The Company also owns six buildings in Hartford, Connecticut. The Company currently occupies approximately 1.8 million square feet of office space in these buildings. The Company also owns other real property, which includes office buildings in Fall River, Massachusetts, and in Irving, Texas, and a data center located in Norcross, Georgia. In addition, the Company leases 220 field and claim offices totaling approximately 5.1 million square feet throughout the United States under leases or subleases with third parties.
The Company, through its subsidiaries, owns an investment portfolio of income-producing properties and real estate funds. Included in this portfolio are four office buildings in which the Company holds a 50% ownership interest located in New York, New York, which collectively accounted for approximately 15% of the carrying value of the property portfolio at December 31, 2005.
All data in the following table for the years 2001 through 2003 represent historical data for TPC. For accounting purposes, the merger of SPC and TPC was accounted for as a reverse acquisition with TPC treated as the accounting acquirer. Accordingly, this transaction was accounted for as a purchase business combination, using TPC’s historical financial information and applying fair value estimates to the acquired assets, liabilities and commitments of SPC as of April 1, 2004. Historical results are not necessarily indicative of results to be expected in the future.
(2) Cumulative effect of changes in accounting principles, net of tax (1) for the year ended December 31, 2002 consisted of a loss of $243 million as a result of a change in accounting for goodwill and other intangible assets; and (2) for the year ended December 31, 2001 included a gain of $5 million as a result of a change in accounting for derivative instruments and hedging activities and a loss of $2 million as a result of a change in accounting for securitized financial assets.
(6) In March 2002, TPC issued common stock through its Initial Public Offering (IPO).
The Company completed the divestiture of its 78% equity interest in Nuveen Investments in 2005, which is described in more detail later in this discussion. The Company’s share of Nuveen Investments’ operating results in 2005 prior to divestiture was classified as discontinued operations, and the Company’s prior year results were reclassified to conform to the 2005 presentation.
• Income from continuing operations of $2.06 billion, or $3.04 per share basic and $2.95 diluted
• Net proceeds of $2.40 billion from the divestiture of Nuveen Investments; loss from discontinued operations resulted from significant tax provision related to sale
• Pretax net investment income of $3.17 billion ($2.44 billion after-tax)
• Total debt of $5.85 billion, down $463 million from December 31, 2004
Income from continuing operations in 2005 totaled $2.06 billion, or $2.95 per share diluted, compared with income from continuing operations of $867 million, or $1.40 per share diluted, in 2004. The increase in income in 2005 reflected the impact of the merger, improved non-catastrophe current year loss experience in the Company’s three business segments, a decline in net unfavorable prior year reserve development and strong growth in net investment income. These factors more than offset a significant increase in the cost of catastrophes (including reinstatement premiums and state assessments), which totaled $2.19 billion in 2005, compared with $772 million in 2004. Catastrophe losses in 2005 primarily related to Hurricanes Katrina, Rita and Wilma, as described in more detail in the following narrative. Net unfavorable prior year reserve development in 2005 totaled $325 million, compared with net unfavorable prior year reserve development of $2.39 billion in 2004. The 2005 total was driven by a charge of $830 million to strengthen asbestos reserves as a result of the Company’s annual asbestos liability review, which was partially offset by other non-asbestos related net favorable prior year reserve development in the Personal and Commercial segments. The net unfavorable prior year reserve development in 2004 total was the result of several significant reserve charges recorded subsequent to the merger and which are discussed in more detail in the following narrative.
Net investment income in 2004 increased $794 million over 2003, largely due to the increase in invested assets resulting from the merger. In addition, strong operational cash flows in 2004 contributed to the growth in invested assets. The average pretax investment yield in 2004 of 4.8% declined from 5.3% in 2003, due to a higher proportion of tax-exempt investments and lower yields on fixed income securities and alternative investments. In addition, SPC’s investment portfolio acquired in the merger was recorded at its fair value as of the merger date in accordance with purchase accounting, which reduced the Company’s reported average investment yield in 2004.
Fee income in 2005 declined 6% when compared with 2004, as the National Accounts market, the primary source of the Company’s fee-based business, experienced increased competition, particularly in the large account sector, as described in more detail in the Commercial segment discussion that follows. In 2004, the 26% increase in fee income reflected higher new business levels resulting, in part, from a third quarter 2003 renewal rights transaction, as well as renewal price increases and an increase in workers’ compensation business written through state residual market pools.
Net pretax realized investment gains in 2005 totaled $17 million, primarily generated from sales of venture capital investments and equity securities. In addition, the Company realized a pretax gain of $21 million from the sale of its Personal Catastrophe Risk operation and $13 million of pretax net gains related to U.S. Treasury futures contracts which are marked to market and settled daily. Net realized investment gains in 2005 were reduced by $109 million of impairment losses, which were concentrated in the venture capital portfolio as described in more detail later in this discussion.
Other revenues in all periods presented primarily consist of premium installment charges.
In the first quarter of 2005, the Company implemented changes in the timing and structure of reinsurance purchased in the Specialty segment. The change in structure resulted in an increase in ceded premiums in 2005 when compared with 2004. The Company also made a modest adjustment to 2004 ceded written premiums to report at inception all ceded written premiums for reinsurance agreements that have minimum amounts required to be ceded. Previously, ceded written premiums for certain of these agreements were reported over the life of the contracts. This adjustment affected only the statistical disclosure of net written premiums on a quarter-by-quarter basis; it did not affect net written premium amounts over the lives of the respective agreements, nor did it impact gross written premiums, earned premiums, operating results or capital. The adjustment was made to conform the statistical measurement of production - net written premiums - across the Company’s businesses.
Claims and claim adjustment expenses of $15.44 billion in 2004 were $6.32 billion higher than the comparable 2003 total, primarily reflecting the impact of the merger. The 2004 net unfavorable prior year reserve development of $2.39 billion included a $928 million charge to increase asbestos reserves, a $290 million charge to increase environmental reserves, a charge of $252 million related to the financial condition of a specific construction contractor, and charges to increase Construction and Surety reserves in the Specialty segment by $500 million and $300 million, respectively. The Company also commuted certain reinsurance agreements with a major reinsurer in 2004 resulting in a $113 million prior year reserve
charge (in addition to a current year loss of $40 million). Commutations are a complete and final settlement with a reinsurer that results in a discharge of all obligations of the parties to the terminated reinsurance agreement. These and other components of 2004 unfavorable prior year reserve development are described in more detail in the segment discussions that follow. Net unfavorable prior year reserve development in 2003 totaled $476 million and was primarily the result of reserve strengthening at the Company’s Gulf subsidiary. The 2004 total also included $761 million of catastrophe losses (net of reinsurance), compared with catastrophe losses of $352 million in 2003.
Cost of Catastrophes. The Company’s cost of catastrophes, net of reinsurance and including reinstatement premiums and state assessments, totaled $2.19 billion in 2005, primarily resulting from Hurricanes Katrina, Rita and Wilma. Hurricane Katrina made landfall in Florida, Louisiana, Mississippi and Alabama in August 2005, Hurricane Rita made landfall in Texas and Louisiana in September 2005 and Hurricane Wilma made landfall in Florida in October 2005. In 2004, the cost of catastrophes, net of reinsurance, totaled $772 million, all of which resulted from four hurricanes - Charley, Frances, Ivan and Jeanne - that also made landfall in the southeastern United States. In 2003, Hurricane Isabel and several storms across the United States accounted for the majority of the $352 million cost of catastrophes. The cost of catastrophes was included in the Company’s business segments in the respective periods as follows:
The following table provides additional information regarding the components of the estimated cost recorded related to catastrophes in 2005.
Reinstatement premiums represent additional premiums payable to reinsurers to restore coverage limits that have been exhausted as a result of reinsured losses under certain excess-of-loss reinsurance treaties and are recorded as a reduction of net written and earned premiums. After payment of these reinstatement premiums, the Company has coverage for one additional limit under its corporate catastrophe treaty and continuing protection under most of its other treaties. The term of the Company’s current corporate catastrophe treaty expires on June 30, 2006. State assessments are recorded as a component of general and administrative expenses.
The $284 million increase in general and administrative expenses in 2005 compared with 2004 primarily reflected the impact of the merger. In addition, the 2005 total included $43 million of state assessments related to catastrophe losses, and also reflected investments made for process re-engineering and to support business growth and product development, primarily in the Personal segment. These factors were partially offset by the benefit of expense efficiencies achieved since the completion of the merger. The Commercial segment in particular has realized significant expense savings since the completion of the merger primarily through the elimination of duplicate functions throughout the combined organization. Included in the 2005 and 2004 totals were $112 million and $92 million, respectively, of amortization expense related to finite-lived intangible assets acquired in the merger, and a benefit of $12 million and $58 million, respectively, associated with the accretion of the fair value adjustment to claims and claim adjustment expenses and reinsurance recoverables. The 2004 total included a $62 million increase in the allowance for uncollectible amounts due from policyholders for loss-sensitive business (primarily high-deductible business). This increase resulted from applying the Company’s credit-based methodology for determining uncollectible amounts to the recoverables acquired in the merger. General and administrative expenses in 2004 also included $29 million of restructuring charges related to the merger.
Catastrophe losses accounted for 10.3 points of the 2005 loss and loss adjustment expense ratio, compared with 4.0 points in 2004. The loss and loss adjustment expense ratio in 2005 included a 1.6 point impact of net unfavorable prior year reserve development, whereas the 2004 ratio included a 12.6 point impact of net unfavorable prior year reserve development. The 2005 loss and loss adjustment expense ratio also reflected an improvement in current accident year non-catastrophe loss experience, compared with 2004, primarily reflecting reduced claim activity. The 1.1 point increase in the 2005 underwriting expense ratio compared with 2004 reflected the impact of reinstatement premiums, state assessments, earned premium declines in the Commercial segment, increased commission expenses in the Personal segment and investments made for process re-engineering and to support business growth and product development, primarily in the Personal segment. These factors were partially offset by expense efficiencies realized since the completion of the merger.
The assets and liabilities related to Nuveen Investments were removed from the respective lines of the Company’s consolidated balance sheet and reported under the caption “Net assets of discontinued operations” in the consolidated balance sheet at December 31, 2004. The current and deferred tax liabilities generated by the difference between the Company’s tax basis and the GAAP basis of its investment in Nuveen Investments are reported on the Company’s consolidated balance sheet as part of the Company’s current and deferred tax liabilities.
Operating income of $756 million in 2005 was 4% lower than operating income of $786 million in 2004, as the significant increase in the cost of catastrophes in 2005 was substantially offset by a decline in net unfavorable prior year reserve development and the impact of the merger. The cost of catastrophes totaled $1.24 billion in 2005, compared with $363 million in 2004. Catastrophes in both years were the result of the hurricanes described in the “Consolidated Overview” section herein. Net unfavorable prior year development totaled $694 million in 2005, compared with $1.34 billion in 2004. The totals in both years were primarily driven by charges to increase asbestos reserves.
The asbestos charge in 2005 resulted, in part, from higher than expected defense costs due to increased trial activity for seriously impaired plaintiffs and prolonged litigation before cases are settled or dismissed. The 2005 charge also considered the January 2006 court decision voiding, on procedural grounds, the previously rendered favorable arbitration decision in the ongoing ACandS litigation. The asbestos charge recorded in 2004 primarily resulted from an increase in litigation costs and activity surrounding peripheral defendants. With regard to environmental reserve additions, the 2005 charge was primarily related to declaratory judgment costs, whereas the significant 2004 charge was related to revised estimates of costs related to settlement initiatives. See the “Asbestos Claims and Litigation” and Environmental Claims and Litigation” sections herein for further discussion of these reserves.
General and administrative expenses in 2005 totaled $1.65 billion, an increase of 5% over the 2004 total of $1.58 billion, which primarily reflected the impact of the merger. The 2004 total included merger-related charges and charges to increase the allowances for estimated amounts due from policyholders receivables. The Commercial segment has realized significant expense savings since the completion of the merger primarily through the elimination of duplicate functions throughout the combined operation.
The Commercial segment’s gross and net written premiums by market were as follows:
In the Commercial Accounts market, net written premiums of $4.39 billion grew $176 million, or 4%, over 2004 volume of $4.21 billion, primarily reflecting the impact of the merger. However, 2005 written premium declined from 2004 on a pro forma combined basis. Business retention levels in this market in 2005 increased over 2004 and were at historically high levels for the year. New business volume also grew over 2004. Renewal price changes in 2005 in Commercial Accounts declined from 2004 and were modestly negative for the year, reflecting the increased competitive market conditions. Commercial Accounts’ net premium volume in 2004 grew $959 million, or 29%, over 2003 volume of $3.25 billion, primarily due to the merger. Retention rates in 2004 were strong and renewal price change increases were essentially flat by the end of the year. New business levels were lower during the second half of 2004 as the benefit from the Atlantic Mutual and Royal & SunAlliance renewal rights transactions entered into in the third quarter of 2003 diminished in the second half of the year.
In the Select Accounts market, net written premiums in 2005 grew 7% over 2004, primarily reflecting the impact of the merger. However, 2005 written premium declined from 2004 on a pro forma combined basis. Business retention levels in 2005 increased over 2004 as the year progressed and were also at historically high levels for the year in total. Renewal price changes in Select Accounts in 2005 were in the low single digit range for the year, which was lower than renewal price increases in 2004. New business levels in Select Accounts declined slightly from 2004. Select Accounts’ 2004 premium volume of $2.56 billion increased $508 million, or 25%, over 2003, reflecting the impact of the merger. Overall retention levels were strong and renewal price increases moderated to the mid single-digits in 2004. Retention and growth in 2004 reflected the Company’s competitive advantage in agency automation, product offerings and service to agents in this high transaction volume business.
In National Accounts, gross written premiums in 2005 grew 9% over 2004, and net written premiums grew $190 million, or 18%, compared with 2004, which reflected the impact of the merger and changes in Discover Re’s reinsurance program. The 25% increase in National Accounts’ net premium volume in 2004 over 2003 reflected new business from the third-quarter 2003 Royal & SunAlliance renewal rights transaction and higher business volumes in residual market pools, the impacts of which were partially offset by a shift to deductible and fee-based products by some of the Company’s clients. During 2005, results of the Company’s Discover Re operation were reclassified from the Specialty segment to National Accounts in the Commercial segment. All prior period amounts were reclassified to be consistent with the 2005 presentation.
Earned premiums in 2005 increased $1.10 billion, or 24%, over 2004, primarily reflecting the impact of the merger. Earned premiums in 2005 were reduced by the $48 million in reinstatement premiums related to the hurricane losses described in the “Consolidated Overview” section herein. Earned premiums in 2005 also reflected the inclusion of one additional month of premium volume totaling $37 million to eliminate a reporting lag at the Company’s operations at Lloyd’s, the impact of which was partially offset by the sale of certain classes of personal insurance business at those Lloyd’s operations. Earned premiums in 2004 were reduced by $76 million of reinstatement premiums primarily related to a reserve charge in the Company’s Bond operation. Earned premiums of $4.64 billion in 2004 grew $3.47 billion over 2003, primarily reflecting the impact of the merger
Claims and claims adjustment expenses in 2005 included $308 million of current year catastrophe losses, compared with catastrophe losses of $209 million recorded in 2004. Catastrophe losses in both periods were driven by the hurricanes described in the “Consolidated Overview” section herein. Net favorable prior year reserve development in 2005 totaled $9 million, as favorable development in International operations was largely offset by unfavorable development related to 2004 hurricane losses in the Personal Catastrophe Risk operation. Net unfavorable prior year reserve development totaled $1.43 billion in 2004, which included charges to increase the estimate of the acquired net construction reserves by $500 million and the acquired net surety reserves in the Company’s Bond operation by $300 million, as well as a $252 million charge related to the financial condition of a construction contractor. The following discussion provides more information regarding the net unfavorable prior year loss development related to these items in 2004, as well as other reserving actions.
Upon having access to each company’s detailed policyholder information, including underwriting, claim, and actuarial files on April 1, 2004, in connection with the closing of the merger, the Company was able to begin the detailed process of developing a uniform and consistent approach to estimating the combined company’s loss reserves. As part of that process, a team of actuaries representing the historical actuarial perspectives, judgments and methods applied by each legacy company, discussed their views, methodologies, and analysis of available data.
Surety Reserves. Personnel from the predecessor companies were also able to share detailed SPC policyholder information related to surety reserves upon completion of the merger. Access to this detailed information enabled the Company to perform a claim-by-claim review of reserves and claims handling strategies during the second quarter of 2004 using the combined expertise of claims adjusters from the legacy companies. This type of review involves considerable judgment, especially with respect to the economic outlook within which claims will be settled, estimates for dates of loss occurrence and evaluations of IBNR exposures for each insured. For example, as a result of the detailed information obtained concerning contractors with reported claims, the Company considered whether or not losses were incurred but not yet reported on one or more additional projects for each contractor examined.
The claim reviews and actuarial analyses were both completed near the end of the second quarter of 2004. Based upon the results of these reviews and analyses, the Company increased its estimate of the acquired surety reserves by $300 million, net of $170 million of reinsurance, and recognized this change in estimate as an income statement charge in the second quarter.
Other items increasing 2004 claims and expenses compared to 2003 include $217 million of charges to increase the allowances for estimated amounts due from reinsurance recoverables, policyholders receivables, and the co-surety on a specific construction contractor claim described above.
The loss and loss adjustment expense ratio in 2005 included a 5.8 point impact from catastrophe losses, whereas the comparable 2004 ratio included a 4.6 point impact from catastrophe losses. The loss and loss adjustment expense ratio for 2005 also included a 0.1 point benefit from net favorable prior year reserve development, whereas the comparable 2004 ratio impact from net unfavorable prior year reserve development totaled 30.8 points. Excluding both factors in each year, the 2005 loss and loss adjustment expense ratio improved over the 2004 ratio, reflecting the significant improvement in current year loss experience in 2005. The impact of prior year reserve development and catastrophe losses in 2003 was negligible.
The 2005 underwriting expense ratio improved 1.7 points compared with 2004, reflecting the impact of the merger and expense efficiencies realized since the completion of the merger. The 2004 underwriting expense ratio was also negatively impacted by an increase to the allowance for estimated amounts due from policyholder receivables and merger-related restructuring costs.
In Domestic Specialty operations, and International Specialty operations excluding Lloyd’s, business retention levels in 2005 were higher than in 2004. New business levels in Domestic Specialty operations were also higher than in 2004. In International Specialty operations excluding Lloyd’s, new business levels in 2005 were lower than in 2004. Renewal price changes in Domestic Specialty operations, while still positive, were down from 2004. As discussed previously, in the first quarter of 2005, the Company implemented changes in the timing and structure of reinsurance purchased in the Specialty segment. Those changes resulted in a slight increase in ceded premiums in 2005 over what would have been ceded prior to the changes being implemented.
The $3.51 billion increase in net written premium volume in 2004 over 2003 reflected the impact of the merger. However, the repositioning of the Bond and Construction books of business primarily accounted for a decline in net written premium volume in 2004 compared with the 2003 pro forma combined premium volume of SPC and TPC. In Construction, that repositioning resulted in reduced retention levels when compared with 2003, and new business levels also declined substantially. In Bond, the repositioning of the book of business was primarily centered in the SPC business acquired in the merger.
Operating income of $775 million in 2005 was $164 million lower than operating income of $939 million in 2004, largely due to the $593 million cost of catastrophes primarily resulting from Hurricanes Katrina, Rita and Wilma in 2005, which are discussed in more detail in the “Consolidated Overview” section herein. The cost of catastrophes in 2004 totaled $189 million, the majority of which resulted from four hurricanes that struck the southeastern United States. The Personal segment in 2005 benefited from continued low non-catastrophe frequency levels, net favorable prior year reserve development of $360 million and strong net investment income levels. In 2004, the $447 million increase in operating income over 2003 was driven by low non-catastrophe frequency levels, particularly in the property line, strong premium growth resulting from unit growth and price increases, and $378 million of net favorable prior year reserve development. Net favorable prior year development in 2003 totaled $212 million.
Refer to the “Net Investment Income” section of the “Consolidated Results of Operations” discussion herein for a description of the factors contributing to the increase in the Company’s net investment income in 2005 and 2004.
Claims and claim adjustment expenses in 2005 included catastrophe losses of $547 million, compared with catastrophe losses of $189 million in 2004. Catastrophe losses in both years were primarily driven by the hurricanes described in the “Consolidated Overview” section herein. Net favorable prior year reserve development in 2005 was $360 million, compared with net favorable prior year reserve development of $378 million in 2004. The favorable prior year development in 2005 and 2004 was primarily driven by further declines in the frequency of non-catastrophe losses and lower than expected severity resulting from recent claim initiatives. The favorable development in both years also reflected the recognition of lower current accident year frequency of non-catastrophe related claims in the Homeowners and Other line of business and an improvement in frequency trends in the Automobile line of business.
Catastrophe losses in 2004 of $189 million were $60 million less than the 2003 catastrophe loss total of $249 million. The 2003 losses resulted from a variety of storms across the United States, including Hurricane Isabel in the third quarter of the year and wildfires in California. Favorable prior year reserve development of $378 million in 2004 was significantly higher than favorable prior year development of $212 million in 2003. The favorable 2003 development was also primarily due to lower than expected frequency of non-catastrophe related homeowners’ losses. The 2003 total also included a $50 million reduction in losses resulting from the September 11, 2001 terrorist attack.
The 2.0 point increase in the underwriting expense ratio in 2005 compared with 2004 reflected an increase in commission expenses, other insurance expenses, and taxes, licenses and fees. The increase in commissions reflected a changing product mix and higher agent profit sharing expenses. The increase in other insurance expenses reflected the impact of continued process re-engineering investments and investments in personnel, technology and infrastructure to support business growth and product development. In addition, reinstatement premiums related to the catastrophe losses reduced earned premium volume by $21 million in 2005, and catastrophe-related assessments from various insurance pools increased taxes, licenses and fees by $25 million. These factors combined to result in a 0.5 point negative impact on the Personal segment’s 2005 underwriting expense ratio. In 2004, the 1.2 increase in the underwriting expense ratio over 2003 reflected the impact of the same investments described above.
Gross and net written premiums in 2004 increased 17% over 2003. Both Automobile and Homeowners and other net written premiums increased in 2004 due to higher new business volumes, the impact of new business associated with the Royal & SunAlliance renewal rights transaction entered into in the third quarter of 2003, continued strong retention, and renewal price increases.
The Personal segment had approximately 6.6 million and 6.3 million policies in force at December 31, 2005 and 2004, respectively. In the Automobile line of business, policies in force at December 31, 2005 increased 4% over the same date in 2004. Policies in force in the Homeowners and Other line of business at December 31, 2005 grew by 5% over the same date in 2004. Effective in the first quarter of 2005, Homeowners and Other policies in force include certain endorsements that had previously not been counted as separate policies. Prior year periods were restated to conform to the current year presentation.
In the Automobile line of business, policies in force at December 31, 2004 increased 9% over 2003. Policies in force in the Homeowners and Other line of business at December 31, 2004 increased by 15% over 2003.
The Company believes that the property and casualty insurance industry has suffered from court decisions and other trends that have attempted to expand insurance coverage for asbestos claims far beyond the intent of insurers and policyholders. As a result, the Company continues to experience a significant number of asbestos claims being tendered to the Company by the Company’s policyholders (which includes others seeking coverage under a policy), including claims against the Company’s policyholders by individuals who do not appear to be impaired by asbestos exposure. Factors underlying these claim filings include intensive advertising by lawyers seeking asbestos claimants, the focus by plaintiffs on new and previously peripheral defendants and entities seeking bankruptcy protection as a result of asbestos-related liabilities. In addition to contributing to the overall number of claims, bankruptcy proceedings may increase the volatility of asbestos-related losses by initially delaying the reporting of claims and later by significantly accelerating and increasing loss payments by insurers, including the Company. Bankruptcy proceedings are also causing increased settlement demands against those policyholders who are not in bankruptcy but that remain in the tort system. Recently, in many jurisdictions, those who allege very serious injury and who can present credible medical evidence of their injuries are receiving priority trial settings in the courts, while those who have not shown any credible disease manifestation have their hearing dates delayed or placed on an inactive docket. This trend, along with the focus on new and previously peripheral defendants, contributes to the loss and loss expense payments experienced by the Company. In addition, the Company’s asbestos-related loss and loss expense experience is impacted by the exhaustion or unavailability due to insolvency of other insurance potentially available to policyholders along with the insolvency or bankruptcy of other defendants. The Company is currently involved in coverage litigation concerning a number of policyholders who have filed for bankruptcy, including, among others, ACandS, Inc., who in some instances have asserted that all or a portion of their asbestos-related claims are not subject to aggregate limits on coverage as described generally in the next paragraph. (Also see “Part I - Item 3, Legal Proceedings”). These trends are expected to continue in the near term. As a result of the factors described above, there is a high degree of uncertainty with respect to future exposure from asbestos claims.
In addition, proceedings have been launched directly against insurers, including the Company, challenging insurers’ conduct in respect of asbestos claims, and, as discussed below, claims by individuals seeking damages arising from alleged asbestos-related bodily injuries. The Company anticipates the filing of other direct actions against insurers, including the Company, in the future. It is difficult to predict the outcome of these proceedings, including whether the plaintiffs will be able to sustain these actions against insurers based on novel legal theories of liability. The Company believes it has meritorious defenses to these claims and has received favorable rulings in certain jurisdictions. Additionally, TPC has entered into settlement agreements, which have been approved by the court in connection with the proceedings initiated by TPC in the Johns Manville bankruptcy court. If the rulings of the bankruptcy court are affirmed through the appellate process, then TPC will have resolved substantially all of the direct action pending claims against it. (Also, see “Part I - Item 3, Legal Proceedings”).
Because each policyholder presents different liability and coverage issues, the Company generally reviews the exposure presented by each policyholder on a policyholder-by-policyholder basis. In the course of this review, the Company considers, among other factors: available insurance coverage, including the role of any umbrella or excess insurance the Company has issued to the policyholder; limits and deductibles; an analysis of each policyholder’s potential liability; the jurisdictions involved; past and anticipated future claim activity and loss development on pending claims; past settlement values of similar claims; allocated claim adjustment expense; potential role of other insurance; the role, if any, of non-asbestos claims or potential non-asbestos claims in any resolution process; and applicable coverage defenses or determinations, if any, including the determination as to whether or not an asbestos claim is a products/completed operation claim subject to an aggregate limit and the available coverage, if any, for that claim. When an estimate of the gross ultimate exposure for indemnity and related claim adjustment expense is determined for a policyholder, the Company calculates, by each policy year, a ceded reinsurance projection based on any applicable facultative and treaty reinsurance, past ceded experience and reinsurance collections. Conventional actuarial methods are not utilized to establish asbestos reserves. The Company’s evaluations have not resulted in any data from which a meaningful average asbestos defense or indemnity payment may be determined.
The Company also compares its historical gross and net loss and expense paid experience, year-by-year, to assess any emerging trends, fluctuations, or characteristics suggested by the aggregate paid activity. Net asbestos losses and expenses paid in 2005 were $399 million, compared with $301 million in 2004. This increase was primarily driven by inclusion of the SPC business for the full year in 2005 and substantial reinsurance recoveries in the third quarter of 2004. Approximately 42% in 2005 and 22% in 2004 of total net paid losses relate to policyholders with whom the Company previously entered into settlement agreements limiting the Company’s liability. The lower percentage experienced in 2004 reflected substantial reinsurance billings during the year. In 2005, gross payments associated with policyholders with settlement agreements totaled $203 million, compared with $199 million in 2004.
At December 31, 2005, net asbestos reserves totaled $4.36 billion, compared with $3.93 billion at December 31, 2004. The Company’s annual ground-up review of asbestos exposures resulted in a reserve increase of $830 million in 2005. In 2004, the Company increased asbestos reserves by $922 million following the same ground-up review process. Those reviews included an analysis of exposures and payment patterns by policyholder category, as well as recent settlements, policyholder bankruptcies, judicial rulings and legislative actions. The asbestos charge in 2005 resulted, in part, from higher than expected defense costs due to increased trial activity for seriously impaired plaintiffs and prolonged litigation before cases are settled or dismissed. The 2005 charge also considered the January 2006 court decision voiding, on procedural grounds, the previously rendered favorable arbitration decision in the ongoing ACandS litigation. The asbestos charge recorded in 2004 primarily resulted from an increase in litigation costs and activity surrounding peripheral defendants.
The policyholders with settlement agreements category includes structured agreements, coverage in place arrangements and, with respect to TPC, Wellington accounts and the settlement of the Statutory and Hawaii Actions and the Common Law Claims (for a fuller description of these matters, see “Item 3 - Legal Proceedings”) (collectively the “Direct Action Settlement”). Reserves are based on the expected payout for each policyholder under the applicable agreement. Structured agreements are arrangements under which policyholders and/or plaintiffs agree to fixed financial amounts to be paid at scheduled times. Structured agreements include the Company’s obligations related to PPG Industries, Inc. (PPG). In May 2002 the Company agreed along with approximately three dozen other insurers and PPG on key terms to settle asbestos related coverage litigation under insurance policies issued to PPG. This settlement is to be incorporated into the Plan of Reorganization (the Plan) proposed as part of the Pittsburgh Corning (PC) bankruptcy proceeding. There remain a number of contingencies to consummation of the settlement including the final execution of documents, court approval of the PC Plan over pending objections, approval of the settlement and possible appeals. Pursuant to the proposed PC Plan, PC along with enumerated affiliated companies (including PPG and Corning) are to receive the protections afforded by Section 524(g) of the Bankruptcy Code from certain asbestos related bodily injury claims. A recent ruling by the Third Circuit Court of Appeals in the In Re Combustion Engineering, Inc. (CE) matter may impact the scope of relief that is potentially available to the debtor and other Plan proponents. As a result, the PC bankruptcy court has sought additional briefing on the impact of the CE decision on the proposed PC Plan. The Company cannot predict what effect the CE decision may have with respect to the bankruptcy court’s approval of the current Plan. A hearing is scheduled to be held on February 28, 2006 before the bankruptcy court. It is not possible to predict how or when the bankruptcy court will rule on the outstanding objections or how an appellate court may rule in the event of an appeal. It is possible that the Company’s single payment contribution pursuant to the proposed settlement of approximately $404 million after reinsurance will be made in calendar year 2006. Coverage in place arrangements represent agreements with major policyholders on specified amounts of coverage to be provided. Payment obligations may be subject to annual maximums and are only made when valid claims are presented. Wellington accounts refer to the 35 defendants that are parties to a 1985 agreement settling certain disputes concerning insurance coverage for their asbestos claims. Many of the aspects of the Wellington agreement are similar to those of coverage in place arrangements in which the parties have agreed on specific amounts of coverage and the terms under which the coverage can be accessed. As more fully described in Item 3, Legal Proceedings, TPC has entered into the Direct Action Settlement which is still subject to a number of contingencies. If those contingencies are met, then TPC will pay up to $502 million, possibly in calendar year 2006. One of the contingencies includes affirmance by all appellate courts of the orders entered by the United States Bankruptcy Court with respect to the Direct Action Settlement. It is not possible to predict how or when the appellate courts will rule on the pending appeals.
environmental claims. In addition, the Company’s asbestos-related claims and claim adjustment expense experience has been impacted by the exhaustion or unavailability due to insolvency of other insurance sources potentially available to policyholders along with the insolvency or bankruptcy of other defendants. It is also not possible to predict changes in the legal and legislative environment and their impact on the future development of asbestos and environmental claims. This development will be affected by future court decisions and interpretations, as well as changes in applicable legislation, including legislation related to asbestos reform. It is also difficult to predict the ultimate outcome of large coverage disputes until settlement negotiations near completion and significant legal questions are resolved or, failing settlement, until the dispute is adjudicated. This is particularly the case with policyholders in bankruptcy where negotiations often involve a large number of claimants and other parties and require court approval to be effective. As part of its continuing analysis of asbestos reserves, which includes an annual ground-up review of asbestos policyholders, the Company continues to study the implications of these and other developments. The Company completed the annual ground-up review during the fourth quarter of 2005. Also see “Part I - Item 3, Legal Proceedings.”
Because of the uncertainties set forth above, additional liabilities may arise for amounts in excess of the current asbestos and environmental reserves. In addition, the Company’s estimate of claims and claim adjustment expenses may change. These additional liabilities or increases in estimates, or a range of either, cannot now be reasonably estimated and could result in income statement charges that could be material to the Company’s operating results and financial condition in future periods.
The Company makes investments in collateralized mortgage obligations (CMOs) that typically have high credit quality, offer good liquidity, and are expected to provide an advantage in yield compared to U.S. Treasury securities. The Company’s investment strategy is to purchase CMO tranches which offer the most favorable return given the risks involved. One significant risk evaluated is prepayment sensitivity. While prepayment risk (either shortening or lengthening of duration) and its effect on total return cannot be fully controlled, particularly when interest rates move dramatically, the investment process generally favors securities that control this risk within expected interest rate ranges. The Company does invest in other types of CMO tranches if a careful assessment indicates a favorable risk/return tradeoff. The Company does not purchase residual interests in CMOs.
For the year ended December 31, 2005, the Company recognized the following other-than-temporary impairments:
• $11 million in the fixed income portfolio related to various issuers due to credit risk associated with the issuer’s deteriorated financial position.
• $80 million in the venture capital portfolio on 22 holdings. Two of the holdings were impaired due to new financings at less than favorable rates. Fifteen holdings experienced fundamental economic deterioration (characterized by less than expected revenues or a fundamental change in product). Three of the holdings were impaired due to the impending sale, liquidation or shutdown of the entity. Two of the holdings were public securities whose cost basis was not anticipated to be recovered over the expected holding period. The Company continually evaluates current developments in the market that have the potential to affect the valuation of the Company’s investments.
• $18 million in its real estate and other holdings. The losses recorded were the result of an equity partnership and a private stock holding which both experienced fundamental deterioration in their financial position.
The Company recognized other-than-temporary impairments of $65 million in the fixed income portfolio during 2003 related to various issuers, with $8 million due to companies filing bankruptcy and the remainder related to credit risk due to the issuer’s deteriorated financial position.
Unrealized investment losses as of December 31, 2005 represent less than 1% of the portfolio, and, therefore, any impact on the Company’s financial position would not be significant.
At December 31, 2005, non-investment grade securities comprised 3% of the Company’s fixed income investment portfolio. Included in those categories at December 31, 2005 were securities in an unrealized loss position that, in the aggregate, had an amortized cost of $907 million and a fair value of $870 million, resulting in a net pretax unrealized investment loss of $37 million. These securities in an unrealized loss position represented less than 2% of the total amortized cost and less than 2% of the fair value of the fixed income portfolio at December 31, 2005, and accounted for 7% of the total pretax unrealized investment loss in the fixed income portfolio.
Resulting purchases and sales of investments are based on cash requirements, the characteristics of the insurance liabilities and current market conditions. The Company identifies investments to be sold to achieve its primary investment goals of assuring the Company’s ability to meet policyholder obligations as well as to optimize investment returns, given these obligations.
The Company expects property casualty market conditions to continue to be competitive throughout 2006. Relative to 2005, within the Commercial and Specialty segments, the Company expects renewal price changes to increase and terms, conditions and insured values to improve for exposures susceptible to catastrophe losses, such as coastal property and oil and gas-related exposures, while renewal price changes for non-catastrophe exposures are expected to be subject to modest declines. Also relative to 2005, within the Personal segment, the Company expects renewal price changes in the automobile market to remain relatively stable or decline modestly, while the homeowners market is expected to remain relatively stable.
Net cash flows provided by operating activities of continuing operations totaled $3.59 billion, $5.07 billion and $3.83 billion in 2005, 2004 and 2003, respectively. Cash flows in 2005 reflected an increase in loss and loss adjustment expense payments primarily related to the catastrophe losses incurred during 2005 and 2004, and an increase in tax payments resulting from higher profitability. Cash flows in 2004 included $867 million in cash proceeds received pursuant to the commutation of specific reinsurance agreements in the second quarter described previously. Cash flows in 2004 also benefited from premium rate and volume increases. The significant reserve adjustments recorded subsequent to the merger in 2004 did not materially impact 2004 cash flows. The Company utilized $2.00 billion and $548 million of net operating loss carryforwards (NOL) during 2005 and 2004, respectively, thereby reducing current regular tax payments by $698 million and $192 million, respectively. Net cash flows provided by operating activities in 2003 benefited from premium rate increases and the receipt of $361 million from Citigroup, Inc., a former affiliate, and $531 million of federal income taxes refunded from the Company’s net operating loss carryback.
The Company’s cash flows in 2005 included $2.40 billion of pretax proceeds (after underwriting fees and transaction costs) from the divestiture of its equity interest in Nuveen Investments. Of this amount, $405 million was received directly by the Company’s insurance subsidiaries, and the remainder was received directly by the holding company. Of the proceeds received directly by the holding company, $1.225 billion was contributed to the capital of the Company’s insurance subsidiaries, with the remainder available for general corporate purposes. Holding company liquidity levels were increased in 2005 through dividends received from the Company’s operating subsidiaries, the retained proceeds from the Nuveen Investments divestiture, the third quarter 2005 proceeds of $442 million from the settlement of the forward purchase contracts for the Company’s common stock related to equity units issued in 2002 (described in more detail below), and the fourth quarter issuance of $400 million of 5.50% senior notes. Net cash flows of discontinued operations were not significant in 2005 or 2004.
The majority of funds available for investment are deployed in a widely diversified portfolio of high quality, liquid intermediate-term taxable U.S. government, corporate and mortgage backed bonds and tax-exempt U.S. municipal bonds. The Company closely monitors the duration of its fixed maturity investments, and investment purchases and sales are executed with the objective of having adequate funds available to satisfy the Company’s insurance and debt obligations. The Company’s management of the duration of the fixed income investment portfolio generally produces a duration that exceeds the duration of the Company’s net insurance liabilities. As the Company’s investment strategy focuses on asset and liability durations, and not specific cash flows, asset sales may be required to satisfy obligations and/or rebalance asset portfolios. The average duration of fixed maturities and short-term securities was 3.9 years at December 31, 2005, compared with 4.1 years at December 31, 2004.
At December 31, 2005, total cash, short-term invested assets and other readily marketable securities aggregating $1.57 billion were held at the holding company level. These assets were primarily funded by dividends from subsidiaries, proceeds from the divestiture of Nuveen Investments, and proceeds from the issuance of common stock and debt as described below. As also noted above, the holding company contributed $1.225 billion of the Nuveen Investment proceeds to the capital of its insurance subsidiaries in the third quarter of 2005. The assets held at the holding company, combined with other sources of funds available, primarily additional dividends from operating subsidiaries, are considered sufficient to meet the liquidity requirements of the Company. These liquidity requirements primarily include shareholder dividends and debt service.
Net maturities and retirements of debt, including the repurchase of Commercial Insurance Resources, Inc.’s (CIRI) outstanding notes, totaled $75 million in 2004. In addition, the Company repurchased the minority interest in CIRI during 2004 for a total cost of $76 million. Cash flows used in financing activities in 2003 included the redemption of $900 million aggregate principal amount of junior subordinated debt securities held by subsidiary trusts, the repayment of $700 million of notes payable to a former affiliate and the repayment of $550 million of short-term debt. Funds used in these repayments were primarily provided by the Company’s issuance of $1.40 billion of senior notes in March 2003 and by cash flows provided by operating activities. These refinancing activities were initiated with the objective of lowering the average interest rate on the Company’s total outstanding debt. Also reflected in 2003 was the issuance of $550 million of short-term Floating Rate Notes which were used to repay the $550 million Promissory Note due in January 2004.
Dividends paid to shareholders totaled $628 million, $642 million and $282 million in 2005, 2004 and 2003, respectively. The Company’s $636 million of common dividends in 2004 were comprised of regular quarterly dividends totaling $522 million and $114 million that had been declared by SPC prior to the merger. That amount consisted of SPC’s regular quarterly dividend at a rate of $0.29 per share ($66 million), and a special $0.21 per share ($48 million) dividend related to the merger. The special dividend declared by SPC prior to the closing of the merger was designed to result in the holders of SPC’s common stock prior to the merger receiving aggregate dividends with record dates in 2004 of $1.16 per share, which was SPC’s indicated annual dividend rate prior to the merger. On February 7, 2006, the Company’s Board of Directors declared a quarterly dividend of $0.23 per share, payable March 31, 2006 to shareholders of record on March 10, 2006.
In 2005 and 2004, the Company acquired 0.8 million and 0.4 million shares, respectively, of common stock from employees as treasury stock primarily to cover payroll withholding taxes in connection with the vesting of restricted stock awards and exercises of stock options. In 2003, TPC repurchased approximately 1.1 million shares (as adjusted for the merger) of common stock at a total cost of $40 million, representing the acquisition of shares under a repurchase program that had been approved by TPC’s board of directors. TPC’s repurchase program was terminated upon completion of the merger.
The Company has the option to defer interest payments on its convertible junior subordinated notes for a period not exceeding 20 consecutive quarterly interest periods. If the Company elects to defer interest payments on the notes, it will not be permitted, with limited exceptions, to pay dividends on its common stock during a deferral period.
Line of Credit Agreements. The Company maintains an $800 million commercial paper program with back-up liquidity consisting of a bank credit agreement. In June 2005, the Company entered into a $1.0 billion, five-year revolving credit agreement with a syndicate of financial institutions. The new credit agreement replaced and consolidated the Company’s three prior bank credit agreements that had collectively provided the Company access to $1.0 billion of bank credit lines. Pursuant to covenants in the new credit agreement, the Company must maintain an excess of consolidated net worth over goodwill and other intangible assets of not less than $10 billion at all times. The Company must also maintain a ratio of total consolidated debt to the sum of total consolidated debt plus consolidated net worth of not greater than 0.40 to 1.00. In addition, the credit agreement contains other customary restrictive covenants as well as certain customary events of default, including with respect to a change in control. At December 31, 2005, the Company was in compliance with these covenants and all other covenants related to its respective debt instruments outstanding. Pursuant to the terms of the credit agreement, the Company has an option to increase the credit available under the facility, no more than once a year, up to a maximum facility amount of $1.5 billion, subject to the satisfaction of a ratings requirement and certain other conditions. There was no amount outstanding under the credit agreement as of December 31, 2005.
The Company is not required to make any contributions to its qualified pension plan in 2006 and does not have a best estimate of contributions expected to be paid to the qualified pension plan. Accordingly, any future contributions are not included in the foregoing contractual obligation table.
The table below presents the amount and estimated future timing of claims and claim related payments. The amounts do not represent the exact liability, but instead represent estimates, generally utilizing actuarial projections techniques, at a given accounting date. These estimates include expectations of what the ultimate settlement and administration of claims will cost based on the Company’s assessment of facts and circumstances then known, review of historical settlement patterns, estimates of trends in claims severity, frequency, legal theories of liability and other factors. Variables in the reserve estimation process can be affected by both internal and external events, such as changes in claims handling procedures, economic inflation, legal trends and legislative changes. Many of these items are not directly quantifiable, particularly on a prospective basis. Additionally, there may be significant reporting lags between the occurrence of the policyholder event and the time it is actually reported to the insurer. The future cash flows related to the items contained in the table below, required estimation of both amount (including severity considerations) and timing. Amount and timing are frequently estimated separately. An estimation of both amount and timing of future cash flows related to claims and claim related payments is generally reliable only in the aggregate with some unavoidable estimation uncertainty.
The following table includes estimated future claims and claims related payments, net of the estimated reinsurance recoveries, where applicable, at December 31, 2005.
(2) Workers’ compensation large deductible policies provide third party coverage in which the Company typically is responsible for paying the entire loss under such policies and then seeks reimbursement from the insured for the deductible amount. “Claims from large deductible policies” represent the estimated future payment for claims and claim related expenses below the deductible amount, net of the estimated recovery of the deductible. The liability and the related deductible receivable for unpaid claims are presented in the consolidated balance sheet as “contractholder payables” and “contractholder receivables,” respectively. Most deductibles for such policies are paid directly from the policyholder’s escrow which is periodically replenished by the policyholder. The payment of the loss amounts above the deductible are reported within “Claims and claim adjustment expenses” in the above table. Because the timing of the collection of the deductible (contractholder receivables) occurs shortly after the payment of the deductible to a claimant (contractholder payables), these cash flows offset each other in the table.
The insurance holding company laws of other states in which the Company’s subsidiaries are domiciled generally contain similar, although in some instances somewhat more restrictive, limitations on the payment of dividends. A maximum of $2.56 billion is available by the end of 2006 for such dividends without prior approval of the Connecticut Insurance Department for Connecticut-domiciled subsidiaries and the Minnesota Department of Commerce for Minnesota-domiciled subsidiaries. The Company received $968 million of dividends from its insurance subsidiaries in 2005.
The NAIC adopted RBC requirements for property casualty companies to be used as minimum capital requirements by the NAIC and states to identify companies that merit further regulatory action. The formulas have not been designed to differentiate among adequately capitalized companies that operate with levels of capital higher than RBC requirements. Therefore, it is inappropriate and ineffective to use the formulas to rate or to rank these companies. At December 31, 2005, all of the Company’s insurance subsidiaries had adjusted capital in excess of amounts requiring any company or regulatory action.
The $2.02 billion increase in property-casualty claims and claim adjustment expense reserves since December 31, 2004 reflected the impact of the significant catastrophe losses incurred in the second half of 2005 and the $830 million net charge to increase asbestos reserves in the fourth quarter of 2005. These increases in reserves were partially offset by claim and claim expense payments from runoff operations, loss payouts for the third quarter 2004 hurricanes, and favorable non-catastrophe loss experience.
Property-casualty claims and claim adjustment expense reserves at December 31, 2004 increased by $24.51 billion over year-end 2003, primarily as a result of the merger with SPC and reserve charges recorded subsequent to the merger. Of the increase in 2004, $19.50 billion resulted from the addition of the acquired reserves, and $2.39 billion, net of reinsurance, was due to net unfavorable prior year reserve development. For discussion of the components of net unfavorable prior year reserve development, see note 9 to the consolidated financial statements.
A key assumption in most actuarial analyses is that past patterns demonstrated in the data will repeat themselves in the future, absent a material change in the associated risk factors discussed below. To the extent a material change affecting the ultimate claim liability is known, such change is quantified to the extent possible through an analysis of internal company and, if available and when appropriate, external data. Such a measurement is specific to the facts and circumstances of the particular claim portfolio and the known change being evaluated. Significant structural changes to the available data, product mix or organization can materially impact the reserve estimation process.
For some lines, the impact of large individual claims can be material to the analysis. These lines are generally referred to as being low frequency/high severity, while lines without this “large claim” sensitivity are referred to as “high frequency/low severity”. Estimates of claim liabilities for low frequency/high severity lines can be sensitive to a few key assumptions. As a result, the role of judgment is much greater for these reserve estimates. In contrast, high frequency/low severity lines tend to have much greater spread of estimation risk, such that the impact of individual claims are relatively minor and the range of reasonable reserve estimates is narrower and more stable.
At least once per quarter, Company management meets with its actuaries to review the latest claim and claim adjustment expense reserve analyses. Based on these analyses, management determines whether its ultimate claim liability estimates should be changed. In doing so, it must evaluate whether the new data provided represents credible actionable information or an anomaly that will have no effect on estimated ultimate claim liability. For example, as described above, payments may have decreased in one geographic region due to fewer claim adjusters being available to process claims. The resulting claim payment patterns would be analyzed to determine whether or not the change in payment pattern represents a change in ultimate claim liability.
While the majority of general liability coverages are written on an “occurrence basis,” certain general liability coverages (such as those covering directors and officers or professional liability) are typically insured on a “claims-made” basis.
The amount of reserve estimate uncertainty also varies significantly by component for the General Liability product line. The components in this product line with the longest latency, longest reporting lags, largest potential dollars involved, and greatest claim settlement complexity are Asbestos and Environmental. Components that include latency, reporting lag and/or complexity issues, but to a materially lesser extent than Asbestos and Environmental, include construction defect, medical malpractice, and other mass tort actions. Many components of General Liability are not subject to material latency or claim complexity risks and hence have materially less uncertainty than the previously mentioned components. In general, policies providing coverage with shorter reporting lags, fewer parties involved in settlement negotiations, only one policy potentially triggered per claim, fewer potential settlement dollars, reasonably foreseeable (and stable) potential hazards/claims and no mass tort potential result in much less reserve estimate uncertainty than policies without those characteristics.
Examples of common risk factors that can change and, thus, affect the required general liability reserves (beyond those included in the general discussion section) include:
Examples of common risk factors that can change and, thus, affect the required workers’ compensation reserves (beyond those included in the general discussion section) include:
Changes in the cost of medical treatments (including prescription drugs) and underlying fee schedules (“inflation”)
Surety has certain components that are generally considered short tail coverages with short reporting lags, although large individual construction and commercial surety contracts can result in a somewhat longer settlement tail, based on the length and complexity of the construction project or commercial transaction being insured. (Large construction projects can take many years to complete.) The frequency of losses in surety correlates with economic cycles as the primary cause of surety loss is the inability to perform financially. The volatility of surety losses is generally related to the type of business performed by the insured, the type of bonded obligation, the amount of limit exposed to loss and the amount of assets available to the insurer to mitigate losses, such as unbilled contract funds, collateral, first and third party indemnity, and other security positions of an insured’s assets. Certain classes of surety claims are very high severity, low frequency in nature. These can include large construction contractors involved with one or multiple large, complex projects as well as certain large commercial surety exposures. Other claim factors affecting reserve variability of surety include litigation related to amounts owed by and due the insured (e.g., salvage and subrogation efforts) and the results of financial restructuring of an insured.
Examples of common risk factors that can change and, thus, affect the required personal automobile reserves (beyond those included in the general discussion section) include:
Examples of common risk factors that can change and, thus, affect the required homeowners reserves (beyond those included in the general reserve discussion section) include:
For the more severe catastrophic events, “demand surge” inflation, whereby the greatly increased demand for building materials such as plywood far surpasses the immediate supply, leading to short-term material increases in building material costs
International and other includes the international product line and other products not discussed above. The principle component of “other” is assumed reinsurance written on an excess-of-loss basis, which may include reinsurance of non-U.S. exposures, and is primarily runoff business.
An investment in a fixed maturity or equity security which is available for sale or reported at fair value is impaired if its fair value falls below its book value and the decline is considered to be other-than-temporary.
• the Company’s ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery.
• the investee loses a principal customer or supplier for which there is no short-term prospect for replacement or experiences other substantial changes in market conditions;
• the regulatory, economic, or technological environment has changed in a way that is expected to adversely affect the investee’s profitability.
• a secondary equity offering at a price substantially lower than the holder’s cost;
• a breach of a covenant or the failure to service debt; and
• the securities owned continue to generate reasonable earnings and dividends, despite a general stock market decline;
• financial condition, market share, backlog and other key statistics indicate growth.
• whether or not the issuer’s progress has been substantially less than expected;
The Company manages the portfolio to maximize long-term return, evaluating current market conditions and the future outlook for the entities in which it has invested. Because this portfolio primarily consists of privately-held, early-stage venture investments, events giving rise to impairment can occur in a brief period of time (e.g., the entity has been unsuccessful in securing additional financing, other investors decide to withdraw their support, complications arise in the product development process, etc.), and decisions are made at that point in time, based on the specific facts and circumstances, with respect to a recognition of “other-than-temporary” impairment or sale of the investment.
The following is a summary of the approximate carrying value of the Company’s non-publicly traded securities at December 31, 2005:
For a discussion of some of the factors that could cause actual results to differ, see “Item 1A - Risk Factors”.
Consolidated Statement of Income for the years ended December 31, 2005, 2004 and 2003
Consolidated Statement of Cash Flows for the years ended December 31, 2005, 2004 and 2003
We have audited the accompanying consolidated balance sheet of The St. Paul Travelers Companies, Inc. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of The St. Paul Travelers Companies, Inc. and subsidiaries internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 27, 2006 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
FAS 123R, which became effective January 1, 2006, requires entities that use the fair-value method of either recognition or disclosure under FAS 123, to apply a modified version of the prospective application. Under modified prospective application, compensation cost is recognized on or after the effective date for all unvested awards, based on their grant-date fair value as calculated under FAS 123 for either recognition or pro forma disclosure purposes.
Mortgage loans are carried at amortized cost. A mortgage loan is considered impaired when it is probable that the Company will be unable to collect principal and interest amounts due. For mortgage loans that are determined to be impaired, a reserve is established for the difference between the amortized cost and fair market value of the underlying collateral. In estimating fair value, the Company uses interest rates reflecting the current real estate financing market returns. Impaired loans were not significant at December 31, 2005 and 2004.
Net realized investment gains and losses are included as a component of pretax revenues based upon specific identification of the investments sold on the trade date. A decline in the value of a security below its amortized cost basis is assessed to determine if the decline is other-than-temporary. If so, the security is deemed to be impaired, and a charge is recorded in net realized investment gains and losses equal to the difference between fair value and carrying value.
Amounts recoverable from reinsurers are estimated in a manner consistent with the associated claim liability. Such recoverables are reported net of an allowance for estimated uncollectible reinsurance recoverables and amounts due from known reinsurer insolvencies. The Company evaluates and monitors the financial condition of its reinsurers under voluntary reinsurance arrangements to minimize its exposure to significant losses from reinsurer insolvencies.
Amounts which vary with and are primarily related to the production of new insurance contracts, primarily commissions and premium-related taxes, are deferred and amortized pro rata over the contract periods in which the related premiums are earned. Deferred acquisition costs are reviewed to determine if they are recoverable from future income and, if not, are charged to expense. Future investment income attributable to related premiums is taken into account in measuring the recoverability of the carrying value of this asset. All other acquisition expenses are charged to operations as incurred.
The Company engages in securities lending activities from which it generates net investment income from the lending of certain of its investments to other institutions for short periods of time. Effective April 1, 2004, the Company entered into a new securities lending agreement. Borrowers of these securities provide collateral equal to at least 102% of the market value of the loaned securities plus accrued interest. This collateral is held by a third-party custodian, and the Company has the right to access the collateral only in the event that the institution borrowing the Company’s securities is in default under the lending agreement. Therefore, the Company does not recognize the receipt of the collateral held by the third-party custodian or the obligation to return the collateral. The loaned securities remain a recorded asset of the Company.
Included in other liabilities in the consolidated balance sheet is the Company’s estimate of its liability for guaranty fund and other insurance-related assessments. The liability for expected state guaranty fund and other premium-based assessments is recognized as the Company writes or becomes obligated to write or renew the premiums on which the assessments are expected to be based. The liability for loss-based assessments is recognized as the related losses are incurred. At December 31, 2005 and 2004, the Company had a liability of $278 million and $249 million, respectively, for guaranty fund and other assessments and related recoverables of $12 million and $31 million, respectively. The liability for such assessments and the related recoverables are not discounted for the time value of money. The assessments are expected to be paid over a period ranging from one year to the life expectancy of certain workers’ compensation claimants and the recoveries are expected to occur over the same period of time.
The Company assigns functional currencies to its foreign operations, which are generally the currencies of the local operating environment. Foreign currency amounts are remeasured to the functional currency, and the resulting foreign exchange gains or losses are reflected in the statement of income. Functional currency amounts are then translated into U.S. dollars. The unrealized gain or loss from this translation, net of tax, is recorded as a part of shareholders’ equity. The change in unrealized foreign currency translation gain or loss during the year, net of tax, is a component of comprehensive income. Both the remeasurement and translation are calculated using current exchange rates for the balance sheets and average exchange rates for the statements of operations.
For stock-based employee awards granted prior to January 1, 2003, the Company accounts for these awards under the recognition and measurement principles of Accounting Principles Board Opinion No. 25 (APB 25), “Accounting for Stock Issued to Employees”, and related interpretations using the prospective recognition transition alternative of FAS 148. For restricted stock awards, the market value on grant date of these awards is recognized as compensation expense ratably over the vesting period. For stock option awards, the awards are granted at an exercise price equal to the market value of the underlying common stock on the date of the grant and accordingly there has been no employee compensation expense recognized in earnings for the stock option awards. The accounting for the awards granted prior to January 1, 2003 using APB 25 will cease upon adoption of FAS 123R January 1, 2006 (see note 1, Accounting Policies Not Yet Adopted - Share-Based Payment).
The following table illustrates the effect on net income and earnings per share for each period indicated as if the Company had applied the fair value recognition provisions of FAS 123 to all outstanding and unvested stock-based employee awards.
(1) Represents compensation expense on all restricted stock and stock option awards granted after January 1, 2003.
Interest rate swaps, equity swaps, credit derivatives, options and forward contracts were not significant at December 31, 2005 and 2004.
The Company is organized into three reportable business segments: Commercial, Specialty and Personal. These segments reflect the manner by which the Company manages its property and casualty insurance products and insurance-related services and represent an aggregation of these products and services based on type of customer, how the business is marketed, and the manner in which the business is underwritten.
Beginning in the second quarter of 2005, the National Accounts underwriting group includes the Company’s Discover Re operation. Discover Re’s results were reclassified to the Commercial segment from the Specialty segment to align the segment reporting structure with the manner in which the Company’s business is managed after changes in the Company’s management structure in 2005. Prior period amounts were restated to reflect the reclassification of Discover Re.
The Commercial segment offers a broad array of property and casualty insurance and insurance-related services to its clients. Commercial is organized into the following three marketing and underwriting groups, each of which focuses on a particular client base and which collectively comprise Commercial’s core operations:
• Select Accounts serves small businesses and offers commercial multi-peril, property, general liability, commercial auto and workers’ compensation insurance.
The Specialty segment was created upon the merger of TPC and SPC. It combined SPC’s specialty operations, including SPC’s Bond and Construction operations, with TPC’s Bond and Construction operations, which were included in TPC’s Commercial segment prior to the merger. The Specialty segment provides a full range of standard and specialized insurance coverages and services through dedicated underwriting, claims handling and risk management groups. The segment comprises two primary groups: Domestic Specialty and International Specialty.
In November 2005, the Company sold its Personal Catastrophe Risk business, which had been included in the Specialty segment. In accordance with terms of the agreement, the Company retained responsibility for the pre-sale loss and loss adjustment expense reserves related to this business and remains responsible for any changes in estimates in those reserves through a quota-share reinsurance agreement. The impact of this transaction is not material to the Company’s ongoing operations.
On November 26, 2002, the Terrorism Risk Insurance Act of 2002 (the Terrorism Act) was enacted into Federal law and established the Terrorism Risk Insurance Program (the Program), a temporary Federal program in the Department of the Treasury, that provided for a system of shared public and private compensation for insured losses resulting from acts of terrorism or war committed by or on behalf of a foreign interest. The Program was scheduled to terminate on December 31, 2005. On December 22, 2005, the Terrorism Risk Insurance Extension Act of 2005 (the Terrorism Extension Act) was enacted into Federal law, reauthorizing the Program through December 31, 2007, while reducing the Federal role under the Program. In order for a loss to be covered under the Program (subject losses), the loss must meet certain aggregate industry loss minimums that vary by Program year of amounts $100 million or less, and must be the result of an event that is certified as an act of terrorism by the U.S. Secretary of the Treasury. The original Program excluded from participation certain of the following types of insurance: Federal crop insurance, private mortgage insurance, financial guaranty insurance, medical malpractice insurance, health or life insurance, flood insurance, and reinsurance. The Terrorism Extension Act exempted from coverage certain additional types of insurance, including commercial automobile, professional liability (other than directors and officers’), surety, burglary and theft, and farm-owners multi-peril. In the case of a war declared by Congress, only workers’ compensation losses are covered by the Terrorism Act and the Terrorism Extension Act. Both Acts generally require that all commercial property casualty insurers licensed in the United States participate in the Program. Under the Program, a participating insurer is entitled to be reimbursed by the Federal Government for a percentage of subject losses, after an insurer deductible, subject to an annual cap. The Federal reimbursement percentage remains at 90% for 2006, but decreases to 85% in 2007. In each case, the deductible is calculated by applying the deductible percentage to the insurer’s direct earned premiums for covered lines from the calendar year immediately preceding the applicable year. The deductible under the Program was 7% for 2003, 10% for 2004 and 15% for 2005, and will be 17.5% for 2006 and 20% for 2007. The Company’s estimated deductible under the Program is $1.91 billion for 2006. The annual cap limits the amount of aggregate subject losses for all participating insurers to $100 billion. Once subject losses have reached the $100 billion aggregate during a program year, there is no additional reimbursement from the U.S. Treasury and an insurer that has met its deductible for the program year is not liable for any losses (or portion thereof) that exceed the $100 billion cap. The Company had no terrorism-related losses in 2005, 2004 or 2003.
On April 1, 2004, TPC merged with a subsidiary of SPC, as a result of which TPC became a wholly-owned subsidiary of The St. Paul Travelers Companies, Inc. For accounting purposes, this transaction was accounted for as a reverse acquisition with TPC treated as the accounting acquirer. Accordingly, this transaction was accounted for as a purchase business combination, using TPC’s historical financial information and applying fair value estimates to the acquired assets, liabilities and commitments of SPC as of April 1, 2004.
The primary reasons for the acquisition were, among other things, a) to create a stronger company that would provide significant benefits to shareholders and to customers alike; b) to capitalize on a common strategic focus on delivering the highest value to customers, agents and brokers and, working together, to expand future opportunities and capture new efficiencies; and c) to strengthen the combined company’s position as a leading provider of property and casualty insurance products.
The purchase price was allocated based on an estimate of the fair value of the assets acquired and liabilities assumed as of April 1, 2004, as follows:
(1) Reflects SPC’s shareholders’ equity of $6,439 million, less SPC’s historical goodwill of $950 million and intangible assets of $138 million.
(5) Represents the excess of the purchase price (cost) over the amounts assigned to the assets acquired and liabilities assumed. None of the goodwill is deductible for tax purposes. The decrease in goodwill compared with that originally reported at the merger date was due to the adjustment related to Nuveen Investments described in (8) below, as well as certain purchase accounting and tax adjustments since the completion of the merger.
(6) Represents identified finite and indefinite life intangible assets, primarily customer-related insurance. See note 4.
Intangible assets subject to amortization (excluding the Nuveen Investments’ intangible assets noted in item 8 of the allocation of the purchase price previously presented) were as follows:
In conjunction with these transactions, the Company recorded a pretax gain on disposal of $345 million ($224 million after-tax) for the year ended December 31, 2005. Additionally, the Company recorded a net operating loss from discontinued operations of $663 million for the year ended December 31, 2005, consisting primarily of $710 million of tax expense which resulted from the difference between the tax basis and the GAAP carrying value of the Company’s investment in Nuveen Investments, partially offset by the Company’s share of Nuveen Investments’ net income for 2005.
Intangible asset amortization expense is estimated to be $153 million in 2006, $145 million in 2007, $126 million in 2008, $100 million in 2009 and $86 million in 2010.
The company is organized into three reportable business segments: Commercial, Specialty and Personal. The accounting policies used to generate the following segment data are the same as those described in the Summary of Significant Accounting Policies in note 1. The amount of investments in equity method investees and total expenditures for additions to long-lived assets other than financial instruments were not significant.
(2) It is not practicable to restate assets by segment for periods prior to the April 1, 2004 merger.
(1) The primary components of other assets in 2005 and 2004 were invested assets, prepaid pension costs and deferred taxes. The primary component of other assets in 2003 was goodwill.
Proceeds from sales of fixed maturities classified as available for sale were $5.19 billion, $7.95 billion and $8.34 billion in 2005, 2004 and 2003, respectively. Gross gains of $129 million, $202 million and $282 million and gross losses of $118 million, $126 million and $147 million were realized on those sales in 2005, 2004 and 2003, respectively.
At December 31, 2005 and 2004, the Company’s insurance subsidiaries had $4.00 billion and $3.39 billion, respectively, of securities on deposit at financial institutions in certain states pursuant to the respective states’ insurance regulatory authorities.
Proceeds from sales of equity securities were $403 million, $265 million and $254 million in 2005, 2004 and 2003, respectively, resulting in gross realized gains of $43 million, $37 million and $22 million and gross realized losses of $9 million, $8 million and $9 million, respectively.
The cost and fair value of investments in venture capital, which are reported as part of other investments in the Company’s consolidated balance sheet, were as follows:
• Municipal Trusts-The Company owns interests in various municipal trusts that were formed for the purpose of allowing more flexibility to generate investment income in a manner consistent with the Company’s investment objectives and tax position. As of both December 31, 2005 and 2004, there were 36 such trusts, which held a combined total of $441 million and $450 million, respectively, in municipal securities, of which $84 million and $84 million, respectively, were owned by outside investors. The net carrying value of the trusts owned by the Company at December 31, 2005 and 2004 was $357 million and $366 million, respectively.
• Venture Capital Entities and Tax Credit Funds - The Company has investments in venture capital entities which are held for the purposes of generating long-term investment returns. The Company also has investments in certain tax credit funds which generate tax benefits. The Company consolidates certain venture capital investments and tax credit funds under the provisions of the FASB Revised Interpretation No. 46, Consolidation of Variable Interest Entities. The combined carrying values of these investments were not significant at December 31, 2005 and 2004.
The Company has significant interests in VIEs which are not consolidated because the Company is not considered to be the primary beneficiary. These entities are as follows:
• The Company has a significant variable interest in one real estate entity. This investment has total assets of approximately $143 million and $117 million as of December 31, 2005 and 2004, respectively. The carrying value of the Company’s share of this investment was approximately $31 million and $38 million at December 31, 2005 and 2004, respectively, which also represented its maximum exposure to loss. The purpose of the Company’s involvement in this entity is to generate investment returns.
• The Company has a significant variable interest in two private equity funds. These investments are held for the purpose of generating long-term investment returns. The combined carrying value of these entities was immaterial at December 31, 2005 and 2004. The Company has an unfunded commitment of $12 million associated with one of these funds. The Company’s exposure to loss is limited to the investment carrying amounts reported in the consolidated balance sheet and the unfunded commitment amount.
At December 31, 2004, three hedge funds were determined to be significant VIEs and had a total value for all investors combined of approximately $175 million. The Company’s share of these funds has a carrying value of approximately $54 million at December 31, 2004. The Company’s involvement with these funds began in the third quarter of 2002. The Company does not have any unfunded commitments related to these funds. The Company’s exposure to loss is limited to the investment carrying amounts reported in the consolidated balance sheet.
• to buy and sell U.S. and non-U.S. assets with primary focus on a diversified pool of structured mortgage and asset-backed securities offering attractive and relative value; and
• Mandatorily redeemable preferred securities of trusts holding solely the subordinated debentures of the Company-These securities were issued by five separate trusts that were established for the sole purpose of issuing the securities to investors, and are fully guaranteed by the Company. The debt that the Company issued to these trusts is included in the “Debt” section of liabilities on the Company’s consolidated balance sheet. That debt had a carrying value of $1.03 billion and $1.04 billion at December 31, 2005 and 2004, respectively.
Additionally, for certain securitized financial assets with contractual cash flows (including asset-backed securities), FASB Emerging Issues Task Force (EITF) 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets, requires the Company to periodically update its best estimate of cash flows over the life of the security. If management determines that the fair value of its securitized financial asset is less than its carrying amount and there has been a decrease in the present value of the estimated cash flows since the last revised estimate, considering both timing and amount, then an other-than-temporary impairment is recognized.
A fixed maturity security is impaired if it is probable that the Company will not be able to collect all amounts due under the security’s contractual terms. Equity securities are impaired when it becomes apparent that the Company will not recover its cost over the expected holding period. Further, for securities expected to be sold, an other-than-temporary impairment charge is recognized if the Company does not expect the fair value of a security to recover prior to the expected date of sale.
• identification and evaluation of investments which have possible indications of impairment;
• analysis of investments with gross unrealized investment losses that have fair values less than 80% of amortized cost during successive quarterly periods over a rolling one-year period;
• review of portfolio manager(s) recommendations for other-than-temporary impairments based on the investee’s current financial condition, liquidity, near-term recovery prospects and other factors, as well as consideration of other investments that were not recommended for other-than-temporary impairments;
• consideration of evidential matter, including an evaluation of factors or triggers that would or could cause individual investments to qualify as having other-than-temporary impairments and those that would not support other-than-temporary impairment; and
• determination of the status of each analyzed investment as other than temporary or not, with documentation of the rationale for the decision.
capital companies to record revenues in the early stages of their development, which can often take three to four years, and does not generally expect them to become profitable for an even longer period of time. With respect to the Company’s valuation of such non-publicly traded venture capital investments, on a quarterly basis, portfolio managers as well as an internal valuation committee review and consider a variety of factors in determining the potential for loss impairment. Factors considered include the following:
The Company’s investment portfolio includes non-publicly traded investments, such as venture capital investments, private equity limited partnerships, joint ventures, other limited partnerships, and certain fixed income securities. Certain venture capital investments that are controlled by the Company are consolidated in the Company’s financial statements. The Company uses the equity method of accounting for joint ventures, limited partnerships and certain private equity securities. Certain other private equity investments, including venture capital investments, are not subject to the provisions of Statement of Financial Accounting Standards (FAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities, but are reported at estimated fair value in accordance with FAS 60, Accounting and Reporting by Insurance Enterprises. The fair value of the venture capital investments is based on an estimate determined by an internal valuation committee for securities for which there is no public market. The internal valuation committee reviews such factors as recent filings, operating results, balance sheet stability, growth, and other business and market sector fundamental statistics in estimating fair values of specific investments. Other non-publicly traded securities are valued based on factors such as management judgment, recent financial information and other market data. An impairment loss is recognized if, based on the specific facts and circumstances, it is probable that the Company will not be able to recover all of the cost of an individual holding.
Underperforming mortgage loans, which include delinquent loans, loans in the process of foreclosure and loans modified at interest rates below market, were $0 and $4 million at December 31, 2005 and 2004, respectively.
The Company monitors creditworthiness of counterparties to financial instruments by using controls that include credit approvals, limits and other monitoring procedures.
Earnings per share (EPS) was computed in accordance with Statement of Financial Accounting Standards No. 128, Earnings per Share (FAS 128). Basic EPS was computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period. The computation of diluted EPS reflected the effect of potentially dilutive securities.
Gross claims and claim adjustment expense reserves at December 31, 2005 increased $2.02 billion over year-end 2004 as a result of the impact of the significant catastrophe losses incurred in the third and fourth quarters of 2005, and an increase to asbestos reserves pursuant to the completion of the Company’s annual review of asbestos reserves in the fourth quarter, both of which are described in more detail in the discussion that follows. Those increases in reserves were partially offset by claim and claim expense payments from runoff operations and other net favorable prior year reserve development in the Company’s Commercial and Personal segments.
Gross claims and claim adjustment expense reserves at December 31, 2004 increased by $24.51 billion over year-end 2003, primarily as a result of the merger with SPC and reserve charges recorded subsequent to the merger. Of the increase in 2004, $19.50 billion resulted from the addition of the acquired operations, and $2.40 billion was due to estimated claims and claim adjustment expenses for claims arising in prior years, which is described in more detail in the discussion that follows.
In 2005, estimated claims and claim adjustment expenses for claims arising in prior years totaled a net $260 million, including $325 million of net unfavorable prior year reserve development impacting the Company’s results of operations which excludes $59 million of accretion of discount. In 2005, estimated claims and claim adjustment expenses for claims arising in prior years included $30 million of net favorable loss development on Commercial loss sensitive policies in various lines; however, since the business to which it relates was subject to premium adjustments, there was no impact on results of operations.
The Specialty segment recorded prior year reserve development of $1.43 billion in 2004, which included the charges to strengthen construction and surety reserves referred to previously, as well as the $252 million charge related to a specific construction contractor and $75 million related to the commutation of agreements with a major reinsurer. Results in 2004 also reflected $150 million of net unfavorable prior year reserve development recorded in TPC’s Construction operation prior to the merger, other reserve increases, and a charge to increase the allowance for estimated amounts due from a co-surety on a specific construction contractor claim.
In 2003, net unfavorable prior year reserve development included in estimated claims and claim adjustment expenses totaled $390 million. That amount included $549 million of net unfavorable development impacting the Company’s results of operations that primarily resulted from $521 million of reserve strengthening at Gulf Insurance Company, a subsidiary that wrote specialty insurance prior to being placed in runoff in 2004. The net 2003 total also included unfavorable development related to American Equity, an operation that was placed in run-off in the second quarter of 2002, and environmental claims.
Those charges were partially offset by net favorable development in other Commercial businesses, principally property coverages, in which the Company experienced lower non-catastrophe-related claim frequency. In 2003, estimated claims and claim adjustment expenses for claims arising in prior years included $42 million of net favorable loss development on Commercial loss sensitive policies in various lines; however, since the business to which it relates was subject to premium adjustments, there was no impact on results of operations.
In addition, Personal recorded $162 million in net favorable prior year reserve development in 2003 principally due to lower than expected non-catastrophe claim frequency in both homeowners and non-bodily injury automobile businesses, and a $50 million reduction in reserves held related to the terrorist attack on September 11, 2001.
It is difficult to estimate the reserves for asbestos and environmental-related claims due to the vagaries of court coverage decisions, plaintiffs’ expanded theories of liability, the risks inherent in complex litigation and other uncertainties, including without limitation, those which are set forth below.
Asbestos Reserves. Because each policyholder presents different liability and coverage issues, the Company generally reviews the asbestos exposure presented by each policyholder on a policyholder-by-policyholder basis. In the course of this review, the Company considers, among other factors: available insurance coverage, including the role of any umbrella or excess insurance the Company has issued to the policyholder; limits and deductibles; an analysis of each policyholder’s potential liability; the jurisdictions involved; past and anticipated future claim activity and loss development on pending claims; past settlement values of similar claims; allocated claim adjustment expense; potential role of other insurance; the role, if any, of non-asbestos claims or potential non-asbestos claims in any resolution process; and applicable coverage defenses or determinations, if any, including the determination as to whether or not an asbestos claim is a products/completed operation claim subject to an aggregate limit and the available coverage, if any, for that claim. When an estimate of the gross ultimate exposure for indemnity and related claim adjustment expense is determined for a policyholder, the Company calculates, by each policy year, a ceded reinsurance projection based on any applicable facultative and treaty reinsurance, as well as past ceded experience and reinsurance collections. Conventional actuarial methods are not utilized to establish asbestos reserves. The Company’s evaluations have not resulted in any data from which a meaningful average asbestos defense or indemnity payment may be determined.
With respect to asbestos exposures, the Company also compares its historical gross and net loss and expense paid experience, year-by-year, to assess any emerging trends, fluctuations, or characteristics suggested by the aggregate paid activity. Net asbestos losses and expenses paid in 2005 were $399 million, compared with $301 million in 2004. This increase was primarily driven by inclusion of the SPC business for the full year in 2005 and substantial reinsurance recoveries in the third quarter of 2004. Approximately 42% in 2005 and 22% in 2004 of total net paid losses relate to policyholders with whom the Company previously entered into settlement agreements limiting the Company’s liability. The lower percentage experienced in 2004 reflected substantial reinsurance billings during the year. In 2005, gross payments associated with policyholders with settlement agreements totaled $203 million, compared with $199 million in 2004.
The $830 million and $928 million asbestos reserve provisions in 2005 and 2004, respectively, were recorded pursuant to the completion of the Company’s annual ground-up asbestos liability review in the fourth quarter, which included an analysis of exposure and claim payment patterns by policyholder category, as well as recent settlements, policyholder bankruptcies,
At December 31, 2005, asbestos reserves, net of reinsurance, were $4.36 billion, compared with $3.93 billion as of December 31, 2004. The Company acquired $311 million of net asbestos reserves in the merger with SPC in 2004.
Environmental Reserves. In establishing environmental reserves, the Company evaluates the exposure presented by each policyholder and the anticipated cost of resolution, if any. In the course of this analysis, the Company considers the probable liability, available coverage, relevant judicial interpretations and historical value of similar exposures. In addition, the Company considers the many variables presented, such as the nature of the alleged activities of the policyholder at each site; the allegations of environmental harm at each site; the number of sites; the total number of potentially responsible parties at each site; the nature of environmental harm and the corresponding remedy at each site; the nature of government enforcement activities at each site; the ownership and general use of each site; the overall nature of the insurance relationship between the Company and the policyholder, including the role of any umbrella or excess insurance the Company has issued to the policyholder; the involvement of other insurers; the potential for other available coverage, including the number of years of coverage; the role, if any, of non-environmental claims or potential non-environmental claims, in any resolution process; and the applicable law in each jurisdiction. Conventional actuarial techniques are not used to estimate these reserves. In 2005, the Company recorded a pretax charge of $30 million, net of reinsurance, primarily for declaratory judgment costs. In 2004, the Company recorded a pretax charge of $290 million, net of reinsurance, to increase environmental reserves due to revised estimates of costs related to recent settlement initiatives. Net environmental losses paid were $246 million, $152 million and $155 million for the years ended December 31, 2005, 2004 and 2003, respectively.
The Company’s consolidated balance sheet includes the debt instruments acquired in the merger, which were recorded at fair value as of the acquisition date. The resulting fair value adjustment is being amortized over the remaining life of the respective debt instruments using the effective-interest method. The amortization of the fair value adjustment reduced interest expense by $54 million and $55 million for the years ended December 31, 2005 and 2004, respectively.
Commercial Paper-The Company maintains an $800 million commercial paper program with $1 billion of back-up liquidity, consisting entirely of bank credit agreements. Interest rates on commercial paper issued in 2005 ranged from 2.3% to 4.4%, and in 2004 ranged from 1.1% to 2.8%.
Medium-Term Notes-The medium-term notes outstanding at December 31, 2005 bear interest rates ranging from 6.38% to 7.42%, with a weighted average rate of 6.76%. Maturity dates on remaining notes outstanding at December 31, 2005 range from 2006 to 2010. During 2005 and 2004, medium-term notes having a par value of $99 million and $59 million, respectively, matured.
3.75%, 5.00%, 6.375% Senior Notes-On March 11, 2003, the Company issued $1.40 billion of senior notes comprising $400 million of 3.75% senior notes due March 15, 2008, $500 million of 5.00% senior notes due March 15, 2013 and $500 million of 6.375% senior notes due March 15, 2033. The notes pay interest semi-annually on March 15 and September 15 of each year, beginning September 15, 2003, are senior unsecured obligations and rank equally with all of the Company’s other senior unsecured indebtedness. The Company may redeem some or all of the notes prior to maturity by paying a “make-whole” premium based on U.S. Treasury rates. The net proceeds from the sale of these notes were contributed to TIGHI, so that TIGHI could prepay and refinance $500 million of 3.60% indebtedness to Citigroup and to redeem $900 million aggregate principal amount of TIGHI’s 8.00% and 8.08% junior subordinated debt securities held by subsidiary trusts. These trusts, in turn, used these funds to redeem $900 million of preferred capital securities on April 9, 2003.
Maturities-The amount of debt obligations, other than commercial paper, that become due in each of the next five years is as follows: 2006, $210 million; 2007, $1.02 billion; 2008, $552 million; 2009, $143 million; and 2010, $273 million.
The current income tax payable was $142 million and $184 million at December 31, 2005 and 2004, respectively, and is included in other liabilities in the consolidated balance sheet.
U.S. income taxes have not been provided on $83 million of the Company’s foreign operations’ undistributed earnings as of December 31, 2005, as such earnings are intended to be permanently reinvested in those operations. Furthermore, any taxes paid to foreign governments on these earnings may be used as credits against the U.S. tax on any dividend distributions from such earnings.
On October 22, 2004, Congress enacted the “American Jobs Creation Act” (AJCA), which provided a temporary incentive for U.S. corporations to repatriate earnings previously reinvested in foreign subsidiaries to obtain an 85% dividends received deduction. In December 2005, the Company repatriated $158 million of cumulative foreign earnings invested outside of the United States, which resulted in an increase in income tax expense of $8 million for the year ended December 31, 2005. See note 1.
The Company’s preferred shareholders’ equity represents the par value of preferred shares outstanding that the Company assumed in the merger related to The St. Paul Companies, Inc. Stock Ownership Plan (SOP) Trust, less the remaining principal balance on the SOP Trust debt. The SOP Trust borrowed funds from a U.S. underwriting subsidiary to finance the purchase of the preferred shares, and the Company guaranteed the SOP debt. The final payment on the SOP debt was made in January 2005.
The SOP Trust may at any time convert any or all of the preferred shares into shares of the Company’s common stock at a rate of eight shares of common stock for each preferred share. The Board of Directors has reserved a sufficient number of authorized common shares to satisfy the conversion of all preferred shares issued to the SOP Trust and the redemption of preferred shares to meet employee distribution requirements. Upon the redemption of preferred shares, the Company will issue shares of common stock to the trust to fulfill the redemption obligations. See note 14.
On February 6, 2006, the Company, under the St. Paul Travelers Companies, Inc. 2004 Incentive Plan, issued 2,401,032 common stock awards in the form of restricted stock, deferred stock and performance share awards to participating officers and other key employees. The restricted stock and deferred stock awards, totaling 2,029,480 shares, generally vest in full after a two-year or three-year period from date of grant. The performance share awards, totaling 371,552 target shares, represent shares which the recipient may earn upon the Company’s attainment of certain performance goals. The performance goals are based upon the Company’s adjusted return on equity over a three-year performance period. If performance falls short of targeted performance none or only a portion of the shares will vest after the three-year performance period from date of grant. If performance exceeds targeted performance, more than 100% (up to a maximum of 160%) of target shares will vest after the three-year performance period from date of grant. The fair value per share attributable to the common stock awards on the date of grant was $44.79. See note 13.
The Company’s 2004 Incentive Plan, the legacy SPC 1994 Stock Incentives Plan and the legacy TPC 2002 Incentive Plan provide settlement alternatives to employees in which the Company repurchases shares to cover tax withholding costs and exercise costs. At December 31, 2005 and 2004, the Company had purchased $47 million and $14 million, respectively, of its common stock under this plan.
Statutory net income of the Company’s insurance subsidiaries was $2.92 billion, $1.58 billion, and $1.95 billion for the years ended December 31, 2005, 2004 and 2003, respectively. Statutory capital and surplus of the Company’s insurance subsidiaries was $17.81 billion and $15.11 billion at December 31, 2005 and 2004, respectively.
(1) Includes foreign currency translation adjustments, changes in value of private equity securities and the cumulative effect of the change in accounting for derivative instruments and hedging activities.
The Company, following the merger, also adopted a compensation program for non-employee directors (the 2004 Director Compensation Program). Under the 2004 Director Compensation Program, non-employee directors’ compensation consists of an annual retainer, a deferred stock award and a stock option award. Each non-employee director may choose to receive all or a portion of his or her annual retainer and any committee chair or co-chair fees paid in the form of cash, common stock or deferred stock. Deferred stock for the annual retainer, and committee chair and co-chair fees, is elected pursuant to the St. Paul Travelers Deferred Compensation Plan for Non-Employee Directors that the Board adopted after the merger and is vested upon grant. The annual deferred stock awards vest one year after the date of award. Any of the deferred stock awards may accumulate until distribution at a future date or upon termination of a director’s service. The shares of the Company’s common stock issued under the 2004 Director Compensation Program, including shares of deferred stock, are awarded under the 2004 Incentive Plan.
On April 1, 2004, in accordance with the merger agreement, the outstanding stock options to purchase shares of TPC common stock were converted into options to purchase the Company’s common stock. These stock options retained substantially the same terms and conditions that were applicable prior to the conversion. The 0.4334 merger exchange ratio was applied to the outstanding TPC stock options to reflect this conversion.
On April 1, 2004, in connection with the merger, the Company assumed 23 million outstanding SPC stock options, of which approximately 4 million remained unvested related to legacy SPC equity-based compensation plans. These stock options retained the same terms and conditions that were applicable prior to the merger. Under the SPC stock option programs, stock option awards were granted having a ten year term with an exercise price equal to the fair value of the Company’s common stock on the date of grant. Generally, options vest 25% each year over a four-year period. Certain stock option awards granted under the SPC 1994 Stock Plan between February 2002 and November 10, 2003 permitted an employee exercising an option to be granted a new option (a reload option) in an amount equal to the number of shares of the Company common stock used to satisfy the exercise price due upon exercise of an option. The reload options are granted at an exercise price equal to the fair market value of the Company common stock on the date of grant, vest one year after the grant date and are exercisable for the remaining term of the related original option.
The following table summarizes the information about stock options outstanding under the Company’s stock option plans at December 31, 2005:
The significant assumptions used in estimating the fair value on the date of the grant for original options and reload options granted in 2005, 2004 and 2003 and for the awards assumed on April 1, 2004 from SPC at the merger were as follows:
In addition, Commercial Insurance Resources, Inc. (CIRI) had equity-based compensation plans in which awards were granted in CIRI’s privately held common stock. In connection with The Travelers Indemnity Company’s purchase of the minority interest of CIRI in 2004, the Company converted CIRI’s outstanding equity-based awards into awards in the Company’s common stock. The converted awards retained the same terms and conditions that were applicable prior to the conversion. The conversion of CIRI outstanding nonvested options into options to purchase the Company’s common stock was considered a modification and therefore the modification guidance of FAS 123 was applied to the converted awards. For these converted options, the excess of the fair value of the modified options issued over the fair value of the original options at the date of exchange was added to the remaining unrecognized compensation cost of the original option and recognized over the remaining vesting period.
circumstances, during this period the stock cannot be sold or transferred by the participant, who is required to render service to the Company during the restricted period. Awards granted to non-U.S. participants are in the form of deferred stock awards. These deferred stock awards are granted at market price and generally vest after three years from the date of grant and are subject to the same conditions as the restricted stock awards except that the shares are not issued until the vesting criteria are satisfied.
In addition to the Company’s equity-based compensation plans discussed above, Nuveen Investments had an equity-based compensation plan in which awards were granted in Nuveen Investments’ publicly traded common stock. The after-tax compensation cost associated with these awards included in the Company’s 2004 net income was approximately $9 million. The compensation cost associated with the Nuveen Investments’ equity-based plan was excluded from the Company’s results in 2005 due to the divestiture of Nuveen Investments (see Note 3).
The Company does not have a best estimate of contributions expected to be paid to the qualified pension plan during the next fiscal year at this time.
The discount rate assumption used to determine the benefit obligation is based on the Moody’s Aa Corporate Bond index adjusted by 25 basis points to reflect the long duration nature of the pension obligation and adjusted to the nearest quarter rate. The discount rate is then back-tested by comparison to a yield curve that reflects the hypothetical portfolio of high quality bonds (rated Aa or higher by a recognized rating agency) for which the timing and amount of cash outflows approximates the estimated payouts of the Plan.
On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (2003 Medicare Act) was enacted. The 2003 Medicare Act introduces a prescription drug benefit under Medicare Part D as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. The Company has concluded that prescription drug benefits available under the SPC postretirement benefit plan are actuarially equivalent to Medicare Part D and thus qualify for the federal subsidy under the 2003 Medicare Act. The Company also expects that the Federal subsidy will offset or reduce the Company’s share of the cost of the underlying postretirement prescription drug coverage on which the subsidy is based. As a result, the estimated effect of the 2003 Medicare Act was reflected in the purchase accounting remeasurement of the SPC postretirement benefit plan on April 1, 2004. The effect of this adjustment was a $29 million reduction (with no tax effect) in the accumulated postretirement benefit obligation as of April 1, 2004 and a reduction of $2 million in net periodic postretirement benefit cost for the year ended December 31, 2004. See note 1.
Pension plan assets are invested for the exclusive benefit of the plan participants and beneficiaries and are intended, over time, to satisfy the benefit obligations under the plan. Risk tolerance is established through consideration of plan liabilities, plan funded status, and corporate financial condition. The asset mix guidelines have been established and are reviewed quarterly. These guidelines are intended to serve as tools to facilitate the investment of plan assets to maximize long-term total return and the ongoing oversight of the plan’s investment performance. The investment portfolio contains a diversified mix of equity and fixed-income investments. Equity investments are diversified across U.S. and non-U.S. stocks. Other assets such as partnerships and real estate are used to enhance long-term returns while improving portfolio diversification. Investment risk is measured and monitored on an ongoing basis through daily and monthly investment portfolio review, annual liability measurements, and periodic asset/liability studies.
The Company, in September 2005, merged the Travelers 401(k) Savings Plan, the St. Paul Companies, Inc. Savings Plus Plan (SPP), and The St. Paul Companies, Inc. Stock Ownership Plan (SOP) into one new plan, the St. Paul Travelers 401(k) Savings Plan (the Savings Plan). Substantially all Company employees are eligible to participate in the Savings Plan. In 2005, the Company matched employee contributions up to 5% of eligible pay, with a maximum annual match of $5,000 which becomes 100% vested after three years of service. The match is primarily in the form of the Company’s common stock which can be reinvested at any time into any other investment option. The expense related to this plan was $63 million for the year ended December 31, 2005.
Prior to the September 2005 plan merger, the Company had a 401(k) savings plan under which substantially all legacy TPC employees and Company employees hired after April 1, 2004, were eligible to participate. In 2004, the Company matched employee contributions up to 5% of eligible pay but not more than $2,500 annually. Prior to 2004, the Company matched employee contributions up to 3% of eligible pay but not more than $1,500 annually. The expense related to this plan was $34 million and $20 million for the years ended December 31, 2004 and 2003, respectively.
Prior to the September 2005 plan merger and in connection with the merger with SPC, the Company assumed The St. Paul Companies, Inc. Savings Plus Plan (SPP), a 401(k) savings plan and The St. Paul Companies, Inc. Stock Ownership Plan (SOP). Substantially all employees who were hired by legacy SPC before April 1, 2004 were eligible to participate in these plans. In 2004 under the SPP, the Company matched 100% of employees’ contributions up to a maximum of 6% of their salary. The match was in the form of preferred shares, to the extent available in the SOP, or in the Company’s common shares. Also allocated to participants were preferred shares equal to the value of dividends on previously allocated shares.
Rent expense was $219 million, $207 million and $115 million in 2005, 2004 and 2003, respectively.
Future minimum annual rental payments under noncancellable operating leases are $173 million, $157 million, $124 million, $87 million, $52 million and $164 million for 2006, 2007, 2008, 2009, 2010 and 2011 and thereafter, respectively. Future sublease rental income aggregating approximately $55 million will partially offset these commitments.
For a derivative instrument to qualify as a hedge, the hedge relationship must be designated and formally documented at inception detailing the particular risk management objective and strategy for the hedge, which includes the item and risk that is being hedged, the derivative that is being used, as well as how effectiveness is being assessed. A derivative has to be highly effective in accomplishing the objective of offsetting either changes in fair value or cash flows for the risk being hedged. The effectiveness of these hedging relationships is evaluated on a retrospective and prospective basis using quantitative measures of correlation. If a hedge relationship is found to be ineffective, it no longer qualifies as a hedge, and any excess gains or losses attributable to such ineffectiveness as well as subsequent changes in fair value are recognized in net realized investment gains (losses). The recognition of gains or losses on derivative instruments that have been designated and qualify as a hedge depends upon whether the derivative instrument is a fair value hedge, a cash flow hedge or a foreign currency hedge.
The Company has foreign currency hedges of net investments in foreign operations in which derivatives (foreign currency forward contracts) hedge the foreign currency exposure. The effective portion of the change in fair value of the derivative hedging the net investment, including any forward premium or discount, is reflected in the accumulated other changes in equity from nonowner sources as part of the foreign currency translation adjustment. For the years ended December 31, 2005 and 2004, the amount included in the foreign currency translation adjustment in equity from nonowner sources was a $2 million loss and a $4 million loss, respectively. During 2005, the Company incurred net realized losses of less than $1 million from hedge ineffectiveness, and in 2004, the Company had no net realized gains or losses from hedge ineffectiveness.
The Company engaged in U.S. Treasury note futures transactions to modify the duration of specific assets within the investment portfolio. The Company enters into 90-day futures contracts on 2-year, 5-year, 10-year and 30-year U.S. Treasury notes which require a daily mark-to-market settlement with the broker. The notional value of the open U.S. Treasury futures contracts was $1.20 billion and $1.33 billion at December 31, 2005 and December 31, 2004, respectively. These derivative instruments are not designated and do not qualify as hedges under FAS 133 and as such the daily mark-to-market changes in fair value are reflected in net realized investment gains (losses). Net realized investment gains (losses) in 2005 and 2004 included net gains of $13 million and net losses of $44 million, respectively, related to U.S. Treasury futures contracts which are settled daily.
The Company owns 6 million stock purchase warrants of Platinum Underwriters, a publicly-held company. These warrants are not designated and do not qualify as hedges under FAS 133 and as such the mark-to-market changes in fair value are reflected in net realized gains (losses).
At December 31, 2005 and 2004, investments in fixed maturities had a fair value, which equaled carrying value, of $58.98 billion and $54.26 billion, respectively. The fair value of investments in fixed maturities for which a quoted market price or dealer quote are not available was $456 million and $574 million at December 31, 2005 and 2004, respectively. See note 1.
The carrying values of cash, short-term securities, mortgage loans, investment income accrued, and payables for securities lending and repurchase agreements approximated their fair values. See notes 1 and 6.
The carrying values of $1.11 billion and $1.14 billion of financial instruments classified as other assets approximated their fair values at December 31, 2005 and 2004, respectively. The carrying values of $5.33 billion and $4.83 billion of financial instruments classified as other liabilities at December 31, 2005 and 2004, respectively, also approximated their fair values. Fair value is determined using various methods including discounted cash flows, as appropriate for the various financial instruments.
The fair value of commercial paper included in debt outstanding at December 31, 2005 and 2004 approximated its book value because of its short-term nature. For other debt, the fair value estimate was based upon the bid price at December 31, 2005 and 2004.
SPC, which is not covered by the bankruptcy court rulings or the settlements described above, has numerous defenses in all of the direct action cases asserting Common Law Claims that are pending against it. SPC’s defenses include the fact that these novel theories have no basis in law; that they are directly at odds with the well-established law pertaining to the insured/insurer relationship; that there is no generalized duty to warn as alleged by the plaintiffs; and that the applicable statute of limitations as to many of these claims has long since expired. Many of these defenses have been raised in initial motions to dismiss filed by SPC and other insurers. There have been favorable rulings during 2003 and 2004 in Texas and during 2004 and 2005 in Ohio on some of these motions filed by SPC and other insurers that dealt with statute of limitations and the validity of the alleged causes of actions. On May 26, 2005, the Court of Appeals of Ohio, Eighth District, affirmed the earliest of these favorable rulings. In Texas, only one court, in June of 2005, has denied the insurers’ initial challenges to the pleadings. That ruling was contrary to the rulings by other courts in similar cases, and SPC intends to continue to defend this case vigorously.
The Company is defending its asbestos and environmental-related litigation vigorously and believes that it has meritorious defenses; however, the outcome of these disputes is uncertain. In this regard, the Company employs dedicated specialists and aggressive resolution strategies to manage asbestos and environmental loss exposure, including settling litigation under appropriate circumstances. For a discussion of other information regarding the Company’s asbestos and environmental exposure, see “Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asbestos Claims and Litigation”, “- Environmental Claims and Litigation” and “- Uncertainty Regarding Adequacy of Asbestos and Environmental Reserves.”
Currently, it is not possible to predict legal outcomes and their impact on the future development of claims and litigation relating to asbestos and environmental claims. Any such development will be affected by future court decisions and interpretations, as well as changes in applicable legislation. Because of these uncertainties, additional liabilities may arise for amounts in excess of the current related reserves. In addition, the Company’s estimate of ultimate claims and claim adjustment expenses may change. These additional liabilities or increases in estimates, or a range of either, cannot now be reasonably estimated and could result in income statement charges that could be material to the Company’s results of operations and financial condition in future periods.
TPC and its board of directors were named as defendants in three putative class action lawsuits brought by shareholders alleging breach of fiduciary duty in connection with the merger of TPC and SPC and seeking injunctive relief as well as unspecified monetary damages. The actions were captioned Henzel, et al. v. Travelers Property Casualty Corp., et al. (Jud. Dist. of Waterbury, Ct. Nov. 17, 2003); Vozzolo v. Travelers Property Casualty Corp., et al. (Jud. Dist. of Waterbury, Ct. Nov. 17, 2003); and Farina v. Travelers Property Casualty Corp., et al. (Jud. Dist. of Waterbury, Ct. December 15, 2003). The Farina complaint also named SPC and its former subsidiary, Adams Acquisition Corp., as defendants, alleging that they aided and abetted the alleged breach of fiduciary duty. On March 18, 2004, TPC and SPC announced that all of these lawsuits had been settled, subject to court approval. Before court approval of the settlement, additional shareholder litigation was commenced, as described below. On September 12, 2005, plaintiffs voluntarily withdrew their complaints without prejudice.
Beginning in August 2004, following post-merger announcements by the Company, various shareholders of the Company commenced fourteen putative class action lawsuits against the Company and certain of its current and former officers and directors in the United States District Court for the District of Minnesota. Plaintiff shareholders alleged that certain disclosures relating to the April 2004 merger between TPC and SPC contained false or misleading statements with respect to the value of SPC’s loss reserves in violation of federal securities laws. These actions were consolidated under the caption In re St. Paul Travelers Securities Litigation I, and a lead plaintiff and lead counsel were appointed. An additional putative class action based on the same allegations was brought in New York State Supreme Court. This action was subsequently transferred to the District of Minnesota and was consolidated with In re St. Paul Travelers Securities Litigation I. On June 24, 2005, the lead plaintiff filed an amended consolidated complaint. The complaint did not specify damages. On August 23, 2005, the Company and the other defendants in In re St. Paul Travelers Securities Litigation I moved to dismiss the amended consolidated complaint. On November 22, 2005, the parties reached an agreement to settle the case. The settlement also encompasses the Henzel, Vozzolo and Farina cases described above. On December 28, 2005, the Court approved the settlement.
The Company believes that the pending lawsuits have no merit and intends to defend vigorously; however, the Company is not able to provide any assurance that the financial impact of one or more of these proceedings will not be material to the Company’s results of operations in a future period. The Company is obligated to indemnify its officers and directors to the extent provided under Minnesota law. As part of that obligation, the Company will advance officers and directors attorneys’ fees and other expenses they incur in defending these lawsuits.
The Company’s Gulf operation brought an action on May 22, 2003, as amended on May 12, 2004, in the Supreme Court of New York, County of New York (Gulf Insurance Company v. Transatlantic Reinsurance Company, et al.), against Transatlantic Reinsurance Company (Transatlantic), XL Reinsurance America, Inc. (XL), Odyssey America Reinsurance Corporation (Odyssey), Employers Reinsurance Company (Employers) and Gerling Global Reinsurance Corporation of America (Gerling), to recover amounts due under reinsurance contracts issued to Gulf and related to Gulf’s February 2003 settlement of a coverage dispute under a vehicle residual value protection insurance policy. The reinsurers have asserted counterclaims seeking rescission of the vehicle residual value reinsurance contracts issued to Gulf and unspecified damages for breach of contract. Separate actions filed by Transatlantic and Gerling have been consolidated with the original Gulf action for pre-trial purposes. On October 1, 2003, Gulf entered into a final settlement agreement with Employers, and all claims and counterclaims with respect to Employers have been dismissed.
On May 26, 2004, the Court denied Gulf’s motion to dismiss certain claims asserted by Transatlantic and a joint motion by Transatlantic, XL and Odyssey for summary judgment against Gulf. Discovery is currently proceeding in the matters. Gulf denies the reinsurers’ allegations, believes that it has a strong legal basis to collect the amounts due under the reinsurance contracts and intends to vigorously pursue the actions.
Based on the Company’s beliefs about its legal positions in its various reinsurance recovery proceedings, the Company does not expect any of these matters to have a material adverse effect on its results of operations in a future period.
As part of ongoing, industry-wide investigations, the Company and its affiliates have received subpoenas and written requests for information from government agencies and authorities. The areas of inquiry addressed to the Company include its relationship with brokers and agents, the Company’s involvement with “non-traditional insurance and reinsurance products,” branding requirements for salvage automobiles and the reporting of workers’ compensation premiums. The Company or its affiliates have received subpoenas or written requests for information, in each case with respect to one or more of the areas described above, from: (i) State of California Office of the Attorney General; (ii) State of California Department of Insurance; (iii) Licensing and Market Conduct Compliance Division, Financial Services Commission of Ontario, Canada; (iv) State of Connecticut Insurance Department; (v) State of Connecticut Office of the Attorney General; (vi) State of Delaware Department of Insurance; (vii) State of Florida Department of Financial Services; (viii) State of Florida Office of Insurance Regulation; (ix) State of Florida Department of Legal Affairs Office of the Attorney General; (x) State of Georgia Office of the Commissioner of Insurance; (xi) State of Illinois Department of Financial and Professional Regulation; (xii) State of Iowa Insurance Division; (xiii) State of Maryland Insurance Administration; (xiv) Commonwealth of Massachusetts Office of the Attorney General; (xv) State of Minnesota Department of Commerce; (xvi) State of Minnesota Office of the Attorney General; (xvii) State of New Hampshire Insurance Department; (xviii) State of New York Office of the Attorney General; (xix) State of New York Insurance Department; (xx) State of North Carolina Department of Insurance; (xxi) State of Ohio Office of the Attorney General; (xxii) State of Ohio Department of Insurance; (xxiii) Commonwealth of Pennsylvania Office of the Attorney General; (xxiv) State of Texas Department of Insurance; (xxv) State of Washington Office of the Insurance Commissioner; (xxvi) State of West Virginia Office of Attorney General; (xxvii) the United States Attorney for the Southern District of New York; and (xxviii) the United States Securities and Exchange Commission. The Company and its affiliates may receive additional subpoenas and requests for information with respect to the areas described above from other agencies or authorities.
The Company’s internal review with respect to finite reinsurance considered finite products the Company both purchased and sold. The Company has completed its review with respect to the identified finite products purchased and sold, and has concluded that no adjustment to previously issued financial statements is required. The related industry-wide investigations previously described are ongoing, as are the Company’s efforts to cooperate with the authorities, and the various authorities could ask that additional work be performed or reach conclusions different from the Company’s. Accordingly, it would be premature to reach any conclusions as to the likely outcome of these matters.
On July 23, 2004, the Company announced that it was seeking guidance from the staff of the Division of Corporation Finance of the Securities Exchange Commission with respect to the appropriate purchase accounting treatment for certain second quarter 2004 adjustments totaling $1.63 billion ($1.07 billion after-tax). The Company recorded these adjustments as charges in its income statement in the second quarter of 2004. Through an informal comment process, the staff of the Division of Corporation Finance has subsequently asked for further information, which the Company has provided. Specifically, the staff has asked for information concerning the Company’s adjustments to certain of SPC’s insurance reserves and reserves for reinsurance recoverables and premiums due from policyholders, and how those adjustments may relate to SPC’s reserves for periods prior to the merger. After reviewing the staff’s questions and comments, the Company continues to believe that its accounting treatment for these adjustments is appropriate. If, however, the staff disagrees, some or all of the adjustments being discussed may not be recorded as charges in the Company’s income statement, thereby increasing net income for the second quarter and full year 2004 and increasing shareholders’ equity at December 31, 2005 and 2004, in each case by the approximate after-tax amount of the change. The effect on tangible shareholders’ equity (adjusted for the effects of deferred taxes associated with goodwill and intangible assets) at December 31, 2005 and 2004 would not be material. Increases to goodwill and deferred tax liabilities would be reflected on the Company’s balance sheet as of April 1, 2004, either due to purchase accounting or adjustment of SPC’s reserves prior to the merger.
The Company has certain contingent obligations for guarantees related to agency loans and letters of credit, issuance of debt securities, third party loans related to venture capital investments and various indemnifications related to the sale of business entities.
Prior to Citigroup’s distribution to its stockholders of a portion of its ownership in TPC in August 2002, TPC provided and purchased services to and from Citigroup affiliated companies, including facilities management, banking and financial functions, benefit coverages, data processing services, and short-term investment pool management services. Charges for these shared services were allocated at cost. In connection with the Citigroup Distribution, TPC and Citigroup and its affiliates entered into a transition services agreement for the provision of certain of these services, tradename and trademark and similar agreements related to the use of trademarks, logos and tradenames and an amendment to the March 26, 2002 Intercompany Agreement with Citigroup. During the first quarter of 2002, Citigroup provided investment advisory services on an allocated cost basis, consistent with prior years. On August 6, 2002, TPC entered into an investment management agreement, which was applied retroactively to April 1, 2002, with an affiliate of Citigroup whereby the affiliate of Citigroup provided investment advisory and administrative services to TPC with respect to its entire investment portfolio for a period of two years and at fees mutually agreed upon, including a component based on investment performance. This agreement was modified and extended through the first quarter of 2005, at which time it was terminated. Charges incurred related to this agreement were $2 million, $58 million and $60 million for the years ended December 31, 2005, 2004 and 2003, respectively. TPC and Citigroup also agreed upon the allocation or transfer of certain other liabilities and assets, and rights and obligations in furtherance of the separation of operations and ownership as a result of the Citigroup Distribution. The net effect of these allocations and transfers, in the opinion of management, was not significant to the Company’s results of operations or financial condition.
The Company had notes payable to Citigroup of $700 million at December 31, 2002, which was repaid during 2003. Interest expense included in the consolidated statement of income was $9 million for the year ended December 31, 2003.
The Company participates in reinsurance agreements with TIC, a former affiliate.
The Company purchased annuities from former affiliates to settle certain claims. Through 2004, the Company had agreed to use TIC as the most preferred provider of annuities, as long as Citigroup maintained competitive ratings and its products are competitively priced. Beginning in 2005, the Company had no preferred provider of annuities. Reinsurance recoverables at December 31, 2005 and 2004 included $791 million and $718 million, respectively, related to these annuities.
The following consolidating financial statements of the Company have been prepared pursuant to Rule 3-10 of Regulation S-X. These consolidating financial statements have been prepared from the Company’s financial information on the same basis of accounting as the consolidated financial statements. The St. Paul Travelers Companies, Inc. has fully and unconditionally guaranteed certain debt obligations of TPC, its wholly-owned subsidiary, which totaled $2.64 billion as of December 31, 2005.
Prior to the merger, TPC fully and unconditionally guaranteed the payment of all principal, premiums, if any, and interest on certain debt obligations of its wholly-owned subsidiary TIGHI. The St. Paul Travelers Companies, Inc. has fully and unconditionally guaranteed such guarantee obligations of TPC. TPC is deemed to have no assets or operations independent of TIGHI. Consolidating financial information for TIGHI has not been presented herein because such financial information would be substantially the same as the financial information provided for TPC.