Selected financial data for the five years ended December 31, 1997 are incorporated by reference from the Corporation's 1997 Annual Report to Shareholders, pages 36 and 37.
Certain statements in this document, as well as certain statements incorporated by reference herein, may be considered to be "forward looking statements" as that term is defined in the Private Securities Litigation Reform Act of 1995, such as statements that include the words or phrases "will likely result", "are expected to", "will continue", "is anticipated", "estimate", "project" or similar expressions. Such statements are subject to certain risks and uncertainties. The factors which could cause actual results to differ materially from those suggested by any such statements include, but are not limited to, those discussed or identified from time to time in the Corporation's public filings with the Securities & Exchange Commission and specifically to: risks or uncertainties associated with the Corporation's expectations with respect to its activity value analysis program, year 2000 liabilities, its market risk evaluations or with respect to announced real estate plans or premium growth and investment income or cash flow projections and, more generally, to: general economic conditions including changes in interest rates and the performance of the financial markets, changes in domestic and foreign laws, regulations and taxes, changes in competition and pricing environments, regional or general changes in asset valuations, the occurrence of significant natural disasters, the inability to reinsure certain risks economically, the adequacy of loss reserves, as well as general market conditions, competition, pricing and restructurings.
Net income, which includes the results of the discontinued operations, amounted to $770 million in 1997 compared with $513 million in 1996 and $697 million in 1995.
Catastrophe losses were $57 million in 1997, $142 million in 1996 and $64 million in 1995. Our initial retention level for each catastrophic event is approximately $100 million. We did not have any recoveries from our catastrophe reinsurance coverage during the past three years since there were no individual catastrophes for which our losses exceeded the initial retention.
For many years, a portion of the U.S. insurance business written by the Corporation's property and casualty subsidiaries was reinsured on a quota share basis with a subsidiary of the Sun Alliance Group plc. Similarly, a subsidiary of the Corporation assumed a portion of Sun Alliance's property and casualty business on a quota share basis. Effective January 1, 1996, the agreements pertaining to the exchange of reinsurance were amended to reduce the portion of each company's business reinsured with the other. Consequently, during 1996, the Corporation's property and casualty subsidiaries retained a greater portion of the business they wrote directly and assumed less reinsurance from Sun Alliance. As a result of the 1996 merger of Sun Alliance with Royal Insurance Holdings plc, these agreements were terminated effective January 1, 1997. Therefore, in 1997, the property and casualty subsidiaries retained an even greater portion of the business they wrote directly and assumed no reinsurance from Sun Alliance. There was an additional impact on net premiums written in the first quarter of 1996 and 1997 due to the effect of the portfolio transfers of unearned premiums as of January 1 of each year resulting from the changes in retention.
After a review of the costs and benefits of our casualty excess of loss reinsurance program, effective January 1, 1996, we modified the program, principally for the excess liability and executive protection classes. The changes included an increase in the initial retention for each loss from $5 million to $10 million and an increase in the initial aggregate amount of losses retained for each year before reinsurance becomes available. These changes in our casualty reinsurance program increased net premiums written in 1996 by approximately $130 million compared with the prior year. During 1996, we continued to evaluate the relative costs and benefits of the program. As a result, effective
January 1, 1997, we again modified the program, increasing the initial retention for each loss from $10 million to $25 million. This change in our casualty reinsurance program increased net premiums written in 1997 by approximately $65 million compared with 1996. These changes have had a positive impact on the cash flows and resulting investment income of the property and casualty subsidiaries.
Net premiums written, as adjusted, increased 9% in 1997 compared with 1996 and 9% in 1996 compared with 1995. We continued to grow our homeowners and other non-automobile business in non-catastrophe prone areas while maintaining our disciplined approach to pricing and risk selection. Personal automobile premiums increased as a result of an increase in the number of in-force policies for high-value automobiles.
Reported premiums from commercial insurance increased 17% in 1997 compared with 15% in 1996. The effect on net premiums written of the changes to the reinsurance agreement with Sun Alliance was as follows:
more so in 1997, by increases in loss reserves for asbestos-related and toxic waste claims. Multiple peril results were similar in 1997 and 1996 as an improvement in 1997 in the property component, due in part to an absence of catastrophe losses, was offset by higher losses in the liability component resulting from an increase in the frequency of large losses. Results for this class benefited in 1995 from an absence of catastrophe losses. Catastrophe losses represented 1.5 percentage points of the loss ratio for this class in 1997 compared with 4.8 percentage points in 1996 and 1.0 percentage point in 1995.
Workers' compensation results were unprofitable in 1997 and 1996 compared with profitable results in 1995. Results deteriorated in 1996 and again in 1997 due in large part to the cumulative effect of price reductions over the past several years. Results continued to benefit, however, from the reform of benefit provisions of workers' compensation laws in many states, and the impact of medical cost containment and disability management activities. Results from our share of the involuntary pools and mandatory business in which we must participate by law have also benefited from these positive factors.
As a result of the changes to the reinsurance agreements with Sun Alliance, there were portfolio transfers of gross loss reserves and reinsurance recoverable as of January 1, 1996 and 1997. The effect of these portfolio transfers was a decrease in gross loss reserves of $184 million and $209 million and a decrease in reinsurance recoverable of $470 million and $244 million in 1997 and 1996, respectively.
During 1997, we experienced overall favorable development of $65 million on loss reserves established as of the previous year-end. This compares with favorable development of $43 million in 1996 and $36 million in 1995. Such favorable development was reflected in operating results in these respective years. Results in each of the past three years benefited from favorable claim severity trends for certain liability classes; this was offset each year in varying degrees by losses incurred relating to asbestos and toxic waste claims.
The process of establishing loss reserves is an imprecise science and reflects significant judgmental factors. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured loss, the reporting of the loss and the settlement of the loss. In fact, approximately 60% of our net loss reserves at December 31, 1997 were for IBNR -- claims that had not yet been reported to us, some of which were not yet known to the insured, and future development on reported claims.
were not filed in court before August 27, 1993. Pacific Indemnity will contribute approximately $538 million to the trust fund and Continental Casualty will contribute the remaining amount. In December 1993, upon execution of the global settlement agreement, Pacific Indemnity and Continental Casualty paid their respective shares into an escrow account. Upon final court approval of the settlement, the amount in the escrow account, including interest earned thereon, will be transferred to the trust fund. All of the parties have agreed to use their best efforts to seek final court approval of the global settlement agreement.
Pacific Indemnity, Continental Casualty and Fibreboard entered into a trilateral agreement to settle all present and future asbestos-related bodily injury claims resulting from insurance policies that were, or may have been, issued to Fibreboard by the two insurers. The trilateral agreement will be triggered if the global settlement agreement is ultimately disapproved. Pacific Indemnity's obligation under the trilateral agreement is therefore similar to, and not duplicative of, that under those agreements described above.
The trilateral agreement reaffirms portions of an agreement reached in March 1992 between Pacific Indemnity and Fibreboard. Among other matters, that 1992 agreement eliminates any Pacific Indemnity liability to Fibreboard for asbestos-related property damage claims.
In July 1995, the United States District Court of the Eastern District of Texas approved the global settlement agreement and the trilateral agreement. The judgments approving these agreements were appealed to the United States Court of Appeals for the Fifth Circuit. In July 1996, the Fifth Circuit Court affirmed the 1995 judgments of the District Court. The objectors to the global agreement appealed to the United States Supreme Court. In June 1997, the United States Supreme Court set aside the ruling by the Fifth Circuit Court that had approved the global agreement and ordered the Fifth Circuit Court to reconsider its approval in light of a June 1997 ruling by the Supreme Court rejecting an unrelated settlement that included several former asbestos manufacturers. In January 1998, the Fifth Circuit Court again affirmed the global settlement agreement, ruling that it was legally distinct from the other settlement. It is expected that objectors to the settlement will petition the Supreme Court to review the decision. The Supreme Court would then have to decide whether to take the appeal.
The trilateral agreement, however, was never appealed to the United States Supreme Court and is final. As a result, management continues to believe that the uncertainty of Pacific Indemnity's exposure with respect to asbestos-related bodily injury claims against Fibreboard has been eliminated.
Since 1993, a California Court of Appeal has agreed, in response to a request by Pacific Indemnity, Continental Casualty and Fibreboard, to delay its decisions regarding asbestos-related insurance coverage issues that are currently before it and involve the three parties exclusively, while the approval of the global settlement is pending in court. Continental Casualty and Pacific Indemnity have dismissed disputes against each other which involved Fibreboard and were in litigation.
receive notices of new asbestos claims and new exposures on existing claims as more peripheral parties are drawn into litigation to replace the now defunct mines and bankrupt manufacturers.
Insurance policies issued to PRPs were not intended to cover the clean-up costs of pollution and, in many cases, did not intend to cover the pollution itself. Pollution was not a recognized hazard at the time many of these policies were written. In more recent years, policies specifically exclude such exposures.
As the costs of environmental clean-up have become substantial, PRPs and others have increasingly filed claims with their insurance carriers. Litigation against insurers extends to issues of liability, coverage and other policy provisions.
There is great uncertainty involved in estimating our liabilities relating to these claims. First, the underlying liabilities of the claimants are extremely difficult to estimate. At any given clean-up site, the allocation of remediation costs among governmental authorities and the PRPs varies greatly. Second, different courts have addressed liability and coverage issues regarding pollution claims and have reached inconsistent conclusions in their interpretation of several issues. These significant uncertainties are not likely to be resolved in the near future.
Uncertainties also remain as to the Superfund law itself, which has generated far more litigation than it has provided cleanup of hazardous waste sites. Superfund's taxing authority expired on December 31, 1995. Notwithstanding continued pressure by the insurance industry and other interested parties to achieve a legislative solution which would reform the liability provisions of the law, Congress has not yet addressed the issue. It is currently not possible to predict the direction that any reforms may take, when they may occur or the effect that any changes may have on the insurance industry.
Reserves for asbestos and toxic waste claims cannot be estimated with traditional loss reserving techniques. We have established case reserves and expense reserves for costs of related litigation where sufficient information has been developed to indicate the involvement of a specific insurance policy. In addition, IBNR reserves have been established to cover additional exposures on both known and unasserted claims. These reserves are continually reviewed and updated. Losses incurred relating to asbestos and toxic waste claims were $125 million in 1997, $151 million in 1996 and $182 million in 1995. Further increases in loss reserves in 1998 and future years are possible as legal and factual issues concerning asbestos and toxic waste claims are clarified, although the amounts cannot be reasonably estimated.
Management believes that the aggregate loss reserves of the property and casualty subsidiaries at December 31, 1997 were adequate to cover claims for losses which had occurred, including both those known to us and those yet to be reported. In establishing such reserves, management considers facts currently known and the present state of the law and coverage litigation. However, given the expansion of coverage and liability by the courts and the legislatures in the past and the possibilities of similar interpretations in the future, particularly as they relate to asbestos and toxic waste claims, as well as the uncertainty in determining what scientific standards will be deemed acceptable for measuring hazardous waste site clean-up, additional increases in loss reserves may emerge that would adversely affect results in future periods. The amount cannot reasonably be estimated at the present time.
The Corporation's property and casualty subsidiaries have an exposure to insured losses caused by hurricanes, earthquakes, winter storms, windstorms and other catastrophic events. The frequency and severity of catastrophes are unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in an area affected by the event and the severity of the event. The Corporation continually assesses its concentration of underwriting exposures in catastrophe prone areas and develops strategies to manage this exposure through individual risk selection, subject to regulatory constraints, and through the purchase of catastrophe reinsurance. In recent years, the Corporation has invested in modeling technologies that allow us to better monitor catastrophe exposures. We also continue to explore and analyze credible scientific evidence, including the impact of global climate change, that may affect our potential exposure under insurance policies.
In 1995, we initiated a project to ensure Year 2000 compliance of the Corporation's computer systems and applications. Management believes that all key systems that are not already Year 2000 compliant will be modified or replaced by the end of 1999 and that the costs to modify or replace such systems will not have a significant impact on the Corporation's operating results or financial position. We are also coordinating with entities with which we interact to address potential Year 2000 issues to minimize the potential adverse consequences, if any, that could result from the failure of such entities to address this issue.
Investment income earned on corporate invested assets and interest and other expenses not allocable to the operating subsidiaries are reflected in the corporate segment. Corporate income after taxes was $36 million in 1997 compared with $20 million in 1996 and $15 million in 1995. The increase in corporate income in 1997 was due primarily to a reduction in interest expense.
Interest rate risk is the price sensitivity of a fixed income security to changes in interest rates. We view these potential changes in price within the overall context of asset and liability management. Our actuaries estimate the payout pattern of our liabilities, primarily our property and casualty loss reserves, to determine their duration, which is the present value of the weighted average payments expressed in years. We set duration targets for our fixed income investment portfolios after consideration of the duration of these liabilities and other factors, which we believe mitigates the overall effect of interest rate risk for the Corporation.
The table below provides information about the Corporation's fixed maturity investments at December 31, 1997 that are sensitive to changes in interest rates. The table presents cash flows of principal amounts and related weighted average interest rates by expected maturity dates. The cash flows are based on the earlier of the call date or the maturity date or, for mortgage-backed securities, expected payment patterns. Actual cash flows could differ from the expected amounts.
Our taxable bond portfolio includes mortgage-backed securities, which comprised 40% and 35% of this portfolio at year-end 1997 and 1996, respectively. About 60% of our mortgage-backed securities holdings at December 31, 1997 related to residential mortgages consisting of government agency pass-through securities, government agency collateralized mortgage obligations (CMOs) and AAA rated non-agency CMOs backed by government agency collateral or single family home mortgages. The majority of the CMOs are actively traded in liquid markets and market value information is readily available from broker/dealers. An additional 35% of our mortgage-backed securities are invested in call protected AAA rated commercial securities.
Foreign currency risk is the sensitivity to foreign exchange rate fluctuations of the market value and investment income related to foreign currency denominated financial instruments. The functional currency of our foreign operations is generally the currency of the local operating environment since their business is primarily transacted in such local currency. We reduce the risks relating to currency fluctuations by maintaining investments in those foreign currencies in which we transact business. Such investments have characteristics similar to our liabilities in those currencies. At December 31, 1997, the property and casualty subsidiaries held foreign investments of $1.1 billion supporting their international operations. Such foreign investments have quality and maturity characteristics similar to our domestic portfolio. The principal currencies creating foreign exchange rate risk for the Corporation are the Canadian dollar and the British pound sterling. The table on the following page provides
In June 1997, a definitive agreement was reached with the purchaser. In November, the sale of almost all of the properties covered by the agreement reached in June was closed for $737 million, which included $628 million in cash and the assumption of $109 million in debt. The buyer is a joint venture formed by Paine Webber Real Estate Securities Inc., Morgan Stanley Real Estate Fund II, L.P. and Gale & Wentworth, L.L.C. Closing on the few remaining properties under the agreement is expected to occur in 1998.
In addition to the November sale to the joint venture, we sold several other commercial properties as well as residential properties in 1997. We are continuing to explore the sale of certain of our remaining properties.
Revenues were $616 million in 1997, $320 million in 1996 and $288 million in 1995. Revenues in 1997 include $380 million from the November sale of real estate properties. Proceeds received from that sale which related to mortgages receivable are not classified as revenues. Revenues in 1996 and 1995 included higher levels of revenues from residential development. Revenues in 1996 also included the sale of rental properties while 1995 revenues included the land sale.
The Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, in the first quarter of 1996. SFAS No. 121 establishes accounting standards for the impairment of long-lived assets, certain identifiable intangibles, and goodwill related to those assets.
SFAS No. 121 requires that we analyze our individual buildings, leased land and development sites on a continuing basis to determine if an impairment loss has occurred. Estimates are made of the revenues and operating costs, plus any additional costs to be incurred to complete development, of the property in the future through an assumed holding period based on our intended use of the property. The time value of money is not considered in assessing whether an impairment has occurred. If it is determined that impairment has occurred, measurement of such impairment is based on the fair value of the assets. The $255 million write-down of real estate assets in 1996 was made in accordance with the provisions of SFAS No. 121.
INVESTMENT GAINS AND LOSSES Net investment gains realized by the Corporation and its property and casualty insurance subsidiaries were as follows:
Sales of equity securities in each of the last three years resulted in realized investment gains due primarily to the significant appreciation in the United States equity markets. A primary reason for the sale of fixed maturities in each of the last three years has been to improve our after-tax portfolio return without sacrificing quality where market opportunities have existed to do so.
Fixed maturities which the Corporation and its insurance subsidiaries have the ability and intent to hold to maturity are classified as held-to-maturity. The remaining fixed maturities, which may be sold prior to maturity to support our investment strategies, such as in response to changes in interest rates and the yield curve or to maximize after-tax returns, are classified as available-for-sale. Fixed maturities classified as held-to-maturity are carried at amortized cost while fixed maturities classified as available-for-sale are carried at market value. At December 31, 1997, 18% of the fixed maturity portfolio was classified as held-to-maturity compared with 22% at December 31, 1996 and 30% at December 31, 1995.
The unrealized market appreciation before tax of those fixed maturities carried at amortized cost was $147 million, $130 million and $178 million at December 31, 1997, 1996 and 1995, respectively. Such unrealized appreciation was not reflected in the consolidated financial statements.
In February 1994, the Board of Directors authorized the repurchase of up to 10,000,000 shares of common stock. Through March 6, 1997, the Corporation repurchased 6,851,600 shares under the 1994 share repurchase program, including 3,148,600 shares repurchased in the first quarter of 1997. On March 7, 1997, the Board of Directors replaced the 1994 program with a new share repurchase program, which authorizes the repurchase of up to 17,500,000 shares of common stock. Through December 31, 1997, the Corporation repurchased 9,791,900 shares under the new repurchase program.
In the aggregate, the Corporation repurchased 12,940,500 shares in open-market transactions in 1997 at a cost of $828 million. In 1996, 1,700,000 shares were repurchased at a cost of $83 million.
The Corporation has outstanding $60 million of unsecured 8 3/4% notes due in 1999. In 1998, the Corporation will pay as a mandatory sinking fund an amount sufficient to redeem $30 million of principal.
As of January 1, 1997, Chubb Capital had outstanding $229 million of 6% exchangeable subordinated notes due May 15, 1998. In 1997, the holders of almost all of the notes elected the option to exchange them into shares of common stock of the Corporation, resulting in the issuance of 5,316,565 shares of common stock. The remaining notes were redeemed.
In July 1997, the Corporation entered into two credit agreements with a group of banks that provide for unsecured borrowings of up to $500 million in the aggregate. The $200 million short term revolving credit facility terminates on July 10, 1998 and may be renewed or replaced. The $300 million medium term revolving credit facility terminates on July 11, 2002. On the respective termination dates, any loans then outstanding become payable. There have been no borrowings under these agreements. These agreements replaced an agreement similar to the medium term agreement, which terminated, as well as the Corporation's lines of credit.