Underwriting income in 2001 has been reduced by net surety bond losses of $220.0 million ($143.0 million after-tax or $0.81 per share) related to the bankruptcy of Enron Corp. Underwriting income in 2002 and 2003 has been increased by reductions in net surety bond losses related to Enron of $88.0 million ($57.2 million after-tax or $0.33 per share) and $17.0 million ($11.1 million after-tax or $0.06 per share), respectively.
Underwriting income has been reduced by net costs of $635.0 million and other charges included costs of $10.0 million (in the aggregate, $420.0 million after-tax or $2.39 per share) related to the September 11 attack.
Federal and foreign income tax in 2002 included a $40.0 million ($0.23 per share) charge to establish a tax valuation allowance from not being able to recognize, for accounting purposes, certain U.S. tax benefits related to European losses. Federal and foreign income tax in 2003 included a $40.0 million ($0.22 per share) credit for the reversal of the tax valuation allowance established in 2002.
changes in interest rates, market credit spreads and the performance of the financial markets, generally and as they relate to credit risks assumed by our Chubb Financial Solutions unit in particular;
The following highlights do not address all of the matters covered in the other sections of Management’s Discussion and Analysis of Financial Condition and Results of Operations or contain all of the information that may be important to the Corporation’s shareholders or the investing public. This
summary should be read in conjunction with the other sections of Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Net income was $809 million in 2003 compared with $223 million in 2002 and $112 million in 2001.
The fundamentals of our property and casualty insurance business are strong. Premium growth was 22% in 2003 and 30% in 2002. Rate increases have been substantial in recent years, often with more favorable policy terms and conditions.
Results in 2001 were adversely affected by net costs of $645 million related to the September 11 attack.
Property and casualty investment income after taxes increased by 11% in 2003 compared with growth of 2% in 2002.
The non-insurance business of Chubb Financial Solutions (CFS) produced a loss before taxes of $127 million in 2003 compared with a loss of $70 million in 2002 and income of $9 million in 2001. As announced in April 2003, we are exiting this business and are running off the financial products portfolio of CFS. We reduced our aggregate notional exposure by $14 billion during 2003 to approximately $25 billion at year end.
We began expensing the cost of stock options in 2003, which resulted in a reduction in net income of $46 million.
As adjusted, property and casualty earnings in 2003 were significantly higher than in the prior two years due primarily to a substantial improvement in underwriting results. Earnings in 2003 also benefited from a significant increase in investment income.
We evaluate the underwriting results of our property and casualty insurance business in the aggregate and also for each of our three separate business units: personal insurance, commercial insurance and specialty insurance.
Statutory accounting principles differ in certain respects from generally accepted accounting principles (GAAP). Under statutory accounting principles applicable to property and casualty insurance companies, policy acquisition and other underwriting expenses are recognized immediately, not at the time premiums are earned. We use underwriting results determined in accordance with GAAP, among other measures, to assess the overall performance of the underwriting operations. To convert underwriting results to a GAAP basis, policy acquisition expenses are deferred and amortized over the period in which the related premiums are earned. Underwriting income (loss) determined in accordance with GAAP is defined as premiums earned less losses incurred and GAAP underwriting expenses incurred.
Net premiums written amounted to $11.1 billion in 2003, an increase of 22% over 2002. Net premiums written increased 30% in 2002 compared with 2001. Premiums written in 2001 included net reinsurance reinstatement premium revenue of $30 million related to the September 11 attack.
About 80% of our net premiums written are in the United States. Premium growth in the U.S. was 22% in 2003 and 31% in 2002. Substantial premium growth was also achieved outside the United States in 2003 and 2002. Reported non-U.S. premiums grew 25% in 2003 and 27% in 2002. In local currencies, such premiums grew 15% and 24% in 2003 and 2002, respectively.
Our property reinsurance program renews each April. The 2002 renewal of the property per risk treaty and property catastrophe treaties in the aggregate cost approximately $120 million more on an
annualized basis, with more restrictive terms, including terrorism exclusions. Our property per risk retention increased from $10 million to $15 million. Our catastrophe treaty for events in the United States was modified to increase our initial retention, to increase the reinsurance coverage at the top and to reduce our participation in certain layers of the program.
increased from $100 million to $150 million during 2002. Our initial retention is generally $25 million outside the United States.
September 11 Attack. The pre-tax costs of $645 million related to the September 11 attack had three components. First, in our insurance business, we incurred estimated net losses and loss expenses of $555 million plus reinsurance reinstatement costs of $50 million, for an aggregate cost of $605 million. Each of our underwriting segments was affected by the September 11 attack. However, the impact was by far the greatest on our financial institutions business. Second, in our reinsurance business written through Chubb Re, we incurred estimated net losses and loss expenses of $110 million and recognized reinstatement premium revenue of $80 million, for a net cost of $30 million. Finally, we recorded a $10 million charge, included in other charges, as our share of the losses publicly estimated by Hiscox plc, a U.K. insurer in which we had a 28% interest during 2001.
Net premiums from personal insurance, which represent 23% of the premiums written by our property and casualty subsidiaries, increased by 12% in 2003 compared with a 17% increase in 2002. In both years, premium growth occurred in all classes. Premium growth was particularly significant in our homeowners business due primarily to higher rates and increased insurance-to-value. Homeowners premiums were up 14% and 22% in 2003 and 2002, respectively, while the in-force policy count remained flat in 2003 after being up slightly in 2002.
Our personal insurance business produced modestly profitable underwriting results in 2003 and 2002 compared with slightly unprofitable results in 2001. Results in 2001 included net costs of $20 million related to the September 11 attack. The combined loss and expense ratios for the classes of business within the personal insurance segment, as reported and as adjusted to exclude the effects of the September 11 attack, were as follows:
Homeowners results were similarly unprofitable in 2003 and 2002 as higher catastrophe losses in 2003 were offset by a decrease in non-catastrophe losses and the impact of improved pricing. Results in 2003 benefited from a decline in fire and water damage losses. Results improved in 2002 compared with 2001. The improvement in 2002 was due to a decrease in the frequency of both catastrophe and non-catastrophe losses. Results in 2002 and 2001 were adversely affected by an increase in the severity of water damage claims, including those related to mold, particularly in Texas. Losses from catastrophes other than the September 11 attack represented 13.4 percentage points of the loss ratio for this class in 2003 compared with 2.9 percentage points in 2002 and 5.4 percentage points in 2001. Homeowners results were modestly profitable in Europe in 2003 compared with unprofitable results in 2002 and 2001. We are in the process of exiting our personal lines business in Continental Europe, with the exception of the ultra high net worth market segment.
Net premiums from commercial insurance, which represent 37% of our total writings, increased by 21% in 2003 compared with a 37% increase in 2002. The substantial premium growth in both years, which occurred in all segments of this business, was due in large part to significantly higher rates as well as an increase in our in-force policy count. Rates increased substantially in 2002 and 2003, although the level of rate increases in 2003 declined from 2002 levels as we experienced more competition in the U.S. marketplace across most lines of business. Despite this, retention levels have remained steady. New business accelerated toward the end of 2001. During 2002, we wrote more than two dollars of new business for every dollar of business we lost; during 2003, this ratio was about 1.7 to 1. The substantial growth in new business was produced with the same tightened underwriting discipline that existed over the past several years. We expect that rates will continue to rise but that the level of rate increases will continue to decline.
Our commercial insurance results were adversely affected by incurred losses of $250 million in 2003, $741 million in 2002 and $61 million in 2001 related to asbestos and toxic waste claims. Results in 2001 were also adversely affected by net costs of $103 million related to the September 11 attack. The combined loss and expense ratios for the classes of business within commercial insurance, as reported and as adjusted to exclude the effects of the asbestos and toxic waste losses and the September 11 attack, were as follows:
On an as adjusted basis, our commercial insurance business produced highly profitable results in 2003 and 2002 compared with unprofitable results in 2001. Results, as adjusted, have shown substantial improvement in each succeeding year. The improvement has been due in large part to the cumulative effect of price increases, better terms and conditions and more stringent risk selection in recent years.
Multiple peril results were highly profitable in 2003 compared with near breakeven results in 2002. The improved results were driven by the property component of this business where incurred losses were flat. Results in 2002 showed modest improvement over 2001 results, as adjusted, due to highly profitable overseas results. Losses from catastrophes other than the September 11 attack represented
3.0 percentage points of the loss ratio for this class in 2003 compared with 2.2 percentage points in 2002 and 3.0 percentage points in 2001.
Workers’ compensation results were profitable in each of the past three years. The strong results were due to higher rates as well as our disciplined risk selection during the past several years.
Property and marine results were highly profitable in 2003 and 2002 compared with highly unprofitable results in 2001. Results in 2003 and 2002 benefited from improved pricing, higher deductibles, better terms and conditions and a low number of severe losses. The strong results in 2003 were achieved despite a $25 million loss that resulted from an adverse arbitration decision rendered against an insurance pool in which we were formerly a 5.5% participant. The decision related to a fire that occurred in 1995. Results in 2001 were adversely affected by a high frequency of large losses, both in the United States and overseas. Losses from catastrophes other than the September 11 attack represented 6.3 percentage points of the loss ratio for this class in 2003 compared with 6.6 percentage points in 2002 and 5.4 percentage points in 2001.
The growth in 2002 and 2003 in executive protection and the professional liability component of our financial institutions business was primarily attributable to higher rates. In response to claim severity trends, we initiated a program in the latter half of 2001 to increase pricing and improve policy terms and to not renew business that did not meet our underwriting criteria. We have implemented tighter terms and conditions, including lower policy limits and higher deductibles. We have continued to reprofile our book of business, generating most of our new business from small and middle market customers. Rate increases moderated during the latter half of 2003 due to increased competition in the marketplace. In the fidelity and standard commercial components of our financial institutions business, rate increases have begun to moderate as well.
Our specialty insurance results in 2001 were adversely affected by net costs of $512 million related to the September 11 attack and Enron-related surety losses of $220 million. Results in 2002 and 2003 benefited from reductions in surety losses related to Enron of $88 million and $17 million, respectively. The combined loss and expense ratios for the classes of business within specialty insurance, as reported and as adjusted to exclude the effects of the September 11 attack and the Enron surety losses and related benefits, were as follows:
Other specialty results, as adjusted, were highly profitable in 2003 and 2002 compared with near breakeven results in 2001. As adjusted, our surety results were highly profitable in each of the past three years. Our reinsurance assumed business generated by Chubb Re and our accident business were both profitable in 2003 and 2002 compared with modestly unprofitable results in 2001.
A property and casualty subsidiary issued a reinsurance contract to an insurer who provides financial guarantees on debt obligations. At December 31, 2003, the amount of aggregate principal commitments related to this contract was approximately $350 million, net of reinsurance. These commitments expire by 2023.
The loss reserves related to asbestos and toxic waste claims, the September 11 attack and our Enron surety exposure are significant components of our total loss reserves, but they distort the growth trend in our loss reserves. Adjusted to exclude such loss reserves, our loss reserves, net of reinsurance recoverable, increased by $2,070 million or 19% in 2003 compared with $1,098 million or 11% in 2002.
Loss reserves for each of our business segments increased in 2002 and again in 2003. The increase was most significant in specialty insurance, due in large part to directors and officers and errors and omissions claim activity and the strong growth in our reinsurance assumed business. There was minimal loss reserve growth in commercial insurance in 2002, reflecting the exposure reductions over the several years prior to 2002.
We continually review and update our loss reserves. Based on all information currently available, we believe that the aggregate loss reserves of the property and casualty subsidiaries at December 31, 2003 were adequate to cover claims for losses that had occurred, including both those known to us and those yet to be reported. In establishing such reserves, we consider facts currently known and the present state of the law and coverage litigation. However, given the judicial decisions and legislative actions that have broadened the scope of coverage and expanded theories of liability in the past and the possibilities of similar interpretations in the future, particularly as they relate to asbestos claims and, to a lesser extent, toxic waste claims, additional liabilities may emerge in future periods for amounts in excess of carried reserves. Such increases in estimates could have a material adverse effect on the Corporation’s future operating results. However, management does not expect that any such increases would have a material effect on the Corporation’s consolidated financial condition or liquidity.
Because loss reserve estimates are subject to the outcome of future events, changes in estimates are unavoidable given that loss trends vary and time is required for changes in trends to be recognized and confirmed. As a result, the actual emergence of losses could vary, perhaps substantially, from the estimate of losses included in our financial statements, particularly when settlements may not occur until well into the future. Estimates are continually reviewed and updated as loss experience develops and new information becomes available. Any changes in estimates are reflected in operating results in the period in which the estimates are changed. Reserve changes that increase previous estimates of ultimate cost are referred to as unfavorable or adverse development or reserve strengthening. Reserve changes that decrease previous estimates of ultimate cost are referred to as favorable development or reserve releases.
During 2003, we experienced overall unfavorable development of $397 million on loss reserves established as of the previous year end. This compares with unfavorable one year development of $790 million in 2002 and favorable development of $196 million in 2001. Such development was reflected in operating results in these respective years.
The unfavorable development in 2003 was due primarily to two factors. First, we strengthened asbestos loss reserves by $250 million in the fourth quarter. Second, we experienced unfavorable development of about $140 million in our executive protection classes, principally directors and officers liability and errors and omissions liability, as adverse loss trends in recent accident years more than offset favorable loss experience in older accident years. The adverse development was due in large part to claims related to the corporate failures and allegations of management misconduct and accounting irregularities in recent years.
The unfavorable development in 2002 was due primarily to our strengthening asbestos and toxic waste loss reserves by $741 million during the year. In addition, we experienced unfavorable development of about $100 million in the homeowners class due to the increase in the severity of water damage and related mold claims. In the executive protection classes, the adverse loss trends in Europe and the United States in the more recent accident years more than offset favorable loss experience in the United States in older accident years, resulting in unfavorable development of about $50 million during 2002. Offsetting the unfavorable development somewhat was the $88 million reduction in surety loss reserves related to the Enron settlement.
In Item 1 of this report, we present an analysis of our consolidated loss reserve development on a calendar year basis for each of the ten years prior to 2003.
Our U.S. property and casualty subsidiaries are required to file annual statements with insurance regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities. These annual statements include an analysis of loss reserves, referred to as Schedule P, that presents accident year loss development information by line of business for the nine years prior to 2003. It is our intention to post the Schedule P for our combined U.S. property and casualty subsidiaries on our website as soon as it becomes available.
The process of establishing loss reserves is complex and imprecise as it must take into consideration many variables that are subject to the outcome of future events. As a result, subjective judgments as to our ultimate exposure to losses are an integral component of our loss reserving process.
We analyze loss reserves in two components: (1) reserves relating to all claims other than asbestos and toxic waste claims and (2) reserves relating to asbestos and toxic waste claims. Within the first component, we review each of the numerous classes of business as part of our overall analysis of loss reserves, taking into consideration the variety of trends that impact the ultimate settlement of claims in each particular class of business. Due to the multitude of such classes and the volume of detail for each, it would not be possible to provide complete quantitative actuarial claim data for all such classes, nor do we believe that such disclosure by class of business would be meaningful or useful to the reader.
Reserves Relating to Claims Other than Asbestos and Toxic Waste Claims. Our loss reserves include amounts related to short tail and long tail classes of business. Short tail classes consist principally of homeowners, commercial property and marine business. For these classes, the estimation of loss reserves is less complex because claims are generally reported and settled shortly after the loss occurs and the claims relate to tangible property.
Reserves Relating to Asbestos and Toxic Waste Claims. The uncertainties relating to asbestos and toxic waste claims on insurance policies written many years ago are exacerbated by inconsistent court decisions as well as judicial interpretations and legislative actions that in some cases have tended to broaden coverage beyond the original intent of such policies and in others have expanded theories of liability. The industry as a whole is engaged in extensive litigation over these coverage and liability issues and is thus confronted with a continuing uncertainty in its efforts to quantify these exposures.
To date, approximately 70 manufacturers and distributors of asbestos products have filed for bankruptcy protection as a result of asbestos liabilities. The rapid increase in both the frequency and severity of claims in recent years accelerated the pace at which these bankruptcies were filed.
The litigation environment has become increasingly adverse. More than half of lawsuits filed in recent years have been filed in five plaintiff oriented states, where significant verdicts historically have been rendered against commercial defendants.
The number of asbestos defendants in bankruptcy has increased, resulting in an increase in the number and cost of declaratory judgment lawsuits to resolve coverage disputes and to effect settlements in the bankruptcy courts.
Significant uncertainty remains as to our ultimate liability relating to asbestos related claims. This uncertainty is due to such factors as the long latency period between asbestos exposure and disease manifestation and the resulting potential for involvement of multiple policy periods for individual claims as well as the increase in the volume of claims by unimpaired plaintiffs and the increase in claims filed under the non-aggregate premises or operations section of general liability policies. There is also the possibility, however remote, of federal legislation that would address the asbestos problem.
Toxic Waste Reserves. Toxic waste claims relate primarily to pollution and related cleanup costs. Our insureds have two potential areas of exposure - hazardous waste dump sites and pollution at the insured site primarily from underground storage tanks and manufacturing processes.
In establishing our toxic waste reserves, we evaluate the exposure presented by each insured. As part of this evaluation, we consider the probable liability, available insurance coverage, past settlement values of similar exposures as well as facts that are unique to each insured.
The Terrorism Risk Insurance Act of 2002 (the Terrorism Act) was signed into law on November 26, 2002. The Terrorism Act established a temporary program under which the federal government will share the risk of loss from certain acts of international terrorism with the insurance industry. The program terminates on December 31, 2005. The Terrorism Act is applicable to almost all commercial lines of insurance. Insurance companies with direct commercial insurance exposure in the United States are required to participate in the program. Each insurer has a separate deductible in the event of an act of terrorism before federal assistance becomes available. The deductible is based on a percentage of direct commercial earned premiums from the previous calendar year. For 2004, that deductible is 10% of direct commercial premiums earned in 2003. For losses above the deductible, the federal government will pay for 90% of covered losses, while the insurer contributes 10%. There is a combined annual aggregate limit for the federal government and all insurers of $100 billion; above this amount, insurers are not liable for covered losses. For certain classes of business, such as workers’
On an after-tax basis, property and casualty investment income increased by 11% in 2003 and 2% in 2002. Management uses property and casualty investment income after-tax, a non-GAAP financial measure, to evaluate its investment performance because it reflects the impact of any change in the proportion of the investment portfolio invested in tax-exempt securities and is therefore more meaningful for analysis purposes than investment income before income tax.
Other charges in 2003 included expenses of $18 million related to the restructuring of our operations in Continental Europe. The restructuring costs consist primarily of severance costs related to branch closings and work force reductions.
Other charges in 2001 included goodwill amortization of approximately $20 million. The accounting for goodwill was changed in 2002 as discussed further under “Changes in Accounting Principles”. As a result, there was no goodwill amortization in 2003 and 2002.
Other charges in 2001 also included the $10 million charge for our share of the losses of Hiscox plc from the September 11 attack.
CFS’s non-insurance business was primarily structured credit derivatives, principally as a counterparty in portfolio credit default swap contracts. The Corporation guaranteed all of these obligations.
The fair value of our credit default swaps is subject to fluctuations arising from, among other factors, changes in credit spreads, the financial ratings of referenced asset-backed securities, actual credit events reducing subordination, credit correlation within a portfolio, anticipated recovery rates related to potential defaults and changes in interest rates. Changes in fair value are included in income in the period of the change. Thus, CFS’s results are subject to volatility, which has had a significant effect on the Corporation’s results of operations from period to period. The market risks associated with our obligations under portfolio credit default swaps are discussed under the Financial Products section of Quantitative and Qualitative Disclosures About Market Risk.
Revenues from the non-insurance business of CFS, primarily consisting of the change in fair value of derivatives contracts, were negative $62 million in 2003, negative $51 million in 2002 and positive $29 million in 2001. Revenues were negative in 2003 and 2002 due to the adverse impact of changes in fair value in both years and the impact in 2003 of the agreement to terminate the two asset-backed portfolio credit default swaps and replace them with a principal and interest guarantee.
At December 31, 2002, the notional amount of CFS’s credit default swaps was approximately $38.7 billion, of which $3.9 billion related to the two asset-backed swaps that had experienced deterioration in credit quality. In connection with our plan to exit the credit derivatives business, we have accelerated the reduction of our notional exposure.
In the fourth quarter of 2003, CFS paid $50 million to terminate the two asset-backed portfolio credit default swaps that had experienced deterioration in credit quality and simultaneously entered into a new contract that guarantees principal and interest obligations on only $2.3 billion of the original $3.9 billion notional amount. The Corporation has guaranteed CFS’s obligations under the new contract. CFS’s potential payment obligations have been extended from the original termination dates of 2007 and 2008 to the date when the last of the underlying obligations expire. Under the new agreement, CFS’s maximum payment obligation is limited to $500 million regardless of the amount of losses that might be incurred on the $2.3 billion of referenced securities. Moreover, if losses are incurred, CFS’s payment obligations are limited to an extended payment schedule under which no payment would be due until 2010 at the earliest.
The principal and interest guarantee is not a derivative contract. Therefore, the liability related to this contract will not be marked-to-market each period. Due to the nature of the guarantee, we will reduce this liability only upon either the expiration or settlement of the guarantee. If actual losses are incurred, a liability for the losses will be established, and a portion of the guarantee liability will be released. The amount released will depend on our evaluation of expected ultimate loss experience.
During 2003, CFS terminated its obligations under certain other portfolio credit default swaps. In addition, CFS entered into a portfolio credit default swap that exactly offsets the provisions of an in force credit default swap with a notional exposure of $500 million. These transactions had almost no impact on CFS’s results of operations.
As a result of these transactions, the notional amount of CFS’s credit default swaps was reduced to $24.7 billion at December 31, 2003. Our realistic loss exposure is a very small portion of the $24.7 billion notional amount due to several factors. Our position is senior to subordinated interests of $5.9 billion in the aggregate. Of the $5.9 billion of subordination, there were only $37 million of defaults through December 31, 2003, none of which has pierced the subordination limits of any of our contracts. In addition, using our internal ratings models, we estimate that the credit ratings of the individual portfolio credit default swaps at December 31, 2003 were either AAA or AA.
We regularly review our invested assets with a fair value below cost to determine if an other than temporary decline in value has occurred. In evaluating whether a decline in value of any investment is other than temporary, we consider various quantitative and qualitative factors including the length of time and the extent to which the fair value has been less than the cost, the financial condition and near term prospects of the issuer, whether the debtor is current on contractually obligated interest and principal payments, and our intent and ability to hold the investment for a period of time sufficient to allow us to recover our cost. If a decline in the fair value of an individual security is deemed to be other than temporary, the difference between cost and estimated fair value is charged to income as a realized investment loss. The fair value of the investment becomes its new cost basis.
In 2002, the Corporation issued $600 million of unsecured 4% senior notes due in 2007 and 24 million mandatorily exercisable warrants to purchase the Corporation’s common stock. The senior notes and warrants were issued together in the form of 7% equity units, each of which initially
Chubb Executive Risk Inc., a wholly owned subsidiary of the Corporation, has outstanding $75 million of unsecured 7 1/8% notes due in 2007. Executive Risk Capital Trust, wholly owned by Chubb Executive Risk, has outstanding $125 million of 8.675% capital securities. The sole assets of the Trust are debentures issued by Chubb Executive Risk. The capital securities are subject to mandatory redemption in 2027 upon repayment of the debentures. The capital securities are also subject to mandatory redemption under certain circumstances beginning in 2007. The Corporation has guaranteed the unsecured notes and the capital securities.
In July 1998, the Board of Directors authorized the repurchase of up to 12,500,000 shares of the Corporation’s common stock. In June 2001, the Board of Directors authorized the repurchase of up to an additional 16,000,000 shares. The 1998 authorization has no expiration; the 2001 authorization expired on June 30, 2003. As of December 31, 2003, 3,287,100 shares remained under the 1998 share repurchase authorization. The Corporation made no share repurchases during 2003. The Corporation repurchased 1,500,000 shares in open-market transactions in 2002 at a cost of $99 million and 7,971,600 shares in 2001 at a cost of $556 million. We do not anticipate that we will repurchase any shares of our common stock in 2004.
It is possible that positive or negative ratings actions may occur in the future. If our ratings were downgraded, the Corporation may incur higher borrowing costs and may have more limited means to access capital.
The following table provides our future payments due by period under contractual obligations as of December 31, 2003, aggregated by type of obligation.
The Corporation had certain commitments totaling $394 million at December 31, 2003 to fund limited partnership investments. These capital commitments can be called by the partnerships during the commitment period (on average, 1-4 years) to fund working capital needs or the purchase of new investments.
Liquidity is a measure of our ability to generate sufficient cash flows to meet the short and long term cash requirements of our business operations.
The declaration and payment of future dividends to the Corporation’s shareholders will be at the discretion of the Corporation’s Board of Directors and will depend upon many factors, including our operating results, financial condition, capital requirements and any regulatory constraints.
factors including underwriting results and our resulting tax position, regulatory requirements, fluctuations in interest rates and consideration of other market risks. Investment decisions are centrally managed by investment professionals based on guidelines established by management and approved by the boards of directors.
Our investment portfolio is primarily comprised of high quality bonds, principally tax-exempt, U.S. Treasury and government agency, mortgage-backed securities and corporate issues as well as foreign bonds that support our international operations. In addition, the portfolio includes equity securities held primarily with the objective of capital appreciation.
Fixed maturity securities that we have the ability and intent to hold to maturity are classified as held-to-maturity. The remaining fixed maturities, which may be sold prior to maturity to support our investment strategies, such as in response to changes in interest rates and the yield curve or to maximize after-tax returns, are classified as available-for-sale. Fixed maturities classified as held-to-maturity are carried at amortized cost while fixed maturities classified as available-for-sale are carried at market value. At December 31, 2003, 2% of the fixed maturity portfolio was classified as held-to-maturity compared with 5% at December 31, 2002 and 8% at December 31, 2001.
The unrealized market appreciation before tax of those fixed maturities carried at amortized cost was $35 million, $56 million and $64 million at December 31, 2003, 2002 and 2001, respectively. Such unrealized appreciation was not reflected in the consolidated financial statements.
period. Prior period financial statements were not restated. The adoption of the fair value method of accounting for stock-based employee compensation plans resulted in a reduction in net income of approximately $46 million in 2003.
In the fourth quarter of 2003, the Corporation adopted Financial Accounting Standards Board Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51. FIN 46 requires that a variable interest entity be consolidated by its primary beneficiary. As a result of its variable interests in a real estate partnership, our real estate subsidiary is the primary beneficiary of the partnership. We applied FIN 46 by retroactively restating prior year financial statements with a cumulative-effect adjustment as of the beginning of the first year restated. The effect of the restatement on previously reported December 31, 2000 shareholders’ equity was a decrease of $33.5 million. The effect on net income for 2001 and 2002, as previously reported, and on net income for 2003 was immaterial.
These changes in accounting are discussed further in Note (2) of the Notes to Consolidated Financial Statements.