national union fire insurance company of pittsburgh pa

Examination Warrant Number 05-PC-121Z Report of Examination of National Union Fire Insurance Company of Pittsburgh, Pa. New York, New York As of December 31, 2005 National Union Fire Insurance Company of Pittsburgh, Pa. TABLE OF CONTENTS Subject Page Salutation .........................................................................................................................................1 Scope of Examination ......................................................................................................................2 History .............................................................................................................................................3 Management and Control: Capitalization .............................................................................................................................3 Stockholders...............................................................................................................................3 Insurance Holding Company System.........................................................................................4 Board of Directors .....................................................................................................................6 Officers ......................................................................................................................................8 Corporate Records: Minutes ....................................................................................................................................10 Articles of Incorporation..........................................................................................................10 By-Laws...................................................................................................................................10 Service and Operating Agreements ...............................................................................................10 Reinsurance: Pooling Agreement ..................................................................................................................12 Ceded .......................................................................................................................................13 Assumed...................................................................................................................................16 Territory and Plan of Operations ...................................................................................................18 Accounts and Records ...................................................................................................................18 Pending Litigation..........................................................................................................................22 Financial Statements: Comparative Statement of Assets, Liabilities, Surplus and Other Funds................................25 Comparative Statement of Income...........................................................................................26 Comparative Statement of Capital and Surplus .......................................................................27 Comparative Statement of Cash Flow .....................................................................................28 Summary of Examination Changes ...............................................................................................29 Notes to Financial Statements: Investments ..............................................................................................................................30 Premium Key Functional Activity (Machine Only) ................................................................32 Non-Machine Key Functional Activity ...................................................................................34 Domestic Brokerage Group – Fusion ......................................................................................36 Loss and Loss Adjustment Expense Reserves .........................................................................40 Reinsurance..............................................................................................................................44 Subsequent Events .........................................................................................................................45 Recommendations: Prior Examination ....................................................................................................................45 Current Examination................................................................................................................45 Conclusion .....................................................................................................................................46 Harrisburg, Pennsylvania May 31, 2007 Honorable Alfred W. Gross Chairman, Financial Condition (E) Committee, NAIC Virginia State Corporation Commission Bureau of Insurance PO Box 1157 Richmond, Virginia 23218 Honorable Stephen J. Johnson, CPA Deputy Insurance Commissioner Commonwealth of Pennsylvania Insurance Department Harrisburg, Pennsylvania Honorable Thomas E. Hampton Secretary, Northeastern Zone (I), NAIC District of Columbia Department of Insurance 810 1st Street, NE Suite 701 Washington, DC 20002 Honorable Kent Michie Secretary, Western Zone (IV), NAIC Utah Department of Insurance 3110 State Office Building P.O. Box 146901 Salt Lake City, Utah 84114-6901 Honorable Merle D. Scheiber Secretary, Midwestern Zone (III), NAIC South Dakota Division of Insurance 445 East Capital Avenue Pierre, SD 57501 Commissioners and Deputy Commissioner: In accordance with instructions contained in Examination Warrant Number 05-PC-121Z, dated, December 7, 2005, an examination was made of National Union Fire Insurance Company of Pittsburgh, Pa. a Pennsylvania domiciled property and casualty insurance company, hereinafter referred to as “Company” or National Union. The examination was conducted at the Company’s main administrative office, located at 70 Pine St., New York, New York 10270-0002. A report of this examination is hereby respectfully submitted. National Union Fire Insurance Company of Pittsburgh, Pa. -2SCOPE OF EXAMINATION The Company was last examined as of December 31, 2001, however, the report was not issued as allegations of accounting improprieties began to surface on or about the date the report was to be issued. This examination covered the four year period from January 1, 2002 through December 31, 2005, and consisted of a general survey of the Company’s business practices and management, and an evaluation of the Company’s financial condition as of the latter date. Material subsequent events were also reviewed. The examination focus was exclusively on the financial reporting for the one year period ended December 31, 2005. The one year examination period was the result of significant control deficiencies that existed at American International Group, Inc. (AIG), the Company’s ultimate parent, during 2005 and prior. These deficiencies are further explained within this report and have been disclosed by AIG in its 10-K filings for the years 2004 – 2006. Both AIG management and the management of the Domestic Brokerage Group have dedicated significant effort and resources to the remediation of these control deficiencies. The decision to examine the AIG group as of 2005 was to use the regulatory examination authority to gauge the depth and pervasiveness of these control deficiencies. The Pennsylvania Insurance Department has determined that the financial statements set forth in the Company’s amended annual statement will be presented in this report on an “as filed” basis and that comments made will be relative to these balances, where appropriate. Additional comments will relate to the deficiencies in the internal control environment, the remediation efforts made through the examination date, and a description of ongoing remediation efforts. The report will also contain comments surrounding future regulatory plans within these areas. We have not concluded on the balance sheet accounts where the associated internal control deficiencies were not fully remediated. However, as explained further in this report, the Company has established a significant allowance provision to provide for the potential exposures related to the internal control weaknesses associated with balance sheet reconciliations. Additionally, we have concluded on other balance sheet accounts, including the Company’s invested assets and the adequacy of its loss and loss adjustment expense reserves. Work programs employed in the performance of this examination were designed to comply with the standards promulgated by the Pennsylvania Insurance Department (“Department”) and the National Association of Insurance Commissioners (“NAIC”). The format of this report is consistent with the current practices of the Department and the examination format prescribed by the NAIC. It is limited to a description of the Company, a discussion of financial items that are of specific regulatory concern, and a factual disclosure of other significant regulatory information. For each year during the period under examination, the Certified Public Accounting (“CPA”) firm of PricewaterhouseCoopers has provided an unqualified opinion based on statutory National Union Fire Insurance Company of Pittsburgh, Pa. -3accounting principles. Relevant work performed by the CPA firm, during its annual audit of the Company, was reviewed during the examination and incorporated into the examination workpapers. HISTORY The Company was incorporated on February 14, 1901, licensed by the Department and commenced business on March 1, 1901. The Company made no amendments to its Articles of Incorporation or its By-laws during the examination year. The Company is currently authorized to transact those classes of insurance described in the Pennsylvania Insurance Company Law (40 P.S. § 382), Subsection (b), Paragraphs (1) fire and allied lines, (2) inland marine and auto physical damage, (3) ocean marine and Subsection (c), Paragraphs (1) fidelity & surety, (2) accident & health, (3) glass, (4) other liability including professional liability, medical malpractice, prepaid legal, etc., (5) boiler & machinery, (6) burglary & theft, (7) credit, (8) water damage, (9) elevator, (10) livestock, (11) auto liability, (12) mine, (13) personal property floater, and (14) workers’ compensation. MANAGEMENT AND CONTROL CAPITALIZATION There was no change in the capital stock during the period under examination. The capital stock at December 31, 2005 consisted of 1,000,000 common shares authorized and 895,750 common shares issued and outstanding with a par value of $5 per share resulting in capital stock of $4,478,750, paid in and contributed surplus of $2,694,091,950 and unassigned funds of $5,349,703,403 and $71,890,338 in aggregate write-ins for special surplus funds. The total capitalization required of the Company, to engage in the types of business for which it is licensed, is $2,350,000 in capital and $1,175,000 in surplus. The Company meets this requirement. STOCKHOLDERS AIG owns 100% of the outstanding common stock of the Company. The Company paid $97,750,282 in dividends to its parent in 2005. All dividends appear to have been approved and paid within the existing regulatory framework. INSURANCE HOLDING COMPANY SYSTEM National Union Fire Insurance Company of Pittsburgh, Pa. -4The Company meets the requirements for filing an insurance holding company system registration statement as directed by the Pennsylvania Insurance Company Law (40 P.S. § 991.1404), Registration of Insurers. Pursuant to this requirement, an Insurance Holding Company System Registration Statement and various amendments thereto, appear to have been timely filed with the Department for the period under examination. The Company is part of the AIG holding company structure which includes insurance companies, management companies, agencies and other enterprises doing business in all states of the United States, including the District of Columbia and around the world. The parent company, AIG, is a publicly traded company, with approximately 23% of the shares owned by C.V. Starr & Co., Inc., Starr International Company, Inc., and The Starr Foundation as of December 31, 2005. The following is an organizational chart of the U.S. domiciled insurance companies within the AIG insurance holding company system as of December 31, 2005: Organizational Chart ♦ AMERICAN INTERNATIONAL GROUP, INC. (PARENT) o AIU INSURANCE COMPANY (52%-Ownership Group A-48%) o AMERICAN HOME ASSURANCE COMPANY 21st CENTURY INSURANCE GROUP (16.9%) • 21st CENTURY INSURANCE COMPANY • 21st CENTURY CASUALTY COMPANY • 21st CENTURY INSURANCE COMPANY OF ARIZONA (100%) AIG HAWAII INSURANCE COMPANY TRANSATLANTIC HOLDINGS (33.86%-Ownership Group B-17.84%) • TRANSATLANTIC REINSURANCE COMPANY • PUTNAM REINSURANCE COMPANY o AIG LIFE INSURANCE COMPANY (78.9%-Ownership Group C-21.1%) o AIG GLOBAL TRADE & POLITICAL RISK INSURANCE COMPANY o AMERICAN INTERNATIONAL INSURANCE COMPANY OF DELAWARE, INC. o AMERICAN INTERNATIONAL LIFE ASSURANCE COMPANY OF N.Y. (77.5%-Ownership Group D-22.5%) o AMERICAN LIFE INSURANCE COMPANY o BIRMINGHAM FIRE INSURANCE COMPANY OF PENNSYLVANIA o CHINA AMERICA HOLDING COMPANY (50%) CHINA AMERICA INSURANCE COMPANY LTD. (DELAWARE) 1 o COMMERCE AND INDUSTRY INSURANCE COMPANY AMERICAN INTERNATIONAL INSURANCE COMPANY (50%-Ownership Group E 50%) MINNESOTA INSURANCE COMPANY AMERICAN INTERNATIONAL INSURANCE COMPANY OF CALIFORNIA INC. AMERICAN INTERNATIONAL INSURANCE COMPANY OF NEW JERSEY o DELAWARE AMERICAN LIFE INSURANCE COMPANY o THE INSURANCE COMPANY OF THE STATE OF PENNSYLVANIA 1 China America Insurance Company, Ltd was dissolved on December 23, 2005. National Union Fire Insurance Company of Pittsburgh, Pa. -5o o LANDMARK INSURANCE COMPANY NATIONAL UNION FIRE INSURANCE COMPANY OF PITTSBURGH, Pa. AMERICAN INTERNATIONAL SPECIALTY LINES INSURANCE COMPANY (70%-Ownership Group F-30%) LEXINGTON INSURANCE COMPANY (70%-Ownership Group F-30%) • JAPAN INTERNAT’L ACCIDENT & FIRE INSURANCE COMPANY LTD. (50%) NATIONAL UNION FIRE INSURANCE COMPANY OF LOUISIANA NHIG HOLDING CORPORATION AUDUBON INSURANCE COMPANY • AUDUBON INDEMNITY COMPANY NEW HAMPSHIRE INSURANCE COMPANY • AMERICAN INTERNATIONAL PACIFIC INSURANCE COMPANY (formerly, AMERICAN FIDELITY INSURANCE COMPANY) • AMERICAN INTERNATIONAL SOUTH INSURANCE COMPANY (formerly, AMERICAN GLOBAL INSURANCE COMPANY) • GRANITE STATE INSURANCE COMPANY • ILLINOIS NATIONAL INSURANCE CO. • NEW HAMPSHIRE INDEMNITY COMPANY, INC. ABEILLE GENERAL INSURANCE COMPANY, INC. (Currently, AIG NATIONAL INSURANCE C0MPANY, INC.) • NEW HAMPSHIRE LIFE INSURANCE COMPANY • UNITED GUARANTY CORPORATION (16.9%-Ownership Group G-83.1%) UNITED GUARANTY INSURANCE COMPANY UNITED GUARANTY MORTGAGE INSURANCE COMPANY UNITED GUARANTY MORTGAGE INSURANCE COMPANY OF NORTH CAROLINA UNITED GUARANTY RESIDENTIAL INSURANCE COMPANY (75%-Ownership Group H-25%) • UNITED GUARANTY COMMERCIAL INSURANCE COMPANY (currently, UNITED GUARANTY MORTGAGE INDEMNITY COMPANY) • UNITED GUARANTY COMMERCIAL INSURANCE COMPANY OF NORTH CAROLINA • UNITED GUARANTY CREDIT INSURANCE COMPANY THE PHILIPPINE AMERICAN LIFE & GENERAL INSURANCE COMPANY (99.78%) PACIFIC UNION ASSURANCE COMPANY o o Referenced Groups: ATHE INSURANCE COMPANY OF THE STATE OF PENNSYLVANIA (8%) BIRMINGHAM FIRE INSURANCE COMPANY OF PENNSYLVANIA (8%) (currently known as AIG CASUALTY COMPANY) NATIONAL UNION FIRE INSURANCE COMPANY OF PITTSBURGH, Pa. (32%) AMERICAN INTERNATIONAL GROUP, INC. (17.84%) COMMERCE AND INDUSTRY INSURANCE COMPANY (21.1%) AMERICAN HOME ASSURANCE COMPANY (22.5%) AMERICAN HOME ASSURANCE COMPANY (25%) BCDE- National Union Fire Insurance Company of Pittsburgh, Pa. -6AIU INSURANCE COMPANY (25%) FTHE INSURANCE COMPANY OF THE STATE OF PENNSYLVANIA (20%) BIRMINGHAM FIRE INSURANCE COMPANY OF PENNSYLVANIA (10%) (currently known as AIG CASUALTY COMPANY). NATIONAL UNION FIRE INSURANCE COMPANY OF PITTSBURGH, Pa. (45.9%) AMERICAN INTERNATIONAL GROUP (36.3%) THE INSURANCE COMPANY OF THE STATE OF PENNSYLVANIA (0.9%) UNITED GUARANTY RESIDENTIAL INSURANCE COMPANY OF NORTH CAROLINA INC. (25%) G- H- BOARD OF DIRECTORS Management of the Company is vested in its Board of Directors (“Board”), which was comprised of the following members as of the examination date, December 31, 2005: Name and Address Merton Bernard Aidinoff New York, New York Steven Jay Bensinger New York, New York Charles H. Dangelo Manasquan, New Jersey David Lawrence Herzog St. Albans, Missouri John William Keogh Manhasset, New York Principal Occupation Director and Retired Partner Sullivan & Cromwell Executive Vice President and Chief Financial Officer American International Group, Inc. Vice President American International Group, Inc. Senior Vice President and Comptroller American International Group, Inc. Senior Vice President American International Group, Inc. (no longer with the Company) Senior Vice President American International Group, Inc. Executive Vice President American International Group, Inc. Executive Vice President and Chief Investment Officer American International Group, Inc. Robert Edward Lewis New York, New York Kristian Philip Moor Fairfield, Connecticut Win Jay Neuger New York, New York National Union Fire Insurance Company of Pittsburgh, Pa. -7Ernest Theodore Patrikis New York, New York Senior Vice President and General Counsel American International Group, Inc. (no longer with the Company) Executive Vice President / Senior Actuary American International Group, Inc. Senior Vice President and Treasurer National Union Fire Insurance Company Vice President American International Group, Inc. Executive Vice President American International Group, Inc. Robert Michael Sandler Bridgewater, New Jersey Robert Scott Higgins Schimek Newtown, Pennsylvania Nicholas Shaw Tyler Montclair, New Jersey Nicholas Charles Walsh New York, New York All directors are elected annually at the stockholder meeting and are elected to serve a term of one year. These elections appear to have been held within the confines of the Company’s by-laws. AIG has established a Code of Conduct Policy for use and guidance of its employees, including officers of AIG, to disclose any potential conflicts between their personal interests and the interests of AIG or any of its subsidiaries. Since 2005, all officers and employees are required to recertify to the Code of Conduct on an annual basis. Pennsylvania Holding Company Law, namely, (40 P.S. 991.1405 (c) (3)) Standards of transactions between insurer and affiliate (within the holding company system) states, in part, that “not less than one-third of the directors of any domestic insurer and not less than one-third of the members of each committee of the board of directors of any domestic insurer shall be persons who are not officers or employees of such insurer or of any entity controlling, controlled by or under common control with such insurer and who are not beneficial owners of a controlling interest in the voting stock of such insurer of any such entity. At least one such person must be included in any quorum for the transaction of business at any meeting of the board of directors or any committee thereof. Likewise, Pennsylvania Holding Company Law, (40 P.S. 991.1405 (c) (4)) Standards of transactions between affiliates (within the holing company system), further states that “the board of directors of a domestic insurer shall establish one or more committees comprised solely of directors who are not officers or employees of the insurer or of any entity controlling, controlled by or under common control with the insurer and who are not beneficial owners of a controlling interest in the voting stock of the insurer or any such entity. The committee or committees shall have the responsibility for recommending the selection of independent certified public accountants, reviewing the insurer’s financial condition, the scope and results of the independent audit and any internal audit, nominating candidates for director for election by shareholders or National Union Fire Insurance Company of Pittsburgh, Pa. -8policyholders, evaluating the performance of officers deemed to be principal officers of the insurer and recommending to the board of directors the selection and compensation of the principal officers.” An extension of the Pennsylvania Holding Company Law, (40 P.S. 991.1405 (c) (5)) proclaims that the cited laws above shall not apply to a domestic insurer if the person controlling such insurer is an insurer or a publicly held corporation having a board of directors and committees thereof which already meet the requirements of paragraphs (3) and (4). The Company’s parent, AIG, Inc.’s board membership has the necessary independence and has established independent committees to comply with paragraphs (3) and (4) as cited above. The Board of Directors appointed two committees during the examination period. These committees appear to have acted in accordance with the Company’s by-laws. The following Committees and their respective membership were serving the Board at the examination date: Executive Committee Steven J. Bensinger John W. Keogh Kristian P. Moor Nominating Committee M. Bernard Aidinoff The Finance, Audit and Compensation Committees of AIG, Inc., performed the functions required by the Company’s mandatory committees that were outlined in the Company’s by-laws. OFFICERS As of the examination date, December 31, 2005, the following officers were appointed and serving in accordance with the Company’s by-laws: Name Title Kristian Philip Moor John William Keogh Gregory James Flood John Russell Benedetto Christopher V. Blum Charles H. Dangelo Frank Hienmen Douglas Jr. Neil Anthony Faulkner Heather Fox Irwin Harold Goldfarb Kenneth Vincent Harkins Chairman of the Board of Directors President and Chief Executive Officer Chief Operating Officer and Executive Vice President Senior Vice President Senior Vice President and Associate General Counsel Senior Vice President Senior Vice President and Actuary Senior Vice President Senior Vice President and Chief Underwriting Officer Senior Vice President Senior Vice President and General Counsel National Union Fire Insurance Company of Pittsburgh, Pa. -9Brian Robert Inselberg Paul Lavelle Peter Joseph McKenna Scott Alan Meyer John Anthony Rudolf Charles Ross Schader Robert Scott Higgins Schimek Michael Wayne Smith Nicholas Charles Walsh Mark Timothy Willis Douglas Merle Worman Carl E. Chamberlain John Gardiner Colona Daniel Francis Conway Kenneth Bryan Cornell Hans Karl-Erik Danielsson Agustin Formoso, Jr. Vincent Peter Forte Lucy Ann Galioto Louis Philip Iglesias Russell Mark Johnston Win Jay Neuger Richard Thomas Pisano James J. Rowland Richard Ruggiano Robert Edwin Staples Nicholas Shaw Tyler Edward Francis Andrzejewski Drew Beauchamp William Watson Fish Adam Craig Reed Elizabeth Margaret Tuck Amy Marie Cinquegrana Lawrence Scott Golodner Mark Harold Paffmann Senior Vice President Senior Vice President Senior Vice President Senior Vice President Senior Vice President Senior Vice President Senior Vice President and Treasurer Senior Vice President Senior Vice President Senior Vice President Senior Vice President Vice President Vice President Vice President Vice President Vice President Vice President Vice President Vice President Vice President Vice President Vice President Vice President and Comptroller Vice President and Assistant Comptroller Vice President Vice President Vice President Assistant Vice President Assistant Vice President Assistant Vice President Assistant Vice President Secretary Assistant Secretary Assistant Comptroller Assistant Comptroller CORPORATE RECORDS National Union Fire Insurance Company of Pittsburgh, Pa. -10MINUTES A review of the corporate minutes indicated the annual meetings of the stockholder and election of directors of the Company were held in compliance with the Company’s by-laws. Minutes of the stockholder annual meetings indicate that the prior year’s actions of the officers and directors of the Company were ratified. Quorums were present at all stockholder and Board of Director meetings. Company officers were appointed at the Board of Director’s Annual Meeting. A review of the minutes also indicates the Company’s investment transactions are approved quarterly by the Board of Directors and the meetings are all generally well attended. ARTICLES OF INCORPORATION There were no amendments to the Company’s Articles of Incorporation during the examination year. BY-LAWS There were no amendments to the Company’s by-laws during the examination year. SERVICE AND OPERATING AGREEMENTS Inter-Company Pooling Agreement The Commercial Lines Pool also known as the American Home / National Union Fire pool was formed by the execution of an Inter-Company Pooling Agreement (“Pooling Agreement”). As amended, the pooling agreement establishes a “pool” in which participants share a fixed percentage of insurance assets and liabilities. The current pool members are: • • • • • • • • • • • National Union Fire Insurance Company of Pittsburgh, Pa. (PA) - 38% American Home Assurance Company (NY) - 36% Commerce and Industry Insurance Company (NY) - 10% Birmingham Fire Insurance Company of Pennsylvania (PA) - 5% The Insurance Company of the State of Pennsylvania (PA) - 5% New Hampshire Insurance Company (PA) - 5% AIU Insurance Company (NY) - 1% American International South Insurance Company (PA) - 0% Granite State Insurance Company (PA) - 0% American International Pacific Insurance Company (CO)- 0% Illinois National Insurance Co. (IL) - 0% Based on work performed by the Company’s independent CPAs, the Pooling Agreement has not changed since 1995. Therefore, no changes have been made during the period since the National Union Fire Insurance Company of Pittsburgh, Pa. -11last examination of the Company. Service and Expense Agreement The pooled companies are party to a Service and Expense Sharing Agreement with AIG and its affiliated companies. AIG is to share/supply certain operating expenses, equipment, office space, overhead expenses, services and personnel. Settlement for these equipment and services shall be quarterly, as per the agreement. In the ordinary course of business, the Company utilizes the services of certain affiliated companies for data center systems, investment, salvage, subrogation and recovery services, and claims management. These companies are AIG Data Center, Inc., AIG Global Investment Corp., AIG Recovery, Inc., and AIG Domestic Claims, Inc., respectively. Services from the aforementioned affiliates are provided under the Service and Expense Agreement with AIG, Inc. This Service & Expense Agreement has been amended twice since the last examination of the Company as of December 31, 2001. Each of these amendments added new affiliates to the original agreement. Tax Allocation Agreement The pooled member companies file a consolidated federal income tax return with the U.S. parent, AIG, a Delaware domiciled corporation. Each Company’s tax liability is calculated based upon its respective share of consolidated taxable income. The agreement further provides that each member shall receive reimbursement to the extent that their losses and other credits result in a reduction of the current year’s consolidated tax liability, not to exceed their liability as if filed on an individual basis. Capital Maintenance Agreements These agreements provide that in the event that the respective Company’s Total Adjusted Capital falls below 200% of the Company’s Authorized Control Level Risk Based Capital, AIG, shall provide a capital contribution to the Company in the amount that equals the difference between the Company’s Total Adjusted Capital and 200% of the Company’s Authorized Control Level RBC. Security Lending Agreements The pooled companies are also party to Security Lending Agreements with AIG Global Security Lending Corp. These various agreements allow AIG Global Securities Lending Corp., to negotiate the terms and conditions of transactions necessary for a securities lending program. The agreement also allows for AIG Global Securities Lending Corp., to take such actions to manage the “Lenders” relationship with banks, brokers, and counterparties in connection with security lending transactions. National Union Fire Insurance Company of Pittsburgh, Pa. -12Investment Advisory Agreements The pooled companies have agreements with AIG Global Investment Corp., to provide investment advisory services to include investment advisory accounts. The agreement authorizes the Manager to supervise and direct all investments and to exercise whatever powers the Company may possess with respect to its invested assets. Investment transactions will be in accordance with investment objectives of the Company and subject to restrictions established by the Company, as communicated to the Manager in writing from time to time. With regard to these limitations, the Manager may buy, sell, exchange, convert and otherwise trade in and engage in investment transactions of any nature whatsoever involving any stocks, bonds, commercial paper, money market instruments and other securities and assets when it deems appropriate and without prior consultation with the Company. REINSURANCE POOLING AGREEMENT The Company participates in an inter-company pooling agreement with ten affiliates. The Pool is known as the American Home/National Union Fire Pool (“Pool”). The pooling agreement provides for the pooling of premiums, losses and expenses, based on the pool participation percentages of these eleven pool companies. The pooling agreement became effective in 1978. The pooled companies and their assumed pooling percentages as of December 31, 2005 were as follows: Pool Company AIU Insurance Company American Home Assurance Company American International Pacific Insurance Company American International South Insurance Company Birmingham Fire Insurance Company of Pennsylvania Commerce and Industry Insurance Company Granite State Insurance Company Illinois National Insurance Co. State of Domicile New York New York Colorado Pennsylvania Pennsylvania New York Pennsylvania Illinois Pool % 1% 36% 0% 0% 5% 10% 0% 0% National Union Fire Insurance Company of Pittsburgh, Pa. -13National Union Fire Insurance Co. of Pittsburgh, Pa. New Hampshire Insurance Company The Insurance Company of the State of Pennsylvania Total Pool Pennsylvania Pennsylvania Pennsylvania 38% 5% 5% 100% CEDED External treaty reinsurance is placed by AIG’s Global Reinsurance Division (GRD). Reinsurance officers within GRD are aligned with specific AIG Profit Centers and are responsible for determining structures, negotiating, and placing individual treaty reinsurance programs. GRD’s Catastrophe (CAT) Unit reviews, analyzes, and assists in placing AIG’s overall CAT reinsurance. Reinsurance placed by GRD will be ceded from various legal entities of AIG. AIG maintains extensive reinsurance, with programs placed with U.S. domestic, international and offshore reinsurance facilities. Management’s goal is to fully place its traditional excess of loss catastrophe reinsurance cover in order to limit the effect of a severe catastrophic event. AIG’s reinsurance strategy is to retain a higher amount of low layer exposures, which could be absorbed through its earnings stream. AIG also maintains a strong risk management approach which has been in place well before Hurricane Andrew (1992) and the Northridge Earthquake (1994). The group’s lower direct exposure to catastrophes, coupled with heavy reinsurance utilization, serve to limit AIG’s net pretax probable maximum loss (PML) from a 250-year earthquake and 100-year hurricane to a modest percentage of surplus. AIG’s primary Domestic General Insurance Division is the Domestic Brokerage Group (DBG), an overview of the DBG reinsurance profit centers is as follows: American Home (AHAC) AHAC is a major writer of Excess Casualty & Umbrella and Workers’ Compensation insurance. There is a minimum reliance on treaty reinsurance thus resulting in high net retentions. Facultative reinsurance is purchased for selected risks. There were no treaty placements for AHAC for 2005. AIG Risk Management (AIGRM) AIGRM is a major writer of Primary Casualty business tailored to serve the needs of construction and transportation businesses, as well as Commercial Accounts and National Accounts. Lines of business include Excess Casualty, Umbrella, Auto Liability, General Liability, Workers’ Compensation, and Surety. There is a minimum reliance on treaty National Union Fire Insurance Company of Pittsburgh, Pa. -14reinsurance. Facultative reinsurance is purchased for selected risks. There were no significant treaty placements in 2005. All current reinsurance is facultative or captive treaties. National Union (NUFIC) NUFIC is the focal point for financial products within the Domestic Brokerage Group (DBG), (D&O, E&O, EPLI, Misc. Professional, and Fidelity). Product lines are supported by a number of specific treaties. Due to the number of existing and new products being offered by National Union, there exists a number of treaties to support the individual and less mature products. Facultative is purchased, but is not pervasive due to the number of existing treaty reinsurance arrangements. AIG Environmental AIG Environmental is a major writer of environmental liability. The portfolio includes umbrella and primary liability, environmental surety and auto liability. Most of the reinsurance requirements of this profit center are met by the two treaty programs, casualty excess and surety. WorldSource (WSource) WSource provides access to world markets for US Domestic Companies. Major lines of business include property, casualty, auto, products recall, and workers’ compensation. As many of the exposures written exist overseas, WSource accesses the international property treaty and facultative markets. Facultative reinsurance is purchased primarily for property capacity. Treaty coverages exist for the more exposed casualty lines. Lexington Insurance Company (LEX) LEX is AIG’s major surplus lines writer writing multiple lines of business. Business is written through its major divisions which are Property, Casualty, Marine, Programs, and Medical/Healthcare. The approach to reinsurance structures for this profit center varies by line of business and size of the portfolio. The retention under the program portfolio is significantly lower than most of the directly written books. Lexington has extensive property reinsurance which is placed through domestic and foreign reinsurers. The program consists of working and excess layers that cover all property business. Traditionally, Lexington has been a big purchaser of pro rata treaty reinsurance. Lexington will purchase facultative reinsurance business to provide capacity or supplement treaty reinsurance. Starr Excess Starr Excess is a writer of high excess casualty business, primarily in casualty and financial lines. This profit center will write excess over AIG or other third party companies. Reinsurance is purchased mainly to control high aggregates, both on a treaty and facultative basis. National Union Fire Insurance Company of Pittsburgh, Pa. -15Aviation This profit center covers all aviation related exposures; products include Liability, Hull Risks, Warranty Risk and Satellite Liability. Due to the focus of the business unit, reinsurance is purchased on a more traditional treaty reinsurance basis. Property Cats AIG purchases catastrophe protection separately for its commercial and personal lines business. Property catastrophe covers as of December 31, 2005: Corporate Property Catastrophe Covers Treaty Name 1st Domestic Cat XOL 2nd Domestic Cat XOL 3rd Domestic Cat XOL 4th Domestic Cat XOL Max Limits $250M XS 500M $250M XS 750M $250M XS 1B $250M XS 1.25B AIG Net 50% 10% 10% 20% Personal Lines Property Catastrophe Covers Treaty Name Limits AIG Net 2.50% 2.50% 2.50% 2.50% 1st Domestic Personal Lines Cat $100M XS 100M XOL 2nd Domestic Personal Lines Cat $100M XS 200M XOL 3rd Domestic Personal Lines Cat $100M XS 300M XOL 4th Domestic Personal Lines Cat $100M XS 400M XOL The Company cedes 50% of its business classified as other liability occurrence and products liability occurrence to American International Reinsurance Company, Ltd., of National Union Fire Insurance Company of Pittsburgh, Pa. -16Bermuda. Effective January 1, 2006 this treaty was cancelled and all business was placed in runoff. The Company’s net retention for December 31, 2005 is as follows: Gross Premium W ritten Ceded Premium W ritten Net W ritten Net Retention $ $ 28,235,929,402 21,148,950,574 7,086,978,828 25.10% ASSUMED As of December 31, 2005 the Company’s assumed premium written is as follows: Assumed Premium US Inter-company Pooling Affiliated US Non Pool Affiliates Other - Non US Other US Unaffiliated Mandatory Pools Voluntary Pools and Associations Other Non US Insurers Total $ 17,339,127,000 3,823,342,000 990,696,000 209,213,000 203,746,000 920,000 80,603,000 $ 22,647,647,000 Percent 76.56% 16.88% 4.37% 0.92% 0.90% 0.01% 0.36% 100.00% The Company participates in an inter-company pooling agreement with ten affiliates. The Pool is known as the American Home/National Union Fire pool (“Pool”). The pooling agreement provides for the pooling of premiums, losses and expenses, based on the pool participation percentages of these eleven pool companies. The pooling agreement became effective in 1978. As pool manager the Company assumes premiums from the affiliates and retrocedes based upon pool percentages. The Company is a member of an AIG internal facility known as the Compulsory Cessions Auxiliary Account (CCAA). The CCAA account allows AIG to retain business by ceding selected treaties to affiliated companies. The facility retains additional amounts over the retentions determined by the profit center managers. For certain new and renewal business, various member companies of AIG, including AIG Europe, AIRCO, AISLIC, AIU, AIUO, ALICO, American Home, Commerce & Industry, Commerce & Industry of Canada, HSBIIC, Illinois National, ISOP, Landmark, Lexington, New Hampshire Insurance, NUFIC, NUFLA, PhilamLife and Starr Excess, cede business to the "CCAA" program. Some of the business ceded to the CCAA is between different divisions of companies within the same intercompany pool. For example, any business written National Union Fire Insurance Company of Pittsburgh, Pa. -17on the paper of members of the Lexington Pool stays within that pool without cession to American Home. American Home or Lexington (on behalf of the respective pools) retains 100% of the CCAA’s participation. Risk Transfer Treaty placement is in accordance with the AIG Risk Transfer Policy that was adopted October 1, 2005. All assumed and ceded treaties and autofac and obligatory facultative arrangements (excluding captives) must be evaluated by reinsurance services personnel. In the case of a captive, the risk transfer assessment is conducted at the business unit level. If the treaty/certificate contains one or more characteristics or contractual features that are intended to mitigate risk transfer, they are identified on a risk transfer worksheet. The Reinsurance Officer and the Business Unit CFO, or his designee must assist in the determination of whether or not an actuarial analysis is required and whether or not there is sufficient risk transfer to allow for reinsurance accounting treatment. Evidence of this analysis and approval by a Reinsurance Officer and the Business Unit CFO, or his designee is required. In accordance with SFAS No. 113 (paragraph 11), a risk transfer analysis is not required if substantially all of the insurance risk relating to the reinsured portions of the underlying insurance contracts has been assumed by the reinsurer. If none of the potential loss mitigating features summarized in the risk transfer worksheet is present, risk transfer is deemed to be self evident and the reinsurance transaction qualifies for reinsurance accounting treatment. When a risk transfer worksheet is required, it must be included in the treaty/certificate file no later than when the treaty/certificate is bound and be available on request. The documentation of the risk transfer worksheet will vary based on circumstances, but the general requirements are outlined in the risk transfer worksheet. The documentation must state the conclusion and the basis thereof, and be sufficient to support the conclusion. The examination team reviewed a sample of treaties from selected profit centers that were entered into in 2005. These treaties were after the 2004 restatements and before the formal adoption of the Risk Transfer Policy. Because of issues of control (including the nature and timing of certain commutations) over reinsurance ceded ( both direct and indirectly) to Union Excess Reinsurance Company, a Barbados domiciled company, AIG concluded that cessions to Union Excess did not result in risk transfer from AIG as consolidated and therefore did not qualify for reinsurance accounting treatment. Accordingly, as part of the 2004 restatement, these cessions were adjusted to reflect deposit accounting. Union Excess has been included in AIG’s consolidated financial statements. As a result of certain facts and circumstances related to the ownership and control of Richmond Insurance Company, a Barbados domiciled company; Richmond Insurance Company has been included in AIG’s consolidated financial statements. Because of AIG’s ability to exert control over Richmond, AIG concluded that reinsurance ceded to that entity did not result in sufficient transfer of risk, and as part of the 2004 restatement, were adjusted from reinsurance accounting to deposit accounting. National Union Fire Insurance Company of Pittsburgh, Pa. -18TERRITORY AND PLAN OF OPERATIONS The Company is licensed in all states, the District of Columbia, Guam and Puerto Rico. The Company writes nearly all forms of property and liability coverages, specializing primarily in commercial and industrial risks. Workers Compensation is the largest line of business constituting 33% followed by “Other Liabilities” with 31% and the remaining 36% distributed over all other lines, none of which exceed 10%. The states with the largest volume of direct written premiums are California (15%), New York (8%), Florida (6%), Texas (5%), Pennsylvania (4%) and New Jersey (4%). Direct and Assumed Premium Ceded Premium Net Written Premium Percentage of Total (Net) Percentage of Total (Gross) Line of Business December 31, 2005 Fire Allied lines Homeowners multiple peril Commercial multiple peril Ocean marine Inland marine Medical malpractice - occurrence Medical malpractice - claims-made Earthquake Group accident and health Other accident and health Workers' compensation Other liability - occurrence Other liability - claims-made Products liability - occurrence Products liability - claims-made Private passenger auto liability Commercial auto liability Auto physical damage Aircraft Fidelity Surety Burglary and theft Boiler and machinery Totals $ 570,848,476 543,423,519 253,976,169 580,422,834 554,203,282 973,108,434 51,114,093 79,417,314 10,609,969 1,070,023,601 423,595,659 6,702,016,616 5,106,217,198 3,945,072,781 116,018,481 783,773 2,528,546,804 1,561,328,854 1,369,662,389 1,254,788,819 293,043,877 67,085,022 12,887,995 167,733,443 $ 28,235,929,402 $ 473,030,222 461,693,416 195,500,044 417,373,134 469,048,725 870,762,253 41,188,473 66,025,088 6,791,721 707,360,021 381,002,032 4,336,773,997 4,324,657,963 2,555,580,564 78,052,373 492,993 2,017,449,293 1,218,831,750 1,094,621,557 1,015,977,369 213,335,755 48,522,235 8,118,711 146,760,885 $ 21,148,950,574 $ 97,818,254 81,730,103 58,476,125 163,049,700 85,154,557 102,346,181 9,925,620 13,392,226 3,818,248 362,663,580 42,593,627 2,365,242,619 781,559,235 1,389,492,217 37,966,108 290,780 511,097,511 342,497,104 275,040,832 238,811,450 79,708,122 18,562,787 4,769,284 20,972,558 $ 7,086,978,828 1.4 % 1.2 % 0.8 % 2.3 % 1.2 % 1.4 % 0.1 % 0.2 % 0.1 % 5.1 % 0.6 % 33.4 % 11.0 % 19.6 % 0.5 % 0.0 % 7.2 % 4.8 % 3.9 % 3.4 % 1.1 % 0.3 % 0.1 % 0.3 % 100.0 % 2.0% 1.9% 0.9% 2.1% 2.0% 3.4% 0.2% 0.3% 0.0% 3.8% 1.5% 23.7% 18.1% 14.0% 0.4% 0.0% 9.0% 5.5% 4.9% 4.4% 1.0% 0.2% 0.0% 0.6% 100.0% ACCOUNTS AND RECORDS The accounts and records reviewed included an evaluation of the Company’s operational and organizational controls. The areas evaluated included computer systems, accounting systems, organizational structure, and the processing structure. The Company operates in a computer-dominated environment. The Pennsylvania Insurance Department engaged the services of INS Services, Inc., as an outside consultant to perform a review of AIG’s information systems (“I/S”) controls. The engagement instructed INS Services, Inc., to base their review on the NAIC’s Exhibit C, Information Systems Questionnaire (“ISQ”). National Union Fire Insurance Company of Pittsburgh, Pa. -19- The results of the INS Services, Inc., review have been provided to the Company, incorporated and relied upon within the examination process where appropriate. The following represents the Material Weaknesses and Significant Deficiencies that were disclosed by the Company in its December 31, 2004, 2005 and 2006 audited financial statements and reported in the appropriate 10-K’s pursuant to the Company’s compliance with Section 404 of the Sarbanes-Oxley Act (SOX). The table identifies the changes that occurred to the reportable internal control issues over the 3 year period from December 31, 2004 to December 31, 2006. Description 1. Control environment 2. Controls over the evaluation of risk transfer 3. Controls over income tax accounting 4. Controls over accounting for certain derivatives transactions 5. Controls over certain balance sheet reconciliations 2004 Report Year / Type Material Weakness Material Weakness Material Weakness Material Weakness Material Weakness 2005 Report Year / Type N/A – Remediated N/A – Remediated Material Weakness Material Weakness Material Weakness 2006 Report Year / Type N/A N/A Material Weakness N/A – Remediated Not yet fully remediated The following comments in numerical order relate to the control description in the above table. 1. (From AIG’s 2004 10K): Control environment: Certain of AIG’s controls within its control environment were not effective to prevent certain members of senior management, including the former Chief Executive Officer and former Chief Financial Officer, from having the ability, which in certain instances was utilized, to override certain controls and effect certain transactions and accounting entries. In certain of these instances, such transactions and accounting entries appear to have been largely motivated to achieve desired accounting results and were not properly accounted for in accordance with GAAP. Further, in certain of these instances, information critical to an effective review of transactions, accounting entries, and certain entities used in these transactions and accounting entries, were not disclosed to the appropriate financial and accounting personnel, regulators and AIG’s independent registered public accounting firm. As a result, discussion and thorough legal, accounting, actuarial or other professional analysis did not occur. This control deficiency is based primarily on these overrides. Specifically, this control deficiency permitted the following: National Union Fire Insurance Company of Pittsburgh, Pa. -20• Creation of Capco, a special purpose entity used to effect transactions that were recorded to convert, improperly, underwriting losses to investment losses and that were not correctly accounted for in accordance with GAAP, resulting in a misstatement of premiums and other considerations, realized capital gains (losses), incurred policy losses and benefits and related balance sheet accounts. • Incorrect recording under GAAP of reinsurance transactions that did not involve sufficient risk transfer, such as the Gen Re transaction, and in some cases also related to entities which should have been consolidated, such as Union Excess and Richmond. This incorrect recording under GAAP resulted in a misstatement of premiums and other considerations, incurred policy losses and benefits, net investment income, reinsurance assets, deferred policy acquisition costs, other assets, reserve for losses and loss expenses, reserve for unearned premiums, other liabilities and retained earnings. See below for a related discussion under Controls over the evaluation of risk transfer. • Various transactions, such as Covered Calls and certain “Top Level” Adjustments, converted realized and unrealized gains into investment income, thereby incorrectly applying GAAP, resulting in a misstatement of net investment income, realized capital gains (losses), and accumulated other comprehensive income. • Incorrect recording under GAAP of changes to loss reserves and changes to loss reserves through “Top Level” Adjustments without adequate support, resulting in a misstatement of incurred policy losses and benefits, reserves for losses and loss expenses, foreign currency translation adjustments and retained earnings. 2. (From AIG’s 2004 10-K): Controls over the evaluation of risk transfer: AIG did not maintain effective controls over the proper evaluation, documentation and disclosure of whether certain insurance and reinsurance transactions involved sufficient risk transfer to qualify for insurance and reinsurance accounting. These transactions included Gen Re, Union Excess, Richmond and certain transactions involving AIG Re, AIG Risk Finance and AIG Risk Management. As a result, AIG did not properly account for these transactions under GAAP, resulting in a misstatement of premiums and other considerations, incurred policy losses and benefits, net investment income, reinsurance assets, deferred policy acquisition costs, other assets, reserve for losses and loss expenses, reserve for unearned premiums, other liabilities and retained earnings. 3. (From AIG’s 2004 10K): Controls over income tax accounting: AIG did not maintain effective controls over the determination and reporting of certain components of the provision for income taxes and related deferred income tax balances. Specifically, AIG did not maintain effective controls to review and monitor the accuracy of the components of the income tax provision calculations and related deferred income taxes and to monitor the differences between the income tax basis and the financial reporting basis of assets and liabilities to effectively reconcile the differences to the deferred income tax balances. As a result, deferred income taxes payable, retained earnings and accumulated other comprehensive income were misstated under GAAP. (From AIG’s 2005 10K-A): Controls over income tax accounting: AIG did not maintain National Union Fire Insurance Company of Pittsburgh, Pa. -21effective controls over the determination and reporting of certain components of the provision for income taxes and related deferred income tax balances. Specifically, AIG did not maintain effective controls to review and monitor the accuracy of the components of the income tax provision calculations and related income tax balances and to monitor the differences between the income tax basis and the financial reporting basis of assets and liabilities to effectively reconcile the differences to the deferred income tax balances. As a result, income tax expense, income taxes payable, deferred income tax assets and liabilities, retained earnings and accumulated other comprehensive income were misstated under GAAP. (From AIG’s 2006 10K): Controls over income tax accounting: AIG did not maintain effective controls over the determination and reporting of certain components of the provision for income taxes and related income tax balances. Specifically, AIG did not maintain effective controls to review and monitor the accuracy of the components of the income tax provision calculations and related income tax balances and to monitor the differences between the income tax basis and the financial reporting basis of assets and liabilities to effectively reconcile the differences to the deferred income tax balances. These control deficiencies resulted in adjustments to income tax expense, income taxes payable and deferred income tax asset and liability accounts in the 2006 annual and interim consolidated financial statements. Furthermore, these control deficiencies could result in a material misstatement of the annual or interim AIG consolidated financial statements that would not be prevented or detected. Accordingly, AIG management has concluded that these control deficiencies constitute a material weakness. 4. (From AIG’s 2004 10K): Controls over the accounting for certain derivative transactions: AIG did not maintain effective controls over the evaluation and documentation of whether certain derivative transactions qualified under GAAP for hedge accounting, resulting in a misstatement of net investment income, realized capital gains (losses), other revenues, accumulated other comprehensive income (loss) and related balance sheet accounts. (From AIG’s 2005 10K-A): Controls over the accounting for certain derivative transactions: AIG did not maintain effective controls over the evaluation and documentation of whether certain derivative transactions qualified under GAAP for hedge accounting. As a result, net investment income, realized capital gains (losses), other revenues, accumulated other comprehensive income (loss) and related balance sheet accounts were misstated under GAAP. 5. (From AIG’s 2004 10K): Controls over certain balance sheet reconciliations: AIG did not maintain effective controls to ensure the accuracy of certain balance sheet accounts in certain key segments of AIG’s operations, principally in the Domestic Brokerage Group. Specifically, accounting personnel did not perform timely reconciliations and did not properly resolve reconciling items for premium receivables, reinsurance recoverables and intercompany accounts. As a result, insurance acquisition and other operating expenses, premiums and insurance balances receivable, reinsurance assets, other assets and retained earnings were misstated under GAAP. National Union Fire Insurance Company of Pittsburgh, Pa. -22(From AIG’s 2005 10K-A): Controls over certain balance sheet reconciliations: AIG did not maintain effective controls to ensure the accuracy of certain balance sheet accounts in certain key segments of AIG’s operations, principally in the Domestic Brokerage Group. Specifically, accounting personnel did not perform timely reconciliations and did not properly resolve reconciling items for premium receivables, reinsurance recoverables and intercompany accounts. As a result, premiums and other considerations, incurred policy losses and benefits, insurance acquisition and other operating expenses, premiums and insurance balances receivable, reinsurance assets, reserve for losses and loss expenses, reserve for unearned premiums, other assets and retained earnings were misstated under GAAP. It should be noted that the December 31, 2005 Annual Statement was amended and refiled separately during the on site field examination. It is recommended the Company, during the remediation of the above control weaknesses and deficiencies, implement the necessary accounting systems that will service all the requirements of statutory insurance accounting. PENDING LITIGATION The Company and American International Specialty Lines Insurance Company (ASLIC) have been named defendants in two putative class actions in state court in Alabama that arose out of the 1999 settlement of class and derivative litigation involving Caremark Rx, Inc. (Caremark). An excess policy issued by a subsidiary of AIG with respect to the 1999 litigation was expressly stated to be without limit of liability. In the current actions, plaintiffs allege that the judge approving the 1999 settlement was misled as to the extent of available insurance coverage and would not have approved the settlement had he known of the existence and/or unlimited nature of the excess policy. They further allege that the AIG Defendants and Caremark are liable for fraud and suppression for misrepresenting and/or concealing the nature and extent of coverage. In their complaint, plaintiffs request compensatory damages for the 1999 class in the amount of $3.2 billion, plus punitive damages. The AIG Defendants deny the allegations of fraud and suppression and have asserted, inter alia, that information concerning the excess policy was publicly disclosed months prior to the approval of the settlement. The AIG Defendants further assert that the current claims are barred by the statute of limitations and that plaintiffs’ assertions that the statute was tolled cannot stand against the public disclosure of the excess coverage. Plaintiffs, in turn, have asserted that the disclosure was insufficient to inform them of the nature of the coverage and did not start the running of the statute of limitations. The trial court is currently considering, under standards mandated by the Alabama Supreme Court, whether a class action can be certified. Various federal and state regulatory agencies are reviewing certain other transactions and practices of AIG and its subsidiaries, including the Company, in connection with certain industry-wide and other inquiries including, but not limited to, insurance brokerages practices relating to contingent commissions and the liability of certain AIG subsidiaries, including the National Union Fire Insurance Company of Pittsburgh, Pa. -23Company, for taxes, assessments and surcharges relating to the underreporting or misreporting of workers compensation premium. It is possible that additional civil or regulatory proceedings could be filed. Since October 19, 2004, AIG or its subsidiaries have been named as a defendant in numerous complaints that were filed in federal court and in state court and removed to federal court. These cases generally allege that AIG and its subsidiaries violated federal and various state antitrust laws, and anti-racketeering laws, various state deceptive and unfair practice laws and certain state laws governing fiduciary duties. The alleged basis of these claims is that there was a conspiracy between insurance companies and insurance brokers with regard to the use of bidding practices for insurance coverage and with regard to the practices involving compensation paid to insurance producers in certain sectors of the insurance industry. The Judicial Panel on Multidistrict Litigation entered an order consolidating most of these cases and transferring them to the United States District Court for the District of New Jersey. FINANCIAL STATEMENTS The financial condition of the Company, as of December 31, 2005, and the results of its operations for the one-year period reported upon under this examination, are reflected as filed in the following statements: • • • • Statement of Assets, Liabilities, Surplus and Other Funds; Statement of Income; Statement of Capital and Surplus; Statement of Cash Flow. These financial statements are being presented as filed with no examination adjustments recorded. The financial statements are the results of the Company’s operations in a period within which the financial reporting controls around this reporting were admittedly deficient. Many of these control issues were pervasive throughout these financial statements and although in certain instances adjustments can be identified they have not been made to these financial statements, as other unidentified misstatements may exist. The following sections of this report contain a spreadsheet which lists for informational purposes examination adjustments that have been identified during this examination. The Company has embarked on a corporate-wide remediation project that is currently underway and addressing these control deficiencies. It is because of this deficient control environment that the Pennsylvania Insurance Department has decided to present the financial statements within this report as reported by the Company. This remediation process, given the size of AIG the ultimate parent of the Company, will be extensive with final remediation projected to be completed by 2008. National Union Fire Insurance Company of Pittsburgh, Pa. -24The aforementioned pervasive control deficiencies were identified and reserved for by the Company via a FAS 5 reserve reported on its December 31, 2005 balance sheet. This reserve had the following evolution since its original posting to the writing of this report and continues to evolve on a quarterly basis. Note: The table presented below is for the Commercial Pool. To derive the Company specific amounts, apply the pooling participation percentage. FAS 5 Reserve Area Reserve for Uncollect BPR Reserve for Credit Risk Reserve for Financial Acctg Reserve for Financial Acctg Reserve for Uncoll Reins Reserve Reinsurance Reinsuance Assumed Reseve Reinsurance Ceded Reserve for Intercompany Accrual for WC Assessment Liability Reserve for OLD Reserve for Management Acct Reserve for Treasury Reserve For Transport Miscellaneous Total 12-31-05 FAS 5 Balances ($174,884,585) (515,625,766) 51,893,607 (372,344,522) (160,000,000) (70,000,000) ($1,240,961,266) 2006 Change in Reserve $112,711,540 82,924,384 3,330,780 52,957,496 106,632,678 (193,395,904) (122,052) 13,285,278 18,510,334 (336,543,671) 12,400,000 (9,700,000) (1,239,750) ($138,248,887) 2006 Charge Offs $42,176,647 173,871,603 (55,224,387) (44,574) 66,786,246 (3,100,000) 134,104,573 (9,226,144) (12,364,176) $336,979,788 12-31-06 FAS 5 As of 3/16/07 ($19,996,398) (258,829,779) 52,912,922 (198,925,598) (193,395,904) (122,052) 10,185,278 (7,385,093) (9,226,144) (406,543,671) 35,824 (9,700,000) (1,239,750) ($1,042,230,365) National Union Fire Insurance Company of Pittsburgh, Pa. -25Statement of Assets, Liabilities, Surplus and Other Funds As of December 31, 2005 Bonds Preferred stocks Common stocks Cash and short-term investments Other invested assets Aggregate write-ins for invested assets Subtotals, cash and invested assets Investment income due and accrued Agents' balances or uncollected premiums Amounts recoverable from reinsurers (reinsurance) Funds held by or deposited with reinsured companies Current federal income tax recoverable and interest thereon Net deferred tax asset Guaranty funds receivable or on deposit Receivables from parent, subsidiaries and affiliates Aggregate write-ins for other than invested assets Totals $ 10,806,318,683 2,110,149,649 6,445,975,722 219,566,751 1,425,422,511 (24,379) 21,007,408,937 193,850,739 2,195,252,492 419,911,311 25,025,674 763,168,704 385,905,930 21,215,557 826,889,429 2,923,096,654 $ 28,761,725,427 Losses $ 10,065,092,115 Reinsurance payable on paid loss and loss adjustment expenses 153,630,289 Loss adjustment expenses 1,721,207,577 Commissions payable, contingent commissions & similar charges 2,777,705 Other expenses (excluding taxes, licenses & fees) 1,206,823 Taxes, licenses and fees (excluding federal & foreign income tax) 116,220,719 Unearned premium 4,291,223,545 Ceded reinsurance premiums payable (net of ceding commissions) 429,326,927 Funds held by company under reinsurance treaties 267,739,649 Amounts withheld or retained by company for account of others 8,227,591 Provision for reinsurance 201,761,032 Payable to parent, subsidiaries and affiliates 886,988,964 Payable for securities 225,860,121 Aggregate write-ins for liabilities 2,270,297,929 Total liabilities Aggregate write-ins for special surplus funds Common capital stock Gross paid in and contributed surplus Unassigned funds (surplus) Surplus as regards policyholders Totals 20,641,560,986 71,890,338 4,478,750 2,694,091,950 5,349,703,403 8,120,164,441 $ 28,761,725,427 National Union Fire Insurance Company of Pittsburgh, Pa. -26Statement of Income For the Year Ended December 31, 2005 Underwriting Income Premiums earned Deductions: Losses incurred Loss expenses incurred Other underwriting expenses incurred Total underwriting deductions Net underwriting gain or (loss) Investment Income Net investment income earned Net realized capital gains or (losses) Net investment gain or (loss) Other Income Net gain or (loss) from agents' or premium balances charged off Aggregate write-ins for miscellaneous income Total other income Net income before dividends to policyholders and before federal and foreign income taxes Dividends to policyholders Federal and foreign income taxes incurred Net income (153,838,465) 96,776,443 (57,062,022) 24,019,393 20,290 (107,916,256) $ 131,915,359 747,551,126 44,691,008 792,242,134 $ 7,035,963,104 5,207,674,754 1,138,284,118 1,401,164,951 7,747,123,823 (711,160,719) National Union Fire Insurance Company of Pittsburgh, Pa. -27Statement of Capital and Surplus For the Year Ended December 31, 2005 Surplus as regards policyholders, December 31, previous year Net income Change in net unrealized capital gains or (losses) less capital gains tax of $18,068,105 Change in net deferred income tax Change in non-admitted assets Change in provision for reinsurance Surplus adjustments: Paid in Dividends to stockholders (cash) Aggregate write-ins for gains and losses in surplus Change in surplus as regards policyholder for the year Surplus as regards policyholders, December 31, current year $ 7,376,821,528 131,915,359 697,683,841 46,236,877 (88,388,310) 132,934,713 199,830,000 (97,750,282) (279,119,285) 743,342,913 $ 8,120,164,441 National Union Fire Insurance Company of Pittsburgh, Pa. -28Statement of Cash Flow For the Year Ended December 31, 2005 Cash from Operations Premiums collected net of reinsurance Net investment income Miscellaneous income Total income Benefit and loss related payments Commissions, expenses paid and aggregate write-ins for deductions Dividends to policyholders Federal and foreign income taxes paid (recovered) Total deductions Net cash from operations Cash from Investments Proceeds from investments sold, matured or repaid: Bonds Stocks Other invested assets Miscellaneous proceeds Total investment proceeds Cost of investments acquired: Bonds Stocks Other invested assets Miscellaneous applications Total investments acquired Net cash from investments Cash from Financing and Miscellaneous Services Other cash provided (applied): Capital and paid in surplus, less treasury stock Net deposits on deposit-type contracts and other insurance liabilities (cash provided/applied) Dividends to stockholders (paid) Other cash provided or (applied) Net cash from financing and miscellaneous sources Reconciliation of cash and short-term investments: Net change in cash and short-term investments Cash and short-term investments: Beginning of the year End of the year $ (5,734,585) 225,301,336 219,566,751 199,830,000 (291,326,772) 146,976,923 122,709,191 (115,764,504) 2,374,908,106 677,784,215 2,990,746,482 305,581,608 6,349,020,411 3,915,482,446 521,239,637 3,182,722,892 34,081,915 7,653,526,890 (1,304,506,479) $ 6,733,345,322 720,254,715 (57,062,022) 7,396,538,015 3,931,978,115 2,000,737,903 926,650 48,358,949 5,982,001,617 1,414,536,398 National Union Fire Insurance Company of Pittsburgh, Pa. -29SUMMARY OF EXAMINATION CHANGES There have been no examination adjustments made to the Company’s reported financial statements as a result of this examination; however, the following schedule has identified those financial statement misstatements that were able to be quantified. The Company posted several reserves to accommodate the identified control weaknesses and resulting potential misstatements. These reserves, referred to as FAS 5 reserves, were recorded as of December 31, 2005 and continue to be evaluated by management. The evolution of these reserves further illustrates the Company’s efforts to remediate these identified control weakness. The balance sheet reconciliation process was deemed a material weakness as of December 31, 2005, and as of December 31, 2006 was considered a significant deficiency. This indicates the Company has made progress in this area but continues in many instances to be unable to reconcile accounts back to detailed source documentation. The inability to reconcile the balance sheet may result in misstatements in the financial statements that could remain undetected. A review of the Company’s high deductible program and the accounting surrounding the program has led the examination team to believe the Company has operated this program without effectively reconciling the individual contracts within the insured accounts. Coupled with this lack of reconciliation is the Company’s inability to age high deductible receivables relative to the operation of these programs to determine the admissibility of the resulting receivables. As this lack of reconciliation and aging was discovered, the examination team became unable to determine the accuracy of the receivable asset or potential reserve credits for this program. The Company continues to remediate this significant deficiency. Given the limitations in any financial reporting system the Company has used spreadsheet calculations to determine accounting entries. This process commonly referred to as the non-machine process resulted in some 10,000 transactions in 2005. The controls over this process were not functioning properly and may have resulted in significant misstatements. The examination of 200 of these entries, 200 selected based on other Company deficiencies, did not lend enough credibility to the process for the examination team to verify the accuracy and completeness of the process. In December 2005, the Company instituted new procedures to correct this deficiency. The following schedule identifies those adjustments that have not been made for purposes of this examination: National Union Fire Insurance Company of Pittsburgh, Pa. -30- Description Decrease Reinsurance Recoverables Increase Provision for Unauthorized Reinsurance Disallow over 90 Day Penalty Calculation Total National Union Fire / Non-Pooled exam Adjustments Fidalgo Assets in Violation of SSAP 62 Violation of PA Regulation 148a Total Pooled Surplus Effect ($402,225,398) (118,203,606) (193,000,000) ($713,429,004) ($55,000,000) (49,824,190) ($104,824,190) NOTES TO FINANCIAL STATEMENTS INVESTMENTS As of December 31, 2005, the Company’s invested assets were distributed as follows: Assets Percent of Invested Assets Bonds Stocks: Preferred stock Common stock Non-affiliated Affiliated subsidiaries Cash Short-term investments Other invested assets Aggregate write-ins for invested assets Total invested assets $10,806,318,683 2,110,149,649 675,073,638 5,770,902,084 50,752,348 168,814,403 1,425,422,511 (24,379) $21,007,408,937 51.44% 10.04% 3.22% 27.47% 0.24% 0.80% 6.79% 0.00% 100.00% The Company’s bond and short-term investment portfolio had the following quality and maturity profiles: National Union Fire Insurance Company of Pittsburgh, Pa. -31or Less Security Class 1 Class 2 Class 3 Class 4 Class 5 Through 5 Years 538,862,986 50,518,327 30,486,013 68,788,155 Through 10 Years $ $ $ $ $ 7,943,582,508 79,937,438 53,126,978 55,302,557 23,689,628 Through 20 Years $ $ $ $ $ Years $ 249,408,453 $ $ 8,735,887 $ $ 5,395,310 $ $ 22,907,929 $ $ - $ 1,378,512,904 $ 386,602,782 17,533,506 $ 8,499,961 24,866,837 $ 9,267,223 1,982,706 $ 13,770,404 - $ 3,354,602 At December 31, 2005 the Company’s cash and invested assets portfolio was liquid, fairly well diversified and of high credit quality. The bond portfolio consisted almost exclusively (89.7%) of low-risk, tax exempt state and local bonds (“municipals”). Municipals fall into three categories: state general obligation bonds, local general obligation bonds, and special revenue issues. State and local general obligation issues are backed by the full taxing authority of the issuer; these bonds are usually highly rated and have low default risk. These type bonds made up slightly over 46.2% of the all municipal holdings at year end. Of the bonds owned by the Company 95.6% fell into the NAIC 1 designation class. Preferred stocks comprised slightly over 10% of invested assets. Of the total investment in preferred stocks 99.5% is in Subsidiaries and Affiliates. Common stocks comprised 31% of the portfolio, of which $5.771 billion (27.5%) were affiliate holdings. The Pennsylvania Insurance Department has not adopted any of the prescribed or permitted accounting practices that differ from those found in NAIC Statutory Accounting Principles. However, the Department has permitted the Company to utilize the independent audit of the Company’s Parent (the combined upstream holding company) to support the requirements for audited U.S. GAAP equity of the investments in non insurance and foreign insurance entities, i.e. departure from SSAP 88, paragraph 8. Unaffiliated holdings were well diversified and consisted of relatively small holdings in a large number of mainly domestic concerns. The largest concentration of investment was $1.957 billion in International Lease Finance Corp and $1.795 billion in Lexington Insurance Company. Other invested assets consisted of investments in Limited Partnerships. At December 31, 2005 the Company could be called upon for an additional capital investment of up to $422.5 million. The Pennsylvania Insurance Department has also permitted the Company to utilize audited financial statements prepared on a basis of accounting other than U.S. GAAP to value investments in joint ventures, limited partnerships and hedge funds, i.e. departure from SSAP 48. The Company’s custodial agreement was reviewed and found to be compliant with Pennsylvania Insurance Regulations, Chapter 148A. The Company has a written investment policy as required by Pennsylvania Insurance Company Law (40 P.S. § 653b Section 518b) and the policy appears to be adhered to by the Company. National Union Fire Insurance Company of Pittsburgh, Pa. -32PREMIUM KEY FUNCTIONAL ACTIVITY (Machine only) Eleven companies in the American Home/ National Union Pool (Pool) together with certain other general insurance company subsidiaries of AIG operate within the Domestic Brokerage Group (DBG), which is the primary domestic insurance division of AIG, producing over 55 percent of the net written general insurance premium written by AIG, and approximately 90 percent of the Gross Written Premium (GWP) by the Pool companies. The remaining 10 percent of the GWP by the Pool was produced by American International Underwriters (AIU), a marketing unit consisting of wholly owned agencies and insurance companies. AIU is a part of AIG’s Foreign General Insurance group, which also includes business written by AIG’s foreignbased insurance subsidiaries operating in Asia, the Pacific Rim, the United Kingdom, Europe, Africa, the Middle East and Latin America. The Foreign General Insurance group accounted for 24 percent of AIG’s general insurance net premiums written during 2005. DBG, mainly through independent brokers, writes all classes of commercial insurance including large commercial or industrial property insurance, excess liability, inland marine, environmental, workers compensation and excess and umbrella coverages, DBG also offers many specialized forms of insurance such as aviation, accident and health, equipment breakdown, directors and officers liability (D&O), difference-in-conditions, kidnap-ransom, export credit and political risk, and various types of professional errors and omissions coverages. Any licensed broker is able to submit business to DBG without the traditional agent-company contractual relationship, but such broker usually has no authority to commit DBG to accept a risk. In addition to these “indemnity” products, the Pool companies through AIG Risk Management (AIGRM) provide insurance and risk management programs for large corporate customers. These programs, collectively known as Loss-Sensitive programs, include mainly workers’ compensation, primary general liability, and commercial auto coverages. Losssensitive coverage normally involves several of the coverages for a particular period. All such policies for a given client are combined and accounted for as a “contract”. In general, under loss-sensitive programs, the company accepts minimal or no risk, using one or a combination of high-deductible policies, captives, cash and/or note collateral programs, etc. Aside from the minimal insurance risk on some of these products, the only other risk assumed by the Company is credit risk. Client account administration as well as record keeping and reporting functions for the loss-sensitive business are performed by the FUSION department of AIG. Premium related transactions enter the Companies’ reporting system as either “Machine” or “Non-Machine” entries. Machine transactions are generated by the underwriting systems, which in turn interface with the Companies’ Billings and Collections (B&C) system and ultimately post to the general ledger. Non-Machine entries are manual journal entries initiated by various profit centers or the DBG Comptrollers department. Examples of non machine entries would be accrual of business booked in the last 7-10 days of each calendar quarter where direct posting to the general ledger is halted for quarter-end closing (pipeline), recording of the business written overseas, and other “Topside” adjusting entries. National Union Fire Insurance Company of Pittsburgh, Pa. -33Due to prevalence, complexity, and significance of Loss-sensitive products as well as the Non-machine entries, these two areas were examined separately as stand alone processes. Summary of Findings - Examination of “Machine” Premium Process: A) Control Deficiencies: In testing of controls over the premium process, the independent auditors identified three main control deficiencies during their testing: I. Coding In testing of premium transactions processed through various underwriting systems the Company’s auditors noted several coding exceptions existed within several of the underwriting systems. II. Authority violations Test of controls included review of letters of authority to ensure the validity of the premium entered into the underwriting system. Approximately 5 percent of the sampled transactions failed this test where they were not supported by any referral or approval. III. Underwriting Resource Division (URD) The URD is one of the key controls identified by the Company. The review of the URD reports indicated URD had also identified issues related to coding, pricing, and insufficient or missing documentation. However this control was not operating properly since the same types of errors were still present at the time of the independent audit, indicating no effective action was taken to address errors reported by URD. Management concluded, and the auditors concurred, that significant effort was required to ensure that controls over the premium process would be robust and could be sustained going forward. B) Additional Allowance Provision (FAS-5 Reserve) During the examination period, the Company continued its remediation efforts in order to address the material weaknesses and significant deficiencies identified in the evaluation of internal controls and the effectiveness of those controls. As a result of this undertaking in the Billings & Collection (B&C) key activity area, approximately $174 million of provision (FAS-5 Reserve) was set aside as of the examination date. Subsequent to the examination date, during 2006, the evolution of the FAS 5 reserve continued and continues as of the writing of this report. Since the nature of the majority of the errors and unsubstantiated balances giving rise to the FAS-5 reserve in the B&C key activity related to the age of the unsupported transactions, and National Union Fire Insurance Company of Pittsburgh, Pa. -34immaterial benefit gained from substantial efforts required from the Company in determining the exact time period to which each of the unreconciled/unsupported transactions belonged, the examiner determined it not to be unreasonable to attribute the entire amount of FAS-5 reserve activity in 2006, to transactions originated in 2005 or prior. C) Deposit Accounting – Direct Business: In its Annual Statement “Notes to Financial Statements” item C, regarding accounting policy the Company stated: “Premium contracts, regardless of risk transfer, have been reported as insurance provided that they were issued to serve valid insurance purposes, and as part of the insureds’ normal business practices or statutory requirement to do business” A letter agreement between the Company and participating regulatory states allows this accounting practice. This issue is under continued discussion by the National Association of Insurance Commissioners’ (NAIC) Statutory Accounting Practices and Procedures Working Group. D) Examination Recommendation: Continue monitoring the remediation efforts underway via periodic examination visits and or an accelerated examination cycle. NON MACHINE KEY FUNCTIONAL ACTIVITY (all underwriting areas) Financial data flows into the general ledger through journal entries classified by the Company as either machine or non machine. Machine entries are those transactions which are system generated and require no manual intervention. These entries are automated transactions between various systems that are interfaced with each other as well as the general ledger. Non machine entries are those transactions that are manually posted into the various systems due to lack of system interface or as an adjustment which cannot be generated through the machine process. There are also certain entries classified as non machine that are actually entered through a semi-automated process which requires only minimal manual intervention such as pooling and apportionment transactions. Machine and non machine entries are categorized as self reversing or permanent transactions. Permanent entries are actual values (not estimates) or other entries that would have a permanent impact on the accounts. Self reversing entries are used to record transactions such as accruals, estimates and transactions that would otherwise be machine entries, made necessary after the general ledger cut-off. Non machine transactions are entered through specific journal codes assigned to the various departments throughout the Company and are supported by batch numbers that are used to identify the actual entry into the general ledger. The use of non machine entries is prevalent throughout all companies and processes and has National Union Fire Insurance Company of Pittsburgh, Pa. -35a significant impact on financial reporting. Non-machine entries are initiated and/or booked through the following departments and locations: • • • • • • • • • • • • All Profit Centers (initiation only - no direct posting to the general ledger) Financial Accounting – New York Reinsurance Accounting – New York Treasury – New York Premiums and Collections – New York Claims – New York Management Accounting – New York Aviation Accounting – Atlanta Fusion – Berkeley Heights, NJ Lexington & Landmark, Boston Corporate Accounting – Canada Starr Excess - Bermuda In 2005, non machine transactions were entered through 34 journal codes using approximately 10,000 batches totaling approximately $6 trillion (absolute value). Our review focused on those non machine transactions where the data flow is created and entered by a staff person (manual processes) that had a significant impact on operations. This focus reduced the total number of batches subject to our review to approximately 7,000 totaling approximately 66,000 transaction lines and $1 trillion (absolute value). For our review of this process we selected 200 batches across all companies under examination. The documentation provided by the Company for the batches selected was insufficient to support the validity of the journal entries made to the financially significant systems and confirmed a material weakness related to the controls surrounding the non-machine process during the time period covered by this examination. There were no documented policies and procedures, including supporting documentation requirements, in respect to the processing of the transactions, and the Company did not adequately monitor the journal entries for accuracy and reliability. The Company’s reported material weakness related to account reconciliations also contributed to the control deficiency in the non-machine process. As account reconciliations were not being performed or not performed in a timely manner, management’s ability to readily detect any errors or deficiencies in the process was greatly diminished. To assess the validity of the transactions selected for review, we met individually with the staff person responsible for each entry to obtain reasonable assurance as to the necessity and accuracy of the recorded transactions. Our review is on going and in several instances the additional information and explanations provided were adequate, in others inadequate, and in still others no additional information or explanation was provided. During 2005, Company management began remediation efforts to address the control weakness. As part of the remediation effort, on December 1, 2005, a non machine journal entry procedure went into effect throughout DBG that is required to be followed by all departments. The procedure requires that each non machine entry have a cover page, a detailed journal entry, National Union Fire Insurance Company of Pittsburgh, Pa. -36auditable support and a transaction posting report. The procedure also requires the preparer and approver to initial the auditable support attached to the journal entry for completeness and accuracy and that the journal entries be part of the monthly reconciliation process to ensure that each entry is accounted for and accompanied by adequate documentation. To ensure compliance with the procedure, the Company established a Quality Control Department (QCD) to conduct periodic examinations of sample journal entries to ensure that the procedure is being followed and that the recorded transactions are accurate and complete. Non machine transactions were sampled and reviewed by the QCD for compliance in 2006 on a quarterly basis. Initial QCD reviews in 2006 indicated that a primary concern was the lack of adequate auditable documentation supporting the journal entries reviewed which is consistent with our review of the 2005 sample transactions. By 4Q 2006, while some individual areas within the Company did not, the Company as a whole received a high internal rating from the QCD for compliance with the procedure indicating that the entries posted to the general ledger have been reviewed and were posted completely and accurately. Before the control deficiencies noted in this process can be considered remediated, the Company will need to demonstrate that the improvements derived by the control enhancements are sustainable over several periods and that the results are independently verified. While enhancements to the control environment will continue to be developed and implemented, management expects the remediation of the control weaknesses in this process to be completed by the 4Q 2007. Examination Recommendation: Continue monitoring the remediation efforts underway via periodic examination visits and or an accelerated examination cycle. DOMESTIC BROKERAGE GROUP – FUSION Fusion is an accounting and service unit responsible for post bind service functions such as billing of premium and losses to the insured, program adjustments, and ensuring income statement and balance sheet integrity and customer service for complex accounts written by AIG for all Risk Management Group divisions, World Source and Global Energy. The annual gross written premium of these businesses is approximately $5 billion of the $32.7 billion written by AIG DBG. Fusion Balance Sheet Remediation Project Background AIG did not maintain effective controls to ensure the accuracy of certain balance sheet accounts in certain key segments of AIG’s operations, principally in the Domestic Brokerage Group. Specifically, accounting personnel did not perform timely reconciliations and did not properly resolve reconciling items for premium and insurance balances receivable, reinsurance recoverable and also other assets were misstated. This material weakness resulted in management concluding and the Company’s independent auditor concurring that an increase in reserves held was required as of December 31, 2005. National Union Fire Insurance Company of Pittsburgh, Pa. -37Detail of the provision is as follows: Note: These balances are for the Commercial Pool only and do not include the provision that was established for other DBG entities. Remediation Exposure: Model Balance Non Legal - Projected error Loss Sensitive Legal - credit risk on clients accounts in legal status Total RMG Credit Risk Additional Exposures: Excess of Self-Insured Retention Machine Deductible Non Large Risk Rating Plans / Plan B Texas (RML’s Class Action Lawsuit) Toxic / Environmental Claims Deferred Paid Loss Receivables Group 2 (Risk Management Group) Booked Premium Receivable Group 10 (National Acct.) 18 (AIG Global) 85 (NH Assoc) run-off TPA Payable/Other Total Additional Exposures Other Liabilities - Contingencies: Deductible premium tax underpayment AIG Settlement with States Total Other Liabilities - Contingencies Total FUSION Total 12/31/05 $134.8 179.7 $314.5 $ 35.6 25.6 16.9 30.5 7.1 51.3 12.7 21.4 -0$201.1 $ 51.3 100.0 $151.3 $666.9 Remediation Exposure Model Balance Non Legal - Projected Error AIG DBG has underwritten loss sensitive business (including workers compensation, general liability, product liability, and auto liability) for approximately the past 30 years. DBG Fusion management has recognized that exposure exists in the client account information residing in the sub-ledgers due to historically poor booking, system conversions and a lack of attention paid to inactive accounts. The booking process is complicated by the size of the contracts and the number of underlying policies to each contract. Management’s remediation efforts have included: a) identification and application of resources; b) general ledger to subledger reconciliations; c) substantiation of sub-ledger balances; and d) aging of the sub-ledgers and reconciling items. Management has quantified the potential exposures through both modeling and specific identification. A model was designed by Fusion management to project National Union Fire Insurance Company of Pittsburgh, Pa. -38the corrections identified from completed client account corrections (approximately 1,500 contracts out of an approximate population of 4,000 contracts) to the remaining un-reconciled population. Management had established a provision in the amount of $134.8M as of December 31, 2005 with respect to this modeled credit risk exposure. Loss Sensitive Legal - credit risk on clients accounts in legal status Management undertook a 2005 reserve reassessment of all Fusion clients in a legal status (i.e. in bankruptcy, legal collection or a buyout situation). For each client in legal status, management identified the associated recoverable balances related to both paid and future losses as well as any security held by DBG against these balances to calculate an under-secured position. To determine the expected recoverable amount of these balances, management used the Obligor Risk Rating (internal credit model) assigned to the client, the associated expected default rate (assigned by AIG Credit Risk department) and expected default rate (generated from historical loss data from this business). Management had established a provision in the amount of $179.5M as of December 31, 2005 with respect to this default exposure. Additional Exposures Fusion exposure is categorized into several areas including open receivables balances (both legal and potential issues), other exposure areas with ongoing project work (e.g. toxic claims and excess of self insured retention), and specifically identified areas (e.g. Texas residual market load). Management had established a provision in the amount of $201.1million as of December 31, 2005 with respect to these identified exposures. Other Liabilities - Contingencies In addition, a $151.3M provision for other contingent liabilities had been established reflecting premium tax underpayment for Deductible Policies and related settlements with states. Amounts Receivable Under High Deductible Policies The Company markets certain loss sensitive products for its large corporate clients under high deductible plans. These plans include workers compensation, primary general liability, and various other insurance products. Loss reserves for the various plans are recorded based on actuarial studies. Theoretically, these programs/plans should only represent a credit risk to AIG. When AIG pays a loss on behalf of its client, a receivable under the high deductible policy is established. These receivables are required to be secured by collateral in the form of letter(s) of credit, a trust account, or cash as required by AIG. As of December 31, 2005, the Commercial Lines Pool reported $877,145,780 (net of $46,244,043 penalty) in deductible recoverables of which $462,240,439 is unsecured (or under secured), and a $10,247,000,000 reduction to Loss Reserves (i.e. Reserve Credits with respect to the high deductible program). These reserve credits, however, are not permitted if any amount due from the insured is uncollectible. SSAP #65, paragraph #35, states in part “…however, no National Union Fire Insurance Company of Pittsburgh, Pa. -39reserve credit shall be permitted for any claim where any amount due from the insured has been determined to be uncollectible.” According to Company management, these reserve credits are not reversed (provision established) until all collection efforts have been exhausted … often taking longer than one year. Company management represented that deductible recoverable balances are recorded net of a 10% statutory penalty in accordance with SSAP No. 65, and that adequate FAS 5 provisions have been booked to address various exposures both identified and modeled. Inquiry of management indicated that significantly under secured account balances could be cases whereby the collateral has long been exhausted, no collateral established due to credit worthiness rating, or in some cases collateral not yet identified (balance sheet remediation project). In other instances account balances relate to clients subsequently placed in bankruptcy. The determination of the collectibility of account balances is not based on statutory valuation, (i.e. receivable aging). Management described collection processes that often exceed one year. Reserve credits taken for high deductible policies for any claim where any amount due from the insured has been determined to be uncollectible shall be reversed in accordance with paragraph #35, SSAP #65. Additionally, receivables not anticipated to be collected shall be non-admitted. The following observations were noted during our examination of the asset for Amounts Receivable Under High Deductible Policies: • Other than the 10% non-admit penalty as required by SSAP No. 65, Paragraph 37 for deductible recoverables in excess of collateral, the Company applies only GAAP concepts for considering the collectibility of receivables, rather than the statutory concepts for collectibility (i.e., items over 90 days due). Because of this, the Company considers some receivables as recoverable, even though they may be more than one year overdue. DBG FUSION management continues in its efforts to remediate the material weaknesses in balance sheet reconciliations. The Company has established a $667M exposure reserve as a result of these control deficiencies. The Company cannot provide an aging for deductible recoverables. Because the Company has not considered statutory concepts for collectibility, the associated reserve credits that are taken for high deductible policies are not reviewed to determine the allowability pursuant to SSAP no. 65, Paragraph 35. • • • • Based on the foregoing observations, the examiner expresses no opinion as the amounts reported by the Company as of December 31, 2005. Examination Recommendation: Continue monitoring the remediation efforts underway via periodic examination National Union Fire Insurance Company of Pittsburgh, Pa. -40visits and or an accelerated examination cycle. LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES INS Consultants, Inc. (INS) has been engaged by the Pennsylvania Insurance Department to conduct an independent review of the American Home / National Union Pool in conjunction with the financial condition examination by the Pennsylvania Insurance Department. INS’ evaluation was conducted on both a gross and net of reinsurance basis. INS analysis of the American Home/National Union Pool December 31, 2005 reserve adequacy produced an indicated loss and loss adjustment expense reserve deficiency of $447,406,000 on a net basis and a redundancy of $342,465,000 on a gross basis. The INS estimated net inadequacy represents 1.4% of the total Pool carried reserve. No adjustment is proposed since the carried amount is within a reasonable range of the INS estimate. Total indicated net loss and loss adjustment expense reserves by statutory company as of December 31, 2005 are as follows: ($000) December 31, 2005 Annual Statement Net Loss & LAE Reserve AIU Insurance Company American International Pacific Insurance Company American International South Insurance Company American Home Assurance Company Birmingham Fire Insurance Company of PA Commerce and Industry Insurance Company Granite State Insurance Company Illinois National Insurance Co. The Insurance Company of the State of Pennsylvania National Union Fire Insurance Company of Pittsburgh, Pa. New Hampshire Insurance Company $ 529,507 0 0 11,620,078 1,550,829 3,199,169 0 0 1,550,829 11,786,300 1,550,829 National Union Fire Insurance Company of Pittsburgh, Pa. -41$ 31,787,541 Total Pool AIG, engaged the actuarial firm of Milliman, Inc. (“Milliman”) to perform an independent study of loss and loss adjustment expense reserves of the Commercial Lines Pool, of which the Company is a member, as of December 31, 2005. As a result of the Milliman study, and after considering the adverse developments experienced for certain classes of business including excess casualty, directors and officers liability, excess workers’ compensation, and asbestos and environmental liability, the pool members increased the reserves in a number of areas and, consequently, reserves calculated by Milliman on both a gross and net basis very closely approximate reserves held by the Pool. The following schedule shows the two year development of loss and loss adjustment expenses reported by the Company at December 31 of each of the years noted below and the percent of the reported surplus that the development represents: Reserves reported at December 31 Developed through Amount of development ($000 omitted) Development as a percentage of initial surplus 2000 2001 2002 2003 2004 2002 2003 2004 2005 2006 1,167,409 1,378,518 1,726,449 3,289,097 2,011,772 18.8% 21.5% 29.3% 47.7% 27.3% The significant reserve development reported from each of the yearend dates is attributable to adverse development, primarily from accident years 2002 and prior, pertaining to the excess casualty, directors and officers liability, excess workers compensation, and asbestos and environmental liability classes. Reserve developments from accident years 2003 and subsequent have generally been favorable. The exceptionally high development indicated at December 31, 2003 is attributable to the reserve strengthening recorded in calendar years 2004 and 2005, which culminated with the completion of the Milliman study. The development from 2004 is primarily attributable to the strengthening recognized in 2005, whereas the Company experienced only a relatively minor amount of adverse development in 2006. In 2006 the Company entered into a Capital Maintenance Agreement with its ultimate parent, AIG. The agreement requires AIG to maintain total adjusted capital at 200% of the National Union Fire Insurance Company of Pittsburgh, Pa. -42Company’s Authorized Control Level RBC. The Company’s independent auditors, PricewaterhouseCoopers (“PwC”) performed an extensive amount of audit work related to the Company’s Losses and Loss Adjustment Expenses for the year ended December 31, 2005. PwC audit and actuarial personnel performed in-depth reviews of numerous AIG claims divisions and business segments. Several judgmental samples were taken by PwC and compared against hard copy claim files. Data fields from the Corporate Reporting System (“CRS”) such as policy number, claim number, date of loss, reserve amount, etc., were compared to the hard copy claim file with few minor exceptions. PwC also performed a SAS 70 review of AIG’s primary claims organization, AIG Domestic Claims, Inc. Significant items noted in the SAS 70 review and listed in order of significance with respect to control objectives are as follows: • “Control Objective G, states, Controls provide reasonable assurance that AIGDC Systems, programs and data are secured from unauthorized use or distribution. The controls, however, do not address the effective assignment of access privileges to applications. In addition, the controls do not include an effective review of access privileges on a periodic basis. These deficiencies result in controls not being suitably designed to achieve Control Objective G. Management has committed to remediate these matters going forward.” “Control Objective F, states, Controls provide reasonable assurance that development and maintenance of AIGDC Systems are properly authorized, tested, approved and documented before implementation. Our tests of operating effectiveness revealed that there is no process in place for maintaining authorized approver lists. As a result, controls were not operating effectively to achieve Control Objective F.” “Due to the record retention policies of AIGDC, we were unable to obtain sufficient evidential matter for the entire period of January 1, 2005 to December 31, 2005, to evaluate the operating effectiveness of certain controls in meeting Control Objective A, Controls provide reasonable assurance that claim information such as date of loss, location code, status code, line of business, insured name, claimant name and loss and loss adjustment expense payments are input into the AIGCS Claim System completely, accurately and in a timely manner, Control Objective C, Controls provide reasonable assurance that claim reserve estimates are established completely, accurately and in a timely manner, and Control Objective E, Controls provide reasonable assurance that claims paid are in accordance with applicable policy provisions and are supported by appropriate documentation.” • • Examination Recommendation: Because of the material adverse development in 2005 and 2006 described above, the Department recommends that the Company perform liquidity analyses testing the sensitivity of AIG’s financial position to the combined stresses of ratings downgrade, reserve development and financial market deterioration. Continued reserve development is often symptomatic of National Union Fire Insurance Company of Pittsburgh, Pa. -43other financial concerns. It is the Pennsylvania Insurance Department’s, in consultation with the Department’s Actuary, position that if material adverse development continues, then clearly the Department must continue to get independent reserve reviews until such time as the Company can provide stable reserve estimates. Loss Reserve Credits Related to High Deductibles The Company markets certain loss sensitive products for its large corporate clients under high deductible plans. These plans include workers compensation, primary general liability, and various other insurance products. Loss reserves (i.e. ultimate exposure) for the various plans are calculated based on actuarial studies. These studies are passed along to AIG’s credit department in order to secure the appropriate security collateral from the insured. When AIG pays a loss on behalf of its client, a receivable under the high deductible policy is established. These receivables are required to be secured by collateral in the form of letter(s) of credit, a trust account, or cash as required by AIG. Loss Reserves for the insured’s ultimate exposure do not have to be recorded on the Company’s books and records so long as collectibilty is not an issue. SSAP #65 states in part “… however, no reserve credit shall be permitted for any claim where any amount due from the insured has been determined to be uncollectible.” The Company disclosed in Note #31 to its Annual Statement that they had recorded $3.9 billion in reserve credits taken for high deductible policies. Some of these reserve credits, however, are for Companies in bankruptcy or for whom receivable amounts due the Company appear uncollectible. The Company calculates a penalty to recognize the disallowance of the reserve credit on a GAAP basis since its systems cannot statutorily age amounts due from the insured – the basis for disallowing the reserve credits under statutory accounting. Because of its inability to statutorily age amounts due from insureds, the examination team cannot determine the adequacy of the Company’s GAAP basis penalty for either uncollectible accounts or the amount of reserve credits requiring reversal related to high deductible policies. Examination Recommendation: Continue monitoring the remediation efforts underway via periodic examination visits and or an accelerated examination cycle. Outstanding Loss Drafts Outstanding Loss Drafts (“OLD”) at December 31, 2005 on a pooled basis total $1,415,474,005. This balance is net of approximately $12 billion in unmatched debit amounts and $10.5 billion in unmatched credits. The amount allocated to the Company based on its 38% pooling percentage is $537,880,123 (38% X $1,415,474.005). During the years 2004 and 2005 the Company was in the process of remediating this account. As of December 31, 2005, $70 million in unsupported pooled debit amounts were reserved for future write off. National Union Fire Insurance Company of Pittsburgh, Pa. -44The remediation process has continued into years 2006 and 2007. In the third quarter of 2006, an additional unsupported $225 million was reserved for future write off. In the fourth quarter another $111.5 million was reserved for future write off. Unsupported December 31, 2005 balances of $406.5 million have thus far been reserved for future write off as of December 31, 2005 and December 31, 2006. The Company continues to require significant outside resources to assist them in this remediation process. This is due to the fact that many of the approximately 4,000 accounts, whose activity has flowed through the Outstanding Loss Drafts account, have not been reconciled for many years. Much of the activity in OLD is 15 – 20 years old. The Company continues to monitor activity in the OLD account and is waiting for the passage of several more quarters in the hopes that the balance will stabilize. The Examiners are uncertain whether additional reserves / write-offs of OLD amounts will be necessary. Examination Recommendation: Continue monitoring the remediation efforts underway via periodic examination visits and or an accelerated examination cycle. REINSURANCE The examination of the reinsurance process within the Company determined that in 2005 management identified a significant deficiency in the reinsurance operations in conjunction with the loss sensitive business and concluded that it had not maintained effective controls over the monitoring of the completeness, accuracy, and reporting (internal and external) of certain reinsurance transactions in a timely manner. The identified deficiencies may have resulted in examination adjustments. As stated earlier, there are no adjustments being made for this examination report. The area noted in this examination is as follows: Intercompany Reinsurance The Company has established a FAS 5 reserve for an out of balance condition of the intercompany reinsurance receivables. The Company’s balance includes outstanding reserves that have not yet been completely reviewed but expect that there may be adjustments forthcoming to the ceded unearned premium reserves. The Company has stated that these adjustments have not been included in the FAS 5 reserves. The remediation of this issue has not yet begun and is expected to be fully remediated by the end of 2008. Until this remediation effort is complete it would be impossible to get an accurate FAS 5 balance as of December 31, 2006. Examination Recommendation: Continue monitoring the remediation efforts underway via periodic examination visits and or an accelerated examination cycle. National Union Fire Insurance Company of Pittsburgh, Pa. -45SUBSEQUENT EVENTS The following events have been deemed significant for disclosure by the Pennsylvania Insurance Department as subsequent events. The National Association of Insurance Commissioners’ financial examiners handbook calls for a risk focused examination that ultimately develops a supervisory plan for the continued monitoring of domestic insurers. Given, the control issues evident at the Company, during this examination, the Pennsylvania Insurance Department has identified a supervisory plan as part of its overall regulation of the Company, that will run in concert with the Company’s planned remediation efforts. It will be part of the supervisory plan to assess the efforts made to address the control weaknesses as this process continues. Permitted Practice Requests: On January 30, 2007, AIG requested two, year-end 2006, permitted practices from the states of Delaware, New York, and Pennsylvania. The permitted practice request represented a continuation of the year-end 2005 permitted practices requests regarding departure from SAAP 48 and SSAP 88, paragraph 8. The Pennsylvania Insurance Department has permitted the Company to utilize the Independent audit of the Company’s Parent (the combined upstream holding company) to support the requirement for audited U.S. GAAP equity of the investments in non insurance and foreign insurance entities, i.e., departure from SSAP 88, paragraph 8. Additionally, the Department has also permitted the Company to utilize audited financial statement prepared on a basis of accounting other than U.S. GAAP to value investment in joint ventures, limited partnerships and hedge funds, i.e., departure from SSAP 48. RECOMMENDATIONS PRIOR EXAMINATION The prior examination report was not made public and any comments within that report will not be presented as a prior recommendation. CURRENT EXAMINATION As a result of the current examination, the following recommendations are being made: 1. It is recommended the Company, during the remediation of the identified control weaknesses and deficiencies, implement the necessary accounting systems that will service all the National Union Fire Insurance Company of Pittsburgh, Pa. -46statutory requirements of insurance accounting. (See Accounts and Records page 22). 2. It is recommended the Company continue their remediation efforts and regularly update the Pennsylvania Insurance Department of the remediation status and milestones as they are achieved. (See Premium Key Functional Activity Machine only Page 34, Non Machine Key Functional Activity page 36, Domestic Brokerage Group – Fusion page 40, Loss Reserve Credits Related to High Deductibles, page 43, Outstanding Loss Drafts, page 44, and Reinsurance page 44). 3. It is recommended that the Company perform, liquidity analyses testing the sensitivity of the Company’s financial position to the combined stresses of ratings downgrade, reserve development and financial market deterioration. (See Loss and Loss Adjustment Expenses, page 42.) CONCLUSION As a result of this examination, the financial condition of National Union Fire Insurance Company of Pittsburgh, Pa, as of December 31, 2005, has been reported as filed by the Company without an ultimate conclusion reached by the Department on those filed statements. This examination was conducted by Barry Armstrong, CFE, Peter Bliss, CFE, Anthony Cardone, CFE, Andrew E. Chiodini, CFE, Maria Chysikos, CFE, Frederick Doran, CFE, Hameed Faridani, CFE, Richard Fluhr, CFE, Joseph Funkhouser, CFE, Shannon Higgins, Craig Jackson, CFE, Kelly Willison, CFE, Larry Kimble, Francis M. Matejik, CFE, Dennis McGovern, CFE, John Normile, CFE, John Vincent Normile, Richard Randour, CFE, Robert Rodack, CFE, Mary Rodack, CFE, Patrick White, CFE, Gerald J. Hickey, CFE, with the latter in charge. National Union Fire Insurance Company of Pittsburgh, Pa. -47- Respectfully David G. DelBiondo, CPA Director, Bureau of Financial Examinations William M. Fedak, CFE Examination Manager Gerald Hickey, CFE Examiner-in-Charge Representing the NAIC Northeastern Zone Richard Fluhr, CFE Representing the NAIC Mid-Western Zone Francis M. Matejik, CFE Representing California and the NAIC Western Zone The CFE designation has been conferred by an organization not affiliated with the federal or any state government. However the CFE designation is the only designation recognized by the NAIC for the purposes of performing statutory examinations of insurance companies.