Business context and reporting period
The Hanover Insurance Group, Inc. filed this unaudited Form 10-Q for the quarter and six months ended June 30, 2010. Its continuing operations are primarily property and casualty insurance, reported in Personal Lines, Commercial Lines, and Other Property and Casualty. Results from the sale of FAFLIC and certain legacy businesses are reported as discontinued operations. Dollar amounts below are in millions unless stated otherwise.
Financial results and key metrics
| Metric | Q2 2010 | Q2 2009 | Six months 2010 | Six months 2009 |
|---|---|---|---|---|
| Total revenue | $768.3 | $696.4 | $1,514.9 | $1,395.3 |
| Net income | $2.3 | $64.4 | $44.1 | $90.2 |
| Income from continuing operations | $2.2 | $63.1 | $44.4 | $83.3 |
| Diluted net income per share | $0.05 | $1.25 | $0.94 | $1.75 |
| Net premiums written, P&C | $802.0 | $663.1 | $1,527.2 | $1,293.0 |
| P&C segment income before tax | $14.6 | $76.3 | $72.3 | $126.2 |
- Underwriting and margins: The consolidated GAAP combined ratio was 106.1% in Q2 versus 96.4% a year earlier, and 103.0% for the first half versus 98.8%. Ratios above 100% indicate underwriting losses before investment income. P&C underwriting losses were $46.6 in Q2 and $48.4 for the first half.
- Losses and catastrophe activity: Losses and LAE were $498.4 in Q2 and $930.0 for the first half. Catastrophe losses were $85.0 in Q2 and $119.4 for the first half, compared with $30.2 and $67.6 in the respective 2009 periods. Favorable prior-year reserve development was $24.4 in Q2 and $61.5 for the first half, below the prior-year first-half $85.4.
- Investment income and gains: Net investment income was $61.8 in Q2 and $122.9 for the first half, versus $61.3 and $126.2. Net realized investment gains were $0.2 in Q2 and $11.1 for the first half, compared with losses of $3.6 and $9.7. First-half 2010 impairment losses recognized in earnings were $6.1, down from $23.2.
- Cash flow and liquidity: First-half operating cash flow was negative $92.5, versus negative $45.1 in 2009; the company cited a $100.0 pension contribution as a principal factor. Investing cash flow was positive $36.6 and financing cash flow positive $0.5. Consolidated cash and equivalents were $260.9 at June 30, down from $316.5 at year-end. Management reported $350.0 of fixed maturities and cash at the holding company and said it expected those assets to cover holding-company obligations through the rest of 2010.
- Balance sheet and capital: Total assets were $8,373.4, total liabilities $6,021.8, and shareholders’ equity $2,351.6. Long-term debt increased to $632.4 from $433.9, largely following issuance of $200.0 of 7.50% senior notes due 2020. P&C statutory surplus was $1,752.0, and Hanover Insurance’s RBC ratio was 331% on the Industry Scale. The company reported compliance with debt covenants.
- Investment portfolio: Fixed maturities were $4,893.8 at fair value, with a $224.1 net unrealized gain; approximately 93% of the portfolio was investment grade. The filing notes that market volatility, credit deterioration, defaults, and forced sales could lead to further realized or unrealized losses.
Material changes versus the prior comparable period
- Revenue rose, with first-half net premiums written increasing 18.1% to $1,527.2. Commercial Lines net premiums written grew 39.5% to $800.4, driven in part by the OneBeacon renewal-rights transaction and AIX program business; Commercial Lines premiums exceeded Personal Lines premiums in the first half.
- Despite premium growth, earnings declined sharply. Q2 net income fell to $2.3 from $64.4 and first-half net income to $44.1 from $90.2. Management attributed the decline mainly to higher catastrophe losses, less favorable prior-year reserve development, and increased underwriting expenses. Prior-year results also included a $34.3 pretax gain on debt retirement.
- Commercial Lines segment income fell to $16.9 in Q2 from $50.9 and to $39.7 for the first half from $98.5. Personal Lines recorded a Q2 segment loss of $3.5, compared with income of $25.6; first-half segment income was $31.0, modestly above $28.7.
- Shareholders’ equity was nearly unchanged from year-end, while accumulated other comprehensive income increased to $126.2 from $28.8, reflecting investment appreciation. Treasury stock increased following repurchases; the company bought back $130.6 of shares in the first half and paid $24.3 in dividends.
Outlook, commentary, risks and unusual items
- No specific earnings or revenue guidance is provided. Management said it expects less favorable prior-year reserve development in future periods than in recent years and cautioned that lower new-money yields could further reduce investment returns.
- Management described continuing pricing pressure and a difficult economic environment. It is investing in products, technology, specialty businesses, and geographic expansion, while pursuing agency relationships, account rounding, and disciplined underwriting. It said profitable growth and successful execution are not assured.
- Management identified material uncertainty in loss reserves, including long-tail claims, medical-cost inflation, new products and geographies, and adverse legal or regulatory developments. Net loss reserves were approximately $2.1 billion; management stated that a one-percentage-point change in the aggregate loss and LAE ratio could affect P&C segment income by about $25 million, based on 2009 premiums.
- Michigan legal development after quarter-end: On August 1, 2010, the Michigan Supreme Court overturned the Kreiner standard, which management expects could increase unresolved past and future auto bodily-injury claims. The company had established reserves in anticipation of the decision but said adequacy remains uncertain. The July 8, 2010 ruling invalidating Michigan restrictions on credit-score use and possible Massachusetts regulatory changes add market uncertainty.
- Approximately 50 Hurricane Katrina-related cases remained as of June 30. The Road Home litigation’s anti-assignment issue was certified to the Louisiana Supreme Court; the company’s reserves assume no liability in that or similar litigation and that it will prevail on disputed coverage issues. The Durand pension-plan class action is not expected by management to materially affect financial position, though a particular period’s results or plan funding could be affected.
- Other notable items include the $100.0 pension contribution, the Campania acquisition for approximately $24, accelerated share repurchases, and a quarterly dividend of $0.25 per share. The OneBeacon renewal-rights business is being transitioned to Hanover forms and systems, a process expected to continue until late 2011.
- Effective July 1, the company renewed catastrophe reinsurance, added full reinsurance coverage for a $200 million excess-of-$700 million Northeast layer, and bought an additional $100 million excess-of-$900 million Northeast layer. In July it also committed to borrow $46.3 million from the FHLBB at a weighted-average fixed rate of 3.88% to help finance a Worcester office-building project. The project’s estimated development costs are $65–$70 million.
- Management said holding-company assets should meet obligations without additional subsidiary dividends, but insurance-subsidiary dividends are subject to regulatory limits. The $150 million syndicated credit facility expired in June 2010 and was not renewed; there were no borrowings under it.
Most important facts for investors to verify
- Whether the elevated catastrophe burden, particularly the $119.4 first-half total, persists and how renewed reinsurance changes exposure.
- How the Michigan Supreme Court decision affects claim severity, reserves, rate adequacy, and future reported results.
- Whether reserve development continues to moderate as management expects, and how actual claims compare with actuarial estimates.
- Whether Commercial Lines growth from OneBeacon, AIX, and specialty businesses converts into acceptable underwriting margins as expenses and combined ratios remain elevated.
- Holding-company liquidity, debt service, dividend capacity, share repurchases, and the funding and collateral requirements of the FHLBB borrowings and Worcester project.
- Potential outcomes and reserve assumptions in the Road Home and Durand litigation, and any effects of state or federal regulatory changes.