filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Management’s discussion and analysis of financial condition and results of operations is comprised of the following sections:
OVERVIEW
We are a holding company and have five reportable segments comprised of four individual operating subsidiaries, CNA Financial Corporation (“CNA”), Diamond Offshore Drilling, Inc. (“Diamond Offshore”), Boardwalk Pipeline Partners, LP (“Boardwalk Pipeline”) and Loews Hotels Holding Corporation (“Loews Hotels & Co”); and the Corporate segment. The operations of Consolidated Container Company LLC (“Consolidated Container”) since the acquisition date in the second quarter of 2017 are included in the Corporate segment. Each of our operating subsidiaries is 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.
We rely upon our invested cash balances and distributions from our subsidiaries to generate the funds necessary to meet our obligations and to declare and pay any dividends to our shareholders. The ability of our subsidiaries to pay dividends is subject to, among other things, the availability of sufficient earnings and funds in such subsidiaries, applicable state laws, including in the case of the insurance subsidiaries of CNA, laws and rules governing the payment of dividends by regulated insurance companies (see Note 14 of the Notes to Consolidated Financial Statements included under Item 8) and compliance with covenants in their respective loan agreements. Claims of creditors of our subsidiaries will generally have priority as to the assets of such subsidiaries over our claims and those of our creditors and shareholders.
Unless the context otherwise requires, references in this Report to “Loews Corporation,” “the Company,” “Parent Company,” “we,” “our,” “us” or like terms refer to the business of Loews Corporation excluding its subsidiaries.
The following discussion should be read in conjunction with Item 1A, Risk Factors, and Item 8, Financial Statements and Supplementary Data of this Form 10-K.
RESULTS OF OPERATIONS
Consolidated Financial Results
The following table summarizes net income attributable to Loews Corporation by segment and net income per share attributable to Loews Corporation for the years ended December 31, 2018, 2017 and 2016:
| Year Ended December 31 | 2018 | 2017 (a) | 2016 | |||||||||
| (In millions) | ||||||||||||
| CNA Financial | $ | 726 | $ | 801 | $ | 774 | ||||||
| Diamond Offshore | (112 | ) | (27 | ) | (186 | ) | ||||||
| Boardwalk Pipeline | 135 | 380 | 89 | |||||||||
| Loews Hotels & Co | 48 | 64 | 12 | |||||||||
| Corporate | (161 | ) | (54 | ) | (35 | ) | ||||||
| Net income attributable to Loews Corporation | $ | 636 | $ | 1,164 | $ | 654 | ||||||
| Basic net income per common share | $ | 1.99 | $ | 3.46 | $ | 1.93 | ||||||
| Diluted net income per common share | $ | 1.99 | $ | 3.45 | $ | 1.93 | ||||||
| (a) | Net income for the year ended December 31, 2017 includes a significant net benefit of $200 million, resulting from the Tax Cuts and Jobs Act of 2017 (“Tax Act”). This net benefit primarily relates to the remeasurement of Loews’s net deferred tax liability precipitated by the lowering of the U.S. federal corporate tax rate from 35% to 21%. This net benefit is comprised of a net benefit of $294 million and $27 million at Boardwalk Pipeline and Loews Hotels & Co partially offset by charges of $78 million, $36 million and $7 million at CNA, Diamond Offshore and Corporate. |
|---|
2018 Compared with 2017
Consolidated net income attributable to Loews Corporation for 2018 was $636 million, or $1.99 per share, compared to $1.16 billion, or $3.45 per share, in 2017.
Net income attributable to Loews Corporation in 2018 decreased as compared to the prior year primarily due to the prior year net benefit of $200 million from the Tax Act. Excluding the impact of the Tax Act, earnings decreased due to lower results at CNA and Diamond Offshore partially offset by higher earnings at Loews Hotels & Co and Boardwalk Pipeline.
2017 Compared with 2016
Consolidated net income attributable to Loews Corporation for 2017 was $1.16 billion, or $3.45 per share, compared to $654 million, or $1.93 per share, in 2016.
Net income attributable to Loews Corporation in 2017 increased as compared to the prior year partially due to the net benefit from the Tax Act discussed above. Absent this benefit, net income increased $310 million primarily from higher earnings at CNA, Loews Hotels & Co and Diamond Offshore. Net income for 2017 and 2016 included asset impairment charges at Diamond Offshore of $32 million and $267 million (both after tax and noncontrolling interests).
CNA Financial
The following table summarizes the results of operations for CNA for the years ended December 31, 2018, 2017 and 2016 as presented in Note 20 of the Notes to Consolidated Financial Statements included under Item 8. For further discussion of Net investment income and Net realized investment results, see the Investments section of this MD&A.
| Year Ended December 31 | 2018 | 2017 | 2016 | |||||||||
| (In millions) | ||||||||||||
| Revenues: | ||||||||||||
| Insurance premiums | $ | 7,312 | $ | 6,988 | $ | 6,924 | ||||||
| Net investment income | 1,817 | 2,034 | 1,988 | |||||||||
| Investment gains (losses) | (57 | ) | 122 | 62 | ||||||||
| Non-insurance warranty revenue (Notes 1 and 13) | 1,007 | 390 | 361 | |||||||||
| Operating revenues and other | 55 | 49 | 49 | |||||||||
| Total | 10,134 | 9,583 | 9,384 | |||||||||
| Expenses: | ||||||||||||
| Insurance claims and policyholders’ benefits | 5,572 | 5,310 | 5,283 | |||||||||
| Amortization of deferred acquisition costs | 1,335 | 1,233 | 1,235 | |||||||||
| Non-insurance warranty expense (Notes 1 and 13) | 923 | 299 | 271 | |||||||||
| Other operating expenses | 1,203 | 1,224 | 1,287 | |||||||||
| Interest | 138 | 203 | 167 | |||||||||
| Total | 9,171 | 8,269 | 8,243 | |||||||||
| Income before income tax | 963 | 1,314 | 1,141 | |||||||||
| Income tax expense | (151 | ) | (419 | ) | (279 | ) | ||||||
| Net income | 812 | 895 | 862 | |||||||||
| Amounts attributable to noncontrolling interests | (86 | ) | (94 | ) | (88 | ) | ||||||
| Net income attributable to Loews Corporation | $ | 726 | $ | 801 | $ | 774 | ||||||
2018 Compared with 2017
Net income attributable to Loews Corporation decreased $75 million in 2018 as compared with 2017 primarily due to lower net investment income driven by limited partnership investments and lower favorable net prior year loss reserve development partially offset by lower net catastrophe losses. Earnings were also impacted by lower net realized investment results driven by lower net realized investment gains on sales of securities. Favorable net prior year loss reserve development of $181 million and $308 million was recorded in 2018 and 2017.
2017 Compared with 2016
Net income attributable to Loews Corporation increased $27 million in 2017 as compared with 2016 primarily due to improved non-catastrophe current accident year underwriting results, lower adverse prior year reserve development recorded under the 2010 asbestos and environmental pollution (“A&EP”) loss portfolio transfer, higher net investment income and higher net realized investment results. These increases were partially offset by higher net catastrophe losses in 2017, and a loss of $24 million (after tax and noncontrolling interests) on the early redemption of debt in 2017. As a result of the Tax Act, CNA’s net deferred tax assets were remeasured as of the date of enactment, resulting in a one-time decrease to net income of $87 million ($78 million after noncontrolling interests).
CNA’s Property & Casualty and Other Insurance Operations
CNA’s Property & Casualty Operations include its Specialty, Commercial and International lines of business. CNA’s Other Insurance Operations outside of Property & Casualty Operations include its long term care business that is in run-off, certain corporate expenses, including interest on CNA’s corporate debt, and certain property and casualty businesses in run-off, including CNA Re and A&EP. CNA’s products and services are primarily marketed through independent agents, brokers and managing general underwriters to a wide variety of customers, including small, medium and large businesses, insurance companies, associations, professionals and other groups. We believe the presentation of CNA as one reportable segment is appropriate in accordance with applicable accounting standards on segment reporting. However, for purposes of this discussion and analysis of the results of operations, we provide greater detail with respect to CNA’s Property & Casualty Operations and Other Insurance Operations to enhance the reader’s understanding and to provide further transparency into key drivers of CNA’s financial results.
Core income (loss) is calculated by excluding from net income (loss) (i) net realized investment gains or losses, (ii) income or loss from discontinued operations, (iii) any cumulative effects of changes in accounting guidance and (iv) deferred tax asset and liability remeasurement as a result of an enacted U.S. federal tax rate change. In addition, core income (loss) excludes the effects of noncontrolling interests. The calculation of core income (loss) excludes net realized investment gains or losses because net realized investment gains or losses are generally driven by economic factors that are not necessarily consistent with key drivers of underwriting performance, and are therefore not considered an indication of trends in insurance operations. Core income (loss) is deemed to be a non-GAAP financial measure and management believes this measure is useful to investors as management uses this measure to assess financial performance.
Property & Casualty Operations
In evaluating the results of the Property & Casualty Operations, CNA utilizes the loss ratio, the expense ratio, the dividend ratio and the combined ratio. These ratios are calculated using GAAP financial results. 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 insurance underwriting and acquisition expenses, including the amortization of deferred acquisition costs, to net earned premiums. The dividend ratio is the ratio of policyholders’ dividends incurred to net earned premiums. The combined ratio is the sum of the loss, expense and dividend ratios. In addition, CNA also utilizes renewal premium change, rate, retention and new business in evaluating operating trends. Renewal premium change represents the estimated change in average premium on policies that renew, including rate and exposure changes. Rate represents the average change in price on policies that renew excluding exposure changes. Retention represents the percentage of premium dollars renewed in comparison to the expiring premium dollars from policies available to renew. Renewal premium change, rate and retention presented for the prior year are updated to reflect subsequent activity on policies written in the period. New business represents premiums from policies written with new customers and additional policies written with existing customers.
The following tables summarize the results of CNA’s Property & Casualty Operations for the years ended December 31, 2018, 2017 and 2016.
| Year Ended December 31, 2018 | Specialty | Commercial | International | Total | ||||||||||||||||
| (In millions, except %) | ||||||||||||||||||||
| Net written premiums | $ | 2,744 | $ | 3,060 | $ | 1,018 | $ | 6,822 | ||||||||||||
| Net earned premiums | 2,732 | 3,050 | 1,001 | 6,783 | ||||||||||||||||
| Net investment income | 439 | 500 | 57 | 996 | ||||||||||||||||
| Core income (loss) | 629 | 357 | (19 | ) | 967 | |||||||||||||||
| Other performance metrics: | ||||||||||||||||||||
| Loss and loss adjustment expense ratio | 55.9 | % | 67.3 | % | 69.8 | % | 63.1 | % | ||||||||||||
| Expense ratio | 32.1 | 33.1 | 36.7 | 33.2 | ||||||||||||||||
| Dividend ratio | 0.2 | 0.7 | 0.4 | |||||||||||||||||
| Combined ratio | 88.2 | % | 101.1 | % | 106.5 | % | 96.7 | % | ||||||||||||
| Rate | 2% | 1% | 3% | 2% | ||||||||||||||||
| Renewal premium change | 3 | 3 | 7 | 4 | ||||||||||||||||
| Retention | 84 | 85 | 76 | 83 | ||||||||||||||||
| New business | $ | 353 | $ | 566 | $ | 307 | $ | 1,226 | ||||||||||||
| Year Ended December 31, 2017 | ||||||||||||||||||||
| Net written premiums | $ | 2,731 | $ | 2,922 | $ | 881 | $ | 6,534 | ||||||||||||
| Net earned premiums | 2,712 | 2,881 | 857 | 6,450 | ||||||||||||||||
| Net investment income | 522 | 658 | 52 | 1,232 | ||||||||||||||||
| Core income | 582 | 369 | 8 | 959 | ||||||||||||||||
| Other performance metrics: | ||||||||||||||||||||
| Loss and loss adjustment expense ratio | 56.5 | % | 67.0 | % | 67.0 | % | 62.6 | % | ||||||||||||
| Expense ratio | 32.0 | 35.1 | 37.8 | 34.2 | ||||||||||||||||
| Dividend ratio | 0.2 | 0.6 | 0.3 | |||||||||||||||||
| Combined ratio | 88.7 | % | 102.7 | % | 104.8 | % | 97.1 | % | ||||||||||||
| Rate | 1% | 0% | 0% | 0% | ||||||||||||||||
| Renewal premium change | 3 | 3 | 2 | 3 | ||||||||||||||||
| Retention | 89 | 86 | 80 | 86 | ||||||||||||||||
| New business | $ | 242 | $ | 568 | $ | 275 | $ | 1,085 |
| Year Ended December 31, 2016 | Specialty | Commercial | International | Total | ||||||||||||||||
| (In millions, except %) | ||||||||||||||||||||
| Net written premiums | $ | 2,738 | $ | 2,883 | $ | 821 | $ | 6,442 | ||||||||||||
| Net earned premiums | 2,743 | 2,840 | 806 | 6,389 | ||||||||||||||||
| Net investment income | 497 | 657 | 51 | 1,205 | ||||||||||||||||
| Core income | 606 | 355 | 21 | 982 | ||||||||||||||||
| Other performance metrics: | ||||||||||||||||||||
| Loss and loss adjustment expense ratio | 54.3 | % | 67.1 | % | 61.0 | % | 60.8 | % | ||||||||||||
| Expense ratio | 32.1 | 36.7 | 38.1 | 34.9 | ||||||||||||||||
| Dividend ratio | 0.2 | 0.3 | 0.2 | |||||||||||||||||
| Combined ratio | 86.6 | % | 104.1 | % | 99.1 | % | 95.9 | % | ||||||||||||
| Rate | 1 | % | (2 | )% | (1 | )% | (1 | )% | ||||||||||||
| Renewal premium change | 2 | 3 | (1 | ) | 2 | |||||||||||||||
| Retention | 88 | 84 | 76 | 85 | ||||||||||||||||
| New business | $ | 239 | $ | 530 | $ | 240 | $ | 1,009 |
2018 Compared with 2017
Total net written premiums increased $288 million in 2018 as compared with 2017 primarily due to increases in Commercial and International. Excluding the effect of Small Business premium rate adjustments as discussed in Note 19 of the Notes to Consolidated Financial Statements included under Item 8, net written premiums for Commercial increased $86 million driven by positive renewal premium change partially offset by a higher level of ceded reinsurance. Excluding the effect of foreign currency exchange rates, net written premiums for International increased $115 million or 12.6% in 2018 as compared with 2017, driven by higher new business, positive renewal premium change and a favorable change in estimate of ultimate premium partially offset by a higher level of ceded reinsurance. The trend in net earned premiums was consistent with net written premiums in Commercial and International in 2018 as compared with 2017.
Core income increased $8 million in 2018 as compared with 2017. Excluding the favorable effect of the corporate income tax rate change and the Small Business premium rate adjustments, core income decreased approximately $179 million due to lower net investment income, driven by limited partnership returns, and lower favorable net prior year loss reserve development partially offset by lower net catastrophe losses and improved non-catastrophe current accident year underwriting results.
Pretax net catastrophe losses were $252 million in 2018 as compared with $380 million in 2017. For 2018 and 2017, Specialty had net catastrophe losses of $26 million and $44 million, Commercial had net catastrophe losses of $193 million and $272 million and International had net catastrophe losses of $33 million and $64 million.
Favorable net prior year loss reserve development of $150 million and $174 million was recorded in 2018 and 2017 for Specialty. Favorable net prior year loss reserve development of $25 million and $115 million was recorded in 2018 and 2017 for Commercial and favorable net prior year loss reserve development of $4 million and $9 million was recorded in 2018 and 2017 for International. Further information on net prior year development is included in Note 8 of the Notes to Consolidated Financial Statements included under Item 8.
Specialty’s combined ratio of 88.2% improved 0.5 points in 2018 as compared with 2017. The loss ratio improved 0.6 points primarily due to an improved current accident year loss ratio partially offset by lower favorable net prior year loss reserve development. The expense ratio in 2018 was consistent with 2017.
Commercial’s combined ratio of 101.1% improved 1.6 points in 2018 as compared with 2017. The loss ratio increased 0.3 points driven by lower favorable net prior year loss reserve development partially offset by lower net catastrophe losses. Excluding the Small Business premium rate adjustments, the expense ratio improved 1.5 points driven by lower employee costs and IT spend.
International’s combined ratio of 106.5% increased 1.7 points in 2018 as compared with 2017. The loss ratio increased 2.8 points, primarily due to elevated property losses and professional liability losses in CNA’s London operation and lower favorable net prior year loss reserve development partially offset by lower net catastrophe losses. The expense ratio improved 1.1 points in 2018 as compared with 2017 driven by higher net earned premiums partially offset by higher acquisition expenses.
Effective October 1, 2018, Hardy no longer writes property treaty, marine hull and construction all risk/erection all risk through the Lloyd’s platform. While these three classes combined represented a relatively small component of International’s business when combined with other underwriting actions, it will result in lower net written premiums within International’s business.
2017 Compared with 2016
Total net written premiums increased $92 million in 2017 as compared with 2016. Net written premiums for International increased $60 million in 2017 as compared with 2016 due to higher new business, positive renewal premium change and higher retention. Excluding the effect of foreign currency exchange rates and premium development, net written premiums for International increased 8.1% in 2017. Net written premiums for Specialty were consistent with 2016. New business, renewal premium change and retention also remained at consistent levels for Specialty. Net written premiums for Commercial increased $39 million in 2017 as compared with 2016, primarily driven by higher new business within Middle Markets, strong retention and positive renewal premium change. This was partially offset by an unfavorable premium rate adjustment within its Small Business unit as discussed in Note 19 to the Consolidated Financial Statements under Item 8. The change in net earned premiums for Commercial and International was consistent with the trend in net written premiums.
Core income decreased $23 million in 2017 as compared with 2016 driven by higher net catastrophe losses, partially offset by improved non-catastrophe current accident year underwriting results and higher net investment income. In addition, results reflect the favorable period over period effect of foreign currency exchange.
Pretax net catastrophe losses were $380 million in 2017 as compared with $165 million in 2016 as 2017 was impacted by Hurricanes Harvey, Irma and Maria. For 2017 and 2016, Specialty had net catastrophe losses of $44 million and $17 million, Commercial had net catastrophe losses of $272 million and $117 million and International had net catastrophe losses of $64 million and $31 million.
Favorable net prior year loss reserve development of $174 million and $247 million was recorded in 2017 and 2016 for Specialty. Favorable net prior year loss reserve development of $115 million as compared with unfavorable net prior year loss reserve development of $15 million was recorded in 2017 and 2016 for Commercial and favorable net prior year loss reserve development of $9 million and $58 million was recorded in 2017 and 2016 for International. Further information on net prior year development is included in Note 8 of the Notes to Consolidated Financial Statements included under Item 8.
Specialty’s combined ratio increased 2.1 points in 2017 as compared with 2016. The loss ratio increased 2.2 points primarily due to lower favorable net prior year loss reserve development and higher net catastrophe losses. The loss ratio, excluding catastrophes and development, improved 1.5 points. The expense ratio in 2017 was consistent with 2016.
Commercial’s combined ratio improved 1.4 points in 2017 as compared with 2016. The loss ratio improved 0.1 points primarily due to the favorable period over period effect of net prior year loss reserve development, partially offset by higher net catastrophe losses. The loss ratio, excluding catastrophes and development, improved 1.7 points. The expense ratio improved 1.6 points in 2017 as compared with 2016 reflecting both CNA’s ongoing efforts to improve productivity and the actions taken in last year’s third and fourth quarters to reduce expenses.
International’s combined ratio increased 5.7 points in 2017 as compared with 2016. The loss ratio increased 6.0 points primarily due to lower favorable net prior year loss reserve development and higher net catastrophe losses, partially offset by lower current accident year large losses. The loss ratio excluding catastrophes and development improved 3.0 points. The expense ratio improved 0.3 points in 2017 as compared with 2016 primarily due to the higher net earned premiums.
Other Insurance Operations
The following table summarizes the results of CNA’s Other Insurance Operations for the years ended December 31, 2018, 2017 and 2016.
| Years Ended December 31 | 2018 | 2017 | 2016 | |||||||||
| (In millions) | ||||||||||||
| Net earned premiums | $ | 530 | $ | 539 | $ | 536 | ||||||
| Net investment income | 821 | 802 | 783 | |||||||||
| Core loss | (122 | ) | (40 | ) | (158 | ) |
2018 Compared with 2017
The core loss was $122 million in 2018, an increase of $82 million as compared with 2017. Excluding the unfavorable effect of the corporate income tax rate change, core loss increased by approximately $4 million. Persistency continues to benefit from a high proportion of policyholders choosing to reduce benefits in lieu of premium rate increases. The favorable persistency trend was partially offset by a significant number of policies converting to a fully paid-up status with modest future benefits following the termination of a large group account. The reserves associated with these converted policies were, on average, slightly higher than the previously recorded carried reserves, resulting in a negative financial impact. Morbidity continues to trend in line with expectations. Additionally, the release of long term care claim reserves resulting from the annual claims experience study was slightly lower in 2018 as compared with 2017. The core loss was also impacted by non-recurring costs of $27 million associated with the transition to a new IT infrastructure service provider and higher adverse net prior year reserve development recorded in 2018 for A&EP under the loss portfolio transfer as compared with 2017, as further discussed in Note 8 of the Notes to Consolidated Financial Statements included under Item 8, partially offset by lower interest expense.
2017 Compared with 2016
Core loss was $40 million in 2017, an improvement of $118 million as compared with 2016. This improvement was primarily driven by lower adverse prior year reserve development in 2017 for A&EP under the loss portfolio transfer, as further discussed in Note 8 of the Notes to Consolidated Financial Statements included under Item 8. In addition, the improvement also reflects a higher release of long term claim reserves resulting from the annual claims experience study as compared with 2016, higher net investment income and improved results in the long term care business driven by favorable morbidity partially offset by unfavorable persistency.
Non-GAAP Reconciliation of Core Income to Net Income
The following table reconciles core income to net income attributable to Loews Corporation for the CNA segment for the years ended December 31, 2018, 2017 and 2016:
| Year Ended December 31 | 2018 | 2017 | 2016 | |||||||||
| (In millions) | ||||||||||||
| Core income (loss): | ||||||||||||
| Property & Casualty Operations | $ | 967 | $ | 959 | $ | 982 | ||||||
| Other Insurance Operations | (122 | ) | (40) | (158 | ) | |||||||
| Total core income | 845 | 919 | 824 | |||||||||
| Realized investment gains (losses) (after tax) | (43 | ) | 82 | 43 | ||||||||
| Charge related to the Tax Act | (87) | |||||||||||
| Consolidating adjustments including purchase accounting and | ||||||||||||
| noncontrolling interests | (76 | ) | (113) | (93 | ) | |||||||
| Net income attributable to Loews Corporation | $ | 726 | $ | 801 | $ | 774 | ||||||
Referendum on the United Kingdom’s Membership in the European Union
In 2016, the United Kingdom (“U.K.”) approved an exit from the European Union (“E.U.”), commonly referred to as “Brexit.” Brexit is scheduled to be completed in early 2019. As treaties between the U.K. and the E.U. have not been finalized, as of January 1, 2019, CNA intends to write business in the E.U. through its recently established European subsidiary in Luxembourg as its U.K.-domiciled subsidiary will presumably no longer provide a platform for CNA’s operations throughout the European continent. As a result of such structural changes and modification to CNA’s European operations, the complexity and cost of regulatory compliance of its European business has increased and will likely continue to result in elevated expenses.
Diamond Offshore
Overview
Over the past five years, crude oil prices have been volatile, reaching a high of $115 per barrel in 2014, but dropping to $55 per barrel by the end of 2014. In 2015, oil prices continued to decline, closing at $37 per barrel at the end of that year, and continuing to fall to a low of $28 per barrel during 2016 before recovering to nearly $57 per barrel by the end of 2016. While the price of crude oil continued to fluctuate in 2017 and 2018, as of the date of this Report, the current spot price for Brent crude was in the $60 per barrel range. As a result of this volatility in commodity price and its uncertain future, the offshore drilling industry has experienced a substantial decline in demand for its services, as well as a significant decline in dayrates for contract drilling services. Although demand and offshore utilization increased during 2018, with industry-wide floater utilization averaging near 60% at the end of 2018 based on analyst reports, dayrates remain low as the increase in oil prices from earlier lows has not yet resulted in significantly higher dayrates. If dayrates increase, offshore drillers with more available floaters and/or unpriced options for currently committed rigs will be better positioned to take advantage of the market recovery as it materializes.
Tendering activity has also increased. During 2018 and continuing into 2019, there was an increase in contract tenders for late 2019 and 2020 project commencements, primarily for work in the North Sea and Australia floater markets. Industry analysts also predict that there will be additional opportunities in the West Africa market in the near term. Reflective of the uncertainty in the market, many of these tenders have been limited to single-well jobs, with options for future wells. Although some geographic areas appear to be improving, other markets show little or no sign of recovery at this time.
From a supply perspective, industry analysts have reported that during 2018, the global supply of floater rigs decreased for the fourth consecutive year, with 20 floaters being scrapped during the year. Based on these reports, over 200 drilling rigs, including 119 floaters, have been retired since 2014. However, the offshore floater market remains oversupplied, as there are drilling rigs across all water depth categories that are not contracted or that are cold stacked as of the date of this Report. Industry reports also indicate that there remain approximately 40 newbuild
floaters on order with scheduled deliveries in 2019 and 2020, most of which have not yet been contracted for future work. In addition, several rig reactivations were announced during 2018 and in early 2019, including the ongoing reactivations of the Ocean Endeavor and Ocean Onyx that have been brought out of cold stack to fulfill newly-acquired contracts. These factors provide for a continued, challenging offshore drilling market in the near term.
Contract Drilling Backlog
Diamond Offshore’s contract drilling backlog was $2.0 billion, $2.0 billion and $2.4 billion as of January 1, 2019 (based on contract information known at that time), October 1, 2018 (the date reported in our Quarterly Report on Form 10-Q for the quarter ended September 30, 2018) and January 1, 2018 (the date reported in our Annual Report on Form 10-K for the year ended December 31, 2017). The contract drilling backlog by year as of January 1, 2019 is $0.9 billion in 2019, $0.8 billion in 2020 and an aggregate of $0.3 billion in 2021 and 2022. Contract drilling backlog excludes a future gross margin commitment of $30 million in 2019, $30 million in 2020 and an aggregate of $75 million for the 2021 through 2023 payable by a customer in the form of a guarantee of gross margin to be earned on future contracts or by direct payment at the end of each period pursuant to terms of an existing contract.
Contract drilling backlog includes only firm commitments (typically represented by signed contracts) and is calculated by multiplying the contracted operating dayrate by the firm contract period. Diamond Offshore’s calculation also assumes full utilization of its drilling equipment for the contract period (excluding scheduled shipyard and survey days); however, the amount of actual revenue earned and the actual periods during which revenues are earned will be different than the amounts and periods stated above due to various factors affecting utilization such as weather conditions and unscheduled repairs and maintenance. Contract drilling backlog excludes revenues for mobilization, demobilization, contract preparation and customer reimbursables. Changes in Diamond Offshore’s contract drilling backlog between periods are generally a function of the performance of work on term contracts, as well as the extension or modification of existing term contracts and the execution of additional contracts. In addition, under certain circumstances, Diamond Offshore’s customers may seek to terminate or renegotiate its contracts, which could adversely affect its reported backlog.
Results of Operations
Diamond Offshore’s pretax operating income (loss) is primarily a function of contract drilling revenue earned less contract drilling expenses incurred or recognized. The two most significant variables affecting Diamond Offshore’s contract drilling revenues are dayrates earned and rig utilization rates achieved by its rigs, each of which is a function of rig supply and demand in the marketplace. Revenues are also affected by the acquisition or disposal of rigs, rig mobilizations, required surveys and shipyard projects.
Operating expenses represent all direct and indirect costs associated with the operation and maintenance of Diamond Offshore’s drilling equipment. The principal components of Diamond Offshore’s operating costs are, among other things, direct and indirect costs of labor and benefits, repairs and maintenance, freight, regulatory inspections, boat and helicopter rentals and insurance.
The following table summarizes the results of operations for Diamond Offshore for the years ended December 31, 2018, 2017 and 2016 as presented in Note 20 of the Notes to Consolidated Financial Statements included under Item 8:
| Year Ended December 31 | 2018 | 2017 | 2016 | |||||||||
| (In millions) | ||||||||||||
| Revenues: | ||||||||||||
| Net investment income | $ | 8 | $ | 2 | $ | 1 | ||||||
| Investment losses | (12 | ) | ||||||||||
| Contract drilling revenues | 1,060 | 1,451 | 1,525 | |||||||||
| Other revenues | 25 | 47 | 75 | |||||||||
| Total | 1,093 | 1,500 | 1,589 | |||||||||
| Expenses: | ||||||||||||
| Contract drilling expenses | 723 | 802 | 772 | |||||||||
| Other operating expenses | ||||||||||||
| Impairment of assets | 27 | 100 | 680 | |||||||||
| Other expenses | 446 | 471 | 518 | |||||||||
| Interest | 123 | 149 | 90 | |||||||||
| Total | 1,319 | 1,522 | 2,060 | |||||||||
| Loss before income tax | (226 | ) | (22 | ) | (471 | ) | ||||||
| Income tax benefit | 30 | 4 | 111 | |||||||||
| Amounts attributable to noncontrolling interests | 84 | (9 | ) | 174 | ||||||||
| Loss attributable to Loews Corporation | $ | (112 | ) | $ | (27 | ) | $ | (186 | ) | |||
2018 Compared with 2017
Contract drilling revenue decreased $391 million in 2018 as compared with 2017, primarily due to 955 fewer revenue earning days, combined with the effect of lower average daily revenue earned. Contract drilling expense decreased $79 million in 2018 as compared with 2017, primarily due to reduced costs of $52 million for currently cold-stacked and previously-owned rigs, which had incurred contract drilling expense in 2017, combined with decreased costs for the current rig fleet of $27 million. The decrease in contract drilling expense for the current fleet reflects lower labor and personnel costs and other rig operating costs and the deferral of costs associated with contract preparation activities for rigs as they prepare for new contracts in 2019, partially offset by increased costs for repairs and maintenance and related rig operating costs.
Interest expense decreased $26 million in 2018 as compared with 2017, primarily due to the absence of costs resulting from the redemption of debt in 2017, partially offset by incremental interest expense from senior notes issued in 2017.
Net loss attributable to Loews Corporation increased $85 million in 2018 as compared with 2017, primarily due to lower revenue from contract drilling services discussed above. The decrease in net results was partially offset by lower depreciation expense, primarily due to a lower asset base in 2018 as a result of the sale of rigs and asset impairments, lower impairment charges and a net income tax benefit.
2017 Compared with 2016
Contract drilling revenue decreased $74 million in 2017 as compared with 2016, primarily due to lower average daily revenue, partially offset by the favorable impact of an aggregate 353 incremental revenue earning days. Total contract drilling expense increased $30 million in 2017 as compared with 2016, reflecting higher amortized rig mobilization expense of $25 million and incremental contract drilling costs associated with the drillships of $28 million, partially offset by a net reduction in other rig operating and overhead costs of $23 million.
Net results improved $159 million in 2017 as compared with 2016, primarily due to a lower aggregate impairment charge recognized in 2017 of $100 million ($32 million after taxes and noncontrolling interests) as compared with $680 million ($267 million after taxes and noncontrolling interests) in 2016 and reduced depreciation expense, primarily due to a lower depreciable asset base as a result of asset impairments recognized in 2016 and 2017. In addition, results reflect a net reduction in rig operating results and an increase in interest expense due to a loss of $35 million ($11 million after tax and noncontrolling interests) related to the redemption of debt in 2017 and a reduction in interest capitalized during 2017 due to the completion of construction projects in 2016.
The income tax provision for the year ended December 31, 2017 includes a $36 million one-time charge related to the Tax Act, which consisted of: (i) a $75 million charge for the mandatory, deemed repatriation of foreign earnings, inclusive of the utilization of certain tax attributes offset by a provisional liability for uncertain tax positions related to such attributes, (ii) a $74 million credit resulting from the remeasurement of net deferred tax liabilities at the lower corporate tax rate and (iii) a $35 million charge recorded at the Loews Corporation level for the difference between the book basis and tax basis in Diamond Offshore.
Boardwalk Pipeline
On June 29, 2018, Boardwalk GP, LP (“General Partner”), the general partner of Boardwalk Pipeline and an indirect wholly owned subsidiary of the Company, elected to exercise its right to purchase all of the issued and outstanding common units representing limited partnership interests in Boardwalk Pipeline not already owned by the General Partner or its affiliates pursuant to Section 15.1(b) of Boardwalk Pipeline’s Third Amended and Restated Agreement of Limited Partnership, as amended (“Limited Partnership Agreement”). On July 18, 2018, the General Partner completed the transaction for a cash purchase price, determined in accordance with the Limited Partnership Agreement, of $12.06 per unit, or approximately $1.5 billion, in the aggregate. For further information on this transaction, see Note 2 of the Notes to Consolidated Financial Statements included under Item 8.
Overview
Boardwalk Pipeline derives revenues primarily from the transportation and storage of natural gas and natural gas liquids (“NGLs”). Transportation services consist of firm natural gas transportation, where the customer pays a capacity reservation charge to reserve pipeline capacity at receipt and delivery points along pipeline systems, plus a commodity and fuel charge on the volume of natural gas actually transported, and interruptible natural gas transportation, under which the customer pays to transport gas only when capacity is available and used. The transportation rates Boardwalk Pipeline is able to charge customers are heavily influenced by market trends (both short and longer term), including the available natural gas supplies, geographical location of natural gas production, the demand for gas by end-users such as power plants, petrochemical facilities and liquefied natural gas (“LNG”) export facilities and the price differentials between the gas supplies and the market demand for the gas (basis differentials). Rates for short term firm and interruptible transportation services are influenced by shorter term market conditions such as current and forecasted weather.
Boardwalk Pipeline offers firm natural gas storage services in which the customer reserves and pays for a specific amount of storage capacity, including injection and withdrawal rights, and interruptible storage and parking and lending (“PAL”) services where the customer receives and pays for capacity only when it is available and used. The value of Boardwalk Pipeline’s storage and PAL services (comprised of parking gas for customers and/or lending gas to customers) is affected by natural gas price differentials between time periods, such as between winter and summer (time period price spreads), price volatility of natural gas and other factors. Boardwalk Pipeline’s storage and parking services have greater value when the natural gas futures market is in contango (a positive time period price spread, meaning that current price quotes for delivery of natural gas further in the future are higher than in the nearer term), while its lending service has greater value when the futures market is backwardated (a negative time period price spread, meaning that current price quotes for delivery of natural gas in the nearer term are higher than further in the future). The value of both storage and PAL services may also be favorably impacted by increased volatility in the price of natural gas, which allows Boardwalk Pipeline to optimize the value of its storage and PAL capacity.
Boardwalk Pipeline also transports and stores NGLs. Contracts for Boardwalk Pipeline’s NGLs services are generally fee based or based on minimum volume requirements, while others are dependent on actual volumes transported. Boardwalk Pipeline’s NGLs storage rates are market-based and contracts are typically fixed price
arrangements with escalation clauses. Boardwalk Pipeline is not in the business of buying and selling natural gas and NGLs other than for system management purposes, but changes in natural gas and NGLs prices may impact the volumes of natural gas or NGLs transported and stored by customers on its systems. Due to the capital intensive nature of its business, Boardwalk Pipeline’s operating costs and expenses typically do not vary significantly based upon the amount of products transported, with the exception of fuel consumed at its compressor stations and not included in a fuel tracker.
Firm Agreements
A substantial portion of Boardwalk Pipeline’s transportation and storage capacity is contracted for under firm agreements. For the year ended December 31, 2018, approximately 87% of Boardwalk Pipeline’s revenues, excluding retained fuel, were derived from fixed fees under firm agreements. The table below shows a rollforward of operating revenues under committed firm agreements in place as of December 31, 2017 to December 31, 2018, including agreements for transportation, storage and other services, over the remaining term of those agreements:
| As of December 31, 2018 | ||||
| (In millions) | ||||
| Total projected operating revenues under committed firm agreements as of December 31, 2017 | $ | 8,870 | ||
| Adjustments for: | ||||
| Actual revenues recognized from firm agreements in 2018 (a) | (1,087 | ) | ||
| Firm agreements entered into in 2018 | 1,350 | |||
| Total projected operating revenues under committed firm agreements as of December 31, 2018 | $ | 9,133 | ||
| (a) | Reflects an increase of $55 million in Boardwalk Pipeline’s actual 2018 revenues recognized from fixed fees under firm agreements as compared with its expected 2018 revenues from fixed fees under firm agreements, including agreements for transportation, storage and other services as of December 31, 2017, primarily due to an increase from contract renewals that occurred in 2018. |
|---|
During 2018, Boardwalk Pipeline entered into approximately $1.4 billion of new firm agreements, of which approximately half of this amount was related to contract renewals and the other half was from new growth projects executed in 2018, but will not be placed into service until 2020 or later years. For Boardwalk Pipeline’s customers that are charged maximum tariff rates related to its FERC-regulated operating subsidiaries, the revenues expected to be earned from fixed fees under committed firm agreements reflect the current tariff rate for such services for the term of the agreements, however, the tariff rates may be subject to future adjustment. The revenues expected to be earned from fixed fees under committed firm agreements do not include additional revenues Boardwalk Pipeline has recognized and may recognize under firm agreements based on actual utilization of the contracted pipeline or storage capacity, any expected revenues for periods after the expiration dates of the existing agreements, execution of precedent agreements associated with growth projects or other events that occurred or will occur subsequent to December 31, 2018.
Contract Renewals
Each year a portion of Boardwalk Pipeline’s firm transportation and storage agreements expire. Demand for firm service is primarily based on market conditions which can vary across Boardwalk Pipeline’s pipeline systems. The amount of change in firm reservation fees under contract reflects the overall market trends, including the impact from Boardwalk Pipeline’s growth projects. Boardwalk Pipeline focuses its marketing efforts on enhancing the value of the capacity that is up for renewal and works with customers to match gas supplies from various basins to new and existing customers and markets, including aggregating supplies at key locations along its pipelines to provide end-use customers with attractive and diverse supply options. If the market perceives the value of Boardwalk Pipeline’s available capacity to be lower than its long term view of the capacity, Boardwalk Pipeline may seek to shorten contract terms until market perception improves.
Over the past several years, as a result of current market conditions, Boardwalk Pipeline has renewed some expiring contracts at lower rates or for shorter terms than in the past. In addition to normal contract expirations, in the 2018 to 2020 timeframe, transportation agreements associated with its Gulf South, Texas Gas and Gulf Crossing pipeline expansion projects, which were placed into service in 2008 and 2009, will expire or have expired. In late 2017 and throughout 2018, a substantial portion of the capacity becoming available from the 2018 expiring expansion project contracts was renewed or the contracts were restructured, usually at lower rates or lower volumes. As the terms of these remaining expansion contracts expire through 2020, Boardwalk Pipeline’s transportation contract expirations are expected to be at a higher than normal level. If these contracts are renewed at current market rates, the revenues earned from these transportation contracts would be materially lower than they are today.
Pipeline System Maintenance
Boardwalk Pipeline incurs substantial costs for ongoing maintenance of its pipeline systems and related facilities, including those incurred for pipeline integrity management activities, equipment overhauls, general upkeep and repairs. These costs are not dependent on the amount of revenues earned from its transportation services. PHMSA has developed regulations that require transportation pipeline operators to implement integrity management programs to comprehensively evaluate certain areas along pipelines and take additional measures to protect pipeline segments located in highly populated areas. These regulations have resulted in an overall increase in Boardwalk Pipeline’s ongoing maintenance costs, including maintenance capital and maintenance expense. PHMSA has proposed more prescriptive regulations related to operations of Boardwalk Pipeline’s interstate natural gas and NGLs pipelines which, if adopted as proposed, will cause Boardwalk Pipeline to incur increased capital and operating costs, experience operational delays and result in potential adverse impacts to its ability to reliably serve its customers. While these proposed regulations have not yet been finalized, they are representative of the types of regulatory changes that can be enacted which would affect Boardwalk Pipeline’s operations and the cost of operating its facilities.
Maintenance costs may be capitalized or expensed, depending on the nature of the activities. For any given reporting period, the mix of projects that Boardwalk Pipeline undertakes will affect the amounts it records as property, plant and equipment on its balance sheet or recognizes as expenses, which impacts Boardwalk Pipeline’s earnings. In 2019, Boardwalk Pipeline expects to spend approximately $365 million to maintain its pipeline systems, of which approximately $150 million is expected to be maintenance capital. In 2018, Boardwalk Pipeline spent $314 million, of which $108 million was recorded as maintenance capital.
FERC Matters
The Tax Act changed several provisions of the federal tax code, including a reduction in the maximum corporate tax rate. In addition, the FERC issued a series of policies and orders throughout 2018 which addressed the inclusion of federal income tax allowances in interstate pipeline companies’ rates. In March of 2018, the FERC issued a Revised Policy Statement reversing its long-standing policy by stating that it will no longer permit master limited partnerships to include an income tax allowance in their cost-of-service. The purchase of the outstanding common units by the General Partner in 2018 and its election to be treated as a corporation for federal income tax purposes, precluded the impact these policies and orders would have on the ability of Boardwalk Pipeline’s FERC-regulated natural gas pipelines to include an income tax allowance in their cost-of-service.
The FERC also issued an order which required all FERC-regulated natural gas pipelines to make a one-time informational filing reflecting the impacts of the Tax Act and the Revised Policy Statement on each individual pipeline’s cost-of-service. Texas Gas Transmission, LLC filed its informational filing on October 11, 2018, and Gulf South Pipeline Company, LP and Gulf Crossing Pipeline Company LLC made their filings on December 6, 2018, which included an income tax component in each of the pipelines’ cost-of-service. Customers were provided an opportunity to protest or comment on each pipeline’s informational filing. Through the date of this filing, the protests received on Boardwalk Pipeline’s pipelines were limited in terms of numbers and scope. This procedure could lead to challenges to a pipeline’s currently effective maximum applicable rates pursuant to Section 5 of the NGA. To date, the FERC has initiated four Section 5 proceedings against non-affiliated interstate natural gas pipelines and has notified other non-affiliated natural gas pipelines that no further action will be taken with respect to their information filings. As of February 13, 2019, Texas Gas, Gulf South and Gulf Crossing’s informational filings remain open.
Even without action on Boardwalk Pipeline’s informational filings, the FERC and/or its customers could challenge the maximum applicable rates that any of its regulated pipelines are allowed to charge in accordance with Section 5 of the NGA. The Tax Act and the Revised Policy Statement may increase the likelihood of such a challenge. If such a challenge is successful for any of its pipelines, the revenues associated with transportation and storage services the pipeline provides pursuant to cost-of-service rates could materially decrease in the future, which would adversely affect the revenues on that pipeline going forward.
On April 19, 2018, the FERC issued a Certificate Policy Statement NOI, thereby initiating a review of its policies on certification of natural gas pipelines facilities, including an examination of its long-standing Policy Statement on Certification of New Interstate Natural Gas Pipeline Facilities, issued in 1999, that is used to determine whether to grant certificates for new pipeline and storage projects and expansions. Comments on the Certificate Policy Statement NOI were due on July 25, 2018, and Boardwalk Pipeline is unable to predict what, if any, changes may be proposed that will affect its natural gas pipeline business or when such proposals, if any, might become effective. Boardwalk Pipeline does not expect that any change in this policy would affect it in a materially different manner than any other natural gas pipeline company operating in the U.S.
Results of Operations
The following table summarizes the results of operations for Boardwalk Pipeline for the years ended December 31, 2018, 2017 and 2016 as presented in Note 20 of the Notes to Consolidated Financial Statements included under Item 8:
| Year Ended December 31 | 2018 | 2017 | 2016 | |||||||||
| (In millions) | ||||||||||||
| Revenues: | ||||||||||||
| Other revenue, primarily operating | $ | 1,227 | $ | 1,325 | $ | 1,316 | ||||||
| Total | 1,227 | 1,325 | 1,316 | |||||||||
| Expenses: | ||||||||||||
| Operating | 820 | 861 | 835 | |||||||||
| Interest | 176 | 171 | 183 | |||||||||
| Total | 996 | 1,032 | 1,018 | |||||||||
| Income before income tax | 231 | 293 | 298 | |||||||||
| Income tax (expense) benefit | (28 | ) | 232 | (61 | ) | |||||||
| Amounts attributable to noncontrolling interests | (68 | ) | (145 | ) | (148 | ) | ||||||
| Net income attributable to Loews Corporation | $ | 135 | $ | 380 | $ | 89 | ||||||
2018 Compared with 2017
Total revenues decreased $98 million in 2018 as compared with 2017. Excluding the net effect of items offset in fuel and transportation expense, primarily retained fuel, operating revenues decreased $63 million due to lower transportation revenues of $43 million, which resulted primarily from contract expirations and recontracting at overall lower average rates, partially offset by revenues from growth projects placed into service and higher system utilization. In addition, storage and parking and lending revenues decreased due to unfavorable market conditions.
Operating expenses decreased $41 million in 2018 as compared with 2017. Excluding items offset in operating revenues and the $47 million loss on sale of a processing plant in 2017, operating expenses increased $34 million primarily due to higher depreciation expense and property taxes from an increased asset base from recently completed growth projects and increased employee related costs.
In 2017, we recorded a one-time decrease to income tax expense of $294 million at the holding company level, as a result of the Tax Act. This decrease was a result of remeasuring the net deferred tax liabilities at the lower corporate tax rate.
Net income attributable to Loews Corporation decreased $245 million in 2018 as compared with 2017 as a result of the Tax Act, discussed above, partially offset by the impact of the Company now owning 100% of Boardwalk Pipeline.
2017 Compared with 2016
Total revenues increased $9 million in 2017 as compared with 2016. Excluding the net effect of $13 million of proceeds received from the settlement of a legal matter in 2016 and items offset in fuel and transportation expense, primarily retained fuel, operating revenues increased $44 million. The increase was driven by growth projects recently placed into service, partially offset by a decrease in storage and PAL revenues, primarily from the effects of unfavorable market conditions on time period price spreads and a decrease in revenues associated with the sale of a processing plant, discussed in Note 6 of the Notes to Consolidated Financial Statements under Item 8, and the Southwestern contract restructuring.
Operating expenses increased $26 million in 2017 as compared with 2016. Excluding items offset in operating revenues and the $47 million loss on sale of a processing plant, operating expenses decreased $5 million primarily due to lower administrative and general expenses due to higher capitalization rates from the increase in capital projects and lower employee incentive costs, largely offset by higher operations and maintenance expenses, primarily due to growth projects recently placed into service and a higher number of maintenance projects. Interest expense decreased $12 million primarily due to higher capitalized interest from growth projects.
Net income increased $291 million in 2017 as compared with 2016 as a result of the Tax Act in 2017 and the changes discussed above.
Loews Hotels & Co
The following table summarizes the results of operations for Loews Hotels & Co for the years ended December 31, 2018, 2017 and 2016 as presented in Note 20 of the Notes to Consolidated Financial Statements included under Item 8:
| Year Ended December 31 | 2018 | 2017 | 2016 | |||||||||
| (In millions) | ||||||||||||
| Revenues: | ||||||||||||
| Operating revenue | $ | 628 | $ | 577 | $ | 557 | ||||||
| Gain on sale of owned hotel | 23 | |||||||||||
| Revenues related to reimbursable expenses | 104 | 105 | 110 | |||||||||
| Total | 755 | 682 | 667 | |||||||||
| Expenses: | ||||||||||||
| Operating | 533 | 502 | 489 | |||||||||
| Asset impairments at owned hotels | 22 | |||||||||||
| Reimbursable expenses | 104 | 105 | 110 | |||||||||
| Depreciation | 67 | 63 | 63 | |||||||||
| Equity income from joint ventures | (73 | ) | (81 | ) | (41 | ) | ||||||
| Interest | 29 | 28 | 24 | |||||||||
| Total | 682 | 617 | 645 | |||||||||
| Income before income tax | 73 | 65 | 22 | |||||||||
| Income tax expense | (25 | ) | (1 | ) | (10 | ) | ||||||
| Net income attributable to Loews Corporation | $ | 48 | $ | 64 | $ | 12 | ||||||
2018 Compared with 2017
Operating revenues increased $51 million and operating expenses increased $31 million in 2018 as compared with 2017 primarily due to the improved performance of several owned hotels, primarily the Loews Miami Beach Hotel. Total revenues for 2018 include a $23 million gain on sale of the Loews Annapolis Hotel. Asset impairments in 2018 reflect reductions in the carrying value of two owned properties.
Equity income from joint ventures decreased $8 million in 2018 as compared with 2017 primarily due to a net benefit of $10 million from a gain on the sale of an equity interest in a joint venture hotel property partially offset by an impairment charge related to an equity interest in a second joint venture hotel property in 2017. Absent this net benefit, equity income from joint ventures increased $2 million primarily due to the improved performance of the Universal Orlando joint venture properties.
Net income attributable to Loews Corporation decreased $16 million. Excluding the effect of the corporate income tax rate change, net income increased approximately $5 million primarily due to the changes discussed above.
2017 Compared with 2016
Operating revenues increased $20 million and operating expenses increased $13 million in 2017 as compared with 2016 primarily due to an increase in revenue and expenses upon completion of renovations at the Loews Miami Beach Hotel.
Equity income from joint ventures increased $40 million in 2017 as compared with 2016 primarily due to a $25 million gain on the sale of an equity interest in the Loews Don CeSar Hotel, a joint venture hotel property, in February of 2017, increased equity income from Universal Orlando joint venture properties and the absence of a $13 million impairment charge related to an equity interest in a joint venture hotel property in 2016. These increases were partially offset by a $15 million impairment charge in 2017 related to an equity interest in a joint venture hotel property.
Interest expense increased $4 million in 2017 as compared with 2016 primarily due to property-level debt incurred to fund acquisitions in 2016 along with reduced capitalized interest.
Loews Hotels & Co recorded a $27 million decrease to income tax expense resulting from the effect of the lower U.S. federal corporate tax rate on its net deferred tax liabilities.
Net income increased $52 million primarily due to the changes discussed above.
Corporate
Corporate operations consist primarily of investment income at the Parent Company, operating results of Consolidated Container from the May 22, 2017 acquisition date, corporate interest expenses and other corporate administrative costs. Investment income includes earnings on cash and short term investments held at the Parent Company to meet current and future liquidity needs, as well as results of limited partnership investments and the trading portfolio.
The following table summarizes the results of operations for Corporate for the years ended December 31, 2018, 2017 and 2016 as presented in Note 20 of the Notes to Consolidated Financial Statements included under Item 8:
| Year Ended December 31 | 2018 | 2017 | 2016 | |||||||||
| (In millions) | ||||||||||||
| Revenues: | ||||||||||||
| Net investment income (loss) | $ | (10 | ) | $ | 146 | $ | 146 | |||||
| Other revenues | 867 | 499 | 3 | |||||||||
| Total | 857 | 645 | 149 | |||||||||
| Expenses: | ||||||||||||
| Operating and other | 956 | 618 | 131 | |||||||||
| Interest | 108 | 95 | 72 | |||||||||
| Total | 1,064 | 713 | 203 | |||||||||
| Loss before income tax | (207 | ) | (68 | ) | (54 | ) | ||||||
| Income tax benefit | 46 | 14 | 19 | |||||||||
| Net loss attributable to Loews Corporation | $ | (161 | ) | $ | (54 | ) | $ | (35 | ) | |||
2018 Compared with 2017
Net investment loss was $10 million in 2018 as compared with income of $146 million in 2017 primarily due to negative returns from equity based investments in the trading portfolio and limited partnership investments.
Other revenues increased $368 million in 2018 as compared with 2017 due to Consolidated Container’s revenues reflecting a full year of operations in 2018 as compared with approximately seven months of operations in 2017. In addition, the increase also reflects the pass-through effect of higher year-over-year resin prices. Consolidated Container’s contracts generally provide for resin price changes to be passed through to its customers on a short-term lag, generally about one month. When a pass-through occurs, revenues and expenses generally change by the same amount so that Consolidated Container’s gross margin returns to the same level as prior to the change in prices.
Operating and other expenses increased $338 million in 2018 as compared with 2017 primarily due to an increase of $349 million of Consolidated Container’s expenses reflecting a full year of operations in 2018 as compared with approximately seven months of operations in 2017 and higher average resin prices from Consolidated Container’s operations. This increase is partially offset by the absence of costs related to the acquisition of Consolidated Container in 2017 and decreased corporate overhead expenses. Interest expense increased $13 million in 2018 as compared with 2017, primarily due to interest expense associated with Consolidated Container’s term loan reflecting a full year of operations in 2018 as compared with approximately seven months of operations in 2017.
Net results decreased $107 million in 2018 as compared with 2017 primarily due to the changes discussed above and the impact of the lower corporate tax rate in 2018 providing a lower benefit to corporate losses.
2017 Compared with 2016
Net investment income was flat in 2017 as compared with 2016 primarily due to improved performance from limited partnership investments offset by lower results from equity based investments in the trading portfolio.
Other revenues increased $496 million in 2017 as compared with 2016 primarily due to $498 million of revenue from Consolidated Container’s operations for the period since the acquisition date.
Operating and other expenses increased $487 million in 2017 as compared with 2016 primarily due to $479 million of expenses for Consolidated Container’s operations for the period since the acquisition date. In addition, operating expenses increased due to costs related to the acquisition of Consolidated Container, partially offset by the absence of prior year expenses related to the implementation of the 2016 Incentive Compensation Plan. Interest expense increased $23 million in 2017 as compared with 2016 primarily due to interest expense associated with Consolidated Container’s $605 million term loan from the date of acquisition.
Corporate recorded an $8 million increase to income tax expense resulting from the effect of the lower corporate tax rate on net deferred tax assets.
Net results decreased $19 million in 2017 as compared with 2016 primarily due to the changes discussed above.
LIQUIDITY AND CAPITAL RESOURCES
Parent Company
Parent Company cash and investments, net of receivables and payables, totaled $3.1 billion at December 31, 2018 as compared to $4.9 billion at December 31, 2017. In 2018, we received $878 million in dividends from our subsidiaries, including a special dividend from CNA of $485 million. Cash outflows included the payment of $1.5 billion to fund the purchase of common units in Boardwalk Pipeline as discussed above, $1.0 billion to fund treasury stock purchases, $80 million of cash dividends to our shareholders and approximately $92 million of net cash contributions to Loews Hotels & Co. As a holding company we depend on dividends from our subsidiaries and returns on our investment portfolio to fund our obligations. We also have an effective Registration Statement on Form S-3 on file with the Securities and Exchange Commission (“SEC”) registering the future sale of an unlimited amount of our
debt and equity securities. We are not responsible for the liabilities and obligations of our subsidiaries and there are no Parent Company guarantees.
As of February 1, 2019, there were 311,299,326 shares of Loews common stock outstanding. Depending on market and other conditions, we may purchase our shares and shares of our subsidiaries outstanding common stock in the open market or otherwise. In 2018, we purchased 20.3 million shares of Loews common stock. As of February 8, 2019, we had purchased an additional 0.9 million shares of Loews common stock in 2019 at an aggregate cost of $44 million.
The Company currently has an unsecured debt rating of A with a negative outlook from Fitch Rating, Inc., a corporate credit and senior debt rating of A with a stable outlook from S&P Global Ratings (“S&P”) and an unsecured debt rating of A3 with a stable outlook from Moody’s Investors Service (“Moody’s”). Should one or more rating agencies downgrade our credit ratings from current levels, or announce that they have placed us under review for a potential downgrade, our cost of capital could increase and our ability to raise new capital could be adversely affected.
Future uses of our cash may include investing in our subsidiaries, new acquisitions, dividends and/or repurchases of our and our subsidiaries’ outstanding common stock. The declaration and payment of future dividends to holders of our common stock will be at the discretion of our Board of Directors and will depend on many factors, including our earnings, financial condition and business needs.
Subsidiaries
CNA’s cash provided by operating activities was $1.2 billion in 2018 and $1.3 billion in 2017. Cash provided by operating activities in 2018 reflected higher income taxes paid and higher net claim payments, partially offset by an increase in premiums collected as compared with 2017. In 2017, cash provided by operating activities reflected higher net claim payments and a lower level of distributions on limited partnerships, partially offset by lower IT spend and an increase in premiums collected as compared with 2016.
CNA paid dividends of $3.30 per share on its common stock, including a special dividend of $2.00 per share in 2018. On February 8, 2019, CNA’s Board of Directors declared a quarterly dividend of $0.35 per share and a special dividend of $2.00 per share payable March 14, 2019 to shareholders of record on February 25, 2019. CNA’s declaration and payment of future dividends is at the discretion of its Board of Directors and will depend on many factors, including CNA’s earnings, financial condition, business needs and regulatory constraints. The payment of dividends by CNA’s 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 Continental Casualty Company (“CCC”), a subsidiary of CNA, 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 by the Illinois Department of Insurance (the “Department”), are determined based on the greater of the prior year’s statutory net income or 10% of statutory surplus as of the end of the prior year, as well as the timing and amount of dividends paid in the preceding 12 months. Additionally, ordinary dividends may only be paid from earned surplus, which is calculated by removing unrealized gains from unassigned surplus. As of December 31, 2018, CCC is in a positive earned surplus position. The maximum allowable dividend CCC could pay during 2019 that would not be subject to the Department’s prior approval is $1.4 billion, less dividends paid during the preceding 12 months measured at that point in time. CCC paid dividends of $1.0 billion in 2018. 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.
Diamond Offshore’s cash provided by operating activities decreased approximately $262 million in 2018 as compared with 2017, primarily due to lower cash receipts for contract drilling services of $312 million, partially offset by a net decrease in cash expenditures for contract drilling services and other working capital requirements of $8 million and lower income tax payments, net of refunds, of $42 million. The decrease in cash flow from operations is primarily the result of reduced demand for Diamond Offshore’s contract drilling services, which continued into 2018, partially offset by its cost control initiatives.
Diamond Offshore expects capital expenditures in 2019 to be approximately $340 million to $360 million. Projects for 2019 include $110 million in capitalized costs associated with the reactivation and upgrade of the Ocean Onyx, approximately $20 million associated with the reactivation of the Ocean Endeavor and other capital expenditures under its capital maintenance and replacement programs, including equipment upgrades for the Ocean BlackHawk and Ocean BlackHornet. At December 31, 2018, Diamond Offshore has no significant purchase obligations, except for those related to its direct rig operations, which arise during the normal course of business.
As of February 8, 2019, Diamond Offshore had no outstanding borrowings under its credit agreements.
In 2018, S&P downgraded Diamond Offshore’s corporate credit rating to B from B+ with a negative outlook and Moody’s downgraded Diamond Offshore’s corporate credit rating to B2 from Ba3 with a negative outlook. These credit ratings are below investment grade and could raise Diamond Offshore’s cost of financing. As a consequence, Diamond Offshore may not be able to issue additional debt in amounts and/or with terms that it considers to be reasonable. One or more of these occurrences could limit Diamond Offshore’s ability to pursue other business opportunities.
Diamond Offshore will make periodic assessments of its capital spending programs based on industry conditions and will make adjustments if it determines they are required. 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 access the capital markets by issuing debt or equity securities will be dependent on its results of operations, current financial condition, current credit ratings, current market conditions and other factors beyond its control.
Boardwalk Pipeline’s cash provided by operating activities decreased $71 million in 2018 compared to 2017, primarily due to the change in net income.
For 2018 and 2017, Boardwalk Pipeline’s capital expenditures were $468 million and $708 million, consisting of a combination of growth and maintenance capital. During 2018, Boardwalk Pipeline purchased $19 million of natural gas to be used as base gas for its pipeline system. Boardwalk Pipeline expects total capital expenditures to be approximately $450 million in 2019, including approximately $150 million for maintenance capital and $300 million related to growth projects.
As of February 11, 2019, Boardwalk Pipeline had $630 million of outstanding borrowings under its credit facility, resulting in an available borrowing capacity of approximately $870 million. Boardwalk Pipeline anticipates that its existing capital resources, including its revolving credit facility and cash flows from operating activities, will be adequate to fund its operations for 2019.
During 2019, Loews Hotels & Co anticipates funding approximately $95 million to its joint venture developments in progress, which will be derived from cash on hand, cash generated from operations and cash contributions from Loews Corporation.
Off-Balance Sheet Arrangements
At December 31, 2018 and 2017, we did not have any off-balance sheet arrangements.
Contractual Obligations
Our contractual payment obligations are as follows:
| Payments Due by Period | ||||||||||||||||||||
| Less than | More than | |||||||||||||||||||
| December 31, 2018 | Total | 1 year | 1-3 years | 3-5 years | 5 years | |||||||||||||||
| (In millions) | ||||||||||||||||||||
| Debt (a) | $ | 16,183 | $ | 899 | $ | 2,408 | $ | 3,112 | $ | 9,764 | ||||||||||
| Operating leases | 702 | 75 | 158 | 125 | 344 | |||||||||||||||
| Claim and claim adjustment expense reserves (b) | 23,396 | 5,427 | 6,131 | 3,109 | 8,729 | |||||||||||||||
| Future policy benefit reserves (c) | 26,920 | (409 | ) | (125 | ) | 597 | 26,857 | |||||||||||||
| Purchase and other obligations | 757 | 309 | 142 | 135 | 171 | |||||||||||||||
| Total | $ | 67,958 | $ | 6,301 | $ | 8,714 | $ | 7,078 | $ | 45,865 | ||||||||||
| (a) | Includes estimated future interest payments. |
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| (b) | The claim and claim adjustment expense reserves reflected above are not discounted and represent CNA’s estimate of the amount and timing of the ultimate settlement and administration of gross claims based on its assessment of facts and circumstances known as of December 31, 2018. See the Insurance Reserves section of this MD&A for further information. |
|---|
| (c) | The future policy benefit reserves reflected above are not discounted and represent CNA’s estimate of the ultimate amount and timing of the settlement of benefits based on its assessment of facts and circumstances known as of December 31, 2018. Additional information on future policy benefit reserves is included in Note 1 of the Notes to Consolidated Financial Statements included under Item 8. |
|---|
Further information on our commitments, contingencies and guarantees is provided in the Notes to Consolidated Financial Statements included under Item 8.
INVESTMENTS
Investment activities of non-insurance subsidiaries primarily include investments in fixed income securities, including short term investments. The Parent Company portfolio also includes equity securities, including short sales and derivative instruments, and investments in limited partnerships. These types of investments generally present greater volatility, less liquidity and greater risk than fixed income investments and are included within Results of Operations – Corporate.
We enter into short sales and invest in certain derivative instruments that are used for asset and liability management activities, income enhancements to our portfolio management strategy and to benefit from anticipated future movements in the underlying markets. If such movements do not occur as anticipated, then significant losses may occur. Monitoring procedures include senior management review of daily reports of existing positions and valuation fluctuations to seek to ensure that open positions are consistent with our portfolio strategy.
Credit exposure associated with non-performance by counterparties to our derivative instruments is generally limited to the uncollateralized change in fair value of the derivative instruments recognized in the Consolidated Balance Sheets. We mitigate the risk of non-performance by monitoring the creditworthiness of counterparties and diversifying derivatives by using multiple counterparties. We occasionally require collateral from our derivative investment counterparties depending on the amount of the exposure and the credit rating of the counterparty.
Insurance
CNA maintains a large portfolio of fixed maturity and equity securities, including large amounts of corporate and government issued debt securities, residential and commercial mortgage-backed securities, and other asset-backed securities and investments in limited partnerships which pursue a variety of long and short investment strategies across a broad array of asset classes. CNA’s investment portfolio supports its obligation to pay future insurance claims and provides investment returns which are an important part of CNA’s overall profitability.
Net Investment Income
The significant components of CNA’s net investment income are presented in the following table. Fixed income securities, as presented, include both fixed maturity securities and non-redeemable preferred stock.
| Year Ended December 31 | 2018 | 2017 | 2016 | |||||||||
| (In millions) | ||||||||||||
| Fixed income securities: | ||||||||||||
| Taxable fixed income securities | $ | 1,449 | $ | 1,397 | $ | 1,421 | ||||||
| Tax-exempt fixed income securities | 384 | 427 | 405 | |||||||||
| Total fixed income securities | 1,833 | 1,824 | 1,826 | |||||||||
| Limited partnership and common stock investments | (42 | ) | 207 | 158 | ||||||||
| Other, net of investment expense | 26 | 3 | 4 | |||||||||
| Pretax net investment income | $ | 1,817 | $ | 2,034 | $ | 1,988 | ||||||
| Fixed income securities after tax and noncontrolling interests | $ | 1,351 | $ | 1,185 | $ | 1,180 | ||||||
| Net investment income after tax and noncontrolling interests | $ | 1,341 | $ | 1,308 | $ | 1,280 | ||||||
| Effective income yield for the fixed income securities portfolio, before tax | 4.7 | % | 4.7 | % | 4.8 | % | ||||||
| Effective income yield for the fixed income securities portfolio, after tax | 3.9 | % | 3.4 | % | 3.5 | % |
Net investment income before tax and noncontrolling interests decreased $217 million in 2018 as compared with 2017. The decrease was driven by limited partnership and common stock investments, which returned (1.9)% in 2018 as compared with 9.1% in the prior year. The lower return in 2018 included the change in fair value of common stock investments. Despite the decline in limited partnership income, net investment income after tax and noncontrolling interests increased $33 million in 2018 as compared with 2017 driven by the lower federal corporate income tax rate.
Net investment income after tax and noncontrolling interests increased $28 million in 2017 as compared with 2016. The increase was driven by limited partnership and common stock investments, which returned 9.1% in 2017 as compared with 6.4% in the prior year.
Net Realized Investment Gains (Losses)
The components of CNA’s net realized investment results are presented in the following table:
| Year Ended December 31 | 2018 | 2017 | 2016 | |||||||||
| (In millions) | ||||||||||||
| Realized investment gains (losses): | ||||||||||||
| Fixed maturity securities: | ||||||||||||
| Corporate and other bonds | $ | 26 | $ | 114 | $ | 39 | ||||||
| States, municipalities and political subdivisions | 36 | 14 | 29 | |||||||||
| Asset-backed | (58 | ) | (6 | ) | (2 | ) | ||||||
| Total fixed maturity securities | 4 | 122 | 66 | |||||||||
| Non-redeemable preferred stock | (74 | ) | 1 | |||||||||
| Short term and other | 13 | (5 | ) | |||||||||
| Total realized investment gains (losses) | (57 | ) | 122 | 62 | ||||||||
| Income tax (expense) benefit | 14 | (40 | ) | (19 | ) | |||||||
| Amounts attributable to noncontrolling interests | 5 | (9 | ) | (4 | ) | |||||||
| Net realized investment gains (losses) attributable to Loews Corporation | $ | (38 | ) | $ | 73 | $ | 39 | |||||
Net realized investment results before tax and noncontrolling interests decreased $179 million in 2018 as compared with 2017. The decrease was driven by lower net realized gains on sales of securities and the decline in fair value of non-redeemable preferred stock. Net realized investment gains before tax and noncontrolling interests increased $60 million in 2017 as compared with 2016, driven by lower OTTI losses recognized in earnings.
Further information on CNA’s realized gains and losses, including OTTI losses, is set forth in Notes 1 and 3 of the Notes to Consolidated Financial Statements included under Item 8.
Portfolio Quality
The following table presents the estimated fair value and net unrealized gains (losses) of CNA’s fixed maturity securities by rating distribution:
| December 31, 2018 | December 31, 2017 | |||||||||||||||||||||||
| Net | Net | |||||||||||||||||||||||
| Unrealized | Unrealized | |||||||||||||||||||||||
| Estimated | Gains | Estimated | Gains | |||||||||||||||||||||
| Fair Value | (Losses) | Fair Value | (Losses) | |||||||||||||||||||||
| (In millions) | ||||||||||||||||||||||||
| U.S. Government, Government agencies and Government-sponsored enterprises | $ | 4,334 | $ | (24 | ) | $ | 4,514 | $ | 21 | |||||||||||||||
| AAA | 3,027 | 245 | 1,954 | 152 | ||||||||||||||||||||
| AA | 6,510 | 512 | 8,982 | 914 | ||||||||||||||||||||
| A | 8,768 | 527 | 9,643 | 952 | ||||||||||||||||||||
| BBB | 14,205 | 274 | 13,554 | 1,093 | ||||||||||||||||||||
| Non-investment grade | 2,702 | (73 | ) | 2,840 | 140 | |||||||||||||||||||
| Total | $ | 39,546 | $ | 1,461 | $ | 41,487 | $ | 3,272 | ||||||||||||||||
As of December 31, 2018 and 2017, only 1% and 2% of CNA’s fixed maturity portfolio was rated internally.
The following table presents CNA’s available-for-sale fixed maturity securities in a gross unrealized loss position by ratings distribution:
| Gross | ||||||||
| Estimated | Unrealized | |||||||
| December 31, 2018 | Fair Value | Losses | ||||||
| (In millions) | ||||||||
| U.S. Government, Government agencies and Government-sponsored enterprises | $ | 2,889 | $ | 53 | ||||
| AAA | 359 | 7 | ||||||
| AA | 788 | 12 | ||||||
| A | 2,391 | 62 | ||||||
| BBB | 6,971 | 262 | ||||||
| Non-investment grade | 1,905 | 125 | ||||||
| Total | $ | 15,303 | $ | 521 | ||||
The following table presents the maturity profile for these available-for-sale fixed maturity securities. Securities not due to mature on a single date are allocated based on weighted average life:
| Gross | ||||||||
| Estimated | Unrealized | |||||||
| December 31, 2018 | Fair Value | Losses | ||||||
| (In millions) | ||||||||
| Due in one year or less | $ | 218 | $ | 7 | ||||
| Due after one year through five years | 2,409 | 57 | ||||||
| Due after five years through ten years | 10,479 | 347 | ||||||
| Due after ten years | 2,197 | 110 | ||||||
| Total | $ | 15,303 | $ | 521 | ||||
Duration
A primary objective in the management of CNA’s investment portfolio is to optimize return relative to the corresponding liabilities and respective liquidity needs. CNA’s views on the current interest rate environment, tax regulations, asset class valuations, specific security issuer and broader industry segment conditions as well as domestic and global economic conditions, are some of the factors that enter into an investment decision. CNA also continually monitors exposure to issuers of securities held and broader industry sector exposures and may from time to time adjust such exposures based on its views of a specific issuer or industry sector.
A further consideration in the management of CNA’s investment portfolio is the characteristics of the corresponding liabilities and the ability to align the duration of the portfolio to those liabilities and to meet future liquidity needs, minimize interest rate risk and maintain a level of income sufficient to support the underlying insurance liabilities. For portfolios where future liability cash flows are determinable and typically long term in nature, CNA segregates investments for asset/liability management purposes. The segregated investments support the long term care and structured settlement liabilities in Other Insurance Operations.
The effective durations of CNA’s fixed income securities and short term investments are presented in the following table. Amounts presented are net of payable and receivable amounts for securities purchased and sold, but not yet settled.
| December 31, 2018 | December 31, 2017 | |||||||||||||||
| Effective | Effective | |||||||||||||||
| Estimated | Duration | Estimated | Duration | |||||||||||||
| Fair Value | (In Years) | Fair Value | (In Years) | |||||||||||||
| (In millions of dollars) | ||||||||||||||||
| Investments supporting Other Insurance Operations | $ | 16,212 | 8.4 | $ | 16,797 | 8.4 | ||||||||||
| Other investments | 25,428 | 4.4 | 26,817 | 4.4 | ||||||||||||
| Total | $ | 41,640 | 6.0 | $ | 43,614 | 5.9 | ||||||||||
The investment portfolio is periodically analyzed for changes in duration and related price risk. Additionally, CNA periodically reviews the sensitivity of the portfolio to the level of foreign exchange rates and other factors that contribute to market price changes. A summary of these risks and specific analysis on changes is included in the Quantitative and Qualitative Disclosures about Market Risk included under Item 7A.
Short Term Investments
The carrying value of the components of CNA’s Short term investments are presented in the following table:
| December 31 | 2018 | 2017 | ||||||
| (In millions) | ||||||||
| Short term investments: | ||||||||
| Commercial paper | $ | 705 | $ | 905 | ||||
| U.S. Treasury securities | 185 | 355 | ||||||
| Other | 396 | 176 | ||||||
| Total short term investments | $ | 1,286 | $ | 1,436 | ||||
INSURANCE RESERVES
The level of reserves CNA maintains represents its best estimate, as of a particular point in time, of what the ultimate settlement and administration of claims will cost based on CNA’s assessment of facts and circumstances known at that time. Reserves are not an exact calculation of liability but instead are complex estimates that CNA derives, generally utilizing a variety of actuarial reserve estimation techniques, from numerous assumptions and expectations about future events, both internal and external, many of which are highly uncertain. As noted below, CNA reviews its reserves for each segment of its business periodically, and any such review could result in the need to increase reserves in amounts which could be material and could adversely affect our results of operations and equity and CNA’s business and insurer financial strength and corporate debt ratings. Further information on reserves is provided in Note 8 of the Notes to Consolidated Financial Statements included under Item 8.
Property and Casualty Claim and Claim Adjustment Expense Reserves
CNA maintains loss reserves to cover its estimated ultimate unpaid liability for claim and claim adjustment expenses, including the estimated cost of the claims adjudication process, for claims that have been reported but not yet settled (case reserves) and claims that have been incurred but not reported (“IBNR”). IBNR includes a provision for development on known cases as well as a provision for late reported incurred claims. Claim and claim adjustment expense reserves are reflected as liabilities and are included on the Consolidated 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 carried case and IBNR reserves as of each balance sheet date are provided in the discussion that follows and in Note 8 of the Notes to Consolidated Financial Statements included under Item 8.
There is a risk that CNA’s recorded reserves are insufficient to cover its estimated ultimate unpaid liability for claims and claim adjustment expenses. Unforeseen emerging or potential claims and coverage issues are 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.
In addition, CNA’s property and casualty insurance subsidiaries also have actual and potential exposures related to A&EP claims, which could result in material losses. To mitigate the risks posed by CNA’s exposure to A&EP claims and claim adjustment expenses, CNA completed a transaction with National Indemnity Company (“NICO”), under which substantially all of CNA’s legacy A&EP liabilities were ceded to NICO effective January 1, 2010. See Note 8 of the Notes to the Consolidated Financial Statements included under Item 8 for further discussion about the transaction with NICO, its impact on CNA’s results of operations and the deferred retroactive reinsurance gain.
Establishing Property & Casualty Reserve Estimates
In developing claim and claim adjustment expense (“loss” or “losses”) reserve estimates, CNA’s actuaries perform detailed reserve analyses that are staggered throughout the year. The data is organized at a reserve group level. A reserve group can be a line of business covering a subset of insureds such as commercial automobile liability for small or middle market customers, it can encompass several lines of business provided to a specific set of customers such as aging services, or it can be a particular type of claim such as construction defect. Every reserve group is reviewed
at least once during the year, but most are reviewed more frequently. The analyses generally review losses gross of ceded reinsurance and apply the ceded reinsurance terms to the gross estimates to establish estimates net of reinsurance. In addition to the detailed analyses, CNA reviews actual loss emergence for all products each quarter.
Most of CNA’s business can be characterized as long-tail. For long-tail business, it will generally be several years between the time the business is written and the time when all claims are settled. CNA’s long-tail exposures include commercial automobile liability, workers’ compensation, general liability, medical professional liability, other professional liability and management liability coverages, assumed reinsurance run-off and products liability. Short-tail exposures include property, commercial automobile physical damage, marine, surety and warranty. Property & Casualty Operations contain both long-tail and short-tail exposures. Other Insurance Operations contain long-tail exposures.
Various methods are used to project ultimate losses for both long-tail and short-tail exposures.
The paid development method estimates ultimate losses by reviewing paid loss patterns and applying them to accident or policy years with further expected changes in paid losses. Selection of the paid loss pattern may require consideration of several factors including the impact of inflation on claim costs, the rate at which claims professionals make claim payments and close claims, the impact of judicial decisions, the impact of underwriting changes, the impact of large claim payments and other factors. Claim cost inflation itself may require evaluation of changes in the cost of repairing or replacing property, changes in the cost of medical care, changes in the cost of wage replacement, judicial decisions, legislative changes and other factors. Because this method assumes that losses are paid at a consistent rate, changes in any of these factors can affect the results. Since the method does not rely on case reserves, it is not directly influenced by changes in their adequacy.
For many reserve groups, paid loss data for recent periods may be too immature or erratic for accurate predictions. This situation often exists for long-tail exposures. In addition, changes in the factors described above may result in inconsistent payment patterns. Finally, estimating the paid loss pattern subsequent to the most mature point available in the data analyzed often involves considerable uncertainty for long-tail products such as workers’ compensation.
The incurred development method is similar to the paid development method, but it uses case incurred losses instead of paid losses. Since the method uses more data (case reserves in addition to paid losses) than the paid development method, the incurred development patterns may be less variable than paid patterns. However, selection of the incurred loss pattern typically requires analysis of all of the same factors described above. In addition, the inclusion of case reserves can lead to distortions if changes in case reserving practices have taken place, and the use of case incurred losses may not eliminate the issues associated with estimating the incurred loss pattern subsequent to the most mature point available.
The loss ratio method multiplies earned premiums by an expected loss ratio to produce ultimate loss estimates for each accident or policy year. This method may be useful for immature accident or policy periods or if loss development patterns are inconsistent, losses emerge very slowly, or there is relatively little loss history from which to estimate future losses. The selection of the expected loss ratio typically requires analysis of loss ratios from earlier accident or policy years or pricing studies and analysis of inflationary trends, frequency trends, rate changes, underwriting changes and other applicable factors.
The Bornhuetter-Ferguson method using paid loss is a combination of the paid development method and the loss ratio method. This method normally determines expected loss ratios similar to the approach used to estimate the expected loss ratio for the loss ratio method and typically requires analysis of the same factors described above. This method assumes that future losses will develop at the expected loss ratio level. The percent of paid loss to ultimate loss implied from the paid development method is used to determine what percentage of ultimate loss is yet to be paid. The use of the pattern from the paid development method typically requires consideration of the same factors listed in the description of the paid development method. The estimate of losses yet to be paid is added to current paid losses to estimate the ultimate loss for each year. For long-tail lines, this method will react very slowly if actual ultimate loss ratios are different from expectations due to changes not accounted for by the expected loss ratio calculation.
The Bornhuetter-Ferguson method using incurred loss is similar to the Bornhuetter-Ferguson method using paid loss except that it uses case incurred losses. The use of case incurred losses instead of paid losses can result in development patterns that are less variable than paid patterns. However, the inclusion of case reserves can lead to distortions if changes in case reserving have taken place, and the method typically requires analysis of the same factors that need to be reviewed for the loss ratio and incurred development methods.
The frequency times severity method multiplies a projected number of ultimate claims by an estimated ultimate average loss for each accident or policy year to produce ultimate loss estimates. Since projections of the ultimate number of claims are often less variable than projections of ultimate loss, this method can provide more reliable results for reserve groups where loss development patterns are inconsistent or too variable to be relied on exclusively. In addition, this method can more directly account for changes in coverage that affect the number and size of claims. However, this method can be difficult to apply to situations where very large claims or a substantial number of unusual claims result in volatile average claim sizes. Projecting the ultimate number of claims may require analysis of several factors, including the rate at which policyholders report claims to CNA, the impact of judicial decisions, the impact of underwriting changes and other factors. Estimating the ultimate average loss may require analysis of the impact of large losses and claim cost trends based on changes in the cost of repairing or replacing property, changes in the cost of medical care, changes in the cost of wage replacement, judicial decisions, legislative changes and other factors.
Stochastic modeling produces a range of possible outcomes based on varying assumptions related to the particular reserve group being modeled. For some reserve groups, CNA uses models which rely on historical development patterns at an aggregate level, while other reserve groups are modeled using individual claim variability assumptions supplied by the claims department. In either case, multiple simulations using varying assumptions are run and the results are analyzed to produce a range of potential outcomes. The results will typically include a mean and percentiles of the possible reserve distribution which aid in the selection of a point estimate.
For many exposures, especially those that can be considered long-tail, a particular accident or policy year may not have a sufficient volume of paid losses to produce a statistically reliable estimate of ultimate losses. In such a case, CNA’s actuaries typically assign more weight to the incurred development method than to the paid development method. As claims continue to settle and the volume of paid loss increases, the actuaries may assign additional weight to the paid development method. For most of CNA’s products, even the incurred losses for accident or policy years that are early in the claim settlement process will not be of sufficient volume to produce a reliable estimate of ultimate losses. In these cases, CNA may not assign much, if any, weight to the paid and incurred development methods. CNA may use the loss ratio, Bornhuetter-Ferguson and/or frequency times severity methods. For short-tail exposures, the paid and incurred development methods can often be relied on sooner primarily because CNA’s history includes a sufficient number of years to cover the entire period over which paid and incurred losses are expected to change. However, CNA may also use the loss ratio, Bornhuetter-Ferguson and/or frequency times severity methods for short-tail exposures.
For other more complex reserve groups where the above methods may not produce reliable indications, CNA uses additional methods tailored to the characteristics of the specific situation.
Periodic Reserve Reviews
The reserve analyses performed by CNA’s actuaries result in point estimates. Each quarter, the results of the detailed reserve reviews are summarized and discussed with CNA’s senior management to determine the best estimate of reserves. CNA’s senior management considers many factors in making this decision. CNA’s recorded reserves reflect its best estimate as of a particular point in time based upon known facts and circumstances, consideration of the factors cited above and its judgment. The carried reserve differs from the actuarial point estimate as discussed further below.
Currently, CNA’s recorded reserves are modestly higher than the actuarial point estimate. For Property & Casualty Operations, the difference between CNA’s reserves and the actuarial point estimate is primarily driven by uncertainty with respect to immature accident years, claim cost inflation, changes in claims handling, changes to the tort environment which may adversely affect claim costs and the effects from the economy. For CNA’s legacy A&EP liabilities, the difference between CNA’s reserves and the actuarial point estimate is primarily driven by the potential tail volatility of run-off exposures.
The key assumptions fundamental to the reserving process are often different for various reserve groups and accident or policy years. Some of these assumptions are explicit assumptions that are required of a particular method, but most of the assumptions are implicit and cannot be precisely quantified. An example of an explicit assumption is the pattern employed in the paid development method. However, the assumed pattern is itself based on several implicit assumptions such as the impact of inflation on medical costs and the rate at which claim professionals close claims. As a result, the effect on reserve estimates of a particular change in assumptions typically cannot be specifically quantified, and changes in these assumptions cannot be tracked over time.
CNA’s recorded reserves are management’s best estimate. In order to provide an indication of the variability associated with CNA’s net reserves, the following discussion provides a sensitivity analysis that shows the approximate estimated impact of variations in significant factors affecting CNA’s reserve estimates for particular types of business. These significant factors are the ones that CNA believes could most likely materially affect the reserves. This discussion covers the major types of business for which CNA believes a material deviation to its reserves is reasonably possible. There can be no assurance that actual experience will be consistent with the current assumptions or with the variation indicated by the discussion. In addition, there can be no assurance that other factors and assumptions will not have a material impact on CNA’s reserves.
The three areas for which CNA believes a significant deviation to its net reserves is reasonably possible are (i) professional liability, management liability and surety products; (ii) workers’ compensation and (iii) general liability.
Professional liability, management liability and surety products include professional liability coverages provided to various professional firms, including architects, real estate agents, small and mid-sized accounting firms, law firms and other professional firms. They also include D&O, employment practices, fiduciary, fidelity and surety coverages, as well as insurance products serving the health care delivery system. The most significant factor affecting reserve estimates for these liability coverages is claim severity. Claim severity is driven by the cost of medical care, the cost of wage replacement, legal fees, judicial decisions, legislative changes and other factors. Underwriting and claim handling decisions such as the classes of business written and individual claim settlement decisions can also affect claim severity. If the estimated claim severity increases by 9%, CNA estimates that net reserves would increase by approximately $400 million. If the estimated claim severity decreases by 3%, CNA estimates that net reserves would decrease by approximately $150 million. CNA’s net reserves for these products were approximately $4.7 billion as of December 31, 2018.
For workers’ compensation, since many years will pass from the time the business is written until all claim payments have been made, the most significant factor affecting workers’ compensation reserve estimate is claim cost inflation on claim payments. Workers’ compensation claim cost inflation is driven by the cost of medical care, the cost of wage replacement, expected claimant lifetimes, judicial decisions, legislative changes and other factors. If estimated workers’ compensation claim cost inflation increases by 100 basis points for the entire period over which claim payments will be made, CNA estimates that its net reserves would increase by approximately $350 million. If estimated workers’ compensation claim cost inflation decreases by 100 basis points for the entire period over which claim payments will be made, CNA estimates that its net reserves would decrease by approximately $300 million. Net reserves for workers’ compensation were approximately $4.0 billion as of December 31, 2018.
For general liability, the most significant factor affecting reserve estimates is claim severity. Claim severity is driven by changes in the cost of repairing or replacing property, the cost of medical care, the cost of wage replacement, judicial decisions, legislation and other factors. If the estimated claim severity for general liability increases by 6%, CNA estimates that its net reserves would increase by approximately $200 million. If the estimated claim severity for general liability decreases by 3%, CNA estimates that its net reserves would decrease by approximately $100 million. Net reserves for general liability were approximately $3.4 billion as of December 31, 2018.
Given the factors described above, it is not possible to quantify precisely the ultimate exposure 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, additional claims are reported and settled and additional information becomes available in subsequent periods. In reviewing CNA’s reserve estimates, CNA makes adjustments in the period that the need for such adjustments is determined. These reviews have resulted in CNA’s identification of information and trends that have caused CNA to change its reserves in prior periods and could lead to CNA’s
identification of a need for additional material increases or decreases in claim and claim adjustment expense reserves, which could materially affect our results of operations and equity and CNA’s business and insurer financial strength and corporate debt ratings positively or negatively. See Note 8 of the Notes to the Consolidated Financial Statements included under Item 8 for additional information about reserve development.
The following table summarizes gross and net carried reserves for CNA’s Property & Casualty Operations:
| December 31 | 2018 | 2017 | ||||||
| (In millions) | ||||||||
| Gross Case Reserves | $ | 6,671 | $ | 6,913 | ||||
| Gross IBNR Reserves | 9,287 | 9,156 | ||||||
| Total Gross Carried Claim and Claim Adjustment Expense Reserves | $ | 15,958 | $ | 16,069 | ||||
| Net Case Reserves | $ | 6,063 | $ | 6,343 | ||||
| Net IBNR Reserves | 8,290 | 8,232 | ||||||
| Total Net Carried Claim and Claim Adjustment Expense Reserves | $ | 14,353 | $ | 14,575 | ||||
| The following table summarizes the gross and net carried reserves for other insurance businesses in run-off, including CNA Re and A&EP: | ||||||||
| December 31 | 2018 | 2017 | ||||||
| (In millions) | ||||||||
| Gross Case Reserves | $ | 1,208 | $ | 1,371 | ||||
| Gross IBNR Reserves | 1,217 | 1,065 | ||||||
| Total Gross Carried Claim and Claim Adjustment Expense Reserves | $ | 2,425 | $ | 2,436 | ||||
| Net Case Reserves | $ | 96 | $ | 94 | ||||
| Net IBNR Reserves | 96 | 111 | ||||||
| Total Net Carried Claim and Claim Adjustment Expense Reserves | $ | 192 | $ | 205 | ||||
Long Term Care Policyholder Reserves
CNA’s Other Insurance Operations includes its run-off long term care business as well as structured settlement obligations not funded by annuities related to certain property and casualty claimants. Long term care policies provide benefits for nursing homes, assisted living facilities and home health care subject to various daily and lifetime caps. Generally, policyholders must continue to make periodic premium payments to keep the policy in force and CNA has the ability to increase policy premiums, subject to state regulatory approval.
CNA maintains both claim and claim adjustment expense reserves as well as future policy benefit reserves for policyholder benefits for its long term care business. Claim and claim adjustment expense reserves consist of estimated reserves for long term care policyholders that are currently receiving benefits, including claims that have been incurred but are not yet reported. In developing the claim and claim adjustment expense reserve estimates for CNA’s long term care policies, its actuaries perform a detailed claim experience study on an annual basis. The study reviews the sufficiency of existing reserves for policyholders currently on claim and includes an evaluation of expected benefit utilization and claim duration. CNA’s recorded claim and claim adjustment expense reserves reflect CNA management’s best estimate after incorporating the results of the most recent study. In addition, claim and claim adjustment expense reserves are also maintained for the structured settlement obligations.
Future policy benefit reserves represent the active life reserves related to CNA’s long term care policies and are the present value of expected future benefit payments and expenses less expected future premium. The determination of these reserves is fundamental to CNA’s financial results and requires management to make estimates and assumptions about expected investment and policyholder experience over the life of the contract. Since many of these contracts may be in force for several decades, these assumptions are subject to significant estimation risk.
The actuarial assumptions that management believes are subject to the most variability are morbidity, persistency, discount rate and anticipated future premium rate increases. Persistency can be affected by policy lapses, benefit reductions and death. Discount rate is influenced by the investment yield on assets supporting long term care reserves which is subject to interest rate and market volatility and may also be affected by changes to the Internal Revenue Code. As a result of this variability, CNA’s long term care reserves may be subject to material increases if actual experience develops adversely to its expectations.
Annually, management assesses the adequacy of its long term care future policy benefit reserves by performing a gross premium valuation (“GPV”) to determine if there is a premium deficiency. Management also uses the GPV process to evaluate the adequacy of the claim and claim adjustment expense reserves for structured settlement obligations. Under the GPV, management estimates required reserves using best estimate assumptions as of the date of the assessment without provisions for adverse deviation. The GPV required reserves are then compared to the recorded reserves. If the GPV required reserves are greater than the existing recorded reserves, the existing assumptions are unlocked and future policy benefit reserves are increased to the greater amount. Any such increase is reflected in CNA’s results of operations in the period in which the need for such adjustment is determined, and could materially adversely affect our results of operations and equity and CNA’s business and insurer financial strength and corporate debt ratings. Periodically, CNA engages independent third parties to assess the appropriateness of its best estimate assumptions and the associated GPV required reserves. The last independent assessment was performed in 2017.
CNA’s most recent GPV indicated its future policy benefit reserves for long term care business were not deficient in the aggregate, but profits are expected to be recognized in early years followed by losses in later years. In that circumstance, future policy benefit reserves are increased in the profitable years by an amount necessary to offset losses that are projected to be recognized in later years. The amount of the additional future policy benefit reserves recorded in each quarterly period is based on the ratio of the present value of future losses divided by the present value of future profits from the most recently completed GPV applied to long term care core income.
The GPV process was performed in the third quarter of 2018 as compared to the fourth quarter of 2017. The September 30, 2018 GPV indicated recorded reserves included a margin of approximately $182 million. A summary of the changes in the estimated reserve margin is presented in the table below:
| (In millions) | ||||
| Long term care active life reserve - change in estimated reserve margin | ||||
| 2017 estimated margin | $ | 246 | ||
| Changes in underlying morbidity assumptions | (213 | ) | ||
| Changes in underlying persistency assumptions and inforce policy inventory | (86 | ) | ||
| Changes in underlying discount rate assumptions | 17 | |||
| Changes in underlying premium rate action assumptions | 178 | |||
| Changes in underlying expense and other assumptions | 40 | |||
| 2018 estimated margin | $ | 182 | ||
The decrease in the margin in 2018 was driven by the removal of the future morbidity improvement assumption and extending the period of mortality improvement within the persistency assumptions. These unfavorable drivers were partially offset by higher than expected rate increases on active rate action programs and favorable changes to the underlying expense and discount rate assumptions.
The table below summarizes the estimated pretax impact on CNA’s results of operations from various hypothetical revisions to its active life reserve assumptions. The annual GPV process involves updating all assumptions to the then current best estimate, and historically all significant assumptions have been revised each year. In the hypothetical revisions table below, CNA has assumed that revisions to such assumptions would occur in each policy type, age and duration within each policy group and would occur absent any changes, mitigating or otherwise, in the other assumptions. Although such hypothetical revisions are not currently required or anticipated, CNA believes they could
occur based on past variances in experience and its expectations of the ranges of future experience that could reasonably occur. Any required increase in the recorded reserves resulting from the hypothetical revision in the table below would first reduce the margin in the carried reserves before it would affect results of operations. Any actual adjustment would be dependent on the specific policies affected and, therefore, may differ from the estimates summarized below. The estimated impacts to results of operations in the table below are after consideration of the existing margin.
| Estimated Reduction | ||||
| 2018 GPV | to Pretax Income | |||
| (In millions) | ||||
| Hypothetical revisions | ||||
| Morbidity: | ||||
| 5% increase in morbidity | $ | 460 | ||
| 10% increase in morbidity | 1,103 | |||
| Persistency: | ||||
| 5% decrease in active life mortality and lapse | $ | 31 | ||
| 10% decrease in active life mortality and lapse | 253 | |||
| Discount rates: | ||||
| 50 basis point decline in future interest rates | $ | 140 | ||
| 100 basis point decline in future interest rates | 500 | |||
| Premium rate actions: | ||||
| 50% decrease in anticipated future premium rate increases | $ | - |
The following table summarizes policyholder reserves for CNA’s long term care operations:
| December 31, 2018 | Claim and claim adjustment expenses | Future policy benefits | Total | |||||||||
| (In millions) | ||||||||||||
| Long term care | $ | 2,761 | $ | 9,113 | $ | 11,874 | ||||||
| Structured settlement annuities | 530 | 530 | ||||||||||
| Other | 14 | 14 | ||||||||||
| Total | 3,305 | 9,113 | 12,418 | |||||||||
| Shadow adjustments (a) | 115 | 1,250 | 1,365 | |||||||||
| Ceded reserves (b) | 181 | 234 | 415 | |||||||||
| Total gross reserves | $ | 3,601 | $ | 10,597 | $ | 14,198 | ||||||
| December 31, 2017 | ||||||||||||
| Long term care | $ | 2,568 | $ | 8,959 | $ | 11,527 | ||||||
| Structured settlement annuities | 547 | 547 | ||||||||||
| Other | 16 | 16 | ||||||||||
| Total | 3,131 | 8,959 | 12,090 | |||||||||
| Shadow adjustments (a) | 159 | 1,990 | 2,149 | |||||||||
| Ceded reserves (b) | 209 | 230 | 439 | |||||||||
| Total gross reserves | $ | 3,499 | $ | 11,179 | $ | 14,678 | ||||||
| (a) | To the extent that unrealized gains on fixed income securities supporting long term care products and annuity contracts would result in a premium deficiency if those gains were realized an increase in Insurance reserves is recorded, after tax and noncontrolling interests, as a reduction of net unrealized gains through Other comprehensive income (loss) (“Shadow Adjustments”). |
|---|
| (b) | Ceded reserves relate to claim or policy reserves fully reinsured in connection with a sale or exit from the underlying business. |
|---|
CATASTROPHES AND RELATED REINSURANCE
CNA generally defines catastrophe loss events in the U.S. consistent with the definition of the Property Claims Service (“PCS”). PCS defines a catastrophe as an event that causes damage of $25 million or more in direct insured losses to property and affects a significant number of policyholders and insurers. For events outside of the U.S., CNA defines a catastrophe as an industry recognized event that generates an accumulation of claims amounting to more than $1 million for the International line of business.
Catastrophes are an inherent risk of the property and casualty insurance business and have contributed to material period-to-period fluctuations in CNA’s results of operations and/or equity. CNA reported catastrophe losses, net of reinsurance, of $252 million, $380 million and $165 million for the years ended December 31, 2018, 2017 and 2016. Net catastrophe losses for the year ended December 31, 2018 included $88 million related to Hurricane Michael, $47 million related to the California wildfires and $33 million related to Hurricane Florence. The remaining net catastrophe losses in 2018 resulted primarily from U.S. weather related events. Net catastrophe losses for the year ended December 31, 2017 included $256 million related to Hurricanes Harvey, Irma and Maria and also required reinsurance reinstatement premium of $4 million. The remaining net catastrophe losses in 2017 resulted primarily from the California wildfires and U.S. weather related events. Net catastrophe losses for the year ended December 31, 2016 related primarily to U.S. weather-related events and the Fort McMurray wildfires.
CNA generally seeks to manage its exposure to catastrophes through the purchase of catastrophe reinsurance and has catastrophe reinsurance treaties that cover property and workers’ compensation losses. CNA conducts an ongoing review of its risk and catastrophe coverages and from time to time make changes as it deems appropriate. The following discussion summarizes CNA’s most significant catastrophe reinsurance coverage at January 1, 2019.
Group North American Property Treaty
CNA purchased corporate catastrophe excess-of-loss treaty reinsurance covering its U.S. states and territories and Canadian property exposures underwritten in its North American and European companies. Exposures underwritten through Hardy are excluded. The treaty has a term of January 1, 2019 to May 1, 2020. The 2019 treaty provides coverage for the accumulation of losses from catastrophe occurrences above CNA’s per occurrence retention of $250 million up to $1.0 billion. There is no co-participation for the treaty term. Losses stemming from terrorism events are covered unless they are due to a nuclear, biological or chemical attack. All layers of the treaty provide for one full reinstatement.
Group Workers Compensation Treaty
CNA also purchased corporate Workers Compensation catastrophe excess-of-loss treaty reinsurance for the period January 1, 2019 to January 1, 2020 providing $275 million of coverage for the accumulation of covered losses related to natural catastrophes above CNA’s retention of $25 million. The treaty provides $475 million of coverage for the accumulation of covered losses related to terrorism events above CNA’s retention of $25 million. Of the $475 million in terrorism coverage, $200 million is provided for nuclear, biological, chemical and radiation events. One full reinstatement is available for the first $275 million above the retention, regardless of the covered peril. CNA also purchased a targeted facultative facility to address exposure accumulations in specific peak terrorism zones.
Terrorism Risk Insurance Program Reauthorization Act of 2015 (“TRIPRA”)
CNA’s principal reinsurance protection against large-scale terrorist attacks, including nuclear, biological, chemical or radiological attacks, is the coverage currently provided through TRIPRA which runs through the end of 2020. TRIPRA provides a backstop for insurance-related losses resulting from any “act of terrorism”, which is certified by the Secretary of Treasury in consultation with the Secretary of Homeland Security for losses that exceed a threshold of $180 million industry-wide for calendar year 2019, with the threshold increasing to $200 million for 2020. Under the current provisions of the program, in 2019 the federal government will reimburse 81% of CNA’s covered losses in excess of its applicable deductible up to a total industry program cap of $100 billion. This amount will decrease to 80% in the year 2020. CNA’s deductible is based on eligible commercial property and casualty earned premiums for the preceding calendar year. Based on 2018 earned premiums, CNA’s estimated deductible under the program is $1.4 billion for 2019. If an act of terrorism or acts of terrorism result in covered losses exceeding the $100 billion annual
industry aggregate limit, Congress would be responsible for determining how additional losses in excess of $100 billion will be paid.
CRITICAL ACCOUNTING ESTIMATES
The preparation of the Consolidated Financial Statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and the related notes. Actual results could differ from those estimates.
The Consolidated Financial Statements and accompanying notes have been prepared in accordance with GAAP, applied on a consistent basis. We continually evaluate the accounting policies and estimates used to prepare the Consolidated Financial Statements. In general, our estimates are based on historical experience, evaluation of current trends, information from third party professionals and various other assumptions that we believe are reasonable under the known facts and circumstances.
We consider the accounting policies discussed below to be critical to an understanding of our Consolidated Financial Statements as their application places the most significant demands on our judgment. Due to the inherent uncertainties involved with these types of judgments, actual results could differ significantly from estimates, which may have a material adverse impact on our results of operations and/or equity and CNA’s insurer financial strength and corporate debt ratings.
Insurance Reserves
Insurance reserves are established for both short and long-duration insurance contracts. Short-duration contracts are primarily related to property and casualty insurance 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 are primarily related to long term care policies and are estimated using actuarial estimates about morbidity and persistency as well as assumptions about expected investment returns and future premium rate increases. The reserve for unearned premiums represents the portion of premiums written related to the unexpired terms of coverage. The reserving process is discussed in further detail in the Insurance Reserves section of this MD&A.
Reinsurance and Other Receivables
Exposure exists with respect to the collectibility of ceded property and casualty and life reinsurance to the extent that any reinsurer is unable to meet its obligations or disputes the liabilities CNA has ceded under reinsurance agreements. An allowance for doubtful accounts on reinsurance receivables is recorded on the basis of periodic evaluations of balances due from reinsurers, reinsurer solvency, industry experience and current economic conditions. Further information on CNA’s reinsurance receivables is included in Note 16 of the Notes to Consolidated Financial Statements included under Item 8.
Additionally, exposure exists with respect to the collectibility of amounts due from customers on other receivables. An allowance for doubtful accounts is recorded on the basis of periodic evaluations of balances due, currently as well as in the future, historical reinsurer default data, management’s experience and current economic conditions.
If actual experience differs from the estimates made by management in determining the allowances for doubtful accounts on reinsurance and other receivables, net receivables as reflected on our Consolidated Balance Sheets may not be collected. Therefore, our results of operations and/or equity could be materially adversely affected.
Valuation of Investments and Impairment of Securities
Fixed maturity and equity securities are carried at fair value on the balance sheet. Fair value represents the price that would be received in a sale of an asset in an orderly transaction between market participants on the measurement date, the determination of which requires us to make a significant number of assumptions and judgments. Securities with the greatest level of subjectivity around valuation are those that rely on inputs that are significant to the estimated fair value and that are not observable in the market or cannot be derived principally from or corroborated by observable market data. These unobservable inputs are based on assumptions consistent with what we believe other market
participants would use to price such securities. Further information on fair value measurements is included in Note 4 of the Notes to Consolidated Financial Statements included under Item 8.
CNA’s investment portfolio is subject to market declines below amortized cost that may be other-than-temporary and therefore result in the recognition of impairment losses in earnings. Factors considered in the determination of whether or not a decline is other-than-temporary include a current intention or need to sell the security or an indication that a credit loss exists. Significant judgment exists regarding the evaluation of the financial condition and expected near-term and long term prospects of the issuer, or the underlying collateral, the relevant industry conditions and trends, and whether CNA expects to receive cash flows sufficient to recover the entire amortized cost basis of the security. Further information on CNA’s process for evaluating impairments is included in Note 1 of the Notes to Consolidated Financial Statements included under Item 8.
Long Term Care Policies
Future policy benefit reserves for CNA’s long term care policies are based on certain assumptions including morbidity, persistency, inclusive of mortality, discount rates and future premium rate increases. The adequacy of the reserves is contingent upon actual experience and CNA’s future expectations related to these key assumptions. If actual or CNA’s expected future experience differs from these assumptions, the reserves may not be adequate, requiring CNA to add to reserves.
A prolonged period during which interest rates remain at levels lower than those anticipated in CNA’s reserving discount rate assumption could result in shortfalls in investment income on assets supporting CNA’s obligations under long term care policies, which may also require an increase to CNA’s reserves. In addition, CNA may not receive regulatory approval for the premium rate increases it requests.
These changes to CNA’s reserves could materially adversely impact our results of operations and equity. The reserving process is discussed in further detail in the Insurance Reserves section of this MD&A.
Impairment of Long-Lived Assets
We review our long-lived assets for impairment when changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We use a probability-weighted cash flow analysis to test property and equipment for impairment based on relevant market data. If an asset is determined to be impaired, a loss is recognized to reduce the carrying amount to the fair value of the asset. Management’s cash flow assumptions are an inherent part of our asset impairment evaluation and the use of different assumptions could produce results that differ from the reported amounts.
Income Taxes
Deferred income taxes are recognized for temporary differences between the financial statement and tax return bases of assets and liabilities. Any resulting future tax benefits are recognized to the extent that realization of such benefits is more likely than not, and a valuation allowance is established for any portion of a deferred tax asset that management believes may not be realized. The assessment of the need for a valuation allowance requires management to make estimates and assumptions about future earnings, reversal of existing temporary differences and available tax planning strategies. If actual experience differs from these estimates and assumptions, the recorded deferred tax asset may not be fully realized, resulting in an increase to income tax expense in our results of operations. In addition, the ability to record deferred tax assets in the future could be limited resulting in a higher effective tax rate in that future period.
ACCOUNTING STANDARDS UPDATE
For a discussion of accounting standards updates that have been adopted or will be adopted in the future, please read Note 1 of the Notes to Consolidated Financial Statements included under Item 8.
FORWARD-LOOKING STATEMENTS
Investors are cautioned that certain statements contained in this Report as well as some statements in other SEC filings and periodic press releases of us and our subsidiaries and some oral statements made by us and our subsidiaries and our and their officials during presentations may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Act”). Forward-looking statements include, without limitation, any statement that does not directly relate to any historical or current fact and may project, indicate or imply future results, events, performance or achievements. Such statements may contain the words “expect,” “intend,” “plan,” “anticipate,” “estimate,” “believe,” “will be,” “will continue,” “will likely result,” and similar expressions. In addition, any statement concerning future financial performance (including future revenues, earnings or growth rates), ongoing business strategies or prospects, and possible actions taken by us or our subsidiaries are also forward-looking statements as defined by the Act. Forward-looking statements are based on current expectations and projections about future events and are inherently subject to a variety of risks and uncertainties, many of which are beyond our control, that could cause actual results to differ materially from those anticipated or projected.
Developments in any of the risks or uncertainties facing us or our subsidiaries, including those described under Item 1A, Risk Factors of this Report and in our other filings with the SEC, could cause our results to differ materially from results that have been or may be anticipated or projected. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements. Forward-looking statements speak only as of the date they are made and we expressly disclaim any obligation or undertaking to update these statements to reflect any change in our expectations or beliefs or any change in events, conditions or circumstances on which any forward-looking statement is based.
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