TABLE OF CONTENTS
Introduction 32
Executive Overview 32
Description of Operating Segments 34
Results of Operations - Net Income 34
Segment Results 36
Investments 46
Other Items 52
Income Taxes 53
Critical Accounting Estimates 54
Statutory Surplus of U.S. Insurance Subsidiaries 54
Lloyd's Capital Requirement 55
Liquidity and Capital Resources 55
Off-Balance Sheet Arrangements 57
Contingencies and Regulatory Matters 57
Risks and Forward-Looking Statements 57
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Introduction
The following Management's Discussion and Analysis of Financial Condition and
Results of Operations is intended to assist readers in understanding the interim
consolidated results of operations and financial condition of The Hanover
Insurance Group, Inc. and its subsidiaries ("THG"). Consolidated results of
operations and financial condition are prepared in accordance with generally
accepted accounting principles in the United States of America ("U.S. GAAP").
This discussion should be read in conjunction with the interim consolidated
financial statements and related footnotes included elsewhere in this Quarterly
Report on Form 10-Q and Management's Discussion and Analysis of Financial
Condition and Results of Operations contained in our 2011 Annual Report on Form
10-K filed with the Securities and Exchange Commission on February 29, 2012.
Results of operations include the accounts of The Hanover Insurance Company
("Hanover Insurance") and Citizens Insurance Company of America ("Citizens"),
our principal U.S. domiciled property and casualty companies; Chaucer Holdings
plc ("Chaucer"), and certain other insurance and non-insurance subsidiaries.
Effective July 1, 2011, we acquired Chaucer, a specialist insurance underwriting
group which operates through the Society and Corporation of Lloyd's ("Lloyd's")
and is domiciled in the United Kingdom ("U.K."). Results of operations include
Chaucer's results in periods subsequent to July 1, 2011. Accordingly, our
results for the first six months of 2011 do not include Chaucer's results.
Additionally, our results of operations include our discontinued operations,
consisting primarily of our former life insurance businesses, our accident and
health business and our third party administrator.
Executive Overview
Business operations consist of four operating segments: Commercial Lines,
Personal Lines, Chaucer and Other Property and Casualty.
We completed the acquisition of Chaucer on July 1, 2011, which has added
meaningful business volumes to our quarterly results and has affected the
comparability of our interim consolidated financial statements and related
footnotes. For the three and six months ended June 30, 2012, our discussion of
the results of operations includes results from all of our segments. Results of
operations for the comparable periods in 2011 do not include any results of
Chaucer.
Segment income excluding taxes and interest was $116.7 million for the six
months ended June 30, 2012 compared to $2.5 million in the same period in 2011,
an increase of $114.2 million. This increase is primarily due to decreased
catastrophe and non-catastrophe weather-related losses in the first six months
of 2012 in our domestic insurance companies and $55.3 million of segment income
generated by Chaucer. This was partially offset by unfavorable development on
prior years' loss and loss adjustment expense ("LAE") reserves ("prior years'
loss reserves") in our domestic operations. Pre-tax catastrophe losses were
$114.7 million for the six months ended June 30, 2012, of which $9.8 million
related to our Chaucer segment. During the six months ended June 30, 2011,
pre-tax catastrophe losses were $206.4 million. There was net development on
prior years' loss reserves of zero for the six months ended June 30, 2012,
compared to favorable development of $43.8 million in the same period in 2011.
During the six months ended June 30, 2012, $26.8 million of favorable
development related to our Chaucer segment was offset by $26.8 million of
unfavorable development related to our domestic operations.
Commercial Lines
We believe our unique approach to the small commercial market, distinctiveness
in the middle market, and continued development of specialty lines provides us
with a diversified portfolio of products and delivers significant value to
agents and policyholders. The small commercial and middle market businesses are
expected to contribute to premium growth in Commercial Lines over the next
several years. We continue to pursue our core strategy of developing strong
partnerships with agents, distinctive products, franchise value through limited
distribution, and industry segmentation.
Growth in our specialty lines continues to be an important part of our strategy,
supported by several acquisitions over the past several years. Commercial Lines
segment net written premium grew by 13.7% in the first six months of 2012,
driven by both our specialty businesses and our core commercial businesses.
We believe these efforts have driven, and will continue to drive, improvement in
our overall mix of business and ultimately our underwriting profitability.
Underwriting results improved in the first six months of 2012, as compared to
the same period in 2011, primarily due to decreased catastrophe losses and
increases in rate, partially offset by unfavorable development on prior years'
loss reserves, particularly with respect to our surety contract business.
The competitive nature of the Commercial Lines market requires us to be highly
disciplined in our underwriting process to ensure that we write business at
acceptable margins. Also, we continue to seek rate increases across our
commercial lines, most notably in our property lines as a result of the
heightened catastrophe and non-catastrophe weather-related losses that we
experienced in recent years and in workers' compensation as a result of economic
stress. In our surety bond business, we continue to shift the business mix
toward commercial surety from contract surety and enhance the underwriting tools
and standards that we employ.
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Personal Lines
In our Personal Lines business, we focus on partnering with high quality,
value-added agencies that deliver consultative selling and stress the importance
of account rounding (the conversion of single policy customers to accounts with
multiple policies and additional coverages). Almost 70% of our policies in force
are account business. We are focused on making investments that help maintain
profitability, build a distinctive position in the market, help diversify us
geographically from our historical core states of Michigan, Massachusetts, New
York, and New Jersey and provide us with profitable growth opportunities.
During the six months ended June 30, 2012, Personal Lines segment net written
premiums were $718.5 million compared to $716.0 for the six months ended
June 30, 2011. Our ongoing exposure management actions may possibly result in
modest declines in our overall Personal Lines net written premiums in 2012.
Underwriting results improved in the first six months of 2012, as compared to
the same period in 2011, primarily due to decreased catastrophe and
non-catastrophe weather-related losses, partially offset by unfavorable
development on prior years' loss reserves. Unfavorable development on prior
years' loss reserves for the six months ended June 30, 2012 was $11.6 million,
compared to favorable development of $20.0 million for the six months ended
June 30, 2011. Similar to our strategy in Commercial Lines, we continue to seek
additional rate increases in our personal automobile and homeowners lines as a
result of the catastrophe and non-catastrophe weather-related losses that the
industry experienced in recent years. In addition, continued increases in
premium are expected in our target growth states as we seek to improve
profitability and diversify from our existing core states.
Chaucer
In our Chaucer business, we deploy 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.
Together, our underwriting strength, diverse portfolio and Lloyd's membership
underpin our ability to actively manage the scale, composition and profitable
development of this business.
During the six months ended June 30, 2012, our Chaucer segment net written
premiums were $530.0 million and net earned premiums were $473.5 million. We
benefited from improved pricing within our marine, property and energy classes,
following recent high levels of insured market losses. We were not able to
achieve meaningful rate increases in the aviation and casualty classes. Also,
U.K. motor market rates were relatively flat, following two years of significant
increases. However, 2012 underwriting results are generally favorable, due to
relatively benign loss activity in most classes.
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Description of Operating Segments
Primary business operations include insurance products and services currently
provided through four operating segments. These operating segments are
Commercial Lines, Personal Lines, Chaucer and Other Property and Casualty.
Commercial Lines includes commercial multiple peril, commercial automobile,
workers' compensation and other commercial coverages, such as specialty program
business, inland marine, surety and other bonds, professional liability and
management liability. Personal Lines includes personal automobile, homeowners
and other personal coverages. Chaucer includes energy, marine and aviation, U.K.
motor, property, and casualty and other coverages (which includes international
liability, specialist coverages, and syndicate participations). The Other
Property and Casualty segment consists of Opus Investment Management, Inc.,
which markets investment management services to institutions, pension funds and
other organizations; earnings on holding company assets; and, a voluntary pools
business which is in run-off. We present the separate financial information of
each segment consistent with the manner in which our chief operating decision
maker evaluates results in deciding how to allocate resources and in assessing
performance.
We report interest expense related to our debt separately from the earnings of
our operating segments. This consists of interest on our senior debentures,
junior debentures, subordinated notes, advances under our collateralized
borrowing program with the Federal Home Loan Bank of Boston ("FHLBB"), letter of
credit facility, and capital securities.
Results of Operations - Net Income
Consolidated net income includes the results of our four operating segments
(segment income), which we evaluate on a pre-tax basis and we exclude interest
expense on debt. Segment income excludes certain other items which we believe
are not indicative of our core operations, such as income taxes and net realized
investment gains and losses, including net gains and losses on certain
derivative instruments. Such gains and losses are excluded since they are
determined by interest rates, financial markets and the timing of sales. Also,
segment income excludes net gains and losses on disposals of businesses,
discontinued operations, costs to acquire businesses, restructuring costs,
extraordinary items, the cumulative effect of accounting changes and certain
other items. Although the items excluded from segment income may be significant
components in understanding and assessing our financial performance, we believe
a discussion of segment income enhances an investor's understanding of our
results of operations by segregating income attributable to the core operations
of the business. However, segment income should not be construed as a substitute
for net income.
Catastrophe losses and prior year reserve development are significant components
in understanding and assessing the financial performance of our business.
Management reviews and evaluates catastrophes and prior year reserve development
separate from the other components of earnings. Catastrophes and prior-year
reserve development are not predictable as to timing or the amount that will
affect the results of our operations and have affected our results in the past
few years. Management believes that providing certain financial metrics and
trends excluding the effects of catastrophes and prior year reserve development
helps investors to understand the variability in periodic earnings and to
evaluate the underlying performance of our operations.
Consolidated net income for the three months ended June 30, 2012 was $20.8
million, compared to a loss of $32.2 million for the three months ended June 30,
2011. The $53.0 million increase is primarily due to a decrease in catastrophe
losses, income from our Chaucer segment and the gain from the sale of our third
party administrator, Citizens Management Inc. ("CMI"), which was completed on
April 30, 2012, (see also "Other Items"). Additionally, there were lower costs
related to acquired businesses in 2012 as compared to 2011. The higher level of
these costs in 2011 related to the Chaucer acquisition. These increases were
partially offset by a decrease in favorable development on prior years' loss
reserves and a decrease in realized gains.
Consolidated net income for the six months ended June 30, 2012 was $70.5
million, compared to a loss of $2.9 million for the six months ended June 30,
2011. The $73.4 million increase is primarily due to a decrease in catastrophe
losses, income from our recently acquired Chaucer segment, growth in earned
premiums in our domestic insurance companies, the gain from the sale of CMI and
the aforementioned lower costs related to acquired businesses. These increases
were partially offset by a decrease in favorable development on prior years'
loss reserves and a decrease in realized gains.
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The following table reflects segment income and a reconciliation of total
segment income to consolidated net income.
Three Months Ended Six Months Ended
June 30, June 30,
(in millions) 2012 2011 2012 2011
Segment income (loss) before income
taxes:
Commercial Lines $ (9.4) $ (25.3) $ 24.5 $ (7.1)
Personal Lines 12.3 (22.8) 39.8 7.5
Chaucer 29.8 - 55.3 -
Other Property and Casualty (1.7) 0.8 (2.9) 2.1
Total 31.0 (47.3) 116.7 2.5
Interest expense (15.9) (10.8) (32.1) (21.2)
Total segment income (loss) before
income taxes 15.1 (58.1) 84.6 (18.7)
Income tax benefit (expense) on
segment income (5.1) 19.7 (28.6) 6.2
Net realized investment gains
(losses) (3.4) 13.4 (0.3) 16.7
Net gain (loss) from retirement of
debt - 0.3 - (2.2)
Costs related to acquired businesses (0.9) (11.1) (2.4) (13.8)
Loss on derivative instruments - (4.7) - (4.7)
Net foreign exchange gains 0.3 - - -
Income tax benefit on non-segment
income 3.8 7.7 7.2 11.6
Income (loss) from continuing
operations 9.8 (32.8) 60.5 (4.9)
Gain from sale of Citizens
Management, Inc., net of taxes 10.9 - 10.9 -
Net gain (loss) from other
discontinued operations, net of taxes 0.1 0.6 (0.9) 2.0
Net Income (loss) $ 20.8 $ (32.2) $ 70.5 $ (2.9)
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Segment Results
The following is our discussion and analysis of the results of operations by
business segment. The segment results are presented before interest expense and
income taxes and other items which management believes are not indicative of our
core operations, including realized gains and losses.
The following table summarizes the results of operations for the periods
indicated:
Three Months Ended Six Months Ended
June 30, June 30,
(In millions) 2012 2011 2012 2011
Segment revenues
Net premiums written $ 1,197.6 $ 815.4 $ 2,214.4 $ 1,565.3
Net premiums earned $ 1,050.0 $
770.5 $ 2,085.6 $ 1,532.2
Net investment income
68.4 61.0 137.2 121.4
Fees and other income 13.7 10.2 29.6 19.9
Total segment revenues 1,132.1 841.7 2,252.4 1,673.5
Losses and operating expenses
Losses and LAE 732.1 617.5 1,393.5 1,128.5
Policy acquisition expenses 233.1 162.7 461.2 325.2
Other operating expenses 135.9 108.8 281.0 217.3
Total losses and operating
expenses 1,101.1 889.0 2,135.7 1,671.0
Segment income (loss) before
interest and income taxes $ 31.0 $ (47.3) $ 116.7 $ 2.5
Three Months Ended June 30, 2012 Compared to Three Months Ended June 30, 2011
Segment income was $31.0 million in the three months ended June 30, 2012,
compared to a loss of $47.3 million in the three months ended June 30, 2011, an
increase in earnings of $78.3 million. Chaucer's results accounted for $29.8
million of this income. Catastrophe related activity for our Commercial and
Personal Lines businesses in the quarter was $70.8 million, compared to $156.7
million in the same period of 2011, a decrease of $85.9 million. Excluding the
impact of catastrophe related activity, earnings for our Commercial and Personal
Lines businesses decreased by $37.4 million. This decrease was primarily due to
unfavorable development on prior years' loss reserves in the quarter compared to
favorable development in the same period of 2011. Unfavorable development on
prior years' loss reserves in Commercial and Personal Lines was $22.3 million in
the quarter, compared to favorable development of $15.3 million in the same
period in 2011.
Net premiums written grew by $382.2 million in the three months ended June 30,
2012, compared to the three months ended June 30, 2011, and net premiums earned
grew by $279.5 million. Chaucer accounted for $329.8 million of the premiums
written increase and $236.5 million of the net premiums earned increase. The
balance of the growth is primarily attributable to Commercial Lines, resulting
from strong retention, rate increases and targeted new business expansion.
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Production and Underwriting Results
The following table summarizes GAAP financial information including net premiums
written and loss, LAE, expense and combined ratios for the Commercial Lines,
Personal Lines and Chaucer segments. Loss, LAE, catastrophe loss and combined
ratios shown below include prior year reserve development. These items are not
meaningful for our Other Property and Casualty segment.
Three months ended June 30, 2012
(dollars in millions) Gross
Written Net Written Net Earned Catastrophe Loss & LAE Expense Combined
Premium Premium Premium Loss Ratios Ratios Ratios Ratios
Commercial Lines $ 564.2 $ 496.7 $ 449.2 8.5 73.3 36.4 109.7
Personal Lines 414.3 371.1 364.3 8.9 75.1 26.9 102.0
Chaucer 438.6 329.8 236.5 1.4 54.7 37.2 91.9
Total $ 1,417.1 $ 1,197.6 $ 1,050.0 7.1 69.8 33.3 103.1
Three months ended June 30, 2011
(dollars in millions) Gross
Written Net Written Net Earned Catastrophe Loss & LAE Expense Combined
Premium Premium Premium Loss Ratios Ratios Ratios Ratios
Commercial Lines $ 494.6 $ 440.5 $ 408.5 18.9 75.5 39.0 114.5
Personal Lines 399.7 374.6 361.9 22.0 85.4 26.8 112.2
Total $ 894.3 $ 815.1 $ 770.4 20.3 80.1 33.3 113.4
The following table summarizes net premiums written, and loss and LAE and
catastrophe loss ratios by line of business for the Commercial Lines and
Personal Lines segments. Loss and LAE and catastrophe loss ratios include prior
year reserve development.
Three Months Ended June 30,
2012 2011
Cata- Cata-
Net Loss & strophe Net Loss & strophe
Premiums LAE Loss Premiums LAE Loss
(dollars in millions) Written Ratios Ratios Written Ratios Ratios
Commercial Lines:
Commercial multiple peril $ 153.5 79.1 23.7 $ 144.7 97.0 41.6
Commercial automobile 71.0 75.8 0.5 64.7 60.5 1.1
Workers' compensation 48.8 73.0 - 44.2 62.8 -
Other commercial 223.4 68.1 1.9 186.9 66.2 11.2
Total Commercial Lines $ 496.7 73.3 8.5 $ 440.5 75.5 18.9
Personal Lines:
Personal automobile $ 227.5 75.8 1.3 $ 229.6 71.0 2.7
Homeowners 132.3 76.2 22.6 133.2 114.3 58.8
Other personal 11.3 47.2 6.6 11.8 62.3 14.2
Total Personal Lines $ 371.1 75.1 8.9 $ 374.6 85.4 22.0
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The following table summarizes premiums written on a gross and net basis and net
premiums earned by line of business for the Chaucer segment.
Three Months Ended
June 30, 2012
Gross Net
Written Written Net Earned
(in millions) Premium Premium Premium
Chaucer:
Energy $ 127.7 $ 87.9 $ 44.2
Marine and Aviation 93.0 66.1 58.3
U.K. Motor 76.6 67.3 60.3
Property 92.1 77.8 44.5
Casualty and Other 49.2 30.7 29.2
Total Chaucer $ 438.6 $ 329.8 $ 236.5
The following table summarizes GAAP underwriting results for the Commercial
Lines, Personal Lines, Chaucer and Other Property and Casualty segments and
reconciles it to segment income.
Three Months Ended June 30,
2012 2011
Other Other
Property Property
(in millions) Commercial Personal Chaucer and Commercial Personal and
Lines Lines Casualty Total Lines Lines Casualty Total
GAAP underwriting profit (loss), excluding prior year
reserve development and catastrophes
$ 8.2
$ 29.8 $ 17.4 $ (0.8) $ 54.6
$ 7.7 $ 26.7 $ (0.1) $ 34.3
Prior year favorable (unfavorable) loss and LAE reserve
development (14.5) (7.8) 5.1 - (17.2) 9.3 5.9 0.1 15.3
Pre-tax catastrophe effect (38.4) (32.4) (3.3) - (74.1) (77.1) (79.6) - (156.7)
GAAP underwriting profit (loss) (44.7) (10.4) 19.2 (0.8) (36.7) (60.1) (47.0) - (107.1)
Net investment income 35.0 21.3 10.2 1.9 68.4 34.0 23.1 3.9 61.0
Fees and other income 3.1 3.2 5.1 2.3 13.7 5.4 3.2 1.6 10.2
Other operating expenses (2.8) (1.8) (4.7) (5.1) (14.4) (4.6) (2.1) (4.7) (11.4)
Segment income (loss) before interest and income taxes $ (9.4)
$ 12.3 $ 29.8 $ (1.7) $ 31.0 $ (25.3) $ (22.8) $ 0.8 $ (47.3)
Commercial Lines
Commercial Lines net premiums written was $496.7 million in the three months
ended June 30, 2012, compared to $440.5 million in the three months ended
June 30, 2011. This $56.2 million increase was primarily driven by strong
retention, rate increases, and targeted new business expansion, including growth
in the AIX program business.
Commercial Lines underwriting loss in the three months ended June 30, 2012 was
$44.7 million, compared to $60.1 million for the three months ended June 30,
2011, an improvement of $15.4 million. This was primarily due to decreased
catastrophe losses, partially offset by unfavorable development on prior years'
loss reserves. Catastrophe losses for the three months ended June 30, 2012 were
$38.4 million, compared to $77.1 million for the three months ended June 30,
2011, a decrease of $38.7 million. Unfavorable development on prior years' loss
reserves for the three months ended June 30, 2012 was $14.5 million, compared to
favorable development of $9.3 million for the three months ended June 30, 2011,
a change of $23.8 million.
Commercial Lines current accident year underwriting profit, excluding
catastrophes, was $8.2 million in the three months ended June 30, 2012, compared
to $7.7 million for the three months ended June 30, 2011, an increase of $0.5
million. The current quarter's results benefited from growth in earned premium
and the resulting positive effect on our expense ratio, partially offset by
higher current accident year losses.
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Pricing in Commercial Lines continues to improve as the industry responds to
recent weather-related losses and trends and other factors; however, our ability
to increase Commercial Lines net premiums written while maintaining or improving
underwriting results may be affected by continuing price competition and the
current challenging economic environment. Over the past few years, we have noted
a trend of weather-related catastrophe and non-catastrophe losses that have been
in excess of longer term averages. Accordingly, we have incorporated increased
levels of weather-related loss costs into our expectations.
Personal Lines
Personal Lines net premiums written was $371.1 million in the three months ended
June 30, 2012, compared to $374.6 million in the three months ended June 30,
2011, an decrease of $3.5 million. The most significant factors contributing to
this decrease were our continued exposure management actions that focus on
driving profit improvement through both rate increases and more selective
portfolio management. Our actions to reduce exposures, including increases in
rate, have resulted in an increase in policy attrition. During the quarter, we
terminated relationships with certain agencies in New York, New Jersey and
Connecticut as part of our exposure management actions. These decreases were
partially offset by higher rates in both our homeowners and personal automobile
lines and an increase in policies in force of 3.5% in our target growth states.
Net premiums written in the personal automobile line of business decreased by
0.9%, resulting primarily from a decline in policies in force of 2.6%, primarily
as a result of fewer policies in force in New York, Connecticut, Florida,
Oklahoma and New Jersey, which we attribute to more selective portfolio
management, and to the attrition resulting from rate increases we have
implemented despite the competitive pricing environment. This reduction in
policies in force was partially offset by the overall effect of rate increases.
Net premiums written in the homeowners line of business decreased 0.7%,
resulting primarily from a decline in policies in force of 2.0%, primarily as a
result of fewer policies in force in New York, Michigan and New Jersey,
partially offset by the overall effect of rate increases.
Personal Lines underwriting loss for the three months ended June 30, 2012 was
$10.4 million, compared to $47.0 million for the three months ended June 30,
2011, an improvement of $36.6 million. This was primarily due to decreased
catastrophe losses and non-catastrophe weather-related losses, partially offset
by unfavorable development on prior years' loss reserves. Catastrophe losses for
the three months ended June 30, 2012 were $32.4 million, compared to $79.6
million for the three months ended June 30, 2011, a decrease of $47.2 million.
Unfavorable development on prior years' loss reserves for the three months ended
June 30, 2012 was $7.8 million, compared to favorable development of $5.9
million for the three months ended June 30, 2011, a change of $13.7 million.
Personal Lines current accident year underwriting profit, excluding
catastrophes, was $29.8 million in the three months ended June 30, 2012,
compared to $26.7 million for the three months ended June 30, 2011. This $3.1
million improvement in non-catastrophe current accident year results was
primarily due to lower non-catastrophe weather-related losses in our personal
automobile and homeowners lines.
Although we have been able to obtain rate increases in our Personal Lines
markets and believe that this ability will continue, our ability to maintain and
increase Personal Lines net written premium and to maintain and improve
underwriting results may be affected by price competition, recent
weather-related losses, and regulatory and legal developments. Over the past few
years, we have noted a trend of weather-related catastrophe and non-catastrophe
losses that have been in excess of longer term averages. Accordingly, we have
incorporated more increased levels of weather-related activity and loss trends
into our expectations. Our rate actions could adversely affect our ability to
increase our policies in force and new business. There is no assurance that we
will be able to maintain our current level of production or maintain or increase
rates. In addition, our ongoing exposure management may possibly result in
modest declines in our overall personal lines net written premiums in 2012.
Chaucer
Chaucer's net premiums written was $329.8 million for the three months ended
June 30, 2012. By line of business, Chaucer's net premiums written were
comprised of 26.7% energy, 23.6% property, 20.4% U.K. motor, 20.0% marine and
aviation, and 9.3% casualty and other lines. This mix of business is driven and
supported by our specialist underwriting strategy which is focused on actively
managing the premium portfolio and risk exposures. Casualty and other lines are
primarily comprised of Chaucer's specialist and international liability lines of
business.
Chaucer's underwriting profit for the three months ended June 30, 2012 was $19.2
million. Catastrophe losses for the three months ended June 30, 2012 were $3.3
million. Favorable development on prior years' loss reserves for the three
months ended June 30, 2012 was $5.1 million.
Chaucer's underwriting profit, excluding prior year loss development and
catastrophes, was $17.4 million in the three months ended June 30, 2012.
Underwriting expenses of $88.1 million represented 37.2% of earned premium.
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We have achieved, and expect to continue to achieve, rate increases for a
majority of Chaucer lines in 2012. Recent natural catastrophe losses,
particularly those affecting the U.S., New Zealand, Japan and Thailand, have
triggered property rate rises in the majority of catastrophe-exposed
territories. Policy terms and conditions are improving in our energy portfolio,
as markets respond to losses in 2011. Within our marine line of business, hull
and liability rates are also increasing. The market conditions in our casualty
and aviation businesses remain challenging, with over-capacity affecting
pricing. In our U.K. motor business, we currently expect limited growth, since
current rate increases are slightly below claims inflation following significant
price increases since 2010. There can be no assurance that we will be able to
maintain or increase our rates in light of economic and regulatory conditions in
our markets.
Other Property and Casualty
Other Property and Casualty segment loss was $1.7 million for the three months
ended June 30, 2012, compared to a profit of $0.8 million for the three months
ended June 30, 2011. The $2.5 million decrease is primarily due to lower net
investment income in our holding company.
Six Months Ended June 30, 2012 Compared to Six Months Ended June 30, 2011
Segment income was $116.7 million in the six months ended June 30, 2012,
compared to $2.5 million in the six months ended June 30, 2011, an increase in
earnings of $114.2 million. Chaucer's results accounted for $55.3 million of
segment income in the six months ended June 30, 2012. Catastrophe related
activity for our Commercial and Personal Lines businesses for the six months
ended June 30, 2012 was $104.9 million, compared to $206.4 million for the six
months ended June 30, 2011, a decrease of $101.5 million. Excluding the impact
of catastrophe related activity, earnings for our Commercial and Personal Lines
businesses decreased by $42.6 million. This decrease was primarily due to
unfavorable development on prior years' loss reserves, partially offset by more
favorable current accident year results. Unfavorable development on prior years'
loss reserves in Commercial and Personal Lines was $26.8 million for the six
months ended June 30 2012, compared to favorable development of $43.8 million
for the six months ended June 30, 2011, a change of $70.6 million. The favorable
current accident year results are primarily due to a lower level of
non-catastrophe weather-related losses in Personal Lines.
Net premiums written grew by $649.1 million in the six months ended June 30,
2012, compared to the six months ended June 30, 2011, and net premiums earned
grew by $553.4 million. Chaucer accounted for $530.0 million of net premiums
written and $473.5 million of net premiums earned in the six months ended
June 30, 2012. The balance of the growth is primarily attributable to Commercial
Lines, resulting from strong retention, rate increases and targeted new business
expansion.
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Production and Underwriting Results
The following table summarizes GAAP financial information including net premiums
written and loss, LAE, expense and combined ratios for the Commercial Lines,
Personal Lines and Chaucer segments. Loss, LAE, catastrophe loss and combined
ratios shown below include prior year reserve development. These items are not
meaningful for our Other Property and Casualty segment.
Six months ended June 30, 2012
(dollars in millions) Gross
Written Net Written Net Earned Catastrophe Loss & LAE Expense Combined
Premium Premium Premium Loss Ratios Ratios Ratios Ratios
Commercial Lines $ 1,096.8 $ 965.6 $ 884.1 5.6 67.5 37.6 105.1
Personal Lines 787.5 718.5 727.6 7.6 72.9 27.1 100.0
Chaucer 820.3 530.0 473.5 2.1 56.1 36.7 92.8
Total $ 2,704.6 $ 2,214.1 $ 2,085.2 5.5 66.8 33.8 100.6
Six months ended June 30, 2011
(dollars in millions) Gross
Written Net Written Net Earned Catastrophe Loss & LAE Expense Combined
Premium Premium Premium Loss Ratios Ratios Ratios Ratios
Commercial Lines $ 961.4 $ 849.0 $ 809.3 12.9 69.9 39.3 109.2
Personal Lines 766.2 716.0 722.8 14.1 77.9 26.9 104.8
Total $ 1,727.6 $ 1,565.0 $ 1,532.1 13.5 73.7 33.4 107.1
The following table summarizes net premiums written, and loss and LAE and
catastrophe loss ratios by line of business for the Commercial Lines and
Personal Lines segments. Loss and LAE and catastrophe loss ratios include prior
year reserve development.
Six Months Ended June 30,
2012 2011
Cata- Cata-
Net Loss & strophe Net Loss & strophe
Premiums LAE Loss Premiums LAE Loss
(dollars in millions) Written Ratios Ratios Written Ratios Ratios
Commercial Lines:
Commercial multiple peril $ 301.5 68.1 15.4 $ 281.9 86.2 28.5
Commercial automobile 141.7 73.7 0.6 126.7 61.9 0.7
Workers' compensation 103.8 72.8 - 90.0 64.6 -
Other commercial 418.6 63.6 1.2 350.4 60.2 7.5
Total Commercial Lines $ 965.6 67.5 5.6 $ 849.0 69.9 12.9
Personal Lines:
Personal automobile $ 460.6 75.5 1.2 $ 460.7 70.0 1.4
Homeowners 237.3 70.1 19.2 234.4 94.9 38.4
Other personal 20.6 51.4 6.1 20.9 48.8 8.5
Total Personal Lines $ 718.5 72.9 7.6 $ 716.0 77.9 14.1
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The following table summarizes premiums written on a gross and net basis and net
premiums earned by line of business for the Chaucer segment.
Six Months Ended
June 30, 2012
Gross Net Net
Written Written Earned
(in millions) Premium Premium Premium
Chaucer:
Energy $ 199.0 $ 111.2 $ 83.6
Marine and Aviation 192.5 124.6 112.5
U.K. Motor 143.2 112.8 121.8
Property 179.8 107.4 91.2
Casualty and Other 105.8 74.0 64.4
Total Chaucer $ 820.3 $ 530.0 $ 473.5
The following table summarizes GAAP underwriting results for the Commercial
Lines, Personal Lines, Chaucer and Other Property and Casualty segments and
reconciles it to segment income.
Six Months Ended June 30,
2012 2011
Other Other
Property Property
(in millions) Commercial Personal and Commercial Personal and
Lines Lines Chaucer Casualty Total Lines Lines Casualty Total
GAAP underwriting profit (loss), excluding prior year reserve
development and catastrophes
$
17.3 $ 60.8 $ 16.9 $ (1.0) $
94.0 $ 4.9 $ 41.2 $ (0.1) $ 46.0
Prior year favorable (unfavorable) loss and LAE reserve development (15.0) (11.6) 26.8 (0.2) - 23.6 20.0 0.2
43.8
Pre-tax catastrophe effect (49.5) (55.4) (9.8) - (114.7) (104.6) (101.8) -
(206.4)
GAAP underwriting profit (loss) (47.2) (6.2) 33.9 (1.2) (20.7) (76.1) (40.6) 0.1
(116.6)
Net investment income 70.7 42.9 19.6 4.0 137.2 67.6 45.8 8.0
121.4
Fees and other income 8.2 6.7 10.4 4.3 29.6 10.3 6.3 3.3
19.9
Other operating expenses (7.2) (3.6) (8.6) (10.0) (29.4) (8.9) (4.0) (9.3)
(22.2)
Segment income (loss) before interest and income taxes $ 24.5 $ 39.8 $ 55.3 $ (2.9) $ 116.7 $ (7.1) $ 7.5 $ 2.1 $ 2.5
Commercial Lines
Commercial Lines net premiums written was $965.6 million in the six months ended
June 30, 2012, compared to $849.0 million in the six months ended June 30, 2011.
This $116.6 million increase was primarily driven by strong retention, rate
increases, and targeted new business expansion.
Commercial Lines underwriting loss in the six months ended June 30, 2012 was
$47.2 million, compared to $76.1 million for the six months ended June 30, 2011,
an improvement of $28.9 million. This was primarily due to decreased catastrophe
losses and growth in earned premium and the resulting positive effect on our
expense ratio, partially offset by unfavorable development on prior years' loss
reserves. Catastrophe losses for the six months ended June 30, 2012 were $49.5
million, compared to $104.6 million for the six months ended June 30, 2011, a
decrease of $55.1 million. Unfavorable development on prior years' loss reserves
for the six months ended June 30, 2012 was $15.0 million, compared to favorable
development of $23.6 million for the six months ended June 30, 2011, a change of
$38.6 million.
Commercial Lines current accident year underwriting profit, excluding
catastrophes, was $17.3 million in the six months ended June 30, 2012, compared
to $4.9 million for the six months ended June 30, 2011, an increase of $12.4
million. These results benefited from growth in earned premium and the resulting
positive effect on our expense ratio, and from what we believe to be an improved
mix of business.
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Personal Lines
Personal Lines net premiums written was $718.5 million in the six months ended
June 30, 2012, compared to $716.0 million in the six months ended June 30, 2011,
an increase of $2.5 million. The factors contributing to this modest increase
were higher rates in both our homeowners and personal automobile lines and an
increase in policies in force of 3.5% in our target growth states. These
increases were partially offset by our continued exposure management actions.
Our actions to reduce exposures, including increases in rate, have resulted in
an increase in policy attrition.
Net premiums written in the personal automobile line of business for the six
months ended June 30, 2012 were $460.6 million comparable to $460.7 million for
the six months ended June 30, 2011. Growth in premiums resulting primarily from
rate increases were offset by a decline in policies in force of 2.6%, primarily
as a result of fewer policies in force in New York, Connecticut, Florida,
Oklahoma and New Jersey which we attribute to more selective portfolio
management, and to attrition resulting from rate increases we have implemented
despite the competitive pricing environment. Net premiums written in the
homeowners line of business increased 1.2%, resulting primarily from rate
increases, partially offset by a decline in policies in force of 2.0%, primarily
as a result of fewer policies in force in New York, Michigan and New Jersey.
Personal Lines underwriting loss for the six months ended June 30, 2012 was $6.2
million, compared to $40.6 million for the six months ended June 30, 2011, an
improvement of $34.4 million. This was primarily due to decreased catastrophe
losses and non-catastrophe weather-related losses, partially offset by
unfavorable development on prior years' loss reserves. Catastrophe losses for
the six months ended June 30, 2012 were $55.4 million, compared to $101.8
million for the six months ended June 30, 2011, a decrease of $46.4 million.
Unfavorable development on prior years' loss reserves for the six months ended
June 30, 2012 was $11.6 million, compared to favorable development of $20.0
million for the six months ended June 30, 2011, a change of $31.6 million.
Personal Lines current accident year underwriting profit, excluding
catastrophes, was $60.8 million in the six months ended June 30, 2012, compared
to $41.2 million for the six months ended June 30, 2011. This $19.6 million
increase was primarily due to lower non-catastrophe weather-related losses in
our personal automobile and homeowners lines.
Chaucer
Chaucer's net premiums written was $530.0 million for the six months ended
June 30, 2012. By line of business, Chaucer's net premiums written were
comprised of 23.5% marine and aviation, 21.3% U.K. motor, 21.0% energy, 20.3%
property, and 13.9% casualty and other lines. This mix of business was driven
and supported by our specialist underwriting strategy which is focused on
actively managing the premium portfolio and risk exposures.
Chaucer's underwriting profit for the six months ended June 30, 2012 was $33.9
million. Catastrophe losses for the six months ended June 30, 2012 were $9.8
million, principally due to U.S. tornadoes and the earthquake in Italy.
Favorable development on prior years' loss reserves for the six months ended
June 30, 2012 was $26.8 million.
Chaucer's underwriting profit, excluding prior year loss development and
catastrophes, was $16.9 million in the six months ended June 30, 2012.
Underwriting expenses of $174.0 million represented 36.7% of earned premium.
Other Property and Casualty
Other Property and Casualty segment loss was $2.9 million for the six months
ended June 30, 2012, compared to a profit of $2.1 million for the six months
ended June 30, 2011. The $5.0 million decrease is primarily due to lower net
investment income in our holding company.
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Reserve for Losses and Loss Adjustment Expenses
The table below provides a reconciliation of the gross beginning and ending
reserve for unpaid losses and loss adjustment expenses (including Chaucer with
respect to the six month period ended June 30, 2012) as follows:
Six Months Ended
June 30,
(in millions) 2012 2011
Gross loss and LAE reserves, beginning of period $ 5,760.3 $ 3,277.7
Reinsurance recoverable on unpaid losses 1,931.8 1,115.5
Net loss and LAE reserves, beginning of period 3,828.5 2,162.2
Net incurred losses and LAE in respect of losses
occurring in:
Current year 1,393.5 1,172.3
Prior years - (43.8)
Total incurred losses and LAE 1,393.5 1,128.5
Net payments of losses and LAE in respect of
losses occurring in:
Current year 476.1 507.5
Prior years 868.4 513.2
Total payments 1,344.5 1,020.7
Effect of foreign exchange rate changes 3.8 -
Net reserve for losses and LAE, end of period 3,881.3 2,270.0
Reinsurance recoverable on unpaid losses 1,972.1 1,136.4
Gross reserve for losses and LAE, end of period $ 5,853.4 $ 3,406.4
The table below summarizes the gross reserve for losses and LAE by line of
business.
(in millions) June 30, December 31,
2012 2011
Workers' Compensation $ 553.3 $ 544.7
Commercial Automobile 250.8 234.9
Commercial Multiple Peril 589.1 550.0
AIX 257.8 239.6
Other Commercial 352.5 360.1
Total Commercial 2,003.5 1,929.3
Personal Automobile 1,353.2 1,366.3
Homeowners and Other 142.5 131.9
Total Personal 1,495.7 1,498.2
Total Chaucer 2,354.2 2,332.8
Total loss and LAE reserves $ 5,853.4 $ 5,760.3
Other Commercial lines are primarily comprised of our professional liability,
general liability, umbrella, and marine lines. Included in the above table, in
the Chaucer segment, are $278.9 million and $302.8 million of reserves related
to Chaucer's Syndicate 4000, consisting of financial and professional liability
lines written in 2008 and prior as of June 30, 2012 and December 31, 2011,
respectively. Also included in the above table, primarily in Other Commercial
lines, are $57.8 million and $59.8 million of asbestos and environmental
reserves as of June 30, 2012 and December 31, 2011, respectively.
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Prior Year Development
Loss and LAE reserves for claims incurred in prior years had net development of
zero for the six months ended June 30, 2012 compared to favorable development of
$43.8 million for the six months ended June 30, 2011. The 2012 activity by
segment includes favorable development of $26.8 million for Chaucer, offset by
unfavorable development of $26.8 million in other segments, including $15.0
million, $11.6 million and $0.2 million for Commercial Lines, Personal Lines and
Other Property and Casualty, respectively. The primary drivers of reserve
development for the six months ended June 30, 2012 were as follows:
- Favorable development of previously established reserves in Chaucer's lines
of business as follows:
¡ energy line, primarily in the 2009 and 2010 accident years,
¡ marine and aviation lines, primarily in the 2007 and 2008 accident
years, and
¡ within casualty and other lines, specialist liability lines,
primarily in the 2010 and 2011 accident years.
- Within other commercial lines, primarily higher than expected losses in our
surety line, and to a lesser extent, our AIX program business.
- Higher than expected losses within our commercial automobile line,
primarily related to liability coverage in the 2011 accident year.
- Partially offsetting the unfavorable development within Commercial Lines
was lower than expected losses within our commercial multiple peril line
related to the 2008 through 2011 accident years.
- Within personal lines, higher than expected losses within our personal
automobile line, primarily related to liability coverage in the 2011
accident year, and higher than expected homeowners losses from
non-catastrophe weather related activity in the latter half of 2011.
The primary drivers for reserve development during the six months ended June 30,
2011 were as follows:
- Lower than expected losses within our personal automobile line across all
coverages, primarily related to the 2008 through 2010 accident years.
- Lower than expected losses within the commercial multiple peril line,
related to the 2008 through 2010 accident years.
- Lower than expected losses within the workers' compensation line, primarily
related to the 2006 through 2009 accident years.
- Within our other commercial lines, our commercial umbrella line contributed
to the favorable development, partially offset by unfavorable development
in our professional liability line, primarily related to the 2009 and 2010
accident years.
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Investments
Investment Results
Net investment income increased $7.5 million, or 12.3%, to $68.5 million for the
three months ended June 30, 2012, and $15.9 million, or 13.1%, to $137.3 million
for the six months ended June 30, 2012. The increase in both periods is
primarily due to the acquisition of Chaucer and its related assets and
investment income, partially offset by the impact of lower new money yields on
fixed maturities. Also, net investment income increased from investments in
dividend-yielding equity securities, various higher yielding investment grade
fixed maturity securities and investment partnerships, partially offset by the
impact of lower operational cash flows in 2012. Average pre-tax earned yield for
the U.S. domiciled companies on fixed maturities was 5.14% and 5.35% for the
three months ended June 30, 2012 and 2011, respectively, and 5.17% and 5.32% for
the six months ended June 30, 2012 and 2011, respectively. Chaucer's average
pre-tax earned yield on fixed maturities was 2.30% and 2.25% for the three and
six months ended June 30, 2012, respectively. We expect average investment
yields to continue to decline as new money rates remain at historically low
levels.
Investment Portfolio
We held cash and investment assets diversified across several asset classes, as
follows:
June 30, 2012 December 31, 2011
% of % of
Carrying Total Carrying Total
(dollars in millions) Value Carrying Value Carrying
Value Value
Fixed maturities, at fair value $ 6,534.8 85.4% $ 6,284.7 83.3%
Equity securities, at fair value 367.5 4.8 246.4 3.3
Cash and cash equivalents 520.8 6.8 820.4 10.9
Other investments 229.1 3.0 190.2 2.5
Total cash and investments $ 7,652.2 100.0% $ 7,541.7 100.0%
Cash and Investments
Total cash and investments increased $110.5 million, or 1.5%, for the six months
ended June 30, 2012, of which fixed maturities increased $250.1 million,
equities increased $121.1 million, other investments increased $38.9 million and
cash and cash equivalents decreased $299.6 million. Fixed maturities increased
and cash and cash equivalents decreased primarily due to the investment of a
substantial portion of Chaucer's cash into fixed maturities. The value of fixed
maturities also increased as a result of market value appreciation. Equity
securities increased primarily from additional purchases of publicly traded,
dividend-yielding stocks, exchange traded funds and mutual funds.
Our fixed maturity portfolio is comprised of corporate securities, taxable and
tax-exempt municipal securities, residential mortgage-backed securities,
commercial mortgage-backed securities, foreign government securities,
asset-backed securities and U.S. government securities.
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The following table provides information about the investment types of our fixed
maturities portfolio:
June 30, 2012
(in millions) Change in Net
Amortized Net Unrealized Unrealized
Investment Type Cost Fair Value Gain During 2012
U.S. Treasury and government
agencies $ 190.5 $ 198.8 $ 8.3 $ 0.7
Foreign government 302.7 304.5 1.8 1.9
Municipals:
Taxable 807.3 883.0 75.7 17.3
Tax exempt 142.3 147.3 5.0 (0.1)
Corporate 3,371.6 3,580.0 208.4 51.0
Asset-backed:
Residential mortgage-backed 805.3 839.1 33.8 1.3
Commercial mortgage-backed 343.9 358.9 15.0 3.5
Asset-backed 219.7 223.2 3.5 (0.1)
Total fixed maturities $ 6,183.3 $ 6,534.8 $ 351.5$ 75.5
Net unrealized gains on fixed maturities increased $75.5 million to $351.5
million at June 30, 2012, compared to $276.0 million at December 31, 2011.
Amortized cost and fair value by rating category were as follows:
June 30, 2012 December 31, 2011
Rating Agency % of Total % of Total
(dollars in millions) Equivalent Amortized Fair Fair Amortized Fair Fair
NAIC Designation Designation Cost Value Value Cost Value Value
1 Aaa/Aa/A $ 4,405.8 $ 4,644.2 71.1% $ 4,325.1 $ 4,510.7 71.8%
2 Baa 1,413.5 1,512.6 23.1 1,338.7 1,419.7 22.6
3 Ba 155.1 166.4 2.6 151.2 160.0 2.5
4 B 141.0 145.9 2.2 134.5 136.4 2.2
5 Caa and lower 54.2 52.2 0.8 47.1 44.7 0.7
6 In or near default 13.7 13.5 0.2 12.1 13.2 0.2
Total fixed maturities $ 6,183.3 $ 6,534.8 100.0% $ 6,008.7 $ 6,284.7 100.0%
Based on ratings by the National Association of Insurance Commissioners
("NAIC"), approximately 94% of the fixed maturity portfolio consisted of
investment grade securities at June 30, 2012 and December 31, 2011. The quality
of our fixed maturity portfolio remains strong based on ratings, capital
structure position, support through guarantees, underlying security, issuer
diversification and yield curve position.
In accordance with Lloyd's operating guidelines, we are required to deposit
funds at Lloyd's to support our underwriting operations. These funds are
available only to fund claim obligations. These restricted assets consisted of
approximately $404 million of fixed maturities and $125 million of cash and cash
equivalents as of June 30, 2012. We also deposit funds with various state and
governmental authorities. For a discussion of our deposits with state and
governmental authorities, see also Note 3 - "Investments" of the Notes to
Consolidated Financial Statements in our Annual Report on Form 10-K for the year
ended December 31, 2011.
Our fixed maturity and equity securities are classified as available-for-sale
and are carried at fair value. Financial instruments whose value is determined
using significant management judgment or estimation constitute less than 2% of
the total assets we measured at fair value. See also Note 7 - "Fair Value" of
the Notes to Interim Consolidated Financial Statements.
Although we expect to invest new funds primarily in investment grade fixed
maturities, we have invested, and expect to continue to invest, a portion of
funds in common equity securities and below investment grade fixed maturities
and other assets.
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Municipal bond exposure
Our municipal bond portfolio constitutes approximately 13% of invested assets at
June 30, 2012 and is 98% investment grade, without regard to any insurance
enhancement. Currently, approximately 27% of the municipal bond portfolio has an
insurance enhancement. The portfolio is well diversified by geography, sector
and source of payment, and consists primarily of taxable securities.
Approximately 63% of the portfolio is invested in revenue bonds and 37% in
general obligation bonds. Revenue bonds are backed by the revenue stream
generated by the services provided by the issuer, while general obligation bonds
are backed by the authority that issued the debt and are secured by the taxing
powers of those authorities.
European sovereign and non-sovereign debt exposure
Our European fixed maturity credit exposure at June 30, 2012 was as follows:
Non-Sovereign
(in millions) Sovereign Foreign Agency Financial Non-Financial Total
Amortized Fair Amortized Fair Amortized Fair Amortized Fair Amortized Fair
Country: Cost Value Cost Value Cost Value Cost Value Cost Value
United Kingdom $ 88.4 $ 89.0 $ - $ - $ 335.6 $ 337.4 $ 234.1 $ 245.7 $ 658.1 $ 672.1
Germany 0.2 0.2 51.6 52.0 0.2 0.2 65.9 69.4 117.9 121.8
Switzerland - - - - 16.1 16.3 63.6 69.3 79.7 85.6
France - - 4.8 4.8 18.4 17.0 56.4 58.8 79.6 80.6
Supranationals - - 75.3 75.7 - - - - 75.3 75.7
The Netherlands - - 13.8 13.9 24.0 24.3 9.1 10.8 46.9 49.0
Spain - - - - 12.4 12.3 27.5 27.2 39.9 39.5
Sweden - - 1.0 1.0 14.9 15.5 12.8 13.2 28.7 29.7
Italy - - - - - - 16.1 15.5 16.1 15.5
Belgium - - - - - - 12.9 13.5 12.9 13.5
Ireland - - - - - - 9.4 10.4 9.4 10.4
Portugal - - - - - - 10.8 10.0 10.8 10.0
Norway - - 3.3 3.4 2.6 2.5 3.2 3.5 9.1 9.4
Luxembourg - - - - - - 9.5 9.3 9.5 9.3
Denmark - - - - - - 1.8 1.8 1.8 1.8
Total $ 88.6 $ 89.2 $ 149.8 $ 150.8 $ 424.2 $ 425.5 $ 533.1 $ 558.4 $ 1,195.7 $ 1,223.9
Our sovereign debt totals $89.2 million, or 1.2% of investment assets, and is
almost exclusively limited to the highly rated country of the U.K. We have no
sovereign debt of lower rated countries such as Greece, Ireland, Italy, Portugal
and Spain ("GIIPS"). Our supranational and foreign agency exposure totals $150.8
million, or 2.0% of investment assets, and primarily consists of debt securities
from the highly rated countries of Germany, the Netherlands, France and Norway.
Exposure to European banks, excluding those that are based in the U.K., totals
$88.1 million, or 1.2% of investment assets. Also, we hold money market funds
totaling $113.3 million, or 1.5% of investment assets, which are comprised of a
well-diversified portfolio of short-term debt securities of predominately large
financial institutions domiciled in highly rated countries. The remainder of our
European non-sovereign debt exposure, excluding the U.K., is $312.7 million,
which represents 4.1% of investment assets. Generally, these securities are high
quality, large cap multi-national companies that are well diversified by sector,
country and issuer. Included in our non-financial, non-sovereign exposure are
credits domiciled in Spain, Italy, Ireland and Portugal totaling $63.1 million,
or 0.8% of investment assets. These consist of large market capitalization
issuers that provide essential products and/or services.
The table above represents all European countries in which we have exposure. We
determined country exposures based on the country of domicile for the ultimate
parent company of the various issuers we hold; however, in light of the economic
and financial inter-relatedness and dependencies that exist among European
countries and related financial systems, economic turmoil in one country could
trigger a contagion effect on other countries. We believe the quality of our
European credit exposure remains sound based on ratings and issuer strength,
position in the capital structure, support through guarantees and partial
government ownership by highly rated countries, diversity and quality of
non-financial issuers and blend of industry exposures, and yield curve position.
We believe that we do not have meaningful indirect exposures in our portfolio
and we do not invest in credit derivatives.
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We manage our country exposure using fundamental analysis coupled with relative
value considerations. Investment decisions are based on the combination of a
top-down macroeconomic perspective and bottom-up credit security analysis. We
monitor political and economic developments; progress toward attainment of
growth and budget targets; developments related to policy, reform and regulatory
initiatives from European officials; progress toward funding objectives,
including the availability and cost of funding; outlook for credit ratings;
ability of banks to meet increased regulatory capital standards, operate in a
weakened macroeconomic environment, and maintain adequate liquidity and
sufficient access to capital to meet funding requirements; and contagion
throughout the financial system as evidenced by increased costs for interbank
funding, lower prices for stocks and corporate bonds, as well as the
availability of capital.
We actively manage our current holdings and seek securities with the best
combination of credit strength and valuation. As we invest new capital, we have
a defensive bias based on the uncertainty regarding the strength and duration of
economic recovery, downside risks as a result of the European debt crisis and
our belief that volatility will remain high based on these challenges.
Accordingly, some areas of our focus include providers of essential services or
products best positioned to navigate the period of weak growth; industrials with
greater international exposure, either locally or via exports, particularly to
the developing world, which we view more favorably based on higher growth
assumptions for emerging market economies; and financial institutions best
positioned regarding asset quality, liquidity and capital adequacy.
Overall economic growth remains weak throughout the European region and is
expected to have a dampening effect on earnings growth and credit quality for
some time. Volatility remains high and European sovereign risk premiums are
elevated, although down from peak levels. Officials in Europe have not been able
to engineer a lasting solution to the debt crisis or find a way to address the
twin objectives of stimulating economic growth while balancing fiscal budgets.
However, we believe leaders remain committed to protecting the currency union
and improving financial stability. Although the timing and degree of success
toward achieving sustained improvement regarding the European crisis remains
highly uncertain, we do not anticipate that any future developments related to
our European sovereign and non-sovereign debt exposure will have a material
effect on our financial condition, results of operation or liquidity.
Other-than-Temporary Impairments
For the three months ended June 30, 2012, we recognized $1.6 million of
other-than-temporary impairments ("OTTI") on fixed maturities and equity
securities in earnings. OTTI on debt securities was $1.4 million, of which $0.9
million related to a below investment grade corporate bond in the utilities
sector that we intend to sell and $0.5 million related to estimated credit
losses on corporate and residential mortgage-backed securities. Additionally, we
recognized OTTI on common stock of $0.2 million. For the three months ended
June 30, 2011, we recognized in earnings $0.8 million of OTTI on below
investment grade fixed maturity securities which we intended to sell, including
$0.6 million related to corporate bonds and $0.2 million related to municipal
bonds.
For the first six months of 2012, we recognized in earnings $3.5 million of
OTTI, of which $3.3 million related to fixed maturities and $0.2 million related
to equity securities. OTTI on debt securities consisted of $2.4 million of below
investment grade corporate bonds, primarily in the utilities sector, that we
intend to sell and $0.9 million related to estimated credit losses, including
$0.5 million on investment grade residential mortgage-backed securities and $0.4
million on below investment grade corporate bonds primarily in the industrial
sector. For the first six months of 2011, we recognized $2.2 million of OTTI on
fixed maturity and equity securities in earnings. OTTI on debt securities was
$1.7 million, primarily on below investment grade bonds that we intended to
sell, of which $0.9 million was related to a municipal bond, $0.6 million
related to corporate bonds and $0.2 million related to estimated credit losses
on investment grade residential mortgage-backed securities. Additionally, we
recognized OTTI on a common stock of $0.5 million.
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Unrealized Losses
The following table provides information about our fixed maturities and equity
securities that are in an unrealized loss position. (See also Note 6 -
"Investments" of the Notes to Interim Consolidated Financial Statements.)
June 30, 2012 December 31, 2011
Gross Gross
Unrealized Unrealized
(in millions) Losses Fair Value Losses Fair Value
Fixed maturities:
Investment grade:
12 months or less $ 5.1 $ 497.8 $ 27.1 $ 1,175.5
Greater than 12 months 16.9 131.0 14.3 108.9
Total investment grade fixed
maturities 22.0 628.8 41.4 1,284.4
Below investment grade:
12 months or less 5.4 45.3 9.9 126.9
Greater than 12 months 6.2 61.2 3.7 14.7
Total below investment grade fixed
maturities 11.6 106.5 13.6 141.6
Equity securities:
12 months or less 4.9 76.9 8.8 87.2
Greater than 12 months 1.1 7.9 - -
Total equity securities 6.0 84.8 8.8 87.2
Total $ 39.6 $ 820.1 $ 63.8 $ 1,513.2
Gross unrealized losses on fixed maturities and equity securities decreased
$24.2 million, or 37.9%, to $39.6 million at June 30, 2012, compared to $63.8
million at December 31, 2011. The decrease in unrealized losses was primarily
attributable to lower interest rates and tightening of credit spreads across all
sectors. At June 30, 2012, gross unrealized losses consist primarily of $21.7
million of corporate fixed maturities, $8.1 million of mortgage-backed
securities, $6.0 million of equity securities and $2.7 million in municipal
securities.
We view the gross unrealized losses on fixed maturities and equity securities as
being temporary since it is our assessment that these securities will recover in
the near term, allowing us to realize their anticipated long-term economic
value. With respect to gross unrealized losses on fixed maturities, we do not
intend to sell, nor is it more likely than not we will be required to sell, such
debt securities before this expected recovery of amortized cost (See also
"Liquidity and Capital Resources"). With respect to equity securities, we have
the intent and ability to retain such investments for the period of time
anticipated to allow for this expected recovery in fair value. The risks
inherent in our assessment methodology include the risk that, subsequent to the
balance sheet date, market factors may differ from our expectations; the global
economic recovery is less robust than we expect or reverts to recessionary
trends; we may decide to subsequently sell a security for unforeseen business
needs; or changes in the credit assessment or equity characteristics from our
original assessment may lead us to determine that a sale at the current value
would maximize recovery on such investments. To the extent that there are such
adverse changes, an OTTI would be recognized as a realized loss. Although
unrealized losses are not reflected in the results of financial operations until
they are realized or deemed "other-than-temporary", the fair value of the
underlying investment, which does reflect the unrealized loss, is reflected in
our Consolidated Balance Sheets.
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The following table sets forth gross unrealized losses for fixed maturities by
maturity period and for equity securities at June 30, 2012 and December 31,
2011. Actual maturities may differ from contractual maturities because borrowers
may have the right to call or prepay obligations, with or without call or
prepayment penalties, or we may have the right to put or sell the obligations
back to the issuers.
June 30, December 31,
(in millions) 2012 2011
Due in one year or less $ 0.5 $ 1.9
Due after one year through five years 7.0
18.9
Due after five years through ten years 7.2 11.2
Due after ten years 10.0 12.9
24.7 44.9
Mortgage-backed and asset-backed securities 8.9 10.1
Total fixed maturities 33.6 55.0
Equity securities 6.0 8.8
Total fixed maturities and equity securities $ 39.6 $
63.8
The carrying values of defaulted fixed maturity securities on non-accrual status
at June 30, 2012 and December 31, 2011 were not material. The effects of
non-accruals compared with amounts that would have been recognized in accordance
with the original terms of the fixed maturities, were reductions in net
investment income of $1.2 million for the six months ended June 30, 2012 and
2011. Any defaults in the fixed maturities portfolio in future periods may
negatively affect investment income.
Our investment portfolio and shareholders' equity can be significantly impacted
by changes in market values of our securities. As the U.S. and global financial
markets and economies remain unstable, market volatility could increase and
defaults on fixed income securities could occur. As a result, we could incur
additional realized and unrealized losses in future periods, which could have a
material adverse impact on our results of operations and/or financial position.
Fiscal and monetary policies in place, primarily in the United States and
Europe, are supportive of moderate economic growth. The removal or modification
of these policies could have an adverse effect 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.
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Other Items
Net income also includes the following items:
Three Months Ended June 30,
Other
Commercial Personal Property and Discontinued
(in millions) Lines Lines Chaucer Casualty Operations Total
2012
Net realized investment losses $ (1.9) $ (1.1) $ (0.4) $ - $ - $ (3.4)
Costs related to acquired businesses - - - (0.9) - (0.9)
Net foreign exchange gains - - - 0.3 - 0.3
Gain from sale of Citizens Management, Inc - - - - 10.9 10.9
Other discontinued operations, net of taxes - - - - 0.1
0.1
2011
Net realized investment gains $ 1.4 $ 0.5 $ - $ 11.5 $ - $ 13.4
Gain from the retirement of debt - - - 0.3 -
0.3
Costs related to acquired businesses - - - (11.1) -
(11.1)
Loss on derivative instruments - - - (4.7) -
(4.7)
Discontinued operations, net of taxes - - - - 0.6 0.6
Six Months Ended June 30,
Other
Commercial Personal Property and Discontinued
(in millions) Lines Lines Chaucer Casualty Operations Total
2012
Net realized investment gains (losses) $ (0.2) $ 0.1 $ (0.3) $ 0.1 $ - $ (0.3)
Costs related to acquired businesses - - - (2.4) -
(2.4)
Gain from sale of Citizens Management, Inc - - - - 10.9
10.9
Other discontinued operations, net of taxes - - - - (0.9)
(0.9)
2011
Net realized investment gains $ 2.8 $ 2.1 $ - $ 11.8 $ - $ 16.7
Net loss from the retirement of debt - - - (2.2) -
(2.2)
Costs related to acquired businesses - - - (13.8) -
(13.8)
Loss on derivative instruments - - - (4.7) -
(4.7)
Discontinued operations, net of taxes - - - - 2.0
2.0
We manage investment assets for our Commercial Lines, Personal Lines, and Other
Property and Casualty segments based on the requirements of our U.S. combined
property and casualty companies. We allocate the investment income, expenses and
realized gains to our Commercial Lines, Personal Lines and Other Property and
Casualty segments based on actuarial information related to the underlying
businesses. We manage investment assets separately for our Chaucer segment.
Net realized losses on investments were $3.4 million for the three months ended
June 30, 2012 compared to net realized gains on investments of $13.4 million for
the three months ended June 30, 2011. Net realized losses in 2012 are primarily
due to a $5.1 million loss on futures contracts relating to the release of tax
capital loss carryforwards and $1.6 million of impairments principally from
fixed maturities, partially offset by $3.3 million of gains recognized primarily
from the sale of fixed maturities. Net realized gains in 2011 are primarily due
to $14.1 million of gains recognized from the sale of fixed maturities,
partially offset by $0.8 million of other-than-temporary impairments from fixed
maturities.
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Net realized losses on investments were $0.3 million for the six months ended
June 30, 2012 compared to net realized gains on investments of $16.7 million for
the six months ended June 30, 2011. Net realized losses in 2012 are primarily
due to the aforementioned $5.1 million loss on futures contracts and $3.5
million of impairments principally from fixed maturities, partially offset by
$7.4 million of gains recognized primarily from the sale of fixed maturities as
well as $0.7 million of gains on foreign currency hedges. Net realized gains in
2011 are primarily due to $18.5 million of gains recognized from the sale of
fixed maturities, partially offset by $2.2 million of other-than-temporary
impairments from fixed maturities and to a lesser extent, equity securities.
Acquisition costs were $0.9 million for the three months ended June 30, 2012
compared to $11.1 million for the three months ended June 30, 2011. Acquisition
costs were $2.4 million for the six months ended June 30, 2012 compared to $13.8
million for the six months ended June 30, 2011. Acquisition costs primarily
consist of advisory, legal, and accounting costs associated with the acquisition
of Chaucer on July 1, 2011. See Note 3 - "Acquisitions" in this Form 10-Q for
additional information.
On April 30, 2012, we completed the sale of our third party administration
subsidiary, Citizens Management, Inc ("CMI"). CMI provided third party workers'
compensation and disability program administration services (such as claims
administration, loss prevention and medical cost containment and in-house excess
workers' compensation coverage) to public entities, self-insured employers and
group programs. CMI generated total revenues of $4.4 million during the four
months ended April 30, 2012 and $12.5 million during the year ended December 31,
2011. Income before taxes totaled $0.7 million during the first four months of
2012, while contributing $2.0 million during 2011. Assets and shareholder's
equity transferred as part of this sale totaled $10.9 million and $0.6 million,
respectively. This sale resulted in a gain of $10.9 million after taxes and is
included in discontinued operations.
Income Taxes
We are subject to the tax laws and regulations of the U.S. and foreign countries
in which we operate. We file a consolidated U.S. federal income tax return that
includes the holding company and its U.S. subsidiaries. Generally, taxes are
accrued at the U.S. statutory tax rate of 35% for income from the U.S.
operations. Our primary non-U.S. jurisdiction is the U.K. The U.K. statutory
rate decreased from 26% to 25% effective April 1, 2012. We accrue taxes on
certain non-U.S. income that is subject to U.S. tax as a result of being owned
by a U.S. shareholder at the U.S. rate. Foreign tax credits, where available,
are utilized to offset U.S. tax as permitted. Certain of our non-U.S. income is
not subject to U.S. tax until repatriated. Foreign taxes on this non-U.S. income
are accrued at the local foreign rate and do not have an accrual for U.S.
deferred taxes since these earnings are intended to be permanently reinvested
overseas.
Three Months Ended June 30, 2012 Compared to Three Months Ended June 30, 2011
The provision for income taxes from continuing operations was an expense of $1.3
million in the three months ended June 30, 2012, compared to a benefit of $27.4
million during the same period in 2011. These provisions resulted in
consolidated effective tax rates of 11.7% of pre-tax income and 45.5% of pre-tax
loss for the three months ended June 30, 2012 and 2011, respectively. These
provisions reflect the significant fluctuations in pre-tax GAAP results from
2011 to 2012, i.e. pre-tax loss in 2011 versus pre-tax income in 2012, and
changes in our valuation allowance related to capital loss carryforwards of an
increase of $1.1 million and a decrease of $4.7 million in the second quarter of
2012 and 2011, respectively. In addition, these provisions reflect the benefits
related to tax planning strategies implemented in prior years that had been
reflected in Accumulated Other Comprehensive Income of $3.6 million and $2.1
million in the second quarter of 2012 and 2011, respectively. Absent these
benefits, the provision for income taxes from continuing operations would have
been an expense of $3.8 million or 34.2% and a benefit of $20.6 million or 34.2%
for the three months ended June 30, 2012 and 2011, respectively.
Income tax provision on segment income was an expense of $5.1 million during the
three months ended June 30, 2012, compared to a benefit of $19.7 million during
the same period in 2011. These provisions resulted in effective tax rates for
segment income of 33.8% and 33.9% in 2012 and 2011, respectively.
Six Months Ended June 30, 2012 Compared to Six Months Ended June 30, 2011
The provision for income taxes from continuing operations was an expense of
$21.4 million for the six months ended June 30, 2012, compared to a benefit of
$17.8 million during the same period in 2011. These provisions resulted in
consolidated effective tax rates of 26.1% and 78.4% for the six months ended
June 30, 2012 and 2011, respectively. These provisions reflect the significant
fluctuations in pre-tax GAAP results from 2011 to 2012, i.e. pre-tax loss in
2011 versus pre-tax income in 2012, and decreases in our valuation allowance
related to capital loss carryforwards of $5.8 million in the first six months of
2011. In addition, these provisions reflect the benefits related to tax planning
strategies implemented in prior years that had been reflected in Accumulated
Other Comprehensive Income of $6.6 million and $4.1 million in the first six
months of 2012 and 2011, respectively. Absent these benefits, the provision for
income taxes from continuing operations would have been an expense of $28.0
million or 34.2% and a benefit of $7.9 million or 34.8% for the six months ended
June 30, 2012 and 2011, respectively.
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Income tax provision on segment income was an expense of $28.6 million during
the six months ended June 30, 2012, compared to a benefit of $6.2 million during
the same period in 2011. These provisions resulted in effective tax rates for
segment income of 33.8% and 33.2% in 2012 and 2011, respectively. The increase
in the effective rate is primarily due to higher projected underwriting income
in 2012.
In June 2012, we completed a transaction which resulted in the realization, for
tax purposes only, of unrealized gains in our investment portfolio of $69.6
million. This transaction enabled us to realize capital loss carryforwards to
offset this gain, and resulted in the release of $24.4 million of the valuation
allowance we held against the deferred tax asset related to these capital loss
carryforwards. The release of $24.4 million was recorded as a benefit in
accumulated other comprehensive income. This amount will be released into income
from continuing operations, related to non-segment income, in future years, as
the investment securities subject to these transactions are sold or mature.
The valuation allowance related to our deferred tax asset was $1.1 million at
June 30, 2012, compared to $35.9 million at December 31, 2011, a decrease of
$34.8 million. The decrease in this valuation allowance resulted from the
transaction described above which utilized our capital loss carryforwards,
unrealized appreciation in our investment portfolio, and gain on sale of
business included in our Consolidated Statements of Income. Accordingly, we
recorded decreases in our valuation allowance of $31.9 million as an adjustment
to accumulated other comprehensive income and $2.9 million in discontinued
operations.
Critical Accounting Estimates
Interim consolidated financial statements have been prepared in conformity with
U.S. GAAP and include certain accounting policies that we consider to be
critical due to the amount of judgment and uncertainty inherent in the
application of those policies. While we believe that the amounts included in our
consolidated financial statements reflect our best judgment, the use of
different assumptions could produce materially different accounting estimates.
As disclosed in our 2011 Annual Report on Form 10-K, we believe the following
accounting estimates are critical to our operations and require the most
subjective and complex judgment:
- Reserve for losses and loss expenses
- Reinsurance recoverable balances
- Pension benefit obligations
- Other-than-temporary impairments ("OTTI")
- Deferred tax assets
For a more detailed discussion of these critical accounting estimates, see our
Annual Report on Form 10-K for the year ended December 31, 2011.
Statutory Surplus of U.S. Insurance Subsidiaries
The following table reflects statutory surplus of our U.S. insurance
subsidiaries:
(in millions) June 30, 2012 December 31, 2011
Total Statutory Surplus - U.S. Insurance Subsidiaries $ 1,655.1
$ 1,582.8
The statutory surplus for our U.S. insurance subsidiaries increased $72.3
million during the first six months of 2012, primarily due to underwriting
results, an increase in unrealized gains, and from changes in admitted tax
assets and other non-admitted assets.
The NAIC prescribes an annual calculation regarding risk based capital ("RBC").
RBC ratios for regulatory purposes are expressed as a percentage of the capital
required to be above the Authorized Control Level (the "Regulatory Scale");
however, in the insurance industry, RBC ratios are widely expressed as a
percentage of the Company Action Level. The following table reflects the Company
Action Level, the Authorized Control Level and RBC ratios for Hanover Insurance
(which includes Citizens and other U.S. insurance subsidiaries), as of June 30,
2012, expressed both on the Industry Scale (Total Adjusted Capital divided by
the Company Action Level) and Regulatory Scale (Total Adjusted Capital divided
by Authorized Control Level):
Company Authorized RBC Ratio RBC Ratio
Action Control Industry Regulatory
(dollars in millions) Level Level Scale Scale
The Hanover Insurance Company$ 604.3$ 302.2 272% 544%
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Lloyd's Capital Requirement
Chaucer corporate members operate in the Lloyd's market, which requires that
these members deposit funds, referred to as "Funds at Lloyd's", to support their
underwriting interests. Lloyd's sets required capital annually for all
participating syndicates based on each syndicate's business plans, the rating
and reserving environment, and discussions with regulatory and rating agencies.
Although the minimum capital levels are set by Lloyd's, it is the responsibility
of Chaucer to continually monitor the risk profiles of its managed syndicates to
ensure that the level of funding remains appropriate. Such capital is comprised
of cash and cash equivalents, investments, undrawn letters of credit provided by
various banks and other assets. At June 30, 2012, we are in compliance with the
capital requirements. We have the following securities, assets and letters of
credit pledged to Lloyd's to satisfy these capital requirements at June 30, 2012
and expect to be able to meet these capital requirements in the future.
(in millions)
Letters of credit $ 180.0
Reinsurance treaty 95.0
Fixed maturities, at fair value
403.7
Cash and cash equivalents
124.8
Total securities, assets and letters of credit pledged to Lloyd's $
803.5
Liquidity and Capital Resources
Liquidity is a measure of our ability to generate sufficient cash flows to meet
the cash requirements of business operations. As a holding company, our primary
ongoing source of cash is dividends from our insurance subsidiaries. However,
dividend payments to us by our U.S. insurance subsidiaries are subject to
limitations imposed by regulators, such as prior notice periods and the
requirement that dividends in excess of a specified percentage of statutory
surplus or prior year's statutory earnings receive prior approval (so called
"extraordinary dividends").
Dividend payments to the holding company by our Chaucer business are regulated
by U.K. law. Dividends from Chaucer are dependent on dividends from its
subsidiaries. Annual dividend payments from Chaucer are limited to retained
earnings that are not restricted by capital and other requirements for business
at Lloyd's. Also, Chaucer must provide advance notice to the U.K.'sFinancial
Services Authority ("FSA") of certain proposed dividends or other payments from
FSA regulated entities. There are currently no plans to repatriate dividends to
our holding company from Chaucer. In connection with an intercompany borrowing
arrangement with the holding company, interest on a $300 million note is paid by
Chaucer on a quarterly basis to the holding company. This interest approximates
$5 million quarterly and may be deferred at the election of the holding company.
If deferred, the interest is added to the principal. For the six months ended
June 30, 2012, Chaucer has paid $16 million of interest, including $5 million
relating to 2011 to the holding company.
Sources of cash for our insurance subsidiaries primarily consist of premiums
collected, investment income and maturing investments. Primary cash outflows are
paid claims, losses and loss adjustment expenses, policy acquisition expenses,
other underwriting expenses and investment purchases. Cash outflows related to
losses and loss adjustment expenses can be variable because of uncertainties
surrounding settlement dates for liabilities for unpaid losses and because of
the potential for large losses either individually or in the aggregate. We
periodically adjust our investment policy to respond to changes in short-term
and long-term cash requirements.
Net cash provided by operating activities was $59.3 million during the first six
months of 2012, as compared to $102.7 million during the first six months of
2011. The $43.4 million decrease primarily resulted from an increase in loss and
LAE payments, partially offset by an increase in premiums.
Net cash used in investing activities was $326.0 million during the first six
months of 2012, as compared to net cash provided by investing activities of
$130.7 million during the first six months of 2011. 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 CMI. In 2011,
cash provided was primarily related to net sales of fixed maturities used to
fund the Chaucer acquisition.
Net cash used in financing activities was $41.0 million during the first six
months of 2012, as compared to net cash provided by financing activities of
$195.5 million during the first six months of 2011. During 2012, cash used in
financing activities primarily resulted from the payment of dividends to
shareholders, repurchases of our common stock and repayments of collateral held
for our securities lending program, partially offset by the proceeds from the
FHLBB debt borrowings. During 2011, cash provided by financing activities
primarily resulted from the issuance, on June 17, 2011, of $300.0 million of
unsecured senior debentures. Cash received from the issuance of debt was
partially offset by the repurchase of $57.2 million of our junior debentures,
repayments of collateral related to our securities lending program, and the
payment of dividends to our shareholders.
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At June 30, 2012, THG, as a holding company, held approximately $183.7 million
of fixed maturities and cash. We believe our holding company assets are
sufficient to meet our future obligations, which consists primarily of our
dividends to shareholders (as and to the extent declared), the interest on our
senior debentures, additional funds relating to the purchase of Chaucer, certain
costs associated with benefits due to our former life employees and agents, and
to the extent required, payments related to indemnification of liabilities
associated with the sale of various subsidiaries. We do not expect that it will
be necessary to dividend additional funds from our insurance subsidiaries in
order to fund 2012 holding company obligations; however, we may decide to do so.
Dividends to common shareholders are subject to quarterly board approval and
declaration. During the first six months of 2012, we paid two quarterly
dividends, as declared by the Board, of $0.30 per share to our shareholders
totaling $27.0 million. We believe that our holding company assets are
sufficient to provide for future shareholder dividends should the Board of
Directors declare them.
We expect to continue to generate sufficient positive operating cash to meet all
short-term and long-term cash requirements relating to current operations,
including the funding of our qualified defined benefit pension plan and the
Chaucer pension plan. Based upon the current estimate of liabilities and certain
assumptions regarding investment returns and other factors, our qualified
defined benefit pension plan is essentially fully funded as of June 30, 2012. As
a result, we currently expect that significant cash contributions will not be
required for this plan for several years. The Chaucer pension plan is
approximately $30 million underfunded as of June 30, 2012. The ultimate payment
amounts for both the defined benefit plan and the Chaucer pension plan are based
on several assumptions, including but not limited to, the rate of return on plan
assets, the discount rate for benefit obligations, mortality experience,
interest crediting rates and the ultimate valuation and determination of benefit
obligations. Since differences between actual plan experience and our
assumptions are likely, changes to our funding obligations in future periods are
possible.
Our insurance subsidiaries maintain a high degree of liquidity within their
respective investment portfolios in fixed maturity and short-term investments.
We believe that the quality of the assets we hold will allow us to realize the
long-term economic value of our portfolio, including securities that are
currently in an unrealized loss position. We do not anticipate the need to sell
these securities to meet our insurance subsidiaries' cash requirements since we
expect our insurance subsidiaries to generate sufficient operating cash to meet
all short-term and long-term cash requirements. However, there can be no
assurance that unforeseen business needs or other items will not occur causing
us to have to sell those securities in a loss position before their values fully
recover, thereby causing us to recognize impairment charges in that time period.
Since October 2007 and through June 2012, our Board of Directors has authorized
aggregate repurchases of our common stock of up to $500 million. As of June 30,
2012, we have $125.2 million available for repurchases under these repurchase
authorizations. Repurchases may be executed using open market purchases,
privately negotiated transactions, accelerated repurchase programs or other
transactions. We are not required to purchase any specific number of shares or
to make purchases by any certain date under this program. During the first six
months of 2012 we purchased 0.3 million shares of our common stock through open
market purchases at a cost of $10.0 million. Total repurchases under this
program as of June 30, 2012 were 8.8 million shares at a cost of $374.8 million.
Additionally, from time to time, we may also repurchase debt.
On August 2, 2011, we entered into a $200.0 million committed syndicated credit
agreement which expires in August 2015, with an option to increase the facility
to $250.0 million assuming no default and satisfaction of certain other
conditions. The agreement also includes a $50 million sub-facility for standby
letters of credit that can be used for general corporate purposes. Borrowings,
if any, under this agreement are unsecured and incur interest at a rate per
annum equal to, at our option, a designated base rate or the three - month LIBOR
plus applicable margin. The agreement provides covenants, including but not
limited to, maintaining at least a certain level of consolidated equity, maximum
consolidated leverage ratios, and an RBC ratio at our primary U.S. domiciled
property and casualty companies. We had no borrowings under this agreement in
2011 and 2012.
In November 2011, we entered into a Standby Letter of Credit Facility Agreement
(the "Facility Agreement") not to exceed $180.0 million outstanding at any one
time, with the option to increase the amount available for issuances of letters
of credit to $270.0 million in the aggregate on one occasion only during the
term of the Facility Agreement (subject to the consent of all lenders and
assuming no default and satisfaction of other specified conditions). The
agreement provides certain covenants including, but not limited to, the
syndicates' financial condition. The Facility Agreement is used to provide
regulatory capital supporting Chaucer's underwriting through two managed
syndicates. The Facility Agreement expires on December 31, 2016. A letter of
credit commission fee on outstanding letters of credit is payable quarterly, and
ranges from 1.50% to 2.125% per annum, depending on our credit ratings for
portions that are not cash collateralized, and 0.30% per annum for portions that
are cash collateralized. In the first six months of 2012, we collateralized
$33.0 million of the $180.0 million outstanding letter of credit. In addition to
the commission fee on the uncollateralized outstanding letter of credit, a
commitment fee in respect of the unutilized commitments under the Facility
Agreement is payable quarterly, and ranges from 0.60% to 0.85% per annum,
depending on our credit ratings. Chaucer is also required to pay customary
agency fees.
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Simultaneous with the Facility Agreement, in November 2011, we entered into a
Guaranty Agreement (the "Guaranty Agreement") with Lloyds TSB Bank plc, as
Facility Agent and Security Agent, pursuant to which, we unconditionally
guarantee the obligations of Chaucer under the Facility Agreement. The Guaranty
Agreement contains certain financial covenants that require us to maintain a
minimum net worth, a minimum risk-based capital ratio at our primary U.S.
domiciled property and casualty companies and a maximum leverage ratio, and
certain negative covenants that limit our ability, among other things, to incur
or assume certain debt, grant liens on our property, merge or consolidate,
dispose of assets, materially change the nature or conduct of our business and
make restricted payments (except, in each case, as provided by certain
exceptions). The Guaranty Agreement also contains certain customary
representations and warranties.
At June 30, 2012, we were in compliance with the covenants of the aforementioned
debt agreements.
Off-Balance Sheet Arrangements
We currently do not have any material off-balance sheet arrangements that are
reasonably likely to have a material effect on our financial position, revenues,
expenses, results of operations, liquidity, capital expenditures, or capital
resources.
Contingencies and Regulatory Matters
Information regarding contingencies and regulatory matters appears in Part
I-Note 12 "Commitments and Contingencies" of the Notes to Interim Consolidated
Financial Statements.
Risks and Forward-Looking Statements
Information regarding risk factors and forward-looking information appears in
Part II - Item 1A of this Quarterly Report on
Form 10-Q and in Part I - Item 1A of our Annual Report on Form 10-K for the
fiscal year ended December 31, 2011. This Management's Discussion and Analysis
should be read and interpreted in light of such factors.
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ITEM 3
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
Our market risks, the ways we manage them, and sensitivity to changes in
interest rates, equity price risk, and foreign currency exchange risk are
summarized in Management's Discussion and Analysis of Financial Condition and
Results of Operations as of December 31, 2011, included in our Annual Report on
Form 10-K for the year ended December 31, 2011. There have been no material
changes in the first six months of 2012 to these risks or our management of
them.
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ITEM 4
CONTROLS AND PROCEDURES
Disclosure Controls and Procedures Evaluation
Under the supervision and with the participation of our management, including
our Chief Executive Officer and Chief Financial Officer, we conducted an
evaluation of our disclosure controls and procedures, as such term is defined
under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as
amended (the "Exchange Act").
Limitations on the Effectiveness of Controls
Our management, including our Chief Executive Officer and Chief Financial
Officer, does not expect that our disclosure controls over financial reporting
will prevent all error and all fraud. A control system, no matter how well
designed and operated, can provide only reasonable, not absolute, assurance that
the control system's objectives will be met. Further, the design of a control
system must reflect the fact that there are resource constraints, and the
benefits of controls must be considered relative to their costs. Because of the
inherent limitations in all control systems, no evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, have been detected. These inherent limitations include the realities that
judgments in decision-making can be faulty and that breakdowns can occur because
of simple error or mistake. Controls can also be circumvented by the individual
acts of some persons, by collusion of two or more people, or by management
override of the controls. The design of any system of controls is based in part
on certain assumptions about the likelihood of future events, and there can be
no assurance that any design will succeed in achieving its stated goals under
all potential future conditions. Over time, controls may become inadequate
because of changes in conditions or deterioration in the degree of compliance
with policies or procedures. Because of the inherent limitations in a
cost-effective control system, misstatements due to error or fraud may occur and
not be detected.
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
Based on our controls evaluation, our Chief Executive Officer and Chief
Financial Officer concluded that as of the end of the period covered by this
quarterly report, our disclosure controls and procedures were effective to
provide reasonable assurance that (i) the information required to be disclosed
by us in reports that we file or submit under the Exchange Act is recorded,
processed, summarized and reported within the time periods specified in the
SEC's rules and forms and (ii) material information is accumulated and
communicated to our management, including our Chief Executive Officer and Chief
Financial Officer, as appropriate to allow timely decisions regarding required
disclosure.
Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Exchange Act Rule
13a-15(f). Under the supervision and with the participation of our management,
including our Chief Executive Officer and the Chief Financial Officer, we
conducted an evaluation of the internal control over financial reporting, as
required by Rule 13a-15(d) of the Exchange Act, to determine whether any changes
occurred during the period covered by this quarterly report on Form 10-Q that
have materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting. Based on that evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that there were no such
changes during the quarter ended June 30, 2012, that have materially affected,
or are reasonably likely to materially affect, our internal control over
financial reporting.
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