Fire and Marine owns our corporate headquarters buildings, located at 385 Washington Street and 130 West Sixth Street, St. Paul, MN. These buildings are adjacent to one another and consist of approximately 1.1 million square feet of gross floor space. Fire and Marine also owns property in Woodbury, MN where its Administrative Services Building and off-site computer processing operations are located.
We own a building in London, England, which houses a portion of our U.K. operations. We retained ownership of another building in London subsequent to the sale of Minet Holdings plc to Aon Corporation in 1997, which is being leased to an outside party. In a transaction completed in March 2001, we sold a 50% interest in this building. In April 2003, we completed the sale of our 68-acre office campus in Baltimore, MD that we acquired as part of our merger with USF&G Corporation in 1998. As part of the sale agreement, we agreed to lease a portion of the office space on the campus until September 2004. In August 2003, we sold a parking ramp we owned in downtown St. Paul, MN for total proceeds of approximately $5 million.
Our operating subsidiaries rent or lease office space in most cities in which they operate.
· statements concerning claims made on surety bonds and the amounts we may ultimately pay with respect to these claims; and
· changes in the demand for, pricing of, or supply of our products;
· additional statement of operations charges if our loss reserves are insufficient;
· the impact of the September 11, 2001 terrorist attack and the ensuing global war on terrorism on the insurance industry in general, the implementation of the Terrorism Risk Insurance Act and potential further intervention in the insurance and reinsurance markets to make available insurance coverage for acts of terrorism;
· risks relating to our potential exposure to losses arising from acts of terrorism and sabotage;
· changes in domestic and foreign laws, tax laws and changes in the regulation of our businesses, which affect our profitability and our growth, including risks relating to possible Federal legislation regarding asbestos-related claims;
· the possibility of downgrades in our ratings significantly adversely affecting us, including, but not limited to, reducing the number of insurance policies we write, generally, or causing clients who require an insurer with a certain rating level to use higher-rated insurers or causing us to borrow at higher interest rates;
· unfavorable developments in environmental litigation involving policy coverage and liability issues;
· the risk that our subsidiaries may be unable to pay dividends to us in sufficient amounts to enable us to meet our obligations and pay future dividends;
· our dependence on the business provided to us by agents and brokers;
· risks related to our ability to efficiently and effectively integrate the Company’s businesses with the businesses of Travelers in a timely manner following the Proposed Merger, including those arising from the diversion of management resources to the integration process and potential business disruptions resulting from employee uncertainty and lack of focus;
· risks related to our ability to realize the cost savings and synergies that we expect to achieve in the Proposed Merger;
The company generates its return on capital primarily by taking in premiums, net of the expenses to generate those premiums as well as other expenses, and investing them, predominantly in fixed income securities, until the company pays out losses related to the insurance coverage provided. The primary factors impacting returns which are monitored regularly by the company include:
The company experienced its fifth consecutive year of generally increasing prices in 2003. These increases exceeded increases in our estimated loss trends, resulting in improved margins and cash flow. Average price increases during 2003 were 20% in our specialty commercial segment and 11% in our commercial lines segment. While the overall absolute level of price increases in 2003 slowed from 2002 levels, we expect overall price increases in 2004 to continue to exceed overall increases in estimated loss trends. However, the property and casualty insurance industry has historically been highly cyclical, and price competition in the years leading up to 1999 generally resulted in declining profitability in the industry. The company has implemented internal management reporting to monitor pricing and profitability, allowing the company to take actions to maximize profitability as pricing or premium adequacy trends change.
Investment returns are a major component of the company’s revenue and profitability. At December 31, 2003, nearly 90% of the company’s investment portfolio consisted of fixed income securities, securities on loan and short-term investments. Lower rates of return on new money invested in recent years have required higher premium levels to generate the same returns on capital. The Company believes that decreasing interest rates since the beginning of 2000 have been one of the factors causing property-liability insurance prices to increase. Likewise, increases in new money investment rates will increase investment income, but may result in increased price competition in the industry as companies could generate the same return on equity at lower premium levels. However, if new money investment rates increase, the value of our fixed income portfolio will decrease.
During 2003, the Company’s average new money investment rate was 4.5% for taxable bonds and 3.1% for tax-exempts, which reduced the average imbedded pre-tax yield in our long-term fixed income portfolio to 5.7% at December 31, 2003, down from 6.2% a year earlier.
Management estimates the amount it expects to pay claimants for insured losses and the cost of investigating, resolving and processing those claims. Given the inherent uncertainty in the reserving process and that many of the coverages we offer involve claims that may not ultimately be settled for many years after they are incurred, our estimates may be materially different from the amounts we ultimately pay or incur with respect to insured losses. If our estimates change, we make adjustments to our reserves and these adjustments are reflected in our income statements for the current period. One measure management uses to assess our profitability is our statutory combined ratio, which reflects the sum of the statutory loss ratio (incurred losses as a percentage of earned premium) and the statutory expense ratio described above. Our loss ratio improved from 79.9 in 2002 to 73.4 in 2003. Over the past two years, increasing pricing has significantly improved the combined ratio in our ongoing segments, which dropped from 108.6 in 2001 to 95.8 in 2002 and 91.7 in 2003.
Management believes that the Proposed Merger with Travelers Property Casualty Corp., announced on November 17, 2003, will be a transforming event for The St. Paul. Management believes that the Proposed Merger will create a premier property and casualty insurance company that will be well positioned for long-term success and the creation of superior shareholder value in the highly competitive property and casualty insurance industry. Management believes that the combined company will have significant product breadth and geographic reach and will be uniquely positioned as the property casualty insurer of choice for agents, brokers and customers across the United States. Management believes that The St. Paul will benefit from the combined financial resources, management and personnel of the two companies and will be better able to capitalize on opportunities in the insurance industry. In addition, management believes that the Proposed Merger will permit The St. Paul to derive significant advantages from the more efficient utilization of the assets, management and personnel of two companies. These significant opportunities do not come without risks. In particular, it will be a significant challenge to integrate the businesses of The St. Paul and Travelers in an efficient and effective manner. Furthermore, since the risks and uncertainties facing each of The St. Paul and Travelers differ, the results of operations, financial condition and liquidity of the combined company may be affected by risks and uncertainties different from those currently effecting each of The St. Paul and Travelers on a stand-alone basis. We currently expect the Proposed Merger to close in the second quarter of 2004.
The following table summarizes our results for each of the last three years.
Our pretax income from continuing operations of $836 million in 2003 was significantly higher than the 2002 total of $176 million, due to strong improvement in results produced by our ongoing property-liability underwriting segments. Our 2003 result included a total of $646 million in pretax loss provisions to strengthen prior-year loss reserves, of which $350 million was recorded in our runoff Health Care operation and $260 million was recorded in our other runoff operations. Our majority-owned asset management subsidiary, Nuveen Investments, Inc., achieved its ninth consecutive year of record results in 2003, driven by a significant increase in assets under management. In 2002, our pretax results included a $472 million loss provision, net of reinsurance, related to a settlement agreement we entered into with respect to the Western MacArthur asbestos litigation (described in more detail later in this discussion). Our pretax loss of $1.43 billion in 2001 was dominated by $941 million of pretax losses resulting from the September 11, 2001 terrorist attack and pretax provisions totaling $735 million to strengthen prior-year loss reserves in our Health Care business center. The 2003 and 2002 pretax losses in the “Parent company and other operations” category (which primarily consists of management, administrative and debt service expenses at the holding company level) were significantly higher than comparable loss in 2001 primarily due to an increase in distributions related to preferred securities issued in the fourth quarter of 2001.
As a result of implementing the provisions of a new accounting pronouncement in 2002 (discussed in more detail later in this discussion), we did not record any goodwill amortization expense in 2003 or 2002. In 2001, expenses related to goodwill totaled $114 million, which included $73 million of goodwill write-downs related to businesses we decided to exit. Amortization expense related to other intangible assets totaled $31 million in 2003, compared with $18 million in 2002 and $2 million in 2001.
2002 vs. 2001-Earned premiums in 2002 grew 1% over 2001, as the positive impacts of significant price increases in 2001 and 2002 and new business in many of our ongoing operations were largely offset by our withdrawal from several lines of business and the transfer of our ongoing reinsurance operations to Platinum. Earned premiums of $5.52 billion generated by our two ongoing property-liability underwriting segments in 2002 grew 24% over comparable 2001 earned premiums of $4.44 billion, whereas earned premiums produced by our runoff segment in 2002 declined 33% compared with 2001. Net investment income declined 4% from 2001, primarily due to reduced yields on new investments. Realized investment losses in 2002 were concentrated in our venture capital and equity portfolios and included losses originating from sales of investments, as well as impairment write-downs. The majority of our Other revenues consisted of risk management consulting fees and claim servicing fees in our insurance underwriting operations and foreign exchange gains and losses.
In the first quarter of 2003, we revised our property-liability insurance business segment reporting structure to reflect the manner in which those businesses are managed. Our property-liability underwriting operations consist of two segments constituting our ongoing operations (Specialty Commercial and
· The results of our participation in voluntary insurance pools, as well as loss development on business underwritten prior to 1980 (prior to 1988 for business acquired in our merger with USF&G Corporation in 1998), previously included in our Commercial Lines segment, are now included in the Other segment. In addition to our participation in voluntary insurance pools, this prior year business included the majority of our environmental and asbestos liability exposures. The oversight of these exposures is the responsibility of the same management team responsible for oversight of the other components of the Other segment.
In addition, in the fourth quarter of 2003, our Specialty Programs business center, previously reported in our Specialty Commercial segment, was moved to our Commercial Lines segment to more accurately reflect the manner in which this business is underwritten and managed. See the “Commercial Lines” segment discussion below for a further description of the Specialty Programs business center. All data for 2002 and 2001 included in this report were restated to be consistent with the changes made to our segment reporting structure in the first and fourth quarters of 2003.
In accordance with provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” since Surety & Construction, International & Lloyd’s, Health Care, and Reinsurance were reported as separate segments during 2002 and are considered to be of continuing significance in analyzing the results of our operations, we continue to separately present and discuss (as appropriate) in Note 3 to our consolidated financial statements and in Management’s Discussion and Analysis, information about those businesses in 2003 and the corresponding periods of 2002 and 2001.
The transaction resulted in a pretax gain of $29 million and an after-tax loss of $54 million in the year ended December 31, 2002. The after-tax loss was driven by the write-off of approximately $73 million in deferred tax assets associated with previously incurred losses related to St. Paul Re’s United Kingdom-based operations, as well as approximately $10 million in taxes associated with the pretax gain.
Our investment in Platinum is included in “Other investments.” The estimated income from our 14% proportionate equity ownership in Platinum is included in our statement of operations as a component of
“Net investment income.” Our option to purchase additional Platinum shares is carried at market value ($65 million and $61 million at December 31, 2003 and 2002, respectively), with changes in its fair value recorded as other realized gains or losses in our statement of operations. In 2003 and 2002, we recorded net pretax realized gains of $4 million and $7 million, respectively, related to this option.
In December 2003, we completed the sale of Camperdown UK Limited, one of our Lloyd’s corporate names and the vehicle for our participation on the 2003 and prior years of account, to Foltus Investments Limited. We recognized a $2 million pretax gain on this transaction. At Lloyd’s, we underwrite business through a single syndicate (“Syndicate 5000”) for which we provide 100% of the capital. In 2003, Fire and Marine entered into a 100% quota share reinsurance agreement directly with Syndicate 5000 that in effect transferred Syndicate 5000’s underwriting results for the 2003 year of account to Fire and Marine. In order to continue our ongoing operations at Lloyd’s, we activated two corporate names that will be used for 2004 and future years of account to underwrite Syndicate 5000 business.
In the third quarter of 2003, we sold our subsidiary Botswana Insurance Company Ltd. for total proceeds of $11 million, and recorded a pretax loss of less than $1 million.
In December 2002, we sold our insurance operations in Spain and Argentina and all of our operations in Mexico except our surety business. Proceeds from these sales totaled $29 million, and we recorded a pretax gain of $4 million related to the sales.
In March 2002, we completed our acquisition of London Guarantee Insurance Company (“London Guarantee,” now operating under the name “St. Paul Guarantee”), a specialty property-liability insurance company focused on providing surety products and management liability, bond, and professional indemnity products. The total cost of the acquisition was approximately $80 million, of which approximately $18
In December 2001, we purchased the right to seek to renew surety bond business previously underwritten by Fireman’s Fund Insurance Company (“Fireman’s Fund”), without assuming past liabilities. We paid Fireman’s Fund $10 million in consideration, which we recorded as an intangible asset and which we expect to amortize over nine years. Based on the volume of business renewed during 2002, we made a modest additional payment to Fireman’s Fund in the first quarter of 2003. That amount was also recorded as an intangible asset and is being amortized on an accelerated basis over the remaining life of the intangible asset.
In January 2001, we acquired the right to seek to renew a book of municipality insurance business from Penco, a program administrator for Willis North America Inc., for a total consideration of $3.5 million. The cost was recorded as an intangible asset and is being amortized over five years.
NONSTANDARD AUTO INSURANCE-In 1999, Prudential purchased our nonstandard auto insurance business marketed under the Victoria Financial and Titan Auto brands for $175 million in cash (net of a $25 million dividend paid by these operations to our property-liability insurance operations prior to closing). We recorded an estimated after-tax loss of $83 million on the sale, representing the estimated excess of carrying value of these entities at closing date over proceeds to be received from the sale, plus estimated income through the disposal date. This excess primarily consisted of goodwill. We recorded an after-tax loss on disposal of $9 million in 2000, primarily representing additional losses incurred through the disposal date in May, and an additional after-tax loss on disposal of $5 million in 2001, primarily representing tax adjustments made to the sale transaction.
The following table presents the components of discontinued operations reported in our consolidated statement of operations for each of the last three years.
Pursuant to the provisions of the settlement agreement, on November 22, 2002, the MacArthur Companies filed voluntary petitions under Chapter 11 of the Bankruptcy Code to permit the channeling of all current and future asbestos-related claims solely to a trust to be established pursuant to Section 524(g) of the Bankruptcy Code. Consummation of most elements of the settlement agreement was contingent upon bankruptcy court approval of the settlement agreement as part of a broader plan for the reorganization of the MacArthur Companies (the “Plan”). In January 2004, the U.S. Bankruptcy Court for the Northern District of California issued an order approving the settlement agreement with the MacArthur Companies and confirming the MacArthur Companies’ proposed plan of reorganization. We are awaiting final confirmation of the Bankruptcy Court order.
Our gross asbestos reserves at December 31, 2002 included $740 million of reserves related to Western MacArthur ($442 million of net reserves after consideration of $295 million of estimated net reinsurance recoverables and $3 million of bankruptcy fees recoverable from others). On January 16, 2003, pursuant to the terms of the settlement agreement, we paid the remaining $740 million settlement amount, plus interest, to the bankruptcy trustee in respect of this matter. As a result, at December 31, 2003 our gross asbestos reserves included no amount related to Western MacArthur.
From time to time asbestos reform bills have been introduced in the U.S. Congress. Some of these proposed laws seek to reduce or eliminate current personal injury litigation by replacing it with a statutory compensation program funded by contributions from a variety of sources which may include companies that formerly manufactured, distributed or sold asbestos products and insurers that underwrote certain asbestos risks. Many of these reform efforts would not cover asbestos property damage claims and other categories of asbestos exposure including future personal injury claims if the compensation fund ultimately proves insufficient. The prospects for the passage of an asbestos reform bill remain uncertain and the effect of any such future asbestos legislative reform on us would depend upon a variety of factors including the total size of any compensation fund, the portions allocated to various commercial groups and the formula for allocating contributions among insurers. If any asbestos litigation reform is enacted in the future, our contribution allocation could be significantly larger than our current asbestos reserve.
In 2001, we recorded estimated net pretax losses totaling $941 million related to the terrorist attack that occurred on September 11, 2001, consisting of the following components.
In 2002, we and other insurers obtained a summary judgment ruling that the World Trade Center property loss was a single occurrence. Certain insureds, including the World Trade Center’s leaseholder, appealed that ruling, asking the court to determine that the property loss constituted two separate occurrences rather than one. In September 2003, the U.S. Circuit Court of Appeals for the Second Circuit ruled that under terms of the policy form we used to underwrite property coverage for the World Trade Center, the terrorist attack constituted one occurrence. Additionally, through separate litigation, the aviation losses could be deemed four separate events rather than three, for purposes of insurance and reinsurance coverage. Even if the courts ultimately rule against us regarding the number of occurrences or events, we believe the additional amount of estimated after-tax losses, net of reinsurance, that we would record would not be material to our results of operations.
The (benefits) detriments on our business segments related to the terrorist attack for each year in the three-year period ended December 31, 2003 are shown in the following table.
Through December 31, 2003, we paid a total of $512 million in net losses related to the terrorist attack since it occurred, including $205 million during the year ended December 31, 2003.
Refer to Item 3 of this report for a discussion of the status of certain litigation matters involving The St. Paul.
We have entered into certain off-balance-sheet arrangements in the course of conducting our insurance operations, and from the sale of businesses. These arrangements are typically related to transactions involving guarantees, derivative instruments, or variable interest entities. We have disclosed the effects of these arrangements in our footnotes to the consolidated financial statements, specifically Notes 7, 10, 12 and 16 included in Item 8 of this report. Management does not believe that these arrangements have had, or are reasonably likely to have, a material future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
The St. Paul Companies, Inc. is a holding company with subsidiaries operating in the property-liability insurance industry and the asset management industry. We combine our financial statements with those of our subsidiaries and present them on a consolidated basis in accordance with United States generally accepted accounting principles. Our significant accounting policies are set forth in Note 1 to our consolidated financial statements. The following is a summary of the critical accounting policies related to accounting estimates that 1) require us to make assumptions about highly uncertain matters and 2) could materially impact our consolidated financial statements if we made different assumptions. After the Proposed Merger, management of the combined company will make decisions regarding the integration of claims handling practices, actuarial practices and other operational procedures. These decisions may impact management’s estimate of insurance loss and loss adjustment expense reserves.
Adjustments to previously estimated reserves, both positive and negative, are reflected in our financial results in the periods in which they are made, and are referred to as prior period development. Because of the high level of uncertainty involved in these estimates, revisions to our estimated reserves could have a material impact on our results of operations in the period recognized, and ultimate actual payments for claims and LAE could turn out to be significantly different from our estimates.
Our historical methodology (through first quarter 2002) for reviewing the adequacy of environmental and asbestos reserves utilized a survival ratio metric, which considered ending reserves in relation to calendar year paid losses. When the environmental reserve analyses were completed in the second quarter of 2002, we supplemented our survival ratio diagnostics with the detailed additional analyses referred to above, and concluded that our environmental reserves were redundant by approximately $150 million. Based on our additional analyses, we released approximately $150 million of environmental reserves in the second quarter of 2002. Had we continued to rely solely on our analysis of survival ratio, we would have recorded no adjustment to our environmental reserves through the six months ended June 30, 2002.
Our reported written premiums, earned premiums and losses and LAE reflect the net effects of assumed and ceded reinsurance. Premiums are recorded at the inception of each policy, based on information received from ceding companies and their brokers. For excess-of-loss contracts, the amount of premium is usually contractually documented at inception, and no management judgment is necessary in accounting for this. Premiums are earned on a pro rata basis over the coverage period. For proportional treaties, the amount of premium is normally estimated at inception by the ceding company. We account for such premium using the initial estimates, and adjust them once a sufficient period for actual premium reporting has elapsed. Reinstatement and additional premiums are written at the time a loss event occurs where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms. Reinstatement premiums are the premiums charged for the restoration of the reinsurance limit of a catastrophe contract to its full amount after payment by the reinsurer of losses as a result of an occurrence. These premiums relate to the future coverage obtained during the remainder of the initial policy term, and are earned over the remaining policy term. Additional premiums are premiums charged after coverage has expired that are related to experience during the policy term, which are earned immediately.
We estimate and record an allowance for reinsurance amounts that may not be collectible, due to credit issues, disputes over coverage, or other considerations.
We continually monitor the difference between our cost and the estimated fair value of investments, which involves uncertainty as to whether declines in value are temporary in nature. If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in our common shareholders’ equity. If we believe the decline is “other than temporary,” we write down the carrying value of the investment and record a realized loss on our statement of operations. Our assessment of a decline in value includes our current judgment as to the financial position and future prospects of the entity that issued the investment security. If that judgment changes in the future, we may ultimately record a realized loss after having originally concluded that the decline in value was temporary. The following
In our venture capital portfolio, the sale of a large portion of one of our investment holdings generated a pretax gain of $171 million in 2003, which was largely offset by impairment realized losses totaling $143 million related to 38 of our investment holdings. Fourteen of those holdings were impaired due to a merger or sale at a value less than our cost. Eleven holdings experienced fundamental economic deterioration (characterized by gross margins being less than expected, product pricing not meeting initial projections due to market conditions, and greater than expected manufacturing expenses). Six holdings
were written down because the entities’ progress was substantially less than planned and additional financing was required at values less than our cost. An additional six holdings were impaired due to cessation of operations of the entity. Finally, one holding was impaired because market demand for its product was less than expected.
Realized losses in our venture capital portfolio in 2002 included $56 million of losses resulting from the sale of the majority of our partnership investment holdings, and impairment write-downs in 25 of our holdings totaling $122 million. These holdings were impaired for the same general reasons noted above for the 2003 impairments: seven holdings were impaired because market demand for their products was less than expected; seven holdings were written down because the entities’ progress was less than planned and additional financing would be required; five holdings were impaired due to fundamental economic deterioration (as defined above); four holdings were impaired due to a merger or sale at less than our cost; and two holdings were impaired due to cessation of operations.
Our investment portfolio also includes non-publicly traded securities, the vast majority of which are held in our venture capital and real estate portfolios. Our venture capital investments represent ownership interests in small- to medium-sized companies, which are carried at estimated fair value. Fair values are based on an estimate determined by an internal valuation committee for securities for which there is no public market. The internal valuation committee reviews such factors as recent financings, operating results, balance sheet stability, growth, and other business and market sector fundamental statistics in estimating fair values of specific investments. For our real estate joint ventures, we use the equity method of accounting, meaning that we carry these investments at cost, adjusted for our share of earnings or losses, and reduced by cash distributions from the partnerships and valuation adjustments. Due to time constraints in obtaining financial results from the partnerships, the results of these operations are recorded
on a one-month lag. If events occur during the lag period which are material to our consolidated results, the impact is included in current period results.
· the degree to which an issuer is current or in arrears in making principal and interest payments on the debt securities in question;
· the issuer’s fixed-charge ratio at the date of acquisition and date of evaluation;
Equities-On a monthly basis, these investments are reviewed by portfolio managers for impairment. In general, the managers focus their attention on those equity securities whose market value was less than 80% of their cost for six consecutive months. Factors considered in evaluating potential impairment include the following.
· the relationship of market prices per share to book value per share at date of acquisition and date of evaluation;
· the price-earnings ratio at the time of acquisition and date of evaluation;
· our ability and intent to hold the security for a period of time sufficient to allow for recovery in the market value;
· the financial condition and near-term prospects of the issuer, including any specific events that may influence the issuer’s operations;
· whether or not the issuer’s progress has been substantially less than expected;
· whether or not the valuations have declined significantly in the entity’s market sector;
The size of our investment portfolio allows our portfolio managers a degree of flexibility in determining which individual investments should be sold to achieve our primary investment goals of assuring our ability to meet our commitments to policyholders and other creditors and maximizing our investment returns. In order to meet the objective of maintaining a flexible portfolio that can achieve these goals, our fixed income and equity portfolios are classified as “available-for-sale.” We continually evaluate these portfolios, and our purchases and sales of investments are based on our cash requirements, the characteristics of our insurance liabilities, and current market conditions. At the time we determine an “other than temporary” impairment in the value of a particular investment to have occurred, we consider the current facts and circumstances and make a decision to either record a write-down in the carrying value of the security or sell the security; in either case, recognizing a realized loss.
impairment can occur in a brief period of time (e.g., the entity has been unsuccessful in securing additional financing, other investors decide to withdraw their support, complications arise in the product development process, etc.), and decisions are made at that point in time, based on the specific facts and circumstances, with respect to a recognition of “other than temporary” impairment, or sale of the investment.
SFAS No. 141-In 2002, we adopted the provisions of SFAS No. 141, “Business Combinations,” which established financial accounting and reporting standards for business combinations. (Nuveen Investments had applied the relevant provisions of this statement to its 2001 acquisition of Symphony Asset Management LLC). The statement requires all business combinations initiated subsequent to June 30, 2001 to be accounted for under the purchase method of accounting. In addition, this statement required that intangible assets that can be identified and meet certain criteria be recognized as assets apart from goodwill.
SFAS No. 144-During 2002, we also implemented the provisions of SFAS No. 144, “Accounting for Impairment of Long-Lived Assets”. As a result of implementation, we monitor the recoverability of the value of our long-lived assets to be held and used based on our estimate of the future cash flows (undiscounted and without interest charges) expected to result from the use of each asset and its eventual disposition considering any events or changes in circumstances which indicate that the carrying value of an asset may not be recoverable. We monitor the value of our long-lived assets to be disposed of and report them at the lower of carrying value or fair value less our estimated cost to sell. We had no impairment adjustments related to our long-lived assets in 2002.
the measurement of those instruments at fair value. We have limited involvement with derivative instruments, primarily for purposes of hedging against fluctuations in market indices, foreign currency exchange rates and interest rates. We also have entered into a variety of other financial instruments considered to be derivatives, but which are not designated as hedges, that we utilize to minimize the potential impact of market movements in certain investment portfolios. Our adoption of SFAS No 133, as amended, did not have a material impact on our financial position or results of continuing operations.
In the first quarter of 2003, we eliminated the one-quarter reporting lag for our underwriting operations at Lloyd’s to coincide with the timing of reporting for all of our other international operations. As a result, our consolidated results for 2003 included the results of those operations for the fourth quarter of 2002 and all quarters of 2003. The incremental impact on our property-liability operations of eliminating the reporting lag, consisting of the results of these operations for the three months ended December 31, 2003, was as follows.
In 2003, we reclassified certain commission expenses related to our operations at Lloyd’s. In prior years, we determined commission expense based on premiums reported by the Lloyd’s market (net of commissions) using an estimated average commission rate. Until recently, gross premiums (prior to reduction for commissions) were not readily available from the Lloyd’s market. In 2003, we began recording actual commission expense for our Lloyd’s business. We reclassified prior period results to record actual commission expense on a basis consistent with that implemented in 2003. There was no impact to net income or shareholders’ equity as previously reported for any prior periods, because the reclassification had the impact of increasing previously reported premiums and commission expense in equal and offsetting amounts. For the year ended December 31, 2003, this reclassification had the impact of increasing both net earned premiums and policy acquisition costs by $81 million compared with what would have been recorded under our prior method of estimation. In addition, net written premiums increased by $116 million in 2003 (a portion of which was due to the elimination of the one-quarter reporting lag). For the year ended December 31, 2002, the impact was an increase to both net earned premiums and policy acquisition costs of $112 million and an increase to net written premiums of $91 million. For the year ended December 31, 2001, the impact was an increase to both net earned premiums and policy acquisition costs of $112 million and an increase to net written premiums of $132 million.
* Statutory ratios are not meaningful in a runoff environment because the Company has generally ceased underwriting new business in these operations.
In discussions that follow, we sometimes use the term “prior-year loss development,” which refers to the income statement impact of changes in the provision for losses and LAE in a given year for claims incurred in periods prior to the year of the income statement impact. Similarly, we sometimes refer to “current-year loss development” or “current accident year loss activity,” which refers to the income statement impact of recording the provision for losses and LAE in a given year for losses incurred in that year.
Net written premium volume of $215 million in our runoff segment in 2003 consisted primarily of prior-year premium adjustments in our reinsurance operations and reporting endorsements (as defined in the “Health Care” section of this report) in our Health Care operation. In our runoff segment, 2002 premiums of $1.21 billion were 60% below the 2001 total of $3.03 billion, reflecting our decision at the end of 2001 to exit those lines of business.
The strong improvement in underwriting results in our ongoing segments in both 2003 and 2002 reflected the impact of significant price increases over the last several years and the success of our efforts to improve the quality of our book of business. Our ongoing segments’ underwriting results in 2001 included $279 million of losses related to the September 11, 2001 terrorist attack.
Catastrophe losses. Effective January 1, 2003, we changed our disclosure regarding catastrophe losses. We no longer classify all losses from Insurance Services Office (ISO)-defined catastrophes as
We consider our Surety and Construction business centers to be specialty operations, because each business requires specialized underwriting, risk management and claim expertise. Our Surety business center underwrites surety bonds, which are agreements under which one party (the surety) guarantees to another party (the owner or obligee) that a third party (the contractor or principal) will perform in accordance with contractual obligations. For Contract Surety, we provide bid, performance and payment bonds, to a broad spectrum of clients specializing in general contracting, highway and bridge construction, asphalt paving, underground and pipeline construction, manufacturing, civil and heavy engineering, and mechanical and electrical construction. Bid bonds provide financial assurance that the bid has been submitted in good faith and that the contractor intends to enter into the contract at the price bid and provide the required performance and payment bonds. Performance bonds require us to fulfill the contractor’s obligations to the obligee should the contractor fail to perform under the contract. Payment bonds guarantee that the contractor will pay certain subcontractor, labor and material bills associated with a project. For Commercial Surety, we currently offer license and permit bonds, reclamation bonds, fiduciary bonds, court bonds, public official bonds, indemnity bonds, workers’ compensation self-insurer bonds, transfer agent indemnity bonds, depository bonds, and other miscellaneous bonds. In addition to its U.S. operations, our Surety business center includes our Mexican subsidiary, Afianzadora Insurgentes, the largest surety bond underwriter in Mexico, and our Canadian operation St. Paul Guarantee, the largest surety bond underwriter in Canada. In total, based on 2002 premium volume, our surety operations are the largest in North America. The Construction business center offers a variety of products and services, including traditional insurance and risk management solutions, to a broad range of contractors and parties responsible for construction projects.
Our International & Lloyd’s operation consists of the following components: our ongoing operations at Lloyd’s, and our ongoing specialty commercial operations outside of the United States, including our Global Accounts business center (collectively referred to hereafter as “international specialties”). Through a single syndicate at Lloyd’s (for which we provide 100% of the capital), we underwrite insurance in four
The following table summarizes results for this segment for the last three years. In accordance with provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” since our Surety and Construction business centers were combined and reported as a separate segment in 2002, and our International & Lloyd’s operations were reported as a separate segment in 2002, we continue to separately present and discuss their results for each of the years in the three-year period ended December 31, 2003 because they are considered to be of continuing significance in analyzing the results of our operations.
Virtually all business centers in the Specialty category contributed to the $182 million increase in underwriting profitability in 2003. The most notable improvements over 2002 were achieved by the Technology business center, with a $99 million increase in underwriting profit, and Financial & Professional Services, with a $39 million increase in underwriting profit. The Technology result in 2003 included $74 million of favorable prior-year loss development. Improved underwriting discipline with respect to risk selection, significant price increases in recent years and the addition of profitable new business through acquisitions have contributed to increased profitability in the Specialty category.
The success of our underwriting and pricing actions throughout this category were reflected in the $188 million improvement in profitability over 2001. Underwriting profits in Financial & Professional Services in 2002 were $74 million higher than in 2001. Personal Catastrophe Risk achieved a $37 million increase in profitability over 2001. All of our operations in the Specialty category benefited in 2002 from strong price increases and the relative lack of catastrophe losses. Underwriting results in 2001 included $51 million of losses related to the September 11, 2001 terrorist attack.
2003 vs. 2002-Net written premium volume of $1.33 billion in 2003 included $64 million of incremental premiums from the elimination of the one-quarter reporting lag at our operations at Lloyd’s (the remaining $3 million of incremental premiums described earlier in this discussion were recorded in our runoff Other segment). Excluding that additional $64 million, premium volume in 2003 of $1.27 billion was still 44% higher than in 2002. We experienced strong growth in our operations at Lloyd’s due to price increases, new business, favorable foreign currency exchange impacts and our increased participation in Lloyd’s following the consolidation of most of our Lloyd’s operations into one wholly-owned syndicate in 2003. Our total Lloyd’s premium volume in 2003 was $705 million (including the impact of the elimination of the one quarter reporting lag), compared with $398 million in 2002. In our international specialty operations, premium volume of $627 million was 30% higher than comparable 2002 premiums of $483
2002 vs. 2001-At Lloyd’s, 2002 premium volume of $398 million grew 24% over comparable 2001 premiums of $320 million, primarily driven by strong price increases and new business in certain classes of our Personal Lines business. In addition, Aviation premiums increased significantly due to our increased participation in that coverage in 2002. In our international specialty operations, premium volume of $483 million was 22% higher than the 2001 total of $397 million, driven by price increases and new business throughout these operations. The 2001 total included approximately $44 million of incremental premiums from the elimination of the one-quarter reporting lag.
Our international specialty operations and our operations at Lloyd’s both contributed to the $291 million improvement in underwriting results in 2002 compared with 2001. Price increases and the absence of significant weather-related losses were factors in the improvement over 2001. Underwriting results in 2001 included $90 million of losses related to the September 11, 2001 terrorist attack.
The Surety underwriting loss totaled $168 million in 2003, compared with an underwriting loss of $111 million in 2002. Surety’s 2003 underwriting loss included an $59 million pretax loss provision (net of reinsurance) related to one of our accounts that was in bankruptcy and unable to perform its bonded obligations. In April 2003, a bankruptcy court approved the sale of substantially all of the assets of the account. Following that approval, we received claim notices with respect to approximately $120 million of bonds securing certain workers’ compensation and retiree health benefit obligations of the account. We originally recorded a net pretax loss provision of $89 million when the claim notices were received and determined to be valid. In the fourth quarter of 2003, we re-estimated the amount of reinsurance recoverable related to that pretax loss, and recorded a $27 million reduction in our net loss. Conversely, in the fourth quarter of 2003, we recorded a $27 million provision to strengthen our Surety operation’s prior-year loss reserves, primarily related to a re-estimation of reinsurance recoverable related to losses incurred in 2002 associated with Enron Corporation’s bankruptcy. The 2002 Surety underwriting loss included a $34 million loss provision recorded after a judicial decision regarding surety bonds issued in connection with the construction of two large Brazilian oil rigs.
The Construction underwriting profit of $7 million in 2003 represented a significant improvement over the 2002 underwriting loss of $110 million, which included significant charges to strengthen prior-year reserves, as discussed in more detail below. The improvement over 2002 reflected the impact of significant price increases and our efforts to improve the quality of our book of business through the nonrenewal of underperforming accounts and the selective addition of new business.
We continue with our intention to exit the segments of the commercial surety market discussed above by ceasing to write new business and, where possible, terminating the outstanding bonds. Since October 2000, when we made a strategic decision to significantly reduce the exposures in these segments, our total commercial surety gross open bond exposure has decreased by over 56% as of December 31, 2003. We will continue to be a market for traditional commercial surety business, which includes low-limit business such as license and permit, probate, public official, and customs bonds.
In the contract surety business, creditworthiness is a primary underwriting consideration and the underwriting process involves a number of factors, including consideration of a contractor’s financial condition, business prospects, experience and management. The risk in respect of a contract surety bond changes over time. Such risk tends to decrease as the related construction project is completed, but may increase to the extent the financial condition of the contractor deteriorates or difficulties arise during the course of the project. Losses in the contract surety business can occur as a result of a contractor’s failure to complete its bonded obligations in accordance with the contract terms. Such losses, if any, would be estimated by estimating the cost to complete the remaining work (which may include amounts advanced to the contractor by the surety) and the contractor’s unpaid bills, offset by monies due to the contractor, reinsurance and the estimated net realizable value of collateral. While our contract surety business typically has not been characterized by high severity losses, it is possible, given the current economic climate, that significant losses could occur.
under a bond, we and any other co-surety or co-sureties on the bond typically are jointly and severally liable for such obligations. As a result, our losses could significantly increase to the extent such an event or events occur.
If the contractor were to fail to complete its bonded projects, we estimate that our aggregate additional loss, net of estimated collateral, reinsurance recoveries and participation by co-sureties (one of which has experienced ratings downgrades and is in runoff), would likely not exceed $75 million on an after-tax basis, assuming a 35% statutory tax rate. Given the uncertainties relating to the contractor’s business and other factors, there is no assurance that our estimate and our potential exposure will not increase.
Our analysis of trends for our general liability coverages in 2002 revealed case reserve strengthening occurring throughout the year. In addition, actual loss development during the year continued to exceed our expectations. The average paid closed claim trend had exceeded the average case reserve trend in the recent development. The average outstanding case reserve increased from $54,000 at year-end 2001 to $66,000 at year-end 2002. The average paid claim increased from $18,000 at year-end 2001 to $28,000 at year-end 2002. While the average paid claim was still below the average case reserve, this development in the data caused us to revise our trends and increase our estimate of ultimate losses. We increased our estimate of required loss reserves and recorded a $93 million increase to loss reserves. However, no changes were made to any other underlying assumptions.
The remaining reserve charge of $20 million related to workers’ compensation coverages (with beginning 2002 reserves of $363 million), primarily from the 2001 accident year. This charge resulted from a comprehensive claim review which focused on, among other data, a better estimate of our life-time benefit obligations. As a result of this review, we increased the number of claims identified as receiving life-time benefits and, accordingly, increased the related loss reserves. No changes were made to our underlying assumptions.
Surety’s 2002 underwriting loss was $111 million, compared with a loss of $4 million in 2001. The 2002 results reflected prior-year reserve charges of $104 million, which included $34 million related to the judgment regarding the Petrobras oil rig construction related to a 1996 incident, and $7 million for the settlement of litigation related to surety contracts issued on behalf of Enron Corporation related to a 2001 reported incident. Surety’s underwriting results in 2002 were also negatively impacted by reinstatement premiums paid for contract surety reinsurance, which reduced our net earned premiums, as well as an increase in losses in our contract surety business where we have experienced a higher than normal level of loss frequency.
In addition to the Petrobras and Enron events referred to above, we experienced an increase in the frequency of losses in 2002, with much of this increase being tied to the economic downturn in North America. Included in the $104 million of prior-year development for 2002 was a fourth-quarter provision totaling $63 million in our domestic surety operations as detailed in the following table. The entire Surety business center prior year reserve charge was driven by development on specific claims. Since surety losses are not recognized until the period a claim is filed, no changes were made to assumptions. The insurance
The Commercial Lines segment includes our Small Commercial, Middle Market Commercial and Property Solutions business centers, as well as the results of our limited involvement in involuntary insurance pools. The Small Commercial business center services commercial firms that typically have between one and fifty employees through its proprietary St. Paul Mainstreet(SM) and St. Paul Advantage(SM) products, with a particular focus on offices, wholesalers, retailers, artisan contractors and other service risks. The Middle Market Commercial business center offers comprehensive insurance coverages for a wide variety of manufacturing, wholesale, service and retail exposures, as well as programs for selected industries that are national in scope and have similar risk characteristics such as franchises and associations. The majority of these programs were formerly classified as a separate “Specialty Programs” business center in our Specialty Commercial segment but were reclassified in 2003 to our Middle Market Commercial business center in the Commercial Lines segment to more accurately reflect the manner in which this business is underwritten and managed. This business center also offers loss-sensitive casualty programs, including significant deductible and self-insured retention options, for the higher end of the middle market sector. The Property Solutions business center combines our Large Accounts Property business with the commercial portion of our catastrophe risk business and allows us to take a unified approach to large property risks.
2003 vs. 2002-The 26% increase in net written premium volume in 2003 over 2002 was driven by a combination of higher customer retention, continued price increases, and significant new business generated by our acquisition of the right to renew certain business previously underwritten by Kemper Insurance Companies (described in more detail earlier in this discussion). After several years of significant
price increases and selective re-underwriting of our book of business in this segment, our focus in 2003 was on retaining the quality new business developed in recent years. Although the pace of price increases began to slow in 2003, continued favorable market conditions and our strong presence in the marketplace provided us with the opportunity to achieve further price increases, where appropriate. Price increases across the entire segment averaged 11% for the year. Throughout the Commercial Lines segment in 2003, we continued to nonrenew underperforming classes of business and utilize our distribution network to capitalize on new business opportunities. The Kemper renewal rights transaction provided an influx of quality exposures that augmented the solid base of business we have built in recent years.
The following table summarizes key financial data for each of the last three years in this segment. The table excludes statutory ratios, which are not meaningful in a runoff environment because the Company has generally ceased underwriting new business in these operations.
2003 vs. 2002-Written premiums in 2003 primarily consisted of extended reporting endorsements and a small amount of professional liability coverage for other professionals such as dentists, nurse anesthetists, and other healthcare professionals who are not physicians or surgeons. These “Other Professional” policies were part of three-year policies that we had committed to prior to our exit from the Health Care lines of business in 2001. Additionally, we are required to offer reporting endorsements to claims-made policy holders at the time their policies are not renewed. These endorsements cover losses that occurred in prior periods that have not yet been reported. Unlike typical policies, premiums on these endorsements are fully earned, and the expected losses are fully reserved, at the time the endorsement is written. The vast majority of reporting endorsements underwritten in 2003 pertained to physicians’ and surgeons’ liability coverage.
The 2002 underwriting loss included $85 million in provisions to increase net prior accident year loss reserves, comprised specifically of a $97 million charge in the second quarter of the year, and reductions totaling $12 million throughout the year resulting primarily from reinsurance contract commutations. The majority of remaining losses in 2002 consisted of current-year loss provisions related to reporting endorsements. Details regarding the $97 million prior-year loss provision recorded in the second quarter of 2002 are included in the following table.
Analysis of Loss Provisions Recorded. In the years ended December 31, 2003, 2002 and 2001, we recorded net provisions of $350 million, $85 million and $735 million, respectively, to strengthen prior accident year loss reserves in our Health Care operation. The following table presents a rollforward of loss activity for the Health Care operation for the years ended December 31, 2003, 2002 and 2001. This information includes loss amounts and claim data for our entire domestic Health Care operation, whereas tables presented elsewhere in this discussion relate only to our domestic medical malpractice line of business.
In general, the reserve increases discussed below have primarily resulted from claim payments being greater than anticipated due to the recent escalation of large jury awards, which included substantially higher than expected pain and suffering awards. This affected our view of not only those cases going to trial, but also our view of all cases where settlements are negotiated and the threat of a large jury verdict aids the plaintiff bar in the negotiation process. The recent escalation in claim costs in the periods noted below that resulted from these developments was significantly higher than originally projected trends (which had not forecasted the change in the judicial environment), and has now been considered in our actuarial analysis and the projection of ultimate loss costs. In addition, a portion of the reserve increase in the fourth quarter of 2001 resulted from information obtained from the work of a Health Care Claims Task Force, created during the first half of 2001, which focused resolution efforts on our largest claims with the intent of lowering our ultimate loss costs.
In the first quarter, we determined that trends that had begun to appear in the third and fourth quarters of 2000 with respect to the book of business of ACIC were outside of expected trends, resulting in increases to our expected average case reserve outstanding and average paid claims. Within the Fire & Marine book of business, we also observed a continuation of the increase in the average outstanding case reserve levels and in the average paid claims. We believe the principal cause of these increases was the judicial trend noted above. We revised our estimate of ultimate losses and made a reserve addition of $90 million. In the second quarter, we determined that the sharp increases in average paid claims and outstanding case reserve levels during the prior quarters and the second quarter of 2001 indicated a need to increase our actuarial estimate of required reserves (without changing our projected trends) in light of the adverse judicial awards noted above, and we made a reserve addition of $105 million. In the third quarter, while case reserve levels increased, the average paid claims were within an expected level. Certain of our models indicated a need for increased reserves, while other methods, including the results of stress testing the underlying assumptions (primarily the level of case reserves and paid activity), indicated that reserves were appropriate in total for our Health Care segment. Management considered all available information and determined that reserves were appropriate as of September 30, 2001.
In the second quarter of 2002, average paid claims for medical malpractice lines were again somewhat above expectations, rising to $130,000 for the quarter. This, coupled with an additional increase in the
average outstanding case reserve to $148,000, prompted management to reflect these new increased averages in its reserve analysis and record a reserve increase of $97 million.
In the third quarter of 2002, although our average paid claim decreased slightly to $126,000, our average outstanding claim reserve increased to $166,000. We believed that increases in the average outstanding claim reserve was due to both the claim mix and case strengthening as described above and was not unexpected in a runoff environment. Accordingly, we did not record any reserve charge given the favorable effects we anticipate realizing in future ultimate payments.
In the fourth quarter of 2002, the average paid claim increased to $153,000 and the average outstanding case reserve increased to $181,000, which we believe was attributable to the previously described observations and was reasonable relative to our expectations. Also during the fourth quarter, we determined that our claim inventory had been reduced considerably and had matured to a level at which we appropriately began to consider other more relevant data and statistics suitable for evaluating reserves in a runoff environment.
During 2002, and as described above, we concluded that the impact of settling claims in a runoff environment was causing abnormal effects on our average paid claims, average outstanding claims, and the amount of average case reserves established for new claims-all of which are traditional statistics used by our actuaries to develop indicated ranges of expected loss. Taking these changing statistics into account, we developed varying interpretations of our data which implied added uncertainty to our evaluation of these reserves. It is our belief that this data, when appropriately evaluated in light of the impact of our migration to a runoff environment, supports our view that we will realize significant savings on our ultimate claim costs.
In the fourth quarter of 2002, we established specific tools and metrics to more explicitly monitor and validate our key assumptions supporting our reserve conclusions since we believe that our traditional statistics and reserving methods needed to be supplemented in order to provide a more meaningful analysis. The tools we developed track the three primary indicators which are influencing our expectations
and include: a) newly reported claims, b) reserve development on known claims and c) the “redundancy ratio,” comparing the cost of resolving claims to the reserve established for that individual claim.
Development on known claims-As part of executing our runoff claims strategy, the inventory of claim-specific case reserves was reviewed during 2002 in an effort to reserve each claim as appropriately as possible. This effort was in its advanced stages at the end of 2002, and our expectations for additional reserve strengthening on known claims was considered to be minimal. We did not expect additional case development on medical malpractice claims to exceed 3% of existing case reserves.
In the third quarter of 2003, the dollar amount of newly reported claims totaled $108 million, approximately 10% higher than we anticipated in our original estimate of the required level of reserves at year-end 2002. However, through the first nine months of 2003, the dollar amount of newly reported claims was approximately 7% lower than we anticipated due to the positive variance in the first quarter. Loss development on known claims during the third quarter of 2003 was worse than anticipated. Our actual redundancy ratio continued to improve in the third quarter of 2003; however, since newly reported claims and loss development on known claims again did not improve as much as we expected in the third quarter, the required reserve redundancy had increased from the previously estimated range of 35% to 40% to approximately 45%.
2002 vs. 2001-The significant decline in written premium volume in 2002 compared with 2001 was primarily due to reduced volume from the lines of business targeted for exit at the end of 2001. Also contributing to the decline in premium volume in 2002 was the rescission of several large reinsurance contracts, which reduced written premiums by $137 million. In addition, St. Paul Re ceded written premiums of $158 million in the fourth quarter related to the transfer of business to Platinum, representing unearned premiums as of the date of transfer on business incepting subsequent to January 1, 2002. These
St. Paul Re’s underwriting loss of $22 million in 2002 included a $40 million detriment from aggregate excess-of-loss reinsurance treaties, primarily related to the commutation of a portion of one aggregate excess-of-loss reinsurance treaty that was exclusive to our reinsurance operations. The 2002 result also included $23 million of losses related to the September 11, 2001 terrorist attack, which were partially offset by favorable loss experience on business underwritten in 2002, driven by significant price increases and benefits derived from exiting unprofitable lines of business. Catastrophe and other weather-related losses in 2002 totaled $31 million, comprised primarily of losses associated with flooding in Europe in August. The underwriting loss of $726 million in 2001 was dominated by $556 million of losses related to the September 11, 2001 terrorist attack. Other catastrophe and weather-related losses of $66 million in 2001 were driven by losses from the explosion of a chemical plant in France and tropical storm Allison in the United States. The remainder of underwriting losses in 2001 were concentrated in North American casualty and property reinsurance business.
This category includes the results of the following international insurance operations: 1) our runoff operations at Lloyd’s, primarily consisting of the following lines of business written through four syndicates, across which our ownership ranged from 54% to 100% and which ceased underwriting in 2001 or the first quarter of 2002: casualty insurance and reinsurance, non-marine reinsurance, professional liability insurance (particularly for financial customers, and directors’ and officers’ liability insurance) and our participation in the insuring of the Lloyd’s Central Fund; 2) Unionamerica, the London-based underwriting unit acquired as part of our purchase of MMI in 2000. Unionamerica underwrote liability and property coverages, including medical malpractice and other professional liability and directors’ and officers’ liability, both inside and outside of Lloyd’s, on both an insurance and excess-of-loss reinsurance basis; 3) all other international runoff lines of business we decided to exit at the end of 2001, consisting of health care business in the United Kingdom, Canada and Ireland, as well as our underwriting operations in Germany, France, the Netherlands, Argentina, Mexico (excluding surety business), Spain, Australia, New Zealand, Botswana and South Africa. (In 2003, we sold our operations in Botswana, and in 2002, we sold our operations in Argentina, Mexico and Spain); and 4) the results of our participation in voluntary insurance pools, as well as loss development on business underwritten prior to 1980 (prior to 1988 for business acquired in our merger with USF&G Corporation in 1998). We have a management team in place for the operations comprising this category to ensure that our outstanding claim obligations are settled in an expeditious and economical manner.
2003 vs. 2002-Despite placing all of the operations in this category in runoff at the beginning of 2002, we continue to underwrite business in selected markets while we attempt to sell certain of those operations, accounting for the $60 million of premium volume in 2003. The $374 million underwriting loss included $285 million in provisions to strengthen prior-year loss reserves and $89 million of current year losses and underwriting expenses.
Lloyd’s accounted for $159 million of the underwriting loss in 2003, driven by $108 million of adverse loss development on business written in prior years and poor current-year results from North American liability business, and financial and professional business, as well as an increase in the provision for uncollectible reinsurance. (The elimination of the one-quarter reporting lag for our operations at Lloyd’s accounted for $48 million of our reported underwriting loss for Lloyd’s in this category in 2003). Unionamerica’s underwriting loss in 2003 of $104 million included $67 million of adverse prior year loss development and a $21 million increase in the provision for uncollectible reinsurance, with the remainder reflecting current year losses related to strengthened loss assumptions on contracts still in effect in 2003.
These current year losses are centered in three lines of business underwritten through the Lloyd’s market that are now managed by Unionamerica: insurance of non-U.S. medical malpractice, excess-of-loss reinsurance of directors’ and officers’ liability business, and U.S. surplus lines business. All other international runoff lines of business accounted for $58 million of underwriting losses in 2003, compared with $56 million of losses in 2002. The underwriting loss on domestic lines underwritten prior to 1980 (prior to 1988 for business acquired in our merger with USF&G Corporation in 1998) was $53 million, the majority of which was comprised of $46 million of adverse prior year development primarily attributable to an increase in asbestos reserves during the fourth quarter of 2003. Adverse prior-year reserve development of $43 million in our other international lines occurred throughout the year in various lines of business and in various increments.
The following table summarizes prior year reserve charges in 2003 by line of business or operation.
The following table summarizes the composition and carrying value of our property-liability investment segment’s portfolio at the end of 2003 and 2002. More information on each investment class follows the table.
We participate in a securities lending program whereby certain fixed income securities from our portfolio are loaned to other institutions for short periods of time. We receive a fee from the borrower in return. We require collateral equal to 102% of the fair value of the loaned securities, and we record the cash collateral received as a liability. The collateral is invested in short-term investments and reported as such on our balance sheet. The carrying value of the securities on loan is removed from fixed income securities on the balance sheet and shown as a separate investment asset. We continue to earn interest on the securities on loan, and earn a portion of the interest related to the short-term investments.
participation in the securities lending program described above and the resulting reclassification of those securities to a separate balance sheet caption. We carry these securities on our balance sheet at fair value, with the appreciation or depreciation recorded in shareholders’ equity, net of taxes. The fair values of our bonds fluctuate with changes in market interest rates, changes in yield differentials between fixed income asset classes and changes in the perceived creditworthiness of corporate obligors. At the end of 2003, the pretax unrealized appreciation of our fixed income portfolio was $862 million, compared with unrealized appreciation of $1.0 billion at the end of 2002, with the decline due to higher market interest rates in 2003. The 10-year U.S. Treasury yield rose 43 basis points during 2003. In 2002, by contrast, that same U.S. Treasury yield declined by 123 basis points, causing a significant increase in the unrealized appreciation of the portfolio over year-end 2001.
Our decision whether to purchase taxable or tax-exempt securities is driven by corporate tax considerations, and the relationship between taxable and tax-exempt yields at the time of purchase. In recent years, the availability of corporate Net Operating Loss carryforwards and Alternative Minimum Tax carryforwards has increased our ability to benefit from taxable investment income. Accordingly, a significant majority of our new fixed income purchases in recent years have consisted of taxable bonds. The average yield on taxable bonds purchased in 2003 was 4.5%, compared with 5.3% in 2002 and 6.5% in 2001. The decline of these average investment yields in both 2003 and 2002 reflected the impact of the Federal Reserve rate actions and general economic weakness. Taxable bonds accounted for 77% of our fixed income portfolio at year-end 2003, compared with 75% at the end of 2002. The bond portfolio in total carried a weighted average pretax yield of 5.7% at December 31, 2003, compared with 6.2% at the end of 2002.
Pretax investment income generated by our fixed income securities, securities on loan and short-term investments in 2003 totaled $1.02 billion, down 7% from 2002 investment income of $1.09 billion. Our investment income in 2003 was negatively impacted by yields on new investments purchased during the last several years, which were significantly lower than yields on investments that matured in those years. In addition, significant loss and loss adjustment expense payments, including payments related to our runoff operations and the $747 million Western MacArthur asbestos settlement payment, prevented significant growth in our invested asset base during 2003. In 2002, pretax investment income from fixed income investments was 1% below 2001 income of $1.11 billion. The effect of the decline in yields available on new investments in 2002 was substantially offset by an increase in funds invested, largely due to the capital infusion and sales of equity investments.
Additional information regarding our fixed income portfolio is disclosed in the Critical Accounting Policies section of this discussion.
REAL ESTATE AND MORTGAGE LOANS-Real estate ($775 million) and mortgage loans ($63 million) accounted for 4% of our total property-liability investments at the end of 2003. Our real estate holdings primarily consist of commercial office and warehouse properties that we own directly or in which we have a partial interest through joint ventures. Our properties are geographically distributed throughout the United States and had an occupancy rate of 89.7% at year-end 2003, compared with 89.9% in 2002. Real estate investments produced pretax investment income of $61 million in 2003, compared with $67 million in 2002. Our real estate investment cash flows of $106 million in 2003 were slightly higher than cash flows of $105 million in 2002. These cash flows equated to cash yields of 10.8% and 10.4% for 2003 and 2002, respectively. We made no significant real estate purchases in 2003 or 2002.
At December 31, 2003, we had long-term commitments to fund venture capital investments totaling $792 million which are subject to certain termination provisions as further described in Note 16 to the consolidated financial statements included in Item 8 of this report.
REALIZED INVESTMENT GAINS AND LOSSES-The following table summarizes our property-liability operations’ pretax realized gains and losses by investment class for each of the last three years.
During 2003, we sold fixed income securities with a cumulative amortized cost of $940 million, generating gross pretax gains of $39 million. These gains were partially offset by impairment write-downs totaling $17 million, including $9 million related to asset/mortgage backed securities and $4 million related to Healthsouth Corporation. We recorded additional impairment write-downs totaling $4 million in our fixed income portfolio during 2003 related to nine other issuers. Each of these write-downs was carried out by writing our stated book value down to our estimate of net realizable value. We continued to reduce our equity investment holdings in 2003, and sales of those investments in a rebounding market environment resulted in net pretax gains of $40 million for the year. Impairment write-downs in our equity portfolio totaled $6 million in 2003. In our venture capital portfolio, the sale of a large portion of one of our investment holdings generated a pretax gain of $171 million in 2003, which was largely offset by impairment realized losses totaling $143 million related to 38 of our investment holdings. Fourteen of those holdings were impaired due to a merger or sale at a value less than our cost. Eleven holdings experienced fundamental economic deterioration (characterized by gross margins being less than expected, product pricing not meeting initial projections due to market conditions, and greater than expected manufacturing expenses). Six holdings were written down because the entities’ progress was substantially less than planned and additional financing was required at values less than our cost. An additional six holdings were impaired due to cessation of operations of the entity. Finally, one holding was impaired because market demand for its product was less than expected.
During 2002, we sold fixed income securities with a cumulative amortized cost of $2.5 billion, generating gross pretax gains of $185 million. These gains were partially offset by impairment write-downs totaling $74 million, including $15 million related to our investment in debt securities issued by WorldCom Corporation, $13 million related to TXU Eastern Funding and $10 million related to NRG Energy. We recorded additional impairment write-downs totaling $36 million in our fixed income portfolio during 2002 related to 22 other issuers. Those write-downs resulted from bankruptcy filings or substantial deterioration in the financial condition of those issuers. Realized losses from our equity portfolio in 2002 primarily consisted of those resulting from sales following the strategic decision to re-allocate funds to the fixed maturity portfolio, and impairment write-downs totaling $26 million.
In our venture capital portfolio, realized losses in 2002 included $56 million of losses resulting from the sale of the majority of our partnership investment holdings, and impairment write-downs in 25 of our holdings totaling $122 million. These holdings were impaired for the same general reasons noted above for the 2003 impairments: seven holdings were impaired because market demand for their products was less than expected; seven holdings were written down because the entities’ progress was less than planned and additional financing would be required; five holdings were impaired due to fundamental economic deterioration (as defined above); four holdings were impaired due to a merger or sale at less than our cost; and two holdings were impaired due to cessation of operations.
Pretax realized losses in the fixed income category in 2001 were driven by write-downs in the carrying value of certain of our bond holdings, including a $20 million write-down of various Argentina government and corporate bonds following economic upheaval in that country, and a $19 million write-down in debt securities issued by Enron Corporation following that company’s bankruptcy filing. We recorded additional impairment write-downs totaling $38 million in our fixed income portfolio during 2001 related to 19 other issuers. We did not record any impairment write-downs in our equity portfolio in 2001. Realized losses in our venture capital portfolio primarily resulted from impairment write-downs, which in the aggregate
totaled $88 million, related to 31 of our direct venture capital investments. These holdings were impaired for the same reasons described above for 2003 and 2002.
For publicly-traded securities in our venture capital portfolio in each year, the amounts of write-downs were determined by writing our investments down to quoted market prices. For non-publicly-traded securities, the write-downs to estimated net realizable value were reviewed and approved by our internal valuation committee, which, on a quarterly basis, evaluates recent financings, operating results, balance sheet stability, growth, and other business and sector fundamentals in determining fair values of the specific investments. On an ongoing basis, our venture capital portfolio managers monitor the activities of both our publicly-traded and non-publicly-traded securities, keeping in mind developments that might give rise to necessary valuation adjustments. These managers may report any such developments to the internal valuation committee.
Our loss reserves reflect estimates of total losses and loss adjustment expenses we will ultimately have to pay under insurance policies, surety bonds and reinsurance agreements. These include losses that have been reported but not settled, and losses that have been incurred but not yet reported to us (“IBNR”). Loss reserves for certain workers’ compensation business and certain assumed reinsurance contracts are discounted to present value. We reduce our loss reserves for estimates of salvage and subrogation.
While our reported reserves make a reasonable provision for all of our unpaid loss and loss adjustment expense obligations, it is important to note that the process of estimating required reserves does, by its very nature, involve uncertainty. The level of uncertainty can be influenced by such factors as the existence of long tail coverage forms and changes in claim handling practices. Many of our insurance subsidiaries have written long-tail coverages such as medical professional liability, large deductible workers’ compensation and assumed reinsurance. In addition, claim handling practices change and evolve over the years. For example, new initiatives are commenced, claim offices are reorganized and relocated, claim handling responsibilities of individual adjusters are changed, use of a call center is increased, use of technology is increased, caseload issues and case reserving practices are monitored more frequently, etc.
However, these are sources of uncertainty that we have recognized and for which we have appropriately reserved.
The following table summarizes the composition of our gross and net loss and loss adjustment expense reserves by major product line as of December 31, 2003 and 2002. Our loss and LAE reserves related to our foreign operations are presented in total in the table, as those operations do not classify their business using the same product line definitions as our domestic operations.
(3) Includes property and casualty loss experience since casualty only is not available. Also, claim counts are not available on assumed reinsurance. Loss settlement amounts include defense and cost containment expenses whereas costs to administer include only adjusting and other related payments.
General Liability (Non-E&A)-Includes insurance coverage protecting the insured against legal liability resulting from negligence, carelessness, or failure to act causing property damage or personal injury to others. Claims on these coverages are usually paid to third party claimants. While we offer coverage that may result in low-frequency, high-severity claims (i.e. excess umbrella, large accounts), the majority of the non-E&A general liability business is generally stable and predictable due to the volume of business written. Although the cost of administering these claims comprises a large portion of the overall claim cost, the actual average loss payment per claim is generally low. The most significant risk for this line is unexpected increases in inflation, either economic or social. The number of newly reported claims continued to decline in 2003 driven by an underlying decrease in our exposure to loss. Premiums have increased in the last several years due to pricing, but the actual number of exposures insured has dropped. Paid losses and closed claims declined in 2003 due to a decrease in reported claims in recent years. The increase in paid dollars in 2002 was the result of closing more claims in 2002 than we did in 2001.
Environmental-This exposure relates to general liability coverage on policies which may be interpreted to cover environmental-related exposures. The information presented above represents business reported as “Not underwritten” Environmental losses as described in the following section of this report. Payment totals for these coverages are driven by a few very large claims, accompanied by a large number of very small claims. While the number of new reported claims appears to increase, they are primarily matters for which there is no expectation of claim payment, or for policies that have not been identified as cases where the underwriter intended coverage. A significant portion of the cost of administering these claims relates to claims that are eventually settled without payment. Changes in social, judicial, legislative and economic conditions could result in future unforeseen developments and require reserve adjustments.
Assumed Reinsurance-This portion of our business represents our reported Reinsurance segment and includes property and liability loss exposures assumed on both a proportional and excess of loss basis. There are both low frequency, high severity exposures as well as some event-driven high-severity exposures. A significant portion of the high exposure business was catastrophe related. As of November 2, 2002, we were no longer significantly exposed to subsequent events due to the transfer of our ongoing reinsurance operations to Platinum Underwriters Holdings, Ltd. Although our property exposure (included in this data) is not considered long tail, our casualty exposure is considered long tail and-similar to our primary general liability exposures-is sensitive to the risk of unexpected increases in inflation. The larger loss settlement amounts from 2001 through 2003 were primarily due to losses resulting from the September 11, 2001 terrorist attack.
Note 11 to the consolidated financial statements includes a reconciliation of our beginning and ending loss and loss adjustment expense reserves for each of the years 2003, 2002 and 2001. That reconciliation shows that we recorded an increase in the loss provision from continuing operations for claims incurred in prior years totaling $646 million in 2003, $1.0 billion in 2002 and $577 million in 2001.
Our runoff Health Care operation accounted for $350 million of the total 2003 prior-year provision, and our “Other runoff” operations accounted for $285 million of the prior-year provision. We recorded $25 million of favorable prior-year loss development in our runoff reinsurance operations. Of the 2002 total, $472 million resulted from the settlement of the Western MacArthur asbestos litigation, as described in more detail earlier in this discussion. The majority of the remaining 2002 prior year development was concentrated in our Health Care, Surety, Construction, and Other operations. The increase in prior-year
development, both of which continue to evolve and are complicated by aggressive litigation against insurers, including us. Estimating ultimate liability is also complicated by the difficulty of assessing what rights, if any, we may have to seek contribution from other insurers of any policyholder.
In the second quarter of 2002, we also supplemented our survival ratio analysis of asbestos reserves with a detailed claims analysis. We determined that, excluding the impact of the Western MacArthur settlement, our asbestos reserves were adequate; however, including that impact, we determined that our asbestos reserves were inadequate.
The table below represents a reconciliation of total gross and net environmental reserve development for each of the years in the three-year period ended December 31, 2003. Amounts in the “net” column are reduced by reinsurance recoverables. The disclosure of environmental reserve development includes all claims related to environmental exposures. Additional disclosure has been provided to separately identify loss payments and reserve amounts related to policies that were specifically underwritten to cover environmental exposures, referred to as “Underwritten,” as well as amounts related to environmental exposures that were not specifically underwritten, referred to as “Not Underwritten.” In 1988, we
completed our implementation of a pollution exclusion in our commercial general liability policies; therefore, activity related to accident years after 1988 generally relates to policies underwritten to include environmental exposures.
For the year 2001, the gross and net environmental “underwritten” reserves at the beginning of the year totaled $27 million and $26 million, respectively, and at the end of the year both totaled $28 million. For 2002, the year-end gross and net environmental “underwritten” reserves were both $36 million, and at December 31, 2003 the gross reserves were $37 million and net reserves were $36 million. These reserves relate to policies that were specifically underwritten to include environmental exposures. These “underwritten” reserve amounts are included in the total reserve amounts in the preceding table.
Our reserves for environmental and asbestos losses at December 31, 2003 represent our best estimate of our ultimate liability for such losses, based on all information currently available. Because of the inherent difficulty in estimating such losses, however, we cannot give assurances that our ultimate liability for environmental and asbestos losses will, in fact, match current reserves. We continue to evaluate new information and developing loss patterns, as well as the potential impact of our determination to seek earlier and ultimately less costly resolutions of certain pending asbestos and environmental related litigations. Future changes in our estimates of our ultimate liability for environmental and asbestos claims may be material to our results of operations, but we do not believe they will materially impact our liquidity or overall financial position.
Total gross environmental and asbestos reserves at December 31, 2003, of $803 million represented approximately 4% of gross consolidated reserves of $19.4 billion.
We hold a 79% interest in Nuveen Investments, Inc. (“Nuveen Investments”), which constitutes our asset management segment. Nuveen Investments’ core businesses are asset management and related research, as well as the development, marketing and distribution of investment products and services for the affluent, high-net-worth and institutional market segments. Nuveen Investments distributes its investment products and services, including individually managed accounts, closed-end exchange-traded funds and mutual funds, to the affluent and high-net-worth market segments through unaffiliated intermediary firms including broker/dealers, commercial banks, affiliates of insurance providers, financial planners, accountants, consultants and investment advisors. Nuveen Investments also provides managed account services to several institutional market segments and channels. The company markets its capabilities under four distinct brands: NWQ, a leader in value-style equities; Nuveen Investments, a leader in tax-free investments; Rittenhouse, a leader in growth-style equities; and Symphony, a leading institutional manager of market-neutral alternative investment portfolios. Nuveen Investments is listed on the New York Stock Exchange, trading under the symbol “JNC.”
Nuveen Investments’ primary business activities generate three principal sources of revenue: (1) advisory fees earned on assets under management, including separately managed accounts, exchange-traded funds and mutual funds; (2) underwriting and distribution revenues earned upon the sale of certain investment products and (3) performance fees earned on certain institutional accounts based on the performance of such accounts. Advisory fees accounted for 90%, 90% and 88% of Nuveen Investments’ total revenues in 2003, 2002 and 2001, respectively.
ACQUISITIONS-In August 2002, Nuveen Investments acquired NWQ Investment Management Company, Inc. (“NWQ”), an asset management firm based in Los Angeles with approximately $6.9 billion of assets under management in both retail and institutional managed accounts at the time of the acquisition. NWQ specializes in value-oriented equity investments and has significant relationships among institutions and financial advisors. The NWQ purchase price included up to an additional $20 million payable to the seller over a five-year period under terms of a strategic alliance agreement, of which $2.5 million was paid in 2003. The purchase price was funded through a combination of available cash and borrowings under an intercompany credit facility between The St. Paul and Nuveen Investments.
In July 2001, Nuveen Investments acquired Symphony Asset Management LLC (“Symphony”), an institutional investment manager based in San Francisco with approximately $4 billion in assets under management at the time of the acquisition. The acquisition of Symphony expanded Nuveen Investment’s product offerings to include managed accounts and funds designed to reduce risk through market-neutral and other strategies for institutional investors.
Assets under management at the end of 2003 totaled $95.4 billion, 20% higher than the year-end 2002 total of $79.7 billion. The increase was driven by the strong net flows during the year, as well as $6.2 billion of equity and bond market appreciation. Managed assets at the end of the year were comprised of $47.1 billion of exchange-traded funds, $25.7 billion of retail managed accounts, $10.3 billion of institutional managed accounts, and $12.3 billion of mutual funds.
Capital resources consist of funds deployed or available to be deployed to support our business operations. The following table summarizes the components of our capital resources at the end of each of the last three years.
PREFERRED EQUITY-Preferred shareholders’ equity consisted of the par value of the Series B preferred shares we issued to our Stock Ownership Plan (SOP) Trust, less the remaining principal balance of the SOP Trust debt. During 2003, 2002 and 2001, the trust made principal payments of $18 million, $13 million and $14 million, respectively, on the Trust debt.
· St. Paul Capital Trust I issued 23,000,000 preferred securities generating gross proceeds of $575 million, the proceeds of which were used to purchase subordinated debentures issued by us. We make quarterly interest payments at a rate of 7.6% on the debentures, which have a mandatory redemption date of October 15, 2050. The preferred securities issued by the trust in turn pay a quarterly distribution at an annual rate of 7.6%. We can redeem the debentures on or after November 13, 2006. The proceeds of such redemption would be used by the trust to redeem a like amount of its preferred securities.
· USF&G Capital Trusts I, II and III each issued $100 million of preferred securities in 1997 and 1996, the proceeds of which were used to purchase subordinated debentures issued by USF&G Corporation, which made semi-annual interest payments at rates of 8.5%, 8.47% and 8.312%, respectively. We assumed the liability for these debentures upon our merger with USF&G Corporation in 1998. Since the merger, we have repurchased and retired securities from each trust from time to time in open market transactions. The debentures related to the USF&G Capital Trust I, II and III have mandatory redemption dates of December 15, 2045, January 10, 2027 and July 1, 2046, respectively. Debentures related to each trust may, however, be redeemed earlier under certain conditions that vary among the three trusts. The proceeds of such redemptions would be used to redeem a like amount of each trust’s preferred securities.
vs. 2001-The $541 million net increase in reported debt obligations in 2002 over 2001 was primarily due to new debt issuances to fund capital contributions and loans to our operating subsidiaries. In March 2002, we issued $500 million of 5.75% senior notes that mature in 2007, the proceeds of which were primarily used to repay a like amount of our commercial paper outstanding at the time. In July 2002, we sold 17.8 million of our common shares in a public offering for gross consideration of $431 million, or $24.20 per share. In a separate concurrent public offering, we sold 8.9 million equity units, each having a stated amount of $50, for gross consideration of $443 million. Each equity unit initially consists of a three-year forward purchase contract for our common stock and our unsecured $50 senior note due in August 2007. Total annual distributions on the equity units are at the rate of 9.00%, consisting of interest on the note at a rate of 5.25% and fee payments under the forward contract of 3.75%. The forward contract requires the investor to purchase, for $50, a variable number of shares of our common stock on the settlement date of August 16, 2005. The $46 million present value of the forward contract fee payments was recorded as a reduction to our reported common shareholders’ equity. The number of shares to be purchased will be determined based on a formula that considers the average trading price of the stock immediately prior to the time of settlement in relation to the $24.20 per share price at the time of the offering. Had the settlement date been December 31, 2003 or 2002, we would have issued approximately 15 million common shares based on the average trading price of our common stock immediately prior to that date. The combined net proceeds of these offerings, after underwriting commissions and other fees and expenses, were approximately $842 million, of which $750 million was contributed as capital to our insurance underwriting subsidiaries.
Throughout 2002, medium-term notes totaling $49 million matured, and their repayment was funded through internally generated funds. In July 2002, Nuveen Investments entered into and fully drew down a $250 million revolving line of credit with The St. Paul. Nuveen Investments used a portion of the proceeds to reduce the amount of debt outstanding on its revolving bank line of credit from $183 million at the end of June 2002 to $55 million at December 31, 2002.
COMPANY-OBLIGATED MANDATORILY REDEEMABLE PREFERRED SECURITIES-As noted above, these securities were issued by five business trusts that were fully guaranteed by The St. Paul. Prior to the adoption of the provisions of FIN 46(R) with respect to these trusts in 2003, the trusts were included in our consolidated financial statements and the securities they issued were included in our balance sheet as a separate line between liabilities and shareholders’ equity. In accordance with generally accepted accounting principles, we did not restate prior year financial statements upon our adoption of FIN 46(R).
MAJOR ACQUISITIONS AND DIVESTITURES-In March 2002, we completed our acquisition of London Guarantee (now St. Paul Guarantee) for a total cost of approximately $80 million, financed with internally generated funds.
Our operational cash flows in 2002 were negatively impacted by the $248 million payment made in June related to the Western MacArthur asbestos litigation settlement, net payments of $289 million associated with our transfer of unearned premium balances and other reinsurance-related balances to Platinum Underwriters Holdings, Ltd. in November, loss payments totaling $242 million related to the September 11, 2001 terrorist attack and contributions to our pension plans totaling $158 million in December. Loss and loss adjustment expense payments from our other business segments in runoff, where our written premium volume was significantly less than in 2001, also negatively impacted our consolidated operating cash flows.
We believe our financial strength continues to provide us with the flexibility and capacity to obtain funds externally through debt or equity financings on both a short-term and long-term basis. We continue to maintain an $800 million commercial paper program with $600 million of back-up liquidity, consisting entirely of bank credit agreements. In January 2003, we established a program providing for the offering of up to $500 million of medium-term notes. As of February 27, 2004, we had not issued any notes under this program. The consummation of the Proposed Merger would trigger a technical event of default under certain of our credit agreements; however, the lenders have agreed to waive the technical event of default, contingent upon the consummation of the Proposed Merger.
We primarily depend on dividends from our subsidiaries to pay dividends to our shareholders, service our debt, and pay expenses. St. Paul Fire and Marine Insurance Company (“Fire and Marine”) is our lead U.S. property-liability underwriting subsidiary and its dividend paying capacity is limited by the laws of Minnesota, its state of domicile. Fire and Marine’s ability to receive dividends from its direct and indirect subsidiaries is also subject to restrictions of their respective states or other jurisdictions of domicile. Business and regulatory considerations may impact the amount of dividends actually paid. Approximately $774 million will be available to us from payment of ordinary dividends by Fire and Marine in 2004. Any dividend payments beyond the $774 million limitation are subject to prior approval of the Minnesota Commissioner of Commerce. In 2003, we received dividends in the form of cash and securities totaling $625 million from our U.S. underwriting subsidiaries. We received no cash dividends from our U.S. property-liability underwriting subsidiaries in 2002. In 2001, we received dividends in the form of cash and securities of $827 million from Fire and Marine.
We are not aware of any current recommendations by regulatory authorities that, if implemented, might have a material impact on our liquidity, capital resources or operations.
regularly analyze the financial performance and condition of insurers. Any ratings downgrades, or the potential for ratings downgrades, could adversely affect our ability to market and distribute products and services, which could have an adverse effect on our business, financial condition and results of operations.
In April 2003, Moody’s Investors Services, Inc. lowered certain of our financial ratings and those of our insurance underwriting subsidiaries and established a stable outlook on the ratings going forward. In June 2003, A.M. Best Co. also lowered certain of our financial ratings while affirming those of our insurance underwriting subsidiaries and maintaining stable outlooks for both sets of ratings going forward.
In connection with the announcement of the Proposed Merger in November 2003, A.M. Best, Moody’s Investor Service (Moody’s), Standard & Poor’s Ratings Services (S&P) and Fitch Ratings (Fitch) announced the following rating actions:
· Moody’s: Confirmed the financial strength and debt ratings; raised the financial strength rating outlook from stable to positive; confirmed the stable outlook for debt ratings.
· S&P: Placed the financial strength and debt ratings on CreditWatch with positive implications and indicated that the ratings could be affirmed or raised by one notch.
· Fitch: Placed the debt ratings on Rating Watch positive and indicated that the long term debt rating could be upgraded by one or two notches.
· A.M. Best: Revised the implications of its review of our financial strength and debt ratings from positive to developing, following our announcement of a $350 million pretax charge in the 2003 fourth quarter to increase reserves for our Health Care business, which is in runoff.
At December 31, 2000, our discount rate assumption was determined based on a weighted average of the rates expected to be used to settle our obligations, considering the portion of our obligation expected to be settled by annuity payments and the portion expected to be settled by lump sum payments. At December 31, 2001, considering the impact of the plan design change to add a cash balance formula, we determined that the vast majority of the participants electing to remain under the traditional pension formula would select the annuity payment option. As such, we determined our projected benefit obligation was more appropriately calculated using strictly the rate at which we believed we could settle the annuity obligations. Based on our assumption that the vast majority of the participants electing to remain under the traditional pension formula would select the annuity payment option, we eliminated from our discount rate determination the lower rate that we assume would otherwise be used to settle lump sum payments, and thereby increased our discount rate as of December 31, 2001. In 2002, the declining interest rate environment caused us to reduce our discount rate and LTROR as of December 31, 2002. In 2003, the declining interest rate environment caused us to reduce our discount rate as of December 31, 2003. The LTROR remained the same.
of comparison, for the six-year period and 20-year period ended December 31, 2003 and 2002, our arithmetic average actual returns on our U.S. plan assets were 6.70% and 12.56%, respectively, for 2003 and 7.71% and 12.48%, respectively, for 2002. Funding decisions are made based on a number of factors, including the minimum regulatory funding requirements, the maximum tax-deductible contributions, the estimated market value of plan assets in relation to our accumulated benefit obligation, current market conditions and other business factors. During 2002, we made contributions to the U.S. plan and the United Kingdom plans of approximately $149 million and $9 million, respectively, that were primarily necessitated by the significant decline in market value of equity investments held by the plans, which was consistent with general market trends during 2002. During 2003, we made contributions to the U.S. plan and the foreign plans of approximately $30 million and $6 million, respectively.
The following table presents the impact of consolidated net pension cost (income) on our results of operations (before and after the impact of a curtailment loss resulting from plan design changes in 2001) for the years 2003, 2002, and 2001, respectively.
The following table presents our postretirement benefits plan assumptions as of December 31.
The following table presents the impact of postretirement expense (income) on our results of operations (before and after the impact of curtailment gains resulting from plan design changes in 2002 and 2001) for the years 2003, 2002, and 2001, respectively.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure,” which provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. This statement requires additional disclosures in the event of a voluntary change. It also no longer permits the use of the original prospective method of transition for changes to the fair value based method for fiscal years beginning after December 15, 2003. We currently account for stock-based compensation under APB Opinion No. 25, “Accounting for Stock Issued to Employees”, using the intrinsic value method, and have not made a determination regarding any change to the fair value method.
· Lloyd’s Syndicates-We participate in various Lloyd’s syndicates at varying levels. We continue to evaluate the implications of FIN 46(R) with respect to these syndicates, and at this time we are not able to quantify the impact of adoption on our consolidated financial statements.
incurred. In addition, the GAAP expense ratio uses net earned premiums rather than net written premiums as the denominator.
Underwriting Results By Segment (a GAAP financial measure): Our reported underwriting results are our best measure of profitability for our property-liability underwriting segments and accordingly are disclosed in the footnotes to our financial statements required by SFAS No.131 Disclosures about Segments of an Enterprise and Related Information. Underwriting results are calculated by subtracting incurred losses and loss adjustment expenses and underwriting expenses (as adjusted for items such as the impact of deferred policy acquisition costs) from net earned premiums. We do not allocate net investment income to our respective underwriting segments.
Independent Auditors-Our independent auditors, KPMG LLP, have audited the consolidated financial statements. Their audit was conducted in accordance with auditing standards generally accepted in the United States of America, which includes the consideration of our internal controls to the extent necessary to form an independent opinion on the consolidated financial statements prepared by management.
Audit Committee-The audit committee of the Board of Directors, composed solely of independent directors, assists the Board of Directors in overseeing management’s discharge of its financial reporting responsibilities. The committee meets with management, our director of internal audit and representatives of KPMG LLP to discuss significant changes to financial reporting principles and policies and internal controls and procedures proposed or contemplated by management, our internal auditors or KPMG LLP. Additionally, the committee undertakes on behalf of the Board of Directors the selection, evaluation and, if applicable, replacement of our independent auditors; and in the evaluation of the independence of the independent auditors. Both internal audit and KPMG LLP have access to the audit committee without management’s presence.
Code of Conduct-We recognize our responsibility for maintaining a strong ethical climate. This responsibility is addressed in the company’s written code of conduct.
As discussed in the notes to the consolidated financial statements, in 2001 the Company adopted the provisions of the Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” and, as also described in the notes to the consolidated financial statements, in 2002 the Company adopted the provisions of the Statement of Financial Accounting Standards No. 141, “Business Combinations” and the Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” and, as also described in the notes to the consolidated financial statements, in 2003 the Company adopted the provisions of Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities.”
Accounting Principles-We prepare our consolidated financial statements in accordance with United States generally accepted accounting principles (“GAAP”). We follow the accounting standards established by the Financial Accounting Standards Board (“FASB”) and the American Institute of Certified Public Accountants (“AICPA”).
Indebtedness of Venture Capital Management-We have made loans to certain members of management of our Venture Capital investment operation. The loans are secured by each individual’s ownership interest in the limited liability companies that hold most of our venture capital investments, and accrue interest at the applicable federal rate for loans of such maturity. The total amount receivable under this program, included in “Other Assets” at December 31, 2003 and 2002, was $7 million.
Discontinued Operations-See Note 17 in this report for a summary of our discontinued operations.
reserves for property-liability losses and loss adjustment expenses. We continually review our estimates and make adjustments as necessary, but actual results could turn out to be significantly different from what we expected when we made these estimates.
Premiums Earned-Premiums on insurance policies are our largest source of revenue. For all of our non-Lloyd’s business, we recognize premiums as revenues evenly over the policy terms using the daily pro rata method. In 2003, we changed the method by which we recognize premium revenue at our operations at Lloyd’s. Prior to 2003, such revenue was recognized using the “one-eighths” method, whereby we converted Lloyd’s syndicate accounts to U.S. GAAP on a quarterly basis. Since Lloyd’s accounting does not recognize the concept of earned premium, we calculated earned premium as part of the conversion to GAAP, assuming business was written at the middle of each quarter, effectively breaking the calendar year into earnings periods of eighths. In 2003, we began recognizing Lloyd’s premium revenue in a manner that more accurately reflects the underlying policy terms and exposures and is more consistent with the method by which we recognize premium revenue in our non-Lloyd’s business. This change did not have a material impact on our consolidated financial statements for the year ended December 31, 2003.
Revenues in our Health Care operation include premiums generated from extended reporting endorsements. Our medical liability claims-made policies gave our insureds the right to purchase a reporting endorsement, which is also referred to as “tail coverage,” at the time their policies expired. This endorsement protected an insured against any claims that arise from a medical incident that occurred while the claims-made policy was in force, but which had not yet been reported by the time the policy expired. Premiums on these endorsements are fully earned as revenue, and the expected losses are reserved, at the time the endorsement is written.
We record premiums that we have not yet recognized as revenues as unearned premiums on our balance sheet. Assumed reinsurance premiums are recognized as revenues proportionately over the contract period. Premiums earned are recorded in our statement of operations, net of our cost to purchase reinsurance.
subrogation recoveries. Estimated amounts recoverable from reinsurers on paid and unpaid losses and LAE, net of an allowance for estimated unrecoverable amounts, are reflected as assets.
For reported losses, we establish reserves on a “case” basis within the parameters of coverage provided in the insurance policy or reinsurance agreement. For IBNR losses, we estimate reserves using established actuarial methods. Our case and IBNR reserve estimates consider such variables as past loss experience, changes in legislative conditions, changes in judicial interpretation of legal liability and policy coverages, and inflation. We consider not only monetary increases in the cost of what we insure, but also changes in societal factors that influence jury verdicts and case law and, in turn, claim costs.
Reserves for environmental and asbestos exposures cannot be estimated solely with the traditional loss reserving techniques described above, which rely on historical accident year development factors and take into consideration the previously mentioned variables. Environmental and asbestos reserves are more difficult to estimate than our other loss reserves because of legal issues, societal factors and difficulty in determining the parties who may ultimately be held liable. Therefore, in addition to taking into consideration the traditional variables that are utilized to arrive at our other loss reserve amounts, we also look at the length of time necessary to clean up polluted sites, controversies surrounding the identity of the responsible party, the degree of remediation deemed to be necessary, the estimated time period for litigation expenses, judicial expansions of coverage, medical complications arising with asbestos claimants’ advanced age, case law, and the history of prior claim development. We also consider the impact of changes in the legal environment, including our experience in the Western MacArthur matter, in establishing our reserves for other asbestos and environmental cases. Generally, case reserves and loss adjustment expense reserves are established where sufficient information has been obtained to indicate coverage under a specific insurance policy. We also consider end of period reserves in relation to paid losses in a period. Furthermore, IBNR reserves are established to cover additional estimated exposures related to policyholders that haven’t as yet asserted any claims as well as development on reserves assumed from other entities. These reserves are continually reviewed and updated as additional information is acquired.
Lloyd’s-We participate in Lloyd’s as the owner of a managing agency and the provider of capital to the syndicates managed by that managing agency. Lloyd’s syndicates determine their underwriting results on an underwriting year basis with results being declared only after three years. In converting from Lloyd’s accounting to U.S. GAAP the most significant adjustments relate to the earning of premiums and the recognition of losses on an accident year basis. Where we do not provide 100% of the capital to a syndicate we record our pro rata share of syndicate assets, liabilities, revenues and expenses. (Also see discussion under “Premiums Earned” above.)
Guarantee Fund and Other Insurance-Related Assessments-We establish an accrual related to estimated future guarantee fund payments and other insurance-related assessments, primarily second injury funds. Guarantee fund payments are based on our historical experience as well as for specific known events or insolvencies. Loss-based second injury fund assessments are accrued based on our total loss reserves for the relevant states and lines of business. As of December 31, 2003 and 2002, we carried an accrual of $44 million and $43 million, respectively, for these payments, which are expected to be disbursed as assessed during a period of up to 30 years. We also establish assets related to the recovery of these costs when appropriate. As of December 31, 2003 and 2002, we carried assets of $17 million and $15 million for premium tax offsets, respectively, and $4 million and $11 million for policy surcharges, respectively. This accrual is subject to change following revisions to assessments that may be enacted by any of the states where we write business.
We hold a 79% interest in Nuveen Investments, Inc. (“Nuveen Investments,” formerly The John Nuveen Company), which constitutes our asset management segment. Nuveen Investments’ core businesses are asset management and related research, as well as the development, marketing and distribution of investment products and services for the affluent, high-net-worth and institutional market
segments. Nuveen Investments distributes its investment products and services, including individually managed accounts, closed-end exchange-traded funds and mutual funds, to the affluent and high-net-worth market segments through unaffiliated intermediary firms including broker/dealers, commercial banks, affiliates of insurance providers, financial planners, accountants, consultants and investment advisors. Nuveen Investments also provides managed account services to several institutional market segments and channels.
Nuveen Investments has three principal sources of revenue: advisory fees on assets under management, including separately managed accounts, closed-end exchange-traded funds and mutual funds; underwriting and distribution revenues earned upon the sale of certain investment products; and performance fees earned on certain institutional accounts based on the performance of such accounts.
Advisory revenue accounted for 90% of Nuveen Investments’ consolidated revenues in 2003. Total advisory fee income earned during any period is directly related to the market value of the assets managed. Advisory fee income increases or decreases with a rise or fall, respectively, in the level of assets under management. Investment advisory fees are recognized as services are provided. With respect to funds, Nuveen Investments receives fees based either on each fund’s average daily net assets or on a combination of the average daily net assets and gross interest income. With respect to managed accounts, Nuveen Investments generally earns fees, on a quarterly basis, based on the value of the assets managed on a particular date, such as the last calendar day of a quarter, or on the average asset value for the period.
Through its subsidiary, Symphony, which manages equity and fixed-income market-neutral accounts and funds for institutional investors, Nuveen Investments earns performance fees for investment performance above specifically defined benchmarks. These fees are recognized as revenue only at the performance measurement date contained in the individual account management agreement. Currently, approximately 80% of such measurement dates fall in the second half of the calendar year.
We use the equity method of accounting for our real estate joint ventures, which means we carry these investments at cost, adjusted for our share of undistributed earnings or losses, and reduced by cash distributions from the joint ventures and valuation adjustments. Due to time constraints in obtaining financial results, the results of these joint venture operations are recorded on a one-month lag. If events occur during the lag period that are significant to our consolidated results, the impact is included in the current period results.
Venture Capital-Our venture capital investments represent ownership interests in small- to medium-sized companies. These investments are made through limited partnerships or direct ownership. The limited partnerships are carried at our equity in the estimated market value of the investments held by these limited partnerships. The investments we own directly are carried at estimated fair value. Fair values are based on quoted market prices obtained from third-party pricing services for publicly traded stock, or an estimate of value as determined by an internal valuation committee for privately-held securities. Due to time constraints in obtaining financial results, the operations of the limited partnerships are recorded on a one-quarter lag. If security-specific events occur during the lag period that are significant to our consolidated results, the impact is included in the current period results.
Equities-Our equity securities are also classified as available-for-sale and carried at estimated fair value, which is based on quoted market prices obtained from a third-party pricing service.
Realized Investment Gains and Losses-We record the cost of each individual investment so that when we sell an investment, we are able to identify and record that transaction’s gain or loss on our statement of operations.
With respect to our venture capital portfolio, we manage our portfolio to maximize return, evaluating current market conditions and the future outlook for the entities in which we have invested. Because this portfolio primarily consists of privately-held, early-stage venture investments, events giving rise to impairment can occur in a brief period of time (e.g., the entity has been unsuccessful in securing additional financing, other investors decide to withdraw their support, complications arise in the product development process, etc.), and decisions are made at that point in time, based on the specific facts and circumstances, with respect to a recognition of “other than temporary” impairment, or sale of the investment.
Unrealized Appreciation or Depreciation on Investments-For investments we carry at estimated fair value, we record the difference between cost and fair value, net of deferred taxes, as a part of common shareholders’ equity. This difference is referred to as unrealized appreciation or depreciation on investments. The change in unrealized appreciation or depreciation during the year is a component of other comprehensive income.
Derivative Financial Instruments-We record all derivative financial instruments on our balance sheet at fair value. The accounting treatment for the gain or loss due to changes in the fair value of these instruments is dependent on whether the derivative qualifies as a hedge. If the derivative does not qualify as a hedge, the gains or losses are included in our statement of operations as a realized gain or losswhen they occur. If the derivative qualifies as a hedge, the accounting treatment varies based on the type of risk being hedged. Generally, however, the portion of the hedge deemed effective is recorded on the balance sheet at fair value, and the portion deemed ineffective is recorded in the statement of operations as a realized gain or loss. To qualify for hedge accounting treatment, the hedging relationship is formally documented at the inception of the hedge detailing the risk management objectives and strategy for undertaking the hedge. In addition, we assess both at the inception of the hedge and on a quarterly basis, whether the derivative is highly effective in accomplishing the risk management objectives. If it is determined that the derivative is not highly effective, hedge accounting treatment is discontinued and any gains and losses associated with the hedge’s ineffectiveness are recognized as a realized gain or loss in the
See Note 7 for further information regarding the types of derivative financial instruments that we hold.
In the first quarter of 2002, we adopted the provisions of SFAS No. 141, “Business Combinations” (“SFAS No. 141”) and SFAS No. 142, “Goodwill and Other Intangible Assets,” (“SFAS No. 142”). In a business combination, the excess of the amount we paid over the fair value of the acquired company’s tangible net assets is recorded as either an intangible asset, if it meets certain criteria, or goodwill. Intangible assets with a finite useful life (generally over four to 20 years) are amortized to expense over their estimated life, on a basis expected to be consistent with their estimated future cash flows. Intangible assets with an indefinite useful life and goodwill, which represents the excess purchase price over the fair value of tangible and intangible assets, are no longer amortized, effective January 1, 2002, but remain subject to tests for impairment. Prior to our adoption of SFAS Nos. 141 and 142, we amortized goodwill and intangible assets over periods of up to 40 years, generally on a straight-line basis. See Note 22 to the consolidated financial statements included herein for further information regarding goodwill and intangible assets included in our consolidated balance sheet.
We monitor the recoverability of the value of our long-lived assets to be held and used based on our estimate of the future cash flows (undiscounted and without interest charges) expected to result from the use of the asset and its eventual disposition considering any events or changes in circumstances which indicate that the carrying value of an asset may not be recoverable. We monitor the value of our long-lived assets to be disposed of and report them at the lower of carrying value or fair value less our estimated cost to sell. We had no impairment adjustments related to our long-lived assets in 2003, 2002 or 2001.
We account for income taxes under the asset and liability method. Deferred income tax assets and liabilities are recognized for the differences between the financial and income tax reporting bases of assets and liabilities based on enacted tax rates and laws. The deferred income tax provision or benefit generally reflects the net change in deferred income tax assets and liabilities during the year. The current income tax provision generally reflects the tax consequences of revenues and expenses currently taxable or deductible on income tax returns.
In November 2002, concurrent with the transfer of our continuing reinsurance operations as described in Note 19, we received warrants to purchase up to six million additional common shares of Platinum Underwriters Holdings, Ltd. as partial consideration for the transferred business. We carry the warrants as an asset on our balance sheet at their market value, which was $65 million and $61 million at December 31, 2003 and 2002, respectively.
In September 2001, we received approximately 190 million Old Mutual plc ordinary shares as partial consideration for the sale of our life insurance subsidiary to Old Mutual. The shares were valued at $300 million at the time of closing.
On November 17, 2003, The St. Paul and Travelers Property Casualty Corp. (“Travelers”) announced the signing of a definitive merger agreement that will create The St. Paul Travelers Companies, Inc. (“St. Paul Travelers”), which would be the nation’s second largest property-casualty insurer based on 2002 A.M. Best data concerning direct premiums written. The merger agreement is filed as an exhibit to this report. The Board of Directors of each company unanimously agreed to the tax-free, stock-for-stock merger (the “Proposed Merger” or the “merger”). Under the terms of the merger agreement, Adams Acquisition Corp., a wholly-owned subsidiary of The St. Paul, will merge into Travelers, resulting in Travelers becoming a wholly-owned subsidiary of The St. Paul, and holders of Travelers Class A and Class B common stock will receive 0.4334 common share of The St. Paul for each Travelers share. The St. Paul expects to issue approximately 437 million shares of its common stock in the Proposed Merger. The transaction is subject to customary closing conditions, including the approval by shareholders of both companies as well as certain regulatory approvals. Special shareholder meetings to vote on the Proposed Merger are scheduled for March 19, 2004 in St. Paul, MN and Hartford, CT. On December 23, 2003, the Federal Trade Commission granted early termination of the waiting period required by the Hart-Scott-Rodino Antitrust Improvements Act of 1976 in connection with the Proposed Merger. The companies are seeking approval of the merger in 11 states and from various foreign regulatory authorities. The transaction is expected to close in the second quarter of 2004.
All information included in the consolidated financial statements and notes to consolidated financial statements in this report reflects only the results of The St. Paul, and does not reflect any impact of the Proposed Merger.
The consummation of the merger would trigger a technical event of default under certain of our credit agreements; however, the lenders have agreed to waive the technical event of default, contingent upon the consummation of the merger.
· Our Surety & Construction operations, previously reported together as a separate specialty segment, are now separate components of our Specialty Commercial segment.
· Our ongoing International operations and our ongoing operations at Lloyd’s, previously reported together as a separate specialty segment, are now separate components of our Specialty Commercial segment.
· Our Health Care, Reinsurance and Other operations, each previously reported as a separate runoff business segment, have been combined into a single Other runoff segment and are under common management. “Runoff” means that we have ceased or plan to cease underwriting business as soon as possible.
· The results of our participation in voluntary insurance pools, as well as loss development on business underwritten prior to 1980 (prior to 1988 for business acquired in our merger with USF&G Corporation in 1998), previously included in our Commercial Lines segment, are now included in the Other segment. In addition to our participation in voluntary insurance pools, this prior year business included the majority of our environmental and asbestos liability exposures. The oversight
Segment Information-After the revisions to our segment structure described above, our reportable segments in our property-liability operations consisted of the following:
The Specialty Commercial segment includes our Surety and Construction operations, our ongoing International & Lloyd’s operations, and the following nine specialty business centers that in total comprise the “Specialty” component of this segment: Technology, Financial and Professional Services, Marine, Personal Catastrophe Risk, Public Sector Services, Discover Re, Umbrella/Excess & Surplus Lines, Excess and Surplus Lines Underwriting Facilities and Oil & Gas. These business centers are considered specialty operations because each provides dedicated underwriting, claim and risk control services that require specialized expertise and focuses exclusively on the respective customers it serves. Our Surety business center underwrites surety bonds, which are agreements under which one party (the surety) guarantees to another party (the owner or obligee) that a third party (the contractor or principal) will perform in accordance with contractual or legal obligations. The Construction business center offers a variety of products and services, including traditional insurance consisting of workers’ compensation, general liability
and commercial auto coverages, and risk management solutions, to a broad range of contractors and parties responsible for construction projects. Our ongoing International operations consist of our specialty underwriting operations in the United Kingdom, Canada (other than Surety) and the Republic of Ireland, and the international exposures of most U.S. underwriting business. At Lloyd’s, our ongoing operations are comprised of the following types of insurance coverage we underwrite mostly through a single wholly-owned syndicate: Aviation, Marine, Global Property and Personal Lines.
The Commercial Lines segment focuses on commercial clientele, and although we targetcertain commercial customer groups and industries, we do not have underwriting, claim or risk service personnel with specialized expertise dedicated exclusively to these groups or industries. Accordingly, the business centers within Commercial Lines are not considered “specialty” businesses. The Commercial Lines segment includes our Small Commercial, Middle Market Commercial and Property Solutions business centers, as well as the results of our limited involvement in involuntary insurance pools. The Small Commercial business center services commercial firms that typically have between one and fifty employees through its proprietary St. Paul Mainstreet (SM) and St. Paul Advantage (SM) products, with a particular focus on offices, wholesalers, retailers, artisan contractors and other service risks. The Middle Market Commercial business center offers comprehensive insurance coverages for a wide variety of manufacturing, wholesale, service and retail exposures, as well as programs for selected industries that are national in scope and have similar risk characteristics such as franchises and associations. The majority of these programs were formerly classified as a separate “Specialty Programs” business center in our Specialty Commercial segment but were reclassified in 2003 to our Middle Market Commercial business center in the Commercial Lines segment to more accurately reflect the manner in which this business is underwritten and managed. This business center also offers loss-sensitive casualty programs, including significant deductible and self-insured retention options, for the higher end of the middle market sector. The Property Solutions business center combines our Large Accounts Property business with the commercial portion of our catastrophe risk business and allows us to take a unified approach to large property risks.
The summary below presents revenues and pretax income from continuing operations for our reportable segments. The revenues of our asset management segment include investment income and realized investment gains. Revenues reported for our insurance underwriting segments represent earned premiums in those segments. The table also presents identifiable assets for our property-liability underwriting operation in total, and our asset management segment.
Geographic Areas-The following summary presents financial data of our continuing operations based on their location.
The following table summarizes premiums earned by major product line for the years ended December 31, 2003, 2002 and 2001. Our earned premiums related to our foreign operations are presented in total in the table, as those operations do not classify their business using the same product line definitions as our domestic operations.
Elimination of One-Quarter Reporting Lags-In the first quarter of 2003, we eliminated the one-quarter reporting lag for our underwriting operations at Lloyd’s to coincide with the timing of reporting for all of our other international operations. As a result, our consolidated results for 2003 included the results of those operations for the fourth quarter of 2002 and all quarters of 2003. The incremental impact on our property-liability operations of eliminating the reporting lag, consisting of the results of these operations for the three months ended December 31, 2003, was as follows.
Restricted Investments-Our subsidiaries Unionamerica and St. Paul Re-U.K., are required, as accredited U.S. reinsurers, to hold certain investments in trust in the United States. These trust funds had a fair value of $434 million at December 31, 2003. Additionally, Unionamerica has funds deposited with third parties to be used as collateral to secure various liabilities on behalf of insureds, cedants and other creditors. These funds had a fair value of $41 million at December 31, 2003. We also have $359 million of
Investment Activity-Following is a summary of our investment purchases, sales and maturities.
Realized and Unrealized Investment Gains (Losses)-The following summarizes our pretax realized investment gains and losses, and the change in unrealized appreciation or depreciation of investments recorded in common shareholders’ equity and in comprehensive income.
Derivative financial instruments include futures, forward, swap and option contracts and other financial instruments with similar characteristics. We have had limited involvement with these instruments, primarily for purposes of hedging against fluctuations in foreign currency exchange rates and interest rates. All investments, investment techniques and risk management strategies, including the use of derivative instruments, have some degree of market and credit risk associated with them. We believe our derivatives’ market risk substantially offsets the market risk associated with fluctuations in interest rates, foreign currency exchange rates and market prices. We seek to reduce our credit risk exposure by conducting derivative transactions only with reputable, investment-grade counterparties, and by seeking to avoid concentrations of exposure individually or with related parties.
Cash Flow Hedges-We have purchased forward foreign currency contracts that are designated as cash flow hedges. They are utilized to minimize our exposure to fluctuations in foreign exchange rates from our expected foreign currency payments, and settlement of our foreign currency payables and receivables. For the years ended December 31, 2003 and 2002 we recognized a loss of $4 million and a gain of $1 million, respectively, on the cash flow hedges, which is included in Other Comprehensive Income (“OCI”). The
comparable amount for the year ended December 31, 2001 was a $2 million loss. The amounts included in OCI will be realized into earnings concurrent with the timing of the hedged cash flows. We anticipate that a loss of approximately $1 million will be reclassified into earnings within the next twelve months. For the years ended December 31, 2003, 2002 and 2001 we recognized a gain of less than $1 million, neither a gain nor a loss, and a loss of less than $1 million, respectively, in the statement of operations representing the portion of the forward contracts deemed ineffective.
Non-Hedge Derivatives-We have other financial instruments that are considered to be derivatives, but which are not designated as hedges. These include our investment in stock purchase warrants of Platinum, received as partial consideration from the sale of our reinsurance business (see Note 19), stock warrants in our venture capital business and foreign exchange forward contracts. For the years ended December 31, 2003, 2002 and 2001 we recorded $7 million, $13 million and $3 million, respectively, of realized gains in continuing operations related to those non-hedge derivatives. Income from discontinued operations relating to non-hedge derivatives associated with the sale of our life insurance business included a loss of $22 million and a gain of $17 million for the periods ending December 31, 2002 and 2001, respectively.
Reconciliation of Loss Reserves-The following table represents a reconciliation of beginning and ending consolidated property-liability insurance loss and loss adjustment expense (“LAE”) reserves for each of the last three years.
In 2003, the total of $646 million in provisions for losses and LAE for claims incurred in prior years included $350 million in our Health Care operation, $108 in our runoff operations at Lloyd’s and $88 million in our runoff Unionamerica operation. In 2002, the total of $999 million in provisions for losses and LAE for claims incurred in prior years included $472 million in our runoff Other segment related to the Western MacArthur asbestos settlement agreement, $217 million in our Surety and Construction operations in our Specialty Commercial segment, $135 million in our runoff operations at Lloyd’s and $97 million in our runoff Health Care operation. In 2001, the $577 million provision to increase prior-year loss reserves was driven by a $735 million provision recorded in our Health Care operation.
During 2002, we concluded that the impact of settling claims in a runoff environment in our Health Care segment was causing abnormal effects on our average paid claims, average outstanding claims, and the amount of average case reserves established for new claims-all of which are traditional statistics used by our actuaries to develop indicated ranges of expected loss. Taking these changing statistics into account, we developed varying interpretations of our data, which implied added uncertainty in our evaluation of these reserves.
In the fourth quarter of 2002, we established specific tools and indicators to more explicitly monitor and validate our key assumptions supporting our Health Care reserve conclusions since our traditional statistics and reserving methods needed to be supplemented in order to provide a more meaningful analysis. The tools that were developed tracked three primary indicators which are influencing our expectations and include: a) newly reported claims, b) reserve development on known claims and c) the “redundancy ratio,” comparing the cost of resolving claims to the reserve established for that individual claim. These three indicators are related such that if one deteriorates, additional improvement on another is necessary for us to conclude that further reserve strengthening is not necessary.
The three indicators described above are related such that if one deteriorates, additional improvement on another is necessary for us to conclude that further reserve strengthening is not necessary. The results of these indicators support our current view that we have recorded a reasonable provision for our medical malpractice exposures as of December 31, 2003 and our analysis continues to support our belief that we will realize favorable effects in our ultimate costs and that our current loss reserves will prove to be a reasonable provision.
In addition to the exposures discussed above with respect to energy trading companies and companies in bankruptcy, our commercial surety business as of December 31, 2003 included seven accounts with gross pretax bond exposures greater than $100 million each, before reinsurance. The majority of these accounts have investment grade ratings, and all accounts continue to perform their bonded obligations.
In the third quarter of 2003, we made collateralized advances to a construction contractor that had failed to make payments under certain of its debt obligations. These third quarter advances did not impact our results of operations because the loss incurred was offset by our estimated recoverable.
In recent months, the contractor has completed a restructuring of its finances and entered into revised credit agreements with its lenders. As part of our strategy to mitigate our ultimate exposure to this account by facilitating the contractor’s efforts to complete bonded projects, we made additional advances for which we recorded an after-tax loss, net of estimated reinsurance and co-surety participation, of approximately $13 million in the fourth quarter of 2003. We have not changed our estimate of the recoverable from that established at the end of the third quarter of 2003. Any future changes in our estimate of the recoverable, whether positive or negative, will affect our results of operations. We may make further advances and, subject to our underwriting criteria, we may also decide to issue bonds for new projects undertaken by this contractor.
In 2003, we secured excess of loss reinsurance coverage for our commercial surety exposures in the form of two new treaties providing $500 million of aggregate loss limits over a five-year period, with a maximum recovery of $100 million per principal for gas supply bonds and $150 million per principal for other bonds. The reinsurance program does not extend coverage to the small number of commercial surety accounts which were in bankruptcy at the inception of the reinsurance treaties.
Components of Income Tax Expense (Benefit)-The components of income tax expense (benefit) on continuing operations are as follows.
Major Components of Deferred Income Taxes on Our Balance Sheet-Differences between the tax basis of assets and liabilities and their reported amounts in the consolidated financial statements that will result in taxable or deductible amounts in future years are called temporary differences. The tax effects of temporary differences that give rise to the deferred tax assets and deferred tax liabilities are presented in the following table.
We have not provided taxes on approximately $483 million of undistributed earnings related to our majority ownership of Nuveen Investments as of December 31, 2003, because we currently do not expect those earnings to become taxable to us.
Debt consisted of the following components at December 31, 2003 and 2002.
Interest Entities”(as revised) (“FIN 46(R)”) applied to the five business trusts that issued mandatorily redeemable preferred securities to investors which were fully guaranteed by us. As a result, we deconsolidated these trusts, and now report our borrowings from these trusts as debt on our consolidated balance sheet. In years prior to 2003, the preferred securities issued by these trusts and guaranteed by us were reported in our balance sheet as a separate line item between total liabilities and shareholders’ equity, and referred to as “company-obligated mandatorily redeemable securities of trusts holding solely subordinated debentures of the company.” Prior to 2003, the debt issued by us to the trusts was eliminated in consolidation. The following is a summary of the provisions of the five business trusts, each of which was formed for the sole purpose of issuing those securities.
Our total distribution expense related to all of these preferred securities prior to deconsolidation was $70 million in 2002 and $33 million in 2001. In 2003, our interest expense related to our debt to these trusts totaled $72 million.
5.75% Senior Notes-In March 2002, we issued $500 million of senior notes due in 2007. Proceeds from the issuance were primarily used to repay a portion of our commercial paper outstanding.
consideration of $443 million. Each equity unit initially consists of a forward purchase contract for the company’s common stock (maturing in 2005), and an unsecured $50 senior note of the company (maturing in 2007). Total annual distributions on the equity units are at the rate of 9.00%, consisting of interest on the note at a rate of 5.25% and fee payments under the forward contract of 3.75%. The forward contract requires the investor to purchase, for $50, a variable number of shares of our common stock on the settlement date of August 16, 2005. The $46 million present value of the forward contract fee payments was recorded as a reduction to our reported common shareholders’ equity in 2002. The number of shares to be purchased will be determined based on a formula that considers the average trading price of the stock immediately prior to the time of settlement in relation to the $24.20 per share price at the time of the offering. Had the settlement date been December 31, 2003, we would have issued approximately 15 million common shares based on the average trading price of our common stock immediately prior to that date. The majority of proceeds from the offering were contributed as capital to our insurance underwriting subsidiaries, with the balance being used for general corporate purposes.
Nuveen Investments’ Debt-In September 2003, Nuveen Investments issued $300 million of 4.22% notes in a private placement. The notes mature in 2008. A portion of the proceeds was used to refinance existing debt and repay a $105 million loan from The St. Paul. The remainder will be used for Nuveen Investments’ general corporate purposes. The $302 million carrying value of Nuveen Investments’ newly-issued debt in the foregoing table included the unamortized gains from the cancellation of prior interest rate swap transactions in connection with the private placement, as well as unamortized private placement debt issue costs. Nuveen Investments’ debt at December 31, 2002 consisted of borrowings outstanding under its revolving bank line of credit. At December 31, 2002, the weighted average interest rate on debt outstanding under the bank line of credit was approximately 2.0%.
Variable Rate Borrowings-A number of our real estate entities are parties to variable rate loan agreements aggregating $64 million. The borrowings mature in the year 2030, with principal paydowns starting in the year 2006. The interest rate is set weekly by a third party, and was 1.65% at December 31, 2003 and 2.05% at December 31, 2002.
The SOP Trust may at any time convert any or all of the preferred shares into shares of our common stock at a rate of eight shares of common stock for each preferred share. Our Board of Directors has reserved a sufficient number of our authorized common shares to satisfy the conversion of all preferred shares issued to the SOP Trust and the redemption of preferred shares to meet employee distribution requirements. Upon the redemption of preferred shares, we will issue shares of our common stock to the trust to fulfill the redemption obligations.
Issuance of Common Shares-In July 2002, we sold 17.8 million of our common shares in a public offering for gross consideration of $431 million, or $24.20 per share.
Dividend Restrictions-We primarily depend on dividends from our subsidiaries to pay dividends to our shareholders, service our debt, and pay expenses. St. Paul Fire and Marine Insurance Company (“Fire and Marine”) is our lead U.S. property-liability underwriting subsidiary and its dividend paying capacity is limited by the laws of Minnesota, its state of domicile. Business and regulatory considerations may impact the amount of dividends actually paid. Approximately $774 million will be available to us from payment of ordinary dividends by Fire and Marine in 2004. Any dividend payments beyond the $774 million limitation would require prior approval of the Minnesota Commissioner of Commerce. Fire and Marine’s ability to receive dividends from its direct and indirect underwriting subsidiaries is subject to restrictions under the laws of their respective states or other jurisdictions of domicile. During 2003, we received dividends in the form of cash and securities of $625 million from our U.S. underwriting subsidiaries. We received no cash dividends from our U.S. property-liability underwriting subsidiaries in 2002. In 2001, we received dividends in the form of cash and securities of $827 million from Fire and Marine.
St. Paul Guarantee’s assets and liabilities were included in our consolidated balance sheet beginning June 30, 2002, and the results of their operations since the acquisition date were included in our consolidated statements of operations for the twelve months ended December 31, 2002. St. Paul Guarantee produced net written premiums of $57 million and an underwriting loss of $6 million since the acquisition date. In the fourth quarter of 2002 we made a purchase accounting adjustment related to our deferred tax assumptions, which decreased goodwill by $2 million.
Fireman’s Fund Surety Business-In December 2001, we purchased the right to seek to renew surety bond business previously underwritten by Fireman’s Fund Insurance Company (“Fireman’s Fund”), without assuming past liabilities. We paid Fireman’s Fund $10 million in 2001 for this right, which we recorded as an intangible asset and which we are amortizing on an accelerated basis over nine years. Based on the volume of business renewed during 2002, we made a modest additional payment to Fireman’s Fund in the first quarter of 2003. That amount was also recorded as an intangible asset and is being amortized on an accelerated basis over the remaining life of the intangible asset.
In December 2003, we completed the sale of Camperdown UK Limited, one of our Lloyd’s corporate names and the vehicle for our participation on the 2003 and prior year of account, to Foltus Investments Limited. We recognized a $2 million pretax gain on this transaction. At Lloyd’s, we underwrite business through a single syndicate (“Syndicate 5000”) for which we provide 100% of the capital. In 2003, Fire and Marine entered into a 100% quota share reinsurance agreement directly with Syndicate 5000 that in effect transferred Syndicate 5000’s underwriting results for the 2003 year of account to Fire and Marine. In order to continue our ongoing operations at Lloyd’s, we activated two corporate names that will be used for 2004 and future years of account to underwrite Syndicate 5000 business.
Material guarantees or indemnifications provided as part of these sales are discussed in Note 16 Commitments, Contingencies and Guarantees.
· We have a significant variable interest in two real estate entities, but we are not considered to be the primary beneficiary. The total carrying value of these entities was approximately $48 million as of September 30, 2003, which also represents our maximum exposure to loss. The purpose of our involvement in these entities is to generate investment returns.
· We also have certain remaining variable interests in Camperdown UK Limited, an entity that we sold in 2003. We utilized this entity as one of our corporate names and the vehicle for our participation at Lloyd’s for 2003 and prior years of account through a single syndicate (“Syndicate 5000”). Our variable interest results from an agreement to indemnify the purchaser for losses arising out of adverse changes in underwriting, foreign exchange and foreign tax results. The maximum amount of this indemnification obligation is $203 million. In addition, in 2003 we entered into a 100% quota share reinsurance agreement with Syndicate 5000 that in effect transferred Syndicate 5000’s underwriting results for the 2003 year of account to us.
For those employees covered under the cash balance pension formula, we maintain a cash balance pension account to measure the amount of benefits payable to an employee. For each plan year an employee is an active participant, the cash balance pension account is increased for pay credits and interest credits. Pay credits are calculated based on age, vesting service and actual pensionable earnings, and added to the account on the first day of the next plan year. Interest credits are added at the end of each calendar quarter. These benefits vest after five years of service. If an employee is vested under the cash balance
formula when their employment with us ends, they are eligible to receive the formula amount in their cash balance pension account.
We maintain noncontributory, unfunded pension plans to provide certain company employees with pension benefits in excess of limits imposed by federal tax law. These unqualified pension plans are not material and are not included in the tables that follow.
These benefits vest after five years of service. If an employee is vested under the cash balance formula when their employment with us ends, they are eligible to receive the amount in their health account. Our obligations under this plan are accounted for under, and included in the 2003 results of, the defined benefit pension plan.
The following tables provide a reconciliation of the changes in the plans’ portion of the SPC Plans’ benefit obligations and fair value of assets over the two-year period ending December 31, 2003, and a statement of the funded status as of December 31, 2003 and 2002.
The expected long-term rate of return on plan assets for our U.S. plans only, is estimated based on the plan’s actual historical return results, the expected allocation of plan assets by investment class, market conditions and other relevant factors. We evaluate only whether the actual allocation has fallen within an expected range, and we then evaluate actual asset returns in total, rather than by asset class, giving consideration to the fact that our equity investments have a higher volatility than our other investment classes, which is consistent with the market in general.
Our U.S. and foreign pension plans weighted-average asset allocations at December 31, 2003, and our U.S. pension plans only at December 31, 2002 by asset category are as follows:
Our U.S. pension plan assets are invested in a prudent manner for the exclusive benefit of the plan participants and beneficiaries. The investment horizon is long-term; therefore the assets of the plan are intended, over time, to satisfy the benefit obligations under the plan. Risk tolerance is established through careful consideration of plan liabilities, plan funded status, and corporate financial condition. The asset mix guidelines have been established and are reviewed quarterly. These guidelines are intended to serve as tools to facilitate the investment of plan assets to maximize long-term total return and the ongoing oversight of the plan’s investment performance. The investment portfolio contains a diversified blend of equity and fixed-income investments. Furthermore, equity investments are diversified across U.S. and
non-U.S. stocks. Other assets such as partnerships and real estate are used judiciously to enhance long-term returns while improving portfolio diversification. Investment risk is measured and monitored on an ongoing basis through daily and monthly investment portfolio review, annual liability measurements, and periodic asset/liability studies.
Our U.S. pension plans total fair value of plan assets as of December 31, 2003 and 2002 are $1.096 billion and $992 million, respectively. Our U.S. pension plans 2003 expected long-term rate of return on assets is 8.50%.
Our other postretirement benefit plan weighted-average asset allocations at December 31, 2003, and 2002, by asset category are as follows:
We do not expect to contribute to our pension plan or our postretirement benefit plan in 2004.
As of January 1, 1998, the Preferred Stock Ownership Plan (“PSOP”) and the Employee Stock Ownership Plan (“ESOP”) were merged into The St. Paul Companies, Inc. Stock Ownership Plan (“SOP”). The plan allocates preferred shares semiannually to those employees participating in our Savings Plus Plan. Under the SOP, we match 100% of employees’ contributions up to a maximum of 6% of their salary. We also allocate preferred shares equal to the value of dividends on previously allocated shares.
The SOP (formerly the ESOP) borrowed funds to finance the purchase of common stock for future allocation to qualified participating U.S. employees. The final principal payment on the trust’s loan was made in 1998. As the principal of the trust loan was paid, a pro rata amount of our common stock was released for allocation to eligible participants. Common stock dividends on shares allocated under the former ESOP are paid directly to participants.
Non-U.S. Plans-In the past we had separate stock option plans for certain employees of our non-U.S. based operations. The options granted under these plans were priced at the market price of our common stock on the grant date. Generally, they can be exercised from three to 10 years after the grant date.
The following tables summarize the status of fixed stock options outstanding and exercisable at December 31, 2003.
The fair value effect of stock options reported in Note 1 is derived by application of the Black-Scholes option-pricing model. The significant assumptions used during the year in estimating the fair value on the date of the grants are as follows:
Any outstanding unvested restricted shares granted in 2003 and prior under our U.S. Plan will immediately vest upon consummation of the Proposed Merger, which constitutes a Change in Control as defined by the Plan.
The primary purpose of our ceded reinsurance program, including the aggregate excess-of-loss coverages discussed below, is to protect us from potential losses in excess of what we are prepared to accept. We expect the companies to which we have ceded reinsurance to honor their obligations. In the event these companies are unable to honor their obligations to us, we will pay these amounts. We have established allowances for possible nonpayment of amounts due to us. At December 31, 2003 and 2002, our provision for uncollectible reinsurance totaled $134 million and $122 million, respectively.
We report balances pertaining to reinsurance transactions “gross” on the balance sheet, meaning that reinsurance recoverables on unpaid losses and ceded unearned premiums are not deducted from insurance reserves but are recorded as assets.
The largest concentration of our total reinsurance recoverables and ceded unearned premiums at December 31, 2003 and 2002 was with General Reinsurance Corporation (“Gen Re”). Gen Re (with approximately 17% and 19% of our recoverables at the end of 2003 and 2002, respectively) is rated “A+ +” by A.M. Best, “Aaa” by Moody’s and “AAA” by Standard & Poor’s for its financial strength. Approximately 6% of our reinsurance recoverables and ceded unearned premiums at December 31, 2003 were with Platinum Underwriters Holdings, Ltd.
Approximately 94% of our domestic reinsurance recoverable balances at December 31, 2003 were with reinsurance companies having financial strength ratings of A- or higher by A.M Best or Standard & Poor’s, were from state sponsored facilities or reinsurance pools, or were collateralized reinsurance programs associated with certain of our insurance operations. We have an internal credit security committee, which uses a comprehensive credit risk review process in selecting our reinsurers. This process considers such factors as ratings by major ratings agencies, financial condition, parental support, operating practices, and market news and developments. The credit security committee convenes quarterly to evaluate these factors and take action on our approved list of reinsurers, as necessary.
Aggregate Excess-of-Loss Reinsurance Treaties-In 2001, we entered into two aggregate excess-of-loss reinsurance treaties. Under the terms of the reinsurance treaties, we transferred, or “ceded,” insurance losses and loss adjustment expenses to our reinsurers, along with the related written and earned premiums. One of these treaties was corporate-wide, with coverage triggered when our insurance losses and LAE across all lines of business reached a certain level, as prescribed by terms of the treaty. We did not cede any losses to the corporate treaty in 2001, but we recorded a $34 million net detriment in 2001 related to a similar treaty we were party to in 2000, primarily due to adjustments for cessions made in 2000. We were not party to such a treaty in 2003 or 2002. Our reinsurance operation was party to a separate aggregate excess-of-loss treaty in 2002 and 2001. The results of our reinsurance operation in 2002 and 2001 included a $34 million detriment and a $159 million benefit, respectively, related to those treaties. The detriment in 2002 primarily resulted from the commutation of a portion of the 2001 treaty. We did not cede any losses to our reinsurance operations’ 2002 excess-of-loss treaty. The 2001 benefit resulted from losses ceded to the 2001 treaty.
The effect of assumed and ceded reinsurance on premiums written, premiums earned and insurance losses and loss adjustment expenses is as follows (including the impact of the reinsurance treaties).
Generally, we expect that our obligations to make the capital contributions listed in the table above will be largely funded by distributions we receive from our venture capital investments. The maximum amount of new capital we are obligated to contribute to satisfy those obligations to Fund VI in any calendar year without receiving any offsetting distributions from our venture capital operation is $250 million and, on a cumulative basis over the life of Fund VI, no more than $325 million. In addition, we can elect to discontinue funding Fund VI at any time. If we do so, we must contribute $250 million (not reflected in the table above) to a termination fund and pay certain termination and management fees. Alternatively, once 70% of the Fund VI capital has been committed, we must elect either to commit a material amount of additional capital to a new venture capital fund or agree to contribute an additional $150 million (not reflected in the table above) to Fund VI.
Lease Commitments-A portion of our business activities is conducted in rented premises. We also enter into leases for equipment, such as office machines and computers. Our total rental expense was $96 million in 2003, $86 million in 2002 and $83 million in 2001. Certain leases are noncancelable, and we would remain responsible for payment even if we stopped using the space or equipment. On December 31, 2003, the minimum rents for which we would be liable under these types of leases are as follows: $113 million in 2004, $89 million in 2005, $76 million in 2006, $67 million in 2007, $60 million in 2008 and $102 million thereafter. We are also the lessor under various subleases on our office facilities. The minimum rentals to be received under noncancelable subleases are as follows: $19 million in 2004, $16 million in 2005, $15 million in 2006, $12 million in 2007, $12 million in 2008 and $14 million thereafter.
Acquisition of Renewal Rights-In May 2003, we entered into a contingent consideration agreement as part of our purchase price of the right to seek to renew certain business from Kemper Insurance Companies (“Kemper”). We are obligated to make an additional payment in June 2004 based on the amount of premium volume we ultimately renew during the twelve months subsequent to this purchase. We believe it is highly unlikely that any additional payment would exceed $30 million. At December 31, 2003, we had accrued $10 million toward this additional obligation, recorded in “Other liabilities.”
Joint Ventures-Our subsidiary, Fire and Marine, is a party to five separate joint ventures, in each of which Fire and Marine is a 50% owner of various real estate holdings and does not exercise control over the joint ventures, financed by non-recourse mortgage notes. Because we own only 50% of the holdings, we do not consolidate these entities and the joint venture debt does not appear on our balance sheet. Our maximum exposure under each of these joint ventures, in the event of foreclosure of a property, is limited to our carrying value in the joint venture, ranging individually from $6 million to $27 million, and cumulatively totaling $58 million at December 31, 2003.
Although the ultimate outcome of these matters is not presently determinable, it is possible that the resolution of one or more matters may be material to our results of operations; however, we do not believe that the total amounts that we and our subsidiaries will ultimately have to pay in all of these lawsuits will have a material effect on our liquidity or overall financial position.
The following is a summary of certain litigation matters with contingencies:
· Boson v. Union Carbide Corp., et al; Abernathy v. Ace American Ins. Co-In 2003, lawsuits were filed in Texas and Ohio against certain of our subsidiaries, and other insurers and non-insurer corporate defendants, asserting liability for failing to warn of the dangers of asbestos. It is difficult to predict the outcome for financial exposure represented by this type of litigation in light of the broad nature of the relief requested and the novel theories asserted. We believe, however, that the cases are without merit and we intend to contest them vigorously. In this regard, we filed special exceptions in all of the Texas cases. In October 2003, a court ruled on the special exceptions in 11 of those cases, dismissing the cases with prejudice. Subsequently, the court dismissed another case on the same grounds. We view these as significant rulings in our favor. The special exceptions in the remaining 50 cases have not yet been ruled upon. We intend to file similar motions to dismiss in the Ohio cases.
· Farina v. Travelers Property Casualty Corp., et al-A purported class action was recently filed in Connecticut state court against Travelers Property Casualty Corp. and its board of directors alleging that they breached their fiduciary duties to Travelers’ shareholders in connection with the adoption of the merger and the merger agreement with the Company. The complaint seeks injunctive relief
as well as unspecified monetary damages. The complaint also names the Company and its subsidiary Adams Acquisition Corp. as defendants, alleging that they aided and abetted the alleged breach of fiduciary duty. We believe this suit is wholly without merit and intend to vigorously defend against it.
Corporate Securities-Through the issuance of our debt securities, we have guaranteed to indemnify the financial institutions against any loss, liability, claim, damage, or expense, including taxes that may arise out of the administration of the debt arrangement. There are no contractual monetary limits placed on these guarantees, and they survive until the applicable statutes of limitation expire.
Swap Agreements-We are party to a number of interest rate swaps. Each party to a standard swap agreement agrees to indemnify the other for tax liabilities that may arise out of the swap transactions. We have no way to value the potential liability or asset that may arise due to these tax issues, and there are no contractual monetary limits placed on these indemnifications.
Sales of Business Entities-In the ordinary course of selling business entities to third parties, we have 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 us and/or our subsidiaries following the closing, and in certain cases obligations arising from undisclosed liabilities, adverse reserve development, premium deficiencies or certain named litigation. Such indemnification provisions generally survive for periods ranging from 12 months following the applicable closing date to the expiration of the relevant statutes of limitation, or in some cases agreed upon term limitations. As of December 31, 2003,
Life Insurance-In September 2001, we completed the sale of our life insurance company, Fidelity and Guaranty Life Insurance Company and its subsidiary, Thomas Jefferson Life (together, “F&G Life”) to Old Mutual plc (“Old Mutual”), for $335 million in cash and $300 million in ordinary shares of Old Mutual. In June 2002, we sold all of the Old Mutual shares we were holding for a total net consideration of $287 million, resulting in a pretax realized loss of $13 million that was recorded as a component of discontinued operations on our statement of operations in 2002. At the time of the sale of the Old Mutual shares, there was a derivative “collar” agreement in place that would have determined any possible adjustment to the original F&G Life sale price one year after the closing date. The collar was recorded on our balance sheet as an asset and had a fair value of $12 million when we sold our Old Mutual shares. We agreed to terminate the collar at no value as part of the sale of our Old Mutual shares. That $12 million pretax loss was also included in discontinued operations on our statement of operations in 2002.
Minet-In 1997, we sold our insurance brokerage operation, Minet Holdings plc (“Minet”) to Aon Corporation. We recorded expenses in discontinued operations in each of the last three years related to the Minet sale. In 2003, the expense recorded primarily represented an adjustment to the tax provision on the sale, whereas the expenses recorded in 2002 and 2001 primarily represented additional funds due Aon pursuant to provisions of the sale agreement.
The following table summarizes our discontinued operations, including our life insurance business, our standard personal insurance business, our nonstandard auto business and our insurance brokerage business, Minet (sold in 1997), for each year in the three-year period ended December 31, 2003.
The following table summarizes our total loss from discontinued operations, for each operation sold, for the three-year period ended December 31, 2003.
December 2001 Strategic Review-In December 2001, we announced the results of a strategic review of all of our operations, which included a decision to exit all business underwritten in our Health Care operations, narrow the product offerings of our reinsurance operation, exit certain business at Lloyd’s and cease to underwrite business in several countries where we were unlikely to achieve competitive scale. Related to this strategic review, we wrote off $73 million of goodwill, and we recorded a pretax charge of $62 million, including $46 million of employee-related costs, $9 million of occupancy-related costs,
The employee-related costs represent severance and related benefits such as outplacement services to be paid to, or incurred on behalf of, employees to be terminated by the end of 2002. We estimated that a total of approximately 1,200 employees would ultimately be terminated under this action, with approximately 800 employees expected to be terminated by the end of 2002. The remaining 400 employees were not included in the restructuring charge since they would either be terminated after 2002 or were part of one of the operations that was to be sold. Of the total, approximately 650 worked in offices outside the U.S. (some of which have now been closed), approximately 300 worked in our Health Care business (which was exited), and the remaining 250 were spread throughout our domestic operations. A total of 713 of the estimated 800 positions were eliminated. The remaining 87 positions represented employees who found alternate positions within the company or external employment before termination.
The occupancy-related cost represents excess space created by the terminations, calculated by determining the anticipated excess space, by location, as a result of the terminations. The percentage of excess space in relation to the total leased space was then applied to the current lease costs over the remaining lease period. The amounts payable under the existing leases were not discounted, and sublease income was included in the calculation only for those locations where sublease agreements were in place. The equipment costs represent the net book value of computer and other equipment that will no longer be used following the termination of employees and closing of offices. The legal costs represented our estimate of fees to be paid to outside legal counsel to obtain regulatory approval to exit certain states or countries.
Other Restructuring Charges-Since 1997, we have recorded in continuing operations four other restructuring charges related to actions taken to improve our operations.
In connection with our merger with USF&G, in the second quarter of 1998 we recorded a pretax charge to net income of $292 million, primarily consisting of severance and other employee-related costs related to the termination of approximately 2,200 positions, facilities exit costs, asset impairments and transaction costs.
All actions have been taken and all obligations have been met regarding these other restructuring charges, with the exception of certain remaining lease commitments. The lease commitment charges related to excess space created by the cost reduction actions. The charge was calculated by determining the percentage of anticipated excess space, by location, and the current lease costs over the remaining lease period. The amounts payable under the existing leases were not discounted, and sublease income was included in the calculation only for those locations where sublease agreements were in place.
As part of this transaction, we contributed $122 million of cash to Platinum and transferred $349 million in assets relating to the insurance reserves that we also transferred. In exchange, we acquired six million common shares, representing a 14% equity ownership interest in Platinum, and a ten-year option to buy up to six million additional common shares at an exercise price of $27 per share, which represents 120% of the initial public offering price of Platinum’s shares.
As noted above, the transfer of reserves to Platinum at the inception of the quota share reinsurance agreements was based on the September 30, 2002 balances. In March 2003, we transferred to Platinum $137 million of additional insurance reserves, consisting of $72 million in unearned premiums (net of ceding commissions) and $65 million in existing reserves for losses and loss adjustment expenses. We also transferred cash and other assets having a value equal to the additional insurance reserves transferred. This transfer of additional assets and liabilities reflected business activity between September 30, 2002 and the November 2, 2002 inception date of the quota share reinsurance agreements, and our estimate of amounts due under the adjustment provisions of the quota share reinsurance agreements. Our insurance reserves at December 31, 2002 included our estimate, at that time, of amounts due to Platinum under the quota share reinsurance agreements, which totaled $54 million. The $83 million increase in our estimate of amounts due to Platinum under the quota share reinsurance agreements resulted in a pretax underwriting loss of $6 million in the first quarter of 2003. During the second quarter of 2003, we reached final agreement with Platinum regarding the adjustment provisions of the quota share reinsurance agreements and no further adjustments to the transferred assets and liabilities will occur.
For business underwritten in the United States and the United Kingdom, until October 31, 2003, Platinum had the right to underwrite specified reinsurance business on our behalf in cases where Platinum was unable to underwrite that business because it had yet to obtain necessary regulatory licenses or approval to do so, or Platinum had not yet been approved as a reinsurer by the ceding company. We entered into this agreement solely as a means to accommodate Platinum through a transition period. Any business written by Platinum on our policy forms during this transition period was fully ceded to Platinum under the quota share reinsurance agreements.
The following Platinum-related balances were included in our consolidated balance sheet as of December 31, 2003.
On June 3, 2002, we announced that we and certain of our subsidiaries had entered into an agreement settling all existing and future claims arising from any insuring relationship of United States Fidelity and Guaranty Company (“USF&G”), St. Paul Fire and Marine Insurance Company and their affiliates and subsidiaries, including us (collectively, the “USF&G Parties”) with any of MacArthur Company, Western MacArthur Company (“Western MacArthur”), and Western Asbestos Company (“Western Asbestos”) (together, the “MacArthur Companies”).
On March 26, 2002, a trial commenced in the Western MacArthur litigation which was planned to occur in three phases over the course of approximately one year, and which involved complex questions of fact and law. Among the issues to be addressed in the first phase of the trial were the standing of Western MacArthur to recover under Western Asbestos’ policies issued by USF&G (USF&G never insured Western MacArthur and disputed Western Asbestos’ purported assignment of its insurance rights to Western MacArthur) and the existence and terms and conditions of the policies, including the issue of whether the policies contained products hazard coverage and, if so, whether the policies included aggregate limits for products hazard liability. USF&G believed it had, and continues to believe that it has, meritorious defenses to the purported assignments of insurance rights by Western Asbestos to Western MacArthur, which Western MacArthur alleged occurred in the 1967-1970 time period and in 1997, and which were allegedly ratified in 1999. USF&G also believed that it had a strong position that the policies did not contain products hazard coverage, but that even if they did the coveragewas subject to products hazard aggregates, which limited the USF&G Parties’ exposure. As the trial began, the Company believed that it could resolve the case by litigation or settlement within the existing asbestos reserves (gross asbestos reserve totaled $478 million as of December 31, 2001) on the basis of the foregoing defenses, a belief supported by Western MacArthur’s November 1999 settlement of a similar claim brought against another defendant insurer for $26 million. Given the facts and circumstances known by management at the time we filed our annual report on Form 10-K, we believed that our best estimate of aggregate asbestos reserves as of December 31, 2001 made a reasonable provision for Western MacArthur and all other asbestos claims.
The first phase of the trial began on March 26, 2002. During the second quarter of 2002, developments in the trial caused us to reassess our exposure based on the increased possibility of an adverse outcome in the first phase of the litigation. Among the significant developments in the trial between April 1 and May 15, 2002 were evidentiary decisions by the trial judge to exclude evidence favorable to USF&G regarding the assignment issue and to allow into evidence unfavorable evidence regarding other insurers’ policies on the aggregate limits issue, and unexpected adverse testimony on the aggregate limits issue. These developments led us to believe that there was an increased risk that the jury could find that USF&G’s policies did not contain aggregate limits for products hazard claims.
As of May 15, 2002, the date on which we filed our Form 10-Q for the quarter ended March 31, 2002, the trial and settlement discussions were ongoing, but the parties to the settlement discussions had been unable to reach agreement on structure, amount and other significant terms. At that time, we were prepared to end settlement discussions based on our continued belief that we could litigate our position and possibly reach a more favorable outcome than a negotiated settlement would provide. In such circumstances, we perceived the possible outcomes as ranging from minimal amounts well within our existing asbestos reserves to unknown higher amounts (potentially higher than the amount in the final settlement agreement, discussed below). Accordingly, we believed that we could not estimate a reasonable range of potential loss for the Western MacArthur claim, and therefore could make no disclosure of such a range. However, at the time we filed such report on Form 10-Q, we believed, based on various adverse developments during the course of the first phase of the trial through May 15, that although the ultimate outcome of the Western MacArthur case was not determinable at that time, it was possible that its resolution could be material to our results of operations, and we made disclosure of this fact in such report. We did not disclose a range of possible outcomes, as we were unable to do so at the time of the filing.
Pursuant to the provisions of the settlement agreement, on November 22, 2002, the MacArthur Companies filed voluntary petitions under Chapter 11 of the Bankruptcy Code to permit the channeling of all current and future asbestos-related claims solely to a trust to be established pursuant to Section 524(g) of the Bankruptcy Code. Consummation of most elements of the settlement agreement was contingent upon bankruptcy court approval of the settlement agreement as part of a broader plan for the reorganization of the MacArthur Companies (the “Plan”). In January 2004, the U.S. Bankruptcy Court for the Northern District of California issued an order approving the settlement agreement with the MacArthur Companies, and confirming the MacArthur Companies’ proposed plan of reorganization. We are awaiting final confirmation of the Bankruptcy Court order. Final approval of the Plan involves substantial uncertainties that include the resolution of various appeals from the Bankruptcy Court’s order.
The following table represents a rollforward of asbestos reserve activity in 2002 related to the Western MacArthur matter.
Our gross asbestos reserves at December 31, 2002 included $740 million of reserves related to Western MacArthur ($442 million of net reserves after consideration of $295 million of estimated net reinsurance recoverables and $3 million of bankruptcy fees recoverable from others). On January 16, 2003, pursuant to the terms of the settlement agreement, we paid the remaining $740 million settlement amount, plus interest, to the bankruptcy trustee in respect of this matter. At December 31, 2003 our gross asbestos reserves included no material amount related to Western MacArthur.
The Terrorism Risk Insurance Act of 2002 was signed into law in November 2002. This temporary legislation remains in effect until December 31, 2005, and requires insurers to offer coverage for certain types of terrorist acts in their commercial property and liability insurance policies, and establishes a federal program to reimburse insurers for a portion of losses so insured.
In the second quarter of 2003, we completed our annual evaluation of our recorded goodwill for impairment in accordance with provisions of SFAS No. 142, which concluded that none of our goodwill was impaired.
In connection with our reclassification of certain assets previously accounted for as goodwill to other intangible assets in 2002, we established a deferred tax liability of $6 million in the second quarter of 2002. That provision was classified as a cumulative effect of accounting change effective as of January 1, 2002.
The increase in goodwill in our Asset Management segment resulted from Nuveen Investments’ purchase of shares from minority shareholders.
The NAIC published revised statutory accounting practices in connection with its codification project, which became effective January 1, 2001. The cumulative effect to our property-liability insurance operations of the adoption of these practices was to increase statutory surplus by $126 million, primarily related to the treatment of deferred taxes.
Other comprehensive income is defined as any change in our equity from transactions and other events originating from non-owner sources. In our case, those changes are comprised of our reported net income, changes in unrealized appreciation of investments, changes in the unrealized gain or loss on foreign currency translation adjustments and derivatives, and changes in the minimum pension liability adjustment for our unqualified pension plan. The following summaries present the components of our other comprehensive income, other than net income, for the last three years.
Included in fourth quarter 2003 net income were $57 million of net after-tax realized gains, including after-tax gains of $40 million from the sale of shares of a public company held in our venture capital portfolio, after-tax impairment write-downs of $29 million, and after-tax net realized investment gains of $46 million. Fourth quarter 2003 pretax underwriting losses of $367 million were comprised of profits of $182 million from ongoing business segments and losses of $549 million from segments that are being exited. Runoff underwriting results included a $350 million reserve charge in Health Care, current period underwriting losses of $26 million, an increase in the allowance for uncollectible reinsurance recoverables of $37 million, a $45 million loss provision for incurred but not reported asbestos claims, and prior period reserve increases in other runoff businesses.