The Company leases its principal executive offices in New York, New York, as well as 210 field and claim offices totaling approximately 5.5 million square feet throughout the United States under leases or subleases with third parties. The Company also leases offices in the United Kingdom, Canada and the Republic of Ireland that house operations (primarily for the Financial, Professional & International Insurance segment) in those locations. The Company owns six buildings in Hartford, Connecticut, consisting of approximately 1.8 million square feet of office space. The Company also owns office buildings located at 385 Washington Street and 130 West Sixth Street, St. Paul, Minnesota. These buildings are adjacent to one another and consist of approximately 1.1 million square feet of gross floor space. The Company also owns other real property, including office buildings in Denver, Colorado and Fall River, Massachusetts, as well as a data center located in Norcross, Georgia.
The Company owns a building in London, England, which houses a portion of its Financial, Professional & International Insurance segment's operations in the United Kingdom.
•Net income of $3.22 billion, or $6.69 per share basic and $6.62 diluted
•Pretax net realized investment gains of $264 million ($173 million after-tax)
Diluted net income per share of $6.33 in 2009 increased by 32% over diluted net income per share of $4.81 in 2008. Net income of $3.62 billion in 2009 was 24% higher than 2008 net income of $2.92 billion. The higher rate of growth in per share income compared with growth in income reflected the favorable impact of the Company's common share repurchases over the previous twelve months. The increase in net income in 2009 was primarily driven by a significant decline in catastrophe losses. In addition, the increase reflected net realized investment gains (versus net realized investment losses in 2008), lower non-catastrophe weather-related losses and fewer large property losses, partially offset by reductions in underwriting margins related to pricing and loss cost trends, a decline in net favorable prior year reserve development and lower fee income. Catastrophe losses in 2009 totaled $457 million, compared with $1.41 billion in 2008. The 2008 total was principally comprised of $1.26 billion of claims and claim adjustment expenses and $141 million of property windpool assessments that were included in general and administrative expenses. Net favorable prior year reserve development totaled $1.33 billion in 2009, compared with $1.54 billion in 2008. Net income in 2009 included a net benefit of $89 million due to the favorable resolution of various prior year tax matters and an $87 million benefit from a reduction in the estimate of property windpool assessments related to Hurricane Ike. These assessments had been classified as a component of the cost of catastrophes in 2008 and are discussed in more detail in the "general and administrative expenses" section that follows). Net income in 2008 reflected an $89 million tax benefit related to the sale of a subsidiary.
In 2009, earned premiums totaled $21.42 billion, a decrease of $161 million, or 1%, from 2008. In the Business Insurance segment, earned premiums in 2009 declined 2% from 2008. In the Financial, Professional & International Insurance segment, earned premiums in 2009 declined 3% from 2008. In the Personal Insurance segment, earned premiums increased 2% over 2008.
(a)Excludes net unrealized investment gains and losses, net of tax, and reflects cash, receivables for investment sales, payables on investment purchases and accrued investment income.
(b)Excludes net realized investment gains and losses and net unrealized investment gains and losses.
Net investment income of $2.78 billion in 2009 was $16 million, or less than 1%, lower than in 2008, primarily resulting from a significant decline in short-term interest rates, a lower average level of long-term fixed maturity invested assets and the unfavorable impact of foreign currency exchange rates. Those factors were largely offset by improved returns from non-fixed maturity investments, which generated negative net investment income of $40 million in 2009, compared with negative net investment income of $222 million in 2008. The improved performance from non-fixed income investments in 2009 reflected improving investment market conditions in the second half of the year. The average pretax yield on the total investment portfolio was 3.8% in both 2009 and 2008.
The following table sets forth information regarding the Company's net realized investment gains (losses).
In 2009, impairments included in net income totaled $258 million. Impairments in the fixed maturity portfolio in 2009 were $169 million and included $81 million of impairments related to structured mortgage securities, $70 million related to various issuers' deteriorated financial position and $18 million with respect to securities that the Company either had the intent to sell or did not have the ability to assert an intention to hold until recovery in fair value. Equity impairments in 2009 were $79 million, the majority of which were related to issuers in the financial services industry. Impairments in 2009 also included $10 million related to other investments.
In 2008, impairments included $186 million related to the deteriorated financial position of various issuers (including $70 million related to securities issued by Lehman Brothers Holdings Inc. and its subsidiaries), $113 million related to externally managed securities with respect to which the Company did not have the ability to assert an intention to hold until recovery in fair value, $64 million related to structured mortgage securities and $57 million related to securities the Company had identified for potential sale prior to a recovery in fair value.
Other Net Realized Investment Gains-Other net realized investment gains in 2010 totaled $290 million, compared with $275 million in 2009. In September 2010, the Company sold substantially all of its remaining common stock holdings in Verisk Analytics, Inc. (Verisk) for total proceeds of approximately $230 million as part of a secondary public offering of Verisk. The Company recorded a pretax realized investment gain of $205 million on this sale in 2010. The 2010 total also included $96 million of net realized investment gains related to fixed maturity investments and $25 million of net realized investment gains related to equity securities. These gains were partially offset by $30 million of net realized investment losses related to U.S. Treasury futures contracts, which require a daily mark-to-market settlement and are used to shorten the duration of the Company's fixed maturity investment portfolio.
Claims and claim adjustment expenses totaled $13.21 billion in 2010, $802 million, or 6%, higher than the 2009 total of $12.41 billion, primarily reflecting the significant increase in catastrophe losses, the modest decline in net favorable prior year reserve development and the impact of loss cost trends. Catastrophe losses in 2010 and 2009 totaled $1.11 billion and $457 million, respectively. Net favorable prior year reserve development in 2010 and 2009 totaled $1.25 billion and $1.33 billion, respectively. Catastrophe losses in 2010 primarily resulted from several severe wind and hail storms, as well as severe winter storms. Catastrophe losses in 2009 primarily resulted from several wind and hail storms, as well as flooding.
Claims and claim adjustment expenses totaled $12.41 billion in 2009, $585 million, or 5%, lower than the 2008 total of $12.99 billion, primarily reflecting the significant decline in catastrophe losses, lower non-catastrophe weather-related losses and fewer large property losses, mostly offset by the modest decline in net favorable prior year reserve development and the impact of loss cost trends. Total claims and claim adjustment expenses in 2009 included $457 million for the cost of catastrophes and $1.33 billion of net favorable prior year reserve development, whereas the comparable 2008 total included $1.26 billion for the cost of catastrophes and $1.54 billion of net favorable prior year reserve development. Catastrophe losses in 2008 primarily resulted from Hurricanes Ike, Gustav and Dolly.
In 2010, general and administrative expenses totaled $3.41 billion, an increase of $40 million, or 1%, over the 2009 total of $3.37 billion. The 2009 total included a reduction of $87 million in the estimate of property windpool assessments related to Hurricane Ike due to a decline in estimated insurance industry losses related to Hurricane Ike. Excluding that adjustment in 2009, general and administrative expenses in 2010 were $47 million, or 1%, lower than in 2009. The decline was concentrated in the Business Insurance segment, and was largely offset by higher expenses in the Personal Insurance segment resulting from the Company's direct to consumer initiative and in the Financial, Professional & International Insurance segment due to employee- and technology-related costs to enhance operations and support future business growth.
General and administrative expenses totaled $3.37 billion in 2009, a decrease of $152 million, or 4%, from the comparable 2008 total of $3.52 billion. The decrease reflected changes in the estimates of windpool assessments related to Hurricane Ike. During 2008, the Company recorded $141 million of
hurricane-related assessments in general and administrative expenses. The Company subsequently recorded an $87 million reduction in these estimated assessments in 2009 due to a decline in estimated insurance industry losses related to Hurricane Ike. Adjusting for the impact of windpool assessments in both 2009 and 2008, general and administrative expenses in 2009 increased 2% over 2008. The increase reflected the impact of continued investments to support business growth and product development, including the Company's direct to consumer initiative in the Personal Insurance segment, partially offset by the favorable impact of changes in foreign currency exchange rates on expenses in the Financial, Professional & International Insurance segment.
The consolidated loss and loss adjustment expense ratio of 61.0% in 2010 was 3.7 points higher than the loss and loss adjustment expense ratio of 57.3% in 2009. Catastrophe losses accounted for 5.2 points and 2.1 points of the 2010 and 2009 loss and loss adjustment expense ratios, respectively. The 2010 and 2009 consolidated loss and loss adjustment expense ratios included 5.8 point and 6.2 point benefits from net favorable prior year reserve development, respectively. The consolidated loss and loss adjustment expense ratios excluding catastrophe losses and prior year reserve development in 2010 was 0.2 points higher than the 2009 ratio on the same basis, primarily reflecting the impact of reduced underwriting margins related to pricing and loss cost trends in the Business Insurance segment, largely offset by earned rate increases modestly outpacing loss cost trends in the Personal Insurance segment.
In 2009, the consolidated underwriting expense ratio of 31.9% was 0.6 points lower than the consolidated underwriting expense ratio of 32.5% in 2008. The underwriting expense ratio in 2009 included a 0.4 point benefit from the reduction in the estimate of windpool assessments described above, whereas the underwriting expense ratio in 2008 included a 0.7 point increase due to the impact of the windpool assessments. Adjusting for these factors in both years, the underwriting expense ratio for 2009 was 0.5 points higher than the respective 2008 underwriting expense ratio, primarily reflecting the impact of continued investments to support business growth and product development, including the Company's direct to consumer initiative in the Personal Insurance segment, as well as salary increases in the normal course of business.
Gross and net written premiums in 2009 both decreased 2% from 2008. Overall, business retention remained at high levels in 2009. Renewal premium changes remained stable as improving rate trends offset the impact of lower coverage demands from existing policyholders due to general economic
conditions. New business volume declined slightly from 2008, as modest growth in the Business Insurance segment was offset by lower new business volume in the Financial, Professional & International Insurance and Personal Insurance segments.
Operating income of $2.30 billion in 2010 was $289 million, or 11%, lower than 2009 operating income of $2.59 billion, primarily reflecting the significant increase in catastrophe losses, the modest decline in net favorable prior year reserve development, reduced underwriting margins related to pricing and loss cost trends and a higher number of large losses, partially offset by an increase in net investment income and a decline in general and administrative expenses. In addition, operating income in 2009 included benefits of $42 million from the favorable resolution of various prior year tax matters and a $38 million reduction in the estimate of property windpool assessments related to Hurricane Ike. Catastrophe losses in 2010 totaled $437 million, compared with $176 million in 2009. Net favorable prior year reserve development totaled $901 million in 2010, compared with $1.03 billion in 2009.
Earned premiums of $10.77 billon in 2010 decreased $202 million, or 2%, from 2009. In 2009, earned premiums of $10.97 billion decreased $212 million, or 2%, from 2008. The declines in both years were primarily attributable to reduced insured exposures due to lower levels of economic activity.
Refer to the "Net Investment Income" section of "Consolidated Results of Operations" herein for a discussion of the changes in the Company's net investment income in 2010 and 2009 as compared with the prior year.
National Accounts is the primary source of fee income due to its service businesses, which include claim and loss prevention services to large companies that choose to self-insure a portion of their insurance risks, as well as claims and policy management services to workers' compensation residual market pools. The $21 million and $84 million declines, respectively, in fee income in 2010 and 2009 compared with the preceding year primarily reflected lower new business volume due to lower levels of economic activity and lower serviced premium and claim volume due to the de-population of workers' compensation residual market pools. The declines in both years also reflected the impact of both lower claim volume and lower loss costs (as fees are based either on the number of claims serviced or as a percentage of losses) driven by workers' compensation reforms, as well as overall lower claim frequency and increased competition.
primarily concentrated in the general liability, commercial multi-peril, commercial automobile and commercial property product lines for recent accident years, reflecting greater reductions in frequency than the Company expected based upon long-term frequency trends that have been declining. The general liability and commercial multi-peril product lines experienced better than anticipated loss development that was attributable to several factors, including what the Company believes to be improved legal and judicial environments, as well as enhanced risk control, underwriting and claim process initiatives. The commercial automobile line of business experienced better than expected loss development that was attributable to what the Company believes to be more favorable legal and judicial environments, claim handling initiatives and improvements in auto safety technology. The commercial property product line improvement primarily occurred in the 2007 and 2008 accident years as a result of better than expected loss development for certain large national property and inland marine exposures. In addition, the commercial property product line's 2005 accident year experience improved due to the litigation environment relating to, and ongoing claim settlements for, Hurricane Katrina. The net favorable prior year reserve development in these product lines in 2009 was partially offset by $185 million and $70 million increases to asbestos reserves and environmental reserves, respectively (discussed in more detail in the "Asbestos Claims and Litigation" and "Environmental Claims and Litigation" sections herein).
The amortization of deferred acquisition costs totaled $1.75 billion in 2010, $26 million lower than the comparable total of $1.78 billion in 2009. In 2009, the total of $1.78 billion was $43 million lower than the 2008 total of $1.82 billion. The declines in both years were consistent with the declines in earned premiums.
General and administrative expenses in 2010 totaled $1.90 billion, $62 million, or 3%, lower than in 2009. The 2009 total included a $38 million reduction in the estimate of property windpool assessments related to Hurricane Ike. Adjusting for that reduction in 2009, general and administrative expenses in 2010 were $100 million, or 5%, lower than in 2009, driven by a decline in loss-based assessments that reflected the impact of favorable prior year reserve development and favorable rate changes, as well as a decline in employee-related expenses and a reduction in the amount of the
Company's corporate advertising expense allocated to this segment resulting from a change in focus to the Personal Insurance segment's direct to consumer initiative in 2010.
General and administrative expenses in 2009 totaled $1.97 billion, $113 million lower than the comparable 2008 total of $2.08 billion. The majority of the decrease reflected the impact of estimates of windpool assessments related to Hurricane Ike in each year. During 2008, the Company recorded $62 million of hurricane-related assessments in general and administrative expenses. Subsequently, during the first half of 2009, the Company recorded a $38 million reduction in these assessments due to a decline in estimated insurance industry losses related to Hurricane Ike.
The GAAP combined ratio of 86.1% in 2009 was 4.1 points lower than the GAAP combined ratio of 90.2% in 2008.
In Business Insurance Core, gross and net written premiums decreased by 2% and less than 1%, respectively, from 2009. In 2009, Business Insurance Core gross and net written premiums decreased by 4% and 3% from 2008, respectively. The difference in rates of decline between gross and net written premiums in 2010 and 2009 was concentrated in National Accounts. A significant portion of gross written premiums for products offered by both Discover Re and Residual Markets is ceded to other insurers and residual market pools. As a result, the decline in gross written premiums did not have a proportional impact on net written premiums. The decline in gross and net written premiums in 2010 and 2009 was driven in large part by lower levels of economic activity that impacted exposure changes at renewal, audit premium adjustments, policy endorsements and mid-term cancellations.
In 2009, net written premiums of $2.49 billion were 1% lower than in 2008. Business retention rates in 2009 remained strong but declined slightly from the prior year. Renewal premium changes were slightly negative in 2009 but were improved over 2008, as the impact of a continued improving rate trend was partially offset by the impact of general economic conditions. New business levels increased when compared with 2008 due to various product and customer initiatives.
National Accounts. Net written premiums of $806 million in 2010 were 11% lower than in 2009, reflecting reduced insurance exposures driven by lower levels of economic activity, less prior year retrospective premium adjustments and the loss of a large account. Despite the loss of that account, business retention rates remained high in 2010.
In 2009, net written premiums of $902 million were 9% lower than in 2008, driven by the loss of a large account, negative renewal premium changes that reflected the impact of general economic conditions, and lower premium volume from property and workers' compensation involuntary residual markets. Despite the impact of the loss of a large account, business retention rates remained high in 2009.
Target Risk Underwriting. Net written premiums of $1.57 billion in 2010 were slightly higher than in 2009. Premium growth in the Boiler & Machinery and Inland Marine business units was driven by increases in new business volume coupled with increases in business retention rates. Growth in these business units was largely offset by a decline in National Property premium volume, driven by reductions in renewal premium changes and new business levels.
In 2009, net written premiums of $889 million were 5% lower than in 2008. The decline was attributable to both the National Programs and Northland business units, which experienced continued negative renewal premium changes that reflected competitive market conditions and the impact of general economic conditions, primarily on the commercial trucking, entertainment and leisure industries.
Claims and claim adjustment expenses in 2009 totaled $1.75 billion, a decrease of $22 million, or 1%, from 2008. The decrease in 2009 was driven by a $73 million favorable impact of foreign currency exchange rates. A decrease in net favorable prior year reserve development was largely offset by declines in catastrophe losses and large losses in International. Net favorable prior year reserve development totaled $168 million and $274 million in 2009 and 2008, respectively. Net favorable prior year reserve development in 2009 was driven by better than expected loss development in International, particularly in the United Kingdom and Canada. In addition, the Aviation and Property lines of business at Lloyd's experienced net favorable prior year reserve development in 2009. In Bond & Financial Products, better than expected loss development for the contract surety business within the fidelity and surety product line for recent accident years also resulted in net favorable prior year reserve development in 2009. The catastrophe losses included in claims and claim adjustment expenses in 2009 totaled $3 million, compared with $73 million in 2008.
The amortization of deferred acquisition costs totaled $612 million in 2010, $10 million, or 2%, lower than the comparable 2009 total of $622 million, consistent with the decline in earned premiums. In 2009, the amortization of deferred acquisition costs totaled $622 million, $30 million, or 5%, lower than the comparable 2008 total of $652 million, driven by the favorable impact of foreign currency exchange rates and changes in the mix of business.
The underwriting expense ratio of 36.8% in 2010 was 0.8 points higher than the underwriting expense ratio of 36.0% in 2009. The increase primarily reflected the impact of increases in employee- and technology-related costs to enhance operations and support future business growth.
Gross and net written premiums in 2010 decreased 5% and 2%, respectively, compared with 2009. Net written premiums for Bond & Financial Products in 2010 declined 3% from 2009, primarily reflecting the impact of underwriting actions taken and competitive market conditions in the Professional Liability and Public Company Liability business units. In addition, construction and commercial surety gross and net written premium volume declined in 2010 compared with 2009, reflecting the impact of the economic downturn. These factors were partially offset on a net basis by a reduction in reinsurance costs. In International, the 1% decline in net written premiums in 2010 compared with 2009 primarily reflected the impact of intentional underwriting actions and competitive market conditions. Those factors were largely offset by changes in the structure of the Company's reinsurance that modestly increased retentions to directionally align retentions in the Company's International business with its U.S. practices, as well as the favorable impact of foreign currency exchange rates. In late 2008, the Company commenced an exclusive relationship with a broker in the Republic of Ireland that significantly increased the 2009 volume of personal automobile coverage written and also resulted in the Company writing personal household coverages. The Company ceased writing business through this relationship in the fourth quarter of 2010.
Gross written premiums of $3.71 billion in 2009 decreased 6% from 2008, and net written premiums of $3.29 billion in 2009 decreased 5% from 2008. The decline in gross and net written premiums was primarily attributable to the unfavorable impact of foreign currency exchange rates in International. The remainder of the decline was driven by the impact of the economic downturn on construction and commercial surety business volume, underwriting actions taken and competitive market conditions in the Professional Liability and Public Company Liability components of Bond & Financial Products' management liability business, partially offset by growth in Ireland.
In 2009, operating income of $601 million was $136 million, or 29%, higher than in 2008, driven by the significant decline in catastrophe losses and a reduction in the estimate of property windpool assessments, partially offset by investments in the direct to consumer initiative and loss cost trends. Catastrophe losses in 2009 and 2008 totaled $278 million and $618 million, respectively. The 2008 total was comprised of $541 million of claims and claim adjustment expenses and $77 million of property windpool assessments that were included in general and administrative expenses. Net favorable prior year reserve development in 2009 and 2008 totaled $135 million and $143 million, respectively.
Refer to the "Net Investment Income" section of "Consolidated Results of Operations" herein for a discussion of the change in the Company's net investment income in 2010 and 2009 as compared with the prior year.
In 2009, claims and claim adjustment expenses of $4.62 billion were slightly higher than in 2008, as the impacts of loss cost trends and increased business volume were largely offset by the significant decline in catastrophe losses. Catastrophe losses included in claims and claim adjustment expenses in 2009 totaled $278 million, compared with $541 million in 2008. Catastrophe losses in 2009 primarily resulted from several wind and hail storms, as well as flooding. Catastrophe losses in 2008 primarily resulted from Hurricanes Ike and Gustav, as well as tornado, wind and hail storms in various regions of the United States throughout the year. Net favorable prior year reserve development in 2009 totaled $135 million, compared with $143 million in 2008. Net favorable prior year reserve development in 2009 primarily reflected favorable loss development related to Hurricanes Ike and Katrina, as well as the 2007 California wildfires.
Net favorable prior year reserve development in 2008 was primarily driven by favorable loss development related to Hurricane Katrina and better than expected loss development from recent accident years for the Homeowners and Other product line. This improvement was driven in part by claim initiatives as well as better than expected outcomes on 2007 catastrophe-related claims. In addition, the Homeowners and Other product line experienced improvement in older accident years for the umbrella line as well as favorable experience from accident year 2007 for allied coverages due to less than expected claim activity.
The amortization of deferred acquisition costs totaled $1.44 billion in 2010, compared with $1.42 billion in 2009 and $1.41 billion in 2008. The increases in 2010 and 2009 over the preceding year were consistent with earned premium increases in both years.
General and administrative expenses of $867 million in 2010 were $83 million higher than in 2009. The total in 2009 reflected a $48 million reduction in the estimate of property windpool assessments related to Hurricane Ike. Adjusting for the impact of the reduction in windpool assessments in 2009, general and administrative expenses in 2010 increased $35 million, or 4%, over 2009, primarily
reflecting growth in business volume and continued costs supporting business growth and product development, including the Company's direct to consumer initiative.
The underwriting expense ratio of 30.2% in 2010 was 0.6 points higher than the underwriting expense ratio of 29.6% in 2009. The 2009 underwriting expense ratio included a 0.7 point benefit from the reduction in the estimate of windpool assessments described above.
In 2009, the underwriting expense ratio of 29.6% was 1.2 points lower than the underwriting expense ratio of 30.8% in 2008. The 2009 underwriting expense ratio included a 0.7 point benefit from the reduction in the estimate of windpool assessments described above, whereas the 2008 underwriting expense ratio included a 1.1 point increase due to the impact related to the windpool assessments. Adjusting for these factors in both years, the underwriting expense ratio for 2009 was 0.6 points higher than the 2008 underwriting expense ratio, primarily reflecting expenses resulting from the Company's direct to consumer initiative.
Gross and net Agency written premiums in 2010 both increased 5% over the respective totals in 2009. In 2009, gross and net Agency written premiums both increased by 2% over the respective 2008 totals.
In 2010, net written premiums in the Agency Automobile line of business increased 3% over 2009, primarily reflecting the impact of the introduction of twelve-month policy terms in certain markets in 2010. Excluding the impact of the change in policy terms in 2010, Agency Automobile net written premiums were virtually level with 2009. Business retention rates remained strong and new business levels increased over 2009. Renewal premium changes were positive in 2010 but declined slightly from 2009.
In 2009, net written premiums in the Agency Homeowners and Other line of business grew 5% over 2008, driven by increases in renewal premium changes. New business volume was consistent with 2008 and business retention rates remained strong and consistent with 2008.
For its Agency business, the Personal Insurance segment had approximately 7.6 million and 7.4 million active policies at December 31, 2010 and 2009, respectively. In the Agency Automobile line of business, active policies at December 31, 2010 increased 2% over the same date in 2009. Active policies in the Agency Homeowners and Other line of business at December 31, 2010 grew by 3% over the same date in 2009.
The $85 million increase in operating loss for Interest Expense and Other in 2010 compared with 2009 primarily reflected $39 million of expenses related to the Company's purchase and retirement of a significant portion of its 6.25% fixed-to-floating rate junior subordinated debentures. The operating loss in 2010 also included a $12 million increase in tax expense associated with recent federal health care legislation and an increase in interest expense. In addition, the operating loss in 2009 included a benefit of $28 million from the favorable resolution of various prior year tax matters. After-tax interest expense in 2010 totaled $252 million, compared with $248 million in 2009.
The $24 million decline in operating loss for Interest Expense and Other in 2009 compared with 2008 primarily reflected the benefit of $28 million in 2009 from the favorable resolution of various prior year tax matters. After-tax interest expense in 2009 totaled $248 million, compared with $239 million in 2008.
bankruptcy court's January 20, 2011 judgment. (For a description of these matters, see note 15 of notes to the consolidated financial statements).
In the third quarter of 2010, the Company completed its annual in-depth asbestos claim review and noted the continuation of recent trends, which include:
The completion of these reviews and analyses in the third quarter resulted in a net $140 million increase in the Company's asbestos reserves, driven by increases in the Company's estimate of 1) projected settlement and defense costs related to a broad number of policyholders; 2) costs of litigating asbestos-related coverage matters; and 3) projected payments on assumed reinsurance
accounts. This increase included a $70 million benefit from the reduction in the allowance for uncollectible reinsurance resulting from a recent favorable ruling related to a reinsurance dispute and an increase in estimated reinsurance recoverables. In 2009, the Company recorded a $185 million increase in asbestos reserves, primarily driven by a slight increase in the Company's assumption for projected defense costs related to many policyholders. The Company recorded a $70 million increase to asbestos reserves in 2008, which was driven by a change in the estimated costs associated with litigating asbestos coverage matters and a change in estimated losses for certain individual policyholders. Overall, the company's assessment of the underlying asbestos environment did not change significantly from recent periods.
The resolution of environmental exposures by the Company generally occurs by settlement on a policyholder-by-policyholder basis as opposed to a claim-by-claim basis. Generally, the Company strives to extinguish any obligations it may have under any policy issued to the policyholder for past, present and future environmental liabilities and extinguish any pending coverage litigation dispute with the policyholder. This form of settlement is commonly referred to as a "buy-back" of policies for future environmental liability. In addition, many of the agreements have also extinguished any insurance obligation which the Company may have for other claims, including but not limited to asbestos and other cumulative injury claims. The Company and its policyholders may also agree to settlements which extinguish any liability arising from known specified sites or claims. Where appropriate, these agreements also include indemnities and hold harmless provisions to protect the Company. The Company's general purpose in executing these agreements is to reduce the Company's potential environmental exposure and eliminate the risks presented by coverage litigation with the policyholder and related costs.
In establishing environmental reserves, the Company evaluates the exposure presented by each policyholder and the anticipated cost of resolution, if any. In the course of this analysis, the Company generally considers the probable liability, available coverage, relevant judicial interpretations and historical value of similar exposures. In addition, the Company considers the many variables presented, such as the nature of the alleged activities of the policyholder at each site; the allegations of environmental harm at each site; the number of sites; the total number of potentially responsible parties at each site; the nature of environmental harm and the corresponding remedy at each site; the nature of government enforcement activities at each site; the ownership and general use of each site; the overall nature of the insurance relationship between the Company and the policyholder, including the role of any umbrella or excess insurance the Company has issued to the policyholder; the involvement of other insurers; the potential for other available coverage, including the number of years of coverage; the role, if any, of non-environmental claims or potential non-environmental claims in any resolution process; and the applicable law in each jurisdiction. Conventional actuarial techniques are not used to estimate these reserves.
both on- and off-site waste disposal activities; the potential for adverse development; the potential for additional new claims beyond previous expectations; and the potential higher costs for new settlements.
In December 2008, the Company completed the sale of Unionamerica, which comprised its United Kingdom-based runoff insurance and reinsurance businesses. Included in the claims and claim adjustment expense reserves transferred to the purchaser were gross and net environmental reserves of $40 million and $33 million, respectively.
As a result of the processes and procedures described above, management believes that the reserves carried for asbestos and environmental claims at December 31, 2010 are appropriately established based upon known facts, current law and management's judgment. However, the uncertainties surrounding the final resolution of these claims continue, and it is difficult to determine the ultimate exposure for asbestos and environmental claims and related litigation. As a result, these reserves are subject to revision as new information becomes available and as claims develop. The continuing uncertainties include, without limitation, the risks and lack of predictability inherent in complex litigation, any impact from the bankruptcy protection sought by various asbestos producers and other asbestos defendants, a further increase or decrease in the cost to resolve, and/or the number of, asbestos and environmental claims beyond that which is anticipated, the role of any umbrella or excess policies the Company has issued, the resolution or adjudication of disputes pertaining to the amount of available coverage for asbestos and environmental claims in a manner inconsistent with the Company's previous assessment of these claims, the number and outcome of direct actions against the Company, future developments pertaining to the Company's ability to recover reinsurance for asbestos and environmental claims and the unavailability of other insurance sources potentially available to policyholders, whether through exhaustion of policy limits or through the insolvency of other participating insurers. In addition, uncertainties arise from the insolvency or bankruptcy of policyholders and other defendants. It is also not possible to predict changes in the legal, regulatory and legislative environment and their impact on the future development of asbestos and environmental claims. This development will be affected by future court and regulatory decisions and interpretations, including the outcome of legal challenges to legislative and/or judicial reforms establishing medical criteria for the pursuit of asbestos claims, as well as changes in applicable legislation. It is also difficult
The carrying value of the Company's fixed maturity portfolio at December 31, 2010 totaled $62.82 billion. The Company closely monitors the duration of its fixed maturity investments, and investment purchases and sales are executed with the objective of having adequate funds available to satisfy the Company's insurance and debt obligations. The weighted average credit quality of the Company's fixed maturity portfolio, both including and excluding U.S. Treasury securities, was "Aa2" at both December 31, 2010 and 2009. Below investment grade securities represented 3.0% and 2.7% of the total fixed maturity investment portfolio at December 31, 2010 and 2009, respectively. The average effective duration of fixed maturities and short-term securities was 3.6 (3.9 excluding short-term securities) at December 31, 2010 and 3.9 (4.2 excluding short-term securities) at December 31, 2009. The decline in duration primarily resulted from the impact of declining market yields and tightening investment spreads on existing holdings of mortgage-backed securities (which impact the assumptions related to optional pre-payments), an increase in pre-refunded municipal bonds and general portfolio management decisions.
The carrying values of investments in fixed maturities classified as available for sale at December 31, 2010 and 2009 were as follows:
(3)Included in commercial mortgage-backed securities and project loans are $146 million of securities guaranteed by the U.S. government and $9 million by government sponsored enterprises.
The Company bases its investment decision on the credit characteristics of the municipal security; however, its municipal bond portfolio includes a number of securities that were enhanced by third-party insurance for the payment of principal and interest in the event of an issuer default. The downgrade during 2009 and 2008 of credit ratings of insurers of these securities resulted in a corresponding downgrade in the ratings of the securities to the underlying rating of the respective security. Of the insured municipal securities in the Company's investment portfolio at December 31, 2010, approximately 99% were rated at A3 or above, and approximately 90% were rated at Aa3 or above, without the benefit of insurance. The Company believes that a loss of the benefit of insurance would not result in a material adverse impact on the Company's results of operations, financial position or liquidity, due to the underlying credit strength of the issuers of the securities, as well as the Company's ability and intent to hold the securities. The average credit rating of the underlying issuers of these securities was "Aa2" at December 31, 2010. The average credit rating of the entire municipal bond portfolio was "Aa1" at December 31, 2010 with and without the third-party insurance.
The following table shows the geographic distribution of the Company's investments in debt securities issued by foreign governments at December 31, 2010.
At December 31, 2010 and 2009, the "mortgage-backed securities, collateralized mortgage obligations and pass-through securities" and "asset-backed and other" categories in the foregoing table included collateralized mortgage obligations backed by alternative documentation mortgages and asset-backed securities collateralized by sub-prime mortgages with a collective fair value of $297 million and $270 million, respectively (comprising approximately 0.5% and 0.4% of the Company's total fixed maturity investments at December 31, 2010 and 2009, respectively). The disruption in secondary investment markets for mortgage-backed securities provided the Company with the opportunity to selectively acquire additional such securities at discounted prices. The Company purchased $31 million and $74 million of such securities in the years ended December 31, 2010 and 2009, respectively. The Company defines sub-prime mortgage-backed securities as investments in which the underlying loans primarily exhibit one or more of the following characteristics: low FICO scores, above-prime interest rates, high loan-to-value ratios or high debt-to-income ratios. Alternative documentation securitizations are those in which the underlying loans primarily meet the government-sponsored entities' requirements for credit score but do not meet the government-sponsored entities' guidelines for documentation, property type, debt and loan-to-value ratios. The average credit rating on these securities and obligations held by the Company was "Baa2" and "A3" at December 31, 2010 and 2009, respectively.
At December 31, 2010 and 2009, the carrying value of the Company's other investments was $2.93 billion and $2.95 billion, respectively. The Company's other investments are primarily comprised of private equity limited partnerships, hedge funds, real estate partnerships, joint ventures, mortgage loans, venture capital (through direct ownership and limited partnerships) and trading securities, which are subject to more volatility than the Company's fixed maturity investments. These asset classes have historically provided a higher return than fixed maturities but are subject to more volatility. Net investment income provided by these asset classes totaled $304 million in 2010, compared with negative net investment income of $106 million and $292 million in 2009 and 2008, respectively. The negative net investment income in 2009 and 2008 reflected market conditions.
The Company has engaged in securities lending activities from which it generates net investment income by lending certain of its investments to other institutions for short periods of time. The Company has not incurred any investment losses in its securities lending program for the years ended December 31, 2010, 2009 and 2008.
Net pretax unrealized investment gains totaled $2.83 billion at both December 31, 2010 and 2009, compared with net pretax unrealized losses of $253 million at December 31, 2008. The Company's fixed maturities and equity securities portfolios at December 31, 2010 experienced increases in valuations compared with the prior year-end, which were offset by a decrease in net unrealized appreciation on other investments that primarily resulted from the Company's sale of substantially all of its remaining common stock holdings in Verisk Analytics, Inc. That sale generated a pretax realized investment gain of $205 million in 2010. The improvement in the Company's net unrealized gain position at December 31, 2009 over the prior year end is primarily attributable to the Company's fixed maturity investments. In 2009, yields on municipal fixed maturity securities declined, which increased the market value of the Company's portfolio of such securities. In addition, in 2009 credit spreads narrowed on other non-municipal fixed maturity securities which also resulted in an increase in the market value of those securities.
The following table summarizes, for all fixed maturities and equity securities reported at fair value for which fair value is less than 80% of amortized cost at December 31, 2010, the gross unrealized investment loss by length of time those securities have continuously been in an unrealized loss position of greater than 20% of amortized cost:
At December 31, 2010, below investment grade securities comprised 3.0% of the Company's fixed maturity investment portfolio. Included in below investment grade securities at December 31, 2010 were securities in an unrealized loss position that, in the aggregate, had an amortized cost of $605 million and a fair value of $564 million, resulting in a net pretax unrealized investment loss of $41 million. These securities in an unrealized loss position represented approximately 1% of both the total amortized cost and the fair value of the fixed maturity portfolio at December 31, 2010 and accounted for 17% of the total gross pretax unrealized investment loss in the fixed maturity portfolio at December 31, 2010.
For the year ended December 31, 2010, the Company recognized the following other-than-temporary impairments:
In making underwriting and reinsurance decisions for hurricane and earthquake exposures, the Company uses third-party proprietary computer modeling in an attempt to estimate the likelihood that the loss from a single event occurring in a one-year timeframe will equal or exceed a particular amount. The tables below set forth the estimated probabilities that losses from a single event occurring in a one-year timeframe will equal or exceed the indicated loss amounts (expressed in dollars and as a percentage of the Company's common equity). For example, on the basis described below the tables, the Company estimates that there is a one percent chance that the Company's loss from a single U.S. hurricane occurring in a one-year timeframe would equal or exceed $1.1 billion, or 5% of the Company's common equity at December 31, 2010.
loss amount in a one-year timeframe, not over a multi-year timeframe. Also, because the probabilities relate to a single event, the probabilities do not address the likelihood of more than one event occurring in a particular period, and, therefore, the amounts do not address potential aggregate catastrophe losses occurring in a one-year timeframe.
Moreover, the Company is exposed to the risk of material losses from other than property and workers' compensation coverages arising out of hurricanes and earthquakes, and it is exposed to catastrophe losses from perils other than hurricanes and earthquakes, such as windstorms, hail, wildfires, severe winter weather, floods, volcanic eruptions and acts of terrorism.
Severe weather events over the last several years have underscored the unpredictability of future climate trends and created uncertainty regarding insurers' exposures to financial loss as a result of catastrophe and other weather-related events. Some scientists believe that, in recent years, changing
•The full range of potential liability exposures related to climate change continues to evolve. Through the Company's Emerging Issues Committee and its Committee on Climate, Energy and the Environment, the Company works with its business units and corporate groups as appropriate to identify and try to assess climate change-related liability issues, which are continually evolving and often hard to fully evaluate. See "Risk Factors-The effects of emerging claim and coverage issues on our business are uncertain."
The Company's reinsurance recoverables totaled $11.52 billion at December 31, 2010, a decline of $1.30 billion from year-end 2009, primarily reflecting cash collections and the impact of net favorable prior year reserve development, partially offset by a reduction in the allowance for uncollectible reinsurance resulting from a recent favorable ruling relating to a reinsurance dispute.
The Company has also entered into Master Security Agreements with certain reinsurers. These agreements define conditions that require the reinsurer to provide collateral. The specific conditions and the amounts and form of collateral to be provided by these agreements vary based on a number of factors including, but not limited to, the reinsurers' legal structure and trading history with the Company.
Included in reinsurance recoverables are certain amounts related to structured settlements. Structured settlements comprise annuities purchased from various life insurance companies to settle certain personal physical injury claims, of which workers' compensation claims comprise a significant portion. In cases where the Company did not receive a release from the claimant, the structured settlement is included in reinsurance recoverables as the Company retains the contingent liability to the claimant. In the event that the life insurance company fails to make the required annuity payments, the Company would be required to make such payments. In the third quarter of 2010, Old Mutual plc, the parent of a U.S. life insurance company that is one of the largest issuers of structured settlements included in the Company's reinsurance recoverables, agreed to sell its U.S. life insurance business to a hedge fund buyer, pending regulatory approval. The Company currently cannot predict the impact of the transaction, if approved, on the long-term creditworthiness of the annuity issuer. The following table presents the Company's top five groups by structured settlements at December 31, 2010 (in
Many reinsurance companies and life insurance companies were negatively impacted by turbulent economic conditions during 2009 and 2008. A number of such companies were subjected to downgrades and/or negative outlook changes by various ratings agencies, including those with which the Company conducts business. The Company considers these factors in assessing the adequacy of its allowance for uncollectible amounts.
The Company expects retention levels (the amount of expiring premium that renews, before the impact of renewal premium changes) will remain strong, generally consistent with recent periods. In the Business Insurance segment, the Company expects a slightly improving trend in renewal premium changes, including the components of rate changes and insured exposures, during 2011 compared with 2010. In the Financial, Professional & International Insurance segment, the Company expects that renewal premium changes, including the components of rate changes and insured exposures, will not meaningfully change during 2011 compared with 2010. In the Personal Insurance segment, the Company expects that Agency Automobile renewal premium changes, while positive, will decrease slightly in 2011 from levels in 2010. For its Agency Homeowners' and Other business, the Company expects renewal premium changes in 2011 will remain generally consistent with 2010.
While economic conditions have recently improved, there is continued uncertainty regarding the timing and strength of any economic recovery. The trend may not continue. Further, if growth continues, it may be at a slow rate for an extended period of time. In addition, other economic conditions, such as the commercial and residential real estate environment and employment rates, may continue to be weak. If weak economic conditions persist or deteriorate, low levels of economic activity could impact exposure changes at renewal and our ability to write business at acceptable rates. Additionally, such low levels of economic activity could adversely impact audit premium adjustments, policy endorsements and mid-term cancellations after policies are written. All of the foregoing, in turn, could adversely impact net written premiums in 2011. Since earned premiums lag net written premiums, earned premiums could be adversely impacted in 2011 and into 2012.
Underwriting Gain/Loss. In Business Insurance, the anticipated impact of competitive market conditions and general economic conditions on the Company's earned premiums, as discussed above, coupled with an expected modest increase in loss costs, will likely result in modestly reduced underwriting profitability during 2011, as compared with 2010. In Financial, Professional & International Insurance, the anticipated impact of a decline in earned premiums resulting from lower levels of written premiums in 2010, combined with higher employee- and technology-related costs to enhance operations and support future business growth, will likely result in modestly reduced underwriting profitability during 2011 as compared with 2010. In Personal Insurance, the anticipated impact of continued positive renewal premium changes on the Company's earned premiums, as discussed above, combined with an expected modest increase in loss costs, will likely result in modestly increased underwriting profitability during 2011, as compared with 2010. In Personal Insurance, the Company's direct to consumer initiative, discussed above, while intended to enhance the Company's long-term ability to compete successfully in a consumer-driven marketplace, is expected to remain unprofitable for a number of years as this book of business grows and matures.
Investment Portfolio. The Company expects to continue to focus its investment strategy on maintaining a high-quality investment portfolio and a relatively low average effective duration.
Net investment income is a material contributor to the Company's results of operations. While interest rates have recently risen above the historic lows experienced in the second half of 2010, the Company expects investment returns for its fixed maturity investment portfolio to be slightly lower in 2011 than in recent periods due to lower reinvestment yields available for maturing long-term fixed maturity investments. Short-term interest rates are expected to remain at or near historically low levels. The Company expects investment income in its non-fixed maturity investment portfolio in 2011 to be generally consistent with 2010. However, if general economic conditions and/or investment market conditions deteriorate in 2011, the Company could also experience a reduction in net investment income and/or significant realized investment losses, including impairments. The Company expects its fixed income assets, including its municipal portfolio, to provide adequate risk-adjusted returns and support its insurance operations over the long-term. For further discussion of the Company's municipal
bond portfolio, see "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations-Investment Portfolio" in this report.
The Company had a net after-tax unrealized investment gain of $1.74 billion in its fixed maturity investment portfolio at December 31, 2010. While the Company does not attempt to predict future interest rate movements, a rising interest rate environment would reduce the market value of fixed maturity investments and, therefore, reduce shareholders' equity, and a declining interest rate environment would have the opposite effects.
Liquidity is a measure of a company's ability to generate sufficient cash flows to meet the short- and long-term cash requirements of its business operations. The liquidity requirements of the Company's business have been met primarily by funds generated from operations, asset maturities and income received on investments. Cash provided from these sources is used primarily for claims and claim adjustment expense payments and operating expenses, and in recent years, for common share repurchases. The timing and amount of catastrophe claims are inherently unpredictable. Such claims increase liquidity requirements. The timing and amount of reinsurance recoveries may be affected by reinsurer solvency and reinsurance coverage disputes. Additionally, the variability of asbestos-related claim payments, as well as the volatility of potential judgments and settlements arising out of litigation, may also result in increased liquidity requirements. It is the opinion of the Company's management that the Company's future liquidity needs will be adequately met from all of the above sources.
The Company currently utilizes uncollateralized letters of credit issued by major banks with an aggregate limit of approximately $537 million to provide much of the capital needed to support its obligations at Lloyd's. If uncollateralized letters of credit are not available at a reasonable price or at all in the future, the Company can collateralize these letters of credit or may have to seek alternative means of supporting its obligations at Lloyd's, which could include utilizing holding company funds on hand.
Net cash flows provided by operating activities totaled $3.05 billion, $4.23 billion and $3.14 billion in 2010, 2009 and 2008, respectively. Cash flows in 2010 reflected a higher level of claims and claim adjustment expense payments due to the impact of loss cost trends and a higher level of catastrophe loss payments, as well as a lower level of reinsurance recoveries, partially offset by declines in the amount of contributions to the Company's pension plan and lower claims and claim adjustment expense payments related to operations in runoff as compared with 2009. Cash flows in 2009 reflected a decline in catastrophe loss payments, a higher level of reinsurance recoveries, a reduction in the amount of contributions to the Company's pension plan and lower claims and claim adjustment expense payments related to operations in runoff as compared with 2008. Those runoff payments in 2008 included the Company's one-time net payment of $365 million associated with the final settlement of asbestos claims related to ACandS, Inc. In the years ended December 31, 2010, 2009 and 2008, the Company contributed $35 million, $260 million and $450 million, respectively, to its pension plan.
Net cash flows provided by investing activities totaled $2.11 billion in 2010, compared with net cash flows used in investing activities of $899 million and $162 million in 2009 and 2008, respectively. The Company's consolidated total investments at December 31, 2010 decreased by $2.24 billion from year-end 2009, driven by the net sales and maturities of fixed maturity investments. The proceeds from those sales and maturities, along with operating cash flows of $3.05 billion in 2010, were the primary sources of funding for the Company's $5.04 billion of common share repurchases in 2010. Net pretax unrealized appreciation of investments at December 31, 2010 was virtually unchanged from the same date in 2009. The Company's consolidated total investments at December 31, 2009 increased by $4.23 billion from year-end 2008, primarily reflecting a $3.08 billion pretax increase in the unrealized appreciation of investments since year-end 2008 and investment purchases resulting from strong cash flows from operations, partially offset by $3.29 billion of common share repurchases made during 2009. The improvement in the Company's net unrealized investment gain position at December 31, 2009 over the prior year is primarily attributable to the Company's fixed maturity investments. The improved valuations on these holdings reflect the changing market conditions in 2009 which included a significant narrowing of credit spreads.
In the first half of 2011, the Company expects to fund its investment in J. Malucelli with cash from internal sources. See "Part I-Item 1 - Financial, Professional & International Insurance" in this report for further information regarding this investment.
The primary goals of the Company's asset-liability management process are to satisfy the insurance liabilities and maintain sufficient liquidity to cover fluctuations in projected liability cash flows. Generally, the expected principal and interest payments produced by the Company's fixed maturity portfolio adequately fund the estimated runoff of the Company's insurance reserves. Although this is not an exact cash flow match in each period, the substantial degree by which the market value of the fixed maturity portfolio exceeds the expected present value of the net insurance liabilities, as well as the positive cash flow from newly sold policies and the large amount of high quality liquid bonds, contributes to the Company's ability to fund claim payments without having to sell illiquid assets or access credit facilities.
The amounts of debt obligations, other than commercial paper, that becomes due in 2011, 2012 and 2013 are $9 million, $250 million and $500 million, respectively.
Dividends. Dividends paid to shareholders totaled $673 million, $693 million and $715 million in 2010, 2009 and 2008, respectively. On February 2, 2011, the Company's board of directors declared a quarterly dividend of $0.36 per share, payable March 31, 2011 to shareholders of record on March 10, 2011. The declaration and payment of future dividends to holders of the Company's common stock will be at the discretion of the Company's board of directors and will depend upon many factors, including the Company's financial position, earnings, capital requirements of the Company's operating subsidiaries, legal requirements, regulatory constraints and other factors as the board of directors deems relevant. Dividends would be paid by the Company only if declared by its board of directors out of funds legally available, subject to any other restrictions that may be applicable to the Company.
Share Repurchases. The Company's board of directors has approved common share repurchase authorizations under which repurchases may be made from time to time in the open market, pursuant to pre-set trading plans meeting the requirements of Rule 10b5-1 under the Securities Exchange Act of 1934, in private transactions or otherwise. The authorizations do not have a stated expiration date. The timing and actual number of shares to be repurchased in the future will depend on a variety of factors, including the Company's financial position, earnings, catastrophe losses, capital requirements of the Company's operating subsidiaries, legal requirements, regulatory constraints, other investment opportunities (including mergers and acquisitions), market conditions and other factors. The following table summarizes repurchase activity in 2010 and remaining repurchase capacity at December 31, 2010.
From the inception of the first authorization in May 2006 through December 31, 2010, the Company repurchased a cumulative total of 288.9 million shares for a total cost of $14.49 billion, or $50.15 per share.
In 2010, 2009 and 2008, the Company acquired 1.3 million, 1.5 million and 0.8 million shares, respectively, of common stock from employees as treasury stock primarily to cover payroll withholding taxes related to the vesting of restricted stock awards and exercises of stock options.
Capital resources reflect the overall financial strength of the Company and its ability to borrow funds at competitive rates and raise new capital to meet its needs. The following table summarizes the components of the Company's capital structure at December 31, 2010 and 2009.
The $1.86 billion decrease in total capitalization from December 31, 2009 primarily reflected the impact of common share repurchases and dividends to shareholders, partially offset by net income in 2010.
The debt-to-total capital ratio excluding net unrealized gains on investments is calculated by dividing (a) debt by (b) total capitalization excluding net unrealized gains and losses on investments, net of taxes. Net unrealized gains and losses on investments can be significantly impacted by both discretionary and other economic factors and are not necessarily indicative of operating trends. Accordingly, in the opinion of the Company's management, the debt-to-total capital ratio calculated on this basis provides another useful metric for investors to understand the Company's financial leverage position. The Company's debt-to-total capital ratio of 21.9% at December 31, 2010 calculated on this basis was within the Company's target range.
Shelf Registration. In December 2008, the Company filed with the Securities and Exchange Commission a universal shelf registration statement for the potential offering and sale of securities. The Company may offer these securities from time to time at prices and on other terms to be determined at the time of offering. During 2010 and 2009, the Company issued securities with a principal amount of $1.25 billion and $500 million, respectively, under the shelf registration statement.
Share Repurchase Authorization. At December 31, 2010, the Company had $1.51 billion of capacity remaining under its share repurchase authorization approved by the board of directors. In January 2011, the board of directors approved a share repurchase authorization that added an additional $5 billion of repurchase capacity to the $1.51 billion of capacity that remained at December 31, 2010.
The contractual obligations related to debt, operating leases, purchase obligations, long-term unfunded investment commitments, estimated claims and claim-related payments (gross of the
The estimated future cash inflows from the Company's reinsurance contracts that qualify for reinsurance accounting are as follows:
The Company manages its business and evaluates its liabilities for claims and claim adjustment expense on a net of reinsurance basis. The estimated cash flows on a net of reinsurance basis are as follows:
(12)The Company's current liabilities related to unrecognized tax benefits from uncertain tax positions are $1.12 billion. Offsetting these liabilities are deferred tax assets of $1.01 billion associated with the temporary differences that would exist if these positions become realized. The above table does not include an analysis of liabilities reported for structured settlements for which the Company has purchased annuities and remains contingently liable in the event of default by the company issuing the annuity. The Company is not reasonably likely to incur material future payment obligations under such agreements. In addition, the Company does not have a best estimate of contributions expected to be paid to its qualified pension plan. Accordingly, any future contributions are not included in the foregoing table.
of the Brazilian Reais prior to the closing of the transaction, the Company entered into a foreign currency option contract on February 7, 2011 in the notional amount of R$635 million which expires on March 31, 2011. The joint venture transaction is subject to customary closing conditions and is expected to be finalized in the first half of 2011.
The insurance holding company laws of other states in which the Company's subsidiaries are domiciled generally contain similar, although in some instances somewhat more restrictive, limitations on the payment of dividends. A maximum of $3.61 billion is available by the end of 2011 for such dividends without prior approval of the Connecticut Insurance Department. The Company may choose to accelerate the timing within 2011 and/or increase the amount of dividends from its insurance subsidiaries in 2011, which could result in certain dividends being subject to approval by the Connecticut Insurance Department. The holding company received $6.59 billion of dividends from its domestic insurance subsidiaries in 2010, including $5.26 billion of dividends that were subject to regulatory approval, primarily due to the Company's request for the accelerated timing of payment.
The NAIC adopted RBC requirements for property casualty companies to be used as minimum capital requirements by the NAIC and states to identify companies that merit further regulatory action. The formulas have not been designed to differentiate among adequately capitalized companies that operate with levels of capital higher than RBC requirements. Therefore, it is inappropriate and ineffective to use the formulas to rate or to rank these companies. At December 31, 2010, all of the Company's insurance subsidiaries had adjusted capital in excess of amounts requiring any company or regulatory action.
Claims and claim adjustment expense reserves (loss reserves) represent management's estimate of ultimate unpaid costs of losses and loss adjustment expenses for claims that have been reported and claims that have been incurred but not yet reported. Loss reserves do not represent an exact calculation of liability, but instead represent management estimates, generally utilizing actuarial expertise and projection techniques, at a given accounting date. These loss reserve estimates are expectations of what the ultimate settlement and administration of claims will cost upon final resolution in the future, based on the Company's assessment of facts and circumstances then known, review of historical settlement patterns, estimates of trends in claims severity and frequency, expected interpretations of legal theories of liability and other factors. In establishing loss reserves, the Company also takes into account estimated recoveries from reinsurance, salvage and subrogation. The loss reserves are reviewed regularly by qualified actuaries employed by the Company.
The process of estimating loss reserves involves a high degree of judgment and is subject to a number of variables. These variables can be affected by both internal and external events, such as changes in claims handling procedures, changes in individuals involved in the reserve estimation process, economic inflation, legal trends and legislative changes, among others. The impact of many of these items on ultimate costs for claims and claim adjustment expenses is difficult to estimate. Loss reserve estimation difficulties also differ significantly by product line due to differences in claim complexity, the volume of claims, the potential severity of individual claims, the determination of occurrence date for a claim and reporting lags (the time between the occurrence of the policyholder event and when it is actually reported to the insurer). Informed judgment is applied throughout the process, including the application of various individual experiences and expertise to multiple sets of data and analyses. The Company continually refines its loss reserve estimates in a regular ongoing process as historical loss experience develops and additional claims are reported and settled. The Company rigorously attempts to consider all significant facts and circumstances known at the time loss reserves are established. Due to the inherent uncertainty underlying loss reserve estimates including, but not limited to, the future settlement environment, final resolution of the estimated liability for claims and claim adjustment expenses may be higher or lower than the related loss reserves at the reporting date. Therefore, actual paid losses, as claims are settled in the future, may be materially different in amount than current loss reserves-favorable or unfavorable.
Because establishment of loss reserves is an inherently uncertain process involving estimates, currently established loss reserves may change. The Company reflects adjustments to loss reserves in the results of operations in the period the estimates are changed.
A portion of the Company's gross claims and claim adjustment expense reserves (totaling $3.30 billion at December 31, 2010) are for asbestos and environmental claims and related litigation. While the ongoing review of asbestos and environmental claims and associated liabilities considers the inconsistencies of court decisions as to coverage, plaintiffs' expanded theories of liability and the risks
In most cases, multiple estimation methods will be valid for the particular facts and circumstances of the claim liabilities being evaluated. This will result in a range of reasonable estimates for any particular claim liability. The Company uses such range analyses to back test whether previously established estimates for reserves at the reporting segments are reasonable, given subsequent information. Reported values found to be closer to the endpoints of a range of reasonable estimates are subject to further detailed reviews. These reviews may substantiate the validity of management's recorded estimate or lead to a change in the reported estimate.
A major component of the claim tail is the reporting lag. The reporting lag, which is the time between the event triggering a claim and the reporting of the claim to the insurer, makes estimating IBNR inherently more uncertain. In addition, the greater the reporting lag, the greater the proportion of IBNR to the total claim liability for the product line. Writing new products with material reporting lags can result in adding several years worth of IBNR claim exposure before the reporting lag exposure becomes clearly observable, thereby increasing the risk associated with pricing and reserving such products. The most extreme example of claim liabilities with long reporting lags are asbestos claims.
The results of such methodologies are subjected to various reasonability and diagnostic tests, including paid-to-incurred loss ratios, implied incurred-loss-to-earned-premium ratios and non-zero claim severity trends. An actual versus expected analysis is also performed comparing actual loss development to expected development based on the prior review. Additional analyses may be performed based on the results of these diagnostics, including the investigation of other actuarial methods.
The following section details reserving considerations and common risk factors by product line. There are many additional risk factors that may impact ultimate claim costs. Each risk factor presented will have a different impact on required reserves. Also, risk factors can have offsetting or compounding effects on required reserves. For example, in workers' compensation, the use of expensive medical procedures that result in medical cost inflation may enable workers to return to work faster, thereby lowering indemnity costs. Thus, in almost all cases, it is impossible to discretely measure the effect of a single risk factor and construct a meaningful sensitivity expectation.
In order to provide information on reasonably possible reserving changes by product line, the historical changes in year-end loss reserves over a one-year period are provided for the U.S. product lines. This information is provided for both the Company and the industry for the nine most recent years, and is based on the most recent publicly available data for the reported line(s) that most closely match the individual product line being discussed. These changes were calculated, net of reinsurance, from statutory annual statement data found in Schedule P of those statements, and represent the reported reserve development on the beginning-of-the-year claim liabilities divided by the beginning claim liabilities, all accident years combined, excluding non-defense related claim adjustment expense.
Data presented for the Company includes history for the entire Travelers group (U.S. companies only), whether or not the individual subsidiaries were originally part of SPC or TPC. This treatment is required by the statutory reporting instructions promulgated by state regulatory authorities for Schedule P. Comparable data for non-U.S. companies is not available.
While the majority of general liability coverages are written on an "occurrence" basis, certain general liability coverages (such as those covering directors and officers or professional liability) are typically insured on a "claims-made" basis.
This line is typically the largest source of reserve estimate uncertainty in the United States (excluding assumed reinsurance contracts covering the same risk). Major contributors to this reserve estimate uncertainty include the reporting lag (i.e., the length of time between the event triggering coverage and the actual reporting of the claim), the number of parties involved in the underlying tort action, whether the "event" triggering coverage is confined to only one time period or is spread over multiple time periods, the potential dollars involved (in the individual claim actions), whether such claims were reasonably foreseeable and intended to be covered at the time the contracts were written (i.e., coverage dispute potential), and the potential for mass claim actions. Claims with longer reporting lags result in greater inherent risk. This is especially true for alleged claims with a latency feature, particularly where courts have ruled that coverage is spread over multiple policy years, hence involving multiple defendants (and their insurers and reinsurers) and multiple policies (thereby increasing the potential dollars involved and the underlying settlement complexity). Claims with long latencies also
increase the potential recognition lag (i.e., the lag between writing a type of policy in a certain market and the recognition that such policies have potential mass tort and/or latent claim exposure).
Historically, the one-year change in the reserve estimate for this product line, excluding estimated asbestos and environmental amounts, over the last nine years has varied from -5% to 14% (averaging 2%) for the Company and from -5% to 7% (averaging 1%) for the industry overall. The Company's year-to-year changes are driven by, and are based on, observed events during the year. Because the
believes that the industry's range of historical outcomes is illustrative of reasonably possible one-year changes in reserve estimates for this product line. Property reserves represent approximately 3% of the Company's total loss reserves.
Since property is considered a short tail coverage, the one year change for property can be more volatile than that for the longer tail product lines. This is due to the fact that the majority of the reserve for property relates to the most recent accident year, which is subject to the most uncertainty for all product lines. This recent accident year uncertainty is relevant to property because of weather related events which, notwithstanding 2010 experience, tend to be concentrated in the second half of the year, and generally are not completely resolved until the following year. Reserve estimates associated with major catastrophes may take even longer to resolve. The reserve estimates for this product line are also potentially subject to material changes due to uncertainty in measuring ultimate losses for unprecedented significant catastrophes such as the events of September 11, 2001 and Hurricane Katrina.
See "Property risk factors" and "General liability risk factors," discussed above, with regard to reserving risk for commercial multi-peril.
The Company's change in reserve estimate for this product line was 0% for 2010, -8% for 2009 and -16% for 2008. The 2009 and 2008 changes were attributable to several factors, including improved legal and judicial environments, and enhanced risk control, underwriting and claim process initiatives. Also contributing to the change was improvement in the litigation environment relating to, and ongoing claim settlements for, Hurricane Katrina.
Historically, the one-year change in the reserve estimate for this product line over the last nine years has varied from -10% to 9% (averaging -3%) for the Company, and from -3% to 9% (averaging 1%) for the industry overall. The Company's year-to-year changes are driven by, and are based on, observed events during the year. The Company believes that its range of historical outcomes is illustrative of reasonably possible one-year changes in reserve estimates for this product line. Commercial automobile reserves represent approximately 7% of the Company's total loss reserves.
The Company's change in reserve estimate for this product line was -1% in 2010, -1% in 2009 and 1% for 2008.
Historically, the one-year change in the reserve estimate for this product line over the last nine years has varied from -10% to 138% (averaging 19%) for the Company, and from -13% to 24% (averaging 6%) for the industry overall. The Company's year-to-year changes are driven by, and are based on, observed events during the year. Because the high end of the Company's range was due to acquired business in 2004, the Company believes that the industry's range of historical outcomes is illustrative of reasonably possible one-year changes in reserve estimates for this product line. Fidelity and surety reserves represent approximately 3% of the Company's total loss reserves.
The Company's change in reserve estimate for this product line was -6% for 2010, -7% for 2009 and -10% for 2008. The 2010 change was driven by better than expected loss development due to lower than expected claim activity and loss severity, primarily for the contract surety business in this product line for the 2008 and prior accident years. The 2009 and 2008 changes were a result of better than expected loss development for the contract surety business within this product line, primarily driven by favorable settlements on large claims from older accident years.
The Company's change in reserve estimate for this product line was 0% for 2010, 0% for 2009 and -1% for 2008. The decrease in 2008 was primarily due to better than expected results from changes in claim handling practices as well as initiatives to fight fraud.
Homeowners is generally considered a short tail coverage. Most payments are related to the property portion of the policy, where the claim reporting and settlement process is generally restricted to the insured and the insurer. Claims on property coverage are typically reported soon after the actual damage occurs, although delays of several months are not unusual. The claim is settled when the two parties agree on the amount due in accordance with the policy contract language and the appropriate payment is made (or alternatively, the property replacement/repair is performed by the insurer). The resulting settlement process is typically fairly short term, although exceptions do exist.
Unanticipated changes in risk factors can affect reserves. As an indicator of the causal effect that a change in one or more risk factors could have on reserves for homeowners and personal lines other, a
1% increase (decrease) in incremental paid loss development for each future calendar year could result in a 1.1% increase (decrease) in loss reserves.
Historically, the one-year change in the reserve estimate for this product line (excluding the umbrella line of business, which for statutory reporting purposes is included with the general liability line of business) over the last nine years has varied from -31% to 3% (averaging -12%) for the Company, and from -8% to 11% (averaging -2%) for the industry overall. The Company's year-to-year changes are driven by, and are based on, observed events during the year. The Company believes that its range of historical outcomes is illustrative of reasonably possible one-year changes in reserve estimates for this product line. Homeowners and personal lines other reserves represent approximately 3% of the Company's total loss reserves.
This line combines both liability and property coverages; however, the majority of the reserves relate to property. While property is considered a short tail coverage, the one year change for property can be more volatile than that for the longer tail product lines. This is due to the fact that the majority of the reserve for property relates to the most recent accident year, which is subject to the most uncertainty for all product lines. This recent accident year uncertainty is relevant to property because of weather related events which tend to be concentrated in the second half of the year, and generally are not completely resolved until the following year. Reserve estimates associated with major catastrophes may take even longer to resolve.
The Company's change in reserve estimate for this product line (excluding the umbrella line of business) was 2% for 2010, -14% for 2009 and -13% for 2008. The Company's change in reserve estimate for this product line including the umbrella line of business was -4% for 2010, -12% for 2009 and -12% for 2008. The 2010 change reflected favorable loss development in the 2008 and prior accident years, primarily for the umbrella line of business, partially offset by unfavorable loss development in the 2009 accident year for the homeowners line of business that was driven by higher than anticipated late-reported claims related to storms in 2009. The 2009 change primarily reflected favorable loss development related to Hurricanes Ike and Katrina, as well as the 2007 California wildfires. The 2008 change was primarily driven by favorable loss development related to Hurricane Katrina, by claim initiatives, by better than expected outcomes on 2007 catastrophe-related claims and by improvements in older accident years for the umbrella line.
International and other claim liabilities result from a mix of coverages, currencies and jurisdictions/countries. The common characteristic is the need to customize the analysis to the individual component, and the inability to rely on data characterizations and reporting requirements in the U.S. statutory reporting framework.
Unanticipated changes in risk factors can affect reserves. As an indicator of the causal effect that a change in one or more risk factors could have on reserves for International and other (excluding asbestos and environmental), a 1% increase (decrease) in incremental paid loss development for each future calendar year could result in a 1.3% increase (decrease) in loss reserves. International and other reserves (excluding asbestos and environmental) represent approximately 8% of the Company's total loss reserves.
various reinsurance agreements. The Company employs dedicated specialists and aggressive strategies to manage reinsurance collections and disputes.
The $1.04 billion decline in net reinsurance recoverables since December 31, 2009 reflected cash collections and the impact of net favorable prior year reserve development, partially offset by a reduction in the allowance for uncollectible reinsurance that included the impact of a $70 million benefit resulting from the summary judgment in the reinsurance dispute referenced above. As a result, at December 31, 2010, reinsurance recoverables included the full $251 million owed to the Company under the terms of the related reinsurance agreement.
-Level 1-Unadjusted quoted market prices for identical assets or liabilities in active markets that the Company has the ability to access.
The Company conducts a periodic review to identify and evaluate invested assets having other-than-temporary impairments. Some of the factors considered in identifying other-than-temporary impairments include: (1) for fixed maturity investments, whether the Company intends to sell the investment or whether it is more likely than not that the Company will be required to sell the investment prior to an anticipated recovery in value; (2) for non-fixed maturity investments, the Company's ability and intent to retain the investment for a reasonable period of time sufficient to allow for an anticipated recovery in value; (3) the likelihood of the recoverability of principal and interest for fixed maturity securities (i.e., whether there is a credit loss), or cost for equity securities; (4) the length of time and extent to which the fair value has been less than amortized cost for fixed maturity securities or cost for equity securities; and (5) the financial condition, near-term and long-term prospects for the issuer, including the relevant industry conditions and trends, and implications of rating agency actions and offering prices.
See note 1 of notes to the Company's consolidated financial statements for a further discussion of investment impairments.
This report contains, and management may make, certain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical facts, may be forward-looking statements. Words such as "may," "will," "should," "likely," "anticipates," "expects," "intends," "plans," "projects," "believes," "estimates" and similar expressions are used to identify these forward-looking statements. Specifically, statements about the Company's share repurchase plans and statements about the potential impact of investment markets and other economic conditions on the Company's investment portfolio and underwriting results, among others, are forward looking, and the Company may also make forward-looking statements about, among other things:
•the sufficiency of the Company's asbestos and other reserves (including, among other things, asbestos claim payment patterns);
•the Company's proposed joint venture with J. Malucelli Participações em Seguros e Resseguros S.A.
Consolidated Statement of Changes in Shareholders' Equity for the years ended December 31, 2010, 2009 and 2008
We have audited the accompanying consolidated balance sheet of The Travelers Companies, Inc. and subsidiaries as of December 31, 2010 and 2009, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2010. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
The consolidated financial statements include the accounts of The Travelers Companies, Inc. (together with its subsidiaries, the Company). The preparation of the consolidated financial statements in conformity with U.S. generally accepted accounting principles (GAAP) requires management 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 consolidated financial statements and the reported amounts of revenues and claims and expenses during the reporting period. Actual results could differ from those estimates. Certain reclassifications have been made to the 2009 and 2008 financial statements to conform to the 2010 presentation. All material intercompany transactions and balances have been eliminated.
In June 2008, the FASB issued updated guidance that addressed whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, should be included in the earnings allocation in computing earnings per share (EPS) under the "two-class method." Under the guidance, participating securities are re-defined to include unvested share-based payment awards that contain non-forfeitable dividends or dividend equivalents as participating securities to be included in the computation of EPS using the "two-class method." Outstanding unvested restricted stock and deferred stock units issued under employee compensation programs containing such dividend participation features are considered participating securities subject to the "two-class method" in computing EPS rather than the "treasury stock method."
In April 2009, the FASB issued updated guidance, which provides clarification that an other-than-temporary impairment is recognized when an entity has the intent to sell a debt security or when it is more likely than not that an entity will be required to sell the debt security before its anticipated recovery in value.
The guidance was effective for interim periods ending after June 15, 2009. The adoption of the guidance on April 1, 2009 resulted in an increase in retained earnings of $71 million, which was offset by a corresponding decrease in "accumulated other changes in equity from nonowner sources" of the same amount.
As a result of adopting the guidance, the amounts of net investment income, net realized investment losses from impairment charges and net income reported for the twelve months ended December 31, 2009 were different than the amounts that would have been reported under the previous accounting guidance. The guidance resulted in less net realized investment losses from impairments, and accordingly, an increase in net income of approximately $65 million after-tax ($100 million pretax) or $0.11 per share (basic and diluted) in 2009. That increase was partially offset by a slight decrease in net investment income and, accordingly, net income, of less than $0.01 per share (basic and diluted) due to a decrease in the accretion of the non-credit loss component of impaired securities to the Company's projection of expected value for the twelve months ended December 31, 2009.
In December 2010, the FASB issued updated guidance that modifies the goodwill impairment test. Under the updated guidance, goodwill is tested for impairment using a two-step process. The first step is to identify potential impairments by comparing the estimated fair value of a reporting unit to its carrying value, including goodwill. If the carrying value of a reporting unit exceeds the estimated fair value, a second step is performed to measure the amount of impairment, if any. The second step is to determine the implied fair value of the reporting unit's goodwill, measured in the same manner as goodwill is recognized in a business combination, and compare that amount with the carrying amount of the goodwill. If the carrying value of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess.
The updated guidance requires that if the carrying amount of a reporting unit becomes zero or negative, the second step of the impairment test must be performed when it is more likely than not that a goodwill impairment loss exists. In considering whether it is more likely than not that an impairment loss exists a company is required to evaluate qualitative factors, including the factors presented in existing guidance that trigger an interim impairment test of goodwill (e.g. a significant adverse change in business climate or an anticipated sale of a reporting unit). For public entities, the provisions of the guidance are effective for annual and interim periods beginning after December 15, 2010. The Company does not expect that the provisions of the guidance will have a material effect on its results of operations, financial position or liquidity.
The Company uses the equity method of accounting for private equity limited partnerships, hedge funds and real estate partnerships. The partnerships and the hedge funds generally report investments on their balance sheet at fair value. The financial statements prepared by the investee are received by the Company on a lag basis, with the lag period generally dependent upon the type of underlying investments. The private equity and real estate partnerships provide financial information quarterly which is generally available to investors, including the Company, within three to six months following the date of the reporting period. The hedge funds provide financial information monthly, which is generally available to investors within one month following the date of the reporting period. The Company regularly requests financial information from the partnerships prior to the receipt of the partnerships' financial statements, and records any material information obtained from these requests in its financial statements.
Investment income from fixed maturities and mortgage loans is recognized based on the constant effective yield method which includes an adjustment for estimated principal repayments, if any. The effective yield used to determine amortization for fixed maturities subject to prepayment risk (e.g., asset-backed, loan-backed and structured securities) is recalculated and adjusted periodically based upon actual historical and/or projected future cash flows, which are obtained from a widely-accepted securities data provider. The adjustments to the yield for highly rated prepayable fixed maturities are accounted for using the retrospective method. The adjustments to the yield for non-highly rated prepayable fixed maturities are accounted for using the prospective method. Dividends on equity securities (including those with transfer restrictions) and venture capital investments are recognized in income when declared. Rental income on real estate is recognized on a straight-line basis
For fixed maturity investments that the Company does not intend to sell or for which it is more likely than not that the Company would not be required to sell before an anticipated recovery in value, the Company separates the credit loss component of the impairment from the amount related to all other factors and reports the credit loss component in net realized investment gains (losses). The
The Company determines the credit loss component of fixed maturity investments by utilizing discounted cash flow modeling to determine the present value of the security and comparing the present value with the amortized cost of the security. If the amortized cost is greater than the present value of the expected cash flows, the difference is considered a credit loss and recognized in net realized investment gains (losses).
A mortgage loan is considered impaired when it is probable that the Company will be unable to collect principal and interest amounts due. For mortgage loans that are determined to be impaired, a reserve is established for the difference between the amortized cost and the fair market value of the underlying collateral. In estimating fair value, the Company uses interest rates reflecting the current real estate financing market returns.
Claims and claim adjustment expense reserves represent estimates for unpaid reported and unreported claims incurred and related expenses. The reserves are adjusted regularly based upon experience. Included in the claims and claim adjustment expense reserves in the consolidated balance sheet are certain reserves discounted to the present value of estimated future payments. The liabilities for losses for most long-term disability and annuity claim payments, primarily arising from workers' compensation insurance and workers' compensation excess insurance policies, were discounted using a rate of 5% at both December 31, 2010 and 2009. These discounted reserves totaled $2.09 billion and $2.16 billion at December 31, 2010 and 2009, respectively.
The Company performs a continuing review of its claims and claim adjustment expense reserves, including its reserving techniques and its reinsurance. The reserves are also reviewed regularly by qualified actuaries employed by the Company. These reserves represent the estimated ultimate cost of
all unpaid claims and claim adjustment expenses. Since the reserves are based on estimates, the ultimate liability may be more or less than such reserves. The effects of changes in such estimated reserves are included in the results of operations in the period in which the estimates are changed. Such changes in estimates could occur in a future period and may be material to the Company's results of operations and financial position in such period.
Included in other liabilities in the consolidated balance sheet is the Company's estimate of its liability for guaranty fund and other insurance-related assessments. The liability for expected state guaranty fund and other premium-based assessments is recognized as the Company writes or becomes obligated to write or renew the premiums on which the assessments are expected to be based. The liability for loss-based assessments is recognized as the related losses are incurred. At December 31, 2010 and 2009, the Company had a liability of $235 million and $293 million, respectively, for guaranty fund and other insurance-related assessments and related recoverables of $6 million at both dates. The liability for such assessments and the related recoverables are not discounted for the time value of money. The loss-based assessments are expected to be paid over a period ranging from one year to the life expectancy of certain workers' compensation claimants and the recoveries are expected to occur over the same period of time.
Treasury stock represents the cost of common stock repurchased by the Company, which stock represents authorized and unissued shares of the Company under the Minnesota Business Corporation Act.
•Commercial Accounts provides mid-sized businesses with property and casualty products, including property, general liability, commercial multi-peril, commercial auto and workers' compensation insurance.
•Public Sector Services provides insurance products and services to public entities including municipalities, counties, Indian Nation gaming organizations and selected special government districts such as water and sewer utilities. The policies written by this unit typically cover property, commercial auto, general liability and errors and omissions exposures.
•Target Risk Underwriting. The following units serve commercial businesses requiring specialized product underwriting, claims handling and risk management services:
schools, retailers, and service businesses. These insurance programs cover losses on buildings, business personal property and business interruption exposures.
•Global Accounts provides insurance to U.S. companies with foreign property and liability exposures (home-foreign), and foreign organizations with property and liability exposures located in the United States (reverse-flow), as part of a global program.
The Financial, Professional & International Insurance segment includes surety and financial liability coverages, which primarily use credit-based underwriting processes, as well as property and casualty products that are primarily marketed on a domestic basis in the United Kingdom, the Republic of Ireland and Canada, and on an international basis through Lloyd's. The segment includes the following groups:
The cost of the Company's catastrophe treaty program is included in the Company's ceded premiums and is allocated among reportable business segments based on an estimate of actual market reinsurance pricing using expected losses calculated by the Company's catastrophe model, adjusted for any experience adjustments.
(1)The primary component of Interest Expense and Other is after-tax interest expense of $252 million, $248 million and $239 million in 2010, 2009 and 2008, respectively. The operating
loss in 2010 included $39 million of after-tax expenses related to the Company's purchase and retirement of a significant portion of its 6.25% fixed-to-floating rate junior subordinated debentures. The operating loss in 2009 included a benefit of $28 million from the favorable resolution of various prior year tax matters.
(1)The major components of other assets at December 31, 2010 and 2009 were other intangible assets and deferred taxes.
The Company's fixed maturity investment portfolio at December 31, 2010 and 2009 included $4.16 billion and $5.21 billion, respectively, of residential mortgage-backed securities, which include pass-through-securities and collateralized mortgage obligations (CMO). Included in the totals at December 31, 2010 and 2009 were $2.09 billion and $2.63 billion, respectively, of GNMA, FNMA and FHLMC (excluding FHA project loans) guaranteed residential mortgage-backed pass-through securities classified as available for sale. Also included in those totals were residential CMOs classified as available for sale with a fair value of $2.07 billion and $2.58 billion, respectively. Approximately 38% and 37% of the Company's CMO holdings were guaranteed by or fully collateralized by securities issued by GNMA, FNMA or FHLMC at December 31, 2010 and 2009, respectively. The average credit rating of all of the above securities was 'Aa1' at both December 31, 2010 and 2009.
At December 31, 2010 and 2009, the Company held commercial mortgage-backed securities (CMBS, including FHA project loans) of $549 million and $714 million, respectively, which are included in "All other corporate bonds" in the tables above. At December 31, 2010 and 2009, approximately $155 million and $236 million of these securities, respectively, or the loans backing such securities, contained guarantees by the U.S. government or a government-sponsored enterprise, and $20 million at both dates were comprised of Canadian non-guaranteed securities. The average credit rating of the $394 million of non-guaranteed securities at December 31, 2010 was "Aaa," and 90% of those securities were issued in 2004 and prior years. The CMBS portfolio is supported by loans that are diversified across economic sectors and geographical areas.
At December 31, 2010 and 2009, the Company's insurance subsidiaries had $4.51 billion and $4.46 billion, respectively, of securities on deposit at financial institutions in certain states pursuant to the respective states' insurance regulatory requirements. Funds deposited with third parties to be used as collateral to secure various liabilities on behalf of insureds, cedants and other creditors had a fair value of $86 million and $103 million at December 31, 2010 and 2009, respectively. Other investments pledged as collateral securing outstanding letters of credit had a fair value of $88 million and $98 million at December 31, 2010 and 2009, respectively.
Proceeds from sales of equity securities were $201 million, $65 million and $53 million in 2010, 2009 and 2008, respectively. Gross gains of $128 million, $13 million and $6 million and gross realized losses of less than $1 million, $2 million and $4 million were realized on those sales in 2010, 2009 and 2008, respectively. In 2010, proceeds from the sales of equity securities and gross gains realized on those sales included $115 million and $102 million, respectively, from the sale of substantially all of the Company's remaining common stock holdings in Verisk Analytics, Inc. (Verisk), a portion of which was classified as an equity security at the time of sale.
Proceeds from the sale of real estate investments totaled $10 million in 2010. Gross gains of $3 million were realized on those sales and there were no gross losses. In 2009, there were no sales of real estate investments. Proceeds from the sale of real estate investments totaled $25 million in 2008. Gross gains of $2 million were realized on those sales and there were no gross losses. The Company had no real estate held for sale at December 31, 2010 and 2009. Accumulated depreciation on real estate held for investment purposes was $200 million and $170 million at December 31, 2010 and 2009, respectively.
The Company is involved in the normal course of business with VIEs primarily as a passive investor in limited partner equity interests issued by third party VIEs. These include certain of the Company's investments in private equity limited partnerships, hedge funds and real estate partnerships where the Company is not related to the general partner. These investments are generally accounted for under the equity method and reported in the Company's consolidated balance sheet as other investments unless the Company is deemed the primary beneficiary. These equity interests generally cannot be redeemed. Distributions from these investments are received by the Company as a result of liquidation of the underlying investments of the funds and/or as income distribution. The Company's maximum exposure to loss with respect to these investments is limited to the investment carrying
amounts reported in the Company's consolidated balance sheet and any unfunded commitment. Neither the carrying amounts nor the unfunded commitments related to these VIEs are material.
(2)Included in the fair value and gross unrealized losses are $521 million and $62 million, respectively, related to fixed maturity investments having a credit loss recognized in net realized investment gains (losses) as a result of applying the updated other-than-temporary impairment guidance effective April 1, 2009. See note 1. The following table summarizes, for all fixed maturities and equity securities reported at fair value for which fair value is less than 80% of amortized cost at December 31, 2010, the gross unrealized
These unrealized losses at December 31, 2010 represented less than 1% of the combined fixed maturity and equity security portfolios on a pretax basis and less than 1% of shareholders' equity on an after-tax basis.
Concentrations of credit risk arise from exposure to counterparties that are engaged in similar activities and have similar economic characteristics that could cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions. The Company seeks to mitigate credit risk by actively monitoring the creditworthiness of counterparties, obtaining collateral as deemed appropriate, and applying controls that include credit approvals, limits of credit exposure, and other monitoring procedures.
At December 31, 2010 and 2009, other than U.S. Treasury securities and obligations of U.S. Government and government agencies and authorities, the Company was not exposed to any concentration of credit risk of a single issuer greater than 5% of shareholders' equity of the Company.
Included in fixed maturities are below investment grade assets totaling $1.88 billion and $1.80 billion at December 31, 2010 and 2009, respectively. The Company defines its below investment grade assets as those securities rated below investment grade by external rating agencies, or the equivalent by the Company when a public rating does not exist. Such assets include publicly traded below investment grade bonds and certain other privately issued bonds that are classified as below investment grade loans.
The Company uses U.S. Treasury note futures transactions to modify the effective duration of specific assets within the investment portfolio and enters into 90-day futures contracts on 2-year, 5-year, 10-year and 30-year U.S. Treasury notes which require a daily mark-to-market and settlement with the broker. The notional value of the open U.S. Treasury futures contracts was $400 million and $350 million at December 31, 2010 and 2009, respectively. Net realized investment gains (losses) in 2010, 2009 and 2008 included net losses of $30 million, net gains of $23 million and net losses of $53 million, respectively, related to U.S. Treasury futures contracts.
The Company purchases investments that have embedded derivatives, primarily convertible debt securities. These embedded derivatives are carried at fair value with changes in value reflected in net realized investment gains (losses). Derivatives embedded in convertible debt securities are reported on a combined basis with their host instrument and are classified as fixed maturity securities. The Company recorded a net realized investment loss of $1 million in 2010, a net realized investment gain of $1 million in 2009 and a net realized investment loss of $77 million in 2008 related to these embedded derivatives. The Company divested substantially all of its holdings in convertible debt securities in 2008.
The Company's estimates of fair value for financial assets and financial liabilities are based on the framework established in the fair value accounting guidance. The framework is based on the inputs used in valuation, gives the highest priority to quoted prices in active markets, and requires that observable inputs be used in the valuations when available. The disclosure of fair value estimates in the fair value accounting guidance hierarchy is based on whether the significant inputs into the valuation are observable. In determining the level of the hierarchy in which the estimate is disclosed, the highest priority is given to unadjusted quoted prices in active markets and the lowest priority to unobservable inputs that reflect the Company's significant market assumptions. The three levels of the hierarchy are as follows:
•Level 1-Unadjusted quoted market prices for identical assets or liabilities in active markets that the Company has the ability to access.
The Company utilizes a pricing service to estimate fair value measurements for approximately 99% of its fixed maturities. The pricing service utilizes market quotations for fixed maturity securities that have quoted prices in active markets. Since fixed maturities other than U.S. Treasury securities generally do not trade on a daily basis, the pricing service prepares estimates of fair value measurements for these securities using its proprietary pricing applications, which include available relevant market information, benchmark curves, benchmarking of like securities, sector groupings and matrix pricing. Additionally, the pricing service uses an Option Adjusted Spread model to develop prepayment and interest rate scenarios.
The Company holds privately placed corporate bonds and estimates the fair value of these bonds using an internal matrix that is based on market information regarding interest rates, credit spreads and liquidity. The underlying source data for calculating the matrix of credit spreads relative to the U.S. Treasury curve are the BofA Merrill Lynch U.S. Corporate Index and the BofA Merrill Lynch High Yield BB Rated Index. The Company includes the fair value estimates of these corporate bonds in Level 2, since all significant inputs are market observable. As many of these securities are issued by public companies, the Company compares the estimates of fair value to the fair values of these companies' publicly traded debt to test the validity of the internal pricing matrix.
For public common and preferred stocks, the Company receives prices from a nationally recognized pricing service that are based on observable market transactions and includes these estimates in the amount disclosed in Level 1. The estimated fair value of stocks having transfer restrictions that expire within one year was determined by adjusting the observed market price of the securities for a liquidity discount which takes into consideration the restrictions that existed at December 31, 2010 and 2009 and is based on market observable inputs. As a result of adjusting the market price to reflect the impact of the transfer restrictions on estimated fair value, the Company discloses these holdings in Level 2. Infrequently, current market quotes in active markets are unavailable for certain non-redeemable preferred stocks held by the Company. In these instances, the Company receives an estimate of fair value from the pricing service that provides fair value estimates for the Company's fixed maturities. The service utilizes some of the same methodologies to price the non-redeemable preferred stocks as it does for the fixed maturities. The Company includes the fair value estimate for these non-redeemable preferred stocks in the amount disclosed in Level 2.
At December 31, 2009, the Company held common stocks with transfer restrictions that were scheduled to expire after one year. The Company estimated the fair value of these stocks at December 31, 2009 using the same methodology described above for common stock restrictions that expire within a year, and disclosed the fair value in Level 2. In 2010, the Company sold substantially all of these shares.
At December 31, 2010 and 2009, the Company held investments in non-public common and preferred equity securities, with fair value estimates of $57 million and $60 million, respectively, reported in other investments, where the fair value estimate is determined either internally or by an external fund manager based on recent filings, operating results, balance sheet stability, growth and other business and market sector fundamentals. Due to the significant unobservable inputs in these valuations, the Company includes the total fair value estimate for all of these investments at December 31, 2010 and 2009 in the amount disclosed in Level 3. The Company holds investments in various publicly-traded securities which are reported in other investments. The $42 million and $46 million fair value of these investments at December 31, 2010 and 2009, respectively, is disclosed in Level 1. These investments include securities in the Company's trading portfolio, mutual funds and other small holdings.
At December 31, 2010 and 2009, the Company held $37 million and $39 million, respectively, of convertible bonds containing embedded conversion options that are valued separately from the host bond contract in the amount disclosed in Level 2-fixed maturities. At December 31, 2009, the Company held non-public stock warrants in a public company for which it estimated fair value using an
option pricing model with observable market inputs. Since these warrants were not market traded and information concerning market participants was not available, the Company included their fair value estimate of $94 million in Level 3-other investments. The Company sold these warrants in the fourth quarter of 2010.
The following tables present the level within the fair value hierarchy at which the Company's financial assets and financial liabilities are measured on a recurring basis at December 31, 2010 and 2009.
Transfers out of Level 3 during 2009 included a $230 million transfer resulting from a private common stock holding undergoing an initial public offering. The new public security has transfer restrictions and is reported in Level 2.
The Company had no financial assets or financial liabilities that were measured at fair value on a non-recurring basis during the years ended December 31, 2010 and 2009.
The carrying values of $647 million and $629 million of financial instruments classified as other assets approximated their fair values at December 31, 2010 and 2009, respectively. The carrying values of $3.75 billion and $3.89 billion of financial instruments classified as other liabilities at December 31, 2010 and 2009, respectively, also approximated their fair values. Fair value is determined using various methods including discounted cash flows, as appropriate for the various financial instruments.
through 2014. The Program excludes from participation the following types of insurance: Federal crop insurance, private mortgage insurance, financial guaranty insurance, medical malpractice insurance, health or life insurance, flood insurance, and reinsurance, commercial automobile, professional liability (other than directors and officers'), surety, burglary and theft, and farm-owners multi-peril. In the case of a war declared by Congress, only workers' compensation losses are covered by the Program. All commercial property and casualty insurers licensed in the United States are generally required to participate in the Program. Under the Program, a participating insurer is entitled to be reimbursed by the Federal Government for 85% of subject losses, after an insurer deductible, subject to an annual cap.
The following table presents the carrying amount of the Company's goodwill by segment at December 31, 2010 and 2009:
The following presents a summary of the Company's other intangible assets by major asset class at December 31, 2010 and 2009:
(1)In December 2008, the Company sold its United Kingdom based subsidiary, Unionamerica Holdings, Ltd., which was in runoff.
The $1.31 billion decline in reinsurance recoverables since December 31, 2009 reflected cash collections and the impact of net favorable prior year reserve development, partially offset by a reduction in the allowance for uncollectible reinsurance. The $1.22 billion decline in reinsurance recoverables at December 31, 2009 compared with the prior year end primarily reflected various commutation agreements and collections on reinsurance recoverables, including those related to prior years' hurricane losses.
In 2010, estimated claims and claim adjustment expenses incurred included $1.42 billion of net favorable development for claims arising in prior years, including $1.25 billion of net favorable prior year reserve development impacting the Company's results of operations, which excludes $45 million of accretion of discount.
Business Insurance. Net favorable prior year reserve development in 2010 totaled $901 million, driven by better than expected loss development in the property, general liability and workers' compensation product lines for multiple accident years, as well as in assumed reinsurance, which is in runoff. The property product line improvement primarily occurred in the 2008 and 2009 accident years as a result of better than expected loss development in Industry-Focused Underwriting and Target Risk Underwriting. The general liability product line improvement was concentrated in excess coverages for accident years 2006 and prior and reflected what the Company believes are favorable legal and judicial environments. Net favorable prior year reserve development in the workers' compensation product line was concentrated in accident years 2007 and prior and resulted from better than expected loss development. The improvement in assumed reinsurance resulted primarily from favorable resolutions of claims and disputes from accident years 2002 and prior. In addition, better than expected loss development in the Business Insurance segment in recent years resulted in a favorable re-estimation of reserves for unallocated loss adjustment expenses in 2010. The net favorable prior year reserve development in these product lines in 2010 was partially offset by $140 million and $35 million increases to asbestos and environmental reserves, respectively.
Business Insurance. Net favorable prior year reserve development totaled $1.03 billion in 2009, driven by better than expected loss development primarily concentrated in the general liability, commercial multi-peril, commercial automobile and commercial property product lines for recent accident years. The general liability and commercial multi-peril product lines experienced better than anticipated loss development that was attributable to several factors, including what the Company believes is improved legal and judicial environments, as well as enhanced risk control, underwriting and claim process initiatives. The commercial automobile line of business experienced better than expected loss development that was attributable to what the Company believes is more favorable legal and judicial environments, claim handling initiatives and improvements in auto safety technology. The commercial property product line improvement primarily occurred in the 2007 and 2008 accident years as a result of better than expected loss development for certain large national property and inland marine exposures. In addition, the commercial property product line's 2005 accident year experience improved due to the litigation environment relating to, and ongoing claim settlements for, Hurricane Katrina. The net favorable prior year reserve development in these product lines in 2009 was partially offset by a $185 million increase to asbestos reserves and a $70 million increase to environmental reserves.
development in certain large inland marine claim exposures and in ceded recoveries for commercial property large claims. In addition, the commercial multi-peril and property product lines' 2005 accident year results experienced improvement due to the litigation environment relating to, and ongoing claim settlements for, Hurricane Katrina. The commercial automobile product line improvement was attributable to several factors, including what the Company believes is improved legal and judicial environments, as well as enhanced risk control, underwriting and claim process initiatives. The net favorable prior year reserve development in the foregoing product lines in 2008 was partially offset by net unfavorable prior year reserve development in the workers' compensation product line, primarily driven by higher than anticipated medical costs related to 2004 and prior accident years, and by a $70 million and $85 million increase to asbestos and environmental reserves, respectively.
Personal Insurance. Net favorable prior year reserve development in 2008 totaled $143 million, primarily driven by favorable loss development related to Hurricane Katrina, and better than expected loss development from recent accident years for the Homeowners and Other product line. This improvement was driven in part by claim initiatives as well as better than expected outcomes on 2007 catastrophe-related claims. In addition, the Homeowners and Other product line experienced improvement in older accident years for the umbrella line as well as favorable experience from accident year 2007 for allied coverages due to less than expected claim activity.
At December 31, 2010 and 2009, the Company's claims and claim adjustment expense reserves included $2.90 billion and $3.15 billion, respectively, for asbestos and environmental-related claims, net of reinsurance.
The Company's quarterly asbestos reserve review includes an analysis of exposure and claim payment patterns by policyholder category, as well as recent settlements, policyholder bankruptcies, judicial rulings and legislative actions. The Company also analyzes developing payment patterns among policyholders in the Home Office, Field Office and Assumed Reinsurance and Other categories as well as projected reinsurance billings and recoveries. In addition, the Company reviews its historical gross and net loss and expense paid experience, year-by-year, to assess any emerging trends, fluctuations, or characteristics suggested by the aggregate paid activity. Conventional actuarial methods are not utilized to establish asbestos reserves nor have the Company's evaluations resulted in any way of determining a meaningful average asbestos defense or indemnity payment.
Net asbestos losses paid in 2010, 2009 and 2008 were $350 million, $341 million and $658 million, respectively. (Asbestos payments in 2008 included the Company's one-time net payment of $365 million associated with the settlement of the ACandS, Inc. matter). Approximately 32%, 41% and 59% of total net paid losses in 2010, 2009 and 2008, respectively, related to policyholders with whom the Company had entered into settlement agreements limiting the Company's liability.
Asbestos and Environmental Reserves. As a result of the processes and procedures described above, management believes that the reserves carried for asbestos and environmental claims at December 31, 2010 are appropriately established based upon known facts, current law and management's judgment. However, the uncertainties surrounding the final resolution of these claims continue, and it is difficult to determine the ultimate exposure for asbestos and environmental claims and related litigation. As a result, these reserves are subject to revision as new information becomes available and as claims develop. The continuing uncertainties include, without limitation, the risks and lack of predictability inherent in complex litigation, any impact from the bankruptcy protection sought by various asbestos producers and other asbestos defendants, a further increase or decrease in the cost to resolve and/or the number of asbestos and environmental claims beyond that which is anticipated, the role of any umbrella or excess policies the Company has issued, the resolution or adjudication of disputes pertaining to the amount of available coverage for asbestos and environmental claims in a manner inconsistent with the Company's previous assessment of these claims, the number and outcome of direct actions against the Company, future developments pertaining to the Company's ability to recover reinsurance for asbestos and environmental claims and the unavailability of other insurance sources potentially available to policyholders, whether through exhaustion of policy limits or through the insolvency of other participating insurers. In addition, uncertainties arise from the insolvency or bankruptcy of policyholders and other defendants. It is also not possible to predict changes in the legal, regulatory and legislative environment and their impact on the future development of asbestos and environmental claims. This development will be affected by future court and regulatory decisions and interpretations, including the outcome of legal challenges to legislative and/or judicial reforms establishing medical criteria for the pursuit of asbestos claims, as well as changes in applicable legislation. It is also difficult to predict the ultimate outcome of complex coverage disputes until settlement negotiations near completion and significant legal questions are resolved or, failing settlement, until the dispute is adjudicated. This is particularly the case with policyholders in bankruptcy where negotiations often involve a large number of claimants and other parties and require court approval to be effective. As part of its continuing analysis of asbestos and environmental reserves, the Company continues to study the implications of these and other developments.
discounted to the date of redemption on a semi-annual basis (assuming a 360-day year consisting of twelve 30-day months) at the then current Treasury rate (as defined) plus 15 basis points for the 2020 senior notes and 20 basis points for the 2040 notes.
Commercial Paper-The Company maintains an $800 million commercial paper program with $1 billion of back-up liquidity, consisting entirely of a bank credit agreement that expires on June 10, 2013. (See "Line of Credit Agreement" discussion that follows). Interest rates on commercial paper issued in 2010 ranged from 0.2% to 0.3%, and in 2009 ranged from 0.2% to 0.7%.
September 15. From and including March 15, 2017, the debentures will bear interest at an annual rate equal to three-month LIBOR plus 2.215%, payable quarterly on March 15, June 15, September 15 and December 15 of each year. The Company can redeem the debentures at its option, in whole or in part, at any time on or after March 15, 2017 at a redemption price of 100% of the principal amount being redeemed plus accrued but unpaid interest. The Company can redeem the debentures at its option prior to March 15, 2017 (a) in whole at any time or in part from time to time or (b) in whole, but not in part, in the event of certain tax or rating agency events relating to the debentures, at a redemption price equal to the greater of 100% of the principal amount being redeemed and the applicable make-whole amount, in each case plus any accrued and unpaid interest.
The Company's consolidated balance sheet includes the debt instruments acquired in the merger, which were recorded at fair value as of the acquisition date. The resulting fair value adjustment is being amortized over the remaining life of the respective debt instruments using the effective-interest method. The amortization of the fair value adjustment reduced interest expense by $4 million and $11 million for the years ended December 31, 2010 and 2009, respectively.
Maturities-The amount of debt obligations, other than commercial paper, that become due in each of the next five years is as follows: 2011, $9 million; 2012, $250 million; 2013, $500 million; 2014, none; and 2015, $400 million.
On June 10, 2010, the Company entered into a three-year, $1.0 billion revolving credit agreement with a syndicate of financial institutions, replacing its five-year, $1.0 billion credit agreement that expired on that date. Pursuant to the credit agreement covenants, the Company must maintain a minimum consolidated net worth (generally defined as shareholders' equity plus certain trust preferred and mandatorily convertible securities, reduced for goodwill and other intangible assets) of $14.35 billion. The Company must also maintain a ratio of total debt to the sum of total debt plus consolidated net worth of not greater than 0.40 to 1.00. In addition, the credit agreement contains other customary restrictive covenants as well as certain customary events of default, including with respect to a change in control, which is defined to include the acquisition of 35% or more of the Company's voting stock and certain changes in the composition of the Company's board of directors. At December 31, 2010, the Company was in compliance with these covenants. Generally, the cost of borrowing under this agreement will range from LIBOR plus 100 basis points to LIBOR plus 175 basis points depending on the Company's credit ratings. At December 31, 2010, that cost would have been LIBOR plus 125 basis points had there been any amounts outstanding under the credit agreement. This line of credit also supports the Company's commercial paper program.
In December 2008, the Company filed with the Securities and Exchange Commission a universal shelf registration statement for the potential offering and sale of securities. The Company may offer these securities from time to time at prices and on other terms to be determined at the time of offering. During 2010 and 2009, the Company issued securities with a principal amount of $1.25 billion and $500 million, respectively, under the shelf registration statement.
In January 2011, the board of directors approved a share repurchase authorization that added an additional $5 billion of repurchase capacity to the $1.51 billion of capacity remaining at December 31, 2010.
For tax return purposes, as of December 31, 2010, the Company had net operating loss (NOL) carryforwards on a regular tax basis and an alternative minimum tax (AMT) basis of approximately $59 million and $25 million, respectively. These NOL carryforwards expire, if unused, in 2018. The amount and timing of realizing the benefit of NOL carryforwards depends on future taxable income and limitations imposed by tax laws. The benefit of the NOL carryforward has been recognized in the consolidated financial statements.
The following is a reconciliation of the beginning and ending amount of unrecognized tax benefits for the years ended December 31, 2010 and 2009:
The IRS is conducting an examination of the Company's U.S. income tax returns for 2007 and 2008. The Company does not expect any significant changes to its liability for unrecognized tax benefits during the next twelve months.
The Company has a share-based incentive compensation plan, The Travelers Companies, Inc. Amended and Restated 2004 Stock Incentive Plan (the 2004 Incentive Plan), which replaced prior share-based incentive compensation plans (legacy plans). The purposes of the 2004 Incentive Plan are to align the interests of the Company's non-employee directors, executive officers and other employees with those of the Company's shareholders, and to attract and retain personnel by providing incentives in the form of stock-based awards. The 2004 Incentive Plan permits grants of nonqualified stock options, incentive stock options, stock appreciation rights, restricted stock, restricted stock units, deferred stock, deferred stock units, performance awards and other stock-based or stock-denominated awards with respect to the Company's common stock. The number of shares of the Company's common stock authorized for grant under the 2004 Incentive Plan is 35 million shares, subject to additional shares that may be available for awards as described below. The Company has a policy of issuing new shares to settle the exercise of stock option awards and the vesting of other equity awards.
In addition to the stock option awards described above, certain stock option awards that were granted under legacy plans permit an employee exercising an option to be granted a new option (a reload option) at an exercise price equal to the closing price of the Company's common stock on the date on which the original option is exercised. The reload option is permitted on certain stock option awards granted prior to January 2003 at an amount equal to the number of shares of the common stock used to satisfy both the exercise price and withholding taxes due upon exercise of an option and vest either six months or one year after the grant date and are exercisable for the remaining term of the related original option.
The fair value of each option award is estimated on the date of grant by application of a variation of the Black-Scholes option pricing model using the assumptions noted in the following table. The expected term of newly granted stock options is the time to vest plus half the remaining time to expiration. This considers the vesting restriction and represents an even pattern of exercise behavior over the remaining term. Reload options are exercisable for the remaining term of the original option and therefore would generally have a shorter expected term. Beginning in April 2010, due to the Company having attained sufficient history with respect to changes in its stock prices over time, the expected volatility assumption is based on the historical volatility of the Company's common stock for the same period as the estimated option term based on the mid-month of the option grant. Prior to April 2010, the expected volatility was based on the average historical volatility of the common stock of an industry peer group of entities due to the limited Company stock history. The expected dividend is based upon the Company's current quarter dividend annualized and assumed to be constant over the expected option term. The risk-free interest rate for each option is the interpolated market yield for the mid-month of the option grant on a U.S. Treasury bill with a term comparable to the expected option term of the granted stock option. Shares received through option exercises under the reload program are subject to either a one-year or two-year restriction on sale. A discount, as measured by the estimated cost of protecting against changes in market value, 5% for one year sales restrictions and 10% for two year sales restrictions, has been applied to the fair value of reload options granted to reflect these sales restrictions. The following assumptions were used in estimating the fair value of options on grant date for the years ended December 31, 2010, 2009 and 2008:
On February 1, 2011, the Company, under the 2004 Stock Incentive Plan, granted 2,346,767 stock option awards with an exercise price of $56.81 per share. The fair value attributable to the stock option awards on the date of grant was $12.94 per share.
The Company, commencing with equity grants on or after January 1, 2007, issues restricted stock unit awards to eligible officers and key employees under the Equity Awards program established pursuant to the 2004 Incentive Plan. A restricted stock unit represents the right to receive a share of common stock. These restricted stock unit awards are granted at market price, generally vest three years from the date of grant, do not have voting rights and the underlying shares of common stock are not issued until the vesting criteria is satisfied.
A summary of restricted stock units, deferred stock awards and performance share activity under the Company's 2004 Incentive Plan and legacy plans as of and for the year ended December 31, 2010 is as follows:
(3)Represents the current year change in estimated performance shares to reflect the attainment of performance goals for the awards that were granted in each of the years 2006 through 2010. On February 1, 2011, the Company, under the 2004 Stock Incentive Plan, granted 1,662,334 common stock awards in the form of restricted stock units, deferred stock and performance share awards to participating officers, non-employee directors and other key employees. The restricted stock units and deferred stock awards totaled 929,157 shares while the performance share awards totaled 733,177 shares. The fair value per share attributable to the common stock awards on the date of grant was $56.81.
The amount of compensation cost for awards subject to a service condition is based on the number of shares expected to be issued and is recognized over the time period for which service is to be provided (requisite service period). Awards granted to retiree-eligible employees or to employees who become retiree-eligible before an award's vesting date are considered to have met the requisite service condition. The compensation cost for awards subject to a performance condition is based upon the probable outcome of the performance condition, which on the grant date reflects an estimate of attaining 100% of the performance shares granted. The compensation cost reflects an estimated annual forfeiture rate from 3.5% to 5% over the requisite service period of the awards. That estimate is revised if subsequent information indicates that the actual number of instruments expected to vest is likely to differ from previous estimates. Compensation costs for awards are recognized on a straight-line basis over the requisite service period. For awards that have a graded vesting schedule, the compensation cost is recognized on a straight-line basis over the requisite service period for each separate vesting portion of the award as if the award was, in substance, multiple awards. The total compensation cost for all share-based incentive compensation awards recognized in earnings for the years ended December 31, 2010, 2009 and 2008 was $128 million, $127 million and $123 million, respectively. Included in these amounts are compensation cost adjustments of $10 million, $11 million and $6 million, for the years ended December 31, 2010, 2009 and 2008, respectively, that reflected the cost associated with the updated estimate of performance shares due to attaining certain performance levels from the date of the initial grant of the performance awards. The related tax benefits recognized in earnings were $44 million, $44 million and $42 million for the years ended December 31, 2010, 2009 and 2008, respectively.
Cash received from the exercise of employee stock options under share-based compensation plans totaled $408 million and $180 million in 2010 and 2009, respectively. The tax benefit realized for tax deductions from employee stock options exercised during 2010 and 2009 totaled $28 million and $17 million, respectively.
The total accumulated benefit obligation for the Company's defined benefit pension plans was $2.54 billion and $2.36 billion at December 31, 2010 and 2009, respectively. The Qualified Domestic Plan accounted for $2.37 billion and $2.19 billion of the total accumulated benefit obligation at December 31, 2010 and 2009, respectively, whereas the Nonqualified and Foreign Plans accounted for $0.17 billion of the total accumulated benefit obligation at both December 31, 2010 and 2009.
For pension plans with an accumulated benefit obligation in excess of plan assets, the aggregate projected benefit obligation was $2.56 billion and the aggregate accumulated benefit obligation was $2.53 billion at December 31, 2010. The fair value of plan assets for the above plans was $2.42 billion and $2.25 billion at December 31, 2010 and 2009, respectively.
The Company has discretion regarding whether to provide additional funding and when to provide such funding to its qualified pension plan. During 2010 and 2009, the Company voluntarily made contributions totaling $35 million and $260 million, respectively, to the qualified pension plan. The Company has not determined whether or not additional funding will be made during 2011. There is no required contribution to the qualified pension plan during 2011.
diversification of asset types, fund strategies and fund managers. The current target allocations for plan assets are 55% to 65% equity securities and 20% to 40% fixed income securities. Equity securities primarily include investments in large, medium and small-cap companies primarily located in the United States. Fixed income securities include corporate bonds of companies from diversified industries, mortgage-backed securities, U.S. Treasury securities and debt securities issued by foreign governments. Other investments include a hedge fund and two private equity funds that follow several different strategies.
Equity securities included 797,600 shares of the Company's common stock with a market value of $44 million at December 31, 2010. On January 28, 2011, the Company purchased these shares from the pension plan under the Company's share repurchase authorization for a total cost of approximately $45 million, the market value on that date.
The following tables present the level within the fair value hierarchy at which the financial assets of the Company's pension plans are measured on a recurring basis at December 31, 2010 and 2009.
The Company's overall investment strategy is to achieve a mix of approximately 35% to 65% of investments for long-term growth and 35% to 60% for near-term insurance payments with a wide diversification of asset types, fund strategies and fund managers. The current target allocations for plan assets are 0% to 10% equity securities and 20% to 60% fixed income securities, with the remainder allocated to short-term securities. Equity securities include an investment in a small-mid growth fund investing in companies primarily located in the United States. Fixed income securities include corporate bonds of companies from diversified industries, mortgage-backed securities and U.S. Treasuries.
The Company's other postretirement benefit plan had financial assets of $20 million at December 31, 2010 and 2009, which are measured at fair value on a recurring basis. The assets are
primarily short-term securities and corporate bonds, and categorized as level 2 in the fair value hierarchy.
Rent expense was $206 million, $211 million and $220 million in 2010, 2009 and 2008, respectively.
This section describes the major pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the Company or any of its subsidiaries is a party or to which any of the Company's properties is subject.
In March 2002, the plaintiffs in consolidated asbestos actions pending before a mass tort panel of judges in West Virginia state court amended their complaint to include TPC as a defendant, alleging that TPC and other insurers breached alleged duties to certain users of asbestos products. The plaintiffs seek damages, including punitive damages. Lawsuits seeking similar relief and raising similar allegations, primarily violations of purported common law duties to third parties, have also been asserted in various state courts against TPC and SPC. The claims asserted in these suits are collectively referred to as the Common Law Claims.
various state courts in Texas and Ohio, and enjoining certain attorneys from filing any further lawsuits against TPC based on similar allegations. Notwithstanding the injunction, additional common law claims were filed against TPC.
On March 22, 2010, the Second Circuit issued an opinion in which it found that the notice of the 1986 Orders provided to the remaining objector was insufficient to bar contribution claims by that objector against TPC. On April 5, 2010, TPC filed a Petition for Rehearing and Rehearing En Banc with the Second Circuit, requesting further review of its March 22, 2010 opinion, which was denied on May 25, 2010. On August 18, 2010, TPC filed a Petition for Writ of Certiorari in the United States Supreme Court seeking review of the Second Circuit's March 22, 2010 opinion, and a Petition for a Writ of Mandamus seeking an order from the Supreme Court requiring the Second Circuit to comply
The plaintiffs in the Statutory and Hawaii actions and the Common Law Claims actions filed Motions to Compel with the bankruptcy court on September 2, 2010 and September 3, 2010, respectively, arguing that all conditions precedent to the settlements have been met and seeking to require TPC to pay the settlement amounts. On September 30, 2010, TPC filed an Opposition to the plaintiffs' Motions to Compel on the grounds that the conditions precedent to the settlements, principally the requirement that all contribution claims be barred, have not been met in light of the Second Circuit's March 22, 2010 opinion. On December 16, 2010, the bankruptcy court granted the plaintiffs' motions and ruled that TPC was required to fund the settlements. On January 20, 2011, the bankruptcy court entered judgment in accordance with its December 16, 2010 ruling and ordered TPC to pay the settlement amounts plus prejudgment interest. On January 21, 2011, TPC filed an appeal with the U.S. District Court for the Southern District of New York from the bankruptcy court's January 20, 2011 judgment.
Broker Anti-Trust Litigation-In 2005, four putative class action lawsuits were brought against a number of insurance brokers and insurers, including the Company, by plaintiffs who allegedly purchased insurance products through one or more of the defendant brokers. The plaintiffs alleged that various insurance brokers conspired with each other and with various insurers, including the Company, to artificially inflate premiums, allocate brokerage customers and rig bids for insurance products offered to those customers. To the extent they were not originally filed there, the federal class actions were transferred to the U.S. District Court for the District of New Jersey and were consolidated for pre-trial proceedings with other class actions under the caption In re Insurance Brokerage Antitrust Litigation. On August 1, 2005, various plaintiffs, including the four named plaintiffs in the above-referenced class actions, filed an amended consolidated class action complaint naming various brokers and insurers, including the Company, on behalf of a putative nationwide class of policyholders. The
complaint included causes of action under the Sherman Act, the Racketeer Influenced and Corrupt Organizations Act (RICO), state common law and the laws of the various states prohibiting antitrust violations. The complaint sought monetary damages, including punitive damages and trebled damages, permanent injunctive relief, restitution, including disgorgement of profits, interest and costs, including attorneys' fees. All defendants moved to dismiss the complaint for failure to state a claim. After giving plaintiffs multiple opportunities to replead, the court dismissed the Sherman Act claims on August 31, 2007 and the RICO claims on September 28, 2007, both with prejudice, and declined to exercise supplemental jurisdiction over the state law claims. The plaintiffs appealed the district court's decisions to the U.S. Court of Appeals for the Third Circuit. On August 16, 2010, the Third Circuit affirmed the district court's dismissal of all Sherman Act and RICO claims against certain defendants, including the Company, except for Sherman Act and RICO claims involving the sale of excess casualty insurance through one defendant broker, as well as all state law claims, which they remanded to the district court for further proceedings. On October 1, 2010, defendants, including the Company, filed renewed motions to dismiss the remanded claims. The Company continues to believe that these claims are without merit and intends to defend them vigorously.
Additional individual actions have been brought in state and federal courts against the Company involving allegations similar to those in In re Insurance Brokerage Antitrust Litigation, and further actions may be brought. The Company believes that all of these lawsuits have no merit and intends to defend vigorously.
Other-In addition to those described above, the Company is involved in numerous lawsuits, not involving asbestos and environmental claims, arising mostly in the ordinary course of business operations, either as a liability insurer defending third-party claims brought against policyholders or as an insurer defending claims brought against it relating to coverage or the Company's business practices. In addition, from time to time, the Company is involved in proceedings addressing disputes with its reinsurers regarding the collection of amounts due under the Company's reinsurance agreements. While the ultimate resolution of these legal proceedings could be material to the Company's results of operations in a future period, in the opinion of the Company's management, none would likely have a material adverse effect on the Company's financial position or liquidity.
Investment Commitments-The Company has unfunded commitments to private equity limited partnerships and real estate partnerships in which it invests. These commitments totaled $1.26 billion and $1.32 billion at December 31, 2010 and 2009, respectively. Additionally, in November 2010, an indirect subsidiary of the Company entered into a definitive agreement to commence a joint venture with J. Malucelli Participações em Seguros e Resseguros S.A, a Brazilian company ("J. Malucelli"), through the acquisition of approximately 43% of J. Malucelli's common stock. J. Malucelli is currently the market leader in surety in Brazil based on market share. The purchase price for this acquisition will be R$625 million Brazilian Reais (the U.S. dollar equivalent of which will depend on the exchange rate at closing) plus an amount based on a Brazilian inter-bank lending rate (CDI) from January 1, 2011 through the closing date of the transaction. At December 31, 2010, R$625 million Brazilian Reais was equivalent to approximately $377 million in U.S. dollars. In order to reduce its exposure to a significant strengthening of the Brazilian Reais prior to the closing of the transaction, the Company entered into a foreign currency option contract on February 7, 2011 in the notional amount of R$635 million which expires on March 31, 2011. The joint venture transaction is subject to customary closing conditions and is expected to be finalized in the first half of 2011.
The Company has contingent obligations for guarantees related to letters of credit, issuance of debt securities, certain investments, third-party loans related to certain investments and various indemnifications, including those related to the sale of business entities. The Company also provides standard indemnifications to service providers in the normal course of business. The indemnification clauses are often standard contractual terms. Certain of these guarantees and indemnifications have no stated or notional amounts or limitation to the maximum potential future payments, and, accordingly, the Company is unable to develop an estimate of the maximum potential payments for such arrangements. At December 31, 2010, the maximum amount of the Company's obligation for guarantees of certain investments and third-party loans related to certain investments that are quantifiable was $84 million, approximately $40 million of which would be recoverable from a third party.
In the ordinary course of selling business entities to third parties, the Company has agreed to indemnify purchasers for losses arising out of breaches of representations and warranties with respect to the business entities being sold, covenants and obligations of the Company and/or its subsidiaries following the closing, and in certain cases obligations arising from undisclosed liabilities, adverse reserve development, imposition of additional taxes due to either a change in the tax law or an adverse interpretation of the tax law, or certain named litigation. Such indemnification provisions generally survive for periods ranging from two years following the applicable closing date to the expiration of the relevant statutes of limitations, although, in some cases, there may be other agreed upon term limitations or no term limitations. Certain of these contingent obligations are subject to deductibles which have to be incurred by the obligee before the Company is obligated to make payments. The maximum amount of the Company's contingent obligation for indemnifications related to the sale of business entities that are quantifiable was $1.34 billion at December 31, 2010, of which $12 million was recognized on the balance sheet at that date.
There were no significant noncash financing or investing activities during the years ended December 31, 2010, 2009 and 2008.