The Company, through its subsidiaries, owns an investment portfolio of income-producing properties and real estate funds. Included in this portfolio are four office buildings in which the Company holds a 50% ownership interest located in New York, New York, which collectively accounted for approximately 13% of the carrying value of the property portfolio at December 31, 2004.
All data in the following table for the years 2000 through 2003 represent historical data for TPC. For accounting purposes, the merger of SPC and TPC was accounted for as a reverse acquisition with TPC treated as the accounting acquirer. Accordingly, this transaction was accounted for as a purchase business combination, using TPC’s historical financial information and applying fair value estimates to the acquired assets, liabilities and commitments of SPC as of April 1, 2004.
Northland Company and its subsidiaries (Northland) from Citigroup. On October 3, 2001, Citigroup contributed the capital stock of Commercial Guaranty Casualty Insurance Company to TPC. During April 2000, TPC completed a cash tender offer and acquired all of Travelers Insurance Group Holdings Inc.’s (TIGHI) outstanding shares of common stock that were not already owned by TPC for approximately $2.41 billion financed by a loan from Citigroup. On May 31, 2000, TPC acquired the surety business of Reliance Group Holdings, Inc. (Reliance Surety). Includes amounts related to Northland, Commercial Guaranty Casualty, the remainder of TIGHI and Reliance Surety from their dates of acquisition.
(4) Earning per share, year-end common shares outstanding, cash dividends per share and book value per share were restated for the years prior to 2004 to reflect the impact of the merger with SPC.
(5) In March 2002, TPC issued common stock through its Initial Public Offering (IPO). See note 1 of notes to the Company’s consolidated financial statements.
(6) Dividends per common share reflect the recapitalization effected as part of TPC’s corporate reorganization in 2002. See note 1 to the Company’s consolidated financial statements. During 2002, TPC paid dividends of $5.10 billion in the form of a note payable and $158 million in cash to Citigroup, its then sole shareholder. During 2001, TPC paid dividends of $526 million to Citigroup, its then sole shareholder.
For more information regarding the completion of the merger, including the calculation and allocation of the purchase price, refer to note 2 to the Company’s consolidated financial statements included in this report.
In 2002, TPC completed a corporate reorganization in connection with its initial public offering of common stock. For more information regarding that reorganization and stock offering, refer to note 3 to the Company’s consolidated financial statements included in this report.
As a result of the April 1, 2004 merger of TPC and SPC, total assets and liabilities increased by $42.99 billion and $34.23 billion, respectively, adding $8.76 billion to the Company’s shareholders’ equity.
Total catastrophe losses of $772 million pretax (net of reinsurance) and $511 million after-tax, primarily resulting from Hurricanes Charley, Frances, Ivan and Jeanne in the third quarter
GAAP combined ratio of 107.7, including 12.6 points from unfavorable prior year reserve development and 4.0 points from catastrophe losses
Moderating rate environment due to more aggressive pricing in the marketplace
Total assets of $111.82 billion, including $64.71 billion of investments; fixed maturities and short-term securities comprise 92% of total investments
Total debt of $6.62 billion, including $3.98 billion assumed in the merger
The Company provides a wide range of property and casualty insurance products and services to businesses, government units, associations and individuals, primarily in the United States and in selected international markets. Through its majority ownership of Nuveen Investments, Inc. (Nuveen Investments), it also has a presence in the asset management industry.
Index to Financial Statements Consolidated net written premiums were as follows:
The $5.74 billion, or 43%, increase in consolidated net written premiums in 2004 compared with 2003 primarily reflected the impact of the merger. On a pro forma combined basis, net written premiums in 2004 were level with 2003. Business retention levels in the majority of the Company’s insurance operations remained consistent with 2003 levels, as the Company focused on retaining its existing book of well priced, profitable business. Rate increases, however, continued to moderate in 2004, reflecting more aggressive pricing in the marketplace. New business volume in the Commercial and Specialty segments in 2004 declined when compared with the combined new business volume of SPC and TPC in the prior year, reflecting the competitive marketplace and the impact of new business premiums in 2003 from renewal rights transactions. The non-renewal of certain commercial property, construction and surety risks and certain personal lines business in the Company’s operations at Lloyd’s also negatively impacted premium volume in 2004. Personal net written premiums increased 17% in 2004 over 2003, due to strong organic growth, new business resulting from a renewal rights transaction, strong business retention levels and price increases.
Net written premiums increased $1.26 billion, or 11%, in 2003. The increase was primarily due to higher but moderating rate increases, new business growth in favorable markets and strong retention across all major lines of business. These factors were partially offset by the withdrawal in 2002 of business at American Equity Insurance Company and Commercial Guaranty Casualty Insurance Company, both subsidiaries of The Northland Company (Northland), a subsidiary of the Company, and a one-time additional $115 million of net written premiums in 2002 due to the termination of certain reinsurance contracts by Northland. Net written premiums for Northland’s subsidiaries in 2003 were $547 million, a decrease of 34% from the 2002 total of $825 million. Commercial net written premiums, excluding business written in Northland’s subsidiaries, increased $1.03 billion, or 16%, in 2003. Personal net written premiums increased $506 million, or 11%, in 2003.
Index to Financial Statements During the second quarter of 2004, the company recorded $500 million and $300 million of net unfavorable prior year reserve development related to Specialty’s construction and surety reserves, respectively, acquired in the merger. Upon having access to each company’s detailed policyholder information, including underwriting, claim, and actuarial files on April 1, 2004, in connection with the closing of the merger, the Company was able to begin the detailed process of developing a uniform and consistent approach to estimating the combined company’s loss reserves. As part of that process, a team of actuaries representing the historical actuarial perspectives, judgments and methods applied by each legacy company, discussed their views, methodologies, and analysis of available data.
In addition to the discussion in the Critical Accounting Estimates section of this report, other items specifically considered in the process of developing a uniform and consistent approach to estimating the combined company’s loss reserves include interpreting the actuarial and claim data in a uniform manner and determining an appropriate level of data segmentation for estimation purposes. This type of analysis involves a high degree of judgment and can, and often does, lead to reserve estimates that differ materially from those of prior periods, particularly in low frequency, high severity and complex exposures. In addition, since the reserving process also considers the expectations of future outcomes, the actuaries involved had to analyze their differing views on key assumptions, such as predicting inflation, estimating claim development patterns and determining expectations related to judicial rulings and interpretations, among others. This “informed judgment” is brought into the process by individuals such as actuaries, underwriters, claim adjusters, and company management. Ultimately, this process required an analysis of the varying actuarial judgments and forward-looking assessments. The result was similar to a single, ongoing insurance enterprise obtaining more information in a reporting period than it had previously and identifying a change in estimate in its insurance reserves in that period. Accordingly, the Company recorded a $500 million and $300 million charge for construction and surety, respectively, in the second quarter of 2004.
Index to Financial Statements Claims and claim adjustment expenses decreased $2.02 billion, or 18%, in 2003 primarily due to a decline in unfavorable prior year reserve development in 2003, which was partially offset by increased loss costs, growth in business volume and higher catastrophe losses. Catastrophe losses, net of reinsurance, were $352 million in 2003 compared to $84 million in 2002. Unfavorable prior year reserve development included in claims and claim adjustment expenses was $476 million for 2003, compared to $3.09 billion in 2002. Unfavorable prior year reserve development in 2002 included $2.95 billion of asbestos incurred losses (prior to the benefit related to recoveries under the Citigroup indemnification agreement), whereas 2003 included no asbestos-related unfavorable prior year reserve development.
Amortization of deferred acquisition costs increased $174 million, or 10%, in 2003, reflecting higher commission and premium taxes associated with the increases in earned premiums previously described. Interest expense increased $9 million, or 6%, in 2003 due to certain one time costs associated with first and second quarter refinancing activities that lowered average interest costs, and higher levels of temporary debt. General and administrative expenses increased $217 million, or 15%, in 2003, reflecting business growth and higher commissions that resulted from improved underwriting results.
Effective Tax Rate. The Company’s effective tax rate was 12.2%, 24.1% and (183.4)% in 2004, 2003 and 2002, respectively. The decrease in the 2004 effective rate primarily reflected the impact of an increase in nontaxable investment income on a lower level of pretax income. The 2003 increase in the effective rate reflected a higher level of pretax income associated with improved underwriting performance. The 2002 effective rate reflected the impact of the 2002 asbestos charge previously discussed, as well as the impact of non-taxable recoveries of $520 million related to the Citigroup indemnification agreement.
During the third quarter of 2003, TPC purchased from Royal & SunAlliance USA (RSA), an unaffiliated insurer, the renewal rights to RSA’s commercial lines national accounts, middle market and marine businesses, and standard and preferred personal lines businesses. Also during the third quarter of 2003, TPC purchased from Atlantic Mutual, an unaffiliated insurer, the renewal rights to the majority of Atlantic Mutual’s commercial lines inland marine and ocean cargo businesses written by Atlantic Mutual’s Marine Division. The minimum purchase price for both transactions, which has been paid, was $48 million. The final purchase price, which is expected to be determined in 2005 and is currently estimated to be $66 million, is dependent on the level of business renewed by the Company.
“Operating income” in the following discussion represents net income excluding the after-tax impact of net realized investment gains (losses).
Index to Financial Statements Operating income of $862 million in 2004 declined $199 million, or 19%, from 2003, which did not include the results of SPC. Included in 2004 results were $233 million of after-tax catastrophe losses, compared with after-tax catastrophe losses of $67 million in 2003. Also impacting 2004 operating income was net after-tax unfavorable prior year reserve development of $802 million ($1.18 billion, pretax), primarily related to asbestos and environmental reserve strengthening. Net after-tax unfavorable prior year reserve development totaled $439 million in 2003.
Net investment income in 2004 increased $384 million over 2003 due largely to the increase in invested assets as a result of the merger, strong operational cash flows that contributed to the growth in invested assets over 2003, and investment income related to the initial public trading of an investment. Also impacting net investment income was the effect of a decline in pretax investment yields due to a higher proportion of tax-exempt investments, and lower yields on fixed income securities and alternative investments.
Claim and claim adjustment expenses in 2004 included $1.18 billion of net unfavorable prior year reserve development in the Commercial segment, of which $927 million represented a provision to strengthen asbestos reserves primarily as a result of the completion of the Company’s annual asbestos liability review in the fourth quarter and $286 million represented a provision to strengthen environmental reserves. The asbestos provision primarily resulted from an increase in litigation costs and activity surrounding peripheral defendants. With regard to the environmental provision, new claims for hazardous waste and pollution continue to decline, though the pace of the decrease has slowed. The average severity of claims has increased, however, leading the Company to conclude that reserves for environmental losses needed to be increased. In June 2004, the Company decided to commute certain reinsurance agreements with a major reinsurer, resulting in a prior year reserve charge of $38 million. Also included in net unfavorable prior-year reserve development in the Commercial segment in 2004 was a strengthening of Gulf reserves, which was more than offset by favorable prior year reserve development in core Commercial operations due to reductions in the frequency of non-catastrophe related losses. In 2003, unfavorable prior-year loss development in the Commercial segment totaled $676 million, the most significant component of which was $521 million of reserve strengthening in the Gulf operations. That reserve strengthening was primarily related to a line of business that insured the residual values of leased vehicles and that had been placed in runoff in late 2001, and the resolution of a residual value claim dispute.
Also included in claim and claim adjustment expenses in 2004 were catastrophe losses of $358 million, compared with catastrophe losses of $103 million in 2003. The losses in 2004 primarily resulted from the four hurricanes that made landfall in the southeastern United States in the third quarter, whereas the 2003 losses resulted from a variety of storms throughout the year, including Hurricane Isabel.
Other items increasing 2004 claims and expenses compared to 2003 include $72 million of charges to increase the allowances for estimated amounts due from reinsurance recoverables and policyholders receivables, previously described in the Consolidated Overview section.
Claims and claim adjustment expenses in 2003 decreased $2.23 billion, or 30%, primarily due to a significant decline in unfavorable prior year reserve development, which was partially offset by an increase in catastrophe losses and increased loss costs resulting from growth in business volume. Catastrophe losses totaled $103 million in 2003, compared with no catastrophe losses in 2002. Catastrophe losses in 2003 were primarily the result of a severe winter storm in Colorado in the first quarter, severe storms in the second quarter in a number of Southern and Midwestern states and Hurricane Isabel in the third quarter. Unfavorable prior year reserve development included in claims and claim adjustment expenses was $676 million in 2003 compared to $3.12 billion in 2002. The most significant component of 2003 prior year development was the Gulf reserve strengthening of $521 million referred to previously. In addition to the Gulf charges, unfavorable prior-year reserve development in 2003 included charges associated with American Equity Insurance Company and an increase in environmental reserves. No asbestos-related prior year reserve development was recorded in 2003. Unfavorable prior year reserve development in 2002 included $2.95 billion of asbestos-related charges (prior to the benefit related to recoveries under the Citigroup indemnification agreement). For additional information see “-Asbestos Claims and Litigation.”
Separately, the Company strengthened its environmental reserves in the 2002 fourth quarter, which was mostly offset by reductions in its reserves for other general liability exposures. These actions were taken as a result of payment and settlement experience. In addition, in 2003 the Company strengthened prior year reserves for certain run-off lines of business, including assumed reinsurance, and experienced favorable development in certain on-going businesses.
Amortization of deferred acquisition costs increased $82 million, or 9%, in 2003, reflecting higher commission and premium taxes associated with the increase in earned premiums. General and administrative expenses in 2003 increased $150 million, or 18%, over 2002, driven by business growth and higher commission expense that resulted from improved underwriting results.
Index to Financial Statements The 33.9 point improvement in the 2003 GAAP loss and loss adjustment expense ratio over 2002 primarily resulted from lower unfavorable prior year reserve development. The prior-year asbestos-related charges in 2002 added 36.8 points to that year’s loss and loss adjustment expense ratio, whereas in 2003 no prior-year asbestos-related charges were incurred. The favorable impact of premium rate increases that exceeded loss cost trends in 2003 was largely offset by the impact of catastrophe losses. No catastrophe losses were incurred in 2002. The 0.6 point decrease in the underwriting expense ratio in 2003 compared with 2002 was primarily due to the benefits of the favorable rate environment and higher fee income, largely offset by higher commissions that result from improved underwriting performance.
Commercial net written premiums in 2004 increased $1.35 billion, or 20%, over 2003, primarily reflecting the impact of the merger. Business retention rates remained strong and renewal price change increases moderated to the low-single digit levels in 2004. New business volume declined, however, when compared with the combined new business volume of SPC and TPC in 2003, reflecting the increasingly competitive marketplace and the impact of higher premium flow in 2003 associated with several renewal rights transactions.
Select Accounts’ 2004 premium volume of $2.56 billion increased $508 million, or 25%, over 2003, reflecting the impact of the merger. Overall retention rates were strong and renewal price increases moderated to the mid single-digits. Retention and growth were strongest in smaller, high transaction volume accounts, reflecting the Company’s competitive advantage in agency automation, product offerings and service to agents.
Commercial net written premiums increased $532 million, or 8%, in 2003. Renewal price increases, higher new business levels, and strong customer retention across all major lines of business combined to drive premium growth over 2002. This premium growth was partially offset by the decrease in net written premiums at the Northland subsidiaries due to the withdrawal in 2002 of business at certain of those subsidiaries and a one-time
additional $115 million of net written premium in 2002 related to the termination of certain reinsurance contracts. Net written premiums for the Northland subsidiaries were $547 million in 2003 compared to $825 million in 2002. The Commercial business of those subsidiaries is included with Commercial Accounts.
Select Accounts net written premiums in 2003 increased $178 million, or 10%, over 2002. The increase primarily reflected renewal price increases, new business and strong retention. New business growth was especially strong in property, general liability and commercial multi-peril lines of business. Select Accounts retention levels in 2003 were strongest for small commercial business handled through the Company’s Service Centers, while premium growth was centered in the commercial multi-peril and property product lines.
National Accounts net written premiums in 2003 increased $190 million, or 30%, over 2002, primarily due to the continued benefit from rate increases, higher new business levels that, in part, resulted from the Company’s third quarter 2003 renewal rights transaction with Royal & SunAlliance and higher business volume in residual market pools.
The following discussion provides more information regarding the net unfavorable prior year loss development related to the construction and surety reserves, acquired in the merger as well as other net reserving actions.
The claim reviews and actuarial analyses were both completed near the end of the second quarter of 2004. Based upon the results of these reviews and analyses, the Company increased its estimate of the acquired net surety reserves by $300 million, net of $170 million of reinsurance, and recognized this change in estimate as an income statement charge in the second quarter.
Also during the last half of the second quarter of 2004, a participating co-surety on this exposure announced that insurance regulators had approved its submitted run-off plan. Based upon industry’s knowledge of the co-surety’s run-off plan and the Company’s analysis of its financial condition, the Company concluded that it was unlikely to collect the full amount projected to be owed by the co-surety and established an appropriate level of reserves.
The $50 million increase in operating earnings in 2003 over 2002 reflected strong results from the Company’s Bond operation. The $201 million, or 21%, increase in earned premiums over 2002 primarily resulted from premium rate increases, growth in targeted new business and strong customer retention. The $5 million decline in net investment income in 2003 primarily reflected a reduction in pretax investment yields from 6.0% in 2002 to 5.3% in 2003.
The $3.54 billion increase in net written premium volume over 2003 reflected the impact of the merger. However, the repositioning of the Bond and Construction books of business primarily accounted for a decline in net written premium volume in 2004 compared with the 2003 combined premium volume of SPC and TPC. In Construction, that repositioning resulted in reduced retention levels when compared with 2003, and new business
In International Specialty, acquired in the merger, business retention levels (excluding Lloyd’s) were strong relative to pre-merger levels. New business levels were consistent with 2003, while the rate of renewal price change increases moderated to the low-single digit levels. The Company continued to focus on retaining its profitable book of existing international specialty business. At Lloyd’s, premium volume was negatively impacted by the planned non-renewal of certain personal lines insurance coverages.
The $218 million, or 21%, increase in net written premiums in 2003 over 2002 reflected a favorable premium rate environment and strong new business, particularly in Bond’s executive liability lines.
The $758 million, or 16%, growth in earned premiums over 2003 was primarily due to an increase in organic new business volume, new business associated with the Royal & SunAlliance renewal rights transaction completed in the third quarter of 2003, continued strong business retention levels and renewal price increases. Net investment income in 2004 grew 22% over 2003, driven by strong operational cash flows during the year that contributed to a significant growth in invested assets since the end of 2003. In addition, net investment income in 2004 benefited from $39 million of income resulting from the initial public trading of an investment in the first
Claim and claim adjustment expenses in 2004 included $378 million of favorable prior-year reserve development, primarily driven by a decline in the frequency of non-catastrophe related homeowners’ losses, as well as an improvement in the frequency and severity trends in the automobile line of business. In 2003, favorable prior-year reserve development totaled $212 million, also primarily due to a decline in the frequency of non-catastrophe related homeowners’ losses. The 2003 total included a $50 million reduction in the provision for losses resulting from the September 11, 2001 terrorist attack. In addition, claim and claim adjustment expenses in 2004 reflected the benefit of lower current accident year frequency of non-catastrophe claims in the homeowners’ line of business than in 2003. Claims and expenses in 2004 included catastrophe losses of $189 million, compared with catastrophe losses of $249 million in 2003. The 2004 losses were primarily the result of the four hurricanes described previously, whereas the 2003 losses resulted from a variety of storms across the United States, including Hurricane Isabel in the third quarter of the year and wildfires in California. Claims and expenses in 2004 also reflected continued investments in process re-engineering pilots targeted to improve loss severity.
Earned premiums increased $468 million, or 11%, in 2003, primarily due to higher rates, growth in new business volumes and strong retention levels. Net investment income in 2003 decreased $24 million compared with 2002, despite an increase in average invested assets resulting from strong operational cash flows. The decline resulted from a reduction in pretax investment yields, which reflected a lower interest rate environment, the shortening of the average effective duration of the fixed maturity portfolio, a higher proportion of tax-exempt investments and slightly lower returns from the Company’s private equity investments.
Claim and claim adjustment expenses in 2003 included favorable prior-year reserve development of $212 million, compared with favorable development of $30 million in 2002. The favorable development in 2003 resulted from improvement in non-catastrophe-related claim frequency for both homeowners and non-bodily-injury automobile businesses, and a $50 million reduction in reserves related to the terrorist attack on September 11, 2001 (also due to lower than expected claim frequency). Catastrophe losses of $249 million in 2003 were significantly higher than comparable losses of $84 million in 2002. Catastrophe losses in both years were driven by numerous storms across the United States. Losses in 2003 also reflected the impact of Hurricane Isabel and wildfires in California.
In the Automobile line of business, policies in force at December 31, 2004 increased 9% over 2003. Policies in force in the Homeowners and other line of business at December 31, 3004 increased by 15% over 2003. Effective in the first quarter of 2004, Homeowners and other policies in force exclude certain endorsements to Homeowners policies previously considered separate policies in force. Policy totals for 2003 and 2002 were restated to conform to the 2004 presentation.
Nuveen Investments’ total revenues of $390 million in 2004, from the SPC and TPC merger date, were driven by continued strong growth in assets under management. Gross sales of investment products totaled $19.86 billion, consisting of $16.76 billion of retail and institutional managed accounts, $1.87 billion of closed-
end exchange-traded funds and $1.23 billion of mutual funds. Nuveen Investments’ positive net flows (equal to the sum of sales, reinvestments and exchanges, less redemptions) totaled $11.23 billion during the nine months ended December 31, 2004. Net flows were positive across all product lines in 2004. Assets under management grew by $14.53 billion, or 14.4%, since the merger date, driven by the positive net flows and market appreciation during that period. Assets under management at December 31, 2004 were comprised of $50.21 billion of exchange-traded funds, $36.98 billion of retail managed accounts, $15.58 billion of institutional managed accounts, and $12.68 billion of mutual funds. Investment advisory fees accounted for 93% of Nuveen Investments revenues for the nine months ended December 31, 2004.
loss and loss expense experience as a result of the exhaustion or unavailability due to insolvency of other insurance potentially available to policyholders along with the insolvency or bankruptcy of other defendants. The Company is currently involved in coverage litigation concerning a number of policyholders who have filed for bankruptcy, including, among others, ACandS, Inc., who in some instances have asserted that all or a portion of their asbestos-related claims are not subject to aggregate limits on coverage as described generally in the next paragraph. (Also see “Part I-Item 3, Legal Proceedings”). These trends are expected to continue through 2005. As a result of the factors described above, there is a high degree of uncertainty with respect to future exposure from asbestos claims.
In some instances, policyholders continue to assert that their claims for asbestos-related insurance are not subject to aggregate limits on coverage and that each individual bodily injury claim should be treated as a separate occurrence under the policy. It is difficult to predict whether these policyholders will be successful on both issues or whether the Company will be successful in asserting additional defenses. To the extent both issues are resolved in policyholders’ favor and other additional Company defenses are not successful, the Company’s coverage obligations under the policies at issue would be materially increased and bounded only by the applicable per-occurrence limits and the number of asbestos bodily injury claims against the policyholders. Accordingly, it is difficult to predict the ultimate cost of the claims for coverage not subject to aggregate limits.
In addition, proceedings have been launched directly against insurers, including the Company, challenging insurers’ conduct in respect of asbestos claims, and, as discussed below, claims by individuals seeking damages arising from alleged asbestos-related bodily injuries. The Company anticipates the filing of other direct actions against insurers, including the Company, in the future. It is difficult to predict the outcome of these proceedings, including whether the plaintiffs will be able to sustain these actions against insurers based on novel legal theories of liability. The Company believes it has meritorious defenses to these claims and has received favorable rulings in certain jurisdictions. Additionally, TPC has entered into settlement agreements, which have been approved by the court in connection with the proceedings initiated by TPC in the Johns Manville bankruptcy court. If the rulings of the bankruptcy court are affirmed through the appellate process, then TPC will have resolved substantially all of the pending claims against it of this nature. (Also, see “Item 3 - Legal Proceedings”).
The Company also compares its historical gross and net loss and expense paid experience, year-by-year, to assess any emerging trends, fluctuations, or characteristics suggested by the aggregate paid activity. Net asbestos
losses and expenses paid in 2004 were $301 million, compared with $452 million in 2003. Approximately 22% in 2004 and 57% in 2003 of total net paid losses relate to policyholders with whom the Company previously entered into settlement agreements that would limit the Company’s liability. The decrease in the percentage of net paid settlements to total paid losses in 2004 primarily reflected an increase in reinsurance billings in 2004, which related to gross payments made in prior periods. In 2004, gross payments associated with policyholders with settlement agreements totaled $199 million, compared with $289 million in 2003.
PC Plan. Oral argument is scheduled to take place on March 16, 2005. The Company cannot predict what effect the CE decision may have with respect to the bankruptcy court’s approval of the current Plan. The Company believes that completion of the settlement is reasonably likely although it is not possible to predict how or when the bankruptcy court will rule on the outstanding objections or how an appellate court may rule in the event of an appeal. It is possible that the Company’s single payment contribution pursuant to the proposed settlement of approximately $395 million after reinsurance will be made in calendar year 2005. Coverage in place arrangements represent agreements with major policyholders on specified amounts of coverage to be provided. Payment obligations may be subject to annual maximums and are only made when valid claims are presented. Wellington accounts refer to the 35 defendants that are parties to a 1985 agreement settling certain disputes concerning insurance coverage for their asbestos claims. Many of the aspects of the Wellington agreement are similar to those of coverage in place arrangements in which the parties have agreed on specific amounts of coverage and the terms under which the coverage can be accessed. As more fully described in Item 3, Legal Proceedings, TPC has entered into the Direct Action Settlement which is still subject to a number of contingencies. If those contingencies are met, then TPC will pay up to $502 million, possibly in calendar year 2005. One of the contingencies includes affirmance by all appellate courts of the orders entered by the United States Bankruptcy Court with respect to the Direct Action Settlement. It is not possible to predict how or when the appellate courts will rule on the pending appeals. Ten new policyholders were added to the “policyholders with settlement agreements” category during 2004, including seven resulting from the acquisition of SPC. During the course of 2004, the Company made final payments to four policyholders, including one that arose during the year.
Other policyholders with active claims are identified as home office review or field office review policyholders. Policyholders are identified for home office review based upon, among other factors: aggregate ultimate expected payments in excess of a specified threshold (currently $100,000), perceived level of exposure, number of reported claims, products/completed operations and potential “non-product” exposures, size of policyholder and geographic distribution of products or services sold by the policyholder. During 2004, there were 285 policyholders added to the home office review. The acquisition of SPC accounted for 222 of those policyholders, while the TPC count increased by 63. Paid losses for policyholders in the home office review category increased by $30 million during the year, primarily due to the addition of the SPC policyholders to this category. Accounts under field office review increased by 444 policyholders over year-end 2003. The acquisition of SPC accounted for 516 of those policyholders, while the TPC count was reduced by 72.
Index to Financial Statements The following table displays activity for asbestos losses and loss expenses and reserves:
(1) Includes $800 million related to incurred asbestos losses subject to the Citigroup indemnification agreement in 2002.
The duration of the Company’s investigation and review of these claims and the extent of time necessary to determine an appropriate estimate, if any, of the value of the claim to the Company vary significantly and are dependent upon a number of factors. These factors include, but are not limited to, the cooperation of the policyholder in providing claim information, the pace of underlying litigation or claim processes, the pace of
As a result of the processes and procedures described above, management believes that the reserves carried for asbestos and environmental claims at December 31, 2004 are appropriately established based upon known facts, current law and management’s judgment. However, the uncertainties surrounding the final resolution of these claims continue, and it is difficult to determine the ultimate exposure for asbestos and environmental claims and related litigation. As a result, these reserves are subject to revision as new information becomes available and as claims develop. The continuing uncertainties include, without limitation, the risks and lack of predictability inherent in major litigation, any impact from the bankruptcy protection sought by various asbestos producers and other asbestos defendants, a further increase or decrease in asbestos and environmental claims which cannot now be anticipated, the role of any umbrella or excess policies the Company has issued, the resolution or adjudication of some disputes pertaining to the amount of available coverage for asbestos claims in a manner inconsistent with
Because of the uncertainties set forth above, additional liabilities may arise for amounts in excess of the current related reserves. In addition, the Company’s estimate of claims and claim adjustment expenses may change. These additional liabilities or increases in estimates, or a range of either, cannot now be reasonably estimated and could result in income statement charges that could be material to the Company’s operating results and financial condition in future periods.
Because the primary purpose of the investment portfolio is to fund future claims payments, the Company employs a conservative investment philosophy. The Company’s fixed maturity portfolio at December 31, 2004 totaled $54.26 billion, comprising $53.93 billion of publicly traded fixed maturities and $328 million of private fixed maturities. The weighted average quality ratings of the Company’s publicly traded fixed maturity portfolio and private fixed maturity portfolio at December 31, 2004 were AA2 and A3, respectively. Included in the fixed maturity portfolio at that date was approximately $1.78 billion of below investment grade securities. During 2004, holdings of tax-exempt securities were increased to $26.58 billion to take advantage of their relatively high credit quality and attractive after-tax yields. The average effective duration of the fixed maturity portfolio, including short-term investments, was 4.1 years as of December 31, 2004 (4.4 years excluding short-term investments), unchanged from December 31, 2003.
Index to Financial Statements The following table sets forth the Company’s combined fixed maturity investment portfolio classified by Moody’s Investors Service ratings:
The Company’s other investments are primarily comprised of venture capital, through direct ownership and limited partnerships, private equity limited partnerships, joint ventures, other limited partnerships and trading securities, which are subject to more volatility than the Company’s fixed income investments, but historically have provided a higher return. At December 31, 2004, the carrying value of the Company’s other investments was $3.56 billion.
$5 million in the equity portfolio when it became apparent that the cost basis of those securities would not be recovered over the expected holding period.
$40 million in its venture capital portfolio on 16 holdings. Three of the holdings were impaired due to new financings at less than favorable rates. Five holdings experienced fundamental economic deterioration (characterized by less than expected revenues or a fundamental change in product). Eight of the holdings were impaired due to the impending sale, liquidation or shutdown of the entity. The Company continues to evaluate current developments in the market that have the potential to affect the valuation of the Company’s investments.
$10 million in its real estate and other holdings. The losses recorded were the result of falling rental rates and occupancies in three of the Company’s real estate investment holdings.
The Company recognized other-than-temporary impairments of $65 million in the fixed income portfolio during 2003 related to various issuers, with $8 million due to companies filing bankruptcy and the remainder related to credit risk associated with the issuer’s deteriorated financial position.
The Company believes that the prices of the securities identified above were temporarily depressed primarily as a result of market dislocation and generally poor cyclical economic conditions. Further, unrealized losses as of December 31, 2004 represent less than 1% of the portfolio, and, therefore, any impact on the Company’s financial position would not be significant.
Index to Financial Statements Following are the pretax realized losses on investments sold during the year ended December 31, 2004:
The Company expects market conditions in the property casualty insurance sector to continue to be quite competitive throughout 2005. Commercial pricing at the end of 2004 had declined to the low single-digit range and may turn negative in 2005 for certain products in some markets. In general, the pricing environment in the Specialty segment is expected to be better than in Commercial, largely due to the specialized nature of the Specialty businesses. Within Personal, the Company expects to see increased price competition in the auto segment, while the homeowners segment is expected to remain stable.
In January 2005, the Company announced that it will explore strategic alternatives to divest its majority ownership position in Nuveen Investments, thereby providing the Company with the opportunity to increase its financial flexibility.
Index to Financial Statements As required by various state laws and regulations, the Company’s insurance subsidiaries are subject to assessments from state-administered guaranty associations, second-injury funds and similar associations. In the opinion of the Company’s management, these assessments will not have a material impact on the Company’s results of operations.
Net cash flows provided by operating activities totaled $5.24 billion, $3.83 billion and $2.93 billion in 2004, 2003 and 2002, respectively. Cash flows in 2004 included $867 million in cash proceeds received pursuant to the commutation of specific reinsurance agreements in the second quarter described previously. Cash flows in 2004 also benefited from premium rate and volume increases. The previously discussed adjustments recorded in the second quarter did not materially impact year-to-date 2004 cash flows. The Company utilized $550 million of net operating loss carryforwards (NOL) during 2004, thereby reducing current regular tax payments by $193 million. At December 31, 2004, the Company had significant NOLs available to offset future taxable income. See note 11 to the consolidated financial statements for further information regarding NOLs.
Net cash flows provided by operating activities for all three years were negatively impacted by payments for asbestos and environmental liabilities and, in 2004, for reinsurance, health care and certain international runoff operations. Included in the Company’s structured agreement component of asbestos loss reserves at December 31, 2004 was $395 million (net of reinsurance) for the Company’s single payment contribution to the proposed settlement related to PPG, and $502 million for the Company’s settlement of the Statutory and Hawaii Actions and the Common Law Claims. Although each of these settlements is subject to certain contingencies or final orders and relief as previously discussed, it is possible that these settlement amounts will be paid in 2005.
Net cash flows used in investing activities totaled $4.79 billion, $2.48 billion and $2.27 billion in 2004, 2003 and 2002, respectively. The increase in 2004 corresponds to the increase in operational cash flows, which were invested predominantly in fixed maturity securities. In 2003, cash used in investing activities was partly offset by sales of securities to fund net payment activity related to debt and junior subordinated debt securities held by subsidiary trusts of $772 million. The 2002 net cash flows used in investing activities principally reflected investing of net cash from operating activities and the receipt of $4.09 billion from the first quarter 2002 initial public offering and the concurrent issuance of $867 million of convertible notes payable, partially offset by the repayment of $6.35 billion of notes payable to a former affiliate.
Index to Financial Statements The Company also invests much smaller amounts in equity securities, venture capital and real estate. These investment classes have the potential for higher returns but also involve varying degrees of risk, including less stable rates of return and less liquidity.
The primary goal of the Company’s asset liability management process is to satisfy the insurance liabilities and manage the interest rate risk embedded in those insurance liabilities. Generally, the expected principal and interest payments produced by the Company’s fixed income portfolio adequately fund the estimated runoff of the Company’s insurance reserves. Although this is not an exact cash flow match in each period, the substantial degree by which the market value of the fixed income portfolio exceeds the present value of the net insurance liabilities provides assurance of the Company’s ability to fund the payment of claims through the sale of securities or a restructuring of the portfolio, if necessary, without jeopardizing its asset-liability management objectives. The Company does not believe that the impact of selling securities before anticipated or the use of credit facilities to pay for policyholder liabilities, if necessary, would have a material impact on future liquidity or results of operations.
Net cash flows used in financing activities totaled $546 million, $1.10 billion and $800 million in 2004, 2003 and 2002, respectively. The 2004 outflows were primarily attributable to dividends paid to shareholders of $642 million. Net maturities and retirements of debt, including the repurchase of CIRI’s outstanding notes, totaled $75 million in 2004. In addition, the Company repurchased the minority interest in CIRI during the second quarter for a total cost of $76 million.
Cash flows used in financing activities in 2003 were primarily attributable to the redemption of $900 million aggregate principal amount of junior subordinated debt securities held by subsidiary trusts, the repayment of $700 million of notes payable to a former affiliate and the repayment of $550 million of short-term debt. Funds used in these repayments were primarily provided by the Company’s issuance of $1.40 billion of senior notes in March 2003 and by cash flows provided by operating activities. These refinancing activities were initiated with the objective of lowering the average interest rate on the Company’s total outstanding debt. Also reflected in 2003 was the issuance of $550 million of short-term Floating Rate Notes which were used to repay the $550 million Promissory Note due in January 2004. Net cash flows used in financing activities in 2003 also included dividends paid to shareholders of $282 million. The 2002 cash flows used in financing activities reflects the repayment of $6.35 billion of notes payable to Citigroup. These payments were partially offset by the receipt of $4.09 billion from the first quarter 2002 initial public offering and the issuance of $917 million of convertible notes payable.
The Company paid $636 million of common dividends in 2004, comprised of regular quarterly dividends totaling $522 million and $114 million that had been declared by SPC prior to the merger. That amount consisted of SPC’s regular quarterly dividend at a rate of $0.29 per share ($66 million), and a special $0.21 per share ($48 million) dividend related to the merger. The special dividend declared by SPC prior to the closing of the merger was designed to result in the holders of SPC’s common stock prior to the merger receiving aggregate dividends with record dates in 2004 of $1.16 per share, which was SPC’s indicated annual dividend rate prior to the merger. On January 26, 2005, the Company’s Board of Directors declared a quarterly dividend of $0.22 per share, payable March 31, 2005 to shareholders of record on March 10, 2005.
In February 2002, TPC paid a dividend of $1.00 billion to Citigroup in the form of a non-interest bearing note payable on December 31, 2002. On December 31, 2002, this note was repaid in its entirety. Also in February 2002, TPC paid an additional dividend of $3.70 billion to Citigroup in the form of a note payable in two installments. This note was substantially prepaid following the offerings. The balance of $150 million was due on May 9, 2004. This note was prepaid on May 8, 2002. In March 2002, TPC paid a dividend of $395 million to Citigroup in the form of a note. This note was prepaid following the offerings.
In August 2002, CIRI issued $50 million aggregate principal amount of 6.0% convertible notes which were to mature on December 31, 2032 unless earlier redeemed or repurchased. The Company repurchased these notes in 2004. See note 10 of notes to the Company’s consolidated financial statements for further discussion.
In December 2002, TPC entered into a loan agreement with an unaffiliated lender and borrowed $550 million under a promissory note due in January 2004. The Promissory Note carried a variable interest rate of LIBOR plus 25 basis points per annum. On February 5, 2003, TPC issued $550 million of Floating Rate Notes due in February 2004. The proceeds from these notes were used to repay the $550 million due on the Promissory Note. The Floating Rate Notes also carried a variable interest rate of LIBOR plus 25 basis points per annum. On March 14, 2003 and June 17, 2003, the Company repurchased $75 million and $24 million, respectively, of the Floating Rate Notes at par plus accrued interest. The remaining $451 million were repaid on September 5, 2003.
Index to Financial Statements In July 2002, concurrent with the issuance of 17.8 million of SPC common shares in a public offering, SPC issued 8.9 million equity units, each having a stated amount of $50, for gross consideration of $443 million. Each equity unit initially consists of a forward purchase contract for the Company’s common stock (maturing in August 2005), and an unsecured $50 senior note of the Company (maturing in 2007). Total annual distributions on the equity units are at the rate of 9.00%, consisting of interest on the note at a rate of 5.25% and fee payments under the forward contract of 3.75%. The forward contract requires the investor to purchase, for $50, a variable number of shares of the Company’s common stock on the settlement date of August 16, 2005. The number of shares to be purchased will be determined based on a formula that considers the average closing price of the Company’s stock on each of 20 consecutive trading days ending on the third trading day immediately preceding the settlement date, in relation to the $24.20 per share price of common stock at the time of the offering. Had the settlement date been December 31, 2004, the Company would have issued approximately 15 million common shares based on the average closing price of the Company’s common stock immediately prior to that date. Holders of the equity units have the opportunity to participate in a required remarketing of the senior note component. The initial remarketing date is May 11, 2005. The interest rate on the senior notes will be reset on the date of the remarketing and they will bear interest from the date of the settlement of the successful remarketing at the reset rate.
The Company currently intends to refinance certain maturing debt in 2005, including the $238 million of 7.875% senior notes due April 15, 2005, the $79 million of 7.125% senior notes due June 1, 2005, and a portion of the medium term notes with maturities in 2005.
Line of Credit Agreements. Effective April 17, 2003, TPC entered into the following line of credit agreements with Citibank, a subsidiary of Citigroup, TPC’s former parent: (i) a $250 million 45-month revolving line of credit (the 45-Month Line of Credit), and (ii) a $250 million 364-day revolving line of credit (the TPC 364-Day Line of Credit and, together with the 45-Month Line of Credit, the TPC Lines of Credit). TPC may, with Citibank’s consent, extend the commitment of the 364-day Line of Credit for additional 364-day periods under the same terms and conditions. TPC has the option, provided there is no default or event of default, to convert outstanding advances under the 364-Day Line of Credit at the commitment termination date to a term loan maturing no later than one year from the commitment termination date.
Index to Financial Statements Pursuant to covenants in the 5-Year Line of Credit and STA 364-Day Line of Credit, supporting the Company’s commercial paper program, the Company must maintain an excess of consolidated net worth over goodwill and other intangible assets of not less than $10 billion at all times. The Company must also maintain a ratio of total consolidated debt to the sum of total consolidated debt plus consolidated net worth of not greater than 0.40 to 1.00. Pursuant to the covenants in the 45-Month Line of Credit, TPC and its subsidiaries must maintain, as of the last day of any fiscal quarter, combined statutory capital and surplus in excess of $5.50 billion and a leverage ratio of total consolidated debt to total consolidated capital of less than 0.45 to 1.00. There were no ratings based triggers for the Company Line of Credit. At December 31, 2004, the Company was in compliance with these covenants and all other covenants related to its respective debt instruments outstanding.
The following table excludes short-term obligations. The table also excludes estimated cash flows of claim and claim related payments, which are presented in the table that follows. The contractual obligations, which include only liabilities at December 31, 2004 with a cash payment requirement for settlement, were as follows:
(1) See note 10 of the notes to the Company’s consolidated financial statements for a further discussion.
(3) Includes agreements with vendors to purchase system software administration and maintenance services.
The Company is not required to make any contributions to its qualified pension plan in 2005 and does not have a best estimate of contributions expected to be paid to the qualified pension plan. Accordingly, any future contributions are not included in the foregoing contractual obligation table.
The following table includes estimated future claims and claims related payments, net of the estimated reinsurance recoveries, where applicable, at December 31, 2004.
(1) The amounts in “Claims and claim adjustment expenses” in the table above represent the estimated timing of future payments for both reported and unreported claims incurred and related claim adjustment expenses, net of reinsurance recoverables. Therefore, estimated future payments include cash inflows related to reinsurance arrangements that qualify for reinsurance accounting. A reinsurance agreement must indemnify the insurer from insurance risk, i.e., the agreement must transfer amount and timing risk, in order to qualify for reinsurance accounting. Timing risk is transferred if the agreement requires timely reimbursement from the reinsurer to the insurer. Since the timing and amount of cash inflows from such reinsurance agreements are highly correlated to the underlying payment of claims and claim adjustment expenses by the insurer, the analysis above presents the estimated cash outlay for reported and unreported claims incurred and related claim adjustment expense, net of reinsurance. Reinsurance agreements that do not transfer both amount and
timing risk are accounted for as deposits and included in “Reinsurance contracts accounted for as deposits” in the table above.
(2) Workers compensation large deductible policies provide third party coverage in which the Company typically is responsible for paying the entire loss under such policies and then seeks reimbursement from the insured for the deductible amount. “Claims from large deductible policies” represent the estimated future payment for claims and claim related expenses below the deductible amount, net of the estimated recovery of the deductible. The liability and the related deductible receivable for unpaid claims are presented in the consolidated balance sheet as “contractholder payable” and “contractholder receivable,” respectively. Most deductibles for such policies are paid directly from the policyholder’s escrow which is periodically replenished by the policyholder. The payment of the loss amounts above the deductible are reported within “Claims and claim adjustment expenses” in the above table. Because the timing of the collection of the deductible (contractholder receivable) occurs shortly after the payment of the deductible to a claimant (contractholder payable), these cash flows offset each other in the table.
The estimated timing of the payment of the contractholder payables and the collection of contractholder receivables for workers’ compensation policies is presented below:
(3) The amounts in “Loss-based assessments” relate to estimated future payments of second-injury fund assessments which would result from payment of current claim liabilities. Second injury funds cover the cost of any additional benefits for aggravation of a pre-existing condition. For loss-based assessments, the cost is shared by the insurance industry and self-insureds, funded through assessments to insurance companies and self-insureds based on losses. Amounts relating to second-injury fund assessments are included in “other liabilities” in the consolidated balance sheet.
(4) The amounts in “Reinsurance contracts accounted for as deposits” represent estimated future nominal payments for reinsurance agreements that are accounted for as deposits. Amounts payable under deposit agreements are included in “other liabilities” in the consolidated balance sheet. The amounts reported in the table are presented on a nominal basis and have not been adjusted to reflect the time value of money. Accordingly, the amounts above will differ from the Company’s balance sheet to extent that deposit values in the balance sheet have been discounted using deposit accounting.
The above table does not include an analysis of liabilities reported for structured settlements for which the Company has purchased annuities and remains contingently liable in the event of default by the company issuing the annuity. The Company is not reasonably likely to incur future payment obligations under such agreements. See note 9 of the Company’s consolidated financial statements for a further discussion.
The insurance holding company laws of other states in which the Company’s subsidiaries are domiciled generally contain similar, although in some instances somewhat more restrictive, limitations on the payment of dividends. A maximum of $2.61 billion is available by the end of 2005 for such dividends without prior approval of the Connecticut Insurance Department for Connecticut-domiciled subsidiaries and the Minnesota Department of Commerce for Minnesota-domiciled subsidiaries. The Company received $2.09 billion of dividends from its insurance subsidiaries in 2004.
The Company has entered into certain contingent obligations for guarantees related to agency loans and letters of credit, issuance of debt securities, third party loans related to venture capital investments and various indemnifications related to the sale of business entities to third parties. See note 17 to the Company’s consolidated financial statements. The Company does not expect these arrangements to have a material effect on the Company’s financial condition, changes in financial condition, revenues and expenses, results of operations, liquidity, capital expenditures or capital resources.
Claim and claim adjustment expense reserves (loss reserves) represent management’s estimate of ultimate unpaid costs of losses and loss adjustment expenses for claims that have been reported and claims that have been incurred but not yet reported. Loss reserves do not represent an exact calculation of liability, but instead represent management estimates, generally utilizing actuarial expertise and projection techniques, at a given accounting date. These loss reserve estimates are expectations of what the ultimate settlement and administration of claims will cost upon final resolution in the future, based on the Company’s assessment of facts and circumstances then known, review of historical settlement patterns, estimates of trends in claims severity and frequency, expected interpretations of legal theories of liability and other factors. In establishing reserves, the Company also takes into account estimated recoveries, reinsurance, salvage and subrogation. The reserves are reviewed regularly by a qualified actuary employed by the Company.
The process of estimating loss reserves involves a high degree of judgment and is subject to a number of variables. These variables can be affected by both internal and external events, such as changes in claims
handling procedures, economic inflation, legal trends and legislative changes, among others. The impact of many of these items on ultimate costs for loss and loss adjustment expenses is difficult to estimate. Loss reserve estimation difficulties also differ significantly by product line due to differences in claim complexity, the volume of claims, the potential severity of individual claims, the determination of occurrence date for a claim and reporting lags (the time between the occurrence of the policyholder event and when it is actually reported to the insurer). Informed judgment is applied throughout the process. The Company continually refines its loss reserve estimates in a regular ongoing process as historical loss experience develops and additional claims are reported and settled. The Company rigorously attempts to consider all significant facts and circumstances known at the time loss reserves are established. Due to the inherent uncertainty underlying loss reserve estimates including but not limited to the future settlement environment, final resolution of the estimated liability will be different from that anticipated at the reporting date. Therefore, actual paid losses in the future may yield a materially different amount than currently reserved-favorable or unfavorable.
As described earlier, the Company acquired SPC’s runoff health care reserves in the merger, which are included in the General Liability product line in the table below. SPC decided to exit this market at the end of 2001 and ceased underwriting new business as quickly as regulatory considerations allowed. SPC had experienced significant adverse loss development on its health care loss reserves both prior to and since its decision to exit this market. The Company continues to utilize specific tools and metrics to explicitly monitor and validate its key assumptions supporting its conclusions with regard to these reserves. These tools and metrics were established to more explicitly monitor and validate key assumptions supporting the Company’s reserve conclusions since management believed that its traditional statistics and reserving methods needed to be supplemented in order to provide a more meaningful analysis. The tools developed track three primary indicators which influence those conclusions and include: newly reported claims; reserve development on known claims; and the “redundancy ratio,” which compares the cost of resolving claims to the reserve established for that individual claim. These three indicators are related such that if one deteriorates, additional improvement on another is necessary for the Company to conclude that further reserve strengthening is not necessary. The results of these indicators in 2004 support the Company’s current view that it has recorded a reasonable provision for its medical malpractice exposures as of December 31, 2004. However, the Company will take reserve actions in the future if these indicators no longer support this view.
Index to Financial Statements Claims and claim adjustment expense reserves by product line were as follows:
Index to Financial Statements In most cases, multiple estimation methods will be valid for the particular facts and circumstances of the claim liabilities being evaluated. This will result in a range of reasonable estimates for any particular claim liability. The Company uses such range analyses to back test whether previously established estimates for reserves at the reporting segments are reasonable, given subsequent information. Reported values found to be closer to the endpoints of a range of reasonable estimates are subject to further detailed reviews. These reviews may substantiate the validity of management’s recorded estimate or lead to a change in the reported estimate.
The exact boundary points of these ranges are more qualitative than quantitative in nature, as no clear line of demarcation exists to determine when the set of underlying assumptions for an estimation method switches from being reasonable to unreasonable. As a result, the Company does not believe that the endpoints of these ranges are or would be comparable across companies. In addition, potential interactions among the different estimation assumptions for different product lines make the aggregation of individual ranges a highly judgmental and inexact process.
Such an assessment requires considerable judgment. It is frequently not possible to determine whether a change in the data is an anomaly until sometime after the event. Even if a change is determined to be permanent, it is not always possible to reliably determine the extent of the change until sometime later. The overall detailed analyses supporting such an effort can take several months to perform. This is due to the need to evaluate the underlying cause of the trends observed, and may include the gathering or assembling of data not previously available. It may also include interviews with experts involved with the underlying processes. As a result, there can be a time lag between the emergence of a change and a determination that the change should be reflected in the Company’s estimated claim liabilities. The final estimate selected by management in a reporting period is a function of these detailed analyses of past data, adjusted to reflect any new actionable information.
the specific coverage provided, the jurisdiction and specific policy provisions such as self-insured retentions. There are numerous components underlying the general liability product line. Some of these have relatively moderate payment patterns (with most of the claims for a given accident year closed within 5 to 7 years), while others can have extreme lags in both reporting and payment of claims (e.g., a reporting lag of a decade for “construction defect” claims).
General liability reserves are generally analyzed as two components: primary and excess/umbrella, with the primary component generally analyzed separately for bodily injury and property damage. Bodily injury liability payments reimburse the claimant for damages pertaining to physical injury as a result of the policyholder’s legal obligation arising from non-intentional acts such as negligence, subject to the insurance policy provisions. In some cases the damages can include future wage loss (which is a function of future earnings power and wage inflation) and future medical treatment costs. Property damage liability payments result from damages to the claimant’s private property arising from the policyholder’s legal obligation for non-intentional acts. In most cases, property damage losses are a function of costs as of the loss date, or soon thereafter. In addition, sizable or unique exposures are reviewed separately, such as asbestos, environmental, other mass torts, construction defect, medical malpractice and large unique accounts that would otherwise distort the analysis. These unique categories often require a very high degree of judgment and require reserve analyses that do not rely on traditional actuarial methods.
See the discussions under the property and general liability product lines with regard to reserving risk for commercial multi-peril.
These are administrative bodies that evaluate whether or not a given claim for workers’ compensation benefits is valid. Duties include the determination of whether a given injury arose out of the scope of employment, or the determination of the degree of injury where disputes exist.
Personal automobile includes both short and long tail coverages. The payments that are made quickly typically pertain to auto physical damage (property) claims and property damage (liability) claims. The payments that take longer to finalize and are more difficult to estimate relate to bodily injury claims. Reporting lags are relatively short and the claim settlement process for personal automobile liability generally is the least complex of the liability products. It is generally viewed as a high frequency, low to moderate severity.product line. Overall, the claim liabilities for this line create a moderate estimation risk.
Homeowners is generally considered a short tail coverage. Most payments are related to the property portion of the policy, where the claim reporting and settlement process is generally restricted to the insured and the
Index to Financial Statements International and other claim liabilities result from a mix of coverages, currencies and jurisdictions/countries. The common characteristic is the need to customize the analysis to the individual component, and the inability to rely on data characterizations and reporting requirements in the U.S. statutory reporting framework.
International and other reserves are generally analyzed by program/pool, country and general coverage category (e.g., U.S. Liability-excess of loss reinsurance, or General Liability - Municipalities - by country.) The business is also generally split by direct versus assumed reinsurance for a given coverage/jurisdiction. Where the underlying insured hazard is outside the United States, the underlying coverages are generally similar to those described under the General Liability and Automobile discussion above, but under a different legal system. Where the underlying hazard is within the U.S., the coverage involved is typically that of General Liability, but on an excess or excess-of-loss reinsurance basis. Excess exposure requires the insured to “prove” not only claims under the policy, but also the prior payment of claims reaching up to the excess policy’s attachment point.
The following table summarizes the composition of the Company’s reinsurance recoverable assets:
Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured business. The Company evaluates and monitors the financial condition of its reinsurers under voluntary reinsurance arrangements to minimize its exposure to significant losses from reinsurer insolvencies. In addition, in the ordinary course of business, the Company may become involved in coverage disputes with its reinsurers. Some of these disputes could result in lawsuits and arbitrations brought by or against the reinsurers to determine the Company’s rights and obligations under the various reinsurance agreements. The Company employs dedicated specialists and aggressive strategies to manage reinsurance collections and disputes.
The following presents the Company’s top five reinsurers, except Lloyd’s of London (Lloyd’s), which is discussed in more detail below, by reinsurance recoverable at December 31, 2004 (in millions):
Fixed maturities for which fair value is less than 80% of amortized cost for more than one quarter are evaluated for other-than-temporary impairment. A fixed maturity is impaired if it is probable that the Company will not be able to collect all amounts due under the security’s contractual terms.
the length of time and the extent to which fair value has been below cost. It is likely that the decline will become “other-than-temporary” if the market value has been below cost for six to nine months or more;
the financial condition and near-term prospects of the issuer. The issuer may be experiencing depressed and declining earnings relative to competitors, erosion of market share, deteriorating financial position, lowered dividend payments, declines in securities ratings, bankruptcy, and financial statement reports that indicate an uncertain future. Also, the issuer may experience specific events that may influence its operations or earnings potential, such as changes in technology, discontinuation of a business segment, catastrophic losses or exhaustion of natural resources; and
the Company’s ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery.
factors that raise doubts about the investee’s ability to continue as a going concern, such as negative cash flows from operations, working-capital deficiencies, investment advisors’ recommendations, or non-compliance with regulatory capital requirements or debt covenants;
a breach of a covenant or the failure to service debt; and
Index to Financial Statements For fixed maturity and equity investments, factors that may indicate that a decline in value is not other-than-temporary include the following:
the investment is performing as expected and is current on all expected payments;
The carrying values of real estate properties are reviewed for impairment when events or changes in circumstances indicate that the carrying amount may not be recoverable. The review for impairment includes an estimate of the undiscounted cash flows expected to result from the use and eventual disposition of the real estate property. An impairment loss is recognized if the expected future undiscounted cash flows exceed the carrying value of the real estate property.
whether or not the valuations have declined significantly in the entity’s market sector;
The Company manages the portfolio to maximize long-term return, evaluating current market conditions and the future outlook for the entities in which it has invested. Because this portfolio primarily consists of
privately-held, early-stage venture investments, events giving rise to impairment can occur in a brief period of time (e.g., the entity has been unsuccessful in securing additional financing, other investors decide to withdraw their support, complications arise in the product development process, etc.), and decisions are made at that point in time, based on the specific facts and circumstances, with respect to a recognition of “other-than-temporary” impairment or sale of the investment.
On July 23, 2004, the Company announced that it was seeking guidance from the staff of the Division of Corporation Finance of the Securities Exchange Commission with respect to the appropriate purchase accounting treatment for certain second quarter 2004 adjustments totaling $1.63 billion ($1.07 billion after-tax). The Company recorded these adjustments as charges in its income statement in the second quarter of 2004. Through an informal comment process, the staff of the Division of Corporation Finance has subsequently asked for further information relating to these adjustments, and the dialogue is ongoing. Specifically, the staff has asked for information concerning the Company’s adjustments to certain of SPC’s insurance reserves and reserves for reinsurance recoverables and premiums due from policyholders, and how those adjustments may relate to SPC’s reserves for periods prior to the merger. After reviewing the staff’s questions and comments and discussions with the Company’s independent auditors, the Company continues to believe that its accounting treatment for these adjustments is appropriate. If, however, the staff disagrees, some or all of the adjustments being discussed may not be recorded as charges in the Company’s income statement, thereby increasing net income for the second quarter and full year 2004 and increasing shareholders’ equity at December 31, 2004, in each case by the approximate after-tax amount of the change. The effect on tangible shareholders’ equity (adjusted for the effects of deferred taxes associated with goodwill and intangible assets) at December 31, 2004 would not be material. Increases to goodwill and deferred tax liabilities would be reflected on the Company’s balance sheet as of April 1, 2004, either due to purchase accounting or adjustment of SPC’s reserves prior to the merger.
The $749 million increase in reserves for losses and loss adjustment expenses on a statutory basis from December 31, 2002 to December 31, 2003 was primarily due to business growth, and reserve strengthening at Gulf which increased reserves by $521 million and American Equity which increased reserves by $115 million, partially offset by asbestos and environmental net loss payments of $607 million.
Prior to the Citigroup Distribution on August 20, 2002, unearned compensation expense associated with the Citigroup restricted common stock grants is included in other assets in the consolidated balance sheet. Following the Citigroup Distribution and the issuance of replacement stock awards in TPC’s class A and class B shares on August 20, 2002, the unamortized unearned compensation expense associated with these awards is included as unearned compensation in the consolidated balance sheet. Unearned compensation expense is recognized as a charge to income ratably over the vesting period. The after-tax compensation cost charged to earnings for these restricted stock and deferred stock awards was $26 million, $17 million and $17 million for the years ended December 31, 2004, 2003 and 2002, respectively. See note 13 of notes to the Company’s consolidated financial statements for a discussion of restricted common stock awards.
Consolidated Statement of Income (Loss) for the years ended December 31, 2004, 2003 and 2002
Consolidated Statement of Cash Flows for the years ended December 31, 2004, 2003 and 2002
We have audited the accompanying consolidated balance sheet of The St. Paul Travelers Companies, Inc. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of income (loss), changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2004. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of The St. Paul Travelers Companies, Inc., and subsidiaries internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 16, 2005 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
In connection with the merger, each issued and outstanding share of TPC class A and class B common stock (including the associated preferred stock purchase rights) was exchanged for 0.4334 of a share of the Company’s common stock. Share and per share amounts for all periods presented have been restated to reflect the exchange of TPC’s common stock, par value $0.01 per share, for the Company’s common stock without designated par value. Common stock and additional paid-in capital in the consolidated balance sheet were also restated to give effect to the difference in par value of the exchanged shares. Cash was paid in lieu of fractional shares of the Company’s common stock. Immediately following consummation of the merger, historical TPC shareholders held approximately 66% of the Company’s common stock. For further information regarding the merger, see note 2.
TPC was reorganized in connection with its initial public offering (IPO) on March 21, 2002. TPC issued common stock representing approximately 23% of TPC’s common equity. After the IPO, Citigroup Inc. (together with its consolidated subsidiaries, Citigroup) beneficially owned all of the 500 million shares of TPC’s outstanding class B common stock, each share of which is entitled to seven votes, and 269 million shares of TPC’s class A common stock, each share of which is entitled to one vote, representing at the time 94% of the combined voting power of all classes of TPC’s voting securities and 77% of the equity interest in TPC. (All class A and class B share amounts presented are unadjusted for the merger of TPC and SPC). For further information on the IPO and related corporate reorganization, see note 3.
guidance on the dilutive effect of contingently convertible debt instruments. EITF 04-8 requires that contingently convertible debt instruments are included in diluted earnings per share, under the if-converted method, regardless of whether the market price trigger has been met. Under FAS 128, Earnings Per Share, contingently convertible debt instruments which contain market price triggers were excluded from the computation of diluted earnings per share until the market trigger conditions were met.
The Company has $893 million of 4.50% convertible junior subordinated notes outstanding which are subject to the new EITF 04-8 guidance. These convertible junior subordinated notes mature on April 15, 2032 unless earlier redeemed, repurchased or converted. The notes are convertible into approximately 17 million shares of the Company’s common stock at the option of the holder after March 27, 2003 and prior to April 15, 2032 if at any time certain contingency conditions are met. On or after April 18, 2007, the notes may be redeemed at the Company’s option.
EITF 04-8 is effective for fiscal years ended after December 15, 2004 and requires restatement of prior period earnings per share for comparative periods. Accordingly, the Company has restated diluted earnings per share for prior periods to include the impact of the convertible junior subordinated notes where the impact of including these securities was dilutive. See note 7 for the impact on earnings per share.
The following entities, which were acquired in the merger, are consolidated under FIN 46R:
The Company has a significant variable interest in one real estate entity. This investment has total assets of approximately $117 million as of December 31, 2004. The carrying value of the Company’s share of this investment was approximately $38 million at December 31, 2004, which also represents its maximum exposure to loss. The purpose of the Company’s involvement in this entity is to generate investment returns.
The Company also has a variable interest in Camperdown UK Limited, which SPC sold in December 2003. The Company’s variable interest results from an agreement to indemnify the purchaser in the event a specified reserve deficiency develops, a reserve-related foreign exchange impact occurs, or a foreign tax adjustment is imposed on a pre-sale reporting period. The maximum amount of this indemnification obligation is $200 million. The fair value of this obligation as of December 31, 2004 was $44 million.
Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003
On December 8, 2003, President Bush signed the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (2003 Medicare Act) into law. The 2003 Medicare Act introduces a prescription drug benefit under Medicare Part D as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. On January 12, 2004, FASB issued Staff Position FAS 106-1, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (FSP 106-1), which permits sponsors of retiree health care benefit plans that provide prescription drug benefits to make a one-time election to defer accounting for the effects of the 2003 Medicare Act. FASB Staff Position FAS 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (FSP 106-2), was issued on May 19, 2004, supersedes FSP 106-1 and provides guidance on the accounting for the effects of the 2003 Medicare Act for sponsors of retiree health care benefit plans that provide prescription drug benefits. FSP 106-2 also requires certain disclosures regarding the effect of the federal subsidy.
Effective January 1, 2003, the Company adopted the fair value method of accounting for its employee stock-based compensation plans as defined in FASB Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (FAS 123), using the prospective recognition transition alternative of FASB Statement of Financial Accounting Standards No. FAS 148, Accounting for Stock Based Compensation-Transition and Disclosure (FAS 148). FAS 123 indicates that the fair value based method is the preferred method of accounting. The Company has elected to use the prospective recognition transition alternative of FAS 148. Under this alternative only the awards granted, modified, or settled after January 1, 2003 will be accounted for in accordance with the fair value method. The adoption of FAS 123 did not have a significant impact on the Company’s results of operations, financial condition or liquidity.
Mortgage loans are carried at amortized cost. A mortgage loan is considered impaired when it is probable that the Company will be unable to collect principal and interest amounts due. For mortgage loans that are determined to be impaired, a reserve is established for the difference between the amortized cost and fair market value of the underlying collateral. In estimating fair value, the Company uses interest rates reflecting the current real estate financing market returns. Impaired loans were not significant at December 31, 2004 and 2003.
The Company’s real estate investments include warehouses and office buildings and other commercial land and properties that are directly owned. Real estate properties are carried at cost less accumulated depreciation. Buildings are depreciated on a straight line basis over the shorter of the expected useful life of the building or 39 years. Accumulated depreciation on real estate held for investment purposes was $22 million and $0 at December 31, 2004 and 2003, respectively.
Other investments include: venture capital investments, through direct ownership and limited partnerships; private equity limited partnerships; joint ventures, other limited partnerships, and trading securities. Venture capital investments owned directly are consolidated in the Company’s financial statements. The Company uses the equity method of accounting for joint ventures, limited partnerships and certain private equity securities. Undistributed income is reported in net investment income. Trading securities are marked to market with the change in fair value recognized in net investment income during the current period.
Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured business. Such recoverables are reported net of an allowance for estimated uncollectible reinsurance recoverables and amounts due from known reinsurer insolvencies. The Company evaluates and monitors the financial condition of its reinsurers under voluntary reinsurance arrangements to minimize its exposure to significant losses from reinsurer insolvencies.
Other intangible assets that are not deemed to have an indefinite useful life continue to be amortized over their useful lives. The carrying amount of intangible assets that are not deemed to have an indefinite useful life is regularly reviewed for indicators of impairments in value in accordance with FAS 144. Impairment is recognized only if the carrying amount of the intangible asset is not recoverable from its undiscounted cash flows and is measured as the difference between the carrying amount and the fair value of the asset.
Included in the claims and claim adjustment expense reserves in the consolidated balance sheet are certain reserves discounted to the present value of estimated future payments. The liabilities for losses for some long-term disability payments under workers’ compensation insurance and workers’ compensation excess insurance, which totaled $2.06 billion and $1.33 billion at December 31, 2004 and 2003, respectively, have been discounted using rates of 3.5% to 5.0%. Reserves related to certain fixed and determinable asbestos-related settlements, where all payment amounts and their timing are known, were discounted using a range of interest rates from 2.3% to 5.5% and totaled $48 million and $445 million at December 31, 2004 and 2003, respectively. Reserves for certain assumed reinsurance coverage acquired in the merger, discounted using rates of 5.0% to 7.5%, were $116 million at December 31, 2004.
$31 million and $15 million, respectively. The liability for such assessments and their related recoveries are not discounted for the time value of money. The assessments are expected to be paid over a period ranging from one year to the life expectancy of certain workers’ compensation claimants and the recoveries are expected to occur over the same period of time.
The Company’s insurance subsidiaries, domiciled principally in the states of Connecticut and Minnesota, prepare statutory financial statements in accordance with the accounting practices prescribed or permitted by the insurance departments of the states of domicile. Prescribed statutory accounting practices are those practices that are incorporated directly or by reference in state laws, regulations, and general administrative rules applicable to all insurance enterprises domiciled in a particular state. Permitted statutory accounting practices include practices not prescribed by the domiciliary state, but allowed by the domiciliary state regulatory authority. The St. Paul Fire and Marine Insurance Company (Fire and Marine) was granted a permitted practice in 2004 by the Minnesota Department of Commerce regarding the valuation of certain investments in affiliated limited liability companies, allowing it to value these investments based on their audited GAAP equity, which totaled $398 million as of December 31, 2004. It is not practicable to determine the impact on statutory surplus of this permitted practice. The impact of any other permitted accounting practices on statutory surplus of the Company is not material.
Recoveries from former affiliate consist of the recoveries under the Citigroup indemnification agreement.
The Company assigns functional currencies to its foreign operations, which are generally the currencies of the local operating environment. Foreign currency amounts are remeasured to the functional currency, and the resulting foreign exchange gains or losses are reflected in the statement of income (loss). Functional currency amounts are then translated into U.S. dollars. The unrealized gain or loss from this translation, net of tax, is recorded as a part of shareholders’ equity. The change in unrealized foreign currency translation gain or loss during the year, net of tax, is a component of comprehensive income. Both the remeasurement and translation are calculated using current exchange rates for the balance sheets and average exchange rates for the statements of operations.
Additionally, in conjunction with the Citigroup Distribution in August 2002 (described in more detail in note 3), the Company issued replacement awards for Citigroup awards. These replacement awards were issued at the intrinsic value of each Citigroup option and the ratio of exercise price per share to the market value per share was not reduced. Accordingly there was no compensation cost recognized in earnings for these replacement awards.
Upon completion of the merger on April 1, 2004, the Company was organized into four reportable business segments: Commercial, Specialty, Personal (these three segments collectively represent the Company’s insurance segments) and Asset Management. The insurance segments reflect how the Company manages its property and casualty insurance products and insurance-related services and represent an aggregation of these products and services based on type of customer, how the business is marketed, and the manner in which the business is underwritten. The Asset Management segment comprises the Company’s 79% interest in Nuveen Investments.
For periods prior to the April 1, 2004 merger completion date, segments have been restated from the historical presentation of TPC to conform to the new segment presentation of the Company, where practicable. As a result, prior period Bond and Construction results were reclassified from the historical TPC Commercial Lines segment to the historical Specialty segment.
Invested and other assets and net investment income (NII) of historical TPC had been specifically identified by reporting segment prior to the merger. Beginning in the second quarter of 2004, the Company developed a methodology to allocate NII and invested assets to the identified segments. This methodology allocates pretax NII based upon an investable funds concept, which takes into account liabilities (net of non-invested assets) and appropriate capital considerations for each segment. The investment yield for investable funds reflects the duration of the loss reserves’ future cash flows, the interest rate environment at the time the losses were incurred and A+ rated corporate debt instruments. This duration yield will be compared to the average portfolio yield and a new average yield will be determined. It is this average yield that will be used in the calculation of NII on investable funds. Yields will be updated annually. Invested assets are allocated to segments in proportion to the pretax allocation of NII. It is not practicable to apply this methodology to historical businesses and, as such, actual (versus allocated) NII is included in revenues and operating income of the restated segments for periods prior to the merger. The Company believes that the differences are not significant to a comparison with the new segment presentation. It is also not practicable to present total assets for restated Commercial and Specialty segments for periods prior to the merger.
The Commercial segment offers a broad array of property and casualty insurance and insurance-related services to its clients. Commercial is organized into three marketing and underwriting groups, each of which focuses on a particular client base and which collectively comprise Commercial’s core operations. The marketing and underwriting groups include the following:
Commercial Accounts serves primarily mid-sized businesses for casualty products and large and mid- sized businesses for property products.
Select Accounts serves small businesses and offers property, liability, commercial auto and workers’ compensation insurance.
Homeowners policies are available for dwellings, condominiums, mobile homes and rental property contents. Protection against losses to dwellings and contents from a wide variety of perils is included in these policies, as well as coverage for liability arising from ownership or occupancy.
The Asset Management segment is comprised of the Company’s majority interest in Nuveen Investments, Inc., whose core businesses are asset management and related research, as well as the development, marketing and distribution of investment products and services for the affluent, high-net-worth and institutional market segments. Nuveen Investments distributes its investment products and services, including individually managed accounts, closed-end exchange-traded funds and mutual funds, to the affluent and high-net-worth market segments through unaffiliated intermediary firms including broker/dealers, commercial banks, affiliates of insurance providers, financial planners, accountants, consultants and investment advisors. Nuveen Investments also provides managed account services to several institutional market segments and channels. Nuveen Investments markets its capabilities under four distinct brands: Rittenhouse (“blue-chip” growth-style equities); NWQ (value-style equities); Nuveen (fixed-income investments); and Symphony (an institutional manager of market-neutral alternative investment portfolios). Nuveen Investments is listed on the New York Stock Exchange, trading under the symbol “JNC.” The Company’s interest in Nuveen Investments was approximately 79% at December 31, 2004.
On November 26, 2002, the Terrorism Risk Insurance Act of 2002 (the Terrorism Act) was enacted into Federal law and established the Terrorism Insurance Program (the Program), a temporary Federal program in the Department of the Treasury, that provides for a system of shared public and private compensation for insured losses resulting from acts of terrorism or war committed by or on behalf of a foreign interest. In order for a loss to be covered under the Program (subject losses), the loss must be the result of an event that is certified as an act
of terrorism by the U.S. Secretary of Treasury. In the case of a war declared by Congress, only workers’ compensation losses are covered by the Terrorism Act. The Terrorism Act generally requires that all commercial property casualty insurers licensed in the United States participate in the Program. The Program terminates on December 31, 2005. Under the Program, a participating insurer is entitled to be reimbursed by the Federal Government for 90% of subject losses, after an insurer deductible, subject to an annual cap. In each case, the deductible percentage is applied to the insurer’s subject direct earned premiums from the calendar year immediately preceding the applicable year. The deductible under the Program was 7% for 2003, 10% for 2004 and is 15% for 2005. The Program also contains an annual cap that limits the amount of aggregate subject losses for all participating insurers to $100 billion. Once subject losses have reached the $100 billion aggregate during a program year, there is no additional reimbursement from the U.S. Treasury and an insurer that has met its deductible for the program year is not liable for any losses (or portion thereof) that exceed the $100 billion cap. The Company’s estimated deductible under this federal program is $2.51 billion for 2005. The Company had no terrorism-related losses in 2004 or 2003. If the Program is not renewed for periods after January 1, 2006, the benefits of the Program will not be available to the Company, and the Company will be subject to losses from acts of terrorism subject only to the terms and provisions of applicable policies.
The stock price used in determining the purchase price was based on an average of the closing prices of SPC common stock for the two trading days before through the two trading days after SPC and TPC announced their merger agreement on November 17, 2003. The purchase price also includes the fair value of the SPC stock options, the fair value adjustment to SPC’s preferred stock, and other costs of the transaction. The purchase price was approximately $8.76 billion, and was calculated as follows:
The purchase price has been allocated based on an estimate of the fair value of the assets acquired and liabilities assumed as of April 1, 2004, as follows:
(1) Reflects SPC’s shareholders’ equity of $6,439, less SPC’s historical goodwill of $950 and intangible assets of $138.
supporting the loss reserves. The fair value adjustment is reported as an intangible asset on the consolidated balance sheet, and the amounts measured in accordance with the acquirer’s accounting policies for insurance contracts are reported as part of the claims and claim adjustment expense reserves and reinsurance recoverables. The intangible asset will be recognized into income over the expected payment pattern. Because the time value of money and the risk adjustment (cost of capital) components of the intangible asset run off at different rates, the amount recognized in income may be a net benefit in some periods and a net expense in other periods.
(a) Primarily includes customer-related insurance intangibles based on rates derived from expected business retention and profitability levels.
(c) See item 7 of the allocation of the purchase price previously presented.
In 2002, TPC effected a corporate reorganization under which it transferred substantially all of its assets to affiliates of its then parent company, Citigroup Inc. (together with its consolidated subsidiaries, Citigroup), other than the capital stock of Travelers Insurance Group Holdings Inc. (TIGHI). Citigroup also assumed all of TPC’s third-party liabilities, other than liabilities relating to TIGHI and TIGHI’s active employee. TPC then effected a recapitalization whereby the previously outstanding shares of its common stock (1,500 shares), all of which were owned by Citigroup, were changed into 269 million shares of class A common stock and 500 million shares of class B common stock. Finally, TPC amended and restated its certificate of incorporation and bylaws.
Pursuant to TPC’s corporate reorganization, which was completed on March 19, 2002, TPC’s consolidated financial statements were adjusted to exclude the accounts of certain formerly wholly-owned TPC subsidiaries, principally The Travelers Insurance Company (TIC) and its subsidiaries, certain other wholly-owned noninsurance subsidiaries of TPC and substantially all of TPC’s assets and certain liabilities not related to the property casualty business.
On August 20, 2002, in connection with the Citigroup Distribution, stock-based awards held by TPC employees on that date under Citigroup’s various incentive plans were cancelled and replaced by awards under TPC’s own incentive programs (see note 13 to the Company’s consolidated financial statements for a further discussion), which awards were granted on substantially the same terms, including vesting, as the former Citigroup awards.
The following transactions were completed in conjunction with the 2002 corporate reorganization, offerings and Citigroup Distribution:
In February 2002, TPC paid a dividend of $1.00 billion to Citigroup in the form of a non-interest bearing note payable on December 31, 2002. TPC repaid this note on December 31, 2002. Also in February 2002, TPC paid an additional dividend of $3.70 billion to Citigroup in the form of a note payable in two installments. This note was substantially prepaid following the offerings. The balance of $150 million was due on May 9, 2004. The remaining portion of this note was prepaid on May 8, 2002. In March 2002, TPC paid a dividend of $395 million to Citigroup in the form of a note. This note was prepaid following the offerings.
On February 28, 2002, TPC sold CitiInsurance to other Citigroup affiliated companies for $403 million, its net book value. TPC applied $138 million of the proceeds from this sale to repay intercompany indebtedness to Citigroup. In addition, TPC purchased from Citigroup affiliated companies the premises located at One Tower Square, Hartford, Connecticut and other properties for $68 million. Additionally, certain liabilities relating to employee benefit plans and lease obligations were assigned and assumed by Citigroup affiliated companies. In connection with these assignments, TPC transferred $172 million and $88 million, respectively, to Citigroup affiliated companies.
processing services and short-term investment pool management services. Charges for these shared services were allocated at cost. In connection with the Citigroup Distribution, TPC and Citigroup and its affiliates entered into a transition services agreement for the provision of certain of these services, tradename and trademark and similar agreements related to the use of trademarks, logos and tradenames in an amendment to the March 26, 2002 Intercompany Agreement with Citigroup. During the first quarter of 2002, Citigroup provided investment advisory services on an allocated cost basis, consistent with prior years. On August 6, 2002, TPC entered into an investment management agreement, which was applied retroactive to April 1, 2002, with an affiliate of Citigroup whereby the affiliate of Citigroup provided investment advisory and administrative services to TPC, with respect to its entire investment portfolio for a period of two years and at fees mutually agreed upon, including a component based on investment performance. This agreement was modified and extended through the first quarter of 2005. Charges incurred related to this agreement were $58 million for the year ended December 31, 2004, $60 million for the year ended December 31, 2003 and $47 million for the period from April 1, 2002 through December 31, 2002.
The December 31, 2004 ending balance of $1.70 billion includes $1.33 billion of intangible assets acquired in the merger (see note 2). Contract-based intangibles include management contracts associated with Nuveen Investments’ asset management business based on the present value of expected cash flows related to the management contracts. At December 31, 2003, the Company had $422 million of intangible assets, with a gross
Intangible asset amortization expense is estimated to be $165 million in 2005, $169 million in 2006, $161 million in 2007, $137 million in 2008 and $110 million in 2009.
The Company had goodwill with a carrying amount of $2.41 billion as of December 31, 2003. As a result of the acquisition of SPC, $2.89 billion of goodwill was recorded on April 1, 2004. Changes in goodwill in 2004 also included a decrease of $44 million representing additional purchase accounting adjustments for changes in the estimated fair value of assets acquired and liabilities assumed as of April 1, 2004, and an increase of $20 million primarily related to Nuveen Investments’ purchase of common shares from minority shareholders.
The company comprises four reportable business segments: Commercial, Specialty, Personal and Asset Management.
The accounting policies used to generate the following segment data are the same as those described in the Summary of Significant Accounting Policies in note 1. The amount of investments in equity method investees and total expenditures for additions to long-lived assets other than financial instruments were not significant.
The following tables summarize the components of the Company’s revenues, operating income (loss) and total assets by reportable business segments:
(1) The primary component of Interest Expense and Other is after-tax interest expense of $151 million, $105 million and $100 million in 2004, 2003 and 2002, respectively.
Revenues from internal customers for the years ended December 31, 2004, 2003 and 2002 were not significant. Foreign assets at December 31, 2004 and 2003 also were not significant. The Company does not have revenue from transactions with a single customer amounting to 10 percent or more of its revenues.
The following table presents revenues of the Company’s operations based on location:
The Company makes investments in collateralized mortgage obligations (CMOs) that typically have high credit quality, offer good liquidity and are expected to provide an advantage in yield compared to U.S. Treasury securities. The Company’s investment strategy is to purchase CMO tranches which offer the most favorable return given the risks involved. One significant risk evaluated is prepayment sensitivity. The Company does invest in other types of CMO tranches if a careful assessment indicates a favorable risk/return tradeoff. The Company does not purchase residual interests in CMOs.
At December 31, 2004 and 2003, the Company held CMOs classified as available for sale with a fair value of $3.30 billion and $3.06 billion, respectively (excluding Commercial Mortgage-Backed Securities of $953 million and $875 million, respectively). Approximately 53% and 60% of the Company’s CMO holdings are guaranteed by or fully collateralized by securities issued by GNMA, FNMA or FHLMC at December 31, 2004 and 2003, respectively. In addition, the Company held $4.66 billion and $3.80 billion of GNMA, FNMA, FHLMC or FHA mortgage-backed pass-through securities classified as available for sale at December 31, 2004 and 2003, respectively. Virtually all of these securities are rated Aaa.
At December 31, 2004, the Company had $2.60 billion of securities on loan as part of a tri-party lending agreement, and at December 31, 2003, the Company had $562 million of securities on loan for which cash collateral was received. At December 31, 2004 and 2003, respectively, $32 million and $135 million of securities were subject to dollar-roll repurchase agreements.
Proceeds from sales of fixed maturities classified as available for sale were $7.95 billion, $8.34 billion and $12.52 billion in 2004, 2003 and 2002, respectively. Gross gains of $202 million, $282 million and $571 million and gross losses of $126 million, $147 million and $148 million were realized on those sales in 2004, 2003 and 2002, respectively.
Proceeds from sales of equity securities were $264 million, $254 million and $127 million in 2004, 2003 and 2002, respectively, resulting in gross realized gains of $37 million, $22 million and $18 million and gross realized losses of $8 million, $9 million and $14 million, respectively.
The Company’s real estate investments include warehouses, office buildings, land, and other commercial real estate assets that are directly owned. The Company negotiates commercial leases with individual tenants through unrelated, licensed real estate brokers. Negotiated terms and conditions include, among others, rental rates, length of lease period and improvements to the premises to be provided by the landlord.
Future minimum rental income expected on operating leases relating to the Company’s real estate properties is $95 million, $82 million, $69 million, $55 million, $39 million, and $58 million for 2005, 2006, 2007, 2008, 2009 and 2010 and thereafter, respectively.
The cost and fair value of investments in venture capital, which were acquired in the merger and are reported as part of other investments in the Company’s consolidated balance sheet, were as follows:
identification and evaluation of investments which have possible indications of impairment;
review of portfolio manager(s) recommendations for other-than-temporary impairments based on the investee’s current financial condition, liquidity, near-term recovery prospects and other factors, as well as consideration of other investments that were not recommended for other-than-temporary impairments;
Other investments include venture capital investments acquired in the merger, which are generally non-publicly traded instruments in early-stage companies and, historically, having a holding period of four to seven years. These investments have primarily been made in the health care, software and computer services, and networking and information technologies infrastructures industries. The Company typically is involved with venture capital companies early in their formation, as they are developing and determining the viability of, and market demand for, their product. Generally, the Company does not expect these venture capital companies to record revenues in the early stages of their development, which can often take three to four years, and does not generally expect them to become profitable for an even longer period of time. With respect to the Company’s valuation of such non-publicly traded venture capital investments, on a quarterly basis, portfolio managers as well as an internal valuation committee review and consider a variety of factors in determining the potential for loss impairment. Factors considered include the following:
whether or not the issuer’s progress has been substantially less than expected;
whether or not the internal valuation committee believes it is probable that the issuer will need financing within six months at a lower price than our carrying value; and
whether or not the Company has the ability and intent to hold the security for a period of time sufficient to allow for recovery, enabling it to receive value equal to or greater than our cost.
Included in fixed maturities are below investment grade assets totaling $1.78 billion and $2.06 billion at December 31, 2004 and 2003, respectively. The Company defines its below investment grade assets as those securities rated below investment grade by external rating agencies, or the equivalent by the Company’s investment advisors when a public rating does not exist. Such assets include publicly traded below investment grade bonds and certain other privately issued bonds that are classified as below investment grade loans.
The Company evaluates and monitors the financial condition of its reinsurers under voluntary reinsurance arrangements to minimize its exposure to significant losses from reinsurer insolvencies. In addition, in the ordinary course of business, the Company may become involved in coverage disputes with its reinsurers. In recent years, the Company has experienced an increase in the frequency of these reinsurance coverage disputes. Some of these disputes could result in lawsuits and arbitrations brought by or against the reinsurers to determine the Company’s rights and obligations under the various reinsurance agreements. The Company employs dedicated specialists and strategies to manage reinsurance collections and disputes.
The allowance for estimated uncollectible reinsurance recoverables was $751 million and $387 million at December 31, 2004 and December 31, 2003, respectively. Of the $364 million increase in 2004, $256 million was merger-related and $108 million resulted from the Company’s ongoing review process described above.
The Company assumed 100% of the workers’ compensation premiums previously written by the Accident Department of its former affiliate, The Travelers Insurance Company (TIC).
In 2004, estimated claims and claim adjustment expenses for claims arising in prior years totaled a net $2.40 billion, including $2.39 billion of net unfavorable prior year reserve development impacting the Company’s results of operations, excluding $75 million of accretion of discount. Pretax net unfavorable prior year reserve development included $928 million to strengthen asbestos reserves primarily as a result of the completion of the Company’s annual asbestos liability review in the fourth quarter, $290 million to strengthen environmental reserves, reserve adjustments related to the merger of $500 million for construction and $300 million for surety, $252 million related to a specific construction contractor, $113 million related to the commutation of agreements with a major reinsurer, and other net reserving actions
In the Personal segment, net favorable prior year reserve development was $378 million, driven by a decline in the frequency of non-catastrophe homeowners’ losses, as well as a reduction in the frequency and severity of losses in the automobile line of business.
In 2003, net unfavorable prior year reserve development included in estimated claims and claim adjustment expenses totaled $390 million. That amount included $549 million of net unfavorable development impacting the Company’s results of operations that primarily resulted from $521 million of reserve strengthening at Gulf Insurance Company, a subsidiary that wrote specialty insurance prior to being placed in runoff in 2004. The net 2003 total also included unfavorable development related to American Equity, an operation that was placed in run-off in the second quarter of 2002, and environmental claims. Those provisions were partially offset by net favorable development in other Commercial businesses, principally property coverages, in which the Company experienced lower non-catastrophe-related claim frequency. In 2003, estimated claims and claim adjustment expenses for claims arising in prior years included $42 million of net favorable loss development on Commercial loss sensitive policies in various lines; however, since the business to which it relates was subject to premium adjustments, there was no impact on results of operations.
In addition, Personal recorded $162 million in net favorable prior year reserve development in 2003 principally due to continued reduced levels of non-catastrophe claim frequency in both homeowners and non-bodily injury automobile businesses, and a $50 million reduction in reserves held related to the terrorist attack on September 11, 2001.
In 2002, estimated claims and claim adjustment expenses for claims arising in prior years was a net unfavorable development of $3.03 billion. This included $3.13 billion of net unfavorable development which impacted results of operations primarily due to unfavorable development of $2.95 billion related to asbestos. Claims arising in prior years for 2002 also included unfavorable development of $150 million related to environmental claims and favorable development of $100 million related to cumulative injury claims. In addition, estimated claims and claim adjustment expenses for claims arising in prior years included net unfavorable development, primarily related to certain Commercial coverages, predominantly in assumed reinsurance specialty businesses, partially offset by favorable development in Commercial workers’ compensation and Personal automobile. In 2002, estimated claims and claim adjustment expenses for claims arising in prior years included $71 million of net favorable loss development on Commercial loss sensitive policies in various lines; however, since the business to which it relates is subject to premium adjustments, there is no impact on results of operations.
Because each policyholder presents different liability and coverage issues, the Company generally evaluates the asbestos exposure presented by each policyholder on a policyholder-by-policyholder basis. In the course of this evaluation, the Company considers: available insurance coverage, including the role of any umbrella or excess insurance the Company has issued to the policyholder; limits and deductibles; an analysis of each policyholder’s potential liability; the jurisdictions involved; past and anticipated future claim activity and loss development on pending claims; past settlement values of similar claims; allocated claim adjustment expense; potential role of other insurance; the role, if any, of non-asbestos claims or potential non-asbestos claims in any resolution process; and applicable coverage defenses or determinations, if any, including the determination as to whether or not an asbestos claim is a products/completed operation claim subject to an aggregate limit and the available coverage, if any, for that claim. When the gross ultimate exposure for indemnity and related claim adjustment expense is determined for a policyholder, the Company calculates, by each policy year, a ceded reinsurance projection based on any applicable facultative and treaty reinsurance, as well as past ceded experience and reinsurance collections. Conventional actuarial methods are not utilized to establish asbestos reserves. The Company’s evaluations have not resulted in any data from which a meaningful average asbestos defense or indemnity payment may be determined.
With respect to asbestos exposures, the Company also compares its historical gross and net loss and expense paid experience, year-by-year, to assess any emerging trends, fluctuations, or characteristics suggested by the aggregate paid activity. Net asbestos losses and expenses paid in 2004 were $301 million, compared with $452
million in 2003. Approximately 22% in 2004 and 57% in 2003 of total net paid losses relate to policyholders with whom the Company previously entered into settlement agreements that would limit the Company’s liability. The decrease in the percentage of net paid settlements to total paid losses in 2004 primarily reflected an increase in reinsurance billings in 2004, which related to gross payments made in prior periods. In 2004, gross payments associated with policyholders with settlement agreements totaled $199 million, compared with $289 million in 2003.
At December 31, 2004, asbestos reserves, net of reinsurance, were $3.93 billion, compared with $2.98 billion as of December 31, 2003. The Company acquired $311 million of net asbestos reserves in the merger with SPC. Net incurred asbestos losses and loss adjustment expenses totaled $928 million in 2004, driven by a $922 million provision to strengthen reserves in the fourth quarter following completion of the Company’s annual ground-up review of asbestos exposures. That review included an analysis of exposure and claim payment patterns by policyholder category, as well as recent settlements, policyholder bankruptcies, state judicial rulings and legislative actions. The $922 million provision was largely driven by an increase in litigation costs and activity surrounding peripheral defendants.
At December 31, 2003, asbestos reserves were $2.98 billion compared to $3.40 billion as of December 31, 2002. The decrease primarily reflected the $452 million of payments made during the course of 2003, partly offset by accretion of discounts of $25 million on reserves for certain policyholders with structured agreements. Other than accretion of discounts, there were no additions to asbestos reserves in 2003 compared to an addition of $2.95 billion in 2002.
As a result of the processes and procedures described above, management believes that the reserves carried for asbestos and environmental claims at December 31, 2004 are appropriately established based upon known
The Company’s consolidated balance sheet includes the debt instruments acquired in the merger, which were recorded at fair value as of the acquisition date. The resulting fair value adjustment is being amortized over the remaining life of the respective debt instruments using the effective-interest method. The amortization of the fair value adjustment reduced interest expense by $56 million for the year ended December 31, 2004.
5.25% Senior Notes-In July 2002, concurrent with the issuance of 17.8 million of SPC common shares in a public offering, SPC issued 8.9 million equity units, each having a stated amount of $50, for gross consideration of $443 million. Each equity unit initially consists of a forward purchase contract for the Company’s common stock (maturing in July 2005), and an unsecured $50 senior note of the company (maturing in 2007). Total annual distributions on the equity units are at the rate of 9.00%, consisting of interest on the note at a rate of 5.25% and fee payments under the forward contract of 3.75%. The forward contract requires the investor to purchase, for $50, a variable number of shares of the Company’s common stock on the settlement date of August 16, 2005. The number of shares to be purchased will be determined based on a formula that considers the average trading price of the Company’s stock immediately prior to the time of settlement in relation to the $24.20 per share price of common stock at the time of the offering. Had the settlement date been December 31, 2004, the Company would have issued approximately 15 million common shares based on the average trading price of the Company’s common stock immediately prior to that date.
Zero Coupon Convertible Notes-The zero coupon convertible notes mature in 2009, but are redeemable at the option of the holder for an amount equal to the original issue price plus accreted original issue discount.
3.75%, 5.00%, 6.375% Senior Notes-On March 11, 2003, the Company issued $1.40 billion of senior notes comprising $400 million of 3.75% senior notes due March 15, 2008, $500 million of 5.00% senior notes due March 15, 2013 and $500 million of 6.375% senior notes due March 15, 2033. The notes pay interest semi-annually on March 15 and September 15 of each year, beginning September 15, 2003, are senior unsecured obligations and rank equally with all of the Company’s other senior unsecured indebtedness. The Company may redeem some or all of the notes prior to maturity by paying a “make-whole” premium based on U.S. Treasury rates. The net proceeds from the sale of these notes were contributed to TIGHI, so that TIGHI could prepay and refinance $500 million of 3.60% indebtedness to Citigroup and to redeem $900 million aggregate principal amount of TIGHI’s 8.00% to 8.08% junior subordinated debt securities held by subsidiary trusts. These trusts, in turn, used these funds to redeem $900 million of preferred capital securities on April 9, 2003.
6.00% Convertible Notes-In August 2002, CIRI, a subsidiary of the Company, issued $50 million aggregate principal amount of 6.0% convertible notes (the CIRI Notes) which were to mature on December 31, 2032 unless earlier redeemed or repurchased. Pursuant to a Purchase Agreement between Trident II L.P., Marsh & McLennan Employees’ Securities Company, L.P., Marsh & McLennan Capital Professionals Fund, L.P., Trident Gulf Holding, LLC and The Travelers Indemnity Company (Indemnity), Indemnity agreed to purchase the aggregate principal amount of the CIRI Notes. This transaction was finalized in May 2004.
Maturities-The amount of debt obligations, other than commercial paper, that become due in each of the next five years is as follows: 2005, $420 million; 2006, $210 million; 2007, $1.02 billion; 2008, $857 million; and 2009, $119 million.
Prior to the merger, SPC was party to the following line of credit agreements with a syndicate of banks: (i) a $330 million 364-day revolving line of credit (the SPC 364-Day Line of Credit), and (ii) a $270 million 5-year revolving line of credit (the 5-Year Line of Credit and, together with the SPC 364-Day Line of Credit, the SPC Lines of Credit). SPC may, with bank syndicate consent, extend the commitment of the SPC 364-day Line of Credit for additional 364-day periods under the same terms and conditions.
commitment for each line of credit, a utilization fee. The applicable margin and the rates on which the commitment fee and utilization fee are based vary based upon the Company’s long-term senior unsecured non-credit-enhanced debt ratings.
Covenants. Pursuant to covenants in the 5-Year Line of Credit and STA 364-Day Line of Credit, the Company must maintain an excess of consolidated net worth over goodwill and other intangible assets of not less than $10 billion at all times. The Company must also maintain a ratio of total consolidated debt to the sum of total consolidated debt plus consolidated net worth of not greater than 0.40 to 1.00. Pursuant to the covenants in the 45-Month Line of Credit, TPC and its subsidiaries must maintain, as of the last day of any fiscal quarter, combined statutory capital and surplus in excess of $5.50 billion and a leverage ratio of total consolidated debt to total consolidated capital of less than 0.45 to 1.00. There were no ratings based triggers for the Company Lines of Credit. At December 31, 2004, the Company was in compliance with these covenants and all other covenants related to its respective debt instruments outstanding.
If the Company determines that any of its deferred tax assets will not result in future tax benefits, a valuation allowance must be established for the portion of these assets that are not expected to be realized. The net change in the valuation allowance for deferred tax assets was an increase of $128 million in 2004 relating to foreign operations. Based predominantly upon a review of the Company’s anticipated future taxable income, but also including all other available evidence, both positive and negative, the Company’s management concluded that it is “more likely than not” that the net deferred tax assets will be realized.
For tax return purposes, as of December 31, 2004, the Company had NOL carryforwards that expire, if unused, in 2017-2021 and foreign tax credit (FTC) carryforwards that expire, if unused, in 2009-2013. The amount and timing of realizing the benefits of NOL and FTC carryforwards depend on future taxable income and limitations imposed by tax laws. The approximate amounts of those NOLs on a regular tax basis and an alternative minimum tax (AMT) basis were $2.09 billion and $276 million, respectively. The approximate amounts of the FTCs both on a regular tax basis and an AMT basis were $27 million. The benefits of the NOL and FTC carryforwards have been recognized in the consolidated financial statements.
Taxes on the GAAP basis in excess of tax basis of approximately $1.96 billion related to the Company’s majority ownership of Nuveen Investments have not been recognized as of December 31, 2004. In January 2005, the Company announced that it will explore strategic alternatives to divest its majority ownership position in Nuveen Investments, which may result in a transaction that is tax-free, taxable, or some combination thereof.
Holders of preferred stock have a preference upon liquidation, dissolution or winding up of the Company of $100 per share.
On January 25, 2005, the Company, through its Capital Accumulation Program (CAP) and on January 25, 2005 and February 4, 2005, through its Equity Awards program, issued 2,048,729 common stock awards in the form of restricted stock and deferred stock to participating officers and other key employees. The fair value per share of the common stock was $36.97 and $38.16 on January 25, 2005 and February 4, 2005, respectively. These awards generally vest after a two-year period for the 2005 CAP awards and three years for the 2005 awards issued under the Equity Awards program. On January 22, 2004 and January 23, 2003, the Company issued under the CAP program 847,593 and 842,368 shares, respectively, of common stock in the form of restricted stock to participating officers and other key employees. The fair value per share of the common stock was $41.35 and $37.33, respectively. The restricted stock awards in 2004 and 2003 generally vest after a three-year period.
All shares of TPC common stock that were held by the Company as treasury stock at the merger date of April 1, 2004, were cancelled and retired as of that date.
Except for shares delivered to or retained in the SPC 1994 Stock Plan and the TPC 2002 Incentive Plan in connection with the payment of the exercise price of and, as to TPC option grants, the withholding of taxes applicable to the exercise of, outstanding options under those plans that have reload features, the provisions of the preceding paragraph that result in shares becoming available for future grants under the 2004 Incentive Plan also apply to any awards granted under the SPC1994 Stock Plan and the TPC 2002 Incentive Plan that were outstanding on the effective date of the 2004 Stock Plan. In addition, the number of shares of common stock available for grant under the 2004 Stock Plan will not be reduced by shares subject to awards granted under the 2004 Incentive Plan upon the assumption of or in substitution for awards in connection with business combinations (as defined in the 2004 Incentive Plan).
retainer and any committee chair or co-chair fees paid in the form of cash, common stock or deferred stock. Deferred stock for the annual retainer, and committee chair and co-chair fees, is elected pursuant to the St. Paul Travelers Deferred Compensation Plan for Non-Employee Directors that the Board adopted after the merger and is vested upon grant. The annual deferred stock awards vest one year after the date of award. Any of the deferred stock awards may accumulate until distribution at a future date or upon termination of a director’s service. The shares of the Company’s common stock issued under the 2004 Director Compensation Program, including shares of deferred stock, are awarded under the 2004 Incentive Plan.
Also under the TPC 2002 Incentive Plan, TPC had established a Wealthbuilder stock option program which provided for the granting of stock options to all employees meeting certain requirements, having the same terms as the management grants described above except that the awards granted under this program did not contain stock option reload features. TPC ceased issuing stock-option awards under the Wealthbuilder stock option program after June 2002.
Prior to the IPO in March 2002, TPC participated in various stock option plans sponsored by its former affiliate, Citigroup, that provided for the granting of stock options in Citigroup common stock to officers and key employees, and, in the case of certain stock option programs, to all employees meeting specific requirements.
The following table summarizes the information about stock options outstanding under the Company’s stock option plans at December 31, 2004:
All original and reload stock options granted under the Company’s stock option programs had an exercise price equal to the market value of the Company’s common stock on the date of grant. The stock option awards of SPC assumed in the merger on April 1, 2004, the awards of CIRI converted on August 4, 2004, and the replacement awards granted on August 20, 2002 retained the intrinsic value of the awards immediately prior to being assumed, converted or replaced and therefore the exercise price either exceeded the market value or was less than the market value on those respective dates. The following table presents the weighted average exercise price and weighted average grant date fair value information with respect to these grants:
The significant assumptions used in estimating the fair value on the date of the grant for original options and reload options granted in 2004, 2003 and 2002 and for the awards assumed on April 1, 2004 from SPC at the merger and replacement awards issued August 20, 2002 to TPC employees who held Citigroup stock option awards on that date were as follows:
In connection with the Citigroup Distribution, the exchange of options in conjunction with a spinoff is considered a modification and therefore the modification guidance of FAS 123 was applied to the replacement awards issued on August 20, 2002. For vested replacement options, any excess of the fair value of the modified options issued over the fair value of the original options at the date of exchange was recognized as additional compensation cost. For nonvested replacement options, any excess of the fair value of the modified options issued over the fair value of the original options at the date of exchange is added to the remaining unrecognized compensation cost of the original option and recognized over the remaining vesting period.
Also, CIRI had equity-based compensation plans in which awards were granted in CIRI’s privately held common stock. In connection with Indemnity’s purchase of the minority interest of CIRI (see note 2) the Company converted CIRI’s outstanding equity based-awards into awards in the Company’s common stock. The converted awards retained the same terms and conditions that were applicable prior to the conversion. The conversion of CIRI outstanding nonvested options into options to purchase the Company’s common stock is considered a modification and therefore the modification guidance of FAS 123 was applied to the converted awards. For these converted options, the excess of the fair value of the modified options issued over the fair value of the original options at the date of exchange is added to the remaining unrecognized compensation cost of the original option and recognized over the remaining vesting period.
The Company may issue awards of restricted stock and deferred stock to eligible officers and key employees pursuant to the 2004 Incentive Plan. Such awards include restricted stock grants under the Capital Accumulation Program (CAP) and Equity Awards program established pursuant to the 2004 Incentive Plan. Awards issued under the CAP program are in the form of restricted stock and the number of shares included in the restricted stock award is calculated at a 10% discount from the market price on the date of the award and generally vest in full after a two-year period from the date of grant. Other restricted stock awards issued under the Equity Awards program generally vest in full after a three-year period from the date of grant. Except under limited circumstances, during this period the stock cannot be sold or transferred by the participant, who is required to render service to the Company during the restricted period. Awards granted to non-U.S. participants are in the form of deferred stock awards. These deferred stock awards are granted at market price and generally vest after three years from the date of grant and are subject to the same conditions as the restricted stock awards except that the shares are not issued until the vesting criteria are satisfied.
On April 1, 2004, in connection with the merger, the Company assumed approximately 240,000 of outstanding SPC restricted stock awards related to SPC equity-based compensation plans. These restricted stock awards retained the same terms and conditions that were applicable prior to the merger. Under the SPC 1994 Stock Plan, the awards of restricted stock were subject to completing a specified objective or period of employment, generally one to five years. Under the SPC Capital Accumulation Plan, implemented in 2002, the number of shares included in the restricted stock award is calculated at a 10% discount from the market price at the date of the award and generally vests in full after a two-year period. The unvested restricted stock awards require the holder to render service during the vesting period and are therefore considered unearned compensation. At April 1, 2004, the estimated fair value of the unvested restricted stock awards subject to amortization was $9 million and has been included in unearned compensation as a separate component of equity. The unearned compensation expense is being recognized as a charge to income over the remaining vesting period.
On August 20, 2002, in connection with the Citigroup Distribution, the unvested outstanding awards of restricted stock and deferred shares held by TPC employees on that date under Citigroup CAP, were cancelled and replaced by awards comprised primarily of 1.3 million newly issued shares of TPC’s common stock (which reflects adjustment for the merger) at a total market value of $53 million based on the closing price of the TPC’s common stock on August 20, 2002. These replacement awards were granted on substantially the same terms, including vesting, as the former Citigroup awards. The value of these newly issued shares along with the
common stock received in the Citigroup Distribution on the Citigroup restricted shares, were equal to the value of the cancelled Citigroup restricted share awards.
Unearned compensation expense is recognized as a charge to income ratably over the vesting period. The after-tax compensation cost charged to earnings for these restricted stock and deferred stock awards was $26 million, $17 million and $17 million for the years ended December 31, 2004, 2003 and 2002, respectively.
For pension plans with an accumulated benefit obligation in excess of plan assets, the aggregate projected benefit obligation and the aggregate accumulated benefit obligation were $106 million and $102 million, respectively, at December 31, 2004 and were each $28 million at December 31, 2003. The fair value of plan assets for the above plans was $23 million and $0 at December 31, 2004 and 2003, respectively.
As an indicator of sensitivity, increasing the assumed health care cost trend rate by 1% would have increased the accumulated postretirement benefit obligation by $39 million at December 31, 2004, and the aggregate of the service and interest cost components of net postretirement benefit expense by $4 million for the year ended December 31, 2004. Decreasing the assumed health care cost trend rate by 1% would have decreased the accumulated postretirement benefit obligation at December 31, 2004 by $32 million and the aggregate of the service and interest cost components of net postretirement benefit expense by $3 million for the year ended December 31, 2004. The sensitivity of the foregoing hypothetical changes in the assumed health care cost trend rates to the accumulated postretirement benefit obligation at December 31, 2003, and the aggregate of the service and interest cost components of net postretirement benefit expense for the year ended December 31, 2003 was negligible.
The Company has a 401(k) savings plan under which substantially all legacy TPC employees and Company employees hired after April 1, 2004, are eligible to participate. In 2004, the Company matched employee contributions up to 5% of eligible pay but not more than $2,500 annually. Prior to 2004, the Company matched employee contributions up to 3% of eligible pay but not more than $1,500 annually. The expense related to this plan was $34 million, $20 million and $17 million for the years ended December 31, 2004, 2003 and 2002, respectively.
In connection with the merger, the Company assumed The St. Paul Companies, Inc. Savings Plus Plan (SPP), a 401(k) savings plan and The St. Paul Companies, Inc. Stock Ownership Plan (SOP). Substantially all employees who were hired by legacy SPC before April 1, 2004 are eligible to participate in these plans. In 2004 under the SPP, the Company matched 100% of employees’ contributions up to a maximum of 6% of their salary. The match was in the form of preferred shares, to the extent available in the SOP, or in the Company’s common shares. Also allocated to participants were preferred shares equal to the value of dividends on previously allocated shares.
To finance the preferred stock purchase for future allocation to qualified employees, the SOP borrowed $150 million at 9.4% from a primary U.S. underwriting subsidiary. As the principal and interest of the trust’s loan is paid, a pro rata amount of preferred stock is released for allocation to participating employees. Each share of preferred stock pays a dividend of $11.72 annually and is currently convertible into eight shares of our common stock. Preferred stock dividends on all shares held by the trust are used to pay a portion of the SOP obligation. In addition to dividends paid to the trust, additional cash contributions are made to the SOP as necessary in order to meet the SOP’s debt obligation.
The following table details the shares held in the SOP at December 31, 2004:
The SOP allocated the final 71,346 preferred shares in 2004. The SOP has no preferred shares available for future allocations.
For fair value hedges, changes in the fair value of derivatives are reflected in net realized investment gains (losses), together with changes in the fair value of the related hedged item. At December 31, 2004, the amount that the Company expects to include in earnings over the next twelve months for fair value hedges is not significant. The Company did not utilize fair value hedges during the year ended December 31, 2003. The Company’s fair value hedges result from Nuveen Investments’ utilization of interest rate swaps entered into to hedge a portion of the fair value of its private placement debt. The swaps were terminated in 2004.
For cash flow hedges, the accounting treatment depends on the effectiveness of the hedge. To the extent these derivatives are effective in offsetting the variability of the hedged cash flows, changes in the derivatives’ fair value will not be included in current earnings but are reported in accumulated other changes in equity from nonowner sources. These changes in fair value will be included in the earnings of future periods when earnings are also affected by the variability of the hedged cash flows. At December 31, 2004, the amount that the Company expects to include in net realized investment gains (losses) over the next twelve months for these cash flow hedges is not significant. To the extent these derivatives are not effective, changes in their fair value are immediately included in net realized investment gains (losses). The Company’s cash flow hedges primarily include hedges of floating rate available-for-sale securities and certain forecasted transactions up to a maximum tenure of one year.
The effectiveness of these hedging relationships is evaluated on a retrospective and prospective basis using quantitative measures of correlation. If a hedge relationship is found to be ineffective, it no longer qualifies as a hedge, and any excess gains or losses attributable to such ineffectiveness as well as subsequent changes in fair value are recognized in net realized investment gains (losses). During the years ended December 31, 2004 and 2003, the Company had no realized gains or losses from hedge ineffectiveness.
Derivatives that are not designated or do not qualify as hedges are also carried at fair value with changes in value reflected in net realized investment gains (losses). The Company has certain U.S. treasury futures contracts and foreign currency forward contracts, which are not designated as hedges at December 31, 2004 and 2003.
16. DERIVATIVE FINANCIAL INSTRUMENTS AND FAIR VALUE OF FINANCIAL INSTRUMENTS, Continued
are ultimately reflected as an element of the yield. For cash flow hedges, any changes in fair value of the end-user derivative remain in accumulated other changes in equity from nonowner sources, and are included in earnings of future periods when earnings are also affected by the variability of the hedged cash flow. If the hedged relationship was discontinued because a forecasted transaction will not occur when scheduled, any changes in fair value of the end-user derivative are immediately reflected in net realized investment gains (losses). During the years ended December 31, 2004 and 2003, the Company had no discontinued forecasted transactions.
As a result of the merger, the Company acquired 6 million stock purchase warrants of Platinum Underwriters, a publicly held company. These warrants are not designated and do not qualify as hedges under FAS 133 and as such the mark to market is reflected in net realized gains (losses).
Nuveen Investments entered into swap agreements that have not been designated as hedging instruments. The swap agreements are used to support new products offered by Nuveen Investments. The mark-to-market valuations were not significant and are reflected in results of operations.
At December 31, 2004 and 2003, investments in fixed maturities had a fair value, which equaled carrying value, of $54.26 billion and $33.05 billion, respectively. The fair value of investments in fixed maturities for which a quoted market price or dealer quote are not available was $574 million and $685 million at December 31, 2004 and 2003, respectively. See note 1.
The following section describes the major pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the Company or its subsidiaries are a party or to which any of the Company’s property is subject.
TPC is involved in three significant proceedings relating to ACandS, Inc. (ACandS), formerly a national distributor and installer of products containing asbestos, including ACandS’ bankruptcy proceedings. The proceedings involve disputes as to whether and to what extent any of ACandS’ potential liabilities for bodily injury asbestos claims are covered by insurance policies issued by TPC. These proceedings have resulted in decisions favorable to TPC, although those decisions are subject to appellate review. The status of the various proceedings is described below.
ACandS filed for bankruptcy in September 2002 (In re: ACandS, Inc., pending in the U.S. Bankruptcy Court for the District of Delaware). In its proposed plan of reorganization, ACandS sought to establish a trust to pay asbestos bodily injury claims against it and sought to assign to the trust its rights under the insurance policies
issued by TPC. The proposed plan and disclosure statement filed by ACandS claimed that ACandS had settled the vast majority of asbestos-related bodily injury claims currently pending against it for approximately $2.80 billion. ACandS asserts that, based on a prior agreement between TPC and ACandS and ACandS’ interpretation of the July 31, 2003 arbitration panel ruling described below, TPC is liable for 45% of the $2.80 billion. On January 26, 2004, the bankruptcy court issued a decision rejecting confirmation of ACandS’ proposed plan of reorganization. The bankruptcy court found, consistent with TPC’s objections to ACandS’ proposed plan, that the proposed plan was not fundamentally fair, was not proposed in good faith and did not comply with Section 524(g) of the Bankruptcy Code. ACandS has filed a notice of appeal of the bankruptcy court’s decision and has filed objections to the bankruptcy court’s findings of fact and conclusions of law in the United States District Court. TPC has moved to dismiss the appeal and objections and has also filed an opposition to ACandS’ objections.
An arbitration was commenced in January 2001 to determine whether and to what extent ACandS’ financial obligations for bodily injury asbestos claims are subject to insurance policy aggregate limits. On July 31, 2003, the arbitration panel ruled in favor of TPC that asbestos bodily injury claims against ACandS are subject to the aggregate limits of the policies issued to ACandS, which have been exhausted. In October 2003, ACandS commenced a lawsuit seeking to vacate the arbitration award as beyond the panel’s scope of authority (ACandS, Inc. v. Travelers Casualty and Surety Co., U.S.D.Ct., E.D. Pa.). On September 16, 2004, the Court entered an order denying ACandS’ motion to vacate the arbitration award. On October 6, 2004, ACandS filed a notice of appeal. Briefing of the appeal is complete. Oral argument has not been scheduled.
In the other proceeding, a related case pending before the same court and commenced in September 2000 (ACandS v. Travelers Casualty and Surety Co., U.S.D. Ct., E.D. Pa.), ACandS sought a declaration of the extent to which the asbestos bodily injury claims against ACandS are subject to occurrence limits under insurance policies issued by TPC. TPC filed a motion to dismiss this action based upon the July 31, 2003 arbitration decision described above. The Court found the dispute was moot as a result of the arbitration panel’s decision. The Court, therefore, based on the arbitration panel’s decision, dismissed the case. On October 6, 2004, ACandS filed a notice of appeal. This appeal has been consolidated with the appeal referenced in the paragraph above. Briefing of the appeal is complete. Oral argument has not been scheduled.
All of the actions against TPC described in the preceding paragraph, other than the Hawaii Actions, had been subject to a temporary restraining order entered by the federal bankruptcy court in New York that had previously presided over and approved the reorganization in bankruptcy of TPC’s former policyholder Johns-Manville. In August 2002, the bankruptcy court conducted a hearing on TPC’s motion for a preliminary injunction prohibiting further prosecution of the lawsuits pursuant to the reorganization plan and related orders. At the conclusion of this hearing, the court ordered the parties to mediation, appointed a mediator and continued the temporary restraining order. During 2003, the same bankruptcy court extended the existing injunction to apply to an additional set of cases filed in various state courts in Texas and Ohio as well as to the attorneys who are prosecuting these cases. The order also enjoined these attorneys and their respective law firms from commencing any further lawsuits against TPC based upon these allegations without the prior approval of the court. Notwithstanding the injunction, additional Common Law Claims were filed and served on TPC.
On August 17, 2004, the bankruptcy court entered an order approving the settlements and clarifying its prior orders that all of the pending Statutory and Hawaii Actions and substantially all Common Law Claims pending against TPC are barred. The order also applies to similar direct action claims that may be filed in the future.
Five appeals were taken from the August 17, 2004 ruling. These appeals have been consolidated and are currently pending. The parties have completed briefing all of the issues and await a date for oral argument. The Company has no obligation to pay any of the settlement amounts unless and until the orders and relief become final and are not subject to any further appellate review. It is not possible to predict how appellate courts will rule on the pending appeals.
The Company is defending its asbestos and environmental-related litigation vigorously and believes that it has meritorious defenses; however, the outcome of these disputes is uncertain. In this regard, the Company employs dedicated specialists and aggressive resolution strategies to manage asbestos and environmental loss exposure, including settling litigation under appropriate circumstances. For a discussion of other information regarding the Company’s asbestos and environmental exposure, see “Management’s Discussion and Analysis of
TPC and its board of directors were named as defendants in three putative class action lawsuits brought by shareholders alleging breach of fiduciary duty in connection with the merger of TPC and SPC and seeking injunctive relief as well as unspecified monetary damages. The actions were captioned Henzel, et al. v. Travelers Property Casualty Corp., et al. (Jud. Dist. of Waterbury, Ct. Nov. 17, 2003); Vozzolo v. Travelers Property Casualty Corp., et al. (Jud. Dist. of Waterbury, Ct. Nov. 17, 2003); and Farina v. Travelers Property Casualty Corp., et al. (Jud. Dist. of Waterbury, Ct. December 15, 2003). The Farina complaint also named SPC and its former subsidiary, Adams Acquisition Corp., as defendants, alleging that they aided and abetted the alleged breach of fiduciary duty. On March 18, 2004, TPC and SPC announced that all of these lawsuits had been settled, subject to court approval of the settlements. The settlement included a modification to the termination fee that could have been paid had the merger not been completed, additional disclosure in the proxy statement distributed in connection with the merger and a nominal amount for attorneys’ fees. Before court approval of the settlement, additional shareholder litigation was commenced, as described below. In light of that litigation, the parties are evaluating how to proceed.
In addition, five other actions against the Company and certain of its current and former officers and directors are pending in the United States District Court for the District of Minnesota. Two of these actions, Kahn v. The St. Paul Travelers Companies, Inc., et al. (Nov. 2, 2004) and Michael A. Bernstein Profit Sharing Plan v. The St. Paul Travelers Companies, Inc., et al. (Nov. 10, 2004), are putative class actions brought by certain shareholders of the Company against the Company and certain of its current and former officers and directors. In these two actions, plaintiff shareholders allege violations of federal securities laws in connection with the Company’s alleged failure to make disclosure relating to the practice of paying brokers commissions on a contingent basis. Two derivative actions have been brought against all current directors of the Company, naming the Company as a nominal defendant. In Rowe v. Fishman, et al. (Oct. 22, 2004), the plaintiff shareholder alleges state law claims, including breach of fiduciary duty, based on allegations similar to those alleged in In re St. Paul Travelers Securities Litigation described above. In Clark v. Fishman, et al. (Nov. 18,
Four putative class action lawsuits have been brought against a number of insurance brokers and insurers, including the Company, by plaintiffs who allegedly purchased insurance products through one or more of the defendant brokers. The complaints are captioned Shell Vacations LLC v. Marsh & McLennan Companies, Inc. (N.D. Ill. Jan. 14, 2005), Redwood Oil Company v. Marsh & McLennan Companies, Inc. (N.D. Ill. Jan. 21, 2005); Boros v. Marsh & McLennan Companies, Inc. (N.D. Cal. Feb. 4, 2005) and Mulcahey v. Arthur J. Gallagher & Co. (D.N.J. February 23, 2005). Plaintiffs allege that various insurance brokers conspired with each other and with various insurers, including the Company, to allocate brokerage customers and rig bids for insurance products offered to those customers. The complaints include causes of action under the Sherman Act, the Racketeer Influenced and Corrupt Organizations Act, federal and state common law and the laws of the various states prohibiting antitrust violations and unfair and/or deceptive trade practices. Plaintiffs seek monetary damages, including punitive damages and trebled damages, permanent injunctive relief, restitution, including disgorgement of profits, interest and costs, including attorneys’ fees. The Company believes that these lawsuits have no merit and intends to defend vigorously.
In addition to those described above, the Company is involved in numerous lawsuits, not involving asbestos and environmental claims, arising mostly in the ordinary course of business operations either as a liability insurer defending third-party claims brought against policyholders or as an insurer defending coverage claims brought against it. While the ultimate resolution of these legal proceedings could be significant to the Company’s results of operations in a future quarter, in the opinion of the Company’s management it would not be likely to have a material adverse effect on the Company’s results of operations for a calendar year or on the Company’s financial condition or liquidity.
On July 23, 2004, the Company announced that it was seeking guidance from the staff of the Division of Corporation Finance of the Securities Exchange Commission with respect to the appropriate purchase accounting treatment for certain second quarter 2004 adjustments totaling $1.63 billion ($1.07 billion after-tax). The Company recorded these adjustments as charges in its income statement in the second quarter of 2004. Through an informal comment process, the staff of the Division of Corporation Finance has subsequently asked for further information relating to these adjustments, and the dialogue is ongoing. Specifically, the staff has asked for information concerning the Company’s adjustments to certain of SPC’s insurance reserves and reserves for reinsurance recoverables and premiums due from policyholders, and how those adjustments may relate to SPC’s reserves for periods prior to the merger. After reviewing the staff’s questions and comments, the Company continues to believe that its accounting treatment for these adjustments is appropriate. If, however, the staff disagrees, some or all of the adjustments being discussed may not be recorded as charges in the Company’s income statement, thereby increasing net income for the second quarter and full year 2004 and increasing shareholders’ equity at December 31, 2004, in each case by the approximate after-tax amount of the change. The effect on tangible shareholders’ equity (adjusted for the effects of deferred taxes associated with goodwill and intangible assets) at December 31, 2004 would not be material. Increases to goodwill and deferred tax liabilities would be reflected on the Company’s balance sheet as of April 1, 2004, either due to purchase accounting or adjustment of SPC’s reserves prior to the merger.
Nuveen Investments’ Acquisition-As of December 31, 2004, the Company’s asset management subsidiary, Nuveen Investments, may be required to make additional payments of up to $120 million related to their acquisition of Symphony Asset Management, LLC (Symphony), based on Symphony reaching specified performance and growth targets.
SPC’s Sale of Minet-In May 1997, SPC completed the sale of its insurance brokerage operation, Minet, to Aon Corporation. SPC agreed to indemnify Aon against any future claims for professional liability and other specified events that occurred or existed prior to the sale. The Company assumed obligations related to this indemnification upon consummation of the merger. The Company monitors its exposure under these claims on a regular basis. The Company believes reserves for reported claims are adequate, but it does not have information on unreported claims to estimate a range of additional liability. From 1997 to 2004, SPC purchased insurance to cover a portion of its exposure to such claims. Under the sale agreement, SPC also committed to acquire a minimum level of reinsurance brokerage services from Aon through 2012. That commitment requires the Company to make a contractual payment to Aon to the extent such minimum level of service is not acquired. The maximum annual amount payable to Aon for such services and any such contractual payment related to that commitment is $20 million. SPC also had commitments under lease agreements through 2015 for vacated space (included in lease commitment totals in note 15), as well as a commitment to make payments to a former Minet executive. The Company assumed all obligations to these commitments upon consummation of the merger.
In conjunction with the purchase of TIGHI’s outstanding shares in April 2000, TPC borrowed $2.20 billion pursuant to a note agreement with Citigroup. This note was prepaid during 2002 following the offerings. Interest expense included in the consolidated statement of income was $6 million in 2002.
SPC had made loans to certain current and former executive officers for their purchase of the Company’s common stock in the open market. These were full-recourse loans, further secured by a pledge of the stock purchased with the proceeds. The loans accrued interest at the applicable federal rate for loans of such maturity. Loans to former executive officers were being repaid in accordance with agreed-upon terms. The total amount receivable under this program was $1 million on December 31, 2003. This program was terminated effective March 20, 2002; consequently, no new loans were made after that date. All loans were repaid as of December 31, 2004.