Hanover Insurance Group, Inc. — FY2016 Form 10-K
Reporting period: Fiscal year ended December 31, 2016. Although the request references 2016 Q4, this is an annual filing; it also reports fourth-quarter results and reserve changes. Hanover is a property and casualty insurer operating through Commercial Lines, Personal Lines, Chaucer (Lloyd’s specialty insurance) and Other.
Financial performance and position
| Metric | 2016 | 2015 |
|---|---|---|
| Total revenues | $4,945.8 million | $5,034.0 million |
| Net premiums earned | $4,628.1 million | $4,704.8 million |
| Net premiums written | $4,698.8 million | $4,616.8 million |
| Income before income taxes | $192.3 million | $439.4 million |
| Net income | $155.1 million | $331.5 million |
| Diluted earnings per share | $3.59 | $7.40 |
| Operating income before interest and taxes, non-GAAP | $322.8 million | $466.1 million |
| Net cash provided by operating activities | $737.6 million | $438.4 million |
| Cash and investments | $8,732.1 million | $8,292.2 million |
| Total assets | $14,220.4 million | $13,781.2 million |
| Debt, carrying value | $786.4 million | $803.1 million |
| Shareholders’ equity | $2,857.5 million | $2,844.4 million |
The 2016 effective tax rate was 18.8%, versus 24.7% in 2015. Net investment income was $279.4 million, essentially flat year over year; the earned yield on the total investment portfolio was 3.38%, down from 3.44%. The filing says average yields are expected to continue declining as new-money yields remain below embedded book yields.
The total combined ratio was 98.6%, compared with 95.7% in 2015. By segment, 2016 combined ratios were 105.1% for Commercial Lines, 92.3% for Personal Lines and 90.4% for Chaucer. A ratio below 100% generally indicates underwriting profit before investment income. Catastrophe losses were $125.1 million, down from $181.3 million.
Investments were predominantly fixed maturities: $7.33 billion, or 84% of cash and investments; equity securities were $584.4 million. About 94% of fixed maturities were investment grade. Operating cash flow improved, primarily because of lower reinsurance payments and claims payments than in 2015. Investing activities used $495.4 million and financing activities used $295.0 million in 2016.
Material changes versus 2015
- Net income fell $176.4 million, while operating income before interest and taxes declined $143.3 million. The main operating factor was a shift from $94.3 million of favorable prior-year non-catastrophe reserve development in 2015 to $140.3 million unfavorable development in 2016. Including favorable catastrophe reserve development, total prior-year reserve development was $105.4 million unfavorable in 2016 versus $116.1 million favorable in 2015.
- Fourth-quarter domestic reserve review increased prior-year reserves by $174.1 million, excluding catastrophes; $161.5 million related to Commercial Lines. Management cited higher-severity liability losses, greater assumed tail risk and higher legal defense and claim-adjustment costs. The after-tax impact reduced fourth-quarter diluted EPS by $2.66.
- Commercial Lines underwriting results weakened sharply: underwriting loss was $122.0 million versus $12.7 million in 2015. Unfavorable prior-year development was $223.0 million, particularly in AIX program business, general liability and surety. Current accident-year underwriting profit excluding catastrophes improved to $171.1 million.
- Personal Lines underwriting profit increased to $103.8 million from $72.0 million, supported by lower catastrophe losses, rate increases and better current-year loss performance. Net premiums written rose 5.2%.
- Chaucer underwriting profit declined to $80.3 million from $131.5 million, and net premiums written fell 8.2%, mainly because of increased ceded reinsurance, reduced energy volumes amid low oil prices, and aviation declines. Competitive rate pressure was expected to continue in 2017.
- Net premiums written increased 1.8% overall, as domestic growth more than offset lower Chaucer volumes. Net premiums earned declined 1.6%.
Guidance, outlook, risks and unusual items
- Outlook: The filing provides no specific earnings or EPS guidance. Management said it would continue pursuing rate increases and improving business mix in Commercial and Personal Lines, subject to competition and regulation. Chaucer would selectively manage underwriting in a pressured market. The 2017 domestic reinsurance program was substantially consistent with 2016, but the filing cautions that planned placements and renewals were not assured.
- Debt refinancing: Hanover issued $375 million of 4.50% senior debentures due 2026 and used proceeds plus cash to redeem higher-coupon notes. The transaction generated an $86.1 million pre-tax loss ($57.4 million after tax); interest expense fell to $54.9 million from $60.6 million. Debt carrying value was $786.4 million at year-end.
- Reserving uncertainty: Net loss and LAE reserves were $4.67 billion, and 52% of aggregate net reserves were IBNR. Management states estimates could change materially; a one-point change in the aggregate loss and LAE ratio was estimated to affect operating income by about $46 million. Commercial liability, AIX, surety and long-tail claims are important areas of uncertainty.
- Reinsurance and concentration: Reinsurance recoverables were $2.61 billion, including $911.2 million from Michigan’s MCCA; the MCCA amount represented 34.9% of total reinsurance receivables. Reinsurance does not discharge Hanover’s obligations to policyholders, and counterparty collection risk remains. The company reported a $13.1 million allowance for uncollectible reinsurance.
- Other risks: The filing highlights catastrophe and weather losses, geographic concentration in Michigan and the Northeast, pricing and claims inflation, regulatory constraints, investment and interest-rate risk, foreign exchange, cyber and operational disruption, and uncertainty around Brexit’s effect on Chaucer’s European market access.
- Contingencies: In the Durand pension litigation, the company could not reasonably estimate the potential liability; the case concerns alleged underpayments of lump-sum pension benefits and related fiduciary claims. Other ordinary-course proceedings were not expected to materially affect financial position, though individual-period results could be affected.
- Capital and shareholder returns: U.S. insurance subsidiaries had statutory capital and surplus of $2.17 billion and a 245% Company Action Level RBC ratio. Hanover paid $80.4 million in common dividends and repurchased $105.6 million of shares in 2016. Management expected sufficient holding-company assets to meet 2017 obligations, while dividends remain subject to board decisions and insurance-subsidiary restrictions.
Most important facts for investors to verify
- Whether 2016’s commercial liability and AIX reserve strengthening fully reflects adverse severity and legal-cost trends, and how those trends develop in subsequent quarters.
- Subsequent reserve development by segment and accident year, especially Commercial Lines, surety, AIX programs and Chaucer’s long-tail business.
- Whether planned 2017 rate actions keep pace with loss-cost inflation and improve Commercial Lines underwriting profitability without impairing retention or growth.
- The collectability, concentration and collateral quality of the $2.61 billion reinsurance recoverable balance, particularly the MCCA and Lloyd’s-related balances.
- Actual 2017 reinsurance placement, pricing, terms and catastrophe protection, including any remaining unplaced coverage.
- Holding-company liquidity, subsidiary dividend capacity, debt covenants and the sustainability of dividends and share repurchases.
- Developments in the Durand litigation and any resulting pension funding obligations; the filing does not provide a clear estimate of potential exposure.