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 December 31, 2006, the Company had accrued $2.3 billion of gross loss and loss expense reserves compared to $2.1 billion at December 31, 2005.
In addition to case reserves, we maintain estimates of reserves for losses and loss expenses incurred but not yet reported (“IBNR”). Using generally accepted actuarial reserving techniques, 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. The actuarial techniques used are part of a comprehensive reserving process that includes two primary components. The first component is a detailed quarterly reserve analysis performed by our internal actuarial staff, which is managed independently from the operating units. In completing this analysis, the actuaries are required to make numerous assumptions, including, for example, the selection of loss development factors and the weight to be applied to each individual actuarial indication. These indications include paid and incurred versions for the following actuarial methodologies: loss development, Bornhuetter-Ferguson, Berquist-Sherman, and frequency/severity. Additionally, the actuaries must gather substantially similar data in sufficient volume to ensure the statistical credibility of the data. The second component of the analysis is the projection of the expected ultimate loss ratio for each line of business for the current accident year. This projection is part of the Company’s planning process wherein the expected loss ratios are reviewed and updated each quarter. This review includes actual versus expected pricing changes, loss trend assumptions, and updated prior period loss ratios from the most recent quarterly reserve analysis.
Financial Highlights of Results for years ended December 31, 2006, 2005, and 2004
as increased reinsurance retentions. For further discussion on the prior year development in loss and loss expense reserves, see the discussion on “Net Loss and Loss Expense Reserves” in Item 1. “Business” and Note 8 of Item 8. “Financial Statements and Supplementary Data” in this Form 10-K.
Growth and profitability in this line of business is driven by enhancements to the bond underwriting process, including the successful rollout of our automated bond system in late 2005.
The following table presents information regarding our available-for-sale fixed maturities that were in an unrealized loss position at December 31, 2006 by contractual maturity:
An increase in the pre-tax marketing bonus from the National Flood Insurance Program (“NFIP”) of 87% to $2.8 million in 2006 compared to $1.5 million in 2005 and $1.8 million in 2004.
In December 2005, we divested ourselves of our 100% ownership in CHN Solutions (Alta Services, LLC and Consumer Health Network Plus, LLC), which had historically been reported as part of the managed care component of the Diversified Insurance Services segment. These companies were sold for approximately $16 million in proceeds at an after-tax net loss of approximately $2.6 million. For further information regarding this divestiture, see Note 15 in Item 8. “Financial Statements and Supplementary Data” of this Form 10-K.
We have audited the accompanying consolidated balance sheets of Selective Insurance Group, Inc. and its subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2006. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules I to VI. These consolidated financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
As discussed in Note 2 to the consolidated financial statements, in 2006 the Company changed its definition of cash equivalents for presentation in the statement of cash flows and, in 2005, changed its method of accounting for share-based payments.
Diversified Insurance Services, which provide human resource administration outsourcing products and services, and federal flood insurance administrative services.
Short-term investments are comprised of certain money market instruments, savings accounts, commercial paper, other debt issues purchased with a maturity of less than one year, and variable rate demand notes, carried at cost which approximates fair value. The associated income is included in “Net investment income earned.”
Reserves for losses and loss expenses are made up of both case reserves and reserves for claims incurred but not yet reported (“IBNR”). Case reserves result from claims that have been reported to the Insurance Subsidiaries and are estimated at the amount of ultimate payment. IBNR reserves are established based on generally accepted 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. In applying generally accepted actuarial techniques, Selective also considers a range of possible loss and loss adjustment expense reserves in establishing IBNR.
(g) Selective is not exposed to significant concentrations of credit risk within its investment portfolio. The largest investment in the securities of any one issuer was $19.3 million at December 31, 2006 and $23.2 million at December 31, 2005.
Assumed premiums written and earned decreased in 2006 compared to 2005 primarily due to reduction in mandatory pool assumptions. Ceded written premiums increased in 2006 compared to 2005, primarily due to increases in flood premiums that are 100% ceded to the National Flood Insurance Program, as well as increases in reinsurance costs. Offsetting the increase in the flood premiums was the termination of the New Jersey Homeowners Property 75% Quota Share treaty (“Quota Share Treaty”) effective January 1, 2006. In 2005, ceded written premiums were $21.1 million and ceded earned premiums were $20.4 million for the Quota Share Treaty. The Quota Share Treaty termination was effective as of January 1, 2006 and there was no prospective coverage for 2006. Consequently in 2006, Selective received a return of premium of $11.3 million previously ceded to this treaty and still unearned as of December 31, 2005. The overall effect of the termination of this treaty was to reduce ceded written premiums by $32.4 million for 2006 compared to 2005 and ceded earned premiums by $20.4 million for 2006 compared to 2005. The flood ceded premiums and losses are as follows:
Between May 3 and 4, 2006, Selective separately negotiated two private transactions under Section 3(a)(9) of the Securities Act of 1933, as amended, through which it exchanged a total of 153,961 of the Convertible Notes, representing approximately $58.5 million of the $115.9 million carrying value outstanding at the time of conversion for 3,996,304 shares of Selective Insurance Group, Inc. Common Stock, and cash. Selective incurred additional expense of $2.1 million, which represents the incremental consideration in connection with the transactions, and charged the unamortized debt costs of $1.5 million to stockholders’ equity as part of the equity issuance transaction. No conversions occurred during 2005. If the remaining Convertible Notes were converted, Selective would be required to issue 4.0 million shares of Common Stock.
Selective offers a voluntary defined contribution 401(k) retirement savings plan to employees who meet eligibility requirements. Participants, other than highly compensated employees as defined by the IRS, can contribute up to 50% of their defined compensation to the Retirement Savings Plan. Highly compensated employees are limited to 8% of their defined compensation. Contributions by participants are matched 65% by the Company up to a maximum of 7% of defined compensation. Effective January 1, 2006, Selective Insurance Retirement Savings Plan (“Retirement Savings Plan”) was amended to include additional enhanced matching contributions and non-elective contributions for otherwise eligible employees who, because of a date of hire after December 31, 2005, are not eligible for the Retirement Income Plan for Selective Insurance Company of America (“Retirement Income Plan”). For those employees, following one year of service, the Company matches, dollar for dollar, up to 2% of the employee’s base pay contributions. In addition, the Company makes non-elective contributions to the Retirement Savings Plan equal to 2% of the employee’s base pay effective with the first pay following one year of service.
The Selective Insurance Group, Inc. Cash Incentive Plan (“Cash Incentive Plan”) was adopted and approved by the Board of Directors effective March 1, 2006 and approved by stockholders on April 27, 2005. Under the Cash Incentive Plan, the Board of Directors’ SEBC may grant cash incentive units in such amounts and with such terms and conditions as it shall determine, subject to the provisions of the Cash Incentive Plan. The initial dollar value of these grants will be adjusted to reflect the percentage increase or decrease in the total shareholder return on the Common Stock of Selective over a specified performance period. In addition, for certain grants, the number of units granted will be adjusted to reflect Selective’s performance on specified indicators as compared to targeted peer companies. Each award granted under the Cash Incentive Plan shall be evidenced by an agreement containing such restrictions as the SEBC may, in its sole discretion, deem necessary or desirable and which are not in conflict with the terms of the Cash Incentive Plan. During 2006, Selective issued 79,384 cash units, net of forfeitures of 728.
As of December 31, 2006, 468,000 shares of Selective’s Common Stock were available for issuance pursuant to outstanding stock option awards under the Stock Option Plan for Directors, under which future grants ceased being available with the approval of the Stock Plan. All non-employee directors participated in this plan and automatically received an annual nonqualified option to purchase 6,000 shares of Common Stock at not less than fair value on the date of grant, which was on March 1. Options under this plan vested on the first anniversary of the grant and must be exercised by the tenth anniversary of the grant. Under the Stock Option Plan for Directors, Selective granted 66,000 options during 2005, and 60,000 options during 2004.