Our property and casualty group’s earnings increased in 2006 as compared to the prior year due primarily to improved catastrophe losses in both Commercial Lines and Personal Lines. Catastrophe losses were unusually high in 2005 primarily due to Hurricane Katrina. The improved earnings also resulted from increased favorable development of prior years’ reserves and improved current accident year results, primarily in Commercial Lines. Partially offsetting these improved earnings was an increase in underwriting and loss adjustment expenses. Over the past several years, we have made significant investments and increased expenses in order to, among other things, strengthen our product offerings and service capabilities, improve technology and our operating models, build expertise in our personnel and expand our distribution capabilities. The ability to achieve profitable premium growth in 2007 and later years in order to earn adequate returns on such investments and expenses, and to grow further without proportionate increases in expenses, is key to our current strategy.
Commercial Lines’ segment income decreased $93.0 million to a loss of $35.0 million for the year ended December 31, 2005, compared to income of $58.0 million in 2004, primarily due to Hurricane Katrina, and to a lesser extent, Hurricane Rita. The decrease in segment income was partially offset by more favorable development of prior years’ reserves and an increase in underwriting profit, excluding prior year reserve development and catastrophes.
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 $22 million impact on property and casualty segment income, based on 2006 full year premiums.
We perform actuarial reviews on certain detailed line of business coverages. These individual estimates are summarized into six broader lines of business: personal automobile, homeowners, workers’ compensation, commercial automobile, commercial multiple peril and other personal and commercial lines.
Estimated loss reserves for claims occurring in prior years developed favorably by $118.1 million and $65.7 million during 2006 and 2005, respectively, while loss reserves for prior years developed unfavorably by $1.3 million during 2004. The favorable loss reserve development during the year ended December 31, 2006 is primarily the result of lower bodily injury claim frequency in the personal automobile line, primarily in the 2005 and 2004 accident years, and lower severity in the workers’ compensation line, primarily in the 2004 and 2003 accident years. In addition, lower frequency of liability claims in the commercial multiple peril line for the 2003, 2004 and 2005 accident years and lower frequency of bodily injury claims in the commercial automobile line, primarily in the 2004 and 2005 accident years, contributed to the favorable loss development.
The following table summarizes the results of operations for the periods indicated related to the Discontinued Operations segment, primarily consisting of the AFLIAC variable life insurance and annuity business. This business was sold as of December 31, 2005; therefore, there were no earnings during 2006 and we do not expect future results related to the operations of this business. However, as discussed in “Loss on Sale of AFLIAC Variable Life Insurance and Annuity Business” below, we have made certain contractual indemnities to Goldman Sachs relating to the pre-sale activities of the business sold.
As a result of an increase in the actual return on assets in 2006, as well as demographic participant changes and a slight increase in the 2006 year-end discount rate, we expect our pre-tax pension expense to decrease by approximately $18 million in 2007 from an expense of $12.9 million in 2006 to a benefit of $4.6 million in 2007.
The total adjusted statutory capital position of Hanover Insurance improved during 2006, from $1.2 billion at December 31, 2005 to $1.5 billion at December 31, 2006. This increase is primarily due to improved underwriting results in our property and casualty business, as well as a benefit resulting from a decrease in the additional minimum pension liability associated primarily with our qualified defined benefit pension plan. The total adjusted statutory capital position of FAFLIC declined during 2006, from $195.2 million at December 31, 2005 to $179.9 million at December 31, 2006. The decrease in statutory surplus primarily resulted from the $40.0 million dividend declared to the holding company in December 2006 and from losses incurred as a result of an agreement to provide transition services to Goldman Sachs in connection with the sale of our variable life insurance and annuity business (see Life Companies on pages 46 to 49 of this Form 10-K for further information). In addition, FAFLIC statutory surplus decreased as a result of lower underwriting results and the adoption of new statutory accounting principles. These decreases were partially offset by the utilization of our net operating loss carryforwards and the recognition of tax attributes, as well as a benefit resulting from a decrease in the additional minimum pension liability associated primarily with our qualified defined benefit pension plan.
Inland Marine Insurance - A type of coverage developed for shipments that do not involve ocean transport. It covers articles in transit by all forms of land and air transportation as well as bridges, tunnels and other means of transportation and communication. Floater policies that cover expensive personal items such as fine art and jewelry are included in this category.
Deferred income taxes are generally recognized when assets and liabilities have different values for financial statement and tax reporting purposes, and for other temporary taxable and deductible differences as defined by Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (“Statement No. 109”). These differences result primarily from tax credit carryforwards, loss and LAE reserves, policy reserves, capital loss carryforwards, policy acquisition expenses and employee benefit plans. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that all or some portion of the deferred tax assets will not be realized.
In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities Including an amendment of FASB Statement No. 115 (“Statement No. 159”). Statement No. 159 permits a company to choose, at specified election dates, to measure at fair value certain eligible financial assets and liabilities that are not currently required to be measured at fair value. The specified election dates include, but are not limited to, the date when an entity first recognizes the item, when an entity enters into a firm commitment or when changes in the financial instrument causes it to no longer qualify for fair value accounting under a different accounting standard. An entity may elect the fair value option for eligible items that exist at the effective date. At that date, the difference between the carrying amounts and the fair values of eligible items for which the fair value option is elected should be recognized as a cumulative effect adjustment to the opening balance of retained earnings. The fair value option may be elected for each entire financial instrument, but need not be applied to all similar instruments. Once the fair value option has been elected, it is irrevocable. Unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. Statement No. 159 is effective as of the beginning of fiscal years that begin after November 15, 2007. The Company is currently assessing the effect of adopting Statement No. 159.
Effective January 1, 2004, the Company adopted SOP 03-1 (see Note 1P - New Accounting Pronouncements). Upon adoption, the Company recorded a cumulative effect of change in accounting principle of $57.2 million, net of taxes.
GMDB reserves were adjusted by $52.1 million in 2005 as a result of the elimination of future GMDB claims due to the sale of the Company’s variable life insurance and annuity business.
The following table provides information about the Company’s fixed maturities and equity securities that have been continuously in an unrealized loss position at December 31, 2006 and 2005:
At December 31, 2006, the Company had no concentration of investments in a single investee that exceeded 10% of shareholders’ equity except for investments with Federal Home Loan Mortgage Corporation with a fair value of $747.1 million and Federal National Mortgage Association with a fair value of $423.0 million. At December 31, 2005, the Company had no concentration of investments in a single investee that exceeded 10% of shareholders’ equity except for investments with Federal Home Loan Mortgage Corporation with a fair value of $729.9 million and Federal National Mortgage Association with a fair value of $436.7 million.
The following table reflects the amounts recognized in Accumulated Other Comprehensive Loss relating to the Company’s defined benefit pension plans as of December 31, 2006 and the estimated amount that will be amortized from Accumulated Other Comprehensive Loss into net periodic pension cost in 2007.
Includes assets related to the Company’s discontinued group life and health operations.
The total reserve for losses and LAE decreased by $294.8 million in 2006 and increased by $390.1 million in 2005. The decrease in 2006 was mostly a result of payments to insureds for Hurricanes Katrina and Rita. The increase in 2005 was mostly as a result of additional direct reserves, prior to reinsurance ceded, for hurricanes Katrina and Rita.
Several actions pending against various insurers, including THG, were consolidated for purposes of pretrial discovery and motion practice under the caption In re Katrina Canal Breaches Consolidated Litigation, Civil Action No. 05-4182 in the United States District Court, Eastern District of Louisiana. On November 27, 2006, the Federal District Court issued an Order in these consolidated cases denying the Company’s motion to dismiss. The Court held that the flood exclusions utilized in the forms of homeowners and commercial lines policies issued by the Company and a number of other insurance carriers were ambiguous because such exclusions did not specify that they applied to flooding caused by negligent acts or omissions as well as to flooding caused by natural incidents such as Acts of God. The plaintiffs in these cases claim, among other things, that the efficient proximate cause of their losses was the third-party negligence of Orleans Levee District in the maintenance of the canal walls or in its failure to warn the plaintiffs and others of the impending water intrusion. The Federal District Court ordered that discovery proceed on the questions of whether there was such negligence and whether such negligence was in fact the efficient proximate cause of such losses.