We own our headquarters, located at 440 Lincoln Street, Worcester, Massachusetts, with approximately 803,000 square feet.
Net income was $391.0 million in 2018, compared to $186.2 million in 2017, an increase of $204.8 million, primarily due to the gain from the sale of our former Chaucer business and an increase in operating income.
As discussed further in “Discontinued Operations” below, on December 28, 2018, we completed the sale of Chaucer to China Re. We subsequently completed the sale of our Chaucer-related Irish entity on February 14, 2019. The sale of the Australian entities is pending, subject only to local regulatory approval, and is expected to close in the first quarter of 2019. We received $28 million of additional consideration for the Irish entity, and we expect to receive $13 million of additional consideration related to the Australian entities.
Our account-focused approach to the small commercial market, distinctiveness in the middle market, and continued development of specialty lines provides us with a diversified portfolio of products and delivers significant value to agents and policyholders. Each of these businesses is expected to contribute to premium growth in Commercial Lines over the next several years as we continue to pursue our core strategy of developing strong partnerships with agents, enhanced franchise value through limited distribution, distinctive products and coverages, and continued investment in industry segmentation.
These efforts have driven, and we believe they will continue to drive, improvement in our overall mix of business and our underwriting profitability. Commercial Lines net premiums written grew by 6.0% in 2018, due to growth in small commercial, middle market, and the professional lines within our specialty business. Approximately 4.9% of this growth was due to rate and exposure increases, strong retention and targeted new business expansion, with the balance being attributable to improved reinsurance reinstatement activity.
Underwriting results improved in 2018, as compared to 2017, primarily due to lower catastrophe losses, higher favorable development on prior years’ loss reserves, a reduction in reinsurance reinstatement premiums driven by prior year large loss activity, and lower expenses, partially offset by higher non-catastrophe current accident year losses. Catastrophe losses were $142.3 million in 2018, a decrease of $28.3 million when compared to 2017. Favorable development on prior years’ loss reserve in 2018 was $34.1 million, compared to $9.4 million in 2017, an increase of $24.7 million. Reinsurance reinstatement premium, net of ceding commissions, had an unfavorable impact of $0.9 million in 2018, compared to $22.4 million in 2017, a favorable change of $21.5 million. 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.
Personal Lines focuses on partnering with high quality, value-oriented agencies that deliver consultative selling and stress the importance of account rounding (the conversion of single policy customers to accounts with multiple policies and additional coverages, to address customers’ broader objectives). Approximately 84% of our policies in force are account business. We are focused on seeking profitable growth opportunities, building a distinctive position in the market, and diversifying geographically.
We report interest expense on debt separately from the earnings of our operating segments. This consists of interest on our senior debentures, subordinated debentures, and collateralized borrowings with the Federal Home Loan Bank (“FHLB”).
Consolidated net income was $391.0 million in 2018, compared to $186.2 million in 2017, an increase of $204.8 million. The year over year comparison of consolidated net income reflects a $131.9 million gain, net of taxes, on the sale of our Chaucer business. Additionally, operating income before interest expense and income taxes increased $79.2 million, primarily due to lower catastrophe losses and higher net investment income. Income increased from our discontinued operations, primarily Chaucer and, to a lesser extent, our discontinued life business, which incurred a 2017 reserve charge related to our participation in a long-term care pool (See also “Discontinued Operations” section below). Also, income tax expense on operating income decreased $20.2 million, driven by a decrease in the U.S. statutory tax rate from 35% to 21% effective January 1, 2018. These increases in net income were partially offset by net realized and unrealized investment losses, net of taxes, of $30.9 million in 2018, compared to net realized investment gains, net of taxes, of $26.2 million in 2017, principally related to reductions in fair value of equity securities. Effective January 1, 2018, we implemented ASU 2016-01, which requires that the changes in fair value of equity securities be presented in net income. Prior to then, these changes were recognized through accumulated other comprehensive income (see also Note 1 - “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements). Net income was also affected by $22.3 million in losses, net of taxes, associated with the repayment of debt in 2018.
Consolidated net income was $186.2 million in 2017, compared to $155.1 million in 2016, an increase of $31.1 million. Operating income before interest expense and income taxes increased $134.4 million, primarily attributable to the year-over-year changes in development on prior years’ loss reserves. Unfavorable development on prior years’ loss reserves was $1.2 million in 2017 compared to $235.6 million in 2016. Additionally, our results in 2017 benefitted from improved non-catastrophe current accident year underwriting results and higher investment income. These increases were partially offset by a $134.4 million increase in current year catastrophe losses. The year over year comparison of consolidated net income was also affected by a $102.2 million decrease in earnings from the Chaucer business, now reclassified as discontinued operations, from income of $89.1 million in 2016 to losses of $13.1 million in 2017, primarily resulting from higher catastrophe losses. Also, consolidated net income in 2016 included a $57.4 million loss, after taxes, associated with the repayment of debt that did not recur in 2017. These increases in net income were partially offset by increases in 2017 of $15.8 million of after-tax losses from discontinued life operations, primarily due to an increase in our long-term care pool reserves.
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 three 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, and may also be presented, “excluding catastrophes”. Prior years’ reserve development and catastrophes 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 includes development on prior years’ catastrophe reserves and, unless otherwise indicated, such development is excluded from discussions of prior year loss and LAE reserve development.
Operating income before interest expense and income taxes was $406.5 million for the year ended December 31, 2018, compared to $327.3 million for the year ended December 31, 2017, an increase of $79.2 million. This increase was primarily due to lower catastrophe losses, higher net investment income, a favorable change in reinsurance reinstatement premiums driven by prior year large loss activity, earned premium growth and lower expenses, partially offset by higher non-catastrophe current accident year losses.
Operating income before interest expense and income taxes was $327.3 million for the year ended December 31, 2017, compared to $192.9 million for the year ended December 31, 2016, an increase of $134.4 million. This increase was primarily due to a favorable change in development on prior years’ loss reserves, partially offset by higher catastrophe losses. Unfavorable development on prior years’ loss reserves was $1.2 million for the year ended December 31, 2017, compared to unfavorable development of $235.6 million for the year ended December 31, 2016, a favorable change of $234.4 million. In 2016, we recognized a reserve charge of $174.1 million following the 2016 fourth quarter reserve review. Catastrophe-related activity for the year ended December 31, 2017 was $251.5 million, compared to $117.1 million for the year ended December 31, 2016, an increase of $134.4 million. This increase in catastrophe losses was primarily due to hurricanes Harvey, Irma and Maria that occurred in the third quarter of 2017, the California wildfires that occurred in the fourth quarter of 2017, and a Midwest wind event that occurred in the first quarter of 2017.
The following table summarizes GAAP underwriting results for the Commercial Lines, Personal Lines, and Other segments and reconciles them to operating income (loss) before interest expense and income taxes.
Commercial Lines net premiums written were $2,610.7 million for the year ended December 31, 2018, compared to $2,462.0 million for the year ended December 31, 2017. This $148.7 million increase was primarily driven by pricing increases, strong retention, and targeted new business expansion, in addition to reductions in reinstatement premiums. Reinsurance reinstatements were $0.5 million unfavorable in 2018 compared to $27.8 million unfavorable in 2017. The year over year favorable change was $27.3 million due to several 2017 large losses above our retention level in our surety, inland marine and commercial multiple peril lines. The reinstatement premiums represent the pro-rata reinsurance premium charged for reinstating the amount of reinsurance coverage utilized as a result of the incurred losses that are reimbursable under our reinsurance treaties. See the Glossary of Selected Insurance Terms - “Reinstatement premium”.
Personal Lines net premiums written were $1,774.1 million for the year ended December 31, 2018, compared to $1,647.1 million for the year ended December 31, 2017, an increase of $127.0 million. This was primarily due to higher renewal premium driven by rate increases and strong retention, as well as new business growth.
We have been able to obtain rate increases in our Personal Lines markets and believe that our ability to obtain these increases will continue. However, our ability to maintain Personal Lines net premiums written may be affected by price competition, and regulatory and legal developments. Additionally, these factors along with weather-related loss volatility may also affect our ability to maintain and improve underwriting results. We monitor these trends and consider them in our rate actions.
Other operating losses were $5.4 million for the year ended December 31, 2018, compared to $8.8 million for the year ended December 31, 2017, an improvement of $3.4 million, primarily due to higher net investment income.
Other operating losses were $8.8 million for the year ended December 31, 2017, compared to $19.5 million for the year ended December 31, 2016, an improvement of $10.7 million, primarily due to 2016 unfavorable prior year reserve development in our run-off voluntary pools business (See “2016 Loss and LAE Development, excluding catastrophes” section below for further discussion).
Management’s process for establishing loss reserves is a comprehensive process that involves input from multiple functions throughout our organization, including actuarial, finance, claims, legal, underwriting, distribution and business operations management. The process incorporates facts currently known, as well as the current, and in some cases, the anticipated, state of the law and coverage litigation. Based on information currently available, we believe that the aggregate loss reserves at December 31, 2018 were adequate to cover claims for losses that had occurred as of that date, including both those known to us and those yet to be reported. However, as described below, there are significant uncertainties inherent in the loss reserving process. Our estimate of the ultimate liability for losses that had occurred as of December 31, 2018 is expected to change in future periods as we obtain further information, and such changes could have a material effect on our results of operations and financial position.
Case reserves are established by our claim personnel individually on a claim by claim basis and based on information specific to the occurrence and terms of the underlying policy. For some classes of business, average case reserves are used initially. Case reserves are periodically reviewed and modified based on new or additional information pertaining to the claim.
The IBNR reserve includes a provision for claims that have occurred but have not yet been reported to us, some of which may not yet be known to the insured, as well as a provision for future development on reported claims. IBNR represents a significant proportion of our total net loss reserves, particularly for long-tail liability classes. In fact, approximately 48% of our aggregate net loss reserves at December 31, 2018 were for IBNR losses and loss expenses.
Given the inherent complexity of our loss reserve estimation process and the potential variability of the assumptions used, the actual emergence of losses will vary, perhaps substantially, from the estimate of losses included in our financial statements, particularly in those instances where settlements or other claim resolutions do not occur until well into the future. Our net loss reserves at December 31, 2018 were $3.8 billion. Therefore, a relatively small percentage change in the estimate of net loss reserves would have a material effect on our results of operations.
We regularly update our reserve estimates as new information becomes available and additional events occur which may impact the resolution of unsettled claims. Reserve adjustments are reflected in the results of operations as adjustments to losses and LAE. Often, these adjustments are recognized in periods subsequent to the period in which the underlying policy was written and the loss event occurred. When these types of subsequent adjustments affect prior years, they are described separately as “prior year reserve development”. Such development can be either favorable or unfavorable to our financial results and may vary by line of business. As discussed below, estimated loss and LAE reserves for claims occurring in prior years, in the aggregate, developed unfavorably by $0.4 million, $1.2 million and $235.6 million for the years ended December 31, 2018, 2017, and 2016, respectively, although there was considerable variance by line of business. Additionally, our estimated loss and LAE reserves for catastrophe claims occurring in prior years developed favorably by $9.3 million, favorably by $1.4 million, and unfavorably by $2.6 million for the years ended December 31, 2018, 2017, and 2016, respectively. There can be no assurance that current loss and LAE reserves will be sufficient.
Some risk factors affect multiple lines of business. Examples include changes in claim handling and claim reserving practices, changes in claim settlement patterns, regulatory and legislative actions, court actions, timeliness of claim reporting, state mix of claimants, and degree of claimant fraud. Additionally, there is also a higher degree of uncertainty due to growth in our newly acquired businesses, with respect to which we have less familiarity and, in some cases, limited historical claims experience. The extent of the impact of a risk factor will also vary by components within a line of business. Individual risk factors are subject to interactions with other risk factors within line of business components. Thus, risk factors can have offsetting or compounding effects on required reserves.
We are also defendants in various litigation matters, including putative class actions, which may seek punitive damages, bad faith or extra-contractual damages, legal fees and interest, or claim a broader scope of policy coverage or settlement and payment obligations than our interpretation. Resolution of these cases are often highly unpredictable and could involve material unanticipated damage awards. We have experienced, and others in the industry have reported, increased attorney involvement in claims, delayed submissions of medical and other expense claims, and a trend toward higher valued settlements and litigation, all of which contribute to uncertainty regarding reserve estimates.
Short-tail classes consist principally of automobile physical damage, homeowners property, commercial property and marine business. For these property coverages, claims are generally reported and settled shortly after the loss occurs because the claims relate to tangible property and are more likely to be discovered shortly after the loss occurs. Consequently, the estimation of loss reserves for these classes is generally less complex.
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
Bornheutter-Ferguson methods utilize the product of the expected ultimate losses times the proportion of ultimate losses estimated to be unreported or unpaid to calculate IBNR. The expected ultimate losses are based upon current estimates of ultimate losses from prior accident years, adjusted to reflect expected earned premium, current rating, claims cost levels and changes in business mix. The expected losses, and corresponding loss ratios, are a critical component of Bornheutter-Ferguson methodologies and provide a general reasonability guide.
For longer-tailed lines of business, applying the loss development factor method often requires even more judgment in selecting development factors, as well as more significant extrapolation. For those long-tailed lines of business with high frequency and relatively low per-loss severity (e.g., personal automobile liability), volatility will often be sufficiently modest for the loss development factor method to be given significant weight, even in the most recent accident years, but expected loss methods and adjusted loss methods are always considered and frequently utilized in the selection process. For those long-tailed lines of business with low frequency and high loss potential (e.g., commercial general liability), anticipated loss experience is less predictable because of the small number of claims and erratic claim severity patterns. In these situations, the loss development factor methods may not produce a reliable estimate of ultimate losses in the most recent accident years since many claims either have not yet been reported or are only in the early stages of the settlement process. Therefore, the loss reserve estimates for these accident years may be based on methods less reliant on extrapolation, such as Bornheutter-Ferguson. Over time, as a greater number of claims are reported and the statistical credibility of loss experience increases, loss development factor methods or adjusted loss methods are given increasing weight.
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.
As stated above, numerous factors (both internal and external) contribute to the inherent uncertainty in the process of establishing loss reserves, including changes in the rate of inflation for goods and services related to insured damages (e.g., medical care, home repairs, etc.), changes in the judicial interpretation of policy provisions, and settlement obligations, changes in the general attitude of juries in determining damage awards, legislative actions, such as expanding liability, coverage mandates or expanding or suspending statutes of limitations which otherwise limit the times within which claims can be made, changes in the extent of insured injuries, changes in the trend of expected frequency and/or severity of claims, changes in our book of business (e.g., change in mix due to new product offerings, new geographic areas, etc.), changes in our underwriting practices, and changes in claim handling procedures and/or systems. Regarding our indirect business from voluntary and involuntary pools, we are provided loss estimates by managers of each pool. We adopt reserve estimates for the pools that consider this information and other facts.
The future impact of the various factors that contribute to the uncertainty in the loss reserving process is impossible to predict. There is potential for significant variation in the development of loss reserves, particularly for long-tailed classes of business and classes of business that are more vulnerable to economic or political risks.
The estimation of claims and claims expense reserves for catastrophes also comprises estimates of losses from reported claims and IBNR, primarily for damage to property. In general, our estimates for catastrophe reserves are determined on an event basis by considering various sources of available information, including specific loss estimates reported to us based on claim adjuster inspections, overall industry loss estimates, and our internal data regarding exposures related to the geographical location of the event. However, depending on the nature of the catastrophe, the estimation process can be further complicated by other impediments. For
Monoline and Multiple Peril General Liability - loss reserves recorded for monoline and multiple peril general liability on U.S. voluntary business were $787.7 million as of December 31, 2018. A key assumption for monoline and multiple peril general liability is the implied adequacy of the underlying case reserves. A ten point change in case adequacy (e.g., 10% deficiency changed to 0% or 20% deficiency) would have changed total reserves by approximately $87 million, either positive or negative, at December 31, 2018.
Specialty Programs - loss reserves recorded for the AIX program business were $339.6 million as of December 31, 2018. Two key assumptions underlying the actuarial reserve analysis for specialty programs are the inflation rate underlying the estimated reserve for our commercial automobile liability, general liability and workers’ compensation coverages, as well as the tail factor selection for workers’ compensation. A five point change to the embedded inflation rate for the aforementioned coverages, and a one point change in the workers’ compensation tail factor on AIX program business would have changed total reserves by approximately $52 million at December 31, 2018.
The following table provides a reconciliation of the gross beginning and ending reserve for unpaid losses and loss adjustment expenses.
“Other commercial lines - Other lines” in the table above, is primarily comprised of management and professional liability, marine, miscellaneous commercial property, healthcare, and fidelity lines. Loss and LAE reserves in our “Total Other Segment” relate to our run-off voluntary assumed reinsurance pools business.
In 2018, net unfavorable loss and LAE development, excluding catastrophes, was $0.4 million. Commercial Lines favorable development of $34.1 million was primarily due to lower than expected losses of $31.0 million within the workers’ compensation line in accident years 2015 through 2017; $25.1 million in other commercial lines, primarily in our professional and management liability and monoline general liability lines, related to the 2014 through 2016 accident years; and our surety line in accident years 2015 and 2017; partially offset by higher than expected losses in AIX programs and business classes which have since been terminated. Also partially offsetting the favorable Commercial Lines development was higher than expected losses of $23.2 million in the commercial automobile line, driven by higher bodily injury severity in the 2014, 2016, and 2017 accident years. Personal Lines unfavorable
As of December 31, 2018, we have $38.9 million of net asbestos and environmental reserves, comprised of $8.9 million of direct reserves and $30.0 million of assumed reinsurance pool reserves. This compares to net reserves of $39.8 million and $41.1 million as of December 31, 2017 and 2016, respectively. Ending loss and LAE reserves for all direct business written by our property and casualty companies related to asbestos and environmental damage liability were $8.9 million, $9.5 million, and $9.9 million, net of reinsurance of $18.7 million, $20.2 million, and $19.9 million for the years ended December 31, 2018, 2017 and 2016, respectively. Activity for our direct asbestos and environmental reserves was not significant to our 2018, 2017 or 2016 financial results. As a result of our historical direct underwriting mix of Commercial Lines policies toward smaller and middle market risks, past asbestos and environmental damage liability loss experience has remained minimal in relation to our total loss and LAE incurred experience. Although we attempt to limit our exposures to asbestos and environmental damage liability through specific policy exclusions, we have been and may continue to be subject to claims related to these exposures.
In addition to reserves we carry to cover exposure in our direct business, we have established gross and net loss and LAE reserves for assumed reinsurance pool business with asbestos and environmental damage liability of $30.0 million, $30.3 million and $31.2 million at December 31, 2018, 2017 and 2016, 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.
We estimate our ultimate liability for asbestos, environmental and toxic tort liability claims, whether resulting from direct business, assumed reinsurance or pool business, based upon currently known facts, reasonable assumptions where the facts are not known, current law and methodologies currently available. Although these outstanding claims are not significant, their existence gives rise to uncertainty and are discussed because of the possibility that they may become significant. We believe that, notwithstanding the evolution of case law expanding liability in asbestos and environmental claims, recorded reserves related to these claims are adequate.
The change in net unrealized gains (losses) on fixed maturities, from a gain of $92.2 million at year-end 2017 to a loss of $84.4 million at year-end 2018, was primarily due to higher prevailing interest rates and wider credit spreads in 2018.
Based on ratings by the National Association of Insurance Commissioners (“NAIC”), approximately 95% and 94% of the fixed maturity portfolio consisted of investment grade securities at December 31, 2018 and 2017, respectively. The quality of our fixed maturity portfolio remains strong based on ratings, capital structure position, support through guarantees, underlying security, issuer diversification and yield curve position.
Our investment portfolio primarily consists of fixed maturity securities whose fair value is susceptible to market risk, including interest rate changes. See also “Quantitative and Qualitative Disclosures about Market Risk” included in Management’s Discussion and Analysis of Financial Condition. Duration is a measurement used to quantify our inherent interest rate risk and analyze invested assets relative to our reserve liabilities.
Other investments consist primarily of our interest in corporate middle market and real estate limited partnerships. Corporate middle market limited partnerships may invest in senior or subordinated debt, preferred or common equity or a combination thereof, of middle market businesses. Real estate limited partnerships invest in debt and/or equity of real properties.
We view gross unrealized losses on fixed maturities 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. Further, 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”). Inherent in our assessment are the risks that market factors may differ from our expectations; the global economy reverts to recessionary trends; we may decide to subsequently sell a security for unforeseen business needs; or changes in the credit assessment 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 on fixed maturities 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.
As of January 1, 2018, we adopted ASC Update No. 2016-01, (Subtopic 825-10) Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU No. 2016-01”), which resulted in a cumulative effect adjustment of $97.8 million, net of tax, recorded in retained earnings. See Item O. “New Accounting Pronouncements” in Note 1 - “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements for additional information. Beginning in 2018, our equity securities are carried at fair value with increases and decreases in fair value recorded in net income. Previously, changes in fair value on equity securities were recorded in accumulated other comprehensive income, a component of shareholders’ equity.
Monetary policies in developed economies have become more divergent recently, but remain generally supportive of moderate economic growth. Major central banks continue to closely monitor developments in global financial markets and the outlook for growth, and reportedly are committed to adjust monetary policy as required to provide liquidity, support growth and achieve inflation targets. In the United States, the Federal Reserve (the “Fed”) increased its target for the federal funds rate by 1.00% in 2018, including 0.25% in December, raising its target range to 2.25% to 2.50%. The Fed continues to signal that economic activity will expand at a moderate pace, labor conditions will remain strong with inflation stabilized around its 2% objective over the medium term. The Fed has communicated that it will be patient as it determines the timing and size of future adjustments to the federal funds rate, which will depend on realized and expected economic conditions relative to its objectives of maximum employment and 2% inflation. While the Fed believes near-term risks to the economic outlook appear roughly balanced, it continues to closely monitor inflation indicators and global economic and financial developments. One such development being watched carefully is the trade/tariff negotiations between the United States and its various trade partners. Should these negotiations lead to a shift or break-down in global trade patterns, there could be negative implications for certain issuers, sectors, or the economy at large.
Operations are subject to risk resulting from interest rate fluctuations, which may adversely impact the valuation of the investment portfolio. In a rising interest rate environment, the value of the fixed maturity sector, which comprises approximately 74% of our investment portfolio, may decline as a result of decreases in the fair value of the securities. Our intent is to hold securities to maturity and recover the decline in valuation as prices accrete to par. However, our intent may change prior to maturity due to changes in the financial markets, our analysis of an issuer’s credit metrics and prospects, or as a result of changes in cash flow needs. Interest rate fluctuations may also reduce net investment income and as a result, profitability. The portfolio may realize lower yields and therefore lower net investment income on securities because securities with prepayment and call features may prepay at a different rate than originally projected. Also, funds may not be available to invest at higher interest rates.
Our equity securities portfolio is exposed to equity price risk arising from potential volatility in equity market prices. Portfolio characteristics are analyzed regularly and price risk is actively managed through a variety of techniques. A hypothetical increase or decrease of 10% in the market price of our equity securities would have resulted in an increase or decrease in the fair value of the equity securities portfolio of approximately $46 million at December 31, 2018 and $58 million at December 31, 2017.
Net realized losses on investments were $50.7 million for 2018, and $21.1 million and $10.2 million of net realized gains for 2017 and 2016, respectively. Net realized losses in 2018 were primarily due to $43.4 million of losses from the net change in fair value of equity securities that are now required to be reflected in net income, due to the implementation of ASU 2016-01 effective January 1, 2018. (See also Item O. “New Accounting Pronouncements” in Note 1 - “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements.) This change in fair value of equity securities resulted from prevailing market conditions. Additionally, in 2018 we recognized $4.6 million of OTTI losses, and $2.7 million of losses recognized from the sale of securities, primarily fixed maturities. Net realized gains in 2017 were primarily due to $26.6 million of gains recognized from the sale of securities, primarily equities, and to a lesser extent, fixed maturities. These gains were partially offset by $5.6 million of OTTI losses. Net realized gains in 2016 were primarily due to $36.6 million of gains recognized from the sale of securities, primarily equities, and to a lesser extent, fixed maturities. These gains were partially offset by $27.4 million of OTTI losses.
Included in “other non-operating items” above in 2017 were $10.2 million of employee termination costs associated with a company-wide expense savings initiative.
Discontinued operations primarily include our former Chaucer business and discontinued accident and health and former life insurance businesses. In 2018, discontinued operations, in total, generated a gain of $152.0 million, net of tax, primarily related to the sale of the Chaucer business. In 2017, discontinued operations, in total, generated a loss of $29.9 million, net of tax, primarily related to the long-term care pool in our discontinued accident and health business and, to a lesser extent, the Chaucer business. In 2016, discontinued operations contributed $88.1 million of income, primarily related to the Chaucer business. See also “Discontinued Operations - Chaucer Business” below and Note 2 - “Dispositions of businesses” in the Notes to Consolidated Financial Statements.
As discussed above, the Chaucer business includes both the gain related to the sale and the income or loss from Chaucer’s then current operations.
The following table summarizes the components of the estimated gain related to the sale of the Chaucer business as of December 28, 2018. This gain below excludes an expected gain on the Irish and Australian entities associated with the Chaucer business. We subsequently completed the sale of our Chaucer-related Irish entity on February 14, 2019. The sale of the Australian entities is pending, subject only to local regulatory approval. We received $28 million of additional consideration for the Irish entity, and we expect to receive $13 million of additional consideration related to the Australian entities.
Chaucer’s income before income taxes for the year ended December 31, 2017 was $8.6 million, compared to $126.3 million for the year ended December 31, 2016, a decline of $117.7 million. This decrease is primarily due to higher catastrophe losses. Catastrophe losses for the year ended December 31, 2017 were $131.1 million, compared to $8.0 million for the year ended December 31, 2016, an increase of $123.1 million. Chaucer’s income before taxes, excluding catastrophes, was $139.7 million in the year ended December 31, 2017, compared to $134.3 million for the year ended December 31, 2016. This $5.4 million increase was primarily due to lower non-catastrophe current accident year losses and higher net investment income, partially offset by lower favorable prior years’ reserve development.
In 2018, the favorable loss and LAE development ratio was 4.3%, excluding catastrophes, primarily due to lower than expected losses in the political, energy, marine, and treaty lines, partially offset by higher than expected losses in the casualty lines. In 2017, the favorable loss and LAE development ratio was 4.0%, excluding catastrophes, primarily as a result of lower than expected losses in the energy and political lines, partially offset by higher than expected losses in the treaty line, primarily a result of higher than expected losses in Chaucer’s U.S. casualty business. In 2016, the favorable loss and LAE development ratio was 11.4%, excluding catastrophes, primarily due to lower than expected losses in the energy, casualty, political, and treaty lines. Partially offsetting the 2016 favorable loss and LAE development was the unfavorable impact of foreign exchange rate movements on prior years’ loss reserves.
Chaucer held cash and investment assets diversified across several asset classes, as follows:
Earned yields on the investment portfolio were 2.21%, 2.03% and 1.97% for the years ended December 31, 2018, 2017, and 2016, respectively.
Most of Chaucer’s transactions are denominated in the currencies that we use to settle transactions with Lloyd’s, specifically the U.S. Dollar, the U.K. Pound Sterling (“GBP”) and the Canadian Dollar. These are Chaucer’s functional currencies under U.S. GAAP. A portion of Chaucer’s transactions and its assets and liabilities are denominated in other currencies, such as the Euro, the Swiss Franc, the Australian Dollar, and the Japanese Yen. Changes in the value of these currencies versus the functional currencies, particularly versus the GBP, cause transactional gains and losses during each reporting period. During 2018 and 2017, the GBP was relatively stable against most currencies. In contrast, the GPB weakened meaningfully against most currencies in 2016. We believe that this was due, in large part, to the effect of the U.K’s referendum vote to discontinue its membership in the European Union (“Brexit Referendum”). The following table summarizes the total effect of Chaucer’s foreign exchange transactional gains and losses on comprehensive income:
During 2018, foreign exchange losses, on a net basis, reduced pre-tax income by approximately $0.3 million, compared to approximately $1.4 million in 2017 and $22.7 million in 2016. For 2018, this impact primarily resulted from the revaluation of investments in overseas deposits. For 2017 and 2016, this impact primarily resulted from the revaluation of loss and LAE reserves. In addition, during 2018, pre-tax unrealized foreign exchange gains from investment securities were approximately $0.5 million, which was reflected as an increase to accumulated other comprehensive income, compared to $0.6 million in 2017 and $8.3 million in 2016.
We are subject to the tax laws and regulations of the U.S. and foreign countries in which we operate. We file a consolidated U.S. federal income tax return that includes our holding company and its U.S. subsidiaries. Generally, taxes are accrued at the U.S. statutory tax rate for income from the U.S. operations. In December 2017, the U.S. statutory rate decreased from 35% to 21%, effective January 1, 2018. Our primary non-U.S. jurisdiction was the U.K., until the sale of our U.K. subsidiaries, largely completed December 28, 2018. The U.K. statutory tax rate ranged between 20% and 19% during the period 2016 through 2018. We accrue taxes on certain non-U.S. income that is subject to U.S. tax at the enacted U.S. tax rate. Foreign tax credits, where available, are utilized to offset U.S. tax as permitted.
The income tax provision on operating income was an expense of $69.3 million, $89.5 million and $46.3 million for 2018, 2017 and 2016, respectively. These provisions resulted in effective tax rates for operating income of 19.2%, 31.7% and 32.7% in 2018, 2017 and 2016, respectively. The provisions for 2018 and 2017 reflect the aforementioned excess tax benefit related to stock-based compensation of $2.3 million and $5.3 million, respectively. In addition, the 2018 provision included the aforementioned tax benefit related to prior years of $4.3 million. Absent these items, the provision for income taxes for 2018 and 2017 would have been expense of $75.9 million, or 21.0% and $94.8 million, or 33.6%.
The income tax provision on the gain from the disposal of Chaucer business was an expense of $42.5 million. This provision includes a write off of $8.0 million of deferred tax assets primarily attributable to Lloyd’s underwriting losses.
On December 22, 2017, the TCJA was enacted in the U.S. The Act substantially changed many aspects of the U.S. Tax code, including reducing the U.S. corporate income tax rate from 35% to 21%. While the new corporate rate is effective on January 1, 2018, we have recognized the impact of the rate change on our deferred tax balances as of the enactment date. The effect of this re-measurement of our deferred tax balances is a provision of $9.4 million for the year ended December 31, 2017. This provision is recorded as a component of income tax expense in continuing operations and within discontinued operations as a component of income from Chaucer business. A tax benefit of $4.1 million was recognized in continuing operations and an expense of $13.5 million was recognized in discontinued operations. This amount includes the revaluation of deferred taxes initially recorded through other comprehensive income and recorded through discontinued operations, such as unrealized appreciation on investments, employee benefit plan-related items, foreign currency translation adjustments and reserve adjustments for discontinued business. Deferred taxes related to the revaluation of our pension plans at December 31, 2017, as well as changes in unrealized gains and losses occurring after the Act’s enactment date, are recorded at 21% in other comprehensive income.
The Act also created a territorial tax system, which will generally allow companies to repatriate future non-U.S. sourced earnings without incurring additional U.S. taxes, by providing a 100% exemption on dividends received from certain non-U.S. subsidiaries. Although most of our non-U.S. income had been previously subject to U.S. taxes, a portion of our non-U.S. income had been
In addition, the Act limited various existing deductions such as executive compensation and introduced new income taxes on certain low-taxed non-U.S. income. Under the Act, the exemption from the $1 million limitation on certain executive compensation has been eliminated. As a result, we have recognized a provision of $0.2 million for the year ended December 31, 2017.
The cumulative effect of the enactment of TCJA is an expense of $22.3 million for the year ended December 31, 2017, comprising the aforementioned three components. Our estimates are not based upon provisional amounts, as defined in the SEC’s Staff Accounting Bulletin No. 118.
The discussion and analysis of our financial condition and results of operations are based upon the consolidated financial statements. These statements have been prepared in accordance with U.S. GAAP, which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. The following critical accounting estimates are those which we believe affect the more significant judgments and estimates used in the preparation of our financial statements. Additional information about other significant accounting policies and estimates may be found in Note 1-“Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements.
See “Reserve for Losses and Loss Adjustment Expenses” within “Results of Operations - Segments” for a discussion of our critical accounting estimates for loss reserves.
To determine the expected long-term return on plan assets, we generally consider historical mean returns by asset class for passive indexed strategies, as well as current and expected asset allocations, and adjust for certain factors that we believe will have an impact on future returns. Actual returns on plan assets in any given year seldom result in the achievement of the expected rate of return on assets. Actual returns on plan assets in excess of these expected returns will generally reduce our net actuarial losses (or increase actuarial gains) that are reflected in the accumulated other comprehensive income balance in shareholders’ equity, whereas actual returns on plan assets that are less than expected returns will generally increase our net actuarial losses (or decrease actuarial gains) that are reflected in accumulated other comprehensive income. These gains or losses are amortized into expense in future years. The U.S. qualified plan held assets consisting of approximately 85% fixed maturities and 15% equities at December 31, 2018.
The expected return on asset assumption was 4.75% and 5.00% in 2018 and 2017, respectively. Asset returns are reflected net of administrative expenses.
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 available positive and negative evidence, including reversals of deferred tax liabilities, projected future taxable income in each tax jurisdiction, tax planning strategies and recent financial operations. Valuation allowances are established if, based on the weight of available information, it is more likely than not that all or some portion of the deferred tax assets will not be realized. The determination of the valuation allowance for our deferred tax assets requires management to make certain judgments and assumptions. Our judgments and assumptions are subject to change given the inherent uncertainty in predicting future performance and specific industry and investment market conditions. Changes in valuation allowances are generally reflected in income tax expense or as an adjustment to other comprehensive income depending on the nature of the item for which the valuation allowance is being recorded.
The following are the components of our deferred tax assets and liabilities as of December 31, 2018.
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 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 $140.0 million in dividends to the holding company during 2018. In 2017, Hanover Insurance paid $296.8 million in dividends to the holding company, which included $80.0 million of extraordinary dividends. In 2016, a $218.8 million ordinary dividend was paid by Hanover Insurance.
Sources of cash for our insurance subsidiaries primarily consist of premiums collected, investment income and maturing investments. Primary cash outflows are paid claims, losses and loss adjustment expenses, policy and contract acquisition expenses, other underwriting expenses, and investment purchases. Cash outflows related to losses and loss adjustment expenses can be variable because of uncertainties surrounding settlement dates for liabilities for unpaid losses and because of the potential for large losses either individually or in the aggregate. We periodically adjust our investment policy to respond to changes in short-term and long-term cash requirements.
Net cash provided by operating activities was $551.3 million during 2018, as compared to $704.6 million during 2017 and $743.4 million in 2016. During 2018, the $153.3 million decrease in cash provided was primarily the result of higher loss payments, the contribution made to the qualified defined benefit plan and taxes paid, partially offset by an increase in premiums collected. During 2017, the $38.8 million decrease in cash provided was primarily the result of higher loss payments and taxes paid to foreign jurisdictions, partially offset by an increase in premiums collected.
Debt included in the maturity less than 1 year category reflects our advances from the FHLB that were repaid on January 2, 2019. No interest payments are provided for this item. Debt in the maturity in excess of 5 years category 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.
Information regarding litigation and legal contingencies appears in Note 18 - “Commitments and Contingencies” in the Notes to Consolidated Financial Statements. Information related to certain regulatory and industry developments are contained in “Regulation” in Part 1 - Item 1 and in “Risk Factors” in Part 1 - Item 1A.
Management’s Discussion and Analysis contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. For a discussion of indicators of forward-looking statements and specific important factors that could cause actual results to differ materially from those contained in forward-looking statements, see “Risk Factors” in Part 1 - Item 1A. This Management’s Discussion and Analysis should be read and interpreted in light of such factors.
Frequency - The number of claims occurring during a given coverage period.
Inland Marine Insurance - In Commercial Lines, this is a type of coverage developed for insuring businesses against physical losses to property such as contractor’s equipment, builder’s risk and goods in transit that do not involve ocean transport. It covers articles in transit by all forms of land and air transportation as well as bridges, tunnels and other means of transportation and communication. In the context of Personal Lines, this term relates to floater policies that cover expensive personal items such as fine art and jewelry.
Loss costs - An amount of money paid for an insurance claim.
Unearned premiums - The portion of a premium representing the unexpired amount of the contract term as of a certain date.
We have audited the accompanying consolidated balance sheets of The Hanover Insurance Group, Inc. and its subsidiaries as of December 31, 2018 and 2017, and the related consolidated statements of income, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2018, including the related notes and financial statement schedules listed in the index appearing under Item 15(a)(2) (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
The Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under item 9A. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
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 property and casualty companies; and 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 Chaucer Holdings Limited (“Chaucer”), a specialist insurance underwriting group which operates through the Society and Corporation of Lloyd’s (“Lloyd’s”), and the Company’s accident and health and former life insurance businesses. All intercompany accounts and transactions have been eliminated. On December 28, 2018, the Company completed the sale of Chaucer to China Reinsurance (Group) Corporation (“China Re”). The sale of the Chaucer-related Irish entity was completed on February 14, 2019 for proceeds of $28 million. The sale of the Australian entities for proceeds of $13 million is pending, subject only to local regulatory approval, and is expected to close in the first quarter of 2019. Accordingly, as of December 31, 2018 and for all prior periods presented in this Annual Report on Form 10-K, Chaucer’s accounts have been classified as discontinued operations in the Consolidated Statements of Income and as held-for-sale in the Consolidated Balance Sheets (See Note 2 - “Discontinued Operations”).
Investments in limited partnerships include interests in private equity funds. Effective January 1, 2018, in accordance with the provisions of ASC Update No. 2016-01, when the Company’s interest in the partnership is so minor that it exercises virtually no influence over operating and financial policies, the limited partnership investment is accounted for at fair value with unrealized gains and losses reported in net income. Previously, such investments were accounted for under the cost method. All other investments in limited partnership interests are accounted for in accordance with the equity method of accounting.
Realized investment gains and losses on sales are reported as a component of revenues based upon specific identification of the investment assets sold. When an other-than-temporary decline in value of a specific investment is deemed to have occurred, and a charge to earnings is required, the Company recognizes a realized investment loss. Changes in the fair value of equity securities are reported in net realized and unrealized investment gains (losses), including increases and decreases in fair value on securities that are still held and realized gains and losses on securities that have been sold.
Prior to the sale of Chaucer on December 28, 2018, the Company also held investments in overseas deposits; such deposits were maintained in overseas funds and were managed exclusively by Lloyd’s. These funds were required in order to protect policyholders in overseas markets and enabled the Company to operate in these markets. Net investment income and realized and unrealized investment gains (losses) related to overseas deposits are included in income (loss) from Chaucer business within discontinued operations.
Deferred acquisition costs (“DAC”) for each operating segment are reviewed to determine if the costs are recoverable from future income, including investment income. If such costs are determined to be unrecoverable, they are expensed at the time of determination. Although recoverability of DAC is not assured, the Company believes it is more likely than not that all of these costs will be recovered. The amount of DAC considered recoverable, however, could be reduced in the near term if the estimates of total revenues discussed above are reduced or permanently impaired as a result of a disposition of a line of business. The amount of amortization of DAC could be revised in the near term if any of the estimates discussed above are revised.
business and the balance is disclosed separately in the financial statements. However, the ultimate amount of the reinsurance recoverable is not known until all losses and claims are settled. Allowances are established for amounts deemed uncollectible and reinsurance recoverables are recorded net of these allowances. The Company evaluates the financial condition of its reinsurers and monitors concentration risk to minimize its exposure to significant credit losses from individual reinsurers.
In accordance with the provisions of ASC 350, Intangibles- Goodwill and Other, the Company carries its goodwill at cost, net of amortization accumulated prior to January 1, 2002, and net of impairments. Increases to goodwill are generated through acquisition and represent the excess of the cost of an acquisition over the fair value of net assets acquired, including any intangibles acquired. Since January 1, 2002, goodwill is no longer amortized but rather, is reviewed for impairment. Additionally, acquisitions can also produce intangible assets, which have either a definite or indefinite life. Intangible assets with definite lives are amortized over that life, whereas those intangible assets determined to have an indefinite life are reviewed at least annually for impairment.
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 would be 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 2018 and 2017 with no impairments recognized. At December 31, 2018 and 2017, the Company held goodwill of $178.8 million and intangible assets with indefinite lives of $15.0 million.
All losses, LAE and unearned premium liabilities are based on the various estimates discussed in this note. Although the adequacy of these amounts cannot be assured, the Company believes that it is more likely than not that these liabilities and accruals will be sufficient to meet future obligations of policies in force. The amount of liabilities and accruals, however, could be revised in the near-term if the estimates discussed above are revised.
The Company is subject to the tax laws and regulations of the U.S. and foreign countries in which it operates. The Company files a consolidated U.S. federal income tax return that includes the holding company and its U.S. subsidiaries. Generally, taxes are accrued at the U.S. statutory tax rate for income from the U.S. operations. In December 2017, the Tax Cuts and Jobs Act (“TCJA”) was enacted, which reduced the U.S. statutory rate from 35% to 21%, effective January 1, 2018. See Note 7 - “Income Taxes” for a discussion of this new law. The Company accrues taxes on certain non-U.S. income that is subject to U.S. tax at the enacted U.S. tax rate. Foreign tax credits, where available, are utilized to offset U.S. tax as permitted.
Deferred income taxes are generally recognized when assets and liabilities have different values for financial statement and tax reporting purposes, and for other temporary taxable and deductible differences as defined by ASC 740, Income Taxes (“ASC 740”). These temporary differences are measured at the balance sheet date using enacted tax rates expected to apply to taxable income in the years the temporary differences are expected to reverse. These differences result primarily from insurance reserves, deferred acquisition costs, investments, and employee benefit plans.
Earnings per share (“EPS”) for the years ended December 31, 2018, 2017 and 2016 is based on a weighted average of the number of shares outstanding during each year. Basic and diluted EPS is computed by dividing income available to common stockholders by the weighted average number of shares outstanding for the period. The weighted average shares outstanding used to calculate basic EPS differ from the weighted average shares outstanding used in the calculation of diluted EPS due to the effect of dilutive employee stock options, nonvested stock grants and other contingently issuable shares. If the effect of such items is antidilutive, the weighted average shares outstanding used to calculate diluted EPS are equal to those used to calculate basic EPS.
In February 2018, the Financial Accounting Standards Board (“FASB”) issued ASC Update No. 2018-02 (Topic 220) Income Statement - Reporting Comprehensive Income: Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. This ASC update allows for a reclassification into retained earnings of the stranded tax effects in AOCI resulting from the enactment of the TCJA. Current guidance requires the effect of a change in tax laws or rates on deferred tax balances to be reported in income from continuing operations in the accounting period that includes the period of enactment, even if the related income tax effects were originally charged or credited directly to AOCI. The amount of the reclassification would include the effect of the change in the U.S. federal corporate income tax rate on the gross deferred tax amounts at the date of the enactment of the TCJA related to items in AOCI. The updated guidance is effective for interim and annual periods beginning after December 15, 2018. Early adoption
is permitted. The Company early adopted this guidance effective January 1, 2018 with a cumulative effect adjustment, which reclassified $6.5 million of benefits from AOCI to retained earnings with no overall impact on the Company’s financial position.
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 implemented this guidance effective January 1, 2018. The implementation of this guidance did not have an effect on the Company’s 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. The Company implemented this guidance effective January 1, 2018. Implementing this guidance did not have an impact on the Company’s statement of cash flows, as restricted cash, if any, has already been included in total cash and cash equivalents.
In October 2016, the FASB issued ASC Update No. 2016-16, (Topic 740) Income Taxes - Intra-Entity Transfers of Assets Other Than Inventory. Under current GAAP, the tax effects of intra-entity transfers of assets (intercompany sales) are deferred until the assets are sold to an outside party or otherwise recovered through use. This ASC update eliminates this deferral of taxes for assets other than inventory and requires the recognition of taxes when the transfer occurs. The updated guidance is effective for interim and annual periods beginning after December 15, 2017, and should be applied on a modified retrospective basis through a cumulative-effect adjustment to retained earnings. Early adoption is permitted, but this election must be made in the first interim period of the adoption year. The Company implemented this guidance effective January 1, 2018. Implementation of this guidance did not have a net impact on the Company’s financial position or results of operations.
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. The Company implemented this guidance effective January 1, 2018. The adoption of ASC Update No. 2016-15 did not have a significant impact on the Company’s statement of cash flows.
In January 2016, the FASB issued ASC Update No. 2016-01, (Subtopic 825-10) Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU No. 2016-01”). This ASC update requires unconsolidated equity investments to be measured at fair value with changes in the fair value recognized in net income, except for those accounted for under the equity method. This update eliminates the cost method for equity investments without readily determinable fair values, replacing it with other methods, including the use of Net Asset Value (“NAV”). Additionally, when a public entity is required to measure fair value for disclosure purposes and holds financial instruments measured at amortized cost, the updated guidance requires these instruments to be measured using exit price. It also requires financial assets and financial liabilities to be presented separately in the notes to the financial statements, grouped by measurement category and form of financial asset. The updated guidance is effective for
annual periods beginning after December 15, 2017. In February 2018, the FASB issued ASC Update No. 2018-03, (Subtopic 825-10) Technical Corrections and Improvements to Financial Instruments - Overall. This ASC update clarifies the transition method for equity investments without readily determinable fair values. Specifically, if an entity elects to measure these investments at cost, less impairment, adjusted for changes resulting from observable price changes in orderly transactions for an identical or similar investment of the same issuer (the “measurement alternative”), then transition is prospective. For all others, transition is modified retrospective, requiring a cumulative effect adjustment. This ASU is effective for annual periods beginning after December 15, 2017, and interim periods within those years beginning after June 15, 2018. Early adoption is permitted for interim periods beginning after December 15, 2017 as long as ASU No. 2016-01 has been adopted. The Company implemented this guidance effective January 1, 2018 concurrent with ASU No. 2016-01 for certain limited partnerships without readily determinable fair values. The implementation of these standards resulted in a benefit to retained earnings, through a cumulative effect adjustment, of $97.8 million, including a reclassification of after-tax unrealized gains of $95.2 million from AOCI and an adjustment of $2.6 million of gains to record partnership investments at NAV.
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. The Company implemented this guidance effective January 1, 2018. The effect of implementing this guidance was not material to the Company’s financial position or results of operations.
In June 2016, the FASB issued ASC Update No. 2016-13, (Topic 326) Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments. This ASC update introduces new guidance for the accounting for credit losses on financial instruments within its scope. A new model, referred to as the current expected credit losses model, requires an entity to determine credit-related impairment losses for financial instruments held at amortized cost and to estimate these expected credit losses over the life of an exposure (or pool of exposures). The estimate of expected credit losses should consider both historical and current information, reasonable and supportable forecasts, as well as estimates of prepayments. The estimated credit losses and subsequent adjustment to such loss estimates will be recorded through an allowance account which is deducted from the amortized cost of the financial instrument, with the offset recorded in current earnings. ASC No. 2016-13 also modifies the impairment model for available-for-sale debt securities. The new model will require an estimate of expected credit losses only when the fair value is below the amortized cost of the asset, thus the length of time the fair value of an available-for-sale debt security has been below the amortized cost will no longer affect the determination of whether a credit loss exists. In addition, credit losses on available-for-sale debt securities will be limited to the difference between the security’s amortized cost basis and its fair value. In November 2018, the FASB issued ASC Update No. 2018-19, Codification Improvements to Topic 326, Financial Instruments-Credit Losses, which explicitly states that receivables arising from operating leases are not within the scope of Subtopic 326-20. ASC Update No. 2016-13 and related guidance is effective for interim and annual periods beginning after December 15, 2019. Early adoption is permitted for periods beginning after December 15, 2018. The Company expects to adopt ASC Update No. 2016-13 on January 1, 2020 and is evaluating the impact on its financial position and results of operations, which it does not expect to be material.
The following table summarizes the components of the estimated gain related to the sale of the Chaucer business as of December 28, 2018. This gain below excludes an expected gain on the Irish and Australian entities associated with the Chaucer business. The Company subsequently completed the sale of its Chaucer-related Irish entity on February 14, 2019. The sale of the Australian entities is pending, subject only to local regulatory approval, and is expected to close in the first quarter of 2019. The Company received $28
Initial consideration for Chaucer Holdings Limited as determined in the sales and purchase agreement was $779 million. This amount, along with $28 million in cash proceeds received for the sale of the Irish entity on February 14, 2019, $13 million in cash proceeds to be received upon the closing of the sale of the Australian entities, estimated contingent consideration of $31.7 million, and an $85 million pre-signing dividend from Chaucer that was received in the second quarter of 2018, results in expected total proceeds from the entire transaction of $936.7 million. These amounts were partially offset by $17.0 million paid to China Re to adjust the purchase price for amounts received by the Company from Chaucer prior to December 28, 2018.
As part of the transaction, investments held by Chaucer were transferred to China Re resulting in the recognition of net realized investment losses that were previously reflected in accumulated other comprehensive income. Additionally, Chaucer’s deferred pension obligations and currency translation obligations previously recognized in accumulated other comprehensive income were recognized as losses associated with the transaction.
In accordance with Lloyd’s operating guidelines, the Company deposited funds at Lloyd’s to support Chaucer underwriting operations. These funds are available only to fund claim obligations. At December 31 2017, fixed maturities with a fair value of $528.1 million and cash of $7.1 million, respectively, were on deposit with Lloyd’s.
Prior to the sale, the Company was subject to concentration of risk with respect to reinsurance ceded with respect to the Lloyd’s syndicates. The Lloyd’s Syndicates total reinsurance receivable balance for the Chaucer business was $443.0 million as of December 31, 2017.
The increase in ceded reinsurance premiums from 2016 through 2018 is primarily due to Chaucer’s planned increase in reinsurance purchases.
The increase in ceded losses and LAE from 2016 through 2018 is primarily due to higher catastrophe loss activity in certain Chaucer lines and due to the aforementioned increase in reinsurance purchases.
For Chaucer’s 2016 U.S. casualty treaty lines, the Company entered into a whole account aggregate excess of loss contract. The contract covers the U.S. casualty treaty lines exposures, except specialty risks and workers’ compensation clash. This contract does not meet the risk transfer requirements of GAAP and was accounted for using the deposit accounting method. The impact of reinsurance contracts subject to deposit accounting were recognized through net investment income rather than losses. Net investment income for this contract of approximately $8 million was recognized for each of the years ended December 31, 2018 and December 31, 2017 and $3 million was recognized for the year ended December 31, 2016.
During 1999, the Company exited its accident and health insurance business, consisting of its Employee Benefit Services business, its Affinity Group Underwriters business and its accident and health assumed reinsurance pool business. Prior to 1999, these businesses comprised substantially all of the former Corporate Risk Management Services segment. Accordingly, the operating results of the discontinued segment have been reported in accordance with Accounting Principles Board Opinion No. 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions (“APB Opinion No. 30”). On January 2, 2009, Hanover Insurance directly assumed a portion of the accident and health business; and therefore continues to apply APB Opinion No. 30 to this business. In addition, the remainder of the Discontinued First Allmerica Financial Life Insurance Company (“FAFLIC”) accident and health business was reinsured by Hanover Insurance in connection with the sale of FAFLIC to Commonwealth Annuity.
At December 31, 2018 and 2017, the portion of the discontinued accident and health business that was directly assumed had assets of $81.6 million and $76.9 million, respectively, consisting primarily of invested assets, and liabilities of $81.4 million and $83.1 million, respectively, consisting primarily of policy liabilities. At December 31, 2018 and 2017, 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.
The Company’s former life insurance businesses include indemnity obligations and other activities.
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 $7.4 million and $11.0 million as of December 31, 2018 and 2017, respectively.
At December 31, 2018 and 2017, fixed maturities with fair values of $299.9 million and $286.9 million, respectively, were on deposit with various state governmental authorities or trustees.
The following tables provide information about the Company’s available-for-sale fixed maturity securities that were in an unrealized loss position at December 31, 2018 and 2017 including the length of time the securities have been in an unrealized loss position:
Equity securities are carried at fair value. Effective January 1, 2018, increases or decreases in the fair value of equity securities are reported in net realized and unrealized investment gains (losses) in the Consolidated Statements of Income. Previously, equity securities were categorized as available-for-sale and unrealized gains and losses were reported in AOCI, a separate component of shareholders’ equity. On January 1, 2018, the Company recorded a cumulative effect adjustment which included the reclassification of net unrealized gains on equity securities of $142.5 million, pre-tax, from AOCI to retained earnings. As of December 31, 2017, the Company held equity securities with a fair value of $576.2 million and a cost of $433.7 million.
Other investments also include interests in limited partnerships of $235.7 million and $186.4 million at December 31, 2018 and December 31, 2017, respectively.
At December 31, 2018 and 2017, the Company’s exposure to concentration of investments in a single investee that exceeded 10% of shareholders’ equity included securities of a U.S. government-sponsored agency, as well as mortgage participations with a highly rated single third party with a carry value of $396.7 million and $356.8 million, respectively.
At December 31, 2018, there were contractual investment commitments of up to $162.9 million.
The components of net investment income from continuing operations were as follows:
Effective January 1, 2018, with the implementation of ASC No. 2016-01, the change in fair value of limited partnerships previously reported using the cost method are reported in net investment income, of which $5.3 million relates to holding gains on securities still owned at December 31, 2018.
The carrying values of fixed maturity securities on non-accrual status at December 31, 2018 and 2017 were not material. The effects of non-accruals for the years ended December 31, 2018, 2017 and 2016, compared with amounts of net investment income that would have been recognized in accordance with the original terms of the fixed maturities were also not material.
Net realized and unrealized gains (losses) on investments from continuing operations, including OTTI, were as follows:
For the years ended December 31, 2017 and 2016, there were net unrealized gains on equity securities of $56.8 million and $37.8 million, respectively, recognized in AOCI.
For 2016, total OTTI from continuing operations was $20.6 million. Of this amount, $27.4 million was recognized in earnings including $6.8 million which was transferred from unrealized losses in AOCI. The $27.4 million of OTTI recognized in earnings was related primarily to $16.0 million of fixed maturity securities that the Company intended to sell, $8.4 million of credit impairments and $2.7 million of equities.
The methodology and significant inputs used to measure the amount of credit losses on fixed maturities in 2018, 2017 and 2016 were as follows:
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability, i.e., exit price, in an orderly transaction between market participants. The Company emphasizes the use of observable market data whenever available in determining fair value. Fair values presented for certain financial instruments are estimates which, in many cases, may differ significantly from the amounts that could be realized upon immediate liquidation. A hierarchy of the three broad levels of fair value are as follows, with the highest priority given to Level 1 as these are the most observable, and the lowest priority given to Level 3:
Generally, all prices provided by the pricing service, except actively traded securities with quoted market prices, are reported as Level 2.
Due to the adoption of ASU No. 2016-01, certain classifications are not comparable to the prior year. See Note 1 - “New Accounting Pronouncements”.
The Company has processes designed to ensure that the values received from its third-party pricing service are accurately recorded, that the data inputs and valuation approaches and techniques utilized are appropriate and consistently applied, and that the assumptions are reasonable and consistent with the objective of determining fair value. The Company performs a review of the fair value hierarchy classifications and of prices received from its pricing service on a quarterly basis. The Company reviews the pricing services’ policies describing its methodology, processes, practices and inputs, including various financial models used to value securities. Also, the Company reviews the portfolio pricing, including a process for which securities with changes in prices that exceed a defined threshold are verified to independent sources, if available. If upon review, the Company is not satisfied with the validity of a given price, a pricing challenge would be submitted to the pricing service along with supporting documentation for its review. The Company does not adjust quotes or prices obtained from the pricing service unless the pricing service agrees with the Company’s challenge. During 2018 and 2017, the Company did not adjust any prices received from its pricing service.
During the years ended December 31, 2018 and 2017, 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 2018 or 2017. There were no Level 3 liabilities held by the Company for years ended December 31, 2018 and 2017.
The Company has outstanding 7.625% unsecured senior debentures with a par value of $62.6 million as of December 31, 2018 and 2017 and mature on October 15, 2025. Additionally, the Company has outstanding unsecured senior debentures that were issued on April 8, 2016 with a par value of $375.0 million, as of December 31, 2018 and 2017 and mature on April 15, 2026. Both of the Company’s outstanding senior debentures are subject to certain restrictive covenants, including limitations on the issuance or disposition of stock of restricted subsidiaries and limitations on liens, and pay interest semi-annually.
The Company has outstanding $175.0 million aggregate principal amount of 6.35% subordinated unsecured debentures due March 30, 2053. These debentures pay interest quarterly. The Company may redeem these debentures in whole at any time, or in part from time to time, on or after March 30, 2018, at a redemption price equal to their principal amount plus accrued and unpaid interest. In addition, the Company’s subordinated debentures maturing February 3, 2027 have a par value of $50.1 million as of December 31, 2018 and $59.7 million as of December 31, 2017 and pay cumulative dividends semi-annually at 8.207%.
In 2009, Hanover Insurance received a $125.0 million advance through its membership in the FHLB. This collateralized advance bears interest at a fixed rate of 5.50% per annum over a twenty-year term. As collateral to FHLB, the Company pledged government agency securities with a fair value of $234.7 million and $223.6 million, for the aggregate borrowings of $125.0 million as of December 31, 2018 and December 31, 2017, respectively. The fair value of the collateral pledged must be maintained at certain specified levels of the borrowed amount, which can vary depending on the type of assets pledged. If the fair value of this collateral declines below these specified levels, the Company would be required to pledge additional collateral or repay outstanding borrowings. The Company is permitted to voluntarily repay the outstanding borrowings at any time, subject to a repayment fee. As a requirement of membership in the FHLB, the Company maintains a certain level of investment in FHLB stock. Total holdings of FHLB stock were $8.7 million and $8.5 million at December 31, 2018 and 2017, respectively. At December 31, 2018, the Company notified FHLB of its intent to repay its $125 million advance and recorded a pre-tax charge of $26.3 million related to the pre-payment provision.
The following are the components of the Company’s deferred tax assets and liabilities, (excluding those associated with its discontinued operations.)
Deferred tax assets are reduced by a valuation allowance if it is more likely than not that all or some portion of the deferred tax assets will not be realized. The Company believes it is more likely than not that the deferred tax assets will be realized.
In prior years, the Company completed several transactions which resulted in, for tax purposes only, realized gains in its investment portfolio. As a result of these transactions, the Company was able to utilize capital losses carried forward and to release the valuation allowance recorded against the deferred tax asset related to these losses. The releases of valuation allowances were recorded as a benefit in accumulated other comprehensive income. Previously unrealized benefits of $9.2 million, $12.7 million and $20.7 million, are recognized as part of income from continuing operations during 2018, 2017 and 2016, respectively. The remaining amount of $35.6 million in accumulated other comprehensive income will be released into income from continuing operations in future years, as the investment securities subject to these transactions are sold or mature.
In 2019, the Company is expecting to release $1.7 million of liability due to the expiration of a statute of limitations.
The Act also created a territorial tax system, which will generally allow companies to repatriate future non-U.S. sourced earnings without incurring additional U.S. taxes, by providing a 100% exemption on dividends received from certain non-U.S. subsidiaries. Although most of the Company’s non-U.S. income had been previously subject to U.S. taxes, a portion of its non-U.S. income had been indefinitely reinvested overseas and was not subject to U.S. tax until repatriated. These non-U.S. earnings were subject to a one-time mandatory toll charge totaling $12.7 million, which was recorded as a component of income tax expense in discontinued Chaucer business for the year ended December 31, 2017.
The Act modified the provisions applicable to the determination of the tax basis of unpaid loss reserves. These modifications impact the payment pattern and applicable interest rate. The Act instructed the Treasury Department to provide discount factors and other guidance necessary to determine the appropriate transition adjustment. This information was released in November 2018 and the
transition adjustment has been determined to total $126.2 million, resulting in a deferred tax liability of $26.5 million. This transitional amount will be taken into account ratably over eight years beginning in calendar year 2018. These provisions have no overall effect on the net deferred tax asset or income tax expense for the years ended December 31, 2017 and 2018.
The following table provides 2018 target allocations and actual invested asset allocations for 2018 and 2017.
The following tables present, for each hierarchy level, the U.S. qualified defined benefit plan’s investment assets that are measured at fair value at December 31, 2018 and 2017. Refer to Note 5 - “Fair Value” for a description of the different levels in the Fair Value Hierarchy.
Chaucer also provides a defined contribution plan for its employees which includes employer contributions. Prior to its sale, the Company’s expense included $4.5 million, $4.8 million and $3.9 million for 2018, 2017 and 2016, respectively, related to these benefits; such costs are reflected in discontinued operations.
In addition to the Company’s pension plans, the Company has postretirement medical benefits that it provides to former agents of its discontinued life businesses and retirees and their dependents. The plans, which are funded by the Company through either a Health Reimbursement Arrangement (“HRA”) or directly, provide access to benefits including hospital and major medical, with certain limits, and have varying co-payments and deductibles, depending on the plan. Generally, employees who were actively employed on December 31, 1995 became eligible with at least 15 years of service after the age of 40. Effective January 1, 1996, the Company revised these benefits so as to establish limits on future benefit payments to beneficiaries of retired participants and to restrict eligibility to then current employees. Effective January 1, 2018, the Plan was amended to further limit benefits and no longer provide benefits to current employees. Employees who retired prior to then were limited to a post-age 65 benefit. The population of agents receiving postretirement benefits was frozen as of December 31, 2002, when the Company ceased its distribution of proprietary life and annuity products. This plan is unfunded.
The estimated amortization to be recognized in net periodic benefit cost in 2019 is de minimis.
The following table provides the assumed health care cost trend rates used for 2018 and 2017. A one-percentage point change in these assumptions would be de minimis.
The amount reclassified from accumulated other comprehensive income for the pension and postretirement benefits was allocated approximately 40% to loss adjustment expenses and 60% to other operating expenses for each of the years ended December 31, 2018, 2017 and 2016.
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, 2018, there were 4,343,301 shares available for grants under the 2014 Stock Plan.
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 2018, 2017 and 2016 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.
The weighted average grant date fair value of options granted during the years ended December 31, 2018, 2017 and 2016 was $16.30, $13.05 and $10.83, respectively.
The fair value of shares that vested during the years ended December 31, 2018 and 2017 was $9.3 million and $8.3 million, respectively. As of December 31, 2018, the Company had unrecognized compensation expense of $3.7 million related to unvested stock options that is expected to be recognized over a weighted average period of 1.5 years.
Stock grants may be awarded to eligible employees at a price established by the Committee (which may be zero). Under the 2014 Stock Plan, the Company may award shares of restricted stock, restricted stock units, as well as shares of unrestricted stock. Restricted stock grants may vest based upon performance criteria, market criteria or continued employment and be in the form of shares or units. Vesting periods are established by the Committee.
In 2018, 2017 and 2016, the Company granted market-based awards totaling 31,688, 56,571, and 87,213, respectively, to certain members of senior management, which are included in the table above as performance and market-based restricted stock activity. The vesting of these stock units is based on the relative total shareholder return (“TSR”) of the Company. This metric is generally based on relative TSR for a three year period as compared to a group of Property and Casualty peer companies. The fair value of market-based awards was estimated at the date of grant using a valuation model. These units have the potential to range from 0% to 150% of the shares disclosed.
In 2018, market-based restricted stock units of 3,115 were included as granted due to completion levels in excess of 100% for units granted in 2015. The weighted average grant date fair value of these awards was $70.24. In 2017, market-based restricted stock units of 5,881 were included as granted due to completion levels in excess of 100% for units granted in 2014. The weighted average grant date fair value of these awards was $56.45. In 2016, performance and market-based stock units of 2,268 and 30,134 were included as granted due to completion levels in excess of 100% for units granted in 2014 and 2013, respectively. The weighted average grant date fair value of these awards was $57.00 and $41.77, respectively.
The intrinsic value of restricted stock and restricted stock units that vested during the years ended December 31, 2018, 2017 and 2016 was $2.9 million, $2.3 million and $5.4 million, respectively. The intrinsic value for performance and market-based restricted stock units that vested in 2018, 2017 and 2016 was $0.6 million, $0.6 million and $5.8 million, respectively. There were 10,330 shares, 53,840 shares and 63,740 shares of market-based awards that forfeited in 2018, 2017 and 2016, respectively. Also, during 2018 and 2017, there were 43,449 shares and 1,090 shares, respectively, of performance-based awards that forfeited.
The following table provides weighted average share information used in the calculation of the Company’s basic and diluted earnings per share:
Diluted earnings per share during 2018, 2017 and 2016 excludes 0.3 million, 0.4 million and 0.6 million, respectively, of common shares issuable under the Company’s stock compensation plans, because their effect would be antidilutive.
On December 30, 2018, the Board of Directors of the Company declared a special dividend of $4.75 per share to be paid on January 25, 2019. The Company held liabilities of $193.4 million at December 31, 2018 for payment of this obligation.
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 $87.9 million, $99.9 million and $70.0 million in 2018, 2017 and 2016, respectively. At January 1, 2019, the maximum dividend payable without prior approval is $19.2 million. In December 2019, the maximum dividend declared payable without prior approval will increase by $87.9 million to a total amount of $107.1 million.
Dividend payments previously paid by Chaucer to THG were regulated by U.K. law, whereby advance notice was provided to the U.K.’s Prudential Regulatory Authority. Dividend payments of $85.0 million and $79.5 million were made in 2018 and 2016, respectively.
The Company’s primary business operations include insurance products and services provided through three operating segments: Commercial Lines, Personal Lines and Other. 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, surety and specialty property. Personal Lines includes personal automobile, homeowners and other personal coverages. Included in the Other segment are Opus Investment Management, Inc., which markets investment management services to institutions, pension funds and other organizations; earnings on holding company assets; holding company and other expenses, including certain costs associated with retirement benefits due to the Company’s former life insurance employees and agents; and, a run-off voluntary pools business. On December 28, 2018, the Company completed the sale of Chaucer, the major portion of our Lloyd’s international specialty business, to China Re. The Chaucer-related Irish entity was subsequently sold on February 14, 2019. The sale of the Australian entities is pending, subject only to local regulatory approval, and is expected to close in the first quarter of 2019. Accordingly, as of December 31, 2018, and for all prior periods, Chaucer’s results of operations have been classified as Discontinued Operations in the Consolidated Statements of Income and assets and liabilities related to the Chaucer business have been classified as held-for-sale in the Consolidated Balance Sheets (see Note 2 - “Discontinued Operations”). Certain ongoing expenses have been reclassified from Chaucer to the other three operating segments. 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.
The Company reports interest expense related to debt separately from the earnings of its operating segments. For 2018, this consisted of interest on the Company’s senior debentures, subordinated debentures, collateralized borrowings with the FHLB, and a letter of credit facility through the completion of the sale of Chaucer on December 28, 2018.
Management evaluates the results of the aforementioned segments based on operating income before taxes, excluding interest expense on debt. Operating income before taxes excludes certain items which are included in net income, such as net realized and unrealized investment gains (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 may be important components in understanding and assessing the Company’s overall financial performance, management believes that the presentation of operating income before taxes enhances an investor’s understanding of the Company’s results of operations by highlighting net income attributable to the core operations of the business. However, operating income before taxes 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.
The Company reviews the assets of its U.S. Companies collectively and does not allocate them among the Commercial Lines, Personal Lines and Other segments.
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 $70.9 million and $108.8 million in 2018, $62.8 million and $81.4 million in 2017, and $58.6 million and $75.0 million in 2016. The MCCA represented 59.3% of the total reinsurance receivable balance at December 31, 2018. Reinsurance recoverables related to MCCA were $977.1 million and $930.6 million at December 31, 2018 and 2017, 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, 2018, the Company believes that it has no significant exposure to uncollectible reinsurance balances from this entity.
Carried reserves for each line of business and coverage are determined based on the quarterly loss reserving process. In making the determination, the Company considers numerous quantitative and qualitative factors. Quantitative factors include actual payments made and changes in case reserve estimates in the period, as compared to previously experienced patterns, 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, concerns that the Company does not have sufficient or quality historical reported and paid loss and LAE information with respect to a particular line or segment of business, effects of the economy and political outlook, perceived anomalies in the historical results, evolving trends or other factors.
In 2017, net favorable loss and LAE development was $0.2 million, primarily as a result of net favorable development of $10.8 million for Commercial Lines, partially offset by unfavorable development of $9.4 million for Personal Lines. Commercial Lines favorable development was primarily due to lower than expected losses within the workers’ compensation line in accident years 2012 through 2016. Personal Lines unfavorable development was primarily due to higher than expected losses in homeowners for accident year 2016. In addition, Other segment unfavorable development of $1.2 million was due to higher than expected losses in our runoff voluntary pools business.
In 2016, net unfavorable loss and LAE development was $238.2 million, primarily as a result of net unfavorable development of $219.3 million for Commercial Lines. The net unfavorable Commercial Lines development primarily resulted from higher than expected losses in other commercial lines of $169.7 million, which includes the AIX program business. This was primarily driven by AIX programs and business classes, general liability coverages in accident years 2012 through 2015, and surety bonds in accident years 2012 through 2015. The Company also experienced higher than expected losses within the commercial multiple peril lines of $68.8 million for accident years 2012 through 2015 and commercial automobile of $27.5 million in accident years 2012 through 2014, both primarily within liability coverages. Partially offsetting the unfavorable development was lower than expected losses of $46.7 million within the workers’ compensation line, primarily related to accident years 2013 through 2015, and, to a lesser extent, the commercial umbrella line primarily related to the 2015 accident year.
As a result of the 2016 fourth quarter reserve review, carried reserves for prior accident years, excluding catastrophes, were increased by $174.1 million in the fourth quarter of 2016, of which $161.5 million related to Commercial Lines. The majority of this adjustment was attributed to long-tailed commercial liability coverages, including AIX program business and was largely driven by worsening trends in the number and nature of high severity losses and higher than anticipated legal defense costs. The Company reacted to this adverse emergence by updating its assumptions about loss severity, loss development patterns, expected loss ratios and loss adjustment expenses for the most recent accident years, placing greater weight on the adverse severity trends experienced in the most recent calendar years. The adverse prior year development for the Other segment was due to run-off voluntary assumed reinsurance pools business. The reserve increase was primarily based on an updated third-party actuarial study received in the fourth quarter for a pool that primarily consists of asbestos and environmental exposures.
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, commercial automobile liability lines and general liability and umbrella - occurrence presentation includes AIX program business.
On February 16, 2018, the Court entered an order limiting the claims of those participants who received lump sum distributions prior to March 13, 2002 to alleged violations of ERISA’s disclosure requirements and breaches of fiduciary duty. Subsequently, the parties entered into settlement discussions and have reached a settlement, which the Court preliminarily approved on December 18, 2018. The Court will consider whether to give final approval to the settlement at a hearing on March 22, 2019. Provided the Court approves the settlement, the Company does not believe the resulting settlement amount will be material to the Company’s financial position or have a material effect on its results of operations.
The following table provides statutory net income for the years ended December 31 and statutory capital and surplus as of December 31 for the periods indicated:
As a result of the sale of Chaucer, (see Note 2 - “Discontinued Operations”), on December 30, 2018 the Board of Directors declared a special dividend of $4.75 per share (see Note 12 - “Earnings Per Share and Shareholders’ Equity Transactions”).
On January 2, 2019, pursuant to the terms of an ASR agreement, the Company paid $250.0 million and received an initial delivery of approximately 1.8 million shares of our common stock, which is approximately 80% of the total number of shares expected to be repurchased under this agreement.