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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 March 31, 2010

 

¨	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 44,844,632 as of May 1, 2010.

 

 

 

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TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION
		Item 1.		Financial Statements
				Consolidated Statements of Income		3
				Consolidated Balance Sheets		4
				Consolidated Statements of Shareholders’ Equity		5
				Consolidated Statements of Comprehensive Income		6
				Consolidated Statements of Cash Flows		7
				Notes to Interim Consolidated Financial Statements		8
		Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations		31
		Item 3.		Quantitative and Qualitative Disclosures About Market Risk		69
		Item 4.		Controls and Procedures		69
PART II. OTHER INFORMATION
		Item 1.		Legal Proceedings		70
		Item 1A.		Risk Factors		71
		Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds		75
		Item 6.		Exhibits		76
SIGNATURES						77

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PART I - FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

THE HANOVER INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF INCOME

 

		(Unaudited) Three Months  Ended March 31,
(In millions, except per share data)		2010				2009
REVENUES
Premiums		$	666.5			$	632.0
Net investment income			61.1				64.9
Net realized investment gains (losses):
Net realized gains from sales and other			13.6				10.4
Total other-than-temporary impairment losses on securities			(0.5	)			(16.5	)
Portion of loss previously recognized in other comprehensive income			(2.2	)			—
Net other-than-temporary impairment losses on securities recognized in earnings			(2.7	)			(16.5	)
Total net realized investment gains (losses)			10.9				(6.1	)
Fees and other income			8.1				8.1
Total revenues			746.6				698.9
LOSSES AND EXPENSES
Losses and loss adjustment expenses			431.6				428.3
Policy acquisition expenses			154.4				143.1
Other operating expenses			101.3				94.2
Total losses and expenses			687.3				665.6
Income before federal income taxes			59.3				33.3
Federal income tax (benefit) expense:
Current			(28.3	)			12.6
Deferred			45.4				0.5
Total federal income tax expense			17.1				13.1
Income from continuing operations			42.2				20.2
Discontinued operations (See Note 3):
Gain from discontinued FAFLIC business			—				5.0
Loss from operations of discontinued accident and health business (net of income tax expense of $0.1 in 2010 and a benefit of $0.1 in 2009)			(0.6	)			(3.3	)
Gain on disposal of variable life and annuity business			0.2				3.9
Net income		$	41.8			$	25.8
PER SHARE DATA
Basic
Income from continuing operations		$	0.89			$	0.40
Discontinued operations:
Gain from discontinued FAFLIC business			—				0.10
Loss from operations of discontinued accident and health business			(0.01	)			(0.07	)
Gain on disposal of variable life and annuity business			—				0.08
Net income per share		$	0.88			$	0.51
Weighted average shares outstanding			47.5				51.1
Diluted
Income from continuing operations		$	0.88			$	0.39
Discontinued operations:
Gain from discontinued FAFLIC business			—				0.10
Loss from operations of discontinued accident and health business			(0.01	)			(0.06	)
Gain on disposal of variable life and annuity business			—				0.07
Net income per share		$	0.87			$	0.50
Weighted average shares outstanding			48.2				51.4

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

 

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THE HANOVER INSURANCE GROUP, INC.

CONSOLIDATED BALANCE SHEETS

 

(In millions, except per share data)		(Unaudited) March 31, 2010				December 31, 2009
ASSETS
Investments:
Fixed maturities, at fair value (amortized cost of $4,588.3 and $4,520.3)		$	4,742.3			$	4,615.6
Equity securities, at fair value (cost of $38.2 and $57.3)			45.9				69.2
Mortgage loans and other long-term investments			28.5				32.3
Total investments			4,816.7				4,717.1
Cash and cash equivalents			209.2				316.5
Accrued investment income			53.9				52.3
Premiums, accounts and notes receivable, net			654.6				590.8
Reinsurance receivable on paid and unpaid losses and unearned premiums			1,188.4				1,197.9
Deferred policy acquisition costs			306.9				286.3
Deferred federal income taxes			164.4				228.6
Goodwill			171.4				171.4
Other assets			368.6				351.2
Assets of discontinued operations			134.4				130.6
Total assets		$	8,068.5			$	8,042.7
LIABILITIES
Policy liabilities and accruals:
Losses and loss adjustment expenses		$	3,187.1			$	3,153.9
Unearned premiums			1,365.0				1,300.5
Total policy liabilities and accruals			4,552.1				4,454.4
Expenses and taxes payable			395.7				603.2
Reinsurance premiums payable			53.0				58.5
Long-term debt			632.3				433.9
Liabilities of discontinued operations			133.2				134.1
Total liabilities			5,766.3				5,684.1
Commitments and contingencies (See Note 14)
SHAREHOLDERS’ EQUITY
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			1,799.1				1,808.5
Accumulated other comprehensive income			67.8				28.8
Retained earnings			1,173.8				1,141.1
Treasury stock at cost (15.9 million and 13.0 million shares)			(739.1	)			(620.4	)
Total shareholders’ equity			2,302.2				2,358.6
Total liabilities and shareholders’ equity		$	8,068.5			$	8,042.7

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

 

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THE HANOVER INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

 

		(Unaudited) Three Months Ended March 31,
(In millions)		2010				2009
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			1,808.5				1,803.8
Employee and director stock-based awards and other			(9.4	)			(1.0	)
Balance at end of period			1,799.1				1,802.8
ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
NET UNREALIZED APPRECIATION (DEPRECIATION) ON INVESTMENTS AND DERIVATIVE INSTRUMENTS:
Balance at beginning of period			107.7				(276.1	)
Net appreciation during the period:
Net appreciation on available-for-sale securities			57.7				48.6
(Provision) benefit for deferred federal income taxes			(20.3	)			0.2
			37.4				48.8
Balance at end of period			145.1				(227.3	)
DEFINED BENEFIT PENSION AND POSTRETIREMENT PLANS:
Balance at beginning of period			(78.9	)			(108.7	)
Amounts arising in the period			—				(0.6	)
Amortization during the period:
Amount recognized as net periodic benefit cost			2.5				5.0
Provision for deferred federal income taxes			(0.9	)			(1.5	)
			1.6				2.9
Balance at end of period			(77.3	)			(105.8	)
Total accumulated other comprehensive income (loss)			67.8				(333.1	)
RETAINED EARNINGS
Balance at beginning of period			1,141.1				949.8
Net income			41.8				25.8
Dividends to shareholders			(12.3	)			—
Treasury stock issued for less than cost			(3.0	)			(1.4	)
Recognition of share-based compensation			6.2				2.1
Balance at end of period			1,173.8				976.3
TREASURY STOCK
Balance at beginning of period			(620.4	)			(482.2	)
Shares purchased at cost			(126.0	)			—
Net shares reissued at cost under employee stock-based compensation plans			7.3				3.2
Balance at end of period			(739.1	)			(479.0	)
Total shareholders’ equity		$	2,302.2			$	1,967.6

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

 

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THE HANOVER INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

 

		(Unaudited) Three Months  Ended March 31,
(In millions)		2010				2009
Net income		$	41.8			$	25.8
Other comprehensive income (loss):
Available-for-sale securities:
Net appreciation during the period			57.7				48.6
(Provision) benefit for deferred federal income taxes			(20.3	)			0.2
Total available-for-sale securities			37.4				48.8
Pension and postretirement benefits:
Amounts arising in the period			—				(0.6	)
Amortization recognized as net periodic benefit costs:
Net actuarial loss			4.3				6.8
Prior service cost			(1.4	)			(1.4	)
Transition asset			(0.4	)			(0.4	)
Total amortization recognized as net periodic benefit costs			2.5				5.0
Provision for deferred federal income taxes			(0.9	)			(1.5	)
Total pension and postretirement benefits			1.6				2.9
Other comprehensive income			39.0				51.7
Comprehensive income		$	80.8			$	77.5

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

 

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THE HANOVER INSURANCE GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

		(Unaudited) Three Months  Ended March 31,
(In millions)		2010				2009
CASH FLOWS FROM OPERATING ACTIVITIES
Net income		$	41.8			$	25.8
Adjustments to reconcile net income to net cash used in operating activities:
Gain on disposal of variable life and annuity business			(0.2	)			(3.9	)
Gain from sale of FAFLIC			—				(5.0	)
Net realized investment (gains) losses			(10.2	)			9.3
Net amortization and depreciation			4.1				2.3
Stock-based compensation expense			2.8				2.7
Amortization of deferred benefit plan costs			2.5				5.0
Deferred federal income taxes			45.4				0.5
Change in deferred acquisition costs			(19.4	)			0.6
Change in premiums and notes receivable, net of reinsurance premiums payable			(68.6	)			(12.6	)
Change in accrued investment income			(1.4	)			(1.6	)
Change in policy liabilities and accruals, net			43.6				(43.4	)
Change in reinsurance receivable			28.7				14.0
Change in expenses and taxes payable			(177.1	)			(58.6	)
Other, net			(12.0	)			3.4
Net cash used in operating activities			(120.0	)			(61.5	)
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from disposals and maturities of available-for-sale fixed maturities			232.3				511.6
Proceeds from disposals of equity securities and other investments			25.2				—
Proceeds from mortgages sold, matured or collected			3.6				0.4
Proceeds from the sale of FAFLIC			—				105.8
Cash transferred with sale of FAFLIC			—				(108.1	)
Purchase of available-for-sale fixed maturities			(256.4	)			(624.2	)
Purchase of equity securities and other investments			(0.7	)			(7.7	)
Net cash used to acquire Benchmark Professional Insurance Service, Inc.			(0.4	)			—
Net cash used to acquire Campania Holding Company, Inc			(6.1	)			—
Capital expenditures			(2.2	)			(0.1	)
Net cash used in investing activities			(4.7	)			(122.3	)
CASH FLOWS FROM FINANCING ACTIVITIES
Exercise of options			0.8				0.3
Proceeds from the issuance of long term debt			198.0				—
Change in collateral related to securities lending program			(42.8	)			0.8
Dividends paid to shareholders			(12.3	)			—
Treasury stock purchased at cost			(126.0	)			—
Other, net			(0.1	)			—
Net cash provided by financing activities			17.6				1.1
Net change in cash and cash equivalents			(107.1	)			(182.7	)
Net change in cash related to discontinued operations			(0.2	)			130.8
Cash and cash equivalents, beginning of period			316.5				397.7
Cash and cash equivalents, end of period		$	209.2			$	345.8

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. On January 2, 2009, the Company sold First Allmerica Financial Life Insurance Company (“FAFLIC”) to Commonwealth Annuity and Life Insurance Company (“Commonwealth Annuity”), a subsidiary of the Goldman Sachs Group, Inc. (“Goldman Sachs”). Results related to the sale of FAFLIC are reported as discontinued operations. Accounts associated with the accident and health business that was retained by the Company have been classified as assets and liabilities of discontinued operations in the consolidated Balance Sheets (See Note 3 – Discontinued Operations).

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 three months ended March 31, 2010 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 2009 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.

2. New Accounting Pronouncements

Recently Implemented Standards

Accounting Standards Codification (“ASC”) 105, Generally Accepted Accounting Principles (“ASC 105”) 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 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.

As of April 1, 2009, the Company adopted the guidance included in ASC 320, Investments – Debt and Equity Securities (“ASC 320”), which modifies the assessment of other-than-temporary impairments (“OTTI”) for fixed maturity securities, as well as the method of recording and reporting OTTI. Under the new guidance, if a company intends to sell or more likely than not will be required to sell a fixed maturity 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 fixed maturity security, or more likely than not will not be required to sell it, the company is required to 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. A cumulative effect adjustment was recognized by the Company upon adoption of this guidance to reclassify the non-credit component of previously recognized impairments from retained earnings to other comprehensive income. The Company increased the amortized cost basis of these fixed maturity securities and recorded a cumulative effect adjustment of $33.3 million as an increase to retained earnings and reduction to accumulated other comprehensive income. (See further disclosure in Note 8 – Investments).

 

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ASC 805, Business Combinations (“ASC 805”) contains guidance 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.

In December 2009, the FASB issued ASC Update 2009-17, Consolidation (Topic 810) – Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities (“ASC Update 2009-17”) which codified Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretation No. 46(R). This guidance amends FASB Interpretation No. 46R, Consolidation of Variable Interest Entities an interpretation of ARB No. 51 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. ASC Update 2009-17 is effective as of the beginning of the first annual reporting period that begins after November 15, 2009. The Company implemented this guidance as of January 1, 2010. The effect of implementing this guidance was not material to the Company’s financial position or results of operations.

ASC 820, Fair Value Measurements and Disclosures (“ASC 820”) includes guidance that was issued by the FASB which is 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. This fair value guidance in ASC 820 was effective for interim and annual reporting periods ending after June 15, 2009.

In August 2009, the FASB issued ASC Update No. 2009-05, Fair Value Measurements and Disclosures (Topic 820): Measuring Liabilities at Fair Value. 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.

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.

In January 2010, the FASB issued ASC Update 2010-06 (Topic 820) – Improving Disclosures about Fair Value Measurements (“ASC Update 2010-06). This update amends ASC 820 and requires new and clarified disclosures for fair value measurements. The guidance requires that transfers in and out of Levels 1 and 2 be disclosed separately, including a description of the reasons for such transfers. Additionally, the reconciliation of fair value measurements of Level 3 assets should separately disclose information about purchases, sales, issuance and settlements in a gross, rather than net disclosure presentation. The guidance further clarifies that fair value disclosures should be separately presented for each class of assets and liabilities and disclosures should be provided for valuation techniques and inputs for both recurring and non-recurring fair value measurements related to Level 2 and Level 3 categories. The disclosure guidance provided in the update is effective for reporting periods beginning after December 15, 2009. The Company implemented this guidance effective at January 1, 2010. Implementing this guidance did not have an effect on the Company’s financial position or results of operations.

 

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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. Furthermore, the implementation as of October 1, 2009 of ASC Update No. 2009-05 and ASC Update No. 2009-12 did not have a material effect on the Company’s financial position or results of operations. (See further disclosure in Note 9 – Fair Value).

ASC 855, Subsequent Events (“ASC 855”) and as modified by ASC update 2010-9, Amendments to Certain Recognition and Disclosure Requirements, 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 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 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 and the updated guidance as of December 31, 2009. The effect of implementing the guidance was not material to the Company’s financial position or results of operations.

In December 2009, the FASB issued ASC Update 2009-16 Transfers and Servicing (Topic 860) – Accounting for Transfers of Financial Assets (“ASC Update 2009-16”) which codified Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets an amendment of FASB Statement No. 140. This guidance revises FASB Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Extinguishment of Liabilities a replacement of FASB Statement 125 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. ASC Update 2009-16 is effective prospectively, for annual periods beginning after November 15, 2009, and interim and annual periods thereafter. The Company has implemented this guidance as of January 1, 2010. The effect of implementing this guidance was not material to the Company’s financial position or results of operations.

3. Discontinued Operations

Discontinued operations consist of: (i) FAFLIC’s discontinued operations, including both the loss associated with the sale of FAFLIC on January 2, 2009 and the loss or income resulting from its prior business operations; (ii) losses or gains associated with the sale of the variable life insurance and annuity business in 2005; and (iii) the discontinued accident and health business.

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

 

		(Unaudited) Three Months  Ended March 31,
(In millions)		2010				2009
Gain from operations of discontinued FAFLIC business, net of taxes		$	—			$	5.0
Gain on disposal of variable life and annuity business, net of taxes		$	0.2			$	3.9
Loss from discontinued accident and health business, net of taxes		$	(0.6	)		$	(3.3	)

 

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FAFLIC Discontinued Operations

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 recognized, in 2008, a $77.3 million loss associated with this transaction.

The gain from FAFLIC’s discontinued operations was $5.0 million for the three months ended March 31, 2009 and resulted from a change in the Company’s estimate of indemnification liabilities related to the sale.

As of March 31, 2010, the Company’s total gross indemnification liability was $1.2 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.

Variable Life Insurance and Annuity Business

On December 30, 2005, the Company sold its run-off variable life insurance and annuity business to Goldman Sachs, including the reinsurance of 100% of the variable business of FAFLIC. The Company agreed to indemnify Goldman Sachs for certain litigation, regulatory matters and other liabilities relating to the pre-closing activities of the business that was sold. In the first quarter of 2009, the Company recorded a gain of $3.9 million, net of tax, primarily due to a change in the Company’s estimate of indemnification liabilities.

As of March 31, 2010, the Company’s total gross liability for guarantees and indemnifications provided in connection with the disposal of its variable life insurance and annuity business was $5.2 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.

Accident and Health Insurance Business

During 1999, the Company exited its accident and health insurance business, consisting of its Employee Benefit Services business, its Affinity Group Underwriters business and its accident and health assumed reinsurance pool business. Prior to 1999, these businesses comprised substantially all of the former Corporate Risk Management Services segment. Accordingly, the operating results of the discontinued segment have been reported in accordance with Accounting Principles Board Opinion No. 30, Reporting the Results of Operations – Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions (“APB Opinion No. 30”). On January 2, 2009, Hanover Insurance directly assumed a portion of the accident and health business; and therefore continues to apply APB Opinion No. 30 to this business. In addition, the remainder of the FAFLIC accident and health business was reinsured by Hanover Insurance and has been reported in accordance with ASC 205.

At March 31, 2010 and December 31, 2009, the portion of the discontinued accident and health business that was directly assumed had assets of $56.5 million and $54.0 million, respectively, consisting primarily of invested assets and reinsurance recoverables, and liabilities of approximately $50.4 million and $48.7 million, respectively, consisting primarily of policy liabilities. At March 31, 2010 and December 31, 2009, the assets and liabilities of this business, as well as those of the reinsured portion of the accident and health business are classified as assets and liabilities of discontinued operations in the Consolidated Balance Sheets.

4. Other Significant Transactions

On March 31, 2010, the Company acquired the Campania Holding Company, Inc. (“Campania”) for approximately $24 million, subject to various terms and conditions. Campania specializes in insurance solutions for the healthcare industry.

On March 22, 2010, the Company paid a dividend of 25 cents per share to its issued and outstanding common stock shareholders of record at the close of business on March 8, 2010. The total dividend paid in the first quarter was $12.3 million. This dividend is the first under a new quarterly dividend schedule, announced on October 8, 2009. On an annualized basis, this dividend represents a 33% increase over the annual dividend of 75 cents, paid in December 2009. The holding company receives dividends from its insurance subsidiaries; such dividends are restricted through state regulation. Both Citizens and Hanover paid

 

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dividends to their parent companies in 2009. Citizens cannot pay a dividend to Hanover without the prior approval of the state regulators until June 2010. In June 2010, the maximum amount of this dividend, without the prior approval of state regulators would be $70.3 million. Hanover cannot pay a dividend to the holding company without the prior approval of the state regulators until December 2010. In December 2010, the maximum amount of this dividend, without the prior approval of the state regulators would be $173.7 million.

On February 26, 2010, the Company’s Board of Directors authorized a $100 million increase to its existing common stock repurchase program. This increase was in addition to two previous increases of $100 million each, approved on December 8, 2009 and September 24, 2009. As a result of these most recent increases, the program provides for aggregate repurchases of up to $400 million. Under the repurchase authorizations, the Company may repurchase its common stock from time to time, in amounts and prices and at such times as deemed 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. On March 30, 2010 and December 8, 2009, the Company entered into accelerated share repurchase agreements with Barclays Bank PLC acting through its agent, Barclays Capital, Inc., for the immediate repurchase of 2.3 million and 2.4 million shares, respectively, of the Company’s common stock at costs of approximately $100.9 million and $100.6 million, respectively. Total repurchases under this program as of March 31, 2010 were 7.9 million shares at a cost of $334.2 million.

On February 23, 2010, the Company issued $200.0 million aggregate principal amount of 7.50% senior unsecured notes due March 1, 2020. The senior debentures are subject to certain restrictive covenants, including limitations on the Company’s ability to incur, issue, assume or guarantee certain secured indebtedness; and the issuance or disposition of capital stock of restricted subsidiaries. These debentures pay interest semi annually on March 1 and September 1.

On December 3, 2009, the Company entered into a renewal rights and asset purchase agreement with OneBeacon Insurance Group (“OneBeacon”). Through this agreement, the Company acquired access to a portion of OneBeacon’s small and middle market commercial business at renewal, including industry programs and middle market niches. Consideration for this transaction was approximately $23 million plus certain additional consideration, and primarily reflects or represents purchased intangible assets, which are included as Other assets in our Consolidated Balance Sheets. The agreement is effective for renewals beginning January 1, 2010.

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 $143.9 million and $142.0 million as of March 31, 2010 and December 31, 2009, respectively. 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 totaled $5.6 million through March 31, 2010. The proceeds from the borrowing were used by Hanover Insurance to acquire AIX Holdings, Inc. (“AIX”) and its subsidiaries from the holding company.

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 affect 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, and $1.1 million of Senior Debentures. The Company recognized a pre-tax gain of $34.5 million in 2009 as a result of such purchases. During the first quarter of 2010, the Company repurchased $0.4 million of the Junior Debentures at

 

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a slight gain. As of March 31, 2010, a principal amount of $165.3 million of their Junior Debentures and $121.6 million of these Senior Debentures, which are not held by the Company, remained outstanding.

5. Debt

Long-term debt consists of the following:

 

(In millions)		(Unaudited) March 31, 2010			December 31, 2009
Senior debentures (unsecured) maturing March 1, 2020		$	199.3		$	—
Senior debentures (unsecured) maturing March 16, 2025			121.4			121.4
Holding Company junior subordinated debentures			165.3			165.7
FHLBB borrowing			125.0			125.0
Capital securities			17.3			17.8
Surplus notes			4.0			4.0
		$	632.3		$	433.9

On February 23, 2010, the Company issued $200 million aggregate principal amount of 7.50% senior unsecured notes due March 1, 2020. The senior debentures are subject to certain restrictive covenants, including limitations on the Company’s ability to incur, issue, assume or guarantee certain secured indebtedness; and the issuance or disposition of capital stock of restricted subsidiaries. These debentures pay interest semi annually (See also Note 4 – Other Significant Transactions). The Company is in compliance with all covenants.

The Company also holds senior unsecured notes issued October 16, 1995 with a face value of $200.0 million. In 2009, the Company repurchased a portion of these senior debentures with a face value of $78.4 million. The remaining senior debentures 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 (See also Note 4 – Other Significant Transactions). These securities are subject to certain restrictive covenants, with which the Company is in compliance.

AFC Capital Trust I issued $300.0 million of preferred securities in 1997, 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 Company’s 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 $165.3 million and $165.7 million as of March 31, 2010 and December 31, 2009, respectively, 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). These securities are subject to certain restrictive covenants, with which the Company is in compliance. In addition, the Company holds $3.0 million of capital securities related to Professionals Direct, Inc., and $14.3 million of capital securities related to AIX Holdings, Inc. as of March 31, 2010.

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 of $143.9 million and $142.0 million as of March 31, 2010 and December 31, 2009, respectively (See also Note 4 – Other Significant Transactions). The Company is in compliance with the covenants associated with this borrowing.

In June 2007, the Company entered into a $150.0 million committed syndicated credit agreement which expires in June 2010. Borrowings, if any, under this agreement are unsecured and incur interest at a rate per annum equal to, at the Company’s option, a designated base rate or the Eurodollar rate plus applicable margin. The agreement provides covenants, including, but not limited to, maintaining a certain level of equity and an RBC ratio in the Company’s primary property and casualty companies of at least 175% (based on the Industry Scale). The Company is in compliance with the covenants of this agreement. The Company had no borrowings under this line of credit during the first quarter of 2010 and prior. Additionally, the Company had no commercial paper borrowings as of March 31, 2010 and we do not anticipate utilizing commercial paper in the near term. We may not renew or replace this syndicated credit agreement upon expiration.

 

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Interest expense was $9.3 million for the three months ended March 31, 2010 and $35.5 million for the year ended December 31, 2009 and included interest related to the Company’s junior subordinated debentures, FHLBB borrowing, senior debentures, capital securities and surplus notes. All interest expense is recorded in other operating expenses.

6. Federal Income Taxes

Federal income tax expense for the three months ended March 31, 2010 and 2009 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.

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. In September 2009, the Company received a Revenue Agents Report for the 2005 and 2006 IRS audit. The Company has agreed to all proposed adjustments other than a disallowance of Separate Account Dividends Received Deductions for which the Company has requested an Appeals conference. Due to available net operating loss carryovers and the 2005 sale of Allmerica Financial Life Insurance and Annuity Company, the effects of the proposed adjustments do not materially affect the Company’s financial position. The IRS audits of the years 2007 and 2008 commenced in April 2010. The Company and its subsidiaries are still subject to U.S. state income tax examinations by tax authorities for years after 1998.

7. 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) Three Months Ended March 31,
(In millions)		2010				2009				2010				2009
		Pension Benefits								Postretirement Benefits
Service cost – benefits earned during the period		$	—			$	—			$	—			$	—
Interest cost			8.2				8.5				0.7				0.7
Expected return on plan assets			(8.8	)			(6.1	)			—				—
Recognized net actuarial loss			4.2				6.7				0.1				0.1
Amortization of transition asset			(0.4	)			(0.4	)			—				—
Amortization of prior service cost			—				—				(1.4	)			(1.4	)
Net periodic cost (benefit)		$	3.2			$	8.7			$	(0.6	)		$	(0.6	)

On January 4, 2010, the Company made a discretionary contribution of $100 million to the qualified defined benefit pension plan. With this contribution, and based upon the current estimate of liabilities and certain assumptions regarding investment return and other factors, the Company’s qualified defined benefit pension plan is essentially fully funded.

 

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8. Investments

A. Fixed maturities and equity securities

The Company holds investments in fixed maturities and equity securities, which are classified as available for sale, in accordance with ASC 320, Investments – Debt and Equity Securities.

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

 

(In millions)		(Unaudited) March 31, 2010
		Gross Unrealized Losses
		Amortized Cost (1)				Gross Unrealized Gains				Unrealized Losses				OTTI Unrealized Losses (2)				Fair Value
U.S. Treasury securities and U.S. government and agency securities		$	352.0			$	3.7			$	1.7			$	—			$	354.0
States and political subdivisions			883.4				16.3				17.9				—				881.8
Foreign governments			3.1				—				—				—				3.1
Corporate fixed maturities			2,319.8				156.9				8.2				28.8				2,439.7
Residential mortgage-backed securities			804.8				36.1				1.8				9.2				829.9
Commercial mortgage-backed securities			347.1				15.7				6.8				—				356.0
Total fixed maturities, including assets of discontinued operations			4,710.2				228.7				36.4				38.0				4,864.5
Less: fixed maturities of discontinued operations			(121.9	)			(7.3	)			(1.0	)			(6.0	)			(122.2	)
Total fixed maturities, excluding discontinued operations		$	4,588.3			$	221.4			$	35.4			$	32.0			$	4,742.3
Equity securities, excluding discontinued operations		$	38.2			$	8.9			$	1.2			$	—			$	45.9

 

(In millions)		December 31, 2009
		Gross Unrealized Losses
		Amortized Cost (1)				Gross Unrealized Gains				Unrealized Losses				OTTI Unrealized Losses (2)				Fair Value
U.S. Treasury securities and U.S. government and agency securities		$	355.2			$	3.2			$	3.7			$	—			$	354.7
States and political subdivisions			844.7				13.1				25.6				—				832.2
Foreign governments			3.0				—				—				—				3.0
Corporate fixed maturities			2,243.7				131.4				14.3				29.9				2,330.9
Residential mortgage-backed securities			858.8				29.7				3.4				10.7				874.4
Commercial mortgage-backed securities			334.5				10.1				7.4				—				337.2
Total fixed maturities, including assets of discontinued operations			4,639.9				187.5				54.4				40.6				4,732.4
Less: fixed maturities of discontinued operations			(119.6	)			(6.0	)			(2.0	)			(6.8	)			(116.8	)
Total fixed maturities, excluding discontinued operations		$	4,520.3			$	181.5			$	52.4			$	33.8			$	4,615.6
Equity securities, excluding discontinued operations		$	57.3			$	12.2			$	0.3			$	—			$	69.2

(1)	Amortized cost for fixed maturities and cost for equity securities.

(2)

Represents other-than-temporary impairments recognized in accumulated other comprehensive income. Amount excludes net unrealized gains on impaired securities relating to changes in the value of such securities subsequent to the impairment measurement date of $37.0 million and $30.1 million as of March 31, 2010 and December 31, 2009, respectively.

 

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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) March 31, 2010
		Amortized Cost				Fair Value
Due in one year or less		$	183.4			$	186.2
Due after one year through five years			1,345.6				1,413.7
Due after five years through ten years			1,510.3				1,575.5
Due after ten years			1,670.9				1,689.1
Total fixed maturities, including assets of discontinued operations			4,710.2				4,864.5
Less: fixed maturities of discontinued operations			(121.9	)			(122.2	)
Total fixed maturities, excluding assets of discontinued operations		$	4,588.3			$	4,742.3

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 March 31, 2010 and December 31, 2009:

 

		(Unaudited) March 31, 2010
		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		$	0.7		$	105.4		$	1.0		$	5.5		$	1.7		$	110.9
States and political subdivisions			5.4			226.9			11.7			166.7			17.1			393.6
Corporate fixed maturities			3.2			105.0			8.4			106.3			11.6			211.3
Residential mortgage-backed securities			2.5			38.3			8.5			0.2			11.0			98.5
Commercial mortgage-backed securities			0.5			8.7			6.3			23.4			6.8			32.1
Total investment grade			12.3			484.3			35.9			362.1			48.2			846.4
Below investment grade (2):
States and political subdivisions			0.1			8.8			0.7			2.9			0.8			11.7
Corporate fixed maturities			10.5			98.6			14.9			138.6			25.4			237.2
Total below investment grade			10.6			107.4			15.6			141.5			26.2			248.9
Total fixed maturities			22.9			591.7			51.5			503.6			74.4			1,095.3
Equity securities:
Common equity securities			1.2			8.0			—			—			1.2			8.0
Total (3)		$	24.1		$	599.7		$	51.5		$	503.6		$	75.6		$	1,103.3

(1)	Includes $38.0 million unrealized loss related to other-than-temporary impairment losses recognized in other comprehensive income, of which $13.6 million are below investment grade aged greater than 12 months.

(2)	Substantially all below investment grade securities with an unrealized loss had been rated by the NAIC, Standard & Poor’s or Moody’s at March 31, 2010.

(3)	Includes discontinued accident and health business of $7.0 million in gross unrealized losses with $52.8 million in fair value at March 31, 2010.

 

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		December 31, 2009
		12 months or less						Greater than 12 months						Total
(In millions)		Gross Unrealized Losses			Fair Value			Gross Unrealized Losses			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		$	3.7		$	170.8		$	—		$	—		$	3.7		$	170.8
States and political subdivisions			9.0			275.2			15.6			176.5			24.6			451.7
Corporate fixed maturities			3.4			115.8			13.3			152.7			16.7			268.5
Residential mortgage-backed securities			6.6			89.1			7.5			62.6			14.1			151.7
Commercial mortgage-backed securities			0.4			13.5			7.0			30.0			7.4			43.5
Total investment grade			23.1			664.4			43.4			421.8			66.5			1,086.2
Below investment grade (2):
States and political subdivisions			0.2			8.7			0.8			8.2			1.0			16.9
Corporate fixed maturities			10.6			84.1			16.9			150.1			27.5			234.2
Total below investment grade			10.8			92.8			17.7			158.3			28.5			251.1
Total fixed maturities			33.9			757.2			61.1			580.1			95.0			1,337.3
Equity securities:
Common equity securities			—			—			0.3			1.4			0.3			1.4
Total (3)		$	33.9		$	757.2		$	61.4		$	581.5		$	95.3		$	1,338.7

(1)	Includes $40.6 million unrealized loss related to other-than-temporary impairment losses recognized in other comprehensive income, of which $14.8 million are below investment grade aged greater than 12 months.

(2)	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, 2009.

(3)	Includes discontinued accident and health business of $8.8 million in gross unrealized losses with $55.0 million in fair value at December 31, 2009.

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 several factors and circumstances, including 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; 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 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 March 31, 2010 and December 31, 2009.

 

		(Unaudited) March 31, 2010
(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		$	1.7		$	—			$	—			$	—			$	1.7			$	—			$	—		$	—			$	—			$	1.7
States and political subdivisions			1.9			4.3				4.0				6.9				17.1				0.7				—			0.1				0.8				17.9
Corporate fixed maturities			—			1.2				4.1				6.3				11.6				13.0				6.5			5.9				25.4				37.0
Residential mortgage-backed securities			1.5			0.9				0.9				7.7				11.0				—				—			—				—				11.0
Commercial mortgage-backed securities			—			0.6				6.2				—				6.8				—				—			—				—				6.8
Total fixed maturities, including discontinued operations			5.1			7.0				15.2				20.9				48.2				13.7				6.5			6.0				26.2				74.4
Less: losses included in discontinued operations			—			(0.1	)			(0.7	)			(3.2	)			(4.0	)			(2.4	)			—			(0.6	)			(3.0	)			(7.0	)
Total fixed maturities, excluding discontinued operations		$	5.1		$	6.9			$	14.5			$	17.7			$	44.2			$	11.3			$	6.5		$	5.4			$	23.2			$	67.4

 

		December 31, 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		$	3.7		$	—			$	—			$	—			$	3.7			$	—			$	—			$	—			$	—			$	3.7
States and political subdivisions			4.1			7.3				4.8				8.4				24.6				0.8				—				0.2				1.0				25.6
Corporate fixed maturities			—			1.4				7.1				8.2				16.7				11.8				9.7				6.0				27.5				44.2
Residential mortgage-backed securities			2.4			1.4				7.9				2.4				14.1				—				—				—				—				14.1
Commercial mortgage-backed securities			0.5			0.8				6.1				—				7.4				—				—				—				—				7.4
Total fixed maturities, including discontinued operations			10.7			10.9				25.9				19.0				66.5				12.6				9.7				6.2				28.5				95.0
Less: losses included in discontinued operations			—			(0.2	)			(1.4	)			(3.2	)			(4.8	)			(0.5	)			(2.8	)			(0.7	)			(4.0	)			(8.8	)
Total fixed maturities, excluding discontinued operations		$	10.7		$	10.7			$	24.5			$	15.8			$	61.7			$	12.1			$	6.9			$	5.5			$	24.5			$	86.2

C. Other-than-temporary impairments

For the first three months of 2010, total other-than-temporary impairments on fixed maturities and equity securities were $0.5 million. Of this amount, $2.7 million was recognized in earnings, of which $2.2 million was transferred from unrealized losses in accumulated other comprehensive income, net of taxes.

Of the $2.7 million loss recorded in earnings, $1.8 million was estimated credit losses on fixed maturities for which a portion of the impairment was recognized in other comprehensive income, either in the current or prior periods.

 

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The methodology and significant inputs used to measure the amount of credit losses in the quarter ended March 31, 2010 are as follows:

Asset-backed securities, including commercial and residential mortgage backed securities ($1.6 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; and

Corporate bonds ($0.2 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.

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 March 31, 2010 for which the non-credit portion of the loss is included in other comprehensive income:

 

(In millions)		(Unaudited) Three Months  Ended March 31, 2010
Credit losses as of the beginning of the period		$	22.1
Credit losses for which an OTTI was not previously recognized			0.2
Additional credit losses on securities for which an OTTI was previously recognized			1.6
Reductions for securities sold during the period			(0.6	)
Credit losses as of March 31, 2010		$	23.3

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) Three Months Ended March 31, 2010									(Unaudited) Three Months Ended March 31, 2009
(In millions)		Proceeds from Voluntary Sales			Gross Gains			Gross Losses			Proceeds from Voluntary Sales			Gross Gains			Gross Losses
Fixed maturities		$	95.2		$	6.0		$	—		$	381.9		$	15.7		$	4.9
Equity securities			25.1			6.2			—			—			—			—

9. Fair Value

The Company follows the guidance in ASC 820, Fair Value Measurements and Disclosures (“ASC 820”), 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. 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.

Fair value is defined 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.

 

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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.

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 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 year:

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 for those securities using pricing applications based on a market approach. Inputs into the fair value pricing applications which are common to all asset classes include benchmark U.S. Treasury security yield curves, reported trades of identical or similar fixed maturity securities, broker/dealer quotes of identical or similar fixed maturity securities and structural characteristics of the security, such as maturity date, coupon, mandatory principal payment dates, frequency of interest and principal payments and optional principal redemption features. Inputs into the fair value applications that are unique by asset class include, but are not limited to:

 

•

States and political subdivisions - overall credit quality, including assessments of the level and variability of: sources of payment such as income or property taxes, levies or user fees; credit support such as insurance; state or local economic and political base; natural resource availability; and, susceptibility to natural or man-made catastrophic events such as hurricanes, earthquakes or acts of terrorism.

 

•

Corporate fixed maturities - overall credit quality, including assessments of the level and variability of: industry economic sensitivity; company financial policies; quality of management; regulatory environment; competitive position; indenture restrictive covenants; and, security or collateral.

 

•

Residential mortgage backed securities, U.S. agency pass-thrus and collateralized mortgage obligations (“CMOs”) - estimates of prepayment speeds based upon: historical prepayment rate trends; underlying collateral interest rates; geographic concentration; vintage year; borrower credit quality characteristics; interest rate and yield curve forecasts; U.S. government support programs; tax policies; and, delinquency/default trends.

 

•

Residential mortgage backed securities, non-agency CMOs - estimates of prepayment speeds based upon: historical prepayment rate trends; underlying collateral interest rates; geographic concentration; vintage year; borrower credit quality characteristics; interest rate and yield curve forecasts; U.S. government support programs; tax policies; delinquency/default trends; and severity of loss upon default and length of time to recover proceeds following default.

 

•

Commercial mortgage-backed securities - overall credit quality, including assessments of the level and variability of: collateral type such as office, retail, residential, lodging, other; geographic concentration by region, state, metropolitan service area and locale; vintage year; historical collateral performance including defeasance, delinquency, default and special servicer trends; and, capital structure support features.

Generally, all prices provided by the pricing service, except actively traded securities with quoted market prices, are reported as Level 2.

 

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The Company holds privately placed fixed maturity securities and certain other fixed maturity securities 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 utilizing the market approach. The Company will use observable market data as inputs into the fair value applications, as discussed in the determination of Level 2 fair values, 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. Unobservable judgment reflected in the Company’s matrix model accounts for estimates of additional spread required by market participants for factors such as issue size, structural complexity, high bond coupon, long maturity term or other unique features. 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.

Legal Indemnities

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

Long-term Debt

The fair value of long-term debt is 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.

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

 

(In millions)		(Unaudited) March 31, 2010								December 31, 2009
		Carrying Value				Fair Value				Carrying Value				Fair Value
Financial Assets
Cash and cash equivalents		$	209.5			$	209.5			$	316.7			$	316.7
Fixed maturities			4,864.5				4,864.5				4,732.4				4,732.4
Equity securities			45.9				45.9				69.3				69.3
Mortgage loans			10.6				11.3				14.1				15.0
Total financial assets, including financial assets of discontinued operations			5,130.5				5,131.2				5,132.5				5,133.4
Less: financial assets of discontinued operations			(122.5	)			(122.5	)			(117.1	)			(117.1	)
Total financial assets of continuing operations		$	5,008.0			$	5,008.7			$	5,015.4			$	5,016.3
Financial Liabilities
Deposit contracts		$	1.4			$	1.4			$	2.0			$	2.0
Legal indemnities			6.4				6.4				7.0				7.0
Long-term debt			632.3				612.5				433.9				387.9
Total financial liabilities of continuing operations (1)		$	640.1			$	620.3			$	442.9			$	396.9

(1)	There were no financial liabilities associated with the discontinued operations.

 

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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 three months ended March 31, 2010, 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 between levels of the fair value hierarchy are reported 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.

The Company currently holds fixed maturity securities and equity securities 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 March 31, 2010 and December 31, 2009.

 

		(Unaudited) Fair Value at March 31, 2010
(In millions)		Total				Level 1				Level 2				Level 3
Fixed maturities:
U.S. Treasury securities and U.S. government and agency securities		$	354.0			$	106.7			$	247.3			$	—
States and political subdivisions			881.8				—				866.6				15.2
Foreign governments			3.1				—				3.1				—
Corporate fixed maturities			2,439.7				—				2,386.3				53.4
Residential mortgage-backed securities, U.S. agency backed			653.9				—				653.9				—
Residential mortgage-backed securities, non-agency			176.0				—				174.6				1.4
Commercial mortgage-backed securities			356.0				—				350.1				5.9
Total fixed maturities			4,864.5				106.7				4,681.9				75.9
Equity securities			37.8				32.6				2.4				2.8
Total investment assets at fair value, including assets of discontinued operations			4,902.3				139.3				4,684.3				78.7
Investment assets of discontinued operations at fair value			(122.2	)			(0.3	)			(121.9	)			—
Total investment assets of continuing operations at fair value		$	4,780.1			$	139.0			$	4,562.4			$	78.7

 

		Fair Value at December 31, 2009
(In millions)		Total				Level 1				Level 2				Level 3
Fixed Maturities:
U.S. Treasury securities and U.S. Government and agency securities		$	354.7			$	100.6			$	254.1			$	—
States and political subdivisions			832.2				—				816.7				15.5
Foreign governments			3.0				—				3.0				—
Corporate fixed maturities			2,330.9				—				2,292.8				38.1
Residential mortgage-backed securities, U.S. agency backed			689.0				—				689.0				—
Residential mortgage-backed securities, non-agency			185.4				—				185.4				—
Commercial mortgage-backed securities			337.2				—				331.0				6.2
Total fixed maturities			4,732.4				100.6				4,572.0				59.8
Equity securities			60.6				51.0				6.8				2.8
Total investment assets at fair value, including assets of discontinued operations			4,793.0				151.6				4,578.8				62.6
Investment assets of discontinued operations at fair value			(116.9	)			(0.3	)			(116.6	)			—
Total investment assets of continuing operations at fair value		$	4,676.1			$	151.3			$	4,462.2			$	62.6

 

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

 

		(Unaudited) Quarter Ended March 31, 2010
		Fixed Maturities
(In millions)		States and political subdivisions				Corporate				Residential mortgage backed securities, non- agency				Commercial mortgage backed securities				Total				Equities				Total Assets
Balance January 1, 2010		$	15.5			$	38.1			$	—			$	6.2			$	59.8			$	2.8			$	62.6
Transfers into Level 3			—				13.5				—				—				13.5				—				13.5
Total gains (losses):
Included in earnings			—				0.1				—				—				0.1				(0.3	)			(0.2	)
Included in other comprehensive income			0.1				0.1				—				(0.1	)			0.1				0.3				0.4
Purchases and sales:
Purchases			—				2.3				1.4				—				3.7				—				3.7
Sales			(0.4	)			(0.7	)			—				(0.2	)			(1.3	)			—				(1.3	)
Balance March 31, 2010		$	15.2			$	53.4			$	1.4			$	5.9			$	75.9			$	2.8			$	78.7
		(Unaudited) Quarter Ended March 31, 2009
		Fixed Maturities
(In millions)		States and political subdivisions				Corporate				Residential mortgage  backed securities, U.S. agency backed				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	)
Transfers out of Level 3			—				—				—				(7.7	)			(7.7	)			—				(7.7	)
Total (losses) gains:
Included in earnings			(0.2	)			0.3				0.2				—				0.3				—				0.3
Included in other comprehensive income			(0.4	)			(0.1	)			—				—				(0.5	)			—				(0.5	)
Purchases and sales:
Purchases			2.1				3.5				—				—				5.6				—				5.6
Sales			(0.4	)			(2.7	)			(7.1	)			(0.2	)			(10.4	)			—				(10.4	)
Balance March 31, 2009		$	19.2			$	42.1			$	—			$	9.3			$	70.6			$	1.2			$	71.8

During the three months ended March 31, 2010, the Company transferred fixed maturities that were previously classified as Level 2 into Level 3. During the three months ended March 31, 2009, the Company transferred fixed maturities that were previously classified as Level 3 into Level 2. In both years, the transfers were primarily the result of assessing the significance of unobservable inputs on the fair value measurement. There were no transfers in or out of Level 1 during the quarters ended March 31, 2010 or 2009.

The following table summarizes gains and losses due to changes in fair value that are recorded in net income for Level 3 assets.

 

		(Unaudited) Quarter Ended March 31, 2010											(Unaudited) Quarter Ended March 31, 2009
(In millions)		Other-than- temporary impairments				Net  realized investment gains			Total				Other-than- temporary impairments			Net  realized investment gains (losses)				Total
Level 3 Assets:
Fixed maturities:
States and political subdivisions		$	—			$	—		$	—			$	—		$	(0.2	)		$	(0.2	)
Corporate fixed maturities			—				0.1			0.1				—			0.3				0.3
Residential mortgage-backed securities, U.S. agency backed			—				—			—				—			0.2				0.2
Total fixed maturities			—				0.1			0.1				—			0.3				0.3
Equity securities			(0.3	)			—			(0.3	)			—			—				—
Total assets		$	(0.3	)		$	0.1		$	(0.2	)		$	—		$	0.3			$	0.3

 

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10. Other Comprehensive Income

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

 

		(Unaudited) Three Months  Ended March 31,
(In millions)		2010			2009
Unrealized appreciation on available-for-sale securities:
Unrealized holding gains arising during period, net of income tax (provision) benefit of $(20.7) in 2010 and $0.2 in 2009		$	46.1		$	39.5
Less: reclassification adjustment for gains (losses) included in net income, net of income tax expense of $0.4 million in 2010			8.7			(9.3	)
Other comprehensive income		$	37.4		$	48.8

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 inland marine, bond, specialty program business, professional liability and management liability. In addition, the Other Property and Casualty segment consists of: Opus Investment Management, Inc., which markets investment management services to institutions, pension funds and other organizations; earnings on holding company assets; as well as voluntary pools in which the Company has not actively participated since 1995. 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. 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.

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, capital securities, surplus notes and advances under the Company’s collateralized borrowing program with FHLBB.

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. Although the items excluded from segment income may be significant components in understanding and assessing the Company’s financial performance, management believes that the presentation of segment income enhances an investor’s 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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Summarized below is financial information with respect to business segments:

 

		(Unaudited) Three Months  Ended March 31,
(In millions)		2010				2009
Segment revenues:
Property and Casualty:
Personal Lines		$	395.3			$	394.8
Commercial Lines			336.2				304.3
Other Property and Casualty			5.3				6.9
Total Property and Casualty			736.8				706.0
Intersegment revenues			(1.1	)			(1.0	)
Total segment revenues			735.7				705.0
Adjustments to segment revenues:
Net realized investment gains (losses)			10.9				(6.1	)
Total revenues		$	746.6			$	698.9
Segment income before federal income taxes and discontinued operations:
Property and Casualty:
Personal Lines:
GAAP underwriting income (loss)		$	6.7			$	(26.5	)
Net investment income			25.6				27.6
Other income			2.2				2.0
Personal Lines segment income			34.5				3.1
Commercial Lines:
GAAP underwriting (loss) income			(8.8	)			15.4
Net investment income			32.0				31.6
Other (loss) income			(0.4	)			0.6
Commercial Lines segment income			22.8				47.6
Other Property and Casualty:
GAAP underwriting income			0.3				—
Net investment income			3.5				5.5
Other net expenses			(3.4	)			(6.3	)
Other Property and Casualty segment income (loss)			0.4				(0.8	)
Total Property and Casualty			57.7				49.9
Interest expense on debt			(9.3	)			(10.4	)
Segment income before federal income taxes			48.4				39.5
Adjustments to segment income:
Net realized investment gains (losses)			10.9				(6.1	)
Other items			—				(0.1	)
Income from continuing operations before federal income taxes		$	59.3			$	33.3

 

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Summarized below is financial information with respect to business segments:

 

		Identifiable Assets
(In millions)		(Unaudited) March 31, 2010				December 31, 2009
Property and Casualty (1)		$	7,944.6			$	7,922.6
Assets of discontinued operations (2)			134.4				130.6
Intersegment eliminations			(10.6	)			(10.5	)
Total		$	8,068.4			$	8,042.7

 

(1)	The Company reviews assets based on the total Property and Casualty Group and does not allocate between the Personal Lines, Commercial Lines and Other Property and Casualty segments.

(2)	Includes assets related to the Company’s discontinued accident and health insurance business.

12. Stock-based Compensation

Compensation cost and the related tax benefits were as follows:

 

		(Unaudited) Three Months Ended March 31,
(In millions)		2010				2009
Stock-based compensation expense		$	2.8			$	2.7
Tax benefit			(1.0	)			(0.9	)
Stock-based compensation expense, net of taxes		$	1.8			$	1.8

Stock Options

Information on the Company’s stock option plan activity is summarized below.

 

		(Unaudited) Three Months Ended March 31, 2010						(Unaudited) Three Months Ended March 31, 2009
(In whole shares and dollars)		Shares			Weighted Average Exercise Price			Shares			Weighted Average Exercise Price
Outstanding, beginning of period		3,131,142			$	39.16		2,998,821			$	41.02
Granted		389,750				42.45		520,000				34.19
Exercised		(24,550	)			33.52		(10,500	)			29.64
Forfeited or cancelled		(20,750	)			48.39		(26,250	)			51.18
Expired		(125,400	)			44.91		(184,100	)			52.07
Outstanding, end of period		3,350,192				39.31		3,297,971				39.28

 

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Restricted Stock and Restricted Stock Units

The following tables summarize activity information about employee restricted stock and restricted stock units:

 

		(Unaudited) Three Months Ended March 31, 2010						(Unaudited) Three Months Ended March 31, 2009
(In whole shares and dollars)		Shares			Weighted Average Grant Date Fair Value			Shares			Weighted Average Grant Date Fair Value
Restricted stock and restricted stock units:
Outstanding, beginning of period		700,904			$	41.12		470,905			$	45.41
Granted		320,525				42.43		273,160				34.22
Vested and exercised		(105,577	)			48.31		(4,162	)			44.58
Forfeited		(16,310	)			40.82		(2,518	)			45.66
Outstanding, end of period		899,542				40.75		737,385				41.31
Performance-based restricted stock units:
Outstanding, beginning of period (1)		145,635			$	42.79		164,442			$	46.10
Granted (1)		41,250				42.15		47,375				34.19
Vested and exercised		(31,558	)			48.46		(40,507	)			46.28
Forfeited (2)		(15,352	)			47.64		—				—
Outstanding, end of period (1)		139,975				40.79		171,310				42.15

(1)

Performance based restricted stock units are based upon the achievement of the performance metric at 100%. These units have the potential to range from 0% to 175% of the shares disclosed, which varies based on grant year and individual participation level. Increases to the 100% target level are reflected as granted in the period in which performance-based stock unit goals are achieved.

(2)	In 2010, 11,472 performance-based stock units were included as forfeited due to completion levels less than 100% for units originally granted in 2007. The weighted average grant date fair value for these awards was $48.46.

13. Earnings Per Share

The following table provides share information used in the calculation of the Company’s basic and diluted earnings per share:

 

		(Unaudited) Three Months Ended March 31,
(In millions, except per share data)		2010				2009
Basic shares used in the calculation of earnings per share			47.5				51.1
Dilutive effect of securities:
Employee stock options			0.3				0.1
Non-vested stock grants			0.4				0.2
Diluted shares used in the calculation of earnings per share			48.2				51.4
Per share effect of dilutive securities on income from continuing operations and net income		$	(0.01	)		$	(0.01	)

Diluted earnings per share for the three months ended March 31, 2010 and 2009 excludes 1.6 million and 3.1 million, respectively, of common shares issuable under the Company’s stock compensation plans, because their effect would be antidilutive.

 

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14. Commitments and Contingencies

LITIGATION

Durand Litigation

On March 12, 2007, a putative class action suit captioned Jennifer A. Durand v. The Hanover Insurance Group, Inc., The Allmerica Financial Cash Balance Pension Plan was filed in the United States District Court for the Western District of Kentucky. The named plaintiff, a former employee who received a lump sum distribution from the Company’s Cash Balance Plan (the “Plan”) at or about the time of her termination, claims that she and others similarly situated did not receive the appropriate lump sum distribution because in computing the lump sum, the Company understated the accrued benefit in the calculation. The Company filed a Motion to Dismiss on the basis that the Plaintiff failed to exhaust administrative remedies, which motion was granted without prejudice in a decision dated November 7, 2007. This decision was reversed by an order dated March 24, 2009 issued by the United States Court of Appeals for the Sixth Circuit, and the case was remanded to the district court.

The Plaintiff filed an Amended Complaint on December 11, 2009. In response, the Company filed a Motion to Dismiss on January 30, 2010. In addition to the pending calculation of the lump sum distribution claim, the Amended Complaint includes: (a) a claim that the Plan failed to calculate participants’ account balances properly because interest credits were based solely upon the performance of each participant’s selection from among various hypothetical investment options (as the Plan provided) rather than crediting the greater of that performance or the 30 year Treasury rate; (b) a claim that the 2004 Plan amendment, which changed interest crediting for all participants from the performance of participant’s investment selections to the 30 year Treasury rate, reduced benefits in violation of the Employee Retirement Income Security Act of 1974 (“ERISA”) for participants who had account balances as of the amendment date by not continuing to provide them performance-based interest crediting on those balances; and (c) claims for breach of fiduciary duty and ERISA notice requirements for not properly informing participants of the various interest crediting and lump sum distribution matters of which Plaintiffs complain. In the Company’s judgment, the outcome is not expected to be material to its financial position, although it could have a material effect on the results of operations for a particular quarter or annual period and on the funding of the Plan.

Hurricane Katrina Litigation

The Company has been named as a defendant in various litigation including putative class actions, relating to disputes arising from damages which occurred as a result of Hurricane Katrina in 2005. As of March 31, 2010, there were approximately 50 such cases. These cases have been filed in both Louisiana state courts and federal district courts. These cases generally involve, among other claims, disputes as to the amount of reimbursable claims in particular cases (e.g. how much of the damage to an insured property is attributable to flood and therefore not covered, and how much is attributable to wind, which may be covered), as well as the scope of insurance coverage under homeowners and commercial property policies due to flooding, civil authority actions, loss of landscaping, business interruption and other matters. Certain of these cases claim a breach of duty of good faith or violations of Louisiana insurance claims handling laws or regulations and involve claims for punitive or exemplary damages.

On August 23, 2007, the State of Louisiana (individually and on behalf of the State of Louisiana, Division of Administration, Office of Community Development) filed a putative class action in the Civil District Court for the Parish of Orleans, State of Louisiana, entitled State of Louisiana, individually and on behalf of State of Louisiana, Division of Administration, Office of Community Development ex rel The Honorable Charles C. Foti, Jr., The Attorney General For the State of Louisiana, individually and as a class action on behalf of all recipients of funds as well as all eligible and/or future recipients of funds through The Road Home Program v. AAA Insurance, et al., No. 07-8970. The Complaint named as defendants over 200 foreign and domestic insurance carriers, including the Company. Plaintiff seeks to represent a class of current and former Louisiana citizens who have applied for and received or will receive funds through Louisiana’s “Road Home” program. On August 29, 2007, Plaintiff filed an Amended Petition in this case, asserting myriad claims, including claims for breach of: contract, the implied covenant of good faith and fair dealing, fiduciary duty and Louisiana’s bad faith statutes. Plaintiff seeks relief in the form of, among other things, declarations that (a) the efficient proximate cause of losses suffered by putative class members was windstorm, a covered peril under their policies; (b) the second efficient proximate cause of their losses was storm surge, which Plaintiff contends is not excluded under class members’ policies; (c) the damage caused by water entering affected parishes of Louisiana does not fall within the definition of “flood”; (d) the damages caused by water entering Orleans Parish and the surrounding area was a result of a man-made occurrence and are properly covered under class members’ policies; (e) many class members suffered total losses to their residences; and (f) many class members are entitled to recover the full value for their residences stated on their policies pursuant to the Louisiana Valued Policy Law. In accordance with these requested declarations, Plaintiff seeks to recover amounts that it alleges should have been paid to policyholders under their insurance agreements, as well as penalties, attorneys’ fees, and costs. The case has been removed to the Federal District Court for the Eastern District of Louisiana.

 

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On March 5, 2009, the court issued an Order granting in part and denying in part a Motion to Dismiss filed by Defendants. The court dismissed all claims for bad faith and breach of fiduciary duty and all claims for flood damages under policies with flood exclusions or asserted under the Valued Policy Law, but rejected the insurers’ arguments that the purported assignments from individual claimants to the state were barred by anti-assignment provisions in the insurers’ policies. On April 16, 2009, the court denied a Motion for Reconsideration of its ruling regarding the anti-assignment provisions, but certified the issue as ripe for immediate appeal. On April 30, 2009, Defendants filed a Petition for Permission to Appeal to the United States Court of Appeals for the Fifth Circuit, which was granted. Defendants’ appeal is currently pending.

The Company has established its loss and LAE reserves on the assumption that it will not have any liability under the “Road Home” or similar litigation, and that it will otherwise prevail in litigation as to the cause of certain large losses and not incur extra contractual or punitive damages.

REGULATORY AND INDUSTRY DEVELOPMENTS

Certain unfavorable economic conditions may contribute to an increase in the number of insurance companies that are under regulatory supervision. This may result in an increase in mandatory assessments by state guaranty funds, or voluntary payments by solvent insurance companies to cover losses to policyholders of insolvent or rehabilitated companies. Mandatory assessments, which are subject to statutory limits, can be partially recovered through a reduction in future premium taxes in some states. The Company is not able to reasonably estimate the potential impact of any such future assessments or voluntary payments.

Over the past three years, state-sponsored insurers, reinsurers and involuntary pools have increased significantly, particularly in those states which have Atlantic or Gulf Coast exposures. As a result, the potential assessment exposure of insurers doing business in such states and the attendant collection risks have increased, particularly, in the Company’s case, in the states of Massachusetts, Louisiana and Florida. Such actions and related regulatory restrictions on rate increases, underwriting and the ability to non-renew business may limit the Company’s ability to reduce the potential exposure to hurricane related losses. At this time, the Company is unable to predict the likelihood or impact of any such potential assessments or other actions.

In February 2009, the Governor of Michigan called upon every automobile insurer operating in the state to freeze personal automobile insurance rates for 12 months to allow time for the legislature to enact comprehensive automobile insurance reform. In addition, she endorsed a number of proposals by her appointed Automobile and Home Insurance Consumer Advocate which would, among other things, change the current rate approval process from the current “file and use” system to “prior approval”, mandate “affordable” rates, eliminate territorial ratings, reduce the threshold for lawsuits to be filed in “at fault” incidents, and prohibit the use of certain underwriting criteria such as credit-based insurance scores. The Michigan legislature is currently considering these and other proposals, including one to require insurance companies to offer “low cost” personal automobile prices. The Office of Financial and Insurance Regulation (“OFIR”) had previously issued regulations prohibiting the use of credit scores to rate personal lines insurance policies, which regulations are the subject of litigation being reviewed by the Michigan Supreme Court. Oral arguments were held before the Supreme Court on October 7, 2009. Pending a determination by the Michigan Supreme Court, OFIR is enjoined from disapproving rates on the basis that they are based in part on credit-based insurance scores. On November 9, 2009, the Michigan Board of Canvassers issued preliminary approval allowing proponents to begin collecting signatures as the first step in placing a ballot initiative in front of voters in November of 2010. The proposed ballot question would require a number of changes for the property and casualty market, including, subject to limitations, the rollback of rates by up to 20% for all lines with the exception of workers’ compensation and surety, and an additional 20% rollback of personal automobile rates for “good drivers”. Proponents must present over 300,000 valid signatures by late May 2010. At this time, the Company is unable to predict the likelihood of adoption or impact on its business of any such proposals or regulations, but any such restrictions could have an adverse effect on its results of operations.

From time to time, proposals have been made to establish a federal based insurance regulatory system and to allow insurers to elect either federal or state-based regulation (“optional federal chartering”). In light of the current economic crisis and the focus on increased regulatory controls, particularly with regard to financial institutions, there has been renewed interest in such proposals. In fact, several proposals have been introduced to create a system of optional federal chartering, to create federal oversight mechanisms for insurance or insurance holding companies which are systemically important to the United States financial system and to create a national office to monitor insurance companies. The Company cannot predict the impact that any such change will have on its operations or business or on that of its competitors.

 

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OTHER MATTERS

The Company has been named a defendant in various other legal proceedings arising in the normal course of business. In addition, the Company is involved, from time to time, in examinations, investigations and proceedings by governmental and self-regulatory agencies. The potential outcome of any such action or regulatory proceedings in which the Company has been named a defendant or the subject of an inquiry or investigation, and its ultimate liability, if any, from such action or regulatory proceedings, is difficult to predict at this time. In the Company’s opinion, based on the advice of legal counsel, the ultimate resolutions of such proceedings will not have a material effect on its financial position, although they could have a material effect on the results of operations for a particular quarter or annual period.

RESIDUAL MARKETS

The Company is required to participate in residual markets in various states, which generally pertain to high risk insureds, disrupted markets or lines of business or geographic areas where rates are regarded as excessive. The results of the residual markets are not subject to the predictability associated with the Company’s own managed business, and are significant to the workers’ compensation line of business, the homeowners line of business and both the personal and commercial automobile lines of business.

15. Subsequent Events

There were no subsequent events requiring adjustments to the financial statements. Additionally, there were no subsequent events requiring disclosure.

 

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PART I

ITEM 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

TABLE OF CONTENTS

 

Introduction		32
Executive Overview		32-34
Description of Operating Segments		34
Results of Operations		34-35
Segment Results		36
Property and Casualty		36-50
Discontinued Operations		50-51
Other Items		51-52
Investment Portfolio		52-57
Income Taxes		57-58
Critical Accounting Estimates		58-60
Other Significant Transactions		60-61
Statutory Surplus of Insurance Subsidiaries		62
Liquidity and Capital Resources		62-63
Off-Balance Sheet Arrangements		64
Contingencies and Regulatory Matters		64-66
Risks and Forward-Looking Statements		66
Glossary of Selected Insurance Terms		66-68

 

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Introduction

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to assist readers in understanding the interim consolidated results of operations and financial condition of The Hanover Insurance Group, Inc. and subsidiaries (“THG”) and should be read in conjunction with the interim Consolidated Financial Statements and related footnotes included elsewhere in this Quarterly Report on Form 10-Q and the Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our 2009 Annual Report on Form 10-K filed with the Securities and Exchange Commission.

Our results of operations include the accounts of The Hanover Insurance Company (“Hanover Insurance”) and Citizens Insurance Company of America (“Citizens”), our principal property and casualty companies; and certain other insurance and non-insurance subsidiaries. On January 2, 2009, we sold First Allmerica Financial Life Insurance Company (“FAFLIC”) to Commonwealth Annuity and Life Insurance Company (“Commonwealth Annuity”), a subsidiary of The Goldman Sachs Group, Inc. (“Goldman Sachs”). For all prior periods presented, operations from FAFLIC are reflected as discontinued operations.

Executive Overview

Our property and casualty business includes our Personal Lines segment, our Commercial Lines segment and our Other Property and Casualty segment.

With respect to segment results, in the first quarter of 2010, our pre-tax segment earnings improved from the same period in 2009. More favorable current accident year results contributed to the overall improvement. In addition, we recorded pre-tax catastrophe losses of $34.4 million, a decrease of $3.0 million from the same period in 2009. These improvements were partially offset by higher underwriting expenses and decreased favorable development on prior years’ loss and loss adjustment expense (“LAE”) reserves.

We, and the industry in general, continue to experience pricing pressures and in recent years the property and casualty industry has reported overall negative growth. These pressures are particularly acute in Michigan, which accounts for almost 25% of our net written premium. We believe that our ongoing agency relationships, position in the marketplace and strong product set, position us well in Michigan relative to many of our competitors.

We have made an explicit decision to invest further in our business despite the fact that our expense ratio is higher than that of some of our peer companies and other competitors. In Personal Lines, we are investing to improve the competitiveness of our products and in technology and systems enhancements intended to make our interactions with agents more efficient. In Commercial Lines, most of our investments, including the recently announced OneBeacon renewal rights transaction, are directed toward expanding our product capabilities and offerings in various niches and differentiated products, as well as investments in systems improvements. In addition, we recently started to expand our Commercial Lines offerings into selected states in the western part of the country. As a result of these actions, our Commercial Lines net written premiums exceeded our Personal Lines net written premiums for the first time during this quarter.

Personal Lines

In our Personal Lines business, the market continues to be very competitive, with continued pressure on agents from direct writers, as well as the increased usage of real time comparative rating tools. We maintain our focus on partnering with high quality, value added agencies which stress the importance of account rounding, which is the conversion of single policy customers to accounts with multiple policies and/or additional coverages, and consultative selling. We are focused on making investments that are intended to help us maintain profitability, build a distinctive position in the market, such as through our “Think Hanover” initiative, and provide us with profitable growth opportunities.

Our Think Hanover initiative is intended to enhance retention and strengthen our value proposition for agents, including by introducing broad and innovative product offerings. In 2009, we introduced a substantially improved product suite (The Hanover Household) and made it easier for agents to write more lines of business per household. We also modified our operating model and agency automation, which is intended to deliver a competitive sales and services experience for agents (Front Line Excellence).

Current market conditions continue to be challenging as pricing pressures and economic conditions remain difficult, especially in Michigan. These competitive and economic pressures have limited our ability to grow and retain business in Michigan, our largest state, and elsewhere. We are working closely with our partner agents in Michigan and our other core states to remain a significant writer with strong margins.

During the first quarter of 2010, we continued our mix management initiatives relating to our Connections^® Auto product to improve the overall profitability of the business. We remain focused on reducing our growth in less profitable automobile segments and increasing our multi-car and total account business consistent with our account rounding strategy. We believe that

 

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market conditions will remain challenging and competitive in Personal Lines. We experienced relatively flat growth levels in the first quarter of 2010 and expect that trend to continue during the year as the industry continues to be impacted by the difficult economic environment.

We believe that our Connections Auto product will help us profitably grow our market share over time. The Connections Auto product is designed to be competitively priced for a wide spectrum of drivers through its multivariate rating application, which calculates rates based upon the magnitude and correlation of multiple risk factors. At the same time, a core strategy is to broaden our portfolio offerings and write “total accounts”, which are accounts that include multiple personal line coverages for the same customer. Account business historically provides us with stronger margins and superior retention. Total account business represents approximately two-thirds of our Personal Lines business.

Our homeowners product, Connections^® Home, is intended to improve our competitiveness for total account business by making it easier and more efficient for our agents to write business with us and by providing more comprehensive coverage options for policyholders. In addition, in 12 states we have introduced a more sophisticated, multi-variate pricing approach to our Homeowners product which is intended to better align rates with the underlying risk of each customer. We plan to continue to implement this price segmentation in our other states. We also continue to refine our products and work closely with high potential agents to increase the percentage of business they place with us and to ensure that it is consistent with our preferred mix of business. Additionally, we remain focused on diversifying our state mix beyond our four core states of Michigan, Massachusetts, New York and New Jersey. We expect these efforts to contribute to profitable growth and improved retention in our Personal Lines segment over time.

Commercial Lines

The Commercial Lines market remains competitive. Price competition requires us to be highly disciplined in our underwriting process to ensure that we write business only at acceptable margins. In certain lines of business where the economy may be a particularly important factor, such as surety and workers’ compensation, we have endeavored to adjust pricing and/or take a more conservative approach to risk selection in order to more appropriately reflect the higher risk of loss.

In December 2009, we entered into a renewal rights agreement with OneBeacon Insurance Group (“OneBeacon”), further strengthening our competitive position and advancing our expansion efforts in the western states. Through the agreement, we acquired access to a portion of OneBeacon’s small and middle market commercial business at renewal, much of which fits into our current industry specific programs and middle market niches. At the same time, the transaction allows for expansion of our segment, niche and industry-specific program business. On January 1, 2010, we began renewing these policies through a reinsurance arrangement with OneBeacon whereby such policies are underwritten on OneBeacon policy forms and using OneBeacon systems. In the second quarter of 2010, we will begin to convert future renewals to our policy forms. We expect this conversion process to extend until late 2011.

We also continue to develop our specialty businesses, which on average are expected to offer higher margins over time and enable us to deliver a more complete product portfolio to our agents and policyholders. Our specialty lines, including marine and bond lines, now account for approximately one third of our Commercial Lines premiums written. Growth in our specialty lines continues to be a significant part of our strategy. Our ongoing focus on expanding our product offerings in specialty businesses is evidenced by our acquisitions. Over the past three years, we have acquired several specialty businesses, including Professionals Direct, Inc. (“PDI”), which we market as Hanover Professionals, a professional liability insurance carrier for principally small to medium-sized legal practices; Verlan Holdings, Inc. (“Verlan”), which we market as Hanover Specialty Industrial, a specialty company providing property insurance to small and medium-sized chemical, paint, solvent and other manufacturing and distribution companies; and AIX Holdings, Inc. (“AIX”), a specialty property and casualty insurance carrier that focuses on underwriting and managing program business. In January 2010, we acquired Benchmark Professional Insurance Services, Inc., a provider of insurance solutions to the design professionals industry, including architects and engineers. Most recently, we acquired Campania Holding Company, Inc. (“Campania”) on March 31, 2010, which specializes in insurance solutions for the healthcare professionals industry, including durable medical equipment suppliers, behavioral health specialists, eldercare providers, and podiatrists. In addition to our specialty lines, we have developed several niche insurance programs, such as for schools, religious institutions and moving and storage companies, and have added additional segmentation to our core middle market commercial products, including real estate, hospitality, wholesale distributors and human services organizations, such as non-profit youth and community service organizations. As a complimentary initiative, we have introduced products focused on management liability, specifically non-profit directors and officers liability and employment practices liability, and coverage for private company directors and officers liability.

In addition, we have made a number of enhancements to our core products and technology platforms that are intended to drive more total account placements in our small commercial business, which we believe will enhance margins. Our focus continues to be on improving and expanding our partnerships with select agents.

 

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We believe our specialty capabilities and small commercial platform, coupled with increased distinctiveness in the middle market through these acquisitions, our development of niches, and better segmentation, provides us with a more diversified portfolio of products and enables us to deliver significant value to our agents and policyholders. We believe these efforts will enable us to improve the overall mix of our business and ultimately our underwriting profitability.

Investment Portfolio

Recent developments have illustrated that the U.S. and global financial markets and economies, while recovering, remain tenuous as market values have and are expected to continue to fluctuate. Issuers of securities continue to be challenged by adverse business and liquidity circumstances and therefore unanticipated defaults in corporate bonds could increase, particularly with respect to non-investment grade securities. Credit spreads of taxable municipal bonds, corporate bonds and residential mortgage-backed securities tightened during the period, resulting in increased unrealized gains in the first quarter of 2010. The first quarter of 2010 has continued the positive momentum the financial markets experienced in the latter half of 2009; however, uncertainty still exists in these markets, and with respect to the potential impact on our business of the current difficult economy.

Our investment holdings totaled approximately $5 billion at March 31, 2010 and consist primarily of investment grade fixed maturities and cash and cash equivalents, with net unrealized gain positions of approximately $164 million.

Description of Operating Segments

Our 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 inland marine, bonds, specialty program business, professional liability and management 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 business in which we have not actively participated since 1995. Additionally, prior to the sale of FAFLIC on January 2, 2009, our operations included the results of this run-off life insurance and annuity business as a separate segment. We present the separate financial information of each segment consistent with the manner in which our chief operating decision maker evaluates results in deciding how to allocate resources and in assessing performance.

We report interest expense related to our corporate debt separately from the earnings of our operating segments. Corporate debt consists of our senior debentures, our junior subordinated debentures, capital securities, surplus notes and advances under our collateralized borrowing program with the Federal Home Loan Bank of Boston (“FHLBB”).

Results of Operations

Our consolidated net income includes the results of our three operating segments (segment income), which we evaluate on a pre-tax basis, and our interest expense on debt. Segment income excludes certain items which we believe are not indicative of our core operations. The income of our segments excludes items 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. Although the items excluded from segment income may be significant components in understanding and assessing our financial performance, we believe segment income enhances an investor’s understanding of our 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 (“GAAP”).

Catastrophe losses are a significant component in understanding and assessing the financial performance of our business. However, catastrophic events, such as Hurricanes Katrina, Ike and Gustav make it difficult to assess the underlying trends in this business. Management believes that providing certain financial metrics and trends excluding the effects of catastrophes helps investors to understand the variability in periodic earnings and to evaluate the underlying performance of our operations.

Our consolidated net income for the first quarter of 2010 was $41.8 million, compared to $25.8 million for the same period in 2009. The $16.0 million improvement is primarily due to a $17.0 million improvement in our net realized investment position from a loss of $6.1 million in the first quarter of 2009 to a gain of $10.9 million in the first quarter of 2010. In addition, after-tax segment income increased by $5.6 million, primarily driven by more favorable current accident year results and lower catastrophe losses, partially offset by higher underwriting expenses. These increases were partially offset by a decrease of $6.0 million in earnings from our discontinued operations.

 

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The following table reflects segment income as determined in accordance with generally accepted accounting principles and a reconciliation of total segment income to consolidated net income.

 

		Three Months Ended March 31,
(In millions)		2010				2009
Segment income before federal income taxes:
Property and Casualty
Personal Lines		$	34.5			$	3.1
Commercial Lines			22.8				47.6
Other Property and Casualty			0.4				(0.8	)
Total Property and Casualty			57.7				49.9
Interest expense on debt			(9.3	)			(10.4	)
Total segment income before federal income taxes			48.4				39.5
Federal income tax expense on segment income			(16.4	)			(13.1	)
Net realized investment gains (losses)			10.9				(6.1	)
Other non-operating items			—				(0.1	)
Federal income tax expense on non-segment income			(0.7	)			—
Income from continuing operations, net of taxes			42.2				20.2
Discontinued operations:
Gain from discontinued FAFLIC business, net of taxes			—				5.0
Loss from discontinued accident and health business, net of taxes			(0.6	)			(3.3	)
Gain on disposal of variable life insurance and annuity business, net of taxes			0.2				3.9
Net income		$	41.8			$	25.8

 

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Segment Results

The following is our discussion and analysis of the results of operations by business segment. The segment results are presented before taxes and other items which management believes are not indicative of our core operations, including realized gains and losses.

Property and Casualty

The following table summarizes the results of operations for the Property and Casualty group for the periods indicated:

 

		Three Months Ended March 31,
(In millions)		2010			2009
Net premiums written		$	725.2		$	629.9
Net premiums earned		$	666.5		$	632.0
Net investment income			61.1			64.7
Other income			9.2			9.3
Total segment revenues			736.8			706.0
Losses and LAE			431.6			428.3
Policy acquisition expenses			154.4			143.1
Other operating expenses			93.1			84.7
Total losses and operating expenses			679.1			656.1
Segment income		$	57.7		$	49.9

Three Months Ended March 31, 2010 Compared to Three Months Ended March 31, 2009

The Property and Casualty group’s segment income increased $7.8 million, or 15.6%, to $57.7 million, in the first quarter of 2010, compared to $49.9 million in the first quarter of 2009. Catastrophe related activity decreased by $3.0 million in the quarter, to $34.4 million, from $37.4 million in the same period of 2009. Excluding the impact of catastrophe related activity, earnings would have increased by $4.8 million. This increase was primarily due to more favorable current accident year results, partially offset by higher underwriting expenses, decreased favorable development on prior years’ reserves and lower net investment income. Current accident year results were more favorable by approximately $21 million, with improvements in both Personal and Commercial Lines. This improvement was partially offset by an increase in underwriting and other operating expenses of approximately $9 million, primarily due to costs associated with our OneBeacon renewal rights transaction and our Commercial Lines westward expansion initiative, increased costs in our specialty business, including our recently acquired subsidiaries, and higher technology costs. Additionally, favorable development on prior years’ loss and loss adjustment expense reserves decreased by approximately $4 million. Net investment income decreased $3.6 million compared to the first quarter of 2009.

 

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Production and Underwriting Results

The following table summarizes GAAP net premiums written and GAAP loss, LAE, expense and combined ratios for the Personal Lines and Commercial Lines segments. GAAP loss, LAE, catastrophe loss and combined ratios shown below include prior year reserve development. These items are not meaningful for our Other Property and Casualty segment.

 

		Three Months Ended March 31,
		2010							2009
(In millions, except ratios)		GAAP Net Premiums Written			GAAP Loss Ratios (1)(2)		Cata- strophe loss ratios (3)		GAAP Net Premiums Written			GAAP Loss Ratios (1)(2)		Cata- strophe loss ratios (3)
Personal Lines:
Personal automobile		$	241.1		60.4		0.3		$	249.2		61.7		0.4
Homeowners			99.2		59.2		12.8			89.7		81.6		22.9
Other personal			9.3		31.4		1.0			8.3		32.3		2.0
Total Personal Lines			349.6		59.1		4.3			347.2		66.8		7.1
Commercial Lines:
Workers’ compensation			39.9		51.4		—			33.5		44.0		—
Commercial automobile			63.0		51.2		1.0			48.0		47.8		0.4
Commercial multiple peril			135.4		59.4		14.0			93.1		64.2		11.2
Other commercial			137.0		44.7		3.5			108.1		30.9		1.1
Total Commercial Lines			375.3		51.2		6.2			282.7		46.5		4.2
Total		$	724.9		55.5		5.2		$	629.9		58.2		5.9
		2010							2009
		GAAP LAE Ratio			GAAP Expense Ratio		GAAP Combined Ratio (4)(5)		GAAP LAE Ratio			GAAP Expense Ratio		GAAP Combined Ratio (4)(5)
Personal Lines			10.2		28.0		97.3			11.5		28.1		106.4
Commercial Lines			8.0		43.5		102.7			6.9		40.6		94.0
Total			9.2		34.9		99.7			9.6		33.3		101.1

(1)	GAAP loss ratio is a common industry measurement of the results of property and casualty insurance underwriting. This ratio reflects incurred claims compared to premiums earned. Our GAAP loss ratios include catastrophe losses.

(2)	Includes policyholders’ dividends.

(3)	Catastrophe loss ratio reflects incurred catastrophe claims compared to premiums earned.

(4)

GAAP combined ratio is a common industry measurement of the results of property and casualty insurance underwriting. This ratio is the sum of incurred claims, claim expenses and underwriting expenses incurred to premiums earned. Our GAAP combined ratios also include the impact of catastrophes. Federal income taxes, net investment income and other non-underwriting expenses are not reflected in the GAAP combined ratio.

(5)	Total includes favorable development of $0.3 million for the quarter ended March 31, 2010, which is reflected in our Other Property and Casualty segment.

 

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The following table summarizes GAAP underwriting results for the Personal Lines, Commercial Lines and Other Property and Casualty segments and reconciles it to GAAP segment income.

 

		Three Months Ended
		March 31, 2010																March 31, 2009
		Personal Lines				Commercial Lines				Other Property and Casualty				Total				Personal Lines				Commercial Lines				Other Property and Casualty				Total
GAAP underwriting profit (loss), excluding prior year reserve development and catastrophes		$	7.8			$	(12.3	)		$	—			$	(4.5	)		$	(8.6	)		$	(6.3	)		$	—			$	(14.9	)
Prior year favorable reserve development			14.7				22.1				0.3				37.1				8.1				33.1				—				41.2
Pretax catastrophe effect			(15.8	)			(18.6	)			—				(34.4	)			(26.0	)			(11.4	)			—				(37.4	)
GAAP underwriting profit (loss)			6.7				(8.8	)			0.3				(1.8	)			(26.5	)			15.4				—				(11.1	)
Net investment income (1)			25.6				32.0				3.5				61.1				27.6				31.6				5.5				64.7
Fees and other income			3.3				4.4				1.5				9.2				3.5				4.4				1.4				9.3
Other operating expenses			(1.1	)			(4.8	)			(4.9	)			(10.8	)			(1.5	)			(3.8	)			(7.7	)			(13.0	)
Segment income (loss)		$	34.5			$	22.8			$	0.4			$	57.7			$	3.1			$	47.6			$	(0.8	)		$	49.9

(1)	We manage investment assets for our property and casualty business based on the requirements of the entire Property and Casualty group. We allocate net investment income to each of our Property and Casualty segments based on actuarial information related to the underlying business.

Personal Lines

Personal Lines’ net premiums written increased $2.4 million, or 0.7%, to $349.6 million for the first quarter of 2010. The most significant factors contributing to higher net premiums written were rate increases in automobile and homeowners and growth in policies in force in our targeted growth states. These increases were partially offset by reductions in policies in force in our core states.

Net premiums written in the personal automobile line of business declined 3.3%, primarily as a result of lower policies in force in MA, NY and FL, which we attribute to our efforts to improve or maintain margins in those states. Net premiums written in the homeowners line of business increased 10.6%, resulting from an increase in policies in force of 4.7% at the end of the first quarter of 2010, compared to the first quarter of 2009, and from rate increases. This increase in policies in force reflects increases in the majority of our states, due to our account rounding initiatives.

Personal Lines underwriting profit, excluding prior year reserve development and catastrophes, increased $16.4 million, to $7.8 million, in the first quarter of 2010, compared to a loss of $8.6 million in the first quarter of 2009. This increase was primarily due to more favorable current accident year results of approximately $16 million, primarily due to lower frequency of losses which we attribute to both improved weather and an improved mix towards account business, and to rate increases in both the personal automobile and homeowners lines.

Favorable prior year development during the first three months of 2010 increased by $6.6 million from $8.1 million to $14.7 million. Included in this increase was $2 million of favorable LAE reserve development related principally to a change in cost factors used for establishing unallocated loss adjustment expense reserves.

Although we have been able to obtain rate increases in our Personal Lines markets, our ability to maintain and increase Personal Lines net written premium and to maintain and improve underwriting results could be affected by increasing price competition, regulatory and legal developments and the difficult economic conditions, particularly in Michigan, which is our largest state.

Most of our new personal automobile business and an increasing proportion of our entire personal automobile business, currently approximately 59%, is written with our Connections Auto product, with the remainder written with our legacy products. Connections Auto is designed to match the rate with the underlying risk for segmented groups of customers in a highly competitive marketplace. Because of the competitiveness of this market, it generally has lower margins than our established book of legacy products. Our ability to grow and be profitable will depend, in part, on our ability to improve margins in the Connections Auto product and through our agency-centric, account rounding strategy, particularly as Connections Auto products account for an increasing proportion of our total personal automobile business.

New business, whether written through our Connections Auto or legacy products, generally experiences higher loss ratios than our renewal business, and is more difficult to predict, particularly in states in which we have less experience and data. Our ability to maintain or increase earnings could be adversely affected if the loss ratios for new business on our “rounded” accounts do not

 

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meet our expectations. However, we believe that complete accounts offer better profitability and retention over time. Our ability to grow could be adversely affected by adjustments to enhance risk segmentation and by agency management actions.

It is difficult to predict the impact that the current recessionary environment will have on our Personal Lines business. Our ability to increase pricing may continue to be impacted as agents and consumers become more price sensitive, customers shop for policies more frequently or aggressively, and agents increase their utilization of comparative rating models. Additionally, new business premiums, retention levels and renewal premiums may decrease as policyholders reduce coverages or change deductibles to reduce premiums, home values decline, foreclosures increase and policyholders retain older or less expensive automobiles. Additionally, claims frequency could increase as policyholders submit and pursue claims more aggressively than in the past, fraud incidences may increase, or we may experience higher incidents of abandoned properties or poorer maintenance which may also result in more claims activity. We have also experienced higher incidents of claims for uninsured or underinsured policy coverages as a greater percentage of the motoring public eliminates or reduces their liability coverages, thus exposing our policyholders to the greater likelihood of making claims against their own uninsured or underinsured automobile coverages. Our Personal Lines segment could also be affected by an ensuing consolidation of independent insurance agencies.

In addition, as discussed under “Contingencies and Regulatory Matters – Other Regulatory Matters”, certain states have taken, and others may take, actions which significantly affect the property and casualty insurance market, including ordering rate reductions for personal automobile and homeowners insurance products and subjecting insurance companies that do business in that state to onerous underwriting or other restrictions and potentially significant assessments. Such state actions or our responses thereto could have a significant impact on our underwriting margins and growth prospects, as well as our ability to manage exposures to hurricane or other high risk losses.

Notwithstanding these concerns, we believe that our agency distribution strategy, the strength of our market share in key states, our account rounding strategy, the relatively inelastic demand for insurance products and our capital position, place us in a good position to manage these issues and concerns relative to many of our peer competitors.

Commercial Lines

Commercial Lines’ net premiums written increased $92.6 million, or 32.8%, to $375.3 million for the first quarter of 2010. This increase was primarily driven by increased premiums associated with the OneBeacon renewal rights transaction of $67.6 million, and growth in our managed program business through AIX, which accounted for $15.1 million, as well as growth in various niche and segmented businesses. Also affecting the overall growth comparison in net premiums was a slight improvement in rate. Renewal retention in our workers’ compensation line decreased compared to the prior year, as we sought to improve our mix of business through a variety of pricing and underwriting actions in a very competitive environment. Additionally, our core lines’ premium was affected by a decrease in exposures in workers’ compensation and commercial multiple peril as a result of the difficult economic conditions.

Commercial Lines underwriting loss, excluding prior year reserve development and catastrophes, increased $6.0 million, to a loss of $12.3 million, in the first quarter of 2010, compared to a loss of $6.3 million in the first quarter of 2009. This change was primarily due to approximately $11 million of higher operating expenses, principally attributable to costs associated with our OneBeacon renewal rights transaction and our westward expansion initiative, increased employee related expenses, and increased costs in our specialty business, including our recently acquired subsidiaries, partially offset by more favorable current accident year results of approximately $5 million. Ex-catastrophe current accident year losses were lower in the current quarter when compared to the prior year quarter, primarily driven by lower frequency of losses in the commercial multiple peril and commercial automobile lines. We attribute the lower loss frequency to improved weather.

Favorable prior year development decreased by $11.0 million in the first quarter of 2010 compared to the same period in the prior year. Included in the current quarter results was approximately $8 million of favorable LAE development, principally related to a change in the cost factors used for establishing unallocated loss adjustment expense reserves. LAE in the first quarter of 2009 included a benefit of approximately $10 million, including $8 million associated with prior accident years, related to a change in our unallocated loss adjustment expense reserving methodology.

We continue to experience significant price competition in all lines of business in our Commercial Lines segment. The industry is also experiencing overall rate decreases. Our ability to increase Commercial Lines’ net premiums written while maintaining or improving underwriting results is expected to be affected by continuing price competition and the difficult economic conditions.

It is difficult to measure and predict the impact of the current difficult economic environment on our Commercial Lines segment. We may continue to experience downward pressure on new business levels, retention and renewal rates and renewal premiums. The overall decline in the economy has resulted in reductions in demand for insurance products and services as more companies cease to do business and there are fewer business start-ups, particularly as small businesses are affected by a decline in overall consumer and business spending. In addition, economic conditions may also continue to impact our surety bond business, especially in the small to middle market contractor business.

 

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In addition, some businesses have reduced or eliminated coverages to reduce costs and there has been a reduction in payroll levels, which has reduced workers’ compensation premiums without a corresponding decrease in workers’ compensation losses. Our Commercial Lines segment could also be affected by an ensuing consolidation of independent insurance agencies.

Notwithstanding these concerns, we believe that our agency distribution strategy, our broad product offerings, the strength of our growing specialty businesses, disruptions in the marketplace which may result in improved pricing and new business, the relatively inelastic demand for insurance products and our capital position, place us in a good position to manage these issues and concerns relative to many of our peer competitors.

Other Property and Casualty

Segment income of the Other Property and Casualty segment increased $1.2 million, to $0.4 million for the quarter ended March 31, 2010, from a loss of $0.8 million in the same period of 2009. The increase is primarily due to lower employee benefit costs.

Investment Results

Net investment income before taxes decreased $3.6 million, or 5.6%, to $61.1 million for the quarter ended March 31, 2010. This decrease was primarily due to the utilization of fixed maturities to fund certain corporate actions, such as the 2009 stock and corporate debt repurchases and a $100.0 million contribution to our pension plan on January 4, 2010. The impact of lower new money yields over the past twelve months also contributed to the decline. The average pre-tax yield on fixed maturities was 5.5% for the first quarter of 2010 and 5.8% for the first quarter of 2009. If new money rates remain at their current lower levels, they will result in further declines in average pre-tax investment yields in future periods.

Reserve for Losses and Loss Adjustment Expenses

Overview of Loss Reserve Estimation Process

We maintain reserves for our property and casualty products to provide for our ultimate liability for losses and loss adjustment expenses (our “loss reserves”) with respect to reported and unreported claims incurred as of the end of each accounting period. These reserves are estimates, taking into account past loss experience, modified for current trends, as well as prevailing economic, legal and social conditions. Loss reserves represent our largest liability.

Our loss reserves include case estimates for claims that have been reported and estimates for claims that have been incurred but not reported (“IBNR”) at the balance sheet date. They also include estimates of the expenses associated with processing and settling all reported and unreported claims, less estimates of anticipated salvage and subrogation recoveries. Our loss reserves are not discounted to present value.

Case reserves are established by our claim personnel individually on a claim by claim basis and based on information specific to the occurrence and terms of the underlying policy. For some classes of business, average case reserves are used initially. Case reserves are periodically reviewed and modified based on new or additional information pertaining to the claim.

IBNR reserves are estimated by management and our reserving actuaries on an aggregate basis for each line of business, coverage and accident year for all loss and loss expense liabilities not reflected within the case reserves. The sum of the case reserves and the IBNR reserves represents our estimate of total unpaid loss and loss adjustment expense.

We regularly review our loss reserves using a variety of actuarial techniques. We update the reserve estimates as historical loss experience develops, additional claims are reported and resolved and new information becomes available. Any changes in estimates are reflected in operating results in the period in which the estimates are changed.

IBNR reserve estimates are generally calculated by first projecting the ultimate cost of all claims that have occurred or are expected to occur in the future in aggregate and then subtracting reported losses and loss expenses. Reported losses include cumulative paid losses and loss expenses plus case reserves. The IBNR reserve includes a provision for claims that have occurred but have not yet been reported to us, some of which may not yet be known to the insured, as well as a provision for future development on reported claims. IBNR represents a significant proportion of our total net loss reserves, particularly for long tail liability classes. In fact, approximately 49% of our aggregate net loss reserves at March 31, 2010 were for IBNR losses and loss expenses.

Management’s process for establishing loss reserves is primarily based on the results of our reserving actuaries quarterly reserving process; however, there are a number of other factors in addition to the actuarial point estimates as further described under the section below entitled “Loss and LAE Reserves by Line of Business.” In establishing our loss reserves, we consider facts currently known and the present state of the law and coverage litigation. Based on all information currently available, we believe that the

 

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aggregate loss reserves at March 31, 2010 were adequate to cover claims for losses that had occurred as of that date, including both those known to us and those yet to be reported. However, as described below, there are significant uncertainties inherent in the loss reserving process. It is therefore possible that management’s estimate of the ultimate liability for losses that had occurred as of March 31, 2010 may change, which could have a material effect on our results of operations and financial condition.

Management’s Review of Judgments and Key Assumptions

We determine the amount of our loss reserves based on an estimation process that is very complex and uses information from both company specific and industry data, as well as general economic information. The estimation process is a combination of objective and subjective information, the blending of which requires significant actuarial and business judgment. There are various assumptions required including future trends in frequency and severity of claims, trends in total loss costs, operational changes in claim handling processes, and trends related to general economic and social conditions. As a result, informed subjective estimates and judgments as to our ultimate exposure to losses are an integral component of our loss reserving process.

Given the inherent complexity of our loss reserving process and the potential variability of the assumptions used, the actual emergence of losses could vary, perhaps substantially, from the estimate of losses included in our financial statements, particularly in those instances where settlements do not occur until well into the future. Our net loss reserves at March 31, 2010 were $2.1 billion. Therefore, a relatively small percentage change in the estimate of net loss reserves would have a material effect on our results of operations.

There is greater inherent uncertainty in estimating insurance reserves for certain types of property and casualty insurance lines, particularly workers’ compensation and other liability lines, where a longer period of time may elapse before a definitive determination of ultimate liability and losses may be made. In addition, the technological, judicial, regulatory and political climates involving these types of claims change regularly. There is also greater uncertainty in establishing reserves with respect to new business, particularly new business which is generated with respect to newly introduced product lines, by newly appointed agents or in geographies in which we have less experience in conducting business, such as the program business written by our recently acquired AIX subsidiary. In such cases, there is less historical experience or knowledge and less data upon which the actuaries can rely. Historically, we have limited the issuance of long-tailed other liability policies, including directors and officers (“D&O”) liability, errors and omissions (“E&O”) liability and medical malpractice liability. With the acquisition of Hanover Professionals in 2007, which writes lawyers professional errors and omissions coverage, and the introduction of new specialty coverages, we are modestly increasing and expect to continue to increase our exposure to longer-tailed liability lines, including D&O coverages.

We regularly update our reserve estimates as new information becomes available and further events occur which may impact the resolution of unsettled claims. Reserve adjustments are reflected in the results of operations as adjustments to losses and LAE. Often, these adjustments are recognized in periods subsequent to the period in which the underlying policy was written and the loss event occurred. These types of subsequent adjustments are described separately as “prior year reserve development”. Such development can be either favorable or unfavorable to our financial results and may vary by line of business.

Inflation generally increases the cost of losses covered by insurance contracts. The effect of inflation varies by product. Our property and casualty insurance premiums are established before the amount of losses and LAE and the extent to which inflation may affect such expenses are known. Consequently, we attempt, in establishing rates and reserves, to anticipate the potential impact of inflation and increasing medical costs in the projection of ultimate costs. We have experienced increasing medical and attendant care costs, including those associated with personal automobile personal injury protection claims, particularly in Michigan, as well as in our workers’ compensation line in most states. This increase is reflected in our reserve estimates, but continued increases could contribute to increased losses and LAE in the future.

We regularly review our reserving techniques, our overall reserving position and our reinsurance. Based on (i) our review of historical data, legislative enactments, judicial decisions, legal developments in impositions of damages and policy coverage, political attitudes and trends in general economic conditions, (ii) our review of per claim information, (iii) our historical loss experience and that of the industry, (iv) the relatively short-term nature of most policies written by us, and (v) our internal estimates of required reserves, we believe that adequate provision has been made for loss reserves. However, establishment of appropriate reserves is an inherently uncertain process and there can be no certainty that current established reserves will prove adequate in light of subsequent actual experience. A significant change to the estimated reserves could have a material impact on our results of operations and financial position. An increase or decrease in reserve estimates would result in a corresponding decrease or increase in financial results. For example, each one percentage point change in the aggregate loss and LAE ratio resulting from a change in reserve estimation is currently projected to have an approximate $25 million impact on property and casualty segment income, based on 2009 full year premiums.

 

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As discussed below, estimated loss and LAE reserves for claims occurring in prior years developed favorably by $37.1 million and $41.2 million for the quarters ended March 31, 2010 and 2009, respectively, which represents 1.7% and 1.9% of net loss reserves held, respectively.

The major causes of material uncertainty relating to ultimate losses and loss adjustment expenses (“risk factors”) generally vary for each line of business, as well as for each separately analyzed component of the line of business. In some cases, such risk factors are explicit assumptions of the estimation method and in others, they are implicit. For example, a method may explicitly assume that a certain percentage of claims will close each year, but will implicitly assume that the legal interpretation of existing contract language will remain unchanged. Actual results will likely vary from expectations for each of these assumptions, resulting in an ultimate claim liability that is different from that being estimated currently.

Some risk factors will affect more than one line of business. Examples include changes in claim department practices, changes in settlement patterns, regulatory and legislative actions, court actions, timeliness of claim reporting, state mix of claimants, and degree of claimant fraud. Additionally, there is also a higher degree of uncertainty due to growth in our newly acquired companies, for which we have limited historical claims experience. The extent of the impact of a risk factor will also vary by components within a line of business. Individual risk factors are also subject to interactions with other risk factors within line of business components. Thus, risk factors can have offsetting or compounding effects on required reserves.

We are also defendants in various litigation, including putative class actions, which claim punitive damages or claim a broader scope of policy coverage than our interpretation, particularly in connection with losses incurred from Hurricane Katrina. The reserves established with respect to Hurricane Katrina assume that we will prevail with respect to these matters (See also “Contingencies and Regulatory Matters”). Although we believe our current Hurricane Katrina reserves are adequate, there can be no assurance that our ultimate costs associated with this event will not substantially exceed these estimates. We have fully utilized all of our available reinsurance with respect to losses and LAE related to Hurricane Katrina.

Loss and LAE Reserves by Line of Business

Reserves Other than those Relating to Asbestos and Environmental Claims

Our loss reserves include amounts related to short tail and long tail classes of business. “Tail” refers to the time period between the occurrence of a loss and the settlement of the claim. The longer the time span between the incidence of a loss and the settlement of the claim, the more the ultimate settlement amount can vary.

Short tail classes consist principally of automobile physical damage, homeowners, commercial property and marine business. For these coverages, claims are generally reported and settled shortly after the loss occurs because the claims relate to tangible property and are more likely to be discovered shortly after the loss occurs. Consequently, the estimation of loss reserves for these classes is less complex.

While 56% of our written premium is in short tailed classes of business, most of our loss reserves relate to longer tail liability classes of business. Long tail classes include commercial liability, automobile liability, workers’ compensation and other types of third party coverage. For many liability claims, significant periods of time, ranging up to several years or more, may elapse between the occurrence of the loss, the discovery and reporting of the loss to us and the settlement of the claim. As a result, loss experience in the more recent accident years for the long tail liability coverage has limited statistical credibility because a relatively small proportion of losses in these accident years are reported claims and an even smaller proportion are paid losses. An accident year is the calendar year in which a loss is incurred. Liability claims are also more susceptible to litigation and can be significantly affected by changing contract interpretations, the legal environment and the expense of protracted litigation. Consequently, the estimation of loss reserves for these coverages is more complex and typically subject to a higher degree of variability compared to short tail coverages.

Most of our indirect business from voluntary and involuntary pools is long tail casualty reinsurance. Reserve estimates for this business are therefore subject to the variability caused by extended loss emergence periods. The estimation of loss reserves for this business is further complicated by delays between the time the claim is reported to the ceding insurer and when it is reported by the ceding insurer to us and by our dependence on the quality and consistency of the loss reporting by the ceding company.

Our reserving actuaries, who are independent of the business units, perform a comprehensive review of loss reserves for each of the numerous classes of business we write at the end of each quarter. This review process takes into consideration a variety of trends that impact the ultimate settlement of claims, including the emergence of paid and reported losses relative to expectations.

The loss reserve estimation process relies on the basic assumption that past experience, adjusted for the effects of current developments and likely trends, is an appropriate basis for predicting future outcomes. As part of this process, our actuaries use a

 

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variety of actuarial methods that analyze experience, trends and other relevant factors. The principal standard actuarial methods used by our actuaries in the loss reserve reviews include loss development factor methods, expected loss methods (Bornheutter-Ferguson), and adjusted loss methods (Berquist-Sherman).

Loss development factor methods generally assume that the losses yet to emerge for an accident year are proportional to the paid or reported loss amount observed so far. Historical patterns of the development of paid and reported losses by accident year can be predictive of the expected future patterns that are applied to current paid and reported losses to generate estimated ultimate losses by accident year.

Bornheutter-Ferguson methods calculate IBNR directly for each accident year as the product of expected ultimate losses times the proportion of ultimate losses estimated to be unreported or unpaid (obtained from the loss development factor methods). Expected ultimate losses are determined by multiplying the expected loss ratio times earned premium. The expected loss ratio uses loss ratios from prior accident years adjusted to reflect current revenue and cost levels. The expected loss ratio is a critical component of Bornheutter-Ferguson and provides a general reasonability guide for all reserving methods.

Berquist-Sherman methods are used in cases where historical development patterns may be deemed less optimal for use in estimating ultimate losses of recent accident years. Under these methods, patterns of historical paid or reported losses are first adjusted to reflect current payment settlement patterns and case reserve adequacy and then evaluated in the same manner as the paid or reported loss development factor methods described above. The reported loss development factor method can be less appropriate when the adequacy of case reserves suddenly changes, while the paid loss development factor method can likewise be less appropriate when settlement patterns suddenly change.

For some low volume and high volatility classes of business, special reserving techniques are utilized that estimate IBNR by selecting the loss ratio that balances actual reported losses to expected reported losses as defined by the estimated underlying reporting pattern.

In completing their loss reserve analysis, our actuaries are required to determine the most appropriate actuarial methods to employ for each line of business, coverage and accident year. Each estimation method has its own pattern, parameter and/or judgmental dependencies, with no estimation method being better than the others in all situations. The relative strengths and weaknesses of the various estimation methods when applied to a particular class of business can also change over time, depending on the underlying circumstances. In many cases, multiple estimation methods will be valid for the particular facts and circumstances of the relevant class of business. The manner of application and the degree of reliance on a given method will vary by line of business and coverage, and by accident year based on our actuaries’ evaluation of the above dependencies and the potential volatility of the loss frequency and severity patterns. The estimation methods selected or given weight by our actuaries at a particular valuation date are those that are believed to produce the most reliable indication for the loss reserves being evaluated. Selections incorporate input from claims personnel, pricing actuaries, and underwriting management on loss cost trends and other factors that could affect ultimate losses.

For short tail classes, the emergence of paid and incurred losses generally exhibits a reasonably stable pattern of loss development from one accident year to the next. Thus, for these classes in the vast majority of cases, the loss development factor method is generally appropriate. In certain cases where there is a relatively low level of reliability placed on the available paid and incurred loss data, expected loss methods or adjusted loss methods are considered appropriate for the most recent accident year.

For long tail lines of business, applying the loss development factor method often requires more judgment in selecting development factors as well as more significant extrapolation. For those long tail lines of business with high frequency and relatively low per-loss severity (e.g., personal automobile liability), volatility will often be sufficiently modest for the loss development factor method to be given significant weight, even in the most recent accident years, but expected loss methods and adjusted loss methods are always considered and frequently utilized in the selection process. For those long tail lines of business with low frequency and high loss potential (e.g., commercial liability), anticipated loss experience is less predictable because of the small number of claims and erratic claim severity patterns. In these situations, the loss development factor methods may not produce a reliable estimate of ultimate losses in the most recent accident years since many claims either have not yet been reported or are only in the early stages of the settlement process. Therefore, the actuarial estimates for these accident years are based on methods less reliant on extrapolation, such as Bornheutter-Ferguson. Over time, as a greater number of claims are reported and the statistical credibility of loss experience increases, loss development factor methods or adjusted loss methods are given increasingly more weight.

Using all the available data, our actuaries select an indicated loss reserve amount for each line of business, coverage and accident year based on the various assumptions, projections and methods. The total indicated reserve amount determined by our actuaries is an aggregate of the indicated reserve amounts for the individual classes of business. The ultimate outcome is likely to fall within a

 

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range of potential outcomes around this indicated amount, but the indicated amount is not expected to be precisely the ultimate liability.

As stated above, numerous factors (both internal and external) contribute to the inherent uncertainty in the process of establishing loss reserves, including changes in the rate of inflation for goods and services related to insured damages (e.g., medical care, home repairs, etc.), changes in the judicial interpretation of policy provisions, changes in the general attitude of juries in determination of damages, legislative actions, changes in the extent of insured injuries, changes in the trend of expected frequency and/or severity of claims, changes in our book of business (e.g., change in mix due to new product offerings, new geographic areas, etc.), changes in our underwriting norms, and changes in claim handling procedures and/or systems. Regarding our indirect business from voluntary and involuntary pools, we are provided loss estimates by managers of each pool. We adopt reserve estimates for the pools that consider this information and other facts.

In addition, we must consider the uncertain effects of emerging or potential claims and coverage issues that arise as legal, judicial and social conditions change. These issues could have a negative effect on our loss reserves by either extending coverage beyond the original underwriting intent or by increasing the number or size of claims. As a result of these potential issues, the uncertainties inherent in estimating ultimate claim costs on the basis of past experience have further complicated the already complex loss reserving process. For example, in the state of Michigan, tort compensation for non-economic damages (for example, pain and suffering) caused by ownership or use of a motor vehicle is limited by statute to circumstances where the injured person suffered death, serious impairment of body function or permanent serious disfigurement. The application of this statute has been defined by the Supreme Court of Michigan in the so-called Kreiner decision. Accordingly, we establish our actuarial point estimates based upon our understanding of the current state of the law. There have been and currently are efforts to change the controlling statute or judicial interpretation in ways which would expand an injured person’s right to sue for non-economic damages; for example, a decision of the Supreme Court of Michigan which could effect this standard is believed to be imminent. If implemented, such changes may not only impact future claims, but also past claims which are not settled and therefore an unfavorable adjustment to existing loss reserves would likely be required.

As part of our loss reserving analysis, we take into consideration the various factors that contribute to the uncertainty in the loss reserving process. Those factors that could materially affect our loss reserve estimates include loss development patterns and loss cost trends, rate and exposure level changes, the effects of changes in coverage and policy limits, business mix shifts, the effects of regulatory and legislative developments, the effects of changes in judicial interpretations, the effects of emerging claims and coverage issues and the effects of changes in claim handling practices. In making estimates of reserves, however, we do not necessarily make an explicit assumption for each of these factors. Moreover, all estimation methods do not utilize the same assumptions and typically no single method is determinative in the reserve analysis for a line of business and coverage. Consequently, changes in our loss reserve estimates generally are not the result of changes in any one assumption. Instead, the variability will be affected by the interplay of changes in numerous assumptions, many of which are implicit to the approaches used.

For each line of business and coverage, we regularly adjust the assumptions and actuarial methods used in the estimation of loss reserves in response to our actual loss experience, as well as our judgments regarding changes in trends and/or emerging patterns. In those instances where we primarily utilize analyses of historical patterns of the development of paid and reported losses, this may be reflected, for example, in the selection of revised loss development factors. In those long tail classes of business that comprise a majority of our loss reserves and for which loss experience is less predictable due to potential changes in judicial interpretations, potential legislative actions and potential claims issues, this may be reflected in a judgmental change in our estimate of ultimate losses for particular accident years.

The future impact of the various factors that contribute to the uncertainty in the loss reserving process is extremely difficult to predict. There is potential for significant variation in the development of loss reserves, particularly for long tail classes of business. We do not derive statistical loss distributions or confidence levels around our loss reserve estimate, and as a result, do not have reserve range estimates to disclose. Actuarial ranges of reasonable estimates are not a true reflection of the potential volatility between carried loss reserves and the ultimate settlement amount of losses incurred prior to the balance sheet date. This is due, among other reasons, to the fact that actuarial ranges are developed based on known events as of the valuation date whereas the ultimate disposition of losses is subject to the outcome of events and circumstances that were unknown as of the valuation date.

The following tables and related discussion includes disclosure of possible variation from current actuarial estimates of loss reserves due to a change in certain key assumptions for the primary long tail coverages within our major lines of business which typically represent the areas of greatest uncertainty in our reserving process. We believe that the estimated variation in reserves detailed below is a reasonable estimate of the possible variation that may occur in the future, and are provided to illustrate the relationship between claim reporting patterns and expected loss ratios, respectively, on actuarial loss reserve estimates for the lines identified. However, if such variation did occur, it would likely occur over a period of several years and therefore its impact on our results of operations would be spread over the same period. It is important to note, however, that there is the potential for

 

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future variation greater than the amounts discussed below and for any such variations to be recognized in a single quarterly or annual period.

As noted, the tables below illustrate the relationship between the impact on our actuarial loss reserve estimates of reasonably likely variations to claim reporting patterns and expected actuarial estimates of ultimate loss costs, two key actuarial assumptions used to estimate our net reserves at March 31, 2010, from the assumptions utilized by our actuaries. The five point change to our expected loss ratio selections, which incorporate variability in both ultimate frequency and severity, are within the historical variation present in our prior accident year development. The three month change to reporting patterns represent claims reporting that is both faster and slower than our current reporting assumption for reported loss patterns and this degree of change is within the historical variation present in actual reporting patterns. A faster reporting pattern results in lower indicated net loss reserves due to the presumption that a higher proportion of ultimate claims have been reported thus far; and therefore, a lower proportion of ultimate claims needs to be carried as IBNR. A slower reporting pattern results in higher indicated net loss reserves due to the presumption that a lower proportion of ultimate claims have been reported thus far; and therefore, a higher proportion of ultimate claims needs to be carried as IBNR.

The results show the cumulative dollar difference between our current actuarial estimate and the estimate that we would develop if our understanding with respect to loss reporting patterns and ultimate loss costs were different by three months or five points, respectively. No consideration has been given to potential correlation or lack of correlation among key assumptions or among lines of business and coverage. As a result, it would be inappropriate to take the amounts described below and add them together in an attempt to estimate volatility in total. While we believe these are reasonably likely scenarios, we do not believe the reader should consider the below sensitivity analysis as an actual reserve range.

Expected Dollar Effect on Actuarial Loss Reserve Estimates

 

Personal Automobile Bodily Injury

(In millions)

 

 

		Change in Expected Loss Ratio
Reporting Pattern		5 points lower				Unchanged				5 points higher
3 months faster		$	(15	)		$	(12	)		$	(9	)
Unchanged			(4	)			—				4
3 months slower			20				24				29

 

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Example: Personal Automobile Bodily Injury, if losses are actually developing and emerging three months slower than we anticipate in our models, our actuarial estimate for this coverage would be understated by $24 million. If our assumed payment patterns are consistent with our expectations, but the expected loss ratio in our model is 5% too low, then our actuarial estimate for this coverage would be understated by $4 million.

Expected Dollar Effect on Actuarial Loss Reserve Estimates

 

Workers’ Compensation Indemnity

(In millions)

 

 

		Change in Expected Loss Ratio
Reporting Pattern		5 points lower				Unchanged				5 points higher
3 months faster		$	(4	)		$	(1	)		$	2
Unchanged