UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: September 30, 2003 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ___________to______________ Commission file number: 0-8641 SELECTIVE INSURANCE GROUP, INC. ------------------------------- (Exact name of registrant as specified in its charter) New Jersey 22-2168890 ------------------------------ ---------------------------------- (State or other jurisdiction of (IRS Employer Identification No.) incorporation or organization) 40 Wantage Avenue Branchville, New Jersey 07890 ------------------------------ ---------- (Address of principal executive (Zip Code) offices) (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 Act) Yes [X] No [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date: <TABLE> <S> <C> Common stock, par value $2 per share, outstanding as of October 31, 2003: 27,168,083 </TABLE>
SELECTIVE INSURANCE GROUP, INC Consolidated Balance Sheets <TABLE> <CAPTION> UNAUDITED SEPTEMBER 30, DECEMBER 31, (in thousands, except share amounts) 2003 2002 - --------------------------------------------------------------------------------------------------------------------- <S> <C> <C> ASSETS Investments: Debt securities, held-to-maturity - at amortized cost (fair value: $83,179-2003; $114,785-2002) $ 79,314 109,318 Debt securities, available-for-sale - at fair value (amortized cost: $1,845,381-2003; $1,671,347-2002) 1,954,796 1,772,061 Equity securities, available-for-sale - at fair value (cost of: $152,651-2003; $ 120,036-2002) 254,402 196,913 Short-term investments - (at cost which approximates fair value) 37,424 24,700 Other investments 29,859 23,559 -------------- ------------ Total investments 2,355,795 2,126,551 Cash 149 2,228 Interest and dividends due or accrued 22,233 22,689 Premiums receivables, net of allowance for uncollectible accounts of: 433,979 353,935 $3,121-2003 and $2,814-2002 Other trade receivables, net of allowance for uncollectible accounts of: 21,243 19,769 $1,079-2003; $867-2002 Reinsurance recoverable on paid losses and loss expenses 6,411 7,272 Reinsurance recoverable on unpaid losses and loss expenses 187,451 160,374 Prepaid reinsurance premiums 53,983 46,141 Deferred federal income tax - 8,707 Real estate, furniture, equipment, and software development-at cost, net of accumulated depreciation and amortization 53,180 52,424 Deferred policy acquisition costs 173,769 148,158 Goodwill 43,612 42,808 Other assets 28,660 38,791 -------------- ------------ Total assets $ 3,380,465 3,029,847 ============== ============ LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES: Reserve for losses $ 1,368,337 1,232,322 Reserve for loss expenses 183,345 171,103 Unearned premiums 679,894 557,141 Senior convertible notes 115,937 115,937 Notes payable 121,500 145,500 Current federal income tax 9,257 2,565 Deferred federal income tax 2,113 - Other liabilities 185,381 153,177 -------------- ------------ Total liabilities 2,665,764 2,377,745 -------------- ------------ 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: 41,426,666-2003; 40,780,950-2002 82,853 81,562 Additional paid-in capital 109,541 95,435 Retained earnings 592,971 562,553 Accumulated other comprehensive income 137,258 115,434 Treasury stock - at cost (shares: 14,274,087-2003; 14,185,020-2002) (197,458) (195,295) Unearned stock compensation and notes receivable from stock sales (10,464) (7,587) -------------- ------------ Total stockholders' equity 714,701 652,102 -------------- ------------ Total liabilities and stockholders' equity $ 3,380,465 3,029,847 ============== ============ </TABLE> See accompanying notes to unaudited interim consolidated financial statements. 2
SELECTIVE INSURANCE GROUP, INC. Consolidated Statements of Income <TABLE> <CAPTION> UNAUDITED UNAUDITED QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, (in thousands, except per share amounts) 2003 2002 2003 2002 - ------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Revenues: Net premiums written $ 317,513 267,439 $ 947,779 817,171 Net (increase) in unearned premiums and prepaid reinsurance premiums (27,832) (15,448) (114,912) (86,387) --------- ------- --------- ------- Net premiums earned 289,681 251,991 832,867 730,784 Net investment income earned 27,324 24,493 84,103 74,097 Net realized gains 1,029 1,521 8,373 1,219 Diversified insurance services revenue 24,453 21,321 69,272 60,873 Other income 855 1,134 2,299 2,874 --------- ------- --------- ------- Total revenues 343,342 300,460 996,914 869,847 --------- ------- --------- ------- Expenses: Losses incurred 172,821 157,342 502,546 457,136 Loss expenses incurred 31,363 25,632 90,481 75,815 Policy acquisition costs 91,132 79,071 263,412 224,499 Dividends to policyholders 914 1,358 3,852 4,685 Interest expense 4,145 3,452 13,135 10,457 Diversified insurance services expenses 21,592 19,416 61,865 55,975 Other expenses 2,494 350 6,383 5,684 --------- ------- --------- ------- Total expenses 324,461 286,621 941,674 834,251 --------- ------- --------- ------- Income from continuing operations, before federal income tax 18,881 13,839 55,240 35,596 --------- ------- --------- ------- Federal income tax expense (benefit) : Current 5,970 3,904 13,394 9,067 Deferred (1,806) (1,177) (657) (3,250) --------- ------- --------- ------- Total federal income tax expense 4,164 2,727 12,737 5,817 --------- ------- --------- ------- Loss from discontinued operations, net of tax - - - (708) Gain on disposition of discontinued operations, net of tax - - - 586 --------- ------- --------- ------- Total discontinued operations, net of tax - - - (122) --------- ------- --------- ------- Net income $ 14,717 11,112 $ 42,503 29,657 ========= ======= ========= ======= Earnings per share: Basic net income from continuing operations $ 0.56 0.43 $ 1.63 1.18 Basic net income from discontinued operations - - - - --------- ------- --------- ------- Basic net income $ 0.56 0.43 $ 1.63 1.18 ========= ======= ========= ======= Diluted net income from continuing operations $ 0.53 0.41 $ 1.54 1.11 Diluted net income from discontinued operations - - - - --------- ------- --------- ------- Diluted net income $ 0.53 0.41 $ 1.54 1.11 ========= ======= ========= ======= Dividends to stockholders $ 0.15 0.15 $ 0.45 0.45 </TABLE> See accompanying notes to unaudited interim consolidated financial statements. 3
SELECTIVE INSURANCE GROUP, INC. Consolidated Statements of Stockholders' Equity <TABLE> <CAPTION> UNAUDITED NINE MONTHS ENDED SEPTEMBER 30, (in thousands, except per share amounts) 2003 2002 - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Common stock: Beginning of year $ 81,562 79,177 Dividend reinvestment plan (shares: 33,714-2003; 35,294-2002) 67 71 Convertible subordinated debentures (shares: 16,522 -2003; 347,312-2002) 33 695 Stock purchase and compensation plans (shares: 595,480-2003; 612,623-2002) 1,191 1,225 ------------- -------- End of period 82,853 81,168 ------------- -------- Additional paid-in capital: Beginning of year 95,435 77,126 Dividend reinvestment plan 801 790 Convertible subordinated debentures 86 1,764 Stock purchase and compensation plans 13,219 11,350 ------------- -------- End of period 109,541 91,030 ------------- -------- Retained earnings: Beginning of year 562,553 536,188 Net income 42,503 42,503 29,657 29,657 Cash dividends to stockholders ($0.45 per share) (12,085) (11,649) ------------- -------- End of period 592,971 554,196 ------------- -------- Accumulated other comprehensive income: Beginning of year 115,434 98,037 Other comprehensive income, increase in net unrealized gains on available-for-sale securities, net of deferred income tax effect 21,824 21,824 17,738 17,738 ------------- ------------ -------- ------ End of period 137,258 115,775 ------------- -------- Comprehensive income 64,327 47,395 ============ ====== Treasury stock: Beginning of year (195,295) (192,284) Acquisition of treasury stock (shares 89,067-2003; 105,031-2002) (2,163) (2,436) ------------- -------- End of period (197,458) (194,720) ------------- -------- Unearned stock compensation and notes receivable from stock sales: Beginning of year (7,587) (7,084) Unearned stock compensation (6,625) (3,784) Amortization of deferred compensation expense and amounts received on notes 3,748 2,745 ------------- -------- End of period (10,464) (8,123) ------------- -------- Total stockholders' equity $ 714,701 639,326 ============= ======== </TABLE> The Company 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. See accompanying notes to unaudited interim consolidated financial statements. 4
SELECTIVE INSURANCE GROUP, INC. Consolidated Statements of Cash Flows <TABLE> <CAPTION> UNAUDITED NINE MONTHS ENDED SEPTEMBER 30, (in thousands) 2003 2002 - ------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> OPERATING ACTIVITIES Net income $ 42,503 29,657 ----------- -------- 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 121,180 75,812 Increase in unearned premiums, net of prepaid reinsurance and advance premiums 116,198 87,508 Decrease (increase) in federal income tax recoverable 5,761 (1,419) Depreciation and amortization 7,806 6,719 Amortization of deferred compensation 3,693 2,638 Increase in premiums receivables (80,044) (47,769) Increase in other trade receivables (1,474) (394) Increase in deferred policy acquisition costs (25,611) (22,399) Decrease in interest and dividends due or accrued 456 2,197 Decrease in reinsurance recoverable on paid losses and loss expenses 861 6,777 Net realized gains on investments (8,373) (1,219) Net realized gain on sale of subsidiary - (901) (Decrease) increase in pension liability (1,918) 592 Increase in accrued salaries and benefits 7,928 5,825 Increase in accrued insurance expenses 8,766 4,864 Other, net 9,815 (18,135) ----------- -------- Net adjustments 165,044 100,696 ----------- -------- Net cash provided by operating activities 207,547 130,353 ----------- -------- INVESTING ACTIVITIES Purchase of debt securities, available-for-sale (456,228) (525,987) Purchase of equity securities, available-for-sale (36,379) (7,769) Purchase of other investments (7,366) (6,312) Purchase and adjustments of subsidiaries acquired (net of cash equivalents acquired of $1,127 in 2002) (804) (3,139) Sale of subsidiary (net of cash of $385) - 15,421 Sale of debt securities, available-for-sale 168,627 184,437 Redemption and maturities of debt securities, held-to-maturity 30,068 47,940 Redemption and maturities of debt securities, available-for-sale 118,142 73,576 Sale of equity securities, available-for-sale 6,344 15,940 Proceeds from other investments 1,066 9 Increase in net payable for security transactions 16,371 55,672 Net additions to real estate, furniture, equipment and software development (7,203) (8,833) ----------- -------- Net cash used in investing activities (167,362) (159,045) ----------- -------- FINANCING ACTIVITIES Dividends to stockholders (12,085) (11,649) Principal payment of notes payable (24,000) - Acquisition of treasury stock (2,163) (2,436) Net proceeds from issuance of senior convertible notes - 98,214 Net proceeds from dividend reinvestment plan 868 861 Net proceeds from stock purchase and compensation plans 7,785 8,791 Proceeds received on notes receivable from stock sales 55 107 ----------- -------- Net cash (used in) provided by financing activities (29,540) 93,888 ----------- -------- Net increase in short-term investments and cash 10,645 65,196 Short-term investments and cash at beginning of year 26,928 26,450 ----------- -------- Short-term investments and cash at end of period $ 37,573 91,646 =========== ======== SUPPLEMENTAL DISCLOSURES OF CASH FLOWS INFORMATION Cash paid during the period for: Interest $ 13,738 9,364 Federal income tax 6,371 6,600 Supplemental schedule of non-cash financing activity: Conversion of convertible subordinated debentures 117 2,459 Unearned stock compensation 6,625 3,784 </TABLE> See accompanying notes to unaudited interim consolidated financial statements. 5
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The interim consolidated financial statements are unaudited, but reflect all adjustments which, in the opinion of management, are necessary to provide a fair statement of the results of the Selective Insurance Group, Inc. and its consolidated subsidiaries for the interim periods presented. References herein to "Selective" are to Selective Insurance Group, Inc. All such adjustments are of a normal recurring nature. The results of operations for any interim period are not necessarily indicative of results for a full year. These interim consolidated financial statements cover the third quarters ended September 30, 2003 (Third Quarter 2003) and September 30, 2002 (Third Quarter 2002) and the nine month periods ended September 30, 2003 (Nine Months 2003) and September 30, 2002 (Nine Months 2002). This document should be read in conjunction with the consolidated financial statements and notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2002. 2. RECLASSIFICATIONS Certain amounts in the Company's prior year interim consolidated financial statements have been reclassified to conform to the 2003 presentation. Such reclassification had no effect on the Company's net income or stockholders' equity. 3. DISCONTINUED OPERATIONS In December 2001, the Company's management adopted a plan to divest itself of its 100% ownership interest in PDA Software Services, Inc. (PDA). During May 2002, the Company sold all of the issued and outstanding shares of capital stock and certain software applications of PDA for proceeds of $16.5 million at a net gain of $0.6 million. The tax benefit included in the loss from discontinued operations was $0.4 million for Nine Months 2002. There were no amounts recorded in 2003 or for Third Quarter 2002. Operating results from discontinued operations are as follows: <TABLE> <CAPTION> UNAUDITED, UNAUDITED, QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, (in thousands) 2003 2002 2003 2002 - ------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> Net revenue $ - - $ - 8,186 Pre-tax loss - - - (1,085) After-tax loss $ - - $ - (708) </TABLE> 4. SEGMENT INFORMATION The Company is primarily engaged in writing property and casualty insurance. The Company has classified its business into three segments, which is at the same level of disaggregation as that reviewed by senior management: Insurance Operations (commercial lines underwriting, personal lines underwriting), Investments, and Diversified Insurance Services. Insurance Operations are evaluated based on accounting principles generally accepted in the United States of America (GAAP) underwriting results. Investments are evaluated based on after-tax investment returns, and the Diversified Insurance Services are evaluated based on several measures including, but not limited to, results of operations in accordance with GAAP. The Company does not aggregate any of its operating segments. The GAAP underwriting results of the Insurance Operations segment are determined taking into account net premiums earned, incurred losses and loss expenses, policyholders dividends, policy acquisition costs and other underwriting expenses. Management of the Investments segment is separate from the Insurance Operations segment and, therefore, has been classified as a separate segment. The operating results of the Investments segment takes into account net investment income and net realized gains and losses. The Diversified Insurance Services segment is managed independently from the other segments and, therefore, has been classified separately. The Diversified Insurance Services segment consists of managed care, flood operations and human resource administration outsourcing (HR Outsourcing). The segment results are determined taking into account the net revenues generated in each of the businesses, less the costs of operations. Selective and its subsidiaries provide services to each other in the normal course of business. These transactions totaled $7.0 million for Third Quarter 2003 and $20.1 million for Nine Months 2003, compared with $6.4 million for Third Quarter 2002 and $26.4 million for Nine Months 2002. These transactions were eliminated in all consolidated statements. 6
In computing the results of each segment, no adjustment is made for interest expense, net general corporate expenses or federal income taxes. The Company 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 in the case of the Investments segment) and pre-tax income (loss) for the individual segments: <TABLE> <CAPTION> REVENUE BY SEGMENT UNAUDITED, UNAUDITED, QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, (in thousands) 2003 2002 2003 2002 - ----------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> INSURANCE OPERATIONS: Commercial lines net premiums earned $ 235,564 201,819 $ 674,911 582,049 Personal lines net premiums earned 54,117 50,172 157,956 148,735 Miscellaneous income 838 1,084 2,177 2,507 ----------- ------- ----------- ------- Total insurance operations revenues 290,519 253,075 835,044 733,291 INVESTMENTS: Net investment income 27,324 24,493 84,103 74,097 Net realized gain on investments 1,029 1,521 8,373 1,219 ----------- ------- ----------- ------- Total investment revenues 28,353 26,014 92,476 75,316 DIVERSIFIED INSURANCE SERVICES: Diversified insurance services revenues, from continuing operations 24,453 21,321 69,272 60,873 ----------- ------- ----------- ------- TOTAL ALL SEGMENTS 343,325 300,410 996,792 869,480 ----------- ------- ----------- ------- Other income 17 50 122 367 ----------- ------- ----------- ------- TOTAL REVENUES FROM CONTINUING OPERATIONS $ 343,342 300,460 $ 996,914 869,847 =========== ======= =========== ======= </TABLE> <TABLE> <CAPTION> UNAUDITED, UNAUDITED, INCOME (LOSS), BEFORE FEDERAL INCOME TAX QUARTER ENDED NINE MONTHS ENDED BY SEGMENT SEPTEMBER 30, SEPTEMBER 30, (in thousands) 2003 2002 2003 2002 - ----------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> INSURANCE OPERATIONS: Commercial lines underwriting $ 70 (5,818) $ (15,394) (15,785) Personal lines underwriting (6,350) (4,302) (11,392) (14,694) ----------- ------- ----------- ------- Underwriting loss, before federal income tax (6,280) (10,120) (26,786) (30,479) INVESTMENTS: Net investment income 27,324 24,493 84,103 74,097 Net realized gain on investments 1,029 1,521 8,373 1,219 ----------- ------- ----------- ------- Total investment income, before federal income tax 28,353 26,014 92,476 75,316 DIVERSIFIED INSURANCE SERVICES: Income from continuing operations, before federal income tax 2,861 1,905 7,407 4,898 ----------- ------- ----------- ------- TOTAL ALL SEGMENTS 24,934 17,799 73,097 49,735 ----------- ------- ----------- ------- Interest expense (4,145) (3,452) (13,135) (10,457) General corporate expenses (1,908) (508) (4,722) (3,682) ----------- ------- ----------- ------- INCOME FROM CONTINUING OPERATIONS, BEFORE FEDERAL INCOME TAX $ 18,881 13,839 $ 55,240 35,596 =========== ======= =========== ======= </TABLE> 7
5. REINSURANCE The following table is a listing of direct, assumed and ceded amounts by income statement caption: <TABLE> <CAPTION> UNAUDITED, UNAUDITED, QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, (in thousands) 2003 2002 2003 2002 - -------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Premiums written: Direct $ 345,274 297,030 $ 1,036,897 898,765 Assumed 13,469 9,448 24,313 18,696 Ceded (41,230) (39,039) (113,431) (100,290) ---------- ------- ------------ -------- Net $ 317,513 267,439 $ 947,779 817,171 ========== ======= ============ ======== Premiums earned: Direct $ 317,951 277,942 $ 919,591 806,337 Assumed 7,374 6,193 18,865 15,599 Ceded (35,644) (32,144) (105,589) (91,152) ---------- ------- ------------ -------- Net $ 289,681 251,991 $ 832,867 730,784 ========== ======= ============ ======== Losses and loss expenses incurred: Direct $ 236,425 184,474 $ 642,401 547,791 Assumed 6,022 5,932 15,949 15,468 Ceded (38,263) (7,432) (65,323) (30,308) ---------- ------- ------------ -------- Net $ 204,184 182,974 $ 593,027 532,951 ========== ======= ============ ======== </TABLE> Flood business, which we cede 100% to the National Flood Insurance Program (NFIP), is included in the above amounts as follows: <TABLE> <CAPTION> UNAUDITED, UNAUDITED, QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, (in thousands) 2003 2002 2003 2002 - ----------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Ceded premiums written $ (19,302) (15,314) $ (50,177) (40,736) Ceded premiums earned (15,240) (12,590) (43,051) (35,061) Ceded losses and loss expenses incurred (27,416) (2,422) (31,044) (4,203) </TABLE> - Included in direct losses and loss expenses incurred for Quarter and Nine Months ended September 30, 2003 are losses from Hurricane Isabel. $24.2 million of these losses are flood related which we 100% cede to the NFIP and $10.0 million are non-flood related. - Included in ceded losses and loss expenses incurred from our flood business for Quarter Ended and Nine Months ended September 30, 2003 are $24.2 million of losses incurred from Hurricane Isabel. - In addition to flood business, increases in ceded written and earned premium are primarily related to our Terrorism treaty placed on February 1, 2003. - Assumed written and earned premium increased primarily due to an increase in mandatory pool assumptions. Our property and casualty excess of loss treaties were renewed effective July 1, 2003. Under our casualty treaty, the Company retains the first $2.0 million of any casualty loss as well as 25% of the next $3.0 million in excess of the $2.0 million retention. The casualty program provides coverage of $47.2 million in excess of the Company's $2.0 million retention and $0.8 million participation. The casualty treaty distinguishes between Terrorism Risk Insurance Act (TRIA), and non-TRIA losses. Non-TRIA losses are treated like any other loss. The annual aggregate limit for certified terrorism (TRIA) losses is capped at two times each layer's occurrence limit, or $96.0 million. Consistent with the 2002 treaty, nuclear, biological and chemical losses are excluded, but there is no exclusion for mold losses or cyber risks. The following additional exclusions were added to the 2003 - 2004 treaty: 1) "Fortune 500" companies ($8.0 plus billion in sales); 2) war; 3) asbestos; and 4) pharmaceutical manufacturers. Due to the type of exposures the Company insures, these additional exclusions are not expected to have a material impact on our results. Under the property excess of loss treaty, the Company retains the first $2.0 million of any loss and 25% of any loss up to $1.3 million in the $5.0 million excess of $5.0 million second layer. This is a change from 2002, when the Company had no participation in the second layer. The current treaty provides coverage of up to $16.8 million per risk in excess of the Company's $2.0 million retention and $1.3 million participation in the second layer . In 2002, the treaty provided coverage of up to $13.0 million per risk in excess of the Company's retention of $2.0 million. As with the casualty treaty, the property treaty distinguishes between certified and non-certified terrorism losses. The 8
policy provides coverage for certified terrorism losses for all risks up to a $75.0 million total insured value, per location. The policy provides annual certified terrorism limits of $9.0 million for the first layer, $15.0 million for the second layer and $20.0 million for the third layer. Claims arising from non-certified terrorist acts are treated like any other loss and are not subject to limitations or annual aggregate caps. Consistent with the 2002 treaty, nuclear, biological and chemical losses are excluded. The estimated reinsurance cost for the property and casualty excess of loss treaties decreased approximately $1.1 million over the fiscal year ending September 2003. 6. COMPREHENSIVE INCOME The Company's comprehensive income for Third Quarter 2003, Nine Months 2003, and the corresponding periods in the prior year are: <TABLE> <CAPTION> UNAUDITED, UNAUDITED, QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, (in thousands) 2003 2002 2003 2002 - ----------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net income $ 14,717 11,112 $ 42,503 29,657 ----------- ------ ----------- ------ Other comprehensive income (loss), increase (decrease) in net unrealized gain on available-for-sale securities, net of deferred income tax effect (12,747) 15,315 21,824 17,738 ----------- ------ ----------- ------ Comprehensive income $ 1,970 26,427 $ 64,327 47,395 =========== ====== =========== ====== </TABLE> 7. CONCENTRATION OF CREDIT RISK Financial instruments that could potentially subject the Company to concentration of credit risk include accounts receivable associated with our human resource administration outsourcing subsidiary, which acts as a co-employer with certain clients. As a co-employer, we contractually assume substantial employer rights, responsibilities and risks of our clients' employees, who are considered co-employees. These accounts receivable, which are included in other trade receivables on the consolidated balance sheets, consist of service fees to be paid by our clients. Under the accrual method, earned but unpaid wages at the end of each period related to the Company's worksite employees are recognized as an accrued payroll liability as well as an account receivable during the period in which wages are earned by the worksite employee. Subsequent to the end of each period, such wages are paid and the related co-employer service fees are billed. Accrued co-employer payroll and related service fees were $15.1 million as of September 30, 2003 and $17.0 million as of September 30, 2002. Certain states limit a co-employer's liability for earned payroll to minimum wage. This would reduce the Company's potential liability for accrued co-employer payroll. In the event that a client does not pay their related payroll and service fees prior to the applicable payroll date, the Company has the right to cancel the co-employer contract or at its option, require letters of credit or other collateral. The Company has generally not required such collateral. As of September 30, 2003 the maximum exposure to any one account for earned payroll is approximately $1.3 million. If the financial condition of a client were to deteriorate rapidly, resulting in nonpayment, the Company's accounts receivable balances could grow and the Company could be required to provide for allowances, which would decrease net income in the period that such determination was made. HR outsourcing is also subject to geographic concentration. Approximately 43% of co-employer client payroll is within the state of Florida. Other east coast states, including Georgia, Maryland, New Jersey, Virginia, North Carolina, South Carolina, Pennsylvania, New York, and Delaware, account for substantially all of our other business. Consequently, changes to economic or regulatory conditions in these states could adversely affect the HR outsourcing operations. 8. STOCK-BASED COMPENSATION The FASB Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (FAS 123) establishes financial accounting and reporting standards for stock-based compensation plans. As permitted by FAS 123, the Company uses the accounting method prescribed by Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees" (APB 25) to account for its stock-based compensation plans. Companies using APB 25 are required to make pro forma footnote disclosures of net income and earnings per share as if the fair value method of accounting, as defined in FAS 123, had been applied. As of December 31, 2002, the Company adopted the FASB Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" (FAS 148). FAS 148 amends FAS 123 to 9
provide alternative methods of transition to FAS 123's fair value method of accounting for stock-based compensation. The Company has adopted the pro forma footnote disclosure-only provisions of FAS 123. Based on the fair value method consistent with the provisions of FAS 123, the Company's net income and earnings per share would have been reduced to the following pro forma amounts indicated below: <TABLE> <CAPTION> UNAUDITED, UNAUDITED, QUARTER ENDED NINE MONTHS SEPTEMBER 30, ENDED SEPTEMBER 30, (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 2003 2002 2003 2002 - ---------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net income, as reported $ 14,717 11,112 42,503 29,657 Add: Stock-based employee compensation reported in net income, net of related tax effect 1,078 207 2,400 1,715 Deduct: Total stock-based employee compensation expense determined under fair value-based method for all awards, net of related tax effects (771) (620) (3,136) (3,001) ----------- ------ ------ ------ Pro forma net income $ 15,024 10,699 41,767 28,371 =========== ====== ====== ====== Net income per share: Basic - as reported $ 0.56 0.43 1.63 1.18 Basic - pro forma 0.57 0.42 1.60 1.13 Diluted - as reported 0.53 0.41 1.54 1.11 Diluted - pro forma 0.54 0.40 1.52 1.06 </TABLE> 9. COMMITMENTS AND CONTINGENCIES Included in other investments is approximately $29.8 million of investments in limited partnerships as of September 30, 2003, and $23.5 million as of December 31, 2002. At September 30, 2003 the Company has an additional limited partnership investment commitment of up to $21.7 million. There is no certainty that any additional investment will be required. On May 21, 2003, a purported class action was brought against Consumer Health Network Plus, LLC, Alta Services, LLC and Selective Insurance Company of America , wholly-owned subsidiaries of Selective, together with ten other unrelated defendants. The lawsuit alleges that the defendants breached participating provider agreements and were unjustly enriched. We are vigorously defending this action, as we believe the Company has significant defenses to defeat the action. Further, since the suit remains in its early stages, management cannot at this time provide a meaningful estimate or range of estimates of a potential loss, if any. FORWARD-LOOKING STATEMENTS Some of the statements in this report, including information incorporated by reference contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements relate to our intentions, beliefs, projections, estimations or forecasts of future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our or our industry's actual results, levels of activity, or performance to be materially different from those expressed or implied by the forward-looking statements. In some cases, you can identify forward-looking statements by use of words such as "may," "will," "could," "would," "should," "expect," "plan," "anticipate," "target," "project," "intend," "believe," "estimate," "predict," "potential," "pro forma," "seek," "likely" or "continue" or other comparable terminology. These statements represent our expectations and we can give no assurance that such expectations will prove to be correct. 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 hurricanes, tornadoes, windstorms, earthquakes, hail, severe winter weather, fires, explosions and terrorism; - adverse economic, market or regulatory conditions; - our concentration in a number of east coast and midwestern states; - the adequacy of our loss reserves; - the cost and availability of reinsurance; - our ability to collect on reinsurance and the solvency of our reinsurers; 10
- uncertainties related to insurance 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 A.M. Best, Standard & Poor's, Moody's and Fitch; - 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. We undertake no obligation, other than as may be required under the federal securities laws, to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. We do not assume responsibility for the accuracy and completeness of the forward-looking statements. All of the forward-looking statements in this report are qualified by reference to the factors discussed under "Risk Factors" beginning on page 16 of our Annual Report on Form 10-K for the year ended December 31, 2002. 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 cannot 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. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in Section 27A of the Securities Act. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion relates to our results of operations, financial condition, liquidity and capital resources, off-balance sheet arrangements, contractual obligations and contingent liabilities and commitments and critical accounting policies for the interim periods indicated. This discussion is prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) unless otherwise noted. RESULTS OF OPERATIONS The following discussion is a comparison of the third quarter ended September 30, 2003 (Third Quarter 2003) and the nine month period ended September 30, 2003 (Nine Months 2003) to the third quarter ended September 30, 2002 (Third Quarter 2002) and the nine month period ended September 30, 2002 (Nine Months 2002). Our net income was $14.7 million, or $0.53 per diluted share, for Third Quarter 2003, compared with $11.1 million, or $0.41 per diluted share, for Third Quarter 2002. Our net income was $42.5 million, or $1.54 per diluted share, for Nine Months 2003, compared with $29.7 million, or $1.11 per diluted share, for Nine Months 2002. Included in net income are net realized capital gains, after-tax, of $0.7 million for Third Quarter 2003 and $5.4 million for Nine Months 2003, compared with $1.0 million for Third Quarter 2002 and $0.8 million for Nine Months 2002. OPERATING SEGMENTS The Company is primarily engaged in writing property and casualty insurance. The Company has classified its businesses into three segments: Insurance Operations (commercial lines underwriting, personal lines underwriting), Investments, and Diversified Insurance Services (managed care, flood insurance and human resource administration outsourcing). Insurance Operations are evaluated based on underwriting results determined in accordance with GAAP; Investments are evaluated based on after-tax investment returns; and the Diversified Insurance Services are evaluated based on several measures including, but not limited to, results of operations determined in accordance with GAAP. For an additional description of accounting policies, refer to Note 1 to our consolidated financial statements on pages 43 through 47 of our 2002 Annual Report to Shareholders (incorporated herein by reference to our Annual Report on Form 10-K for the year ended December 31, 2002) and the discussion beginning on page 20 of this report on Form 10-Q. See Note 4 to the September 30, 2003 unaudited interim consolidated financial statements on pages 6 and 7 of this report on Form 10-Q for revenues and related income before federal income tax for each individual segment discussed below. 11
Insurance Operations Segment <TABLE> <CAPTION> Unaudited, Unaudited, ALL LINES Quarter ended September 30, Nine Months ended September 30, ($ in thousands) 2003 2002 2003 2002 - ------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> GAAP INSURANCE OPERATIONS RESULTS Net premiums written $ 317,513 267,439 947,779 817,171 ============= ============= ======= ======= Net premiums earned $ 289,681 251,991 832,867 730,784 Less: Losses and loss expenses incurred 204,184 182,974 593,027 532,951 Net underwriting expenses incurred 90,863 77,779 262,774 223,627 Dividends to policyholders 914 1,358 3,852 4,685 ------------- ------------- ------- ------- Underwriting loss $ (6,280) (10,120) (26,786) (30,479) ------------- ------------- ------- ------- GAAP RATIOS: Loss and loss expense ratio 70.5% 72.6 71.2% 72.9 Underwriting expense ratio 31.4% 30.9 31.5% 30.6 Dividends to policyholders ratio 0.3% 0.5 0.5% 0.7 ------------- ------------- ------- ------- Combined ratio 102.2% 104.0 103.2% 104.2 ============= ============= ======= ======= </TABLE> Net premiums written increased by approximately $50.1 million, or 19%, to $317.5 million in Third Quarter 2003 and by $130.6 million, or 16%, to $947.8 million in Nine Months 2003 when compared with the same periods in 2002. Net premiums written for Third Quarter 2003 included $68.3 million in net new business written, an increase of 31% compared with $52.2 million in Third Quarter 2002. Nine Months 2003 included $203.7 million in net new business written, an 18% increase over $172.0 million for Nine Months 2002. The lower combined ratio reflects almost four years of commercial lines renewal premium price increases totaling 75%. These renewal premium price increases were approximately 12% in Third Quarter 2003 compared with approximately 19% in Third Quarter 2002 and 13% for Nine Months 2003 compared with 19% for Nine Months 2002. The loss and loss expense ratio decreased 2.1 points to 70.5% for Third Quarter 2003 and 1.7 points to 71.2% for Nine Months 2003 when compared with the same periods in 2002. The improvements are primarily due to increased premium rates, underwriting improvements and improved retention, mainly in our commercial lines business, which comprises over 82% of net premium written. The Third Quarter 2003 loss and loss expense ratio was negatively impacted by $13.5 million of weather-related catastrophes, or 4.7 points, compared with $3.1 million, or 1.2 points, in Third Quarter 2002. Included in Nine Months 2003 results were weather-related catastrophe events that occurred mainly in the first and third quarters of 2003, adding $25.3 million to losses incurred and 3.0 points to the loss and loss expense ratio, compared with $10.4 million and 1.4 points for Nine Months 2002. The underwriting expense ratio increased 0.5 points to 31.4% for Third Quarter 2003 and 0.9 points to 31.5% for Nine Months 2003 compared with the same periods in 2002. Expenses related to employee retirement plans increased $0.6 million, or 34%, for Third Quarter 2003 when compared with Third Quarter 2002 and $2.2 million, or 40%, for Nine Months 2003 when compared to the same period in 2002. Additionally, profit-based agent commissions incurred increased $2.5 million, or 60% for Third Quarter 2003 and $6.0 million, or 50% for Nine Months 2003 when compared with the same periods one year earlier due to improved underwriting profitability. These profit-based commissions are offered to agents to incent them to increase their premium volume with their most profitable business. However, these commissions are deferred and expensed ratably in relation to earned premium for proper matching.. As our insurance business has become more profitable, these commissions have increased, however not necessarily proportionate with earned premium, because some of our agents do not quality for these commissions because their level of profitability does not meet company standards. Also impacting the expense ratio is a changed deferred acquisition cost amortization estimate that management believes better matches underwriting expenses with earned premium by quarter. The change in estimate will have no impact for the full year. Overall productivity, as measured by fiscal year net premiums written per insurance operations employee, was approximately $662,000 for the twelve-month period ended September 30, 2003, up from $580,000 for the same period in 2002. Our strategic initiatives which are designed to either reduce costs and/or increase business include: i) streamlined processing for small commercial lines accounts (One & Done); ii) a web-based commercial lines automated system, and iii) claim and underwriting Service Centers. These initiatives are partially offsetting the increased expenses noted above and increasing our productivity measure. 12
Commercial Lines Underwriting <TABLE> <CAPTION> Unaudited, Unaudited, COMMERCIAL LINES Quarter ended September 30, Nine Months ended September 30, ($ in thousands) 2003 2002 2003 2002 - --------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> GAAP INSURANCE OPERATIONS RESULTS Net premiums written $ 261,397 215,265 $ 780,821 662,026 ============= ======= ============= ======= Net premiums earned $ 235,564 201,819 $ 674,911 582,049 Less: Losses and loss expenses incurred 160,688 142,099 472,270 412,001 Net underwriting expenses incurred 73,892 64,180 214,183 181,148 Dividends to policyholders 914 1,358 3,852 4,685 ------------- ------- ------------- ------- Underwriting loss $ 70 (5,818) $ (15,394) (15,785) ------------- ------- ------------- ------- GAAP RATIOS: Loss and loss expense ratio 68.2% 70.4 70.0% 70.8 Underwriting expense ratio 31.4% 31.8 31.7% 31.1 Dividends to policyholders ratio 0.4% 0.7 0.6% 0.8 ------------- ------- ------------- ------- Combined ratio 100.0% 102.9 102.3% 102.7 ============= ======= ============= ======= </TABLE> Commercial Lines Underwriting accounted for approximately 82% of net premiums written in Nine Months 2003 compared with 81% in Nine Months 2002. Net premiums written increased $46.1 million, or 21%, to $261.4 million for Third Quarter 2003 and $118.8 million, or 18%, to $780.8 million for Nine Months 2003 compared with the same periods in 2002. Net premiums written included $59.3 million in net new business written for Third Quarter 2003, a 34% increase when compared with $44.2 million in net new business written for Third Quarter 2002, and $177.9 million in net new business written in Nine Months 2003, a 17% increase when compared with $152.1 million in net new business written in Nine Months 2002. For Third Quarter 2003, the Commercial Lines Underwriting combined ratio decreased 2.9 points to 100.0% from 102.9% for the same period in 2002. The lower combined ratio is driven by our renewal premium price increases, which continue to outpace loss trends. We have had fourteen straight quarters of double-digit renewal premium price increases, including increases that averaged 12% in Third Quarter 2003 compared with 19% in Third Quarter 2002, and 13% for Nine Months 2003 compared with 19% for Nine Months 2002. At our current pricing level, we are six points above current loss trends. Importantly, policyholder retention improved 3 points to 81% for Nine Months 2003, compared with the same period last year. We monitor retention closely because ultimately, higher retentions yield better loss ratios and lower expenses. Underwriting initiatives across our commercial lines business have also resulted in improved loss ratios in those lines. Our Commercial Lines Underwriting combined ratio for Nine Months 2003 decreased to 102.3% from 102.7% for Nine Months 2002. This 0.4 point decrease is mainly attributable to the renewal price increases, higher retention and underwriting improvements discussed above. For Third Quarter 2003 the Commercial Lines Underwriting loss and loss expense ratio decreased 2.2 points while Nine Months 2003 decreased 0.8 points when compared with the same periods in 2002. Included in the Third Quarter 2003 ratio are the impact of weather-related catastrophes, including Hurricane Isabel, of 3.7 points compared with 1.2 points in Third Quarter 2002. Nine Months 2003 include 2.8 points from weather-related storms, including Hurricane Isabel and severe winter storms which occurred in the first three months of 2003, compared with 1.3 points for Nine Months 2002. Aside from the severe weather, our commercial property business, which accounted for 14% of Commercial Lines Underwriting net earned premium for Third Quarter 2003 and for Third Quarter 2002, posted favorable results for the quarter, with a loss and loss expense ratio of 61.5%, including 19.6 points from catastrophes. For the same period last year, the loss and loss expense ratio was 57.5%, including 5.9 points from catastrophes. In addition to price, the progress we have made in our commercial property line can be attributed to: 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. Also contributing to the Commercial Lines Underwriting improvement is our commercial automobile line of business, which accounted for 28% of Commercial Lines Underwriting net premiums earned in Third Quarter 2003 and 27% in Third Quarter 2002. This line registered another strong quarter, with a loss and loss expense ratio of 63.5%, down over six points compared with Third Quarter 2002. This line has been favorably impacted by a vehicle mix which contains a smaller percentage of heavy vehicles. Underwriting initiatives that more accurately target vehicle costs and classifications have also contributed to the improvement. Our workers' compensation business, which accounted for 23% of commercial lines underwriting net premiums earned in Third Quarter 2003 and 24% in Third Quarter 2002, showed a modest improvement when compared with the same period last year, posting a loss and loss expense ratio of 82.5% for Third Quarter 2003, compared with 83.1% for Third Quarter 2002. Even though these results are getting better, they are still unacceptable on their own. Our account-based strategy focuses on writing this line as a companion product, with only 5% of workers compensation policies being stand-alone. Workers 13
compensation insurance continues to be impacted by external factors, including: a regulatory climate that makes it difficult to obtain rate increases in some states; inflationary medical costs; increasing indemnity benefits; the slow economic recovery; and a decreasing number of workers' compensation only providers. However, we believe the strict underwriting measures we have put in place over the last three years, including: writing primarily small- to mid-size employers in low to medium hazard classes, requiring job site inspections and increasing by 36% the number of highly trained loss control representatives we employ, coupled with an aggressive pricing strategy, will make this a more manageable line for Selective. Personal Lines Underwriting <TABLE> <CAPTION> Unaudited, Unaudited, PERSONAL LINES Quarter ended September 30, Nine Months ended September 30, ($ in thousands) 2003 2002 2003 2002 - -------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> GAAP INSURANCE OPERATIONS RESULTS Net premiums written $ 56,116 52,174 $ 166,958 155,145 ============ ====== ============= ======= Net premiums earned $ 54,117 50,172 $ 157,956 148,735 Less: Losses and loss expenses incurred 43,496 40,875 120,757 120,950 Net underwriting expenses incurred 16,971 13,599 48,591 42,479 ------------ ------ ------- ------- Underwriting (loss) $ (6,350) (4,302) $ (11,392) (14,694) ------------ ------ ------- ------- GAAP RATIOS: Loss and loss expense ratio 80.4% 81.5 76.4% 81.3 Underwriting expense ratio 31.3% 27.1 30.8% 28.6 ------------ ------ ------- ------- Combined ratio 111.7% 108.6 107.2% 109.9 ============ ====== ======= ======= </TABLE> Personal Lines Underwriting accounted for approximately 18% of net premiums written for Nine Months 2003 compared with 19% for Nine Months 2002. Personal Lines Underwriting net premiums written increased $3.9 million, or 8%, to $56.1 million for Third Quarter 2003 and $11.8 million, or 8%, to $167.0 million for Nine Months 2003 when compared with the same periods in 2002. Net premiums written included net new business written of $8.9 million in Third Quarter 2003, a 12% increase when compared with $8.0 million in Third Quarter 2002. Net new business written in Nine Months 2003 was $25.8 million, a 30% increase over the $19.9 million written in Nine Months 2002. Personal Lines Underwriting combined ratio was 111.7% for Third Quarter 2003, up 3.1 points from the same period in 2002. The increase reflects: increased weather-related catastrophe losses of $4.9 million, or 9.0 points, in Third Quarter 2003 compared with $0.7 million, or 1.5 points in Third Quarter 2002. These losses were mainly in our homeowners line of business, which accounted for 15% of personal lines net earned premium for Third Quarter 2003, compared with 13% for Third Quarter 2002. Homeowners had a loss and loss expense ratio of 127.6% for Third Quarter 2003, of which 54.7 points are attributable to weather-related catastrophes, primarily Hurricane Isabel, compared with 75.5% for Third Quarter 2002, which had 6.6 points from catastrophes. This line was further impacted by several non-catastrophe large losses in Third Quarter 2003. Partially offsetting the poor homeowners results were improved personal automobile results, which constituted 82% of personal lines underwriting net premium earned in Third Quarter 2003 and 83% in Third Quarter 2002. The personal automobile line produced a loss and loss expense ratio of 73.2% for Third Quarter 2003, compared with 79.1% for Third Quarter 2002. The improved results were attributable to our business in New Jersey, which accounted for 72% of our overall personal automobile net premiums written for Third Quarter 2003 and 71% for Third Quarter 2002, and 73% for Nine Months 2003 and 2002. In New Jersey we are earning higher premiums from price and tier changes, which increased average premium per vehicle 23% since December 31, 2000. These pricing improvements are reflected in our New Jersey personal automobile loss and loss expense ratio of 72.4% for Third Quarter 2003, over a six-point improvement from the same period in 2002. While we are encouraged by our progress, the New Jersey personal automobile insurance market remains volatile. In May 2003, legislation was introduced that, if passed, would reverse some of this progress by allowing claimants to file lawsuits for non-economic damages without proving that the injuries sustained had a serious impact on their life. We cannot presently predict if, or when, this legislation may pass, however, if it does, this change could generate a significant increase in liability losses and could lead to liability rate inadequacy and could adversely affect the Company's results of operations. However, the Company would file for premium rate increases to help offset these adverse effects. Efforts to control our exposure in New York, due to the high cost of required participation in the involuntary personal automobile market, are beginning to pay off. Our net premiums written in New York decreased 17%, to $2.1 million, for Third Quarter 2003 compared with $2.5 million for Third Quarter 2002, and 12% to $6.8 million for Nine Months 2003 compared with $7.7 million for the same period last year. Since December 31, 2002, the number of vehicles in-force in New York has dropped 19%, to below 9,000. Our assigned risk charge, while still excessive, was $0.4 million for Third Quarter 14
2003, compared with $1.0 million for Third Quarter 2002 and $1.6 million for Nine Months 2003 compared with $2.5 million for Nine Months 2002. We have further renegotiated this charge, which is applied to our quota of the New York automobile involuntary plan premium from 72.5% to 33.3% effective January 1, 2004. We anticipate that the reduction in this charge will save us approximately $1.1 million in 2004. The Personal Lines Underwriting expense ratio increased 4.2 points to 31.3% at Third Quarter 2003 from 27.1% at Third Quarter 2002. The increase is attributable to higher profit based commissions paid to our independent agents of $1.2 million, or 2.2 points in Third Quarter 2003, compared with $0.7 million, or 1.4 points in Third Quarter 2002. Additionally, in Third Quarter 2002, a one-time underwriting benefit of $1.5 million or 2.9 points was recorded from certain non-voluntary pools. The Personal Lines Underwriting combined ratio was 107.2% for Nine Months 2003, down 2.7 points from the same period in 2002. The decrease is attributable to a 6.9 point decrease in our personal automobile loss and loss expense ratio for Nine Months 2003 to 74% compared with 80.9% for the same period in 2002. These improvements reflect the pricing and other initiatives discussed above. Reinsurance The Insurance Subsidiaries follow the customary practice of ceding a portion of their risks and paying to reinsurers a portion of the premiums received under the policies. This reinsurance program permits greater diversification of business and the ability to offer increased coverage while limiting maximum net losses. The Insurance Subsidiaries are parties to reinsurance contracts under which certain types of policies are automatically reinsured without the need for approval by the reinsurer of individual risks covered (treaty reinsurance), reinsurance contracts handled on an individual policy or per-risk basis requiring the agreement of the reinsurer as to each risk insured (facultative reinsurance) and limits (automatic facultative reinsurance). Reinsurance does not legally discharge an insurer from its liability for the full face amount of its policies, but does make the reinsurer liable to the insurer to the extent of the reinsurance ceded. Our property and casualty excess of loss treaties were renewed effective July 1, 2003, with reduced premium rates and increased protection in the structure. Under our casualty treaty, the Company retains the first $2.0 million of any casualty loss as well as 25% of the next $3.0 million in excess of the $2.0 million retention. The casualty program provides coverage of $47.2 million in excess of the Company's $2.0 million retention and $0.8 million participation. This structure is unchanged from 2002. In light of the Terrorism Risk Insurance Act of 2002 (TRIA), the casualty treaty distinguishes between certified (TRIA or foreign acts) and non-certified (all other or domestic) losses. Non-certified terrorism losses are treated like any other losses. The annual aggregate limit for certified terrorism (TRIA) losses is capped at two times each layer's occurrence limit, or $96.0 million. Consistent with the 2002 treaty: nuclear, biological and chemical losses are excluded from the casualty excess of loss treaty however; our terrorism excess of loss treaty does cover these exposures once our $15.0 million annual aggregate deductible is met. There is no exclusion for mold or cyber risks in this contract. The following additional exclusions were added to the 2003 - 2004 treaty: 1) "Fortune 500" companies ($8 plus billion in sales); 2) war; 3) asbestos; and 4) pharmaceutical manufacturers. Due to the types of exposures the Company insures, these additional exclusions are not expected to have a material impact on our results. Under the property excess of loss treaty, the Company retains the first $2.0 million of any loss and 25% of any loss (up to $1.3 million) in the $5.0 million excess of $5.0 million second layer. This is a change from 2002, when the Company had no participation in the second layer. The current treaty provides coverage of up to $16.8 million per risk in excess of the Company's $2.0 million retention and $1.3 million participation in the second layer. In 2002, the treaty provided coverage of up to $13.0 million per risk in excess of the Company's retention of $2.0 million. As with the casualty treaty, the property treaty distinguishes between certified and non-certified terrorism losses. The policy provides coverage for certified terrorism (TRIA) losses for all risks up to $75.0 million in total insured value per location. The policy provides annual certified terrorism limits of $9.0 million for the first layer, $15.0 million for the second layer and $20.0 million for the third layer. Claims arising from non-certified terrorist acts are treated like any other losses and are not subject to limitations or annual aggregate caps. Nuclear, biological and chemical losses are excluded from the property excess of loss treaty however; our terrorism excess of loss treaty does cover these exposures once our $15.0 million annual aggregate deductible is met. There is no exclusion for mold or cyber risks in this contract. Consistent with the 2002 treaty: nuclear, biological and chemical losses are excluded. The estimated reinsurance cost for the property and casualty excess of loss treaties decreased approximately $1.1 million, for the contract year ending June 2004, compared to contract year ending June 2003. Investments Segment Although lower interest rates continue to put pressure on investment returns, we generated a 12% increase in investment income to $27.3 million for Third Quarter 2003, up from $24.5 million for Third Quarter 2002. For Nine Months 2003 we generated a 14% increase to $84.1 million, compared with $74.1 million for the same period last year. The increase reflects 15
an increased asset base as our overall investment portfolio reached $2.4 billion at September 30, 2003, compared with $2.1 billion at September 30, 2002. The increased asset base is driven by $207.5 million of operating cash flow for Nine Months 2003 compared with $130.4 million for Nine Months 2002 due to improved underwriting results. Also, contributing to the increase were our limited partnership investments. These investments, which are subject to market fluctuations, added $0.2 million, after-tax, to investment income for Third Quarter 2003, compared with a loss of $0.4 million for Third Quarter 2002 and income of $1.7 million for Nine Months 2003 compared with a loss of $50,000 for Nine Months 2002. The after-tax portfolio yield is 3.7%, compared with 3.9% for the same period last year, reflecting downward pressure from maturing bonds that are being replaced by bonds with lower interest rates. We anticipate that we will be out of the Alternative Minimum Tax position by year-end, which will continue to drive our appetite for tax-advantaged investments. The timing of this shift is working to the advantage of our investment portfolio, as municipal bonds remain attractive relative to Treasury securities on a historical basis. We continue to maintain a conservative, diversified investment portfolio, with our bond holdings representing 86% of invested assets. Approximately 63% of our debt securities portfolio is rated "AAA." Our portfolio has an average rating of "AA," with only 1% of the portfolio rated below investment grade. The Company regularly reviews its investment portfolio for declines in value, focusing attention on securities whose market value is less than 85% of their cost/amortized cost at the time of review. If we believe 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. Our assessment of a decline in value includes our current judgment as to the financial position and future prospects of the entity that issued the investment security. Broad changes in the overall market or interest rate environment, generally will not lead to a write-down. If our judgment about an individual security changes in the future we may ultimately record a realized loss after having originally concluded that the decline in value was temporary, which could have a material impact on our net income and financial position of future periods. In evaluating potential impairment of debt securities we evaluate certain factors, including but not limited to the following: - 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 debt 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. In evaluating potential impairment of equity securities, we evaluate certain factors, including but not limited to the following: - Whether the decline appears to be issuer or industry specific; - 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 losses are determined on the basis of the cost of specific investments sold or written-down, and are credited or charged to income. Realized losses include impairment charges from investment write-downs for other than temporary declines, if any, in the period such determination is made. Realized gains net of realized losses included losses of $1.2 million attributed to impairment charges from investment write-downs during Third Quarter 2003. There were no impairment charges recorded during Third Quarter 2002. The Company realized gains and losses from the sale of available-for-sale debt and equity securities during Third Quarter 2003 and Third Quarter 2002 and during Nine Months 2003 and Nine Months 2002. 16
The following tables present the period of time that these securities, sold at a loss during these periods, were continuously in an unrealized loss position prior to sale: <TABLE> <CAPTION> Unaudited, Unaudited, Quarter ended September 30, Quarter ended September 30, 2003 2002 --------------------------- ---------------------------- Fair Value on Realized Fair Value on Realized (in millions) Sale Date Loss Sale Date Loss - ------------------------- ------------ ------------ ------------- ------------ <S> <C> <C> <C> <C> Period of time in an unrealized loss position Debt securities: 0 - 6 months $ 17.5 0.3 7.8 0.2 7 - 12 months - - 5.0 - Greater than 12 months - - - - ------------ ------------ ------------ ------------ Total debt securities 17.5 0.3 12.8 0.2 ------------ ------------ ------------ ------------ Equities: 0 - 6 months 1.0 0.1 - - 7 - 12 months - - - - Greater than 12 months - - - - ------------ ------------ ------------ ------------ Total equities 1.0 0.1 - - ------------ ------------ ------------ ------------ Total $ 18.5 0.4 12.8 0.2 ============ ============ ============ ============ </TABLE> <TABLE> <CAPTION> Unaudited, Unaudited, Nine Months ended September 30, Nine Months ended September 30, 2003 2002 --------------------------- --------------------------- Fair Value on Realized Fair Value on Realized (in millions) Sale Date Loss Sale Date Loss - ------------------------- ------------ ------------ ------------ ------------ <S> <C> <C> <C> <C> Period of time in an unrealized loss position Debt securities: 0 - 6 months $ 22.5 0.3 26.6 4.7 7 - 12 months - - - - Greater than 12 months - - 2.4 0.7 ------------ ------------ ------------ ------------ Total debt securities 22.5 0.3 29.0 5.4 ------------ ------------ ------------ ------------ Equities: 0 - 6 months 1.0 0.1 - - 7 - 12 months - - - - Greater than 12 months - - - - ------------ ------------ ------------ ------------ Total equities 1.0 0.1 - - ------------ ------------ ------------ ------------ Total $ 23.5 0.4 29.0 5.4 ============ ============ ============ ============ </TABLE> These securities were sold despite the fact that they were in a loss position due to heightened credit risk of the individual security sold, the need to reduce our exposure to certain issuers, industries or sectors in light of changing economic conditions, or tax planning strategies. 17
UNREALIZED LOSSES The following table summarizes, for all available-for-sale securities in an unrealized loss position at September 30, 2003 and December 31, 2002, 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: <TABLE> <CAPTION> Unaudited (in millions) September 30, 2003 December 31, 2002 - ---------------------------- --------------------------- --------------------------- Gross Gross Period of time in unrealized Fair Unrealized Fair Unrealized loss position Value Loss Value Loss ------------ ------------ ------------ ------------ <S> <C> <C> <C> <C> Debt securities: 0 - 6 months $ 187.5 3.4 110.8 3.3 7 - 12 months 5.6 - 12.9 0.3 Greater than 12 months 10.8 0.9 19.8 3.0 ------------ ------------ ------------ ------------ Total debt securities 203.9 4.3 143.5 6.6 ------------ ------------ ------------ ------------ Equities: 0 - 6 months 5.2 0.2 15.6 2.3 7 - 12 months - - 15.9 3.2 Greater than 12 months 17.1 2.5 8.3 2.4 ------------ ------------ ------------ ------------ Total equities 22.3 2.7 39.8 7.9 ------------ ------------ ------------ ------------ Total $ 226.2 7.0 183.3 14.5 ============ ============ ============ ============ </TABLE> The following table presents information regarding our available-for-sale debt securities that were in an unrealized loss position at September 30, 2003 by maturity: <TABLE> <CAPTION> Amortized Fair (in millions) Cost Value - --------------------------------------------- -------- -------- <S> <C> <C> One year or less $ 24.2 23.4 Due after one year through five years 37.7 37.1 Due after five years through ten years 106.4 104.4 Due after ten years through fifteen years 39.9 39.0 Due after fifteen years - - -------- -------- Total $ 208.2 203.9 ======== ======== </TABLE> At September 30, 2003 our investment portfolio included non-investment grade securities with an amortized cost of $26.8 million, 1% of the portfolio, and a fair value of $27.6 million. At December 31, 2002, non-investment grade securities in our investment portfolio represented less than 1% of the portfolio, with an amortized cost of $14.7 million and a fair value of $13.3 million. The unrealized loss on these securities represented 12% of our total unrealized loss at September 30, 2003, and 10% at December 31, 2002. The fair value of these securities was determined by independent pricing services or bid prices provided by various broker dealers. The Company did not have a material investment in non-traded securities at September 30, 2003, or at December 31, 2002. The Company regularly reviews the diversification of the investment portfolio compared with an investment grade corporate index. At September 30, 2003, 19% of the market value of our corporate bond and preferred stock portfolios were represented by investments in banks, only one of which was in an unrealized loss position, compared with 11% in the benchmark corporate index. The average Moody's rating for the banking portfolio is "A1" with the lowest rated securities at "Baa1" and the average Standard and Poor's rating is "A", with the lowest rated security at "BBB". 18
Diversified Insurance Services Segment <TABLE> <CAPTION> Unaudited, Unaudited, Quarter ended September 30, Nine Months ended September 30, ($ IN THOUSANDS) 2003 2002 2003 2002 - ------------------------------------------ ------------ ------------ ------------- ---------------- <S> <C> <C> <C> <C> MANAGED CARE Net revenue $ 5,375 5,845 $ 17,412 17,243 Pre-tax profit 953 549 3,015 2,464 FLOOD INSURANCE Net revenue 7,386 5,268 17,917 14,036 Pre-tax profit 2,400 1,374 4,590 3,028 HUMAN RESOURCE ADMINISTRATION OUTSOURCING Net revenue 11,137 9,753 32,453 28,229 Pre-tax (loss) (520) (37) (408) (885) OTHER Net revenue 555 455 1,490 1,365 Pre-tax profit 28 19 210 291 TOTAL Net revenue 24,453 21,321 69,272 60,873 Pre-tax profit 2,861 1,905 7,407 4,898 Net income, from continuing operations 1,892 1,256 4,972 3,266 Return on net revenue 7.7 % 5.9 7.2 % 5.4 </TABLE> The Diversified Insurance Services segment's continuing operations generated $24.5 million of revenue and $1.9 million of net income for Third Quarter 2003 compared with $21.3 million of revenue and $1.3 million of net income for the Third Quarter 2002. Continuing operations from these same businesses generated $69.3 million of revenue and $5.0 million of net income for Nine Months 2003 compared with $60.9 million of revenue and $3.3 million of net income for the same period in 2002. The segment generated a return on net revenue of 7.7% for the Third Quarter 2003 and 7.2% for the Nine Months 2003, compared with 5.9% for the Third Quarter 2002 and 5.4% for the Nine Months 2002. Managed Care Our medical provider network has expanded to 92,178 locations as of September 30, 2003 from 81,454 locations as of September 30, 2002. Network and client expansion as well as pricing continue to be our key initiatives. Revenues decreased 8% to $5.4 million for Third Quarter 2003 compared with $5.8 million for Third Quarter 2002 due to the loss of several large clients. Nine Months 2003 increased slightly to $17.4 million compared with $17.2 million for Nine Months 2002. Despite reduced revenues, pre-tax profit improved to $1.0 million for Third Quarter 2003 compared with $0.5 million for Third Quarter 2002 and $3.0 million for Nine Months 2003 compared with $2.5 million for Nine Months 2002 primarily due to expense reduction initiatives. Flood Insurance Premium growth of 26.0% for Third Quarter 2003 and 23.2% for Nine Months 2003 compared with the same periods a year ago have been driven by enhanced marketing efforts with the personal lines underwriting operation. These efforts have resulted in new business of $5.6 million for Third Quarter 2003 compared with $4.0 million for the comparable period last year, and $14.6 million for Nine Months 2003 compared with $10.8 million for the same period last year. This growth brings our total premium served to $62.7 million compared with $51.4 million a year ago. Premium growth has resulted in increased servicing fees of $6.5 million for Third Quarter 2003 compared with $5.2 million for Third Quarter 2002 and $16.8 million for Nine Months 2003 compared with $13.8 million for Nine Months 2002. Included in Third Quarter 2003 net revenue is $0.8 million from claim administrative servicing fees from Hurricane Isabel claims. Pre-tax profit increased to $2.4 million due to the aforementioned growth and claim administration fees for Third Quarter 2003 compared with $1.4 million for Third Quarter 2002 and $4.6 million for Nine Months 2003 compared with $3.0 million for Nine Months 2002. Human Resource Administration Outsourcing (HR outsourcing) Revenue for Selective HR Solutions Inc., provider of our human resources administration outsourcing product, was $11.1 million for Third Quarter 2003, up 14% compared with $9.8 million last year. Nine Months 2003 increased 15% to $32.5 million compared with $28.2 million for Nine Months 2002. Pre-tax loss was $0.5 million for Third Quarter 2003, while Third Quarter 2002 broke even. For Nine Months 2003, pre-tax loss was $0.4 million compared with a pre-tax loss of $0.9 million for same period last year. Third Quarter 2003 and Nine Months 2003, were impacted by a one-time pre-tax charge of $0.5 million for the potential escheatment of certain payroll-related checks. On a year-to-date basis, pricing continues to move higher, as our workers' compensation fees increased 9.5% and client administration fees rose 6%. For Nine Months 2003, we added 4,314 new worksite lives, which pushed our total to 20,198 compared with 21,592 at the same time last year. 19
Federal Income Taxes Total federal income tax expense increased $1.4 million for Third Quarter 2003 and $6.9 million for Nine Months 2003 to $4.2 million and $12.7 million, respectively, compared with the same periods last year. 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 Third Quarter 2003 was 22%, compared with 20% for the same period last year and 23% for Nine Months 2003, compared with 16% for the same period last year. The increase is attributable to improved underwriting results, increased capital gains on investment sales and the re-balancing of our debt securities portfolio. This re-balancing increased our allocation to taxable bonds in order to maximize after-tax yield. Financial Condition, Liquidity and Capital Resources Selective Insurance Group, Inc. (Parent) is an insurance holding company whose principal assets are investments in its insurance and Diversified Insurance Services subsidiaries. The Parent's primary means of meeting its liquidity requirements is through dividends from these subsidiaries. The payment of dividends from the insurance subsidiaries is governed by state regulatory requirements, and these dividends are generally payable only from earned surplus as reported in our statutory Annual Statements as of the preceding December 31. Dividends from Diversified Insurance Services subsidiaries are restricted only by the operating needs of those subsidiaries. Based upon the 2002 statutory financial statements, the insurance subsidiaries are permitted to pay the Parent in 2003 ordinary dividends in the aggregate amount of $51.1 million. There can be no assurance that the insurance subsidiaries will be able to pay dividends to the Parent in the future in an amount sufficient to enable the Parent to meet its liquidity requirements. For additional information regarding regulatory limitations on the payment of dividends by the insurance subsidiaries to the Parent and amounts available for the payment of such dividends, refer to Note 7 to our Consolidated Financial Statements on page 54 and 55 of the 10-K section of our Annual Report to Shareholders for the year ended December 31, 2002. Dividends to stockholders are declared and paid at the discretion of the Board based upon the Company's operating results, financial condition, capital requirements, contractual restrictions and other relevant factors. On November 4, 2003 the Board has declared a 2 cent increase in the cash dividend to $0.17 per share payable to stockholders of record. The Parent has paid regular quarterly cash dividends to its stockholders for 74 consecutive years and currently plans to continue to pay quarterly cash dividends. The Parent's cash requirements include principal and interest payments on the various senior notes and subordinated debentures, dividends to stockholders and general operating expenses. Effective November 4, 2003, the Board of Directors has approved a new common stock repurchase program. Under the program, that runs until November 30, 2005, the Parent has the authority to repurchase up to 2.5 million shares. Under our previous common stock repurchase program, which ran from 1996 to May 31, 2003, the Parent had repurchased a total of 7.3 million shares of its common stock at a total cost of approximately $140.5 million. The Parent generates cash from the sale of its common stock under various stock plans, the dividend reinvestment program, and from investment income. For Nine Months 2003, cash provided by operating activities was $207.5 million compared with $130.4 million for Nine Months 2002. The improvement is a result of the significant net premium written growth and improved underwriting results. Total assets increased 12%, or $350.6 million, at September 30, 2003 from December 31, 2002. Invested assets increased $229.2 million primarily due to net purchases of $186.9 million funded by $207.5 million of operating cash flow, $33.6 million increase in net unrealized gains on the portfolio, and $10.3 million of bonds purchased in late September that did not settle until October. Increased premium volume drove increases in premium receivables of $80.0 million and deferred policy acquisition costs of $25.6 million. Reinsurance recoverable on unpaid losses and loss expenses increased $27.1 million due to $19.1 million of flood reserves from Hurricane Isabel, which we 100% ceded to the National Flood Insurance Program. Securities receivable, classified within other assets, decreased $6.0 million due to bonds sold in late December that settled in January 2003. Total liabilities increased 12%, or $288.0 million, at September 30, 2003 from December 31, 2002. Increased premium volume is primarily responsible for the increase in unearned premium reserves of $122.8 million. Loss and loss expense reserves increased $148.3 million as a result of: (i) increasing loss trends, which include inflation and rising medical costs, (ii) $19.1 million of flood reserves from Hurricane Isabel mentioned above and (iii) $10.0 million in non-flood related losses from Hurricane Isabel as of September 30, 2003. Securities payable, classified within other liabilities, increased $10.3 million for the reason noted above. Deferred federal income tax liability increased $10.8 million from a receivable of $8.7 million at December 31, 2002 to a payable of $2.1 million at September 30, 2003 primarily due to the increase in unrealized gains in the debt and equity portfolios. Notes payable decreased $24.0 million due to a scheduled payment in May on the 8.63% Senior Notes of $6.0 million and a scheduled payment in August on the 8.77% Senior Notes of $18.0 million. 20
OFF-BALANCE SHEET ARRANGEMENTS, CONTRACTUAL OBLIGATIONS AND CONTINGENT LIABILITIES AND COMMITMENTS At September 30, 2003 and 2002, the Company 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, the Company is not exposed to any financing, liquidity, market or credit risk that could arise if the Company had engaged in such relationships. Our future cash payments associated with 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, 2002. We fully expect to have the capacity to repay and/or refinance these obligations as they come due. As of September 30, 2003 we have available revolving lines of credit amounting to $45.0 million, a $5.0 million decrease from the $50.0 million available at December 31, 2002, under which no balances are outstanding as of either period. 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 16 to our consolidated financial statements on page 64 of the 10-K section of our Annual Report to Shareholders for the year ended December 31, 2002. CRITICAL ACCOUNTING POLICIES We have identified the policies below as critical to our business operations and the understanding of our results of operations. For a detailed discussion of the application of these and other accounting policies, see Note 1 to our consolidated financial statements on pages 43 through 47 of our 2002 Annual Report to Shareholders. Note that our preparation of the unaudited interim consolidated financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurance that actual results will not differ from those estimates. Reserves for Losses and Loss Expenses Significant 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 September 30, 2003, the Company had accrued $1.6 billion of loss and loss expense reserves compared with $1.4 billion at December 31, 2002. When a claim is reported to an insurance subsidiary, its 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 losses. The estimate reflects the informed judgment of such 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). 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. By using both estimates of reported claims and IBNR determined using generally accepted actuarial reserving techniques, we estimate the ultimate net liability for losses and loss expenses. We have established a range of reasonably possible IBNR losses for non-environmental net claims of approximately $523.5 million to $666.5 million at December 31, 2002. A range has not been established at September 30, 2003 because management believes it would not be meaningful. A low and high reasonable IBNR selection was derived primarily by considering the range of indications calculated using standard 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. Our net carried IBNR reserves for non-environmental claims, including loss expense reserves, were $686.5 million at September 30, 2003 and $588.5 million at December 31, 2002. The ultimate actual liability may be higher or lower than reserves established. We do not discount to present value that portion of our loss and loss expense reserves expected to be paid in future periods. However, the loss reserves include anticipated recoveries from salvage and subrogation. Reserves are reviewed by both internal and independent actuaries for adequacy on a periodic basis. When reviewing reserves, we analyze historical data and estimate the impact of various factors such as: (i) per claim information; (ii) 21
Company and industry 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. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method, however, 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. Included in the loss and loss expense reserves above are amounts for environmental claims, both asbestos and non-asbestos. 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 the Insurance Subsidiaries have contained a more expansive exclusion for losses related to environmental claims. Our asbestos and non-asbestos environmental claims have arisen primarily from exposures in municipal government, small commercial risks and homeowners policies. 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, management is not aware of any emerging trends that could 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. After taking into account all relevant factors, we believe that the reserve for net losses and loss expenses at September 30, 2003, is adequate to provide for the ultimate net costs of claims incurred as of that date. Establishment of appropriate reserves is an inherently uncertain process and there can be no certainty that currently established reserves will prove adequate in light of subsequent actual experience. Premium Revenue Net 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. 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. It should be noted that 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. 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. Deferred Policy Acquisition Costs Policy 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. The methods of making such estimates and establishing the deferred costs are continually reviewed by the Company, and any adjustments there from are made in the accounting period in which the adjustment arose. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There have been no material changes in the information about market risk set forth in our Annual Report on Form 10-K for the year-ended December 31, 2002. ITEM 4. CONTROL AND PROCEDURES Management has developed and implemented a policy and procedure for reviewing disclosure controls and procedures and internal controls on a quarterly basis. Management, including the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's 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 of the end of the period covered by this report. Based on that evaluation, the company's Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective. There have not been any changes in the company's internal controls over financial reporting (as such term is defined in Rules 13a - 15(f) and 15d - 15(f) under the Securities Exchange Act of 1934) during the fiscal quarter to which this report relates 22
that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS - NONE ITEM 2. CHANGES IN SECURITIES - NONE ITEM 3. DEFAULTS UPON SENIOR SECURITIES - NONE ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - NONE ITEM 5. OTHER INFORMATION - NONE ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (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. (b) Reports on Form 8-K: On October 8, 2003, the Company furnished a report on Form 8-K under Item 12 thereof announcing the impact of weather-related catastrophe on third quarter 2003 results. The Company's press release dated October 8, 2003 was attached as Exhibit 99.1. No other reports on Form 8-K were filed during the period covered by this report, however On May 6, 2003, the Company furnished a report on Form 8-K under Item 12 thereof (but provided under Item 9 pursuant to SEC interim guidance for Item 12) with respect to the issuance of a press release announcing its financial results for the quarter ended March 31, 2003. The Company's press release dated May 6, 2003 was attached as Exhibit 99.1. 23
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. SELECTIVE INSURANCE GROUP, INC. REGISTRANT By: /s/ Gregory E. Murphy November 11, 2003 - ---------------------------------- Gregory E. Murphy Chairman, President and Chief Executive Officer By: /s/ Dale A. Thatcher November 11, 2003 - ---------------------------------- Dale A. Thatcher Executive Vice President of Finance, Chief Financial Officer and Treasurer 24
SELECTIVE INSURANCE GROUP, INC. INDEX TO EXHIBITS <TABLE> <CAPTION> Exhibit No. - ----------- <S> <C> * 11 Statement Re: Computation of Per Share Earnings. * 31.1 Certification of Chief Executive Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002, * 31.2 Certification of Chief Financial Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002, * 32.1 Certification of Chief Executive Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002. * 32.2 Certification of Chief Financial Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002. </TABLE> - ------------------------- * Filed herewith 25