To Our Shareholders
Frederick H. Eppinger
President and Chief Executive Officer
The improvements and investments we made in 2005, in addition to those made in the prior two years, have enabled us to deliver on our promises to our agents and their customers, and have created substantial value for our shareholders.
In fact, The Wall Street Journal in its annual Shareholders Scoreboard reported that our company generated the single best three-year shareholder return among all property and casualty companies tracked for the period through year-end 2005. Our average compound annual return for the three-year period was 60.9 percent—nearly three times higher than the average for all property and casualty companies.
The results of our work over the past three years are encouraging and give us great confidence in our future. But, we know we must remain focused on improving every day if we are going to build a world class regional company.
Foundational Strength in Place
The significant advances we made during 2005 further strengthened our financial position, improved the overall risk profile of our company and increased our core earnings power. Our actions enhanced our company’s focus and positioned us for greater success in 2006.
The progress we made in 2005 is not readily apparent in our financial results, however, due to the impact of two extraordinary events; the sale of our variable life insurance and annuity business and the impact of Hurricane Katrina.
While the life sale focused our company squarely on the property and casualty business and generated gross proceeds of $360 million, it also resulted in an after-tax, non-cash loss of $444 million, which reduced our net income. Hurricane Katrina also had a dramatic impact.
While our strong reinsurance program minimized the impact, Katrina still generated losses of $162 million on a net-of-tax basis.
It is important to note that in spite of these two events, we enhanced our capital position and affirmed our financial standing in the industry, maintaining our “A-” “Excellent” A.M. Best Co. financial strength ratings, and gaining the trust and confidence of our key stakeholders.
Sale of the Variable Life Insurance and Annuity Business
The sale of our variable life insurance and annuity business to The Goldman Sachs Group was an important transaction that clarified our future.
Our life business had been placed in run-off in late 2002. Since that time, our strategy had been to prudently manage this business in order to maximize and monetize the cash flow it generated. Our decision to sell the business was consistent with that strategy and was the best answer for our company.
This transaction will create value for us in both the short and long term. Over the long term, we will benefit from our enhanced focus on the property and casualty business. In the short term, the proceeds generated through the sale will enable us to deliver value for our shareholders by accelerating the release of capital from our life companies and providing us with considerably more financial flexibility.
Effective with the closing of the transaction at year-end, we instituted a share buyback program of up to $200 million, which we plan to execute through 2006. This share repurchase program complemented the shareholder dividend that we also reinstituted in 2005. Even after the execution of these capital management programs, our holding company is expected to have sufficient liquidity to cover its fixed obligations for several years.
Impact of Hurricane Katrina
Mark Welzenbach and John Urankar are leading our Claims organization through a total redesign that supports our business needs and financial objectives for the future.
Hurricane Katrina was an event of unparalleled magnitude for our industry and for our company. This storm hit directly in our largest concentration of coastal business, Louisiana, and it will cost us more than any single catastrophe in our company’s history.
Providing for and responding to catastrophes of this nature is our business. It is what we must do well as a top-quartile company, and I am proud of the way our company and our people responded under extraordinarily difficult circumstances.
We overcame tremendous challenges, quickly getting adjusters on the ground in the affected areas, assessing damage, making advance payments and helping our agents and customers begin the process of rebuilding their lives.
Katrina tested many in our industry, insurers and re-insurers alike, requiring many to raise capital in order to meet their financial obligations. We passed the Katrina test, confirming the progress we had made and the financial strength of our company.
Despite the significant losses sustained from Hurricane Katrina, we ended the year with $54 million dollars in after-tax segment income, and with more statutory capital than we had at the beginning of the year. Our statutory surplus increased by over $100 million during 2005, up 10% to $1.2 billion, and we improved our capitalization ratios and operating leverage. Our ability to withstand the impact of Hurricane Katrina while generating meaningful earnings and increasing our capital is a testimony to the strength of the underlying earnings power in our Property and Casualty business.
Catastrophes are very much a part of our business, and we manage our business with an objective of earning at least our cost of capital on average over time. However, given the events of 2005, it is helpful to look at earnings excluding catastrophes.
Catastrophe losses were $304 million in 2005, compared to $99 million in 2004. Excluding the impact of these catastrophes, our 2005 Property and Casualty pre-tax segment earnings were up $120 million, or40%, compared to 2004. On this basis, both our Personal Lines and Commercial Lines businesses recorded earnings improvement, with a 38% earnings growth in Personal Lines and a 47% earnings growth in Commercial Lines.*
The growing earnings power of our company clearly demonstrates that the investments and the improvements we have made in each of our business segments are having the desired effect.
Creating a Distinctive Position
While strengthening the foundation on which we are building our business, we also continued to make great progress on the strategic initiatives that we believe will sustain our performance and position us for greater success going forward. The investments we have made in our business have enabled us to foster more and stronger relationships with our agents and to meet the product and service expectations of our agents and their customers. We have begun to see these investments generate growth in our business and we expect the rate of growth to accelerate as these and other enhancements take hold.
Commercial Lines
Sophia Phillips and Dick Van Steenburgh have driven significant improvements in our Bond and Marine capabilities, generating excellent business results while strengthening our Commercial Lines value proposition.
In Commercial Lines, our company is positioned to be one of the very best in the small to mid-market business segment, offering a distinctive operating model by partnering our experienced field team with winning agents. We also have developed expertise in specialty businesses that can be leveraged across our distribution system and provide opportunity for higher growth and improved margins.
Despite competitive market conditions, we have been able to generate high-quality new business growth while improving our mix.
We will continue to leverage our position into 2006. Our objective is to maintain the focus on growth in small commercial and first-tier middle market, which we define as policies with annual premiums up to$200,000, where we can capitalize on our distinctive strategy and value proposition.
Our ability to continue to grow in 2006 will be driven by the strength and distinctiveness of the business model that we have developed, which is aligned closely with the needs of growing mid-sized agents.
We are now ready to offer our agents a unique opportunity; what we call a “total solutions approach.” This approach provides our agents with a broad product portfolio, quick turnaround on quoting activity, partnerships with knowledgeable underwriters, and a responsive, local service team.
We believe this business model will be a winning value proposition for our target agents and will make us a “must have” carrier in our agents’ portfolio.
Personal Lines
In Personal Lines, our strategy has been to strengthen our foundation by improving our profitability and mix of business, while investing in products and an operating model that will allow us to compete aggressively in the market.
Jose Trasancos and Cilsy Harris led the development of Connections Auto in record time, providing a state-of the-art product platform to support our Personal Lines value proposition.
Our growth objective in Personal Lines is supported by ConnectionsTM Auto, our new multi-variate auto product, and is augmented by a broad product offering. Our focus in this business is to provide a “total account solution,” offering the capability to meet customers’ total personal insurance needs, with an integrated family of products and without gaps in coverage. At the same time, we have the sophistication in our product and the breadth of coverage to support the changing needs of our customers through their various life stages.
Backing up our growth efforts, we have created a field presence with regional vice presidents of the highest caliber in our key markets and we have made many enhancements to our service model that make it easy for agents to do business with us.
As in Commercial Lines, it is this comprehensive approach to the needs of our agent partners and customers that will make us a distinctive carrier in our agent’s portfolio.
The successful launch of Connections Auto was critical to the execution of our Personal Lines strategy during 2005. This product was launched in April and was rolled out during the year in eight states: Florida, Illinois, Indiana, Maine, New York, Tennessee, Virginia and Michigan. It represents a dramatic improvement in our product portfolio and positions us to profitably write a much broader spectrum of the market, with greater underwriting precision, and supports our efforts to boost penetration in our existing markets as well as our expansion efforts into new markets.
The initial market response to this product has been overwhelmingly positive, resulting in significant sales activity. Through the final eight months of 2005, we wrote more than 34,000 new Connections Auto policies.
We are encouraged that this product, in combination with significantly improved service, will help build more and deeper partnerships with winning agents going forward, as it did during 2005, when previously dormant agencies began working with us again and we appointed approximately 300 new Personal Lines agents.
We fully expect to continue the growth momentum created by the Connections Auto launch, as we roll the product out in nine additional states during 2006.
Our Strategy is Sound and Remains Unchanged
Our success in 2005 has confirmed that our strategy is sound.
The strong financial leadership of Joe Freitas and Michael Lorion has helped to deepen our understanding of the economics of our business, leading to better decision making and ultimately higher returns.
Today, the foundation of our business is solid. Our company is in excellent financial condition, and we have the leadership team in place to build our business.
Success in our industry has everything to do with strong execution and it is people that make that happen. I am very proud of the leadership team that we have assembled, complementing existing talent with some of the finest talent from the industry to create a company that has the capability and drive to make things happen.
The quality of our people enabled us to achieve a great deal during 2005, including completing the complex sale of our variable life insurance and annuity business, responding effectively to Hurricane Katrina, and bringing Connections Auto to market in record time.
Outlook
Dan Mastrototaro and Mike Christiansen are part of one of the most experienced and responsive field leadership teams in the business, driving strong results today while building our leadership capabilities for the future.
With competition increasing and a shakeout underway in the property and casualty business, we have a clear vision for the future—to become a world class regional property and casualty insurance company—one that achieves top-quartile financial position, provides our agent partners with top-quartile products and service, and is a place where the best people in our business want to work.
We entered 2006 poised to grow both our Personal and Commercial Lines of business. The signs of our progress are everywhere. But, we are not done. We take pride in all we have accomplished, but we focus every day on what we have yet to achieve.
Our immediate focus is to further improve our overall financial condition, continually strengthen our team, create more and stronger partnerships with our agent partners, develop better products and provide more responsive service.
Our company is uniquely positioned today as a super regional, offering our independent agent partner sand their customers the best attributes of both national and regional companies. In the months and years ahead, our goal is to exploit that competitive advantage, creating significant value for our shareholders and all of our other stakeholders, as we create a very special, truly great company.
I have every confidence we will do just that.
Sincerely,
Frederick H. Eppinger
President and Chief Executive Officer
* Actual GAAP 2005 pre-tax Property and Casualty segment earnings (including losses and loss adjustment expenses from Hurricane Katrina and other catastrophe losses in 2004 and 2005 and related reinstatement premium in 2005) decreased $84 million, or 43%, as compared to 2004, reflecting a 6% increase in Personal Lines and a 160% decline in Commercial Lines. Property and Casualty total segment income is reconciled to net income on page 27 of the attached Annual Report on Form 10-K.
