· Income from continuing operations and net income of $4.21 billion, or $6.12 per share basic and $5.91 diluted
The Company provides a wide range of property and casualty insurance products and services to businesses, government units, associations and individuals, primarily in the United States and in selected International markets.
(a) Adjusted for the impact of unrealized investment gains and losses, receivables for investment sales and payables on investment purchases. Reduced for payables for securities lending in 2004. (There were no such payables at December 31, 2006 or 2005).
Claims and claim adjustment expenses of $14.93 billion in 2005 were $512 million lower than the 2004 total of $15.44 billion. The 2005 total included $2.03 billion of catastrophe losses, compared with $761 million of such losses in 2004. The cost of catastrophes is discussed in more detail in the following narrative. The 2005 total also included $325 million of net unfavorable prior year reserve development, as described above, compared with $2.39 billion of net unfavorable prior year reserve development in 2004. Claims and claim adjustment expenses in 2005 also reflected improvement in current accident year non-catastrophe related loss experience as compared with 2004.
The 2004 net unfavorable prior year reserve development of $2.39 billion included a $928 million charge to increase asbestos reserves and a $290 million charge to increase environmental reserves.
Other 2004 Claims and Expenses. Other items increasing the 2004 claims and expenses included $296 million of charges to increase the allowances for estimated uncollectible amounts due from reinsurance recoverables, policyholders receivables, and co-surety participations on a specific construction contractor claim. The increase in the allowance for uncollectible reinsurance recoverables recognized a change in estimated disputes with reinsurers and is based upon the Company’s reinsurance strategy of reduced reinsurance utilization, including the cessation of ongoing business relationships with certain of SPC’s reinsurers, and aggressive collection of reinsurance recoverables. A charge was also recorded to increase the estimated uncollectible amounts due from policyholders for loss sensitive business (primarily high deductible business). This increase recognized a change in estimated uncollectible amounts due and resulted from applying the Company’s credit based methodology for determining uncollectible amounts to the recoverables acquired in the merger. Because reinsurance recoverables and amounts due from policyholders for loss sensitive business are insurance contract-related assets, these assets are subject to the same types of estimation variables as loss reserves.
National Accounts. Net written premiums in 2006 declined by $95 million, or 8%, from 2005, primarily reflecting a reduction in premiums related to favorable loss experience on business priced on a loss-sensitive basis and lower new business volume, partially offset by the decline in ceded premiums at Discover Re due to a change in the structure of reinsurance coverage. In 2005, net written premiums grew $190 million, or 18%, over 2004, reflecting the impact of the merger and changes in Discover Re’s reinsurance program.
Claims and claims adjustment expenses in 2006 totaled $1.79 billion, compared with $1.82 billion during the same period of 2005. The 2006 total included no catastrophe losses and $14 million of net favorable prior year reserve development, whereas the 2005 total included $158 million of catastrophe losses and $72 million of net favorable prior year reserve development. Net favorable prior year reserve development in 2005 was attributable to the better than anticipated favorable impact from changes in underwriting and pricing strategies for International property-related exposures.
Contributing to the decline in written premiums was the sale of certain credit-related personal lines classes of business previously written at Lloyd’s in 2005. The decline was partially offset by the elimination of the reporting lag at Lloyd’s and premium growth in Bond & Financial Products. In 2005, approximately $114 million of gross written premiums previously written in the Company’s Gulf operation (included in the Business Insurance segment) were written in Bond & Financial Products, compared with $90 million of gross written premiums in 2004.
The Company continues to be involved in coverage litigation concerning a number of policyholders, some of whom have filed for bankruptcy, including, among others, ACandS, Inc., who in some instances have asserted that all or a portion of their asbestos-related claims are not subject to aggregate limits on coverage. (See “Part I-Item 3, Legal Proceedings”). In these instances, policyholders also may assert that each individual bodily injury claim should be treated as a separate occurrence under the policy. It is difficult to predict whether these policyholders will be successful on both issues. To the extent both issues are resolved in policyholders’ favor and other Company defenses are not successful, the Company’s coverage obligations under the policies at issue would be materially increased and bounded only by the applicable per-occurrence limits and the number of asbestos bodily injury claims against the policyholders.
significantly and are dependent upon a number of factors. These factors include, but are not limited to, the cooperation of the policyholder in providing claim information, the pace of underlying litigation or claim processes, the pace of coverage litigation between the policyholder and the Company and the willingness of the policyholder and the Company to negotiate, if appropriate, a resolution of any dispute pertaining to these claims. Because these factors vary from claim-to-claim and policyholder-by-policyholder, the Company cannot provide a meaningful average of the duration of an environmental claim. However, based upon the Company’s experience in resolving these claims, the duration may vary from months to several years.
· $4 million in the equity portfolio when it became apparent that the cost basis of those securities would not be recovered over the expected holding period.
The following presents the Company’s top five reinsurer groups, by reinsurance recoverables at December 31, 2006 (in millions):
In recent years, the state insurance regulatory framework has come under increased federal scrutiny, and some state legislatures have considered or enacted laws that may alter or increase state authority to regulate insurance companies and insurance holding companies. Further, the National Association of Insurance Commissioners (NAIC) and state insurance regulators continually reexamine existing laws and regulations, specifically focusing on modifications to holding company regulations, interpretations of existing laws and the development of new laws and regulations. In addition, Congress and some federal agencies from time to time investigate the current condition of insurance regulation in the United States to determine whether to impose federal or national regulation or to allow an optional federal charter, similar to the option available to most banks. We cannot predict with certainty the effect any proposed or future legislation or NAIC initiatives may have on the conduct of our business. Insurance laws or regulations that are adopted or amended may be more restrictive than current requirements or may result in higher costs. Although the United States federal government does not directly regulate the insurance business, changes in federal legislation, regulation and/or administrative policies in several areas, including changes in financial services regulation (e.g. the repeal of the McCarran-Ferguson Act) and federal taxation, can significantly harm the insurance industry, including us.
The primary goals of the Company’s asset liability management process are to satisfy the insurance liabilities, manage the interest rate risk embedded in those insurance liabilities, and maintain sufficient liquidity to cover fluctuations in projected liability cash flows. Generally, the expected principal and
Recoverables attributable to structured settlements relate primarily to personal injury claims, for which the Company has purchased annuities and remains contingently liable in the event of a default by the companies issuing the annuities. Recoverables attributable to mandatory pools and associations relate primarily to workers’ compensation service business and have the obligation of the participating insurance companies on a joint and several basis supporting these cessions.
Certain venture capital investments that are controlled by the Company are consolidated in the Company’s financial statements. The underlying investments of these venture capital investments are reported at estimated fair value. The fair value of the venture capital investments is based on an estimate determined by the external fund manager and reviewed by the Company for investments in which there is no public market. The external fund manager reviews such factors as recent filings, operating results, balance sheet stability, growth, and other business and market sector fundamental statistics in estimating fair values of specific investments.
Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R)
In September 2006, the staff of the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108), as an interpretation by the SEC staff of the process of quantifying financial statement misstatements for purposes of determining whether a misstatement is material. SAB 108 was issued to address diversity in practice used by registrants in quantifying financial statement misstatements, and the potential under the current practice for the build up of improper amounts on the balance sheet. SAB 108 requires registrants to quantify the impact of correcting all misstatements, including both the carryover and reversing effects of prior year statements, on the current year financial statements (i.e., the income statement and the balance sheet). Staff Accounting Bulletin No. 99, Materiality, which requires that both qualitative and quantitative factors be evaluated in determining whether a misstatement is material to the financial statements, is not affected by the issuance of SAB 108.
The Company’s real estate investments include warehouses, office buildings and other commercial land and properties that are directly owned. Real estate properties are carried at cost less accumulated depreciation. Buildings are depreciated on a straight-line basis over the shorter of the expected useful life of the building or 39 years. Accumulated depreciation on real estate held for investment purposes was $82 million and $48 million at December 31, 2006 and 2005, respectively. Real estate held for sale is carried at the lower of cost or fair value less estimated costs to sell.
undiscounted cash flows are less than the carrying value of the real estate property. The impairment loss is measured as the amount by which the carrying amount exceeds fair value.
Investment income from fixed maturities and mortgage loans is recognized based on the constant effective yield method including estimated principal repayments, if any. The effective yield used to determine amortization for fixed maturities subject to prepayment risk (e.g., asset-backed, loan-backed and structured securities) is recalculated and adjusted periodically based upon actual historical and/or projected future cash flows, which are obtained from a widely-accepted securities data provider. The adjustments to the yield for highly rated prepayable fixed maturities are accounted for using the retrospective method. The adjustments to the yield for non-highly rated prepayable fixed maturities are accounted for using the prospective method. Dividends on equity securities are recognized in income when declared. Rental income on real estate is recognized on a straight-line basis over the lease term. See note 3 for further discussion. Undistributed income for equity method investments is reported in net investment income.
Derivatives that do not qualify for hedge accounting are carried at fair value with the changes in fair value reflected in the consolidated statement of income in net realized investment gains (losses).
The company is organized into three reportable business segments: Business Insurance; Financial, Professional & International Insurance; and Personal Insurance. The accounting policies used to generate the following segment data are the same as those described in the Summary of Significant Accounting Policies in note 1. The amount of investments in equity method investees and total expenditures for additions to long-lived assets other than financial instruments were not material.
(1) The primary components of other assets in 2006 were accrued over-funded benefit plan assets and deferred taxes, and in 2005 were invested assets, prepaid pension costs and deferred taxes. Beginning in 2006, the Company allocated a higher percentage of invested assets held at the parent company to its reportable business segments to be consistent with the manner in which management reviews segment results.
Revenues from internal customers for the years ended December 31, 2006, 2005 and 2004 were not material. Foreign assets at December 31, 2006 and 2005 also were not significant. The Company does not have revenue from transactions with a single customer amounting to 10 percent or more of its revenues.
At December 31, 2006 and 2005, the Company’s insurance subsidiaries had $4.44 billion and $4.00 billion, respectively, of securities on deposit at financial institutions in certain states pursuant to the respective states’ insurance regulatory requirements.
Other. Other Investments also include private equity limited partnerships, joint ventures, other limited partnerships, mortgage loans and trading securities.
On November 26, 2002, the Terrorism Risk Insurance Act of 2002 (the Terrorism Act) was enacted into Federal law and established the Terrorism Risk Insurance Program (the Program), a temporary Federal program in the Department of the Treasury, that provided for a system of shared public and private compensation for insured losses resulting from acts of terrorism or war committed by or on behalf of a foreign interest. The Program was scheduled to terminate on December 31, 2005. In December 2005, the Terrorism Risk Insurance Extension Act of 2005 (the Terrorism Extension Act) was enacted into Federal law, reauthorizing the Program through December 31, 2007, while reducing the Federal role under the Program.
There are also risks which impact the estimation of ultimate costs for catastrophes. For example, the estimation of reserves related to hurricanes can be affected by the inability by the Company and its insureds to access portions of the impacted areas, the complexity of factors contributing to the losses, the legal and regulatory uncertainties and the nature of the information available to establish the reserves. Complex factors include, but are not limited to: determining whether damage was caused by flooding versus wind; evaluating general liability and pollution exposures; estimating additional living expenses; the impact of demand surge; infrastructure disruption; fraud; the effect of mold damage and business interruption costs; and reinsurance collectibility. The timing of a catastrophe’s occurrence, such as at or near the end of a reporting period, can also affect the information available to us in estimating reserves for that reporting period. The estimates related to catastrophes are adjusted as actual claims emerge.
Medium-Term Notes-The medium-term notes outstanding at December 31, 2006 bear interest rates ranging from 6.38% to 7.42%, with a weighted average rate of 6.71%. Maturity dates on remaining notes outstanding at December 31, 2006 range from 2007 to 2010. During 2006 and 2005, medium-term notes having a par value of $56 million and $99 million, respectively, matured.
The fair value of each option award is estimated on the date of grant by application of a variation of the Black-Scholes option pricing model using the assumptions noted in the following table. The expected term of newly granted stock options is the time to vest plus half the remaining time to expiration. This considers the vesting restriction and represents an even pattern of exercise behavior over the remaining term. Reload options are exercisable for the remaining term of the original option and therefore would