10-Q 1 tenq203.txt FORM 10-Q 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, 2003 ----------------- or TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE ----- SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ------------ ------------ Commission File Number 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 July 25, 2003, was 227,799,983. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES TABLE OF CONTENTS Page No. PART I. FINANCIAL INFORMATION -------- Consolidated Statements of Operations (Unaudited), Three and Six Months Ended June 30, 2003 and 2002 3 Consolidated Balance Sheets, June 30, 2003 (Unaudited) and December 31, 2002 4 Consolidated Statements of Shareholders' Equity, Six Months Ended June 30, 2003 (Unaudited) and Twelve Months Ended 6 December 31, 2002 Consolidated Statements of Comprehensive Income (Loss) (Unaudited), Six Months Ended June 30, 2003 and 2002 7 Consolidated Statements of Cash Flows (Unaudited), Six Months Ended June 30, 2003 and 2002 8 Notes to Consolidated Financial Statements (Unaudited) 9 Forward-Looking Statement Disclosure and Certain Risks 28 Management's Discussion and Analysis of Financial Condition and Results of Operations 30 Qualitative and Quantitative Disclosures about Market Risk 60 Controls and Procedures 60 PART II. OTHER INFORMATION Item 1 through Item 5 61 Item 6 62 Signatures 62 EXHIBIT INDEX 63 Item 1. Financial Statements. 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, 2003 and 2002 (In millions, except per share data) Three Months Ended Six Months Ended June 30 June 30 ------------------ ---------------- 2003 2002 2003 2002 ------ ------ ------ ------ Revenues: Premiums earned $ 1,700 $ 1,956 $ 3,429 $ 3,914 Net investment income 274 286 556 579 Asset management 106 90 208 184 Realized investment gains (losses) 68 (32) 29 (70) Other 23 44 63 71 ------ ------ ------ ------ Total revenues 2,171 2,344 4,285 4,678 ------ ------ ------ ------ Expenses: Insurance losses and loss adjustment expenses 1,192 1,986 2,328 3,379 Policy acquisition expenses 377 441 784 874 Operating and administrative expenses 294 281 614 593 ------ ------ ------ ------ Total expenses 1,863 2,708 3,726 4,846 ------ ------ ------ ------ Income (loss) from continuing operations before income taxes and cumulative effect of accounting change 308 (364) 559 (168) Income tax expense (benefit) 93 (146) 163 (98) ------ ------ ------ ------ Income (loss) before cumulative effect of accounting change 215 (218) 396 (70) Cumulative effect of accounting change, net of taxes - - - (6) ------ ------ ------ ------ Income (loss) from continuing operations 215 (218) 396 (76) Discontinued operations: Loss on disposal, net of taxes (1) (5) (1) (14) ------ ------ ------ ------ Loss from discontinued operations, net of taxes (1) (5) (1) (14) ------ ------ ------ ------ Net income (loss) $ 214 $ (223) $ 395 $ (90) ====== ====== ====== ====== Basic earnings (loss) per share: Income (loss) from continuing operations $ 0.94 $ (1.07) $ 1.71 $ (0.41) Discontinued operations, net of taxes (0.01) (0.02) (0.01) (0.06) ------ ------ ------ ------ Net income (loss) $ 0.93 $ (1.09) $ 1.70 $ (0.47) ====== ====== ====== ====== Diluted earnings (loss) per share: Income (loss) from continuing operations $ 0.89 $ (1.07) $ 1.64 $ (0.41) Discontinued operations, net of taxes - (0.02) - (0.06) ------ ------ ------ ------ Net income (loss) $ 0.89 $ (1.09) $ 1.64 $ (0.47) ====== ====== ====== ====== Dividends declared per common share $ 0.29 $ 0.29 $ 0.58 $ 0.58 ====== ====== ====== ====== See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS June 30, 2003 (unaudited) and December 31, 2002 (In millions) 2003 2002 Assets ------ ------ Investments: Fixed income $16,956 $17,188 Real estate and mortgage loans 857 874 Venture capital 547 581 Equities 352 394 Securities on loan 857 806 Other investments 843 738 Short-term investments 1,895 2,152 ------ ------ Total investments 22,307 22,733 Cash 177 315 Reinsurance recoverables: Unpaid losses 7,490 7,777 Paid losses 962 523 Ceded unearned premiums 787 813 Receivables: Underwriting premiums 2,784 2,711 Interest and dividends 242 247 Other 214 218 Deferred policy acquisition costs 653 532 Deferred income taxes 1,179 1,267 Office properties and equipment 363 459 Goodwill 894 874 Intangible assets 148 139 Other assets 2,338 1,351 ------ ------ Total Assets $40,538 $39,959 ====== ====== See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (continued) June 30, 2003 (unaudited) and December 31, 2002 (In millions) 2003 2002 Liabilities ------ ------ Insurance reserves: Losses and loss adjustment expenses $21,320 $22,626 Unearned premiums 4,177 3,802 ------ ------ Total insurance reserves 25,497 26,428 Debt 2,535 2,713 Payables: Reinsurance premiums 1,020 1,010 Accrued expenses and other 1,033 963 Securities lending collateral 874 822 Other liabilities 2,414 1,388 ------ ------ Total Liabilities 33,373 33,324 ------ ------ Company-obligated mandatorily redeemable preferred securities of trusts holding solely subordinated debentures of the company 890 889 ------ ------ Shareholders' Equity Preferred: Stock Ownership Plan - convertible preferred stock 101 105 Guaranteed obligation - Stock Ownership Plan (33) (40) ------ ------ Total Preferred Shareholders' Equity 68 65 ------ ------ Common: Common stock 2,635 2,606 Retained earnings 2,734 2,473 Accumulated other comprehensive income, net of taxes: Unrealized appreciation of investments 846 671 Unrealized loss on foreign currency translation (10) (68) Unrealized gain (loss) on derivatives 2 (1) ------ ------ Total accumulated other comprehensive income 838 602 ------ ------ Total Common Shareholders' Equity 6,207 5,681 ------ ------ Total Shareholders' Equity 6,275 5,746 ------ ------ Total Liabilities, Redeemable Preferred Securities of Trusts and Shareholders' Equity $40,538 $39,959 ====== ====== See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Six Months Ended June 30, 2003 (unaudited) and Twelve Months Ended December 31, 2002 (In millions) 2003 2002 ------ ------ Preferred Shareholders' Equity Stock Ownership Plan - convertible preferred stock: Beginning of period $ 105 $ 111 Redemptions during the period (4) (6) ------ ------ End of period 101 105 ------ ------ Guaranteed obligation - Stock Ownership Plan: Beginning of period (40) (53) Principal payments 7 13 End of period ------ ------ (33) (40) Total Preferred ------ ------ Shareholders' Equity 68 65 ------ ------ Common Shareholders' Equity: Common stock: Beginning of period 2,606 2,192 Stock issued: Stock incentive plans 20 32 Preferred shares redeemed 8 13 Net proceeds from stock offering - 413 Present value of equity unit forward purchase contracts - (46) Other 1 2 ------ ------ End of period 2,635 2,606 ------ ------ Retained earnings: Beginning of period 2,473 2,500 Net income 395 218 Dividends declared on common stock (132) (252) Dividends declared on preferred stock, net of taxes (4) (9) Deferred compensation - restricted stock (6) (5) Tax benefit on employee stock options, and other changes 12 28 Premium on preferred shares redeemed (4) (7) ------ ------ End of period 2,734 2,473 ------ ------ Unrealized appreciation on investments, net of taxes: Beginning of period 671 442 Change during the period 175 229 ------ ------ End of period 846 671 ------ ------ Unrealized loss on foreign currency translation, net of taxes: Beginning of period (68) (76) Currency translation adjustments 58 8 ------ ------ End of period (10) (68) ------ ------ Unrealized gain (loss) on derivatives, net of taxes: Beginning of period (1) (2) Change during the period 3 1 ------ ------ End of period 2 (1) ------ ------ Total Common Sharehoders' Equity 6,207 5,681 ------ ------ Total Shareholders' Equity $ 6,275 $ 5,746 ====== ====== See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (Unaudited) For the three months and six months ended June 30, 2003 and 2002 (In millions) Three Months Six Months Ended June 30 Ended June 30 ------------- ------------- (in millions) 2003 2002 2003 2002 ----------- ----- ----- ----- ----- Net income (loss) $ 214 $ (223) $ 395 $ (90) ----- ----- ----- ----- Other comprehensive income (loss), net of taxes: Change in unrealized appreciation of investments 168 139 175 21 Change in unrealized loss on foreign currency translation 40 7 58 11 Change in unrealized loss on derivatives 1 2 3 2 ----- ----- ----- ----- Other comprehensive income (loss) 209 148 236 34 ----- ----- ----- ----- Comprehensive income (loss) $ 423 $ (75) $ 631 $ (56) ===== ===== ===== ===== See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Six Months Ended June 30, 2003 and 2002 (Unaudited) (In millions) 2003 2002 ------ ------ Operating Activities: Net income (loss) $ 395 $ (90) Adjustments: Loss from discontinued operations 1 14 Change in property-liability insurance reserves (1,209) 332 Change in reinsurance balances 125 (136) Change in deferred acquisition costs (112) (21) Change in insurance premiums receivable (43) 55 Change in accounts payable and accrued expenses (130) (90) Change in income taxes payable /refundable 61 104 Realized investment (gains) losses (29) 70 Provision for federal deferred tax expense (benefit) 2 (82) Depreciation and amortization 46 43 Cumulative effect of accounting change - 6 Other 60 (123) ------ ------ Net Cash Provided (Used) by Operating Activities (833) 82 ------ ------ Investing Activities: Net sales of short-term investments 323 287 Purchases of other investments (2,120) (3,834) Proceeds from sales and maturities of other investments 2,783 3,975 Change in open security transactions 119 (184) Purchase of office property and equipment (24) (37) Sales of office property and equipment 73 10 Acquisitions, net of cash acquired (5) (59) Other (157) (51) ------ ------ Net Cash Provided by Continuing Operations 992 107 Net Cash Used by Discontinued Operations (16) (5) ------ ------ Net Cash Provided by Investing Activities 976 102 ------ ------ Financing Activities: Dividends paid on common and preferred stock (136) (123) Proceeds from issuance of debt 145 498 Repayment of debt and preferred securities (336) (526) Subsidiary's repurchase of common shares (21) (105) Stock options exercised and other 58 84 ------ ------ Net Cash Used by Financing Activities (290) (172) ------ ------ Effect of exchange rate changes on cash 9 3 ------ ------ Increase (decrease) in cash (138) 15 Cash at beginning of period 315 151 ------ ------ Cash at end of period $ 177 $ 166 ====== ====== See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Unaudited June 30, 2003 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 ("GAAP"). 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. With respect to those underwriting lines of business that we have placed in runoff, we believe the process of estimating required reserves for losses and loss adjustment expenses has an increased level of risk and uncertainty due to regulatory and other business considerations. 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, 2002. 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. In 2003, we changed the method by which we recognize premium revenue at our operations at Lloyd's. Prior to 2003, such revenue was recognized using the "one-eighths" method, which reflected the fact that we converted Lloyd's syndicate accounts to U.S. GAAP on a quarterly basis. Since Lloyd's accounting does not recognize the concept of earned premium, we calculated earned premium as part of the conversion to GAAP, assuming business was written at the middle of each quarter, effectively breaking the calendar year into earnings periods of eighths. In 2003, we began recognizing Lloyd's premium revenue in a manner that more accurately reflects the underlying policy terms and exposures and is more consistent with the method by which we recognize premium revenue in our non-Lloyd's business. This change did not have a material impact on our consolidated financial statements for the three months or six months ended June 30, 2003. In the first quarter of 2003, we eliminated the one-quarter reporting lag for our operations at Lloyd's, the impact of which is discussed in more detail in Note 7 of this report. Some amounts in the 2002 consolidated financial statements have been reclassified to conform to the 2003 presentation. In particular, we reclassified certain commissions in our operations at Lloyd's, which is discussed in more detail in Note 7 of this report. These reclassifications had no effect on net income, comprehensive income or shareholders' equity, as previously reported. New Accounting Policy - Goodwill and Intangible Assets ------------------------------------------------------ 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 practice in the way intangible assets with indefinite useful lives, including goodwill, are tested for impairment on an annual basis. Generally, 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. In the second quarter of 2002, we completed an evaluation for impairment of our recorded goodwill in accordance with the provisions of THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 1 - Basis of Presentation (continued) ----------------------------------------- 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 previously reported results for the first quarter of 2002, reducing net income for that period from the originally reported $139 million, or $0.63 per common share (diluted) to $133 million, or $0.60 per common share (diluted). We evaluate our goodwill for impairment on an annual basis. If an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount, we will test for impairment between annual tests. In the second quarter of 2003, we peformed our annual evaluation for impairment of recorded goodwill in accordance with provisions of SFAS No. 142. That evaluation concluded that none of our goodwill was impaired. Stock Option Accounting ----------------------- We follow the provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), FASB Interpretation 44, "Accounting for Certain Transactions involving Stock Compensation (an interpretation of APB Opinion No. 25)," and other related interpretations in accounting for our stock option plans utilizing the "intrinsic value method" described in that literature. We also follow the disclosure provisions of SFAS No. 123, "Accounting for Stock-Based Compensation" for our option plans, as amended by SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure; an amendment of FASB Statement No. 123". These require pro forma net income and earnings per share information, which is calculated assuming we had accounted for our stock option plans under the "fair value method" described in those Statements. Had we calculated compensation expense on a combined basis for our stock option grants based on the "fair value method" described in SFAS No. 123, our net income and earnings per share would have been reduced to the pro forma amounts as indicated in the following table. Three Months Six Months Ended June 30 Ended June 30 ------------- ------------- (in millions, except per share data) 2003 2002 2003 2002 ----- ----- ----- ----- Net income (loss): As reported* $ 214 $(223) $ 395 $ (90) Less: Additional stock- based employee compensation expense determined under fair value-based method for all awards, net of related tax effects (12) (9) (22) (16) ----- ----- ----- ----- Pro forma $ 202 $(232) $ 373 $(106) ===== ===== ===== ===== Basic earnings (loss) per common share: As reported $0.93 $(1.09) $1.70 $(0.47) ===== ===== ===== ===== Pro forma $0.87 $(1.13) $1.61 $(0.55) ===== ===== ===== ===== Diluted earnings (loss) per common share: As reported $0.89 $(1.09) $1.64 $(0.47) ===== ===== ===== ===== Pro forma $0.84 $(1.13) $1.55 $(0.55) ===== ===== ===== ===== *As reported net income (loss) included $1 million and $2 million of stock-based compensation expenses, net of related tax benefits, for the quarters ended June 30, 2003 and 2002, respectively. On a year-to-date basis, as reported net income (loss) included $3 million and $5 million of such expenses, respectively. 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, 2003 and 2002. Three Months Ended Six Months Ended June 30 June 30 (in millions, except ------------------ ---------------- (per share data) 2003 2002 2003 2002 -------------- ----- ----- ----- ----- Earnings Basic: Net income (loss), as reported $ 214 $ (223) $ 395 $ (90) Preferred stock dividends, net of taxes (2) (2) (4) (4) Premium on preferred shares redeemed (2) (2) (4) (5) ----- ----- ----- ----- Net income (loss) available to common shareholders $ 210 $ (227) $ 387 $ (99) ===== ===== ===== ===== Diluted: Net income (loss) available to common shareholders $ 210 $ (227) $ 387 $ (99) Dilutive effect of affiliates - - (1) - Effect of dilutive securities: Convertible preferred stock 1 - 3 - Zero coupon convertible notes 1 - 2 - ----- ----- ----- ----- Net income (loss) available to common shareholders $ 212 $ (227) $ 391 $ (99) ===== ===== ===== ===== Common Shares Basic: Weighted average common shares outstanding 228 208 228 208 ===== ===== ===== ===== Diluted: Weighted average common shares outstanding 228 208 228 208 Effect of dilutive securities: Stock options and other incentive plans 1 - 1 - Convertible preferred stock 6 - 6 - Zero coupon convertible notes 2 - 2 - Equity unit stock purchase contracts 3 - 2 - ----- ----- ----- ----- Total 240 208 239 208 ===== ===== ===== ===== Earnings (Loss) per Common Share Basic $ 0.93 $(1.09) $ 1.70 $(0.47) ===== ===== ===== ===== Diluted $ 0.89 $(1.09) $ 1.64 $(0.47) ===== ===== ===== ===== 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. The following table summarizes our investment purchases, sales and maturities (excluding short-term investments) for the six months ended June 30, 2003 and 2002. Six Months Ended June 30 ---------------- (in millions) 2003 2002 ----- ----- Purchases: Fixed income $1,660 $3,168 Equities 332 537 Real estate and mortgage loans - 3 Venture capital 65 119 Other investments 63 7 ----- ----- Total purchases 2,120 3,834 ----- ----- Proceeds from sales and maturities: Fixed income 2,277 2,502 Equities 422 1,376 Real estate and mortgage loans 9 55 Venture capital 46 36 Other investments 29 6 ----- ----- Total sales and maturities 2,783 3,975 ----- ----- Net sales $ 663 $ 141 ===== ===== Change in Unrealized Appreciation. The change in unrealized appreciation or depreciation of investments recorded in common shareholders' equity and other comprehensive income was as follows: Six Twelve Months Ended Months Ended June 30 December 31 (in millions) 2003 2002 ----------- ------------ ------------ Pretax: Fixed income $ 219 $ 446 Equities 55 (17) Venture capital (24) (88) Other 15 8 ----- ----- Total increases in pretax unrealized appreciation 265 349 Increase in deferred taxes (90) (120) ----- ----- Total change in unrealized appreciation, net of taxes $ 175 $ 229 ===== ===== 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) 2003 2002 2003 2002 ----------- ----- ----- ----- ----- Income tax expense (benefit): Federal current $ 22 $ (67) $ 150 $ (29) Federal deferred 66 (85) 2 (82) ----- ----- ----- ----- Total federal income tax expense (benefit) 88 (152) 152 (111) Foreign 3 4 7 8 State 2 2 4 5 ----- ----- ----- ----- Total income tax expense (benefit) on continuing operations $ 93 $(146) $ 163 $ (98) ===== ===== ===== ===== Note 5 - Commitments, Contingencies and Guarantees -------------------------------------------------- Commitments - We have long-term commitments to fund venture capital investments through one of our subsidiaries, St. Paul Venture Capital VI, LLC, as well as through new and existing partnerships and certain other venture capital entities. During the first six months of 2003, payments made in the ordinary course of funding these venture capital investments reduced our total future estimated obligations by $68 million from year-end 2002. For further information regarding these and other commitments, refer to Note 17 on pages 82 to 84 of our 2002 Annual Report to Shareholders. Contingencies - In the ordinary course of conducting business, we (and certain 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 but not limited to liability under environmental protection laws and for injury caused by exposure to asbestos products. Plaintiffs in these and other 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 may ultimately have to pay in all of these lawsuits will have a material effect on our liquidity or overall financial position. Note 17 on page 83 of our 2002 Annual Report to Shareholders includes a summary of certain litigation matters with contingencies, including the following two matters for which there were additional developments in 2003. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 5 - Commitments, Contingencies and Guarantees (continued) ------------------------------------------------------------- Asbestos Settlement Agreement - On June 3, 2002, we announced that we and certain of our subsidiaries had entered into an agreement settling all existing and future claims arising from any insuring relationship of United States Fidelity and Guaranty Company ("USF&G"), St. Paul Fire and Marine Insurance Company ("Fire and Marine") and their affiliates and subsidiaries, including us, with any of MacArthur Company, Western MacArthur Company, and Western Asbestos Company (together, the "MacArthur Companies"). There can be no assurance that this agreement will receive bankruptcy court approval. For a full discussion of the Western MacArthur settlement agreement, refer to Note 3 to the financial statements on pages 68 and 69 of our 2002 Annual Report to Shareholders. In the first quarter of 2003, we made a payment of $747 million, (which included $7 million interest), related to the Western MacArthur settlement agreement. This amount, along with $60 million of an initial $235 million payment made in the second quarter of 2002, is being held in escrow pending final bankruptcy court approval of the settlement agreement as part of a broader plan for the reorganization of the MacArthur Companies (the "Plan"). At least $60 million from the initial payment and the $747 million paid in 2003 would be returned to us if the Plan is not approved by the bankruptcy court. Accordingly, as of June 30, 2003, these payments remain recorded in the amounts of $807 million in both "Other Assets" and "Other Liabilities" pending approval of the Plan. Purported Class Action Shareholder Suit - In the fourth quarter of 2002, several purported class action lawsuits were filed against our chief executive officer, our chief financial officer, and us. In the first quarter of 2003, the lawsuits were consolidated into a single action which makes various allegations relating to the adequacy of our previous public disclosures and reserves relating to the Western MacArthur asbestos litigation, and seeks unspecified damages and other relief. We view this action as without merit and are contesting it vigorously. In addition, in 2003, lawsuits have been filed in Texas and Ohio (Boson v. Union Carbide Corp., et al; and Abernathy v. Ace American Ins. Co., et al) against certain of our subsidiaries, and other insurers and non-insurer corporate defendants, asserting liability for failing to warn of the dangers of asbestos. It is difficult to predict the outcome for financial exposure represented by this type of litigation in light of the broad nature of the relief requested and the novel theories asserted. We believe, however, that the cases are without merit and we intend to contest them vigorously. Guarantees - In prior periods we provided certain guarantees for agency loans, issuances of debt securities, third party loans related to venture capital investments, and certain tax indemnifications related to our swap agreements. In addition, we provided various guarantees and indemnifications in the ordinary course of selling business entities, as well as guarantees and indemnifications in connection with the transfer of ongoing reinsurance operations to Platinum Underwriters Holdings, Ltd. See Note 2 in our Annual Report to Shareholders for a more detailed description of the Platinum transfer. During the second quarter of 2003, we paid $13 million to Metropolitan Property and Casualty Insurance Company pursuant to a reserve guarantee entered into in connection with the sale of our standard personal lines insurance business. (see Note 12 for a more detailed description of that sale). In addition, guarantee expirations or reductions in outstanding obligations resulted in an additional $12 million decline in outstanding guarantees. These decreases in guarantees were partially offset by a decline in the U.S. dollar against other currencies. All of these factors resulted in a net decrease of $21 million in potential obligations for guarantees that existed as of December 31, 2002. For a full description of the nature and amount of these guarantees and indemnifications, refer to Note 17 on pages 82 to 84 of our 2002 Annual Report to Shareholders. In May 2003, we entered into a contingent consideration agreement as part of our purchase of the right to seek to renew certain business from Kemper Insurance Companies ("Kemper") See Note 11 in this report for further explanation of the terms of the Kemper transaction. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 6 - Debt ------------- Debt consisted of the following at June 30, 2003 and December 31, 2002: June 30, 2003 December 31, 2002 --------------- ----------------- (in millions) Book Fair Book Fair ----------- Value Value Value Value ----- ----- ----- ----- 5.75% senior notes $ 499 $ 535 $ 499 $ 515 Medium-term notes 482 529 523 559 5.25% senior notes 443 471 443 461 7.875% senior notes 249 276 249 274 8.125% senior notes 249 303 249 280 Commercial paper 154 154 379 379 Nuveen line of credit borrowings 130 130 55 55 Zero coupon convertible notes 110 112 107 110 7.125% senior notes 80 88 80 87 Variable rate borrowings 64 64 64 64 ----- ----- ----- ----- Total debt obligations 2,460 2,662 2,648 2,784 Fair value of interest rate swap agreements 75 75 65 65 ----- ----- ----- ----- Total debt reported on balance sheet $2,535 $2,737 $2,713 $2,849 ===== ===== ===== ===== During the first quarter of 2003, Nuveen Investments repaid $145 million it had previously borrowed from The St. Paul under an intercompany revolving line of credit, and The St. Paul used the proceeds to repay a like amount of its commercial paper outstanding. Nuveen Investments funded the repayment to us by borrowing $145 million under its revolving bank line of credit, of which $70 million was repaid in the second quarter. At June 30, 2003, 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, all of which qualified for hedge accounting, totaled $730 million. Their aggregate fair value at June 30, 2003 was recorded as an asset of $75 million, with the same amount included in the carrying value of our debt. Note 7 - Segment Information ---------------------------- In the first quarter of 2003, we revised our property-liability insurance business segment reporting structure to reflect the manner in which those businesses are now managed. In 2003, our property-liability underwriting operations consist of two segments constituting our ongoing operations (Specialty Commercial and Commercial Lines), and one segment comprising our runoff operations (Other). All data for 2002 included in this report has been restated to be consistent with the new reporting structure in 2003. The following is a summary of changes made to our segments in the first quarter of 2003. - Our Surety & Construction operations, previously reported together as a separate specialty segment, are now separate components of our Specialty Commercial segment. - Our ongoing International operations and our ongoing operations at Lloyd's, previously reported together as a separate specialty segment, are now separate components of our Specialty Commercial segment. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 7 - Segment Information (continued) --------------------------------------- - Our Health Care, Reinsurance and Other operations, each previously reported as a separate runoff business segment, have been combined into a single Other runoff segment and are now under common management. "Runoff" means that we have ceased or plan to cease underwriting business as soon as possible. - The results of our participation in voluntary insurance pools, as well as loss development on business underwritten prior to 1980 (prior to 1988 for business acquired in our merger with USF&G Corporation in 1998), previously included in our Commercial Lines segment, are now included in the Other segment. That prior year business includes the majority of our environmental and asbestos liability exposures. The oversight of these exposures is the responsibility of the same management team responsible for oversight of the other components of the Other segment. In accordance with provisions of SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," since Surety & Construction, International & Lloyd's, Health Care, and Reinsurance were reported as separate segments during 2002 and are considered to be of continuing significance in analyzing the results of our operations, we continue to separately present and discuss (as appropriate) in this note to our consolidated financial statements information about those businesses in 2003 and the corresponding period of 2002. In addition to our property-liability business segments, we also have a property-liability investment operation segment, as well as an asset management segment, consisting of our majority ownership in Nuveen Investments. The accounting policies of these segments are the same as those described in Note 1 in our 2002 Annual Report to Shareholders. We evaluate performance based on underwriting results for our property-liability insurance segments, investment income and realized gains for our investment operations segment, and on pretax income for our asset management segment. Property- liability underwriting assets are reviewed and managed in total for purposes of decision-making. We do not allocate assets to specific underwriting segments. Assets are specifically identified for our asset management segment. After the revisions to our segment structure described above, our reportable segments in our property-liability operations consisted of the following: The Specialty Commercial segment includes our combined Surety & Construction operation, our ongoing International & Lloyd's operations, and the following nine specialty business centers that in total comprise the "Specialty" component of this segment: Technology, Financial and Professional Services, Marine, Personal Catastrophe Risk, Public Sector Services, Discover Re, Excess & Surplus Lines, Specialty Programs and Oil & Gas. These business centers are considered specialty operations because each provides products and services requiring specialty expertise and focuses on the respective customer group served. Our Surety business center underwrites surety bonds, which are agreements under which one party (the surety) guarantees to another party (the owner or obligee) that a third party (the contractor or principal) will perform in accordance with contractual obligations. The Construction business center offers a variety of products and services, including traditional insurance and risk management solutions, to a broad range of contractors and parties responsible for construction projects. Our ongoing International operations consist of our specialty underwriting operations in Canada (other than Surety), the United Kingdom and the Republic of Ireland, and the international exposures of most U.S. underwriting business. At Lloyd's, our ongoing operations are comprised of the following types of insurance coverage we underwrite through a single wholly-owned syndicate: Aviation, Marine, Global Property and Personal Lines. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 7 - Segment Information (continued) --------------------------------------- The Commercial Lines segment includes our Small Commercial, Middle Market Commercial and Property Solutions business centers, as well as the results of our limited involvement in involuntary insurance pools. The Small Commercial business center services commercial firms that typically have between one and fifty employees through its proprietary St. Paul Mainstreet (SM) and St. Paul Advantage (SM) products, with a particular focus on offices, wholesalers, retailers, artisan contractors and other service risks. The Middle Market Commercial business center offers comprehensive insurance coverages for a wide variety of manufacturing, wholesale, service and retail exposures. This business center also offers loss-sensitive casualty programs, including significant deductible and self-insured retention options, for the higher end of the middle market sector. The Property Solutions business center combines our Large Accounts Property business with the commercial portion of our catastrophe risk business and allows us to take a unified approach to large property risks. The Other segment includes the results of the lines of business we placed in runoff in late 2001 and early 2002, including our former Health Care and Reinsurance segments, and the results of the following international operations: our runoff operations at Lloyd's; Unionamerica, the London-based underwriting unit acquired as part of our purchase of MMI in 2000; and international operations we decided to exit at the end of 2001. This segment also includes the results of our participation in voluntary insurance pools, as well as loss development on business underwritten prior to 1980 (prior to 1988 for business acquired in our merger with USF&G Corporation in 1998). That prior year business includes the majority of our environmental and asbestos liability exposures. Our Health Care operation historically provided a wide range of medical liability insurance products and services throughout the entire health care delivery system. Our Reinsurance operations historically underwrote treaty and facultative reinsurance for a wide variety of property and liability exposures. As described in more detail on page 24 of our 2002 Annual Report to Shareholders, in November 2002 we transferred our ongoing reinsurance operations to Platinum Underwriters Holdings, Ltd. The summary below presents revenue and pretax income from continuing operations for our reportable segments. The revenues of our asset management segment include investment income and realized investment gains. 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) 2003 2002 2003 2002 ----------- ----- ----- ----- ----- Revenues from Continuing Operations: Underwriting: Specialty Commercial: Specialty $ 551 $ 438 $1,053 $ 867 Surety and Construction 312 291 624 566 International and Lloyd's 253 205 546 356 ----- ----- ----- ----- Total Specialty Commercial 1,116 934 2,223 1,789 Commercial Lines 476 424 938 850 ----- ----- ----- ----- Total Ongoing Insurance Operations 1,592 1,358 3,161 2,639 ----- ----- ----- ----- Other: Health Care 11 140 43 300 Reinsurance 69 305 173 682 Other Runoff 28 153 52 293 ----- ----- ----- ----- Total Other 108 598 268 1,275 ----- ----- ----- ----- Total Runoff Insurance Operations 108 598 268 1,275 ----- ----- ----- ----- Total Underwriting 1,700 1,956 3,429 3,914 ----- ----- ----- ----- Investment operations: Net investment income 274 283 554 573 Realized investment gains (losses) 71 (38) 38 (77) ----- ----- ----- ----- Total investment operations 345 245 592 496 ----- ----- ----- ----- Other 22 38 62 65 ----- ----- ----- ----- Total property- liability insurance 2,067 2,239 4,083 4,475 ----- ----- ----- ----- Asset management 106 90 208 184 ----- ----- ----- ----- Total reportable segments 2,173 2,329 4,291 4,659 Parent company and other operations (2) 15 (6) 19 ----- ----- ----- ----- Total revenues $2,171 $2,344 $4,285 $4,678 ===== ===== ===== ===== 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) 2003 2002 2003 2002 ----------- ----- ----- ----- ----- Income (Loss) from Continuing Operations Before Income Taxes and Cumulative Effect of Accounting Change: Underwriting result: Specialty Commercial: Specialty $ 82 $ 52 $ 141 $ 61 Surety and Construction (87) 4 (73) 6 International and Lloyd's 17 17 62 0 ----- ----- ----- ----- Total Specialty Commercial 12 73 130 67 Commercial Lines 36 48 74 43 ----- ----- ----- ----- Total Ongoing Insurance Operations 48 121 204 110 ----- ----- ----- ----- Other: Health Care (16) (96) (33) (93) Reinsurance (15) (5) 3 11 Other Runoff (18) (611) (118) (630) ----- ----- ----- ----- Total Other (49) (712) (148) (712) ----- ----- ----- ----- Total Runoff Insurance Operations (49) (712) (148) (712) ----- ----- ----- ----- Total Underwriting result (1) (591) 56 (602) Investment operations: Net investment income 274 283 554 573 Realized investment gains (losses) 71 (38) 38 (77) ----- ----- ----- ----- Total investment operations 345 245 592 496 ----- ----- ----- ----- Other (20) (12) (53) (38) ----- ----- ----- ----- Total property- liability insurance 324 (358) 595 (144) ----- ----- ----- ----- Asset management: Pretax income, before minority interest 56 50 109 99 Minority interest (12) (11) (23) (22) ----- ----- ----- ----- Total asset management 44 39 86 77 ----- ----- ----- ----- Total reportable segments 368 (319) 681 (67) Parent company and other operations (60) (45) (122) (101) ----- ----- ----- ----- Total income (loss) from continuing operations before income taxes and cumulative effect of accounting change $ 308 $ (364) $ 559 $ (168) ===== ===== ===== ===== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 7 - Segment Information (continued) --------------------------------------- Elimination of Reporting Lag - Lloyd's -------------------------------------- In the first quarter of 2003, we eliminated the one-quarter reporting lag for our underwriting operations at Lloyd's to coincide with the timing of reporting for all of our other international operations. As a result, our consolidated results in the first six months of 2003 included the results of those operations for the fourth quarter of 2002 and the first six months of 2003, whereas our results for the six months ended June 30, 2002 included the results of those operations for the fourth quarter of 2001 and the first quarter of 2002. The year-to-date incremental impact on our property-liability operations of eliminating the reporting lag was as follows. (in millions) ----------- Specialty Commercial Other Total ---------- ------ ------ Net written premiums $ 52 $ 2 $ 54 Decrease in unearned premiums (14) (4) (18) ----- ----- ----- Net earned premiums 66 6 72 Incurred losses and underwriting expenses 63 11 74 ----- ----- ----- Underwriting result 3 (5) (2) Net investment income 1 1 2 Other expenses (2) (1) (3) ----- ----- ----- Total pretax income (loss) $ 2 $ (5) $ (3) ===== ===== ===== Reclassification of Lloyd's Commission Expenses ----------------------------------------------- In the first quarter of 2003, we reclassified certain commission expenses related to our operations at Lloyd's. In prior years, we determined commission expense based on premiums reported by the Lloyd's market (net of commissions) using an estimated average commission rate. Until recently, gross premiums (prior to reduction for commissions) were not available from the Lloyd's market. That information is now available for current and prior periods, and in the first quarter of 2003, we began recording actual commission expense for our Lloyd's business. We reclassified prior period results to record actual commission expense on a basis consistent with that implemented in the first quarter of 2003. There was no impact to net income or shareholders' equity as previously reported for any prior periods, because the reclassification had the impact of increasing previously reported premiums and commission expense in equal and offsetting amounts. For the second quarter and first six months of 2003, this reclassification had the impact of increasing both net earned premiums and policy acquisition costs by $14 million and $39 million, respectively, compared with what would have been recorded under our prior method of estimation. In addition, net written premiums increased by $3 million and $79 million, respectively (a portion of which was due to the elimination of the one-quarter reporting lag). For the second quarter and first six months of 2002, the impact was an increase to both net earned premiums and policy acquisition costs of $37 million and $60 million, respectively, and an increase to net written premiums of $55 million and $66 million, respectively. 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 protect us against earnings volatility and from potential losses in excess of the amount we are prepared to accept. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 8 - Reinsurance (continued) ------------------------------- 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 for possible nonpayment of amounts due to us. 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) 2003 2002 2003 2002 ---- ---- ---- ---- Premiums written Direct $2,017 $1,773 $4,039 $3,746 Assumed 275 691 998 1,350 Ceded (498) (621) (1,266) (1,135) ----- ----- ----- ----- Net premiums written $1,794 $1,843 $3,771 $3,961 ===== ===== ===== ===== Premiums earned Direct $1,900 $1,869 $3,832 $3,684 Assumed 361 675 903 1,265 Ceded (561) (588) (1,306) (1,035) ----- ----- ----- ----- Net premiums earned $1,700 $1,956 $3,429 $3,914 ===== ===== ===== ===== Insurance losses and loss adjustment expenses Direct $1,274 $2,204 $2,520 $3,716 Assumed 317 428 627 776 Ceded (399) (646) (819) (1,113) ----- ----- ----- ----- Net insurance losses and loss adjustment expenses $1,192 $1,986 $2,328 $3,379 ===== ===== ===== ===== In conjunction with the transfer of our continuing reinsurance business (previously operating under the name "St. Paul Re") to Platinum Underwriters Holdings, Ltd. ("Platinum") in November 2002, we entered into various agreements with Platinum and its subsidiaries, including quota share reinsurance agreements by which Platinum reinsured substantially all of the reinsurance contracts entered into by St. Paul Re on or after January 1, 2002. This transfer (based on September 30, 2002 balances) included $125 million of unearned premium reserves (net of ceding commissions), $200 million of existing loss and loss adjustment expense reserves and $24 million of other reinsurance-related liabilities. The transfer of unearned premium reserves to Platinum was accounted for as prospective reinsurance, while the transfer of existing loss and loss adjustment expense reserves was accounted for as retroactive reinsurance. Data in the foregoing table for 2003 include amounts related to the quota share reinsurance agreements with Platinum, as detailed in Note 16 of this report. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 8 - Reinsurance (continued) ------------------------------- As noted above, the transfer of reserves to Platinum at the inception of the quota share reinsurance agreements was based on the September 30, 2002 balances. In March 2003, we transferred to Platinum $137 million of additional insurance reserves, consisting of $72 million in unearned premiums (net of ceding commissions) and $65 million in existing reserves for losses and loss adjustment expenses. We also transferred cash and other assets having a value equal to the additional insurance reserves transferred. This transfer of additional assets and liabilities reflected business activity between September 30, 2002 and the November 2, 2002 inception date of the quota share reinsurance agreements, and our estimate of amounts due under the adjustment provisions of the quota share reinsurance agreements. Our insurance reserves at December 31, 2002 included our estimate, at that time, of amounts due to Platinum under the quota share reinsurance agreements, which totaled $54 million. The $83 million increase in our estimate of amounts due to Platinum under the quota share reinsurance agreements resulted in a pretax underwriting loss of $6 million in the first quarter of 2003. During the second quarter of 2003, we reached final agreement with Platinum regarding the adjustment provisions of the quota share reinsurance agreements and no further adjustments to the transferred assets and liabilities will occur. 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 5 in our 2002 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 elimination of approximately 700 positions), $9 million of occupancy-related costs, $4 million of equipment charges and $3 million of legal costs. Note 18 on pages 84 and 85 of our 2002 Annual Report to Shareholders provides more information on this charge. 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 2002 Payments Adjustments 2003 -------- ---------- -------- ----------- ---------- Employee- related $ 46 $ 14 $ (2) $ (1) $ 11 Occupancy- related 9 8 (1) - 7 Equipment charges 4 N/A N/A N/A N/A Legal costs 3 - - - - ----- ----- ----- ----- ----- Total $ 62 $ 22 $ (3) $ (1) $ 18 ===== ===== ===== ===== ===== Other Restructuring Charges - Since 1997, we have recorded several restructuring and other charges related to acquisitions, mergers and actions taken to improve our operations. Note 18 in our 2002 Annual Report to Shareholders also provides more detailed information regarding these other charges. All actions have been taken and all obligations had 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 employee positions. 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: (in millions) ----------- Original Reserve Reserve Pre-tax at Dec. 31, at June 30, Charge 2002 Payments Adjustments 2003 -------- ---------- -------- ----------- ---------- Lease commitments charged to earnings: $ 91 $ 24 $ (4) - $ 20 ===== ===== ===== ===== ===== Note 10 - Goodwill and Other Intangible Assets ---------------------------------------------- In the first quarter of 2002, we implemented the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets," which established financial accounting and reporting for acquired goodwill and other intangible assets. As a result of implementing the provisions of this statement, we did not record any goodwill expense in 2002 or 2003. Amortization expense associated with intangible assets totaled $7 million for the second quarter of 2003 and $12 million for year to date 2003, compared with $5 million and $9 million, in the same respective 2002 periods. The following presents a summary of our acquired intangible assets. As of June 30, 2003 (in millions) ------------------------------------------- ----------- Gross Foreign Amortizable Carrying Accumulated Exchange Net intangible assets: Amount Amortization Effects Amount -------- ------------ -------- ------ Present value of future profits $ 70 $ (22) $ 5 $ 53 Customer relationships 67 (7) - 60 Renewal rights 43 (9) - 34 Internal use software 2 (1) - 1 ----- ----- ---- ---- Total $ 182 $ (39) $ 5 $ 148 ===== ===== ==== ==== At June 30, 2003, we estimated our amortization expense for the next five years to be as follows: $18 million in 2004, $17 million in 2005, $15 million in 2006, $12 million in 2007, and $12 million in 2008. The changes in the carrying value of goodwill on our balance sheet were as follows. (in millions) ----------- Balance at Balance at Goodwill by Dec. 31, Goodwill Impairment June 30, Segment 2002 Acquired Losses 2003 ----------- -------- -------- --------- --------- Specialty Commercial $ 80 $ 3 $ - $ 83 Commercial Lines 33 - - 33 Asset Management 752 17 - 769 Property-Liability Investment Operations 9 - - 9 ----- ----- ----- ----- Total $ 874 $ 20 $ - $ 894 ===== ===== ===== ===== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 10 - Goodwill and Other Intangible Assets (continued) --------------------------------------------------------- The increase in goodwill in our Asset Management segment was a result of Nuveen Investments' purchase of shares from minority shareholders, as well as an additional payment of $2 million for contingent consideration related to a prior period acquisition. The increase in goodwill in our Specialty Commercial segment was due to the effects of foreign exchange rates applied to existing goodwill balances. In the second quarter of 2003, we peformed our annual evaluation for impairment of recorded goodwill in accordance with provisions of SFAS No. 142. That evaluation concluded that none of our goodwill was impaired. For further information regarding our accounting for goodwill and intangible assets, refer to Note 1 on page 9 of this report. Note 11 - Purchase of Renewal Rights ------------------------------------ In May 2003, we purchased the right to seek renewal of several lines of insurance business previously underwritten by Kemper Insurance Companies. The initial payment for this right was recorded as an intangible asset (characterized as renewal rights) and will be amortized on an accelerated basis over four years. The portfolio of business involved in this transaction includes the following lines: technology, small commercial, middle market commercial, inland and ocean marine, and architects' and engineers' professional liability. We did not assume any past liabilities with this purchase; however, we may be obligated to make an additional payment in June 2004 based on the amount of premium volume we ultimately renew during the twelve months subsequent to this purchase. We believe it is highly unlikely that any additional payment would exceed $30 million. Note 12 - Discontinued 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 September 30, 1999 closing date. Under the reserve-related agreements, we agreed to pay for any deficiencies in those reserves and would share in any redundancies that developed by September 30, 2002. Any losses incurred by us under these agreements were reflected in discontinued operations in the period during which they were incurred. At December 31, 2002, our analysis indicated that we owed Metropolitan $13 million related to the reserve agreements, which was paid in April 2003. In the first six months of 2003 and 2002, we recorded pretax losses of $300,000 and $6 million, respectively, in discontinued operations, related to claims in respect of pre-sale losses. 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, with notional amounts totaling $730 million. They are designated as fair value hedges for a portion of our medium-term and senior notes, as they were entered into for the purpose of managing the effect of interest rate fluctuations on this debt. The terms of the THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 13 - Derivative Financial Instruments (continued) ----------------------------------------------------- swaps match those of the debt instruments, and the swaps are therefore considered 100% effective. The balance sheet impact related to the movements in interest rates for the six months ended June 30, 2003 and June 30, 2002 was a $10 million increase and a $13 million increase, respectively, in the fair value of the swaps and the related debt on the balance sheet. The impacts within the statement of operations are offsetting. Cash Flow Hedges: We have entered into forward foreign currency contracts that are designated as cash flow hedges. They are utilized to reduce our exposure to foreign exchange rate fluctuations that may impact our expected foreign currency payments, or the settlement of our foreign currency payables and receivables. In the six months ended June 30, 2003, we recognized a $3 million gain on the cash flow hedges, which is included in "Other Comprehensive Income." The comparable amount for the six months ended June 30, 2002 was a $2 million gain. The amounts included in Other Comprehensive Income will be realized in earnings concurrent with the timing of the hedged cash flows. We do not anticipate any Other Comprehensive Income will be reclassified into earnings within the next twelve months. In the six months ended June 30, 2003 and June 30, 2002, the ineffective portion of the hedge resulted in a gain of less than $1 million in both periods. Non-Hedge Derivatives: We have entered into a variety of other financial instruments that are considered to be derivatives, but which are not designated as hedges. Included in investments are stock purchase warrants of Platinum Underwriters Holdings, Ltd., received as partial consideration from the sale of our reinsurance business in 2002, and stock warrants in our venture capital business. We recorded $5 million and $2 million of income in continuing operations for the six months ended June 30, 2003 and June 30, 2002 respectively, relating to the change in the market value of these warrants during the period. We also recorded a $21 million loss in discontinued operations for the six months ended June 30, 2002 relating to non-hedge derivatives associated with the sale of our life business. Note 14 - Variable Interest Entities ------------------------------------ In January 2003, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"), which requires consolidation of all variable interest entities ("VIE") by the primary beneficiary, as these terms are defined in FIN 46, effective immediately for VIEs created after January 31, 2003. The consolidation requirements apply to VIEs existing on January 31, 2003 for reporting periods beginning after June 15, 2003. In addition, it requires expanded disclosure for all VIEs. The following discusses VIE's which may be subject to the consolidation or disclosure provisions of FIN 46 once compliance with those provisions becomes required with respect to those VIE's: Municipal Trusts: We have purchased interests in certain unconsolidated trusts holding highly rated municipal securities that were formed for the purpose of enabling the company to more flexibly generate investment income in a manner consistent with our investment objectives and tax position. As of June 30, 2003, there were 36 of such trusts, which held a combined total market value of $455 million in municipal securities. We own approximately 100% of 28 of these trusts, which are reflected in our financial statements. The remaining 8 trusts, which represent $84 million in market value of securities, are not currently consolidated in our results. Joint Ventures: Our subsidiary, Fire and Marine, is a party to six separate joint ventures, in each of which Fire and Marine is a 50% owner of various real estate holdings and does not exercise control over the joint ventures, financed by non-recourse mortgage notes. Because we own only 50% of the holdings, we do not consolidate these entities and the joint venture debt does not appear on our balance sheet. Our maximum exposure under each of these joint ventures, in the event of foreclosure of a property, is limited to our carrying value in the joint venture, ranging individually up to $28 million, and cumulatively totaling $60 million at June 30, 2003. The total assets included in these joint ventures as of June 30, 2003 were $191 million, and total debt was $232 million. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 14 - Variable Interest Entities (continued) ----------------------------------------------- Below Investment Grade Asset-Backed Securities. We have investments in certain asset-backed securities that are below investment grade and have variable interests. We carry these investments at their fair value and their current carrying value is $14 million on our consolidated balance sheet. Private Equity Investments. We have investments in certain private equity investments that have a carrying value of $547 million. We anticipate some of these entities may require consolidation upon adoption of the Interpretation in the third quarter. Lloyd's Syndicates. In the normal course of business, we invest in various syndicates at Lloyds. In some cases, predominantly prior to 2002, we have provided less than 100% of the syndicate's capacity, sharing the risks and rewards proportionately with the other capital providers. Other Investments. We have investments in insurance, low- income housing and real estate entities in which we are not a majority owner, but as a result of other variable interests, consolidation or disclosure may be necessary upon adoption of FIN 46 in the third quarter. We are currently in the process of determining our maximum exposure to loss with regard to these entities. Collateralized Bond Obligations (CBO's). We hold two CBO's which are VIE's in which we may be considered the Primary Beneficiary. The carrying value of these CBO's as of June 30, 2003 was zero. Note 15 - Health Care Exposures ------------------------------- During 2002, we concluded that the impact of settling Health Care claims in a runoff environment was causing abnormal effects on our average paid claims, average outstanding claims, and the amount of average case reserves established for new claims - all of which are traditional statistics used by our actuaries to develop indicated ranges of expected loss. Considering these changing statistics, we developed varying interpretations of the underlying data, which added more uncertainty to our evaluation of these reserves. It is our belief that this additional data, when evaluated in light of the impact of our migration to a runoff environment, supports our view that we will realize significant savings on our ultimate Health Care claim costs. In the fourth quarter of 2002, we established specific tools and metrics to more explicitly monitor and validate our key assumptions supporting our Health Care reserve conclusions since we believe that our traditional statistics and reserving methods needed to be supplemented in order to provide a more meaningful analysis. The tools we developed track the three primary indicators which are influencing our expectations and include: a) newly reported claims, b) reserve development on known claims and c) the "redundancy ratio," which compares the cost of resolving claims to the reserve established for that individual claim. In the first quarter of 2003, we evaluated the adequacy of our previously established medical malpractice reserves in the context of the three indicators described above. The dollar amount of newly reported claims in the quarter totaled $118 million, approximately 25% less than we anticipated in our original estimate of the required level of redundancy at year-end 2002. With regard to development on known claims, loss activity in the first quarter of 2003 was within our expectations. Case development on incurred years 2001 and prior was minimal, and case development on the 2002 incurred year totaled $39 million, within our year-end 2002 estimate of no more than 3% of development. For the first quarter of 2003, our redundancy ratio was within our expected range of between 35% and 40%. In the second quarter of 2003, the dollar amount of newly reported claims totaled $127 million, approximately 5% higher than we anticipated in our original estimate of the required level of reserves at year-end 2002. Nevertheless, through the first half of 2003, the dollar amount of newly reported claims was approximately 12% lower than we anticipated. Loss development on known claims during the second quarter of 2003 was negative, THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 15 - Health Care Exposures (continued) ------------------------------------------ but not as negative as we anticipated. Our actual redundancy ratio continued to improve in the second quarter of 2003; however, since newly reported claims and loss development on known claims did not improve as much as we expected in the second quarter, the required reserve redundancy has increased modestly from the previously estimated range of 35% to 40%. The three indicators described above are related such that if one deteriorates, additional improvement on another is necessary for us to conclude that further reserve strengthening is not necessary. While the recent results of these indicators support our current view that we have recorded a reasonable provision for our medical malpractice exposures as of June 30, 2003, there is a reasonable possibility that we may incur additional unfavorable prior-year loss development if these indicators significantly change from our current expectations. If these indicators deteriorate, we believe that a reasonable estimate of an additional loss provision could amount to up to $250 million. However, our analysis as of this point in time continues to support our belief that we will realize favorable effects in our ultimate costs and that our current loss reserves will prove to be a reasonable provision. Note 16 - Related Party Transaction - Platinum Underwriters Holdings, Ltd. -------------------------------------------------------------------------- Under the quota share reinsurance agreements with Platinum described in more detail in Note 8 of this report, we ceded the following amounts to Platinum in first six months of 2003. (in millions) ----------- Net written premiums $ 265 Decrease in unearned premiums (43) ---- Net earned premiums 308 Incurred losses and loss adjustment expenses 205 Underwriting expenses 79 ---- Net ceded result $ 24 ==== The following Platinum-related balances were included in our consolidated balance sheet at June 30, 2003. (in millions) ----------- Assets: Reinsurance recoverable-paid losses $ 23 Reinsurance recoverable-unpaid losses $427 Ceded unearned premiums $117 Liabilities: Funds held for reinsurers $ 18 Ceded premiums payable $161 Note 17 - Surety Claim ---------------------- We had previously reported in a Current Report on Form 8-K dated April 30, 2003 that in April 2003 we began to receive surety claim notices related to one of our accounts that was in bankruptcy. In the second quarter of 2003, we recorded an $86 million pretax loss provision (net of reinsurance) related to that account's inability to perform its bonded obligations. In April 2003, a bankruptcy court approved the sale of substantially all of the assets of the account. Following that approval, we received claim notices with respect to approximately $120 million of bonds securing certain workers' compensation and retiree health benefit obligations of the account. The $86 million net pretax loss provision recorded in the second quarter of 2003 represents our estimated loss in this matter. We reported this loss in a Current Report on Form 8-K dated July 25, 2003. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Forward-Looking Statement Disclosure and Certain Risks ------------------------------------------------------ This report contains certain forward-looking statements within the meaning of the Private 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 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, pricing, revenues, earnings, cash flow and investment income; - price increases, improved loss experience, and expense savings resulting from the restructuring and other actions and initiatives announced in recent years; - statements concerning the anticipated bankruptcy court approval of the Western MacArthur asbestos litigation settlement; - statements concerning our expectations in our Health Care operation as we settle claims in a runoff environment; and - statements concerning claims made on surety bonds and the amounts we may ultimately pay with respect to these claims. In light of the risks and uncertainties inherent in future projections, many of which are beyond our control, actual results could differ materially from those in forward-looking statements. These 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; - our ability to effectively implement price increases; - general economic conditions, including changes in interest rates and the performance of financial markets; - additional statement of operations charges if our loss reserves are insufficient; - our exposure to natural catastrophic events, which are unpredictable, with a frequency or severity exceeding our estimates, resulting in material losses; - the possibility that claims cost trends that we anticipate in our businesses may not develop as we expect; - the impact of the September 11, 2001 terrorist attack and the ensuing global war on terrorism on the insurance and reinsurance industry in general, the implementation of the Terrorism Risk Insurance Act and potential further 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 sabotage; - risks relating to our continuing ability to obtain reinsurance covering catastrophe, surety and other exposures at appropriate prices and/or in sufficient amounts; - risks relating to the collectibility of reinsurance and adequacy of reinsurance to protect us against losses; - risks relating to actual and potential credit exposures, including to derivatives counterparties and related to co- surety arrangements; - risks and uncertainties relating to international political developments, including the possibility of warfare, and their potential effect on economic conditions; - changes in domestic and foreign laws, tax laws and changes in the regulation of our businesses, which affect our profitability and our growth, including risks relating to possible Federal legislation regarding asbestos-related claims; - the possibility of downgrades in our ratings significantly adversely affecting us, including, but not limited to, 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 or causing us to borrow at higher interest rates; THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Forward-Looking Statement Disclosure and Certain Risks (continued) ----------------------------------------------------------------- - the risk that our investment portfolio suffers reduced returns or investment losses, which could reduce our profitability; - the effect of financial market and interest rate conditions on pension plan assumptions, asset valuations and contribution levels; - the impact of assessments and other surcharges for guaranty funds and second-injury funds and other mandatory pooling arrangements; - risks related to the business underwritten on our policy forms on behalf of Platinum Underwriters Holdings, Ltd. ("Platinum") and fully reinsured to Platinum pursuant to the quota share reinsurance agreements entered into in connection with the transfer of our ongoing reinsurance operations to Platinum in 2002; - loss of significant customers; - risks relating to the decision of the bankruptcy court with respect to the approval of the settlement of the Western MacArthur matter; - changes in our estimate of insurance industry losses resulting from the September 11, 2001 terrorist attack; - unfavorable developments in non-Western MacArthur related asbestos litigation (including claims that certain asbestos- related insurance policies are not subject to aggregate limits); - unfavorable developments in environmental litigation involving policy coverage and liability issues; - the effects of emerging claim and coverage issues on our business, including developments relating to issues such as mold conditions, construction defects and changes in interpretation of the named insured provision with respect to the uninsured/underinsured motorist coverage in commercial automobile policies; - the growing trend of plaintiffs targeting property-liability insurers, including us, in purported class action litigation relating to claim-handling and other practices; - the risk that our subsidiaries may be unable to pay dividends to us in sufficient amounts to enable us to meet our obligations and pay future dividends; - the cyclicality of the property-liability insurance industry causing fluctuations in our results; - risks relating to our asset management business, including the risk of material reductions to assets under management from a significant rise in interest rates, declining equity markets or poor investment performance; - our dependence on the business provided to us by agents and brokers; - our implementation of new strategies and initiatives; - and various other matters. Item 2. Management's Discussion and Analysis of Financial ------ Condition and Results of Operations. ----------------------------------- THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES June 30, 2003 The St. Paul Companies, Inc. ("The St. Paul") is incorporated as a general business corporation under the laws of the State of Minnesota. The St. Paul and its subsidiaries constitute one of the oldest insurance organizations in the United States, dating back to 1853. We are a management company principally engaged, through our subsidiaries, in providing commercial property- liability insurance products and services. We also have a presence in the asset management industry through our 79% majority ownership of Nuveen Investments, Inc. As a management company, we oversee the operations of our subsidiaries and provide them with capital, management and administrative services. Based on total revenues in 2002, we ranked No. 207 on the Fortune 500 list of the largest companies in the United States. Our Internet website address is stpaul.com. We make available, free of charge, on or through our website, annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. Our website address is an inactive textual reference only and the contents of the website are not part of this report. Consolidated Highlights ----------------------- The following table summarizes our results for the three months and six months ended June 30, 2003 and 2002. Three Months Six Months Ended June 30 Ended June 30 ------------- ------------- (in millions, except 2003 2002 2003 2002 per-share amounts) ---- ---- ---- ---- ----------------- Pretax income (loss) before cumulative effect of accounting change: Property-liability insurance: Underwrit ing result $ (1) $(591) $ 56 $(602) Net investment income 274 283 554 573 Realized investment gains (losses) 71 (38) 38 (77) Other expenses (20) (12) (53) (38) ---- ---- ---- ---- Total property- liability insurance 324 (358) 595 (144) Asset management 44 39 86 77 Parent and other operations (60) (45) (122) (101) ---- ---- ---- ---- Income (loss) from continuing operations before income taxes and cumulative effect of accounting change 308 (364) 559 (168) Income tax expense (benefit) 93 (146) 163 (98) ---- ---- ---- ---- Income (loss) from continuing operations before cumulative effect of accounting change 215 (218) 396 (70) Cumulative effect of accounting change, net of taxes - - - (6) ---- ---- ---- ---- Income (loss) from continuing operations 215 (218) 396 (76) Discontinued operations, net of taxes (1) (5) (1) (14) ---- ---- ---- ---- Net income (loss) $ 214 $(223) $ 395 $ (90) ==== ==== ==== ==== Net income (loss) per common share (basic) $0.93 $(1.09) $1.70 $(0.47) ==== ==== ==== ==== Net income (loss) per common share (diluted) $0.89 $(1.09) $1.64 $(0.47) ==== ==== ==== ==== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- Consolidated Results -------------------- Our pretax income from continuing operations of $308 million in the second quarter of 2003, which included an $86 million pretax loss provision related to a surety exposure (described in more detail on page 44 of this report), was significantly better than our pretax loss of $364 million in the same period of 2002, which included a $585 million pretax loss provision related to a settlement agreement with respect to certain asbestos litigation (described in more detail on pages 35 and 36 of this report). Excluding the impact of that $585 million loss provision in 2002, our second-quarter 2003 pretax income was over $85 million higher than the adjusted 2002 income of $221 million, driven in large part by realized investment gains in our property-liability operations. Through the first half of 2003, our pretax income from continuing operations totaled $559 million, compared with pretax income of $417 million (adjusted to exclude that $585 million impact of the asbestos litigation loss provision) in the same 2002 period. The improvement resulted from a $115 million increase in realized investment gains in our property-liability operations, and significant improvement in underwriting results generated by our two ongoing underwriting segments - Specialty Commercial and Commercial Lines. Our asset management subsidiary, Nuveen Investments, Inc., also contributed to the improvement in our second-quarter and year-to-date results in 2003. In our "Parent and other operations," pretax losses in the second quarter and first half of 2003 exceeded those in the same periods of 2002 primarily due to an increase in realized investment losses. Presentation of Certain Information Based on Statutory Accounting Principles ---------------------------------------------------------------------------- Our U.S. property-liability insurance operations comprise the majority of our operations. These operations are required under applicable state insurance legislation and regulations to publicly report information on the basis of Statutory Accounting Principles ("SAP"), including net written premiums, statutory loss and loss adjustment expense ratio, and statutory underwriting expense ratio information. We provide in this report selected SAP information for all of our property-liability underwriting operations, as well as certain GAAP information for such operations. The types of SAP information included herein are common measures of the performance of a property-liability insurer, and we believe the inclusion of such information will aid investors in comparing our results with those of our peers in the industry. In addition, management uses this SAP information to monitor our financial performance. Definitions of the statutory information included herein are included under "Definitions of Certain Statutory Accounting Terms" on page 60 of this report. Elimination of Reporting Lag - Lloyd's -------------------------------------- In the first quarter of 2003, we eliminated the one-quarter reporting lag for our underwriting operations at Lloyd's to coincide with the timing of reporting for all of our other international operations. As a result, our consolidated results in the first six months of 2003 included the results of those operations for the fourth quarter of 2002 and the first six months of 2003, whereas our results for the six months ended June 30, 2002 included the results of those operations for the fourth quarter of 2001 and the first quarter of 2002. The year-to-date incremental impact on our property-liability operations of eliminating the reporting lag was as follows. (in millions) ----------- Specialty Commercial Other Total ---------- ------ ------ Net written premiums $ 52 $ 2 $ 54 Decrease in unearned premiums (14) (4) (18) ----- ----- ----- Net earned premiums 66 6 72 Incurred losses and underwriting expenses 63 11 74 ----- ----- ----- Underwriting result 3 (5) (2) Net investment income 1 1 2 Other expenses (2) (1) (3) ----- ----- ----- Total pretax income (loss) $ 2 $ (5) $ (3) ===== ===== ===== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- Since the elimination of the one-quarter reporting lag in our Lloyd's operations makes the information for the first six months of 2003 not comparable to the information for the same period of 2002, we have presented information adjusted to remove the effect of the elimination in this Management's Discussion and Analysis. We believe that investors will find it helpful to have this information, as well as information prepared in accordance with United States generally accepted accounting principles ("GAAP"), when reviewing our results for the first half of 2003. Such adjusted information is reconciled to the information reported in accordance with GAAP whenever it is presented. Reclassification of Lloyd's Commission Expenses ----------------------------------------------- In the first quarter of 2003, we reclassified certain commission expenses related to our operations at Lloyd's. In prior years, we determined commission expense based on premiums reported by the Lloyd's market (net of commissions) using an estimated average commission rate. Until recently, gross premiums (prior to reduction for commissions) were not available from the Lloyd's market. That information is now available for current and prior periods, and in the first quarter of 2003, we began recording actual commission expense for our Lloyd's business. We reclassified prior period results to record actual commission expense on a basis consistent with that implemented in the first quarter of 2003. There was no impact to net income or shareholders' equity as previously reported for any prior periods, because the reclassification had the impact of increasing previously reported premiums and commission expense in equal and offsetting amounts. For the second quarter and first six months of 2003, this reclassification had the impact of increasing both net earned premiums and policy acquisition costs by $14 million and $39 million, respectively, compared with what would have been recorded under our prior method of estimation. In addition, net written premiums increased by $3 million and $79 million, respectively (a portion of which was due to the elimination of the one-quarter reporting lag). For the second quarter and first six months of 2002, the impact was an increase to both net earned premiums and policy acquisition costs of $37 million and $60 million, respectively, and an increase to net written premiums of $55 million and $66 million, respectively. Sale of Baltimore Office Campus ------------------------------- In April 2003, we completed the sale of our 68-acre office campus in Baltimore, MD. We recorded a pretax impairment writedown of $14 million in the first quarter of 2003 related to the sale, which was recorded as an operating expense in our property- liability operations. On an after-tax basis at the statutory Federal tax rate of 35%, the writedown totaled $9 million, or $0.04 per common share (diluted). Transfer of Ongoing Reinsurance Operations to Platinum Underwriters Holdings, Ltd. ------------------------------------------------------- On November 1, 2002, we completed the transfer of our continuing reinsurance business (previously operating under the name "St. Paul Re") and certain related assets, including renewal rights, to Platinum Underwriters Holdings, Ltd. ("Platinum"), a Bermuda company formed in 2002 that underwrites property and casualty reinsurance on a worldwide basis. As part of this transaction, we contributed $122 million of cash to Platinum and transferred $349 million in assets relating to the insurance reserves that we also transferred. In exchange, we acquired six million common shares, representing a 14% equity ownership interest in Platinum, and a ten-year option to buy up to six million additional common shares at an exercise price of $27 per share, which represents 120% of the initial public offering price of Platinum's shares. In conjunction with the transfer of our continuing reinsurance business to Platinum, we entered into various agreements with Platinum and its subsidiaries, including quota share reinsurance agreements by which Platinum reinsured substantially all of the reinsurance contracts entered into by St. Paul Re on or after January 1, 2002. This transfer (based on September 30, 2002 balances) included $125 million of unearned premium reserves (net of ceding commissions), $200 million of existing loss and loss adjustment expense reserves and $24 million of other reinsurance- related liabilities. The transfer of unearned premium reserves to Platinum was accounted for as prospective reinsurance, while the transfer of existing loss and loss adjustment expense reserves was accounted for as retroactive reinsurance. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- As noted above, the transfer of reserves to Platinum at the inception of the quota share reinsurance agreements was based on the September 30, 2002 balances. In March 2003, we transferred to Platinum $137 million of additional insurance reserves, consisting of $72 million in unearned premiums (net of ceding commissions) and $65 million in existing reserves for losses and loss adjustment expenses. We also transferred cash and other assets having a value equal to the additional insurance reserves transferred. This transfer of additional assets and liabilities reflected business activity between September 30, 2002 and the November 2, 2002 inception date of the quota share reinsurance agreements, and our estimate of amounts due under the adjustment provisions of the quota share reinsurance agreements. Our insurance reserves at December 31, 2002 included our estimate, at that time, of amounts due to Platinum under the quota share reinsurance agreements, which totaled $54 million. The $83 million increase in our estimate of amounts due to Platinum under the quota share reinsurance agreements resulted in a pretax underwriting loss of $6 million in the first quarter of 2003. During the second quarter of 2003, we reached final agreement with Platinum regarding the adjustment provisions of the quota share reinsurance agreements and no further adjustments to the transferred assets and liabilities will occur. For business underwritten in the United States and the United Kingdom, until October 31, 2003, Platinum has the right to underwrite specified reinsurance business on our behalf in cases where Platinum is unable to underwrite that business because it has yet to obtain necessary regulatory licenses or approval to do so, or Platinum has not yet been approved as a reinsurer by the ceding company. We entered into this agreement solely as a means to accommodate Platinum through a transition period. Any business written by Platinum on our policy forms during this transition period is being fully ceded to Platinum under the quota share reinsurance agreements. Our investment in Platinum is included in "Other investments." The estimated income from our 14% proportionate equity ownership in Platinum is included in our statement of operations as a component of "Net investment income." Our option to purchase additional Platinum shares is carried at market value ($59 million at June 30, 2003), with changes in its fair value recorded as other realized gains or losses in our statement of operations. In the first six months of 2003, we recorded a net pretax realized loss of $2 million related to this option, including a $4 million pretax gain in the second quarter. Revisions to Business Segment Reporting Structure ------------------------------------------------- In the first quarter of 2003, we revised our property-liability insurance business segment reporting structure to reflect the manner in which those businesses are now managed. Our property- liability underwriting operations now consist of two segments constituting our ongoing operations (Specialty Commercial and Commercial Lines), and one segment comprising our runoff operations (Other). The composition of those respective segments is described in greater detail in the analysis of their results on pages 42 through 52 of this discussion. All data for 2002 included in this report were restated to be consistent with the new reporting structure in 2003. The following is a summary of changes made to our segments in the first quarter of 2003. - Our Surety & Construction operations, previously reported together as a separate specialty segment, are now separate components of our Specialty Commercial segment. - Our ongoing International operations and our ongoing operations at Lloyd's, previously reported together as a separate specialty segment, are now separate components of our Specialty Commercial segment. - Our Health Care, Reinsurance and Other operations, each previously reported as a separate runoff business segment, have been combined into a single Other runoff segment and are under common management. "Runoff" means that we have ceased or plan to cease underwriting business as soon as possible. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- - The results of our participation in voluntary insurance pools, as well as loss development on business underwritten prior to 1980 (prior to 1988 for business acquired in our merger with USF&G Corporation in 1998), previously included in our Commercial Lines segment, are now included in the Other segment. That prior year business included the majority of our environmental and asbestos liability exposures. The oversight of these exposures is the responsibility of the same management team responsible for oversight of the other components of the Other segment. In accordance with provisions of SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," since Surety & Construction, International & Lloyd's, Health Care, and Reinsurance were reported as separate segments during 2002 and are considered to be of continuing significance in analyzing the results of our operations, we continue to separately present and discuss (as appropriate) in Note 7 to our consolidated financial statements and in Management's Discussion and Analysis, information about those businesses in 2003 and the corresponding periods of 2002. Our operations in runoff do not qualify as "discontinued operations" for accounting purposes. For the six months ended June 30, 2003, these runoff operations collectively accounted for $268 million, or 8%, of our reported net earned premiums, and generated underwriting losses totaling $148 million (an amount that does not include investment income from the assets maintained to support these operations). For the six months ended June 30, 2002, these runoff operations collectively accounted for $1.28 billion, or 33%, of our net earned premiums, and generated underwriting losses totaling $712 million, an amount that included the $585 million pretax loss provision related to the asbestos litigation settlement agreement. Terrorism Risk and Legislation ------------------------------ On November 26, 2002, President Bush signed into law the Terrorism Risk Insurance Act of 2002, or TRIA. TRIA establishes a temporary federal program which requires U.S. and other insurers to offer coverage in their commercial property and casualty policies for losses resulting from terrorists' acts committed by foreign persons or interests in the United States or with respect to specified U.S. air carriers, vessels or missions abroad. The coverage offered may not differ materially from the terms, amounts and other coverage limitations applicable to other policy coverages. These requirements terminate at the end of 2004 unless the Secretary of the Treasury extends them to 2005. Under TRIA, the U.S. Secretary of the Treasury determines whether an act is a covered terrorist act, and if it is covered, losses resulting from that act ultimately are shared among insurers, the federal government and policyholders. Generally, insurers pay all losses to policyholders, retaining a defined "deductible" and 10% of losses above that deductible. The federal government will reimburse insurers for 90% of losses above the deductible and, under certain circumstances, the federal government will require insurers to levy surcharges on policyholders to recoup for the federal government its reimbursements paid. An insurer's deductible in 2003 is 7% of the insurer's 2002 direct earned premiums, and rises to 10% of 2003 direct earned premiums in 2004 and, if the program continues in 2005, 15% of 2004 direct earned premiums in 2005. Federal reimbursement of the insurance industry is limited to $100 billion in each of 2003, 2004 and 2005, and no insurer that has met its deductible shall be liable for the payment of its portion of the aggregate industry insured loss that exceeds $100 billion, thereby capping the insurance industry's and each insurer's ultimate exposure to terrorist acts covered by TRIA. TRIA voided terrorist exclusions in policies in-force on November 26, 2002 to the extent of the TRIA coverage required to be offered and imposed requirements on insurers to offer the TRIA coverage to policyholders at rates chosen by the insurers on policies in-force on November 26, 2002 and all policies renewed or newly offered thereafter. Policyholders may accept or decline coverage at the offered rate and, with respect to policies in- force on November 26, 2002, TRIA coverage remains in effect until the policyholder fails to purchase the coverage within a specified period following the insurer's rate quotation for the TRIA coverage. We have fully implemented our interim, or in some cases long-term, rating plans in all states. In states where we have not implemented long-term rating plans, such long-term rating plans have been developed to replace the interim plans and will be filed. Six states have outstanding questions on our interim TRIA filings, and we continue to work with those states to resolve their questions about our filings. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- We believe it is too early to determine TRIA's impact on the insurance industry generally or on us. Our domestic insurance subsidiaries are subject to TRIA and, in the event of a terrorist act covered by TRIA, coverage would attach after losses of approximately $430 million (calculated based on 7% of our TRIA- qualifying calendar year 2002 direct earned premium total) Accordingly, TRIA's federal reimbursement provisions alone do not protect us from losses from foreign terrorist acts that could be material to our results of operations or financial condition. Furthermore, there is substantial uncertainty in determining the appropriate rates for offering TRIA coverage (and coverage for terrorist acts generally), and our quoted rates could be too low and attract poor risks or, alternatively, could be higher than our competitors and result in the loss of business. There are numerous interpretive issues in connection with TRIA's implementation by the Secretary of the Treasury that remain to be resolved, including the timing of federal reimbursement for TRIA losses, the standards for obtaining the federal reimbursement and the mechanisms for allocating losses exceeding insurers' deductibles. We currently have property reinsurance that would cover only a portion of our deductible. In April 2003, we renewed our terrorism reinsurance coverage, as described in the following discussion. There can be no assurance TRIA will achieve its objective of creating a viable private insurance market for terrorism coverage prior to TRIA's expiration, and rates and forms used by us and our competitors may vary widely in the future. Regardless of TRIA, some state insurance regulators do not permit terrorism exclusions in various coverages we write, and currently, we have not excluded coverage for terrorist acts by domestic terrorists (e.g., the Oklahoma bombing) in our domestic coverages, or resulting from terrorist acts occurring outside the United States from our international coverages. Accordingly, our exposure to losses from terrorist acts is not limited to TRIA coverages. Losses from terrorists' acts, whether arising under TRIA coverages or otherwise, could be material to our results of operations and financial condition. Purchase of Terrorism Coverage and Exposure to Future Terrorist Events ---------------------------------------------------------------------- After the terrorist attacks in September 2001, reinsurers, in general, specifically excluded terrorism coverage from property reinsurance treaties that subsequently renewed. As a result, in the second quarter of 2002, we purchased limited specific terrorism coverage in the form of two separate property reinsurance treaties. Those treaties expired on April 1, 2003, on which date we renewed our coverage in the form of a combined per-risk and catastrophe terrorism occurrence treaty. The treaty provides both certified and non-certified TRIA coverage. (To be TRIA certified, the terrorist act must be sponsored by an international group or state and damage caused must exceed a financial threshold, whereas non-certified coverage refers to acts of domestic terrorism). In addition, we secured non- certified TRIA terrorism coverage in our standard property reinsurance treaty renewals in April 2003 as part of our overall ceded reinsurance program. We renewed the majority of our reinsurance treaties covering workers' compensation in July 2003, and the majority of treaties covering general liability business in August 2002; those renewals included coverage for terrorism. Our reinsurance treaties do not cover acts of terrorism involving nuclear, biological or chemical events. There can be no assurance that we will be able to secure terrorism reinsurance coverage on expiring treaties each year. Asbestos Settlement Agreement ----------------------------- On June 3, 2002, we announced that we and certain of our subsidiaries had entered into an agreement settling all existing and future claims arising from any 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 ("Western MacArthur"), and Western Asbestos Company ("Western Asbestos") (together, the "MacArthur Companies"). For a full description of the circumstances leading up to the agreement, refer to Note 3 on pages 68 and 69 of our 2002 Annual Report to Shareholders. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- Pursuant to the provisions of the settlement agreement, on November 22, 2002, the MacArthur Companies filed 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 who has been 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 bankruptcy court approval of the Plan will be obtained. Upon final approval of the Plan, 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 net income for the three months and six months ended June 30, 2002, net of expected reinsurance recoveries and the re-evaluation and application of asbestos and environmental reserves, was a loss of approximately $380 million. In the fourth quarter of 2002, we revised upward our estimated reinsurance recoverables related to this settlement, reducing the after-tax impact of the settlement on calendar year 2002 net income to a loss of $307 million. This calculation reflected payments of $235 million during the second quarter of 2002, and $747 million on January 16, 2003 (including interest). The $747 million payment, together with at least $60 million of the original $235 million, shall be returned to USF&G Parties if the Plan is not finally approved. Accordingly, as of June 30, 2003 we had recorded those payments of $807 million in both "Other Assets" and "Other Liabilities," since the Plan had not yet been approved. The settlement agreement also provided for the USF&G Parties to pay $13 million (which was paid in the second quarter of 2002) 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, up to $175 million of the $235 million will be paid to 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. Possible Asbestos Legislation ----------------------------- A number of asbestos reform bills have been introduced in the U.S. Congress. A proposed law sponsored by Senator Orrin Hatch would replace most of the current asbestos personal injury litigation with a statutory compensation program funded by contributions from companies that formerly manufactured, distributed or sold asbestos products and insurers that underwrote certain asbestos risks. Current reform efforts would not cover asbestos property damage claims and may not cover other categories of asbestos exposure including future personal injury claims if the compensation fund ultimately proves insufficient. The prospects for the passage of an asbestos reform bill remain uncertain and the effect of any such future asbestos legislative reform on us will depend upon a variety of factors including the total size of the compensation fund, the portion allocated to each commercial group and the formula for allocating contributions among insurers. In the event of any future asbestos legislative reform, our contribution allocation could be significantly larger than our current asbestos reserve. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- Cumulative Effect of Accounting Change -------------------------------------- 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 practice in the way intangible assets with indefinite useful lives, including goodwill, are tested for impairment on an annual basis. Generally, 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. In the second quarter of 2002, we completed our initial evaluation for impairment of our recorded goodwill 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 previously reported results for the first quarter of 2002, reducing net income for that period from the originally reported $139 million, or $0.63 per common share (diluted) to $133 million, or $0.60 per common share (diluted). In the second quarter of 2003, we peformed our annual evaluation for impairment of recorded goodwill in accordance with provisions of SFAS No. 142. That evaluation concluded that none of our goodwill was impaired. As a result of implementing the provisions of SFAS No. 142, we no longer amortize our goodwill assets. Amortization expense associated with intangible assets totaled $12 million in the first six months of 2003, compared with $9 million in the same 2002 period. 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 regularly evaluate the adequacy of our estimated net losses related to the attack, weighing all factors that may impact the total net losses we will ultimately incur. During 2002, we recorded an additional loss provision of $20 million, and a $33 million reduction in our estimated provision for uncollectible reinsurance related to the attack. In the second quarter of 2003, we recorded a $24 million reduction in losses related to the attack, virtually all of which was recorded in our reinsurance operations, the results of which are reported in our runoff "Other" segment. Through June 30, 2003, we have made net loss payments totaling $452 million related to the attack since it occurred, of which $145 million were made in the first half of 2003. For further information regarding the impact of the terrorist attack on our operations, refer to Note 4 on page 69 of our 2002 Annual Report to Shareholders. Discontinued 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 September 30, 1999 closing date. Under the reserve-related agreements, we agreed to pay for any deficiencies in those reserves and would share in any redundancies that developed by September 30, 2002. Any losses incurred by us under these agreements were reflected in discontinued operations in the period during which they were incurred. At December 31, 2002, our analysis indicated that we owed Metropolitan $13 million related to the reserve agreements, which was paid in April 2003. In the first six months of 2003 and 2002, we recorded pretax losses of $300,000 and $6 million, respectively, in discontinued operations, related to claims in respect of pre-sale losses. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- Critical Accounting Policies ---------------------------- Overview - On pages 30 through 32 of our 2002 Annual Report to Shareholders, we identified and described 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 consolidated financial statements if we made different assumptions. Those policies were unchanged at June 30, 2003, except for a change related to the recognition of premium revenue as described below. In 2003, we changed the method by which we recognize premium revenue at our operations at Lloyd's. Prior to 2003, such revenue was recognized using the "one-eighths" method, which reflected the fact that we converted Lloyd's syndicate accounts to U.S. GAAP on a quarterly basis. Since Lloyd's accounting does not recognize the concept of earned premium, we calculated earned premium as part of the conversion to GAAP, assuming business was written at the middle of each quarter, effectively breaking the calendar year into earnings periods of eighths. In 2003, we began recognizing Lloyd's premium revenue in a manner that more accurately reflects the underlying policy terms and exposures and is more consistent with the method by which we recognize premium revenue in our non-Lloyd's business. This change did not have a material impact on our consolidated financial statements for the three months or six months ended June 30, 2003. The following discussion provides an update to various financial disclosures related to critical accounting policies pertaining to our 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 we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in our common shareholders' equity. If we believe the decline is "other than temporary," we write down the carrying value of the investment and record a realized loss on our statement of operations. Our assessment of a decline in value includes our current judgment as to the financial position and future prospects of the entity that issued the investment security. If that judgment changes in the future we may ultimately record a realized loss after having originally concluded that the decline in value was temporary. The following table summarizes the total pretax gross unrealized loss recorded in our common shareholders' equity at June 30, 2003 and Dec. 31, 2002, by invested asset class. (in millions) ----------- June 30, Dec. 31, 2003 2002 ------- ------- Fixed income (including securities on loan) $ 25 $ 52 Equities 10 37 Venture capital 114 119 ----- ----- Total unrealized loss $149 $208 ===== ===== At June 30, 2003 and December 31, 2002, the carrying value of our consolidated invested asset portfolio included $1.30 billion and $1.03 billion of net pretax unrealized gains, respectively. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- The following table summarizes, for all securities in an unrealized loss position at June 30, 2003 and Dec. 31, 2002, the aggregate fair value and gross unrealized loss by length of time those securities have been continuously in an unrealized loss position. June 30, 2003 December 31, 2002 ------------------- ------------------- (in millions) Gross Gross ----------- Fair Unrealized Fair Unrealized Value Loss Value Loss ----- ---------- ----- ---------- Fixed income (including securities on loan): 0 - 6 months $ 686 $ 8 $ 673 $ 27 7 - 12 months 103 11 198 9 Greater than 12 months 79 6 198 16 ----- ----- ----- ----- Total 868 25 1,069 52 ----- ----- ----- ----- Equities: 0 - 6 months 63 8 144 15 7 - 12 months 2 -* 80 20 Greater than 12 months 13 2 4 2 ----- ----- ----- ----- Total 78 10 228 37 ----- ----- ----- ----- Venture capital: 0 - 6 months 15 11 60 49 7 - 12 months 46 36 39 25 Greater than 12 months 76 67 44 45 ----- ----- ----- ----- Total 137 114 143 119 ----- ----- ----- ----- Total $1,083 $ 149 $1,440 $ 208 ===== ===== ===== ===== *Total unrealized losses on these securities were less than $1 million at June 30, 2003. At June 30, 2003, our fixed income investment portfolio included non-investment grade securities and nonrated securities that in total comprised approximately 2% of the portfolio. Included in those categories at that date were securities in an unrealized loss position that, in the aggregate, had an amortized cost of $94 million and a fair value of $84 million, resulting in a net pretax unrealized loss of $10 million. These securities represented 1% of the total amortized cost and fair value of the fixed income portfolio at June 30, 2003, and accounted for 40% of the total pretax unrealized loss in the fixed income portfolio. Included in those categories at Dec. 31, 2002 were securities in an unrealized loss position that, in the aggregate, had an amortized cost of $160 million and a fair value of $140 million, resulting in a net pretax unrealized loss of $20 million. These securities represented 1% of the total amortized cost and fair value of the fixed income portfolio at Dec. 31, 2002, and accounted for 38% of the total pretax unrealized loss in the fixed income portfolio. The following table presents information regarding fixed income investments that were in an unrealized loss position at June 30, 2003, by remaining period to maturity date. (in millions) Amortized Estimated ----------- Cost Fair Value --------- ---------- Remaining period to maturity date: One year or less $ 101 $ 99 Over one year through five years 114 111 Over five years through ten years 213 208 Over ten years 191 187 Asset/mortgage-backed securities with various maturities 274 263 ------ ------ Total $ 893 $ 868 ====== ====== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance ---------------------------- Overview -------- Our consolidated second-quarter written premiums of $1.79 billion were 3% below comparable 2002 premiums of $1.84 billion. In the first six months of 2003, reported premium volume of $3.77 billion was 5% lower than reported 2002 six-month volume of $3.96 billion. The decline in both periods of 2003 was concentrated in our runoff "Other" segment and was primarily due to our November 2002 transfer of ongoing reinsurance operations to Platinum. In our ongoing Specialty Commercial and Commercial Lines segments, total net written premium volume of $1.71 billion in the second quarter was 13% ahead of comparable 2002 premiums of $1.51 billion. The rate of growth in second-quarter 2003 premiums over the same 2002 period was impacted by the one-quarter reporting lag elimination. Our second-quarter 2003 ongoing operations included $81 million of premium volume from our Lloyd's operations for the three months ended June 30, 2003, which is historically a period of low premium volume at Lloyd's. Our second-quarter 2002 ongoing operations, however, were reported on a one-quarter lag and therefore included $217 million of premium volume from our operations at Lloyd's for the three months ended March 31, 2002, which is historically a high volume period at Lloyd's due to the timing of coverage renewals. Our year-to-date ongoing operations' premium volume of $3.58 billion was 23% higher than the 2002 six-month total of $2.92 billion. The strong growth in 2003 was driven by price increases and new business throughout our ongoing operations. That year-to-date 2003 ongoing total also included $52 million of incremental premium volume resulting from the elimination of the one-quarter reporting lag at our operations at Lloyd's. Our consolidated statutory loss ratio, which measures insurance losses and loss adjustment expenses as a percentage of earned premiums, was 69.4 in the second quarter of 2003, compared with a loss ratio of 101.5 in the same 2002 period. The 2002 ratio included a 29.9-point impact from the $585 million loss provision related to the asbestos litigation settlement described on pages 35 and 36 of this report, which was recorded in our runoff "Other" segment. In our ongoing operations, the second-quarter 2003 loss ratio of 66.9 was over five points worse than the comparable 2002 loss ratio of 61.7, primarily due to an $86 million loss provision recorded in our Surety business center related to one of our insureds (discussed in more detail on page 44 of this report). Excluding that surety loss in 2003, our ongoing operations' loss ratio of 61.4 was slightly improved over the comparable 2002 loss ratio of 61.7. Through the first six months of 2003, our ongoing segments' loss ratio excluding that surety loss was 61.1, nearly five points better than the comparable 2002 loss ratio of 66.0. That improvement reflected the impact of price increases in recent years and our efforts to upgrade the quality of our business, both of which have resulted in a significant reduction in current-year loss activity throughout the majority of our ongoing operations. Effective January 1, 2003, we changed our disclosure regarding catastrophe losses. We no longer classify all losses from Insurance Services Office (ISO)-defined catastrophes as "catastrophe losses." We revised our definition of losses reported as "catastrophes" to include only those events that generate losses beyond a level normally expected in our business. This revised definition has no impact on recorded results for either the current or prior period. Catastrophe losses reported in prior periods have been reclassified to conform to our new definition. In the first six months of 2003, we recorded a net $21 million reduction in the provision for catastrophes incurred in prior years, nearly all of which was recorded in our runoff Reinsurance operations and was related to the September 11, 2001 terrorist attack. In the first six months of 2002, we recorded a net $3 million reduction in the provision for catastrophe losses incurred in prior years. Our consolidated statutory expense ratio, measuring underwriting expenses as a percentage of net written premiums, was 28.4 in the second quarter of 2003, compared with the 2002 second-quarter ratio of 30.9. In our ongoing operations, the second-quarter 2003 expense ratio of 28.4 was over a point better than the comparable 2002 expense ratio of 29.7. The improvement in 2003 reflected the positive effects of strong price increases and our expense reduction efforts. Through the first six months of 2003, our ongoing operations' expense ratio of 29.4 was slightly higher than the 2002 six-month expense ratio of 29.2, primarily due to the impact of the reclassification of Lloyd's commission expense, and the impact on that commission expense of eliminating the one- quarter reporting lag. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Prior-Year Loss Development --------------------------- "Prior-year loss development" refers to the calendar year income statement impact of changes in the provision for losses and loss adjustment expenses for claims incurred in prior accident years. The following table summarizes net loss and loss adjustment expense ("LAE") reserves at December 31, 2002 and June 30, 2003 for each of our property-liability segments (and the material components thereof), and the amount of unfavorable (favorable) prior-year loss development recorded in those respective operations in the first six months of 2003. Net Loss and LAE Reserves ------------------------- Year-to-date Dec. 31, June 30, Prior-Year Loss (in millions) 2002 2003 Development ----------- ------- ------- ---------------- Ongoing operations: Specialty Commercial: Specialty $ 2,043 $ 2,229 $ 1 Surety & Construction 1,369 1,504 - International & Lloyd's 987 1,165 1 ------ ------ ---- Total Specialty Commercial 4,399 4,898 2 ------ ------ ---- Commercial Lines 2,495 2,486 2 ------ ------ ---- Total Ongoing Operations 6,894 7,384 4 ------ ------ ---- Runoff Operations: Other: Health Care 1,970 1,575 (1) Reinsurance 3,043 2,600 (22) Other Runoff 2,942 2,271 70 ------ ------ ---- Total Runoff Operations 7,955 6,446 47 ------ ------ ---- Total Underwriting $14,849 $13,830 $ 51 ====== ====== ==== Specific circumstances leading to the reserve development recorded in the first six months of 2003 are discussed in more detail in the respective segment discussions that follow. The table on the following page summarizes key financial results (from continuing operations) by property-liability underwriting business segment (underwriting results are presented using GAAP measures; combined ratios are presented on a statutory accounting basis). In the first quarter of 2003, we implemented a new segment reporting structure for our property-liability underwriting operations. Data for 2002 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 for the three months and six months ended June 30, 2003 and 2002. In addition to "prior-year loss development," we sometimes refer to "current-year loss development" or "current accident year loss activity," which refers to the calendar year income statement impact of recording the provision for losses and LAE for losses incurred in the current accident year. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- % of Total Three Months Ended Six Months Ended Premiums June 30 June 30 ---------- ------------------ ---------------- ($ in millions) 2003 2002 2003 2002 ------------- ------ ------ ------ ------ Specialty Commercial Net written premiums 68% $1,214 $1,122 $2,546 $2,033 Underwriting result $12 $73 $130 $67 Combined ratio 96.6 91.8 94.1 95.4 Commercial Lines Net written premiums 27% $494 $384 $1,029 $883 Underwriting result $36 $48 $74 $43 Combined ratio 92.3 91.3 91.2 95.1 Other Net written premiums 5% $86 $337 $196 $1,045 Underwriting result $(49) $(712) $(148) $(712) Combined ratio 135.6 228.3 153.7 158.7 --- ------ ------ ------ ------ Total Property- Liability Insurance Net written premiums 100% $1,794 $1,843 $3,771 $3,961 ==== ====== ====== ====== ====== Underwriting result $(1) $(591) $56 $(602) ====== ====== ====== ====== Statutory Combined Ratio Loss and loss adjustment expense ratio 69.4 101.5 67.4 86.3 Underwriting expense ratio 28.4 30.9 30.2 29.5 ------ ------ ------ ------ Combined Ratio 97.8 132.4 97.6 115.8 ====== ====== ====== ====== Specialty Commercial -------------------- The Specialty Commercial segment includes our combined Surety & Construction operation, our ongoing International & Lloyd's operations, and the following nine specialty business centers that in total comprise the "Specialty" component of this segment: Technology, Financial and Professional Services, Marine, Personal Catastrophe Risk, Public Sector Services, Discover Re, Excess & Surplus Lines, Specialty Programs and Oil & Gas. These business centers are considered specialty operations because each provides products and services requiring specialty expertise and focuses on the respective customer group served. Our Surety business center underwrites surety bonds, which are agreements under which one party (the surety) guarantees to another party (the owner or obligee) that a third party (the contractor or principal) will perform in accordance with contractual obligations. The Construction business center offers a variety of products and services, including traditional insurance and risk management solutions, to a broad range of contractors and parties responsible for construction projects. Our ongoing International operations consist of our specialty underwriting operations in Canada (other than surety), the United Kingdom and the Republic of Ireland, and the international exposures of most U.S. underwriting business. At Lloyd's, our ongoing operations are comprised of the following types of insurance coverage we underwrite through a single wholly-owned syndicate: Aviation, Marine, Global Property and Personal Lines. The following table provides supplemental information for this segment for the three months and six months ended June 30, 2003 and 2002. 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 ------------------ ---------------- ($ in millions) 2003 2002 2003 2002 ------------- ------ ------ ------ ------ SPECIALTY Net written premiums $632 $438 $1,164 $911 Percentage increase over 2002 44% 28% Underwriting result $82 $52 $141 $61 Statutory combined ratio: Loss and loss adjustment expense ratio 60.4 63.9 61.3 67.9 Underwriting expense ratio 23.6 23.5 24.2 24.1 ------ ------ ------ ------ Combined ratio 84.0 87.4 85.5 92.0 ====== ====== ====== ====== SURETY & CONSTRUCTION Net written premiums $341 $328 $673 $673 Percentage increase over 2002 4% -% Underwriting result $(87) $4 $(73) $6 Statutory combined ratio: Loss and loss adjustment expense ratio 91.0 62.5 76.8 63.1 Underwriting expense ratio 33.4 34.8 33.3 33.0 ------ ------ ------ ------ Combined ratio 124.4 97.3 110.1 96.1 ====== ====== ====== ====== INTERNATIONAL & LLOYD'S Net written premiums $241 $356 $709 $449 Percentage change from 2002 (32%) 58% Underwriting result $17 $17 $62 $- Statutory combined ratio: Loss and loss adjustment expense ratio 61.1 64.2 57.4 70.4 Underwriting expense ratio 29.3 28.5 34.2 30.5 ------ ------ ------ ------ Combined ratio 90.4 92.7 91.6 100.9 ====== ====== ====== ====== TOTAL SPECIALTY COMMERCIAL SEGMENT Net written premiums $1,214 $1,122 $2,546 $2,033 Percentage increase over 2002 8% 25% Underwriting result $12 $73 $130 $67 Statutory combined ratio: Loss and loss adjustment expense ratio 69.2 63.5 64.7 66.9 Underwriting expense ratio 27.4 28.3 29.4 28.5 ------ ------ ------ ------ Combined ratio 96.6 91.8 94.1 95.4 ====== ====== ====== ====== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Specialty --------- Virtually all business centers in the Specialty category contributed to the strong premium growth over the second quarter and first half of 2002. The pace of premium growth for the first six months of 2003 was less than that in the second quarter of the year due to the impact of increased ceded reinsurance costs in the first quarter of the year. Financial and Professional Services' second-quarter 2003 premiums of $154 million were 72% higher than in the same period of 2002, driven by price increases and new business principally generated by our December 2002 acquisition of the right to seek to renew the professional and financial risk practice business of Royal & SunAlliance. Specialty Programs' written premiums of $62 million in the second quarter were nearly double the comparable 2002 total of $33 million, primarily due to price increases and new business. Personal Catastrophe Risk second-quarter net premiums of $51 million were significantly higher than those in the same 2002 period, due to a change in our reinsurance program related to this business that has resulted in less business being ceded to other insurers. The improvements in both second-quarter and year-to-date 2003 underwriting results compared with the same periods of 2002 occurred in virtually every business center in the Specialty category, reflecting the impact of price increases in recent quarters and the addition of profitable new business. Surety & Construction --------------------- Net written premiums generated by our Surety business center totaled $147 million in the second quarter of 2003, compared with $140 million in the same 2002 period. Through the first half of 2003, Surety's written premium volume of $240 million was 3% below the comparable 2002 total of $247 million, primarily due to the closing of certain field offices, the impact of underwriting actions to improve the risk profile of our book of business, and increased reinsurance costs. The Surety underwriting loss totaled $88 million in the second quarter of 2003, compared with an underwriting loss of $2 million in the same 2002 period. We had previously reported in a Current Report on Form 8-K dated April 30, 2003 that in April 2003 we began to receive surety claim notices related to one of our accounts that was in bankruptcy. In the second quarter of 2003, we recorded an $86 million pretax loss provision (net of reinsurance) related to that account's inability to perform its bonded obligations. In April 2003, a bankruptcy court approved the sale of substantially all of the assets of the account. Following that approval, we received claim notices with respect to approximately $120 million of bonds securing certain workers' compensation and retiree health benefit obligations of the account. The $86 million net pretax loss provision recorded in the second quarter of 2003 represents our estimated loss in this matter. We reported that loss in a Current Report on Form 8-K dated July 25, 2003. In our Surety operation, we continue to experience an increase in the frequency of reported losses, primarily resulting from the continuing economic downturn in North America. Certain segments of our surety business tend to be characterized by low frequency but potentially high severity losses. Within our commercial surety segments, we have exposures related to a small number of accounts, which are now in various stages of bankruptcy proceedings. In addition, certain other accounts have experienced deterioration in creditworthiness since we issued bonds to them. Given the current economic climate and its impact on these companies, we may experience an increase in claims and, possibly, incur high severity losses. Such losses would be recognized in the period in which the claims are filed and determined to be a valid loss under the provisions of the surety bond issued. With regard to commercial surety bonds issued on behalf of companies operating in the energy trading sector, our aggregate pretax exposure, net of facultative reinsurance, is with five companies for a total of approximately $396 million ($328 million of which is from gas supply bonds), an amount that will decline over the contract periods. The largest individual exposure approximates $187 million (pretax). These companies all continue to perform their bonded obligations and, therefore, no claims have been filed. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- In addition to our largest exposure discussed above with respect to energy trading companies, our commercial surety business as of June 30, 2003 included seven accounts with gross pretax bond exposures greater than $100 million each, before reinsurance. The majority of these accounts have investment grade ratings, and all accounts continue to perform their bonded obligations. In 2003, we secured excess of loss reinsurance coverage for our commercial surety exposures in the form of two new treaties providing $500 million of aggregate loss limits over a five-year period, with a maximum recovery of $100 million per principal for gas supply bonds and $150 million per principal for other bonds. The reinsurance program does not extend coverage to the small number of commercial surety accounts which were in bankruptcy at the inception of the reinsurance treaties. We continue with our intention to exit the segments of the commercial surety market discussed above by ceasing to write new business and, where possible, terminating the outstanding bonds. Since October 2000, when we made a strategic decision to significantly reduce the exposures in these segments, our total commercial surety gross open bond exposure has decreased by over 50% as of June 30, 2003. We will continue to be a market for traditional commercial surety business, which includes low-limit business such as license and permit, probate, public official, and customs bonds. In our contract surety business, creditworthiness is a primary underwriting consideration and the underwriting process involves a number of factors, including consideration of a contractor's financial position, experience and management. Our risk in respect of a contract surety bond changes over time. Such risk tends to decrease as the related construction project is completed, but may increase to the extent the financial condition of the contractor deteriorates or difficulties arise during the course of the project. While our contract surety business typically has not been characterized by high severity losses, it is possible, given the current economic climate, that significant losses could occur. Some of our contract surety business, particularly with respect to larger accounts, is written on a co-surety basis with other surety underwriters in order to manage and limit our aggregate exposure. Certain of these sureties have experienced, and may continue to experience, deterioration in their financial condition and financial strength ratings. If a loss is incurred and a co-surety fails to meet its obligations under the bond, the other co-surety or co-sureties on the bond typically are jointly and severally liable for such obligations. As a result, our losses could significantly increase. In our Construction business center, net written premiums of $194 million were slightly higher than net written premium volume of $188 million in the second quarter of 2002, while year-to-date premiums of $433 million were 2% higher than premiums of $426 million in the same 2002 period. The impact on written premiums from higher prices during 2003 was largely offset by a reduction in new business. Construction's second-quarter 2003 underwriting profit totaled $1 million, compared with a profit of $6 million in the same 2002 period. Through the first half of 2003, the underwriting profit of $25 million was significantly higher than the comparable 2002 profit of $7 million, primarily due to an improvement in current-year loss experience. International & Lloyd's ----------------------- Net written premiums of $241 million in the second quarter were 32% below comparable 2002 premiums of $356 million. The decline was primarily due to the effects of the elimination of the one- quarter reporting lag at our Lloyd's operations. Reported results for the second quarter of 2003 represent activity for the quarter ended June 30, 2003, which is typically a low premium volume quarter at Lloyd's, whereas reported results for the second quarter of 2002 represent activity for the quarter ended March 31, 2002, which is typically a high-volume quarter for Lloyd's due to the timing of coverage renewals. Also impacting second-quarter 2003 volume was a reduction in estimated THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- premiums recorded in prior periods for certain Lloyd's business. For the six months ended June 30, 2003, written premium volume of $709 million for the International & Lloyd's category included $52 million of incremental premiums from the elimination of the one-quarter reporting lag at Lloyd's (the remaining $2 million of incremental premiums described on page 31 of this report were recorded in our runoff Other segment). Excluding that additional $52 million, premium volume in 2003 of $657 million was 46% higher than 2002 six-month written premiums of $449 million. The significant growth was concentrated in our operations at Lloyd's, due to price increases, new business and our increased participation in Lloyd's following the consolidation of most of our Lloyd's operations into one wholly-owned syndicate in 2002. Our International operations also achieved strong growth over 2002, recording premiums of $160 million and $262 million for the three months and six months ended June 30, 2003, respectively, compared with premiums of $139 million and $209 million in the respective periods of 2002. Price increases, new business and favorable foreign currency translation effects were all factors contributing to the growth in premiums in the first half of 2003. The International & Lloyd's underwriting profit of $17 million in the second quarter of 2003 was level with the underwriting profit in the same 2002 period. For the first half of 2003, the underwriting profit of $62 million, which included a $3 million benefit attributable to the elimination of the one-quarter reporting lag, was significantly improved over the break-even underwriting result in the same period of 2002. The improvement in 2003 results was largely due to strong results from our operations in Canada and the United Kingdom, as well as from our Lloyd's operations. Commercial Lines ---------------- The Commercial Lines segment includes our Small Commercial, Middle Market Commercial and Property Solutions business centers, as well as the results of our limited involvement in involuntary insurance pools. The Small Commercial business center services commercial firms that typically have between one and fifty employees through its proprietary St. Paul Mainstreet (SM) and St. Paul Advantage (SM) products, with a particular focus on offices, wholesalers, retailers, artisan contractors and other service risks. The Middle Market Commercial business center offers comprehensive insurance coverages for a wide variety of manufacturing, wholesale, service and retail exposures. This business center also offers loss-sensitive casualty programs, including significant deductible and self-insured retention options, for the higher end of the middle market sector. The Property Solutions business center combines our Large Accounts Property business with the commercial portion of our catastrophe risk business and allows us to take a unified approach to large property risks. The following table summarizes key financial data for this segment for the three months and six months ended June 30, 2003 and 2002. Three Months Ended Six Months Ended June 30 June 30 ------------------ ---------------- ($ in millions) 2003 2002 2003 2002 ------------- ------ ------ ------ ------ Net written premiums $494 $384 $1,029 $883 Percentage increase over 2002 29% 17% Underwriting result $36 $48 $74 $43 Statutory combined ratio: Loss and loss adjustment expense ratio 61.5 57.8 61.7 64.2 Underwriting expense ratio 30.8 33.5 29.5 30.9 ------ ------ ------ ------ Combined ratio 92.3 91.3 91.2 95.1 ====== ====== ====== ====== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- All business centers in this segment contributed to the growth in net written premiums in the second quarter and first six months of 2003. Although the pace of price increases continued to slow in the second quarter, we achieved significant growth throughout this segment while maintaining strong levels of profitability. Written premiums of $173 million in the Small Commercial business center were 16% higher than comparable second-quarter 2002 volume of $149 million. In the Middle Market business center, second- quarter written premiums of $288 million increased 34% over the same period of 2002, driven by strong growth in our Large Casualty and Inland Marine business. Property Solutions' written premiums of $23 million in the second quarter were 68% higher than the comparable 2002 total. Our business retention levels increased slightly over 2002, and new business throughout the Commercial Lines segment has been a significant contributor to premium growth in 2003. The decline in underwriting profitability in the second quarter of 2003 compared with the same period of 2002 was influenced in part by an increase in weather-related losses. Through the first half of 2003, however, underwriting profits were $31 million higher than the same period of 2002, driven by continued improvement in our current-year loss experience in each of the business centers comprising this segment. We have been successful in adding new business in the first six months of 2003 that meets our pricing and underwriting criteria while maintaining strict control over expense growth. The 1.4-point improvement in the expense ratio compared with the first six months of 2002 reflected the combined impact of a decline in net commission expense and our expense control efforts. Other ----- This segment includes the results of the lines of business we placed in runoff in late 2001 and early 2002, including our former Health Care and Reinsurance segments, and the results of the following operations: our runoff operations at Lloyd's; Unionamerica, the London-based underwriting unit acquired as part of our purchase of MMI in 2000; and international operations we decided to exit at the end of 2001. We have a management team in place for these operations, seeking to ensure that our outstanding claim obligations are settled in an expeditious and economical manner. This segment also includes the results of our participation in voluntary insurance pools, as well as loss development on business underwritten prior to 1980 (prior to 1988 for business acquired in our merger with USF&G Corporation in 1998). That prior year business includes the majority of our environmental and asbestos liability exposures. The oversight of these exposures is the responsibility of the same management team responsible for oversight of the other components of the Other segment. Our Health Care operation historically provided a wide range of medical liability insurance products and services throughout the entire health care delivery system. Our Reinsurance operations historically underwrote treaty and facultative reinsurance for a wide variety of property and liability exposures. As described in more detail on pages 32 and 33 of this report, in November 2002 we transferred our ongoing reinsurance operations to Platinum Underwriters Holdings, Ltd. The following table summarizes key financial data for the Other segment for the three months and six months ended June 30, 2003 and 2002. The table excludes statutory ratios, as they are less meaningful in a runoff environment because of the significant decline in net written and earned premiums. 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 ------------------ ---------------- ($ in millions) 2003 2002 2003 2002 ------------- ------ ------ ------ ------ HEALTH CARE Net written premiums $7 $32 $26 $142 Percentage decline from 2002 (78%) (82%) Underwriting result $(16) $(96) $(33) $(93) REINSURANCE Net written premiums $63 $201 $128 $663 Percentage decline from 2002 (69%) (81%) Underwriting result $(15) $(5) $3 $11 OTHER RUNOFF Net written premiums $16 $104 $42 $240 Percentage decline from 2002 (85%) (83%) Underwriting result $(18) $(611) $(118) $(630) ----- ----- ----- ----- TOTAL OTHER SEGMENT Net written premiums $86 $337 $196 $1,045 ===== ===== ===== ===== Percentage decline from 2002 (74%) (81%) Underwriting result $(49) $(712) $(148) $(712) ===== ===== ===== ===== Other Segment Overview ---------------------- The Other segment in total generated a $49 million underwriting loss in the second quarter of 2003, compared with a loss of $712 million in the same 2002 period that included the $585 million provision related to the asbestos litigation settlement agreement. As described in more detail in the following discussion, the year-to-date segment underwriting loss of $148 million included $47 million of net unfavorable prior-period loss development, including $8 million that emerged in the second quarter of the year. The remainder of the six-month underwriting loss primarily resulted from provisions for losses on current accident year business, and expenses associated with the runoff lines of business in this segment. Health Care ----------- We announced our decision to exit the medical liability insurance market at the end of 2001. Written premiums for all periods presented in the foregoing table primarily consisted of premiums generated by extended reporting endorsements and professional liability coverages underwritten prior to our nonrenewal notifications becoming effective in several states. We are required to offer reporting endorsements 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 recorded, at the time the endorsement is written. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- In 2000 and 2001, we recorded cumulative prior-year reserve charges of $225 million and $735 million, respectively, in our Health Care operations, ultimately leading to our decision at the end of 2001 to exit this market. In general, the reserve increases primarily resulted from claim payments being greater than anticipated due to the recent escalation of large jury awards, which included substantially higher than expected pain and suffering awards. This affected our view of not only those cases going to trial, but also our view of all cases where settlements are negotiated and the threat of a large jury verdict aids the plaintiff bar in the negotiation process. The recent escalation in claim costs that resulted from these developments was significantly higher than originally projected trends (which had not forecasted the change in the judicial environment), and has now been considered in our actuarial analysis and the projection of ultimate loss costs. In addition, a portion of the reserve increase in the fourth quarter of 2001 resulted from information obtained from the work of a Health Care Claims Task Force, created during the first half of 2001, which focused resolution efforts on our largest claims with the intent of lowering our ultimate loss costs. The following presents a summary of trends we observed within our Health Care operation for each quarter of 2002 and the first two quarters of 2003. For a discussion of quarterly trends observed in 2000 and 2001, refer to page 40 of our 2002 Annual Report to Shareholders. 2002 ---- Following the cumulative prior-year reserve charges of $735 million in 2001, activity in the first quarter of 2002 developed according to projections. Average paid claims for the full year of 2001 for medical malpractice lines had been $117,000, including a fourth quarter average of $124,000. The phrase "average paid claims" as used herein excludes claims which were settled or closed for which no loss or loss expense was paid. In the first quarter of 2002, the average paid loss was down to $111,000. We interpreted this as a positive sign that prior year reserve charges up to this point had been adequate. The average outstanding case reserve increased slightly from $141,000 in the fourth quarter of 2001 to $144,000 in the first quarter of 2002, but this was interpreted as a relatively benign change, given inflation and the promising decrease in average payment amounts. No additional reserve action was taken. In the second quarter of 2002, average paid claims for medical malpractice lines were somewhat above expectations, rising to $130,000 for the quarter. This, coupled with an additional increase in the average outstanding case reserve to $148,000, prompted management to reflect these new increased averages in its reserve analysis and record a reserve increase of $97 million. Throughout 2002, we initiated significant changes to our Health Care claims organization and resolution process. During the third quarter of 2002, we began to see the results of executing this strategy. Specifically, caseloads per adjuster had begun to decline substantially and the process for providing oversight on high exposure cases had been streamlined, enabling a more expeditious approach to our handling of these medical malpractice claims - including the establishment of stronger case reserves. We also added staff with expertise in high exposure litigation management to assist claim handlers in aggressively pursuing appropriate resolutions on a file-by-file basis. This allowed us to establish more effective resolution strategies to either resolve claims prior to going to trial or, for those claims deemed as non-meritorious, maintain an aggressive defense. We have also become more selective in determining which cases are taken to trial and more willing to make use of our right to select defense counsel in those instances that we decide to litigate. This has caused our ratio of defense verdicts to plaintiff verdicts to improve over prior years. We began to more effectively manage our claim disposition strategies to limit the number of catastrophic verdicts. We believe that executing this strategy has increased our ability to reduce our ultimate indemnity losses. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- As noted above, as part of our focus on claim resolution, we have increased our emphasis on routinely reviewing our case reserves and have put in place a process where managers actively review each adjuster's entire inventory of pending files to assure, among other things, that case reserves are adequate to support settlement values. In addition, as we have moved further into runoff, our mix of paid and outstanding claims has changed and we expect that our statistical data will reflect fewer new claims. We expect our claim counts will go down and the average size of our outstanding and paid claims will go up since newly reported claims are often settled at minimal loss or loss expense cost. In the third quarter of 2002, although our average paid claim decreased slightly to $126,000, our average outstanding claim reserve increased to $166,000. We believed that increases in the average outstanding claim reserve were due to both the claim mix and case strengthening as described above and were not unexpected in a runoff environment. Accordingly, we did not record any reserve charge given the favorable effects we anticipate realizing in future ultimate payments. In the fourth quarter of 2002, the average paid claim increased to $153,000 and the average outstanding case reserve increased to $181,000, which we believe was attributable to the previously described observations and was reasonable relative to our expectations. Also during the fourth quarter, we determined that our claim inventory had been reduced considerably and had matured to a level at which we appropriately began to consider other more relevant data and statistics suitable for evaluating reserves in a runoff environment. During 2002, and as described above, we concluded that the impact of settling claims in a runoff environment was causing abnormal effects on our average paid claims, average outstanding claims, and the amount of average case reserves established for new claims - all of which are traditional statistics used by our actuaries to develop indicated ranges of expected loss. Taking these changing statistics into account, we developed varying interpretations of our data, which implied added uncertainty to our evaluation of these reserves. It is our belief that this data, when appropriately evaluated in light of the impact of our migration to a runoff environment, supports our view that we will realize significant savings on our ultimate claim costs. In the fourth quarter of 2002, we established specific tools and metrics to more explicitly monitor and validate our key assumptions supporting our reserve conclusions since we believe that our traditional statistics and reserving methods needed to be supplemented in order to provide a more meaningful analysis. The tools we developed track the three primary indicators which are influencing our expectations and include: a) newly reported claims, b) reserve development on known claims and c) the "redundancy ratio," comparing the cost of resolving claims to the reserve established for that individual claim. Emergence of newly reported claims - Our Health Care book of business was put into runoff at the end of 2001, and our outstanding exposure has rapidly dropped, as expected. Since the majority of coverage we offered was on a claims-made basis and notification of the claim must be made within the policy period, the potential for unreported claims has decreased significantly. We expected that the emergence of newly reported medical malpractice claims, with incurred years of 2002 or prior, would not exceed 40% of our year-end 2002 outstanding case reserve amount. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Development on known claims - As part of executing our runoff claims strategy, the inventory of claim-specific case reserves was reviewed during 2002 in an effort to reserve each claim as appropriately as possible. This effort is in its advanced stages, and our expectations for additional reserve strengthening on known claims is considered to be minimal. We expected additional case development on medical malpractice claims would not exceed 3% of year-end 2002 case reserves. Case redundancy - While there were claims settlements which exceeded the claim-specific reserve that had been established, on the whole, claims are being settled at a level significantly less than the individual case reserve previously carried. During 2001, the amount of excess reserves above settled amounts as a percentage of previously established reserves (referred to as a redundancy ratio) were in the range of 25% to 30%. By the end of 2002, the redundancy ratio had increased to between 35% and 40%. We expect this ratio to stay within this range to support our best estimate of a reasonable provision for our loss reserves. 2003 ---- In 2003, we evaluated the adequacy of our previously established medical malpractice reserves in the context of the three indicators described above. The dollar amount of newly reported claims in the first quarter totaled $118 million, approximately 25% less than we anticipated in our original estimate of the required level of redundancy at year-end 2002. With regard to development on known claims, loss activity in the first quarter of 2003 was within our expectations. Case development on incurred years 2001 and prior was minimal, and case development on the 2002 incurred year totaled $39 million, within our year- end 2002 estimate of no more than 3% of development. For the first quarter of 2003, our redundancy ratio was within our expected range of between 35% and 40%. In the second quarter of 2003, the dollar amount of newly reported claims totaled $127 million, approximately 5% higher than we anticipated in our original estimate of the required level of reserves at year-end 2002. Nevertheless, through the first half of 2003 the dollar amount of newly reported claims was approximately 12% lower than we anticipated. Loss development on known claims during the second quarter of 2003 was negative, but not as negative as we anticipated. Our actual redundancy ratio continued to improve in the second quarter of 2003; however, since newly reported claims and loss development on known claims did not improve as much as we expected in the second quarter, the required reserve redundancy has increased modestly from the previously estimated range of 35% to 40%. The three indicators described above are related such that if one deteriorates, additional improvement on another is necessary for us to conclude that further reserve strengthening is not necessary. While the recent results of these indicators support our current view that we have recorded a reasonable provision for our medical malpractice exposures as of June 30, 2003, there is a reasonable possibility that we may incur additional unfavorable prior year loss development if these indicators significantly change from our current expectations. If these indicators deteriorate, we believe that a reasonable estimate of an additional loss provision could amount to up to $250 million. However, our analysis as of this point in time continues to support our belief that we will realize favorable effects in our ultimate costs and that our current loss reserves will prove to be a reasonable provision. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Reinsurance ----------- In November 2002, we transferred our ongoing reinsurance operations to Platinum Underwriters Holdings, Ltd. ("Platinum") while retaining liabilities generally for reinsurance contracts incepting prior to January 1, 2002. Written premium volume recorded in the second quarter and first half of 2003 consisted entirely of premium adjustments relating to reinsurance business underwritten in prior years. The underwriting loss of $15 million recorded in the second quarter of 2003 was driven by $4 million of net unfavorable development on losses incurred in prior years on North American casualty classes of business, losses recorded related to premiums received from prior underwriting years and expenses associated with operating in a runoff environment. The second-quarter 2003 underwriting result also included the impact of $24 million of favorable development related to the September 11, 2001 terrorist attack, which was substantially offset by unfavorable development in other coverages in the Reinsurance category of the Other segment. On a year-to-date basis, the underwriting profit of $3 million in 2003 was driven by favorable development recorded in the first quarter on losses incurred in prior years. Results for the first half of 2003 also included a $6 million underwriting loss related to the transfer of additional assets and reserves to Platinum pursuant to an adjustment mechanism (as described in more detail on pages 32 and 33 of this report). Underwriting results for the three months and six months ended June 30, 2002 benefited from the absence of significant catastrophes and favorable development on catastrophe losses incurred in prior years. Other Runoff ------------ This category includes the results of the following operations: our runoff operations at Lloyd's; Unionamerica, the London-based underwriting unit acquired as part of our purchase of MMI in 2000; and international operations we decided to exit at the end of 2001. The $118 million underwriting loss in the first six months of 2003 in this category included $35 million of loss provisions to increase prior-year reserves in our runoff syndicates at Lloyd's in the first quarter of 2003. The unfavorable development was concentrated in North American casualty coverages, as well as specific lines associated with Financial Institutions and Professional coverages. We experienced deterioration in those same syndicates throughout 2002, leading us to increase reserve levels. In the first quarter of 2003, further analysis undertaken by an independent party on our behalf in connection with Lloyds' compliance with annual regulatory requirements provided us with additional information and analyses, which led us to record the $35 million loss provision. Also contributing to the underwriting loss in this segment in the first half of 2003 was $31 million of unfavorable prior-year development recorded in the first quarter primarily related to several specific large losses in a number of countries within our exited international operations where we have ceased underwriting business. In the second quarter, we recorded $4 million of adverse prior-year development resulting from a single large loss in one of our operations in runoff. The remainder of the year-to- date underwriting loss was the result of provisions for losses on current accident year business, and expenses associated with the runoff lines of business in this segment. The significant underwriting losses in this category for the second quarter and first half of 2002 were driven by the $585 million loss provision related to the Western MacArthur asbestos litigation settlement agreement, described in more detail on pages 35 and 36 of this report. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Investment Operations --------------------- Pretax net investment income in our property-liability insurance operations totaled $274 million in the second quarter of 2003, 4% below pretax investment income of $283 million in the same period of 2002. Through the first half of 2003, pretax investment income of $554 million was 3% lower than the comparable 2002 total of $573 million. Our investment income in recent quarters has been negatively impacted by declining yields on new investments and a reduction in funds available for investment due to significant cash payments for insurance losses and loss adjustment expenses, including payments related to our runoff operations. In addition, we made a planned payment of $747 million (including interest) in mid-January 2003 related to the settlement of the Western MacArthur asbestos litigation, further reducing our invested asset base in 2003. Since the end of 1999, average new money rates on taxable and tax-exempt fixed-income securities have fallen from 7.2% and 5.4%, respectively, to 4.2% and 3.8%, respectively, at June 30, 2003. The market value of our $15.7 billion fixed income portfolio exceeded its cost by $1.23 billion at June 30, 2003. Approximately 96% of that portfolio is rated at investment grade (BBB or above). The weighted average pretax yield on those investments was 6.0% at June 30, 2003, down from 6.5% a year earlier. Net pretax realized investment gains in our property-liability insurance operations totaled $71 million in the second quarter of 2003, compared with realized losses of $38 million in the same 2002 period. The gains in 2003 were concentrated in venture capital and were almost entirely the result of the sale in May 2003 of a portion of our investment in Select Comfort Corporation, a manufacturer of adjustable air-supported beds, which generated a pretax gain of $69 million. In the second quarter of 2002, realized investment losses originated primarily from our equity investments, as we made a strategic decision to liquidate a substantial portion of that portfolio and redeploy those funds in fixed income securities. On a year-to-date basis, net pretax realized investment gains totaled $38 million in 2003, compared with realized losses of $77 million in the same 2002 period. In the first half of 2003, we sold fixed income securities with a cumulative amortized cost of $478 million, generating gross pretax gains of $25 million. Those gains were partially offset by impairment writedowns totaling $16 million. Net pretax realized losses generated by sales from our equity portfolio totaled $4 million in the first half of 2003. In our venture capital portfolio, pretax realized gains from the sale of securities totaled $94 million in the first six months of 2003, an amount that was partially offset by impairment writedowns totaling $53 million. In the first half of 2002, we sold fixed income securities with a cumulative amortized cost of $874 million, generating gross pretax gains of $24 million. Those gains were partially offset by impairment writedowns totaling $13 million attributable to WorldCom Corporation and Adelphia Corporation bonds in our portfolio. In our venture capital portfolio, impairment writedowns totaled $28 million in the first half of 2002. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued 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. Our ultimate liability for environmental claims is difficult to estimate because of these legal issues. Insured parties have submitted claims for losses that in our view are not covered in their respective insurance policies, and the final 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 our ultimate liability for asbestos claims is also very 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. Late in 2001, we hired a new Executive Vice President of Claims, with extensive experience with environmental and asbestos claims handling and environmental and asbestos reserves, who conducted a summary level review of our environmental and asbestos reserves. As a result of observations made in this review, we undertook more detailed actuarial and claims analyses of environmental reserves. No adjustment to reserves was made in the fourth quarter of 2001, since management did not have a sufficient basis for making an adjustment until such supplemental analyses were completed, and we believed our environmental and asbestos reserves were adequate as of December 31, 2001. Our historical methodology (through first quarter 2002) for reviewing the adequacy of environmental and asbestos reserves utilized a survival ratio method, which considers ending reserves in relation to calendar year paid losses. When the environmental reserve analyses were completed in the second quarter of 2002, we supplemented our survival ratio analysis with the detailed additional analyses referred to above, and concluded that our environmental reserves were redundant by approximately $150 million. Based on our additional analyses, we released approximately $150 million of environmental reserves in the second quarter of 2002. Had we continued to rely solely on our survival ratio analysis, we would have recorded no adjustment to our environmental reserves through the six months ended June 30, 2002. In the second quarter of 2002, we also supplemented our survival ratio analysis of asbestos reserves with a detailed claims analysis. We determined that, excluding the impact of the Western MacArthur settlement, our asbestos reserves were adequate; however, including that impact, we determined that our asbestos reserves were inadequate. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Environmental and Asbestos Claims (continued) -------------------------------------------- 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 35 and 36 of this report, in the second quarter of 2002 we entered into a definitive agreement to settle asbestos claims for a total gross cost of $995 million arising from any insuring relationship we and certain of our subsidiaries may have had with MacArthur Company, Western MacArthur Company or Western Asbestos Company. The table below represents a reconciliation of total gross and net environmental reserve development for the six months ended June 30, 2003, and the years ended December 31, 2002 and 2001. 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, primarily 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. Six Months Ended Environmental June 30, 2003 2002 2001 ------------- ---------------- ----------- ----------- (in millions) Gross Net Gross Net Gross Net ----------- ----- ---- ----- ---- ----- ---- Beginning reserves $370 $298 $604 $519 $684 $573 Incurred losses 22 (1) (2) (3) 6 21 Reserve reduction - - (150) (150) - - Paid losses: Not underwritten (68) (39) (70) (56) (74) (63) Underwritten (6) (6) (12) (12) (12) (12) ----- ---- ----- ---- ----- ---- Ending reserves $318 $252 $370 $298 $604 $519 ===== ==== ===== ==== ===== ==== The $150 million reduction of environmental reserves in 2002 discussed previously was included in the gross and net incurred losses for 2002. For 2001, the year-end gross and net environmental "underwritten" reserves were both $28 million, at December 31, 2002 such gross and net reserves were both $36 million, and at June 30, 2003, such gross and net reserves were $38 million and $37 million, respectively. 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 ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Environmental and Asbestos Claims (continued) -------------------------------------------- The following table represents a reconciliation of total gross and net reserve development for asbestos claims for the six months ended June 30, 2003 and the years ended December 31, 2002 and 2001. No policies have been underwritten to specifically include asbestos exposure. Six Months Ended Asbestos June 30, 2003 2002 2001 ------------- ---------------- ----------- ----------- (in millions) Gross Net Gross Net Gross Net ----------- ----- ---- ----- ---- ----- ---- Beginning reserves $1,245 $778 $577 $387 $471 $315 Incurred losses 23 - 846 482 167 116 Reserve increase - - 150 150 - - Paid losses (836) (494) (328) (241) (61) (44) ----- ---- ----- ---- ----- ---- Ending reserves $432 $284 $1,245 $778 $577 $387 ===== ==== ===== ==== ===== ==== Paid losses in 2003 include $740 million related to the Western MacArthur litigation settlement. Included in gross incurred losses in 2002 were $995 million of losses related to the Western MacArthur settlement. Also included in the gross and net incurred losses for the year ended December 31, 2002, but reported separately in the above table, was a $150 million increase in asbestos reserves. Gross paid losses in 2002 include the $248 million Western MacArthur payment made in June 2002. In 2001, we completed a periodic analysis of environmental and asbestos reserves at one of our subsidiaries in the United Kingdom. The analysis was based on a policy-by-policy review of our known and unknown exposure to damages arising from environmental pollution and asbestos litigation. The analysis concluded that loss experience for environmental exposures was developing more favorably than anticipated, while loss experience for asbestos exposures was developing less favorably than anticipated. The divergence in loss experience had an offsetting impact on respective reserves for environmental and asbestos exposures; as a result, we recorded a $48 million reduction in net incurred environmental losses in 2001, and an increase in net incurred asbestos losses for the same amount. For a discussion of potential Federal asbestos legislation, refer to the "Possible Asbestos Legislation" section on page 36 of this report. Our reserves for environmental and asbestos losses at June 30, 2003 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, we believe, 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 of $750 million at June 30, 2003 represented approximately 4% of gross consolidated loss reserves of $21.3 billion. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Asset Management ---------------- Our asset management segment consists of our 79% majority ownership interest in Nuveen Investments, Inc. ("Nuveen Investments," formerly The John Nuveen Company). Nuveen Investments provides individually managed accounts, closed-end exchange-traded funds and mutual funds to the affluent and high- net-worth market segments through unaffiliated intermediary firms. Nuveen Investments also provides managed account services to several institutional market segments and channels. Highlights of Nuveen Investments' performance for the three months and six months ended June 30, 2003 and 2002 were as follows. Three Months Ended Six Months Ended June 30 June 30 ------------------ ---------------- (in millions) 2003 2002 2003 2002 ----------- ------ ------ ------ ------ Revenues $ 106 $ 90 $ 208 $ 184 Expenses 50 40 99 85 ------ ------ ------ ------ Pretax earnings 56 50 109 99 Minority interest (12) (11) (23) (22) ------ ------ ------ ------ The St. Paul's share of pretax earnings $ 44 $ 39 $ 86 $ 77 ====== ====== ====== ====== Assets under management $88,258 $68,496 ====== ====== Nuveen Investments' gross investment product sales totaled a record $5.4 billion in the second quarter of 2003, reflecting expanding relationships with high-end financial advisors and consultants, as well as improving equity markets. Product sales in the comparable 2002 period totaled $3.3. billion. The strong growth over 2002 was driven by an increase in sales of closed-end exchange-traded funds, which primarily resulted from Nuveen Investments' introduction of their second preferred and convertible income fund in June. Retail and institutional managed accounts, as well as mutual funds, also contributed to the growth in product sales over 2002. Second-quarter 2003 sales were comprised of $2.8 billion of closed-end exchange-traded funds, $2.2 billion of retail and institutional and managed accounts and $0.4 billion of mutual funds. Nuveen Investments' net flows (equal to the sum of sales, reinvestments and exchanges, less redemptions and withdrawals) during the first six months of 2003 totaled $5.2 billion, more than double comparable 2002 net flows of $2.5 billion. Net flows through the first six months of 2003 were positive across all product lines. An increase in assets under management accounted for the growth in Nuveen Investments' revenues over the second quarter and first six months of 2002. Assets under management at the end of the second quarter consisted of $45.3 billion of closed-end exchange- traded funds, $21.7 billion of retail managed accounts, $12.3 billion of mutual funds and $9.0 billion of institutional managed accounts. The significant increase in managed assets over the same time a year ago was driven by Nuveen Investments' acquisition of NWQ Investment Management Company Inc. in August 2002, positive net flows and market appreciation. Assets under management at the end of 2002 totaled $79.7 billion. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Capital Resources ----------------- Common shareholders' equity of $6.21 billion at June 30, 2003 grew $526 million over the year-end 2002 total of $5.68 billion, driven by our net income of $395 million in the first half of 2003 and a $175 million increase in the after-tax unrealized appreciation of our investment portfolio. The decline in market interest rates during the first half of 2003 had a positive impact on the market value of our fixed income investment portfolio. Total debt outstanding at June 30, 2003 of $2.53 billion declined by $178 million from the year-end 2002 total of $2.71 billion, largely due to a net $225 million reduction in commercial paper outstanding. During the first quarter, Nuveen Investments repaid $145 million it had previously borrowed from The St. Paul under an intercompany revolving line of credit, and we used the proceeds to repay a like amount of our commercial paper outstanding. Nuveen Investments funded its repayment to us by borrowing $145 million under its revolving bank line of credit, of which Nuveen repaid $70 million in the second quarter. Debt outstanding also declined as a result of maturities of medium- term notes totaling $41 million in the first half of 2003, which were funded with internally generated funds. Our ratio of total debt obligations to total capitalization (defined as the sum of debt obligations, shareholders' equity and redeemable preferred securities) of 26% at the end of the second quarter was down from the year-end 2002 ratio of 29%. Net interest expense related to debt totaled $57 million in the first six months of 2003, compared with $53 million in the same 2002 period. The increase was primarily due to our issuance in March 2002 of $500 million of 5.75% Senior Notes and our issuance in July 2002 of $443 million of 5.25% Senior Notes, which offset a decline in interest expense related to our floating rate debt. We made no major capital improvements in the first half of 2003, and none are anticipated during the remainder of the year. Our ratio of earnings to fixed charges was 6.05 for the first six months of 2003, and our ratio of earnings to combined fixed charges and preferred stock dividend requirements was 5.72. 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 dividend requirements" by $175 million. Fixed charges consist of interest expense, distributions on preferred 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. In our insurance operations, short-term cash needs primarily consist of funds to pay insurance losses and loss adjustment expenses and day-to-day operating expenses. Those needs are generally met through 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. Net cash flows used by continuing operations totaled $833 million in the first six months of 2003, compared with cash provided from continuing operations of $82 million in the same period of 2002. Operational cash outflows in 2003 were dominated by our January 2003 payment of $747 million related to the Western MacArthur asbestos litigation settlement. Operational cash flows in the first half of 2002 were negatively impacted by a $248 million payment related to the Western MacArthur settlement. Our operations in runoff, in which we are no longer underwriting new business but continue to pay insurance losses and loss adjustment expenses, also contributed to the negative operational cash flows in 2003. For the second quarter of 2003, however, our consolidated cash flows from operations were positive (totaling $72 million), driven by favorable underwriting results from our ongoing underwriting business segments. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Liquidity (continued) -------------------- Net loss payments related to the September 11, 2001 terrorist attack totaled $145 million in the first half of 2003, compared with payments of $148 million in the same 2002 period. We expect consolidated operational cash flows during the second half of 2003 to continue to grow due to continuing price increases and improvement in the quality of our book of business in our ongoing business segments. This improvement in ongoing cash flows, however, will continue to be negatively impacted by insurance losses and loss adjustment expenses payable related to our operations in runoff. In April 2003, Moody's Investors Services, Inc. lowered certain of our financial ratings and those of our insurance underwriting subsidiaries and established a stable outlook on the ratings going forward. In June 2003, A.M. Best Co. also lowered certain of our financial ratings while affirming those of our insurance underwriting subsidiaries and maintaining stable outlooks for both sets of ratings going forward. 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. We continue to maintain an $800 million commercial paper program with $600 million of back-up liquidity, now consisting entirely of bank credit agreements. Impact of Accounting Pronouncements to be Adopted in the Future --------------------------------------------------------------- In January 2003, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"), which requires consolidation of all variable interest entities ("VIE") by the primary beneficiary, as these terms are defined in FIN 46, effective immediately for VIEs created after January 31, 2003. The consolidation requirements apply to VIEs existing on January 31, 2003 for reporting periods beginning after June 15, 2003. In addition, it requires expanded disclosure for all VIEs. We continue the process of evaluating FIN 46 and the related interpretations, and at this time we are not able to quantify the impact of adoption on our consolidated financial statements. However, we believe such adoption may have an impact on our consolidated financial statements and may affect the structure of future financial transactions that we may undertake. In April 2003, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities," which amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133. In particular, this Statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative and clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. This Statement is generally effective for contracts entered into or modified after June 30, 2003 and is to be applied prospectively. We do not expect the adoption of SFAS No. 149 to have a material impact on our consolidated financial statements. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity," which establishes standards for how an issuer classifies such financial instruments. This Statement requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments are currently classified as equity. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise shall be effective at the beginning of the first interim period beginning after June 15, 2003. For financial instruments created before the issuance date of this Statement and still existing at the beginning of the interim period of adoption, transition shall be achieved by reporting the cumulative effect of a change in accounting principle by initially measuring the financial instruments at fair value or other measurement attribute required by this Statement. We will adopt the provisions of this Statement in the quarter ended September 30, 2003, at which time we will reclassify those securities currently classified between liabilities and equity as "Company-obligated mandatorily redeemable preferred securities of trusts holding solely subordinated debentures of the company" to our liabilities. We do not expect the cumulative effect of a change in accounting principle to be recorded in the quarter ended September 30, 2003 to have a material impact on our consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Definitions of Certain Statutory Accounting Terms ------------------------------------------------- Expense Ratio - We use the statutory definition of expenses in calculating expense ratios disclosed in this report. Expenses are divided by net written premiums to arrive at the expense ratio. "Statutory" expenses differ from "GAAP" expenses primarily with regard to policy acquisition costs, which are not deferred and amortized for statutory purposes, but rather recognized as incurred. Written and Earned Premiums - Net "written" premiums are a statutory measure of premium volume that differs from the net "earned" premiums reported in our GAAP statement of operations. Written premiums for a period can be reconciled to earned premiums by adding or subtracting the change in unearned premium reserves in the period. Loss Ratio - We use the statutory definition of loss ratio. This ratio is calculated by dividing the sum of losses and loss adjustment expenses incurred by net earned premiums. Net earned premiums, and losses and loss adjustment expenses, are also GAAP measures. Combined Ratio - This ratio is the sum of the expense ratio and the loss ratio. Underwriting Result - We calculate underwriting results using statutory financial information adjusted for certain items (such as the amortization of deferred policy acquisition costs) to arrive at an underwriting result as calculated with GAAP measures. Our reported underwriting result is calculated by subtracting incurred losses and loss adjustment expenses and underwriting expenses (as adjusted for items such as the impact of deferred policy acquisition costs) from net earned premiums. This represents our best measure of profitability for our property-liability underwriting segments. A reconciliation of statutory underwriting results to our reported underwriting results can be found in the statistical supplement available on our web site. Item 3. Quantitative and Qualitative Disclosures about Market Risk. ------ ---------------------------------------------------------- For a description of our risk management policies and procedures, see the "Exposures to Market Risk" section of Management's Discussion and Analysis on pages 54 and 55 of our 2002 Annual Report to Shareholders. Item 4. Controls and Procedures. ------ ----------------------- An evaluation was carried out under the supervision and with the participation of the Company's management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-14(c) under the Securities Exchange Act of 1934), as of June 30, 2003. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the design and operation of these disclosure controls and procedures were effective. Since filing its Quarterly Report on Form 10-Q for the period ended March 31, 2003 on May 15, 2003, the Company has investigated and identified instances of noncompliance with existing internal controls and possibly with the Foreign Corrupt Practices Act relating to its Mexican subsidiary. As of the date of filing of this Quarterly Report on Form 10-Q, the Company has not identified that any material adjustment to its financial statements is necessary as a result of its investigation. The Company has notified the U.S. Securities and Exchange Commission, the U.S. Department of Justice and the Mexican Bonding and Insurance Commission of this matter. This matter does not affect the conclusions expressed in the preceding paragraph. PART II OTHER INFORMATION Item 1. Legal Proceedings. The information set forth in the "Contingencies" section (which updates information in our Annual Report on Form 10-K for the year ended December 31, 2002 pertaining to the Western MacArthur settlement agreement and certain purported class action shareholder lawsuits) of 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. The St. Paul's annual shareholders' meeting was held on May 6, 2003. (1) All twelve persons nominated for directors by the board of directors were named in proxies for the meeting which were solicited pursuant to Regulation 14A under the Securities Exchange Act of 1934. There was no solicitation in opposition to the nominees as listed in the proxy statements. All twelve nominees were elected by the following votes: In favor Withheld ----------- --------- Carolyn H. Byrd 203,146,124 4,030,033 John H. Dasburg 190,849,839 16,326,318 Janet M. Dolan 192,115,009 15,061,148 Kenneth M. Duberstein 191,968,031 15,208,126 Jay S. Fishman 202,673,345 4,502,812 Lawrence G. Graev 202,511,450 4,664,707 Thomas R. Hodgson 203,176,566 3,999,591 William H. Kling 192,015,778 15,160,379 James H. Lawrence 204,144,219 3,031,938 John A. MacColl 203,953,607 3,222,550 Glen D. Nelson 191,990,505 15,185,652 Gordon M. Sprenger 191,960,649 15,215,508 (2) By a vote of 200,722,978 in favor, 5,226,461 against and 1,227,217 abstaining, the shareholders ratified the selection of KPMG LLP as the independent auditors for The St. Paul. (3) By a vote of 10,564,806 in favor, 170,348,645 against and 2,414,693 abstaining, the shareholders rejected a shareholder proposal to recommend that the Personnel and Compensation Committee of the Board of Directors terminate The St. Paul's Senior Executive Performance Plan. 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 in a Form 8-K Current Report dated April 30, 2003 a press release related to the announcement of claim notices being received for our largest individual exposure regarding commercial surety bonds issued on behalf of companies now in bankruptcy. 2) The St. Paul furnished in a Form 8-K Current Report dated April 30, 2003 a press release related to the announcement of financial results for the quarter ended March 31, 2003. 3) The St. Paul furnished in a Form 8-K Current Report dated July 25, 2003 a press release related to the announcement of the anticipated impact on second-quarter 2003 financial results of losses recorded for a surety exposure. 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: July 30, 2003 By Bruce A. Backberg ------------- ----------------- Bruce A. Backberg Senior Vice President (Authorized Signatory) Date: July 30, 2003 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*........................................... (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*............................................ (31) Rule 13a-14(a)/15d-14(a) Certifications (a) Certification by Jay S. Fishman.....................(1) (b) Certification by Thomas A. Bradley..................(1) (32) Section 1350 Certifications (a) Certification by Jay S. Fishman.....................(1) (b) Certification by Thomas A. Bradley..................(1) (99) Additional exhibits*.......................................... * These items are not applicable. (1) Filed herewith.