· the risk that our investment portfolio suffers reduced returns or investment losses, which could reduce our profitability;
· risks related to our ability to consummate the Proposed Merger in a timely fashion, including the possibility of delays resulting from shareholder or regulatory approvals and other matters beyond our control and potentially adverse consequences, including announced rating agency downgrades, in the event the transaction is not consummated;
· efficiency of the Company’s operations and ability of management to control expenses; and
(See further discussion of asbestos reserves in the “Environmental and Asbestos Claims” section of this discussion).
The following two tables provide additional information regarding our venture capital investment holdings in an unrealized loss position at December 31, 2003 and 2002. The tables indicate the period of time the securities had been in an unrealized loss position and the amount of unrealized loss as a percentage of our investment in the holding.
The following table presents information regarding those fixed income investments, by remaining period to maturity date, that were in an unrealized loss position at December 31, 2003.
· whether or not we have the ability and intent to hold the security for a period of time sufficient to allow for recovery, enabling us to receive value equal to or greater than our cost.
· the dividend policy of the issuer at date of acquisition and date of evaluation;
· We also have certain remaining variable interests in Camperdown UK Limited, an entity that we sold in 2003. We utilized this entity as one of our corporate names and the vehicle for our participation at Lloyd’s for 2003 and prior years of account through a single syndicate (“Syndicate 5000”). Our variable interest results from an agreement to indemnify the purchaser in the event a specified reserve deficiency develops, a reserve-related foreign exchange impact occurs, or a foreign tax adjustment is imposed on a pre-sale reporting period. The maximum amount of this indemnification obligation is $203 million. In addition, in 2003 we entered into a 100% quota share reinsurance agreement with Syndicate 5000 that in effect transferred Syndicate 5000’s underwriting results for the 2003 year of account to us.
Reinsurance treaties. In 2001, we entered into two aggregate excess-of-loss reinsurance treaties. Under the terms of the reinsurance treaties, we transferred, or “ceded,” insurance losses and loss adjustment expenses to our reinsurers, along with the related written and earned premiums. One of these treaties was corporate-wide, with coverage triggered when our insurance losses and LAE across all lines of business reached a certain level, as prescribed by terms of the treaty. We did not cede any losses to the corporate treaty in 2001, but we recorded a $34 million net detriment in 2001 related to a similar treaty we were party to in 2000, primarily due to adjustments for cessions made in 2000. We did not enter into such a treaty in 2003 or 2002. Our reinsurance operation was party to a separate aggregate excess-of-loss treaty in 2002 and 2001. The results of our reinsurance operation in 2002 and 2001 included a $34 million detriment and a $159 million benefit, respectively, related to those treaties. The detriment in 2002 primarily resulted from the commutation of a portion of the 2001 treaty. We did not cede any losses to our reinsurance operations’ 2002 excess-of-loss treaty. The 2001 benefit resulted from losses ceded to the 2001 treaty.
In the fourth quarter of 2001, we revised certain actuarial assumptions based on the adverse trends observed in the prior three quarters. Average case reserve levels increased significantly due to our efforts to identify cases that could be expected to have a significant impact and manage them to closure more actively. Based on the evolving trends we had observed emerging in prior quarters, as well as escalating claim payments observed in the fourth quarter of 2001, we concluded that average payments were not only at a new sustained and higher level, but that they could also increase beyond those average payments, and/or at a rate faster than inflation. We thus concluded it was appropriate at that time to change the actuarial assumptions we had been using in our development pattern to consider higher loss severities and a faster rate of growth for losses. Specifically, during the fourth quarter of 2001, we adjusted our assumptions with respect to the expected ultimate incurred and paid losses at each 12-month period from the reported loss date. These assumptions increased the expected ultimate incurred loss from a 2% increase over our estimated incurred at 108 months following the reported date, to a 24% increase over estimated incurred at 12 months following the reported date. Similarly, we increased our expected ultimate paid loss assumption from a 3% increase over our paid losses at 108 months following the reported date to a 46% increase over our assumption of the paid losses at 12 months following the reported date. After careful analysis and determination of development patterns and the resulting revision of our actuarial assumptions described above, a charge to reserves of $540 million was determined to be necessary and was recorded during the fourth quarter of 2001.
FIXED INCOME SECURITIES-Our portfolio of fixed income investments is primarily composed of high-quality, intermediate-term taxable U.S. government, corporate and mortgage-backed bonds, and tax-exempt U.S. municipal bonds. We manage this portfolio conservatively, investing almost exclusively in investment-grade securities.
VENTURE CAPITAL-Venture capital comprised 2% of our property-liability invested assets (at cost) at the end of 2003. These private investments span a variety of industries but are concentrated in telecommunications, information technology, health care and consumer products. In 2003, we invested $134 million in this asset class, compared with $138 million in 2002. Our total return on average net venture capital investments (encompassing dividend income, realized gains and losses, and the change in unrealized appreciation) was 12.3% in 2003, (41.0%) in 2002 and (41.5%) in 2001. The positive return in 2003 was driven by net pretax realized investment gains of $51 million, the components of which are described in more detail below. Venture capital returns in 2002 and 2001 were negatively impacted by significant declines in the unrealized appreciation of our investments. Additionally in 2002, losses from investments sales and impairment write-downs were significant, as described in more detail below. The carrying value of the venture capital portfolio at year-end 2003 and 2002 included unrealized appreciation of $24 million and $4 million, respectively.
In the fourth quarter of 2003, we updated our detailed actuarial analysis for both asbestos and environmental reserves pertaining to our exposure from direct policyholders and relied more heavily on these analyses in determining the adequacy of our reserve provision for the remaining unreported losses. For non-workers’ compensation asbestos claims we supplemented this detailed analysis with an additional analysis to determine an estimate of reserves specifically for policyholders who have not as yet tendered their first asbestos claim. As a result of these studies we increased net asbestos reserves by $77 million ($44 million in our ongoing operations and $33 million in our runoff operations) and net environmental reserves by $14 million (all in our ongoing operations). In addition, reviews of assumed and non-domestic exposures caused us to increase net asbestos reserves by $13 million and reduce net environmental reserves by $1 million (all of which was recorded in our runoff operations).
The following table represents a reconciliation of total gross and net reserve development for asbestos claims for each of the years in the three-year period ended December 31, 2003. No policies have been underwritten to specifically include asbestos exposure.
Assets under management at the end of 2002 of $79.7 billion, were 16% higher than the year-end 2001 total of $68.5 billion. The NWQ acquisition accounted for approximately $7 billion of the increase, with the remainder due to strong net flows that more than offset equity market declines. Managed assets at the end of the year were comprised of $39.9 billion of exchange-traded funds, $19.4 billion of retail managed accounts, $8.5 billion of institutional managed accounts, and $11.9 billion of mutual funds.
· Common dividends. We declared common dividends totaling $264 million in 2003, $252 million in 2002 and $235 million in 2001. In February 2004, The St. Paul’s board of directors declared a quarterly dividend of $0.29 per share payable April 16, 2004, level with the 2003 quarterly rate.
Subsequent to these initial announcements, A.M. Best, S&P and Fitch announced the following:
Our pension plan measurement date for purposes of our consolidated financial statements is December 31. The market-related value of plan assets is determined based on their fair value at the measurement date. The projected benefit obligation is determined based on the present value of projected benefit distributions at an assumed discount rate. The discount rate used reflects the rate at which we believe the pension plan obligations could be effectively settled at the measurement date, as though the pension benefits of all plan participants were determined as of that date. At December 31, 2003 and 2002, the discount rates used to calculate our projected benefit obligation were 6.00% and 6.50%, respectively, for our consolidated pension plans, which encompass our U.S. plan (including Nuveen Investments’ plan), our Canada plan and our U.K. plans. For our U.S. plan, which constituted 94% of our consolidated pension plan assets at December 31, 2003, such rates were determined based on the Moody’s Investor Services AA Long-Term Industrial December Average Bond yield with a duration of approximately 11 to 13 years (which correlates to the expected duration of our pension obligations), rounded up to the nearest quarter percent.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of The St. Paul Companies, Inc. and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.
Because many of the coverages we offer involve claims that may not ultimately be settled for many years after they are incurred, subjective judgments as to our ultimate exposure to losses are an integral and necessary component of our loss reserving process. We record our reserves by considering a range of estimates bounded by a high and low point. Within that range, we record management’s best estimate. We continually review our reserves, using a variety of statistical and actuarial techniques to analyze current claim costs, frequency and severity data, and prevailing economic, social and legal factors. We adjust reserves established in prior years as loss experience develops and new information becomes available. Adjustments to previously estimated reserves are reflected in our financial results in the periods in which the changes in estimate are made.
Nuveen Investments repurchased and retired 1.7 million and 5.7 million of its common shares from minority shareholders in 2003 and 2002, respectively, for a total cost of $42 million in 2003 and $151 million in 2002. No shares were repurchased from The St. Paul in those years. Our percentage ownership remained at 79% in 2003 as the effect of Nuveen Investments’ repurchases were partially offset by Nuveen
We capitalize certain internally developed software costs incurred during the application development stage of a project. These costs include external direct costs associated with the project and payroll and related costs for employees who devote time to the project. We begin to amortize costs once the software is ready for its intended use, and amortize them over the software’s expected useful life, generally five years.
In 2003, Nuveen Investments entered into a series of interest rate swap transactions as hedges against changes in a portion of the fair value of private placement debt. All of the interest rate swap transactions were designated as fair value hedges to mitigate the changes in fair value of the hedged portion of the private placement debt. Certain of these interest rate swap transactions were terminated. The cancellation of these interest rate swap transactions resulted in a total gain of approximately $4 million, which will be amortized over the term of the private placement debt. At December 31, 2003, the remaining open interest rate swap transaction had a notional amount of $50 million and had a fair value of less than $100,000.
With regard to commercial surety bonds issued on behalf of companies operating in the energy trading sector, our aggregate pretax exposure, net of facultative reinsurance, is with five companies for a total of approximately $367 million ($305 million of which is from gas supply bonds), an amount that will decline over the contract periods. The largest individual exposure approximates $181 million (pretax). These companies all continue to perform their bonded obligations and, therefore, no claims have been filed.
71¤8% Senior Notes-The 71¤8% senior notes mature on June 1, 2005.
Postretirement Benefits Other Than Pensions-We provide certain health care and life insurance benefits for retired employees (and their eligible dependents), who are in the traditional formula. We currently anticipate that most covered employees will become eligible for these benefits if they retire while working for us. The cost of these benefits is shared with the retiree. The benefits are generally provided through our employee benefit trust, to which periodic contributions are made to cover benefits paid during the year. We accrue postretirement benefits expense during the period of the employee’s service.
The following table provides the components of our net periodic benefit cost for the years 2003, 2002 and 2001.
All outstanding unvested options granted in 2003 and prior under our U.S. plans will immediately vest upon consummation of the Proposed Merger, which constitutes a Change in Control as defined by those plans.
the aggregate amount of our quantifiable indemnification obligations in effect for sales of business entities was $2.2 billion, with a deductible amount of $72 million. The deductible amount represents an aggregate minimum threshold which our obligations must exceed before we would be obligated to make any payments.
In addition, we have agreed to provide indemnification to third party purchasers for certain losses associated with sold business entities that are not limited by a contractual monetary amount. As of December 31, 2003, we had outstanding unlimited indemnification obligations in connection with the sales of certain of our business entities for tax liabilities arising prior to a purchaser’s ownership of an entity, losses arising out of employee matters relating to acts or omissions of such business entity or us prior to the closing, losses resulting out of such sold business entities being deemed part of The St. Paul group prior to their respective sales to third parties for purposes of Internal Revenue Code Section 412 or Title IV of ERISA, and in some cases losses arising from certain litigation and undisclosed liabilities. These indemnification obligations survive until the applicable statutes of limitation expire, or until the agreed upon contract terms expire.
Under the quota share reinsurance agreements with Platinum, we ceded the following amounts to Platinum in 2003.
At December 31, 2003, our estimated intangible asset amortization expense for the next five years was as follows.