1 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...June 30, 2001 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) <TABLE> <S> <C> New Jersey 22-2168890 - ------------------------------------------ ------------------------------------ State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) </TABLE> <TABLE> <S> <C> 40 Wantage Avenue Branchville, New Jersey 07890 - ------------------------------------------- --------------------------- (Address of principal executive offices) (Zip Code) </TABLE> (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 the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date: Common stock, par value $2 per share, outstanding as of July 31, 2001: 25,401,667
2 SELECTIVE INSURANCE GROUP, INC Consolidated Balance Sheets <TABLE> <CAPTION> Unaudited - --------------------------------------------------------------------------------------------------------- June 30, December 31, ($ in thousands, except share amounts) 2001 2000 - --------------------------------------------------------------------------------------------------------- <S> <C> <C> ASSETS INVESTMENTS: Debt securities, held-to-maturity - at amortized cost (fair value: $206,286-2001; $231,057-2000) $ 198,762 225,177 Debt securities, available-for-sale - at fair value (amortized cost: $1,271,087-2001; $1,184,698-2000) 1,298,813 1,202,758 Equity securities, available-for-sale - at fair value (cost of: $112,497-2001; $104,830-2000) 236,305 239,578 Short-term investments - (at cost which approximates fair value) 31,760 95,908 Other investments 14,199 13,642 ---------- ---------- Total investments 1,779,839 1,777,063 Cash 8,520 8,759 Interest and dividends due or accrued 23,078 22,808 Premiums receivables 316,852 274,031 Other trade receivables 27,089 24,915 Reinsurance recoverable on paid losses and loss expenses 13,855 9,332 Reinsurance recoverable on unpaid losses and loss expenses 173,177 160,869 Prepaid reinsurance premiums 33,751 33,097 Current Federal income tax 528 1,681 Deferred Federal income tax 8,831 8,971 Real estate, furniture, equipment, and software development 56,434 57,820 Deferred policy acquisition costs 131,356 118,413 Goodwill 47,670 49,338 Other assets 26,710 25,905 ---------- ---------- Total assets $2,647,690 2,573,002 ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES: Reserve for losses $1,115,986 1,099,929 Reserve for loss expenses 167,833 172,727 Unearned premiums 483,490 436,506 Convertible subordinated debentures 3,835 3,848 Notes payable 159,786 159,786 Other liabilities 129,968 122,409 ---------- ---------- Total liabilities 2,060,898 1,995,205 ---------- ---------- STOCKHOLDERS' EQUITY: Common stock of $2 par value per share: Authorized shares: 180,000,000 Issued: 39,323,132-2001; 38,783,742-2000 78,646 77,568 Additional paid-in capital 73,179 63,074 Retained earnings 535,283 525,669 Accumulated other comprehensive income 98,497 99,325 Treasury stock - at cost (shares: 13,923,391-2001; 13,577,266-2000) (189,295) (181,552) Deferred compensation expense and notes receivable from stock sales (9,518) (6,287) ---------- ---------- Total stockholders' equity 586,792 577,797 ---------- ---------- Total liabilities and stockholders' equity $2,647,690 2,573,002 ========== ========== </TABLE> See accompanying notes to unaudited consolidated financial statements. 2
3 SELECTIVE INSURANCE GROUP, INC. Consolidated Statements of Income <TABLE> <CAPTION> ($ in thousands, except per share amounts) Unaudited Unaudited Quarter ended Six Months ended June 30, June 30, -------------------------- ------------------------- 2001 2000 2001 2000 -------------------------- ------------------------- <S> <C> <C> <C> <C> Revenues: Net premiums written $ 235,697 218,089 $ 475,613 431,050 Net increase in unearned premiums and prepaid reinsurance premiums (19,431) (17,463) (46,330) (30,598) --------- --------- --------- --------- Net premiums earned 216,266 200,626 429,283 400,452 Net investment income earned 23,920 24,498 47,728 47,798 Net realized gains 1,564 446 2,404 2,719 Diversified insurance services revenue 22,001 18,364 43,724 36,031 Other income 690 1,311 1,463 2,092 --------- --------- --------- --------- Total revenues 264,441 245,245 524,602 489,092 --------- --------- --------- --------- Expenses: Losses incurred 135,770 136,081 273,394 263,868 Loss expenses incurred 22,845 17,420 42,179 35,941 Policy acquisition costs 66,408 66,510 131,774 128,366 Dividends to policyholders 2,045 1,569 3,800 3,450 Interest expense 3,646 3,534 7,293 6,242 Diversified insurance services expenses 20,743 17,380 40,903 33,771 Other expenses 2,993 2,224 5,812 4,350 --------- --------- --------- --------- Total expenses 254,450 244,718 505,155 475,988 --------- --------- --------- --------- Income before Federal income tax 9,991 527 19,447 13,104 --------- --------- --------- --------- Federal income tax expense(benefit) : Current 669 (2,175) 1,841 (487) Deferred 431 (404) 415 (425) --------- --------- --------- --------- Total Federal income tax expense (benefit) 1,100 (2,579) 2,256 (912) --------- --------- --------- --------- Net income $ 8,891 3,106 $ 17,191 14,016 ========= ========= ========= ========= Earnings per share: Basic $ 0.36 0.12 $ 0.70 0.55 Diluted $ 0.34 0.12 $ 0.66 0.53 Dividends to stockholders $ 0.15 0.15 $ 0.30 0.30 </TABLE> See accompanying notes to unaudited consolidated financial statements. 3
4 SELECTIVE INSURANCE GROUP, INC. Consolidated Statements of Stockholders' Equity <TABLE> <CAPTION> Unaudited Unaudited June 30, June 30, ($ in thousands, except per share amounts) 2001 2000 - ----------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Common stock: Beginning of year $ 77,568 75,929 Dividend reinvestment plan (shares: 24,806-2001;34,089-2000) 49 68 Convertible subordinated debentures (shares: 1,835-2001; 172,451-2000) 4 345 Stock purchase and compensation plans (shares: 512,749-2001; 283,153-2000) 1,025 566 --------- --------- End of period 78,646 76,908 --------- --------- Additional paid-in capital: Beginning of year 63,074 53,470 Dividend reinvestment plan 524 510 Convertible subordinated debentures 9 862 Stock purchase and compensation plans 9,572 4,038 --------- --------- End of period 73,179 58,880 --------- --------- Retained Earnings: Beginning of year 525,669 514,477 Net income 17,191 17,191 14,016 14,016 Cash dividends to stockholders ($.30 per share) (7,577) (7,771) --------- --------- End of period 535,283 520,722 --------- --------- Accumulated other comprehensive income: Beginning of year 99,325 76,694 Other comprehensive income-decrease in net unrealized gains on available-for-sale securities, net of deferred income tax effect (828) (828) (2,619) (2,619) --------- ------- --------- -------- End of period 98,497 74,075 --------- --------- Comprehensive income 16,663 11,397 ======= ======== Treasury stock: Beginning of year (181,552) (143,875) Acquisition of treasury stock (shares: 346,125-2001; 1,555,385-2000) (7,743) (26,798) --------- --------- End of period (189,295) (170,673) --------- --------- Deferred compensation expense and notes receivable from stock sales: Beginning of year (6,287) (6,731) Deferred compensation expense (4,995) (2,824) Amortization of deferred compensation expense and amounts received on notes 1,764 1,598 --------- --------- End of period (9,518) (7,957) --------- --------- Total stockholders' equity $ 586,792 551,955 ========= ========= </TABLE> See accompanying notes to unaudited consolidated financial statements. 4
5 SELECTIVE INSURANCE GROUP, INC. Consolidated Statements of Cash Flows <TABLE> <CAPTION> Unaudited ($ in thousands) Six Months ended June 30, 2001 2000 ---- ---- <S> <C> <C> OPERATING ACTIVITIES Net Income $ 17,191 14,016 --------- --------- Adjustments to reconcile net income to net cash provided by operating activities: (Decrease) increase in reserves for losses and loss expenses, net of reinsurance recoverable on unpaid losses and loss expenses (1,145) 6,373 Net increase in unearned premiums and prepaid reinsurance premiums 46,330 30,598 Federal income tax 1,740 (943) Depreciation and amortization 7,575 7,288 Increase in premiums receivables (42,821) (32,882) Increase in other trade receivables (2,174) (3,870) Increase in deferred policy acquisition costs (12,943) (8,789) Increase (decrease) in interest and dividends due or accrued (270) 670 Increase in reinsurance recoverable on paid losses and loss expenses (4,523) (1,389) Net realized gains on investments (2,404) (2,719) Other- net (1,585) (8,298) --------- --------- Net adjustments (12,220) (13,961) --------- --------- Net cash provided by operating activities 4,971 55 --------- --------- INVESTING ACTIVITIES Purchase of debt securities, available-for-sale (161,001) (76,570) Purchase of equity securities, available-for-sale (14,884) (16,322) Purchase of other investments (562) (1,233) Purchase adjustments of subsidiaries acquired (97) (5,988) Sale of debt securities, available-for-sale 17,507 11,030 Redemption and maturities of debt securities, held-to-maturity 26,436 25,817 Redemption and maturities of debt securities, available-for-sale 56,637 35,193 Sale of equity securities, available-for-sale 10,331 11,527 Proceeds from other investments 5 60 Increase in net payable for security transactions 8,358 5,249 Net additions to real estate, furniture, equipment and software development (2,979) (6,476) --------- --------- Net cash used in investing activities (60,249) (17,713) --------- --------- FINANCING ACTIVITIES Dividends to stockholders (7,577) (7,771) Acquisition of treasury stock (7,743) (26,798) Net proceeds from notes payable -- 88,513 Paydown of short-term debt -- (51,302) Net proceeds from dividend reinvestment plan 573 578 Net proceeds from stock purchase and compensation plans 10,597 4,604 Increase in deferred compensation expense and amounts received on notes receivable from stock sales (4,959) (2,774) --------- --------- Net cash provided by (used in) financing activities (9,109) 5,050 --------- --------- Net decrease in short-term investments and cash (64,387) (12,608) Short-term investments and cash at beginning of year 104,667 57,395 --------- --------- Short-term investments and cash at end of year $ 40,280 44,787 ========= ========= SUPPLEMENTAL DISCLOSURES OF CASH FLOWS INFORMATION Cash paid during the period for: Interest $ 7,118 5,090 Federal income tax -- -- Supplemental schedule of non-cash financing activity: Conversion of convertible subordinated debentures 13 1,221 </TABLE> See accompanying notes to unaudited consolidated financial statements. 5
6 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The interim 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 (collectively, the "Company") 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 financial statements should be read in conjunction with the financial statements and notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2000. 2. RECLASSIFICATIONS Certain amounts in the Company's prior year consolidated financial statements have been reclassified to conform to the 2001 presentation. Such reclassification had no effect on the Company's net income or stockholders' equity. 3. CURRENT ACCOUNTING PRONOUNCEMENTS In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 141, "Business Combinations" (FAS 141), and Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" (FAS 142). FAS 141 requires the purchase method of accounting be used to record all business combinations effected after June 30, 2001. The Company does not anticipate the adoption of this statement to have a material effect on our results of operations or financial condition. FAS 142 addresses the initial recognition and measurement of goodwill and other intangible assets. FAS 142 changes the accounting for goodwill and intangible assets that have indefinite useful lives from an amortization approach to an impairment-only approach that requires those assets be tested at least annually for impairment. FAS 142 is required to be applied starting with fiscal years beginning after December 15, 2001 and is required to be applied at the beginning of an entity's fiscal year. The statement is to be applied to all goodwill and other intangible assets recognized in an entity's financial statements at that date. Impairment losses that arise due to the initial application of FAS 142 (resulting from an impairment test) are to be reported as a change in accounting principle. Goodwill amortization expense after-tax, which is included in other expenses and Diversified Insurance Services expenses, was $560,000 in Second Quarter 2001, $539,000in Second Quarter 2000, $1,119,000 in Six Months 2001 and $1,076,000 in Six Months 2000, $2,160,000 in 2000, and $1,400,000 in 1999.We are currently evaluating the impact that the adoption of FAS 142 will have on our results of operations and financial condition. 4. SEGMENT INFORMATION We are primarily engaged in writing property and casualty insurance. We have classified our business into three segments, which are Insurance Operations (commercial lines underwriting, personal lines underwriting), Investments, and Diversified Insurance Services. We evaluate the performance of the insurance segment based on its underwriting results prepared in accordance with accounting principles generally accepted in the United States of America (GAAP), we evaluate Investments performance based on after-tax investment returns, and we evaluate performance in Diversified Insurance Services in terms of net income and earnings before interest, taxes, depreciation and amortization (EBITDA) returns on revenue. The GAAP underwriting results of the Insurance Operations segment are determined taking into account net premiums earned, incurred losses and loss expenses, policy acquisition costs and other underwriting expenses and policyholders dividends. Management of the investment portfolio is separate from the other segments and, therefore, has been classified as a separate segment. The operating results of the Investments segment take into account net investment income and net realized gains and losses. The Diversified Insurance Services segment is also managed independently from the other segments and, therefore, has been classified separately. The Diversified Insurance Services segment consists of the flood business managed for the National Flood Insurance Program, medical cost containment operations, professional employer organization operations, and software development and program administration operations. The segment's results are determined taking into account the net revenues generated in each of the businesses, less the costs of operations. In computing the results of each segment, no adjustment is made for interest expense, net general corporate expenses or 6
7 federal income taxes. We do not maintain separate investment portfolios for the segments and, therefore, do not allocate assets to the segments. The following summaries present revenues (net investment income and net realized gains or losses in the case of the investments segment) and pre-tax income for the individual segments: Revenue by segment <TABLE> <CAPTION> ($ in thousands) Unaudited, Quarter Unaudited, Six Months ended June 30, ended June 30, --------------------- ---------------------- 2001 2000 2001 2000 - ----------------------------------------- --------- --------- ---------- --------- <S> <C> <C> <C> <C> INSURANCE OPERATIONS: Commercial lines net premiums earned $165,130 148,162 $327,801 294,041 Personal lines net premiums earned 51,136 52,464 101,482 106,411 -------- -------- -------- -------- Total insurance operations revenues 216,266 200,626 429,283 400,452 INVESTMENTS: Net investment income 23,920 24,498 47,728 47,798 Net realized gains on investments 1,564 446 2,404 2,719 -------- -------- -------- -------- Total investment revenues 25,484 24,944 50,132 50,517 DIVERSIFIED INSURANCE SERVICES : 22,001 18,364 43,724 36,031 -------- -------- -------- -------- Total revenues all segments 263,751 243,934 523,139 487,000 -------- -------- -------- -------- Other income 690 1,311 1,463 2,092 -------- -------- -------- -------- TOTAL REVENUES $264,441 245,245 $524,602 489,092 ======== ======== ======== ======== </TABLE> Income or (loss) before Federal income tax by segment <TABLE> <CAPTION> ($ in thousands) Unaudited, Quarter Unaudited, Six Months ended June 30, ended June 30, ------------------------- ------------------------ 2001 2000 2001 2000 - -------------------------------------------------- ----------- --------- --------- --------- <S> <C> <C> <C> <C> INSURANCE OPERATIONS: Commercial lines underwriting $ (8,759) (11,501) $(17,047) (19,718) Personal lines underwriting (2,713) (8,820) (6,696) (11,164) -------- -------- -------- -------- Underwriting loss, before Federal income tax (11,472) (20,321) (23,743) (30,882) INVESTMENTS: Net investment income 23,920 24,498 47,728 47,798 Net realized gains on investments 1,564 446 2,404 2,719 -------- -------- -------- -------- Total investment income, before Fed. income tax 25,484 24,944 50,132 50,517 DIVERSIFIED INSURANCE SERVICES: Income before federal income tax 1,258 984 2,822 2,260 -------- -------- -------- -------- TOTAL ALL SEGMENTS 15,270 5,607 29,211 21,895 Interest expense (3,646) (3,534) (7,293) (6,242) General corporate expenses (1,633) (1,546) (2,471) (2,549) -------- -------- -------- -------- INCOME BEFORE FEDERAL INCOME TAX $ 9,991 527 $ 19,447 13,104 ======== ======== ======== ======== </TABLE> 7
8 5. REINSURANCE The following is a table of assumed and ceded amounts by income statement caption: <TABLE> <CAPTION> Unaudited, Quarter ended Unaudited, Six Months ended June 30, June 30, - ------------------------------------------------------------------------------------- ($ in thousands) 2001 2000 2001 2000 - ------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Premiums written: Assumed $ 2,355 1,361 $ 7,515 6,164 Ceded (26,313) (23,107) (51,125) (44,379) Premiums earned: Assumed 3,756 3,129 7,253 6,567 Ceded (25,377) (23,115) (50,471) (45,606) Losses incurred: Assumed(1) 3,098 745 8,844 1,221 Ceded(1) (15,140) (13,914) (39,126) (31,953) Loss expenses incurred: Assumed 214 33 394 472 Ceded (743) (543) (1,087) (1,119) </TABLE> (1) Assumed and ceded losses increased compared to the comparable period in the prior year due to a large commercial property fire loss in the first quarter of 2001 combined with increased participation in involuntary plans as a result of increases in our voluntary net premiums written. FORWARD-LOOKING STATEMENTS Some of the statements in this report are not historical facts and are "forward-looking statements" (as defined in the Private Securities Litigation Reform Act of 1995), which can be identified by terms such as "believes," "expects," "may," "will," "should," "anticipates," "benefits," the negatives thereof, or by discussions of strategy. Such forward-looking statements involve opinions and predictions, and no assurance can be given that the future results will be achieved since events or results may differ as a result of risks facing the Company. These include, but are not limited to: economic, market or regulatory conditions; reinsurance costs and availability; risks associated with Selective's entry into new markets; diversification in both geographic and business operations; catastrophic events; uncertainties related to rate increases and business retention; changes in New Jersey automobile insurance laws and regulations; and other risks and uncertainties we identify in filings with the Securities and Exchange Commission, including, but not limited to the Annual Report on Form 10-K, although we do not promise to update such forward - looking statements to reflect actual results or changes in assumptions or other factors that could affect these statements. 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 and liquidity for the interim periods indicated. RESULTS OF OPERATIONS The following discussion is a comparison of the second quarter ended June 30, 2001 (Second Quarter 2001) and the six month period ended June 30, 2001 (Six Months 2001) to the second quarter ended June 30, 2000 (Second Quarter 2000) and the six month period ended June 30, 2000 (Six Months 2000). Our net income was $8.9 million, or $0.34 per diluted share, for Second Quarter 2001 compared to $3.1 million, or $0.12 per diluted share, for Second Quarter 2000. Our net income was $17.2 million, or $0.66 per diluted share, for Six Months 2001 compared to $14.0 million, or $0.53 per diluted share, for Six Months 2000. Operating income was $7.9 million, or $0.30 per diluted share, for Second Quarter 2001 compared to $2.8 million, or $0.11 per diluted share, for Second Quarter 2000. Our operating income was $15.6 million, or $0.60 per diluted share, for Six Months 2001 compared to $12.2 million, or $0.46 per diluted share, for Six Months 2000. Operating income, which differs from net income by the exclusion of realized gains or losses on investment sales, is used as an important financial measure by management, analysts and investors but is not intended as a substitute for net income prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). 8
9 OPERATING SEGMENTS We are primarily engaged in writing property and casualty insurance. We have classified our business into three segments, each of which is managed separately. The three segments are Insurance Operations (commercial lines underwriting and personal lines underwriting), Investments and Diversified Insurance Services. We evaluate the performance of the insurance segment based on underwriting results prepared in accordance GAAP, we evaluate performance in Investments based on after-tax investment returns, and we evaluate performance in Diversified Insurance Services based on net income and earnings before interest, taxes, depreciation and amortization (EBITDA) and returns on revenue. For an additional description of accounting policies, refer to Note 1 to our Consolidated Financial Statements on pages 42 through 44 of the Annual Report to shareholders for the year ended December 31, 2000 incorporated by reference in our Annual Report on Form 10-K for the year ended December 31, 2000. See Note 4 to the June 30, 2001 Unaudited Consolidated Financial Statements on pages 6 and 7 of this report on Form 10-Q for revenues and related income before Federal income taxes for each individual segment discussed below. Insurance Operations Segment <TABLE> <CAPTION> ($ in thousands) Unaudited, Quarter ended Unaudited, Six Months ended June 30, June 30, 2001 2000 2001 2000 ------------------------- ------------------------ <S> <C> <C> <C> <C> TOTAL INSURANCE OPERATIONS Net premiums written $ 235,697 218,089 475,613 431,050 ========= ========= ========= ========= Net premiums earned $ 216,266 200,626 429,283 400,452 Losses and loss expenses incurred 158,616 153,501 315,573 299,809 Net underwriting expenses incurred 67,078 65,877 133,653 128,075 Dividends to policyholders 2,044 1,569 3,800 3,450 --------- --------- --------- --------- Underwriting loss $ (11,472) (20,321) (23,743) (30,882) --------- --------- --------- --------- GAAP RATIOS: Loss and loss expense ratio 73.3 % 76.5 73.5 % 74.8 Underwriting expense ratio 31.1 % 32.8 31.1 % 32.0 Dividends to policyholders ratio 0.9 % 0.8 0.9 % 0.9 --------- --------- --------- --------- Combined ratio 105.3 % 110.1 105.5 % 107.7 ========= ========= ========= ========= </TABLE> Net premiums written increased by approximately $18 million, or 8%, to $236 million in Second Quarter 2001 and $45 million, or 10%, to $476 million in Six Months 2001when compared to the same periods last year. Net premiums written included $45 million in net new business written for Second Quarter 2001, an increase of 15% compared to $39 million in Second Quarter 2000. Six Months 2001 included $97 million in net new business written, an 11% increase over $87 million for Six Months 2000. Commercial lines net premiums written increased 11% for Second Quarter 2001 and 14% for Six Months 2001 when compared to the same periods last year. The increase reflected an average commercial lines renewal premium increase of 15% for both periods in 2001. Personal lines net premiums written declined 2% for Second Quarter 2001 mainly due to a decrease in the number of New Jersey private passenger automobile policies written. The combined ratio decreased 4.8 points to 105.3% for Second Quarter 2001 and 2.2 points to 105.5% for Six Months 2001 when compared to the same periods last year. The improvement reflected several factors, including: (i) increasing profit margins in our commercial lines business, which comprises close to 80% of our insurance operations, and (ii) lower weather-related catastrophes in 2001that resulted in an improvement of 1.6 points for Second Quarter 2001 and .7 points for Six Months 2001 when compared to the same periods in 2000. The underwriting expense ratio decreased 1.7 points to 31.1% for Second Quarter 2001 and decreased .9 points to 31.1% for Six Months 2001 compared to the same periods last year. Costs that vary with premium volume declined,including commission expense which decreased due to lower commissions paid to independent insurance agents combined with higher flood servicing commissions earned from the National Flood Insurance Program, which partially offset commission expense. Partially offsetting the decrease in commission expense, labor costs increased due to increased employee benefit costs, new hires, and an increase in the expected payout for our incentive-based reward plan. Overall, productivity, as measured by fiscal year net premiums written per Insurance Operations employee, was approximately $495,000 for the twelve-month period ended June 30, 2001, up from $465,000 for the same period last year. Our strategic initiatives which are designed to either reduce costs and/or increase business include: i) streamlined processing for small commercial lines accounts (One & Done); ii) the Mobile Claim System; and iii) the consolidation of the two New Jersey offices and the consolidation of the Virginia and Maryland regional offices in conjunction with the formation 9
10 of a service center in Virginia. These initiatives are expected to continue to reduce our expense ratio and increase our productivity measure. Commercial Lines Underwriting <TABLE> <CAPTION> COMMERCIAL LINES Unaudited, Quarter ended Unaudited, Six Months June 30, ended June 30, ($ in thousands) 2001 2000 2001 2000 ---------- --------- ----------- --------- <S> <C> <C> <C> <C> GAAP INSURANCE OPERATIONS RESULTS Net premiums written $ 182,005 163,475 $ 371,564 325,540 ========= ========= ========= ========= Net premiums earned $ 165,130 148,162 327,801 294,041 Losses and loss expenses incurred 117,586 107,406 235,380 212,749 Net underwriting expenses incurred 54,258 50,688 105,668 97,560 Dividends to policyholders 2,045 1,569 3,800 3,450 --------- --------- --------- --------- Underwriting loss $ (8,759) (11,501) $ (17,047) (19,718) --------- --------- --------- --------- GAAP RATIOS: Loss and loss expense ratio 71.2 % 72.5 71.8 % 72.3 Underwriting expense ratio 32.9 % 34.2 32.2 % 33.2 Dividends to policyholders ratio 1.2 % 1.1 1.2 % 1.2 --------- --------- --------- --------- Combined ratio 105.3 % 107.8 105.2 % 106.7 ========= ========= ========= ========= </TABLE> Commercial Lines Underwriting, which consists of six strategic business units (SBUs), accounted for approximately 78% of net premiums written in Six Months 2001 compared to 76% in Six Months 2000. Net premiums written increased $19 million, or 11%, to $182 million for Second Quarter 2001 and $46 million, or 14%, to $372 million for Six Months 2001 compared to the same periods in 2000. Net premiums written included $38 million in net new business written for Second Quarter 2001, a 33% increase when compared to $28 million in net new business written for Second Quarter 2000, and $82 million in net new business written in Six Months 2001, a 26% increase when compared to $65 million in net new business written in Six Months 2000. All commercial SBUs reflected increased net premiums written when compared to the prior year. With commercial lines comprising close to 80% of our overall net premiums written, we are taking advantage of the positive pricing trends in the marketplace and the price increases are expected to have a favorable impact on our overall results. In both the Second Quarter 2001and Six Months 2001, we increased renewal premium year over year by approximately 15%, of which about 10 points represented price increases. Renewal retention remained consistent with 2000 for both Second Quarter 2001 and Six Months 2001. For Second Quarter 2001, the Commercial Lines combined ratio decreased 2.5 points to 105.3% and decreased 1.5 points to 105.2% for Six Months 2001 when compared to the same periods in 2000. The lower combined ratio for 2001 reflected an improvement in profitability due to approximately 15% higher premium rates while loss trends have increased approximately 8%. The increase in loss trends reflected higher medical inflation in workers' compensation and auto bodily injury claims as well as higher property claims. The Second Quarter 2001 lower combined ratios also reflected a one-point decrease in catastrophe losses when compared to Second Quarter 2000. 10
11 Personal Lines Underwriting <TABLE> <CAPTION> Unaudited, Quarter Unaudited, Six Months PERSONAL LINES ended June 30, ended June 30, ($ in thousands) 2001 2000 2001 2000 ----------- ---------- ---------- ----------- <S> <C> <C> <C> <C> GAAP INSURANCE OPERATIONS RESULTS Net premiums written $ 53,692 54,614 $ 104,049 105,510 ========= ========= ========= ========= Net premiums earned $ 51,136 52,464 101,482 106,411 Losses and loss expenses incurred 41,029 46,095 80,193 87,060 Net underwriting expenses incurred 12,820 15,189 27,985 30,515 --------- --------- --------- --------- Underwriting (loss) $ (2,713) (8,820) (6,696) (11,164) --------- --------- --------- --------- GAAP RATIOS: Loss and loss expense ratio 80.2 % 87.9 79.0 % 81.8 Underwriting expense ratio 25.1 % 28.9 27.6 % 28.7 --------- --------- --------- --------- Combined ratio 105.3 % 116.8 106.6 % 110.5 ========= ========= ========= ========= </TABLE> Personal Lines Underwriting accounted for approximately 22% of net premiums written for Six Months 2001 compared to 24% for Six Months 2000. Personal Lines Underwriting net premiums written decreased $.9 million, or 2 %, to $54 million for Second Quarter 2001 and $1 million, or 1%, to $104 million for Six Months 2001 when compared to the same periods in 2000. Net premiums written included net new business written of $7 million in Second Quarter 2001, a 34% decrease when compared to $11 million net new business written in Second Quarter 2000, and $15 million net new business written in Six Months 2001 a 31% decrease when compared to $22 million net new business written in Six Months 2000. The Personal Lines SBU combined ratio was 105.3% for Second Quarter 2001, down 11.5 points from the same period in 2000. The improvement includes decreases of: (i) 3.3 points due to lower weather-related catastrophes in Second Quarter 2001 compared to Second Quarter 2000, (ii) approximately 1 point due to the improvement in the Southern region combined ratio in excess of the 44 points attributable to reduced weather related catastrophes in 2001; the ratio was 111.9% in Second Quarter 2001 compared to 169.1% the same period last year; (iii) approximately 1.5 points due to a decrease in our New Jersey private passenger automobile combined ratio to 109.0% for Second Quarter 2001 compared to 111.5% for the same period last year; and (iv) approximately 1point due to a decrease in the combined ratio for our expansion states' personal lines business to 123.2% for Second Quarter 2001 compared to 127.5% for Second Quarter 2000. These improvements reflect reduced catastrophes, price increases and stricter underwriting standards. The Personal Lines SBU combined ratio was 106.6% for Six Months 2001, down 4 points from the same period in 2000. The improvement included a decrease of 1.7 points due to lower weather-related catastrophes in Six Months 2001 compared to the same period last year. While our New Jersey private passenger automobile combined ratio improved to 109.0% for Second Quarter 2001, compared to a 111.5% for Second Quarter 2000, the New Jersey personal automobile marketplace remains a significant challenge. For Six Months 2001 this combined ratio increased to 111.0% compared to 108.0% for Six Months 2000. We believe our rates remain inadequate and we filed for an overall 18.9% rate increase in July 2000. The filing seeks to increase our liability rates which have historically been inadequate and to reduce physical damage rates which are redundant. The filing is still pending and we do not expect a final decision from the New Jersey insurance department before the November 2001 New Jersey Gubernatorial election. In addition to the rate filing, we are in discussions with the New Jersey insurance department regarding revisions to our tier rating structure that determines how we price new business. The Urban Enterprise Zone (UEZ) Program requires New Jersey auto insurers to write, at their voluntary rate levels, an amount of urban auto insurance proportionate to their voluntary market share, which is currently estimated at 2.7% for Selective. As of July 2001, we are in compliance with the assigned number of policies required under the plan and expects to remain in compliance for the balance of 2001. Net premiums earned under the UEZ program declined slightly to $4.1 million for Second Quarter 2001 compared to $4.2 million for Second Quarter 2000 and decreased $.6 million for Six Months 2001 to $8 million from $8.6 million for Six Months 2000. This business continues to generate combined ratios of almost 200%. We are seeking to write business in the UEZ territories through our independent agencies. This will allow us to fill our required share of this business with more adequately 11
12 priced full coverage policies and avoid additional assignments in order to improve results. Other insurance companies comprising nearly 25% of the New Jersey private passenger automobile market have announced plans to withdraw or reduce their writings in the state. As a result of these actions, policyholders with those companies may be forced to seek automobile coverage from other carriers, including Selective, in an insurance marketplace with dramatically reduced capacity. This potential market change may considerably affect our risk of involuntarily increasing our market share in New Jersey. See Part II, Item 5. Other Information on page 15 of this quarterly report on Form 10-Q. 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. Poor property results and a hardening of the reinsurance market resulted in reinsurance premium increases upon renewal of the property and casualty excess of loss treaties. We increased the retention on our property excess of loss program to cover each property occurrence in excess of $2 million up to $15 million, effective July 1, 2001. Prior to this change each property occurrence in excess of $1 million was covered up to $15 million. We estimate that this retention change combined with increased reinsurance premium rates, will result in a net additional cost of $8 million related to both reinsurance premiums and retained loss costs compared to the twelve month policy period ended June 30, 2001. The casualty excess of loss treaty was also renewed effective July 1, 2001 for an increased $4.6 million in reinsurance premium, an increase of almost 100% compared to the twelve-month policy period ended June 30, 2001. Approximately $6 million of the increased cost for reinsurance will be reflected in the third and fourth quarters of 2001, with the other $6 million reflected in the first and second quarters of 2002. INVESTMENTS SEGMENT Net investment income earned for Second Quarter 2001 was $24 million compared to $25 million for Second Quarter 2000 and $48 million for Six Months 2001 compared to $48 million for Six Months 2000. Net investment income earned after-tax for Second Quarter 2001 was $18 million compared to $19 million for the same period last year and $36 million for Six Months 2001 compared to $37 million for Six Months 2000. We had a 4.2% annualized after-tax investment yield for Six Months 2001, down slightly from 4.5% in 2000 reflecting the lower yields currently available for investment. For example, the ten-year treasury rate decreased over sixty basis points to 5.4% at June 30, 2001 compared to 6.03% at June 30, 2000. The year 2000 was a favorable year for our limited partnership investments that would be difficult to duplicate. For Second Quarter 2001, limited partnership investment income is down $0.5 million after-tax from last year, almost fully accounting for the variance in investment income. Realized investment gains after-tax for Second Quarter 2001 increased to $1 million compared to $0.3 million for Second Quarter 2000 and decreased $0.2 million to $1.6 million for Six Months 2001 when compared to the same periods last year. Realized investment gains and losses fluctuate based on investment decisions regarding individual securities as well as tax planning considerations. 12
13 DIVERSIFIED INSURANCE SERVICES SEGMENT <TABLE> <CAPTION> Unaudited Unaudited, Quarter ended Six Months ended June 30, June 30, - ---------------------------------------------------------------------------------------------------------- ($ in thousands) 2001 2000 2001 2000 - ---------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> FLOOD INSURANCE Net Revenue $ 3,423 2,890 $ 6,512 5,487 Income Before Federal Income Tax 400 494 751 965 MEDICAL COST CONTAINMENT Managed Care Net Revenue 2,688 2,053 5,314 3,764 Income Before Federal Income Tax 685 421 1,262 819 Preferred Provider Organization Net Revenue 1,944 1,271 3,931 2,661 Income Before Federal Income Tax 286 260 759 292 PROFESSIONAL EMPLOYER ORGANIZATION Net Revenue 8,737 7,236 17,676 14,361 Loss income Before Federal Income Tax (244) 51 (125) 348 SOFTWARE DEVELOPMENT AND PROGRAM ADMINISTRATION Net Revenue 4,827 4,661 9,519 9,202 Income loss Before Federal Income Tax 36 (276) (32) (277) OTHER Net Revenue 382 253 773 556 Income Before Federal Income Tax 95 34 207 113 TOTAL Net Revenue 22,001 18,364 43,724 36,031 Income Before Federal Income Tax 1,258 984 2,822 2,260 Net Income 770 614 1,774 1,409 Return on Net Revenue 3.5% 3.3% 4.1% 3.9% </TABLE> Diversified Insurance Services segment generated $22.0 million of revenue and $0.8 million of net income for Second Quarter 2001 compared to $18.4 million of revenue and $0.6 million of net income for the Second Quarter 2000. These same businesses generated $43.7 million of revenue and $1.8 million of net income for Six Months 2001 compared to $36.0 million of revenue and $1.4 million of net income for the same period in 2000. Earnings before interest, taxes, depreciation, and amortization (EBITDA) increased 15.6% to $2.8 million for Second Quarter 2001 and 13.5% to $5.9 million for Six Months 2001 compared to the same periods in 2000. The segment generated a return on net revenue of 3.5% for the Second Quarter 2001 and 4.1% for the Six Months 2001, relatively flat compared to the prior year. We expect continued revenue growth in this segment and increased opportunities for these businesses working together with the Insurance Operations. Flood Insurance Direct premiums written attributable to flood insurance increased 18.0% to $10.1 million during Second Quarter 2001 and 18.1% to $19.1 million for Six Months 2001 compared to the same periods one year ago. These increases in premiums resulted in corresponding increases in our underwriting revenues. In addition to underwriting revenues, we generate revenues for handling claims. Together these fees generated $3.4 million of revenue in Second Quarter 2001 compared to $2.9 million in Second Quarter 2000 and $6.5 million of revenue in Six Months 2001 compared to $5.5 million of revenue for Six Months 2000. While premium volume increased, the positive impact on revenue was partially offset by a decreased commission rate received from the National Flood Insurance Program. This factor combined with increased expenses due to start-up costs associated with FloodConnect, LLC reduced pre-tax profit for this unit to $0.4 million in Second Quarter 2001 compared to $0.5 million in Second Quarter 2000 and $0.8 million for Six Months 2001 compared to $1.0 million for Six Months 2000. In July 2001, Selective purchased a Florida based book of flood insurance business. The acquired book includes approximately $4.5 million in premium and just over 15,000 policies, which is anticipated to result in an approximate increase in our annual revenues of $1.4 million. 13
14 Medical Cost Containment - Alta Services (Alta) and Consumer Health Network (CHN) During 2001, Alta increased its client base and generated revenue of $2.7 million in Second Quarter 2001 compared to $2.1 million in Second Quarter 2000 and $5.3 million in Six Months 2001 compared to $3.8 million in Six Months 2000. Pre-tax net income was $0.7 million in the Second Quarter 2001 compared to $0.4 million in Second Quarter 2000 and $1.3 million for Six Months 2001 compared to $0.8 million in Six Months 2000. CHN, our preferred provider organization, has continued to expand its number of network providers, which now includes over 55,000 locations as of the end of the Second Quarter 2001 compared to 46,000 a year ago. An increase in the number of locations coupled with an increase in network utilization generated $1.9 million in revenue in Second Quarter 2001 compared to $1.3 million in Second Quarter 2000 and $3.9 million in Six Months 2001 as compared with $2.7 million in Six Months 2000. CHN's pre-tax net income was $0.3 million during Second Quarter 2001 compared to $0.3 million in Second Quarter 2000 and $0.8 million for Six Months 2001 compared to $0.3 million for Six Months 2000. Professional Employer Organization (PEO) - Selective HR Solutions We have continued to introduce the PEO product in our operating territories during the first half of 2001, building on existing agent/businessowner relationships. During the past year and a half 252 agents have signed on to sell the PEO product with 80 agents making PEO Sales. The number of PEO worksite employees has increased from just under 15,000 a year ago to just over 21,000. Selective HR Solutions generated $8.7 million in revenue in Second Quarter 2001 compared to $7.2 million in Second Quarter 2000 and $17.7 million for Six Months 2001 compared to $14.4 million for Six Months 2000. Variable and infrastructure costs continue to offset the revenue growth, which resulted in a pre-tax loss of $0.2 million during Second Quarter 2001 compared to pre-tax net income of $0.1 million in Second Quarter 2000 and a pre-tax loss of $0.1 million for Six Months 2001 compared to pre-tax net income of $0.3 million for Six Months 2000. Software Development and Program Administration -- PDA Software Services, Inc. PDA broke even for Second Quarter 2001 compared to a loss of $0.3 million during the same period a year ago. Six Month 2001 results were the same as Six Months 2000. These results included acquisition-related costs such as retention bonuses and the amortization of goodwill of $0.5 million in Second Quarter and $1.0 million for Six Months 2001and 2000. The retention bonuses will continue as charges against income through 2002. Revenues were $4.8 million in Second Quarter 2001 compared to $4.7 million in Second Quarter 2000 and $9.5 million in Six Months 2001 compared to $9.2 million in Six Months 2000. FEDERAL INCOME TAXES Total Federal income tax expense increased by $3.7 million to an expense of $1 million for the Second Quarter 2001and by $3 million to an expense of $2 million for Six Months 2001. The increases reflect higher income for the year primarily attributable to a reduction in underwriting losses. Our effective tax rate differs from the Federal corporate rate of 35% primarily as a result of tax-exempt investment income. FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES Selective Insurance Group, Inc. (Parent) is an insurance holding company whose principal assets are its 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 on our statutory annual statements as of the preceding December 31. The Parent's cash requirements also include the cost of shares of common stock repurchased under its common stock repurchase program. As of June 30, 2001, the Parent had repurchased a total of 7.2 million shares at a total cost of $138 million under the program, of which 0.2 million shares were repurchased during First Quarter 2001 at a total cost of $5 million. There were no repurchases made during Second Quarter 2001. On May 4, 2001, the Board of Directors extended the expiration date of the stock repurchase program to May 31, 2002. There are 800,000 shares remaining under the current authorization of 8 million shares. In addition to the cash requirements of the Parent, our overall obligations and cash outflow of the Company also include: claim settlements; commissions; labor costs; premium taxes; general and administrative expenses; investment purchases and capital expenditures. The insurance subsidiaries satisfy their obligations and cash outflow through premium collections, interest and dividend income and maturities of investments. Cash provided by operating activities was $5 million for Six Months 2001 compared to $55,000 for Six Months 2000. The $5 14
15 million increase in cash provided by operating activities was due to the improvement in underwriting results compared to last year. Total assets increased 2.9%, or $75 million, from December 31, 2000 to June 30, 2001. This increase was primarily due to the increase in premium receivables of $43 million resulting from overall premium growth and the seasonality of our book of business, which generates higher volumes of premiums written in the first and second quarter of each year, compared to the fourth quarter. The fluctuations in premium volume have a corresponding impact on outstanding receivables. Additionally, increased use of extended pay plans by policyholders increased the receivable balance by approximately $13 million. Reinsurance recoverables on unpaid losses and loss expenses increased $12 million, and deferred policy acquisition costs increased $13 million due to the growth in premiums written. The increase in total liabilities of 3.3%, or $66 million, from December 31, 2000 to June 30, 2001 was mainly attributable to an increase in unearned premiums of $47 million due to the premiums written fluctuation discussed above. Our reserve for losses increased $16 million due to the growth in premiums written. RECENT LEGISLATION REGARDING PRIVACY OF CONSUMER FINANCIAL INFORMATION On June 1, 2000, federal regulators issued final regulations implementing the provisions of the Financial Services Modernization Act of 1999, also known as the Gramm-Leach-Bliley Act (the "Act"), governing the privacy of consumer financial information. The regulations became effective on November 13, 2000, and the date for compliance with the regulations was July 1, 2001. The regulations limit disclosure by financial institutions of "nonpublic personal information" about individuals who obtain financial products or services for personal, family, or household purposes. The Act and the regulations generally apply to disclosures to nonaffiliated third parties, subject to specified exceptions, but not to disclosures to affiliates. Many states in which we operate have adopted laws that are at least as restrictive as the Act and the regulations. This is an evolving area of regulation requiring our continued monitoring. While we believe we are in compliance with all currently effective and applicable laws effecting our operations, we cannot currently quantify the financial impact we will incur to satisfy revised or additional regulatory requirements that may be imposed in the future. 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, 2000. 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 - The following risk factor is added to the risk factors disclosed in the registrant's Annual Report on Form 10-K for the year ended December 31, 2000: A change in our market share in New Jersey could adversely impact the results in our private passenger automobile business. Insurance companies having an aggregate share of nearly 25% of the market for New Jersey private passenger automobile insurance have publicly announced their intentions to either withdraw from New Jersey or to reduce their writing of private passenger automobile insurance in New Jersey. It is uncertain whether these insurance companies will actually follow through on their announced intentions. The impact of their actions, if any, are also uncertain. However, the withdrawal from New Jersey of insurance companies that write a significant amount of private passenger automobile insurance coverage or the reduction in their writing of that coverage could result in an increase in our market share in New Jersey because of the "take all comers" provision 15
16 of the NJ insurance law. The "take all comers" provision, which applies to insurance companies writing private passenger automobile insurance in the state, requires the insurance companies to insure all drivers who meet certain state mandated eligibility requirements. The New Jersey Urban Enterprise Zone program requires New Jersey auto insurers to involuntarily write private passenger automobile insurance at the same premium rates that are applicable to policies which the insurers voluntarily write. The amount of involuntary insurance which an insurer must write in New Jersey depends on the insurer's market share in New Jersey - the greater the market share the more involuntary coverage the insurer is required to write. The underwriting of involuntary personal automobile insurance in New Jersey is unprofitable. The "take all comers" provision of the law requires us to insure all drivers who meet certain state mandated eligibility requirements. Private passenger automobile insurance which we write in New Jersey currently accounts for approximately 14% of the total net premiums written in our insurance segment, and the UEZ portion of that business is approximately 2%. The Company's results of operations in this segment could be materially adversely affected if the Company was required to write significantly more involuntary automobile insurance. 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: There were no reports on Form 8-K filed during the period covered by this report. 16
17 SELECTIVE INSURANCE GROUP, INC. INDEX TO EXHIBITS Exhibit No. 10.16a Termination agreement, dated May 3, 2001 between Selective Insurance Company of America and Sharon R. Cooper, filed herewith. 11 Statement Re: Computation of Per Share Earnings, filed herewith. 17
18 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 August 13, 2001 - --------------------------------------------------- Gregory E. Murphy Chairman, President and Chief Executive Officer By: /s/ Dale A. Thatcher August 13, 2001 - --------------------------------------------------- Dale A. Thatcher Senior Vice President of Finance, Chief Financial Officer and Treasurer 18