PAGE UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark one) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended . . . . . . . . .September 30, 1998 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 (I.R.S. Employer Identification No.) of 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 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 October 31, 1998: 28,236,811 -1- PAGE SELECTIVE INSURANCE GROUP, INC. ------------------------------- Consolidated Balance Sheets ------------------------------- (dollars in thousands) Unaudited Audited ASSETS September 30 December 31 - ------ 1998 1997 Investments: ------------ ---------- Debt securities, held-to-maturity - at amortized cost (fair value of $388,334-1998; $426,251-1997)......... $ 370,557 410,169 Debt securities, available-for-sale - at fair value (amortized cost of $1,000,306-1998; $1,009,060-1997)..... 1,050,907 1,044,390 Equity securities, available-for-sale - at fair value (cost of $138,216-1998; $120,602-1997)......... 236,355 222,273 Short-term investments -at cost which approximates fair value 37,415 28,781 Other investments - at fair value.......... 31,023 20,077 --------- --------- Total investments ...................... 1,726,257 1,725,690 Cash....................................... 9,967 5,017 Interest and dividends due or accrued ..... 21,699 23,474 Premiums and other receivables............. 253,012 196,786 Reinsurance recoverable on paid losses and loss expenses..................... 10,085 11,088 Reinsurance recoverable on unpaid losses and loss expenses......................... 134,831 124,197 Prepaid reinsurance premiums............... 30,040 31,189 Deferred Federal income tax................ 486 6,489 Real estate, furniture and equipment....... 49,935 45,465 Deferred policy acquisition costs.......... 115,300 98,110 Goodwill................................... 16,328 17,337 Other assets............................... 42,140 21,349 --------- --------- Total assets............................ $ 2,410,080 2,306,191 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY - ------------------------------------ Liabilities: - ----------- Reserve for losses......................... $ 1,005,776 984,393 Reserve for loss expenses.................. 179,171 176,776 Unearned premiums.......................... 417,668 373,766 Convertible subordinated debentures........ 6,272 6,845 Short-term debt ........................... 24,780 17,400 Notes payable.............................. 89,714 89,714 Current Federal income tax................. 1,107 1,747 Other liabilities ......................... 104,810 90,234 --------- --------- Total liabilities....................... 1,829,298 1,740,875 --------- --------- Stockholders' Equity: - -------------------- Common stock of $2 par value per share: Authorized shares-180,000,000 Issued: 36,973,771-1998; 36,363,856-1997... 73,948 72,728 Additional paid-in capital................. 37,822 30,450 Accumulated other comprehensive income- net unrealized gains on available-for-sale securities, net of deferred income tax effect............................ 96,681 89,051 Retained earnings.......................... 469,984 439,811 Treasury stock - at cost (shares: 8,516,624-1998; 7,097,462-1997) (90,749) (59,785) Deferred compensation expense and notes receivable from stock sales........... (6,904) (6,939) --------- --------- Total stockholders' equity ............. 580,782 565,316 --------- --------- Total liabilities and stockholders' equity $ 2,410,080 2,306,191 ========= ========= See accompanying notes to unaudited consolidated financial statements. -2- PAGE SELECTIVE INSURANCE GROUP, INC. ================================ Consolidated Statements of Income (dollars in thousands, except per share data) Unaudited Unaudited Quarter ended Nine Months Ended September 30 September 30 1998 1997 1998 1997 ------ ------ ------ ------ Revenues: - -------- Net premiums written.................$ 196,447 200,680 581,547 573,126 Net increase in unearned premiums and prepaid reinsurance premiums (10,059) (30,764) (45,051) (63,374) ------- ------- ------- ------- Net premiums earned ................. 186,388 169,916 536,496 509,752 Net investment income earned......... 23,604 24,479 72,792 73,605 Net realized gains................... (91) 3,386 2,788 5,355 Other income......................... 2,788 1,120 7,123 3,392 ------- ------- ------- ------- Total revenues.................... 212,689 198,901 619,199 592,104 ------- ------- ------- ------- Expenses: - -------- Losses incurred ..................... 112,431 98,279 325,824 293,934 Loss expenses incurred............... 20,415 20,094 55,388 59,643 Policy acquisition costs............. 58,797 50,978 169,583 153,686 Dividends to policyholders........... 1,040 1,007 3,740 3,300 Interest expense..................... 2,437 2,454 7,003 7,193 Other expenses....................... 2,139 1,857 5,655 6,237 ------- ------- ------- ------- Total expenses.................... 197,259 174,669 567,193 523,993 ------- ------- ------- ------- Income before Federal income tax 15,430 24,232 52,006 68,111 ------- ------- ------- ------- Federal income tax expense: Current.............................. 2,459 5,340 7,614 13,000 Deferred............................. 39 497 1,894 2,912 ------- ------- ------- ------- Total Federal income tax expense......................... 2,498 5,837 9,508 15,912 ------- ------- ------- ------- Net income...........................$ 12,932 18,395 42,498 52,199 ======= ======= ======= ======= Earnings per share: - ------------------ Basic.............................$ 0.46 0.64 1.48 1.81 Diluted...........................$ 0.43 0.60 1.37 1.71 Dividends to stockholders............$ 0.14 0.14 0.42 0.42 See accompanying notes to unaudited consolidated financial statements. -3- PAGE SELECTIVE INSURANCE GROUP, INC. Consolidated Statements of Cash Flows Unaudited Nine months ended Sept. 30 (dollars in thousands) 1998 1997 ---- ---- Operating Activities - -------------------- Net income $ 42,498 52,199 Adjustments to reconcile net income to net cash provided by operating activities: Decrease in interest and dividends due or accrued 1,775 1,286 Increase in premiums and other receivables (56,226) (57,815) Decrease (increase) in reinsurance recoverable on paid losses and loss expenses 1,003 (4,313) Increase in reserves for losses and loss expenses,net of reinsurance recoverable on unpaid losses and loss expenses 13,144 7,966 Increase in unearned premiums, net of prepaid reinsurance premiums 45,051 63,374 Decrease in net Federal income tax asset 1,254 3,215 Increase in deferred policy acquisition costs (17,190) (19,354) Depreciation and amortization 6,500 6,245 Net realized gains on investments (2,788) (5,355) Other - net (3,374) (15,571) ------ ------ Net adjustments (10,851) (20,322) ------ ------ Net cash provided by operating activities 31,647 31,877 ------ ------ Investing Activities - -------------------- Purchase of debt securities, held-to-maturity (12,682) (31,730) Purchase of debt securities, available-for-sale (116,063) (120,948) Purchase of equity securities, available-for-sale (32,250) (21,815) Purchase of other investments (15,451) (9,000) Sale of debt securities, available-for-sale 59,902 29,057 Redemption and maturities of debt securities, held-to-maturities 52,264 54,788 Redemption and maturities of debt securities, available-for-sale 66,454 25,883 Sale of equity securities, available-for-sale 16,387 13,697 Proceeds from other investments 5,316 223 Decreae (increase) in net payable for security transactions (3,715) 2,891 Net additions to real estate, furniture and equipment (9,341) (2,311) ------ ------ Net cash provided by (used in) investing activities $ 10,821 (59,265) ------ ------ See accompanying notes to unaudited consolidated financial statements. -4- PAGE SELECTIVE INSURANCE GROUP, INC. Consolidated Statements of Cash Flows, continued Unaudited Nine months ended Sept 30 (dollars in thousands) 1998 1997 ---- ---- Financing Activities - -------------------- Dividends to stockholders $ (12,325) (12,313) Acquisition of treasury stock (30,964) (3,571) Proceeds from short-term debt 7,380 15,500 Net proceeds from dividend reinvestment plan 859 849 Net proceeds from stock purchase and compensation plans 7,161 10,243 Increase in deferred compensation expense and proceeds received on notes receivable from stock sales (995) (5,964) ------ ------ Net cash (used in) provided by financing activities (28,884) 4,744 ------ ------ Net Increase (decrease) in short-term investments and cash 13,584 (22,644) Short-term investments and cash at beginning of year 33,798 40,022 ------ ------ Short-term investments and cash at end of period $ 47,382 17,378 ====== ====== Supplemental disclosures of cash flow information - ------------------------------------------------- Cash paid during the period for: Interest $ 7,679 7,256 Federal income tax 8,254 12,697 Supplemental schedule of non-cash financing activity: Conversion of convertible subordinated debentures 573 33 See accompanying notes to unaudited consolidated financial statements. -5- PAGE 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 the full year. These financial statements should be read in conjunction with the financial statements and notes thereto contained in the Company's Annual Report on Form 10-K for the year ended December 31, 1997. 2. Adoption of Accounting Policies During 1998, the Company adopted the following accounting policies: (a) The American Institute of Certified Public Accountants issued Statement of Position No. 97-3 "Accounting by Insurance and Other Enterprises for Insurance related Assessments" ("SOP 97-3"). SOP 97-3 establishes standards for accounting for guaranty-fund and certain other insurance related assessments. SOP 97-3 is effective for fiscal years beginning after December 15, 1998 and requires the impact of adoption to be reported as a change in accounting principle. SOP 97-3 was adopted in 1998 by the Company and had no material effect on the Company's results of operations or financial condition. (b) The American Institute of Certified Public Accountants issued Statement of Position No. 98-1 "Accounting for the Costs of Computer Software Developed or Obtained for Internal-Use" ("SOP 98-1"). SOP 98-1 provides guidance on accounting for the costs of computer software developed or obtained for internal-use and when such costs incurred should and should not be capitalized. SOP 98-1 is effective for all fiscal years beginning after December 15, 1998. The provisions of SOP 98-1 should be applied to internal-use software costs incurred in those fiscal years for all projects, including those projects in progress upon initial application of the statement. Earlier application is encouraged in fiscal years for which annual financial statements have not been issued. SOP 98-1 was adopted by the Company during the first quarter of 1998. As a result of SOP 98-1, the Company capitalized $3 million of computer software development costs. -6- PAGE SELECTIVE INSURANCE GROUP, INC. Notes to Unaudited Consolidated Financial Statements, continued (C) Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("FASB 130"), was adopted during the first quarter of 1998. FASB 130 requires the Company to report total comprehensive income in condensed financial statements of interim periods. The following is a presentation of the Company's total comprehensive income for the periods ended September 30, 1998 and 1997. Quarter ended Nine months ended September 30 September 30 -------------- ----------------- (dollars in thousands) 1998 1997 1998 1997 ---- ---- ---- ---- Net income $12,932 18,395 42,498 52,199 ------- ------ ------ ------ Other comprehensive income: Unrealized holding gains (losses) arising during period (11,178) 27,099 14,527 54,363 Less: reclassification adjustment for net realized (gains) losses included in net income 91 (3,386) (2,788) (5,355) ------- ------ ------ ------ Other comprehensive income (loss) before tax (11,087) 23,713 11,739 49,008 Income tax benefit (expense) related to items of other comprehensive income 3,880 (8,300) (4,109) (17,153) ------- ------ ------ ------ Other comprehensive income (loss), net of tax (7,207) 15,413 7,630 31,855 ------- ------ ------ ------ Total comprehensive income $ 5,725 33,808 50,128 84,054 ======= ====== ====== ====== 3. Current Accounting Pronouncements In June of 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No, 133, "Accounting for Derivative Instruments and Hedging Activities" ("FASB 133"). FASB 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. This statement is effective for all fiscal quarters of fiscal years beginning after June 15, 1999, earlier application is encouraged, but it is permitted only as of the beginning of any fiscal quarter that begins after issuance of this statement. This Statement should not be applied retroactively to financial statements of prior periods. The Company does not currently invest in derivative securities, therefore the adoption of this statement is not expected to have a material effect on the Company's results of operations or financial condition. -7- PAGE SELECTIVE INSURANCE GROUP, INC. Notes to Unaudited Consolidated Financial Statements, continued 4. Reinsurance The following is a table of assumed and ceded amounts by income statement caption: Quarter ended Nine months ended September 30 September 30 (in thousands) 1998 1997 1998 1997 - -------------------------------------------------------------------------- Net premiums written: Assumed $ 5,600 7,397 17,644 18,509 Ceded (23,661) (23,280) (58,630) (61,976) Net premiums earned: Assumed $ 4,990 6,882 17,623 17,802 Ceded (18,272) (21,292) (59,779) (62,092) Losses incurred: Assumed $ 3,778 5,094 14,035 10,738 Ceded(1) (10,126) (12,121) (38,457) (21,849) Loss expenses incurred: Assumed $ 425 659 1,620 1,599 Ceded (381) (564) (1,983) (1,434) (1) During the first nine months of 1998, the increase in ceded losses incurred resulted from several severe claims ($11 million in reinsurance recovered) in 1998 and $7 million flood claims. The flood business is ceded 100% to the National Flood Insurance Program and therefore, the Company is a servicer of this type of insurance and bears no risk of policyholder loss. 5. Reclassifications Certain amounts in the Company's prior year consolidated financial statements have been reclassified to conform with the 1998 presentation. All earnings per share amounts for all periods have been presented and restated to conform to FASB 128, "Earnings per Share" requirements. Such reclassification and presentation changes had no effect on the Company's net income or stockholders' equity. -8- PAGE Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations --------------------------------------------------------------- This quarterly report on Form 10-Q contains certain statements that are not historical facts and are considered "forward-looking statements" (as defined in the Private Securities Litigation Reform Act of 1995), which can be identified by terms such as "believes," "expects," "intends," "may," "will," "should," "anticipates," "benefits," the negatives thereof, or by discussion of strategy, goals and/or future expectations. Such forward-looking statements involve opinions and predictions based on current information and assumptions, and no assurance can be given that the future results will be achieved since events or results may materially differ as a result of risks and uncertainties facing the Company. These include, but are not limited to, economic, market or regulatory conditions, competition, and investment risks, as well as risks associated with the Company's entry into new markets, diversification and catastrophic events. The following discussion relates to the Company's results of operations, financial condition and liquidity for the interim periods indicated. References herein to the "Company" are references to Selective Insurance Group, Inc. and its consolidated subsidiaries, collectively. References herein to "Selective" are to Selective Insurance Group, Inc. Results of Operations - --------------------- The following discussion is a comparison of Third Quarter Ended September 30, 1998 ("Third Quarter 1998"), and Nine Months Ended September 30, 1998 ("Nine Months 1998"), to Third Quarter Ended September 30, 1997 ("Third Quarter 1997"), and Nine Months Ended September 30, 1997 ("Nine Months 1997"). During the Third Quarter 1998, certain business classes were reclassified from the Mercantile and Service and Habitational and Recreational SBUs to the Community Services and Organizations SBU (formerly the Public Entities SBU). Prior amounts reported have been reclassified to conform with the Third Quarter 1998 presentation. Revenues Net premiums written for the Nine Months 1998 increased 1%, or $8 million as compared with the same period in 1997. For the Third Quarter 1998 net premiums written decreased 2%, or $4 million, compared with the same period in 1997. Net premiums written for the Third Quarter 1997 and Nine Months 1997 included a one-time benefit of $15 million, and $30 million respectively, pertaining to renewal business only, due to the conversion of New Jersey personal automobile policies from a six month term to an annual term (the "Conversion"), effective April 1, 1997. Excluding the effects of the Conversion, and a one-time increase of $4 million in the Nine Months 1998, which reflected the Company's modification of the New Jersey Homeowners Quota Share Reinsurance Program, the Third Quarter 1998 and Nine Months 1998 net premiums written increased $11 million, or 6% and $34 million, or 6% respectively, when compared with the same periods in 1997. -9- PAGE The commercial SBUs net premiums written increased $10 million, or 8% and $38 million, or 10% for the Third Quarter 1998 and Nine Months 1998, respectively, resulting from increases in all commercial SBUs except for the Community Services and Organizations SBU. These results reflected an increase of $9 million and $32 million of net premiums written from new business written in the commercial SBUs for the Third Quarter 1998 and Nine Months 1998, respectively, over the corresponding prior year periods. This growth in net premiums written from new business was primarily due to the Company's increase in the number of field underwriters (the key contact between the independent agent and the Company), the Company's Midwestern expansion and the Company's strengthening of agency relationships. Net premiums written which were non-renewed due to agency terminations were $7 million and $10 million less during the Third Quarter 1998 and Nine Months 1998 respectively, when compared to the corresponding prior year period. The increases in net premiums written were partially offset by: 1) a reduction in existing business resulting primarily from competition; 2) re-evaluation of certain underwriting risks; and 3) decreasing premium in the community services and organizations SBU mainly due to the continuing trend, in this customer segment, towards self-insurance mechanisms and other alternative markets. The Personal Lines SBU net premiums written remained relatively flat, excluding the effect of the Conversion, for both the Third Quarter 1998 and Nine Months 1998. Net premiums written for the Nine Months 1998 increased primarily due to a reduction in the amount of premium ceded under the New Jersey Homeowners Quota Share Reinsurance Program. These changes resulted in a $2 million increase for the Third Quarter 1998 and $10 million increase for the Nine Months 1998 in homeowners net premiums written ($4 million of which was due to a one-time adjustment in the first quarter of 1998 reflecting the return of a portion of the ceded reinsurance unearned premium reserves from the previous year). In addition, the personal lines SBU has recently introduced enhanced products in some of the Company's territories in order to expand its personal insurance segment. This expansion effort resulted in an increase in net new business written of $3 million for the Third Quarter 1998 and Nine Months 1998. These increases were offset by reductions in personal automobile net premiums written of $2 million for the Third Quarter 1998 and $10 million for the Nine Months 1998 mainly in New Jersey due to a reduction in existing business resulting primarily from competition. The increase in 1998 net premiums written resulted in an increase in net premiums earned. After an insurance policy is sold, net premiums written are recorded for the sales transaction and then earned over the life of the insurance policy (which is generally a one-year term). The growth in the 1998 net premiums written resulted in an increase of 10%, or $16 million, and 5%, or $27 million, in net premiums earned for the Third Quarter 1998 and Nine Months 1998, respectively when compared with the same periods in 1997. Net investment income earned for the Third Quarter 1998 and Nine Months 1998 remained essentially flat over the same periods in 1997. Although the amount of assets generating investment income increased slightly when compared to September 1997, the additional income earned from the growth in invested assets was offset by redemptions and maturities of higher yielding debt securities reinvested at lower fixed income yields currently available in the marketplace. These factors reduced the Company's overall annualized investment -10- PAGE yield as of September 30, 1998 to 5.8%, down from 6.0% for the same period in 1997. In addition, growth in invested assets has been minimal because $31 million of the cash from operations was used during the Nine Months 1998 to repurchase approximately 1.4 million shares of Company stock. Expenses The ratio of losses and loss expenses incurred to net premiums earned for the Third Quarter 1998 and Nine Months 1998 was 71.3% and 71.1%, respectively. These ratios represent a 1.6 point and a 1.7 point increase over the ratios for the Third Quarter 1997 and Nine Months 1997 periods. Weather-related claims of $4 million (before-tax) and $10 million (before-tax), respectively increased these ratios by 2.2 points and 1.8 points for the Third Quarter 1998 and Nine Months 1998, respectively. The weather-related losses primarily impacted the Habitational & Recreational and Mercantile & Service SBU's. Excluding the effects of the weather-related claims, the loss and loss expense ratio decreased 0.6 points for the Third Quarter 1998 and remained flat for the Nine Months 1998, compared to the same periods in 1997. Overall, the commercial SBUs' loss and loss expense ratio increased by 4.1 points and 2.8 points for the Third Quarter 1998 and Nine Months 1998, respectively. These increases reflected weather-related claims which resulted in increases of 2.7 points for the Third Quarter 1998 and 2.2 points for the Nine Months 1998. Excluding the effects of the 1998 weather-related claims, the commercial SBUs loss and loss expense ratio increased by 1.4 points for the Third Quarter 1998 and 0.6 points for the Nine Months 1998. Unfavorable results in both the workers' compensation and commercial automobile lines of insurance contributed to the overall increase in most of the commercial SBUs loss and loss expense ratios. The increase in the loss and loss expense ratio for workers' compensation primarily resulted from the continuing competitive pricing pressures associated with this line of insurance throughout all of the commercial SBUs and some state mandated rate decreases. The adverse results in the commercial automobile line of insurance were mainly due to several severe claims and a slight increase in the frequency of claims. In response to the performance of the commercial automobile business, the Company continues to review this business, including loss control, re-evaluating risk selection and re- evaluating risk classification. These increases were partially offset by improvement in the general liability line of insurance in most of the commercial SBUs. Much of this improvement resulted from the Company's initiatives to reduce legal fees incurred in the course of the claim settlement process. The Personal Lines SBU loss and loss expense ratio decreased by 4.1 points and 0.4 points for both the Third Quarter 1998 and Nine Months 1998 to 69.7% and 73.2%, respectively. The decrease in the Third Quarter 1998 ratio was primarily due to fewer homeowners claims reported compared to the same period in 1997. In addition, New Jersey personal automobile results continued to be favorable at a 75.7% and 75.6% loss and loss expense ratio for the Third Quarter 1998 and Nine Months 1998, respectively. There is an excess profits law in New Jersey, which sets a maximum profit level on personal automobile insurance. Under New Jersey regulations, an insurer's excess profits earned on direct insurance written in New Jersey on -11- PAGE private passenger automobiles, as determined pursuant to an actuarial formula set forth in applicable regulations ("NJ Excess Profits"), are subject to refund or credit to policyholders. A NJ Excess Profits calculation must be made by an insurer for this purpose and submitted to the New Jersey Department of Banking and Insurance each year for the three-year period including the year for which the calculation is done and the two calendar years immediately preceding such year. For the three-year period ended December 31, 1997, the Company's most recent submission indicated that it had no obligation to make an excess profit premium refund. However, if the Company's current profitability continues in its New Jersey personal automobile business, it is possible that it will incur an excess profit premium refund obligation in the future. The Company considers the potential effect of such excess profits in establishing its loss reserves. On May 19, 1998, the Governor of New Jersey signed into law personal automobile insurance reform legislation. The law contains multiple implementation dates that will be determined through the adoption of regulations. One provision of the law reduces average statewide automobile insurance premiums by 15%, with the greatest reductions being applicable to liability-only policies. The Company anticipates that this provision will become effective on or about April 1, 1999, and that its New Jersey personal automobile direct premiums written will be reduced between 11% and 12%, or approximately $17 million. This is less than the average of 15% because a higher proportion of Selective's policies provide physical damage coverage, on which the rate reduction will be lower. The law also contains provisions that are intended to reduce loss costs. These provisions include: (i)revisions to the state's no-fault law; (ii) increased fraud prosecution initiatives; and (iii) the elimination of unnecessary medical tests and the use of medical fee schedules. The Company is currently unable to estimate the extent of such savings, however, believes the new law will not significantly impact its overall after-tax financial results due to reductions in policy acquisition costs (commissions, premium taxes, etc.) from the lower premium volume, and potentially lower costs as a result of the savings provisions included in the law. In addition, the reduction in premiums written as a result of the law should reduce the possibility of a NJ Excess Profits premium refund obligation after the new law is implemented in 1999. The ratio of policy acquisition costs to net premiums earned for the Third Quarter increased from 30.0% to 31.5% in 1998 and from 30.1% to 31.6% for the Nine Months 1998. The 1.5 point increase in the ratio primarily reflected an increase in the relationship of commission expenses, state premium tax expenses and labor costs expressed as a percentage of net premiums earned, which added approximately 0.9 points, 0.1 points and 0.5 points, respectively. Commission expenses increased as a percentage of net premiums earned primarily due to commission incentives to agents to increase profitable business with the Company which resulted in an increase of 0.7 points and an increase in lines of insurance which pay a higher general commission rate than personal -12- PAGE lines which resulted in a 0.2 point increase. State premium tax expenses have increased mainly due to the Company's effort to diversify and write more business outside of New Jersey. Many states have higher state premium tax rates than New Jersey. Labor costs have increased in 1998 primarily due to the Company's staffing increases in its Midwest operation and the hiring of additional field underwriters. Labor cost increases due to staffing additions in the Information Technology Operations have been offset by the capitalization of labor costs associated with the internal development of new information systems. Total Federal income tax expense decreased by approximately $4 million, to $2 million, for the Third Quarter 1998, compared to $6 million for the same period in 1997. For the Nine Months 1998, the Federal income tax expense decreased approximately $6 million, to $10 million, compared to $16 million for the Nine Months in 1997. The Company's effective tax rate was 18.3% for the Nine Months 1998, compared with 23.4% for the Nine Months of 1997. The Company's effective tax rate differs from the Federal corporate rate of 35% primarily as a result of the tax-exempt investment income. The effective tax rate for the Nine Months 1998 was lower than the Nine Months 1997, mainly due to the higher level of underwriting losses in 1998. -13- PAGE Income The table below shows operating income, net realized gains (losses), and net income, including per share amounts for the Quarter and Nine Months Ended 1998 and 1997. - ---------------------------------------------------------------------------- Quarter ended Nine months ended ($ in thousands, September September except for per share data) 1998 1997 1998 1997 - ---------------------------------------------------------------------------- Operating income, excluding net realized gains (net of tax) (1) $12,991 16,194 40,686 48,718 Net realized gains (losses), net of tax (59) 2,201 1,812 3,481 ------ ------ ------ ------ Net income (1) 12,932 18,395 42,498 52,199 ====== ====== ====== ====== Per diluted Share: Operating income (1) .43 .53 1.31 1.59 Net realized gains (losses) .00 .07 .06 .12 Net income (1) .43 .60 1.37 1.71 (1)Operating and net income for the Third Quarter and Nine Months 1998, include weather-related storm losses of $3 million (net of tax), or $.09 per diluted share, and $6 million (net of tax), or $.20 per diluted share, respectively. -14- PAGE Financial Condition, Liquidity and Capital Resources - ---------------------------------------------------- Selective is an insurance holding company whose principal assets are its investments in its insurance subsidiaries. As an insurance holding company, Selective meets its cash requirements through proceeds from the sales of the Company's common stock and dividends from its insurance subsidiaries, the payments of which are subject to state regulatory requirements. The overall obligations and cash outflow of the Company include: claim settlements; commissions; labor costs; premium taxes; general and administrative expenses; investment purchases; interest expenses; capital expenditures with respect to the Company's automation program; principal payments on the senior notes and dividends to policyholders and stockholders. The insurance subsidiaries satisfy their obligations and cash outflow through premium collections, interest and dividend income and maturities of investments. The Company's cash requirements also include the cost of shares of common stock repurchased under its common stock repurchase program. On July 2, 1996, the Company's Board of Directors (the "Board") authorized management to repurchase up to two million shares of Selective's common stock. The stock may be repurchased from time to time in the open market or in privately negotiated transactions. The determination to make such purchases is made based on market conditions, available cash and alternative investment opportunities. On July 28, 1998, the Board authorized Selective to repurchase an additional two million shares of its common stock under the repurchase program. As of September 30, 1998, the Company had repurchased a total of 2.0 million shares at a total cost of $44 million under the program, of which 1.4 million shares were repurchased during the Nine Months 1998 at a total cost of $31 million. For the Nine Months 1998 and Nine Months 1997, cash provided by operating activities remained flat at $32 million. The higher levels of net premiums written during 1998 were offset by an increase in claims paid. The rate at which outstanding claims are being paid and closed has increased due to the implementation of claims management specialists ("CMSs") in the field and improved litigation management. The Company believes that the deployment of the CMSs and the enhanced litigation management programs will result, over the long-term, in more favorable claim settlements. However, the short-term impact of these programs has been an increase in claim payments of approximately $15 to $20 million, which has reduced cash provided by operating activities for the Nine Months 1998. The Company anticipates this trend to continue through the remainder of 1998 and into 1999. The Company expects to generate cash from operations over the balance of the year. Total assets increased 5%, or $104 million, from December 31, 1997 to September 30, 1998. The growth was due to: (i) an increase in premiums and other receivables of $56 million and deferred policy acquisition costs (policy acquisition costs which are deferred and amortized over the life of the policy period) of $17 million primarily due to the increased premium volume; (ii) a $21 million increase in other assets primarily due to a $16 million investment -15- PAGE by the Company to offset a short sale transaction; (iii) an increase in reinsurance recoverable on unpaid losses and loss expense of $11 million due to a few severe claims and an increase in flood claims. The above increases were partially offset by a $6 million decrease in deferred Federal income taxes which mainly reflected the associated deferred taxes on increases in unrealized gains on available-for-sale securities and deferred policy acquisition costs. The rise in total liabilities of 5%, or $88 million, from December 31, 1997 to September 30, 1998 was mainly attributable to an increase in unearned premiums of $44 million and an increase of $24 million in reserves for losses and loss expenses, both driven by the increase in net premiums. The Company, like all users of automated information systems, is addressing the potential "Year 2000" issues that could affect a wide variety of its automated information systems, such as mainframe applications, personal computers, and communications systems. The Company is also addressing the "Year 2000" issues associated with the information systems utilized by its suppliers and its independent insurance agents which could have an impact on the Company. The Company is further addressing risks associated with non- information systems exposures, such as building security systems and heating and ventilation. In 1996, the Company established an internal team dedicated to administering a "Year 2000" Project. This team completed an initial impact and analysis study and began to convert or modify its information systems and applications in 1997. This project is divided into five main areas of initiative as follows: 1) Infrastructure: an initiative to address hardware and the software operating systems needed to utilize this hardware. This initiative has been further divided to examine Mainframe (Enterprise System) and Desktop workstations (PC and LAN). "Year 2000" upgrades were completed for the Mainframe portion in early 1998. Inventory of all PC workstations was completed in August of 1998 and either upgrades or replacement of equipment is underway and expected to be complete first quarter 1999. 2) Applications: an initiative to address the core software systems, such as policy underwriting, claims and general ledger, that process daily business at the Company. A majority of these applications were developed in-house or customized for the Company's operations. Utilizing non-employee external programming teams, these systems were converted, unit tested and replaced in production by January 1998. A series of system integration tests have been planned to test "Year 2000" readiness. One test was completed in 1998, test number two is in progress and two additional tests have been scheduled for 1999. These examinations are intended to synchronize all such systems, introduce new software which is "Year 2000" compatible and test whether "Year 2000" bugs were introduced through routine maintenance. Two new systems, a claim system and general ledger, are currently being implemented and are expected to be complete in early 1999. -16- PAGE 3) Third party review: an initiative to address suppliers and customers. The Company's suppliers include software vendors, service providers and material suppliers. Each of the firms in these areas has been contacted by the Company to obtain written information on the status of their "Year 2000" readiness, and to date the majority of responses indicate "Year 2000" readiness. Software upgrades are being unit tested and included in the integration tests. Contingency plans are being developed as needed for areas deemed at risk due to software delivery delays or the nature of the service. A contingency plan has been developed for each area of risk identified to date. Independent insurance agents are the Company's main business customers and make up the remaining portion of the "Year 2000" review area. The Company has provided "Year 2000" information mailings to all agents. Selective Insurance representatives have spoken at agency functions and a "Year 2000" hotline was created for questions. The Company continues to look for opportunities to provide support and advice to our agents. To ensure that the "Year 2000" awareness campaign has been effective, the Information Technology Group is currently surveying the independent agency force to determine the status of their "Year 2000" readiness. Missing information, regarding the types of hardware and software in the agent's offices, will be obtained by the Agency Management Specialists, the main contact between the Company and the agent, as they visit each office. This information will be evaluated by the Company to develop contingency plans. 4) Insurance Policies: an initiative to address coverage provided to the Company's insureds. The Company believes that most significant "Year 2000" insurance claims are likely to occur in the information technology business sector, and under the error and omissions (E&O) insurance coverages and directors and officers liability (D&O) insurance coverages. The Company does not significantly participate in these markets, nor does it significantly write E&O and D&O coverage types. The Company has communicated to agents and policyholders that we will not provide coverage for "Year 2000" losses with the possible exception of losses involving property damage or bodily injury which are otherwise covered which can not be quantified at this time. The Company plans to use Insurance Services Office ISO exclusionary endorsements that underscore this on all new and renewal commercial lines policies. 5) Administration: an initiative to address overall project plans, methodology, schedule, coordination and miscellaneous items that do not fit other categories. This initiative also includes creating a "Year 2000" awareness campaign and responding to inquiries from outside the Company, such as from independent insurance agents and customers. The failure to correct a material "Year 2000" problem could result in an interruption in, or a failure of, certain normal business activities or operations such as policy underwriting and claim payment. Such failures could materially and adversely affect the Company's results of operations, liquidity and financial condition. Due to the general uncertainty inherent in the "Year 2000" problem, resulting in part from the uncertainty of the "Year 2000" readiness of independent insurance agents, third-party suppliers and customers, the Company is unable to determine at this time whether, or to the -17- PAGE extent to which the consequences of "Year 2000" failures will have a material impact on the Company's results of operations, liquidity or financial condition. The Company's "Year 2000" Project is expected to significantly reduce the Company's level of uncertainty about the "Year 2000" problem and, in particular, about the "Year 2000" readiness within the Company's internal systems. The Company believes that, with the progress of the Project to date, and in the event of the completion of the Project as scheduled, the possibility of significant interruptions of normal operations will be greatly reduced. While the Company feels that "Year 2000" exposures will be adequately addressed before any seriously adverse "Year 2000" situations arise, contingency plans have been developed for material areas of the Company's internal information systems including securing disaster recovery sites provided by outside parties. The Company has secured a first priority status with the disaster recovery provider by complying with their "Year 2000" readiness checklist. The Company does not presently anticipate that costs incurred for the "Year 2000" will be significant or that "Year 2000" issues will have a material impact on its results of operations or financial condition. The Company's early start, some systems already in place designed for "Year 2000" and a centralized mainframe system have helped to reduce the cost of compliance. Our current estimates of the expenses that will be incurred exclusively to ensure "Year 2000" readiness will be approximately $1.5 million, of which approximately $1 million has been spent to date. -18- PAGE Part II - ------- Item 5. Other Information. A duly executed proxy given in connection with Selective's 1999 Annual Meeting of Stockholders will confer discretionary authority on the proxies named therein, or any of them, to vote at such meeting on any matter of which Selective does not have written notice on or before February 15, 1999, which is forty-five days prior to the date on which Selective first mailed its proxy materials for its 1998 Annual Meeting of Stockholders, without advice in Selective's proxy statement as to the nature of such matter. Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits: The exhibits required by Item 601 of Regulation SK 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. -19- PAGE SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SELECTIVE INSURANCE GROUP, INC. Registrant Date: November 16, 1998 By: /s/Gregory E. Murphy -------------------------------------- Gregory E. Murphy President and Chief Operating Officer Date: November 16, 1998 By: /s/David B. Merclean ------------------------------------- David B. Merclean, Senior Vice President and Chief Financial Officer -20- PAGE SELECTIVE INSURANCE GROUP, INC. INDEX TO EXHIBITS Exhibit No. 11 Statement Re Computation of Per Share Earnings, filed herewith. 27 Financial Data Schedule, filed herewith. -21-