We also own office space located at 645 W. Grand River, Howell, Michigan, with approximately 108,000 square feet, a three-building complex located at 808 North Highlander Way, Howell, Michigan, with approximately 176,000 square feet, where various business operations are conducted, and office space located at Thanet Way, Whitstable, United Kingdom, with approximately 40,000 square feet, where we operate our U.K. motor line of business.
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to assist readers in understanding the consolidated results of operations and financial condition of The Hanover Insurance Group, Inc. and subsidiaries (“THG”). Consolidated results of operations and financial condition are prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”). This discussion should be read in conjunction with the Consolidated Financial Statements and related footnotes included elsewhere herein.
Results of operations include the accounts of The Hanover Insurance Company (“Hanover Insurance”) and Citizens Insurance Company of America (“Citizens”), our principal U.S. domiciled property and casualty companies; Chaucer Holdings plc (“Chaucer”), and certain other insurance and non-insurance subsidiaries. Effective July 1, 2011, we acquired Chaucer, a specialist insurance underwriting group which operates through the Society and Corporation of Lloyd’s (“Lloyds”) and is domiciled in the United Kingdom (“U.K.”). Results of operations include Chaucer’s results in periods subsequent to July 1, 2011. Accordingly, our results for the year ended December 31, 2010 do not include any results from Chaucer and our results for the year ended December 31, 2011 include Chaucer’s results for only the period from July 1, 2011 through December 31, 2011. Results of operations for the year ended December 31, 2012 include results from all of our business segments. Additionally, results of operations include our discontinued operations, consisting primarily of our former life insurance businesses, accident and health business and third party administration business.
Business operations consist of four operating segments: Commercial Lines, Personal Lines, Chaucer and Other Property and Casualty.
In several recent years, weather-related catastrophe and non-catastrophe losses have been in excess of longer term averages. Pricing in our Commercial and Personal Lines continues to improve as the industry responds to these increased weather-related losses, as well as to the earnings impact of reduced investment income as a result of low interest rates, and other factors. We are continuing efforts to improve our underwriting results in both our Commercial and Personal Lines, including through rate increases and improvements to our mix of business.
We believe our unique approach to the small commercial market, distinctiveness in the middle market, and continued development of specialty lines provides us with a diversified portfolio of products and delivers significant value to agents and policyholders. The small commercial and middle market businesses are expected to contribute to premium growth in Commercial Lines over the next several years as we continue to pursue our core strategy of developing strong partnerships with agents, distinctive products, franchise value through limited distribution, and industry segmentation. Growth in our specialty lines continues to be an important part of our strategy, with the expansion of our product offerings in these lines supported by several acquisitions of specialized business.
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. Also, we continue to seek rate increases across our lines of business. Rate actions in our commercial automobile and workers’ compensation lines, and our property coverages in our commercial multiple peril line have been supported by industry wide loss trends and severity. In our surety business, we continue to shift the business mix toward commercial surety from contract surety, and to enhance the underwriting tools and standards that we employ.
In our Personal Lines business, we focus on partnering with high quality, value-added agencies that deliver consultative selling and stress the importance of account rounding (the conversion of single policy customers to accounts with multiple policies and additional coverages). Approximately 70% of our policies in force are account business. We are focused on making investments that help maintain profitability, build a distinctive position in the market, help diversify us geographically from our historical core states of Michigan, Massachusetts, New York and New Jersey, and provide us with profitable growth opportunities.
Written premium in Personal Lines increased slightly during 2012. Underwriting results improved modestly in 2012, as compared to 2011, primarily due to decreased catastrophe and non-catastrophe weather-related losses, partially offset by unfavorable development on prior years’ loss reserves. Unfavorable development on prior years’ loss reserves during 2012 was $26.5 million, compared to favorable development of $33.0 million during 2011. Similar to our strategy in Commercial Lines, we continue to seek additional rate increases, subject to regulatory considerations, in our personal automobile line, particularly as a result of recent trends of higher loss severity in bodily injury and personal injury protection claims and homeowners lines as a result of the catastrophe and non-catastrophe weather-related losses that the industry experienced in recent years.
After an encouraging year in our international insurance business, we expect moderating rate increases in 2013, with emerging underwriting opportunities limited to those marine and property markets most affected by Superstorm Sandy. U.K. motor rates decreased in 2012 and we expect this trend to continue in 2013 following significant increases in 2010 and 2011. There can be no assurance that we will be able to maintain or increase our rates in light of economic and regulatory conditions in our markets.
Consolidated net income was $36.7 million in 2011, compared to $151.2 million in 2010. The $114.5 million decrease is primarily driven by a decrease in segment results in our domestic operations, partially offset by income from our Chaucer segment. Additionally, in the year ended December 31, 2011, advisory, legal, and accounting costs associated with the acquisition of Chaucer and other acquisition expenses totaled $16.4 million. We also recorded an $11.3 million loss in connection with a foreign exchange contract entered into in connection with the acquisition of Chaucer, which was partially offset by net foreign exchange gains of $6.7 million.
Segment income was $71.8 million for the year ended December 31, 2011, compared to $222.2 million for the year ended December 31, 2010, a decrease of $150.4 million. Chaucer’s results in the second half of 2011 following its acquisition accounted for $32.9 million of segment income for the year ended December 31, 2011. Catastrophe related losses for our Commercial and Personal Lines businesses were $312.1 million for the year ended December 31, 2011, compared to $160.3 million for the same period in 2010, an increase of $151.8 million. Excluding the impact of catastrophes, earnings for our Commercial and Personal Lines businesses would have decreased by $31.5 million. This decrease was primarily due to higher non-catastrophe weather-related losses and LAE and lower favorable development on prior years’ loss and LAE reserves, partially offset by growth in earned premium and the resulting positive effect on our expense ratio and what we believe is an underlying improvement in our mix of business. Favorable development on prior years’ loss and LAE reserves for the year ended December 31, 2011 was $67.8 million compared to $111.1 million in the prior year, a decrease of $43.3 million.
Commercial Lines net premiums written was $1,902.0 million in the year ended December 31, 2012, compared to $1,703.1 million in the year ended December 31, 2011. This $198.9 million increase was primarily driven by rate increases, strong retention, and targeted new business expansion, including growth in the AIX program business, which grew by approximately $69 million. These factors were partially offset by the effects of exposure management actions and business mix improvement initiatives.
Pricing in Commercial Lines continues to improve. We believe that industry pricing is increasing due to recent weather-related losses, as well as to reduced investment income as a result of low interest rates, and other factors. We are continuing efforts to improve our underwriting results, including through increased rates; however, our ability to increase Commercial Lines net premiums written while maintaining or improving underwriting results may be affected by price competition and the current challenging economic environment. We also expect to continue our efforts to reduce our property exposures in certain geographic areas and classes of business, with a goal of improving our longer-term profitability and reducing earnings volatility. Also, in recent years, weather-related catastrophe and non-catastrophe losses have been in excess of longer term averages. We monitor these trends and consider them in our rate actions.
Personal Lines net premiums written was $1,475.6 million in the year ended December 31, 2012, compared to $1,461.2 million in the year ended December 31, 2011, an increase of $14.4 million. The factors contributing to this modest increase were higher rates in both our homeowners and personal automobile lines. These increases were partially offset by our continued property-focused exposure management actions. Our actions to reduce homeowners policy exposures, including increases in rate, have resulted in an increase in policy attrition.
Although we have been able to obtain rate increases in our Personal Lines markets and believe that our ability to obtain these increases will continue, our ability to maintain Personal Lines net written premium and to maintain and improve underwriting results may be affected by price competition, recent weather-related losses, our exposure management actions, recent loss trends in bodily injury and personal injury protection claims, and regulatory and legal developments. In several recent years, weather-related catastrophe and non-catastrophe losses have been in excess of longer term averages. We monitor these trends and consider them in our rate actions. Our rate and exposure management actions could adversely affect our ability to increase our policies in force and new business. There is no assurance that we will be able to maintain our current level of production or maintain or increase rates.
Chaucer’s net premiums written was $990.5 million for the year ended December 31, 2012. By line of business, Chaucer’s net premiums written were comprised of 26.2% U.K. motor, 23.7% marine and aviation, 19.7% energy, 16.3% property, and 14.1% casualty and other lines. This mix of business was driven and supported by our specialist underwriting strategy which is focused on actively managing the premium portfolio and risk exposures. Additionally, net written premiums for Chaucer are expected to increase significantly in 2013 due to the non-renewal of the capital provision reinsurance treaty with Flagstone Re. During 2012, 12% of Syndicate 1084’s gross written premium was ceded to Flagstone Re. See “Reinsurance” in Item 1 - Business of this Form 10-K for additional information.
Chaucer’s underwriting profit for the year ended December 31, 2012 was $93.5 million, $72.6 million of which is attributable to favorable development on prior years’ loss reserves. Catastrophe losses for the year ended December 31, 2012 were $41.7 million, principally due to Superstorm Sandy and the U.S. drought.
Chaucer’s underwriting profit, excluding prior year loss development and catastrophes, was $62.6 million for the year ended December 31, 2012. Underwriting expenses of $366.1 million represented 37.9% of earned premium.
Other Property and Casualty segment loss was $6.9 million for the year ended December 31, 2012, compared to $0.5 million for the year ended December 31, 2011. The $6.4 million increased loss is primarily due to lower net investment income in our holding company.
Personal Lines net premiums written for the year ended December 31, 2011 was $1,461.2 million, compared to $1,462.9 million for the year ended December 31, 2010, a decrease of $1.7 million. The most significant factors contributing to this small decrease were actions we have taken to reduce our market concentration in Louisiana, and our continued focus on driving profit improvement in our core states through both rate increases and more selective portfolio management, resulting in lower new business activity. These decreases were partially offset by higher rates in both our personal automobile and homeowners lines, and by a net premiums written increase of 7.1% in our target growth states. Continued increases in premium are expected in our target growth states as we seek to improve profitability in those states and diversify from our core states.
Personal Lines underwriting loss for the year ended December 31, 2011 was $72.6 million, compared to a profit of $0.9 million for the year ended December 31, 2010. This increase in losses of $73.5 million is due to higher weather-related losses and LAE, including catastrophes, and to decreased favorable development on prior years loss and LAE reserves, partially offset by lower operating expenses. Catastrophe losses were $163.7 million for the year ended December 31, 2011, including significant winter storms, tornado, hail and windstorm activity in the first half of the year and Hurricane Irene during the third quarter, compared to $98.7 million for the year ended December 31, 2010, an increase of $65.0 million. Favorable development on prior years’ loss and LAE reserves was $33.0 million for the year ended December 31, 2011, compared to $48.8 million for the year ended December 31, 2010, a decrease of $15.8 million. Included in 2010 results was $2.3 million of favorable LAE development, principally related to a change in the cost factors used for establishing unallocated LAE reserves.
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. 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, such as the program business written by our AIX subsidiary, Chaucer’s international liability lines, our professional liability specialty lines, and business written in the western part of the United States. In some of these 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. Historically, we have limited the issuance of long-tailed other liability policies, including directors and officers (“D&O”) liability, errors and omissions (“E&O”) liability and medical professional liability. With the acquisition of Hanover Professionals in 2007, which writes lawyers professional E&O coverage, the acquisition of Campania in
2010, which writes medical professional liability and product liability coverages, and the introduction of new specialty coverages, such as our other professional management liability products, we are increasing, and expect to continue to increase, our exposure to longer-tailed liability lines, including D&O coverages. The Chaucer business acquired in 2011 contains several international and U.S. liability lines, of which financial institution and professional liability, international liability and energy liability, contribute the most uncertainty.
Some risk factors affect multiple lines of business. Examples include changes in claim department practices, changes in settlement patterns, regulatory and legislative actions, court actions, timeliness of claim reporting, state mix of claimants, and degree of claimant fraud. Additionally, there is also a higher degree of uncertainty due to growth in our newly acquired businesses, with respect to which we have less familiarity and, in some cases, limited historical claims experience. The extent of the impact of a risk factor will also vary by components within a line of business. Individual risk factors are subject to interactions with other risk factors within line of business components. Thus, risk factors can have offsetting or compounding effects on required reserves.
Our loss reserves include amounts related to short-tail and long-tail classes of business. “Tail” refers to the time period between the occurrence of a loss and the final settlement of the claim. The longer the time span between the incidence of a loss and the settlement of the claim (i.e. a longer tail), the more the ultimate settlement amount is likely to vary from our original estimate.
While we estimate that a majority of our written premium is in what we would characterize as shorter-tailed classes of business, most of our loss reserves relate to longer-tail liability classes of business. Long-tailed classes include commercial liability, automobile liability, workers’ compensation and other types of third party coverage. Chaucer business longer-tailed lines include aviation liability, marine liability, energy liability, nuclear liability, U.K. motor medical and liability, international liability, specialist liability, and financial institutions and professional liability. 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 environment and the risk and expense of protracted litigation. 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.
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 predicting future outcomes. As part of this process, we use a variety of analytical methods that consider experience, trends and other relevant factors. IBNR reserves are generally calculated by first projecting the ultimate cost of all claims that have been reported or expected to be reported in the future and then subtracting reported losses and loss expenses. Reported losses include cumulative paid losses and loss expenses plus case reserves. Within the comprehensive loss reserving process, standard actuarial methods which include: (1) loss development factor methods; (2) expected loss methods (Bornheutter-Ferguson); and (3) adjusted loss methods (Berquist-Sherman), are given due consideration. These methods are described below:
In addition to the methods described above, various tailored reserving methodologies are used for certain businesses. For example, for some low volume and high volatility classes of business, special reserving techniques are utilized that estimate IBNR by selecting the loss ratio that balances actual reported losses to expected reported losses as defined by the estimated underlying reporting pattern. Also, for some classes with long exposure periods (e.g. energy construction, engineering and political risks), earnings patterns plus an estimated reporting lag applied to the Bornheutter-Ferguson initial expected loss ratio are used to estimate IBNR. This is done in order to reflect the changing average exposure periods by policy year (and consequently accident year).
Management endeavors to apply as much available data as practicable to estimate the loss reserve amount for each line of business, coverage and accident year, utilizing varying assumptions, projections and methods. The ultimate outcome is likely to fall within a range of potential outcomes around this loss reserve estimated amount.
For events designated as catastrophes which affect our Commercial and Personal Lines business segments, we generally calculate IBNR reserves directly as a result of an estimated IBNR claim count and an estimated average claim amount for each event. Such an assessment involves a comprehensive analysis of the nature of the event, of policyholder exposures within the affected geographic area and of available claims intelligence. Depending on the nature of the event, available claims intelligence could include surveys of field claims associates within the affected geographic area, feedback from a catastrophe claims team sent into the area, as well as data on claims reported as of the financial statement date. In addition, loss emergence from similar historical events is compared to the estimated IBNR for our current catastrophe events to help assess the reasonableness of our estimates.
The following discussion presents disclosure related to possible variation in reserve estimates due to changes in key assumptions. This information is provided for illustrative purposes only. Many other assumptions may also lead to material reserve adjustments. If any such variations do occur, they would likely occur over a period of several years and therefore their impact on our results of operations would be recognized during the same period. It is important to note, however, that there is the potential for future variations greater than the amounts described below and for any such variations to be recognized in a single quarterly or annual period. No consideration has been given to potential correlation or lack of correlation among key assumptions or among lines of business and coverage as described below. As a result and because there are so many other factors which affect our reserve estimate, it would be inappropriate to take the amounts described below and add them together in an attempt to estimate volatility in total. While we believe these are reasonably likely scenarios, the reader should not consider the following sensitivity analysis as illustrative of a reserve range.
Syndicate 4000 - reserves recorded for Syndicate 4000 were $272.4 million as of December 31, 2012. An increase in ultimate gross claims of 20% across all Chaucer Syndicate 4000 product classes, primarily crime and professional liability coverage for financial institutions, for year of accounts 2007 and 2008 and doubling the probabilities of a total indemnity loss for each and every assured with potential exposure (or claims notified) to the fraud relating to Bernard L. Madoff, would have increased estimated net IBNR by approximately $52 million at December 31, 2012.
Catastrophe events - a 20% increase in estimated gross ultimate claim deterioration for the 2011 Japan and New Zealand earthquakes and Thailand floods, would have reduced underwriting income by approximately $25 million, including reinstatement premiums. For Superstorm Sandy, a 20% increase on the gross incurred claims for Chaucer and an additional 20% lag in expected reporting patterns on the U.S. direct business, would have reduced underwriting income by $10 million including reinstatement premiums.
The following table provides a reconciliation of the gross beginning and ending reserve for unpaid losses and loss adjustment expenses (results for Chaucer for the year ended December 31, 2011 reflect the period from July 1, 2011 to December 31, 2011).
Favorable development within Commercial Lines was due to lower than expected losses within our commercial multiple peril line related to the 2008 through 2011 accident years.
Within other commercial lines, higher than expected losses in our contract surety line due to the ongoing challenging macroeconomic environment for contractors, and to a lesser extent, our AIX program business primarily related to unexpected severity in commercial automobile liability, commercial multiple peril and general liability in a limited number of programs.
The primary drivers for reserve development during the year ended December 31, 2011 were as follows:
Lower than expected losses within our commercial multiple peril line related to the 2007 through 2010 accident years.
Lower than expected losses in Chaucer’s energy, property and U.K. motor lines, primarily related to the 2009 and 2010 accident years.
Although we attempt to limit our exposures to asbestos and environmental damage liability through specific policy exclusions, we have been and may continue to be subject to claims related to these exposures. Ending loss and LAE reserves for all direct business written by our property and casualty companies related to asbestos and environmental damage liability were $9.8 million, $10.0 million and $10.1 million, net of reinsurance of $20.4 million, $18.7 million, and $19.9 million for the years ended December 31, 2012, 2011 and 2010, respectively.
Activity for our asbestos and environmental reserves was not significant to our 2012, 2011 or 2010 financial results. In recent years, average asbestos and environmental payments have declined modestly. As a result of our historical direct underwriting mix of Commercial Lines policies toward smaller and middle market risks, past asbestos and environmental damage liability loss experience has remained minimal in relation to our total loss and LAE incurred experience.
We estimate our ultimate liability for asbestos, environmental and toxic tort liability claims, whether resulting from direct business, assumed reinsurance or pool business, based upon currently known facts, reasonable assumptions where the facts are not known, current law and methodologies currently available. Although these outstanding claims are not significant, their existence gives rise to uncertainty and are discussed because of the possibility that they may become significant. We believe that, notwithstanding the evolution of case law expanding
liability in asbestos and environmental claims, recorded reserves related to these claims are adequate. Nevertheless, the asbestos, environmental and toxic tort liability reserves could be revised, and any such revisions could have a material adverse effect on our results of operations for a particular quarterly or annual period or on our financial position.
Catastrophe reinsurance serves to protect us, as the ceding insurer, from significant losses arising from a single event such as snow, ice storm, windstorm, hail, hurricane, tornado, riot or other extraordinary events. Although we believe our catastrophe reinsurance program, including our retention and co-participation amounts for 2013, are appropriate given our surplus level and the current reinsurance pricing environment, there can be no assurance that our reinsurance program will provide coverage levels that will prove adequate should we experience losses from one significant or several large catastrophes during 2013. Additionally, as a result of the current economic environment, as well as, losses incurred by reinsurers in recent years, the availability and pricing of appropriate reinsurance programs may be adversely affected in future renewal periods. We may not be able to pass these costs on to policyholders in the form of higher premiums or assessments.
See “Reinsurance” in Item 1 - Business of this Form 10-K for further information on our reinsurance programs.
Total cash and investments increased $501.4 million, or 6.6%, for the year ended December 31, 2012, of which fixed maturities increased $667.5 million, equities increased $69.4 million, other investments increased $20.1 million and cash and cash equivalents decreased $255.6 million. Fixed maturities increased and cash and cash equivalents decreased primarily due to the investment of a substantial portion of Chaucer’s cash into fixed maturities.
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, 2012, compared to 94% at December 31, 2011. 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.
Other investments consisted primarily of overseas deposits, which are U.S. dollar and foreign denominated investments maintained in overseas funds and managed exclusively by Lloyd’s. These funds are required in order to protect policyholders in overseas markets and enable our Chaucer segment to operate in those markets. Access to those funds is restricted and we have no control over the investment strategy. Also included in other investments were investments in limited partnerships, which were accounted for under the equity method of accounting or at cost.
Our municipal bond portfolio constituted approximately 14% of invested assets at December 31, 2012 and was 99% investment grade, without regard to insurance enhancements, which affected approximately 26% of the municipal bond portfolio. The portfolio was well diversified by geography, sector and source of payment, and consisted primarily of taxable securities. Approximately 61% of the portfolio was invested in revenue bonds and 39% in general obligation bonds. Revenue bonds are backed by the revenue stream generated by the services provided by the issuer, while general obligation bonds are backed by the authority that issued the debt and are secured by the taxing powers of those authorities.
The previous table represents all European countries in which we had exposure. We determined country exposures based on the country of domicile for the ultimate parent company of the various issuers we held as of December 31, 2012; however, in light of the economic and financial inter-relatedness and dependencies that exist among European countries and related financial systems, economic turmoil in one country could trigger a contagion effect on other countries. We believe the quality of our European credit exposure remains sound based on ratings and issuer strength, position in the capital structure, support through guarantees and partial government ownership by highly rated countries, diversity and quality of non-financial issuers and blend of industry exposures, and yield curve position. We believe that we do not have meaningful indirect exposures in our portfolio and we do not invest in credit derivatives.
Gross unrealized losses on fixed maturities and equity securities decreased $39.0 million, or 61.1%, which was primarily attributable to lower interest rates and tightening of credit and liquidity spreads across all sectors. At December 31, 2012, gross unrealized losses consist primarily of $14.8 million of corporate fixed maturities, $4.8 million of equity securities, $3.5 million of mortgage-backed securities and $1.1 million in municipal securities.
Additionally in 2011, Chaucer held foreign currency forward contracts utilized to mitigate changes in fair value caused by foreign currency fluctuation in converting the fair value of GBP and Euro denominated investment portfolios into their U.S. dollar denominated equivalent. These portfolios supported U.S. dollar denominated claim reserve liabilities. For the year ended December 31, 2011, we recognized a gain of $6.1 million related to these instruments, which were terminated in October 2011.
Net realized gains on investments were $23.6 million, $28.1 million, and $29.7 million for 2012, 2011, and 2010, respectively. Net realized gains in 2012 were primarily due to $31.8 million of gains recognized from the sale of equities and fixed maturities, partially offset by $7.8 million of other-than-temporary impairments. Net realized gains in 2011 were primarily due to $27.7 million of gains recognized from the sale of fixed maturities and equity securities and $6.1 million of gains on foreign currency hedges, partially offset by $6.9 million of other-than-temporary impairments. Net realized gains in 2010 were due to $43.6 million of gains recognized, primarily from the sale of fixed maturities and equity securities, partially offset by $13.9 million of other-than-temporary impairments.
Operations are subject to risk resulting from interest rate fluctuations which may adversely impact the valuation of the investment portfolio. In a rising interest rate environment, the value of the fixed income sector, which comprises 87% of our investment portfolio, may decline as a result of decreases in the fair value of the securities. Our intent is to hold securities to maturity and recover the decline in valuation as prices accrete to par. However, our intent may change prior to maturity due to changes in the financial markets, our analysis of an issuer’s credit metrics and prospects, or as a result of changes in cash flow needs. Interest rate fluctuations may also reduce net investment income and as a result, profitability. The portfolio may realize lower yields and therefore lower net investment income on securities because the securities with prepayment and call features may prepay at a different rate than originally projected. In a declining interest rate environment, prepayments and calls may increase as issuers exercise their option to refinance at lower rates. The resulting funds would be reinvested at lower yields. In a rising interest rate environment, funds may not be available to invest at higher interest rates.
The majority of our assets are invested in the fixed income markets. Through fundamental research and credit analysis with a focus on value investing, our investment professionals seek to identify a portfolio of stable income-producing higher quality U.S. government, foreign government, municipal, corporate, residential and commercial mortgage-backed securities, and asset-backed securities. We have a general policy of diversifying investments both within and across major investment and industrial sectors to mitigate credit and interest rate risk. We monitor the credit quality of our investments and our exposure to individual markets, borrowers, industries, sectors and, in the case of commercial mortgage-backed securities, property types and geographic locations. In addition, we currently carry debt which is subject to interest rate risk, which was issued at fixed interest rates between 5.50% and 8.207%. Current market conditions do not allow for us to invest assets at similar rates of return; therefore, earnings on a similar level of assets are not sufficient to cover current debt interest costs.
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 $32 million at December 31, 2012 and approximately $25 million at December 31, 2011.
Discontinued operations for the year ended December 31, 2012 primarily include the net gain on the sale of our third party administration subsidiary, CMI, which was completed on April 30, 2012. CMI provided third party workers’ compensation and disability program administration services (such as claims administration, loss prevention and medical cost containment and in-house excess workers’ compensation coverage) to public entities, self-insured employers and group programs. CMI generated total revenues of $4.4 million during the four months ended April 30, 2012 and $12.5 million and $12.0 million during the years ended December 31, 2011 and 2010, respectively. Income before taxes totaled $0.7 million during the first four months of 2012, while contributing $2.0 million and $2.1 million during 2011 and 2010, respectively. Assets and shareholder’s equity transferred as part of this sale totaled $10.9 million and $0.6 million, respectively. This sale resulted in a net gain of $10.8 million after taxes and is included in discontinued operations for the year ended December 31, 2012.
The benefit for income taxes from continuing operations was $17.4 million in 2012, compared to a benefit of $9.9 million and an expense of $56.0 million in 2011 and 2010, respectively. These amounts resulted in consolidated effective federal tax rates of (60.6)%, (45.8)%, and 27.2% on pre-tax income for 2012, 2011, and 2010, respectively. These provisions reflect the decreases in our valuation allowance related to capital loss carryforwards of $7.7 million, $7.5 million, and $9.7 million in 2012, 2011, and 2010, respectively. In addition, these provisions reflect benefits related to tax planning strategies implemented in prior years of $14.3 million, $9.7 million and $3.2 million in 2012, 2011 and 2010, respectively. Absent these benefits, the provision for income taxes for 2012, 2011, and 2010 would have been $4.6 million or 16.0%, $7.3 million or 33.8%, and $68.9 million or 33.5%, respectively. The decrease in 2012 effective tax rate is primarily due to higher income from foreign operations not subject to U.S. tax.
In June 2012, we completed a transaction which resulted in the realization, for tax purposes only, of unrealized gains in our investment portfolio of $69.6 million. This transaction enabled us to realize capital loss carryforwards to offset this gain, and resulted in the release of $24.4 million of the valuation allowance we held against the deferred tax asset related to these capital loss carryforwards. Of the total $24.4 million release, $0.3 million was recorded as an increase in continuing operations and $24.1 million is reflected as a benefit in accumulated other comprehensive income. This $24.1 million will be released into income from continuing operations, related to non-segment income, in future years, as the investment securities subject to these transactions are sold or mature.
In September 2011, we completed a transaction which resulted in the realization, for tax purposes only, of unrealized gains in our investment portfolio of $98.4 million. This transaction enabled us to realize capital loss carryforwards
During 2011, we reduced the valuation allowance related to our deferred tax asset by $55.6 million, from $91.5 million to $35.9 million. There were four principal components to this reduction. First, we decreased the valuation allowance by $29.0 million as a result of the transactions described above which utilized our capital loss carryforwards. Second, we decreased the valuation allowance by $21.9 million on certain unrealized losses as a result of unrealized appreciation in our investment portfolio. This decrease was reflected as an increase in accumulated other comprehensive income. Third, as a result of $28.1 million in net realized gains during 2011, we decreased the valuation allowance by $7.5 million as an increase to income from continuing operations, since these gains utilized our capital loss carryforwards. Fourth, in the 2010 U.S. federal income tax return, we were able to utilize an additional $7.6 million of capital loss carryforwards that expired in 2010. As such, we increased the valuation allowance by $2.6 million with an equal and offsetting increase to the related deferred tax asset. The remaining increase of $0.2 million was attributable to other items reflected as expense from discontinued operations.
In January 2010, we made a $100.0 million pension contribution, which resulted in both a current deduction of $35.0 million and the utilization (reduction) of a deferred tax asset of the same amount. This contribution is the most significant reason the current tax expense is $5.7 million in 2010, representing only approximately 10% of the total provision for federal income taxes from continuing operations.
The discussion and analysis of our financial condition and results of operations are based upon the consolidated financial statements. These statements have been prepared in accordance with GAAP, which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. The following critical accounting estimates are those which we believe affect the more significant judgments and estimates used in the preparation of our financial statements. Additional information about our other significant accounting policies and estimates may be found in Note 1 - “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
For the years ended December 31, 2012 and 2011, the expected rate of return on our qualified plan assets was 6.0% and 6.50%, respectively. The decrease reflects our strategy to shift investment assets from equity securities to fixed maturity investments over several years resulting in our composition of 84% fixed maturities and 16% equities at December 31, 2012, as well as declines in the fixed maturities markets in general. Actual returns of the plan investments generated approximately $57 million and $58 million of gains during 2012 and 2011, respectively, as compared to expected returns of approximately $33 million and $34 million, respectively.
As of December 31, 2012, we determined our discount rate utilizing an independent yield curve which provides for a portfolio of high quality bonds that are expected to match the cash flows of our Chaucer plan due to the longer duration of the plan liabilities. As of December 31, 2011, we determined our discount rate utilizing a 15 Year AA corporate bond index. At December 31, 2012, based upon our Chaucer plan liabilities and cash flows in relation to these yield curves, we decreased our discount rate to 4.80% from 4.90% at December 31, 2011.
The benefit from the investment gains experienced in 2012 was partially offset by a decrease in the discount rate from the prior year, resulting in net actuarial gains for the Chaucer plan of approximately $2.5 million. Investment losses experienced in 2011, combined with the decrease in the discount rate, partially offset by a decrease in the inflation rate and changes in other assumptions, resulted in net actuarial losses for the Chaucer plan of $14.1 million. These gains and losses are reflected as increases and decreases to our accumulated other comprehensive income, respectively. This balance is amortized into earnings in future periods. Given the effect of our actual investment experience in 2012, expected rates of return on investments in 2013 and taking into consideration the slight decrease in discount rates, pension related expenses for the Chaucer plan are expected to decrease in 2013 from $1.8 million to approximately $1.3 million (using the December 31, 2012 GBP to U.S. dollar conversion rate of 1.63).
Holding all other assumptions constant (using the December 31, 2012 GBP to U.S. dollar conversion rate of 1.63), sensitivity to changes in our key assumptions related to our Chaucer pension plan are as follows:
Expected Return on Plan Assets - A 25 basis point increase or decrease in the expected return on plan assets would decrease or increase our pension expense in 2013 by $0.2 million.
analysis as the severity of the decline increases or duration persists.
For our impairment review of asset-backed fixed maturity securities, we forecast our best estimate of the prospective future cash flows of the security to determine if we expect to recover the entire amortized cost basis of the security. Our analysis includes estimates of underlying collateral default rates based on historical and projected delinquency rates and estimates of the amount and timing of potential recovery. We consider available information relevant to the collectability of cash flows, including information about the payment terms of the security, prepayment speeds, the financial condition of the underlying borrowers, collateral trustee reports, credit ratings analysis and other market data when developing our estimate of the expected cash flows.
When an OTTI of a debt security occurs, and we intend to sell or more likely than not will be required to sell the investment before recovery of its amortized cost basis, the amortized cost of the security is reduced to its fair value, with a corresponding charge to earnings, which reduces net income and earnings per share. If we do not intend to sell the fixed maturity investment or more likely than not will not be required to sell it, we separate the OTTI into the amount we estimate represents the credit loss and the amount related to all other factors. The amount of the estimated loss attributable to credit is recognized in earnings, which reduces net income and earnings per share. The amount of the estimated OTTI that is non-credit related is recognized in other comprehensive income, net of applicable taxes.
OTTIs of equity securities are recorded as realized losses, which reduce net income and earnings per share. The new cost basis of an impaired security is not adjusted for subsequent increases in estimated fair value.
For equity method investments, we recognize an impairment when evidence demonstrates that a loss in value that is other-than-temporary has occurred. Evidence of a loss in value that is other-than-temporary may include the absence of an ability to recover the carrying amount of the investment or the inability of the investee to sustain a level of earnings that would justify the carrying amount of the investment. During each period, we evaluate whether an impairment indicator has occurred that may have a significant adverse affect on the carrying value of the investment. Impairment indicators may include: lower expectations of residual value from a limited partnership, reduced valuations of the investments held by limited partnerships, actual recent cash flows that are significantly less than expected cash flows or any other adverse events since the last financial statements received that might affect the value of the investee’s capital. OTTIs of equity method investments are recorded as realized losses, which reduce net income and earnings per share.
The following are the components of our deferred tax assets and liabilities as of December 31, 2012. There is no valuation allowance associated with our deferred tax assets as of December 31, 2012.
We believe the remaining deferred tax asset from other temporary differences will be fully realizable based on our projected future taxable income and recent financial operations. Although we believe that these assets are fully recoverable, there can be no certainty that future events will not affect their recoverability. Future economic conditions and debt market volatility, including increases in interest rates, can adversely impact our tax planning strategies.
The statutory capital and surplus for our U.S. insurance subsidiaries decreased $59.4 million during 2012, primarily due to underwriting losses primarily as a result of Superstorm Sandy.
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 U.S. 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”). No dividends were paid to the holding company by Hanover Insurance in 2012. In 2011, a $99 million ordinary dividend was paid by Hanover. This dividend was used to help fund the acquisition of Chaucer. In 2010, a dividend of $75.0 million was paid by Hanover, providing cash and securities to the holding company.
At December 31, 2012, THG, as a holding company, held approximately $163.2 million of fixed maturities and cash. We believe our holding company assets are sufficient to meet our future obligations, which consists primarily of dividends to our shareholders (as and to the extent declared), the interest on our senior debentures, additional funds relating to the purchase of Chaucer, certain costs associated with benefits due to our former life employees and agents, and to the extent required, payments related to indemnification of liabilities associated with the sale of various subsidiaries. We do not expect that it will be necessary to dividend additional funds from our insurance subsidiaries in order to fund 2013 holding company obligations; however, we may decide to do so.
to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K. During 2011, cash provided by investing activities primarily resulted from $756.1 million of cash and cash equivalents acquired from Chaucer. This increase was partially offset by cash paid for the Chaucer acquisition totaling $468.4 million, which included an $11.3 million payment related to a foreign currency exchange forward contract, and the investment of a portion of our Chaucer segment’s cash into fixed maturities. During 2010, cash used was primarily related to our net purchases of equity securities and fixed maturities. Additionally, cash was used in 2010 in connection with our acquisitions and renewal rights transactions.
Our insurance subsidiaries maintain a high degree of liquidity within their respective investment portfolios in fixed maturity and short-term investments. We believe that the quality of the assets we hold will allow us to realize the long-term economic value of our portfolio, including securities that are currently in an unrealized loss position. We do not anticipate the need to sell these securities to meet our insurance subsidiaries’ cash requirements since we expect our insurance subsidiaries to generate sufficient operating cash to meet all short-term and long-term cash requirements. However, there can be no assurance that unforeseen business needs or other items will not occur causing us to have to sell those securities in a loss position before their values fully recover, thereby causing us to recognize impairment charges in that time period.
Additionally, from time to time, we may also repurchase our debt. In 2012, we called $65.4 million of our subordinated unsecured notes related to Chaucer at par value. These notes had a carrying value of $60.3 million, resulting in a net loss of $5.1 million on the repurchases. In addition,
we called $7.0 million of capital securities related to AIX at par value. These retirements are expected to reduce our annual pre-tax interest costs by approximately $3 million. In 2011, we repurchased, in several transactions, $69.5 million of Junior Debentures at a cost of $72.1 million, resulting in a net loss of $2.6 million. In addition, we repurchased $4.0 million of surplus notes outstanding related to AIX, $8.0 million of capital securities related to AIX and $3.0 million of capital securities related to Professionals Direct, Inc. In 2010, we repurchased $36.5 million of our Junior Debentures at a cost of $38.5 million, resulting in a $2.0 million loss on the repurchases. We may decide to repurchase additional debt on an opportunistic basis.
At December 31, 2012, we were in compliance with the covenants of the aforementioned debt agreements.
Financing obligations generally include repayment of our Senior Debentures, Junior Debentures, borrowings from the FHLBB, and operating lease payments. The following table represents our annual payments related to the contractual principal and interest payments of these financing obligations as of December 31, 2012 and operating lease payments reflect expected cash payments based upon lease terms. In addition, we also have included our estimated payments related to our loss and LAE obligations and our current expectation of payments to be made to support the obligations of our benefit plans. The following table also includes commitments to purchase investment securities at a future date. Actual payments may differ from the contractual and/or estimated payments in the table.
(1) Debt includes our senior debentures due in 2025, which pay annual interest at a rate of 7 5/8%, our senior debentures due in 2020, which pay annual interest at a rate of 7.50%, our senior debentures due in 2021, which pay annual interest at a rate of 6.375%, and our junior subordinated debentures due in 2027, which pay cumulative dividends at an annual rate of 8.207%. Payments related to the principal amounts of these agreements represent contractual maturity; therefore, principal and interest associated with these obligations are reflected in the above table based upon the contractual maturity dates. In addition, we have $125.0 million of borrowings under a collateralized borrowing program with the FHLBB which pays interest monthly at a rate of 5.50% annually. Such borrowings are available for a twenty-year term or through September 25, 2029. We also have $46.3 million of CDAs under this collateralized borrowing program which pays interest monthly. All CDAs under this program with the FHLBB pay interest at a weighted average rate of 3.88%. We repaid these FHLBB CDAs in January 2013; such transaction is reflected in the less than one year category.
The ultimate payment amount for these pension plans are 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.
(4) Non-qualified defined benefit pension and postretirement benefit obligations reflect estimated payments to be made through plan year 2022 for pension, postretirement and postemployment benefits. Estimates of these payments and the payment patterns are based upon historical experience.
(6) Unlike many other forms of contractual obligations, loss and LAE reserves do not have definitive due dates and the ultimate payment dates are subject to a number of variables and uncertainties. As a result, the total loss and LAE reserve payments to be made by period, as shown in the table, are estimates based principally on historical experience.
Dividends received deduction - A corporation is entitled to a special tax deduction from gross income for dividends received from a domestic corporation that is subject to income tax.
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.
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 inland and ocean marine, surety, specialty property, professional liability, management liability and various other program businesses. When discussing net written premiums and other financial measures of our specialty businesses, we may include non-specialty premiums that are written as part of the entire account.
The consolidated financial statements of The Hanover Insurance Group, Inc. (“THG” or the “Company”), include the accounts of The Hanover Insurance Company (“Hanover Insurance”) and Citizens Insurance Company of America (“Citizens”), THG’s principal U.S. domiciled property and casualty companies; Chaucer Holdings plc (“Chaucer”), a specialist insurance underwriting group which operates through the Society and Corporation of Lloyd’s (“Lloyd’s”) and certain other insurance and non-insurance subsidiaries. These legal entities conduct their operations through several business segments discussed in Note 13 - “Segment Information”. The acquisition of Chaucer on July 1, 2011, which has added meaningful business volumes to THG results, has affected the comparability of the consolidated financial statements and related footnotes for the years ended December 31, 2012, 2011 and 2010. Results of operations for the year ended December 31, 2012 include results from all of the Company’s business segments, while results of operations for the year ended December 31, 2011 include Chaucer’s results for only the period from July 1, 2011 through December 31, 2011. Results of operations for 2010 do not include any results from Chaucer. Additionally, the consolidated financial statements include the Company’s discontinued operations, consisting primarily of the Company’s former life insurance businesses, its accident and health business and its third party administrator. All intercompany accounts and transactions have been eliminated.
The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America (“U.S. GAAP”) requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. In the opinion of the Company’s management these financial statements reflect all adjustments, consisting of normal recurring items necessary for a fair presentation of the financial position and results of operations.
Property, equipment, leasehold improvements and capitalized software are recorded at cost, less accumulated depreciation and amortization. Depreciation is provided using the straight-line or accelerated method over the estimated useful lives of the related assets, which generally range from 3 to 30 years. The estimated useful life for capitalized software is generally 5 to 7 years. Amortization of leasehold improvements is provided using the straight-line method over the lesser of the term of the leases or the estimated useful life of the improvements.
The Company tests for the recoverability of goodwill and intangible assets with indefinite lives annually or whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. The Company recognizes impairment losses only to the extent that the carrying amounts of reporting units with goodwill exceed the fair value. The amount of the impairment loss that is recognized is determined based upon the excess of the carrying value of goodwill compared to the implied fair value of the goodwill, as determined with respect to all assets and liabilities of the reporting unit. The Company has performed its annual review of goodwill and intangible assets with indefinite lives for impairment in the fourth quarters of 2012 and 2011 with no impairments recognized.
Premiums for direct and assumed business are reported as earned on a pro-rata basis over the contract period. The unexpired portion of these premiums is recorded as unearned premiums.
Insurance premiums written are generally recorded at the policy inception and are primarily earned on a pro rata basis over the terms of the policies for all products. Premiums written include estimates, primarily in the Chaucer segment, that are derived from multiple sources which include the historical experience of the underlying business, similar businesses and available industry information. These estimates are regularly reviewed and updated and any resulting adjustments are included in the current year’s results. Unearned premium reserves represent the portion of premiums written that relates to the unexpired terms of the underlying in-force insurance policies and reinsurance contracts. Premium receivables reflect the unpaid balance of premium written as of the balance sheet date. Premium receivables are generally short-term in nature and are reported net of 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, 2012 and 2011. 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
The Company’s reporting currency is the U.S. dollar. The functional currencies of the Company’s foreign operations are the U.K. Pounds Sterling (“GBP”), U.S. dollar, and Canadian dollar. Assets and liabilities of foreign operations are translated into the U.S. dollar using the exchange rates in effect at the balance sheet date. Revenues and expenses of foreign operations are translated using the average exchange rate for the period. Gains or losses from translating the financial statements of foreign operations are recorded in the cumulative translation adjustment, as a separate component of accumulated other comprehensive income. Gains and losses arising from transactions denominated in a foreign currency, other than the Company’s functional currencies, are included in net income (loss), except for the Company’s foreign currency denominated available-for-sale investments. The Company’s foreign currency denominated available-for-sale investments’ change in exchange rates between the local currency and the functional currency at each balance sheet date represents an unrealized appreciation or depreciation in value of these securities, and is included as a component of accumulated other comprehensive income.
In July 2012, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Codification (“ASC”) Update No. 2012-02 (Topic 350) Testing Indefinite - Lived Intangible Assets for Impairment. This ASC update allows an entity to first assess qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite - lived intangible asset is impaired. This assessment should be used as a basis for determining whether it is necessary to perform the quantitative impairment test. An entity would not be required to calculate the fair value of the intangible asset and perform the quantitative test unless the entity determines, based upon its qualitative assessment, that it is more likely than not that its fair value is less than its carrying value. The update further improves previous guidance by expanding upon the examples of events and circumstances that an entity should consider in determining whether it is more likely than not that the fair value of an indefinite - lived intangible asset is less than its carrying amount. The update also allows an entity the option to bypass the qualitative assessment for any indefinite-lived intangible asset in any period and proceed directly to performing the quantitative impairment test. An entity will be able to resume performing the qualitative assessment in any subsequent period. This ASC update is effective for annual and interim periods beginning after September 15, 2012, with early adoption permitted. The Company implemented this guidance effective October 1, 2012. The effect of implementing this guidance was not material to the Company’s financial position or results of operations.
In September 2011, the FASB issued ASC Update No. 2011-08 (Topic 350) Testing Goodwill for Impairment. This ASC update allows an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. The update provides that an entity would not be required to calculate the fair value of a reporting unit unless the entity determines, based on its qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. The update further improves previous guidance by expanding upon the examples of events and circumstances that an entity should consider in determining whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Also, the update improves the examples of events and circumstances that should be considered by an entity that has a reporting unit with a zero or negative carrying amount in determining whether to measure an impairment loss, if any, under the second step of the goodwill impairment test. This ASC update is effective for annual and interim periods beginning after December 15, 2011, with early adoption permitted. The Company implemented this guidance effective January 1, 2012. The effect of implementing this guidance was not material to the Company’s financial position or results of operations.
In June 2011, the FASB issued ASC Update No. 2011-05 (Topic 220) Presentation of Comprehensive Income (“ASC Update No. 2011-05”). This ASC update requires companies to present net income and other comprehensive income in either a single continuous statement or in two separate, but consecutive, statements of income and other comprehensive income. The option to present items of other comprehensive income in the statement of changes in equity is eliminated. In addition, an entity is required to present on the face of the financial statements reclassification adjustments from other comprehensive income to net income. This ASC update should be applied retrospectively and except for the provisions related to reclassification adjustment, is effective for interim and annual periods beginning after December 15, 2011. In December 2011, the FASB issued ASC Update 2011-12 (Topic 220) Comprehensive Income which deferred the implementation date of the reclassification adjustment guidance in ASC Update No. 2011-05. The Company implemented the guidance related to financial statements presentation effective January 1, 2012. The effect of implementing the guidance related to financial statements presentation did not have a significant impact to the Company’s financial statement presentation.
In July 2010, the FASB issued ASC Update No. 2010-20 (Topic 310) Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. This ASC update is applicable for financing receivables recognized on a company’s balance sheet that have a contractual right to receive payment either on demand or on fixed or determinable dates. This update enhances the disclosure requirements about the credit quality of financing receivables and the allowance for credit losses, at disaggregated levels. The disclosure guidance provided in the update relating to those required as of the end of the reporting period was effective for interim and annual reporting periods ending on or after December 15, 2010. The effect of implementing the guidance was not significant to the Company’s financial statement disclosures. The disclosure
guidance related to activity that occurs during the reporting period is effective for interim and annual reporting periods beginning on or after December 15, 2010. The implementation of the disclosure guidance related to activity was not significant to the Company’s financial statement disclosures.
This transaction provides broader product and underwriting capabilities, as well as greater geographic and product diversification, advancing the Company’s specialty lines strategy. The acquisition added a presence in the Lloyd’s market, which includes access to international licenses, an excess and surplus insurance business and the ability to syndicate certain risks.
In connection with the transaction, the Company entered into a foreign exchange forward contract, which provided for an economic hedge between the agreed upon purchase price of Chaucer in GBP and currency fluctuations between the GBP and U.S. dollar prior to close. This contract effectively locked in the U.S. dollar equivalent of the purchase price to be delivered in GBP and was settled at a loss of $11.3 million during the year ended December 31, 2011. The loss on the contract was due to a decrease in the exchange rate between the GBP and U.S. dollar, but was partially offset by the lower U.S. dollars required to meet the GBP-based purchase price, resulting in a $6.4 million gain on foreign exchange during the year ended December 31, 2011.
A summary of the fair value of goodwill and the identifiable intangible assets and their respective estimated useful lives at July 1, 2011 is as follows:
The purchase price of the acquisition exceeded the fair value of the net tangible and intangible assets acquired, with the excess purchase price recorded as goodwill. Factors that contributed to the recognition of goodwill included the expected growth rate and profitability of Chaucer and the value of Chaucer’s experienced workforce. Goodwill and certain intangible assets are deductible for income tax purposes.
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. Accordingly, the operating results of the discontinued segment have been reported in accordance with Accounting Principles Board Opinion No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions (“APB Opinion No. 30”). On January 2, 2009, Hanover Insurance directly assumed a portion of the accident and health business; and therefore continues to apply APB Opinion No. 30 to this business. In addition, the remainder of the Discontinued First Allmerica Financial Life Insurance Company (“FAFLIC”) accident and health business was
The accident and health business had no significant financial results that impacted 2012, 2011 or 2010. At December 31, 2012 and 2011, the portion of the discontinued accident and health business that was directly assumed had assets of $72.9 million and $70.4 million, respectively, consisting primarily of invested assets, and liabilities of $52.5 million and $52.1 million, respectively, consisting primarily of policy liabilities. At December 31, 2012 and 2011, the assets and liabilities of this business, as well as those of the reinsured portion of the accident and health business are classified as assets and liabilities of discontinued operations in the Consolidated Balance Sheets.
On April 30, 2012, the Company completed the sale of its third party administration subsidiary, CMI. The Company recognized net gains of $10.8 million after taxes related to this transaction during the year ended December 31, 2012. Included in this amount was a contingent gain with a fair value of $1.7 million that was entirely contributed to the Company’s charitable foundation.
The Company participates in a security lending program for the purpose of enhancing income. Securities on loan to various counterparties had a fair value of $29.2 million and $24.1 million at December 31, 2012 and 2011, respectively, and were fully collateralized by cash. The fair value of the loaned securities is monitored on a daily basis, and the collateral is maintained at a level of at least 102% of the fair value of the loaned securities. Securities lending collateral is recorded by the Company in cash and cash equivalents, with an offsetting liability included in expenses and taxes payable.
At December 31, 2012 and 2011, fixed maturities with fair values of $115.7 million and $103.5 million, respectively, and amortized cost of $106.2 million and $97.0 million, respectively, were on deposit with various state and governmental authorities.
In 2012, the Company realized a loss of $5.1 million on futures contracts relating to the realization for tax purposes only, of unrealized gains in its investment portfolio. Additionally, the Company utilized a foreign currency forward contract to mitigate changes in fair value caused by foreign currency fluctuation in converting GBP denominated securities into their U.S. dollar denominated equivalent. The contract was terminated in March 2012 and the Company recognized a gain of $0.7 million.
of the derivative’s loss were included in the assessment of hedge effectiveness. There was no ineffectiveness on this hedge. The Company expects that $0.2 million will be recognized as an expense over the next 12 months.
During 2011, Chaucer held foreign currency forward contracts utilized to mitigate changes in fair value caused by foreign currency fluctuation in converting the fair value of GBP and Euro denominated investment portfolios into their U.S. dollar denominated equivalent. During the year ended December 31, 2011, the Company recognized a net gain of $6.1 million, reflected in net realized investment gains in the Consolidated Statements of Income, related to these instruments, which were terminated in October 2011.
The Company views the gross unrealized losses on fixed maturities and equity securities as being temporary since it is its assessment that these securities will recover in the near term, allowing the Company to realize the anticipated long-term economic value. The Company employs a systematic methodology to evaluate declines in fair value below amortized cost for fixed maturity securities or cost for equity securities. In determining OTTI of fixed maturity and equity securities, the Company evaluates several factors and circumstances, including the issuer’s overall financial condition; the issuer’s credit and financial strength ratings; the issuer’s financial performance, including earnings trends, dividend payments and asset quality; any specific events which may influence the operations of the issuer; the general outlook for market conditions in the industry or geographic region in which the issuer operates; and the length of time and the degree to which the fair value of an issuer’s securities remains below the Company’s cost. With respect to fixed maturity investments, the Company considers any factors that might raise doubt about the issuer’s ability to make contractual payments as they come due and whether the Company expects to recover the entire amortized cost basis of the security. With respect to equity securities, the Company considers its ability and intent to hold the investment for a period of time to allow for a recovery in value.
The Company had no concentration of investments in a single investee that exceeded 10% of shareholders’ equity except for fixed maturities invested in Federal Home Loan Mortgage Corp., which had a fair value of $415.7 million and $455.0 million as of December 31, 2012 and 2011, respectively.
In 2010, the Company purchased approximately 11 acres of developable land in Worcester, Massachusetts for $5 million. A portion of the land was developed with the construction of a new 200,000 square foot office building and redevelopment of an adjacent parking garage (the “City Square Project”). On December 21, 2012, the Company sold the office building and adjacent garage for $75.9 million, and recognized a gain of $3.3 million. The project was financed, in part, with $46.3 million of FHLBB community development advances (“CDAs”) through the Company’s membership in the FHLBB, which was repaid in January 2013. See Note 6 - “Debt and Credit Arrangements” for additional information related to the Company’s FHLBB program.
At December 31, 2012, there were contractual investment commitments of up to $17.3 million.
The Company held overseas deposits of $169.2 million and $135.1 million at December 31, 2012 and 2011, respectively, which are investments held in overseas funds and managed exclusively by Lloyd’s. These investments are reflected in other investments in the Consolidated Balance Sheets.
For 2011, total OTTI was $4.9 million. Of this amount, $6.9 million was recognized in earnings, including $2.0 million that was transferred from unrealized losses in accumulated other comprehensive income. Of the $6.9 million recorded in earnings, $4.6 million related to fixed maturity securities that the Company intends to sell, $1.4 million related to common stocks and $0.9 million was estimated credit losses on fixed maturity securities.
For 2010, total OTTI was $9.4 million. Of this amount, $13.9 million was recognized in earnings, including $4.5 million that was transferred from unrealized losses in accumulated other comprehensive income. Of the $13.9 million recorded in earnings, $4.4 million related to certain low-income housing tax credit limited partnerships, $4.3 million was estimated credit losses on fixed maturity securities, $3.3 million related to fixed maturity securities that the Company intended to sell and $1.9 million related to common stocks.
The following table provides a reconciliation of gross unrealized investment gains (losses) to the net balance shown in the Consolidated Statements of Comprehensive Income.
Level 1 consists of publicly traded securities, including exchange traded funds, valued at quoted market prices. Level 2 includes securities that are valued using pricing for similar securities and pricing models that incorporate observable inputs. Level 2 also includes fair values obtained from net asset values provided by mutual fund investment managers, upon which subscriptions and redemptions can be executed. Level 3 consists of common or preferred stock of private companies for which observable inputs are not available. Non-binding broker quotes are also included in Level 3.
The Company utilizes a third party pricing service for the valuation of the majority of its equity securities and receives one quote for each equity security. When quoted market prices in an active market are available, they are provided by the pricing service as the fair value and such values are classified as Level 1. Generally, all prices provided by the pricing service, except quoted market prices, are reported as
Changes in the observability of valuation inputs may result in a reclassification of certain financial assets or liabilities within the fair value hierarchy. Reclassifications between levels of the fair value hierarchy are reported as of the beginning of the period in which the reclassification occurs. As previously discussed, the Company utilizes a third party pricing service for the valuation of the majority of its fixed maturities and equity securities. The pricing service has indicated that it will only produce an estimate of fair value if there is objectively verifiable information to produce a valuation. If the pricing service discontinues pricing an investment, the Company will use observable market data to the extent it is available, but may also be required to make assumptions for market based inputs that are unavailable due to market conditions.
The following tables provide, for each hierarchy level, the Company’s assets at December 31, 2012 and 2011 that are measured at fair value on a recurring basis.
During the years ended December 31, 2012 and 2011, the Company transferred fixed maturities between Level 2 and Level 3 primarily a result of assessing the significance of unobservable inputs on the fair value measurement. There were no transfers between Level 1 and Level 2 during 2012 and 2011.
On June 17, 2011, the Company issued $300 million aggregate principal amount of 6.375% senior unsecured debentures due June 15, 2021. Additionally, on February 23, 2010, the Company issued $200.0 million aggregate principal amount of 7.50% senior unsecured debentures due March 1, 2020. The Company also issued 7.625 % senior unsecured debentures with a par value of $200.0 million on October 16, 1995. As of December 31, 2012 and 2011, the remaining 7.625% senior debentures have a $120.9 million and $121.6 million par value, respectively, and mature on October 15, 2025. All of the Company’s senior debentures are subject to certain restrictive covenants, including limitations on the issuance or disposition of stock of restricted subsidiaries and limitations on liens. These debentures pay interest semi-annually.
The Company’s Series B 8.207% Subordinated Deferrable Interest Debentures (“Junior Debentures”) have a par value of $59.7 million as of December 31, 2012 and 2011. These debentures pay cumulative dividends semi-annually at 8.207% and mature February 3, 2027. In 2011, the Company repurchased in several transactions, $69.5 million of these Junior Debentures at a cost of $72.1 million, resulting in a net loss on the repurchases of $2.6 million. Additionally, in 2011, the Company repurchased $8.0 million and $3.0 million of the capital securities related to AIX and PDI, respectively, at par value. In 2012, the Company called the remaining $7.0 million of the capital securities related to AIX at par value.
On July 1, 2011, the Company acquired all of the outstanding shares of Chaucer. As part of this acquisition, 12.0 million aggregate principal amount of floating rate subordinated unsecured notes due November 16, 2034 were assumed. These notes paid interest semi-annually based on the European Inter bank offer rate (Euribor) plus 3.75%. Additionally, the Company also assumed $50.0 million aggregate principal amount of floating rate subordinated unsecured notes due September 21, 2036. These notes paid interest quarterly based on the three-month LIBOR plus 3.1%. During 2012, the Company called these subordinated unsecured notes at par value. These notes had a carrying value of $60.3 million resulting in a net loss on the repurchases of $5.1 million.
In 2009, the Company received a $125.0 million FHLBB advance through the Company’s membership in the FHLBB. This collateralized advance bears interest at a fixed rate of 5.50% per annum over a twenty-year term. In July 2010, the Company committed to $46.3 million of FHLBB CDAs to finance the development of the City Square Project. See Note 3 - “Investments” for additional information on the City Square Project. These CDAs were drawn in several increments from July 2010 to January 2012 and carried fixed interest rates with a weighted average of 3.88%. In January 2013, the Company repaid the $46.3 million of FHLBB CDAs. These CDAs would have matured on July 30, 2020. Interest associated with the $46.3 million was capitalized through the construction phase of the City Square Project.
In June 2012, the Company completed a transaction which resulted in the realization, for tax purposes only, of unrealized gains in its investment portfolio of $69.6 million. This transaction enabled the Company to realize capital loss carryforwards to offset this gain, and resulted in the release of $24.4 million of the valuation allowance held against the deferred tax asset related to these capital loss carryforwards. Of the total $24.4 million release, $0.3 million was recorded as an increase in continuing operations and $24.1 million is reflected as a benefit in accumulated other comprehensive income. This $24.1 million will be released into income from continuing operations, related to non-segment income, in future years, as the investment securities subject to these transactions are sold or mature.
In September 2011, the Company completed a transaction which resulted in the realization, for tax purposes only, of unrealized gains in its investment portfolio of $98.4 million. This transaction enabled the Company to realize capital loss carryforwards to offset this gain, and resulted in the release of $29.0 million of the valuation allowance held against the deferred tax asset related to these capital loss carryforwards. The release of $0.2 million was reflected in income from continuing operations and the remaining amount of $28.8 million was reflected as a benefit in accumulated other comprehensive income. During 2012, the Company recognized $1.4 million of the $28.8 million in income from continuing operations related to non-segment income. The remaining amount will be released into income from continuing operations in future years, as the investment securities subject to these transactions are sold or mature.
In September 2009, as part of the audit of 2005 and 2006, the IRS issued a Revenue Agents Report (“RAR”) which disallowed the dividends received deduction related to separate account assets for both 2005 and 2006. The Company challenged the disallowance by filing a formal protest and requested an IRS Appeals Conference. In 2011, the Company received written notification from the IRS Appeals Division reflecting a proposed settlement including a concession of the separate account dividends received deduction issue. As a result of the proposed settlement with the IRS, the liability for uncertain tax position on the Company’s dividends received deductions related to separate account assets was reduced in 2011. This reduction was partially offset by the settlement of certain receivable balances. The net tax benefit of $2.1 million was recorded as income from discontinued operations.
The Company recognizes interest and penalties related to unrecognized tax benefits in federal income tax expense. In 2011, as part of the settlement of the 2005 and 2006 audit period, the Company reduced its accrued interest by $0.7 million. The Company had accrued interest of $0.4 million and $0.3 million as of December 31, 2012 and 2011, respectively. The Company has not recognized any penalties associated with unrecognized tax benefits.
Prior to 2005, THG provided retirement benefits to substantially all of its employees under defined benefit pension plans. These plans were based on a defined benefit cash balance formula, whereby the Company annually provided
an allocation to each covered employee based on a percentage of that employee’s eligible salary, similar to a defined contribution plan arrangement. In addition to the cash balance allocation, certain transition group employees who had met specified age and service requirements as of December 31, 1994 were eligible for a grandfathered benefit based primarily on the employees’ years of service and compensation during their highest five consecutive plan years of employment. The Company’s policy for the plans is to fund at least the minimum amount required by the Employee Retirement Income Security Act of 1974 (“ERISA”).
As of January 1, 2005, the defined benefit pension plans were frozen and since that date, no further cash balance allocations have been credited to participants. Participants’ accounts are credited with interest daily, based upon the General Agreement of Trades and Tariffs. In addition, the grandfathered benefits for the transition group were also frozen at January 1, 2005 levels with an annual transition pension adjustment calculated at an interest rate equal to 5% per year up to 35 years of completed service, and 3% thereafter.
On January 4, 2010 the Company made a discretionary contribution of $100 million to the qualified defined benefit pension plan. Including this contribution, and based on current estimates of plan liabilities and other assumptions, the qualified defined benefit pension plan is underfunded by approximately $15 million as of December 31, 2012.
Prior to 2002, the Chaucer segment provided defined benefit pension retirement benefits to certain of its employees. As of December 31, 2001, the defined benefit pension plan was closed to new members. The defined benefit obligation for this plan is based on the employees’ years of service and final pensionable salary. Contributions are made at least annually to this plan by both the Company and by employees. As of December 31, 2012, based on current estimates of plan liabilities and other assumptions, this plan is underfunded by approximately $25 million.
Weighted-average assumptions used to determine the U.S. pension benefit obligations are as follows:
The Company utilizes a target allocation strategy, which focuses on creating a mix of assets that will generate modest growth from equity securities while minimizing volatility in the Company’s earnings from changes in the markets and economic environment. Various factors are taken into consideration in determining the appropriate asset mix, such as census data, actuarial valuation information and capital market assumptions. During 2012 and 2011, the plan assets were invested 84% and 82%, respectively, in fixed income securities and 16% and 18%, respectively, in equity securities. The Company reviews and updates, at least annually, the target allocation and makes changes periodically.
The following table provides target allocations and actual invested asset allocations for 2012 and 2011.
Included in total plan assets of $591.6 million at December 31, 2012 were $586.6 million of invested assets carried at fair value and $5.0 million of cash and equivalents. Total plan assets at December 31, 2011 of $574.7 million included $568.8 million of invested assets carried at fair value and $5.9 million of cash and equivalents.
Level 1 securities primarily consist of 466,755 shares of THG common stock held by the plan at December 31, 2012 and 2011. THG common stock is valued at quoted market prices. Securities also classified as Level 1 at December 31, 2012 and 2011 include actively traded mutual funds that are publicly traded and which primarily invest in equity securities that are valued at quoted market prices. Securities classified as Level 2 include investments in commingled pools that primarily invest in publicly traded common stocks and international equity securities. The fair value of each of the Level 2 investments is determined daily as the NAV based on the value of the underlying investments, which is determined independently by the investment manager. The daily NAV, which is not published as a quoted market price for these investments, is used as the basis for transactions. Redemption of these funds is not subject to restriction.
Included in total plan assets of $90.9 million at December 31, 2012 were $90.7 million of invested assets carried at fair value and $0.2 million of cash and equivalents. Total plan assets at December 31, 2011 of $74.3 million included $74.1 million of invested assets carried at fair value and $0.2 million of cash and equivalents.
The following table presents for each hierarchy level the Chaucer defined benefit plan’s investment assets that are measured at fair value at December 31, 2012 and 2011.
Securities classified as Level 2 at December 31, 2012 and 2011 include pooled funds which are valued at the close of business using a third party pricing service. These values are adjusted by the fund manager to reflect outstanding dividends, taxes and investment fees and other expenses to calculate the NAV.
The following table reflects the total amounts recognized in accumulated other comprehensive income relating to both the U.S. defined benefit pension plans and the Chaucer pension plan as of December 31, 2012 and 2011.
The unrecognized net actuarial gains (losses) which exceed 10% of the greater of the projected benefit obligation or the fair value of plan assets are amortized as a component of net periodic pension cost in future years. The following table reflects the total estimated amount of actuarial losses that will be amortized from accumulated other comprehensive income into net periodic pension cost in 2013:
Chaucer also provides a defined contribution plan for its employees which provides for employer provided contributions. The Company’s expense for the year ended December 31, 2012 and the six months ended December 31, 2011 was $4.8 million and $2.4 million, respectively.
Generally, employees who were actively employed on December 31, 1995 became eligible with at least 15 years of service after the age of 40. Effective January 1, 1996, the Company revised these benefits so as to establish limits on future benefit payments to beneficiaries of retired participants and to restrict eligibility to then current employees. In 2009, the Company changed the postretirement medical benefits, only as they relate to current employees who still qualified for participation in the plan under the above formula. For these participants, the plan now provides for only post age 65 benefits. The population of agents receiving postretirement benefits was frozen as of December 31, 2002, when the Company ceased its distribution of proprietary life and annuity products. These plans are unfunded.
The Company has recognized the funded status of its postretirement benefit plans in its Consolidated Balance Sheet. Since these plans are unfunded, the amount recognized in the Consolidated Balance Sheet is equal to the accumulated benefit obligation of these plans. The components of accumulated other comprehensive income or loss are reflected as either a net actuarial gain or loss or a net prior service cost.
The benefit payments are based on the same assumptions used to measure the Company’s benefit obligation at the end of 2013 and reflect benefits attributable to estimated future service.
The components of net periodic postretirement (benefit) expense were as follows:
The following table reflects the estimated amortization to be recognized in net periodic benefit cost in 2013:
Employers are required to measure the funded status of their plans as of the date of their year-end statement of financial position. As such, the Company has utilized a measurement date of December 31, 2012 and 2011, to determine its postretirement benefit obligations, consistent with the date of its Consolidated Balance Sheets. Weighted-average discount rate assumptions used to determine postretirement benefit obligations and periodic postretirement costs are as follows:
A one-percentage point change in assumed health care cost trend rates in each year would have an immaterial effect on net periodic benefit cost during 2012 and accumulated postretirement benefit obligation at December 31, 2012.
On May 16, 2006, the shareholders approved the adoption of The Hanover Insurance Group, Inc. 2006 Long-Term Incentive Plan (the “Plan”). Key employees, directors and certain consultants of the Company and its subsidiaries are eligible for awards pursuant to the Plan, which is administered by the Compensation Committee of the Board of Directors (the “Committee”) of the Company. Under the Plan, awards may be granted in the form of non-qualified or incentive stock options, stock appreciation rights, performance awards, restricted stock, unrestricted stock, stock units, or any other award that is convertible into or otherwise based on the Company’s stock, subject to certain limits. The Plan authorized the issuance of 3,000,000 new shares that may be used for awards. In addition, shares of stock underlying any award granted and outstanding under the Company’s Amended Long-Term Stock Incentive Plan (the “1996 Plan”) as of the adoption date of the Plan that are forfeited, cancelled, expire or terminate without the issuance of stock become available for future grants under the Plan. As of December 31, 2012, there were 1,351,319 shares available for grants under the Plan. The Company utilizes shares of stock held in the treasury account for option exercises and other awards granted under both plans.
Under the 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 Committee at the time of grant. Options granted in 2012, 2011, and 2010 generally vest over 4 years with a 50% vesting rate in the third year and a 50% vesting rate in the fourth year. Options must be exercised not later than ten years from the date of grant.
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, 2012, 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 fair value of shares that vested during the year ended December 31, 2012 was $1.6 million. For the years ended December 31, 2011 and 2010, the market price of shares that vested was lower than the value of these shares on their grant date. As of December 31, 2012, the Company had unrecognized compensation expense of $6.0 million related to unvested stock options that is expected to be recognized over a weighted average period of 2.6 years.
The intrinsic value, which is equal to the fair value for restricted stock and for restricted stock units that vested during the year ended December 31, 2012, was $1.7 million. There was no intrinsic value of performance-based restricted stock since units that would have vested in 2012 were forfeited in the previous year due to the aforementioned completion levels of less than threshold. The intrinsic value of restricted stock units and performance-based restricted units that vested during the year ended December 31, 2011 were $10.2 million and $1.3 million, respectively. The intrinsic value of restricted stock units and performance-based restricted units that vested during the year ended December 31, 2010 were $5.0 million and $1.3 million, respectively.
At December 31, 2012, the aggregate intrinsic value of restricted stock and restricted stock units was $29.1 million and the weighted average remaining contractual life was 1.5 years. The aggregate intrinsic value of performance and market-based restricted stock units was $5.1 million and the weighted average remaining contractual life was 2.7 years. As of December 31, 2012, there was $14.5 million of total unrecognized compensation cost related to unvested restricted stock units and performance and market-based restricted stock units, assuming performance and market-based restricted stock units are achieved at 100% of the performance metric. The cost is expected to be recognized over a weighted-average period of 2.3 years. Compensation cost associated with restricted stock, restricted stock units and performance and market-based restricted stock units is generally calculated based upon grant date fair value, which is determined using current market prices.
Diluted earnings per share during 2012, 2011 and 2010 excludes 1.8 million, 1.6 million and 1.4 million, respectively, of common shares issuable under the Company’s stock compensation plans, because their effect would be antidilutive.
Since October 2007 and through December 2012, the Company’s Board of Directors has authorized aggregate repurchases of the Company’s common stock of up to $500 million. As of December 31, 2012, the Company has $115.2 million available for repurchases under these repurchase authorizations. 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. During 2012, the Company purchased 0.5 million shares of the Company’s common stock through open market purchases at a cost of $20.0 million. On March 30, 2010, the Company entered into an accelerated share repurchase agreement for the immediate repurchase of 2.3 million shares of the Company’s common stock at a cost of $105.0 million. Total repurchases under this program as of December 31, 2012 were 9.1 million shares at a cost of $384.8 million.
Pursuant to New Hampshire’s statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the New Hampshire Insurance Commissioner, is limited to 10% of such insurer’s statutory policyholder surplus as of the preceding December 31. No dividends were declared by Hanover Insurance in 2012. In 2011 and 2010, Hanover Insurance declared dividends to its parent totaling $99.0 million and $75.0 million, respectively. During 2013, the maximum dividend payable without prior approval is $151.9 million.
Pursuant to Michigan’s statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the Michigan Insurance Commissioner, is limited to the greater of 10% of policyholders’ surplus as of December 31 of the immediately preceding year or the statutory net income less net realized gains, for the immediately preceding calendar year. Citizens declared dividends to its parent, Hanover Insurance, totaling $70.0 million, $69.0 million and $70.0 million in 2012, 2011 and 2010, respectively. Citizens cannot pay a further dividend to its parent without prior approval until December 2013, at which time the maximum dividend payable without prior approval would be $68.3 million.
Long-lived assets located outside the U.S. were not material for the year ended December 31, 2012 or 2011. The Company does not have revenue from transactions with a single agent or broker amounting to 10 percent or more of its consolidated revenue.
Rental expenses for operating leases amounted to $22.4 million, $21.1 million and $17.2 million in 2012, 2011 and 2010, respectively. These expenses relate primarily to building leases of the Company. At December 31, 2012, future minimum rental payments under non-cancelable operating leases, were approximately $58.5 million, payable as follows: 2013 - $18.0 million; 2014 - $16.3 million; 2015 - $13.8 million; 2016 - $7.2 million and 2017 and thereafter - $3.2 million. It is expected that in the normal course of business, leases that expire may be renewed or replaced by leases on other property and equipment.
The $103.3 million favorable loss and LAE reserve development during the year ended December 31, 2011 includes favorable loss and LAE reserve development of $35.5 million for Chaucer. The Chaucer favorable development was primarily the result of lower than expected losses in the energy, property and U.K. motor lines, primarily related to the 2009 and 2010 accident years. For Commercial and Personal Lines, the favorable loss and LAE reserve development during the year ended December 31, 2011 was primarily the result of lower than expected losses in the personal automobile line, primarily related to bodily injury coverage in the 2008 through 2010 accident years, the commercial multiple peril line related to the 2007 through 2010 accident years and lower than expected losses in the 2007 through 2010 accident years in the workers’ compensation line. In addition, within other commercial lines, unfavorable development in the professional liability and surety lines were partially offset by favorable development in the healthcare and other commercial property lines.
The quarterly results of operations for 2012 and 2011 are summarized below.
There were no subsequent events requiring adjustment to the financial statements and no additional disclosures required in the notes to the consolidated financial statements except for the repayment of the FHLBB CDAs disclosed in Note 6 - “Debt and Credit Arrangements”.