Selective Insurance - 10-Q quarterly report FY

 

(Mark One)

(Exact name of registrant as specified in its charter)

(973) 948-3000

Including Area Code)

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such report), and (2) has been subject to such filing requirements for the past 90 days.

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Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

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As of March 31, 2007, there were 54,857,753 shares of common stock, par value $2.00, outstanding.

Table of Contents

The accompanying notes are an integral part of these unaudited interim consolidated financial statements.

The accompanying notes are an integral part of these unaudited interim consolidated financial statements.

Selective Insurance Group, Inc. also has authorized, but not issued, 5,000,000 shares of preferred stock without par value of which 300,000 shares have been designated Series A junior preferred stock without par value.

The accompanying notes are an integral part of these unaudited interim consolidated financial statements.

The accompanying notes are an integral part of these unaudited interim consolidated financial statements.

Selective Insurance Group, Inc., through its subsidiaries, (collectively known as “Selective”) offers property and casualty insurance products and diversified insurance services and products. Selective Insurance Group, Inc. was incorporated in New Jersey in 1977 and its main offices are located in Branchville, New Jersey. Selective Insurance Group, Inc.’s Common Stock is publicly traded on the NASDAQ Global Select MarketÒ under the symbol, “SIGI.”

Selective classifies its business into three operating segments:

These interim unaudited consolidated financial statements (“Financial Statements”) include the accounts of Selective Insurance Group, Inc. and its subsidiaries, and have been prepared in conformity with (i) accounting principles generally accepted in the United States of America (“GAAP”) and (ii) the rules and regulations of the United States Securities and Exchange Commission (“SEC”) regarding interim financial reporting. The preparation of Financial Statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported financial statement balances, as well as the disclosure of contingent assets and liabilities. Actual results could differ from those estimates. All significant intercompany accounts and transactions between Selective Insurance Group, Inc. and its subsidiaries are eliminated in consolidation.

These Financial Statements reflect all adjustments that, in the opinion of management, are normal, recurring, and necessary for a fair presentation of Selective’s results of operations and financial condition. These Financial Statements cover the first quarters ended March 31, 2007 (“First Quarter 2007”) and March 31, 2006 (“First Quarter 2006”). These Financial Statements do not include all of the information and disclosures required by GAAP and the SEC for audited financial statements. Results of operations for any interim period are not necessarily indicative of results for a full year. Consequently, these Financial Statements should be read in conjunction with the consolidated financial statements contained in Selective’s Annual Report on Form 10-K for the year ended December 31, 2006 (“2006 Annual Report”).

At December 31, 2006, Selective changed its definition of cash equivalents for presentation in the Statements of Cash Flow. Accordingly, the First Quarter 2006 Statement of Cash Flow has been restated to conform with this policy change. In addition, certain amounts in the Statement of Cash Flow for First Quarter 2006 have been reclassified to conform to reclassifications made to the balance sheet in the prior year. These reclassifications resulted in immaterial changes to individual line items in the operating activities and investing activities sections of the Statements of Cash Flow, but had no impact on total cash flows from operating activities or investing activities. Neither the policy change nor the reclassifications had any effect on Selective’s net income or stockholders’ equity. For additional information, refer to Item 8. “Financial Statements and Supplementary Data,” Note 2 of Selective’s 2006 Annual Report.

On January 1, 2007, Selective adopted Financial Accounting Standards No. 155, Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140 (“FAS 155”). Under the guidance contained in FAS 155, companies are required to evaluate interests in securitized financial assets to identify whether such interests are freestanding derivatives or hybrid financial instruments that contain an embedded derivative. During the fourth quarter of 2006, the Financial Accounting Standards Board (“FASB”) recommended a narrow scope exception for securitized interests if: (i) the securitized interest itself has no embedded derivative (including interest rate related derivatives) that would be required to be accounted for separately other than an embedded derivative that results solely from the embedded call options in the underlying financial assets; and (ii) the investor does not control the right to accelerate the settlement. The adoption of FAS 155 did not have a material impact on the results of operations or financial condition of Selective during First Quarter 2007.

On January 1, 2007, Selective adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 calls for a two-step process to evaluate tax positions based on the recognition, derecognition, and measurement of benefits related to income taxes. The process begins with an initial assessment of whether a tax position, based on its technical merits and applicability to the facts and circumstances, will “more-likely-than-not” be sustained upon examination, including related appeals or litigation. The “more-likely-than-not” threshold is defined as having greater than a 50% chance of being realized upon settlement. Tax positions that are “more-likely-than-not” sustainable are then measured to determine how much of the benefit should be recorded in the financial statements. This determination is made by considering the probabilities of the amounts that could be realized upon ultimate settlement. Each tax position is evaluated individually and must continue to meet the threshold in each subsequent reporting period or the benefit will be derecognized. A position that initially failed to meet the “more-likely-than-not” threshold should be recognized in a subsequent period if: (i) a change in facts and circumstances results in the position’s ability to meet the threshold; (ii) the issue is settled with the taxing authority; or (iii) the statute of limitations expires. FIN 48 is effective for fiscal years beginning after December 15, 2006. Selective has analyzed its tax positions in all federal and state jurisdictions in which it is required to file income tax returns for all open tax years. The open tax years for the federal returns are 2003 though 2006. The Internal Revenue Service completed a limited scope examination of tax year 2003 and 2004 that resulted in a favorable adjustment. Selective did not have any unrecognized tax benefits as of January 1, 2007. Selective believes its tax positions will be sustained on audit and does not anticipate any adjustments that will result in a material change to its financial position. As a result, there was no material change in Selective’s liability for unrecognized tax benefits.

In February 2007, the FASB issued Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115(“FAS 159”), which provides companies with an option to report selected financial assets and liabilities at fair value. FAS 159 requires companies to provide additional information that will help investors and other users of financial statements to more easily understand the effect of the company’s choice to use fair value on its earnings. FAS 159 also requires companies to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet. We are currently evaluating the impact FAS 159 may have on our financial statements.

The following table summarizes the direct, assumed, and ceded reinsurance amounts by income statement caption. For more information concerning reinsurance, refer to Note 7, “Reinsurance” in Item 8. “Financial Statements and Supplementary Data” in Selective’s 2006 Annual Report.

The ceded premiums and losses related to Selective’s Flood operations are as follows:

Selective has classified its operations into three segments, the disaggregated results of which are reported to and used by senior management to manage Selective’s operations:

The Insurance Operations and Diversified Insurance Services segments share a common marketing or distribution system and create new opportunities for independent insurance agents to bring value-added services and products to their customers. Selective’s commercial and personal lines property and casualty insurance products, flood insurance, and human resource administration outsourcing products are principally sold through independent insurance agents.

Selective Insurance Group, Inc. and its subsidiaries also provide services to each other in the normal course of business. These transactions totaled $4.4 million in First Quarter 2007 and $4.8 million in First Quarter 2006. These transactions were eliminated in all consolidated statements. In computing the results of each segment, Selective does not include interest expense, net general corporate expenses, or federal income taxes. Selective does not maintain separate investment portfolios for the segments and therefore, does not allocate assets to the segments.

The following presents revenues from continuing operations (net investment income and net realized gains on investments in the case of the Investments segment) and pre-tax income from continuing operations for the individual segments:

The following tables show the costs of the Retirement Income Plan for Selective Insurance Company of America (“Retirement Income Plan”) and the retirement life insurance component (“Retirement Life Plan”) of the Welfare Benefits Plan for Employees of Selective Insurance Company of America. For more information concerning these plans, refer to Note 16, “Retirement Plans” in Item 8. “Financial Statements and Supplementary Data” in Selective’s 2006 Annual Report.

The components of comprehensive income, both gross and net of tax, for First Quarter 2007 and First Quarter 2006 are as follows:

As of December 31, 2006, Selective adopted Statement of Financial Accounting Standard No. 158,Employer’s Accounting for Defined Benefit Pensions and Other Postretirement Benefits (“FAS 158”). Selective recorded the impact of adopting this standard in accumulated other comprehensive income (“AOCI”), a separate component of stockholders’ equity, resulting in a decrease in equity of $13.7 million, after tax. In addition, Selective included this decrease in AOCI as a component of comprehensive income, which is separately presented in the 2006 Consolidated Statement of Stockholders’ Equity. Subsequent to the filing of our 2006 Annual Report, Selective identified that, although the impact of adopting FAS 158 was properly included as a decrease to AOCI, it should not have been recorded as a component of comprehensive income. The impact of appropriately excluding the FAS 158 adjustment increases comprehensive income from $146.1 million, as presented, to $159.8 million, as adjusted.

On January 30, 2007, the Board of Directors of Selective Insurance Group, Inc. declared a two-for-one stock split of Selective Insurance Group, Inc.’s common stock, par value $2.00 per share (“Common Stock”), in the form of a share dividend of one additional share of Common Stock for each outstanding share of Common Stock (the “Share Dividend”). The Share Dividend was paid on February 20, 2007 to stockholders of record as of the close of business on February 13, 2007. The effect of the Share Dividend has been recognized retroactively in all share and per share data, as well as the capital stock account balances, in the accompanying consolidated financial statements, notes to consolidated financial statements and supplemental financial data.

On March 8, 2007, Selective Insurance Group, Inc. entered into a written trading plan under Rule 10b5-1 under the Securities Exchange Act of 1934 (“Trading Plan”) with a broker to facilitate the purchase of its Common Stock. Rule 10b5-1 allows a company to purchase its shares at times when it ordinarily would not be in the market because of self-imposed trading blackout periods, such as the time preceding its quarterly earnings releases. During First Quarter 2007, Selective Insurance Group, Inc. repurchased approximately 3 million shares of its Common Stock at a total cost of $74.3 million under its authorized stock repurchase program. As of March 31, 2007, there were 2.3 million shares available under the existing share repurchase plan. On April 24, 2007, the Board of Directors extended the share repurchase plan through December 31, 2007.

Other investments, as shown on the consolidated balance sheet, were $165.1 million as of March 31, 2007, and $144.8 million as of December 31, 2006. At December 31, 2006, Selective had additional other investment commitments of up to $110.5 million, of which $20.2 million were paid during First Quarter 2007. At March 31, 2007, Selective had contractual obligations that expire at various dates through 2022 to further invest up to $121.5 million in these other investments. There is no certainty that any such additional investment will be required.

In the ordinary course of conducting business, Selective Insurance Group, Inc. and its subsidiaries are named as defendants in various legal proceedings. Some of these lawsuits attempt to establish liability under insurance contracts issued by Selective’s insurance subsidiaries. Plaintiffs in these lawsuits seek money damages that, in some cases, are extra-contractual in nature or they seek to have the court direct the activities of Selective’s operations in certain ways. Although the ultimate outcome of these matters is not presently determinable, Selective does not believe that the total amounts that it will ultimately have to pay, if any, in all of these lawsuits in the aggregate will have a material adverse effect on its financial condition, results of operations, or liquidity.

In this Quarterly Report on Form 10-Q, Selective and its management discuss and make statements regarding their intentions, beliefs, current expectations, and projections regarding Selective’s future operations and performance. Such statements are “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are often identified by words such as “anticipates,” “believes,” “expects,” “will,” “should” and “intends” and their negatives. Selective and its management caution prospective investors that such forward-looking statements are not guarantees of future performance. Risks and uncertainties are inherent in Selective’s future performance. Factors that could cause actual results to differ materially from those indicated by such forward-looking statements include, but are not limited to, those discussed under Item 1A. “Risk Factors” in Selective’s 2006 Annual Report. These risk factors may not be exhaustive. We operate in a continually changing business environment, and new risk factors emerge from time-to-time. We can neither predict such new risk factors nor can we assess the impact, if any, of such new risk factors on our businesses or the extent to which any factor or combination of factors may cause actual results to differ materially from those expressed or implied in any forward-looking statements in this report. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report might not occur. Selective and its management make forward-looking statements based on currently available information and assume no obligation to update these statements due to changes in underlying factors, new information, future developments, or otherwise.

Selective Insurance Group, Inc., (“Selective,” “we,” or “our”) offers property and casualty insurance products and diversified insurance services through its various subsidiaries. Selective classifies its businesses into three operating segments: (i) Insurance Operations, (ii) Investments, and (iii) Diversified Insurance Services.

The purpose of the Management’s Discussion and Analysis (“MD&A”) is to provide an understanding of the consolidated results of operations and financial condition and known trends and uncertainties that may have a material impact in future periods. Consequently, investors should read the MD&A in conjunction with Selective’s consolidated financial statements in Selective’s 2006 Annual Report. For reading ease, we have written the MD&A in the first person plural.

In the MD&A, we will discuss and analyze the following:

These unaudited interim consolidated financial statements include amounts based on informed estimates and judgments of management for those transactions that are not yet complete. Such estimates and judgments affect the reported amounts in the financial statements. Those estimates and judgments that were most critical to the preparation of the financial statements involved the following: (i) reserves for losses and loss expenses; (ii) deferred policy acquisition costs; (iii) pension and postretirement benefit plan actuarial assumptions; and (iv) other-than-temporary investment impairments. These estimates and judgments require the use of assumptions about matters that are highly uncertain and, therefore, are subject to change as facts and circumstances develop. If different estimates and judgments had been applied, materially different amounts might have been reported in the financial statements. Our 2006 Annual Report, pages 33 through 40, provides a discussion of each of these critical accounting policies.

The above items were partially offset by decreases in NPE on our New Jersey personal automobile book of business attributable to the loss of automobiles repriced at higher pricing levels through our MATRIX pricing system. Our New Jersey personal automobile book of business experienced a 13% reduction in the number of cars we insured during First Quarter 2007 compared to First Quarter 2006 and NPE for our New Jersey personal automobile business was down to $22.7 million for First Quarter 2007 as compared to $26.6 million for First Quarter 2006.

Our Insurance Operations segment writes property and casualty insurance business through seven insurance subsidiaries (the “Insurance Subsidiaries”). Our Insurance Operations segment sells property and casualty insurance products and services primarily in 20 states in the Eastern and Midwestern United States through approximately 800 independent insurance agencies. Selective has at least one Insurance Subsidiary licensed to do business in each of the 50 states. Our Insurance Operations segment consists of two components: (i) commercial lines (“Commercial Lines”), which markets primarily to businesses, and represents approximately 87% of net premiums written (“NPW”), and (ii) personal lines (“Personal Lines”), which markets primarily to individuals and represents approximately 13% of NPW. The underwriting performance of these lines are generally measured by four different statutory ratios: (i) loss and loss expense ratio; (ii) underwriting expense ratio; (iii) dividend ratio; and (iv) combined ratio. For further details regarding these ratios see the discussion in the “Insurance Operations Results” section of Item 1. “Business” of Selective’s 2006 Annual Report.

This decrease was partially offset by the following:

Historically, the results of the property and casualty insurance industry have experienced significant fluctuations due to high levels of competition, economic conditions, interest rates, loss cost trends, and other factors. We expect the industry will continue to see increased pricing pressure in the primary insurance market in 2007, which will exert pressure on the future profitability of Selective’s business. The average forecast, according to the “A.M. Best Review/Preview” dated April 23, 2007, calls for commercial lines net premiums written to be relatively flat for 2007. This represents a slowdown of 1.6% from 2006. The 2007 NPW forecast is ranked the second slowest rate of growth for property and casualty insurers since 1998. Loss trends, which are characterized by changes in frequency and severity, may also impact the future profitability of our business.

When renewal pure price increases are declining and loss costs trend higher, a market cycle shift occurs. General inflation and, notably, medical inflation, can drive loss costs up, leading to higher industry-wide statutory combined ratios. We believe that it is critical to have a clearly defined plan to improve risk selection and mitigate higher frequency and severity trends during market cycles. Some of the tools we use to lower frequency and severity are safety management, managed care, knowledge management, predictive modeling, and enhanced claims review.

Although it is uncertain at this time whether our initiatives will offset macro pricing and loss trends, we have outperformed the industry’s loss and loss adjustment expense ratio by 7.1 points, on average, over the past 10 years.

As competition continues to intensify, managing profitability and growth will be a major focus for us in 2007. Driving profitable organic growth has always been Selective’s strategy, and this will continue throughout 2007. Our growth drivers are:

Other strategic initiatives we are implementing to increase the effectiveness of our field strategy and improve risk selection include:

The following is a discussion on our most significant commercial lines of business:

Total policy counts in this line of business increased 7% in First Quarter 2007 compared to First Quarter 2006; however, new business premiums in this line of business were relatively flat, reflecting the softening market. Further evidence of softening market conditions is illustrated in our renewal price increases, including exposure, which were only 0.1% in First Quarter 2007 compared to 2.7% in First Quarter 2006. Despite the difficult pricing environment, retention remained stable at 77% in First Quarter 2007 compared to First Quarter 2006.

In spite of continued adverse prior year loss development, this line of business is profitable due to our long-term improvement strategy, which focuses on: (i) contractor growth in business segments with lower completed operations exposures; and (ii) improving contractor/subcontractor-underwriting guidelines to minimize losses.

Our multi-faceted workers compensation strategy, which incorporates our knowledge management and predictive modeling initiatives, has enabled us to retain and write more of the best accounts, which has led to First Quarter 2007 increases in total policy counts and direct new voluntary policy premiums of 5% and 19%, respectively, compared to First Quarter 2006. At the same time, these initiatives have allowed us to target price increases for our worst performing business, which contributed to the decrease in our retention in First Quarter 2007 to 79% from 82% in First Quarter 2006 and by improved profitability in our retained business.

The improvement in the statutory combined ratio of this line of 12.1 points in First Quarter 2007 compared to First Quarter 2006 reflects not only the ongoing progress resulting from the execution of our multi-faceted workers compensation strategy, but also favorable prior year statutory development of approximately $2 million or 2.4 points in First Quarter 2007 compared to adverse development in First Quarter 2006 of approximately $3 million or 3.3 points.

Continued strong performance in this line of business is the result of underwriting improvements over the last several years. We have implemented granular rate decreases on accounts to grow this profitable line of business. The total policy count on this line increased 6% in First Quarter 2007 compared to First Quarter 2006, driven by new policy count increases of 9% in First Quarter 2007 compared to First Quarter 2006. However, renewal prices, including exposure, decreased 2.1% in First Quarter 2007 as compared to being flat in First Quarter 2006, which has put pressure on the combined ratio in First Quarter 2007 compared to First Quarter 2006. Additionally, this line of business continues to experience favorable prior year loss development, which was approximately $3 million in First Quarter 2007 compared to approximately $6 million in First Quarter 2006.

Net premiums written for this line of business increased in First Quarter 2007 compared to 2006 due to: (i) increases in direct new policy premium of 3% in First Quarter 2007 to $11.8 million; (ii) stable retention of approximately 80% over the past two years; and (iii) renewal price increases, including exposure, of 1.6% in First Quarter 2007 compared to 3.1% in First Quarter 2006.

The statutory combined ratio for commercial property increased in First Quarter 2007 compared to First Quarter 2006, primarily as a result of increased property losses of $6.8 million. The majority of the increase was the result of increased non-catastrophe weather related losses; however, $1.0 million of the increase did reflect increased catastrophe losses. Despite the increased losses this year, 2007 results continue to be strong as this line of business is benefiting from underwriting improvements over the past five years, including better insurance-to-value estimates across our book of business, a shift to risks of better construction quality and newer buildings, and an overall focus on low to medium hazard property exposures.

 

¹ The statutory ratios include the flood line of business, which is included in the Diversified Insurance Services segment on a GAAP basis and therefore excluded from the GAAP ratios. The total Personal Lines Statutory Combined Ratio excluding flood is 110.3% for First Quarter 2007 compared to 103.5% for First Quarter 2006.

Our investment portfolio consists primarily of fixed maturity investments (82%), but also contains equity securities, short-term investments, and other investments. Our investment philosophy includes certain return and risk objectives for our fixed maturity and equity portfolios. The primary return objective of our fixed maturity portfolio is to maximize after-tax investment yield and income while balancing certain risk objectives, with a secondary objective of meeting or exceeding a weighted-average benchmark of public fixed income indices. The return objective of the equity portfolio is to meet or exceed a weighted-average benchmark of public equity indices. The risk objective for our entire portfolio is to ensure that our investments are structured conservatively, focusing on: (i) asset diversification; (ii) investment quality; (iii) liquidity, particularly to meet the cash obligations of the Insurance Operations segment; (iv) consideration of taxes; and (v) preservation of capital.