Throughout this Management's Discussion and Analysis of Financial Condition and Results of Operations, Selective presents its operations in the way it believes will be most meaningful. Net premiums written, underwriting profit (loss) and combined ratios are presented in accordance with GAAP and accounting principles prescribed by insurance regulatory authorities because these are standard measures of performance used in the insurance industry and thus allow more meaningful comparisons with Selective's competitors.
The underwriting expense ratio decreased 0.4 points to 30.9% for 2004 compared to 31.3% for 2003 and 31.0% for 2002. Overall productivity, as measured by fiscal year net premiums written per insurance operations employee, increased approximately 14% to $789,000 in 2004 compared to $694,000 for 2003 and $592,000 for 2002. Contributing to the productivity gains are our strategic initiatives that are designed to either reduce costs and/or increase business, which include: (i) streamlined processing for small commercial lines accounts (One & Done); and (ii) web-based commercial lines and personal lines automated systems. These technology enhancements allow agents to initiate and self-service a portion of our business from their offices. Currently, agents are originating 85% of all new commercial policies while agency-originated endorsements through our CLAS system have reached almost 55% during the fourth quarter of 2004. Partially offsetting these productivity gains in 2004 and 2003 were increases in profit-based incentives to employees and agents coupled with the costs of complying with Section 404 of the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley). Profit-based incentive to employees and agents resulted in increases to the underwriting expense ratio of 0.8 points in 2004 compared to 2003, while the cost of complying with Section 404 of the Sarbanes-Oxley Act impacted the underwriting expense ratio by 0.2 points in 2004. Our Working Smarter initiative is putting a renewed focus on expense management company-wide and we expect to achieve at least $3.0 million in savings from this initiative, of which $1.0 million is expected in 2005.
On November 26, 2002 the Terrorism Risk Insurance Act of 2002 (TRIA) legislation was signed into law and will terminate on December 31, 2005. The act establishes a temporary federal program of shared public and private compensation for insured commercial property and casualty losses resulting from an "act of terrorism," as defined in the Act (certified loss). Insurance companies with direct commercial insurance exposure in the United States of America are required to participate in the program. Selective offers its commercial policyholders an option to purchase terrorism coverage that will provide protection against a TRIA certified event. Some states require mandatory coverage of terrorism losses for certain lines of business and terrorism cannot be excluded under any workers' compensation policy as a cause of loss. In 2004, approximately 90% of our commercial non-workers compensation policyholders purchased terrorism coverage. See Insurance Regulation section of Item 1. "Business" for further discussion of mandatory terrorism coverages. TRIA limits the certified losses to "international terrorism," defined as an act committed on behalf of any foreign person or foreign interest where the damage from the event is in excess of $5 million and the event was not committed in the course of a war declared by the United States. Terrorism acts related to the use of nuclear, biological and chemical (NBC) weapons are covered by TRIA provided that the Secretary of the Treasury certifies the loss. Each participating insurance company is responsible for paying a deductible before federal assistance becomes available. This deductible is based on a percentage of commercial lines direct earned premiums from the prior calendar year. The deductible equaled or equals: 7% of 2002 commercial lines direct earned premium for the 2003 calendar year, 10% of 2003 commercial direct earned premium for 2004 calendar year and 15% of 2004 commercial direct earned premium for 2005 calendar year. For losses above an insurer's deductible, the federal government will cover 90%, while the insurer contributes 10%. While the provisions of TRIA will serve to mitigate our exposure in the event of a large-scale terrorist attack, our deductible is substantial, approximating $97.0 million in 2004 and $169.0 million in 2005. In addition, it is uncertain whether TRIA will be extended past its current termination date. We continue to monitor concentrations of risk and have purchased a separate terrorism treaty to supplement our protection to this highly unknown exposure.Our Terrorism Excess of Loss treaty, effective February 1, 2003 and renewed effective January 1, 2005, covers $45.0 million in the aggregate in excess of a $15.0 million retention in the aggregate for TRIA certified losses, as well as non-certified NBC losses. All retained TRIA certified and non-certified NBC losses incurred within a calendar year are subject to this treaty. The treaty has a 10% return of premium provision if no losses are ceded to the treaty. The 2005 annual treaty cost remained flat compared with 2004. During 2004, we did not incur any terrorism losses, nor did we cede any losses to this treaty.
The degree to which an issuer is current or in arrears in making principal and interest payments on the fixed maturity securities in question;
The Parent also generates cash from the sale of its common stock under various stock plans, the dividend reinvestment program, and from investment income, all of which totaled $11.4 million in 2004, further reducing the Parent's cash requirements. As part of ongoing capital planning, the Parent successfully completed a $50.0 million bond offering in November 2004. The security is a 30-year senior note with a 7.25% coupon. The Parent contributed $25.0 million of the bond proceeds to the Insurance Subsidiaries as capital. The remainder will be deployed for opportunistic share repurchases or further capital contributions to the Insurance Operations depending on the need for growth. The Parent also currently has available revolving lines of credit amounting to $45.0 million, under which no balances were outstanding as of either December 31, 2004 or 2003. In addition, the Parent has $24.1 million remaining in an irrevocable trust to provide for the repayment of notes having maturities over the next year.
Dividends to stockholders are declared and paid at the discretion of the Board of Directors 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 76 consecutive years. On October 26, 2004, the Board of Directors approved a 12% increase in the cash dividend on the Company's common stock, to $0.19 per share, that was payable on December 1, 2004 to stockholders of record on November 15, 2004. The Parent currently plans to continue to pay quarterly cash dividends. For information regarding restrictions on the Parent's ability to pay dividends to its stockholders, see Item 8. "Financial Statements and Supplementary Data," Note 8(b) to the consolidated financial statements.
At December 31, 2004 and 2003, 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 projected cash payments associated with our estimate of loss and loss expense reserves as of December 31, 2004 are summarized below:
In 1998, New Jersey instituted an Urban Enterprise Zone (UEZ) Program, which requires New Jersey auto insurers to have a market share in certain urban territories that is in proportion to their statewide market share. Due to mandated urban rate caps, the premiums on these UEZ policies are typically insufficient to cover losses. While the law which imposed these urban rate caps was repealed in 1998, the caps continue to be enforced by the New Jersey Department of Banking and Insurance (DOBI).
Insurance companies are subject to financial strength ratings produced by external rating agencies. Higher ratings generally indicate financial stability and a strong ability to pay claims. Ratings are assigned by rating agencies to insurers based upon factors relevant to policyholders. Ratings are not recommendations to buy, hold, or sell any of Selective's securities.
Selective's Insurance Operations and Diversified Insurance Services segments are subject to geographic concentration. Approximately 37% of net premiums written are related to insurance policies written in New Jersey, 43% of SHRS' co-employer service fees are related to business in Florida and 84% of CHN Solutions fees are from New Jersey. Substantially all of Selective's remaining revenues come from the states of Connecticut, Delaware, Georgia, Illinois, Indiana, Iowa, Kentucky, Maryland, Michigan, Minnesota, Missouri, New York, North Carolina, Ohio Pennsylvania, Rhode Island, South Carolina, Virginia, and Wisconsin. Consequently, changes to economic or regulatory conditions in these states could adversely affect Selective.
(1) On November 15, 2004, Selective issued $50 million of 7.25% Senior Notes due 2034. The notes pay interest on May 15 and November 15 each year commencing on May 15, 2005. The Parent contributed $25.0 million of the bond proceeds to the Insurance Subsidiaries as capital. The remainder will be deployed for opportunistic share repurchases or further capital contributions to the Insurance Operations depending on the need for growth.
The following summaries present revenues (net investment income and net realized gains on investments in the case of the Investments segment) and pre-tax income for the individual segments:
Selective's investment objective is to maximize total return while preserving capital to meet plan obligations. To meet this objective Selective's strategy is to utilize a long-term time horizon to design the portfolio in such a manner as for the plan assets to achieve an appropriate balance between equity and fixed maturity securities, alternative investments and cash. The asset allocation is a function of the relative attractiveness of each asset class and its risk/reward characteristics. Selective's investment policy limits its asset allocation in equity investments to a maximum of 60% of the total plan assets and alternative investments to a maximum of 20% of the total plan assets. A combination of equity investments and alternative investments is limited to 70% of the total market value of the plan assets. Each individual category of private equity, hedge funds and real estate has a limit of 10% of total plan assets. Additionally, a limit of 10% of total plan assets is placed on non-U.S. equity investments, while no more than 10% of total plan assets may be invested in the stock of Selective Insurance Group, Inc., the plan sponsor. A limit of 10% of the plan's assets or 20% of fixed maturity securities may be invested in non-investment grade securities.
In May 1996, the stockholders approved the stock compensation plan for nonemployee directors, effective January 1, 1997. The purpose of this plan is to provide for the payment of the annual compensation for the directors' services in shares of Selective's common stock. The amount of common shares available for issuance under the plan is 323,876. Selective issued 13,774 shares during 2004, 9,085 shares during 2003, and 6,479 shares during 2002, and charged to expense $0.6 million in 2004, $0.5 million in 2003 and $0.4 million in 2002. The plan was amended, effective January 1, 2001, to permit the directors to elect to receive up to 50% of their compensation under the plan in cash for each calendar year. Each non-employee director must elect on or before December 20th of each year how compensation for the following year will be paid.
One of Selective's subsidiaries, Selective Insurance Company of the Southeast (SISE), is one of nine property and casualty insurance company defendants named in Howell, et al. v. State Farm, et al., a purported class action filed on May 18, 2004, in the United States District Court for the District of Maryland, Baltimore Division. The court has not yet ruled on class certification. The plaintiffs hold Standard Flood Insurance Policies (SFIP) issued by the defendant insurers, who are participants in the WYO program of the NFIP. The FIA is an agency within the Federal Emergency Management Administration (FEMA). All claims under SFIPs are 100% reinsured by FEMA. The suit alleges that the insurers underpaid flood claims arising from Hurricane Isabel in breach of their contractual obligations, fiduciary duties, and the implied covenant of good faith and fair dealing, and seeks unspecified monetary damages. The insurers, including SISE, have denied the allegations, noting that they adjusted the claims as fiduciary agents of the U.S. Government in accordance with specific federal guidelines. The insurers also have filed a motion to dismiss certain of the claims, which the court has not yet decided. Given the early stages of the litigation, it is extremely difficult to provide a meaningful estimate or range of any potential loss. FEMA's Office of the General Counsel, however, has advised the defendant carriers that, in its opinion, the claims were adjusted in accordance with the law and that FEMA will indemnify and reimburse the defense costs of the defendant insurers, including SISE. Consequently, Selective believes that its exposure in the case is minimal and not material.
The Insurance Subsidiaries prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by the various state insurance departments of domicile. Prescribed statutory accounting practices include state laws, regulations and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (NAIC). Permitted statutory accounting practices encompass all accounting practices that are not prescribed; such practices differ from state to state, may differ from company to company within a state and may change in the future. The Insurance Subsidiaries do not utilize any permitted statutory accounting practices that materially affect the determination of statutory surplus, statutory net income or risk-based capital. As of December 31, 2004 the various state insurance departments of domicile have adopted the NAIC Accounting Practices and Procedures manual, version as of March 2004, in its entirety, as a component of prescribed or permitted practices.