The Continental Corporation-In the fourth quarter of 1994, CNA reached an agreement to purchase the outstanding shares of common stock of The Continental Corporation ("CIC") through a cash merger for approximately $1.1 billion, or $20 a share. This transaction will create the third largest U.S. property and casualty insurance group and make CNA the seventh largest U.S. insurance organization. This acquisition will be accounted for as a purchase. Accordingly, CIC's results of operations will be included in CNA's consolidated
results of operations from the date of acquisition, which is expected in the second quarter of 1995. The transaction closing is subject to the approval of CIC's shareholders and state insurance regulators. CNA and CIC are jointly seeking prompt regulatory approvals. Until the acquisition is complete, CIC will continue to operate independently. As part of the CIC transaction, on December 6, 1994, CNA invested $275 million of cash in exchange for sinking fund preferred stock of CIC. At December 31, 1994, this investment is shown in CNA's financial statements as redeemable preferred stock. CNA has reached an agreement in principle with a syndicate of banks to provide initial financing through a revolving loan facility. The revolving loan facility will have a maturity of five years without any prepayment restrictions. This loan will allow CNA to consummate the merger and facilitate a smooth transition expeditiously, while providing the needed flexibility to determine the ultimate capital structure at a time when it is advantageous to raise debt or a combination of debt and equity in the capital markets. CIC, with approximately 8,000 employees, is headquartered in New York. It is the 11th largest U.S. property and casualty insurance company based on 1993 premium volume, with revenues and net loss for the year ended December 31, 1994 of approximately $5.1 billion and $602.9 million, respectively. Total assets are approximately $16.0 billion at December 31, 1994. CIC's business strengths are in its package policies for commercial and personal lines and its specialty lines business. There will be market efficiencies and economies of scale in many of the product lines both companies write. CNA will be integrating the best features of both companies. CIC has established expertise and market position in the higher margin specialty lines that complement CNA's specialty lines. In personal lines, the combined businesses will create the critical mass needed to be a very low cost producer. CIC's commercial distribution system will enhance CNA's network of strong agency relationships. In 1995, CNA's major priority will be integrating CIC, while continuing to keep CNA's current businesses running smoothly. Transition planning teams will take up this challenge. The transition organization is designed with an overall management structure similar to what CIC and CNA currently have in place, a structure of business units that have a high degree of independence, but share centralized services where it is more efficient.
Alexsis-CNA's Continental Casualty subsidiary has acquired the stock of Alexsis Inc. and related entities ("Alexsis"), wholly owned subsidiaries of Alexander & Alexander Services, Inc., for approximately $45 million in cash, under a definitive agreement signed on January 16, 1995. Alexsis is one of the country's three largest property and casualty third- party administrators ("TPA") with 1994 revenues of more than $100 million and 1,300 employees. Alexsis customers are large organizations that fully or partially self-insure their risks and separately purchase specific administrative services, such as claims administration, from TPA's. The acquisition closed February 28, 1995.
CNA's property and casualty insurance subsidiaries statutory surplus grew from $3.1 billion in 1989 to $3.9 billion in 1991. In 1992, property and casualty surplus declined to $3.1 billion primarily due to $1.5 billion in asbestos reserve increases, partially offset by accounting changes described in Note 1 of the Notes to Consolidated Financial Statements. In 1993, property and casualty surplus rose to approximately $3.6 billion despite another $500 million increase in asbestos reserves relating to Fibreboard. In 1994 surplus declined to $3.4 billion, primarily attributable to realized losses. Statutory surplus of CNA's life insurance subsidiaries grew from $786 million at December 31, 1989 to more than $1 billion at December 31, 1994. Included in the property and casualty surplus increases are capital contributions from CNA to Casualty of $475 million in 1993, $120 million in 1990 and $200 million in 1989. Dividends of $175, $150, $100, $130 and $100 million were paid to CNA by Casualty in 1994, 1993, 1992, 1991 and 1989, respectively. Life statutory surplus includes capital contributions from Casualty to Continental Assurance Company of $100 and $130 million, in 1990 and 1989, respectively. CNA's investment portfolio increased by $1.6 billion, or 6.2%, to $26.9 billion, primarily as a result of securities lending activity of $1.9 billion where CNA sells securities to brokers while agreeing to repurchase them at a future date. This increase was partially offset by a decline in fair values of fixed income securities due to rising interest rates. The liquidity requirements of CNA have been met primarily by funds generated from operations. The principal operating cash flow sources of CNA's property and casualty and life insurance subsidiaries are
premiums and investment income. The primary operating cash flow uses are payments for claims, policy benefits and operating expenses. For the year ended December 31, 1994, CNA's operating activities generated net cash flows of $1.0 billion compared to $1.3 billion in 1993 and $1.0 billion in 1992. The decrease in cash flow, as compared with 1993, is due primarily to Fibreboard claim payments, catastrophe claim payments, and a decline in federal income tax recoveries. CNA believes that future liquidity needs will be met primarily from operations, other than for financing needs related to the CIC acquisition. Additional sources of cash flow include sales and maturities of investments, and financing activities. Net cash flows are invested in marketable securities. Investment strategies employed by CNA's insurance subsidiaries consider the cash flow requirements of the insurance products sold, and the tax attributes of the various types of marketable investments.
Loews Hotels Holding Corporation and subsidiaries. Funds from operations continue to exceed operating requirements. Funds for capital expenditures and working capital requirements are expected to be provided from operations. Funds for any hotel acquisitions would be expected to be provided through the Company.
Bulova Corporation and subsidiaries ("Bulova"). Bulova is a 97% owned subsidiary of the Company. On January 17, 1995, Bulova sold its industrial and defense manufacturing business, Bulova Technologies, Inc., for $20,810,000 in cash. Bulova used $18 million of proceeds to repay its advance from the Company. The sale will result in a small gain to be recorded in the first quarter of 1995. Competition and oversupply of watch products continue to adversely affect Bulova. Bulova may require working capital advances from the Company from time to time. While the Company has no obligation to enter into or maintain arrangements for any funding requirements, it is anticipated that it would be provided through various arrangements with Bulova.
In September 1994 the Company received approximately $270.4 million cash proceeds related to CBS's offer to its shareholders to purchase shares of its common stock. During 1994 the Company purchased 2,559,800 shares of its outstanding Common Stock at an aggregate cost of approximately $226.9 million. The funds required for such purchases were provided from working capital. Depending on market conditions, the Company from time to time may purchase additional shares in the open market or otherwise. In addition, during the year the Company purchased 641,500 shares of CNA's outstanding common stock at an aggregate cost of approximately $39.3 million. The Company continues to seek expansion of existing businesses and acquisitions of new businesses; however, it will continue to resist marginal acquisitions.
markets and are priced by broker-dealers. At December 31, 1994, the amortized cost was in excess of the fair value of asset-backed securities by approximately $181 million, as compared to fair value in excess of amortized cost by approximately $87 million for the comparable period a year ago. CNA limits the risks associated with interest rate fluctuations and prepayment by concentrating its CMO investments in planned amortization classes with relatively short principal repayment windows. CNA avoids investments in complex mortgage derivatives without readily ascertainable market prices. Over the last few years, much concern has been raised regarding the quality of insurance company invested assets. At December 31, 1994, 64% of the general account's debt securities portfolio was invested in U.S. government and affiliated securities, 18% in other AAA rated securities and 11% in AA and A rated securities. CNA's GIC fixed income portfolio is comprised of 29% U.S. government and affiliated securities, 20% other AAA rated securities and 18% in AA and A rated securities. These ratings are primarily from Standard & Poor's (95% of the general account portfolio and 94% of the GIC portfolio). In addition, CNA's investment in mortgage loans and real estate are substantially below the industry average. CNA holds a small amount of derivative instruments for purposes of enhancing income and total return. The derivative instruments are marked to market and reported as realized investment gains and losses. CNA's investment in, and risk in relation to, derivative instruments are not significant.
Reserve strengthening related to prior years, net of reinsurance recoverable, amounted to $590 and $1,617 million for the years 1993 and 1992, respectively. Reserve development includes strengthening of $37, $601 and $1,689 million for years 1994, 1993 and 1992, respectively, for asbestos claims, primarily representing reserve additions related to the Fibreboard litigation, as discussed previously. Adverse reserve development for environmental pollution claim and claim expenses totaled $180, $446 and $48 million, for the years 1994, 1993 and 1992, respectively. Prior to 1993, CNA identified reserves only for reported environmental pollution claims. As of December 31, 1994 and 1993, CNA carried approximately $427 and $340 million, respectively, of claim and claim expense reserves for unreported environmental pollution claims in addition to the $79 and $94 million, respectively, of reserves recorded for reported claims. CNA has not attributed any reinsurance to reserves for unreported claims. The reserves for reported claims cited above are net of reinsurance recoverable of $3 and $5 million at December 31, 1994 and 1993, respectively. See Notes 10 and 18 of the Notes to Consolidated Financial Statements for further discussion of asbestos and environmental pollution exposures. In early 1994, Casualty began to reposition its portfolios to longer maturities. The repositioning was undertaken in order to improve future overall investment returns. Casualty reduced its short-term portfolios and purchased five and ten year government securities. Short-term investments (excluding investments relating to loaned securities) for the property and casualty subsidiaries decreased from $5.1 billion at December 31, 1993 to $2.3 billion at December 31, 1994. Casualty sold approximately $25.0 billion of fixed income and equity securities in 1994, realizing pre-tax net losses of $167.9 million. Of the securities sold, approximately $15, $7 and $3 billion were from the U.S. Treasury, Government mortgage-backed and tax exempt municipal bond portfolios, respectively. CNA sells a variety of individual and group insurance products. The individual and group insurance products currently being marketed consist primarily of term, universal life, participating policies and individual annuity products. Group insurance products include life, accident and health, consisting primarily of major medical and hospitalization, and pension products. Life insurance revenues increased by $80.5 and $87.4 million, or 2.9% and 3.1%, as compared to 1993 and 1992, respectively. Life premium revenues increased by $224.4 and $223.8 million, or 9.4% and 9.4%, as compared to 1993 and 1992, respectively. Life investment income increased by approximately 20% for the same reasons described for property and casualty operations. Short-term investments (excluding investments relating to loaned securities) for the life group decreased from $1.2 billion at December 31, 1993 to $260.7 million at December 31, 1994.
Revenues increased by $6.7 million, or 0.3%, and decreased by $269.9 million, or 12.3%, as compared to 1993 and 1992, respectively. Income before accounting changes increased by $7.2 million, or 2.1%, and decreased by $176.7 million, or 33.7%, as compared to 1993 and 1992, respectively. Revenues increased, as compared to 1993, by approximately $225.0 million, or 11.7%, due to an increase in unit sales volume, partially offset by a decline of approximately $218.3 million, or 11.4%, due to lower unit prices. Compared to 1992, revenues declined by approximately $297.6 million, or 13.6%, due to lower unit prices, partially offset by an increase of approximately $27.7 million, or 1.3%, due to increased sales volume. The price decline as compared to 1992 included an increase of approximately $71.7 million, or 3.3%, from the increase of federal excise taxes of $2.00 per thousand cigarettes on January 1, 1993. Lorillard's unit sales volume increased by 13.3% and 1.4% as compared to 1993 and 1992, respectively. Unit sales volume of the U.S. cigarette industry has increased by 6.2% and declined 9.0% over the same periods. Newport, a premium brand which accounts for two-thirds of Lorillard's unit sales, increased by 11.5% and 2.8% as compared to 1993 and 1992, respectively. With the industry wide list price reduction of premium price brands, effective August 9, 1993, the growth rate of discount brands appears to have slowed and Lorillard's product line has benefited in terms of unit sales. Discount brand sales have increased from an average of 30% during 1992 to an average of 33% during 1994. At December 31, 1994, they represented 31.5% of industry sales. Virtually all of Lorillard's sales are in the premium brand category. Although Lorillard has benefited from an increase in unit sales volume, the overall impact of the pricing changes has reduced industry profit margins. It is expected that lower consumer cigarette consumption will continue to influence overall industry unit volume and the discount category will be a significant influence in overall sales.
U.S. federal excise taxes on cigarettes increased $2.00 per thousand effective January 1, 1993. The effects of any additional federal tax increases, as well as increases by state and local taxing authorities, or manufacturers' price increases cannot be determined, but it is likely they would add to the overall industry decline and the growth in the discount category.
Revenues increased by $15.5 and $86.0 million, or 5.4% and 39.5%, as compared to 1993 and 1992, respectively. Net loss increased by $19.4 million and decreased by $15.2 million as compared to 1993 and 1992, respectively. Diamond Offshore began 1994 with strong demand in the Gulf of Mexico where many of its rigs are located, although utilization declined due to an influx of rigs into the region from other depressed areas of the world. As a result, day rates never responded to the increased demand and were also negatively impacted by a depressed natural gas price during the second half of 1994. Internationally, depressed conditions continued through the first half of 1994 due mainly to depressed oil prices and political instability in some countries. However, a second half improvement in the price of oil strengthened demand as operators reinstated deferred drilling programs. Revenues increased, as compared to 1993, due to higher day rates for international semisubmersible rigs and increased number of offshore turnkey wells drilled. Net loss increased due to higher rig maintenance costs, relocation expenses and increased interest expense. Revenues increased and net loss decreased, as compared to 1992, due to increased utilization and day rates for domestic semisubmersible rigs.
Revenues decreased by $233.1 and $205.6 million, as compared to 1993 and 1992, respectively. Net income decreased by $160.8 and $167.8 million as compared to 1993 and 1992, respectively. Other operations consist primarily of investment income of non-insurance companies and the Company's investment in CBS Inc. Revenues and net income decreased due primarily to realized investment losses from securities transactions. Pre-tax realized investment (losses) gains amounted to $(201.9), $62.5 and $49.2 million for the years ended December 31, 1994, 1993 and 1992, respectively. Realized investment (losses) gains after-tax amounted to $(131.3), $38.7 and $31.3 million for the respective periods. Exclusive of securities transactions, other revenues increased $31.4 and $45.5 million, or 29.8% and 50.0%, due primarily to increased investment income and, as compared to 1992, higher earnings (accounted for under the equity method) of CBS Inc. Net income increased by $9.2 million and decreased by $5.1 million due primarily to the increased revenues discussed above. Net income decreased, as compared to 1992, due to higher interest expense, partially offset by the increased revenues.
Principles of Consolidation-The consolidated financial statements include all significant subsidiaries and all material intercompany accounts and transactions have been eliminated. The equity method of accounting is used for investments in associated companies in which the Company generally has an interest of 20% to 50%.
Investments-Investments in securities, which are held principally by insurance subsidiaries of CNA, are carried as follows: The Company believes it has the ability to hold all fixed income investments until maturity. However, securities may be sold to take advantage of investment opportunities generated by changing interest rates, prepayments, tax and credit considerations, as part of the Company's asset/liability strategy, or for other similar factors. As a result, the Company considers its fixed maturity securities (bonds and redeemable preferred stocks) and equity securities as available for sale and they are carried at fair value. The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in investment income. Derivative instruments are generally held for trading purposes and as such, are marked to market and gains or losses are included in realized investment gains or losses.
Mortgage loans are carried at unpaid principal balances, including unamortized premium or discount. Real estate is carried at depreciated cost. Policy loans are carried at unpaid balances. Short-term investments include U.S. government securities, commercial paper and time deposits and are carried at fair value, which approximates amortized cost. All securities transactions are recorded on the trade date. The cost of securities sold is determined by the identified certificate method. The unrealized gain or loss on investments which are revalued to current market values is net of applicable deferred income taxes and participating policyholders' and minority interests and is reflected as part of shareholders' equity in unrealized (depreciation) appreciation. Investments are written down to estimated fair values and losses are charged to income when a decline in value is considered to be other than temporary. Securities sold under agreements to repurchase-The Company has a securities lending program where securities are loaned to third parties, primarily major brokerage firms. Borrowers of these securities must deposit cash and/or securities equal to 102% of the market value of the securities, plus interest. Cash deposits from these transactions have been invested in short-term investments (primarily U.S. government securities and commercial paper). The Company continues to receive the interest on the loaned debt securities, as beneficial owner, and accordingly the loaned debt securities are included in fixed maturity securities.
Insurance Operations-Premium revenue-Insurance premiums on property and casualty and health insurance contracts (included in life premiums) are earned ratably over the terms of the policies after provision for estimated adjustments on retrospectively rated policies and deductions for ceded insurance. Revenues on universal life type contracts are comprised of contract charges and fees which are recognized over the coverage period when assessed against the policyholders' account balances. Other life insurance premiums are recognized as revenue when due after deductions for ceded insurance. Claim and claim expense reserves-Claim and claim expense reserves, except reserves for structured settlements, workers' compensation lifetime claims and accident and health disability claims, are based on (a) case basis estimates for losses reported on direct business, adjusted in the aggregate for ultimate loss expectations, (b) estimates of unreported losses based upon past experience, (c) estimates of assumed insurance, (d) estimates of future expenses to be incurred in settlement of claims, and (e) estimates of claim recoveries. In establishing these estimates, consideration is given to current conditions and trends as well as past company and industry experience. Structured settlements have been negotiated for claims on certain property and casualty insurance policies. Structured settlements are agreements to provide periodic payments to claimants, which are fixed and determinable as to the amount and time of payment. Certain structured settlements are funded by annuities purchased from CNA's life insurance subsidiary. Related annuity obligations are carried in future policy benefits reserves. Obligations for structured settlements not funded by annuities are carried at discounted values which approximate the alternative cost of annuity purchases. Such reserves, discounted at interest rates ranging from 6.3% to 7.5%, totaled $839,000,000 and $748,900,000 at December 31, 1994 and 1993, respectively. Workers' compensation lifetime claims and accident and health disability claim reserves are discounted at interest rates ranging from 3.5% to 6.0% with mortality and morbidity assumptions reflecting current industry experience. Such discounted reserves totaled $1,114,900,000 and $969,800,000 at December 31, 1994 and 1993, respectively. Claim and claim expense reserves are based on estimates and the ultimate liability may vary significantly from such estimates. Any adjustments that are made to the reserves are reflected in operating income in the year such adjustments are made. See Note 10 for a further discussion of claim and claim expense reserves. Future policy benefits reserves-Reserves for traditional life insurance products are computed based upon net level premium methods using actuarial assumptions as to interest rates, mortality, morbidity, withdrawals and expenses. Actuarial assumptions include a margin for adverse deviations and generally vary by plan, age at issue and policy duration. Interest rates range from 3% to 10.5%, and mortality, morbidity and withdrawal assumptions reflect CNA and industry experience prevailing at the time of issue. Renewal expense estimates include the estimated effects of inflation and expenses beyond the premium paying period. Involuntary risks-CNA's share of involuntary risks is generally a function of its share of the voluntary market by line of insurance in each state. CNA records the estimated effects of its mandatory participation in residual markets on an accrual basis. These estimates are adjusted as premium, claim and expense activity are received from the residual markets' administrators. CNA records assessments for insolvencies as they are paid rather than on an accrual basis. Such an accrual process would be very difficult, as past experience is not a reliable indicator of future activity. Further, information currently available from all the states' life and property and casualty guarantee funds is fairly limited and would not provide reliable data on which to base an estimated liability.
Many states allow recovery of insolvency assessments by a direct offset to premium taxes or a separate policy surcharge. In addition, some states assess prospectively based on current premiums written. Reinsurance-CNA assumes and cedes insurance with other insurers and reinsurers and members of various reinsurance pools and associations. CNA utilizes reinsurance arrangements to limit its maximum loss, to provide greater diversification of risk and to minimize exposures on larger risks. The reinsurance coverages are tailored to the specific risk characteristics of each product line with CNA's retained amount varying by type of coverage. Generally, reinsurance coverage for property risks is on excess of loss, per risk basis. Liability coverages are generally reinsured on a quota share basis in excess of CNA's retained risk. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Deferred policy acquisition costs-Costs of acquiring insurance business, which vary with and are primarily related to the production of such business, are deferred. Such costs include commissions, premium taxes, and certain underwriting and policy issuance costs. Property and casualty acquisition costs are amortized ratably over the period the related premiums are recognized. Anticipated investment income is considered in the determination of the recoverability of deferred policy acquisition costs. Life acquisition costs are capitalized and amortized based on assumptions consistent with those used for computing policy benefit reserves. Acquisition costs on ordinary life business are amortized over the assumed premium paying periods. Universal life and investment annuity acquisition costs are amortized in proportion to the present value of estimated gross profits over the products' assumed durations, which are regularly evaluated and adjusted, as appropriate. To the extent that unrealized gains or losses on available for sale securities would result in an adjustment of deferred policy acquisition costs had those gains or losses actually been realized, the related unamortized deferred policy acquisition costs are recorded as an adjustment of the unrealized gains or losses included in shareholders' equity. Restricted investments-On December 30, 1993, CNA deposited $986,800,000 in an escrow account, pursuant to the Fibreboard Global Settlement Agreement, as discussed in Note 18. The funds are included in short-term investments and are invested in U.S. treasury securities. At December 31, 1994 the escrow account amounted to $1,009,900,000. The escrow account is the prefunding mechanism to the trust fund for future claimants. Participating business-Participating business represented 0.9%, 1.1% and 1.2% of CNA's gross life insurance in force and 1.0%, 1.1% and 1.2% of life insurance premium income for 1994, 1993 and 1992, respectively. Participating policyholders' equity is determined by allocating 90% of related net income or loss and unrealized investment gains or losses to such business, less dividends determined by CNA's Board of Directors. In the accompanying Statements of Consolidated Income, revenues and benefits and expenses include amounts related to participating policies; the net income or loss allocated to participating policyholders' equity is a component of insurance claims and policyholders' benefits. Separate Account business-CNA's life insurance subsidiary, Continental Assurance Company ("CAC"), issues certain investment and annuity contracts, the assets and liabilities of which are legally segregated and reflected in the accompanying Consolidated Balance Sheets as assets and liabilities of Separate Account business. CAC guarantees principal and a specified return to the contractholders of approximately 88% of the Separate Account business. Substantially all assets of the Separate Accounts are carried at fair value. Separate Account liabilities are carried at the higher of contract value or the fair value of the underlying assets. Investment income and gains and losses for the Separate Account accrue to the contractholders and are therefore not included in the Statements of Consolidated Income or Cash Flows, except for funding which may be required under the guarantees. Statutory capital and surplus-Statutory capital and surplus and net income (loss), determined in accordance with accounting practices prescribed or permitted by the Illinois Insurance Department, for property and casualty and life insurance subsidiaries are as follows:
Property, Plant and Equipment-Property, plant and equipment is carried at cost less accumulated depreciation. Depreciation is computed principally by the straight-line method over the estimated useful lives of the various classes of properties. Leaseholds and leasehold improvements are depreciated or amortized over the terms of the related leases (including optional renewal periods where appropriate) or the estimated lives of improvements, if less than the lease term. The principal service lives used in computing provisions for depreciation are as follows:
The amortized cost and market value of fixed maturities at December 31, 1994 and 1993 are shown below by contractual maturity. Actual maturities differ from contractual maturities because securities may be called or prepaid with or without call or prepayment penalties.
Guaranteed investment contracts and deferred annuities of the separate accounts are estimated using discounted cash flow calculations, based on interest rates currently being offered for similar contracts with maturities consistent with those remaining for the contracts being valued. The fair value of the liabilities for variable separate accounts are based on the quoted market values of the underlying assets of each variable separate account. The fair value of other separate account liabilities approximates carrying value. Fair value of long-term debt traded on securities exchanges is based on quoted market prices. The fair values for other long-term debt are based on quoted market prices of comparable instruments adjusted for differences between the quoted instruments and the instruments being valued or are estimated using discounted cash flow analyses, based on current incremental borrowing rates for similar types of borrowing arrangements.
The Company enters into various transactions involving off-balance-sheet financial instruments through a variety of futures, swaps, options, forwards and other contracts (the "Contracts") as part of its investing activities. These Contracts are commonly referred to as derivative instruments since their underlying values may be linked to interest rates, exchange rates, prices of securities and financial or commodity indexes. The Company uses these Contracts for its asset and liability management activities as well as income enhancements for its portfolio management strategy. Entering into these Contracts involves not only the risk of dealing with counterparties and their ability to meet the terms of the Contracts but also the market risk associated with those positions where the Company does not hold an offsetting security. Exposure to market risk is managed in accordance with risk limits set by senior management by buying or selling instruments or entering into offsetting positions. The notional amounts of derivatives shown in the following table does not represent amounts exchanged in these transactions and, therefore, are not a measure of the exposure the Company has through its use of derivative instruments. In addition, notional amounts are presented "gross" and do not reflect the net effect of offsetting positions. The amounts exchanged are calculated on the basis of the notional amounts and the other terms of the derivative instruments. The credit exposure associated with these instruments is generally limited to the positive market value of the instruments and will vary based on changes in market prices. The Company enters into these Contracts with large financial institutions and considers the risk of nonperformance to be remote. In addition, the amounts subject to credit risk are substantially mitigated by many of the Contracts' collateral requirements. The Company's investments in derivative instruments are as follows:
Note: The calculation of estimated potential exposure is based on assumed adverse changes in the underlying reference price or index of (1) 10%, (2) 20% or (3) 5%. Adverse changes on options which differ from those presented above would not necessarily result in a proportionate change to the estimated potential exposure.
The notional values presented in the tables above include purchased options of $475,803,000 and $299,584,000 at December 31, 1994 and 1993, respectively. The Company's measure of exposure represents an estimate of net losses that would be recognized on each class of derivative instrument held by the Company at December 31, assuming immediate adverse market movements of the magnitude described above. The Company believes that the various rates of adverse market movements represent a measure of exposure to loss under assumed adverse conditions considering the remaining maturities of the derivatives and actual market movements in recent past periods. The estimated market exposure does not represent the maximum possible loss nor any expected actual loss, even under adverse conditions, because actual adverse fluctuations would likely differ. In addition, since the Company's investment portfolio is subject to change based on its portfolio management strategy as well as in response to changes in the market, these estimates are not necessarily indicative of the actual results which may occur. The Company also enters into short sales as part of its portfolio management strategy. These sales resulted in proceeds of $117,924,000 and $76,063,000 with fair value liabilities of $144,507,000 and $75,840,000 at December 31, 1994 and 1993, respectively. At December 31, 1993, the Company had commitments to purchase government and municipal securities at a notional value of $211,000,000 and fair value of $100,000. Estimated fair values approximate carrying values and are based on quoted market prices, where available. For securities not actively traded, fair values are estimated using values obtained from independent pricing services, quoted market prices of comparable instruments or present value models. Through August 1, 1989, CNA's property and casualty operations wrote financial guarantee insurance contracts. These contracts primarily represent industrial development bond guarantees and equity guarantees typically extending from ten to thirteen years. For these guarantees, CNA received an advance premium which is recognized over the exposure period and in proportion to the underlying exposure insured. At December 31, 1994 and 1993, gross exposure of financial guarantee insurance contracts amounted to $630,000,000 and $792,000,000, respectively. The degree of risk attached to this exposure is substantially reduced through reinsurance, collateral requirements and diversification of exposures. At December 31, 1994 and 1993, collateral consisting of letters of credit and debt service reserves amounted to $45,000,000 and $48,000,000, respectively. In addition, security interests in real estate are also obtained. Approximately 38% of the risks were ceded to reinsurers at December 31, 1994 and 1993. Total exposure, net of reinsurance, amounted to $393,000,000 and $492,000,000 at December 31, 1994 and 1993, respectively. Gross unearned premium reserves for financial guarantee contracts were $22,000,000 and $33,000,000 at December 31, 1994 and 1993, respectively. Gross claim and claim expense reserves totaled $420,000,000 and $320,000,000 at December 31, 1994 and 1993, respectively.
If the average cost method of accounting had been used for tobacco inventories instead of the LIFO method, such inventories would have been $190,719,000 and $211,227,000 higher at December 31, 1994 and 1993, respectively.
CNA's property and casualty insurance claim and claim expense reserves represent the estimated amounts necessary to settle all outstanding claims, including claims which are incurred but not reported, as of the reporting date. The Company's reserve projections are based primarily on detailed analysis of the facts in each case, CNA's experience with similar cases, and various historical development patterns. Consideration is given to such historical patterns as field reserving trends, loss payments, pending levels of unpaid claims and product mix, as well as court decisions, economic conditions and public attitudes. All of these can affect the estimation of reserves. The effects of inflation, which can be significant, are implicitly considered in the reserving process and part of the recorded reserve balance. Reserves are not present valued except in the case of workers' compensation lifetime claims and accident and health disability claims where the reserves are explicitly discounted at rates allowed by insurance regulators that range from 3.5% to 6.0% and structured settlements where such reserves are discounted at interest rates ranging from 6.3% to 7.5%. Estimating loss reserves is a difficult process as there are many factors that can ultimately affect the final settlement of a claim and, therefore, the reserve that is needed. Changes in the law, results of litigation, medical costs, the cost of repair materials and labor rates can all impact ultimate claim costs. In addition, time can be a critical part of reserving determinations since the longer the span between the incidence of a loss and the payment or settlement of the claim, the more variable the ultimate settlement amount can be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail claims, such as general liability and professional liability claims. Changes in reserves for property and casualty claim and claim expense:
(a) Includes $500,000 and $1,500,000 related to Fibreboard for the years ended December 31, 1993 and 1992, respectively. (b) Excludes life claim and claim expense reserves and intercompany eliminations of $926,000, $858,000 and $699,000 as of December 31, 1994, 1993 and 1992, respectively, included in the Consolidated Balance Sheets.
Environmental Pollution and Asbestos-Potential exposures exist for claims involving environmental pollution, including toxic waste clean-up. Environmental pollution clean-up is the subject of both federal and state regulation. By some estimates, there are thousands of potential waste sites subject to clean-up. The insurance industry is involved in extensive litigation regarding coverage issues. Judicial interpretations in many cases have expanded the scope of coverage and liability beyond the original intent of the policies. The Comprehensive Environmental Response Compensation and Liability Act of 1980 ("Superfund") and comparable state statutes ("mini-Superfund") govern the clean-up and restoration of abandoned toxic waste sites and formalize the concept of legal liability for clean-up and restoration by "Responsible Parties" ("RP's"). Superfund and the mini-Superfunds (Environmental Clean-up Laws or "ECLs") establishes a mechanism to pay for clean-up of waste sites if RP's fail to do so, and to assign liability to RP's. The extent of liability to be allocated to an RP is dependent on a variety of factors. Further, the number of waste sites subject to clean-up is unknown. To date, approximately 1,300 clean- up sites have been identified by the Environmental Protection Agency on its National Priorities List. On the other hand, the Congressional Budget Office is estimating that there will be 4,500 National Priority List sites, and other estimates project as many as 30,000 sites that will require clean-up under ECLs. Very few sites have been subject to clean-up to date. The extent of clean-up necessary and the assignment of liability has not been established. CNA and the insurance industry are disputing coverage for many such claims. Key coverage issues include whether Superfund response costs are considered damages under the policies, trigger of coverage, applicability of pollution exclusions, the potential for joint and several liability and definition of an occurrence. Similar coverage issues exist for clean-up of waste sites not covered under Superfund. To date, courts have been inconsistent in their rulings on these issues. A number of proposals to reform Superfund have been made by various parties, however no reforms were enacted by Congress in 1994. The Superfund taxing authority will expire at the end of 1995 and will, therefore, need to be addressed by the new, 104th Congress. While the next Congress may address this issue, no predictions can be made as to what positions the Congress or the Administration will take and what legislation, if any, will result. If there is legislation, and in some circumstances even if there is no legislation, the federal role in environmental clean-up may be materially reduced in favor of state action. Substantial changes in the federal statute or the activity of the EPA may cause states to reconsider their environmental clean-up statutes and regulations. There can be no meaningful prediction of the pattern of regulation that would result. Due to the inherent uncertainties described above, including the inconsistency of court decisions, the number of waste sites subject to clean-up, and the standards for clean-up and liability, the exposure to CNA for environmental pollution claims cannot be meaningfully quantified. In 1994 and 1993, CNA allocated approximately $427 and $340 million, respectively, of claim and claim expense reserves for unreported environmental pollution claims in addition to the $79 and $94 million, respectively, of reserves recorded for reported claims. CNA has not attributed any reinsurance to reserves for unreported claims. The reserves for reported claims cited above are net of reinsurance recoverable of $3 and $5 million at December 31, 1994 and 1993, respectively. Claim and claim expense reserves represent management's estimates of ultimate liabilities based on currently available facts and law. However, in addition to the uncertainties previously discussed, additional issues related to, among other things, specific policy provisions, multiple insurers and allocation of liability among insurers, consequences of conduct by the insured, missing policies and proof of coverage make quantification of liabilities exceptionally difficult and subject to later adjustment based on new data. The number of claims filed for environmental pollution coverage continues to increase. Approximately 1,900 claims were reported in 1994 and approximately 20,000 claims have been reported to date. Pending claims totaled approximately 9,900 and 10,100 at December 31, 1994 and 1993, respectively. Approximately 10,100 claims were closed through December 31, 1994, of which approximately 9,100 claims were settled without payment, except for claim expenses of $26 million. Settlements for the remaining 1,000 claims totaled $129 million, plus claim expenses of $36 million (net of reinsurance recoveries of $34 and $4 million for claim and claim expenses, respectively). Adverse reserve development for environmental claims totaled $180 and $446 million for the years ended December 31, 1994 and 1993, respectively. The foregoing claims statistics represent claims for accident years 1988 and prior, which coincides with CNA's adoption of the Simplified Commercial General Liability coverage form which included an absolute pollution exclusion. In previous filings, such disclosures included claims for all accident years. The results of operations in future years may continue to be adversely affected by environmental pollution claim and claim expenses. Management will continue to monitor potential liabilities and make further adjustments as warranted.
Gross deferred tax assets amounted to $2,290,300,000, $1,895,689,000 and $1,595,083,000 and liabilities amounted to $611,128,000, $821,279,000 and $485,551,000, for the years ended December 31, 1994, 1993 and 1992, respectively.
Federal, foreign, state and local income tax payments, net of refunds, amounted to approximately $194,947,000, $10,263,000 and $355,853,000 for the years ended December 31, 1994, 1993 and 1992, respectively. The Tax Reform Act of 1986 enacted a new separate parallel tax system referred to as the Alternative Minimum Tax ("AMT") system. AMT is based on a flat rate applied to a broader tax base. It is calculated separately from the regular federal income tax and the higher of the two taxes is paid. The excess of the AMT over regular tax is a tax credit, which can be carried forward indefinitely to reduce regular tax liabilities of future years. At December 31, 1994 the AMT credit totaled approximately $239,600,000. The Company has entered into separate tax allocation agreements with Bulova and CNA, majority-owned subsidiaries in which its ownership exceeds 80% (the "Subsidiaries"). Each agreement provides that the Company will (i) pay to the Subsidiary the amount, if any, by which the Company's consolidated federal income tax is reduced by virtue of inclusion of the Subsidiary in the Company's return, or (ii) be paid by the Subsidiary an amount, if any, equal to the federal income tax which would have been payable by the Subsidiary if it had filed a separate consolidated return. Under these agreements, the federal income tax benefit to CNA amounted to approximately $84,000,000, $17,000,000 and $350,000,000 for the years ended December 31, 1994, 1993 and 1992, respectively, and the federal income tax (expense) benefit to Bulova amounted to approximately $(74,000), $2,500,000 and $(3,300,000) for the years ended December 31, 1994, 1993 and 1992, respectively. Each agreement may be cancelled by either of the parties upon thirty days' written notice. The Company's federal income tax returns have been examined through 1988 and settled through 1983, and the years 1989 and 1990 are currently under examination. While tax liabilities for subsequent years are subject to audit and final determination, in the opinion of management the amount accrued in the consolidated balance sheet is believed to be adequate to cover any additional assessments which may be made by federal, state and local tax authorities and should not have a material effect on the financial condition of the Company, The Revenue Reconciliation Act of 1990 (the "1990 Act") required property and casualty insurance companies to accrue estimated salvage and subrogation recoverable for tax purposes as of January 1, 1990. Under a transition provision of the 1990 Act, for companies that had anticipated salvage and subrogation in determining loss reserves, 87% of such accrual as of January 1, 1990 was forgiven. This special deduction is to be taken ratably over four taxable years beginning in 1990. CNA recognized a tax benefit of approximately $17,000,000 in each of the years ended December 31, 1993 and 1992, respectively. In 1993 the Company increased its deferred tax asset by $31,636,000 due to a 1% increase in the corporate tax rate.
(a) Net of $7,168 held by the Company. (b) Redeemable in whole or in part at January 15, 1997 at 104%, and decreasing percentages thereafter. (c) Redeemable in whole or in part at June 1, 2003 at 104%, and decreasing percentages thereafter. (d) Redeemable in whole or in part at October 15, 2003 at 102%, and decreasing percentages thereafter.
Pension Plans-The Company and its subsidiaries have several non-contributory defined benefit plans for eligible employees. The benefits for certain plans which cover salaried employees and certain union employees are based on formulas which include among others, years of service and average pay. The benefits for one plan which covers union workers under various union contracts and certain salaried employees are based on years of service multiplied by a stated amount. Effective January 1, 1994, a subsidiary of the Company amended its retirement plan to allow for early retirement benefits when years of service and age equals a minimum of 65. This amendment generated an unrecognized prior service cost of $1,600,000. Pension cost includes the following components:
The Company's funding policy is to make contributions in accordance with applicable governmental regulatory requirements. The assets of the plans are invested primarily in interest-bearing obligations and for one plan with an insurance subsidiary of the Company, in its Separate Account business.
In addition to its common stock, the Company has authorized 25,000,000 shares of preferred stock, $.10 par value. Earnings per share, assuming no dilution, are based on the weighted average number of shares outstanding during each year (60,192,000, 64,108,000 and 65,659,000 for the years ended December 31, 1994, 1993 and 1992, respectively). Fully diluted earnings per share assumes conversion of the zero coupon convertible subordinated notes (redeemed in November 1993) and elimination of the related interest charges, net of taxes. Fully diluted earnings per share are not presented for the year ended December 31, 1992 since such dilution is not material.
The Company's hotels in some instances are constructed on leased land or are leased. Other leases cover central office facilities, computer equipment and operating service offices. Rent expense amounted to $78,114,000, $84,946,000 and $85,400,000 for the years ended December 31, 1994, 1993 and 1992, respectively. It is expected, in the normal course of business, that leases which expire will be renewed or replaced by leases on other properties; therefore, it is believed that future minimum annual rental commitments will not be less than the amount of rental expense incurred in 1994. At December 31, 1994 future aggregate minimum rental payments approximated $245,615,000.
Fibreboard Litigation-CNA's primary property and casualty subsidiary, Continental Casualty Company ("Continental"), is party to litigation with Fibreboard Corporation ("Fibreboard") involving coverage for certain asbestos- related claims and defense costs (San Francisco Superior Court, Judicial Council Coordination Proceeding 1072). As described below, Continental, Fibreboard, another insurer (Pacific Indemnity, a subsidiary of the Chubb Corporation), and a negotiating committee of asbestos claimant attorneys have reached a Global Settlement (the "Global Settlement") to resolve all future asbestos-related bodily injury claims involving Fibreboard. Continental, Fibreboard and Pacific Indemnity have also reached an agreement, which is subject to court approval, (the "Trilateral Agreement") on a settlement to resolve the coverage litigation in the event the Global Settlement does not obtain final court approval. The implementation of the Global Settlement or the Trilateral Agreement would have the effect of settling Continental's litigation with Fibreboard. On July 29, 1994 the United States District Court for the Eastern District of Texas preliminarily approved the Global Settlement agreement. A final fairness hearing, to determine whether to finally approve the Global Settlement agreement, commenced on December 12, 1994. During the hearing various parties presented evidence in opposition to the Global Settlement. Also pending in the United States District Court for the Eastern District of Texas is litigation over the Trilateral Agreement. Trial on the issues raised by this agreement occurred on February 13, 1995, with evidence submitted to the Court in opposition to final court approval of the Trilateral Agreement. CNA and the other parties to the Global Settlement agreement and the Trilateral Agreement completed a comprehensive court approved notice program to provide potential claimants information about their rights and possible benefits under the Global Settlement agreement and Trilateral Agreement. Final arguments concerning the Global Settlement agreement occurred on February 27, 1995; the court's rulings are expected in the spring of 1995. No date has been set for final legal arguments for the Trilateral Agreement.
Coverage Litigation-Between 1928 and 1971, Fibreboard manufactured insulation products containing asbestos. Since the 1970's, thousands of claims have been filed against Fibreboard by individuals claiming bodily injury as a result of asbestos exposure. Continental insured Fibreboard under a comprehensive general liability policy between May 4, 1957 and March 15, 1959. Fibreboard disputed the coverage positions taken by its insurers and, in 1979, Fireman's Fund, another of Fibreboard's insurers, brought suit with respect to coverage for defense and indemnity costs. In January 1990, the San Francisco Superior Court (Judicial Council Coordination Proceeding 1072) rendered a decision against the insurers including Continental and Pacific Indemnity. The court held that the insurers owed a duty to defend and indemnify Fibreboard for certain of the asbestos- related bodily injury claims asserted against Fibreboard (in the case of Continental, for all claims involving exposure to Fibreboard's asbestos products if there was exposure to asbestos at any time prior to 1959 including years prior to 1957, regardless of when the claims were asserted or injuries manifested) and that the policies contained no aggregate limit of liability in relation to such claims. The judgment was appealed. The Court of Appeal entered an opinion on November 15, 1993, as modified on December 13, 1993, which substantially affirmed the lower court's decisions on scope of coverage and trigger of coverage issues, as described below. The Court of Appeal withheld its ruling on the issues discrete to Continental and Pacific Indemnity pending final court approval of either the Global Settlement or the Trilateral Agreement described below. On January 27, 1994, the California Supreme Court granted a Petition for Review filed by several insurers, including Continental, of, among other things, the trigger and scope of coverage issues. The order granting review has no effect on the Court of Appeal's order severing the issues unique to Continental and Pacific Indemnity. Continental cannot predict the time frame within which the issues before the California Supreme Court may be resolved. If neither the Global Settlement nor the Trilateral Agreement is approved, it is anticipated that Continental and Pacific Indemnity will resume the appeal process. Continental's appeal of the coverage judgment raises many legal issues. Key issues on appeal under the policy are trigger of coverage, scope of coverage, dual coverage requirements and number of occurrences: . The trial court adopted a continuous trigger of coverage theory under which all insurance policies in effect at any time from first exposure to asbestos until the date of the claim filing or death are triggered. The Court of Appeal endorsed the continuous trigger theory, but modified the ruling to provide that policies are triggered by a claimant's first exposure to the policyholder's products, as opposed to the first exposure to any asbestos product. Therefore, an insurance policy is not triggered if a claimant's first exposure to the policyholder's product took place after the policy period. The court, however, placed the burden on the insurer to prove the claimant was not exposed to its policyholder's product before or during the policy period. The trigger of coverage issue is now on appeal to the California Supreme Court. Continental's position is that its policy is triggered under California law by manifestation of appreciable harm during the policy period. The bodily injury cannot be said to occur within the meaning of the policy until actual physical symptoms and associated functional impairment manifest themselves. Thus, Continental's position is that if existing California law were applied, there would be no coverage under Continental's policy. . The scope of coverage decision imposed a form of "joint and several" liability that makes each triggered policy liable in whole for each covered claim, regardless of the length of the period the policy was in effect. This decision was affirmed by the Court of Appeal, and is now on appeal to the California Supreme Court. Continental's position is that liability for asbestos claims should be shared not jointly, but severally and on a pro rata basis between the insurers and insured. Under this theory, Continental would only be liable for that proportion of the bodily injury that occurred during the 22-month period its policy was in force. . Continental maintains that both the occurrence and the injury resulting therefrom must happen during the policy period for the policy to be triggered. Consequently, if the court holds that the occurrence is exposure to asbestos, Continental's position is that coverage under the Continental policy is restricted to those who actually inhaled Fibreboard asbestos fibers and suffered injury from May 4, 1957 to March 15, 1959. The Court of Appeal withheld ruling on this issue, as noted above. . Continental's policy had a $1 million per occurrence limit. Continental contends the number of occurrences under California law must be determined by the general cause of the injuries, not the number of claimants, and that the cause of the injury was the continuous sale and manufacture of the product. Because the manufacture and sale proceeded from two locations, Continental maintains that there were only two occurrences and thus only $2 million of coverage under the policy. However, the per occurrence limit was interpreted by the trial court to mean that each claim submitted by each individual constituted a separate occurrence. The Court of Appeal withheld ruling on this issue, as noted above.
Even if Continental were successful on appeal on the dual coverage requirements or the number of occurrences, if the final decision in the coverage case affirms the trial court's decision on the existence of the Pacific Indemnity policy, then Continental would still have obligations under the Continental and Pacific Indemnity Agreement described below. Under various reinsurance agreements, Continental has asserted a right to reimbursement for a portion of its potential exposure to Fibreboard. The reinsurers have disputed Continental's right to reimbursement and have taken the position that any claim by Continental is subject to arbitration under provisions in the reinsurance agreement. A Federal court has ruled that the dispute must be resolved by arbitration. There can be no assurance that Continental will be successful in obtaining a recovery under its reinsurance agreements. On April 9, 1993, Continental and Fibreboard entered into an agreement pursuant to which, among other things, the parties agreed to use their best efforts to negotiate and finalize a global class action settlement with asbestos-related bodily injury and death claimants. Through December 31, 1994, Continental, Fibreboard and plaintiff attorneys had reached settlements with respect to approximately 135,000 claims, subject to resolution of the coverage issues, for a maximum settlement amount of approximately $1.58 billion. If neither the Global Settlement nor the Trilateral Agreement receives final court approval, Continental's obligation to pay under all settlements will be partially subject to the results of the pending appeal in the coverage litigation. Minimum amounts payable under all such agreements, regardless of the outcome of coverage litigation, total approximately $751.8 million, of which $486.6 million was paid through December 31, 1994. Continental may negotiate other agreements with various classes of claimants including groups who may have previously reached agreement with Fibreboard. Continental will continue to pursue its appeals in respect of the coverage litigation and all other litigation involving Fibreboard if the Global Settlement or the Trilateral Agreement cannot be implemented.
Global Settlement-On August 27, 1993, Continental, Pacific Indemnity, Fibreboard and a negotiating committee of asbestos claimant attorneys reached an agreement in principle for an omnibus settlement to resolve all future asbestos- related bodily injury claims involving Fibreboard. The Global Settlement was executed on December 23, 1993. The agreement calls for contribution by Continental and Pacific Indemnity of an aggregate of $1.525 billion to a trust fund for a class of all future asbestos claimants, defined generally as those persons whose claims against Fibreboard were neither filed nor settled before August 27, 1993. An additional $10 million is to be contributed to the fund by Fibreboard. The Global Settlement is subject to court approval and possible appeals. As noted below, there is limited precedent with settlements which determine the rights of future claimants to seek relief. Subsequent to the announcement of the agreement in principle, Continental, Fibreboard and Pacific Indemnity entered into the Trilateral Agreement which sets forth the parties' obligations in the event the Global Settlement is not approved by the court. In such case, Continental and Pacific Indemnity would contribute to a settlement fund an aggregate of $2 billion, less certain adjustments. Such fund would be devoted to the payment of Fibreboard's asbestos liabilities other than liabilities in respect of previously settled claims. Continental's share of such fund would be $1.44 billion reduced by a portion of an additional payment of $635 million which Pacific Indemnity has agreed to pay in respect of unsettled present claims and previously settled claims. Continental has agreed that if either the Global Settlement or the Trilateral Agreement is approved, it will assume responsibility for the claims that had been settled and paid before August 27, 1993. A portion of the additional $635 million to be contributed by Pacific Indemnity would be applied to the payment of such claims as well. As a part of the Global Settlement and the Trilateral Agreement, Continental would be released by Fibreboard from any further liability under the comprehensive general liability policy written for Fibreboard by Continental, including but not limited to liability for asbestos- related claims against Fibreboard. The Trilateral Agreement is subject to court approval and possible appeals. Continental and Fibreboard have entered into a supplemental agreement (the "Supplemental Agreement") which governs the interim arrangements and obligations between the parties until such time as the Global Settlement is either approved or disapproved by the court and also governs certain obligations between the parties in the event the Global Settlement is approved, including the payment of claims which are not included in the Global Settlement.
Continental believes that as a result of the Global Settlement and the Trilateral Agreement it has greatly reduced the uncertainty of its exposure with respect to the Fibreboard matter. However, if neither the Global Settlement, nor the Trilateral Agreement is approved and upheld, in light of the factors discussed herein the range of Continental's potential liability cannot be meaningfully estimated and there can be no assurance that the reserves established would be sufficient to pay all amounts which ultimately could become payable in respect of asbestos-related bodily injury liabilities. While it is possible that the ultimate outcome of this matter could have a material adverse impact on the equity of the Company, management does not believe that a further loss material to equity is probable. Management will continue to monitor the potential liabilities with respect to asbestos-related bodily injury claims and will make adjustments to the claim reserves if warranted.
Other Litigation-The Company and its subsidiaries are also parties to other litigation arising in the ordinary course of business. The outcome of this other litigation will not, in the opinion of management, materially affect the Company's results of operations or equity.