-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, BkOYE6h3BWWMli8/AUaWv46fjOQrKCduTYZHkXuSPbaKnGQnkiBKPK2JkS8e1KQ5 vGj/FKqrkL8NkkH+YpkDRQ== 0000086312-02-000011.txt : 20020814 0000086312-02-000011.hdr.sgml : 20020814 20020814134010 ACCESSION NUMBER: 0000086312-02-000011 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20020630 FILED AS OF DATE: 20020814 FILER: COMPANY DATA: COMPANY CONFORMED NAME: ST PAUL COMPANIES INC /MN/ CENTRAL INDEX KEY: 0000086312 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 410518860 STATE OF INCORPORATION: MN FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-10898 FILM NUMBER: 02734031 BUSINESS ADDRESS: STREET 1: 385 WASHINGTON ST CITY: SAINT PAUL STATE: MN ZIP: 55102 BUSINESS PHONE: 6123107911 FORMER COMPANY: FORMER CONFORMED NAME: SAINT PAUL COMPANIES INC DATE OF NAME CHANGE: 19900730 FORMER COMPANY: FORMER CONFORMED NAME: ST PAUL COMPANIES INC/MN/ DATE OF NAME CHANGE: 19990219 FORMER COMPANY: FORMER CONFORMED NAME: ST PAUL FIRE & MARINE INSURANCE CO/MD DATE OF NAME CHANGE: 19990219 10-Q 1 tenq202.txt FORM 10-Q FOR QUARTER ENDED JUNE 30, 2002 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE --- SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2002 ------------- or --- TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ------------ ------------ Commission File Number 001-10898 --------- THE ST. PAUL COMPANIES, INC. ---------------------------------------------------- (Exact name of Registrant as specified in its charter) Minnesota 41-0518860 ------------------------------ ------------------------------ (State or other jurisdiction of (I.R.S. Employer Identification incorporation or organization) No.) 385 Washington St., Saint Paul, MN 55102 ---------------------------------- -------- (Address of principal executive (Zip Code) offices) Registrant's telephone number, including area code: (651) 310-7911 ------------- Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- The number of shares of the Registrant's Common Stock, without par value, outstanding at August 9, 2002, was 226,318,181. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES TABLE OF CONTENTS Page No. PART I. FINANCIAL INFORMATION -------- Consolidated Statements of Income (Unaudited), Three and Six Months Ended June 30, 2002 and 2001 3 Consolidated Balance Sheets, June 30, 2002 (Unaudited) and December 31, 2001 4 Consolidated Statements of Shareholders' Equity, Six Months Ended June 30, 2002 (Unaudited) and Twelve Months Ended December 31, 2001 6 Consolidated Statements of Comprehensive Income (Unaudited), Six Months Ended June 30, 2002 and 2001 7 Consolidated Statements of Cash Flows (Unaudited), Six Months Ended June 30, 2002 and 2001 8 Notes to Consolidated Financial Statements (Unaudited) 9 Management's Discussion and Analysis of Financial Condition and Results of Operations 25 PART II. OTHER INFORMATION Item 1 through Item 6 51 Signatures 52 EXHIBIT INDEX 53 PART I FINANCIAL INFORMATION THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS Unaudited For the three months and six months ended June 30, 2002 and 2001 (In millions, except per share data) Three Months Ended Six Months Ended June 30 June 30 ------------------ ---------------- 2002 2001 2002 2001 ------ ------ ------ ------ Revenues: Premiums earned $1,920 $1,743 $3,855 $3,371 Net investment income 286 300 579 635 Asset management 89 85 179 170 Realized investment gains (losses) (33) 7 (71) 83 Other 52 28 89 65 ------ ------ ------ ------ Total revenues 2,314 2,163 4,631 4,324 ------ ------ ------ ------ Expenses: Insurance losses and loss adjustment expenses 1,986 1,346 3,379 2,529 Policy acquisition expenses 405 356 815 736 Operating and administrative expenses 287 328 605 628 ------ ------ ------ ------ Total expenses 2,678 2,030 4,799 3,893 ------ ------ ------ ------ Income (loss) from continuing operations before income taxes (364) 133 (168) 431 Income tax expense (benefit) (146) 37 (98) 126 ------ ------ ------ ------ Income (loss) before cumulative effect of accounting change (218) 96 (70) 305 Cumulative effect of accounting change, net of taxes - - (6) - ------ ------ ------ ------ Income (loss) from continuing operations (218) 96 (76) 305 Discontinued operations: Operating loss, net of taxes - - - (1) Gain (loss) on disposal, net of taxes (5) 8 (14) 2 ------ ------ ------ ------ Income (loss) from discontinued operations, net of taxes (5) 8 (14) 1 ------ ------ ------ ------ Net income (loss) $ (223) $ 104 $ (90) $ 306 ====== ====== ====== ====== Basic earnings (loss) per share: Income (loss) from continuing operations $(1.07) $ 0.43 $(0.41) $ 1.37 Discontinued operations, net of taxes (0.02) 0.04 (0.06) 0.01 ------ ------ ------ ------ Net income (loss) $(1.09) $ 0.47 $(0.47) $ 1.38 ====== ====== ====== ====== Diluted earnings (loss) per share: Income (loss) from continuing operations $(1.07) $ 0.41 $(0.41) $ 1.32 Discontinued operations, net of taxes (0.02) 0.04 (0.06) 0.01 ------ ------ ------ ------ Net income (loss) $(1.09) $ 0.45 $(0.47) $ 1.33 ====== ====== ====== ====== Dividends declared on common stock $ 0.29 $ 0.28 $ 0.58 $ 0.56 ====== ====== ====== ====== See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS June 30, 2002 (unaudited) and December 31, 2001 (In millions) 2002 2001 Assets: ------- ------- Investments: Fixed maturities, at estimated fair value $ 16,942 15,911 Equities, at estimated fair value 556 1,410 Real estate and mortgage loans 897 972 Venture capital, at estimated fair value 821 859 Securities on loan 644 775 Short-term investments 1,758 2,153 Other investments 94 98 ------- ------ Total investments 21,712 22,178 Cash 166 151 Reinsurance recoverables: Unpaid losses 6,997 6,848 Paid losses 323 351 Ceded unearned premiums 728 667 Receivables: Insurance premiums 3,085 3,123 Interest and dividends 256 260 Other 198 246 Deferred policy acquisition costs 654 628 Deferred income taxes 1,303 1,248 Office properties and equipment 479 486 Goodwill and intangible assets 806 690 Other assets 1,514 1,445 ------- ------ Total Assets $ 38,221 $38,321 ======= ======= See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (continued) June 30, 2002 (unaudited) and December 31, 2001 (In millions) 2002 2001 Liabilities: ------- ------ Insurance reserves: Loss and loss adjustment expenses $ 22,516 $22,101 Unearned premiums 4,105 3,957 ------- ------ Total insurance reserves 26,621 26,058 Debt 2,122 2,130 Payables: Reinsurance premiums 948 943 Accrued expenses and other 787 1,036 Securities lending collateral 657 790 Other liabilities 1,214 1,357 ------- ------ Total Liabilities 32,349 32,314 ------- ------ Company-obligated mandatorily redeemable preferred securities of trusts holding solely subordinated debentures of the company 889 893 ------- ------ Shareholders' Equity: Preferred: SOP convertible preferred stock 108 111 Guaranteed obligation - SOP (48) (53) ------- ------ Total Preferred Shareholders' Equity 60 58 ------- ------ Common: Common stock 2,221 2,192 Retained earnings 2,304 2,500 Accumulated other comprehensive income, net of taxes: Unrealized appreciation of investments 463 442 Unrealized loss on foreign currency translation (65) (76) Unrealized loss on derivatives - (2) ------- ------ Total accumulated other comprehensive income 398 364 ------- ------ Total Common Shareholders' Equity 4,923 5,056 ------- ------ Total Shareholders' Equity 4,983 5,114 ------- ------ Total Liabilities, Redeemable Preferred Securities and And Shareholders' Equity $ 38,221 $38,321 ======= ======= See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Six Months Ended June 30, 2002 (unaudited) and Twelve Months Ended December 31, 2001 (In millions) 2002 2001 ------- ------ Preferred Shareholders' Equity: SOP convertible preferred stock: Beginning of period $ 111 $ 117 Redemptions (3) (6) ------- ------ End of period 108 111 ------- ------ Guaranteed obligation - SOP: Beginning of period (53) (68) Principal payments 5 15 ------- ------ End of period (48) (53) ------- ------ Total preferred shareholders' equity 60 58 ------- ------ Common Shareholders' Equity: Common stock: Beginning of period 2,192 2,238 Stock issued: Stock incentive plans 20 67 Preferred shares redeemed 8 13 Reacquired common shares - (135) Other 1 9 ------- ------ End of period 2,221 2,192 ------- ------ Retained earnings: Beginning of period 2,500 4,243 Net loss (90) (1,088) Dividends declared on common stock (121) (235) Dividends declared on preferred stock, net of taxes (4) (9) Reacquired common shares - (454) Other changes 19 43 ------- ------ End of period 2,304 2,500 ------- ------ Unrealized appreciation on investments, net of taxes: Beginning of period 442 765 Change during the period 21 (323) ------- ------ End of period 463 442 ------- ------ Unrealized loss on foreign currency translation, net of taxes: Beginning of period (76) (68) Change during the period 11 (8) ------- ------ End of period (65) (76) ------- ------ Unrealized loss on derivatives, net of taxes: Beginning of period (2) - Change during the period 2 (2) ------- ------ End of period - (2) ------- ------ Total common shareholders' equity 4,923 5,056 ------- ------ Total shareholders' equity $ 4,983 $ 5,114 ======= ======= See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (Unaudited) (In millions) Three Months Six Months Ended June 30 Ended June 30 -------------- -------------- (in millions) 2002 2001 2002 2001 ----------- ----- ----- ----- ---- Net income (loss) $(223) $ 104 $ (90) $306 ----- ----- ----- ---- Other comprehensive income (loss), net of taxes: Change in unrealized appreciation 139 (130) 21 (243) Change in unrealized loss on foreign currency translation 7 (13) 11 6 Change in unrealized loss on derivatives 2 1 2 (1) ----- ----- ----- --- Other comprehensive income (loss) 148 (142) 34 (238) ----- ----- ----- --- Comprehensive income (loss) $ (75) $ (38) $ (56) $68 ===== ===== ===== ===== See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Six Months Ended June 30, 2002 and 2001 (Unaudited) (In millions) 2002 2001 ------- ------- Operating Activities: Net income (loss) $ (90) $ 306 Adjustments: Loss (gain) from discontinued operations 14 (1) Change in insurance reserves 332 601 Change in reinsurance balances (136) (661) Realized investment losses (gains) 71 (83) Change in deferred acquisition costs (21) (65) Change in insurance premiums receivable 55 (71) Change in accounts payable and accrued expenses (90) (81) Change in income taxes payable/refundable 104 (31) Provision for federal deferred tax expense (benefit) (82) 147 Depreciation and amortization 43 49 Other (118) (155) ------- ------- Net cash provided (used) by continuing operations 82 (45) Net cash provided by discontinued operations - 101 ------- ------- Net cash provided by operating activities 82 56 ------- ------- Investing Activities: Purchases of investments (3,834) (2,968) Proceeds from sales and maturities of investments 3,975 3,198 Net sales of short-term investments 287 267 Change in open security transactions (184) 44 Purchase of office property and equipment (37) (34) Sales of office property and equipment 10 3 Acquisitions, net of cash acquired (59) - Other (51) (13) ------- ------- Net cash provided by continuing operations 107 497 Net cash used by discontinued operations (5) (365) ------- ------- Net cash provided by investing activities 102 132 ------- ------- Financing Activities: Dividends paid on common and preferred stock (123) (124) Proceeds from issuance of debt 498 292 Repayment of debt and preferred securities (526) (161) Repurchase of common shares - (389) Subsidiary's repurchase of common shares (105) (60) Stock options exercised and other 84 59 ------- ------- Net cash used by continuing operations (172) (383) Net cash provided by discontinued operations - 238 ------- ------- Net cash used by financing activities (172) (145) ------- ------- Effect of exchange rate changes on cash 3 (1) ------- ------- Increase in cash 15 42 Cash at beginning of period 151 52 ------- ------- Cash at end of period $ 166 $ 94 ======= ======= See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Unaudited June 30, 2002 Note 1 - Basis of Presentation - ------------------------------ The financial statements include The St. Paul Companies, Inc. and subsidiaries ("The St. Paul" or "the company"), and have been prepared in conformity with United States generally accepted accounting principles. These consolidated financial statements rely, in part, on estimates. Our most significant estimates are those relating to our reserves for losses and loss adjustment expenses. We continually review our estimates and make adjustments as necessary, but actual results could turn out to be significantly different from what we expected when we made these estimates. In the opinion of management, all necessary adjustments, consisting of normal recurring adjustments, have been reflected for a fair presentation of the results of operations, financial position and cash flows in the accompanying unaudited consolidated financial statements. The results for the period are not necessarily indicative of the results to be expected for the entire year. Reference should be made to the "Notes to Consolidated Financial Statements" in our annual report to shareholders for the year ended Dec. 31, 2001. The amounts in those notes have not changed materially except as a result of transactions in the ordinary course of business or as otherwise disclosed in these notes. Some amounts in the 2001 consolidated financial statements have been reclassified to conform to the 2002 presentation. These reclassifications had no effect on net income, comprehensive income or shareholders' equity, as previously reported. New Accounting Policy - Goodwill and Intangible Assets Effective with our first-quarter 2002 adoption of SFAS No. 142, "Goodwill and Other Intangible Assets," as described in Note 10, our accounting for goodwill and intangible assets has changed. In a business combination, the excess of the amount we paid over the fair value of the acquired company's tangible net assets is recorded as either an intangible asset, if it meets certain criteria, or goodwill. Intangible assets with a finite useful life (generally over five to 20 years) are amortized to expense over their estimated life, on a basis expected to be consistent with their estimated future cash flows. Intangible assets with an indefinite useful life and goodwill are no longer amortized, effective January 1, 2002, but remain subject to tests for impairment. In the second quarter of 2002, we completed the evaluation of our recorded goodwill for impairment in accordance with provisions of SFAS No. 142. That evaluation concluded that none of our goodwill was impaired. In connection with our reclassification of certain assets previously accounted for as goodwill to other intangible assets in 2002, we established a deferred tax liability of $6 million in the second quarter of 2002. That provision was classified as a cumulative effect of accounting change effective as of January 1, 2002. In accordance with SFAS No. 142, we restated our results for the first quarter of 2002, reducing net income for that period from the reported $139 million, or $0.63 per common share (diluted), to $133 million, or $0.60 per common share (diluted). THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 2 - Earnings Per Common Share - ---------------------------------- The following table provides the calculation of our earnings per common share for the three months and six months ended June 30, 2002 and 2001: Three Months Six Months Ended June 30 Ended June 30 ------------- ------------- (in millions) 2002 2001 2002 2001 ---- ---- ---- ---- Earnings (Loss) Basic: Net income (loss), as reported $(223) $104 $(90) $306 Preferred stock dividends, net of taxes (2) (2) (4) (4) Premium on preferred shares redeemed (2) (3) (5) (5) ---- ---- ---- ---- Net income (loss) available to common shareholders $(227) $ 99 $(99) $297 ==== ==== ==== ==== Diluted: Net income (loss) available to common shareholders $(227) $ 99 $(99) $297 Effect of dilutive securities: Convertible preferred stock - 2 - 3 Zero coupon convertible notes - 1 - 2 ---- ---- ---- ---- Net income (loss), as adjusted $(227) $102 $(99) $302 ==== ==== ==== ==== Common Shares Basic: Weighted average common shares outstanding 208 214 208 215 ==== ==== ==== ==== Diluted: Weighted average common shares outstanding 208 214 208 215 Effect of dilutive securities: Stock options - 4 - 4 Convertible preferred stock - 7 - 7 Zero coupon convertible notes - 2 - 2 ---- ---- ---- ---- Total 208 227 208 228 ==== ==== ==== ==== Earnings (Loss) per Common Share: Basic $(1.09) $0.47 $(0.47) $1.38 ==== ==== ==== ==== Diluted $(1.09) $0.45 $(0.47) $1.33 ==== ==== ==== ==== Diluted EPS is the same as Basic EPS for both periods of 2002 because Diluted EPS calculated in accordance with Statement of Financial Accounting Standards (SFAS) No. 128, "Earnings Per Share," for our loss from continuing operations, results in a lesser loss per share than the Basic EPS calculation does. The provisions of SFAS No. 128 prohibit this "anti-dilution" of earnings per share, and require that the larger Basic loss per share also be reported as the Diluted loss per share amount. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 3 - Investments - -------------------- Investment Activity. Following is a summary of our investment purchases, sales and maturities for continuing operations. Six Months Ended June 30 ------------------ (in millions) 2002 2001 ----- ----- Purchases: Fixed maturities $3,168 $1,896 Equities 537 868 Real estate and mortgage loans 3 48 Venture capital 119 147 Other investments 7 9 ----- ----- Total purchases 3,834 2,968 ----- ----- Proceeds from sales and maturities: Fixed maturities 2,502 2,061 Equities 1,376 866 Real estate and mortgage loans 55 99 Venture capital 36 22 Other investments 6 150 ----- ----- Total sales and maturities 3,975 3,198 ----- ----- Net sales $ (141) $ (230) ===== ===== Change in Unrealized Appreciation. The increase (decrease) in unrealized appreciation of investments recorded in common shareholders' equity was as follows: Six Twelve Months Ended Months ended June 30 December 31 ------------ ------------ (in millions) 2002 2001 - ------------ -------- -------- Fixed maturities $ 138 $ 187 Equities (23) (347) Venture capital (49) (314) Other (6) (80) -------- -------- Total change in pretax unrealized appreciation - continuing operations 60 (554) Change in deferred taxes (39) 214 -------- -------- Total change in unrealized appreciation - continuing operations, net of taxes 21 (340) Change in pretax unrealized appreciation - discontinued operations - 26 Change in deferred taxes - (9) -------- -------- Total change in unrealized appreciation - discontinued operations, net of taxes - 17 -------- -------- Total change in unrealized appreciation, net of taxes $ 21 $(323) ======== ======== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 4 - Income Taxes - --------------------- The components of income tax expense (benefit) on income from continuing operations were as follows: Three Months Six Months Ended June 30 Ended June 30 ------------- ------------- (in millions) 2002 2001 2002 2001 - ----------- ---- ---- ---- ---- Income tax expense (benefit): Federal current $ (67) $(13) $(29) $ (25) Federal deferred (85) 51 (82) 147 ---- ---- ---- ---- Total federal (152) 38 (111) 122 Foreign 4 (2) 8 (1) State 2 1 5 5 ---- ---- ---- ---- Total income tax expense (benefit) $(146) $ 37 $(98) $126 ==== ==== ==== ==== Note 5 - Contingent Liabilities - ------------------------------- General - In the ordinary course of conducting business, we, and some of our subsidiaries, have been named as defendants in various lawsuits. Some of these lawsuits attempt to establish liability under insurance contracts issued by our underwriting operations, including liability under environmental protection laws and for injury caused by exposure to asbestos products. Plaintiffs in these lawsuits are seeking money damages that in some cases are substantial or extra contractual in nature or are seeking to have the court direct the activities of our operations in certain ways. Although the ultimate outcome of these matters is not presently determinable, it is possible that the resolution of one or more matters may be material to our results of operations; however, we do not believe that the total amounts that we and our subsidiaries will ultimately have to pay in all of these lawsuits will have a material effect on our liquidity or overall financial position. Asbestos Litigation Settlement Agreement - On June 3, 2002, we announced that we and certain of our subsidiaries had entered into an agreement for the settlement of all existing and future claims arising out of an insuring relationship of United States Fidelity and Guaranty Company ("USF&G"), St. Paul Fire and Marine Insurance Company and their affiliates and subsidiaries, including us (collectively, the "USF&G Parties") with any of MacArthur Company, Western MacArthur Company, and Western Asbestos Company (the "MacArthur Companies"). The settlement agreement was filed as an exhibit to our Report on Form 8-K dated July 23, 2002. This description is qualified in its entirety by the terms of the settlement agreement. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 5 - Contingent Liabilities (continued) - ------------------------------------------ The settlement agreement provides that the MacArthur Companies will file voluntary petitions under Chapter 11 of the Bankruptcy Code to permit the channeling of all current and future asbestos- related claims solely to a trust to be established pursuant to Section 524(g) of the Bankruptcy Code. Consummation of most elements of the settlement agreement is contingent upon bankruptcy court approval of the settlement agreement as part of a broader plan for the reorganization of the MacArthur Companies (the "Plan"). Approval of the Plan involves substantial uncertainties that include the need to obtain agreement among existing asbestos plaintiffs, a person to be appointed to represent the interests of unknown, future asbestos plaintiffs, the MacArthur Companies and the USF&G Parties as to the terms of such Plan. Accordingly, there can be no assurance that an acceptable Plan will be developed or that bankruptcy court approval of a Plan will be obtained. Upon final approval of the Plan, and upon payment by the USF&G Parties of the amounts described below, the MacArthur Companies will release the USF&G Parties from any and all asbestos-related claims for personal injury, and all other claims in excess of $1 million in the aggregate, that may be asserted relating to or arising from, directly or indirectly, any alleged coverage provided by any of the USF&G Parties to any of the MacArthur Companies, including any claim for extra-contractual relief. The after-tax impact on our second-quarter and six-months 2002 net of expected reinsurance recoveries and the reevaluation and application of asbestos and environmental reserves, was approximately $380 million. This calculation was based upon payments of $235 million during the second quarter of 2002, and $740 million on the earlier of the final, non-appealable approval of the Plan, or January 15, 2003, plus interest on the $740 million from the settlement date to the date of such payment. The $740 million (plus interest) payment, together with $60 million of the original $235 million, shall be returned to the USF&G Parties if the Plan is not finally approved. The settlement agreement also provides for the USF&G Parties to pay $13 million and to advance certain fees and expenses incurred in connection with the settlement, bankruptcy proceedings, finalization of the Plan and efforts to achieve approval of the Plan subject to a right of reimbursement in certain circumstances of amounts advanced. As a result of the settlement, pending litigation with the MacArthur Companies has been stayed pending final approval of the Plan. Whether or not the Plan is approved, $175 million of the $235 million will be paid to the bankruptcy trustee, counsel for the MacArthur Companies, and persons holding judgments against the MacArthur Companies as of June 3, 2002 and their counsel, and the USF&G Parties will be released from claims by such holders to the extent of $110 million paid to such holders. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 5 - Contingent Liabilities (continued) - ------------------------------------------ Our second-quarter 2002 results of operations included a net pretax loss of $585 million ($380 million after-tax) related to this settlement. Our estimate of the impact of the settlement includes the application of approximately $153 million of asbestos IBNR reserves, and $250 million of reinsurance recoverables, net of an allowance for uncollectible amounts. Related to the Western MacArthur settlement, and as part of an in- depth analysis of our environmental and asbestos reserves, we recorded a $150 million reduction in net environmental reserves, and a corresponding $150 million increase in net asbestos reserves. The loss related to this settlement is calculated as follows: (in millions) Total cost of settlement $ (988) Less: Utilization of existing IBNR loss reserves 153 Reinsurance recoverables, net of an allowance 250 ----- Net pretax loss (585) Tax benefit @ 35% (205) ----- Net after-tax loss $ (380) ===== Our gross asbestos reserves at June 30, 2002 included $740 million of reserves related to this settlement, after a $248 million payment in June 2002. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 6 - Debt - ------------- Debt consisted of the following at June 30, 2002 and December 31, 2001: June 30, 2002 December 31, 2001 ---------------- ----------------- (in millions) Book Fair Book Fair Value Value Value Value ------ ------ ------ ------ Medium-term notes $ 557 $ 580 $ 571 $ 596 5.75% senior notes 498 514 - - 7.875% senior notes 250 272 249 269 8.125% senior notes 249 281 249 275 Nuveen line of credit borrowings 183 183 183 183 Zero coupon convertible notes 105 104 103 106 Commercial paper 100 100 606 606 7.125% senior notes 80 86 80 84 Variable rate borrowings 64 64 64 64 Real estate debt - - 2 2 ------ ------ ------ ------ Total obligations 2,086 2,184 2,107 2,185 Fair value of interest rate swap agreements 36 36 23 23 ------ ------ ------ ------ Total debt reported on balance sheet $2,122 $2,220 $2,130 $2,208 ====== ====== ====== ====== In March 2002, we issued $500 million of 5.75% senior notes due in 2007. Proceeds from the issuance were primarily used to repay a portion of our commercial paper outstanding. At June 30, 2002, we were party to a number of interest rate swap agreements related to several of our debt securities outstanding. The notional amount of these swaps, which qualified for hedge accounting, totaled $480 million, and their aggregate fair value at June 30, 2002 was an asset of $36 million with a corresponding increase to debt on our balance sheet. See note 15 for a discussion of debt issued subsequent to June 30, 2002. Note 7 - Segment Information - ---------------------------- We have seven reportable business segments in our property- liability insurance operations, consisting of Specialty Commercial, Commercial Lines, Surety and Construction, Health Care, Lloyd's and Other, Reinsurance, and Investment Operations. We also have an asset management segment, consisting of our majority ownership in The John Nuveen Company. We evaluate the performance of our property-liability underwriting segments based on GAAP underwriting results. The property-liability investment operation is disclosed as a separate reportable segment because that operation is managed at the corporate level and the invested assets, net investment income and realized gains are not allocated to individual underwriting segments. The asset management segment is evaluated based on its pretax income, which includes investment income. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 7 - Segment Information (continued) - --------------------------------------- The tabular information that follows provides revenue and income data from continuing operations for each of our business segments for the second quarters and first six months of 2002 and 2001. In the fourth quarter of 2001, we implemented a new segment reporting structure for our property-liability underwriting operations. Data for 2001 in the tables have been reclassified to be consistent with the new segment reporting structure. In the fourth quarter of 2001, we also announced our decision to exit certain lines of business. See Note 3 in our 2001 Annual Report to Shareholders. Three Months Six Months Ended June 30 Ended June 30 ------------- ------------- (in millions) 2002 2001 2002 2001 ---- ---- ---- ---- Revenues from continuing operations: Property-liability insurance: Specialty Commercial $ 573 $ 445 $ 1,127 $ 878 Commercial Lines 429 381 861 745 Surety and Construction 294 234 571 469 Health Care 159 182 343 364 Lloyd's and Other 160 204 270 315 ----- ----- ----- ----- Total primary insurance operations 1,615 1,446 3,172 2,771 Reinsurance 305 297 683 600 ----- ----- ----- ----- Total insurance premiums earned 1,920 1,743 3,855 3,371 ----- ----- ----- ----- Investment operations: Net investment income 283 295 573 625 Realized investment gains (losses) (38) 6 (77) 58 ----- ----- ----- ----- Total investment operations 245 301 496 683 ----- ----- ----- ----- Other 43 24 77 59 ----- ----- ----- ----- Total property-liability insurance 2,208 2,068 4,428 4,113 ----- ----- ----- ----- Asset management 91 87 185 174 ----- ----- ----- ----- Total reportable segments 2,299 2,155 4,613 4,287 Parent company, other operations and consolidating eliminations 15 8 18 38 ----- ----- ----- ----- Total revenues $2,314 $2,163 $4,631 $4,325 ===== ===== ===== ===== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 7 - Segment Information (continued) - --------------------------------------- Three Months Six Months Ended June 30 Ended June 30 ------------- ------------- (in millions) 2002 2001 2002 2001 ---- ---- ---- ---- Income (loss) from continuing operations: Property-liability insurance: Specialty Commercial $ 60 $ 17 $ 64 $ 7 Commercial Lines (530) 37 (527) 114 Surety and Construction 5 21 9 41 Health Care (102) (124) (100) (254) Lloyd's and Other (20) (28) (59) (51) ----- ----- ----- ----- Total primary insurance operations (587) (77) (613) (143) Reinsurance (4) (36) 11 (57) ----- ----- ----- ----- Total underwriting result (591) (113) (602) (200) ----- ----- ----- ----- Investment operations: Net investment income 283 295 573 625 Realized investment gains (losses) (38) 6 (77) 58 ----- ----- ----- ----- Total investment operations 245 301 496 683 ----- ----- ----- ----- Other (12) (41) (37) (45) ----- ----- ----- ----- Total property-liability insurance (358) 147 (143) 438 ----- ----- ----- ----- Asset management: Pretax income before minority interest 50 45 99 90 Minority interest (11) (11) (22) (21) ----- ----- ----- ----- Total asset management 39 34 77 69 ----- ----- ----- ----- Total reportable segments (319) 181 (66) 507 Parent company, other operations and consolidating eliminations (45) (48) (102) (76) ----- ----- ----- ----- Total income (loss) from continuing operations before income taxes $ (364) $ 133 $ (168) $ 431 ===== ===== ===== ===== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 8 - Reinsurance - -------------------- Our consolidated financial statements reflect the effects of assumed and ceded reinsurance transactions. Assumed reinsurance refers to our acceptance of certain insurance risks that other insurance companies have underwritten. Ceded reinsurance involves transferring certain insurance risks (along with the related written and earned premiums) we have underwritten to other insurance companies who agree to share these risks. The primary purpose of ceded reinsurance is to reduce earnings volatility and insulate us from potential losses in excess of the amount we are prepared to accept. We expect those with whom we have ceded reinsurance to honor their obligations. In the event these companies are unable to honor their obligations, we will pay these amounts. We have established allowances of approximately $192 million for possible nonpayment of amounts due to us. In the first six months of 2002, we were not party to an all- lines, corporate excess-of-loss reinsurance treaty. In the preceding three years, cessions made under similar treaties had a significant impact on our reported financial results for certain periods. In 2001, we were party to such a treaty that we entered into effective Jan. 1 of that year, but coverage under that treaty was not triggered in the first six months of the year. However, we ceded $9 million and $5 million of written and earned premiums, respectively, related to the treaty in the first six months of 2001, representing the initial premium paid to our reinsurer. Our Reinsurance segment was party to a separate aggregate excess-of-loss reinsurance treaty, unrelated to the corporate treaty, in both 2002 and 2001. Coverage was not triggered under that treaty in the second quarter or first six months of 2002, however St. Paul Re did cede a modest amount of written and earned premiums, representing the initial premium for this treaty. In the second quarter of 2001, St. Paul Re ceded $42 million of written premiums, $40 million of earned premiums and $76 million of insurance losses and loss adjustment expenses, for a net benefit of $36 million as a result of the Reinsurance segment treaty. For the six months ended June 30, 2001, St. Paul Re ceded $45 million of written premiums, $43 million of earned premiums and $102 million of insurance losses and loss adjustment expenses for a net pretax benefit of $59 million. The effect of assumed and ceded reinsurance on premiums written, premiums earned and insurance losses and loss adjustment expenses was as follows: Three Months Six Months Ended June 30 Ended June 30 ------------- -------------- (in millions) 2002 2001 2002 2001 ----- ----- ----- ----- Premiums written Direct $1,773 $1,606 $3,746 $3,219 Assumed 622 778 1,265 1,348 Ceded (606) (531) (1,116) (868) ----- ----- ----- ----- Net premiums written $1,789 $1,853 $3,895 $3,699 ===== ===== ===== ===== Premiums earned Direct $1,869 $1,546 $3,684 $3,028 Assumed 628 715 1,190 1,237 Ceded (577) (518) (1,019) (894) ----- ----- ----- ----- Net premiums earned $1,920 $1,743 $3,855 $3,371 ===== ===== ===== ===== Insurance losses and loss adjustment expenses Direct $2,204 $1,206 $3,716 $2,426 Assumed 428 650 776 1,061 Ceded (646) (510) (1,113) (958) ----- ----- ----- ----- Net insurance losses and loss adjustment expenses $1,986 $1,346 $3,379 $2,529 ===== ===== ===== ===== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 9 - Restructuring Charges - ------------------------------ Fourth Quarter 2001 Strategic Review - In December 2001, we announced the results of a strategic review of all of our operations, which included a decision to exit a number of businesses and countries. Note 3 in our 2001 Annual Report to Shareholders provides more detailed information on this strategic review. Related to this review, we recorded a pretax charge of $62 million, including $46 million of employee-related costs (related to the expected elimination of 800 positions during 2002), $9 million of occupancy-related costs, $4 million of equipment charges and $3 million of legal costs. Note 16 in our 2001 Annual Report to Shareholders provides more information on this charge. During the first six months of 2002, we recorded an additional $3 million of employee-related charges related to this strategic review, as we met the criteria for accrual. As of June 30, 2002, 504 positions had been eliminated. The following presents a rollforward of activity related to this accrual: (In millions) ----------- Original Reserve Reserve Charges to Pre-tax at Dec. 31, at June 30, earnings: Charge 2001 Payments Adjustments 2002 -------- -------- ---------- -------- ----------- ---------- Employee-related $ 46 $ 46 $ (29) $ 3 $ 20 Occupancy-related 9 9 - - 9 Equipment charges 4 N/A N/A N/A N/A Legal costs 3 3 - - 3 ---- ---- ---- ---- ---- Total $ 62 $ 58 $ (29) $ 3 $ 32 ==== ==== ==== ==== ==== Other Restructuring Charges - Since 1997, we have recorded several restructuring and other charges related to actions taken to improve our operations. Note 16 in our 2001 Annual Report to Shareholders provides more detailed information regarding these charges. In connection with our April 2000 acquisition of MMI, we recorded a pretax charge of $28 million, including $4 million of employee- related costs (related to the elimination of approximately 120 positions) and $24 million of occupancy-related costs. In connection with a cost reduction program announced in August 1999, we recorded a pretax charge of $60 million, including $25 million of employee-related costs (related to the elimination of approximately 590 positions), $33 million in occupancy-related charges and $2 million in equipment charges. In connection with our merger with USF&G, in the second quarter of 1998 we recorded a pretax charge to earnings of $292 million, primarily consisting of severance and other employee-related costs (related to the elimination of approximately 2,200 positions), facilities exit costs, asset impairments and transaction costs. All actions have been taken and all obligations have been met regarding these other restructuring charges, with the exception of certain remaining lease commitments. The lease commitment charges related to excess space created by the elimination of positions. During the first six months of 2002, we reduced the lease commitment reserve by $1 million related to sublease activity. We expect to be obligated under certain lease commitments for approximately seven years. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 9 - Restructuring Charges (continued) - ----------------------------------------- The following presents a rollforward of activity related to these lease commitments: Original Reserve Reserve (In millions) Pre-tax at Dec. 31, at June 30, ----------- Charge 2001 Payments Adjustments 2002 -------- ---------- -------- ----------- ---------- Lease commitments charged to earnings: $91 $39 $(5) $(1) $33 ===== ==== ==== ==== ==== Note 10 - Adoption of Accounting Pronouncement - ---------------------------------------------- In the first quarter of 2002, we began implementing the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets," which establishes financial accounting and reporting for acquired goodwill and other intangible assets. The statement changes prior accounting practice in the way intangible assets with indefinite useful lives, including goodwill, are tested for impairment on an annual basis. Generally, it also requires that those assets meeting the criteria for classification as intangible with estimable useful lives be amortized to expense over those lives, while intangible assets with indefinite useful lives and goodwill are not to be amortized. As a result of implementing the provisions of this statement, we did not record any goodwill amortization expense in the first or second quarters of 2002. In the first six months of 2001, goodwill amortization expense totaled $18 million. Amortization expense associated with intangible assets totaled $9 million in the first six months of 2002, compared with $1 million in the same 2001 period. In the second quarter of 2002, we completed the evaluation of our recorded goodwill for impairment in accordance with provisions of SFAS No. 142. That evaluation concluded that none of our goodwill was impaired. In connection with our reclassification of certain assets previously accounted for as goodwill to other intangible assets in 2002, we established a deferred tax liability of $6 million in the second quarter of 2002. That provision was classified as a cumulative effect of accounting change effective as of January 1, 2002. In accordance with SFAS No. 142, we restated our results for the first quarter of 2002, reducing net income for that period from the reported $139 million, or $0.63 per common share (diluted), to $133 million, or $0.60 per common share (diluted). Related to our adoption of SFAS No. 142, we also reviewed the amortization method and useful lives of existing intangible assets, and adjusted as appropriate. Generally speaking, amortization was accelerated and useful lives shortened. The following presents a summary of our acquired intangible assets. As of June 30, 2002 (In millions) ----------------------------------- ----------- Gross Amortizable intangible Carrying Accumulated Net assets: Amount Amortization Amount ---------------------- -------- ------------ ------- Present value of future profits 70.3 $ 10.5 $ 59.8 Customer relationships 43.8 2.1 41.7 Renewal rights 16.2 3.6 12.6 Internal use software 1.6 0.3 1.3 Favorable leases 0.4 0.2 0.2 ------ ----- ------ Total $ 132.3 $ 16.7 $ 115.6 ====== ===== ====== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 10 - Adoption of Accounting Pronouncement (continued) - --------------------------------------------------------- At June 30, 2002, our estimated amortization expense for the next five years was as follows. (In millions) ----------- Estimated amortization expense for the year ended Dec. 31: ------------------------------ 2003 $20 2004 17 2005 15 2006 10 2007 8 The changes in the carrying value of goodwill on our balance sheet were as follows. The increase in goodwill in our Asset Management segment results from Nuveen's purchase of shares from minority shareholders. See Note 11 for a discussion of the increase to the Specialty Commercial and Surety and Construction segments. The increase in goodwill in our Lloyd's and Other segment relates to an increase in syndicate capacity at Lloyd's. (In millions) ----------- Balance at Balance at Dec. 31, Goodwill Impairment June 30, Goodwill by Segment 2001 Acquired Losses 2002 ------------------- ------- ----- ------ -------- Specialty Commercial $ 36 $ 6 $ - $ 42 Commercial LInes 33 - - 33 Surety and Construction 14 13 - 27 Lloyd's and Other 7 5 - 12 Asset Management 519 58 - 577 ---- --- ---- ---- Total $ 609 $ 82 $ - $ 691 ==== === ==== ==== The following presents the pro forma impact of ceasing amortization of goodwill for the three and six-month periods ended June 30, 2001. For Three For Six Months Months Ended Ended June 30, June 30, ------------ ------------- (In millions) 2002 2001 2002 2001 ----------- ----- ----- ----- ----- Reported net income (loss) $(223) $ 104 $ (90) $ 306 Add back goodwill amortization - 9 - 18 ---- ---- ---- ---- Adjusted net income (loss) $(223) $ 113 $ (90) $ 324 ==== ==== ==== ==== Basic earnings per share: Reported net income (loss) $(1.09) $0.47 $(0.47) $1.38 Goodwill amortization - 0.04 - 0.08 ---- ---- ---- ---- Adjusted net income (loss) $(1.09) $0.51 $(0.47) $1.46 ==== ==== ==== ==== Diluted earnings per share: Reported net income (loss) $(1.09) $0.45 $(0.47) $1.33 Goodwill amortization - 0.04 - 0.08 ---- ---- ---- ---- Adjusted net income (loss) $(1.09) $0.49 $(0.47) $1.41 ==== ==== ==== ==== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 11 - Acquisition of London Guarantee - ----------------------------------------- In late March 2002, we completed our acquisition of London Guarantee Insurance Company ("London Guarantee"), a specialty property-liability insurance company focused on providing surety products and management liability, bond, and professional indemnity products. The total cost of the acquisition was approximately $80 million. The preliminary allocation of this purchase price resulted in $20 million of goodwill and $37 million of other intangible assets. The acquisition was funded through internally-generated funds. London Guarantee, headquartered in Toronto, generated approximately $35 million in surety net written premiums for the year ended Dec. 31, 2001, and approximately $18 million in net written premiums from the remaining lines of business we acquired. London Guarantee's assets and liabilities were included in our consolidated balance sheet as of June 30, 2002, and the results of their operations since the acquisition date were included in our statements of operations for the three months and six months ended June 30, 2002. London Guarantee generated net written premiums of $23 million and an underwriting profit of $2 million since the acquisition date. Note 12 - Discontinued Operations - --------------------------------- Life Insurance - -------------- On September 28, 2001, we completed the sale of our life insurance company, Fidelity and Guaranty Life Insurance Company, and its subsidiary, Thomas Jefferson Life, (together, "F&G Life") to Old Mutual plc ("Old Mutual") for $335 million in cash and $300 million in Old Mutual shares. Pursuant to the sale agreement, we were originally required to hold the 190,356,631 Old Mutual shares we received for one year after the closing of the transaction, and the proceeds from the sale of F&G Life were subject to possible adjustment based on the movement of the market price of Old Mutual's shares at the end of the one-year period. The amount of possible adjustment was to be determined by a derivative "collar" agreement included in the sale agreement. In May 2002, Old Mutual granted us a release from the one-year holding requirement in order to facilitate our sale of those shares in a placement made outside the United States, together with a concurrent sale of shares by Old Mutual by means of granting an overallotment option, which was exercised by the underwriters. We sold all of the Old Mutual shares we were holding on June 6, 2002 for a total net consideration of $287 million, resulting in a pretax realized loss of $13 million that was recorded as a component of discontinued operations on our statement of operations. The fair value of the collar agreement was recorded as an asset on our balance sheet and adjusted quarterly. At the time of the sale of the Old Mutual shares, the collar had a fair value of $12 million, which we agreed to terminate at no value as part of the sale. The amount was recorded as a component of discontinued operations on our statement of operations. Standard Personal Insurance Business - ------------------------------------ In 1999, we sold our standard personal insurance operations to Metropolitan Property and Casualty Insurance Company (Metropolitan). Metropolitan purchased Economy Fire & Casualty Company and its subsidiaries (Economy), as well as the rights and interests in those non-Economy policies constituting our remaining standard personal insurance operations. Those rights and interests were transferred to Metropolitan by way of a reinsurance and facility agreement (Reinsurance Agreement). The Reinsurance Agreement relates solely to the non-Economy standard personal insurance policies, and was entered into solely as a means of accommodating Metropolitan through a transition period. The Reinsurance Agreement allows Metropolitan to write non-Economy business on our policy forms while Metropolitan obtains the regulatory license, form and rate approvals necessary to write non-Economy business through their own insurance subsidiaries. Any business written on our policy forms during this transition period is then fully ceded to Metropolitan under the Reinsurance Agreement. We recognized no gain or loss on the inception of the Reinsurance Agreement and will not incur any net revenues or expenses related to the Reinsurance Agreement. All economic risk of post-sale activities related to the Reinsurance Agreement has been transferred to Metropolitan. We anticipate that Metropolitan will pay all claims incurred related to this Reinsurance Agreement. In the event Metropolitan does not honor their obligations to us, we will pay these amounts. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 12 - Discontinued Operations (continued) - -------------------------------------------- As part of the sale to Metropolitan, we guaranteed the adequacy of Economy's loss and loss expense reserves. Under that guarantee, we will pay for any deficiencies in those reserves and will share in any redundancies that develop by Sept. 30, 2002. We remain liable for claims on non-Economy policies that result from losses occurring prior to closing. By agreement, Metropolitan will adjust those claims and share in redundancies in related reserves that may develop. As of June 30, 2002, we have estimated that we will owe Metropolitan $7 million on these guarantees, an estimate that was unchanged from our estimate at Dec. 31, 2001. Any losses incurred by us under these agreements are reflected in discontinued operations in the period they are determined. For the first six months of 2002 and 2001, we recorded pretax losses of $6 million and $19 million, respectively, in discontinued operations, related to pre-sale claims. We have no other contingent liabilities related to the sale. Note 13 - Derivative Financial Instruments - ------------------------------------------ We have the following derivative instruments, which have been designated into one of three categories based on their intended use: Fair Value Hedges: We have several pay-floating, receive-fixed interest rate swaps, totaling $480 million notional amount, that are designated as fair value hedges of a portion of our medium- term and senior notes, that we have entered into for the purpose of managing the effect of interest rate fluctuations on this debt. The terms of the swaps match those of the debt instruments, and the swaps are therefore considered 100% effective. The impact related to the six months ended June 30, 2002 and June 30, 2001 movement in interest rates was a $13 million increase and a $0.5 million increase, respectively, in the fair value of the swaps and the related debt on the balance sheet, with the income statement impacts again offsetting. Cash Flow Hedges: We have purchased foreign currency forward contracts that are designated as cash flow hedges. They are utilized to minimize our exposure to fluctuations in foreign currency values that result from forecasted foreign currency payments, as well as from foreign currency payables and receivables. In the six months ended June 30, 2002, we recognized a $1.8 million gain on the cash flow hedges, which is included in "Other Comprehensive Income." The comparable amount for the six months ended June 30, 2001 was a $1.3 million loss. The amounts included in other comprehensive income will be reclassified into earnings concurrent with the timing of the hedged cash flows. We do not anticipate any of the "Other Comprehensive Income" will be reclassified into earnings within the next twelve months. In both the six months ended June 30, 2002 and June 30, 2001 we recognized a gain of $66 thousand and a $1 million loss, respectively, on the income statement representing the portions of the forward contracts deemed ineffective. Non-Hedge Derivatives: We have entered into a variety of other financial instruments considered to be derivatives, but which are not designated as hedges, that we utilize to minimize the potential impact of market movements in certain investment portfolios. These included our investment in an embedded collar on Old Mutual shares received as partial consideration from the sale of our life insurance business, foreign currency put options on British Pounds Sterling to hedge currency risk associated with our position in Old Mutual shares and stock warrants in our venture capital business. We recorded a $1.5 million gain and a $723 thousand loss, respectively, in continuing operations for both the six months ended June 30, 2002 and June 30, 2001 relating to the change in the market value of these derivatives during the period. We also recorded $21.4 million of losses in discontinued operations for the six months ended June 30, 2002 relating to non-hedge derivatives associated with the sale of our life business. These non-hedge derivatives were terminated during the second quarter of 2002. See Note 12 for further discussion. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 14 - Planned Transfer of Ongoing Reinsurance Operations - ------------------------------------------------------------ On April 25, 2002, we announced that we planned to transfer our ongoing reinsurance operations to a newly formed Bermuda-based reinsurer, Platinum Underwriters Holdings, Ltd. ("Platinum"). We intended to transfer to Platinum certain renewal opportunities and tangible and intangible assets of our reinsurance operation, St. Paul Re, and enter into various agreements with Platinum and its subsidiaries, in exchange for a percentage interest in the common shares of Platinum that will be determined prior to closing. A registration statement for the offering was filed with the U.S. Securities and Exchange Commission on April 25, 2002. On July 9, 2002, we announced that the initial public offering of Platinum was being temporarily postponed due to unfavorable capital market conditions. We intend to complete the transaction as market conditions allow. At the time of the closing of the offering, Platinum will reinsure St. Paul Fire and Marine Insurance Company and St. Paul Reinsurance Company Limited for certain reinsurance contracts incepting in 2002. Platinum will not reinsure the reinsurance liabilities of St. Paul Fire and Marine Insurance Company and St. Paul Reinsurance Company Limited relating to reinsurance contracts incepting prior to January 1, 2002. We will retain those liabilities and the related reserves. Note 15 - Subsequent Events - --------------------------- Common Stock and Equity Units Offerings - --------------------------------------- On July 31, 2002, we completed the sale of 17.8 million of our common shares for gross consideration of $431 million, or $24.20 per share. In addition, in a separate concurrent offering, we completed the sale of 8.9 million of equity units, each having a stated amount of $50, for gross consideration of $443 million. Each equity unit initially consists of a three-year forward purchase contract for our common stock and an unsecured $50 senior note of the company, due August 2007. Total annual distributions on the equity units will be at the rate of 9.00%, consisting of interest on the note at a rate of 5.25% and fee payments under the forward contract at an annual rate of 3.75%. The forward contract requires the investor to purchase, for $50, a variable number of shares of our common stock on the settlement date of August 16, 2005. The number of shares to be purchased will be determined based on a formula that considers the average trading price of the stock immediately prior to the time of settlement in relation to the $24.20 per share price at the time of the offering. The combined net proceeds of the offerings, after underwriting commissions and other fees, were approximately $842 million, of which $750 million was contributed to the surplus of our insurance underwriting subsidiaries. The remainder was retained at the parent company and will be used for general corporate purposes. Form 8-K Dated July 30, 2002 - Surety Ruling - -------------------------------------------- As previously reported in the Current Report on Form 8-K dated July 30, 2002, the United States District Court for the Southern District of New York issued a ruling which could result in a judgment awarding $237 million in insurance payments, plus interest and costs, to Petrobas, an energy company that is majority-owned by the country of Brazil, in a claim related to the construction of two oil rigs. One of our subsidiaries provided a portion of the surety coverage for that construction. We announced on July 30, 2002 that the impact on our after-tax earnings in the third quarter of 2002 as a result of this ruling is not expected to exceed $25 million, net of reinsurance, case reserves and taxes, prior to any recoveries. We believe the recoveries may be significant, but we cannot at this time reasonably estimate them. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations June 30, 2002 Forward-looking Statement Disclosure and Certain Risks ------------------------------------------------------ This report contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements other than historical information or statements of current condition. Words such as "expects," "anticipates," "intends," "plans," "believes," "seeks," or "estimates," or variations of such words, and similar expressions are also intended to identify forward-looking statements. Examples of these forward-looking statements include statements concerning: market and other conditions and their effect on future premiums, revenues, earnings, cash flow and investment income; price increases, improved loss experience and expense savings resulting from the restructuring actions announced in recent years; and statements concerning the anticipated approval of the Western MacArthur asbestos litigation settlement and the anticipated public offering of Platinum Underwriters Holdings, Ltd. In light of the risks and uncertainties inherent in forward- looking statements, many of which are beyond our control, actual results could differ materially from those in forward-looking statements. Forward-looking statements should not be regarded as a representation that anticipated events will occur or that expected objectives will be achieved. Risks and uncertainties include, but are not limited to, the following: changes in the demand for, pricing of, or supply of our products; competitive considerations, including the continued ability to implement price increases, possible actions by competitors and an increase in competition for our products; general economic conditions, including changes in interest rates and the performance of financial markets; the risk that losses related to credit- sensitive insurance products, including surety bonds, could be material in the event of a sustained economic downturn; the possibility of worse-than anticipated loss development from business written in prior years; additional statement of operations charges if our property- liability loss reserves are insufficient; our exposure to natural or man-made catastrophic events, which are unpredictable, with a frequency or severity exceeding our estimates, resulting in material losses; the impact of the Sept. 11, 2001 terrorist attacks and the ensuing global war on terrorism on the insurance and reinsurance industry in general and potential governmental intervention in the insurance and reinsurance markets to make available insurance coverage for acts of terrorism; risks relating to our potential exposure to losses arising from acts of terrorism and our ability to obtain reinsurance covering such exposures; risks relating to our continuing ability to obtain reinsurance covering catastrophe and other exposures at appropriate prices and/or in sufficient amounts; risks relating to the collectibility of reinsurance and the adequacy of reinsurance to protect us against losses; changes in domestic and foreign laws, tax laws and changes in the regulation of our businesses which affect our profitability and our growth; the possibility of downgrades in our claims- paying and financial strength ratings significantly adversely affecting us, including reducing the number of insurance policies we write, generally, or causing clients who require an insurer with a certain rating level to use higher-rated insurers; the risk that our investment portfolio suffers reduced returns or investment losses which could reduce our profitability; the impact of assessments and other surcharges for guaranty funds and second-injury funds and other mandatory pooling arrangements; risks relating to the ability of Platinum Underwriters Holdings, Ltd. to receive required regulatory approvals and undertake a successful public offering of its common shares in the time frame we anticipate, and of the proposed transfer of our going forward reinsurance operations to Platinum; loss of significant customers; risks relating to the approval by the bankruptcy court of the settlement of the Western MacArthur matter; changes in our estimate of insurance industry losses resulting from the Sept. 11, 2001 terrorist attack (including the impact if that attack were deemed two insurable events rather than one); adverse developments in non-Western MacArthur related asbestos litigation (including claims that certain asbestos-related insurance policies are not subject to aggregate limits); adverse developments in environmental litigation involving policy coverage and liability issues; the effects of emerging claim and coverage issues on our business, including adverse judicial decisions and rulings; the inability of our subsidiaries to pay dividends to us in sufficient amounts to enable us to meet our obligations and pay future dividends; the adverse effects of consolidation in the insurance industry on our margins and demand for our products and services; the cyclicality of the property-liability insurance industry causing fluctuations in our results; risks relating to the nature of our asset management business; our dependence on the business provided to us by agents and brokers; our implementation of new strategies, including our intention to withdraw from certain lines of business, as a result of the strategic review completed in late 2001; and various other matters. We undertake no obligation to release publicly the results of any future revisions we may make to forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights ----------------------- The following table summarizes our results for the second quarter and six months ended June 30, 2002 and 2001. Three Months Six Months Ended June 30 Ended June 30 -------------- -------------- (in millions, except per-share amounts) 2002 2001 2002 2001 - ------------------------------------- ---- ---- ---- ---- Pretax income (loss): Property-liability insurance: Underwriting result $(591) $(113) $(602) $(200) Net investment income 283 295 573 625 Realized investment gains (losses) (38) 6 (77) 58 Other expenses (12) (41) (37) (45) ---- ---- ---- ---- Total property-liability insurance (358) 147 (143) 438 Asset management 39 34 77 69 Parent and other (45) (48) (102) (76) ---- ---- ---- ---- Pretax income (loss) from continuing operations before cumulative effect of accounting change (364) 133 (168) 431 Income tax expense (benefit) (146) 37 (98) 126 ---- ---- ---- ---- Income (loss) from continuing operations before cumulative effect of accounting change (218) 96 (70) 305 Cumulative effect of accounting change, net of taxes - - (6) - ---- ---- ---- ---- Income (loss) from continuing operations (218) 96 (76) 305 Discontinued operations, net of taxes (5) 8 (14) 1 ---- ---- ---- ---- Net income (loss) $(223) $ 104 $ (90) $ 306 ==== ==== ==== ==== Per common share (Basic) $(1.09) $0.47 $(0.47) $1.38 ==== ==== ==== ==== Per common share (Diluted) $(1.09) $0.45 $(0.47) $1.33 ==== ==== ==== ==== Consolidated Results - -------------------- Our pretax loss from continuing operations of $364 million in the second quarter of 2002 included a $585 million loss provision recorded upon entering into a settlement agreement with respect to certain asbestos litigation (described in more detail on the following page). Excluding that loss, our second-quarter pretax income from continuing operations of $221 million was $88 million higher than pretax income in the comparable 2001 period, primarily due to strong improvement in underwriting results in our remaining property-liability operations. Through the first half of 2002, our pretax income from continuing operations, excluding the asbestos settlement, totaled $417 million, which was 3% below comparable income of $431 million in the same 2001 period. The decline resulted from significant reductions in realized investment gains and investment income in our property- liability insurance operations, which more than offset a $183 million improvement in underwriting results (excluding the asbestos settlement). In addition, pretax losses in the "Parent and other" category exceeded comparable six-month 2001 losses due to a decline in realized investment gains. Our asset management subsidiary, The John Nuveen Company, achieved an increase in earnings in both the second quarter and first half of 2002 when compared to the same 2001 periods, driven by strong investment product sales and growth in assets under management. The tax benefit on our second-quarter and year-to-date consolidated 2002 pretax loss from continuing operations is higher than would be expected because the tax benefit on the $585 million pretax loss related to the asbestos litigation settlement was recorded at the federal statutory rate of 35%, whereas federal tax expense on our pretax income excluding that settlement was recorded at an effective tax rate that is lower than the statutory rate, primarily because of significant non- taxable income produced by tax-exempt securities in our investment portfolio. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- Asbestos Litigation Settlement Agreement - ---------------------------------------- On June 3, 2002, we announced that we and certain of our subsidiaries had entered into an agreement for the settlement of all existing and future claims arising out of an insuring relationship of United States Fidelity and Guaranty Company ("USF&G"), St. Paul Fire and Marine Insurance Company and their affiliates and subsidiaries, including us (collectively, the "USF&G Parties") with any of MacArthur Company, Western MacArthur Company, and Western Asbestos Company (the "MacArthur Companies"). The settlement agreement was filed as an exhibit to our Report on Form 8-K dated July 23, 2002. This description is qualified in its entirety by the terms of the settlement agreement. The settlement agreement provides that the MacArthur Companies will file voluntary petitions under Chapter 11 of the Bankruptcy Code, in order to permit the channeling of all current and future asbestos-related claims solely to a trust to be established pursuant to Section 524(g) of the Bankruptcty Code. Consummation of most elements of the settlement agreement is contingent upon bankruptcy court approval of the settlement agreement as part of a broader plan for the reorganization of the MacArthur Companies (the "Plan"). Approval of the Plan involves substantial uncertainties that include the need to obtain agreement among existing asbestos plaintiffs, a person to be appointed to represent the interests of unknown, future asbestos plaintiffs, the MacArthur Companies and the USF&G Parties as to the terms of such Plan. Accordingly, there can be no assurance that an acceptable Plan will be developed or that bankruptcy court approval of a Plan will be obtained. Upon final approval of the Plan, and upon payment by the USF&G Parties of the amounts described below, the MacArthur Companies will release the USF&G Parties from any and all asbestos-related claims for personal injury, and all other claims in excess of $1 million in the aggregate, that may be asserted relating to or arising from, directly or indirectly, any alleged coverage provided by any of the USF&G Parties to any of the MacArthur Companies, including any claim for extra-contractual relief. The after-tax impact on our second-quarter and six-months 2002 net of expected reinsurance recoveries and the reevaluation and application of asbestos and environmental reserves, was approximately $380 million. This calculation was based upon payments of $235 million during the second quarter of 2002, and $740 million on the earlier of the final, non-appealable approval of the Plan, or January 15, 2003, plus interest on the $740 million from the settlement date to the date of such payment. The $740 million (plus interest) payment, together with $60 million of the original $235 million, shall be returned to the USF&G Parties if the Plan is not finally approved. The settlement agreement also provides for the USF&G Parties to pay $13 million and to advance certain fees and expenses incurred in connection with the settlement, bankruptcy proceedings, finalization of the Plan and efforts to achieve approval of the Plan subject to a right of reimbursement in certain circumstances of amounts advanced. That amount was also paid in the second quarter. As a result of the settlement, pending litigation with the MacArthur Companies has been stayed pending final approval of the Plan. Whether or not the Plan is approved, $175 million of the $235 million will be paid to the bankruptcy trustee, counsel for the MacArthur Companies, and persons holding judgments against the MacArthur Companies as of June 3, 2002 and their counsel, and the USF&G Parties will be released from claims by such holders to the extent of $110 million paid to such holders. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- Our second-quarter 2002 results of operations included a net pretax loss of $585 million ($380 million after-tax) related to this settlement, calculated as shown in the following table. (See further discussion of asbestos reserves on page 47 of this report). (in millions) ----------- Total cost of settlement $ (988) Less: Utilization of IBNR loss reserves 153 Reinsurance recoverables, net of an allowance 250 ---- Net pretax loss (585) Tax benefit @ 35% (205) ---- Net after-tax loss $ (380) ==== Announcement of Intention to Transfer Ongoing Reinsurance Operations to Bermuda-Based Reinsurer - ------------------------------------- On April 25, 2002, we announced that we planned to transfer our ongoing reinsurance operations to a newly formed Bermuda-based reinsurer, Platinum Underwriters Holdings, Ltd. ("Platinum"). We intend to transfer to Platinum certain renewal opportunities and tangible and intangible assets of our reinsurance operation, St. Paul Re, and enter into various agreements with Platinum and its subsidiaries, in exchange for a percentage interest in the common shares of Platinum that will be determined prior to closing. A registration statement for the offering was filed with the U.S. Securities and Exchange Commission on April 25, 2002. On July 9, 2002, we announced that the initial public offering of Platinum was being temporarily postponed due to unfavorable capital market conditions. We intend to complete the transaction as market conditions allow. At the time of the closing of the offering, Platinum will reinsure St. Paul Fire and Marine Insurance Company and St. Paul Reinsurance Company Limited for certain reinsurance contracts incepting in 2002. Platinum will not reinsure the reinsurance liabilities of St. Paul Fire and Marine Insurance Company and St. Paul Reinsurance Company Limited relating to reinsurance contracts incepting prior to January 1, 2002. We will retain those liabilities and the related reserves. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- Acquisition - ----------- In late March 2002, we completed our acquisition of London Guarantee Insurance Company ("London Guarantee"), a specialty property-liability insurance company focused on providing surety products and management liability, bond, and professional indemnity products. The total cost of the acquisition was approximately $80 million. The preliminary allocation of this purchase price resulted in $20 million of goodwill and $37 million of other intangible assets. The acquisition was funded through internally-generated funds. London Guarantee, headquartered in Toronto, recorded approximately $35 million in surety net written premiums for the year ended Dec. 31, 2001, and approximately $18 million in net written premiums from the remaining lines of business we acquired. London Guarantee's assets and liabilities were included in our consolidated balance sheet as of June 30, 2002, and the results of their operations since the acquisition date were included in our statements of operations for the three months and six months ended June 30, 2002. London Guarantee produced net written premiums of $23 million and an underwriting profit of $2 million since the acquisition date. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- Withdrawal from Certain Lines of Business - ----------------------------------------- In the fourth quarter of 2001, we announced our intention to withdraw from several lines of business in our property-liability insurance operations. Beginning in January 2002, the operations listed below were placed in "runoff," meaning that we have ceased or plan to cease underwriting new business in these operations as soon as possible. We are pursuing the sale of certain of these operations. - All coverages in our Health Care segment; - All underwriting operations in Germany, France, the Netherlands, Argentina, Mexico (excluding surety business, which continues), Spain, Australia, New Zealand, Botswana, and South Africa; - In the United Kingdom, all coverages offered to the construction industry. (Unionamerica, a United Kingdom medical liability underwriting entity that we acquired in 2000, was placed in runoff in late 2000, except for business we are contractually committed to underwrite through certain syndicates at Lloyd's through 2004); - At Lloyd's, casualty insurance and reinsurance, U.S. surplus lines business, non-marine reinsurance and, when our contractual commitment expires at the end of 2003, our participation in the insuring of the Lloyd's Central Fund; - In our reinsurance operations, most North American reinsurance business underwritten in the United Kingdom, all but traditional finite reinsurance business underwritten by St. Paul Re's Financial Solutions business center, bond and credit reinsurance, and aviation reinsurance. Beginning in the second quarter of 2002, we changed our view of the remaining ongoing reinsurance operations due to our announced intent to transfer those ongoing operations to Platinum, and include the results of those operations with those of the lines of business ultimately to be exited by The St. Paul. None of these operations qualify as "discontinued operations" for accounting purposes; therefore, results from these operations are included in their respective property-liability segment results discussed on pages 38 to 44 of this report. For the six months ended June 30, 2002, these operations collectively accounted for $998 million, or 26%, of our reported net written premiums, and generated negative underwriting results totaling $150 million (an amount that does not include investment income from the assets maintained to support these operations). Premium volume for these operations in 2002 was centered in our Reinsurance segment, in our Health Care segment, where we are required to offer continuing coverage to certain policyholders in the form of extended reporting endorsements and where we renewed certain policies prior to approval of an exit plan in certain states, and in our Lloyd's and Other segment, where we are contractually obligated to underwrite business in certain Lloyd's syndicates through 2003 and 2004. For the six months ended June 30, 2001, these operations collectively accounted for $1.32 billion, or 36%, of our net written premiums, and generated negative underwriting results totaling $373 million. Our consolidated net loss and loss adjustment expense reserves of $15.5 billion on June 30, 2002 included approximately $6.3 billion of net reserves for our Reinsurance and Health Care segments. The payments of claims from these reserves and those related to our other runoff operations will negatively impact our investment income in future periods as the invested assets related to these reserves decline. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- Restructuring Charge - -------------------- In December 2001, in connection with the withdrawal from the foregoing lines of business and as part of our overall plan to reduce company-wide expenses, we recorded a $62 million pretax restructuring charge. The majority of the charge - $46 million - pertained to employee-related costs associated with our plan to terminate an estimated total of 800 employees by the end of 2002. As of June 30, 2002, we had terminated 504 employees and made payments of $29 million related to the $46 million charge. The remainder of the $62 million charge consisted of legal, equipment and occupancy-related costs, for which less than $1 million in payments had been made as of June 30, 2002. In the first six months of 2002, we recorded an additional pretax restructuring charge of $3 million, related to additional employee-related expenses that did not meet the criteria for accrual at Dec. 31, 2001. This charge was partially offset by a $1 million reduction in occupancy-related restructuring charges recorded in prior years. Adoption of SFAS No. 142 - ------------------------ In the first quarter of 2002, we began implementing the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets," which established financial accounting and reporting for acquired goodwill and other intangible assets. The statement changed prior accounting requirements in the method by which intangible assets with indefinite useful lives, including goodwill, are tested for impairment on an annual basis. It also required that those assets meeting the criteria for classification as intangible with finite useful lives be amortized to expense over those lives, while intangible assets with indefinite useful lives and goodwill are not to be amortized. As a result of implementing the provisions of this statement, we did not record any goodwill amortization expense in the first six months of 2002. In the first six months of 2001, goodwill amortization expense totaled $18 million. Amortization expense associated with intangible assets totaled $9 million in the first six months of 2002, compared with $1 million in the same 2001 period. In the second quarter of 2002, we completed the evaluation of our recorded goodwill for impairment in accordance with provisions of SFAS No. 142. That evaluation concluded that none of our goodwill was impaired. In connection with our reclassification of certain assets previously accounted for as goodwill to other intangible assets in 2002, we established a deferred tax liability of $6 million in the second quarter of 2002. That provision was classified as a cumulative effect of accounting change effective as of January 1, 2002. In accordance with SFAS No. 142, we restated our results for the first quarter of 2002, reducing net income for that period from the reported $139 million, or $0.63 per common share (diluted) to $133 million, or $0.60 per common share (diluted). September 11, 2001 Terrorist Attack - ----------------------------------- In 2001, we recorded estimated net pretax losses totaling $941 million related to the September 11, 2001 terrorist attack in the United States. We are continually evaluating the adequacy of the net loss provision recorded, based on claim experience, collections from our reinsurers, and other factors. Our estimate was based on our belief that property-liability insurance losses from the terrorist attack will total between $30 billion and $35 billion for the insurance industry as a whole, and on the industry's determination that the attack constituted one event for purposes of determining coverage. In the first six months of 2002, we did not record any additions or reductions to our original estimated loss provision recorded in 2001. Through June 30, 2002, we have made cumulative net loss payments of $210 million related to the attack since it occurred, of which $148 million were made in the first six months of 2002, including $63 million in the second quarter. For further information regarding the impact of the terrorist attack on our operations, refer to Note 2 in our 2001 Annual Report to Shareholders. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ----------------------------------- Purchase of Terrorism Coverage and Exposure to Future Terrorist Events - ---------------------------------------------------------------------- After the terrorist attack in September 2001, reinsurers, in general, specifically excluded terrorism coverage from property reinsurance treaties that subsequently renewed. As a result, in the second quarter, we purchased limited specific terrorism coverage in the form of two separate property reinsurance treaties - a per-risk terrorism treaty and a catastrophe terrorism treaty. The per-risk treaty provides coverage on a per- building, per-event basis for a loss of up to $110 million, after a first layer of $15 million of losses retained by us. The catastrophe terrorism treaty provides coverage of up to $200 million in excess of the first $100 million of losses resulting from catastrophic losses caused by terrorism. Both treaties have one additional set of limits for subsequent terrorism events. In addition, we have renewed the majority of our reinsurance treaties covering our workers' compensation and general liability business. Thus far, those renewals included coverage for terrorism. Our reinsurance treaties do not cover acts of terrorism involving nuclear, biological or chemical detonations. Discontinued Operations - ----------------------- F&G Life - In September 2001, we completed the sale of our life insurance company, Fidelity and Guaranty Life Insurance Company, and its subsidiary, Thomas Jefferson Life, (together, "F&G Life") to Old Mutual plc ("Old Mutual") for $335 million in cash and $300 million of Old Mutual shares. Pursuant to the sale agreement, we were originally required to hold the 190,356,631 Old Mutual shares we received for one year after the closing of the transaction, and the proceeds from the sale of F&G Life were subject to possible adjustment based on the movement of the market price of Old Mutual's shares at the end of the one-year period. The amount of possible adjustment was to be determined by a derivative "collar" agreement included in the sale agreement. In May 2002, Old Mutual granted us a release from the one-year holding requirement in order to facilitate our sale of those shares in a placement made outside the United States, together with a concurrent sale of shares by Old Mutual by means of granting an overallotment option, which was exercised by the underwriters. We sold all of the Old Mutual shares we were holding on June 6, 2002 for a total net consideration of $287 million, resulting in a pretax realized loss of $13 million that was recorded as a component of discontinued operations on our statement of operations. The fair value of the collar agreement was recorded as an asset on our balance sheet and adjusted quarterly. At the time of the sale of the Old Mutual shares, the collar had a fair value of $12 million, which we agreed to terminate at no value as part of the sale. The amount was recorded as a component of discontinued operations on our statement of operations. Standard Personal Insurance - In 1999, we sold our standard personal insurance operations to Metropolitan Property and Casualty Insurance Company (Metropolitan). Metropolitan purchased Economy Fire & Casualty Company and subsidiaries (Economy), and the rights and interests in those non-Economy policies constituting the remainder of our standard personal insurance operations. Those rights and interests were transferred to Metropolitan by way of a reinsurance and facility agreement. We guaranteed the adequacy of Economy's loss and loss expense reserves, and we remain liable for claims on non-Economy policies that result from losses occurring prior to the Sept. 30, 1999 closing date. Under the reserve guarantee, we will pay for any deficiencies in those reserves and will share in any redundancies that develop by Sept. 30, 2002. Any losses incurred by us under these agreements are reflected in discontinued operations in the period during which they are determined. As of June 30, 2002, our analysis indicated that we would owe Metropolitan approximately $7 million related to the reserve guarantee, an estimate that was unchanged from our estimate at Dec. 31, 2001. In the first six months of 2002 and 2001, we recorded pretax losses of $6 million and $19 million, respectively, in discontinued operations, related to pre-sale claims. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- Subsequent Events - ----------------- Issuance of Common Stock and Equity Units - On July 31, 2002, we completed the sale of 17.8 million of our common shares for a gross consideration of $431 million, or $24.20 per share. In addition, in a separate concurrent offering, we completed the sale of 8.9 million of equity units, each having a stated amount of $50, for gross consideration of $443 million. Each equity unit initially consists of a three-year forward purchase contract for our common stock and an unsecured $50 senior note of the company due in August 2007. Total annual distributions on the equity units will be at the rate of 9.00%, consisting of interest on the note at a rate of 5.25% and fee payments under the forward contract of 3.75%. The forward contract requires the investor to purchase, for $50, a variable number of shares of our common stock on the settlement date of August 16, 2005. The number of shares to be purchased will be determined based on a formula that considers the average trading price of the stock immediately prior to the time of settlement in relation to the $24.20 per share price at the time of the offering. The combined net proceeds of the offerings, after underwriting commissions and other fees, were approximately $842 million, of which $750 million was contributed to the surplus of our insurance underwriting subsidiaries. The remainder was retained at the parent company and will be used for general corporate purposes. Form 8-K Dated July 30, 2002 - Surety Ruling - As previously reported in the Current Report on Form 8-K dated July 30, 2002, the United States District Court for the Southern District of New York issued a ruling which could result in a judgment awarding $237 million in insurance payments, plus interest and costs, to Petrobas, an energy company that is majority-owned by the country of Brazil, in a claim related to the construction of two oil rigs. One of our subsidiaries provided a portion of the surety coverage for that construction. We announced on July 30, 2002 that the impact on our after-tax earnings in the third quarter of 2002 as a result of this ruling is not expected to exceed $25 million, net of reinsurance, case reserves and taxes, prior to any recoveries. We believe the recoveries may be significant, but we cannot at this time reasonably estimate them. Critical Accounting Policies - ---------------------------- Overview - The St. Paul Companies, Inc. is a holding company with subsidiaries operating in the property-liability insurance industry and the asset management industry. Our significant accounting policies are described in Note 1 to our 2001 Annual Report to Shareholders. The following is a summary of the critical accounting policies related to accounting estimates that 1) require us to make assumptions about highly uncertain matters and 2) could materially impact our financial statements if we made different assumptions. Insurance Loss and Loss Adjustment Expense ("LAE") Reserves - Our most significant estimates relate to our reserves for property- liability insurance losses and LAE. We establish reserves for the estimated total unpaid cost of losses and LAE, which cover events that have already occurred. These reserves reflect our estimates of the total cost of claims that were reported to us, but not yet paid ("case" reserves), and the cost of claims incurred but not yet reported to us ("IBNR" reserves). For reported losses, we establish case reserves within the parameters of coverage provided in the insurance policy or reinsurance agreement. For IBNR losses, we estimate reserves using established actuarial methods. We continually review our reserves, using a variety of statistical and actuarial techniques to analyze current claim costs, frequency and severity data, and prevailing economic, social and legal factors. We also take into consideration other variables such as past loss experience, changes in legislative conditions, changes in judicial interpretation of legal liability and policy coverages, changes in claims handling practices, and inflation. We consider not only monetary increases in the cost of what we insure, but also changes in societal factors that influence jury verdicts and case law, our approach to claims resolution, and, in turn, claim costs. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- For certain catastrophic events, there is considerable uncertainty underlying the assumptions and associated estimated reserves for losses and LAE. Reserves are reviewed regularly and, as experience develops and additional information becomes known, including revised industry estimates of the magnitude of a catastrophe, the reserves are adjusted as we deem necessary. Because many of the coverages we offer involve claims that may not ultimately be settled for many years after they are incurred, subjective judgments as to our ultimate exposure to losses are an integral and necessary component of our loss reserving process. We analyze our reserves by considering a range of estimates bounded by a high and low point, and record our best estimate within that range. We adjust reserves established in prior years as loss experience develops and new information becomes available. Adjustments to previously estimated reserves, both positive and negative, are reflected in our financial results in the periods in which they are made, and are referred to as prior period development. Because of the high level of uncertainty involved in these estimates, revisions to our estimated reserves could have a material impact on our results of operations in the period recognized, and ultimate actual payments for claims and LAE could turn out to be significantly different from our estimates. Reinsurance - Our reported written premiums, earned premiums and losses and LAE reflect the net effects of assumed and ceded reinsurance. Premiums are recorded at the inception of each policy, based on information received from ceding companies and their brokers. For excess-of-loss contracts, the amount of premium is usually contractually documented at inception, and no management judgment is necessary in accounting for this. Premiums are earned on a pro rata basis over the coverage period. For proportional treaties, the amount of premium is normally estimated at inception by the ceding company. We account for such premium using the initial estimates, and adjust them once a sufficient period for actual premium reporting has elapsed. Reinstatement and additional premiums are written at the time a loss event occurs where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms. Reinstatement premiums are the premiums charged for the restoration of the reinsurance limit of a catastrophe contract to its full amount after payment by the reinsurer of losses as a result of an occurrence. These premiums relate to the future coverage obtained during the remainder of the initial policy term, and are earned over the remaining policy term. Additional premiums are premiums charged after coverage has expired, related to experience during the policy term, which are earned immediately. Reinsurance accounting is followed for assumed and ceded transactions when risk transfer requirements have been met. These requirements involve significant assumptions being made relating to the amount and timing of expected cash flows, as well as the interpretation of underlying contract terms. Reinsurance contracts that do not transfer significant insurance risk are considered financing transactions and are required to be accounted for as deposits. We estimate, and record, an allowance for reinsurance amounts that may not be collectible, due to credit issues, disputes over coverage, or other considerations. Increasing the level of risk and uncertainty involved in estimating reinsurance recoverables is the difficulty of collecting when policies are old or lost. Investments - We continually monitor the difference between our cost and the estimated fair value of our investments, which involves uncertainty as to whether declines in value are temporary in nature. If any of these investments experience a decline in value that we believe is other than temporary, we write down the investment for the decline and record a realized loss on our statement of operations. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance ---------------------------- Overview - -------- Our consolidated reported second-quarter written premiums of $1.79 billion were 3% less than comparable 2001 premiums of $1.85 billion. For the first half of 2002, reported premium volume of $3.90 billion was 5% higher than reported 2001 six-month volume of $3.70 billion. Strong growth in the Specialty Commercial and Surety and Construction segments in 2002 was largely offset by premium declines in our Health Care, Reinsurance and Lloyd's and Other segments, where our runoff operations are concentrated. In addition, second-quarter 2002 written premium volume was reduced by premiums ceded related to the terrorism reinsurance policies purchased as described on page 31 of this report. Excluding premiums produced by those operations to be exited in both years, written premium volume of $1.48 billion in the second quarter was 21% ahead of comparable 2001 premiums of $1.22 billion, and year-to-date volume of $2.90 billion was 22% higher than the adjusted 2001 six-month premium total of $2.38 billion. The strong growth was driven by price increases averaging 26% in the first half of 2002 in our U.S. commercial insurance underwriting operations. We expect the favorable pricing environment to continue throughout the remainder of 2002 and into 2003. In the first half of 2002, we were not party to an all-lines, corporate aggregate excess-of-loss reinsurance treaty. In the preceding three years, cessions made under such treaties had a significant impact on our reported financial results for certain periods. In 2001, we were party to such a treaty that we entered into effective January 1 of that year, but coverage under that treaty was not triggered in the first six months of the year, and the impact of the treaty on our six-month results was limited to cessions of a modest amount of deposit premiums to our reinsurer. Our Reinsurance segment, St. Paul Re, was party to a separate aggregate excess-of-loss treaty, unrelated to the corporate treaty, in both 2002 and 2001. In the second quarter and first six months of 2002, coverage was not triggered under that treaty, but St. Paul Re ceded a modest amount of net written and earned deposit premiums to its reinsurer. In the second quarter of 2001, St. Paul Re ceded $42 million of written premiums, $40 million of earned premiums and $76 million of insurance losses and loss adjustment expenses under that treaty, for a net pretax benefit of $36 million. For the six months ended June 30, 2001, St. Paul Re ceded $45 million of written premiums, $43 million of earned premiums and $102 million of insurance losses and loss adjustment expenses for a net pretax benefit of $59 million. Our reported consolidated loss ratio, which measures insurance losses and loss adjustment expenses as a percentage of earned premiums, was 103.5 for the second quarter of 2002, compared with a reported loss ratio of 77.2 in the same 2001 period. The 2002 ratio was dominated by the $585 million asbestos litigation settlement described on pages 27 and 28 of this report, which was recorded entirely in our Commercial Lines segment. Excluding that loss in 2002 and the benefit of the Reinsurance segment treaty in 2001, our second-quarter 2002 adjusted loss ratio of 73.0 was almost seven points better than the comparable 2001 adjusted ratio of 79.8. The adjusted second-quarter loss ratios in 2002 and 2001 include $97 million and $107 million, respectively, of prior-year reserve strengthening in our Health Care segment. The improvement in 2002 was concentrated in the Reinsurance segment, reflecting the impact of our strategic initiative to exit unprofitable market sectors and a decline in catastrophe losses, and in our Specialty Commercial and Commercial Lines segments, where significant price increases and our focus on underwriting profitability have resulted in a marked improvement in current accident year underwriting results. Catastrophe losses in the second quarter of 2002 totaled $21 million, compared with losses of $69 million in last year's second quarter, the majority of which resulted from Tropical Storm Allison in the United States. Since catastrophe losses are not recognized until an event occurs, the occurrence of a catastrophic event can have a material impact on our results of operations during the period incurred. Subsequent changes to our estimate of catastrophic losses, based on better information, also can materially impact our results of operations during that period. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Our reported consolidated expense ratio, measuring underwriting expenses as a percentage of written premiums, was 28.8 in the second quarter of 2002, compared with the reported 2001 second- quarter ratio of 29.3. Excluding the impact of the Reinsurance segment treaty in 2001, the adjusted second-quarter 2001 ratio of 28.7 was virtually level with the 2002 ratio. The positive effects of strong price increases and our aggressive expense reduction efforts in recent years were somewhat offset in the second quarter of 2002 by premiums ceded for terrorism coverage. Through the first six months of 2002, our reported expense ratio of 28.3 was over a point better than the 2001 six-month ratio of 29.8 (adjusted for the Reinsurance segment treaty). The table on the following page summarizes key financial results (from continuing operations) by property-liability underwriting business segment (underwriting results are presented on a GAAP basis; combined ratios are presented on a statutory accounting basis). In the fourth quarter of 2001, we implemented a new segment reporting structure for our property-liability underwriting operations. Data for 2001 in the table have been reclassified to be consistent with the new segment reporting structure. Following the table is a detailed discussion of the results for each segment. In those discussions, we sometimes use the term "prior accident year loss development" (or similar terms) which refers to an increase or decrease in losses recorded in the current year that relate to losses incurred prior to 2002. Similarly, we sometimes refer to "current accident year loss development" (or similar terms), which refers to losses recorded for events which occurred in 2002. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Three Months Ended Six Months Ended (dollars in millions) June 30 June 30 ------------------- ------------------ ---------------- 2002 2001 2002 2001 ------ ------ ------ ------ Specialty Commercial Written Premiums 30%* $604 $485 $1,180 $941 Underwriting Result $60 $17 $64 $7 Combined Ratio 88.5 95.7 93.8 98.9 Commercial Lines Written Premiums 23%* $381 $388 $887 $818 Underwriting Result $(530) $37 $(527) $114 Combined Ratio 226.5 90.3 161.6 83.1 Surety and Construction Written Premiums 17%* $329 $257 $677 $521 Underwriting Result $5 $21 $9 $41 Combined Ratio 96.7 87.8 95.6 89.1 Health Care Written Premiums 5%* $29 $147 $177 $324 Underwriting Result $(102) $(124) $(100) $(254) Combined Ratio 205.0 175.3 142.4 172.9 Lloyd's and Other Written Premiums 8%* $245 $296 $312 $394 Underwriting Result ----- $(20) $(28) $(59) $(51) Combined Ratio 111.2 113.5 120.9 115.2 ----- ----- ----- ----- Total Primary Insurance Written Premiums 83%* $1,588 $1,573 $3,233 $2,998 Underwriting Result $(587) $(77) $(613) $(143) Combined Ratio 137.8 105.2 120.1 104.6 Reinsurance Written Premiums 17%* $201 $280 $662 $701 Underwriting Result ----- $(4) $(36) $11 $(57) Combined Ratio 104.5 114.6 96.5 107.5 Total Property- Liability Insurance Written Premiums 100% $1,789 $1,853 $3,895 $3,699 GAAP Underwriting ==== Result $(591) $(113) $(602) $(200) Statutory Combined Ratio Loss and Loss Expense Ratio 103.5 77.2 87.7 75.0 Underwriting Expense Ratio 28.8 29.3 28.3 30.2 ----- ----- ----- ----- Combined Ratio 132.3 106.5 116.0 105.2 ===== ===== ===== ===== * Percentage of year-to-date total. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Underwriting Results by Segment - ------------------------------- Specialty Commercial - -------------------- The Specialty Commercial segment includes the following 11 business centers: Technology, Financial and Professional Services, Ocean Marine, Catastrophe Risk, Public Sector Services, Discover Re, Umbrella/Excess & Surplus Lines, Oil and Gas, Transportation, National Programs and International Specialty. These business centers are considered specialty operations because each provides products and services requiring specialty expertise and each focuses on the respective customer group it serves. The following table summarizes results for this segment for the second quarters and six months ended June 30, 2002 and 2001. Three Months Ended Six Months Ended June 30 June 30 ------------------ ---------------- (Dollars in millions) 2002 2001 2002 2001 ------------------- ------ ------ ------ ------ Net written premiums $604 $485 $1,180 $941 Percentage increase over 2001 25% 25% Underwriting result $60 $17 $64 $7 Statutory combined ratio: Loss and loss adjustment expense ratio 66.1 69.3 69.9 72.4 Underwriting expense ratio 22.4 26.4 23.9 26.5 ----- ----- ----- ----- Combined ratio 88.5 95.7 93.8 98.9 ===== ===== ===== ===== The strong premium growth in 2002 was driven by domestic price increases that averaged 28% in the second quarter and 27% year-to- date across the entire segment. The following discussion summarizes results from several of the largest business centers in this segment. - International Specialty - Premium volume of $119 million in the second quarter of 2002 grew 65% over the 2001 second- quarter total, with the increase primarily due to price increases that averaged in excess of 40% in the international markets where we operate. Year-to-date premium volume in 2002 totaled $182 million, 43% higher than the same 2001 period. As part of the strategic initiatives announced at the end of 2001, we are now limiting our ongoing international business to Canada, the United Kingdom and Ireland. The second-quarter loss ratio in this business center improved by over 30 points to 81.2, reflecting the impact of our decision to exit those international markets where we lacked the scale to produce profitable results. The year-to-date loss ratio of 80.6 was nearly 25 points better than the comparable 2001 ratio. - Financial & Professional Services - Written premiums of $108 million in the second quarter of 2002 grew 14% over the same 2001 period, driven by price increases on domestic renewal business averaging 35%. Year-to-date premiums of $224 million in 2002 grew 19% over the first half of 2001. The loss ratio of 65.7 in the second quarter of 2002 was significantly worse than the comparable 2001 ratio of 42.3. The 2001 ratio was driven by favorable prior-year development on lawyers' professional liability business. Current year loss development in 2002 was slightly better than comparable current year development in 2001. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- - Technology - Premium volume of $101 million in the second quarter fell 6% compared with second-quarter 2001 volume, reflecting slowing growth in the technology market sector. Price increases averaged 22% in the second quarter. Through the first half of 2002, premium volume of $200 million was level with the same period of 2001. The loss ratio was 56.2 in the second quarter of 2002, compared with the 2001 second- quarter ratio of 68.2. Improvement in current accident year loss experience was the primary factor driving the reduction in the loss ratio. - Umbrella/Excess & Surplus Lines - Price increases averaging 42% and new business combined to produce second- quarter 2002 written premiums of $61 million, an increase of $29 million over the same period of 2001. Year-to-date premium volume of $123 million was more than double the six- month 2001 total of $56 million. The six-month 2002 loss ratio of 73.6 was nearly nine points better than the comparable 2001 ratio of 82.3. - Public Sector - Written premiums totaled $36 million in 2002's second quarter, down 13% from the same period of 2001 due to a reduction in new business, as well as lower retention rates. Price increases on renewal business averaged 23% in the second quarter of 2002. Six-month 2002 premium volume of $101 million was 11% ahead of the same period last year. The second-quarter loss ratio of 62.7 in 2002 was much improved over the comparable 2001 ratio of 77.0, primarily due to significant improvement in current accident year loss experience. Commercial Lines - ---------------- The Commercial Lines segment includes our Small Commercial, Middle Market Commercial and Large Accounts business centers, as well as the results of our limited involvement in insurance pools. The Small Commercial business center serves small businesses such as retailers, wholesalers, service companies, professional offices, manufacturers and contractors. The Middle Market Commercial business center offers comprehensive insurance coverages for a wide variety of commercial enterprises where annual insurance costs range from $75,000 to $1 million. The Large Accounts business center offers insurance programs to larger commercial businesses that are willing to share insurance risk through significant deductibles and self-insured retentions. The following table summarizes results for this segment for the second quarters and six months ended June 30, 2002 and 2001. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Three Months Ended Six Months Ended June 30 June 30 ------------------ ---------------- (Dollars in millions) 2002 2001 2002 2001 ------------------- ------ ------ ------ ------ Net written premiums $381 $388 $887 $818 Percentage change from 2001 (2%) 8% Underwriting result $(530) $37 $(527) $114 Statutory combined ratio: Loss and loss adjustment expense ratio 193.4 60.6 130.8 52.7 Underwriting expense ratio 33.1 29.7 30.8 30.4 ----- ----- ----- ----- Combined ratio 226.5 90.3 161.6 83.1 ===== ===== ===== ===== The slight decline in second-quarter premium volume compared with 2001 was due to premiums ceded in the quarter related to terrorism reinsurance coverage, and a deliberate focus on price increases which led to a reduction in new business volume, particularly in the Middle Market Commercial business center. The increase in year-to-date premium volume was principally driven by strong price increases, as we took the opportunity presented by favorable market conditions to actively manage our growth while focusing on improving profitability. Price increases across the entire segment averaged 25% in the second quarter and 23% year-to- date. Middle Market Commercial premiums in the second quarter totaled $199 million, compared with $219 million in the same 2001 period. In our Small Commercial business center, second quarter premiums of $149 million grew 7% over the second quarter of 2001. We are in the process of building a field organization and business platform to more efficiently serve the small commercial insurance market. The reported loss ratio and underwriting result in the Commercial Lines segment in the second quarter of 2002 was dominated by the $585 million asbestos litigation settlement described on pages 27 and 28 of this report. Excluding that settlement, the second- quarter 2002 loss ratio was 57.1, over three points improved compared with the 2001 second-quarter ratio of 60.6. The year-to- date 2002 loss ratio without the asbestos settlement was 62.9. Last year's reported six-month loss ratio was unusually favorable due to the impact of a $100 million reduction in previously established reserves that pertained to certain business written in years prior to 1989. Those reserves were reduced based on actuarial analyses, which indicated that ultimate losses on that business would fall short of the established reserves. Excluding the reserve reduction, the six-month 2001 loss ratio was 66.1, over three points worse than the adjusted 2002 six-month ratio. Current accident year results in 2002 for both the Small and Middle Market Commercial business centers improved over comparable results in 2001, reflecting the impact of price increases and an improvement in the quality of our book of business. The 3.4-point expense ratio increase in the second quarter over the prior year primarily reflected the impact of premiums ceded for terrorism reinsurance coverage, which increased the commission component of the expense ratio. Additionally, the 2001 second-quarter expense ratio was impacted by a reduction in our accrual for guaranty funds (recorded in "Pools and other"). Surety and Construction - ----------------------- Our Surety business center underwrites surety bonds, which guarantee that third parties will be indemnified against the nonperformance of contractual obligations. Our Construction business center provides insurance products and services to a broad range of contractors and owners of construction projects. The following table summarizes key financial data for this segment for the second quarters and six months ended June 30, 2002 and 2001. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Three Months Ended Six Months Ended June 30 June 30 ------------------ ---------------- (Dollars in millions) 2002 2001 2002 2001 ------------------- ------ ------ ------ ------ Net written premiums $329 $257 $677 $521 Percentage change from 2001 28% 30% Underwriting profit $5 $21 $9 $41 Statutory combined ratio: Loss and loss adjustment expense ratio 62.2 51.9 62.8 53.0 Underwriting expense ratio 34.5 35.9 32.8 36.1 ----- ----- ----- ----- Combined ratio 96.7 87.8 95.6 89.1 ===== ===== ===== ===== Surety premium volume of $141 million in 2002's second quarter grew 30% over premiums of $108 million in the same 2001 period, driven by $17 million of surety premiums generated by London Guarantee Insurance Company, acquired near the end of March 2002. (See page 28 of this report for further details about the acquisition). Surety's year-to-date premium volume of $251 million grew 18% over the same period of 2001, due to the additional premiums from London Guarantee and $27 million of premiums generated from our acquisition in late 2001 of the right to seek to renew surety business previously underwritten by Fireman's Fund Insurance Company. Excluding the impact of the two acquisitions, our surety premium volume through the first half of 2002 was slightly below comparable 2001 levels, reflecting the tightened underwriting standards we have maintained over the last two years in an uncertain economic environment. In 2001, our Surety operation began to reduce its commercial surety business. In the Construction business center, second-quarter and six-month premium volume of $188 million and $426 million, respectively, was 27% and 39% ahead of the respective periods of 2001. The strong growth was driven by price increases averaging 28% in the first half of the year. The Surety business center accounted for the decline in underwriting profit in this segment compared with the second quarter and first six months of 2001. Surety's six-month loss ratio of 44.4 was nearly eleven points worse than the comparable 2001 ratio of 33.5, primarily due to an increase in the current accident year loss ratio. Despite that deterioration, however, Surety's operations remained profitable, posting a $2 million underwriting profit in 2002, compared with a profit of $32 million in the first half of 2001. In July 2002, we announced that after-tax losses in our Surety operation in the third quarter resulting from a recent court ruling regarding surety bonds issued in connection with the construction of two large Brazilian oil rigs are not expected to exceed $25 million. See page 32 of this report for further details about this ruling. Construction's second-quarter loss ratio of 72.8 was worse than the comparable 2001 ratio of 66.4, due to favorable prior-year loss development in 2001. Despite the loss ratio increase, the Construction business center posted an underwriting profit of $6 million in the second quarter of 2002, level with the same period of 2001. The segment-wide six-month 2002 expense ratio was over three points better than the comparable 2001 ratio, reflecting the combined impact of strong written premium growth and the continued success of expense reduction initiatives in both the Surety and Construction business centers. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Health Care - ----------- Our Health Care segment historically has provided property- liability insurance throughout the entire health care delivery system. In late 2001, we announced our intention to exit that market, subject to applicable regulatory requirements. As a result, we consider the entire segment to be in runoff in 2002. The following table summarizes key financial data for the Health Care segment for the quarters and six months ended June 30, 2002 and 2001. Three Months Ended Six Months Ended June 30 June 30 ------------------ ---------------- (Dollars in millions) 2002 2001 2002 2001 ------------------- ------ ------ ------ ------ Net written premiums $29 $147 $177 $324 Percentage decline from 2001 (80%) (45%) Underwriting result $(102) $(124) $(100) $(254) Statutory combined ratio: Loss and loss adjustment expense ratio 150.4 148.9 113.7 147.8 Underwriting expense ratio 54.6 26.4 28.7 25.1 ----- ----- ----- ----- Combined ratio 205.0 175.3 142.4 172.9 ===== ===== ===== ===== Written premiums in 2002 primarily consisted of premiums generated by extended reporting endorsements, which we are required to offer to claims-made policyholders at the time their policies are nonrenewed. These endorsements cover losses incurred in prior periods that have not yet been reported. Unlike typical policies, premiums on these endorsements are fully earned, and the expected losses are fully reserved, at the time the endorsement is written. Our exit from the Health Care market continues to proceed as planned when we announced the action at the end of 2001. As of June 30, 2002, we had obtained regulatory approval to cease underwriting new business in all but two states, and are nonrenewing policies where such approval had been obtained. The two states where regulatory approval is pending accounted for approximately 6% of net written premium volume in the Health Care segment for the year ended Dec. 31, 2001. We anticipate net written premium volume of approximately $350 million in the Health Care segment for the full year of 2002, with reporting endorsement premiums expected to account for the majority of that total. The underwriting loss in the second quarter and first half of 2002 primarily resulted from an approximately $100 million provision to increase prior accident year loss reserves. In the year ended Dec. 31, 2001, we recorded cumulative provisions of $735 million to strengthen prior accident year loss reserves in this segment. Our continuing actuarial analysis may or may not conclude that further reserve increases are necessary going forward, in part due to the uncertainty related to our assumptions regarding the handling of runoff claims that could prove to be incorrect. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Lloyd's and Other - ----------------- Our Lloyd's and Other segment consists of the following components: our operations at Lloyd's, where we provide capital to five underwriting syndicates and own a managing agency; our participation in the insuring of the Lloyd's Central Fund, which would be utilized if an individual member of Lloyd's were to be unable to pay its share of a syndicate's losses; and results from Unionamerica, a London-based insurance operation we acquired in April 2000 as part of our purchase of MMI Companies, Inc. In late 2001, we announced that we would cease underwriting certain business through Lloyd's beginning in 2002, and would, when current contractual commitments expire in 2003, end our involvement in the insuring of the Lloyd's Central Fund. At Unionamerica, we ceased underwriting new business in late 2000 except for that business we are contractually obligated to underwrite through 2004. The following table summarizes this segment's results for the quarters and six months ended June 30, 2002 and 2001. Three Months Ended Six Months Ended June 30 June 30 ------------------ ---------------- (Dollars in millions) 2002 2001 2002 2001 ------------------- ------ ------ ------ ------ Net written premiums $245 $296 $312 $394 Percentage decline from 2001 (17%) (21%) Underwriting result $(20) $(28) $(59) $(51) Statutory combined ratio: Loss and loss adjustment expense ratio 89.0 94.6 95.1 91.6 Underwriting expense ratio 22.2 18.9 25.8 23.6 ----- ----- ----- ----- Combined ratio 111.2 113.5 120.9 115.2 ===== ===== ===== ===== Our ongoing business in the Lloyd's and Other segment at the beginning of 2002 consisted of the following coverages offered through our involvement at Lloyd's: aviation, marine, financial and professional services, property insurance and personal lines, including kidnap and ransom, accident and health, creditor and other personal specialty products. In April 2002, we announced that we would further narrow the focus of our operations at Lloyd's to four key product lines: marine, personal lines, property and aviation. The decline in reported premium volume in the second quarter and first half of 2002 compared with the same periods of 2001 reflected the impact of our reduced involvement at Lloyd's and a decrease in premiums generated by Unionamerica. Excluding those lines of business in runoff, premium volume in the second quarter and first six months of 2002 increased 41% and 29%, respectively, over the same periods of 2001, driven entirely by strong price increases throughout our ongoing operations in this segment. Our runoff operations at Lloyd's and Unionamerica accounted for the majority of underwriting losses for all periods presented in the above table. Provisions to strengthen prior-year loss reserves were the primary factor contributing to those losses in all periods. Our ongoing operations at Lloyd's produced an underwriting profit of $8 million in the second quarter of 2002, compared with an underwriting profit of $2 million in the same 2001 period. We are continuing to review the role of our operations at Lloyd's in our long-term corporate strategy. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Reinsurance - ----------- Our Reinsurance segment ("St. Paul Re") underwrites treaty and facultative reinsurance for property, liability, ocean marine, surety and certain specialty classes of coverage, and also underwrites "nontraditional" reinsurance, which provides limited traditional underwriting risk combined with financial risk protection. In late 2001, we announced our intention to cease underwriting certain types of reinsurance coverages in 2002, as described in more detail on page 29 of this report. In April 2002, we announced our intention to transfer our ongoing reinsurance operations to a Bermuda-based reinsurer, as described in more detail on page 28 of this report. The following table summarizes key financial data for the Reinsurance segment for the first quarters of 2002 and 2001, excluding the impact of the aggregate excess-of-loss reinsurance treaty exclusive to this segment that is described on page 35 of this report. Three Months Ended Six Months Ended June 30 June 30 ------------------ ---------------- (Dollars in millions) 2002 2001 2002 2001 ------------------- ------ ------ ------ ------ Net written premiums $201 $322 $662 $746 Percentage decline from 2001 (38%) (11%) Underwriting result $(4) $(72) $11 $(116) Statutory combined ratio: Loss and loss adjustment expense ratio 70.0 88.1 67.4 82.1 Underwriting expense ratio 34.5 35.0 29.1 34.3 ----- ----- ----- ----- Combined ratio 104.5 123.1 96.5 116.4 ===== ===== ===== ===== After the actions announced at the end of 2001, our Reinsurance segment in 2002 has focused almost exclusively on property catastrophe reinsurance, excess-of-loss casualty reinsurance, marine reinsurance and traditional finite reinsurance. The decline in premium volume in the second quarter and first six months of 2002 reflected our narrowed business focus, and our total reinsurance exposures were down significantly compared with 2001. Market conditions in worldwide reinsurance markets in 2002 have been characterized by favorable terms and conditions, and strong price increases amid heightened demand for reinsurance coverages. The significant improvement in St. Paul Re's underwriting result in the second quarter and first half of 2002 compared with the same prior-year periods reflected the positive impact of significant price increases, as well as the success of our strategic emphasis on those lines of business we believe offer the greatest potential for profitable results. Underwriting results in both periods of 2002 benefited from the absence of major catastrophes and favorable development on catastrophe losses incurred in prior years, whereas 2001 second-quarter and six-month results included catastrophe losses resulting from Tropical Storm Allison in the United States. The strong improvement in the 2002 year-to-date expense ratio was primarily the result of actions we have taken in 2002 to reduce expenses in this segment, including the closing of branch offices in several locations around the world. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Investment Operations - --------------------- Second-quarter 2002 pretax net investment income in our property- liability insurance operations of $283 million was $12 million, or 4%, below investment income in the same period of 2001. Through the first six months of 2002, investment income totaled $573 million, down 8% from the prior year total of $625 million. Last year's six-month total was unusually high due to $22 million of income generated by the sale of certain properties in our real estate investment portfolio. Our investment income in recent quarters has been negatively impacted by declining yields on new investments and a general reduction in the amount of funds available for investment due to significant cash payments for insurance losses and loss adjustment expenses, particularly in our Health Care, Reinsurance and Lloyd's and Other segments. In addition, we made cumulative premium payments totaling $639 million between the fourth quarter of 1999 and the first quarter of 2001 related to our corporate reinsurance program. Since the end of 1999, average new money rates on taxable and tax-exempt securities have fallen from 7.2% and 5.4%, respectively, to 6.0% and 3.8%, respectively, at June 30, 2002. We expect our investment income levels in future periods to be negatively impacted by the payment of claims related to the September 11, 2001 terrorist attack, as well as claims payable from reserves related to our operations in runoff, as the investment assets related to the reserves decline. In addition, the June 2002 payment of $248 million and the anticipated January 2003 payment of $740 million related to the Western MacArthur asbestos litigation settlement will negatively impact our investment income in future periods. We expect these factors to be mitigated somewhat, however, by continued price increases and improving loss experience in our ongoing insurance operations, as well as investment returns on the net $842 million of proceeds received from our issuance of common stock and equity units in July 2002. Pretax realized investment losses in our property-liability insurance operations totaled $38 million in the second quarter of 2002, compared with realized gains of $6 million in the same 2001 period. Losses in this year's second quarter were centered in our equity portfolio. During the second quarter, we made a strategic decision to liquidate a substantial portion of our equity investment holdings and redeploy those funds in fixed maturities. Accordingly, we reduced our equity investments by approximately $500 million in the second quarter. In addition, we recorded writedowns in the carrying value of WorldCom Corporation and Adelphia Corporation bonds in our portfolio totaling $13 million in the second quarter. Through the first half of 2002, pretax realized losses totaled $77 million, compared with realized gains of $58 million in the same 2001 period. Losses generated by our venture capital portfolio in the first quarter of 2002 accounted for a significant portion of our year-to-date 2002 losses. Pretax realized gains in the first half of 2001 included a gain of $77 million on the sale of our investment in RenaissanceRe Holdings Ltd., a Bermuda-based reinsurer. The market value of our $16.1 billion fixed maturities portfolio exceeded its cost by $699 million at June 30, 2002. Approximately 96% of that portfolio is rated at investment grade (BBB or above). The weighted average pretax yield on those investments was 6.5% at June 30, 2002 down from 6.8% a year ago. Environmental and Asbestos Claims --------------------------------- We continue to receive claims, including through lawsuits, alleging injury or damage from environmental pollution or seeking payment for the cost to clean up polluted sites. We also receive asbestos injury claims, including through lawsuits, arising out of coverages under general liability policies. Most of these claims arise from policies written many years ago. Significant legal issues, primarily pertaining to the scope of coverage, complicate the determination of our alleged liability for both environmental and asbestos claims. In our opinion, court decisions in certain jurisdictions have tended to broaden insurance coverage for both environmental and asbestos matters beyond the intent of the original insurance policies. PAGE> THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Environmental and Asbestos Claims (continued) -------------------------------------------- Our ultimate liability for environmental claims is difficult to estimate because of these legal issues. Insured parties are seeking recovery for losses not covered in their respective insurance policies, and the ultimate resolution of these claims may be subject to lengthy litigation, making it difficult to estimate our potential liability. In addition, variables, such as the length of time necessary to clean up a polluted site and controversies surrounding the identity of the responsible party and the degree of remediation deemed necessary, make it difficult to estimate the total cost of an environmental claim. Estimating the ultimate liability for asbestos claims is more difficult. The primary factors influencing our estimate of the total cost of these claims are case law and a history of prior claim development, both of which continue to evolve and are complicated by aggressive litigation against insurers, including us. Estimating ultimate liability is also complicated by the difficulty of assessing what rights, if any, we may have to seek contribution from other insurers of any policyholder. As a result of developments in the asbestos litigation environment generally, we determined in the first quarter of 2002 that it would be desirable to seek earlier and ultimately less costly resolutions of certain pending asbestos-related litigations. As a result, we have decided where possible to seek to resolve these matters while continuing to vigorously assert defenses in pending litigations. We are taking a similar approach to environmental litigations. As discussed in more detail on pages 27 and 28 of this report, in the second quarter of 2002 we entered into a definitive agreement to settle asbestos claims for a total cost of $988 million arising from an insuring relationship one of our subsidiaries had with Western MacArthur Company. Following a comprehensive review of our known environmental and asbestos exposures, we determined that our environmental reserves were higher than necessary, and that, including the impact of the Western MacArthur settlement, our asbestos reserves were inadequate. As a result, we determined a reclassification adjustment was appropriate. (See further discussion on the following page regarding our asbestos and environmental reserves.) The following table represents a reconciliation of total gross and net environmental reserve development for the six months ended June 30, 2002, and the years ended Dec. 31, 2001 and 2000. Amounts in the "net" column are reduced by reinsurance recoverables. The disclosure of environmental reserve development includes all claims related to environmental exposures. Additional disclosure has been provided to separately identify loss payments and reserve amounts related to policies that were specifically underwritten to cover environmental exposures, referred to as "Underwritten," as well as amounts related to environmental exposures that were not specifically underwritten, referred to as "Not Underwritten." In 1988, we completed our implementation of a pollution exclusion in our commercial general liability policies; therefore, activity related to accident years after 1988 generally relates to policies underwritten to include environmental exposures. The amounts presented for paid losses in the following table as "Underwritten" include primarily exposures related to accident years after 1988 for policies which the underwriter contemplated providing environmental coverage. In addition, certain pre-1988 exposures, such as oil and gas exposures, transportation of hazardous materials exposures, and first party losses are included since, they too, were contemplated by the underwriter to include environmental coverage. "Not Underwritten" primarily represents exposures related to accident years 1988 and prior for policies which were not contemplated by the underwriter to include environmental coverage. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Environmental and Asbestos Claims (continued) -------------------------------------------- 2002 Environmental (six months) 2001 2000 ------------- ---------- ----------- ----------- (In millions) Gross Net Gross Net Gross Net ----------- ----- --- ----- --- ----- --- Beginning reserves $582 $507 $665 $563 $698 $599 Incurred losses (152) (153) 1 18 25 14 Paid losses: Not underwritten (22) (18) (73) (63) (45) (38) Underwritten (6) (5) (11) (11) (13) (12) ---- ---- ---- ---- ---- ---- Ending reserves $402 $331 $582 $507 $665 $563 ==== ==== ==== ==== ==== ==== Included in the gross and net incurred losses for the six months ended June 30, 2002 was a $150 million reduction of environmental reserves. For the year 2000, the gross and net environmental "underwritten" reserves at the beginning of the year totaled $27 million and $25 million, respectively, and at the end of the year totaled $27 million and $26 million, respectively. For 2001, the year-end gross and net environmental "underwritten" reserves were both $28 million, and at June 30, 2002 the gross and net reserves were both $30 million. These reserves relate to policies which were specifically underwritten to include environmental exposures. These "underwritten" reserve amounts are included in the total reserve amounts in the preceding table. The following table represents a reconciliation of total gross and net reserve development for asbestos claims for the six months ended June 30, 2002, and the years ended Dec. 31, 2001 and 2000. No policies have been underwritten to specifically include asbestos exposure. 2002 Asbestos (six months) 2001 2000 -------- ---------- ----------- ----------- (In millions) Gross Net Gross Net Gross Net ----------- ----- --- ----- --- ----- --- Beginning reserves $ 478 $367 $397 $299 $398 $298 Incurred losses 988 737 133 110 41 33 Paid losses (279) (274) (52) (42) (42) (32) ----- ---- ---- ---- ---- ---- Ending reserves $1,187 $830 $478 $367 $397 $299 ===== ==== ==== ==== ==== ==== Included in the gross and net incurred losses for the six months ended June 30, 2002 were $988 million of gross losses and $740 million of net losses related to the Western MacArthur litigation settlement. Also included in the gross and net incurred losses for the six months ended June 30, 2002 was a $150 million increase in asbestos reserves. Gross and net paid losses include the $248 million payment made in June 2002. Our reserves for environmental and asbestos losses at June 30, 2002 represent our best estimate of our ultimate liability for such losses, based on all information currently available. Because of the inherent difficulty in estimating such losses, however, we cannot give assurances that our ultimate liability for environmental and asbestos losses will, in fact, match current reserves. We continue to evaluate new information and developing loss patterns, as well as the potential impact of our determination to seek earlier and ultimately less costly resolutions of certain pending asbestos and environmental related litigations. Future changes in our estimates of our ultimate liability for environmental and asbestos claims may be material to our results of operations, but we do not believe they will materially impact our liquidity or overall financial position. Total gross environmental and asbestos reserves at June 30, 2002, of $1.6 billion represented approximately 7% of gross consolidated reserves of $22.5 billion. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Asset Management ---------------- Our asset management segment consists of our 78% majority ownership interest in The John Nuveen Company (Nuveen). Nuveen provides customized individual accounts, mutual funds, exchange- traded funds and defined portfolios through financial advisors serving the affluent, high net worth and institutional market segments. Highlights of Nuveen's performance for the quarters and six months ended June 30, 2002 and 2001 were as follows: Three Months Ended Six Months Ended June 30 June 30 ------------------ ---------------- (in millions) 2002 2001 2002 2001 ----------- ------ ------ ------ ------ Revenues $ 91 $ 87 $ 185 $ 174 Expenses 41 42 86 84 ---- ---- ---- ---- Pretax earnings 50 45 99 90 Minority interest (11) (11) (22) (21) ---- ---- ---- ---- The St. Paul's share of pretax earnings $ 39 $ 34 $ 77 $ 69 ==== ==== ==== ==== Assets under management $68,496 $62,990 ====== ====== Nuveen's revenue growth in the second quarter and first six months of 2002 was driven by an increase in investment advisory fees over the same periods of 2001. Gross sales of investment products totaled $3.3 billion in the second quarter of 2002, level with the same period of 2001. Second-quarter 2002 sales were comprised of $1.5 billion of retail and institutional managed accounts, $1.4 billion of closed-end exchange-traded funds and $0.4 billion of mutual funds. Nuveen's commitment to core, long-term investment disciplines and specialized investment expertise has led to continued earnings growth despite a challenging investment environment. Difficult market conditions for equity investments caused strong demand for Nuveen's broad range of fixed-income investments in the second quarter of 2002. Nuveen's net flows (equal to the sum of sales, reinvestments and exchanges, less redemptions and withdrawals) during the first half of 2002 totaled $2.5 billion, compared with net flows of $4.7 billion in the same period of 2001. Managed assets at the end of the second quarter consisted of $35.1 billion of exchange-traded funds, $17.0 billion of retail managed accounts, $4.8 billion of institutional managed accounts and $11.6 billion of mutual funds. Total managed assets at June 30, 2002 were down slightly from the comparable total at the end of the first quarter, reflecting the impact of a decline in equity values. Managed assets were, however, 9% higher than a year ago, primarily due to Nuveen's July 2001 acquisition of Symphony Asset Management LLC, an institutional money management firm, which added approximately $4 billion in managed assets. In May 2002, Nuveen announced an agreement to acquire NWQ Investment Management, an asset management firm based in Los Angeles. On August 1, 2002, Nuveen announced that this acquisition had been completed, which added approximately $7 billion to Nuveen's assets under management. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Capital Resources ----------------- Common shareholders' equity totaled $4.92 billion at June 30, 2002, down $133 million, or 3%, from the year-end 2001 total of $5.06 billion. The decline was driven by our net loss of $90 million in the first half of the year and dividends declared on our common stock totaling $121 million. These reductions to equity were partially offset by a $21 million increase in the unrealized appreciation of our investment portfolio and an $11 million reduction in the unrealized loss on foreign currency translation. Total debt at June 30, 2002 of $2.12 billion was virtually level with the year-end 2001 total of $2.13 billion. In March 2002, we issued $500 million of 5.25% senior notes that mature in 2007, the proceeds of which were primarily used to repay a like amount of our commercial paper outstanding. Our ratio of total debt obligations to total capitalization of 26% at the end of the second quarter was level with the year-end 2001 ratio of 26%. Net interest expense related to debt totaled $53 million in the first half of 2002, compared with $59 million in the same period of 2001. Preferred distribution expense related to mandatorily redeemable preferred securities of trusts guaranteed by us totaled $35 million in the first half of 2002, compared with $14 million in the same 2001 period. The increase was due to the issuance of $575 million of 7.6% mandatorily redeemable preferred securities in November 2001. The 17.8 million common shares we issued in July 2002 will increase our common equity by $413 million, net of commissions and expenses paid. The debt component of the equity units we issued in July 2002 will increase the total debt on our balance sheet by $443 million. However, the present value of the stock purchase contracts associated with the equity units will be classified as a contra-equity account reducing our reported common equity by approximately $46 million. Capital expenditures that we might consider during the remainder of 2002 include acquisitions of existing businesses consistent with our commercial insurance focus. As of August 12, 2002 we had the capacity to make up to approximately $89 million in common stock repurchases under a repurchase program authorized by our board of directors in February 2001; however, we do not anticipate repurchasing any of our common shares during the remainder of 2002. For the first six months of 2002, our loss from continuing operations was inadequate to cover "fixed charges" by $168 million and "combined fixed charges and preferred stock dividends" by $175 million. For the first six months of 2001, the ratio of earnings to fixed charges was 6.03, and the ratio of earnings to combined fixed charges and preferred stock dividend requirements was 5.57. Fixed charges consist of interest expense, dividends on preferred capital securities and that portion of rental expense deemed to be representative of an interest factor. Liquidity --------- Liquidity is a measure of our ability to generate sufficient cash flows to meet the short- and long-term cash requirements of our business operations. Our chief source of liquidity is cash provided from operations, which primarily consists of insurance premiums collected and investment income. As necessary, additional liquidity is provided by net sales from our investment portfolio and access to the debt and equity markets. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Liquidity (continued) -------------------- Net cash flows provided by continuing operations totaled $82 million in the first six months of 2002, compared with cash used by continuing operations of $45 million in the same period of 2001. Our operational cash flows in 2002 were negatively impacted by the $248 million payment made in June related to the Western MacArthur asbestos litigation settlement, and loss payments totaling $148 million related to the September 11, 2001 terrorist attack. Operational cash flows generated by our ongoing property-liability operations in 2002 were substantially better than the same period of 2001, due to significant price increases and improving loss experience. In addition, we made no premium payments related to our corporate reinsurance program in the first six months of 2002, whereas such payments totaled $164 million in the same 2001 period. We expect operational cash flows during the remainder of 2002 to continue to be negatively impacted by insurance losses and loss adjustment expenses payable related to the September 11, 2001 terrorist attack, as well as losses payable related to our operations in runoff. However, we expect continued improvement in operational cash flows from ongoing operations in the second half of 2002 as a result of price increases and expense reductions throughout those operations. In the first quarter of 2003, our operational cash flows and, consequently, our future investment income will be negatively impacted by the payment of an additional $740 million related to the Western MacArthur asbestos litigation settlement. This will be offset, however, by the investment income generated by the $842 million of net proceeds received from the common stock and equity units offering that we completed in July 2002. During and subsequent to the second quarter, certain independent financial rating agencies downgraded various ratings of The St. Paul. As a result, we may pay higher interest rates on debt securities we may issue in the future, compared with rates available had the downgrades not occurred. We believe our financial strength continues to provide us with the flexibility and capacity to obtain funds externally through debt or equity financings on both a short-term and long-term basis. The common stock and equity units offering in July 2002 is evidence of this capacity. In addition, the commercial paper market continues to be an efficient and cost effective source of short-term funding. We continue to maintain an $800 million commercial paper program with $600 million of back-up liquidity, consisting of bank credit agreements totaling $540 million entered into during the second quarter and $60 million of highly-liquid, high-quality fixed income securities. Impact of Accounting Pronouncements to be Adopted in the Future - --------------------------------------------------------------- In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143, "Accounting for Asset Retirement Obligations," which establishes financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated retirement costs. It requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are to be capitalized as part of the carrying amount of the long-lived asset. This statement is effective for fiscal years beginning after June 15, 2002. We do not expect the adoption of SFAS No. 143 to have a material impact on our financial statements. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which supersedes SFAS No. 121. The new Statement establishes a single accounting model, based on the framework originally established SFAS No. 121, for long-lived assets to be disposed of by sale, and resolves significant implementation issues related to that Statement. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. We do not expect the adoption of SFAS No. 144 to have a material impact on our financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Impact of Accounting Pronouncements to be Adopted in the Future (continued) - -------------------------------------------------------------------------- In April 2002, the FASB issued SFAS No. 145, "Recission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." The primary impact of SFAS No. 145 was to rescind the requirement to report the gain or loss from the extinguishment of debt as an extraordinary item on the statement of income. The provisions of this Statement are generally effective for fiscal years beginning after May 15, 2002. We do not expect the adoption of SFAS No. 145 to have a material impact on our financial statements. In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," which requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than the current practice of recognizing those costs at the date of a commitment to exit or disposal plan. The provisions of SFAS No. 146 are to be applied prospectively to exit or disposal activities initiated after December 31, 2002. PART II OTHER INFORMATION Item 1. Legal Proceedings. The information set forth in Note 5 to the consolidated financial statements is incorporated herein by reference. Item 2. Changes in Securities. Not applicable. Item 3. Defaults Upon Senior Securities. Not applicable. Item 4. Submission of Matters to a Vote of Security Holders. Not applicable. Item 5. Other Information. Not applicable. Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits. An Exhibit Index is set forth as the last page in this document. (b) Reports on Form 8-K. 1) The St. Paul filed a Form 8-K Current Report dated April 25, 2002 related to the announcement of The St. Paul's intent to transfer its ongoing reinsurance operation to a newly formed Bermuda-based reinsurer, Platinum Underwriters Holdings, Ltd. 2) The St. Paul filed a Form 8-K Current Report dated June 3, 2002 related to the announcement of the settlement of the Western MacArthur asbestos litigation. 3) The St. Paul filed a Form 8-K Current Report dated July 16, 2002 related to the disclosure of the pro forma impact of the adoption of Statement of Financial Standards No. 142, "Goodwill and Other Intangible Assets," on The St. Paul's consolidated results for the years ended Dec. 31, 2001, 2000 and 1999. 4) The St. Paul filed a Form 8-K Current Report dated July 23, 2002 related to the announcement of The St. Paul's financial results for the second quarter and six months ended June 30, 2002. In addition, this Form 8-K included as an exhibit the Western MacArthur asbestos litigation settlement agreement. 5) The St. Paul filed a Form 8-K Current Report dated July 30, 2002 related to the announcement of the anticipated impact on third-quarter 2002 earnings of a United States District Court ruling regarding surety coverage provided by one of The St. Paul's subsidiaries for the construction of two oil rigs in Brazil. 6) The St. Paul filed a Form 8-K Current Report dated July 31, 2002 related to the completion of the sale of common stock and equity units, and included the related documents as exhibits. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. THE ST. PAUL COMPANIES, INC. (Registrant) Date: August 14, 2002 By Bruce A. Backberg --------------- ----------------- Bruce A. Backberg Senior Vice President (Authorized Signatory) Date: August 14, 2002 By John C. Treacy --------------- -------------- John C. Treacy Vice President and Corporate Controller (Principal Accounting Officer) EXHIBIT INDEX Exhibit - ------- (2) Plan of acquisition, reorganization, arrangement, liquidation or succession*.......................................... (3) (i) Articles of incorporation*......................................... (ii) By-laws*.......................................................... (4) Instruments defining the rights of security holders, including indentures*............................................... (10) Material contracts** (a) Retention Incentive Agreement between The St. Paul and Mr. John A. MacColl dated May 20, 2002...........................(1) (b) Settlement Agreement dated June 3, 2002 among MacArthur Company, Western MacArthur Company and Western Asbestos Company, together with each of their predecessors and successors, affiliates and subsidiaries, United States Fidelity & Guaranty Co., The St. Paul Fire and Marine Insurance Company, The St. Paul Companies, Inc., its affiliates and subsidiaries, and the Asbestos Plaintiffs***.................................... (11) Statement re computation of per share earnings**........................(1) (12) Statement re computation of ratios**....................................(1) (15) Letter re unaudited interim financial information*...................... (18) Letter re change in accounting principles*.............................. (19) Report furnished to security holders*................................... (22) Published report regarding matters submitted to vote of security holders*............................................ (23) Consents of experts and counsel*........................................ (24) Power of attorney*...................................................... (99) Additional exhibits*.................................................... * These items are not applicable. ** This exhibit is included only with the copies of this report that are filed with the Securities and Exchange Commission. However, a copy of the exhibit may be obtained from the Registrant for a reasonable fee by writing to The St. Paul Companies, Inc., 385 Washington Street, Saint Paul, MN 55102, Attention: Corporate Secretary. *** Incorporated herein by reference from The St. Paul's Current Report on Form 8-K dated July 23, 2002. (1) Filed herewith. EX-10 3 mccoll.txt EXHIBIT 10 - MATERIAL CONTRACT May 20, 2002 Mr. John A. MacColl 1727 Western Run Road Cockeysville, MD 21030 Re: Retention Incentive ------------------- Dear John: I am writing this letter on behalf of the Personnel & Compensation Committee (the "Committee") of the Board of Directors (the "Board") of The St. Paul Companies, Inc. (the "Company") to confirm the terms and conditions of the retention incentive award described below. As of May 20, 2002, you are hereby awarded a retention incentive award (the "Award") in the amount of $5 million. Except as otherwise provided herein, the Award will fully vest on February 5, 2005, provided you remain employed by the Company until such vesting date. As soon as practicable following the date hereof, the Award will be credited to the Company's rabbi trust and will be deemed invested in the investment vehicles available to participants in the Company's non-qualified deferred compensation plan selected by you, from time to time. The vested Award, plus earnings thereon, will be paid to you in a lump sum on the first date following February 5, 2005 on which no portion of such payment would be non-deductible to the Company for Federal income tax purposes by reason of the application of section 162(m) of the Internal Revenue Code of 1986, as amended, and the regulations thereunder, both as in effect on the date hereof; provided, however, that the vested Award, plus earnings thereon, shall be paid no later than 30 days following the date on which your employment with the Company is terminated by you or by the Company, for any reason, unless you elect, with the consent of the Committee, to defer payment of the vested Award, plus earnings thereon, in accordance with the terms of the Company's non-qualified deferred compensation plan, as in effect from time to time. Notwithstanding anything in this letter agreement to the contrary, (i) if, at any time, your employment is terminated by the Company without Cause (as defined below) or by you for Good Reason (as defined below), the Award, plus earnings thereon, shall fully vest (to the extent not previously vested) and be paid to you no later than 30 days following such termination of employment, and (ii) if at any time prior to February 5, 2005, your employment is terminated due to your death or Disability (as defined below), a pro-rata portion of the Award, plus earnings thereon, shall vest on the date of your death or Disability termination (based on the number of days elapsed since February 5, 2002) and be paid to you or, in the event of your death, to the beneficiary designated by you on the last written beneficiary designation received by the Company with respect to payments hereunder prior to your death (or, if you do not designate a beneficiary or no designated beneficiary survives you, to the personal representative of your estate) within 30 days of your death or Disability. For purposes of this letter agreement, "Cause" shall mean your (i) conviction of, or plea of guilty or nolo contendere to, a misdemeanor that is materially injurious to the Company or a felony; or (ii) willful and continued failure to substantially perform your duties (other than as a result of physical or mental illness), after a demand for substantial performance by the Board. For purposes of this letter agreement, "Good Reason" shall mean, without your express written consent, (i) assignment to you by the Company of duties and responsibilities that are materially inconsistent with your current title and position (Vice Chairman & General Counsel); (ii) reduction in your current base salary or bonus opportunity; (iii) failure by the Company to pay you any compensation when due; or (iv) the Company requiring you to be based anywhere more than 30 miles from your current location (Baltimore) or travel on a basis different from your travel on Company business over the 6 months preceding the date of this letter agreement; provided, however, that if you voluntarily consent to any assignment, reduction, failure to pay, or requirement described above in lieu of exercising your right to resign for Good Reason and deliver such consent to the Company in writing, then such assignment, reduction, failure to pay, or requirement shall not constitute "Good Reason" hereunder, but you shall have the right to resign for Good Reason under this letter agreement as a result of any subsequent assignment, reduction, failure to pay, transfer or change described above. For purposes of clause (i) of this paragraph, in the event of a Reorganization or Sale (as such terms are defined under the Company's Amended and Restated Special Severance Policy as in effect as of the date hereof), you will be deemed to have been assigned duties and responsibilities that are materially inconsistent with your current title and position, unless after such event you retain your title and position with the ultimate parent of the entity that results from the transaction (or set of transactions) that constitutes a Reorganization or Sale. For purposes of this letter agreement, "Disability" shall mean "total and permanent disability" as defined in the Company's long-term disability plan for senior executives (or such other long-term disability plan sponsored by the Company in which you participate at the time the determination of Disability is made). This letter agreement will be governed and construed and enforced in accordance with the laws of the State of Minnesota without reference to rules relating to conflict of laws. This letter agreement is intended to be a binding obligation upon the Company and you. For purposes of this paragraph, the term "Company" shall include the Company, any surviving or resulting entity or successor (whether direct or indirect, by purchase, merger, consolidation, share exchange or otherwise) and any parent or subsidiary of the Company after such event. This letter agreement may be executed in any number of counterparts, which together will constitute one agreement. This letter agreement may be amended only by a subsequent written agreement between you and the Company. If, following a Change in Control (as defined in the Company's Amended and Restated Special Severance Policy), your employment is terminated by the Company other than for Cause or by you for Good Reason, any amount vested or payable under this letter agreement as a result of such termination shall be treated as a "Payment" under paragraph (a) of Exhibit A of the Company's Amended and Restated Special Severance Policy as in effect as of the date hereof. If this letter agreement correctly reflects your understanding, please sign and return one copy to John Clifford for the Company's records. THE ST. PAUL COMPANIES, INC. By: Jay S. Fishman -------------- Jay S. Fishman Title: Chairman and Chief Executive Officer The above letter agreement correctly reflects our understanding, and I hereby confirm my agreement to the same. John A. MaCcoll --------------- John A. MaCcoll Date: June 7, 2002 ------------ EX-11 4 ex11602.txt EXHIBIT 11 - EARNINGS PER SHARE EXHIBIT 11 THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES COMPUTATION OF EARNINGS PER SHARE Three Months and Six Months Ended June 30, 2002 and 2001 (In millions, except per share data) Three Months Ended Six Months Ended June 30 June 30 ------------------ ---------------- (in millions) 2002 2001 2002 2001 ----------- ----- ----- ----- ----- EARNINGS Basic: Net income (loss), as reported $ (223) $ 104 $ (90) $ 306 Preferred stock dividends, net of taxes (2) (2) (4) (4) Premium on preferred shares redeemed (2) (3) (5) (5) ----- ----- ----- ----- Net income (loss) available to common shareholders $ (227) $ 99 $ (99) $ 297 ===== ===== ===== ===== Diluted: Net income (loss) available to common shareholders $ (227) $ 99 $ (99) $ 297 Effect of dilutive securities: Convertible preferred stock - 2 - 3 Zero coupon convertible notes - 1 - 2 ----- ----- ----- ----- Net income (loss), as adjusted $ (227) $ 102 $ (99) $ 302 ===== ===== ===== ===== COMMON SHARES Basic: Weighted average common shares outstanding 208 214 208 215 ===== ===== ===== ===== Diluted: Weighted average common shares outstanding 208 214 208 215 Effect of dilutive securities: Stock options and other incentive plans - 4 - 4 Convertible preferred stock - 7 - 7 Zero coupon convertible notes - 2 - 2 ----- ----- ----- ----- Total 208 227 208 228 ===== ===== ===== ===== EARNINGS (LOSS) PER COMMON SHARE Basic $(1.09) $ 0.47 $(0.47) $ 1.38 ===== ===== ===== ===== Diluted $(1.09) $ 0.45 $(0.47) $ 1.33 ===== ===== ===== ===== Diluted EPS is the same as Basic EPS for both periods of 2002 because Diluted EPS calculated in accordance with Statement of Financial Accounting Standards No. 128, "Earnings Per Share, for The St. Paul's loss from continuing operations, results in a lesser loss per share than the Basic EPS calculation does. The provisions of SFAS No. 128 prohibit this "anti-dilution" of earnings per share, and require that athe larger Basic loss per share also be reported as the Diluted loss per share amount. EX-12 5 ex12602.txt EXHIBIT 12 - COMPUTATION OF RATIOS EXHIBIT 12 THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES COMPUTATION OF RATIOS Three Months and Six Months Ended June 30, 2002 and 2001 (In millions, except ratios) Three Months Ended Six Months Ended June 30 June 30 ------------------ ---------------- (in millions) 2002 2001 2002 2001 ----------- ----- ----- ----- ----- EARNINGS Income (loss) from continuing operations, before income taxes $ (364) $ 133 $ (168) $ 431 Add: fixed charges 53 42 103 86 ----- ----- ----- ----- Income (loss), as adjusted $ (311) $ 175 $ (65) $ 517 ===== ===== ===== ===== FIXED CHARGES AND PREFERRED DIVIDENDS Fixed charges: Interest expense and amortization $ 29 $ 28 $ 55 $ 58 Distributions on redeemable preferred securities 17 7 35 14 Rental expense (1) 7 7 13 14 ----- ----- ----- ----- Total fixed charges 53 42 103 86 Preferred stock dividend requirements 3 3 7 7 ----- ----- ----- ----- Total fixed charges and preferred stock dividend requirements $ 56 $ 45 $ 110 $ 93 ===== ===== ===== ===== Ratio of earnings to fixed charges (2) - 4.22 - 6.03 ===== ===== ===== ===== Ratio of earnings to combined fixed charges and preferred stock dividend requirements (2) - 3.89 - 5.57 ===== ===== ===== ===== (1) Interest portion deemed implicit in total rent expense. (2) The second-quarter 2002 loss is inadequate to cover "fixed charges" by $364 million and "combined fixed charges and preferred stock dividends" by $367 million. The year-to-date 2002 loss is inadequate to cover "fixed charges" by $168 million and "combined fixed charges and preferred stock dividends" by $175 million. -----END PRIVACY-ENHANCED MESSAGE-----