not limited to those discussed or identified from time to time in the Corporation’s public filings with the Securities and Exchange Commission and specifically to risks or uncertainties associated with:
premium price increases and profitability or growth estimates overall or by lines of business, or geographic area, and related expectations with respect to the timing and terms of any required regulatory approvals;
developments in judicial decisions or legislative actions relating to coverage and liability for asbestos and toxic waste claims; and
developments in judicial decisions or regulatory actions relating to coverage and liability for mold claims;
the impact of the current economic climate on companies on whose behalf we have issued surety bonds, and in particular, on those companies that have experienced deterioration in creditworthiness;
the effects of disclosures by and investigations of public companies relating to possible accounting irregularities, practices in the energy and securities industries and other corporate governance issues, including:
The Corporation assumes no obligation to update any forward-looking information set forth in this document, which speak as of the date hereof.
Net income determined in accordance with generally accepted accounting principles (GAAP) was $223 million in 2002 compared with $112 million in 2001 and $715 million in 2000.
Results in 2002 were adversely affected by aggregate net losses of $700 million, or $455 million after-tax, recognized in the third and fourth quarters related to asbestos and toxic waste claims. Results in 2002 were also adversely affected by a tax valuation allowance of $40 million from not being able to recognize for accounting purposes certain U.S. tax benefits related to European losses. Conversely, results in 2002 benefited from a reduction of net surety bond losses of $88 million, or $57 million after-tax, resulting from the settlement of litigation related to Enron.
Results in 2001 and 2002 were impacted by a number of significant items. Results in 2001 were adversely affected by the net costs of $645 million related to the September 11 attack and the net surety losses of $220 million related to Enron. Results in 2002 were adversely affected by the recognition of aggregate net losses of $700 million in the third and fourth quarters related to asbestos and toxic waste claims (the “$700 million asbestos charge”). Results in 2002 benefited from the $88 million reduction in net surety losses resulting from the settlement of litigation related to Enron.
The pre-tax costs of $645 million related to the September 11 attack had three components. First, in our insurance business, we incurred estimated net claims and claim expenses of $555 million plus reinsurance reinstatement costs of $50 million, for an aggregate cost of $605 million. Each of our underwriting segments was affected by the September 11 attack. However, the impact was by far the greatest on our financial institutions business. Second, in our reinsurance business written through Chubb Re, which is included in other specialty results, we incurred estimated net claims and claim expenses of $110 million and recognized reinstatement premium revenue of $80 million, for a net cost of $30 million. Finally, we recorded a $10 million charge, included in other charges, as our share of the losses publicly estimated by Hiscox plc, a U.K. insurer in which we have a minority interest.
The questions that have been raised generally involve the applicable limit of reinsurance coverage available to us, the definition of what constitutes one risk, our accumulation of exposure in the various buildings destroyed or damaged and our adherence to our underwriting guidelines. We have responded to these questions and are continuing discussions with the reinsurers. Most of the reinsurers are paying, although some are reserving their rights as they continue to discuss their open issues with us. One reinsurer is withholding payments pending the resolution of the questions raised.
Based on current information, we estimate that the aggregate amount of reinsurance recoverable under the property per risk reinsurance agreements related to claims arising from the September 11 attack is approximately $1.2 billion. As of December 31, 2002, approximately $655 million had been billed under these agreements. We had collected $355 million of this amount at that date. Of the remaining $300 million billed, $70 million was outstanding for more than 90 days and, as of February 28, 2003, $24 million of that amount has been collected. The amounts billed relate to those individual losses on which we have already made payments to an insured in excess of our $10 million retention. The balance of the $1.2 billion reinsurance recoverable under the property per risk reinsurance treaties relates to similar claims on which we have not yet made such payments.
the commencement of arbitration proceedings to enforce our rights. We believe that our position is strong and that either our responses to the reinsurers’ questions will ultimately satisfy them or we will prevail in arbitration should that become necessary.
The net costs related to the September 11 attack, the Enron surety losses and related settlement, and the asbestos charge are significant components in understanding and assessing our financial performance. However, these items had a distorting effect on our results. The following summary adjusts our reported property and casualty income or loss before taxes to exclude the impact of these items.
As a result of the substantial losses incurred by reinsurers in recent years, the cost of reinsurance in the marketplace has increased significantly and reinsurance capacity for certain coverages, such as terrorism, is limited and expensive.
The potential increase in our net risk concentrations from a catastrophic event that would result from these changes to our reinsurance arrangements may be offset to some degree by changes to our gross risk profile. In particular, we are making a concerted effort to reduce risk aggregations. Despite this effort, our future operating results could be more volatile due to the changes made to our reinsurance program.
It is expected that the cost of reinsurance will continue to increase in 2003. The changes in our reinsurance program in 2003 will be more subtle than in 2002. We expect to discontinue some lower limit treaties that we believe are no longer economical and to increase our participation in certain layers of the treaties that we renew.
The Terrorism Risk Insurance Act of 2002 (the Terrorism Act) was signed into law on November 26, 2002. The Terrorism Act established a program under which the federal government will share the risk of loss from certain acts of international terrorism with the insurance industry. The program terminates on December 31, 2005. The Terrorism Act is applicable to almost all commercial lines of insurance. Insurance companies with direct commercial insurance exposure in the United States are required to participate in the program. Each insurer has a separate deductible in the event of an act of terrorism before federal assistance becomes available. The deductible is based on a percentage of direct commercial earned premiums from the previous calendar year. For 2003, that deductible is 7% of direct commercial earned premiums in 2002. For losses above the deductible, the federal government will pay for 90% of insured losses, while the insurer contributes 10%. For certain classes of business, such as workers’ compensation, terrorism coverage is mandatory. For those classes of business where it is not mandatory, insureds may choose not to accept the terrorism coverage, which would reduce our exposure. While the provisions of the Terrorism Act will serve to mitigate our exposure in the event of a large-scale terrorist attack, our deductible is substantial, approximating $350 million in 2003. Therefore, we continue to monitor concentrations of risk.
The combined loss and expense ratio, expressed as a percentage, is the key measure of underwriting profitability traditionally used in the property and casualty business. We use the statutory definition of combined loss and expense ratio. It is the sum of the ratio of losses to premiums earned (loss ratio) plus the ratio of underwriting expenses to premiums written (expense ratio) after reducing both premium amounts by dividends to policyholders. When the combined ratio is under 100%, underwriting results are generally considered profitable; when the combined ratio is over 100%, underwriting results are generally considered unprofitable.
Our expense ratio decreased in 2002 due to premiums written growing at a substantially higher rate than overhead expenses.
Other personal coverages, which include insurance for personal valuable articles and excess liability, produced highly profitable results in each of the past three years, as favorable loss experience has continued.
Our commercial insurance results, as adjusted, have shown substantial improvement in each succeeding year. On an as adjusted basis, our commercial insurance business produced an underwriting profit in 2002 compared with underwriting losses in 2001 and 2000. The improvement has been due in large part to the cumulative effect of price increases, better terms and conditions and more stringent risk selection in recent years. While all segments of this business have improved, the improvement has been most significant in our casualty and property and marine classes.
Commercial insurance results, particularly in the casualty classes, were adversely affected in each of the past three years by incurred losses relating to asbestos and toxic waste claims. In addition to the $700 million asbestos charge in 2002, asbestos and toxic waste losses were $41 million in 2002, $61 million in 2001 and $31 million in 2000. The as adjusted combined ratios exclude the effect of the $700 million asbestos charge but include the effect of all other asbestos and toxic waste losses.
Results for our casualty business, as adjusted, were profitable in 2002 compared with highly unprofitable results in 2001 and 2000. This business has shown significant improvement in each of the past two years due to higher rates and the culling of business where we could not attain price adequacy. In particular, the automobile component showed substantial improvement, producing highly profitable results in 2002 compared with modestly unprofitable results in 2001 and highly unprofitable results in 2000. Results for the primary liability component also improved in each succeeding year. The excess liability component produced breakeven results in 2002 compared with unprofitable results in 2001 and 2000. As noted above, casualty results in each of the past three years were adversely affected by incurred losses related to asbestos and toxic waste claims.
Workers’ compensation results were highly profitable in 2002 and 2001 compared with near breakeven results in 2000. The strong results in 2002 and 2001 were due to higher rates as well as to a lower frequency of losses, resulting in large part from our disciplined risk selection during the past several years.
Growth in our other specialty insurance business was primarily from Chubb Re, our reinsurance assumed business. Premiums produced by Chubb Re amounted to $488 million in 2002 compared with $199 million in 2001, excluding the net reinstatement premium revenue of $80 million, and $158 million in 2000. We expect reinsurance assumed business to continue to grow significantly in 2003.
Our specialty insurance underwriting results, as adjusted, were unprofitable in 2002 compared with profitable results in 2001 and 2000.
Executive protection results were unprofitable in 2002 compared with profitable results in 2001 and 2000. Results in 2002 were adversely affected by deteriorating claim trends in directors and officers liability and errors and omissions liability business due in large part to the corporate abuses and accounting irregularities in recent years. Results in Europe were particularly unprofitable in 2002. Loss experience in Europe started to deteriorate in 2001 due to adverse trends in loss severity caused by an increase in litigation, often involving European companies being sued in U.S. courts for securities fraud. Loss trends in Europe deteriorated further in 2002. Our employment practices liability business was profitable in 2002 compared with unprofitable results in 2001 and 2000. The improvement was due to our strategy to reduce our exposure to accounts with more than 10,000 employees, which are the accounts that had been generating most of our large losses in this class.
Other specialty results, as adjusted, were highly profitable in 2002 compared with near breakeven results in 2001 and unprofitable results in 2000. Excluding the impact of the Enron bankruptcy, our surety results were highly profitable in each of the past three years. Our reinsurance assumed business generated by Chubb Re produced a modest underwriting gain in 2002 compared with a modest loss in 2001 and 2000. Accident and aviation results also improved in 2002.
Under the gas forward purchase surety bond structure, gas suppliers entered into long-term gas purchase agreements pursuant to which they agreed to supply specified quantities of gas to the beneficiaries under our surety bonds. In exchange for the gas purchase agreement, the beneficiaries under our surety bonds made an agreed upon advance payment for the gas. Our surety bonds secure the suppliers’ obligation to supply gas. Under the terms of these bonds, our entire obligation to pay could be triggered if the related supplier failed to provide gas under its forward purchase contracts or was the subject of a bankruptcy filing.
Each of the suppliers continues to perform its obligations under the related gas forward purchase agreements. However, certain of these suppliers, including Aquila, Inc., have suffered ratings downgrades. If payment under the Aquila surety bonds were triggered or if payment under all of the other gas forward surety bonds were triggered, such payments would have a material adverse effect on the Corporation’s results of operations and liquidity.
Loss reserves, which are our property and casualty subsidiaries’ largest liability, include significant amounts related to the September 11 attack, to our Enron surety exposure and to asbestos and toxic waste claims. The components of our loss reserves were as follows:
Loss reserves for personal insurance and specialty insurance increased significantly in 2002 and 2001. In particular, in specialty insurance, our European directors and officers and errors and omissions loss reserves for the current and prior accident years increased by about $250 million in the aggregate in 2002. Loss reserves for commercial insurance have not increased, reflecting the significant exposure reductions of the past several years and the improved accident year results in these years due to more stringent risk selection.
During 2002, we experienced overall unfavorable development of $790 million on loss reserves established as of the previous year end. This compares with favorable development of $196 million in 2001 and $230 million in 2000. Such development was reflected in operating results in these respective years.
In Item 1 of the Form 10-K, we present an analysis of our consolidated loss reserve development on a calendar year basis for the ten years prior to 2002.
Our U.S. property and casualty subsidiaries are required to file annual statements with insurance regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities. These annual statements include an analysis of loss reserves, referred to as Schedule P, that presents accident year loss development information by line of business for the nine years prior to 2002. It is our intention to post the Schedule P for our combined U.S. property and casualty subsidiaries on our website as soon as it becomes available.
The process of establishing loss reserves is complex and imprecise as it is subject to variables that are influenced by significant judgmental factors. This is true because claim settlements to be made in the future will be impacted by changing rates of inflation, particularly medical cost inflation, and other economic conditions; changing legislative, judicial and social environments; and changes in our claim handling procedures.
Our loss reserves include amounts related to short tail and long tail classes of business. Short tail classes consist principally of homeowners, personal valuable articles and commercial property business. For these classes, the estimation of loss reserves is less complex because claims are generally reported and settled quickly and the claims relate to tangible property.
Reserves for asbestos and toxic waste claims cannot be estimated with traditional actuarial techniques that rely on historical accident year loss development factors. We establish case reserves and expense reserves for costs of related litigation where sufficient information has been developed to indicate the involvement of a specific insurance policy. In addition, IBNR reserves are established to cover additional exposures on both known and unasserted claims.
The uncertainties relating to asbestos and toxic waste claims on insurance policies written many years ago are further exacerbated by inconsistent court decisions as well as judicial interpretations and legislative actions that in some cases have tended to broaden coverage beyond the original intent of such policies and in others have expanded theories of liability. The industry as a whole is engaged in extensive litigation over these coverage and liability issues and is thus confronted with a continuing uncertainty in its efforts to quantify these exposures.
Asbestos remains the most significant and difficult mass tort for the insurance industry in terms of claims volume and dollar exposure. Early court cases established the “continuous trigger” theory with respect to insurance coverage. Under this theory, insurance coverage is deemed to be triggered from the time a claimant is first exposed to asbestos until the manifestation of any disease. This interpretation of a policy trigger can involve insurance companies over many years and increases their exposure to liability.
To date, approximately 65 manufacturers and distributors of asbestos products have filed for bankruptcy protection as a result of asbestos liabilities. The rapid increase in both the frequency and severity of claims in recent years has accelerated the pace at which these bankruptcies have been filed. About 30 of these companies have been pushed into bankruptcy since 2000. In part as a result of these bankruptcies, the volume and value of claims against viable asbestos defendants continue to increase.
Asbestos claims initially focused on the major manufacturers, distributors or installers of asbestos products under the products liability section of primary general liability policies as well as under excess liability policies, both of which typically had aggregate limits that capped an insurer’s liability. In recent years, a number of asbestos claims by insureds are being presented as “non-products” claims, such as those by installers of asbestos products and by property owners who allegedly had asbestos on their property, under the premises or operations section of primary general liability policies. Unlike products exposures, these non-products exposures typically had no aggregate limits, creating potentially greater exposure. Further, in an effort to seek additional insurance coverage, some insureds with installation activities who have substantially eroded their products coverage are presenting new asbestos claims as non-products operations claims or attempting to reclassify old products claims. The extent to which insureds will be liable under such theories and successful in obtaining coverage on this basis is uncertain.
The expanded focus of asbestos litigation beyond asbestos manufacturers and distributors to installers and premises owners has created, in some instances, conflicts among insureds, primary insurers and excess insurers, mainly involving questions regarding allocation of indemnity and expense costs and exhaustion of policy limits. These issues are generating costly coverage litigation with the potential for inconsistent results.
Federal legislation still appears to be the best vehicle for comprehensively addressing the asbestos problem. However, unified support among various defendant and insurer groups considered essential to any possible reform is lacking. We therefore have assumed a continuing unfavorable legal environment with no benefit from any asbestos reform legislation.
In establishing our asbestos reserves, we evaluate the exposure presented by each insured. As part of this evaluation, we consider the available insurance coverage; limits and deductibles; the potential role of other insurance, particularly underlying coverage below our excess liability policies; and applicable coverage defenses, including asbestos exclusions.
Estimates of the ultimate liabilities for traditional asbestos defendants have increased as the number of plaintiff claims has surged over the past few years. The notable increase in claimants as well as potential future claimants has resulted in large settlements of asbestos related litigation. As a result, it now appears more likely that many of these traditional defendants will access higher excess layers of insurance coverage as well as more years of coverage than previously anticipated.
Upon completion of the analysis and assessment of the results, we increased our net asbestos loss reserves by $545 million in the third quarter. Following a thorough review in the fourth quarter by our
Significant uncertainty remains as to our ultimate liability relating to asbestos related claims due to such factors as the long latency period between asbestos exposure and disease manifestation and the resulting potential for involvement of multiple policy periods for individual claims as well as the increase in the volume of claims by plaintiffs who claim exposure but who have no symptoms of asbestos-related disease and an increase in claims filed under the non-aggregate premises or operations section of general liability policies. There is also the possibility of federal legislation that would address the asbestos problem.
Most PRPs named to date are parties who have been generators, transporters, past or present landowners or past or present site operators. The PRPs disposed of toxic materials at a waste dump site or transported the materials to the site. These PRPs had proper government authorization in many instances. Insurance policies issued to PRPs were not intended to cover the clean-up costs of pollution and, in many cases, did not intend to cover the pollution itself. Pollution was not a recognized hazard at the time many of these policies were written. In more recent years, however, policies specifically exclude such exposures.
Uncertainties also remain as to the Superfund law itself. Superfund’s taxing authority expired on December 31, 1995 and has not been re-enacted. Federal legislation appears to be at a standstill. At this time, it is not possible to predict the direction that any reforms may take, when they may occur or the effect that any changes may have on the insurance industry.
Without federal movement on Superfund reform, the enforcement of Superfund liability is shifting to the states. States are being forced to reconsider state-level cleanup statutes and regulations. As individual states move forward, the potential for conflicting state regulation becomes greater. Significant uncertainty remains as to the cost of remediating the state sites. Because of the large number of state sites, such sites could prove even more costly in the aggregate than Superfund sites.
Our property and casualty subsidiaries have exposure to insured losses caused by hurricanes, earthquakes, winter storms, windstorms and other natural catastrophic events. The frequency and severity of natural catastrophes are unpredictable.
The extent of losses from a catastrophe is a function of both the total amount of insured exposure in an area affected by the event and the severity of the event. We continually assess our concentration of underwriting exposures in catastrophe prone areas globally and develop strategies to manage this exposure through individual risk selection, subject to regulatory constraints, and through the purchase
of catastrophe reinsurance. In recent years, we have invested in modeling technologies and concentration management tools that allow us to better monitor and control our accumulations of potential losses from catastrophe exposures. We maintain records showing concentrations of risk in catastrophe prone areas such as California (earthquake and brush fires) and the gulf and east coasts of the United States (hurricanes). We also continue to explore and analyze credible scientific evidence, including the impact of global climate change, that may affect our potential exposure under insurance policies.
In a typical portfolio credit default swap, CFS participates in the senior layer of a structure designed to replicate the performance of a portfolio of corporate securities, a portfolio of asset-backed securities or a specified pool of loans. The structure of these portfolio credit default swaps generally requires CFS to make payment to counterparties to the extent cumulative losses, related to numerous credit events, exceed a specified threshold. The risk below that threshold, referred to as subordination, is assumed by other parties with the primary risk layer sometimes retained by the buyer. The amount of subordination for each contract varies based on the credit quality of the underlying portfolio and
the term to maturity of the contract. Credit events generally arise when one of the referenced entities within a portfolio becomes bankrupt, undergoes a debt restructuring or fails to make timely interest or principal payments on a senior unsecured debt obligation.
The fair value of our credit default swaps is subject to fluctuations arising from, among other factors, changes in credit spreads, the financial ratings of referenced asset-backed securities, actual credit events reducing subordination, credit correlation within a portfolio, anticipated recovery rates related to potential defaults and changes in interest rates. Short term fluctuations in the fair value of our future obligations may have little correlation to the ultimate profitability of this business. The ultimate profitability of this business depends on actual credit events over the lives of the contracts. While we have not had to make any payment under any of the contracts, we cannot be certain that there will never be any payment obligation under the credit default swap portfolio. The market risks associated with our obligations under portfolio credit default swaps are discussed under “Market Risk of Financial Instruments - Credit Derivatives.”
Revenues from the non-insurance business of CFS, principally consisting of the change in fair value of derivative contracts, were $27 million in 2001 and $12 million in 2000. Revenues were negative $52 million in 2002 due to the adverse impact of changes in fair value during the year. This business produced a loss before taxes of $70 million in 2002 compared with income of $9 million in 2001 and $3 million in 2000.
At December 31, 2002, CFS’s aggregate exposure, or retained risk, referred to as notional amounts, from its in-force portfolio credit default swaps was approximately $38.7 billion. The notional amounts are used to express the extent of involvement in swap transactions. These amounts are used to calculate the exchange of contractual cash flows and are not necessarily representative of the potential for gain or loss. The notional amounts are not recorded on the balance sheet.
The notional amount and fair value of our future obligations by type of risk were as follows:
The insurance and reinsurance solutions that CFS develops to meet the risk management needs of its customers are written by our property and casualty subsidiaries. Results from this business are included within our insurance results. A property and casualty subsidiary issued a reinsurance contract to an insurer who provides financial guarantees on asset-backed transactions. At December 31, 2002, the amount of aggregate principal commitments related to this contract was approximately $350 million, net of reinsurance. These commitments expire by 2023.
Corporate and other includes investment income earned on corporate invested assets, interest expense and other expenses not allocated to the operating subsidiaries, and the results of our real estate and other non-insurance subsidiaries. Corporate and other produced a loss before taxes of $74 million in 2002 compared with losses of $23 million and $7 million in 2001 and 2000, respectively. The substantially higher loss in 2002 was due to higher interest expense and lower investment income. The higher interest expense in 2002 was due to the issuance of $600 million of debt in the fourth quarter of 2001. The lower investment income in 2002 was due to the decrease in corporate invested assets resulting from the capital contribution to the property and casualty subsidiaries in the fourth quarter of 2001. In 2000, corporate and other included income of $10 million from a noncompete payment related to the sale of the Corporation’s 50% interest in Associated Aviation Underwriters, Inc. (AAU).
We own approximately $300 million of land which we expect will be developed in the future. In addition, we own approximately $180 million of commercial properties and land parcels under lease. We are continuing to explore the sale of certain of our remaining properties.
Loans receivable, which amounted to $86 million at December 31, 2002, are primarily purchase money mortgages. Such loans, which were issued in connection with our joint venture activities and other property sales, are generally collateralized by buildings and, in some cases, land. We continually evaluate the ultimate collectibility of such loans and establish appropriate reserves.
Decisions to sell securities are governed principally by considerations of investment opportunities and tax consequences. As a result, realized investment gains and losses on the sale of investments may vary significantly from year to year. A primary reason for the sale of fixed maturities in each of the last three years has been to improve our after-tax portfolio return without sacrificing quality where market opportunities have existed to do so.
We regularly review the value of our invested assets for other than temporary impairment. In evaluating whether a decline in value is other than temporary, we consider various factors including the length of time and the extent to which the fair value has been less than the cost, the financial condition and near term prospects of the issuer, whether the debtor is current on contractually obligated interest and principal payments, and our intent and ability to hold the investment for a period of time sufficient to allow us to recover our cost. If a decline in the fair value of an individual security is deemed to be other than temporary, the difference between cost and estimated fair value is charged to income as a realized investment loss.
At December 31, 2002 and 2001, we recorded a deferred income tax asset of $140 million and $90 million, respectively, related to the expected future U.S. tax benefit of the losses and foreign taxes incurred by Chubb Europe. To evaluate the realization of these deferred tax assets, management must consider whether it is more likely than not that Chubb Europe will generate sufficient taxable income to realize the future tax benefit of the deferred tax assets. Management’s judgment is based on its assessment of business plans and related projections of future taxable income that reflect assumptions about increased premium volume, higher rates and improved policy terms as well as available tax planning strategies.
Results in Chubb Europe in 2002 were less favorable than we anticipated due to the deteriorating claim trends. While the tax loss carryforwards and foreign tax credits have no expiration and we expect to generate sufficient taxable income to realize these benefits in the future, we are required under generally accepted accounting principles to consider a relatively near term horizon when we evaluate the likelihood of realizing future tax benefits. During the fourth quarter of 2002, we established a valuation allowance of $40 million for the portion of these assets that we cannot recognize for accounting purposes due to this limitation. If our estimates of future taxable income in Chubb Europe were revised upward or downward, we would need to adjust the valuation allowance accordingly. The effect on the Corporation’s results of operations could be significant.
Our investment portfolio is primarily comprised of high quality bonds, principally tax-exempt, U.S. Treasury, government agency, mortgage-backed securities and corporate issues. In addition, the portfolio includes equity securities held primarily with the objective of capital appreciation.
Fixed maturity securities which we have the ability and intent to hold to maturity are classified as held-to-maturity. The remaining fixed maturities, which may be sold prior to maturity to support our investment strategies, such as in response to changes in interest rates and the yield curve or to maximize after-tax returns, are classified as available-for-sale. Fixed maturities classified as held-to-maturity are carried at amortized cost while fixed maturities classified as available-for-sale are carried at market value. At December 31, 2002, 5% of the fixed maturity portfolio was classified as held-to-maturity compared with 8% at December 31, 2001 and 10% at December 31, 2000.
Changes in the general interest rate environment affect the returns available on new fixed maturity investments. While a rising interest rate environment enhances the returns available, it reduces the market value of existing fixed maturity investments and thus the availability of gains on disposition. A decline in interest rates reduces the returns available on new investments but increases the market value of existing investments, creating the opportunity for realized investment gains on disposition.
In 2002, interest rates declined to their lowest levels in many years while equity returns were negative for the second consecutive year. These trends may continue into 2003, reducing the returns available on the investment of funds.
Market risk represents the potential for loss due to adverse changes in the fair value of financial instruments. Our primary exposure to market risks relates to our investment portfolio, which exposes us to risks related to interest rates and, to a lesser extent, credit quality, prepayment, foreign currency exchange rates and equity prices. We also have exposure to market risks through our credit derivatives business and our debt obligations. Analytical tools and monitoring systems are in place to assess each of these elements of market risk.
Mortgage-backed securities comprised 34% and 33% of our taxable bond portfolio at year-end 2002 and 2001, respectively. About 50% of our mortgage-backed securities holdings at December 31, 2002 related to residential mortgages consisting of government agency pass-through securities, government agency collateralized mortgage obligations (CMOs) and AAA rated non-agency CMOs backed by government agency collateral or single family home mortgages. The majority of the CMOs are actively traded in liquid markets and market value information is readily available from broker/dealers. An additional 27% of our mortgage-backed securities were call protected AAA rated commercial securities. The remaining mortgage-backed holdings were all in investment grade commercial mortgage-backed securities.
currency of our foreign operations is generally the currency of the local operating environment since business is primarily transacted in such local currency. We reduce the risks relating to currency fluctuations by maintaining investments in those foreign currencies in which our property and casualty subsidiaries have loss reserves and other liabilities. Such investments have characteristics similar to our liabilities in those currencies. At December 31, 2002, the property and casualty subsidiaries held non-U.S. investments of $2.4 billion supporting their international operations. These investments have quality and maturity characteristics similar to our domestic portfolio. The principal currencies creating foreign exchange rate risk for the property and casualty subsidiaries are the euro, the British pound sterling and the Canadian dollar. The following table provides information about those fixed maturity investments that are denominated in these currencies. The table presents cash flows of principal amounts in U.S. dollar equivalents by expected maturity dates at December 31, 2002 and 2001. Actual cash flows could differ from the expected amounts.
Equity price risk is the potential loss arising from decreases in the value of equity securities. In general, equities have more year-to-year price variability than intermediate term high grade bonds. However, returns over longer time frames have been consistently higher. Our publicly traded equity securities are high quality, diversified across industries and readily marketable. Our portfolio also includes alternative investments, primarily investment partnerships. These investments by their nature are less liquid than other investments. We actively manage our risk by allocating a comparatively small amount of funds to alternative investments, perform extensive research prior to investing in a new investment and monitor the performance of the entities in which we have invested. A hypothetical decrease of 10% in the market price of each of the equity securities held at December 31, 2002 and 2001 would have resulted in a decrease of $99 million and $71 million, respectively, in the fair value of the equity securities portfolio.
The following table provides information about our portfolio credit default swaps by maturity, including the fair value of future obligations:
The Corporation also has outstanding $300 million of unsecured 6.15% notes due in 2005, $400 million of unsecured 6% notes due in 2011, $100 million of unsecured 6.60% debentures due in 2018 and $200 million of unsecured 6.8% debentures due in 2031. Chubb Capital Corporation, a wholly owned subsidiary, had outstanding $100 million of unsecured 6 7/8% notes due in 2003, which were paid in February when due.
Management continuously monitors the amount of capital resources that the Corporation maintains both for itself and its operating subsidiaries. In connection with our long-term capital strategy, the Corporation from time to time contributes capital to its property and casualty subsidiaries. In addition, in order to satisfy its capital needs as a result of any rating agency capital adequacy or other
In July 1998, the Board of Directors authorized the repurchase of up to 12,500,000 shares of the Corporation’s common stock. In June 2001, the Board of Directors authorized the repurchase of up to an additional 16,000,000 shares. The 1998 authorization has no expiration while the 2001 authorization will expire on June 30, 2003. As of December 31, 2002, 3,287,100 shares remained under the 1998 share repurchase authorization and 8,866,300 shares remained under the 2001 authorization. In the aggregate, the Corporation repurchased 1,500,000 shares in open-market transactions in 2002 at a cost of $99 million, 7,971,600 shares in 2001 at a cost of $556 million and 3,783,400 shares in 2000 at a cost of $242 million. We do not anticipate that we will repurchase any shares of our common stock in 2003.
New cash from operations available for investment by the property and casualty subsidiaries was approximately $1,930 million in 2002 compared with $570 million in 2001 and $560 million in 2000. The increase in new cash in 2002 was due to the significant growth in premium receipts while paid losses were similar in 2002 and 2001. New cash available in 2001 and 2000 was similar as substantial growth in premiums in 2001 was offset by an increase in paid losses.
The Corporation’s liquidity requirements in the past have been met by dividends from its property and casualty subsidiaries and the issuance of commercial paper and debt and equity securities. Liquidity requirements in the future will be met by these sources of funds as well as borrowings from our credit facilities.
Effective January 1, 2002, the Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 may not be applied retroactively to financial statements of prior periods. Under SFAS No. 142, goodwill is no longer amortized. Goodwill amortization was approximately $20 million in both 2001 and 2000. The adoption of SFAS No. 142 is discussed further in Note (2)(a) of the Notes to Consolidated Financial Statements.
Beginning January 1, 2003, the Corporation intends to adopt the fair value method of accounting for stock-based employee compensation plans, which is the method of accounting defined in SFAS No. 123, Accounting for Stock-Based Compensation. Under the fair value method of accounting, compensation cost is measured based on the fair value of the award at the grant date and recognized over the service period. Prior period financial statements will not be restated. The adoption of the fair value method of accounting for stock-based employee compensation plans is expected to result in a decrease in net income in 2003 of approximately $55 million. The adoption of the fair value method of accounting for stock-based employee compensation plans is discussed further in Note (1)(n) of the Notes to Consolidated Financial Statements.
Consolidated financial statements of the Corporation at December 31, 2002 and 2001 and for each of the three years in the period ended December 31, 2002 and the report of independent auditors thereon and the Corporation’s unaudited quarterly financial data for the two-year period ended December 31, 2002 are listed in Item 15(a) of this report.