UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended...March 31, 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) <TABLE> <S> <C> New Jersey 22-2168890 - -------------------------------------------- ------------------------------------- (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 40 Wantage Avenue Branchville, New Jersey 07890 - -------------------------------------------- ------------------------------------- (Address of principal executive offices) (Zip Code) </TABLE> 973-948-3000 --------------------------------- (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such report), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate 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 April 30, 2003: 26,890,757 1
SELECTIVE INSURANCE GROUP, INC Consolidated Balance Sheets <TABLE> <CAPTION> Unaudited March 31, December 31, (in thousands, except share amounts) 2003 2002 - ------------------------------------ ---- ---- <S> <C> <C> ASSETS Investments: Debt securities, held-to-maturity - at amortized cost (fair value: $97,715 - 2003; $114,785 - 2002) $ 92,730 109,318 Debt securities, available-for-sale - at fair value (amortized cost: $1,730,925 - 2003; $1,671,347 - 2002) 1,837,089 1,772,061 Equity securities, available-for-sale - at fair value (cost of: $133,682 - 2003; $120,036 - 2002) 203,192 196,913 Short-term investments - (at cost which approximates fair value) 22,679 24,700 Other investments 23,776 23,559 ----------- --------- Total investments 2,179,466 2,126,551 Cash 2,810 2,228 Interest and dividends due or accrued 21,333 22,689 Premiums receivables, net of allowance for uncollectible accounts of: $2,814 - 2003 and 2002 407,271 353,935 Other trade receivables, net of allowance for uncollectible accounts of: $1,030 - 2003; $867 - 2002 22,086 19,769 Reinsurance recoverable on paid losses and loss expenses 7,957 7,272 Reinsurance recoverable on unpaid losses and loss expenses 165,850 160,374 Prepaid reinsurance premiums 46,259 46,141 Deferred federal income tax 10,110 8,707 Real estate, furniture, equipment, and software development - at cost, net of accumulated depreciation and amortization 52,759 52,424 Deferred policy acquisition costs 159,399 148,158 Goodwill 42,808 42,808 Other assets 34,484 38,791 ----------- --------- Total assets $ 3,152,592 3,029,847 =========== ========= LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES: Reserve for losses $ 1,280,051 1,232,322 Reserve for loss expenses 173,678 171,103 Unearned premiums 613,615 557,141 Senior convertible notes 115,937 115,937 Notes payable 145,500 145,500 Current federal income tax 2,495 2,565 Other liabilities 164,428 153,177 ----------- --------- Total liabilities 2,495,704 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: 41,142,520 - 2003; 40,780,950 - 2002 82,285 81,562 Additional paid-in capital 102,698 95,435 Retained earnings 566,581 562,553 Accumulated other comprehensive income 114,188 115,434 Treasury stock - at cost (shares: 14,246,988 - 2003; 14,185,020 - 2002) (196,737) (195,295) Unearned stock compensation and notes receivable from stock sales (12,127) (7,587) ----------- --------- Total stockholders' equity 656,888 652,102 ----------- --------- Total liabilities and stockholders' equity $ 3,152,592 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 Quarter ended March 31, (in thousands, except per share amounts) 2003 2002 - ---------------------------------------- ---- ---- <S> <C> <C> Revenues: Net premiums written $ 323,403 281,445 Net (increase) in unearned premiums and prepaid reinsurance premiums (56,356) (47,150) --------- ------- Net premiums earned 267,047 234,295 Net investment income earned 27,343 24,504 Net realized gains 3,975 109 Diversified insurance services revenue 21,338 18,833 Other income 782 799 --------- ------- Total revenues 320,485 278,540 --------- ------- Expenses: Losses incurred 170,728 146,505 Loss expenses incurred 28,374 24,372 Policy acquisition costs 84,549 70,694 Dividends to policyholders 1,555 1,921 Interest expense 4,539 3,505 Diversified insurance services expenses 19,471 17,439 Other expenses 1,909 2,426 --------- ------- Total expenses 311,125 266,862 --------- ------- Income from continuing operations, before federal income tax 9,360 11,678 --------- ------- Federal income tax expense (benefit): Current 1,780 5,489 Deferred (458) (4,110) --------- ------- Total federal income tax expense 1,322 1,379 --------- ------- Discontinued operations, net of tax -- 2 --------- ------- Net income $ 8,038 10,301 ========= ======= Earnings per share: Basic net income from continuing operations $ 0.31 0.41 Basic net income from discontinued operations -- -- --------- ------- Basic net income 0.31 0.41 ========= ======= Diluted net income from continuing operations $ 0.29 0.39 Diluted net income from discontinued operations -- -- --------- ------- Diluted net income 0.29 0.39 ========= ======= Dividends to stockholders $ 0.15 0.15 </TABLE> See accompanying notes to unaudited interim consolidated financial statements. 3
SELECTIVE INSURANCE GROUP, INC. Consolidated Statements of Stockholders' Equity <TABLE> <CAPTION> Unaudited Quarter ended March 31, ---------------------------------------------------------- (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: 12,251-2003; 12,687-2002) 24 25 Convertible subordinated debentures (shares: 7,768-2003; 4,095-2002) 16 8 Stock purchase and compensation plans (shares: 341,551-2003; 310,175-2002) 683 621 ------------ ------- End of period 82,285 79,831 ------------ ------- Additional paid-in capital: Beginning of year 95,435 77,126 Dividend reinvestment plan 263 265 Convertible subordinated debentures 39 21 Stock purchase and compensation plans 6,961 6,577 ------------ ------- End of period 102,698 83,989 ------------ ------- Retained earnings: Beginning of year 562,553 536,188 Net income 8,038 8,038 10,301 10,301 Cash dividends to stockholders ($0.15 per share) (4,010) (3,848) ------------ ------- End of period 566,581 542,641 ------------ ------- Accumulated other comprehensive income: Beginning of year 115,434 98,037 Other comprehensive (loss) - decrease in net unrealized gains, on available-for-sale securities, net of deferred income tax effect (1,246) (1,246) (6,021) (6,021) ------------ ------ ------- ------ End of period 114,188 92,016 ------------ ------- Comprehensive income 6,792 4,280 ===== ===== Treasury stock: Beginning of year (195,295) (192,284) Acquisition of treasury stock (shares: 61,968-2003; 71,975-2002) (1,442) (1,509) ------------ ------- End of period (196,737) (193,793) ------------ ------- Unearned stock compensation and notes receivable from stock sales: Beginning of year (7,587) (7,084) Unearned stock compensation (5,488) (5,175) Amortization of deferred compensation expense and amounts received on notes 948 1,387 ------------ ------- End of period (12,127) (10,872) ------------ ------- Total stockholders' equity $ 656,888 593,812 ============ ======= </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 (in thousands) Quarter ended March 31, 2003 2002 ---- ---- <S> <C> <C> OPERATING ACTIVITIES Net income $ 8,038 10,301 --------- ------ 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 44,828 33,502 Increase in unearned premiums, net of prepaid reinsurance premiums 56,357 47,150 Decrease (increase) in net federal income tax recoverable (800) 1,260 Depreciation and amortization 2,236 2,341 Amortization of deferred compensation 920 1,280 Increase in premiums receivables (53,336) (46,176) Increase in other trade receivables (2,317) (529) Increase in deferred policy acquisition costs (11,241) (11,727) Decrease in interest and dividends due or accrued 1,356 2,087 Decrease (increase) in reinsurance recoverable on paid losses and loss expenses (685) 3,887 Net realized (gains) (3,975) (109) Other- net (401) (5,260) --------- ------ Net adjustments 32,942 27,706 --------- ------ Net cash provided by operating activities 40,980 38,007 --------- ------ INVESTING ACTIVITIES Purchase of debt securities, available-for-sale (174,666) (171,454) Purchase of equity securities, available-for-sale (14,534) (238) Purchase of other investments (220) (548) Purchase and adjustments of subsidiaries acquired, (net of cash equivalents acquired of $48 -- (2,624) in 2002) Sale of debt securities, available-for-sale 70,037 105,729 Redemption and maturities of debt securities, held-to-maturity 16,631 16,333 Redemption and maturities of debt securities, available-for-sale 48,251 17,335 Sale of equity securities, available-for-sale 1,499 8,662 Proceeds from other investments 3 3 Increase (decrease) in net payable for security transactions 15,943 (6,862) Net additions to real estate, furniture, equipment and software development (2,382) (4,050) --------- ------ Net cash used in investing activities (39,438) (37,714) --------- ------ FINANCING ACTIVITIES Dividends to stockholders (4,010) (3,848) Acquisition of treasury stock (1,442) (1,509) Net proceeds from dividend reinvestment plan 287 290 Net proceeds from stock purchase and compensation plans 2,156 2,023 Proceeds received on notes receivable from stock sales 28 107 --------- ------ Net cash used in financing activities (2,981) (2,937) --------- ------ Net decrease in short-term investments and cash (1,439) (2,644) Short-term investments and cash at beginning of year 26,928 26,450 --------- ------ Short-term investments and cash at end of period $ 25,489 23,806 ========= ====== SUPPLEMENTAL DISCLOSURES OF CASH FLOWS INFORMATION Cash paid during the period for: Interest $ 4,832 2,534 Federal income tax 2,000 -- Supplemental schedule of non-cash financing activity: Conversion of convertible subordinated debentures 55 29 Unearned stock compensation 5,488 5,175 </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 financial statements 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 unaudited interim consolidated financial statements have been reclassified to conform to 2003 presentation. Such reclassification had no effect on our 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 $16.3 million at a net gain of $0.5 million. <TABLE> <CAPTION> UNAUDITED, QUARTER ENDED MARCH 31, (in thousands) 2003 2002 - -------------- ---- ---- <S> <C> <C> Net revenue $-- 4,456 Pre-tax income -- 7 After-tax income $-- 2 </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 $6.3 million for First Quarter 2003, compared with $15.2 million for First Quarter 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. 6
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, QUARTER ENDED MARCH 31, REVENUE BY SEGMENT 2003 2002 ---- ---- (in thousands) <S> <C> <C> INSURANCE OPERATIONS: Commercial lines net premiums earned $215,625 185,038 Personal lines net premiums earned 51,422 49,257 Miscellaneous income 692 770 -------- ------- Total insurance operations revenues 267,739 235,065 -------- ------- INVESTMENTS: Net investment income 27,343 24,504 Net realized gains on investments 3,975 109 -------- ------- Total investment revenues 31,318 24,613 -------- ------- DIVERSIFIED INSURANCE SERVICES: Diversified insurance services revenues, from continuing operations 21,338 18,833 -------- ------- TOTAL ALL SEGMENTS 320,395 278,511 -------- ------- Other income 90 29 -------- ------- TOTAL REVENUES FROM CONTINUING OPERATIONS $320,485 278,540 ======== ======= </TABLE> <TABLE> <CAPTION> UNAUDITED, INCOME (LOSS), BEFORE FEDERAL INCOME TAX BY SEGMENT QUARTER ENDED MARCH 31, 2003 2002 ---- ---- (in thousands) <S> <C> <C> INSURANCE OPERATIONS: Commercial lines underwriting $(14,207) (3,865) Personal lines underwriting (3,786) (5,177) -------- ------ Underwriting loss, before federal income tax (17,993) (9,042) -------- ------ INVESTMENTS: Net investment income 27,343 24,504 Net realized gains on investments 3,975 109 -------- ------ Total investment income, before federal income tax 31,318 24,613 -------- ------ DIVERSIFIED INSURANCE SERVICES: Income from continuing operations, before federal income tax 1,867 1,394 -------- ------ TOTAL ALL SEGMENTS 15,192 16,965 -------- ------ Interest expense (4,539) (3,505) General corporate expenses (1,293) (1,782) -------- ------ INCOME FROM CONTINUING OPERATIONS, BEFORE FEDERAL INCOME TAX $ 9,360 11,678 ======== ====== </TABLE> 7
5. REINSURANCE The following table is a listing of direct, assumed and ceded amounts by income statement caption: <TABLE> <CAPTION> UNAUDITED, QUARTER ENDED MARCH 31, (in thousands) 2003 2002 - -------------- ---- ---- <S> <C> <C> Premiums written: Direct $ 352,823 306,633 Assumed 5,938 5,656 Ceded (35,358) (30,844) --------- -------- Net $ 323,403 281,445 --------- -------- Premiums earned: Direct $ 296,794 259,579 Assumed 5,493 4,664 Ceded (35,240) (29,948) --------- -------- Net $ 267,047 234,295 --------- -------- Losses and loss expenses incurred: Direct $ 209,418 180,870 Assumed 5,032 3,530 Ceded (15,348) (13,523) --------- -------- Net $ 199,102 170,877 --------- -------- </TABLE> Flood business, which we cede 100% to the National Flood Insurance Program, is included in the above amounts as follows: <TABLE> <CAPTION> UNAUDITED, QUARTER ENDED MARCH 31, (in thousands) 2003 2002 <S> <C> <C> Ceded premiums written $(13,558) (11,564) Ceded premiums earned (13,572) (10,477) Ceded losses and loss expenses incurred (643) (1,106) </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 First Quarter 2003 and the corresponding period in the prior year are: <TABLE> <CAPTION> UNAUDITED, QUARTER ENDED MARCH 31, (in thousands) 2003 2002 -------------- ---- ---- <S> <C> <C> Net income $ 8,038 10,301 Other comprehensive (loss), decrease in net unrealized gains on available-for-sale securities, net of deferred income tax effect (1,246) (6,021) ------- ------ Comprehensive income $ 6,792 4,280 ======= ===== </TABLE> 7. CONCENTRATION OF CREDIT RISK Financial instruments that could potentially subject the Company to concentration of credit risk include accounts receivable associated with our human resource administration outsourcing subsidiary, which acts as a co-employer with certain clients. As a co-employer, we contractually assume substantial employer rights, responsibilities and risks of our clients' employees, who are considered co-employees. These accounts receivable, which are included in other trade receivables on the consolidated balance sheets, consist of service fees to be paid by our clients. Under the accrual method, earned but unpaid wages at the end of each period related to the Company's worksite employees are recognized as an accrued payroll liability as well as an account receivable during the period in which wages are earned by the worksite employee. Subsequent to the end of each period, such wages are paid and the related co-employer service fees are billed. Accrued co-employer payroll and related service fees were $14.0 million as of 8
March 31, 2003 and $15.1 million as of March 31, 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 March 31, 2003 the maximum exposure to any one account for earned payroll is approximately $1.1 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, QUARTER ENDED MARCH 31, (in thousands, except per share amounts) 2003 2002 ---------------------------------------- ---- ---- <S> <C> <C> Net income, as reported $ 8,038 10,301 Add: Stock-based employee compensation reported in net income, net of related tax effect 598 832 Deduct: Total stock-based employee compensation expense determined under fair value-based method for all awards, net of related tax effects (1,612) (1,798) --------- ----- Pro forma net income $ 7,024 9,335 ========= ===== Net income per share: Basic - as reported $ 0.31 0.41 Basic - pro forma 0.27 0.38 Diluted - as reported 0.29 0.39 Diluted - pro forma 0.26 0.35 </TABLE> 9. COMMITMENTS Included in other investments is approximately $23.7 million of investments in limited partnerships as of March 31, 2003, and $23.5 million as of December 31, 2002. At March 31, 2003 the Company has an additional limited partnership investment commitment of up to $16.3 million. There is no certainty that any additional investment will be required. 9
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; - 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. 10
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 period ended March 31, 2003 (First Quarter 2003) to the period ended March 31, 2002 (First Quarter 2002). Net income for First Quarter 2003 was $8.0 million, or $0.29 per diluted share, compared with $10.3 million, or $0.39 per diluted share, for First Quarter 2002. Operating income from continuing operations was $5.5 million, or $0.20 per diluted share, for First Quarter 2003 compared with $10.2 million, or $0.39 per diluted share, for First Quarter 2002. Operating income is used as an important financial measure by management, analysts and investors, because the realization of investment gains and losses in any given period is largely discretionary as to timing and could distort the analysis of trends; however it is not intended as a substitute for net income prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The following is a reconciliation of operating income from continuing operations to net income determined in accordance with GAAP: <TABLE> <CAPTION> Unaudited, Quarter ended March 31, (in thousands) 2003 2002 - -------------- ---- ---- <S> <C> <C> Operating income from continuing operations $5,454 10,228 Capital gains, after-tax 2,584 71 ------ ------ Income from continuing operations, after-tax 8,038 10,299 Income from discontinued operations, after-tax -- 2 ------ ------ Net income $8,038 10,301 ====== ====== </TABLE> Net income and operating income were affected by catastrophe losses stemming from some of the worst winter storms to hit the East Coast in a decade. Catastrophe losses for First Quarter 2003, on an after-tax basis, were approximately $7.7 million, or $0.28 per diluted share, compared with $1.1 million or $0.04 per diluted share in First Quarter of 2002. Further impacting results were other non-catastrophe weather-related property losses of $1.7 million, after-tax, or $0.06 per diluted share for the quarter. Other non-catastrophe weather-related property losses had an immaterial impact on First Quarter 2002 results. OPERATING SEGMENTS The Company is primarily engaged in writing property and casualty insurance. The Company has classified its business 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 is 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 on page 18 of this report on Form 10-Q. 11
See Note 4 to the March 31, 2003 unaudited interim consolidated financial statements on page 7 of this report on Form 10-Q for revenues and related income before federal income tax for each individual segment discussed below. Insurance Operations Segment <TABLE> <CAPTION> Unaudited, ALL LINES Quarter ended March 31, (in thousands) 2003 2002 <S> <C> <C> GAAP INSURANCE OPERATIONS RESULTS Net premiums written $ 323,403 281,445 --------- ------ Net premiums earned 267,047 234,295 Losses and loss expenses incurred 199,102 170,877 Net underwriting expenses incurred 84,383 70,539 Dividends to policyholders 1,555 1,921 --------- ------ Underwriting loss $ (17,993) (9,042) ========= ====== GAAP RATIOS: Loss and loss expense ratio 74.6% 72.9 Underwriting expense ratio 31.5% 30.2 Dividends to policyholders ratio 0.6% 0.8 --------- ------ Combined ratio 106.7% 103.9 ========= ====== </TABLE> Net premiums written for First Quarter 2003 increased approximately $42.0 million, or 15%, to $323.4 million. Included in this increase is $62.9 million in net new business, compared with $71.6 million in net new business for the same period one year ago. Net premiums written for commercial lines increased 16% compared with First Quarter 2002, driven by renewal premium increases that averaged 15% (including estimated exposure growth of five points) during First Quarter 2003. Personal lines net premiums written were up 8% for First Quarter 2003, compared with a decrease of 2% for First Quarter 2002. As of the end of First Quarter 2003, commercial lines net premiums written represented approximately 83% of our total insurance underwriting business. This mix reflects our ongoing strategy to focus on commercial lines as our core operation, while establishing a smaller, but profitable personal lines segment. Our overall combined ratio for First Quarter 2003 was 106.7%, compared with a ratio of 103.9% for the same period last year. First Quarter 2003 included 3 catastrophic events, stemming from some of the worst winter storms to hit the East Coast in a decade, exposing Selective to approximately 650 claims. For First Quarter 2003, these storms added $11.9 million to losses incurred and 4.4 points to the combined ratio, compared with only $1.7 million and 0.7 points, respectively, in First Quarter 2002. Commercial Lines Underwriting <TABLE> <CAPTION> Unaudited, COMMERCIAL LINES Quarter ended March 31, (in thousands) 2003 2002 - -------------- ---- ---- <S> <C> <C> GAAP INSURANCE OPERATION RESULTS Net premiums written $ 269,754 231,914 ========= ====== Net premiums earned 215,625 185,038 Losses and loss expenses incurred 160,193 131,697 Net underwriting expenses incurred 68,084 55,285 Dividends to policyholders 1,555 1,921 --------- ------ Underwriting loss $ (14,207) (3,865) ========= ====== GAAP RATIOS: Loss and loss expense ratio 74.3% 71.2 Underwriting expense ratio 31.6% 29.9 Dividends to policyholders ratio 0.7% 1.0 --------- ------ Combined ratio 106.6% 102.1 ========= ====== </TABLE> Commercial Lines net premiums written increased $37.8 million, or 16%, to $269.8 million for First Quarter 2003 compared with $231.9 million for First Quarter 2002. Net premiums written included approximately $54.8 million in net new business for First Quarter 2003, compared with $67.0 million for the same period one year ago. Renewal price increases continued their upward trend, reaching 15% for First Quarter 2003. Importantly, retention at point of renewal moved higher to 86% for First Quarter 2003, compared with 85% at First Quarter 2002. For First Quarter 2003, the Commercial Lines combined ratio increased 4.5 points to 106.6% when compared with 102.1% for the same period one year ago. The higher combined ratio reflects 4.8 points of catastrophe losses compared with 0.6 points for the same period last year. 12
Also contributing to the increase is a higher underwriting expense ratio of 31.6% for First Quarter 2003, compared with 29.9% for First Quarter 2002. This increase is 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. The Commercial Lines underwriting expense ratio was 31.6% for the full year of 2002. We experienced improvements in underwriting results, as measured by our statutory combined ratio, in all our major casualty lines during the quarter, particularly in our commercial automobile statutory combined ratio that was 90.2% for First Quarter 2003, compared with 99.8% at First Quarter 2002 and our general liability statutory combined ratio that was 94.7% for the quarter, compared with 102.2% for the same period last year. These improvements were due to price increases and underwriting improvements. Our workers' compensation statutory combined ratio improved to 106.7% for First Quarter 2003, compared with 108.0% for First Quarter 2002. We believe our account-based underwriting strategy enhances our position with this challenging line. Workers' compensation is neither a mono-line, nor a targeted growth line for Selective, but rather an important piece of our offering to agents and their customers who want an entire package of protection from Selective. Less than 5% of our workers' compensation business is unsupported. Our underwriting is focused on low-to-medium hazards, with close to 60% of this business in the two lowest hazard groups, as defined by the National Council of Compensation Insurers, and less than one percent in the highest hazard group. Clearly, one of the most challenging components of this line is price, particularly with ongoing medical inflation, which has led to increasing loss trends. We have focused our efforts on increasing price through managed care credit reductions, shifting business to higher pricing tiers and limiting the use of dividend plans. At the same time, we have taken full advantage of all rate opportunities. As a result of these initiatives, over the last three years our workers' compensation pricing increased about 48%, while policy count has declined from 9% of total commercial policy count, to 8% as of First Quarter 2003. In the First Quarter 2003, we received an average price increase of 14%, including 17% in New Jersey, our largest workers' compensation market. These price increases exceeded loss trends by 7.0 points. Personal Lines Underwriting <TABLE> <CAPTION> Unaudited, PERSONAL LINES Quarter ended March 31, (IN THOUSANDS) 2003 2002 - -------------- ---- ---- <S> <C> <C> GAAP INSURANCE OPERATION RESULTS Net premiums written $ 53,649 49,531 ======== ====== Net premiums earned 51,422 49,257 Losses and loss expenses incurred 38,909 39,180 Net underwriting expenses incurred 16,299 15,254 -------- ------ Underwriting loss $ (3,786) (5,177) ======== ====== GAAP RATIOS: Loss and loss expense ratio 75.7% 79.5 Underwriting expense ratio 31.7% 31.0 -------- ------ Combined ratio 107.4% 110.5 ======== ====== </TABLE> Personal Lines Underwriting net premiums written, for the 10 states where we write personal lines, increased $4.1 million, or 8%, for First Quarter 2003 when compared with the same period in 2002. The Personal Lines combined ratio was 107.4% for First Quarter 2003, including 3.1 points of catastrophe losses, down 3.1 points from First Quarter 2002, which was 110.5% and contained 1.1 points of catastrophe losses. Our homeowners line of business experienced a statutory combined ratio of 122.6% for First Quarter 2003, compared with 114.8% in First Quarter 2002. First Quarter 2003 included 20.2 points from catastrophe losses, compared with 7.6 points for the same period last year. However, our personal automobile line of business improved 7.2 points, to a statutory combined ratio of 104.2% in the First Quarter 2003, compared with 111.4% in First Quarter 2002. This line was not significantly impacted by catastrophe losses in either period. The improvement reflects the significant price increases in all our operating territories, along with tightened underwriting guidelines. New Jersey personal automobile had a statutory combined ratio of 102.2% for the quarter, down 6.5 points over the same period last year. Also during First Quarter 2003, the average premium per vehicle in New Jersey increased 11% over First Quarter 2002. This is largely due to the three premium increases we've achieved in the last 15 months. In addition, the number of insured vehicles has declined to about 110,000 for First Quarter 2003, from 118,000 at First Quarter 2002. As a result of our ongoing diversification efforts, New Jersey automobile now represents 10% of company-wide premium volume, down from 11% in First Quarter 2002. As we continue to earn higher premiums from price and tier changes, we expect ongoing improvements in this line. Although we have seen substantial improvement in our New Jersey personal automobile results, they are still unprofitable. In addition, the political environment surrounding New Jersey personal automobile continues to be a challenge, with positive reform 13
efforts as well as negative resistance to the verbal threshold being discussed in the State Assembly. At this time, it remains uncertain what, if any, changes may occur and what impact they may have on the Company's results. New Jersey homeowners had a statutory combined ratio of 120.6% in the First Quarter 2003, compared with a 100.8% in First Quarter 2002. We experienced 30.5 points from catastrophe losses in the quarter, compared with 6.7 points for First Quarter 2002. We are continuing efforts to control our exposure in New York due to the high cost of required participation in the involuntary personal automobile insurance market. Our personal automobile statutory combined ratio in New York was 149.8% for First Quarter 2003, compared with 147.7% for First Quarter 2002. At the end of the First Quarter 2003, the number of insured vehicles in New York was approximately 10,500, a 4% drop from year-end 2002. In our eight other personal lines states, net premiums written increased 18% for First Quarter 2003 to $14.0 million, compared with $11.8 million for the same period last year, reflecting price increases, tier changes and other underwriting actions designed to improve results. For First Quarter 2003, the personal lines statutory combined ratio for these eight states improved almost 6 points, to 106.2%, compared with 111.8% for this period last year. Two years of price and tier changes for these eight states continue to favorably impact net premiums earned. We expect this upward, positive trend to continue with total increases of 7% for automobile and 10% for homeowners in 2003, as personal lines prices continue to push upward, industry-wide. Investments Segment Although lower interest rates continue to put pressure on investment returns, we still generated a 7% increase in after-tax investment income to $19.8 million for First Quarter 2003, up from $18.5 million for First Quarter 2002. The increase reflects an increased asset base as our overall investment portfolio reached $2.2 billion. The after-tax portfolio yield is 3.7%, compared with 4.1% 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 89% of invested assets. Approximately 60% of our debt securities portfolio is rated "AAA." Our portfolio has an average rating of "AA," with only 1% of the portfolio rated below investment grade. The Company regularly reviews its investment portfolio for declines in value, focusing attention on securities whose market value is less than 85% of their cost/amortized cost at the time of review. If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in accumulated other comprehensive income. If we believe the decline is "other than temporary," we write down the carrying value of the investment and record a realized loss in our consolidated statements of income. Our assessment of a decline in value includes our current judgment as to the financial position and future prospects of the entity that issued the investment security. Broad changes in the overall market or interest rate environment, generally will not lead to a write-down. If our judgment about an individual security changes in the future we may ultimately record a realized loss after having originally concluded that the decline in value was temporary, which could have a material impact on our net income and financial position of future periods. In evaluating potential impairment of debt securities we evaluate certain factors, including but not limited to the following: - Whether the decline appears to be issuer or industry specific; - The degree to which an issuer is current or in arrears in making principal and interest payments on the debt securities in question; - The issuer's current financial condition and its ability to make future scheduled principal and interest payments on a timely basis; - Buy/hold/sell recommendations published by outside investment advisors and analysts; and - Relevant rating history, analysis and guidance provided by rating agencies and analysts. In evaluating potential impairment of equity securities, we evaluate certain factors, including but not limited to the following: - Whether the decline appears to be issuer or industry specific; - The relationship of market prices per share to book value per share at the date of acquisition and date of evaluation; - The price-earnings ratio at the time of acquisition and date of evaluation; - The financial condition and near-term prospects of the issuer, including any specific events that may influence the issuer's operations; - The recent income or loss of the issuer; - The independent auditors' report on the issuer's recent financial statements; - The dividend policy of the issuer at the date of acquisition and the date of evaluation; - Any buy/hold/sell recommendations or price projections published by outside investment advisors; and - Any rating agency announcements. 14
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 First Quarter 2003, while First Quarter 2002 had $6.5 million. These securities were written down due to heightened credit risk that was security specific and would not impact other securities held. The Company realized gains and losses from the sale of available-for-sale debt and equity securities during First Quarter 2003 and First 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, Quarter ended March 31, (in millions) 2003 2002 Fair Fair Period of time in an Value on Realized Value on Realized unrealized loss position Sale Date Loss Sale Date Loss - ------------------------ --------- ---- --------- ---- <S> <C> <C> <C> <C> Debt securities: 0 - 6 months $ -- -- -- -- 7 - 12 months -- -- 6.7 0.3 Greater than 12 months 5.0 -- -- -- ----- -- --- --- Total debt securities $ 5.0 -- 6.7 0.3 ===== == === === </TABLE> These securities were sold despite the fact that they were in a loss position due to heightened credit risk of the individual security sold, 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 March 31, 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) March 31, 2003 December 31, 2002 - ------------- --------------------- --------------------- Gross Gross Period of time in unrealized Fair Unrealized Fair Unrealized loss position Value Loss Value Loss - ------------- ----- ---- ----- ---- Debt securities: <S> <C> <C> <C> <C> 0 - 6 months $104.6 0.7 110.8 3.3 7 - 12 months 20.5 1.8 12.9 0.3 Greater than 12 months 13.4 3.0 19.8 3.0 ------ ---- ----- ---- Total debt securities 138.5 5.5 143.5 6.6 ------ ---- ----- ---- Equities: 0 - 6 months 7.7 0.3 15.6 2.3 7 - 12 months 25.4 7.3 15.9 3.2 Greater than 12 months 7.7 3.0 8.3 2.4 ------ ---- ----- ---- Total equities 40.8 10.6 39.8 7.9 ------ ---- ----- ---- Total $179.3 16.1 183.3 14.5 ====== ==== ===== ==== </TABLE> The following table presents information regarding our available-for-sale debt securities that were in an unrealized loss position at March 31, 2003 by maturity: <TABLE> <CAPTION> Amortized Fair (in millions) Cost Value <S> <C> <C> One year or less $ 17.3 16.5 Due after one year through five years 18.6 18.2 Due after five years through ten years 63.2 60.4 Due after ten years through fifteen years 44.9 43.4 Due after fifteen years -- -- ------ ----- Total $144.0 138.5 ====== ===== </TABLE> 15
At March 31, 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 $20.5 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 7% of our total unrealized loss at March 31, 2003, and 10% at December 31, 2002. The fair value of these securities was determined by independent pricing services or bid prices provided by various broker dealers. The Company did not have a material investment in non-traded securities in First Quarter 2003 or First Quarter 2002. The Company regularly reviews the diversification of the investment portfolio compared with an investment grade corporate index. At March 31, 2003, 19% of the market value of our corporate bond and preferred stock portfolios were represented by investments in banks, only one of which was in an unrealized loss position, compared with 11% in the benchmark corporate index. The average Moody's rating for the banking portfolio is "A1" with the lowest rated security at "Baa2" and the average Standard and Poor's rating is "A", with the lowest rated security at "BB-". Diversified Insurance Services Segment <TABLE> <CAPTION> Unaudited, Quarter ended March 31, (IN THOUSANDS) 2003 2002 - -------------- ---- ---- <S> <C> <C> MANAGED CARE Net revenue $ 5,629 5,316 Pre-tax profit 950 816 FLOOD INSURANCE Net revenue 4,604 3,961 Pre-tax profit 772 650 HUMAN RESOURCE ADMINISTRATION OUTSOURCING Net revenue 10,651 9,104 Pre-tax profit (loss) 75 (225) OTHER Net revenue 454 452 Pre-tax profit 70 153 TOTAL Net revenue 21,338 18,833 Pre-tax profit 1,867 1,394 After tax profit 1,301 943 Return on net revenue 6.1% 5.0 </TABLE> Revenue from continuing Diversified Insurance Services businesses for First Quarter 2003 was $21.3 million, up 13% over First Quarter 2002, and our return on revenue from continuing Diversified Insurance Services businesses was 6.1% for First Quarter 2003, compared with 5.0% for First Quarter 2002. We posted net income from continuing operations of $1.3 million for First Quarter 2003, compared with $0.9 million for First Quarter 2002. Managed Care Our medical provider network has expanded to 84,122 locations as of First Quarter 2003 from 77,675 locations as of First Quarter 2002. Network and client expansion as well as pricing initiatives have resulted in an increase in managed care revenues of 6% to $5.6 million for First Quarter 2003 compared with $5.3 million for First Quarter 2002. This growth, combined with pricing initiatives, has also resulted in an increase of pre-tax profit of 16% to $1.0 million in First Quarter 2003 compared with $0.8 million for First Quarter 2002. Flood Insurance First Quarter 2003 premium growth of 17%, compared with First Quarter 2002, resulted in increased servicing fees of $4.6 million compared with $4.0 million in First Quarter 2002. The premium growth also increased pre-tax profit 19%, to $0.8 million, compared with $0.7 million in First Quarter 2002. Growth in new flood business was due, in part, to enhanced marketing efforts with our personal lines operation. We received book rollovers with approximately $0.8 million in premium during the quarter, bringing total flood premium serviced to $55.3 million. More than 6,000 flood agents are now selling for us countrywide. 16
Human Resource Administration Outsourcing (HR outsourcing) HR outsourcing's pricing and cost reduction initiatives that were implemented during 2002 resulted in an increase in revenue of 17%, to $10.7 million, in First Quarter 2003 compared with $9.1 million of revenue for First Quarter 2002. These initiatives have also translated into pre-tax profit of $0.1 million in First Quarter 2003 compared with a pre-tax loss of $0.2 million in First Quarter 2002. Following significant pricing and underwriting enhancements over the last 18 months, this operation is once again profitable. For First Quarter 2003, workers' compensation fees increased 10%, while client administration fees were up 7%. HR outsourcing ended the quarter with 18,735 worksite lives - on track with our tightened underwriting and pricing initiatives. About 42 agents added 2,200 worksite lives this quarter. Federal Income Taxes Total federal income tax expense remained constant at $1.3 million for First Quarter 2003, when compared with First Quarter 2002. The tax benefit from larger underwriting losses was offset by higher taxes on investment income due to a higher proportion of taxable bonds. The overall effective tax rate for First Quarter 2003 was 14% compared with 12% for First Quarter 2002. Our effective tax rate differs from the federal corporate rate of 35% primarily as a result of tax-exempt investment income. FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES Selective Insurance Group, Inc. (Parent) is an insurance holding company whose principal assets are 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 pages 54 and 55 of our Annual Report on Form 10-K 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, as well as the cost of shares of common stock repurchased under our common stock repurchase program, which commenced in 1996 and will terminate effective May 31, 2003. As of March 31, 2003, the Parent had repurchased under the program a total of 7.3 million shares 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 First Quarter 2003, cash provided by operating activities was $41.0 million compared with $38.0 million for First Quarter 2002. The Parent also has available $50.0 million of unused credit lines. Total assets increased 4%, or $122.7 million, at March 31, 2003 from December 31, 2002. The increase was primarily due to: (i) an increase in investments of $52.9 million primarily due to $41.0 million of operating cash flows, and $15.0 million of bonds purchased in late March that did not settle until April and (ii) an increase in premiums receivable of $53.3 million and an increase in deferred policy acquisition costs of $11.2 million, both corresponding with the net premiums written growth for the period. These increases were offset by $4.0 million in dividends paid to stockholders. Total liabilities increased 5%, or $118.0 million, at March 31, 2003 from December 31, 2002. Increased premium volume is primarily responsible for increases in unearned premium reserves of $56.5 million and $50.3 million in loss and loss expense reserves. Also affecting the increase in the loss and loss expense reserves are the weather-related catastrophe losses stemming from the winter storms that hit the East Coast in the First Quarter of 2003. Securities payable, classified within other liabilities, increased $15.0 million for the reason mentioned above. OFF-BALANCE SHEET ARRANGEMENTS, CONTRACTUAL OBLIGATIONS AND CONTINGENT LIABILITIES AND COMMITMENTS At March 31, 2003 and 2002, the Company did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As such, the Company is not exposed to any financing, liquidity, market or credit risk that could arise if the Company had engaged in such relationships. Our future cash payments associated with contractual obligations pursuant to operating leases for office space and equipment, 17
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. We currently have available revolving lines of credit amounting to $50.0 million, under which no balances are outstanding as of either March 31, 2003 or December 31, 2002. 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 our Annual Report on Form 10-K for the year ended December 31, 2002. CRITICAL ACCOUNTING POLICIES We have identified the policies described below as critical to our business operations and the understanding of our results of operations. For a detailed discussion on the application of these and other accounting policies, see Note 1 to our consolidated financial statements on pages 43 through 47 of our Annual Report on Form 10-K for the year ended December 31, 2002. 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 unaudited interim consolidated 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 March 31, 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 March 31, 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 $621.8 million at March 31, 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 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. 18
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 March 31, 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 therefrom 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 As of date within 90 days of the filing date of this report on Form 10-Q, an evaluation of the effectiveness of the design and operation of the Company's disclosure controls and procedures was performed under the supervision and with the participation of the Company's management, including the chief executive officer and chief financial officer. Based on that evaluation, the Company's management, including the chief executive officer and chief financial officer, concluded that the Company's disclosure controls and procedures were effective as of the evaluation date. Subsequent to the evaluation date, there have been no significant changes in the Company's internal controls or in other factors that could significantly affect internal controls. 19
PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS - NONE ITEM 2. CHANGES IN SECURITIES - NONE ITEM 3. DEFAULTS UPON SENIOR SECURITIES - NONE ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Selective's Annual Meeting of Stockholders was held on May 7, 2003. At the Annual Meeting, A. David Brown, William M. Kearns, Jr., S. Griffin McClellan III, John F. Rockart, Ph.D., and J. Brian Thebault, were elected as directors to serve for a term of three years, expiring at the 2006 Annual Meeting of Shareholders and until their successors are elected and qualified. Votes cast for and withheld on the election of directors were as follows: <TABLE> <CAPTION> Votes for Votes withheld --------- -------------- <S> <C> <C> A. David Brown 22,397,164 863,765 William M. Kearns, Jr. 22,346,481 914,448 S. Griffin McClellan III 22,389,835 871,094 John F. Rockart, Ph.D. 22,337,060 923,869 J. Brian Thebault 22,373,231 887,698 </TABLE> There were no broker nonvotes on the election of directors. The directors whose terms of office continued after the Annual meeting are; Paul D. Bauer, William A. Dolan, II, C. Edward Herder, CPCU, Joan M. Lamm-Tennant, Ph.D., Gregory E. Murphy and William M. Rue, CPCU. The shareholder proposal concerning recommendations to the Board of Directors as to management compensation was not approved. Votes cast for and against the shareholder proposal, and the number of abstentions, were as follows: <TABLE> <CAPTION> Votes for Votes against Abstentions <S> <C> <C> <C> 3,495,177 17,086,494 293,153 </TABLE> There were 2,386,105 broker nonvotes on the shareholder proposal. 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. (b) Reports on Form 8-K: There were no reports on Form 8-K filed during the period covered by this report. 20
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 <TABLE> <S> <C> By: /s/ Gregory E. Murphy May 14, 2003 - ------------------------------------------------------------------------ Gregory E. Murphy Chairman, President and Chief Executive Officer By: /s/ Dale A. Thatcher May 14, 2003 - ------------------------------------------------------------------------ Dale A. Thatcher Executive Vice President of Finance, Chief Financial Officer and Treasurer </TABLE> 21
CERTIFICATIONS I, Gregory E. Murphy, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Selective Insurance Group, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and (c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date. 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 By: /s/ Gregory E. Murphy ---------------------------------------- Gregory E. Murphy Chairman, President and Chief Executive Officer 22
I, Dale A. Thatcher, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Selective Insurance Group, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date. 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 By: /s/ Dale A. Thatcher ------------------------------------- Dale A. Thatcher Executive Vice President, Chief Financial Officer and Treasurer 23
INDEX TO EXHIBITS <TABLE> <CAPTION> Exhibit No. <S> <C> *11 Computation of Per Share Earnings, filed herewith. *99.1 Certification of Chief Executive Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002. * 99.2 Certification of Chief Financial Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002. 99.3 Note 1, 7 and 16 to consolidated financial statements of Selective Insurance Group, Inc., December 31, 2002, 2001 and 2000 (incorporated by reference to Selective's Annual Report on Form 10-K for the year ended December 31, 2002, commission file no. 0-8641). </TABLE> - ---------- * Filed herewith 24