CNA FINANCIAL CORP - Annual Report: 2005 (Form 10-K)
Table of Contents
UNITED
STATES
SECURITIES AND EXCHANGE COMMISSION
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM
10-K
þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended December 31, 2005
OR
o
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 1-5823
CNA FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Delaware | 36-6169860 | |
(State or other jurisdiction of | (I.R.S. Employer | |
incorporation or organization) | Identification No.) | |
CNA Center | ||
Chicago, Illinois | 60685 | |
(Address of principal executive offices) | (Zip Code) |
(312) 822-5000
(Registrants telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
(Registrants telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange on | ||
Title of each class | which registered | |
Common Stock with a par value of $2.50 per share |
New York Stock Exchange Chicago Stock Exchange Pacific Exchange |
Securities registered pursuant to Section 12(g) of the Act:
None
None
Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405
of the Securities Act.
Yes... Noü
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or
Section 15 (d) of the Act.
Yes... Noü
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 ü No...
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation SK is
not contained herein, and will not be contained, to the best of registrants knowledge, in
definitive proxy or information statements incorporated by reference in Part III of this Form 10K
or any amendment to this Form 10K. [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer,
or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in
Rule 12b-2 of the Act. (check one):
Large Accelerated Filer ...
Accelerated Filer ü Non-Accelerated Filer ...
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Act).
Yes... Noü
As of February 28, 2006, 256,001,968 shares of common stock were outstanding. The aggregate market
value of the common stock of CNA Financial Corporation held by nonaffiliates of the registrant as
of June 30, 2005 was approximately $635 million based on the closing price of $28.42 per share of
the common stock on the New York Stock Exchange on June 30, 2005.
DOCUMENTS INCORPORATED
BY REFERENCE:
BY REFERENCE:
Portions of the CNA Financial Corporation Proxy Statement prepared for the 2006 annual meeting
of shareholders, pursuant to Regulation 14A, are incorporated by reference into Part III of this
Report.
Table of Contents
Item | Page | |||||||
Number |
Number |
|||||||
1. | 3 | |||||||
1A. | 9 | |||||||
1B. | 16 | |||||||
2. | 16 | |||||||
3. | 16 | |||||||
4. | 16 | |||||||
5. | 17 | |||||||
6. | 18 | |||||||
7. | 19 | |||||||
7A. | 66 | |||||||
8. | 71 | |||||||
9. | 158 | |||||||
9A. | 158 | |||||||
9B. | 159 | |||||||
10. | 160 | |||||||
11. | 160 | |||||||
12. | 161 | |||||||
13. | 161 | |||||||
14. | 161 | |||||||
15. | 162 | |||||||
Consent of Independent Registered Public Accounting Firm | ||||||||
Section 302 Certification | ||||||||
Seection 302 Certification | ||||||||
Section 1350 Certification | ||||||||
Section 1350 Certification |
Table of Contents
PART I
ITEM 1. BUSINESS
CNA Financial Corporation (CNAF) was incorporated in 1967 and is an insurance holding company.
Collectively, CNAF and its subsidiaries are referred to as CNA or the Company. References to
CNA, the Company, we, our, us or like terms refer to the business of CNA and its
subsidiaries. Our property and casualty insurance operations are conducted by Continental Casualty
Company (CCC), incorporated in 1897, and its affiliates, and The Continental Insurance Company
(CIC), organized in 1853, and its affiliates. CIC became an affiliate of ours in 1995 as a result
of the acquisition of The Continental Corporation (Continental). Life and group insurance
operations were either sold or are primarily being managed as a run-off operation. These operations
are primarily conducted within CCC and Continental Assurance Company (CAC). Loews Corporation
(Loews) owned approximately 91% of our outstanding common stock and 100% of our Series H preferred
stock as of December 31, 2005.
We serve a wide variety of customers, including small, medium and large businesses, associations,
professionals, and groups and individuals with a broad range of insurance and risk management
products and services.
Insurance products primarily include property and casualty coverages. Our services include risk
management, information services, warranty and claims administration. Our products and services
are marketed through independent agents, brokers, managing general agents and direct sales.
In 2005, we conducted our operations through four operating segments: Standard Lines, Specialty
Lines, Life and Group Non-Core and Corporate and Other Non-Core. These segments are managed
separately because of differences in their product lines and markets. Discussions of each segment
including the products offered, the customers served, the distribution channels used and
competition are set forth in the Managements Discussion and Analysis (MD&A) included under Item 7
and in Note N of the Consolidated Financial Statements included under Item 8.
Competition
The property and casualty insurance industry is highly competitive both as to rate and service.
Our consolidated property and casualty subsidiaries compete not only with other stock insurance
companies, but also with mutual insurance companies, reinsurance companies and other entities for
both producers and customers. We must continuously allocate resources to refine and improve our
insurance products and services.
Rates among insurers vary according to the types of insurers and methods of operation. We compete
for business not only on the basis of rate, but also on the basis of availability of coverage
desired by customers, ratings and quality of service, including claim adjustment services.
There are approximately 2,400 individual companies that sell property and casualty insurance in the
United States. Our consolidated property and casualty subsidiaries ranked as the fourteenth
largest property and casualty insurance organization and we are the seventh largest commercial
insurance writer in the United States based upon 2004 statutory net written premiums.
Regulation
The insurance industry is subject to comprehensive and detailed regulation and supervision
throughout the United States. Each state has established supervisory agencies with broad
administrative powers relative to licensing insurers and agents, approving policy forms,
establishing reserve requirements, fixing minimum interest rates for accumulation of surrender
values and maximum interest rates of policy loans, prescribing the form and content of statutory
financial reports and regulating solvency and the type and amount of investments permitted. Such
regulatory powers also extend to premium rate regulations, which require that rates not be
excessive, inadequate or unfairly discriminatory. In addition to regulation of dividends by
insurance subsidiaries, intercompany transfers of assets may be subject to prior notice or approval
by the state insurance regulators, depending on the size of such transfers and payments in relation
to the financial position of the insurance affiliates making the transfer or payment.
Insurers are also required by the states to provide coverage to insureds who would not otherwise be
considered eligible by the insurers. Each state dictates the types of insurance and the level of
coverage that must be provided to such involuntary risks. Our share of these involuntary risks is
mandatory and generally a function of our respective share of the voluntary market by line of
insurance in each state.
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Insurance companies are subject to state guaranty fund and other insurance-related assessments.
Guaranty fund and other insurance-related assessments are levied by the state departments of
insurance to cover claims of insolvent insurers.
Reform of the U.S. tort liability system is another issue facing the insurance industry. Over the
last decade, many states have passed some type of reform. In recent years, for example,
significant state general tort reforms have been enacted in Georgia, Ohio, Mississippi and South
Carolina. Specific state legislation addressing state asbestos reform has been passed in Ohio,
Georgia, Florida, and Texas. Several more states will be considering such legislation in the
coming year. Although these states legislatures have begun to address their litigious
environments, some reforms are being challenged in the courts and it will take some time before
they are finalized. Even though there has been some tort reform success, new causes of action and
theories of damages continue to be proposed in state court actions or by legislatures. Continued
unpredictability in the law means that insurance underwriting and rating is expected to continue to
be difficult in commercial lines, professional liability and some specialty coverages.
Although the Federal Government and its regulatory agencies do not directly regulate the business
of insurance, federal legislative and regulatory initiatives can impact the insurance industry in a
variety of ways. These initiatives and legislation include tort reform proposals; proposals to
establish a privately financed trust to process asbestos bodily injury claims; proposals to
overhaul the Superfund hazardous waste removal and liability statutes; proposals to address
terrorism risk and various tax proposals affecting insurance companies. In 1999, Congress passed
the Financial Services Modernization or Gramm-Leach-Bliley Act (GLB Act), which repealed portions
of the Glass-Steagall Act and enabled closer relationships between banks and insurers. Although
functional regulation was preserved by the GLB Act for state oversight of insurance, additional
financial services modernization legislation could include provisions for an alternate federal
system of regulation for insurance companies.
Our domestic insurance subsidiaries are subject to risk-based capital requirements. Risk-based
capital is a method developed by the National Association of Insurance Commissioners (NAIC) to
determine the minimum amount of statutory capital appropriate for an insurance company to support
its overall business operations in consideration of its size and risk profile. The formula for
determining the risk-based capital requirements specifies various factors, weighted based on the
perceived degree of risk, which are applied to certain financial balances and financial activity.
The adequacy of a companys actual capital is evaluated by a comparison to the risk-based capital
requirements, as determined by the formula. Companies below minimum risk-based capital
requirements are classified within certain levels, each of which determines a specified level of
regulatory attention applicable to a company. As of December 31, 2005 and 2004, all of our
domestic insurance subsidiaries exceeded the minimum risk-based capital requirements.
Subsidiaries with insurance operations outside the United States are also subject to regulation in
the countries in which they operate. We have operations in the United Kingdom, Canada and other
countries.
Employee Relations
As of December 31, 2005, we had approximately 10,100 employees and have experienced satisfactory
labor relations. We have never had work stoppages due to labor disputes.
We have comprehensive benefit plans for substantially all of our employees, including retirement
plans, savings plans, disability programs, group life programs and group healthcare programs. See
Note J of the Consolidated Financial Statements included under Item 8 for further discussion of our
benefit plans.
4
Table of Contents
Supplementary Insurance Data
The following table sets forth supplementary insurance data:
Supplementary Insurance Data
Years ended December 31 | 2005 | 2004 | 2003 | |||||||||
(In millions, except ratio information) | ||||||||||||
Trade Ratios GAAP basis (a) |
||||||||||||
Loss and loss adjustment expense ratio |
89.4 | % | 74.6 | % | 111.8 | % | ||||||
Expense ratio |
31.2 | 31.5 | 37.3 | |||||||||
Dividend ratio |
0.3 | 0.2 | 1.4 | |||||||||
Combined ratio |
120.9 | % | 106.3 | % | 150.5 | % | ||||||
Trade Ratios Statutory basis (a) |
||||||||||||
Loss and loss adjustment expense ratio |
92.2 | % | 78.1 | % | 118.1 | % | ||||||
Expense ratio |
31.0 | 27.2 | 34.6 | |||||||||
Dividend ratio |
0.5 | 0.6 | 1.2 | |||||||||
Combined Ratio |
123.7 | % | 105.9 | % | 153.9 | % | ||||||
Individual Life and Group Life Insurance Inforce (b) |
||||||||||||
Individual life |
$ | 10,711 | $ | 11,566 | $ | 330,805 | ||||||
Group life |
9,838 | 45,079 | 58,163 | |||||||||
Total |
$ | 20,549 | $ | 56,645 | $ | 388,968 | ||||||
Other Data Statutory basis (c) |
||||||||||||
Property and casualty companies capital and surplus (d) |
$ | 6,940 | $ | 6,998 | $ | 6,170 | ||||||
Life and group company(ies) capital and surplus |
627 | 1,177 | 707 | |||||||||
Property and casualty companies written premiums to surplus ratio |
1.0 | 1.0 | 1.1 | |||||||||
Life companies capital and surplus-percent to total liabilities |
33.1 | % | 56.0 | % | 13.0 | % | ||||||
Participating policyholders-percent of gross life insurance inforce |
3.5 | % | 1.4 | % | 0.5 | % |
(a) | Trade ratios reflect the results of our property and casualty insurance subsidiaries. Trade ratios are industry measures of property and casualty underwriting results. The loss and loss adjustment expense ratio is the percentage of net incurred claim and claim adjustment expenses and the expenses incurred related to uncollectible reinsurance receivables to net earned premiums. The primary difference in this ratio between accounting principles generally accepted in the United States of America (GAAP) and statutory accounting practices (SAP) is related to the treatment of active life reserves (ALR) related to long term care insurance products written in property and casualty insurance subsidiaries. For GAAP, ALR is classified as claim and claim adjustment expense reserves whereas for SAP, ALR is classified as unearned premium reserves. The expense ratio, using amounts determined in accordance with GAAP, is the percentage of underwriting and acquisition expenses (including the amortization of deferred acquisition expenses) to net earned premiums. The expense ratio, using amounts determined in accordance with SAP, is the percentage of acquisition and underwriting expenses (with no deferral of acquisition expenses) to net written premiums. The dividend ratio, using amounts determined in accordance with GAAP, is the ratio of dividends incurred to net earned premiums. The dividend ratio, using amounts determined in accordance with SAP, is the ratio of dividends paid to net earned premiums. The combined ratio is the sum of the loss and loss adjustment expense, expense and dividend ratios. | |
(b) | The decline in gross inforce is attributable to the sales of the group benefits and the individual life businesses. See Note H of the Consolidated Financial Statements included under Item 8 for additional inforce information. | |
(c) | Other data is determined in accordance with SAP. Life and group statutory capital and surplus as a percent of total liabilities is determined after excluding separate account liabilities and reclassifying the statutorily required Asset Valuation Reserve to surplus. | |
(d) | Surplus includes the property and casualty companies equity ownership of the life and group company(ies) capital and surplus. |
5
Table of Contents
The following table displays the distribution of gross written premiums for our operations by
geographic concentration.
Gross Written Premiums
Percent of Total |
||||||||||||
Years ended December 31 | 2005 |
2004 |
2003 |
|||||||||
California |
9.0 | % | 9.3 | % | 8.5 | % | ||||||
New York |
7.9 | 7.9 | 7.3 | |||||||||
Florida |
7.1 | 7.1 | 7.6 | |||||||||
Texas |
5.7 | 5.4 | 5.7 | |||||||||
Illinois |
4.2 | 5.1 | 9.3 | |||||||||
Pennsylvania |
4.2 | 4.7 | 4.2 | |||||||||
New Jersey |
3.8 | 5.3 | 4.5 | |||||||||
Massachusetts |
3.3 | 3.2 | 3.1 | |||||||||
All other states, countries or political subdivisions (a) |
54.8 | 52.0 | 49.8 | |||||||||
Total |
100.0 | % | 100.0 | % | 100.0 | % | ||||||
(a) | No other individual state, country or political subdivision accounts for more than 3.0% of gross written premiums. |
Approximately 6.1%, 5.0% and 3.2% of our gross written premiums were derived from outside of
the United States for the years ended December 31, 2005, 2004 and 2003. Gross written premiums
from the United Kingdom were approximately 2.8%, 2.3%, and 1.8% of our premiums for the years ended
December 31, 2005, 2004 and 2003. Premiums from any individual foreign country excluding the
United Kingdom were not significant.
Property and Casualty Claim and Claim Adjustment Expenses
The following loss reserve development table illustrates the change over time of reserves
established for property and casualty claim and claim adjustment expenses at the end of the
preceding ten calendar years for our property and casualty insurance operations. The table
excludes our life subsidiary(ies), and as such, the carried reserves will not agree to the
Consolidated Financial Statements included under Item 8. The first section shows the reserves as
originally reported at the end of the stated year. The second section, reading down, shows the
cumulative amounts paid as of the end of successive years with respect to the originally reported
reserve liability. The third section, reading down, shows re-estimates of the originally recorded
reserves as of the end of each successive year, which is the result of our property and casualty
insurance subsidiaries expanded awareness of additional facts and circumstances that pertain to
the unsettled claims. The last section compares the latest re-estimated reserves to the reserves
originally established, and indicates whether the original reserves were adequate or inadequate to
cover the estimated costs of unsettled claims.
The loss reserve development table for property and casualty companies is cumulative and,
therefore, ending balances should not be added since the amount at the end of each calendar year
includes activity for both the current and prior years. Additionally, the development amounts in
the table below are the amounts prior to consideration of any related reinsurance bad debt
allowance impacts.
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Schedule of Loss Reserve Development
Calendar Year Ended | 1995 (a) | 1996 | 1997 | 1998 | 1999 (b) | 2000 | 2001 (c) | 2002 (d) | 2003 | 2004 | 2005 | |||||||||||||||||||||||||||||||||
(In millions) | ||||||||||||||||||||||||||||||||||||||||||||
Originally reported gross
reserves for unpaid claim
and claim adjustment
expenses |
$ | 31,296 | $ | 29,559 | $ | 28,731 | $ | 28,506 | $ | 26,850 | $ | 26,510 | $ | 29,649 | $ | 25,719 | $ | 31,284 | $ | 31,204 | $ | 30,694 | ||||||||||||||||||||||
Originally reported ceded
recoverable |
5,784 | 5,385 | 5,056 | 5,182 | 6,091 | 7,333 | 11,703 | 10,490 | 13,847 | 13,682 | 10,438 | |||||||||||||||||||||||||||||||||
Originally reported net
reserves for unpaid claim
and claim adjustment
expenses |
$ | 25,512 | $ | 24,174 | $ | 23,675 | $ | 23,324 | $ | 20,759 | $ | 19,177 | $ | 17,946 | $ | 15,229 | $ | 17,437 | $ | 17,522 | $ | 20,256 | ||||||||||||||||||||||
Cumulative net paid as of: |
||||||||||||||||||||||||||||||||||||||||||||
One year later |
$ | 6,594 | $ | 5,851 | $ | 5,954 | $ | 7,321 | $ | 6,547 | $ | 7,686 | $ | 5,981 | $ | 5,373 | $ | 4,382 | $ | 2,651 | $ | | ||||||||||||||||||||||
Two years later |
10,635 | 9,796 | 11,394 | 12,241 | 11,937 | 11,992 | 10,355 | 8,768 | 6,104 | | | |||||||||||||||||||||||||||||||||
Three years later |
13,516 | 13,602 | 14,423 | 16,020 | 15,256 | 15,291 | 12,954 | 9,747 | | | | |||||||||||||||||||||||||||||||||
Four years later |
16,454 | 15,793 | 17,042 | 18,271 | 18,151 | 17,333 | 13,244 | | | | | |||||||||||||||||||||||||||||||||
Five years later |
18,179 | 17,736 | 18,568 | 20,779 | 19,686 | 17,775 | | | | | | |||||||||||||||||||||||||||||||||
Six years later |
19,697 | 18,878 | 20,723 | 21,970 | 20,206 | | | | | | | |||||||||||||||||||||||||||||||||
Seven years later |
20,642 | 20,828 | 21,649 | 22,564 | | | | | | | | |||||||||||||||||||||||||||||||||
Eight years later |
22,469 | 21,609 | 22,077 | | | | | | | | | |||||||||||||||||||||||||||||||||
Nine years later |
23,156 | 21,986 | | | | | | | | | | |||||||||||||||||||||||||||||||||
Ten years later |
23,459 | | | | | | | | | | | |||||||||||||||||||||||||||||||||
Net reserves re-estimated
as of: |
||||||||||||||||||||||||||||||||||||||||||||
End of initial year |
$ | 25,512 | $ | 24,174 | $ | 23,675 | $ | 23,324 | $ | 20,759 | $ | 19,177 | $ | 17,946 | $ | 15,229 | $ | 17,437 | $ | 17,522 | $ | 20,256 | ||||||||||||||||||||||
One year later |
25,388 | 23,970 | 23,904 | 24,306 | 21,163 | 21,502 | 17,980 | 17,650 | 17,671 | 18,513 | | |||||||||||||||||||||||||||||||||
Two years later |
24,859 | 23,610 | 24,106 | 24,134 | 23,217 | 21,555 | 20,533 | 18,248 | 19,120 | | | |||||||||||||||||||||||||||||||||
Three years later |
24,363 | 23,735 | 23,776 | 26,038 | 23,081 | 24,058 | 21,109 | 19,814 | | | | |||||||||||||||||||||||||||||||||
Four years later |
24,597 | 23,417 | 25,067 | 25,711 | 25,590 | 24,587 | 22,547 | | | | | |||||||||||||||||||||||||||||||||
Five years later |
24,344 | 24,499 | 24,636 | 27,754 | 26,000 | 25,594 | | | | | | |||||||||||||||||||||||||||||||||
Six years later |
25,345 | 24,120 | 26,338 | 28,078 | 26,625 | | | | | | | |||||||||||||||||||||||||||||||||
Seven years later |
25,086 | 25,629 | 26,537 | 28,437 | | | | | | | | |||||||||||||||||||||||||||||||||
Eight years later |
26,475 | 25,813 | 26,770 | | | | | | | | | |||||||||||||||||||||||||||||||||
Nine years later |
26,618 | 26,072 | | | | | | | | | | |||||||||||||||||||||||||||||||||
Ten years later |
26,848 | | | | | | | | | | | |||||||||||||||||||||||||||||||||
Total net (deficiency)
redundancy |
$ | (1,336 | ) | $ | (1,898 | ) | $ | (3,095 | ) | $ | (5,113 | ) | $ | (5,866 | ) | $ | (6,417 | ) | $ | (4,601 | ) | $ | (4,585 | ) | $ | (1,683 | ) | $ | (991 | ) | $ | | ||||||||||||
Reconciliation to gross
re-estimated reserves: |
||||||||||||||||||||||||||||||||||||||||||||
Net reserves re-estimated |
$ | 26,848 | $ | 26,072 | $ | 26,770 | $ | 28,437 | $ | 26,625 | $ | 25,594 | $ | 22,547 | $ | 19,814 | $ | 19,120 | $ | 18,513 | $ | | ||||||||||||||||||||||
Re-estimated ceded
recoverable |
8,459 | 7,626 | 6,967 | 7,440 | 9,671 | 10,447 | 16,043 | 15,451 | 13,908 | 12,840 | | |||||||||||||||||||||||||||||||||
Total gross re-estimated
reserves |
$ | 35,307 | $ | 33,698 | $ | 33,737 | $ | 35,877 | $ | 36,296 | $ | 36,041 | $ | 38,590 | $ | 35,265 | $ | 33,028 | $ | 31,353 | $ | | ||||||||||||||||||||||
Net (deficiency)
redundancy related to: |
||||||||||||||||||||||||||||||||||||||||||||
Asbestos claims |
$ | (2,361 | ) | $ | (2,463 | ) | $ | (2,362 | ) | $ | (2,120 | ) | $ | (1,543 | ) | $ | (1,478 | ) | $ | (706 | ) | $ | (705 | ) | $ | (64 | ) | $ | (10 | ) | $ | | ||||||||||||
Environmental and mass
tort claims |
(802 | ) | (749 | ) | (776 | ) | (561 | ) | (663 | ) | (654 | ) | (193 | ) | (200 | ) | (52 | ) | (53 | ) | | |||||||||||||||||||||||
Total asbestos,
environmental and mass
tort |
(3,163 | ) | (3,212 | ) | (3,138 | ) | (2,681 | ) | (2,206 | ) | (2,132 | ) | (899 | ) | (905 | ) | (116 | ) | (63 | ) | | |||||||||||||||||||||||
Other claims |
1,827 | 1,314 | 43 | (2,432 | ) | (3,660 | ) | (4,285 | ) | (3,702 | ) | (3,680 | ) | (1,567 | ) | (928 | ) | | ||||||||||||||||||||||||||
Total net (deficiency)
redundancy |
$ | (1,336 | ) | $ | (1,898 | ) | $ | (3,095 | ) | $ | (5,113 | ) | $ | (5,866 | ) | $ | (6,417 | ) | $ | (4,601 | ) | $ | (4,585 | ) | $ | (1,683 | ) | $ | (991 | ) | $ | | ||||||||||||
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(a) | Includes gross reserves of $9,713 million and net reserves of $6,063 million for CIC and its insurance affiliates, which were acquired on May 10, 1995 (the Acquisition Date) and subsequent development thereon. | |
(b) | Ceded recoverable includes reserves transferred under retroactive reinsurance agreements of $784 million as of December 31, 1999. | |
(c) | Effective January 1, 2001, we established a new life insurance company, CNA Group Life Assurance Company (CNAGLA). Further, on January 1, 2001 approximately $1,055 million of reserves were transferred from CCC to CNAGLA. | |
(d) | Effective October 31, 2002, we sold CNA Reinsurance Company Limited (CNA Re U.K.). As a result of the sale, net reserves were reduced by approximately $1,316 million. |
The Company recorded loss reserve development of $991 million in 2005. Included in this
amount is $433 million related to commutations of significant finite reinsurance treaties. Loss
reserve development was also recorded related to the Companys assumed reinsurance operations which
are in run-off, workers compensation and excess workers compensation lines, primarily in accident
years 2003 and prior, the architects and engineers book of business, pollution exposures and large
directors and officers claims.
Additional information regarding our property and casualty claim and claim adjustment expense
reserves and reserve development is set forth in the MD&A included under Item 7 and in Notes A and
F of the Consolidated Financial Statements included under Item 8.
Investments
Information on our investments is set forth in the MD&A included under Item 7 and in Notes A, B, C
and D of the Consolidated Financial Statements included under Item 8.
Available Information
We file annual, quarterly and current reports, proxy statements and other documents with the
Securities and Exchange Commission (SEC) under the Securities Exchange Act of 1934 (Exchange Act).
The public may read and copy any materials that we file with the SEC at the SECs Public Reference
Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation
of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains an
Internet site that contains reports, proxy and information statements, and other information
regarding issuers, including CNA, that file electronically with the SEC. The public can obtain any
documents that we file with the SEC at http://www.sec.gov.
We also make available free of charge on or through our internet website (http://www.cna.com) our
Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and
amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange
Act as soon as reasonably practicable after we electronically file such material with, or furnish
it to, the SEC. Copies of these reports may also be obtained, free of charge, upon written request
to: CNA Financial Corporation, CNA Center, 43 South, Chicago, IL 60685, Attn. Jonathan D. Kantor,
Executive Vice President, General Counsel and Secretary.
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ITEM 1A. RISK FACTORS
Our business faces many risks. We have described below some of the more significant risks which we
face. There may be additional risks that we do not yet know of or that we do not currently
perceive to be significant that may also impact our business. Each of the risks and uncertainties
described below could lead to events or circumstances that have a material adverse effect on our
business, results of operations, financial condition or equity. You should carefully consider and
evaluate all of the information included in this Report and any subsequent reports we may file with
the Securities and Exchange Commission or make available to the public before investing in any
securities we issue.
If we determine that loss reserves are insufficient to cover our estimated ultimate unpaid
liability for claims, we may need to increase our loss reserves.
We maintain loss reserves to cover our estimated ultimate unpaid liability for claims and claim
adjustment expenses for reported and unreported claims and for future policy benefits. Reserves
represent our best estimate at a given point in time. Insurance reserves are not an exact
calculation of liability but instead are complex estimates derived by us, generally utilizing a
variety of reserve estimation techniques from numerous assumptions and expectations about future
events, many of which are highly uncertain, such as estimates of claims severity, frequency of
claims, mortality, morbidity, expected interest rates, inflation, claims handling, case reserving
policies and procedures, underwriting and pricing policies, changes in the legal and regulatory
environment and the lag time between the occurrence of an insured event and the time of its
ultimate settlement. Many of these uncertainties are not precisely quantifiable and require
significant judgment on our part. As trends in underlying claims develop, particularly in
so-called long tail or long duration coverages, we are sometimes required to add to our reserves.
This is called unfavorable development and results in a charge to our earnings in the amount of
the added reserves, recorded in the period the change in estimate is made. These charges can be
substantial and can have a material adverse effect on our results of operations and equity.
Additional information on our reserves is included in Managements Discussion and Analysis (MD&A)
under Item 7 and Note F to the Consolidated Financial Statements included under Item 8.
As industry practices and legal, judicial, social, and other environmental conditions change,
unexpected issues related to claims and coverage may emerge. These issues have had and may
continue to have a negative effect on our business by either extending coverage beyond our
underwriting intent or by increasing the number or size of claims, resulting in further increases
in our reserves which can have a material adverse effect on our results of operations and equity.
The effects of these and other unforeseen emerging claim and coverage issues are extremely hard to
predict. Recent examples of emerging claims and coverage issues include the following:
| increases in the number and size of claims relating to injuries from medical products and exposure to lead; | |
| the effects of accounting and financial reporting scandals and other major corporate governance failures which have resulted in an increase in the number and size of claims, including director and officer and errors and omissions insurance claims; | |
| increases in the volume of class action litigation challenging a range of industry practices including claims handling; | |
| increases in the number of construction defect claims, including claims for a broad range of additional insured endorsements on policies; and | |
| increases in the number of claims alleging abuse by members of the clergy, including passage of legislation to reopen or extend various statutes of limitations. |
In light of the many uncertainties associated with establishing the estimates and making the
assumptions necessary to establish reserve levels, we review and change our reserve estimates in a
regular and ongoing process as experience develops and further claims are reported and settled. In
addition, we periodically undergo state regulatory financial examinations, including review and
analysis of our reserves. If estimated reserves are insufficient for any reason, the required
increase in reserves would be recorded as a charge against our earnings for the period in which
reserves are determined to be insufficient. These charges can be substantial and can materially
adversely affect our results of operations and equity.
Loss reserves for asbestos, environmental pollution and mass torts are especially difficult to
estimate and may result in more frequent and larger additions to these reserves.
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Our experience has been that establishing reserves for casualty coverages relating to asbestos,
environmental pollution and mass tort (which we refer to as APMT) claim and claim adjustment
expenses is subject to uncertainties that are greater than those presented by other claims.
Estimating the ultimate cost of both reported and unreported asbestos, environmental pollution and
mass tort claims is subject to a higher degree of variability due to a number of additional factors
including, among others, the following:
| coverage issues including whether certain costs are covered under the policies and whether policy limits apply; | |
| inconsistent court decisions and developing legal theories; | |
| increasingly aggressive tactics of plaintiffs lawyers; | |
| the risks and lack of predictability inherent in major litigation; | |
| changes in the volume of asbestos, environmental pollution and mass tort claims which cannot now be anticipated; | |
| continued increases in mass tort claims relating to silica and silica-containing products; | |
| the impact of the exhaustion of primary limits and the resulting increase in claims on any umbrella or excess policies we have issued; | |
| the number and outcome of direct actions against us; | |
| our ability to recover reinsurance for these claims; and | |
| changes in the legal and legislative environment in which we operate. |
As a result of this higher degree of variability, we have necessarily supplemented traditional
actuarial methods and techniques with additional estimating techniques and methodologies, many of
which involve significant judgment on our part. Consequently, we may periodically need to record
changes in our claim and claim adjustment expense reserves in the future in these areas in amounts
that may be material. Additional information on APMT is included in MD&A under Item 7 and Note F
to the Consolidated Financial Statements included under Item 8.
Environmental pollution claims. The estimation of reserves for environmental pollution claims
is complicated by the assertion by many policyholders of claims for defense costs and
indemnification. We and others in the insurance industry are disputing coverage for many such
claims. Key coverage issues in these claims include the following:
| whether cleanup costs are considered damages under the policies (and accordingly whether we would be liable for these costs); | |
| the trigger of coverage and the allocation of liability among triggered policies; | |
| the applicability of pollution exclusions and owned property exclusions; | |
| the potential for joint and several liability; and | |
| the definition of an occurrence. |
To date, courts have been inconsistent in their rulings on these issues, thus adding to the
uncertainty of the outcome of many of these claims.
Further, the scope of federal and state statutes and regulations determining liability and
insurance coverage for environmental pollution liabilities have been the subject of extensive
litigation. In many cases, courts have expanded the scope of coverage and liability for cleanup
costs beyond the original intent of our insurance policies. Additionally, the standards for cleanup
in environmental pollution matters are unclear, the number of sites potentially subject to cleanup
under applicable laws is unknown, and the impact of various proposals to reform existing statutes
and regulations is difficult to predict.
Asbestos claims. The estimation of reserves for asbestos claims is particularly difficult for
many of the same reasons discussed above for environmental pollution claims, as well as the
following:
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| inconsistency of court decisions and jury attitudes, as well as future court decisions; | |
| specific policy provisions; | |
| allocation of liability among insurers and insureds; | |
| missing policies and proof of coverage; | |
| the proliferation of bankruptcy proceedings and attendant uncertainties; | |
| novel theories asserted by policyholders and their legal counsel; | |
| the targeting of a broader range of businesses and entities as defendants; | |
| uncertainties in predicting the number of future claims and which other insureds may be targeted in the future; | |
| volatility in claim numbers and settlement demands; | |
| increases in the number of non-impaired claimants and the extent to which they can be precluded from making claims; | |
| the efforts by insureds to obtain coverage that is not subject to aggregate limits; | |
| the long latency period between asbestos exposure and disease manifestation, as well as the resulting potential for involvement of multiple policy periods for individual claims; | |
| medical inflation trends; | |
| the mix of asbestos-related diseases presented; and | |
| the ability to recover reinsurance. |
In addition, a number of our insureds have asserted that their claims for insurance are not subject
to aggregate limits on coverage. If these insureds are successful in this regard, our potential
liability for their claims would be unlimited. Some of these insureds contend that their asbestos
claims fall within the so-called non-products liability coverage within their policies, rather
than the products liability coverage, and that this non-products liability coverage is not
subject to any aggregate limit. It is difficult to predict the extent to which these claims will
succeed and, as a result, the ultimate size of these claims.
Catastrophe losses are unpredictable.
Catastrophe losses are an inevitable part of our business. Various events can cause catastrophe
losses, including hurricanes, windstorms, earthquakes, hail, explosions, severe winter weather and
fires, and their frequency and severity are inherently unpredictable. For example, in 2005, we
experienced substantial losses from Hurricanes Katrina, Rita and Wilma and in 2004, we experienced
substantial losses from Hurricanes Charley, Frances, Ivan and Jeanne. These catastrophes are
unprecedented in modern times. The extent of losses from catastrophes is a function of both the
total amount of insured exposures in the affected areas and the severity of the events themselves.
In addition, as in the case of catastrophe losses generally, it can take a long time for the
ultimate cost to us to be finally determined. As our claim experience develops on a particular
catastrophe, we may be required to adjust our reserves, or take additional unfavorable development,
to reflect our revised estimates of the total cost of claims. We believe we could incur
significant catastrophe losses in the future. Additional information on catastrophe losses is
included in the MD&A under Item 7 and Note F to the Consolidated Financial Statements included
under Item 8.
Our key assumptions used to determine reserves and deferred acquisition costs for our long-term
care product offerings could vary significantly.
Our reserves and deferred acquisition costs for our long-term care product offerings are based on
certain key assumptions including morbidity, which is the frequency of illness, sickness and
diseases contracted, policy persistency, which is the percentage of policies remaining in force,
interest rates, future premium increases and future health care cost trends. If actual experience
differs from these assumptions, the deferred acquisition costs may not be fully recovered and the
reserves may not be adequate, requiring us to add to reserves, or take unfavorable development.
Therefore, our financial results could be adversely impacted.
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We continue to face exposure to losses arising from terrorist acts, despite the passage of the
Terrorism Risk Insurance Extension Act of 2005.
We may bear substantial losses from future acts of terrorism. The Terrorism Risk Insurance
Extension Act of 2005 (TRIEA) extended, until December 31, 2007, the program established by the
Terrorism Risk Insurance Act of 2002. Under this program, insurers are required to offer terrorism
insurance and the federal government will share the risk of loss by commercial property and
casualty insurers arising from future terrorist attacks. TRIEA does not provide complete
protection for future losses derived from acts of terrorism. Additional information on TRIEA is
included in the MD&A under Item 7.
High levels of retained overhead expenses associated with business lines in run-off negatively
impact our operating results.
During the past few years, we ceased offering certain insurance products relating principally to
our life, group and reinsurance segments. Many of these business lines were sold, others have been
placed in run-off and revenue will progressively decrease. Our results of operations have been
materially, adversely affected by the high levels of retained overhead expenses associated with
these run-off operations, and will continue to be so affected if we are not successful in
eliminating or reducing these costs.
Our premium writings and profitability are affected by the availability and cost of reinsurance.
We purchase reinsurance to help manage our exposure to risk. Under our reinsurance arrangements,
another insurer assumes a specified portion of our claim and claim adjustment expenses in exchange
for a specified portion of policy premiums. Market conditions determine the availability and cost
of the reinsurance protection we purchase, which affects the level of our business and
profitability, as well as the level and types of risk we retain. If we are unable to obtain
sufficient reinsurance at a cost we deem acceptable, we may be unwilling to bear the increased risk
and would reduce the level of our underwriting commitments. Additional information on Reinsurance
is included in the MD&A under Item 7 and Note H to the Consolidated Financial Statements included
Item 8.
We may not be able to collect amounts owed to us by reinsurers.
We have significant amounts recoverable from reinsurers which are reported as receivables in our
balance sheets and are estimated in a manner consistent with claim and claim adjustment expense
reserves or future policy benefits reserves. The ceding of insurance does not, however, discharge
our primary liability for claims. As a result, we are subject to credit risk relating to our
ability to recover amounts due from reinsurers. Certain of our reinsurance carriers have
experienced deteriorating financial conditions or have been downgraded by rating agencies. In
addition, reinsurers could dispute amounts which we believe are due to us. If we are not able to
collect the amounts due to us from reinsurers, our claims expenses will be higher which could
materially adversely affect our results of operations or equity. Additional information on
Reinsurance is included in the MD&A under Item 7 and Note H to the Consolidated Financial
Statements included under Item 8.
We incur significant interest expense related to funds withheld from reinsurance arrangements.
We have entered into several property and casualty reinsurance agreements where we retain the ceded
premium as collateral to secure the reinsurers obligations to pay for ceded losses. We are
required to credit interest on these funds withheld balances at specified rates for all periods
in which the funds withheld liability exists. In addition, certain of these reinsurance contracts
require us to pay interest on additional ceded premiums arising from ceded losses as if those
premiums were payable at the inception of the underlying contract. The amount subject to interest
crediting on these funds withheld contracts varies over time based on a number of factors including
the timing of loss payments and the ultimate gross losses incurred. We expect to incur significant
interest costs on these contracts for several years to come. In an effort to reduce future
interest charges, resolve a dispute or unwind an arrangement with a reinsurer that is experiencing
financial difficulties, from time to time, we commute or buy out reinsurance arrangements from
certain reinsurance carriers. Commutations can result in our incurring a significant charge in our
results of operations for the period in which the commutation takes place. Additional information
on reinsurance is included in the MD&A under Item 7 and Note H to the Consolidate Financial
Statements included under Item 8.
Rating agencies may downgrade their ratings of us and thereby adversely affect our ability to write
insurance at competitive rates or at all.
Ratings are an increasingly important factor in establishing the competitive position of insurance
companies. Our insurance company subsidiaries, as well as our public debt, are rated by four major
rating agencies, namely, A.M.
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Best Company, Inc., Standard & Poors Rating Services, Moodys Investors Service, Inc. and Fitch,
Inc. Ratings reflect the rating agencys opinions of an insurance companys financial strength,
operating performance, strategic position and ability to meet its obligations to policyholders and
debtholders. Agency ratings are not a recommendation to buy, sell or hold any security, and may be
revised or withdrawn at any time by the issuing organization. Each agencys rating should be
evaluated independently of any other agencys rating.
In the past several years, the major rating agencies have lowered our financial strength and debt
ratings and due to the intense competitive environment in which we operate, the uncertainty in
determining reserves and the potential for us to take material unfavorable development in the
future, and possible changes in the methodology or criteria applied by the rating agencies, the
rating agencies may take action to lower our ratings in the future. If our property and casualty
insurance financial strength ratings are downgraded below current levels, our business and results
of operations could be materially adversely affected. Among the adverse effects in the event of
such downgrades would be the inability to obtain a material volume of business from certain major
insurance brokers, the inability to sell a material volume of our insurance products to certain
markets, and the required collateralization of certain future payment obligations or reserves.
In addition, we believe that a lowering of the debt ratings of Loews Corporation by certain of the
rating agencies could result in an adverse impact on our ratings, independent of any change in
circumstances at CNA. Each of the major rating agencies that rates Loews currently maintains a
negative outlook. Additional information on our ratings is included in the MD&A under Item 7.
We are subject to extensive federal, state and local governmental regulations that
restrict our ability to do business and generate revenues.
The insurance industry is subject to comprehensive and detailed regulation and supervision
throughout the United States. Most insurance regulations are designed to protect the interests of
our policyholders rather than our investors. Each state in which we do business has established
supervisory agencies that regulate the manner in which we do business. Their regulations relate
to, among other things, the following:
| standards of solvency including risk-based capital measurements; | |
| restrictions on the nature, quality and concentration of investments; | |
| restrictions on our ability to withdraw from unprofitable lines of insurance; | |
| the required use of certain methods of accounting and reporting; | |
| the establishment of reserves for unearned premiums, losses and other purposes; | |
| potential assessments for funds necessary to settle covered claims against impaired, insolvent or failed insurance companies; | |
| licensing of insurers and agents; | |
| approval of policy forms; and | |
| limitations on the ability of our insurance subsidiaries to pay dividends to us. |
Regulatory powers also extend to premium rate regulations which require that rates not be
excessive, inadequate or unfairly discriminatory. The states in which we do business also require
us to provide coverage to persons whom we would not otherwise consider eligible. Each state
dictates the types of insurance and the level of coverage that must be provided to such involuntary
risks. Our share of these involuntary risks is mandatory and generally a function of our
respective share of the voluntary market by line of insurance in each state.
We are subject to capital adequacy requirements and, if we do not meet these requirements,
regulatory agencies may restrict or prohibit us from operating our business.
Insurance companies such as us are subject to risk-based capital standards set by state regulators
to help identify companies that merit further regulatory attention. These standards apply
specified risk factors to various asset, premium and reserve components of our statutory capital
and surplus reported in our statutory basis of accounting financial statements. Current rules
require companies to maintain statutory capital and surplus at a specified minimum level determined
using the risk-based capital formula. If we do not meet these minimum requirements, state
regulators may restrict or prohibit us from operating our business. If we are required to record a
charge against earnings in connection with a change in estimates or circumstances, such as
increasing our reserves in the future as a
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result of unexpectedly poor claims experience or recording realized losses due to impairment of our
investments, we may violate these minimum capital adequacy requirements unless we are able to raise
sufficient additional capital.
Our insurance subsidiaries, upon whom we depend for dividends and advances in order to fund our
working capital needs, are limited by state regulators in their ability to pay dividends.
We are a holding company and are dependent upon dividends, advances, loans and other sources of
cash from our subsidiaries in order to meet our obligations. Dividend payments, however, must be
approved by the subsidiaries domiciliary state departments of insurance and are generally limited
to amounts determined by formula which varies by state. The formula for the majority of the states
is the greater of 10% of the prior year statutory surplus or the prior year statutory net income,
less the aggregate of all dividends paid during the twelve months prior to the date of payment.
Some states, however, have an additional stipulation that dividends cannot exceed the prior years
earned surplus. If we are restricted, by regulatory rule or otherwise, from paying or receiving
inter-company dividends, we may not be able to fund our working capital needs and debt service
requirements from available cash. As a result, we would need to look to other sources of capital
which may be more expensive or may not be available at all.
We are responding to subpoenas, interrogatories and inquiries relating to insurance brokers and
agents, contingent commissions and bidding practices, and certain finite-risk insurance products.
Along with other companies in the industry, we have received subpoenas, interrogatories and
inquiries from: (i) California, Connecticut, Delaware, Florida, Hawaii, Illinois, Minnesota, New
Jersey, New York, North Carolina, Ohio, Pennsylvania, South Carolina, West Virginia and the
Canadian Council of Insurance Regulators concerning investigations into practices including
contingent compensation arrangements, fictitious quotes, and tying arrangements; (ii) the
Securities and Exchange Commission (SEC), the New York State Attorney General, the United States
Attorney for the Southern District of New York, the Connecticut Attorney General, the Connecticut
Department of Insurance, the Delaware Department of Insurance, the Georgia Office of Insurance and
Safety Fire Commissioner and the California Department of Insurance concerning reinsurance products
and finite insurance products purchased and sold by us; (iii) the Massachusetts Attorney General
and the Connecticut Attorney General concerning investigations into anti-competitive practices; and
(iv) the New York State Attorney General concerning declinations of attorney malpractice insurance.
We continue to respond to these subpoenas, interrogatories and inquiries.
Subsequent to receipt of the SEC subpoena, we have been producing documents and providing additional
information at the SECs request. In addition, the SEC and
representatives of the United States Attorneys Office for the Southern District of New York have been conducting interviews with several
of our current and former executives relating to the restatement of our financial results for 2004,
including our relationship with and accounting for transactions with an affiliate that were the
basis for the restatement. The SEC has also recently requested information relating to our current
restatement. It is possible that our analyses of, or accounting treatment for, finite reinsurance
contracts or discontinued operations could be questioned or disputed by regulatory authorities. As a result, further
restatements of our financial results are possible.
We have restated our financial results for prior years and identified material weaknesses in our
internal control over financial reporting.
In February of 2006 we determined that we would restate our annual financial statements for
the years 2001 through 2004, as well as our interim financial statements through September
30, 2005, to correct the accounting for discontinued operations acquired in our merger with
The Continental Corporation in 1995. Additionally, in March of 2006, we determined to
restate our financial results for prior years to correct classification errors within our
Consolidated Statements of Cash Flows. In May of 2005 we determined to restate our
financial results for prior years to correct our accounting for several reinsurance
contracts, primarily with a former affiliate, and to correct our equity accounting for that
affiliate.
As a result of the foregoing restatements, we identified material weaknesses in our internal
control over financial reporting as of December 31, 2005 and 2004, respectively, and
determined that our prior year financial statements could not be relied upon. We also
determined that our internal control over financial reporting as of such dates was not
effective. Our system of internal control over financial reporting is a process designed to
provide reasonable assurance to our management, Audit Committee and Board of Directors
regarding the reliability of our financial reporting and the preparation and fair
presentation of our published financial statements.
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If we fail to maintain effective internal control over financial reporting, we could be
scrutinized by regulators in a manner that extends beyond the SECs requests for information
relating to the restatements (as further described in the prior risk factor). We could also
be scrutinized by securities analysts and investors. As a result of this scrutiny, we could
suffer a loss of public confidence in our financial reporting capabilities and thereby face
adverse effects on our business and the market price of our securities.
Our investment portfolio, which is a key component of our overall profitability, may suffer reduced
returns or losses, especially with respect to our equity investments in limited partnerships which
are often subject to greater leverage and volatility.
Investment returns are an important part of our overall profitability. General economic
conditions, stock market conditions, fluctuations in interest rates, and many other factors beyond
our control can adversely affect the returns and the overall value of our equity investments and
our ability to control the timing of the realization of investment income. In addition, any
defaults in the payments due to us for our investments, especially with respect to liquid corporate
and municipal bonds, could reduce our investment income and realized investment gains or could
cause us to incur investment losses. Further, we invest a portion of our assets in equity
investments, primarily through limited partnerships, which are subject to greater volatility than
our fixed income investments. In some cases, these limited partnerships use leverage and are
thereby subject to even greater volatility. Although limited partnership investments generally
provide higher expected return, they present greater risk and are more illiquid than our fixed
income investments. As a result of these factors, we may not realize an adequate return on our
investments, may incur losses on sales of our investments and may be required to write down the
value of our investments.
We may be adversely affected by the cyclical nature of the property and casualty business.
The property and casualty market is cyclical and has experienced periods characterized by
relatively high levels of price competition, less restrictive underwriting standards and relatively
low premium rates, followed by periods of relatively lower levels of competition, more selective
underwriting standards and relatively high premium rates.
We face intense competition in our industry.
All aspects of the insurance industry are highly competitive and we must continuously allocate
resources to refine and improve our insurance products and services. Insurers compete on the basis
of factors including products, price, services, ratings and financial strength. We may lose
business to competitors offering competitive insurance products at lower prices. We compete with a
large number of stock and mutual insurance companies and other entities for both distributors and
customers. In addition, the Graham-Leach-Bliley Act of 1999 has encouraged growth in the number,
size and financial strength of our potential competitors by removing barriers that previously
prohibited holding companies from simultaneously owning commercial banks, insurers and securities
firms.
We may suffer losses from non-routine litigation and arbitration matters which may exceed the
reserves we have established.
We face substantial risks of litigation and arbitration beyond ordinary course claims and APMT
matters, which may contain assertions in excess of amounts covered by reserves that we have
established. These matters may be difficult to assess or quantify and may seek recovery of very
large or indeterminate amounts that include punitive or treble damages. Accordingly, unfavorable results in these
proceedings could have a material adverse impact on our results of operations.
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Additional information on litigation is included in the MD&A under Item 7 and Note G to the
Consolidated Financial Statements included under Item 8.
We are dependent on a small number of key executives and other key personnel to operate our
business successfully.
Our success substantially depends upon our ability to attract and retain high quality key
executives and other employees. We believe there are only a limited number of available qualified
executives in the business lines in which we compete. We rely substantially upon the services of
our executive officers to implement our business strategy. The loss of the services of any members
of our management team or the inability to attract and retain other talented personnel could impede
the implementation of our business strategies. We do not maintain key man life insurance policies
with respect to any of our employees.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2. PROPERTIES
CNA Center, owned by CAC, a wholly owned subsidiary of CCC, serves as our home office. Our
subsidiaries own or lease office space in various cities throughout the United States and in other
countries. The following table sets forth certain information with respect to our principal office
locations:
Amount (Square Feet) of Building | ||||||||
Owned and Occupied or Leased | ||||||||
Location |
and Occupied by CNA |
Principal Usage |
||||||
CNA Center, 333 S. Wabash, Chicago, Illinois |
904,990 | Principal executive offices of CNAF | ||||||
401 Penn Street, Reading, Pennsylvania |
171,406 | Property and casualty insurance offices | ||||||
2405 Lucien Way, Maitland, Florida |
150,825 | Property and casualty insurance offices | ||||||
40 Wall Street, New York, New York |
124,482 | Property and casualty insurance offices | ||||||
1111 E. Broad Street, Columbus, Ohio |
97,276 | Property and casualty insurance offices | ||||||
675 Placentia Avenue, Brea, California |
78,655 | Property and casualty insurance offices | ||||||
600 N. Pearl Street, Dallas, Texas |
76,666 | Property and casualty insurance offices | ||||||
405 Howard Street, San Francisco, California |
47,667 | Property and casualty insurance offices | ||||||
1100 Cornwall Road, Monmouth Junction, New
Jersey |
41,767 | Property and casualty insurance offices | ||||||
100 CNA Drive, Nashville, Tennessee |
35,653 | Property and casualty insurance offices |
We lease our office space described above except for the CNA Center, the Reading, Pennsylvania
building and the Columbus, Ohio building, which are owned. We consider that our properties are
generally in good condition, are well maintained and are suitable and adequate to carry on our
business.
ITEM 3. LEGAL PROCEEDINGS
Information on our legal proceedings is set forth in Notes F and G of the Consolidated Financial
Statements included under Item 8.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
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PART II
ITEM 5. MARKET FOR THE REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
PURCHASES OF EQUITY SECURITIES
Our common stock is listed on the New York Stock Exchange, the Chicago Stock Exchange and the
Pacific Exchange, and is traded on the Philadelphia Stock Exchange, under the symbol CNA.
As of February 28, 2006, we had 256,001,968 shares of common stock outstanding. Approximately 91%
of our outstanding common stock is owned by Loews. We had 2,183 stockholders of record as of
February 28, 2006 according to the records maintained by our transfer agent.
The table below shows the high and low closing sales prices for our common stock based on the New
York Stock Exchange Composite Transactions.
Common Stock Information
2005 |
2004 |
|||||||||||||||
High |
Low |
High |
Low |
|||||||||||||
Quarter: |
||||||||||||||||
Fourth |
$ | 34.91 | $ | 28.52 | $ | 27.06 | $ | 22.17 | ||||||||
Third |
30.46 | 28.40 | 29.54 | 23.98 | ||||||||||||
Second |
28.90 | 26.21 | 30.49 | 26.32 | ||||||||||||
First |
29.79 | 25.84 | 28.65 | 24.52 |
No dividends have been paid on our common stock in 2005 or 2004. Our ability to pay dividends
is limited by regulatory dividend restrictions on our principal operating insurance subsidiaries.
In addition, the provisions of our Series H Cumulative Preferred Issue (Series H Issue) prohibit
the payment of dividends on our common stock while accrued and unpaid dividends remain outstanding
on the Series H Issue. See the Liquidity and Capital Resources section under Item 7 of this MD&A
and Note L to the Consolidated Financial Statements included under Item 8 for additional
information.
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ITEM 6. SELECTED FINANCIAL DATA
The following table presents selected financial data.
Selected Financial Data
As
of and for the Years Ended December 31 |
2005 |
2004 |
2003 |
2002 |
2001 |
|||||||||||||||
(In millions, except per share data and ratios) | Restated (a) | Restated (a) | Restated (a) | Restated (a) | ||||||||||||||||
Results of Operations: |
||||||||||||||||||||
Revenues |
$ | 9,862 | $ | 9,924 | $ | 11,715 | $ | 12,293 | $ | 13,097 | ||||||||||
Income (loss) from continuing operations |
$ | 243 | $ | 446 | $ | (1,419 | ) | $ | 263 | $ | (1,550 | ) | ||||||||
Income (loss) from discontinued
operations, net of tax |
21 | (21 | ) | 2 | (43 | ) | 6 | |||||||||||||
Cumulative effects of changes in
accounting principles, net of tax |
| | | (57 | ) | (61 | ) | |||||||||||||
Net income (loss) |
$ | 264 | $ | 425 | $ | (1,417 | ) | $ | 163 | $ | (1,605 | ) | ||||||||
Earnings (loss) per Share: |
||||||||||||||||||||
Income (loss) from continuing operations |
$ | 0.68 | $ | 1.49 | $ | (6.52 | ) | $ | 1.18 | $ | (7.99 | ) | ||||||||
Income (loss) from discontinued
operations, net of tax |
0.08 | (0.09 | ) | 0.01 | (0.20 | ) | 0.04 | |||||||||||||
Cumulative effects of changes in
accounting principles, net of tax |
| | | (0.26 | ) | (0.32 | ) | |||||||||||||
Earnings (loss) per share available to
common stockholders |
$ | 0.76 | $ | 1.40 | $ | (6.51 | ) | $ | 0.72 | $ | (8.27 | ) | ||||||||
Financial Condition: |
||||||||||||||||||||
Total investments |
$ | 39,695 | $ | 39,231 | $ | 38,100 | $ | 35,293 | $ | 35,826 | ||||||||||
Total assets |
58,786 | 62,496 | 68,296 | 61,426 | 65,425 | |||||||||||||||
Insurance reserves |
42,436 | 43,653 | 45,494 | 40,250 | 43,721 | |||||||||||||||
Long and short term debt |
1,690 | 2,257 | 1,904 | 2,292 | 2,567 | |||||||||||||||
Stockholders equity |
8,950 | 8,974 | 8,735 | 9,139 | 7,839 | |||||||||||||||
Book value per share |
$ | 31.26 | $ | 31.63 | $ | 30.95 | $ | 37.51 | $ | 35.06 | ||||||||||
Statutory Surplus: |
||||||||||||||||||||
Property and casualty companies (b) |
$ | 6,940 | $ | 6,998 | $ | 6,170 | $ | 6,836 | $ | 6,241 | ||||||||||
Life and group insurance company(ies) |
627 | 1,177 | 707 | 1,645 | 1,752 |
(a) | See Note T of the Consolidated Financial Statements included under Item 8 for further discussion. | |
(b) | Surplus includes the property and casualty companies equity ownership of the life and group company(ies) capital and surplus. |
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ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
Overview
The following discussion should be read in conjunction with Item 1A. Risk Factors, Item 6. Selected
Financial Data and Item 8. Financial Statements and Supplementary Data of this Form 10-K.
We have restated our previously reported financial statements as of December 31, 2004 and for the
years ended December 31, 2004 and 2003 and all related disclosures, as well as our financial data
for the first three interim periods of 2005 and all interim periods of 2004. The restatement is to
correct the accounting for discontinued operations acquired in our merger with The Continental
Corporation in 1995 and to correct classification errors within our Consolidated Statements of Cash
Flows. A current review of discontinued operations identified an overstatement of the net assets
of these discontinued operations and errors in accounting for the periodic results of these
operations. This MD&A gives effect to the restatement of the Consolidated Financial Statements.
See Note T of the Consolidated Financial Statements included under Item 8 for further discussion.
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Index to this MD&A
Managements discussion and analysis of financial condition and results of operations is comprised
of the following sections:
Page No. |
||||
Consolidated Operations |
21 | |||
Net Prior Year Development |
23 | |||
Critical Accounting Estimates |
26 | |||
Reserves Estimates and Uncertainties |
28 | |||
Reinsurance |
30 | |||
Terrorism Insurance |
32 | |||
Restructuring |
32 | |||
Segment Results |
33 | |||
Standard Lines |
33 | |||
Specialty Lines |
37 | |||
Life and Group Non-Core |
40 | |||
Corporate and Other Non-Core |
41 | |||
Asbestos and Environmental Pollution and Mass Tort (APMT) Reserves |
43 | |||
Investments |
49 | |||
Net Investment Income |
49 | |||
Net Realized Investment Gains (Losses) |
51 | |||
Valuation and Impairment of Investments |
54 | |||
Liquidity and Capital Resources |
57 | |||
Cash Flows |
57 | |||
Commitments, Contingencies, and Guarantees |
58 | |||
Regulatory Matters |
59 | |||
Ratings |
60 | |||
Dividends from Subsidiaries |
61 | |||
Loews |
62 | |||
Accounting Pronouncements |
62 | |||
Forward-Looking Statements |
63 |
20
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CONSOLIDATED OPERATIONS
Results of Operations
The following table includes the consolidated results of our operations. For more detailed
components of our business operations and the net operating income financial measure, see the
segment discussions within this MD&A.
Consolidated Operations
Years ended December 31 (In millions, except per share data) |
2005 |
2004 |
2003 |
|||||||||
Revenues: |
||||||||||||
Net earned premiums |
$ | 7,569 | $ | 8,209 | $ | 9,216 | ||||||
Net investment income |
1,892 | 1,680 | 1,656 | |||||||||
Other revenues |
411 | 283 | 383 | |||||||||
Total operating revenues |
9,872 | 10,172 | 11,255 | |||||||||
Claims, Benefits and Expenses: |
||||||||||||
Net incurred claims and benefits |
6,975 | 6,434 | 10,163 | |||||||||
Policyholders dividends |
24 | 11 | 114 | |||||||||
Amortization of deferred acquisition costs |
1,543 | 1,680 | 1,965 | |||||||||
Other insurance related expenses |
829 | 969 | 1,411 | |||||||||
Other expenses |
329 | 326 | 393 | |||||||||
Total claims, benefits and expenses |
9,700 | 9,420 | 14,046 | |||||||||
Operating income (loss) before income tax and minority interest |
172 | 752 | (2,791 | ) | ||||||||
Income tax (expense) benefit on operating income (loss) |
105 | (126 | ) | 1,081 | ||||||||
Minority interest |
(24 | ) | (27 | ) | 6 | |||||||
Net operating income (loss) |
253 | 599 | (1,704 | ) | ||||||||
Realized investment gains (losses), net of participating policyholders and
minority interests |
(10 | ) | (248 | ) | 460 | |||||||
Income tax (expense) benefit on realized investment gains (losses) |
| 95 | (175 | ) | ||||||||
Income (loss) from continuing operations |
243 | 446 | (1,419 | ) | ||||||||
Income (loss) from discontinued operations, net of tax of $(2), $(1) and $(11) |
21 | (21 | ) | 2 | ||||||||
Net income (loss) |
$ | 264 | $ | 425 | $ | (1,417 | ) | |||||
Basic and Diluted Earnings (Loss) per Share: |
||||||||||||
Income (loss) from continuing operations |
$ | 0.68 | $ | 1.49 | $ | (6.52 | ) | |||||
Income (loss) from discontinued operations, net of tax |
0.08 | (0.09 | ) | 0.01 | ||||||||
Basic and diluted earnings (loss) per share available to common stockholders |
$ | 0.76 | $ | 1.40 | $ | (6.51 | ) | |||||
Weighted Average Outstanding Common Stock and Common Stock Equivalents |
256.0 | 256.0 | 227.0 | |||||||||
2005 Compared with 2004
Net income decreased $161 million in 2005 as compared with 2004, due to decreased net operating
income partially offset by improved net investment results.
Net operating income decreased $346 million in 2005 as compared with 2004. This decrease in net
operating income was primarily driven by increased unfavorable net prior year development of $437
million after-tax which includes the impact of significant commutations in 2005 and 2004, decreased
earned premiums, and increased catastrophe impacts in 2005. Partially offsetting these impacts
were increased net investment income, a $115 million after-tax benefit related to a federal income
tax settlement and release of federal income tax reserves, and lower insurance acquisition and
operating expenses. The Standard Lines and Specialty Lines segments
21
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produced a combined ratio of 110.0% and 100.5% for the years ended December 31, 2005 and 2004,
which included an 11.6% and 3.6% impact from significant commutations and catastrophes.
Unfavorable net prior year development of $807 million, including $945 million of unfavorable claim
and allocated claim adjustment expense reserve development and $138 million of favorable premium
development, was recorded in 2005. Unfavorable net prior year development of $134 million,
including $250 million of unfavorable claim and allocated claim adjustment expense reserve
development and $116 million of favorable premium development, was recorded in 2004.
During 2005 and 2004, we commuted several significant reinsurance contracts that resulted in
unfavorable development of $433 million and $76 million, which is included in the development
above, and which were partially offset by the release of previously established allowance for
uncollectible reinsurance. These commutations resulted in an unfavorable impact of $259 million
after-tax and favorable impact of $18 million after-tax in 2005 and 2004. These contracts
contained interest crediting provisions and maintenance charges. Interest charges associated with
the reinsurance contracts commuted were $47 million after-tax and $86 million after-tax in 2005 and
2004. There will be no further interest crediting charges or other charges related to these
commuted contracts in future periods.
Unfavorable net prior year development was also recorded related to the Companys assumed
reinsurance operations which are in run-off, workers compensation and excess workers compensation
lines, primarily in accident years 2003 and prior, the architects and engineers book of business,
pollution exposures and large directors and officers claims.
The impact of catastrophes was $334 million after-tax and $196 million after-tax in 2005 and 2004.
This increase was primarily due to 2005 catastrophe impacts resulting from Hurricanes Katrina,
Wilma, Rita, Dennis and Ophelia and 2004 catastrophe impacts primarily resulting from Hurricanes
Charley, Frances, Ivan and Jeanne. These impacts are net of anticipated reinsurance recoveries,
and include the effect of reinstatement premiums and estimated insurance assessments.
Net realized investment results, after-tax, improved $143 million in 2005 as compared with 2004.
Net results in 2004 included a loss on the sale of the individual life insurance business of $389
million after-tax, which was partly offset by the 2004 gain of $105 million after-tax on the sale
of our investment in Canary Wharf Group PLC (Canary Wharf), a London-based real estate company.
Net earned premiums decreased $640 million in 2005 as compared with 2004. Net earned premiums from
the core property and casualty operations decreased by $309 million, as discussed in more detail in
the segment discussions below. The remainder of the decrease in earned premiums was primarily due
to the sale of the individual life business on April 30, 2004, as well as decreased premiums from
CNA Re which exited the reinsurance market in 2003.
Income from discontinued operations increased $42 million in 2005 as compared to 2004, primarily
due to a decrease in unfavorable net prior year development, including the effects of commutations
of assumed and ceded reinsurance, increased foreign exchange gains and improved investment results
primarily related to realized investment gains.
2004 Compared with 2003
Net results increased $1,842 million in 2004 as compared to 2003, due to increased net operating
income partially offset by decreased net realized investment results. Net operating results
increased $2,303 million in 2004 as compared with 2003. This improvement was due principally to
decreased net unfavorable prior year development of $1,757 million after-tax, $356 million
after-tax decrease in the bad debt provisions for insurance and reinsurance receivables, $66
million after-tax decrease in interest expense related to additional cessions to corporate
aggregate reinsurance treaties and $59 million after-tax decrease in certain insurance related
assessments. These favorable impacts to net income in 2004 were partially offset by increased
catastrophe losses and decreased net realized investment results. The impact of catastrophes was
$196 million after-tax and $93 million after-tax in 2004 and 2003. This increase was primarily due
to catastrophe impacts resulting from Hurricanes Charley, Frances, Ivan and Jeanne in 2004. These
impacts are net of anticipated reinsurance recoveries, and include the effect of reinstatement
premiums and estimated insurance assessments. The Standard Lines and Specialty Lines segments
produced a combined ratio of 100.5% and 150.5% for the years ended December 31, 2004 and 2003.
Unfavorable net prior year development of $134 million, including $250 million of unfavorable claim
and allocated claim adjustment expense reserve development and $116 million of favorable premium
development, was recorded
22
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in 2004. Unfavorable net prior year development of $2,837 million, including $2,296 million of
unfavorable claim and allocated claim adjustment expense reserve development and $541 million of
unfavorable premium development, was recorded in 2003.
Net realized investment results decreased $438 million after-tax in 2004 as compared with 2003.
This decrease in investment results was primarily due to the loss on the sale of the individual
life insurance business of $389 million after-tax and losses on derivatives of $55 million
after-tax. These decreases were partly offset by a $105 million after-tax gain on the sale of our
investment in Canary Wharf, and a reduction in impairment losses for other-than-temporary declines
in market values for fixed maturity and equity securities. Impairment losses of $60 million
after-tax were recorded in 2004 across various sectors, including an after-tax impairment loss of
$36 million related to loans made under a credit facility to a national contractor, while in 2003
impairment losses of $209 million after-tax were recorded across various sectors including the
airline, healthcare and energy industries.
Net earned premiums decreased $1,007 million in 2004 as compared with 2003. The decrease in net
earned premiums was due primarily to reduced premiums from the individual life and group benefits
businesses, as well as CNA Re. Partially offsetting these unfavorable impacts was a $357 million
decrease in premiums ceded to corporate aggregate and other reinsurance treaties in 2004 as
compared to 2003. The 2003 cessions were principally due to the unfavorable net prior year
development recorded in 2003.
Income from discontinued operations decreased $23 million in 2004 as compared to 2003, primarily
due to an increase in unfavorable net prior year development, including the effects of commutations
of assumed and ceded reinsurance and decreased investment results primarily related to realized
investment losses, partially offset by a reduction in expenses and foreign exchange losses.
Net Prior Year Development
The results of operations for the years ended December 31, 2005, 2004 and 2003 were impacted by net
prior year development recorded for the property and casualty and the Corporate and Other Non-Core
segments. Changes in estimates of claim and allocated claim adjustment expense reserves and
premium accruals for prior accident years are defined as net prior year development within this
MD&A. These changes can be favorable or unfavorable. The development discussed below excludes the
impact of the provision for uncollectible reinsurance, but includes the impact of commutations.
See Note H to the Consolidated Financial Statements included under Item 8.
We record favorable or unfavorable premium and claim and allocated claim adjustment expense reserve
development related to the corporate aggregate reinsurance treaties as movements in the claim and
allocated claim adjustment expense reserves for the accident years covered by the corporate
aggregate reinsurance treaties indicate such development is required. While the available limit of
these treaties was fully utilized in 2003, the ceded premiums and losses for an individual segment
may change in subsequent years because of the re-estimation of the subject losses or commutations
of the underlying contracts. In 2005, we commuted a corporate aggregate reinsurance treaty. See
Note H of the Consolidated Financial Statements for further discussion of the corporate aggregate
reinsurance treaties.
23
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The following tables summarize net prior year development by segment for the property and casualty
segments and the Corporate and Other Non-Core segment for the years ended December 31, 2005, 2004
and 2003. For the Life and Group Non-Core segment $5 million and $7 million of favorable
development was recorded in 2005 and 2004, and $62 million of unfavorable development was recorded
in 2003.
2005 Net Prior Year Development
Corporate | ||||||||||||||||
Standard | Specialty | and Other | ||||||||||||||
Lines | Lines | Non-Core | Total | |||||||||||||
(In millions) | ||||||||||||||||
Pretax unfavorable net prior year claim and allocated
claim adjustment expense development excluding the impact
of corporate aggregate reinsurance treaties: |
||||||||||||||||
Core (Non-APMT) |
$ | 376 | $ | 42 | $ | 171 | $ | 589 | ||||||||
APMT |
| | 63 | 63 | ||||||||||||
Total |
376 | 42 | 234 | 652 | ||||||||||||
Ceded losses related to corporate aggregate
reinsurance treaties |
183 | 5 | 57 | 245 | ||||||||||||
Pretax unfavorable net prior year development before
impact of premium development |
559 | 47 | 291 | 897 | ||||||||||||
Unfavorable (favorable) premium development,
excluding impact of corporate aggregate reinsurance
treaties |
(101 | ) | (12 | ) | 11 | (102 | ) | |||||||||
Ceded premiums related to corporate aggregate
reinsurance treaties |
(6 | ) | 19 | 4 | 17 | |||||||||||
Total premium development |
(107 | ) | 7 | 15 | (85 | ) | ||||||||||
Total 2005 unfavorable net prior year development (pretax) |
$ | 452 | $ | 54 | $ | 306 | $ | 812 | ||||||||
Total 2005 unfavorable net prior year development
(after-tax) |
$ | 294 | $ | 35 | $ | 199 | $ | 528 | ||||||||
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2004 Net Prior Year Development
Corporate | ||||||||||||||||
Standard | Specialty | and Other | ||||||||||||||
(In millions) | Lines |
Lines |
Non-Core |
Total |
||||||||||||
Pretax unfavorable net prior
year claim and allocated claim
adjustment expense development
excluding the impact of
corporate aggregate
reinsurance treaties: |
||||||||||||||||
Core (Non-APMT) |
$ | 107 | $ | 75 | $ | 20 | $ | 202 | ||||||||
APMT |
| | 55 | 55 | ||||||||||||
Total |
107 | 75 | 75 | 257 | ||||||||||||
Ceded losses related to
corporate aggregate
reinsurance treaties |
8 | (17 | ) | 9 | | |||||||||||
Pretax unfavorable net prior
year development before impact
of premium development |
115 | 58 | 84 | 257 | ||||||||||||
Unfavorable (favorable)
premium development,
excluding impact of
corporate aggregate
reinsurance treaties |
(96 | ) | (33 | ) | 12 | (117 | ) | |||||||||
Ceded premiums related
to corporate aggregate
reinsurance treaties |
(1 | ) | 5 | (3 | ) | 1 | ||||||||||
Total premium development |
(97 | ) | (28 | ) | 9 | (116 | ) | |||||||||
Total 2004 unfavorable net
prior year development
(pretax) |
$ | 18 | $ | 30 | $ | 93 | $ | 141 | ||||||||
Total 2004 unfavorable net
prior year development
(after-tax) |
$ | 12 | $ | 20 | $ | 60 | $ | 92 | ||||||||
2003 Net Prior Year Development
Corporate | ||||||||||||||||
Standard | Specialty | and Other | ||||||||||||||
Lines | Lines | Non-Core | Total | |||||||||||||
(In millions) | ||||||||||||||||
Pretax unfavorable net prior year claim and allocated
claim adjustment expense development excluding the impact
of corporate aggregate reinsurance treaties: |
||||||||||||||||
Core (Non-APMT) |
$ | 1,423 | $ | 313 | $ | 346 | $ | 2,082 | ||||||||
APMT |
| | 795 | 795 | ||||||||||||
Total |
1,423 | 313 | 1,141 | 2,877 | ||||||||||||
Ceded losses related to corporate aggregate
reinsurance treaties |
(485 | ) | (56 | ) | (102 | ) | (643 | ) | ||||||||
Pretax unfavorable net prior year development before
impact of premium development |
938 | 257 | 1,039 | 2,234 | ||||||||||||
Unfavorable (favorable) premium development,
excluding impact of corporate aggregate reinsurance
treaties |
209 | 6 | (32 | ) | 183 | |||||||||||
Ceded premiums related to corporate aggregate
reinsurance treaties |
269 | 31 | 58 | 358 | ||||||||||||
Total premium development |
478 | 37 | 26 | 541 | ||||||||||||
Total 2003 unfavorable net prior year development (pretax) |
$ | 1,416 | $ | 294 | $ | 1,065 | $ | 2,775 | ||||||||
Total 2003 unfavorable net prior year development
(after-tax) |
$ | 920 | $ | 191 | $ | 692 | $ | 1,803 | ||||||||
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Critical Accounting Estimates
The preparation of the consolidated financial statements in conformity with accounting principles
generally accepted in the United States of America (GAAP) requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and the disclosure of
contingent assets and liabilities at the date of the consolidated financial statements and the
amounts of revenues and expenses reported during the period. Actual results may differ from those
estimates.
Our Consolidated Financial Statements and accompanying notes have been prepared in accordance with
GAAP applied on a consistent basis. We continually evaluate the accounting policies and estimates
used to prepare the Consolidated Financial Statements. In general, our estimates are based on
historical experience, evaluation of current trends, information from third party professionals and
various other assumptions that are believed to be reasonable under the known facts and
circumstances.
The accounting estimates discussed below are considered by us to be critical to an understanding of
our Consolidated Financial Statements as their application places the most significant demands on
our judgment. Note A of the Consolidated Financial Statements included under Item 8 should be read
in conjunction with this section to assist with obtaining an understanding of the underlying
accounting policies related to these estimates. Due to the inherent uncertainties involved with
these types of judgments, actual results could differ significantly from estimates and may have a
material adverse impact on our results of operations or equity.
Insurance Reserves
Insurance reserves are established for both short and long-duration insurance contracts.
Short-duration contracts are primarily related to property and casualty insurance policies where
the reserving process is based on actuarial estimates of the amount of loss, including amounts for
known and unknown claims. Long-duration contracts typically include traditional life insurance and
long term care products and are estimated using actuarial estimates about mortality and morbidity,
as well as assumptions about expected investment returns. Workers compensation lifetime claim
reserves and accident and health claim reserves are calculated using mortality and morbidity
assumptions based on our own and industry experience, and are discounted at interest rates that
range from 3.5% to 6.5% at December 31, 2005 and 2004. The reserve for unearned premiums on
property and casualty and accident and health contracts represents the portion of premiums written
related to the unexpired terms of coverage. The inherent risks associated with the reserving
process are discussed in the Reserves Estimates and Uncertainties section below.
Reinsurance
Amounts recoverable from reinsurers are estimated in a manner consistent with claim and claim
adjustment expense reserves or future policy benefits reserves and are reported as receivables in
the Consolidated Balance Sheets. The ceding of insurance does not discharge us of our primary
liability under insurance contracts written by us. An exposure exists with respect to property and
casualty and life reinsurance ceded to the extent that any reinsurer is unable to meet its
obligations or disputes the liabilities assumed under reinsurance agreements. An estimated
allowance for doubtful accounts is recorded on the basis of periodic evaluations of balances due
from reinsurers, reinsurer solvency, our past experience and current economic conditions.
Reinsurance accounting allows for contractual cash flows to be reflected as premiums and losses, as
compared to deposit accounting, which requires cash flows to be reflected as assets and
liabilities. To qualify for reinsurance accounting, reinsurance agreements must include risk
transfer. Considerable judgment by management may be necessary to determine if risk transfer
requirements are met. We believe we have appropriately applied reinsurance accounting principles
in our evaluation of risk transfer. However, our evaluation of risk transfer and the resulting
accounting could be challenged in connection with regulatory reviews or possible changes in
accounting and/or financial reporting rules related to reinsurance, which could materially
adversely affect our results of operations and/or equity. Further information on our reinsurance
program is included in the Reinsurance section below and Note H of the Consolidated Financial
Statements included under Item 8.
26
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Valuation of Investments and Impairment of Securities
Invested assets are exposed to various risks, such as interest rate, market and credit risks. Due
to the level of risk associated with certain invested assets and the level of uncertainty related
to changes in the value of these assets, it is possible that changes in risks in the near term
could have an adverse material impact on our results of operations or equity.
Our investment portfolio is subject to market declines below book value that may be
other-than-temporary. We have an Impairment Committee, which reviews the investment portfolio on a
quarterly basis, with ongoing analysis as new information becomes available. Any decline that is
determined to be other-than-temporary is recorded as an impairment loss in the results of
operations in the period in which the determination occurred. Further information on our process
for evaluating impairments is included in Note B of the Consolidated Financial Statements included
under Item 8.
Long Term Care Products
Reserves and deferred acquisition costs for our long term care products are based on certain
assumptions including morbidity, policy persistency and interest rates. Actual experience may
differ from our assumptions. The recoverability of deferred acquisition costs and the adequacy of
the reserves are contingent on actual experience related to these key assumptions and other factors
including potential future premium increases and future health care cost trends. Our results of
operations and/or equity may be materially, adversely affected if actual experience varies
significantly from our assumptions.
Pension and Postretirement Benefit Obligations
We make a significant number of assumptions in estimating the liabilities and costs related to our
pension and postretirement benefit obligations to employees under our benefit plans. The
assumptions that most impact these costs are the discount rate, the expected return on plan assets
and the rate of compensation increases. These assumptions are evaluated relative to current market
factors such as inflation, interest rates and fiscal and monetary policies. Changes in these
assumptions can have a material impact on pension obligations and pension expense.
In determining the discount rate assumption, we utilized current market information provided by our
plan actuaries, including a discounted cash flow analysis of our pension and postretirement
obligations and general movements in the current market environment. In particular, the basis for
our discount rate selection was fixed income debt securities that receive one of the two highest
ratings given by a recognized ratings agency. In 2005 and historically, the Moodys Aa Corporate
Bond Index was the benchmark for discount rate selection. The index is used as the basis for the
change in discount rate from the last measurement date. Additionally in 2005, we supplemented our
discount rate decision with a yield curve analysis. The yield curve was applied to expected future
retirement plan payments to adjust the discount rate to reflect the cash flow characteristics of
the plans. The yield curve was developed by the plans actuaries and is a hypothetical double A
yield curve represented by a series of annualized discount rates reflecting bond issues having a
rating of Aa or better by Moodys Investors Service, Inc. or a rating of AA or better by Standard &
Poors. Based on all available information, it was determined that 5.625% and 5.50% were the
appropriate discount rates as of December 31, 2005 to calculate our accrued pension and
postretirement liabilities, respectively. Accordingly, the 5.625% and 5.50% rates will also be
used to determine our 2006 pension and postretirement expense. At December 31, 2004 the discount
rate was 5.875% for both pension and postretirement liabilities.
Further information on our pension and postretirement benefit obligations is included in Note J of
the Consolidated Financial Statements included under Item 8.
Legal Proceedings
We are involved in various legal proceedings that have arisen during the ordinary course of
business. We evaluate the facts and circumstances of each situation, and when we determine it is
necessary, a liability is estimated and recorded. Further information on our legal proceedings and
related contingent liabilities is provided in Notes F and G of the Consolidated Financial
Statements included under Item 8.
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Reserves Estimates and Uncertainties
We maintain reserves to cover our estimated ultimate unpaid liability for claim and claim
adjustment expenses, including the estimated cost of the claims adjudication process, for claims
that have been reported but not yet settled (case reserves) and claims that have been incurred but
not reported (IBNR). Claim and claim adjustment expense reserves are reflected as liabilities and
are included on the Consolidated Balance Sheets under the heading Insurance Reserves.
Adjustments to prior year reserve estimates, if necessary, are reflected in the results of
operations in the period that the need for such adjustments is determined. The carried case and
IBNR reserves are provided in the Segment Results section of this MD&A and in Note F of the
Consolidated Financial Statements included under Item 8.
The level of reserves we maintain represents our best estimate, as of a particular point in time,
of what the ultimate settlement and administration of claims will cost based on our assessment of
facts and circumstances known at that time. Reserves are not an exact calculation of liability but
instead are complex estimates that we derive, generally utilizing a variety of actuarial reserve
estimation techniques, from numerous assumptions and expectations about future events, both
internal and external, many of which are highly uncertain.
Among the many uncertain future events about which we make assumptions and estimates, many of which
have become increasingly unpredictable, are claims severity, frequency of claims, mortality,
morbidity, expected interest rates, inflation, claims handling and case reserving policies and
procedures, underwriting and pricing policies, changes in the legal and regulatory environment and
the lag time between the occurrence of an insured event and the time it is ultimately settled,
referred to in the insurance industry as the tail. These factors must be individually considered
in relation to our evaluation of each type of business. Many of these uncertainties are not
precisely quantifiable, particularly on a prospective basis, and require significant judgment on
our part.
Given the factors described above, it is not possible to quantify precisely the ultimate exposure
represented by claims and related litigation. As a result, we regularly review the adequacy of our
reserves and reassess our reserve estimates as historical loss experience develops, additional
claims are reported and settled and additional information becomes available in subsequent periods.
In addition, we are subject to the uncertain effects of emerging or potential claims and coverage
issues that arise as industry practices and legal, judicial, social and other environmental
conditions change. These issues have had, and may continue to have, a negative effect on our
business by either extending coverage beyond the original underwriting intent or by increasing the
number or size of claims. Examples of emerging or potential claims and coverage issues include:
| increases in the number and size of claims relating to injuries from medical products, and exposure to lead; | |
| the effects of accounting and financial reporting scandals and other major corporate governance failures, which have resulted in an increase in the number and size of claims, including director and officer and errors and omissions insurance claims; | |
| class action litigation relating to claims handling and other practices; | |
| construction defect claims, including claims for a broad range of additional insured endorsements on policies; and | |
| increases in the number of claims alleging abuse by members of the clergy, including passage of legislation to reopen or extend various statutes of limitations. |
The impact of these and other unforeseen emerging or potential claims and coverage issues is
difficult to predict and could materially adversely affect the adequacy of our claim and claim
adjustment expense reserves and could lead to future reserve additions. See the Segment Results
sections of this MD&A and Note F of the Consolidated Financial Statements included under Item 8 for
a discussion of changes in reserve estimates and the impact on our results of operations.
Our experience has been that establishing reserves for casualty coverages relating to asbestos,
environmental pollution and mass tort (APMT) claim and claim adjustment expenses is subject to
uncertainties that are greater than those presented by other claims. Estimating the ultimate cost
of both reported and unreported APMT claims is subject to a higher degree of variability due to a
number of additional factors, including among others:
| coverage issues, including whether certain costs are covered under the policies and whether policy limits apply; |
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| inconsistent court decisions and developing legal theories; | |
| increasingly aggressive tactics of plaintiffs lawyers; | |
| the risks and lack of predictability inherent in major litigation; | |
| changes in the volume of asbestos and environmental pollution and mass tort claims which cannot now be anticipated; | |
| continued increase in mass tort claims relating to silica and silica-containing products; | |
| the impact of the exhaustion of primary limits and the resulting increase in claims on any umbrella or excess policies we have issued; | |
| the number and outcome of direct actions against us; and | |
| our ability to recover reinsurance for asbestos and environmental pollution and mass tort claims. |
It is also not possible to predict changes in the legal and legislative environment and the impact
on the future development of APMT claims. This development will be affected by future court
decisions and interpretations, as well as changes in applicable legislation. It is difficult to
predict the ultimate outcome of large coverage disputes until settlement negotiations near
completion and significant legal questions are resolved or, failing settlement, until the dispute
is adjudicated. This is particularly the case with policyholders in bankruptcy where negotiations
often involve a large number of claimants and other parties and require court approval to be
effective. A further uncertainty exists as to whether a national privately financed trust to
replace litigation of asbestos claims with payments to claimants from the trust will be established
and approved through federal legislation, and, if established and approved, whether it will contain
funding requirements in excess of our carried loss reserves.
Traditional actuarial methods and techniques employed to estimate the ultimate cost of claims for
more traditional property and casualty exposures are less precise in estimating claim and claim
adjustment reserves for APMT, particularly in an environment of emerging or potential claims and
coverage issues that arise from industry practices and legal, judicial and social conditions.
Therefore, these traditional actuarial methods and techniques are necessarily supplemented with
additional estimation techniques and methodologies, many of which involve significant judgments
that are required of management. Due to the inherent uncertainties in estimating reserves for APMT
claim and claim adjustment expenses and the degree of variability due to, among other things, the
factors described above, we may be required to record material changes in our claim and claim
adjustment expense reserves in the future, should new information become available or other
developments emerge. See the Asbestos and Environmental Pollution and Mass Tort Reserves section
of this MD&A and Note F of the Consolidated Financial Statements included under Item 8 for
additional information relating to APMT claims and reserves.
Our recorded reserves, including APMT reserves, reflect our best estimate as of a particular point
in time based upon known facts, current law and our judgment. The reserve analyses performed by
our actuaries result in point estimates. We use these point estimates as the primary factor in
determining the carried reserve. The carried reserve may differ from the actuarial point estimate
as the result of our consideration of the factors noted above including, but not limited to, the
potential volatility of the projections associated with the specific product being analyzed and the
effects of changes in claims handling, underwriting and other factors impacting claims costs that
may not be quantifiable through actuarial analysis. For APMT reserves, the reserve analysis
performed by our actuaries results in both a point estimate and a range. We use the point estimate
as the primary factor in determining the carried reserve but also consider the range given the
volatility of APMT exposures, as noted above.
For Standard Lines, the December 31, 2005 carried net claim and claim adjustment expense reserve is
slightly higher than the actuarial point estimate. For Specialty Lines, the December 31, 2005
carried net claim and claim adjustment expense reserve is also slightly higher than the actuarial
point estimate. For both Standard Lines and Specialty Lines, the difference is primarily due to
the 2005 accident year. The data from the current accident year is very immature from a claim and
claim adjustment expense point of view so it is prudent to wait until experience confirms that the
loss ratios should be adjusted. For Corporate and Other Non-Core, the December 31, 2005 carried
net claim and claim adjustment expense reserve is slightly higher than the actuarial point
estimate. While the actuarial estimates for APMT exposures reflect current knowledge, we feel it
is prudent, based on the history of developments in this area, to reflect some volatility in the
carried reserve until the ultimate outcome of the issues associated with these exposures is
clearer.
In light of the many uncertainties associated with establishing the estimates and making the
assumptions necessary to establish reserve levels, we review our reserve estimates on a regular
basis and make adjustments in the period
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that the need for such adjustments is determined (see Net Prior Year Development above). These
reviews have resulted in our identification of information and trends that have caused us to
increase our reserves in prior periods and could lead to the identification of a need for
additional material increases in claim and claim adjustment expense reserves, which could
materially adversely affect our results of operations, equity, business and insurer financial
strength and debt ratings (see the Ratings section of this MD&A).
The following table presents estimated volatility in carried claim and claim adjustment expense
reserves for the Standard Lines, Specialty Lines and Corporate and Other Non-Core segments. In
addition to the gross carried loss reserves presented below, Claim and Claim Adjustment Expenses as
reflected on the Consolidated Balance Sheet include $3,277 million at December 31, 2005, related to
the Life and Group Non-Core segment.
Estimated Volatility in Gross Carried Loss Reserves by Segment
Gross | ||||||||
Carried | Estimated | |||||||
Loss | Volatility in | |||||||
December 31, 2005 (In millions) |
Reserves |
Reserves |
||||||
Standard Lines |
$ | 15,084 | +/- 7 | % | ||||
Specialty Lines |
5,205 | +/- 7 | % | |||||
Corporate and Other Non-Core |
7,372 | +/- 25 | % |
The estimated volatility noted above does not represent an actuarial range around our gross
loss reserves, and it does not represent the range of all possible outcomes. The volatility
represents an estimate of the inherent volatility associated with estimating loss reserves for the
specific type of business written by each segment, and along with the associated reserve balances,
allows for the quantification of potential earnings impacts in future reporting periods. The
primary characteristics influencing the estimated level of volatility are the length of the claim
settlement period, the potential for changes in medical and other claim costs, changes in the level
of litigation or other dispute resolution processes, changes in the legal environment and the
potential for different types of injuries emerging. Ceded reinsurance arrangements may reduce the
volatility. Since ceded reinsurance arrangements vary by year, volatility in gross reserves may
not result in comparable impacts to net income or stockholders equity.
Reinsurance
We cede insurance to reinsurers to limit our maximum loss, provide greater diversification of risk,
minimize exposures on larger risks and to exit certain lines of business. The ceding of insurance
does not discharge our primary liabilities. Therefore, a credit exposure exists with respect to
property and casualty and life reinsurance ceded to the extent that any reinsurer is unable to meet
the obligations or to the extent that the reinsurer disputes the liabilities assumed under
reinsurance agreements. Property and casualty reinsurance coverages are tailored to the specific
risk characteristics of each product line and our retained amount varies by type of coverage.
Reinsurance contracts are purchased to protect specific lines of business such as property, workers
compensation and professional liability. Corporate catastrophe reinsurance is also purchased for
property and workers compensation exposure. Most reinsurance contracts are purchased on an excess
of loss basis. We also utilize facultative reinsurance in certain lines. In addition, we assume
reinsurance as members of various reinsurance pools and associations.
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The following table summarizes the amounts receivable from reinsurers at December 31, 2005 and
2004.
Components of reinsurance receivables (In millions) |
December 31, 2005 |
December 31, 2004 |
||||||
Reinsurance receivables related to insurance reserves: |
||||||||
Ceded claim and claim adjustment expense |
$ | 10,605 | $ | 13,879 | ||||
Ceded future policy benefits |
1,193 | 1,260 | ||||||
Ceded policyholders funds |
56 | 65 | ||||||
Billed reinsurance receivables |
582 | 684 | ||||||
Reinsurance receivables |
12,436 | 15,888 | ||||||
Allowance for uncollectible reinsurance |
(519 | ) | (546 | ) | ||||
Reinsurance receivables, net of allowance
for uncollectible reinsurance |
$ | 11,917 | $ | 15,342 | ||||
We attempt to mitigate our credit risk related to reinsurance by entering into reinsurance
arrangements with reinsurers that have credit ratings above certain levels and by obtaining
substantial amounts of collateral. The primary methods of obtaining collateral are through
reinsurance trusts, letters of credit and funds withheld balances. Such collateral was
approximately $4,277 million and $6,231 million at December 31, 2005 and 2004. Additionally, we
may enter into reinsurance agreements with reinsurers that are not rated.
During 2005, we sustained catastrophe losses related to Hurricanes Katrina, Rita and Wilma. We
ceded $429 million of these losses to our corporate catastrophe programs. This reinsurance
protection cost us premiums of approximately $64 million, which included reinstatement premiums of
approximately $27 million. The cost of our 2006 corporate catastrophe reinsurance programs will be
approximately $82 million before the impacts of any reinstatement premiums.
The terms of our 2006 programs are different than those of our 2005 programs. The Corporate
Property Catastrophe treaty provides coverage for the accumulation of losses between $200 million
and $700 million arising out of a single catastrophe occurrence in the United States, its
territories and possessions, and Canada. Our co-participation is 25% of the first $125 million
layer and 10% in all remaining layers. Our Marine treaty provides $65 million of protection above
a $20 million retention on the accumulation of losses arising out of a single catastrophe
occurrence.
In addition to these reinsurance treaties, our exposure to aggregation of certain catastrophe
events is further mitigated by an Aggregate Property Catastrophe treaty. The Aggregate Property
Catastrophe treaty covers 95% of $150 million of losses above a retention of $125 million from
named earthquake or wind storm catastrophes in the United States, its territories and possessions,
and Canada, which exceed $35 million. For any single event, the maximum that can be applied to our
retention or recovered under the treaty is $75 million.
Our overall ceded reinsurance program includes certain finite property and casualty contracts that
are entered into and accounted for on a funds withheld basis. Under the funds withheld basis, we
record the cash remitted to the reinsurer for the reinsurers margin, or cost of the reinsurance
contract, as ceded premiums. The remainder of the premiums ceded under the reinsurance contract
not remitted in cash is recorded as funds withheld liabilities. We are required to increase the
funds withheld balance at stated interest crediting rates applied to the funds withheld balance or
as otherwise specified under the terms of the contract. The funds withheld liability is reduced by
any cumulative claim payments made by us in excess of our retention under the reinsurance contract.
If the funds withheld liability is exhausted, interest crediting will cease and additional claim
payments are recoverable from the reinsurer. The significant commuted contracts resulted in an
unfavorable impact of $259 million after-tax in 2005, a favorable impact of $18 million after-tax
in 2004 and an unfavorable impact of $71 million after-tax in 2003. During 2005, we commuted
several of these contracts and as a result, there will be no further interest crediting on these
contracts in future periods. The after-tax interest crediting charges related to these significant
commuted contracts was $47 million, $86 million and $152 million in 2005, 2004 and 2003, and was
reflected as a component of net investment income in our consolidated statements of operations.
In certain circumstances, including significant deterioration of a reinsurers financial strength
ratings, we may engage in commutation discussions with individual reinsurers. The outcome of such
discussions may result in a lump sum settlement that is less than the recorded receivable, net of
any applicable allowance for doubtful accounts. Losses arising from commutations could have an
adverse material impact on our results of operations or equity.
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Further information on our reinsurance program is included in Note H of the Consolidated Financial
Statements included under Item 8.
Terrorism Insurance
CNA and the insurance industry incurred substantial losses related to the 2001 World Trade Center
event. For the most part, the industry was able to absorb the loss of capital from this event, but
the capacity to withstand the effect of any additional terrorism events was significantly
diminished.
The Terrorism Risk Insurance Act of 2002 (TRIA) established a program within the Department of the
Treasury under which insurers are required to offer terrorism insurance and the federal government
will share the risk of loss by commercial property and casualty insurers arising from future
terrorist attacks. Although TRIA expired on December 31, 2005, the Terrorism Risk Insurance
Extension Act of 2005 (TRIEA) extended this program through December 31, 2007. Each participating
insurance company must pay a deductible, ranging from 17.5% of direct earned premiums from covered
commercial insurance lines in 2006 to 20% in 2007, before federal government assistance becomes
available. For losses in excess of a companys deductible, the federal government will cover 90%
of the excess losses in 2006 and 85% of the excess covered losses in 2007, while companies will
retain the remaining 10% in 2006 and the remaining 15% in 2007. Federal reimbursement is available
for a certified act of terrorism after March 31, 2006 only if the aggregate industry insured losses
resulting from such act exceed $50 million in 2006 or $100 million in 2007. Losses covered by the
program will be capped annually at $100 billion; above this amount, insurers are not liable for
covered losses and Congress is to determine the procedures for and the source of any payments.
Amounts paid by the federal government under the program over certain phased limits are to be
recouped by the Department of the Treasury through policy surcharges which cannot exceed 3% of
annual premium.
The program does not cover life or health insurance products or certain lines of property and
casualty insurance such as commercial automobile, surety and professional liability (other than
directors and officers liability insurance). The program also does not generally affect state law
limitations applying to premiums and policies for terrorism coverage.
While TRIEA provides the property and casualty industry with an increased ability to withstand the
effect of a terrorist event through 2007, given the unpredictability of the nature, targets,
severity or frequency of potential terrorist events, our results of operations or equity could
nevertheless be materially adversely impacted by them. We are attempting to mitigate this exposure
through our underwriting practices, as well as policy terms and conditions (where applicable).
Under the laws of certain states, we are generally prohibited from excluding terrorism exposure
from our primary workers compensation policies. Further, in those states that mandate property
insurance coverage of damage from fire following a loss, we are prohibited from excluding terrorism
exposure.
Terrorism-related reinsurance losses are also not covered by TRIEA. As a result, our assumed
reinsurance arrangements either exclude terrorism coverage or significantly limit the level of
coverage.
Over the past several years, we have been underwriting our business to manage our terrorism
exposure through strict underwriting standards, risk avoidance measures and conditional terrorism
exclusions where permitted by law. There is substantial uncertainty as to our ability to
effectively contain our terrorism exposure since, notwithstanding our efforts described above, we
continue to issue forms of coverage, in particular, workers compensation, that are exposed to risk
of loss from a terrorism event.
Restructuring
In 2001, we finalized and approved a plan to restructure the property and casualty segments and
Life and Group Non-Core segment, discontinue the variable life and annuity business and consolidate
certain real estate locations. The remaining accrual related to this plan was $13 million at
December 31, 2005. Approximately $2 million of the remaining accrual, primarily related to lease
termination costs, is expected to be paid in 2006.
Further information on the restructuring plan is included in Note O of the Consolidated Financial
Statements included under Item 8.
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Segment Results
The following discusses the results of operations for our operating segments. Management utilizes
the net operating income financial measure to monitor our operations. Net operating income is
calculated by excluding from net income the after-tax effects of 1) net realized investment gains
or losses, 2) gains or losses from discontinued operations and 3) cumulative effects of changes in
accounting principles. See further discussion regarding how we manage our business in Note N of
the Consolidated Financial Statements included under Item 8. In evaluating the results of the
Standard Lines and Specialty Lines, we utilize the combined ratio, the loss ratio, the expense
ratio and the dividend ratio. These ratios are calculated using GAAP financial results. The loss
ratio is the percentage of net incurred claim and claim adjustment expenses to net earned premiums.
The expense ratio is the percentage of underwriting and acquisition expenses, including the
amortization of deferred acquisition costs, to net earned premiums. The dividend ratio is the
ratio of dividends incurred to net earned premiums. The combined ratio is the sum of the loss,
expense and dividend ratios.
STANDARD LINES
Business Overview
Standard Lines works with an independent agency distribution system and network of brokers to
market a broad range of property and casualty insurance products and services to small,
middle-market and large businesses. The Standard Lines operating model focuses on underwriting
performance, relationships with selected distribution sources and understanding customer needs.
Standard Lines includes Property, Casualty and CNA Global.
Property provides standard and excess property coverage, as well as boiler and machinery to a wide
range of businesses.
Casualty provides standard casualty insurance products such as workers compensation, general and
product liability and commercial auto coverage through traditional products to a wide range of
businesses. The majority of Casualty customers are small and middle-market businesses, with less
than $1 million in annual insurance premiums. Most insurance programs are provided on a guaranteed
cost basis; however, Casualty has the capability to offer specialized, loss-sensitive insurance
programs to those customers viewed as higher risk and less predictable in exposure.
Excess & Surplus (E&S) is included in Casualty. E&S provides specialized insurance and other
financial products for selected commercial risks on both an individual customer and program basis.
Customers insured by E&S are generally viewed as higher risk and less predictable in exposure than
those covered by standard insurance markets. E&Ss products are distributed throughout the United
States through specialist producers, program agents and Property and Casualtys agents and brokers.
E&S has specialized underwriting and claim resources in Chicago, Denver and Columbus.
Property and Casualtys (P&C) field structure consists of 34 branch locations across the country
organized into 4 regions. Each branch provides the marketing, underwriting and risk control
expertise on the entire portfolio of products. The Centralized Processing Operation for small and
middle-market customers, located in Maitland, Florida, handles policy processing and accounting,
and also acts as a call center to optimize customer service. The claims field structure consists
of 23 locations organized into two zones, East and West. Also, Standard Lines, primarily through a
wholly owned subsidiary, ClaimsPlus, Inc., a third party administrator, provides total risk
management services relating to claim and information services to the large commercial insurance
marketplace.
CNA Global consists of Marine and Global Standard Lines.
Marine serves domestic and global ocean marine needs, with markets extending across North America,
Europe and throughout the world. Marine offers hull, cargo, primary and excess marine liability,
marine claims and recovery products and services. Business is sold through national brokers,
regional marine specialty brokers and independent agencies.
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Global Standard Lines is responsible for coordinating and managing the direct business of our
overseas property and casualty operations. This business identifies and capitalizes on strategic
indigenous opportunities and currently has operations in Hawaii, Europe, Latin America and Canada.
The following table details results of operations for Standard Lines.
Results of Operations
Years ended December 31 (In millions) |
2005 |
2004 |
2003 |
|||||||||
Net written premiums |
$ | 4,382 | $ | 4,582 | $ | 4,563 | ||||||
Net earned premiums |
4,410 | 4,917 | 4,532 | |||||||||
Net investment income |
767 | 496 | 408 | |||||||||
Net operating income (loss) |
(41 | ) | 220 | (948 | ) | |||||||
Net realized investment gains |
9 | 139 | 234 | |||||||||
Net income (loss) |
(32 | ) | 359 | (714 | ) | |||||||
Ratios |
||||||||||||
Loss and loss adjustment expense |
87.5 | % | 70.8 | % | 98.0 | % | ||||||
Expense |
32.4 | 34.6 | 42.7 | |||||||||
Dividend |
0.4 | 0.2 | 2.2 | |||||||||
Combined |
120.3 | % | 105.6 | % | 142.9 | % | ||||||
2005 Compared with 2004
Net written premiums for Standard Lines decreased $200 million in 2005 as compared with 2004. This
decrease was primarily driven by decreased premium writings in our casualty lines of business,
increased reinstatement premium in 2005 related to catastrophe losses and decreased rates as
discussed further below. Net earned premiums decreased $507 million in 2005 as compared with 2004.
This decrease was primarily driven by the decline in premiums written. The lower premium is
consistent with our strategy of portfolio optimization. Our priority is a diversified portfolio in
profitable classes of business.
Standard Lines averaged a rate decrease of 1% for 2005 and a rate increase of 4% for 2004 for the
contracts that renewed during those periods. Retention rates of 77% and 70% were achieved for
those contracts that were up for renewal.
Net results decreased $391 million in 2005 as compared with 2004. This decrease was attributable
to declines in both net operating results and net realized investment gains. See the Investments
section of the MD&A for further discussion on net realized investment gains.
Net operating results decreased $261 million in 2005 as compared with 2004. This decrease was due
primarily to increased unfavorable net prior year development of $282 million after-tax including
$185 million after-tax related to significant commutations in 2005, a $135 million after-tax
increase in catastrophe losses, the decreased earned premium as discussed above and decreased
current accident year results. These unfavorable items were partially offset by a $271 million
increase in net investment income and a decrease in the provision for insurance bad debt. See the
Investments section of the MD&A for further discussion on net investment income.
Unfavorable net prior year development of $452 million was recorded in 2005, including $559 million
of unfavorable claim and allocated claim adjustment expense reserve development and $107 million of
favorable premium development. Unfavorable net prior year development of $18 million, including
$115 million of unfavorable claim and allocated claim adjustment expense reserve development and
$97 million of favorable premium development, was recorded in 2004. Further information on
Standard Lines Net Prior Year Development for 2005 and 2004 is included in Note F of the
Consolidated Financial Statements included under Item 8.
During 2005 and 2004, we commuted several significant reinsurance contracts that resulted in
unfavorable development of $285 million and $5 million, which is included in the development above,
and which were partially offset by the release of previously established allowance for
uncollectible reinsurance. These commutations resulted in an unfavorable impact of $173 million
after-tax and favorable impact of $4 million after-tax in 2005 and 2004. These contracts contained
interest crediting provisions. The interest charges associated with the reinsurance
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contracts commuted was $42 million after-tax and $110 million after-tax in 2005 and 2004. There
will be no further interest crediting charges related to these commuted contracts in future
periods.
The impact of catastrophes was $318 million after-tax and $183 million after-tax for 2005 and 2004.
These catastrophe impacts are net of anticipated reinsurance recoveries, and include the effect of
reinstatement premiums and estimated insurance assessments.
The combined ratio increased 14.7 points in 2005 as compared with 2004. The loss ratio increased
16.7 points in 2005 as compared with 2004. These increases were primarily due to increased net
prior year development, increased catastrophe losses and decreased current accident year results.
Catastrophe losses of $470 million and $260 million were recorded in 2005 and 2004.
The following table summarizes the gross and net carried reserves as of December 31, 2005 and 2004
for Standard Lines.
Gross and Net Carried
Claim and Claim Adjustment Expense Reserves
Claim and Claim Adjustment Expense Reserves
December 31, (In millions) |
2005 |
2004 |
||||||
Gross Case Reserves |
$ | 7,033 | $ | 6,904 | ||||
Gross IBNR Reserves |
8,051 | 7,398 | ||||||
Total Gross Carried Claim and Claim
Adjustment Expense Reserves |
$ | 15,084 | $ | 14,302 | ||||
Net Case Reserves |
$ | 5,165 | $ | 4,761 | ||||
Net IBNR Reserves |
6,081 | 4,547 | ||||||
Total Net Carried Claim and Claim Adjustment
Expense Reserves |
$ | 11,246 | $ | 9,308 | ||||
The expense ratio decreased 2.2 points in 2005 as compared with 2004. This decrease in 2005 was
primarily due to a decrease in the provision for insurance bad debt.
The dividend ratio increased 0.2 points in 2005 as compared with 2004. The 2004 ratio was impacted
by favorable dividend development, partially offset by decreased participation in dividend plans
and lower dividend amounts related to the current accident year.
2004 Compared with 2003
Net written premiums for Standard Lines increased $19 million in 2004 as compared with 2003. This
increase was primarily driven by decreased ceded premiums of $270 million to corporate aggregate
and other reinsurance treaties in 2004 as compared with 2003. The 2003 cessions were principally
due to the unfavorable net prior year development recorded in 2003. This favorable impact was
partially offset by lower new business due to increased competition, as well as intentional
underwriting actions in business classified as high hazard. Specifically impacting retention was
the impact of intentional underwriting actions, including reductions in certain silica-related
risks and workers compensation policies classified as high hazard.
Standard Lines averaged rate increases of 4% and 16% for 2004 and 2003 for the contracts that
renewed during those periods. Retention rates of 70% and 72% were achieved for those contracts
that were up for renewal.
Net earned premiums increased $385 million in 2004 as compared with 2003. This increase was
primarily driven by decreased ceded premiums of $270 million related to corporate aggregate and
other reinsurance treaties.
Net results increased $1,073 million in 2004 as compared with 2003. This increase was attributable
to an increase in net operating income, partially offset by a decrease in net realized investment
gains. See the Investments section of the MD&A for further discussion on net realized investment
gains.
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Net operating results increased $1,168 million in 2004 as compared with 2003. This improvement was
due primarily to decreased unfavorable net prior year development of $908 million after-tax, a
decrease in the bad debt provision recorded for insurance receivables of $57 million after-tax, a
decrease in the bad debt provision for reinsurance receivables of $48 million after-tax, decreased
dividend development of $45 million after-tax, a decrease in certain insurance related assessments
of $35 million after-tax and increased net investment income of $57 million after-tax. The
increased net investment income was primarily due to reduced interest charges of $63 million
after-tax related to the corporate aggregate and other reinsurance treaties. These favorable items
were partially offset by increased catastrophe impacts. The impact of catastrophes was $183
million after-tax and $71 million after-tax for 2004 and 2003, as discussed below. These
catastrophe impacts are net of anticipated reinsurance recoveries, and include the effect of
reinstatement premiums and estimated insurance assessments. See the Investments section of the
MD&A for further discussion on net investment income.
The combined ratio decreased 37.3 points in 2004 as compared with 2003. The loss ratio decreased
27.2 points in 2004 as compared with 2003. These improvements were primarily due to decreased net
unfavorable prior year development of $1,398 million and a decrease in the bad debt provision
recorded for reinsurance receivables of $74 million. These favorable impacts on the 2004 loss
ratio were partially offset by increased catastrophe losses. Catastrophe losses of $260 million
and $110 million were recorded in 2004 and 2003. The increased 2004 catastrophe losses were
primarily due to a $235 million loss resulting from Hurricanes Charley, Frances, Ivan and Jeanne.
Unfavorable net prior year development of $18 million was recorded in 2004, including $115 million
of unfavorable claim and allocated claim adjustment expense reserve development and $97 million of
favorable premium development. Unfavorable net prior year development of $1,416 million, including
$938 million of unfavorable claim and allocated claim adjustment expense reserve development and
$478 million of unfavorable premium development, was recorded in 2003. Further information on
Standard Lines Net Prior Year Development for 2004 and 2003 is included in Note F of the
Consolidated Financial Statements included under Item 8.
The expense ratio decreased 8.1 points in 2004 as compared with 2003. This decrease in 2004 was
primarily due to an increased net earned premium base, an $88 million decrease in the provision for
uncollectible insurance receivables, a $54 million decrease in certain insurance related
assessments and reduced expenses as a result of expense reduction initiatives as compared with the
same period in 2003. Partially offsetting these favorable impacts was $14 million of estimated
underwriting assessments related to the 2004 Florida hurricanes.
During 2004, additional bad debt provisions for insurance receivables of $150 million were recorded
as compared to $242 million recorded in 2003. The substantial bad debt provisions for insurance
receivables in 2004 and 2003 were primarily related to Professional Employer Organization (PEO)
accounts. During 2002, Standard Lines ceased writing coverages for PEO businesses, with the last
contracts expiring on June 30, 2003. In the third quarter of 2003, we performed a review of PEO
accounts to estimate ultimate losses and the indicated recoveries under retrospective premium or
high-deductible provisions of the insurance contracts. Based on the 2003 analysis of the credit
standing of the individual PEO accounts and the amount of collateral held, we recorded an increase
in the bad debt provision. In the third quarter of 2004, the review of PEO accounts was updated
and the population of accounts reviewed was expanded to include Temporary Help accounts as well.
Payroll audits performed since the last study identified that the exposure base for many accounts
was higher than expected. In addition, recovery estimates were updated based on current credit
information on the insured. Based on the updated study, we recorded an estimated bad debt
provision of $95 million in the third quarter of 2004 for these accounts.
In 2004, the expense ratio was adversely impacted by an additional $55 million bad debt provision
for insurance receivables. The primary drivers of the provision were the completion of updated
ultimate loss projections on all large account business where the insured is currently in
bankruptcy and a comprehensive review of all billed balances that are past due.
The dividend ratio decreased 2.0 points in 2004 as compared with 2003 due to favorable net prior
year dividend development of $23 million in 2004, as compared to unfavorable net prior year
dividend development of $46 million in 2003, primarily related to workers compensation products.
The favorable 2004 dividend development was related to a review that was completed in 2004 which
indicated dividends were lower than prior expectations based on decreased usage of dividend
programs.
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SPECIALTY LINES
Business Overview
Specialty Lines provides professional, financial and specialty property and casualty products and
services through a network of brokers, managing general underwriters and independent agencies.
Specialty Lines provides solutions for managing the risks of its clients, including architects,
engineers, lawyers, healthcare professionals, financial intermediaries and corporate directors and
officers. Product offerings also include surety and fidelity bonds and vehicle and equipment
warranty services.
Specialty Lines includes the following business groups: Professional Liability Insurance, Surety
and Warranty.
Professional Liability Insurance (CNA Pro) provides management and professional liability insurance
and risk management services, primarily in the United States. This unit provides professional
liability coverages to various professional firms, including architects and engineers, realtors,
non-Big Four accounting firms, law firms and technology firms. CNA Pro also has market positions
in directors and officers (D&O), errors and omissions, employment practices, fiduciary and fidelity
coverages. Specific areas of focus include larger firms as well as privately held firms and
not-for-profit organizations where we offer tailored products for this client segment. Products
within CNA Pro are distributed through brokers, agents and managing general underwriters.
CNA Pro, through CNA HealthPro, also offers insurance products to serve the healthcare delivery
system. Products are distributed on a national basis through a variety of channels including
brokers, agents and managing general underwriters. Key customer segments include long term care
facilities, allied healthcare providers, life sciences, dental professionals and mid-size and large
healthcare facilities and delivery systems.
Surety consists primarily of CNA Surety and its insurance subsidiaries and offers small, medium and
large contract and commercial surety bonds. CNA Surety provides surety and fidelity bonds in all
50 states through a combined network of independent agencies. CNA owns approximately 63% of CNA
Surety.
Warranty provides vehicle warranty service contracts that protect individuals and businesses from
the financial burden associated with breakdown, under-performance or maintenance of a product.
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The following table details results of operations for Specialty Lines.
Results of Operations
Years ended December 31 (In millions) |
2005 |
2004 |
2003 |
|||||||||
Net written premiums |
$ | 2,463 | $ | 2,391 | $ | 2,038 | ||||||
Net earned premiums |
2,475 | 2,277 | 1,840 | |||||||||
Net investment income |
281 | 246 | 201 | |||||||||
Net operating income (loss) |
336 | 324 | (34 | ) | ||||||||
Net realized investment gains |
12 | 54 | 74 | |||||||||
Net income |
348 | 378 | 40 | |||||||||
Ratios |
||||||||||||
Loss and loss adjustment expense |
65.3 | % | 63.3 | % | 89.6 | % | ||||||
Expense |
26.1 | 26.1 | 27.6 | |||||||||
Dividend |
0.2 | 0.2 | 0.2 | |||||||||
Combined |
91.6 | % | 89.6 | % | 117.4 | % | ||||||
2005 Compared with 2004
Net written premiums for Specialty Lines increased $72 million in 2005 as compared with 2004. This
increase was primarily due to improved production, primarily driven by improved retention across
most professional liability insurance lines of business. These favorable impacts were partially
offset by increased ceded premiums for certain professional liability lines of business and
decreased premiums for the warranty business. Due to a change in the warranty product offering,
fees related to the new warranty product are included within other revenues. Written premiums for
the warranty line of business decreased $70 million in 2005 as compared to 2004. Net earned
premiums increased $198 million in 2005 as compared with 2004, which reflects the increased premium
written trend over the past several quarters in Specialty Lines.
Specialty Lines averaged rate increases of 1% and 9% in 2005 and 2004 for the contracts that
renewed during those periods. Retention rates of 86% and 83% were achieved for those contracts
that were up for renewal.
Net income decreased $30 million in 2005 as compared with 2004. This decrease was due primarily to
a $42 million decrease in net realized investment gains partially offset by increased net operating
income. See the Investments section of this MD&A for further discussion on net investment income
and net realized investment gains.
Net operating income increased $12 million in 2005 as compared with 2004. This increase was
primarily driven by an increase in net investment income and increased earned premiums. These
increases to operating income were partially offset by decreased current accident year results.
Additionally, 2004 results were favorably impacted by the release of a previously established
reinsurance bad debt allowance as the result of a significant commutation. Catastrophe impacts
were $16 million after-tax and $11 million after-tax for the years ended December 31, 2005 and
2004.
The combined ratio increased 2.0 points in 2005 as compared with 2004. The loss ratio increased
2.0 points. The 2004 loss ratio was favorably impacted by the release of reinsurance bad debt
reserve as discussed above. Additionally, the 2005 loss ratio was unfavorably impacted by
increased current year accident losses. This was driven by increased surety losses of $110 million
related to a national contractor, before the impacts of minority interest, as discussed in further
detail in Note S of the Consolidated Financial Statements included under Item 8, partially offset
by improved current accident year loss ratios in several professional liability lines of business.
Unfavorable net prior year development was $54 million, including $47 million of unfavorable claim
and allocated claim adjustment expense and $7 million of unfavorable premium development, in 2005.
Unfavorable net prior year development of $30 million, including $58 million of unfavorable claim
and allocated claim adjustment expense development and $28 million of favorable premium
development, was recorded for the same period in 2004. Further information on Specialty Lines Net
Prior Year Development for 2005 and 2004 is included in Note F of the Consolidated Financial
Statements included under Item 8.
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The following table summarizes the gross and net carried reserves as of December 31, 2005 and 2004
for Specialty Lines.
Gross and Net Carried
Claim and Claim Adjustment Expense Reserves
December 31, (In millions) |
2005 |
2004 |
||||||
Gross Case Reserves |
$ | 1,907 | $ | 1,659 | ||||
Gross IBNR Reserves |
3,298 | 3,201 | ||||||
Total Gross Carried Claim and Claim Adjustment
Expense Reserves |
$ | 5,205 | $ | 4,860 | ||||
Net Case Reserves |
$ | 1,442 | $ | 1,191 | ||||
Net IBNR Reserves |
2,352 | 2,042 | ||||||
Total Net Carried Claim and Claim Adjustment
Expense Reserves |
$ | 3,794 | $ | 3,233 | ||||
The expense ratio was the same in 2005 as compared with 2004. The 2005 ratio was impacted by
a change in estimate related to profit commissions in the warranty line of business, which was
offset by the impact of the increased earned premium base.
2004 Compared with 2003
Net written premiums for Specialty Lines increased $353 million and net earned premiums increased
$437 million in 2004 as compared with 2003. This increase was primarily due to rate increases and
improved retention, principally in Professional Liability Insurance, and decreased premiums ceded
to corporate aggregate and other reinsurance treaties of $26 million in 2004 as compared with 2003.
The 2003 ceded premiums were principally driven by the unfavorable net prior year reserve
development in 2003.
Specialty Lines averaged rate increases of 9% and 29% in 2004 and 2003 for the contracts that
renewed during those periods. Retention rates of 83% and 81% were achieved for those contracts
that were up for renewal.
Net income increased $338 million in 2004 as compared with 2003. This increase was due primarily
to increased net operating income, partially offset by a decrease in realized investment gains.
See the Investments section of this MD&A for further discussion on net realized investment gains.
Net operating results improved $358 million in 2004 as compared with 2003. This improvement was
due primarily to decreased unfavorable net prior year development of $171 million after-tax, a
decrease in the bad debt provision for reinsurance receivables of $78 million after-tax, a decrease
in certain insurance related assessments of $8 million after-tax and increased net investment
income. These improvements were partially offset by increased catastrophe losses in 2004. The
impact of catastrophes was $11 million after-tax and $3 million after-tax in 2004 and 2003, as
discussed below. See the Investments section of this MD&A for further discussion on net investment
income.
The combined ratio decreased 27.8 points in 2004 as compared with 2003. The loss ratio decreased
26.3 points due principally to decreased unfavorable net prior year development of $264 million, a
$120 million decrease in bad debt reserves for uncollectible reinsurance and an improvement in the
current net accident year loss ratio. These favorable impacts to the loss ratio were partially
offset by increased catastrophe losses. Catastrophe losses of $15 million and $4 million were
recorded in 2004 and 2003. The increased catastrophe losses in 2004 were due to $12 million of
losses resulting from Hurricanes Charley, Frances, Ivan and Jeanne.
Unfavorable net prior year development was $30 million, including $58 million of unfavorable claim
and allocated claim adjustment expense and $28 million of favorable premium development, in 2004.
Unfavorable net prior year development of $294 million, including $257 million of unfavorable claim
and allocated claim adjustment expense development and $37 million of unfavorable premium
development, was recorded for the same period in 2003.
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Further information on Specialty Lines Net Prior Year Development for 2004 and 2003 is
included in Note F of the Consolidated Financial Statements included under Item 8.
The expense ratio decreased 1.5 points primarily due to the increased earned premium base and a
decrease of $12 million in certain insurance related assessments recorded in 2003. Additionally,
the expense ratio was favorably impacted by decreased underwriting expenses due to our expense
initiatives.
LIFE AND GROUP NON-CORE
Business Overview
The Life and Group Non-Core segment primarily includes the results of the life and group lines of
business that have either been sold or placed in run-off. We sold our group benefits business on
December 31, 2003, our individual life business on April 30, 2004, our CNA Trust business on August
1, 2004 and our specialty medical business on January 6, 2005. The segment includes operating
results for these businesses in periods prior to the sales, the realized gain/loss from the sales
and the effects of the shared corporate overhead expenses which continue to be allocated to the
sold businesses. We continue to service our existing individual long term care commitments, our
payout annuity business and our pension deposit business. We also manage a block of group
reinsurance and life settlement contracts. These businesses are being managed as a run-off
operation. Our group long term care and Index 500 products, while considered non-core, continue to
be actively marketed.
The following table summarizes the results of operations for Life and Group Non-Core.
Results of Operations
Years ended December 31 | 2005 | 2004 | 2003 | |||||||||
(In millions) | ||||||||||||
Net earned premiums |
$ | 704 | $ | 921 | $ | 2,376 | ||||||
Net investment income |
593 | 692 | 821 | |||||||||
Net operating income (loss) |
(51 | ) | (29 | ) | 113 | |||||||
Net realized investment losses |
(19 | ) | (385 | ) | (108 | ) | ||||||
Net income (loss) |
(70 | ) | (414 | ) | 5 |
2005 Compared with 2004
Net earned premiums for Life and Group Non-Core decreased $217 million in 2005 as compared with
2004. The premiums in 2004 include $115 million from the individual life business and $165 million
from the specialty medical business. The 2005 net earned premiums are primarily from the group and
individual long term care business.
Net results improved by $344 million in 2005 as compared with 2004. The improvement in net results
related primarily to a $389 million after-tax realized loss on the sale of the individual life
business in 2004. Also contributing to the improvement in net results is the reduction in 2005 of
significant 2004 items related to the IGI Program as discussed below. Additionally, 2005 results
included $13 million after-tax income related to a service agreement with a purchaser for sold
businesses. These agreements have expired. These results were partially offset by a decline in
net investment income of $99 million. This included a decrease of approximately $64 million from
the trading portfolio which was largely net income neutral due to a corresponding decrease in the
policyholders funds reserves supported by the trading portfolio. In addition, it included the
absence of favorable results from the sold insurance operations as discussed below. Also
unfavorably impacting the 2005 results was a $17 million after-tax provision increase for estimated
indemnification liabilities related to the sold individual life business and unfavorable results
related to the long term care business. See the Investments section of this MD&A for additional
information on net investment income and net realized investment results.
2004 Compared with 2003
Net earned premiums for Life and Group Non-Core decreased $1,455 million in 2004 as compared with
2003. The decrease in net earned premiums was due primarily to the absence of premiums from the
group benefits business and reduced premiums for the individual life business. Net earned premiums for the sold life and
group businesses
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were $115 million and $1,459 million for 2004 and 2003. Net earned premiums also
decreased in most of the remaining lines of business which are in runoff, and this decline is
expected to continue in the future. Partially offsetting this decrease was an increase in net
earned premiums in the specialty medical business, which continued to issue new policies prior to
its sale in January 2005.
Net results decreased by $419 million in 2004 as compared with 2003. The decrease in net results
related primarily to net realized investment losses, including the realized loss of approximately
$389 million after-tax from the sale of the individual life business and reduced results from the
group benefits and individual life businesses. Net realized investment losses in 2003 include a
loss recorded on the sale of the Group Benefits business of $130 million after-tax. Net results
for the sold life and group businesses were losses of $427 million and $36 million, including the
loss on sales and the effects of shared corporate overhead expenses, in 2004 and 2003. In
addition, results for life settlement contracts declined in 2004. These items were partially
offset by reduced increases in individual long term care reserves of $21 million after-tax in 2004
as compared with 2003. Also included in the net results of 2004 and 2003 were the adverse impacts
of $26 million after-tax and $33 million after-tax related to certain accident and health exposures
(IGI Program) and our past participation in accident and health reinsurance programs.
CORPORATE AND OTHER NON-CORE
Overview
Corporate and Other Non-Core includes the results of certain property and casualty lines of
business placed in run-off. CNA Re, formerly a separate property and casualty operating segment,
is currently in run-off and is included in the Corporate and Other Non-Core segment. This segment
also includes the results related to the centralized adjusting and settlement of APMT claims, as
well as the results of our participation in voluntary insurance pools and various other
non-insurance operations. Other operations also include interest expense on corporate borrowings
and intercompany eliminations.
The following table summarizes the results of operations for the Corporate and Other Non-Core
segment, including APMT and intrasegment eliminations.
Results of Operations
Years ended December 31 | 2005 | 2004 | 2003 | |||||||||
(In millions) | ||||||||||||
Net investment income |
$ | 251 | $ | 246 | $ | 226 | ||||||
Revenues |
311 | 358 | 737 | |||||||||
Net operating income (loss) |
9 | 84 | (835 | ) | ||||||||
Net realized investment gains (losses) |
(12 | ) | 39 | 85 | ||||||||
Net income (loss) |
(3 | ) | 123 | (750 | ) |
2005 Compared with 2004
Revenues decreased $47 million in 2005 as compared with 2004. The decrease in revenues was due
primarily to reduced net earned premiums in CNA Re of $134 million due to the exit from the assumed
reinsurance business in 2003 and decreased net realized investment results. Partially offsetting
these decreases was $121 million of interest related to a federal income tax settlement. See Note
E to the Consolidated Financial Statements included under Item 8 for further information.
As previously disclosed, we sold our personal insurance business to The Allstate Corporation
(Allstate) in 1999. Under the revised terms of this transaction, Allstate purchased an option
exercisable during 2005 to purchase 100% of the common stock of five of our insurance subsidiaries
at the fair market value as of the exercise date. Royalty fees earned for the years ended December
31, 2005 and 2004 for personal insurance policies 100% reinsured with Allstate were approximately
$22 million and $29 million. The royalty fee arrangement terminated on September 30, 2005.
Additionally, Allstate exercised its option and purchased the five subsidiaries during the fourth
quarter of 2005. This transaction resulted in a realized gain of $8 million. See Note P of the
Consolidated Financial Statements included under Item 8 for further information regarding this
transaction.
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Net results decreased $126 million in 2005 as compared with 2004. The decrease in net results was
due primarily to a $139 million after-tax increase in unfavorable net prior year development
related primarily to commutations and reserve strengthening, a $51 million decrease in net realized
investment results and a decrease in the provision recorded for uncollectible reinsurance. Net
realized investment results for the year ended December 31, 2005 and 2004 included a $22 million
after-tax and $36 million after-tax impairment related to a national contractor. See Note S to the
Consolidated Financial Statements included under Item 8 for additional information regarding the
national contractor. Partially offsetting these decreases was a $115 million after-tax increase in
net income related to a federal income tax settlement and release of federal income tax reserves.
Unfavorable net prior year development of $306 million was recorded during 2005, including $291
million of unfavorable net prior year claim and allocated claim adjustment expense reserve
development and $15 million of unfavorable premium development. Unfavorable net prior year
development of $93 million was recorded in 2004, including $84 million of unfavorable net prior
year claim and allocated claim adjustment expense reserve development and $9 million of unfavorable
premium development. Further information on Corporate and Other Non-Cores Net Prior Year
Development for 2005 and 2004 is included in Note F of the Consolidated Financial Statements
included under Item 8.
During 2005 and 2004, we commuted several significant reinsurance contracts that resulted in
unfavorable development of $118 million and $39 million, which is included in the development
above, and which was partially offset by the release in 2004 of a previously established allowance
for uncollectible reinsurance. These commutations resulted in unfavorable impacts of $71 million
after-tax and $5 million after-tax in 2005 and 2004. These contracts contained interest crediting
provisions and maintenance charges. Interest charges associated with the reinsurance contracts
commuted were $13 million after-tax and $11 million after-tax in 2005 and 2004. There will be no
further interest crediting charges or other charges related to these commuted contracts in future
periods.
The following table summarizes the gross and net carried reserves as of December 31, 2005 and 2004
for Corporate and Other Non-Core.
Gross and Net Carried
Claim and Claim Adjustment Expense Reserves
Claim and Claim Adjustment Expense Reserves
December 31, | 2005 | 2004 | ||||||
(In millions) | ||||||||
Gross Case Reserves |
$ | 3,297 | $ | 3,806 | ||||
Gross IBNR Reserves |
4,075 | 4,875 | ||||||
Total Gross Carried Claim and Claim
Adjustment Expense Reserves |
$ | 7,372 | $ | 8,681 | ||||
Net Case Reserves |
$ | 1,554 | $ | 1,588 | ||||
Net IBNR Reserves |
1,902 | 1,691 | ||||||
Total Net Carried Claim and Claim
Adjustment Expense Reserves |
$ | 3,456 | $ | 3,279 | ||||
2004 Compared with 2003
Revenues decreased $379 million in 2004 as compared with 2003. The decrease in revenues was due
primarily to reduced net earned premiums in CNA Re due to the exit of the assumed reinsurance
market in October of 2003 and decreased realized investment gains of $62 million pretax. CNA Re
had earned premiums of $125 million and $536 million in 2004 and 2003. See the Investments section
of this MD&A for additional information on net realized investment gains (losses) and net
investment income.
Net income increased $873 million in 2004 as compared with 2003. The increase in net income was
due primarily to a $632 million after-tax decrease in unfavorable net prior year development, a
$168 million after-tax decrease in the provision for uncollectible reinsurance receivables, the
absence in 2004 of a $44 million after-tax increase in unallocated loss adjustment expense (ULAE)
reserves recorded in 2003 and a $16 million after-tax decrease in
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certain insurance related assessments. Additionally, the net results were favorably impacted by
$14 million after-tax of non-recurring income related to a release of purchase accounting reserves
related to real estate leases assumed in connection with the 1995 acquisition of Continental.
Unfavorable net prior year development of $93 million was recorded during 2004, including $84
million of unfavorable net prior year claim and allocated claim adjustment expense reserve
development and $9 million of unfavorable premium development. Unfavorable net prior year
development of $1,065 million was recorded in 2003, including $1,039 million of unfavorable net
prior year claim and allocated claim adjustment expense reserve development and $26 million of
unfavorable premium development. Further information on Corporate and Other Non-Cores Net Prior
Year Development for 2004 and 2003 is included in Note F of the Consolidated Financial Statements
included under Item 8.
Many ceding companies have sought provisions for the collateralization of assumed reserves in the
event of a financial strength ratings downgrade or other triggers. Before exiting the reinsurance
market, CNA Re had been impacted by this trend and had entered into several contracts with rating
or other triggers. See the Ratings section of this MD&A for more information.
APMT Reserves
Our property and casualty insurance subsidiaries have actual and potential exposures related to
asbestos, environmental pollution and mass tort (APMT) claims.
Establishing reserves for APMT claim and claim adjustment expenses is subject to uncertainties that
are greater than those presented by other claims. Traditional actuarial methods and techniques
employed to estimate the ultimate cost of claims for more traditional property and casualty
exposures are less precise in estimating claim and claim adjustment expense reserves for APMT,
particularly in an environment of emerging or potential claims and coverage issues that arise from
industry practices and legal, judicial, and social conditions. Therefore, these traditional
actuarial methods and techniques are necessarily supplemented with additional estimating techniques
and methodologies, many of which involve significant judgments that are required of management.
Accordingly, a high degree of uncertainty remains for our ultimate liability for APMT claim and
claim adjustment expenses.
In addition to the difficulties described above, estimating the ultimate cost of both reported and
unreported APMT claims is subject to a higher degree of variability due to a number of additional
factors, including among others: the number and outcome of direct actions against us; coverage
issues, including whether certain costs are covered under the policies and whether policy limits
apply; allocation of liability among numerous parties, some of whom may be in bankruptcy
proceedings, and in particular the application of joint and several liability to specific
insurers on a risk; inconsistent court decisions and developing legal theories; increasingly
aggressive tactics of plaintiffs lawyers; the risks and lack of predictability inherent in major
litigation; increased filings of claims in certain states; enactment of national federal
legislation to address asbestos claims; a further increase in asbestos and environmental pollution
claims which cannot now be anticipated; liability against our policyholders in environmental
matters; broadened scope of clean-up resulting in increased liability to our policyholders;
increase in number of mass tort claims relating to silica and silica-containing products, and the
outcome of ongoing disputes as to coverage in relation to these claims; a further increase of
claims and claims payment that may exhaust underlying umbrella and excess coverage at accelerated
rates; and future developments pertaining to our ability to recover reinsurance for asbestos,
pollution and mass tort claims.
Due to the inherent uncertainties in estimating claim and claim adjustment expense reserves for
APMT and due to the significant uncertainties described related to APMT claims, our ultimate
liability for these cases, both individually and in aggregate, may exceed the recorded reserves.
Any such potential additional liability, or any range of potential additional amounts, cannot be
reasonably estimated currently, but could be material to our business, results of operations,
equity, insurer financial strength and debt ratings. Due to, among other things, the factors
described above, it may be necessary for us to record material changes in our APMT claim and claim
adjustment expense reserves in the future, should new information become available or other
developments emerge.
We have regularly performed ground up reviews of all open APMT claims to evaluate the adequacy of
our APMT reserves. In performing our comprehensive ground up analysis, we consider input from our
professionals with direct responsibility for the claims, inside and outside counsel with
responsibility for our representation, and our actuarial staff. These professionals review, among
many factors, the policyholders present and predicted future exposures,
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including such factors as claims volume, trial conditions, prior settlement history, settlement
demands and defense costs; the impact of asbestos defendant bankruptcies on the policyholder; the
policies we issued, including such factors as aggregate or per occurrence limits, whether the
policy is primary, umbrella or excess, and the existence of policyholder retentions and/or
deductibles; the existence of other insurance; and reinsurance arrangements.
The following table provides data related to our APMT claim and claim adjustment expense reserves.
APMT Reserves
December 31, 2005 | December 31, 2004 | |||||||||||||||
Environmental | Environmental | |||||||||||||||
Pollution and | Pollution and | |||||||||||||||
Asbestos | Mass Tort | Asbestos | Mass Tort | |||||||||||||
(In millions) | ||||||||||||||||
Gross reserves |
$ | 2,992 | $ | 680 | $ | 3,218 | $ | 755 | ||||||||
Ceded reserves |
(1,438 | ) | (257 | ) | (1,532 | ) | (258 | ) | ||||||||
Net reserves |
$ | 1,554 | $ | 423 | $ | 1,686 | $ | 497 | ||||||||
Asbestos
In the past several years, we have experienced, at certain points in time, significant increases in
claim counts for asbestos-related claims. The factors that led to these increases included, among
other things, intensive advertising campaigns by lawyers for asbestos claimants, mass medical
screening programs sponsored by plaintiff lawyers and the addition of new defendants such as the
distributors and installers of products containing asbestos. During 2004 and 2005, the rate of new
filings appears to have decreased from the filing rates seen in the past several years. Various
challenges to mass screening claimants have been mounted. Nevertheless, we continue to experience
an overall increase in total asbestos claim counts. The majority of asbestos bodily injury claims
are filed by persons exhibiting few, if any, disease symptoms. Recent studies have concluded that
the percentage of unimpaired claimants to total claimants ranges between 66% and up to 90%. Some
courts, including the federal district court responsible for pre-trial proceedings in all federal
asbestos bodily injury actions, have ordered that so-called unimpaired claimants may not recover
unless at some point the claimants condition worsens to the point of impairment. Some plaintiffs
classified as unimpaired have challenged those orders. Therefore, the ultimate impact of the
orders on future asbestos claims remains uncertain.
Several factors are, in managements view, negatively impacting asbestos claim trends. Plaintiff
attorneys who previously sued entities who are now bankrupt are seeking other viable targets. As a
result, companies with few or no previous asbestos claims are becoming targets in asbestos
litigation and, although they may have little or no liability, nevertheless must be defended.
Additionally, plaintiff attorneys and trustees for future claimants are demanding that policy
limits be paid lump-sum into the bankruptcy asbestos trusts prior to presentation of valid claims
and medical proof of these claims. Various challenges to these practices are currently in
litigation and the ultimate impact or success of these tactics remains uncertain. Plaintiff
attorneys and trustees for future claimants are also attempting to devise claims payment procedures
for bankruptcy trusts that would allow asbestos claims to be paid under lax standards for injury,
exposure and causation. This also presents the potential for exhausting policy limits in an
accelerated fashion.
As a result of bankruptcies and insolvencies, management has observed an increase in the total
number of policyholders with current asbestos claims as additional defendants are added to existing
lawsuits and are named in new asbestos bodily injury lawsuits. New asbestos bodily injury claims
also increased substantially in 2003, but the rate of increase has moderated in 2004 and 2005.
We have resolved a number of our large asbestos accounts by negotiating settlement agreements.
Structured settlement agreements provide for payments over multiple years as set forth in each
individual agreement. Payment obligations under those settlement agreements are projected to
terminate by 2016.
In 1985, 47 asbestos producers and their insurers, including CIC, executed the Wellington
Agreement. The agreement intended to resolve all issues and litigation related to coverage for
asbestos exposures. Under this agreement, signatory insurers committed scheduled policy limits and
made the limits available to pay asbestos
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claims based upon coverage blocks designated by the policyholders in 1985, subject to extension by
policyholders. CIC was a signatory insurer to the Wellington Agreement.
We have also used coverage in place agreements to resolve large asbestos exposures. Coverage in
place agreements are typically agreements between us and our policyholders identifying the policies
and the terms for payment of asbestos related liabilities. Claims payments are contingent on
presentation of adequate documentation showing exposure during the policy periods and other
documentation supporting the demand for claims payment. Coverage in place agreements may have
annual payment caps. Coverage in place agreements are evaluated based on claims filings trends and
severities.
We categorize active asbestos accounts as large or small accounts. We define a large account as an
active account with more than $100,000 of cumulative paid losses. We have made closing large
accounts a significant management priority. Small accounts are defined as active accounts with
$100,000 or less of cumulative paid losses. Approximately 81% and 83% of our total active asbestos
accounts are classified as small accounts at December 31, 2005 and December 31, 2004. Small
accounts are typically representative of policyholders with limited connection to asbestos.
We also evaluate our asbestos liabilities arising from our assumed reinsurance business and our
participation in various pools, including Excess & Casualty Reinsurance Association (ECRA).
IBNR reserves relate to potential development on accounts that have not settled and potential
future claims from unidentified policyholders.
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The tables below depict our overall pending asbestos accounts and associated reserves at December
31, 2005 and December 31, 2004.
Pending Asbestos Accounts and Associated Reserves
December 31, 2005
Net Paid Losses | Net Asbestos | Percent of | ||||||||||||||
Number of | in 2005 | Reserves | Asbestos | |||||||||||||
Policyholders | (In millions) | (In millions) | Net Reserves | |||||||||||||
Policyholders with settlement agreements |
||||||||||||||||
Structured Settlements |
13 | $ | 30 | $ | 167 | 11 | % | |||||||||
Wellington |
4 | 2 | 15 | 1 | ||||||||||||
Coverage in place |
34 | 13 | 58 | 4 | ||||||||||||
Fibreboard |
1 | | 54 | 3 | ||||||||||||
Total with settlement agreements |
52 | 45 | 294 | 19 | ||||||||||||
Other policyholders with active accounts |
||||||||||||||||
Large asbestos accounts |
199 | 68 | 273 | 17 | ||||||||||||
Small asbestos accounts |
1,073 | 23 | 135 | 9 | ||||||||||||
Total other policyholders |
1,272 | 91 | 408 | 26 | ||||||||||||
Assumed reinsurance and pools |
| 6 | 143 | 9 | ||||||||||||
Unassigned IBNR |
| | 709 | 46 | ||||||||||||
Total |
1,324 | $ | 142 | $ | 1,554 | 100 | % | |||||||||
Pending Asbestos Accounts and Associated Reserves
December 31, 2004
Net Paid Losses | Net Asbestos | Percent of | ||||||||||||||
Number of | in 2004 | Reserves | Asbestos | |||||||||||||
Policyholders | (In millions) | (In millions) | Net Reserves | |||||||||||||
Policyholders with settlement agreements |
||||||||||||||||
Structured Settlements |
11 | $ | 39 | $ | 175 | 10 | % | |||||||||
Wellington |
4 | 4 | 17 | 1 | ||||||||||||
Coverage in place |
33 | 14 | 76 | 5 | ||||||||||||
Fibreboard |
1 | | 54 | 3 | ||||||||||||
Total with settlement agreements |
49 | 57 | 322 | 19 | ||||||||||||
Other policyholders with active accounts |
||||||||||||||||
Large asbestos accounts |
180 | 47 | 368 | 22 | ||||||||||||
Small asbestos accounts |
1,109 | 23 | 141 | 8 | ||||||||||||
Total other policyholders |
1,289 | 70 | 509 | 30 | ||||||||||||
Assumed reinsurance and pools |
| 8 | 148 | 9 | ||||||||||||
Unassigned IBNR |
| | 707 | 42 | ||||||||||||
Total |
1,338 | $ | 135 | $ | 1,686 | 100 | % | |||||||||
Some asbestos-related defendants have asserted that their insurance policies are not subject
to aggregate limits on coverage. We have such claims from a number of insureds. Some of these
claims involve insureds facing exhaustion of products liability aggregate limits in their policies,
who have asserted that their asbestos-related claims fall within so-called non-products liability
coverage contained within their policies rather than products liability coverage, and that the
claimed non-products coverage is not subject to any aggregate limit. It is difficult to predict
the ultimate size of any of the claims for coverage purportedly not subject to aggregate limits or
predict to what
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extent, if any, the attempts to assert non-products claims outside the products liability
aggregate will succeed. Our policies also contain other limits applicable to these claims, and we
have additional coverage defenses to certain claims. We have attempted to manage our asbestos
exposure by aggressively seeking to settle claims on acceptable terms. There can be no assurance
that any of these settlement efforts will be successful, or that any such claims can be settled on
terms acceptable to us. Where we cannot settle a claim on acceptable terms, we aggressively
litigate the claim. A recent court ruling by the United States Court of Appeals for the Fourth
Circuit has supported certain of our positions with respect to coverage for non-products claims.
However, adverse developments with respect to such matters could have a material adverse effect on
our results of operations and/or equity.
As a result of the uncertainties and complexities involved, reserves for asbestos claims cannot be
estimated with traditional actuarial techniques that rely on historical accident year loss
development factors. In establishing asbestos reserves, we evaluate the exposure presented by each
insured. As part of this evaluation, we consider the available insurance coverage; limits and
deductibles; the potential role of other insurance, particularly underlying coverage below any of
our excess liability policies; and applicable coverage defenses, including asbestos exclusions.
Estimation of asbestos-related claim and claim adjustment expense reserves involves a high degree
of judgment on the part of management and consideration of many complex factors, including:
inconsistency of court decisions, jury attitudes and future court decisions; specific policy
provisions; allocation of liability among insurers and insureds; missing policies and proof of
coverage; the proliferation of bankruptcy proceedings and attendant uncertainties; novel theories
asserted by policyholders and their counsel; the targeting of a broader range of businesses and
entities as defendants; the uncertainty as to which other insureds may be targeted in the future
and the uncertainties inherent in predicting the number of future claims; volatility in claim
numbers and settlement demands; increases in the number of non-impaired claimants and the extent to
which they can be precluded from making claims; the efforts by insureds to obtain coverage not
subject to aggregate limits; long latency period between asbestos exposure and disease
manifestation and the resulting potential for involvement of multiple policy periods for individual
claims; medical inflation trends; the mix of asbestos-related diseases presented and the ability to
recover reinsurance.
We are also monitoring possible legislative reforms on the state and national level, including
possible federal legislation to create a national privately financed trust financed by
contributions from insurers such as us, industrial companies and others, which if established,
could replace litigation of asbestos claims with payments to claimants from the trust. It is
uncertain at the present time whether such legislation will be enacted or, if it is, its impact on
us.
We are involved in significant asbestos-related claim litigation, which is described in Note F of
the Consolidated Financial Statements included under Item 8.
Environmental Pollution and Mass Tort
Environmental pollution cleanup is the subject of both federal and state regulation. By some
estimates, there are thousands of potential waste sites subject to cleanup. The insurance industry
is involved in extensive litigation regarding coverage issues. Judicial interpretations in many
cases have expanded the scope of coverage and liability beyond the original intent of the policies.
The Comprehensive Environmental Response Compensation and Liability Act of 1980 (Superfund) and
comparable state statutes (mini-Superfunds) govern the cleanup and restoration of toxic waste sites
and formalize the concept of legal liability for cleanup and restoration by Potentially
Responsible Parties (PRPs). Superfund and the mini-Superfunds establish mechanisms to pay for
cleanup of waste sites if PRPs fail to do so and assign liability to PRPs. The extent of liability
to be allocated to a PRP is dependent upon a variety of factors. Further, the number of waste
sites subject to cleanup is unknown. To date, approximately 1,500 cleanup sites have been
identified by the Environmental Protection Agency (EPA) and included on its National Priorities
List (NPL). State authorities have designated many cleanup sites as well.
A number of proposals to modify Superfund have been made by various parties. However, no
modifications were enacted by Congress during 2005, and it is unclear what positions Congress or
the Administration will take and what legislation, if any, will result in the future. If there is
legislation, and in some circumstances even if there is no legislation, the federal role in
environmental cleanup may be significantly reduced in favor of state action. Substantial changes
in the federal statute or the activity of the EPA may cause states to reconsider their
environmental cleanup statutes and regulations. There can be no meaningful prediction of the
pattern of regulation that would result or the possible effect upon our results of operations or
equity.
Many policyholders have made claims against us for defense costs and indemnification in connection
with environmental pollution matters. The vast majority of these claims relate to accident years
1989 and prior, which
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coincides with our adoption of the Simplified Commercial General Liability coverage form, which
includes what is referred to in the industry as absolute pollution exclusion. We and the insurance
industry are disputing coverage for many such claims. Key coverage issues include whether cleanup
costs are considered damages under the policies, trigger of coverage, allocation of liability among
triggered policies, applicability of pollution exclusions and owned property exclusions, the
potential for joint and several liability and the definition of an occurrence. To date, courts
have been inconsistent in their rulings on these issues. We noted adverse development in various
pollution accounts in our most recent ground up review. In the course of our review, we did not
observe a negative trend or deterioration in the underlying pollution claims environment. Rather,
individual account estimates changed due to changes in liability and/or coverage circumstances
particular to those accounts. As a result, we increased pollution reserves by $50 million in 2005.
We have made resolution of large environmental pollution exposures a management priority. We have
resolved a number of our large environmental accounts by negotiating settlement agreements. In our
settlements, we sought to resolve those exposures and obtain the broadest release language to avoid
future claims from the same policyholders seeking coverage for sites or claims that had not emerged
at the time we settled with our policyholder. While the terms of each settlement agreement vary,
we sought to obtain broad environmental releases that include known and unknown sites, claims and
policies. The broad scope of the release provisions contained in those settlement agreements
should, in many cases, prevent future exposure from settled policyholders. It remains uncertain,
however, whether a court interpreting the language of the settlement agreements will adhere to the
intent of the parties and uphold the broad scope of language of the agreements.
We classify our environmental pollution accounts into several categories, which include structured
settlements, coverage in place agreements and active accounts. Structured settlement agreements
provide for payments over multiple years as set forth in each individual agreement.
We have also used coverage in place agreements to resolve pollution exposures. Coverage in place
agreements are typically agreements between us and our policyholders identifying the policies and
the terms for payment of pollution related liabilities. Claims payments are contingent on
presentation of adequate documentation of damages during the policy periods and other documentation
supporting the demand for claims payment. Coverage in place agreements may have annual payment
caps.
We categorize active accounts as large or small accounts in the pollution area. We define a large
account as an active account with more than $100,000 cumulative paid losses. We have made closing
large accounts a significant management priority. Small accounts are defined as active accounts
with $100,000 or less cumulative paid losses.
We also evaluate our environmental pollution exposures arising from our assumed reinsurance and our
participation in various pools, including ECRA.
We carry unassigned IBNR reserves for environmental pollution. These reserves relate to potential
development on accounts that have not settled and potential future claims from unidentified
policyholders.
The charts below depict our overall pending environmental pollution accounts and associated
reserves at December 31, 2005 and 2004.
At December 31, 2005
Net | ||||||||||||||||
Environmental | Percent of | |||||||||||||||
Net Paid Losses | Pollution | Environmental | ||||||||||||||
Number of | in 2005 | Reserves | Pollution Net | |||||||||||||
Policyholders | (In millions) | (In millions) | Reserve | |||||||||||||
Policyholders with Settlement Agreements |
||||||||||||||||
Structured settlements |
6 | $ | 10 | $ | 17 | 5 | % | |||||||||
Coverage in place |
16 | 10 | 23 | 7 | ||||||||||||
Total with Settlement Agreements |
22 | 20 | 40 | 12 | ||||||||||||
Other Policyholders with Active Accounts |
||||||||||||||||
Large pollution accounts |
120 | 18 | 63 | 19 | ||||||||||||
Small pollution accounts |
362 | 15 | 50 | 15 | ||||||||||||
Total Other Policyholders |
482 | 33 | 113 | 34 | ||||||||||||
Assumed Reinsurance & Pools |
| 3 | 33 | 10 | ||||||||||||
Unassigned IBNR |
| | 150 | 44 | ||||||||||||
Total |
504 | $ | 56 | $ | 336 | 100 | % | |||||||||
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At December 31, 2004
Net | ||||||||||||||||
Environmental | Percent of | |||||||||||||||
Net Paid Losses | Pollution | Environmental | ||||||||||||||
Number of | in 2004 | Reserves | Pollution Net | |||||||||||||
Policyholders | (In millions) | (In millions) | Reserve | |||||||||||||
Policyholders with Settlement Agreements |
||||||||||||||||
Structured settlements |
2 | $ | 14 | $ | 5 | 1 | % | |||||||||
Coverage in place |
15 | 5 | 16 | 5 | ||||||||||||
Total with Settlement Agreements |
17 | 19 | 21 | 6 | ||||||||||||
Other Policyholders with Active Accounts |
||||||||||||||||
Large pollution accounts |
134 | 18 | 75 | 22 | ||||||||||||
Small pollution accounts |
405 | 14 | 47 | 14 | ||||||||||||
Total Other Policyholders |
539 | 32 | 122 | 36 | ||||||||||||
Assumed Reinsurance & Pools |
| 2 | 36 | 10 | ||||||||||||
Unassigned IBNR |
| | 163 | 48 | ||||||||||||
Total |
556 | $ | 53 | $ | 342 | 100 | % | |||||||||
In 2003, we observed a marked increase in silica claims frequency in Mississippi, where
plaintiff attorneys appear to have filed claims to avoid the effect of tort reform. Since 2003,
silica claims frequency in Mississippi has moderated notably due to implementation of tort reform
measures and favorable court decisions. To date, the most significant silica exposures identified
included a relatively small number of accounts with significant numbers of new claims reported in
2003 and that continued at a far lesser rate in 2004 and 2005. Establishing claim and claim
adjustment expense reserves for silica claims is subject to uncertainties because of disputes
concerning medical causation with respect to certain diseases, including lung cancer, geographical
concentration of the lawsuits asserting the claims, and the large rise in the total number of
claims without underlying epidemiological developments suggesting an increase in disease rates.
Moreover, judicial interpretations regarding application of various tort defenses, including
application of various theories of joint and several liabilities, impede our ability to estimate
the ultimate liability for such claims.
INVESTMENTS
The significant components of net investment income are presented in the following table.
Net Investment Income
Years ended December 31 | 2005 | 2004 | 2003 | |||||||||
(In millions) | ||||||||||||
Fixed maturity securities |
$ | 1,608 | $ | 1,571 | $ | 1,651 | ||||||
Short term investments |
147 | 56 | 63 | |||||||||
Limited partnerships |
254 | 212 | 221 | |||||||||
Equity securities |
25 | 14 | 19 | |||||||||
Income from trading portfolio (a) |
47 | 110 | | |||||||||
Interest on funds withheld and other deposits |
(166 | ) | (261 | ) | (335 | ) | ||||||
Other |
20 | 18 | 85 | |||||||||
Gross investment income |
1,935 | 1,720 | 1,704 | |||||||||
Investment expense |
(43 | ) | (40 | ) | (48 | ) | ||||||
Net investment income |
$ | 1,892 | $ | 1,680 | $ | 1,656 | ||||||
(a) The change in net unrealized gains (losses) on trading securities, included in net
investment income, was $(7) million and $2 million for the years ended December 31, 2005
and 2004.
Net investment income increased in 2005 as compared with 2004. This increase was due to the
reduced interest expense on funds withheld and other deposits and improved results across all other
available-for-sale asset classes, especially short-term investments which reflect the improved
period over period yields. This improvement was
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partly offset by decreases in investment income from the trading portfolio. During 2005, we
commuted several significant reinsurance contracts which contained interest crediting provisions
and as a result, there will be no further interest expense on funds withheld on the commuted
contracts in future periods. The pre-tax interest expense on funds withheld related to these
significant commuted contracts was $72 million, $132 million and $235 million in 2005, 2004, and
2003, and was reflected as a component of net investment income in our consolidated statements of
operations. See Note H of the Consolidated Financial Statements included under Item 8 for
additional information for interest costs on funds withheld and other deposits.
Net investment income was slightly higher in 2004 as compared with 2003. This increase was due
primarily to the reduced interest expense on funds withheld and other deposits. The interest costs
on funds withheld and other deposits increased in 2003 as a result of additional cessions to the
corporate aggregate reinsurance and other treaties due to adverse net prior year development. This
improvement in 2004 was partly offset by decreases in investment income across all other
available-for-sale asset classes which is largely the result of the impacts of the group benefits
and individual life sale transactions that are described in Note P of the Consolidated Financial
Statements included under Item 8. Also, the net investment income of the trading portfolio
positively impacted results for 2004.
The bond segment of the investment portfolio yielded 4.9% in 2005, 4.6% in 2004 and 5.1% in 2003.
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Net Realized Investment Gains (Losses)
The components of net realized investment results are presented in the following table.
Net Realized Investment Gains (Losses)
Years ended December 31 | 2005 | 2004 | 2003 | |||||||||
(In millions) | ||||||||||||
Realized investment gains (losses): |
||||||||||||
Fixed maturity securities: |
||||||||||||
U.S. Government bonds |
$ | (33 | ) | $ | 10 | $ | (70 | ) | ||||
Corporate and other taxable bonds |
(86 | ) | 123 | 380 | ||||||||
Tax-exempt bonds |
12 | 42 | 97 | |||||||||
Asset-backed bonds |
14 | 53 | 42 | |||||||||
Redeemable preferred stock |
3 | 19 | (12 | ) | ||||||||
Total fixed maturity securities |
(90 | ) | 247 | 437 | ||||||||
Equity securities |
38 | 202 | 114 | |||||||||
Derivative securities |
49 | (84 | ) | 78 | ||||||||
Short-term investments |
| (3 | ) | 3 | ||||||||
Other, including dispositions of businesses, net of
participating policyholders interest |
(10 | ) | (601 | ) | (168 | ) | ||||||
Realized investment gains (losses) before allocation to
participating policyholders and minority interests |
(13 | ) | (239 | ) | 464 | |||||||
Allocated to participating policyholders and minority interests |
3 | (9 | ) | (4 | ) | |||||||
Income tax (expense) benefit |
| 95 | (175 | ) | ||||||||
Net realized investment gains (losses), net of participating
policyholders and minority interests |
$ | (10 | ) | $ | (153 | ) | $ | 285 | ||||
Net realized investment results improved $143 million after-tax in 2005 as compared with 2004.
This improvement is primarily the result of a 2004 loss of $389 million after-tax for the sale of
the individual life insurance business, partly offset by reduced gains for equities securities.
Equity results in 2004 included a gain of $105 million after-tax related to our investment in
Canary Wharf Group PLC (Canary Wharf), a London-based real estate company. Also impacting results
for 2005 versus 2004 were decreased results in the overall fixed maturity asset class partly offset
by improved results for the derivatives asset class. Impairment losses of $70 million after-tax
were recorded in 2005 across various sectors, including an after-tax impairment loss of $22 million
related to loans made under a credit facility to a national contractor, that are classified as
fixed maturities. Impairment losses of $60 million after-tax were recorded in 2004 across various
sectors, including an after-tax impairment loss of $36 million related to loans to the national
contractor. For additional information on loans to the national contractor, see Note S of the
Consolidated Financial Statements included under Item 8.
Net realized investment results decreased $438 million after-tax in 2004 as compared with 2003.
This decrease in net realized investment results was primarily due to the loss on the sale of the
individual life insurance business of $389 million after-tax, losses on derivatives of $55 million
after-tax and reduced fixed maturity gains. The derivative securities losses recorded in 2004 were
primarily due to derivative securities held to mitigate the effect of changes in long term interest
rates on the value of the fixed maturity portfolio. These decreases were partly offset by a $105
million after-tax gain related to our investment in Canary Wharf, and a reduction in impairment
losses for other-than-temporary declines in market values for fixed maturity and equity securities.
In 2003, impairment losses of $209 million after-tax were recorded across various sectors
including the airline, healthcare and energy industries.
A primary objective in the management of the fixed maturity and equity portfolios is to maximize
total return relative to underlying liabilities and respective liquidity needs. Our views on the
current interest rate environment, tax regulations, asset class valuations, specific security
issuer and broader industry segment conditions, and the domestic and global economic conditions,
are some of the factors that may enter into a decision to move between asset classes. Based on our
consideration of these factors, in the course of normal investment activity we may, in pursuit of
the total return objective, be willing to sell securities that, in our analysis, are overvalued on
a risk adjusted basis relative to other opportunities that are available at the time in the market;
in turn we may purchase other securities that, according to our analysis, are undervalued in
relation to other securities in the market. In making these value decisions, securities may be
bought and sold that shift the investment portfolio between asset
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classes. We also continually monitor exposure to issuers of securities held and broader industry
sector exposures and may from time to time reduce such exposures based on our views of a specific
issuer or industry sector. These activities will produce realized gains or losses.
The investment portfolio is periodically analyzed for changes in duration and related price change
risk. Additionally, we periodically review the sensitivity of the portfolio to the level of
foreign exchange rates and other factors that contribute to market price changes. A summary of
these risks and specific analysis on changes is included in Item 7A Quantitative and Qualitative
Disclosures about Market Risks included herein. Under certain economic conditions, including but
not limited to a changing interest rate environment, we may hedge the value of the investment
portfolio by utilizing derivative strategies, as discussed further in Notes A and C of the
Consolidated Financial Statements.
We invest in certain derivative financial instruments primarily to reduce our exposure to market
risk (principally interest rate, equity price and foreign currency risk) and credit risk (risk of
nonperformance of underlying obligor). Derivative securities are recorded at fair value at the
reporting date. We also use derivatives to mitigate market risk by purchasing S&P
500â index futures in a notional amount equal to the contract liability relating
to Life and Group Non-Core indexed group annuity contracts. We provided collateral to satisfy
margin deposits on exchange-traded derivatives totaling $64 million as of December 31, 2005. For
over-the-counter derivative transactions we utilize International Swaps and Derivatives Association
(ISDA) Master Agreements that specify certain limits over which collateral is exchanged. As of
December 31, 2005, we provided $2 million of cash as collateral for over-the-counter derivative
instruments.
A further consideration in the management of the investment portfolio is the characteristics of the
underlying liabilities and the ability to align the duration of the portfolio to those liabilities
to meet future liquidity needs, minimize interest rate risk and maintain a level of income
sufficient to support the underlying insurance liabilities. For portfolios where future liability
cash flows are determinable and long term in nature, we segregate assets for asset liability
management purposes.
We classify our fixed maturity securities (bonds and redeemable preferred stocks) and our equity
securities as either available-for-sale or trading, and as such, they are carried at fair value.
The amortized cost of fixed maturity securities is adjusted for amortization of premiums and
accretion of discounts to maturity, which is included in net investment income. Changes in fair
value related to available-for-sale securities are reported as a component of other comprehensive
income. Changes in fair value of trading securities are reported within net investment income.
The following table provides further detail of gross realized gains and gross realized losses on
available-for-sale fixed maturity securities and equity securities.
Realized Gains and Losses
Years ended December 31 | 2005 | 2004 | 2003 | |||||||||
(In millions) | ||||||||||||
Net realized gains (losses) on fixed maturity securities
and equity securities: |
||||||||||||
Fixed maturity securities: |
||||||||||||
Gross realized gains |
$ | 361 | $ | 704 | $ | 1,244 | ||||||
Gross realized losses |
(451 | ) | (457 | ) | (807 | ) | ||||||
Net realized gains (losses) on fixed maturity securities |
(90 | ) | 247 | 437 | ||||||||
Equity securities: |
||||||||||||
Gross realized gains |
73 | 225 | 143 | |||||||||
Gross realized losses |
(35 | ) | (23 | ) | (29 | ) | ||||||
Net realized gains on equity securities |
38 | 202 | 114 | |||||||||
Net realized gains (losses) on fixed maturity and equity
securities |
$ | (52 | ) | $ | 449 | $ | 551 | |||||
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The following table provides details of the largest realized losses from sales of securities
aggregated by issuer including: the fair value of the securities at date of sale, the amount of
the loss recorded and the period of time that the security had been in an unrealized loss position
prior to sale. The period of time that the security had been in an unrealized loss position prior
to sale can vary due to the timing of individual security purchases. Also included is a narrative
providing the industry sector along with the facts and circumstances giving rise to the loss.
Largest Realized Losses from Securities Sold at a Loss
Fair | Months in | |||||||||||
Year ended December 31, 2005 | Value | Unrealized | ||||||||||
Date of | Loss | Loss Prior | ||||||||||
Issuer Description and Discussion | Sale | On Sale | To Sale (a) | |||||||||
(In millions) | ||||||||||||
Various notes and bonds issued by the United States
Treasury. Volatility of interest rates prompted movement
to other asset classes. |
$ | 16,716 | $ | 92 | 0-12+ | |||||||
Manufactures and sells vehicles worldwide under various
brand names. The company also has financing and
insurance operations. The company is experiencing
inventory capacity issues. Losses relate to trades that
took place to reduce issuer exposure. |
356 | 45 | 0-12+ | |||||||||
Agency issued security that is secured by a pool of
federally insured and conventional mortgages. Specific
pools were sold and replaced with non-agency pools to
enhance yield. |
1,326 | 9 | 0-12 | |||||||||
Issuer of high grade state revenue bonds. Loss was
incurred as a result of unfavorable interest rate change. |
242 | 6 | 0-12+ | |||||||||
Large retail food-drug chain. Company was soliciting
bidders, but failed to be acquired. Sold securities to
reduce issuer exposure. |
40 | 6 | 0-6 | |||||||||
Manufactures and sells vehicles worldwide under various
brand names. The company also has financing operations.
The company has been downgraded. Losses relate to trades
that took place to reduce issuer exposure. |
27 | 6 | 0-12 | |||||||||
Large media company that was downgraded to below
investment grade. Losses relate to trades that took
place to reduce issuer exposure. |
74 | 5 | 0-12+ | |||||||||
Issuer of municipal general obligation bonds. Loss was
incurred as a result of unfavorable interest rate change. |
418 | 5 | 0-6 | |||||||||
Issuer of high grade state general obligation bonds.
Loss was incurred as a result of unfavorable interest
rate change. |
244 | 5 | 0-12 | |||||||||
Large domestic passenger and freight airline that filed
for bankruptcy during third quarter 2005. Losses relate
to trades that took place to reduce issuer exposure. |
12 | 5 | 0-6 | |||||||||
$ | 19,455 | $ | 184 | |||||||||
(a) | Represents the range of consecutive months the various positions were in an unrealized loss prior to sale. 0-12+ means certain positions were less than 12 months, while others were greater than 12 months. |
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Valuation and Impairment of Investments
The following table details the carrying value of our general account investment portfolios.
Carrying Value of Investments
December 31, | December 31, | |||||||||||||||
2005 | % | 2004 | % | |||||||||||||
(In millions) | ||||||||||||||||
General account investments: |
||||||||||||||||
Fixed maturity securities available-for-sale: |
||||||||||||||||
U.S. Treasury securities and obligations of government agencies |
$ | 1,469 | 4 | % | $ | 4,346 | 11 | % | ||||||||
Asset-backed securities |
12,859 | 32 | 7,788 | 20 | ||||||||||||
States, municipalities and political subdivisions tax-exempt |
9,209 | 23 | 8,857 | 22 | ||||||||||||
Corporate securities |
6,165 | 15 | 6,513 | 17 | ||||||||||||
Other debt securities |
3,044 | 8 | 3,053 | 8 | ||||||||||||
Redeemable preferred stock |
216 | 1 | 146 | | ||||||||||||
Options embedded in convertible debt securities |
1 | | 234 | 1 | ||||||||||||
Total fixed maturity securities available-for-sale |
32,963 | 83 | 30,937 | 79 | ||||||||||||
Fixed maturity securities trading: |
||||||||||||||||
U.S. Treasury securities and obligations of government agencies |
4 | | 27 | | ||||||||||||
Asset-backed securities |
87 | | 125 | | ||||||||||||
Corporate securities |
154 | 1 | 199 | 1 | ||||||||||||
Other debt securities |
26 | | 35 | | ||||||||||||
Redeemable preferred stock |
| | 4 | | ||||||||||||
Total fixed maturity securities trading |
271 | 1 | 390 | 1 | ||||||||||||
Equity securities available-for-sale: |
||||||||||||||||
Common stock |
289 | 1 | 260 | 1 | ||||||||||||
Preferred stock |
343 | 1 | 150 | | ||||||||||||
Total equity securities available-for-sale |
632 | 2 | 410 | 1 | ||||||||||||
Total equity securities trading |
49 | | 46 | | ||||||||||||
Short term investments available-for-sale |
3,870 | 9 | 5,404 | 14 | ||||||||||||
Short term investments trading |
368 | 1 | 459 | 1 | ||||||||||||
Limited partnerships |
1,509 | 4 | 1,549 | 4 | ||||||||||||
Other investments |
33 | | 36 | | ||||||||||||
Total general account investments |
$ | 39,695 | 100 | % | $ | 39,231 | 100 | % | ||||||||
Our general account investment portfolio consists primarily of publicly traded government
bonds, asset-backed securities, short-term investments, municipal bonds and corporate bonds.
A significant judgment in the valuation of investments is the determination of when an
other-than-temporary impairment has occurred. We analyze securities on at least a quarterly basis.
Part of this analysis is to monitor the length of time and severity of the decline below book
value for those securities in an unrealized loss position. Information on our impairment process
and impairments recorded in 2005, 2004 and 2003 is set forth in Note B of the Consolidated
Financial Statements included under Item 8.
Investments in the general account had a total net unrealized gain of $787 million at December 31,
2005 compared with $1,197 million at December 31, 2004. The unrealized position at December 31,
2005 was comprised of a net unrealized gain of $618 million for fixed maturities, a net unrealized
gain of $170 million for equity securities, and a net unrealized loss of $1 million for short-term
securities. The unrealized position at December 31, 2004 was comprised of a net unrealized gain of
$1,061 million for fixed maturities and a net unrealized gain of $136 million for equity
securities. See Note B of the Consolidated Financial Statements included under Item 8 for further
detail of the unrealized position of our general account investment portfolio.
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Our investment policies for both the general account and separate account emphasize high credit
quality and diversification by industry, issuer and issue. Assets supporting interest rate
sensitive liabilities are segmented within the general account to facilitate asset/liability
duration management.
The following table provides the composition of fixed maturity securities with an unrealized loss
at December 31, 2005 in relation to the total of all fixed maturity securities with an unrealized
loss by contractual maturities.
Contractual Maturity
Percent of | Percent of | |||||||
Market | Unrealized | |||||||
Value | Loss | |||||||
Due in one year or less |
4 | % | 1 | % | ||||
Due after one year through five years |
6 | 5 | ||||||
Due after five years through ten years |
7 | 14 | ||||||
Due after ten years |
22 | 23 | ||||||
Asset-backed securities |
61 | 57 | ||||||
Total |
100 | % | 100 | % | ||||
Our non-investment grade fixed maturity securities available-for-sale as of December 31, 2005
that were in a gross unrealized loss position had a fair value of $874 million. The following
tables summarize the fair value and gross unrealized loss of non-investment grade securities
categorized by the length of time those securities have been in a continuous unrealized loss
position and further categorized by the severity of the unrealized loss position in 10% increments
as of December 31, 2005 and 2004.
Unrealized Loss Aging for Non-investment Grade Securities
Fair Value as a Percentage of Book Value | ||||||||||||||||||||||||
Estimated | Gross Unrealized | |||||||||||||||||||||||
December 31, 2005 | Fair Value | 90-99% | 80-89% | 70-79% | <70% | Loss | ||||||||||||||||||
(In millions) | ||||||||||||||||||||||||
Fixed maturity securities: |
||||||||||||||||||||||||
Non-investment grade: |
||||||||||||||||||||||||
0-6 months |
$ | 632 | $ | 20 | $ | 8 | $ | 1 | $ | | $ | 29 | ||||||||||||
7-12 months |
118 | 4 | 6 | | | 10 | ||||||||||||||||||
13-24 months |
122 | 3 | | | | 3 | ||||||||||||||||||
Greater than 24 months |
2 | | | | | | ||||||||||||||||||
Total non-investment grade |
$ | 874 | $ | 27 | $ | 14 | $ | 1 | $ | | $ | 42 | ||||||||||||
Unrealized Loss Aging for Non-investment Grade Securities
Fair Value as a Percentage of Book Value | ||||||||||||||||||||||||
Estimated | Gross Unrealized | |||||||||||||||||||||||
December 31, 2004 | Fair Value | 90-99% | 80-89% | 70-79% | <70% | Loss | ||||||||||||||||||
(In millions) | ||||||||||||||||||||||||
Fixed maturity securities: |
||||||||||||||||||||||||
Non-investment grade: |
||||||||||||||||||||||||
0-6 months |
$ | 188 | $ | 6 | $ | 1 | $ | | $ | | $ | 7 | ||||||||||||
7-12 months |
69 | 3 | 1 | | | 4 | ||||||||||||||||||
13-24 months |
20 | 1 | 1 | | | 2 | ||||||||||||||||||
Greater than 24 months |
| | | | | | ||||||||||||||||||
Total non-investment grade |
$ | 277 | $ | 10 | $ | 3 | $ | | $ | | $ | 13 | ||||||||||||
As part of the ongoing impairment monitoring process, we evaluated the facts and circumstances
based on available information for each of the non-investment grade securities and determined that
no further impairments were
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appropriate at December 31, 2005. This determination was based on a number of factors that we
regularly consider including, but not limited to: the issuers ability to meet current and future
interest and principal payments, an evaluation of the issuers financial condition and near term
prospects, our assessment of the sector outlook and estimates of the fair value of any underlying
collateral. In all cases where a decline in value is judged to be temporary, we have the intent
and ability to hold these securities for a period of time sufficient to recover the book value of
our investment through a recovery in the fair value of such securities or by holding the securities
to maturity. In many cases, the securities held are matched to liabilities as part of ongoing
asset/liability duration management. As such, we continually assess our ability to hold securities
for a time sufficient to recover any temporary loss in value or until maturity. We believe we have
sufficient levels of liquidity so as to not impact the asset/liability management process.
Our equity securities available-for-sale as of December 31, 2005 that were in an unrealized loss
position had a fair value of $53 million. Under the same process as followed for fixed maturity
securities, we monitor the equity securities for other-than-temporary declines in value. In all
cases where a decline in value is judged to be temporary, we expect to recover the book value of
our investment through a recovery in the fair value of the security.
See Note B of the Consolidated Financial Statements included under Item 8 for further discussion.
Invested assets are exposed to various risks, such as interest rate, market and credit risk. Due
to the level of risk associated with certain invested assets and the level of uncertainty related
to changes in the value of these assets, it is possible that changes in these risks in the near
term, including increases in interest rates, could have an adverse material impact on our results
of operations or equity.
The general account portfolio consists primarily of high quality bonds, 92% and 93% of which were
rated as investment grade (rated BBB or higher) at December 31, 2005 and 2004. The following table
summarizes the ratings of our general account bond portfolio at carrying value.
General Account Bond Ratings
December 31 | 2005 | % | 2004 | % | ||||||||||||
(In millions) | ||||||||||||||||
U.S. Government and affiliated agency securities |
$ | 1,628 | 5 | % | $ | 4,640 | 15 | % | ||||||||
Other AAA rated |
18,233 | 55 | 14,628 | 47 | ||||||||||||
AA and A rated |
6,046 | 18 | 5,597 | 18 | ||||||||||||
BBB rated |
4,499 | 14 | 4,072 | 13 | ||||||||||||
Non investment-grade |
2,612 | 8 | 2,240 | 7 | ||||||||||||
Total |
$ | 33,018 | 100 | % | $ | 31,177 | 100 | % | ||||||||
At December 31, 2005 and 2004, approximately 95% and 99% of the general account portfolio was
issued by U.S. Government and affiliated agencies or was rated by Standard & Poors (S&P) or
Moodys Investors Service (Moodys). The remaining bonds were rated by other rating agencies or
Company management.
The following table summarizes the bond ratings of the investments supporting separate account
products which guarantee principal and a specified rate of interest.
Separate Account Bond Ratings
December 31 | 2005 | % | 2004 | % | ||||||||||||
(In millions) | ||||||||||||||||
U.S. Government and affiliated agency securities |
$ | | | % | $ | | | % | ||||||||
Other AAA rated |
120 | 26 | 156 | 32 | ||||||||||||
AA and A rated |
193 | 41 | 184 | 38 | ||||||||||||
BBB rated |
142 | 31 | 117 | 24 | ||||||||||||
Non investment-grade |
11 | 2 | 29 | 6 | ||||||||||||
Total |
$ | 466 | 100 | % | $ | 486 | 100 | % | ||||||||
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At December 31, 2005 and 2004, 98% and 100% of the separate account portfolio was issued by
U.S. Government agencies or was rated by S&P or Moodys. The remaining bonds were rated by other
rating agencies or Company management.
Non investment-grade bonds, as presented in the tables above, are high-yield securities rated below
BBB by bond rating agencies, as well as other unrated securities that, in the opinion of
management, are below investment-grade. High-yield securities generally involve a greater degree
of risk than investment-grade securities. However, expected returns are anticipated to compensate
for the added risk. This risk is also considered in the interest rate assumptions for the
underlying insurance products.
The carrying value of non-traded securities at December 31, 2005 was $141 million which represents
0.4% of our total investment portfolio. These securities were in a net unrealized gain position of
$115 million at December 31, 2005. Of the non-traded securities, 67% are priced by unrelated third
party sources.
Included in our general account fixed maturity securities at December 31, 2005 are $12,946 million
of asset-backed securities, at fair value, consisting of approximately 64% in collateralized
mortgage obligations (CMOs), 21% in corporate asset-backed obligations, 13% in corporate
mortgage-backed pass-through certificates and 2% in U.S. Government agency issued pass-through
certificates. The majority of CMOs held are actively traded in liquid markets and are primarily
priced by a third party pricing service.
The carrying value of the components of the general account short-term investment portfolio is
presented in the following table.
Short-term Investments
December 31, | December 31, | |||||||
2005 | 2004 | |||||||
(In millions) | ||||||||
Short-term investments available-for-sale: |
||||||||
Commercial paper |
$ | 1,906 | $ | 1,655 | ||||
U.S. Treasury securities |
251 | 2,382 | ||||||
Money market funds |
294 | 174 | ||||||
Other |
1,419 | 1,193 | ||||||
Total short-term investments available-for-sale |
3,870 | 5,404 | ||||||
Short-term investments trading: |
||||||||
Commercial paper |
94 | 46 | ||||||
U.S. Treasury securities |
64 | 300 | ||||||
Money market funds |
200 | 99 | ||||||
Other |
10 | 14 | ||||||
Total short-term investments trading |
368 | 459 | ||||||
Total short-term investments |
$ | 4,238 | $ | 5,863 | ||||
The fair value of collateral held related to securities lending, included in other short-term
investments, was $767 million and $918 million at December 31, 2005 and 2004.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flows
Our principal operating cash flow sources are premiums and investment income from our insurance
subsidiaries. Our primary operating cash flow uses are payments for claims, policy benefits and
operating expenses.
For 2005, net cash provided by operating activities was $2,169 million as compared to $1,968
million in 2004. The increase in cash provided by operations was primarily driven by a reduction
in claims and expense payments, including the impact of $446 million related to commutations. Also
impacting operating cash flows were net tax
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payments of $164 million in 2005 as compared with net tax refunds of $627 million in 2004. In
addition, we received cash of $121 million related to interest on a federal income tax settlement
in 2005.
For 2004, net cash provided by operating activities was $1,968 million as compared to $2,038
million in 2003. The decrease in cash provided by operating activities was primarily driven by a
decrease in premium collections related to the dispositions of the life and group businesses and
CNA Re. Partially offsetting the decrease in premium collections were decreased paid claims and a
federal tax refund received in 2004.
Cash flows from investing activities include purchases and sales of financial instruments, as well
as the purchase and sale of businesses, land, buildings, equipment and other assets not generally
held for resale. The change in cash collateral exchanged as part of the securities lending
activity is included as a cash flow from investing activities.
Net cash used for investing activities was $1,316 million, $2,084 million, and $2,392 million for
2005, 2004, and 2003. Cash flows used by investing activities were related principally to
purchases of fixed maturity securities.
The cash flow from investing activities is impacted by various factors such as the anticipated
payment of claims, financing activity, asset/liability management and individual security buy and
sell decisions made in the normal course of portfolio management. A consideration in management of
the portfolio is the characteristics of the underlying liabilities and the ability to align the
duration of the portfolio to those liabilities to meet future liquidity needs and minimize interest
rate risk. For portfolios where future liability cash flows are determinable and are generally
long term in nature, management segregates assets and related liabilities for asset/liability
management purposes. The asset/liability management strategy is used to mitigate valuation changes
due to interest rate risk in those specific portfolios. Another consideration in the
asset/liability matched portfolios is to maintain a level of income sufficient to support the
underlying insurance liabilities.
For those securities in the portfolio that are not part of a segregated asset/liability management
strategy, the Company typically manages the portfolio to a target duration range dictated by the
underlying insurance liabilities. In managing these portfolios, securities are bought and sold
based on individual security value assessments made, but with the overall goal of meeting the
duration targets.
Cash flows from financing activities include proceeds from the issuance of debt and equity
securities, outflows for repayment of debt, outlays to reacquire equity instruments, and deposits
and withdrawals related to investment contract products issued by us.
For 2005, net cash used for financing activities was $837 million as compared with net cash
provided from financing activities of $61 million in 2004. For the 2003, net cash provided from
financing activities was $322 million.
We believe that our present cash flows from operations, investing activities and financing
activities are sufficient to fund our working capital needs. In addition, we believe we have
adequate liquidity to meet our catastrophe loss obligations.
We have a shelf registration statement under which we may issue an aggregate of $1,500 million of
debt or equity securities. This registration statement was declared effective by the Securities
and Exchange Commission (SEC) on September 14, 2005.
Commitments, Contingencies, and Guarantees
We have various commitments, contingencies and guarantees which we become involved with during the
ordinary course of business. The impact of these commitments, contingencies and guarantees should
be considered when evaluating our liquidity and capital resources.
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A summary of our commitments as of December 31, 2005 is presented in the following table. In 2006,
we expect to make principal and interest payments of approximately $357 million on our debt.
Contractual Commitments
December 31, 2005 | Total | Less than 1 year | 1-3 years | 3-5 years | More than 5 years | |||||||||||||||
(In millions) | ||||||||||||||||||||
Debt (a) |
$ | 2,636 | $ | 357 | $ | 570 | $ | 143 | $ | 1,566 | ||||||||||
Lease obligations |
261 | 53 | 82 | 56 | 70 | |||||||||||||||
Claim and claim expense reserves (b) |
32,861 | 7,522 | 9,610 | 4,969 | 10,760 | |||||||||||||||
Future policy benefits reserves (c) |
10,010 | 200 | 362 | 349 | 9,099 | |||||||||||||||
Policyholder funds reserves (c) |
1,489 | 960 | 285 | 95 | 149 | |||||||||||||||
Guaranteed payment contracts (d) |
22 | 15 | 7 | | | |||||||||||||||
Total |
$ | 47,279 | $ | 9,107 | $ | 10,916 | $ | 5,612 | $ | 21,644 | ||||||||||
(a) | Includes estimated future interest payments, but does not include original issue discount. | ||
(b) | Claim and claim adjustment expense reserves are not discounted and represent our estimate of the amount and timing of the ultimate settlement and administration of claims based on our assessment of facts and circumstances known as of December 31, 2005. See the Reserves Estimates and Uncertainties section of this MD&A for further information. Claim and claim adjustment expense reserves of $15 million related to business which has been 100% ceded to unaffiliated parties in connection with the individual life sale are not included. | ||
(c) | Future policy benefits and policyholder funds reserves are not discounted and represent our estimate of the ultimate amount and timing of the settlement of benefits based on our assessment of facts and circumstances known as of December 31, 2005. Future policy benefit reserves of $968 million and policyholder fund reserves of $51 million related to business which has been 100% ceded to unaffiliated parties in connection with the individual life sale are not included. Additional information on future policy benefits and policyholder funds reserves is included in Note A of the Consolidated Financial Statements included under Item 8. | ||
(d) | Primarily relating to telecommunications and software services. |
Further information on our commitments, contingencies and guarantees is provided in Notes B,
F, G, I and K of the Consolidated Financial Statements included under Item 8.
Regulatory Matters
We have established a plan to reorganize and streamline our U.S. property and casualty insurance
legal entity structure. One phase of this multi-year plan has been completed. This phase served
to consolidate our U.S. property and casualty insurance risks into CCC, as well as realign the
capital supporting these risks. As part of this phase, we implemented a 100% quota share
reinsurance agreement, effective January 1, 2003, ceding all of the net insurance risks of CIC and
its 14 affiliated insurance companies (CIC Group) to CCC. Additionally, the ownership of the CIC
Group was transferred to CCC in order to align the insurance risks with the supporting capital. In
subsequent phases of this plan, we will continue our efforts to reduce both the number of U.S.
property and casualty insurance entities we maintain and the number of states in which these
entities are domiciled. In order to facilitate the execution of this plan, we have agreed to
participate in a working group consisting of several states of the National Association of
Insurance Commissioners. Pursuant to our participation in this working group, we have agreed to
certain time frames and informational provisions in relation to the reorganization plan.
In connection with the approval process for aspects of the reorganization and legal entity
streamlining plan, we agreed to undergo zone regulatory financial examinations of CCC and CIC as of
December 31, 2003, including a review of insurance reserves by an independent actuarial firm. A
zone examination is a vehicle developed by the National Association of Insurance Commissioners for
conducting financial examinations of multi-state licensed insurers. It allows a representative
number of state insurance departments to devote resources to the examination process while
providing an independent and diverse perspective on all areas being reviewed. The CCC examination
specifically included a review of certain finite reinsurance contracts entered into by us and
determined that such contracts possess sufficient risk transfer characteristics necessary to
qualify for accounting treatment as reinsurance on a statutory basis. These zone regulatory
examinations were concluded in 2005 and final examination reports have been issued.
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Along with other companies in the industry, we have received subpoenas, interrogatories and
inquiries from: (i) California, Connecticut, Delaware, Florida, Hawaii, Illinois, Minnesota, New
Jersey, New York, North Carolina, Ohio, Pennsylvania, South Carolina, West Virginia and the
Canadian Council of Insurance Regulators concerning investigations into practices including
contingent compensation arrangements, fictitious quotes, and tying arrangements; (ii) the
Securities and Exchange Commission (SEC), the New York State Attorney General, the United States
Attorney for the Southern District of New York, the Connecticut Attorney General, the Connecticut
Department of Insurance, the Delaware Department of Insurance, the Georgia Office of Insurance and
Safety Fire Commissioner and the California Department of Insurance concerning reinsurance products
and finite insurance products purchased and sold by the Company; (iii) the Massachusetts Attorney
General and the Connecticut Attorney General concerning investigations into anti-competitive
practices; and (iv) the New York State Attorney General concerning declinations of attorney
malpractice insurance. We continue to respond to these subpoenas, interrogatories and inquiries.
Subsequent to receipt of the SEC subpoena, we have been producing documents and providing additional
information at the SECs request. In addition, the SEC and representatives of the United
States Attorneys Office for the Southern District of New York have been conducting interviews with several
of our current and former executives relating to the restatement of our financial results for 2004,
including our relationship with and accounting for transactions with an affiliate that were the
basis for the restatement. The SEC has also recently requested information relating to our current
restatement. It is possible that our analyses of, or accounting treatment for, finite reinsurance
contracts or discontinued operations could be questioned or disputed by regulatory authorities.
As a result, further restatements of our financial results are possible.
Ratings
Ratings are an important factor in establishing the competitive position of insurance companies.
Our insurance company subsidiaries are rated by major rating agencies, and these ratings reflect
the rating agencys opinion of the insurance companys financial strength, operating performance,
strategic position and ability to meet our obligations to policyholders. Agency ratings are not a
recommendation to buy, sell or hold any security, and may be revised or withdrawn at any time by
the issuing organization. Each agencys rating should be evaluated independently of any other
agencys rating. One or more of these agencies could take action in the future to change the
ratings of our insurance subsidiaries.
On Review, Credit Watch and Rating Watch are modifiers used by the ratings agencies to alert
those parties relying on our ratings of the possibility of a rating change within 90 days.
Modifiers are utilized when the agencies are uncertain as to the impact of a company action or
initiative, which could prove to be material to the current rating level. Outlooks accompanied
with ratings are additional modifiers used by the rating agencies of the possibility of a rating
change in the longer term.
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The table below reflects the various group ratings issued by A.M. Best, Fitch, Moodys and S&P as
of February 26, 2006 for the Property and Casualty and Life companies. The table also includes the
ratings for CNAFs senior debt and Continental senior debt.
Insurance Financial Strength Ratings | Debt Ratings | |||||||||||||||||||
Property & Casualty (a) | Life (b) | CNAF | Continental | |||||||||||||||||
CCC | CIC | Senior | Senior | |||||||||||||||||
Group | Group | CAC | Debt | Debt | ||||||||||||||||
A.M. Best |
A | A | A- | bbb | Not rated | |||||||||||||||
Fitch |
A- | A- | A- | BBB- | BBB- | |||||||||||||||
Moodys |
A3 | A3 | Baa1 | Baa3 | Baa3 | |||||||||||||||
S&P |
A- | A- | BBB+ | BBB- | BBB- |
(a) | Fitch and Moodys outlook for the Property & Casualty companies financial strength and holding company debt ratings are stable. All others are negative. | |
(b) | A.M. Best, Fitch and Moodys have a stable outlook while S&P has a negative outlook on the CAC rating. |
On November 3, 2005 and February 17, 2006, Moodys Investors Service and Fitch Ratings
concluded their annual reviews and affirmed CNAs current debt and financial strength ratings. The
Moodys rating outlook was changed to stable from negative and Fitchs current stable outlook was
unchanged.
If our property and casualty insurance financial strength ratings were downgraded below current
levels, our business and results of operations could be materially adversely affected. The
severity of the impact on our business is dependent on the level of downgrade and, for certain
products, which rating agency takes the rating action. Among the adverse effects in the event of
such downgrades would be the inability to obtain a material volume of business from certain major
insurance brokers, the inability to sell a material volume of our insurance products to certain
markets, and the required collateralization of certain future payment obligations or reserves.
In addition, we believe that a lowering of the debt ratings of Loews by certain of these agencies
could result in an adverse impact on our ratings, independent of any change in circumstances at
CNA. Each of the major rating agencies which rates Loews currently maintains a negative outlook,
but none currently has Loews on negative Credit Watch.
We have entered into several settlement agreements and assumed reinsurance contracts that require
collateralization of future payment obligations and assumed reserves if our ratings or other
specific criteria fall below certain thresholds. The ratings triggers are generally more than one
level below our current ratings.
Dividends from Subsidiaries
Our ability to pay dividends and other credit obligations is significantly dependent on receipt of
dividends from our subsidiaries. The payment of dividends to us by our insurance subsidiaries
without prior approval of the insurance department of each subsidiarys domiciliary jurisdiction is
limited by formula. Dividends in excess of these amounts are subject to prior approval by the
respective state insurance departments.
Dividends from CCC are subject to the insurance holding company laws of the State of Illinois, the
domiciliary state of CCC. Under these laws, ordinary dividends, or dividends that do not require
prior approval of the Illinois Department of Financial and Professional Regulation Division of
Insurance (the Department), may be paid only from earned surplus, which is calculated by removing
unrealized gains from unassigned surplus. As of December 31, 2005, CCC is in a positive earned
surplus position, enabling CCC to pay approximately $48 million of dividend payments during 2006
that would not be subject to the Departments prior approval. In February of 2006, the Department
approved extraordinary dividends in the amount of $344 million to be used to fund CNAFs 2006 debt
service and principal repayment requirements.
CNAFs domestic insurance subsidiaries are subject to risk-based capital requirements. Risk-based
capital is a method developed by the NAIC to determine the minimum amount of statutory capital
appropriate for an insurance company to support its overall business operations in consideration of
its size and risk profile. The formula for determining the amount of risk-based capital specifies
various factors, weighted based on the perceived degree of risk, which are applied to certain
financial balances and financial activity. The adequacy of a companys actual
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capital is evaluated by a comparison to the risk-based capital results, as determined by the
formula. Companies below minimum risk-based capital requirements are classified within certain
levels, each of which requires specified corrective action. As of December 31, 2005 and 2004, all
of CNAFs domestic insurance subsidiaries exceeded the minimum risk-based capital requirements.
Loews
Loews has provided the following capital support to us during the past five years:
| In September of 2001, Loews purchased 38.3 million of our common shares for $957 million in a rights offering; | |
| In December of 2002, Loews purchased shares of our newly issued Series H Cumulative Preferred Issue (Series H Issue) for $750 million, which shares remain outstanding; | |
| In November of 2003, Loews purchased shares of our newly issued participating convertible preferred stock for $750 million, which shares converted into 32,327,015 shares of our common stock in April 2004 in accordance with their terms; and | |
| In February of 2004, Loews purchased $346 million of surplus notes of our subsidiary, CCC, in connection with the sales of CCCs individual life and group benefits businesses, which notes were repaid during 2004. |
The Series H Issue is held by Loews and accrues cumulative dividends at an initial rate of 8% per
year, compounded annually. As of December 31, 2005, we have $197 million of undeclared but
accumulated dividends. The Series H Issue dividend amounts for the years ended December 31, 2005
and 2004 have been subtracted from Net Income (Loss) to determine income (loss) available to common
stockholders.
Series H Issue is senior to our common stock as to the payment of dividends and amounts payable
upon any liquidation, dissolution or winding up. No dividends may be declared on our common stock
until all cumulative dividends on the Series H Issue have been paid. We may not issue any equity
securities ranking senior to or on par with the Series H Issue without the consent of a majority of
its stockholders. The Series H Issue is non-voting and is not convertible into any other
securities. It may be redeemed only upon the mutual agreement of CNAF and a majority of the
stockholders of the preferred stock.
Accounting Pronouncements
In January 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial
Accounting Standard No. 155, Accounting for Certain Hybrid Financial Instruments (SFAS
155). SFAS 155 amends FASB Statements No. 133, Accounting for Derivative Instruments and
Hedging Activities (SFAS 133), and No. 140, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities. SFAS 155 also resolves issues addressed
in SFAS 133 Implementation Issue No. D1, Application of Statement 133 to Beneficial Interests
in Securitized Financial Assets. SFAS 155 will improve financial reporting by eliminating the
exemption from applying SFAS 133 to interests in securitized financial assets so that similar
instruments are accounted for in the same manner regardless of the form of the instruments. SFAS
155 will also improve financial reporting by allowing a preparer to elect fair value measurement at
acquisition, at issuance, or when a previously recognized financial instrument is subject to a
remeasurement (new basis) event, on an instrument-by-instrument basis. SFAS 155 is effective for
all financial instruments acquired or issued after the beginning of an entitys first fiscal year
that begins after September 15, 2006. The fair value election provided for in paragraph 4(c) of
SFAS 155 may also be applied upon adoption of SFAS 155 for hybrid financial instruments that had
been bifurcated under paragraph 12 of SFAS 133 prior to the adoption of this Statement. Earlier
adoption is permitted as of the beginning of an entitys fiscal year, provided the entity has not
yet issued financial statements, including financial statements for any interim period for that
fiscal year. Provisions of this Statement may be applied to instruments that an entity holds at
the date of adoption on an instrument-by-instrument basis. Adoption of this standard is not
expected to have a material impact on our results of operations and/or equity.
In September 2005, the Accounting Standards Executive Committee of the American Institute of
Certified Public Accountants issued Statement of Position 05-01, Accounting by Insurance
Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of
Insurance Contracts (SOP 05-01). SOP 05-01 provides
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guidance on accounting by insurance enterprises for deferred acquisition costs on internal
replacements of insurance and investment contracts other than those specifically described in
Statement of Financial Accounting Standard No. 97, Accounting and Reporting by Insurance
Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of
Investments. SOP 05-01 defines an internal replacement as a modification in product benefits,
features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by
amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within
a contract. SOP 05-01 is effective for internal replacements occurring in fiscal years beginning
after December 15, 2006. We are currently evaluating the impact that adopting SOP 05-01 will have
on our operations and financial condition.
In May of
2005, the FASB issued Statement of Financial Accounting Standard No. 154, Accounting
Changes and Error Correction. This standard is a replacement of Accounting Policy Board Opinion
No. 20 and FASB Standard No. 3. Under the new standard, any voluntary changes in accounting
principles should be adopted via a retrospective application of the accounting principle in the
financial statements presented in addition to obtaining an opinion from the auditors that the new
principle is preferred. In addition, adoption of a change in accounting principle required by the
issuance of a new accounting standard would also require retroactive restatement, unless the new
standard includes explicit transition guidelines. This new standard is effective for fiscal years
beginning after December 15, 2005.
In November of 2005, the FASB issued FASB Staff Position (FSP) No. FAS 115-1 and FAS 124-1, The
Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments, as
applicable to debt and equity securities that are within the scope of SFAS No. 115, Accounting
for Certain Investments in Debt and Equity Securities (SFAS 115) and equity securities that are
accounted for using the cost method specified in Accounting Principles Board Opinion No. 18,
The Equity Method of Accounting for Investments in Common Stock. This FSP nullifies
certain requirements of The Emerging Issues Task Force Issue No. 03-1 (EITF 03-01), The Meaning
of Other-Than-Temporary Impairment and its Application to Certain Investments, guidance on
determining whether an impairment is other-than-temporary. This FSP will replace guidance set
forth in EITF 03-01 with references to existing other-than-temporary impairment guidance and will
clarify that an investor should recognize an impairment loss no later than when the impairment is
deemed other than temporary, even if a decision to sell has not been made. The FSP carries forward
the requirements in Issue No. 03-01 regarding required disclosures in the financial statements and
requires additional disclosure related to factors considered in reaching the conclusion that the
impairment is other-than-temporary. In addition, in periods subsequent to the recognition of an
other-than-temporary impairment loss for debt securities, the discount or reduced premium would be
amortized over the remaining life of the security based on future estimated cash flows. This new
guidance for determining whether impairment is other-than-temporary is effective for reporting
periods beginning after December 15, 2005. Adoption of this standard is not expected to have a
material impact on our results of operations and/or equity.
FORWARD-LOOKING STATEMENTS
This report contains a number of forward-looking statements which relate to anticipated future
events rather than actual present conditions or historical events. You can identify
forward-looking statements because generally they include words such as believes, expects,
intends, anticipates, estimates, and similar expressions. Forward-looking statements in this
report include any and all statements regarding expected developments in our insurance business,
including losses and loss reserves for asbestos, environmental pollution and mass tort claims
which are more uncertain, and therefore more difficult to estimate than loss reserves respecting
traditional property and casualty exposures; the impact of routine ongoing insurance reserve
reviews we are conducting; our expectations concerning our revenues, earnings, expenses and
investment activities; expected cost savings and other results from our expense reduction and
restructuring activities; and our proposed actions in response to trends in our business.
Forward-looking statements, by their nature, are subject to a variety of inherent risks and
uncertainties that could cause actual results to differ materially from the results projected in
the forward-looking statement. We cannot control many of these risks and uncertainties. Some
examples of these risks and uncertainties are:
| general economic and business conditions, including inflationary pressures on medical care costs, construction costs and other economic sectors that increase the severity of claims; |
| changes in financial markets such as fluctuations in interest rates, long-term periods of low interest rates, credit conditions and currency, commodity and stock prices; |
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| the effects of corporate bankruptcies, such as Enron and WorldCom, on capital markets, and on the markets for directors and officers and errors and omissions coverages; |
| changes in foreign or domestic political, social and economic conditions; |
| regulatory initiatives and compliance with governmental regulations, judicial decisions, including interpretation of policy provisions, decisions regarding coverage and theories of liability, trends in litigation and the outcome of any litigation involving us, and rulings and changes in tax laws and regulations; |
| effects upon insurance markets and upon industry business practices and relationships of current litigation, investigations and regulatory activity by the New York State Attorney Generals office and other authorities concerning contingent commission arrangements with brokers and bid solicitation activities; |
| legal and regulatory activities with respect to certain non-traditional and finite-risk insurance products, and possible resulting changes in accounting and financial reporting in relation to such products, including our restatement of financial results in May of 2005 and our relationship with an affiliate, Accord Re Ltd., as disclosed in connection with that restatement; |
| regulatory limitations, impositions and restrictions upon us, including the effects of assessments and other surcharges for guaranty funds and second-injury funds and other mandatory pooling arrangements; |
| the impact of competitive products, policies and pricing and the competitive environment in which we operate, including changes in our book of business; |
| product and policy availability and demand and market responses, including the level of ability to obtain rate increases and decline or non-renew under priced accounts, to achieve premium targets and profitability and to realize growth and retention estimates; |
| development of claims and the impact on loss reserves, including changes in claim settlement policies; |
| the effectiveness of current initiatives by claims management to reduce loss and expense ratios through more efficacious claims handling techniques; |
| the performance of reinsurance companies under reinsurance contracts with us; | |
| results of financing efforts, including the availability of bank credit facilities; | |
| changes in our composition of operating segments; |
| weather and other natural physical events, including the severity and frequency of storms, hail, snowfall and other winter conditions, as well as of natural disasters such as hurricanes and earthquakes; |
| man-made disasters, including the possible occurrence of terrorist attacks and the effect of the absence or insufficiency of applicable terrorism legislation on coverages; |
| the unpredictability of the nature, targets, severity or frequency of potential terrorist events, as well as the uncertainty as to our ability to contain our terrorism exposure effectively, notwithstanding the extension until 2007 of the Terrorism Risk Insurance Act of 2002; |
| the occurrence of epidemics; |
| exposure to liabilities due to claims made by insureds and others relating to asbestos remediation and health-based asbestos impairments, as well as exposure to liabilities for environmental pollution, mass tort, and construction defect claims; |
| whether a national privately financed trust to replace litigation of asbestos claims with payments to claimants from the trust will be established or approved through federal legislation, or, if established and approved, whether it will contain funding requirements in excess of our established loss reserves or carried loss reserves; |
| the sufficiency of our loss reserves and the possibility of future increases in reserves; |
| regulatory limitations and restrictions, including limitations upon our ability to receive dividends from our insurance subsidiaries imposed by state regulatory agencies and minimum risk-based capital standards established by the National Association of Insurance Commissioners; |
| the risks and uncertainties associated with our loss reserves as outlined in the Reserves Estimates and Uncertainties section of this Managements Discussion and Analysis of Financial Condition and Results of Operations; |
| the level of success in integrating acquired businesses and operations, and in consolidating, or selling existing ones; |
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| the possibility of further changes in our ratings by ratings agencies, including the inability to access certain markets or distribution channels and the required collateralization of future payment obligations as a result of such changes, and changes in rating agency policies and practices; and |
| the actual closing of contemplated transactions and agreements. |
Our forward-looking statements speak only as of the date on which they are made and we do not
undertake any obligation to update or revise any forward-looking statement to reflect events or
circumstances after the date of the statement, even if our expectations or any related events or
circumstances change.
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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is a broad term related to changes in the fair value of a financial instrument.
Discussions herein regarding market risk focus on only one element of market risk, that is price
risk. Price risk relates to changes in the level of prices due to changes in interest rates,
equity prices, foreign exchange rates or other factors that relate to market volatility of the
rate, index or price underlying the financial instrument. Our primary market risk exposures are
due to changes in interest rates, although we have certain exposures to changes in equity prices
and foreign currency exchange rates. The fair value of the financial instrument is adversely
affected when interest rates rise, equity markets decline and the dollar strengthens against
foreign currency.
Active management of market risk is integral to our operations. We may use the following tools to
manage our exposure to market risk within defined tolerance ranges: (1) change the character of
future investments purchased or sold, (2) use derivatives to offset the market behavior of existing
assets and liabilities or assets expected to be purchased and liabilities to be incurred, or (3)
rebalance our existing asset and liability portfolios.
Sensitivity Analysis
We monitor our sensitivity to interest rate risk by evaluating the change in the value of financial
assets and liabilities due to fluctuations in interest rates. The evaluation is performed by
applying an instantaneous change in interest rates of varying magnitudes on a static balance sheet
to determine the effect such a change in rates would have on our fair value at risk and the
resulting effect on stockholders equity. The analysis presents the sensitivity of the fair value
of our financial instruments to selected changes in market rates and prices. The range of change
chosen reflects our view of changes that are reasonably possible over a one-year period. The
selection of the range of values chosen to represent changes in interest rates should not be
construed as our prediction of future market events, but rather an illustration of the impact of
such events.
The sensitivity analysis estimates the decline in the fair value of our interest sensitive assets
and liabilities that were held on December 31, 2005 and December 31, 2004 due to instantaneous
parallel increases in the period end yield curve of 100 and 150 basis points.
The sensitivity analysis also assumes an instantaneous 10% and 20% decline in the foreign currency
exchange rates versus the United States dollar from their levels at December 31, 2005 and December
31, 2004, with all other variables held constant.
Equity price risk was measured assuming an instantaneous 10% and 25% decline in the S&P 500 Index
(Index) from its level at December 31, 2005 and December 31, 2004, with all other variables held
constant. Our equity holdings were assumed to be highly and positively correlated with the Index.
At December 31, 2005, a 10% and 25% decrease in the Index would result in a $227 million and $567
million decrease compared to a $214 million and $534 million decrease at December 31, 2004, in the
market value of our equity investments.
Of these amounts, under the 10% and 25% scenarios, $4 million and $11 million at December 31, 2005
and $5 million and $14 million at December 31, 2004 pertained to decreases in the fair value of the
separate account investments. These decreases would substantially be offset by decreases in
related separate account liabilities to customers. Similarly, increases in the fair value of the
separate account equity investments would also be offset by increases in the same related separate
account liabilities by the same approximate amounts.
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The following tables present the estimated effects on the fair value of our financial instruments
at December 31, 2005 and December 31, 2004, due to an increase in interest rates of 100 basis
points, a 10% decline in foreign currency exchange rates and a 10% decline in the Index.
Market Risk Scenario 1
Increase (Decrease) | ||||||||||||||||
Market | Interest | Currency | Equity | |||||||||||||
December 31, 2005 | Value | Rate Risk | Risk | Risk | ||||||||||||
(In millions) | ||||||||||||||||
General account: |
||||||||||||||||
Fixed maturity securities available-for-sale |
$ | 32,963 | $ | (1,897 | ) | $ | (89 | ) | $ | (22 | ) | |||||
Fixed maturity securities trading |
271 | (2 | ) | (1 | ) | (2 | ) | |||||||||
Equity securities available-for-sale |
632 | | (6 | ) | (63 | ) | ||||||||||
Equity securities trading |
49 | | | (5 | ) | |||||||||||
Short term investments available-for-sale |
3,870 | (4 | ) | (37 | ) | | ||||||||||
Short term investments trading |
368 | | | | ||||||||||||
Limited partnerships |
1,509 | 1 | | (29 | ) | |||||||||||
Other invested assets |
30 | | | | ||||||||||||
Interest rate swaps |
| 66 | | | ||||||||||||
Equity index futures for trading securities |
| 2 | | (102 | ) | |||||||||||
Other derivative securities |
3 | 3 | 10 | | ||||||||||||
Total general account |
39,695 | (1,831 | ) | (123 | ) | (223 | ) | |||||||||
Separate accounts: |
||||||||||||||||
Fixed maturity securities |
466 | (23 | ) | | | |||||||||||
Equity securities |
44 | | | (4 | ) | |||||||||||
Short term investments |
36 | | | | ||||||||||||
Total separate accounts |
546 | (23 | ) | | (4 | ) | ||||||||||
Total securities |
$ | 40,241 | $ | (1,854 | ) | $ | (123 | ) | $ | (227 | ) | |||||
Debt (carrying value) |
$ | 1,690 | $ | (92 | ) | $ | | $ | | |||||||
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Market Risk Scenario 1
Increase (Decrease) | ||||||||||||||||
Market | Interest | Currency | Equity | |||||||||||||
December 31, 2004 | Value | Rate Risk | Risk | Risk | ||||||||||||
(In millions) | ||||||||||||||||
General account: |
||||||||||||||||
Fixed maturity securities available-for-sale |
$ | 30,937 | $ | (1,824 | ) | $ | (88 | ) | $ | (26 | ) | |||||
Fixed maturity securities trading |
390 | (4 | ) | (1 | ) | (3 | ) | |||||||||
Equity securities available-for-sale |
410 | | (9 | ) | (41 | ) | ||||||||||
Equity securities trading |
46 | | | (5 | ) | |||||||||||
Short term investments available-for-sale |
5,404 | (7 | ) | (10 | ) | | ||||||||||
Short term investments trading |
459 | | | | ||||||||||||
Limited partnerships |
1,549 | 6 | | (18 | ) | |||||||||||
Other invested assets |
42 | | | | ||||||||||||
Interest rate swaps |
(8 | ) | 8 | | | |||||||||||
Equity index futures for trading securities |
| 2 | | (116 | ) | |||||||||||
Other derivative securities |
2 | 7 | (21 | ) | | |||||||||||
Total general account |
39,231 | (1,812 | ) | (129 | ) | (209 | ) | |||||||||
Separate accounts: |
||||||||||||||||
Fixed maturity securities |
486 | (24 | ) | | | |||||||||||
Equity securities |
55 | | | (5 | ) | |||||||||||
Short term investments |
20 | | | | ||||||||||||
Total separate accounts |
561 | (24 | ) | | (5 | ) | ||||||||||
Total securities |
$ | 39,792 | $ | (1,836 | ) | $ | (129 | ) | $ | (214 | ) | |||||
Debt (carrying value) |
$ | 2,257 | $ | (97 | ) | $ | | $ | | |||||||
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The following tables present the estimated effects on the fair value of our financial
instruments at December 31, 2005 and December 31, 2004, due to an increase in interest rates of 150
basis points, a 20% decline in foreign currency exchange rates and a 25% decline in the Index.
Market Risk Scenario 2
Increase (Decrease) | ||||||||||||||||
Market | Interest | Currency | Equity | |||||||||||||
December 31, 2005 | Value | Rate Risk | Risk | Risk | ||||||||||||
(In millions) | ||||||||||||||||
General account: |
||||||||||||||||
Fixed maturity securities available-for-sale |
$ | 32,963 | $ | (2,827 | ) | $ | (178 | ) | $ | (54 | ) | |||||
Fixed maturity securities trading |
271 | (4 | ) | (1 | ) | (4 | ) | |||||||||
Equity securities available-for-sale |
632 | | (11 | ) | (158 | ) | ||||||||||
Equity securities trading |
49 | | | (12 | ) | |||||||||||
Short term investments available-for-sale |
3,870 | (6 | ) | (74 | ) | | ||||||||||
Short term investments trading |
368 | | | | ||||||||||||
Limited partnerships |
1,509 | 1 | | (72 | ) | |||||||||||
Other invested assets |
30 | | | | ||||||||||||
Interest rate swaps |
| 95 | | | ||||||||||||
Equity index futures for trading |
| 3 | (1 | ) | (255 | ) | ||||||||||
Other derivative securities |
3 | 5 | 20 | (1 | ) | |||||||||||
Total general account |
39,695 | (2,733 | ) | (245 | ) | (556 | ) | |||||||||
Separate accounts: |
||||||||||||||||
Fixed maturity securities |
466 | (34 | ) | | | |||||||||||
Equity securities |
44 | | | (11 | ) | |||||||||||
Short term investments |
36 | | | | ||||||||||||
Total separate accounts |
546 | (34 | ) | | (11 | ) | ||||||||||
Total securities |
$ | 40,241 | $ | (2,767 | ) | $ | (245 | ) | $ | (567 | ) | |||||
Debt (carrying value) |
$ | 1,690 | $ | (135 | ) | $ | | $ | | |||||||
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Market Risk Scenario 2
Increase
(Decrease) |
||||||||||||||||
Market | Interest | Currency | Equity | |||||||||||||
December
31, 2004 (In millions) |
Value |
Rate Risk |
Risk |
Risk |
||||||||||||
General account: |
||||||||||||||||
Fixed maturity securities available-for-sale |
$ | 30,937 | $ | (2,703 | ) | $ | (177 | ) | $ | (63 | ) | |||||
Fixed maturity securities trading |
390 | (6 | ) | (1 | ) | (8 | ) | |||||||||
Equity securities available-for-sale |
410 | | (18 | ) | (103 | ) | ||||||||||
Equity securities trading |
46 | | | (11 | ) | |||||||||||
Short term investments available-for-sale |
5,404 | (11 | ) | (20 | ) | | ||||||||||
Short term investments trading |
459 | | | | ||||||||||||
Limited partnerships |
1,549 | 9 | | (46 | ) | |||||||||||
Other invested assets |
42 | | | | ||||||||||||
Interest rate swaps |
(8 | ) | 12 | | | |||||||||||
Equity index futures for trading |
| 3 | | (289 | ) | |||||||||||
Other derivative securities |
2 | 10 | (38 | ) | | |||||||||||
Total general account |
39,231 | (2,686 | ) | (254 | ) | (520 | ) | |||||||||
Separate accounts: |
||||||||||||||||
Fixed maturity securities |
486 | (35 | ) | | | |||||||||||
Equity securities |
55 | | | (14 | ) | |||||||||||
Short term investments |
20 | | | | ||||||||||||
Total separate accounts |
561 | (35 | ) | | (14 | ) | ||||||||||
Total securities |
$ | 39,792 | $ | (2,721 | ) | $ | (254 | ) | $ | (534 | ) | |||||
Debt (carrying value) |
$ | 2,257 | $ | (141 | ) | $ | | $ | | |||||||
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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
CNA Financial Corporation
Consolidated Statements of Operations
2005 |
2004 |
2003 |
||||||||||
Years ended December 31 (In millions, except per share data) |
Restated See Note T |
Restated See Note T |
||||||||||
Revenues: |
||||||||||||
Net earned premiums |
$ | 7,569 | $ | 8,209 | $ | 9,216 | ||||||
Net investment income |
1,892 | 1,680 | 1,656 | |||||||||
Realized investment gains (losses), net of
participating policyholders and minority
interests |
(10 | ) | (248 | ) | 460 | |||||||
Other revenues |
411 | 283 | 383 | |||||||||
Total revenues |
9,862 | 9,924 | 11,715 | |||||||||
Claims, Benefits and Expenses: |
||||||||||||
Insurance claims and policyholders benefits |
6,999 | 6,445 | 10,277 | |||||||||
Amortization of deferred acquisition costs |
1,543 | 1,680 | 1,965 | |||||||||
Other operating expenses |
1,034 | 1,171 | 1,674 | |||||||||
Interest |
124 | 124 | 130 | |||||||||
Total claims, benefits and expenses |
9,700 | 9,420 | 14,046 | |||||||||
Income (loss) before income tax and minority interest |
162 | 504 | (2,331 | ) | ||||||||
Income tax (expense) benefit |
105 | (31 | ) | 906 | ||||||||
Minority interest |
(24 | ) | (27 | ) | 6 | |||||||
Income (loss) from continuing operations |
243 | 446 | (1,419 | ) | ||||||||
Income (loss) from discontinued operations, net of
tax of $(2), $(1) and $(11) |
21 | (21 | ) | 2 | ||||||||
Net income (loss) |
$ | 264 | $ | 425 | $ | (1,417 | ) | |||||
Basic and diluted earnings (loss) per share: |
||||||||||||
Income (loss) from continuing operations |
$ | 0.68 | $ | 1.49 | $ | (6.52 | ) | |||||
Income (loss) from discontinued operations |
0.08 | (0.09 | ) | 0.01 | ||||||||
Basic and diluted earnings (loss) per share
available to common stockholders |
$ | 0.76 | $ | 1.40 | $ | (6.51 | ) | |||||
Weighted average outstanding common stock and common
stock equivalents |
256.0 | 256.0 | 227.0 | |||||||||
The accompanying Notes are an integral part of these Consolidated Financial Statements.
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CNA Financial Corporation
Consolidated Balance Sheets
2005 |
2004 |
|||||||
December 31 | Restated | |||||||
(In millions, except share data) | See Note T | |||||||
Assets |
||||||||
Investments: |
||||||||
Fixed maturity securities at fair value (amortized cost of $32,616 and $30,266) |
$ | 33,234 | $ | 31,327 | ||||
Equity securities at fair value (cost of $511 and $320) |
681 | 456 | ||||||
Limited partnership investments |
1,509 | 1,549 | ||||||
Other invested assets |
33 | 36 | ||||||
Short-term investments at cost, which approximates fair value |
4,238 | 5,863 | ||||||
Total investments |
39,695 | 39,231 | ||||||
Cash |
96 | 95 | ||||||
Reinsurance receivables (less allowance for uncollectible receivables of $519 and $546) |
11,917 | 15,342 | ||||||
Insurance receivables (less allowance for doubtful accounts of $445 and $502) |
1,866 | 2,202 | ||||||
Accrued investment income |
312 | 297 | ||||||
Receivables for securities sold |
565 | 496 | ||||||
Deferred acquisition costs |
1,197 | 1,268 | ||||||
Prepaid reinsurance premiums |
340 | 1,128 | ||||||
Federal income taxes recoverable (includes $68 and $6 due from Loews Corporation) |
62 | | ||||||
Deferred income taxes |
1,105 | 712 | ||||||
Property and equipment at cost (less accumulated depreciation of $546 and $524) |
197 | 235 | ||||||
Goodwill and other intangible assets |
146 | 162 | ||||||
Other assets |
737 | 760 | ||||||
Separate account business |
551 | 568 | ||||||
Total assets |
$ | 58,786 | $ | 62,496 | ||||
The accompanying Notes are an integral part of these Consolidated Financial Statements.
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2005 |
2004 |
|||||||
Restated | ||||||||
See Note T | ||||||||
Liabilities and Stockholders Equity |
||||||||
Liabilities: |
||||||||
Insurance reserves: |
||||||||
Claim and claim adjustment expenses |
$ | 30,938 | $ | 31,523 | ||||
Unearned premiums |
3,706 | 4,522 | ||||||
Future policy benefits |
6,297 | 5,883 | ||||||
Policyholders funds |
1,495 | 1,725 | ||||||
Collateral on loaned securities |
767 | 918 | ||||||
Payables for securities purchased |
129 | 288 | ||||||
Participating policyholders funds |
53 | 63 | ||||||
Short term debt |
252 | 531 | ||||||
Long term debt |
1,438 | 1,726 | ||||||
Reinsurance balances payable |
1,636 | 2,980 | ||||||
Other liabilities |
2,283 | 2,520 | ||||||
Separate account business |
551 | 568 | ||||||
Total liabilities |
49,545 | 53,247 | ||||||
Commitments and contingencies (Notes F, G, I and K) |
||||||||
Minority interest |
291 | 275 | ||||||
Stockholders equity: |
||||||||
Preferred stock (12,500,000 shares authorized) |
||||||||
Series H Issue (no par value; $100,000 stated value; 7,500 shares issued; held by Loews Corporation) |
750 | 750 | ||||||
Common stock ($2.50 par value; 500,000,000 shares authorized; 258,177,285 shares issued; and
256,001,968 and 255,953,958 shares outstanding) |
645 | 645 | ||||||
Additional paid-in capital |
1,701 | 1,701 | ||||||
Retained earnings |
5,621 | 5,357 | ||||||
Accumulated other comprehensive income |
359 | 661 | ||||||
Treasury stock (2,175,317 and 2,223,327 shares), at cost |
(67 | ) | (69 | ) | ||||
9,009 | 9,045 | |||||||
Notes receivable for the issuance of common stock |
(59 | ) | (71 | ) | ||||
Total stockholders equity |
8,950 | 8,974 | ||||||
Total liabilities and stockholders equity |
$ | 58,786 | $ | 62,496 | ||||
The accompanying Notes are an integral part of these Consolidated Financial Statements.
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CNA Financial Corporation
Consolidated Statements of Cash Flows
2005 |
2004 |
2003 |
||||||||||
Years ended December 31 | Restated | Restated | ||||||||||
(In millions) | See Note T | See Note T | ||||||||||
Cash Flows from Operating Activities: |
||||||||||||
Net income (loss) |
$ | 264 | $ | 425 | $ | (1,417 | ) | |||||
Adjustments to reconcile net income (loss) to net cash flows
provided by operating activities: |
||||||||||||
(Income) loss from discontinued operations |
(21 | ) | 21 | (2 | ) | |||||||
Bad debt provision for insurance and reinsurance receivables |
50 | 87 | 602 | |||||||||
Loss (gain) on disposal of property and equipment |
(1 | ) | 36 | 22 | ||||||||
Minority interest |
24 | 27 | (6 | ) | ||||||||
Deferred income tax provision |
(220 | ) | 37 | 74 | ||||||||
Trading securities |
164 | (93 | ) | | ||||||||
Realized investment (gains) losses, net of participating
policyholders and minority interests |
10 | 248 | (460 | ) | ||||||||
Undistributed earnings of equity method investees |
(45 | ) | (67 | ) | (61 | ) | ||||||
Amortization of bond (discount) premium |
(153 | ) | 9 | (79 | ) | |||||||
Depreciation |
54 | 75 | 86 | |||||||||
Changes in: |
||||||||||||
Receivables, net |
3,711 | (632 | ) | (3,478 | ) | |||||||
Deferred acquisition costs |
71 | 194 | (62 | ) | ||||||||
Accrued investment income |
(15 | ) | (12 | ) | (49 | ) | ||||||
Federal income taxes recoverable/payable |
(62 | ) | 596 | (642 | ) | |||||||
Prepaid reinsurance premiums |
788 | 233 | (15 | ) | ||||||||
Reinsurance balances payable |
(1,344 | ) | (318 | ) | 661 | |||||||
Insurance reserves |
(943 | ) | 1,075 | 6,813 | ||||||||
Other, net |
(116 | ) | 43 | 79 | ||||||||
Total adjustments |
1,952 | 1,559 | 3,483 | |||||||||
Net cash flows provided by operating activities-continuing
operations |
$ | 2,216 | $ | 1,984 | $ | 2,066 | ||||||
Net cash flows used by operating activities-discontinued
operations |
$ | (47 | ) | $ | (16 | ) | $ | (28 | ) | |||
Net cash flows provided by operating activities-total |
$ | 2,169 | $ | 1,968 | $ | 2,038 | ||||||
Cash Flows from Investing Activities: |
||||||||||||
Purchases of fixed maturity securities |
$ | (62,990 | ) | $ | (58,379 | ) | $ | (61,456 | ) | |||
Proceeds from fixed maturity securities: |
||||||||||||
Sales |
55,611 | 48,427 | 52,790 | |||||||||
Maturities, calls and redemptions |
4,579 | 4,800 | 6,435 | |||||||||
Purchases of equity securities |
(482 | ) | (351 | ) | (282 | ) | ||||||
Proceeds from sales of equity securities |
316 | 522 | 589 | |||||||||
Purchases of mortgage loans and real estate |
| (27 | ) | | ||||||||
Change in short-term investments |
1,627 | 2,021 | (842 | ) | ||||||||
Change in collateral on loaned securities and derivatives |
(151 | ) | 476 | (111 | ) | |||||||
Change in other investments |
86 | (30 | ) | 133 | ||||||||
Purchases of property and equipment |
(45 | ) | (41 | ) | (65 | ) | ||||||
Dispositions |
57 | 647 | 418 | |||||||||
Other, net |
56 | (167 | ) | 3 | ||||||||
Net cash flows used by investing activities-continuing operations |
$ | (1,336 | ) | $ | (2,102 | ) | $ | (2,388 | ) | |||
Net cash flows provided (used) by investing
activities-discontinued operations |
$ | 20 | $ | 18 | $ | (4 | ) | |||||
Net cash flows used by investing activities-total |
$ | (1,316 | ) | $ | (2,084 | ) | $ | (2,392 | ) | |||
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2005 |
2004 |
2003 |
||||||||||
Restated | Restated | |||||||||||
See Note T | See Note T | |||||||||||
Cash Flows from Financing Activities: |
||||||||||||
Issuance of preferred stock |
$ | | $ | | $ | 750 | ||||||
Principal payments on debt |
(568 | ) | (618 | ) | (387 | ) | ||||||
Proceeds from issuance of debt |
| 972 | | |||||||||
Return of investment contract account balances |
(281 | ) | (479 | ) | (288 | ) | ||||||
Receipts of investment contract account balances |
7 | 181 | 250 | |||||||||
Other, net |
5 | 5 | (3 | ) | ||||||||
Net cash flows provided (used) by financing
activities-continuing operations |
$ | (837 | ) | $ | 61 | $ | 322 | |||||
Net cash flows provided by financing
activities-discontinued operations |
$ | | $ | | $ | | ||||||
Net cash flows provided (used) by financing activities-total |
$ | (837 | ) | $ | 61 | $ | 322 | |||||
Net change in cash |
16 | (55 | ) | (32 | ) | |||||||
Net cash transactions from continuing operations to
discontinued operations |
(42 | ) | 13 | 13 | ||||||||
Net cash transactions from discontinued operations to
continuing operations |
42 | (13 | ) | (13 | ) | |||||||
Cash, beginning of year |
109 | 164 | 196 | |||||||||
Cash, end of year |
$ | 125 | $ | 109 | $ | 164 | ||||||
Cash-continuing operations |
$ | 96 | $ | 95 | $ | 139 | ||||||
Cash-discontinued operations |
29 | 14 | 25 | |||||||||
Cash-total |
125 | 109 | 164 |
The accompanying Notes are an integral part of these Consolidated Financial Statements.
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CNA Financial Corporation
Consolidated Statements of Stockholders Equity
Accumulated | Notes | |||||||||||||||||||||||||||||||
Additional | Other | Receivable | Total | |||||||||||||||||||||||||||||
Preferred | Common | Paid-in | Retained | Comprehensive | Treasury | Related to | Stockholders | |||||||||||||||||||||||||
(In millions) | Stock |
Stock |
Capital |
Earnings |
Income (Loss) |
Stock |
Common Stock |
Equity |
||||||||||||||||||||||||
Balance, January 1, 2003 (As previously
reported) |
$ | 750 | $ | 565 | $ | 1,031 | $ | 6,545 | $ | 604 | $ | (70 | ) | $ | (72 | ) | $ | 9,353 | ||||||||||||||
Prior period adjustment (See Note T) |
| | | (196 | ) | (18 | ) | | | (214 | ) | |||||||||||||||||||||
Balance,
January 1, 2003 (Restated See Note T) |
$ | 750 | $ | 565 | $ | 1,031 | $ | 6,349 | $ | 586 | $ | (70 | ) | $ | (72 | ) | $ | 9,139 | ||||||||||||||
Comprehensive income: |
||||||||||||||||||||||||||||||||
Net loss (Restated See Note T) |
| | | (1,417 | ) | | | | (1,417 | ) | ||||||||||||||||||||||
Other comprehensive income (Restated See
Note T) |
| | | | 266 | | | 266 | ||||||||||||||||||||||||
|
||||||||||||||||||||||||||||||||
Total comprehensive loss (Restated See Note T) |
(1,151 | ) | ||||||||||||||||||||||||||||||
Issuance of Series I preferred stock |
750 | | | | | | | 750 | ||||||||||||||||||||||||
Stock options exercised |
| | | | | 1 | 1 | |||||||||||||||||||||||||
Increase in notes receivable related to
common stock |
| | | | | | (4 | ) | (4 | ) | ||||||||||||||||||||||
Balance,
December 31, 2003 (Restated See Note T) |
1,500 | 565 | 1,031 | 4,932 | 852 | (69 | ) | (76 | ) | 8,735 | ||||||||||||||||||||||
Comprehensive income: |
||||||||||||||||||||||||||||||||
Net income (Restated See Note T) |
| | | 425 | | | | 425 | ||||||||||||||||||||||||
Other comprehensive loss |
| | | | (191 | ) | | | (191 | ) | ||||||||||||||||||||||
|
||||||||||||||||||||||||||||||||
Total comprehensive income (Restated See Note
T) |
234 | |||||||||||||||||||||||||||||||
Conversion of Series I preferred stock to
common stock |
(750 | ) | 80 | 670 | | | | | | |||||||||||||||||||||||
Decrease in notes receivable related to
common stock |
| | | | | | 5 | 5 | ||||||||||||||||||||||||
Balance,
December 31, 2004 (Restated See Note T) |
750 | 645 | 1,701 | 5,357 | 661 | (69 | ) | (71 | ) | 8,974 | ||||||||||||||||||||||
Comprehensive income: |
||||||||||||||||||||||||||||||||
Net income |
| | | 264 | | | | 264 | ||||||||||||||||||||||||
Other comprehensive loss |
| | | | (302 | ) | | | (302 | ) | ||||||||||||||||||||||
|
||||||||||||||||||||||||||||||||
Total comprehensive loss |
(38 | ) | ||||||||||||||||||||||||||||||
Stock options exercised |
| | | | | 2 | | 2 | ||||||||||||||||||||||||
Decrease in notes receivable related to
common stock |
| | | | | | 12 | 12 | ||||||||||||||||||||||||
Balance, December 31, 2005 |
$ | 750 | $ | 645 | $ | 1,701 | $ | 5,621 | $ | 359 | $ | (67 | ) | $ | (59 | ) | $ | 8,950 | ||||||||||||||
The accompanying Notes are an integral part of these Consolidated Financial Statements.
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Notes to Consolidated Financial Statements
Note A. Summary of Significant Accounting Policies
Basis of Presentation
The Consolidated Financial Statements include the accounts of CNA Financial Corporation (CNAF) and
its controlled subsidiaries. Collectively, CNAF and its subsidiaries are referred to as CNA or the
Company. CNAs property and casualty and the remaining life and group insurance operations are
primarily conducted by Continental Casualty Company (CCC), The Continental Insurance Company (CIC)
and Continental Assurance Company (CAC). Loews Corporation (Loews) owned approximately 91% of the
outstanding common stock and 100% of the Series H preferred stock of CNAF as of December 31, 2005.
The Companys individual life insurance business, including its previously wholly owned subsidiary
Valley Forge Life Insurance Company (VFL), was sold on April 30, 2004 to Swiss Re Life & Health
America Inc. (Swiss Re). The results of the individual life insurance business sold through the
date of sale are included in the Consolidated Statement of Operations for the years ended December
31, 2004 and 2003. See Note P for further information.
CNA Group Life Assurance Company (CNAGLA) was sold to Hartford Financial Services Group, Inc. on
December 31, 2003. The results of the group benefits business sold are included in the Consolidated
Statement of Operations for the year ended December 31, 2003. See Note P for further information.
The accompanying Consolidated Financial Statements have been prepared in conformity with accounting
principles generally accepted in the United States of America (GAAP). All significant intercompany
amounts have been eliminated. Certain amounts applicable to prior years have been reclassified to
conform to the
current year presentation, including an adjustment to other revenue and other expenses. These
amounts were previously netted within other revenue. The amounts have
been reclassified to conform to
the 2005 presentation. The preparation of consolidated financial statements in conformity with
GAAP requires management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and the disclosure of contingent assets and liabilities at the date of the
Consolidated Financial Statements and the reported amounts of revenues and expenses during the
reporting period. Actual results may differ from those estimates.
Business
CNAs core property and casualty insurance operations are reported in two business segments:
Standard Lines and Specialty Lines. CNAs non-core operations are managed in two segments: Life
and Group Non-Core and Corporate and Other Non-Core.
CNA serves a wide variety of customers, including small, medium and large businesses; insurance
companies; associations; professionals; and groups and individuals with a broad range of insurance
and risk management products and services.
Core insurance products include property and casualty coverages. Non-core insurance products,
which primarily have been sold or placed in run-off, include life and accident and health
insurance; retirement products and annuities; and property and casualty reinsurance. CNA services
include risk management, information services, healthcare claims management, and claims
administration. CNAs products and services are marketed through independent agents, brokers,
managing general agents and direct sales.
Insurance Operations
Premiums: Insurance premiums on property and casualty and accident and health insurance contracts
are recognized in proportion to the underlying risk insured which principally are earned ratably
over the duration of the policies after deductions for ceded insurance premiums. The reserve for
unearned premiums on these contracts represents the portion of premiums written relating to the
unexpired terms of coverage.
An estimated allowance for doubtful accounts is recorded on the basis of periodic evaluations of
balances due currently or in the future from insureds, including amounts due from insureds related
to losses under high deductible policies, managements experience and current economic conditions.
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Property and casualty contracts that are retrospectively rated contain provisions that result in an
adjustment to the initial policy premium depending on the contract provisions and loss experience
of the insured during the experience period. For such contracts, the Company estimates the amount
of ultimate premiums that the Company may earn upon completion of the experience period and
recognizes either an asset or a liability for the difference between the initial policy premium and
the estimated ultimate premium. The Company adjusts such estimated ultimate premium amounts during
the course of the experience period based on actual results to date. The resulting adjustment is
recorded as either a reduction of or an increase to the earned premiums for the period.
Revenues on interest-sensitive life insurance contracts are composed of contract charges and fees,
which are recognized over the coverage period. Premiums for other life insurance products and
annuities are recognized as revenue when due after deductions for ceded insurance premiums.
Claim and claim adjustment expense reserves: Claim and claim adjustment expense reserves, except
reserves for structured settlements not associated with asbestos and environmental pollution and
mass tort (APMT), workers compensation lifetime claims, accident and health claims and certain
claims associated with discontinued operations, are not discounted and are based on 1) case basis
estimates for losses reported on direct business, adjusted in the aggregate for ultimate loss
expectations; 2) estimates of incurred but not reported losses; 3) estimates of losses on assumed
reinsurance; 4) estimates of future expenses to be incurred in the settlement of claims; 5)
estimates of salvage and subrogation recoveries and 6) estimates of amounts due from insureds
related to losses under high deductible policies. Management considers current conditions and
trends as well as past Company and industry experience in establishing these estimates. The
effects of inflation, which can be significant, are implicitly considered in the reserving process
and are part of the recorded reserve balance. Ceded claim and claim adjustment expense reserves
are reported as a component of reinsurance receivables in the Consolidated Balance Sheets. See
Note Q for further information on claim and claim adjustment expense reserves for discontinued
operations.
Structured settlements have been negotiated for certain property and casualty insurance claims.
Structured settlements are agreements to provide fixed periodic payments to claimants. Certain
structured settlements are funded by annuities purchased from CAC for which the related annuity
obligations are reported in future policy benefits reserves. Obligations for structured
settlements not funded by annuities are included in claim and claim adjustment expense reserves and
carried at present values determined using interest rates ranging from 4.6% to 7.5% at December 31,
2005 and 2004. At December 31, 2005 and 2004, the discounted reserves for unfunded structured
settlements were $843 million and $872 million, net of discount of $1,309 million and $1,367
million.
Workers compensation lifetime claim reserves and accident and health claim reserves are calculated
using mortality and morbidity assumptions based on Company and industry experience, and are
discounted at interest rates that range from 3.5% to 6.5% at December 31, 2005 and 2004. At
December 31, 2005 and 2004, such discounted reserves totaled $1,238 million and $1,893 million, net
of discount of $430 million and $460 million.
Future policy benefits reserves: Reserves for long term care products are computed using the net
level premium method, which incorporates actuarial assumptions as to interest rates, mortality,
morbidity, persistency, withdrawals and expenses. Actuarial assumptions generally vary by plan,
age at issue and policy duration, and include a margin for adverse deviation. Interest rates range
from 6.0% to 8.6% at December 31, 2005 and 2004, and mortality, morbidity and withdrawal
assumptions are based on Company and industry experience prevailing at the time of issue. Expense
assumptions include the estimated effects of inflation and expenses to be incurred beyond the
premium paying period. The net reserves for traditional life insurance products (whole and term
life products) including interest-sensitive contracts were ceded on a 100% indemnity reinsurance
basis to Swiss Re in connection with the sale of the individual life insurance business. See Note
P for further information.
Policyholders funds reserves: Policyholders funds reserves include reserves for universal life
insurance contracts and investment contracts without life contingencies. The liability for policy
benefits for universal life-type contracts is equal to the balance that accrues to the benefit of
policyholders, including credited interest, amounts that have been assessed to compensate the
Company for services to be performed over future periods, and any amounts previously assessed
against policyholders that are refundable on termination of the contract. For investment
contracts, policyholder liabilities are equal to the accumulated policy account values, which
consist of an accumulation of deposit payments plus credited interest, less withdrawals and amounts
assessed through the end of the period.
Guaranty fund and other insurance-related assessments: Liabilities for guaranty fund and other
insurance-related assessments are accrued when an assessment is probable, when it can be reasonably
estimated, and when the
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event obligating the entity to pay an imposed or probable assessment has occurred. Liabilities for
guaranty funds and other insurance-related assessments are not discounted and are included as part
of other liabilities in the Consolidated Balance Sheets. As of December 31, 2005 and 2004, the
liability balance was $67 million. As of December 31, 2005 and 2004, included in other assets were
$10 million and $9 million of related assets for premium tax offsets. The related asset is limited
to the amount that is able to be assessed on future premium collections or policy surcharges from
business written or committed to be written.
Reinsurance: Amounts recoverable from reinsurers are estimated in a manner consistent with claim
and claim adjustment expense reserves or future policy benefits reserves and are reported as
receivables in the Consolidated Balance Sheets. The cost of reinsurance is primarily accounted for
over the life of the underlying reinsured policies using assumptions consistent with those used to
account for the underlying policies. The ceding of insurance does not discharge the primary
liability of the Company. An estimated allowance for doubtful accounts is recorded on the basis of
periodic evaluations of balances due from reinsurers, reinsurer solvency, managements experience
and current economic conditions.
Reinsurance contracts that do not effectively transfer the underlying economic risk of loss on
policies written by the Company are recorded using the deposit method of accounting, which requires
that premium paid or received by the ceding company or assuming company be accounted for as a
deposit asset or liability. The Company primarily records these deposits as either reinsurance
receivables or other assets for ceded recoverables and reinsurance balances payable or other
liabilities for assumed liabilities. At December 31, 2005 and 2004, the Company had approximately
$20 million and $117 million recorded as deposit assets and $57 million and $156 million recorded
as deposit liabilities.
Income on reinsurance contracts accounted for under the deposit method is recognized using an
effective yield based on the anticipated timing of payments and the remaining life of the contract.
When the estimate of timing of payments changes, the effective yield is recalculated to reflect
actual payments to date and the estimated timing of future payments. The deposit asset or
liability is adjusted to the amount that would have existed had the new effective yield been
applied since the inception of the contract. This adjustment is reflected in other revenue or
other operating expense as appropriate.
Participating insurance: Policyholder dividends are accrued using an estimate of the amount to be
paid based on underlying contractual obligations under policies and applicable state laws. When
limitations exist on the amount of net income from participating life insurance contracts that may
be distributed to policyholders, the policyholders share of net income on those contracts that
cannot be distributed is excluded from stockholders equity by a charge to operations and the
establishment of a corresponding liability.
Deferred acquisition costs: Costs, including commissions, premium taxes and certain underwriting
and policy issuance costs which vary with and are related primarily to the acquisition of property
and casualty insurance business, are deferred and amortized ratably over the period the related
premiums are earned. Anticipated investment income is considered in the determination of the
recoverability of deferred acquisition costs.
The excess of first-year commissions over renewal commissions and other first-year costs of
acquiring life insurance business, such as agency and policy issuance expenses, which vary with and
are related primarily to the production of new and renewal business, have been deferred and are
amortized with interest over the expected life of the related contracts. The excess of first-year
ceded expense allowances over renewal ceded expense allowances reduces applicable unamortized
deferred acquisition costs.
Deferred acquisition costs related to non-participating traditional life insurance and accident and
health insurance are amortized over the premium-paying period of the related policies using
assumptions consistent with those used for computing future policy benefits reserves for such
contracts. Assumptions as to anticipated premiums are made at the date of policy issuance or
acquisition and are consistently applied during the lives of the contracts. Deviations from
estimated experience are included in results of operations when they occur. For these contracts,
the amortization period is typically the estimated life of the policy.
For universal life and cash value annuity contracts, the amortization of deferred acquisition costs
is recorded in proportion to the present value of estimated gross margins or profits. The gross
margins or profits result from actual earned interest minus actual credited interest, actual costs
of insurance (mortality charges) minus expected mortality, actual expense charges minus expected
maintenance expenses and surrender charges. Amortization interest rates are based on rates in
effect at the inception or acquisition of the contracts or the latest revised rate applied to the
remaining benefit period, according to product line. Actual gross margins or profits can vary from
the Companys
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estimates resulting in increases or decreases in the rate of amortization. When appropriate, the
Company revises its assumptions of the estimated gross margins or profits of these contracts, and
the cumulative amortization is re-estimated and adjusted through current results of operations. To
the extent that unrealized gains or losses on available-for-sale securities would result in an
adjustment of deferred acquisition costs had they actually been realized, an adjustment is recorded
to deferred acquisition costs and to unrealized investment gains or losses within stockholders
equity.
Deferred acquisition costs are recorded net of ceding commissions and other ceded acquisition
costs. The Company evaluates deferred acquisition costs for recoverability. Adjustments, if
necessary, are recorded in current results of operations.
Investments in life settlement contracts and related revenue recognition: The Company has
purchased investments in life settlement contracts. Under a life settlement contract, CNA obtains
the rights of being the owner and beneficiary to an underlying life insurance policy. The carrying
value of each contract at purchase and at the end of each reporting period is equal to the cash
surrender value of the policy in accordance with Financial Accounting Standards Board (FASB)
Technical Bulletin 85-4, Accounting for Purchases of Life Insurance (FTB 85-4). Amounts
paid to purchase these contracts that are in excess of the cash surrender value, at the date of
purchase, were expensed immediately. Periodic maintenance costs, such as premiums, necessary to
keep the underlying policy inforce are expensed as incurred and are included in other operating
expenses. Revenue is recognized and included in other revenue in the Consolidated Statements of
Operations when the life insurance policy underlying the life settlement contract matures.
Separate Account Business
Separate account assets and liabilities represent contract holder funds related to investment and
annuity products, which are segregated into accounts with specific underlying investment
objectives. In 2003, separate account balances included funds with balances accruing directly to
the contract holders and also funds with performance measures guaranteed by the Company. Net
income accruing to the Company related to the separate accounts, consisting of fee revenue and
investment results in excess of guaranteed returns, were primarily included within other revenue in
the Consolidated Statements of Operations.
In July of 2003, the Accounting Standards Executive Committee (AcSEC) of the American Institute of
Certified Public Accountants (AICPA) issued Statement of Position 03-01, Accounting and
Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for
Separate Accounts (SOP 03-01). SOP 03-01 provides guidance on accounting and reporting by
insurance enterprises for certain nontraditional long-duration contracts and for separate accounts.
SOP 03-01 was effective for financial statements for fiscal years beginning after December 15,
2003. SOP 03-01 did not allow retroactive application to prior years financial statements. CNA
adopted SOP 03-01 at January 1, 2004. The initial adoption of SOP 03-01 did not have a significant
impact on the results of operations or equity of the Company, but did affect the classification and
presentation of certain balance sheet and income statement items.
Under SOP 03-01, the main criterion that needs to be satisfied for separate account presentation is
that results of the investments made by the separate accounts must be directly passed through to
the individual contract holders. Certain of CNAs separate accounts have guaranteed returns not
related to investment performance whereby the contract holders do not bear the losses or receive
the gains from the investment performance; rather, amounts less than or in excess of the guaranteed
amounts accrue to CNA. Upon adoption of SOP 03-01, these separate accounts did not meet the
requirements of SOP 03-01 for separate account presentation. Therefore, the assets supporting these
separate accounts are reflected within general account investments and the related liabilities
within insurance reserves as of December 31, 2004. SOP 03-01 specifically precludes reclassifying
balances for years prior to adoption.
The adoption of SOP 03-01 did not result in a net impact to total assets, total liabilities or
shareholders equity. From an income statement perspective, SOP 03-01 did not impact net income;
however, it required a reclassification within the income statement. Prior to the adoption of SOP
03-01, the net results of the separate accounts were primarily included in Other Revenue. Upon
adopting SOP 03-01, premiums, benefits, net investment income and realized gains are included
within their natural line items. Specifically related to the indexed group annuity contracts, the
underlying portfolio consists of limited partnership investments and a trading portfolio which are
classified as held for trading purposes and are carried at fair value, with both the net realized
and unrealized gains (losses) included within net investment income in the Consolidated Statement
of Operations.
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The Company continues to have variable annuity contracts issued by CAC that meet the criteria for
separate account presentation. The assets and liabilities of these contracts are legally
segregated and reported as assets and liabilities of the separate account business. Substantially
all assets of the separate account business are carried at fair value. Separate account
liabilities are carried at contract values.
Investments
Valuation of investments: CNA classifies its fixed maturity securities (bonds and redeemable
preferred stocks) and its equity securities as either available-for-sale or trading, and as such,
they are carried at fair value. Changes in fair value of trading securities are reported within
net investment income. The amortized cost of fixed maturity securities classified as
available-for-sale is adjusted for amortization of premiums and accretion of discounts to maturity,
which are included in net investment income. Changes in fair value related to available-for-sale
securities are reported as a component of other comprehensive income. Investments are written down
to fair value and losses are recognized in income when a decline in value is determined to be
other-than-temporary.
For asset-backed securities included in fixed maturity securities, the Company recognizes income
using an effective yield based on anticipated prepayments and the estimated economic life of the
securities. When estimates of prepayments change, the effective yield is recalculated to reflect
actual payments to date and anticipated future payments. The net investment in the securities is
adjusted to the amount that would have existed had the new effective yield been applied since the
acquisition of the securities. Such adjustments are reflected in net investment income.
The Companys limited partnership investments are recorded at fair value and typically reflect a
reporting lag of up to three months. Fair value represents CNAs equity in the partnerships net
assets as determined by the General Partner. Changes in fair value, which represents changes in
partnerships net assets, are recorded within net investment income. The majority of the limited
partnerships invest in a substantial number of securities that are readily marketable. The Company
is primarily a passive investor in such partnerships and does not have influence over the
partnerships management, who are committed to operate them according to established guidelines and
strategies. These strategies may include the use of leverage and hedging techniques that
potentially introduce more volatility and risk to the partnerships. In accordance with FASB
Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB
No. 51 (FIN 46R), during 2004, the Company consolidated two limited partnerships which were
previously accounted for using the equity method.
Other invested assets include certain derivative securities, mortgage loans, real estate and policy
loans. Investments in derivative securities are carried at fair value with changes in fair value
reported as a component of realized gains or losses or other comprehensive income, depending on
their hedge designation. Changes in the fair value of derivative securities which are not
designated as hedges, are reported as a component of realized gains or losses. Mortgage loans are
carried at unpaid principal balances, including unamortized premium or discount. Real estate is
carried at depreciated cost. Policy loans are carried at unpaid balances. Short term investments
are generally carried at fair value, which approximates amortized cost. Accumulated depreciation
for mortgage loans and real estate was $1 million and $12 million at December 31, 2005 and 2004.
Realized investment gains and losses: All securities sold resulting in investment gains and losses
are recorded on the trade date. Realized investment gains and losses are determined on the basis of
the cost or amortized cost of the specific securities sold.
Equity in unconsolidated affiliates: CNA uses the equity method of accounting for investments in
companies in which its ownership interest of the voting shares of an investee company enables CNA
to influence the operating or financial decisions of the investee company, but CNAs interest in
the investee does not require consolidation under Accounting Research Bulletin No. 51,
Consolidated Financial Statements (ARB 51) or FIN 46R. CNAs proportionate share of equity
in net income of these unconsolidated affiliates is reported in other revenues.
Securities lending activities: CNA lends securities to unrelated parties, primarily major
brokerage firms. Borrowers of these securities must deposit collateral with CNA of at least 102%
of the fair value of the securities loaned if the collateral is cash or securities. CNA maintains
effective control over all loaned securities and, therefore, continues to report such securities as
fixed maturity securities in the Consolidated Balance Sheets.
Cash collateral received on these transactions is invested in short term investments with an
offsetting liability recognized for the obligation to return the collateral. Non-cash collateral,
such as securities or letters of credit, received by the Company are not reflected as assets of the
Company as there exists no right to sell or repledge the
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collateral. The fair value of collateral held and included in short term investments was $767
million and $918 million at December 31, 2005 and 2004. The fair value of non-cash collateral was
$138 million and $3,783 million at December 31, 2005 and 2004.
Derivative Financial Instruments
All investments in derivatives are recorded at fair value. A derivative is typically defined as an
instrument whose value is derived from an underlying instrument, index or rate, has a notional
amount, requires little or no initial investment and can be net settled. Derivatives include, but
are not limited to, the following types of financial instruments: interest rate swaps, interest
rate caps and floors, put and call options, warrants, futures, forwards, commitments to purchase
forward settlement securities, credit default swaps and combinations of the foregoing. Derivatives
embedded within non-derivative instruments (such as call options embedded in convertible bonds)
must be separated from the host instrument when the embedded derivative is not clearly and closely
related to the host instrument. Collateralized debt obligations (CDO) represent a credit
enhancement product that is typically structured in the form of a swap. The Company has determined
that this product is a derivative under Statement of Financial Accounting Standard No. 133,
Accounting for Derivative Instruments and Hedging Activities (SFAS 133). Changes in the
estimated fair value of CDOs, like other derivative financial instruments with no hedge
designation, are recorded in realized gains or losses as appropriate. The Company has no CDOs in
force as of December 31, 2005 and there was no related realized gain or loss in 2005. The net
impact from CDOs was a realized gain of $5 million and a realized loss of $1 million for the years
ended December 31, 2004 and 2003. The Company no longer issues this product.
The Companys derivatives are reported as other invested assets or other liabilities. Embedded
derivative instruments subject to bifurcation are reported together with the host contract, at fair
value. If certain criteria are met, a derivative may be specifically designated as a hedge of
exposures to changes in fair value, cash flows or foreign currency exchange rates. The accounting
for changes in the fair value of a derivative depends on the intended use of the derivative, the
nature of any hedge designation thereon and whether the derivative was transacted in a designated
trading portfolio.
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The Companys accounting for changes in the fair value of general account derivatives is as
follows:
Nature of Hedge Designation |
Derivatives Change in Fair Value Reflected In: |
|
No hedge designation
|
Realized investment gains or losses | |
Fair value designation
|
Realized investment gains or losses, along with the change in fair value of the hedged asset or liability that are attributable to the hedged risk | |
Cash flow designation
|
Other comprehensive income, with subsequent reclassification to earnings when the hedged transaction, asset or liability impacts earnings | |
Foreign currency designation
|
Consistent with fair value or cash flow above, depending on the nature of the hedging relationship |
The Company formally documents all relationships between hedging instruments and hedged items, as
well as its risk-management objective and strategy for undertaking various hedging transactions.
The Company also formally assesses (both at the hedges inception and on an ongoing basis) whether
the derivatives that are used in hedging transactions have been highly effective in offsetting
changes in fair value or cash flows of hedged items and whether those derivatives may be expected
to remain highly effective in future periods. When it is determined that a derivative for which
hedge accounting has been designated is not (or ceases to be) highly effective, the Company
discontinues hedge accounting prospectively.
Separate account investments held in designated trading portfolios are carried at fair value with
changes therein reflected in investment income. Hedge accounting on derivatives in these separate
accounts is generally not applicable.
The Company uses derivatives in the normal course of business, primarily to attempt to reduce its
exposure to market risk (principally interest rate risk, equity stock price risk and foreign
currency risk) stemming from various assets and liabilities and credit risk (the ability of an
obligor to make timely payment of principal and/or interest). The Companys principal objective
under such risk strategies is to achieve the desired reduction in economic risk, even if the
position will not receive hedge accounting treatment.
The Companys use of derivatives is limited by statutes and regulations promulgated by the various
regulatory bodies to which it is subject, and by its own derivative policy. The derivative policy
limits the authorization to initiate derivative transactions to certain personnel. The policy
generally prohibits the use of non-hedging derivatives with a maturity greater than 18 months.
Derivatives entered into for hedging, regardless of the choice to designate hedge accounting, shall
have a maturity that effectively correlates to the underlying hedged asset or liability. The
policy prohibits the use of derivatives containing greater than one-to-one leverage with respect to
changes in the underlying price, rate or index. The policy also prohibits the use of borrowed
funds, including funds obtained through securities lending, to engage in derivative transactions.
Credit exposure associated with non-performance by the counterparties to derivative instruments is
generally limited to the uncollateralized fair value of the asset related to the instruments
recognized in the Consolidated Balance Sheets. The Company attempts to mitigate the risk of
non-performance by monitoring the creditworthiness of counterparties and diversifying derivatives
to multiple counterparties. The Company requires that all over-the-counter derivative contracts be
governed by an International Swaps and Derivatives Association (ISDA) Master Agreement, and
exchanges collateral under the terms of these agreements with its derivative investment
counterparties depending on the amount of the exposure and the credit rating of the counterparty.
The Company has exposure to economic losses due to interest rate risk arising from changes in the
level of, or volatility of, interest rates. The Company attempts to mitigate its exposure to
interest rate risk through active portfolio management, which includes rebalancing its existing
portfolios of assets and liabilities, as well as changing the characteristics of investments to be
purchased or sold in the future. In addition, various derivative financial instruments are used to
modify the interest rate risk exposures of certain assets and liabilities. These strategies
include the use of interest rate swaps, interest rate caps and floors, options, futures, forwards
and commitments to purchase securities. These instruments are generally used to lock interest
rates or market values, to shorten or lengthen durations of fixed maturity securities or investment
contracts, or to hedge (on an economic basis) interest
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rate risks associated with investments, variable rate debt and life insurance liabilities. The
Company has used these types of instruments as designated hedges against specific assets or
liabilities on an infrequent basis.
The Company is exposed to equity price risk as a result of its investment in equity securities and
equity derivatives. Equity price risk results from changes in the level or volatility of equity
prices, which affect the value of equity securities, or instruments that derive their value from
such securities. CNA attempts to mitigate its exposure to such risks by limiting its investment in
any one security or index. The Company may also manage this risk by utilizing instruments such as
options, swaps, futures and collars to protect appreciation in securities held. CNA uses
derivatives in one of its separate accounts to mitigate equity price risk associated with its
indexed group annuity contracts by purchasing Standard & Poors 500® (S&P 500®) index futures
contracts in a notional amount equal to the contract holder liability, which is calculated using
the S&P 500® rate of return.
The Company has exposure to credit risk arising from the uncertainty associated with a financial
instrument obligors ability to make timely principal and/or interest payments. The Company
attempts to mitigate this risk by limiting credit concentrations, practicing diversification, and
frequently monitoring the credit quality of issuers and counterparties. In addition the Company
may utilize credit derivatives such as credit default swaps to modify the credit risk inherent in
certain investments. Credit default swaps involve a transfer of credit risk from one party to
another in exchange for periodic payments. The Company infrequently designates these types of
instruments as hedges against specific assets.
Foreign exchange rate risk arises from the possibility that changes in foreign currency exchange
rates will impact the fair value of financial instruments denominated in a foreign currency. The
Companys foreign transactions are primarily denominated in Canadian dollars, British pounds and
euros. The Company typically manages this risk via asset/liability currency matching and through
the use of foreign currency forwards. The Company has infrequently designated these types of
instruments as hedges against specific assets or liabilities.
The contractual or notional amounts for derivatives are used to calculate the exchange of
contractual payments under the agreements and are not representative of the potential for gain or
loss on these instruments. Interest rates, equity prices and foreign currency exchange rates
affect the fair value of derivatives. The fair values generally represent the estimated amounts
that CNA would expect to receive or pay upon termination of the contracts at the reporting date.
Dealer quotes are available for substantially all of CNAs derivatives. For derivative instruments
not actively traded, fair values are estimated using values obtained from independent pricing
services, costs to settle or quoted market prices of comparable instruments.
The Company is required to provide collateral for all exchange-traded futures and options
contracts. These margin requirements are determined by the individual exchanges based on the fair
value of the open positions and are in the custody of the exchange. Collateral may also be
required for over-the-counter contracts such as interest rate swaps, credit default swaps and
currency forwards per the ISDA agreements in place. The Company has access to this collateral
pledged subject to replacement and therefore it remains recorded as an asset on the Consolidated
Balance Sheets. The fair value of collateral provided was $66 million and $70 million at December
31, 2005 and 2004 and consisted primarily of U.S. Treasury Bills.
Income Taxes
The Company and its eligible subsidiaries are included in the consolidated federal income tax
return of Loews and its eligible subsidiaries. The Company accounts for income taxes under the
asset and liability method. Under the asset and liability method, deferred income taxes are
recognized for temporary differences between the financial statement and tax return bases of assets
and liabilities. Future tax benefits are recognized to the extent that realization of such
benefits is more likely than not.
Property and Equipment
Property and equipment are carried at cost less accumulated depreciation. Depreciation is based on
the estimated useful lives of the various classes of property and equipment and is determined
principally on the straight-line method. Furniture and fixtures are depreciated over seven years.
Office equipment is depreciated over five years. The estimated lives for data processing equipment
and software range from three to five years. Leasehold improvements are depreciated over the
corresponding lease terms.
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Goodwill and Other Intangible Assets
Goodwill and other indefinite-lived intangible assets of $146 million and $162 million as of
December 31, 2005 and 2004 primarily represents the excess of purchase price over the fair value of
the net assets of acquired entities and businesses. The balance at December 31, 2005 and 2004
primarily related to Specialty Lines. During 2005, the Company sold a subsidiary within Specialty
Lines which reduced the balance by $17 million. See Note P for further information on this
transaction. In addition, Standard Lines acquired renewal rights for a block of insurance
business, increasing the balance by $1 million. Goodwill and indefinite-lived intangible assets
are tested for impairment annually or when certain triggering events require such tests.
Earnings (Loss) per Share Data
Earnings (loss) per share available to common stockholders is based on weighted-average outstanding
shares. Basic and diluted earnings (loss) per share are computed by dividing net income available
to common stockholders by the weighted-average number of shares outstanding for the period of
common stock or common stock equivalents assuming conversion. The weighted average number of
shares outstanding for computing basic and diluted earnings per share was 256.0 million for the
years ended December 31, 2005 and 2004 and 227.0 million for the year ended December 31, 2003.
Included in the weighted-average outstanding shares in 2004 and 2003 is the effect of 32.3 million
shares of CNAF common stock issued on April 20, 2004 in conjunction with the conversion of the $750
million Series I convertible preferred stock issued in 2003. The effect of the preferred shares
has been included in the weighted average shares since issuance.
The Series H Cumulative Preferred Stock Issue (Series H Issue) is held by Loews and accrues
cumulative dividends at an initial rate of 8% per year, compounded annually. As of December 31,
2005, the Company had $197 million of undeclared but accumulated dividends. The Series H Issue
dividend amounts for the years ended December 31, 2005, 2004 and 2003 have been subtracted from Net
Income (Loss) to determine net income (loss) available to common stockholders.
Diluted earnings per share reflect the potential dilution that could occur if securities or other
contracts to issue common stock were exercised or converted into common stock. For the years ended
December 31, 2005, 2004 and 2003, approximately one million shares attributable to the exercise of
outstanding options were excluded from the calculation of diluted earnings per share because the
exercise price of these options was greater than the average market price of CNA common stock.
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The computation of earnings (loss) per share is as follows:
Earnings (Loss) per Share
Years
ended December 31 (In millions, except per share amounts) |
2005 |
2004 |
2003 |
|||||||||
Income (loss) from continuing operations |
$ | 243 | $ | 446 | $ | (1,419 | ) | |||||
Less: undeclared preferred stock dividend |
(70 | ) | (65 | ) | (60 | ) | ||||||
Income (loss) from continuing operations available to common
stockholders |
$ | 173 | $ | 381 | $ | (1,479 | ) | |||||
Weighted average outstanding common stock and common stock equivalents |
256.0 | 256.0 | 227.0 | |||||||||
Effect of dilutive securities, employee stock options |
| | | |||||||||
Adjusted weighted average outstanding common stock and common stock
equivalents assuming conversions |
256.0 | 256.0 | 227.0 | |||||||||
Basic and diluted earnings (loss) per share from continuing
operations available to common stockholders |
$ | 0.68 | $ | 1.49 | $ | (6.52 | ) | |||||
The Company has stock-based compensation plans which are detailed in Note J. The Company
applies the intrinsic value method by following Accounting Policy Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB 25), and related interpretations, in
accounting for its stock-based compensation plan. Under the recognition and measurement principles
of APB 25, no stock-based compensation cost has been recognized as the exercise price of the
granted options equaled the market price of the underlying stock at the grant date.
The following table illustrates the effect on net income (loss) and earnings (loss) per share data
if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting
for Stock-Based Compensation (SFAS 123) to stock-based employee compensation under the
Companys stock-based compensation plans.
Pro Forma Effect of SFAS 123 on Results
Years
ended December 31 (In millions, except per share amounts) |
2005 |
2004 |
2003 |
|||||||||
Income (loss) from continuing operations |
$ | 243 | $ | 446 | $ | (1,419 | ) | |||||
Less: undeclared preferred stock dividend |
(70 | ) | (65 | ) | (60 | ) | ||||||
Income (loss) from continuing operations available to
common stockholders |
173 | 381 | (1,479 | ) | ||||||||
Income (loss) from discontinued operations, net of tax |
21 | (21 | ) | 2 | ||||||||
Net income (loss) available to common stockholders |
194 | 360 | (1,477 | ) | ||||||||
Less: Total stock-based compensation cost determined under
the fair value method, net of tax |
(2 | ) | (2 | ) | (2 | ) | ||||||
Pro forma net income (loss) available to common stockholders |
$ | 192 | $ | 358 | $ | (1,479 | ) | |||||
Basic and diluted earnings (loss) per share, as reported |
$ | 0.76 | $ | 1.40 | $ | (6.51 | ) | |||||
Basic and diluted earnings (loss) per share, pro forma |
$ | 0.75 | $ | 1.39 | $ | (6.52 | ) | |||||
In December of 2004, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standard No. 123 (revised 2004), Share-Based Payment (SFAS 123R), that
amends Statement of Financial Accounting Standard No. 123 (SFAS 123), as originally issued in May
of 1995. SFAS 123R addresses the accounting for share-based payment transactions in which an
enterprise receives employee services in exchange for (a) equity instruments of the enterprise or
(b) liabilities that are based on the fair value of the enterprises equity instruments or that may
be settled by the issuance of such equity instruments. SFAS 123R supercedes Accounting Principles
Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25). After the
effective date of
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this standard, entities will not be permitted to use the intrinsic value method specified in APB 25
to measure compensation expense and generally would be required to measure compensation expense
using a fair-value based method. Public companies are to apply this standard using either the
modified prospective method or the modified retrospective method. The modified prospective method
requires a company to (a) record compensation expense for all awards it grants, modifies,
repurchases or cancels after the date it adopts the standard and (b) record compensation expense
for the unvested portion of previously granted awards that remain outstanding at the date of
adoption. The modified retrospective method requires companies to record compensation expense to
either (a) all prior years for which SFAS 123 was effective (i.e. for all fiscal years beginning
after December 15, 1994) or (b) only to prior interim periods in the year of initial adoption if
the effective date of SFAS 123R does not coincide with the beginning of the fiscal year. SFAS 123R
was effective for the Company January 1, 2006. The Company applied the modified prospective
transition method. The above pro forma disclosure of the effect of SFAS 123 on results reflects the
approximate impact of adoption on the Company, which is not expected to have a material impact on
the results of operations and/or equity of the Company.
Supplementary Cash Flow Information
Cash payments made for interest amounted to approximately $139 million, $123 million and $134
million for the years ended December 31, 2005, 2004 and 2003. The amount of interest paid included
in the supplemental disclosure of cash flow information for the year ended December 31, 2004 was
corrected from $216 million to $123 million. Cash payments made for federal income taxes amounted
to approximately $164 million for the year ended December 31, 2005. Cash refunds received for
federal income taxes amounted to approximately $627 million and $369 million for the years ended
December 31, 2004 and 2003. The non-cash transactions related to notes receivable for the issuance
of common stock amounted to approximately $8 million and $4 million for the years ended December
31, 2005 and 2003. There were no non-cash transactions related to notes receivable for the
issuance of common stock for the year ended December 31, 2004.
Accounting Pronouncements
In December of 2004, the FASB issued SFAS 153, Exchanges of Non-Monetary Assets an amendment of
APB Opinion No. 29. SFAS 153 amends the definition of exchange or exchange transaction and
expands the list of transactions that would not meet the definition of non-monetary transfer. SFAS
153 is effective for fiscal periods beginning after June 15, 2005. Adoption of this standard did
not have a significant impact on the results of operations or equity of the Company.
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Note B. Investments
The significant components of net investment income are presented in the following table.
Net Investment Income
Years
ended December 31 (In millions) |
2005 |
2004 |
2003 |
|||||||||
Fixed maturity securities |
$ | 1,608 | $ | 1,571 | $ | 1,651 | ||||||
Short term investments |
147 | 56 | 63 | |||||||||
Limited partnerships |
254 | 212 | 221 | |||||||||
Equity securities |
25 | 14 | 19 | |||||||||
Income from trading portfolio (a) |
47 | 110 | | |||||||||
Interest on funds withheld and other deposits |
(166 | ) | (261 | ) | (335 | ) | ||||||
Other |
20 | 18 | 85 | |||||||||
Gross investment income |
1,935 | 1,720 | 1,704 | |||||||||
Investment expenses |
(43 | ) | (40 | ) | (48 | ) | ||||||
Net investment income |
$ | 1,892 | $ | 1,680 | $ | 1,656 | ||||||
(a) | The change in net unrealized gains (losses) on trading securities included in net investment income was $(7) million and $2 million for the years ended December 31, 2005 and 2004. |
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Net realized investment gains (losses) and net change in unrealized appreciation
(depreciation) in investments were as follows:
Net Investment Appreciation
Years
ended December 31 (In millions) |
2005 |
2004 |
2003 |
|||||||||
Net realized investment gains (losses): |
||||||||||||
Fixed maturity securities: |
||||||||||||
Gross realized gains |
$ | 361 | $ | 704 | $ | 1,244 | ||||||
Gross realized losses |
(451 | ) | (457 | ) | (807 | ) | ||||||
Net realized gains (losses) on fixed maturity securities |
(90 | ) | 247 | 437 | ||||||||
Equity securities: |
||||||||||||
Gross realized gains |
73 | 225 | 143 | |||||||||
Gross realized losses |
(35 | ) | (23 | ) | (29 | ) | ||||||
Net realized gains on equity securities |
38 | 202 | 114 | |||||||||
Other, including disposition of businesses, net of participating
policyholders interest |
39 | (688 | ) | (87 | ) | |||||||
Net realized investment gains (losses) before allocation to participating
policyholders and minority interests |
(13 | ) | (239 | ) | 464 | |||||||
Allocation to participating policyholders and minority interests |
3 | (9 | ) | (4 | ) | |||||||
Net realized investment gains (losses) |
(10 | ) | (248 | ) | 460 | |||||||
Net change in unrealized appreciation (depreciation) in general account investments: |
||||||||||||
Fixed maturity securities |
(443 | ) | (53 | ) | 372 | |||||||
Equity securities |
34 | (98 | ) | 87 | ||||||||
Other |
(1 | ) | | 2 | ||||||||
Total net change in unrealized appreciation (depreciation) in general account
investments |
(410 | ) | (151 | ) | 461 | |||||||
Net change in unrealized appreciation (depreciation) on other |
(12 | ) | (70 | ) | 6 | |||||||
Allocation to participating policyholders and minority interests |
18 | 19 | (7 | ) | ||||||||
Deferred income tax (expense) benefit |
158 | 55 | (159 | ) | ||||||||
Net change in unrealized appreciation (depreciation) in investments |
(246 | ) | (147 | ) | 301 | |||||||
Net realized gains (losses) and change in unrealized appreciation (depreciation) in
investments |
$ | (256 | ) | $ | (395 | ) | $ | 761 | ||||
Investment securities are exposed to various risks, such as interest rate, market and credit.
Due to the level of risk associated with certain investment securities and the level of uncertainty
related to changes in the value of investment securities, it is possible that changes in these risk
factors in the near term could have an adverse material impact on the Companys results of
operations or equity.
The Companys investment policies emphasize high credit quality and diversification by industry,
issuer and issue. Assets supporting interest rate sensitive liabilities are segmented within the
general account to facilitate asset/liability duration management.
A significant judgment in the valuation of investments is the determination of when an
other-than-temporary decline in value has occurred. The Company follows a consistent and
systematic process for impairing securities that sustain other-than-temporary declines in value.
The Company has established a committee responsible for the impairment process. This committee,
referred to as the Impairment Committee, is made up of three officers appointed by the Companys
Chief Financial Officer. The Impairment Committee is responsible for analyzing watch list
securities on at least a quarterly basis. The watch list includes individual securities that fall
below certain thresholds or that exhibit evidence of impairment indicators including, but not
limited to, a significant adverse change in the financial condition and near term prospects of the
investment or a significant adverse change in legal factors, the business climate or credit
ratings.
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When a security is placed on the watch list, it is monitored for further market value changes and
additional news related to the issuers financial condition. The focus is on objective evidence
that may influence the evaluation of impairment factors.
The decision to impair a security incorporates both quantitative criteria and qualitative
information. The Impairment Committee considers a number of factors including, but not limited to:
(a) the length of time and the extent to which the fair value has been less than book value, (b)
the financial condition and near term prospects of the issuer, (c) the intent and ability of the
Company to retain its investment for a period of time sufficient to allow for any anticipated
recovery in value, (d) whether the debtor is current on interest and principal payments and (e)
general market conditions and industry or sector specific factors.
The Impairment Committees decision to impair a security is primarily based on whether the
securitys fair value is likely to remain below its book value in light of all of the factors
considered. For securities that are impaired, the security is adjusted to fair value and the
resulting losses are recognized in realized gains/losses in the Consolidated Statements of
Operations.
Realized investment losses included $107 million, $93 million and $321 million of pretax impairment
losses for the years ended December 31, 2005, 2004 and 2003. The 2005 impairment losses were
recorded across various sectors. The 2005 and 2004 impairment losses recorded related to a $34
million and $56 million pretax impairment loss related to loans made under a credit facility to a
national contractor, that are classified as fixed maturity securities. See Note S for additional
information on loans to the national contractor. The 2003 impairment was primarily the result of
the continued credit deterioration on specific issuers in the bond and equity markets and the
effects on such markets due to the overall slowing of the economy.
Other realized investment gains (losses) for the years ended December 31, 2005, 2004 and 2003
include gains and losses related to sales of certain operations or affiliates that are described in
Note P.
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The following tables provide a summary of fixed maturity and equity securities investments.
Summary of Fixed Maturity and Equity Securities
Cost or | Gross | Gross Unrealized Losses |
Estimated | |||||||||||||||||
Amortized | Unrealized | Less than | Greater than | Fair | ||||||||||||||||
December
31, 2005 (In millions) |
Cost |
Gains |
12 Months |
12 Months |
Value |
|||||||||||||||
Fixed maturity securities available-for-sale: |
||||||||||||||||||||
U.S. Treasury securities and obligations of
government agencies |
$ | 1,355 | $ | 119 | $ | 4 | $ | 1 | $ | 1,469 | ||||||||||
Asset-backed securities |
12,986 | 43 | 137 | 33 | 12,859 | |||||||||||||||
States, municipalities and political
subdivisions tax-exempt |
9,054 | 193 | 31 | 7 | 9,209 | |||||||||||||||
Corporate securities |
5,906 | 322 | 52 | 11 | 6,165 | |||||||||||||||
Other debt securities |
2,830 | 234 | 18 | 2 | 3,044 | |||||||||||||||
Redeemable preferred stock |
213 | 4 | | 1 | 216 | |||||||||||||||
Options embedded in convertible debt securities |
1 | | | | 1 | |||||||||||||||
Total fixed maturity securities available-for-sale |
32,345 | 915 | 242 | 55 | 32,963 | |||||||||||||||
Total fixed maturity securities trading |
271 | | | | 271 | |||||||||||||||
Equity securities available-for-sale: |
||||||||||||||||||||
Common stock |
140 | 150 | 1 | | 289 | |||||||||||||||
Preferred stock |
322 | 22 | 1 | | 343 | |||||||||||||||
Total equity securities available-for-sale |
462 | 172 | 2 | | 632 | |||||||||||||||
Total equity securities trading |
49 | | | | 49 | |||||||||||||||
Total |
$ | 33,127 | $ | 1,087 | $ | 244 | $ | 55 | $ | 33,915 | ||||||||||
Cost or | Gross | Gross Unrealized Losses |
Estimated | |||||||||||||||||
Amortized | Unrealized | Less than | Greater than | Fair | ||||||||||||||||
December
31, 2004 (In millions) |
Cost |
Gains |
12 Months |
12 Months |
Value |
|||||||||||||||
Fixed maturity securities available-for-sale: |
||||||||||||||||||||
U.S. Treasury securities and obligations of
government agencies |
$ | 4,233 | $ | 126 | $ | 13 | $ | | $ | 4,346 | ||||||||||
Asset-backed securities |
7,706 | 105 | 19 | 4 | 7,788 | |||||||||||||||
States, municipalities and political
subdivisions tax-exempt |
8,699 | 189 | 28 | 3 | 8,857 | |||||||||||||||
Corporate securities |
6,093 | 477 | 52 | 5 | 6,513 | |||||||||||||||
Other debt securities |
2,769 | 295 | 11 | | 3,053 | |||||||||||||||
Redeemable preferred stock |
142 | 6 | | 2 | 146 | |||||||||||||||
Options embedded in convertible debt securities |
234 | | | | 234 | |||||||||||||||
Total fixed maturity securities available-for-sale |
29,876 | 1,198 | 123 | 14 | 30,937 | |||||||||||||||
Total fixed maturity securities trading |
390 | | | | 390 | |||||||||||||||
Equity securities available-for-sale: |
||||||||||||||||||||
Common stock |
148 | 112 | | | 260 | |||||||||||||||
Preferred stock |
126 | 24 | | | 150 | |||||||||||||||
Total equity securities available-for-sale |
274 | 136 | | | 410 | |||||||||||||||
Total equity securities trading |
46 | | | | 46 | |||||||||||||||
Total |
$ | 30,586 | $ | 1,334 | $ | 123 | $ | 14 | $ | 31,783 | ||||||||||
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At December 31, 2005, the carrying value of the general account fixed maturities was $33,234
million, representing 84% of the total investment portfolio. The net unrealized position
associated with the fixed maturity portfolio included $297 million in gross unrealized losses
consisting of municipal securities which represented 13%, corporate bonds which represented 21%,
asset-backed securities which represented 57%, and all other fixed maturity securities which
represented 9%. Within corporate bonds, the largest industry sectors were financial,
communications and consumer cyclical, which as a percentage of total gross unrealized losses were
32%, 19% and 18%. Gross unrealized losses in any single issuer were less than 0.1% of the carrying
value of the total general account fixed maturity portfolio.
The following tables summarize fixed maturity and equity securities in an unrealized loss position
at December 31, 2005 and 2004, the aggregate fair value and gross unrealized loss by length of time
those securities have been continuously in an unrealized loss position.
Unrealized Loss Aging
December 31, 2005 |
December 31, 2004 |
|||||||||||||||
Gross | Gross | |||||||||||||||
Estimated | Unrealized | Estimated | Unrealized | |||||||||||||
(In millions) | Fair Value |
Loss |
Fair Value |
Loss |
||||||||||||
Fixed maturity securities: |
||||||||||||||||
Investment grade: |
||||||||||||||||
0-6 months |
$ | 9,976 | $ | 142 | $ | 7,742 | $ | 53 | ||||||||
7-12 months |
2,739 | 61 | 2,448 | 59 | ||||||||||||
13-24 months |
1,400 | 45 | 368 | 12 | ||||||||||||
Greater than 24 months |
219 | 7 | 2 | | ||||||||||||
Total investment grade |
14,334 | 255 | 10,560 | 124 | ||||||||||||
Non-investment grade: |
||||||||||||||||
0-6 months |
632 | 29 | 188 | 7 | ||||||||||||
7-12 months |
118 | 10 | 69 | 4 | ||||||||||||
13-24 months |
122 | 3 | 20 | 2 | ||||||||||||
Greater than 24 months |
2 | | | | ||||||||||||
Total non-investment grade |
874 | 42 | 277 | 13 | ||||||||||||
Total fixed maturity securities |
15,208 | 297 | 10,837 | 137 | ||||||||||||
Equity securities: |
||||||||||||||||
0-6 months |
49 | 2 | 4 | | ||||||||||||
7-12 months |
1 | | 1 | | ||||||||||||
13-24 months |
| | 1 | | ||||||||||||
Greater than 24 months |
3 | | 3 | | ||||||||||||
Total equity securities |
53 | 2 | 9 | | ||||||||||||
Total fixed maturity and equity securities |
$ | 15,261 | $ | 299 | $ | 10,846 | $ | 137 | ||||||||
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The following tables summarize available-for-sale fixed maturity securities by contract
maturity at December 31, 2005 and 2004. Actual maturities may differ from contractual maturities
because certain securities may be called or prepaid with or without call or prepayment penalties.
Contractual Maturity
December 31, 2005 | December 31, 2004 | |||||||||||||||
Cost or | Estimated | Cost or | Estimated | |||||||||||||
Amortized | Fair | Amortized | Fair | |||||||||||||
(In millions) | Cost |
Value |
Cost |
Value |
||||||||||||
Due in one year or less |
$ | 804 | $ | 806 | $ | 1,048 | $ | 1,054 | ||||||||
Due after one year through five years |
2,166 | 2,202 | 4,433 | 4,480 | ||||||||||||
Due after five years through ten years |
3,417 | 3,523 | 9,238 | 9,577 | ||||||||||||
Due after ten years |
12,972 | 13,573 | 7,451 | 8,038 | ||||||||||||
Asset-backed securities |
12,986 | 12,859 | 7,706 | 7,788 | ||||||||||||
Total |
$ | 32,345 | $ | 32,963 | $ | 29,876 | $ | 30,937 | ||||||||
The carrying value of fixed maturity investments that did not produce income during 2005 was
less than $1 million. The carrying value of fixed maturity investments that did not produce income
during 2004 was $3 million. At December 31, 2005 and 2004, no investments, other than investments
in U.S. government agency securities, exceeded 10% of stockholders equity.
As of December 31, 2005 and 2004, the Company had committed approximately $191 million and $104
million to future capital calls from various third-party limited partnership investments in
exchange for an ownership interest in the related partnerships.
The Company invests in multiple bank loan participations as part of its overall investment strategy
and has committed to additional future purchases and sales. The purchase and sale of these
investments are recorded on the date that the legal agreements are finalized and cash settlement is
made. As of December 31, 2005 and December 31, 2004, the Company had commitments to purchase $82
million and $41 million and sell $12 million and $2 million of various bank loan participations.
When loan participation purchases are settled and recorded they may contain both funded and
unfunded amounts. An unfunded loan represents an obligation by the Company to provide additional
amounts under the terms of the loan participation. The funded portions are reflected on the
Consolidated Balance Sheets, while any unfunded amounts are not recorded until a draw is made under
the loan facility. As of December 31, 2005 and December 31, 2004, the Company had obligations on
unfunded bank loan participations in the amount of $21 million and $3 million.
Investments on Deposit
The Company may from time to time invest in securities that may be restricted in whole or in part.
As of December 31, 2005 and 2004, the Company did not hold any significant positions in investments
whose sale was restricted.
Cash and securities with carrying values of approximately $2.4 billion and $2.6 billion were
deposited by the Companys insurance subsidiaries under requirements of regulatory authorities as
of December 31, 2005 and 2004.
The Companys investments in limited partnerships contain withdrawal provisions that typically
require advanced written notice of up to 90 days for withdrawals. The carrying value of these
investments, reported as a separate line item in the Consolidated Balance Sheets, is $1,509 million
and $1,549 million as of December 31, 2005 and 2004.
Cash and securities with carrying values of approximately $13 million and $18 million were
deposited with financial institutions as collateral for letters of credit as of December 31, 2005
and 2004. In addition, cash and securities were deposited in trusts with financial institutions to
secure reinsurance obligations with various third parties. The carrying values of these deposits
were approximately $356 million and $333 million as of December 31, 2005 and 2004.
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Table of Contents
Note C. Derivative Financial Instruments
A summary of the aggregate contractual or notional amounts, estimated fair values and recognized
gains (losses) related to derivative financial instruments follows.
Derivative Instruments
Contractual/ | Estimated | Estimated | Recognized | |||||||||||||
Notional | Fair Value | Fair Value | Gains | |||||||||||||
As of and for the year ended December 31, 2005 | Amount | Asset | (Liability) | (Losses) | ||||||||||||
(In millions) | ||||||||||||||||
General account |
||||||||||||||||
With hedge designation |
||||||||||||||||
Swaps |
$ | 265 | $ | | $ | (1 | ) | $ | (1 | ) | ||||||
Without hedge designation |
||||||||||||||||
Swaps |
756 | | (8 | ) | 46 | |||||||||||
Futures sold, not yet purchased |
| | | 2 | ||||||||||||
Currency forwards |
15 | | | 2 | ||||||||||||
Equity warrants |
6 | 2 | | | ||||||||||||
Options embedded in convertible debt securities |
12 | 1 | | (33 | ) | |||||||||||
Trading activities |
||||||||||||||||
Futures purchased |
1,058 | | (4 | ) | 18 | |||||||||||
Futures sold, not yet purchased |
166 | | | 2 | ||||||||||||
Currency forwards |
59 | | (1 | ) | (1 | ) | ||||||||||
Commitments to purchase mortgage backed securities |
21 | | | | ||||||||||||
Options purchased |
20 | | | (2 | ) | |||||||||||
Options written |
21 | | | 2 | ||||||||||||
Total general account |
$ | 2,399 | $ | 3 | $ | (14 | ) | $ | 35 | |||||||
Separate accounts |
||||||||||||||||
Options written |
$ | 7 |