Chaucer deploys specialist underwriters in over 30 major insurance and reinsurance classes, including energy, marine and aviation, U.K. motor, property, and casualty and other coverages. We obtain business through Lloyd’s, the leading international insurance and reinsurance market, which provides us with access to specialist business in over 200 countries and territories worldwide through its international licenses, brand reputation and strong security rating. Our underwriting strength, diverse portfolio and Lloyd’s membership underpin our ability to actively manage the scale, composition and profitable development of this business.
unfavorable development on prior years’ loss reserves. Catastrophe related losses for the year ended December 31, 2013 were $38.7 million, compared to $193.4 million for the year ended December 31, 2012, a decrease of $154.7 million. Catastrophe losses in 2012 included $124.8 million of pre-tax losses related to Superstorm Sandy. Unfavorable development on prior years’ loss reserves for the year ended December 31, 2013 was $3.3 million, compared to unfavorable development of $29.0 million for the year ended December 31, 2012, a decrease of $25.7 million.
Other operating loss was $8.0 million for the year ended December 31, 2013, compared to $6.9 million for the year ended December 31, 2012. The $1.1 million increased loss is primarily due to higher employee retirement costs.
We regularly review our reserving techniques, our overall reserving position and our reinsurance. Based on (i) our review of historical data, legislative enactments, judicial decisions, legal developments in impositions of damages and policy coverage, political attitudes and trends in general economic conditions, (ii) our review of per claim information, (iii) our historical loss experience and that of the industry, (iv) the nature of policies written by us, and (v) our internal estimates of required reserves, we believe that adequate provision has been made for loss reserves. However, establishment of appropriate reserves is an inherently uncertain process and there can be no certainty that current established reserves will prove adequate in light of subsequent actual experience. A significant change to the estimated reserves could have a material impact on our results of operations and financial position. An increase or decrease in reserve estimates would result in a corresponding decrease or increase in financial results. For example, each one percentage point change in the aggregate loss and LAE ratio resulting from a change in reserve estimation is currently projected to have an approximate $45 million impact on operating income, based on 2013 full year premiums.
The following discussion presents disclosure related to possible variation in net reserve estimates due to changes in key assumptions. This information is provided for illustrative purposes only. Many other assumptions may also lead to material reserve adjustments. If any such variations do occur, they would likely occur over a period of several years and therefore their impact on our results of operations would be recognized during the same period. It is important to note, however, that there is the potential for future variations greater than the amounts described below and for any such variations to be recognized in a single quarterly or annual period. No consideration has been given to potential correlation or lack of correlation among key assumptions or among lines of business and coverage as described below. As a result and because there are so many other factors which affect our net reserve estimate, it would be inappropriate to take the amounts described below and simply add them together in an attempt to estimate volatility in total. While we believe these are reasonably likely scenarios, the reader should not consider the following sensitivity analysis as illustrative of a reserve range.
Loss and LAE reserves for claims occurring in prior years developed favorably by $76.3 million, $15.8 million and $103.3 million during the years ended December 31, 2013, 2012 and 2011, respectively. The 2013 activity by segment includes favorable development of $94.6 million for Chaucer, partially offset by unfavorable development of $18.3 million in our domestic operations, consisting of $3.3 million, $13.7 million and $1.3 million for Commercial Lines, Personal Lines and Other, respectively. The 2012 activity by segment includes favorable development of $72.6 million for Chaucer, partially offset by unfavorable development of $56.8 million in our domestic operations, consisting of $29.0 million, $26.5 million and $1.3 million for Commercial Lines, Personal Lines and Other, respectively.
Our European fixed maturity credit exposure at December 31, 2013 was as follows:
While the United States is beginning to reduce its extraordinary measures, other major central banks, such as the Bank of England, the European Central Bank and the Bank of Japan, continue with their stimulus policies as they seek higher growth, and in the case of the latter two, fight deflation. 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, increasing the probability of future defaults. While we may experience defaults on fixed income securities, particularly with respect to non-investment grade 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 cash used in investing activities was $358.7 million during 2013, as compared to $562.8 million in 2012 and net cash provided by investing activities of $182.8 million in 2011. During 2013, cash used was primarily related to net purchases of fixed maturities and equity securities. During 2012, cash used was primarily related to net purchases of fixed maturities as we invested cash from Chaucer and net investments in equity securities. Cash used to purchase investments was partially offset by cash received from the sale of a building. See Note 3 - “Investments” in the Notes to Consolidated Financial Statements included in Financial Statements and
In November 2013, we entered into a $200.0 million credit agreement which expires in November 2018, with an option to increase the facility to $300.0 million assuming no default and satisfaction of certain other conditions. Borrowings, if any, under the agreement are unsecured and incur interest at a rate per annum equal to, the higher of (a) the prime commercial lending rate of the administrative agent, (b) the Federal Funds Rate plus half of a percent, or (c) the one month Adjusted LIBOR plus one percent and any applicable margin. The agreement contains financial covenants substantially similar to those in our prior credit agreement including, but not limited to, maintaining at least a certain level of consolidated equity, maximum consolidated leverage ratios and requires certain of our subsidiaries to maintain a minimum RBC ratio. This agreement replaces the previous committed syndicated credit agreement entered in August 2011 for $200.0 million, which was set to expire in August 2015. Both the current and the terminated agreement also include a $50 million sub-facility for standby letters of credit that can be used for general corporate purposes. We had no borrowings under either of the agreements in 2012 and 2013.
Reinsurance - An arrangement in which an insurance company, or a reinsurance company, known as the reinsurer, agrees to indemnify another insurance or reinsurance company, known as the ceding company, against all or a portion of the insurance or reinsurance risks underwritten by the ceding company under one or more policies. Reinsurance can provide a ceding company with several benefits, including a reduction in net liability on risks and catastrophe protection from large or multiple losses. Reinsurance does not legally discharge the primary insurer from its liability with respect to its obligations to the insured.
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 plc (“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 acquisition of Chaucer on July 1, 2011, which has added meaningful business volumes to THG results, has affected the comparability of the consolidated financial statements and related footnotes for the years ended December 31, 2013, 2012 and 2011. Results of operations for the years ended December 31, 2013 and 2012 include results from all of the Company’s business segments, while results of operations for the year ended December 31, 2011 include Chaucer’s results for only the period from July 1, 2011 through December 31, 2011. Additionally, the consolidated financial statements include the Company’s discontinued operations, consisting primarily of the Company’s former life insurance businesses, its accident and health business and prior to April 30, 2012, its third party administration business. All intercompany accounts and transactions have been eliminated. During 2013, the Company increased additional paid-in capital and decreased retained earnings by $34 million to correct the classification of amounts relating to stock-based compensation in prior periods. This reclassification within shareholders’ equity had no impact on net income, assets, liabilities or total shareholders’ equity of the Company for the current or any prior period.
The Company is required to classify its investments into one of three categories: held-to-maturity, available-for-sale or trading. It determines the appropriate classification of fixed maturity and equity securities at the time of purchase and re-evaluates such designation as of each balance sheet date.
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 is 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 2013 and 2012 with no impairments recognized.
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, 2013, 2012 and 2011 from GBP to U.S. dollars using a conversion rate of 1.66, 1.63 and 1.55, respectively. The Company recognized approximately $4.2 million and $6.3 million in foreign currency transaction gains in the Statement of Income during the years ended December 31, 2013 and 2012, respectively. During the six months ended December 31, 2011, the Company recognized $5.1 million of foreign exchange transaction gains including the $6.4 million gain recognized on the foreign currency forward contract associated with the purchase price of Chaucer. See Note 2 - “Acquisitions and Discontinued Operations” for further information.
In accordance with Lloyd’s operating guidelines, the Company deposits funds at Lloyd’s to support underwriting operations. These funds are available only to fund claim obligations. At December 31, 2013 and 2012, fixed maturities with a fair value of approximately $334 million and $497 million, respectively, and cash of $1 million and $3 million, respectively, were on deposit with Lloyd’s.
The following table provides 2013 target allocations and actual invested asset allocations for 2013 and 2012.
The benefit payments are based on the same assumptions used to measure the Company’s benefit obligations at the end of 2013. Benefit payments related to the U.S. qualified plans and the Chaucer plan will be made from plan assets, whereas those payments related to the non-qualified plans will be provided for by the Company.
In addition to the Company’s pension plans, the Company also has postretirement medical benefits that it provides to former agents and retirees and their dependents, and a limited number of full-time employees. The medical plans provide benefits including hospital and major medical, with certain limits, and have varying co-payments and deductibles, depending on the plan. Generally, employees who were actively employed on December 31, 1995 became eligible with at least 15 years of service after the age of 40. Effective January 1, 1996, the Company revised these benefits so as to establish limits on future benefit payments to 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 now provides for only post age 65 benefits. 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, 2013 and 2012, 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:
Cash received for options exercised for the years ended December 31, 2013, 2012 and 2011 was $24.4 million, $2.3 million and $3.9 million, respectively. The intrinsic value of options exercised for the years ended December 31, 2013, 2012 and 2011 was $19.9 million, $1.2 million and $1.8 million, respectively.
Diluted earnings per share during 2013, 2012 and 2011 excludes 0.1 million, 1.8 million and 1.6 million, respectively, of common shares issuable under the Company’s stock compensation plans, because their effect would be antidilutive.
(1) Assumed reinsurance activity primarily relates to the Chaucer segment. In addition, 2011 assumed premiums earned and assumed losses and LAE included $96.0 million and $54.2 million, respectively, related to the 2010 OneBeacon renewal rights transaction.