The Company owns its corporate headquarters buildings located at 385 Washington Street and 130 West Sixth Street, St. Paul, Minnesota. These buildings are adjacent to one another and consist of approximately 1.1 million square feet of gross floor space.
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 Denver, Colorado, Fall River, Massachusetts and Irving, Texas, and a data center located in Norcross, Georgia. In January 2007, the Company acquired a building and adjacent land in Windsor, Connecticut. The Company leases 196 field and claim offices totaling approximately 5.1 million square feet throughout the United States under leases or subleases with third parties.
In the opinion of the Company’s management, the Company’s properties are adequate and suitable for its business as presently conducted and are adequately maintained.
All data in the following table for 2002 and 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.
(1) On April 1, 2004, Travelers Property Casualty Corp. (TPC) merged with a subsidiary of The St. Paul Companies, Inc. (SPC), as a result of which TPC became a wholly-owned subsidiary of SPC and SPC changed its name to The St. Paul Travelers Companies, Inc.
· Total assets of $113.76 billion, up $574 million from December 31, 2005
· Total debt of $5.76 billion, down $90 million from December 31, 2005
· Repurchased 22.8 million common shares for total cost of $1.12 billion under share repurchase program
· Shareholders’ equity of $25.14 billion, up $2.83 billion from December 31, 2005; book value per common share of $36.86, up $4.92 from December 31, 2005
The Company’s discussions related to all items, other than net income, income from continuing operations, income (loss) from discontinued operations, and segment operating income (loss), are presented on a pretax basis, unless otherwise noted. Throughout the following discussion, the Company references the “impact of the merger” in the context of a comparison between 2005 and 2004, referring to the fact that the Company’s 2005 results reflected a full year of combined post-merger operations, whereas the Company’s 2004 results reflected combined post-merger operations for the nine months subsequent to the April 1, 2004 merger date, plus the results of TPC only for the three months ended March 31, 2004.
Earned premiums in 2006 totaled $20.76 billion, an increase of $419 million, or 2%, over the 2005 total of $20.34 billion. Earned premiums in 2006 were negatively impacted by an increase in property catastrophe reinsurance costs. Earned premiums in 2005 were reduced by $121 million of reinstatement premiums, which represent additional premiums payable to reinsurers to maintain coverage limits for certain excess-of-loss reinsurance treaties. In the Personal Insurance segment, earned premium growth of 9% in 2006 reflected strong new business volume and continued renewal price increases. In the Business Insurance segment, earned premiums in 2006 declined 2% from the comparable 2005 total, primarily reflecting the impact of business in runoff and the sale of the Personal Catastrophe Risk operation in November 2005. Earned premiums in the Financial, Professional & International Insurance segment in
The $1.30 billion increase in earned premiums in 2005 over 2004 primarily reflected the impact of the merger, which was partially offset by a significant decline in earned premiums in the Business Insurance segment’s runoff operations and a decline in certain of Business Insurance’s ongoing operations due to a lower level of net written premium volume in the last half of 2004 and first half of 2005. Earned premiums in 2005 were reduced by the $121 million of reinstatement premiums related to catastrophe losses. Earned premiums in 2004 were reduced by $76 million of reinstatement premiums primarily related to reserve charges recorded in the surety operation. Partially offsetting these factors were the impacts of new business growth and increased retention in many of the Company’s insurance operations in 2005.
each segment. The investment yield for investable funds reflects the duration of the loss reserves’ future cash flows, the interest rate environment at the time the losses were incurred and A+ rated corporate debt instrument yields. The investment yield for capital reflects the average yield on the total investment portfolio. It is the application of the yields to the segments’ investable funds and capital that determines the respective business segment’s share of actual net investment income.
The National Accounts market in the Business Insurance segment is the primary source of the Company’s fee-based business. The declines in fee income in 2006 and 2005 compared with the respective prior years is described in the Business Insurance segment discussion that follows.
Other revenues in all periods presented primarily consist of premium installment charges. In addition, other revenues in 2006 included a $42 million gain on the redemption of the Company’s $593 million, 7.60% subordinated debentures.
Gross and net written premiums in 2006 increased 1% and 4%, respectively, over 2005. The disparity between gross and net written premium growth rates in 2006 was concentrated in the Business Insurance segment and was primarily due to a change in the structure of reinsurance coverage in the Company’s Discover Re subsidiary that resulted in a decline in ceded premiums. Net written premium volume in 2006 was negatively impacted by a higher level of premiums ceded for the cost of property catastrophe reinsurance, whereas net written premiums in 2005 were reduced by $121 million of catastrophe-related reinstatement premiums.
Gross and net written premiums in 2005 both increased 7% over 2004, primarily reflecting the impact of the merger. However, gross and net written premium volumes in 2005 were down when compared to 2004 on a pro forma combined basis. The declines were concentrated in the Business Insurance segment, reflecting the planned non-renewal of business in runoff and reduced premium volume in certain ongoing operations due to competitive market conditions. In addition, premium volume in the Business Insurance segment’s Construction operation was lower than in 2004 on a pro forma basis due to the now-completed process of aligning the underwriting profile of the two predecessor companies. Net written premiums in 2005 were reduced by $121 million of catastrophe-related reinstatement premiums, whereas 2004 net written premium volume was reduced by $76 million of reinstatement premiums primarily related to reserving actions in the Financial, Professional & International Insurance segment. Premium volume in the Personal Insurance segment increased over 2004, driven by continued renewal price increases and growth in policies in force in the homeowners line of business. During 2005, the Company experienced strong business retention rates on a company-wide basis, as the Company focused on retaining its existing book of well-priced, profitable business. New business levels in several of the Company’s insurance operations also increased over 2004. Rate increases, however, were generally lower in 2005 compared with 2004, reflecting increased competition and more aggressive pricing in the marketplace. Rates for certain products in selected markets declined from 2004 levels.
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.
In addition, the 2004 total included charges to increase the acquired net construction and surety reserves by $500 million and $300 million, respectively, and a charge of $252 million related to the financial condition of a specific construction contractor. The following discussion provides more information regarding the net unfavorable prior year loss development related to these three items in 2004, as well as other reserving actions.
uniform manner and determining an appropriate level of data segmentation for estimation purposes. This type of analysis involves a high degree of judgment and can, and often does, lead to reserve estimates that differ materially from those of prior periods, particularly in low frequency, high severity and complex exposures. In addition, since the reserving process also considers the expectations of future outcomes, the actuaries involved had to analyze their differing views on key assumptions, such as predicting inflation, estimating claim development patterns and determining expectations related to judicial rulings and interpretations, among others. This “informed judgment” is brought into the process by individuals such as actuaries, underwriters, claim adjusters, and company management. Ultimately, this process required an analysis of the varying actuarial judgments and forward-looking assessments. The result was similar to a single, ongoing insurance enterprise obtaining more information in a reporting period than it had previously and identifying a change in estimate in its insurance reserves in that period. Accordingly, the Company recorded a $500 million and $300 million charge for construction and surety, respectively, in the second quarter of 2004.
Cost of Catastrophes. In 2006, the cost of catastrophes totaled $103 million (net of reinsurance), all of which was incurred in the Personal Insurance segment and resulted from several wind, rain, hail and snow storms in the United States throughout the year. In 2005, the Company’s cost of catastrophes, net of reinsurance and including reinstatement premiums of $121 million and state assessments of $43 million, totaled $2.19 billion, primarily resulting from Hurricanes Katrina, Rita and Wilma. 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. The majority of catastrophe costs in 2005 were incurred in the Business Insurance segment ($1.41 billion) and in the Personal Insurance segment ($593 million) 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.
During the second quarter of 2004, a participating co-surety on the specific construction contractor described above announced that insurance regulators had approved its submitted run-off plan. Based upon industry’s knowledge of the co-surety’s run-off plan and the Company’s analysis of its financial condition, the Company concluded that it was unlikely to collect the full amount projected to be owed by the co-surety and established an appropriate level of reserves. In the second quarter of 2005, the Company reached a settlement with the co-surety whereby the co-surety made a payment to the Company and was released from further financial obligations to the Company in connection with the specific construction exposure. The settlement payment, coupled with the previously established co-surety reserves, approximated the Company’s estimate of the co-surety’s share of the bonded losses related to this exposure.
Interest expense in 2006 was $38 million higher than in 2005, primarily due to the issuance in November 2005 of $400 million, 5.50% senior notes due December 1, 2015, and the issuance in June 2006
The $50 million increase in interest expense in 2005 over 2004 primarily reflected the impact of a full year of interest expense on SPC debt assumed in the merger on April 1, 2004. The Company’s debt outstanding at December 31, 2005 declined by a net $463 million compared with year-end 2004.
The consolidated loss and loss adjustment expense ratio of 57.5% in 2006 improved by 14.4 points compared with 2005, primarily reflecting the decline in catastrophe losses. Catastrophe losses accounted for 0.5 points of the 2006 loss and loss adjustment expense ratio, compared with a 10.3 point impact in 2005. The 2006 loss and loss adjustment expense ratio included a 1.9 point impact from net favorable prior year reserve development, whereas the 2005 loss and loss adjustment expense ratio included a 1.6 point impact from net unfavorable prior year reserve development. The 2006 loss and loss adjustment expense ratio excluding catastrophe losses and prior year reserve development improved over the 2005 ratio on the same basis, reflecting improvement in frequency and severity trends in several lines of business. The underwriting expense ratio for 2006 was 1.2 points higher than the underwriting expense ratio in 2005. The changes primarily reflect the impact of the increase in general and administrative expenses described previously. In addition, the 2006 ratio was negatively impacted by a decline in National Accounts’ fee income, a portion of which is accounted for as a reduction of expenses for purposes of calculating the expense ratio. The underwriting expense ratio in 2005 also included a 0.4 point impact from reinstatement premiums and state assessments.
In March 2005, the Company and Nuveen Investments jointly announced that the Company would implement a program to divest its 78% equity interest in Nuveen Investments, which constituted the Company’s Asset Management segment and was acquired as part of the merger on April 1, 2004. The divestiture was completed through a series of transactions in the second and third quarters of 2005, resulting in net pretax cash proceeds of $2.40 billion.
The Company recorded a net operating loss from discontinued operations of $663 million in 2005, consisting primarily of $710 million of tax expense due to the difference between the tax basis and the
The $187 million increase in earned premiums in 2005 compared with 2004 primarily reflected the impact of the merger, which was largely offset by a significant decline in runoff operations, where business was intentionally being non-renewed, and a decline in certain ongoing operations due to a lower level of written premium volume in the last half of 2004 and first half of 2005. In addition, catastrophe-related reinstatement premiums reduced net earned premium volume in 2005 by $67 million.
Claims and claim adjustment expenses in 2005 of $9.36 billion declined from the 2004 total of $9.84 billion. Included in those totals were $1.32 billion and $532 million, respectively, of catastrophe losses (net of reinsurance). Net unfavorable prior year reserve development totaled $757 million in 2005, as described above. Net unfavorable prior year reserve development totaled $2.03 billion in 2004, which included a $928 million charge to strengthen asbestos reserves, a $290 million charge to strengthen environmental reserves and the $500 million charge to increase construction reserves acquired in the merger described in the “Consolidated Overview” section herein. Also included in the net unfavorable prior year reserve development in 2004 was a $174 million addition to the reserve for uncollectible reinsurance recoverables, $150 million recorded in TPC’s Construction operation prior to the merger, $74 million from the commutation of agreements with a major reinsurer and other net unfavorable prior year reserve development, primarily concentrated in the Company’s Gulf operations. Results in 2004 also reflected increased current year loss ratios on portions of the Construction book of business. Partially offsetting the impact of these factors was favorable prior year reserve development in several core Business Insurance operations, which resulted from reductions in the frequency of non-catastrophe related losses attributable to improved underwriting and pricing strategies in prior years, the results of which emerged in 2004.
Approximately half of the $155 million 2006 pre-tax increase to asbestos reserves was due to an increase in the projected defense costs for ten policyholders. Additionally, $15 million of the pretax reserve adjustment was attributable to a delay in the approval and expected payment of the previously announced settlement with PPG Industries, Inc. as part of the Pittsburgh Corning bankruptcy reorganization plan. The remainder of the reserve adjustment was primarily due to continued litigation activity against smaller, peripheral defendants. In 2005, the asbestos charge 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 $120 million environmental reserve addition in 2006 was primarily due to higher than expected defense and settlement costs. In 2005, the environmental reserve 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.
The loss and loss adjustment expense ratio in 2006 of 60.3% improved by 21.2 points compared with the 2005 ratio of 81.5%, primarily due to the absence of catastrophe losses and net favorable prior year reserve development in 2006 (versus net unfavorable prior year reserve development in 2005). Catastrophe losses accounted for 12.3 points of the 2005 loss and loss adjustment expense ratio. Net favorable prior year reserve development in 2006 provided a 0.2 point benefit to the loss and loss adjustment expense ratio, whereas net unfavorable prior year reserve development in 2005 accounted for 6.8 points of the loss and loss adjustment expense ratio. The 2006 loss and loss adjustment expense ratio excluding catastrophe
The loss and loss adjustment expense ratio in 2005 included a 12.3 point impact from catastrophe losses, compared with a 4.9 point impact from catastrophe losses in 2004. Net unfavorable prior year reserve development accounted for 6.8 points and 18.6 points, respectively, of the 2005 and 2004 loss and loss adjustment expense ratios. Excluding these factors from both years, the 2005 loss and loss adjustment expense ratio improved over the comparable 2004 ratio, reflecting the improvement in current accident year loss experience compared with 2004.
In 2005, Business Insurance Core gross and net written premiums in 2005 increased 10% over the comparable 2004 totals, primarily reflecting the impact of the merger. However, 2005 written premium volume in Business Insurance Core operations declined when compared with 2004 on a pro forma combined basis, reflecting increased competition in the marketplace and the repositioning of the Construction book of business. Throughout Business Insurance Core operations (excluding Construction, due to the impact of repositioning the book of business), business retention levels increased over 2004, renewal pricing was flat with 2004, and new business levels improved over 2004. Net written premiums in 2005 for Business Insurance Core operations were reduced by $67 million of catastrophe-related reinstatement premiums. In Business Insurance Other operations, gross and net written premiums declined 66% and 59%, respectively, from the comparable 2004 totals, primarily reflecting the intentional non-renewal of business in the runoff operations comprising this category.
Select Accounts. Net written premiums of $2.66 billion in 2006 declined 2% from 2005, primarily reflecting the impact of a reduction in premium volume from certain national small business insurance programs, the majority of which was transferred to the Specialized Distribution market. Excluding the impact of the business transferred, net written premiums increased by approximately 2% in 2006. Business retention rates remained strong and increased over 2005, and focused investments in technology and personnel led to improvement in new business volume over 2005. Renewal price changes for the Select Accounts market in 2006 were consistent with 2005, as modest pricing pressures in non-coastal coverages were largely offset by price increases for coastal coverages. In 2005, net written premiums grew 7% over 2004, primarily reflecting the impact of the merger. However, 2005 written premiums declined from 2004 on a pro forma combined basis. Business retention levels in 2005 increased over 2004 and were also at historically high levels. Renewal price changes 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 2005 declined slightly from 2004.
In Business Insurance Other, the 90% and 59% declines in 2006 and 2005 net premium volume, respectively, compared with the respective prior years reflected the impact of business in runoff and the sale of the Company’s Personal Catastrophe Risk operation in November 2005. The runoff healthcare,
reinsurance and international business acquired in the merger produced minimal written premium volume in 2006, 2005 and 2004.
Operating income of $609 million in 2006 increased by $218 million, or 56%, over 2005. The improvement was driven by the absence of catastrophe losses in 2006, an increase in net investment income and growth in business volume, partially offset by a decline in net favorable prior year reserve development and an increase in general and administrative expenses. Operating income in 2006 also benefited from favorable tax impacts from businesses outside of the United States, including an $18 million benefit associated with the pending sale of the Company’s Mexican surety subsidiary, Afianzadora Insurgentes, S.A. de C.V. No catastrophe losses were incurred in 2006, whereas results in 2005 included $191 million in catastrophe costs, the majority of which resulted from Hurricanes Katrina, Rita and Wilma. Net favorable prior year reserve development totaled $14 million in 2006, compared with $72 million in 2005.
Operating income of $391 million in 2005 improved by $713 million over the operating loss of $322 million in 2004. The significant improvement in 2005 operating income reflected net favorable prior year reserve development, as well as strong net investment income, improved current accident year results in Bond & Financial Products, and lower commission expenses in several lines of business. Operating results in 2005 included a cost of catastrophes of $191 million, compared with $51 million in 2004. The operating loss of $322 million in 2004 was driven by net unfavorable prior year reserve development of $739 million, including significant charges related to the surety reserves acquired in the merger and other reserving actions, which are described in more detail in the “Consolidated Overview” section herein.
Claim and claim adjustment expenses totaled $1.82 billion in 2005, down significantly from the 2004 total of $2.35 billion. The 2005 total included $158 million of catastrophe losses, compared with $40 million of catastrophe costs recorded in 2004. Catastrophe losses in both periods were driven by the hurricanes described previously. Net favorable prior year reserve development in 2005 of $72 million was driven by International. Net unfavorable prior year reserve development totaled $739 million in 2004, which included the $300 million charge to increase the estimate of the acquired net surety reserves in Bond & Financial Products, and the $252 million charge related to the financial condition of a specific construction contractor, both of which are described in more detail in the “Consolidated Overview” section herein. Results in 2004 also reflected a $60 million reserve increase related to the commutation of agreements with a major reinsurer, a charge to increase the allowance for estimated uncollectible amounts due from a co-surety on a specific construction contractor claim, and increased current year loss ratios on portions of the Bond & Financial Products book of business.
The loss and loss adjustment expense ratio of 53.7% in 2006 was 3.1 points lower than the ratio of 56.8% in 2005. The 2006 ratio included no impact of catastrophe losses and a 0.4 point benefit from net favorable prior year reserve development, whereas the 2005 ratio included a 5.5 point impact from catastrophes and a 2.3 point benefit from net favorable prior year reserve development. Excluding those factors in each year, the 2006 ratio was slightly higher than the 2005 ratio. The loss and loss adjustment expense ratio in 2004 included a 2.0 point impact from catastrophe losses, and a 29.3 point impact from net
unfavorable prior year reserve development. Excluding both factors in each year, the 2005 loss and loss adjustment expense ratio improved by 7.6 points compared with the 2004 ratio, reflecting the significant improvement in current year loss experience in 2005.
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. 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 Insurance segment benefited from continued low non-catastrophe related frequency levels, net favorable prior year reserve development of $360 million and strong net investment income levels in 2005.
Earned premiums of $6.56 billion in 2006 increased 9% over the 2005 total of $6.03 billion, primarily due to significant new business volume, renewal price increases and continued strong business retention rates over the prior twelve months. Earned premiums in 2005 were reduced by $21 million of catastrophe-related reinstatement premiums. Earned premiums of $6.03 billion in 2005 increased $448 million, or 8%, over 2004 earned premiums of $5.58 billion, reflecting continued strong business retention levels, new business volumes and renewal price increases over the prior twelve months.
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 2006 and 2005.
Claims and claim adjustment expenses in 2006 totaled $3.60 billion, compared with $3.75 billion in 2005. The $154 million decline primarily reflected a reduction in catastrophe losses, which was partially offset by the impact of higher business volume in 2006. Catastrophe losses totaled $103 million in 2006, down significantly from the 2005 total of $547 million.
In 2005, claims and claim adjustment expenses included catastrophe losses of $547 million, compared with $189 million in 2004. Catastrophe losses in both years were primarily the result of hurricanes. Net favorable prior year reserve development in 2005 was $360 million, as described above, compared with net favorable prior year reserve development of $378 million in 2004. In 2004, net favorable prior year reserve development in the Homeowners and Other line of business was driven by a significant decrease in the number of claims, attributable to changes in the marketplace, including higher policy deductible levels and fewer small-dollar claims. These changes resulted in a change in the historical loss development patterns. Net favorable prior year reserve development in the Automobile line of business was driven by better than expected frequency and severity which is believed to have been caused by societal trends. In addition, both
industry and internal initiatives to fight fraud in several states caused a decrease in the total number of claims, as well as a change in the historical loss development patterns.
The loss and loss adjustment expense ratio of 54.8% in 2006 was 7.4 points lower than the comparable 2005 ratio of 62.2%. The 2006 ratio included a 1.6 point impact of catastrophe losses and a 5.5 point benefit from net favorable prior year reserve development. The 2005 loss and loss adjustment expense ratio included a 9.3 point impact of catastrophe losses and a 6.0 point benefit from net favorable prior year reserve development. Excluding those factors from both years, the loss and loss adjustment expense ratio in 2006 was slightly lower than the comparable 2005 ratio, reflecting continued favorable trends in current accident year loss experience. The loss and loss adjustment expense ratio in 2004 included a 3.4 point impact from catastrophe losses and a 6.8 point benefit from net favorable prior year reserve development. Excluding the impact of these factors in both 2005 and 2004, the 2005 loss and loss adjustment expense ratio improved over the 2004 ratio, reflecting better current accident year loss experience.
The Personal Insurance segment’s gross and net written premiums by product line were as follows:
Gross and net written premiums in 2005 increased 6% and 5%, respectively, over 2004. Growth in 2005 was concentrated in the Homeowners and Other product line, driven by continued renewal price increases and new business volume. Business retention rates in both the Automobile and Homeowners and Other lines of business remained strong, and were consistent with 2004. In the Automobile line, renewal price increases in 2005 remained positive, but declined when compared with 2004. However, new business volume in 2005 in the Automobile line increased over 2004, primarily due to the introduction of the Company’s new multivariate pricing product in selected states.
The Personal Insurance segment had approximately 7.1 million and 6.6 million policies in force at December 31, 2006 and 2005, respectively. In the Automobile line of business, policies in force at December 31, 2006 increased 10% over the same date in 2005. Policies in force in the Homeowners and Other line of business at December 31, 2006 grew by 8% over the same date in 2005.
The $21 million decline in net loss for Interest Expense and Other in 2006 compared with 2005 was primarily due to a $27 million after-tax gain realized on the redemption of the Company’s $593 million, 7.6% subordinated debentures. Results in 2006 also reflected the favorable resolution of various prior year federal and state tax matters and the absence of expenses associated with the amortization of discount on forward contracts related to the Company’s divestiture of Nuveen Investments that impacted the 2005 loss. These factors were partially offset by incremental interest expense in 2006 due to the issuance in November 2005 of $400 million, 5.50% senior notes due December 1, 2015, and the issuance in June 2006 of $400 million, 6.25% senior notes due June 20, 2016 and $400 million, 6.75% senior notes due June 20, 2036. The increase in net loss for Interest Expense and Other in 2005 over 2004 was primarily due to incremental interest expense on debt assumed in the merger and a reduction in net investment income, which were mostly offset by the absence of non-recurring merger-related charges and a reduction in non-interest related other expenses in 2005.
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. While the Company has experienced a decrease in asbestos claims over the past two years, the Company continues to receive a significant number of asbestos claims from 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 have also caused 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 are having their hearing dates delayed or placed on an inactive docket. This trend of prioritizing claims involving credible evidence of injuries, 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.
Accordingly, although the Company has seen a moderation in the overall risk associated with these lawsuits, it remains difficult to predict the ultimate cost of these 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, Travelers Property Casualty Corp. (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. On March 29, 2006, the United States District Court for the Southern District of New York substantially affirmed the bankruptcy court’s orders, while vacating that portion of the bankruptcy court’s orders which required all future direct actions against TPC to first be approved by the bankruptcy court before proceeding in state or federal court. Five appeals from the March 29, 2006 ruling were filed in the U.S. Court of Appeals for the Second Circuit, and TPC filed a cross-appeal. Two appellants have voluntarily dismissed their appeals and a motion to dismiss the cross-appeal was filed. Additionally, TPC appealed from a procedural order of the district court relating to the timeliness of the cross-appeal. On January 17, 2007, the Second Circuit dismissed TPC’s cross-appeal and denied TPC’s appeal from the procedural order. The three remaining principal appeals have been consolidated for disposition and remain pending. It is not possible to predict how the appellate court will rule on the pending appeals. If the rulings of the district court are affirmed through the appellate process, then TPC will have resolved substantially all of the pending direct action 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 annually 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. For those policyholders for which an estimate of the gross ultimate exposure for indemnity and related claim adjustment expense is determined, 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.
As in prior years, the 2006 annual review considered active policyholders and litigation cases, including cases challenging the applicability of aggregate limits on asbestos claims. Developing payment trends among policyholders in the Home Office and Field Office as well as Assumed and International categories were also analyzed. In 2006 the Home Office and Field Office categories, which account for the vast majority of the number of policyholders, experienced an overall reduction in new claim filings as well as in gross indemnity and defense payments over prior years.
As a result of these favorable changes in the asbestos environment, and particular in the emergence of more stable payment patterns, beginning in 2007 the Company is now able to supplement the existing annual in-depth process and the existing quarterly asbestos review process with additional aggregate quarterly reserve analyses. These additional analyses provide the Company with an increased ability to detect and respond to emerging trends, including reflecting any such trends, in its quarterly reserve estimates.
Assumed reinsurance exposure primarily consists of reinsurance of excess coverage, including various pool participations. International is exposed to U.S. asbestos liabilities through participations in excess insurance policies, quota share and excess of loss reinsurance policies, and retrocession policies, underwritten in the London insurance market. Details of exposures under the reinsurance and retrocession policies are identified only when the Company is advised by the retrocedant.
At December 31, 2006, approximately 81% of the net environmental reserve (approximately $337 million) was carried in a bulk reserve and included unresolved environmental claims, incurred but not reported environmental claims and the anticipated cost of coverage litigation disputes relating to these claims. The bulk reserve the Company carries is established and adjusted based upon the aggregate volume of in-process environmental claims and the Company’s experience in resolving those claims. The balance, approximately 19% of the net environmental reserve (approximately $81 million), consists of case reserves.
In its review of environmental reserves, the Company considers: the adequacy of reserves for past settlements; changing judicial and legislative trends; the potential for policyholders with smaller exposures to be named in new clean-up actions for both on- and off-site waste disposal activities; the potential for adverse development; the potential for additional new claims beyond previous expectations; and the potential higher costs for new settlements.
The Company has continued to experience a decline in the number of policyholders tendering claims for the first time. These policyholders generally present smaller exposures, have fewer sites and are lower tier defendants. Further, regulatory agencies are utilizing risk-based analysis and more efficient clean-up technologies. However, the Company has experienced higher than expected defense and settlement costs. These increases have been driven in part by adverse judicial developments in certain states regarding the availability of coverage for environmental claims. As a result of these trends, the Company increased environmental reserves by $120 million in 2006. In 2005, the Company recorded a pretax charge of $30 million, primarily for declaratory judgment costs. In 2004, the Company recorded a pretax charge of $290 million due to revised estimates of costs related to settlement initiatives. The increases to environmental reserves in each year were net of reinsurance.
As a result of the processes and procedures described above, management believes that the reserves carried for asbestos and environmental claims at December 31, 2006 are appropriately established based upon known facts, current law and management’s judgment. However, the uncertainties surrounding the final resolution of these claims continue, and it is difficult to determine the ultimate exposure for asbestos and environmental claims and related litigation. As a result, these reserves are subject to revision as new information becomes available and as claims develop. The continuing uncertainties include, without limitation, the risks and lack of predictability inherent in complex litigation, any impact from the bankruptcy protection sought by various asbestos producers and other asbestos defendants, a further increase or decrease in asbestos and environmental claims beyond that which is anticipated, the role of any umbrella or excess policies the Company has issued, the resolution or adjudication of some disputes pertaining to the amount of available coverage for asbestos and environmental claims in a manner inconsistent with the Company’s previous assessment of these claims, the number and outcome of direct actions against the Company and future developments pertaining to the Company’s ability to recover reinsurance for asbestos and 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, although the Company has noted a recent decrease in the number and volatility of asbestos-related bankruptcies. 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
· $7 million in the fixed maturities portfolio, consisting of $6 million resulting from the potential to sell various holdings prior to a recovery in market value, and $1 million related to credit risk associated with various issuers’ deteriorated financial position.
· $11 million in the fixed maturities 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 on unfavorable terms. 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.
· $18 million in its real estate and other investments (excluding venture capital). The losses recorded were the result of an equity partnership and a private stock holding which both experienced fundamental deterioration in their financial position.
· $40 million in its venture capital portfolio on 16 holdings. Three of the holdings were impaired due to new financings on unfavorable terms. Five holdings experienced fundamental economic deterioration (characterized by less than expected revenues or a fundamental change in product). Eight of the holdings were impaired due to the impending sale, liquidation or shutdown of the entity.
· $10 million in its real estate and other investments (excluding venture capital). The losses recorded were the result of falling rental rates and occupancies in three of the Company’s real estate investment holdings.
Following are the pretax realized losses on investments sold during the year ended December 31, 2006:
Ceded reinsurance involves credit risk, except with regard to mandatory pools, and is generally subject to aggregate loss limits. Although the reinsurer is liable to the Company to the extent of the reinsurance ceded, the Company remains liable as the direct insurer on all risks reinsured. Reinsurance recoverables are reported after reductions for known insolvencies and after allowances for uncollectible amounts. The Company also holds collateral, including trust agreements, escrow funds and letters of credit, under certain reinsurance agreements. The Company monitors the financial condition of reinsurers on an ongoing basis and reviews its reinsurance arrangements periodically. Reinsurers are selected based on their financial condition, business practices and the price of their product offerings.
At December 31, 2006, $3.30 billion of reinsurance recoverables were collateralized by letters of credit, trust agreements and escrow funds.
The Company believes that the trend of increased severity and frequency of storms experienced in 2005 and 2004, although not evident in 2006, may continue in the foreseeable future. Given the trend of increased severity and frequency of storms, the Company has reassessed its definition of and exposure to coastal risks, as well as the impact on its reinsurance program. Accordingly, the Company is reviewing the pricing, exposures, return thresholds and terms and conditions it offers in coastal areas. In part as a result of the severity and frequency of storms in 2005 and 2004, the Company’s cost of reinsurance has increased and the amount of reinsurance coverage purchased has been reduced. The cost of reinsurance may continue to increase and availability may continue to decline. To the extent that the Company is not able to reflect the potentially increased costs of increased severity and frequency of storms or reinsurance in its pricing, the Company’s results of operations may be adversely impacted. In particular, in the Personal Insurance segment (and, to a lesser extent, in the Business Insurance segment’s Select Accounts market), the Company expects a delay in its ability to increase pricing to offset these potentially increased costs since the Company cannot increase rates to the extent necessary without the approval of the regulatory authorities of certain states. Also, particularly in light of the frequency and severity of storms in recent years, rating agencies have increased their capital requirements for the Company.
The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. States have from time to time passed legislation that has the effect of limiting the ability of insurers to manage catastrophe risk, such as legislation prohibiting insurers from withdrawing from catastrophe-prone areas. In addition, following catastrophes, there are sometimes legislative initiatives and court decisions which seek to expand insurance coverage for catastrophe claims beyond the original intent of the policies. The Company’s ability or willingness to raise pricing, modify underwriting terms or reduce exposure to certain geographies may be limited due to considerations of public policy, the evolving political environment and/or social responsibilities. The Company may also choose to write business it might not otherwise write for strategic purposes, such as improving access to other underwriting opportunities.
With respect to non-catastrophe related claim frequency, the industry has experienced unprecedented low levels over the last several years, a trend that the Company does not expect to change materially in 2007. The Company expects severity trend, the other component of loss trend, to continue to remain stable for non-catastrophe related claims. Nevertheless, with continued pressure on pricing, it is possible that loss ratios will increase in certain parts of the Company’s business in 2007.
Changes in the general interest rate environment affect the returns available on new investments. While a rising interest rate environment enhances the returns available on new fixed income investments, it reduces the market value of existing fixed maturity investments and the availability of gains on disposition. A decline in interest rates reduces the returns available on new investments but increases the market value of existing investments and the availability of realized investment gains on disposition. In 2006, short-term interest rates and long-term taxable interest rates continued to increase. Additionally, yields available on new investments often exceeded those yields on investments maturing in the investment portfolio. The continuation of an upward trend in interest rates in 2007 would favorably impact the average book yield of the Company’s fixed income holdings.
If the Terrorism Risk Insurance Act of 2002 and Terrorism Risk Insurance Extension Act of 2005 (the Program) is not renewed for periods after January 1, 2008, the benefits of the Program will not be available to the Company, and the Company will be subject to losses from acts of terrorism subject only to the terms and provisions of applicable policies, including policies written in 2007 for which the period of coverage extends into 2008. Given the unpredictable frequency and severity of terrorism losses, as well as the limited terrorism coverage in the Company’s own reinsurance program, future losses from acts of terrorism, particularly those involving nuclear, biological, chemical or radiological events, could be material to the Company’s operating results, financial condition and/or liquidity in future periods, particularly if the Program is not renewed.
For a discussion of potential risks that could impact the Company’s financial condition or results of operations, see Item 1A - “Risk Factors” in this report.
Liquidity is a measure of a company’s ability to generate sufficient cash flows to meet the short- and long-term cash requirements of its business operations. The liquidity requirements of the Company’s business have been met primarily by funds generated from operations, asset maturities and income received on investments. The Company also has access to liquidity through its shelf registration statement
Sale of Subsidiary. 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 proceeds of $442 million from the issuance of common stock (described below) and the issuance of $400 million of 5.50% senior notes.
Debt Transactions. In June 2006, the Company issued $400 million aggregate principal amount of 6.25% senior unsecured notes due June 20, 2016 and $400 million aggregate principal amount of 6.75% senior unsecured notes due June 20, 2036. The notes were issued at a discount, resulting in effective interest rates of 6.30% and 6.86%, respectively. Net proceeds from the issuances (after original issue discount and expenses) totaled approximately $786 million, which the Company applied to the redemption of approximately $593 million of 7.60% subordinated debentures (described in more detail below), $150 million of 6.75% senior notes that matured on November 15, 2006 and $56 million of medium-term notes that matured in the second half of the year.
In November 2006, the Company redeemed $593 million of 7.60% subordinated debentures originally issued in 2001 and due October 15, 2050. The debentures were redeemable by the Company on or after November 13, 2006. In November 2001, St. Paul Capital Trust I, a business trust, issued $575 million of preferred securities, the proceeds of which, along with $18 million in capital provided by the Company, were used to purchase the subordinated debentures issued by the Company. Upon the Company’s redemption of its subordinated debentures in November 2006, St. Paul Capital Trust I in turn used the proceeds to redeem its preferred securities. St. Paul Capital Trust I was then liquidated, and the Company received an $18 million distribution of capital. The Company recorded a $42 million pretax gain on the redemption of the subordinated debentures, representing the remaining unamortized fair value adjustment
In 2005, the Company repaid $815 million of its outstanding debt, primarily comprised of the following: maturities of $238 million of 7.875% senior notes, $79 million of 7.125% senior notes, and $99 million of medium-term notes bearing interest rates ranging from 6.44% to 7.09%; and a net repayment of commercial paper borrowings of $395 million. In November 2005, the Company issued $400 million of 5.50% senior notes maturing in December 2015. The majority of proceeds was used to fund the repayment of commercial paper borrowings, described above, with the remainder used for general corporate purposes.
In July 2002, concurrent with the issuance of 17.8 million of SPC common shares in a public offering, SPC issued 8.9 million equity units, each having a stated amount of $50, for gross consideration of $442 million. Each equity unit initially consisted of a forward purchase contract for the Company’s common stock, which matured in August 2005, and an unsecured $50 senior note of the Company (maturing in 2007). Total annual distributions on the equity units were at the rate of 9.00%, consisting of interest on the note at a rate of 5.25% and fee payments under the forward contract of 3.75%. Holders of the equity units had the opportunity to participate in a required remarketing of the senior note component. The initial remarketing date was May 11, 2005. On that date, the notes were successfully remarketed, and the interest rate on the notes was reset to 5.01%, from 5.25%, effective May 16, 2005. The remarketed notes mature on August 16, 2007. The forward purchase contract required the investor to purchase, for $50, a variable number of shares of the Company’s common stock on the settlement date of August 16, 2005. The number of shares purchased was determined based on a formula that considered the average closing price of the Company’s common stock on each of 20 consecutive trading days ending on the third trading day immediately preceding the settlement date, in relation to the $24.20 per share price of common stock at the time of the offering. On the August 16, 2005 settlement date, the Company issued 15.2 million common shares and received total proceeds of $442 million.
In January 2007, the Company redeemed its 8.47%, $81 million subordinated debentures due January 10, 2027. The redemption was funded internally. An additional $1.02 billion of the Company’s outstanding debt at December 31, 2006 will mature at various times during 2007. The Company plans to refinance these maturities during 2007.
Share Repurchases. On May 2, 2006, the Company’s Board of Directors authorized a program to repurchase up to $2 billion of the Company’s common stock. Under this program, repurchases may be made from time to time in the open market, in accordance with Rule 10b-18 under the Securities Exchange Act of 1934, pursuant to pre-set trading plans meeting the requirements of Rule 10b5-1 under the Securities Exchange Act of 1934, in private transactions or otherwise. This program does not have a stated expiration date. The timing and actual number of shares to be repurchased in the future will depend on a variety of factors, including corporate and regulatory requirements, price, catastrophe losses and other market conditions. During 2006, the Company repurchased 22.8 million common shares under the program for a total cost of approximately $1.12 billion. The average cost per share repurchased in 2006 was $49.20.
In 2006, 2005 and 2004, the Company acquired 1.2 million, 0.8 million and 0.4 million shares, respectively, of common stock from employees as treasury stock primarily to cover payroll withholding taxes related to the vesting of restricted stock awards and exercises of stock options.
Dividends. Dividends paid to shareholders totaled $702 million, $628 million and $642 million in 2006, 2005 and 2004, respectively. On February 7, 2007, the Company’s Board of Directors declared a quarterly dividend of $0.26 per share, payable March 30, 2007 to shareholders of record on March 9, 2007. The declaration and payment of future dividends to holders of the Company’s common stock will be at the discretion of the Company’s Board of Directors and will depend upon many factors, including the
Company’s financial condition, earnings, capital requirements of the Company’s operating subsidiaries, legal requirements, regulatory constraints and other factors as the Board of Directors deems relevant. Dividends would be paid by the Company only if declared by its Board of Directors out of funds legally available, subject to any other restrictions that may be applicable to the Company.
Capital resources reflect the overall financial strength of the Company and its ability to borrow funds at competitive rates and raise new capital to meet its needs. The following table summarizes the components of the Company’s capital structure at December 31, 2006 and 2005.
Share Repurchase Capacity. At December 31, 2006, the Company had $879 million of capacity remaining under the original $2 billion share repurchase program approved by the Board of Directors in 2006. In January 2007, the Company’s board of directors authorized a $3 billion increase to the program, which the Company currently expects to fully utilize by the first quarter of 2009, subject to the factors listed in the “Share Repurchases” section above.
The table below includes 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.
(2) Represents agreements entered into in the ordinary course of business to lease office space, equipment and furniture.
The Company has entered into reinsurance agreements to protect itself from potential losses in excess of the amount it is prepared to accept as described in Note 4 the notes to financial statements.
Reinsurance agreements that do not transfer both amount and timing risk are accounted for as deposits and included in “Reinsurance contracts accounted for as deposits” in the table above.
The amounts reported in the table above and in the table of reinsurance receivables above are presented on a nominal basis and have not been adjusted to reflect the time value of money. Accordingly, the amounts above will differ from the Company’s balance sheet to the extent that the liability for claims and claim adjustment expenses and the related reinsurance receivables have been discounted in the balance sheet. (See note 1 of the financial statements.)
“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.
(9) The amounts in “Loss-based assessments” relate to estimated future payments of second-injury fund assessments which would result from payment of current claim liabilities. Second injury funds cover the cost of any additional benefits for aggravation of a pre-existing condition. For loss-based assessments, the cost is shared by the insurance industry and self-insureds, funded through assessments to insurance companies and self-insureds based on losses. Amounts relating to second-injury fund assessments are included in “other liabilities” in the consolidated balance sheet.
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 $3.07 billion is available by the end of 2007 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 $1.16 billion of dividends from its insurance subsidiaries in 2006.
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, 2006, all of the Company’s insurance subsidiaries had adjusted capital in excess of amounts requiring any company or regulatory action.
The Company considers its most significant accounting estimates to be those applied to claim and claim adjustment expense reserves and related reinsurance recoverables, investment impairments and goodwill impairments.
There are also risks which impact the estimation of ultimate costs for catastrophes. For example, the estimation of reserves related to hurricanes can be affected by the inability by the Company and its insureds to access portions of the impacted areas, the complexity of factors contributing to the losses, the legal and regulatory uncertainties and the nature of the information available to establish the reserves. Complex factors include, but are not limited to, determining whether damage was caused by flooding versus wind; evaluating general liability and pollution exposures; estimating additional living expenses; and estimating the impact of demand surge, infrastructure disruption, fraud, the effect of mold damage and business interruption costs and reinsurance collectibility. The timing of a catastrophe’s occurrence, such as at or near the end of a reporting period, can also affect the information available to us in estimating reserves for that reporting period. The estimates related to catastrophes are adjusted as actual claims emerge.
Asbestos and environmental reserves are included in the General liability, Commercial multi-peril lines and International and other lines in the summary table. Asbestos and environmental reserves are discussed separately; see “Asbestos Claims and Litigation”, “Environmental Claims and Litigation” and “Uncertainty Regarding Adequacy of Asbestos and Environmental Reserves”.
Informed management judgment is applied throughout the reserving process. This includes the application, on a consistent basis over time, of various individual experiences and expertise to multiple sets of data and analyses. In addition to actuaries, experts involved with the reserving process also include underwriting and claims personnel and lawyers, as well as other company management. Therefore, management may have to consider varying individual viewpoints as part of its estimation of loss reserves. It is also likely that during periods of significant change, such as a merger, consistent application of informed judgment becomes even more complicated and difficult.
A major component of the claim tail is the reporting lag. The reporting lag, which is the time between the event triggering a claim and the reporting of the claim to the insurer, makes estimating IBNR inherently more uncertain. In addition, the greater the reporting lag the greater the proportion of IBNR claims to the total claim liability for the product line. Writing new products with material reporting lags can result in adding several years worth of IBNR claim exposure before the reporting lag exposure becomes clearly observable, thereby increasing the risk associated with pricing and reserving such products. The most extreme example of claim liabilities with long reporting lags are asbestos claims.
faced with material uncertainty. Different actuaries may choose different assumptions when faced with such uncertainty, based on their individual backgrounds, professional experiences and areas of focus. Hence, the estimate selected by the various actuaries may differ materially from each other.
The major causes of material uncertainty (“risk factors”) generally will vary for each product line, as well as for each separately analyzed component of the product line. In a few cases, such risk factors are explicit assumptions of the estimation method and in most cases, they are implicit. For example, a method may explicitly assume that a certain percentage of claims will close each year, but will implicitly assume that the legal interpretation of existing contract language will remain unchanged. Actual results will likely vary from expectations for each of these assumptions, resulting in an ultimate claim liability that is different from that being estimated currently.
Some risk factors will affect more than one product line. Examples include changes in claim department practices, changes in settlement patterns, regulatory and legislative actions, court actions, timeliness of claim reporting, state mix of claimants, and degree of claimant fraud. The extent of the impact of a risk factor will also vary by components within a product line. Individual risk factors are also subject to interactions with other risk factors within product line components.
Sudden changes generally cause a one-time shift in claim liability estimates, although there may be some lag in reliable quantification of their impact. Evolutionary changes generally cause a series of shifts in claim liability estimates, as each component of the evolutionary change becomes evident and estimable.
Actuarial methods for analyzing and estimating claim and claim adjustment expense reserves.
While these are the principal methods utilized throughout the Company, those evaluating a particular component for a product line have available to them the full range of methods developed within the casualty actuarial profession. The Company’s actuaries are also continually monitoring developments within the profession for advances in existing techniques or the creation of new techniques that might improve current and future estimates.
· Utilizing individual claim adjuster estimates of the large claims, combined with continual monitoring of the aggregate accuracy of such claim adjuster estimates. (This monitoring may lead to supplemental adjustments to the aggregate of such claim estimates.)
· Utilizing historic longer-term average ratios of large claims to small claims, and applying such ratios to the estimated ultimate small claims from traditional analysis.
· Ground-up analysis of the underlying exposure (typically used for asbestos and environmental).
At least once per quarter, certain 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.
Such an assessment requires considerable judgment. It is frequently not possible to determine whether a change in the data is an anomaly until sometime after the event. Even if a change is determined to be permanent, it is not always possible to reliably determine the extent of the change until sometime later. The overall detailed analyses supporting such an effort can take several months to perform. This is due to the need to evaluate the underlying cause of the trends observed, and may include the gathering or assembling of data not previously available. It may also include interviews with experts involved with the underlying processes. As a result, there can be a time lag between the emergence of a change and a determination that the change should be reflected in the Company’s estimated claim liabilities. The final estimate selected by management in a reporting period is based on these various detailed analyses of past data, adjusted to reflect any new actionable information.
In order to provide information on reasonably possible reserving changes by product line, the historical changes in year-end loss reserves over a one-year period are provided for the U.S. product lines. This information is provided for both the Company and the industry for the nine most recent years, and is based on the most recent publicly available data for the reported line(s) that most closely match the individual product line being discussed. These changes were calculated, net of reinsurance, from statutory annual statement data found in Schedule P of those statements, and represent the reported reserve development on the beginning-of-the-year claim liabilities divided by the beginning claim liabilities, all accident years combined, excluding non-defense related claim adjustment expense. Data presented for the Company includes history for the entire St. Paul Travelers group (U.S. companies only), whether or not the individual subsidiaries were originally part of SPC or TPC. This treatment is required by the statutory reporting instructions promulgated by state regulatory authorities for Schedule P. Comparable data for non-U.S. companies is not available.
General liability is generally considered a long tail line, as it takes a relatively long period of time to finalize and settle claims from a given accident year. The speed of claim reporting and claim settlement is a function of the specific coverage provided, the jurisdiction and specific policy provisions such as self-insured retentions. There are numerous components underlying the general liability product line. Some of these have relatively moderate payment patterns (with most of the claims for a given accident year
Defense costs are also a part of the insured costs covered by liability policies and can be significant, sometimes greater than the cost of the actual paid claims. For some products this risk is mitigated by policy language such that the insured portion of defense costs erodes the amount of policy limit available to pay the claim. Such “defense within the limits” policies are most common for “claims made” products. When defense costs are outside of the limits, amounts paid for defense costs do not erode the policy limits.
This line is typically the largest source of reserve estimate uncertainty in the United States (excluding assumed reinsurance contracts covering the same risk). Major contributors to this reserve estimate uncertainty include the reporting lag (i.e., the length of time between the event triggering coverage and the actual reporting of the claim), the number of parties involved in the underlying tort action, whether the “event” triggering coverage is confined to only one time period or is spread over multiple time periods, the potential dollars involved (in the individual claim actions), whether such claims were reasonably foreseeable and intended to be covered at the time the contracts were written (i.e., coverage dispute potential), and the potential for mass claim actions. Claims with longer reporting lags result in greater inherent risk. This is especially true for alleged claims with a latency feature, particularly where courts have ruled that coverage is spread over multiple policy years, hence involving multiple defendants (and their insurers and reinsurers) and multiple policies (thereby increasing the potential dollars involved and the underlying settlement complexity). Claims with long latencies also increase the potential recognition lag, i.e., the lag between writing a type of policy in a certain market and the recognition that such policies have potential mass tort and/or latent claim exposure.
Historically, the one-year change in the reserve estimate for this product line over the last nine years has varied from -34% to +26% (averaging -4%) for the Company and -14% to +7% (averaging 0%) for the industry overall. The Company’s year-to-year changes are driven by and are based on observed events during the year. Because the high end of the Company’s range of historical adverse development came from certain business that has since been exited, the Company believes that the industry’s range of historical outcomes is illustrative of reasonably possible one-year changes in reserve estimates for this product line.
While property is considered a short tail coverage, the one year change can be more volatile than the longer tail product lines. This is due to the fact that the majority of the reserve relates to the most recent accident year, which is subject to the most uncertainty for all product lines. This recent accident year uncertainty is relevant to property due to weather related events which tend to be concentrated in the last half of the year and generally don’t clearly resolve until the following year.
The Company’s change in reserve estimate for this product line was -11% for 2006, -34% for 2005 and -18% for 2004. The 2006 change primarily reflected less “demand surge” inflation than originally estimated for 2005 accident year non-catastrophe and catastrophe losses. The 2005 and 2004 changes were primarily due to better than expected results from changes in policy provisions as well as underwriting and pricing criteria. The reserve estimates for this product line are also potentially subject to material changes due to uncertainty in measuring ultimate losses for unprecedented significant catastrophes such as the events of September 11, 2001 and Hurricane Katrina. Such material changes did not materialize in 2006, 2005 or 2004.
See “Property risk factors” and “General liability risk factors,” discussed above, with regard to reserving risk for commercial multi-peril.
The Company’s change in reserve estimate for this product line was -7% for 2006, -5% for 2005 and -2% for 2004. The 2006 change was due to better than expected loss development, primarily for accident years 2003 through 2005, which was attributable to favorable legal and judicial environments, claim handling initiatives and improvements in auto safety technology. The 2005 change was due to the effect of increasingly favorable legal and judicial environments as well as better than expected results from changes in policy provisions as well as underwriting and pricing criteria, especially for accident year 2004. The 2004 change was due to better than expected results from underwriting and pricing strategies, especially for accident year 2003.
Workers’ compensation is generally considered a long tail coverage, as it takes a relatively long period of time to finalize claims from a given accident year. While certain payments such as initial medical treatment or temporary wage replacement for the injured worker are made quickly, some other payments are made over the course of several years, such as awards for permanent partial injuries. In addition, some payments can run as long as the injured worker’s life, such as permanent disability benefits and on-going medical care. Despite the possibility of long payment tails, the reporting lags are generally short, settlements are generally not complex, and most of the liability can be considered high frequency with moderate severity. The largest reserve risk generally comes from the low frequency, high severity claims providing lifetime coverage for medical expense arising from a worker’s injury. Overall, the claim liabilities for this line create a somewhat greater than moderate estimation risk.
Examples of common risk factors, or perceptions thereof, that could change and, thus, affect the required workers’ compensation reserves (beyond those included in the general discussion section) include:
Unanticipated changes in risk factors can affect reserves. As an indicator of the causal effect that a change in one or more risk factors could have on reserves for workers’ compensation, a 1% increase (decrease) in incremental paid loss development for each future calendar year could result in a 1.3% increase (decrease) in loss reserves.
Historically, the one-year change in the reserve estimate for this product line over the last nine years has varied from -2% to +2% (averaging -1%) for the Company and -2% to +4% (averaging +1%) for the industry overall. The Company’s year-to-year changes are driven by and are based on observed events during the year. The Company believes that its range of historical outcomes is illustrative of reasonably possible one-year changes in reserve estimates for this product line. Workers’ compensation reserves represent approximately 26% of the Company’s total loss reserves.
The Company’s change in reserve estimate for this product line was 0% for 2006, 0% for 2005 and +1% for 2004.
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 long 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.
Historically, the one-year change in the reserve estimate for this product line over the last nine years has varied from -15% to +138% (averaging +20%) for the Company and -9% to +24% (averaging +7%) for the industry overall. The Company’s year-to-year changes are driven by and are based on observed events during the year. Because the high end of the Company’s range was due to acquired business in 2004, the Company believes that the industry’s range of historical outcomes is illustrative of reasonably possible one-year changes in reserve estimates for this product line. Fidelity and surety reserves represent approximately 3% of the Company’s total loss reserves.
In general, developments on single large claims (both adverse and favorable) are a primary source of changes in reserve estimates for this product line.
Historically, the one-year change in the reserve estimate for this product line over the last nine years has varied from -31% to +3% (averaging -11%) for the Company and -9% to +11% (averaging -2%) for the industry overall. The Company’s year-to-year changes are driven by and are based on observed events during the year. The Company believes that its range of historical outcomes is illustrative of reasonably possible one-year changes in reserve estimates for this product line. Homeowners and personal lines other reserves represent approximately 2% of the Company’s total loss reserves.
The Company’s change in reserve estimate for this product line was -22% for 2006, +3% for 2005 and -31% for 2004. The 2006 change was due to lower than expected additional living expenses related to Hurricane Katrina as well as better than expected non-catastrophe related frequency and severity, due in part to changes in the marketplace, such as higher deductibles and fewer small-dollar claims, and continued evidence of a less than expected impact from demand surge. The 2005 change was driven by additional loss development from the 2004 Florida hurricanes. The 2004 change was driven by favorable
Amounts recoverable from reinsurers are estimated in a manner consistent with the associated claim liability. 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. In addition, in the ordinary course of business, the Company becomes involved in coverage disputes with its reinsurers. Some of these disputes could result in lawsuits and arbitrations brought by or against the reinsurers to determine the Company’s rights and obligations under the various reinsurance agreements. The Company employs dedicated specialists and aggressive strategies to manage reinsurance collections and disputes.
Other investments include venture capital investments, which are generally non-publicly traded instruments in early-stage companies and, historically, have a holding period of four to seven years. These investments have primarily been made in the health care, software and computer services, and networking
With respect to the Company’s valuation of such non-publicly traded venture capital investments, on a quarterly basis, the Company’s portfolio managers and the external fund manager review and consider a variety of factors in determining the valuation of the investments and the potential for other-than-temporary impairments. Factors considered include the following:
· An analysis of whether a fundamental deterioration or improvement has occurred;
· Whether or not the valuations have improved or declined significantly in the investee’s market sector;
· Consideration of evidential matter, including an evaluation of factors or triggers that may cause individual investments to qualify as having other-than-temporary impairments; and
sales of invested assets that were considered temporarily impaired at the balance sheet date, the Company contemporaneously documents its rationale for its change in intent or ability to hold to recovery. The rationale for the change in the Company’s ability and intent generally focuses on changes in the economic facts and circumstances related to the invested asset subsequent to the balance sheet date, significant unforeseen changes in the Company’s liquidity needs, or changes in tax laws or the regulatory environment.
Venture capital investments and non-publicly traded investments are reviewed quarterly for other-than-temporary impairment by the external fund manager and the Company’s portfolio managers. 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. For a further discussion, please see the venture capital investments and non-publicly traded investments sections under the Valuation of Investments above.
Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (FAS 142), provides guidance on accounting for goodwill subsequent to acquisition. Accordingly, the Company performs a review on at least an annual basis, of goodwill held by its reporting units, which are the Company’s three operating and reportable segments: Business Insurance, Financial, Professional & International Insurance and Personal Insurance.
Consolidated Statement of Income for the years ended December 31, 2006, 2005 and 2004
Consolidated Statement of Cash Flows for the years ended December 31, 2006, 2005 and 2004
The preparation of the consolidated financial statements in conformity with U.S. generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and claims and expenses during the reporting period. Actual results could differ from those estimates. Certain reclassifications have been made to prior years’ financial statements to conform to the current year’s presentation, including reclassifications related to the realignment of the Company’s reportable business segments described in the “Nature of Operations” section of this note. All material intercompany transactions and balances have been eliminated.
In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R) (FAS 158). FAS 158 requires an employer to recognize the funded status of a benefit plan as an asset or liability in its statement of financial position, measured as the difference between plan assets at fair value and the benefit obligation, and to recognize as a component of accumulated other changes in equity from nonowner sources, net of tax, actuarial gains or losses and prior service costs or credits that arise during the period but which are not recognized as components of net periodic benefit cost pursuant to FASB Statement No. 87, Employers’ Accounting for Pensions (FAS 87), or FASB Statement No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions (FAS 106). The provisions of FAS 87 and FAS 106 continue to apply in measuring plan assets and benefit obligations, as of the date of the fiscal year-end statement of financial position, and in determining the amount of net periodic benefit cost. The provisions of FAS 158 were effective for fiscal years ending after December 15, 2006 and are not to be applied retrospectively. The Company’s adoption of FAS 158 at December 31, 2006 resulted in an $80 million reduction, net of tax, to shareholders’ equity and is recognized as an adjustment to the ending
balance of accumulated other changes in equity from nonowner sources. The adoption of FAS 158 did not affect the Company’s results of operations or liquidity as FAS 158 does not affect the determination of net periodic pension cost. See note 12.
Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements
SAB 108 was effective for the first interim period of the first fiscal year ending after November 15, 2006, with early adoption encouraged. The adoption of SAB 108 at December 31, 2006 had no effect on the Company’s results of operations, financial condition or liquidity.
In December 2004, the FASB issued Revised Statement of Financial Accounting Standards No. 123, Share-Based Payment (FAS 123R), an amendment to FAS 123, Accounting for Stock-Based Compensation, and a replacement of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. FAS 123R requires public entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award and to recognize that cost over the requisite service period.
date will be from the grant date to the retirement-eligible date rather than to the vesting date. This guidance is to be applied prospectively to new or modified awards granted upon adoption of FAS 123R.
The adoption of FAS 123R at January 1, 2006 using modified prospective application did not have a material effect on the Company’s results of operations, financial condition or liquidity. See note 11.
In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections (FAS 154), which replaced APB Opinion No. 20, Accounting Changes, and FASB Statement of Financial Accounting Standards No. 3, Reporting Changes in Interim Financial Statements. FAS 154 changed the requirements for the accounting for and reporting of a change in accounting principle. It requires retrospective application to prior period financial statements of voluntary changes in accounting principle and changes required by new accounting standards when the standard does not include specific transition provisions, unless it is impracticable to do so. FAS 154 was effective for accounting changes and corrections of errors in fiscal years beginning after December 15, 2005. Early adoption was permitted for accounting changes and corrections of errors made in fiscal years beginning after June 1, 2005. It did not change the transition provisions of any existing accounting pronouncements, including those that were in a transition phase as of December 15, 2005. The adoption of FAS 154 at January 1, 2006 had no effect on the Company’s results of operations, financial condition or liquidity.
In November 2005, the FASB issued FASB Staff Position (FSP) FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The FSP addresses the determination as to when an investment is considered impaired, whether that impairment is other-than-temporary, and the measurement of an impairment loss. It requires the establishment of a new cost basis subsequent to the recognition of an other-than-temporary impairment and certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The FSP is effective for reporting periods beginning after December 15, 2005. The Company had previously implemented these requirements. Therefore, the adoption of the FSP had no effect on the Company’s results of operations, financial condition or liquidity.
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 2004, FSP No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 was issued. This FSP provides accounting and disclosure guidance on how to apply FASB Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, to the repatriation provision of the AJCA. In the fourth quarter of 2005, the Company approved a Domestic Reinvestment Plan in accordance with the AJCA to repatriate foreign earnings prior to December 31, 2005. 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.
FAS 155 permits entities to fair value any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. This election is on a contract-by-contract basis and is irrevocable. Additionally, FAS 155 narrows the exception afforded to interest-only strips and principal-only strips from derivative accounting. In addition, FAS 155 clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives and amends Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities - a replacement of FASB Statement 125, to eliminate the restriction on the passive derivative instruments a Qualifying Special Purpose Entity can hold.
which bifurcation would be required other than an embedded derivative that results from embedded call options in the underlying financial assets. B40 is effective upon the adoption of FAS 155, except for criterion (b) which is not applicable to securitized interests issued before June 30, 2007, and that only include embedded derivatives that have an extremely remote possibility of having greater than a trivial fair value during the life of the securitized interest.
In February 2007, the FASB announced that it plans to issue a FASB Staff Position (FSP) to amend FIN 48. The proposed FSP is expected to be exposed for a 30-day comment period and, if adopted, would be effective at the time a company initially adopts FIN 48.
In September 2006, FASB issued Emerging Issues Task Force Issue No. 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements (EITF 06-4). EITF 06-4 requires a company to recognize a liability and related compensation expense for endorsement split-dollar life insurance policies that provide a benefit to an employee that extends to postretirement periods. The provisions of EITF 06-4 are effective for fiscal years beginning after December 15, 2006. The adoption of EITF 06-4 effective January 1, 2007 did not have a material effect on the Company’s results of operations, financial condition or liquidity.
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (FAS 159). FAS 159 permits an entity to irrevocably elect fair value on a contract-by-contract basis as the initial and subsequent measurement attribute for many financial assets and liabilities and certain other items including property and casualty insurance contracts. Entities electing the fair value option would be required to recognize changes in fair value in earnings and to expense upfront cost and fees associated with the item for which the fair value option is elected. Entities electing the fair value option are required to distinguish on the face of the statement of financial position, the fair value of assets and liabilities for which the fair value option has been elected and similar assets and liabilities measured using another measurement attribute. An entity can accomplish this by either reporting the fair value and non-fair-value carrying amounts as separate line items or aggregate those amounts and disclose parenthetically the amount of fair value included in the aggregate amount.
Fixed maturities include bonds, notes and redeemable preferred stocks. Fixed maturities, including instruments subject to securities lending agreements, are classified as available for sale and are reported at fair value, with unrealized investment gains and losses, net of income taxes, credited or charged directly to accumulated other changes in equity from nonowner sources. Equity securities, which include common and nonredeemable preferred stocks, are classified as available for sale with changes in fair value, net of income tax, charged or credited directly to accumulated other changes in equity from nonowner sources.
Short-term securities, consisting primarily of money market instruments and other debt issues purchased with a maturity of less than one year, are carried at amortized cost, which approximates fair value.
The following table identifies the fair value of fixed maturity securities by pricing source at December 31, 2006 and 2005.
Other investments include venture capital investments, which are generally non-publicly traded instruments in early-stage companies and, historically, have a holding period of four to seven years. These investments have primarily been made in the health care, software and computer services, and networking and information technologies infrastructures industries. The Company typically is involved with venture capital companies early in their formation, as they are developing and determining the viability of, and market demand for, their product. Generally, the Company does not expect these venture 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.
· Whether or not the external fund manager and the Company believe it is probable that the investee will need financing within six months at a lower price than our carrying value; and
· Whether or not the Company has the ability and intent to hold the investment for a period of time sufficient to allow for recovery, enabling it to receive value equal to or greater than our cost.
· 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;
The Company may, from time to time, sell invested assets subsequent to the balance sheet date that were considered temporarily impaired at the balance sheet date for several reasons. For all subsequent sales of invested assets that were considered temporarily impaired at the balance sheet date, the Company contemporaneously documents its rationale for its change in intent or ability to hold to recovery. The rationale for the change in the Company’s ability and intent generally focuses on changes in the economic facts and circumstances related to the invested asset subsequent to the balance sheet date, significant unforeseen changes in the Company’s liquidity needs, or changes in tax laws or the regulatory environment.
An investment in a fixed maturity or equity security which is available for sale is impaired if its fair value falls below its cost or new cost basis and the decline is considered to be other-than-temporary. A fixed maturity security is other-than-temporarily impaired if it is probable that the Company will not be able to collect all amounts due under the security’s contractual terms or where the Company does not have the intent to hold the security. Equity securities are other-than-temporarily 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. Additionally, for certain securitized financial assets with contractual cash flows (including asset-backed securities), the Company periodically updates its best estimate of cash flows over the life of the security. If management determines that the fair value of a 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.
The carrying value of a real estate property is reviewed for impairment when events or changes in circumstances indicate that the carrying amount may not be recoverable. The review for impairment includes an estimate of the undiscounted cash flows expected to result from the use and eventual disposition of the real estate property. An impairment loss is recognized if the expected future
In determining claims and claim adjustment expense reserves, the Company performs a continuing review of its overall position, its reserving techniques and its reinsurance. The reserves are also reviewed periodically by qualified actuaries employed by the Company. These reserves represent the estimated ultimate cost of all incurred claims and claim adjustment expenses. Since the reserves are based on estimates, the ultimate liability may be more or less than such reserves. The effects of changes in such estimated reserves are included in the results of operations in the period in which the estimates are changed. Such changes may be material to the results of operations and financial condition and could occur in a future period.
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. 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, 2006 and 2005, the Company had a liability of $263 million and $278 million, respectively, for guaranty fund and other assessments and related recoverables of $11 million and $12 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.
accordance with contract provisions. Net written premiums for participating dividend policies were approximately 1% of total Company net written premiums for each of the years ended December 31, 2006, 2005 and 2004. Policyholder dividends are accrued against earnings using best available estimates of amounts to be paid. The liability accrued for policyholder dividends totaled $29 million and $30 million at December 31, 2006 and 2005, respectively.
Under the accounting conventions used by Lloyd’s members, each underwriting account is normally kept open for three years and the underwriting results determined at the end of the third year when the account is closed, although a longer period may be required in order to determine reserves at the required degree of accuracy/confidence for exposures having significant uncertainty. When a year of account is closed, a reinsurance contract (the “reinsurance to close” or RITC) is entered into with a subsequent year of account (normally the following year of account) in consideration for which all subsequent underwriting transactions resulting from the closing year and all previous years reinsured therein are brought forward to (accept by) the subsequent year of account. The RITC, which is calculated by the underwriter and approved by the managing agent, comprises an estimate of all net outstanding liabilities of the closing year and all previous years.
Other revenues include revenues from premium installment charges, which are recognized as collected, revenues of noninsurance subsidiaries other than fee income and gains and losses on dispositions of assets and redemption of debt, and other miscellaneous revenues.
The stock-based awards are measured at fair value on the date of grant. Stock option fair value is estimated by application of an option pricing model, while restricted stock and deferred stock fair value is measured at the market price of a share on the grant date.
The compensation cost for awards subject to a service condition is based upon the number of equity instruments for which the requisite service period is expected to be rendered. Awards granted to retiree-eligible or to employees that become retiree-eligible before an awards vesting date are considered to have met the requisite service condition. The compensation cost for awards subject to a performance condition is based upon the probable outcome that the performance condition will be achieved. The compensation cost reflects an estimated annual forfeiture rate of 5% over the requisite service period of the awards. That estimate is revised if subsequent information indicates that the actual number of instruments expected to vest is likely to differ from previous estimates. Compensation cost for awards are recognized on a straight-line basis over the requisite service period. For awards that have a graded vesting schedule, the compensation cost is recognized on a straight-line basis over the requisite service period for each separate vesting portion of the award as if the award was, in substance, multiple awards.
The Company is organized into three reportable business segments: Business Insurance, Financial, Professional & International Insurance and Personal Insurance. In August 2006, the Company announced a realignment of two of its three reportable business segments. The former Commercial and Specialty segments were realigned into two new reportable segments: the Business Insurance segment and the Financial, Professional & International Insurance segment. The Personal segment was renamed Personal Insurance. The changes were designed to reflect the manner in which the Company’s businesses are currently managed and represent an aggregation of products and services based on type of customer, how the business is marketed and the manner in which risks are underwritten. The following discussion reflects the realigned segment reporting structure, and the financial data for prior periods presented has been reclassified to be consistent with the new segment structure.
· Select Accounts serves small businesses for property and casualty products, including commercial multi-peril, property, general liability, commercial auto and workers’ compensation insurance.
· Target Risk Underwriting. The following business units serve commercial businesses requiring specialized product underwriting, claims handling and risk management services:
· National Property serves large and mid-sized customers, including retailers, hospitals, colleges and universities, and owners of industrial parks, office buildings, apartments and amusement parks, covering losses on buildings, business assets and business interruption exposures.
· Ocean Marine serves the marine transportation industry and related services, as well as other businesses involved in international trade. The Company’s product offerings fall under six main coverage categories: marine liability, cargo, hull and machinery, protection and indemnity, pleasure craft, and marine property and liability.
· Boiler & Machinery serves customers ranging from small businesses to Fortune 100 companies, offering comprehensive breakdown coverages for equipment, including property and business interruption coverages. Through the BoilerRe unit, Boiler & Machinery also serves other
· Global Accounts provides insurance to U.S. companies with foreign property and liability exposures (“home-foreign”), and foreign organizations with property and liability exposures located in the United States (“reverse-flow”), as part of a global program.
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. The Company does not purchase residual interests in CMOs.
At December 31, 2006 and 2005, the Company had $1.67 billion and $2.67 billion, respectively, of securities on loan as part of a tri-party lending agreement. At December 31, 2006 and 2005, respectively, $0 and $119 million of securities were subject to dollar-roll repurchase agreements.
Proceeds from sales of fixed maturities classified as available for sale were $4.40 billion, $5.19 billion and $7.95 billion in 2006, 2005 and 2004, respectively. Gross gains of $95 million, $129 million and $202 million and gross losses of $121 million, $118 million and $126 million were realized on those sales in 2006, 2005 and 2004, respectively.
The Company has certain subsidiaries that are required to hold investments in trust in conjunction with its runoff reinsurance businesses. These trust funds had a fair value of $298 million and $374 million at December 31, 2006 and 2005, respectively. Additionally, these subsidiaries have funds deposited with third parties to be used as collateral to secure various liabilities on behalf of insureds, cedants and other creditors. These funds had a fair value of $43 million at both December 31, 2006 and 2005. The Company also had $253 million of other investments pledged as collateral securing outstanding letters of credit.
Proceeds from sales of equity securities were $285 million, $403 million and $265 million in 2006, 2005 and 2004, respectively, resulting in gross realized gains of $29 million, $43 million and $37 million and gross realized losses of $4 million, $9 million and $8 million, respectively.
Short-term investments consist primarily of money market instruments and other debt securities purchased with a maturity of less than one year. The amortized cost of these securities, which totaled $4.94 billion and $4.80 billion at December 31, 2006 and 2005, respectively, approximates their fair value.
· The Company has a significant variable interest in two real estate entities. Of these two investments, one became a reportable VIE in 2006 due to an increase in the Company’s ownership interest. These investments have total assets of approximately $305 million and $299 million as of December 31, 2006 and 2005, respectively. The carrying value of the Company’s share of these investments was approximately $33 million and $38 million at December 31, 2006 and 2005, respectively. 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. The purpose of the Company’s involvement in these entities is to generate investment returns.
The Company has other significant interests in variable interest entities that are not material.
· Mandatorily redeemable preferred securities of trusts holding solely the subordinated debentures of the Company - These securities were issued by four separate trusts that were established for the sole purpose of issuing the securities to investors, and are fully guaranteed by the Company. The subordinated 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 $399 million and $1.03 billion at December 31, 2006 and 2005, respectively. During 2006, the Company redeemed the $593 million, 7.60% subordinated debentures issued to St. Paul Capital Trust I, which in turn redeemed its preferred securities.
At December 31, 2006 and 2005, the Company had concentrations of credit risk in tax-exempt investments of the state of Texas of $3.86 billion and $3.27 billion, respectively, of the state of California of $2.10 billion and $1.54 billion, respectively, and of the state of Illinois of $1.93 billion and $1.84 billion, respectively.
Included in fixed maturities are below investment grade assets totaling $1.78 billion and $1.75 billion at December 31, 2006 and 2005, respectively. The Company defines its below investment grade assets as those securities rated below investment grade by external rating agencies, or the equivalent by the Company’s investment advisors when a public rating does not exist. Such assets include publicly traded below investment grade bonds and certain other privately issued bonds that are classified as below investment grade loans.
$265 million and $346 million at December 31, 2006 and 2005, respectively, are accounted for using deposit accounting and are included in other liabilities in the consolidated balance sheet.
The following table presents the carrying amount of the Company’s goodwill by segment at December 31, 2006 and 2005:
The following presents a summary of other intangible assets by major asset class as of December 31, 2006 and 2005:
(1) The fair value adjustment of $191 million was recorded in connection with the merger in 2004 and was based on management’s estimate of nominal claim and claim expense reserves and reinsurance recoverables (after adjusting for conformity with the acquirer’s accounting policy on discounting of workers’ compensation reserves), expected payment patterns, the April 1, 2004 U.S. Treasury spot rate yield curve, a leverage ratio assumption (reserves to statutory surplus), and a cost of capital expressed as a spread over risk-free rates. The method used calculates a risk adjustment to a risk-free discounted reserve that will, if reserves run off as expected, produce results that yield the assumed cost-of-capital on the capital supporting the loss reserves. The fair value adjustment is reported as an intangible asset on the consolidated balance sheet, and the amounts measured in accordance with the acquirer’s accounting policies for insurance contracts are reported as part of the claims and claim adjustment expense reserves and reinsurance recoverables. The intangible asset will be recognized into income over the expected payment pattern. Because the time value of money and the risk adjustment (cost of capital) components of the intangible asset run off at different rates, the amount recognized in income may be a net benefit in some periods and a net expense in other periods.
(1) In February 2006, the 2003 and prior years of account of Lloyd’s Syndicates 5000 and 779 closed through reinsurance to close into the 2004 year of account. See “Reinsurance to Close” section of note 1. In 2004, acquired amount represents SPC net claims and claim adjustment expense reserves at the April 1, 2004 acquisition date. SPC gross reserves at that date were $19.50 billion.
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. Those increases in reserves were partially offset
by claim and claim expense payments from runoff operations and other net favorable prior year reserve development.
Business Insurance. Net favorable prior year reserve development totaled $21 million in 2006, primarily concentrated in the commercial multi-peril, general liability, property and commercial automobile lines of business, partially offset by increases for asbestos reserves and environmental reserves that are discussed in more detail in the following “Asbestos and Environmental Reserves” section, as well as reserve strengthening for assumed reinsurance business in runoff. The commercial multi-peril and liability lines of business experienced better than anticipated loss development that was attributable to several factors, including improving legal and judicial environments, as well as enhanced risk control, underwriting and claim process initiatives. The favorable prior year reserve development in the property line of business primarily reflected less “demand surge” inflation than originally estimated for 2005 accident year non-catastrophe related and catastrophe losses. “Demand surge” refers to significant short-term increases in building material and labor costs due to a sharp increase in demand for those materials and services. The commercial automobile line of business experienced better than expected loss development which was attributable to the improved legal and judicial environments, claim handling initiatives focused on the automobile line of insurance and improvements in auto safety technology. The reserve strengthening in assumed reinsurance was primarily due to changes in projected loss development driven by an unanticipated change in the claim settlement patterns of the underlying casualty exposures.
Personal Insurance. Net favorable prior year reserve development in 2006 totaled $359 million, driven by better than expected auto bodily injury loss experience and a decline in non-catastrophe losses in the Homeowners and Other line of business, and a reduction in loss estimates for the 2005 hurricanes. In the Automobile line of business, the improvement was partially driven by better than expected results from
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 Business Insurance 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.
Personal Insurance. Net favorable prior year reserve development in 2005 totaled $360 million. In the automobile line of business, the improvement was driven by better than expected results from changes in claim handling practices. These changes included practices which have allowed case reserves to be established more accurately earlier in the claim settlement process, thereby changing historical loss development patterns. In addition, both industry and internal initiatives to fight fraud in several states caused a decrease in the total number of claims, as well as a change in the historical loss development patterns. In the homeowners line of business, the improvement was driven primarily by a significant decrease in the number of claims, attributable to changes in the marketplace, including higher deductibles
In 2004, estimated claims and claim adjustment expenses for claims arising in prior years totaled a net $2.40 billion, including $2.39 billion of net unfavorable prior year reserve development impacting the Company’s results of operations, excluding $75 million of accretion of discount. Net unfavorable prior year reserve development included $928 million to strengthen asbestos reserves, reserve adjustments related to the merger of $500 million for construction and $300 million for surety, $290 million to strengthen environmental reserves, $252 million related to a specific construction contractor, $113 million related to the commutation of agreements with a major reinsurer, and other net reserving actions.
Business Insurance. Net unfavorable prior year reserve development in 2004 totaled $2.03 billion, which included the asbestos and environmental charges that are discussed in more detail in the following “Asbestos and Environmental Reserves” section. Business Insurance results in 2004 also reflected a $500 million charge to strengthen construction reserves, a $174 million addition to the reserve for uncollectible reinsurance recoverables, $150 million of net unfavorable prior year reserve development recorded in TPC’s Construction operation prior to the merger, $74 million related to the commutation of agreements with a major reinsurer, along with a strengthening of Gulf reserves, which was partially offset by favorable prior year reserve development in several core Business Insurance operations due to lower frequency of non-catastrophe related losses attributable to better underwriting and pricing strategies in the prior year, the results of which emerged in the 2004 calendar year.
Personal Insurance. Net favorable prior year reserve development in 2004 was $378 million. In the homeowners line of business, the improvement was driven by a significant decrease in the number of claims, attributable to changes in the marketplace, including higher policy deductible levels and fewer small dollar claims. These changes resulted in a change in the historical loss development patterns. Net favorable prior year reserve development in the Automobile line of business was driven by better than expected frequency and severity which is believed to have been caused by societal trends. In addition, both industry and internal initiatives to fight fraud in several states caused a decrease in the total number of claims, as well as a change in the historical loss development patterns.
For each of the years ended December 31, 2006, 2005 and 2004, changes in allocations between accident years of loss adjustment expenses, pursuant to regulatory reporting requirements, are included in claims and claim adjustment expenses for claims arising in prior years and did not impact results of operations.
At December 31, 2006 and 2005, the Company’s claims and claim adjustment expense reserves included $4.47 billion and $4.79 billion, respectively, for asbestos and environmental-related claims, net of reinsurance.
Asbestos Reserves. Because each policyholder presents different liability and coverage issues, the Company generally reviews the exposure presented by each policyholder at least annually 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. For those policyholders for which an estimate of the gross ultimate exposure for indemnity and related claim adjustment expense is determined, 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 2006 were $469 million, compared with $399 million in 2005. The $70 million net increase is primarily the result of lower reinsurance billings in 2006. Approximately 50% in 2006 and 42% in 2005 of total net paid losses relate to policyholders with whom the Company previously entered into settlement agreements limiting the Company’s liability. At December 31, 2006, net asbestos reserves totaled $4.05 billion, compared with $4.36 billion at December 31, 2005.
The Company recorded pre-tax asbestos reserve additions of $155 million, $830 million and $928 million in 2006, 2005 and 2004, respectively, pursuant to the completion of its annual ground-up asbestos exposure review, which included an analysis of exposure and claim payment patterns by policyholder category, as well as recent settlements, policyholder bankruptcies, judicial rulings and legislative actions. Approximately half of the $155 million 2006 pretax reserve adjustment was due to an increase in the projected defense costs for ten policyholders. Additionally, $15 million of the pretax reserve adjustment was attributable to a delay in the approval and expected payment of the previously announced settlement with PPG Industries, Inc. as part of the Pittsburgh Corning bankruptcy reorganization plan. The remainder of the reserve adjustment was primarily due to continued litigation activity against smaller, peripheral defendants. The asbestos reserve addition 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 reserve addition also considered the January 2006 court decision
voiding, on procedural grounds, the previously rendered favorable arbitration decision in the ongoing ACandS litigation (described in more detail in note 15). The asbestos reserve addition recorded in 2004 primarily resulted from an increase in litigation costs and activity surrounding peripheral defendants.
· a decrease in the number of large asbestos exposures reflecting additional settlement activity;
As a result of these favorable changes in the asbestos environment, and in particular the emergence of more stable payment patterns, beginning in 2007 the Company is now able to supplement the existing annual in-depth process and the existing quarterly asbestos review process with additional aggregate quarterly reserve analyses. These additional analyses will provide the Company with an increased ability to detect and respond to emerging trends, including reflecting any such trends in its quarterly reserve estimates.
The Company has continued to experience a decline in the number of policyholders tendering claims for the first time. These policyholders generally present smaller exposures, have fewer sites and are lower tier defendants. Further, regulatory agencies are utilizing risk-based analysis and more efficient clean-up technologies. However, the Company has experienced higher than expected defense and settlement costs. These increases have been driven in part by adverse judicial developments in certain states regarding the availability of coverage for environmental claims. As a result of these trends, the Company increased environmental reserves by $120 million in 2006. In 2005, the Company recorded a pretax charge of $30 million, primarily for declaratory judgment costs. In 2004, the Company recorded a pretax charge of $290 million due to revised estimates of costs related to recent settlement initiatives. The increases in environmental reserves in each year were net of reinsurance. Gross paid losses in 2006 and 2005 were $189 million and $248 million, respectively.
Asbestos and Environmental Reserves. Because of the uncertainties set forth above, additional liabilities may arise for amounts in excess of the current related 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 in future periods.
2006 Debt Redemptions and Maturities-In November 2006, the Company redeemed $593 million of 7.60% subordinated debentures originally issued in 2001 and due October 15, 2050. The debentures were redeemable by the Company on or after November 13, 2006. In November 2001, St. Paul Capital Trust I, a business trust, issued $575 million of preferred securities, the proceeds of which, along with $18 million in capital provided by the Company, were used to purchase the subordinated debentures issued by the Company. Upon the Company’s redemption of its subordinated debentures in November 2006, St. Paul Capital Trust I in turn used the proceeds to redeem its preferred securities. St. Paul Capital Trust I was then liquidated, and the Company received an $18 million distribution of capital. The Company recorded a $42 million pretax gain on the redemption of the subordinated debentures, representing the remaining unamortized fair value adjustment recorded at the merger date. The gain was recorded in “Other revenues” on the Consolidated Statement of Income. On November 15, 2006, the Company’s $150 million, 6.75% senior notes matured. A portion of the net proceeds from the June 2006 debt issuances described above was also used to fund this maturity.
2005 Equity Unit Transaction-In 2002, the Company issued 8.9 million equity units, each of which initially consisted of a forward purchase contract for the Company’s common stock, and an unsecured $50 senior note of the Company maturing in August 2007. In May 2005, the Company successfully remarketed the $442 million senior note component of the equity units, resetting the annual interest rate from 5.25% to 5.01%. The forward purchase contracts, which required the investor to purchase, for $50, a variable number of shares of the Company’s common stock based on a specific formula, settled in August 2005. On the settlement date, the Company issued 15.2 million common shares and received total proceeds of $442 million.
Zero Coupon Convertible Notes-The zero coupon convertible notes mature in 2009, but are redeemable at the option of the Company for an amount equal to the original issue price plus accreted original issue discount. Each note is convertible at the option of the holder at any time on or prior to maturity, unless previously redeemed by the Company, into common stock of the Company at a conversion rate of 16.6433 shares for each $1,000 principal amount of notes. If all notes outstanding at December 31, 2006 were converted, the Company would issue 2.4 million of its common shares.
Subordinated Debentures-The Company’s four subordinated debenture instruments are all similar in nature. Four separate business trusts issued preferred securities to investors and used the proceeds to purchase the Company’s subordinated debentures. Interest on each of the instruments is paid semi-annually. In January 2007, the Company redeemed the $81 million, 8.47% subordinated debentures due in 2027. The redemption was funded internally.
4.50% Convertible Junior Subordinated Notes-These notes will mature on April 15, 2032, unless earlier redeemed, repurchased or converted. Interest is payable quarterly in arrears. The Company has the option to defer interest payments on the notes for a period not exceeding 20 consecutive interest periods nor beyond the maturity of the notes. During a deferral period, the amount of interest due to holders of the notes will continue to accumulate, and such deferred interest payments will themselves accrue interest. Deferral of any interest can create certain restrictions for the Company. Unless previously redeemed or repurchased, the notes are convertible into shares of common stock at the option of the holders at any time after March 27, 2003 and prior to April 15, 2032 if at any time (1) the average of the daily closing prices of common stock for the 20 consecutive trading days immediately prior to the conversion date is at least 20% above the then applicable conversion price on the conversion date, (2) the notes have been called for redemption, (3) specified corporate transactions have occurred, or (4) specified credit rating events with respect to the notes have occurred. The notes will be convertible into shares of common stock at a conversion rate of 0.4684 shares of common stock for each $25.00 principal amount of notes (equivalent to an initial conversion price of $53.37 per share of common stock), subject to adjustment in certain events. On or after April 18, 2007, the notes may be redeemed at the Company’s option. The notes are general unsecured obligations and are subordinated in right of payment to all existing and future Senior Indebtedness. The notes are also effectively subordinated to all existing and future indebtedness and other liabilities of any of the Company’s current or future subsidiaries. If all notes outstanding at December 31, 2006 were converted, the Company would issue 16.7 million of its common shares.
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 $34 million and $54 million for the years ended December 31, 2006 and 2005, respectively.
On April 1, 2004, The St. Paul Travelers Companies, Inc. fully and unconditionally guaranteed the payment of all principal, premiums, if any, and interest on certain debt obligations of its subsidiaries TPC and Travelers Insurance Group Holdings Inc. (TIGHI). The guarantees pertain to the $400 million 3.75% Notes due 2008, the $500 million 5.00% Notes due 2013, the $200 million 7.75% Notes due 2026, the $893 million 4.5% Convertible Notes due 2032 and the $500 million 6.375% Notes due 2033.
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, 2006, 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, 2006 or 2005.
At December 31, 2006, the Company had $879 million of capacity remaining under the original $2 billion share repurchase program approved by the Board of Directors in 2006. In January 2007, the Company’s board of directors authorized a $3 billion increase to the program.
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. During the years ended December 31, 2006 and 2005, the Company purchased $61 million and $33 million, respectively, of its common stock under this plan.
The Company’s insurance subsidiaries are subject to various regulatory restrictions that limit the maximum amount of dividends available to be paid to their parent without prior approval of insurance regulatory authorities. A maximum of $3.07 billion is available in 2007 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 $1.16 billion of dividends from its insurance subsidiaries in 2006.
Statutory net income of the Company’s insurance subsidiaries was $4.27 billion, $2.92 billion, and $1.58 billion for the years ended December 31, 2006, 2005 and 2004, respectively. Statutory capital and surplus of the Company’s insurance subsidiaries was $20.94 billion and $17.81 billion at December 31, 2006 and 2005, respectively.
Income from continuing operations per diluted share for the year ended December 31, 2004 excluded the weighted average effects of the Company’s $893 million, 4.50% convertible junior subordinated notes convertible into 16.7 million shares of the Company’s common stock, as the impact would have been anti-dilutive.
The current income tax payable was $252 million and $142 million at December 31, 2006 and 2005, respectively, and is included in other liabilities in the consolidated balance sheet.
For tax return purposes, as of December 31, 2006, the Company had a U.S. net operating loss (NOL) carryforward that expires, if unused, in 2017-2018. The amount and timing of realizing the benefit of NOL carryforwards depends on future taxable income and limitations imposed by tax laws. The approximate amounts of those NOLs on a regular tax basis and an alternative minimum tax (AMT) basis were $103 million and $70 million, respectively. The benefit of the NOL carryforward has been recognized in the consolidated financial statements.
The Company has a share-based incentive compensation plan, The St. Paul Travelers Companies, Inc. 2004 Stock Incentive Plan (the 2004 Incentive Plan), which was adopted in July 2004 following the merger of SPC and TPC. The purposes of the 2004 Incentive Plan are to reward the efforts of the Company’s non-employee directors, executive officers and other employees and to attract new personnel by providing incentives in the form of stock-based awards. The 2004 Incentive Plan permits grants of nonqualified stock options, incentive stock options, stock appreciation rights, restricted stock, deferred stock, stock units, performance awards and other stock-based or stock-denominated awards with respect to the Company’s common stock. The number of shares of the Company’s common stock authorized for grant under the 2004 Incentive Plan is 35 million shares, subject to additional shares that may be available for awards as described below.
The Company also has 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 and a deferred stock 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.
Stock option awards granted to eligible officers and key employees were granted having a ten-year term. Prior to January 1, 2007, stock options were granted with an exercise price equal to the fair market value of the Company’s common stock on the day preceding the date of grant. Beginning January 1, 2007, all stock options are granted with an exercise price equal to the fair market value of the Company’s common stock on the date of grant. The stock options granted generally vest upon meeting certain years of service criteria. Except as the Compensation Committee of the Board may allow in the future, stock options cannot be sold or transferred by the participant. The vesting terms for stock options granted under the 2004 Incentive Plan and the legacy TPC and legacy SPC plans are generally as follows:
Options vest over 4-year period, 50% on 2nd anniversary of the date of grant, and 25% of the option shares vest on each of the 3rd and 4th anniversaries of the grant date. Certain 2005 special option shares vest 50% on each of the 4th and 5th anniversaries of the grant date.
In addition to the regular stock option awards described above, certain stock option awards that were granted under the legacy share-based incentive plans of TPC and SPC permit an employee exercising an option to be granted a new option (a reload option) at an exercise price equal to the fair market value of the Company common stock on the day preceding the reload grant. The legacy TPC reload option is permitted on the stock option awards granted prior to January 2003 at an amount equal to the number of shares of the common stock used to satisfy both the exercise price and withholding taxes due upon exercise of an option and vest six months after the grant date and are exercisable for the remaining term of the related original option. The legacy SPC reload option is permitted on stock option awards granted between February 2002 and November 2003 in an amount equal to the number of shares of the common stock used to satisfy both the exercise price and withholding taxes due upon exercise of an option and vest one year after the grant date and are exercisable for the remaining term of the related original option.
The significant assumptions used in estimating the fair value on the date of the grant for original options and reload options granted in 2005 and 2004 and for the awards assumed on April 1, 2004 from SPC at the merger were as follows:
(1) Represents awards for which the requisite service has been rendered including those that are retirement eligible.
The total fair value of shares that vested during the year ended December 31, 2006 was $59 million.
A summary of restricted stock, deferred stock awards and performance share activity under the Company’s 2004 Incentive Plan and the legacy TPC and legacy SPC share-based incentive compensation plans as of and for the year ended December 31, 2006 is as follows:
The compensation cost for awards subject to a service condition is based upon the number of equity instruments for which the requisite service period is expected to be rendered. Awards granted to retiree-eligible or to employees that become retiree-eligible before an award’s vesting date are considered to have met the requisite service condition. The compensation cost for awards subject to a performance condition is based upon the probable outcome that the performance condition will be achieved. The compensation cost reflects an estimated annual forfeiture rate of 5% over the requisite service period of the awards. That estimate is revised if subsequent information indicates that the actual number of instruments expected to vest is likely to differ from previous estimates. Compensation cost for awards are recognized on a straight-line basis over the requisite service period. For awards that have a graded vesting schedule, the compensation cost is recognized on a straight-line basis over the requisite service period for each separate vesting portion of the award as if the award was, in substance, multiple awards. The total compensation cost for all share-based incentive compensation awards recognized in earnings for the year ended December 31, 2006 was $147 million. Included in that amount was approximately $12 million of compensation costs related to awards granted, prior to the adoption of FAS 123R, to retiree-eligible or to employees that became retiree-eligible before the awards vesting date. The related tax benefits recognized in earnings were $51 million for the year ended December 31, 2006.
As of December 31, 2006, there was $125 million of total unrecognized compensation cost related to all nonvested share-based incentive compensation awards. This includes stock options, restricted stock, deferred stock and performance shares granted under the Company’s 2004 Incentive Plan and legacy TPC and legacy SPC share-based incentive compensation plans. The unrecognized compensation cost is expected to be recognized over a weighted-average period of 1.7 years.
The requirement to report unearned compensation as contra-equity in the consolidated balance sheet was eliminated by FAS 123R. Accordingly, the Company’s unearned compensation balances were reclassified to common stock for all years presented.
The incremental effects of applying FAS 158 on individual line items of the Company’s balance sheet at December 31, 2006 were as follows:
For pension plans with an accumulated benefit obligation in excess of plan assets, the aggregate projected benefit obligation and the aggregate accumulated benefit obligation were $123 million and $123 million, respectively, at December 31, 2006 and $186 million and $185 million at December 31, 2005, respectively. The fair value of plan assets for the above plans was $31 million and $88 million at December 31, 2006 and 2005, respectively.
The Company has discretion regarding whether to provide additional funding and when to provide such funding to its qualified pension plan. The Company has not determined whether or not additional funding will be made during the next fiscal year. There is no required contribution to the qualified pension plan during the next fiscal year.
Maximum and minimum targets for asset allocations at December 31, 2006 by asset category were as follows:
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 for the year ended December 31, 2004.
Future minimum annual rental payments under noncancellable operating leases are $185 million, $165 million, $133 million, $87 million, $66 million and $272 million for 2007, 2008, 2009, 2010, 2011 and 2012 and thereafter, respectively. Future sublease rental income aggregating approximately $55 million will partially offset these commitments.
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, 2006 and 2005, the amount included in changes in equity from nonowner sources was a loss of less than $1 million in 2006 and a loss of $2 million in 2005. During 2006, the Company incurred net realized investment losses of approximately $8 million resulting from the dissolution of a designated hedging relationship. During 2006 and 2005, the Company incurred net realized investment losses of less than $1 million 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 $350 million and $1.20 billion at December 31, 2006 and 2005, 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 in 2006 and 2005 included net gains of $30 million and $13 million, respectively, related to U.S. Treasury futures contracts which are settled daily.
The Company uses various financial instruments in the normal course of its business. The Company’s insurance contracts are excluded by FAS 107, Disclosures about Fair Value of Financial Instruments, and, therefore, are not included in the amounts discussed.
The carrying value and fair value of the Company’s debt at December 31, 2006 was $5.76 billion and $5.98 billion, respectively. The respective totals at December 31, 2005 were $5.85 billion and $5.82 billion.
The fair value of commercial paper included in debt outstanding at December 31, 2006 and 2005 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, 2006 and 2005.
Travelers Property Casualty Corp. (TPC) is involved in three significant proceedings (including a bankruptcy proceeding) relating to ACandS, Inc. (ACandS), formerly a national distributor and installer of products containing asbestos. The proceedings involve disputes as to whether and to what extent any of ACandS’ potential liabilities for current or future bodily injury asbestos claims are covered by insurance policies issued by TPC. The status of the various proceedings is described below.
An arbitration was commenced in January 2001 to determine whether and to what extent ACandS’ financial obligations for bodily injury asbestos claims are subject to insurance policy aggregate limits. On July 31, 2003, the arbitration panel ruled in favor of TPC that asbestos bodily injury claims against ACandS are subject to the aggregate limits of the policies issued to ACandS, which have been exhausted. In
The Company continues to believe it has meritorious positions in these ACandS-related proceedings and intends to litigate vigorously.
2003, the same bankruptcy court extended the existing injunction to apply to an additional set of cases filed in various state courts in Texas and Ohio as well as to the attorneys who are prosecuting these cases. The order also enjoined these attorneys and their respective law firms from commencing any further lawsuits against TPC based upon these allegations without the prior approval of the court. Notwithstanding the injunction, additional Common Law Claims were filed and served on TPC.
Five appeals from the March 29, 2006 ruling were filed in the U.S. Court of Appeals for the Second Circuit and TPC filed a cross-appeal. Two appellants voluntarily dismissed their appeals and a motion to dismiss the cross-appeal was filed. Additionally, TPC appealed from a procedural order of the district court relating to the timeliness of the cross-appeal. On January 17, 2007, the Second Circuit dismissed TPC’s cross-appeal and denied TPC’s appeal from the procedural order. The three remaining principal appeals have been consolidated for disposition and remain pending. It is not possible to predict how the appellate court will rule on the pending appeals. The Company has no obligation to pay any of the settlement amounts unless and until the orders and relief become final and are not subject to any further appellate review.
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,
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 7 - 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 in future periods.
value of SPC’s loss reserves yet failed to protect plan participants from continued investment in Company stock. On June 1, 2005, the Company and the other defendants in Spiziri moved to dismiss the complaint. On January 4, 2006, the parties in Spiziri entered into a stipulation of settlement. The settlement remains subject to court approval.
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 denied a joint motion by Transatlantic, XL and Odyssey for summary judgment against Gulf. On December 22, 2006, Gulf and XL entered into a final settlement agreement which resolves all claims between Gulf and XL under the reinsurance agreements at issue in the litigation. Fact and expert discovery are complete with respect to the remaining parties: Transatlantic, Odyssey and Gerling. Gulf, Transatlantic and Gerling have filed motions for partial summary judgment. The Court has not yet set a trial date. 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.
The Company is a defendant in three consolidated lawsuits in the United States District Court for the Eastern District of Louisiana arising out of disputes with certain policyholders over whether insurance coverage is available for flood losses arising from Hurricane Katrina: Chehardy, et al. v. State Farm, et al., C.A. No. 06-1672, 06-1673 and 06-1674, Vanderbrook, et al. v. State Farm Fire & Cas. Co., et al. C.A. No. 05-6323; and Xavier University of Louisiana v. Travelers Property Ca. Co. of America, C.A. No. 06-516. Chehardy and Vanderbrook are proposed class actions in which the Company is one of several insurer defendants. Xavier is an individual suit involving a property insurance policy brought by one of the Company’s insureds. The losses involved in all of these suits allegedly were caused by the failure of the New Orleans levees. On November 27, 2006, the Court issued a ruling in the three consolidated cases denying the motions of the Company and certain other insurers for a summary disposition of the cases. The Court’s ruling does not determine that any additional amounts are owed under any of the Company’s policies or otherwise reach the merits of the policyholders’ claims. The Company disagrees with the ruling and, along with certain other insurers named in the consolidated lawsuits, filed a motion with the United States Court of Appeals for the Fifth Circuit, seeking to have the Court of Appeals accept an immediate appeal from the District Court’s ruling. On February 1, 2007, the Fifth Circuit accepted the appeal.
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 pending inquiry addressed to the Company include its relationship with brokers and agents, and the Company’s involvement with “non-traditional insurance and reinsurance products.” The Company or its affiliates have received subpoenas or requests for information, in each case with respect to one or both 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 Hawaii Office of the Attorney General; (xii) State of Illinois Office of the Attorney General; (xiii) State of Illinois Department of Financial and Professional Regulation; (xiv) State of Iowa Insurance Division; (xv) State of Maryland Office of the Attorney General;
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.
Four putative class action lawsuits are pending against a number of insurance brokers and insurers, including the Company and/or certain of its affiliates, by plaintiffs who allegedly purchased insurance products through one or more of the defendant brokers. Plaintiffs allege that various insurance brokers conspired with each other and with various insurers, including the Company and/or certain of its affiliates, to artificially inflate premiums, allocate brokerage customers and rig bids for insurance products offered to those customers. The complaints are captioned: Redwood Oil Company v. Marsh & McLennan
Companies, Inc., et al. (N.D. Ill. Jan. 21, 2005), Boros v. Marsh & McLennan Companies, Inc., et al. (N.D. Cal. Feb. 4, 2005), Mulcahy v. Arthur J. Gallagher & Co., et al. (D.N.J. Feb. 23, 2005) and Golden Gate Bridge, Highway, and Transportation District v. Marsh & McLennan Companies, Inc., et al. (D.N.J. Feb. 23, 2005). To the extent they were not originally filed there, the federal class actions were transferred by the Judicial Panel on Multidistrict Litigation to the United States District Court for the District of New Jersey and have been consolidated with other class actions under the caption In re Insurance Brokerage Antitrust Litigation, a multidistrict litigation proceeding in that District. On August 1, 2005, various plaintiffs, including the four named plaintiffs in the above-referenced class actions, filed an amended consolidated class action complaint naming various brokers and insurers, including the Company and certain of its affiliates, on behalf of a putative nationwide class of policyholders. The complaint includes causes of action under the Sherman Act, the Racketeer Influenced and Corrupt Organizations Act (“RICO”), state common law and the laws of the various states prohibiting antitrust violations. Plaintiffs seek monetary damages, including punitive damages and trebled damages, permanent injunctive relief, restitution, including disgorgement of profits, interest and costs, including attorneys’ fees. On November 29, 2005, all defendants moved to dismiss the complaint for failure to state a claim. Oral arguments on the defendants’ motion to dismiss were heard on July 26, 2006. On October 3, 2006, the court ruled that the complaint failed to plead actionable claims under the Sherman Act or RICO, provided plaintiffs an opportunity to replead those claims and reserved decision with respect to remaining state law claims. On November 30, 2006, defendants renewed their motions to dismiss. On February 13, 2006, the named plaintiffs moved to certify a nationwide class consisting of all persons who between August 26, 1994 and the date of class certification engaged the services of a broker defendant (or related entity) in connection with the procurement or renewal of insurance and who entered into or renewed a contract of insurance with one or more of the insurer defendants, including the Company. The renewed motion to dismiss and class certification motion remain pending. Also, additional individual actions have been brought in state and federal courts against the Company involving allegations similar to those in In re Insurance Brokerage Antitrust Litigation and further actions may be brought. The Company believes that all of these lawsuits have no merit and intends to defend vigorously.
In addition to those described above, the Company is involved in numerous lawsuits, not involving asbestos and environmental claims, arising mostly in the ordinary course of business operations either as a liability insurer defending third-party claims brought against policyholders, or as an insurer defending claims brought against it relating to coverage or the Company’s business practices. While the ultimate resolution of these legal proceedings could be material to the Company’s results of operations in a future period, in the opinion of the Company’s management, none would likely have a material adverse effect on the Company’s financial condition or liquidity.
On July 23, 2004, the Company announced that it was seeking guidance from the staff of the Division of Corporation Finance of the SEC 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 consolidated statement of income 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 of SPC and TPC. 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 consolidated statement of income, thereby increasing net income for the second quarter and full year 2004 and increasing shareholders’ equity at December 31, 2006, 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, 2006, 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 of SPC and TPC. On May 3, 2006, the Company received a letter from the Division of Enforcement of the SEC (the “Division”) advising the Company that it is conducting an inquiry relating to the second quarter 2004 adjustments and the April 1, 2004 merger of SPC and TPC. The Company is cooperating with the Division’s requests for information.
Investment Commitments-The Company has long-term commitments to fund venture capital investments through its subsidiary, St. Paul Venture Capital VI, LLC, through new and existing partnerships and certain other venture capital entities. The Company’s total future estimated obligations related to its venture capital investments were $87 million and $128 million at December 31, 2006 and 2005, respectively. The Company also has unfunded commitments to partnerships, joint ventures and certain private equity investments in which it invests. These additional commitments were $1.31 billion and $803 million at December 31, 2006 and 2005, respectively.
During 2006, the Company entered into construction loan and performance guarantees relating to an investment in a real estate development joint venture. The maximum obligation for the guarantees was $55 million.
In the ordinary course of selling business entities to third parties, the Company has agreed to indemnify purchasers for losses arising out of breaches of representations and warranties with respect to the business entities being sold, covenants and obligations of the Company and/or its subsidiaries following the close, and in certain cases obligations arising from undisclosed liabilities, adverse reserve development or certain named litigation. Such indemnification provisions generally survive for periods ranging from 12 months following the applicable closing date to the expiration of the relevant statutes of limitations, or in some cases agreed upon term limitations. As of December 31, 2006, the aggregate amount of the Company’s obligation for those indemnifications that are quantifiable related to sales of business entities was $1.85 billion. Certain of these contingent obligations are subject to deductibles which have to be incurred by the obligee before the Company is obligated to make payments. Included in the indemnification obligations at December 31, 2006 was $187 million related to the Company’s variable interest in Camperdown UK Limited, which SPC sold in December 2003. The Company’s variable interest results from an agreement to indemnify the purchaser in the event a specified reserve deficiency develops, a reserve-related foreign exchange impact occurs, or a foreign tax adjustment is imposed on a pre-sale reporting period. The fair value of this obligation as of December 31, 2006 was $65 million, which was included in “Other Liabilities” on the Company’s consolidated balance sheet.
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 and $58 million for the years ended December 31, 2005 and 2004, 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.
On an unaudited pro forma basis for the year ended December 31, 2004, the combined revenues of TPC and SPC totaled $25.20 billion, net income totaled $1.08 billion, and basic and diluted net income per share was $1.61 and $1.58, respectively. This combined information reflects pro forma purchase accounting adjustments as if the acquisition had been consummated as of January 1, 2004. This pro forma information is not necessarily indicative of what would have occurred had the acquisition and related transactions been made on that date, or of future results of the Company.
(b) See note 5 for further discussion of the fair value adjustment.
In 2005, the Company completed the divestiture of its 78% equity interest in Nuveen Investments, which constituted its Asset Management segment, through a series of transactions. The divestiture resulted in net pretax cash proceeds of $2.40 billion. In 2005, the Company recorded a pretax gain on disposal of $345 million ($224 million after-tax), and a net operating loss from discontinued operations of $663 million, 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.
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 $2.49 billion as of December 31, 2006.
21. CONSOLIDATING FINANCIAL STATEMENTS OF THE ST. PAUL TRAVELERS COMPANIES, INC. AND SUBSIDIARIES (Continued)
(1) Due to the averaging of shares, quarterly earnings per share may not add to the total for the full year.