We also own office space located in a three-building complex located at 808 North Highlander Way, Howell, Michigan, with approximately 176,000 square feet, where various business operations are conducted, and office space located at Thanet Way, Whitstable, United Kingdom, with approximately 40,000 square feet, where we operate our U.K. motor line of business. Certain of our properties have been leased to unrelated third parties or are available for lease.
We believe our unique approach to the small commercial market, distinctiveness in the middle market, and continued development of specialty lines provides us with a diversified portfolio of products and delivers significant value to agents and policyholders. The small commercial and middle market businesses are expected to contribute to premium growth in Commercial Lines over the next several years as we continue to pursue our core strategy of developing strong partnerships with agents, distinctive products, franchise value through limited distribution, and industry segmentation. Growth in our specialty lines continues to be an important part of our strategy.
We believe these efforts have driven, and will continue to drive, improvement in our overall mix of business and ultimately our underwriting profitability. Commercial Lines net premiums written grew by 7.4% in 2014, driven by both our core commercial and specialty businesses. This growth is primarily due to rate increases, increased retention and targeted new business expansion.
Personal Lines focuses on partnering with high quality, value-oriented agencies that deliver consultative selling and stress the importance of account rounding (the conversion of single policy customers to accounts with multiple policies and additional coverages). Approximately 78% of our policies in force are account business. We are focused on making investments that help maintain profitability, build a distinctive position in the market, help diversify us geographically from our historical core states of Michigan, Massachusetts, New York and New Jersey, and provide us with profitable growth opportunities.
Underwriting results improved in 2014, as compared to 2013, primarily due to higher earned premiums, favorable development on prior years’ loss reserves, and lower catastrophe losses, partially offset by lower current accident year underwriting results. Chaucer net premiums written grew by 10.2% in 2014, principally related to growth in our casualty line, primarily due to expanded underwriting capabilities, and growth in the marine line, as well as an increase in Chaucer’s economic interests in Syndicate 1084 to 100% for 2014, up from 98% in 2013 and 84% in 2012, and the favorable impact of foreign exchange rate movements.
Chaucer also has continued to experience overall downward pressure on rates in 2014. Rates in the marine, energy and property markets remained under pressure in 2014 due to a continued absence of major losses, to new capital from a variety of sources and high levels of competition. Casualty markets remained weak after several years of rate decreases resulting from low loss activity and high industry capacity, while U.K. motor market rates were flat after several years of decline following significant increases in 2010 and 2011. In response to these challenging market conditions, we continue to actively manage Chaucer’s underwriting portfolio, using our expertise, distinctive underwriting capabilities and market knowledge to target specific attractive underwriting opportunities. We will seek rate increases in the U.K. motor market in 2015 and expect modest rate increases for certain classes of business in the casualty markets.
Primary business operations include insurance products and services currently provided through four operating segments. Our domestic operating segments are Commercial Lines, Personal Lines, and Other. Our international operating segment is Chaucer. Commercial Lines includes commercial multiple peril, commercial automobile, workers’ compensation and other commercial coverages, such as specialty program business, inland marine, management and professional liability and surety. Personal Lines includes personal automobile, homeowners and other personal coverages. Chaucer includes marine and aviation, energy, property, U.K. motor, and casualty and other coverages (which includes international liability, specialist coverages, and syndicate participations). Included in Other are Opus Investment Management, Inc., which markets investment management services to institutions, pension funds and other organizations; earnings on holding company assets; and, a discontinued voluntary pools business. We present the separate financial information of each segment consistent with the manner in which our chief operating decision maker evaluates results in deciding how to allocate resources and in assessing performance.
Consolidated net income was $251.0 million in 2013, compared to $55.9 million in 2012. The $195.1 million increase is primarily due to improved operating results after taxes, which was principally attributable to a decrease in catastrophe losses, higher favorable development on prior years’ loss reserves and an improvement in non-catastrophe current accident year results. In addition, net income increased in 2013 as a result of higher realized gains from the sale of securities, partially offset by losses resulting from the repayment of debt.
The following table reflects operating income for each operating segment and a reconciliation of operating income to consolidated net income.
Favorable development on prior years’ loss reserves was $99.1 million for the year ended December 31, 2014, compared to $76.3 million for the year ended December 31, 2013, an increase of $22.8 million. For 2014, $104.6 million of favorable development related to our Chaucer segment was partially offset by $5.5 million of unfavorable development related to our domestic operations. For the year ended December 31, 2013, $94.6 million of favorable development related to our Chaucer segment was partially offset by $18.3 million of unfavorable development related to our domestic operations.
Commercial Lines current accident year underwriting profit, excluding catastrophes, was $88.7 million for the year ended December 31, 2014, compared to $31.0 million for the year ended December 31, 2013. This $57.7 million improvement was primarily due to lower losses in our surety, commercial multiple peril, inland marine, and specialty property lines. In addition, results benefited from growth in earned premium and underwriting expense efficiencies.
Personal Lines net premiums written were $1,422.8 million for the year ended December 31, 2014, compared to $1,428.0 million for the year ended December 31, 2013, a decrease of $5.2 million. The primary factors contributing to this decrease were our continued property-focused exposure management actions and actions to improve underwriting results in all lines of business. These decreases were partially offset by higher rates in both our homeowners and personal automobile lines, and increased new business volume.
Personal Lines current accident year underwriting profit, excluding catastrophes, was $123.4 million in the year ended December 31, 2014, compared to $118.2 million for the year ended December 31, 2013. This $5.2 million increase was attributable to more favorable loss experience due to rate and underwriting actions, partially offset by higher non-catastrophe weather-related losses in the homeowners line.
Other operating losses were $10.3 million for the year ended December 31, 2014, compared to $8.0 million for the year ended December 31, 2013. The $2.3 million increased loss is primarily due to lower net investment income in our holding company.
Personal Lines net premiums written were $1,428.0 million for the year ended December 31, 2013, compared to $1,475.6 million for the year ended December 31, 2012, a decrease of $47.6 million. The primary factors contributing to this decrease were our continued property-focused exposure management actions and actions to improve underwriting results in all lines of business. These decreases were partially offset by higher rates in both our homeowners and personal automobile lines.
Net premiums written in the personal automobile line of business for the year ended December 31, 2013 were $890.3 million compared to $922.7 million for the year ended December 31, 2012, a decrease of $32.4 million. This decrease was primarily due to a decline in policies in force of 11.0%, primarily from ongoing exposure management actions and actions to improve underwriting results. This reduction in policies in force was partially offset by rate increases. Net premiums written in the homeowners line of business for the year ended December 31, 2013 were $496.7 million compared to $510.2 million for the year ended December 31, 2012, a decrease of $13.5 million. This was attributable to a decline in policies in force of 11.7%, as a result of aforementioned exposure management actions, partially offset by rate increases.
Chaucer’s net premiums written were $1,117.5 million for the year ended December 31, 2013, compared to $990.5 million for the year ended December 31, 2012, an increase of $127.0 million, or 12.8%. This growth was primarily due to the aforementioned increase in Chaucer’s economic interests in Syndicate 1084. Written premium growth was also driven by growth in our marine, casualty, and property lines, due to favorable pricing and specific underwriting opportunities in these markets. Partially offsetting this growth was a reduction in net premiums written in our energy line, primarily due to a reduction of estimated premiums for the exploration and production coverage class, specifically control of well business, and the construction coverage class. This change was based on a reduced volume in actual well footage drilled, following tighter safety regulations worldwide and a reduction of offshore gas exploration in the U.S., and a reduced number and size of new construction projects worldwide. Additionally, strong market competition decreased net premiums in our aviation line.
Management’s process for establishing loss reserves is a comprehensive process that involves input from multiple functions throughout our organization, including finance, actuarial, claims, legal, underwriting, distribution and business operations management. The process incorporates facts currently known and the current, and in some cases, the anticipated, state of the law and coverage litigation. Based on information currently available, we believe that the aggregate loss reserves at December 31, 2014 were adequate to cover claims for losses that had occurred as of that date, including both those known to us and those yet to be reported. However, as described below, there are significant uncertainties inherent in the loss reserving process. Our estimate of the ultimate liability for losses that had occurred as of December 31, 2014 is expected to change in future periods as we obtain further information, and such changes could have a material effect on our results of operations and financial condition.
The IBNR reserve includes a provision for claims that have occurred but have not yet been reported to us, some of which may not yet be known to the insured, as well as a provision for future development on reported claims. IBNR represents a significant proportion of our total net loss reserves, particularly for long-tail liability classes. In fact, approximately 48% of our aggregate net loss reserves at December 31, 2014 were for IBNR losses and loss expenses.
We regularly update our reserve estimates as new information becomes available and additional events occur which may impact the resolution of unsettled claims. Reserve adjustments are reflected in the results of operations as adjustments to losses and LAE. Often, these adjustments are recognized in periods subsequent to the period in which the underlying policy was written and the loss event occurred. When these types of subsequent adjustments affect prior years, they are described separately as “prior year reserve development”. Such development can be either favorable or unfavorable to our financial results and may vary by line of business. As discussed below, estimated loss and LAE reserves for claims occurring in prior years developed favorably by $99.1 million, $76.3 million, and $15.8 million for the years ended December 31, 2014, 2013, and 2012, respectively. However, we have experienced unfavorable development and there can be no assurance that current loss and LAE reserves will be sufficient.
Our loss reserves include amounts related to short-tail and long-tail classes of business. “Tail” refers to the time period between the occurrence of a loss and the final settlement of the claim. The longer the time span between the incidence of a loss and the settlement of the claim (i.e. a longer tail), the more the ultimate settlement amount may likely vary from our original estimate.
Short-tail classes consist principally of automobile physical damage, homeowners property, commercial property and marine business. The Chaucer business, while having more longer-tail coverages than our traditional U.S. business, contains a substantial book of U.K. motor property damage, worldwide property insurance and reinsurance business, including certain high excess property layers, marine property, aviation property and energy property business which has relatively short development patterns. For these property coverages, claims are generally reported and settled shortly after the loss occurs because the claims relate to tangible property and are more likely to be discovered shortly after the loss occurs, and property losses are often more easily valued. Consequently, the estimation of loss reserves for these classes is generally less complex. However, this is less true for our Chaucer reinsurance business and high excess property layers where there is often a longer period of time between the date a claim is incurred and the date the claim is reported compared with our direct insurance operations. Therefore, the risk of delayed recognition of loss reserve development is higher for our assumed reinsurance and high excess property layers than for our direct insurance lines.
In addition, we must consider the uncertain effects of emerging or potential claims and coverage issues that arise as legal, judicial, social conditions, political risks, and economic conditions change. For example, claims which we consider closed may be re-opened as additional damages surface or new liability or damage theories are presented. These and other issues could have a negative effect on our loss reserves by either extending coverage beyond the original underwriting intent or by increasing the number or size of claims.
The future impact of the various factors that contribute to the uncertainty in the loss reserving process is impossible to predict. There is potential for significant variation in the development of loss reserves, particularly for long-tailed classes of business and classes of business that are more vulnerable to economic or political risks. We do not derive statistical loss distributions or confidence levels around our loss reserve estimate, and as a result, we do not establish reserve range estimates.
Personal and Commercial Automobile Bodily Injury - reserves recorded for bodily injury on U.S. voluntary business were $489.8 million as of December 31, 2014. A key assumption for bodily injury is the inflation rate underlying the estimated reserve. A five point change (e.g. 4% changed to 9% or -1%) in the embedded inflation rate would have changed estimated IBNR by approximately $58 million, either positive or negative, respectively, at December 31, 2014.
Personal Automobile Personal Injury Protection Medical Payment - reserves recorded for personal injury protection medical payment on U.S. voluntary business were $169.6 million as of December 31, 2014. A key assumption for this coverage is the inflation rate underlying the estimated reserve. Given the long reporting pattern for this line of business, an additional key assumption is the amount of additional development required to reach full maturity, thereby reflecting ultimate costs, as represented by the tail factor. A five point change in the embedded inflation rate and a one point change to the tail factor assumption (e.g. 1.02 changed to 1.01 or 1.03) would have changed estimated IBNR by approximately $26 million, either positive or negative, at December 31, 2014.
Workers’ Compensation - reserves recorded for workers’ compensation on U.S. voluntary business were $371.7 million as of December 31, 2014. A key assumption for workers’ compensation is the inflation rate underlying the estimated reserve. Given the long reporting pattern for this line of business, an additional key assumption is the amount of additional development required to reach full maturity, thereby reflecting ultimate costs, as represented by the tail factor. A five point change in the embedded inflation rate and a one point change to the tail factor assumption would have changed estimated IBNR by approximately $40 million, either positive or negative, at December 31, 2014.
Casualty classes of business - reserves recorded for casualty classes of Chaucer business were $369 million as of December 31, 2014. An increase in the ultimate loss ratio of 2.5% across all classes and years of account would have increased estimated IBNR by approximately $31 million at December 31, 2014.
The table below provides a reconciliation of the gross beginning and ending reserve for unpaid losses and loss adjustment expenses.
The primary drivers of reserve development for the year ended December 31, 2014 were as follows:
property line, primarily in the 2010 through 2013 accident years, and
Lower than expected losses within our personal automobile line, primarily related to accident year 2013.
The primary drivers of reserve development for the year ended December 31, 2013 were as follows:
within casualty lines, primarily in the 2010 and 2011 accident years, and
Within other commercial lines, higher than expected losses in our contract surety line due to the challenging macroeconomic environment for contractors, and to a lesser extent, our AIX program business primarily related to unexpected severity in commercial automobile liability, commercial multiple peril and general liability in a limited number of programs.
It is not possible to know whether the factors that affected loss reserves in the year ended December 31, 2014 will also occur in future periods. As discussed in detail in this Form 10-K, there are inherent uncertainties in estimating reserves for losses and LAE and we encourage you to read this Form 10-K for more information about our reserving process and the judgments, uncertainties and risks associated therewith.
Although we attempt to limit our exposures to asbestos and environmental damage liability through specific policy exclusions, we have been and may continue to be subject to claims related to these exposures. Ending loss and LAE reserves for all direct business written by our property and casualty companies related to asbestos and environmental damage liability were $10.1 million, $11.5 million and $9.8 million, net of reinsurance of $21.4 million, $20.6 million, and $20.4 million for the years ended December 31, 2014, 2013 and 2012, respectively.
Activity for our asbestos and environmental reserves was not significant to our 2014, 2013 or 2012 financial results. In recent years, average asbestos and environmental payments have declined modestly. As a result of our historical direct underwriting mix of Commercial Lines policies toward smaller and middle market risks, past asbestos and environmental damage liability loss experience has remained minimal in relation to our total loss and LAE incurred experience.
In addition, we have established gross loss and LAE reserves for assumed reinsurance pool business with asbestos and environmental damage liability of $29.1 million, $29.8 million and $30.3 million at December 31, 2014, 2013 and 2012, respectively. These reserves relate to pools in which we have terminated our participation; however, we continue to be subject to claims related to years in which we were a participant. Results of operations from these pools are included in our Other segment. A significant part of our pool reserves relates to our participation in the Excess and Casualty Reinsurance Association (“ECRA”) voluntary pool from 1950 to 1982. In 1982, the pool was dissolved and since that time, the business has been in run-off. Our percentage of the total pool liabilities varied from 1% to 6% during these years. Our participation in this pool has resulted in average paid losses of approximately $2 million annually over the past ten years.
We maintain a reinsurance program designed to protect against large or unusual losses and LAE activity. We utilize a variety of reinsurance agreements that are intended to control our exposure to large property and casualty losses, stabilize earnings and protect capital resources, including facultative reinsurance, excess of loss reinsurance and catastrophe reinsurance. We determine the appropriate amount of reinsurance based upon our evaluation of the risks insured, exposure analyses prepared by consultants, our capital allocation models and on market conditions, including the availability and pricing of reinsurance. Reinsurance contracts do not relieve us from our primary obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to us. We believe that the terms of our reinsurance contracts are consistent with industry practice in that they contain standard terms and conditions with respect to lines of business covered, limit and retention, arbitration and occurrence. Based on an ongoing review of our reinsurers’ financial statements, their history of timely payments to us, reported financial strength ratings from rating agencies, and the analysis and guidance of our reinsurance advisors, we believe that our reinsurers are financially sound.
Catastrophe reinsurance serves to protect us, as the ceding insurer, from significant losses arising from a single event including, among others, hurricanes, tornadoes and other windstorms, earthquakes, hail, severe winter weather, fire, explosions, and terrorism. Although we believe our catastrophe reinsurance program, including our retention and co-participation amounts for 2015, are appropriate given our surplus level and the current reinsurance pricing environment, there can be no assurance that our reinsurance program will provide coverage levels that will prove adequate should we experience losses from one significant or several large catastrophes during 2015. Additionally, as a result of the current economic environment, as well as losses incurred by reinsurers in the past several years, the availability and pricing of appropriate reinsurance programs may be adversely affected in future renewal periods. We may not be able to pass these costs on to policyholders in the form of higher premiums or assessments.
Based on ratings by the National Association of Insurance Commissioners (“NAIC”), approximately 94% of the fixed maturity portfolio consisted of investment grade securities at December 31, 2014 and December 31, 2013. The quality of our fixed maturity portfolio remains strong based on ratings, capital structure position, support through guarantees, underlying security, issuer diversification and yield curve position.
Other investments consisted primarily of overseas deposits, participations in commercial mortgage loan obligations and limited partnerships. Overseas deposits are U.S. dollar and foreign denominated investments maintained in overseas funds and managed exclusively by Lloyd’s. These funds are required in order to protect policyholders in overseas markets and enable Chaucer to operate in those markets. Access to those funds is restricted and we have no control over the investment strategy. Commercial mortgage loan participations represent our interest in commercial mortgage loans originated by a third party. We share, on a pro-rata basis, in all related cash flows of the underlying mortgage loans, which are investment-grade quality and diversified by geographic area and property type.
Gross unrealized losses on fixed maturities and equity securities decreased $47.7 million compared to December 31, 2013, primarily attributable to lower prevailing interest rates and tightening of credit spreads. At December 31, 2014, gross unrealized losses consisted primarily of $31.8 million of corporate fixed maturities, $4.0 million in municipal securities, $3.5 million of U.S. Treasury and government agency securities and $3.0 million of residential mortgage-backed securities.
The following table sets forth gross unrealized losses for fixed maturities by maturity period and for equity securities at December 31, 2014 and 2013. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties, or we may have the right to put or sell the obligations back to the issuers.
We did not use derivative instruments in 2014 or 2013. In 2012, we realized a loss of $5.1 million on futures contracts relating to the release of tax capital loss carryforwards. Additionally, we recognized a gain of $0.7 million on a foreign currency forward used to mitigate changes in fair value caused by foreign currency fluctuation in converting U.K. pound sterling denominated securities into their U.S. dollar denominated equivalent.
Net realized gains on investments were $50.1 million, $33.5 million, and $23.6 million for 2014, 2013, and 2012, respectively. Net realized gains in 2014 were primarily due to $55.4 million of gains recognized from the sale of equity securities and to a lesser extent, fixed maturities, partially offset by $5.5 million of OTTI losses. Net realized gains in 2013 were primarily due to $41.3 million of gains recognized from the sale of equities and fixed maturities, partially offset by $6.0 million of OTTI losses. Net realized gains in 2012 were primarily due to $31.8 million of gains recognized from the sale of equities and fixed maturities, partially offset by $7.8 million of OTTI losses.
In 2013, we consolidated our operations in Howell, Michigan from two buildings into one building. This resulted in a plan to relocate the employees and pursue the sale of one of the buildings. During the fourth quarter of 2014 the building was sold. In 2013, we recognized a loss of $4.7 million in conjunction with the plan to dispose of the building. This was included in other operating expenses in the Consolidated Statements of Income during that year.
The following tables for the years ended December 31, 2014 and 2013 provide information about financial instruments that are sensitive to changes in interest rates. The tables present principal cash flows and related weighted average interest rates by expected maturities. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties, or we may have the right to put or sell the obligations back to the issuers. Mortgage-backed and asset-backed securities are included in the category representing their expected maturity. Available-for-sale securities include both U.S. and foreign-denominated fixed maturities. Additionally, we have assumed available-for-sale securities are similar enough to aggregate those securities for presentation purposes. Specifically, variable rate available-for-sale securities comprise an immaterial portion of the portfolio and do not have a significant impact on weighted average interest rates. Therefore, the variable rate investments are not presented separately; instead they are included in the tables at their current interest rate. Debt is presented at contractual maturities.
Chaucer has exposure to foreign currency risk, most notably in insurance contracts and invested assets. Some of the insurance contracts provide that ultimate losses may be payable in foreign currencies depending on the country of original loss. Foreign currency exchange rate risk exists to the extent that there is an increase in the exchange rate of the foreign currency in which losses are ultimately owed. Thus, Chaucer attempts to manage foreign currency risk by seeking to match liabilities under insurance and reinsurance policies that are payable in foreign currencies with cash and investments that are denominated in such currencies. We may also utilize foreign currency forward contracts as part of our investment strategy. The principal currency creating foreign exchange risk for us is the U.K. pound sterling, and to a lesser extent, the Euro, Canadian dollar, Australian dollar and Swiss franc. A hypothetical 10% reduction in the value of foreign denominated investments would be expected to produce a loss in fair value of approximately $102 million at December 31, 2014 and approximately $112 million at December 31, 2013.
Discontinued operations for the years ended December 31, 2014 and 2013 resulted in losses of $0.3 million and gains of $5.3 million, respectively, net of tax. The 2013 benefit associated with our former life insurance businesses was primarily due to an insurance settlement related to a class action lawsuit.
The income tax provision on operating income was an expense of $108.3 million for 2014, compared to an expense of $100.9 million for 2013 and a benefit of $1.9 million for 2012. These provisions resulted in effective tax rates for operating income of 31.8%, 30.8% and a benefit of 14.4% in 2014, 2013 and 2012, respectively. The increase in the 2014 effective tax rate is primarily due to a modest decrease in the proportion of our income from foreign operations not subject to U.S. taxes and thus taxed at the lower U.K. rate. The tax benefit in 2012 is primarily due to income from foreign operations not subject to U.S. tax and to lower domestic underwriting income.
Included in our deferred tax asset as of December 31, 2014 is an asset of $29.1 million related to operating loss carryforwards. Our pre-tax operating loss is a qualified deficit of $81.9 million generated in the U.K. and has no expiration date. It is our opinion that the U.K. operations will generate sufficient future taxable income to utilize these loss carryforwards. Our estimate of the amount and likely realization of loss carryforwards may change over time.
Included in our deferred tax net asset as of December 31, 2014 are assets of $110.0 million related to alternative minimum tax (“AMT”) credit carryforwards and $15.8 million related to foreign tax credit carryforwards. We may utilize these credits to offset future taxable income. The result of their utilization will be a lower current tax rate offset by a higher deferred tax provision, and also lower cash expenditures for federal income taxes during the utilization period. There is no expiration on AMT credit carryforwards and our foreign tax credit carryforwards will expire beginning in 2022. It is our opinion that there will be sufficient future U.S. and U.K. taxable income to utilize these tax credit carryforwards. Our estimate of the amount and likely realization of tax credit carryforwards may change over time.
In prior years, we completed several transactions which resulted in the realization, for tax purposes only, of unrealized gains in our investment portfolio. We realized $69.6 million in 2012 as a result of such transactions. These transactions enabled us to realize capital loss carryforwards to offset these gains, and resulted in the release of the valuation allowance we held against the deferred tax asset related to these capital loss carryforwards. In 2012, we released $24.4 million of our valuation allowance which was recorded as a benefit in accumulated other comprehensive income. During 2014, 2013 and 2012, we recognized in income from continuing operations, related to non-operating income, $16.2 million, $17.5 million and $14.3 million, respectively. The remaining amount of $91.5 million in accumulated other comprehensive income will be released into income from continuing operations in future years, as the investment securities subject to these transactions are sold or mature.
Expenses related to these plans are generally calculated based upon information available at the beginning of the plan year. Our pre-tax expense related to our defined benefit plans was $10.3 million and $12.6 million for 2014 and 2013, respectively.
Mortality assumptions for the participants in our pension plan are a significant estimate in measuring the expected payments a participant may receive over their lifetime. During 2014, the Society of Actuaries released a series of updated mortality tables resulting from their recent studies measuring mortality rates for various groups of individuals. The updated mortality tables, released in 2014, reflect improved trends in longevity and therefore have the effect of increasing the estimate of benefits to be received by plan participants, as well as the amount of expense that will be recognized. In determining the most appropriate mortality assumptions for our U.S. qualified defined benefit pensions at December 31, 2014, we considered the updated mortality tables issued by the Society of Actuaries, coupled with other mortality information available from the Social Security Administration and our outside actuaries that we believe is more closely aligned with our industry and participant mix to develop assumptions that we believe are most representative of the various characteristics of our participant populations. The use of these updated mortality assumptions increased the benefit obligation for our U.S. qualified defined benefit pension plan by approximately $23 million at December 31, 2014.
Given the positive effect of our actual investment experience in 2014 and our voluntary settlement program, and taking into consideration the decrease in discount rates for 2015 and the new mortality tables, U.S. pension related expenses are expected to increase slightly from $8 million in 2014 to approximately $8.5 million in 2015.
Expected Return on Plan Assets - A 25 basis point increase or decrease in the expected return on plan assets would decrease or increase our pension expense in 2015 by $1.2 million.
As of December 31, 2014 and 2013, we determined the discount rate utilizing an independent yield curve which provides for a portfolio of high quality bonds that are expected to match the cash flows of the Chaucer plan. At December 31, 2014, based upon Chaucer’s plan liabilities and cash flows in relation to these yield curves, we decreased the discount rate to 3.75% from 4.50% at December 31, 2013.
Actuarial losses in 2014 resulting from decreases in the discount rate from the prior year were partially offset by benefits from the investment gains experienced during the year, resulting in net actuarial losses for the Chaucer plan of approximately $5.9 million. The benefits from the investment gains experienced in 2013 were partially offset by decreases in the discount rate from the prior year, resulting in net actuarial gains for the Chaucer plan of approximately $7.5 million in 2013. These losses and gains are reflected as decreases and increases to our accumulated other comprehensive income in 2014 and 2013, respectively. This balance is amortized into earnings in future periods. Given the effect of our actual investment experience in 2014, expected rates of return on investments in 2015 and taking into consideration the decrease in discount rates, pension related benefits for the Chaucer plan are expected to decrease slightly from a benefit of $0.9 million to a benefit of $0.6 million in 2015 (using the December 31, 2014 GBP to U.S. dollar conversion rate of 1.56).
Discount Rate - A 25 basis point increase in the discount rate would decrease our pension expense in 2015 by $0.1 million and decrease our projected benefit obligation by $8.1 million. A 25 basis point reduction in the discount rate would increase our pension expense by $0.6 million and increase our projected benefit obligation by $8.7 million.
The following are the components of our deferred tax assets and liabilities as of December 31, 2014. There were no valuation allowances required as of December 31, 2014.
We have $110.0 million of alternative minimum tax credit carryforwards and $15.8 million of foreign tax credit carryforwards. The alternative minimum tax credit carryforwards have no expiration date and may be used to offset regular federal income taxes due from future income. The foreign tax credit carryforwards will expire beginning in 2022 and may be used to offset federal income taxes due from future foreign sourced income. In addition, we have operating loss carryforwards from our Chaucer segment, which have no expiration date. Based on our projection of future economic conditions, taxable income, reversals of existing taxable temporary liabilities, and our strategic tax planning strategies, we believe that these tax credit carryforwards and operating loss carryforwards will be fully realized.
Liquidity is a measure of our ability to generate sufficient cash flows to meet the cash requirements of business operations. As a holding company, our primary ongoing source of cash is dividends from our insurance subsidiaries. However, dividend payments to us by our U.S. insurance subsidiaries are subject to limitations imposed by regulators, such as prior notice periods and the requirement that dividends in excess of a specified percentage of statutory surplus or prior year’s statutory earnings receive prior approval (so called “extraordinary dividends”). No dividends were paid to the holding company by Hanover Insurance in 2014, 2013 or 2012.
Dividend payments to the holding company by Chaucer are regulated by U.K. law. Dividends from Chaucer are dependent on dividends from its subsidiaries. Annual dividend payments from Chaucer are limited to retained earnings that are not restricted by capital and other requirements for business at Lloyd’s. Also, Chaucer must provide advance notice to the U.K.’s Prudential Regulation Authority (“PRA”) of certain proposed dividends or other payments from PRA regulated entities. Chaucer paid $68.7 million and $13.9 million in dividends during 2014 and 2013, respectively, to the holding company. No dividends were paid by Chaucer to the holding company in 2012.
In connection with an intercompany borrowing arrangement between Chaucer and the holding company, interest on a $300 million note is paid by Chaucer on a quarterly basis to the holding company. This interest may be deferred at the election of the holding company. If deferred, the interest is added to the principal. Chaucer paid $22.5 million and $28.1 million of interest during 2014 and 2013, respectively.
We expect to continue to generate sufficient positive operating cash to meet all short-term and long-term cash requirements relating to current operations, including the funding of our qualified defined benefit pension plan and the Chaucer pension plan. Based upon the
Additionally, from time to time, we may also repurchase our debt on an opportunistic basis. During 2013, we repurchased senior debentures with a net carrying value of $73.8 million at a cost of $93.7 million, resulting in a loss of $19.9 million. Additionally in 2013, we repaid $46.3 million of our FHLBB advances plus prepayment fees of $7.8 million for a total payment of $54.1 million. In 2012, we called $65.4 million of our subordinated unsecured notes related to Chaucer at par value. These notes had a carrying value of $60.3 million, resulting in a net loss of $5.1 million on the repayment. Additional information related to all borrowings is in Note 6 - “Debt and Credit Arrangements” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
We have a $200.0 million credit agreement which expires in November 2018, with an option to increase the facility to $300.0 million assuming no default and satisfaction of certain other conditions. The agreement also includes a $50 million sub-facility for standby letters of credit that can be used for general corporate purposes. Borrowings, if any, under the agreement are unsecured and incur interest at a rate per annum equal to, the higher of (a) the prime commercial lending rate of the administrative agent, (b) the Federal Funds Rate plus half of a percent, or (c) the one month Adjusted LIBOR plus one percent and any applicable margin. The agreement contains financial covenants including, but not limited to, maintaining at least a certain level of consolidated equity, maximum consolidated leverage ratios and requires certain of our subsidiaries to maintain a minimum RBC ratio. We had no borrowings under this agreement during 2013 and 2014.
Membership in the FHLBB provides us with access to additional liquidity based on our stock holdings and pledged collateral. At December 31, 2014, we had additional borrowing capacity of $33.7 million. There were no borrowings outstanding under this agreement at December 31, 2014.
Simultaneous with the Amended Facility Agreement, we entered into a Guaranty Agreement (the “Guaranty Agreement”) with Lloyds Bank plc, as Facility Agent and Security Agent, pursuant to which, we unconditionally guarantee the obligations of Chaucer under the
Financing obligations generally include repayment of our senior debentures, subordinated debentures, borrowings from the FHLBB, and operating lease payments. The following table represents our annual payments related to the contractual principal and interest payments of these financing obligations as of December 31, 2014 and operating lease payments reflect expected cash payments based upon lease terms. In addition, we also have included our estimated payments related to our loss and LAE obligations and our current expectation of payments to be made to support the obligations of our benefit plans. The following table also includes commitments to purchase investment securities at a future date. Actual payments may differ from the contractual and/or estimated payments in the table.
Debt includes our senior debentures due in 2025, which pay annual interest at a rate of 7 5/8%, our senior debentures due in 2020, which pay annual interest at a rate of 7.50%, our senior debentures due in 2021, which pay annual interest at a rate of 6.375%, our subordinated debentures due in 2053, which pay annual interest at a rate of 6.35%, and our subordinated debentures due in 2027, which pay cumulative dividends at an annual rate of 8.207%. Payments related to the principal amounts of these agreements represent contractual maturity; therefore, principal and interest associated with these obligations are reflected in the above table based upon the contractual maturity dates. In addition, we have $125.0 million of borrowings under a collateralized borrowing program with the FHLBB which pays interest monthly at a rate of 5.50% annually. Such borrowings are available for a twenty-year term or through September 25, 2029. Also, interest includes contractual interest related to the uncollateralized portion of our £130.0 million Standby Letter of Credit Facility.
Non-qualified defined benefit pension and postretirement benefit obligations reflect estimated payments to be made through plan year 2024 for pension, postretirement and postemployment benefits. Estimates of these payments and the payment patterns are based upon historical experience.
Catastrophe - A severe loss, resulting from natural and manmade events, including, among others, hurricanes, tornadoes and other windstorms, earthquakes, hail, severe winter weather, fire, explosions, and terrorism.
Catastrophe loss - Loss and directly identified loss adjustment expenses from catastrophes. The Insurance Services Office (“ISO”) Property Claim Services (“PCS”) defines a catastrophe loss as an event that causes $25 million or more in U.S. industry insured property losses and affects a significant number of property and casualty policyholders and insurers. In addition to those catastrophe events declared by ISO, claims management also generally includes within the definition of a “catastrophe loss”, a property loss event that causes approximately $5m international business in the Chaucer segment, management utilizes a “catastrophe loss” definition that is substantially consistent with the ISO definition framework.
The consolidated financial statements of The Hanover Insurance Group, Inc. (“THG” or the “Company”), include the accounts of The Hanover Insurance Company (“Hanover Insurance”) and Citizens Insurance Company of America (“Citizens”), THG’s principal U.S. domiciled property and casualty companies; Chaucer Holdings Limited (“Chaucer”), a specialist insurance underwriting group which operates through the Society and Corporation of Lloyd’s (“Lloyd’s”); and certain other insurance and non-insurance subsidiaries. These legal entities conduct their operations through several business segments discussed in Note 14 - “Segment Information”. The consolidated financial statements also include the Company’s discontinued operations, consisting primarily of the Company’s former life insurance businesses, and its accident and health business. All intercompany accounts and transactions have been eliminated. During 2013, the Company increased additional paid-in capital and decreased retained earnings by $34 million to correct the classification of amounts relating to stock-based compensation in prior periods. This reclassification within shareholders’ equity had no impact on net income, assets, liabilities or total shareholders’ equity of the Company.
Fixed maturities, mortgage participations and other loans that are delinquent are placed on non-accrual status, and thereafter interest income is recognized only when cash payments are received.
Mortgage participations represent interests in investment grade commercial mortgage loans originated and serviced by a third party of which the Company shares, on a pro-rata basis, in all related cash flows of the underlying mortgage loans. Due to certain reacquisition rights retained by the third party in the loan participation, these investments are accounted for as secured borrowings under Accounting Standards Codification (“ASC”) 860, Transfers and Servicing (“ASC 860”).
Property, equipment, leasehold improvements and capitalized software are recorded at cost, less accumulated depreciation and amortization. Depreciation is generally provided using the straight-line method over the estimated useful lives of the related assets, which generally range from 3 to 30 years. The estimated useful life for capitalized software is generally 5 to 7 years. Amortization of leasehold improvements is provided using the straight-line method over the lesser of the term of the leases or the estimated useful life of the improvements.
The Company tests for the recoverability of long-lived assets whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. The Company recognizes impairment losses only to the extent that the carrying amounts of long-
All losses, LAE and unearned premium liabilities are based on the various estimates discussed above. Although the adequacy of these amounts cannot be assured, the Company believes that it is more likely than not that these liabilities and accruals will be sufficient to meet future obligations of policies in force. The amount of liabilities and accruals, however, could be revised in the near-term if the estimates discussed above are revised.
The Company’s debt at December 31, 2014 includes senior debentures, subordinated debentures, and collateralized borrowings with the Federal Home Loan Bank of Boston (“FHLBB”). The senior debentures are carried at principal amount borrowed, net of any applicable unamortized discounts. The subordinated debentures and borrowings under the FHLBB program are carried at principal amount borrowed (See Note 6 - “Debt and Credit Arrangements”).
In February 2013, the FASB issued ASC Update No. 2013-02 (Topic 220) Comprehensive Income Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income (“ASC Update No. 2013-02”). This guidance requires an entity to provide information about the amounts reclassified out of accumulated other comprehensive income (“AOCI”) either on the face of the Statement of Income or in the Notes to the Consolidated Financial Statements. Significant amounts reclassified out of AOCI should be provided by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified in its entirety to net income in the same reporting period. For amounts not required to be reclassified in their entirety to net income, a cross-reference to other disclosures provided for in accordance with U.S. GAAP is required. This guidance was applicable for reporting periods beginning after December 15, 2012. The Company implemented the guidance effective January 1, 2013. The effect of implementing the guidance relates to financial statement presentation and disclosures. (See disclosures in Note 10 - Other Comprehensive Income.)
In April 2014, the FASB issued ASC Update No. 2014-08 (Topic 205 and Topic 360) Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. This ASC update modifies the definition of discontinued operations by limiting discontinued operations reporting to disposals of components of an entity that represent strategic shifts that have (or will have) a major effect on an entity’s operations and financial results. Also, this update requires additional financial statement disclosures about discontinued operations, as well as disposals of an individually significant component of an entity that do not qualify for discontinued operations presentation. This ASC update is effective for all disposals (or classifications as held for sale) of components of an entity that occur within annual and interim periods beginning on or after December 15, 2014 and for all businesses that, on acquisition, are classified as held for sale that also occur within interim and annual periods beginning on or after December 15, 2014. Early adoption is permitted for disposals (or classifications as held for sale) that have not been reported in financial statements previously issued or available for issuance. The Company does not expect the adoption of ASC Update 2014-08 to have a material impact on its financial position or results of operations.
During 1999, the Company exited its accident and health insurance business, consisting of its Employee Benefit Services business, its Affinity Group Underwriters business and its accident and health assumed reinsurance pool business. Prior to 1999, these businesses comprised substantially all of the former Corporate Risk Management Services segment. Accordingly, the operating results of the discontinued segment have been reported in accordance with Accounting Principles Board Opinion No. 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions (“APB Opinion No. 30”). On January 2, 2009, Hanover Insurance directly assumed a portion of the accident and health business; and therefore continues to apply APB Opinion No. 30 to this business. In addition, the remainder of the Discontinued First Allmerica Financial Life Insurance Company (“FAFLIC”) accident and health business was reinsured by Hanover Insurance in connection with the sale of FAFLIC to Commonwealth Annuity, and has been reported in accordance with ASC 205, Presentation of Financial Statements.
At December 31, 2014 and 2013, the portion of the discontinued accident and health business that was directly assumed had assets of $65.2 million and $66.6 million, respectively, consisting primarily of invested assets, and liabilities of $49.7 million and $51.3 million, respectively, consisting primarily of policy liabilities. At December 31, 2014 and 2013, the assets and liabilities of this business, as well as those of the reinsured portion of the accident and health business are classified as assets and liabilities of discontinued operations in the Consolidated Balance Sheets.
The amortized cost and fair value of available-for-sale fixed maturities and the cost and fair value of equity securities were as follows:
OTTI unrealized losses in the tables above represent OTTI recognized in accumulated other comprehensive income. This amount excludes net unrealized gains on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date of $12.3 million and $16.4 million as of December 31, 2014 and 2013, respectively.
At December 31, 2014 and 2013, fixed maturities with fair values of $211.2 million and $142.4 million, respectively, and amortized cost of $196.4 million and $135.2 million, respectively, were on deposit with various state and governmental authorities.
The Company did not use derivative instruments in 2014 or 2013. In 2012, the Company realized a loss of $5.1 million on futures contracts relating to the realization, for tax purposes only, of unrealized gains in its investment portfolio. Additionally, the Company utilized a foreign currency forward contract to mitigate changes in fair value caused by foreign currency fluctuation in converting GBP denominated securities into their U.S. dollar denominated equivalent. The contract was terminated in March 2012 and the Company recognized a gain of $0.7 million.
The following tables provide information about the Company’s fixed maturities and equity securities that were in an unrealized loss position at December 31, 2014 and 2013 including the length of time the securities have been in an unrealized loss position:
During 2014, the Company did not refinance any loans based on terms that differed from current market rates.
In 2012, the Company sold an office building and adjacent garage that it had developed for $75.9 million, and recognized an estimated gain of $3.3 million. In 2013, upon receipt of final construction costs, the gain was adjusted by $(0.9) million, to $2.4 million. The project was financed, in part, with $46.3 million of FHLBB advances through the Company’s membership in the FHLBB, which was repaid in January 2013.
Included in the net realized investment gains (losses) were OTTI of investment securities recognized in earnings totaling $5.5 million, $6.0 million and $7.8 million in 2014, 2013 and 2012, respectively.
For 2012, total OTTI was $7.3 million. Of this amount, $7.8 million was recognized in earnings, including $0.5 million that was transferred from unrealized losses in accumulated other comprehensive income.
The fair value of debt is estimated based on quoted market prices. If a quoted market price is not available, fair values are estimated using discounted cash flows that are based on current interest rates and yield curves for debt issuances with maturities and credit risks consistent with the debt being valued. Debt is reported as Level 2.
During the years ended December 31, 2014 and 2013, the Company transferred fixed maturities between Level 2 and Level 3 primarily as a result of assessing the significance of unobservable inputs on the fair value measurement. There were no transfers between Level 1 and Level 2 during 2014 or 2013.
Net realized investment gains and losses due to changes in fair value that are recorded in net income for Level 3 assets were $0.1 million and $1.5 million for the years ended December 31, 2014 and 2013, respectively.
There were no Level 3 liabilities held by the Company for years ended December 31, 2014 and 2013.
In 2013, the Company repurchased senior debentures maturing October 15, 2025, with a net carrying value of $39.2 million at a cost of $50.5 million, resulting in a loss of $11.3 million. Also in 2013, the Company repurchased senior debentures maturing March 1, 2020, with a net carrying value of $34.6 million at a cost of $43.2 million, resulting in a loss of $8.6 million.
As collateral to FHLBB, Hanover Insurance pledged government agency securities with a fair value of $195.7 million and $148.1 million, for the aggregate borrowings of $125.0 million as of December 31, 2014 and December 31, 2013, respectively. The fair value of the collateral pledged must be maintained at certain specified levels of the borrowed amount, which can vary depending on the type of assets pledged. If the fair value of this collateral declines below these specified levels, Hanover Insurance would be required to pledge additional collateral or repay outstanding borrowings. Hanover Insurance is permitted to voluntarily repay the outstanding borrowings at any time, subject to a repayment fee. As a requirement of membership in the FHLBB, Hanover Insurance maintains a certain level of investment in FHLBB stock. Total holdings of FHLBB stock were $9.3 million at December 31, 2014 and 2013.
Included in the Company’s deferred tax asset as of December 31, 2014 is an asset of $29.1 million related to operating loss carryforwards. The pre-tax operating loss of $81.9 million was generated in the U.K. and has no expiration date. It is the Company’s opinion that the U.K. operations will generate sufficient future taxable income to utilize these loss carryforwards. The Company’s estimate of the amount and likely realization of loss carryforwards may change over time.
During 2014, the Company released the valuation allowance related to its deferred tax assets of $2.9 million which was recorded in 2013. The write off of this valuation allowance resulted from appreciation in the Company’s investment portfolio. The Company recorded the decrease to its valuation allowance of $2.9 million as an adjustment to income tax expense.
Although most of the Company’s non - U.S. income is subject to U.S. federal income tax, certain of its non-U.S. income is not subject to U.S. federal income tax until repatriated. Foreign taxes on this non - U.S. income are accrued at the local foreign tax rate, as opposed to the higher U.S. statutory tax rate, since these earnings currently are expected to be indefinitely reinvested overseas. This assumption could change, as a result of a sale of the subsidiaries, the receipt of dividends from the subsidiaries, a change in management’s intentions, or as a result of various other events. The Company has not made a provision for U.S. taxes on $23.3 million, $20.3 million and $10.0 million of non-U.S. income for 2014, 2013 and 2012, respectively. However, in the future, if such earnings were distributed to the Company, taxes of $21.1 million would be payable on such undistributed earnings and would be reflected in the tax provision for the year in which these earnings are no longer intended to be indefinitely reinvested overseas, assuming all foreign tax credits are realized.
The Company recognizes interest and penalties related to unrecognized tax benefits in federal income tax expense. The Company had accrued interest of $0.5 million and $1.2 million as of December 31, 2014 and 2013, respectively. For the years ended December 31, 2014, 2013 and 2012 the Company recognized interest expense of $0.5 million, $0.8 million and $0.1 million, respectively. The Company has not recognized any penalties associated with unrecognized tax benefits.
The Company or its subsidiaries files income tax returns in the U.S. federal jurisdiction and various state jurisdictions, as well as foreign jurisdictions. The Company and its subsidiaries are subject to U.S. federal income tax examinations by tax authorities for years after 2010, U.S. state income tax examinations for years after 2006 and foreign examinations for years after 2011.
As of January 1, 2005, the defined benefit pension plans were frozen and since that date, no further cash balance allocations have been credited to participants. Participants’ accounts are credited with interest daily, based upon the General Agreement of Trades and Tariffs. In addition, the grandfathered benefits for the transition group were also frozen at January 1, 2005 levels with an annual transition pension adjustment calculated at an interest rate equal to 5% per year up to 35 years of completed service, and 3% thereafter. As of December 31, 2014, based on current estimates of plan liabilities and other assumptions, the projected benefit obligation of the qualified defined benefit pension plans exceeds plan assets by approximately $25 million.
The Company utilizes a target allocation strategy, which focuses on creating a mix of assets that will generate modest growth from equity securities while minimizing volatility in the Company’s earnings from changes in the markets and economic environment. Various factors are taken into consideration in determining the appropriate asset mix, such as census data, actuarial valuation information and capital market assumptions. During 2014 and 2013, the plan assets were invested 85% and 84% in fixed income securities and 15% and 16% in equity securities, respectively. The Company reviews and updates, at least annually, the target allocation and makes changes periodically.
The following table provides 2014 target allocations and actual invested asset allocations for 2014 and 2013.
Securities classified as Level 1 at December 31, 2014 and 2013 include actively traded mutual funds and publicly traded securities, which are valued at quoted market prices. Securities classified as Level 2 at December 31, 2014 and 2013 include a separate investment account, which is invested entirely in the Vanguard Total Bond Market Index Fund, a mutual fund that in turn invests in investment grade fixed maturities, as well as commingled pools and investment grade fixed income securities that are held in a custom fund. The fair value of each of the Level 2 investments is determined daily as the Net Asset Value (“NAV”) based on the value of the underlying investments, which is determined independently by the investment manager. The daily NAV, which is not published as a quoted market price for these investments, is used as the basis for transactions. Redemption of these funds is not subject to restriction. Securities classified as Level 3 at December 31, 2014 include assets held in a fixed account of an insurance company. The fair value of the investment is estimated using a comparable public market financial institution derived fair value curve that uses non-observable inputs for market liquidity and unique credit characteristics of its underlying securities.
Securities classified as Level 1 at December 31, 2014 and 2013 include actively traded mutual funds that are publicly traded and which primarily invest in equity securities that are valued at quoted market prices. Securities classified as Level 2 include investments in commingled pools that primarily invest in publicly traded common stocks and international equity securities. The fair value of each of the Level 2 investments is determined daily as the NAV based on the value of the underlying investments, which is determined independently by the investment manager. The daily NAV, which is not published as a quoted market price for these investments, is used as the basis for transactions. Redemption of these funds is not subject to restriction.
Included in total plan assets of $131.8 million at December 31, 2014 were $130.3 million of invested assets carried at fair value and $1.5 million of cash and equivalents. Total plan assets at December 31, 2013 of $120.2 million included $119.9 million of invested assets carried at fair value and $0.3 million of cash and equivalents.
Securities classified as Level 2 at December 31, 2014 and 2013 include pooled funds which are valued at the close of business using a third party pricing service. These values are adjusted by the fund manager to reflect outstanding dividends, taxes and investment fees and other expenses to calculate the NAV.
Real estate fund investments classified as Level 3 at December 31, 2014 and 2013 are valued based upon the values of the net assets of the fund. Although the NAV is calculated daily, transactions also consider cash inflows and outflows of the fund. The price where units are transacted includes the NAV, which is adjusted for investment charges and other estimated acquisition costs such as legal fees, taxes, planning and architect fees, survey and agent fees, among others.
Includes $59.0 million paid to participants in 2014 in settlement of their pension obligations, essentially as a result of a voluntary lump-sum pension payout program and the termination of a small qualified defined benefit plan.
Chaucer also provides a defined contribution plan for its employees which provides for employer provided contributions. The Company’s expense for 2014, 2013 and 2012 was $6.1 million, $5.0 million and $4.8 million, respectively.
The following table reflects the estimated amortization to be recognized in net periodic benefit cost in 2015:
A one-percentage point change in assumed health care cost trend rates in each year would have an immaterial effect on net periodic benefit cost during 2014 and accumulated postretirement benefit obligation at December 31, 2014.
On May 20, 2014 the shareholders approved The Hanover Insurance Group 2014 Long-Term Incentive Plan (the “2014 Stock Plan”). With respect to new share-based award issuances, the 2014 Stock Plan replaced The Hanover Insurance Group, Inc. 2006 Long-Term Incentive Plan (the “2006 Stock Plan”) and authorized the issuance of 6,100,000 shares in a new share pool plus any shares subject to outstanding awards under the 2006 Stock Plan that may become available for reissuance as a result of the cash settlement, forfeiture, expiration or cancellation of such awards. The 2014 Stock Plan provides for the granting of the same types of awards as the 2006 Stock Plan, which includes stock options and stock appreciation rights (“SARS”), restricted and unrestricted stock, stock units, performance and market-based stock awards, and cash awards. In accordance with the 2014 Stock Plan, the issuance of one share of common stock in the form of an option or SAR will reduce the share pool by one share, whereas the issuance of one share of common stock for the other types of stock awards provided by the plan will reduce the pool by 3.8 shares. As of December 31, 2014, there were 6,138,403 shares available for grants under the 2014 Stock Plan.
Additionally, on May 20, 2014, the shareholders approved The Hanover Insurance Group 2014 Employee Stock Purchase Plan (the “ESPP Plan”) and the Chaucer Share Incentive Plan (the “SIP Plan”), authorizing the issuance of 2,500,000 and 750,000 shares, respectively, under such plans. As of December 31, 2014, 32,681 shares and 18,778 shares have been issued under the ESPP Plan and the SIP Plan, respectively.
Compensation cost for the years ended December 31, 2014, 2013, and 2012 totaled $15.1 million, $12.4 million and $12.8 million, respectively. Related tax benefits were $5.3 million, $4.3 million and $4.5 million, respectively.
The weighted average grant date fair value of options granted during the years ended December 31, 2014, 2013 and 2012 was $8.96, $7.69 and $8.87, respectively.
The Company granted market-based restricted share units in 2014, 2013 and 2012 and performance-based restricted share units in 2011 to certain employees. Share units granted in 2014 and 2013 generally vest after 3 years of continued employment and after the achievement of certain stock performance targets and share units granted in 2012 and 2011 vest after the achievement of certain performance targets at a rate of 50% after 3 years and the remaining 50% after 4 years of continued employment. The Company also granted restricted stock units to eligible employees in 2014 and 2013 that generally vest after 3 years of continued employment. For those restricted stock units granted in 2012, vesting is at a rate of 50% after 3 years and the remaining 50% after 4 years of continued employment. The following table summarizes information about employee restricted stock units:
At December 31, 2014, the aggregate intrinsic value of restricted stock and restricted stock units was $27.5 million and the weighted average remaining contractual life was 1.2 years. The aggregate intrinsic value of performance and market-based restricted stock units was $15.6 million and the weighted average remaining contractual life was 1.3 years. As of December 31, 2014, there was $11.9 million of total unrecognized compensation cost related to unvested restricted stock units and performance and market-based restricted stock units, assuming performance and market-based restricted stock units are achieved at 100% of the performance metric. The cost is expected to be recognized over a weighted average period of 1.7 years. Compensation cost associated with restricted stock, restricted stock units and performance and market-based restricted stock units is generally calculated based upon grant date fair value, which is determined using current market prices.
The Company’s Board of Directors has authorized aggregate repurchases of the Company’s common stock of up to $600 million. As of December 31, 2014, the Company has $116.5 million available for repurchases under these repurchase authorizations. Repurchases may be executed using open market purchases, privately negotiated transactions, accelerated repurchase programs or other transactions. The Company is not required to purchase any specific number of shares or to make purchases by any certain date under this program. During 2014, the Company purchased 0.3 million shares of the Company’s common stock at a cost of $20.4 million.
Pursuant to New Hampshire’s statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the New Hampshire Insurance Commissioner, is limited to 10% of such insurer’s statutory policyholder surplus as of the preceding December 31. No dividends were declared by Hanover Insurance in 2014, 2013 or 2012. During 2015, the maximum dividend payable without prior approval is $205.2 million.
Rental expenses for operating leases amounted to $21.4 million, $21.6 million and $22.4 million in 2014, 2013 and 2012, respectively. These expenses relate primarily to building leases of the Company. At December 31, 2014, future minimum rental payments under non-cancelable operating leases were $62.7 million, payable as follows: 2015 - $17.3 million; 2016 - $14.3 million; 2017 - $11.5 million; 2018 - $8.0 million and 2019 and thereafter - $11.6 million. It is expected that in the normal course of business, leases that expire may be renewed or replaced by leases on other property and equipment.
The Company regularly updates its reserve estimates as new information becomes available and further events occur which may impact the resolution of unsettled claims. Reserve adjustments are reflected in results of operations as adjustments to losses and LAE. Often these adjustments are recognized in periods subsequent to the period in which the underlying policy was written and loss event occurred. These types of subsequent adjustments are described as “prior years’ loss reserves”. Such development can be either favorable or unfavorable to the Company’s financial results and may vary by line of business.
The $76.3 million favorable loss and LAE reserve development during the year ended December 31, 2013 included favorable loss and LAE reserve development of $94.6 million for Chaucer. Chaucer’s favorable development during 2013 was primarily the result of lower than expected losses in the energy line, primarily in the 2009 through 2012 accident years, property line, primarily in the 2011 and 2012 accident years, within casualty and other lines, specialty liability lines, primarily in the 2008 accident year, and the marine and aviation line, primarily in the 2010 through 2012 accident years. For Commercial and Personal Lines, the unfavorable loss and LAE development during 2013 was primarily the result of higher than expected losses within the personal automobile line, due to severity in bodily injury coverage in the 2010 through 2012 accident years, higher than expected large losses in the commercial automobile line, primarily related to liability coverage in the 2009 through 2011 accident years, and higher than expected losses within other commercial lines, primarily in the 2010 through 2012 accident years. Partially offsetting the unfavorable development was lower than expected losses within the workers’ compensation line, primarily in the 2006 through 2011 accident years and lower involuntary pool losses, including a $3.2 million benefit from the settlement of a legal proceeding, and lower than expected losses within the commercial multi-peril line, primarily in the 2012 accident year.
At this time, the Company is unable to provide a reasonable estimate of the potential range of ultimate liability if the outcome of the suit is unfavorable. The extent to which any of the plaintiffs’ multiple theories of liability, some of which are overlapping and others of which are quite complex and novel, are accepted and upheld on appeal will significantly affect the Plan’s or the Company’s potential liability. The statute of limitations applicable to the class has not yet been finally determined and the extent of potential liability, if any, will depend on this final determination. In addition, assuming for these purposes that the plaintiffs prevail with respect to claims that benefits accrued or payable under the Plan were understated, then there are numerous possible theories and other variables upon which any revised calculation of benefits as requested under plaintiffs’ claims could be based. Any adverse judgment in this case against the Plan would be expected to create a liability for the Plan, with resulting effects on the Plan’s assets available to pay benefits. The Company’s future required funding of the Plan could also be impacted by such a liability.
The quarterly results of operations for 2014 and 2013 are summarized below.