UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: March 31, 2006
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)
(I.R.S. 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)
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such report), and (2) has been subject to such filing requirements for the past 90 days.
Yes [ X ] No [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated file [ X ]
Accelerated file [ ]
Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes[ ] No [ X ]
As of March 31, 2006, there were 27,513,041 shares of common stock, par value $2.00, outstanding.
SELECTIVE INSURANCE GROUP, INC.Table of Contents
Page No
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of March 31, 2006 (Unaudited)
and December 31, 2005
1
Unaudited Consolidated Statements of Income for the Quarter Ended
March 31, 2006 and 2005
2
Unaudited Consolidated Statements of Stockholders' Equity for the
Quarter Ended March 31, 2006 and 2005
3
Unaudited Consolidated Statements of Cash Flows for the
4
Notes to Interim Unaudited Consolidated Financial Statements
5
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
Forward - Looking Statements
11
Introduction
Critical Accounting Policies and Estimates
Highlights of First Quarter 2006 and First Quarter 2005 Results
12
Results of Operations and Related Information by Segment
Financial Condition, Liquidity and Capital Resources
25
Federal Income Taxes
27
Adoption of Account Pronouncements
Item 3. Quantitative and Qualitative Disclosures About Market Risk
28
Item 4. Controls and Procedures
PART II. OTHER INFORMATION
29
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 4. Submission of Matters to a Vote of Security Holders
Item 6. Exhibits
30
ITEM I. FINANCIAL STATEMENTS
Unaudited
CONSOLIDATED BALANCE SHEETS
March 31,
December 31,
(in thousands, except share amounts)
2006
2005
ASSETS
Investments:
Fixed maturity securities, held-to-maturity - at amortized cost
(fair value: $13,034 - 2006; $13,881 - 2005)
$
12,662
13,423
Fixed maturity securities, available-for-sale - at fair value
(amortized cost: $2,670,324 - 2006; $2,627,549 - 2005)
2,665,475
2,653,839
Equity securities, available-for-sale - at fair value
(cost of: $190,425 - 2006; $183,349 - 2005)
357,659
338,783
Short-term investments - (at cost which approximates fair value)
174,662
176,525
Alternative investments
75,719
62,975
Total investments
3,286,177
3,245,545
Cash
585
2,983
Interest and dividends due or accrued
31,962
32,579
Premiums receivable, net of allowance for uncollectible
accounts of: $3,394 - 2006; $3,908 - 2005
509,078
465,210
Other trade receivables, net of allowance for uncollectible
accounts of: $204 - 2006; $176 - 2005
15,743
16,553
Reinsurance recoverable on paid losses and loss expenses
6,020
4,549
Reinsurance recoverable on unpaid losses and loss expenses
187,448
218,248
Prepaid reinsurance premiums (Note 5)
56,845
67,157
Deferred federal income tax
3,509
-
Property and Equipment - at cost, net of accumulated
depreciation and amortization of: $97,301 - 2006; $94,730 - 2005
54,159
53,194
Deferred policy acquisition costs
220,553
204,832
Goodwill
33,637
Other assets
48,008
49,128
Total assets
4,453,724
4,393,615
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Reserve for losses
1,817,323
1,799,746
Reserve for loss expenses
295,223
284,303
Unearned premiums
803,985
752,465
Senior convertible notes
115,937
Notes payable
222,704
222,697
Current federal income tax
14,135
2,293
5,663
Commissions payable
51,971
73,872
Accrued salaries and benefits
54,362
68,024
Other liabilities
120,843
87,491
Total liabilities
3,496,483
3,412,491
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: 43,522,645 - 2006; 43,271,273 - 2005
87,045
86,543
Additional paid-in capital
169,080
158,180
Retained earnings
881,504
847,687
Accumulated other comprehensive income
105,550
118,121
Treasury stock - at cost (shares: 16,009,604 - 2006; shares: 14,977,176 - 2005)
(285,938)
(229,407)
Total stockholders' equity (Note 10)
957,241
981,124
Commitments and contingencies (Note 11)
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
(in thousands, except per share amounts)
Revenues:
Net premiums written
431,989
396,778
Net increase in unearned premiums and prepaid reinsurance premiums
(61,832)
(54,038)
Net premiums earned
370,157
342,740
Net investment income earned
36,002
32,362
Net realized gains
7,367
4,598
Diversified Insurance Services revenue
27,278
23,485
Other income
1,862
854
Total revenues
442,666
404,039
Expenses:
Losses incurred
191,363
177,755
Loss expenses incurred
42,337
40,682
Policy acquisition costs
115,478
106,835
Dividends to policyholders
1,208
1,248
Interest expense
5,518
4,377
Diversified Insurance Services expenses
23,746
21,268
Other expenses
8,744
3,433
Total expenses
388,394
355,598
Income from continuing operations, before federal income tax
54,272
48,441
Federal income tax expense (benefit):
Current
16,698
12,234
Deferred
(2,404)
1,198
Total federal income tax expense
14,294
13,432
Net income from continuing operations
39,978
35,009
Income from discontinued operations, net of tax: $321 - 2005
597
Net income before cumulative effect of change in accounting principle
35,606
Cumulative effect of change in accounting principle, net of tax
495
Net income
36,101
Earnings per share:
Basic net income from continuing operations
1.49
1.29
Basic net income from discontinued operations
0.02
Basic cumulative effect of change in accounting principle
Basic net income
1.33
Diluted net income from continuing operations
1.28
1.11
Diluted net income from discontinued operations
Diluted cumulative effect of change in accounting principle
Diluted net income
1.15
Dividends to stockholders
0.22
0.19
UNAUDITED CONSOLIDATED STATEMENTS OF
STOCKHOLDERS' EQUITY
Quarter ended March 31,
($ in thousands, except per share amounts)
Common stock:
Beginning of year
84,936
Dividend reinvestment plan
(shares: 7,982 - 2006; 8,137 - 2005)
16
Convertible subordinated debentures
(shares: 1,412 - 2006; 35,024 - 2005)
70
Stock purchase and compensation plans
(shares: 241,978 - 2006; 471,172 - 2005)
483
943
End of period
85,965
Additional paid-in capital:
142,292
424
357
7
178
10,469
(4,372)
138,455
Retained earnings:
721,483
Cash dividends to stockholders ($0.22 per share - 2006;
$0.19 per share - 2005)
(6,161)
(5,351)
752,233
Accumulated other comprehensive income:
154,536
Other comprehensive loss, decrease in net unrealized
gains on available-for-sale securities, net of deferred income
tax effect of: $(6,769) - 2006; $(16,737) - 2005
(12,571)
(31,084)
123,452
Comprehensive income
27,407
5,017
Treasury stock:
(206,522)
Acquisition of treasury stock
(shares: 1,032,428 - 2006; 91,403 - 2005)
(56,531)
(4,387)
(210,909)
Unearned stock compensation and notes receivable from stock sales:
(14,707)
Reclassification of unearned stock compensation
14,641
Amortization of deferred compensation expense and
amounts received on notes
66
Total stockholders' equity
889,196
Selective Insurance Group, Inc. also has authorized, but not issued, 5,000,000 shares of preferred stock without par value of which 300,000 shares have been designated Series A junior preferred stock without par value.
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOW
(in thousands)
Operating Activities
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
5,915
4,916
Stock compensation expense
4,477
2,369
(7,367)
(4,598)
Deferred tax
(495)
Changes in assets and liabilities:
Increase in reserves for losses and loss expenses, net of reinsurance recoverable
on unpaid losses and loss expenses
59,297
52,580
Increase in unearned premiums, net of prepaid reinsurance and advance premiums
61,864
53,837
Increase in net federal income tax payable
11,843
5,203
Increase in premiums receivable
(43,868)
(54,147)
Decrease (increase) in other trade receivables
810
(9,099)
Increase in deferred policy acquisition costs
(15,721)
(9,759)
Decrease in interest and dividends due or accrued
617
1,036
(Increase) decrease in reinsurance recoverable on paid losses and loss expenses
(1,471)
206
(Decrease) increase in accrued salaries and benefits
(13,662)
4,563
Decrease in accrued insurance expenses
(21,941)
(23,020)
Other-net
1,297
(14,617)
Net adjustments
39,686
10,173
Net cash provided by operating activities
79,664
46,274
Investing Activities
Purchase of fixed maturity securities, available-for-sale
(167,352)
(90,350)
Purchase of equity securities, available-for-sale
(19,777)
(12,780)
Purchase of alternative investments
(12,591)
(2,751)
Net proceeds from sale of subsidiary
376
Sale of fixed maturity securities, available-for-sale
96,880
35,759
Redemption and maturities of fixed maturity securities, held-to-maturity
765
5,131
Redemption and maturities of fixed maturity securities, available-for-sale
55,033
37,642
Sale of equity securities, available-for-sale
21,435
13,096
Proceeds from alternative investments
948
3,635
Purchase of property and equipment
(3,865)
(1,906)
Net cash used in investing activities
(28,148)
(12,524)
Financing Activities
(5,548)
(4,784)
Net proceeds from stock purchase and compensation plans
3,382
4,064
Cash retained for tax deductibility of the increase in value of equity instruments
2,920
2,793
Proceeds received on notes receivable from stock sales
Net cash (used in) financing activities
(55,777)
(2,248)
Net (decrease) increase in short-term investments and cash
(4,261)
31,502
Short-term investments and cash at beginning of year
179,508
98,657
Short-term investments and cash at end of period
175,247
130,159
Supplemental Disclosures of Cash Flows Information
Cash paid during the year for:
Interest
2,464
3,298
Federal income tax
1,935
4,560
Non-cash financing activity:
Conversion of convertible subordinated debentures
10
248
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. OrganizationSelective Insurance Group, Inc. and its subsidiaries, ("Selective") offers property and casualty insurance products and diversified insurance services and products through its various subsidiaries. Selective was incorporated in New Jersey in 1977 and its principal offices are located in Branchville, New Jersey. Selective's common stock is publicly traded on the NASDAQ National Market® under the symbol, "SIGI."
Selective classifies its business into three operating segments:
• Insurance Operations, which sells property and casualty insurance products and services primarily in 20 states in the Eastern and Midwestern United States, and has at least one company licensed to do business in each of the 50 states;
• Investments; and
• Diversified Insurance Services, which provides human resource administration outsourcing products and services, and federal flood insurance administrative services.
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) accounting principles generally accepted in the United States of America ("GAAP") and (ii) the rules and regulations of the United States Securities and Exchange Commission ("SEC") regarding interim financial reporting. The preparation of the interim unaudited consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported financial statement balances, as well as the disclosure of contingent assets and liabilities. Actual results could differ from those estimates. All significant intercompany accounts and transactions between Selective 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 operations and financial condition. These interim unaudited consolidated financial statements cover the first quarters ended March 31, 2006 ("First Quarter 2006") and March 31, 2005 ("First Quarter 2005"). As interim unaudited consolidated financial statements, they do not include all of the information and disclosures required by GAAP and the SEC for audited financial statements. Results of operations for any interim period are not necessarily indicative of results for a full year. Consequently, these 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, 2005 ("2005 Annual Report").
NOTE 3. ReclassificationsCertain amounts in Selective's prior years' interim unaudited consolidated financial statements and related footnotes have been reclassified as a result of the sale of CHN Solutions (Alta Services LLC and Consumer Health Network Plus, LLC). Such reclassifications 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 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. Selective's January 1, 2005 adoption of this accounting pronouncement resulted in an after-tax cumulative effect of change in accounting principle benefit of $0.5 million due to the requirement to estimate the impact of expected forfeitures at the grant date in First Quarter 2005.
NOTE 5. ReinsuranceThe following table contains a listing of direct, assumed and ceded reinsurance amounts by income statement caption. For more information concerning reinsurance, refer to Note 5, "Reinsurance" in Item 8. "Financial Statements and Supplementary Data" in Selective's 2005 Annual Report.
($ in thousands)
Premiums written:
Direct
452,299
426,815
Assumed
5,489
5,893
Ceded
(25,799)
(35,930)
Net
Premiums earned:
396,549
369,562
9,718
9,202
(36,110)
(36,024)
Losses and loss expenses incurred:
237,280
229,887
7,500
7,732
(11,080)
(19,182)
233,700
218,437
Ceded premiums written
(25,279)
(20,164)
Ceded premiums earned
(23,895)
(19,783)
Ceded losses and loss expenses incurred
(5,374)
(7,609)
6
NOTE 6. Segment InformationSelective has classified its operations into three segments, the disaggregated results of which are reported to and used by senior management to manage Selective's operations:
• Insurance Operations (commercial lines and personal lines), which are evaluated based on statutory 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 net investment income and net realized gains and losses; and
• Diversified Insurance Services (federal flood insurance administrative services and human resource administration outsourcing), 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, with a focus on our return on revenue (net income divided by revenues).
The Insurance Operations and Diversified Insurance Services segments share a common marketing or distribution system and create new opportunities for independent insurance agents to bring value-added services and products to their customers. Selective's commercial and personal lines property and casualty insurance products, flood insurance, and human resource administration outsourcing products are principally sold through independent insurance agents.
Selective and its subsidiaries also provide services to each other in the normal course of business. These transactions totaled $6.1 million in First Quarter 2006 and $6.8 million in First Quarter 2005. These transactions were eliminated in all consolidated statements. 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 presents revenues from continuing operations (net investment income and net realized gains on investments in the case of the Investments segment) and pre-tax income from continuing operations for the individual segments:
Unaudited,
Revenue by segment
Insurance Operations:
Commercial automobile net premiums earned
80,511
77,649
Workers compensation net premiums earned
75,801
69,253
General liability net premiums earned
99,090
86,016
Commercial property net premiums earned
44,390
40,210
Business owners' policy net premiums earned
11,791
11,921
Bonds net premiums earned
3,918
3,862
Other net premiums earned
180
215
Total commercial lines net premiums earned
315,681
289,126
Personal automobile net premiums earned
38,076
42,991
Homeowners net premiums earned
14,527
9,049
1,873
1,574
Total personal lines net premiums earned
54,476
53,614
Miscellaneous income
1,861
840
Total insurance operations revenues
372,018
343,580
Net investment income
Net realized gain on investments
Total investment revenues
43,369
36,960
Diversified Insurance Services:
Human resource administration outsourcing
17,150
15,607
Flood insurance
8,921
6,892
Other
1,207
986
Total diversified insurance services revenues
Total all segments:
442,665
404,025
14
Income (loss) from continuing operations before federal income tax
Commercial lines underwriting
22,796
13,536
Personal lines underwriting
(1,854)
3,110
Underwriting income, before federal income tax
20,942
16,646
Total investment income, before federal income tax
Income before federal income tax
3,532
2,217
67,843
55,823
(5,518)
(4,377)
General corporate expenses
(8,053)
(3,005)
Income from continuing operations before federal income tax
8
NOTE 7. Discontinued OperationsIn December 2005, Selective sold its 100% ownership interest in CHN Solutions (Alta Services LLC and Consumer Health Network Plus, LLC), which had historically been reported as part of the "Managed Care" component of the Diversified Insurance Services segment, for $16.4 million, which produced an after-tax loss of $2.6 million. Selective has reclassified prior period amounts on the interim unaudited consolidated statements of income to present the operating results of CHN Solutions as a discontinued operation.
Operating results from discontinued operations are as follows:
March 31, 2005
Net revenue
4,267
Pre-tax profit
919
After-tax profit
Intercompany transactions related to the discontinued operations are as follows:
2,307
129
84
NOTE 8. Retirement PlansThe following tables show the costs of the Retirement Income Plan for Selective Insurance Company of America ("Retirement Income Plan") and the retirement life insurance component ("Retirement Life Plan") of the Welfare Benefits Plan for Employees of Selective Insurance Company of America. For more information concerning these plans, refer to Note 14, "Retirement Plans" in Item 8. "Financial Statements and Supplementary Data" in Selective's 2005 Annual Report.
Retirement Income Plan
Retirement Life Plan
Components of Net Periodic Benefit Cost:
Service cost
1,760
1,798
92
100
Interest cost
2,016
1,854
103
95
Expected return on plan assets
(2,406)
(2,253)
Amortization of unrecognized prior service cost
38
(8)
Amortization of unrecognized net loss
415
288
Net periodic cost
1,823
1,725
187
Weighted-Average Expense Assumptions
for the years ended December 31:
Discount rate
5.50
%
5.75
8.00
Rate of compensation increase
4.00
9
NOTE 9. Comprehensive IncomeThe components of comprehensive income, both gross and net of tax, for First Quarter 2006 and First Quarter 2005 are as follows:
First Quarter 2006
Gross
Tax
Components of other comprehensive income:
Unrealized holding losses during the period
(11,973)
(4,191)
(7,782)
Reclassification adjustment
(2,578)
(4,789)
Other comprehensive loss
(19,340)
(6,769)
34,932
7,525
First Quarter 2005
50,121
14,020
(43,228)
(15,130)
(28,098)
(4,593)
(1,607)
(2,986)
(47,821)
(16,737)
2,300
(2,717)
NOTE 10. Stockholders' EquityEffective April 26, 2005, the Board of Directors approved a plan to repurchase up to 5.0 million shares of Selective common stock through April 26, 2007. During First Quarter 2006, Selective repurchased approximately 952,000 shares of its common stock at a total cost of $52.1 million under Selective's authorized stock repurchase program. As of March 31, 2006, there are 3.7 million shares remaining under the authorization. No shares were purchased under the authorized program in First Quarter 2005.
NOTE 11. Commitments and ContingenciesAlternative investments, as shown on the consolidated balance sheet, were $75.7 million as of March 31, 2006, and $63.0 million as of December 31, 2005. At December 31, 2005, Selective had additional investment commitments of up to $64.5 million, of which $5.6 million were paid during First Quarter 2006. At March 31, 2006, Selective has contractual obligations that expire at various dates through 2017 to further invest up to $53.2 million in these alternative investments. There is no certainty that any such additional investment will be required.
NOTE 12. LitigationIn the ordinary course of conducting business, Selective and its subsidiaries are named as defendants in various legal proceedings. Some of these lawsuits attempt to establish liability under insurance contracts issued by our insurance subsidiaries. Plaintiffs in these lawsuits are seeking money damages that, in some cases, are extra-contractual in nature or they are seeking to have the court direct the activities of Selective's operations in certain ways. Although the ultimate outcome of these matters is not presently determinable, Selective does not believe that the total amounts that it will ultimately have to pay, if any, in all of these lawsuits in the aggregate will have a material adverse effect on its financial condition, results of operations, or liquidity.
NOTE 13. Subsequent EventBetween May 3 and 4, 2006, Selective separately negotiated two private transactions under Section 3(a)(9) of the Securities Act of 1933 in which it exchanged a total of 153,961, or approximately $58.5 million, of its Senior Convertible Notes due 2032 in the original principal amount of $305 million for 1,998,152 shares of Selective common stock, par value $2.00 per share, and cash.
Forward-Looking StatementsIn this Quarterly Report on Form 10-Q, Selective and its management discuss and make statements regarding their intentions, beliefs, current expectations, and projections regarding Selective's future operations and performance. Such statements are "forward-looking" statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are often identified by words such as "anticipates," "believes," "expects," "will," "should" and "intends" and their negatives. Selective and its management caution prospective investors that such forward-looking statements are not guarantees of future performance. Risks and uncertainties are inherent in Selective's future performance. Factors that could cause actual results to differ materially from those indicated by such forward-looking statements include, but are not limited to, those discussed under Item 1A. "Risk Factors" in Selective's 2005 Annual Report. These risk factors may not be exhaustive. We operate in a continually changing business environment, and new risk factors emerge from time-to-time. We can neither predict such new risk factors nor can we assess the impact, if any, of such new risk factors on our businesses or the extent to which any factor or combination of factors may cause actual results to differ materially from those expressed or implied in any forward-looking statements in this report. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report might not occur. Selective and its management make forward-looking statements based on currently available information and assume no obligation to update these statements due to changes in underlying factors, new information, future developments, or otherwise.IntroductionSelective Insurance Group, Inc., ("Selective," "we," or "our") offers property and casualty insurance products and diversified insurance services through its various subsidiaries. Selective classifies its businesses into three operating segments: (i) Insurance Operations, (ii) Investments, and (iii) Diversified Insurance Services.
The purpose of the Management's Discussion and Analysis ("MD&A") is to provide an understanding of the consolidated results of operations and financial condition and known trends and uncertainties that may have a material impact in future periods. Consequently, investors should read the MD&A in conjunction with Selective's consolidated financial statements in Selective's 2005 Annual Report. For reading ease, we have written the MD&A in the first person plural.
In the MD&A, we will discuss and analyze the following:
• Critical Accounting Policies and Estimates;
• Highlights of Results for First Quarter 2006 and First Quarter 2005;
• Results of Operations and Related Information by Segment;
• Financial Condition, Liquidity, and Capital Resources;
• Federal Income Taxes; and
• Adoption of Accounting Pronouncements.
Critical Accounting Policies and EstimatesThese unaudited interim consolidated financial statements include amounts based on informed estimates and judgments of management for those transactions that are not yet complete. Such estimates and judgments affect the reported amounts in the financial statements. Those estimates and judgments that were most critical to the preparation of the financial statements involved the following: (i) reserves for losses and loss expenses; (ii) deferred policy acquisition costs; (iii) pension and postretirement benefit plan actuarial assumptions; and (iv) other-than-temporary investment impairments. These estimates and judgments require the use of assumptions about matters that are highly uncertain and therefore are subject to change as facts and circumstances develop. If different estimates and judgments had been applied, materially different amounts might have been reported in the financial statements. For a discussion of each of these critical accounting policies, refer to pages 30 through 35 in our 2005 Annual Report on Form 10-K.
Change
% or
Points
Diluted net income per share from continuing
operations
15
Diluted net income per share
Diluted weighted-average outstanding shares
31,902
32,151
(1)
GAAP combined ratio
94.3
95.1
(0.8)
pts
Statutory combined ratio
93.0
93.5
(0.5)
Annualized return on average equity
16.5
16.3
0.2
• Revenues increased in First Quarter 2006 compared to First Quarter 2005 primarily due to net premiums earned ("NPE") growth of 8% in First Quarter 2006 as compared to First Quarter 2005. Increases in NPE are attributed to the following:
o Direct voluntary new business written of $80.8 million in First Quarter 2006 compared to $68.3 million in First Quarter 2005;
o Commercial Lines renewal retention, which remained relatively level in First Quarter 2006 compared to First Quarter 2005;
o Commercial Lines renewal premium price increases, including exposure, that averaged 3.4% in First Quarter 2006 down from 6% in First Quarter 2005; and
o Increased investment income due to a higher investment asset base resulting from the following: (i) strong operating cash flows of $486.5 million since December 31, 2004, and (ii) our $100.0 million debt offering in the fourth quarter of 2005, partially offset by treasury stock purchases of 1,287,164 shares at a total cost of $68.4 million since December 31, 2004.
o The above items were partially offset by increased competition in the New Jersey personal automobile market, which resulted in a decrease in rates of 4.9% along with a 7% reduction in the number of cars we insured during First Quarter 2006 compared to First Quarter 2005. Net premiums earned for our New Jersey personal automobile business were down to $26.6 million for First Quarter 2006 as compared to $31.3 million for First Quarter 2005.
• Net income from continuing operations increased in First Quarter 2006 compared to First Quarter 2005 primarily due to:
o Commercial Lines underwriting and pricing improvements over the last few years and strong new business growth partially offset by increased catastrophe losses in First Quarter 2006 compared to First Quarter 2005; and
o After-tax investment income, which increased $3.5 million, or 14%, for First Quarter 2006 as compared to First Quarter 2005 resulting from the higher investment asset base discussed above.
Insurance Operations Our Insurance Operations segment derives substantially all of its revenues from insurance policy premiums. We predominantly write annual policies of which the associated premiums are defined as net premiums written ("NPW"). These NPW are recognized into revenue as net premiums earned ("NPE") ratably over the life of the insurance policy. Expenses fall into three categories: (i) losses associated with claims and various loss expenses incurred for adjusting claims; (ii) expenses related to the issuance of insurance policies, such as agent commissions, premium taxes, and other underwriting expenses, including employee compensation and benefits; and (iii) policyholder dividends.
Our insurance subsidiaries ("Insurance Subsidiaries") are regulated by each of the states in which they do business. They are required to file financial statements with such states prepared in accordance with accounting principles prescribed by, or permitted by, the Insurance Subsidiary's state of domicile ("Statutory Accounting Principles" or "SAP"). SAP have been promulgated by the National Association of Insurance Commissioners ("NAIC") and adopted by the various states. Selective evaluates the performance of its Insurance Subsidiaries in accordance with SAP. Incentive-based compensation to independent agents and employees is based on SAP results and our rating agencies use SAP information to evaluate our performance as well as for industry comparative purposes.
The underwriting performance of insurance companies is measured under SAP by four different ratios:
i. Loss and loss expense ratio, which is calculated by dividing incurred loss and loss expenses by NPE;
ii. Underwriting expense ratio, which is calculated by dividing all expenses related to the issuance of insurance policies by NPW;
iii. Dividend ratio, which is calculated by dividing policyholder dividends by NPE; and
iv. Combined ratio, which is the sum of the loss and loss expense ratio, the underwriting expense ratio, and the dividend ratio.
A statutory combined ratio under 100% generally indicates that an insurance company is generating an underwriting profit and a statutory combined ratio over 100% generally indicates that an insurance company is generating an underwriting loss. The statutory combined ratio does not reflect investment income, federal income taxes, or other non-operating income or expense.
SAP differs from GAAP accounting, under which Selective is required to report its financial results to the United States Securities and Exchange Commission ("SEC"), in many ways, but the most notable differences impacting our reported net income are as follows:
• Under SAP, underwriting expenses are recognized when incurred; whereas under GAAP, underwriting expenses are deferred and amortized over the life of the policy;
• Under SAP, the underwriting expense ratio is calculated using NPW as the denominator; whereas NPE is used as the denominator under GAAP; and
• Under SAP, the results of our flood line of business are included in our Insurance Operations segment, whereas under GAAP, these results are included within our Diversified Insurance Services segment.
We believe that only providing a GAAP presentation of financial information for our Insurance Operations segment would make it more difficult for investors, agents, and customers to evaluate our success or failure in our insurance business.
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Summary of Insurance Operations
All Lines
GAAP Insurance Operations Results:
NPW
NPE
Less:
Losses and loss expenses incurred
Net underwriting expenses incurred
114,307
106,409
(3)
Underwriting income
26
GAAP Ratios:
Loss and loss expense ratio
63.1
63.7
(0.6)
Underwriting expense ratio
30.9
31.0
(0.1)
Dividends to policyholders ratio
0.3
0.4
Combined ratio
Statutory Ratios: 1
63.0
64.2
(1.2)
29.7
28.9
0.8
1 The statutory ratios include the flood line of business, which is included in the Diversified Insurance Services Segment on a GAAP basis and therefore excluded from the GAAP ratios. The total Statutory Combined Ratio excluding flood is 93.5% for First Quarter 2006 compared to 93.9% for First Quarter 2005.
• NPW increased due to:
o Commercial Lines renewal retention, which remained relatively level in First Quarter 2006 compared to First Quarter 2005; and
o Commercial Lines renewal premium price increases, including exposure, that averaged 3.4% in First Quarter 2006 down from 6.0% in First Quarter 2005.
o The above items were partially offset by increased competition in the New Jersey personal automobile market, which resulted in a decrease in rates of 4.9% along with a 7% reduction in the number of cars we insured during First Quarter 2006 compared to First Quarter 2005. Net premiums written for our New Jersey personal automobile business were down to $25.2 million for First Quarter 2006 as compared to $28.0 million for First Quarter 2005.
• The improvement in the GAAP loss and loss expense ratio in First Quarter 2006 compared to First Quarter 2005 was primarily attributable to ongoing underwriting improvements mainly in our Commercial Lines business, specifically in our Commercial Automobile, General Liability, and Business Owners' Policy ("BOP") lines of business. These improvements were partially offset by an increase in weather-related catastrophe losses, which accounted for $3.2 million in incurred losses or 0.9 points of the GAAP loss and loss expense ratio for First Quarter 2006, compared to $0.4 million or 0.1 points for First Quarter 2005.
Insurance Operations OutlookDuring 2005, the financial performance of the property/casualty insurance industry incurred catastrophe losses on more than 3.3 million claims valued at approximately $60 billion for the industry. Despite these record losses, the industry recorded a statutory combined ratio of 100.9%. The reinsurance industry, however, posted a statutory combined ratio of 129%, reflecting the impact of the risks assumed related to these catastrophic losses. The growth in our book of business along with the hardening of the reinsurance market and reinsurers' models of catastrophic risk have led to higher property catastrophe costs in 2006 compared to 2005. In addition to higher property catastrophe costs, we also anticipate continued pricing pressure in the primary market in 2006, which is evidenced by Commercial Lines renewal pure price decreases of 1.6% for First Quarter 2006 compared to increases of 1.6% for First Quarter 2005. Barring excess catastrophe losses, we are anticipating achieving an underwriting profit for a third consecutive year in 2006. In First Quarter 2006, our commercial lines net premiums written growth of 6%, was more than twice the A.M. Best industry estimated growth rate for 2006.
We anticipate our profitability in 2006 will continue to be driven by our field strategy, which we consider to be a key competitive advantage that allows us to maneuver more favorably through challenging market conditions. This field strategy will allow us to grow our new business with our agencies. The strategic initiatives we are implementing to increase the effectiveness of our field strategy are as follows:
• Market Planning. Through business demographic and geographic analysis, this strategy: (i) identifies underserved markets in existing territories; (ii) identifies other areas for potential organic growth that may require additional agent appointments or field underwriter deployment; and (iii) enhances our ability to replicate success across different markets;
• Knowledge Management. We are accumulating and organizing existing underwriting data to enhance underwriting and pricing decisions; and
• Workers Compensation. This strategy includes six key initiatives that focus on predictive modeling, premium leakage, premium audit procedures, and other operational improvements.
Terrorism continues to remain an overall industry concern. The two-year extension of the Terrorism Risk Insurance Act of 2002 ("TRIA") that was approved by Congress on December 22, 2005, will serve to mitigate our exposure in the event of a large-scale terrorist attack; however, our deductible is substantial at $160 million in 2006. We continue to monitor concentrations of risk and have purchased a separate terrorism treaty to supplement our protection to this unknown exposure.
Technology also continues to play a critical role in our success. Our leading edge agency integration technology, xSelerate, is creating new business opportunities in allowing for the automated movement of key underwriting data from an agent's management system to our systems. This technology allows for seamless quoting and rating capabilities, which is an example of why we are ranked so highly by our agents for "ease of doing business."
On April 19, 2006, A.M. Best reaffirmed our A+ (Superior) financial strength rating for the 45thconsecutive year. In support of the rating, A.M. Best cited Selective's "solid capitalization, historically favorable operating performance and strong regional presence within the small commercial lines business segment." As less than 9% of personal and commercial lines carriers attain an A+ rating, this is a competitive advantage that reinforces our agents' decision to make us their carrier of choice.
Review of Underwriting Results by Line of Business
Commercial Lines Results
Commercial Lines
370,641
348,168
195,979
180,937
95,698
93,405
68
62.1
62.6
30.3
32.3
(2.0)
92.8
95.3
(2.5)
Statutory Ratios:
62.0
(1.1)
29.5
29.4
0.1
91.9
92.9
(1.0)
• The increases in NPW and NPE were the result of:
o Direct voluntary new business written of $71.7 million for First Quarter 2006, a 17% increase compared to $61.2 million in direct voluntary new business written in First Quarter 2005;
o Year-on-year renewal retention that remained relatively level for First Quarter 2006 as compared to First Quarter 2005; and
o Renewal premium price increases, including exposure, that averaged 3.4% for First Quarter 2006, down from 6.0% for First Quarter 2005.
• The improvement in the GAAP combined ratio is attributable to:
o Ongoing underwriting and pricing improvements over the past several years; and
o Improvements in our BOP line of business, driven by the successful implementation of a correction plan for this line, which generated a 22.5 point improvement in the combined ratio to 83.0% for First Quarter 2006 as compared to 105.5% for First Quarter 2005.
o The above items were partially offset by Commercial Lines loss costs increasing by 1.6% for the quarter combined with average earned premiums that were flat for the same period.
General Liability
Statutory NPW
117,675
104,160
Statutory NPE
93.9
% of total statutory commercial NPW
32
2.0
The profitability in this line of business reflects our long-term improvement strategy incorporating the following: (i) focusing our contractor growth on business segments with lower completed operations exposures; (ii) requiring subcontractors to carry equal insurance limits, up to $1.0 million, to those carried by the general contractors; (iii) placing mold limitations or exclusions on most policies; and (iv) requiring that our insureds be named on any potential subcontractors' policy as an additional insured on a primary and noncontributory basis. The policy count on this line of business increased 10% as of March 31, 2006 as compared to March 31, 2005.
Workers Compensation
93,895
91,046
75,816
69,264
110.3
108.9
1.4
Given our account-based underwriting approach, the inclusion of workers compensation coverage is often necessary to write an overall profitable account; however, we don't view this line as a loss leader. We are aggressively working on making improvements to the profitability of this line, although we recognize that it will take some time. For that reason, our Knowledge Management and Predictive Modeling efforts were initially focused on workers compensation. We adopted an improvement plan in 2005 which includes six key initiatives including predictive modeling, loss control and maximizing our quality agency relationships. Independent of other factors, we believe our multifaceted strategy will produce a 7-point improvement in the Workers Compensation combined ratio over the next two years. The policy count on this line of business increased 4% as of March 31, 2006 as compared to March 31, 2005.
Commercial Automobile
92,044
90,463
82.3
85.3
(3.0)
Continued strong performance in this line is the result of underwriting and pricing improvements over the last several years. As we continue to write accounts and grow this book of business, we have implemented granular rate decreases to remain competitive in the current marketplace. The policy count on this line of business increased 6% as of March 31, 2006 as compared to March 31, 2005 and renewal price remained flat in First Quarter 2006, compared to a 3.2% increase in First Quarter 2005.
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Commercial Property
49,218
45,766
79.8
77.3
2.5
The continued strong performance in the Commercial Property line of business is primarily attributable to higher prices and underwriting improvements that have been made over the past five years, 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. The favorable performance of this line of business for First Quarter 2006 was partially offset by catastrophe losses of $2.5 million or 0.6 points compared to minimal catastrophe losses in First Quarter 2005. The policy count on this line of business increased 6% as of March 31, 2006 as compared to March 31, 2005.
Business Owners' Policy
12,761
12,045
11,794
11,925
83.0
105.5
(22.5)
The statutory combined ratio for our BOP line of business improved 22.5 points for First Quarter 2006 compared to First Quarter 2005 and has achieved its second consecutive quarter of a combined ratio under 100%. This improvement is the result of our completed BOP correction plan that included pricing and underwriting actions focused on eliminating certain consistently unprofitable classes of business and growing more profitable segments. With our BOP correction plan completed and our BOP rewrite in place in all of our states, we are beginning to see our new business increase. New business for First Quarter 2006 was up 21% as compared to First Quarter 2005.
Bonds
4,359
4,216
3,926
3,873
86.1
76.8
9.3
Profitability in this line of business is driven by enhancements to the bond underwriting process, including the successful rollout of our automated bond system in 2005. Results for First Quarter 2006 compared to First Quarter 2005 were negatively impacted by ceded reinstatement premiums of $0.4 million, which added 7.7 points to the statutory combined ratio. These ceded reinstatement premiums became necessary due to a large loss ceded to our reinsurers, which exceeded our expectations of annual ceded losses.
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Commercial Lines OutlookA major factor in the ongoing performance of our Commercial Lines business is the state of pricing in the marketplace. Although there is increased pressure to reduce prices in order to maintain or build marketshare, we continue to see some level of stability in overall price levels. In the quarter, commercial renewal price increases were 3.4%, including approximately 5 points of exposure growth. On a pure price basis, prices were down slightly. Retention has remained steady at 79%. We have seen the greatest level of price competition in our large account sector, which we write through our Selective Risk Managers ("SRM"). SRM handles accounts with policy premium in excess of $250,000 or $150,000 for a single line of business. SRM business accounts for approximately 11% of our premium volume. With a company-wide average account size of about $8,000, the bulk of our business is in the small to middle market, which historically has been less price sensitive. We expect to see continued pricing pressure in all sectors over the course of the year.
Personal Lines Results
Personal Lines
61,348
48,610
37,721
37,500
18,609
13,004
43
Underwriting income (loss)
(160)
69.2
69.9
(0.7)
34.2
24.3
9.9
103.4
94.2
9.2
69.0
69.4
(0.4)
30.8
26.9
3.9
99.8
96.3
3.5
1 The statutory ratios include the flood line of business, which is included in the Diversified Insurance Services Segment on a GAAP basis and therefore excluded from the GAAP ratios. The total Personal Lines Statutory Combined Ratio excluding flood is 103.5% for First Quarter 2006 compared to 98.9% for First Quarter 2005.
• The increase in NPW reflects the impact of the termination of the New Jersey Homeowners Property 75% Quota Share Treaty effective January 1, 2006. Termination of this treaty resulted in the return of $11.3 million in ceded premiums in 2006. Excluding the effect of this ceded premium return, NPW would have increased 3% for First Quarter 2006 as compared to First Quarter 2005. This increase is the result of the following:
o A 55% increase in NPW in our Homeowners' line of business, excluding the effect of the ceded premium return, resulting from the retention of New Jersey homeowners' business that had previously been ceded under the Quota Share Treaty; and
o A 3% increase in NPW in our expansion states, with a 9.9 point improvement on the related statutory combined ratio for First Quarter 2006 compared to First Quarter 2005.
o The two increases above were partially offset by a 7% decrease in the number of cars we insure in New Jersey as of March 31, 2006 compared to March 31, 2005 and a 4.9% decrease in New Jersey automobile rates for First Quarter 2006 as compared to First Quarter 2005. These changes are a result of increased levels of competition, mainly from direct insurance writers that have entered the marketplace. Net premiums written for our New Jersey personal automobile business were down to $25.2 million for First Quarter 2006 as compared to $28.0 million for First Quarter 2005.
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36,056
39,182
(11)
102.2
99.1
3.1
% of total statutory personal NPW
59
81
(22.0)
The statutory combined ratios for First Quarter 2006 compared to First Quarter 2005, were negatively impacted by decreases in statutory NPW driven by increased competition in the New Jersey automobile market. This increasingly competitive marketplace has resulted in a 4.9% decrease in rates and a 7% decrease in the number of cars we insure as noted above.
The New Jersey automobile market contains many new market entrants, including well-capitalized national carriers. This increased competition, coupled with our rating plans that currently are not competitive due to a historically restrictive regulatory environment, has led to overall pricing pressure in the Personal Automobile line of business. We are actively addressing this issue through the strategy discussed in the "Personal Lines Outlook" below.
Homeowners
23,522
7,896
198
61
104.3
98.9
5.4
22.0
Our Homeowners statutory NPW for First Quarter 2006 as compared to First Quarter 2005 increased due to the termination of the Quota Share Treaty effective January 1, 2006, which resulted in the return of $11.3 million in ceded premiums in First Quarter 2006. Excluding this ceded premium return, NPW would have increased 55% as compared to First Quarter 2005, which is due to the retention of New Jersey homeowners' business that had previously been ceded. The overall statutory combined ratio for this line of business was negatively impacted by an additional $5.1 million in commissions that were incurred in First Quarter 2006 due to the termination of the treaty. Overall, the termination of this treaty negatively impacted the statutory combined ratio by 3.1 points.
Personal Lines OutlookPersonal Lines comprise nearly half of all U.S. property and casualty premiums. Independent agents have increased their personal lines market share to 37% and we believe they will continue to be a factor in the personal lines marketplace. Our strategy is designed to differentiate Selective from the other companies that compete in the agency channel through market consistency, breadth of appetite, and ease of doing business. To improve our competitive position in the overall personal lines markets in each of our primary operating states, we have taken the following strategic steps:
• Management Restructure: We have realigned the Personal Lines management roles to place a greater emphasis on product management, marketing, and project management.
• Pricing Design: Our pricing redesign for our automobile business will be implemented in all of our personal lines states in 2006, beginning with New Jersey, and we will be implementing a new pricing structure for our homeowners business in mid-to-late 2007.
• Technology: With the rollout of SelectPlus™, our personal lines automated underwriting system, over 80 percent of our agents are inputting data directly into the system for new business and almost 50 percent are issuing endorsements through the system. We expect to introduce xSelerate for use in our Personal Lines business in the third quarter of 2006.
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• Service Center: We will open our Personal Lines Service Center in the second quarter of 2006, with a pilot group of New Jersey agents. This service center will allow us to assume certain policyholder service duties from our agents so that they may concentrate on sales and improved service to larger, more complex, business. The rollout of the center to other Personal Lines states is expected to occur in 2007. We believe the Personal Lines Service Center will be a selling point for new business opportunities with agents.
InvestmentsOur investment philosophy includes certain return and risk objectives for our fixed maturity and equity portfolios. The primary return objective of the fixed maturity portfolio is to maximize after-tax investment yield and income while balancing certain risk objectives, with a secondary objective of meeting or exceeding a weighted-average benchmark of public fixed income indices. The return objective of the equity portfolio is to exceed a weighted-average benchmark of public equity indices. The risk objectives for all portfolios are to ensure investments are being structured with a focus on: (i) asset diversification, (ii) investment quality, (iii) liquidity, (iv) consideration of taxes, and (v) preservation of capital. Managing investment risk by adhering to these objectives is intended to protect the interests of our stockholders, and the policyholders of our Insurance Subsidiaries and, enhance our financial strength and underwriting capacity. The following table presents the Moody's Investor Service and Standard & Poor's ratings of our fixed maturity portfolio, which demonstrates the quality of our investment portfolio:
Rating
Aaa/AAA
Aa/AA
A/A
Baa/BBB
Total
Our fixed maturity investments represent 82% of total invested assets. We continue to invest our fixed maturity portfolio primarily in intermediate-term securities to manage overall interest rate risk. The average duration of the fixed maturity portfolio, excluding short-term investments, was 4.2 years at March 31, 2006 compared with 4.3 years at March 31, 2005. The current duration of our fixed maturities is within our historical range and is monitored and managed to maximize yield and mitigate interest rate risk. To provide liquidity, while maintaining consistent performance, fixed maturity investments are "laddered" so that some issues are always approaching maturity and provide a source of predictable cash flow for claim payments in the ordinary course of business. In addition, we purchase reinsurance coverage for protection against any significantly large claims or catastrophes that may occur during the year.
Summary of Investments
Net investment income, before tax
Net investment income, after tax
28,178
24,663
Total invested assets
2,880,071
Effective tax rate
21.7
23.8
(2.1)
Annual after-tax yield on investment portfolio
3.4
21
• Increased invested assets in fixed income securities driven by substantial cash flows from operations of $406.8 million for full year 2005 and $79.7 million in First Quarter 2006 as well as proceeds from the November 2005 debt offering which added approximately $100 million in assets.
• This increase was partially offset by our use of a portion of our short-term investments to fund treasury stock purchases of 335,264 shares for approximately $16.3 million for full year 2005 and 951,900 shares for approximately $52.1 million for First Quarter 2006, our short-term investment income increased to $1.6 million in First Quarter 2006 compared to $0.5 million in First Quarter 2005 due to higher short-term rates and larger average daily balances.
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 $7.4 million in First Quarter 2006 compared to $4.6 million of net realized gains in First Quarter 2005. The majority of the increase in net realized gains reflects the sale of certain long-term equity holdings during First Quarter 2006. There were no write-downs in First Quarter 2006 or First Quarter 2005. We maintain a high quality and liquid investment portfolio and the sale of the securities that resulted in net realized gains did not change the overall liquidity of the investment portfolio. Our philosophy for sales of securities generally is to reduce our exposure to securities and sectors when economic evaluations or the fundamentals for that security or sector have deteriorated and/or for tax planning purposes. We generally have a long investment time horizon and our turnover is low, which has resulted in many securities accumulating large unrealized gains. Every purchase or sale is made with the intent of improving future investment returns.
The following table summarizes our net realized gains by investment type:
March 31, 2006
Held-to-maturity fixed maturities
Gains
Losses
Available-for-sale fixed maturities
516
191
(1,757)
(776)
Available-for-sale equity securities
8,896
5,296
(288)
(117)
Total net realized gains
The securities sold in First Quarter 2006 and 2005 have not diminished the overall liquidity of our portfolio because of the high quality and active market for our investment portfolio. Our liquidity requirements in the past have been met by operating cash flow from our Insurance Operations and Diversified Insurance Services segments and the issuance of debt and equity securities. We expect our liquidity requirements in the future to be met by these sources of funds or, if necessary, borrowings from our credit facilities. For a further discussion of our liquidity requirements, refer to the "Financial Condition, Liquidity and Capital Resources" section below.
22
Period of time in an
unrealized loss position
($ in millions)
Fair
Value on
Realized
Sale Date
Loss
Fixed maturities:
0 - 6 months
34.8
22.7
7 - 12 months
15.3
Greater than 12 months
13.7
5.8
Total fixed maturities
63.8
1.2
28.5
0.7
Equity Securities:
2.6
0.9
Total equity securities
67.3
1.5
29.2
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 purposes.
Unrealized LossesAs of March 31, 2006 and December 31, 2005, the following table summarizes 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, for all available-for-sale securities that have continuously been in an unrealized loss position:
Period of time in an unrealized loss
Position
December 31, 2005
Unrealized
Value
750.1
7.2
962.7
8.0
768.0
16.0
164.8
3.0
223.0
6.1
124.1
1,741.1
29.3
1,251.6
14.4
Equities:
11.9
7.4
12.2
9.4
0.5
1,753.3
29.6
1,261.0
14.9
Ten-year U.S. Treasury yields rose 46 basis points in First Quarter 2006 to 4.85%, which contributed to our increase in unrealized losses during First Quarter 2006.
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Contractual Maturities
Amortized
Cost
One year or less
48.6
48.1
Due after one year through five years
779.2
767.0
Due after five years through ten years
886.7
871.0
Due after ten years through fifteen years
55.9
55.0
1,770.4
Investments OutlookWe believe that pre-tax investment income will continue to grow as a result of strong cash flow from Insurance Operations. Ten-year U.S. Treasury yields reached 4.85% at the end of First Quarter 2006, up from 4.39% at year-end 2005. Given the rise in interest rates, our overall portfolio yield is beginning to increase as older bonds mature and are replaced by higher yielding bonds. To manage our interest rate risk, we aim to keep portfolio duration stable and to maintain a well-laddered maturity structure for our fixed maturity portfolio. With regard to our equity portfolio, we are committed to pursuing opportunities in industries with favorable fundamentals and will continue to reduce exposure to those stocks or sectors with less favorable fundamentals and valuations. Additionally, our alternative investment portfolio has performed well over the past few years and as a result we are looking to modestly grow this investment class as a percentage of our overall portfolio, which should contribute to lowering our overall portfolio risk given that these investments have a low correlation to other investment asset classes.
Diversified Insurance Services SegmentIn December 2005, we sold our 100% ownership in CHN Solutions (Alta Services LLC and Consumer Health Network Plus, LLC), which had historically been reported as part of the managed care component of the Diversified Insurance Services segment, for $16.4 million, resulting in an after-tax net loss of $2.6 million. For further information regarding this divestiture, see Note 7 in Item 1. "Financial Statements" of this Quarterly Report on Form 10-Q.
The Diversified Insurance Services operations consist of two core functions: human resource administration outsourcing ("HR Outsourcing") and flood insurance. We believe these operations are within markets that continue to offer opportunity for growth. During First Quarter 2006, these operations provided a contribution of $0.07 per diluted share compared to $0.05 per diluted share in First Quarter 2005. Contributions from the Diversified Insurance Services segment, particularly the Flood business, continue to provide a level of mitigation to insurance pricing cycles and the adverse impact that catastrophe losses have on our Insurance Operations segment. We measure the performance of these operations based on several measures, including, but not limited to, results of operations in accordance with GAAP, with a focus on our return on revenue (net income divided by revenues). The results for this segment's continuing operations are as follows:
HR Outsourcing
Revenue
792
482
64
Flood Insurance
2,220
1,320
520
2,359
1,467
After-tax return on revenue
8.6
6.2
2.4
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• Profitability improvements in our HR Outsourcing business in First Quarter 2006 compared to First Quarter 2005 are mainly due to (i) improved margins on State Unemployment Tax Act assessments, health benefits and workers compensation; and (ii) increased average administration fee per worksite employee to $652 in First Quarter 2006 compared to $632 in First Quarter 2005.
• As of March 31, 2006, our worksite lives were up 11% to 24,911 compared to 22,416 as of March 31, 2005. To improve sales, during First Quarter 2006 we unveiled a new marketing strategy and a new agent commission structure for our basic human resources outsourcing product, which we refer to as our employer protection program ("EPP"). The EPP is designed to assist business owners in managing the risk of employee-related liabilities.
• Flood premium in force was $98.8 million on approximately 226,000 policies at March 31, 2006, compared to premium in force of $80.7 million on approximately 191,000 policies at March 31, 2005.
• Revenue increases were mainly attributable to the increase in flood premium in force as noted above, as well as the accrual of the fiscal year 2005-2006 marketing bonus from the National Flood Insurance Program ("NFIP") in First Quarter 2006 of $1.0 million. This growth was partially offset by a decrease in the fee paid to us by the NFIP of 0.4 points to 30.8% from 31.2%, which was effective for the fiscal year beginning on October 1, 2005.
• Pre-tax profit increased as a direct result of the revenue increases discussed above.
Diversified Insurance Services Outlook
Our HR Outsourcing products offer an additional potential agency revenue stream for our independent agents. During First Quarter 2006, we repositioned the human resource outsourcing products as the EPP, which assists business owners manage the risk of employee-related liabilities. Agent training regarding the EPP is currently underway and based on initial positive feedback, we expect to recognize some synergies created from this product in 2006.
Our ability to provide flood insurance is a significant component of our Diversified Insurance Services strategy. In 2005, the destruction caused by the active hurricane season stressed the NFIP with flood losses currently estimated by the Federal Emergency Management Agency ("FEMA") to be in excess of $20 billion. We continue to monitor developments with the NFIP regarding its ability to pay claims in the event of another large-scale disaster Congress controls the Federal agency's borrowing authority, which topped out after Hurricane Katrina, and is again nearing maximum capacity. At this point, it is uncertain what impact, if any, this will have on our flood operations. In addition, regulators are considering a reduction in the expense allowance which is paid to writers of flood insurance. A reduction of this rate, which is currently 30.8%, could adversely affect our results of operations for this business.
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 cash and short-term investments ("cash equivalent(s)") position at March 31, 2006 was $175.2 million compared to $179.5 million at December 31, 2005. Our sources of cash consist of dividends from our subsidiaries, the issuance of debt and equity securities, as well as the sale of our common stock under our employee and agent stock purchase plans. Our ability to receive dividends from our subsidiaries, however, is restricted. Dividends from our Insurance Subsidiaries to the parent 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, and are generally payable only from earned surplus as reported in the statutory annual statemen ts of those subsidiaries as of the preceding December 31. Based on the 2005 unaudited statutory financial statements, the Insurance Subsidiaries are permitted to pay to us, in 2006, ordinary dividends in the aggregate amount of approximately $120.6 million, of which $15.0 million has been paid through March 31, 2006. For additional information regarding dividends restrictions, refer to Note 7 "Indebtedness" and Note 8, "Stockholders' Equity" of the Notes to Consolidated Financial Statements, included in Item 8. "Financial Statements and Supplementary Data" of our 2005 Annual Report on Form 10-K.
Our Insurance Subsidiaries generate cash flows primarily from insurance float. Float is money that an insurance company holds for a limited time. In an insurance operation, float arises because premiums are collected before losses are paid. This interval can extend over many years. During that time, the insurer invests the money and generates investment income. The duration of the fixed maturity portfolio is 4.2 years as of March 31, 2006, while the Insurance Subsidiaries' liabilities have a duration of approximately 2.9 years. To provide liquidity, while maintaining consistent performance, fixed maturity investments are "laddered" so that some issues are always approaching maturity and provide a source of predictable cash flow for claim payments during the ordinary course of business. In addition, the Insurance Subsidiaries purchase reinsurance coverage for protection against any significantly large claims or catastrophes that may occur during the year. As of March 31, 2006, our consolidated investments portfolio was $3.3 billion compared to $3.2 billion at December 31, 2005.
We also have available revolving lines of credit totaling $45.0 million, under which no balances were outstanding as of either March 31, 2006 or December 31, 2005. These lines of credit are scheduled to expire in June 2006, and we expect to renew them with similar terms.
Selective HR Solutions ("SHRS"), our HR Outsourcing business, generates cash flows from their operations. Dividends from SHRS to the parent company are restricted by the operating needs of this entity as well as Professional Employer Organization licensing requirements to maintain a current ratio of at least 1:1. SHRS provided dividends to the parent company of $0.9 million in First Quarter 2006 and $1.0 million in First Quarter 2005.
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 the notes payable that we issued on May 4, 2000 (the "2000 Senior Notes"). All such covenants were met during First Quarter 2006 and 2005. For further information regarding our notes payable, see Note 7 of the Notes to Consolidated Financial Statements, entitled, "Indebtedness", included in Item 8. "Financial Statements and Supplementary Data" of our 2005 Annual Report on Form 10-K. At March 31, 2006, the amount available for dividends to holders of our common stock, in accordance with our restrictions of the 2000 Senior Notes, was $303.7 million. Our ability to continue to pay dividends to our stockholders is also dependent in large part on the dividend paying ability of our Insurance Subsidiaries and the subsidiaries in our Diversified Insurance Services segment to pay dividends to the parent company. Restrictions on the ability of our subsidiaries, particularly the Insurance Subsidiaries, to declare and pay dividends to the parent company could materially affect our ability to pay principal and interest on indebtedness and dividends on common stock.
Our liquidity requirements in the past have been met by dividends from our subsidiaries as well as the issuance of debt and equity securities. The Insurance Subsidiary liquidity requirements have historically been met by cash receipts from operations, consisting of insurance premiums and investment income. These cash receipts have historically provided more than sufficient funds to pay losses, operating expenses, and dividends to the parent company. In the future, we expect our liquidity requirements, as well as the liquidity requirements of our subsidiaries, to be met by these sources of funds.
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 March 31, 2006, we had stockholders' equity of $957.2 million and total debt of $339.4 million.
As active capital managers, we continually monitor our cash requirements as well as the amount of capital resources that we maintain at the holding company and operating subsidiary levels. As part of our long-term capital strategy, we strive to maintain a 25% debt-to-capital ratio and a premiums to surplus ratio sufficient to maintain an "A+ (Superior)" financial strength A.M. Best Rating for our Insurance Subsidiaries. On April 19, 2006, A.M. Best reaffirmed the A+ (Superior) financial strength rating of our Insurance Subsidiaries for the 45th consecutive year. Based on our analysis and market conditions, we may take a variety of actions including, but not limited to, contributing capital to subsidiaries in our Insurance Operations and Diversified Insurance Services segments, issuing additional debt and/or equity securities, repurchasing shares of our common stock, or increasing stockholders' dividends. During First Quarter 2006, we repurchased approximately 952,000 shares of our common stock under our authorized repurchase program for a total cost of $52.1 million. These repurchases were predominately funded by the proceeds from our $100 million bond offering in November 2005.
Additionally, 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 operating expenses, income taxes, the purchase of investments, and other expenses. 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. For further details regarding our cash requirements refer to the section below titled "Contractual Obligations and Contingent Liabilities and Commitments."
Off-Balance Sheet Arrangements At March 31, 2006 and December 31, 2005, 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.
Contractual Obligations and Contingent Liabilities and Commitments
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, 2005. 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 March 31, 2006 or December 31, 2005. At March 31, 2006, we had an additional alternative investment commitment of up to $53.2 million; but there is no certainty that any such additional investment will be required. We have issued no material 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 17 of the Notes to Consolidated Financial Statements, included in Item 8. "Financial Statements and Supplementary Data," of our 2005 Annual Report.
Federal Income TaxesTotal federal income tax expense increased $0.9 million for First Quarter 2006 to $14.3 million, compared to First Quarter 2005. The increase was attributable to increased pre-tax income driven by our Investments and Insurance Operations segments. 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 First Quarter 2006 was 26%, compared with 28% for First Quarter 2005.
Adoption of Accounting Pronouncement
In June 2005, the NAIC Property and Casualty Reinsurance Study Group ("Study Group") approved enhanced disclosure requirements for insurers that utilized reinsurance with limited risk transfer features, also known as finite reinsurance. These enhanced disclosure requirements have had no impact on us, as we only use traditional forms of reinsurance and do not use finite risk reinsurance. The Study Group also approved a standard reinsurance attestation supplement to be signed by an insurer's CEO and CFO attesting that there are no side agreements and that the reporting entity complies with all of the requirements set forth in Statements of Statutory Accounting Principles No. 62, "Property and Casualty Reinsurance" for all contracts entered into, renewed, or amended on or after January 1, 1994. Selective filed these attestations with the NAIC and the Insurance Subsidiaries' domiciliary states for the first time on March 1, 2006 for its 2005 annual statutory filings.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKThere have been no material changes in the information about market risk set forth in our 2005 Annual Report.ITEM 4. CONTROLS AND PROCEDURESOur management, with the participation of our 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 ("Exchange Act")), 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 are: (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 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 First Quarter 2006 that materially affected, or are 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 PROCEEDSThe following table below sets forth information regarding purchases made by, or on behalf of, Selective, of Selective Insurance Group, Inc. common stock during the periods indicated:
Total Number of
Maximum Number
Average
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
January 1-31, 2006
595
55.47
4,664,736
February 1-28, 2006
814,846
55.02
735,400
3,929,336
March 1-31, 2006
216,987
53.77
216,500
3,712,836
1,032,428
54.75
951,900
During First Quarter 2006, 74,133 shares were purchased from employees in connection with the vesting of restricted stock and 6,395 shares were purchased from employees in connection with stock option exercises. All of these repurchases were made in connection with satisfying tax withholding obligations with respect to 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 Selective's common stock on the dates of the purchases.
On April 26, 2005, the Board of Directors authorized a stock repurchase program of up to 5.0 million shares, which is scheduled to expire on April 26, 2007. During First Quarter 2006, 951,900 shares were repurchased, leaving 3,712,836 shares remaining to be purchased under the authorized program.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERSSelective Insurance Group Inc.'s 2006 Annual Meeting of Stockholders was held on April 26, 2006. Voting was conducted in person and by proxy as follows:
(a) Stockholders voted to elect the following four (4) Class II directors, each to serve until the 2009 annual meeting of stockholders or when a successor has been duly elected and qualified, as follows:
For
Withheld
A. David Brown
22,314,199
1,289,005
William M. Kearns, Jr.
22,488,207
1,114,997
S. Griffin McClellan III
22,531,952
1,071,252
J. Brian Thebault
22,404,284
1,198,921
Stockholders voted to elect the following two (2) Class III directors, each to serve until the 2008 annual meeting of stockholders or when a successor has been duly elected and qualified, as follows:
John C. Burville
22,389,491
1,213,714
John F. Rockart
23,109,503
493,702
Stockholders voted to elect the following one (1) Class I director, to serve until the 2007 annual meeting of stockholders or when a successor has been duly elected and qualified, as follows:
W. Marston Becker
23,102,839
500,365
Continuing directors whose terms do not expire until the 2007 annual meeting of stockholders are Gregory E. Murphy and William M. Rue. Continuing directors whose terms do not expire until the 2008 annual meeting of stockholders are: Paul D. Bauer, Joan M. Lamm-Tennant, and Ronald L. O'Kelley.
(c) Stockholders voted to ratify the appointment of KPMG LLP as independent public accountants for the fiscal year ending December 31, 2006 as follows: 23,355,840 shares voted for this proposal; 114,444 shares voted against it, and 132,921 shares abstained.
ITEM 6. EXHIBITS
(a) Exhibits:Exhibit No.
* 10.1
Amendment No. 1 to the Selective Insurance Group, Inc. Cash Incentive Plan, dated April 25, 2006.
* 10.2
Form of Selective Insurance Group, Inc. 2005 Omnibus Stock Plan Stock Option Agreement.
* 10.3
Form of Selective Insurance Group, Inc. 2005 Omnibus Stock Plan Restricted Stock Agreement.
* 10.4
* 10.5
Form of Selective Insurance Group, Inc. Cash Incentive Plan Cash Incentive Unit Award Agreement.
* 10.6
* 11
Statement Re: Computation of Per Share Earnings.
* 31.1
Rule 13a-14(a) Certification of the Chief Executive Officer of Selective Insurance Group, Inc. (Section 302 of the Sarbanes-Oxley Act of 2002).
* 31.2
Rule 13a-14(a) Certification of the Chief Financial Officer of Selective Insurance Group, Inc. (Section 302 of the Sarbanes-Oxley Act of 2002).
* 32.1
Certification of Chief Executive Officer of Selective Insurance Group, Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
* 32.2
Certification of Chief Financial Officer of Selective Insurance Group, Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
* Filed herewith
SIGNATURESPursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
SELECTIVE INSURANCE GROUP, INC.Registrant
By: /s/ Gregory E. Murphy
May 5, 2006
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
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