We conduct our business operations primarily in our company-owned facilities in Worcester, Massachusetts and Howell, Michigan. We also lease offices throughout the United States for branch sales, underwriting and claims processing functions, and the operations of acquired subsidiaries.
Net income was $425.1 million in 2019, compared to $391.0 million in 2018, an increase of $34.1 million, primarily due to an increase in the net change in fair value of equity securities and from an increase in operating income in 2019. Net income in 2018 benefitted from the gain on the sale of Chaucer and Chaucer income earned during a portion of the year prior to its sale.
Operating income before interest expense and income taxes (a non-GAAP financial measure; see also “Results of Operations - Consolidated - Non-GAAP Financial Measures”) was $453.6 million in 2019 compared to $406.5 million in 2018, an increase of $47.1 million. This increase is primarily due to lower catastrophe losses, earned premium growth, lower expenses and higher net investment income, partially offset by higher non-catastrophe current accident year losses.
Underwriting results improved in 2019, as compared to 2018, primarily due to lower catastrophe losses, earned premium growth and lower expenses, partially offset by higher current accident year large property loss activity in our specialty industrial property line and, to a lesser extent, our inland marine and Hanover Programs lines. The competitive nature of the Commercial Lines market requires us to be highly disciplined in our underwriting process to ensure that we write business at acceptable margins, and we continue to seek rate increases across our lines of business.
Net premiums written grew by 5.7% in 2019, primarily due to higher renewal premium, driven by rate increases. Underwriting results declined in 2019, as compared to 2018, primarily due to higher non-catastrophe current accident year losses, partially offset by earned premium growth and lower expenses. We continue to seek rate increases that meet or exceed underlying loss cost trends, subject to regulatory and competitive considerations.
Primary business operations include insurance products and services currently provided through three operating segments: Commercial Lines, Personal Lines and Other. Commercial Lines includes commercial multiple peril, commercial automobile, workers’ compensation, and other commercial coverages, such as management and professional liability, marine, Hanover Programs, specialty industrial and commercial property, monoline general liability and surety. Personal Lines includes personal automobile, homeowners, and other personal coverages, such as umbrella. Included in the “Other” segment are Opus Investment Management, Inc., which markets investment management services to institutions, pension funds, and other organizations; earnings on holding company assets; holding company and other expenses, including certain costs associated with retirement benefits due to our former life insurance employees and agents; and a run-off voluntary property and casualty pools business. The operations of Chaucer are classified as discontinued operations for the period ending December 31, 2019, and all prior periods presented. We present the separate financial information of each segment consistent with the manner in which our chief operating decision maker evaluates results in deciding how to allocate resources and in assessing performance.
Consolidated net income was $425.1 million in 2019, compared to $391.0 million in 2018, an increase of $34.1 million. The year over year comparison of consolidated net income reflects an increase in after-tax net realized and unrealized investment gains of $132.1 million, principally related to the changes in fair value of equity securities. Additionally, operating income before interest expense and income taxes increased $47.1 million, primarily due to lower catastrophe losses, earned premium growth, lower expenses and higher net investment income, partially offset by higher current accident year large loss activity, particularly in the property lines. The increase in the year over year net income comparison was partially offset by the $131.9 million gain from the sale of our former Chaucer business in 2018.
Consolidated net income was $391.0 million in 2018, compared to $186.2 million in 2017, an increase of $204.8 million. The year over year comparison of consolidated net income reflects a $131.9 million gain, net of taxes, on the sale of our former Chaucer business. Additionally, operating income before interest expense and income taxes increased $79.2 million, primarily due to lower catastrophe losses and higher net investment income. Income increased from our discontinued operations, primarily Chaucer and, to a lesser extent, our discontinued life businesses, which incurred a 2017 reserve charge related to our participation in a long-term care pool (See also “Discontinued Operations” section below). Also, income tax expense on operating income decreased $20.2 million, driven by a decrease in the U.S. statutory tax rate from 35% to 21% effective January 1, 2018. These increases in net income were partially offset by net realized and unrealized investment losses, net of taxes, of $30.9 million in 2018, compared to net realized investment gains, net of taxes, of $26.2 million in 2017, principally related to reductions in fair value of equity securities. Effective January 1, 2018, we implemented ASU 2016-01, which requires that the changes in fair value of equity securities be presented in net income. Prior to then, these changes were recognized through accumulated other comprehensive income (see also Note 1 - “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements). Net income was also affected by $22.3 million in losses, net of taxes, associated with the repayment of debt in 2018.
In addition to consolidated net income, discussed above, we assess our financial performance based upon pre-tax “operating income,” and we assess the operating performance of each of our three operating segments based upon the pre-tax operating income (loss) generated by each segment. As reflected in the table above, operating income before taxes excludes interest expense on debt and certain other items which we believe are not indicative of our core operations, such as net realized and unrealized investment gains and losses. Such gains and losses are excluded since they are determined by interest rates, financial markets and the timing of sales. Also, operating income before taxes excludes net gains and losses on disposals of businesses, gains and losses related to the repayment of debt, discontinued operations, costs to acquire businesses, restructuring costs, the cumulative effect of accounting changes and certain other items. Although the items excluded from operating income before taxes are important components in understanding and assessing our overall financial performance, we believe a discussion of operating income before taxes enhances an investor’s understanding of our results of operations by highlighting net income attributable to the core operations of the business. However, operating income before taxes, which is a non-GAAP measure, should not be construed as a substitute for income before income taxes or income from continuing operations, and operating income should not be construed as a substitute for net income.
The following table summarizes GAAP underwriting results for the Commercial Lines, Personal Lines and Other segments and reconciles them to operating income (loss) before interest expense and income taxes.
We are continuing to manage underwriting performance through increased rates, pricing segmentation, specific underwriting actions and targeted new business growth. Our ability to achieve overall rate increases is affected by the current competitive pricing environment, particularly within our workers’ compensation line, which may hamper our ability to grow in this portion of our business.
Personal Lines underwriting profit for the year ended December 31, 2019 was $59.1 million, compared to $66.6 million for the year ended December 31, 2018, a decrease of $7.5 million. Catastrophe losses for the year ended December 31, 2019 were $86.1 million, compared to $76.9 million for the year ended December 31, 2018, an increase of $9.2 million. Unfavorable development on prior years’ loss reserves for the year ended December 31, 2019 was $26.6 million, compared to $33.3 million for the year ended December 31, 2018, a decrease of $6.7 million.
In addition, and as discussed under “Risk Factors - Michigan PIP Reform”, Michigan enacted major reforms of its current system governing personal and commercial automobile insurance. Michigan business represents 47% of our total personal automobile net premiums written. We currently believe the net impact of these reforms should not be significant to our total net premiums written and underwriting income in 2020; however, in light of the uncertainties attendant to these reforms, no assurances can be provided.
Other operating income was $8.6 million for the year ended December 31, 2019, compared to other operating losses of $5.4 million for the year ended December 31, 2018, an improvement of $14.0 million. This was primarily due to higher net investment income, which includes the investment of the remaining proceeds from the Chaucer sale transaction. All of the proceeds of the Chaucer transaction were distributed in 2019 through share repurchases or special dividends, and therefore will not be available for investment in 2020.
Management’s process for establishing loss reserves is a comprehensive process that involves input from multiple functions throughout our organization, including actuarial, finance, claims, legal, underwriting, distribution and business operations management. The process incorporates facts currently known, as well as the current, and in some cases, the anticipated, state of the law and coverage litigation. Based on information currently available, we believe that the aggregate loss reserves at December 31, 2019 were adequate to cover claims for losses that had occurred as of that date, including both those known to us and those yet to be reported. However, as described below, there are significant uncertainties inherent in the loss reserving process. Our estimate of the ultimate liability for losses that had occurred as of December 31, 2019 is expected to change in future periods as we obtain further information, and such changes could have a material effect on our results of operations and financial position.
Given the inherent complexity of our loss reserve estimation process and the potential variability of the assumptions used, the actual emergence of losses will vary, perhaps substantially, from the estimate of losses included in our financial statements, particularly in those instances where settlements or other claim resolutions do not occur until well into the future. Our net loss reserves at December 31, 2019 were $4.1 billion. Therefore, a relatively small percentage change in the estimate of net loss reserves would have a material effect on our results of operations.
There is greater inherent uncertainty in estimating insurance reserves for certain types of property and casualty insurance lines, particularly liability lines, where a longer period of time may elapse before a definitive determination of ultimate liability and losses may be made (sometimes referred to as “long-tail” business). In addition, the technological, judicial, regulatory and political climates involving these types of claims are continuously evolving. There is also greater uncertainty in establishing reserves with respect to business that is new to us, particularly new business which is generated with respect to newly introduced product lines, by newly appointed agents or in geographies in which we have less experience in conducting business. In such cases, there is less historical experience or knowledge and less data upon which we can rely. A combination of business that is both new to us and has longer development periods provides even greater uncertainty in estimating insurance reserves. In our management and professional liability lines, we are modestly increasing, and expect to continue to increase, our exposure to longer-tailed liability lines, including directors and officers liability, errors and omissions liability and product liability coverages. In addition, in recent periods we have experienced extensions of the “tails” in certain lines of business as the full value of claims are presented later than had been our historical experience.
We regularly update our reserve estimates as new information becomes available and additional events occur which may impact the resolution of unsettled claims. Reserve adjustments are reflected in the results of operations as adjustments to losses and LAE. Often, these adjustments are recognized in periods subsequent to the period in which the underlying policy was written and the loss event occurred. When these types of subsequent adjustments affect prior years, they are described separately as “prior year reserve development”. Such development can be either favorable or unfavorable to our financial results and may vary by line of business. As discussed below, estimated loss and LAE reserves for claims occurring in prior years, in the aggregate, developed favorably by $0.9 million for the year ended December 31, 2019 and unfavorably by $0.4 million and $1.2 million for the years ended December 31, 2018 and 2017, respectively, although there was some significant variance by line of business. Additionally, our estimated loss and LAE reserves for catastrophe claims occurring in prior years developed favorably by $27.5 million, $9.3 million and $1.4 million for the years ended December 31, 2019, 2018 and 2017, respectively. There can be no assurance that current loss and LAE reserves will be sufficient.
We regularly review our reserving techniques, our overall reserving position and our reinsurance. Based on (i) our review of historical data, legislative enactments, judicial decisions, legal developments in impositions of damages and policy coverage, political attitudes and trends in general economic conditions, (ii) our review of per claim information, (iii) our historical loss experience and that of the industry, (iv) the nature of policies written by us, and (v) our internal estimates of required reserves, we believe that adequate provision has been made for loss reserves. However, establishment of appropriate reserves is an inherently uncertain process, and there can be no certainty that current established reserves will prove adequate in light of subsequent actual experience. A significant change to the estimated reserves would have a material impact on our results of operations and financial position. An increase or decrease in reserve estimates would result in a corresponding decrease or increase in financial results. For example, each one percentage point change in the aggregate loss and LAE ratio resulting from a change in reserve estimation is currently projected to have an approximate $45 million impact on operating income, based on 2019 full year premiums.
While we estimate that approximately half of our written premium is in, what we would characterize as shorter-tail classes of business, most of our loss reserves relate to longer-tail liability classes of business. Long-tailed classes include automobile liability, commercial liability, third-party coverage and workers’ compensation. For many liability claims, significant periods of time, ranging up to several years or more, may elapse between the occurrence of the loss, the discovery and reporting of the loss to us and the settlement of the claim. As a result, loss experience in the more recent accident years for long-tailed liability coverage has limited statistical credibility because a relatively small proportion of losses in these accident years (the calendar years in which losses are incurred) are reported claims and an even smaller proportion are paid losses. Liability claims are also more susceptible to litigation and can be significantly affected by changing contract interpretations, the legal, political and social environment, the risk and expense of protracted litigation and inflation. Consequently, the estimation of loss reserves for these coverages is more complex and typically subject to a higher degree of variability and uncertainty compared to short-tailed coverages.
Most of our indirect business from our run-off voluntary and ongoing involuntary pools is assumed long-tailed casualty reinsurance. Reserve estimates for this business are therefore subject to the variability caused by extended loss emergence periods. The estimation of loss reserves for this business is further complicated by delays between the time the claim is reported to the ceding insurer and when it is reported by the ceding insurer to the pool manager and then to us, and by our dependence on the quality and consistency of the loss reporting by the ceding company and actuarial estimates by the pool manager. These reserving factors also apply to our discontinued assumed accident and health reinsurance pools and arrangements that are included in our liabilities of discontinued life businesses (See “Risk Factors” in Part I - Item 1A for further discussion).
For each line of business and coverage, we regularly adjust the assumptions and methods used in the estimation of loss reserves in response to our actual loss experience, as well as our judgments regarding changes in trends and/or emerging patterns. In those instances where we primarily utilize analyses of historical patterns of the development of paid and reported losses, this may be reflected, for example, in the selection of revised loss development factors. In longer-tailed classes of business and for which loss experience is less predictable due to potential changes in judicial interpretations, potential legislative actions, the cost of litigation or determining liability and the ultimate loss, inflation, potential claims and other issues, this may be reflected in a judgmental change in our estimate of ultimate losses for particular accident years. Most of the insurance policies we have written over many years are written on an “occurrence” basis, which means we insure specified acts or events which occurred during the covered period, even if claims first arise from such events many years later. For example, the industry incurred significant losses as a result of claims arising from asbestos and environmental damage which occurred decades ago and was not known at such time, and in many cases policy limits were available for each year during which such occurrence policies were in place.
The estimation of claims and claims expense reserves for catastrophes also comprises estimates of losses from reported claims and IBNR, primarily for damage to property. In general, our estimates for catastrophe reserves are determined on an event basis by considering various sources of available information, including specific loss estimates reported to us based on claim adjuster inspections, overall industry loss estimates, our internal data regarding exposures related to the geographical location of the event and estimates of potential subrogation recoveries. However, depending on the nature of the catastrophe, the estimation process can be further complicated by other impediments. For example, for hurricanes, other severe wind storms and wildfires, complications often include the inability of insureds to promptly report losses, delays in the ability of claims adjusting staff to inspect losses, difficulties in determining whether wind storm losses are covered by our homeowners policy (generally for damage caused by wind or wind driven rain) or are specifically excluded from coverage caused by flood, and challenges in estimating additional living expenses, assessing the impact of demand surge, exposure to mold or smoke damage and the effects of numerous other considerations. Another example is the complication of estimating the cost of business interruption coverage on commercial lines policies. Estimates for catastrophes which occur at or near the end of a financial reporting period may be even less reliable since we will have less claims data available and little time to complete our estimation process. In such situations, we may adapt our practices to accommodate the circumstances.
Personal and Commercial Automobile Bodily Injury - loss reserves recorded for bodily injury on voluntary business were $713.5 million as of December 31, 2019. A key assumption for bodily injury is the inflation rate underlying the estimated reserve. A five point change (e.g., 4% changed to 9% or -1%) in the embedded inflation rate would have changed total reserves by approximately $90 million, either positive or negative, respectively, at December 31, 2019.
Monoline and Multiple Peril General Liability - loss reserves recorded for monoline and multiple peril general liability on voluntary business were $846.7 million as of December 31, 2019. A key assumption for monoline and multiple peril general liability is the implied adequacy of the underlying case reserves. A ten point change in case adequacy (e.g., 10% deficiency changed to 0% or 20% deficiency) would have changed total reserves by approximately $92 million, either positive or negative, at December 31, 2019.
The following table summarizes the gross reserve for losses and LAE by line of business.
The following table summarizes prior year unfavorable (favorable) development by segment for the periods indicated:
In 2019, favorable catastrophe development was $27.5 million, primarily due to lower than expected losses related to the 2017 and 2018 California wildfires, including the sale of subrogation rights on certain California wildfire losses, and the 2018 hurricane Florence. In 2018, favorable catastrophe development was $9.3 million, primarily due to lower than expected losses related to the 2017 hurricanes Harvey, Irma and Maria and California wildfires. In 2017, favorable catastrophe development was $1.4 million, primarily due to lower than expected losses related to the 2016 hurricane Matthew.
As of December 31, 2019, we have $37.9 million of net asbestos and environmental reserves, comprised of $8.4 million of direct reserves and $29.5 million of assumed reinsurance pool reserves. This compares to net reserves of $38.9 million and $39.8 million as of December 31, 2018 and 2017, respectively. Ending loss and LAE reserves for all direct business written by our property and casualty companies related to asbestos and environmental damage liability were $8.4 million, $8.9 million and $9.5 million, net of reinsurance of $17.6 million, $18.7 million and $20.2 million for the years ended December 31, 2019, 2018 and 2017, respectively. Activity for our direct asbestos and environmental reserves was not significant to our 2019, 2018 or 2017 financial results. As a result of our historical direct underwriting mix of Commercial Lines policies toward smaller and middle market risks, past asbestos and environmental damage liability loss experience has remained minimal in relation to our total loss and LAE incurred experience. Although we attempt to limit our exposures to asbestos and environmental damage liability through specific policy exclusions, we have been and may continue to be subject to claims related to these exposures.
The increase in net investment income in 2019 was primarily due to the continued investment of operational cash flows and the investment of proceeds from the sale of Chaucer prior to their deployment, partially offset by lower limited partnership income and the impact of lower new money yields. In 2018, the increase in net investment income was primarily due to the investment of higher operational cash flows and higher limited partnership income, partially offset by the impact of lower fixed income new money yields. We expect average fixed income yields to continue to decline as new money rates remain lower than embedded book yields.
Total cash and investments decreased $96.4 million, or 1.2%, for the year ended December 31, 2019, primarily attributable to $550 million of accelerated share repurchases, shareholder dividend payments of $386 million, including special dividends of $289 million, and repayment of the Federal Home Loan Bank (“FHLB”) debt and related prepayment fees of $151 million. These decreases were partially offset by operational cash flows of approximately $536 million and market value appreciation of approximately $423 million.
The increase in net unrealized gains on fixed maturities was primarily due to lower prevailing interest rates and tighter credit spreads.
Based on ratings by the National Association of Insurance Commissioners (“NAIC”), approximately 95% of the fixed maturity portfolio consisted of investment grade securities at December 31, 2019 and 2018. The quality of our fixed maturity portfolio remains strong based on ratings, capital structure position, support through guarantees, underlying security, issuer diversification and yield curve position.
Mortgage and other loans consist primarily of commercial mortgage loan participations, which represent our interest in commercial mortgage loans originated by a third-party. We share, on a pro-rata basis, in all related cash flows of the underlying mortgage loans, which are investment-grade quality and diversified by geographic area and property type.
Although we expect to invest new funds primarily in investment grade fixed maturities, we have invested, and expect to continue to invest, a portion of funds in limited partnerships, common equity securities, below investment grade fixed maturities and other investment assets.
For the years ended December 31, 2019, 2018 and 2017, we recognized in earnings $2.0 million, $4.6 million and $5.6 million, respectively, of other-than-temporary impairments (“OTTI”). In 2019, OTTI consisted entirely of corporate fixed maturity securities. In 2018, OTTI consisted of $2.6 million on fixed maturities and $2.0 million on other invested assets. In 2017, OTTI consisted of $2.0 million on other invested assets, $1.8 million on fixed maturities and $1.8 million on equity securities.
The following table sets forth gross unrealized losses for fixed maturities by maturity period at December 31, 2019 and 2018. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties, or we may have the right to put or sell the obligations back to the issuers.
The valuation of the investment portfolio is subject to risk resulting from interest rate fluctuations, which may adversely impact the valuation of the investment portfolio. In a rising interest rate environment, the value of the fixed maturity sector, which comprises approximately 81% of our investment portfolio, may decline as a result of decreases in the fair value of the securities. Our intent is to hold securities to maturity and recover the decline in valuation as prices accrete to par. However, our intent may change prior to maturity due to changes in the financial markets, our analysis of an issuer’s credit metrics and prospects or as a result of changes in cash flow needs. Interest rate fluctuations may also reduce net investment income and, as a result, profitability. The portfolio may realize lower yields and therefore lower net investment income on securities because securities with prepayment and call features may prepay at a different rate than originally projected. Also, funds may not be available to invest at higher interest rates.
The following table illustrates the estimated impact on the fair value of our fixed maturity portfolio at December 31, 2019 and 2018 of hypothetical changes in prevailing interest rates, defined as changes in interest rates on U.S. Treasury debt. It does not reflect changes in credit spreads, liquidity spreads and other factors that also affect the value of securities. Since changes in prevailing interest rates are often accompanied by changes in these other factors, the reader should not assume that an actual change in interest rates would result in the values illustrated.
Our equity securities portfolio is exposed to equity price risk arising from potential volatility in equity market prices. Portfolio characteristics are analyzed regularly and price risk is actively managed through a variety of techniques. A hypothetical increase or decrease of 10% in the market price of our equity securities would have resulted in an increase or decrease in the fair value of the equity securities portfolio of approximately $58 million at December 31, 2019 and $46 million at December 31, 2018, which amounts, after taxes, would be reported in net income.
We manage investment assets for our Commercial Lines, Personal Lines and Other segments based on the requirements of our combined property and casualty companies. We allocate the investment income, expenses and realized gains and losses to our Commercial Lines, Personal Lines and Other segments based on actuarial information related to the underlying businesses. We managed investment assets separately for our former Chaucer business.
Initial consideration for Chaucer Holdings Limited as determined in the sales and purchase agreement was $779 million. This amount, along with $28 million in cash proceeds received from the sale of the Irish entity on February 14, 2019 and $13 million from the sale of the Australian entities on April 10, 2019, estimated contingent consideration of $31.7 million, and an $85 million pre-signing dividend from Chaucer that was received in the second quarter of 2018, results in expected total proceeds from the entire transaction of $936.7 million. These amounts were partially offset by $17.0 million paid to China Re to adjust the purchase price for amounts received by the Company from Chaucer prior to December 28, 2018.
Included in the previously recorded $174.4 million gain was $31.7 million of contingent proceeds, which were subject to change, based on development of Chaucer’s 2018 catastrophe losses. During the first half of 2019, Chaucer experienced unfavorable development on its 2018 catastrophe losses, primarily due to higher than expected losses for hurricane Michael, Typhoon Jebi and a Colombian dam construction loss. Accordingly, we updated and reduced our best estimate of pre-tax contingent proceeds by $9.7 million. We received a cash payment of $22.0 million in final settlement of the contingent proceeds.
The following table summarizes the results of operations for Chaucer for the periods indicated:
Chaucer’s income before income taxes for the year ended December 31, 2018 was $24.7 million, compared to $8.6 million for the year ended December 31, 2017, an improvement of $16.1 million. This increase is primarily due to lower catastrophe losses. Catastrophe losses for the year ended December 31, 2018 were $85.8 million, compared to $131.1 million for the year ended December 31, 2017, a decrease of $45.3 million. Chaucer’s income before taxes, excluding catastrophes, was $110.5 million in the year ended December 31, 2018, compared to $139.7 million for the year ended December 31, 2017. This $29.2 million decline was primarily due to higher non-catastrophe current accident year large losses and higher expenses, primarily driven by higher brokerage costs due to a change in business mix
We currently have a qualified defined benefit plan and several smaller non-qualified benefit plans. Additionally, we held a defined benefit pension plan for our international subsidiary, Chaucer, until its sale on December 28, 2018. Accordingly, this discussion focuses on our domestic plans only. In order to measure the liabilities and expense associated with these plans, we must make various estimates and key assumptions, including discount rates used to value liabilities, assumed rates of return on plan assets, employee turnover rates and anticipated mortality rates. These estimates and assumptions are reviewed at least annually and are based on our historical experience, as well as current facts and circumstances. In addition, we use outside actuaries to assist in measuring the expenses and liabilities associated with our defined benefit pension plan.
Two significant assumptions used in the determination of benefit plan obligations and expenses that are dependent on market factors, which have been subject to a greater level of volatility in recent years, are the discount rate and the return on plan asset assumptions. The discount rate enables us to state expected future benefit payments as a present value on the measurement date. We also use this discount rate in the determination of our pre-tax pension expense or benefit. A lower discount rate increases the present value of benefit obligations and increases pension expense. We determined our discount rate for the domestic plan utilizing independent yield curves which provide for a portfolio of high quality bonds that are expected to match the cash flows of our pension plans. Bond information used in the yield curve included only those rated Aa or better as of December 31, 2019 and 2018, respectively, and had been rated by at least two well-known rating agencies. The discount rates used to value liabilities in our qualified pension plans were 3.75% and 4.50% as of December 31, 2019 and 2018, respectively.
To determine the expected long-term return on plan assets, we generally consider historical mean returns by asset class for passive indexed strategies, as well as current and expected asset allocations, and adjust for certain factors that we believe will have an impact on future returns. Actual returns on plan assets in any given year seldom result in the achievement of the expected rate of return on assets. Actual returns on plan assets in excess of these expected returns will generally reduce our net actuarial losses (or increase actuarial gains) that are reflected in the accumulated other comprehensive income balance in shareholders’ equity, whereas actual returns on plan assets that are less than expected returns will generally increase our net actuarial losses (or decrease actuarial gains) that are reflected in accumulated other comprehensive income. These gains or losses are amortized into expense in future years. In 2019, we changed our asset allocation for our U.S. qualified plan from approximately 85% fixed maturities and 15% equities to approximately 90% fixed maturities and 10% equities.
Expenses related to our defined benefit plan are generally calculated based upon information available at the beginning of the plan year. Our pre-tax expense related to our domestic qualified defined benefit plan was $7.6 million and $6.5 million for 2019 and 2018, respectively. As a result of favorable market returns in 2019, a $10.0 million contribution into the qualified benefit plan and favorable mortality experience for which decreases in the discount rate only partially offset the favorable investment experience during the year, our pension expense related to our domestic qualified defined benefit plan is expected to decrease from $7.6 million in 2019 to $0.3 million in 2020.
The realization of deferred tax assets depends upon the existence of sufficient taxable income within the carryback or carryforward periods under the tax law in the applicable tax jurisdiction. Consideration is given to available positive and negative evidence, including reversals of deferred tax liabilities, projected future taxable income in each tax jurisdiction, tax planning strategies and recent financial operations. Valuation allowances are established if, based on the weight of available information, it is more likely than not that all or some portion of the deferred tax assets will not be realized. The determination of the valuation allowance for our deferred tax assets requires management to make certain judgments and assumptions. Our judgments and assumptions are subject to change given the inherent uncertainty in predicting future performance and specific industry and investment market conditions. Changes in valuation allowances are generally reflected in income tax expense or as an adjustment to other comprehensive income, depending on the nature of the item for which the valuation allowance is being recorded.
The following are the components of our deferred tax assets and liabilities as of December 31, 2019.
As of December 31, 2019, we did not have a valuation allowance and believe it is more likely than not that the remaining deferred tax assets will be realized.
The NAIC prescribes an annual calculation regarding risk based capital (“RBC”). RBC ratios for regulatory purposes, as described in the glossary, are expressed as a percentage of the capital required to be above the Authorized Control Level (the “Regulatory Scale”); however, in the insurance industry, RBC ratios are widely expressed as a percentage of the Company Action Level. The following table reflects the Company Action Level, the Authorized Control Level and RBC ratios for Hanover Insurance (which includes Citizens and other insurance subsidiaries), as of December 31, 2019 and 2018, expressed both on the Industry Scale (Total Adjusted Capital divided by the Company Action Level) and Regulatory Scale (Total Adjusted Capital divided by Authorized Control Level):
Liquidity is a measure of our ability to generate sufficient cash flows to meet the cash requirements of business operations. As a holding company, our primary ongoing source of cash is dividends from our insurance subsidiaries. However, dividend payments to us by our insurance subsidiaries are subject to limitations imposed by regulators, such as prior notice periods and the requirement that dividends in excess of a specified percentage of statutory surplus or prior year’s statutory earnings receive prior approval (so called “extraordinary dividends”). Hanover Insurance paid $140.0 million in dividends to the holding company in both 2019 and 2018. In 2017, Hanover Insurance paid $296.8 million in dividends to the holding company, which included $80.0 million of extraordinary dividends.
Sources of cash for our insurance subsidiaries primarily consist of premiums collected, investment income and maturing investments. Primary cash outflows are paid claims, loss reserves, policy and contract acquisition expenses, other underwriting expenses and investment purchases. Cash outflows related to loss reserves can be variable because of uncertainties surrounding settlement dates for liabilities for unpaid losses and because of the potential for large losses, either individually or in the aggregate. We periodically adjust our investment policy to respond to changes in short-term and long-term cash requirements.
Net cash provided by operating activities was $602.9 million during 2019, as compared to $551.3 million during 2018 and $704.6 million in 2017. During 2019, the $51.6 million increase in cash provided was primarily the result of an increase in premiums collected, partially offset by higher loss payments. During 2018, the $153.3 million decrease in cash provided was primarily the result of higher loss payments, the contribution made to the qualified defined benefit plan and taxes paid, partially offset by an increase in premiums collected.
Net cash used in financing activities was $1,099.3 million during 2019, as compared to $171.0 million during 2018 and $111.7 million in 2017. During 2019, cash used in financing activities primarily resulted from repurchases of common stock through three accelerated share repurchase (“ASR”) agreements, the payments of two special dividends in addition to regular quarterly dividends to shareholders, and the repayment of the FHLB advances. (See further discussion below for additional information regarding the special dividend, the ASR agreements and the repayment of the FHLB advances). During 2018, cash used in financing activities primarily resulted from the payment of dividends to shareholders and repurchases of common stock. During 2017, cash used in financing activities primarily resulted from the payment of dividends to shareholders and repurchases of common stock, partially offset by cash inflows related to option exercises.
Dividends to common shareholders are subject to quarterly board approval and declaration. During 2019, our Board declared dividends that totaled $195.0 million. This included three quarterly dividends of $0.60 per share and one quarterly dividend of $0.65 per share, as well as a special dividend declared in December 2019 of $2.50 per share, or approximately $96 million. In addition to these dividends, in January 2019, we also paid a special dividend of $4.75 per share, that had been declared on December 30, 2018, totaling $192.6 million. We believe that our holding company assets are sufficient to provide for future shareholder dividends, should the Board of Directors declare them.
The Board of Directors authorized a stock repurchase program which provides for aggregate repurchases of our common stock of up to $900 million, including a $300 million increase to the program on December 5, 2019. Under the repurchase authorization, we may repurchase, from time to time, common shares in amounts, at prices and at such times as we deem appropriate, subject to market conditions and other considerations. Repurchases may be executed using open market purchases, privately negotiated transactions, accelerated repurchase programs or other transactions. We are not required to purchase any specific number of shares or to make purchases by any certain date under this program. On January 2, 2019, pursuant to the terms of an accelerated share repurchase (“ASR”) agreement executed on December 30, 2018 (the “December 2018 ASR”), we paid $250.0 million in exchange for approximately 2.1 million shares of our common stock. In accordance with its terms, this agreement terminated on June 28, 2019. Also on June 28, 2019, pursuant to the terms of a second ASR agreement (the “June ASR”), we paid $150.0 million in exchange for approximately 1.1 million shares of our common stock. In accordance with its terms, the June ASR terminated on October 28, 2019. On December 9, 2019, pursuant to the terms of a third ASR agreement (the “December 2019 ASR”) we paid $150.0 million in exchange for shares of our common stock. Under the terms of the December 2019 ASR, we received an initial delivery of approximately 0.9 million shares of our common stock, which is approximately 80% of the total number of shares expected to be received under this agreement. Final settlement of the December 2019 ASR is expected to occur not later than March 25, 2020. During 2019, in total we repurchased approximately 4.2 million shares at a cost of $563.6 million.
From time to time, we may repurchase our debt on an opportunistic basis. On January 2, 2019, we repaid $125 million of our FHLB advances that were due 2029 and had an interest rate of 5.5%, along with related prepayment fees of $26 million which were recognized as a non-operating charge in 2018. We maintain our membership in FHLB which provides us with access to additional liquidity; the amount of such liquidity is based on our holdings of FHLB stock and pledged collateral. At December 31, 2019, we had additional borrowing capacity of $86.7 million. There were no borrowings outstanding under this short-term facility at December 31, 2019; however, we have borrowed and may continue to borrow, from time to time, through this facility to provide short-term liquidity.
At December 31, 2019, we were in compliance with the covenants of our debt and credit agreements.
Amounts represent non-qualified defined benefit pension and postretirement benefit obligations and reflect estimated payments to be made through plan year 2029 for pension, postretirement, and postemployment benefits, although it is likely that payments will be made beyond 2029. Estimates of these payments and the payment patterns are based upon historical experience. We do not expect to make any significant contributions to our qualified plan in order to meet our minimum funding requirements for the next several years; therefore, no contributions for this plan are included in this schedule. However, additional contributions may be required in the future based on the level of pension assets and liabilities in future periods. The ultimate payment amount for our pension plan is based on several assumptions, including, but not limited to, the rate of return on plan assets, the discount rate for benefit obligations, mortality experience, interest crediting rates and the ultimate valuation of benefit obligations. Differences between actual plan experience and our assumptions are likely and will likely result in changes to our funding obligations in future periods.
Exposure - As it relates to underwriting, a measure of the rating units or premium basis of a risk; for example, an exposure of a number of automobiles. As it relates to loss events, the maximum value of claims made on an insurer from an event or events that would result in the total exhaustion of the cover or indemnity offered by an insurance policy.
Loss adjustment expenses (“LAE”) - Expenses incurred in the adjusting, recording, and settlement of claims. These expenses include both internal company expenses and outside services. Allocated LAE (“ALAE”) refers to defense and cost containment expenses, including legal fees, court costs, and investigation fees. Unallocated LAE (“ULAE”) refers to expenses that generally cannot be associated with a specific claim. ULAE includes internal costs such as salaries, fringe benefits and other overhead costs associated with the claim settlement process and external adjustment and appraisal fees.
Price(ing) increase or decrease (Personal Lines) - The estimated cumulative premium effect of approved rate actions applied to policies available for renewal, regardless of whether or not policies are actually renewed. Pricing changes do not represent actual increases or decreases realized by THG.
Securities Lending - We have, from time to time, engaged our banking provider to lend securities from our investment portfolio to third parties. These lent securities are fully collateralized by cash. When securities are lent, we monitor the fair value of the securities on a daily basis to assure that the collateral is maintained at a level of at least 102% of the fair value of the loaned securities. We record securities lending collateral as a cash equivalent, with an offsetting liability in expenses and taxes payable.
Specialty Lines - A major component of our other commercial lines. There is no accepted industry definition of “specialty lines”, but for our purpose specialty lines consist of products such as marine, surety, specialty industrial property, professional liability, management liability and various other program businesses. When discussing net premiums written and other financial measures of our specialty businesses, we may include non-specialty premiums that are written as part of the entire account.
(1) Ratios may not be comparable to similarly titled measures of other companies.
As described in Notes 1 and 15 to the consolidated financial statements, loss and loss adjustment expense reserves were $5.7 billion as of December 31, 2019. These liabilities are determined using case basis evaluations and statistical analyses of historical loss patterns and represent estimates of the ultimate cost of all losses incurred but not paid. The loss reserve estimation process relies on the basic assumption that past experience, adjusted for the effects of current developments and likely trends, is an appropriate basis for management to predict future outcomes. As part of this process, management uses a variety of analytical methods that consider experience, trends and other relevant factors, as well as considers numerous quantitative and qualitative factors, including the maturity of the accident year, the level of volatility within a particular class of business, the sufficiency or quality of historical reported and paid loss and loss adjustment expenses information, legal and regulatory developments and changes in underwriting, claim handling and case reserving practices. The Company’s ultimate incurred but not reported (“IBNR”) reserves are estimated by management and reserving actuaries on an aggregate basis for each line of business or coverage for loss and loss expense liabilities not reflected within the case reserves.
The principal considerations for our determination that performing procedures relating to the valuation of loss and loss adjustment expense reserves is a critical audit matter are there was significant judgment by management when developing their estimate. This in turn led to a high degree of auditor judgment, subjectivity and effort in performing procedures and evaluating audit evidence relating to the various analytical methods and factors used by management in developing the estimate, such as historical loss patterns and other relevant quantitative and qualitative factors, which included the maturity of the accident year, the level of volatility within a particular class of business, and the sufficiency or quality of historical reported and paid loss and loss adjustment expenses information. Also, our audit effort included the involvement of professionals with specialized skill and knowledge to assist in performing procedures and evaluating the audit evidence obtained from these procedures.
Other investments consist primarily of mortgage participations and limited partnerships. Mortgage participations represent interests in commercial mortgage loans originated and serviced by a third-party of which the Company shares, on a pro-rata basis, in all related cash flows of the underlying mortgage loans. Mortgage participations are stated at unpaid principal balances adjusted for deferred fees or expenses, net of reserves. Reserves on mortgages are established and are collectively evaluated based on losses expected by the Company for loans that may not be collectible in full. In establishing reserves, the Company considers, among other things, the estimated fair value of the underlying collateral. Prior to May 2018, certain reacquisition rights retained by the third-party in the loan participations required that these investments be accounted for as secured borrowings under Accounting Standards Codification (“ASC”) 860, Transfers and Servicing.
Investments in limited partnerships include interests in private equity funds which are accounted for in accordance with the equity method of accounting. Prior to January 1, 2018, when the Company’s interest in the partnership was minor, certain limited partnership investments were accounted for under the cost method.
The Company has operating and financing leases recorded at the present value of future minimum lease payments, less accumulated depreciation and amortization. Depreciation is generally provided using the straight-line method over the estimated useful lives of the related assets, which generally ranges from 4 to 6 years for real estate and fleet leases.
Insurance premiums written are generally recorded at the policy inception and are primarily earned on a pro-rata basis over the terms of the policies for all products. Premiums written may also include estimates that are derived from multiple sources, which include the historical experience of the underlying business, similar businesses and available industry information. These estimates are regularly reviewed and updated, and any resulting adjustments are included in the current year’s results. Unearned premium reserves represent the portion of premiums written that relates to the unexpired terms of the underlying in-force insurance policies and reinsurance contracts. Premium receivables reflect the unpaid balance of premium written as of the balance sheet date. Premium receivables are generally short-term in nature and are reported net of an allowance for estimated uncollectible premium accounts. The Company reviews its receivables for collectability at the balance sheet date. The allowance for uncollectible accounts was not material as of December 31, 2019 and 2018. Ceded premiums are charged to income over the applicable term of the various reinsurance contracts with third-party reinsurers. Reinsurance reinstatement premiums, when required, are recognized in the same period as the loss event that gave rise to the reinstatement premiums. Losses and related expenses are matched with premiums, resulting in their recognition over the lives of the contracts. This matching is accomplished through estimated and unpaid losses and amortization of deferred acquisition costs.
The Company is subject to the tax laws and regulations of the U.S. and foreign countries in which it operates. The Company files a consolidated U.S. federal income tax return that includes the holding company and its U.S. subsidiaries. Generally, taxes are accrued at the U.S. statutory tax rate for income from the U.S. operations. In December 2017, the Tax Cuts and Jobs Act (“TCJA”) was enacted, which reduced the U.S. statutory rate from 35% to 21%, effective January 1, 2018. See Note 7 - “Income Taxes” for a discussion of this law. The Company accrues taxes on certain non-U.S. income that is subject to U.S. tax at the enacted U.S. tax rate. Foreign tax credits, where available, are utilized to offset U.S. tax as permitted.
Deferred income taxes are generally recognized when assets and liabilities have different values for financial statement and tax reporting purposes, and for other temporary taxable and deductible differences as defined by ASC 740, Income Taxes (“ASC 740”). These temporary differences are measured at the balance sheet date using enacted tax rates expected to apply to taxable income in the years the temporary differences are expected to reverse. These differences result primarily from insurance reserves, deferred acquisition costs, investments, software capitalization and employee benefit plans.
Earnings per share (“EPS”) for the years ended December 31, 2019, 2018 and 2017 is based on a weighted average of the number of shares outstanding during each year. Basic and diluted EPS is computed by dividing income available to common stockholders by the weighted average number of shares outstanding for the period. The weighted average shares outstanding used to calculate basic EPS differ from the weighted average shares outstanding used in the calculation of diluted EPS due to the effect of dilutive employee stock options, nonvested stock grants and other contingently issuable shares. If the effect of such items is antidilutive, the weighted average shares outstanding used to calculate diluted EPS are equal to those used to calculate basic EPS.
In March 2017, the FASB issued ASC Update No. 2017-08, Receivables - Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. This guidance shortens the amortization period of premiums on certain purchased callable debt securities to the earliest call date. The updated guidance is effective for annual and interim periods beginning after December 15, 2018, and should be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. The Company implemented this guidance effective January 1, 2019. Implementing this guidance resulted in a cumulative effect adjustment which reclassified unrealized losses, net of tax, of $1.5 million from accumulated other comprehensive income to retained earnings.
In January 2016, the FASB issued ASC Update No. 2016-01, (Subtopic 825-10) Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities. This ASC update requires unconsolidated equity investments to be measured at fair value with changes in the fair value recognized in net income, except for those accounted for under the equity method. This update eliminates the cost method for equity investments without readily determinable fair values, replacing it with other methods, including the use of Net Asset Value (“NAV”). Additionally, when a public entity is required to measure fair value for disclosure purposes and holds financial instruments measured at amortized cost, the updated guidance requires these instruments to be measured using exit price. It also requires financial assets and financial liabilities to be presented separately in the notes to the financial statements, grouped by measurement category and form of financial asset. The updated guidance is effective for annual periods beginning after December 15, 2017. In February 2018, the FASB issued ASC Update No. 2018-03, (Subtopic 825-10) Technical Corrections and Improvements to Financial Instruments - Overall. This ASC update clarifies the transition method for equity investments without readily determinable fair values. Specifically, if an entity elects to measure these investments at cost, less impairment, adjusted for changes resulting from observable price changes in orderly transactions for an identical or similar investment of the same issuer (the “measurement alternative”), then transition is prospective. For all others, transition is modified retrospective, requiring a cumulative effect adjustment. This ASU is effective for annual periods beginning after December 15, 2017, and interim periods within those years beginning after June 15, 2018. Early adoption is permitted for interim periods beginning after December 15, 2017 as long as ASU No. 2016-01 has been adopted. The Company implemented this guidance effective January 1, 2018 concurrent with ASU No. 2016-01 for certain limited partnerships without readily determinable fair values. The implementation of these standards resulted in a benefit to retained earnings, through a cumulative effect adjustment, of $97.8 million, including a reclassification of after-tax unrealized gains of $95.2 million from AOCI and an adjustment of $2.6 million of gains to record partnership investments at NAV.
In 2019 and 2020, the FASB has issued several updates to ASC Update No. 2016-13, including the issuance in April 2019, ASC Update 2019-04, Codification Improvements to Topic 326, Financial Instruments - Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments, the issuance in May 2019, ASC Update 2019-05, Financial Instruments - Credit Losses (Topic 326): Targeted Transition Relief, the issuance in November 2019, ASC Update No. 2019-11, Codification Improvements to Topic 326, Financial Instruments - Credit Losses and the issuance in February 2020, ASC Update 2020-02, Financial Instruments - Credit Losses (Topic 326) and Leases (Topic 842) - Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 119 and Update to SEC Section on Effective Date Related to Accounting Standards Update No. 2016-02, Leases (Topic 842). ASC Update 2016-13 and the related, updated guidance are effective for interim and annual periods beginning after December 15, 2019. The Company does not expect the adoption of ASC Update No. 2016-13 and the related updates to have a material impact on its financial position or results of operations.
In December 2019, the FASB issued ASC Update No. 2019-12 Income Taxes (Topic 740) - Simplifying the Accounting for Income Taxes. This ASC update removes certain exceptions to the general principles in ASC 740, Income Taxes, including intraperiod tax allocation when there is a loss from continuing operations, foreign subsidiary treatment under certain conditions and for calculating interim income taxes when the year-to-date loss exceeds the anticipated loss. This update also clarifies and amends existing guidance related to changes in tax laws, business combinations and employee stock plans, among others. The updated guidance is effective for interim and annual periods beginning after December 15, 2020. Early adoption is permitted, including interim periods. The Company does not expect the adoption of ASC Update No. 2019-12 to have a material effect on its financial position or results of operations.
In August 2018, the FASB issued ASC Update No. 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract. This ASC update requires the capitalization of implementation costs incurred in a hosting arrangement that is a service contract consistent with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). The guidance also requires an entity to expense the capitalized implementation costs of a hosting arrangement that is a service contract over the term of the hosting agreement, and apply impairment guidance consistent with long-lived assets. ASC Update No. 2018-15 also provides specific guidelines related to the presentation of these capitalized implementation costs and related expenses in the financial statements. The updated guidance is effective for interim and annual periods beginning after December 15, 2019, and should be applied either retrospectively or prospectively to all implementation costs incurred after the date of adoption. Early adoption is permitted, including interim periods. The Company does not expect the adoption of ASC Update No. 2018-15 to have a material impact on its financial position or results of operations.
In August 2018, the FASB issued ASC Update No. 2018-13 (Topic 820) Fair Value Measurement, Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement. The update removes the requirement for disclosure of the following: 1) the amount and reasons for transfers between level 1 and level 2 of the fair value hierarchy, 2) the policy for timing of transfers between levels, and 3) the valuation processes for level 3 fair value measurements. This update also added a requirement to disclose the changes in unrealized gains and losses for the period included in other comprehensive income for recurring level 3 fair value measurements held at the end of the reporting period and the range and weighted average of significant unobservable inputs used to develop level 3 fair value measurements, in addition to other fair value disclosure modifications. The updated guidance is effective for interim and annual periods beginning after December 15, 2019, and should be applied prospectively for certain of the disclosure requirements and retrospectively to all periods presented upon the effective date for other disclosure requirements. An entity is permitted to early adopt any removed or modified disclosures upon issuance of the update and delay adoption of additional disclosures until periods beginning after December 15, 2019, the effective date of the standard. Implementing this guidance is not expected to have an impact on the Company’s financial position or results of operations as the update is disclosure related.
In June 2016, the FASB issued ASC Update No. 2016-13, (Topic 326) Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments (“ASC Update No. 2016-13”). This ASC update introduces new guidance for the accounting for credit losses on financial instruments within its scope. A new model, referred to as the current expected credit losses model, requires an entity to determine credit-related impairment losses for financial instruments held at amortized cost and to estimate these expected credit losses over the life of an exposure (or pool of exposures). The estimate of expected credit losses should consider both historical and current information, reasonable and supportable forecasts, as well as estimates of prepayments. The estimated credit losses and subsequent adjustment to such loss estimates, will be recorded through an allowance account which is deducted from the amortized cost of the financial instrument, with the offset recorded in current earnings. ASC Update No. 2016-13 also modifies the impairment model for available-for-sale debt securities. The new model will require an estimate of expected credit losses only when the fair value is below the amortized cost of the asset, thus the length of time the fair value of an available-for-sale debt security has been below the amortized cost will no longer affect the determination of whether a credit loss exists. In addition, credit losses on available-for-sale debt securities will be limited to the difference between the security’s amortized cost basis and its fair value. In November 2018, the FASB issued ASC Update No. 2018-19, Codification Improvements to Topic 326, Financial Instruments - Credit Losses, which explicitly states that receivables arising from operating leases are not within the scope of Subtopic 326-20.
In addition, we recognized an income tax charge of $1.2 million in 2019 related to new tax regulations that were issued on June 14, 2019 by the U.S. Department of the Treasury, with an effective date retroactive to January 1, 2018. These new regulations retroactively changed the taxation of certain non-U.S. income. Although the impact of these regulations relates to the calculation of the income tax expense related to the sale of Chaucer, unlike the $42.5 million of income tax expense, noted above, that was reflected in discontinued operations, ASC 740, Income Taxes, prescribes that the effect of certain retroactive tax law changes be presented in continuing operations. Accordingly, we have presented this charge as a separate component of our non-operating items from continuing operations. (See also Note - 7 “Income Taxes” below). Additionally, in the third quarter of 2019, the Company recognized $3.4 million of tax benefits related to prior years, which are reflected in Discontinued Operations.
On February 14, 2019, the Company completed the sale of its Chaucer-related Irish entity and on April 10, 2019 finalized the sale of the Australian entities, completing the transfer of all Chaucer-related companies. Collectively, these entities constituted the Chaucer business in 2018 and prior, whereas just the Irish and Australian entities comprised the Chaucer business reported in its results in 2019, until their respective sales to China Re. The sale of the Irish entity provided total proceeds of $28 million and resulted in a pre-tax gain of $0.4 million, with a related income tax benefit of $0.5 million. The sale of the Australian entities for total proceeds of $13 million resulted in a pre-tax gain of $1.2 million and a related income tax expense of $0.1 million.
The following table summarizes the results of operations for Chaucer for the years ended December 31, 2018 and 2017:
The increase in ceded losses and LAE from 2017 to 2018 was primarily due to higher catastrophe loss activity in certain Chaucer lines and due to the aforementioned increase in reinsurance purchases.
During 1999, the Company exited its accident and health insurance business, consisting of its Employee Benefit Services business, its Affinity Group Underwriters business and its accident and health assumed reinsurance pool business. Prior to 1999, these businesses comprised substantially all of the former Corporate Risk Management Services segment. On January 2, 2009, Hanover Insurance directly assumed a portion of the accident and health business and the remainder of the Discontinued First Allmerica Financial Life Insurance Company (“FAFLIC”) accident and health business was reinsured by Hanover Insurance in connection with the sale of FAFLIC to Commonwealth Annuity.
OTTI unrealized losses in the tables above represent OTTI recognized in accumulated other comprehensive income. This amount excludes net unrealized gains on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date of $4.2 million and $7.4 million as of December 31, 2019 and 2018, respectively.
At December 31, 2019 and 2018, fixed maturities with fair values of $308.7 million and $299.9 million, respectively, were on deposit with various state governmental authorities or trustees.
Effective January 1, 2018, increases or decreases in fair value of equity securities are no longer reported as unrealized gains and losses in accumulated other comprehensive income. Instead, they are reported in net realized and unrealized investment gains (losses) in the Consolidated Statements of Income.
At December 31, 2019, scheduled maturities of mortgage participations and other mortgage loans were as follows: due in 2021 - $57.4 million; in 2022 - $28.1 million; 2023 - $16.8 million; 2024 - $78.0 million and thereafter - $260.9 million. There were no scheduled loan maturities in 2020. Actual maturities could differ from contractual maturities because borrowers may have the right to prepay obligations with or without prepayment penalties and loans may be refinanced. During 2019, the Company did not refinance any loans based on terms that differed from current market rates.
At December 31, 2019 and 2018, the Company’s exposure to concentration of investments in a single investee that exceeded 10% of shareholders’ equity included securities of U.S. government-sponsored agencies, as well as mortgage participations with a highly rated single third party of $432.3 million and $396.7 million, respectively.
At December 31, 2019, there were contractual investment commitments of up to $239.5 million.
Effective January 1, 2018, with the implementation of ASC No. 2016-01, the change in fair value of limited partnerships previously reported using the cost method is reported in net investment income, of which $4.6 million of holding losses and $5.3 million of holding gains relates to securities still owned at December 31, 2019 and 2018, respectively.
Effective January 1, 2018, as a result of the implementation of ASC No. 2016-01, net realized and unrealized investment losses include changes in the fair value of equity securities. Previously, equity securities were categorized as available-for-sale and unrealized gains and losses were reported in AOCI, a separate component of shareholders’ equity.
For the year ended December 31, 2017, there were net unrealized gains on equity securities of $56.8 million recognized in AOCI.
The Company has processes designed to ensure that the values received from its third-party pricing service are accurately recorded, that the data inputs and valuation approaches and techniques utilized are appropriate and consistently applied, and that the assumptions are reasonable and consistent with the objective of determining fair value. The Company performs a review of the fair value hierarchy classifications and of prices received from its pricing service on a quarterly basis. The Company reviews the pricing services’ policies describing its methodology, processes, practices and inputs, including various financial models used to value securities. Also, the Company reviews the portfolio pricing, including a process for which securities with changes in prices that exceed a defined threshold are verified to independent sources, if available. If upon review, the Company is not satisfied with the validity of a given price, a pricing challenge would be submitted to the pricing service along with supporting documentation for its review. The Company does not adjust quotes or prices obtained from the pricing service unless the pricing service agrees with the Company’s challenge. During 2019 and 2018, the Company did not adjust any prices received from its pricing service.
Limited partnerships measured at fair value using the net asset value (“NAV”) based on an ownership interest in partners’ capital have not been included in the hierarchy tables. At December 31, 2019 and 2018, the fair values of these investments were $183.6 million and $171.5 million, respectively, approximately 2% of total investment assets.
The Company has outstanding 7.625% unsecured senior debentures with a par value of $62.6 million as of December 31, 2019 and 2018 and mature on October 15, 2025. Additionally, the Company has outstanding unsecured senior debentures that were issued on April 8, 2016 with a par value of $375.0 million, as of December 31, 2019 and 2018 and mature on April 15, 2026. Both of the Company’s outstanding senior debentures are subject to certain restrictive covenants, including limitations on the issuance or disposition of stock of restricted subsidiaries and limitations on liens, and pay interest semi-annually.
At December 31, 2019, the Company had a $200.0 million credit agreement which expires in April 2024. The Company had no borrowings under this agreement as of December 31, 2019.
Provisions for income taxes have been calculated in accordance with the provisions of ASC 740. Income from continuing operations before income taxes and a summary of the components of income tax expense in the Consolidated Statements of Income are shown below:
The Company recognizes interest and penalties related to unrecognized tax benefits in federal income tax expense. For the years ended December 31, 2019, 2018 and 2017 the Company recognized a de minimis amount of net interest and has not recognized any penalties associated with unrecognized tax benefits. During 2019, the Company released $0.3 million of accrued interest due to the expiration of a statute of limitations.
On December 22, 2017, the Tax Cuts and Jobs Act (“TCJA”, “U.S. Tax Reform” or “the Act”) was enacted in the U.S. The Act substantially changed many aspects of the U.S. Tax code, including a reduction in the U.S. corporate income tax rate from 35% to 21%. While the new corporate rate is effective on January 1, 2018, the Company has recognized the impact of the rate change on its deferred tax balances as of the enactment date. The effect of this re-measurement of the Company’s deferred tax balances was a provision of $9.4 million for the year ended December 31, 2017. This provision was recorded as a component of income tax expense in continuing operations and as a component of the Chaucer business and reflected a tax benefit of $4.1 million and an expense of $13.5 million, respectively. This amount included the revaluation of deferred taxes initially recorded through other comprehensive income and recorded through discontinued operations, such as unrealized appreciation on investments, employee benefit plan-related items, foreign currency translation adjustments and reserve adjustments for discontinued business. Deferred taxes related to the revaluation of the Company’s pension plans at December 31, 2017, as well as changes in unrealized gains and losses occurring after the Act’s enactment date, were recorded at 21% in other comprehensive income.
The following table provides its year-end 2019 target allocations and actual invested asset allocations at December 31, 2019 and 2018.
The amount reclassified from accumulated other comprehensive income for the pension and postretirement benefits was allocated approximately 40% to loss adjustment expenses and 60% to other operating expenses for each of the years ended December 31, 2019, 2018 and 2017.
Additionally, on May 20, 2014, shareholders approved The Hanover Insurance Group 2014 Employee Stock Purchase Plan (the “ESPP Plan”) authorizing the issuance of 2,500,000 shares under such plan. As of December 31, 2019, 2,354,582 shares were available for grant under the ESPP Plan.
Under the 2014 Stock Plan, options may be granted to eligible employees, directors or consultants at an exercise price equal to the market price of the Company’s common stock on the date of grant. Option shares may be exercised subject to the terms prescribed by the Compensation Committee of the Board of Directors (the “Committee”) at the time of grant. Options granted in 2019, 2018 and 2017 generally vest over 3 years with 33 1/3% vesting in each year. Options must be exercised not later than ten years from the date of grant.
Cash received for options exercised for the years ended December 31, 2019, 2018 and 2017 was $12.3 million, $14.3 million and $20.5 million, respectively. The intrinsic value of options exercised for the years ended December 31, 2019, 2018 and 2017 was $10.1 million, $9.6 million and $15.6 million, respectively.
The excess tax benefit realized from options exercised for the years ended December 31, 2019, 2018 and 2017 was $1.7 million, $1.6 million and $4.0 million, respectively. The aggregate intrinsic value at December 31, 2019 for shares outstanding and shares exercisable was $54.7 million and $40.4 million, respectively. At December 31, 2019, the weighted average remaining contractual life for shares outstanding and shares exercisable was 7.1 years and 6.1 years, respectively. Additional information about employee options outstanding and exercisable at December 31, 2019 is included in the following table:
The fair value of each option is estimated on the date of grant using the Black-Scholes option pricing model. For all options granted through December 31, 2019, the exercise price equaled the market price on the grant date. Compensation cost related to options is based upon the grant date fair value and expensed on a straight-line basis over the service period for each separately vesting portion of the option as if the option was, in substance, multiple awards.
The Company granted market-based restricted share units in 2019, 2018 and 2017. Additionally, in 2019 the Company granted performance-based restricted share units. These units generally vest after 3 years of continued employment and after the achievement of certain stock performance targets. The Company also granted time-based restricted stock units to eligible employees in 2019, 2018 and 2017 that generally vest after 3 years of continued employment.
In 2019, 2018 and 2017, the Company granted market-based awards totaling 24,410, 31,688, and 56,571, respectively, to certain members of senior management, which are included in the table above as performance and market-based restricted stock activity. The vesting of these stock units is based on the relative total shareholder return (“TSR”) of the Company. This metric is generally based on relative TSR for a three year period as compared to a group of Property and Casualty peer companies. The fair value of market-based awards was estimated at the date of grant using a valuation model. These units have the potential to range from 0% to 150% of the shares disclosed.
In 2019, the Company also granted performance-based restricted stock units totaling 18,195 to certain members of senior management, which are included in the table above as performance and market-based restricted stock activity. The vesting of these stock units is determined through the use of a performance-based metric (return on equity) and has the potential to range from 0% to 150% of the shares disclosed.
The increase in intrinsic value from grant date of restricted stock and restricted stock units that vested during the years ended December 31, 2019, 2018 and 2017 was $3.7 million, $2.9 million and $2.3 million, respectively. The intrinsic value for performance and market-based restricted stock units that vested in 2019, 2018 and 2017 was $1.1 million in 2019 and $0.6 million in both 2018 and 2017. There were 1,674 shares, 10,330 shares and 53,840 shares of market-based awards that forfeited in 2019, 2018 and 2017, respectively. Also, during 2019, 2018 and 2017, there were 996 shares, 43,449 shares and 1,090 shares, respectively, of performance-based awards that forfeited. The performance-based awards in 2018 and 2017 related to Chaucer.
The Board of Directors authorized a stock repurchase program which provides for aggregate repurchases of up to $900 million, including a $300 million increase to the program on December 5, 2019. Under the repurchase authorization, the Company may repurchase, from time to time, common stock in amounts, at prices and at such times as the Company deems appropriate, subject to market conditions and other considerations. Repurchases may be executed using open market purchases, privately negotiated transactions, accelerated repurchase programs or other transactions. The Company is not required to purchase any specific number of shares or to make purchases by any certain date under this program. Pursuant to the terms of ASR agreements executed on December 30, 2018 (the “December 2018 ASR”) and on June 28, 2019 (the “June ASR”), the Company repurchased approximately 3.2 million shares of its common stock for $400.0 million. On December 9, 2019, pursuant to the terms of a third ASR agreement (the “December 2019 ASR”) the Company paid $150.0 million and received an initial delivery of approximately 0.9 million shares of common stock, which was approximately 80% of the total number of shares expected to be repurchased under the December 2019 ASR. Final settlement of the December 2019 ASR is expected to occur not later than March 25, 2020.
Pursuant to New Hampshire’s statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the New Hampshire Insurance Commissioner, is limited to the lesser of 10% of such insurer’s statutory policyholder surplus as of the preceding December 31, or statutory net income less net realized gains. Hanover Insurance declared and paid dividends to its parent totaling $140.0 million in both 2019 and 2018, and $296.8 million in 2017. In 2017, the $296.8 million dividend included $80.0 million of extraordinary dividends. At January 1, 2020, the maximum dividend payable without prior approval is $106.5 million. In May 2020, the maximum dividend declared payable without prior approval will increase by $140.0 million to a total amount of $246.5 million.
The Company reports interest expense related to debt separately from the earnings of its operating segments. For 2019, this consisted of interest on the Company’s senior and subordinated debentures.
The Company reviews the assets of its Property and Casualty Companies collectively and does not allocate them among the Commercial Lines, Personal Lines and Other segments.
Carried reserves for each line of business and coverage are determined based on the quarterly loss reserving process. In making the determination, the Company considers numerous quantitative and qualitative factors. Quantitative factors include actual payments made and changes in case reserve estimates in the period, as compared to previously experienced patterns, the maturity of the accident year, trends observed over the recent past, the level of volatility within a particular class of business, the estimated effects of reinsurance, including reinstatement premiums, general economic trends and other factors. Qualitative factors may include legal and regulatory developments, changes in claim handling and case reserving practices, recent entry into new markets or products, changes in underwriting practices, concerns that the Company does not have sufficient or quality historical reported and paid loss and LAE information with respect to a particular line or segment of business, effects of the economy and political outlook, perceived anomalies in the historical results, evolving trends or other factors.
The Company regularly updates its reserve estimates as new information becomes available and further events occur which may impact the resolution of unsettled claims. Reserve adjustments are reflected in results of operations as adjustments to losses and LAE. Often these adjustments are recognized in periods subsequent to the period in which the underlying policy was written and loss event occurred. These types of subsequent adjustments are described as loss and LAE “development”. Such development can be either favorable or unfavorable to the Company’s financial results and may vary by line of business. In this section, all amounts presented include catastrophe losses and LAE.
Within other commercial lines, general liability is comprised of both monoline and claims-made general liability. Claims-made general liability is primarily comprised of certain management and professional liability coverages. Other lines is primarily comprised of miscellaneous commercial property, specialty industrial property, healthcare and fidelity lines. Loss and LAE reserve development in the Other Segment is related to run-off voluntary property-casualty assumed reinsurance pools business.
In 2019, net favorable loss and LAE development was $28.4 million, primarily as a result of net favorable Commercial Lines development of $53.3 million, partially offset by unfavorable Personal Lines development of $23.7 million. Commercial Lines favorable development was primarily due to lower than expected losses of $32.6 million within the workers’ compensation line in accident years 2015 through 2018, as well as within the commercial multiple peril line in accident years 2015 through 2016 and within other commercial lines. These were partially offset by higher than expected losses in the commercial automobile line driven by higher bodily injury severity and personal injury protection losses. In addition, commercial lines favorable development includes lower than expected losses related to the 2017 and 2018 California wildfires, including the sale of subrogation rights on certain California wildfire losses, and hurricane Florence in 2018. Within other commercial lines, lower than expected losses in the marine line, primarily in accident years 2015 through 2018, general liability lines and surety line were partially offset by higher than expected losses in Hanover Programs, primarily in accident years 2011, 2013, 2015 and 2017. Personal Lines unfavorable development was primarily due to higher than expected losses of $21.6 million in the personal automobile line, driven by bodily injury severity and personal injury protection in accident years 2016 through 2017. In addition, Other Segment unfavorable development of $1.2 million was due to the Company’s run-off voluntary property-casualty pools business, which includes asbestos and environmental reserves.
In 2018, net favorable loss and LAE development was $8.9 million, primarily as a result of net favorable Commercial Lines development of $40.9 million, partially offset by unfavorable Personal Lines development of $30.8 million. Commercial Lines favorable development was primarily due to lower than expected losses of $31.0 million within the workers’ compensation line in accident years 2015 through 2017 and $29.1 million in other commercial lines, partially offset by higher than expected losses of $23.2 million in the commercial automobile line, driven by higher bodily injury severity in the 2014, 2016 and 2017 accident years. Within other commercial lines, lower than expected losses in the general liability lines, related to the 2014 through 2016 accident years, marine line in accident years 2015 through 2017, and surety line was partially offset by higher than expected losses in Hanover Programs primarily in accident years 2010 through 2014. Personal Lines unfavorable development was primarily due to higher than expected losses of million in the personal automobile line, driven by bodily injury severity in the 2015 and 2016 accident years and in the homeowners line in accident years 2015 through 2017. In addition, Other Segment unfavorable development of $1.2 million was due to the Company’s run-off voluntary property-casualty pools business, which includes asbestos and environmental reserves.
The table below summarizes the gross, ceded and net reserve for losses and LAE and reconciles to the incurred claims development in the following section. Accordingly, the commercial multiple peril, workers’ compensation, commercial automobile liability lines and general liability and umbrella - occurrence presentation includes Hanover Programs business.
General liability and umbrella - occurrence is primarily comprised of our commercial monoline general liability and umbrella coverages. General liability - claims made is primarily comprised of our commercial professional and management liability lines. Within total Commercial Lines and other, other lines is primarily comprised of marine, surety, specialty industrial and commercial property, product liability, voluntary pools, healthcare and fidelity lines. Included in the above table, primarily in other lines, are $55.5 million and $57.6 million of gross asbestos and environmental reserves as of December 31, 2019 and 2018, respectively.
Incurred claim count information presented represents claim frequency by individual claimant and measures the frequency of direct claim settlements that have resulted in or are expected to result in claim payments. Claim count information is presented in a manner consistent with that used in the quarterly loss reserving process. A single claim event, particularly in automobile lines, may result in multiple individual claimants and, therefore, multiple claim counts. Incurred claim counts are comprised of outstanding claims and those that are closed with a loss payment and exclude those that are closed without a loss payment. A single claim event may result in multiple claims closed with a payment when a claim is subsequently reopened with further payment. In this case, a reopened claim payment is counted as an incremental claim settlement. Claim count information is not available for direct and assumed participations in various involuntary pools and residual market mechanisms, which represent approximately 5% or less of the total gross earned premium and gross incurred claims for the lines presented. Incurred claim counts are also not adjusted for the effect of claims ceded as part of reinsurance programs, although the incurred losses and cumulative paid losses presented in the following tables are presented net of reinsurance ceded.
The following table is information about average historical claims duration as of December 31, 2019. The table is computed based on the paid and incurred claims data, net of reinsurance, for the accident years presented in the preceding claims development tables.
The Company has been named a defendant in various legal proceedings arising in the normal course of business. In addition, the Company is involved, from time to time, in examinations, investigations and proceedings by governmental and self-regulatory agencies. The potential outcome of any such action or regulatory proceedings in which the Company has been named a defendant or the subject of an inquiry or investigation, and its ultimate liability, if any, from such action or regulatory proceedings, is difficult to predict at this time. The ultimate resolutions of such proceedings are not expected to have a material effect on its financial position, although they could have a material effect on the results of operations for a particular quarter or annual period.
The Company is required to participate in residual markets in various states, which generally pertain to high risk insureds, disrupted markets or lines of business or geographic areas where rates are regarded as excessive. The results of the residual markets are not subject to the predictability associated with the Company’s own managed business, and are significant to both the personal and commercial automobile lines of business.
The Company’s insurance subsidiaries are required to file annual statements with state regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis), as codified by the National Association of Insurance Commissioners (“NAIC”). Permitted statutory accounting practices encompass all accounting practices that are not prescribed; such practices differ from state to state, may differ from company to company within a state, and may change in the future. The Company’s insurance subsidiaries did not have any permitted practices as of or for the years ended December 31, 2019, 2018 and 2017.
During the fourth quarter of 2018, the Company recognized $26.3 million of prepayment fees related to its FHLB advance (see Note 6 - “Debt and Credit Arrangements”).