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, 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 offices) (Zip Code) (973) 948-3000 ---------------------------------------- (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such report), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the 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: Common stock, par value $2 per share, outstanding as of July 31, 2003: 27,004,834
SELECTIVE INSURANCE GROUP, INC Consolidated Balance Sheets <TABLE> <CAPTION> UNAUDITED JUNE 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: $92,592-2003; $114,785-2002) $ 87,895 109,318 Debt securities, available-for-sale - at fair value (amortized cost: $1,800,617-2003; $1,671,347-2002) 1,937,420 1,772,061 Equity securities, available-for-sale - at fair value (cost of: $143,583-2003; $ 120,036-2002) 237,557 196,913 Short-term investments - (at cost which approximates fair value) 23,508 24,700 Other investments 26,218 23,559 ------------- ---------- Total investments 2,312,598 2,126,551 Cash 568 2,228 Interest and dividends due or accrued 22,531 22,689 Premiums receivables, net of allowance for uncollectible accounts of: $3,002-2003 and $2,814-2002 433,365 353,935 Other trade receivables, net of allowance for uncollectible accounts of: $1,088-2003; $867-2002 21,162 19,769 Reinsurance recoverable on paid losses and loss expenses 10,443 7,272 Reinsurance recoverable on unpaid losses and loss expenses 163,163 160,374 Prepaid reinsurance premiums 48,397 46,141 Deferred federal income tax - 8,707 Real estate, furniture, equipment, and software development-at cost, net of accumulated depreciation and amortization 53,099 52,424 Deferred policy acquisition costs 166,519 148,158 Goodwill 43,571 42,808 Other assets 32,784 38,791 ------------- ---------- Total assets $ 3,308,200 3,029,847 ============= ========== LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES: Reserve for losses $ 1,299,838 1,232,322 Reserve for loss expenses 178,542 171,103 Unearned premiums 646,477 557,141 Senior convertible notes 115,937 115,937 Notes payable 139,500 145,500 Current federal income tax 3,636 2,565 Deferred federal income tax 10,783 - Other liabilities 201,489 153,177 ------------- ---------- Total liabilities 2,596,202 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: 41,257,983-2003; 40,780,950-2002 82,516 81,562 Additional paid-in capital 105,037 95,435 Retained earnings 582,306 562,553 Accumulated other comprehensive income 150,005 115,434 Treasury stock - at cost (shares: 14,253,553-2003; 14,185,020-2002) (196,906) (195,295) Unearned stock compensation and notes receivable from stock sales (10,960) (7,587) ------------- ---------- Total stockholders' equity 711,998 652,102 ------------- ---------- Total liabilities and stockholders' equity $ 3,308,200 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 SIX MONTHS ENDED JUNE 30, JUNE 30, (in thousands, except per share amounts) 2003 2002 2003 2002 - ----------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Revenues: Net premiums written $ 306,863 268,287 $ 630,266 549,732 Net (increase) in unearned premiums and prepaid reinsurance premiums (30,724) (23,789) (87,080) (70,939) --------- --------- --------- -------- Net premiums earned 276,139 244,498 543,186 478,793 Net investment income earned 29,436 25,100 56,779 49,604 Net realized gains (losses) 3,369 (411) 7,344 (302) Diversified insurance services revenue 23,481 20,720 44,819 39,553 Other income 662 940 1,444 1,739 --------- --------- --------- -------- Total revenues 333,087 290,847 653,572 569,387 --------- --------- --------- -------- Expenses: Losses incurred 158,997 153,289 329,725 299,794 Loss expenses incurred 30,744 25,811 59,118 50,183 Policy acquisition costs 87,731 74,734 172,280 145,428 Dividends to policyholders 1,383 1,406 2,938 3,327 Interest expense 4,451 3,499 8,990 7,005 Diversified insurance services expenses 20,801 19,121 40,273 36,560 Other expenses 1,980 2,907 3,889 5,333 --------- --------- --------- -------- Total expenses 306,087 280,767 617,213 547,630 --------- --------- --------- -------- Income from continuing operations, before federal income tax 27,000 10,080 36,359 21,757 --------- --------- --------- -------- Federal income tax expense(benefit): Current 5,644 (328) 7,424 5,163 Deferred 1,607 2,037 1,149 (2,073) --------- --------- --------- -------- Total federal income tax expense 7,251 1,709 8,573 3,090 --------- --------- --------- -------- Loss from discontinued operations, net of tax - (712) - (708) Gain on disposition of discontinued operations, net of tax - 586 - 586 --------- --------- --------- -------- Total discontinued operations, net of tax - (126) - (122) --------- --------- --------- -------- Net income $ 19,749 8,245 $ 27,786 18,545 ========= ========= ========= ======== Earnings per share: Basic net income from continuing operations $ 0.76 0.33 $ 1.07 0.75 Basic net income from discontinued operations - - - (0.01) --------- --------- --------- -------- Basic net income $ 0.76 0.33 $ 1.07 0.74 ========= ========= ========= ======== Diluted net income from continuing operations $ 0.72 0.31 $ 1.01 0.70 Diluted net income from discontinued operations - - - - --------- --------- --------- -------- Diluted net income $ 0.72 0.31 $ 1.01 0.70 ========= ========= ========= ======== Dividends to stockholders $ 0.15 0.15 $ 0.30 0.30 </TABLE> See accompanying notes to unaudited interim consolidated financial statements. 3
SELECTIVE INSURANCE GROUP, INC. Consolidated Statements of Stockholders' Equity <TABLE> <CAPTION> UNAUDITED SIX MONTHS ENDED JUNE 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: 23,545-2003; 23,052-2002) 47 46 Convertible subordinated debentures (shares: 16,522-2003; 18,219-2002) 33 37 Stock purchase and compensation plans (shares: 436,966-2003; 523,305-2002) 874 1,047 ---------- ------- End of period 82,516 80,307 ---------- ------- Additional paid-in capital: Beginning of year 95,435 77,126 Dividend reinvestment plan 531 525 Convertible subordinated debentures 86 92 Stock purchase and compensation plans 8,985 10,966 ---------- ------- End of period 105,037 88,709 ---------- ------- Retained earnings: Beginning of year 562,553 536,188 Net income 27,786 27,786 18,545 18,545 Cash dividends to stockholders ($0.30 per share) (8,033) (7,707) ---------- ------- End of period 582,306 547,026 ---------- ------- 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 34,571 34,571 2,423 2,423 ---------- ------ ------- ------ End of period 150,005 100,460 ---------- ------- Comprehensive income 62,357 20,968 ====== ====== Treasury stock: Beginning of year (195,295) (192,284) Acquisition of treasury stock (shares 68,533-2003; 96,200-2002) (1,611) (2,221) ---------- ------- End of period (196,906) (194,505) ---------- ------- Unearned stock compensation and notes receivable from stock sales: Beginning of year (7,587) (7,084) Unearned stock compensation (5,436) (5,085) Amortization of deferred compensation expense and amounts received on notes 2,063 2,426 ---------- ------- End of period (10,960) (9,743) ---------- ------- Total stockholders' equity $ 711,998 612,254 ========== ======= </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 SIX MONTHS ENDED JUNE 30, (in thousands) 2003 2002 - ------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> OPERATING ACTIVITIES Net income $ 27,786 18,545 ----------- --------- 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 72,166 48,910 Increase in unearned premiums, net of prepaid reinsurance premiums 87,080 70,938 Decrease (increase) in federal income tax recoverable 1,946 (1,919) Depreciation and amortization 4,797 4,323 Amortization of deferred compensation 2,035 2,319 Increase in premiums receivables (79,430) (65,257) Increase in other trade receivables (1,393) (1,006) Increase in deferred policy acquisition costs (18,361) (19,904) Decrease in interest and dividends due or accrued 158 162 Decrease (increase) in reinsurance recoverable on paid losses and loss expenses (3,171) 6,491 Net realized (gains) losses on investments (7,344) 302 Net realized (gain) on sale of subsidiary - (901) Increase in pension liability 3,104 1,652 Other, net 10,934 7,782 ----------- --------- Net adjustments 72,521 53,892 ----------- --------- Net cash provided by operating activities 100,307 72,437 ----------- --------- INVESTING ACTIVITIES Purchase of debt securities, available-for-sale (315,275) (324,718) Purchase of equity securities, available-for-sale (24,589) (2,678) Purchase of other investments (3,156) (688) Purchase and adjustments of subsidiaries acquired (net of cash equivalents acquired of $1,127 in 2002) (763) (3,139) Sale of subsidiary (net of cash of $385) - 15,421 Sale of debt securities, available-for-sale 130,919 148,837 Redemption and maturities of debt securities, held-to-maturity 21,472 31,883 Redemption and maturities of debt securities, available-for-sale 61,284 39,417 Sale of equity securities, available-for-sale 1,665 15,342 Proceeds from other investments 497 6 Increase in net payable for security transactions 40,261 832 Net additions to real estate, furniture, equipment and software development (4,859) (6,729) ----------- --------- Net cash used in investing activities (92,544) (86,214) ----------- --------- FINANCING ACTIVITIES Dividends to stockholders (8,033) (7,707) Principal payment of notes payable (6,000) - Acquisition of treasury stock (1,611) (2,221) Net proceeds from dividend reinvestment plan 578 571 Net proceeds from stock purchase and compensation plans 4,423 6,928 Proceeds received on notes receivable from stock sales 28 107 ----------- --------- Net cash used in financing activities (10,615) (2,322) ----------- --------- Net decrease in short-term investments and cash (2,852) (16,099) Short-term investments and cash at beginning of year 26,928 26,450 ----------- --------- Short-term investments and cash at end of period $ 24,076 10,351 =========== ========= SUPPLEMENTAL DISCLOSURES OF CASH FLOWS INFORMATION Cash paid during the period for: Interest $ 8,854 6,836 Federal income tax 6,371 4,300 Supplemental schedule of non-cash financing activity: Conversion of convertible subordinated debentures 117 127 Unearned stock compensation 5,436 5,085 </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 second quarters ended June 30, 2003 (Second Quarter 2003) and June 30, 2002 (Second Quarter 2002) and the six month periods ended June 30, 2003 (Six Months 2003) and June 30, 2002 (Six 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 amount of tax benefit included in loss from discontinued operations is $0.4 million for Second Quarter 2002 and Six Months 2002. The amount of tax expense for the Second Quarter 2002 and Six Months 2002 for the gain on disposition of discontinued operations is $0.4 million. Operating results from discontinued operations are as follows: <TABLE> <CAPTION> UNAUDITED, UNAUDITED, QUARTER ENDED SIX MONTHS JUNE 30, ENDED JUNE 30, (in thousands) 2003 2002 2003 2002 - --------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net revenue $ - 3,729 $ - 8,186 Pre-tax loss - (1,092) - (1,085) After-tax loss $ - (712) $ - (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 $6.8 million for Second Quarter 2003 and $13.1 million for Six Months 2003, compared with $5.0 million 6
for Second Quarter 2002 and $20.2 million for Six Months 2002. These transactions were eliminated in all consolidated statements. 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 or losses in the case of the Investments segment) and pre-tax income (loss) for the individual segments: <TABLE> <CAPTION> UNAUDITED, UNAUDITED, QUARTER ENDED SIX MONTHS ENDED REVENUE BY SEGMENT JUNE 30, JUNE 30, (in thousands) 2003 2002 2003 2002 - ------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> INSURANCE OPERATIONS: Commercial lines net premiums earned $ 223,722 195,192 $ 439,347 380,230 Personal lines net premiums earned 52,417 49,306 103,839 98,563 Miscellaneous income 646 653 1,338 1,423 =========== ======== =========== ======== Total insurance operations revenues 276,785 245,151 544,524 480,216 INVESTMENTS: Net investment income 29,436 25,100 56,779 49,604 Net realized gain (loss) on investments 3,369 (411) 7,344 (302) =========== ======== =========== ======== Total investment revenues 32,805 24,689 64,123 49,302 DIVERSIFIED INSURANCE SERVICES: Diversified insurance services revenues, from continuing operations 23,481 20,720 44,819 39,553 ----------- -------- ----------- -------- TOTAL ALL SEGMENTS 333,071 290,560 653,466 569,071 =========== ======== =========== ======== Other income 16 287 106 316 ----------- -------- ----------- -------- TOTAL REVENUES FROM CONTINUING OPERATIONS $ 333,087 290,847 $ 653,572 569,387 =========== ======== =========== ======== </TABLE> <TABLE> <CAPTION> UNAUDITED, UNAUDITED, INCOME (LOSS), BEFORE FEDERAL INCOME TAX QUARTER ENDED SIX MONTHS ENDED BY SEGMENT JUNE 30, JUNE 30, (in thousands) 2003 2002 2003 2002 - ------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> INSURANCE OPERATIONS: Commercial lines underwriting $ (1,256) (6,102) $ (15,464) (9,967) Personal lines underwriting (1,257) (5,215) (5,042) (10,392) ----------- -------- ----------- -------- Underwriting loss, before federal income tax (2,513) (11,317) (20,506) (20,359) INVESTMENTS: Net investment income 29,436 25,100 56,779 49,604 Net realized gain (loss) on investments 3,369 (411) 7,344 (302) ----------- -------- ----------- -------- Total investment income, before federal income tax 32,805 24,689 64,123 49,302 DIVERSIFIED INSURANCE SERVICES: Income from continuing operations, before federal income tax 2,680 1,599 4,546 2,993 ----------- -------- ----------- -------- TOTAL ALL SEGMENTS 32,972 14,971 48,163 31,936 ----------- -------- ----------- -------- Interest expense (4,451) (3,499) (8,990) (7,005) General corporate expenses (1,521) (1,392) (2,814) (3,174) ----------- -------- ----------- -------- INCOME FROM CONTINUING OPERATIONS, BEFORE FEDERAL INCOME TAX $ 27,000 10,080 36,359 21,757 =========== ======== =========== ======== </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 JUNE 30, SIX MONTHS ENDED JUNE 30, (in thousands) 2003 2002 2003 2002 - ---------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Premiums written: Direct $ 342,114 297,064 $ 694,937 603,697 Assumed 5,082 3,760 11,020 9,416 Ceded (40,333) (32,537) (75,691) (63,381) ----------- ------- ----------- -------- Net $ 306,863 268,287 $ 630,266 549,732 =========== ======= =========== ======== Premiums earned: Direct $ 308,160 270,778 $ 604,954 530,357 Assumed 6,174 4,910 11,667 9,574 Ceded (38,195) (31,190) (73,435) (61,138) ----------- ------- ----------- -------- Net $ 276,139 244,498 $ 543,186 478,793 =========== ======= =========== ======== Losses and loss expenses incurred: Direct $ 196,141 182,688 $ 405,559 363,512 Assumed 5,495 5,993 10,527 9,536 Ceded (11,895) (9,581) (27,243) (23,071) ----------- ------- ----------- -------- Net $ 189,741 179,100 $ 388,843 349,977 =========== ======= =========== ======== </TABLE> Flood business, which we cede 100% to the National Flood Insurance Program, is included in the above amounts as follows: <TABLE> <CAPTION> UNAUDITED, UNAUDITED, QUARTER ENDED SIX MONTHS JUNE 30, ENDED JUNE 30, (in thousands) 2003 2002 2003 2002 - ---------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Ceded premiums written $ (17,317) (13,858) (30,875) (25,422) Ceded premiums earned (14,239) (11,995) (27,811) (22,472) Ceded losses and loss expenses incurred (3,169) (850) (3,812) (1,956) </TABLE> Additional increases in ceded written and earned premium is primarily related to the increase in reinsurance rates and subject premium for our major reinsurance treaties. 6. COMPREHENSIVE INCOME The Company's comprehensive income for Second Quarter 2003, Six Months 2003, and the corresponding periods in the prior year are: <TABLE> <CAPTION> UNAUDITED, UNAUDITED, QUARTER ENDED SIX MONTHS JUNE 30, ENDED JUNE 30, (in thousands) 2003 2002 2003 2002 - ---------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net income $ 19,749 8,245 $ 27,786 18,545 ---------- ------ --------- ------ Other comprehensive income, increase in net unrealized gain on available-for-sale securities, net of deferred income tax effect 35,817 8,443 34,571 2,423 ---------- ------ --------- ------ Comprehensive income $ 55,566 16,688 $ 62,357 20,968 ========== ====== ========= ====== </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 8
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 $13.6 million as of June 30, 2003 and $15.5 million as of June 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 June 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 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 SIX MONTHS JUNE 30, ENDED JUNE 30, (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 2003 2002 2003 2002 - -------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net income, as reported $ 19,749 8,245 27,786 18,545 Add: Stock-based employee compensation reported in net income, net of related tax effect 724 675 1,322 1,507 Deduct: Total stock-based employee compensation expense determined under fair value-based method for all awards, net of related tax effects (753) (676) (2,365) (2,382) --------- ----- ------ ------ Pro forma net income $ 19,720 8,244 26,743 17,670 ========= ===== ====== ====== Net income per share: Basic - as reported $ 0.76 0.33 1.07 0.74 Basic - pro forma 0.76 0.33 1.03 0.71 Diluted - as reported 0.72 0.31 1.01 0.70 Diluted - pro forma 0.72 0.31 0.98 0.66 </TABLE> 9. COMMITMENTS AND CONTINGENCIES Included in other investments is approximately $26.2 million of investments in limited partnerships as of June 30, 2003, and $23.5 million as of December 31, 2002. At June 30, 2003 the Company has an additional limited partnership investment commitment of up to $25.6 million, including a $10.0 million commitment to a limited partnership, which the Company has made no investment in as of June 30, 2003. There is no certainty that any additional investment will be required. 9
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 will vigorously defend this action, as we believe the Company has significant defenses to defeat the action. Further, since the suit has only been recently filed and an answer is not required until September 12, 2003, management cannot at this time provide a meaningful estimate or range of estimates of a potential loss, if any. 10. SUBSEQUENT EVENT 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 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. 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 and $1.3 million participation in the second layer. As with the casualty treaty, the property treaty distinguishes between certified and non-certified terrorism losses. The 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 terroism 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 June 2003. 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; - uncertainties related to insurance rate increases and business retention; 10
- 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. RESULTS OF OPERATIONS The following discussion is a comparison of the second quarter ended June 30, 2003 (Second Quarter 2003) and the six month period ended June 30, 2003 (Six Months 2003) to the second quarter ended June 30, 2002 (Second Quarter 2002) and the six month period ended June 30, 2002 (Six Months 2002). Our net income was $19.7 million, or $0.72 per diluted share, for Second Quarter 2003, compared with $8.2 million, or $0.31 per diluted share, for Second Quarter 2002. Our net income was $27.8 million, or $1.01 per diluted share, for Six Months 2003, compared with $18.5 million, or $0.70 per diluted share, for Six Months 2002. Included in net income are net realized capital gains, after-tax, of $2.2 million for Second Quarter 2003 and $4.8 million for Six Months 2003, compared with net realized capital losses, after-tax, of $0.3 million for Second Quarter 2002 and $0.2 million for Six Months 2002. OPERATING SEGMENTS The Company is primarily engaged in writing property and casualty insurance. The Company has classified its businesses into three segments: Insurance Operations (commercial lines underwriting, personal lines underwriting), Investments, and Diversified Insurance Services (managed care, flood insurance and human resource administration outsourcing). Insurance Operations are evaluated based on underwriting results determined in accordance with GAAP; Investments are evaluated based on after-tax investment returns; and the Diversified Insurance Services are evaluated based on several measures including, but not limited to, results of operations determined in accordance with GAAP. For an additional description of accounting policies, refer to Note 1 to our consolidated financial statements on pages 43 through 47 of our 2002 Annual Report to Shareholders (incorporated herein by reference to our Annual Report on Form 10-K for the year ended December 31, 2002) and the discussion beginning on page 20 of this report on Form 10-Q. See Note 4 to the June 30, 2003 unaudited interim consolidated financial statements on pages 6 and 7 of this report on Form 10-Q for revenues and related income before federal income tax for each individual segment discussed below. 11
Insurance Operations Segment <TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------- Unaudited, Unaudited, ALL LINES Quarter ended June 30, Six Months ended June 30, ($ in thousands) 2003 2002 2003 2002 - ------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> GAAP INSURANCE OPERATIONS RESULTS Net premiums written $ 306,863 268,287 630,266 549,732 ========= ========== ======== ========= Net premiums earned $ 276,139 244,498 543,186 478,793 Less: Losses and loss expenses incurred 189,741 179,100 388,843 349,977 Net underwriting expenses incurred 87,528 75,309 171,911 145,848 Dividends to policyholders 1,383 1,406 2,938 3,327 --------- ---------- -------- --------- Underwriting loss $ (2,513) (11,317) (20,506) (20,359) --------- ---------- -------- --------- GAAP RATIOS: Loss and loss expense ratio 68.7 % 73.2 71.6 % 73.1 Underwriting expense ratio 31.7 % 30.8 31.7 % 30.5 Dividends to policyholders ratio 0.5 % 0.6 0.5 % 0.7 --------- ---------- -------- --------- Combined ratio 100.9 % 104.6 103.8 % 104.3 ========= ========== ======== ========= </TABLE> Net premiums written increased by approximately $38.6 million, or 14%, to $306.9 million in Second Quarter 2003 and by $80.5 million, or 15%, to $630.3 million in Six Months 2003 when compared with the same periods in 2002. Net premiums written for Second Quarter 2003 included $70.9 million in net new business written, an increase of 33% compared with $53.4 million in Second Quarter 2002. Six Months 2003 included $136.9 million in net new business written, an 11% increase over $123.1 million for Six Months 2002. The lower combined ratio reflects three-plus years of commercial lines renewal premium price increases, which were approximately 13% in Second Quarter 2003 compared with approximately 19% in Second Quarter 2002 and 14% for Six Months 2003 compared with 19% for Six Months 2003. The loss and loss expense ratio decreased 4.5 points to 68.7% for Second Quarter 2003 and 1.5 points to 71.6% for Six 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 our insurance operations. Also contributing to the decrease were lower weather-related catastrophe losses, which had an immaterial impact on our Second Quarter 2003 loss ratio, compared with 2.4 points for Second Quarter 2002. However, included in Six Months 2003 results were three weather-related catastrophe events that occurred in the first quarter of 2003, adding $11.8 million to losses incurred and 2.2 points to the loss and loss expense ratio, compared with $7.2 million and 1.5 points for Six Months 2002. The underwriting expense ratio increased 0.9 points to 31.7% for Second Quarter 2003 and 1.2 points to 31.7% for Six Months 2003 compared with the same periods last year. This increase is partially attributable to 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. Expenses realted to employee retirement plans increased $0.8 million, or 14%, for Second Quarter 2003 when compared with Second Quarter 2002 and $1.6 million, or 15%, for Six Months 2003 when compared to the same period last year. Additionally, profit-based agent commissions incurred increased $1.2 milion, or 29% for Second Quarter 2003 and $3.5 million, or 45% for Six Months 2003 when compared with the same periods one year earlier due to improved underwriting profitability. Overall productivity, as measured by fiscal year net premiums written per insurance operations employee, was approximately $639,000 for the twelve-month period ended June 30, 2003, up from $574,000 for the same period in 2002. Our strategic initiatives which are designed to either reduce costs and/or increase business include: i) streamlined processing for small commercial lines accounts (One & Done); ii) a web-based commercial lines automated system, and iii) claim and underwriting Service Centers. These initiatives are expected to reduce our underwriting expense ratio and increase our productivity measure. 12
Commercial Lines Underwriting <TABLE> <CAPTION> Unaudited, Unaudited, COMMERCIAL LINES Quarter ended June 30, Six Months ended June 30, ($ in thousands) 2003 2002 2003 2002 - -------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> GAAP INSURANCE OPERATIONS RESULTS Net premiums written $ 249,670 214,847 $ 519,424 446,761 ========= ========== ========== ========= Net premiums earned $ 223,722 195,192 $ 439,347 380,230 Less: Losses and loss expenses incurred 151,388 138,205 311,582 269,902 Net underwriting expenses incurred 72,207 61,683 140,291 116,968 Dividends to policyholders 1,383 1,406 2,938 3,327 --------- ---------- ---------- --------- Underwriting loss $ (1,256) (6,102) $ (15,464) (9,967) --------- ---------- ---------- --------- GAAP RATIOS: Loss and loss expense ratio 67.7 % 70.8 70.9 % 70.9 Underwriting expense ratio 32.3 % 31.6 31.9 % 30.8 Dividends to policyholders ratio 0.6 % 0.7 0.7 % 0.9 --------- ---------- ---------- --------- Combined ratio 100.6 % 103.1 103.5 % 102.6 ========= ========== ========== ========= </TABLE> Commercial Lines Underwriting accounted for approximately 82% of net premiums written in Six Months 2003 compared with 81% in Six Months 2002. Net premiums written increased $34.8 million, or 16%, to $249.7 million for Second Quarter 2003 and $72.7 million, or 16%, to $519.4 million for Six Months 2003 compared with the same periods in 2002. Net premiums written included $62.3 million in net new business written for Second Quarter 2003, a 35% increase when compared with $46.2 million in net new business written for Second Quarter 2002, and $120.0 million in net new business written in Six Months 2003, an 8% increase when compared with $111.2 million in net new business written in Six Months 2002. For Second Quarter 2003, the Commercial Lines Underwriting combined ratio decreased 2.5 points to 100.6% from 103.1% for the same period in 2002. The lower combined ratio reflects renewal premium price increases of 13% in Second Quarter 2003 compared with 19% in Second Quarter 2002 and 14% for Six Months 2003 compared with 19% for Six Months 2003. Importantly, retention improved 3 points for Second Quarter and 2 points for Six Months 2003, compared with the same periods last year. We monitor retention closely because ultimately, higher retentions yield better loss ratios and lower expenses. Our commercial property line, which accounted for 10% of commercial lines net premiums earned for both Second Quarter 2003 and Second Quarter 2002, was a big driver for the improvement in the quarter, posting a loss and loss expense ratio of 38.3% for Second Quarter 2003, about 31-points below the loss and loss expense ratio for Second Quarter 2002. Commercial automobile, which accounted for 28% of commercial lines net premiums earned in Second Quarter 2003 and 27% in Second Quarter 2002, also registered a strong quarter, with a loss and loss expense ratio of 64.1%, down almost seven-points compared with Second Quarter 2002. These improvements in Second Quarter 2003 were mainly due to price increases, underwriting improvements and decreased weather-related catastrophe losses of $4.3 million, or 2.3 points when compared with Second Quarter 2002. Our workers' compensation business, which accounted for 24% of commercial lines net premiums earned in Second Quarter 2003 and 25% in Second Quarter 2002, continued to under-perform, posting a loss and loss expense ratio of 87.2% for Second Quarter 2003, compared with 89.7% for Second Quarter 2002. Even though these results are unacceptable on their own, our account-based strategy ensures we do not write this line as a stand-alone product. Instead, it is offered as a companion product to one of our more profitable lines of business. In fact, less than 5% of our workers' compensation business is unsupported. Our appetite is for low-to-medium hazards that do not pose a high potential for catastrophic loss. We continue to tighten underwriting guidelines to eliminate the most unprofitable classes of business, and we're taking full advantage of rate opportunities, where allowed by law, as well as additional pricing opportunities generated by credit reductions, higher pricing tiers and limited use of dividend plans. As a result of these initiatives, over the last three years, our workers' compensation pricing increased 48%, while policy count declined to 8% of our total commercial policy count, from 9% during that same period. For the first six months of 2003, we received an additional overall price increase of 14%, including 16% in New Jersey, our largest workers' compensation market. New Jersey workers' compensation net premiums written where $15.7 million, or 6% of total commercial lines net premiums written, for Second Quarter 2003 and $34.0 million, or 7% of total commercial lines net premiums written, for Six Months 2003. Our Commercial Lines Underwriting combined ratio for Six Months 2003 increased to 103.5% from 102.6% for Six Months 2002. This 0.9 point increase is mainly attributable to weather-related catastrophe losses in First Quarter 2003 that impacted losses incurred by $10.1 million, or 2.3 points for Six Months 2003, compared with $5.2 million, or 1.4 points for Six Months 2002. Also impacting the combined ratio was the changed deferred acquisition cost amortization estimate discussed above. 13
Personal Lines Underwriting <TABLE> <CAPTION> Unaudited, Unaudited, PERSONAL LINES Quarter ended June 30, Six Months ended June 30, ($ in thousands) 2003 2002 2003 2002 - ------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> GAAP INSURANCE OPERATIONS RESULTS Net premiums written $ 57,193 53,440 $ 110,842 102,971 ========= ========== ========= ========= Net premiums earned $ 52,417 49,306 $ 103,839 98,563 Less: Losses and loss expenses incurred 38,353 40,895 77,261 80,075 Net underwriting expenses incurred 15,321 13,626 31,620 28,880 --------- ---------- --------- --------- Underwriting (loss) $ (1,257) (5,215) $ (5,042) (10,392) --------- ---------- --------- --------- GAAP RATIOS: Loss and loss expense ratio 73.2 % 82.9 74.4 % 81.2 Underwriting expense ratio 29.2 % 27.6 30.5 % 29.3 --------- ---------- --------- --------- Combined ratio 102.4 % 110.5 104.9 % 110.5 ========= ========== ========= ========= </TABLE> Personal Lines Underwriting accounted for approximately 18% of net premiums written for Six Months 2003 compared with 19% for Six Months 2002. Personal Lines Underwriting net premiums written increased $3.8 million, or 7%, to $57.2 million for Second Quarter 2003 and $7.9 million, or 8%, to $110.8 million for Six Months 2003 when compared with the same periods in 2002. Net premiums written included net new business written of $8.6 million in Second Quarter 2003, a 19% increase when compared with $7.2 million in Second Quarter 2002. Net new business written in Six Months 2003 was $16.9 million, a 42% increase over the $11.9 million written in Six Months 2002. Personal Lines Underwriting combined ratio was 102.4% for Second Quarter 2003, down 8.1 points from the same period in 2002. The decrease reflects: (i) fewer weather-related catastrophe losses of, $0.2 million, or 0.3 points, in Second Quarter 2003 compared with $1.5 million, or 3.0 points in Second Quarter 2002 mainly in our homeowners line of business, and (ii) a six-point decrease in our personal automobile combined ratio to 103.8% for Second Quarter 2003 compared with 110.0% for the same period in 2002. In New Jersey which accounted for 72% of our overall personal automobile net premiums written for Second Quarter 2003 and 2002, and 73% for Six Months 2003 and 2002 we are making progress in our personal automobile book of business as we earn higher premiums from price and tier changes. Average premium per vehicle is up 21% since December 31, 2000. These improvements are reflected in our New Jersey personal automobile loss and loss expense ratio of 73.8% for Second Quarter 2003, close to an eight-point improvement from the same period in 2002. Additionally, (i) State lawmakers passed automobile insurance reform legislation this quarter that offers the opportunity for improved rate adequacy, a less restrictive excess profits calculation, and more streamlined rate filings; (ii) New Jersey average premium per vehicle increased 10% over Second Quarter 2002 levels; and (iii) the number of insured vehicles has declined by about 2,000 since December 31, 2002 to 109,000. Efforts to control our exposure in New York, due to the high cost of required participation in the involuntary automobile insurance market, are ongoing. Our net premiums written in New York decreased 12%, to $1.8 million, for Second Quarter 2003 compared with $2.0 million for Second Quarter 2002, and 10% to $3.6 million for Six Months 2003 compared with $4.0 million for the same period last year. Since December 31, 2002, the number of vehicles we insure has dropped 12%, to below 10,000. A 15% rate increase for New York personal automobile, effective April 15, 2003, has been approved and implemented. We are pursuing additional rate increases later this year, however there is no quarantee that this request will be approved. While we've seen improvements in the loss and loss expense ratio for this business, the business remains unprofitable due to the adverse impact of the assigned risk charges incurred. The loss and loss expense ratio for Second Quarter 2003 was 64.5% compared with 77.0% for the same period last year, and 74.6% for Six Months 2003 compared with 83.0% for Six Months 2002. The assigned risk charges were $0.6 million for Second Quarter 2003 and added almost 34 points to the New York automobile personal lines underwriting expense ratio, compared with $0.9 million and 46 points for Second Quarter 2002. These charges were $1.2 million, or 34 points, for Six Months 2003 compared with $1.5 million, or 38 points, for Six Months 2002. Overall, these assigned risk charges added 1.2 points to the overall personal lines underwriting expense ratio for Second Quarter and Six Months 2003, compared with 1.8 points for Second Quarter 2002, and 1.5 points for Six Months 2002. Personal Lines Underwriting combined ratio was 104.9% for Six Months 2003, down 5.6 points from the same period in 2002. The decrease is attributable to a 6.2-point decrease in our personal automobile combined ratio to 103.8% for Six Months 2003 compared with 110.0% for the same period in 2002. These improvements reflect the pricing and other initiatives discussed above. 14
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 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 Copany 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 losses for all risks up to $75.0 million in total insured value per location. The policy provides annual certified terroism 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, over the fiscal year ending June 2003. Investments Segment Although lower interest rates continue to put pressure on investment returns, we generated a 15% increase in after-tax investment income to $21.4 million for Second Quarter 2003, up from $18.6 million for Second Quarter 2002. For Six Months 2003 we generated an 11% increase to $41.2 million, compared with $37.1 million for the same period last year. The increase reflects an increased asset base as our overall investment portfolio reached $2.3 billion at June 30, 2003, compared with $2.1 billion at December 31, 2002. The increased asset base is driven by $100.3 million of operating cash flow for Six Months 2003 compared with $72.4 million for Six 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 $1.3 million, after-tax, to investment income for Second Quarter 2003, compared with $0.1 million for Second Quarter 2002 and $1.5 million for Six Months 2003 compared with $0.4 for Six Months 2002. The after-tax portfolio yield is 3.7%, compared with 4.0% for the same period last year, reflecting downward pressure from maturing bonds that are being replaced by bonds with lower interest rates. We continue to maintain a conservative, diversified investment portfolio, with our bond holdings representing 88% of invested assets. Approximately 62% 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 15
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. There were no impairment charges recorded during Second Quarter 2003 or Second Quarter 2002. The Company realized gains and losses from the sale of available-for-sale debt and equity securities during Second Quarter 2003 and Second Quarter 2002. The following table presents the period of time that debt securities, sold at a loss during these periods, were continuously in an unrealized loss position prior to sale. Equity securities sold during these periods were not in a continuous unrealized loss position prior to sale: <TABLE> <CAPTION> Unaudited, Unaudited, Quarter ended June 30, Quarter ended June 30, (in millions) 2003 2002 - -------------------------------------------------------------------------------------------------- Fair Fair Period of time in an unrealized Value on Realized Value on Realized loss position Sale Date Loss Sale Date Loss --------- -------- --------- -------- <S> <C> <C> <C> <C> Debt securities: 0 - 6 months $ - - 7.1 4.3 7 - 12 months - - - - Greater than 12 months - - 2.3 0.6 --------- -------- --------- -------- Total debt securities $ - - 9.4 4.9 ========= ======== ========= ======== </TABLE> <TABLE> <CAPTION> Unaudited, Unaudited, Six Months ended June 30, Six Months ended June 30, (in millions) 2003 2002 - -------------------------------------------------------------------------------------------------- Fair Fair Period of time in an unrealized Value on Realized Value on Realized loss position Sale Date Loss Sale Date Loss --------- -------- --------- -------- <S> <C> <C> <C> <C> Debt securities: 0 - 6 months $ - - 7.1 4.3 7 - 12 months - - 6.7 0.3 Greater than 12 months 5.0 - 2.3 0.6 --------- -------- --------- -------- Total debt securities $ 5.0 - 16.1 5.2 ========= ======== ========= ======== </TABLE> 16
These securities were sold despite the fact that they were in a loss position due to heightened credit risk of the individual security sold, or the need to reduce our exposure to certain issuers, industries or sectors in light of changing economic conditions. UNREALIZED LOSSES The following table summarizes, for all available-for-sale securities in an unrealized loss position at June 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) June 30, 2003 December 31, 2002 - -------------------------------------------------------------------------------------------------- Gross Gross Period of time in unrealized loss Fair Unrealized Fair Unrealized position Value Loss Value Loss --------- -------- --------- -------- <S> <C> <C> <C> <C> Debt securities: 0 - 6 months $ 67.7 0.9 110.8 3.3 7 - 12 months 16.8 0.3 12.9 0.3 Greater than 12 months 19.5 2.0 19.8 3.0 --------- -------- --------- -------- Total debt securities 104.0 3.2 143.5 6.6 --------- -------- --------- -------- Equities: 0 - 6 months 12.9 0.1 15.6 2.3 7 - 12 months 9.9 0.2 15.9 3.2 Greater than 12 months 16.1 3.5 8.3 2.4 --------- -------- --------- -------- Total equities 38.9 3.8 39.8 7.9 --------- -------- --------- -------- Total $ 142.9 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 June 30, 2003 by maturity: <TABLE> <CAPTION> Amortized Fair (in millions) Cost Value - ----------------------------------------------------------------------------------- <S> <C> <C> One year or less $ 19.6 18.6 Due after one year through five years 21.2 21.0 Due after five years through ten years 39.9 38.8 Due after ten years through fifteen years 26.5 25.6 Due after fifteen years - - --------- ----- Total $ 107.2 104.0 ========= ===== </TABLE> At June 30, 2003 our investment portfolio included non-investment grade securities with an amortized cost of $21.1 million, or less than 1% of the portfolio, and a fair value of $21.8 million. At December 31, 2002, non-investment grade securities in our investment portfolio also represented less than 1% of the portfolio, with an amortized cost of $14.7 million and a fair value of $13.3 million. The unrealized loss on these securities represented 10% of our total unrealized loss at June 30, 2003, and at December 31, 2002. The fair value of these securities was determined by independent pricing services or bid prices provided by various broker dealers. The Company did not have a material investment in non-traded securities at June 30, 2003, or at December 31, 2002. The Company regularly reviews the diversification of the investment portfolio compared with an investment grade corporate index. At June 30, 2003, 20% of the market value of our corporate bond and preferred stock portfolios were represented by investments in banks, only one of which was in an unrealized loss position, compared with 11% in the benchmark corporate index. The average Moody's rating for the banking portfolio is "A1" with the lowest rated security at "Baa2" and the average Standard and Poor's rating is "A", with the lowest rated security at "B+". 17
Diversified Insurance Services Segment <TABLE> <CAPTION> Unaudited, Unaudited, Quarter ended June 30, Six months ended June 30, ($ IN THOUSANDS) 2003 2002 2003 2002 - ---------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> MANAGED CARE Net revenue $ 6,409 6,082 $ 12,037 11,398 Pre-tax profit 1,113 1,099 2,063 1,915 FLOOD INSURANCE Net revenue 5,926 4,807 10,531 8,768 Pre-tax profit 1,418 1,004 2,190 1,654 HUMAN RESOURCE ADMINISTRATION OUTSOURCING Net revenue 10,665 9,372 21,316 18,476 Pre-tax profit (loss) 36 (624) 111 (848) OTHER Net revenue 481 459 935 911 Pre-tax profit 113 120 182 272 TOTAL Net revenue 23,481 20,720 44,819 39,553 Pre-tax profit 2,680 1,599 4,546 2,993 Net income 1,779 1,068 3,080 2,010 Return on net revenue 7.6% 5.2 6.9% 5.1 </TABLE> The Diversified Insurance Services segment's continuing operations generated $23.5 million of revenue and $1.8 million of net income for Second Quarter 2003 compared with $20.7 million of revenue and $1.1 million of net income for the Second Quarter 2002. Continuing operations from these same businesses generated $44.8 million of revenue and $3.1 million of net income for Six Months 2003 compared with $39.6 million of revenue and $2.0 million of net income for the same period in 2002. The segment generated a return on net revenue of 7.6% for the Second Quarter 2003 and 6.9% for the Six Months 2003, compared with 5.2% for the Second Quarter 2002 and 5.1% for the Six Months 2002. Managed Care Our medical provider network has expanded to 89,086 locations as of June 30, 2003 from 80,400 locations as of June 30, 2002. Network and client expansion as well as pricing initiatives have resulted in an increase in managed care revenues of 5% to $6.4 million for Second Quarter 2003 compared with $6.1 million for Second Quarter 2002 and 6% to $12.0 million for Six Months 2003 compared with $11.4 million for Six Months 2002. Pre-tax profit remained relatively flat for the Second Quarter 2003 compared with the same period in 2002. Included in Second Quarter 2003 results is a one-time, pre-tax $0.5 million lease and related expense charge involving the consolidation of the managed care operation to one office location. The move is expected to generate annual pre-tax savings of $0.4 million. This charge had less of an impact on pre-tax profit for the Six Months 2003, which increased 8% to $2.1 million compared with $1.9 million for Six Months 2002. Flood Insurance Premium growth of 25% for Second Quarter 2003 and 22% for Six 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 $5.1 million for Second Quarter 2003 compared with $3.8 million for the comparable period last year, and $9.0 million for Six Months 2003 compared with $6.8 million for the same period last year. This growth brings our total premium served to $58.7 million compared with $48.8 million a year ago. Premium growth has resulted in increased servicing fees of $5.9 million for Second Quarter 2003 compared with $4.8 million for Second Quarter 2002 and $10.5 million for Six Months 2003 compared with $8.8 million for Six Months 2002. Pre-tax profit has also increased due to this growth to $1.4 million for Second Quarter 2003 compared with $1.0 million for Second Quarter 2002 and $2.2 million for Six Months 2003 compared with $1.7 million for Six Months 2002. Human Resource Administration Outsourcing (HR outsourcing) Revenue for Selective HR Solutions Inc., provider of our human resources outsourcing product, was $10.7 million for Second Quarter 2003, up 14% compared with $9.4 million last year. Six Months 2003 increased 15% to $21.3 million compared with $18.5 million for Six Months 2002. Pre-tax profit was $36,000 for Second Quarter 2003, compared with a pre-tax loss of $0.6 million for the Second Quarter 2002. For Six Months 2003, pre-tax profit was $0.1 million compared with a pre-tax loss of $0.8 million for same period last year. On a year-to-date basis, pricing continues to move higher, as our workers' compensation fees increased 11% and client administration fees rose 7%. For Six Months 2003, we added 3,500 new worksite lives, which pushed our total to 19,700. 18
Federal Income Taxes Total federal income tax expense increased by $5.5 million for both Second Quarter 2003 and for Six Months 2003 to $7.3 million and $8.6 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 Second Quarter 2003 was 27%, compared with 17% for the same period last year and 24% for Six Months 2003, compared with 14% 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. 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. Our common stock repurchase program, which commenced in 1996 terminated on May 31, 2003. Up to termination, the Parent had repurchased under the stock repurchase program 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 Six Months 2003, cash provided by operating activities was $100.3 million compared with $72.4 million for Six Months 2002. The improvement is a result of the significant net premium written growth and improved underwriting results. Total assets increased 9%, or $278.4 million, at June 30, 2003 from December 31, 2002. Invested assets increased $186.0 million primarily due to $100.3 million of operating cash flow, $53.2 million increase in net unrealized gains on the portfolio, and $34.9 million of bonds purchased in late June that did not settle until July. Increased premium volume drove increases in premium receivables of $79.4 million and deferred policy acquisition costs of $18.4 million. 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 9%, or $218.5 million, at June 30, 2003 from December 31, 2002. Increased premium volume is primarily responsible for the increase in unearned premium reserves of $89.3 million. Loss and loss expense reserves increased $75.0 million as a result of increasing loss trends, which include inflation and rising medical costs. Loss trends have increased 6% since year-end, however our price increases are outpacing these loss trends by approximately 7 points. Securities payable, classified within other liabilities, increased $34.9 million for the reason noted above. Deferred federal income tax liability increased $19.5 million from a receivable of $8.7 million at December 2002 to a payable of almost $10.8 million at June 2003 primarily due to the increase in unrealized gains in the debt and equity portfolios. Notes payable decreased $6.0 million due to a scheduled payment in May on the 8.63% Senior Notes. OFF-BALANCE SHEET ARRANGEMENTS, CONTRACTUAL OBLIGATIONS AND CONTINGENT LIABILITIES AND COMMITMENTS At June 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 19
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 June 30, 2003 and December 31, 2002 we have available revolving lines of credit amounting to $50.0 million, under which no balances are outstanding as of either period. As of July 1, 2003, our available revolving lines of credit have been revised to $45.0 million. 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 June 30, 2003, the Company had accrued $1.5 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 June 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 $624.1 million at June 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) 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 20
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 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 June 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 that have materially affected, are reasonably likely to materially affect, the Company's internal control over financial reporting. 21
PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS - On May 21, 2003, a purported class action was brought against Consumer Health Network Plus, LLC (CHN), Alta Services, LLC (Alta) and Selective Insurance Company of America (SICA), wholly-owned subsidiaries of Selective, together with ten other unrelated defendants, in the New Jersey Superior Court in Camden County by Berlin Medical Associates, P.A. and four other New Jersey health care providers. The plaintiffs allege they are entitled to unspecified compensatory damages with interest, punitive damages, attorneys fees, costs and an injunction against the defendants. The plaintiffs allege that the defendants took improper and unauthorized reductions from the providers' fees for services submitted under automobile insurance policies providing coverage for personal injury protection (PIP) under New Jersey law. The plaintiffs purport to represent the interests of a class consisting of all New Jersey healthcare providers (excluding hospitals) who are or were members of these PPOs. Defendants' responses to the complaint are due by September 12, 2003. CHN, Alta and SICA are vigorously defending against these claims. We believe the Company has significant defenses to defeat this action. 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 April 3, 2003, the Company filed a report on Form 8-K announcing the impact of weather-related catastrophe and other large property losses on first quarter 2003 results. The Company's press release dated April 3, 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. 22
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 11, 2003 - ----------------------------------------------- Gregory E. Murphy Chairman, President and Chief Executive Officer By: /s/ Dale A. Thatcher August 11, 2003 - ----------------------------------------------- Dale A. Thatcher Executive Vice President of Finance, Chief Financial Officer and Treasurer 23
SELECTIVE INSURANCE GROUP, INC. INDEX TO EXHIBITS Exhibit No. *10.1 Seventh amendment, dated June 27, 2003, effective through June 26, 2004, to the $25,000,000 Line of Credit Agreement dated October 22, 1999, between Wachovia Bank, National Association (formerly known as First Union National Bank) and Selective Insurance Group, Inc. and Selective Insurance Company of America. *10.2 Amendment, dated June 30, 2003, to the Promissory Note of $20,000,000 Line of Credit with State Street Bank and Trust Company with respect to Selective Insurance Company of America and Selective Insurance Group, Inc. *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. - -------------------- * Filed herewith 24