Net operating income from continuing operations decreased $346 million in 2005 as compared with 2004. This decrease in net operating income was primarily driven by increased unfavorable net prior year development of $437 million after-tax which includes the impact of significant commutations in 2005 and 2004, decreased earned premiums, and increased catastrophe impacts in 2005. Partially offsetting these impacts were increased net investment income, a $115 million after-tax benefit related to a federal income tax settlement and release of federal income tax reserves, and lower insurance acquisition and operating expenses.
Reserves and deferred acquisition costs for our long term care products are based on certain assumptions including morbidity, policy persistency and interest rates. The recoverability of deferred acquisition costs and the adequacy of the reserves are contingent on actual experience related to these key assumptions and other factors such as future health care cost trends. If actual experience differs from these assumptions, the deferred acquisition costs may not be fully recovered and the reserves may not be adequate, requiring us to add to reserves, or take unfavorable development. Therefore, our financial results could be adversely impacted.
Property and Casualty’s (P&C) field structure consists of 33 branch locations across the country organized into 4 regions. Each branch provides the marketing, underwriting and risk control expertise on the entire portfolio of products. The Centralized Processing Operation for small and middle-market customers, located in Maitland, Florida, handles policy processing and accounting, and also acts as a call center to optimize customer service. The claims structure consists of a centralized claim center designed to efficiently handle property damage and medical only claims and 18 claim office locations around the country handling the more complex claims. Also, Standard Lines provides total risk management services relating to claim and information services to the large commercial insurance marketplace, through a wholly-owned subsidiary, ClaimsPlus, Inc., a third party administrator.
Unfavorable net prior year development of $452 million was recorded in 2005, including $559 million of unfavorable claim and allocated claim adjustment expense reserve development and $107 million of favorable premium development. Unfavorable net prior year development of $18 million, including $115 million of unfavorable claim and allocated claim adjustment expense reserve development and $97 million of favorable premium development, was recorded in 2004. Further information on Standard Lines Net Prior Year Development for 2005 and 2004 is included in Note F of the Consolidated Financial Statements included under Item 8.
Warranty provides vehicle warranty service contracts that protect individuals and businesses from the financial burden associated with mechanical breakdown or maintenance.
Net realized investment results improved $143 million in 2005 compared with 2004. This improvement was primarily the result of a 2004 loss of $389 million on the sale of the individual life insurance business, partly offset by reduced gains for equities securities. Equity results in 2004 included a gain of $105 million related to our investment in Canary Wharf Group PLC, a London-based real estate company. Also impacting results for 2005 versus 2004 were decreased results in the overall fixed maturity asset class partly offset by improved results for the derivatives asset class. OTTI losses of $70 million were recorded in 2005 across various sectors, including an OTTI loss of $22 million related to loans made under a credit facility to a national contractor, that are classified as fixed maturities. OTTI losses of $60 million were recorded in 2004 across various sectors, including an OTTI loss of $36 million related to loans to the national contractor. For additional information on loans to the national contractor, see Note S of the Consolidated Financial Statements included under Item 8. Other realized investment gains (losses) for the year ended December 31, 2005 and 2004 include gains and losses related to the sales of certain operations or affiliates that are described in Note P of the Consolidated Financial Statements included under Item 8.
Claim and claim adjustment expense reserves are presented net of anticipated amounts due from insureds related to losses under high deductible policies of $2.5 billion and $2.8 billion as of December 31, 2006 and 2005. A portion of these amounts is supported by collateral. The Company also has an allowance for uncollectible deductible amounts, which is presented as a component of the allowance for doubtful accounts included in the Insurance receivables on the Consolidated Balance Sheets.
Investments in life settlement contracts and related revenue recognition: The Company has purchased investments in life settlement contracts. Under a life settlement contract, CNA obtains the rights of being the owner and beneficiary to an underlying life insurance policy. The carrying value of each contract at purchase and at the end of each reporting period is equal to the cash surrender value of the policy. Amounts paid to purchase these contracts that are in excess of the cash surrender value, at the date of purchase, were expensed immediately.
financial decisions of the investee company, but CNA’s interest in the investee does not require consolidation. CNA’s proportionate share of equity in net income of these unconsolidated affiliates is reported in other revenues.
All investments in derivatives are recorded at fair value. A derivative is typically defined as an instrument whose value is “derived” from an underlying instrument, index or rate, has a notional amount, requires little or no initial investment and can be net settled. Derivatives include, but are not limited to, the following types of financial instruments: interest rate swaps, interest rate caps and floors, put and call options, warrants, futures, forwards, commitments to purchase securities, credit default swaps and combinations of the foregoing. Derivatives embedded within non-derivative instruments (such as call options embedded in convertible bonds) must be separated from the host instrument when the embedded derivative is not clearly and closely related to the host instrument.
In November of 2005, the FASB issued FASB Staff Position (FSP) No. 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments (FSP 115-1), as applicable to debt and equity securities that are within the scope of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (SFAS 115) and equity securities that are accounted for using the cost method specified in Accounting Principles Board Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. FSP 115-1 nullified certain requirements of The Emerging Issues Task Force Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments (EITF 03-1), which provided guidance on determining whether an impairment is other-than-temporary. FSP 115-1 replaced guidance set forth in EITF 03-1 with references to existing other-than-temporary impairment guidance and clarified that an investor should recognize an impairment loss no later than when the impairment is deemed other-than-temporary, even if a decision to sell has not been made. FSP 115-1 carried forward the requirements in EITF 03-1 regarding required disclosures in the financial statements and requires additional disclosure related to factors considered in reaching the conclusion that the impairment is not other-than-temporary. In addition, in periods subsequent to the recognition of an other-than-temporary impairment loss for debt securities, the discount or reduced premium would be amortized over the remaining life of the security based on future estimated cash flows. FSP 115-1 was effective for reporting periods beginning after December 15, 2005 and was adopted by the Company as of January 1, 2006. Adoption of this standard increased income by approximately $3 million for the year ended December 31, 2006 related to the amortization of discount or reduced premium resulting from previously impaired securities. The Company has included the required additional disclosures in Note B.
A significant judgment in the valuation of investments is the determination of when an OTTI has occurred. The Company follows a consistent and systematic process for determining and recording an OTTI. The Company has established a committee responsible for the OTTI process. This committee, referred to as the Impairment Committee, is made up of three officers appointed by the Company’s Chief Financial Officer. The Impairment Committee is responsible for analyzing watch list securities on at least a quarterly basis. The watch list includes individual securities that fall below certain thresholds or that exhibit evidence of OTTI indicators including, but not limited to, a significant adverse change in the financial condition and near term prospects of the issuer or a significant adverse change in legal factors, the business climate or credit ratings.
their insureds. In September 2006, CCC entered into a settlement with plaintiffs and on November 15, 2006, the Circuit Court of Kanawha County dismissed plaintiffs’ claims against CCC. While no party filed an opposition to the settlement, the time for seeking leave to appeal that dismissal order to the West Virginia Supreme Court of Appeals has not yet expired. In the event the dismissal order is appealed to the West Virginia Supreme Court and the dismissal order is set aside, numerous factual and legal issues would determine the final result in Adams, the outcome of which cannot be predicted with any reliability. These issues include: (a) the legal sufficiency and factual validity of the novel statutory claims pled by the claimants; (b) the applicability of claimants’ legal theories to insurers who issued excess policies and/or neither defended nor controlled the defense of certain policyholders; (c) the possibility that certain of the claims are barred by various Statutes of Limitation; (d) the fact that the imposition of duties would interfere with the attorney-client privilege and the contractual rights and responsibilities of the parties to the Company’s insurance policies; (e) whether plaintiffs’ claims are barred in whole or in part by injunctions that have been issued by bankruptcy courts that are overseeing, or that have overseen, the bankruptcies of various insureds; (f) whether some or all of the named plaintiffs or members of the plaintiff class have released CCC from the claims alleged in the Amended Complaint when they resolved their underlying asbestos claims; (g) the appropriateness of the case for class action treatment; and (h) the potential and relative magnitude of liabilities of co-defendants. Accordingly, the extent of losses beyond any amounts that may be accrued are not readily determinable at this time.
Approximately $53 million of unfavorable net prior year claim and allocated claim adjustment expense reserve development was related to reviews of liquor liability, trucking and habitational business that indicated that the number of large claims was higher than previously expected in recent accident years. The remainder of the favorable net prior year claim and allocated claim adjustment expense reserve development was primarily a result of improved experience on several coverages on middle market business, mainly in accident year 2004.
Additionally, there was $19 million of unfavorable net prior year claim and allocated claim adjustment expense reserve development and $6 million of favorable premium development related to the corporate aggregate reinsurance treaties, excluding the impact of a corporate aggregate reinsurance commutation as discussed above.
During the fourth quarter of 2005, the Company executed significant commutation agreements with certain reinsurers, including the commutation of a corporate aggregate reinsurance agreement. These agreements resulted in approximately $62 million of unfavorable claim and allocated claim adjustment expense reserve development.
The Company noted adverse development in various pollution accounts in its most recent ground up review. In the course of its review, the Company did not observe a negative trend or deterioration in the underlying pollution claims environment. Rather, individual account estimates changed due to changes in liability and/or coverage circumstances particular to those accounts. As a result, the Company increased pollution reserves by $50 million in 2005.
Numerous unresolved factual and legal issues remain that are critical to the final result, the outcome of which cannot be predicted with any reliability. Accordingly, the extent of losses are not readily determinable at this time. However, based on facts and circumstances presently known in the opinion of management, an unfavorable outcome would not materially adversely affect the equity of the Company, although results of operations may be adversely affected.