UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549FORM 10-Q
(Mark One)
[X]
Quarterly report pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934
For the quarterly period ended: June 30, 2005
OR
[ ]
Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from to Commission file number: 0-8641
SELECTIVE INSURANCE GROUP, INC.(Exact Name of Registrant as Specified in Its Charter)
New Jersey
22-2168890
(State or Other Jurisdiction of Incorporation or Organization)
(IRS Employer Identification No.)
40 Wantage Avenue
Branchville, New Jersey
07890
(Address of Principal Executive Offices)
(Zip Code)
(973) 948-3000
(Registrant's Telephone Number, Including Area Code)
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.
Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)
As of June 30, 2005, there were 28,385,596 shares of common stock, par value $2, outstanding.
SELECTIVE INSURANCE GROUP, INC.
Table of Contents
Page No
PART I
FINANCIAL INFORMATION
Item 1.
Financial Statements
Consolidated Balance Sheets as of June 30, 2005
(Unaudited) and December 31, 2004
1
Unaudited Consolidated Statements of Income for the
Quarter and Six Months Ended June 30, 2005 and 2004
2
Unaudited Consolidated Statements of Stockholders' Equity for the
Six Months Ended June 30, 2005 and 2004
3
Unaudited Consolidated Statements of Cash Flows for the
4
Notes to Interim Unaudited Consolidated Financial Statements
5
Item 2.
Managements' Discussion and Analysis of Financial
Condition and Results of Operations
Forward - Looking Statements
14
Introduction
15
Result of Operations
16
Financial Condition, Liquidity and Capital Resources
28
Federal Income Taxes
30
Critical Accounting Policies and Estimates
Business Outlook
34
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
35
Item 4.
Controls and Procedures
PART II
OTHER INFORMATION
Unregistered Sales of Equity Securities and Use of Proceeds
Submission of Matters to a Vote of Security Holders
Item 6.
Exhibits
PART 1 - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Unaudited
CONSOLIDATED BALANCE SHEETS
June 30,
December 31,
($ in thousands, except per share amounts)
2005
2004
ASSETS
Investments:
Fixed maturity securities, held-to-maturity - at amortized cost
(fair value: $31,109-2005; $42,211-2004)
$
30,254
40,903
Fixed maturity securities, available-for-sale - at fair value
(amortized cost: $2,399,962-2005; $2,247,253-2004)
2,475,391
2,325,969
Equity securities, available-for-sale - at fair value
(cost of: $180,609-2005; $172,900-2004)
331,051
331,931
Short-term investments - (at cost which approximates fair value)
74,955
98,657
Other investments
49,196
44,083
Total investments
2,960,847
2,841,543
Cash
297
-
Interest and dividends due or accrued
29,510
27,947
Premiums receivable, net of allowance for uncollectible
accounts of: $3,667-2005; $3,236-2004
516,516
430,426
Other trade receivables, net of allowance for uncollectible
accounts of: $632-2005; $681-2004
25,998
17,478
Reinsurance recoverable on paid losses and loss expenses
6,625
5,841
Reinsurance recoverable on unpaid losses and loss expenses
201,720
218,772
Prepaid reinsurance premiums
61,318
58,264
Current federal income tax recoverable
7,732
Property and Equipment - at cost, net of accumulated
depreciation and amortization of: $94,059-2005; $89,213-2004
53,882
55,144
Deferred policy acquisition costs
202,632
186,917
Goodwill
43,230
Other assets
60,733
43,838
Total assets
4,171,040
3,929,400
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Reserve for losses
1,683,919
1,609,788
Reserve for loss expenses
248,797
225,429
Unearned premiums
778,372
702,111
Senior convertible notes
115,937
Notes payable
141,382
147,380
Current federal income tax payable
3,127
Deferred federal income tax
23,657
29,803
Commissions payable
53,662
66,881
Accrued salaries and benefits
54,960
50,071
Other liabilities
128,043
96,855
Total liabilities
3,228,729
3,047,382
Stockholders' Equity:
Preferred stock of $0 par value per share:
Authorized shares: 5,000,000; no shares issued or outstanding
Common stock of $2 par value per share:
Authorized shares: 180,000,000
Issued: 43,076,784-2005; 42,468,099-2004
86,154
84,936
Additional paid-in capital
144,698
142,292
Retained earnings
778,917
721,483
Accumulated other comprehensive income
146,816
154,536
Treasury stock - at cost (shares: 14,691,188-2005; 14,529,067-2004)
(214,274)
(206,522)
Unearned stock compensation and notes receivable from stock sales
(14,707)
Total stockholders' equity
942,311
882,018
Commitments and contingencies
Total liabilities and stockholders' equity
The accompanying notes are an integral part of these unaudited interim consolidated financial statements.
UNAUDITED CONSOLIDATED STATEMENTS OF INCOME
Quarter ended
Six Months ended
Revenues:
Net premiums written
369,621
349,250
766,399
724,512
Net increase in unearned premiums and prepaid reinsurance premiums
(19,169)
(23,264)
(73,207)
(83,220)
Net premiums earned
350,452
325,986
693,192
641,292
Net investment income earned
32,747
28,662
65,109
58,122
Net realized gains
559
154
5,157
5,500
Diversified Insurance Services revenue
29,697
26,395
57,449
50,626
Other income
904
940
1,758
1,717
Total revenues
414,359
382,137
822,665
757,257
Expenses:
Losses incurred
184,169
172,613
361,924
349,172
Loss expenses incurred
41,625
36,537
82,307
70,295
Policy acquisition costs
109,485
102,205
216,320
199,669
Dividends to policyholders
1,094
964
2,342
2,053
Interest expense
4,288
3,918
8,665
7,923
Diversified Insurance Services expenses
24,281
22,968
48,897
45,006
Other expenses
5,735
2,913
9,168
5,584
Total expenses
370,677
342,118
729,623
679,702
Income before federal income tax and cumulative effect
of change in accounting principle
43,682
40,019
93,042
77,555
Federal income tax expense (benefit):
Current
15,057
10,564
27,613
18,936
Deferred
(3,453)
581
(2,255)
2,217
Total federal income tax expense
11,604
11,145
25,358
21,153
Net income before cumulative effect of change in accounting principle
32,078
28,874
67,684
56,402
Cumulative effect of change in accounting principle, net of tax
495
Net income
68,179
Earnings per share:
Basic net income before cumulative effect of change in accounting principle
1.18
1.08
2.49
2.12
Basic cumulative effect of change in accounting principle
0.02
Basic net income
2.51
Diluted net income before cumulative effect of change in accounting principle
1.02
0.92
2.15
1.80
Diluted cumulative effect of change in accounting principle
Diluted net income
2.17
Dividends to stockholders
0.19
0.17
0.38
0.34
UNAUDITED CONSOLIDATED STATEMENTS OF
STOCKHOLDERS' EQUITY
Common stock:
Beginning of year
83,135
Dividend reinvestment plan
(shares: 16,119-2005; 18,230-2004)
32
36
Convertible subordinated debentures
(shares: 35,024-2005; 18,923-2004)
70
38
Stock purchase and compensation plans
(shares: 557,542-2005; 565,898 -2004)
1,116
1,132
End of period
84,341
Additional paid-in capital:
113,283
702
628
178
98
1,526
19,050
133,059
Retained earnings:
612,208
Cash dividends to stockholders
($0.38 per share-2005; $0.34 per share-2004)
(10,745)
(9,367)
659,243
Accumulated other comprehensive income:
148,452
Other comprehensive loss, decrease in net unrealized
gains on available-for-sale securities, net of
deferred income tax effect of:
$(4,157)-2005; $(14,807)-2004
(7,720)
(27,499)
120,953
Comprehensive income
60,459
28,903
Treasury stock:
(197,792)
Acquisition of treasury stock
(shares 162,121-2005; 81,574-2004)
(7,752)
(2,913)
(200,705)
Unearned stock compensation and notes receivable from stock sales:
(9,502)
Unearned stock compensation
14,641
(11,829)
Amortization of deferred compensation expense and
amounts received on notes
66
3,806
(17,525)
779,366
Selective Insurance Group, Inc. also has authorized and unissued, 5 million shares of preferred stock, without par value of which 300,000 shares have been designated as Series A junior preferred stock without par value.
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
Adjustments to reconcile net income to net cash provided by operating activities:
Increase in reserves for losses and loss expenses, net of reinsurance recoverable
on unpaid losses and loss expenses
114,551
92,828
Increase in unearned premiums, net of prepaid reinsurance and advance premiums
73,341
82,150
Decrease in net federal income tax payable
(13,114)
(6,898)
Depreciation and amortization
10,256
7,984
Stock compensation expense
6,209
3,751
Gain on sale of real estate
(183)
Increase in premiums receivable
(86,090)
(75,442)
Increase in other trade receivables
(8,520)
(2,920)
Increase in deferred policy acquisition costs
(15,715)
(19,178)
Decrease in interest and dividends due or accrued
(1,523)
(1,047)
Increase in reinsurance recoverable on paid losses and loss expenses
(784)
(659)
(5,157)
(5,500)
(495)
Increase in accrued salaries and benefits
4,889
569
Decrease in accrued insurance expenses
(12,691)
(7,112)
Other-net
(15,570)
1,246
Net adjustments
49,587
69,589
Net cash provided by operating activities
117,766
125,991
Purchase of fixed maturity securities, available-for-sale
(287,411)
(326,317)
Purchase of equity securities, available-for-sale
(21,800)
(28,049)
Purchase of other investments
(5,809)
(3,576)
Purchase of subsidiaries acquired (net of short-term investments and cash acquired
of $4,890 in 2004)
(407)
Sale of fixed maturity securities, available-for-sale
74,796
135,767
Redemption and maturities of fixed maturity securities, held-to-maturity
10,710
12,924
Redemption and maturities of fixed maturity securities, available-for-sale
81,543
98,865
Sale of equity securities, available-for-sale
20,345
26,931
Proceeds from other investments
5,006
4,886
Net additions to property and equipment
(4,135)
(4,630)
Net cash used in investing activities
(126,755)
(83,606)
(9,587)
(8,393)
Principal payments of notes payable
(6,000)
Net proceeds from stock purchase and compensation plans
6,348
6,303
Cash retained for tax deductibility of the increase in value of equity instruments
2,509
Repayment of notes receivable from stock sales
55
Net cash used in financing activities
(14,416)
(10,948)
Net (decrease) increase in short-term investments and cash
(23,405)
31,437
Short-term investments and cash at beginning of year
23,055
Short-term investments and cash at end of period
75,252
54,492
SUPPLEMENTAL DISCLOSURES OF CASH FLOWS INFORMATION
Cash paid during the period for:
Interest
8,639
7,857
Federal income tax
35,962
28,050
Supplemental schedule of non-cash financing activity:
Conversion of convertible subordinated debentures
248
136
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. OrganizationSelective Insurance Group, Inc., ("Selective") offers property and casualty insurance products and diversified insurance services products through its various subsidiaries. Selective classifies its businesses into three operating segments: (i) Insurance Operations; (ii) Investments; and (iii) Diversified Insurance Services. Selective was incorporated in New Jersey in 1977 and its main offices are located in Branchville, New Jersey. Selective common stock is publicly traded on the NASDAQ National Market®under the symbol, "SIGI."
NOTE 2. Basis of PresentationThese interim unaudited consolidated financial statements include the accounts of Selective and its subsidiaries, and have been prepared in conformity with (i) generally accepted accounting principles 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. All significant intercompany accounts and transactions between Selective and its subsidiaries are eliminated in consolidation.
These interim unaudited consolidated 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 the operations and financial condition. These interim unaudited consolidated financial statements cover the second quarters ended June 30, 2005 ("Second Quarter 2005") and June 30, 2004 ("Second Quarter 2004") and the six-month periods ended June 30, 2005 ("Six Months 2005") and June 30, 2004 ("Six Months 2004"). As interim unaudited consolidated financial statements, they do not include all of the information and disclosures required by GAAP for complete financial statements. Results of operations for any interim period are not necessarily indicative of results for a full year. Consequently, these interim unaudited consolidated 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, 2004.
NOTE 3. ReclassificationsCertain amounts in Selective's prior year interim unaudited consolidated financial statements and related footnotes have been reclassified to conform to the 2005 presentation, but such reclassification has had no effect on Selective's net income or stockholders' equity.
NOTE 4. Adoption of Accounting PronouncementsIn December 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment" ("FAS 123R"), requiring public companies to record share based (including employee stock options) compensation expense on the income statement at the fair value of the share award on the date of grant for fiscal years beginning after June 15, 2005. As permitted, Selective early adopted FAS 123R as of January 1, 2005. See Note 6 below for further information regarding the adoption of FAS 123R.
NOTE 5. ReinsuranceThe following table is a listing of direct, assumed and ceded amounts by income statement caption. For more information concerning reinsurance, refer to Note 6, "Reinsurance" in Item 8 "Financial Statements and Supplementary Data" in Selective's Annual Report on Form 10-K for the fiscal year ended December 31, 2004.
Unaudited,
($ in thousands)
Premiums written:
Direct
403,445
379,033
830,261
782,140
Assumed
7,364
7,473
13,256
13,341
Ceded
(41,188)
(37,256)
(77,118)
(70,969)
Net
Premiums earned:
377,867
351,875
747,428
694,381
10,625
8,553
19,827
16,575
(38,040)
(34,442)
(74,063)
(69,664)
Losses and loss expenses incurred:
241,180
221,730
471,067
444,098
9,524
7,296
17,256
14,256
(24,910)
(19,876)
(44,092)
(38,887)
225,794
209,150
444,231
419,467
Selective's Flood business is ceded 100% to the National Flood Insurance Program and included in the above amounts as follows:
Ceded premiums written
(24,105)
(21,033)
(44,269)
(37,157)
Ceded premiums earned
(20,739)
(17,268)
(40,522)
(33,844)
Ceded losses and loss expenses incurred
(17,640)
(5,736)
(25,250)
(10,793)
NOTE 6. Share-Based PaymentsEffective January 1, 2005, Selective adopted FAS 123R, using the modified prospective application method, to account for its share-based compensation plans. Previously, Selective applied Accounting Principles Board ("APB") Opinion No. 25 "Accounting for Stock Issued to Employees," ("APB 25") as was permitted by FASB Statement No. 123 "Accounting for Stock Based Compensation" ("FAS 123").
Selective's adoption of FAS 123R did not have a material effect on (i) income before cumulative effect of change in accounting principle and (ii) basic or diluted earnings per share before cumulative effect of change in accounting principle in Second Quarter 2005 or Six Months 2005. Although, upon adoption, Selective did recognize a cumulative effect of change in accounting principle resulting in a net income benefit of $0.5 million, which corresponded to the requirement of estimating forfeitures at the date of grant. FAS 123R also eliminated the presentation of the contra-equity account, "Unearned Stock Compensation," from the face of the Consolidated Balance Sheets resulting in a reclassification of $14.7 million to "Additional Paid-in Capital."
6
The following table shows a pro forma reconciliation of net income reported under APB 25 to pro forma net income and earnings per share under FAS 123 for the Three Months and Six Months ended June 30, 2004:
June 30,2004
June 30, 2004
Net income, as reported
Add: Stock-based compensation reported in net
income, net of related tax effect
1,346
2,550
Deduct: Total stock-based compensation expense
determined under fair value-based method for all awards,
net of related tax effects
(1,058)
(3,201)
Pro forma net income
29,162
55,751
Net income per share:
Basic - as reported
Basic - pro forma
1.09
2.09
Diluted - as reported
Diluted - pro forma
0.93
1.78
In determining expense to be recorded for stock options granted under Selective's share-based compensation plans, the fair value of each option award is estimated on the date of grant using the Black Scholes option valuation model ("Black Scholes"). The following are the significant assumptions utilized in applying Black Scholes : (i) risk-free interest rate, which is the implied yield currently available on U.S. Treasury zero-coupon issues with an equal remaining term; (ii) expected term, which is based on historical experience of similar awards; (iii) dividend yield, which is determined by dividing the expected per share dividend during the coming year by the grant date stock price; and (iv) expected volatility, which is based on the volatility of Selective's stock price over a historical period comparable to the expected term. In applying Black Scholes, Selective uses the weighted average assumptions illustrated in the following table:
Employee Stock Purchase Plan
All Other Option Plans
Risk-free interest rate
2.58
%
3.99
3.60
Expected term
6 months
7 years
Dividend yield
1.7
2.1
1.9
Expected volatility
26
The expense recorded for restricted stock awards and stock compensation for nonemployee directors, as described below, is determined utilizing the number of awards granted and the grant date fair value.
Under FAS 123R the compensation expense for the share-based compensation plans charged against income before cumulative effect of change in accounting principle before tax was $3.7 million in Second Quarter 2005 and $6.0 million in Six Months 2005 with a corresponding income tax benefit of $1.2 million in Second Quarter 2005 and $1.9 million in Six Months 2005. In accordance with APB 25, Selective had compensation expense that was charged against income before tax of $2.0 million in Second Quarter 2004 and $3.9 million in Six Months 2004 with a corresponding income tax benefit of $0.7 million for Second Quarter 2004 and $1.3 million in Six Months 2004.
2005 Omnibus Stock PlanThe 2005 Omnibus Stock Plan ("Stock Plan") was adopted and approved by the Board of Directors effective as of April 1, 2005, and approved by stockholders' on April 27, 2005. With the Stock Plan's approval, no further grants are available under (i) Selective Stock Option Plan III; (ii) Stock Option Plan for Directors; or (iii) the Stock Compensation Plan for Nonemployee Directors, but awards outstanding under these plans and Stock Option Plan II, which ceased issuing grants on September 1, 2002, shall continue in effect according to the terms of those plans and any applicable award agreements.
7
Under the Stock Plan, the Board of Directors' Salary and Employee Benefits Committee ("SEBC") may grant stock options, stock appreciation rights, restricted stock, phantom stock, stock bonuses, and other awards in such amounts and with such terms and conditions, as it shall determine. The Corporate Governance and Nominating Committee makes such determinations for any grants made to Directors. Each Stock Plan award (except unconditional stock bonuses and the cash component of Director compensation) shall be evidenced by an agreement containing such restrictions as the SEBC or the Corporate Governance and Nominating Committee may in its sole discretion deem necessary or desirable and which are not in conflict with the terms of the Stock Plan. During Six Months 2005, Selective did not issue awards under the Stock Plan and 1,760,000 shares remain available for issuance pursuant to future award grants.
Stock Option Plan IIAs of June 30, 2005, 490,656 shares of Selective's common stock remain available for issuance pursuant to outstanding stock option and restricted stock awards granted under Stock Option Plan II, under which future grants ceased being available on September 1, 2002. Under this plan, employees were granted qualified and nonqualified stock options, with or without stock appreciation rights ("SARs"), and restricted or unrestricted stock at (i) not less than fair value on the date of grant and (ii) subject to certain vesting periods as determined by the SEBC. Restricted stock awards also could be subject to the achievement of performance objectives as determined by the SEBC. The maximum exercise period for an option grant under this plan is ten years from the date of the grant. Selective experienced restricted forfeitures under the plan of 950 shares during Six Months 2005 and 13,188 shares during Six Months 2004.
During the vesting period, dividends are earned on the restricted shares and held in escrow subject to the same vesting period and conditions set forth in the award agreement. Effective September 3, 1996, dividends earned on the restricted shares were reinvested in Selective's common stock at fair value. Selective issued, net of forfeitures, 1,754 restricted shares from the dividend reinvestment plan reserves during Six Months 2005 and 3,178 during Six Months 2004.
Stock Option Plan IIIAs of June 30, 2005, there were 273,104 shares of Selective's common stock available for issuance pursuant to outstanding stock options and restricted stock awards granted under Stock Option Plan III, under which future grants ceased being available with the approval of the Stock Plan. Under this plan, employees were granted qualified and nonqualified stock options, with or without SARs, and restricted or unrestricted stock (i) at not less than fair value on the date of grant and (ii) subject to certain vesting restrictions determined by the SEBC. Restricted stock awards also could be subject to achievement of performance objectives as determined by the SEBC. The maximum exercise period for an option grant under this plan is ten years from the date of the grant. Under this plan, Selective granted options to purchase 105,663 shares without SARS during Six Months 2005 and options to purchase 104,600 shares without SARS during Six Months 2004.
Selective also granted 313,018 restricted shares during Six Months 2005 and 317,384 restricted shares during Six Months 2004 and experienced forfeitures of 1,934 shares during Six Months 2005 and 21,159 shares during Six Months 2004. During the vesting period, dividends earned on restricted shares are reinvested in Selective's common stock at fair value. Selective issued, net of forfeitures, 7,205 restricted shares from the dividend reinvestment plan reserves during Six Months 2005 and 4,940 restricted shares during Six Months 2004.
Stock Option Plan for DirectorsAs of June 30, 2005, 294,000 shares of Selective's common stock were available for issuance pursuant to outstanding stock option awards under Selective's Stock Option Plan for Directors, under which future grants ceased being available with the approval of the 2005 Omnibus Stock Plan. All non-employee directors participated in this plan and automatically received a nonqualified option to purchase 3,000 shares of common stock at not less than fair value annually on March 1. Options under this plan vest on the first anniversary of the grant and must be excercised by the tenth anniversary of the grant. Under this plan, Selective granted 33,000 options during Six Months 2005, and 30,000 options during Six Months 2004.
8
Stock Compensation Plan for Nonemployee DirectorsAs of June 30, 2005, there were 47,625 shares of Selective's common stock available for issuance pursuant to outstanding stock option awards under Selective's Stock Compensation Plan for Nonemployee Directors, under which future grants ceased being available with the approval of the 2005 Omnibus Stock Plan. Under this plan, directors could elect to receive a portion of their annual compensation in shares of Selective's common stock. Selective issued 10,919 shares during Six Months 2005 and 5,232 shares during Six Months 2004 under this plan.
Employee Stock Purchase PlanUnder Selective's Employee Stock Purchase Plan ("ESPP"), there are 244,231 shares of common stock available for purchase. The ESPP is available to all employees who meet its eligibility requirements. The ESPP provides for the issuance of options to purchase shares of common stock. The purchase price is the lower of: (i) 85% of the closing market price at the time the option is granted or (ii) 85% of the closing price at the time the option is exercised. Shares are generally issued on June 30 and December 31 of each year. Under the ESPP plan, Selective issued 24,051 shares to employees during Six Months 2005 and 25,677 shares during Six Months 2004.
The weighted-average fair value of options and stocks granted per share for Selective's stock plans, during Six Months 2005 and Six Months 2004 is as follows:
Stock options
13.14
9.65
Restricted stock
45.05
34.83
Stock Compensation Plan for Nonemployee Directors
44.95
33.80
Employee Stock Purchase Plan (ESPP):
Six month option
3.24
2.31
15% of grant date market value
6.57
4.84
Total ESPP
9.81
7.15
A summary of the stock option transactions under Selective's share-based payment plans is as follows:
Weighted
Average
Remaining
Aggregate
Number
Exercise
contractual
Intrinsic Value
of shares
Price
Life in years
Outstanding at January 1, 2005
927,276
22.90
Granted 2005
138,663
44.60
Exercised 2005
(140,636)
21.51
Forfeited or expired 2005
(2,700)
19.44
Outstanding at June 30, 2005
922,603
26.38
5.7
21,372
Exercisable at June 30, 2005
783,940
23.16
5.0
20,685
The total intrinsic value of options exercised was $3.6 million during Six Months 2005 and $3.2 million during Six Months 2004.
9
A summary of the restricted stock transactions under Selective's share-based payment plans is as follows:
Grant Date
Fair Value
Restricted Stock Awards at January 1, 2005
953,438
26.69
313,108
Vested 2005
(190,104)
22.79
Forfeited 2005
(2,884)
28.60
Restricted Stock Awards at June 30, 2005
1,073,558
32.73
As of June 30, 2005, total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under Selective's stock plans was $19.0 million. That cost is expected to be recognized over a weighted-average period of 2.1 years. The total fair value of restricted stock vested was $9.1 million for Six Months 2005 and $4.8 million for Six Months 2004. In connection with the restricted stock vestings, the total fair value of the dividend reinvestment plan shares that also vested was $0.9 million during Six Months 2005 and $0.5 million during Six Months 2004.
NOTE 7. Segment InformationSelective classifies its businesses into three operating segments, the disaggregated results of which are used by senior management to manage Selective's operations:
Insurance Operations (commercial lines and personal lines), which are evaluated based on GAAP underwriting results (net premiums earned, incurred losses and loss expenses, policyholders dividends, policy acquisition costs and other underwriting expenses) and statutory combined ratios;
Investments, which are evaluated based on after-tax net investment income and net realized gains and losses; and
Diversified Insurance Services (flood insurance, human resource administration outsourcing and managed care), which, because they are not dependent on insurance underwriting cycles, are evaluated based on several measures including, but not limited to, results of operations in accordance with GAAP.
Selective does not aggregate any of its operating segments.
The Insurance Operations and Diversified Insurance Services segments share either complementary (common marketing or distribution system) or vertical (one business uses another's products or services in its own product or supply output) services. Selective's commercial and personal lines property and casualty insurance products, flood insurance, and HR administration outsourcing products are principally sold through Selective's appointed independent insurance agents. Selective's managed care business provides services to its property and casualty insurance claims operations and to other insurance carriers. Selective and its subsidiaries also provide services to each other in the normal course of business. These transactions totaled $7.3 million for Second Quarter 2005 and $14.1 million for Six Months 2005 compared with $7.1 million for Second Quarter 2004 and $13.5 million for Six Months 2004. These transactions are eliminated in all consolidated statements.
10
In computing the results of each segment, Selective does not make adjustments for 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 summaries present revenues (net investment income and net realized gains on investments in the case of the Investments segment) and pre-tax income for the individual segments:
Revenue by segment
Insurance Operations:
Commercial automobile net premiums earned
78,499
74,409
156,148
146,867
Workers' compensation net premiums earned
73,829
65,909
143,082
128,869
General liability net premiums earned
88,993
76,356
175,009
148,523
Commercial property net premiums earned
41,173
37,525
81,383
74,169
Business owners' policy net premiums earned
11,547
12,489
23,468
24,715
Bonds net premiums earned
3,973
3,197
7,835
6,218
Other net premiums earned
199
227
414
448
Total commercial lines net premiums earned
298,213
270,112
587,339
529,809
Personal automobile net premiums earned
41,480
45,966
84,471
91,850
Homeowners' net premiums earned
9,234
8,483
18,283
16,768
1,525
1,425
3,099
2,865
Total personal lines net premiums earned
52,239
55,874
105,853
111,483
Miscellaneous income
841
743
1,681
1,489
Total insurance operations revenues
351,293
326,729
694,873
642,781
Net investment income
Net realized gain on investments
Total investment revenues
33,306
28,816
70,266
63,622
Diversified Insurance Services:
Human resource administration outsourcing
14,956
13,315
30,563
26,361
Flood insurance
8,477
7,233
15,369
12,960
Managed Care
5,466
5,227
10,004
10,077
Other
798
620
1,513
1,228
Total diversified insurance services revenues
Total all segments
414,296
381,940
822,588
757,029
63
197
77
228
Income, before federal income tax and cumulative effect
of change in accounting by segment
Commercial lines underwriting
20,163
11,261
33,699
21,049
Personal lines underwriting
(6,196)
2,873
(3,086)
(190)
Underwriting income, before federal income tax
13,967
14,134
30,613
20,859
Total investment income, before federal income tax
Income before federal income tax
5,416
3,427
8,552
5,620
52,689
46,377
109,431
90,101
(4,288)
(3,918)
(8,665)
(7,923)
General corporate expenses
(4,719)
(2,440)
(7,724)
(4,623)
Income before federal income tax and cumulative
effect of change in accounting principle
11
NOTE 8. Retirement Plans
The following tables relate to Selective's Retirement Income and Postretirement Plans. For more information concerning these plans, refer to Note 15, "Retirement Plans" in Item 8 "Financial Statements and Supplementary Data" in Selective's Annual Report on Form 10-K for the fiscal year ended December 31, 2004.
Retirement Income Plan
Postretirement Plan
Components of Net Periodic Benefit Cost:
Service cost
1,798
1,402
99
83
Interest cost
1,854
1,808
94
96
Expected return on plan assets
(2,252)
(1,672)
Amortization of unrecognized prior service cost
37
53
(8)
Amortization of unrecognized net loss
288
286
Net periodic cost
1,725
1,877
185
171
Weighted-Average Expense Assumptions
For the years ended December 31:
Discount rate
5.75
6.25
8.00
8.25
Rate of compensation increase
4.00
5.00
3,596
2,804
166
3,708
3,616
189
192
(4,505)
(3,344)
75
106
(16)
576
572
3,450
3,754
372
342
for the years ended December 31:
Selective disclosed in Note 15 of the Notes to Consolidated Financial Statements, included in Item 8. "Financial Statements and Supplementary Data" of its Annual Report on Form 10-K for the year ended December 31, 2004, that it expected to contribute $8.0 million to its retirement income plan in 2005. During the first quarter of 2005, $8.0 million was contributed. Selective does not anticipate making any further contributions to the retirement income plan during 2005.
12
NOTE 9. Comprehensive IncomeThe components of comprehensive income, both gross and net of tax, for Second Quarter 2005 and Second Quarter 2004 are as follows:
Second Quarter 2005
Gross
Tax
Components of other comprehensive income:
Unrealized holding gains during the period
36,463
12,762
23,701
Reclassification adjustment
(518)
(181)
(337)
Other comprehensive income
35,945
12,581
23,364
79,627
24,185
55,442
Second Quarter 2004
Unrealized holding losses during the period
(77,011)
(26,954)
(50,057)
(104)
(36)
(68)
Other comprehensive loss
(77,115)
(26,990)
(50,125)
Comprehensive loss
(37,096)
(15,845)
(21,251)
The components of comprehensive income, both gross and net of tax, for Six Months 2005 and Six Months 2004 are as follows:
Six Months 2005
93,803
25,624
(6,765)
(2,367)
(4,398)
(5,111)
(1,789)
(3,322)
(11,876)
(4,156)
81,927
21,468
Six Months 2004
(36,856)
(12,900)
(23,956)
(5,450)
(1,907)
(3,543)
(42,306)
(14,807)
35,249
6,346
NOTE 10. Stockholder's Equity
Effective April 26, 2005, the Board of Directors (i) approved a new plan to repurchase up to 5.0 million shares of common stock over the next two years, and (ii) cancelled the existing stock repurchase program, under which Selective could have repurchased 2.4 million shares through November 30, 2005. Under the new plan, Selective repurchased approximately 70,000 shares at a cost of $3.3 million during Second Quarter 2005 and Six Months 2005.
13
ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
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 "Risk Factors" in Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Selective's Annual Report on Form 10-K for the fiscal year ended December 31, 2004 ("Annual Report"). Those portions of the Annual Report are incorporated by reference into this report. 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.Factors that could cause our actual results to differ materially from those projected, forecasted or estimated by us in forward-looking statements, include, but are not limited to:
the frequency and severity of catastrophic events, including, but not limited to, hurricanes, tornadoes, windstorms, earthquakes, hail, severe winter weather, fires, explosions and terrorism;
adverse economic, market, regulatory, legal or judicial conditions;
the concentration of our business in a number of east coast and midwestern states;
the adequacy of our loss reserves;
the adequacy of our loss expense reserves;
the cost and availability of reinsurance;
our ability to collect on reinsurance and the solvency of our reinsurers;
uncertainties related to insurance premium rate increases and business retention;
changes in insurance regulations that impact our ability to write and/or cease writing insurance policies in one or more states particularly changes in New Jersey automobile insurance laws and regulations;
our ability to maintain favorable ratings from rating agencies;
fluctuations in interest rates and the performance of the financial markets;
our entry into new markets and businesses; and
other risks and uncertainties we identify in this report and other filings with the Securities and Exchange Commission.
IntroductionSelective Insurance Group, Inc., ("Selective") offers property and casualty 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 prospects. Consequently, investors should read the MD&A in conjunction with Selective's consolidated financial statements on Form 10-K of our Annual Report for the year-ended December 31, 2004. For convenience and reading ease, we have written the MD&A in the first person plural.
In the MD&A, we will discuss and analyze the following:
Highlights of Second Quarter 2005 and Six Months 2005 Results
Results of Operations and Related Information by Segment
Financial Condition, Liquidity, and Capital Resources
Adoption of Accounting Pronouncement
Off-Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments
Change
20
21
19
32,172
32,402
(1)
32,225
32,311
96.0
95.7
0.3
95.6
96.7
(1.1)
pts
94.9
95.0
(0.1)
94.2
95.3
14.0
14.6
(0.6)
14.9
14.8
0.1
Revenues increased in Second Quarter 2005 compared to Second Quarter 2004 and in Six Months 2005 compared to Six Months 2004, primarily due to net premiums earned ("NPE") growth of 8% in Second Quarter 2005 and Six Months 2005 compared to Second Quarter 2004 and Six Months 2004.
Net income increased in Second Quarter 2005 compared to Second Quarter 2004 and in Six Months 2005 compared to Six Months 2004 primarily due to after-tax investment income, which increased 17% for Second Quarter 2005 as compared to Second Quarter 2004 and 15% for Six Months 2005 as compared to Six Months 2004.
The Second Quarter 2005 and Six Months 2005 GAAP combined ratios remained profitable and are at approximately the same levels as Second Quarter 2004 and Six Months 2004 despite a net reserve adjustment of $7.5 million discussed in the section titled "Personal Automobile."
Insurance Operations
Our Insurance Operations segment sells property and casualty insurance products and services in 50 states and currently writes business in 20 primary states in the Eastern and Mid-Western United States through approximately 750 independent insurance agencies. Our Insurance Operations segment consists of two lines of business: (i) commercial lines ("Commercial Lines"), which markets primarily to businesses, and represents approximately 85% of net premiums written ("NPW"), and (ii) personal lines ("Personal Lines"), which markets primarily to individuals and represents approximately 15% of NPW.
Our Insurance Operations segment is comprised of 6 insurance subsidiaries ("Insurance Subsidiaries") that write its business. In Second Quarter 2005, A.M. Best Company ("A.M. Best") ranked our Insurance Subsidiaries as the nation's 51st largest property and casualty group based on the combined statutory net premiums written or premiums for all sold policies in its list of "Top Property/Casualty Writers" based on 2004 data.
In 2005, to address ongoing changes in the property and casualty marketplace, our Insurance Operations segment adopted several key strategies to achieve performance objectives over the next several years:
The Insurance Operations segment derives substantially all of its revenues from NPE, which are the premiums recognized as revenue ratably over the life of the insurance policies. Expenses fall into two categories: (i) losses associated with claims and various loss adjustment expenses ("LAE") and (ii) expenses related to the issuance of insurance policies, such as agent commissions, premium taxes, and other underwriting expenses, including employee compensation and benefits.
Under GAAP, the underwriting performance of insurance companies is measured by three different ratios of losses and expenses to net premiums earned:
Loss and loss expense ratio, which is determined by dividing incurred loss and LAE by NPE;
Underwriting expense ratio, which is determined by dividing all expenses related to the issuance of insurance policies by NPE; and
Combined ratio, which is the sum of the loss and loss expense ratio and the underwriting expense ratio.
A combined ratio under 100% indicates that an insurance company is generating an underwriting profit and a combined ratio over 100% indicates that an insurance company is generating an underwriting loss.
As part of the regulation of Selective's Insurance Subsidiaries in the various states, Selective is required to file financial statements with the various states prepared in accordance with Statutory Accounting Practices ("SAP") promulgated by the National Association of Insurance Commissions ("NAIC") and adopted by the various states. SAP differs from GAAP accounting in many ways, but the most notable income related differences are as follows:
Under SAP, underwriting expenses are recognized when incurred; whereas they are deferred and amortized over the life of the policy in correlation with the related premium revenue under GAAP.
Under SAP, the underwriting expense ratio is calculated using NPW as the denominator; whereas NPE is used under GAAP.
We make extensive use of SAP information in the management of the Insurance Operations. Many of our rating agencies also use SAP information to evaluate our performance.
All Lines
GAAP Insurance Operations Results:
NPW
NPE
Less:
Losses and loss expenses incurred
Net underwriting expenses incurred
109,597
101,738
216,006
198,913
Underwriting income
47
GAAP Ratios:
Loss and loss expense ratio
64.4
64.2
0.2
64.1
65.4
(1.3)
Underwriting expense ratio
31.3
31.2
31.0
Dividends to policyholders ratio
Combined ratio
Statutory Ratios:
63.9
(0.2)
64.0
65.3
30.7
30.6
29.9
29.7
NPW increased due to:
Net new business written of $79.4 million for the Second Quarter 2005 compared to $68.1 million in Second Quarter 2004 and $148.3 million in the Six Months 2005 compared to $144.3 million for Six Months 2004;
Commercial Lines retention which remained constant in Second Quarter 2005 and Six Months 2005 compared to Second Quarter 2004 and Six Months 2004;
Commercial Lines renewal premium price increases that averaged 3% in Second Quarter 2005 and 5% in the Six Months 2005 compared to 9% in Second Quarter 2004 and 10% in the Six Months 2004; and
Partially offsetting the items above, increased competition in the New Jersey personal automobile market resulted in: (i) a 12% reduction in the number of cars we insure since June 30, 2004; and (ii) an average decrease of 3%, including exposure, in New Jersey personal automobile premium per policy for the twelve month period ending June 30, 2005 compared to the twelve month period ending June 30, 2004.
The increase in the Second Quarter 2005 GAAP loss and loss expense ratio when compared to Second Quarter 2004 was primarily attributable to an adverse judicial ruling impacting New Jersey personal automobile results that eliminated the application of the serious life impact standard to personal automobile cases under the verbal tort threshold of the New Jersey Automobile Insurance Cost Reduction Act ("AICRA"). This was partially offset by: (i) loss ratio improvements generated by increased premium rates and underwriting improvements mainly in our Commercial Lines business; and (ii) a decrease in weather-related catastrophe losses, which accounted for $0.8 million in incurred losses and added 0.2 points to the GAAP loss and loss expense ratio for the Second Quarter 2005, compared to $2.6 million and 0.8 points for Second Quarter 2004.
The improvement in the Six Month 2005 GAAP loss and loss expense ratio when compared to Six Months 2004 was due to: (i) increased premium rates and underwriting improvements mainly in our Commercial Lines business, and (ii) a decrease in weather-related catastrophe losses, which accounted for $1.2 million in incurred losses and added 0.2 points to the GAAP loss and loss expense ratio for the Six Months 2005, compared with $7.3 million and 1.1 points for Six Months 2004. These improvements were partially offset by the Personal Automobile reserve increase in Second Quarter 2005, which resulted in an increase in the overall GAAP loss and loss expense ratio for Six Months 2005 of 1.1 points.
17
Commercial Lines Results
Commercial Lines
317,489
290,831
665,657
610,829
182,283
171,138
363,220
337,519
94,673
86,749
188,078
169,188
79
60
61.1
63.4
(2.3)
61.8
63.7
(1.9)
31.7
32.1
(0.4)
32.0
31.9
0.4
93.2
95.9
(2.7)
(1.8)
60.6
63.3
61.9
63.6
(1.7)
31.4
31.8
30.3
30.4
92.4
95.5
(3.1)
92.6
94.4
The increases in NPW and NPE were the result of:
Commercial Automobile
81,453
81,129
171,915
166,810
83.7
87.5
(3.8)
84.4
86.2
27
These results reflect the cumulative effect of price increases over the last five years, underwriting improvements, and positive prior year loss and loss expense development.
18
General Liability
97,800
84,966
201,960
175,063
97.7
94.0
1.5
31
29
The marginal fluctuation in the statutory combined ratios is due to the leveling off of our incurred loss and loss expense experience in this line of business, resulting in more stable prior year losses. Overall our solid performance in the line reflects the past five years of ongoing underwriting, pricing and loss control initiatives.
Workers' Compensation
78,272
68,941
169,317
153,864
115.7
110.0
112.2
105.5
6.7
24
25
Overall this line is not performing at a profitable level, primarily due to adverse prior year loss and loss expense development being driven by increasing medical costs. To expand on the corrective actions that have been taken in the past and that are already underway, we have begun work on a comprehensive workers' compensation strategy that combines basic underwriting execution and our Knowledge Management strategy discussed in the "Insurance Operations" section above. Our efforts include: (i) a profitability plan for each of our primary operating states; (ii) defined underwriting appetites and enhanced guidelines within selected classes of those we insure; (iii) on-line tools that enhance risk selection and ease of use; (iv) multi-disciplinary teams to review loss drivers, including: claims performance, loss control risk improvement, automation of premium audit, and loss leakage; and (v) new information tools, such as predictive modeling, to price risks in a more granular fashion. For Six Months 2005 compared to Six Months 2004, workers' compensation policy count was flat, whereas the overall commercial lines policy count increased approximately 6%. Workers' compensation renewal price increases were up 9% for Six Months 2005, including a 9% pure rate increase in New Jersey, which represents 25% of workers' compensation statutory net premiums written.
Commercial Property
43,481
39,067
89,246
80,707
62.4
78.9
(16.5)
69.7
86.5
(16.8)
The improvement in the statutory combined ratio is primarily attributable to higher prices and underwriting improvements that have been made over the past five-year period, which include 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. Additionally, improvements in this line of business were partially attributable to decreased weather-related catastrophe losses during Second Quarter 2005 of $0.3 million, or 0.8 points, and $0.3 million, or 0.4 points, for Six Months 2005 compared to $1.8 million, or 4.7 points, during Second Quarter 2004 and $4.5 million, or 6.0 points, during Six Months 2004.
Business Owners' Policy
11,518
12,845
(10)
23,563
26,320
90.7
103.9
(13.2)
98.2
106.5
(8.3)
The decrease in premiums in this line is due to the elimination of certain classes of business from our underwriting eligibility guidelines. The increased profitability in this line of business is the result of pricing and underwriting actions that were taken over the past year, including the elimination of certain classes of business that have been consistently unprofitable and focusing growth on more profitable segments.
Bonds
4,591
3,566
8,807
7,276
73.1
103.7
(30.6)
75.0
133.8
(58.8)
Improvements in our bond line of business during 2005 reflect enhancements to the bond underwriting process during 2004. Six Months 2004 included a charge of approximately $2.0 million, or 32.0 points, which related to salvage and subrogation recoverables for prior accident years.
Personal Lines Results
52,132
58,419
(11)
100,742
113,683
(7)
(5)
43,511
38,012
81,011
81,948
14,924
14,989
27,928
29,725
(6)
(316)
(1524)
83.3
68.0
15.3
76.5
73.5
3.0
28.6
26.9
26.4
26.7
(0.3)
111.9
17.0
102.9
100.2
2.7
82.1
67.8
14.3
75.7
73.3
2.4
24.4
2.5
25.8
1.1
109.0
92.2
16.8
102.6
99.1
3.5
Personal Lines NPW decreased primarily due to:
The following contributed to the changes in the Personal Lines GAAP underwriting expense ratios: (i) increased losses under the New Jersey Homeowners Quota Share program that reduced the amount of our profit percentage thereby increasing our underwriting expense ratio by 0.7 points in Second Quarter 2005 compared to Second Quarter 2004 and 0.3 points in Six Months 2005 compared to Six Months 2004; and (ii) increased 2005 supplemental commissions to agents and profit-based incentive compensation to employees, which added 0.8 points in Second Quarter 2005 compared to Second Quarter 2004 and 0.7 points in Six Months 2005 compared to Six Months 2004. Improvements of 1.4 points in the Six Months 2005 underwriting expense ratio compared to Six Months 2004, were primarily due to a reduction of 0.9 points related to our New Jersey and New York limited assignment and distributions ("LAD") charges.
Personal Automobile
39,968
47,368
79,150
94,009
118.1
21.4
108.5
97.8
10.7
81
The Second Quarter 2005 and Six Months 2005 results for this line of business were significantly impacted by our reserving actions taken in light of a recent New Jersey Supreme Court decisions. The New Jersey Supreme Court decisions eliminated the application of the serious life impact standard to personal automobile cases under the verbal tort threshold of New Jersey's AICRA. As a result of this ruling, we analyzed our claim files and loss experience pre and post the New Jersey AICRA, which resulted in an increase to our New Jersey personal automobile reserves of $13.0 million or 31.3 points for Second Quarter 2005 and 15.4 points for Six Months 2005. The implementation of AICRA, combined with our rating and tiering actions, had enabled us to achieve profitability in the New Jersey personal automobile line of business over the last two years. However, factoring higher expected claim costs into our New Jersey personal automobile excess profits calculation resulted in the elimination of an excess profits reserve of $5.5 million or 13.3 points for Second Quarter 2005 and 6.5 points for Six Months.
The decreases in statutory NPW were primarily due to competition in the New Jersey automobile market, which represents 70% of our total personal automobile net premiums written. The increase in competition reflects many new market entrants in New Jersey, including well capitalized national carriers, and fewer regulatory constraints, which has resulted in: (i) a 12% reduction in the number of cars we insure since June 30, 2004; and (ii) an average decrease of 3%, including exposure, in New Jersey personal automobile premium per policy for the twelve month period ended June 30, 2005 compared to the twelve month period ended June 30, 2004. While the number of cars we insure has decreased on an overall basis, our underwriting actions have led to an improved new business personal automobile policy count of 23% in Second Quarter 2005 compared to Second Quarter 2004 and 6% in Six Months 2005 compared to Six Months 2004.
Given the New Jersey market conditions, we continue to review our position and will take additional actions as necessary. At present, we continue to implement a series of rating and underwriting initiatives targeting the best accounts, while also considering the potential withdrawal of certain previously filed New Jersey personal automobile rate decreases. New Jersey personal automobile now represents only 7% of company-wide premium, down from 22% a decade ago. For the balance of 2005, we now expect our New Jersey personal automobile business to generate a statutory combined ratio of 101.0%.
Homeowners
10,567
9,529
18,463
16,771
94.8
91.9
2.9
97.0
111.6
(14.6)
Our overall performance reflects lower catastrophe losses and premium growth. Weather-related catastrophe losses were only $0.1 million, or 1.4 points, during Second Quarter 2005 and $0.3 million or 1.7 points, for Six Months 2005 compared to $0.6 million or 6.7 points, during Second Quarter 2004 and $1.2 million or 6.9 points, during Six Months 2004. The 2.9 point increase in the homeowners' statutory combined ratio in Second Quarter 2005 compared to Second Quarter 2004, is the result of large fire losses during Second Quarter 2005.
Reinsurance
Reinsurance renewal negotiations for our July 1, 2005 excess of loss treaties have been successfully completed. Highlights include:
Property Excess of Loss
Increased treaty capacity $5 million to $25 million, including our $2 million retention.
Treaty rate reduced 15%, despite increase in capacity.
Estimated premium of $9.1 million, compared to expired of $9.6 million; reflects lower rate offset by higher subject premium.
Estimated $0.6 million will be realized in annual facultative cost savings due to the rate reduction of the treaty renewal coupled with increased treaty capacity; total estimated cost reduction of $1.1 million.
Savings reflect our favorable loss experience driven by the property underwriting initiatives implemented over the last four years.
Terrorism losses covered up to $54 million in the aggregate; excludes nuclear, biological, radiological or chemical events (covered under Terrorism treaty for $45.0 million excess of a $15.0 million retention).
Casualty Excess of Loss
Restructured casualty treaty into two separate contracts to more efficiently transfer workers' compensation ("WC") risk, while retaining more of the predictable casualty lines.
First treaty covers WC losses only; acts like a drop down cover for WC losses, up to $3 million in excess of a $2 million retention per occurrence; provides up to $18 million in aggregate annual limits; WC losses have more reinsurance than under previous contract, which covered 50% for losses of $3 million in excess of a $2 million retention.
Second treaty covers all casualty business, including WC, up to $45 million in excess of $5 million per occurrence; all casualty lines except WC now have a retention of $5 million; under the expired program, reinsurance covered 50% for all losses of $3 million in excess of a $2 million retention.
First layer ($3 million excess of $2 million) premium reduced $1.2 million or 22%, due to elimination of non-WC coverage.
Upper layers ($45 million excess of $5 million) rates reduced 7%; offset by increase in subject premium, producing a modest premium increase of $0.1 million.
Overall estimated premium of $13.5 million compared to expired $14.6 million.
Estimated additional retained non-WC losses of $2.5 million offset by $1.1 million in premium reduction, yield total cost increase under new structure of $1.4 million; substantially lower than cost to renew old structure.
Obtained higher annual aggregate terrorism limits of $115 million for both casualty treaties, compared to $93 million for expired contract; excludes nuclear, biological, radiological and chemical losses (covered under Terrorism treaty for $45.0 million excess of a $15.0 million retention).
22
Investments
Our Investments segment preserves capital and generates earnings through the investment of capital from the Insurance Operations and Diversified Insurance Services segments. Our investment portfolio consists primarily of fixed maturity investments, but we also hold short-term investments, equity securities, and other investments. Our investment philosophy is to maximize after-tax returns over extended periods of time while providing liquidity and preserving assets and stockholders' equity.
25,230
21,555
49,893
43,378
23.0
24.8
23.4
25.4
(2.0)
3.4
Growth in net investment income, before tax, of $4.1 million in Second Quarter 2005 compared to Second Quarter 2004 was primarily due to: (i) increased invested assets and (ii) increased income of approximately $1 million from investments in various limited partnerships. The investment portfolio reached $3.0 billion in value at June 30, 2005, an increase of 16%, compared to $2.6 billion at June 30, 2004. The increase in invested assets was due to substantial cash flows from operations of $367.1 million in 2004 and $117.8 million in Six Months 2005. Our debt offering in November 2004 added approximately $50 million in assets. However, growth in net investment income in 2005 was dampened by lower available reinvestment rates on fixed maturities that matured over the past year. Although short-term interest rates have risen, investment yields on new money are still lower than the overall portfolio yield, which continues to put pressure on investment returns.
We continue to maintain a conservative, diversified investment portfolio, with fixed maturity investments representing 85% of invested assets. Sixty-seven percent of our fixed maturities portfolio is rated "AAA" while the portfolio has an average rating of "AA," Standard & Poor's second highest credit quality rating. High credit quality continues to be a cornerstone of our investment strategy, as evidenced by the fact that almost 100% of the fixed maturities are investment grade.
The following table presents the Moody's and Standard & Poor's ratings of our fixed maturities portfolio:
Rating
Aaa/AAA
67%
64%
Aa/AA
18%
21%
A/A
11%
Baa/BBB
4%
Total
100%
Our fixed maturity investment strategy is to make security purchases that are attractively priced in relation to perceived credit risks. We manage the interest rate risk associated with holding fixed maturity investments by monitoring and maintaining the average duration of the portfolio with a view toward achieving an adequate after-tax return without subjecting the portfolio to an unreasonable level of interest rate risk. We invest our fixed maturities portfolio primarily in intermediate-term securities to limit overall interest rate risk of fixed maturity investments. The average duration of the fixed maturity portfolio, excluding short-term investments at June 30, 2005 was 4.4 years compared with 4.3 years at June 30, 2004. To provide liquidity while maintaining consistent performance, fixed maturity investments are "laddered" so that some issues are always approaching maturity, thereby providing a source of predictable cash flow. Managing investment risk by adhering to these strategies is intended to protect the interests of our stockholders as well as those of our policyholders and, at the same time, enhance our financial strength and underwriting capacity.
At June 30, 2005, our investment portfolio included two non-investment grade securities with an amortized cost and fair value of $7 million, or 0.3% of the portfolio. At December 31, 2004, non-investment grade securities in our investment portfolio represented 0.2% of the portfolio, with an amortized cost of $5.0 million, and a fair value of $5.1 million. The fair value of these securities was determined by independent pricing services or bid prices provided by various broker dealers. We did not have a material investment in non-traded securities at June 30, 2005 or December 31, 2004.
23
We regularly review our entire investment portfolio for declines in value. If we believe that a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in accumulated other comprehensive income. If we believe the decline is "other than temporary," we write down the carrying value of the investment and record a realized loss in our Consolidated Statements of Income. Management's assessment of a decline in value includes current judgment as to the financial position and future prospects of the entity that issued the investment security. Broad changes in the overall market or interest rate environment generally will not lead to a write-down. During Second Quarter 2005, we wrote-off one investment that we concluded was impaired for other than temporary declines in fair value of $1.2 million. The FASB recently adopted recommendations by its staff to nullify strict interpretations regarding the effects of fluctuations in interest rates on the market value of securities when determining whether an investment is other-than-temporarily impaired. We believe this solidified our approach in evaluating our portfolio for other-than-temporary impairment. Our evaluation for other than temporary impairment of fixed maturity securities, includes, but is not limited to, the evaluation of the following factors:
Whether the decline appears to be issuer or industry specific;
The degree to which an issuer is current or in arrears in making principal and interest payments on the fixed maturity securities in question;
The issuer's current financial condition and its ability to make future scheduled principal and interest payments on a timely basis;
Buy/hold/sell recommendations published by outside investment advisors and analysts; and
Relevant rating history, analysis and guidance provided by rating agencies and analysts.
Our evaluation for other than temporary impairment of equity securities and other investments, includes, but is not limited to, the evaluation of the following factors:
The relationship of market prices per share to book value per share at the date of acquisition and date of evaluation;
The price-earnings ratio at the time of acquisition and date of evaluation;
The financial condition and near-term prospects of the issuer, including any specific events that may influence the issuer's operations;
The recent income or loss of the issuer;
The independent auditors' report on the issuer's recent financial statements;
The dividend policy of the issuer at the date of acquisition and the date of evaluation;
Any buy/hold/sell recommendations or price projections published by outside investment advisors; and
Any rating agency announcements.
Realized Gains and LossesRealized gains and losses are determined on the basis of the cost of specific investments sold or written-down, and are credited or charged to income. Our Investments segment included net realized gains before tax of $0.6 million in Second Quarter 2005 compared to $0.2 million of net realized gains in Second Quarter 2004, and $5.2 million in net realized gains in Six Months 2005 compared to $5.5 million in realized gains in Six Months 2004. Net realized gains include impairment charges from one write-down for other than temporary declines in fair value of $1.2 million for Second Quarter 2005. There were no write-downs in Second Quarter 2004. We maintain a high quality and liquid investment portfolio and the sale of the securities that resulted in net realized gains did not change the overall liquidity of the investment portfolio. Our philosophy for sales of securities generally is to reduce our exposure to securities and sectors when economic evaluations or the fundamentals for that security or sector have deteriorated and/or for tax planning purposes. We generally have a long investment time horizon and our turnover is low, which has resulted in many securities accumulating large unrealized gains. Every purchase or sale is made with the intent of improving future investment returns.
The following table summarizes our net realized gains by investment type:
June 30, 2005
Held-to-maturity fixed maturities
Gains
41
50
46
Losses
Available-for-sale fixed maturities
2,285
376
3,255
(1,166)
(4,450)
(1,943)
(4,470)
Available-for-sale equity securities
3,365
2,737
8,661
7,366
(1,866)
(468)
(1,983)
(701)
Total net realized gains
Generally, the Insurance Subsidiaries have a duration mismatch between assets and liabilities. The duration of the fixed maturity portfolio is 4.4 years while the Insurance Subsidiaries liabilities have a duration of approximately 2.6 years. The current duration of our fixed maturities is within our historical range, and is monitored and managed to maximize yield yet limit interest rate risk. The duration mismatch is managed by utilizing a laddered maturity structure so that liquidation of available-for-sale fixed maturities should not be necessary in the ordinary course of business. Liquidity is always a consideration when buying or selling securities, but because of the high quality and active market for our investment portfolio, the securities sold have not diminished the overall liquidity of our portfolio.
We realized gains and losses from the sale of available-for-sale debt and equity securities during Second Quarter and Six Months 2005 and Second Quarter and Six Months 2004. The following tables present the period of time that securities sold at a loss were continuously in an unrealized loss position prior to sale:
Period of time in an
unrealized loss position
($ in millions)
Fair
Value on
Realized
Sale Date
Loss
Fixed maturities:
0 - 6 months
7.1
99.7
4.4
7 - 12 months
Greater than 12 months
12.4
Total fixed maturities
34.4
0.7
Equity Securities:
5.1
0.5
Total equity securities
36.5
1.4
104.8
4.9
29.8
4.5
18.2
62.9
0.8
6.9
65.6
2.2
106.6
5.2
These securities were sold despite the fact that they were in a loss position. The decision to sell these securities was due to: (i) heightened credit risk during the period of the individual security sold; (ii) the decision to reduce our exposure to certain issuers, industries or sectors in light of changing economic conditions; or (iii) tax efficiency purposes.
Unrealized LossesThe following table summarizes, for all available-for-sale securities in an unrealized loss position at June 30, 2005 and December 31, 2004, the aggregate fair value and gross pre-tax unrealized loss recorded in our accumulated other comprehensive income, by asset class and by length of time those securities have continuously been in an unrealized loss position:
Period of time in an unrealized loss
Position
December 31, 2004
Unrealized
Value
231.9
1.3
349.7
96.4
60.0
58.3
0.9
5.8
386.6
3.7
415.5
3.3
Equities:
15.4
1.6
3.1
2.0
402.0
5.3
420.6
3.6
The following table presents information regarding our available-for-sale fixed maturities that were in an unrealized loss position at June 30, 2005 by contractual maturity:
Contractual Maturities
Amortized
Cost
One year or less
31.1
Due after one year through five years
259.9
257.4
Due after five years through ten years
95.4
Due after ten years through fifteen years
Due after fifteen years
389.3
Diversified Insurance Services Segment
Our Diversified Insurance Services segment provides fee-based revenues that help mitigate potential volatility in the results of operations of our Insurance Operations segment. These revenues contribute to earnings and increase operating cash flow. Our Diversified Insurance Services segment provides: (i) human resource administration outsourcing ("HR Outsourcing") products and services; (ii) the servicing of federal flood insurance, which is also sold to commercial customers and homeowners by the Insurance Subsidiaries; and (iii) managed care products and services.
% Change
1,040
585
78
1,523
712
114
2,161
1,737
3,480
3,108
1,777
915
2,765
1,428
438
190
131
784
111
58
52
3,572
2,252
59
5,636
3,718
12.0
8.5
9.8
7.3
HR Outsourcing
Profitability improvements in this business are mainly due to price increases and operating expense reductions that have been implemented over the past few years.
Our average administration fee per worksite employee increased to $639 for Six Months 2005 compared to $576 for Six Months 2004.
As of June 30, 2005, our worksite lives were up 7% to 23,885 compared to 22,245 as of June 30, 2004. Although this product offers an additional potential agency revenue stream for our independent agents, this product is outside of the traditional insurance arena and as a result has been met with some reluctance by our agency distribution force. This reluctance, coupled with the softening of the insurance market, has led to slower than anticipated growth through our agency distribution sales channel and, consequently, in our overall worksite lives.
Flood Insurance
The number of in force policies increased to approximately 196,000 at June 30, 2005 compared to approximately 176,000 policies at June 30, 2004.
Flood premium in force was $85.1 million at June 30, 2005, compared to $72.0 million at June 30, 2004.
Revenue increases were mainly attributable to: (i) increased claims handling fees and (ii) expanded marketing efforts and the competitive advantage provided by our on-line flood system has driven this premium growth. This growth was partially tempered by a decrease in the fee paid to us by the National Flood Insurance Program of 0.6 points to 31.2% from 31.8%, which was effective for the fiscal year beginning on October 1, 2004.
Pre-tax profit increased as a direct result of the revenue increases for both Second Quarter and Six Months 2005 compared to Second Quarter and Six Months 2004. Further increases in pre-tax profit are expected over time as we experience certain economies of scale.
Profitability increased mainly due to better expense management and a 10% reduction in the managed care workforce during 2004.
CHN Solutions remains the #1 preferred provider organization in New Jersey based on network membership as determined by Business News New Jersey.
During Six Months 2005, our medical provider network expanded to approximately 99,000 locations from 95,000 locations at December 31, 2004.
Capital resources and liquidity represent our overall financial strength and our ability to generate cash flows from business operations, borrow funds at competitive rates and raise new capital to meet operating and growth needs.
Liquidity
Liquidity is a measure of our ability to generate sufficient cash flows to meet the short and long term cash requirements of our business operations. Our consolidated sources of cash consist of premium collections by our Insurance Subsidiaries, fee income from our Diversified Insurance Services subsidiaries, and income from our investment portfolio. We also generate cash from the sale of our common stock under our stock plans.
Our Insurance Subsidiaries provide liquidity in that premiums are generally received months or even years before losses are paid under the policies purchased by such premiums. These timing differences enable us to invest with a longer time horizon than our liability duration. This, in turn, enables us to generate greater returns for our stockholders. We also generate cash from Diversified Insurance Services subsidiaries fee income and the sale of our common stock under our stock plans. Historically, cash receipts from operations, consisting of insurance premiums, fee income and investment income, have provided more than sufficient funds to pay losses, operating expenses and dividends to the holding company. After satisfying our cash requirements, excess cash flows are used to build the investment portfolio and thereby increase future investment income. As of June 30, 2005, we had $3.0 billion in investments compared to $2.8 billion at December 31, 2004. We also have available formal revolving lines of credit totaling $45.0 million, under which no balances were outstanding as of either June 30, 2005 or December 31, 2004.
Our cash and short-term investments ("cash equivalent(s)") position at June 30, 2005 was $75.3 million compared to $98.7 million at December 31, 2004. This level of cash equivalents is in line with our investment approach given the rising short-term interest rate environment coupled with a relatively flat yield curve. The decrease in our cash equivalent position was primarily attributable to cash equivalents used in investing and financing activities of $141.2 million offset by strong cash flows provided by operating activities of $117.8 million in Six Months 2005. Included in the $141.2 million of cash flows used in investing and financing activities was $122.6 million that we reinvested in our investment portfolio, $9.6 million, which we paid in cash dividends to stockholders and $7.8 million, which we used to buy back the Company's stock. Notable cash outflows included within cash flows provided by operating activities were: (i) $52.1 million in payments under the annual cash incentive and agent profit-based commission programs, (ii) $8.0 million in payments made to further fund our retirement income plan and (iii) $36.0 million in federal tax payments.
Dividends on shares of our common stock are declared and paid at the discretion of our Board of Directors based on our operating results, financial condition, capital requirements, contractual restrictions and other relevant factors. Our ability to declare dividends is restricted by covenants contained in our notes payable that we issued on May 4, 2000 (the 2000 Senior Notes) and August 12, 1994 (1994 Senior Notes). For further information regarding our notes payable, see Note 8 of the Notes to Consolidated Financial Statements, entitled, "Indebtedness", included in Item 8. "Financial Statements and Supplementary Data" of our Annual Report in Form 10-K for the year ended December 31, 2004. All such covenants were met during 2004 and 2003. At June 30, 2005, the amount available for additional dividends to holders of our common stock under such restrictions was $331.6 million for the 1994 Senior Notes and $293.8 million for the 2000 Senior Notes. Our ability to continue to pay dividends to our stockholders is also dependent in large part on the dividend paying ability of our Insurance and Diversified Insurance Services subsidiaries. Restrictions on the ability of those subsidiaries, particularly the Insurance Subsidiaries, to declare and pay dividends to us could materially affect our ability to pay principal and interest on indebtedness and dividends on common stock.
Generally, payments from our Insurance Subsidiaries to the holding company are subject to the approval and/or review of the insurance regulators in the respective domiciliary states of the Insurance Subsidiaries under insurance holding company acts, which generally require any transaction between related companies be fair and equitable to the insurance company and its policyholders. All of the states in which our Insurance Subsidiaries are domiciled regulate the payment of dividends. Some states, including New Jersey, North Carolina and South Carolina, require advance notice to the state insurance commissioner prior to the Insurance Subsidiaries declaring any dividends and distributions payable to us. During the notice period, the state insurance commissioner may disallow all or part of the proposed ordinary dividend upon determination that (i) the insurer's surplus is not reasonable in relation to its liabilities and adequate to its financial needs and those of the policyholders, or (ii) in the case of New Jersey, the insurer is otherwise in a hazardous financial condition. In addition, our Insurance Subsidiaries are not permitted to pay extraordinary dividends without the prior approval of the insurance commissions of their domiciliary state. Insurance regulators may block dividends or other payments to affiliates that would otherwise be permitted without prior approval upon determination that, because of the financial condition of the Insurance Subsidiary or otherwise, payment of a dividend or any other payment to an affiliate would be detrimental to an Insurance Subsidiary's policyholders or creditors. We do not believe that any of these restrictions should limit the ability of the Insurance Subsidiaries to pay dividends to us now or in the foreseeable future. Dividends are generally payable only from earned surplus as reported in the statutory annual statements of our Insurance Subsidiaries as of the preceding December 31. Based on the 2004 unaudited statutory financial statements, the insurance subsidiaries should be permitted to pay to us in 2005 ordinary dividends in the aggregate amount of approximately $103 million.
Our Diversified Insurance Services subsidiaries may also declare and pay dividends. Potential dividends are restricted only by the operating needs of the subsidiaries, with the exception of our flood insurance operation, which is restricted by the same limitations of our Insurance Subsidiaries noted above. Sources of funds for the Diversified Insurance Services subsidiaries primarily consist of fee income. Such funds are applied primarily to payment of operating expenses as well as dividends and other payments. Cash flows from operations in the Diversified Insurance Services segment of $8.6 million in Six Months 2005, and $6.5 million in Six Months 2004, resulted in dividends to us of $3.7 million in Six Months 2005 and $7.1 million in Six Months 2004.
Our liquidity requirements in the past have been met by operating cash flow from our Insurance Operations and Diversified Insurance Services segments and the issuance of debt and equity securities. We expect our liquidity requirements in the future to be met by these sources of funds or, if necessary, borrowings from our credit facilities.
Capital Resources
Capital resources provide protection for policyholders, furnish the financial strength to support the business of underwriting insurance risks and facilitate continued business growth. At June 30, 2005, we had stockholders' equity of $942.3 million and total debt of $266.2 million.
We continuously monitor the amount of capital resources that we maintain at the holding company and operating subsidiaries. In connection with our long-term capital strategy, we from time-to-time contribute capital to subsidiaries in our Insurance Operations and Diversified Insurance Services segments. In order to satisfy capital needs as a result of any rating agency capital adequacy or other rating issue, or in the event we were to need additional capital to make strategic investments, we may take a variety of actions, including the issuance of additional debt and/or equity securities.
Our cash requirements include principal and interest payments on senior convertible notes, various notes payable and convertible subordinated debentures, dividends to stockholders, and payment of claims and other insurance operating expenses, income taxes, the purchase of investments, and other expenses. We have remaining contractual obligations pursuant to various notes payable of $18.0 million in 2005, of which the entire outstanding balance has been set-aside in an irrevocable trust valued at $18.1 million as of June 30, 2005.
Our operating obligations and cash outflows include the following: claim settlements; agents' commissions; labor costs; premium taxes; general and administrative expenses; investment purchases; and capital expenditures. We have additional commitments for limited partnership investments of up to $41.5 million; but there is no certainty that any additional investment will be required. As part of ongoing asset/liability duration management, we do not generally match securities held to liabilities. The duration of the fixed maturity portfolio is 4.4 years while the Insurance Subsidiaries liabilities have a duration of approximately 2.6 years. The current duration of fixed maturities is within our historical range and is consistent with our investment philosophy. By using a laddered maturity structure, we do not need to liquidate available-for-sale fixed maturities in the ordinary course of business.
On April 26, 2005 our Board of Directors adopted a share repurchase program authorizing us to repurchase up to 5.0 million shares of our common stock. During Second Quarter 2005 approximately 70,000 shares were repurchased at an average price per share of $47.55. The repurchase program will expire on April 26, 2007.
Ratings
We are rated by major rating agencies, which provide opinions of our financial strength, operating performance, strategic position, and ability to meet policyholder obligations. The principal agencies that issue financial strength ratings for the property and casualty insurance industry are: A.M. Best, Standard & Poor's Rating Services ("S&P"), Moody's Investor Service ("Moody's") and Fitch Ratings Service ("Fitch"). We believe that our ability to write insurance business is most influenced by our rating from A.M. Best. Currently, we are rated "A+" (Superior) by A.M. Best, which is their second highest of fifteen ratings. Our insurance business has been rated "A+" by A.M. Best for 44 consecutive years. The financial strength reflected by our AM Best rating is a competitive advantage in the marketplace and influences where independent insurance agents place their bu siness. A significant downgrade from A.M. Best, could have a material adverse affect on our insurance business. We believe that ratings from S&P, Moody's and Fitch, although important, have less of an impact on its business. A rating downgrade to below "A-" in the A.M. Best or S&P rating would be considered an event of default under the terms of our line of credit agreements. Ratings are an important factor in establishing our competitive position in the insurance markets.
There can be no assurance that our ratings will continue for any given period of time or that they will not be changed. It is possible that positive or negative ratings actions by one or more of the rating agencies may occur in the future. If our ratings were downgraded, we may incur higher borrowing costs and may have more limited means to access capital. In addition, reductions in our ratings could adversely affect the competitive position of our Insurance Operations, including a possible reduction in demand for our products in certain markets. We review our financial debt agreements for any potential rating triggers that could dictate a material change in terms if our credit ratings were to suddenly and drastically change.
Federal Income TaxesTotal federal income tax expense increased $0.5 million for Second Quarter 2005 to $11.6 million and $4.2 million for Six Months 2005 to $25.4 million, compared to Second Quarter and Six Months 2004. The increase was attributable to improved underwriting results. Our effective tax rate differs from the federal corporate rate of 35% primarily as a result of tax-advantaged investment income. The effective tax rate for the Second Quarter 2005 was 27%, compared with 28% for the Second Quarter 2004 and 27% for both the Six Months 2005 and Six Months 2004.
Critical Accounting Policies and EstimatesRefer to pages 45 through 48 in our Annual Report on Form 10-K for the fiscal year end December 31, 2004 for a discussion regarding our critical accounting policies and estimates.
Reserves for Losses and Loss ExpensesSignificant periods of time can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer and the insurer's payment of that loss. To recognize liabilities for unpaid losses and loss expenses, insurers establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported net losses and loss expenses. As of June 30, 2005, we had accrued $1.9 billion of loss and loss expense reserves compared to $1.8 billion at December 31, 2004.
When a claim is reported to an Insurance Subsidiary, our claims personnel establish a "case reserve" for the estimated amount of the ultimate payment. The amount of the reserve is primarily based upon a case‑by‑case evaluation of the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the type of loss. The estimate reflects the informed judgment of claims personnel based on general insurance reserving practices, as well as the experience and knowledge of the claims person. Until the claim is resolved, these estimates are revised as deemed necessary by the responsible claims personnel based on subsequent developments and periodic reviews of the cases.
In accordance with industry practice, we maintain, in addition to case reserves, estimates of reserves for losses and loss expenses incurred but not yet reported ("IBNR"). Using generally accepted actuarial reserving techniques, we project our estimate of ultimate losses and loss expenses at each reporting date. The difference between: (i) projected ultimate loss and loss expense reserves and (ii) case loss reserves and loss expense reserves thereon are carried as the IBNR reserve. A range of possible IBNR reserves is determined annually and considered in addition to the most recent loss trends and other factors in establishing IBNR for each reporting period. Loss trends include, but are not limited to, large loss activity, environmental claim activity, large case reserve additions or reductions for prior accident years, and reinsurance recoverable issues. We also consider factors such as: (i) per claim information; (ii) industry and our historical loss experience; (iii) legislative enactments, judicial decisions, legal developments in the imposition of damages, and changes in political attitudes; and (iv) trends in general economic conditions, including the effects of inflation. Based on the consideration of the range of possible IBNR reserves, recent loss trends and other factors, IBNR is established and the ultimate net liability for losses and loss expenses is determined. Such an assessment requires considerable judgment given that it is frequently not possible to determine whether a change in the data is an anomaly until some time after the event. Even if a change is determined to be permanent, it is not always possible to reliably determine the extent of the change until some time later. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves because the eventual deficiency or redundancy is affected by many factors. Our internal actuaries review reserves on a quarterly basis. In addition, we use independent actuaries to periodically review reserves and to provide an annual opinion on the adequacy of reserves for our statutory filings. The changes in these estimates, resulting from the continuous review process and the differences between estimates and ultimate payments, are reflected in the consolidated statements of income for the period in which such estimates are changed. Any changes in the liability estimate may be material to the results of operations in future periods.
The following tables provide case and IBNR reserves for losses, reserves for loss expenses, and reinsurance recoverable on unpaid losses and loss expenses as of June 30, 2005 and December 31, 2004:
As of June 30, 2005
recoverable
Loss Reserves
on unpaid
Case
IBNR
Loss Expense
losses and
Reserves
loss expenses
Net reserves
Commercial automobile
91,992
194,044
286,036
30,629
6,189
310,476
Workers' compensation
321,384
261,659
583,043
66,230
71,896
577,377
General liability
132,706
335,394
468,100
98,352
29,108
537,344
Commercial property
16,849
2,338
19,187
1,057
2,703
17,541
Business owners' policy
20,037
23,037
43,074
6,197
5,512
43,759
1,846
3,203
5,049
350
6,416
610
2,650
3,260
2,912
Total commercial lines
585,424
822,325
1,407,749
204,184
116,108
1,495,825
Personal automobile
129,674
106,061
235,735
39,862
68,166
207,431
12,919
7,775
20,694
2,527
2,618
20,603
9,476
10,265
19,741
2,224
14,828
7,137
Total personal lines
152,069
124,101
276,170
44,613
85,612
235,171
737,493
946,426
1,730,996
As of December 31, 2004
reserves
93,076
180,766
273,842
28,541
6,098
296,285
Workers compensation
298,803
245,897
544,700
53,913
68,692
529,921
133,706
299,666
433,372
88,946
29,403
492,915
18,616
1,890
20,506
1,200
1,048
20,658
18,549
22,810
41,359
5,994
5,160
42,193
1,267
3,438
4,705
1,664
696
5,673
640
2,649
3,289
224
3,070
564,657
757,116
1,321,773
180,263
111,321
1,390,715
131,387
96,399
227,786
39,870
67,410
200,246
11,507
8,496
20,003
2,418
2,427
19,994
31,206
9,020
40,226
2,878
37,614
5,490
174,100
113,915
288,015
45,166
107,451
225,730
738,757
871,031
1,616,445
In light of the many uncertainties associated with establishing the estimates and making the assumptions necessary to establish reserve levels, we review our reserve estimates on a regular basis as described above and make adjustments in the period that the need for such adjustment is determined. These reviews, from time-to-time, result in our identifying information and trends that cause us to increase some reserves and decrease other reserves for prior periods and could lead to the identification of a need for additional increases in loss and loss expense reserves, which could materially adversely affect our results of operations, equity, business, insurer financial strength and debt ratings. As of June 30, 2005, we had accrued $1,731.0 million of net loss and loss expense reserves compared to $1,616.4 million as of December 31, 2004 due to normal business growth. We experienced total adverse development in our loss and loss expense reserves of $5.6 million in Six Months 2005, which included net prior year development of $6.0 million related to an adverse judicial ruling by the New Jersey Supreme Court and the New Jersey excess profits reserve discussed in the "Personal Automobile" section above. The remaining $0.4 million prior year development resulted from increases to our loss reserves for general liability and workers' compensation lines of business offset by reductions in commercial automobile. In Six Months 2004, we experienced adverse development of $3.0 million, which was primarily the result of reductions in expected bond subrogation recoveries in our bond line of business.
As of December 31, 2004, we established a range of reasonably possible reserves for net claims of approximately $1,529 million to $1,695 million. A low and high reasonable reserve selection was derived primarily by considering the range of indications calculated using generally accepted actuarial techniques. Such techniques assume that past experience, adjusted for the effects of current developments and anticipated trends, are an appropriate basis for predicting future events. Although this range reflects the most likely scenarios, it is possible that the final outcomes may fall above or below these amounts. This range does not include a provision for potential increases or decreases associated with environmental reserves, as we believe that it is not meaningful to calculate a range given the uncertainties associated with environmental claims. Included in our net carried loss and loss expense reserves were net reserves for environmental claims of $38.5 million at June 30, 2005 and December 31, 2004. We do not discount to present value that portion of our loss reserves expected to be paid in future periods; however, the loss reserves include anticipated recoveries for salvage and subrogation claims.
Environmental claims, both asbestos and non‑asbestos, are included in the loss and loss expense reserves on the consolidated balance sheets. These claims have arisen primarily under older policies containing exclusions for environmental liability which certain courts, in interpreting such exclusions, have determined do not bar such claims. The emergence of these claims is slow and highly unpredictable. Since 1986, policies issued by our Insurance Subsidiaries have contained a more expansive exclusion for losses related to environmental claims. In addition, a portion of our environmental losses relate to homeowners claims covering the leakage of certain underground storage tanks. Our asbestos and non‑asbestos environmental claims have arisen primarily from insured exposures in municipal government, small commercial risks, and homeowners policies. During 2004, we also experienced adverse development in our homeowners line of business as a result of unfavorable trends in claims for groundwater contamination caused by leakage of certain underground heating oil storage tanks in New Jersey. Increased frequency was triggered, in part, by the state's robust real estate market, leading to an increase in home tank inspections. To address this issue, we began restricting writings of policies with coverage for underground heating oil storage tanks approximately two years ago, and we are reviewing possible coverage changes for existing business.
IBNR reserve estimation for environmental claims is often difficult because, in addition to other factors, there are significant uncertainties associated with critical assumptions in the estimation process such as average clean-up costs, third-party costs, potentially responsible party shares, allocation of damages, insurer litigation costs, insurer coverage defenses and potential changes to state and federal statutes. However, we are not aware of any emerging trends that would result in future reserve adjustments. Moreover, normal historically-based actuarial approaches are difficult to apply because relevant history is not available. In addition, while models can be applied, such models can produce significantly different results with small changes in assumptions. As a result, management does not calculate a specific environmental loss range, as it believes it would not be meaningful.
Premium RevenueNet premiums written equal direct premiums written, plus assumed premiums less ceded premiums. All three components of net premiums written are recognized in revenue over the period that coverage is provided. We had net premiums written of $369.6 million for Second Quarter 2005 and $766.4 million for Six Months 2005 compared with $349.3 million for Second Quarter 2004 and $724.5 million for Six Months 2004. The vast majority of our net premiums written have a coverage period of twelve months. This means we record 1/12 of the net premiums written as earned premium each month, until the full amount is recognized. When premium rates increase, the effect of those increases would not immediately affect earned premium. Rather, those increases will be recognized ratably over the period of coverage. We earned net premiums of $350.5 million for Second Quarter 2005 and $693.2 million for Six Months 2005 compared with $326.0 million for Second Quarter 2004 and $641.3 million for Six Months 2004. Unearned premiums and prepaid reinsurance premiums, which are recorded on the consolidated balance sheets, represent that portion of premiums written that are applicable to the unexpired terms of policies in force. As of June 30, 2005 we had unearned premiums of $778.4 million and prepaid reinsurance premiums of $61.3 million compared with unearned premiums of $702.1 million and prepaid reinsurance premiums of $58.3 million as of December 31, 2004.
Deferred Policy Acquisition CostsPolicy acquisition costs, which include commissions, premium taxes, fees, and certain other costs of underwriting policies, are deferred and amortized over the same period in which the related premiums are earned. Deferred policy acquisition costs are limited to the estimated amounts recoverable after providing for losses and loss expenses that are expected to be incurred, based upon historical and current experience. Anticipated investment income is considered in determining whether a premium deficiency exists. We continually review the methods of making such estimates and establishing the deferred costs, and any adjustments there from are made in the accounting period in which the adjustment arose. As of June 30, 2005, we had deferred policy acquisition costs of $202.6 million compared with $186.9 million as of December 31, 2004.
Adoption of Accounting PronouncementIn December 2004, the FASB issued FAS 123R, which requires that compensation expense be measured on the income statement for all share-based payments (including employee stock options) at grant date fair value of the equity instruments. Implementation is required for fiscal years beginning after June 15, 2005, and early adoption is permitted. We adopted FAS 123R as of January 1, 2005. For further information on the impact of our adoption of FAS 123R in 2005, see Note 6 to the unaudited interim consolidated financial statements included in Item 1."Financial Statements" of this Form 10-Q.
33
Off-Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and CommitmentsAt June 30, 2005 and December 31, 2004, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.
Our future cash payments associated with loss and loss expense reserves and contractual obligations pursuant to operating leases for office space and equipment, senior convertible notes, convertible subordinated debentures and notes payable have not materially changed since December 31, 2004. We expect to have the capacity to repay and/or refinance these obligations as they come due.
We currently have available revolving lines of credit amounting to $45.0 million, under which no balances are outstanding as of either June 30, 2005 or December 31, 2004. At June 30, 2005, we had an additional limited partnership investment commitment of up to $41.5 million; but there is no certainty that any such additional investment will be required. We have issued no guarantees on behalf of others and have no trading activities involving non-exchange traded contracts accounted for at fair value. We have no material transactions with related parties other than those disclosed in Note 18 of the Notes to Consolidated Financial Statements, included in Item 8. "Financial Statements and Supplementary Data", of our Annual Report on Form 10-K for the year ended December 31, 2004.
We expect continued earnings momentum in 2005 given our overall strong performance coupled with the strategies outlined above. Barring catastrophe losses in excess of 1.5 points on the GAAP and statutory combined ratios for the remainder of the year, we expect the following:
A GAAP combined ratio below 96%;
An overall Statutory combined ratio of 95%;
Increased after-tax investment income by 12% compared to 2004; and
Diversified Insurance Services revenue growth of 11% and return on revenue of 7%.
Pricing in the property and casualty insurance industry is cyclical. From 2000 through 2004, commercial renewal pricing was increasing, resulting in improved earnings. In 2004, the rate of increase had significantly diminished and actually declined in some segments of the market. This trend continued during the first six months of 2005 as our commercial renewal pricing increased approximately 5% including exposure and only 1% excluding exposure. Although pricing pressure is an indication of higher levels of competition in the marketplace as companies try to increase market share, industry fundamentals are conducive to sound pricing. Those fundamentals include the following: (i) a low interest rate environment, (ii) increasing loss cost trends, (iii) higher reinsurance costs than historic levels, (iv) rating agency pressures to maintain operating returns, and (v) greater information availability and transparency in the industry. A GAAP combined ratio of approximately 95% equates to a return on average equity of approximately 15% for us. As the pricing environment and industry fundamentals continue to change, we must continually balance the competitive pressures to reduce prices with preservation of the franchise and providing returns to stockholders. Ultimately, we strive to outperform the industry regardless of the market conditions.
The property and casualty insurance marketplace is growing increasingly competitive and we are experiencing much greater pricing pressure, but we believe the commercial lines marketplace still provides opportunities for profitable growth. In an effort to increase our market share, we have established certain strategic initiatives including "market planning," which identifies organic growth opportunities by examining business demographics to target opportunities in underserved markets and identify potential growth areas that may require additional agent or field underwriter deployment. Selective's Commercial Lines NPW of $1 billion in 2004 represents a 1% market share in our 20 primary states, which we believe indicates substantial opportunities in our current operating territories.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKThere have been no material changes in the information about market risk set forth in our Annual Report on Form 10-K for the fiscal year-ended December 31, 2004.ITEM 4. CONTROLS AND PROCEDURESOur management, with the participation of its Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures were: (i) effective in recording, processing, summarizing, and reporting information on a timely basis that we are required to disclose in the reports that we file or submit under the Securities Exchange Act of 1934 "the Exchange Act"); and (ii) effective in ensuring that information that we are required to disclose in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. No changes in our internal control over financial reporting (as such term is defined in Rule 13a-15(f) of the Exchange Act) occurred during the Second Quarter 2005 that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II - OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
The following table below sets forth information regarding our purchase of our common stock during the periods indicated:
Total Number of
Maximum Number
Shares Purchased
of Shares that May Yet
Shares
Price Paid
as Part of Publicly
Be Purchased Under the
Period
Purchased1
Per Share
Announced Program
Announced Program2
April 1-30
5,000,000
May 1-31
43,028
47.13
42,400
4,957,600
June 1-30
27,690
48.14
27,364
4,930,236
70,718
47.53
69,764
The Second Quarter 2005 included 679 shares purchased from employees in connection with the vesting of restricted stock. The remaining 275 shares were purchases from employees in connection with stock option exercises. All of these repurchases were made in connection with satisfying tax withholding obligations of those employees. These shares were not purchased as part of the publicly announced program. The shares were purchased at the average of the high and low prices of the Company's common stock on the dates of the purchases.
On April 26, 2005, the Board of Directors cancelled the existing stock repurchase plan and authorized a 5.0 million-share repurchase program scheduled to expire on April 26, 2007.
Item 4. Submission of Matters to a Vote of Security Holders
Our 2005 Annual Meeting of Stockholders was held on April 27, 2005. The results of the voting, which was conducted in person and by proxy, were included in Item 4. "Submission of Matters to a Vote of Security Holders," on Form 10-Q for the period ended March 31, 2005.
Item 6. Exhibits
(a) Exhibits:The exhibits required by Item 601 of Regulation S-K are listed in the Exhibit Index, which immediately precedes the exhibits filed with this Form 10-Q.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Registrant
By: /s/ Gregory E. Murphy
August 5, 2005
Gregory E. MurphyChairman of the Board, President and Chief Executive Officer
By: /s/ Dale A. Thatcher
Dale A. ThatcherExecutive Vice President, Chief Financial Officer and Treasurer
INDEX TO EXHIBITS
Exhibit No.
* 10.1
Ninth amendment, dated June 24, 2005, effective through June 23, 2006, to the $25,000,000 Line of Credit Agreement dated October 22, 1999, between Wachovia Bank, National Association (formerly known as First Union National Bank) and Selective Insurance Group, Inc. and Selective Insurance Company of America.
* 10.2
Amendment, dated June 27, 2005, to the Promissory Note of $20,000,000 Line of Credit with State Street Bank and Trust Company with respect to Selective Insurance Company of America and Selective Insurance Group, Inc.
* 10.3
2005 Omnibus Stock Plan Amendment
* 10.4
2005 Omnibus Stock Plan Restricted Stock Agreement
* 11
Statement Re: Computation of Per Share Earnings.
* 31.1
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002,
* 31.2
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002,
* 32.1
Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,
* 32.2
Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
* Filed herewith