When a claim is reported to an insurance subsidiary, 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 their knowledge, experience, and general insurance reserving practices. Until the claim is resolved, these estimates are revised as deemed appropriate by the responsible claims personnel based on subsequent developments and periodic reviews of the case.
Historically, the results of the property and casualty insurance industry have experienced significant fluctuations due to high levels of competition, economic conditions, interest rates, loss cost trends, and other factors. During 2007, the industry experienced low levels of catastrophe losses and a softening market characterized by accelerated competition, leading to pricing deterioration in the primary insurance market that was worse than originally anticipated. We expect this trend to continue into 2008. The average forecast, according to the “U.S. Property/Casualty - Review & Preview” from A.M. Best (the “Forecast”) dated January 28, 2008, calls for negative growth in NPW of 0.6% in 2008. This is in addition to the estimated negative growth in NPW of 1.2% for 2007 discussed in the Forecast and results from an across-the-board softening in the personal and commercial lines pricing environments, a weakening economy, leakage of premium to government operated reinsurers and strong interest in alternative forms of risk transfer, including various forms of self insurance, captives, and catastrophe bonds. The 2008 NPW forecast, if accurate, would represent the first decline in total industry annual premiums since 1943. As a result, we may need to reduce our pricing, which could lead to a decrease in margins in order to retain our best business. Accelerated competition in the marketplace, coupled with low premium growth rates, has also led to an increased interest in merger and acquisition activity within the industry. The Forecast also indicates an increase in the expected statutory combined ratio in 2008 compared to the 2007 expectation, indicating that underwriting performance in the industry, although still profitable, is deteriorating.
The GAAP loss and loss expense ratio increased 0.7 points in 2007 compared to 2006 and 1.2 points in 2006 compared to 2005, primarily due to: (i) lower pricing on our commercial book of business; and, (ii) increases in property losses. Included in total property losses were catastrophe losses that decreased $3.6 million, or 0.3 points, to $12.0 million in 2007 compared to 2006 and increased $11.8 million or 0.9 points to $15.6 million in 2006 compared to 2005. The GAAP loss and loss expense ratio increases were partially offset by: (i) underwriting improvements related to the implementation of our long-term strategies; and, (ii) favorable prior year loss and loss expense development within our workers compensation and commercial auto lines of business.
This deterioration in the loss and loss expense ratio was partially offset by a reduction in catastrophe losses of $2.2 million, to $2.9 million in 2007.
The Casualty Excess of Loss program was renewed effective July 1, 2007, with no changes to the expiring structure. The total program currently provides the following coverage:
Effective January 1, 2008, we entered into a new treaty which covers our participation in the involuntary National Council on Compensation Insurance (NCCI) pool, a residual workers compensation market. The treaty provides 100% Quota Share coverage, including terrorism coverage, for the 2008 underwriting year business assumed from NCCI and has an aggregate combined ratio limit of approximately 142%. The treaty is placed with two carriers both rated “A+” by A. M. Best and we expect to cede $6.0 million in premium in 2008. We believe that the protection provided within this treaty for residual market business will be especially beneficial given current market conditions and the expected deterioration in the experience of the NCCI pool.
Reserves are reviewed for adequacy on a periodic basis. As part of the periodic review, Selective considers the range of possible loss and loss expense reserves, determined at the beginning of the year, in evaluating reserve adequacy. When reviewing reserves, Selective analyzes historical data and estimates the impact of various factors such as: (i) per claim information; (ii) Selective 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. Based upon such reviews, Selective believes that the estimated reserves for losses and loss expenses are adequate to cover the ultimate cost of claims. The changes in these estimates, resulting from the continuous review process and the differences between estimates and ultimate payments, are reflected in the consolidated statements of income for the period in which such estimates are changed.
On January 1, 2007, Selective adopted Financial Accounting Standards No. 155, Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140 (“FAS 155”). Under the guidance contained in FAS 155, companies are required to evaluate interests in securitized financial assets to identify whether such interests are freestanding derivatives or hybrid financial instruments that contain an embedded derivative. During the fourth quarter of 2006, the Financial Accounting Standards Board (“FASB”) recommended a narrow scope exception for securitized interests if: (i) the securitized interest itself has no embedded derivative (including interest rate related derivatives) that would be required to be accounted for separately other than an embedded derivative that results solely from the embedded call options in the underlying financial assets; and (ii) the investor does not control the right to accelerate the settlement. The adoption of FAS 155 did not have a material impact on the results of operations or financial condition of Selective during 2007.
In the second quarter of 2007, Selective restructured its personal lines department. As part of this restructuring, an early retirement enhancement option was offered to eligible employees. The present value of the enhancement to be made in conjunction with this early retirement option is equal to $0.9 million for the Retirement Income Plan and $0.1 million for the Postretirement Plan.
On April 26, 2006, Selective’s stockholders approved the Selective Insurance Group, Inc. Stock Purchase Plan for Independent Insurance Agencies (“Agent Plan”). This plan replaced the previous agent purchase plan under which no further purchases could be made as of July 1, 2006. Under the Agent Plan, there were 2,778,735 shares of Common Stock available for purchase as of December 31, 2007. The Agent Plan provides for quarterly offerings in which independent insurance agencies and certain eligible persons associated with the agencies with contracts with the Insurance Subsidiaries can purchase Selective’s Common Stock at a 10% discount with a one year restricted period during which the shares purchased cannot be sold or transferred. Collectively, under the current and prior plans, Selective issued shares to agents in the amount of 157,375 in 2007, 153,478 in 2006, and 158,856 in 2005 and charged to expense $0.4 million in 2007, 2006, and 2005, with a corresponding income tax benefit of $0.1 million in each year.
A summary of the stock option transactions under Selective’s share-based payment plans is as follows:
Rue Insurance placed human resource outsourcing contracts with Selective HR resulting in revenues to Selective HR of $69,000 in 2007, $62,000 in 2006, and $64,000 in 2005. In return, Selective HR paid commissions to Rue Insurance of $15,000 in 2007, $14,000 in 2006, and $15,000 in 2005.
In the ordinary course of conducting business, Selective and its subsidiaries are named as defendants in various legal proceedings. Most of these proceedings are claims litigation involving Selective’s seven insurance subsidiaries (the “Insurance Subsidiaries”) as either (a) liability insurers defending or providing indemnity for third-party claims brought against insureds or (b) insurers defending first-party coverage claims brought against them. Selective accounts for such activity through the establishment of unpaid loss and loss adjustment expense reserves. Selective’s management expects that the ultimate liability, if any, with respect to such ordinary-course claims litigation, after consideration of provisions made for potential losses and costs of defense, will not be material to Selective’s consolidated financial condition, results of operations, or cash flows.