The executive offices of the Corporation are in Warren, New Jersey. The administrative offices of the P&C Group are located in Warren and Whitehouse Station, New Jersey. The P&C Group maintains zone administrative and branch offices in major cities throughout the United States and also has offices in Canada, Europe, Australia, Latin America and Asia. Office facilities are leased with the exception of buildings in Whitehouse Station, New Jersey and Simsbury, Connecticut. Management considers its office facilities suitable and adequate for the current level of operations.
Underwriting income reflected net losses of $24 million ($16 million after-tax or $0.04 per share) in 2006, $35 million ($23 million after-tax or $0.06 per share) in 2005, $75 million ($49 million after-tax or $0.13 per share) in 2004, $250 million ($163 million after-tax or $0.45 per share) in 2003 and $741 million ($482 million after-tax or $1.39 per share) in 2002 related to asbestos and toxic waste claims.
Underwriting income in 2005 reflected net costs of $462 million ($300 million after-tax or $.74 per share) related to Hurricane Katrina.
Management’s Discussion and Analysis of Financial Condition and Results of Operations addresses the financial condition of the Corporation as of December 31, 2006 compared with December 31, 2005 and the results of operations for each of the three years in the period ended December 31, 2006. This discussion should be read in conjunction with the consolidated financial statements and related notes and the other information contained in this report.
Certain statements in this document are “forward-looking statements” as that term is defined in the Private Securities Litigation Reform Act of 1995 (PSLRA). These forward-looking statements are made pursuant to the safe harbor provisions of the PSLRA and include statements regarding expectations as to our loss reserve and reinsurance recoverable estimates, including our estimated gross and net losses from Hurricane Katrina; the impact of future catastrophes on our financial condition and results of operations; asbestos liability developments; the number and severity of surety-related claims; the cost and availability of reinsurance in 2007; premium volume, rates and competition; the impact of investigations into market practices in the property and casualty insurance industry and any resulting business reforms; changes to our producer compensation program; our expected income stream from the transaction with Harbor Point Limited; estimates with respect to our credit derivatives exposure; the run-off of our real estate portfolio; and our capital adequacy and funding of liquidity needs. Forward-looking statements are made based upon management’s current expectations and beliefs concerning trends and future developments and their potential effects on us. These statements are not guarantees of future performance. Actual results may differ materially from those suggested by forward-looking statements as a result of risks and uncertainties, which include, among others, those discussed or identified from time to time in our public filings with the Securities and Exchange Commission and those associated with:
claims and litigation arising out of stock option “backdating,” spring loading” and other option grant practices by public companies;
claims and litigation arising out of practices in the financial services industry;
In December 2006, we entered into a settlement agreement with the Attorneys General of New York, Connecticut and Illinois resolving all issues arising out of those officials’ investigations with respect to property and casualty insurance market practices. The settlement did not require that we pay a fine or penalty. Our cost under the settlement was $17 million.
The profitability of the property and casualty insurance business depends on the results of both underwriting operations and investments. We view these as two distinct operations since the underwriting functions are managed separately from the investment function. Accordingly, in assessing our performance, we evaluate underwriting results separately from investment results.
Net premiums written from our insurance business grew 2% in 2006 and 4% in 2005. Premiums in 2005 were reduced by reinsurance reinstatement premium costs of $102 million related to Hurricane Katrina. Premiums in 2006 benefited from a $20 million reduction of previously accrued reinsurance reinstatement premium costs. Premiums in the United States, which represent almost 80% of our insurance premiums, grew by 1% in 2006 and 3% in 2005. Insurance premiums outside the U.S. grew 4% in 2006 and 8% in 2005. In local currencies, such growth was 3% and 6% in 2006 and 2005, respectively.
Our casualty clash treaty and our property reinsurance treaties expire on April 1, 2007. While we expect that reinsurance rates may rise somewhat in 2007, particularly as they relate to property risks, the final structure and amount of coverage purchased will be determinants of our ceded reinsurance premium cost in 2007. We expect that the availability of reinsurance for certain coverages, such as terrorism, will continue to be very limited in 2007.
Most of our ceded reinsurance arrangements consist of excess of loss and catastrophe contracts that protect against a specified part or all of certain types of losses over stipulated amounts arising from any one occurrence or event. Therefore, unless we incur losses that exceed our initial retention under these contracts, we do not receive any loss recoveries. As a result, in certain years, we cede premiums to other insurance companies and receive few, if any, loss recoveries. However, in a year in which there is a significant catastrophic event (such as Hurricane Katrina) or a series of large individual losses, we may receive substantial loss recoveries. The impact of ceded reinsurance on net premiums written and earned and on net losses and loss expenses incurred for the three years ended December 31, 2006 is presented in Note (10) of the Notes to Consolidated Financial Statements.
Statutory accounting principles applicable to property and casualty insurance companies differ in certain respects from generally accepted accounting principles (GAAP). Under statutory accounting principles, policy acquisition and other underwriting expenses are recognized immediately, not at the time premiums are earned. Management uses underwriting results determined in accordance with GAAP, among other measures, to assess the overall performance of our underwriting operations. To convert statutory underwriting results to a GAAP basis, policy acquisition expenses are deferred and amortized over the period in which the related premiums are earned. Underwriting income determined in accordance with GAAP is defined as premiums earned less losses incurred and GAAP underwriting expenses incurred.
The loss ratio was significantly lower in 2006 than in 2005, reflecting the favorable loss experience resulting from our disciplined underwriting in recent years as well as lower catastrophe losses. The loss ratio was modestly higher in 2005 than in 2004 due to higher catastrophe losses, primarily from Hurricane Katrina.
During 2006, a large percentage of our claims from Hurricane Katrina were settled. As a result, there were many adjustments, both favorable and unfavorable, to our loss estimates for individual claims related to this event. These adjustments produced a reduction in our estimates for gross losses and reinsurance recoverable of $190 and $175 million, respectively, as well as a $20 million reduction of previously accrued reinsurance reinstatement premium costs. We still have over $500 million of reinsurance available for this event under our catastrophe treaty if our gross losses are higher than our current estimate. Therefore, while it is possible that our estimate of ultimate losses related to
Net premiums written from personal insurance, which represented 29% of our premiums written in 2006, increased by 6% in both 2006 and 2005. Net premiums written for the classes of business within the personal insurance segment were as follows:
In 2006 and 2005, premium growth was driven by our homeowners business. The growth in our homeowners business in both years was due to increased insurance-to-value and, to a lesser extent, modestly higher rates. The in-force policy count for this class of business had minimal growth in both years. Homeowners premiums in 2005 were reduced by reinsurance reinstatement premium costs of $17 million related to Hurricane Katrina. Premium growth in our personal automobile business in 2006 and 2005 was due to selective initiatives outside the United States. Premiums in the U.S. declined in both years due to our maintaining underwriting discipline in an increasingly competitive marketplace. Growth in our other personal business, which includes insurance for excess liability, yacht and accident coverages, was similar in both years.
our homeowners results. The combined loss and expense ratios for the classes of business within the personal insurance segment were as follows:
Our personal automobile results were profitable in each of the past three years. Results in 2006 were more profitable than in 2005 due to lower claim frequency and favorable loss development related to prior accident years. Results in 2005 were slightly less profitable than in 2004 due to reserve strengthening in the liability component related to prior accident years.
Homeowners results were profitable in each of the last three years. Results improved significantly in 2005 and again in 2006. The improvement was largely the result of better pricing and a reduction in water damage losses primarily through contract wording changes related to mold coverage and loss remediation measures that we have implemented over the past few years as well as lower catastrophe losses. The impact of catastrophes accounted for 5.7 percentage points of the combined loss and expense ratio for this class in 2006 compared with 9.8 percentage points in 2005 and 12.6 percentage points in 2004.
Other personal business produced profitable results in each of the past three years. Results in 2006 were less profitable than those in 2005 and 2004. Our excess liability business has deteriorated in each of the past two years due to inadequate pricing and unfavorable loss development related to prior accident years. Our yacht business was highly profitable in 2006 compared with unprofitable results in 2005 and 2004. Our accident business was highly profitable in all three years.
Growth in our commercial classes in 2006 and 2005 was limited due to a competitive marketplace. Rates were generally stable but were under competitive pressure in some classes of business, particularly non-catastrophe exposed property risks and certain casualty risks. Multiple peril and property and marine premiums in 2005 were reduced by reinsurance reinstatement premium costs of $19 million and $66 million, respectively, related to Hurricane Katrina. In 2006, property and marine premiums benefited from a $20 million reduction of previously accrued reinsurance reinstatement premium costs. Excluding the reinsurance reinstatement premiums, multiple peril premiums declined
1% in 2006 and were flat in 2005 compared with the respective prior years and property and marine premiums grew 5% in both 2006 and 2005.
Retention levels of our existing customers remained steady over the last three years. New business volume was slightly higher in 2006 compared with 2005, with the increase coming from outside the U.S. New business volume in 2005 was significantly lower than in 2004 due to decreased submission activity, which was the result of our competitors working to retain their better accounts. We have continued to maintain our underwriting discipline in the competitive market, renewing business and writing new business only where we believe we are securing acceptable rates and appropriate terms and conditions for the exposures.
Our commercial insurance business produced profitable underwriting results in each of the past three years, particularly in 2006 and 2004. These profitable results were due in large part to the cumulative effect of price increases in prior years, better terms and conditions and more stringent risk selection. Results in each year also benefited from low non-catastrophe property losses. Results in 2005 were less profitable than in 2006 and 2004, largely due to substantially higher catastrophe losses, primarily from Hurricane Katrina. The impact of catastrophes accounted for 8.3 percentage points of the combined loss and expense ratio for our commercial insurance business in 2005 whereas such impact was negligible in 2006 and 2004.
Workers’ compensation results were highly profitable in each of the past three years. Results were more profitable in each succeeding year due to favorable claim cost trends. Results in all three years benefited from our disciplined risk selection during the past several years.
few large non-catastrophe losses. The impact of catastrophes was negligible in 2006. Catastrophes accounted for 27.2 percentage points of the combined loss and expense ratio in 2005 and 1.8 percentage points in 2004. The impact of catastrophes in 2004 reflects a $20 million reduction in net loss reserves related to the September 11, 2001 attack.
Our professional liability business improved substantially in 2005 and again in 2006, producing profitable results in 2006 compared with near breakeven results in 2005 and highly unprofitable results in 2004. The fidelity component of our professional liability business was highly profitable in each of the past three years due to favorable loss experience. The results of the directors and officers liability,
Our surety business tends to be characterized by infrequent but potentially high severity losses. We continue to manage our exposure on an absolute basis and by specific bond type. The majority of our obligations are intended to be performance-based guarantees. When losses occur, they are mitigated, at times, by the customer’s balance sheet, contract payments, collateral and bankruptcy recoveries.
To promote and distribute our insurance products, we rely on independent brokers and agents. Accordingly, our business is dependent on the willingness of these brokers and agents to recommend our products to their customers. Prior to 2007, we had agreements in place with certain insurance agents and brokers under which, in addition to the standard commissions that we pay, we agreed to pay commissions that were contingent on the volume and/or the profitability of business placed with us.
We have been involved in the ongoing investigations of certain business practices in the property and casualty insurance industry by various Attorneys General and other regulatory authorities of several states, the U.S. Securities and Exchange Commission, the U.S. Attorney for the Southern District of New York and certain non-U.S. regulatory authorities with respect to, among other things, (1) potential conflicts of interest and anti-competitive behavior arising from the payment of contingent commissions to brokers and agents and (2) loss mitigation and finite reinsurance arrangements. In connection with these investigations, we have received subpoenas and other requests for information from various regulators. We have been cooperating fully with these investigations. Although no regulatory action has been initiated against us, it is possible that one or more regulatory authorities will bring an action against us with respect to some or all of the issues that are the focus of these ongoing investigations.
On December 21, 2006, we entered into an Assurance of Discontinuance with the Attorneys General of New York, Connecticut and Illinois, resolving all issues arising out of those officials’ investigations of the market practices described above. As part of this agreement, we agreed to contribute $15 million to a settlement fund established for the benefit of certain customers. We also agreed to pay $2 million to help defray the costs of the investigations by the Attorneys General. In addition, we agreed to implement certain business reforms, including discontinuing the payment of contingent commissions in the United States on all insurance lines beginning in 2007. The settlement did not require that we pay a fine or penalty.
In lieu of paying contingent commissions, we will pay, beginning in 2007, guaranteed supplemental compensation to all agents and brokers with whom we previously had contingent commission agreements. Under this arrangement, agents and brokers will be paid a percentage of written premiums on eligible lines of business in a calendar year based upon their prior performance. We do not believe that our payment of guaranteed supplemental compensation in lieu of contingent commissions or any of the other business reforms that we are implementing will have a material adverse effect on the Corporation’s business, results of operations or financial condition.
Chubb and certain of its subsidiaries have been named in legal proceedings brought by private plaintiffs arising out of the investigations into the payment of contingent commissions to brokers and agents. These legal proceedings are further described in Note (14) of the Notes to Consolidated Financial Statements.
We cannot predict at this time the ultimate outcome of the ongoing investigations and legal proceedings referred to above, including any potential amounts that we may be required to pay in connection with them.
The extent of losses from a natural 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. We regularly assess our concentration of risk exposures in catastrophe exposed areas globally and have strategies and underwriting standards to manage this exposure through individual risk selection, subject to regulatory constraints, and through the purchase of catastrophe reinsurance. We have invested in modeling technologies and a risk concentration management tool that allow us to monitor and control our accumulations of potential losses in catastrophe exposed areas in the United States, such as California and the gulf and east coasts, as well as in such areas in other countries. Actual results may differ materially from those suggested by the model. We also continue to actively explore and analyze credible scientific evidence, including the impact of global climate change, that may affect our ability to manage exposure under the insurance policies we issue.
It is unclear at this time whether Congress will reauthorize TRIA for periods subsequent to December 31, 2007. Regardless of whether or not TRIA is extended, we will continue to manage this type of catastrophic risk by monitoring terrorism risk aggregations. Nevertheless, given the unpredictability of the targets, frequency and severity of potential terrorist events as well as the very limited terrorism reinsurance coverage available in the market, the occurrence of any such events could have a material adverse effect on the Corporation’s results of operations, financial condition or liquidity.
We also have exposure outside the United States to risk of loss from acts of terrorism. In some jurisdictions, we have access to government mechanisms that would mitigate our exposure.
Our loss reserves include case estimates for claims that have been reported and estimates for claims that have been incurred but not reported as well as estimates of the expenses associated with processing and settling all reported and unreported claims, less estimates of anticipated salvage and subrogation recoveries. Estimates are based upon past loss experience modified for current trends as well as prevailing economic, legal and social conditions. Our loss reserves are not discounted to present value.
Loss reserves, net of reinsurance recoverable, increased by $1.0 billion or 5% in 2006. The most significant increases occurred in the commercial casualty, workers’ compensation and professional liability classes of business. The decreases in gross loss reserves and reinsurance recoverable during 2006 in the property and marine, multiple peril and homeowners classes were due to payments and reductions in our loss estimates related to Hurricane Katrina. The decrease in reinsurance recoverable in the professional liability classes was due primarily to significant recoveries related to older accident years and the discontinuation of the per risk treaty in 2005.
In establishing the loss reserves of our property and casualty subsidiaries, we consider facts currently known and the present state of the law and coverage litigation. Based on all information currently available, we believe that the aggregate loss reserves at December 31, 2006 were adequate to cover claims for losses that had occurred as of that date, including both those known to us and those yet to be reported. However, as described below, there are significant uncertainties inherent in the loss reserving process. It is therefore possible that management’s estimate of the ultimate liability for losses that had occurred as of December 31, 2006 may change, which could have a material effect on the Corporation’s results of operations and financial condition.
Short tail classes consist principally of homeowners, commercial property and marine business. For these classes, the estimation of loss reserves is less complex because claims are generally reported and settled shortly after the loss occurs and the claims relate to tangible property.
Our actuaries perform a comprehensive annual review of loss reserves for each of the numerous classes of business we write prior to the determination of the year end carried reserves. The review process takes into consideration the variety of trends that impact the ultimate settlement of claims in each particular class of business. A similar, but somewhat less comprehensive, review is performed for the major classes of business prior to the determination of the June 30 carried reserves. At the end of the first and third quarters, our actuaries review the emergence of paid and reported losses relative to expectations and, as necessary, conduct reserve reviews for particular classes of business.
Loss development factor methods generally assume that the losses yet to emerge for an accident year are proportional to the paid or reported loss amount observed so far. Reported losses include cumulative paid losses plus case reserves. Historical patterns of the development of paid and reported losses by accident year are applied to current paid and reported losses to generate estimated ultimate losses by accident year.
For certain long tail classes of business, however, anticipated loss experience is less predictable because of the small number of claims and/or erratic claim severity patterns. These classes include directors and officers liability, errors and omissions liability and commercial excess liability, among others. For these classes, the actuarial estimates for the most recent accident years are based on less extrapolatory methods, such as expected loss ratio and Bornheutter-Ferguson methods. Over time, as a greater number of claims are reported and the statistical credibility of loss experience increases, loss development factor methods are given increasingly more weight.
Using all the available data, our actuaries select an indicated loss reserve amount for each class of business based on the various assumptions, projections and methods. The total indicated reserve amount determined by our actuaries is an aggregate of the indicated reserve amounts for the individual classes of business. The ultimate outcome is likely to fall within a range of potential outcomes around this indicated amount, but the indicated amount is not expected to be precisely the ultimate liability.
Senior management meets with the actuaries at the end of each quarter to review the results of the latest loss reserve analysis. Based on this review, management determines the carried reserve for
In addition, we must consider the uncertain effects of emerging or potential claims and coverage issues that arise as legal, judicial and social conditions change. These issues can have a negative effect on our loss reserves by either extending coverage beyond the original underwriting intent or by increasing the number or size of claims. Recent examples of such issues include the number of directors and officers liability claims arising out of stock option “backdating” practices by certain public companies, the number and size of directors and officers liability and errors and omissions liability claims arising out of investment banking practices and accounting and other corporate malfeasance, and exposure to claims asserted for bodily injury as a result of long-term exposure to harmful products or substances. As a result of issues such as these, the uncertainties inherent in estimating ultimate claim costs on the basis of past experience have grown, further complicating the already complex loss reserving process.
Two of the larger components of our loss reserves relate to the professional liability classes other than fidelity and commercial excess liability. The respective reported loss development patterns are key assumptions in estimating loss reserves for these classes of business, both as applied directly to more mature accident years and as applied indirectly (e.g., via Bornheutter-Ferguson methods) to less mature accident years.
Reserves for the professional liability classes other than fidelity were $6.9 billion, net of reinsurance, at December 31, 2006. Based on a review of our loss experience, if the loss development factor for each accident year changed such that the cumulative loss development factor for the most recent accident year changed by 10%, we estimate that the net reserves for the professional liability classes other than fidelity would change by approximately $600 million, in either direction. This degree of change in the reported loss development pattern is within the historical variation around the averages in our data.
Reserves Relating to Asbestos and Toxic Waste Claims. The estimation of loss reserves relating to asbestos and toxic waste claims on insurance policies written many years ago is subject to greater uncertainty than other types of claims due to inconsistent court decisions as well as judicial
New asbestos claims and new exposures on existing claims have continued despite the fact that usage of asbestos has declined since the mid-1970’s. Each claim filing typically names dozens of defendants. The plaintiffs’ bar has solicited new claimants through extensive advertising and through asbestos medical screenings. A vast majority of asbestos bodily injury claims have been filed by claimants who do not show any signs of asbestos related disease. New asbestos cases are often filed in those jurisdictions with a reputation for judges and juries that are extremely sympathetic to plaintiffs.
There have been several recent positive events in the asbestos environment:
Various challenges to mass screening claimants have been mounted, including a June 2005 U.S. District Court decision in Texas. Many believe that this decision is leading to higher medical evidentiary standards. For example, several asbestos injury settlement trusts have refused new claims that were based on the diagnosis of physicians or screening companies named in the case, citing questions regarding their reliability. Further investigations of the medical screening process for asbestos claims are underway.
Our other asbestos exposures involve products and non-products liability on the part of “peripheral” defendants, including a mix of manufacturers, distributors and installers of certain products that contain asbestos in small quantities and owners or operators of properties where asbestos was present. Generally, these insureds are named defendants on a regional rather than a nationwide basis. As the financial resources of traditional asbestos defendants have been depleted, plaintiffs are targeting these viable peripheral parties with greater frequency and, in many cases, for larger awards.
Asbestos claims against the major manufacturers, distributors or installers of asbestos products were typically presented under the products liability section of primary general liability policies as well as under excess liability policies, both of which typically had aggregate limits that capped an insurer’s exposure. In recent years, a number of asbestos claims by insureds are being presented as “non-products” claims, such as those by installers of asbestos products and by property owners or operators who allegedly had asbestos on their property, under the premises or operations section of primary general liability policies. Unlike products exposures, these non-products exposures typically had no aggregate limits on coverage, creating potentially greater exposure. Further, in an effort to seek additional insurance coverage, some insureds with installation activities who have substantially eroded their products coverage are presenting new asbestos claims as non-products operations claims or attempting to reclassify previously settled products claims as non-products claims to restore a portion of previously exhausted products aggregate limits. It is difficult to predict whether insureds will be successful in asserting claims under non-products coverage or whether insurers will be successful in asserting additional defenses. Accordingly, the ultimate cost to insurers of the claims for coverage not subject to aggregate limits is uncertain.
Our actuaries and claim personnel perform periodic analyses of our asbestos related exposures. The analyses during 2004 noted that both the number of peripheral asbestos defendants for whom we established reserves and the average severity of these claims were somewhat higher than expected. In
the efforts by insureds to obtain coverage not subject to aggregate limits;
In establishing our toxic waste reserves, we evaluate the exposure presented by each insured. As part of this evaluation, we consider a variety of factors including: the probable liability, available insurance coverage, relevant judicial interpretations, past settlement values of similar claims as well as facts that are unique to each insured.
The following table presents a reconciliation of our beginning and ending loss reserves, net of reinsurance recoverable, related to toxic waste claims. There are virtually no reinsurance recoveries related to these claims.
Ceded reinsurance contracts do not relieve our primary obligation to our policyholders. Consequently, an exposure exists with respect to reinsurance recoverable to the extent that any reinsurer is unable to meet its obligations or disputes the liabilities assumed under the reinsurance contracts. We are selective in regard to our reinsurers, placing reinsurance with only those reinsurers with strong balance sheets and superior underwriting ability, and we monitor the financial strength of our reinsurers on an ongoing basis. Nevertheless, in recent years, certain of our reinsurers have experienced financial difficulties or exited the reinsurance business. In addition, we may become involved in coverage disputes with our reinsurers. A provision for estimated uncollectible reinsurance is recorded based on periodic evaluations of balances due from reinsurers, the financial condition of the reinsurers, coverage disputes and other relevant factors.
A reconciliation of our beginning and ending loss reserves, net of reinsurance, for the three years ended December 31, 2006 is as follows:
The net favorable development of $296 million in 2006 was due to various factors. The most significant factors were:
We experienced favorable development of about $190 million in the short tail homeowners and commercial property classes, primarily related to the 2005 accident year. This favorable development arose from the lower than expected emergence of losses during 2006 relative to expectations used to establish our loss reserves at the end of 2005. The severity of late reported property claims that emerged during 2006 was lower than expected and case development, including salvage recoveries, on previously reported claims was better than expected. Because the incidence of property losses is subject to a considerable element of fortuity, reserve estimates for these classes are based on an analysis of past loss experience on average over a period of years. As a result, the favorable development in 2006 was recognized but had a relatively modest effect on our determination of carried property loss reserves at December 31, 2006.
We experienced favorable development of about $45 million in the professional liability classes other than fidelity. Favorable development in the 2004 and 2005 accident years more than offset continued unfavorable development in accident years 2000 through 2002. Reported loss activity related to accident years 2004 and 2005 was less than expected due to a favorable business climate, lower policy limits and better terms and conditions. While these accident years are somewhat immature, we concluded that there was sufficient evidence to modestly decrease the
expected loss ratios for these accident years. On the other hand, we continued to experience significant reported loss activity related to the 2000 through 2002 accident years, largely from claims related to corporate failures and allegations of management misconduct and accounting irregularities. As a result, we increased the expected loss ratios for these accident years. The fact that our initial estimates for accident years 2003 and subsequent are developing favorably was recognized as one among several factors in the determination of loss reserves for the 2006 accident year for these classes. Other factors included the specific aspects of the current claim environment and the recent downward trend in prices.
We experienced adverse development of about $100 million in the commercial liability classes, including $24 million related to asbestos and toxic waste claims. The adverse development was primarily due to reported loss activity in accident years prior to 1997 that was worse than expected. Modestly adverse development in the 1997 through 2002 accident years was offset by favorable development in the more recent accident years. The loss activity in accident years prior to 1997 primarily related to specific individual excess liability and other liability claims, which are inherently volatile. Therefore, this adverse development had little overall effect on our determination of carried loss reserves for these classes at December 31, 2006.
We experienced adverse development of about $200 million in the professional liability classes other than fidelity. The adverse development resulted from continued significant reported loss activity related to accident years 1998 through 2002, largely from claims related to corporate failures and allegations of management misconduct and accounting irregularities. As a result, we increased the expected loss ratios for these accident years. Conversely, reported loss activity related to accident years 2003 and 2004 was less than expected due to a favorable business climate, lower policy limits and better terms and conditions. While these accident years are somewhat immature, we concluded that there was sufficient evidence to modestly decrease the expected loss ratios for these accident years.
We experienced adverse development of about $175 million related to accident years prior to 1996, including $35 million related to asbestos claims. The adverse development was due largely to our strengthening loss reserves for commercial liability classes, primarily commercial excess liability. There was significant reported loss activity during 2005 related to these older accident years, which caused us to extend the expected loss emergence period.
We experienced favorable development of about $60 million in the fidelity classes due to lower than expected reported loss emergence, mainly related to more recent accident years.
We experienced adverse development of about $185 million related to accident years prior to 1995, including $75 million related to asbestos claims. We strengthened loss reserves for certain commercial liability classes due to significant reported loss activity during 2004 related to these older accident years.
Our U.S. property and casualty subsidiaries are required to file annual statements with insurance regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities. These annual statements include an analysis of loss reserves, referred to as Schedule P, that presents accident year loss development information by line of business for the nine years prior to 2006. It is our intention to post the Schedule P for our combined U.S. property and casualty subsidiaries on our website as soon as it becomes available.
The effective tax rate on our investment income was 19.8% in 2006 compared with 19.7% in 2005 and 19.8% in 2004. The effective tax rate fluctuates as the result of our holding a different proportion of our investment portfolio in tax-exempt securities during each year.
On an after-tax basis, property and casualty investment income increased by 10% in 2006 and 11% in 2005. Management uses property and casualty investment income after-tax, a non-GAAP financial measure, to evaluate its investment performance because it reflects the impact of any change in the proportion of the investment portfolio invested in tax-exempt securities and is therefore more meaningful for analysis purposes than investment income before income tax.
Corporate and other includes investment income earned on corporate invested assets, interest expense and other expenses not allocated to the operating subsidiaries, and the results of our real
estate and other non-insurance subsidiaries. The results of Chubb Financial Solutions (CFS), which were previously reported separately, are now included in corporate and other. CFS, which provided customized financial products to corporate clients, has been in run-off since April 2003.
Corporate and other also included income from our investment in a corporate joint venture, Allied World Assurance Company, Ltd. We acquired an interest in Allied World in 2001 and used the equity method of accounting for this investment. Income from this investment did not have a material effect on the Corporation’s results of operations in any year but did fluctuate significantly from quarter to quarter. In July 2006, Allied World sold previously unissued shares of common stock through an initial public offering. As a result of the public offering, we no longer consider Allied World to be a corporate joint venture. Accordingly, the equity method of accounting is no longer used for this investment. Instead, our investment in Allied World is now classified as an equity security. As such, it is carried at market value as of the balance sheet date with unrealized appreciation or depreciation credited or charged to comprehensive income. Consequently, income from our investment in Allied World will now only include any dividends we receive and gains or losses from any sale of our investment.
Real estate operations resulted in a loss before taxes of $3 million in 2006 compared with losses of $41 million in 2005 and $25 million in 2004. The improvement in real estate results in 2006 was due to a significant decrease in impairment losses compared with 2005. During 2005, we committed to a plan to sell a parcel of land in New Jersey that we had previously intended to hold and develop. The decision to sell the property was based on our assessment of the real estate market and our concern about zoning issues. As a result of our decision to sell this property, we reassessed the recoverability of its carrying value. Based on our reassessment, we recognized an impairment loss of $48 million during the year to reduce the carrying value of the property to its estimated fair value. The loss in 2004 was due primarily to the recognition of impairment losses on two commercial properties.
Real estate revenues were $202 million in 2006, $115 million in 2005 and $70 million in 2004. The higher revenues in 2006 were due to the sale of one commercial property for approximately $110 million.
In a typical portfolio credit default swap, CFS participated in the senior layer of a structure designed to replicate the performance of a portfolio of corporate or asset-backed securities. The
CFS produced near breakeven results in 2006 compared with a loss before taxes of $9 million in 2005 and $19 million in 2004. The loss in 2005 related to the termination of a principal and interest guarantee contract. The loss in 2004 related to the termination of CFS’s obligations under several portfolio credit default swaps.
Since we decided to exit this business, CFS has terminated certain portfolio credit default swaps with the original counterparties at negotiated settlement amounts. CFS has also entered into credit default swaps with third parties that effectively offset existing credit default swaps. As of December 31, 2006, the notional amount of such offsetting credit default swaps was approximately $1.7 billion.
In addition to portfolio credit default swaps, CFS entered into a derivative contract linked to an equity market index that terminates in 2012 and a few other insignificant transactions.
The net realized gains on other invested assets represent our share of changes in the estimated fair value of limited partnerships in which we have an interest.
In 2004, we sold The Chubb Institute. Under the terms of the sale, we recognized a loss of $31 million.
Information related to investment securities in an unrealized loss position at December 31, 2006 and 2005 is included in Note (4)(b) of the Notes to Consolidated Financial Statements.
In 2002, Chubb issued $600 million of unsecured 4% senior notes due in 2007 and 24 million mandatorily exercisable warrants to purchase its common stock. The notes and warrants were issued together in the form of 7% equity units, each of which initially represented $25 principal amount of notes and one warrant. In August 2005, the notes were successfully remarketed as required by their
Chubb and its insurance subsidiaries are rated by major rating agencies. These ratings reflect the rating agency’s opinion of our financial strength, operating performance, strategic position and ability to meet our obligations to policyholders.
It is possible that positive or negative rating actions by one or more of the rating agencies may occur in the future. If our ratings were downgraded, we may incur higher borrowing costs and may have more limited means to access capital. In addition, a downgrade in our financial strength ratings could adversely affect the competitive position of our insurance operations, including a possible reduction in demand for our products in certain markets.
Our property and casualty subsidiaries maintain investments in highly liquid, short-term and other marketable securities. Accordingly, we do not anticipate selling long-term fixed maturity investments to meet any liquidity needs.
Chubb has a revolving credit agreement with a group of banks that provides for unsecured borrowings of up to $500 million. The revolving credit facility terminates on June 22, 2010. On the termination date of the agreement, any loans then outstanding become payable. There have been no borrowings under this agreement. Various interest rate options are available to Chubb, all of which are based on market interest rates. The agreement contains customary restrictive covenants including a covenant to maintain a minimum consolidated shareholders’ equity, as adjusted. At December 31, 2006, Chubb was in compliance with all such covenants. The facility is available for general corporate purposes and to support our commercial paper borrowing arrangement.
The above table excludes certain commitments totaling $1.5 billion at December 31, 2006 to fund limited partnership investments. These capital commitments can be called by the partnerships during the commitment period (on average, 1 to 5 years) to fund working capital needs or the purchase of new investments.
The above table also excludes estimated future cash flows related to our carried loss reserves at December 31, 2006. There is typically no stated contractual commitment associated with property and casualty insurance loss reserves. The obligation to pay a claim arises only when a covered loss event occurs and a settlement is reached. The vast majority of our loss reserves relate to claims for which
settlements have not yet been reached. Our loss reserves therefore represent estimates of future payments. These estimates are dependent on the outcome of claim settlements that will occur over many years. Accordingly, the payment of the loss reserves is not fixed as to either amount or timing.
The Corporation does not have any off-balance sheet arrangements that are reasonably likely to have a material effect on the Corporation’s financial condition, results of operations, liquidity or capital resources, other than as disclosed in Note (14) of the Notes to Consolidated Financial Statements.
The main objectives in managing our investment portfolios are to maximize after-tax investment income and total investment returns while minimizing credit risks in order to provide maximum support to the insurance underwriting operations. Investment strategies are developed based on many factors including underwriting results and our resulting tax position, regulatory requirements, fluctuations in interest rates and consideration of other market risks. Investment decisions are centrally managed by investment professionals based on guidelines established by management and approved by the boards of directors of Chubb and the respective operating companies.
Our investment portfolio is primarily comprised of high quality bonds, principally tax-exempt, U.S. Treasury and government agency, mortgage-backed securities and corporate issues as well as foreign government and corporate bonds that support our international operations. In addition, the portfolio includes equity securities, primarily publicly traded common stocks, and other invested assets, primarily private equity limited partnerships, all of which are held with the objective of capital appreciation.
In our U.S. operations, during 2006, 2005 and 2004, we invested new cash in tax-exempt bonds and, to a lesser extent, equity securities. In 2005 and 2004, we also invested new cash in taxable bonds, whereas in 2006 we decreased our holdings of taxable bonds, principally U.S. Treasury securities. In 2005, the taxable bonds we invested in were primarily mortgage-backed securities and, to a lesser extent, corporate bonds. In 2004, the taxable bonds were primarily U.S. Treasury securities and mortgage-backed securities and, to a lesser extent, corporate bonds. Our objective is to achieve the appropriate mix of taxable and tax-exempt securities in our portfolio to balance both investment and tax strategies. At December 31, 2006, 65% of our U.S. fixed maturity portfolio was invested in tax-exempt bonds compared with 60% at December 31, 2005 and 59% at December 31, 2004.
Changes in the general interest rate environment affect the returns available on new fixed maturity investments. While a rising interest rate environment enhances the returns available on new investments, it reduces the market value of existing fixed maturity investments and thus the availability of gains on disposition. A decline in interest rates reduces the returns available on new investments but increases the market value of existing investments, creating the opportunity for realized investment gains on disposition.
The unrealized market appreciation before tax of those fixed maturities carried at amortized cost was $7 million, $11 million and $21 million at December 31, 2006, 2005 and 2004, respectively. Such unrealized appreciation was not reflected in the consolidated financial statements.
Effective December 31, 2006, we adopted Statement of Financial Accounting Standards (SFAS) No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R). SFAS No. 158 requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in the funded status in comprehensive income in the year in which the changes occur. Retrospective application is not permitted. The adoption of SFAS No. 158 reduced shareholders’ equity at December 31, 2006 by $281 million. Adoption of the Statement did not have any effect on the Corporation’s net income in 2006 and will not in future years. The adoption of the SFAS No. 158 is discussed further in Note (2)(c) of the Notes to Consolidated Financial Statements.