The Hanover Insurance Group, Inc. — Q3 2012 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2012. Amounts are in millions of dollars except per-share data and ratios. The company operates Commercial Lines, Personal Lines, Chaucer, and Other Property and Casualty. Chaucer was acquired July 1, 2011, so nine-month comparisons include Chaucer for nine months in 2012 but only three months in 2011.
Financial performance
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Total revenue | $1,157.7 | $1,108.0 | $3,406.7 | $2,795.7 |
| Net premiums earned | $1,071.0 | $1,018.6 | $3,156.6 | $2,550.8 |
| Net income (loss) | $40.4 | $(10.0) | $110.9 | $(12.9) |
| Diluted EPS | $0.89 | $(0.22) | $2.44 | $(0.28) |
| Segment income before tax | $62.9 | $(8.2) | $179.6 | $(5.7) |
| Combined ratio | 100.2% | 106.9% | 100.5% | 107.0% |
| Operating cash flow | Not separately stated | Not separately stated | $204.6 | $286.3 |
Q3 premiums grew 5.1% year over year; revenue rose 4.5%. For the first nine months, premiums increased 23.8% and revenue 21.9%, with much of the growth reflecting the longer Chaucer consolidation period. Q3 pre-tax income was $53.2 million versus a $19.3 million loss; nine-month pre-tax income was $135.1 million versus a $42.0 million loss.
The combined ratio improved in both comparison periods, indicating better underwriting performance overall, though the nine-month comparison is affected by Chaucer’s partial-year inclusion in 2011. Catastrophe losses were $51.9 million in Q3 versus $99.6 million, and $166.6 million for nine months versus $306.0 million. Nine-month prior-year reserve development was favorable by $8.3 million, compared with $72.6 million favorable in 2011; 2012 domestic operations had $35.6 million of unfavorable development, partly offset by $43.9 million favorable at Chaucer.
By segment, Q3 pre-tax income was $8.1 million for Commercial Lines, $14.7 million for Personal Lines, and $42.0 million for Chaucer; Other Property and Casualty recorded a $1.9 million loss. For the first nine months, the respective results were $32.6 million, $54.5 million, $97.3 million, and a $4.8 million loss.
Financial position, investments, debt, and liquidity
- At September 30, total assets were $13,330.1 million, total liabilities $10,630.7 million, and shareholders’ equity $2,699.4 million. Equity increased from $2,484.0 million at year-end 2011.
- Cash and cash equivalents were $462.0 million, down from $820.4 million at December 31, 2011. Total investments were $7,444.8 million, up from $6,721.3 million; total cash and investments were $7,906.8 million, up 4.8%.
- Debt was $917.5 million, versus $911.1 million at year-end. The company reported compliance with debt-agreement covenants and no borrowings under its $200 million committed credit agreement. It gave notice of intent to call Chaucer’s $50 million and €12 million floating-rate subordinated notes in Q4 2012.
- Nine-month operating cash flow fell to $204.6 million from $286.3 million, primarily due to increased loss and LAE payments. Investing activities used $528.5 million, mainly for net investment purchases; financing activities used $58.6 million. Ending cash was $462.0 million.
- U.S. insurance subsidiaries’ statutory surplus was $1,670.8 million, up $88.0 million from year-end 2011. The company reported Hanover Insurance’s risk-based capital ratio as 269% on the industry scale and 538% on the regulatory scale.
- Net investment income increased 2.1% in Q3 and 9.1% for nine months. Management expects investment yields to continue declining as new-money rates remain historically low. Approximately 95% of fixed maturities were investment grade. Unrealized gains on available-for-sale securities contributed to higher equity and other comprehensive income.
Material changes, outlook, and risks
- Management attributed improved earnings primarily to lower catastrophe and non-catastrophe weather losses, higher premiums, and Chaucer’s contribution. Commercial Lines’ nine-month net written premiums rose 13.8%, driven by rate increases, retention, and new business. Personal Lines growth was modest amid deliberate exposure reductions and policy attrition.
- Management described ongoing rate increases and underwriting discipline as priorities. It noted pricing competition, challenging economic conditions, weather losses, and the risk that rate actions could reduce policy growth. Chaucer reported favorable conditions in several lines but ongoing competitive pressure in casualty, aviation, and U.K. motor.
- No specific earnings or revenue guidance was provided. Management said results for the interim periods are not necessarily indicative of full-year results and expects continued pressure on investment yields.
- The company recognized a $10.8 million after-tax gain on the April 2012 sale of Citizens Management, Inc.; $1.7 million of the Q3 contingent gain was contributed to its charitable foundation. Nine-month discontinued operations contributed a net gain of $9.5 million.
- Adoption of revised insurance acquisition-cost guidance reduced opening 2012 stockholders’ equity by $25.8 million after tax. A tax-planning transaction released $35.9 million of valuation allowance during the first nine months; the filing records most of the benefit in other comprehensive income, with amounts expected to flow into earnings in future periods as related securities are sold or mature.
- Key exposures include uncertain loss-reserve estimates, catastrophe frequency and severity, reinsurance recoverability and availability, investment-market volatility and defaults, low interest rates, foreign exchange, and regulatory or competitive changes. The company stated European sovereign and non-sovereign debt developments were not expected to materially affect its condition, results, or liquidity, while noting broader contagion risk.
- In the Durand pension litigation, the company could not reasonably estimate potential liability. In the Louisiana Road Home litigation, class allegations were dismissed, but assigned policyholder claims remain; management preliminarily did not expect the case’s resolution to be material. Other legal or regulatory matters could affect a particular reporting period.
- Disclosure controls were concluded effective at quarter-end, and management reported no material change in internal control over financial reporting during the quarter.
Most important facts for investors to verify
- How much of the reported year-over-year growth reflects Chaucer’s consolidation timing, versus underlying organic premium and earnings trends.
- Whether improving combined ratios persist as catastrophe losses vary and domestic prior-year reserves show unfavorable development.
- The adequacy of loss reserves, especially Commercial Lines surety and auto, Personal Lines auto and homeowners, and the Chaucer reserve portfolio.
- Whether declining investment yields, realized or unrealized investment losses, or reinsurance recoverables materially affect future earnings, capital, or liquidity.
- The financial and capital effects of calling Chaucer’s subordinated notes, and the eventual outcomes of the Durand and Louisiana litigation.