-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, AoBL+g/QFS4PXJa5ol1W+qn6xgd6gf8S+Dv2vXckFzwyWdZDAusn/AXLXTUcCCHG hPF4hJ69YYSxl78uK+fw8g== 0000086312-03-000012.txt : 20031030 0000086312-03-000012.hdr.sgml : 20031030 20031030143416 ACCESSION NUMBER: 0000086312-03-000012 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 20030930 FILED AS OF DATE: 20031030 FILER: COMPANY DATA: COMPANY CONFORMED NAME: ST PAUL COMPANIES INC /MN/ CENTRAL INDEX KEY: 0000086312 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 410518860 STATE OF INCORPORATION: MN FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-10898 FILM NUMBER: 03966294 BUSINESS ADDRESS: STREET 1: 385 WASHINGTON ST CITY: SAINT PAUL STATE: MN ZIP: 55102 BUSINESS PHONE: 6123107911 FORMER COMPANY: FORMER CONFORMED NAME: ST PAUL FIRE & MARINE INSURANCE CO/MD DATE OF NAME CHANGE: 19990219 FORMER COMPANY: FORMER CONFORMED NAME: ST PAUL COMPANIES INC/MN/ DATE OF NAME CHANGE: 19990219 FORMER COMPANY: FORMER CONFORMED NAME: SAINT PAUL COMPANIES INC DATE OF NAME CHANGE: 19900730 10-Q 1 tenq303.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 September 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 October 24, 2003, was 228,156,507. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES TABLE OF CONTENTS Page No. PART I. FINANCIAL INFORMATION -------- Consolidated Statements of Operations (Unaudited), Three and Nine Months Ended September 30, 2003 and 2002 3 Consolidated Balance Sheets, September 30, 2003 (Unaudited) and December 31, 2002 4 Consolidated Statements of Shareholders' Equity, Nine Months Ended September 30, 2003 (Unaudited) and Twelve Months Ended 6 December 31, 2002 Consolidated Statements of Comprehensive Income (Loss) (Unaudited), Nine Months Ended September 30, 2003 and 2002 7 Consolidated Statements of Cash Flows (Unaudited), Nine Months Ended September 30, 2003 and 2002 8 Notes to Consolidated Financial Statements (Unaudited) 9 Forward-Looking Statement Disclosure and Certain Risks 32 Management's Discussion and Analysis of Financial Condition and Results of Operations 34 Qualitative and Quantitative Disclosures about Market Risk 66 Controls and Procedures 66 PART II. OTHER INFORMATION Item 1 through Item 6 67 Signatures 67 EXHIBIT INDEX 68 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 nine months ended September 30, 2003 and 2002 (In millions, except per share data) Three Months Ended Nine Months Ended September 30 September 30 ------------------ ---------------- 2003 2002 2003 2002 ------ ------ ------ ------ Revenues: Premiums earned $ 1,808 $ 1,937 $ 5,237 $ 5,851 Net investment income 279 302 835 881 Asset management 121 102 329 286 Realized investment gains (losses) 4 (78) 33 (148) Other 34 34 97 105 ------ ------ ------ ------ Total revenues 2,246 2,297 6,531 6,975 ------ ------ ------ ------ Expenses: Insurance losses and loss adjustment expenses 1,220 1,494 3,548 4,873 Policy acquisition expenses 389 384 1,173 1,258 Operating and administrative expenses 306 324 920 917 ------ ------ ------ ------ Total expenses 1,915 2,202 5,641 7,048 ------ ------ ------ ------ Income (loss) from continuing operations before income taxes and cumulative effect of accounting change 331 95 890 (73) Income tax expense (benefit) 94 26 257 (72) ------ ------ ------ ------ Income (loss) before cumulative effect of accounting change 237 69 633 (1) Cumulative effect of accounting change, net of taxes (21) - (21) (6) ------ ------ ------ ------ Income (loss) from continuing operations 216 69 612 (7) Discontinued operations, net of taxes (2) (6) (3) (19) ------ ------ ------ ------ Net income (loss) $ 214 $ 63 $ 609 $ (26) ====== ====== ====== ====== Basic earnings (loss) per share: Income (loss) before cumulative effect of accounting change $ 1.02 $ 0.29 $ 2.72 $ (0.06) Cumulative effect of accounting change, net of taxes (0.09) - (0.09) (0.03) ------ ------ ------ ------ Income (loss) from continuing operations 0.93 0.29 2.63 (0.09) Discontinued operations, net of taxes (0.01) (0.02) (0.01) (0.09) ------ ------ ------ ------ Net income (loss) $ 0.92 $ 0.27 $ 2.62 $ (0.18) ====== ====== ====== ====== Diluted earnings (loss) per share: Income (loss) before cumulative effect of accounting change $ 0.98 $ 0.29 $ 2.61 $ (0.06) Cumulative effect of accounting change, net of taxes (0.09) - (0.09) (0.03) ------ ------ ------ ------ Income (loss) from continuing operations 0.89 0.29 2.52 (0.09) Discontinued operations, net of taxes (0.01) (0.02) (0.01) (0.09) ------ ------ ------ ------ Net income (loss) $ 0.88 $ 0.27 $ 2.51 $ (0.18) ====== ====== ====== ====== Dividends declared per common share $ 0.29 $ 0.29 $ 0.87 $ 0.87 ====== ====== ====== ====== See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS September 30, 2003 (unaudited) and December 31, 2002 (In millions) 2003 2002 Assets ------ ------ Investments: Fixed income $16,689 $17,188 Real estate and mortgage loans 868 874 Venture capital 532 581 Equities 334 394 Securities on loan 982 806 Other investments 859 738 Short-term investments 2,409 2,152 ------ ------ Total investments 22,673 22,733 Cash 253 315 Reinsurance recoverables: Unpaid losses 7,210 7,777 Paid losses 1,088 523 Ceded unearned premiums 703 813 Receivables: Underwriting premiums 2,574 2,711 Interest and dividends 259 247 Other 231 218 Deferred policy acquisition costs 691 532 Deferred income taxes 1,159 1,267 Office properties and equipment 349 459 Goodwill 906 874 Intangible assets 140 139 Other assets 2,127 1,351 ------ ------ Total Assets $40,363 $39,959 ====== ====== See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (continued) September 30, 2003 (unaudited) and December 31, 2002 (In millions) 2003 2002 Liabilities ------ ------ Insurance reserves: Losses and loss adjustment expenses $20,899 $22,626 Unearned premiums 4,223 3,802 ------ ------ Total insurance reserves 25,122 26,428 Debt 3,573 2,713 Payables: Reinsurance premiums 894 1,010 Accrued expenses and other 993 963 Securities lending collateral 1,000 822 Other liabilities 2,513 1,388 ------ ------ Total Liabilities 34,095 33,324 ------ ------ Company-obligated mandatorily redeemable preferred securities of trusts holding solely subordinated debentures of the company - 889 ------ ------ Shareholders' Equity Preferred: Stock Ownership Plan - convertible preferred stock 99 105 Guaranteed obligation - Stock Ownership Plan (23) (40) ------ ------ Total Preferred Shareholders' Equity 76 65 ------ ------ Common: Common stock 2,646 2,606 Retained earnings 2,882 2,473 Accumulated other comprehensive income, net of taxes: Unrealized appreciation of investments 689 671 Unrealized loss on foreign currency translation (23) (68) Unrealized loss on derivatives (2) (1) ------ ------ Total accumulated other comprehensive income 664 602 ------ ------ Total Common Shareholders' Equity 6,192 5,681 ------ ------ Total Shareholders' Equity 6,268 5,746 ------ ------ Total Liabilities, Mandatorily Redeemable Preferred Securities and Shareholders' Equity $40,363 $39,959 ====== ====== See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Nine Months Ended September 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 (6) (6) ------ ------ End of period 99 105 ------ ------ Guaranteed obligation - Stock Ownership Plan: Beginning of period (40) (53) Principal payments 17 13 End of period ------ ------ (23) (40) Total Preferred ------ ------ Shareholders' Equity 76 65 ------ ------ Common Shareholders' Equity: Common stock: Beginning of period 2,606 2,192 Stock issued: Stock incentive plans 27 32 Preferred shares redeemed 12 13 Net proceeds from stock offering - 413 Present value of equity unit forward purchase contracts - (46) Other 1 2 ------ ------ End of period 2,646 2,606 ------ ------ Retained earnings: Beginning of period 2,473 2,500 Net income 609 218 Dividends declared on common stock (198) (252) Dividends declared on preferred stock, net of taxes (6) (9) Deferred compensation - restricted stock (4) (5) Tax benefit on employee stock options, and other changes 15 28 Premium on preferred shares redeemed (6) (7) Reacquired shares (1) - ------ ------ End of period 2,882 2,473 ------ ------ Unrealized appreciation on investments, net of taxes: Beginning of period 671 442 Change during the period 18 229 ------ ------ End of period 689 671 ------ ------ Unrealized loss on foreign currency translation, net of taxes: Beginning of period (68) (76) Currency translation adjustments 45 8 ------ ------ End of period (23) (68) ------ ------ Unrealized loss on derivatives, net of taxes: Beginning of period (1) (2) Change during the period (1) 1 ------ ------ End of period (2) (1) ------ ------ Total Common Sharehoders' Equity 6,192 5,681 ------ ------ Total Shareholders' Equity $ 6,268 $ 5,746 ====== ====== See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) For the three months and nine months ended September 30, 2003 and 2002 (In millions) Three Months Nine Months Ended September 30 Ended September 30 ------------------ ------------------ (in millions) 2003 2002 2003 2002 ----------- ----- ----- ----- ----- Net income (loss) $ 214 $ 63 $ 609 $ (26) ----- ----- ----- ----- Other comprehensive income (loss), net of taxes: Change in unrealized appreciation of investments (157) 164 18 185 Change in unrealized loss on foreign currency translation (13) (8) 45 3 Change in unrealized loss on derivatives (4) - (1) 2 ----- ----- ----- ----- Other comprehensive income (loss) (174) 156 62 190 ----- ----- ----- ----- Comprehensive income $ 40 $ 219 $ 671 $ 164 ===== ===== ===== ===== See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Nine Months Ended September 30, 2003 and 2002 (Unaudited) (In millions) 2003 2002 ------ ------ Operating Activities: Net income (loss) $ 609 $ (26) Adjustments: Loss from discontinued operations 3 19 Change in property-liability insurance reserves (1,369) 163 Change in reinsurance balances 429 (181) Change in deferred acquisition costs (160) 2 Change in insurance premiums receivable 140 342 Change in accounts payable and accrued expenses (99) (72) Change in income taxes payable /refundable 70 186 Realized investment (gains) losses (33) 148 Provision for federal deferred tax expense (benefit) 84 (133) Depreciation and amortization 70 67 Cumulative effect of accounting change 21 6 Other (55) (86) ------ ------ Net Cash Provided (Used) by Operating Activities (290) 435 ------ ------ Investing Activities: Net purchases of short-term investments (162) (679) Purchases of other investments (3,613) (6,011) Proceeds from sales and maturities of other investments 4,167 5,929 Change in open security transactions 59 111 Venture capital distributions - 77 Purchase of office property and equipment (34) (47) Sales of office property and equipment 79 10 Acquisitions, net of cash acquired (15) (195) Other (25) 67 ------ ------ Net Cash Provided (Used) by Continuing Operations 456 (738) Net Cash Used by Discontinued Operations (19) (1) ------ ------ Net Cash Provided (Used) by Investing Activities 437 (739) ------ ------ Financing Activities: Dividends paid on common and preferred stock (204) (185) Proceeds from issuance of debt 300 941 Repayment of debt and preferred securities (346) (534) Net proceeds from issuance of common shares - 413 Subsidiary's repurchase of common shares (31) (133) Stock options exercised and other 68 70 ------ ------ Net Cash Provided (Used) by Financing Activities (213) 572 ------ ------ Effect of exchange rate changes on cash 4 10 ------ ------ Increase (decrease) in cash (62) 278 Cash at beginning of period 315 151 ------ ------ Cash at end of period $ 253 $ 429 ====== ====== See notes to consolidated financial statements. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Unaudited September 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 December 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 nine months ended September 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. Partial Adoption of FIN 46 - -------------------------- In 2003, we partially adopted the provisions of FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"), which sets forth accounting and disclosure rules for "variable interest entities," as defined in the Interpretation. See Note 14 in this report for further discussion regarding the impact of our partial adoption of FIN 46. Adoption of SFAS No. 150 - ------------------------ In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity", which generally requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). We adopted the provisions of SFAS 150 in the third quarter of 2003. Our only financial instruments that fell within the scope of SFAS No. 150 were the "Company-obligated mandatorily redeemable preferred securities of trusts holding solely subordinated debentures of the company" that had been classified as a separate line between liabilities and shareholders' equity on our consolidated balance sheet. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 1 - Basis of Presentation (continued) - ----------------------------------------- These securities were issued by five separate trusts which are included in our consolidated financial statements. In accordance with SFAS No. 150, we have reclassified these securities to liabilities on our consolidated balance sheet in 2003, where they are included in our total debt outstanding. The carrying value of these securities in total is $897 million, representing the present value of the expected future payment of these obligations, discounting at the respective dividend distribution rates implicit at inception, which were equal to the contract rates, as prescribed by SFAS No. 150. Adoption of SFAS No. 142 - ------------------------ In the first quarter of 2002, we began implementing the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets," which established financial accounting and reporting for acquired goodwill and other intangible assets. The statement changed prior accounting 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 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. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 1 - Basis of Presentation (continued) - ----------------------------------------- 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 Nine Months Ended September 30 Ended September 30 ------------------ ------------------ (in millions, except per share data) 2003 2002 2003 2002 ----- ----- ----- ----- Net income (loss): As reported* $ 214 $ 63 $ 609 $ (26) Less: Additional stock- based employee compensation expense determined under fair value-based method for all awards, net of related tax effects (9) (11) (30) (28) ----- ----- ----- ----- Pro forma $ 205 $ 52 $ 579 $ (54) ===== ===== ===== ===== Basic earnings (loss) per common share: As reported $0.92 $ 0.27 $2.62 $(0.18) ===== ===== ===== ===== Pro forma $0.88 $ 0.22 $2.49 $(0.31) ===== ===== ===== ===== Diluted earnings (loss) per common share: As reported $0.88 $ 0.27 $2.51 $(0.18) ===== ===== ===== ===== Pro forma $0.86 $ 0.22 $2.38 $(0.31) ===== ===== ===== ===== *As reported net income (loss) included $1 million of stock-based compensation expenses, net of related tax benefits, in each of the quarters ended September 30, 2003 and 2002, respectively. On a year-to-date basis, as reported net income (loss) included $4 million and $7 million of such expenses, respectively, in 2003 and 2002. 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 nine months ended September 30, 2003 and 2002. Three Months Ended Nine Months Ended September 30 September 30 (in millions, except ------------------ ----------------- (per share data) 2003 2002 2003 2002 -------------- ----- ----- ----- ----- Earnings Basic: Net income (loss), as reported $ 214 $ 63 $ 609 $ (26) Preferred stock dividends, net of taxes (2) (2) (6) (6) Premium on preferred shares redeemed (2) (1) (6) (6) ----- ----- ----- ----- Net income (loss) available to common shareholders $ 210 $ 60 $ 597 $ (38) ===== ===== ===== ===== Diluted: Net income (loss) available to common shareholders $ 210 $ 60 $ 597 $ (38) Dilutive effect of affiliates (1) - (3) - Effect of dilutive securities: Convertible preferred stock 1 2 5 - Zero coupon convertible notes 1 1 2 - ----- ----- ----- ----- Net income (loss) available to common shareholders $ 211 $ 63 $ 601 $ (38) ===== ===== ===== ===== Common Shares Basic: Weighted average common shares outstanding 228 221 228 212 ===== ===== ===== ===== Diluted: Weighted average common shares outstanding 228 221 228 212 Effect of dilutive securities: Stock options and other incentive plans 1 1 1 - Convertible preferred stock 6 6 6 - Zero coupon convertible notes 2 2 2 - Equity unit stock purchase contracts 3 - 2 - ----- ----- ----- ----- Total 240 230 239 212 ===== ===== ===== ===== Earnings (Loss) per Common Share Basic $ 0.92 $ 0.27 $ 2.62 $(0.18) ===== ===== ===== ===== Diluted $ 0.88 $ 0.27 $ 2.51 $(0.18) ===== ===== ===== ===== Diluted EPS is the same as Basic EPS for the nine months ended September 30, 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 nine months ended September 30, 2003 and 2002. Nine Months Ended September 30 ------------------ (in millions) 2003 2002 ----- ----- Purchases: Fixed income $3,022 $4,856 Equities 434 644 Real estate and mortgage loans - 3 Venture capital 84 160 Other investments 73 348 ----- ----- Total purchases 3,613 6,011 ----- ----- Proceeds from sales and maturities: Fixed income 3,514 4,225 Equities 553 1,570 Real estate and mortgage loans 10 76 Venture capital 58 53 Other investments 32 5 ----- ----- Total sales and maturities 4,167 5,929 ----- ----- Net purchases (sales) $ (554) $ 82 ===== ===== 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: Nine Months Ended Year Ended September 30 December 31 (in millions) 2003 2002 ----------- ------------ ------------ Pretax: Fixed income $ (16) $ 446 Equities 51 (17) Venture capital (14) (88) Other 20 8 ----- ----- Total increases in pretax unrealized appreciation 41 349 Increase in deferred taxes (23) (120) ----- ----- Total change in unrealized appreciation, net of taxes $ 18 $ 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 (loss) from continuing operations before cumulative effect of accounting change were as follows: Three Months Nine Months Ended Ended September 30 September 30 ------------- ------------- (in millions) 2003 2002 2003 2002 ----------- ----- ----- ----- ----- Income tax expense (benefit): Federal current $ 2 $ 72 $ 152 $ 43 Federal deferred 83 (51) 84 (133) ----- ----- ----- ----- Total federal income tax expense (benefit) 85 21 236 (90) Foreign 5 2 12 10 State 4 3 9 8 ----- ----- ----- ----- Total income tax expense (benefit) on income (loss) from continuing operations before cumulative effect of accounting change $ 94 $ 26 $ 257 $ (72) ===== ===== ===== ===== 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 nine months of 2003, payments made in the ordinary course of funding these venture capital investments reduced our total future estimated obligations by $92 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 in the period during which such resolution occurs. 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. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 5 - Commitments, Contingencies and Guarantees (continued) - ------------------------------------------------------------- Note 17 on page 83 of our 2002 Annual Report to Shareholders includes a summary of certain litigation matters with contingencies, including the following matters for which there were additional developments in 2003. 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 September 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. Boson v. Union Carbide Corp., et al; and Abernathy v. Ace American Ins. Co., et al - In 2003, lawsuits have been filed in Texas and Ohio 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. In this regard, we filed special exceptions in all of the Texas cases. In October 2003, a court ruled on the special exceptions in 11 of those cases, dismissing the cases with prejudice. We view this as a significant ruling in our favor. The special exceptions in the remaining 51 cases have not yet been ruled upon. World Trade Center Litigation - In 2002, we and certain other insurers obtained a summary judgment ruling that the World Trade Center ("WTC") property loss on September 11, 2001 was a single occurence. Certain insureds, including the WTC's leaseholder, appealed that ruling, asking the court to determine that the property loss constituted two separate occurrences rather than one. In September 2003, the U.S Circuit Court of Appeals for the Second Circuit of New York ruled that under terms of the policy form we used to underwrite property coverage for the WTC, the terrorist attack constituted one occurrence. 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 THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 5 - Commitments, Contingencies and Guarantees (continued) - ------------------------------------------------------------- Platinum Underwriters Holdings, Ltd. See Note 2 in our Annual Report to Shareholders for a more detailed description of the Platinum transfer. During the first nine months of 2003, guarantee expirations, reductions in outstanding obligations, the effects of foreign exchange rates, and the adoption of FIN 46, "Consolidation of Variable Interest Entities" ("FIN 46"), resulted in a $37 million decrease in potential obligations for guarantees that were disclosed 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 the third quarter of 2003, we sold our subsidiary Botswana Insurance Company Ltd. for total proceeds of $11 million, and recorded a pretax loss of less than $1 million. As part of the sale agreement, we agreed to provide certain indemnifications to the third party purchaser. While the agreement included an unlimited indemnification provision in connection with tax liabilities arising prior to the transfer of ownership, with survival until the applicable statutes of limitation expire, we estimate that the fair value of this guarantee is not material to our consolidated financial statements. Note 6 - Debt - ------------- Debt consisted of the following at September 30, 2003 and December 31, 2002: September 30, 2003 December 31, 2002 ------------------ ----------------- (in millions) Book Fair Book Fair ----------- Value Value Value Value ----- ----- ----- ----- Debt: ---- 5.75% senior notes $ 499 $ 538 $ 499 $ 515 Medium-term notes 470 510 523 559 5.25% senior notes 443 467 443 461 Nuveen notes payable 302 302 55 55 7.875% senior notes 249 272 249 274 8.125% senior notes 249 309 249 280 Commercial paper 140 140 379 379 Zero coupon convertible notes 111 113 107 110 7.125% senior notes 80 87 80 87 Variable rate borrowings 64 64 64 64 ----- ----- ----- ----- Subtotal-debt 2,607 2,802 2,648 2,784 ----- ----- ----- ----- Mandatorily redeemable preferred securities: ------------------------------- 7.6% securities 575 612 - - 7.625% securities 121 120 - - 8.47% securities 78 82 - - 8.312% securities 70 75 - - 8.5% securities 53 58 - - ----- ----- ----- ----- Subtotal-redeemable preferred securities 897 947 - - ----- ----- ----- ----- Fair value of interest rate swap agreements 69 69 65 65 ----- ----- ----- ----- Total debt reported on balance sheet $3,573 $3,818 $2,713 $2,849 ===== ===== ===== ===== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 6 - Debt (continued) - ------------------------ As described in more detail in Note 1 of this report, in the third quarter of 2003, we adopted the provisions of SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." As a result, the "Company-obligated mandatorily preferred securities of trusts holding solely subordinated debentures of the company" ("Mandatorily redeemable preferred securities" in the foregoing table) previously reported separately on our consolidated balance sheet between liabilities and shareholders' equity are now included in liabilities as a component of debt. These securities were issued by five separate trusts and are subject to mandatory redemption on dates ranging from 2027 to 2050, but can be redeemed earlier in accordance with conditions that vary among the five trusts. For a complete description of these mandatorily redeemable preferred securities, refer to Note 13 on pages 76 through 78 in our 2002 Annual Report to Shareholders. In accordance with provisions of SFAS No. 150, prior periods were not restated to conform with the 2003 classification of these securities as liabilities. Accordingly, our consolidated balance sheet for the year ended December 31, 2002, presents these securities as a separate line between liabilities and shareholders' equity. In September 2003, Nuveen Investments issued $300 million of 4.22% notes in a private placement. The notes mature in 2008. A portion of the proceeds was used to refinance existing debt and repay a $105 million loan from The St. Paul. The remainder will be used for Nuveen Investments' general corporate purposes. The $302 million carrying value of Nuveen Investments' newly-issued debt in the foregoing table includes the unamortized gain from the cancellation of prior interest rate swap transactions entered into in anticipation of the private placement, as well as unamortized private placement debt issue costs. At September 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 $880 million. Their aggregate fair value at September 30, 2003, was recorded as an asset of $69 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. - 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. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 7 - Segment Information (continued) - --------------------------------------- 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 the United Kingdom, Canada (other than Surety) 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 mostly through a single wholly-owned syndicate: Aviation, Marine, Global Property and Personal 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 ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 7 - Segment Information (continued) - --------------------------------------- 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, including our participation in the insuring of the Lloyd's Central Fund; 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 Nine Months Ended Ended September 30 September 30 ------------- ------------- (in millions) 2003 2002 2003 2002 ----------- ----- ----- ----- ----- Revenues from Continuing Operations: Underwriting: Ongoing Operations: Specialty Commercial: Specialty $ 609 $ 462 $1,662 $1,329 Surety and Construction 323 285 947 851 International and Lloyd's 270 229 816 585 ----- ----- ----- ----- Total Specialty Commercial 1,202 976 3,425 2,765 Commercial Lines 523 421 1,461 1,271 ----- ----- ----- ----- Total Ongoing Insurance Operations 1,725 1,397 4,886 4,036 ----- ----- ----- ----- Runoff Operations: Other: Health Care 20 143 63 443 Reinsurance 46 303 219 985 Other Runoff 17 94 69 387 ----- ----- ----- ----- Total Other 83 540 351 1,815 ----- ----- ----- ----- Total Underwriting 1,808 1,937 5,237 5,851 ----- ----- ----- ----- Investment operations: Net investment income 279 300 833 873 Realized investment gains (losses) 5 (74) 43 (151) ----- ----- ----- ----- Total investment operations 284 226 876 722 ----- ----- ----- ----- Other 37 30 98 94 ----- ----- ----- ----- Total property- liability insurance 2,129 2,193 6,211 6,667 ----- ----- ----- ----- Asset management 121 102 329 286 ----- ----- ----- ----- Total reportable segments 2,250 2,295 6,540 6,953 Parent company and other operations (4) 2 (9) 22 ----- ----- ----- ----- Total revenues $2,246 $2,297 $6,531 $6,975 ===== ===== ===== ===== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 7 - Segment Information (continued) - --------------------------------------- Three Months Nine Months Ended Ended September 30 September 30 ------------- ------------- (in millions) 2003 2002 2003 2002 ----------- ----- ----- ----- ----- Income (Loss) from Continuing Operations Before Income Taxes and Cumulative Effect of Accounting Change: Underwriting result: Ongoing Operations: Specialty Commercial: Specialty $ 107 $ 60 $ 248 $ 121 Surety and Construction (40) (38) (113) (32) International and Lloyd's 12 34 74 34 ----- ----- ----- ----- Total Specialty Commercial 79 56 209 123 Commercial Lines 58 41 132 84 ----- ----- ----- ----- Total Ongoing Insurance Operations 137 97 341 207 ----- ----- ----- ----- Runoff Operations: Other: Health Care (4) (71) (37) (164) Reinsurance (1) (25) 2 (14) Other Runoff (60) (96) (178) (726) ----- ----- ----- ----- Total Other (65) (192) (213) (904) ----- ----- ----- ----- Total Underwriting result 72 (95) 128 (697) Investment operations: Net investment income 279 300 833 873 Realized investment gains (losses) 5 (74) 43 (151) ----- ----- ----- ----- Total investment operations 284 226 876 722 ----- ----- ----- ----- Other (9) (18) (61) (55) ----- ----- ----- ----- Total property- liability insurance 347 113 943 (30) ----- ----- ----- ----- Asset management: Pretax income, before minority interest 61 53 170 152 Minority interest (12) (11) (35) (33) ----- ----- ----- ----- Total asset management 49 42 135 119 ----- ----- ----- ----- Total reportable segments 396 155 1,078 89 Parent company and other operations (65) (60) (188) (162) ----- ----- ----- ----- Total income (loss) from continuing operations before income taxes and cumulative effect of accounting change $ 331 $ 95 $ 890 $ (73) ===== ===== ===== ===== 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 nine months of 2003 included the results of those operations for the fourth quarter of 2002 and the first nine months of 2003, whereas our results for the nine months ended September 30, 2002, included the results of those operations for the fourth quarter of 2001 and the first six months of 2002. The year-to-date incremental impact on our property-liability operations of eliminating the reporting lag, consisting of the results of these operations for the quarter ended September 30, 2003, was as follows. (in millions) ----------- Specialty Commercial Other Total ---------- ------ ------ Net written premiums $ 83 $ 5 $ 88 Decrease in unearned premiums (20) - (20) ----- ----- ----- Net earned premiums 63 5 68 Incurred losses and underwriting expenses 69 23 92 ----- ----- ----- Underwriting result (6) (18) (24) Net investment income 2 2 4 Other income 6 - 6 ----- ----- ----- Total pretax income (loss) $ 2 $ (16) $ (14) ===== ===== ===== 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 third quarter and first nine months of 2003, this reclassification had the impact of increasing both net earned premiums and policy acquisition costs by $22 million and $61 million, respectively, compared with what would have been recorded under our prior method of estimation. In addition, net written premiums increased by $13 million and $92 million for the third quarter and first nine months of 2003, respectively (a portion of which was due to the elimination of the one-quarter reporting lag). For the third quarter and first nine months of 2002, the impact was an increase to both net earned premiums and policy acquisition costs of $9 million and $69 million, respectively, and an increase to net written premiums of $8 million and $74 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 effects of assumed and ceded reinsurance on premiums written, premiums earned and insurance losses and loss adjustment expenses were as follows: Three Months Nine Months Ended Ended September 30 September 30 ------------- ------------- (in millions) 2003 2002 2003 2002 ----------- ---- ---- ---- ---- Premiums written Direct $2,150 $1,883 $6,189 $5,629 Assumed 314 432 1,312 1,782 Ceded (516) (493) (1,782) (1,628) ----- ----- ----- ----- Net premiums written $1,948 $1,822 $5,719 $5,783 ===== ===== ===== ===== Premiums earned Direct $2,050 $1,942 $5,882 $5,626 Assumed 344 487 1,246 1,752 Ceded (586) (492) (1,891) (1,527) ----- ----- ----- ----- Net premiums earned $1,808 $1,937 $5,237 $5,851 ===== ===== ===== ===== Insurance losses and loss adjustment expenses Direct $1,379 $1,420 $3,899 $5,136 Assumed 243 288 870 1,064 Ceded (402) (214) (1,221) (1,327) ----- ----- ----- ----- Net insurance losses and loss adjustment expenses $1,220 $1,494 $3,548 $4,873 ===== ===== ===== ===== 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 at Charges to Pre-tax at Dec. 31, September 30, earnings: Charge 2002 Payments Adjustments 2003 -------- ---------- -------- ----------- ---------- Employee- related $ 46 $ 14 $ (2) $ - $ 12 Occupancy- related 9 8 (2) - 6 Equipment charges 4 N/A N/A N/A N/A Legal costs 3 - - - - ----- ----- ----- ----- ----- Total $ 62 $ 22 $ (4) $ - $ 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 at Pre-tax at Dec. 31, September 30, Charge 2002 Payments Adjustments 2003 -------- ---------- -------- ----------- ---------- Lease commitments charged to earnings: $ 91 $ 24 $ (7) - $ 17 ===== ===== ===== ===== ===== 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 and $20 million for the three months and nine months ended September 30, 2003, respectively, compared with $5 million and $14 million, in the respective 2002 periods. The following presents a summary of our acquired intangible assets. As of September 30, 2003 (in millions) ------------------------------------------- ----------- Gross Foreign Amortizable Carrying Accumulated Exchange Net intangible assets: Amount Amortization Effects Amount -------- ------------ -------- ------ Present value of future profits $ 70 $ (24) $ 4 $ 50 Customer relationships 67 (8) - 59 Renewal rights 43 (13) - 30 Internal use software 2 (1) - 1 ----- ----- ---- ---- Total $ 182 $ (46) $ 4 $ 140 ===== ===== ==== ==== At September 30, 2003, we estimated our amortization expense for the next five years to be as follows: $24 million in 2004, $20 million in 2005, $16 million in 2006, $13 million in 2007, and $11 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 September 30, Segment 2002 Acquired Losses 2003 ----------- -------- -------- --------- --------- Specialty Commercial $ 80 $ 2 $ - $ 82 Commercial Lines 33 - - 33 Asset Management 752 29 - 781 Property-Liability Investment Operations 9 1 - 10 ----- ----- ----- ----- Total $ 874 $ 32 $ - $ 906 ===== ===== ===== ===== 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 Specialty Commercial segment was due to the effects of foreign exchange rates applied to existing goodwill balances. The increase in goodwill in our Asset Management segment was a result of Nuveen Investments' purchase of shares from minority shareholders, as well as additional payments of $12 million for contingent consideration related to a prior period acquisition. The increase to goodwill in our Property-Liability Investment Operations segment was due to the adoption of FIN 46, "Consolidation of Variable Interest Entities" ("FIN 46"), and the resultant consolidation of certain venture capital operations. See Note 14 in this report for a description of the adoption of FIN 46. In the second quarter of 2003, we performed 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 in 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 unlikely that any additional payment would exceed $30 million. Our consolidated gross written premiums for the third quarter and nine months ended September 30, 2003 included approximately $165 million and $199 million, respectively, attributable to business underwritten as a result of this purchase of renewal rights, the majority of which were included in our Commercial Lines segment. 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. In the first nine months of 2003 and 2002, we recorded pretax losses of $3 and $12 million, respectively, in discontinued operations, related to claims in respect of pre-sale losses. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued 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 $880 million (including $150 million at Nuveen Investments, as described below). 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 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 nine months ended September 30, 2003, and September 30, 2002, was a $4 million increase and a $42 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. During the quarter ended September 30, 2003, Nuveen Investments entered into a series of interest rate swap transactions with notional amounts totaling $150 million. All of the interest rate swap transactions were designated as fair value hedges as they mitigated the changes in fair value of the hedged portion of the $300 million of debt Nuveen Investments issued in September 2003 in a private placement (one-half of the total firm commitment of $300 million). Prior to the close of the private placement debt, the swap transactions were terminated. The cancellation of these interest rate swap transactions resulted in a total gain to the Company of $3 million. In accordance with generally accepted accounting principles, this gain is being amortized over the term of the private placement debt. 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 nine months ended September 30, 2003, we recognized a less than $1 million gain on the cash flow hedges, which is included in "Other Comprehensive Income." The comparable amount for the nine months ended September 30, 2002, was a $1 million gain. The amounts included in Other Comprehensive Income will be realized in earnings concurrent with the timing of the hedged cash flows. We anticipate that a $1 million loss will be reclassified into earnings within the next twelve months. In the nine months ended September 30, 2003, and September 30, 2002, the ineffective portion of the hedge resulted in a gain of less than $1 million in both periods. During the quarter ended September 30, 2003, in anticipation of its private placement debt issuance, Nuveen Investments entered into two treasury rate lock transactions with an aggregate notional amount of $100 million. These treasury rate locks were designated as cash-flow hedges. The treasury rate locks were settled for approximately $2 million. We deferred this loss in "Other Comprehensive Income" as the treasury rate locks were considered highly effective in eliminating the interest rate risk on the forecasted debt issuance. Amounts accumulated in other comprehensive income will be reclassified to earnings commensurate with the recognition of the interest expense on the newly issued debt. 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, stock warrants in our venture capital business, and foreign currency forwards. We recorded $14 million and $2 million of income in continuing operations for the nine months ended September 30, 2003, and September 30, 2002, respectively, relating to the change in the market value of these derivatives during the period. We also recorded a $21 million loss in discontinued operations for the nine months ended September 30, 2002, relating to non-hedge derivatives associated with the sale of our life business. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued 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. Accordingly, we began applying the consolidation requirements for these new VIEs in the first quarter of 2003. For VIEs created before January 31, 2003, FIN 46 was originally effective for reporting periods beginning after June 15, 2003, which for us is the quarter ended September 30, 2003. However, on October 9, 2003 the FASB issued FASB Staff Position ("FSP") FIN 46-6, "Effective Date of FASB Interpretation No. 46, Consolidation of Variable Interest Entities," which deferred the effective date until the first interim or annual period ending after December 15, 2003, but permitted early and partial adoption. As a result of our partial adoption of FIN 46, we consolidated twelve entities (summarized below) that we had not previously consolidated. As a result, we recorded a loss of $21 million (net of a deferred tax benefit of $3 million) on our consolidated statements of operations in the third quarter of 2003, classified as a "cumulative effect of accounting change" and representing the cumulative impact of FIN 46 on periods prior to the July 1, 2003 date of adoption. The entities consolidated were as follows. - Investment - We hold an investment in an insurance company that provides insurance coverage to markets in Baltimore and Washington D.C. Our investment includes a substantial majority of the company's convertible preferred stock, but none of its voting common stock. As a result of our economic interest in the entity, we have the majority exposure to variability through our preferred stock ownership and a loan to the company, both of which are considered variable interests as defined in FIN 46. Accordingly, we began consolidating this entity in the third quarter. The carrying value of this investment is approximately $3 million. - Municipal Trusts - We own interests in various municipal trusts that were formed for the purpose of allowing us to more flexibly generate investment income in a manner consistent with our investment objectives and tax position. As of September 30, 2003, there were 36 such trusts, which held a combined total of $450 million in municipal securities, of which eight had not been included in our consolidated financial statements prior to our adoption of FIN 46 because we did not hold majority ownership in them. However, we do have the majority exposure to variability for these trusts. Therefore, we began consolidating these eight trusts in the third quarter of 2003. - Venture Capital Entities - In our venture capital investment portfolio, we have numerous investments in small- to medium-sized companies, in which we have variable interests through stock ownership and, in some cases, loans. All of these investments are held for the purpose of generating investment returns, and the companies in which we invest span a variety of business sectors, including technology, telecommunications and healthcare. As a result of our review of this portfolio, we identified three entities that were required to be consolidated under the provisions of FIN 46. The consolidation of the foregoing entities had the net impact of increasing (decreasing) the balance sheet and statement of operations' captions by the amounts indicated in the following table. Municipal Venture (in millions) Investment Trusts Capital Total ----------- ---------- --------- ------- ----- Assets $(14) $ 84 $ (1) $ 69 Liabilities 3 84 3 90 ---- ---- ---- ---- Cumulative effect of accounting change $(17) $ - $ (4) $ (21) ==== ==== ==== ==== Other revenue $ - $ 1 $ 1 $ 2 Operating and administrative expenses $ - $ 1 $ 1 $ 2 THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 14 - Variable Interest Entities (continued) - ----------------------------------------------- In addition to the foregoing entities that were consolidated pursuant to FIN 46, we also hold significant interests in other variable interest entities for which we are not considered to be the primary beneficiary. FIN 46 requires that information about these entities be disclosed, as follows. - We have a significant variable interest in two real estate entities, but we are not considered to be the primary beneficiary. The total carrying value of these entities was approximately $57 million as of September 30, 2003, which also represents our maximum exposure to loss. The purpose of our involvement in these entities is to generate investment returns. Our partial adoption of FIN 46 specifically excluded the following items. - Mandatorily redeemable preferred securities of trusts holding solely subordinated debentures of the company ("Preferred Securities") - These securities have a carrying value of $897 million and are currently reported in the liability section of our Consolidated Balance Sheet, as newly required under SFAS 150 (see further discussion regarding the adoption of SFAS 150 in Note 1 of this report). These securities were issued by five separate trusts that were established for the sole purpose of issuing the securities to investors and are currently included in our consolidated financial statements. We are currently evaluating the implications of FIN 46 with regard to these trusts. - Lloyd's Syndicates - We participate in various Lloyd's syndicates at varying levels. These syndicates are essentially markets where insureds can obtain coverage for a variety of risks. We continue to evaluate the implications of FIN 46 with respect to these syndicates. 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. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Note 15 - Health Care Exposures (continued) - ------------------------------------------ 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, 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%. In the third quarter of 2003, the dollar amount of newly reported claims totaled $108 million, approximately 10% higher than we anticipated in our original estimate of the required level of reserves at year-end 2002. However, through the first nine months of 2003, the dollar amount of newly reported claims was approximately 7% lower than we anticipated due to the positive variance in the first quarter. Loss development on known claims during the third quarter of 2003 was worse than anticipated. Our actual redundancy ratio continued to improve in the third quarter of 2003; however, since newly reported claims and loss development on known claims again did not improve as much as we expected in the third quarter, the required reserve redundancy has increased from the previously estimated range of 35% to 40% to approximately 45%. 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 results of these indicators support our current view that we have recorded a reasonable provision for our medical malpractice exposures as of September 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. As noted above, development on known claims is a key metric in our evaluation of our Health Care reserves. While we have experienced adverse development on known claims at year-end 2002, the magnitude of that development has declined throughout 2003. If, however, we experience further adverse reserve development on those claims, and such development is not offset by a favorable change in our estimate of newly reported claims, and we further conclude that an increase in the required redundancy ratio to a level above 45% is necessary, we may determine that additional reserving actions are necessary. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued 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 the first nine months of 2003. (in millions) ----------- Net written premiums $ 347 Decrease in unearned premiums (74) ---- Net earned premiums 421 Incurred losses and loss adjustment expenses 209 Underwriting expenses 105 ---- Net ceded result $ 107 ==== The following Platinum-related balances were included in our consolidated balance sheet at September 30, 2003. (in millions) ----------- Assets: Reinsurance recoverable-paid losses $ 30 Reinsurance recoverable-unpaid losses $435 Ceded unearned premiums $ 84 Liabilities: Funds held for reinsurers $ 17 Ceded premiums payable $164 Note 17 - Surety Claim and Exposure - ----------------------------------- In 2003, we recorded an $89 million pretax loss provision (net of reinsurance) in our Surety underwriting operation related to one of our accounts that was in bankruptcy and unable 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 $89 million net pretax loss provision recorded in 2003 represented our estimated loss in this matter. We have provided surety bond coverage to a construction contractor that failed to make payments under certain of its debt obligations during the third quarter of 2003. The contractor has developed a plan to restructure its operations and financing, and is negotiating revisions to its credit arrangements. In the third quarter of 2003, following our detailed review of this plan, we made collateralized advances to the contractor. Based on information available to us, we believe that the contractor will be able to complete projects as contemplated by its plan. As part of the plan, we may issue bonds for new projects undertaken by the contractor, subject to our underwriting criteria. We expect our advances to be fully repaid by cash flow from the contractor's operations, planned asset sales, reinsurance recoveries and, if necessary, recovery on collateral. Accordingly, we do not expect to incur a significant loss with respect to this account. However, in the unlikely event that the contractor fails to complete all of its current projects, we estimate that our aggregate loss, net of estimated collateral, reinsurance recoveries and participation by co-sureties (one of which has experienced ratings downgrades and is in runoff), would not exceed $80 million, on an after-tax basis assuming a 35% statutory tax rate. Note 18 - Subsequent Event - -------------------------- In October 2003, we sold our subsidiary, Octagon Risk Services, Inc., a claim management and consulting services company, for proceeds of approximately $30 million. 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; - statements concerning claims made on surety bonds and the amounts we may ultimately pay with respect to these claims; and - statements concerning our estimated maximum exposure in respect of a contract surety customer. 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; - in the case of a large contract surety exposure, risks relating to the implementation of the customer's restructuring plan; - 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 September 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. Annual statements for our domestic insurance subsidiaries that were filed with state regulatory authorities in the last two years are also available through our website. 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 nine months ended September 30, 2003 and 2002. Three Months Nine Months Ended Ended September 30 September 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 $ 72 $ (95) $ 128 $(697) Net investment income 279 300 833 873 Realized investment gains (losses) 5 (74) 43 (151) Other expenses (9) (18) (61) (55) ---- ---- ---- ---- Total property- liability insurance 347 113 943 (30) Asset management 49 42 135 119 Parent and other operations (65) (60) (188) (162) ---- ---- ---- ---- Income (loss) from continuing operations before income taxes and cumulative effect of accounting change 331 95 890 (73) Income tax expense (benefit) 94 26 257 (72) ---- ---- ---- ---- Income (loss) from continuing operations before cumulative effect of accounting change 237 69 633 (1) Cumulative effect of accounting change, net of taxes (21) - (21) (6) ---- ---- ---- ---- Income (loss) from continuing operations 216 69 612 (7) Discontinued operations, net of taxes (2) (6) (3) (19) ---- ---- ---- ---- Net income (loss) $ 214 $ 63 $ 609 $ (26) ==== ==== ==== ==== Net income (loss) per common share (basic) $0.92 $ 0.27 $2.62 $(0.18) ==== ==== ==== ==== Net income (loss) per common share (diluted) $0.88 $ 0.27 $2.51 $(0.18) ==== ==== ==== ==== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- Consolidated Results - -------------------- Our pretax income from continuing operations of $331 million in the third quarter of 2003 (before the cumulative effect of accounting change) was significantly better than comparable pretax income of $95 million in the same period of 2002, driven by strong improvement in underwriting results and the realization of net investment gains versus realized net investment losses in the prior period. Through the first nine months of 2003, our pretax income from continuing operations totaled $890 million (before the cumulative effect of accounting change), compared with a pretax loss of $73 million in the same 2002 period that included a $585 million pretax loss provision related to a settlement agreement with respect to certain asbestos litigation (described in more detail on pages 42 and 43 of this report). Excluding the impact of that $585 million loss provision in 2002, our year-to-date 2003 pretax income was over $370 million higher than the adjusted 2002 income of $512 million, reflecting strong improvement in underwriting profitability in our two ongoing underwriting segments - Specialty Commercial and Commercial Lines - - and a $181 million increase in realized investment gains. Our asset management subsidiary, Nuveen Investments, Inc., also contributed to the improvement in our third-quarter and year-to- date results in 2003. In our "Parent and other operations," pretax losses in the first nine months of 2003 exceeded those in the same periods of 2002 primarily due to an increase in realized investment losses and a decline in investment income. 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 66 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 nine months of 2003 included the results of those operations for the fourth quarter of 2002 and the first nine months of 2003, whereas our results for the nine months ended September 30, 2002 included the results of those operations for the fourth quarter of 2001 and the first six months of 2002. The year-to-date incremental impact on our property-liability operations of eliminating the reporting lag, consisting of the results of these operations for the quarter ended September 30, 2003, was as follows. (in millions) ----------- Specialty Commercial Other Total ---------- ------ ------ Net written premiums $ 83 $ 5 $ 88 Decrease in unearned premiums (20) - (20) ----- ----- ----- Net earned premiums 63 5 68 Incurred losses and underwriting expenses 69 23 92 ----- ----- ----- Underwriting result (6) (18) (24) Net investment income 2 2 4 Other income 6 - 6 ----- ----- ----- Total pretax income (loss) $ 2 $ (16) $ (14) ===== ===== ===== 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 nine months of 2003 not comparable to the information for the same period of 2002, we have presented, in certain places herein, 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 nine months 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 third quarter and first nine months of 2003, this reclassification had the impact of increasing both net earned premiums and policy acquisition costs by $22 million and $61 million, respectively, compared with what would have been recorded under our prior method of estimation. In addition, net written premiums increased by $13 million and $92 million for the third quarter and first nine months of 2003, respectively (a portion of which was due to the elimination of the one-quarter reporting lag). For the third quarter and first nine months of 2002, the impact was an increase to both net earned premiums and policy acquisition costs of $9 million and $69 million, respectively, and an increase to net written premiums of $8 million and $74 million, respectively. 2003 Cumulative Effect of Accounting Change-Partial Adoption of FIN 46 - ---------------------------------------------------------------------- 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. Accordingly, we began applying the consolidation requirements for these new VIEs in the first quarter of 2003. For VIEs created before January 31, 2003, FIN 46 was originally effective for reporting periods beginning after June 15, 2003, which for us is the quarter ended September 30, 2003. However, on October 9, 2003 the FASB issued FASB Staff Position ("FSP") FIN 46-6, "Effective Date of FASB Interpretation No. 46, Consolidation of Variable Interest Entities," which deferred the effective date until the first interim or annual period ending after December 15, 2003, but permitted early and partial adoption. As a result of our partial adoption of FIN 46, we consolidated twelve entities (summarized below) that we had not previously consolidated. As a result, we recorded a loss of $21 million (net of a deferred tax benefit of $3 million) on our consolidated statements of operations in the third quarter of 2003, classified as a "cumulative effect of accounting change" and representing the cumulative impact of FIN 46 on periods prior to the July 1, 2003 date of adoption. The entities consolidated were as follows. - Investment - We hold an investment in an insurance company that provides insurance coverage to markets in Baltimore and Washington D.C. Our investment includes a substantial majority of the company's convertible preferred stock, but none of its voting common stock. As a result of our economic interest in the entity, we have the majority exposure to variability through our preferred stock ownership and a loan to the company, both of which are considered variable interests as defined in FIN 46. Accordingly, we began consolidating this entity in the third quarter. The carrying value of this investment is approximately $3 million. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- - Municipal Trusts - We own interests in various municipal trusts that were formed for the purpose of allowing us to more flexibly generate investment income in a manner consistent with our investment objectives and tax position. As of September 30, 2003, there were 36 such trusts, which held a combined total of $450 million in municipal securities, of which eight had not been included in our consolidated financial statements prior to our adoption of FIN 46 because we did not hold majority ownership in them. However, we do have the majority exposure to variability for these trusts. Therefore, we began consolidating these eight trusts in the third quarter of 2003. - Venture Capital Entities - In our venture capital investment portfolio, we have numerous investments in small- to medium-sized companies, in which we have variable interests through stock ownership and, in some cases, loans. All of these investments are held for the purpose of generating investment returns, and the companies in which we invest span a variety of business sectors, including technology, telecommunications and healthcare. As a result of our review of this portfolio, we identified three entities that were required to be consolidated under the provisions of FIN 46. The consolidation of the foregoing entities had the net impact of increasing (decreasing) the balance sheet and statement of operations' captions by the amounts indicated in the following table. Municipal Venture (in millions) Investment Trusts Capital Total ----------- ---------- --------- ------- ----- Assets $(14) $ 84 $ (1) $ 69 Liabilities 3 84 3 90 ---- ---- ---- ---- Cumulative effect of accounting change $(17) $ - $ (4) $ (21) ==== ==== ==== ==== Other revenue $ - $ 1 $ 1 $ 2 Operating and administrative expenses $ - $ 1 $ 1 $ 2 In addition to the foregoing entities that were consolidated pursuant to FIN 46, we also hold significant interests in other variable interest entities for which we are not considered to be the primary beneficiary. FIN 46 requires that information about these entities be disclosed, as follows. - We have a significant variable interest in two real estate entities, but we are not considered to be the primary beneficiary. The total carrying value of these entities was approximately $57 million as of September 30, 2003, which also represents our maximum exposure to loss. The purpose of our involvement in these entities is to generate investment returns. Our partial adoption of FIN 46 specifically excluded the following items. - Mandatorily redeemable preferred securities of trusts holding solely subordinated debentures of the company ("Preferred Securities") - These securities have a carrying value of $897 million and are currently reported in the liability section of our Consolidated Balance Sheet, as newly required under SFAS 150 (see further discussion regarding the adoption of SFAS 150 on page 38 of this report). These securities were issued by five separate trusts that were established for the sole purpose of issuing the securities to investors and are currently included in our consolidated financial statements. We are currently evaluating the implications of FIN 46 with regard to these trusts. - Lloyd's Syndicates - We participate in various Lloyd's syndicates at varying levels. These syndicates are essentially markets where insureds can obtain coverage for a variety of risks. We continue to evaluate the implications of FIN 46 with respect to these syndicates. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- 2002 Cumulative Effect of Accounting Change - Adoption of SFAS No. 142 - ---------------------------------------------------------------------- In the first quarter of 2002, we began implementing the provisions of Statement of Financial Accounting Standards ("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 $20 million in the first nine months of 2003, compared with $14 million in the same 2002 period. Adoption of SFAS No. 150 - ------------------------ In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity", which generally requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). We adopted the provisions of SFAS 150 in the third quarter of 2003. Our only financial instruments that fell within the scope of SFAS No. 150 were the "Company-obligated mandatorily redeemable preferred securities of trusts holding solely subordinated debentures of the company" that had been classified as a separate line between liabilities and shareholders' equity on our consolidated balance sheet. These securities were issued by five separate trusts which are included in our consolidated financial statements. In accordance with SFAS No. 150, we have reclassified these securities to liabilities on our consolidated balance sheet in 2003, where they are included in our total debt outstanding. The carrying value of these securities in total is $897 million, representing the present value of the expected future payment of these obligations, discounting at the respective dividend distribution rates implicit at inception, which were equal to the contract rates, as prescribed by SFAS No. 150. 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). THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- Purchase of Renewal Rights from Kemper Insurance Companies - ---------------------------------------------------------- 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 unlikely that any additional payment would exceed $30 million. Our consolidated gross written premiums for the third quarter and nine months ended September 30, 2003 included approximately $165 million and $199 million, respectively, attributable to business underwritten as a result of this purchase of renewal rights, the majority of which were included in our Commercial Lines segment. 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. 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 THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- 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 ($58 million at September 30, 2003), with changes in its fair value recorded as other realized gains or losses in our statement of operations. In the first nine months of 2003, we recorded a net pretax realized loss of $3 million related to this option, including a $1 million pretax loss in the third 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 48 through 59 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 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. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- Our operations in runoff do not qualify as "discontinued operations" for accounting purposes. For the nine months ended September 30, 2003, these runoff operations collectively accounted for $351 million, or 7%, of our reported net earned premiums, and generated underwriting losses totaling $213 million (an amount that does not include investment income from the assets maintained to support these operations). For the nine months ended September 30, 2002, these runoff operations collectively accounted for $1.82 billion, or 31%, of our net earned premiums, and generated underwriting losses totaling $904 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. We believe it is too early to determine TRIA's impact on the insurance industry generally or specifically on us. Our domestic insurance subsidiaries and certain business we underwrite through Lloyd's 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 ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- 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 2003; those renewals included both certified and non- certified TRIA coverage. Generally, 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. 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 ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- 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 September 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 - ----------------------------- From time to time asbestos reform bills have been introduced in the U.S. Congress. Some of these proposed laws seek to reduce or eliminate current personal injury litigation by replacing it with a statutory compensation program funded by contributions from a variety of sources which may include companies that formerly manufactured, distributed or sold asbestos products and insurers that underwrote certain asbestos risks. Many of these reform efforts would not cover asbestos property damage claims and 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 would depend upon a variety of factors including the total size of any compensation fund, the portions allocated to various commercial groups and the formula for allocating contributions among insurers. If any asbestos litigation reform is enacted in the future, our contribution allocation could be significantly larger than our current asbestos reserve. 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. No additional major adjustments were recorded in the third quarter of 2003. Through September 30, 2003, we have made net loss payments totaling $471 million related to the attack since it occurred, of which $164 million were made in the first nine months 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. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- 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 nine months of 2003 and 2002, we recorded pretax losses of $3 and $12 million, respectively, in discontinued operations, related to claims in respect of pre-sale losses. 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 September 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 nine months ended September 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 September 30, 2003 and Dec. 31, 2002, by invested asset class. (in millions) ----------- Sept. 30, Dec. 31, 2003 2002 ------- ------- Fixed income (including securities on loan) $ 40 $ 52 Equities 10 37 Venture capital 95 119 ----- ----- Total unrealized loss $145 $208 ===== ===== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Consolidated Highlights (continued) ---------------------------------- At September 30, 2003 and December 31, 2002, the carrying value of our consolidated invested asset portfolio included $1.07 billion and $1.03 billion of net pretax unrealized gains, respectively. The following table summarizes, for all securities in an unrealized loss position at September 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. September 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 $1,298 $ 24 $ 673 $ 27 7 - 12 months 126 4 198 9 Greater than 12 months 137 12 198 16 ----- ----- ----- ----- Total 1,561 40 1,069 52 ----- ----- ----- ----- Equities: 0 - 6 months 77 7 144 15 7 - 12 months 9 1 80 20 Greater than 12 months 8 2 4 2 ----- ----- ----- ----- Total 94 10 228 37 ----- ----- ----- ----- Venture capital: 0 - 6 months 55 21 60 49 7 - 12 months 6 6 39 25 Greater than 12 months 85 68 44 45 ----- ----- ----- ----- Total 146 95 143 119 ----- ----- ----- ----- Total $1,801 $ 145 $1,440 $ 208 ===== ===== ===== ===== At September 30, 2003, non-investment grade securities comprised less than 2% of our consolidated fixed income investment portfolio, and nonrated securities comprised less than one half of one percent of that portfolio. Included in those categories at that date were securities in an unrealized loss position that, in the aggregate, had an amortized cost of $99 million and a fair value of $92 million, resulting in a net pretax unrealized loss of $7 million. These securities represented 1% of the total amortized cost and fair value of the fixed income portfolio at September 30, 2003, and accounted for 18% 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 September 30, 2003, by remaining period to maturity date. (in millions) Amortized Estimated ----------- Cost Fair Value --------- ---------- Remaining period to maturity date: One year or less $ 130 $ 128 Over one year through five years 305 301 Over five years through ten years 477 464 Over ten years 287 279 Asset/mortgage-backed securities with various maturities 402 389 ------ ------ Total $1,601 $1,561 ====== ====== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance ---------------------------- Overview - -------- Our total net written premiums of $1.95 billion in the third quarter of 2003 were 7% higher than comparable 2002 premiums of $1.82 billion, driven by price increases and new business throughout our ongoing operations, which more than offset an 81% decline in volume in our runoff "Other" segment. In our ongoing Specialty Commercial and Commercial Lines segments, total net written premium volume of $1.89 billion in the third quarter was 24% ahead of the comparable 2002 total of $1.52 billion. In the first nine months of 2003, reported premium volume of $5.72 billion was slightly below reported 2002 nine-month volume of $5.78 billion. Strong growth in our ongoing segments was offset by a $1.1 billion decline in the "Other" segment that was primarily due to our November 2002 transfer of our ongoing reinsurance operations to Platinum. Our year-to-date ongoing operations' premium volume of $5.46 billion was 23% higher than the 2002 nine-month total of $4.43 billion. The year-to-date 2003 ongoing operations' total included $83 million of incremental premium volume resulting from the elimination of the one-quarter reporting lag at our operations at Lloyd's, and also benefited from incremental premiums resulting from our purchase of the right to renew certain business previously underwritten by Kemper Insurance Companies (discussed in more detail on page 39 of this report). Our consolidated statutory loss ratio, which measures insurance losses and loss adjustment expenses as a percentage of earned premiums, was 66.3 in the third quarter of 2003, compared with a loss ratio of 77.1 in the same 2002 period. In our ongoing operations, the third-quarter 2003 loss ratio of 62.7 was over one point better than the comparable 2002 loss ratio of 63.9, primarily due to continued improvement in our current-year loss experience. Through the first nine months of 2003, our ongoing segments' loss ratio was 63.4, which included a 1.8 point impact from an $89 million loss provision recorded in our Surety business center related to one of our accounts (discussed in more detail on page 50 of this report). The nine-month ongoing segments' 2002 loss ratio of 65.3 included a 0.9 point impact from a $34 million loss provision recorded in the Surety business center for a claim related to the construction of two oil rigs. Excluding those factors in both years, our ongoing segments' adjusted nine-month 2003 loss ratio of 61.6 was nearly three points better than the comparable adjusted 2002 loss ratio of 64.4. 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 improvement in current-year loss experience 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 we believe 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 nine months of 2003, we recorded a net $26 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 nine months of 2002, we recorded a net $40 million provision for catastrophe losses incurred in prior years, the majority of which was recorded in our Reinsurance operations and was related to flooding in Europe. Our consolidated statutory expense ratio, measuring underwriting expenses as a percentage of net written premiums, was 27.7 in the third quarter of 2003, nearly one point better than the 2002 third-quarter ratio of 28.6. In our ongoing operations, the third-quarter 2003 expense ratio of 28.2 was level with the comparable 2002 expense ratio. Through the first nine months of 2003, our ongoing operations' expense ratio of 29.0 was slightly higher than the 2002 nine-month expense ratio of 28.8, 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 September 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 nine months of 2003. Net Loss and LAE Reserves ------------------------- Year-to-date Dec. 31, Sept. 30, Prior-Year Loss (in millions) 2002 2003 Development ----------- ------- ------- ---------------- Ongoing operations: Specialty Commercial: Specialty $ 2,043 $ 2,284 $ 11 Surety & Construction 1,369 1,608 - International & Lloyd's 987 1,200 - ------ ------ ---- Total Specialty Commercial 4,399 5,092 11 ------ ------ ---- Commercial Lines 2,495 2,543 4 ------ ------ ---- Total Ongoing Operations 6,894 7,635 15 ------ ------ ---- Runoff Operations: Other: Health Care 1,970 1,411 (1) Reinsurance 3,043 2,454 (22) Other Runoff 2,942 2,189 109 ------ ------ ---- Total Other 7,955 6,054 86 ------ ------ ---- Total Underwriting $14,849 $13,689 $101 ====== ====== ==== Specific circumstances leading to the reserve development recorded in the first nine months of 2003 are discussed in more detail in the respective segment discussions that follow. The table on the following page summarizes key financial results (from continuing operations) by property-liability underwriting business segment (underwriting results are presented using GAAP measures; combined ratios are presented on a statutory accounting basis). In the first quarter of 2003, we implemented a new segment reporting structure for our property-liability underwriting operations. Data for 2002 in the table have been reclassified to be consistent with the new segment reporting structure. Following the table is a detailed discussion of the results for each segment for the three months and nine months ended September 30, 2003 and 2002. In addition to "prior-year loss development," we sometimes refer to "current-year loss development" or "current accident year loss activity," which refers to the calendar year income statement impact of recording the provision for losses and LAE for losses incurred in the current accident year. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- % of Total Three Months Ended Nine Months Ended Premiums September 30 September 30 ---------- ------------------ ----------------- ($ in millions) 2003 2002 2003 2002 ------------- ------ ------ ------ ------ Specialty Commercial Net written premiums 67% $1,269 $1,064 $3,815 $3,097 Underwriting result $79 $56 $209 $123 Combined ratio 92.5 93.7 93.5 94.7 Commercial Lines Net written premiums 29% $620 $453 $1,649 $1,336 Underwriting result $58 $41 $132 $84 Combined ratio 87.2 88.5 89.7 92.9 Other* Net written premiums 4% $59 $305 $255 $1,350 Underwriting result $(65) $(192) $(213) $(904) --- ------ ------ ------ ------ Total Property- Liability Insurance Net written premiums 100% $1,948 $1,822 $5,719 $5,783 ==== ====== ====== ====== ====== Underwriting result $72 $ (95) $128 $(697) ====== ====== ====== ====== Statutory Combined Ratio Loss and loss adjustment expense ratio 66.3 77.1 67.0 83.3 Underwriting expense ratio 27.7 28.6 29.3 29.2 ------ ------ ------ ------ Combined Ratio 94.0 105.7 96.3 112.5 ====== ====== ====== ====== *The table excludes statutory combined ratios for the "Other" segment, as they are less meaningful in a runoff environment because of the significant decline in net written and earned premiums. 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 the United Kingdom, Canada (other than surety) 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 mostly 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 nine months ended September 30, 2003 and 2002. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Three Months Ended Nine Months Ended September 30 September 30 ------------------ ----------------- ($ in millions) 2003 2002 2003 2002 ------------- ------ ------ ------ ------ SPECIALTY Net written premiums $701 $523 $1,865 $1,434 Percentage increase over 2002 34% 30% Underwriting result $107 $60 $248 $121 Statutory combined ratio: Loss and loss adjustment expense ratio 58.6 64.1 60.3 66.6 Underwriting expense ratio 23.4 22.6 23.9 23.6 ------ ------ ------ ------ Combined ratio 82.0 86.7 84.2 90.2 ====== ====== ====== ====== SURETY & CONSTRUCTION Net written premiums $280 $280 $953 $953 Percentage increase over 2002 -% -% Underwriting result $(40) $(38) $(113) $(32) Statutory combined ratio: Loss and loss adjustment expense ratio 76.2 78.2 76.6 68.2 Underwriting expense ratio 38.9 37.5 34.9 34.3 ------ ------ ------ ------ Combined ratio 115.1 115.7 111.5 102.5 ====== ====== ====== ====== INTERNATIONAL & LLOYD'S Net written premiums $288 $261 $997 $710 Percentage change from 2002 10% 40% Underwriting result $12 $34 $74 $34 Statutory combined ratio: Loss and loss adjustment expense ratio 62.3 56.6 59.0 65.0 Underwriting expense ratio 29.9 25.3 32.9 28.6 ------ ------ ------ ------ Combined ratio 92.2 81.9 91.9 93.6 ====== ====== ====== ====== TOTAL SPECIALTY COMMERCIAL SEGMENT Net written premiums $1,269 $1,064 $3,815 $3,097 Percentage increase over 2002 19% 23% Underwriting result $79 $56 $209 $123 Statutory combined ratio: Loss and loss adjustment expense ratio 64.2 66.5 64.5 66.7 Underwriting expense ratio 28.3 27.2 29.0 28.0 ------ ------ ------ ------ Combined ratio 92.5 93.7 93.5 94.7 ====== ====== ====== ====== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Specialty - --------- Almost all business centers in the Specialty category contributed to the strong premium growth over the third quarter and first nine months of 2002. Financial and Professional Services' third- quarter 2003 premiums of $177 million were 75% 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, and the May 2003 acquisition of the right to seek to renew architects' and engineers' professional liability business from Kemper Insurance Companies. Through the first nine months of 2003, Financial and Professional Services written premiums totaled $455 million, compared with $288 million in the same period of 2002. Technology's written premiums of $107 million in the third quarter were 27% higher than the comparable 2002 total of $84 million, primarily due to price increases and new business. Personal Catastrophe Risk third-quarter net premiums of $40 million were more than double 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 reinsurers. The improvements in third-quarter and year-to-date 2003 underwriting results compared with the same periods of 2002 occurred throughout the business centers in the Specialty category, reflecting the impact of price increases and the addition of profitable new business. The Technology and Financial and Professional Services business centers recorded the most notable improvements over the third quarter of 2002, posting underwriting profits of $32 million and $26 million, respectively. We recorded an $11 million provision for prior- year losses in the Specialty category in 2003, the majority of which was concentrated in our Discover Re operation, due to the recognition of uncollectible reinsurance and an increase in estimated losses related to a single large account. Surety & Construction - --------------------- Net written premiums generated by our Surety business center totaled $133 million in the third quarter of 2003, compared with $136 million in the same 2002 period. Through the first nine months of 2003, Surety's written premium volume of $373 million was 3% below the comparable 2002 total of $383 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 $6 million in the third quarter of 2003, compared with an underwriting loss of $45 million in the same 2002 period. The 2002 loss was driven by a $34 million loss provision recorded after a judicial decision regarding surety bonds issued in connection with the construction of two large Brazilian oil rigs. Through the first nine months of 2003, Surety's underwriting loss of $104 million included an $89 million pretax loss provision (net of reinsurance) related to one of our accounts that was in bankruptcy and unable 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 $89 million net pretax loss provision recorded in 2003 represented our estimated loss in this matter. Surety's year-to-date 2002 underwriting loss totaled $46 million. 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. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- 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 $385 million ($318 million of which is from gas supply bonds), an amount that will decline over the contract periods. The largest individual exposure approximates $186 million (pretax). These companies all continue to perform their bonded obligations and, therefore, no claims have been filed. In addition to our largest exposure discussed above with respect to energy trading companies, our commercial surety business as of September 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 54% as of September 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 the 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 condition, business prospects, experience and management. The 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. Losses in the contract surety business can occur as a result of a contractor's failure to complete its bonded obligations in accordance with the contract terms. Such losses, if any, would be estimated by estimating the cost to complete the remaining work (which may include amounts advanced to the contractor by the surety) and the contractor's unpaid bills, offset by monies due to the contractor, reinsurance and the estimated net realizable value of collateral. 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 one of our co-sureties fails to meet its obligations under a bond, we and any 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 to the extent such an event or events occur. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- We have provided surety bond coverage to a construction contractor that failed to make payments under certain of its debt obligations during the third quarter of 2003. The contractor has developed a plan to restructure its operations and financing, and is negotiating revisions to its credit arrangements. In the third quarter of 2003, following our detailed review of this plan, we made collateralized advances to the contractor. Based on information available to us, we believe that the contractor will be able to complete projects as contemplated by its plan. As part of the plan, we may issue bonds for new projects undertaken by the contractor, subject to our underwriting criteria. We expect our advances to be fully repaid by cash flow from the contractor's operations, planned asset sales, reinsurance recoveries and, if necessary, recovery on collateral. Accordingly, we do not expect to incur a significant loss with respect to this account. However, in the unlikely event that the contractor fails to complete all of its current projects, we estimate that our aggregate loss, net of estimated collateral, reinsurance recoveries and participation by co-sureties (one of which has experienced ratings downgrades and is in runoff), would not exceed $80 million, on an after-tax basis assuming a 35% statutory tax rate. In our Construction business center, third-quarter net written premiums of $147 million were slightly higher than net written premium volume of $144 million in the third quarter of 2002, while year-to-date premiums of $580 million were 2% higher than premiums of $570 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 third- quarter 2003 underwriting loss of $35 million was driven by an increased provision for current accident year losses. International & Lloyd's - ----------------------- Net written premiums of $288 million in the third quarter were 10% higher than comparable 2002 premiums of $261 million. For the nine months ended September 30, 2003, written premium volume of $997 million for the International & Lloyd's category included $83 million of incremental premiums from the elimination of the one-quarter reporting lag at Lloyd's (the remaining $5 million of incremental premiums described on page 35 of this report were recorded in our runoff Other segment). Excluding that additional $83 million, premium volume in 2003 of $914 million was 29% higher than 2002 nine-month written premiums of $710 million. We experienced strong growth 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. In our International operations, premiums of $414 million for the nine months ended September 30, 2003, were 15% higher than comparable premiums of $360 million in the same 2002 period. Price increases, new business and favorable foreign currency translation effects were all factors contributing to the growth in premiums in the first nine months of 2003. The International & Lloyd's underwriting profit of $12 million in the third quarter of 2003 declined $22 million from the same period of 2002, due to losses in the personal lines business unit at Lloyd's. For the first nine months of 2003, however, the underwriting profit of $74 million, which included $6 million in losses attributable to the elimination of the one-quarter reporting lag, was significantly improved over the $34 million underwriting profit in the same period of 2002. The improvement in 2003 results was largely due to strong results from our operations in Canada and the United Kingdom, as well as from our overall Lloyd's operations, compared with the same period of 2002. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Commercial Lines - ---------------- The Commercial Lines segment includes our Small Commercial, Middle Market Commercial and Property Solutions business centers, as well as the results of our limited involvement in involuntary insurance pools. The Small Commercial business center services commercial firms that typically have between one and fifty employees through its proprietary St. Paul Mainstreet (SM) and St. Paul Advantage (SM) products, with a particular focus on offices, wholesalers, retailers, artisan contractors and other service risks. The Middle Market Commercial business center offers comprehensive insurance coverages for a wide variety of manufacturing, wholesale, service and retail exposures. This business center also offers loss-sensitive casualty programs, including significant deductible and self-insured retention options, for the higher end of the middle market sector. The Property Solutions business center combines our Large Accounts Property business with the commercial portion of our catastrophe risk business and allows us to take a unified approach to large property risks. The following table summarizes key financial data for this segment for the three months and nine months ended September 30, 2003 and 2002. Three Months Ended Nine Months Ended September 30 September 30 ------------------ ----------------- ($ in millions) 2003 2002 2003 2002 ------------- ------ ------ ------ ------ Net written premiums $620 $453 $1,649 $1,336 Percentage increase over 2002 37% 23% Underwriting result $58 $41 $132 $84 Statutory combined ratio: Loss and loss adjustment expense ratio 59.2 57.9 60.8 62.1 Underwriting expense ratio 28.0 30.6 28.9 30.8 ------ ------ ------ ------ Combined ratio 87.2 88.5 89.7 92.9 ====== ====== ====== ====== The strong premium growth in the third quarter and first nine months of 2003 over the comparable periods of 2002 was primarily due to new business volume, including that resulting from our purchase of the right to renew certain business previously underwritten by Kemper Insurance Companies (described in more detail on page 39 of this report). Price increases and strong business retention levels have also played a role in premium growth in 2003. Written premiums of $224 million in the Small Commercial business center were 36% higher than comparable third- quarter 2002 volume of $164 million. In the Middle Market business center, third-quarter written premiums of $369 million increased 42% over the same period of 2002. Through the first nine months of 2003, Middle Market premium volume totaled $1 billion, compared with $788 in the same period of 2002. Throughout our Commercial Lines segment, we continue to nonrenew underperforming classes of business, pursue further rate increases where appropriate and leverage our distribution network to capitalize on new business opportunities. Strong improvement in current accident year loss experience in 2003 was the primary factor contributing to the significant increase in underwriting profitability in the third quarter and first nine months of 2003 over the same periods of 2002. That improvement occurred despite a significant increase in weather- related losses in 2003. We have been successful in adding new business in the first nine months of 2003 that meets our pricing and underwriting criteria while maintaining strict control over expense growth. The nearly two-point improvement in the expense ratio compared with the first nine months of 2002 reflected the success of our expense control efforts. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- 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 international operations: our runoff operations at Lloyd's, including our participation in the insuring of the Lloyd's Central Fund; 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 42 and 43 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 nine months ended September 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. Three Months Ended Nine Months Ended September 30 September 30 ------------------ ----------------- ($ in millions) 2003 2002 2003 2002 ------------- ------ ------ ------ ------ HEALTH CARE Net written premiums $1 $37 $27 $179 Percentage decline from 2002 (97%) (85%) Underwriting result $(4) $(71) $(37) $(164) REINSURANCE Net written premiums $40 $230 $168 $893 Percentage decline from 2002 (83%) (81%) Underwriting result $(1) $(25) $2 $(14) OTHER RUNOFF Net written premiums $18 $38 $60 $278 Percentage decline from 2002 (53%) (78%) Underwriting result $(60) $(96) $(178) $(726) ----- ----- ----- ----- TOTAL OTHER SEGMENT Net written premiums $59 $305 $255 $1,350 ===== ===== ===== ===== Percentage decline from 2002 (81%) (81%) Underwriting result $(65) $(192) $(213) $(904) ===== ===== ===== ===== THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Other Segment Overview - ---------------------- The Other segment in total generated a $65 million underwriting loss in the third quarter of 2003, compared with a loss of $192 million in the same 2002 period. As described in more detail in the following discussion, the year-to-date segment underwriting loss of $213 million included $86 million of net unfavorable prior-period loss development, including $39 million that emerged in the third quarter of the year. The year-to-date total also included $18 million in losses attributable to the elimination of the one-quarter reporting lag. The remainder of the nine-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 were required to offer reporting endorsements to claims-made policyholders at the time their policies were 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. Effective in the third quarter of 2003, our obligation to offer reporting endorsements was substantially satisfied. 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. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- 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. 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. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- 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. 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%. In the third quarter of 2003, the dollar amount of newly reported claims totaled $108 million, approximately 10% higher than we anticipated in our original estimate of the required level of reserves at year-end 2002. However, through the first nine months of 2003, the dollar amount of newly reported claims was approximately 7% lower than we anticipated due to the positive variance in the first quarter. Loss development on known claims during the third quarter of 2003 was worse than anticipated. Our actual redundancy ratio continued to improve in the third quarter of 2003; however, since newly reported claims and loss development on known claims again did not improve as much as we expected in the third quarter, the required reserve redundancy has increased from the previously estimated range of 35% to 40% to approximately 45%. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- 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 results of these indicators support our current view that we have recorded a reasonable provision for our medical malpractice exposures as of September 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. As noted above, development on known claims is a key metric in our evaluation of our Health Care reserves. While we have experienced adverse development on known claims at year-end 2002, the magnitude of that development has declined throughout 2003. If, however, we experience further adverse reserve development on those claims, and such development is not offset by a favorable change in our estimate of newly reported claims, and we further conclude that an increase in the required redundancy ratio to a level above 45% is necessary, we may determine that additional reserving actions are necessary. 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 third quarter and first nine months of 2003 consisted entirely of premium adjustments relating to reinsurance business underwritten in prior years. The year-to-date 2003 underwriting profit of $2 million included the impact of $23 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 and expenses associated with operating in a runoff environment. Results for the first nine months 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 39 and 40 of this report). Underwriting losses for the three months and nine months ended September 30, 2002, were driven by $21 million of losses related to the September 11, 2001, terrorist attack that were reallocated from our primary insurance operations to our Reinsurance operations. 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 $178 million underwriting loss in the first nine months of 2003 in this category included $109 million of loss provisions to increase prior-year reserves, of which $39 million was recorded in the third quarter. In our runoff syndicates at Lloyd's, which accounted for $47 million of the year-to-date prior-year provision, 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 a $35 million prior-year loss provision. An analysis completed during the third quarter of 2003 indicated that reported losses had been in excess of those projected, and an additional $12 million provision was recorded. Our Unionamerica business accounted for $38 million of the year- to-date provision to increase prior-year reserves, all of which was recorded in the third quarter. We performed a comprehensive review of Unionamerica loss reserves in the third quarter that included a thorough analysis of individual claims and case reserves, and compared our conclusions regarding their adequacy with conclusions reached after a similar review in 2002. The primary factor contributing to the decision to record the additional loss provision was an increase in the expected future level of newly reported losses, based on higher than expected levels of actual newly reported losses in recent quarters. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Property-Liability Insurance (continued) --------------------------------------- Also contributing to the underwriting loss in the first nine months of 2003 was $25 million of unfavorable prior-year development primarily related to several specific large losses in a number of countries within our exited international operations where we have ceased underwriting business. 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 in the first nine months 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 42 and 43 of this report. Investment Operations - --------------------- Pretax net investment income in our property-liability insurance operations totaled $279 million in the third quarter of 2003, 7% below pretax investment income of $300 million in the same period of 2002. Through the first nine months of 2003, pretax investment income of $833 million was 5% lower than the comparable 2002 total of $873 million. Our investment income in 2003 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 4.4% and 3.9%, respectively, at September 30, 2003. The market value of our $15.7 billion fixed income portfolio exceeded its cost by $992 million at September 30, 2003. Approximately 98% of that portfolio is rated at investment grade (BBB or above). The weighted average pretax yield on those investments was 5.9% at September 30, 2003, down from 6.4% a year earlier. Net pretax realized investment gains in our property-liability insurance operations totaled $5 million in the third quarter of 2003, compared with realized losses of $74 million in the same 2002 period. In the third quarter of 2002, realized investment losses were concentrated in our venture capital portfolio, where we sold the majority of our partnership investments, which generated a pretax loss of approximately $56 million. On a year- to-date basis, net pretax realized investment gains totaled $43 million in 2003, compared with realized losses of $151 million in the same 2002 period. The gains in 2003 were concentrated in venture capital and were almost entirely the result of the sale of a large portion of our investment in Select Comfort Corporation, a manufacturer of adjustable air-supported beds, which generated a pretax gain of $109 million. The year-to-date losses in 2002 included the losses from the sale of venture capital partnerships discussed above and losses from the sale of equity investments totaling $41 million. In the first nine months of 2003, we sold fixed income securities with a cumulative amortized cost of $617 million, generating gross pretax gains of $34 million. Those gains were partially offset by impairment writedowns totaling $17 million. Net pretax realized gains generated by sales from our equity portfolio totaled $12 million in the first nine months of 2003. In our venture capital portfolio, pretax realized gains from the sale of securities totaled $137 million in the first nine months of 2003 (primarily resulting from the Select Comfort sale), an amount that was partially offset by impairment writedowns totaling $99 million. In the first nine months of 2002, we sold fixed income securities with a cumulative amortized cost of $2 billion, generating gross pretax gains of $131 million. Those gains were partially offset by impairment writedowns totaling $39 million. In our venture capital portfolio, impairment writedowns totaled $55 million in the first nine months 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 42 and 43 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 nine months ended September 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. Nine Months Ended Environmental September 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 (88) (59) (70) (56) (74) (63) Underwritten (6) (6) (12) (12) (12) (12) ----- ---- ----- ---- ----- ---- Ending reserves $298 $232 $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 September 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 nine months ended September 30, 2003 and the years ended December 31, 2002 and 2001. No policies have been underwritten to specifically include asbestos exposure. Nine Months Ended Asbestos September 30, 2003 2002 2001 ------------- ------------------ ----------- ----------- (in millions) Gross Net Gross Net Gross Net ----------- ----- ---- ----- ---- ----- ---- Beginning reserves $1,245 $778 $577 $387 $471 $315 Incurred losses 23 2 846 482 167 116 Reserve increase - - 150 150 - - Paid losses (861) (516) (328) (241) (61) (44) ----- ---- ----- ---- ----- ---- Ending reserves $407 $264 $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 43 of this report. Our reserves for environmental and asbestos losses at September 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 $705 million at September 30, 2003 represented approximately 3% of gross consolidated loss reserves of $20.9 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 nine months ended September 30, 2003 and 2002 were as follows. Three Months Ended Nine Months Ended September 30 September 30 ------------------ ----------------- (in millions) 2003 2002 2003 2002 ----------- ------ ------ ------ ------ Revenues $ 121 $ 102 $ 329 $ 286 Expenses 60 49 159 134 ------ ------ ------ ------ Pretax earnings 61 53 170 152 Minority interest (12) (11) (35) (33) ------ ------ ------ ------ The St. Paul's share of pretax earnings $ 49 $ 42 $ 135 $ 119 ====== ====== ====== ====== Assets under management $90,059 $76,928 ====== ====== Nuveen Investments' strong revenue and earnings growth in the third quarter was driven by continuing momentum in retail managed accounts, and the introduction of new closed-end, exchange-traded funds over the last 12 months. Managed account sales totaled $2.8 billion in the third quarter of 2003, compared with $1.9 billion in the same 2002 period. The increase reflected strong demand for value equity portfolios and municipal accounts. In the third quarter, Nuveen Investments raised approximately $300 million with the introduction of its first exchange-traded fund that blends debt and equity investment strategies. Also in the third quarter, Nuveen Investments raised $945 million in exchange- traded fund assets through the issuance of preferred shares that leveraged the convertible and preferred income fund first offered in June. Through the first nine months of 2003, gross investment product sales totaled $14.0 billion, compared with $11.3 billion in the same 2002 period. Nuveen Investments' net flows (equal to the sum of sales, reinvestments and exchanges, less redemptions and withdrawals) during the first nine months of 2003 totaled $7.3 billion, 42% higher than comparable 2002 net flows of $5.1 billion. Assets under management at the end of the third quarter consisted of $46.1 billion of closed-end exchange-traded funds, $23.0 billion of retail managed accounts, $12.1 billion of mutual funds and $8.9 billion of institutional managed accounts. The 17% increase in managed assets over the same time a year ago was driven by $9.5 billion in positive net flows and $3.6 billion of equity 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 $6.19 billion at September 30, 2003 grew $511 million over the year-end 2002 total of $5.68 billion, driven by our net income of $609 million in the first nine months of 2003. Common dividends declared through the first nine months of 2003 totaled $198 million. Our reported debt outstanding at September 30, 2003 of $3.57 billion grew significantly over our reported debt of $2.71 billion at December 31, 2002, entirely due to our adoption of SFAS No. 150. The "Company-obligated mandatorily preferred securities of trusts holding solely subordinated debentures of the company" previously reported separately on our consolidated balance sheet between liabilities and shareholders' equity are now included in liabilities as a component of debt. These securities were issued by five separate trusts and are subject to mandatory redemption on dates ranging from 2027 to 2050, but can be redeemed earlier in accordance with conditions that vary among the five trusts. In accordance with provisions of SFAS No. 150, prior periods were not restated to conform with the 2003 classification of these securities as liabilities. Excluding the $897 million impact of the balance sheet reclassification, debt outstanding at September 30, 2003 of $2.68 billion declined slightly from the year-end 2002 total of $2.71 billion, largely due to a net $239 million reduction in commercial paper outstanding. A significant portion of that reduction in commercial paper was funded by Nuveen Investments' repayment of an intercompany loan from The. St. Paul. Debt outstanding also declined as a result of maturities of medium-term notes totaling $53 million in the first nine months of 2003, which were funded with internally generated funds. These reductions in debt were largely offset by a $247 million increase in Nuveen Investments' debt over year-end 2002. In the third quarter, Nuveen Investments issued $300 million of 4.22% notes due in September 2008 in a private placement. A portion of the proceeds was used to refinance existing debt and repay a $105 million loan from The St. Paul. The remainder will be used for Nuveen Investments' general corporate purposes. Our ratio of total debt and mandatorily redeemable preferred securities to total capitalization (defined as the sum of debt obligations, shareholders' equity and mandatorily redeemable preferred securities) was 36% at the end of the third quarter, down from the comparable year-end 2002 ratio of 39%. Net interest and dividend distribution expense related to debt and preferred securities totaled $138 million in the first nine months of 2003, compared with $133 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, the impact of which more than offset a decline in interest expense related to our floating rate debt. We made no major capital improvements in the first nine months of 2003, and none are anticipated during the remainder of the year. Our ratio of earnings to fixed charges was 6.32 for the first nine months of 2003, compared with 0.54 in the same period of 2002. Our ratio of earnings to combined fixed charges and preferred stock dividend requirements was 5.98, compared with 0.51 in the same period of 2002. 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. THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES Management's Discussion, Continued Liquidity (continued) -------------------- Net cash flows used by continuing operations totaled $290 million in the first nine months of 2003, compared with cash provided by continuing operations of $435 million in the same period of 2002. Operational cash outflows in the first nine months of 2003 were dominated by our January 2003 payment of $747 million related to the Western MacArthur asbestos litigation settlement. In the same period of 2002, operational cash flows were negatively impacted by a $248 million payment related to the Western MacArthur settlement. In the third quarter of 2003, however, our consolidated cash flows provided by operations totaled $543 million, driven by favorable underwriting results from our ongoing underwriting business segments and a decline in the negative cash flow impact of our operations in runoff, where we are no longer underwriting new business but continue to pay insurance losses and loss adjustment expenses. We expect consolidated operational cash flows during the final quarter 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. Net loss payments related to the September 11, 2001 terrorist attack totaled $164 million in the first nine months of 2003, compared with payments of $208 million in the same 2002 period. 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 - --------------------------------------------------------------- As discussed in more detail on page 36 of this report, on October 9, 2003, the FASB issued FASB Staff Position ("FSP") FIN 46-6, "Effective Date of FASB Interpretation No. 46, Consolidation of Variable Interest Entities," which deferred the effective date of FIN 46 until the first interim or annual period ending after December 15, 2003, which for us would be the period ended December 31, 2003. Under the partial adoption provisions of the FSP, we early-adopted the consolidation and disclosure provisions of this interpretation on July 1, 2003. Our partial adoption specifically excluded the following items. - Mandatorily redeemable preferred securities of trusts holding solely subordinated debentures of the company - These securities were issued by five separate trusts that were established for the sole purpose of issuing the securities to investors and are currently included in our consolidated financial statements. We are currently evaluating the implications of FIN 46 with regard to these trusts. It is possible that evaluation will conclude that the trusts should be "deconsolidated" from our financial statements. We continue to monitor developments at the FASB regarding this issue. Should we conclude that FIN 46 requires such deconsolidation, we have determined that there would be no "cumulative effect of accounting change" recorded upon deconsolidation; however, our consolidated assets and liabilities would each increase by approximately $31 million. - Lloyd's Syndicates - We participate in various Lloyd's syndicates at varying levels. We continue to evaluate the implications of FIN 46 with respect to these syndicates, and at this time we are not able to quantify the impact of adoption 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 losses and loss adjustment expenses incurred by net earned premiums. Net earned premiums, and losses and loss adjustment expenses, are GAAP measures. Combined Ratio - This ratio is the sum of the statutory expense ratio and the statutory 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 GAAP 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. The GAAP underwriting result represents our best measure of profitability for our property-liability underwriting segments. We do not allocate net investment income to our respective 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-15(e) under the Securities Exchange Act of 1934), as of September 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 June 30, 2003 on July 31, 2003, the Company has completed its investigation of instances of noncompliance with existing internal controls and possibly with the Foreign Corrupt Practices Act relating to its Mexican subsidiary. The Company has not identified that any material adjustment to its financial statements is necessary as a result of its investigation. The Company has submitted the results of its investigation to the U.S. Securities and Exchange Commission, the U.S. Department of Justice and the Mexican Bonding and Insurance Commission. 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. Not applicable. Item 5. Other Information. Not applicable. Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits. An Exhibit Index is set forth as the last page in this document. (b) Reports on Form 8-K. 1) The St. Paul 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. 2) The St. Paul furnished in a Form 8-K Current Report dated July 30, 2003 a press release related to the announcement of the company's financial results for the quarter and six months ended June 30, 2003. 3) The St. Paul furnished in a Form 8-K Current Report dated October 29, 2003 a press release related to the announcement of the company's financial results for the quarter and nine months ended September 30, 2003. 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: October 30, 2003 By Bruce A. Backberg --------------- ----------------- Bruce A. Backberg Senior Vice President (Authorized Signatory) Date: October 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..................................................(1) (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. EX-3 3 ex03303.txt EXHIBIT 3 INDEX ARTICLE I. OFFICES Page Sec. 1 Registered Office 1 Sec. 2 Principal Executive Office 1 ARTICLE II. MEETINGS OF SHAREHOLDERS Sec. 1 Place of Meeting 1 Sec. 2 Regular Annual Meeting 1 Sec. 3 Special Meeting 1 Sec. 4 Notice 2 Sec. 5 Record Date 2 Sec. 6 Quorum 2 Sec. 7 Voting Rights 2 Sec. 8 Proxies 2 Sec. 9 Act of the Shareholders 2 Sec. 10 Business of the Meeting 2 Sec. 11 Nomination of Directors 3 ARTICLE III. BOARD OF DIRECTORS Sec. 1 Board to Manage 4 Sec. 2 Number and Term of Office 4 Sec. 3 Meetings of the Board 4 Sec. 4 Advance Action by Absent Directors 5 Sec. 5 Electronic Communications 5 Sec. 6 Quorum 5 Sec. 7 Act of the Board 5 Sec. 8 Board-Appointed Committees 5 ARTICLE IV. OFFICERS Sec. 1 Required Officers 6 Sec. 2 Chairman 6 Sec. 3 President 6 Sec. 4 Chief Financial Officer 7 Sec. 5 Corporate Secretary 7 ARTICLE V. SHARE CERTIFICATES/TRANSFER Sec. 1 Certificated and Uncertificated Shares 8 Sec. 2 Transfer of Shares 8 Sec. 3 Lost, Stolen or Destroyed Certificates 8 ARTICLE VI. GENERAL PROVISIONS Sec. 1 Voting of Shares 8 Sec. 2 Execution of Documents 8 Sec. 3 Transfer of Assignment of Securities 9 Sec. 4 Fiscal Year 9 Sec. 5 Seal 9 Sec. 6 Indemnification 9 BYLAWS OF THE ST. PAUL COMPANIES, INC. ARTICLE I Offices ------- Section 1. Registered Office. The registered office of the corporation required by Chapter 302A of the Minnesota Statutes ("Chapter 302A") to be maintained in the State of Minnesota is 385 Washington Street, St. Paul, Minnesota 55102. Section 2. Principal Executive Office. The principal executive office of the corporation, where the chief executive officer of the corporation has an office, is 385 Washington Street, St. Paul, Minnesota 55102. ARTICLE II Meetings of Shareholders ------------------------ Section 1. Place of Meeting. All meetings of the shareholders shall be held at the registered office of the corporation or, except for a meeting called by or at the demand of a shareholder, at such other place as may be fixed from time to time by the board of directors (the "board"). Section 2. Regular Annual Meeting. A regular annual meeting of shareholders shall be held on the first Tuesday of May of each year for the purpose of electing directors and for the transaction of any other business appropriate for action by the shareholders. Section 3. Special Meetings. Special meetings of the shareholders may be called at any time by the Chief Executive Officer or the Chief Financial Officer or by two or more directors or by a shareholder or shareholders holding ten percent or more of the voting power of all shares entitled to vote; except that a special meeting called by shareholders for the purpose of considering any action to directly or indirectly facilitate or effect a business combination, including any action to change or otherwise affect the composition of the board of directors for that purpose, must be called by twenty-five percent or more of the voting power of all shares entitled to vote. A shareholder or shareholders holding the requisite voting power may demand a special meeting of shareholders only by giving the written notice of demand required by law. Special meetings shall be held on the date and at the time and place fixed as provided by law. Section 4. Notice. Notice of all meetings of shareholders shall be given to every holder of voting shares in the manner and pursuant to the requirements of Chapter 302A. Section 5. Record Date. The board shall fix a record date not more than 60 days before the date of a meeting of shareholders as the date for the determination of the holders of voting shares entitled to notice of and to vote at the meeting. Section 6. Quorum. The holders of a majority of the voting power of the shares entitled to vote at a meeting present in person or by proxy at the meeting are a quorum for the transaction of business. If a quorum is present when a meeting is convened, the shareholders present may continue to transact business until adjournment sine die, even though the withdrawal of a number of shareholders originally present leaves less than the proportion otherwise required for a quorum. Section 7. Voting Rights. Unless otherwise provided in the terms of the shares, a shareholder has one vote for each share held on a record date. A shareholder may cast a vote in person or by proxy. Such vote shall be by written ballot unless the chairman of the meeting determines to request a voice vote on a particular matter. Section 8. Proxies. The chairman of the meeting shall, after shareholders have had a reasonable opportunity to vote and file proxies, close the polls after which no further ballots, proxies, or revocations shall be received or considered. Section 9. Act of the Shareholders. Except as otherwise provided by Chapter 302A of the restated articles of incorporation of the corporation, the shareholders shall take action by the affirmative vote of the holders of a majority of the voting power of the shares present at the time a vote is cast. Section 10. Business of the Meeting. At any annual meeting of shareholders, only such business shall be conducted as shall have been brought before the meeting (i) by or at the direction of the board or (ii) by any shareholder who is entitled to vote with respect thereto and who complies with the notice procedures set forth in this section 10. For business to be properly brought before an annual meeting by a shareholder, the shareholder must have given timely notice thereof in writing to the corporate secretary. To be timely, a shareholder's notice must be delivered or mailed to and received at the principal executive office of the corporation not less than 60 days prior to the date of the annual meeting; provided, however, that in the event that less than 70 days' notice or prior public disclosure of the date of the meeting is given or made to shareholders, notice by the shareholders to be timely must be received not later than the close of business on the 10th day following the day of which such notice of the date of the annual meeting was mailed or such public disclosure was made. A shareholder's notice to the corporate secretary shall set forth as to each matter such shareholder proposes to bring before the annual meeting (i) a brief description of the business desired to be brought before the annual meeting and the reasons for conducting such business at the annual meeting (ii) the name and address, as they appear on the corporation's share register, of the shareholder proposing such business; (iii) the class and number of shares of the corporation's capital stock that are beneficially owned by such shareholder and (iv) any material interest of such shareholder in such business. No shareholder proposal will be eligible for inclusion in the corporation's proxy materials or form of proxy for any annual meeting of shareholders unless received by the corporate secretary of the corporation on or before the first day of December next preceding the date of the annual meeting. Notwithstanding anything in the bylaws to the contrary, no business shall be brought before or conducted at the annual meeting except in accordance with the provisions of this section 10. The officer of the corporation or other person presiding over the annual meeting shall, if the facts so warrant, determine and declare to the meeting that business was not properly brought before the meeting in accordance with the provisions of this section 10 and, if he shall so determine, he shall so declare to the meeting and any such business so determined to be not properly brought before the meeting shall not be transacted. At any special meeting of shareholders, the business transacted shall be limited to the purposes stated in the notice of the meeting. With respect to a special meeting held pursuant to the demand of a shareholder or shareholders, the purposes shall be limited to those specified in the demand in the event that the shareholder or shareholders are entitled by law to call the meeting because the board does not do so. Section 11. Nomination of Directors. Only persons who are nominated in accordance with the procedures set forth in these bylaws shall be eligible for election as directors. Nominations of persons for election to the board of the corporation may be made at a meeting of shareholders at which directors are to be elected only (i) by or at the direction of the board or (ii) by any shareholder of the corporation entitled to vote for the election of directors at the meeting who complies with the notice procedures set forth in this section 11. Such nominations, other than those made by or at the direction of the board, shall be made by timely notice in writing to the corporate secretary. To be timely, a shareholder's notice shall be delivered or mailed to and received at the principal executive office of the corporation not less than 60 days prior to the date of the meeting, provided, however, that in the event that less than 70 days' notice or prior disclosure of the date of this meeting is given or made to shareholders, notice by the shareholders to be timely must be so received not later than the close of business on the 10th day following the date on which such notice of the date of the meeting was mailed or such public disclosure was made. Such shareholder's notice shall set forth (i) as to each person whom such shareholder proposes to nominate for election as a director, all information relating to such person that is required to be disclosed in solicitations of proxies for election of directors, or is otherwise required, in each case pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended (including such person's written consent to being named in the proxy statement as a nominee and to serving as a director if elected), and (ii) as to the shareholder giving the notice (a) the name and address, as they appear on the corporation's share register, of such shareholder and (b) the class and number of shares of the corporation's capital stock that are beneficially owned by such shareholder, and shall be accompanied by the written consent of each such person to serve as a director of the corporation, if elected. At the request of the board any person nominated by the board for election as a director shall furnish to the corporate secretary that information required to be set forth in a shareholder's notice of nomination which pertains to the nominee. No person shall be eligible for election as a director of the corporation unless nominated in accordance with the provisions of this section 11. The officer of the corporation or other person presiding at the meeting shall, if the facts so warrant, determine and declare to the meeting that a nomination was not made in accordance with such provisions and, if he shall so determine, he shall so declare to the meeting and the defective nomination shall be disregarded. ARTICLE III Board of Directors ------------------ Section 1. Board to Manage. The business and affairs of the corporation shall be managed by or under the direction of the board. Section 2. Number and Term of Office. The number of directors shall be at least ten (10) but not more than eighteen (18), as determined from time to time by the board. Each director shall be elected to serve for a term that expires at the next regular annual meeting of the shareholders and when a successor is elected and has qualified, or at the time of the earlier death, resignation, removal or disqualification of the director. [Amended on 5/3/94.] Section 3. Meetings of the Board. The board may hold meetings either within or without the State of Minnesota at such places as the board may select. If the board fails to select a place for a meeting, the meeting shall be held at the principal executive office of the corporation. Four regular meetings of the board shall be held each year. One shall be held immediately following the regular annual meeting of the shareholders. The other three regular meetings shall be held on dates and at times determined by the board. No notice of a regular meeting is required if the date, time and place of the meeting has been announced at a previous meeting of the board. A special meeting of the board may be called by any director or by the chief executive officer by giving, or causing the corporate secretary to give at least twenty-four hours notice to all directors of the date, time and place of the meeting. Section 4. Advance Action by Absent Directors. A director may give advance written consent or opposition to a proposal to be acted on at a board meeting. Section 5. Electronic Communications. A board meeting may be held and participation in a meeting may be effected by means of communications permitted by Chapter 302A. Section 6. Quorum. At all meetings of the board, a majority of the directors then holding office is a quorum for the transaction of business. In the absence of a quorum, a majority of the directors present may adjourn a meeting from time to time until a quorum is present. If a quorum is present when a meeting is convened, the directors present may continue to transact business until adjournment sine die even though the withdrawal of a number of directors originally present leaves less than the proportion otherwise required for a quorum. Section 7. Act of the Board. The board shall take action by the affirmative vote of at least a majority of the directors present at a meeting. In addition, the board may act without a meeting by written action signed by all of the directors then holding office. Section 8. Board-Appointed Committees. A resolution approved by the affirmative vote of a majority of the directors then holding office may establish committees having the authority of the board in the management of the business of the corporation to the extent provided in the resolution and each such committee is subject at all times to the direction and control of the board except as provided by Chapter 302A with respect to a committee of disinterested persons. ARTICLE IV Officers -------- Section 1. Required Officers. The corporation shall have officers who shall serve as chief executive officer and chief financial officer and such other officers as the board shall determine from time to time. Section 2. Chairman. The board shall at its regular meeting each year immediately following the regular annual shareholders meeting elect from its number a chairman who shall serve until the next regular meeting of the board immediately following the regular annual shareholders meeting. The chairman shall be the chief executive officer of the corporation and shall (a) have general policy level responsibility for the management of the business and affairs of the corporation; (b) have responsibility for development and implementation of long range plans for the corporation; (c) preside at all meetings of the board and of the shareholders; (d) see that all the orders and resolutions of the board are carried into effect; (e) perform other duties prescribed by the board or these bylaws. In the absence of the president, the chairman shall assume the duties of the president. Section 3. President. The board shall at its regular meeting each year immediately following the regular annual shareholders meeting elect a president who shall serve until the next regular meeting of the board immediately following the regular annual meeting of the shareholders. The president shall be the chief operating officer of the corporation and shall (a) have responsibility for the operational aspects of the business and affairs of the corporation; (b) have responsibility to direct and guide operations to achieve corporate profit, growth and social responsibility objectives; and (c) perform other duties prescribed by the board and these bylaws. In the absence of the chairman, the president shall assume the duties of chairman. In the event of the inability of both the chairman and the president to act, then the executive vice president with the greatest seniority in office, if any, the senior vice president with the greatest seniority in office, if any, or if neither of the foregoing is available, then the vice president with the greatest seniority in that office shall perform the duties and exercise the powers of the chairman and the president during the period of their inability or until the next meeting of the executive committee or the board. Section 4. Chief Financial Officer. The board shall elect one or more officers, however denominated, to serve at the pleasure of the board who shall together share the function of chief financial officer. The function of chief financial officer shall be to (a) cause accurate financial records to be maintained for the corporation; (b) cause all funds belonging to the corporation to be deposited in the name of and to the credit of the corporation in banks and other depositories selected pursuant to general and specific board resolutions; (c) cause corporate funds to be disbursed as appropriate in the ordinary course of business; (d) cause appropriate internal control systems to be developed, maintained, improved and implemented; and (e) perform other duties prescribed by the board, the chairman or the president. Section 5. Corporate Secretary. The board shall elect a corporate secretary who shall serve at the pleasure of the board. The corporate secretary shall (a) be present at and maintain records of and certify proceedings of the board and the shareholders and, if requested, of the executive committee and other board committees; (b) serve as custodian of all official corporate records other than those of a financial nature; (c) cause the corporation to maintain appropriate records of share transfers and shareholders; and (d) perform other duties prescribed by the board, the chairman or the president. In the absence of the corporate secretary, a secretary, assistant secretary or other officer shall be designated by the president to carry out the duties of corporate secretary. ARTICLE V Share Certificates/Transfer --------------------------- Section 1. Certificated and Uncertificated Shares. The shares of this corporation shall be either certificated shares or uncertificated shares. Each holder of duly issued certificated shares is entitled to a certificate of shares, which shall be in such form as prescribed by law and adopted by the board. [Amended 8/5/03.] Section 2. Transfer of Shares. Transfer of shares on the books of the corporation shall be made by the transfer agent and registrar in accordance with procedures adopted by the board. Section 3. Lost, Stolen or Destroyed Certificates. No certificate for certificated shares of the corporation shall be issued in place of one claimed to be lost, stolen or destroyed except in compliance with Section 336.8-405, Minnesota Statutes, as amended from time to time, and the corporation may require a satisfactory bond of indemnity protecting the corporation against any claim by reason of the lost, stolen or destroyed certificate. [Amended 8/5/03.] ARTICLE VI General Provisions ------------------ Section 1. Voting of Shares. The chairman, president, any vice president or the corporate secretary, unless some other person is appointed by the board, may vote shares of any other corporation held or owned by the corporation and may take any required action with respect to investments in other types of legal entities. Section 2. Execution of Documents. Deeds, mortgages, bonds, contracts and other documents and instruments pertaining to the business and affairs of the corporation may be signed and delivered on behalf of the corporation by the chairman, president, any vice president or corporate secretary or by such other person or by such other officers as the board may specify. Section 3. Transfer of Assignment of Securities. The chairman, the president, the chief financial officer, the treasurer, or any vice president, corporate secretary, secretary or assistant secretary of the corporation shall execute the transfer and assignment of any securities owned by or held in the name of the corporation. The transfer and assignment of securities held in the name of a nominee of the corporation may be accomplished pursuant to the contract between the corporation and the nominee. Section 4. Fiscal Year. The fiscal year of the corporation shall end on December 31 of each year. Section 5. Seal. The corporation shall have a circular seal bearing the name of the corporation and an impression of a man at a plow, a gun leaning against a stump and an Indian on horseback. Section 6. Indemnification. Subject to the limitations of the next sentence, the corporation shall indemnify and make permitted advances to a person made or threatened to be made a party to a proceeding by reason of his former or present official capacity against judgments, penalties, fines (including without limitation excise taxes assessed against the person with respect to an employee benefit plan), settlements and reasonable expenses (including without limitation attorneys' fees and disbursements) incurred by him in connection with the proceeding in the manner and to the fullest extent permitted or required by Section 302A.521, Minnesota Statutes 1981 Supplement, as amended from time to time. Notwithstanding the foregoing, the corporation shall neither indemnify nor make advances under Section 302A.521 to any person who at the time of the occurrence or omission claimed to have given rise to the matter which is the subject of the proceeding only had an agency relationship to the corporation and was not at that time an officer, director or employee thereof unless such person and the corporation were at that time parties to a written contract for indemnification or advances with respect to such matter or unless the board specifically authorizes such indemnification or advances. EX-11 4 ex11903.txt EXHIBIT 11 EXHIBIT 11 THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES COMPUTATION OF EARNINGS PER SHARE Three Months and Nine Months Ended September 30, 2003 and 2002 (In millions, except per share data) Three Months Ended Nine Months Ended September 30 September 30 ------------------ ---------------- (in millions) 2003 2002 2003 2002 ----------- ----- ----- ----- ----- Earnings (Loss) Basic: Net income (loss), as reported $ 214 $ 63 $ 609 $ (26) Preferred stock dividends, net of taxes (2) (2) (6) (6) Premium on preferred shares redeemed (2) (1) (6) (6) ----- ----- ----- ----- Net income (loss) available to common shareholders $ 210 $ 60 $ 597 $ (38) ===== ===== ===== ===== Diluted: Net income (loss) available to common shareholders $ 210 $ 60 $ 597 $ (38) Dilutive effect of affiliates (1) - (3) - Effect of dilutive securities: Convertible preferred stock 1 2 5 - Zero coupon convertible notes 1 1 2 - ----- ----- ----- ----- Net income (loss) available to common shareholders $ 211 $ 63 $ 601 $ (38) ===== ===== ===== ===== Common Shares Basic: Weighted average common shares outstanding 228 221 228 212 ===== ===== ===== ===== Diluted: Weighted average common shares outstanding 228 221 228 212 Effect of dilutive securities: Stock options and other incentive plans 1 1 1 - Convertible preferred stock 6 6 6 - Zero coupon convertible notes 2 2 2 - Equity unit stock purchase contracts 3 - 2 - ----- ----- ----- ----- Total 240 230 239 212 ===== ===== ===== ===== Earnings (Loss) per Common Share Basic $ 0.92 $ 0.27 $ 2.62 $(0.18) ===== ===== ===== ===== Diluted $ 0.88 $ 0.27 $ 2.51 $(0.18) ===== ===== ===== ===== Diluted EPS is the same as Basic EPS for the nine months ended September 30, 2002, because Diluted EPS calculated in accordance with Statement of Financial Accounting Standards (SFAS) No. 128, "Earnings Per Share," for The St. Paul's loss from continuing operations, results in a lesser loss per share than the Basic EPS calculation does. The provisions of SFAS No. 128 prohibit this "anti-dilution" of earnings per share, and require that the larger Basic loss per share also be reported as the Diluted loss per share amount. EX-12 5 ex12303.txt EXHIBIT 12 EXHIBIT 12 THE ST. PAUL COMPANIES, INC. AND SUBSIDIARIES COMPUTATION OF RATIOS Three Months and Nine Months Ended September 30, 2003 and 2002 (In millions, except ratios) Three Months Ended Nine Months Ended September 30 September 30 ------------------ ----------------- (in millions) 2003 2002 2003 2002 ----------- ------ ------ ------ ------ EARNINGS Income (loss) from continuing operations, before income taxes $ 331 $ 95 $ 890 $ (73) Add: fixed charges 57 56 168 160 ------ ------ ------ ------ Income (loss), as adjusted $ 388 $ 151 $1,058 $ 87 ====== ====== ====== ====== FIXED CHARGES AND PREFERRED DIVIDENDS Fixed charges: Interest expense and amortization $ 31 $ 30 $ 91 $ 84 Distributions on redeemable preferred securities 17 17 52 53 Rental expense (1) 9 9 25 23 ------ ------ ------ ------ Total fixed charges 57 56 168 160 Preferred stock dividend requirements 3 4 9 10 ------ ------ ------ ------ Total fixed charges and preferred stock dividend requirements $ 60 $ 60 $ 177 $ 170 ====== ====== ====== ====== Ratio of earnings to fixed charges 6.85 2.68 6.32 0.54 ====== ====== ====== ====== Ratio of earnings to combined fixed charges and preferred stock dividend requirements 6.49 2.53 5.98 0.51 ====== ====== ====== ====== (1) Interest portion deemed implicit in total rent expense. EX-31 6 ex31a303.txt EXHIBIT 31(A) EXHIBIT 31(a) CERTIFICATION I, Jay S. Fishman, Chairman and Chief Executive Officer, certify that: 1. I have reviewed this Quarterly Report on Form 10-Q for the quarter ended September 30, 2003 of The St. Paul Companies, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a- 15(e) and 15d-15(e)) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: October 30, 2003 By: Jay S. Fishman ---------------- -------------- Jay S. Fishman Chairman and Chief Executive Officer EX-31 7 ex31b303.txt EXHIBIT 31(B) EXHIBIT 31(b) CERTIFICATION I, Thomas A. Bradley, Chief Financial Officer, certify that: 1. I have reviewed this Quarterly Report on Form 10-Q for the quarter ended September 30, 2003 of The St. Paul Companies, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a- 15(e) and 15d-15(e)) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: October 30, 2003 By: Thomas A. Bradley ---------------- ----------------- Thomas A. Bradley Executive Vice President and Chief Financial Officer EX-32 8 ex32a303.txt EXHIBIT 32(A) EXHIBIT 32(a) CERTIFICATION Pursuant to 18 U.S.C. Section 1350, the undersigned officer of The St. Paul Companies, Inc. (the "Company"), hereby certifies that the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2003 (the "Report") fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and that the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Dated: October 30, 2003 Jay S. Fishman ---------------- -------------- Name: Jay S. Fishman Title: Chief Executive Officer EX-32 9 ex32b303.txt EXHIBIT 32(B) EXHIBIT 32(b) CERTIFICATION Pursuant to 18 U.S.C. Section 1350, the undersigned officer of The St. Paul Companies, Inc. (the "Company"), hereby certifies that the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2003 (the "Report") fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and that the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Dated: October 30, 2003 Thomas A. Bradley ---------------- ----------------- Name: Thomas A. Bradley Title: Executive Vice President and Chief Financial Officer -----END PRIVACY-ENHANCED MESSAGE-----