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EX-10.1 - FEDERAL HOME LOAN BANK OF BOSTON AGREEMENT FOR ADVANCES - HANOVER INSURANCE GROUP, INC.dex101.htm
EX-31.2 - SECTION 302 CFO CERTIFICATION - HANOVER INSURANCE GROUP, INC.dex312.htm
EX-32.2 - SECTION 906 CFO CERTIFICATION - HANOVER INSURANCE GROUP, INC.dex322.htm
EX-31.1 - SECTION 302 CEO CERTIFICATION - HANOVER INSURANCE GROUP, INC.dex311.htm
EX-32.1 - SECTION 906 CEO CERTIFICATION - HANOVER INSURANCE GROUP, INC.dex321.htm
EX-10.2 - THE HANOVER INSURANCE GROUP RETIREMENT SAVINGS PLAN - HANOVER INSURANCE GROUP, INC.dex102.htm
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2009

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission File Number 1-13754

 

 

THE HANOVER INSURANCE GROUP, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   04-3263626

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

440 Lincoln Street, Worcester, Massachusetts 01653

(Address of principal executive offices) (Zip Code)

(508) 855-1000

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   x    Accelerated filer   ¨
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

The number of shares outstanding of the registrant’s common stock was 50,032,721 as of November 1, 2009.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION

  

Item 1.

  

Financial Statements

  
  

Consolidated Statements of Income

   3-4
  

Consolidated Balance Sheets

   5
  

Consolidated Statements of Shareholders’ Equity

   6
  

Consolidated Statements of Comprehensive Income

   7
  

Consolidated Statements of Cash Flows

   8
  

Notes to Interim Consolidated Financial Statements

   9-37

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   38-86

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

   87

Item 4.

  

Controls and Procedures

   88

PART II. OTHER INFORMATION

Item 1.

  

Legal Proceedings

   89-90

Item 1A.

  

Risk Factors

   90-94

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

   95

Item 6.

  

Exhibits

   96

SIGNATURES

   97


Table of Contents

PART I - FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

THE HANOVER INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF INCOME

 

     (Unaudited)
Quarter Ended
September 30,
    (Unaudited)
Nine Months Ended
September 30,
 

(In millions)

   2009     2008     2009     2008  

REVENUES

        

Premiums

   $ 637.4      $ 621.1      $ 1,899.4      $ 1,858.1   

Net investment income

     62.1        65.5        188.3        193.9   

Net realized investment losses:

        

Total other-than-temporary impairment losses on securities

     (4.5     (53.1     (39.1     (66.7

Portion of loss recognized in other comprehensive income

     (1.6     —          9.8        —     
                                

Net other-than-temporary impairment losses on securities recognized in earnings

     (6.1     (53.1     (29.3     (66.7

Realized gains from sales and other

     6.1        0.3        19.6        6.0   
                                

Total net realized investment losses

     —          (52.8     (9.7     (60.7

Fees and other income

     9.0        8.3        25.8        25.7   
                                

Total revenues

     708.5        642.1        2,103.8        2,017.0   
                                

LOSSES AND EXPENSES

        

Losses and loss adjustment expenses

     403.0        474.2        1,225.1        1,239.7   

Policy acquisition expenses

     146.8        139.7        434.7        416.1   

Gain from retirement of corporate debt

     (0.2     —          (34.5     —     

Other operating expenses

     91.4        77.2        281.1        247.1   
                                

Total losses and expenses

     641.0        691.1        1,906.4        1,902.9   
                                

Income (loss) before federal income taxes

     67.5        (49.0     197.4        114.1   
                                

Federal income tax expense (benefit):

        

Current

     17.8        (1.1     42.8        40.6   

Deferred

     1.1        (4.4     22.7        11.8   
                                

Total federal income tax expense (benefit)

     18.9        (5.5     65.5        52.4   
                                

Income (loss) from continuing operations

     48.6        (43.5     131.9        61.7   

Discontinued operations (See Notes 3 and 4 ):

        

Gain (loss) from discontinued FAFLIC business (net of income tax benefit (expense) of $0.3 and $(1.7) for the quarters ended September 30, 2009 and 2008 and $0.3 and $(1.3) for the nine months ended September 30, 2009 and 2008), including loss on assets held-for-sale of $6.1 and $72.2 for the quarter and nine months ended September 30, 2008

     0.4        (21.7     6.3        (92.9

Gain (loss) from operations of discontinued accident and health business (net of income tax expense of $0.4 and $0.5 for the quarter and nine months ended September 30, 2009)

     0.7        —          (2.4     —     

Income from operations of AMGRO (net of income tax benefit of $1.3 for the nine months ended September 30, 2008), including gain on disposal of $11.1 in 2008

     —          —          —          10.1   

Gain on disposal of variable life insurance and annuity business (net of income tax benefit of $2.6 and $3.0 for the quarter and nine months ended September 30, 2008)

     —          2.7        4.1        8.1   

Other discontinued operations

     —          0.7        —          (0.5
                                

Net income (loss)

   $ 49.7      $ (61.8   $ 139.9      $ (13.5
                                

 

3


Table of Contents

THE HANOVER INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF INCOME (CONTINUED)

 

 

     (Unaudited)
Quarter Ended
September 30,
    (Unaudited)
Nine Months Ended
September 30,
 
     2009    2008     2009     2008  

PER SHARE DATA

         

Basic

         

Income (loss) from continuing operations

   $ 0.96    $ (0.85   $ 2.59      $ 1.20   

Discontinued operations:

         

Gain (loss) from discontinued FAFLIC business (net of income tax benefit (expense) of $0.01 and $(0.03) for the quarters ended September 30, 2009 and 2008 and $0.01 and $(0.03) for the nine months ended September 30, 2009 and 2008), including loss on assets held-for-sale of $0.12 and $1.39 for the quarter and nine months ended September 30, 2008

     0.01      (0.42     0.12        (1.81

Gain (loss) from operations of discontinued accident and health business (net of income tax expense of $0.01 for the quarter and nine months ended September 30, 2009)

     0.01      —          (0.04     —     

Income from operations of AMGRO (net of income tax benefit of $0.03 for the quarter and nine months ended September 30, 2008), including gain on disposal of $0.21 in 2008

     —        —          —          0.20   

Gain on disposal of variable life insurance and annuity business (net of income tax benefit of $0.05 and $0.06 for the quarter and nine months ended September 30, 2008)

     —        0.05        0.08        0.16   

Other discontinued operations

     —        0.01        —          (0.01
                               

Net income (loss) per share

   $ 0.98    $ (1.21   $ 2.75      $ (0.26
                               

Weighted average shares outstanding

     50.7      51.0        51.0        51.3   
                               

Diluted

         

Income (loss) from continuing operations

   $ 0.95    $ (0.85   $ 2.57      $ 1.19   

Discontinued operations:

         

Gain (loss) from discontinued FAFLIC business (net of income tax benefit (expense) of $0.01 and $(0.03) for the quarters ended September 30, 2009 and 2008 and $0.01 and $(0.03) for the nine months ended September 30, 2009 and 2008), including loss on assets held-for-sale of $0.12 and $1.39 for the quarter and nine months ended September 30, 2008

     0.01      (0.42     0.12        (1.80

Gain (loss) from operations of discontinued accident and health business (net of income tax expense of $0.01 for the quarter and nine months ended September 30, 2009)

     0.01      —          (0.05     —     

Income from operations of AMGRO (net of income tax benefit of $0.03 for the quarter and nine months ended September 30, 2008), including gain on disposal of $0.21 in 2008

     —        —          —          0.20   

Gain on disposal of variable life insurance and annuity business (net of income tax benefit of $0.05 and $0.06 for the quarter and nine months ended September 30, 2008)

     —        0.05        0.08        0.16   

Other discontinued operations

     —        0.01        —          (0.01
                               

Net income (loss) per share

   $ 0.97    $ (1.21   $ 2.72      $ (0.26
                               

Weighted average shares outstanding

     51.2      51.0        51.4        51.8   
                               

The accompanying notes are an integral part of these consolidated financial statements.

 

4


Table of Contents

THE HANOVER INSURANCE GROUP, INC.

CONSOLIDATED BALANCE SHEETS

 

(In millions, except per share data)

   (Unaudited)
September 30,
2009
    December 31,
2008
 

ASSETS

    

Investments:

    

Fixed maturities, at fair value (amortized cost of $4,696.3 and $4,382.0 )

   $ 4,805.1      $ 4,140.9   

Equity securities, at fair value (cost of $109.8 and $97.6)

     122.0        76.2   

Mortgage loans

     20.4        31.1   

Other long-term investments

     16.7        18.4   
                

Total investments

     4,964.2        4,266.6   
                

Cash and cash equivalents

     233.2        397.7   

Accrued investment income

     53.4        52.3   

Premiums, accounts and notes receivable, net

     616.7        578.5   

Reinsurance receivable on paid and unpaid losses, benefits and unearned premiums

     1,111.3        1,129.6   

Deferred policy acquisition costs

     285.3        264.8   

Deferred federal income taxes

     216.4        285.6   

Goodwill

     170.0        169.9   

Other assets

     309.7        315.7   

Assets of discontinued operations

     128.4        1,769.5   
                

Total assets

   $ 8,088.6      $ 9,230.2   
                

LIABILITIES

    

Policy liabilities and accruals:

    

Losses and loss adjustment expenses

   $ 3,084.8      $ 3,201.3   

Unearned premiums

     1,322.6        1,246.3   

Contractholder deposit funds and other policy liabilities

     1.5        1.8   
                

Total policy liabilities and accruals

     4,408.9        4,449.4   
                

Expenses and taxes payable

     645.1        622.3   

Reinsurance premiums payable

     63.4        61.3   

Long-term debt

     433.8        531.4   

Liabilities of discontinued operations

     130.3        1,678.6   
                

Total liabilities

     5,681.5        7,343.0   
                

Commitments and contingencies (Note 14)

    

SHAREHOLDERSEQUITY

    

Preferred stock, $0.01 par value, 20.0 million shares authorized, none issued

     —          —     

Common stock, $0.01 par value, 300.0 million shares authorized, 60.5 million shares issued

     0.6        0.6   

Additional paid-in capital

     1,807.8        1,803.8   

Accumulated other comprehensive loss

     (10.8     (384.8

Retained earnings

     1,121.4        949.8   

Treasury stock at cost (10.4 and 9.6 million shares)

     (511.9     (482.2
                

Total shareholders’ equity

     2,407.1        1,887.2   
                

Total liabilities and shareholders’ equity

   $ 8,088.6      $ 9,230.2   
                

The accompanying notes are an integral part of these consolidated financial statements.

 

5


Table of Contents

THE HANOVER INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

 

     (Unaudited)
Nine Months Ended
September 30,
 

(In millions)

   2009     2008  

PREFERRED STOCK

    

Balance at beginning and end of period

   $ —        $ —     
                

COMMON STOCK

    

Balance at beginning and end of period

     0.6        0.6   
                

ADDITIONAL PAID-IN CAPITAL

    

Balance at beginning of period

     1,803.8        1,822.6   

Tax benefit from stock options

     —          0.6   

Employee and director stock-based awards

     4.0        (21.7
                

Balance at end of period

     1,807.8        1,801.5   
                

ACCUMULATED OTHER COMPREHENSIVE LOSS

    

NET UNREALIZED (DEPRECIATION) APPRECIATION ON AVAILABLE FOR SALE SECURITIES AND DERIVATIVE INSTRUMENTS:

    

Balance at beginning of period

     (276.1     5.5   

Cumulative effect of change in accounting principle

     (33.3     —     
                

Balance at beginning of period, as adjusted

     (309.4     5.5   

Net appreciation (depreciation) during the period:

    

Net appreciation (depreciation) on available-for-sale securities and derivative instruments

     428.8        (197.4

(Provision) benefit for deferred federal income taxes

     (30.2     2.2   
                
     398.6        (195.2
                

Balance at end of period

     89.2        (189.7
                

DEFINED BENEFIT PENSION AND POSTRETIREMENT PLANS:

    

Balance at beginning of period

     (108.7     (25.9

Amounts arising in the period

     (1.6     (0.8

Amortization during the period:

    

Amount recognized as net periodic benefit cost

     14.9        (2.7

(Provision) benefit for deferred federal income taxes

     (4.6     1.2   
                
     8.7        (2.3
                

Balance at end of period

     (100.0     (28.2
                

Total accumulated other comprehensive loss

     (10.8     (217.9
                

RETAINED EARNINGS

    

Balance at beginning of period

     949.8        946.9   

Cumulative effect of change in accounting principle

     33.3        —     
                

Balance at beginning of period, as adjusted

     983.1        946.9   

Net income (loss)

     139.9        (13.5

Treasury stock issued for less than cost and other

     (4.1     (9.4

Recognition of share-based compensation

     2.5        14.7   
                

Balance at end of period

     1,121.4        938.7   
                

TREASURY STOCK

    

Balance at beginning of period

     (482.2     (450.7

Shares purchased at cost

     (36.2     (58.5

Net shares reissued at cost under employee stock-based compensation plans

     6.5        26.4   
                

Balance at end of period

     (511.9     (482.8
                

Total shareholders’ equity

   $ 2,407.1      $ 2,040.1   
                

The accompanying notes are an integral part of these consolidated financial statements.

 

6


Table of Contents

THE HANOVER INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

 

     (Unaudited)
Quarter Ended
September 30,
    (Unaudited)
Nine Months Ended
September 30,
 

(In millions)

   2009     2008     2009     2008  

Net income (loss)

   $ 49.7      $ (61.8   $ 139.9      $ (13.5

Other comprehensive income (loss):

        

Available-for-sale securities:

        

Net appreciation (depreciation) during the period

     189.4        (117.4     428.8        (197.5

(Provision) benefit for deferred federal income taxes

     (30.4     0.1        (30.2     2.2   
                                

Total available-for-sale securities

     159.0        (117.3     398.6        (195.3
                                

Derivative instruments:

        

Net appreciation during the period

     —          0.5        —          0.1   

Provision for deferred federal income taxes

     —          (0.1     —          —     
                                

Total derivative instruments

     —          0.4        —          0.1   
                                
     159.0        (116.9     398.6        (195.2
                                

Pension and postretirement benefits:

        

Amounts arising in the period

     —          —          (1.6     (0.8

Amortization recognized as net periodic benefit costs:

        

Net actuarial loss

     6.8        0.7        20.4        2.2   

Prior service cost

     (1.5     (1.2     (4.3     (3.7

Transition asset

     (0.4     (0.4     (1.2     (1.2
                                

Total amortization recognized as net periodic benefit costs

     4.9        (0.9     14.9        (2.7

(Provision) benefit for deferred federal income taxes

     (1.7     0.3        (4.6     1.2   
                                

Total pension and postretirement benefits

     3.2        (0.6     8.7        (2.3
                                

Other comprehensive income (loss)

     162.2        (117.5     407.3        (197.5
                                

Comprehensive income (loss)

   $ 211.9      $ (179.3   $ 547.2      $ (211.0
                                

The accompanying notes are an integral part of these consolidated financial statements.

 

7


Table of Contents

THE HANOVER INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

     (Unaudited)
Nine Months Ended
September 30,
 

(In millions)

   2009     2008  

CASH FLOWS FROM OPERATING ACTIVITIES

    

Net income

   $ 139.9      $ (13.5

Adjustments to reconcile net income to net cash provided by operating activities:

    

Gain on disposal of variable life insurance and annuity business

     (4.1     (8.1

(Gain) estimated loss from sale of FAFLIC

     (6.3     72.2   

Gain on sale of AMGRO, Inc.

     —          (11.1

Loss on sale from other discontinued operations

     —          0.5   

Gain from retirement of corporate debt

     (34.5     —     

Net realized investment losses

     13.0        83.7   

Net amortization and depreciation

     9.0        14.1   

Stock-based compensation expense

     8.9        8.9   

Amortization of deferred benefit plan costs

     14.9        (3.5

Deferred federal income taxes

     22.7        33.3   

Change in deferred acquisition costs

     (20.4     (16.2

Change in premiums and notes receivable, net of reinsurance premiums payable

     (35.1     44.4   

Change in accrued investment income

     (1.2     (1.1

Change in policy liabilities and accruals, net

     (36.5     (60.0

Change in reinsurance receivable

     27.2        111.4   

Change in expenses and taxes payable

     (80.8     (102.9

Other, net

     10.2        22.4   
                

Net cash provided by operating activities

     26.9        174.5   
                

CASH FLOWS FROM INVESTING ACTIVITIES

    

Proceeds from disposals and maturities of available-for-sale fixed maturities

     1,749.2        646.4   

Proceeds from disposals of equity securities and other investments

     1.4        7.9   

Proceeds from mortgages sold, matured or collected

     10.7        14.6   

Proceeds from collections of installment finance and notes receivable

     —          192.2   

Proceeds from the sale of FAFLIC

     105.8        —     

Cash transferred with sale of FAFLIC

     (108.1     —     

Net cash used to acquire Verlan Holdings, Inc

     —          (26.4

Purchase of available-for-sale fixed maturities

     (2,078.4     (594.6

Purchase of equity securities and other investments

     (31.0     (24.8

Capital expenditures

     (6.6     (7.4

Disbursements to fund installment finance and notes receivable

     —          (178.6

Other investing items

     1.5        0.7   
                

Net cash (used in) provided by investing activities

     (355.5     30.0   
                

CASH FLOWS FROM FINANCING ACTIVITIES

    

Withdrawals from trust instruments supported by funding obligations

     —          (21.0

Exercise of options

     1.6        7.9   

Change in collateral related to securities lending program

     75.8        8.5   

Proceeds from long-term debt borrowing

     125.0        —     

Repurchase of long-term debt

     (125.9     —     

Treasury stock purchased at cost

     (36.1     (58.5

Other financing activities

     0.1        0.1   
                

Net cash provided by (used in) financing activities

     40.5        (63.0
                

Net change in cash and cash equivalents

     (288.1     141.5   

Net change in cash related to discontinued operations

     123.6        (37.8

Cash and cash equivalents, beginning of period

     397.7        210.6   
                

Cash and cash equivalents, end of period

   $ 233.2      $ 314.3   
                

The accompanying notes are an integral part of these consolidated financial statements.

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation and Principles of Consolidation

The accompanying unaudited consolidated financial statements of The Hanover Insurance Group, Inc. (“THG” or the “Company”) have been prepared in accordance with generally accepted accounting principles for interim financial information and with the requirements of Form 10-Q.

The interim consolidated financial statements of THG include the accounts of The Hanover Insurance Company (“Hanover Insurance”), and Citizens Insurance Company of America (“Citizens”), THG’s principal property and casualty companies; and certain other insurance and non-insurance subsidiaries. These legal entities conduct their operations through several business segments discussed in Note 11. All significant intercompany accounts and transactions have been eliminated. The Company’s results of operations also included the results of First Allmerica Financial Life Insurance Company (“FAFLIC”) through December 31, 2008. On January 2, 2009, the Company sold FAFLIC to Commonwealth Annuity and Life Insurance Company (“Commonwealth Annuity”) a subsidiary of the Goldman Sachs Group, Inc. (“Goldman Sachs”). Accordingly, the FAFLIC business was classified as a discontinued operation in accordance with ASC 205, Presentation of Financial Statements - Discontinued Operations (“ASC 205”) (formerly included under Statement of Financial Accounting Standards No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets (“Statement No. 144”)) and prior periods in the consolidated Statements of Income have been reclassified to conform to this presentation. Additionally, as of December 31, 2008, a portion of FAFLIC’s accounts were classified as assets and liabilities of discontinued operations in the consolidated Balance Sheets (See Note 3 – Discontinued Operations of FAFLIC Business).

The accompanying interim consolidated financial statements reflect, in the opinion of the Company’s management, all adjustments necessary for a fair presentation of the financial position and results of operations. The results of operations for the nine months ended September 30, 2009 are not necessarily indicative of the results to be expected for the full year. These financial statements should be read in conjunction with the Company’s 2008 Annual Report on Form 10-K filed with the Securities and Exchange Commission.

The preparation of financial statements in conformity with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. Certain prior year amounts have been reclassified to conform to current year presentation.

2. New Accounting Pronouncements

Recently Implemented Standards

ASC 105, Generally Accepted Accounting Principles (“ASC 105”) (formerly Statement of Financial Accounting Standards No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles a replacement of FASB Statement No. 162) reorganized by topic existing accounting and reporting guidance issued by the Financial Accounting Standards Board (“FASB”) into a single source of authoritative generally accepted accounting principles (“GAAP”) to be applied by nongovernmental entities. All guidance contained in the Accounting Standards Codification (“ASC”) carries an equal level of authority. Rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. Accordingly, all other accounting literature will be deemed “non-authoritative”. ASC 105 is effective on a prospective basis for financial statements issued for interim and annual periods ending after September 15, 2009. The Company has implemented the guidance included in ASC 105 as of July 1, 2009. The implementation of this guidance changed the Company’s references to GAAP authoritative guidance but did not impact the Company’s financial position or results of operations.

ASC 855, Subsequent Events (“ASC 855”) (formerly Statement of Financial Accounting Standards No. 165, Subsequent Events) includes guidance that was issued by the FASB in May 2009, and is consistent with current auditing standards in defining a subsequent event. Additionally, the guidance provides for disclosure regarding the existence and timing of a company’s evaluation of its subsequent events. ASC 855 defines two types of subsequent events, “recognized” and “non-recognized”. Recognized subsequent events provide additional evidence

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

about conditions that existed at the date of the balance sheet and are required to be reflected in the financial statements. Non-recognized subsequent events provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date and, therefore; are not required to be reflected in the financial statements. However, certain non-recognized subsequent events may require disclosure to prevent the financial statements from being misleading. This guidance was effective prospectively for interim or annual financial periods ending after June 15, 2009. The Company implemented the guidance included in ASC 855 as of April 1, 2009. The effect of implementing this guidance was not material to the Company’s financial position or results of operations.

ASC 944, Financial Services – Insurance (“ASC 944”) contains guidance that was previously issued by the FASB in May 2008 as Statement of Financial Accounting Standards No. 163, Accounting for Financial Guarantee Insurance Contracts – an interpretation of FASB Statement No. 60 that provides for changes to both the recognition and measurement of premium revenues and claim liabilities for financial guarantee insurance contracts that do not qualify as a derivative instrument in accordance with ASC 815, Derivatives and Hedging (formerly included under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities). This financial guarantee insurance contract guidance also expands the disclosure requirements related to these contracts to include such items as a company’s method of tracking insured financial obligations with credit deterioration, financial information about the insured financial obligations, and management’s policies for placing and monitoring the insured financial obligations. ASC 944, as it relates to financial guarantee insurance contracts, was effective for fiscal years beginning after December 15, 2008, except for certain disclosures related to the insured financial obligations, which were effective for the third quarter of 2008. The Company does not have financial guarantee insurance products, and, accordingly, the implementation of this portion of ASC 944 did not have an effect on the Company’s results of operations or financial position.

ASC 805, Business Combinations (“ASC 805”) (formerly included under Statement of Financial Accounting Standards No. 141 (revised 2007), Business Combinations) contains guidance that was issued by the FASB in December 2007. It requires the acquiring entity in a business combination to recognize all assets acquired and liabilities assumed in a transaction at the acquisition-date fair value, with certain exceptions. Additionally, the guidance requires changes to the accounting treatment of acquisition related items, including, among other items, transaction costs, contingent consideration, restructuring costs, indemnification assets and tax benefits. ASC 805 also provides for a substantial number of new disclosure requirements. ASC 805 also contains guidance that was formerly issued as FSP FAS 141(R)-1, Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies which was intended to provide additional guidance clarifying application issues regarding initial recognition and measurement, subsequent measurement and accounting, and disclosure of assets and liabilities arising from contingencies in a business combination. ASC 805 was effective for business combinations initiated on or after the first annual reporting period beginning after December 15, 2008. The Company implemented this guidance effective January 1, 2009. Implementing this guidance did not have an effect on the Company’s financial position or results of operations; however it will likely have an impact on the Company’s accounting for future business combinations, but the effect is dependent upon acquisitions, if any, that are made in the future.

ASC 810, Consolidation (“ASC 810”) includes new guidance issued by the FASB in December 2007 governing the accounting for and reporting of noncontrolling interests (previously referred to as minority interests). This guidance established reporting requirements which include, among other things, that noncontrolling interests be reflected as a separate component of equity, not as a liability. It also requires that the interests of the parent and the noncontrolling interest be clearly identifiable. Additionally, increases and decreases in a parent’s ownership interest that leave control intact shall be reflected as equity transactions, rather than step acquisitions or dilution gains or losses. This guidance also requires changes to the presentation of information in the financial statements and provides for additional disclosure requirements. ASC 810 was effective for fiscal years beginning on or after December 15, 2008. The Company implemented this guidance as of January 1, 2009. The effect of implementing this guidance was not material to the Company’s financial position or results of operations.

ASC 825, Financial Instruments (“ASC 825”) includes guidance which was issued in February 2007 by the FASB and was previously included under Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities Including an amendment of FASB Statement No. 115. The related sections within ASC 825 permit a company to choose, at specified election dates, to measure at fair value certain eligible financial assets and liabilities that are not currently required to be measured at fair value. The specified election dates include, but are not limited to, the date when an entity first recognizes the item, when an entity enters into a firm commitment or when changes in the financial instrument causes it to no longer qualify for fair value accounting under a different accounting standard. An entity may elect the fair value option for eligible items that exist at the effective date. At that date, the difference between the carrying amounts and the fair values of eligible items for which the fair value option is elected should be recognized as a cumulative effect adjustment to the opening balance of retained earnings. The fair value option may be elected for each entire financial instrument, but need not be applied to all similar instruments. Once the fair value option has been

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

elected, it is irrevocable. Unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. This guidance was effective as of the beginning of fiscal years that began after November 15, 2007. The Company did not elect to implement the fair value option for eligible financial assets and liabilities as of January 1, 2008.

ASC 820, Fair Value Measurements and Disclosures (“ASC 820”) (formerly included under Statement of Financial Accounting Standards No. 157, Fair Value Measurements) includes guidance that was issued by the FASB in September 2006 that created a common definition of fair value to be used throughout generally accepted accounting principles. ASC 820 applies whenever other standards require or permit assets or liabilities to be measured at fair value, with certain exceptions. This guidance established a hierarchy for determining fair value which emphasizes the use of observable market data whenever available. It also required expanded disclosures which include the extent to which assets and liabilities are measured at fair value, the methods and assumptions used to measure fair value and the effect of fair value measures on earnings. ASC 820 also provides additional guidance for estimating fair value when the volume and level of activity for the asset or liability have significantly decreased. The emphasis of ASC 820 is that fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between willing market participants, under current market conditions. ASC 820 also further clarifies the guidance to be considered when determining whether or not a transaction is orderly and clarifies the valuation of securities in markets that are not active. This guidance includes information related to a company’s use of judgment, in addition to market information, in certain circumstances to value assets which have inactive markets.

Fair value guidance in ASC 820 was initially effective for fiscal years beginning after November 15, 2007 and for interim periods within those fiscal years for financial assets and liabilities. The effective date of ASC 820 for all non-recurring fair value measurements of nonfinancial assets and nonfinancial liabilities was fiscal years beginning after November 15, 2008. Guidance related to fair value measurements in an inactive market was effective in October 2008 and guidance related to orderly transactions under current market conditions was effective for interim and annual reporting periods ending after June 15, 2009.

The Company applied the provisions of ASC 820 to its financial assets and liabilities upon adoption at January 1, 2008 and adopted the remaining provisions relating to certain nonfinancial assets and liabilities on January 1, 2009. The difference between the carrying amounts and fair values of those financial instruments held upon initial adoption, on January 1, 2008, was recognized as a cumulative effect adjustment to the opening balance of retained earnings and was not material to the Company’s financial position or results of operations. The Company implemented the guidance related to orderly transactions under current market conditions as of April 1, 2009, which also was not material to the Company’s financial position or results of operations. See further disclosure in Note 6 – Fair Value.

Recently Issued Standards

In August 2009, the FASB issued ASC Update No. 2009-05, Fair Value Measurements and Disclosures (Topic 820): Measuring Liabilities at Fair Value (“ASC Update No. 2009-05”). This update amends ASC 820, Fair Value Measurements and Disclosures and provides further guidance on measuring the fair value of a liability. The guidance establishes the types of valuation techniques to be used to value a liability when a quoted market price in an active market for the identical liability is not available, such as the use of an identical or similar liability when traded as an asset. The guidance also further clarifies that a quoted price in an active market for the identical liability at the measurement date and the quoted price for the identical liability when traded as an asset in an active market when no adjustments to the quoted price of the asset are required are both Level 1 fair value measurements. If adjustments are required to be applied to the quoted price, it results in a level 2 or 3 fair value measurement. The guidance provided in the update is effective for the first reporting period (including interim periods) beginning after issuance. The Company does not expect that the implementation of ASC Update No. 2009-05 will have a material effect on its financial position or results of operations.

In September 2009, the FASB issued ASC Update No. 2009-12, Fair Value Measurements and Disclosures (Topic 820): Investments in Certain Entities that Calculate Net Asset Value per Share (or Its Equivalent) (“ASC Update No. 2009-12”). This update sets forth guidance on using the net asset value per share provided by an investee to estimate the fair value of an alternative investment. Specifically, the update permits a reporting entity to measure the fair value of this type of investment on the basis of the net asset value per share of the investment (or its equivalent) if all or substantially all of the underlying investments used in the calculation of the net asset value is consistent with ASC 820. The update also requires additional disclosures by each major category of investment, including, but not limited to, fair value of underlying investments in the major category, significant investment strategies, redemption restrictions, and unfunded commitments related to investments in the major category. The amendments in this update are effective for interim and annual periods ending after December 15, 2009 with early application permitted. The Company does not expect that the implementation of ASC Update No. 2009-12 will have a material effect on its financial position or results of operations.

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

In June 2009, FASB issued Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretation No. 46(R) (“Statement No. 167”). Statement No. 167 amends FASB Interpretation No. 46R, Consolidation of Variable Interest Entities an interpretation of ARB No. 51 (“FIN 46R”) to require an analysis to determine whether a company has a controlling financial interest in a variable interest entity. This analysis identifies the primary beneficiary of a variable interest entity as the enterprise that has a) the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and b) the obligation to absorb losses of the entity that could potentially be significant to the variable interest entity or the right to receive benefits from the entity that could potentially be significant to the variable interest entity. The statement requires an ongoing assessment of whether a company is the primary beneficiary of a variable interest entity when the holders of the entity, as a group, lose power, through voting or similar rights, to direct the actions that most significantly affect the entity’s economic performance. This statement also enhances disclosures about a company’s involvement in variable interest entities. Statement No. 167 is effective as of the beginning of the first annual reporting period that begins after November 15, 2009. Although Statement No. 167 has not been incorporated into the Codification, in accordance with ASC 105, the standard shall remain authoritative until it is integrated. The Company does not expect the adoption of Statement No. 167 to have a material impact on its financial position or results of operations.

In June 2009, the FASB issued Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets an amendment of FASB Statement No. 140 (“Statement No. 166”). Statement No. 166 revises FASB Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Extinguishment of Liabilities a replacement of FASB Statement 125 (“Statement No. 140”) and requires additional disclosures about transfers of financial assets, including securitization transactions, and any continuing exposure to the risks related to transferred financial assets. It also eliminates the concept of a “qualifying special-purpose entity”, changes the requirements for derecognizing financial assets, and enhances disclosure requirements. Statement No. 166 is effective prospectively, for annual periods beginning after November 15, 2009, and interim and annual periods thereafter. Although Statement No. 166 has not been incorporated into the Codification, in accordance with ASC 105, the standard shall remain authoritative until it is integrated. The Company does not expect the adoption of Statement No. 166 will have a material impact on its financial position or results of operations.

3. Discontinued Operations of FAFLIC Business

On January 2, 2009, THG sold its remaining life insurance subsidiary, FAFLIC, to Commonwealth Annuity, a subsidiary of Goldman Sachs. Approval was obtained from the Massachusetts Division of Insurance for a pre-close dividend from FAFLIC consisting of designated assets with a statutory book value of approximately $130 million. Total proceeds from the sale, including the dividend, were approximately $230 million, net of transaction costs. Additionally, coincident with the sale transaction, Hanover Insurance and FAFLIC entered into a reinsurance contract whereby Hanover Insurance assumed FAFLIC’s discontinued accident and health insurance business. THG has also indemnified Commonwealth Annuity for certain litigation, regulatory matters and other liabilities related to the pre-closing activities of the business transferred.

The Company accounted for the disposal of its FAFLIC business as a discontinued operation in accordance with ASC 205. For the year ended December 31, 2008, the Company recognized a $77.3 million loss associated with the sale transaction.

The following table summarizes the results for this discontinued business for the periods indicated:

 

     (Unaudited)
Quarter Ended
September 30,
    (Unaudited)
Nine Months Ended
September 30,
 

(In millions)

   2009    2008     2009    2008  

Gain (loss) from discontinued FAFLIC business, net of taxes

   $ 0.4    $ (21.7   $ 6.3    $ (92.9

For the quarter ended September 30, 2009, the Company recognized income from discontinued operations of $0.4 million, primarily resulting from a tax adjustment relating to the FAFLIC operations in prior tax years. Net losses of $21.7 million in the third quarter of 2008 include net realized investment losses of $15.6 million, primarily resulting from other-than-temporary impairments, principally in the financial services sector. Additionally, the Company recognized an increase to the preliminary estimate of loss associated with the sale transaction of $6.1 million. Total revenues associated with the FAFLIC business in the third quarter of 2008 were $4.7 million. This business also generated a loss before taxes of $13.9 million during that period.

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

For the nine months ended September 30, 2009, the Company recognized income from discontinued operations of $6.3 million, primarily resulting from a change in the Company’s estimate of indemnification liabilities related to the sale, the release of sale-related accruals and the aforementioned tax adjustment. Net losses of $92.9 million in the first nine months of 2008 primarily reflect the Company’s preliminary estimate of the loss associated with the sale transaction and net realized investment losses of $23.0 million, primarily resulting from the aforementioned other-than-temporary impairments and losses associated with the sale of fixed maturities. These losses were partially offset by favorable results, primarily attributable to both the traditional and group retirement lines of business. Total revenues associated with the FAFLIC business in the first nine months of 2008 were $44.6 million. This business also generated a loss before taxes of $19.4 million during that period.

In connection with the sales transaction, the Company agreed to indemnify Commonwealth Annuity for certain legal, regulatory and other matters that existed as of the sale. Accordingly, the Company established a gross liability in accordance with ASC 460, Guarantees (“ASC 460”) (formerly FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others) of $9.9 million. As of September 30, 2009, the Company’s total gross liability related to these guarantees was $1.9 million. The Company regularly reviews and updates this liability for legal and regulatory matter indemnities. Although the Company believes its current estimate for this liability is appropriate, there can be no assurance that these estimates will not materially increase in the future. Adjustments to this reserve are recorded in the results of the Company in the period in which they are determined.

Included in “Assets of discontinued operations” as of December 31, 2008 were $1,710.4 million of assets that were included in the sale of FAFLIC. Included in “Liabilities of discontinued operations” as of December 31, 2008 were $1,627.6 million of liabilities that were included in the sale of FAFLIC. In accordance with ASC 205, the following table details the major assets and liabilities reflected in these captions.

 

(In millions)

   December 31,
2008
 

Assets:

  

Cash and investments

   $ 1,182.2   

Reinsurance recoverable

     241.5   

Separate account assets

     263.4   

Other assets

     49.3   

Valuation allowance

     (26.0
        

Total assets

   $ 1,710.4   
        

Liabilities:

  

Policy liabilities

   $ 1,305.6   

Separate account liabilities

     263.4   

Trust instruments supported by funding obligations

     15.0   

Other liabilities

     43.6   
        

Total liabilities

   $ 1,627.6   
        

4. Other Significant Transactions

On September 25, 2009, Hanover Insurance received an advance of $125 million through its membership in the Federal Home Loan Bank of Boston (“FHLBB”) as part of a collateralized borrowing program. This advance bears interest at a fixed rate of 5.50% per annum over a twenty-year term. As collateral to FHLBB, Hanover Insurance has pledged government agency securities with a fair value of $142.8 million as of September 30, 2009. The fair value of the collateral pledged must be maintained at certain specified levels of the borrowed amount, which can vary depending on the type of assets pledged. If the fair value of this collateral declines below these specified levels, Hanover Insurance would be required to pledge additional collateral or repay outstanding borrowings. Hanover Insurance is permitted to voluntarily repay the outstanding borrowings at any time, subject to a repayment fee. As a requirement of membership in the FHLBB, Hanover Insurance acquired $2.5 million of FHLBB stock, and as a condition to participating in the FHLBB’s collateralized borrowing program, it was required to purchase additional shares of FHLBB stock in an amount equal to 4.5% of its outstanding borrowings; such purchases have totaled $5.6 million through September 30, 2009. The proceeds from the borrowing were used by Hanover Insurance to acquire AIX Holding, Inc. (“AIX”) and its subsidiaries from the holding company.

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

On September 24, 2009, the Company’s Board of Directors authorized a $100 million increase to its existing common stock repurchase program. The Board of Directors, on October 16, 2007, had initially authorized the repurchase of up to $100 million of common stock. As a result of the increase, the program now provides for aggregate repurchases of up to $200 million. Under the repurchase authorization, the Company may repurchase its common stock from time to time, in amounts and prices and at such times as we deem appropriate, subject to market conditions and other considerations. The Company’s repurchases may be executed using open market purchases, privately negotiated transactions, accelerated repurchase programs or other transactions. The Company is not required to purchase any specific number of shares or to make purchases by any certain date under this program. In the first nine months of 2009, the Company purchased 0.9 million shares at a cost of $36.1 million. Total repurchases under this program as of September 30, 2009 were 2.3 million shares at a cost of $96.3 million.

The Company liquidated AFC Capital Trust I (the “Trust”) on July 30, 2009. Each holder of 8.207% Series B Capital Securities (“Capital Securities”) as of that date received a principal amount of the Company’s Series B 8.207% Junior Subordinated Deferrable Interest Debentures (“Junior Debentures”) due February 3, 2027 equal to the liquidation amount of the Capital Securities held by such holder. The liquidation of the Trust did not have a material effect on the Company’s results of operations or financial position.

On June 29, 2009, prior to liquidating the Trust, the Company completed a cash tender offer to repurchase a portion of its Capital Securities that were issued by the Trust and a portion of its 7.625% Senior Debentures (“Senior Debentures”) due in 2025 that were issued by THG. As of that date, $69.3 million of Capital Securities were tendered at a price equal to $800 per $1,000 of face value. In addition, the Company accepted for tender a principal amount of $77.3 million of Senior Debentures. Depending on the time of tender, holders of the Senior Debentures accepted for purchase received a price of either $870 or $900 per $1,000 of face value. Separately, the Company held $65.0 million of Capital Securities previously repurchased at a discount in the open market prior to the tender offer. In addition, during the third quarter of 2009, the Company repurchased an additional $1.1 million of Senior Debentures. Including securities repurchased through the tender offer, and before and subsequent to the tender offer, the Company recognized a pre-tax gain of $0.2 million and $34.5 million in the quarter and nine months ended September 30, 2009. The most significant portion of the gain was recognized in the second quarter of 2009 due to the consolidation of the Trust as of June 30, 2009. The Company assessed the remaining risks of the Trust at June 30, 2009, taking into consideration the then pending liquidation and determined that the previously unconsolidated Trust should be consolidated in accordance with ASC 810, Consolidation (formerly FASB Interpretation No. 46(R)- Consolidation of Variable Interest Entities – an Interpretation of ARB No. 51). As of September 30, 2009, a principal amount of $165.7 million of Junior Debentures and $121.6 million of Senior Debentures not held by the Company remained outstanding.

On November 28, 2008, the Company acquired AIX for approximately $100 million, subject to various terms and conditions. AIX is a specialty property and casualty insurer that underwrites and manages program business.

On June 2, 2008, the Company completed the sale of its premium financing subsidiary, AMGRO, Inc., to Premium Financing Specialists, Inc. The Company recorded a gain of $11.1 million related to this sale, which was reflected in the Consolidated Statement of Income as part of Discontinued Operations in the second quarter of 2008.

On March 14, 2008, the Company acquired all of the outstanding shares of Verlan Holdings, Inc. (“Verlan”) for $29.0 million. Verlan, now referred to as Hanover Specialty Property, is a specialty company providing property insurance to small and medium-sized manufacturing and distribution companies that are highly protected fire risks.

On December 30, 2005, the Company sold its variable life insurance and annuity business to Goldman Sachs, including the reinsurance of 100% of the variable business of FAFLIC. THG agreed to indemnify Goldman Sachs for certain litigation, regulatory matters and other liabilities related to the pre-closing activities of the business that was sold. The Company accounted for the disposal as a discontinued operation in accordance with ASC 205, Presentation of Financial Statements – Discontinued Operations (formerly referred to as Statement No. 144). In the first nine months of 2008, the Company recognized a benefit of $8.1 million, including $5.8 million resulting from the release of liabilities associated with the estimated liabilities for certain contractual indemnities to Goldman Sachs recorded in accordance with ASC 460 – Guarantees (formerly FASB Interpretation No. 45), and a $2.6 million benefit resulting from a settlement with the IRS related to tax years 1995 through 2001. The $4.1 million gain in the first nine months of 2009 also related to a change in the Company’s estimate of indemnification liabilities.

5. Investments

A. Fixed maturities and equity securities

The Company accounts for its investments in fixed maturities and equity securities, which are classified as available-for-sale, in accordance with ASC 320, Investments – Debt and Equity Securities (“ASC 320”), formerly included under FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities (“Statement No. 115”).

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The amortized cost and fair value of available-for-sale fixed maturities and equity securities were as follows:

 

(In millions)

   (Unaudited)
September 30, 2009
 
     Amortized
Cost (1)
    Gross
Unrealized
Gains
    Gross Unrealized Losses     Fair
Value
 
         Unrealized
Losses
    OTTI
Unrealized
Losses (2)
   

U.S. Treasury securities and U.S. government and agency securities

   $ 385.8      $ 4.7      $ 1.9      $ —        $ 388.6   

States and political subdivisions

     836.0        23.8        12.8        2.9        844.1   

Foreign governments

     2.9        —          —          —          2.9   

Corporate fixed maturities

     2,324.5        147.1        37.3        32.7        2,401.6   

Residential mortgage-backed securities

     922.1        34.3        9.6        8.4        938.4   

Commercial mortgage-backed securities

     336.7        13.4        12.3        —          337.8   
                                        

Total fixed maturities, including assets of discontinued operations

     4,808.0        223.3        73.9        44.0        4,913.4   

Less: fixed maturities of discontinued operations

     (111.7     (7.7     (4.2     (6.9     (108.3
                                        

Total fixed maturities, excluding discontinued operations

   $ 4,696.3      $ 215.6      $ 69.7      $ 37.1      $ 4,805.1   
                                        

Equity securities, excluding discontinued operations

   $ 109.8      $ 12.3      $ 0.1      $ —        $ 122.0   
                                        

 

(In millions)

   December 31, 2008  
     Amortized
Cost (1)
    Gross
Unrealized
Gains
    Gross Unrealized Losses    Fair
Value (3)
 
         Unrealized
Losses
    OTTI
Unrealized
Losses
  

U.S. Treasury securities and U.S. government and agency securities

   $ 344.8      $ 11.6      $ 0.8      $ —      $ 355.6   

States and political subdivisions

     758.7        3.9        35.7        —        726.9   

Foreign governments

     4.6        0.2        —          —        4.8   

Corporate fixed maturities

     2,745.5        26.2        261.1        —        2,510.6   

Residential mortgage-backed securities

     1,097.5        23.2        21.9        —        1,098.8   

Commercial mortgage-backed securities

     480.1        0.9        50.0        —        431.0   
                                       

Total fixed maturities, including assets of discontinued operations

     5,431.2        66.0        369.5        —        5,127.7   

Less: fixed maturities of discontinued operations (4)

     (1,049.2     (14.0     (76.4     —        (986.8
                                       

Total fixed maturities, excluding discontinued operations

   $ 4,382.0      $ 52.0      $ 293.1      $ —      $ 4,140.9   
                                       

Equity securities, excluding discontinued operations

   $ 97.6      $ 3.4      $ 24.8      $ —      $ 76.2   
                                       

 

(1)

Amortized cost for fixed maturities and cost for equity securities.

(2)

Represents other-than-temporary impairments recognized in accumulated other comprehensive income in accordance with ASC 320. Amount excludes $26.2 million of net unrealized gains on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date.

(3)

Included $42.2 million of trust preferred capital securities of a THG affiliated entity that were designated as held-to-maturity and carried at amortized cost.

(4)

Fixed maturities of discontinued operations as of December 31, 2008 included the discontinued FAFLIC business and discontinued accident and health business. Due to the January 2, 2009 sale of FAFLIC, fixed maturities with an amortized cost of $949.9 million, gross unrealized gains of $12.2 million, gross unrealized losses of $60.7 million and fair value of $901.4 million transferred to the buyer.

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The amortized cost and fair value by maturity periods for fixed maturities are shown below. 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 the Company may have the right to put or sell the obligations back to the issuers. Mortgage-backed securities are included in the category representing their stated maturity.

 

(In millions)

   (Unaudited)
September 30, 2009
 
     Amortized
Cost
    Fair Value  

Due in one year or less

   $ 114.2      $ 114.0   

Due after one year through five years

     1,492.1        1,545.8   

Due after five years through ten years

     1,478.0        1,528.8   

Due after ten years

     1,723.7        1,724.8   
                

Total fixed maturities, including assets of discontinued operations

     4,808.0        4,913.4   

Less: fixed maturities of discontinued operations

     (111.7     (108.3
                

Total fixed maturities, excluding assets of discontinued operations

   $ 4,696.3      $ 4,805.1   
                

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

B. Securities in an unrealized loss position

The following tables provide information about the Company’s fixed maturities and equity securities that are in an unrealized loss position at September 30, 2009 and December 31, 2008:

 

     (Unaudited)
September 30, 2009
     12 months or less    Greater than 12 months    Total

(In millions)

   Gross
Unrealized
Losses and
OTTI
   Fair Value    Gross
Unrealized
Losses and
OTTI
   Fair Value    Gross
Unrealized
Losses and
OTTI (1)
   Fair Value

Fixed maturities:

                 

Investment grade:

                 

U.S. Treasury securities and U.S. government and agency securities

   $ 1.9    $ 90.1    $ —      $ —      $ 1.9    $ 90.1

States and political subdivisions

     3.2      92.1      9.0      123.6      12.2      215.7

Corporate fixed maturities (2)

     4.1      75.6      32.3      193.5      36.4      269.1

Residential mortgage-backed securities

     3.9      64.6      4.8      72.1      8.7      136.7

Commercial mortgage-backed securities

     1.2      3.3      11.1      48.9      12.3      52.2
                                         

Total investment grade

     14.3      325.7      57.2      438.1      71.5      763.8

Below investment grade (3):

                 

States and political subdivisions

     —        —        3.5      8.6      3.5      8.6

Corporate fixed maturities (2)

     19.7      89.8      13.9      132.2      33.6      222.0

Residential mortgage-backed securities

     4.7      9.5      4.6      19.5      9.3      29.0
                                         

Total below investment grade

     24.4      99.3      22.0      160.3      46.4      259.6
                                         

Total fixed maturities

     38.7      425.0      79.2      598.4      117.9      1,023.4
                                         

Equity securities:

                 

Common equity securities

     0.1      0.1      —        —        0.1      0.1
                                         

Total equity securities

     0.1      0.1      —        —        0.1      0.1
                                         

Total (4)

   $ 38.8    $ 425.1    $ 79.2    $ 598.4    $ 118.0    $ 1,023.5
                                         

 

(1) Includes $44.0 million unrealized loss related to other-than-temporary impairment losses recognized in other comprehensive income.
(2) Gross unrealized losses on corporate fixed maturities include $44.4 million in the financial sector, $19.9 million in the industrial sector, and $5.7 million in utilities and other.
(3) Substantially all below investment grade securities with an unrealized loss had been rated by the NAIC, Standard & Poor’s or Moody’s at September 30, 2009.
(4) Includes discontinued accident and health business of $11.1 million in gross unrealized losses with $36.3 million in fair value at September 30, 2009.

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

     (Unaudited)
December 31, 2008
 
     12 months or less     Greater than 12 months     Total  

(In millions)

   Gross
Unrealized
Losses
    Fair Value     Gross
Unrealized
Losses
    Fair Value     Gross
Unrealized
Losses
    Fair Value  

Fixed maturities:

            

Investment grade:

            

U.S. Treasury securities and U.S. government and agency securities

   $ 0.8      $ 75.8      $ —        $ —        $ 0.8      $ 75.8   

States and political subdivisions

     27.1        362.4        3.9        56.5        31.0        418.9   

Corporate fixed maturities

     110.3        1,273.7        91.0        422.0        201.3        1,695.7   

Residential mortgage-backed securities

     18.7        120.6        3.2        30.2        21.9        150.8   

Commercial mortgage-backed securities

     26.4        273.8        23.6        146.0        50.0        419.8   
                                                

Total investment grade

     183.3        2,106.3        121.7        654.7        305.0        2,761.0   

Below investment grade (1):

            

States and political subdivisions

     4.7        6.9        —          —          4.7        6.9   

Corporate fixed maturities

     59.8        145.7        —          —          59.8        145.7   

Residential mortgage-backed securities

     —          1.5        —          —          —          1.5   
                                                

Total below investment grade

     64.5        154.1        —          —          64.5        154.1   
                                                

Total fixed maturities

     247.8        2,260.4        121.7        654.7        369.5        2,915.1   
                                                

Equity securities:

            

Perpetual preferred securities

     —          —          13.4        28.5        13.4        28.5   

Common equity securities

     11.4        32.3        —          —          11.4        32.3   
                                                

Total equity securities

     11.4        32.3        13.4        28.5        24.8        60.8   
                                                

Total fixed maturities and equity securities, including discontinued operations

     259.2        2,292.7        135.1        683.2        394.3        2,975.9   

Less: fixed maturities and equity securities of discontinued operations (2)

     (42.0     (420.7     (34.4     (200.3     (76.4     (621.0
                                                

Total fixed maturities and equity securities, excluding discontinued operations

   $ 217.2      $ 1,872.0      $ 100.7      $ 482.9      $ 317.9      $ 2,354.9   
                                                

 

(1) Substantially all below investment grade securities with an unrealized loss had been rated by the NAIC, Standard & Poor’s, or Moody’s at December 31, 2008.
(2) Fixed maturities of discontinued operations as of December 31, 2008 included the discontinued FAFLIC business and discontinued accident and health business. Due to the January 2, 2009 sale of FAFLIC, fixed maturities with total gross unrealized losses of $60.7 million and fair value of $568.7 million transferred to the buyer.

The Company employs a systematic methodology to evaluate declines in fair value below amortized cost for all investments. The methodology utilizes a quantitative and qualitative process ensuring that available evidence concerning the declines in fair value below amortized cost is evaluated in a disciplined manner. In determining whether a decline in fair value below amortized cost is other-than-temporary, the Company evaluates the issuer’s overall financial condition; the issuer’s credit and financial strength ratings; the issuer’s financial performance, including earnings trends, dividend payments and asset quality; any specific events which may influence the operations of the issuer including governmental actions such as the enactment of The Emergency Economic Stabilization Act of 2008 and receipt of related funds; a weakening of the general market conditions in the industry or geographic region in which the issuer operates; the length of time and the degree to which the fair value of an issuer’s securities remains below the Company’s cost; and with respect to fixed maturity investments, any factors that might raise doubt about the issuer’s ability to pay all amounts due according to the contractual terms and whether the Company expects to recover the entire amortized cost basis of the security; and with respect to equity securities, the Company’s ability and intent to hold the investment for a period of time to allow for a recovery in value. The Company applies these factors to all securities.

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following tables provide information on the Company’s gross unrealized losses of fixed maturity securities by credit ratings, including ratings of securities with third party guarantees, as of September 30, 2009 and December 31, 2008.

 

     (Unaudited)
September 30, 2009
 

(In millions)

   AAA     AA    A     BBB     Total
investment
grade
    BB     B     CCC
and
below
    Total
below
investment
grade
    Total  

U.S. Treasury securities and U.S government and agency securities

   $ 1.9      $ —      $ —        $ —        $ 1.9      $ —        $ —        $ —        $ —        $ 1.9   

States and political subdivisions

     1.1        1.6      2.8        6.7        12.2        0.6        —          2.9        3.5        15.7   

Corporate fixed maturities

     0.2        2.0      16.3        17.9        36.4        19.1        7.0        7.5        33.6        70.0   

Residential mortgage-backed securities

     4.6        1.6      0.7        1.8        8.7        2.3        3.7        3.3        9.3        18.0   

Commercial mortgage-backed securities

     3.1        1.9      7.3        —          12.3        —          —          —          —          12.3   
                                                                               

Total fixed maturities, including discontinued operations

     10.9        7.1      27.1        26.4        71.5        22.0        10.7        13.7        46.4        117.9   

Less: losses included in discontinued operations

     (0.1     —        (1.2     (3.9     (5.2     (0.8     (3.9     (1.2     (5.9     (11.1
                                                                               

Total fixed maturities, excluding discontinued operations

   $ 10.8      $ 7.1    $ 25.9      $ 22.5      $ 66.3      $ 21.2      $ 6.8      $ 12.5      $ 40.5      $ 106.8   
                                                                               

 

     (Unaudited)
December 31, 2008
 

(In millions)

   AAA     AA     A     BBB     Total
investment
grade
    BB     B     CCC
and
below
    Total
below
investment
grade
    Total  

U.S. Treasury securities and U.S. government and agency securities

   $ 0.8      $ —        $ —        $ —        $ 0.8      $ —        $ —        $ —        $ —        $ 0.8   

States and political subdivisions

     3.2        11.4        11.3        5.1        31.0        3.2        1.5        —          4.7        35.7   

Corporate fixed maturities

     0.5        2.5        79.7        118.6        201.3        15.0        26.3        18.5        59.8        261.1   

Residential mortgage-backed securities

     19.4        2.5        —          —          21.9        —          —          —          —          21.9   

Commercial mortgage-backed securities

     32.9        6.3        10.8        —          50.0        —          —          —          —          50.0   
                                                                                

Total fixed maturities, including discontinued operations

     56.8        22.7        101.8        123.7        305.0        18.2        27.8        18.5        64.5        369.5   

Less: losses included in discontinued operations (1)

     (17.3     (2.2     (19.8     (28.9     (68.2     (2.3     (3.8     (2.1     (8.2     (76.4
                                                                                

Total fixed maturities, excluding discontinued operations

   $ 39.5      $ 20.5      $ 82.0      $ 94.8      $ 236.8      $ 15.9      $ 24.0      $ 16.4      $ 56.3      $ 293.1   
                                                                                

 

(1) Fixed maturities of discontinued operations as of December 31, 2008 included the discontinued FAFLIC business and discontinued accident and health business. Due to the January 2, 2009 sale of FAFLIC, fixed maturities with total gross unrealized losses of $60.7 million transferred to the buyer.

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

C. Other-than-temporary impairments

As of April 1, 2009, the Company implemented the guidance included in ASC 320, which modifies the assessment of other-than-temporary impairments (“OTTI”) on debt securities, as well as the method of recording and reporting other-than-temporary impairments.

Under the new guidance, if a company intends to sell or more likely than not will be required to sell a debt security before recovery of its amortized cost basis, the amortized cost of the security is reduced to its fair value, with a corresponding charge to earnings. If a company does not intend to sell the debt security, or more likely than not will not be required to sell it, ASC 320 requires that the company separate the other-than-temporary impairment into the portion which represents the credit loss and the amount related to all other factors. The amount of the estimated loss attributable to credit is recognized in earnings and the amount related to non-credit factors is recognized in other comprehensive income, net of applicable taxes.

ASC 320 requires a cumulative effect adjustment upon adoption to reclassify the non-credit component of previously recognized impairments from retained earnings to other comprehensive income. The Company reviewed previously recognized OTTI recorded through realized losses on securities held at April 1, 2009, which was approximately $121 million, and determined that $33.3 million of these OTTI were related to non-credit factors, such as interest rates and market conditions. Accordingly, the Company increased the amortized cost basis of these debt securities and recorded a cumulative effect adjustment of $33.3 million within shareholders’ equity. The cumulative effect adjustment had no effect on total shareholders’ equity as it increased retained earnings and reduced accumulated other comprehensive income.

Current period other-than-temporary impairments

For the first nine months of 2009, OTTI on fixed maturities and equity securities was $39.1 million, of which $29.3 million was recognized in earnings and the remaining $9.8 million was recorded as unrealized loss in accumulated other comprehensive income (“OCI”), net of taxes.

For the three months ended September 30, 2009, total OTTI on fixed maturities and equity securities was $4.5 million, of which $6.1 million was recognized in earnings and a reduction of $1.6 million was recognized in OCI, net of taxes. Of the $6.1 million loss recorded in earnings, $4.0 million was estimated credit losses on debt securities for which a portion of the impairment was recognized in OCI, either in the current or prior periods, and $2.1 million was losses for which the entire difference between amortized cost and fair value was charged to earnings. The $1.6 million reduction of OTTI in OCI was primarily due to the reclassification of losses on previously impaired securities into earnings during the quarter, partially offset by additional OTTI on newly impaired securities.

The methodology and significant inputs used to measure the amount of credit losses in the quarter ended September 30, 2009 are as follows:

Corporate bonds ($1.8 million) - the Company utilized a financial model that derives expected cash flows based on probability-of-default factors by credit rating and asset duration and loss-given-default factors based on security type. These factors are based on historical data provided by an independent third-party rating agency;

Asset-backed securities, including commercial and residential mortgage backed securities ($1.4 million)—the Company utilized cash flow estimates based on bond specific facts and circumstances that include collateral characteristics, expectations of delinquency and default rates, loss severity, prepayment speeds and structural support, including subordination and guarantees;

Municipals ($0.8 million) - the Company utilized cash flow estimates based on bond specific facts and circumstances that may include the political subdivision’s taxing authority, the issuer’s ability to adjust user fees or other sources of revenue to satisfy its debt obligations and the ability to access insurance or guarantees.

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following table provides a rollforward of the cumulative amounts related to the Company’s credit loss portion of the OTTI losses on debt securities held as of September 30, 2009 for which the non-credit portion of the loss is included in other comprehensive income:

 

     (Unaudited)  

(In millions)

   Quarter Ended
September 30, 2009
    Period from April 1, 2009 to
September 30, 2009
 

Credit losses as of the beginning of the period

   $ 19.9      $ 17.3   

Credit losses for which an OTTI was not previously recognized

     0.9        3.5   

Additional credit losses on securities for which an OTTI was previously recognized

     3.1        3.1   

Reductions for securities sold during the period

     (0.4     (0.4
                

Credit losses as of September 30, 2009

   $ 23.5      $ 23.5   
                

D. Proceeds from voluntary sales

The proceeds from voluntary sales of available-for-sale securities and the gross realized gains and gross realized losses on those sales were as follows:

 

     (Unaudited)
Quarter Ended
September 30, 2009
   (Unaudited)
Nine Months Ended
September 30, 2009

(In millions)

   Proceeds
from
voluntary
sales
   Gross
gains
   Gross
losses
   Proceeds
from
voluntary
sales
   Gross
gains
   Gross
losses

Fixed maturities

   $ 247.2    $ 7.4    $ 2.0    $ 1,243.8    $ 30.5    $ 12.0

Equity securities

     —        —        —        —        —        —  

6. Fair Value

Effective January 1, 2008, the Company implemented the guidance now included in ASC 820, Fair Value Measurements and Disclosures, (formerly included under Statement No. 157) as it relates to the fair value of its financial assets and liabilities. ASC 820 provides for a standard definition of fair value to be used in new and existing pronouncements, including ASC 825, Financial Instruments (formerly included under Statement of Financial Accounting Standards No. 107, Disclosures about Fair Value of Financial Instruments). This guidance requires disclosure of fair value information about certain financial instruments (insurance contracts, real estate, goodwill and taxes are excluded) for which it is practicable to estimate such values, whether or not these instruments are included in the balance sheet. The fair values presented for certain financial instruments are estimates which, in many cases, may differ significantly from the amounts that could be realized upon immediate liquidation.

ASC 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability, i.e., exit price, in an orderly transaction between market participants and also provides a hierarchy for determining fair value, which emphasizes the use of observable market data whenever available. The three broad levels defined by the hierarchy are as follows, with the highest priority given to Level 1 as these are the most reliable, and the lowest priority given to Level 3:

Level 1 – Quoted prices in active markets for identical assets.

Level 2 – Quoted prices for similar assets in active markets, quoted prices for identical or similar assets in markets that are not active, or other inputs that are observable or can be corroborated by observable market data, including model-derived valuations.

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Level 3 – Unobservable inputs that are supported by little or no market activity.

When more than one level of input is used to determine fair value, the financial instrument is classified as Level 1, 2 or 3 according to the lowest level input that has a significant impact on the fair value measurement.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments and have not changed during the period:

Cash and Cash Equivalents

For these short-term investments, the carrying amount approximates fair value.

Fixed Maturities

Level 1 securities generally include U.S. Treasury issues and other securities that are highly liquid and for which quoted market prices are available. Level 2 securities are valued using pricing for similar securities and pricing models that incorporate observable inputs including, but not limited to yield curves and issuer spreads. Level 3 securities include issues for which little observable data can be obtained, primarily due to the illiquid nature of the securities, and for which significant inputs used to determine fair value are based on the Company’s own assumptions. Non-binding broker quotes are also included in Level 3.

The Company utilizes a third party pricing service for the valuation of the majority of its fixed maturity securities and receives one quote per security. When quoted market prices in an active market are available, they are provided by the pricing service as the fair value and such values are classified as Level 1. Since fixed maturities other than U.S. Treasury securities generally do not trade on a daily basis, the pricing service prepares estimates of fair value measurements for other securities using pricing applications which include available relevant market information, benchmark curves, benchmarking of like securities, sector groupings and prepayment assumptions, when necessary. Inputs into these applications include, but are not limited to, benchmark yields, reported trades, broker/dealer quotes, issuer spreads, bids, offers and reference data. Generally, all prices provided by the pricing service, except quoted market prices, are reported as Level 2.

The Company holds privately placed corporate bonds and certain other bonds that do not have an active market and for which the pricing service cannot provide fair values. The Company determines fair values for these securities using either matrix pricing or broker quotes. The Company will use observable market data to the extent it is available, but is also required to use a certain amount of unobservable judgment due to the illiquid nature of the securities involved. These matrix-priced securities are reported as Level 2 or Level 3, depending on the significance of the impact of unobservable judgment on the security’s value. Additionally, the Company may obtain non-binding broker quotes which are reported as Level 3.

Equity Securities

Level 1 includes publicly traded securities valued at quoted market prices. Level 2 includes securities that are valued using pricing for similar securities and pricing models that incorporate observable inputs. Level 3 consists of common stock of private companies for which observable inputs are not available.

The Company utilizes a third party pricing service for the valuation of the majority of its equity securities and receives one quote for each equity security. When quoted market prices in an active market are available, they are provided by the pricing service as the fair value and such values are classified as Level 1. Generally, all prices provided by the pricing service, except quoted market prices, are reported as Level 2. Occasionally, the Company may obtain non-binding broker quotes which are reported as Level 3.

Mortgage Loans

Fair values are estimated by discounting the future contractual cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings.

Policy Loans

The carrying amount reported in the Consolidated Balance Sheets approximates fair value since policy loans have no defined maturity dates and are inseparable from the insurance contracts. Policy loans were included in discontinued operations at December 31, 2008 and were sold on January 2, 2009.

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Derivative Instruments

These Level 3 valuations are derived from the counterparties’ internally developed models which do not necessarily represent observable market data. Derivatives were included in discontinued operations at December 31, 2008 and were sold on January 2, 2009.

Separate Account Assets

The Company’s separate accounts are invested in variable insurance trust funds which have a daily net asset value obtainable from an active market. Separate accounts were included in discontinued operations at December 31, 2008 and were sold on January 2, 2009.

Investment Contracts (Without Mortality Features)

Fair values for liabilities under guaranteed investment type contracts are estimated using discounted cash flow calculations using current interest rates for similar contracts with maturities consistent with those remaining for the contracts being valued. Liabilities under supplemental contracts without life contingencies are estimated based on current fund balances while other individual contract funds represent the present value of future policy benefits. Other liabilities are based on current surrender values. The contracts associated with the Company’s former life insurance business were included in discontinued operations at December 31, 2008 and were sold on January 2, 2009.

Legal Indemnities

Fair values are estimated using probability-weighted discounted cash flow analyses.

Trust Instruments Supported by Funding Obligations

Fair values are estimated using discounted cash flow calculations using current interest rates for similar contracts with maturities consistent with those remaining for the contracts being valued. Trust instruments supported by funding obligations were included in discontinued operations at December 31, 2008 and were sold on January 2, 2009.

Long-term Debt

The fair value of long-term debt was estimated based on quoted market prices. If a quoted market price is not available, fair values are estimated using discounted cash flows that are based on current interest rates and yield curves for debt issuances with maturities and credit risks consistent with the debt being valued.

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The estimated fair values of the financial instruments were as follows:

 

(In millions)

   (Unaudited)
September 30, 2009
    December 31, 2008  
     Carrying
Value
    Fair
Value
    Carrying
Value
    Fair
Value
 

Financial Assets

        

Cash and cash equivalents

   $ 241.3      $ 241.3      $ 529.5      $ 529.5   

Fixed maturities

     4,913.4        4,913.4        5,127.7        5,127.7   

Equity securities

     122.0        122.0        76.3        76.3   

Mortgage loans

     20.4        21.8        31.1        33.1   

Policy loans

     —          —          111.1        111.1   
                                

Total financial assets, including financial assets of discontinued

          operations

     5,297.1        5,298.5        5,875.7        5,877.7   

Less: financial assets of discontinued operations

     (116.4     (116.4     (1,229.8     (1,229.8
                                

Total financial assets of continuing operations

   $ 5,180.7      $ 5,182.1      $ 4,645.9      $ 4,647.9   
                                

Financial Liabilities

        

Derivative instruments

   $ —        $ —        $ 0.2      $ 0.2   

Supplemental contracts without life contingencies

     2.3        2.3        18.5        18.5   

Dividend accumulations

     —          —          81.1        81.1   

Other individual contract deposit funds

     —          —          5.5        5.5   

Other group contract deposit funds

     —          —          25.4        25.3   

Legal indemnities

     7.9        7.9        11.3        11.3   

Trust instruments supported by funding obligations

     —          —          15.0        15.9   

Long-term debt

     433.8        381.2        531.4        325.8   
                                

Total financial liabilities, including financial liabilities of discontinued operations

     444.0        391.4        688.4        483.6   

Less: financial liabilities of discontinued operations

     —          —          (138.9     (139.7
                                

Total financial liabilities of continuing operations

   $ 444.0      $ 391.4      $ 549.5      $ 343.9   
                                

The Company performs a review of the fair value hierarchy classifications and of prices received from its third party pricing service on a quarterly basis. The Company reviews the pricing services’ policy describing its processes, practices and inputs, including various financial models used to value securities. Also, the Company reviews the portfolio pricing. Securities with changes in prices that exceed a defined threshold are verified to independent sources such as Bloomberg. If upon review, the Company is not satisfied with the validity of a given price, a pricing challenge would be submitted to the pricing service along with supporting documentation for its review. The Company does not adjust quotes or prices obtained from the pricing service unless the pricing service agrees with the Company’s challenge. During the nine months ended September 30, 2009, the Company did not adjust any prices received from brokers or its pricing service.

Changes in the observability of valuation inputs may result in a reclassification of certain financial assets or liabilities within the fair value hierarchy. Reclassifications related to Level 3 of the fair value hierarchy are reported as transfers in or out of Level 3 as of the beginning of the period in which the reclassification occurs. As previously discussed, the Company utilizes a third party pricing service for the valuation of the majority of its fixed maturities and equity securities. The pricing service has indicated that it will only produce an estimate of fair value if there is objectively verifiable information to produce a valuation. If the pricing service discontinues pricing an investment, the Company will use observable market data to the extent it is available, but may also be required to make assumptions for market based inputs that are unavailable due to market conditions.

During the nine months ended September 30, 2009, the Company transferred certain assets that were previously classified as Level 3 into Level 2, primarily as a result of assessing the significance of unobservable inputs on the fair value measurement.

The Company currently holds fixed maturity securities and equity securities, and prior to January 2, 2009 also held separate account assets, for which fair value is determined on a recurring basis. The following tables present for each hierarchy level, the Company’s assets that were measured at fair value at September 30, 2009 and December 31, 2008.

 

24


Table of Contents

THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

     (Unaudited)
Fair Value at September 30, 2009

(In millions)

   Total     Level 1     Level 2     Level 3

Fixed maturities:

        

U.S. Treasury securities and U.S. government and agency securities

   $ 388.6      $ 142.7      $ 245.9      $ —  

States and political subdivisions

     844.1        —          827.0        17.1

Foreign governments

     2.9        —          2.9        —  

Corporate fixed maturities

     2,401.6        —          2,356.2        45.4

Residential mortgage-backed securities

     938.4        —          938.4        —  

Commercial mortgage-backed securities

     337.8        —          326.9        10.9
                              

Total fixed maturities

     4,913.4        142.7        4,697.3        73.4

Equity securities

     111.7        96.8        13.7        1.2
                              

Total investment assets at fair value, including assets of discontinued operations

     5,025.1        239.5        4,711.0        74.6

Investment assets of discontinued operations at fair value

     (108.3     (0.3     (108.0     —  
                              

Total investment assets of continuing operations at fair value

   $ 4,916.8      $ 239.2      $ 4,603.0      $ 74.6
                              

 

     Fair Value at December 31, 2008  

(In millions)

   Total     Level 1     Level 2     Level 3  

Fixed maturities:

        

U.S. Treasury securities and U.S. government and agency securities

   $ 355.6      $ 101.4      $ 254.2      $ —     

States and political subdivisions

     726.9        —          718.3        8.6   

Foreign governments

     4.8        1.8        3.0        —     

Corporate fixed maturities

     2,468.4        —          2,414.3        54.1   

Mortgage-backed securities

     1,529.8        —          1,503.4        26.4   
                                

Total fixed maturities (1)

     5,085.5        103.2        4,893.2        89.1   

Equity securities

     64.9        52.9        10.8        1.2   

Separate account assets

     263.4        263.4        —          —     
                                

Total investment assets at fair value, including assets of discontinued operations

     5,413.8        419.5        4,904.0        90.3   

Investment assets of discontinued operations

     (1,250.3     (304.4     (940.1     (5.8
                                

Total investment assets of continuing operations at fair value

   $ 4,163.5      $ 115.1      $ 3,963.9      $ 84.5   
                                

 

(1) Excludes $42.2 million of trust preferred capital securities of a THG affiliated entity that are designated as held-to-maturity that are carried at amortized cost.

The following tables present a reconciliation for all assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3).

 

     (Unaudited)
Quarter Ended September 30, 2009
 
     Fixed Maturities             

(In millions)

   States and
political
subdivisions
    Corporate     Commercial
mortgage
backed
securities
   Total     Equities    Total Assets  

Balance June 30, 2009

   $ 18.4      $ 41.6      $ 10.6    $ 70.6      $ 1.2    $ 71.8   

Total (losses) gains:

              

Included in earnings

     (0.1     —          —        (0.1     —        (0.1

Included in other comprehensive income

     0.2        1.6        0.3      2.1        —        2.1   

Net purchases

     0.7        5.6        —        6.3        —        6.3   

Net transfers out of Level 3

     (2.1     (3.4     —        (5.5     —        (5.5
                                              

Balance September 30, 2009

   $ 17.1      $ 45.4      $ 10.9    $ 73.4      $ 1.2    $ 74.6   
                                              

 

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Table of Contents

THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

     (Unaudited)
Quarter Ended September 30, 2008
 
     Fixed Maturities                         

(In millions)

   States and
political
subdivisions
    Corporate     Residential
mortgage
backed
securities
    Commercial
mortgage
backed
securities
    Total     Equities    Derivative
Assets
    Total
Assets
    Derivative
Liabilities
 

Balance June 30, 2008

   $ 9.5      $ 72.6      $ 7.1      $ 10.5      $ 99.7      $ 1.2    $ 6.4      $ 107.3      $ (2.0

Total (losses) gains:

                   

Included in earnings

     —          (0.2     —          —          (0.2     —        (1.6     (1.8     (0.3

Included in other comprehensive income

     (0.2     (3.2     0.1        (0.1     (3.4     —        0.4        (3.0     —     

Net (redemptions) purchases

     —          (7.7     (0.1     (0.2     (8.0     —        (2.3     (10.3     2.3   

Net transfers (out of) into Level 3

     —          (0.6     —          15.7        15.1        —        —          15.1        —     
                                                                       

Balance September 30, 2008

     9.3        60.9        7.1        25.9        103.2        1.2      2.9        107.3        —     

Less: discontinued operations

     —          (3.4     —          (2.8     (6.2     —        (2.9     (9.1     —     
                                                                       

Balance September 30, 2008, continuing operations

   $ 9.3      $ 57.5      $ 7.1      $ 23.1      $ 97.0      $ 1.2    $ —        $ 98.2      $ —     
                                                                       

 

     (Unaudited)
Nine Months Ended September 30, 2009
 
     Fixed Maturities             

(In millions)

   States and
political
subdivisions
    Corporate     Residential
mortgage
backed
securities
    Commercial
mortgage
backed
securities
    Total     Equities    Total Assets  

Balance January 1, 2009

   $ 18.2      $ 44.5      $ 6.9      $ 19.5      $ 89.1      $ 1.2    $ 90.3   

Assets of discontinued operations sold with FAFLIC

     (0.1     (3.4     —          (2.3     (5.8     —        (5.8

Total (losses) gains:

               

Included in earnings

     (0.3     (0.4     0.2        —          (0.5     —        (0.5

Included in other comprehensive income

     (0.6     3.5        —          0.9        3.8        —        3.8   

Net purchases (redemptions)

     2.0        13.1        (7.1     2.8        10.8        —        10.8   

Net transfers out of Level 3

     (2.1     (11.9     —          (10.0     (24.0     —        (24.0
                                                       

Balance September 30, 2009

   $ 17.1      $ 45.4      $ —        $ 10.9      $ 73.4      $ 1.2    $ 74.6   
                                                       

 

     (Unaudited)
Nine Months Ended September 30, 2008
 
     Fixed Maturities                          

In millions)

   States and
political
subdivisions
    Corporate     Residential
mortgage
backed
securities
    Commercial
mortgage
backed
securities
    Total     Equities     Derivative
Assets
    Total
Assets
    Derivative
Liabilities
 

Balance January 1, 2008

   $ —        $ 9.7      $ —        $ 20.8      $ 30.5      $ 1.3      $ 5.8      $ 37.6      $ (1.1

Total (losses) gains:

                  

Included in earnings

     —          (0.7     —          —          (0.7     —          (0.7     (1.4     (1.2

Included in other comprehensive income

     (0.6     (1.7     (0.1     (0.7     (3.1     (0.1     0.1        (3.1     —     

Net (redemptions) purchases

     (0.1     (1.8     (0.4     (0.3     (2.6     —          (2.3     (4.9     2.3   

Net transfers into Level 3

     10.0        55.4        7.6        6.1        79.1        —          —          79.1        —     
                                                                        

Balance September 30, 2008

     9.3        60.9        7.1        25.9        103.2        1.2        2.9        107.3        —     

Less: discontinued operations

     —          (3.4     —          (2.8     (6.2     —          (2.9     (9.1     —     
                                                                        

Balance September 30, 2008, continuing operations

   $ 9.3      $ 57.5      $ 7.1      $ 23.1      $ 97.0      $ 1.2      $ —        $ 98.2      $ —     
                                                                        

 

26


Table of Contents

THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The tables below summarize gains and losses due to changes in fair value, including both realized and unrealized gains and losses, recorded in net income for Level 3 assets and liabilities.

 

     (Unaudited)
Quarter Ended September 30, 2009
    (Unaudited)
Quarter Ended September 30, 2008
 

(In millions)

   Other-than-
temporary
impairments
    Net realized
investment
losses
    Total     Net realized
investment
losses
    Loss from
discontinued
FAFLIC business
    Total  

Level 3 Assets:

            

Fixed maturities:

            

States and political subdivisions

   $ —        $ (0.1   $ (0.1   $ —        $ —        $ —     

Corporate fixed maturities

     (0.1     0.1        —          (0.2     —          (0.2
                                                

Total fixed maturities

     (0.1     —          (0.1     (0.2     —          (0.2

Derivative assets

     —          —          —          —          (1.6     (1.6
                                                

Total Assets

   $ (0.1   $ —        $ (0.1   $ (0.2   $ (1.6   $ (1.8
                                                

Level 3 Liabilities:

            

Derivative liabilities

   $ —        $ —        $ —        $ —        $ (0.3   $ (0.3
                                                

 

     (Unaudited)
Nine Months Ended September 30, 2009
    (Unaudited)
Nine Months Ended September 30, 2008
 

(In millions)

   Other-than-
temporary
impairments
    Net realized
investment
(losses) gains
    Total     Net realized
investment
losses
    Loss from
discontinued
FAFLIC
business
    Total  

Level 3 Assets:

            

Fixed maturities:

            

States and political subdivisions

   $ —        $ (0.3   $ (0.3   $ —        $ —        $ —     

Corporate fixed maturities

     (0.9     0.5        (0.4     (0.7     —          (0.7

Residential mortgage backed securities

       0.2        0.2        —          —          —     
                                                

Total fixed maturities

     (0.9     0.4        (0.5     (0.7     —          (0.7

Derivative assets

     —          —          —          —          (0.7     (0.7
                                                

Total Assets

   $ (0.9   $ 0.4      $ (0.5   $ (0.7   $ (0.7   $ (1.4
                                                

Level 3 Liabilities:

            

Derivative liabilities

   $ —        $ —        $ —        $ —        $ (1.2   $ (1.2
                                                

 

27


Table of Contents

THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

7. Debt

Long-term debt consists of the following:

 

     (Unaudited)
September 30,2009
   December 31, 2008
(In millions)          

Debt related to junior subordinated debentures

   $ 183.4    $ 327.9

FHLBB borrowing

     125.0      —  

Senior debentures (unsecured)

     121.4      199.5

Surplus notes

     4.0      4.0
             
   $ 433.8    $ 531.4
             

AFC Capital Trust I (“the Trust”), issued $300.0 million of preferred securities in 1997 (“Capital Securities”), the proceeds of which were used to purchase junior subordinated debentures issued by the Company. The Company liquidated the Trust on July 30, 2009. Each holder of Capital Securities as of that date received a principal amount of the companies Series B Junior Subordinated Deferrable Interest Debentures equal to the liquidation amount of the Capital Securities held by such holder. These junior subordinated debentures have a face value of $165.7 million and, consistent with the Capital Securities, pay cumulative dividends semi-annually at 8.207% and mature February 3, 2027 (See also Note 4 – Other Significant Transactions) In addition, the Company holds $3.1 million of junior subordinated debentures related to Professionals Direct, Inc., and $14.6 million of junior subordinated debentures related to AIX Holdings, Inc.

In September 2009, Hanover Insurance received an advance of $125.0 million through its membership in the FHLBB as part of a collateralized borrowing program. This advance bears interest at a fixed rate of 5.50% per annum over a twenty-year term. As collateral to FHLBB, Hanover Insurance has pledged government agency securities with a fair value as of September 30, 2009 of approximately $142.8 million. (See also Note 4 – Other Significant Transactions.)

As of September 30, 2009 the Company had repurchased senior debentures with a face value of approximately $78.4 million. (See also Note 4 – Other Significant Transactions.) The remaining senior debentures of the Company have a $121.6 million face value, pay interest semi-annually at a rate of 7.625% and mature on October 16, 2025. The senior debentures are subject to certain restrictive covenants, including limitations on the issuance or disposition of stock of restricted subsidiaries and limitations on liens. The Company is in compliance with all covenants.

 

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Table of Contents

THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

8. Federal Income Taxes

Federal income tax expense for the nine months ended September 30, 2009 and 2008 has been computed using estimated effective tax rates. These rates are revised, if necessary, at the end of each successive interim period to reflect the current estimates of the annual effective tax rates.

In the first nine months of 2009, the Company decreased its valuation allowance related to its deferred tax asset by $118.9 million, from $348.2 million to $229.3 million. The decrease in this valuation allowance resulted from unrealized appreciation of the Company’s investment portfolio. Accordingly, the Company recorded net decreases in its valuation allowance of $108.4 million as an adjustment to Accumulated Other Comprehensive Income and $11.6 million as an adjustment to Retained Earnings for the cumulative effect of adopting revised investment asset impairment guidance under ASC 320. These decreases are partially offset by increases in its valuation allowance of $1.1 million as an adjustment to Discontinued Operations in its Consolidated Statements of Income.

The Company or its subsidiaries files income tax returns in the U.S. federal jurisdiction and various state jurisdictions. With few exceptions, the Company and its subsidiaries are no longer subject to U.S. federal income tax examinations by tax authorities for years before 2005. The IRS audits of the years 2005 and 2006 commenced in December 2007. The Company and its subsidiaries are still subject to U.S. state income tax examinations by tax authorities for years after 1998.

9. Pension and Other Postretirement Benefit Plans

The Company’s defined benefit pension plans, which provided retirement benefits based on a cash balance formula, were frozen as of January 1, 2005; therefore, no further cash balance allocations have been credited for plan years beginning on or after January 1, 2005. In addition, certain transition group employees were eligible for a grandfathered benefit based upon service and compensation; such benefits were also frozen at January 1, 2005 levels with an annual transition pension adjustment. The Company has additional unfunded pension plans and postretirement plans to provide benefits to certain full-time employees, former agents, retirees and their dependents.

The components of net periodic benefit cost for pension and other postretirement benefit plans are as follows:

 

     (Unaudited)
Quarter Ended September 30,
 

(In millions)

   2009     2008     2009     2008  
     Pension Benefits     Postretirement Benefits  

Service cost – benefits earned during the period

   $ 0.1      $ —        $ —        $ 0.1   

Interest cost

     8.4        8.3        0.7        0.8   

Expected return on plan assets

     (6.4     (8.5     —          —     

Recognized net actuarial loss

     6.7        0.6        0.1        0.1   

Amortization of transition asset

     (0.4     (0.4     —          —     

Amortization of prior service cost

     —          —          (1.4     (1.3
                                

Net periodic cost (benefit)

   $ 8.4      $ —        $ (0.6   $ (0.3
                                

 

     (Unaudited)
Nine Months Ended September 30,
 
     2009     2008     2009     2008  
     Pension Benefits     Postretirement Benefits  

Service cost – benefits earned during the period

   $ 0.1      $ —        $ 0.1      $ 0.3   

Interest cost

     25.4        24.7        2.1        2.4   

Expected return on plan assets

     (19.1     (25.4     —          —     

Recognized net actuarial loss

     20.2        1.9        0.2        0.3   

Amortization of transition asset

     (1.2     (1.2     —          —     

Amortization of prior service cost

     —          —          (4.3     (3.7
                                

Net periodic cost (benefit)

   $ 25.4      $ —        $ (1.9   $ (0.7
                                

 

29


Table of Contents

THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

In April and September 2009, the Company contributed $30.0 million and $15.2 million, respectively, to its qualified plan related to the 2008 plan year. Approximately $32 million of these contributions is discretionary. No further contributions are required to be made in 2009 related to the 2009 plan year.

10. Other Comprehensive Income

The following table provides a reconciliation of gross unrealized investment gains (losses) to the net balance shown in the Consolidated Statements of Comprehensive Income:

 

     (Unaudited) Quarter
Ended September 30,
    (Unaudited)
Nine Months Ended
September 30,
 

(In millions)

   2009    2008     2009     2008  

Unrealized appreciation (depreciation) on available-for-sale securities:

         

Unrealized holding gains (losses) arising during period, net of income tax (expense) benefit of $(26.9) and $0.1 for the quarters ended September 30, 2009 and 2008 and $(26.7) and $2.2 for the nine months ended September 30, 2009 and 2008

   $ 162.5    $ (229.9   $ 389.2      $ (323.2

Less: reclassification adjustment for losses included in net income, net of income tax benefit of $3.5 for the quarter and year ended September 30, 2009

     3.5      (112.6     (9.4     (127.9
                               

Total available-for-sale securities

     159.0      (117.3     398.6        (195.3
                               

Unrealized depreciation on derivative instruments:

         

Unrealized holding losses arising during period, net of income tax benefit of $0.6 and $0.7 for the quarter and nine months ended September 30, 2008

     —        (0.9     —          (1.3

Less: reclassification adjustment for losses included in net income, net of income tax benefit of $0.7 for the quarter and nine months ended September 30, 2008

     —        (1.3     —          (1.4
                               

Total derivative instruments

     —        0.4        —          0.1   
                               

Other comprehensive income (loss)

   $ 159.0    $ (116.9   $ 398.6      $ (195.2
                               

11. Segment Information

The Company’s primary business operations include insurance products and services in three property and casualty operating segments. These segments are Personal Lines, Commercial Lines, and Other Property and Casualty. Personal Lines includes personal automobile, homeowners and other personal coverages, while Commercial Lines includes commercial multiple peril, commercial automobile, workers’ compensation, and other commercial coverages, such as bonds, inland marine business and professional liability. In addition, the Other Property and Casualty segment consists of: Opus Investment Management, Inc. (“Opus”), which markets investment management services to institutions, pension funds and other organizations; earnings on holding company assets; as well as voluntary pools in which the Company has not actively participated since 1995. Prior to its sale on June 2, 2008, AMGRO Inc., the Company’s premium financing business, was also included in the Other Property and Casualty segment. Additionally, prior to the sale of FAFLIC on January 2, 2009, the operations included the results of this run-off life insurance and annuity business as a separate segment. This business is now reflected as discontinued operations. Certain ongoing expenses were also reclassified from this former life segment to the Property and Casualty business. The separate financial information of each segment is presented consistent with the way results are regularly evaluated by the chief operating decision maker in deciding how to allocate resources and in assessing performance. A summary of the Company’s reportable segments is included below.

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The Company reports interest expense related to its corporate debt separately from the earnings of its operating segments. Corporate debt consists of the Company’s senior debentures, junior subordinated debentures, surplus notes and advances under the Company’s recently established collateralized borrowing program with the FHLBB. Subordinated debentures are held by the holding company and several subsidiaries.

Management evaluates the results of the aforementioned segments on a pre-tax basis. Segment income excludes certain items which are included in net income, such as federal income taxes and net realized investment gains and losses, because fluctuations in these gains and losses 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, restructuring costs, extraordinary items, the cumulative effect of accounting changes and certain other items. While these items may be significant components in understanding and assessing the Company’s financial performance, management believes that the presentation of segment income enhances understanding of the Company’s results of operations by highlighting net income attributable to the core operations of the business. However, segment income should not be construed as a substitute for net income determined in accordance with generally accepted accounting principles.

 

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THE HANOVER INSURANCE GROUP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Summarized below is financial information with respect to business segments:

 

     (Unaudited)
Quarter Ended
September 30,
    (Unaudited)
Nine Months Ended
September 30,
 

(In millions)

   2009     2008     2009     2008  

Segment revenues:

        

Property and Casualty:

        

Personal Lines

   $ 397.2      $ 402.1      $ 1,186.0      $ 1,208.7   

Commercial Lines

     308.4        288.3        912.5        857.1   

Other Property and Casualty

     3.9        5.4        17.9        16.6   
                                

Total Property and Casualty

     709.5        695.8        2,116.4        2,082.4   

Intersegment revenues

     (1.0     (0.9     (2.9     (4.7
                                

Total segment revenues

     708.5        694.9        2,113.5        2,077.7   

Adjustments to segment revenues:

        

Net realized investment losses

     —          (52.8     (9.7     (60.7
                                

Total revenues

   $ 708.5      $ 642.1      $ 2,103.8      $ 2,017.0   
                                

Segment income (loss) before federal income taxes:

        

Property and Casualty:

        

Personal Lines:

        

GAAP underwriting loss

   $ (4.1   $ (13.7   $ (33.4   $ (13.0

Net investment income

     27.8        30.1        81.4        89.1   

Other

     3.7        1.7        8.1        7.7   
                                

Personal Lines segment income

     27.4        18.1        56.1        83.8   

Commercial Lines:

        

GAAP underwriting income (loss)

     5.2        (38.7     41.3        18.1   

Net investment income

     31.9        31.5        93.2        92.9   

Other

     1.6        0.6        2.7        3.1   
                                

Commercial Lines segment income (loss)

     38.7        (6.6     137.2        114.1   

Other Property and Casualty:

        

GAAP underwriting income

     10.3        —          10.6        0.3   

Net investment income

     2.4        3.7        13.3        11.3   

Other net expenses

     (5.2     (1.4     (17.4     (4.8