Underwriting income has been reduced by net costs of $635.0 million and other charges includes costs of $10.0 million (in the aggregate, $420.0 million after-tax or $2.39 per share) related to the September 11 attack. Underwriting income also has been reduced by net surety bond losses of $220.0 million ($143.0 million after-tax or $0.81 per share) related to the bankruptcy of Enron Corp.
Management’s discussion and analysis of financial condition and results of operations addresses the financial condition of the Corporation and its subsidiaries as of December 31, 2002 compared with December 31, 2001 and the Corporation’s results of operations for each of the three years in the period ended December 31, 2002. This discussion should be read in conjunction with the consolidated financial statements and related notes beginning on page.
global political conditions and the occurrence of any terrorist attacks, including any nuclear, biological or chemical events;
any impact from the bankruptcy protection sought by various asbestos producers and other related businesses;
the effects on the energy markets and the companies that participate in them, and in particular as they may relate to concentrations of risk in our surety business;
the effects on the capital markets and the markets for directors and officers and error and omissions insurance;
claims and litigation arising out of accounting and other corporate governance disclosures by other companies;
any downgrade in our claims-paying, financial strength or credit ratings; and
changes in interest rates, market spreads and the performance of the financial markets, generally and as they relate to credit risks assumed by our Chubb Financial Solutions unit in particular;
Operating income, which excludes after-tax realized investment gains and losses, was $201 million in 2002 compared with $111 million in 2001 and $681 million in 2000. Management uses operating income, a non-GAAP financial measure, to evaluate its performance because the realization of investment gains and losses in any given period is largely discretionary as to timing and could distort the analysis of trends. Operating income should only be analyzed in conjunction with, and not in lieu of, net income.
Results in 2001 were adversely affected by two large loss events. In the third quarter, we incurred net costs of $645 million, or $420 million after-tax, related to the September 11 attack in the United States. Then, in the fourth quarter, we recognized net surety bond losses of $220 million, or $143 million after-tax, arising from the bankruptcy of Enron Corp.
We estimate that our gross claims and claim expenses from the September 11 attack were about $3.2 billion. Most of the claims were from property exposure and business interruption losses. We also had significant workers’ compensation losses. Our net claims and claim expenses of $665 million were significantly lower than the gross amount due to various reinsurance agreements. Our property exposures were protected by facultative reinsurance, property per risk treaties that limited our net loss per risk, and our property catastrophe treaties. Our workers’ compensation losses were protected by a casualty catastrophe treaty and a casualty “clash” treaty that operates like a catastrophe treaty.
Our property per risk reinsurance coverage is in several layers, with separate treaties covering each layer. About 30 reinsurers and 25 individual Lloyds syndicates participate in these treaties. Many of these reinsurers participate in each of the layers. In 2001, these treaties provided limits of up to $140 million for each individual risk in excess of the initial $10 million that we retained. We have approximately 30 individual property claims in excess of $10 million from the September 11 attack. The property per risk reinsurance agreements apply to each of these claims.
Business interruption claims from the September 11 attack will take some time to resolve, while potential liability claims could take years to resolve. Also, certain of our reinsurers are questioning our interpretation and/or application of some provisions of our property per risk reinsurance agreements.
We are optimistic that many of the outstanding concerns can be resolved through the ongoing discussions with our reinsurers. Nonetheless, we continue to monitor this situation closely and to consider all alternatives available to us under the property per risk reinsurance agreements, including
Our loss reserve estimates related to the September 11 attack are subject to considerable uncertainty. However, we continue to believe that, whether we resolve the open issues with our reinsurers through discussions or through arbitration proceedings, our estimate of our net costs related to the September 11 attack is reasonable. It is possible that our estimate of ultimate gross losses related to the September 11 attack, as well as the collectibility of related reinsurance recoverables, may change in the future, and that the change in estimate could have a material effect on the Corporation’s results of operations. However, we do not expect that any such change would have a material effect on the Corporation’s financial condition or liquidity.
The surety losses arising from the Enron bankruptcy relate to bonds issued to various obligees in connection with Enron commitments. Although certain of these surety bonds were the subject of litigation, we recognized our maximum exposure of $220 million, net of reinsurance, in the fourth quarter of 2001. As of the end of 2002, the litigation was settled, resulting in an $88 million reduction in our surety loss reserves.
In October 2002, our actuaries and outside actuarial consultants completed their periodic ground-up exposure based analysis of our asbestos related liabilities. Upon completion of the analysis and assessment of the results, we increased our net loss reserves by $625 million in the third quarter. In the fourth quarter, we reduced our previous estimate of reinsurance recoverable on potential asbestos claims, resulting in an additional increase in our net loss reserves of $75 million. Our asbestos related exposure is further discussed under “Loss Reserves.”
As adjusted, property and casualty earnings in 2002 were higher than in the prior year due primarily to a substantial improvement in underwriting results. Earnings in 2001 were similar to those in 2000.
Net premiums written amounted to $9.0 billion in 2002, an increase of 30% over 2001. Net premiums written increased 10% in 2001 compared with 2000. Premiums written in 2001 included net reinsurance reinstatement premium revenue of $30 million related to the September 11 attack.
In 2001, premium growth in personal lines was strong. In our commercial classes, which include multiple peril, casualty, workers’ compensation and property and marine, the marketplace improved with many of our competitors increasing rates. As a result, our commercial lines premiums began to increase as we retained more of our accounts at renewal and wrote more new business. Premium growth in specialty lines was restricted in 2001, primarily due to the lack of growth in our executive protection business caused by our writing fewer multi-year policies as well as our initiative to increase pricing and to not renew underperforming accounts.
Premium growth in 2002 was strong in all segments of our business due primarily to higher rates. Premium growth was exceptionally strong in the commercial classes. In the wake of heavy insurance industry losses in recent years, exacerbated by the tragic event of September 11, 2001, many insurance companies have sought substantial price increases, raised deductibles, reduced coverage limits or declined outright to renew coverage. In this environment, we are seeing more opportunities to write new business and we are retaining more of our accounts. We are getting substantial rate increases on business we write, often with more favorable policy terms and conditions. We expect that this trend will continue throughout 2003.
Premium growth in 2002 in our other specialty insurance business was primarily from Chubb Re, our reinsurance business that began operations in 1999.
Our casualty per risk and casualty clash treaties in the aggregate cost approximately $20 million more in 2002 than in the previous year. We did not renew a workers’ compensation catastrophe treaty in 2002 that had substantially reduced our net losses from the September 11 attack because the terms and price that were offered were unreasonable.
Our property reinsurance program was renewed in April 2002. The property per risk treaty and property catastrophe treaties in the aggregate cost approximately $120 million more on an annualized basis, with more restrictive terms, including terrorism exclusions. Our property per risk retention increased from $10 million to $15 million. Our catastrophe treaty for events in the United States was modified to increase our initial retention, to increase the reinsurance coverage at the top and to reduce our participation in certain layers of the program. The program now provides coverage for individual catastrophic events of approximately 87% of losses between $150 million and $650 million.
Underwriting results in 2002 were adversely affected by the $700 million asbestos charge, but such results benefited from the $88 million reduction in surety losses resulting from the settlement of litigation related to Enron. Underwriting results in 2001 were adversely affected by net costs of $635 million related to the September 11 attack and the Enron related surety losses of $220 million.
The combined loss and expense ratio, as reported and as adjusted to exclude the effects of the asbestos charge, the Enron surety losses and related settlement, and the September 11 attack, was as follows:
The loss ratio, as adjusted, was similar in the past three years. Losses from catastrophes other than the September 11 attack were $98 million in 2002 which represented 1.2 percentage points of the loss ratio compared with $114 million or 1.7 percentage points in 2001 and $72 million or 1.2 percentage points in 2000. Other than reinsurance recoveries related to the September 11 attack, we did not have any recoveries from our catastrophe reinsurance program during the three year period since there were no other individual catastrophes for which our losses exceeded the initial retention. Our initial retention level for each catastrophic event in the United States was increased from $100 million to $150 million during 2002. Our initial retention is generally $25 million outside the United States.
Net premiums from personal insurance, which represent 26% of the premiums written by our property and casualty subsidiaries, increased by 17% in 2002 compared with a 15% increase in 2001. In both years, premium growth occurred in all classes. However, as planned, growth in our in-force policy count slowed in 2002. Premium growth in 2002 was particularly significant in our homeowners business due primarily to higher rates and increased insurance-to-value. Homeowners premiums were up 22% in 2002, while the in-force policy count was up 3%.
Homeowners results improved in 2002 but remained unprofitable. Results continued to be adversely affected by an increase in the severity of water damage claims, including those related to
mold, particularly in Texas. The improvement in 2002 was due to a decrease in the frequency of both catastrophe and non-catastrophe losses, the latter resulting in large part from the mild winter weather in the eastern half of the United States. Results deteriorated significantly in 2001 compared with 2000 due primarily to the substantial increase in the frequency and severity of water damage and mold claims as well as rate deficiencies in several states. Losses from catastrophes other than the September 11 attack represented 2.9 percentage points of the loss ratio for this class in 2002 compared with 5.4 percentage points in 2001 and 7.3 percentage points in 2000. Homeowners results were unprofitable in Europe in each of the past three years. We are in the process of disengaging from our personal lines operations in Continental Europe.
Our remediation plan relating to our homeowners business, which began in the latter part of 2001, is on track. We have made substantial progress in implementing rate increases in states where rates have been deficient. However, we continue to be concerned about the proliferation of water damage claims, including those related to mold. We have made regulatory filings in most states to introduce contract changes that would enable us to treat mold as a separate peril available at an appropriate price. These changes have been implemented in 17 states, including Texas, and approved in 11 other states. If necessary, we will reduce our presence in states where we cannot attain rate adequacy due to regulatory constraints or adverse loss trends.
Our personal automobile business was profitable in each of the last three years. Profitability increased modestly in 2002. Profitability decreased in 2001 compared with 2000 due to an increase in the frequency of losses in the liability component of this business. Results in each year benefited from stable loss severity.
Our commercial insurance results were adversely affected in 2002 by the $700 million asbestos charge and in 2001 by net costs of $103 million related to the September 11 attack. The combined loss and expense ratios for the classes of business within commercial insurance, as reported and as adjusted to exclude the effects of the asbestos charge and the September 11 attack, were as follows:
Multiple peril results, as adjusted, showed modest improvement in 2002 due to highly profitable overseas results. The improved results in 2001 compared with 2000 were principally in the liability component of this business due to a lower frequency and severity of losses. Losses from catastrophes other than the September 11 attack represented 2.2 percentage points of the loss ratio for this class in 2002 and 3.0 percentage points in 2001. There were virtually no catastrophe losses in 2000.
Property and marine results were profitable in 2002 compared with highly unprofitable results in 2001 and 2000. Results in 2002 benefited from improved pricing, higher deductibles and better terms and conditions. Results in 2001 and 2000 were adversely affected by a high frequency of large losses, both in the United States and overseas. Losses from catastrophes other than the September 11 attack represented 6.6 percentage points of the loss ratio for this class in 2002 compared with 5.4 percentage points in 2001 and 1.7 percentage points in 2000.
Net premiums from specialty insurance, which represent 37% of our total writings, increased by 34% in 2002 compared with a 10% increase in 2001. Premiums in 2001 included net reinsurance reinstatement premium revenue of $35 million related to the September 11 attack, primarily consisting of $80 million of premium revenue in our reinsurance business offset in part by costs of $40 million in our financial institutions business.
Our strategy of working closely with our customers and our ability to differentiate our products continue to enable us to renew a considerable percentage of our executive protection and financial institutions business. The growth in 2002 in executive protection and the professional liability component of our financial institutions business was primarily attributable to higher rates. In response to claim severity trends, we initiated a program in 2001 to increase pricing and improve policy terms and to not renew business that no longer met our underwriting criteria. We have implemented better terms and conditions, including lower policy limits and higher deductibles. Most of our new business is coming from the small to mid-size market. In the standard commercial component of our financial institutions business, rates were higher as well. Growth of this business was somewhat restrained by
our management of terrorism exposure concentrations and higher reinsurance costs. Executive protection premium growth in 2001 was only 6% due to our writing fewer multi-year policies and the non-renewal of unprofitable business. Excluding the reinsurance reinstatement costs of $40 million in 2001, financial institutions premium growth was 19% in 2002 and 14% in 2001.
Our specialty insurance results in 2002 benefited from the $88 million reduction in surety losses resulting from the settlement of litigation related to Enron. Results were adversely affected in 2001 by net costs of $512 million related to the September 11 attack and the Enron-related surety losses of $220 million. The combined loss and expense ratios for the classes of business within specialty insurance, as reported and as adjusted to exclude the effects of the September 11 attack and the Enron surety losses and related settlement, were as follows:
Our financial institutions business, as adjusted, produced unprofitable results in 2002 compared with profitable results in 2001 and 2000. The fidelity component of this business was highly profitable in each of the last three years due to favorable loss experience. Results for the professional liability component were highly unprofitable in 2002 compared with modestly unprofitable results in 2001 and profitable results in 2000. The deterioration in 2002 was due to the same claim trends in the United States and Europe experienced in our executive protection business. The standard commercial
business written on financial institutions produced profitable results in 2002 and 2001 compared with breakeven results in 2000. Results have improved in each succeeding year due in large part to the rate increases and more stringent risk selection in recent years.
The surety business tends to be characterized by infrequent but potentially high severity losses. Since the end of 2001, we have been reducing our exposure on an absolute basis and by specific bond type. The majority of our obligations are intended to be performance-based guarantees. When losses occur, they are mitigated by the customer’s balance sheet, contract proceeds and bankruptcy recovery.
Notwithstanding our efforts to manage and reduce our surety exposure, we continue to have substantial commercial surety exposure for outstanding bonds. In that regard, we have exposures related to commercial surety bonds issued on behalf of companies that have experienced deterioration in creditworthiness. Given the current economic climate and its impact on these and other companies, there is an increased likelihood that we may experience an increase in filed claims and may incur high severity losses. Such losses would be recorded if and when claims are filed and determined to be valid.
As a result of disarray in the surety reinsurance market caused by several years of declining prices and high losses, the availability of surety reinsurance in the near term has been significantly reduced. As a result, our future surety results could be more volatile.
We have in force several gas forward purchase surety bonds similar to those we issued on behalf of Enron. The total amount of bonds with one principal, Aquila, Inc., is $550 million. These bonds are uncollateralized. The combined amount of all other gas forward surety bonds is approximately $245 million. Approximately $135 million of these bonds are uncollateralized. Our obligations under these bonds will decline over the terms of the bonds, the longest of which extends until 2012. There is currently no reinsurance in place covering our obligations under any of these bonds.
The loss reserves related to the September 11 attack, our Enron surety exposure and asbestos and toxic waste claims are significant components of our total loss reserves, but they distort the growth trend in our loss reserves. Adjusted to exclude such loss reserves, our loss reserves, net of reinsurance recoverable, increased by $1,098 million or 11% in 2002 compared with $249 million or 3% in 2001.
A reconciliation of the beginning and ending liability for unpaid claims and claim adjustment expenses for the three years ended December 31, 2002 is included in Note (9) of the Notes to Consolidated Financial Statements.
The favorable development in 2001 and 2000 was due primarily to favorable claim experience in our commercial excess liability and executive protection coverages, offset in part by losses incurred related to asbestos and toxic waste claims.
Long-tail classes include directors and officers liability, errors and omissions liability and other executive protection coverages, commercial excess liability and other liability classes. Most of our loss reserves relate to long tail liability classes of business. For many liability claims significant periods of time, ranging up to several years or more, may elapse between the occurrence of the loss, the reporting of the loss and the settlement of the claim. The longer the time span between the incidence of a loss and the settlement of the claim, the more the ultimate settlement amount can vary. For the long tail liability classes, a relatively small proportion of net losses in the more recent accident years are reported claims and an even smaller proportion are paid losses. Therefore, a relatively large proportion of our net losses for these classes are reserves for incurred but not reported (IBNR) losses - claims that had not yet been reported to us, some of which were not yet known to the insured, and future development on reported claims. In fact, approximately 60% of our aggregate net loss reserves at December 31, 2002 were for IBNR.
We use a variety of actuarial methods that analyze experience trends and other relevant factors to estimate loss reserves. These methods generally utilize analyses of historical patterns of the development of paid and reported losses by accident year by class of business. This process relies on the basic assumption that past experience, adjusted for the effects of current developments and likely trends, is an appropriate basis for predicting future outcomes. For certain long tail classes of business where
anticipated loss experience is less predictable because of the small number of claims and/or erratic claim severity patterns, estimates are based on both expected losses and actual reported losses. These classes include directors and officers liability, errors and omissions liability and commercial excess liability, among others. For these classes, we judgmentally set ultimate losses for each accident year based on our evaluation of loss trends and the current risk environment. The expected ultimate losses are adjusted as the accident years mature.
Our most significant individual asbestos exposures involve product liability on the part of “traditional” defendants who manufactured, distributed or installed asbestos products. We wrote excess liability and/or general liability coverages for these insureds. While these insureds are relatively few in number, such exposure has increased in recent years due to the increased volume of claims, the erosion of much of the underlying limits and the bankruptcies of target defendants.
Our other asbestos exposures involve non-product liability on the part of “peripheral” defendants, including a mix of manufacturers, distributors and installers of certain products that contain asbestos in small quantities and owners of properties on which asbestos exists. Generally, these insureds are named defendants on a regional rather than a nationwide basis. As the financial resources of traditional asbestos defendants have been depleted, plaintiffs are targeting these peripheral parties with greater frequency and, in many cases, for larger awards. In addition, the plaintiffs’ bar continues to solicit new claimants through extensive advertising and through asbestos medical screenings. Litigation is then initiated even though many of the claimants do not show any signs of asbestos-related disease. Thus, new asbestos claims and new exposures on existing claims have continued unabated despite the fact that usage of asbestos has declined since the mid-1970’s. Based on published projections, we expect that we will continue receiving asbestos claims at the current rate for at least the next several years.
In the third quarter of 2002, our actuaries and outside actuarial consultants commenced their periodic ground-up exposure based analysis of our asbestos related liabilities. As part of this analysis, they considered the following recent adverse trends:
internal actuarial, claims and reinsurance personnel, we reduced our previous estimate of reinsurance recoverable on potential asbestos claims. As a result, our net asbestos loss reserves increased by an additional $75 million.
Hazardous waste sites are another potential exposure. Under the federal “Superfund” law and similar state statutes, when potentially responsible parties (PRPs) fail to handle the clean-up at a site, regulators have the work done and then attempt to establish legal liability against the PRPs. Most sites have multiple PRPs.
Toxic waste losses appear to be developing as expected due to relatively stable claim trends. In many cases, claims are being settled for less than initially anticipated due to various factors, including more efficient site remediation efforts and increasing success with policy buy backs.
Despite the stable claim trends, we increased our toxic waste loss reserves by $80 million in the third quarter of 2002 based on the most recent estimate of our actuaries and actuarial consultants as to our ultimate exposure.
The following table presents a reconciliation of the beginning and ending loss reserves, net of reinsurance recoverable, related to toxic waste claims. There are virtually no reinsurance recoveries related to these claims.
We continually review and update our loss reserves. Based on all information currently available, we believe that the aggregate loss reserves of the property and casualty subsidiaries at December 31, 2002 were adequate to cover claims for losses that had occurred, including both those known to us and those yet to be reported. In establishing such reserves, we consider facts currently known and the present state of the law and coverage litigation. However, given the judicial decisions and legislative actions that have broadened the scope of coverage and expanded theories of liability in the past and the possibilities of similar interpretations in the future, particularly as they relate to asbestos claims and, to a lesser extent, toxic waste claims, additional increases in loss reserves may emerge in future periods. Such increases could have a material adverse effect on the Corporation’s future operating results. However, management does not expect that any such increases would have a material effect on the Corporation’s consolidated financial condition or liquidity.
The tragic event of September 11 changed the way the property and casualty insurance industry views catastrophic risk. Numerous classes of business have become exposed to terrorism related catastrophic risks in addition to the catastrophic risks related to natural occurrences. This has required us to change how we identify and evaluate risk accumulations. We have changed our underwriting protocols to address terrorism and the limited availability of terrorism reinsurance. However, given the uncertainty of the potential threats, we cannot be sure that we have addressed all the possibilities.
Property and casualty investment income before taxes increased by 3% both in 2002 compared with 2001 and in 2001 compared with 2000. Growth in 2002 and 2001 was due to an increase in invested assets, which reflected substantial cash flow from operations over the period. Growth in 2002 also benefited from capital contributed to the property and casualty subsidiaries by the Corporation in the fourth quarter of 2001. Growth in both years was dampened by lower available reinvestment rates on fixed maturities that matured in each year.
The effective tax rate on our investment income was 18.2% in 2002 compared with 17.0% in 2001 and 16.4% in 2000. The effective tax rate increased each year as a result of our holding a somewhat smaller proportion of our investment portfolio in tax-exempt securities. On an after-tax basis, property and casualty investment income increased by 2% in 2002 and in 2001. Management uses property and casualty investment income after-tax, a non-GAAP financial measure, to evaluate its investment performance because it reflects the impact of any change in the proportion of our investment portfolio invested in tax-exempt securities and is therefore more meaningful for analysis purposes than investment income before taxes.
Other charges in both 2001 and 2000 included goodwill amortization of approximately $20 million. The accounting for goodwill was changed in 2002, as discussed further under “Changes in Accounting Principles.” As a result, there was no goodwill amortization in 2002.
Other charges in 2001 included a $10 million charge for our share of the losses of Hiscox plc from the September 11 attack.
Chubb Financial Solutions (CFS) was organized by the Corporation in 2000 to develop and provide customized products to address specific financial needs of corporate clients. CFS operates through both the capital and insurance markets. Since its inception, CFS’s non-insurance business has been primarily structured credit derivatives, principally as a counterparty in portfolio credit default swap contracts. The Corporation guarantees all of these obligations.
Portfolio credit default swaps are derivatives and are carried in the financial statements at estimated fair value, which represents management’s best estimate of the cost to exit our positions. Changes in fair value are included in income in the period of the change. Thus, CFS’s results are subject to volatility, which could have a significant effect on the Corporation’s results of operations from period to period. Valuation models are used to estimate the fair value of our obligation in each credit default swap. Such valuations require considerable judgment and are subject to significant uncertainty.
Our realistic loss exposure is a very small portion of the $38.7 billion notional amount due to several factors. Our position is senior to subordinated interests of $6.4 billion in the aggregate. Of the $6.4 billion of subordination, there were only $97 million of defaults through December 31, 2002, none of which has pierced the subordination limits of any of our contracts. In addition, the underlying credits are primarily investment grade corporate credits and highly rated asset-backed securities.
In addition to portfolio credit default swaps, CFS has entered into a derivative contract linked to an equity market index and a few other insignificant non-insurance transactions.
In February 2003, we announced that we are reviewing our strategic alternatives with respect to CFS. Although the risk financing business continues to have attractive growth characteristics and recent market movements have resulted in a favorable pricing environment for writing high quality credit default swaps, several recent developments have led us to examine our continuing commitment to this business. Most significantly, in order to take advantage of very attractive market conditions in the property and casualty insurance business, we will need to commit increasing amounts of capital to this business, which could limit the capital resources available to support CFS’s risk financing business. Also, our corporate debt rating has been downgraded to A+, which could limit our opportunities to participate competitively in the AAA credit default swap layer. Finally, as we saw in 2002, CFS’s business increases the volatility of our earnings due to mark-to-market accounting requirements.
Real estate operations resulted in a loss before taxes of $6 million in 2002 compared with a loss of $4 million in both 2001 and 2000. These amounts are included in the corporate and other results. In each year, we sold selected commercial properties as well as residential properties. Real estate revenues were $76 million in 2002, $87 million in 2001 and $75 million in 2000.
In 2002, net realized gains on the sale of equities of $85 million were partially offset by writedowns of $67 million due to the recognition of other than temporary impairment on certain securities. Net realized gains on the sale of fixed maturities of $62 million were reduced by other than temporary impairment writedowns of $46 million. In 2001, realized gains on sales of equity securities and fixed maturities of $46 million and $34 million, respectively, were substantially offset by other than temporary impairment writedowns on certain securities. The increase in writedowns in 2002 and 2001 was due to credit deterioration and corporate failures, particularly in the telecommunications and, to a lesser extent, energy-related industries.
We establish deferred income taxes on the undistributed earnings of foreign subsidiaries. Similarly, we establish deferred tax assets related to the expected future U.S. tax benefit of losses and foreign taxes incurred by our foreign subsidiaries. In the last three years, Chubb Insurance Company of Europe (Chubb Europe) has incurred substantial losses. These losses were the result of underwriting losses due to inadequate prices and adverse claim trends, particularly for directors and officers liability and errors and omissions liability coverages.
In 2002, we invested new cash in mortgage-backed securities and, to a lesser extent, U.S. Treasury securities. In 2001, we invested new cash primarily in corporate bonds. In 2000, we invested new cash primarily in mortgage-backed securities. In each year, we tried to achieve the appropriate mix of taxable and tax-exempt securities in our portfolio to balance both investment and tax strategies. At December 31, 2002, 53% of our fixed maturity portfolio was invested in tax-exempt bonds compared with 59% at December 31, 2001 and 63% at December 31, 2000.
The unrealized market appreciation before tax of those fixed maturities carried at amortized cost was $56 million, $64 million and $69 million at December 31, 2002, 2001 and 2000, respectively. Such unrealized appreciation was not reflected in the consolidated financial statements.
Interest rate risk is the price sensitivity of a security that promises a fixed return to changes in interest rates. Changes in market interest rates directly affect the market value of our fixed income securities. We view the potential changes in price of our fixed income investments within the overall context of asset and liability management. Our actuaries estimate the payout pattern of our liabilities, primarily our property and casualty loss reserves, to determine their duration, which is the present value of the weighted average payments expressed in years. We set duration targets for our fixed income investment portfolios after consideration of the duration of these liabilities and other factors, which we believe mitigates the overall effect of interest rate risk for the Corporation and its subsidiaries.
We have consistently invested in high quality marketable securities. As a result, we believe that we have minimal credit quality risk. Approximately 65% of taxable bonds in our portfolio are issued by the U.S. Treasury or U.S. government agencies or rated AA or better by Moody’s or Standard & Poor’s. Of the tax-exempt bonds, more than 90% are rated AA or better with more than 60% rated AAA. Approximately 3% of our bond portfolio is below investment grade. Our taxable bonds have an average maturity of five years, while our tax-exempt bonds mature on average in eight years.
Prepayment risk refers to the changes in prepayment patterns related to decreases and increases in interest rates that can either shorten or lengthen the expected timing of the principal repayments and thus the average life and the effective yield of a security. Such risk exists primarily within our portfolio of mortgage-backed securities. We monitor such risk regularly and invest primarily in those classes of mortgage-backed securities that are less subject to prepayment risk.
Foreign currency risk is the sensitivity to foreign exchange rate fluctuations of the market value and investment income related to foreign currency denominated financial instruments. The functional
The Corporation, through CFS’s business, assumes exposure to credit risk through portfolio credit default swaps. In a typical portfolio credit default swap, the occurrence of certain defined credit events related to referenced entities within a specified portfolio will result in a deterioration of the
subordination. When losses related to cumulative credit events exceed the subordination, the contract requires CFS to make payment to its counterparty. These obligations are guaranteed by the Corporation.
Our in-force portfolio credit default swaps mature within a range of two to nine years. However, certain credit default swaps on asset-backed portfolios include extension options under which the counterparty may continue to participate in the swap through the maturity of all referenced securities within the portfolio. In the event that an extension option is exercised by the counterparty, CFS would be entitled to additional periodic fee payments. At December 31, 2002, the average expected remaining weighted average life of the business was approximately 4.6 years.
We also have interest rate risk on our debt obligations. The following table provides information about our long term debt obligations and related interest rate swap at December 31, 2002. For debt obligations, the table presents expected cash flow of principal amounts and related weighted average interest rates by maturity date. For the interest rate swap, the table presents the notional amount and related average interest rates by maturity date.
In November 2002, the Corporation issued $600 million of unsecured 4% senior notes due in 2007 and 24 million mandatorily exercisable warrants to purchase the Corporation’s common stock. The senior notes and warrants were issued together in the form of 7% equity units, each of which initially represents $25 principal amount of senior notes and one warrant. The net proceeds of $582 million were contributed to our property and casualty subsidiaries. Each warrant obligates the investor to purchase for $25 a variable number of shares of the Corporation’s common stock on November 16, 2005. The number of shares to be purchased will be determined based on a formula that considers the market price of our common stock immediately prior to the time of settlement in relation to the $56.64 per share sale price of our common stock at the time the equity units were offered. Upon settlement of the warrants, the Corporation will receive proceeds of approximately $600 million and will issue between approximately 8,700,000 and 10,600,000 shares of common stock. The equity units are further described in Notes 10(b) and 21(c) of the Notes to Consolidated Financial Statements.
future rating issues, or in the event the Corporation were to need additional capital to make strategic investments in light of market opportunities, the Corporation may take a variety of actions, which could include the issuance of debt and/or equity securities.
The Corporation and its insurance subsidiaries are rated by major rating agencies. These ratings reflect the rating agency’s opinion of our financial strength, operating performance, capital resources, strategic position and ability to meet our obligations to policyholders. Several of the rating agencies lowered certain of our ratings in the fourth quarter of 2002.
The following table summarizes the Corporation’s credit ratings from the major independent rating organizations as of March 10, 2003.
The following table summarizes our property and casualty subsidiaries’ financial strength ratings from the major independent rating organizations as of March 10, 2003.
Ratings are an important factor in establishing our competitive position in our operating businesses. There can be no assurance that our ratings will continue for any given period of time or that they will not be changed. Further reductions in our ratings could adversely affect the competitive position of our operating businesses.
Following the announcement of our fourth quarter 2002 earnings, including our reported actions taken to strengthen our asbestos reserves and our reserves for directors and officers liability and errors and omissions liability coverages in Europe, Standard & Poor’s Ratings Services (S&P) placed certain of our ratings on “CreditWatch” with negative implications. S&P is currently conducting a review and has announced that it expects the ratings on our operating companies to remain in the “AA” category and the ratings on the Corporation to remain in the “A” category.
It is possible that negative ratings actions may occur. If our ratings are downgraded, the Corporation may incur higher borrowing costs and may have more limited means to access capital. In addition, the competitive position of CFS’s non-insurance operations, which is dependent on the strength of the Corporation’s parental guarantee, could be adversely affected and, as described below under “Liquidity,” we may be required to provide collateral under certain of CFS’s credit default swap arrangements.
In our property and casualty subsidiaries, premiums are generally received months or even years before losses are paid under the policies purchased by such premiums. These funds are used first to make current claim and expense payments. The balance is invested to augment the investment income generated by the existing portfolio. Historically, cash receipts from operations, consisting of insurance premiums and investment income, have provided more than sufficient funds to pay losses, operating expenses and dividends to the Corporation.
In addition to the cash from operations, the property and casualty subsidiaries received capital contributions from the Corporation of $1 billion in the fourth quarter of 2002 and $750 million in the fourth quarter of 2001. In 2001, $250 million was used by a property and casualty subsidiary to fund the purchase of a 19% interest in Allied World Assurance Holdings, Ltd, a newly formed Bermuda-based insurer. In 2002, the interest in Allied World Assurance Holdings was transferred as a dividend from the property and casualty subsidiary to the Corporation.
CFS’s derivatives business subjects the Corporation, through its parental guarantee, to liquidity risk related to the uncertain timing of any potential cash payments to counterparties as well as contractual collateral postings upon a ratings downgrade of the Corporation and/or an increase in the fair value of obligations to a particular counterparty. If the Corporation were downgraded two notches to “A-” and the fair value of CFS’s future obligations were to remain unchanged relative to the year end 2002 carried amount, we would be required to post collateral of approximately $20 million.
As a holding company, the Corporation’s ability to continue to pay dividends to shareholders and to satisfy its obligations, including the payment of interest and principal on debt obligations, relies on the availability of liquid assets in the Corporation, which is dependent in large part on the dividend paying ability of its property and casualty subsidiaries. Various state insurance laws restrict the Corporation’s property and casualty subsidiaries as to the amount of dividends they may pay to the Corporation without the prior approval of regulatory authorities. The restrictions are generally based on net income and on certain levels of policyholders’ surplus as determined in accordance with statutory accounting practices. Dividends in excess of such thresholds are considered “extraordinary” and require prior regulatory approval. During 2002, these subsidiaries paid cash dividends to the Corporation totaling $240 million. The maximum dividend distribution that may be made by the property and casualty subsidiaries to the Corporation during 2003 without prior approval is approximately $445 million.
We believe that our strong financial position and conservative debt level provide us with the flexibility and capacity to obtain funds externally through debt or equity financings on both a short term and long term basis. However, should our ratings be downgraded and should there be a prolonged disruption of the capital markets caused by war or terrorism, our ability to access the markets to satisfy our liquidity requirements could be adversely affected.
The Corporation has lines of credit with a group of banks pursuant to two agreements entered into in June 2002 that provide for unsecured borrowings of up to $500 million in the aggregate. The $250 million short term revolving credit facility terminates on June 27, 2003 and may be renewed or replaced. The $250 million medium term revolving credit facility terminates on June 28, 2007. On the respective termination dates for these agreements, any loans then outstanding become payable. There have been no borrowings under these agreements. Various interest rate options are available to the Corporation, all of which are based on market interest rates. The facilities replaced, on substantially the same terms, $500 million of revolving credit facilities that were to expire in July 2002. The facilities are available for general corporate purposes and to support our commercial paper borrowing arrangement.