We also own office space located in a three-building complex located at 808 North Highlander Way, Howell, Michigan, with approximately 140,000 square feet, where various business operations are conducted. Certain of our properties have been leased to unrelated third parties or are available for lease.
We lease office space located at 30 Fenchurch Street, London, United Kingdom. We also lease offices throughout the United States and in select locations worldwide for branch sales, underwriting and claims processing functions, and the operations of acquired subsidiaries.
Net income was $186.2 million in 2017, compared to $155.1 million in 2016, an increase of $31.1 million. Contributing to this increase was higher operating income before interest expense and income taxes of $13.5 million (a non-GAAP financial measure; see also “Results of Operations - Consolidated - Non-GAAP Financial Measures” and operating income discussion below for further details). Additionally, net income in 2016 was adversely affected by prepayment charges of $56.0 million, net of tax, which we paid in connection with the redemption of $380.0 million in higher coupon debt following our issuance of $375.0 million of 4.50% senior debentures. Net income for 2017 also includes $22.3 million of expenses related to the enactment of the Tax Cuts and Jobs Act in 2017, as well as $16.8 million of after-tax losses from discontinued operations, primarily due to an increase in our long-term care pool reserves.
In February 2017, we announced our go-forward strategy, called “Hanover 2021”. This strategy reinforces our commitment to our agency partners and is designed to generate growth by leveraging the strengths of our agent-centered distribution strategy, including expansion of our agency footprint in underpenetrated geographies as warranted. We also plan to increase our capabilities in specialty markets and increase investments designed to develop growth solutions for our agency distribution channel. Our goal is to grow responsibly in all of our businesses, while managing volatility.
Underwriting results improved in 2017, as compared to 2016, primarily due to a favorable change in prior years’ loss reserve development, partially offset by higher catastrophe losses. Favorable development on prior years’ loss reserve in 2017 was $9.4 million, compared to unfavorable development of $223.0 million in 2016. Catastrophe losses were $170.6 million in 2017, an increase of $100.5 million when compared to 2016. This increase is primarily due to hurricanes Harvey and Irma that occurred in the third
Personal Lines focuses on partnering with high quality, value-oriented agencies that deliver consultative selling and stress the importance of account rounding (the conversion of single policy customers to accounts with multiple policies and additional coverages, to address customers’ broader objectives). Approximately 83% of our policies in force are account business. We are focused on making investments that provide us with profitable growth opportunities, build a distinctive position in the market and diversify us geographically.
Primary business operations include insurance products and services currently provided through four operating segments. Our domestic operating segments are Commercial Lines, Personal Lines, and Other. Our international operating segment is Chaucer. Commercial Lines includes commercial multiple peril, commercial automobile, workers’ compensation and other commercial coverages, such as inland marine, specialty program business, management and professional liability, surety and specialty property. Personal Lines includes personal automobile, homeowners and other personal coverages. Chaucer underwriting divisions include marine, aviation and political, casualty (which includes international liability, specialist coverages, and run-off syndicate participations), energy, property and assumed reinsurance treaty business (“treaty”). Included in the “Other” segment are Opus Investment Management, Inc., which markets investment management services to institutions, pension funds and other organizations; earnings on holding company assets; holding company and other expenses, including certain costs associated with retirement benefits due to our former life insurance employees and agents; and a run-off voluntary pools business. We present the separate financial information of each segment consistent with the manner in which our chief operating decision maker evaluates results in deciding how to allocate resources and in assessing performance.
gains and losses are excluded since they are determined by interest rates, financial markets and the timing of sales. Also, operating income before taxes excludes net gains and losses on disposals of businesses, gains and losses related to the repayment of debt, discontinued operations, costs to acquire businesses, restructuring costs, the cumulative effect of accounting changes and certain other items. Although the items excluded from operating income before taxes are important components in understanding and assessing our overall financial performance, we believe a discussion of operating income before taxes enhances an investor’s understanding of our results of operations by highlighting net income attributable to the core operations of the business. However, operating income before taxes, which is a non-GAAP measure, should not be construed as a substitute for income before income taxes, and operating income should not be construed as a substitute for net income.
Net premiums written increased by $259.4 million for the year ended December 31, 2017, compared to the year ended December 31, 2016. This improvement was due to growth in each of our domestic and Chaucer segments.
Operating income before interest expense and income taxes was $322.8 million for the year ended December 31, 2016, compared to $466.1 million for the year ended December 31, 2015, a decrease of $143.3 million. This decrease was primarily due to higher unfavorable prior years’ loss reserve development, partially offset by lower catastrophe and current accident year losses. Unfavorable development on prior years’ loss reserves was $140.3 million for the year ended December 31, 2016, compared to favorable development of $94.3 million for the year ended December 31, 2015, a change of $234.6 million. Catastrophe-related activity for the year ended December 31, 2016 was $125.1 million, compared to $181.3 million for the year ended December 31, 2015, a decrease of $56.2 million. Lower current accident year losses in our domestic segment in 2016 compared to 2015 were partially offset by higher losses in our Chaucer segment.
The following table summarizes net premiums written, and loss and LAE and catastrophe loss ratios by line of business for the Commercial Lines and Personal Lines segments. Loss and LAE and catastrophe loss ratios include prior year reserve development.
Prior to January 1, 2017, treaty was reflected in the casualty, property and marine, aviation and political lines. The tables above reflect 2016 and 2015 information presented in the revised underwriting divisions.
Commercial Lines underwriting profit for the year ended December 31, 2017 was $12.7 million, compared to underwriting loss of $122.0 million for the year ended December 31, 2016, a change of $134.7 million. Favorable development on prior years’ loss reserves (“prior year development”) for the year ended December 31, 2017 was $9.4 million, compared to unfavorable development of $223.0 million for the year ended December 31, 2016, a favorable change of $232.4 million, primarily due to the aforementioned reserve charge following our 2016 fourth quarter reserve review. Catastrophe-related losses for the year ended December 31, 2017 were $170.6 million, compared to $70.1 million for the year ended December 31, 2016, an increase of $100.5 million. This increase is primarily due to hurricanes Harvey and Irma that occurred in the third quarter, the California wildfires that occurred in the fourth quarter, and a large Midwest hail event that occurred in the second quarter.
Personal Lines current accident year underwriting profit, excluding catastrophes, was $174.4 million in the year ended December 31, 2017, compared to $155.1 million for the year ended December 31, 2016. This $19.3 million increase was primarily a result of earned premium growth and lower expenses. Also, higher current accident year losses in our homeowners line were substantially offset by lower losses in our personal automobile line.
We have been able to obtain rate increases in our Personal Lines markets and believe that our ability to obtain these increases will continue. However, our ability to maintain Personal Lines net premiums written may be affected by price competition, our exposure management actions, and regulatory and legal developments. Additionally, these factors along with weather-related loss volatility may also affect our ability to maintain and improve underwriting results. We monitor these trends and consider them in our rate actions.
million in 2016, representing the increase in Chaucer’s retained group share of its 2013 year of account that was closed and reinsured into its 2014 year of account. As we have 100% economic interest in Syndicate 1084 for all years of account after 2013, we did not have significant RITC impacts in 2017 and do not anticipate any further impact from RITC. Excluding the RITC impact, net written premium increased 6.4%.
Chaucer’s current accident year underwriting profit, excluding catastrophes, was $51.9 million in the year ended December 31, 2017, compared to an underwriting loss of $7.0 million for the year ended December 31, 2016. This $58.9 million improvement was primarily due to lower large losses in our political line, including losses from commodity price-sensitive trade credit coverages in 2016, and lower losses in our energy line.
Other operating losses were $7.9 million for the year ended December 31, 2017, compared to $18.3 million for the year ended December 31, 2016, an improvement of $10.4 million, primarily due to 2016 unfavorable prior year reserve development in our run-off voluntary pools business (See “2016 Loss and LAE Development, excluding catastrophes” section below for further discussion).
Most of Chaucer’s transactions are denominated in the currencies that we use to settle transactions with Lloyd’s, specifically the U.S. Dollar, the U.K. Pound Sterling (“GBP”) and the Canadian Dollar. These are Chaucer’s functional currencies under U.S. GAAP. A portion of Chaucer’s transactions and its assets and liabilities are denominated in other currencies, such as the Euro, the Swiss Franc, the Australian Dollar and the Japanese Yen. Changes in the value of these currencies versus the functional currencies, particularly versus the GBP, cause transactional gains and losses during each reporting period. During 2017, the GBP was relatively stable against most currencies. In contrast, the GPB weakened meaningfully against most currencies in 2016. We believe that this was due, in large part, to the effect of the U.K’s referendum vote to discontinue its membership in the European Union (“Brexit Referendum”). During 2015, the GBP strengthened against most currencies. The following table summarizes the total effect of Chaucer’s foreign exchange transactional gains and losses on comprehensive income:
Our ultimate IBNR reserves are estimated by management and our reserving actuaries on an aggregate basis for each line of business or coverage for loss and loss expense liabilities not reflected within the case reserves. The sum of the case reserves and the IBNR reserves represents our estimate of total unpaid losses and loss adjustment expenses.
The IBNR reserve includes a provision for claims that have occurred but have not yet been reported to us, some of which may not yet be known to the insured, as well as a provision for future development on reported claims. IBNR represents a significant proportion of our total net loss reserves, particularly for long-tail liability classes. In fact, approximately 51% of our aggregate net loss reserves at December 31, 2017 were for IBNR losses and loss expenses.
Inflation generally increases the cost of losses covered by insurance contracts. The effect of inflation varies by product. Our property and casualty insurance premiums are established before the amount of losses and LAE and the extent to which inflation may affect such expenses are known. Consequently, we attempt, in establishing rates and reserves, to anticipate the potential impact of inflation in the projection of ultimate costs. For example, we monitor and have seen recent increasing trends in medical costs, wages and legal costs, which are key considerations in setting reserve assumptions for workers’ compensation and other liability lines. We are also monitoring the continued advancements in technology and design found in automobiles and homes and the potential for increased claims settlement costs that may result from repairs or replacement of such equipment. Increases are reflected in our current reserve estimates, but continued increases could contribute to increased losses and LAE in the future.
We are also defendants in various litigation matters, including putative class actions, which may seek punitive damages, bad faith or extra-contractual damages, legal fees and interest, or claim a broader scope of policy coverage or settlement and payment obligations than our interpretation. Resolution of these cases are often highly unpredictable and could involve material unanticipated damage awards.
While we estimate that a majority of our written premium is in what we would characterize as shorter-tailed classes of business, most of our loss reserves relate to longer-tail liability classes of business. Long-tailed classes include commercial liability, automobile liability, workers’ compensation, contract surety and other types of third-party coverage. Chaucer’s longer-tailed lines include aviation liability, trade credit and political risk classes, marine liability, energy liability, nuclear liability, U.S. casualty treaty liability, international liability, specialist liability, and financial institutions and professional liability. For many liability claims, significant periods of time, ranging up to several years or more, may elapse between the occurrence of the loss, the discovery and reporting of the loss to us and the settlement of the claim. As a result, loss experience in the more recent accident years for long-tailed liability coverage has limited statistical credibility because a relatively small proportion of losses in these accident years (the calendar years in which losses are incurred) are reported claims and an even smaller proportion are paid losses. Liability claims are also more susceptible to litigation and can be significantly affected by changing contract interpretations, the legal environment, the risk and expense of protracted litigation and inflation. Consequently, the estimation of loss reserves for these coverages is more complex and typically subject to a higher degree of variability and uncertainty compared to short-tailed coverages.
Most of our indirect business from our run-off voluntary and ongoing involuntary pools is assumed long-tailed casualty reinsurance. Reserve estimates for this business are therefore subject to the variability caused by extended loss emergence periods. The estimation of loss reserves for this business is further complicated by delays between the time the claim is reported to the ceding insurer and when it is reported by the ceding insurer to the pool manager and then to us, and by our dependence on the quality and consistency of the loss reporting by the ceding company and actuarial estimates by the pool manager. These reserving factors also apply to our discontinued assumed accident and health reinsurance pools and arrangements that are included in our liabilities of discontinued operations (See “Risk Factors” in Part I - Item 1A of this Form 10-K for further discussion).
For each line of business and coverage, we regularly adjust the assumptions and methods used in the estimation of loss reserves in response to our actual loss experience, as well as our judgments regarding changes in trends and/or emerging patterns. In those instances where we primarily utilize analyses of historical patterns of the development of paid and reported losses, this may be reflected, for example, in the selection of revised loss development factors. In longer-tailed classes of business and for which loss experience is less predictable due to potential changes in judicial interpretations, potential legislative actions, the cost of litigation or determining liability and the ultimate loss, inflation, potential claims and other issues, this may be reflected in a judgmental change in our estimate of ultimate losses for particular accident years.
New classes of business - claims reserves recorded for new classes of Chaucer business (primarily within international liability, U.S. casualty treaty and, to a lesser extent, new business written in overseas offices) were $223.9 million as of December 31, 2017. An increase in the ultimate loss ratio by 5%, 10% and 15% in the 2015 and prior, 2016 and 2017 years of account, respectively, on these classes would have increased total reserves by approximately $33 million at December 31, 2017.
Catastrophe events - for hurricanes Harvey, Irma and Maria, a 25% increase in estimated gross ultimate claims for Chaucer and a 20% increase in net ultimate claims deterioration on the U.S. direct business would have reduced underwriting income by approximately $21 million.
“Other commercial lines - Other lines” in the table above, is primarily comprised of fidelity, marine, miscellaneous property and healthcare lines. Loss and LAE reserves in our “Total Other Segment” relate to our run-off voluntary assumed reinsurance pools business. Also included in the above table are $59.4 million, $61.0 million and $57.7 million of asbestos and environmental reserves as of December 31, 2017, 2016 and 2015, respectively. Included in the Chaucer segment are $100.9 million, $117.0 million and $166.0 million of reserves as of December 31, 2017, 2016 and 2015, respectively, related to Chaucer’s financial and professional liability lines written in 2008 and prior periods.
In 2017, favorable catastrophe development was $25.5 million, primarily due to lower than expected property losses for Chaucer’s treaty line of $18.5 million. In 2016, favorable catastrophe development was $34.9 million, primarily due to lower than expected property losses in Chaucer’s treaty line of $20.2 million and, to a lesser extent, in Chaucer’s property line. In 2015, favorable catastrophe development was $21.8 million, primarily due to lower than expected property losses in Chaucer’s treaty line of $19.3 million and, to a lesser extent, in Chaucer’s property line, partially offset by higher than expected losses in our homeowners line, within our Personal lines segment.
As a result of our 2016 fourth quarter reserve review of domestic lines of business, carried domestic reserves for prior accident years, excluding catastrophes, were increased by $174.1 million in the fourth quarter, of which $161.5 million related to Commercial Lines. The majority of this adjustment was attributed to our long-tailed commercial liability coverages, including our AIX program business and was largely driven by worsening trends in the number and nature of high severity losses and higher than anticipated legal defense costs. We reacted to this adverse emergence by updating our assumptions about loss severity, loss development patterns, expected loss ratios and loss adjustment expenses for the most recent accident years, placing greater weight on the adverse severity trends experienced in the most recent calendar years. The adverse prior year development for our Other segment was due to our run-off voluntary assumed reinsurance pools business. The reserve increase was based on an updated third-party actuarial study received in the fourth quarter for the Excess and Casualty Reinsurance Association (“ECRA”) pool that primarily consists of asbestos and environmental exposures.
In 2015, net favorable loss and LAE development was $94.3 million, primarily as a result of favorable development of $120.1 million for Chaucer, partially offset by net unfavorable development of $45.2 million for Commercial Lines.
See “Reinsurance” in Item 1 - Business of this Form 10-K for information on our reinsurance programs.
The increase in net investment income in both 2017 and 2016 was primarily due to the investment of higher operational cash flows and to acquisitions of additional higher yielding asset classes, including private equity partnerships and commercial loan participations. Net investment income in 2017 also benefited from an increase in income on certain reinsurance contracts subject to deposit accounting. These increases were partially offset by the impact of lower new money yields. Additionally, in 2016 net investment income declined due to lower investment assets resulting from our repurchases of stock and repayments of debt. We expect average fixed income investment yields to continue to decline as new money rates remain lower than embedded book yields.
We deposit funds with various state and governmental authorities as well as with Lloyd’s. See Note 3 - “Investments” in the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K for additional information.
For the years ended December 31, 2017, 2016 and 2015, we recognized in earnings $5.9 million, $27.9 million and $26.8 million, respectively, of other-than-temporary impairments (“OTTI”). In 2017, OTTI consisted of $2.1 million on fixed maturities, $2.0 million on other invested assets and $1.8 million on equity securities. In 2016, OTTI consisted primarily of $16.1 million on fixed maturities we intended to sell, $8.8 million related to estimated credit losses on fixed maturities and $2.7 million on equity securities. In 2015, OTTI consisted of $16.0 million related to estimated credit losses on fixed maturities, $4.0 million on fixed maturities we intended to sell and $6.8 million on equities. OTTI in 2016 and 2015 related to the energy sector was $16.6 million and $19.6 million, respectively.
Monetary policies in the developed economies, particularly in the United States, Europe and Japan, are supportive of moderate economic growth, while fiscal policies are more divergent and subject to change. Major central banks continue to closely monitor developments in global financial markets and the outlook for growth and are committed to adjust monetary policy as required to provide liquidity, support growth and achieve inflation targets. In the United States, the Federal Reserve (the “Fed”) increased its target for the federal funds rate by 0.75% in 2017, including 0.25% in December, and raised its range to 1.25% to 1.50%. The Fed expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate and steady reductions in the size of its balance sheet. This is supported by its view that economic activity will expand at a moderate pace, labor conditions will remain strong and inflation will rise and stabilize around its 2 percent objective over the medium term. The Fed has communicated that the timing and size of future adjustments to the federal funds rate will depend on the realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. While the Fed believes near-term risks to the economic outlook appear roughly balanced, it continues to closely monitor inflation indicators and global economic and financial developments.
While the United States, Canada and the United Kingdom have ended their extraordinary measures and begun to tighten monetary policy, other major central banks continue with their stimulus policies as they seek higher growth and confront inflation and inflation expectations running below target. The removal, modification or suggestion of changes in these policies could have an adverse effect on prevailing market interest rates and on issuers’ level of business activity or liquidity. Fundamental conditions in the corporate sector generally remain sound. While we may experience defaults on fixed income securities, particularly with respect to non-investment grade debt securities, it is difficult to foresee which issuers, industries or markets will be affected. As a result, the value of our fixed maturity portfolio could change rapidly in ways we cannot currently anticipate, and we could incur additional realized and unrealized losses in future periods.
Net realized gains on investments were $23.7 million, $8.6 million, and $19.5 million for 2017, 2016, and 2015, respectively. Net realized gains in 2017 were primarily due to $30.8 million of gains recognized from the sale of securities, primarily equities, and to a lesser extent, fixed maturities. These gains were partially offset by $5.9 million of OTTI losses. Net realized gains in 2016 were primarily due to $36.4 million of gains recognized from the sale of securities, primarily equities, and to a lesser extent, fixed maturities. These gains were partially offset by $27.9 million of OTTI losses. Net realized gains in 2015 were primarily due to $39.9 million of gains recognized from the sale of equity securities and, to a lesser extent, fixed maturities, and $6.4 million of gains from other investments, primarily partnerships. These gains were partially offset by $26.8 million of OTTI losses.
Discontinued operations primarily include our discontinued accident and health and former life insurance businesses. In 2017, discontinued operations, in total, generated a loss of $16.8 million, net of tax, primarily related to the long-term care pool within our discontinued accident and health business. During the fourth quarter of 2017, we received updated future cash flow projections from the manager of our long-term care pool that reflected a significant increase in projected claim costs. As a result of this deterioration in morbidity, partially offset by more favorable future premium rate increases, we increased our long-term care pool reserves by $23.3 million, before tax. See also “Discontinued Operations” in Part I - Item 1 of this Form 10-K.
In 2016, we redeemed senior debentures with a net carrying value of $375.2 million at a cost of $461.3 million, resulting in a loss of $86.1 million. Additionally, in 2016 we repurchased senior debentures with a net carrying value of $11.9 million at a cost of $14.1 million, resulting in a loss of $2.2 million. In 2015, through several transactions, we repurchased senior debentures with a net carrying value of $90.2 million at a cost of $114.3 million, resulting in a loss of $24.1 million.
Operations are subject to risk resulting from interest rate fluctuations, which may adversely impact the valuation of the investment portfolio. In a rising interest rate environment, the value of the fixed maturity sector, which comprises 83% of our investment portfolio, may decline as a result of decreases in the fair value of the securities. Our intent is to hold securities to maturity and recover the decline in valuation as prices accrete to par. However, our intent may change prior to maturity due to changes in the financial markets, our analysis of an issuer’s credit metrics and prospects, or as a result of changes in cash flow needs. Interest rate fluctuations may also reduce net investment income and as a result, profitability. The portfolio may realize lower yields and therefore lower net investment income on securities because the securities with prepayment and call features may prepay at a different rate than originally projected. Also, funds may not be available to invest at higher interest rates.
The following table illustrates the estimated impact on the fair value of our fixed maturity portfolio at December 31, 2017 and 2016 of hypothetical changes in prevailing interest rates, defined as changes in interest rates on U.S. Treasury debt. It does not reflect changes in credit spreads, liquidity spreads and other factors that affect the value of securities. Since changes in prevailing interest rates are often accompanied by changes in these other factors, the reader should not assume that an actual change in interest rates would result in the values illustrated.
The provision for income taxes from continuing operations was an expense of $98.5 million, $36.2 million and $108.6 million in 2017, 2016 and 2015, respectively. These amounts resulted in consolidated effective tax rates of 32.7%, 18.8% and 24.7% on pre-tax income for 2017, 2016 and 2015, respectively. The provision for 2017 reflects a one-time expense of $22.3 million related to the enactment of the Tax Cuts and Jobs Act (“TCJA”,”U.S. Tax Reform” or “the Act”). See “U.S. Tax Reform” below for a discussion of this new law. This expense consisted of a revaluation of our net deferred tax assets, due to the reduction of the U.S. statutory tax rate from 35% to 21%, and the recognition of federal income taxes on previously untaxed income from foreign operations of $9.6 million and $12.7 million, respectively. The provision for 2017 also included excess tax benefits related to stock-based compensation of $5.3 million. The adoption of ASC Update No. 2016-09 on January 1, 2017 required the inclusion of excess tax benefits from stock-based compensation in the income statement, whereas prior to the adoption, these excess tax benefits were recognized in additional paid-in capital. The provisions in 2017, 2016 and 2015 reflect benefits related to tax planning strategies implemented in prior years of $12.7 million, $20.7 million and $13.3 million, respectively. Finally, the provision for 2015 reflects a $15.6 million tax savings, net of a $1.7 million provision for uncertain tax positions, on the transfer of the U.K. motor business. The transfer of the U.K. motor business was structured as a tax-free reorganization exempt from current U.S. and U.K. taxation under the business exemption and substantial shareholdings exemption rules, respectively. Absent these items, the provision for income taxes for 2017, 2016, and 2015 would have been expenses of $94.2 million, or 31.2%, $56.9 million, or 29.6%, and $137.5 million, or 31.3%, respectively. The lower effective tax rate in 2016 is primarily due to lower underwriting income.
The income tax provision on operating income was an expense of $84.0 million, $83.5 million and $125.5 million for 2017, 2016 and 2015, respectively. These provisions resulted in effective tax rates for operating income of 29.2%, 31.2% and 30.9% in 2017, 2016 and 2015, respectively. The provision for 2017 reflects the aforementioned excess tax benefit related to stock-based compensation of $5.3 million. Absent this item, the provision for income taxes for 2017 would have been expense of $89.3 million, or 31.0%.
Included in our deferred tax net asset as of December 31, 2017 are assets of $23.1 million related to alternative minimum tax (“AMT”) credit carryforwards. Although the enactment of TCJA repeals the corporate alternative minimum tax effective January 1, 2018, the remaining AMT credits carried forward will continue to be utilized to offset future taxable income for tax years beginning in 2018.
During 2017, we recorded an increase to our uncertain tax positions of $0.9 million related to the recognition of federal income taxes on previously untaxed earnings from foreign operations. This amount is partially offset by a decrease in our uncertain tax positions of $0.6 million due to the expiration of a statute of limitation, for a net change of $0.3 million. We are subject to U.S. federal and state examinations and foreign examinations for years after 2013. There are no ongoing audits on our open tax years.
In prior years, we completed several transactions which resulted in the realization, for tax purposes only, of unrealized gains in our investment portfolio. As a result of these transactions, we were able to realize capital losses carried forward and to release the valuation allowance recorded against the deferred tax asset related to these losses. The releases of valuation allowances were recorded as a benefit in accumulated other comprehensive income. Previously unrealized benefits of $12.7 million, $20.7 million and $13.3 million attributable to non-operating income, are recognized as part of our income from continuing operations during 2017, 2016 and 2015, respectively. The remaining amount of $44.8 million in accumulated other comprehensive income will be released into income from continuing operations in future years, as the investment securities subject to these transactions are sold or mature.
The Act also created a territorial tax system, which will generally allow companies to repatriate future non-U.S. sourced earnings without incurring additional U.S. taxes, by providing a 100% exemption on dividends received from certain non-U.S. subsidiaries. Although most of our non-U.S. income had been previously subject to U.S. taxes, a portion of our non-U.S. income had been indefinitely reinvested overseas and was not subject to U.S. tax until repatriated. These non-U.S. earnings are now subject to a one-time mandatory toll charge totaling $12.7 million, which also is recorded as a component of income tax expense in continuing operations for the year ended December 31, 2017.
To determine the expected long-term return on plan assets, we generally consider historical mean returns by asset class for passive indexed strategies, as well as current and expected asset allocations, and adjust for certain factors that we believe will have an impact on future returns. Actual returns on plan assets in any given year seldom result in the achievement of the expected rate of return on assets. Actual returns on plan assets in excess of these expected returns will generally reduce our net actuarial losses (or increase actuarial gains) that are reflected in the accumulated other comprehensive income balance in shareholders’ equity, whereas actual returns on plan assets that are less than expected returns will generally increase our net actuarial losses (or decrease actuarial gains) that are reflected in accumulated other comprehensive income. These gains or losses are amortized into expense in future years. The U.S. qualified plan held assets consisting of approximately 85% fixed maturities and 15% equities at December 31, 2017. The composition of Chaucer’s plan assets are approximately 55% equities, 35% fixed maturities, and 10% real estate funds at December 31, 2017.
Expenses related to our defined benefit plans are generally calculated based upon information available at the beginning of the plan year. Our pre-tax expense related to our defined benefit plans was $13.7 million and $11.7 million for 2017 and 2016, respectively. Given the positive effect of our actual investment experience in 2017, and taking into consideration the decrease in discount rates for 2017, pension related expenses are expected to decrease from $13.7 million in 2017 to $6.2 million in 2018.
Holding all other assumptions constant (using the December 31, 2017 GBP to U.S. dollar conversion rate of 1.35), sensitivity to changes in our key assumptions related to our pension plans is as follows:
As of December 31, 2017, we have $23.1 million of alternative minimum tax credit carryforwards. Although the enactment of TCJA repeals the corporate alternative minimum tax effective January 1, 2018, the remaining AMT credits carried forward will continue to be utilized to offset future taxable income for tax years beginning in 2018. We believe it is more likely than not that the remaining deferred tax assets will be realized.
The statutory capital and surplus for our U.S. insurance subsidiaries decreased $96.3 million during 2017, primarily due to a $296.8 million dividend paid by Hanover Insurance to THG and the effect related to the enactment of the Tax Cuts and Jobs Act, partially offset by operating results and increases in unrealized gains on investments.
Beginning in 2017, the NAIC modified the RBC formula to require the inclusion of catastrophe risk. Accordingly, the 2016 values have been restated to reflect this change.
Liquidity is a measure of our ability to generate sufficient cash flows to meet the cash requirements of business operations. As a holding company, our primary ongoing source of cash is dividends from our insurance subsidiaries. However, dividend payments to us by our U.S. insurance subsidiaries are subject to limitations imposed by regulators, such as prior notice periods and the requirement that dividends in excess of a specified percentage of statutory surplus or prior year’s statutory earnings receive prior approval (so called “extraordinary dividends”). Hanover Insurance paid $296.8 million in dividends to the holding company during 2017. This includes $80.0 million of extraordinary dividends. In 2016, a $218.8 million ordinary dividend was paid by Hanover Insurance and no dividends were paid to the holding company by Hanover Insurance in 2015.
In connection with an intercompany borrowing arrangement between Chaucer and a wholly owned non-insurance subsidiary of the holding company, interest on a $300 million note is paid by Chaucer on a quarterly basis to this affiliate, which is ultimately available to provide dividends to the holding company. In 2017, Chaucer paid $20.7 million of interest related to this note, of which $20.2 million was then dividended to the holding company. Prior to 2017, interest related to this borrowing arrangement was paid directly to the holding company. Chaucer paid interest to the holding company totaling $22.4 million and $22.5 million in 2016 and 2015, respectively, related to this note.
Net cash provided by operating activities was $704.6 million during 2017, as compared to $743.4 million in 2016 and $444.7 million in 2015. During 2017, the $38.8 million decrease in cash provided was primarily the result of higher loss payments and taxes paid to foreign jurisdictions, partially offset by an increase in premiums collected. The $298.7 million increase in 2016 compared to 2015 was primarily due to lower reinsurance payments in 2016 as compared to 2015. In 2015, reinsurance payments were made in connection with the disposal of the U.K. motor business that did not recur in 2016. Also contributing to the increase in cash were lower claims payments during 2016. These increases were partially offset by slightly lower premium collections during 2016.
Net cash used in financing activities was $111.7 million during 2017, as compared to $300.8 million during 2016 and $301.0 million in 2015. During 2017, cash used in financing activities primarily resulted from the payment of dividends to shareholders and repurchases of common stock, partially offset by cash inflows related to option exercises. During 2016, cash used in financing activities primarily resulted from the repayment of debt, repurchases of common stock, and payment of dividends to shareholders. These cash outflows were partially offset by cash inflows related to the issuance of $375 million of senior unsecured debentures. During 2015, cash used in financing activities primarily resulted from repurchases of common stock, repayments of debt and dividend payments to shareholders.
Dividends to common shareholders are subject to quarterly board approval and declaration. During 2017, as declared by the Board, we paid three quarterly dividends of $0.50 per share and one quarterly dividend of $0.54 per share to our shareholders totaling $86.8 million. We believe that our holding company assets are sufficient to provide for future shareholder dividends should the Board of Directors declare them.
Membership in the FHLBB provides us with access to additional liquidity based on our stock holdings and pledged collateral. At December 31, 2017, we had additional borrowing capacity of $81.3 million. There were no borrowings outstanding under this short-term facility at December 31, 2017; however, we have borrowed and may continue to borrow, from time to time, through this facility to provide short-term liquidity.
(or $317.3 million). The Facility Agreement, like the Prior Facility Agreement, provides certain covenants including, but not limited to, the syndicates’ financial condition. The Facility Agreement provides regulatory capital supporting Chaucer’s underwriting activities for the 2018 and 2019 years of account and each prior open year of account. The Prior Facility Agreement provided regulatory capital supporting Chaucer’s underwriting activities for the 2016 and 2017 years of account and each prior open year of account. The Facility Agreement is generally renewed biennially to support new underwriting years.
The Facility agreement is subject to a letter of credit commission fee on outstanding letters of credit, which is payable quarterly. The Facility Agreement fee ranges from 0.90% to 1.50% per annum, depending on our credit ratings for portions that are not cash collateralized, 0.25% per annum for portions that are cash collateralized, and 0.40% per annum for portions that are cash-equivalent collateralized, whereas the Prior Facility Agreement fee ranged from 1.125% to 1.50% per annum, also dependent on our credit ratings for portions that were not cash collateralized, and 0.275% per annum for portions that were cash collateralized. We may, from time to time, collateralize a portion of the outstanding letter of credit. In addition to the commission fee on the uncollateralized outstanding letter of credit, a commitment fee in respect of the unutilized commitments under the Facility Agreement is payable quarterly, and ranges from 0.315% to 0.525% per annum, depending on our credit ratings. Unutilized commitment fees for the Prior Facility Agreement were also payable quarterly, and ranged from 0.394% to 0.525% per annum, depending on our credit ratings. Chaucer is also required to pay customary agency fees. We paid $3.3 million and $3.5 million in fees during 2017 and 2016, respectively.
At December 31, 2017, we were in compliance with the covenants of our debt and credit agreements.
Debt includes our senior debentures due in 2026, which pay annual interest at a rate of 4.50%, our senior debentures due in 2025, which pay annual interest at a rate of 7.625%, our subordinated debentures due in 2053, which pay annual interest at a rate of 6.35%, and our subordinated debentures due in 2027, which pay cumulative dividends at an annual rate of 8.207%. Payments related to the principal amounts of these agreements represent contractual maturity; therefore, principal and interest associated with these obligations are reflected in the above table based upon the contractual maturity dates. In addition, we have $125.0 million of borrowings under a collateralized borrowing program with the FHLBB that pays interest monthly at a rate of 5.50% annually. Such borrowings are available for a twenty-year term or through September 25, 2029. Also, interest includes contractual interest related to the uncollateralized portion of our £220.0 million Standby Letter of Credit Facility.
Amounts represent non-qualified defined benefit pension and postretirement benefit obligations and reflect estimated payments to be made through plan year 2026 for pension, postretirement and postemployment benefits, although it is likely that payments will be made beyond 2026. Estimates of these payments and the payment patterns are based upon historical experience. We do not expect to make any significant contributions to our U.S. qualified plan in order to meet our minimum funding requirements for the next several years. Additionally, based upon our recent triennial funding review of the Chaucer plan and related contributions made in 2017, we don’t expect to make further contributions to this plan for the next several years. Therefore, no contributions for those plans are included in this schedule. However, additional contributions may be required in the future to both plans based on the level of pension assets and liabilities in future periods.
Unlike many other forms of contractual obligations, loss and LAE reserves do not have definitive due dates and the ultimate payment dates are subject to a number of variables and uncertainties. As a result, the total loss and LAE reserve payments to be made by period, as shown in the table, are estimates based principally on historical experience.
Funds at Lloyd’s - Funds held in trust or otherwise pledged at Lloyd’s as security for the policyholders and to support a corporate member’s overall underwriting activities. The funds must be in a form approved by Lloyd’s and be maintained at certain specified levels.
Statutory accounting practices - Recording transactions and preparing financial statements in accordance with the rules and procedures prescribed or permitted by insurance regulatory authorities including the NAIC, which in general reflect a liquidating, rather than going concern, concept of accounting.
The consolidated financial statements of The Hanover Insurance Group, Inc. (“THG” or the “Company”), include the accounts of The Hanover Insurance Company (“Hanover Insurance”) and Citizens Insurance Company of America (“Citizens”), THG’s principal U.S. domiciled property and casualty companies; Chaucer Holdings Limited (“Chaucer”), a specialist insurance underwriting group which operates through the Society and Corporation of Lloyd’s (“Lloyd’s”); and certain other insurance and non-insurance subsidiaries. These legal entities conduct their operations through several business segments discussed in Note 14 - “Segment Information”. The consolidated financial statements also include the Company’s discontinued operations, consisting primarily of the Company’s former life insurance and accident and health businesses. All intercompany accounts and transactions have been eliminated.
Realized investment gains and losses are reported as a component of revenues based upon specific identification of the investment assets sold. When an other-than-temporary decline in value of a specific investment is deemed to have occurred, and a charge to earnings is required, the Company recognizes a realized investment loss.
The Company reviews investments in an unrealized loss position to identify other-than-temporary declines in value. When it is determined that a decline in value of an equity security is other-than-temporary, the Company reduces the cost basis of the security to fair value with a corresponding charge to earnings. When an other-than-temporary decline in value of a debt security is deemed to have occurred, the Company must assess whether it intends to sell the security or more likely than not will be required to sell the
security before recovery of its amortized cost basis. If the debt security meets either of these two criteria, an other-than-temporary impairment (“OTTI”) is recognized in earnings equal to the entire difference between the security’s amortized cost basis and its fair value at the impairment measurement date. If the Company does not intend to sell the debt security and it is not more likely than not the Company will be required to sell the security before recovery of its amortized cost basis, the credit loss portion of an OTTI is recorded through earnings while the portion attributable to all other factors is recorded separately as a component of other comprehensive income. The amount of the OTTI that relates to credit is estimated by comparing the amortized cost of the fixed maturity security with the net present value of the security’s projected future cash flows, discounted at the effective interest rate implicit in the investment prior to impairment. The non-credit portion of the impairment is equal to the difference between the fair value and the net present value of the security’s cash flows at the impairment measurement date. Once an OTTI has been recognized, the new amortized cost basis of the security is equal to the previous amortized cost less the amount of OTTI recognized in earnings. For equity method investments, an impairment is recognized when evidence demonstrates that an other-than-temporary loss in value has occurred, including the absence of the ability to recover the carrying amount of the investment or the inability of the investee to sustain a level of earnings that would justify the carrying amount of the investment.
The Company tests for the recoverability of goodwill and intangible assets with indefinite lives annually or whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. The Company recognizes impairment losses only to the extent that the carrying amounts of reporting units with goodwill exceed the fair value. The amount of the impairment loss that would be recognized is determined based upon the excess of the carrying value of goodwill compared to the implied fair value of the goodwill, as determined with respect to all assets and liabilities of the reporting unit. The Company has performed its annual review of goodwill and intangible assets with indefinite lives for impairment in the fourth quarters of 2017 and 2016 with no impairments recognized. At December 31, 2017 and 2016, Chaucer held intangible assets with indefinite lives of $51.4 million and $47.0 million, respectively, which represents approximately 78% and 76% of the Company’s balance, respectively. In addition, at December 31, 2017 and 2016, goodwill held by Chaucer was $13.8 million and $6.0 million, respectively. The remaining balance relates to the U.S. Companies.
The Company’s debt at December 31, 2017 includes senior debentures, subordinated debentures, and collateralized borrowings with the Federal Home Loan Bank of Boston (“FHLBB”). Debt instruments are carried at principal amount borrowed, net of any applicable unamortized discounts and issuance costs. See Note 6 - “Debt and Credit Arrangements”.
The Company is subject to the tax laws and regulations of the U.S. and foreign countries in which it operates. The Company files a consolidated U.S. federal income tax return that includes the holding company and its U.S. subsidiaries. Generally, taxes are accrued at the U.S. statutory tax rate for income from the U.S. operations. On December 22, 2017, the Tax Cuts and Jobs Act (“TCJA”) was enacted in the U.S. reducing the U.S. corporate tax rate from 35% to 21%, effective January 1, 2018. See Note 7 - “Income Taxes” for a discussion of this new law. The Company’s primary non-U.S. jurisdiction is the United Kingdom (“U.K.”). In November 2015, the U.K. statutory tax rate decreased from 20% to 19% effective April 1, 2017. A further decrease in the U.K. tax rate was enacted in September 2016 to reduce the U.K. statutory rate to 17% effective April 1, 2020. The Company accrues taxes on certain non-U.S. income that is subject to U.S. tax at the enacted U.S. tax rate. Foreign tax credits, where available, are utilized to offset U.S. tax as permitted.
Earnings per share (“EPS”) for the years ended December 31, 2017, 2016 and 2015 is based on a weighted average of the number of shares outstanding during each year. Basic and diluted EPS is computed by dividing income available to common stockholders by the weighted average number of shares outstanding for the period. The weighted average shares outstanding used to calculate basic EPS differ from the weighted average shares outstanding used in the calculation of diluted EPS due to the effect of dilutive employee stock options, nonvested stock grants and other contingently issuable shares. If the effect of such items is antidilutive, the weighted average shares outstanding used to calculate diluted EPS are equal to those used to calculate basic EPS.
The Company manages its exposure to foreign currency risk primarily by matching assets and liabilities denominated in the same currency. To the extent that assets and liabilities in foreign currencies are not matched, the Company is exposed to foreign currency risk. For functional currencies, the related exchange rate fluctuations are reflected in other comprehensive income (loss). The Company translated Chaucer’s balance sheet at December 31, 2017 and 2016 from GBP to U.S. dollars using a conversion rate of 1.35 and 1.23, respectively. The Company recognized $1.1 million and $22.3 million in foreign currency transaction losses in the Consolidated Statements of Income during the years ended December 31, 2017 and 2016, respectively, and $8.5 million in foreign currency transaction gains for the year ended December 31, 2015. These amounts include realized gains of Euro denominated securities of $1.7 million in 2017, and losses of Euro dominated securities of $0.7 million and $3.4 million in 2016 and 2015, respectively.
In March 2016, the Financial Accounting Standards Board (“FASB”) issued ASC Update No. 2016-09, (Topic 718) Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting (“ASC Update No. 2016-09”). This ASC update requires all excess tax benefits and tax deficiencies to be recognized as income tax expense or benefit in the income statement, and be treated as discrete items in the reporting period in which they occur. Additionally, excess tax benefits will be classified with other income tax cash flows as an operating activity and cash paid by an employer when directly withholding shares for tax withholding purposes will be classified as a financing activity. Awards that are used to settle employee tax liabilities will be allowed to qualify for equity classification for withholdings up to the maximum statutory tax rates in applicable jurisdictions. Regarding forfeitures, a company can make an entity-wide accounting policy election to either continue estimating the number of awards that are expected to vest or account for forfeitures when they occur. The updated guidance was effective for interim and annual periods beginning after December 15, 2016. The Company implemented this guidance effective January 1, 2017 and will retain its current forfeiture policy of accruing the compensation cost based on the number of awards that are expected to vest. Prior period cash flow statements have been retrospectively adjusted to present excess tax benefits and cash paid by an employer when withholding shares for tax withholding purposes in accordance with the updated guidance. The adoption of this guidance did not result in any cumulative effect adjustments. The effect this guidance will have on the Company’s results of operations in future periods is dependent on the future tax benefits or deficiencies that are recognized related to stock-based compensations awards, and could be material in any one quarterly or annual period.
In April 2015, the FASB issued ASC Update No. 2015-03, (Subtopic 835-30) Interest-Imputation of Interest: Simplifying the Presentation of Debt Issuance Costs. This ASC update requires that debt issuance costs be presented in the balance sheet as a direct deduction from the carrying amount of a debt liability, consistent with debt discounts or premiums, and amortization of debt issuance cost shall be reported as interest expense. The recognition and measurement guidance for debt issuance costs are not affected by the amendments in this ASC update. The updated guidance is to be applied on a retrospective basis and early adoption is permitted. The update is effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. The Company implemented this guidance effective January 1, 2016. The effect of implementing this guidance was not material to the Company’s financial position or results of operations.
In February 2018, the FASB issued ASC Update No. 2018-02 (Topic 220) Income Statement - Reporting Comprehensive Income: Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. This ASC update allows for a reclassification into retained earnings of the stranded tax effects in accumulated other comprehensive income (“AOCI”) resulting from the enactment of the TCJA. Current guidance requires the effect of a change in tax laws or rates on deferred tax balances to be reported in income from continuing operations in the accounting period that includes the period of enactment, even if the related income tax effects were originally charged or credited directly to AOCI. The amount of the reclassification would include the effect of the change in the U.S. federal corporate income tax rate on the gross deferred tax amounts at the date of the enactment of the TCJA related to items in AOCI. The updated guidance is effective for interim and annual periods beginning after December 15, 2018. Early adoption is permitted. The Company expects to adopt the updated guidance effective January 1, 2018. The adoption will not have a material impact on the Company’s financial position or results of operations.
In March 2017, the FASB issued ASC Update No. 2017-08, (Subtopic 310-20) Receivables - Nonrefundable Fees and Other Costs: Premium Amortization on Purchased Callable Debt Securities. This guidance shortens the amortization period of premiums on certain purchased callable debt securities to the earliest call date. The updated guidance is effective for annual and interim periods beginning after December 15, 2018, and should be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. Early adoption is permitted, including adoption in an interim period. The Company does not expect the adoption of ASC Update No. 2017-08 to have a material impact on its financial position or results of operations.
In November 2016, the FASB issued ASC Update No. 2016-18 (Topic 230) Statement of Cash Flows - Restricted Cash (a consensus of the FASB Emerging Issues Task Force). The amendments in this update require that restricted cash and restricted cash equivalents be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. Current GAAP does not include specific guidance on the cash flow classification and presentation of changes in restricted cash. The updated guidance is effective for interim and annual periods beginning after December 15, 2017 and is required to be applied using a retrospective transition method to each period presented. Early adoption is permitted, including adoption in an interim period. However, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. Implementing this guidance is not expected to have an impact on the Company’s statement of cash flows, as restricted cash, if any, is currently included in total cash and cash equivalents.
In February 2016, the FASB issued ASC Update No. 2016-02, (Topic 842) Leases. This ASC update requires a lessee to recognize a right-of-use asset, which represents the lessee’s right to use a specified asset for the lease term, and a corresponding lease liability, which represents a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis, for all leases that extend beyond 12 months. For finance or capital leases, interest on the lease liability will be recognized separately from amortization of the right-of-use asset in the statements of income and comprehensive income. In addition, the repayment of the principal portion of
Discontinued operations primarily consist of the Company’s discontinued accident and health business and its former life insurance businesses that were sold prior to 2009.
At December 31, 2017 and 2016, the portion of the discontinued accident and health business that was directly assumed had assets of $76.9 million and $57.6 million, respectively, consisting primarily of invested assets, and liabilities of $83.1 million and $49.3 million, respectively, consisting primarily of policy liabilities. At December 31, 2017 and 2016, the assets and liabilities of this business, as well as those of the reinsured portion of the accident and health business are classified as assets and liabilities of discontinued operations in the Consolidated Balance Sheets.
The Company’s former life insurance businesses include indemnity obligations and other activities for which it established reserves.
OTTI unrealized losses in the tables above represent OTTI recognized in accumulated other comprehensive income. This amount excludes net unrealized gains on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date of $11.5 million and $21.4 million as of December 31, 2017 and 2016, respectively.
The Company enters into various agreements that may require its fixed maturities to be held as collateral by others. At December 31, 2017 and 2016, fixed maturities with fair values of $225.7 million and $201.8 million, respectively, were held as collateral for the FHLBB collateralized borrowing program. See Note 6-“Debt and Credit Arrangements” for additional information related to the Company’s FHLBB program.
The following tables provide information about the Company’s fixed maturities and equity securities that were in an unrealized loss position at December 31, 2017 and 2016 including the length of time the securities have been in an unrealized loss position:
Beginning in 2018, upon the implementation of ASU No. 2016-01, all increases or decreases in fair value on equity securities will be reflected in net income as they occur, rather than other comprehensive income, eliminating the requirement to monitor these securities for OTTI. See also Note 1 - “Summary of Significant Accounting Policies, New Accounting Pronouncements”.
The Company’s mortgage participations and other mortgage loans were $365.8 million and $297.6 million at December 31, 2017 and 2016, respectively. Participating interests in commercial mortgage loans are originated and serviced by a third-party. For these investments, the Company shares, on a pro-rata basis, in all related cash flows of the underlying mortgages. Mortgage participations and other mortgage loans were comprised of the following property types and geographic locations.
At December 31, 2017, scheduled maturities of mortgage participations and other mortgage loans were as follows: due in 2020 - $25.0 million; 2021 - $49.1 million; 2022 - $26.7 million and thereafter - $265.0 million. There were no scheduled loan maturities in 2018 or 2019. Actual maturities could differ from contractual maturities because borrowers may have the right to prepay obligations with or without prepayment penalties and loans may be refinanced. During 2017, the Company did not refinance any loans based on terms that differed from current market rates.
The Company’s exposure to concentration of investments in a single investee that exceeded 10% of shareholders’ equity included securities of U.S. government-sponsored agencies and authorities, as well as mortgage participations with a highly rated single third party with a fair value of $356.8 million and $295.9 million, at December 31, 2017 and 2016, respectively.
Included in the net realized investment gains (losses) were OTTI of investment securities recognized in earnings totaling $5.9 million, $27.9 million and $26.8 million in 2017, 2016 and 2015, respectively.
For 2016, total OTTI was $21.2 million. Of this amount, $27.9 million was recognized in earnings including $6.7 million which was transferred from unrealized losses in AOCI. The $27.9 million of OTTI recognized in earnings was related primarily to $16.1 million of fixed maturity securities that the Company intended to sell, $8.8 million of credit impairments and $2.7 million of equities.
For 2015, total OTTI was $49.5 million. Of this amount, $26.8 million was recognized in earnings and the remaining $22.7 million was recorded as unrealized losses in AOCI. The $26.8 million of OTTI recognized in earnings was related to $16.0 million of credit impairments, $4.0 million of fixed maturity securities that the Company intended to sell and $6.8 million of equities.
Municipals - overall credit quality, including assessments of the level and variability of: sources of payment such as income, sales or property taxes, levies or user fees; credit support such as insurance; state or local economic and political base; natural resource availability; and susceptibility to natural or man-made catastrophic events such as hurricanes, earthquakes or acts of terrorism.
The Company holds privately placed fixed maturity securities and certain other fixed maturity securities that do not have an active market and for which the pricing service cannot provide fair values. The Company determines fair values for these securities using either matrix pricing utilizing the market approach or broker quotes. The Company will use observable market data as inputs into the fair value techniques, as discussed in the determination of Level 2 fair values, to the extent it is available, but is also required to use a certain amount of unobservable judgment due to the illiquid nature of the securities involved. Unobservable judgment reflected in the Company’s matrix model accounts for estimates of additional spread required by market participants for factors such as issue size, structural complexity, high bond coupon or other unique features. These matrix-priced securities are reported as Level 2 or Level 3, depending on the significance of the impact of unobservable judgment on the security’s value. Additionally, the Company may obtain non-binding broker quotes which are reported as Level 3.
Other investments primarily include mortgage participations, cost basis limited partnerships, and overseas trust funds required in connection with the Company’s Lloyd’s business. Fair values of mortgage participations are estimated by discounting the contractual cash flows using the rates at which similar loans would be made to borrowers with comparable credit ratings and are reported as Level 3. The fair values of cost basis limited partnerships are based on the net asset value provided by the general partner adjusted for recent financial information and are excluded from the fair value hierarchy. Fair values of overseas trust funds are provided by the investment manager based on quoted prices for similar instruments in active markets and are reported as Level 2.
The Company has processes designed to ensure that the values received from its third-party pricing service are accurately recorded, that the data inputs and valuation approaches and techniques utilized are appropriate and consistently applied, and that the assumptions are reasonable and consistent with the objective of determining fair value. The Company performs a review of the fair value hierarchy classifications and of prices received from its pricing service on a quarterly basis. The Company reviews the pricing services’ policies describing its methodology, processes, practices and inputs, including various financial models used to value securities. Also, the Company reviews the portfolio pricing, including a process for which securities with changes in prices that exceed a defined threshold are verified to independent sources, if available. If upon review, the Company is not satisfied with the validity of a given price, a pricing challenge would be submitted to the pricing service along with supporting documentation for its review. The Company does not adjust quotes or prices obtained from the pricing service unless the pricing service agrees with the Company’s challenge. During 2017 and 2016, the Company did not adjust any prices received from its pricing service.
Investments measured at fair value using net asset value based on an ownership interest in partners’ capital have not been included in the tables above. At December 31, 2017 and 2016, the fair values of these investments were $149.4 million and $94.1 million which are approximately 2% and 1% of total investment assets, respectively.
The following tables provide a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3).
In 2016, in addition to the redemption of the senior debentures maturing June 15, 2021 and March 1, 2020, the Company repurchased senior debentures maturing October 15, 2025, with a carrying value of $11.9 million at a cost of $14.1 million, resulting in a pre-tax loss of $2.2 million. In 2017, the Company did not repurchase any long-term debt instruments.
Provisions for income taxes have been calculated in accordance with the provisions of ASC 740. A summary of the components of income before income taxes and income tax expense in the Consolidated Statements of Income are shown below:
In prior years, the Company completed several transactions which resulted in the realization, for tax purposes only, of unrealized gains in its investment portfolio. As a result of these transactions, the Company was able to realize capital losses carried forward and to release the valuation allowance recorded against the deferred tax asset related to these losses. The releases of valuation allowances were recorded as a benefit in accumulated other comprehensive income. Previously unrealized benefits of $12.7 million, $20.7 million and $13.3 million attributable to non-operating income, are recognized as part of income from continuing operations during 2017, 2016 and 2015, respectively. The remaining amount of $44.8 million in accumulated other comprehensive income will be released into income from continuing operations in future years, as the investment securities subject to these transactions are sold or mature.
There are no tax positions at December 31, 2017, 2016 and 2015 for which the ultimate deductibility is highly certain, but for which there is uncertainty about the timing of such deductibility. Because of the impact of deferred tax accounting, other than interest and penalties, a change in the timing of deductions would not impact the annual effective tax rate.
The Company recognizes interest and penalties related to unrecognized tax benefits in federal income tax expense. The Company had accrued interest of $0.2 million as of December 31, 2017 and 2016. For the years ended December 31, 2016 and 2015 the Company recognized a release of interest of $0.4 million and expense of $0.1 million, respectively. The Company has not recognized any penalties associated with unrecognized tax benefits.
The Act modified the provisions applicable to the determination of the tax basis of unpaid loss reserves. These modifications impact the payment pattern and applicable interest rate. The Act instructed the Treasury Department to provide discount factors and other guidance necessary to determine the appropriate transition adjustment. This information has not been released; accordingly, we have applied the law existing prior to the enactment of the Act. These provisions would have no effect on the December 31, 2017 net deferred tax asset or income tax expense.
The Company recognizes the funded status of its defined benefit plans in its Consolidated Balance Sheets. The funded status is measured as the difference between the fair value of plan assets and the projected benefit obligation of the Company’s defined benefit plans. The Company is required to aggregate separately all overfunded plans from all underfunded plans.
As of January 1, 2005, the defined benefit pension plans were frozen and since that date, no further cash balance allocations have been credited to participants. Participants’ accounts are credited with interest daily, based upon the General Agreement of Trades and Tariffs rate (the 30-year Treasury Bond interest rate). In addition, the grandfathered benefits for the transition group were also frozen at January 1, 2005 levels with an annual transition pension adjustment calculated at an interest rate equal to 5% per year up to 35 years of completed service, and 3% thereafter. As of December 31, 2017, based on current estimates of plan liabilities and other assumptions, the projected benefit obligation of the qualified defined benefit pension plan exceeds plan assets by approximately $41 million.
Prior to 2002, the Chaucer segment provided defined benefit pension retirement benefits to certain of its employees. As of December 31, 2001, the defined benefit pension plan was closed to new members and as of December 31, 2016, the plan was no longer accruing for future salary increases. The defined benefit obligation for this plan is based on the employees’ years of service and final pensionable salary. Contributions are made to this plan by the Company in amounts and according to the timing determined as part of the plan’s triennial funding review. As of December 31, 2017, based on current estimates of plan liabilities and other assumptions, the projected benefit obligation of the qualified defined benefit pension plan exceeds plan assets by approximately $2 million.
The expected rates of return were determined by using historical mean returns for each asset class, adjusted for certain factors believed to have an impact on future returns. These returns are generally weighted to the plan’s actual asset allocation, and are net of administrative expenses. For the U.S. defined benefit plans, a decrease in the expected return on plan assets for 2017 to 5.00% reflects long-term expectations to remain generally consistent with 2016; however, pension administration costs are expected to increase slightly. For the Chaucer plan, the expected rate of return on plan assets was 4.80% and 5.45%, for the years ended December 31, 2017 and 2016, respectively. The decrease in expected returns reflects the overall market conditions and uncertainties globally, which is affecting all of the asset classes in the Chaucer plan. The Company reviews and updates, at least annually, its expected return on plan assets based on changes in the actual assets held by the plans and market conditions.
The Company utilizes a target allocation strategy, which focuses on creating a mix of assets that will generate modest growth from equity securities while minimizing volatility in the Company’s earnings from changes in the markets and economic environment. Various factors are taken into consideration in determining the appropriate asset mix, such as census data, actuarial valuation information and capital market assumptions. The Company reviews and updates, at least annually, the target allocation and makes changes periodically.
The following tables present, for each hierarchy level, the U.S. qualified defined benefit plan’s investment assets that are measured at fair value at December 31, 2017 and 2016. Refer to Note 5 - “Fair Value” for a description of the different levels in the Fair Value Hierarchy.
Securities classified as Level 1 at December 31, 2017 and 2016 include actively traded mutual funds and publicly traded securities, which are valued at quoted market prices. Securities classified as Level 3 at December 31, 2017 and 2016 include assets held in a fixed account of an insurance company. The fair value of the investment is estimated using a comparable public market financial institution derived fair value curve that uses non-observable inputs for market liquidity and unique credit characteristics of its underlying securities.
The table below provides a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3).
The following table reflects the benefit obligations, fair value of plan assets and funded status of the plans at December 31, 2017 and 2016.
Contributions include $0.2 million of Chaucer employee contributions during 2016. All other contributions for all plans were made by the Company.
The benefit payments are based on the same assumptions used to measure the Company’s benefit obligations at the end of 2017. Benefit payments related to the U.S. qualified plan and the Chaucer plan will be made from plan assets held in trusts and not included with Company assets, whereas those payments related to the non-qualified plans will be provided for by the Company. Expected benefits related to the Chaucer pension plan were converted to U.S. dollars at an exchange rate of 1.35.
Chaucer also provides a defined contribution plan for its employees that provides for employer provided contributions. The Company’s expense for 2017, 2016 and 2015 was $4.8 million, $3.9 million and $4.8 million, respectively.
beneficiaries of retired participants and to restrict eligibility to then current employees. In 2009, the Company changed the postretirement medical benefits, only as they relate to current employees who still qualified for participation in the plan under the above formula. For these participants, the plan provided for only post age 65 benefits. In 2015, the Company further amended the plan to only provide this benefit to those participants who retire before January 1, 2018, further limiting the number of current employees who were eligible to participate in this plan. The population of agents receiving postretirement benefits was frozen as of December 31, 2002, when the Company ceased its distribution of proprietary life and annuity products. This plan is unfunded.
Employers are required to measure the funded status of their plans as of the date of their year-end statement of financial position. As such, the Company has utilized a measurement date of December 31, 2017 and 2016, to determine its postretirement benefit obligations, consistent with the date of its Consolidated Balance Sheets. Weighted average discount rate assumptions used to determine postretirement benefit obligations and periodic postretirement costs are as follows:
The amount reclassified from accumulated other comprehensive income for the pension and postretirement benefits was allocated approximately 40% to loss adjustment expenses and 60% to other operating expenses for each of the years ended December 31, 2017, 2016 and 2015.
Additionally, on May 20, 2014, shareholders approved The Hanover Insurance Group 2014 Employee Stock Purchase Plan (the “ESPP Plan”) and the Chaucer Share Incentive Plan (the “SIP Plan”), authorizing the issuance of 2,500,000 and 750,000 shares, respectively, under such plans. As of December 31, 2017, 2,389,881 shares and 685,798 shares were available for grant under the ESPP Plan and the SIP Plan, respectively.
Under the 2014 Stock Plan, options may be granted to eligible employees, directors or consultants at an exercise price equal to the market price of the Company’s common stock on the date of grant. Option shares may be exercised subject to the terms prescribed by the Compensation Committee of the Board of Directors (the “Committee”) at the time of grant. Options granted in 2017, 2016 and 2015 generally vest over 3 years with 33 1/3% vesting in each year. Options must be exercised not later than ten years from the date of grant.
The fair value of shares that vested during the years ended December 31, 2017 and 2016 was $8.3 million and $26.8 million, respectively. As of December 31, 2017, the Company had unrecognized compensation expense of $3.4 million related to unvested stock options that is expected to be recognized over a weighted average period of 1.9 years.
In 2017, 2016 and 2015, the Company granted market-based awards totaling 56,571, 87,213, and 80,738, respectively, to certain members of senior management, which are included in the table above as performance and market-based restricted stock activity. The vesting of these stock units is based on the relative total shareholder return (“TSR”) of the Company. This metric is generally based on relative TSR for a three year period as compared to a group of Property and Casualty peer companies. The fair value of market based awards was estimated at the date of grant using a valuation model. These units have the potential to range from 0% to 150% of the shares disclosed. Included in the amount granted above in 2017 were 5,881 shares related to market-based awards that achieved a payout in excess of 100%.
The intrinsic value of restricted stock and restricted stock units that vested during the years ended December 31, 2017, 2016 and 2015 was $2.3 million, $5.4 million and $4.4 million, respectively. The intrinsic value for performance and market-based restricted stock units that vested in 2017, 2016 and 2015 was $0.6 million, $5.8 million and $2.6 million, respectively. Forfeitures included in the table above for 2017 include market-based awards of 53,840 and performance-based awards of 1,090. Forfeitures included in the table above for 2016 and 2015 related entirely to market-based restricted stock units.
Pursuant to New Hampshire’s statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the New Hampshire Insurance Commissioner, is limited to the lesser of 10% of such insurer’s statutory policyholder surplus as of the preceding December 31, or statutory net income less net realized gains. Hanover Insurance declared and paid dividends to its parent, totaling $296.8 million in 2017. This includes $80.0 million of extra ordinary dividends. In 2016, a $218.8 million ordinary dividend was declared and paid by Hanover Insurance and no dividends were declared by Hanover Insurance in 2015. Hanover Insurance cannot declare a further dividend to its parent without prior approval until May 2018, at which time the maximum dividend payable without prior approval would be $207.1 million.
Dividend payments from Chaucer to its parent are regulated by U.K. law. Dividends from Chaucer are dependent on dividends from its subsidiaries. Annual dividend payments from Chaucer are limited to retained earnings that are not restricted by capital and other requirements for business at Lloyd’s. Also, Chaucer must provide advance notice to the U.K.’s Prudential Regulation Authority (“PRA”) of certain proposed dividends or other payments from PRA regulated entities. No dividends were paid to THG by Chaucer entities in 2017. Dividend payments to THG from Chaucer entities totaled $79.5 million and $61.3 million in 2016 and 2015, respectively.
Long-lived assets located outside the U.S. were not material for the years ended December 31, 2017 or 2016. The Company does not have revenue from transactions with a single agent or broker amounting to 10 percent or more of its consolidated revenue.
Rental expenses for operating leases amounted to $18.1 million, $18.5 million and $17.4 million in 2017, 2016 and 2015, respectively. These expenses relate primarily to building leases of the Company. At December 31, 2017, future minimum rental payments under non-cancelable operating leases were $53.6 million, payable as follows: 2018 - $16.9 million; 2019 - $14.1 million; 2020 - $11.6 million; 2021 - $6.8 million and 2022 and thereafter - $4.2 million. It is expected that in the normal course of business, leases that expire may be renewed or replaced by leases on similar property and equipment.
In the normal course of business, the Company seeks to reduce the losses that may arise from catastrophes or other events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurance enterprises or reinsurers. Reinsurance transactions are accounted for in accordance with the provisions of ASC 944.
As a condition to conduct certain business in various states, the Company is required to participate in residual market mechanisms, facilities and pooling arrangements such as the Michigan Catastrophic Claims Association (“MCCA”). The Company is subject to concentration of risk with respect to reinsurance ceded to the MCCA. Funding for MCCA comes from assessments against automobile insurers based upon their share of insured automobiles in the state. Insurers are allowed to pass along this cost to Michigan automobile policyholders. The Company ceded to the MCCA premiums earned and losses and LAE incurred of $62.8 million and $81.4 million in 2017, $58.6 million and $75.0 million in 2016 and $67.7 million and $78.8 million in 2015. The MCCA represented 30.4% of the total reinsurance receivable balance at December 31, 2017. Reinsurance recoverables related to MCCA were $930.6 million and $911.2 million at December 31, 2017 and 2016, respectively. Because the MCCA is supported by assessments permitted by statute, and there have been no significant uncollectible balances from MCCA identified during the three years ending December 31, 2017, the Company believes that it has no significant exposure to uncollectible reinsurance balances from this entity. The Lloyd’s Syndicates total reinsurance receivable balance was $526.3 million as of December 31, 2017, as compared to $506.8 million as of December 31, 2016. The Lloyd’s receivable represented 17.2% of the total reinsurance receivable balance at December 31, 2017.
Carried reserves for each line of business and coverage are determined based on this quarterly loss reserving process. In making the determination, the Company considers numerous quantitative and qualitative factors. Quantitative factors include changes in reserve estimates in the period, the maturity of the accident year, trends observed over the recent past, the level of volatility within a particular class of business, the estimated effects of reinsurance, including reinstatement premiums, general economic trends, and other factors. Qualitative factors may include legal and regulatory developments, changes in claim handling and case reserving practices, recent entry into new markets or products, changes in underwriting practices, concerns that the Company does not have sufficient or quality historical reported and paid loss and LAE information with respect to a particular line or segment of business, effects of the economy and political outlook, perceived anomalies in the historical results, evolving trends or other factors.
The Company regularly updates its reserve estimates as new information becomes available and further events occur which may impact the resolution of unsettled claims. Reserve adjustments are reflected in results of operations as adjustments to losses and LAE. Often these adjustments are recognized in periods subsequent to the period in which the underlying policy was written and loss event occurred. These types of subsequent adjustments are described as “prior years’ loss reserves”. Such development can be either favorable or unfavorable to the Company’s financial results and may vary by line of business. In this section, all amounts presented include catastrophe losses and LAE, unless otherwise indicated.
As a result of continuing trends in the Company’s business, reserves including catastrophes have been re-estimated for all prior accident years and were decreased by $58.4 million in 2017, increased $105.4 million in 2016 and decreased $116.1 million in 2015.
In 2017, net favorable loss and LAE development was $58.4 million, primarily as a result of favorable development of $58.2 million for Chaucer. Chaucer’s favorable development during 2017 was primarily the result of lower than expected losses in the energy line of $31.7 million in accident years 2011 through 2016 and in the political line of $17.2 million in accident years 2013 through 2016. Within the treaty line, lower than expected losses of $22.9 million in the property lines primarily due to catastrophes in accident years 2015 and 2016 were partially offset by higher than expected losses of $17.8 million in the specialist liability lines primarily due to the U.S casualty business in accident years 2015 and 2016.
Chaucer’s favorable development was primarily the result of lower than expected losses in the treaty line of $47.1 million, primarily in accident years 2012 through 2014, in the energy line of $42.1 million, primarily in the 2012 through 2014 accident years, in the casualty line of $21.9 million, primarily in the 2008, 2011 and 2013 accident years and in the aviation and political lines of $21.1 million, primarily in the 2010, 2012 and 2013 accident years. Chaucer’s favorable development was also partially attributable to the favorable impact of foreign exchange rate movements on prior years’ loss reserves.
For the following net reserve components, commercial multiple peril, workers’ compensation, commercial automobile liability, general liability and umbrella - occurrence, general liability - claims made, personal automobile liability, homeowners and Chaucer core lines, the Company is presenting incurred claims development tables by accident year. The commercial multiple peril, workers’ compensation, commercial automobile liability and general liability and umbrella - occurrence lines presentation includes AIX program business. In each of these tables, the Company is presenting the number of years for which claims are typically outstanding, which is consistent with the period at which substantially all of the reserve development has emerged based on past history. The tables presented below include cumulative incurred loss and allocated loss adjustment expenses (“ALAE”), cumulative paid loss and ALAE and IBNR balances at December 31, 2017. IBNR includes both incurred but not reported liabilities and expected development on reported claims. In addition, cumulative incurred claim counts are presented as of December 31, 2017 and claim duration is presented in a separate table disclosing the average annual percentage payout of incurred claims by age, net of reinsurance. Claim duration is calculated as an average of paid loss and ALAE divided by incurred loss and ALAE by elapsed year. The incurred claims development tables presented are reconciled to the net carried reserves in the preceding table as of December 31, 2017.
The incurred and cumulative paid losses and ALAE, IBNR and incurred claim counts retroactively include AIX business for all periods presented, including those periods that pre-date the acquisition of AIX on November 30, 2008.
Chaucer incurred losses and ALAE and paid losses and ALAE that are denominated in foreign currencies are converted to U.S. dollars as of December 31, 2017, the most recent balance sheet date, for all years presented.
The following table is information about average historical claims duration as of December 31, 2017. The table is computed based on the paid and incurred claims data, net of reinsurance, for the accident years presented in the preceding claims development tables.
The plaintiff filed an Amended Complaint adding two new named plaintiffs and additional claims on December 11, 2009. Two of the three new claims set forth in the Amended Complaint were dismissed by the District Court, which action was upheld in November 2015 by the U.S. Court of Appeals, Sixth Circuit. The District Court, however, did allow to stand the portion of the Amended Complaint which set forth claims against the Company for breach of fiduciary duty and failure to meet notice requirements arising under the Employee Retirement Income Security Act of 1974 (“ERISA”) from the various interest crediting and lump sum distribution matters of which plaintiffs complain, but only as to plaintiffs’ “whipsaw” claim that remained in the case. On December 17, 2013, the Court entered an order certifying a class to bring “whipsaw” and related breach of fiduciary duty claims consisting of all persons who received a lump sum distribution between March 1, 1997 and December 31, 2003. The Company filed a summary judgment motion, prior to the decision on the appeal, that was based on the statute of limitations and seeks to dismiss the subclass of plaintiffs who received lump sum distributions prior to March 13, 2002. This summary judgment motion has been stayed pending additional discovery.
The Company is required to participate in residual markets in various states, which generally pertain to high risk insureds, disrupted markets or lines of business or geographic areas where rates are regarded as excessive. The results of the residual markets are not subject to the predictability associated with the Company’s own managed business, and are significant to both the personal and commercial automobile lines of business and the workers’ compensation line of business.
Per diluted share amounts in the fourth quarter exclude commons stock equivalents since the impact of these instruments was antidilutive.
In the fourth quarter of 2016, the Company recorded an adjustment to increase carried reserves for prior accident years by $174.1 million. The after-tax effect of this charge was to decrease diluted earnings per share from income from continuing operations in the quarter by $2.66. See also Note 17 - “Liabilities for Outstanding Claims, Losses and Loss Adjustment Expenses” for further information.