Operating income before interest expense and income taxes (a non-GAAP financial measure; see also “Results of Operations - Consolidated” below) was $322.8 million in 2016 compared to $466.1 million in 2015, a decrease of $143.3 million. This decrease is due to unfavorable development on prior years’ loss and LAE reserves (“prior years’ loss reserves”), partially offset by lower catastrophe losses and current accident year losses. Unfavorable development on prior years’ loss reserves was $140.3 million in 2016, compared to favorable development of $94.3 million in 2015. Pre-tax catastrophe losses were $125.1 million in 2016, compared to $181.3 million during 2015. As explained later in this document, a portion of the change in operating income before interest expense and income taxes is also attributable to the effect of foreign exchange fluctuations. The fourth quarter of 2016 included a reserve charge of $174.1 million as a result of our fourth quarter reserve review. See also “2016 Fourth Quarter Domestic Business Loss and LAE Reserve Increase” section below for further discussion.
Underwriting results declined in 2016, as compared to 2015, due to a significant increase in unfavorable development on prior years’ loss reserves, partially offset by lower current accident year losses and lower catastrophe losses. Excluding the aforementioned reserve charge in the fourth quarter of 2016, current accident year results improved across most lines. The competitive nature of the Commercial Lines market requires us to be highly disciplined in our underwriting process to ensure that we write business at acceptable margins, and we continue to seek rate increases across our lines of business.
Underwriting results declined in 2016, as compared to 2015, primarily due to higher current accident year losses, lower favorable development on prior years’ loss reserves, and higher expenses, partially offset by lower catastrophe losses. Chaucer’s net premiums written declined by 8.2% in 2016, primarily due to a planned increase in ceded reinsurance premiums, as we continue to manage our overall underwriting risk given the challenging market conditions.
Consolidated net income was $331.5 million in 2015, compared to $282.0 million in 2014. The increase of $49.5 million is primarily due to higher operating income of $47.3 million, principally from lower catastrophe losses and a lower expense ratio. Additionally, consolidated net income in 2015 included the $40.6 million net gain from the disposal of the U.K. motor business. These increases were partially offset by lower net realized investment gains and an increase in net losses from repayments of debt. Net realized investment gains decreased during 2015 primarily as a result of an increase in other-than-temporary impairments (“OTTI”), and from lower gains from the sale of securities. Additionally, the year ended December 31, 2014 included after-tax losses of $7.9 million from the settlement of a portion of the defined benefit pension plan obligation.
The following table reflects operating income before interest expense and income taxes for each operating segment and a reconciliation to consolidated net income from operating income before interest expense and income taxes (a non-GAAP measure).
In addition to consolidated net income, discussed above, we assess our financial performance based upon pre-tax “operating income,” and we assess the operating performance of each of our four operating segments based upon the pre-tax operating income (loss) generated by each segment. As reflected in the table above, operating income before taxes excludes interest expense on debt and certain other items which we believe are not indicative of our core operations, such as net realized investment gains and losses. Such gains and losses are excluded since they are determined by interest rates, financial markets and the timing of sales. Also, operating income before taxes excludes net gains and losses on disposals of businesses, gains and losses related to the repayment of debt, discontinued operations, costs to acquire businesses, restructuring costs, the cumulative effect of accounting changes and certain other items. Although the items excluded from operating income before taxes are important components in understanding and assessing our overall financial performance, we believe a discussion of operating income before taxes enhances an investor’s understanding of our results of operations by highlighting net income attributable to the core operations of the business. However, operating income before taxes, which is a non-GAAP measure, should not be construed as a substitute for income before income taxes, and operating income should not be construed as a substitute for net income.
Catastrophe losses and prior years’ reserve development are significant components in understanding and assessing the financial performance of our business. Management reviews and evaluates catastrophes and prior years’ reserve development separately from the other components of earnings. References to “current accident year underwriting results” exclude prior accident year reserve development. Catastrophes and prior years’ reserve development are not predictable as to timing or the amount that will affect the results of our operations and have an effect on each year’s operating and net income. Management believes that providing certain financial metrics and trends excluding the effects of catastrophes and prior years’ reserve development helps investors to understand the variability in periodic earnings and to evaluate the underlying performance of our operations. Discussion of catastrophe losses in this Management’s Discussion and Analysis of Financial Condition and Results of Operations includes development on prior years’ catastrophe reserves and, unless otherwise indicated, such development is excluded from discussions on prior year loss and LAE reserve development.
Although we endeavor to balance assets and liabilities for our foreign currencies, a certain level of net exposure to exchange rate fluctuations persists. We monitor and seek to limit the extent of this exposure. These transactional foreign exchange gains and losses are unlikely to be material to our financial position, although they may be more significant to our financial results of operations in any one period.
Commercial Lines underwriting loss for the year ended December 31, 2016 was $122.0 million, compared to $12.7 million for the year ended December 31, 2015, a change of $109.3 million. Unfavorable development on prior years’ loss reserves (“prior year development”) for the year ended December 31, 2016 was $223.0 million, compared to $45.2 million for the year ended December 31, 2015, an unfavorable change of $177.8 million, primarily due to higher than expected losses in other commercial lines of $168.0 million, which includes our AIX program business of $75.3 million. This was principally driven by losses in accident years 2014 and prior, primarily from programs which have since been terminated, as well as higher than expected losses in our general liability lines of $56.0 million, and higher than expected losses in surety lines of $35.3 million. We also experienced unfavorable prior year development in our commercial multiple peril line of $74.2 million and in our commercial automobile line of $27.5 million. These items were partially offset by favorable prior year development in our workers’ compensation line of $46.7 million. Catastrophe-related losses decreased for the year ended December 31 2016 at $70.1 million, compared to $88.7 million for the year ended December 31, 2015.
We are continuing efforts to improve our underwriting results, including through increased rates; however, our ability to increase Commercial Lines net premiums written while maintaining or improving underwriting results is expected to be affected by price competition and the challenging economic environment. We continue to monitor these trends and consider them in our rate actions.
Chaucer’s underwriting profit for the year ended December 31, 2016 was $80.3 million, compared to $131.5 million for the year ended December 31, 2015, a decrease of $51.2 million. This decrease is primarily due to higher current accident year losses, lower favorable prior year reserve development and higher expenses, partially offset by lower catastrophe losses. Favorable development on prior years’ loss reserves for the year ended December 31, 2016 was $95.3 million, compared to $120.1 million for the year ended December 31, 2015, a decrease of $24.8 million, including the effect of foreign exchange fluctuations (see “Foreign Exchange” section above for further discussion). Catastrophe losses for the year ended December 31, 2016 were $8.0 million, compared to $16.8 million for the year ended December 31, 2015, a decrease of $8.8 million.
Commercial Lines net premiums written were $2,281.9 million for the year ended December 31, 2015, compared to $2,155.9 million for the year ended December 31, 2014. This $126.0 million increase was primarily driven by pricing increases, increased retention, and targeted new business expansion.
Chaucer’s current accident year underwriting profit, excluding catastrophes, was $28.2 million in the year ended December 31, 2015, compared to $46.7 million for the year ended December 31, 2014. This $18.5 million decline was primarily due to higher large losses in the energy line, partially offset by lower losses in the aviation and property lines.
Our loss reserves include case estimates for claims that have been reported and estimates for claims that have been incurred but not reported (“IBNR”) at the balance sheet date. They also include estimates of the expenses associated with processing and settling all reported and unreported claims, less estimates of anticipated salvage and subrogation recoveries. Our property and casualty loss reserves are not discounted to present value.
We determine the amount of our loss reserves based on an estimation process that is very complex and considers information from both company specific and industry data, as well as general economic and other information. The estimation process is a combination of objective and subjective information, the blending of which requires significant professional judgment. There are various assumptions required, including future trends in frequency and severity of claims, operational changes in claim handling and case reserving practices, and trends related to general economic and social conditions. Informed judgments as to our ultimate exposure to losses are an integral component of our loss reserve estimation process.
There is greater inherent uncertainty in estimating insurance reserves for certain types of property and casualty insurance lines, particularly liability lines, where a longer period of time may elapse before a definitive determination of ultimate liability and losses may be made. In addition, the technological, judicial, regulatory and political climates involving these types of claims are continuously evolving. There is also greater uncertainty in establishing reserves with respect to business that is new to us, particularly new business which is generated with respect to newly introduced product lines, by newly appointed agents or in geographies in which we have less experience in conducting business, such as certain new program business written by AIX, Chaucer’s U.S. casualty treaty and international liability lines, our professional liability specialty lines, our excess and surplus specialty lines, and business written in the western part of the United States. In some of these cases, there is less historical experience or knowledge and less data upon which we can rely. A combination of business that is both new to us and has longer development periods provides even greater uncertainty in estimating insurance reserves. In our management and professional liability lines, we are modestly increasing, and expect to continue to increase, our exposure to longer-tailed liability lines, including directors and officers liability, errors and omissions liability and product liability coverages. The Chaucer business acquired in 2011 contains several liability lines, of which financial institution and professional liability, U.S. casualty treaty liability, international liability and energy liability, contribute the most uncertainty. Chaucer’s U.S. casualty treaty lines have grown in 2015 and 2016, due to our expanded underwriting capabilities.
Our loss reserves include amounts related to short-tail and long-tail classes of business. “Tail” refers to the time period between the occurrence of a loss and the final settlement of the claim. The longer the time span between the incidence of a loss and the settlement of the claim (i.e., a longer tail), the more the ultimate settlement amount may likely vary from our original estimate.
Loss development factor methods generally assume that the losses yet to emerge for an accident year are proportional to the paid or reported loss amount observed to date. Historical patterns of the development of paid and reported losses by accident year can be predictive of the expected future patterns that are applied to current paid and reported losses to generate estimated ultimate losses by accident year.
In addition to the methods described above, various tailored reserving methodologies are used for certain businesses. For example, for some low volume and high volatility classes of business, special reserving techniques are utilized that estimate IBNR by selecting the loss ratio that balances actual reported losses to expected reported losses as defined by the estimated underlying reporting pattern. Also, for some classes with long exposure periods (e.g., energy, construction, engineering and political risks), earnings patterns plus an estimated reporting lag applied to the Bornheutter-Ferguson initial expected loss ratio are used to estimate IBNR. This is done in order to reflect the changing average exposure periods by policy year (and consequently accident year).
Our carried reserves for each line of business and coverage are determined based on this quarterly loss reserving process. In making the determination, we consider numerous quantitative and qualitative factors. Quantitative factors include changes in reserve estimates in the period, the maturity of the accident year, trends observed over the recent past, the level of volatility within a particular class of business, the estimated effects of reinsurance, including reinstatement premiums, general economic trends, and other factors. Qualitative factors may include legal and regulatory developments, changes in claim handling and case reserving practices, recent entry into new markets or products, changes in underwriting practices or business mix, concerns that we do not have sufficient or quality historical reported and paid loss and LAE information with respect to a particular line or segment of our business, effects of the economy and political outlook, perceived anomalies in the historical results, evolving trends or other factors. In doing so, we must evaluate whether a change in the data represents credible actionable information or an anomaly. Such an assessment requires considerable judgment. Even if a change is determined to be apparent, it is not always possible to determine the extent of the change. As a result, there can be a time lag between the emergence of a change and a determination that the change should be partially or fully reflected in the carried loss reserves. In general, changes are made more quickly to reserves for more mature accident years and less volatile classes of business.
In addition, we must consider the uncertain effects of emerging or potential claims and coverage issues that arise as legal, judicial, social conditions, political risks, and economic conditions change. For example, claims which we consider closed may be re-opened as additional damages surface or new liability or damage theories are presented. Also, historically we have observed more frequent and higher severity in workers’ compensation, bodily injury and other liability claims, and more credit related losses (for example, in our surety business) during periods of economic uncertainty or high unemployment. These and other issues could have a negative effect on our loss reserves by either extending coverage beyond the original underwriting intent or by increasing the number or size of claims.
Personal Automobile Personal Injury Protection Medical Payment - reserves recorded for personal injury protection medical payment on U.S. voluntary business were $144.2 million as of December 31, 2016. A key assumption for this coverage is the inflation rate underlying the estimated reserve. Given the long reporting pattern for this line of business, an additional key assumption is the amount of additional development required to reach full maturity, thereby reflecting ultimate costs, as represented by the tail factor. A five point change in the embedded inflation rate and a one point change to the tail factor assumption (e.g., 1.02 changed to 1.01 or 1.03) would have changed total reserves by approximately $67 million, either positive or negative, at December 31, 2016.
Workers’ Compensation - reserves recorded for workers’ compensation on U.S. voluntary business were $369.2 million as of December 31, 2016. A key assumption for workers’ compensation is the inflation rate underlying the estimated reserve. Given the long reporting pattern for this line of business, an additional key assumption is the amount of additional development required to reach full maturity, thereby reflecting ultimate costs, as represented by the tail factor. A five point change in the embedded inflation rate and a one point change to the tail factor assumption would have changed total reserves by approximately $83 million, either positive or negative, at December 31, 2016.
New classes of business - claims reserves recorded for new classes of Chaucer business (primarily within international liability, U.S. casualty treaty and new lines written in overseas offices) were $221.7 million as of December 31, 2016. An increase in the ultimate loss ratio by 5%, 10% and 15% in the 2014 and prior, 2015 and 2016 years of account, respectively, on these classes would have increased total reserves by approximately $33 million at December 31, 2016.
Casualty classes of business - claims reserves recorded for casualty classes of Chaucer business were $457.6 million as of December 31, 2016. An increase in the ultimate loss ratio of 2.5% across all classes and years of account would have increased total reserves by approximately $41 million at December 31, 2016.
In 2016, total net unfavorable prior year loss and LAE development, including catastrophe losses, was $105.4 million, or approximately 2% of total net reserves, comprised of unfavorable non-catastrophe loss and LAE development of $140.3 million, partially offset by favorable catastrophe loss development of $34.9 million. In 2015, total net favorable prior year loss and LAE development, including catastrophe losses, was $116.1 million, or approximately 3% of total net reserves, comprised of favorable non-catastrophe loss and LAE development of $94.3 million and favorable catastrophe loss development of $21.8 million. In 2014, total net favorable prior year loss and LAE development, including catastrophe losses, was $117.4 million, or approximately 3% of total net reserves, comprised of favorable non-catastrophe loss and LAE development of $99.1 million and favorable catastrophe loss development of $18.3 million.
It is not possible to know whether the factors that affected loss reserves in the year ended December 31, 2016 will also occur in future periods. As discussed in detail in this Form 10-K, there are inherent uncertainties in estimating reserves for losses and LAE and we encourage you to read this Form 10-K for more information about our reserving process and the judgments, uncertainties and risks associated therewith.
The table below provides a summary of (favorable)/unfavorable loss and LAE reserve development, excluding catastrophes.
Chaucer’s favorable development during 2016 was primarily the result of lower than expected losses in the energy line of $27.6 million, primarily in the 2013 through 2015 accident years, in the marine and aviation line of $24.2 million, primarily in the 2008, 2009, 2014 and 2015 accident years and in the property line of $17.5 million, primarily in the 2013 through 2015 accident years. Additionally, Chaucer experienced lower than expected losses within casualty and other lines, specifically the specialist and international liability lines, of $13.4 million, primarily in the 2014 and prior accident years. Partially offsetting Chaucer’s favorable development was the unfavorable impact of foreign exchange rate movements on prior years’ loss reserves. See “Foreign Exchange” section above for further discussion.
The net unfavorable Commercial Lines development primarily resulted from higher than expected large losses within the commercial automobile coverages of $23.1 million, which includes the AIX program business, primarily related to liability coverage in the 2009 through 2012 accident years. Partially offsetting the unfavorable development was lower than expected losses within the workers’ compensation line, primarily related to the 2007 through 2012 accident years, and the surety line, primarily related to the 2013 accident year.
In 2016, favorable catastrophe development was $34.9 million, primarily due to lower than expected losses in our property line, within our Chaucer segment, of $28.1 million and to a lesser extent, in our commercial multiple peril line, within Commercial Lines. In 2015, favorable catastrophe development was $21.8 million, primarily due to lower than expected losses in our property line, within our Chaucer segment, of $25.3 million, partially offset by higher than expected losses in our homeowners line, within our Personal Lines segment. In 2014, favorable catastrophe development was $18.3 million, primarily due to lower than expected losses in our property, marine and energy lines, within our Chaucer segment, of $23.2 million, partially offset by higher than expected losses in our Commercial Lines segment.
The table below provides a summary of (favorable)/unfavorable loss and LAE reserve development excluding catastrophes for the three months ended December 31, 2016:
For the three months ended December 31, 2016, prior year favorable reserve development for catastrophes was $2.0 million for our domestic business.
Through the first nine months of 2016, we recorded $61.5 million of unfavorable loss and LAE reserve development for our domestic business excluding catastrophes, driven by higher than expected large losses in our commercial liability coverages, primarily in our commercial multiple peril line and both our AIX program business and general liability coverages that are within other commercial lines. Additionally, we incurred higher than expected legal defense costs, a component of LAE expenses, during the first nine months of 2016. Other product lines also reported increased claim activity, including commercial automobile and surety.
There was an increased level of loss and LAE activity recorded in certain lines in 2015 that continued throughout 2016, and in some cases intensified into the fourth quarter, and appears to represent longer-term trends that management concluded required recognition. As a result of these trends, during the fourth quarter of 2016, we performed a more in-depth actuarial reserve review in several areas. We assessed the recent large loss activity in our monoline and multiple peril general liability and surety lines and the emergence of such relative to the timing and amounts of expected large losses. For surety, the majority of the recent large loss activity emerged throughout 2016 and intensified during the fourth quarter. We also conducted additional analyses of our general liability coverages and AIX program business within other commercial lines. The results of these analyses indicated that the assumed tail risk included in the loss development patterns needed to be increased. Our claims and actuarial staff also conducted a review of legal defense costs and other claim-specific adjusting expenses as a result of an emerging trend of increased expenses in the these areas over recent quarters. This review concluded that the ultimate costs of these loss adjustment expense were higher than previously estimated, causing management to record an increase in estimated LAE, primarily in our commercial multiple peril and general liability product lines.
In addition, we have established gross and net loss and LAE reserves for assumed reinsurance pool business with asbestos and environmental damage liability of $31.2 million, $27.7 million and $29.1 million at December 31, 2016, 2015 and 2014, respectively. These reserves relate to pools in which we have terminated our participation; however, we continue to be subject to claims related to years in which we were a participant. Results of operations from these pools are included in our Other segment. A significant part of our pool reserves relates to our participation in the ECRA voluntary pool from 1950 to 1982. In 1982, the pool was dissolved and since that time, the business has been in run-off. Our percentage of the total pool liabilities varied from 1% to 6% during these years. Our participation in this pool has resulted in average paid losses of approximately $2 million annually over the past ten years. Our ECRA reserves were increased by $7.4 million based on an updated third-party actuarial study received in the fourth quarter.
See “Reinsurance” in Item 1 - Business of this Form 10-K for further information on our reinsurance programs and “Reinsurance Recoverable Balances” within “Critical Accounting Estimates” in Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-K for discussion of our critical accounting estimates for reinsurance recoverable balances.
The increase in net investment income in both 2016 and 2015 was primarily due to the investment of higher operational cash flows and to additional income from our commercial mortgage loan participations, private equity partnerships and equity securities. These increases were partially offset by the impact of lower new money yields, the effect of lower investment assets associated with our repurchases of stock, repayments of debt and the transfer of the U.K. motor business. We expect average investment yields to continue to decline as new money rates remain lower than embedded book yields.
Equity securities primarily consist of income-oriented large capitalization common stocks and U.S. market equity index exchange traded funds.
For the years ended December 31, 2016, 2015 and 2014 we recognized in earnings $27.9 million, $26.8 million, and $5.5 million, respectively, of OTTI on fixed maturity and equity securities. In 2016, OTTI consisted primarily of $16.1 million on fixed maturities we intended to sell, $8.8 million related to estimated credit losses on fixed maturities and $2.7 million on equity securities. In 2015, OTTI consisted of $16.0 million related to estimated credit losses on fixed maturities, $4.0 million on fixed maturities we intended to sell and $6.8 million on equities. OTTI in 2016 and 2015 related to the energy sector was $16.6 million and $19.6 million, respectively.
We view gross unrealized losses on fixed maturities and equity securities as temporary since it is our assessment that these securities will recover in the near term, allowing us to realize their anticipated long-term economic value. With respect to gross unrealized losses on fixed maturities, we do not intend to sell, nor is it more likely than not we will be required to sell, such debt securities before this expected recovery of amortized cost (see also “Liquidity and Capital Resources” in Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-K). With respect to equity securities, we have the intent and ability to retain such investments for the period of time anticipated to allow for this expected recovery in fair value. Inherent in our assessment are the risks that, subsequent to the balance sheet date, market factors may differ from our expectations; the global economic recovery is less robust than we expect or reverts to recessionary trends; unexpected fiscal, tax or trade policies may be implemented with unfavorable impacts on investment values; stress in the commodities sectors, including oil and gas and metals and mining, may persist for an extended period of time; we may decide to subsequently sell a security for unforeseen business needs; or changes in the credit assessment or equity characteristics from our original assessment may lead us to determine that a sale at the current value would maximize recovery on such investments. To the extent that there are such adverse changes, an OTTI would be recognized as a realized loss. Although unrealized losses are not reflected in the results of financial operations until they are realized or deemed “other-than-temporary”, the fair value of the underlying investment, which does reflect the unrealized loss, is reflected in our Consolidated Balance Sheets.
We manage investment assets for our Commercial Lines, Personal Lines, and Other segments based on the requirements of our U.S. combined property and casualty companies. We allocate the investment income, expenses and realized gains and losses to our Commercial Lines, Personal Lines and Other segments based on actuarial information related to the underlying businesses. We manage investment assets separately for our Chaucer segment.
Chaucer has exposure to foreign currency risk, most notably in insurance contracts and invested assets. Some of the insurance contracts provide that ultimate losses may be payable in foreign currencies depending on the country of original loss. Foreign currency exchange rate risk exists to the extent that there is an increase in the exchange rate of the foreign currency in which losses are ultimately owed. Thus, Chaucer attempts to manage foreign currency risk by seeking to match liabilities under insurance and reinsurance policies that are payable in foreign currencies with cash and investments that are denominated in such currencies. We may also utilize foreign currency forward contracts as part of our investment strategy. The principal currency creating foreign exchange investment risk for us is the U.K. pound sterling, and to a lesser extent, the Canadian dollar, Euro, Australian dollar and Swiss franc. A hypothetical 10% reduction in the value of foreign denominated investments would be expected to produce a loss in fair value of approximately $58 million and $59 million at December 31, 2016 and 2015, respectively.
The income tax provision on operating income was an expense of $83.5 million, $125.5 million and $108.3 million for 2016, 2015 and 2014, respectively. These provisions resulted in effective tax rates for operating income of 31.2%, 30.9% and 31.8% in 2016, 2015 and 2014, respectively. The increase in the 2016 effective tax rate is primarily due to a decrease in our operating income for 2016, whereas the decrease in the 2015 effective tax rate is primarily due to the increase in our recognition of foreign tax credits.
During 2014, we released the valuation allowance related to our deferred tax assets of $2.9 million recorded in 2013. The release of this valuation allowance resulted from appreciation in our investment portfolio and is recorded as a $2.9 million decrease in our income tax expense.
The IRS audits of the years 2007 through 2010 were settled in 2014 with no material impact to our financial position or results of operations. There is no ongoing audit on our open tax years.
See “Reserve for Losses and Loss Adjustment Expenses” within “Results of Operations - Segments” in Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-K for a discussion of our critical accounting estimates for loss reserves.
We share insurance risk of the primary underlying contracts with various insurance entities through the use of reinsurance contracts. As a result, when we experience loss events that are subject to a reinsurance contract, reinsurance recoveries are recorded. The amount of the reinsurance recoverable can vary based on the size of the individual loss or the aggregate amount of all losses in a particular line, book of business or an aggregate amount associated with a particular accident year. The valuation of losses recoverable depends on whether the underlying loss is a reported loss, or an incurred but not reported loss. For reported losses, we value reinsurance recoverables at the time the underlying loss is recognized, in accordance with contract terms. For incurred but not reported losses, we estimate the amount of reinsurance recoverable based on the terms of the reinsurance contracts and historical reinsurance recovery information and apply that information to the gross loss reserve estimates. The most significant assumption we use is the average size of the individual losses for those claims that have occurred but have not yet been reported to us. The reinsurance recoverable is based on what we believe are reasonable estimates and is disclosed separately on the financial statements. However, the ultimate amount of the reinsurance recoverable is not known until all losses are settled.
Net actuarial losses of $40.5 million and $5.9 million were reflected as decreases to accumulated other comprehensive income in 2016 and 2015, respectively. Net actuarial losses in 2016 resulted primarily from decreases in the discount rate as compared to the prior year that were partially offset by benefits from investments gains experienced during the year. Net actuarial losses in 2015 resulted primarily from lower than expected investment gains that were experienced during the year that were partially offset by a slight increase from the change in the discount rate as compared to the prior year. The change in these actuarial gains and losses is amortized into earnings in future periods. In 2016 and 2015, amortization of actuarial losses from prior years was $10.1 million and $10.5 million, respectively.
Expenses related to our defined benefit plans are generally calculated based upon information available at the beginning of the plan year. Our pre-tax expense related to our defined benefit plans was $11.7 million and $10.9 million for 2016 and 2015, respectively. Given the positive effect of our actual investment experience in 2016, and taking into consideration the decrease in discount rates for 2017, pension related expenses are expected to increase from $11.7 million in 2016 to approximately $13.7 million in 2017.
Temporary declines in market value are recorded as unrealized losses, which do not affect net income and earnings per share, but reduce accumulated other comprehensive income, which is reflected in our Consolidated Balance Sheets. We cannot provide assurance that the OTTIs will be adequate to cover future losses or that we will not have substantial additional impairments in the future. See “Investments” in Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-K for further discussion regarding OTTIs and securities in an unrealized loss position.
The statutory capital and surplus for our U.S. insurance subsidiaries decreased $19.4 million during 2016, primarily due to a $218.8 million dividend paid by Hanover Insurance to THG and an increase in the minimum pension liability, partially offset by operating results and unrealized and realized gains on investments.
The NAIC prescribes an annual calculation regarding risk based capital (“RBC”). RBC ratios for regulatory purposes, as described in the glossary, are expressed as a percentage of the capital required to be above the Authorized Control Level (the “Regulatory Scale”); however, in the insurance industry, RBC ratios are widely expressed as a percentage of the Company Action Level. The following table reflects the Company Action Level, the Authorized Control Level and RBC ratios for Hanover Insurance (which includes Citizens and other U.S. insurance subsidiaries), as of December 31, 2016 and 2015, expressed both on the Industry Scale (Total Adjusted Capital divided by the Company Action Level) and Regulatory Scale (Total Adjusted Capital divided by Authorized Control Level):
Chaucer, through its corporate member, operates in the Lloyd’s market, which requires that each member deposit funds, referred to as “Funds at Lloyd’s”, to support its underwriting interests. Lloyd’s sets required capital annually for all participating syndicates based on each syndicate’s business plans, the rating and reserving environment, and discussions with regulatory and rating agencies. Although the minimum capital levels are set by Lloyd’s, it is the responsibility of Chaucer to continually monitor the risk profiles of its managed syndicates to ensure that the level of funding remains appropriate. Such capital is comprised of investments, undrawn letters of credit provided by various banks, and cash and cash equivalents.
Liquidity is a measure of our ability to generate sufficient cash flows to meet the cash requirements of business operations. As a holding company, our primary ongoing source of cash is dividends from our insurance subsidiaries. However, dividend payments to us by our U.S. insurance subsidiaries are subject to limitations imposed by regulators, such as prior notice periods and the requirement that dividends in excess of a specified percentage of statutory surplus or prior year’s statutory earnings receive prior approval (so called “extraordinary dividends”). Hanover Insurance paid $218.8 million in dividends to the holding company during 2016. No dividends were paid to the holding company by Hanover Insurance in 2015 or 2014.
In connection with an intercompany borrowing arrangement between Chaucer and the holding company, interest on a $300 million note is paid by Chaucer on a quarterly basis to the holding company. This interest may be deferred at the election of the holding company. If deferred, the interest is added to the principal. Chaucer paid interest to the holding company totaling $22.4 million in 2016 and $22.5 million in both 2015 and 2014.
Net cash used in investing activities was $495.4 million during 2016, as compared to $171.5 million during 2015 and $600.7 million in 2014. During 2016, cash used in investing activities primarily related to net purchases of fixed maturities, commercial mortgage loan participations, and other investments. These cash outflows were partially offset by proceeds from net sales of equity securities. During 2015, cash used in investing activities primarily related to net purchases of commercial mortgage loan participations and fixed maturities. These cash outflows were partially offset by net cash received from the disposal of the U.K. motor business. In 2014, cash used in investing activities primarily related to net purchases of fixed maturities, equity securities, and other investments. See Note 3 - “Investments” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
At December 31, 2016, THG, as a holding company, held approximately $126.5 million of fixed maturities and cash. We believe our holding company assets will be sufficient to meet our 2017 obligations, which consist primarily of dividends to our shareholders (as and to the extent declared), the interest on our senior and subordinated debentures, certain costs associated with benefits due to our former life employees and agents, and, to the extent required, payments related to indemnification of liabilities associated with the sale of various subsidiaries. As discussed below, we have, and opportunistically may continue to, repurchase our common stock and debt. We may decide to provide funds to the holding company for these or other opportunities through dividends or short-term intercompany lending arrangements.
We expect to continue to generate sufficient positive operating cash to meet all short-term and long-term cash requirements relating to current operations, including the funding of our qualified defined benefit pension plan and the Chaucer pension plan. Based upon the current estimate of liabilities and certain assumptions regarding investment returns and other factors, our qualified defined benefit pension plan and Chaucer pension plan collectively have plan liabilities in excess of plan assets of approximately $69 million. The ultimate payment amounts for our benefit plans are based on several assumptions, including but not limited to, the rate of return on plan assets, the discount rate for benefit obligations, mortality experience, interest crediting rates, inflation and the ultimate valuation and determination of benefit obligations. Since differences between actual plan experience and our assumptions are almost certain, changes both positive and negative to our current funding status and ultimately our obligations in future periods are likely.
We have a $200.0 million credit agreement which expires in November 2018, with an option to increase the facility to $300.0 million assuming no default and satisfaction of certain other conditions. The agreement also includes a $50 million sub-facility for standby letters of credit that can be used for general corporate purposes. Borrowings, if any, under the agreement are unsecured and incur interest at a rate per annum equal to, the higher of (a) the prime commercial lending rate of the administrative agent, (b) the Federal Funds Rate plus half of a percent, or (c) the one month Adjusted LIBOR plus one percent and any applicable margin. The agreement contains financial covenants including, but not limited to, maintaining at least a certain level of consolidated equity, maximum consolidated leverage ratios and requires certain of our subsidiaries to maintain a minimum RBC ratio. We had no borrowings under this agreement during 2016, 2015 and 2014.
On October 15, 2015, we entered into a Standby Letter of Credit Facility Agreement (the “Facility Agreement”) not to exceed £170.0 million (or $209.6 million) outstanding at any one time, with the option to increase the amount available for issuances of letters of credit to £235.0 million (or $289.8 million) in the aggregate on one occasion only during the term of the Facility Agreement (subject to the consent of all lenders and assuming no default and satisfaction of other specified conditions). The Facility Agreement provides certain covenants including, but not limited to, the syndicates’ financial condition. The Facility Agreement provides regulatory capital supporting Chaucer’s underwriting activities for the 2015, 2016 and 2017 years of account and each prior open year of account. The Facility Agreement is generally renewed biennially to support new underwriting years.
The Facility agreement is subject to a letter of credit commission fee on outstanding letters of credit that is payable quarterly. The Facility Agreement fee ranges from 1.125% to 1.50% per annum, depending on our credit ratings for portions that are not cash collateralized, and 0.275% per annum for portions that are cash collateralized. We may, from time to time, collateralize a portion of the outstanding letter of credit. In addition to the commission fee on the uncollateralized outstanding letter of credit, a commitment fee in respect of the unutilized commitments under the Facility Agreement is payable quarterly, and ranges from 0.394% to 0.525% per annum, depending on our credit ratings. Chaucer is also required to pay customary agency fees. We paid $3.5 million and $3.7 million in interest costs in 2016 and 2015, respectively.
Simultaneous with the Facility Agreement, we entered into a Guaranty Agreement (the “Guaranty Agreement”) with Lloyds Bank plc, as Facility Agent and Security Agent, pursuant to which, we unconditionally guarantee the obligations of Chaucer under the Facility Agreement. The Guaranty Agreement contains certain financial covenants that require us to maintain a minimum net worth, a minimum risk-based capital ratio at our primary U.S. domiciled property and casualty companies and a maximum leverage ratio, and certain negative covenants that limit our ability, among other things, to incur or assume certain debt, grant liens on our property, merge or consolidate, dispose of assets, materially change the nature or conduct of our business and make restricted payments (except, in each case, as provided by certain exceptions). The Guaranty Agreement also contains certain customary representations and warranties.
Debt includes our senior debentures due in 2026, which pay annual interest at a rate of 4.50%, our senior debentures due in 2025, which pay annual interest at a rate of 7.625%, our subordinated debentures due in 2053, which pay annual interest at a rate of 6.35%, and our subordinated debentures due in 2027, which pay cumulative dividends at an annual rate of 8.207%. Payments related to the principal amounts of these agreements represent contractual maturity; therefore, principal and interest associated with these obligations are reflected in the above table based upon the contractual maturity dates. In addition, we have $125.0 million of borrowings under a collateralized borrowing program with the FHLBB that pays interest monthly at a rate of 5.50% annually. Such borrowings are available for a twenty-year term or through September 25, 2029. Also, interest includes contractual interest related to the uncollateralized portion of our £170.0 million Standby Letter of Credit Facility.
Information regarding litigation and legal contingencies appears in Note 18-“Commitments and Contingencies” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K. Information related to certain regulatory and industry developments are contained in “Regulation” in Part 1 - Item 1 of this Form 10-K and in “Risk Factors” in Part 1 - Item 1A of this Form 10-K.
Catastrophe loss - Loss and directly identified loss adjustment expenses from catastrophes, including development on prior years’ catastrophe loss reserves. The Insurance Services Office (“ISO”) Property Claim Services (“PCS”) defines a catastrophe loss as an event that causes $25 million or more in U.S. industry insured property losses and affects a significant number of property and casualty policyholders and insurers. In addition to those catastrophe events declared by ISO, claims management also generally includes within the definition of a “catastrophe loss”, a property loss event that causes approximately $5 million or more in Company insured losses and affects in excess of one hundred policy holders or multiple independent risks. For the international business in our Chaucer segment, management utilizes a “catastrophe loss” definition that is substantially consistent with the ISO definition framework.
Funds at Lloyd’s - Funds held in trust at Lloyd’s as security for the policyholders and to support a corporate member’s overall underwriting activities. The funds must be in a form approved by Lloyd’s and be maintained at certain specified levels.
The Authorized Control Level authorizes the commissioner of the state of domicile to take whatever regulatory actions are considered necessary to protect the best interest of the policyholders and creditors of the insurer.
Specialty Lines - A major component of our other commercial lines. There is no accepted industry definition of “specialty lines”, but for our purpose specialty lines consist of products such as inland and ocean marine, surety, specialty property, professional liability, management liability and various other program businesses. When discussing net premiums written and other financial measures of our specialty businesses, we may include non-specialty premiums that are written as part of the entire account.
The consolidated financial statements of The Hanover Insurance Group, Inc. (“THG” or the “Company”), include the accounts of The Hanover Insurance Company (“Hanover Insurance”) and Citizens Insurance Company of America (“Citizens”), THG’s principal U.S. domiciled property and casualty companies; Chaucer Holdings Limited (“Chaucer”), a specialist insurance underwriting group which operates through the Society and Corporation of Lloyd’s (“Lloyd’s”); and certain other insurance and non-insurance subsidiaries. These legal entities conduct their operations through several business segments discussed in Note 14 - “Segment Information”. The consolidated financial statements also include the Company’s discontinued operations, consisting primarily of the Company’s former life insurance businesses, and its accident and health business. All intercompany accounts and transactions have been eliminated.
Fixed maturities and equity securities are classified as available-for-sale and are carried at fair value, with unrealized gains and losses, net of taxes, reported in accumulated other comprehensive income, a separate component of shareholders’ equity. The amortized cost of fixed maturities is adjusted for amortization of premiums and accretion of discounts to maturity.
Investments in limited partnership interests include interests in private equity funds. Where the Company’s interest is so minor that it exercises virtually no influence over operating and financial policies, investments in limited partnership interests are accounted for in accordance with the cost method of accounting; all other investments in limited partnership interests are accounted for in accordance with the equity method of accounting.
The Company tests for the recoverability of goodwill and intangible assets with indefinite lives annually or whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. The Company recognizes impairment losses only to the extent that the carrying amounts of reporting units with goodwill exceed the fair value. The amount of the impairment loss that is recognized is determined based upon the excess of the carrying value of goodwill compared to the implied fair value of the goodwill, as determined with respect to all assets and liabilities of the reporting unit. The Company has performed its annual review of goodwill and intangible assets with indefinite lives for impairment in the fourth quarters of 2016 and 2015 with no impairments recognized. At December 31, 2016 and 2015, Chaucer held intangible assets with indefinite lives of $47.0 million and $56.2 million, respectively, which represents approximately 76% and 74% of the Company’s balance, respectively. In addition, at December 31, 2016 and 2015, goodwill held by Chaucer was $6.0 million and $7.2 million, respectively. The remaining balance relates to the U.S. Companies. The changes in the value of intangible assets with indefinite lives from December 31, 2015 represent foreign exchange differences arising during 2016 whereas the changes in the value of intangible assets with indefinite lives during 2015 were primarily related to the disposition of the U.K. motor business on June 30, 2015. See Note 2 - “Dispositions of Businesses”.
The Company’s debt at December 31, 2016 includes senior debentures, subordinated debentures, and collateralized borrowings with the Federal Home Loan Bank of Boston (“FHLBB”). Debt instruments are carried at principal amount borrowed, net of any applicable unamortized discounts and issuance costs. See Note 6 - “Debt and Credit Arrangements”.
The realization of deferred tax assets depends upon the existence of sufficient taxable income within the carryback or carryforward periods under the tax law in the applicable tax jurisdiction. Consideration is given to all available positive and negative evidence, including reversals of deferred tax liabilities, projected future taxable income, tax planning strategies and recent financial operations. Valuation allowances are established if, based on available information, it is determined that it is more likely than not that all or some portion of the deferred tax assets will not be realized. Changes in valuation allowances are generally reflected in income tax expense or as an adjustment to other comprehensive income (loss) depending on the nature of the item for which the valuation allowance is being recorded.
In May 2015, the Financial Accounting Standards Board (“FASB”) issued ASC Update No. 2015-09, (Topic 944) Financial Services- Insurance: Disclosures about Short-Duration Contracts. This ASC update requires several additional disclosures regarding short-duration insurance contracts, including; disaggregated incurred and paid claims development information, quantitative and qualitative information about claim frequency and duration, and the sum of incurred but not reported liabilities plus expected development on reported claims included in the liability for unpaid claims and claim adjustment expenses along with a description of reserving methodologies. This information is required to be presented by accident year, for the number of years for which claims typically remain outstanding, but need not exceed 10 years. A reconciliation of the claims development disclosures to the aggregate carrying amount of the liability for unpaid claims and claim adjustment expenses, including a separate disclosure for reinsurance recoverables is also required for each period presented in the statement of financial position. In addition, this ASC update requires insurance entities to disclose information about significant changes in methodologies and assumptions used to calculate the liability for unpaid claims and claim adjustment expenses, including reasons for the change and the effects on the financial statements. The updated guidance is effective for annual periods beginning after December 15, 2015, and interim periods within annual periods beginning after December 15, 2016. Early adoption is permitted. The Company implemented this guidance beginning with its disclosures for the year ended December 31, 2016. The effect of implementing this guidance was not material to the Company’s financial position or results of operations, as the update is disclosure related.
In August 2014, the FASB issued ASC Update No. 2014-15, (Subtopic 205-40) Presentation of Financial Statements- Going Concern. This ASC update provides guidance on determining when and how to disclose going concern uncertainties in the financial statements, and requires management to perform interim and annual assessments of an entity’s ability to continue as a going concern within one year of the date the financial statements are issued. The updated guidance is effective for annual periods ending after December 15, 2016 and interim periods thereafter. Early adoption is permitted. The Company implemented this guidance beginning with the year-ended December 31, 2016. The effect of implementing this guidance was not material to the Company’s financial position or results of operations.
In January 2017, the FASB issued ASC Update No. 2017-01, (Topic 805) Business Combinations - Clarifying the Definition of a Business. The amendments in this update provide a more robust framework to use in determining when a set of assets and activities constitute a business. This guidance narrows the definition of a business by providing specific requirements that contribute to the creation of outputs that must be present to be considered a business. The guidance further clarifies the appropriate accounting when substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or a group of similar identifiable assets is that of an acquisition (disposition) of assets, not a business. This framework will reduce the number of transactions that an entity must further evaluate to determine whether transactions are business combinations or asset acquisitions. The updated guidance is effective for interim and annual periods beginning after December 15, 2017, and should be applied on a prospective basis. Early adoption is permitted only for transactions that have not been reported in financial statements that have been issued. The Company does not expect the adoption of ASC Update No. 2017-01 to have a material impact on its financial position or results of operations.
In November 2016, the FASB issued ASC Update No. 2016-18 (Topic 230) Statement of Cash Flows - Restricted Cash (a consensus of the FASB Emerging Issues Task Force). The amendments in this update require that restricted cash and restricted cash equivalents be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. Current GAAP does not include specific guidance on the cash flow classification and presentation of changes in restricted cash. The updated guidance is effective for interim and annual periods beginning after December 15, 2017 and is required to be applied using a retrospective transition method to each period presented. Early adoption is permitted, including adoption in an interim period. However, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. Implementing this guidance is not expected to have a significant impact on the Company’s statement of cash flows, as restricted cash, if any, is currently included in total cash and cash equivalents.
In August 2016, the FASB issued ASC Update No. 2016-15, (Topic 230) Classification of Certain Cash Receipts and Cash Payments. This ASC update provides specific guidance on the presentation of certain cash flow items where there is currently diversity in practice, including, but not limited to, debt prepayment or debt extinguishment costs, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, and distributions received from equity method investees. The updated guidance is effective for interim and annual periods beginning after December 15, 2017, and should be applied retrospectively unless impracticable. Early adoption is permitted. The Company is currently evaluating the impact of the adoption of ASC Update No. 2016-15.
In February 2016, the FASB issued ASC Update No. 2016-02, (Topic 842) Leases. This ASC update requires a lessee to recognize a right-of-use asset, which represents the lessee’s right to use a specified asset for the lease term, and a corresponding lease liability, which represents a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis, for all leases that extend beyond 12 months. For finance or capital leases, interest on the lease liability will be recognized separately from amortization of the right-of-use asset in the statements of income and comprehensive income. In addition, the repayment of the principal portion of the lease liability will be classified as a financing activity while the interest component will be included in the operating section of the statement of cash flows. For operating leases, the asset and liability will be amortized as a single lease cost, such that the cost of the lease is allocated over the lease term, on a generally straight-line basis, with all cash flows included within operating activities in the statement of cash flows. The updated guidance is effective for interim and annual periods beginning after December 15, 2018 and is required to be implemented by applying a modified retrospective transition approach. The Company is continuing to evaluate the impact of the adoption of ASC Update No. 2016-02 on its results of operations. It is expected that assets and liabilities will increase based on the present value of remaining lease payments for leases in place at the adoption date; however, the impact is not expected to be significant to the Company’s financial position.
In May 2014, the FASB issued ASC Update No. 2014-09, (Topic 606) Revenue from Contracts with Customers. This ASC was issued to clarify the principles for recognizing revenue. Insurance contracts and financial instrument transactions are not within the scope of this updated guidance, and; therefore, only an insignificant amount of the Company’s revenue is subject to this updated guidance. In August 2015, the FASB issued ASC Update No. 2015-14, (Topic 606) Revenue from Contracts with Customers, which deferred the effective date of ASC Update No. 2014-09 by one year. Accordingly, the updated guidance is effective for periods beginning after December 15, 2017 and is not expected to have a material effect on the Company’s financial position or results of operations.
Reflects $17.2 million of indefinite-lived intangible assets associated with the U.K. motor business upon THG’s purchase of Chaucer in July 2011 and $0.5 million of goodwill.
As part of the reinsurance agreement, investments were transferred, resulting in the recognition of net realized investment gains that were previously reflected in accumulated other comprehensive income.
At December 31, 2016 and 2015, the portion of the discontinued accident and health business that was directly assumed had assets of $57.6 million and $54.5 million, respectively, consisting primarily of invested assets, and liabilities of $49.3 million and $46.5 million, respectively, consisting primarily of policy liabilities. At December 31, 2016 and 2015, the assets and liabilities of this business, as well as those of the reinsured portion of the accident and health business are classified as assets and liabilities of discontinued operations in the Consolidated Balance Sheets.
Discontinued operations for the years ended December 31, 2016, 2015 and 2014 resulted in losses of $1.0 million, gains of $0.7 million and losses of $0.3 million, respectively, net of tax.
OTTI unrealized losses in the tables above represent OTTI recognized in accumulated other comprehensive income. This amount excludes net unrealized gains on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date of $21.4 million and $1.1 million as of December 31, 2016 and 2015, respectively.
The Company enters into various agreements that may require its fixed maturities to be held as collateral by others. At December 31, 2016 and 2015, fixed maturities with a fair value of $217.9 million and $188.1 million, respectively, were held as collateral for collateralized borrowings and other arrangements. Of these amounts, $201.8 million and $176.0 million related to the FHLBB collateralized borrowing program at December 31, 2016 and 2015, respectively. See Note 6-“Debt and Credit Arrangements” for additional information related to the Company’s FHLBB program.
Equity securities and other balances at December 31, 2016, 2015 and 2014 include after-tax net appreciation on other invested assets of $2.5 million, $2.2 million and $2.6 million, respectively.
At December 31, 2016, there were contractual investment commitments of up to $128.8 million.
The carrying values of fixed maturity securities on non-accrual status at December 31, 2016 and 2015 were not material. The effects of non-accruals for the years ended December 31, 2016, 2015 and 2014, compared with amounts of net investment income that would have been recognized in accordance with the original terms of the fixed maturities, were reductions of $1.1 million, $0.8 million and $2.1 million, respectively.
For 2016, total OTTI was $21.2 million. Of this amount, $27.9 million was recognized in earnings including $6.7 million which was transferred from unrealized losses in accumulated other comprehensive income (“AOCI”). The $27.9 million of OTTI recognized in earnings relates primarily to $16.1 million of fixed maturity securities that the Company intended to sell, $8.8 million of credit impairments and $2.7 million of equities.
For 2015, total OTTI was $49.5 million. Of this amount, $26.8 million was recognized in earnings and the remaining $22.7 million was recorded as unrealized losses in AOCI. The $26.8 million of OTTI recognized in earnings relates to $16.0 million of credit impairments, $4.0 million of fixed maturity securities that the Company intended to sell and $6.8 million of equities.
The methodology and significant inputs used to measure the amount of credit losses on fixed maturities in 2016 and 2015 were as follows:
Corporate bonds - the Company utilized a financial model that derives expected cash flows based on probability-of-default factors by credit rating and asset duration and loss-given-default factors based on security type. These factors are based on historical data provided by an independent third-party rating agency. In addition, other market data relevant to the realizability of contractual cash flows may be considered.
Proceeds from sales of fixed maturities in 2015 included proceeds of $379.6 million from the transfer of fixed maturity investments in connection with the disposal of the U.K. motor business and related gross gains of $6.4 million and gross losses of $0.6 million.
The Company utilizes a third-party pricing service for the valuation of the majority of its fixed maturity securities and receives one quote per security. When quoted market prices in an active market are available, they are provided by the pricing service as the fair value and such values are classified as Level 1. Since fixed maturities other than U.S. Treasury securities generally do not trade on a daily basis, the pricing service prepares estimates of fair value for those securities using pricing applications based on a market approach. Inputs into the fair value pricing common to all asset classes include: benchmark U.S. Treasury security yield curves; reported trades of identical or similar fixed maturity securities; broker/dealer quotes of identical or similar fixed maturity securities and structural characteristics such as maturity date, coupon, mandatory principal payment dates, frequency of interest and principal payments, and optional redemption features. Inputs into the fair value applications that are unique by asset class include, but are not limited to:
U.S. government agencies - determination of direct versus indirect government support and whether any contingencies exist with respect to the timely payment of principal and interest.
The Company utilizes a third-party pricing service for the valuation of the majority of its equity securities and receives one quote for each equity security. When quoted market prices in an active market are available, they are provided by the pricing service as the fair value and such values are classified as Level 1. The Company holds certain equity securities that have been issued by privately held entities that do not have an active market and for which the pricing service cannot provide fair values. Generally, the Company estimates fair value for these securities based on the issuer’s book value and market multiples. These securities are reported as Level 2 or Level 3 depending on the significance of the impact of unobservable judgment on the security’s value. Additionally, the Company may obtain non-binding broker quotes which are reported as Level 3.
Changes in the observability of valuation inputs may result in a reclassification of certain financial assets or liabilities within the fair value hierarchy. Reclassifications between levels of the fair value hierarchy are reported as of the beginning of the period in which the reclassification occurs. As previously discussed, the Company utilizes a third-party pricing service for the valuation of the majority of its fixed maturities and equity securities. The pricing service has indicated that it will only produce an estimate of fair value if there is objectively verifiable information to produce a valuation. If the pricing service discontinues pricing an investment, the Company will use observable market data to the extent it is available, but may also be required to make assumptions for market based inputs that are unavailable due to market conditions.
During the years ended December 31, 2016 and 2015, the Company transferred fixed maturities between Level 2 and Level 3 primarily as a result of assessing the significance of unobservable inputs on the fair value measurement. There were no transfers between Level 1 and Level 2 during 2016 or 2015. There were no Level 3 liabilities held by the Company for years ended December 31, 2016 and 2015.
In 2016, in addition to the redemption of the senior debentures maturing June 15, 2021 and March 1, 2020, the Company repurchased senior debentures maturing October 15, 2025, with a carrying value of $11.9 million at a cost of $14.1 million, resulting in a pre-tax loss of $2.2 million.
At December 31, 2016, the Company had a $200.0 million credit agreement which expires in November 2018. The Company had no borrowings under this agreement. Additionally, the Company had a Standby Letter of Credit Facility not to exceed £170.0 million (or $209.6 million). This Letter of Credit Facility provides regulatory capital supporting Chaucer’s underwriting activities for the 2015, 2016 and 2017 years of account and each prior open year of account. Simultaneous with this agreement, THG entered into a Guaranty Agreement with Lloyds Bank plc, as Facility Agent and Security Agent, pursuant to which THG unconditionally guarantees the obligations of Chaucer under the Letter of Credit Facility.
Interest expense was $54.9 million, $60.6 million, and $65.8 million in 2016, 2015 and 2014, respectively. At December 31, 2016, the Company was in compliance with the covenants associated with all of its debt indentures and credit arrangements.
The table below provides a reconciliation of the beginning and ending liability for uncertain tax positions as follows:
In 2014, the IRS audits of the years 2007 through 2010 were settled with no material impact to the Company’s financial position or results of operations.
In 2017, the Company is expecting to release $0.6 million of liability due to the expiration of a statute of limitations.
Prior to 2005, THG provided retirement benefits to substantially all of its employees under defined benefit pension plans. These plans were based on a defined benefit cash balance formula, whereby the Company annually provided an allocation to each covered employee based on a percentage of that employee’s eligible salary, similar to a defined contribution plan arrangement. In addition to the cash balance allocation, certain transition group employees who had met specified age and service requirements as of December 31, 1994 were eligible for a grandfathered benefit based primarily on the employees’ years of service and compensation during their highest five consecutive plan years of employment. The Company’s policy for the plans is to fund at least the minimum amount required by the Employee Retirement Income Security Act of 1974 (“ERISA”).
Prior to 2002, the Chaucer segment provided defined benefit pension retirement benefits to certain of its employees. As of December 31, 2001, the defined benefit pension plan was closed to new members, and as of December 31, 2016 the plan is no longer accruing for future salary increases. The defined benefit obligation for this plan is based on the employees’ years of service and final pensionable salary. Contributions are made at least annually to this plan by both the Company and by employees. As of December 31, 2016, based on current estimates of plan liabilities and other assumptions, the projected benefit obligation of the qualified defined benefit pension plan exceeds plan assets by approximately $16 million.
The salary increase assumption as of December 31, 2016 is used to calculate the curtailment gain that resulted from the cessation of future salary increases.
Securities classified as Level 1 at December 31, 2016 and 2015 include actively traded mutual funds and publicly traded securities, which are valued at quoted market prices. Securities classified as Level 3 at December 31, 2016 and 2015 include assets held in a fixed account of an insurance company. The fair value of the investment is estimated using a comparable public market financial institution derived fair value curve that uses non-observable inputs for market liquidity and unique credit characteristics of its underlying securities.
The Plan also holds investments measured at fair value using NAV based on the value of the underlying investments, which is determined independently by the investment manager and have not been included in the table above. These include investments in commingled pools and investment-grade fixed income securities, held in a custom fund, and commingled pools that primarily invest in publicly traded common stocks and international equity securities. The daily NAV, which is not published as a quoted market price for these investments, is used as the basis for transactions. Redemption of these funds is not subject to restriction. The fair values of these investments are as follows:
The Chaucer plan only holds cash and equivalents and investments measured at fair value using NAV. These investments include pooled funds that are valued at the close of business using a third-party pricing service. These values are adjusted by the fund manager to reflect outstanding dividends, taxes and investment fees and other expenses to calculate the NAV.
The following table reflects the benefit obligations, fair value of plan assets and funded status of the plans at December 31, 2016 and 2015.
The following table reflects the total amounts recognized in accumulated other comprehensive income relating to both the U.S. defined benefit pension plans and the Chaucer pension plan as of December 31, 2016 and 2015.
The unrecognized net actuarial gains (losses) which exceed 10% of the greater of the projected benefit obligation or the fair value of plan assets are amortized as a component of net periodic pension cost over the next five years. The following table reflects the total estimated amount of actuarial losses that will be amortized from accumulated other comprehensive income into net periodic pension cost in 2017 (the estimated expense related to the Chaucer plan was converted to U.S. dollars at an exchange rate of 1.23):
In accordance with ERISA guidelines, the Company is not required to fund its U.S. qualified benefit plan in 2017. The Company expects to contribute $3.2 million to its U.S. non-qualified pension plan to fund 2017 benefit payments and at a minimum, $7.4 million to the Chaucer pension plan; although additional contributions may be made into the Chaucer plan. (Estimated contributions related to the Chaucer plan were converted to U.S. dollars at an exchange rate of 1.23). At this time, no additional discretionary contributions are expected to be made into the U.S. plans during 2017, and the Company does not expect that any funds will be returned from the plans to the Company during 2017.
Chaucer also provides a defined contribution plan for its employees that provides for employer provided contributions. The Company’s expense for 2016, 2015 and 2014 was $3.9 million, $4.8 million and $6.1 million, respectively.
The following table reflects the estimated amortization to be recognized in net periodic benefit cost in 2017:
On May 20, 2014, shareholders approved The Hanover Insurance Group 2014 Long-Term Incentive Plan (the “2014 Stock Plan”). With respect to new share-based award issuances, the 2014 Stock Plan replaced The Hanover Insurance Group, Inc. 2006 Long-Term Incentive Plan (the “2006 Stock Plan”) and authorized the issuance of 6,100,000 shares in a new share pool plus any shares subject to outstanding awards under the 2006 Stock Plan that may become available for reissuance as a result of the cash settlement, forfeiture, expiration or cancellation of such awards. The 2014 Stock Plan provides for the granting of the same types of awards as the 2006 Stock Plan, including stock options and stock appreciation rights (“SARS”), restricted and unrestricted stock, stock units, performance and market-based stock awards, and cash awards. In accordance with the 2014 Stock Plan, the issuance of one share of common stock in the form of an option or SAR will reduce the share pool by one share, whereas the issuance of one share of common stock for the other types of stock awards provided by the plan will reduce the pool by 3.8 shares. As of December 31, 2016, there were 5,332,623 shares available for grants under the 2014 Stock Plan.
Additionally, on May 20, 2014, shareholders approved The Hanover Insurance Group 2014 Employee Stock Purchase Plan (the “ESPP Plan”) and the Chaucer Share Incentive Plan (the “SIP Plan”), authorizing the issuance of 2,500,000 and 750,000 shares, respectively, under such plans. As of December 31, 2016, 2,411,811 shares and 699,018 shares were available for grant under the ESPP Plan and the SIP Plan, respectively.
Under the 2014 Stock Plan, options may be granted to eligible employees, directors or consultants at an exercise price equal to the market price of the Company’s common stock on the date of grant. Option shares may be exercised subject to the terms prescribed by the Compensation Committee of the Board of Directors (the “Committee”) at the time of grant. Options granted in 2016, 2015 and 2014 generally vest over 3 years with 33 1/3% vesting in each year. Options must be exercised not later than ten years from the date of grant.
Included in outstanding shares at the end of 2015 in this table and in subsequent metrics were 128,334 options that were previously granted to the Company’s former CEO. These options were subsequently forfeited in 2016 and are included in the table in the amounts forfeited or cancelled in 2016.
The fair value of each option is estimated on the date of grant using the Black-Scholes option pricing model. For all options granted through December 31, 2016, the exercise price equaled the market price on the grant date. Compensation cost related to options is based upon the grant date fair value and expensed on a straight-line basis over the service period for each separately vesting portion of the option as if the option was, in substance, multiple awards.
The weighted average grant date fair value of options granted during the years ended December 31, 2016, 2015 and 2014 was $10.83, $9.72 and $8.96, respectively.
The Company granted market-based restricted share units in 2016, 2015 and 2014. These units generally vest after 3 years of continued employment and after the achievement of certain stock performance targets. The Company also granted restricted stock units to eligible employees in 2016, 2015 and 2014 that generally vest after 3 years of continued employment.
Included in outstanding shares at the end of 2015 were 56,500 market-based restricted stock units that were previously granted to the Company’s former CEO. These units were subsequently forfeited in 2016 and are included above in the amounts forfeited in 2016.
The intrinsic value of restricted stock and restricted stock units that vested during the years ended December 31, 2016, 2015 and 2014 was $5.4 million, $4.4 million and $4.2 million, respectively. The intrinsic value for performance and market-based restricted stock units that vested in 2016, 2015 and 2014 was $5.8 million, $2.6 million and $0.3 million, respectively. Forfeitures included in the table above for 2016, 2015 and 2014 related entirely to market-based restricted stock units.
At December 31, 2016, the aggregate intrinsic value of restricted stock units was $24.5 million and the weighted average remaining contractual life was 1.4 years. The aggregate intrinsic value of performance and market-based restricted stock units was $10.5 million and the weighted average remaining contractual life was 2.1 years. As of December 31, 2016, there was $17.4 million of total unrecognized compensation cost related to unvested restricted stock units and performance and market-based restricted stock units, assuming performance and market-based restricted stock units are achieved at 100% of the performance metric. The cost is expected to be recognized over a weighted average period of 2.4 years. Compensation cost associated with restricted stock, restricted stock units and performance and market-based restricted stock units is generally calculated based upon grant date fair value, which is determined using current market prices.
Diluted earnings per share during 2016, 2015 and 2014 excludes 0.6 million, 0.6 million and 0.7 million, respectively, of common shares issuable under the Company’s stock compensation plans, because their effect would be antidilutive.
The Company’s Board of Directors has authorized aggregate repurchases of the Company’s common stock of up to $900 million. Under the repurchase authorizations, the Company may repurchase, from time to time, common shares in amounts, at prices and at such times as the Company deems appropriate, subject to market conditions and other considerations. Repurchases may be executed using open market purchases, privately negotiated transactions, accelerated repurchase programs or other transactions. The Company is not required to purchase any specific number of shares or to make purchases by any certain date under this program. As of December 31, 2016, the Company has $183.6 million available for repurchases under these repurchase authorizations. During 2016, the Company purchased 1.3 million shares of the Company’s common stock at a cost of $105.6 million.
Pursuant to Michigan’s statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the Michigan Insurance Commissioner, is limited to the greater of 10% of policyholders’ surplus as of December 31 of the immediately preceding year or the statutory net income less net realized gains, for the immediately preceding calendar year. Citizens declared dividends to its parent, Hanover Insurance, totaling $70.0 million, $63.0 million and $66.0 million in 2016, 2015 and 2014, respectively. At December 31, 2016, the maximum dividend payable without prior approval was $30.0 million. In December 2017, the maximum dividend declared payable without prior approval will increase by $70.0 million to a total amount of $100.0 million.
The Company’s primary business operations include insurance products and services provided through four operating segments. The domestic operating segments are Commercial Lines, Personal Lines and Other, and the Company’s international operating segment is Chaucer. Commercial Lines includes commercial multiple peril, commercial automobile, workers’ compensation, and other commercial coverages, such as inland marine, specialty program business, management and professional liability and surety. Personal Lines includes personal automobile, homeowners and other personal coverages. Chaucer includes marine and aviation, property, energy, casualty and other coverages (which includes international liability, specialist coverages, and syndicate participations), and U.K. motor business prior to June 30, 2015. Effective June 30, 2015, the Company transferred it U.K. motor business to an unaffiliated party. Included in Other are Opus Investment Management, Inc., which markets investment management services to institutions, pension funds and other organizations; earnings on holding company assets; and, a discontinued voluntary pools business. The separate financial information is presented consistent with the way results are regularly evaluated by the chief operating decision maker in deciding how to allocate resources and in assessing performance.
Rental expenses for operating leases amounted to $18.5 million, $17.4 million and $20.4 million in 2016, 2015 and 2014, respectively. These expenses relate primarily to building leases of the Company. At December 31, 2016, future minimum rental payments under non-cancelable operating leases were $61.7 million, payable as follows: 2017 - $16.7 million; 2018 - $15.1 million; 2019 - $12.2 million; 2020 - $9.6 million and 2021 and thereafter - $8.1 million. It is expected that in the normal course of business, leases that expire may be renewed or replaced by leases on other property and equipment.
As a condition to conduct certain business in various states, the Company is required to participate in residual market mechanisms, facilities and pooling arrangements such as the Michigan Catastrophic Claims Association (“MCCA”). The Company is subject to concentration of risk with respect to reinsurance ceded to the MCCA. Funding for MCCA comes from assessments against automobile insurers based upon their share of insured automobiles in the state. Insurers are allowed to pass along this cost to Michigan automobile policyholders. The Company ceded to the MCCA premiums earned and losses and LAE incurred of $58.6 million and $75.0 million in 2016, $67.7 million and $78.8 million in 2015 and $73.4 million and $99.2 million in 2014. The MCCA represented 34.9% of the total reinsurance receivable balance at December 31, 2016. Reinsurance recoverables related to MCCA were $911.2 million and $906.5 million at December 31, 2016 and 2015, respectively. Because the MCCA is supported by assessments permitted by statute, and there have been no significant uncollectible balances from MCCA identified during the three years ending December 31, 2016, the Company believes that it has no significant exposure to uncollectible reinsurance balances from this entity. The Lloyd’s Syndicates total reinsurance receivable balance was $506.8 million as of December 31, 2016, as compared to $606.5 million as of December 31, 2015. The Lloyd’s receivable represented 19.4% of the total reinsurance receivable balance at December 31, 2016.
Effective June 30, 2015, the Company transferred its U.K. motor business through a 100% reinsurance arrangement. This transaction resulted in the increase of approximately $196 million, $133 million and $90 million for ceded premiums written, premiums earned and losses and LAE, respectively, for the year ended December 31, 2015. See also “Disposal of U.K. Motor Business” in Note 2 - “Dispositions of Businesses”.
Management’s process for establishing loss reserves is a comprehensive process that involves input from multiple functions throughout the organization, including actuarial, finance, claims, legal, underwriting, distribution and business operations management. A review of loss reserves for each of the classes of business which the Company writes is conducted regularly, generally quarterly. This review process takes into consideration a variety of trends that impact the ultimate settlement of claims. Where appropriate, the review includes a review of overall payment patterns and the emergence of paid and reported losses relative to expectations.
For events designated as catastrophes which affect the Commercial and Personal Lines business segments, the Company generally calculates IBNR reserves directly as a result of an estimated IBNR claim count and an estimated average claim amount for each event. Such an assessment involves a comprehensive analysis of the nature of the event, of policyholder exposures within the affected geographic area and of available claims intelligence. For events designated as catastrophes that affect the Chaucer business segment, the Company initially calculates IBNR reserves using a ground up exposure by exposure analysis based on each cedant or insured. These are supported by broker supplied information, catastrophe modeling and industry event estimates.
In 2015, net favorable loss and LAE development was $116.1 million, primarily as a result of favorable development of $153.0 million for Chaucer, partially offset by net unfavorable development of $47.2 million for Commercial Lines. As a result of the Company’s year-end 2015 reserve review of domestic commercial and personal lines of business, carried reserves were adjusted among several of these lines of business, impacting the prior year development by line, although these adjustments had no impact on aggregate domestic carried reserves.
For the three months ended December 31, 2016, prior year reserve development for catastrophes was favorable of $2.0 million for the domestic business.
Through the first nine months of 2016, the Company recorded $61.5 million of unfavorable loss and LAE reserve development for the domestic business, excluding catastrophes, driven by higher than expected large losses in commercial liability coverages, primarily in the commercial multiple peril line and both the AIX program business and general liability coverages that are within other commercial lines. Additionally, the Company incurred higher than expected legal defense costs, a component of LAE expenses, during the first nine months of 2016. Other product lines also reported increased claim activity, including commercial automobile and surety.
There was an increased level of loss and LAE activity recorded in certain lines in 2015 that continued throughout 2016, and in some cases intensified into the fourth quarter, and appears to represent longer-term trends that management concluded required recognition. As a result of these trends, during the fourth quarter of 2016, the Company performed a more in-depth actuarial reserve review in several areas. The Company assessed the recent large loss activity in the monoline and multiple peril general liability and surety lines and the emergence of such relative to the timing and amounts of expected large losses. For surety, the recent large loss activity emerged throughout 2016 and intensified during the fourth quarter. The Company also conducted additional analyses of general liability coverages and AIX program business within other commercial lines. The results of these analyses indicated that the assumed tail risk included in the loss development patterns needed to be increased. Claims and actuarial staff also conducted a review of legal defense costs and other claim-specific adjusting expenses as a result of an emerging trend of increased expenses in these areas over recent quarters. This review concluded that the ultimate costs of these loss adjustment expenses were higher than previously estimated, causing management to record an increase in estimated LAE, primarily in the commercial multiple peril and general liability product lines.
The table below summarizes the gross, ceded and net reserve for losses and LAE and reconciles to the incurred claims development in the following section. Accordingly, the commercial multiple peril, workers’ compensation and commercial automobile liability lines presentation includes AIX program business. Chaucer is presented in two components, its ongoing core lines and it’s reinsured and run-off lines.
For the following net reserve components, commercial multiple peril, workers’ compensation, commercial automobile liability, personal automobile liability and Chaucer core lines, the Company is presenting incurred claims development tables by accident year. The commercial multiple peril, workers’ compensation and commercial automobile liability lines presentation includes AIX program business. In each of these tables, the Company is presenting the number of years for which claims are typically outstanding, which is consistent with the period at which substantially all of the reserve development has emerged based on past history. The tables presented below include cumulative incurred loss and allocated loss adjustment expenses (“ALAE”), cumulative paid loss and ALAE and IBNR balances at December 31, 2016. IBNR includes both incurred but not reported liabilities and expected development on reported claims. In addition, cumulative incurred claim counts are presented as of December 31, 2016 and claim duration is presented in a separate table disclosing the average annual percentage payout of incurred claims by age, net of reinsurance. Claim duration is calculated as an average of paid loss and ALAE divided by incurred loss and ALAE by elapsed year. The incurred claims development tables presented are reconciled to the net carried reserves in the preceding table as of December 31, 2016.
For Chaucer core lines, the incurred claim count information presented represents claim frequency by individual claimant and measures the frequency of expected claim settlements that have resulted in or are expected to result in claim payments. While claim count information is only utilized in a limited portion of Chaucer’s quarterly loss reserving process, the counts in the following Chaucer table are presented in a manner consistent with those used by the actuaries. A single claim event may result in multiple individual claimants, and therefore, multiple claim counts. Incurred claim counts are comprised of outstanding claims and those that are closed with a loss payment and exclude those that are closed without payment. A single claim event may result in multiple claims closed with a payment when payments are made in multiple currencies. In this case, the payment in each currency is counted as an incremental claim count. A portion of the coverholder and assumed reinsurance business is reported as block claims, which represent multiple underlying individual claims for a particular loss event or for multiple loss events. Claim count information is not available for the underlying claims related to block claims, and block claims represent approximately 10% of gross incurred losses for Chaucer core lines. Therefore, these block claims are not included in the claim count information presented. Incurred claim counts are also not adjusted for the effects of claims ceded as part of reinsurance programs, although the incurred losses and cumulative paid losses presented in the following tables are presented net of reinsurance ceded.
The following table is information about average historical claims duration as of December 31, 2016. The table is computed based on the paid and incurred claims data, net of reinsurance, for the accident years presented in the preceding claims development tables.
At this time, the Company is unable to provide a reasonable estimate of the potential range of ultimate liability if the outcome of the suit is unfavorable. The statute of limitations applicable to the sub-class consisting of all persons who received lump sum distributions between March 1, 1997 and March 12, 2002 has not yet been finally determined, and the extent of potential liability, if any, will depend on this determination. In addition, assuming for these purposes that the plaintiffs prevail with respect to claims that benefits accrued or payable under the Plan were understated, then there are numerous possible theories and other variables upon which any revised calculation of benefits as requested under plaintiffs’ claims could be based. Any adverse judgment in this case against the Plan would be expected to create a liability for the Plan, with resulting effects on the Plan’s assets available to pay benefits. The Company’s future required funding of the Plan could also be impacted by such a liability.
The following table provides statutory net income for the year ended December 31 and statutory capital and surplus as of December 31 for the periods indicated:
The quarterly results of operations for 2016 and 2015 are summarized below.