Business context and reporting period
The Hanover Insurance Group, Inc. filed this Form 10-K for the fiscal year ended December 31, 2012. It underwrites U.S. commercial and personal property-and-casualty insurance through independent agents, and international specialty insurance through Chaucer at Lloyd’s. Results include four segments: Commercial Lines, Personal Lines, Chaucer and Other Property and Casualty. Chaucer was acquired July 1, 2011, so 2012 includes a full year of Chaucer results versus six months in 2011; this limits year-over-year comparability.
Financial performance and key metrics
| Metric | 2012 | 2011 |
|---|---|---|
| Total revenue | $4.591 billion | $3.932 billion |
| Net premiums written | $4.368 billion | $3.593 billion |
| Net investment income | $276.6 million | $258.2 million |
| Income before income taxes | $28.7 million | $21.6 million |
| Income from continuing operations | $46.1 million | $31.5 million |
| Net income | $55.9 million | $36.7 million |
| Operating cash flow | $408.2 million | $221.7 million |
| Debt at year-end | $849.4 million | $911.1 million |
Revenue growth largely reflects Chaucer’s full-year contribution. Net income also included a $17.4 million income-tax benefit and $9.8 million of discontinued-operations income, including a $10.8 million after-tax gain on the sale of Citizens Management, Inc. Quarterly results were uneven: fourth-quarter 2012 continuing-operations loss was $55.3 million and net loss was $55.0 million.
Segment income before interest and taxes was $75.1 million, versus $71.8 million. Chaucer contributed $136.8 million; Commercial Lines recorded an $80.3 million loss; Personal Lines earned $25.5 million; and Other Property and Casualty lost $6.9 million. Consolidated combined ratio was 104.4% (above 100% indicates underwriting losses before investment income). By segment, combined ratios were 112.2% for Commercial Lines, 103.8% for Personal Lines and 90.3% for Chaucer.
Catastrophe losses were $369.9 million, including $198.1 million of pre-tax losses from Superstorm Sandy. Prior-year reserve development was $15.8 million favorable overall, comprising $72.6 million favorable in Chaucer offset by $56.8 million unfavorable in domestic operations. Net loss and loss-adjustment-expense reserves were $6.197 billion gross and $4.123 billion net; reserves increased from $5.760 billion gross at year-end 2011.
Cash and investments totaled $8.043 billion, including $564.8 million cash and cash equivalents; fixed maturities were $6.952 billion, about 95% investment grade. Shareholders’ equity was $2.595 billion, up from $2.484 billion. U.S. insurance-subsidiary statutory surplus fell to $1.523 billion from $1.583 billion, and statutory net income was a $47.3 million loss. Total reinsurance recoverables were $2.480 billion, including $856.3 million due from Michigan’s MCCA. Operating cash flow improved; investing activities used $562.8 million, primarily reflecting investment purchases, and financing activities used $133.4 million.
Material changes versus the prior comparable period
- Net premiums written increased about 21.6%, with Chaucer accounting for most of the increase; Commercial Lines also grew on rate increases, retention and targeted new business. Personal Lines premiums rose modestly.
- Commercial Lines segment income fell from $16.3 million to an $80.3 million loss, principally due to adverse reserve development and higher catastrophe losses.
- Chaucer segment income rose from $32.9 million to $136.8 million, reflecting a full year of ownership and lower loss activity in most classes.
- Overall favorable reserve development declined sharply, from $103.3 million in 2011 to $15.8 million in 2012.
- Investment assets rose 6.6% to $8.043 billion; net investment income increased, although fixed-maturity earned yield declined to 4.26% from 4.84%.
- The company adopted revised deferred-acquisition-cost accounting retrospectively, reducing opening 2012 shareholders’ equity by $25.8 million after tax; management said the effect on results and cash flows was not material.
Outlook, management commentary, risks and unusual items
Management reported improving pricing in U.S. Commercial and Personal Lines and intends to pursue rate increases, refine business mix and reduce selected geographic and property exposures. It expects Chaucer rate increases to moderate in 2013, with opportunities concentrated in certain marine and property markets; U.K. motor rates were expected to continue declining. The filing provides no consolidated earnings or revenue guidance.
Key risks include catastrophe severity and frequency, reserve-estimation uncertainty and adverse development, medical and repair-cost inflation, competitive and regulatory limits on pricing or market exits, and dependence on reinsurance recoveries. U.S. geographic concentration is notable: Michigan represented 22.6% of combined Commercial and Personal Lines net written premiums, and more than half of Personal Lines premium came from Michigan and Massachusetts. Reinsurance does not release the company from policyholder obligations; the MCCA recoverable is a significant concentration. Some 2013 reinsurance placements remained incomplete at filing, and federal terrorism coverage under TRIPRA was due to expire December 31, 2014.
Other items to note include a $5.1 million loss on debt retirement, $7.8 million of investment impairment losses recognized in earnings, and a $15.3 million underwriting loss from residual-market and pooling mechanisms. The Durand pension-plan class action remained unresolved; the company could not reasonably estimate potential liability. The Chaucer pension plan was underfunded by approximately $26 million. Management said it did not expect additional insurance-subsidiary dividends to be necessary for 2013 holding-company obligations, while noting that subsidiary dividends are regulatorily restricted.
PricewaterhouseCoopers issued an unqualified opinion on the financial statements and internal control over financial reporting. Management also concluded disclosure controls and internal control over financial reporting were effective at year-end.
Important facts for investors to verify
- Whether domestic underwriting results improve: the combined ratio was 104.4%, with Commercial Lines at 112.2% and Personal Lines at 103.8%.
- Whether reserve assumptions hold, particularly for auto bodily injury and personal injury protection, surety, AIX programs, newer Chaucer lines and Syndicate 4000 run-off exposures.
- Whether catastrophe losses, including Sandy-related claims, develop beyond current estimates and how much reinsurance is collectible.
- How the $856.3 million MCCA recoverable and other reinsurance concentrations perform, and whether planned reinsurance coverage is placed on acceptable terms.
- Whether earnings quality is sustainable apart from the tax benefit, discontinued-operation gain, reserve development and catastrophe effects.
- How rate trends, policy attrition, Michigan and Massachusetts concentration, and Chaucer’s anticipated premium and market mix affect future profitability and capital.
- Potential outcome and financial effect of the Durand litigation, and progress in pension funding and statutory surplus.