==============================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2003
OR
[ ] 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 1-6541
LOEWS CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 13-2646102
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
667 Madison Avenue, New York, N.Y. 10021-8087
(Address of principal executive offices) (Zip code)
(212) 521-2000
(Registrant's telephone number, including area code)
NOT APPLICABLE
(Former name, former address and former fiscal year, if changed since last
report)
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 X No
------ ------
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes X No
------ ------
Class Outstanding at August 1, 2003
- ------------------------------ -----------------------------
Common stock, $1.00 par value 185,447,050 shares
Carolina Group stock, $0.01 par value 39,910,000 shares
==============================================================================
1
INDEX
Page
Part I. Financial Information No.
-----
Item 1. Financial Statements
Consolidated Condensed Balance Sheets
June 30, 2003 and December 31, 2002 3
Consolidated Condensed Statements of Income
Three and Six months ended June 30, 2003 and 2002 4
Consolidated Condensed Statements of Cash Flows
Six months ended June 30, 2003 and 2002 6
Notes to Consolidated Condensed Financial Statements 8
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 64
Item 3. Quantitative and Qualitative Disclosures about Market Risk 126
Item 4. Disclosure Controls and Procedures 130
Part II. Other Information
Item 1. Legal Proceedings 130
Item 4. Submission of Matters to a Vote of Security Holders 132
Item 6. Exhibits and Reports on Form 8-K 134
2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements.
Loews Corporation and Subsidiaries
CONSOLIDATED CONDENSED BALANCE SHEETS
- ------------------------------------------------------------------------------------------------
(In millions)
June 30, December 31,
2003 2002
- ------------------------------------------------------------------------------------------------
Assets
Investments:
Fixed maturities, amortized cost of $29,535.3 and $26,688.8 $31,326.0 $27,433.7
Equity securities, cost of $743.8 and $1,002.8 975.4 1,120.5
Other investments 1,522.2 1,420.8
Short-term investments 9,192.5 10,161.7
- ------------------------------------------------------------------------------------------------
Total investments 43,016.1 40,136.7
Cash 187.7 185.4
Receivables-net 17,740.6 16,601.0
Property, plant and equipment-net 3,896.2 3,138.2
Deferred income taxes 139.3 627.2
Goodwill 446.7 177.8
Other assets 4,224.3 3,999.2
Deferred acquisition costs of insurance subsidiaries 2,620.2 2,551.4
Separate account business 3,428.9 3,102.7
- ------------------------------------------------------------------------------------------------
Total assets $75,700.0 $70,519.6
================================================================================================
Liabilities and Shareholders' Equity:
Insurance reserves:
Claim and claim adjustment expense $27,943.9 $27,369.9
Future policy benefits 7,759.2 7,408.9
Unearned premiums 5,198.3 4,820.0
Policyholders' funds 550.2 580.1
- ------------------------------------------------------------------------------------------------
Total insurance reserves 41,451.6 40,178.9
Payable for securities purchased 2,118.1 799.1
Securities sold under agreements to repurchase 1,389.9 552.4
Long-term debt, less unamortized discount 6,076.4 5,651.9
Reinsurance balances payable 2,840.1 2,763.3
Other liabilities 4,206.4 4,340.8
Separate account business 3,428.9 3,102.7
- ------------------------------------------------------------------------------------------------
Total liabilities 61,511.4 57,389.1
Minority interest 1,956.2 1,895.3
Shareholders' equity 12,232.4 11,235.2
- ------------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $75,700.0 $70,519.6
================================================================================================
See accompanying Notes to Consolidated Condensed Financial Statements.
3
Loews Corporation and Subsidiaries
CONSOLIDATED CONDENSED STATEMENTS OF INCOME
- ------------------------------------------------------------------------------------------------
(In millions)
Three Months Ended Six Months Ended
June 30, June 30,
------------------------- -------------------------
2003 2002 2003 2002
---------------------------------------------------
(Restated) (Restated)
Revenues:
Insurance premiums $ 2,195.6 $ 2,825.3 $ 4,575.8 $ 5,661.5
Investment income, net of expense 445.2 539.9 901.8 1,002.9
Investment gains (losses) 419.3 (195.0) 323.7 (171.5)
Manufactured products (including excise
taxes of $163.4, $176.1, $320.3 and $356.5) 814.3 1,068.0 1,698.3 2,072.8
Other 375.9 413.3 699.9 878.1
- -----------------------------------------------------------------------------------------------
Total 4,250.3 4,651.5 8,199.5 9,443.8
- -----------------------------------------------------------------------------------------------
Expenses:
Insurance claims and policyholders'
benefits 2,066.9 2,382.2 3,936.7 4,692.3
Amortization of deferred acquisition
costs 481.0 461.4 939.2 901.5
Cost of manufactured products sold 475.7 600.5 956.9 1,208.2
Other operating expenses 848.6 793.5 1,633.0 1,668.8
Interest 75.7 78.2 149.4 154.7
- -----------------------------------------------------------------------------------------------
Total 3,947.9 4,315.8 7,615.2 8,625.5
- -----------------------------------------------------------------------------------------------
302.4 335.7 584.3 818.3
- -----------------------------------------------------------------------------------------------
Income tax expense 87.9 122.6 180.8 293.8
Minority interest (0.3) 14.3 (1.3) 42.3
- -----------------------------------------------------------------------------------------------
Total 87.6 136.9 179.5 336.1
- -----------------------------------------------------------------------------------------------
Income from continuing operations 214.8 198.8 404.8 482.2
Discontinued operations-net (31.0)
Cumulative effect of change in
accounting principle-net (39.6)
- -----------------------------------------------------------------------------------------------
Net income $ 214.8 $ 198.8 $ 404.8 $ 411.6
===============================================================================================
Net income attributable to:
Loews common stock:
Income from continuing operations $ 189.8 $ 157.4 $ 351.2 $ 422.8
Discontinued operations-net (31.0)
Cumulative effect of change in
accounting principle-net (39.6)
- -----------------------------------------------------------------------------------------------
Loews common stock 189.8 157.4 351.2 352.2
Carolina Group stock 25.0 41.4 53.6 59.4
- ----------------------------------------------------------------------------------------------
Total $ 214.8 $ 198.8 $ 404.8 $ 411.6
==============================================================================================
4
Loews Corporation and Subsidiaries
CONSOLIDATED CONDENSED STATEMENTS OF INCOME (Continued)
- ------------------------------------------------------------------------------------------------
(In millions, except per share data)
Three Months Ended Six Months Ended
June 30, June 30,
------------------------ -------------------------
2003 2002 2003 2002
---------------------------------------------------
(Restated) (Restated)
Income per share of Loews common stock:
Income from continuing operations $ 1.02 $ 0.84 $ 1.89 $ 2.23
Discontinued operations-net (0.16)
Cumulative effect of change in
accounting principle-net (0.21)
- ------------------------------------------------------------------------------------------------
Net income $ 1.02 $ 0.84 $ 1.89 $ 1.86
================================================================================================
Net income per share of Carolina Group stock $ 0.63 $ 1.03 $ 1.34 $ 1.48
================================================================================================
Weighted average number of shares
outstanding:
Loews common stock 185.45 188.19 185.45 189.63
Carolina Group stock 39.91 40.25 39.91 40.25
See accompanying Notes to Consolidated Condensed Financial Statements.
5
Loews Corporation and Subsidiaries
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
- ------------------------------------------------------------------------------------------------
(In millions)
Six Months Ended
June 30,
-------------------------
2003 2002
-------------------------
Restated
Operating Activities:
Net income $ 404.8 $ 411.6
Adjustments to reconcile net income to net cash used in
operating activities-net (189.1) 206.8
Loss on disposal of discontinued operations 33.5
Cumulative effect of change in accounting principle-net 39.6
Changes in assets and liabilities-net:
Reinsurance receivable (657.3) 48.2
Other receivables (26.7) (36.5)
Federal income taxes (250.4) 873.0
Prepaid reinsurance premiums (115.6) (228.5)
Deferred acquisition costs (96.7) (91.7)
Insurance reserves and claims 1,276.2 (225.4)
Reinsurance balances payable 76.8 (4.0)
Other liabilities (133.9) (6.2)
Trading securities 206.1 (400.2)
Other-net 80.4 172.8
- -----------------------------------------------------------------------------------------------
574.6 793.0
- ------------------------------------------------------------------------------------------------
Investing Activities:
Purchases of fixed maturities (39,296.3) (39,678.8)
Proceeds from sales of fixed maturities 34,363.7 35,840.7
Proceeds from maturities of fixed maturities 3,086.9 2,719.8
Securities sold under agreements to repurchase 837.5 1,530.6
Purchases of equity securities (203.7) (548.2)
Proceeds from sales of equity securities 279.2 516.3
Change in short-term investments 1,437.1 (1,545.3)
Purchases of property, plant and equipment (289.7) (189.8)
Proceeds from sales of property, plant and equipment 3.4 92.8
Change in other investments (29.4) (162.4)
Purchase of Texas Gas (802.8)
- ------------------------------------------------------------------------------------------------
(614.1) (1,424.3)
- ------------------------------------------------------------------------------------------------
6
Loews Corporation and Subsidiaries
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS (Continued)
- ------------------------------------------------------------------------------------------------
(In millions)
Six Months Ended
June 30,
-------------------------
2003 2002
-------------------------
Restated
Financing Activities:
Dividends paid to Loews shareholders $ (91.6) $ (75.0)
Dividends paid to minority interests (15.1) (20.0)
Issuance of Loews common stock 0.2 0.5
Issuance of Carolina Group stock 1,069.6
Purchases of Loews treasury shares (309.2)
Purchases of treasury shares by subsidiaries (16.9)
Principal payments on long-term debt (543.6) (0.5)
Issuance of long-term debt 706.4
Receipts credited to policyholders 0.6 0.3
Withdrawals of policyholders account balances (13.2) (26.3)
Other (1.9) 9.6
- ------------------------------------------------------------------------------------------------
41.8 632.1
- ------------------------------------------------------------------------------------------------
Net change in cash 2.3 0.8
Cash, beginning of period 185.4 181.3
- ------------------------------------------------------------------------------------------------
Cash, end of period $ 187.7 $ 182.1
================================================================================================
See accompanying Notes to Consolidated Condensed Financial Statements.
7
Loews Corporation and Subsidiaries
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
- ------------------------------------------------------------------------------
1. Basis of Presentation
Loews Corporation is a holding company. Its subsidiaries are engaged in the
following lines of business: property, casualty and life insurance (CNA
Financial Corporation ("CNA"), a 90% owned subsidiary); the production and
sale of cigarettes (Lorillard, Inc. ("Lorillard"), a wholly owned subsidiary);
the operation of hotels (Loews Hotels Holding Corporation ("Loews Hotels"), a
wholly owned subsidiary); the operation of offshore oil and gas drilling rigs
(Diamond Offshore Drilling, Inc. ("Diamond Offshore"), a 54% owned
subsidiary); the operation of an interstate natural gas transmission pipeline
system (Texas Gas Transmission, LLC ("Texas Gas"), a wholly owned subsidiary);
and the distribution and sale of watches and clocks (Bulova Corporation
("Bulova"), a 97% owned subsidiary).
In May of 2003, a subsidiary of the Company acquired 100% of the capital
stock of Texas Gas Transmission Corporation (now known as Texas Gas
Transmission, LLC) from The Williams Companies, Inc. The transaction value was
approximately $1.05 billion. See Note 9 for additional discussion of the Texas
Gas acquisition.
Unless the context otherwise requires, the terms "Company" and "Registrant"
as used herein mean Loews Corporation excluding its subsidiaries.
In the opinion of management, the accompanying consolidated condensed
financial statements reflect all adjustments (consisting of only normal
recurring accruals) necessary to present fairly the financial position as of
June 30, 2003 and December 31, 2002 and the results of operations for the
three and six months ended June 30, 2003 and 2002 and changes in cash flows
for the six months ended June 30, 2003 and 2002.
Results of operations for the second quarter and the first half of each of
the years reported herein is not necessarily indicative of results of
operations for that entire year.
Reference is made to the Notes to Consolidated Financial Statements in the
2002 Annual Report to Shareholders on Form 10-K which should be read in
conjunction with these consolidated condensed financial statements.
Certain amounts applicable to prior periods have been reclassified to
conform to the classifications followed in 2003.
Restatement for CNA's Life Settlement Contract Accounting - As a result of a
routine review of CNA's periodic filings by the Division of Corporation
Finance of the Securities and Exchange Commission, the Company has restated
its results of operations prior to September 30, 2002. The restated financial
statements reflect an adjustment to the Company's historical accounting for
CNA's investment in life settlement contracts and the related revenue
recognition. The impact of this adjustment on operating results was
insignificant.
Accounting Changes - Effective January 1, 2002, in accordance with Statement
of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other
Intangible Assets," the Company recorded a $39.6 million goodwill impairment
charge as a cumulative effect of a change in accounting principle, adjusted to
reflect purchase accounting adjustments, net of income taxes and minority
8
interest of $5.8 and $6.4 million, respectively, primarily related to CNA's
Specialty Lines and Life Operations.
In June of 2001, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 143, "Accounting for Asset Retirement Obligations." SFAS No. 143
applies to the accounting and reporting obligations associated with the
retirement of tangible long-lived assets and the associated asset retirement
costs. This Statement applies to legal obligations associated with the
retirement of long-lived assets that result from the acquisition,
construction, development and/or the normal operation of a long-lived asset,
except for certain obligations of lessees. Adoption of this Statement in
January 2003 has not had a material impact on the Company's results of
operations or equity.
In January of 2003, the FASB issued Interpretation No. ("FIN") 46,
"Consolidation of Variable Interest Entities, an Interpretation of ARB No.
51." This Interpretation clarifies the application of ARB No. 51,
"Consolidated Financial Statements," to certain entities in which equity
investors do not have the characteristics of a controlling financial interest.
Prior to the issuance of this Interpretation, ARB No. 51 defined a controlling
financial interest as ownership of a majority voting interest. FIN 46 requires
an entity to consolidate a variable interest entity even though the entity
does not, either directly or indirectly, own more than 50% of the outstanding
voting shares. FIN 46 defines a variable interest entity as having one or both
of the following characteristics (1) the equity investment at risk is not
sufficient to permit the entity to finance its activities without additional
subordinated financial support from other parties or (2) the equity investors
lack one or more of the following (a) the direct or indirect ability to make
decisions about the entity's activities through voting rights or similar
rights, (b) the obligation to absorb the expected losses of the entity, if
they occur, which makes it possible for the entity to finance its activities
and (c) the right to receive the expected residual returns of the entity, if
they occur, which is the compensation for the risk of absorbing the expected
losses. FIN 46 applies immediately to variable interest entities created after
January 31, 2003, and for variable interest entities created before February
1, 2003, no later than the beginning of the first interim or annual reporting
period beginning after June 15, 2003. The Company is currently evaluating the
impact FIN 46 may have on its consolidated financial statements.
On April 30, 2003 the FASB issued SFAS No. 149, "Amendment of Statement 133
on Derivative Instruments and Hedging Activities." SFAS No. 149 amends and
clarifies accounting for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities under SFAS
No. 133. SFAS No. 149 is effective for contracts entered into or modified
after June 30, 2003 and for hedging relationships designated after June 30,
2003. The Company is currently in the process of evaluating the impact SFAS
No. 149 may have on its consolidated condensed financial statements.
On May 15, 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with characteristics of both Liabilities and Equity."
SFAS No. 150 establishes standards for classifying and measuring as
liabilities certain financial instruments that embody obligations of the
issuer and have characteristics of both liabilities and equity. SFAS No. 150
modifies the accounting and financial statement disclosures of three types of
financial instruments that, under previous guidance, issuers could account for
as equity. SFAS No. 150 is effective for all financial instruments created or
modified after May 31, 2003 and to other instruments as of September 1, 2003.
The Company does not have any financial instruments outstanding to which the
provisions of SFAS No. 150 apply, therefore the adoption of SFAS No. 150 is
9
not expected to have a material impact on the equity or results of operations
of the Company.
Stock option plans - The Company has elected to follow Accounting Principles
Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees" and
related interpretations in accounting for its employee stock options and
awards. Under APB No. 25, no compensation expense is recognized when the
exercise prices of options equals the fair value (market price) of the
underlying stock on the date of grant.
SFAS No. 123, "Accounting for Stock-Based Compensation," requires the
Company to disclose pro forma information regarding option grants made to its
employees. SFAS No. 123 specifies certain valuation techniques that produce
estimated compensation charges for purposes of valuing stock option grants.
These amounts have not been included in the Company's Consolidated Condensed
Statements of Income, in accordance with APB No. 25. Several of the Company's
subsidiaries also maintain their own stock option plans. The pro forma effect
of applying SFAS No. 123 includes the Company's share of expense related to
its subsidiaries' plans as well. The Company's pro forma net income and the
related basic and diluted income per share of Loews common stock and Carolina
Group stock would have been as follows:
Three Months Ended Six Months Ended
June 30, June 30,
------------------------ -------------------------
2003 2002 2003 2002
---------------------------------------------------
(In millions, except per share data)
Net income:
Loews common stock:
Net income as reported $ 189.8 $ 157.4 $ 351.2 $ 352.2
Deduct: Total stock-based employee
compensation expense determined under
the fair value based method, net (1.3) (1.0) (2.5) (1.9)
- ------------------------------------------------------------------------------------------------
Pro forma net income $ 188.5 $ 156.4 $ 348.7 $ 350.3
================================================================================================
Carolina Group stock:
Net income as reported $ 25.0 $ 41.4 $ 53.6 $ 59.4
Deduct: Total stock-based employee
compensation expense determined under
the fair value based method, net
- ------------------------------------------------------------------------------------------------
Pro forma net income $ 25.0 $ 41.4 $ 53.6 $ 59.4
================================================================================================
Net income per share:
Loews common stock:
As reported $ 1.02 $ 0.84 $ 1.89 $ 1.86
Pro forma 1.02 0.83 1.88 1.84
Carolina Group stock:
As reported 0.63 1.03 1.34 1.48
Pro forma 0.63 1.03 1.34 1.48
================================================================================================
Comprehensive Income - Comprehensive income includes all changes to
shareholders' equity, except those resulting from investments by shareholders
and distributions to shareholders. For the three and six months ended June 30,
10
2003 and 2002, comprehensive income totaled $703.0, $408.7, $1,088.6 and
$380.0 million, respectively. Comprehensive income includes net income,
unrealized appreciation (depreciation) of investments and foreign currency
translation gains or losses.
2. Investments
Three Months Ended Six Months Ended
June 30, June 30,
------------------------ -------------------------
2003 2002 2003 2002
---------------------------------------------------
(In millions)
Investment income consisted of:
Fixed maturity securities $ 426.1 $ 510.0 $ 855.5 $ 967.1
Short-term investments 26.0 27.4 54.5 57.8
Limited partnerships 74.4 37.7 97.7 44.5
Equity securities 6.7 8.7 12.0 16.9
Interest expense on funds withheld and
other deposits (93.5) (56.4) (140.2) (114.5)
Other 29.1 27.2 65.5 61.5
- ------------------------------------------------------------------------------------------------
Total investment income 468.8 554.6 945.0 1,033.3
Investment expenses (23.6) (14.7) (43.2) (30.4)
- ------------------------------------------------------------------------------------------------
Investment income-net $ 445.2 $ 539.9 901.8 $ 1,002.9
================================================================================================
Investment gains (losses) are as follows:
Trading securities:
Derivative instruments $ (24.3) $ (13.2) $ (17.6) $ (3.2)
Equity securities, including short
positions 45.9 (46.4) 8.6 (37.3)
- ------------------------------------------------------------------------------------------------
21.6 (59.6) (9.0) (40.5)
Other than trading:
Fixed maturities 395.9 (170.3) 360.0 (163.4)
Equity securities 58.1 41.7 58.1 48.9
Short?term investments (1.7) 26.4 3.6 33.7
Other, including guaranteed separate
account business (54.6) (33.2) (89.0) (50.2)
- ------------------------------------------------------------------------------------------------
Investment gains (losses) 419.3 (195.0) 323.7 (171.5)
Income tax (expense) benefit (144.1) 68.4 (110.0) 61.9
Minority interest (24.5) 8.7 (19.6) 7.5
- ------------------------------------------------------------------------------------------------
Investment gains (losses)-net $ 250.7 $ (117.9) $ 194.1 $(102.1)
================================================================================================
Realized investment losses included $31.0, $292.0, $286.0 and $310.0 million
of pretax other than temporary impairment losses for the three and six months
ended June 30, 2003 and 2002. The impairment losses recorded for the three and
six months ended June 30, 2003 were primarily for securities in certain market
sectors, including the airline, healthcare and energy industries. For the
three and six months ended June 30, 2002, the impairment losses recorded
related primarily to the credit deterioration of a specific equity holding.
3. Earnings Per Share
Companies with complex capital structures are required to present basic and
diluted earnings per share. Basic earnings per share excludes dilution and is
11
computed by dividing net income attributable to each class of common stock by
the weighted average number of common shares of each class of common stock
outstanding for the period. Diluted earnings per share reflects the potential
dilution that could occur if securities or other contracts to issue common
stock were exercised or converted into common stock. For the three and six
months ended June 30, 2003 and 2002, income per common share assuming dilution
is the same as basic income per share because the impact of securities that
could potentially dilute basic income per common share is insignificant or
antidilutive for the periods presented.
Options to purchase 0.88, 0.30, 0.84 and 0.25 million shares of Loews common
stock were outstanding for the three and six months ended June 30, 2003 and
2002, respectively, but were not included in the computation of diluted
earnings per share because the options' exercise prices were greater than the
average market price of the common shares and, therefore, the effect would be
antidilutive. Options to purchase 0.39, 0.20, 0.37 and 0.20 million shares of
Carolina Group stock were outstanding for the three and six months ending June
30, 2003 and 2002, but were not included in the computation of diluted
earnings per share because the options' exercise prices were greater than the
average market price of the common shares and, therefore, the effect would be
antidilutive.
The attribution of income to each class of common stock was as follows:
Three Months Ended Six Months Ended
June 30, June 30,
------------------------- -------------------------
2003 2002 2003 2002
----------------------------------------------------
(In millions)
Loews common stock:
Consolidated net income $ 214.8 $ 198.8 $ 404.8 $ 411.6
Less income attributable to
Carolina Group stock 25.0 41.4 53.6 59.4
- ------------------------------------------------------------------------------------------------
Income attributable to Loews common stock $ 189.8 $ 157.4 $ 351.2 $ 352.2
================================================================================================
Carolina Group stock:
Carolina Group net income $ 108.4 $ 178.8 $ 232.8 $ 329.5
Less net income for January 2002 73.1
- ------------------------------------------------------------------------------------------------
Income available to Carolina Group stock 108.4 178.8 232.8 256.4
Weighted average economic interest of the
Carolina Group stock 23.01% 23.17% 23.01% 23.17%
- ------------------------------------------------------------------------------------------------
Income attributable to
Carolina Group stock $ 25.0 $ 41.4 $ 53.6 $ 59.4
================================================================================================
12
4. Loews and Carolina Group Consolidating Condensed Financial Information
On February 6, 2002, the Company sold 40,250,000 shares of a new class of
its common stock, referred to as Carolina Group stock, for net proceeds of
$1.1 billion. This stock is designed to track the performance of the Carolina
Group, which consists of the Company's ownership interest in Lorillard;
notional, intergroup debt owed by the Carolina Group to the Loews Group ($2.3
billion outstanding at June 30, 2003), bearing interest at the annual rate of
8.0% and, subject to optional prepayment, due December 31, 2021; any and all
liabilities, costs and expenses of the Company and Lorillard arising out of
the past, present or future business of Lorillard, and all net income or net
losses from the assets and liabilities attributed to the Carolina Group. Each
outstanding share of Carolina Group stock has 1/10 of a vote per share.
The issuance of Carolina Group stock has resulted in a two class common
stock structure for the Company. During the year ended December 31, 2002, the
Company purchased, for the account of the Carolina Group, 340,000 shares of
Carolina Group stock. As of June 30, 2003, the outstanding Carolina Group
stock represents a 23.01% economic interest in the economic performance of the
Carolina Group. The Loews Group consists of all of the Company's assets and
liabilities other than the 23.01% economic interest represented by the
outstanding Carolina Group stock, and includes as an asset the notional,
intergroup debt of the Carolina Group. Holders of the Company's common stock
and of Carolina Group stock are shareholders of Loews Corporation and are
subject to the risks related to an equity investment in Loews Corporation.
The Company has separated, for financial reporting purposes, the Carolina
Group and Loews Group. The following schedules present the consolidating
condensed financial information for these individual groups. Neither group is
a separate company or legal entity. Rather, each group is intended to reflect
a defined set of assets and liabilities.
13
Loews and Carolina Group
Consolidating Condensed Balance Sheet Information
Carolina Group Adjustments
------------------------------------ Loews and
June 30, 2003 Lorillard Other Consolidated Group Eliminations Total
- ------------------------------------------------------------------------------------------------
(In millions)
Assets:
Investments $1,596.2 $ 149.8 $ 1,746.0 $ 41,270.1 $43,016.1
Cash 1.4 0.6 2.0 185.7 187.7
Receivables-net 26.4 0.2 26.6 17,746.0 $ (32.0)(a) 17,740.6
Property, plant and
equipment-net 205.7 205.7 3,690.5 3,896.2
Deferred income taxes 461.9 461.9 (322.6)(c) 139.3
Goodwill 446.7 446.7
Other assets 435.4 435.4 3,788.9 4,224.3
Investment in combined
attributed net assets
of the Carolina Group 1,714.3 (2,336.0)(a)
621.7 (b)
Deferred acquisition
costs of insurance
subsidiaries 2,620.2 2,620.2
Separate account business 3,428.9 3,428.9
- ------------------------------------------------------------------------------------------------
Total assets $2,727.0 $ 150.6 $ 2,877.6 $ 74,891.3 $ (2,068.9) $75,700.0
================================================================================================
Liabilities and Shareholders' Equity:
Insurance reserves $ 41,451.6 $41,451.6
Payable for securities
purchased 2,118.1 2,118.1
Securities sold under
agreements to
repurchase 1,389.9 1,389.9
Long-term debt, less
unamortized discount $ 2,336.0 $ 2,336.0 6,076.4 $ (2,336.0)(a) 6,076.4
Deferred income taxes 322.6 (322.6)(c)
Reinsurance balances
payable 2,840.1 2,840.1
Other liabilities $1,327.8 21.3 1,349.1 2,889.3 (32.0)(a) 4,206.4
Separate account business 3,428.9 3,428.9
- ------------------------------------------------------------------------------------------------
Total liabilities 1,327.8 2,357.3 3,685.1 60,516.9 (2,690.6) 61,511.4
Minority interest 1,956.2 1,956.2
Shareholders' equity 1,399.2 (2,206.7) (807.5) 12,418.2 621.7 (b) 12,232.4
- ------------------------------------------------------------------------------------------------
Total liabilities and
shareholders' equity $2,727.0 $ 150.6 $ 2,877.6 $ 74,891.3 $ (2,068.9) $75,700.0
================================================================================================
(a) To eliminate the intergroup notional debt and interest payable/receivable.
(b) To eliminate the Loews Group's 76.99% equity interest in the combined attributed net
assets of the Carolina Group.
(c) To reclass debit and credit balances to the amounts in consolidation.
14
Loews and Carolina Group
Consolidating Condensed Balance Sheet Information
Carolina Group Adjustments
------------------------------------ Loews and
December 31, 2002 Lorillard Other Consolidated Group Eliminations Total
- ------------------------------------------------------------------------------------------------
(In millions)
Assets:
Investments $ 1,640.7 $ 150.3 $1,791.0 $38,345.7 $40,136.7
Cash 2.0 0.2 2.2 183.2 185.4
Receivables-net 30.2 30.2 16,603.9 $ (33.1) (a) 16,601.0
Property, plant and
equipment-net 197.8 197.8 2,940.4 3,138.2
Deferred income taxes 437.0 437.0 190.2 627.2
Goodwill 177.8 177.8
Other assets 469.2 469.2 3,530.0 3,999.2
Investment in combined
attributed net assets
of the Carolina Group 1,757.9 (2,438.1) (a)
680.2 (b)
Deferred acquisition
costs of insurance
subsidiaries 2,551.4 2,551.4
Separate account business 3,102.7 3,102.7
- ------------------------------------------------------------------------------------------------
Total assets $ 2,776.9 $ 150.5 $2,927.4 $69,383.2 $(1,791.0) $70,519.6
================================================================================================
Liabilities and Shareholders' Equity:
Insurance reserves $40,178.9 $40,178.9
Payable for securities
purchased 799.1 799.1
Securities sold under
agreements to repurchase 552.4 552.4
Long-term debt, less
unamortized discount $ 2,438.1 $ 2,438.1 5,651.9 $(2,438.1) (a) 5,651.9
Reinsurance balances
payable 2,763.3 2,763.3
Other liabilities $ 1,352.1 20.7 1,372.8 3,001.1 (33.1) (a) 4,340.8
Separate account business 3,102.7 3,102.7
- ------------------------------------------------------------------------------------------------
Total liabilities 1,352.1 2,458.8 3,810.9 56,049.4 (2,471.2) 57,389.1
Minority interest 1,895.3 1,895.3
Shareholders' equity 1,424.8 (2,308.3) (883.5) 11,438.5 680.2 (b) 11,235.2
- ------------------------------------------------------------------------------------------------
Total liabilities and
shareholders' equity $ 2,776.9 $ 150.5 $ 2,927.4 $69,383.2 $(1,791.0) $70,519.6
================================================================================================
(a) To eliminate the intergroup notional debt and interest payable/receivable.
(b) To eliminate the Loews Group's 76.99% equity interest in the combined attributed net
assets of the Carolina Group.
15
Loews and Carolina Group
Consolidating Condensed Statement of Income Information
Carolina Group Adjustments
Three Months Ended ------------------------------------ Loews and
June 30, 2003 Lorillard Other Consolidated Group Eliminations Total
- ------------------------------------------------------------------------------------------------
(In millions)
Revenues:
Insurance premiums $2,195.6 $2,195.6
Investment income, net $ 10.6 $ 0.6 $ 11.2 481.3 $(47.3)(a) 445.2
Investment (losses) gains (2.1) (2.1) 421.4 419.3
Manufactured products 780.9 780.9 33.4 814.3
Other 375.9 375.9
- ------------------------------------------------------------------------------------------------
Total 789.4 0.6 790.0 3,507.6 (47.3) 4,250.3
- ------------------------------------------------------------------------------------------------
Expenses:
Insurance claims and
policyholders' Benefits 2,066.9 2,066.9
Amortization of deferred
acquisition costs 481.0 481.0
Cost of manufactured
products sold 461.7 461.7 14.0 475.7
Other operating expenses (b) 113.4 0.1 113.5 735.1 848.6
Interest 47.3 47.3 75.7 (47.3)(a) 75.7
- ------------------------------------------------------------------------------------------------
Total 575.1 47.4 622.5 3,372.7 (47.3) 3,947.9
- ------------------------------------------------------------------------------------------------
214.3 (46.8) 167.5 134.9 302.4
- -----------------------------------------------------------------------------------------------
Income tax expense (benefit) 75.7 (16.6) 59.1 28.8 87.9
Minority interest (0.3) (0.3)
- ------------------------------------------------------------------------------------------------
Total 75.7 (16.6) 59.1 28.5 87.6
- ------------------------------------------------------------------------------------------------
Income from operations 138.6 (30.2) 108.4 106.4 214.8
Equity in earnings of the
Carolina Group 83.4 (83.4)(c)
- ------------------------------------------------------------------------------------------------
Net income $ 138.6 $(30.2) $ 108.4 $ 189.8 $(83.4) $ 214.8
================================================================================================
(a) To eliminate interest on the intergroup notional debt.
(b) Includes $0.1 of expenses allocated by the Loews Group to the Carolina Group for services
provided pursuant to a services agreement, which eliminate in these consolidating
statements.
(c) To eliminate the Loews Group's intergroup interest in the earnings of the Carolina Group.
16
Loews and Carolina Group
Consolidating Condensed Statement of Income Information
Carolina Group Adjustments
Three Months Ended --------------------------------- Loews and
June 30, 2002 Lorillard Other Consolidated Group Eliminations Total
- ------------------------------------------------------------------------------------------------
(In millions) (Restated) (Restated)
Revenues:
Insurance premiums $2,825.3 $2,825.3
Investment income, net $ 10.3 $ 0.3 $ 10.6 579.3 $ (50.0)(a) 539.9
Investment gains (losses) 7.8 7.8 (202.8) (195.0)
Manufactured products 1,026.9 1,026.9 41.1 1,068.0
Other 0.7 0.7 412.6 413.3
- ------------------------------------------------------------------------------------------------
Total 1,045.7 0.3 1,046.0 3,655.5 (50.0) 4,651.5
- ------------------------------------------------------------------------------------------------
Expenses:
Insurance claims and
policyholders' benefits 2,382.2 2,382.2
Amortization of deferred
acquisition costs 461.4 461.4
Cost of manufactured
products sold 580.6 580.6 19.9 600.5
Other operating expenses (b) 119.5 119.5 674.0 793.5
Interest 50.0 50.0 78.2 (50.0)(a) 78.2
- -----------------------------------------------------------------------------------------------
Total 700.1 50.0 750.1 3,615.7 (50.0) 4,315.8
- -----------------------------------------------------------------------------------------------
345.6 (49.7) 295.9 39.8 335.7
- -----------------------------------------------------------------------------------------------
Income tax expense (benefit) 136.6 (19.5) 117.1 5.5 122.6
Minority interest 14.3 14.3
- -----------------------------------------------------------------------------------------------
Total 136.6 (19.5) 117.1 19.8 136.9
- -----------------------------------------------------------------------------------------------
Income from operations 209.0 (30.2) 178.8 20.0 198.8
Equity in earnings of the
Carolina Group 137.4 (137.4)(c)
- -----------------------------------------------------------------------------------------------
Net income $ 209.0 $(30.2) $ 178.8 $ 157.4 $(137.4) $ 198.8
================================================================================================
(a) To eliminate interest on the intergroup notional debt.
(b) Includes $0.1 of expenses allocated by the Carolina Group to the Loews Group for computer
related charges and $0.1 of expenses allocated by Loews Group to the Carolina Group for
services provided pursuant to a services agreement, which eliminate in these consolidating
statements.
(c) To eliminate the Loews Group's intergroup interest in the earnings of the Carolina Group.
17
Loews and Carolina Group
Consolidating Condensed Statement of Income Information
Carolina Group Adjustments
Six Months Ended ------------------------------------ Loews and
June 30, 2003 Lorillard Other Consolidated Group Eliminations Total
- ------------------------------------------------------------------------------------------------
(In millions)
Revenues:
Insurance premiums $4,575.8 $4,575.8
Investment income, net $ 18.5 $ 1.2 $ 19.7 977.6 $ (95.5)(a) 901.8
Investment (losses) gains (1.8) (1.8) 325.5 323.7
Manufactured products 1,625.1 1,625.1 73.2 1,698.3
Other (0.2) (0.2) 700.1 699.9
- ------------------------------------------------------------------------------------------------
Total 1,641.6 1.2 1,642.8 6,652.2 (95.5) 8,199.5
- ------------------------------------------------------------------------------------------------
Expenses:
Insurance claims and
policyholders' benefits 3,936.7 3,936.7
Amortization of deferred
acquisition costs 939.2 939.2
Cost of manufactured
products sold 921.4 921.4 35.5 956.9
Other operating expenses (b) 254.6 0.2 254.8 1,378.2 1,633.0
Interest 95.5 95.5 149.4 (95.5)(a) 149.4
- ------------------------------------------------------------------------------------------------
Total 1,176.0 95.7 1,271.7 6,439.0 (95.5) 7,615.2
- ------------------------------------------------------------------------------------------------
465.6 (94.5) 371.1 213.2 584.3
- -----------------------------------------------------------------------------------------------
Income tax expense
(benefit) 173.5 (35.2) 138.3 42.5 180.8
Minority interest (1.3) (1.3)
- ------------------------------------------------------------------------------------------------
Total 173.5 (35.2) 138.3 41.2 179.5
- ------------------------------------------------------------------------------------------------
Income from operations 292.1 (59.3) 232.8 172.0 404.8
Equity in earnings of the
Carolina Group 179.2 (179.2)(c)
- ------------------------------------------------------------------------------------------------
Net income $ 292.1 $(59.3) $ 232.8 $ 351.2 $(179.2) $ 404.8
================================================================================================
(a) To eliminate interest on the intergroup notional debt.
(b) Includes $0.1 of expenses allocated by the Carolina Group to the Loews Group for computer
related charges and $0.1 of expenses allocated by Loews Group to the Carolina Group for
services provided pursuant to a service agreement, which eliminate in these consolidating
statements.
(c) To eliminate the Loews Group's intergroup interest in the earnings of the Carolina Group.
18
Loews and Carolina Group
Consolidating Condensed Statement of Income Information
Carolina Group Adjustments
Six Months Ended --------------------------------- Loews and
June 30, 2002 Lorillard Other Consolidated Group Eliminations Total
- ------------------------------------------------------------------------------------------------
(In millions) (Restated) (Restated)
Revenues:
Insurance premiums $5,661.5 $5,661.5
Investment income, net $ 21.5 $ 0.3 $ 21.8 1,060.1 $ (79.0)(a) 1,002.9
Investment gains (losses) 10.6 10.6 (182.1) (171.5)
Manufactured products 2,000.0 2,000.0 72.8 2,072.8
Other 0.7 0.7 877.4 878.1
- ------------------------------------------------------------------------------------------------
Total 2,032.8 0.3 2,033.1 7,489.7 (79.0) 9,443.8
- ------------------------------------------------------------------------------------------------
Expenses:
Insurance claims and
policyholders' benefits 4,692.3 4,692.3
Amortization of deferred
acquisition costs 901.5 901.5
Cost of manufactured
products sold 1,172.9 1,172.9 35.3 1,208.2
Other operating expenses (b) 238.9 0.1 239.0 1,429.8 1,668.8
Interest 79.0 79.0 154.7 (79.0)(a) 154.7
- -----------------------------------------------------------------------------------------------
Total 1,411.8 79.1 1,490.9 7,213.6 (79.0) 8,625.5
- -----------------------------------------------------------------------------------------------
621.0 (78.8) 542.2 276.1 818.3
- -----------------------------------------------------------------------------------------------
Income tax expense (benefit) 243.5 (30.8) 212.7 81.1 293.8
Minority interest 42.3 42.3
- -----------------------------------------------------------------------------------------------
Total 243.5 (30.8) 212.7 123.4 336.1
- -----------------------------------------------------------------------------------------------
Income from operations 377.5 (48.0) 329.5 152.7 482.2
Equity in earnings of the
Carolina Group 270.1 (270.1)(c)
- -----------------------------------------------------------------------------------------------
Income from continuing
operations 377.5 (48.0) 329.5 422.8 (270.1) 482.2
Discontinued operations- net (31.0) (31.0)
Cumulative effect of
change in accounting
principle-net (39.6) (39.6)
- ------------------------------------------------------------------------------------------------
Net income $ 377.5 $(48.0) $ 329.5 $ 352.2 $(270.1) $ 411.6
================================================================================================
(a) To eliminate interest on the intergroup notional debt.
(b) Includes $0.1 of expenses allocated by the Carolina Group to the Loews Group for computer
related charges and $0.1 of expenses allocated by Loews Group to the Carolina Group for
services provided pursuant to a services agreement, which eliminate in these consolidating
statements.
(c) To eliminate the Loews Group's intergroup interest in the earnings of the Carolina Group.
19
Loews and Carolina Group
Consolidating Condensed Statement of Cash Flows Information
Carolina Group Adjustments
Six Months Ended ---------------------------------- Loews and
June 30, 2003 Lorillard Other Consolidated Group Eliminations Total
- -----------------------------------------------------------------------------------------------
(In millions)
Net cash provided (used)
in operating activities $ 289.8 $ (58.9) $ 230.9 $ 463.8 $(120.1) $ 574.6
- ------------------------------------------------------------------------------------------------
Investing activities:
Purchases of property and
equipment (27.8) (27.8) (261.9) (289.7)
Proceeds from sales of
property and equipment 3.4 3.4
Change in short-term
investments 54.4 0.5 54.9 1,382.2 1,437.1
Other investing activities (1,662.8) (102.1) (1,764.9)
- ------------------------------------------------------------------------------------------------
26.6 0.5 27.1 (539.1) (102.1) (614.1)
- ------------------------------------------------------------------------------------------------
Financing activities:
Dividends paid to
shareholders (317.0) 160.9 (156.1) (55.6) 120.1 (91.6)
Reduction of intergroup
notional debt (102.1) (102.1) 102.1
Other financing activities 133.4 133.4
- ------------------------------------------------------------------------------------------------
(317.0) 58.8 (258.2) 77.8 222.2 41.8
- ------------------------------------------------------------------------------------------------
Net change in cash (0.6) 0.4 (0.2) 2.5 2.3
Cash, beginning of period 2.0 0.2 2.2 183.2 185.4
- ------------------------------------------------------------------------------------------------
Cash, end of period $ 1.4 $ 0.6 $ 2.0 $ 185.7 $ 187.7
================================================================================================
20
Loews and Carolina Group
Consolidating Condensed Statement of Cash Flows Information
Carolina Group Adjustments
Six Months Ended ----------------------------------- Loews and
June 30, 2002 Lorillard Other Consolidated Group Eliminations Total
- ------------------------------------------------------------------------------------------------
(In millions) (Restated) (Restated)
Net cash provided (used)
by operating activities $ 372.1 $ (27.8) $ 344.3 $ 608.1 $ (159.4) $ 793.0
- ------------------------------------------------------------------------------------------------
Investing activities:
Purchases of property and
equipment (23.5) (23.5) (166.3) (189.8)
Proceeds from sales of
property and equipment 2.6 2.6 90.2 92.8
Change in short-term
investments (98.6) (47.6) (146.2) (1,399.1) (1,545.3)
Other investing activities 218.0 218.0
- ------------------------------------------------------------------------------------------------
(119.5) (47.6) (167.1) (1,257.2) (1,424.3)
- ------------------------------------------------------------------------------------------------
Financing activities:
Dividends paid to
shareholders (252.0) 74.7 (177.3) (57.1) 159.4 (75.0)
Other financing activities 707.1 707.1
- ------------------------------------------------------------------------------------------------
(252.0) 74.7 (177.3) 650.0 159.4 632.1
- ------------------------------------------------------------------------------------------------
Net change in cash 0.6 (0.7) (0.1) 0.9 0.8
Cash, beginning of period 1.0 0.7 1.7 179.6 181.3
- ------------------------------------------------------------------------------------------------
Cash, end of period $ 1.6 $ 1.6 $ 180.5 $ 182.1
================================================================================================
21
5. Reinsurance
CNA assumes and cedes reinsurance with other insurers, reinsurers and
members of various reinsurance pools and associations. CNA utilizes
reinsurance arrangements to limit its maximum loss, provide greater
diversification of risk, minimize exposures on larger risks and to exit
certain lines of business.
Interest cost on reinsurance contracts accounted for on a funds withheld
basis is credited during all periods in which a funds withheld liability
exists. Interest cost, which is included in net investment income, was $93.5
and $56.4 million for the three months ended June 30, 2003 and 2002 and $140.2
and $114.5 million for the six months ended June 30, 2003 and 2002. The amount
subject to interest crediting rates on such contracts was $2,500.0 and
$2,766.0 million at June 30, 2003 and December 31, 2002.
The amount subject to interest crediting on these funds withheld contracts
will vary over time based on a number of factors, including the timing of loss
payments and ultimate gross losses incurred. CNA expects that it will continue
to incur significant interest costs on these contracts for several years.
The ceding of insurance does not discharge the primary liability of CNA.
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 assumed under reinsurance agreements.
As previously reported in the Company's Annual Report on Form 10-K for the
year ended December 31, 2002, CNA has reinsurance receivables from several
reinsurers who have recently experienced multiple downgrades of their
financial strength ratings, have announced that they will no longer accept new
business and are placing their books of business into run-off. One of CNA's
principal credit exposures from these recent events arises from reinsurance
receivables from Gerling Global ("Gerling").
CNA has been in discussions with Gerling with respect to resolving a dispute
concerning possession of collateral on three CNA HealthPro treaties, and is in
discussions regarding a possible commutation of all other reinsurance
arrangements between CNA and Gerling. The three CNA HealthPro treaties were
commuted as of June 30, 2003, which resulted in a $37.0 million pretax loss.
Life premiums are primarily from long duration contracts, property and
casualty premiums and accident and health premiums are primarily from short
duration contracts.
22
The effects of reinsurance on earned premiums are shown in the following
table.
Direct Assumed Ceded Net
-------------------------------------------
Six Months Ended June 30, 2003
-------------------------------------------
Property and casualty . . . . . . . . . . . . $5,281.0 $376.0 $2,222.0 $3,435.0
Accident and health . . . . . . . . . . . . . 788.0 55.0 29.0 814.0
Life . . . . . . . . . . . . . . . . . . . . 529.0 9.0 211.0 327.0
-------------------------------------------
Total earned premiums . . . . . . . . . . . . $6,598.0 $440.0 $2,462.0 $4,576.0
===========================================
Six Months Ended June 30, 2002
-------------------------------------------
Property and casualty . . . . . . . . . . . . $ 4,882.0 $ 409.0 $1,897.0 $ 3,394.0
Accident and health . . . . . . . . . . . . . 1,859.0 75.0 4.0 1,930.0
Life . . . . . . . . . . . . . . . . . . . . 538.0 18.0 218.0 338.0
-------------------------------------------
Total earned premiums . . . . . . . . . . . . $ 7,279.0 $ 502.0 $2,119.0 $ 5,662.0
===========================================
CNA has an aggregate reinsurance treaty related to the 1999 through 2001
accident years that covers substantially all of CNA's property and casualty
lines of business (the "Aggregate Cover"). The Aggregate Cover provides for
two sections of coverage. These coverages attach at defined loss ratios for
each accident year. Coverage under the first section of the Aggregate Cover,
which is available for all accident years covered by the treaty, has a $500.0
million limit per accident year of ceded losses and an aggregate limit of $1.0
billion of ceded losses for the three accident years. The ceded premiums
associated with the first section are a percentage of ceded losses and for
each $500.0 million of limit the ceded premium is $230.0 million. The second
section of the Aggregate Cover, which only relates to accident year 2001,
provides additional coverage of up to $510.0 million of ceded losses for a
maximum ceded premium of $310.0 million. Under the Aggregate Cover, interest
charges on the funds withheld liability accrue at 8.0% per annum. If the
aggregate loss ratio for the three-year period exceeds certain thresholds,
additional premiums may be payable and the rate at which interest charges are
accrued would increase to 8.25% per annum commencing in 2006.
During the second quarter of 2003, as a result of the unfavorable reserve
development recorded related to accident year 2000, losses of $78.0 million
were ceded under the first section of the Aggregate Cover. In 2001, as a
result of reserve additions including those related to accident year 1999, the
$500.0 million limit related to the 1999 accident year under the first section
was fully utilized and losses of $510.0 million were ceded under the second
section as a result of losses related to the September 11, 2001 World Trade
Center Disaster and related events ("WTC event").
23
The impact of the Aggregate Cover on pretax results of operations was as
follows:
Three Months Ended Six Months Ended
June 30, June 30,
- ------------------------------------------------------------------------------------------------
2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------
(In millions)
Ceded earned premiums $ (28.0) $ (28.0)
Ceded claim and claim adjustment expense 78.0 78.0
Interest charges (22.0) $ (12.0) (35.0) $ (25.0)
- ------------------------------------------------------------------------------------------------
Pretax benefit (expense) $ 28.0 $ (12.0) $ 15.0 $ (25.0)
================================================================================================
In 2001, CNA entered into a one-year aggregate reinsurance treaty related to
the 2001 accident year covering substantially all property and casualty lines
of business in the Continental Casualty Company pool (the "CCC Cover"). The
loss protection provided by the CCC Cover has an aggregate limit of
approximately $760.0 million of ceded losses. The ceded premiums are a
percentage of ceded losses. The ceded premium related to full utilization of
the $760.0 million of limit is $456.0 million. The CCC Cover provides
continuous coverage in excess of the second section of the Aggregate Cover
discussed above. Under the CCC Cover, interest charges on the funds withheld
generally accrue at 8.0% per annum. The interest rate increases to 10.0% per
annum if the aggregate loss ratio exceeds certain thresholds. Losses of $745.0
million have been ceded under the CCC Cover through June 30, 2003.
The impact of the CCC Cover on pretax results of operations was as follows:
Three Months Ended Six Months Ended
June 30, June 30,
- ------------------------------------------------------------------------------------------------
2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------
(In millions)
Ceded earned premiums $ (91.0) $ (91.0) $ (61.0)
Ceded claim and claim adjustment expense 126.0 126.0 93.0
Interest charges (27.0) $ (6.0) (35.0) (16.0)
- ------------------------------------------------------------------------------------------------
Pretax benefit (expense) $ 8.0 $ (6.0) $ 16.0
================================================================================================
24
6. Receivables
June 30, December 31,
2003 2002
- ------------------------------------------------------------------------------------------------
(In millions)
Reinsurance $13,352.6 $12,695.3
Other insurance 3,401.4 3,163.2
Security sales 688.5 493.3
Accrued investment income 380.2 316.8
Other 369.9 294.8
- -----------------------------------------------------------------------------------------------
Total 18,192.6 16,963.4
Less: Allowance for doubtful accounts on reinsurance receivables 239.9 195.7
Allowance for doubtful accounts and cash discounts 212.1 166.7
- -----------------------------------------------------------------------------------------------
Receivables-net $17,740.6 $16,601.0
===============================================================================================
7. Claim and Claim Adjustment Expense Reserves
CNA's property and casualty insurance claim and claim adjustment expense
reserves represent the estimated amounts necessary to settle all outstanding
claims, including claims that are incurred but not reported ("IBNR") as of the
reporting date. CNA's reserve projections are based primarily on detailed
analysis of the facts in each case, CNA's experience with similar cases and
various historical development patterns. Consideration is given to such
historical patterns as field reserving trends and claims settlement practices,
loss payments, pending levels of unpaid claims and product mix, as well as
court decisions, economic conditions and public attitudes.
Establishing claim and claim adjustment expense reserves, including claim
and claim adjustment expense reserves for catastrophic events that have
occurred, is an estimation process. Many factors can ultimately affect the
final settlement of a claim and, therefore, the necessary reserve. Changes in
the law, results of litigation, medical costs, the cost of repair materials
and labor rates can all affect ultimate claim costs. In addition, time can be
a critical part of reserving determinations since the longer the span between
the incidence of a loss and the payment or settlement of the claim, the more
variable the ultimate settlement amount can be. Accordingly, short-tail
claims, such as property damage claims, tend to be more reasonably estimable
than long-tail claims, such as workers compensation, general liability and
professional liability claims. 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.
Catastrophes are an inherent risk of the property and casualty insurance
business and have contributed to material period-to-period fluctuations in the
Company's results of operations and equity. The level of catastrophe losses
experienced in any period cannot be predicted and can be material to the
results of operations or equity of the Company.
APMT Reserves
CNA's property and casualty insurance subsidiaries have actual and potential
exposures related to APMT claims.
25
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 CNA management, accordingly, a high degree of uncertainty remains
for CNA's 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 CNA; 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 to avoid the
application of tort reform statute effective dates; a further increase in
asbestos and environmental claims which cannot now be anticipated; continued
increase in mass tort claims relating to silica and silica-containing
products, and the outcome of ongoing disputes as to coverage in relation to
these claims; the role the exhaustion of primary limits for certain accounts
and increased demands on any umbrella or excess policies CNA has issued; and
future developments pertaining to CNA's ability to recover reinsurance for
asbestos and environmental claims.
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, it may be necessary for CNA to record
material changes in its APMT claim and claim adjustment expense reserves in
the future, should new information become available or other developments
emerge.
Since 1999, CNA has performed semi-annual ground-up reviews of all open APMT
claims to evaluate the adequacy of CNA's APMT reserves. The completion of a
comprehensive ground up analysis of its APMT exposures, previously scheduled
for the second quarter, will be completed in the third quarter of 2003.
Significant resources were dedicated to the proposed national asbestos reform
legislation and to support regulatory reviews. As such, CNA plans to complete
its more formal and comprehensive analysis in the third quarter of 2003. CNA
considers input from its analyst professionals with direct responsibility for
the claims, inside and outside counsel with responsibility for representation
of CNA, and its actuarial staff. These professionals review, among many
factors, the policyholder's present and future exposures, including such
factors as claims volume, trial conditions, settlement demands and defense
costs; the policies issued by CNA, 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.
26
Due to the significant uncertainties previously described related to APMT
claims, the 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 CNA's business, insurer
financial strength and debt ratings and the Company's results of operations
and equity.
The following table provides data related to CNA's APMT claim and claim
adjustment expense reserves:
June 30, 2003 December 31, 2002
- ------------------------------------------------------------------------------------------------
Environmental Environmental
Pollution and Pollution and
Mass Tort Asbestos Mass Tort Asbestos
- ------------------------------------------------------------------------------------------------
(In millions)
Gross reserves $ 780.0 $1,662.0 $ 830.0 $1,758.0
Ceded reserves (299.0) (501.0) (313.0) (527.0)
- ------------------------------------------------------------------------------------------------
Net reserves $ 481.0 $1,161.0 $ 517.0 $1,231.0
================================================================================================
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 to
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 1,200 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.
Many policyholders have made claims against various CNA insurance
subsidiaries 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 coincides with CNA's adoption of the
Simplified Commercial General Liability coverage form, which includes what is
referred to in the industry as an "absolute pollution exclusion." CNA 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,
27
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.
A number of proposals to reform Superfund have been made by various parties.
However no reforms were enacted by Congress during 2002 or during the first
six months of 2003, 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 the
Company's results of operations or equity.
During 2002 and continuing into 2003, mass tort claims arising from alleged
injury due to exposure to silica and silica containing products have been
increasing. CNA is monitoring silica mass tort claims to assess what, if any,
impact the increased claims may have on mass tort reserves. As to other mass
tort subtypes, CNA has not experienced material negative development either in
the number of claims or in the emergence of new policyholders seeking coverage
for known mass tort sub-types. CNA's ultimate liability for its environmental
pollution and mass tort claims is impacted by several factors including
ongoing disputes with policyholders over scope and meaning of coverage terms
and, in the area of environmental pollution, court decisions that continue to
restrict the scope and applicability of the absolute pollution exclusion
contained in policies issued by CNA post 1989. Due to the inherent
uncertainties described above, including the inconsistency of court decisions,
the number of waste sites subject to cleanup, and in the area of environmental
pollution, the standards for cleanup and liability, the ultimate liability of
CNA for environmental pollution and mass tort claims may vary substantially
from the amount currently recorded.
As of June 30, 2003 and December 31, 2002, CNA carried approximately $481.0
and $517.0 million of claim and claim adjustment expense reserves, net of
reinsurance recoverables, for reported and unreported environmental pollution
and mass tort claims. There was no environmental pollution and mass tort net
claim and claim adjustment expense reserve development for the three and six
months ended June 30, 2003 and 2002. CNA paid environmental pollution-related
claims and mass tort-related claims, net of reinsurance recoveries, of $36.0
and $58.0 million for the six months ended June 30, 2003 and 2002.
Asbestos
CNA's property and casualty insurance subsidiaries also have exposure to
asbestos-related claims. Estimation of asbestos-related claim and claim
adjustment expense reserves involves many of the same limitations discussed
above for environmental pollution claims, such as inconsistency of court
decisions, specific policy provisions, allocation of liability among insurers
and insureds, and additional factors such as missing policies and proof of
coverage. Furthermore, estimation of asbestos-related claims is difficult due
to, among other reasons, the proliferation of bankruptcy proceedings and
attendant uncertainties, 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.
28
In the past several years, CNA has experienced 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. Currently, the majority of
asbestos bodily injury claims are filed by persons exhibiting few, if any,
disease symptoms. It is estimated that approximately 90% of the current non-
malignant asbestos claimants do not meet the American Medical Association's
definition of impairment. 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 claimant's condition worsens to the point of
impairment.
Some asbestos-related defendants have asserted that their claims for
insurance are not subject to aggregate limits on coverage. CNA has 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 extent, if any, the attempts to assert "non-
products" claims outside the products liability aggregate will succeed. CNA
has attempted to manage its 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 CNA. Where CNA cannot settle a claim on acceptable
terms it aggressively litigates the claim. Adverse developments with respect
to such matters discussed in this paragraph could have a material adverse
effect on the Company's results of operations or equity.
Certain asbestos litigations in which CNA is currently engaged are described
below:
On February 13, 2003, CNA announced it had resolved asbestos related
coverage litigation and claims involving A.P. Green Industries, A.P. Green
Services and Bigelow - Liptak Corporation. Under the agreement, CNA will be
required to pay $74.0 million, net of reinsurance recoveries, over a ten year
period. The settlement resolves CNA's liabilities for all pending and future
asbestos claims involving A.P. Green Industries, Bigelow - Liptak Corporation
and related subsidiaries, including alleged "non-products" exposures. The
settlement is subject to bankruptcy court approval and confirmation of a
bankruptcy plan containing a channeling injunction to protect CNA from any
future claims.
CNA is engaged in insurance coverage litigation with underlying plaintiffs
who have asbestos bodily injury claims against the former Robert A. Keasbey
Company ("Keasbey") in New York State court (Continental Casualty Co. v.
Nationwide Indemnity Co. et al., No. 601037/03 (N.Y. County)). Keasbey, a
currently dissolved corporation, was a seller and installer of asbestos-
containing insulation products in New York and New Jersey. Thousands of
plaintiffs have filed bodily injury claims against Keasbey; however, Keasbey's
involvement at a number of work sites is a highly contested issue. Therefore,
the defense disputes the percentage of valid claims against Keasby. CNA issued
Keasbey primary policies for 1970-1987 and excess policies for 1972-1978. CNA
has paid an amount substantially equal to the policies' aggregate limits for
29
products and completed operations claims. Claimants against Keasbey allege,
among other things, that CNA owes coverage under sections of the policies not
subject to the aggregate limits, an allegation CNA vigorously contests in the
lawsuit.
CNA has insurance coverage disputes related to asbestos bodily injury claims
against Burns & Roe Enterprises, Inc. ("Burns & Roe"). Originally raised in
litigation, now stayed, these disputes are currently part of In re: Burns &
Roe Enterprises, Inc., pending in the U.S. Bankruptcy Court for the District
of New Jersey, No. 00-41610. Burns & Roe provided engineering and related
services in connection with construction projects. At the time of its
bankruptcy filing, Burns & Roe faced approximately 11,000 claims alleging
bodily injury resulting from exposure to asbestos as a result of construction
projects in which Burns & Roe was involved. CNA allegedly provided primary
liability coverage to Burns & Roe from 1956-1969 and 1971-1974, along with
certain project-specific policies from 1964-1970.
CIC issued certain primary and excess policies to Bendix Corporation
("Bendix"), now part of Honeywell International Inc. ("Honeywell"). Honeywell
faces approximately 50,000 pending asbestos bodily injury claims resulting
from alleged exposure to Bendix friction products. CIC's primary policies
allegedly covered the period from at least 1939 (when Bendix began to use
asbestos in its friction products) to 1983, although the parties disagree
about whether CIC's policies provided product liability coverage before 1940
and from 1945 to 1956. CIC asserts that it owes no further material
obligations to Bendix under any primary policy. Honeywell alleges that two
primary policies issued by CIC covering 1969-1975 contain occurrence limits
but not product liability aggregate limits for asbestos bodily injury claims.
CIC has asserted, among other things, that even if Honeywell's allegation is
correct, which CNA denies, its liability is limited to a single occurrence
limit per policy or per year, and in the alternative, a proper allocation of
losses would substantially limit its exposure under the 1969-1975 policies to
asbestos claims. These and other issues are being litigated in Continental
Insurance Co., et al. v. Honeywell International Inc., No. MRS-L-1523-00
(Morris County, New Jersey).
Policyholders have also initiated litigation directly against CNA and other
insurers in four jurisdictions: Ohio, Texas, West Virginia and Montana. In the
Ohio action, plaintiffs allege the defendants negligently performed duties
undertaken to protect the public from the effects of asbestos (Varner v. Ford
Motor Co., et al., (Cuyahoga County, Ohio)). Similar lawsuits have also been
filed in Texas against CNA, and other insurers and non-insurer corporate
defendants asserting liability for failing to warn of the dangers of asbestos
(Boson v. Union Carbide Corp., et al. (District Court of Nueces County,
Texas)). CNA has been named in Adams v. Aetna, Inc., et al. (Circuit Court of
Kanhwha County, West Virginia), a purported class action against CNA and other
insurers, alleging that the defendants violated West Virginia's Unfair Trade
Practices Act in handling and resolving asbestos claims against their
policyholders. A direct action has also been filed in Montana (Pennock, et al.
v. Maryland Casualty, et al., First Judicial District Court of Lewis & Clark
County, Montana) by eight individual plaintiffs (all employees of W.R. Grace &
Co. (W.R. Grace)) and their spouses against CNA, Maryland Casualty and the
State of Montana. This action alleges that CNA failed to fulfill its
obligations as W.R. Grace's Workers Compensation carrier because of the
alleged negligent failure of CNA to warn of or otherwise protect W.R. Grace
employees from the dangers of asbestos at a W.R. Grace vermiculite mining
facility in Libby, Montana. This action is currently stayed as to CNA because
of W.R. Grace's pending bankruptcy. On July 23, 2003, the stay of the
litigation was lifted by the District Court as to Maryland Casualty. The time
30
for an appeal by Maryland Casualty has not expired. The stay of the litigation
may also be lifted as to CNA.
CNA is vigorously defending these and other cases and believes that it has
meritorious defenses to the claims asserted. However, there are numerous
factual and legal issues to be resolved in connection with these claims, and
it is extremely difficult to predict the outcome or ultimate financial
exposure represented by these matters. Adverse developments with respect to
any of these matters could have a material adverse effect on CNA's business,
insurer financial strength and debt ratings and 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, CNA evaluates the exposure presented by each insured. As
part of this evaluation, CNA considers the available insurance coverage;
limits and deductibles; the potential role of other insurance, particularly
underlying coverage below any CNA 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; 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.
CNA is also monitoring possible legislative reforms, including the possible
creation of a national privately financed trust, which if established and
approved through federal legislation, could replace litigation of asbestos
claims with payments to claimants from the trust. It is uncertain at the
present time whether such a trust will be created or, if it is, what will be
the terms and conditions of its establishment or its impact on the Company.
As of June 30, 2003 and December 31, 2002, CNA carried approximately
$1,161.0 and $1,231.0 million of claim and claim adjustment expense reserves,
net of reinsurance recoverables, for reported and unreported asbestos-related
claims. There was no asbestos-related net claim and claim adjustment expense
reserve development for the three and six months ended June 30, 2003 and 2002.
CNA paid asbestos-related claims, net of reinsurance, of $70.0 million for the
six months ended June 30, 2003 and had net reinsurance recoveries of $15.0
million for the six months ended June 30, 2002.
Other Reserves
Net unfavorable prior year development of $522.0 million, including $358.0
million of unfavorable claim and allocated claim adjustment expense reserve
development and $164.0 million of unfavorable premium development, was
recorded for the six months ended June 30, 2003. The net unfavorable prior
31
year reserve development not associated with the unfavorable premium
development was recorded principally in the property and casualty companies. A
brief summary of these lines of business and the associated reserve
development is discussed below.
Standard Lines
The gross carried claim and claim adjustment expense reserves for Standard
Lines were $11,793.0 and $11,576.0 million at June 30, 2003 and December 31,
2002. The net carried claim and claim adjustment expense reserves for Standard
Lines were $7,127.0 and $7,262.0 million at June 30, 2003 and December 31,
2002.
Unfavorable net prior year reserve development of approximately $310.0
million, including $233.0 million of unfavorable claim and allocated claim
adjustment expense reserve development and $77.0 million of unfavorable
premium development, was recorded for large account business, driven by
workers compensation exposures. This reserve development resulted from the
completion of reserve reviews for large account business where the insured is
often responsible for a portion of the losses, and claims are handled by CNA.
The review did not cover the large account business where the claims are
handled by a third-party administrator. Initial reserves for this business are
set based on the expected losses associated with the individual accounts
covered and the terms of the individual plans. Based on analyses completed
during the second quarter, it became apparent that the assumptions regarding
the number and size of the losses, which were used to estimate the expected
losses were no longer appropriate. The analysis showed that the actual number
of claims and the average claim size were larger than expected. The
development was recorded in accident years prior to 2002.
Approximately $21.0 million of unfavorable net prior year claim and
allocated claim adjustment expense reserve development resulted from a program
covering facilities that provide services to developmentally disabled
individuals. The development was due to an increase in the size of known
claims and increases in policyholder defense costs. The reserve development
was recorded in accident years prior to 2001.
Approximately $25.0 million of unfavorable net prior year premium
development was recorded related to a second quarter 2003 reevaluation of
losses ceded to a reinsurance contract covering middle market workers
compensation exposures. The reevaluation of losses led to a new estimate of
the number and dollar amount of claims that would be ceded under the
reinsurance contract. As a result of the reevaluation of losses, CNA recorded
approximately $36.0 million of unfavorable claim and allocated claim
adjustment expense reserve development, which was ceded under the contract.
The development was recorded in accident year 2000.
Unfavorable net prior year claim and allocated claim adjustment expense
reserve development of approximately $36.0 million was recorded for a program
covering tow truck and ambulance operators, primarily impacting the 2001
accident year. CNA had previously expected that loss ratios for this business
would be similar to its middle market commercial automobile liability
business. During 2002, CNA ceased writing business under this program.
Offsetting these unfavorable developments was a $75.0 million underwriting
benefit from cessions to corporate aggregate reinsurance treaties. The benefit
is comprised of $180.0 million of ceded losses and $105.0 million of ceded
premiums for accident years 2000 and 2001. See Note 5 for further discussion.
32
Favorable prior year claim and allocated claim adjustment expense reserve
development was also recorded in property lines during 2003. The favorable
reserve development was principally from accident years 2001 and 2002 and was
the result of the lower than expected number of large losses in recent years.
Specialty Lines
The gross carried claim and claim adjustment expense reserves for Specialty
Lines were $6,085.0 and $5,874.0 million at June 30, 2003 and December 31,
2002. The net carried claim and claim adjustment expense reserves for
Specialty Lines were $3,467.0 and $3,373.0 million at June 30, 2003 and
December 31, 2002.
Unfavorable net prior year claim and allocated claim adjustment expense
reserve development of approximately $75.0 million was recorded related to a
recent adverse arbitration decision involving a single large property and
business interruption loss. The decision was rendered against a voluntary
insurance pool in which CNA was a participant. The loss was caused by a fire
which occurred in 1995. CNA no longer participates in this pool.
Approximately $50.0 million of unfavorable net prior year claim and
allocated claim adjustment expense reserve development was recorded for
directors and officers exposures. The reserve development was a result of a
claims review that was completed during the second quarter of 2003. The
unfavorable net prior year reserve development was primarily due to securities
class action cases related to certain known corporate malfeasance cases and
investment banking firms. The reserve development was recorded primarily in
accident years 2001 and 2002.
Approximately $37.0 million of losses were recorded as the result of a
commutation of three ceded reinsurance treaties covering CNA HealthPro
relating to accident years 1999 through 2001. See Note 5 for further
discussion.
Approximately $21.0 million of unfavorable net prior year claim and
allocated claim adjustment expense reserve development was recorded in the
Surety line of business as the result of recent developments on one large
claim.
CNA Re
The gross carried claim and claim adjustment expense reserves for CNA Re
were $2,064.0 and $2,264.0 million at June 30, 2003 and December 31, 2002. The
net carried claim and claim adjustment expense reserves for CNA Re were
$1,217.0 and $1,362.0 million at June 30, 2003 and December 31, 2002.
Unfavorable net prior year claim and allocated claim adjustment expense
reserve development of approximately $25.0 million was recorded primarily for
directors and officers exposures. The reserve development was a result of a
claims review that was completed during the second quarter of 2003. The
unfavorable net prior year reserve development was primarily due to securities
class action cases related to certain known corporate malfeasance cases and
investment banking firms. The reserve development was recorded in accident
years 2000 and 2001.
Offsetting this unfavorable development was a $10.0 million underwriting
benefit from cessions to corporate aggregate reinsurance treaties. The benefit
is comprised of $24.0 million of ceded losses and $14.0 million of ceded
premiums for accident years 2000 and 2001. See Note 5 for further discussion.
33
8. Shareholders' Equity
June 30, December 31,
2003 2002
- -----------------------------------------------------------------------------------------------
(In millions of dollars, except per share data)
Preferred stock, $0.10 par value,
Authorized - 100,000,000 shares
Common stock:
Loews common stock, $1.00 par value:
Authorized - 600,000,000 shares
Issued and outstanding - 185,447,050 and 185,441,200 shares $ 185.4 $ 185.4
Carolina Group stock, $0.01 par value:
Authorized - 600,000,000 shares
Issued - 40,250,000 shares 0.4 0.4
Additional paid-in capital 1,114.4 1,114.2
Earnings retained in the business 9,717.8 9,404.6
Accumulated other comprehensive income 1,222.1 538.3
- ------------------------------------------------------------------------------------------------
12,240.1 11,242.9
Less treasury stock, at cost (340,000 shares of Carolina Group stock) 7.7 7.7
- -----------------------------------------------------------------------------------------------
Total shareholders' equity $12,232.4 $11,235.2
================================================================================================
Investments in securities, which are held principally by insurance
subsidiaries of CNA are considered available-for-sale, and are carried at fair
value. Changes in fair value are recorded as a component of accumulated other
comprehensive income in shareholders' equity, net of applicable deferred
income taxes and participating policyholders' and minority interest.
Investments are written down to estimated fair values and impairment losses
are recognized in income when a decline in value is determined to be other
than temporary (See Note 2).
9. Significant Transactions
Texas Gas Transmission, LLC
In May of 2003, the Company, through a wholly owned subsidiary, TGT
Pipeline, LLC ("TGT"), acquired Texas Gas from The Williams Companies, Inc.
("Williams"). The transaction value was approximately $1.05 billion, which
included $250.0 million of existing Texas Gas debt. The results of Texas Gas
have been included in the consolidated condensed financial statements from the
date of acquisition. The Company funded the approximately $802.8 million
balance of the purchase price, including transaction costs and closing
adjustments, with $527.8 million of its available cash and $275.0 million of
proceeds from an interim loan incurred by Texas Gas.
Upon completion of the acquisition, TGT, the immediate parent of Texas Gas,
issued $185.0 million of 5.2% Notes due 2018 and Texas Gas Transmission, LLC
issued $250.0 million of 4.6% Notes due 2015. The net offering proceeds of
approximately $431.0 million were used to repay the $275.0 million interim
loan and to retire approximately $132.7 million principal amount of Texas
Gas's existing $150.0 million of 8.625% Notes due 2004 and to pay related
34
tender premiums. Texas Gas intends to use the balance of the offering
proceeds, together with cash on hand, to retire the remaining 2004 notes.
Texas Gas owns and operates a 5,800-mile natural gas pipeline system that
transports natural gas originating in the Louisiana Gulf Coast and East Texas
and running north and east through Louisiana, Arkansas, Mississippi,
Tennessee, Kentucky, Indiana and into Ohio, with smaller diameter lines
extending into Illinois. Texas Gas has a delivery capacity of 2.8 billion
cubic feet (Bcf) per day and a working storage capacity of 55 Bcf.
The preliminary allocation of purchase price to the assets and liabilities
of Texas Gas, in millions, pending final purchase value adjustments, which are
not expected to be material, is as follows:
Current assets $ 81.6
Property, plant and equipment 663.4
Goodwill 280.5
Other non-current assets 133.0
Current liabilities (58.9)
Long-term debt, including current portion (249.0)
Other liabilities and deferred credits (47.8)
- -----------------------------------------------------------------------------
$ 802.8
=============================================================================
The following unaudited pro forma financial information is presented as if
Texas Gas had been acquired as of the beginning of each period presented. The
pro forma amounts include certain adjustments, including a reduction of
depreciation expense based on the preliminary allocation of purchase price to
property, plant and equipment; adjustment of interest expense to reflect the
issuance of debt by Texas Gas and TGT, and redemption of $132.7 million
principal amount of Texas Gas's existing notes; and the related tax effect of
these items. The pro forma amounts do not reflect any adjustments related to
the separation of Texas Gas from Williams for certain services provided by
Williams under a transition services agreement.
(In millions, except per share data)
Three Months Ended Six Months Ended
June 30, June 30,
----------------------- -------------------------
2003 2002 2003 2002
-------------------------------------------------
(Restated) (Restated)
Total revenues $4,280.6 $4,703.9 $8,315.7 $9,578.7
Income from continuing operations 219.0 202.9 438.3 509.7
Net income 219.0 202.9 438.3 439.1
Income per share of Loews common stock:
Income from continuing operations 1.05 0.86 2.07 2.37
Net income 1.05 0.86 2.07 2.00
================================================================================================
35
The pro forma information does not necessarily reflect the actual results
that would have occurred had the companies been combined during the periods
presented, nor is it necessarily indicative of future results of operations.
Third Party Risk Management Business
During the second quarter of 2003, CNA entered into an agreement, whereby
Cunningham Lindsey, U.S. ("Cunningham Lindsey"), a subsidiary of Lindsey
Morden Group, Inc. acquired the business of RSKCo Services, Inc. ("RSKCo").
Included in the sale was the RSKCo trademarked name, as well as all claims and
other risk management services business provided by RSKCo that is not sold in
connection with insurance products of other CNA subsidiaries. After the first
anniversary of the sale, CNA will fund a pre-sale capital contribution to
RSKCo of $12.0 million, and will receive sales proceeds determined as a result
of gross revenues of the sold business for the first year following the sale,
and the agreed fair value of the fixed assets included in the sale. In
addition, CNA will provide RSKCo with certain transition services at no charge
for the six months following the sale. CNA has recorded an estimated pretax
loss on this sale of $16.0 million. The business sold represented annual
revenues of approximately $40.0 million.
As a result of this agreement, Cunningham Lindsey assumed assets and
liabilities of $72.0 and $56.0 million. At December 31, 2002 the assets and
liabilities of the RSKCo business sold were $71.0 and $54.0 million.
National Postal Mail Handlers Union Contract Termination
During 2002, CNA sold Claims Administration Corporation and transferred the
National Postal Handlers Union group benefits plan (the "Mail Handlers Plan")
to First Health Group Corporation. Revenues for the Mail Handlers Plan were
$537.0 million for the three months ended June 30, 2002 and $1,153.0 million
for the six months ended June 30, 2002.
CNA Vida Disposition
In the first quarter of 2002, CNA completed the sale of the common stock of
CNA Holdings Limited and its subsidiaries ("CNA Vida"), CNA's life operations
in Chile, to Consorcio Financiero S.A. ("Consorcio"). In connection with the
sale, CNA received proceeds of $73.0 million and recorded an after-tax loss
from discontinued operations of $31.0 million. This loss is composed of $32.8
million, net of tax, realized loss on the sale of CNA Vida and income of $1.8
million, net of tax, from CNA Vida's operations for 2002.
Personal Insurance Transaction
CNA entered into a retroactive reinsurance agreement as part of the sale of
CNA's personal insurance business to The Allstate Corporation ("Allstate") in
1999. CNA shares in indemnity and claim and allocated claim adjustment
expenses if payments related to losses incurred prior to October 1, 1999 on
the CNA policies transferred to Allstate exceed the claim and allocated claim
adjustment expense reserves of approximately $1.0 billion at the date of sale.
CNA must begin to reimburse Allstate for claim and allocated claim adjustment
expense payments when cumulative claim payments after October 1, 1999 on
losses occurring prior to that date exceed the $1.0 billion. CNA's remaining
obligation valued under this loss sharing provision as of October 1, 2003,
will be settled by agreement of the parties or by an independent actuarial
review of the unpaid claim liabilities as of that date. Cumulative payments of
indemnity and allocated loss adjustment expenses on such policies exceeded
36
$1.0 billion during the second quarter of 2003. CNA has established reserves
for its estimated liability under this loss sharing arrangement.
10. Statutory Accounting Practices
CNA's insurance subsidiaries are domiciled in various jurisdictions. These
subsidiaries prepare statutory financial statements in accordance with
accounting practices prescribed or permitted by the respective jurisdictions'
insurance regulators. Prescribed statutory accounting practices are set forth
in a variety of publications of the National Association of Insurance
Commissioners ("NAIC") as well as state laws, regulations and general
administrative rules. CNA's insurance subsidiaries follow one significant
permitted accounting practice at June 30, 2003, related to discounting of
certain non-tabular workers compensation claims. The impact of this permitted
practice was to increase statutory surplus by approximately $31.0 and $56.0
million at June 30, 2003 and December 31, 2002. This practice was followed by
an acquired company, and CNA received permission to eliminate the effect of
the permitted practice over a ten-year period, which ends in 2003.
11. Business Segments
The Company's reportable segments are based on its individual operating
subsidiaries. Each of the principal operating subsidiaries are headed by a
chief executive officer who is responsible for the operation of its business
and has the duties and authority commensurate with that position. Investment
gains (losses) and the related income taxes, excluding those of CNA Financial,
are included in the Corporate and other segment.
CNA's insurance products include property and casualty coverages; life,
accident and health insurance; and retirement products and annuities. CNA's
services include risk management, information services, health care management
and claims administration. CNA's products and services are marketed through
agents, brokers, managing general agents and direct sales.
The Other Insurance segment is comprised primarily of losses and expenses
related to the centralized adjusting and settlement of APMT claims, certain
run-off insurance operations and other operations. This segment's results also
include interest expense on CNA's corporate borrowings, eBusiness initiatives
and CNA UniSource. Beginning in 2003, expenses related to eBusiness were
allocated to the operating segments of CNA.
Lorillard's principal products are cigarettes marketed under the brand names
of Newport, Kent, True, Maverick and Old Gold with substantially all of its
sales in the United States.
Loews Hotels owns and/or operates 19 hotels, 17 of which are in the United
States and two are in Canada.
Diamond Offshore's business primarily consists of operating 47 offshore
drilling rigs that are chartered on a contract basis by companies engaged in
exploration and production of hydrocarbons. Offshore rigs are mobile units
that can be relocated based on market demand. As of June 30, 2003, 28 of these
rigs were located in the Gulf of Mexico, 5 were located in Brazil and the
remaining 14 were located in various other foreign markets.
Texas Gas owns and operates a 5,800-mile natural gas pipeline system that
transports natural gas originating in the Louisiana Gulf Coast and East Texas
and running north and east through Louisiana, Arkansas, Mississippi,
Tennessee, Kentucky, Indiana and into Ohio, with smaller diameter lines
37
extending into Illinois. Texas Gas has a delivery capacity of 2.8 billion
cubic feet ("Bcf") per day and a working storage capacity of 55 Bcf.
Bulova distributes and sells watches and clocks under the brand names of
Bulova, Wittnauer, Caravelle and Accutron with substantially all of its sales
in the United States and Canada. Substantially all watches and clocks are
purchased from foreign suppliers.
The accounting policies of the segments are the same as those described in
the summary of significant accounting policies in Note 1 of the Notes to
Consolidated Financial Statements in the Annual Report on Form 10-K for the
year ended December 31, 2002. In addition, CNA does not maintain a distinct
investment portfolio for each of its insurance segments, and accordingly,
allocation of assets to each segment is not performed. Therefore, investment
income and investment gains (losses) are allocated based on each segment's
carried insurance reserves, as adjusted.
38
The following tables set forth the Company's consolidated revenues and
income by business segment:
Three Months Ended Six Months Ended
June 30, June 30,
- ------------------------------------------------------------------------------------------------
2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------
(Restated) (Restated)
(In millions)
Revenues (a):
CNA Financial:
Property and casualty $ 2,172.6 $ 2,044.4 $ 4,293.1 $ 4,049.1
Life 442.8 344.7 802.5 758.3
Group 433.7 878.5 777.7 1,874.8
Other Insurance 59.2 44.7 80.5 75.8
- ------------------------------------------------------------------------------------------------
Total CNA Financial 3,108.3 3,312.3 5,953.8 6,758.0
Lorillard 791.5 1,037.9 1,643.4 2,022.2
Loews Hotels 85.4 82.0 161.8 159.2
Diamond Offshore 167.9 195.8 319.9 407.7
Texas Gas 23.1 23.1
Bulova 33.7 41.4 74.8 74.1
Corporate and other 40.4 (17.9) 22.7 22.6
- ------------------------------------------------------------------------------------------------
Total $ 4,250.3 $ 4,651.5 $ 8,199.5 $ 9,443.8
================================================================================================
Pretax income (a):
CNA Financial:
Property and casualty $ (25.1) $ 87.2 $ 128.3 $ 226.1
Life 51.6 (10.6) 15.3 48.4
Group 57.4 9.6 34.0 46.5
Other Insurance 7.7 (43.5) 22.0 (105.7)
- ------------------------------------------------------------------------------------------------
Total CNA Financial 91.6 42.7 199.6 215.3
Lorillard 216.4 337.9 467.4 610.4
Loews Hotels 9.0 10.3 17.0 19.8
Diamond Offshore (18.9) 8.6 (47.7) 36.3
Texas Gas 2.6 2.6
Bulova 2.9 4.6 7.2 7.6
Corporate and other (1.2) (68.4) (61.8) (71.1)
- ------------------------------------------------------------------------------------------------
Total $ 302.4 $ 335.7 $ 584.3 $ 818.3
================================================================================================
Net income (a):
CNA Financial:
Property and casualty $ (2.1) $ 54.8 $ 99.2 $ 137.6
Life 31.6 (6.4) 10.8 27.9
Group 34.8 6.3 21.5 27.9
Other Insurance 10.0 (23.9) 22.3 (59.5)
- ------------------------------------------------------------------------------------------------
Total CNA Financial 74.3 30.8 153.8 133.9
Lorillard 140.0 203.9 293.3 370.6
Loews Hotels 5.7 6.7 10.8 12.7
Diamond Offshore (9.3) 1.7 (21.4) 10.4
Texas Gas 1.6 1.6
Bulova 1.9 2.6 4.9 4.2
Corporate and other 0.6 (46.9) (38.2) (49.6)
- ------------------------------------------------------------------------------------------------
Income from continuing operations 214.8 198.8 404.8 482.2
Discontinued operations-net (31.0)
Cumulative effect of change in
accounting principles-net (39.6)
- -----------------------------------------------------------------------------------------------
Total $ 214.8 $ 198.8 $ 404.8 $ 411.6
===============================================================================================
39
(a) Investment gains (losses) included in Revenues, Pretax income and Net
income are as follows:
Three Months Ended Six Months Ended
June 30, June 30,
- --------------------------------------------------------------------- -------------------------
2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------
(In millions)
Revenues and pretax income:
CNA Financial:
Property and casualty $ 282.7 $ (62.7) $ 291.4 $ (51.7)
Life 28.1 (53.3) (23.2) (42.0)
Group 20.2 (26.9) (32.0) (17.3)
Other Insurance 57.7 (19.4) 76.4 (50.3)
- ------------------------------------------------------------------------------------------------
Total CNA Financial 388.7 (162.3) 312.6 (161.3)
Corporate and other 30.6 (32.7) 11.1 (10.2)
- ------------------------------------------------------------------------------------------------
Total $ 419.3 $(195.0) $ 323.7 $(171.5)
================================================================================================
Net income:
CNA Financial:
Property and casualty $ 167.7 $ (36.3) $ 173.4 $ (28.3)
Life 16.4 (30.1) (13.6) (23.9)
Group 11.8 (15.5) (18.7) (10.0)
Other Insurance 34.5 (12.0) 45.4 (29.5)
- ------------------------------------------------------------------------------------------------
Total CNA Financial 230.4 (93.9) 186.5 (91.7)
Corporate and other 20.3 (24.0) 7.6 (10.4)
- ------------------------------------------------------------------------------------------------
Total $ 250.7 $(117.9) $ 194.1 $(102.1)
================================================================================================
12. Legal Proceedings
Insurance Related
IGI Contingency
In 1997, CNA Reinsurance Company Limited ("CNA Re Ltd.") entered into an
arrangement with IOA Global, Ltd. ("IOA"), an independent managing general
agent based in Philadelphia, Pennsylvania, to develop and manage a book of
accident and health coverages. Pursuant to this arrangement, IGI Underwriting
Agencies, Ltd. ("IGI"), a personal accident reinsurance managing general
underwriter, was appointed to underwrite and market the book under the
supervision of IOA. Between April 1, 1997 and December 1, 1999, IGI underwrote
a number of reinsurance arrangements with respect to personal accident
insurance worldwide (the "IGI Program"). Under various arrangements, CNA Re
Ltd. both assumed risks as a reinsurer and also ceded a substantial portion of
those risks to other companies, including other CNA insurance subsidiaries and
ultimately to a group of reinsurers participating in a reinsurance pool known
as the Associated Accident and Health Reinsurance Underwriters ("AAHRU")
Facility. CNA's Group Operations business unit participated as a pool member
in the AAHRU Facility in varying percentages between 1997 and 1999.
CNA has determined that a portion of the premiums assumed under the IGI
Program related to United States workers compensation "carve-out" business.
40
Some of these premiums were received from John Hancock Financial Services,
Inc. ("John Hancock"). CNA is aware that a number of reinsurers with workers
compensation carve-out insurance exposure, including John Hancock, have
disavowed their obligations under various legal theories. If one or more such
companies are successful in avoiding or reducing their liabilities, then it is
likely that CNA's potential liability will also be reduced. Moreover, based on
information known at this time, CNA believes it has strong grounds to
successfully challenge its alleged exposure on a substantial portion of its
United States workers compensation carve-out business, including all purported
exposure derived from John Hancock, through legal action.
As noted, CNA arranged substantial reinsurance protection to manage its
exposures under the IGI Program. CNA believes it has valid and enforceable
reinsurance contracts with the AAHRU Facility and other reinsurers with
respect to the IGI Program, including the United States workers compensation
carve-out business. However, certain reinsurers dispute their liabilities to
CNA, and CNA has commenced arbitration proceedings against such reinsurers.
CNA has established reserves for its estimated exposure under the IGI
Program, other than that derived from John Hancock, and an estimate for
recoverables from retrocessionaires. CNA has not established any reserve for
any exposure derived from John Hancock because, as indicated, CNA believes the
contract will be rescinded.
CNA is pursuing a number of loss mitigation strategies with respect to the
entire IGI Program. Although the results of these various actions to date
support the recorded reserves, the estimate of ultimate losses is subject to
considerable uncertainty due to the complexities described above. As a result
of these uncertainties, the results of operations in future periods may be
adversely affected by potentially significant reserve additions. Management
does not believe that any such reserve additions would be material to the
equity of CNA, although results of operations may be adversely affected. CNA's
position in relation to the IGI Program was unaffected by the sale of CNA Re
Ltd. in 2002.
California Wage and Hour Litigation
In Ernestine Samora, et al. v. CCC, Case No. BC 242487, Superior Court of
California, County of Los Angeles, California and Brian Wenzel v. Galway
Insurance Company, Superior Court of California, County of Orange No.
BC01CC08868 (coordinated), two former CNA employees, filed lawsuits on behalf
of purported classes of CNA employees asserting they worked hours for which
they should have been compensated at a rate of one and one-half times their
base hourly wage over a four-year period. The cases were coordinated and an
amended complaint was filed which alleges overtime claims under California law
over a four-year period. In June 2002, CNA filed a responsive pleading denying
the material allegations of the amended complaint. CNA intends to defend this
case vigorously. Due to the recent commencement of discovery and the
uncertainty of how the courts may interpret California law as applied to the
facts of these cases, the extent of losses beyond any amounts that may be
accrued are not readily determinable at this time. Based on facts and
circumstances presently known, however, in the opinion of management, the
outcome will not materially affect the equity of the Company, although results
of operations may be adversely affected.
Voluntary Market Premium Litigation
CNA, along with dozens of other insurance companies, is a defendant in
sixteen purported class action cases brought by large policyholders, which
41
generally allege that the defendants, as part of an industry-wide conspiracy,
included improper charges in their retrospectively rated and other loss-
sensitive insurance premiums. Fourteen lawsuits were brought as class actions
in state courts and two in federal court. Among the claims asserted were
violations of state antitrust laws, breach of contract, fraud and unjust
enrichment. In two of the cases, the defendants won dismissals on motions and,
in four others, class certification was denied after hearing. Plaintiffs
voluntarily dismissed their claims in four states. In the federal court case,
Sandwich Chef of Texas, Inc., et al. v. Reliance National Indemnity Insurance
Company, et al., Civil Action No. H-98-1484, United States District Court for
the Southern District of Texas, the district court certified a multi-state
class but was reversed on interlocutory appeal by the U.S. Court of Appeals
for the Fifth Circuit. Due to the uncertainty of how the courts may interpret
state and federal law as applied to the facts of the cases, the extent of
potential losses beyond any amounts that may be accrued are not readily
determinable at this time. Based on facts and circumstances presently known,
however, in the opinion of management the outcome will not materially affect
the equity of the Company, although results of operations may be adversely
affected.
Environmental Pollution and Mass Tort and Asbestos ("APMT") Reserves
CNA is also a party to litigation and claims related to APMT cases arising
in the ordinary course of business. See Note 7 for further discussion.
Tobacco Related
Tobacco Related Product Liability Litigation
Approximately 4,500 product liability cases are pending against cigarette
manufacturers in the United States. Lorillard is a defendant in approximately
4,100 of these cases.
The pending product liability cases are comprised of the following types of
cases:
"Conventional product liability cases" are brought by individuals who allege
cancer or other health effects caused by smoking cigarettes, by using
smokeless tobacco products, by addiction to tobacco, or by exposure to
environmental tobacco smoke. Approximately 1,600 cases are pending, including
approximately 1,175 cases against Lorillard. Included in this group are
approximately 1,100 cases pending in a single West Virginia court that has
been consolidated for trial. Lorillard is a defendant in approximately 1,000
of the 1,100 consolidated West Virginia cases.
"Flight Attendant cases" are brought by non-smoking flight attendants
alleging injury from exposure to environmental smoke in the cabins of
aircraft. Plaintiffs in these cases may not seek punitive damages for injuries
that arose prior to January 15, 1997. Lorillard is a defendant in each of the
approximately 2,800 pending Flight Attendant cases.
"Class action cases" are purported to be brought on behalf of large numbers
of individuals for damages allegedly caused by smoking. Approximately 40 of
these cases are pending against Lorillard. Lorillard is not a defendant in
approximately 25 additional class actions that are pending against other
cigarette manufacturers and assert claims on behalf of smokers of "light"
cigarettes.
42
"Reimbursement cases" are brought by or on behalf of entities who seek
reimbursement of expenses incurred in providing health care to individuals who
allegedly were injured by smoking. Plaintiffs in these cases have included the
U.S. federal government, U.S. state and local governments, foreign
governmental entities, hospitals or hospital districts, American Indian
tribes, labor unions, private companies, and private citizens suing on behalf
of taxpayers. Lorillard is a defendant in most of the approximately 40 pending
Reimbursement cases.
"Contribution cases" are brought by private companies, such as asbestos
manufacturers or their insurers, who are seeking contribution or indemnity for
court claims they incurred on behalf of individuals injured by their products
but who also allegedly were injured by smoking cigarettes. Lorillard is a
defendant in each of the approximately 10 pending Contribution cases.
Excluding the flight attendant and the consolidated West Virginia suits,
approximately 600 product liability cases are pending against U.S. cigarette
manufacturers. Lorillard is a defendant in approximately 275 of the 600 cases.
The Company, which is not a defendant in any of the flight attendant or the
consolidated West Virginia matters, is a defendant in fewer than 35 of the
actions.
Plaintiffs assert a broad range of legal theories in these cases, including,
among others, theories of negligence, fraud, misrepresentation, strict
liability, breach of warranty, enterprise liability (including claims asserted
under the Racketeering Influenced and Corrupt Organizations Act), civil
conspiracy, intentional infliction of harm, violation of consumer protection
statutes, violation of antitrust statutes, injunctive relief, indemnity,
restitution, unjust enrichment, public nuisance, claims based on antitrust
laws and state consumer protection acts, and claims based on failure to warn
of the harmful or addictive nature of tobacco products.
Plaintiffs in most of the cases seek unspecified amounts of compensatory
damages and punitive damages, although some seek damages ranging into the
billions of dollars. Plaintiffs in some of the cases seek treble damages,
statutory damages, disgorgement of profits, equitable and injunctive relief,
and medical monitoring, among other damages.
During July of 2003, the first phase of trial ended in the case of Scott v.
The American Tobacco Company, et al. (District Court, Orleans Parish,
Louisiana), a class action case in which Lorillard is a defendant. The jury
found in favor of the defendants as to the primary relief sought by the
certified class, medical monitoring. The jury also rejected plaintiffs' design
defect claims. However, the jury returned findings in favor of the class as to
certain other issues, such as whether defendants failed to disclose the
addictiveness of nicotine, whether defendants marketed to children, and
whether cigarette smokers in Louisiana would benefit from smoking cessation
aids or programs. The jury was not permitted to award damages in the July
verdict and the case is now expected to proceed to additional phases of trial.
It is not clear, however, how the subsequent phase or phases of trial will be
conducted, nor is it known whether the parties will immediately attempt to
pursue an appeal from the July 2003 verdict.
During May of 2003, the Florida Third District Court of Appeal vacated the
judgment entered in favor of a class of Florida smokers in the case of Engle
v. R.J. Reynolds Tobacco Co., et al. The judgment reflected an award of
punitive damages to the class of approximately $145.0 billion, including $16.3
billion against Lorillard. The court of appeals also decertified the class
ordered during pre-trial proceedings. See "Class Action Cases."
43
The Mississippi Supreme Court has issued a ruling in a product liability
case brought against cigarette manufacturers in which it held that the
Mississippi Product Liability Act "precludes all tobacco cases that are based
on products liability." It is uncertain what affect, if any, this ruling will
have on litigation against cigarette manufacturers in Mississippi. Neither
Lorillard, nor the Company, were parties to this case. Lorillard is a
defendant in approximately 40 other cases in Mississippi.
During March of 2003, a verdict in favor of a class of Illinois residents
who smoked Philip Morris' "light" brand cigarettes was returned in Price v.
Philip Morris U.S.A. (Circuit Court, Madison County, Illinois). The court
awarded the class approximately $7.1 billion in actual damages. It also
awarded $3.0 billion in punitive damages to the State of Illinois, which was
not a party to the suit. The court awarded plaintiffs' counsel approximately
$1.8 billion in fees and costs. Philip Morris USA has noticed an appeal from
the judgment to the Illinois Court of Appeals. Pursuant to Philip Morris USA's
application, the court reduced the dollar amount of the bond it was required
to post in order to pursue the appeal (the "bond reduction order"). Plaintiffs
noticed a separate appeal, and the Illinois Court of Appeals has remanded the
bond reduction order to the trial court with directions that it reconsider the
ruling. Philip Morris USA has appealed the Court of Appeals' decision on the
bond reduction order to the Illinois Supreme Court. As of August 1, 2003, the
Illinois Supreme Court had not ruled whether it would review the bond
reduction order. Philip Morris USA has initiated an action in the Circuit
Court of Cook County, Illinois, in which it seeks a declaration that the state
has released any right or interest in the punitive damages award. Neither
Lorillard nor the Company are parties in this matter. See "Class Action
Cases."
CONVENTIONAL PRODUCT LIABILITY CASES - Approximately 1,600 cases are pending,
including approximately 1,175 cases against Lorillard. This total includes
approximately 1,100 cases pending in a single West Virginia court that have
been consolidated for trial. Lorillard is a defendant in approximately 1,000
of the 1,100 consolidated West Virginia cases. The Company, which is not a
defendant in any of the consolidated West Virginia cases, is a defendant in
five of the pending cases.
Since January 1, 2001 and through August 1, 2003, verdicts have been
returned in 23 matters. Lorillard was a defendant in two of the cases. Defense
verdicts were returned in 15 of the cases, including both tried against
Lorillard.
Twelve cases are pending in which verdicts have been returned in favor of
the plaintiffs. Neither the Company nor Lorillard were defendants in any of
these cases. These twelve cases, and the verdict amounts, are below:
Boerner v. Brown & Williamson Tobacco Corporation (U.S. District Court,
Eastern District, Arkansas). During May of 2003, plaintiffs were awarded $4.0
million in actual damages and $15.0 million in punitive damages. Following
trial, the court dismissed the punitive damages verdict and entered a final
judgment that is limited to the award of actual damages. As of August 1, 2003,
the deadline for the parties to seek further relief from the trial court or to
pursue an appeal had not expired.
Eastman v. Brown & Williamson Tobacco Corporation, et al. (Circuit Court,
Pinellas County, Florida). During April of 2003, plaintiff was awarded $6.5
million in actual damages. Defendants have appealed.
44
Bullock v. Philip Morris USA (Superior Court, Los Angeles County,
California). During September and October of 2002, plaintiff was awarded $5.5
million in actual damages and $28.0 billion in punitive damages. The court
reduced the punitive damages award to $28.0 million. Philip Morris has
appealed.
Figueroa v. R.J. Reynolds Tobacco Company (U.S. District Court, Puerto
Rico). During September of 2002, plaintiffs were awarded $1.0 million in
actual damages. The court granted the defendant's motion for judgment as a
matter of law and entered a final judgment in favor of R.J. Reynolds.
Plaintiffs have appealed.
Schwarz v. Philip Morris Incorporated (Circuit Court, Multnomah County,
Oregon). During March of 2002, plaintiff was awarded approximately $120,000 in
economic damages, $50,000 in noneconomic damages and $150.0 million in
punitive damages, although the court subsequently reduced the punitive damages
award to $100.0 million. Many of plaintiff's claims were directed to
allegations that the defendant had made false representations regarding the
low tar cigarettes smoked by the decedent. Philip Morris has appealed.
Burton v. R.J. Reynolds Tobacco Company, et al. (U.S. District Court,
Kansas). During February of 2002, plaintiff was awarded approximately $200,000
in actual damages and the jury determined that plaintiff was entitled to
punitive damages. During June of 2002, the court awarded plaintiff $15.0
million in punitive damages from R.J. Reynolds. R.J. Reynolds has appealed.
Kenyon v. R.J. Reynolds Tobacco Company (Circuit Court, Hillsborough County,
Florida). During December of 2001, plaintiff was awarded $165,000 in actual
damages. During May of 2003, the Florida Court of Appeal affirmed the judgment
in favor of the plaintiff. R.J. Reynolds has sought reconsideration of the
ruling. As of August 1, 2003, the court had not ruled on Reynolds' motion for
reconsideration.
Boeken v. Philip Morris Incorporated (Superior Court, Los Angeles County,
California). During June of 2001, plaintiff was awarded $5.5 million in actual
damages and $3.0 billion in punitive damages. The court reduced the punitive
damages award to $100.0 million. Philip Morris has appealed.
Jones v. R.J. Reynolds Tobacco Co. (Circuit Court, Hillsborough County,
Florida). During October of 2000, plaintiff was awarded $200,000 in actual
damages. The court granted the defendant's motion for new trial. The Florida
Court of Appeal affirmed this ruling. Plaintiff has filed for permission to
appeal to the Florida Supreme Court.
Whiteley v. Raybestos-Manhattan, Inc., et al. (Superior Court, San Francisco
County, California). During March of 2000, plaintiffs were awarded $1.0
million in economic damages, $500,000 in noneconomic damages, $250,000 in loss
of consortium and $20.0 million in punitive damages from Philip Morris and
R.J. Reynolds. Both defendants have appealed.
Williams v. Philip Morris, Inc. (Circuit Court, Multnomah County, Oregon).
During March of 1999, plaintiff was awarded $21,000 in economic damages,
$800,000 in actual damages and $79.5 million in punitive damages. The court
reduced the punitive damages award to $32.0 million. During 2002, the Oregon
Court of Appeals affirmed the verdict and reinstated the full amount of the
punitive damages award. The Oregon Supreme Court declined to review the case.
Philip Morris has filed a petition for writ of certiorari with the U.S.
Supreme Court. As of August 1, 2003, the Court had not ruled whether it would
grant review of the petition.
45
Henley v. Philip Morris Incorporated (Superior Court, San Francisco County,
California). During February of 1999, plaintiff was awarded $1.5 million in
actual damages and $50.0 million in punitive damages, although the court
reduced the latter award to $25.0 million. The California Court of Appeals
affirmed the judgment in two separate rulings issued in 2001 and 2003. The
California Supreme Court remanded the case to the Court of Appeals following
both decisions and directed to reconsider its rulings. The case is now before
the California Court of Appeals.
Defense verdicts have been returned in the following 15 matters since
January 1, 2001. Unless otherwise noted, neither Lorillard nor the Company was
a defendant in these matters:
Reller v. Philip Morris USA (Superior Court, Los Angeles County,
California). During July of 2003, the jury found that a smoker's lung cancer
was caused by smoking but declined to award damages. As of August 1, 2003, a
judgment reflecting the verdict had not been entered.
Welch v. Brown & Williamson Tobacco Corporation, et al. (Circuit Court,
Jackson County, Missouri). A defense verdict was returned during June of 2003.
Plaintiff has filed a motion for new trial. As of August 1, 2003, the court
had not ruled on the motion for new trial.
Lucier v. Philip Morris USA, et al. (Superior Court, Sacramento County,
California). A defense verdict was returned during February of 2003. The court
has denied plaintiffs' motion for new trial. Plaintiffs have appealed.
Carter v. Philip Morris USA (Court of Common Pleas, Philadelphia County,
Pennsylvania). A defense verdict was returned during January of 2003. The
court has denied plaintiff's motion for new trial. Plaintiff has appealed.
Conley v. R.J. Reynolds Tobacco Co., et al. (U.S. District Court, Northern
District of California). A defense verdict was returned during December of
2002. Plaintiffs have appealed.
Tompkin v. The American Tobacco Company, et al. (U.S. District Court,
Northern District, Ohio). Lorillard is a defendant in this matter. A defense
verdict was returned during October of 2001. Plaintiff has appealed.
In nine cases in which defendants prevailed at trial after January 1, 2001,
plaintiffs either chose not to appeal or have withdrawn their appeals and the
cases are concluded. These nine matters and the dates of the verdicts are
Allen v. R.J. Reynolds Tobacco Company, et al. (U.S. District Court, Southern
District, Florida, February of 2003); Inzerilla v. The American Tobacco
Company, et al. (Supreme Court, Queens County, New York, February of 2003);
Tune v. Philip Morris Incorporated (Circuit Court of Pinellas County, Florida,
May of 2002); Hyde v. Philip Morris Incorporated (U.S. District Court, Rhode
Island, March of 2002); DuJack v. Brown & Williamson Tobacco Corporation
(Superior Court of Connecticut at Rockville, November of 2001); Mehlman v.
Philip Morris, Inc., et al. (Superior Court, Middlesex County, New Jersey, May
of 2001); Grinnell v. The American Tobacco Company (District Court, Jefferson
County, Texas, March of 2001); Little v. R.J. Reynolds Tobacco Company, et al.
(U.S. District Court, South Carolina, February of 2001) and Apostolou v. The
American Tobacco Company, et al. (Supreme Court, Kings County, New York,
January of 2001). Lorillard was a defendant in one of these nine matters,
Apostolou v. The American Tobacco Company, et al.
46
As of August 1, 2003, trial was proceeding in one tobacco product liability
case in which neither Lorillard nor the Company were defendants, Eiser v.
Brown & Williamson Tobacco Corporation, et al., pending in the Court of Common
Pleas of Philadelphia County, Pennsylvania. Some cases against U.S. cigarette
manufacturers and manufacturers of smokeless tobacco products are scheduled
for trial during the remainder of 2003 and beyond. As of August 1, 2003,
Lorillard is a defendant in one trial scheduled for 2003. A consolidated trial
involving the approximately 1,000 cases pending against Lorillard in the
Circuit Court of Ohio County, West Virginia, had been scheduled for trial
during 2003 but that trial date has been vacated. A new date for the
consolidated trial was not scheduled as of August 1, 2003 and it is not known
whether this trial will begin during 2003. The Company is not a defendant in
any of the cases scheduled for trial during 2003 as of August 1, 2003. The
trial dates are subject to change.
FLIGHT ATTENDANT CASES - As of August 1, 2003, approximately 2,800 Flight
Attendant cases were pending. Lorillard and three other cigarette
manufacturers are the defendants in each of these matters. The Company is not
a defendant in any of these cases. These suits were filed as a result of a
settlement agreement by the parties, including Lorillard, in Broin v. Philip
Morris Companies, Inc., et al. (Circuit Court, Dade County, Florida, filed
October 31, 1991), a class action brought on behalf of flight attendants
claiming injury as a result of exposure to environmental tobacco smoke. The
settlement agreement, among other things, permitted the plaintiff class
members to file these individual suits. These individuals may not seek
punitive damages for injuries that arose prior to January 15, 1997.
During October of 2000, the Circuit Court of Miami-Dade County, Florida
entered an order that may be construed to hold that the flight attendants are
not required to prove the substantive liability elements of their claims for
negligence, strict liability and breach of implied warranty in order to
recover damages. The court further ruled that the trials of these suits are to
address whether the plaintiffs' alleged injuries were caused by their exposure
to environmental tobacco smoke and, if so, the amount of damages to be
awarded. It is not clear how the trial judges will apply this order. The
defendants' appeals were rejected as premature. Defendants retain the right to
appeal this order in the future.
Verdicts have been returned in five of the flight attendant cases. Lorillard
has been a defendant in each of these five cases. In one of the cases, the
plaintiff was awarded $5.5 million in actual damages, although the court
reduced the award to $500,000. Defendants have noticed an appeal from this
verdict and plaintiff has noticed a cross-appeal. Defendants have prevailed in
the four other cases. In one of them, the court granted plaintiff's motion for
new trial and defendants have appealed.
As of August 1, 2003, approximately 10 flight attendant cases were scheduled
for trial during 2003 and 2004. Trial dates are subject to change.
CLASS ACTION CASES - Lorillard is a defendant in approximately 40 pending
cases. The Company is a defendant in two of these cases. In most of the
pending cases, plaintiffs purport to seek class certification on behalf of
groups of cigarette smokers, or the estates of deceased cigarette smokers, who
reside in the state in which the case was filed. The pending class action
cases against Lorillard include approximately 25 separate suits filed in a
single Nevada court in which the plaintiffs assert virtually identical class
definitions. Neither Lorillard nor the Company are defendants in approximately
25 additional class action cases pending against other cigarette manufacturers
47
in various courts throughout the nation. Many of these 25 cases assert claims
on behalf of smokers of "light" cigarettes.
Cigarette manufacturers, including Lorillard, have defeated motions for
class certification in a total of 33 cases, 12 of which were in state court
and 21 of which were in federal court. These 33 cases were filed in 16 states,
the District of Columbia and the Commonwealth of Puerto Rico.
The Engle Case - One of the class actions pending against Lorillard is Engle
v. R.J. Reynolds Tobacco Co., et al. (Circuit Court, Dade County, Florida,
filed May 5, 1994), a case in which a jury awarded approximately $16.3 billion
in punitive damages against Lorillard during 2000 as part of a $145.0 billion
verdict against all of the defendants. During May of 2003, a Florida appellate
court reversed the judgment and decertified the class. This matter is
described below.
A three-phase trial plan governed Engle when trial began in July of 1998.
The first phase involved certain issues deemed common to the certified class,
which was defined as Florida residents, and survivors of Florida residents,
who were injured or died from medical conditions allegedly caused by addiction
to cigarettes. The trial's first phase ended on July 7, 1999 with findings
against the defendants, including Lorillard. Among other things, the jury
found that cigarette smoking is addictive and causes lung cancer and a variety
of other diseases, that the defendants concealed information about the health
risks of smoking, and that defendants' conduct rose to a level that would
permit a potential award or entitlement to punitive damages. The jury was not
asked to award damages in the Phase One verdict, and the verdict permitted the
trial to proceed to a second phase.
In the first portion of Phase Two, on April 7, 2000, the jury returned a
verdict against the defendants and awarded three plaintiffs $12.5 million in
damages for their individual claims.
In the second part of Phase Two, on July 14, 2000, the jury awarded
approximately $145.0 billion in punitive damages against all defendants,
including $16.3 billion against Lorillard. The judgment provided that the
jury's awards bear interest at the rate of 10% per year.
Lorillard noticed an appeal from the final judgment to the Florida Third
District Court of Appeal and posted its appellate bond in the amount of $100.0
million pursuant to Florida legislation enacted in May of 2000 limiting the
amount of an appellate bond required to be posted in order to stay execution
of a judgment for punitive damages in a certified class action. While
Lorillard believes this legislation is valid and that any challenges to the
possible application or constitutionality of this legislation would fail,
during May of 2001, Lorillard entered into an agreement with the plaintiffs
(the "Engle Agreement") in which it contributed $200.0 million to a fund held
for the benefit of the Engle plaintiffs that may not be recoverable by
Lorillard even if the challenges to the judgment are resolved in favor of the
defendants. The $200.0 million contribution included the $100.0 million that
Lorillard posted as collateral for the appellate bond. Accordingly, Lorillard
recorded a pretax charge of $200.0 million in the second quarter of the year
ended December 31, 2001. Two other defendants executed agreements with the
plaintiffs that are similar to Lorillard's. As a result, the class has agreed
to a stay of execution, with respect to Lorillard and the two other defendants
on its punitive damages judgment until appellate review is completed,
including any review by the U.S. Supreme Court.
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The Engle Agreement provides that in the event that Lorillard, Inc.'s
balance sheet net worth falls below $921.2 million (as determined in
accordance with generally accepted accounting principles in effect as of July
14, 2000), the stay granted in favor of Lorillard in the Engle Agreement would
terminate and the class would be free to challenge the Florida legislation. As
of June 30, 2003, Lorillard, Inc. had a balance sheet net worth of
approximately $1.4 billion.
In addition, the Engle Agreement requires Lorillard to obtain the written
consent of class counsel or the court prior to selling any trademark of or
formula comprising a cigarette brand having a U.S. market share of 0.5% or
more during the preceding calendar year. The Engle Agreement also requires
Lorillard to obtain the written consent of the Engle class counsel or the
court to license to a third party the right to manufacture or sell such a
cigarette brand unless the cigarettes to be manufactured under the license
will be sold by Lorillard. It is not clear how the Engle Agreement is affected
by the decertification of the class and by the order vacating the judgment.
Lorillard is a defendant in eleven separate cases pending in the Florida
courts in which the plaintiffs claim that they are members of the Engle class,
that all liability issues associated with their claims were resolved in the
earlier phases of the Engle proceedings, and that trials on their claims
should proceed immediately. Lorillard is opposing trials of these actions on
the grounds that they should be considered during Phase Three of the Engle
case and should be stayed while the Engle appeal is proceeding. Additional
cases with similar contentions are pending against other cigarette
manufacturers. In one of the matters in which Lorillard was not a party, a
jury in the Circuit Court of Miami-Dade County, Florida returned a verdict in
favor of the plaintiffs during June of 2002 in the case of Lukacs v. Brown &
Williamson Tobacco Corporation, et al. and awarded them $500,000 in economic
damages, $24.5 million in noneconomic damages and $12.5 million in damages for
loss of consortium. The court has reduced the loss of consortium award to
$125,000. No post-trial motions are scheduled to be filed in Lukacs as a final
judgment reflecting the verdict will not be entered until the Engle appeal is
resolved.
Lorillard believes that the Engle case should not have been certified as a
class action. Lorillard further believes that class certification in the Engle
case was inconsistent with the majority of federal and state court decisions
which have held that mass smoking and health claims are inappropriate for
class treatment. Lorillard, along with the other defendants, appealed to the
Florida Third District Court of Appeal and challenged class certification as
well as numerous other legal errors it believed occurred during the trial. On
May 21, 2003, the court vacated the judgment reflecting the verdicts,
including the punitive damages award, and further ordered that the class was
to be decertified. Plaintiffs have sought reconsideration of this ruling,
including certification of certain issues to the Florida Supreme Court. As of
August 1, 2003, the Court of Appeals had not ruled whether it would permit
rehearing of its May 21 order.
Other Class Action Cases - In six additional class actions in which Lorillard
is a defendant, courts have granted plaintiffs' motions for class
certification. Two of these matters have been resolved in favor of the
defendants and plaintiffs' claims in a third case were resolved through a
settlement agreement. These six matters are listed below in alphabetical
order:
Blankenship v. American Tobacco Company, et al. (Circuit Court, Ohio County,
West Virginia, filed January 31, 1997). During 2000, the court certified a
49
class comprised of certain West Virginia cigarette smokers who sought, among
other things, medical monitoring. During November of 2001, the jury returned a
verdict in favor of the defendants, including Lorillard. Plaintiffs have
noticed an appeal.
Broin v. Philip Morris Companies, Inc., et al. (Circuit Court, Dade County,
Florida, filed October 31, 1991). This is the matter concluded by a settlement
agreement and discussed under "Flight Attendant Cases" above.
Brown v. The American Tobacco Company, Inc., et al. (Superior Court, San
Diego County, California, filed June 10, 1997). During 2001, the court
certified a class comprised of adult residents of California who smoked at
least one of defendants' cigarettes between June 10, 1993 and April 23, 2001
and who were exposed to defendants' marketing and advertising activities in
California. Trial is scheduled to begin during September of 2003. As of August
1, 2003, however, it appeared that the trial would be delayed.
Daniels v. Philip Morris, Incorporated, et al. (Superior Court, San Diego
County, California, filed August 2, 1998). During 2000, the court certified a
class comprised of California residents who, while minors, smoked at least one
cigarette between April of 1994 and December 31, 1999. During 2002, the court
granted defendants' motion for summary judgment and entered final judgment in
their favor. Plaintiffs have appealed.
In re: Simon II Litigation v. R.J. Reynolds Tobacco Company, et al. (U.S.
District Court, Eastern District, New York, filed September 6, 2000). During
2002, the case was certified as a nationwide non-opt out class comprised of
the punitive damages claims asserted by individuals who allege certain
injuries or medical conditions allegedly caused by smoking. Certain
individuals, including those who allege membership in the class certified in
Engle v. R.J. Reynolds Tobacco Company, et al., were excluded from the class.
Defendants are appealing the ruling.
Scott v. The American Tobacco Company, et al. (District Court, Orleans
Parish, Louisiana, filed May 24, 1996). The court certified a class comprised
of certain cigarette smokers resident in the State of Louisiana who desire to
participate in medical monitoring or smoking cessation programs and who began
smoking prior to September 1, 1988, or who began smoking prior to May 24, 1996
and allege that defendants undermined compliance with the warnings on
cigarette packages. Jury selection began during 2001, but the jury did not
begin hearing evidence until January of 2003. During July of 2003, the jury
returned a verdict in the first phase of trial that resolved some of
plaintiffs' claims in favor of the defendants but found in favor of the class
as to certain other matters. See above for a discussion of the jury's
findings.
In addition to the above, motions for class certification have been granted
in some cases in which Lorillard is not a defendant. One of these is the case
of Price v. Philip Morris USA (Circuit Court, Madison County, Illinois, filed
February 10, 2000, and formerly known as Miles). The court in Price certified
a class comprised of Illinois residents who smoked Philip Morris' cigarettes
labeled as "light" or "ultra light." During 2003, the court returned a verdict
in favor of the class; see above for a discussion of the judgment entered in
plaintiffs' favor at trial and the developments concerning the defendant's
actions to bond and pursue an appeal.
REIMBURSEMENT CASES - The cases settled by the State Settlement Agreements
described below are concluded. Approximately 40 other suits are pending in
which Lorillard is a defendant. The Company is a defendant in 26 of the
50
pending cases. Plaintiffs in 28 of the cases are foreign governments that have
filed suit in U.S. courts. The plaintiffs in the remaining pending cases
include the U.S. federal government, several U.S. county or city governments,
American Indian tribes, hospitals or hospital districts, private companies and
private citizens suing on behalf of taxpayers. Plaintiffs in some of these
cases seek certification as class actions.
U.S. Federal Government Action - The U.S. federal government filed a
reimbursement suit on September 22, 1999 in the U.S. District Court for the
District of Columbia against Lorillard, other U.S. cigarette manufacturers,
some parent companies and two trade associations. The Company is not a
defendant in this action. Plaintiff asserted claims under the Medical Care
Recovery Act, the Medicare as Secondary Payer provisions of the Social
Security Act, and the Racketeer Influenced and Corrupt Organizations Act. The
court has dismissed plaintiff's Medical Care Recovery Act and the Medicare as
Secondary Payer provisions of the Social Security Act claims. In a recent
filing, the government stated that it is seeking an aggregate of $289.0
billion in disgorgement of profits from the defendants, including Lorillard,
as well as injunctive relief.
Reimbursement Cases filed by Foreign Governments in U.S. Courts - Cases have
been brought in U.S. courts by 13 nations, more than 20 Brazilian states or
cities, and one Canadian province. Some of the cases have been voluntarily
dismissed, while courts have granted defendants' dismissal motions in some of
the other matters. Twenty-seven of the cases are pending. Both the Company and
Lorillard are named as defendants in most of these cases, although both have
been dismissed from three suits that remain pending against other defendants.
Other pending Reimbursement cases - In addition to the cases described
above, approximately 15 Reimbursement cases are pending against Lorillard.
Plaintiffs in these suits include U.S. city or county governments, hospitals
or hospital districts, American Indian tribes, private companies and private
citizens suing on behalf of taxpayers.
Excluding the cases filed by U.S. state governments that are described
below, defendants have successfully defended many of the Reimbursement cases.
For instance, each of the approximately 75 cases filed by labor union health
and welfare funds were dismissed, either due to orders that granted
defendants' dispositive motions or as the result of plaintiffs voluntarily
withdrawing their claims. In addition, various courts of appeal have affirmed
orders dismissing cases in favor of the defendants. For instance, during
February of 2003, the Appellate Division of the New York Supreme Court
affirmed the order dismissing the case filed by approximately 170 New York
hospitals or hospital districts, while the U.S. Supreme Court denied the
petition for writ of certiorari filed by the plaintiff in one of the tribal
cases during January of 2003. During May of 2003, the Florida Supreme Court
denied the appeal filed by the Republic of Venezuela that sought review of the
orders dismissing the case in favor of the defendants. Many of the cases filed
by other foreign governments in U.S. courts are pending in Florida.
Since January 1, 2001, one of the Reimbursement cases has been tried. During
June of 2001, a jury in the U.S. District Court for the Eastern District of
New York returned a verdict in Blue Cross and Blue Shield of New Jersey, Inc.,
et al. v. Philip Morris, Incorporated, et al., and awarded damages against the
defendants, including Lorillard. In this trial, the jury heard evidence as to
the claims of only one of the plan plaintiffs, Empire Blue Cross and Blue
Shield, referred to as "Empire." In its verdict, the jury found in favor of
the defendants on some of Empire's claims, one of which precluded the jury
from considering Empire's claims for punitive damages. The jury found in favor
51
of Empire on certain other of plaintiff's claims. As a result of these
findings, a final judgment was entered in which Empire was awarded a total of
approximately $17.8 million in actual damages, including approximately $1.5
million attributable to Lorillard. Empire was awarded approximately $55,000 in
pre-judgment interest for a total award against Lorillard of approximately
$1.6 million. The court has awarded plaintiff's counsel approximately $38.0
million in attorneys' fees. The defendants have noticed an appeal to the U.S.
Court of Appeals for the Second Circuit from the final judgment and from the
order awarding plaintiff's counsel attorneys' fees. The Court of Appeals heard
argument of defendants' appeal during February of 2003.
In addition to the above, the District Court of Jerusalem, Israel, has
permitted a private insurer in Israel, Clalit Health Services, to make service
outside the jurisdiction on the Company and Lorillard with a suit in which
Clalit Health Services seeks damages for providing treatment to individuals
allegedly injured by cigarette smoking. The Company and Lorillard have
separately moved to set aside the order that permitted service outside the
jurisdiction. As of August 1, 2003, the court had not ruled on the motions to
set aside the attempted service.
SETTLEMENT OF STATE REIMBURSEMENT LITIGATION - On November 23, 1998,
Lorillard, Philip Morris Incorporated, Brown & Williamson Tobacco Corporation
and R.J. Reynolds Tobacco Company, the "Original Participating Manufacturers,"
entered into a Master Settlement Agreement with 46 states, the District of
Columbia, the Commonwealth of Puerto Rico, Guam, the U.S. Virgin Islands,
American Samoa and the Commonwealth of the Northern Mariana Islands to settle
the asserted and unasserted health care cost recovery and certain other claims
of those states. These settling entities are generally referred to as the
"Settling States." The Original Participating Manufacturers had previously
settled similar claims brought by Mississippi, Florida, Texas and Minnesota,
which together with the Master Settlement Agreement are generally referred to
as the "State Settlement Agreements."
The State Settlement Agreements provide that the agreements are not
admissions, concessions or evidence of any liability or wrongdoing on the part
of any party, and were entered into by the Original Participating
Manufacturers to avoid the further expense, inconvenience, burden and
uncertainty of litigation.
Lorillard recorded pretax charges of $180.1, $291.9, $377.6 and $587.7
million ($116.3, $176.5, $236.9 and $357.2 million after taxes), for the three
and six months ended June 30, 2003 and 2002, respectively, to accrue its
obligations under the State Settlement Agreements. Lorillard's portion of
ongoing adjusted payments and legal fees is based on its share of domestic
cigarette shipments in the year preceding that in which the payment is due.
Accordingly, Lorillard records its portions of ongoing settlement payments as
part of cost of manufactured products sold as the related sales occur.
The State Settlement Agreements require that the domestic tobacco industry
make annual payments in the following amounts, subject to adjustment for
several factors, including inflation, market share and industry volume: 2003,
$10.9 billion; 2004 through 2007, $8.4 billion; and thereafter, $9.4 billion.
In addition, the domestic tobacco industry is required to pay settling
plaintiffs' attorneys' fees, subject to an annual cap of $500.0 million, as
well as an additional amount of $250.0 million in 2003. These payment
obligations are the several and not joint obligations of each settling
defendant.
52
The State Settlement Agreements also include provisions relating to
significant advertising and marketing restrictions, public disclosure of
certain industry documents, limitations on challenges to tobacco control and
underage use laws, and other provisions.
In addition, as part of the Master Settlement Agreement, the Original
Participating Manufacturers committed to work cooperatively with the tobacco
growing community to address concerns about the potential adverse economic
impact on that community. On January 21, 1999, the Original Participating
Manufacturers reached an agreement to establish a $5.2 billion trust fund
payable between 1999 and 2010 to compensate the tobacco growing communities in
14 states. Payments to the trust fund are to be allocated among the Original
Participating Manufacturers according to their relative market share of
domestic cigarette shipments, except that Philip Morris paid more than its
market share in 1999 but will have its payment obligations reduced in 2009 and
2010 to make up for the overpayment. Of the total $5.2 billion, a total of
$1.6 billion was paid since 1999 through June 30, 2003, $146.0 million of
which was paid by Lorillard. Lorillard believes its remaining payments under
the agreement will total approximately $348.0 million. All payments will be
adjusted for inflation, changes in the unit volume of domestic cigarette
shipments, and the effect of new increases in state or federal excise taxes on
tobacco products that benefit the tobacco growing community.
The Company believes that the State Settlement Agreements will materially
adversely affect its cash flows and operating income in future years. The
degree of the adverse impact will depend, among other things, on the rates of
decline in U.S. cigarette sales in the premium price and discount price
segments, Lorillard's share of the domestic premium price and discount price
cigarette segments, and the effect of any resulting cost advantage of
manufacturers not subject to significant payment obligations under the State
Settlement Agreements. Almost all domestic manufacturers have agreed to become
subject to the terms of the Master Settlement Agreement, however, under the
terms of the Master Settlement Agreement, manufacturers other than the
Original Participating Manufacturers retain much of their cost advantage.
CONTRIBUTION CLAIMS - Approximately 10 cases are pending against Lorillard.
The Company is a defendant in one of these cases. Plaintiffs seek recovery of
funds expended by them to individuals whose asbestos disease or illness was
alleged to have been caused in whole or in part by smoking-related illnesses.
FILTER CASES - Claims have been brought against Lorillard by smokers as well
as former employees of Lorillard seeking damages resulting from alleged
exposure to asbestos fibers that were incorporated into filter material used
in one brand of cigarettes manufactured by Lorillard for a limited period of
time, ending almost 50 years ago. Approximately 60 such matters are pending
against Lorillard. The Company is a defendant in one of these matters. Since
January 1, 2000 and through August 1, 2003, Lorillard has paid, or has reached
agreement to pay, a total of approximately $17.8 million in payments of
judgments and settlements to finally resolve approximately 45 previously
pending claims. In Sachs v. Lorillard Tobacco Co., the only filter case tried
to a verdict since January 1, 2001, the jury found in favor of Lorillard.
Other Tobacco - Related
TOBACCO - RELATED ANTITRUST CASES - Wholesalers and Direct Purchaser Suits -
Lorillard and other domestic and international cigarette manufacturers and
their parent companies, including the Company, were named as defendants in
nine separate federal court actions brought by tobacco product wholesalers for
violations of U.S. antitrust laws and international law. The complaints allege
53
that defendants conspired to fix the price of cigarettes to wholesalers since
1993 in violation of the Sherman Act. These actions seek certification of a
class including all domestic and international wholesalers similarly affected
by such alleged conduct, and damages, injunctive relief and attorneys' fees.
These actions were consolidated for pre-trial purposes in the U.S. District
Court for the Northern District of Georgia. The Court granted class
certification for a four-year class (beginning in 1996 and ending in 2000) of
domestic direct purchasers. The Company has been voluntarily dismissed without
prejudice from all direct purchaser cases. On July 11, 2002, the Court granted
motions for summary judgment filed by Lorillard and all other defendants
dismissing the actions in their entirety. Plaintiffs appeal in the U.S. Court
of Appeals for the Eleventh Circuit was argued May 1, 2003.
Indirect Purchaser Suits - Approximately 30 suits are pending in various
state courts alleging violations of state antitrust laws which permit indirect
purchasers, such as retailers and consumers, to sue under price fixing or
consumer fraud statutes. Approximately 18 states permit such suits. Lorillard
is a defendant in all but one of these indirect purchaser cases. Two indirect
purchaser suits in New York and Florida, have been dismissed in their entirety
and plaintiffs have withdrawn their appeals. The Arizona indirect purchaser
suit was dismissed by the trial court, but the dismissal was reversed on
appeal, and an appeal from the reversal to the Arizona Supreme Court was
argued in January of 2003. While two state courts have granted plaintiffs'
motions to certify a class of consumers, two other state courts have refused
to do so, and other motions seeking class certification have been deferred by
other courts pending resolution of the federal case discussed above. The
decision granting certification in New Mexico is being appealed by the
defendants. In Kansas, a Motion to Compel against Lorillard (and other
defendants) seeking certain documents for which Lorillard has claimed
privilege and a motion to extend discovery deadlines are pending before the
court. The Company was also named as a defendant in most of these indirect
purchaser cases but has been voluntarily dismissed without prejudice from all
of them.
Tobacco Growers Suit - DeLoach v. Philip Morris Inc., et al. (U.S. District
Court, Middle District of North Carolina, filed February 16, 2000). Lorillard
is named as a defendant in a lawsuit that, after several amendments, alleges
only antitrust violations. The other major domestic tobacco companies and the
major leaf buyers are also defendants. On April 3, 2002 the court certified a
class consisting of all persons holding a quota (the licenses that a farmer
must either own or rent to sell the crop) to grow, and all domestic producers
who sold flue-cured or burley tobacco at anytime from February 1996 to
present. All of the defendants, with the exception of R.J. Reynolds Tobacco
Company, have entered into an agreement to settle the litigation. Pursuant to
the settlement agreement, Lorillard will pay the class $20.0 million. In
addition, Lorillard has committed to buy 20 million pounds of domestic tobacco
for each of the next ten years. Lorillard has also committed to purchase at
least 35% of its annual total requirements for flue-cured and burley tobacco
domestically for the same period. Lorillard will also be responsible for 10%
of the plaintiffs' attorneys' fees, to be determined by the court after class
approval. The court has given preliminary approval to the settlement. Class
notice and the settlement agreement have been sent to class members. A hearing
on whether final approval will be granted is scheduled to be held on October
1, 2003.
REPARATION CASES - During 2002, the Company was named as a defendant in three
cases in which plaintiffs seek reparations for the alleged financial benefits
derived from the uncompensated use of slave labor. The Company was named as a
defendant in these matters as a result of conduct purportedly engaged in by
54
Lorillard and various other entities. Plaintiffs in these suits seek various
types of damages including disgorgement of profits, restitution and punitive
damages. Plaintiffs seek class certification on behalf of the descendants of
enslaved African Americans.
Defenses
Lorillard believes that it has valid defenses to the cases pending against
it. Lorillard also believes it has valid bases for appeal of the adverse
verdicts against it. To the extent the Company is a defendant in any of the
lawsuits described in this section, the Company believes that it is not a
proper defendant in these matters and has moved or plans to move for dismissal
of all such claims against it. While Lorillard intends to defend vigorously
all tobacco products liability litigation, it is not possible to predict the
outcome of any of this litigation. Litigation is subject to many
uncertainties, and it is possible that some of these actions could be decided
unfavorably. Lorillard may enter into discussions in an attempt to settle
particular cases if it believes it is appropriate to do so.
In addition, some developments on health issues related to tobacco products
have received widespread media attention, which could have adverse effects on
the ability of Lorillard to prevail in smoking and health litigation. These
developments also could prompt the filing of additional litigation. These
developments include, but are not limited to, the release of industry
documents beginning in 1998 and the adverse outcomes in some of the cases
tried during the past few years, some of which have resulted in awards to the
plaintiffs for billions of dollars. Defendants have appealed, or intend to
appeal, each of the verdicts returned to date in which plaintiffs were awarded
damages.
Except for the impact of the State Settlement Agreements as described above,
management is unable to make a meaningful estimate of the amount or range of
loss that could result from an unfavorable outcome of pending litigation and,
therefore, no provision has been made in the consolidated condensed financial
statements for any unfavorable outcome. It is possible that the Company's
results of operations or cash flows in a particular quarterly or annual period
or its financial position could be materially affected by an unfavorable
outcome of certain pending litigation.
OTHER LITIGATION - The Company and its subsidiaries are also parties to other
litigation arising in the ordinary course of business. The outcome of this
other litigation will not, in the opinion of management, materially affect the
Company's results of operations or equity.
13. Contingencies
Guarantees
CNA has provided guarantees related to irrevocable standby letters of credit
for certain of its subsidiaries. Certain of these subsidiaries have been sold;
however, the irrevocable standby letter of credit guarantees remain in effect.
CNA would be required to remit prompt payment on the letters of credit in
question if the primary obligor drew down on these letters of credit and
failed to repay such loans in accordance with the terms of the letters of
credit. The maximum potential amount of future payments that CNA could be
required to pay under these guarantees is approximately $30.0 million at June
30, 2003.
55
CNA holds an investment in a real estate joint venture. In the normal course
of business, CNA, on a joint and several basis with other unrelated insurance
company shareholders, has committed to continue funding the operating deficits
of this joint venture. Additionally, CNA and the other unrelated shareholders,
on a joint and several basis, have guaranteed an operating lease for an office
building, which expires in 2016.
The guarantee of the operating lease is a parallel guarantee to the
commitment to fund operating deficits; consequently, the separate guarantee to
the lessor is not expected to be triggered as long as the joint venture
continues to be funded by its shareholders and continues to make its annual
lease payments.
In the event that the other parties to the joint venture are unable to meet
their commitments in funding the operations of this joint venture, CNA would
be required to assume the obligation for the entire office building operating
lease. The maximum potential future lease payments at June 30, 2003 that CNA
could be required to pay under this guarantee are approximately $324.0
million. If CNA were required to assume the entire lease obligation, CNA would
have the right to pursue reimbursement from the other shareholders and would
have the right to all sublease revenues.
CNA has recorded a liability of approximately $9.0 and $10.0 million as of
June 30, 2003 and December 31, 2002 for its share of estimated future
operating deficits of this joint venture through 2016.
CNA has provided guarantees of the indebtedness of certain of its
independent insurance producers. These guarantees expire in 2003. CNA would be
required to remit prompt and complete payment when due, should the primary
obligor default. In the event of default on the part of the primary obligor,
CNA has a right to any and all shares of common stock of the primary obligor.
The maximum potential amount of future payments that CNA could be required to
pay under these guarantees is approximately $7.0 million at June 30, 2003.
CNA Surety
CCC provided an excess of loss reinsurance contract to the insurance
subsidiaries of CNA Surety Corporation ("CNA Surety") over a period that
expired on December 31, 2000 (the "stop loss contract"). The stop loss
contract limits the net loss ratios for CNA Surety with respect to certain
accounts and lines of insurance business. In the event that CNA Surety's
accident year net loss ratio exceeds 24% for 1997 through 2000 (the
"contractual loss ratio"), the stop loss contract requires CCC to pay amounts
equal to the amount, if any, by which CNA Surety's actual accident year net
loss ratio exceeds the contractual loss ratio multiplied by the applicable net
earned premiums. The minority shareholders of CNA Surety do not share in any
losses that apply to this contract. There were no reinsurance balances payable
under this stop loss contract as of June 30, 2003 and December 31, 2002.
Effective October 1, 2002, CCC provides an excess of loss protection for new
and renewal bonds for CNA Surety for per principal exposures that exceed $60.0
million since October 1, 2002 in two parts - a) $40.0 million excess of $60.0
million and b) $50.0 million excess of $100.0 million for CNA Surety. This
excess of loss protection is necessary primarily to support new and renewal
bonds for contract surety accounts with bonded backlogs or work-in-process in
excess of $60.0 million. In consideration for the reinsurance coverage
provided by the $40.0 million excess of $60.0 million contract, CNA Surety
will pay to CCC, on a quarterly basis, a premium equal to $3.0 million. In
consideration for the reinsurance coverage provided by the $50.0 million
56
excess of $100.0 million, the insurance subsidiaries of CNA Surety will pay
$6.0 million in premium to CCC.
In March of 2003, CNA entered into a credit agreement with a large national
contractor, which undertakes projects for the construction of government and
private facilities, to provide loans to the contractor in a maximum aggregate
amount of $86.4 million (the "Credit Facility"). Of the $86.4 million
capacity, $62.1 million, including accrued interest, was outstanding at June
30, 2003. The Credit Facility and all related loans will mature in March of
2006. Advances under the Credit Facility bear interest at the prime rate plus
6.0%. Payment of 3.0% of the interest is deferred until the Credit Facility
matures, and the remainder is to be paid monthly in cash. Loans under the
credit facility are secured by a pledge of substantially all of the assets of
the contractor and certain of its affiliates.
In addition, in June of 2003, CNA and one of its subsidiaries provided
repayment guarantees to certain creditors of the contractor and a subsidiary
of the contractor amounting to $8.7 million. Such guarantees were provided in
order to allow the contractor to receive financial accommodations from a
creditor and in order to comply with certain regulatory requirements. Under
the terms of the guarantees, any payments made by CNA, or any of its
subsidiaries, would be considered a draw under the Credit Facility.
CNA Surety has provided significant surety bond protection for projects by
this contractor through surety bonds underwritten by CCC or its affiliates.
The loans were provided by CNA to help the contractor meet its liquidity
needs.
In March of 2003, CNA also purchased the contractor's outstanding bank debt
for $16.4 million. The contractor retired the bank debt by paying CNA $16.4
million, with $11.4 million of the payoff amount being funded under the new
Credit Facility and $5.0 million from money loaned to the contractor by its
shareholders. Under its purchase agreement with the banks, CNA is also
required to reimburse the banks for any draws upon approximately $6.5 million
in outstanding letters of credit issued by the banks for the contractor's
benefit that expire between May and August of 2003. Any amounts paid by CNA to
the banks as reimbursements for draws upon the banks' letters of credit will
become obligations of the contractor to CNA as draws upon the Credit Facility.
The Company has purchased a participation interest in one-third of the loans
and commitments under the new Credit Facility, on a dollar-for-dollar basis,
up to a maximum of $25.0 million. Although the Company does not have rights
against the contractor directly under the participation agreement, it shares
recoveries and certain fees under the Credit Facility proportionally with CNA.
The contractor has initiated a restructuring plan that is intended to reduce
costs and improve cash flow, and a chief restructuring officer has been
appointed to manage execution of the plan. CNA, through its affiliate CNA
Surety, intends to continue to provide surety bonds on behalf of the
contractor during this restructuring period, subject to the contractor's
initial and ongoing compliance with CNA Surety's underwriting standards. Any
losses arising from bonds issued or assumed by the insurance subsidiaries of
CNA Surety to the contractor are excluded from CNA Surety's $45.0 million
excess of $15.0 million per principal reinsurance program with unaffiliated
reinsurers in place in 2003. As a result, CNA Surety retains the first $60.0
million of losses on bonds written with an effective date of September 30,
2002 and prior, and CCC will incur 100% of losses above that retention level
on bonds with effective dates prior to September 30, 2002. Through facultative
reinsurance contracts with CCC, CNA Surety's exposure on bonds written from
57
October 1, 2002 through December 31, 2002 has been limited to $20.0 million
per bond.
Indemnification and subrogation rights, including rights to contract
proceeds on construction projects in the event of default, exist that reduce
CNA Surety's and ultimately CNA's exposure to loss. While CNA believes that
the contractor's restructuring efforts are expected to be successful and
provide sufficient cash flow for its operations and repayment of its
borrowings under the credit facility, the contractor's failure to achieve its
restructuring plan or perform its contractual obligations under the credit
facility and underlying all of CNA's surety bonds could have a material
adverse effect on the Company's future results of operations. If such failures
occur, CNA estimates the surety loss, net of indemnification and subrogation
recoveries, but before the effects of corporate aggregate reinsurance
treaties, if any, and minority interest could be up to $200.0 million.
Other
As of June 30, 2003 and December 31, 2002, CNA had committed approximately
$97.0 and $141.0 million for future capital calls from various third-party
limited partnership investments in exchange for an ownership interest in the
related partnership.
CNA 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
June 30, 2003, CNA had commitments to purchase $157.0 million and commitments
to sell $46.0 million of various bank loan participations.
In the normal course of investing activities, CCC had committed
approximately $51.0 million as of June 30, 2003 to future capital calls from
certain of its unconsolidated affiliates in exchange for an ownership interest
in such affiliates.
In the normal course of business, CNA has obtained letters of credit in
favor of various unaffiliated insurance companies, regulatory authorities and
other entities. As of June 30, 2003 and December 31, 2002 there were
approximately $195.0 and $222.0 million of outstanding letters of credit.
CNA has a commitment to purchase up to a $100.0 million floating rate note
issued by the California Earthquake Authority in the event of an earthquake
during calendar year 2003 that results in California earthquake related losses
greater than $4.2 billion.
The Company is obligated to make future payments totaling $517.6 million for
non-cancelable operating leases expiring from 2003 through 2014 primarily for
office space and data processing, office and transportation equipment.
Estimated future minimum payments under these contracts are as follows: $47.9
million in 2003; $79.0 million in 2004; $69.5 million in 2005; $58.7 million
in 2006; $49.4 million in 2007; and $213.1 million in 2008 and beyond.
Additionally, CNA has entered into a limited number of guaranteed payment
contracts, primarily relating to telecommunication services, amounting to
approximately $24.0 million. Estimated future minimum purchases under these
contracts are as follows: $6.0 million in 2003; $13.0 million in 2004; and
$5.0 million in 2005.
In the ordinary course of selling business entities and assets to third
parties, CNA has agreed to indemnify purchasers for losses arising out of
58
breaches of representation and warranties with respect to the business
entities or assets being sold, including, in certain cases, losses arising
from undisclosed liabilities or certain named litigation. Such indemnification
provisions generally survive for periods ranging from six months following the
applicable closing date to the expiration of the relevant statutes of
limitation. As of June 30, 2003, the aggregate amount of quantifiable
indemnification agreements in effect for sales of business entities and assets
was $375.0 million.
In addition, CNA has agreed to provide indemnification to third party
purchasers for certain losses associated with sold business entities or assets
that are not limited by a contractual monetary amount. As of June 30, 2003,
CNA had outstanding unlimited indemnifications in connection with the sales of
certain of its business entities or assets for tax liabilities arising prior
to a purchaser's ownership of an entity or asset, defects in title at the time
of sale, employee claims arising prior to closing and in some cases losses
arising from certain litigation and undisclosed liabilities. These
indemnification agreements survive until the applicable statutes of limitation
expire, or until the agreed upon contract terms expire. CNA has recorded
approximately $15.0 million of liabilities related to these quantifiable and
unquantifiable indemnification agreements.
14. Consolidating Financial Information
The following schedules present the Company's consolidating balance sheet
information at June 30, 2003 and December 31, 2002, and consolidating
statements of income information for the six months ended June 30, 2003 and
2002. These schedules present the individual subsidiaries of the Company and
their contribution to the consolidated financial statements. Amounts presented
will not necessarily be the same as those in the individual financial
statements of the Company's subsidiaries due to adjustments for purchase
accounting, income taxes and minority interests. In addition, many of the
Company's subsidiaries use a classified balance sheet which also leads to
differences in amounts reported for certain line items. This information also
does not reflect the impact of the Company's issuance of Carolina Group stock.
Lorillard is reported as a 100% owned subsidiary and does not include any
adjustments relating to the tracking stock structure. See Note 4 for
consolidating information of the Carolina Group and Loews Group.
The Corporate and Other column primarily reflects the parent company's
investment in its subsidiaries, invested cash portfolio and corporate long-
term debt. The elimination adjustments are for intercompany assets and
liabilities, interest and dividends, the parent company's investment in
capital stocks of subsidiaries, and various reclasses of debit or credit
balances to the amounts in consolidation. Purchase accounting adjustments have
been pushed down to the appropriate subsidiary.
59
Loews Corporation
Consolidating Balance Sheet Information
CNA Loews Diamond Texas Corporate Elimin-
June 30, 2003 Financial Lorillard Hotels Offshore Gas Bulova and Other ations Total
- ------------------------------------------------------------------------------------------------------------------------
(In millions)
Assets:
Investments $37,862.7 $ 1,596.2 $ 101.7 $ 597.3 $ 35.3 $ 2.0 $ 2,820.9 $43,016.1
Cash 140.3 1.4 8.2 17.6 3.4 7.0 9.8 187.7
Receivables 17,375.3 26.4 26.2 151.0 47.1 76.3 41.5 $ (3.2) 17,740.6
Property, plant and
equipment 284.4 205.7 386.6 2,313.1 658.1 15.7 32.6 3,896.2
Deferred income taxes 222.7 461.9 23.2 (568.5) 139.3
Goodwill 136.0 2.6 27.6 280.5 446.7
Investments in capital
stocks of subsidiaries 12,751.8 (12,751.8)
Other assets 3,203.7 435.4 104.3 87.0 170.3 82.6 458.9 (317.9) 4,224.3
Deferred acquisition costs
of insurance subsidiaries 2,620.2 2,620.2
Separate account business 3,428.9 3,428.9
- ------------------------------------------------------------------------------------------------------------------------
Total assets $65,274.2 $ 2,727.0 $ 629.6 $3,193.6 $1,194.7 $ 206.8 $ 16,115.5 $(13,641.4) $75,700.0
========================================================================================================================
Liabilities and Shareholders'
Equity:
Insurance reserves $41,451.6 $41,451.6
Payable for securities
purchased 1,264.9 $ 2.7 $ 850.5 2,118.1
Securities sold under
agreements to repurchase 985.1 404.8 1,389.9
Long-term debt, less
unamortized discounts 2,158.2 146.8 $ 925.9 $ 807.9 2,297.6 $ (260.0) 6,076.4
Reinsurance balances payable 2,840.1 2,840.1
Deferred income taxes 37.6 352.5 178.4 (568.5)
Other liabilities 2,617.6 $ 1,327.8 193.5 132.0 125.2 $ 55.9 95.6 (341.2) 4,206.4
Separate account business 3,428.9 3,428.9
- ------------------------------------------------------------------------------------------------------------------------
Total liabilities 54,746.4 1,327.8 380.6 1,410.4 933.1 55.9 3,826.9 (1,169.7) 61,511.4
Minority interest 1,150.5 0.2 800.6 4.9 1,956.2
Shareholders' equity 9,377.3 1,399.2 248.8 982.6 261.6 146.0 12,288.6 (12,471.7) 12,232.4
- ------------------------------------------------------------------------------------------------------------------------
$65,274.2 $ 2,727.0 $ 629.6 $3,193.6 $1,194.7 $ 206.8 $ 16,115.5 $(13,641.4) $75,700.0
========================================================================================================================
60
Loews Corporation
Consolidating Balance Sheet Information
CNA Loews Diamond Corporate
December 31, 2002 Financial Lorillard Hotels Offshore Bulova and Other Eliminations Total
- ------------------------------------------------------------------------------------------------------------------------
(In millions)
Assets:
Investments $35,271.2 $ 1,640.7 $ 104.6 $ 794.1 $ 1.4 $ 2,324.7 $40,136.7
Cash 126.2 2.0 4.8 18.4 8.7 25.3 185.4
Receivables 16,262.1 30.2 24.2 147.0 87.6 52.7 $ (2.8) 16,601.0
Property, plant and equipment 292.4 197.8 391.2 2,207.5 16.3 33.0 3,138.2
Deferred income taxes 772.2 437.0 22.6 0.3 (604.9) 627.2
Goodwill 140.8 2.6 34.4 177.8
Investments in capital stocks
of subsidiaries 11,451.2 (11,451.2)
Other assets 3,130.1 469.2 95.5 92.2 74.3 160.0 (22.1) 3,999.2
Deferred acquisition costs of
insurance subsidiaries 2,551.4 2,551.4
Separate account business 3,102.7 3,102.7
- ------------------------------------------------------------------------------------------------------------------------
Total assets $61,649.1 $ 2,776.9 $ 622.9 $3,293.6 $210.9 $14,047.2 $(12,081.0) $70,519.6
========================================================================================================================
Liabilities and Shareholders' Equity:
Insurance reserves $40,178.9 $40,178.9
Payable for securities
purchased 531.2 $ 4.0 $ 263.9 799.1
Securities sold under
agreements to repurchase 552.4 552.4
Long-term debt, less
unamortized discounts 2,292.1 145.8 $ 917.8 2,296.2 5,651.9
Reinsurance balances payable 2,763.3 2,763.3
Deferred income taxes 47.1 374.0 183.8 $ (604.9)
Other liabilities 2,659.7 $ 1,352.1 195.7 141.3 $ 67.5 87.3 (162.8) 4,340.8
Separate account business 3,102.7 3,102.7
- ------------------------------------------------------------------------------------------------------------------------
Total liabilities 52,080.3 1,352.1 392.6 1,433.1 67.5 2,831.2 (767.7) 57,389.1
Minority interest 1,055.0 0.2 835.4 4.7 1,895.3
Shareholders' equity 8,513.8 1,424.8 230.1 1,025.1 138.7 11,216.0 (11,313.3) 11,235.2
- ------------------------------------------------------------------------------------------------------------------------
Total liabilities and
shareholders' equity $61,649.1 $ 2,776.9 $ 622.9 $3,293.6 $210.9 $14,047.2 $(12,081.0) $70,519.6
========================================================================================================================
61
Loews Corporation
Consolidating Statement of Income Information
Six Months Ended CNA Loews Diamond Texas Corporate Elimin-
June 30, 2003 Financial Lorillard Hotels Offshore Gas Bulova and Other ations Total
- ------------------------------------------------------------------------------------------------------------------------
(In millions)
Revenues:
Insurance premiums $ 4,577.6 $ (1.8) $ 4,575.8
Investment income, net 859.1 $ 18.5 $ 0.9 $ 7.5 $ 0.1 $ 15.7 901.8
Intercompany interest
and dividends 335.4 (335.4)
Investment gains (losses) 312.6 (1.8) (1.1) 14.0 323.7
Manufactured products 1,625.1 74.4 (1.2) 1,698.3
Other 204.5 (0.2) 160.9 312.4 $ 23.1 0.3 (1.1) 699.9
- ------------------------------------------------------------------------------------------------------------------------
Total 5,953.8 1,641.6 161.8 318.8 23.1 74.8 362.8 (337.2) 8,199.5
- ------------------------------------------------------------------------------------------------------------------------
Expenses:
Insurance claims and
policyholders' benefits 3,936.7 3,936.7
Amortization of deferred
acquisition costs 939.2 939.2
Cost of manufactured
products sold 921.4 35.3 0.2 956.9
Other operating expenses 811.3 254.6 140.2 356.7 15.8 32.3 23.9 (1.8) 1,633.0
Interest 67.0 4.6 10.9 4.7 62.2 149.4
- ------------------------------------------------------------------------------------------------------------------------
Total 5,754.2 1,176.0 144.8 367.6 20.5 67.6 86.3 (1.8) 7,615.2
- ------------------------------------------------------------------------------------------------------------------------
199.6 465.6 17.0 (48.8) 2.6 7.2 276.5 (335.4) 584.3
- ------------------------------------------------------------------------------------------------------------------------
Income tax expense (benefit) 29.6 173.5 6.2 (9.4) 1.0 2.2 (22.3) 180.8
Minority interest 16.2 (17.6) 0.1 (1.3)
- ------------------------------------------------------------------------------------------------------------------------
Total 45.8 173.5 6.2 (27.0) 1.0 2.3 (22.3) 179.5
- -----------------------------------------------------------------------------------------------------------------------
Net income $ 153.8 $ 292.1 $ 10.8 $ (21.8) $ 1.6 $ 4.9 $ 298.8 $(335.4) $ 404.8
========================================================================================================================
62
Loews Corporation
Consolidating Statement of Income Information
Six Months Ended CNA Loews Diamond Corporate
June 30, 2002 Financial Lorillard Hotels Offshore Bulova and Other Eliminations Total
- ------------------------------------------------------------------------------------------------------------------------
(In millions) (Restated) (Restated)
Revenues:
Insurance premiums $ 5,663.3 $ (1.8) $ 5,661.5
Investment income, net 927.9 $ 21.5 $ 0.8 $ 17.2 $ 0.2 $ 35.3 1,002.9
Intercompany interest
and dividends 255.8 (255.8)
Investment gains (losses) (161.3) 10.6 12.2 (33.0) (171.5)
Manufactured products 2,000.0 72.8 2,072.8
Other 328.1 0.7 158.4 390.5 1.1 (0.7) 878.1
- ------------------------------------------------------------------------------------------------------------------------
Total 6,758.0 2,032.8 159.2 419.9 74.1 257.4 (257.6) $ 9,443.8
- ------------------------------------------------------------------------------------------------------------------------
Expenses:
Insurance claims and
policyholders' benefits 4,692.3 4,692.3
Amortization of deferred
acquisition costs 901.5 901.5
Cost of manufactured
products sold 1,172.9 35.3 1,208.2
Other operating expenses 873.8 238.9 134.7 359.6 31.2 32.4 (1.8) 1,668.8
Interest 75.1 4.7 11.8 63.1 154.7
- ------------------------------------------------------------------------------------------------------------------------
Total 6,542.7 1,411.8 139.4 371.4 66.5 95.5 (1.8) 8,625.5
- ------------------------------------------------------------------------------------------------------------------------
215.3 621.0 19.8 48.5 7.6 161.9 (255.8) 818.3
- ------------------------------------------------------------------------------------------------------------------------
Income tax expense (benefit) 55.5 243.5 7.1 17.7 3.3 (33.3) 293.8
Minority interest 25.9 16.2 0.1 0.1 42.3
- ------------------------------------------------------------------------------------------------------------------------
Total 81.4 243.5 7.1 33.9 3.4 (33.2) 336.1
- ------------------------------------------------------------------------------------------------------------------------
Income from continuing
operations 133.9 377.5 12.7 14.6 4.2 195.1 (255.8) 482.2
Discontinued operations-net (31.0) (31.0)
Cumulative effect of change
in accounting principle-net (39.6) (39.6)
- ------------------------------------------------------------------------------------------------------------------------
Net income $ 63.3 $ 377.5 $ 12.7 $ 14.6 $ 4.2 $195.1 $ (255.8) $ 411.6
========================================================================================================================
63
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.
- ------------------------------------------------------------------------------
OVERVIEW
Loews Corporation is a holding company. Its subsidiaries are engaged in the
following lines of business: property, casualty and life insurance (CNA
Financial Corporation ("CNA"), a 90% owned subsidiary); the production and
sale of cigarettes (Lorillard, Inc. ("Lorillard"), a wholly owned subsidiary);
the operation of hotels (Loews Hotels Holding Corporation ("Loews Hotels"), a
wholly owned subsidiary); the operation of offshore oil and gas drilling rigs
(Diamond Offshore Drilling, Inc. ("Diamond Offshore"), a 54% owned
subsidiary); the operation of an interstate natural gas transmission pipeline
system (Texas Gas Transmission, LLC ("Texas Gas"), a wholly owned subsidiary);
and the distribution and sale of watches and clocks (Bulova Corporation
("Bulova"), a 97% owned subsidiary).
Management's discussion and analysis of financial condition and results of
operations is comprised of the following sections:
Page No.
--------
Consolidated Financial Results 65
Classes of Common Stock 67
Parent Company Structure 67
Critical Accounting Estimates 68
Results of Operations by Business Segment 70
CNA Financial
Reserves - Estimates and Uncertainties 70
Third Quarter Reserve Review 73
Reinsurance 74
Terrorism Exposure 76
Restructuring 77
Expense Initiatives 78
Non-GAAP Financial Measures 78
Property and Casualty Segment 80
Group Segment 86
Life Segment 87
Other Insurance Segment 88
APMT Reserves 89
Lorillard 96
Loews Hotels 100
Diamond Offshore 100
Texas Gas 101
Bulova 102
Corporate 102
Liquidity and Capital Resources
CNA Financial 103
Lorillard 107
Loews Hotels 108
Diamond Offshore 108
Texas Gas 109
Bulova 109
Majestic Shipping 109
Corporate 110
Investments 111
Accounting Standards 122
64
Forward-Looking Statements Disclaimer 123
The following discussion should be read in conjunction with the Company's
Consolidated Condensed Financial Statements and Notes thereto.
CONSOLIDATED FINANCIAL RESULTS
The Company reported consolidated net income (including both the Loews Group
and Carolina Group) for the 2003 second quarter of $214.8 million, compared to
$198.8 million for the second quarter of 2002.
Consolidated net income in the second quarter of 2003 includes net
investment gains of $250.7 million, compared to a loss of $117.9 million in
the second quarter of 2002.
Net income attributable to Loews common stock for the second quarter of 2003
amounted to $189.8 million or $1.02 per share, compared to $157.4 million or
$0.84 per share in the comparable period of the prior year. Net income in the
second quarter of 2003 includes net investment gains attributable to Loews
common stock of $251.0 million, compared to losses of $119.1 million in the
comparable period of the prior year.
Results for the quarter ended June 30, 2003, included $277.3 million (after
tax and minority interest) of unfavorable net prior year reserve development
in CNA's property and casualty segment, of which approximately 80% relates to
accident year 2000 and prior. The significant unfavorable net prior year
premium and loss development was recorded primarily for workers compensation,
directors and officers coverages, and a recent adverse arbitration decision
involving a single large property and business interruption loss that occurred
in 1995. The results also included an increase in the bad debt reserves for
reinsurance and insurance receivables, catastrophe losses for the Texas
tornados and Midwest rain storms and decreased net investment income. These
adverse items were more than offset by increased net investment gains and
strong current accident year results. Results for the quarter were also
impacted by lower net income from Lorillard due to an increase in sales
promotion expenses and lower total sales unit volume.
Net investment results increased $368.6 million (after tax and minority
interest) in the second quarter of 2003 as compared with the same period in
2002. This increase was due primarily to increased gains on sales of fixed
maturity securities and a decrease in investment related impairment charges in
the second quarter of 2003. Investment related impairment losses (after tax
and minority interest) were $18.0 million for the second quarter of 2003 as
compared with $169.2 million for the same period in 2002.
Net income attributable to Carolina Group stock for the second quarter of
2003 was $25.0 million or $0.63 per Carolina Group share, compared to $41.4
million, or $1.03 per Carolina Group share in the second quarter of 2002.
Six Months Ended June 30, 2003 Compared With 2002
Net income for the first half of 2002 included a loss from discontinued
operations at CNA of $31.0 million or $0.16 per share of Loews common stock
and a charge for accounting changes of $39.6 million or $0.21 per share of
Loews common stock, related to accounting for goodwill and other intangible
assets at CNA.
Consolidated income from continuing operations for the first half of 2003
was $404.8 million, compared to $482.2 million in the comparable period of the
65
prior year. Income from continuing operations includes net investment gains of
$194.1 million (after tax and minority interest), compared to a loss of $102.1
million (after tax and minority interest) in the comparable period of the
prior year. The lower results reflect the unfavorable net prior year premium
and loss development recorded in the second quarter of 2003 for the property
and casualty segment as discussed above and the lower results from Lorillard,
partially offset by the improvement in net investment gains.
Income from continuing operations attributable to Loews common stock for the
first half of 2003 amounted to $351.2 million or $1.89 per share, compared to
$422.8 million or $2.23 per share in the comparable period of the prior year.
Income from continuing operations includes net investment gains attributable
to Loews common stock of $194.4 million, compared to losses of $103.6 million
in the comparable period of the prior year.
Net income attributable to Carolina Group stock for the first half of 2003
amounted to $53.6 million or $1.34 per Carolina Group share, compared to $59.4
million or $1.48 per share in the comparable period of the prior year.
Components of Net Income
The following table provides a reconciliation of net income attributable to
Loews common stock:
June 30,
- ------------------------------------------------------------------------------
Three Months Six Months
- ------------------------------------------------------------------------------
2003 2002 2003 2002
- ------------------------------------------------------------------------------
(In millions)
Income (loss) before net investment
gains (losses) attributable to
Loews common stock $ (61.2) $ 276.5 $ 156.8 $ 526.4
Net investment gains (losses) 251.0 (119.1) 194.4 (103.6)
- ------------------------------------------------------------------------------
Income from continuing operations 189.8 157.4 351.2 422.8
Discontinued operations-net (a) (31.0)
Cumulative effect of changes
in accounting principle-net (b) (39.6)
- ------------------------------------------------------------------------------
Net income attributable to
Loews common stock $ 189.8 $ 157.4 $ 351.2 $ 352.2
==============================================================================
(a) In the first quarter of 2002, CNA sold its life operations in Chile.
(b) Represents the effect of the adoption of SFAS No. 142, which was a change
in accounting for goodwill and other intangible assets at CNA.
66
CLASSES OF COMMON STOCK
The issuance of Carolina Group stock has resulted in a two class common
stock structure for Loews Corporation. Carolina Group stock, commonly called a
tracking stock, is intended to reflect the economic performance of a defined
group of assets and liabilities of the Company referred to as the Carolina
Group. The principal assets and liabilities attributed to the Carolina Group
are (a) the Company's 100% stock ownership interest in Lorillard, Inc.; (b)
notional, intergroup debt owed by the Carolina Group to the Loews Group ($2.3
billion outstanding at June 30, 2003), bearing interest at the annual rate of
8.0% and, subject to optional prepayment, due December 31, 2021; and (c) any
and all liabilities, costs and expenses arising out of or related to tobacco
or tobacco-related businesses.
As of June 30, 2003, the outstanding Carolina Group stock represents a
23.01% economic interest in the economic performance of the Carolina Group.
The Loews Group consists of all the Company's assets and liabilities other
than the 23.01% economic interest represented by the outstanding Carolina
Group stock, and includes as an asset the notional, intergroup debt of the
Carolina Group.
The existence of separate classes of common stock could give rise to
occasions where the interests of the holders of Loews common stock and
Carolina Group stock diverge or conflict or appear to diverge or conflict.
Subject to its fiduciary duties, the Company's board of directors could, in
its sole discretion, from time to time, make determinations or implement
policies that affect disproportionately the groups or the different classes of
stock. For example, Loews's board of directors may decide to reallocate
assets, liabilities, revenue, expenses and cash flows between groups, without
the consent of shareholders. The board of directors would not be required to
select the option that would result in the highest value for holders of
Carolina Group stock.
As a result of the flexibility provided to Loews's board of directors, it
might be difficult for investors to assess the future prospects of the
Carolina Group based on the Carolina Group's past performance.
The creation of the Carolina Group and the issuance of Carolina Group stock
does not change the Company's ownership of Lorillard, Inc. or Lorillard,
Inc.'s status as a separate legal entity. The Carolina Group and the Loews
Group are notional groups that are intended to reflect the performance of the
defined sets of assets and liabilities of each such group as described above.
The Carolina Group and the Loews Group are not separate legal entities and the
attribution of assets and liabilities to the Loews Group or the Carolina Group
does not affect title to the assets or responsibility for the liabilities.
Holders of the Company's common stock and of Carolina Group stock are
shareholders of Loews Corporation and are subject to the risks related to an
equity investment in Loews Corporation.
PARENT COMPANY STRUCTURE
The Company is a holding company and derives substantially all of its cash
flow from its subsidiaries, principally Lorillard. The Company relies upon its
invested cash balances and distributions from its subsidiaries to generate the
funds necessary to meet its obligations and to declare and pay any dividends
to its stockholders. The ability of the Company's subsidiaries to pay
dividends is subject to, among other things, (i) the availability of
sufficient funds in such subsidiaries, (ii) applicable state laws, (iii) in
67
the case of the insurance subsidiaries of CNA, laws and rules governing the
payment of dividends by regulated insurance companies (see Liquidity and
Capital Resources - CNA, below), and (iv) any agreements by the subsidiaries
restricting the payment of dividends. Claims of creditors of the Company's
subsidiaries will generally have priority as to the assets of such
subsidiaries over the claims of the Company and its creditors and
stockholders.
At June 30, 2003, the book value per share of Loews common stock was $66.96,
compared to $61.68 at December 31, 2002.
CRITICAL ACCOUNTING ESTIMATES
The preparation of 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 amounts
reported in the consolidated condensed financial statements and the related
notes. Actual results could differ from those estimates.
The consolidated condensed financial statements and accompanying notes have
been prepared in accordance with GAAP, applied on a consistent basis. The
Company continually evaluates the accounting policies and estimates used to
prepare the consolidated condensed financial statements. In general,
management's 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 management to be
critical to an understanding of the Company's financial statements as their
application places the most significant demands on management's judgment. Due
to the inherent uncertainties involved with this type of judgment, actual
results could differ significantly from estimates and have a material adverse
impact on the Company's 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 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. The inherent risks associated with the reserving process
are discussed below, in Reserves - Estimates and Uncertainties. Additionally,
a review of Results of Operations for CNA's segment results, Environmental
Pollution and Mass Tort and Asbestos Reserves, and Third Quarter Reserve
Review sections is necessary to understand the sensitivity of management's
estimate.
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 a receivable in the Consolidated Condensed
Balance Sheets. The cost of reinsurance related to long-duration contracts is
accounted for over the life of the underlying reinsured policies using
assumptions consistent with those used to account for the underlying policies.
68
The ceding of insurance does not discharge the primary liability of CNA. An
estimated allowance for doubtful accounts is recorded on the basis of
periodic evaluations of balances due from reinsurers, reinsurer solvency,
management's experience and current economic conditions. Further information
on reinsurance is provided in the Reinsurance section that follows.
Tobacco Litigation
Lorillard and other cigarette manufacturers continue to be confronted with
substantial litigation. Plaintiffs in most of the cases seek unspecified
amounts of compensatory damages and punitive damages, although some seek
damages ranging into the billions of dollars. Plaintiffs in some of the cases
seek treble damages, statutory damages, disgorgement of profits, equitable and
injunctive relief, and medical monitoring, among other damages.
Lorillard believes that it has valid defenses to the cases pending against
it. Lorillard also believes it has valid bases for appeal of the adverse
verdicts against it. To the extent the Company is a defendant in any of the
lawsuits, the Company believes that it is not a proper defendant in these
matters and has moved or plans to move for dismissal of all such claims
against it. While Lorillard intends to defend vigorously all tobacco products
liability litigation, it is not possible to predict the outcome of any of this
litigation. Litigation is subject to many uncertainties, and it is possible
that some of these actions could be decided unfavorably. Lorillard may enter
into discussions in an attempt to settle particular cases if it believes it is
appropriate to do so.
On May 21, 2003 a three judge panel of the Third District Court of Appeal in
Miami, Florida reversed a trial court's certification of a statewide class and
dismissed the Engle class action in its entirety. A $16.3 billion punitive
damage judgment against Lorillard had been awarded by a jury in this case, in
July of 2000, as part of the juries' award of $145.0 billion in punitive
damages against the major cigarette companies. Plaintiffs are seeking
reconsideration of the panel's decision and to have certain questions of law
certified for decision to the Florida Supreme Court. The Company and Lorillard
believe that the panel's decision should be upheld on further appeals.
Except for the impact of the State Settlement Agreements as described in
Note 12 of the Notes to Consolidated Condensed Financial Statements included
in Item 1 of this Report, management is unable to make a meaningful estimate
of the amount or range of loss that could result from an unfavorable outcome
of pending litigation and, therefore, no provision has been made in the
consolidated condensed financial statements for any unfavorable outcome. It is
possible that the Company's results of operations, cash flows and its
financial position could be materially affected by an unfavorable outcome of
certain pending litigation.
Valuation of Investments and Impairment of Securities
The Company classifies its holdings of fixed maturity securities (bonds and
redeemable preferred stocks) and equity securities, which are held principally
by insurance subsidiaries, as available-for-sale, and are carried at fair
value. Changes in fair value are recorded as a component of accumulated other
comprehensive income in shareholders' equity, net of applicable deferred
income taxes and participating policyholders' and minority interest. The
amortized cost of fixed maturity securities is adjusted for amortization of
premiums and accretion of discounts to maturity, which are included in
investment income.
69
The Company's investment portfolio is subject to market declines below book
value that may be other-than-temporary. CNA has an Impairment Committee, which
reviews its 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 period in which the
determination occurred. See "Investments - CNA" in this Management's
Discussion and Analysis of Financial Condition and Results of Operations
("MD&A") and Note 2 of the Notes to Consolidated Condensed Financial
Statements included in Item 1 for information related to the Company's
impairment charges.
Securities in the parent company's investment portfolio that are not part of
its cash management activities are classified as trading securities in order
to reflect the Company's investment philosophy. These investments are carried
at fair value with the net unrealized gain or loss included in the
Consolidated Condensed Statements of Income.
RESULTS OF OPERATIONS BY BUSINESS SEGMENT
CNA Financial
CNA conducts its operations through five operating groups: Standard Lines,
Specialty Lines and CNA Re (these groups comprise the Company's Property-
Casualty segment); Group Operations and Life Operations. In addition to these
five operating segments, certain other activities are reported in the Other
Insurance segment.
During 2002, CNA underwent management changes and strategic realignment.
These events have changed the way CNA manages its operations and makes
business decisions and, therefore, necessitated a change in CNA's reportable
segments. The financial results for the segment changes are reflected
throughout the MD&A.
The Other Insurance segment is principally comprised of losses and expenses
related to the centralized adjusting and settlement of APMT claims, certain
run-off insurance operations and other operations including CNA's interest
expense on its corporate borrowings.
Certain amounts applicable to prior periods have been reclassified to
conform to the current period presentation.
Reserves - Estimates and Uncertainties
CNA maintains reserves to cover its estimated ultimate unpaid liability for
claim and claim adjustment expenses and future policy benefits, including the
estimated cost of the claims adjudication process, for claims that have been
reported but not yet settled and claims that have been incurred but not
reported. Claim and claim adjustment expense and future policy benefit
reserves are reflected as liabilities on the Consolidated Condensed Balance
Sheets under the heading "Insurance Reserves." Adjustments to prior year
reserve estimates, if necessary, are reflected in results of operations in the
period that the need for such adjustments is determined.
The level of Insurance Reserves maintained by CNA represents management's
best estimate, as of a particular point in time, of what the ultimate
settlement and administration of claims will cost based on its assessment of
facts and circumstances known at that time. Insurance Reserves are not an
exact calculation of liability but instead are complex estimates that are
derived by CNA, generally utilizing a variety of actuarial reserve estimation
70
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 CNA makes 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 the
Company's evaluation of each type of business. Many of these uncertainties are
not precisely quantifiable, particularly on a prospective basis, and require
significant judgment on the part of CNA's management.
Given the factors described above, it is not possible to quantify precisely
the ultimate exposure or range of exposures represented by claims and related
litigation. As a result, CNA regularly reviews the adequacy of its reserves
and reassesses its reserve estimates as historical loss experience develops
and additional claims are reported and settled or additional information
becomes available in subsequent periods.
In addition, CNA is 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 CNA's business
by either extending coverage beyond the original underwriting intent or by
increasing the number or size of claims. Recent examples of emerging or
potential claims and coverage issues include:
. increases in the number and size of water damage claims, including those
related to expenses for testing and remediation of mold conditions;
. increases in the number and size of claims relating to injuries from
medical products, and exposure to lead;
. changes in interpretation of the named insured provision with respect to
the uninsured/underinsured motorist coverage in commercial automobile
policies;
. the effects of recently uncovered 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; and
. a growing trend of plaintiffs targeting insurers in class action
litigation relating to claims handling and other practices; and
. increases in the number of construction defect claims.
The future 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 CNA's claim and claim adjustment expense reserves and
could lead to future reserve additions. See CNA's Segment Results for a
discussion of changes in reserve estimates and the impact on CNA's results of
operations.
CNA's experience has been that establishing reserves for casualty coverages
relating to APMT claim and claim adjustment expenses is subject to
71
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;
. 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;
. increased filings of claims in certain states to avoid the application of
tort reform statute effective dates;
. the risks and lack of predictability inherent in major litigation;
. a further increase or decrease in asbestos and environmental claims which
cannot now be anticipated;
. continued increase in mass tort claims relating to silica and silica-
containing products, and the outcome of ongoing disputes as to coverage
in relation to these claims;
. the role the exhaustion of primary limits for certain accounts and
increased demands of any umbrella or excess policies CNA has issued;
. the number and outcome of direct actions against CNA; and
. future developments pertaining to CNA's ability to recover reinsurance
for asbestos and environmental claims.
It is also not possible to predict changes in the legal and legislative
environment and their 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 CNA's carried loss reserves.
Due to the factors described above, among others, 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 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
72
traditional actuarial methods and techniques are necessarily supplemented with
additional estimating techniques and methodologies, many of which involve
significant judgments that are required of CNA 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, CNA may be required to record material changes in its claim
and claim adjustment expense reserves in the future, should new information
become available or other developments emerge. See the Environmental Pollution
and Mass Tort and Asbestos Reserves section of the MD&A for additional
information relating to APMT claims and reserves.
CNA's recorded Insurance Reserves, including APMT reserves, reflect
management's best estimate as of a particular point in time based upon known
facts, current law and management's judgment. In light of the many
uncertainties associated with establishing the estimates and making the
assumptions necessary to establish reserve levels, CNA reviews its reserve
estimates on a regular basis and makes adjustments in the period that the need
for such adjustments is determined. These reviews have resulted in CNA
identifying information and trends that have caused CNA to increase its
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 CNA's business, insurer financial
strength and debt ratings and the Company's results of operations or equity.
Third Quarter Reserve Review
Adverse trends in APMT and certain non-APMT property and casualty segments
continue to impact the property and casualty insurance industry. As noted in
Reserves - Estimates and Uncertainties, CNA reviews its Insurance Reserves on
a regular basis. As part of these reviews, CNA has noted an increase in
reported construction defect claims. In addition, other volatile exposures
will also be reviewed on a comprehensive basis in the third quarter.
While CNA continues to monitor and evaluate its APMT exposures on a regular
basis, the completion of a comprehensive ground up analysis of its APMT
exposures, previously scheduled for the second quarter, will be completed in
the third quarter of 2003. Significant resources were dedicated to the
proposed national asbestos reform legislation, as discussed in Reserves -
Estimates and Uncertainties section of the MD&A, and to support the regulatory
reviews described below. As such, CNA plans to complete its more formal and
comprehensive analysis in the third quarter of 2003.
In addition, in connection with routine state regulatory exams of
Continental Casualty Company ("CCC") and Continental Insurance Company
("CIC"), an independent actuarial firm is in the process of reviewing CNA's
property and casualty Insurance Reserves as of December 31, 2001. CNA intends
to have the independent actuarial firm update its review to include an
assessment of its December 31, 2002 property and casualty Insurance Reserves
using more recent data. These independent reviews are expected to be completed
by December 31, 2003. CNA will consider the results of these independent
actuarial reviews in the reserving process. It is uncertain as to what action,
if any, the state departments of insurance may take as a result of these
examinations.
While CNA management believes that CNA's property and casualty Insurance
Reserves as of June 30, 2003 are appropriate and represent CNA management's
best estimate of what the ultimate settlement and administration of claims
will cost based on its assessment of facts and circumstances known at that
time, CNA, as a result of the Third Quarter Reviews, the reviews being
73
conducted by the independent actuarial firm and other factors deemed relevant
by the Company, may in future periods determine that its recorded Insurance
Reserves are not sufficient and may need to increase its reserves by amounts
that may be material, which could adversely affect CNA's business, insurer
financial strength and debt ratings (see the Ratings section of Liquidity -
CNA, in the MD&A) and the Company's results of operations and equity.
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.
Reinsurance
CNA assumes and cedes reinsurance with other insurers, reinsurers and
members of various reinsurance pools and associations. CNA utilizes
reinsurance arrangements to limit its maximum loss, provide greater
diversification of risk, minimize exposures on larger risks and to exit
certain lines of business.
Interest cost on reinsurance contracts accounted for on a funds withheld
basis is credited during all periods in which a funds withheld liability
exists. Interest cost, which is included in net investment income, was $93.5
and $56.4 million for the three months ended June 30, 2003 and 2002 and $140.2
and $114.5 million for the six months ended June 30, 2003 and 2002. The amount
subject to interest crediting rates on such contracts was $2,500.0 and
$2,766.0 million at June 30, 2003 and December 31, 2002.
The amount subject to interest crediting on these funds withheld contracts
will vary over time based on a number of factors, including the timing of loss
payments and ultimate gross losses incurred. CNA expects that it will continue
to incur significant interest costs on these contracts for several years.
The ceding of insurance does not discharge the primary liability of CNA.
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 assumed under reinsurance agreements.
As previously reported in the Company's Annual Report on Form 10-K for the
year ended December 31, 2002, CNA has reinsurance receivables from several
reinsurers who have recently experienced multiple downgrades of their
financial strength ratings, have announced that they will no longer accept new
business and are placing their books of business into run-off. One of CNA's
principal credit exposures from these recent events arises from reinsurance
receivables from Gerling Global ("Gerling").
CNA has been in discussions with Gerling with respect to resolving a dispute
concerning possession of collateral on three CNA HealthPro treaties, and is in
discussions regarding a possible commutation of all other reinsurance
arrangements between CNA and Gerling. The three CNA HealthPro treaties were
commuted as of June 30, 2003, which resulted in a $37.0 million pretax loss.
CNA estimates that these commutations will reduce pretax interest expense
related to these treaties by approximately $8.0 million over the balance of
2003 and $11.0 million in 2004.
In certain circumstances, including significant deterioration of a
reinsurer's financial strength ratings, CNA may engage in other 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
74
commutations, including any related to Gerling, could have an adverse material
impact on the Company's results of operations or equity.
CNA has established an allowance for doubtful accounts to provide for
estimated uncollectible reinsurance receivables. The allowance for doubtful
accounts was $239.9 and $195.7 million at June 30, 2003 and December 31, 2002.
CNA increased the allowance by $40.0 million in the second quarter of 2003 in
recognition of deterioration of the financial strength ratings of several
reinsurers. While CNA believes the allowance for doubtful accounts is adequate
based on existing collateral and information currently available, failure of
reinsurers to meet their obligations could have a material adverse impact on
the Company's results of operations or equity.
CNA has an aggregate reinsurance treaty related to the 1999 through 2001
accident years that covers substantially all of CNA's property and casualty
lines of business (the "Aggregate Cover"). The Aggregate Cover provides for
two sections of coverage. These coverages attach at defined loss ratios for
each accident year. Coverage under the first section of the Aggregate Cover,
which is available for all accident years covered by the treaty, has a $500.0
million limit per accident year of ceded losses and an aggregate limit of $1.0
billion of ceded losses for the three accident years. The ceded premiums
associated with the first section are a percentage of ceded losses and for
each $500.0 million of limit the ceded premium is $230.0 million. The second
section of the Aggregate Cover, which only relates to accident year 2001,
provides additional coverage of up to $510.0 million of ceded losses for a
maximum ceded premium of $310.0 million. Under the Aggregate Cover, interest
charges on the funds withheld liability accrue at 8% per annum. If the
aggregate loss ratio for the three-year period exceeds certain thresholds,
additional premiums may be payable and the rate at which interest charges are
accrued would increase to 8.25% per annum commencing in 2006.
During the second quarter of 2003, as a result of the unfavorable reserve
development recorded related to accident year 2000, losses of $78.0 million
were ceded under the first section of the Aggregate Cover. In 2001, as a
result of reserve additions including those related to accident year 1999, the
$500.0 million limit related to the 1999 accident year under the first section
was fully utilized and losses of $510.0 million were ceded under the second
section as a result of losses related to the September 11, 2001 World Trade
Center Disaster and related events ("WTC event").
The impact of the Aggregate Cover on pretax results of operations was as
follows:
Three Months Ended Six Months Ended
June 30, June 30,
- --------------------------------------------------------------------- -------------------------
2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------
(In millions)
Ceded earned premiums $ (28.0) $ (28.0)
Ceded claim and claim adjustment expense 78.0 78.0
Interest charges (included in net
investment income) (22.0) $ (12.0) (35.0) $ (25.0)
- ------------------------------------------------------------------------------------------------
Pretax benefit (expense) $ 28.0 $ (12.0) $ 15.0 $ (25.0)
================================================================================================
75
In 2001, CNA entered into a one-year aggregate reinsurance treaty related to
the 2001 accident year covering substantially all property and casualty lines
of business in the Continental Casualty Company pool (the "CCC Cover"). The
loss protection provided by the CCC Cover has an aggregate limit of
approximately $760.0 million of ceded losses. The ceded premiums are a
percentage of ceded losses. The ceded premium related to full utilization of
the $760.0 million of limit is $456.0 million. The CCC Cover provides
continuous coverage in excess of the second section of the Aggregate Cover
discussed above. Under the CCC Cover, interest charges on the funds withheld
generally accrue at 8.0% per annum. The interest rate increases to 10.0% per
annum if the aggregate loss ratio exceeds certain thresholds. Losses of $745.0
million have been ceded under the CCC Cover through June 30, 2003.
The impact of the CCC Cover on pretax results of operations was as follows:
Three Months Ended Six Months Ended
June 30, June 30,
- --------------------------------------------------------------------- -------------------------
2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------
(In millions)
Ceded earned premiums $ (91.0) $ (91.0) $ (61.0)
Ceded claim and claim adjustment expenses 126.0 126.0 93.0
Interest charges (27.0) $ (6.0) (35.0) (16.0)
- ------------------------------------------------------------------------------------------------
Pretax benefit (expense) $ 8.0 $ (6.0) $ 16.0
================================================================================================
The impact by operating segment of the Aggregate Cover and the CCC Cover on
results of operations was as follows:
Three Months Ended Six Months Ended
June 30, June 30,
- --------------------------------------------------------------------- -------------------------
2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------
(In millions)
Standard Lines $ 36.0 $ (13.0) $ 23.0 $ (25.0)
Specialty Lines (2.0) (2.0) (4.0) (4.0)
CNA Re 2.0 (3.0) (3.0) 20.0
- ------------------------------------------------------------------------------------------------
Total Property and Casualty 36.0 (18.0) 16.0 (9.0)
Corporate and Other (1.0)
- ------------------------------------------------------------------------------------------------
Pretax benefit (expense) $ 36.0 $ (18.0) $ 15.0 $ (9.0)
================================================================================================
Terrorism Exposure
CNA and the insurance industry incurred substantial losses related to the
WTC event. For the most part, the industry was able to absorb the loss of
76
capital from these losses, but the capacity to withstand the effect of any
additional terrorism events was significantly diminished.
On November 26, 2002, the President of the United States of America, signed
into law the Terrorism Risk Insurance Act of 2002 (the "Act"), which
established a program within the Department of the Treasury under which the
federal government will share the risk of loss from future terrorist attacks
with the insurance industry. The Act terminates on December 31, 2005. Each
participating insurance company must pay a deductible before federal
government assistance becomes available. This deductible is based on a
percentage of direct earned premiums for commercial insurance lines from the
previous calendar year, and rises from 1.0% from date of enactment to December
31, 2002 (the "Transition Period") to 7.0% during the first subsequent
calendar year, 10.0% in year two and 15.0% in year three. For losses in excess
of a company's deductible, the federal government will cover 90.0% of the
excess losses, while companies retain the remaining 10.0%. Losses covered by
the program will be capped annually at $100.0 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
3.0% of annual premium.
Insurance companies providing commercial property and casualty insurance are
required to participate in the program, but it does not cover life or health
insurance products. State law limitations applying to premiums and policies
for terrorism coverage are not generally affected under the program, but they
are pre-empted in relation to prior approval requirements for rates and forms.
The Act has policyholder notice requirements in order for insurers to be
reimbursed for terrorism-related losses and, from the date of enactment until
December 31, 2004, a mandatory offer requirement for terrorism coverage,
although the coverage may be rejected by insureds. The Secretary of the
Department of the Treasury has discretion to extend this offer requirement
until December 31, 2005.
While the Act provides the property and casualty industry with an increased
ability to withstand the effect of a terrorist event through 2005, given the
unpredictability of the nature, targets, severity or frequency of potential
terrorist events, the Company's results of operations or equity could
nevertheless be materially adversely impacted by them. CNA is attempting to
mitigate this exposure through its underwriting practices, policy terms and
conditions (where applicable) and the use of reinsurance. In addition, under
state laws, CNA is generally prohibited from excluding terrorism exposure from
its primary workers compensation, individual life and group life and health
policies. In those states that mandate property insurance coverage of damage
from fire following a loss, CNA is also prohibited from excluding terrorism
exposure under such coverage.
Reinsurers' obligations for terrorism-related losses under reinsurance
agreements are not covered by the Act. CNA's current reinsurance arrangements
either exclude terrorism coverage or significantly limit the level of
coverage.
Restructuring
As previously reported in the Company's Annual Report on Form 10-K for the
year ended December 31, 2002, CNA finalized and approved two separate
restructuring plans in 2001. The first plan related to CNA's Information
Technology operations (the "IT Plan"). The second plan related to
77
restructuring the property and casualty segments and Life Operations,
discontinuation of the variable life and annuity business and consolidation of
real estate locations (the "2001 Plan").
No restructuring and other related charges related to the IT Plan were
incurred for the three and six months ended June 30, 2003 and 2002. During
2003, $1.0 million in payments were charged against the liability. As of June
30, 2003, the accrued liability relating to employee termination and related
benefit costs was $4.0 million. The remaining accrual is expected to be paid
through 2004.
No restructuring and other related charges related to the 2001 Plan were
incurred for the three and six months ended June 30, 2003 and 2002. During
2003, $11.0 million in payments for occupancy and employee related costs and
$1.0 million of other restructuring costs were charged against the liability.
As of June 30, 2003, the accrued liability, relating primarily to lease
termination costs, was $26.0 million. Of the remaining accrual, approximately
$6.0 million is expected to be paid in the remainder of 2003.
Expense Initiatives
CNA has launched a $200.0 million expense reduction initiative. The primary
components of the initiative are a reduction of the current workforce by
approximately five percent, lower commissions and other acquisition costs,
principally related to workers compensation, and reduced spending in other
areas. Strategies expected to realize such savings are anticipated to be
implemented over the next year.
Non-GAAP Financial Measures
The MD&A discusses certain GAAP and non-GAAP financial measures in order to
provide information used by CNA management to monitor CNA's operating
performance. Management utilizes various financial measures to monitor CNA's
insurance operations and investment portfolio. Underwriting results, which are
derived from certain income statement amounts, are considered non-GAAP
financial measures and are used by management to monitor performance of CNA's
insurance operations. CNA's investment portfolio is monitored through analysis
of various quantitative and qualitative factors and certain decisions related
to the sale or impairment of investments that produce realized gains and
losses. Net realized investment gains and losses, which are comprised of
after-tax realized investment gains and losses net of participating
policyholders' and minority interest are a non-GAAP financial measure.
Underwriting results are computed as net earned premiums less net incurred
claims and the cost incurred to settle these claims, acquisition expenses,
underwriting expenses, and dividend expenses. CNA's management uses
underwriting results to monitor its insurance operations' results without the
impact of certain factors, including investment income, other revenues, other
expenses, minority interest, income tax benefit (expense) and net realized
investment gains or losses. Management excludes these factors in order to
analyze the direct relationship between the net earned premiums and the
related claims and the cost incurred to settle these claims, acquisition
expenses, underwriting expenses and dividend expenses.
Management excludes after-tax net realized investment gains or losses when
analyzing the insurance operations because net realized investment gains or
losses related to CNA's available-for-sale investment portfolio are largely
discretionary, except for losses related to other-than-temporary impairments,
78
and are generally driven by economic factors that are not necessarily
consistent with key drivers of underwriting performance.
Operating ratios are calculated using insurance results and are used by the
insurance industry and regulators such as state departments of insurance and
the National Association of Insurance Commissioners for financial regulation
and as a basis of comparison among companies. The ratios discussed in CNA's
MD&A are calculated using GAAP financial results and include the loss and loss
adjustment expense ratio ("loss ratio") as well as the expense, dividend and
combined ratios. 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.
CNA's investment portfolio is monitored by management through analyses of
various factors including unrealized gains and losses on securities, portfolio
duration and exposure to interest rate, market and credit risk. Based on such
analyses, CNA may impair an investment security in accordance with its policy,
or sell a security. Such activities will produce realized gains and losses.
While management uses various non-GAAP financial measures to monitor various
aspects of CNA's performance, relying on any measure other than net income,
which is the most directly comparable GAAP measure to underwriting results and
realized gains and losses, is not a complete representation of financial
performance. Management believes that its process of evaluating performance
through the use of these non-GAAP financial measures provides a basis for
understanding the operations and the impact to net income as a whole.
Management also believes that investors find these non-GAAP financial measures
described above useful to help interpret the underlying trends and
performance, as well as to provide visibility into the significant components
of net income.
Throughout the MD&A, CNA's business segment results are discussed using
Underwriting Results, which as described above is a non-GAAP measure. The
following reconciliations are provided in order to understand the differences
between Underwriting Results and net income (loss).
79
Three Months Ended Six Months Ended
June 30, June 30,
- --------------------------------------------------------------------- -------------------------
2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------
(In millions)
Underwriting loss $(493.0) $(125.0) $(568.0) $(229.0)
Net investment income 185.0 257.0 389.0 453.0
Other revenues 85.0 113.0 177.0 251.0
Other expenses (84.0) (95.0) (161.0) (197.0)
- ------------------------------------------------------------------------------------------------
(Loss) income, before income tax
benefit (expense), minority interest
and net realized investment gains (losses) (307.0) 150.0 (163.0) 278.0
Income tax expense (benefit) 120.0 (41.0) 85.0 (80.0)
Minority interest 17.2 (17.9) 3.8 (32.1)
- ------------------------------------------------------------------------------------------------
Operating (loss) income (169.8) 91.1 (74.2) 165.9
Realized investment gains (losses), net of
participating policyholders' and
minority interest 264.2 (58.3) 272.2 (48.3)
Income tax (benefit) expense on realized
investment gains (losses) (96.5) 22.0 (98.8) 20.0
- ------------------------------------------------------------------------------------------------
(Loss) income from continuing operations (2.1) 54.8 99.2 137.6
Cumulative effect of change in accounting
principle-net (33.3)
- ------------------------------------------------------------------------------------------------
Net (loss) income $ (2.1) $ 54.8 $ 99.2 $ 104.3
================================================================================================
Operating Results
Property and Casualty
CNA conducts its property and casualty operations through the following
operating segments: Standard Lines, Specialty Lines and CNA Re. In addition
to those operating segments, certain other are reported in the Other segment.
80
The following table summarizes key components of the Property and Casualty
Segment results of operations for the three and six months ended June 30, 2003
and 2002:
Three Months Ended Six Months Ended
June 30, June 30,
- ------------------------------------------------------------------------------------------------
2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------
(In millions)
Net written premiums $ 1,694.0 $ 1,788.0 $ 3,667.0 $ 3,578.0
Net earned premiums 1,621.0 1,735.0 3,437.0 3,396.0
Underwriting loss (493.0) (125.0) (568.0) (229.0)
(Loss) income before net realized
investment gains (losses) (169.8) 91.1 (74.2) 165.9
Net realized investment gains (losses) 167.7 (36.3) 173.4 (28.3)
(Loss) income from continuing operations (2.1) 54.8 99.2 137.6
Ratios
Loss and loss adjustment expense 91.6% 76.0% 81.0% 74.3%
Expense 38.1 30.3 34.7 31.5
Dividend 0.7 0.9 0.8 1.0
- ------------------------------------------------------------------------------------------------
Combined 130.4% 107.2% 116.5% 106.8%
================================================================================================
Three Months Ended June 30, 2003 Compared with 2002
Net written premiums for the Property-Casualty Segment decreased $94.0
million and net earned premiums decreased $114.0 million for the three months
ended June 30, 2003 as compared with the same period in 2002. These decreases
were due primarily to increased ceded premiums related to corporate aggregate
and other reinsurance treaties. Partially offsetting these items were rate and
production increases and new business through out the Property-Casualty
segment.
Standard Lines averaged rate increases of 17.0% and 28.0% for the three
months ended June 30, 2003 and 2002 for the contracts that renewed during the
period. Retention rates of 74.0% and 66.0% were achieved for those contracts
that were up for renewal.
Specialty Lines averaged rate increases of 24.0% for the three months ended
June 30, 2003 and 2002 for the contracts that renewed during the period.
Retention rates of 80.0% and 76.0% were achieved for those contracts that were
up for renewal.
Income from continuing operations decreased $56.9 million for the three
months ended June 30, 2003 as compared with the same period in 2002. The
decrease in results was primarily due to decreased underwriting results and
decreased net investment income, partially offset by increased net realized
investment gains.
The combined ratio increased 23.2 points and underwriting results decreased
$368.0 million for the three months ended June 30, 2003 as compared with the
same period in 2002. This change was due to increases in the loss and expense
ratios. The loss ratio increased 15.6 points due principally to unfavorable
net prior year development discussed below and $59.0 million of catastrophe
81
losses, primarily related to Texas tornados and Midwest rain storms in 2003.
Catastrophe losses were $6.0 million for the three months ended June 30, 2002.
Partially offsetting these items were improvements in the current net accident
year loss ratio and cessions to corporate aggregate reinsurance treaties.
The expense ratio increased 7.8 points as a result of a decreased net earned
premium base and a $39.0 million increase in pretax bad debt expense,
primarily related to Excess and Surplus ("E&S") lines. Based on recent
experience with troubled unsecured creditors, an increase in the bad debt
reserve was deemed appropriate. Also increasing the expense ratio was
approximately $17.0 million of expenses related to eBusiness in 2003. The 2002
eBusiness expenses were included in the Other Insurance segment.
Unfavorable net prior year development, including premium and claim and
allocated claim adjustment expense reserve development, of $485.0 million,
including $254.0 million of unfavorable claim and allocated claim adjustment
expense reserve development and $231.0 million of unfavorable premium
development, was recorded for the three months ended June 30, 2003.
Unfavorable net prior year development of $49.0 million, including $51.0
million of unfavorable claim and claim adjustment expense reserve development
and $2.0 million of favorable premium development, was recorded for the same
period in 2002.
Unfavorable net prior year development of approximately $310.0 million,
including $233.0 million of unfavorable claim and allocated claim adjustment
expense reserve development and $77.0 million of unfavorable premium
development, was recorded for large account business, driven by workers
compensation exposures. This development resulted from the completion of
reserve reviews for large account business where the insured is often
responsible for a portion of the losses, and claims are handled by CNA. The
review did not cover the large account business where claims are handled by a
third-party administrator ("TPA"). Initial reserves for this business are set
based on the expected losses associated with the individual accounts covered
and the terms of the individual plans. Based on analyses completed during the
second quarter, it became apparent that the assumptions regarding the number
and size of the losses, which were used to estimate the expected losses were
no longer appropriate. The analysis showed that the actual number of claims
and the average claim size were larger than expected. The development was
recorded in accident years prior to 2002.
Unfavorable net prior year claim and allocated claim adjustment expense
reserve development of approximately $75.0 million was recorded related to a
recent adverse arbitration decision involving a single large property and
business interruption loss. The decision was rendered against a voluntary
insurance pool in which CNA was a participant. The loss was caused by a fire
which occurred in 1995. CNA no longer participates in this pool.
Unfavorable net prior year claim and allocated claim adjustment expense
reserve development of approximately $75.0 million was recorded primarily for
directors and officers exposures. The reserve development was a result of a
claims review in the second quarter of 2003 of securities class action cases
related to certain known corporate malfeasance cases and investment banking
firms. The development was recorded in accident years 2000 through 2002.
Approximately $37.0 million of losses were recorded as the result of a
commutation of three ceded reinsurance treaties covering CNA HealthPro related
to accident years 1999 through 2001. Further information regarding this
commutation is provided in the Reinsurance section of the MD&A.
82
Approximately $25.0 million of unfavorable net prior year premium
development was recorded related to a second quarter 2003 reevaluation of
losses ceded to a reinsurance contract covering middle market workers
compensation exposures. The reevaluation of losses led to a new estimate of
the number and dollar amount of claims that would be ceded under the
reinsurance contract. As a result of the reevaluation of losses, CNA recorded
approximately $36.0 million of unfavorable claim and allocated claim
adjustment expense reserve development, which was ceded under this contract.
The development was recorded in accident year 2000.
Approximately $21.0 million of unfavorable net prior year claim and
allocated claim adjustment expense reserve development was recorded in the
Surety line of business as the result of recent developments on one large
claim.
Approximately $11.0 million of unfavorable net prior year claim and
allocated claim adjustment expense reserve development resulted from a program
covering facilities that provide services to developmentally disabled
individuals. This development was due to an increase in the size of known
claims and increases in policyholder defense costs. The reserve development
was recorded to accident years prior to 2001.
Unfavorable net prior year claim and claim adjustment expense reserve
development of approximately $11.0 million was recorded for a program covering
tow truck and ambulance operators, primarily impacting the 2001 accident year.
CNA had previously expected that loss ratios for this business would be
similar to its middle market commercial automobile liability business. During
2002, CNA ceased writing business under this program.
Offsetting these unfavorable reserve developments was an $85.0 million
underwriting benefit from cessions to corporate aggregate reinsurance
treaties. The benefit is comprised of $204.0 million of ceded losses and
$119.0 million of ceded premiums for accident years 2000 and 2001. See the
Reinsurance section of the MD&A for further discussion of CNA's aggregate
reinsurance treaties.
Recent concerns about reinsurance security, prompted in part by rating
agency downgrades of several reinsurer's financial strength ratings, have
impacted the reinsurance marketplace. Many ceding companies are seeking
provisions for the collateralization of assumed reserves in the event of a
financial strength ratings downgrade or other triggers. CNA Re has been
impacted by this trend and has entered into several contracts with rating or
other triggers. See the Ratings section of the MD&A for more information.
Six Months Ended June 30, 2003 Compared with 2002
Net written premiums for the Property-Casualty Segment increased $89.0
million and net earned premiums increased $41.0 million for the six months
ended June 30, 2003 as compared with the same period in 2002. These increases
were due primarily to increased ceded premiums related to corporate and other
aggregate reinsurance treaties. Partially offsetting this item were rate and
production increases and new business through out the Property-Casualty
segment.
Standard Lines averaged rate increases of 19.0% and 29.0% for the six months
ended June 30, 2003 and 2002 for the contracts that renewed during the period.
Retention rates of 73.0% and 66.0% were achieved for those contracts that were
up for renewal.
83
Specialty Lines averaged rate increases of 27.0% and 21.0% for the six
months ended June 30, 2003 and 2002 for the contracts that renewed during the
period. Retention rates of 80.0% and 76.0% were achieved for those contracts
that were up for renewal.
Income from continuing operations decreased $38.4 million for the six months
ended June 30, 2003 as compared with the same period in 2002. The decrease in
net income was primarily due to decreased underwriting results and decreased
net investment income partially offset by increased net realized investment
gains.
In addition, net income for the first quarter of 2002 included a non-
recurring currency translation gain on U.S. dollar denominated investments
held by an Argentinean subsidiary. The Argentine government changed its local
currency and required conversion of all U.S. denominated investments to
Argentine Pesos. This conversion resulted in a translation gain of $18.0
million, which was partially offset by a write-off of the goodwill of that
entity in the amount of $10.0 million.
The combined ratio increased 9.7 points and underwriting results decreased
$339.0 million for the six months ended June 30, 2003 as compared with the
same period in 2002. This change was due to increases in the loss and expense
ratios. The loss ratio increased 6.7 points due principally to unfavorable net
prior year development discussed below and $72.0 million of catastrophe
losses, primarily related to Texas tornados and Midwest rain storms.
Catastrophe losses were $9.0 million for the six months ended June 30, 2002.
Partially offsetting these declines were improvements in the current net
accident year loss ratio and cessions to corporate aggregate reinsurance
treaties.
The expense ratio increased 3.2 points as a result of a decreased net earned
premium base and a $39.0 million increase in pretax bad debt expense,
primarily related to Excess and Surplus ("E&S") lines. Based on recent
experience with troubled unsecured creditors, an increase in the bad debt
reserve was deemed appropriate. Also increasing the expense ratio was
approximately $33.0 million of expenses related to eBusiness in 2003. The 2002
eBusiness expenses were included in the Other Insurance segment.
Unfavorable net prior year development, including premium and claim and
allocated claim adjustment expense reserve development, of $514.0 million,
including $343.0 million of unfavorable claim and allocated claim adjustment
expense reserve development and $171.0 million of unfavorable premium
development, was recorded for the three months ended June 30, 2003.
Unfavorable net prior year reserve development of $10.0 million, including
$13.0 million of unfavorable claim and allocated claim adjustment expense
reserve development and $3.0 million of favorable premium development, was
recorded for the same period in 2002, of which $32.0 million of favorable
development, including $93.0 million of favorable claim and allocated claim
adjustment expense reserve development and $61.0 million of unfavorable
premium development, related primarily to the corporate aggregate reinsurance
treaties discussed below. The gross carried claim and allocated claim
adjustment expense reserve was $19,942.0 and $19,714.0 million at June 30,
2003 and December 31, 2002. The net carried claim and claim adjustment expense
reserve was $11,811.0 and $11,997.0 million at June 30, 2003 and December 31,
2002.
Unfavorable net prior year development of approximately $310.0 million,
including $233.0 million of unfavorable claim and allocated claim adjustment
expense reserve development and $77.0 million of unfavorable premium
84
development, was recorded for large account business, driven by workers
compensation exposures. This reserve development resulted from the completion
of reserve reviews for large account business where the insured is often
responsible for a portion of the losses, and claims are handled by CNA. The
review did not cover the large account business where claims are handled by a
TPA. Initial reserves for this business are set based on the expected losses
associated with the individual accounts covered and the terms of the
individual plans. Based on analyses completed during the second quarter, it
became apparent that the assumptions regarding the number and size of the
losses, which were used to estimate the expected losses were no longer
appropriate. The analysis showed that the actual number of claims and the
average claim size were larger than expected. The development was recorded in
accident years prior to 2002.
Unfavorable net prior year reserve claim and allocated claim adjustment
reserve development of approximately $75.0 million was recorded related to a
recent adverse arbitration decision involving a single large property and
business interruption loss. The decision was rendered against a voluntary
insurance pool in which CNA was a participant. The loss was caused by a fire
which occurred in 1995. CNA no longer participates in this pool.
Unfavorable net prior year claim and allocated claim adjustment expense
development of approximately $75.0 million was recorded primarily for
directors and officers exposures. The reserve development was a result of a
claims review in the second quarter of 2003 of securities class action cases
related to certain known corporate malfeasance cases and investment banking
firms. The reserve development was recorded in accident years 2000 through
2002.
Approximately $37.0 million of losses were recorded as the result of a
commutation of three ceded reinsurance treaties covering CNA HealthPro related
to accident years 1999 through 2001. Further information regarding this
commutation is provided in the Reinsurance section of the MD&A.
Unfavorable net prior year claim and allocated claim adjustment expense
reserve development of approximately $36.0 million was recorded for a program
covering tow truck and ambulance operators, primarily impacting the 2001
accident year. CNA had previously expected that loss ratios for this business
would be similar to its middle market commercial automobile liability
business. During 2002, CNA ceased writing business under this program.
Approximately $25.0 million of unfavorable net prior year premium
development was recorded related to a second quarter 2003 reevaluation of
losses ceded to a reinsurance contract covering middle market workers
compensation exposures. The reevaluation of losses led to a new estimate of
the number and dollar amount of claims that would be ceded under the
reinsurance contract. As a result of the reevaluation of losses, CNA recorded
approximately $36.0 million of unfavorable claim and allocated claim
adjustment expense reserve development, which was ceded under this contract.
The development was recorded in accident year 2000.
Approximately $21.0 million of unfavorable net prior year claim and
allocated claim adjustment expense reserve development was recorded in the
Surety line of business as the result of recent developments on one large
claim.
Approximately $21.0 million of unfavorable net prior year claim and
allocated claim adjustment expense reserve development resulted from a program
covering facilities that provide services to developmentally disabled
85
individuals. The development was due to an increase in the size of known
claims and increases in policyholder defense costs. The reserve development
was recorded in accident years prior to 2001.
Favorable prior year claim and allocated claim adjustment expense reserve
development was recorded in property lines primarily in the first quarter of
2003. The favorable reserve development was principally from accident years
2001 and 2002 and was the result of the lower than expected number of large
losses in recent years.
Offsetting these unfavorable developments was an $85.0 million underwriting
benefit from cessions to corporate aggregate reinsurance treaties. The benefit
is comprised of $204.0 million of ceded losses and $119.0 million of ceded
premiums for accident years 2000 and 2001. Favorable development of $32.0
million, including $93.0 million of favorable claim and allocated claim
adjustment expense reserve development and $61.0 million of unfavorable
premium development, was recorded for the six months ended June 30, 2002,
related primarily to the WTC event discussed below. See Reinsurance for
further discussion of CNA's aggregate reinsurance treaties.
During the first quarter of 2002, CNA Re revised its estimate of premiums
and losses related to the WTC event. In estimating CNA Re's WTC event losses,
CNA performed a treaty-by-treaty analysis of exposure. CNA's original loss
estimate was based on a number of assumptions including the loss to the
industry, the loss to individual lines of business and the market share of CNA
Re's cedants. Information that became available in the first quarter of 2002
resulted in CNA Re increasing its estimate of WTC event related premiums and
losses on its property facultative and property catastrophe business. The
impact of increasing the estimate of gross WTC event losses by $144.0 million
was fully offset on a net of reinsurance basis (before the impact of the CCC
Cover) by higher reinstatement premiums and a reduction of return premiums. As
a result, additional cessions were recorded to the CCC Cover.
Group
Three Months Ended June 30, 2003 Compared with 2002
Net earned premiums for Group Operations decreased $491.0 million for the
three months ended June 30, 2003 as compared with the same period in 2002. The
decrease in net earned premiums was due primarily to the transfer of the Mail
Handlers Plan. Net earned premiums for the Mail Handlers Plan were $535.0
million for the three months ended June 30, 2002. This item was partially
offset by premium growth in the disability, life and long term care products
within Group Benefits due to increased new sales and rate increases.
Group Operations achieved rate increases that averaged approximately 7.0%
and 6.0% for the three months ended June 30, 2003 and 2002 for the disability,
accident and life lines of business within Group Benefits for those contracts
that were renewed during the period. Premium persistency rates of
approximately 84.0% and 83.0% were achieved for those contracts that were up
for renewal for the three months ended June 30, 2003 and 2002.
Income from continuing operations increased by $28.5 million for the three
months ended June 30, 2003 as compared with the same period in 2002. The
increase in net operating income related primarily to an increase in net
realized investment gains, the positive impact of premium growth within Group
Benefits and the absence of unfavorable net operating results related to the
variable products business, which was sold to The Phoenix Companies, Inc. in
the third quarter of 2002. These items were partially offset by the absence of
86
net income related to the Mail Handlers Plan. See Investments for further
discussion on net investment income and net realized gains (losses).
Six Months Ended June 30, 2003 Compared with 2002
Net earned premiums for Group Operations decreased $1,081.0 million for the
six months ended June 30, 2003 as compared with the same period in 2002. The
decrease in net earned premiums was due primarily to the transfer of the Mail
Handlers Plan. Net earned premiums for the Mail Handlers Plan were $1,151.0
million for the six months ended June 30, 2002. This item was partially offset
by premium growth in the disability, life and long term care products within
Group Benefits due to increased new sales and rate increases.
Group Operations achieved rate increases that averaged approximately 6.0%
and 5.0% for the six months ended June 30, 2003 and 2002 for the disability,
accident and life lines of business within Group Benefits of those contracts
that were renewed during the period. Premium persistency rates of
approximately 86.0% and 79.0% were achieved for those contracts that were up
for renewal for the six months ended June 30, 2003 and 2002.
Income from continuing operations decreased by $6.4 million for the six
months ended June 30, 2003 as compared with the same period in 2002. The
decrease in net income related primarily to increased net realized investment
losses and the absence of net income related to the Mail Handlers Plan. These
items were partially offset by the absence of unfavorable results related to
the variable products business, which was sold to The Phoenix Companies, Inc.
in the third quarter of 2002, the positive impact of premium growth within
Group Benefits and favorable single premium guaranteed annuities mortality.
See Investments for further discussion of net investment income and net
realized gains (losses).
Life
Three Months Ended June 30, 2003 Compared with 2002
Net earned premiums for Life Operations increased $29.0 million for the
three months ended June 30, 2003 as compared with the same period in 2002. The
increase in net earned premiums was due primarily to higher sales of
structured settlement annuities and growth in the individual long term care
and life insurance products.
During the three months ended June 30, 2003, CNA completed a review of its
individual long term care product offerings. The focus of the review was to
determine whether the current products provide adequate pricing flexibility
under the range of reasonably possible claims experience levels. Based on the
review and current market conditions, CNA decided to significantly reduce new
sales of this product and certain infrastructure costs, and recorded $4.0
million pretax of associated severance costs in the second quarter of 2003.
Premium will continue to be received on inforce business, but the actions to
reduce new business will lower the rate of overall premium growth for this
line. CNA does not expect these actions to have a material adverse impact on
the results of operations.
Income from continuing operations increased by $38.0 million for the three
months ended June 30, 2003 as compared with the same period in 2002. The
increase in net income related primarily to increased net realized investment
gains and a $2.7 million improvement in net operating results for life
settlement contracts. Partially offsetting these items were unfavorable
individual long term care morbidity due to increased severity, the severance
87
costs noted above and decreased net investment income. See Investments for
further discussion on net investment income and net realized gains (losses).
Six Months Ended June 30, 2003 Compared with 2002
Net earned premiums for Life Operations increased $45.0 million for the six
months ended June 30, 2003 as compared with the same period in 2002. The
increase in net earned premiums was due primarily to growth in the individual
long term care product, higher sales of structured settlement annuities and
growth in life insurance products.
Income from continuing operations decreased by $17.1 million for the six
months ended June 30, 2003 as compared with the same period in 2002. The
decrease in net income related primarily to unfavorable individual long term
care morbidity, due to increased severity, the write-off of $4.5 million
after-tax of capitalized software costs and lower net investment income,
partially offset by increased net realized investment gains and a $3.6 million
improvement in results for life settlement contracts. Also contributing to the
decrease were severance costs related to the individual long term care
product. See Investments for further discussion on net investment income and
net realized gains (losses).
Other Insurance
Three Months Ended June 30, 2003 Compared with 2002
Total revenues, which include net earned premiums, net investment income,
other revenue and realized investment gains, increased $14.5 million for the
three months ended June 30, 2003 as compared with the same period in 2002. The
increase in total revenues was due primarily to increased realized investment
gains, partially offset by reduced revenues from CNA UniSource and reduced net
earned premiums in group reinsurance due to the exit of these businesses in
2002.
Income from continuing operations increased $33.9 million for the three
months ended June 30, 2003 as compared with the same period in 2002. The
increase was due primarily to increased net realized investment gains,
partially offset by a $23.4 million addition (after tax and minority interest)
to the allowance for doubtful accounts in recognition of deterioration of the
financial strength rating of several reinsurers. The 2003 results were
favorably impacted by the absence of eBusiness expenses, which beginning in
2003 were included in the property and casualty operating segments of CNA. In
addition, reduced losses from CNA UniSource favorably impacted net income. See
Investments for further discussion of net investment income and net realized
gains (losses).
Unfavorable net prior year claim and allocated claim adjustment expense
reserve development of $6.0 million related to certain run-off operations was
recorded for the three months ended June 30, 2003. Favorable net prior year
claim and allocated claim adjustment expense reserve development of $12.0
million was recorded for the same period in 2002.
Six Months Ended June 30, 2003 Compared with 2002
Total revenues, which include net earned premiums, net investment income,
other revenue and realized investment gains, increased $4.7 million for the
six months ended June 30, 2003 as compared with the same period in 2002. The
increase in total revenues was due primarily to increased realized investment
gains, partially offset by reduced revenues from CNA UniSource and reduced net
88
earned premiums in group reinsurance due to the exit of these businesses in
2002.
Income from continuing operations improved $81.8 million for the six months
ended June 30, 2003 as compared with the same period in 2002. The 2003 income
from continuing operations was favorably impacted by increased net realized
investment gains and the absence of eBusiness expenses, which beginning in
2003 were included in the property and casualty operating segments of the
Company. In addition, reduced losses from CNA UniSource favorably impacted the
results from operations. Partially offsetting these increases was a $23.4
million after-tax addition to the allowance for doubtful accounts in
recognition of deterioration of the financial strength rating of several
reinsurers. See Investments for further discussion on net investment income
and net realized gains (losses).
Unfavorable net prior year development, including premium and claim and
allocated claim adjustment expense reserve development, of $3.0 million,
including $9.0 million of unfavorable claim and allocated claim adjustment
expense reserve development and $6.0 million of favorable premium development,
related to certain run-off operations was recorded for the six months ended
June 30, 2003. Favorable net prior year development of $13.0 million,
including $10.0 million of favorable claim and claim adjustment expense
reserve development and $3.0 million of favorable premium development, was
recorded for the same period in 2002. The gross carried claim and allocated
claim adjustment expense reserve was $5,077.0 and $4,847.0 million at June 30,
2003 and December 31, 2002. The net carried claim and claim adjustment expense
reserve was $1,896.0 and $2,002.0 million for June 30, 2003 and December 31,
2002.
CNA entered into a retroactive reinsurance agreement as part of the sale of
CNA's personal insurance business to The Allstate Corporation ("Allstate") in
1999. CNA shares in indemnity and claim and allocated claim adjustment
expenses if payments related to losses incurred prior to October 1, 1999 on
the CNA policies transferred to Allstate exceed the claim and allocated claim
adjustment expense reserves of approximately $1.0 billion at the date of sale.
CNA must begin to reimburse Allstate for claim and allocated claim adjustment
expense payments when cumulative claim payments after October 1, 1999 on
losses occurring prior to that date exceed the $1.0 billion. CNA's remaining
obligation valued under this loss sharing provision as of October 1, 2003,
will be settled by agreement of the parties or by an independent actuarial
review of the unpaid claim liabilities as of that date. Cumulative payments of
indemnity and allocated loss adjustment expenses on such policies exceeded
$1.0 billion during the second quarter of 2003. CNA has established reserves
for its estimated liability under this loss sharing arrangement.
APMT Reserves
CNA's property and casualty insurance subsidiaries have actual and potential
exposures related to 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 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
89
methodologies, many of which involve significant judgments that are required
of CNA management. Accordingly a high degree of uncertainty remains for CNA's
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 CNA; 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 to avoid the
application of tort reform statute effective dates; a further increase in
asbestos and environmental claims which cannot now be anticipated; continued
increase in mass tort claims relating to silica and silica-containing
products, and the outcome of ongoing disputes as to coverage in relation to
these claims; the role the exhaustion of primary limits for certain accounts
and increased demands on any umbrella or excess policies CNA has issued; and
future developments pertaining to CNA's ability to recover reinsurance for
asbestos and environmental claims.
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, it may be necessary for CNA to record
material changes in its APMT claim and claim adjustment expense reserves in
the future, should new information become available or other developments
emerge.
The following table provides data related to CNA's APMT claim and claim
adjustment expense reserves:
June 30, 2003 December 31, 2002
- ------------------------------------------------------------------------------------------------
Environmental Environmental
Pollution and Pollution and
Mass Tort Asbestos Mass Tort Asbestos
- ------------------------------------------------------------------------------------------------
(In millions)
Gross reserves $ 780.0 $1,662.0 $ 830.0 $1,758.0
Ceded reserves (299.0) (501.0) (313.0) (527.0)
- ------------------------------------------------------------------------------------------------
Net reserves $ 481.0 $1,161.0 $ 517.0 $1,231.0
================================================================================================
Since 1999, CNA has performed semi-annual ground-up reviews of all open APMT
claims to evaluate the adequacy of CNA's APMT reserves. As noted in Third
Quarter Reserve Reviews, CNA is currently undergoing a ground-up review of all
open APMT claims. In doing so, CNA considers input from its analyst
professionals with direct responsibility for the claims, inside and outside
counsel with responsibility for representation of CNA, and its actuarial
staff. These professionals review, among many factors, the policyholder's
90
present and future exposures, including such factors as claims volume, trial
conditions, settlement demands and defense costs; the policies issued by CNA,
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.
Due to significant uncertainties previously described related to APMT
claims, the ultimate liability for these cases, both individually and in
aggregate, may exceed the recorded reserves. Prior reviews have at times
resulted in CNA strengthening its APMT reserves and management may strengthen
CNA's reserves as a result of the Third Quarter Reserve Reviews and any
subsequent reserve studies. Any such potential additional liability or range
of potential additional amounts, cannot be reasonably estimated currently, but
could be material to CNA's business, insurer financial strength and debt
ratings and the Company's results of operations and equity.
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 to
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 1,200 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.
Many policyholders have made claims against various CNA insurance
subsidiaries 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 coincides with CNA's adoption of the
Simplified Commercial General Liability coverage form, which includes what is
referred to in the industry as an "absolute pollution exclusion." CNA 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.
A number of proposals to reform Superfund have been made by various parties.
However no reforms were enacted by Congress during 2002 or during the first
six months of 2003, 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
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cleanup statutes and regulations. There can be no meaningful prediction of the
pattern of regulation that would result or the possible effect upon the
Company's results of operations or equity.
During 2002 and continuing into 2003, mass tort claims arising from alleged
injury due to exposure to silica and silica containing products have been
increasing. CNA is monitoring silica mass tort claims to assess what, if any,
impact the increased claims may have on mass tort reserves. As to other mass
tort subtypes, CNA has not experienced material negative development either in
the number of claims or in the emergence of new policyholders seeking coverage
for known mass tort sub-types. CNA's ultimate liability for its environmental
pollution and mass tort claims is impacted by several factors including
ongoing disputes with policyholders over scope and meaning of coverage terms
and, in the area of environmental pollution, court decisions that continue to
restrict the scope and applicability of the absolute pollution exclusion
contained in policies issued by CNA post 1989. Due to the inherent
uncertainties described above, including the inconsistency of court decisions,
the number of waste sites subject to cleanup, and in the area of environmental
pollution, the standards for cleanup and liability, the ultimate liability of
CNA for environmental pollution and mass tort claims may vary substantially
from the amount currently recorded.
As of June 30, 2003 and December 31, 2002, CNA carried approximately $481.0
and $517.0 million of claim and claim adjustment expense reserves, net of
reinsurance recoverables, for reported and unreported environmental pollution
and mass tort claims. There was no environmental pollution and mass tort net
claim and claim adjustment expense reserve development for the three and six
months ended June 30, 2003 and 2002. CNA paid environmental pollution-related
claims and mass tort-related claims, net of reinsurance recoveries, of $36.0
and $58.0 million for the six months ended June 30, 2003 and 2002.
Asbestos
CNA's property and casualty insurance subsidiaries also have exposure to
asbestos-related claims. Estimation of asbestos-related claim and claim
adjustment expense reserves involves many of the same limitations discussed
above for environmental pollution claims, such as inconsistency of court
decisions, specific policy provisions, allocation of liability among insurers
and insureds, and additional factors such as missing policies and proof of
coverage. Furthermore, estimation of asbestos-related claims is difficult due
to, among other reasons, the proliferation of bankruptcy proceedings and
attendant uncertainties, 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.
In the past several years, CNA has experienced 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. Currently, the majority of
asbestos bodily injury claims are filed by persons exhibiting few, if any,
disease symptoms. It is estimated that approximately 90% of the current non-
malignant asbestos claimants do not meet the American Medical Association's
definition of impairment. 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
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unless at some point the claimant's condition worsens to the point of
impairment.
Since 2002, at least 17 companies filed for bankruptcy protection citing
costs associated with asbestos claims litigation as a basis for filing. Since
1982, at least 67 companies, including the 17 companies that filed since 2002,
that mined asbestos, or manufactured or used asbestos-containing products,
have filed for bankruptcy. This phenomenon has prompted plaintiff attorneys to
file claims against companies that had only peripheral involvement with
asbestos. Many of these defendants were users or distributors of asbestos-
containing products, or manufacturers of products in which asbestos was
encapsulated. These defendants include equipment manufacturers, brake, gasket,
and sealant manufacturers, and general construction contractors. According to
a comprehensive report on asbestos litigation recently released by the Rand
Corporation, over 6,000 companies have been named as defendants in asbestos
lawsuits, with 75 out of 83 different types of industries in the United States
impacted by asbestos litigation. The study found that a typical claimant names
70 to 80 defendants, up from an average of 20 in the early years of asbestos
litigation.
Some asbestos-related defendants have asserted that their claims for
insurance are not subject to aggregate limits on coverage. CNA has 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 extent, if any, the attempts to assert "non-
products" claims outside the products liability aggregate will succeed. CNA
has attempted to manage its 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 CNA. Where CNA cannot settle a claim on acceptable
terms it aggressively litigates the claim. Adverse developments with respect
to such matters discussed in this paragraph could have a material adverse
effect on CNA's results of operations or equity.
Certain asbestos litigations in which CNA is currently engaged are described
below:
On February 13, 2003, CNA announced it had resolved asbestos related
coverage litigation and claims involving A.P. Green Industries, A.P. Green
Services and Bigelow - Liptak Corporation. Under the agreement, CNA will be
required to pay $74.0 million, net of reinsurance recoveries, over a ten year
period. The settlement resolves CNA's liabilities for all pending and future
asbestos claims involving A.P. Green Industries, Bigelow - Liptak Corporation
and related subsidiaries, including alleged "non-products" exposures. The
settlement is subject to bankruptcy court approval and confirmation of a
bankruptcy plan containing a channeling injunction to protect CNA from any
future claims.
CNA is engaged in insurance coverage litigation with underlying plaintiffs
who have asbestos bodily injury claims against the former Robert A. Keasbey
Company ("Keasbey") in New York State court (Continental Casualty Co. v.
Nationwide Indemnity Co. et al., No. 601037/03 (N.Y. County)). Keasbey, a
currently dissolved corporation, was a seller and installer of asbestos-
containing insulation products in New York and New Jersey. Thousands of
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plaintiffs have filed bodily injury claims against Keasbey; however Keasbey's
involvement at a number of worksites is a highly contested issue. Therefore,
the defense disputes the percentage of such claimants with possibly valid
claims against Keasbey. CNA issued Keasbey primary policies for 1970-1987 and
excess policies for 1972-1978. CNA has paid an amount substantially equal to
the policies' aggregate limits for products and completed operations claims.
Claimants against Keasbey allege, among other things, that CNA owes coverage
under sections of the policies not subject to the aggregate limits, an
allegation CNA vigorously contests in the lawsuit.
CNA has insurance coverage disputes related to asbestos bodily injury claims
against Burns & Roe Enterprises, Inc. ("Burns & Roe"). Originally raised in
litigation, now stayed, these disputes are currently part of In re: Burns &
Roe Enterprises, Inc., pending in the U.S. Bankruptcy Court for the District
of New Jersey, No. 00-41610. Burns & Roe provided engineering and related
services in connection with construction projects. At the time of its
bankruptcy filing, Burns & Roe faced approximately 11,000 claims alleging
bodily injury resulting from exposure to asbestos as a result of construction
projects in which Burns & Roe was involved. CNA allegedly provided primary
liability coverage to Burns & Roe from 1956-1969 and 1971-1974, along with
certain project-specific policies from 1964-1970.
CIC issued certain primary and excess policies to Bendix Corporation
("Bendix"), now part of Honeywell International Inc ("Honeywell"). Honeywell
faces approximately 50,000 pending asbestos bodily injury claims resulting
from alleged exposure to Bendix friction products. CIC's primary policies
allegedly covered the period from at least 1939 (when Bendix began to use
asbestos in its friction products) to 1983, although the parties disagree
about whether CIC's policies provided product liability coverage before 1940
and from 1945 to 1956. CIC asserts that it owes no further material
obligations to Bendix under any primary policy. Honeywell alleges that two
primary policies issued by CIC covering 1969-75 contain occurrence limits but
not product liability aggregate limits for asbestos bodily injury claims. CIC
has asserted, among other things, that even if Honeywell's allegation is
correct, which CNA denies, its liability is limited to a single occurrence
limit per policy or per year, and in the alternative, a proper allocation of
losses would substantially limit its exposure under the 1969-75 policies to
asbestos claims. These and other issues are being litigated in Continental
Insurance Co., et al. v. Honeywell International Inc., No. MRS-L-1523-00
(Morris County, New Jersey).
Policyholders have also initiated litigation directly against CNA and other
insurers in four jurisdictions: Ohio, Texas, West Virginia and Montana. In the
Ohio action, plaintiffs allege the defendants negligently performed duties
undertaken to protect the public from the effects of asbestos (Varner v. Ford
Motor Co., et al., (Cuyahoga County, Ohio)). Similar lawsuits have also been
filed in Texas against CNA, and other insurers and non-insurer corporate
defendants asserting liability for failing to warn of the dangers of asbestos
(Boson v. Union Carbide Corp., et al. (District Court of Nueces County,
Texas)). CNA has been named in Adams v. Aetna, Inc., et al. (Circuit Court of
Kanhwha County, West Virginia), a purported class action against CNA and other
insurers, alleging that the defendants violated West Virginia's Unfair Trade
Practices Act in handling and resolving asbestos claims against their
policyholders. A direct action has also been filed in Montana (Pennock, et al.
v. Maryland Casualty, et al., First Judicial District Court of Lewis & Clark
County, Montana) by eight individual plaintiffs (all employees of W.R. Grace &
Co. (W.R. Grace)) and their spouses against CNA, Maryland Casualty and the
State of Montana. This action alleges that CNA failed to fulfill its
obligations as W.R. Grace's Workers Compensation carrier because of the
94
alleged negligent failure of CNA to warn of or otherwise protect W.R. Grace
employees from the dangers of asbestos at a W.R. Grace vermiculite mining
facility in Libby, Montana. This action is currently stayed as to CNA because
of W.R. Grace's pending bankruptcy. On July 23, 2003, the stay of the
litigation was lifted by the District Court as to Maryland Casualty. The time
for an appeal by Maryland Casualty has not expired. The stay of the litigation
may also be lifted as to CNA. It is difficult to predict the outcome or
financial exposure represented by this type of litigation in light of the
broad nature of the relief requested and the novel theories asserted.
CNA is vigorously defending these and other cases and believes that it has
meritorious defenses to the claims asserted. However, there are numerous
factual and legal issues to be resolved in connection with these claims and it
is extremely difficult to predict the outcome or ultimate financial exposure
represented by these matters. Adverse developments with respect to any of
these matters could have a material adverse effect on CNA's business, insurer
financial strength and debt ratings and CNA's 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, CNA evaluates the exposure presented by each insured. As
part of this evaluation, CNA considers the available insurance coverage;
limits and deductibles; the potential role of other insurance, particularly
underlying coverage below any CNA 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
95
for individual claims;
. medical inflation trends;
. the mix of asbestos-related diseases presented and
. the ability to recover reinsurance.
CNA is also monitoring possible legislative reforms, including the possible
creation of a national privately financed trust, which if established and
approved through federal legislation, could replace litigation of asbestos
claims with payments to claimants from the trust. It is uncertain at the
present time whether such a trust will be created or, if it is, what will be
the terms and conditions of its establishment or its impact on CNA.
As of June 30, 2003 and December 31, 2002, CNA carried approximately
$1,161.0 and $1,231.0 million of claim and claim adjustment expense reserves,
net of reinsurance recoverables, for reported and unreported asbestos-related
claims. There was no asbestos-related net claim and claim adjustment expense
reserve development for the three and six months ended June 30, 2003 and 2002.
CNA paid asbestos-related claims, net of reinsurance, of $70.0 million for the
six months ended June 30, 2003 and had net reinsurance recoveries of $15.0
million for the six months ended June 30, 2002.
Lorillard
The tobacco industry in the United States, including Lorillard, continues to
be faced with a number of issues that have or may adversely impact the
business, results of operations and financial condition of Lorillard and the
Company, including the following:
. A substantial volume of litigation seeking compensatory and punitive
damages ranging into the billions of dollars, as well as equitable and
injunctive relief, arising out of allegations of cancer and other health
effects resulting from the use of cigarettes, addiction to smoking or
exposure to environmental tobacco smoke, including claims for
reimbursement of health care costs allegedly incurred as a result of
smoking, as well as other alleged damages.
. A $16.3 billion punitive damage judgment against Lorillard in Engle v.
R.J. Reynolds Tobacco Company, et al., a class action case in state court
in Florida in which the jury awarded a total of $145.0 billion in
punitive damages against all the defendants. On May 21, 2003 a three
judge panel of the Third District Court of Appeal reversed the trial
court's certification of the class and dismissed the case. On July 16,
2003 the plaintiff class filed a motion seeking reconsideration of the
panel's decision and seeking to have certain questions of law certified
for decision to the Florida Supreme Court.
. Substantial annual payments by Lorillard, continuing in perpetuity, and
restrictions on marketing and advertising agreed to under the terms of
the settlement agreements entered into between the major cigarette
manufacturers, including Lorillard, and each of the 50 states, the
District of Columbia, the Commonwealth of Puerto Rico and certain other
U.S. territories (together, the "State Settlement Agreements").
. Increases in state excise taxes and laws restricting smoking in public
places continue to adversely impact cigarette sales in the United States.
In the second quarter of 2003, domestic United States cigarette volume
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declined by 2.5% for the industry and 8.4% for Lorillard as compared to
the second quarter of 2002 (a decline of 7.8% and 10.9% respectively for
the first half of 2003 compared to the first half of 2002), according to
information provided by Management Science Associates, Inc. ("MSAI").
. Increases in industry-wide promotional expenses and sales incentives
implemented in reaction to the volume declines and impact of state excise
tax increases, and continuing intense competition among the four largest
cigarette manufacturers, including Lorillard, and many smaller
participants who have gained market share in recent years, principally in
the discount and deep-discount cigarette segment. Reflecting this, market
share for the deep discount brands increased 0.50 share points from 7.25%
in the second quarter of 2002 to 7.75% in the second quarter of 2003, as
estimated by MSAI.
. Continuing increases in state excise taxes on cigarette sales in the
second quarter of 2003, ranging from $0.25 per pack to $0.52 per pack, in
four states, as well as scheduled increases in other states throughout
2003 and proposals for additional increases in federal, state and local
excise taxes. Lorillard believes that increases in excise and similar
taxes have had an adverse impact on sales of cigarettes and that future
increases, the extent of which cannot be predicted, could result in
further volume declines for the cigarette industry, including Lorillard,
and an increased sales shift toward lower priced discount cigarettes
rather than premium brands.
. Increasing sales of counterfeit cigarettes in the United States, which
adversely impact sales by the manufacturer of the counterfeited brands
and potentially damage the value and reputation of those brands.
. Increases in actual and proposed federal, state and local regulation of
the tobacco industry and governmental restrictions on smoking.
See Part II, Item 1 - Legal Proceedings and Note 12 of the Notes to
Consolidated Condensed Financial Statements included in Part I, Item 1 of this
Report, for information with respect to the Engle action and other litigation
against cigarette manufacturers and the State Settlement Agreements.
Revenues decreased by $246.4 and $378.8 million, or 23.7% and 18.7%, and net
income decreased by $63.9 and $77.3 million, or 31.4% and 20.9%, for the three
and six months ended June 30, 2003, respectively, as compared to the
corresponding periods of the prior year.
Net income for the three months ended June 30, 2003 was reduced by a charge
of $16.8 million (net of taxes) related to the tobacco growers settlement
discussed in Liquidity and Capital Resources. Excluding that charge, net
income would have decreased by $47.1 million or 23.1%. Net income for the six
months ended June 30, 2003 included charges of $16.8 million in the second
quarter and $17.1 million in the first quarter of 2003 (net of taxes) related
to the tobacco growers settlement and an agreement with the Brown & Williamson
Corporation (the "B&W Agreement"). Excluding these charges, net income would
have decreased by $43.4 million, or 11.7% for the six months ended June 30,
2003.
The decline in revenues and net income reflect lower net sales of $246.0 and
$374.9 million due to decreased unit sales volume of approximately $58.4 and
$164.7 million and lower average unit prices which decreased revenues by
approximately $187.6 and $210.2 million. Unit sales volume declined 8.2% and
10.1% and sales promotion expenses increased for the three and six months
97
ended June 30, 2003 as compared to the comparable periods of the prior year.
Lorillard increased promotional expenses in the second quarter of 2003 in
response to higher competitive premium brand promotional spending and price
pressure due to the continued increases in state excise taxes.
The decline in net income also reflects charges for the tobacco growers
settlement and the B&W Agreement, partially offset by reduced tobacco
settlement costs. The $111.8 and $210.1 million decrease in tobacco settlement
costs for the three and six months ended June 30, 2003, as compared to the
comparable periods of the prior year, is due to the expiration of up-front
payments ($50.8 and $92.3 million), reduced charges for lower unit sales
volume ($15.6 and $42.2 million) and other adjustments ($45.4 and $75.6
million).
For the six months ended June 30, 2003, Lorillard's net wholesale price of
cigarettes increased by an average of $2.03 per thousand cigarettes ($0.04 per
pack of 20 cigarettes), or 1.6%, before the impact of any promotional
activities. Federal excise taxes are included in the price of cigarettes and
remained at $19.50 per thousand cigarettes ($0.39 per pack of 20 cigarettes).
The decreased unit prices reflect the increase in promotional expenses,
mostly in the form of retail/price promotions and other discounts provided to
retailers and passed through to the consumer, partially offset by the higher
average net wholesale prices in 2003.
Lorillard's total (U.S. domestic, Puerto Rico and certain U.S. Territories)
unit sales volume decreased 8.2% and 10.1% for the three and six months ended
June 30, 2003 as compared to the same periods a year ago while domestic
wholesale volume decreased 8.4% and 10.9% for the three and six months ended
June 30, 2003, as compared to the corresponding periods in 2002. Total
Newport's unit sales volume decreased by 6.5% and 7.9% for the three and six
months ended June 30, 2003 and domestic U.S. volume declined 6.7% and 8.9% for
the three and six months ended June 30, 2003 as compared to the corresponding
periods in 2002. In addition to pricing pressure due to the increases in state
excise taxes and the competitive impact of deep discount brands, Lorillard's
volume for the six months ended June 30, 2003 was affected by generally weak
economic conditions and ongoing limitations imposed by Philip Morris' retail
merchandising arrangements.
On May 5, 2003 Lorillard lowered the wholesale list price of its discount
brand, Maverick, by $11.00 per thousand cigarettes in an effort to reposition
the brand to be more competitive in the deep discount price cigarette segment.
Deep discount price brands produced by manufacturers who are not obligated
by the same payment terms of the State Settlement Agreements have continued to
increase their market share, which increased by 1.19 share points for the six
months ended June 30, 2003 to 7.91% of the domestic market. As a result of
lower payments, these companies can price their brands at a significant
advantage, by as much as 66%, as compared with offerings from the major
cigarette manufacturers.
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Three Months Ended Six Months Ended
June 30, June 30,
- ------------------------------------------------------------------------------------------------
2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------
Lorillard's share of the domestic market (1) 8.96% 9.55% 9.17% 9.50%
Lorillard's premium segment as a percentage
of its total domestic volume (1) 95.5% 94.5% 95.7% 94.5%
Newport share of the premium segment (1) 10.9% 11.7% 11.2% 11.4%
Total menthol segment market share for the industry (2) 26.6% 26.0% 26.7% 26.2%
Newport's share of the menthol segment 30.4% 29.8% 30.1% 30.3%
Newport as a percentage of Lorillard's (3):
Total volume 89.9% 88.2% 90.2% 88.1%
Net sales 89.1% 89.0% 91.3% 91.6%
Sources:
(1)Management Science Associates
(2)Excel - Retail Shipment Data (proprietary Lorillard data)
(3)Lorillard Shipment Reports
Total Lorillard and Newport second quarter 2003 share of domestic wholesale
shipments compared unfavorably with the prior year's quarter due to heavy
buying by wholesalers in the second quarter of 2002 in anticipation of
numerous state excise tax increases. Major introductions of competitive
premium brands in the second quarter 2003 disproportionately affected all
other shares, and the continued competitive price promotional pressures were
also contributing factors.
Lorillard's premium products sold as a percent of its total domestic volume
remained relatively flat for the three and six months ended June 30, 2003 as
compared to the same period of 2002.
Menthol cigarettes as a percent of the total industry remained relatively
flat. Newport, the industry's largest menthol brand, share of the menthol
segment improved to 30.4% in the second quarter of 2003, versus 29.8% in the
comparable period of 2002 and maintained an approximate 30% share of the
menthol segment in the first half of 2003.
Newport, a premium brand, accounted for approximately 90% of Lorillard's
unit sales for the three and six months ended June 30, 2003 as compared to
approximately 88% for the comparable periods of 2002.
Overall, domestic industry unit sales volume decreased 2.5% and 7.8% for the
three and six months ended June 30, 2003 as compared with corresponding
periods of 2002. Industry sales for premium brands were 73.8% and 73.4% of the
total domestic market for the three and six months ended June 30, 2003, as
compared to 72.0% and 73.3% of the total domestic market in the comparable
periods of 2002. Industry and Lorillard sales volume comparisons for the three
and six months ended June 30, 2003 were negatively impacted due to wholesaler
inventory adjustments during the first half of 2002. Wholesale inventories
increased in January of 2002 following the inventory reduction in the fourth
quarter of 2001 as a result of the federal excise tax increase that took
effect on January 1, 2002. In addition, wholesale inventories increased during
February and March of 2002 in anticipation of an industry price increase that
occurred in early April of 2002. After inventory reductions in April of 2002,
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wholesale inventories increased in May and June in anticipation of numerous
state excise tax increases scheduled for June 1 and July 1 of 2002.
Lorillard recorded pretax charges of $180.1, $291.9, $377.6 and $587.7
million ($116.3, $176.5, $236.9 and $357.2 million after taxes), for the three
and six months ended June 30, 2003 and 2002, respectively, to record its
obligations under various settlement agreements. Lorillard's portion of
ongoing adjusted settlement payments and related legal fees are based on its
share of domestic cigarette shipments in the year preceding that in which the
payment is due. Accordingly, Lorillard records its portions of ongoing
settlement payments as part of cost of manufactured products sold as the
related sales occur.
The State Settlement Agreements impose a stream of future payment
obligations on Lorillard and the other major U.S. cigarette manufacturers and
place significant restrictions on their ability to market and sell cigarettes.
The Company believes that the implementation of the State Settlement
Agreements will materially adversely affect its consolidated results of
operations and cash flows in future periods. The degree of the adverse impact
will depend, among other things, on the rates of decline in U.S. cigarette
sales in the premium and discount segments, Lorillard's share of the domestic
premium and discount segments, and the effect of any resulting cost advantage
of manufacturers not subject to all of the payments of the State Settlement
Agreements.
Loews Hotels
Revenues increased by $3.4 and $2.6 million, or 4.1% and 1.6%, and net
income decreased by $1.0 and $1.9 million or 14.9% and 15.0%, respectively,
for the three and six months ended June 30, 2003 as compared to the
corresponding periods of the prior year.
Revenues increased for the three and six months ended June 30, 2003, as
compared to 2002, due primarily to an increase in equity income from the
Universal Orlando properties reflecting the opening of the Royal Pacific
Hotel, partially offset by a decline in revenue per available room and lower
other hotel operating revenues. Revenue per available room decreased by $8.42
and $5.57, or 6.6% and 4.5%, to $118.24 and $117.72, respectively, due
primarily to lower occupancy rates, reflecting the continued economic weakness
and its impact on the travel industry.
Revenue per available room is an industry measure of the combined effect of
occupancy rates and average room rates on room revenues. Other hotel operating
revenues include, among other items, guest charges for food and beverages,
telecommunication services, garage and parking fees.
Net income decreased for the three and six months ended June 30, 2003, due
to the reduction in revenue per available room, partially offset by the
addition of the Royal Pacific Hotel at the Universal Orlando properties.
Diamond Offshore
Diamond Offshore's revenues vary based upon demand, which affects the number
of days the fleet is utilized and the dayrates earned. When a rig is idle, no
dayrate is earned and revenues will decrease as a result. Revenues can also
increase or decrease as a result of the acquisition or disposal of rigs. In
order to improve utilization or realize higher dayrates, Diamond Offshore may
mobilize its rigs from one market to another. During periods of mobilization,
however, revenues may be adversely affected. As a response to changes in
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demand, Diamond Offshore may withdraw a rig from the market by stacking it or
may reactivate a rig stacked previously, which may decrease or increase
revenues, respectively.
Operating income is primarily affected by revenue factors, but is also a
function of varying levels of operating expenses. Operating expenses generally
are not affected by changes in dayrates and may not be significantly affected
by fluctuations in utilization. For instance, if a rig is to be idle for a
short period of time, Diamond Offshore may realize few decreases in operating
expenses since the rig is typically maintained in a prepared state with a full
crew. In addition, when a rig is idle, Diamond Offshore is responsible for
certain operating expenses such as rig fuel and supply boat costs, which are
typically a cost of the operator under drilling contracts. However, if the rig
is to be idle for an extended period of time, Diamond Offshore may reduce the
size of a rig's crew and take steps to "cold stack" the rig, which lowers
expenses and partially offsets the impact on operating income.
Revenues decreased by $27.9 and $87.8 million, or 14.2% and 21.5%, and net
income decreased by $11.0 and $31.8 million for the three and six months ended
June 30, 2003, as compared to the corresponding periods of the prior year.
Revenues decreased due primarily to lower contract drilling revenue of $22.6
and $76.4 million, reduced investment income of $4.3 and $9.7 million, and
lower revenues from reimbursable expenses.
Revenues from high specification floaters and other semisubmersible rigs
decreased by $15.8 and $63.2 million, or 8.1% and 15.5%, for the three and six
months ended June 30, 2003, as compared the corresponding periods of the prior
year. The decrease reflects lower dayrates ($19.7 and $44.2 million) and lower
utilization ($1.5 and $23.8 million), partially offset by revenues generated
by the Ocean Patriot and the Ocean Vanguard ($5.4 and $6.3 million), which
were acquired in March 2003 and December 2002.
Revenues from jack-up rigs decreased $3.7 and $9.7 million, or 1.9% and
2.4%, due primarily to decreased dayrates ($1.5 and $3.8 million) and
decreased utilization ($2.2 and $5.9 million) for the three and six months
ended June 30, 2003, compared to the corresponding periods of 2002.
Investment income decreased by $4.3 and $9.7 million, or 56.4% and 56.5%,
for the three and six months ended June 30, 2003, primarily due to a reduction
in marketable securities held and lower yields on cash and marketable
securities for the three and six months ended June 30, 2003, compared to the
corresponding periods of 2002.
Net income decreased due primarily to the lower revenues for the three and
six months ended June 30, 2003 as discussed above and, for the three months
ended June 30, 2003, increased contract drilling expenses, partially offset by
a reduction in depreciation expense related to a change in the estimated
useful lives and salvage values of Diamond Offshore's drilling rigs.
Texas Gas
Revenues and net income for the three and six months ended June 30, 2003
reflect six weeks of operations from May 17, 2003, the date of acquisition.
See Note 9 of the Notes to Consolidated Condensed Financial Statements.
101
Bulova
Revenues and net income decreased by $7.7 and $0.7 million, or 18.6% and
26.9%, for the three months ended June 30, 2003 as compared to the
corresponding period of the prior year. Revenues and net income increased by
$0.7 and $0.7 million, or 0.9% and 16.7%, for the six months ended June 30,
2003, as compared to the corresponding period of the prior year.
Net sales decreased $7.7 million, or 18.8%, and increased $1.6 million, or
2.2%, for the three and six months ended June 30, 2003, as compared to the
corresponding periods of the prior year. The decrease in sales for the quarter
ended June 30, 2003 is primarily attributable to a decline in watch and clock
unit volume, partially offset by an increase in watch and clock selling
prices, respectively, as compared to the corresponding period of the prior
year. The increase in sales for the six months ended June 30, 2003 is
attributable to higher watch selling prices and clock unit sales volume,
partially offset by a decline in watch unit sales volume and clock selling
prices, as compared to the corresponding period of the prior year.
Net income for the three months ended June 30, 2003 decreased primarily due
to the decline in net sales discussed above. Net income for the six months
ended June 30, 2003 increased due primarily to the increased net sales and a
lower effective tax rate reflecting a settlement of prior years' franchise
taxes, partially offset by lower royalty income.
Corporate
Corporate operations consist primarily of investment income, including
investment gains (losses) from non-insurance subsidiaries, as well as equity
earnings from a shipping joint venture through Majestic Shipping Corporation
("Majestic"), corporate interest expenses and other corporate administrative
costs. Majestic, a wholly owned subsidiary, owns a 49% common stock interest
in Hellespont Shipping Corporation ("Hellespont"). Hellespont is engaged in
the business of owning and operating six ultra large crude oil tankers that
are used primarily to transport crude oil from the Persian Gulf to a limited
number of ports in the Far East, Northern Europe and the United States.
Exclusive of investment gains (losses), revenues declined by $5.0 million
and net loss decreased by $3.2 million for the three months ended June 30,
2003, and revenues decreased by $21.2 million and net loss increased by $6.6
million for the six months ended June 30, 2003, as compared to the
corresponding periods of the prior year.
Revenues decreased for the three months ended June 30, 2003 due primarily to
lower investment income of $15.9 million, partially offset by improved results
from shipping operations of $9.5 million. Net loss decreased for the three
months ended June 30, 2003 due to improved results from shipping operations of
$6.2 million, partially offset by the reduced investment income. Revenues
decreased and net loss increased for the six months ended June 30, 2003 due
primarily to lower investment income of $21.3 million ($8.6 million after
taxes) reflecting reduced yields on invested assets and lower results from
shipping operations of $4.1 million ($2.7 million after taxes).
102
The components of investment gains (losses) included in Corporate operations
are as follows:
Three Months Ended Six Months Ended
June 30, June 30,
- ------------------------------------------------------------------------------------------------
2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------
(In millions)
Derivative instruments $ (24.3) $ (13.2) $ (17.6) $ (3.2)
Equity securities, including short positions 45.9 (46.4) 8.6 (37.3)
Short-term investments (7.9) 16.8 (6.7) 24.1
Other 16.9 10.1 26.8 6.2
- ------------------------------------------------------------------------------------------------
30.6 (32.7) 11.1 (10.2)
Income tax (expense) benefit (10.6) 11.4 (3.8) 3.5
Minority interest 0.3 (2.7) 0.3 (3.7)
- ------------------------------------------------------------------------------------------------
Net gain (loss) $ 20.3 $ (24.0) $ 7.6 $ (10.4)
================================================================================================
LIQUIDITY AND CAPITAL RESOURCES
CNA
The principal operating cash flow sources of CNA's property and casualty and
life insurance subsidiaries are premiums and investment income. The primary
operating cash flow uses are payments for claims, policy benefits and
operating expenses.
For the six months ended June 30, 2003, net cash provided by operating
activities was $115.0 million as compared with $435.0 million for the same
period in 2002. The decrease related primarily to lower federal income tax
refunds in 2003 as compared with 2002.
Cash flows from investing activities include purchases and sales of
financial instruments, as well as the purchase and sale of land, buildings,
equipment and other assets not generally held for resale.
For the six months ended June 30, 2003, net cash provided by investing
activities was $48.0 million as compared with net cash used by investing
activities of $410.0 million for the same period in 2002. This improvement
related principally to sales of fixed maturity securities.
Cash flows from financing activities include proceeds from the issuance of
debt or equity securities, outflows for dividends or repayment of debt and
outlays to reacquire equity instruments.
For the six months ended June 30, 2003, net cash used by financing
activities was $149.0 million as compared with $22.0 million for the same
period in 2002. Cash flows used by financing activities were related
principally to repayment of debt.
CNA is closely managing the cash flows related to claims and reinsurance
recoverables from the WTC event. It is anticipated that significant claim
payments will be made prior to receipt of the corresponding reinsurance
103
recoverables. CNA does not anticipate any liquidity problems resulting from
these payments. As of July 3, 2003, CNA has paid $533.0 million in claims and
recovered $363.0 million from reinsurers.
CNA's estimated gross pretax losses for the WTC event were $1,648.0 million
pretax ($958.3 million after-tax and minority interest). Net pretax losses
before the effect of corporate aggregate reinsurance treaties were $727.0
million. Approximately 1.0%, 72.0% and 21.0% of the reinsurance recoverables
on the estimated losses related to the WTC event are from companies with S&P
ratings of AAA, AA or A.
Debt Financing
CNA has an existing shelf registration statement under which it may issue an
aggregate of $549.0 million of debt or equity securities, declared effective
by the SEC.
See the Company's Annual Report on Form 10-K for the year ended December 31,
2002 for a detailed discussion of the Company's debt.
During the first quarter of 2003, The Continental Corporation
("Continental") repaid its $128.0 million, 7.250% Senior Note, due March 1,
2003.
CNA pays a facility fee to the lenders for having funds available for loans
under the credit facility maturing April 30, 2004. The fee varies based on the
long term debt ratings of CNA. At June 30, 2003 and December 31, 2002, the
facility fee was 17.5 basis points.
CNA pays interest on any outstanding debt/borrowings under the facility
based on a rate determined using the long term debt ratings of CNA. The
interest rate is equal to the London Interbank Offering Rate ("LIBOR") plus
57.5 basis points. Further, if CNA has outstanding loans greater than 50.0% of
the amounts available under the facility, CNA will also pay a utilization fee
of 12.5 basis points on such loans. At June 30, 2003 and December 31, 2002,
the weighted-average interest rate on the borrowings under the facility,
including facility fees and utilization fees, was 2.2% and 2.3%.
A Moody's downgrade of the CNA senior debt rating from Baa2 to Baa3 would
increase the facility fee from 17.5 basis points to 25.0 basis points. The
applicable interest rate would increase from LIBOR plus 57.5 basis points to
LIBOR plus 75.0 basis points. The utilization fee would remain unchanged on
the facility at 12.5 basis points.
CNA Surety Corporation ("CNA Surety"), a 64.0% owned and consolidated
subsidiary of CNA, pays interest on any outstanding borrowings under its
credit agreement based on an applicable margin determined by the amount of
leverage of CNA. The current interest rate on any borrowings under the
facility is LIBOR plus 45.0 basis points. In addition, CNA Surety pays a
facility fee that is currently 12.5 basis points. If the utilization of the
credit facility is greater than 50.0% of the amount available under the
facility, an additional fee of 5.0 basis points will be incurred. At June 30,
2003, the aggregate commitment of the term loan component of the credit
agreement was reduced by $5.0 million to an aggregate commitment of $25.0
million. Effective January 30, 2003, CNA Surety entered into an interest rate
swap on the term loan portion of its credit agreement, which uses the 3-month
LIBOR to determine the swap increment. The term loan interest rate on June 30,
2003 was 2.6%. At June 30, 2003, the weighted-average interest rate on the
$55.0 million of outstanding borrowings under the credit agreement, including
104
facility fees and utilization fees was 2.3%. At December 31, 2002, the
weighted-average interest rate on the $60.0 million of outstanding borrowings
under the credit agreement, including facility fees and utilization fees was
2.0%. At June 30, 2003 and December 31, 2002, CNA Surety was in compliance
with all restrictive debt covenants.
Commitments and Contingencies
See Note 13 of the Notes to the Consolidated Condensed Financial Statements
for information related to CNA Surety's related party transactions with CNA.
The impact of these transactions should be considered when evaluating CNA's
liquidity and capital resources.
See Note 13 of the Notes to the Consolidated Condensed Financial Statements
for information related to CNA's commitments and contingencies. The impact of
these commitments and contingencies should be considered when evaluating CNA's
liquidity and capital resources.
CNA has commitments and contingencies that should be considered when
evaluating liquidity and capital resources.
Dividend Paying Ability
CNA's ability to pay dividends and other credit obligations is significantly
dependent on receipt of dividends from its subsidiaries. The payment of
dividends to CNA by its insurance subsidiaries without prior approval of the
insurance department of each subsidiary's 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 Insurance, may be paid only from earned surplus, which is
calculated by removing unrealized gains from unassigned surplus. As of June
30, 2003, CCC's earned surplus was in a positive position, thereby enabling
CCC to pay approximately $1,258.0 million of dividend payments during 2003
that would not be subject to the Department's prior approval. The actual level
of dividends paid in any year is determined after an assessment of available
dividend capacity, holding company liquidity and cash needs as well as the
impact the dividends will have on the statutory surplus of the applicable
insurance company.
In addition, by agreement with the New Hampshire Insurance Department, as
well as certain other state insurance departments, dividend payments for the
CIC pool are restricted to internal and external debt service requirements
through September 2003 up to a maximum of $85.0 million annually, without the
prior approval of the New Hampshire Insurance Department. CNA is currently in
discussions with the New Hampshire Insurance Department, which may result in
the extension of the term of this agreement through September 2004.
Ratings
Ratings have become an increasingly important factor in establishing the
competitive position of insurance companies. CNA's insurance company
subsidiaries are rated by major rating agencies, and these ratings reflect the
rating agency's opinion of the insurance company's financial strength,
operating performance, strategic position and ability to meet its obligations
to policyholders. Agency ratings are not a recommendation to buy, sell or hold
105
any security, and may be revised or withdrawn at any time by the issuing
organization. Each agency's rating should be evaluated independently of any
other agency's rating. One or more of these agencies could take action in the
future to change the ratings of CNA's insurance subsidiaries.
The actions that can be taken by rating agencies are changes in ratings or
modifiers. "On Review," "Credit Watch" and "Rating Watch" are modifiers used
by the ratings agencies to alert those parties relying on CNA's ratings of the
possibility of a rating change in the near term. 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. Modifiers are
generally used to indicate a possible change in rating within ninety days.
On August 7, 2003, the rating agencies took various actions with respect to
CNA's ratings. AM Best confirmed that the existing CNA insurance financial
strength and debt ratings remained unchanged. S&P placed all of CNA's
insurance financial strength and debt rating on Credit Watch with negative
implications. Moody's placed all of CNA's insurance financial strength and
debt ratings on review for possible downgrade. Fitch has lowered the insurance
financial strength ratings and senior debt ratings one level and placed all of
the ratings on Rating Watch Negative status.
The table below reflects the various group ratings issued by A.M. Best, S&P,
Moody's and Fitch as of August 7, 2003 for the Property and Casualty and Life
and Group companies. The table also includes the ratings for CNA's senior debt
and Continental senior debt.
Insurance Financial Strength Ratings Debt Ratings
- ------------------------------------------------------------------------------------------------
Property and Casualty Life & Group CNA Continental
- ------------------------------------------------------------------------------------------------
CCC CIC Senior Senior
Group Group CAC/VFL CNAGLA Debt Debt
- ------------------------------------------------------------------------------------------------
A.M. Best A A A A bbb bbb-
Fitch A- A- A+ A BBB- BBB-
Moody's A3 A3 A2* NR Baa2 Baa3
S&P A- A- A NR BBB- BBB-
NR = Not Rated
All modifiers for the insurance financial strength and debt ratings as
evaluated by Fitch are Rating Watch Negative, as evaluated by Moody's are on
review for possible downgrade, and as evaluated by S&P are Credit Watch with
negative implications.
*Continental Assurance Corporation ("CAC") and Valley Forge Life Insurance
Company ("VFL") are rated separately by Moody's and both have an A2 rating.
If CNA's ratings were downgraded, the Company's results of operations and/or
equity could be materially adversely affected. Among potential adverse effects
in the event of such downgrading would be the inability of CNA to access
certain markets or distribution channels, and also the required
collateralization of future payment obligations or reserves.
106
CNA has entered into several settlement agreements and assumed reinsurance
contracts that require collateralization of future payment obligations and
assumed reserves if CNA's ratings or other specific criteria fall below
certain thresholds. The ratings triggers are generally more than one level
below CNA's August 7, 2003 ratings.
Lorillard
Lorillard and other cigarette manufacturers continue to be confronted with
substantial litigation and regulatory issues. Approximately 4,500 product
liability cases are pending against cigarette manufacturers in the United
States. Of these, approximately 1,100 cases are pending in a West Virginia
court, and approximately 2,800 cases have been brought by flight attendants
alleging injury from exposure to environmental tobacco smoke in the cabins of
aircraft. Lorillard is a defendant in all of the flight attendant suits served
to date and is a defendant in most of the cases pending in West Virginia.
Except for the impact of the State Settlement Agreements as described in Note
12 of the Notes to Consolidated Condensed Financial Statements included in
Item 1 of this Report, management is unable to make a meaningful estimate of
the amount or range of loss that could result from an unfavorable outcome of
pending litigation and, therefore, no provision has been made in the
consolidated condensed financial statements for any unfavorable outcome. It is
possible that the Company's results of operations, cash flows and its
financial position could be materially affected by an unfavorable outcome of
certain pending litigation.
The terms of the State Settlement Agreements require significant payments to
be made to the Settling States which began in 1998 and continue in perpetuity.
Lorillard's cash payment under the State Settlement Agreements in the first
six months of 2003 was approximately $617.7 million. In 2003, Lorillard
anticipates its total payments under the State Settlement Agreements to range
from $750.0 to $800.0 million in accordance with the terms of those
agreements.
See Part II, Item 1 - Legal Proceedings and Note 12 of the Notes to
Consolidated Condensed Financial Statements included in Part I of this Report
for additional information regarding this settlement and other litigation
matters.
In 1977, Lorillard sold substantially all of its cigarette trademarks
outside of the United States and the international business associated with
those brands. Lorillard received notice from Brown & Williamson Tobacco
Corporation ("B&W"), a successor to the purchaser, that sought indemnity under
certain provisions of the 1977 Agreement with respect to suits brought by
various foreign jurisdictions, and certain cases brought in foreign countries
by individuals concerning periods prior to June 1977 and during portions of
1978. In 2003, Lorillard entered into a settlement agreement with B&W and paid
$28.0 million to B&W for a release of all indemnity obligations and the
agreement by B&W and its affiliates to terminate all rights to use the
Lorillard name within 18 months.
On May 16, 2003, Lorillard and several other tobacco manufacturers and
tobacco leaf buyers reached a settlement with a class of U.S. tobacco growers
and quota holders who filed suit alleging antitrust violations in the
purchasing of domestic tobacco leaf. The settlement calls for Lorillard to pay
the class $20.0 million and requires that Lorillard purchase at least 20
million pounds of U.S. leaf tobacco each year through 2013. Lorillard has
committed to purchase at least 35% of its annual total requirements for flue-
cured and burley tobacco domestically for the same period. Lorillard will also
107
be responsible for 10% of the plaintiffs' attorneys' fees, to be determined by
the court after class approval. The settlement has received preliminary
approval from the court and still must be approved by members of the class.
Lorillard's marketable securities totaled $1,596.2 and $1,640.7 million at
June 30, 2003 and December 31, 2002. At June 30, 2003, fixed maturity
securities represented 93.8% of the total investment in marketable securities
including 9.5% invested in Treasury Notes with an average duration of
approximately 10 years, 21.9% invested in overnight repurchase agreements and
62.5% invested in money market accounts.
The principal source of liquidity for Lorillard's business and operating
needs is internally generated funds from its operations. Lorillard's operating
activities resulted in a net cash inflow of approximately $289.8 million for
the six months ended June 30, 2003, compared to $372.1 million for the
corresponding period of the prior year. Lorillard believes based on current
conditions, that cash flows from operating activities will be sufficient to
enable it to meet its obligations under the State Settlement Agreements and to
fund its capital expenditures. Lorillard cannot predict the impact on its cash
flows of cash requirements related to any future settlements or judgments,
including cash required to bond any appeals, if necessary, or the impact of
subsequent legislative actions, and thus can give no assurance that it will be
able to meet all of those requirements.
Loews Hotels
In July of 2003 Loews Hotels sold a New York City property, the Metropolitan
Hotel, for approximately $109.0 million. The Company expects to record a
pretax gain of approximately $90.0 million in the third quarter of 2003.
Funds from operations continue to exceed operating requirements. Funds for
other capital expenditures and working capital requirements are expected to be
provided from existing cash balances and operations.
Diamond Offshore
At June 30, 2003, Diamond Offshore's cash and marketable securities totaled
$614.9 million, down from $812.5 million at December 31, 2002. Cash provided
by operating activities for the six months ended June 30, 2003 decreased by
$129.2 million to $36.4 million, compared to $165.6 million in 2002. The
decrease in cash flow from operating activities is primarily due to a decline
in results of operations in 2003, as compared to the prior year. Diamond
Offshore also paid $63.5 million in 2003 to acquire the Ocean Patriot.
During the first six months of 2003, Diamond Offshore spent $81.4 million,
including capitalized interest expense, for rig upgrades. These expenditures
were primarily for the deepwater upgrade of the Ocean Rover ($56.1 million),
and upgrades to three of Diamond Offshore's jack-ups ($25.2 million). Two of
these upgrades were completed in the first half of 2003 and one is expected to
be completed during the fourth quarter of 2003. Diamond Offshore expects to
spend approximately $115.0 million for rig upgrade capital expenditures during
2003 for the completion of the Ocean Rover upgrade ($70.0 million) and the
three remaining jack-up upgrades ($45.0 million).
The upgrade of the Ocean Rover, which began in January 2002, was completed
early in July 2003 on time and under budget. The project was completed for
approximately $189.0 million, below management's original estimated cost of
$200.0 million. The rig commenced its contract with Murphy Sabah Oil Company,
108
Ltd. on July 10, 2003 for a minimum three well drilling program offshore
Malaysia.
During the six months ended June 30, 2003, Diamond Offshore spent $52.7
million in association with its ongoing rig equipment replacement and
enhancement programs and to meet other corporate requirements. In addition
Diamond Offshore spent $65.0 million ($63.5 million capitalized to rig
equipment) for the purchase of the third-generation semisubmersible drilling
rig, Omega, renamed the Ocean Patriot. Diamond Offshore has budgeted
approximately $100.0 to $110.0 million in 2003 for capital expenditures
associated with its ongoing rig equipment replacement and enhancement programs
and other corporate requirements.
Cash required to meet Diamond Offshore's capital commitments is determined
by evaluating rig upgrades to meet specific customer requirements and by
evaluating Diamond Offshore's ongoing rig equipment replacement and
enhancement programs, including water depth and drilling capability upgrades.
It is the opinion of Diamond Offshore's management that operating cash flows
and existing cash reserves will be sufficient to meet these capital
commitments; however, periodic assessments will be made based on industry
conditions. In addition, Diamond Offshore may, from time to time, issue debt
or equity securities, or a combination thereof, to finance capital
expenditures, the acquisition of assets and businesses or for general
corporate purposes. Diamond Offshore's ability to issue any such securities
will be dependent on Diamond Offshore's results of operations, its current
financial condition, current market conditions and other factors beyond its
control.
Texas Gas
In May of 2003, the Company acquired Texas Gas from The Williams Companies,
Inc. The transaction value was approximately $1.05 billion, which included
$250.0 million of existing Texas Gas debt. The Company funded the
approximately $802.8 million balance of the purchase price, including
transaction costs and closing adjustments, with $527.8 million of its
available cash and $275.0 million of proceeds from an interim loan incurred at
the subsidiary level.
Upon completion of the acquisition, TGT Pipeline, LLC, a wholly owned
subsidiary of the Company and the immediate parent of Texas Gas, issued $185.0
million of 5.2% Notes due 2018 and Texas Gas issued $250.0 million of 4.6%
Notes due 2015. The net offering proceeds of approximately $431.0 million were
used to repay the $275.0 million interim loan and to retire approximately
$132.7 million principal amount of Texas Gas's existing $150.0 million of
8.625% Notes due 2004. Texas Gas intends to use the balance of the offering
proceeds, together with cash on hand, to retire the remaining 2004 notes.
Bulova
At June 30, 2003, Bulova's cash and marketable securities totaled $9.0
million, down from $10.2 million at December 31, 2002. Bulova does not
currently expect to incur any material capital expenditures.
Majestic Shipping
As previously reported in the Company's 2002 Annual Report on Form 10-K, in
2002 and 2003, subsidiaries of Hellespont acquired four new supertankers for
approximately $370.8 million. Hellespont issued to Majestic a $57.5 million
promissory note. The ships were financed by bank debt of up to $200.0 million,
109
guaranteed by Hellespont. As of June 30, 2003, the full $200.0 million
principal amount of this debt was outstanding. The Company has agreed to
provide credit support for this bank debt by making available to the borrowers
an operating cash flow credit facility of up to an aggregate amount of $25.0
million, none of which is outstanding.
Corporate
On April 25, 2003, the Company filed a shelf Registration Statement on Form
S-3 registering the future sale of up to $1.5 billion of debt and/or equity
securities, which was declared effective by the Securities and Exchange
Commission on May 6, 2003.
As of June 30, 2003, there were 185,447,050 shares of Loews common stock
outstanding and 39,910,000 shares of Carolina Group stock outstanding.
Depending on market conditions, the Company from time to time may purchase
shares of its, and its subsidiaries', outstanding common stock in the open
market or otherwise.
In December of 2002, the Company purchased from CNA $750.0 million of CNA
series H cumulative preferred stock. (the "Preferred Issue"). CNA used $250.0
million of the proceeds from the Preferred Issue to prepay a $250.0 million
one-year bank term loan due April 29, 2003 and an additional $250.0 million
was contributed to CCC to improve its statutory surplus.
CNA completed a common stock rights offering in September of 2001,
successfully raising $1,006.0 million (40.3 million shares sold at $25.00 per
share). The Company purchased 38.3 million shares issued in connection with
the rights offering for $957.0 million.
The Company has been a major source of capital for CNA's liquidity and
capital resource needs.
The Company continues to pursue conservative financial strategies while
seeking opportunities for responsible growth.
110
INVESTMENTS
Insurance
The significant components of CNA's investment income are presented in the
following table:
Three Months Ended Six Months Ended
June 30, June 30,
- --------------------------------------------------------------------- -------------------------
2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------
(In millions)
Fixed maturity securities $ 422.0 $ 496.0 $ 842.0 $ 943.0
Short term investments 12.0 11.0 32.0 27.0
Limited partnerships 75.0 37.0 98.0 44.0
Equity securities 4.0 8.0 9.0 15.0
Interest on funds withheld and other deposits (93.0) (56.0) (140.0) (114.0)
Other 18.0 18.0 43.0 39.0
- ------------------------------------------------------------------------------------------------
Gross investment income 438.0 514.0 884.0 954.0
Investment expense (11.0) (12.0) (25.0) (26.0)
- ------------------------------------------------------------------------------------------------
Net investment income $ 427.0 $ 502.0 $ 859.0 $ 928.0
================================================================================================
CNA experienced lower net investment income for the three and six months
ended June 30, 2003 as compared with the same periods in 2002. The decrease
was due primarily to lower investment yields on fixed maturity securities and
increased interest costs on funds withheld and other deposits, partially
offset by increased limited partnership income. The interest costs on funds
withheld and other deposits increased principally as a result of additional
cessions to the corporate aggregate reinsurance and other treaties due to
additional development recorded for the three months ended June 30, 2003. See
the Reinsurance section for further discussion of CNA's aggregate reinsurance
treaties.
The bond segment of the investment portfolio yielded 5.4% and 6.1% for the
six months ended June 30, 2003 and 2002.
111
The components of net realized investment gains (losses) are presented in
the following table:
Three Months Ended Six Months Ended
June 30, June 30,
- --------------------------------------------------------------------- -------------------------
2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------
(In millions)
Realized investment gains (losses):
Fixed maturity securities:
U.S. Government bonds $ 37.2 $ 43.9 $ 75.3 $ 49.0
Corporate and other taxable bonds 244.5 (257.7) 126.3 (249.1)
Tax-exempt bonds 75.1 13.9 94.5 15.7
Asset-backed bonds 23.6 18.5 41.5 28.0
Redeemable preferred stock (5.3) (1.0) (10.4) (15.1)
- ------------------------------------------------------------------------------------------------
Total fixed maturity securities 375.1 (182.4) 327.2 (171.5)
Equity securities 58.1 41.8 58.1 49.0
Derivative securities (54.5) (12.8) (76.7) (34.0)
Other invested assets 12.0 (7.9) 3.0 (3.8)
Allocated to participating policyholders'
and minority interest (2.0) (1.0) 1.0 (1.0)
- ------------------------------------------------------------------------------------------------
Total investment gains (losses) 388.7 (162.3) 312.6 (161.3)
Income tax benefit (expense) (133.5) 57.0 (106.2) 58.4
Minority Interest (24.8) 11.4 (19.9) 11.2
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Net realized investment gains (losses) $ 230.4 $ (93.9) $ 186.5 $ (91.7)
================================================================================================
Net realized investment results increased $324.3 million (after tax and
minority interest) for the three months ended June 30, 2003 as compared with
the same period in 2002. This change was due primarily to increased net gains
on sales of fixed maturity securities and a reduction in after-tax impairment
losses, partially offset by increased realized losses for derivative
securities. Impairment losses of $18.0 million (after tax and minority
interest) were recorded across several sectors for the three months ended June
30, 2003. Impairment losses of $169.2 million (after tax and minority
interest) were recorded primarily in the communications sector for the same
period in 2002.
Net realized investment results increased $278.2 million (after tax and
minority interest) for the six months ended June 30, 2003 as compared with the
same period in 2002. This change was due primarily to increased net gains on
sales of fixed maturity securities and a $13.5 million reduction in impairment
losses (after tax and minority interest), partially offset by increased
realized losses for derivative securities. Impairment losses of $167.4 million
(after tax and minority interest) were recorded across several sectors,
including the airline, healthcare and energy industries, for the six months
ended June 30, 2003. Impairment losses of $179.6 million (after tax and
minority interest) were recorded primarily in the communications sector for
the same period in 2002.
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. In achieving this goal, assets may be sold to take
112
advantage of market conditions or other investment opportunities or for credit
or tax considerations. This activity will produce realized gains and losses.
CNA classifies its fixed maturity securities (bonds and redeemable preferred
stocks) and its equity securities as available-for-sale, 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 are reported
as a component of other comprehensive income.
The following table provides further detail of gross realized gains and
gross realized losses on fixed maturity securities and equity securities:
Three Months Ended Six Months Ended
June 30, June 30,
- --------------------------------------------------------------------- -------------------------
2003 2002 2003 2002
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(In millions)
Net realized gains (losses) on fixed
maturity securities and equity securities:
Fixed maturity securities:
Gross realized gains $ 410.0 $ 217.0 $ 695.0 $ 357.0
Gross realized losses 35.0 399.0 368.0 528.0
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Net realized gains (losses) on fixed
maturity securities 375.0 (182.0) 327.0 (171.0)
- ------------------------------------------------------------------------------------------------
Equity securities:
Gross realized gains 58.0 74.0 70.0 133.0
Gross realized losses 32.0 12.0 84.0
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Net realized gains on equity securities 58.0 42.0 58.0 49.0
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Net realized gains (losses) on fixed
maturity and equity securities $ 433.0 $(140.0) $ 385.0 $(122.0)
================================================================================================
The following table provides details of the largest realized losses from
sales of securities aggregated by issuer for the three and six months ended
June 30, 2003, including: the fair value of the securities at sales date, 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 footnoted is a narrative
providing the industry sector along with the facts and circumstances giving
rise to the loss.
113
Fair Months in
Value at Unrealized
Date of Loss Loss Prior
Issuer Description and Discussion Sale On Sale To Sale
- ------------------------------------------------------------------------------------------------
(In millions)
A company which operates supermarkets and discount
stores in the U.S. and Europe. Also supplies
food to institutional foodservice companies (a) $ 34.0 $12.0 0-6
A company which manufactures rubber and rubber-related Various,
chemicals. They also manufacture and distribute tires (b) 23.0 9.0 0-24
A company which provides and operates a network of in-
patient and outpatient surgery and rehabilitation Various,
facilities (c) 122.0 8.0 0-12
A company which provides wholesale financing and capital
loans to auto retail dealerships and vehicle leasing Various,
companies (d) 18.0 7.0 0-12
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$197.0 $36.0
================================================================================================
(a) The issuer is under investigation for accounting fraud. Losses relate to
trades that took place to reduce issuer exposure.
(b) These losses relate to trades that took place to reduce issuer exposure.
Remaining holdings have been impaired in the first quarter of 2003.
(c) The issuer is under investigation for accounting fraud and various
security issues relating to management. These losses relate to trades
that took place to reduce issuer exposure. Remaining holdings have been
impaired in the first quarter of 2003.
(d) The issuer's financial condition is in good standing and is investment
grade quality. A decision was made to reduce the portfolio's overall
exposure to this issuer.
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 risks in the near term could have an
adverse material impact on CNA's results of operations or equity.
A significant judgment in the valuation of investments is the determination
of when an other-than-temporary decline in value has occurred. CNA follows a
consistent and systematic process for impairing securities that sustain other-
than-temporary declines in value. CNA 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 CNA's 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.
When a security is placed on the watch list, it is monitored for further
market value changes and additional news related to the issuer's financial
114
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: (1) the length of time and the extent
to which the market value has been less than book value, (2) the financial
condition and near term prospects of the issuer, (3) 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, (4) whether the debtor is current on
interest and principal payments and (5) general market conditions and industry
or sector specific factors. The Impairment Committee's decision to impair a
security is primarily based on whether the security's fair value is likely to
remain significantly below its book value in light of all of the factors
considered above. For securities that are impaired, the security is written
down to fair value and the resulting losses are recognized in realized
gains/losses in the Consolidated Condensed Statements of Operations.
Substantially all invested assets are marketable securities classified as
available-for-sale in the accompanying Consolidated Condensed Financial
Statements. Accordingly, changes in fair value for these securities are
reported in other comprehensive income.
The following table details the carrying value of CNA's general account
investment portfolios:
June 30, 2003 December 31, 2002
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(In millions)