We own our headquarters, located at 440 Lincoln Street, Worcester, Massachusetts, with approximately 944,000 square feet.
We lease our office space located at 30 Fenchurch Street, London, United Kingdom, where we manage our Chaucer segment. We also lease offices throughout the United States and in select locations worldwide for branch sales, underwriting and claims processing functions, and the operations of acquired subsidiaries.
(1) Includes results of Chaucer Holdings plc for the period from July 1, 2011 through December 31, 2011.
Our results of operations include the accounts of The Hanover Insurance Company (“Hanover Insurance”) and Citizens Insurance Company of America (“Citizens”), our principal U.S. domiciled property and casualty companies; Chaucer Holdings plc (“Chaucer”), and certain other insurance and non-insurance subsidiaries. Effective July 1, 2011, we acquired Chaucer, a specialist insurance underwriting group which operates through the Society and Corporation of Lloyd’s (“Lloyds”) and is domiciled in the United Kingdom (“U.K.”). Our results of operations include Chaucer’s results for the period from July 1, 2011 through December 31, 2011. Additionally, our results of operations include our discontinued operations, consisting of our former life insurance and accident and health businesses.
We believe our small commercial capabilities, distinctiveness in the middle market, and continued development of specialty lines provides us with a diversified portfolio of products and delivers significant value to agents and policyholders. The small commercial and middle market accounts are expected to significantly contribute to premium growth in Commercial Lines over the next several years. We expect to pursue our core strategy of developing deep partnerships with agents, distinctive products, franchise value through limited distribution, and industry segmentation.
We believe these efforts have and will continue to drive improvement in our overall mix of business and ultimately our underwriting profitability. Our losses and loss adjustment expenses were higher in 2011 as compared to the prior year, primarily due to the high level of catastrophe losses and, to a lesser extent, non-catastrophe weather-related losses. Notwithstanding the increase in losses and LAE, there was a modest increase in current accident year income primarily due to the growth in earned premium and changes to our mix of business.
The competitive nature of the Commercial Lines market requires us to be highly disciplined in our underwriting process to ensure that we write business only at acceptable margins. In certain lines of business where a weak economy may be a particularly important factor, such as surety and workers’ compensation, we endeavor to adjust pricing or take a more conservative approach to risk selection in order to more appropriately reflect the higher risk of loss. Additionally, we are seeking additional rate increases in our property lines as a result of the heightened catastrophe and non-catastrophe weather-related losses that we experienced in 2011.
In our Personal Lines business, we focus on partnering with high quality, value-added agencies that deliver consultative selling and stress the importance of account rounding (the conversion of single policy customers to accounts with multiple policies and additional coverages). Almost 70% of our policies in force in 2011 were account business. We are focused on making investments that help maintain profitability, build a distinctive position in the market, help diversify us geographically from our historical core states of Michigan, Massachusetts, New York, and New Jersey and provide us with profitable growth opportunities.
We deploy specialist underwriters in over 30 major insurance and reinsurance classes throughout our diversified portfolio, which includes property, marine and aviation, energy, U.K. motor and casualty. We access business through Lloyd’s, the leading international insurance and reinsurance market, which provides us with access to specialist business in over 200 countries and territories worldwide through its international licenses, brand reputation and strong security rating.
We currently expect underwriting opportunities to increase, and terms and conditions to improve across the majority of international risk classes for our Chaucer business in 2012. This follows a difficult period for international insurance markets since 2010, with increased frequency and severity of both natural and man-made catastrophes worldwide.
We expect to focus more of our capital and underwriting capabilities in those areas where we expect rates to be more favorable, in particular, for catastrophe-exposed property, marine and energy risks, and less toward business where rates are currently under pressure, notably casualty and aviation. We also expect to benefit from continued rate increases in the U.K. motor market, which comprised approximately 28% of Chaucer’s net written premium for the six months ended December 31, 2011. We are also seeking opportunities to diversify the business further, including the development of new lines of business, such as international liability, that we expect to meet our return on capital criteria.
Our primary business operations include insurance products and services currently provided through four operating segments. These operating segments are Commercial Lines, Personal Lines, Chaucer and Other Property and Casualty. Commercial Lines includes commercial multiple peril, commercial automobile, workers’ compensation and other commercial coverages, such as specialty program business, inland marine, surety and other bonds, professional liability and management liability. Personal Lines includes personal automobile, homeowners and other personal coverages. Chaucer includes property, marine and aviation, energy, U.K. motor, and casualty and other coverages (which includes international liability, specialist coverages, and syndicate participations). The Other Property and Casualty segment consists of Opus Investment Management, Inc., which markets investment management services to institutions, pension funds and other organizations; earnings on holding company assets; and, a voluntary pools business which is in run-off. We present the separate financial information of each segment consistent with the manner in which our chief operating decision maker evaluates results in deciding how to allocate resources and in assessing performance.
Our consolidated net income includes the results of our four operating segments (segment income), which we evaluate on a pre-tax basis and excluding interest expense on debt. Segment income excludes certain other items which we believe are not indicative of our core operations, such as income taxes and net realized investment gains and losses, including net gains and losses on certain derivative instruments. Such gains and losses are excluded since they are determined by interest rates, financial markets and the timing of sales. Also, segment income excludes net gains and losses on disposals of businesses, discontinued operations, costs to acquire businesses, restructuring costs, extraordinary items, the cumulative effect of accounting changes and certain other items. Although the items excluded from segment income may be significant components in understanding and assessing our financial performance, we believe a discussion of segment income enhances an investor’s understanding of our results of operations by segregating income attributable to the core operations of the business. However, segment income should not be construed as a substitute for net income determined in accordance with generally accepted accounting principles in the United States of America (“GAAP”).
Our consolidated net income was $37.1 million in 2011, compared to $154.8 million in 2010. The $117.7 million decrease is primarily driven by an increase in catastrophe losses and non-catastrophe weather-related activity, partially offset by income from our Chaucer segment. Additionally, in the year ended December 31, 2011, advisory, legal, and accounting costs associated with the acquisition of Chaucer and other acquisition expenses totaled $16.4 million. We also recorded an $11.3 million loss in connection with a foreign exchange contract entered into in connection with the acquisition of Chaucer, which was partially offset by net foreign exchange gains of $6.7 million.
Our consolidated net income was $154.8 million in 2010, compared to $197.2 million in 2009. The $42.4 million decrease is primarily driven by higher catastrophe losses, which increased $39.9 million, net of taxes. Results in 2009 included a $34.5 million pre-tax gain ($22.3 million, net of taxes) associated with a tender offer, whereby we repurchased at a discount a portion of our mandatorily redeemable preferred securities and our senior debentures. In 2010, we repurchased junior debentures which resulted in a $2.0 million loss. In addition, earnings from our discontinued operations decreased by $7.8 million. Partially offsetting these decreases was a $28.3 million increase in net realized investment gains, from a gain of $1.4 million in 2009, to a gain of $29.7 million in 2010.
The following table summarizes net premiums written and loss, LAE, expense and combined ratios for the Commercial Lines, Personal Lines and Chaucer segments. Results for Chaucer reflect the period from July 1, 2011 to December 31, 2011. Loss and LAE, catastrophe loss and combined ratios include prior year reserve development. These items are not meaningful for our Other Property and Casualty segment.
Commercial Lines underwriting loss for the year ended December 31, 2011 was $121.3 million, compared to $20.6 million for the year ended December 31, 2010, an increase in losses of $100.7 million. This was due to higher weather-related losses and LAE, including catastrophes, and decreased favorable development on prior years loss and LAE reserves, partially offset by growth in earned premium and the resulting positive effect on our expense ratio. Catastrophe losses for the year ended December 31, 2011 were $148.4 million, primarily due to Hurricane Irene during the third quarter, significant tornado, hail and windstorm activity in the second quarter and winter storms in the first quarter, compared to $61.6 million for the year ended December 31, 2010, an increase of $86.8 million. Favorable development on prior years’ loss and LAE reserves for the year ended December 31, 2011 was $34.7 million, compared to $61.5 million for the year ended December 31, 2010, a decrease of $26.8 million. Included in 2010 results was $7.5 million of favorable LAE development, principally related to a change in the cost factors used for establishing unallocated LAE reserves.
Net premiums written in the personal automobile line of business declined 2.6%, primarily as a result of fewer policies in force in Michigan, Massachusetts, New York and Florida. We attribute the decrease in policies in force to more selective portfolio management, and to rate increases we have implemented despite the competitive pricing environment. Net premiums written in the homeowners line of business increased 4.5%, resulting primarily from rate increases.
Personal Lines underwriting profit, excluding prior year loss and LAE reserve development and catastrophes, was $57.7 million for the year ended December 31, 2011, compared to $51.5 million for the year ended December 31, 2010, an increase of $6.2 million. This increase in non-catastrophe current accident year results was primarily due to lower operating expenses and what we believe is an improved mix of business, partially offset by non-catastrophe weather-related losses.
Although we have been able to obtain rate increases in our Personal Lines markets, our ability to maintain and increase Personal Lines net written premium and to maintain and improve underwriting results could be affected by price competition, regulatory and legal developments and the current challenging economic conditions, particularly
Chaucer’s underwriting profit for the six months ended December 31, 2011 was $11.3 million. Catastrophe losses for the six months ended December 31, 2011 were $49.5 million, principally due to floods in Thailand and Denmark. Favorable development on prior years’ loss and LAE reserves for the six months ended December 31, 2011 was $35.5 million.
Chaucer’s underwriting profit, excluding prior year loss and LAE development and catastrophes, was $25.3 million in the six months ended December 31, 2011. Underwriting expenses of $181.8 million represented 35.9% of earned premium.
Commercial Lines net premiums written was $1,584.8 million for the year ended December 31, 2010, compared to $1,136.3 million for the year ended December 31, 2009. This $448.5 million increase was primarily driven by increased premiums associated with the OneBeacon renewal rights transaction of $289.1 million, and growth in our managed program business through AIX, which accounted for $63.9 million, as well as growth in various niche and segmented businesses. Also benefiting the overall growth comparison in net premiums written was a slight improvement in rate.
Commercial Lines underwriting loss for the year ended December 31, 2010 was $20.6 million, compared to a profit of $60.9 million for the year ended December 31, 2009, a decrease of $81.5 million. This decrease was primarily due to a reduction in favorable prior year loss and LAE reserve development, increased catastrophe losses resulting from several severe hail, wind and thunderstorm events, and to higher expenses, partially offset by more favorable current accident year loss results. Catastrophe losses for the year ended December 31, 2010 were $61.6 million, compared to $28.6 million for the year ended December 31, 2009, an increase of $33.0 million. This increase was primarily in our commercial multiple peril line.
Commercial Lines underwriting loss, excluding prior year loss and LAE reserve development and catastrophes, for the year ended December 31, 2010, was $20.5 million, compared to $14.6 million for the year ended December 31, 2009. This $5.9 million increase in losses was primarily due to increased operating expenses, principally attributable to costs associated with our westward expansion initiative, increased variable compensation, and increased costs in our specialty business. These factors were partially offset by more favorable current accident year loss results, primarily in our surety bond and commercial multiple peril businesses.
Favorable development on prior years’ loss and LAE reserves was $48.8 million for the year ended December 31, 2010, compared to $39.4 million for the year ended December 31, 2009, an increase of $9.4 million. Included in the current year results was $2.3 million of favorable LAE development, principally related to a change in the cost factors used for establishing unallocated loss adjustment expense reserves. LAE in 2009 included a benefit of $2.0 million, including $1.6 million associated with prior accident years, related to a change in our unallocated loss adjustment expense reserving methodology.
IBNR reserves are generally calculated by first projecting the ultimate cost of all claims that have occurred or are expected to occur in the future and then subtracting reported losses and loss expenses. Reported losses include cumulative paid losses and loss expenses plus case reserves. The IBNR reserve includes a provision for claims that have occurred but have not yet been reported to us, some of which may not yet be known to the insured, as well as a provision for future development on reported claims. IBNR represents a significant proportion of our total net loss reserves, particularly for long-tail liability classes. In fact, approximately 42% of our aggregate net loss reserves at December 31, 2011 were for IBNR losses and loss expenses.
There is greater inherent uncertainty in estimating insurance reserves for certain types of property and casualty insurance lines, particularly liability lines, where a longer period of time may elapse before a definitive determination of ultimate liability and losses may be made. In addition, the technological, judicial, regulatory and political climates involving these types of claims are continuously evolving. There is also greater uncertainty in establishing reserves with respect to business that is new to us, particularly new business which is generated with respect to newly introduced product lines, by newly appointed agents or in geographies in which we have less experience in conducting business, such as the program business written by our AIX subsidiary, Chaucer’s international liability lines, our new professional liability specialty lines, and business written in the western part of the United States. In some of these cases, there is less historical experience or knowledge and less data upon which we can rely. A combination of business that is both new to us and has longer development periods, provides even greater uncertainty in estimating insurance reserves. Historically, we have limited the issuance of long-tailed other liability policies, including directors and officers (“D&O”) liability, errors and omissions (“E&O”) liability and medical professional liability. With the acquisition of Hanover Professionals in 2007, which writes lawyers professional E&O coverage, the acquisition of Campania in 2010, which writes medical professional liability and product liability coverages, and the introduction of new specialty coverages, such as our other professional management liability products, we are increasing, and expect to continue to increase, our exposure to longer tailed liability lines, including D&O coverages. The Chaucer business acquired this year contains several international and U.S. liability lines, of which financial institution and professional liability, international liability and energy liability, contribute the most uncertainty.
We regularly review our reserving techniques, our overall reserving position and our reinsurance. Based on (i) our review of historical data, legislative enactments, judicial decisions, legal developments in impositions of damages and policy coverage, political attitudes and trends in general economic conditions, (ii) our review of per claim information, (iii) our historical loss experience and that of the industry, (iv) the nature of policies written by us, and (v) our internal estimates of required reserves, we believe that adequate provision has been made for loss reserves. However, establishment of appropriate reserves is an inherently uncertain process and there can be no certainty that current established reserves will prove adequate in light of subsequent actual experience. A significant change to the estimated reserves could have a material impact on our results of operations and financial position. An increase or decrease in reserve estimates would result in a corresponding decrease or increase in financial results. For example, each one percentage point change in the aggregate loss and LAE ratio resulting from a change in reserve estimation is currently projected to have an approximate $36 million impact on segment income, based on 2011 full year premiums.
Our loss reserves include amounts related to short-tail and long-tail classes of business. “Tail” refers to the time period between the occurrence of a loss and the final settlement of the claim. The longer the time span between the incidence of a loss and the settlement of the claim, the more the ultimate settlement amount is likely to vary from our original estimate.
Short-tail classes consist principally of automobile physical damage, homeowners property, commercial property and marine business. The Chaucer business, while having
Berquist-Sherman methods are used for estimating reserves in business lines where historical development patterns may be deemed less reliable for more recent accident years’ ultimate losses. Under these methods, patterns of historical paid or reported losses are first adjusted to reflect current payment settlement patterns and case reserve adequacy and then evaluated in the same manner as the loss development factor methods described above. The reported loss development factor method can be less appropriate when the adequacy of case reserves suddenly changes, while the paid loss development factor method can likewise be less appropriate when settlement patterns suddenly change.
For longer tailed lines of business, applying the loss development factor method often requires even more judgment in selecting development factors, as well as more significant extrapolation. For those long-tailed lines of business with high frequency and relatively low per-loss severity (e.g., personal automobile liability), volatility will often be sufficiently modest for the loss development factor method to be given significant weight, even in the most recent accident years, but expected loss methods and adjusted loss methods are always considered and frequently utilized in the selection process. For those long-tailed lines of business with low frequency and high loss potential (e.g., commercial liability), anticipated loss experience is less predictable because of the small number of claims and erratic claim severity patterns. In these situations, the loss development factor methods may not produce a reliable estimate of ultimate losses in the most recent accident years since many claims either have not yet been reported or are only in the early stages of the settlement process. Therefore, the loss reserve estimates for these accident years are based on methods less reliant on extrapolation, such as Bornheutter-Ferguson. Over time, as a greater number of claims are reported and the statistical credibility of loss experience increases, loss development factor methods or adjusted loss methods are given increasing weight.
Our carried reserves for each line of business and coverage are determined based on this quarterly loss reserving process. In making the determination, we consider numerous quantitative and qualitative factors. Quantitative factors include changes in reserve estimates in the period, the maturity of the accident year, trends observed over the recent past, the level of volatility within a particular class of business, the estimated effects of reinsurance, including reinstatement premiums, general economic trends, and other factors. Qualitative factors may include legal and regulatory developments, changes in claim handling, recent entry into new markets or products, changes in underwriting practices, concerns that we do not have sufficient or quality historical reported and paid loss and LAE information with respect to a particular line or segment of our business, effects of the economy and political outlook, perceived anomalies in the historical results, evolving trends or other factors. In doing so, we must evaluate whether a change in the data represents credible actionable information or an anomaly. Such an assessment requires considerable judgment. Even if a change is determined to be apparent, it is not always possible to determine the extent of the change. As a result, there can be a time lag between the emergence of a change and a determination that the change should be partially or fully reflected in the carried loss reserves. In general, changes are made more quickly to reserves for more mature accident years and less volatile classes of business.
In addition, we must consider the uncertain effects of emerging or potential claims and coverage issues that arise as legal, judicial, social conditions, political risks, and economic conditions change. For example, claims which we consider closed may be re-opened as additional damages surface or new liability theories are presented. These and other issues could 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. As a result, the uncertainties inherent in estimating ultimate claim costs on the basis of past experience further complicate the already complex loss reserving process.
As part of our loss reserving analysis, we consider the various factors that contribute to the uncertainty in the loss reserving process. Those factors that could materially affect our loss reserve estimates include loss development patterns and loss cost trends, reporting lags, rate and exposure level changes, the effects of changes in coverage and policy limits, business mix shifts, the effects of regulatory and legislative developments, the effects of changes in judicial interpretations, the effects of emerging claims and coverage issues and the effects of changes in claim handling practices. In making estimates of reserves, however, we do not necessarily make an explicit assumption for each of these factors. Moreover, all estimation methods do not utilize the same assumptions and typically no single method is determinative in the reserve analysis for a line of business and coverage. Consequently, changes in our loss reserve estimates generally are not the result of changes in any one assumption. Instead, the variability will be affected by the interplay of changes in numerous assumptions, many of which are implicit to the approaches used.
For each line of business and coverage, we regularly adjust the assumptions and methods used in the estimation of loss reserves in response to our actual loss experience, as well as our judgments regarding changes in trends and/or emerging patterns. In those instances where we primarily utilize analyses of historical patterns of the development of paid and reported losses, this may be reflected, for example, in the selection of revised loss development factors. In longer tailed classes of business and for which loss experience is less predictable due to potential changes in judicial interpretations, potential legislative actions, the cost of litigation or determining liability and the ultimate loss, inflation and potential claims issues, this may be reflected in a judgmental change in our estimate of ultimate losses for particular accident years.
The estimation of claims and claims expense reserves for catastrophes also comprises estimates of losses from reported claims and IBNR, primarily for damage to property. In general, our estimates for catastrophe reserves are determined on an event basis by considering various sources of available information, including specific loss estimates reported to us based on claim adjuster inspections, overall industry loss estimates, and our internal data regarding exposures related to the geographical location of the event. However, depending on the nature of the catastrophe, the estimation process can be further complicated by other impediments. For example, for hurricanes, complications often include the inability of insureds to promptly report losses, delays in the ability of claims adjusting staff to inspect losses, difficulties in determining whether losses are covered by our homeowners policy (generally for damage caused by wind or wind driven rain) or are specifically excluded from coverage caused by flood, and challenges in estimating additional living expenses, assessing the impact of demand surge, exposure to mold damage, and the effects of numerous other considerations. Estimates for catastrophes which occur at or near the end of a financial reporting period may be even less reliable since we will have less claims data available and little time to complete our estimation process. In such situations, we may adapt our practices to accommodate the circumstances.
The following discussion presents disclosure related to possible variation in reserve estimates due to changes in key assumptions. This information is provided for illustrative purposes only. Many other assumptions may also lead to material reserve adjustments. If any such variations do occur, they would likely occur over a period of several years and therefore their impact on our results of operations would be spread over the same period. It is important to note, however, that there is the potential for future variations greater than the amounts described below and for any such variations to be recognized in a single quarterly or annual period. No consideration has been given to potential correlation or lack of correlation among key assumptions or among lines of business and coverage as described below. As a result and because there are so many other factors which affect our reserve estimate, it would be inappropriate to take the amounts described below and add them together in an attempt to estimate volatility in total. While we believe these are reasonably likely scenarios, the reader should not consider the following sensitivity analysis as illustrative of a reserve range.
Personal and Commercial Automobile Bodily Injury - reserves recorded for bodily injury on voluntary business were $437.1 million as of December 31, 2011. A key assumption for bodily injury is the inflation rate underlying the estimated reserve. A 5% change in the imbedded inflation would have changed estimated IBNR by approximately $47 million, either positive or negative, respectively, at December 31, 2011.
Workers’ Compensation - reserves recorded for workers’ compensation on voluntary business were $295.7 million as of December 31, 2011. A key assumption for workers’ compensation is the inflation rate underlying the estimated reserve. Given the long reporting pattern for this line of business, an additional key assumption is the amount of additional development required to reach full maturity, thereby reflecting ultimate costs, as represented by the tail factor. A 5% change in the imbedded inflation and a one point change to the tail factor assumption (e.g. 1.02 changed to 1.01 or 1.03) would have changed estimated IBNR by approximately $37 million, either positive or negative, at December 31, 2011.
Specialty Programs - reserves recorded (including allocated LAE) for the AIX Companies were $162.7 million as of December 31, 2011. A key assumption for specialty programs is the expected loss and allocated LAE ratio (“ELR”) underlying the actuarial reserve analysis. A five point change to the ELR on AIX would have changed estimated IBNR by approximately $6 million at December 31, 2011.
Chaucer Syndicate 4000- a nine month delay in the reporting of claims to the assumed development of Syndicate 4000 financial institution claims and doubling the probabilities of a total indemnity loss for each and every assured with potential exposure (or claims notified) to the fraud relating to Bernard L. Madoff, would have increased estimated IBNR by approximately $48 million at December 31, 2011.
Chaucer catastrophe events- assuming a 20% increase in estimated gross ultimate claim deterioration for the 2011 calendar year catastrophe events regarding the Japan and New Zealand earthquakes, Thailand, Denmark and Australia floods and Hurricane Irene, would have increased estimated IBNR by approximately $26 million at December 31, 2011.
Loss and LAE reserves for Chaucer were $2,332.8 million as of December 31, 2011. For our Commercial and Personal Lines businesses, total loss and LAE reserves increased by $149.8 million for the year ended December 31, 2011, primarily due to growth in our Commercial Lines business and catastrophe losses in the period. Other commercial lines are primarily comprised of our professional liability, general liability, umbrella, and marine lines. Included in the above table, in the Chaucer segment, is $302.8 million of reserves related to Chaucer’s participation in Syndicate 4000, consisting of financial and professional liability lines written in 2008 and prior. Also included in the above table, primarily in other commercial lines, are $59.8 million, $63.9 million and $76.8 million of asbestos and environmental reserves as of December 31, 2011, 2010 and 2009, respectively.
Additionally, within other commercial lines, unfavorable development in our professional liability and surety lines were partially offset by favorable development in our healthcare and other commercial property lines.
Lower than expected losses within our personal automobile line across all coverages, primarily related to the 2009 accident year.
Lower than expected losses within the commercial multiple peril line in liability coverages, primarily related to the 2007 through 2009 accident years.
Lower than expected losses within the surety line, lower projected losses in our run-off voluntary pools and lower projected exposures to asbestos and environmental liability for our direct written business.
Partially offsetting the favorable development was unfavorable non-catastrophe weather-related property loss development, primarily related to our homeowners, commercial property and personal automobile physical damage lines.
As a result of our historical direct underwriting mix of Commercial Lines policies toward smaller and middle market risks, past asbestos and environmental damage liability loss experience has remained minimal in relation to our total loss and LAE incurred experience.
During the year ended December 31, 2009, our ECRA pool reserves were lowered by $6.3 million as the result of an actuarial study completed by the ECRA pool manager. We reviewed the ECRA actuarial study, concurred that the study was reasonable, and adopted its estimate. In addition, we recorded additional favorable development of $4.3 million in the same year on a separate large claim settlement within these pools. Because of the inherent uncertainty regarding the types of claims in these pools, we cannot provide assurance that our reserves will be sufficient.
We maintain a reinsurance program designed to protect against large or unusual losses and LAE activity. We utilize a variety of reinsurance agreements that are intended to control our exposure to large property and casualty losses, stabilize earnings and protect capital resources, including facultative reinsurance, excess of loss reinsurance and catastrophe reinsurance. We determine the appropriate amount of reinsurance based upon our evaluation of the risks insured, exposure analyses prepared by consultants, our capital allocation models and on market conditions, including the availability and pricing of reinsurance. Reinsurance contracts do not relieve us from our primary obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to us. We believe that the terms of our reinsurance contracts are consistent with industry practice in that they contain standard terms and conditions with respect to lines of business covered, limit and retention, arbitration and occurrence. Based on an ongoing review of our reinsurers' financial statements, reported financial strength ratings from rating agencies, and the analysis and guidance of our reinsurance advisors, we believe that our reinsurers are financially sound.
See “Reinsurance” in Item 1 - Business of this Form 10-K on pages 17 to 20 for further information on our reinsurance programs.
Net investment income before taxes was $258.2 million, $247.2 million and $251.7 million for the years ended December 31, 2011, 2010 and 2009, respectively. The increase in net investment income in 2011 compared to 2010 was due to the acquisition of Chaucer and its related investment income, which contributed $16.9 million, partially offset by the impact of lower new money yields on fixed maturities. Higher dividend income from equity securities and lower investment expenses also contributed to the increase in net investment income. The decrease in net investment income in 2010 compared to 2009 was primarily due to the utilization of fixed maturities to fund certain corporate actions, such as stock and debt repurchases and $100 million contribution to our pension plan in January 2010. Lower new money yields also contributed to the decline. These decreases were partially offset by higher income from the investment of cash, principally into the bond market, and the investment of proceeds from our senior debt issuances. The average pre-tax earned yields on fixed maturities were 5.30%, 5.46% and 5.53% for the years ended December 31, 2011, 2010 and 2009, respectively, for the U.S. domiciled companies. Chaucer’s average pre-tax earned yield on fixed maturities was 2.10% for the period from acquisition at July 1, 2011 through December 31, 2011. We expect declines in average investment yields to continue as new money rates remain at historically low levels.
Total cash and investments increased $2.3 billion, or 43.5%, for the year ended December 31, 2011. The increase is attributable to the acquisition of Chaucer, with total cash and investments of $2.4 billion at December 31, 2011, consisting of $1,571.4 million of fixed maturities, $621.6 million of cash and cash equivalents, $137.8 million of other investments and $21.5 million of equity securities. Excluding Chaucer’s cash and investments, the investment portfolio decreased approximately 1% for the year.
Our fixed maturity portfolio is comprised of corporate securities, taxable and tax-exempt municipal securities, residential mortgage-backed securities, commercial mortgage-backed securities, U.S. government securities, foreign government securities and asset-backed securities.
Based on ratings by the National Association of Insurance Commissioners (“NAIC”), approximately 94% of the fixed maturity portfolio consisted of investment grade securities at December 31, 2011, compared to 93% at December 31, 2010. The quality of our fixed maturity portfolio remains strong based on ratings, capital structure position, support through guarantees, underlying security, issuer diversification and yield curve position.
Commercial mortgage-backed securities (“CMBS”) constitute $379.1 million of our invested assets, of which approximately 16% is fully defeased with U.S. government securities. The portfolio is seasoned, with approximately 58% of our CMBS holdings from pre-2005 vintages, 14% from the 2005 vintage, 8% from the 2007 vintage, 4% from the 2006 vintage, and 16% from 2010 and later vintages. The CMBS portfolio is of high quality, with approximately 81% being AAA rated and 19% rated AA or A. The CMBS portfolio has a weighted average loan-to-value ratio of 72% and credit enhancement of approximately 27% as of December 31, 2011.
Other investments consist primarily of overseas deposits, which are investments maintained in overseas funds and managed exclusively by Lloyd’s. These funds are required in order to protect policyholders in overseas markets and enable our Chaucer segment to operate in those markets. Access to those funds is restricted and we have no control over the investment strategy. Also included in other investments are investments in limited partnerships, which are accounted for under the equity method of accounting or at cost.
In addition, and in accordance with Lloyd’s operating guidelines, we are required to deposit funds at Lloyd’s to support our underwriting operations. These funds are available only to fund claim obligations. These restricted assets consisted of approximately $372 million of fixed maturities and $94 million of cash and cash equivalents as of December 31, 2011. We also deposit funds with various state and governmental authorities in the U.S. For a discussion of our deposits with state, governmental and regulatory authorities, see also Note 3-“Investments” on pages 99 to 102 of the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
Our fixed maturity and equity securities are classified as available-for-sale and are carried at fair value. Financial instruments whose value is determined using significant management judgment or estimation constitute less than 2% of the total assets we measured at fair value. (See also Note 5-“Fair Value” on pages 105 to 109 of the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K).
Our European fixed maturity credit exposure at December 31, 2011 was as follows:
Gross unrealized losses on fixed maturities and equity securities decreased $3.7 million, or 5.5%, to $63.8 million at December 31, 2011, compared to $67.5 million at December 31, 2010. The decrease in unrealized losses was primarily attributable to lower interest rates, partially offset by greater equity losses and widening of credit spreads across all sectors. At December 31, 2011, gross unrealized losses consist primarily of $40.3 million of corporate fixed maturities, $9.4 million of mortgage-backed securities, $8.8 million of equity securities, and $3.9 million in municipal securities.
We view the gross unrealized losses on fixed maturities and equity securities as being temporary since it is our assessment that these securities will recover in the near term, allowing us to realize their anticipated long-term economic value. With respect to gross unrealized losses on fixed maturities, we do not intend to sell, nor is it more likely than not we will be required to sell, such debt securities before this expected recovery of amortized cost (See also “Liquidity and Capital Resources” on pages 75 to 79 of this Form 10-K.). With respect to equity securities, we have the intent and ability to retain such investments for the period of time anticipated to allow for this expected recovery in fair value. The risks inherent in our assessment methodology include the risk that, subsequent to the balance sheet date, market factors may differ from our expectations; the global economic recovery is less robust than we expect or reverts to recessionary trends; we may decide to subsequently sell a security for unforeseen business needs; or changes in the credit assessment or equity characteristics from our original assessment may lead us to determine that a sale at the current value would maximize recovery on such investments. To the extent that there are such adverse changes, an OTTI would be recognized as a realized loss. Although unrealized losses are not reflected in the results of financial operations until they are realized or deemed “other-than-temporary”, the fair value of the underlying investment, which does reflect the unrealized loss, is reflected in our Consolidated Balance Sheets.
The following table sets forth gross unrealized losses for fixed maturities by maturity period and for equity securities at December 31, 2011 and 2010. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties, or we may have the right to put or sell the obligations back to the issuers.
Fiscal and monetary policies in place, primarily in the United States and Europe, are supportive of moderate economic growth. The removal or modification of these policies could have an adverse effect on issuers’ level of business activity or liquidity, increasing the probability of future defaults. While we may experience defaults on fixed income securities, particularly with respect to non-investment grade securities, it is difficult to foresee which issuers, industries or markets will be affected. As a result, the value of our fixed maturity portfolio could change rapidly in ways we cannot currently anticipate. Depending on market conditions, we could incur additional realized and unrealized losses in future periods.
In April 2011, we entered into a foreign currency forward contract to hedge the foreign currency exchange risk embedded in the purchase price of Chaucer, which was denominated in U.K. pound sterling (“GBP”). This contract had a notional amount of £297.9 million and was settled on July 14, 2011. For the year ended December 31, 2011, we recognized a loss of $11.3 million in income from continuing operations. The loss on the contract was due to a decrease in the exchange rate between the GBP and the U.S. dollar, but was more than offset by the lower U.S. dollars required to meet the GBP-based purchase price. Since a foreign currency hedge in which the hedged item is a forecasted transaction relating to a business combination does not qualify for hedge accounting under ASC 815, Derivatives and Hedging (“ASC 815”), we did not apply hedge accounting to this transaction. See Note 2-“Acquisitions and Discontinued Operations” on pages 96 to 98 of the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K for additional information.
Additionally, Chaucer held foreign currency forward contracts utilized to mitigate changes in fair value caused by foreign currency fluctuation in converting the fair value of GBP and Euro denominated investment portfolios into their U.S. dollar denominated equivalent. These portfolios supported U.S. dollar denominated claim reserve liabilities. We recognized a gain of $6.1 million related to these instruments. All Chaucer forward contracts were terminated in October 2011.
We manage investment assets for our Commercial Lines, Personal Lines, and Other Property and Casualty segments based on the requirements of our U.S. combined property and casualty companies. We allocate the investment income, expenses and realized gains to our Commercial Lines, Personal Lines and Other Property and Casualty segments based on actuarial information related to the underlying businesses. We manage investment assets separately for our Chaucer segment.
In 2011, we repurchased in several transactions, $69.5 million of our Series B 8.207% Subordinated Deferrable Interest Debentures (“Junior Debentures”) at a cost of $72.1 million, resulting in a net loss of $2.6 million on the repurchases. In addition, we repurchased $8.0 million of capital securities related to AIX Holdings, Inc. (“AIX”) at a cost of $7.7 million, resulting in a gain of $0.3 million. The net loss on all debt repurchases in 2011 was $2.3 million. In 2010, we repurchased $36.5 million of these Junior Debentures at a cost of $38.5 million, resulting in a loss of $2.0 million on the repurchase. During 2009, we completed a cash tender offer to repurchase a portion of our 8.207% Series B Capital Securities due in 2027 that were issued by AFC Capital Trust I (subsequently redeemed and exchanged for Junior Debentures) and a portion of our 7.625% Senior Debentures due in 2025 that were issued by THG. AFC Capital Trust I was subsequently liquidated as of July 30, 2009. As a result of these actions and including securities repurchased prior and subsequent to the tender offer, we recorded a pre-tax gain of $34.5 million in 2009.
Acquisition costs were $16.4 million for 2011 and primarily consist of advisory, legal, and accounting costs associated with the acquisition of Chaucer. See Note 2 - “Acquisitions and Discontinued Operations” on pages 96 to 98 of the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
In 2011, 2010 and 2009, we recognized a gain of $4.0 million, $1.8 million and $12.0 million, respectively, related to the sale of FAFLIC and the variable life insurance and annuity business. These gains were primarily due to reductions in the estimate of indemnification liabilities related to the sales. Gains in 2011 also included $1.7 million related to a settlement with the Internal Revenue Service (“IRS”) related to tax years 2005 and 2006 and other tax related items. See also “Income Taxes” on pages 68 and 69 of this Form 10-K.
The discontinued accident and health business had no significant financial results that impacted 2011 or 2010. The loss of $2.6 million in 2009 was primarily from net realized investment losses resulting from other-than-temporary impairments.
Our operations are subject to risk resulting from interest rate fluctuations which may adversely impact the valuation of the investment portfolio. In a rising interest rate environment, the value of the fixed income sector, which comprises 83% of our investment portfolio, may decline as a result of decreases in the fair value of the securities. Our intent is to hold securities to maturity and recover the decline in valuation as prices accrete to par. However, our intent may change prior to maturity due to changes in the financial markets, our analysis of an issuer's credit metrics and prospects, or as a result of changes in cash flow needs. Interest rate fluctuations may also reduce net investment income and as a result, profitability. The portfolio may realize lower yields and therefore lower net investment income on securities because the securities with prepayment and call features may prepay at a different rate than originally projected. In a declining interest rate environment, prepayments and calls may increase as issuers exercise their option to refinance at lower rates. The resulting funds would be reinvested at lower yields. In a rising interest rate environment, the funds may not be available to invest at higher interest rates.
The following tables for the years ended December 31, 2011 and 2010 provide information about our financial instruments that are sensitive to changes in interest rates.
The tables present principal cash flows and related weighted-average interest rates by expected maturities. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties, or we may have the right to put or sell the obligations back to the issuers. Mortgage-backed and asset-backed securities are included in the category representing their expected maturity. Available-for-sale securities include both U.S. and foreign-denominated fixed maturities. Additionally, we have assumed our available-for-sale securities are similar enough to aggregate those securities for presentation purposes. Specifically, variable rate available-for-sale securities comprise an immaterial portion of the portfolio and do not have a significant impact on weighted-average interest rates. Therefore, the variable rate investments are not presented separately; instead they are included in the tables at their current interest rate. Debt is presented at contractual maturities, except for the debt for previously acquired subsidiaries. We have presented this debt in the category that reflects the more likely payments, which is expected to be earlier than their contractual maturities.
Our Chaucer segment has exposure to foreign currency risk, most notably in its insurance contracts and its invested assets. Some of its insurance contracts provide that ultimate losses may be payable in foreign currencies depending on the country of original loss. Foreign currency exchange rate risk exists to the extent that there is an increase in the exchange rate of the foreign currency in which losses are ultimately owed. Thus, our Chaucer segment attempts to manage its foreign currency risk by seeking to match its liabilities under insurance and reinsurance policies that are payable in foreign currencies with cash and investments that are denominated in such currencies. We may also utilize foreign currency forward contracts as part of our investment strategy. The principal currencies creating foreign exchange risk for us are the U.K. pound sterling and the Canadian dollar. A hypothetical 10%
reduction in the value of foreign denominated investments would be expected to produce a loss in fair value of approximately $128 million at December 31, 2011. In 2010, we did not have material exposure to foreign currency related risk.
The benefit for income taxes from continuing operations was $9.6 million in 2011 and the provision for income taxes from continuing operations were $57.9 million and $83.1 million in 2010 and 2009, respectively. These amounts resulted in consolidated effective federal tax rates of (43.0)%, 27.4%, and 30.7% on pre-tax income for 2011, 2010, and 2009, respectively. These provisions reflect the decreases in our valuation allowance related to capital loss carryforwards of $7.5 million, $9.7 million, and $6.9 million in 2011, 2010, and 2009, respectively. In addition, the 2011 and 2010 provisions reflect benefits related to tax planning strategies implemented in prior years of $9.5 million and $3.2 million, respectively. Absent these benefits, the provision for income taxes for 2011, 2010, and 2009 would have been $7.4 million or 33.2%, $70.8 million or 33.5%, and $90.0 million or 33.2%, respectively.
Our income tax expense on segment income was $2.9 million for 2011, compared to $61.2 million for 2010 and $77.5 million in 2009. The decreases in 2011 and 2010 are primarily due to lower segment income.
Included in our deferred tax net asset as of December 31, 2011 is an asset of $31.7 million related to U.S. capital loss carryforwards. Our pre-tax capital losses carried forward are $90.5 million, including $80.0 million resulting from the sale of FAFLIC in 2009. At December 31, 2011, we have a full valuation allowance against this asset, since it is our opinion that it is more likely than not that the asset will not be realized. In addition, at December 31, 2011, we have a deferred tax asset of $33.6 million related to U.S. net operating loss carryforwards and we have a deferred tax asset of $14.5 million related to foreign net operating loss carryforwards. Our pre-tax U.S. operating loss carryforward of $95.9 will expire beginning in 2031. Our pre-tax foreign operating loss carryforwards of $62.1 million were generated in the U.K. and have no expiration date. It is our opinion that there will be sufficient future U.S. and U.K. taxable income to utilize these loss carryforwards. Our estimate of the gross amount and likely realization of loss carryforwards may change over time.
In January, July, September, and December 2010, we completed transactions which resulted in the realization, for tax purposes only, of unrealized gains in our investment portfolio of $98.4 million, $37.1 million, $31.1 million, and $120.8 million, respectively. These transactions enabled us to realize capital loss carryforwards to offset these gains, and resulted in the release of $66.2 million and $34.4 million in 2010 and 2009, respectively, of the valuation allowance we held against the deferred tax asset related to these capital loss carryforwards. The total release of $100.6 million was accounted for as an increase in income from continuing operations of $3.2 million and $6.0 million in 2010 and 2009, respectively, with the remaining $91.4 million reflected as a benefit in accumulated and other comprehensive income at December 31, 2010. During 2011, we recognized $9.5 million of the $91.4 million in income from continuing operations, related to non-segment income. The remaining amount will be released into income from continuing operations in future years, as the investment securities subject to these transactions are sold or mature.
The discussion and analysis of our financial condition and results of operations are based upon the consolidated financial statements. These statements have been prepared in accordance with GAAP, which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during
the reporting period. Actual results could differ from those estimates. The following critical accounting estimates are those which we believe affect the more significant judgments and estimates used in the preparation of our financial statements. Additional information about our other significant accounting policies and estimates may be found in Note 1-“Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data on pages 89 to 96 of this Form 10-K.
See “Segment Results - Reserves for Losses and Loss Adjustment Expenses” on pages 49 to 58 of this Form 10-K for a discussion of our critical accounting estimates for loss reserves.
We currently have a U.S. qualified defined benefit plan, a defined benefit pension plan for our international subsidiary, Chaucer, and several smaller qualified and non-qualified benefit plans. We account for our pension plans in accordance with ASC 715, Compensation - Retirement Benefits. In order to measure the liabilities and expense associated with these plans, we must make various estimates and key assumptions, including discount rates used to value liabilities, assumed rates of return on plan assets, employee turnover rates and anticipated mortality rates. Additionally, our Chaucer pension plan also must take into consideration inflation rates, specifically related to participant salary increases. These estimates and assumptions are reviewed at least annually and are based on our historical experience, as well as current facts and circumstances. In addition, we use outside actuaries to assist in measuring the expenses and liabilities associated with our defined benefit pension plans.
Two significant assumptions used in the determination of benefit plan obligations and expenses that are dependent on market factors, which have been subject to a greater level of volatility over the past few years, are the discount rate and the return on plan asset assumptions. The discount rate enables us to state expected future cash flows as a present value on the measurement date. We also use this
The benefit from the investment gains experienced in 2011 was essentially offset by a decrease in the discount rate from the prior year. In 2010, an actuarial loss of approximately $32 million primarily resulting from a decrease in the discount rate from the prior year was partially offset by the benefit from investment gains of approximately $21 million. These net losses resulted in adjustments to our accumulated net actuarial losses in 2011 and 2010 of approximately $0.4 million and $10.7 million, respectively, which are reflected as decreases to our accumulated other comprehensive income. The change in these actuarial gains and losses is amortized into earnings in future years. The adjustments to accumulated other comprehensive income from these actuarial losses occurring in 2011 and 2010 were offset by the amortization of actuarial losses from prior years of $14.0 million and $15.8 million in 2011 and 2010, respectively. Given the effect of our actual investment experience in 2011, and taking into consideration the decrease in discount rates in 2012, U.S. pension related expenses in 2012 are expected to decrease from 2011. Accordingly, we expect our pre-tax pension expense for the U.S. qualified defined benefit pension plan to decrease from approximately $9 million in 2011 to approximately $6 million in 2012.
Expected Return on Plan Assets - A 25 basis point increase or decrease in the expected return on plan assets would decrease or increase our pension expense in 2012 by $1.4 million.
Collectively, investment losses experienced in 2011, combined with the decrease in the discount rate, partially offset by a decrease in the inflation rate and changes in other assumptions, resulted in net actuarial losses for the Chaucer plan of approximately $14.1 million. These losses are reflected as a decrease to our accumulated other comprehensive income. This balance is amortized into earnings in future periods. Taking into consideration actual investment performance and the decrease in discount rates in 2012, pension related expenses for the Chaucer plan are expected to increase in 2012 from $0.4 million to approximately $1.8 million (using the December 31, 2011 GBP to U.S. dollar conversion rate of 1.55).
Discount Rate - A 25 basis point increase in the discount rate would decrease our pension expense in 2012 by $0.1 million and decrease our projected benefit obligation by $6.4 million. A 25 basis point reduction in the discount rate would increase our pension expense by $0.1 million and increase our projected benefit obligation by $7.0 million.
We employ a systematic methodology to evaluate declines in fair values below amortized cost for all fixed maturity and equity security investments. The methodology utilizes a quantitative and qualitative process which seeks to ensure that available evidence concerning the declines in fair value below amortized cost is evaluated in a disciplined manner. In determining whether a decline in fair value below amortized cost is other-than-temporary, we evaluate several factors and circumstances, including the issuer’s overall financial condition; the issuer’s credit and financial strength ratings; the issuer’s financial performance, including earnings trends, dividend payments and asset quality; any specific events which may influence the operations of the issuer; the general outlook for market conditions in the industry or geographic region in which the issuer operates; and the length of time and the degree to which the fair value of an issuer’s securities remains below our cost. With respect to fixed maturity investments, we consider factors that might raise doubt about the issuer’s ability to pay amounts due according to the contractual terms and whether we expect to recover the entire amortized cost basis of the security. With respect to equity securities, we consider our ability and intent to hold the investment for a period of time to allow for a recovery in value. We apply these factors to all securities.
borrowers, collateral trustee reports, credit ratings analysis and other market data when developing our estimate of the expected cash flows.
Other-than-temporary impairments of equity securities are recorded as realized losses, which reduce net income and earnings per share. The new cost basis of an impaired security is not adjusted for subsequent increases in estimated fair value.
For equity method investments, we recognize impairment when evidence demonstrates that a loss in value that is other-than-temporary has occurred. Evidence of a loss in value that is other-than-temporary may include the absence of an ability to recover the carrying amount of the investment or the inability of the investee to sustain a level of earnings that would justify the carrying amount of the investment. During each period, we evaluate whether an impairment indicator has occurred that may have a significant adverse affect on the carrying value of the investment. Impairment indicators may include: lower expectations of residual value from a limited partnership, reduced valuations of the investments held by limited partnerships, actual recent cash flows that are significantly less than expected cash flows or any other adverse events since the last financial statements received that might affect the value of the investee’s capital. Other-than-temporary impairments of limited partnerships are recorded as realized losses, which reduce net income and earnings per share.
Temporary declines in market value are recorded as unrealized losses, which do not affect net income and earnings per share, but reduce accumulated other comprehensive income, which is reflected in our Consolidated Balance Sheets. We cannot provide assurance that the other-than-temporary impairments will be adequate to cover future losses or that we will not have substantial additional impairments in the future. (See “Investments” on pages 59 to 64 of this Form 10-K for further discussion regarding other-than-temporary impairments and securities in an unrealized loss position).
The realization of deferred tax assets depends upon the existence of sufficient taxable income within the carryback or carryforward periods under the tax law in the applicable tax jurisdiction. Consideration is given to available positive and negative evidence, including reversals of deferred tax liabilities, projected future taxable income in each tax jurisdiction, tax planning strategies and recent financial operations. Valuation allowances are established if, based on the weight of available information, it is more likely than not that all or some portion of the deferred tax assets will not be realized. The determination of the valuation allowance for our deferred tax assets requires management to make certain judgments and assumptions. Our judgments and assumptions are subject to change given the inherent uncertainty in predicting future performance and specific industry and investment market conditions. Changes in valuation allowances are generally reflected in federal income tax expense or as an adjustment to other comprehensive income (loss) depending on the nature of the item for which the valuation allowance is being recorded.
The following are the components of our deferred tax assets and liabilities with the associated valuation allowance as of December 31, 2011.
We have $112.2 million of alternative minimum tax credit carryforwards. The alternative minimum tax credit carryforwards have no expiration date and may be used to offset regular federal income taxes due from future income. Based on our projected future taxable income, we expect to utilize these tax credits during the next four to five years. In addition, we have operating loss carryforwards that relate to current year U.S. net operating loss and foreign net operating loss carryforwards from our recently acquired Chaucer segment. The U.S. net operating loss carryforwards expire in 2031 and the Chaucer net operating loss carryforwards have no expiration date. Based on our projection of future economic conditions, taxable income, reversals of existing taxable temporary liabilities, and our strategic planning strategies, we believe that these operating loss carryforwards will be fully realized.
Our capital loss carryforwards relate to the loss from the sale of FAFLIC in 2009 and expire in 2014. In making our valuation allowance assessment for this deferred tax asset, we considered our carryforward capacity, reversals of deferred tax liabilities related to our investment portfolio, and tax planning strategies that include holding a portion of debt securities with market value losses until recovery and selling appreciated securities to offset capital losses. Given the nature and the magnitude of the loss and our ability to generate limited capital gains based on current market conditions in the next three years, we believe it is more likely than not that these assets will not be realized.
The statutory surplus for our U.S. insurance subsidiaries decreased $164.5 million during 2011, primarily due to a $99 million ordinary dividend paid to the holding company by Hanover Insurance in April 2011 and from changes in admitted tax assets. This dividend from Hanover Insurance was used to help fund the acquisition of Chaucer.
The NAIC prescribes an annual calculation regarding risk based capital (“RBC”). RBC ratios for regulatory purposes, as described in the glossary, are expressed as a percentage of the capital required to be above the Authorized Control Level (the “Regulatory Scale”); however, in the insurance industry, RBC ratios are widely expressed as a percentage of the Company Action Level. The following table reflects the Company Action Level, the Authorized Control Level and RBC ratios for Hanover Insurance (which includes Citizens and other U.S. insurance subsidiaries), as of December 31, 2011 and 2010, expressed both on the Industry Scale (Total Adjusted Capital divided by the Company Action Level) and Regulatory Scale (Total Adjusted Capital divided by Authorized Control Level):
Liquidity is a measure of our ability to generate sufficient cash flows to meet the cash requirements of business operations. As a holding company, our primary ongoing source of cash is dividends from our insurance subsidiaries. However, dividend payments to us by our U.S. insurance subsidiaries are subject to limitations imposed by regulators, such as prior notice periods and the requirement that dividends in excess of a specified percentage of statutory surplus or prior year’s statutory earnings receive prior approval (so called “extraordinary dividends”). On April 15, 2011, a $99 million ordinary dividend was paid to the holding company by Hanover Insurance. This dividend was used to help fund the acquisition of Chaucer. In 2010 and 2009, dividends of $75.0 million and $153.7 million, respectively, were paid by Hanover, providing cash and securities to the holding company.
Dividend payments to the holding company by our Chaucer business are regulated by U.K. law. Dividends from Chaucer are dependent on dividends from its subsidiaries. Annual dividend payments from Chaucer are limited to retained earnings that are not restricted by capital and other requirements for business at Lloyd’s. Also, Chaucer must provide advance notice to the U.K.’s Financial Services Authority (“FSA”) of certain proposed dividends or other payments from FSA regulated entities. There are currently no plans to repatriate dividends to our holding company from Chaucer.
Sources of cash for our insurance subsidiaries primarily consist of premiums collected, investment income and maturing investments. Primary cash outflows are paid claims, losses and loss adjustment expenses, policy acquisition expenses, other underwriting expenses and investment purchases. Cash outflows related to losses and loss adjustment expenses can be variable because of uncertainties surrounding settlement dates for liabilities for unpaid losses and because of the potential for large losses either individually or in the aggregate. We periodically adjust our investment policy to respond to changes in short-term and long-term cash requirements.
Net cash provided by operating activities was $221.7 million during 2011, compared to net cash provided by operations of $83.6 million in 2010 and $91.6 million in 2009. The $138.1 million increase in net cash provided by operating activities in 2011 compared to 2010 primarily resulted from the absence, in 2011, of a $100.0 million contribution made to our qualified defined benefit pension plan in 2010, and increased premium collections in 2011, primarily associated with OneBeacon business written in 2010 and our Chaucer business. The $8.0 million decrease in net cash provided by operating activities in 2010 compared to 2009 primarily resulted from a $100 million contribution to our qualified defined benefit pension plan in January 2010. In addition, cash was used to provide for higher operating expenses and increased loss and LAE payments in 2010. These cash uses in 2010 were almost entirely offset by cash provided by increased written premium in 2010.
At December 31, 2011, THG, as a holding company, held approximately $206 million of fixed maturities and cash. We believe our holding company assets are sufficient to meet our future obligations, which consists primarily of the interest on our senior debentures, our dividends to shareholders (as and to the extent declared), additional funds relating to the purchase of Chaucer, certain costs associated with benefits due to our former life employees and agents, and to the extent required, payments related to indemnification of liabilities associated with the sale of various subsidiaries. We do not expect that it will be necessary to dividend additional funds from our insurance subsidiaries in order to fund 2012 holding company obligations; however, we may decide to do so.
Our insurance subsidiaries maintain a high degree of liquidity within their respective investment portfolios in fixed maturity and short-term investments. We believe that the quality of the assets we hold will allow us to realize the long-term economic value of our portfolio, including securities that are currently in an unrealized loss position. We do not anticipate the need to sell these securities to meet our insurance subsidiaries’ cash requirements. We expect our insurance subsidiaries to generate sufficient operating cash to meet all short-term and long-term cash requirements. However, there can be no assurance that unforeseen business needs or other items will not occur causing us to have to sell those securities in a loss position before their values fully recover, thereby causing us to recognize impairment charges in that time period.
Since October 2007 and through December 2010, our Board of Directors has authorized aggregate repurchases of our common stock of up to $500 million. Our repurchases may be executed using open market purchases, privately negotiated transactions, accelerated repurchase programs or other transactions. We are not required to purchase any specific number of shares or to make purchases by any certain date under this program. During 2011, we repurchased 0.6 million shares of our common stock through open market purchases at a cost of $21.7 million. On March 30, 2010 and December 8, 2009, we entered into accelerated share repurchase agreements with Barclays Bank plc, acting through its agent Barclays Capital, Inc., and utilized a portion of our existing share repurchase
authorization for the immediate repurchase of 2.3 million and 2.4 million shares, respectively, of our common stock at a cost of $105.0 million and $105.2 million, respectively. Total repurchases under this program as of December 31, 2011 were 8.6 million shares at a cost of $364.8 million.
In November 2011, we entered into a Standby Letter of Credit Facility Agreement (the “Facility Agreement”) not to exceed $180.0 million outstanding at any one time, with the option to increase the amount available for issuances of letters of credit to $270.0 million in the aggregate on one occasion only during the term of the Facility Agreement (subject to the consent of all lenders and assuming no default and satisfaction of other specified conditions). The agreement provides certain covenants including, but not limited to, the syndicates’ financial condition. The Facility Agreement is used to provide regulatory capital supporting Chaucer’s underwriting through two managed syndicates. The Facility Agreement expires on December 31, 2016. A letter of credit commission fee on outstanding letters of credit is payable quarterly, and ranges from 1.50% to 2.125% per annum, depending on our credit ratings for portions that are not cash collateralized, and 0.30% per annum for portions that are cash collateralized. A commitment fee in respect of the unutilized commitments under the Facility Agreement is payable quarterly, and ranges from 0.60% to 0.85% per annum, depending on our credit ratings. Chaucer is also required to pay customary agency fees. We were in compliance with the covenants at December 31, 2011. The Facility Agreement replaces the aforementioned £90.0 million Standby Letter of Credit Facility entered into by Chaucer in 2010.
Our financing obligations generally include repayment of our Senior Debentures, Junior Debentures, subordinated debt, borrowings from the FHLBB, and operating lease payments. The following table represents our annual payments related to the contractual principal and interest payments of these financing obligations as of December 31, 2011 and operating lease payments reflect expected cash payments based upon lease terms. In addition, we also have included our estimated payments related to our loss and LAE obligations and our current expectation of payments to be made to support the obligations of our benefit plans. The following table also includes commitments to purchase investment securities at a future date. Actual payments may differ from the contractual and/or estimated payments in the table.
(3) In 2010, we contributed $100.0 million to our qualified defined benefit pension plan and do not expect to make any significant additional contributions in order to meet our minimum funding requirements. However, additional contributions may be required in the future based on the level of pension assets and liabilities in future periods.
Chaucer pension plan funding obligations reflect estimated payments to be made through plan year 2019 based on a payment schedule determined by the plan’s trustees. Additional contributions may be required for unfunded benefit obligations, if any, after plan year 2019 as determined by the plan’s trustees. For purposes of this table, we used the foreign currency exchange rate of 1.55 at December 31, 2011 to determine the future cash payments.
Management’s Discussion and Analysis contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. For a discussion of indicators of forward-looking statements and specific important factors that could cause actual results to differ materially from those contained in forward-looking statements, see Part I - Item 1A on pages 22 to 37 of this Annual Report of Form 10-K for the fiscal year ended December 31, 2011. This Management’s Discussion and Analysis should be read and interpreted in light of such factors.
Current accident year loss results - A non-GAAP measure of the estimated earnings impact of current premiums offset by estimated loss experience and expenses for the current accident year. This measure includes the estimated increase in revenue associated with higher prices (premiums), including those caused by price inflation and changes in exposure, partially offset by higher volume driven expenses and inflation of loss costs. Volume driven expenses include policy acquisition costs such as commissions paid to property and casualty agents, which are typically based on a percentage of premium dollars.
Security Lending - We engage our banking provider to lend securities from our investment portfolio to third parties. These lent securities are fully collateralized by cash. We monitor the fair value of the securities on a daily basis to assure that the collateral is maintained at a level of at least 102% of the fair value of the loaned securities. We record securities lending collateral as a cash equivalent, with an offsetting liability in expenses and taxes payable.
As described in Management’s Report on Internal Control Over Financial Reporting, management has excluded Chaucer Holdings PLC (“Chaucer”), which was acquired on July 1, 2011, from its assessment of the effectiveness of internal control over financial reporting as of December 31, 2011. We have also excluded Chaucer from our audit of internal control over financial reporting. The total assets and total revenues of Chaucer constitute approximately $4 billion or 31.7% and $541 million or 13.8%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2011.
The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates.
In the opinion of the Company’s management these financial statements reflect all adjustments, consisting of normal recurring items necessary for a fair presentation of the financial position and results of operations. The acquisition of Chaucer on July 1, 2011, which has added meaningful business volumes to THG’s second half of fiscal year 2011 results, has affected the comparability of the consolidated financial statements.
In accordance with the provisions of ASC 320, Investments - Debt and Equity Securities (“ASC 320”), the Company is required to classify its investments into one of three categories: held-to-maturity, available-for-sale or trading. The Company determines the appropriate classification of fixed maturity and equity securities at the time of purchase and re-evaluates such designation as of each balance sheet date.
The Company reviews investments in an unrealized loss position to identify other-than-temporary declines in value. On April 1, 2009, the Company adopted accounting guidance which modified the assessment of other-than-temporary impairments (“OTTI”) on debt securities, as well as the method of recording and reporting other-than-temporary impairments. When it is determined that a decline in value of an equity security is other-than-temporary, the Company reduces the cost basis of the security to fair value with a corresponding charge to earnings. When an other-than-temporary decline in value of a debt security is deemed to have occurred, the Company must assess whether it intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis. If the debt security meets either of these two criteria, an other-than-temporary impairment is recognized in earnings equal to the entire difference between the security’s amortized cost basis and its fair value at the impairment measurement date. If the Company does not intend to sell the debt security and it is not more likely than not the Company will be required to sell the security before recovery of its amortized cost basis, the credit loss portion of an other-than-temporary impairment is recorded through earnings while the portion attributable to all other factors is recorded separately as a component of other comprehensive income. The amount of the other-than-temporary impairment that relates to credit is estimated by comparing the amortized cost of the fixed maturity security with the net present value of the fixed maturity security’s projected future cash flows, discounted at the effective interest rate implicit in the investment prior to impairment. The non-credit portion of the impairment is equal to the difference between the fair value and the net present value of the fixed maturity security at the impairment measurement date. Once an OTTI
has been recognized, the new amortized cost basis of the security is equal to the previous amortized cost less the amount of OTTI recognized in earnings. Prior to the adoption of this guidance on April 1, 2009, an other-than-temporary impairment recognized in earnings for fixed maturity securities was equal to the difference between amortized cost and fair value at the time of impairment. For equity method investments, an impairment is recognized when evidence demonstrates that an other-than-temporary loss in value has occurred, including the absence of the ability to recover the carrying amount of the investment or the inability of the investee to sustain a level of earnings that would justify the carrying amount of the investment.
The Company tests for the recoverability of long-lived assets whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. The Company recognizes impairment losses only to the extent that the carrying amounts of long-lived assets exceed the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the assets. When an impairment loss occurs, the Company reduces the carrying value of the asset to fair value. Fair values are estimated using discounted cash flow analysis.
The Company tests for the recoverability of goodwill and intangible assets with indefinite lives annually or whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. The Company recognizes impairment losses only to the extent that the carrying amounts of reporting units with goodwill exceed the fair value. The amount of the impairment loss that is recognized is determined based upon the excess of the carrying value of goodwill compared to the implied fair value of the goodwill, as determined with respect to all assets and liabilities of the reporting unit. The Company has performed its annual review of goodwill and intangible assets with indefinite lives for impairment in the fourth quarters of 2011 and 2010 with no impairments recognized.
Liabilities for outstanding claims, losses and loss adjustment expenses (“LAE”) are estimates of payments to be made on property and casualty contracts for reported losses and LAE and estimates of losses and LAE incurred but not reported. These liabilities are determined using case basis evaluations and statistical analyses of historical loss patterns and represent estimates of the ultimate cost of all losses incurred but not paid. These estimates are continually reviewed and adjusted as necessary; adjustments for our property and casualty business are reflected in current operations. Estimated amounts of salvage and subrogation on unpaid property and casualty losses are deducted from the liability for unpaid claims.
Insurance premiums written are generally recorded at the policy inception and are primarily earned on a pro rata basis over the terms of the policies for all products. Premiums written include estimates, primarily in the Chaucer segment, that are derived from multiple sources which include the historical experience of the underlying
business, similar businesses and available industry information. These estimates are regularly reviewed and updated and any resulting adjustments are included in the current year’s results. Unearned premium reserves represent the portion of premiums written that relates to the unexpired terms of the underlying in-force insurance policies and reinsurance contracts. Premium receivables reflect the unpaid balance of premium written as of the balance sheet date. Premium receivables are generally short-term in nature and are reported net of allowance for estimated uncollectible premium accounts. The Company reviews its receivables for collectibility at the balance sheet date. The allowance for uncollectible accounts was not material as of December 31, 2011 and 2010. Ceded premiums are charged to income over the applicable term of the various reinsurance contracts with third party reinsurers. Reinsurance reinstatement premiums, when required, are recognized in the same period as the loss event that gave rise to the reinstatement premiums. Losses and related expenses are matched with premiums, resulting in their recognition over the lives of the contracts. This matching is accomplished through estimated and unpaid losses and amortization of deferred policy acquisition costs.
The Company is subject to the tax laws and regulations of the U.S. and foreign countries in which it operates. The Company files a consolidated U.S. federal income tax return that includes the holding company and its U.S. subsidiaries. Generally, taxes are accrued at the U.S. rate of 35% for income from the U.S. operations. The Company’s primary non-U.S. jurisdiction is the U.K. with a current tax rate of 26%. However, THG accrues taxes on certain non-U.S. income which is subject to U.S. tax as a result of being owned by a U.S. shareholder at the U.S. rate. Foreign tax credits, where available, are utilized to offset U.S. tax as permitted. Certain non-U.S. income is not subject to U.S. tax until repatriated. Foreign taxes on this non-U.S. income are accrued at the local foreign rate and do not have an accrual for U.S. deferred taxes as these earnings are intended to be permanently reinvested overseas.
Deferred income taxes are generally recognized when assets and liabilities have different values for financial statement and tax reporting purposes, and for other temporary taxable and deductible differences as defined by ASC 740, Income Taxes (“ASC 740”). These temporary differences are measured at the balance sheet date using enacted tax rates expected to apply to taxable income in the years the temporary differences are expected to reverse. These differences result primarily from insurance reserves, deferred policy acquisition costs, tax credit carryforwards, loss carryforwards, and employee benefit plans.
The Company recognizes the fair value of compensation costs for all share-based payments, including employee stock options, in the financial statements. Unvested awards are generally expensed on a straight line basis, by tranche, over the vesting period of the award. The Company’s stock-based compensation plans are discussed further in Note 10 - “Stock-Based Compensation Plans”.
Earnings per share (“EPS”) for the years ended December 31, 2011, 2010 and 2009 is based on a weighted average of the number of shares outstanding during each year. Basic and diluted EPS is computed by dividing income available to common stockholders by the weighted average number of shares outstanding for the period. The weighted average shares outstanding used to calculate basic EPS differ from the weighted average shares outstanding used in the calculation of diluted EPS due to the effect of dilutive employee stock options, nonvested stock grants and other contingently issuable shares. If the effect of such items is antidilutive, the weighted average shares outstanding used to calculate diluted EPS equal those used to calculate basic EPS.
in effect at the balance sheet date. Revenues and expenses of foreign operations are translated using the average exchange rate for the period. Gains or losses from translating the financial statements of foreign operations are recorded in cumulative translation adjustment, as a separate component of accumulated other comprehensive income. Gains and losses arising from transactions denominated in a foreign currency, other than the Company’s functional currencies, are included in net income (loss), except for the Company’s foreign currency denominated available-for-sale investments. The Company’s foreign currency denominated available-for-sale investments’ change in exchange rates between the local currency and the functional currency at each balance sheet date represents an unrealized appreciation or depreciation in value of these securities, and is included as a component of accumulated other comprehensive income.
In December 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Codification (“ASC”) Update No. 2010-29 (Topic 805) Disclosure of Supplementary Pro Forma Information for Business Combinations (a consensus of the FASB Emerging Issues Task Force). This update provides clarity on the presentation of comparable pro forma financial statements for business combinations. Revenues and earnings of the combined entity should be disclosed as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. Additionally, this update requires the disclosure to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The disclosure guidance provided in this ASC update is effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. The Company implemented this guidance as of January 1, 2011. Implementing this guidance did not have an effect on the Company’s financial position or results of operations upon adoption; however, the disclosure requirements were applied to the Company’s acquisition of Chaucer. See Note 2 - “Acquisitions and Discontinued Operations” for pro forma results of operations of THG and Chaucer.
In December 2010, the FASB issued ASC Update No. 2010-28 (Topic 350) When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts (a consensus of the FASB Emerging Issues Task Force). This update modifies Step 1 of the goodwill impairment test for companies with zero or negative carrying amounts to require Step 2 of the goodwill impairment test to be performed if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist. This ASC update was effective for annual and interim periods beginning after December 15, 2010. The Company implemented this guidance as of January 1, 2011. The effect of implementing this guidance was not material to the Company’s financial position or results of operations.
In July 2010, the FASB issued ASC Update No. 2010-20 (Topic 310) Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. This ASC update is applicable for financing receivables recognized on a company’s balance sheet that have a contractual right to receive payment either on demand or on fixed or determinable dates. This update enhances the disclosure requirements about the credit quality of financing receivables and the allowance for credit losses, at disaggregated levels. The disclosure guidance provided in the update relating to those required as of the end of the reporting period was effective for interim and annual reporting periods ending on or after December 15, 2010. The effect of implementing the guidance was not significant to the Company’s financial statement disclosures. The disclosure guidance related to activity that occurs during the reporting period is effective for interim and annual reporting periods beginning on or after December 15, 2010. The implementation of the disclosure guidance related to activity was not significant to the Company’s financial statement disclosures.
In January 2010, the FASB issued ASC Update No. 2010-06 (Topic 820) - Improving Disclosures about Fair Value Measurements. This update amends ASC 820 and
In December 2009, the FASB issued ASC Update No. 2009-17, Consolidation (Topic 810) - Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities which codified Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretation No. 46(R). This guidance amends FASB Interpretation No. 46R, Consolidation of Variable Interest Entities an interpretation of ARB No. 51 to require an analysis to determine whether a company has a controlling financial interest in a variable interest entity. This analysis identifies the primary beneficiary of a variable interest entity as the enterprise that has a) the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and b) the obligation to absorb losses of the entity that could potentially be significant to the variable interest entity or the right to receive benefits from the entity that could potentially be significant to the variable interest entity. The statement requires an ongoing assessment of whether a company is the primary beneficiary of a variable interest entity when the holders of the entity, as a group, lose power, through voting or similar rights, to direct the actions that most significantly affect the entity’s economic performance. This statement also enhances disclosures about a company’s involvement in variable interest entities. This ASC update was effective as of the beginning of the first annual reporting period that began after November 15, 2009. The Company implemented this guidance as of January 1, 2010. The effect of implementing this guidance was not material to the Company’s financial position or results of operations.
In September 2011, the FASB issued ASC Update No. 2011-08 (Topic 350) Testing Goodwill for Impairment. This ASC update allows an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. The update provides that an entity would not be required to calculate the fair value of a reporting unit unless the entity determines, based on its qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. The update further improves previous guidance by expanding upon the examples of events and circumstances that an entity should consider in determining whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Also, the update improves the examples of events and circumstances that should be considered by an entity that has a reporting unit with a zero or negative carrying amount in determining whether to measure an impairment loss, if any, under the second step of the goodwill impairment test. This ASC update is effective for annual and interim periods beginning after December 15, 2011, with early adoption permitted. The Company does not expect the adoption of this ASC to have a material impact on its financial position or results of operations.
In May 2011, the FASB issued ASC Update No. 2011-04 (Topic 820) Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASC update results in a consistent definition of fair value and common requirements for measurement of and disclosure about fair value between U.S. GAAP and International Financial Reporting Standards (“IFRS”). The new guidance includes changes to how and when the valuation premise of highest and best use applies, clarification on the application of blockage factors and other premiums and discounts, as well as new and revised disclosure requirements. This ASC update is effective for interim and annual periods beginning after December 15, 2011. The Company does not expect the adoption of this ASC to have a material impact on its financial position or results of operations.
In October 2010, the FASB issued ASC Update No. 2010-26 (Topic 944), Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts (a consensus of the FASB Emerging Issues Task Force). This ASC update provides clarity in defining which costs relating to the acquisition of new or renewal insurance contracts qualify for deferral, commonly known as deferred acquisition costs. Additionally, this update specifies that only costs associated with the successful acquisition of a policy or contract may be deferred, whereas industry practice historically included costs relating to unsuccessful contract acquisition. This ASC is effective for fiscal years beginning after December 15, 2011. Retrospective application to all prior periods upon the date of adoption is also permitted. The Company has elected to apply this guidance retrospectively. Management anticipates that the implementation of this ASC would result in an after-tax reduction to our stockholders’ equity as of January 1, 2012 of approximately $26 million, or approximately 1%. The adoption of this guidance is not expected to have a material impact on our results of operations on either a historical or prospective basis.
Liabilities for outstanding claims, losses and LAE are estimates of payments to be made on health insurance contracts for reported losses and LAE and estimates of losses and LAE incurred but not reported. These liabilities are determined using case basis evaluations and statistical analyses of historical loss patterns and represent estimates of the ultimate cost of all losses incurred but not paid. These estimates are continually reviewed and adjusted as necessary; adjustments are reflected in discontinued operations. Although the adequacy of these amounts cannot be assured, the Company believes that it is more likely than not that policy liabilities and accruals will be sufficient to meet future obligations of policies in force. The amount of liabilities and accruals, however, could be revised in the near-term if the estimates discussed above are revised.
On July 1, 2011, the Company acquired Chaucer, a United Kingdom (“U.K.”) insurance business. Chaucer is a leading specialist managing agency at Lloyd’s. Chaucer underwrites business in several lines of business, including property, marine and aviation, energy, U.K. motor and casualty and other coverages (which include international liability, specialist coverages, and syndicate participations). Chaucer is headquartered in London, with a regional presence in Whitstable, England and locations in Houston, Singapore, Buenos Aires, and Copenhagen.
The difference between the aggregate purchase price at signing and closing is attributable to the effect of currency fluctuations between the GBP and the U.S. dollar, as well as a change in outstanding shares.
The purchase price has been allocated as follows based on an estimate of the fair value of assets acquired and liabilities assumed as of July 1, 2011 (converted to U.S. dollars using an exchange rate of 1.6053):
A summary of the preliminary fair value of goodwill and the identifiable intangible assets and their respective estimated useful lives at July 1, 2011 is as follows:
The following unaudited pro forma information presents the combined revenues, net income and net income per share of THG and Chaucer for the years ended December 31, 2011, 2010, and 2009 with pro forma purchase accounting adjustments as if the acquisition had been consummated as of January 1, 2009. This pro forma information is not necessarily indicative of what would have occurred had the acquisition and related transactions been made on the dates indicated, or of future results of the Company. Amounts in 2010 and 2009 are converted from GBP to U.S. dollar at rates of 1.55 and 1.57, respectively.
On January 2, 2009, THG sold its remaining life insurance subsidiary, FAFLIC, to Commonwealth Annuity and Life Insurance Company (“Commonwealth Annuity”), a subsidiary of The Goldman Sachs Group, Inc. (“Goldman Sachs”). Previously, on December 30, 2005, the Company sold its variable life insurance and annuity business to Goldman Sachs, including the reinsurance of 100% of the variable business of FAFLIC. THG agreed to indemnify Commonwealth Annuity and Goldman Sachs for certain litigation, regulatory matters and other liabilities relating to the pre-closing activities of the businesses that were sold. As of December 31, 2011, the Company’s total gross liability related to these guarantees was $3.8 million. The Company regularly reviews and updates this liability for legal and regulatory matter indemnities. Although the Company believes its current estimate for this liability is appropriate, there can be no assurance that these estimates will not materially increase in the future. Adjustments to this reserve are recorded in the results of the Company in the period in which they are determined.
In 2011, 2010 and 2009, the Company recognized gains of $4.0 million, $1.8 million and $12.0 million, respectively, related to the Discontinued FAFLIC and Variable Life Insurance and Annuity Business. These gains were primarily due to reductions in the estimate of indemnification liabilities related to the sales. Gains in 2011 also included $1.7 million related to a settlement with the Internal Revenue Service (“IRS”) for tax years 2005 and 2006 and other tax related items. See also Note 7-“Income Taxes” for additional information.
The accident and health business had no significant financial results that impacted 2011 or 2010. The loss of $2.6 million 2009 was primarily from net realized investment losses resulting from other-than-temporary impairments. At December 31, 2011 and 2010, the portion of the discontinued accident and health business that was directly assumed had assets of $70.4 million and $59.3 million, respectively, consisting primarily of invested assets and reinsurance recoverables, and liabilities of $52.1 million and $53.2 million, respectively, consisting primarily of policy liabilities. At December 31, 2011 and 2010, the assets and liabilities of this business, as well as those of the reinsured portion of the accident and health business are classified as assets and liabilities of discontinued operations in the Consolidated Balance Sheets.
The Company participates in a security lending program for the purpose of enhancing income. Securities on loan to various counterparties had a fair value of $24.1 million and $65.2 million at December 31, 2011 and 2010, respectively, and were fully collateralized by cash. The fair value of the loaned securities is monitored on a daily basis, and the collateral is maintained at a level of at least 102% of the fair value of the loaned securities. Securities lending collateral is recorded by the Company in cash and cash equivalents, with an offsetting liability included in expenses and taxes payable.
In accordance with Lloyd’s operating guidelines, the Company deposits funds at Lloyd’s to support underwriting operations. These funds are available only to fund claim obligations. These restricted assets consisted of approximately $372 million of fixed maturities and $94 million of cash and cash equivalents as of December 31, 2011.
In April 2011, the Company entered into a foreign currency forward contract as an economic hedge of the foreign currency exchange risk embedded in the purchase price of Chaucer, which was denominated in GBP. For the year ended December 31, 2011, the Company recorded a loss of $11.3 million, reflected in other operating expenses in the Consolidated Statements of Income. This contract had a notional amount of £297.9 million and was settled on July 14, 2011. Since a foreign currency hedge in which the hedged item is a forecasted transaction relating to a business combination does not qualify for hedge accounting under ASC 815, Derivatives and Hedging (“ASC 815”), the Company did not apply hedge accounting to this transaction. See Note 2 - “Acquisitions and Discontinued Operations” for additional information.
In May 2011, the Company entered into a treasury lock forward agreement to hedge the interest rate risk associated with the planned issuance of senior debt, which was completed on June 17, 2011. This hedge qualified as a cash flow hedge under ASC 815. It matured in June 2011 and resulted in a loss of $1.9 million, which was recorded in accumulated other comprehensive income and will be recognized as an expense over the term of the senior notes. All components of the derivative’s loss were included in the assessment of hedge effectiveness. There was no ineffectiveness on this hedge. The Company expects $0.2 million will be recognized as an expense over the next 12 months.
Equity securities and other balances at December 31, 2011, 2010 and 2009 include after-tax net appreciation on other invested assets of $1.9 million, $1.8 million and $1.3 million, respectively. Fixed maturities at December 31, 2011 include $1.2 million of after-tax net depreciation associated with derivative instruments.
The Company had no concentration of investments in a single investee that exceeded 10% of shareholders’ equity except for fixed maturities invested in Federal Home Loan Mortgage Corp., which had a fair value of $455.0 million and $439.1 million as of December 31, 2011 and 2010, respectively.
On June 14, 2010, the Company purchased approximately 11 acres of developable land in Worcester, Massachusetts for $5 million. A portion of the land will be developed with the construction of a new 200,000 square foot office building and the redevelopment of an adjacent parking garage (the “City Square Project”). In addition, the Company signed a 17 year lease agreement with a tenant for the new building and garage. The tenant is an unaffiliated public company with an investment grade credit rating. During 2011 and 2010, the Company capitalized $8.3 million and $12.4 million, respectively, in related construction, lease acquisition, legal, architectural and associated costs. Development costs are estimated between $65 million and $70 million and the project will be financed, in part, through the issuance of collateralized debt through the Company’s membership in the FHLBB. See Note 6-“Debt and Credit Arrangements” for additional information related to the Company’s FHLBB program.
ASC 320 required a cumulative effect adjustment upon adoption to reclassify the non-credit component of previously recognized impairments from retained earnings to other comprehensive income. The Company reviewed previously recognized OTTI recorded through realized losses on securities held at April 1, 2009, which was approximately $121 million, and determined that $33.3 million of these OTTI were related to non-credit factors, such as interest rates and market conditions. Accordingly, the Company increased the amortized cost basis of these debt securities and recorded a cumulative effect adjustment of $33.3 million within shareholders’ equity. The cumulative effect adjustment had no effect on total shareholders’ equity as it increased retained earnings and reduced accumulated other comprehensive income.
For 2011, total OTTI was $4.9 million. Of this amount, $6.9 million was recognized in earnings, including $2.0 million that was transferred from unrealized losses in accumulated other comprehensive income. Of the $6.9 million recorded in earnings, $4.6 million related to fixed maturity securities that the Company intends to sell, $1.4 million related to common stocks and $0.9 million was estimated credit losses on fixed maturity securities. Other-than-temporary impairments recognized on fixed maturity securities during 2011 primarily included $3.4 million on below investment grade corporate bonds principally in the industrial and utilities sectors, $1.0 million on below investment grade municipal bonds and $0.9 million on investment grade residential mortgage-backed securities.
For 2010, total OTTI was $9.4 million. Of this amount, $13.9 million was recognized in earnings, including $4.5 million that was transferred from unrealized losses in accumulated other comprehensive income. Of the $13.9 million recorded in earnings, $4.4 million related to certain low-income housing tax credit limited partnerships, $4.3 million was estimated credit losses on fixed maturity securities, $3.3 million related to fixed maturity securities that the Company intended to sell and $1.9 million related to common stocks. Other-than-temporary impairments recognized on fixed maturity securities during 2010 primarily included $2.9 million on below investment grade corporate bonds principally in the industrial and utilities sectors and $2.7 million on investment grade residential mortgage-backed securities and $1.2 million on investment grade corporate bonds in the industrial sector.
For 2009, total OTTI was $42.2 million. Of this amount, $32.9 million was recognized in earnings and the remaining $9.3 million was recorded as unrealized losses in accumulated other comprehensive income. Of the OTTI recognized in earnings, $15.7 million related primarily to below investment grade corporate bonds in the industrial sector that the Company intended to sell and $9.6 million was from equities, including perpetual preferred securities primarily in the financial sector. In addition, the Company recorded OTTI of $7.6 million that was estimated credit losses, primarily on below investment grade fixed maturity securities, including $4.1 million on corporate bonds, $2.1 million on residential mortgage-backed securities and $1.4 million on a municipal bond.
The methodology and significant inputs used to measure the amount of credit losses on fixed maturities in 2011, 2010 and 2009 were as follows:
Municipals-the Company utilized cash flow estimates based on bond specific facts and circumstances that may include the political subdivision’s taxing authority, the issuer’s ability to adjust user fees or other sources of revenue to satisfy its debt obligations and the ability to access insurance or guarantees.
The effective date of the section of ASC 320 requiring this disclosure was April 1, 2009. Therefore, 2009 data in the above table represents results for the period of April 1 through December 31, 2009.
When more than one level of input is used to determine fair value, the financial instrument is classified as Level 2 or 3 according to the lowest level input that has a significant impact on the fair value measurement.
Corporate fixed maturities - overall credit quality, including assessments of the level and variability of: industry economic sensitivity; company financial policies; quality of management; regulatory environment; competitive position; restrictive covenants; and security or collateral.
Commercial mortgage-backed securities - overall credit quality, including assessments of the level and variability of: collateral type such as office, retail, residential, lodging, or other; geographic concentration by region, state, metropolitan statistical area and locale; vintage year; historical collateral performance including defeasance, delinquency, default and special servicer trends; and capital structure support features.
Level 1 includes publicly traded securities valued at quoted market prices. Level 2 includes securities that are valued using pricing for similar securities and pricing models that incorporate observable inputs. Level 2 also includes fair values obtained from net asset values provided by mutual fund investment managers, upon which subscriptions and redemptions can be executed. Level 3 consists of common or preferred stock of private companies for which observable inputs are not available.
Fair values of overseas trust funds are provided by the investment manager based on quoted prices for similar instruments in active markets and are reported as Level 2.
The fair value of debt was estimated based on quoted market prices. If a quoted market price is not available, fair values are estimated using discounted cash flows that are based on current interest rates and yield curves for debt issuances with maturities and credit risks consistent with the debt being valued.
The Company has processes designed to ensure that the values received from its third party pricing service are accurately recorded, that the data inputs and valuation techniques utilized are appropriate and consistently applied and that the assumptions are reasonable and consistent with the objective of determining fair value. The Company performs a review of the fair value hierarchy classifications and of prices received from its pricing service on a quarterly basis. The Company reviews the pricing services’ policies describing its methodology, processes, practices and inputs, including various financial models used to value securities. Also, the Company reviews the portfolio pricing. Securities with changes in prices that exceed a defined threshold are verified to independent sources if available. If upon review, the Company is not satisfied with the validity of a given price, a pricing challenge would be submitted to the pricing service along with supporting documentation for its review. The Company does not adjust quotes or prices obtained from the pricing service unless the pricing service agrees with the Company’s challenge. During 2011 and 2010, the Company did not adjust any prices received from brokers or its pricing service.
There were no Level 3 liabilities held by the Company for the years ended December 31, 2011 and 2010.
On July 1, 2011, the Company acquired all of the outstanding shares of Chaucer. As part of this acquisition, 12.0 million aggregate principal amount of floating rate subordinated unsecured notes issued by Chaucer in 2004, due November 16, 2034, were assumed. These notes pay interest semi-annually based on the European Inter bank offer rate (Euribor) plus 3.75%. These notes are converted from Euro to GBP at current rates and then translated to U.S. dollars based upon the December 31, 2011 exchange rate between the GBP and U.S. dollar of 1.55. Additionally, the Company also assumed $50.0 million aggregate principal amount of floating rate subordinated unsecured notes issued by Chaucer in 2006 and due September 21, 2036. These notes pay interest quarterly based on the three-month LIBOR plus 3.1%.
The following are the components of the Company’s deferred tax assets and liabilities (excluding those associated with their discontinued operations).
Deferred tax assets are reduced by a valuation allowance if it is more likely than not that all or some portion of the deferred tax assets will not be realized. Certain prior year amounts have been reclassified to conform to the current year presentation.
At December 31, 2011, the Company has a deferred tax asset of $31.7 million related to U.S. capital loss carryforwards. The pre-tax capital losses carried forward are $90.5 million, including $80.0 million resulting from the sale of
In September 2011, the Company completed a transaction which resulted in the realization, for tax purposes only, of unrealized gains in our investment portfolio of $98.4 million. This transaction enabled the Company to realize capital loss carryforwards to offset this gain, and resulted in the release of $29.0 million of the valuation allowance held against the deferred tax asset related to these capital loss carryforwards. The release of $0.2 million was reflected in income from continuing operations and the remaining amount of $28.8 million was reflected as a benefit in accumulated other comprehensive income. This amount will be released into income from continuing operations, related to non-segment income, in future years, as the investment securities subject to these transactions are sold or mature.
In January, July, September, and December 2010, the Company completed transactions which resulted in the realization, for tax purposes only, of unrealized gains in its investment portfolio of $98.4 million, $37.1 million, $31.1 million, and $120.8 million, respectively. These transactions enabled the Company to realize capital loss carryforwards to offset these gains, and resulted in the release of $66.2 million and $34.4 million in 2010 and 2009, respectively, of the valuation allowance it held against its deferred tax asset related to these capital loss carryforwards. The total release of $100.6 million was accounted for as an increase in income from continuing operations of $3.2 million and $6.0 million in 2010 and 2009, respectively, with the remaining $91.4 million reflected as a benefit in accumulated other comprehensive income at December 31, 2010. During 2011, the Company recognized $9.5 million of the $91.4 million in income from continuing operations related to non-segment income. The remaining amount will be released into income from continuing operations in future years, as the investment securities subject to these transactions are sold or mature.
since these gains utilized the Company’s capital loss carryforwards. The remaining $1.1 million decrease was attributable to other items reflected as income from discontinued operations.
Certain of the Company’s non-U.S. income is not subject to U.S. tax until repatriated. Foreign taxes on this non - U.S. income are accrued at the local foreign tax rate, as opposed to the higher U.S. statutory tax rate, since these earnings currently are expected to be permanently reinvested overseas. This assumption could change, as a result of a sale of the subsidiaries, the receipt of dividends from the subsidiaries, a change in management’s intentions, or as a result of various other events. At December 31, 2011, the Company has not made a provision for U.S. taxes on $3.4 million of non-U.S. income. However, in the future, if such earnings were distributed to the Company, taxes of $1.5 million would be payable on such undistributed earnings and would be reflected in the tax provision for the year in which these earnings are no longer intended to be permanently reinvested overseas, assuming all foreign tax credits are realized.
In September 2009, as part of the audit of 2005 and 2006, the IRS issued a Revenue Agents Report (“RAR”) which disallowed the dividends received deduction related to separate account assets for both 2005 and 2006. The Company challenged the disallowance by filing a formal protest and requested an IRS Appeals Conference. In 2011, the Company received written notification from the IRS Appeals Division reflecting a proposed settlement including a concession of the separate account dividends received deduction issue. As a result of the proposed settlement with the IRS, the liability for uncertain tax position on the Company’s dividends received deductions related to separate account assets was reduced in the current year. This reduction was partially offset by the settlement of certain receivable balances. The net tax benefit of $2.1 million is recorded as income from discontinued operations.
The Company recognizes interest and penalties related to unrecognized tax benefits in federal income tax expense. In 2011, as part of the settlement of the 2005 and 2006 audit period, the Company reduced its accrued interest by $0.7 million. The Company had accrued interest of $0.3 million and $1.0 million as of December 31, 2011 and 2010, respectively. The Company has not recognized any penalties associated with unrecognized tax benefits.
The Company recognizes the funded status of its defined benefit plans in its Consolidated Balance Sheet. The funded status is measured as the difference between the fair value of plan assets and the projected benefit obligation of the Company’s defined benefit plans. The Company is required to aggregate separately all overfunded plans from all underfunded plans.
In order to measure the expense associated with these plans, management must make various estimates and assumptions, including discount rates used to value liabilities, assumed rates of return on plan assets, employee turnover rates and anticipated mortality rates, for example. The estimates used by management are based on the Company’s historical experience, as well as current facts and circumstances. In addition, the Company uses outside actuaries to assist in measuring the expense and liability associated with these plans.
The Company utilizes a measurement date of January 1st to determine its periodic pension costs. Weighted-average assumptions used to determine net periodic pension costs for the U.S. defined benefit plans are as follows:
Weighted-average assumptions used to determine net periodic pension costs for the Chaucer pension Plan are as follows:
The Company utilizes a target allocation strategy, which focuses on creating a mix of assets that will generate modest growth from equity securities while minimizing volatility in the Company’s earnings from changes in the markets and economic environment. Various factors are taken into consideration in determining the appropriate asset mix, such as census data, actuarial valuation information and capital market assumptions. During 2011 and 2010, the plan assets were shifted out of equity securities and into fixed income securities to the current allocation of 82% in fixed income securities and 18% in equity securities. The Company reviews and updates, at least annually, the target allocation and makes changes periodically.
which is determined independently by the investment manager. The daily NAV, which is not published as a quoted market price for these investments, is used as the basis for transactions. Redemption of these funds is not subject to restriction.
Level 1 securities primarily consist of 466,755 shares and 141,462 shares of THG common stock held by the plan at December 31, 2011 and 2010, respectively. THG common stock is valued at quoted market prices. Securities also classified as Level 1 at December 31, 2011 and 2010 include actively traded mutual funds that are publicly traded and which primarily invest in equity securities that are valued at quoted market prices. Securities classified as Level 2 include investments in commingled pools that primarily invest in publicly traded common stocks and international equity securities. The fair value of each of the Level 2 investments is determined daily as the NAV based on the value of the underlying investments, which is determined independently by the investment manager. The daily NAV, which is not published as a quoted market price for these investments, is used as the basis for transactions. Redemption of these funds is not subject to restriction.
The investment strategy of the Chaucer defined benefit pension plan is to invest primarily in growth assets in the form of equity funds which are expected to provide a positive return that exceeds inflation over the longer term in order to protect the existing and future liabilities of the pension plan. In order to reduce volatility and diversify the portfolio, the target allocation includes an exposure to corporate bond and commercial property funds. The plan will be reviewed annually and target allocation changes will be made as appropriate. The following table provides target allocations and actual invested asset allocations for 2011.
Included in total plan assets of $74.3 million at December 31, 2011 were $74.1 million of invested assets carried at fair value and $0.2 million of cash and equivalents.
The table below provides a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the period from July 1, 2011 through December 31, 2011.
The components of total net periodic pension cost, including both the U.S. and Chaucer pension plans, are as follows:
On January 4, 2010, the Company made a discretionary contribution of $100.0 million to the U.S. qualified defined benefit pension plan. These funds were invested primarily in fixed income investments. With this contribution, and based upon the current estimate of liabilities and certain assumptions regarding investment return and other factors, the Company’s U.S. qualified defined benefit pension plan is overfunded by approximately $4 million. In addition, the Company expects to contribute $3.1 million to its U.S. non-qualified pension plans to fund 2012 benefit payments, and $2.9 million to the Chaucer pension plan. At this time, no additional discretionary contributions are expected to be made to the plans during 2012 and the Company does not expect that any funds will be returned from the plans to the Company during 2012.
In addition to the Company’s pension plans, the Company also has postretirement medical and death benefits that it provides to certain full-time employees, former agents and retirees and their dependents. Benefits include hospital, major medical and a payment at death up to retirees’ final annual salary with certain limits. The medical plans have varying co-payments and deductibles, depending on the plan.
The Company applies the guidance in ASC 715 and as such, has recognized the funded status of its postretirement benefit plans in its Consolidated Balance Sheet. Since these plans are unfunded, the amount recognized in the Consolidated Balance Sheet is equal to the accumulated benefit obligation of these plans. The components of accumulated other comprehensive income or loss are reflected as either a net actuarial gain or loss or a net prior service cost. There are no unrecognized transition assets or obligations associated with these plans.
The benefit payments are based on the same assumptions used to measure the Company’s benefit obligation at the end of 2011 and reflect benefits attributable to estimated future service.
A one-percentage point change in assumed health care cost trend rates in each year would have an immaterial effect on net periodic benefit cost during 2011 and accumulated postretirement benefit obligation at December 31, 2011.
performance awards, restricted stock, unrestricted stock, stock units, or any other award that is convertible into or otherwise based on the Company’s stock, subject to certain limits. The Plan authorized the issuance of 3,000,000 new shares that may be used for awards. In addition, shares of stock underlying any award granted and outstanding under the Company’s Amended Long-Term Stock Incentive Plan (the “1996 Plan”) as of the adoption date of the Plan that are forfeited, cancelled, expire or terminate without the issuance of stock become available for future grants under the Plan. As of December 31, 2011, there were 1,825,096 shares available for grants under the Plan. The Company utilizes shares of stock held in the treasury account for option exercises and other awards granted under both plans.
Cash received for options exercised for the years ended December 31, 2011, 2010 and 2009 was $3.9 million, $12.1 million and $3.1 million, respectively. The intrinsic value of options exercised for the years ended December 31, 2011, 2010 and 2009 was $1.8 million, $2.6 million and $0.6 million, respectively.
The excess tax expense realized from options exercised for the year ended December 31, 2011 was $1.5 million. The excess tax expense realized from options exercised for both the years ended December 31, 2010 and 2009 was $0.1 million. The aggregate intrinsic value at December 31, 2011 for shares outstanding and shares exercisable was $4.3 million and $3.9 million, respectively. At December 31, 2011, the weighted average remaining contractual life for shares outstanding and shares exercisable was 4.8 years and 2.9 years, respectively. Additional information about employee options outstanding and exercisable at December 31, 2011 is included in the following table:
The fair value of shares that vested during the years ended December 31, 2011, 2010 and 2009 was lower than the value of these shares on their grant date. As of December 31, 2011, the Company had unrecognized compensation expense of $5.5 million related to unvested stock options that is expected to be recognized over a weighted average period of 2.5 years.
Time-based restricted stock units granted in 2011 were significantly lower compared to 2010 and 2009 due to a shift in awards granted in 2011 to non-executive officers from time-based restricted stock units to time-based cash awards.
Performance based restricted stock units are based upon the achievement of the performance metric at 100%. These units have the potential to range from 0% to 150% of the shares disclosed, which varies based on grant year and individual participation level. Increases above the 100% target level are reflected as granted in the period in which performance-based stock unit goals are achieved. Decreases below the 100% target level are reflected as forfeited. In 2011, performance-based stock units of 47,375 were included as forfeited due to completion levels of less than the threshold achievement level for shares granted in 2009. The weighted average grant date fair value for these awards was $34.19. In 2010, performance-based stock units of 11,472 were included as forfeited due to completion levels less than 100% for units granted in 2007. The weighted average grant date fair value for these awards was $48.46. Additionally, in 2010, 25,055 performance-based stock units were included as forfeited due to completion levels of less than 100% for units originally granted in 2008. The weighted average grant date fair value for these awards was $45.21.
At December 31, 2011, the aggregate intrinsic value of restricted stock and restricted stock units was $26.9 million and the weighted average remaining contractual life was 2.1 years. The aggregate intrinsic value of performance based restricted stock units was $2.4 million and the weighted average remaining contractual life was 2.8 years. As of December 31, 2011, there was $15.2 million of total unrecognized compensation cost related to unvested restricted stock units and performance-based restricted stock units, assuming performance-based restricted stock units are achieved at 100% of the performance metric. The cost is expected to be recognized over a weighted-average period of 2.4 years. Compensation cost associated with restricted stock, restricted stock units and performance-based restricted stock units is generally calculated based upon grant date fair value, which is determined using current market prices.
Diluted earnings per share during 2011, 2010 and 2009 excludes 1.6 million, 1.4 million and 2.1 million, respectively, of common shares issuable under the Company’s stock compensation plans, because their effect would be antidilutive.
Since October 2007 and through December 2011, the Company’s Board of Directors has authorized aggregate repurchases of the Company’s common stock of up to $500 million. As of December 31, 2011, the Company has $135.2 million available for repurchases under these repurchase authorizations. The Company may repurchase its common stock from time to time, in amounts and prices and at such times as deemed appropriate, subject to market conditions and other considerations. The Company’s repurchases may be executed using open market purchases, privately negotiated transactions, accelerated repurchase programs or other transactions. The Company is not required to purchase any specific number of shares or to make purchases by any certain date under this program. During 2011, the Company repurchased 0.6 million shares of the Company’s common stock through open market purchases at a cost of $21.7 million. On March 30, 2010 and December 8, 2009, the Company entered into accelerated share repurchase agreements for the immediate repurchase of 2.3 million and 2.4 million shares, respectively, of the Company’s common stock at a cost of $105.0 million and $105.2 million, respectively. Total repurchases under this program as of December 31, 2011 were 8.6 million shares at a cost of $364.8 million.
Pursuant to New Hampshire’s statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the New Hampshire Insurance Commissioner, is limited to 10% of such insurer’s statutory policyholder surplus as of the preceding December 31. Hanover Insurance declared dividends to its parent totaling $99.0 million, $75.0 million, and $153.7 million in 2011, 2010 and 2009, respectively. Hanover Insurance can pay additional dividends of $58.8 million to its parent without prior approval until April 2012. If no dividends are declared prior to April 2012, the maximum dividend payable without prior approval would increase at that time to $157.8 million.
Dividend payments from Chaucer to its parent are regulated by U.K. law. Dividends from Chaucer are dependent on dividends from its subsidiaries. Annual dividend payments from Chaucer are limited to retained earnings that are not restricted by capital and other requirements for business at Lloyd’s. Also, Chaucer must provide advance notice to the U.K.’s Financial Services Authority (“FSA”) of certain proposed dividends or other payments from FSA regulated entities. There are currently no plans to repatriate dividends from Chaucer to its parent.
The Company reports interest expense related to its debt separately from the earnings of its operating segments. The Company’s debt consists of senior debentures, junior debentures, subordinated notes, advances under the Company’s collateralized borrowing program with the FHLBB, and capital securities.
Prior to the acquisition of Chaucer, the Company’s revenues were generated exclusively in the U.S. Revenues attributable to foreign countries are a result of the Chaucer acquisition. The following table presents gross written premium (“GWP”) based on the location of the risk for the year ended December 31, 2011:
Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company; consequently, allowances are established for amounts deemed uncollectible. The Company determines the appropriate amount of reinsurance based on evaluations of the risks accepted and analyses prepared by consultants and on market conditions (including the availability and pricing of reinsurance). The Company also believes that the terms of its reinsurance contracts are consistent with industry practice in that they contain standard terms with respect to lines of business covered, limit and retention, arbitration and occurrence. The Company believes that its reinsurers are financially sound. This belief is based upon an ongoing review of its reinsurers' financial statements, reported financial strength ratings from rating agencies, reputations in the marketplace, and the analysis and guidance of THG's reinsurance advisors.
(1) Assumed reinsurance activity in 2011 primarily related to our Chaucer segment. In addition, 2011 assumed premiums earned and assumed losses and LAE included $96.0 million and $54.2 million, respectively, related to the 2010 OneBeacon renewal rights transactions. Assumed reinsurance activity in 2010 primarily related to the OneBeacon renewal rights transaction.
The favorable loss and LAE reserve development during the year ended December 31, 2009 is primarily the result of lower than expected losses in the personal automobile line, primarily in the 2005 through 2008 accident years, lower than expected losses in the workers’ compensation line, primarily in the 2000 through 2008 accident years and lower than expected losses in the commercial multiple peril line, primarily in the 2005 through 2007 accident years. In addition, lower than expected losses in the surety business, lower projected losses in the Company’s run-off voluntary pools and lower projected exposures to asbestos and environmental liability for direct written business contributed to the favorable development. Partially offsetting the favorable development was unfavorable non-catastrophe weather-related property loss development, primarily related to the homeowners, commercial property and personal automobile physical damage lines. In 2009, the Company changed its unallocated loss adjustment expense
reserving methodology from that based on cash payments to that based on unit costs, which resulted in a $20.0 million benefit, of which $16.0 million related to prior years. The Company believes that the methodology based on unit costs is more representative of its future costs of settling existing claims.
Loss and LAE reserves related to asbestos and environmental damage liability, primarily in other commercial lines, were $59.8 million, $63.9 million and $76.8 million as of December 31, 2011, 2010 and 2009, respectively. Ending loss and LAE reserves for all direct business written by the Company related to asbestos and environmental damage liability, included in the reserve for losses and LAE, were $10.0 million, $10.1 million and $11.3 million, net of reinsurance of $18.7 million for 2011 and $19.9 million for both 2010 and 2009. As a result of the Company’s historical direct underwriting mix of Commercial Lines policies toward smaller and middle market risks, past asbestos and environmental damage liability loss experience has remained minimal in relation to the Company’s total loss and LAE incurred experience. In addition, the Company has established gross loss and LAE reserves for its run-off voluntary assumed reinsurance pool business with asbestos and environmental damage liability of $31.1 million, $33.9 million and $45.6 million at December 31, 2011, 2010 and 2009, respectively. These reserves relate to pools in which the Company has terminated its participation; however, the Company continues to be subject to claims related to years in which it was a participant. Because of the inherent uncertainty regarding the types of claims in these pools, the Company cannot provide assurance that its reserves will be sufficient.
The Company estimates its ultimate liability for asbestos, environmental and toxic tort liability claims, whether resulting from direct business, assumed reinsurance and pool business, based upon currently known facts, reasonable assumptions where the facts are not known, current law and methodologies currently available. Although these outstanding claims are not significant, their existence gives rise to uncertainty and are discussed because of the possibility that they may become significant. The Company believes that, notwithstanding the evolution of case law expanding liability in asbestos and environmental claims, recorded reserves related to these claims are adequate. The asbestos, environmental and toxic tort liability could be revised in the near term if the estimates used in determining the liability are revised, and any such revisions could have a material adverse effect on the Company’s results of operations for a particular quarterly or annual period or its financial position.
On March 12, 2007, a putative class action suit captioned Jennifer A. Durand v. The Hanover Insurance Group, Inc., The Allmerica Financial Cash Balance Pension Plan was filed in the United States District Court for the Western District of Kentucky. The named plaintiff, a former employee who received a lump sum distribution from the Company’s Cash Balance Plan (the “Plan”) at or about the time of her termination, claims that she and others similarly situated did not receive the appropriate lump sum distribution because in computing the lump sum, the Company understated the accrued benefit in the calculation.
At this time, the Company is unable to provide a reasonable estimate of the potential range of ultimate liability if the outcome of the suit is unfavorable. This matter is still
in the early stages of litigation. The extent to which any of the Plaintiffs’ multiple theories of liability, some of which are overlapping and others of which are quite complex and novel, are accepted and upheld on appeal will significantly affect the Plan’s or the Company’s potential liability. It is not clear whether a class will be certified or, if certified, how many former or current Plan participants, if any, will be included. The statute of limitations applicable to the alleged class has not yet been finally determined and the extent of potential liability, if any, will depend on this final determination. In addition, assuming for these purposes that the Plaintiffs prevail with respect to claims that benefits accrued or payable under the Plan were understated, then there are numerous possible theories and other variables upon which any revised calculation of benefits as requested under Plaintiffs’ claims could be based. It is likely that any adverse judgment in this case would be against the Plan. Such a judgment would be expected to create a liability for the Plan, with resulting effects on the Plan’s assets available to pay benefits. The Company’s future required funding of the Plan could also be impacted by such a liability.
In August 2007, the State of Louisiana filed a putative class action in the Civil District Court for the Parish of Orleans, State of Louisiana, entitled State of Louisiana, individually and on behalf of State of Louisiana, Division of Administration, Office of Community Development ex rel The Honorable Charles C. Foti, Jr., The Attorney General For the State of Louisiana, individually and as a class action on behalf of all recipients of funds as well as all eligible and/or future recipients of funds through The Road Home Program v. AAA Insurance, et al., No. 07-8970. The complaint named as defendants over 200 foreign and domestic insurance carriers, including the Company, and asserts a right to benefit payments from insurers on behalf of current and former Louisiana citizens who have applied for and received or will receive funds through Louisiana’s “Road Home” program. The case was thereafter removed to the Federal District Court for the Eastern District of Louisiana.
(1) Per diluted share amounts in the second and third quarters exclude common stock equivalents, since the impact of these instruments was antidilutive.