The Corporation owns and leases office space in various parts of the country. The principal office buildings consist of facilities owned in Fairfield and Hamilton, Ohio. These office buildings service all of the Corporation's segments. The Fairfield, Ohio office building is subject to a mortgage with an outstanding balance of $2.7 million as of December 31, 2005.
(ALL AMOUNTS ARE IN ACCORDANCE WITH GAAP UNLESS OTHERWISE NOTED; NUMBER OF WEIGHTED AVERAGE SHARES AND DOLLARS IN MILLIONS, EXCEPT SHARE AND PER SHARE DATA)
(3) Loss adjustment expense ratio measures loss adjustment expenses as a percentage of net premiums earned.
* Adjusted for effect of EITF Issue No. 04-8 in 2005, 2004, 2003 and 2002, see Footnote 9, Earnings Per Share.
The following discussion of financial condition and results of operation highlights significant factors influencing the results and financial position of the Consolidated Corporation. This discussion should be read in conjunction with the consolidated financial statements and related notes, all of which are integral parts of the following analysis of the results of operations and financial position.
The Consolidated Corporation adopted the Emerging Issues Task Force ("EITF") Consensus 04-8 "The Effect of Contingently Convertible Debt on Diluted Earnings per Share" in December 2004. See Item 15, Note 9 - Earnings Per Share in the Notes to the Consolidated Financial Statements on page 80 of the Annual Report on Form 10-K.
Financial results continued to show improvements during 2005 resulting from improvements in both loss and LAE ratios as a result of favorable claim frequency, adequate pricing, favorable prior year reserve development and lower catastrophe losses. Catastrophe losses decreased $17.7 in 2005, even though the industry experienced its worst ever year for natural catastrophes. Underwriting expenses decreased during the year as expense savings resulting from the Cost Structure Efficiency (CSE) initiative are becoming realized. The year also benefited from a favorable Internal Revenue Service (IRS) settlement adjustment and an accrual reversal for the exit of the New Jersey private passenger auto business. Offsetting some of the favorable items mentioned above was $9.0 related to loss on retirement of the convertible debt incurred in connection with the call/redemption of the Convertible Notes. For additional information on these transactions, see Item 15, Note 3 - Income Taxes on page 72, Note 7 - Other Contingencies and Commitments on pages 77-79 and Note 15 - Debt in the Notes to the Consolidated Financial Statements, on pages 82 and 83 of this Annual Report on Form 10-K.
The improved financial results for 2004 compared to 2003 were driven by significantly improved loss experience, including lower LAE, a result of cost reduction programs that have been implemented. The improved loss and LAE ratios are the result of disciplined underwriting and improved pricing methodologies, reduced claim frequency, a decline in large losses (losses greater than $250,000 per loss) and favorable prior years reserve development. During 2004, underwriting and LAE were impacted by increased severance and other related costs, primarily associated with the CSE initiative and expenses related to the Proformance transaction. As previously discussed, in 2001, OCNJ entered into a transaction which effectively exited the Group from the New Jersey private passenger auto market. For additional information regarding this transaction, see Item 15, Note 7 - Other Contingencies and Commitments in the Notes to the Consolidated Financial Statements on pages 77-79 of this Annual Report on Form 10-K.
Consolidated before-tax net investment income for the three years ended December 31, 2005, 2004 and 2003 was $201.4 ($146.8 after tax), $201.2 ($137.0 after tax) and $208.7 ($138.4 after tax), respectively. The effective tax rate on investment income for the three years ended December 31, 2005, 2004 and 2003 was 27.1%, 31.9% and 33.7%, respectively.
Before-tax investment income for 2005 was slightly higher than the same period of 2004 as the impact of growth in the investment portfolio resulting from positive operating cash flows was partially offset by lower before tax investment yields on new investments and the Consolidated Corporation's increased tax-exempt security portfolio. Investments in tax exempt securities increased from $100.0 at December 31, 2003 to approximately $1.3 billion at December 31, 2005. Additionally, before tax investment income was favorably impacted in 2005 by $2.5 of interest income received from the IRS as a result of a favorable tax settlement. This favorable impact was somewhat offset by a reduction in investment income as a result of the reduction in cash equivalent holdings which were used during 2005 to fund the call/redemption of the Corporation's 5.0% Convertible Notes. As a result of the strategy to invest more heavily into tax-exempt securities, the effective tax rate on investment income was reduced to 27.1% thereby generating an increase in after-tax investment income.
In addition to the change in investment strategy and the increase in invested assets described above, which were also applicable to 2004, the $7.5 decrease in 2004 consolidated before-tax net investment income compared to 2003 is a result of increased investment expenses due to outside management fees, the allocation
of interest income pertaining to investments held in a reinsurance treaty fund and significantly lower reinvestment rates than on maturing securities, offset by a favorable amortization adjustment in 2004 on certain fixed income securities.
Consolidated before-tax realized net investment gains amounted to $47.4, $23.0 and $35.9 for the years ended 2005, 2004 and 2003, respectively. Included in the 2005 consolidated before-tax realized net investment gains was $40.9 of net gains in the sale of common stocks which were the result of a portfolio reallocation strategy implemented by the Consolidated Corporation whereby equity holdings in certain common stocks that had appreciated in value over time and had become a significant percentage of the Consolidated Corporation's common stock portfolio were reduced. In all periods presented there were no material losses on the disposal of any specific security or in any specific sector.
Invested assets comprise a majority of the consolidated assets. Consequently, accounting policies related to investments are critical. See further discussion of important investment accounting policies in the "Critical Accounting Policies" section of this MD&A and in Item 15, Notes to Consolidated Financial Statements, Note 1C, Investments, on page 67 of this Annual Report on Form 10-K.
Future impairment charges could be material to the results of operations. The amount of the before-tax other-than-temporary impairment charge recorded was $2.4, $8.7 and $10.5 for the years ended 2005, 2004 and 2003, respectively. This impairment charge represents less than 0.5% of the market value of the investment portfolio at December 31, 2005, 2004 and 2003, respectively. The 2005 impairment charges relate to companies in various industries. Included in both the 2004 and 2003 impairment charges were $5.1 and $5.9, respectively, related to fixed income securities issued by companies in the airline industry.
The following tables summarize for all available-for-sale and held-to-maturity securities, the total gross unrealized losses, excluding securities with gross unrealized gains, by investment category and length of time the securities have continuously been in an unrealized loss position as of December 31, 2005 and December 31, 2004:
As part of its evaluation of the aggregate $21.0 unrealized loss on securities in the investment portfolio at December 31, 2005, management performed a more intensive review of securities with a higher unrealized loss percentage when compared with their cost or amortized cost. Based on this review of each security, management believes that unrealized losses on these securities were temporary declines in value at December 31, 2005. In the table above, there are approximately 420 securities represented. Of this total, 11 securities have unrealized loss positions greater than 5% of their market values at December 31, 2005, with none
The Consolidated Corporation maintains an identifiable intangible asset referred to as "Agent Relationships." See the "Critical Accounting Policies" section of this MD&A on page 42 and Note 1I - Summary of Significant Accounting Policies - Agent Relationships on page 68 and Note 13 - Agent Relationships in the Notes to the Consolidated Financial Statements on page 82 of this Annual Report on Form 10-K for additional information. In 2005, the before-tax amortization and impairment costs related to this asset were $12.3 compared with $20.6 in 2004 and $18.7 in 2003. At December 31, 2005, the largest individual agent asset carrying value was $5.3, which represents the maximum future impairment charge for an individual agent, compared to $5.6 at December 31, 2004. Based upon historical performance of this agent, it is unlikely the agent will become impaired or cancelled in the near term. For the approximately 230 individual agents remaining that represent the total agent relationships intangible asset, the average asset carrying value as of December 31, 2005, was $0.5 which compares to approximately 250 agents with an average asset carrying value of $0.5 at December 31, 2004.
P.A.R.I.S.(sm), an internally developed software application for policy administration, rating and issuance, was introduced into production in 2002. The Group capitalizes costs incurred during the application development stage, primarily relating to payroll and payroll-related costs for employees, along with costs incurred for external consultants who are directly associated with the internal-use software project. The Group ceases capitalization when the development effort is substantially complete and rollout begins. Rollout begins when the application has been placed into service for one or more states for an individual major product line and ends when the application is placed into service for the final state. The rollout period can exceed one year for an individual
Insurance industry financial measures are included in the next several sections of this MD&A that discuss results of operations. Statutory surplus, a financial measure that is required by insurance regulators and used to monitor financial strength, is discussed in the "Statutory Surplus" section of the "Liquidity and Capital Resources" section on pages 54 and 55 of this MD&A.
The table below summarizes property and casualty premiums on a gross and net basis for the year ended December 31, 2005 compared with the same period of 2004 and 2003, respectively:
All Lines gross premiums written declined in 2005 when compared with the prior year due primarily to all three operating segments experiencing declines in new business premium production as a result of an increase in price competition, partially offset by slightly better retention rates. All Lines net premiums written declined slightly when compared with the prior year with both the Commercial and Personal Lines operating segments experiencing declines, offset almost entirely by an increase in the Specialty Lines operating segment. The slight declines in net premiums written is the result of the reasons cited above partially offset by lower ceded premiums resulting from higher retention limits in our 2005 reinsurance program when compared with the 2004 program. All Lines gross and net premiums written increased slightly in 2004 over 2003 as a result of improved retention rates and price increases in 2004.
New Jersey remains the Group's largest state, with 11.6% of the total net premiums written during 2005, even after the Group ceased writing in the New Jersey private passenger auto and personal umbrella markets in early 2002. The Group continues to underwrite other product lines in the New Jersey market.
- ------------- (1) When used in this Annual Report on Form 10-K, renewal price increase means the average increase in premium for policies renewed by the Group. The average increase in premiums for each renewed policy is calculated by comparing the total expiring premium for the policy with the total renewal premium for the same policy. Renewal price increases include, among other things, the effects of rate increases and changes in the underlying insured exposures of the policy. Only policies issued by the Group in the previous policy term with the same policy identification codes are included. Therefore, renewal price increases do not include changes in premiums for newly issued policies and business assumed through reinsurance agreements. Renewal price increases also do not reflect the cost of any reinsurance purchased on the policies issued.
In 2004, the impact of the favorable development for prior accident years' losses and LAE was concentrated in the Commercial and Specialty Lines operating segments. In 2004, the Specialty Lines segment experienced significant favorable development for prior years' losses and LAE, primarily due to a reduction in estimated future costs for claims adjuster related expenses. The total provision reduction for prior years' losses and LAE of $21.8 before-tax represents 0.8% of loss and LAE reserves as of year-end 2003.
During 2003, the Group reported adverse development of $34.1 for prior years' losses and LAE, representing 1.4% of loss and LAE reserves as of year-end 2002. This adverse development was concentrated in the Commercial and Personal Lines operating segments.
Catastrophe losses, net of reinsurance and their impact on the combined ratio, for each of the last three years were:
The seven-year historical catastrophe impact on the loss ratio compared to 2005 actual impact for all lines of business is as follows:
The underwriting expense ratio, which measures underwriting expenses as a percentage of net premiums earned, decreased by 3.1 points in 2005. The 2005 underwriting expense ratio was favorably impacted by the Group's focus on expense management, including implementation of additional process efficiencies that have continued to allow for reduced staffing levels and by a $5.1 reduction to the surplus guarantee accrual related to the sale of the Group's New Jersey private passenger auto business to Proformance Insurance Company
The 2004 underwriting expense ratio when compared to 2003 was favorably impacted by a reduction in employee related costs, a non-recurring reduction in assessments, fees and premium taxes and by other operating efficiencies. These improvements were partially offset by 1.1 points of expense related to the Proformance surplus guarantee.
The Consolidated Corporation has three reportable segments: Commercial, Specialty and Personal Lines. These reportable segments represent the Consolidated Corporation's operating segments. Within each operating segment are distinct insurance product lines that generate revenues by selling a variety of commercial, surety and personal insurance products. The Commercial Lines operating segment sells commercial multiple peril, commercial auto, general liability and workers' compensation insurance as its primary products. The Specialty Lines operating segment sells commercial umbrella, excess insurance and fidelity and surety insurance as its primary products. The Personal Lines operating segment sells personal automobile and homeowners insurance as its primary products. The Corporation also has an all other segment, which derives its revenue from investment income. For additional information relating to the Consolidated Corporation's reportable segments see Item 15, Notes to the Consolidated Financial Statements, Note 12 - Segment Information on pages 81 and 82 of this Annual Report on Form 10-K.
The table below presents the calendar year and accident year combined ratios calculated on a statutory basis. The loss and LAE ratio components of the accident year combined ratio measure losses and LAE arising from insured events that occurred in the respective accident year. The current accident year excludes losses and LAE for insured events that occurred in prior accident years.
Commercial Lines results for 2005 included a lower level of catastrophe losses which added 2.2 points to the Commercial Lines combined ratio in 2005, compared to 2.4 points and 2.6 points in 2004 and 2003 respectively.
The Personal Lines combined ratio for 2005 decreased 18.1 points over the same period last year, as all components of the combined ratio saw improvements. The loss and LAE ratios improved 14.0 points over 2004 resulting from lower catastrophe losses, favorable development on prior years' reserves and favorable claim frequency trends. The 2005 loss ratio included 1.5 points related to catastrophe losses verses 4.9 points and 4.8
points in 2004 and 2003, respectively. Favorable prior years reserve development was $36.9 or 7.6 points in 2005, compared to adverse development of $2.6 or 0.5 points and $14.4 or 3.0 points in 2004 and 2003, respectively. The underwriting expense ratio improved 4.1 points, which included a 1.1 point reduction related to the Proformance surplus guarantee, compared to a 3.2 point increase in 2004.
Management of the Consolidated Corporation has identified the policies listed below as significant accounting policies that are critical to the Consolidated Corporation's business operations and influence the consolidated results of operations and financial performance. The policies listed below were selected as they require a higher degree of complexity or use subjective judgments or assessments. Changes in these judgments, assessments or estimates could have a material adverse impact on the Consolidated Corporation's financial statements. These policies follow accounting principles generally accepted in the United States. A summary of each critical accounting policy follows. Management discusses the development and selection of these accounting policies with the Audit Committee of the Board of Directors and the Audit Committee has reviewed the Consolidated Corporation's MD&A. For a complete discussion on the application of these and other accounting policies, see Item 15, Note 1, Summary of Significant Accounting Changes, in the Notes to Consolidated Financial Statements, on pages 67-69 of this Annual Report on Form 10-K.
credit risk to minimize exposure to significant losses from reinsurer insolvencies. Each year, the Group reviews financial statements and calculates various ratios used to identify reinsurers who no longer meet appropriate standards of financial strength. Reinsurers who fail these tests are reviewed and those that are determined by the Group to have insufficient financial strength are removed from the program at renewal. Additionally, a large number of reinsurers are utilized to mitigate concentration of risk. To the extent that any reinsuring companies are unable to meet obligations under the ceded reinsurance agreements, the Group would remain liable to the policyholder. Amounts recoverable from reinsurers are calculated in a manner consistent with the reinsurance contract and are reported net of an estimated allowance for uncollectible reinsurance amounts, as deemed necessary. At December 31, 2005 and 2004, no reinsurer accounted for more than 15 percent of the reinsurance recoverable amount. As a result of these controls, amounts of uncollectible reinsurance have not been significant. There are several programs that provide reinsurance coverage and the programs in effect for 2005 are discussed in the "Reinsurance Programs" section of Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operation, on page 55 of this Annual Report on Form 10-K. Additionally, reinsurance is further discussed in Item 15, Note 1K, Summary of Significant Accounting Policies on page 68 and Note 6, Reinsurance, in the Notes to the Consolidated Financial Statements on page 77 of this Annual Report on Form 10-K.
The agent relationships asset is an identifiable intangible asset representing the excess of cost over the fair value of net assets acquired in connection with the 1998 GAI commercial lines acquisition. This purchase price was allocated to specifically identifiable intangible assets based on their estimated values as determined by appropriate valuation models. The agent relationships asset is amortized on a straight-line basis over an estimated useful life of twenty-five years. The estimated useful life was based on the Group's actual experience for agency appointment terms for similar agents, which averaged approximately twenty-five years in length. The estimated useful life is evaluated on an annual basis or as events or circumstances arise that may impact the useful life of the asset. The asset is evaluated quarterly as events or circumstances, such as cancellation of agents, indicate a possible inability to recover the carrying amount. Cancellation of certain agents for reasons such as lack of revenue production or poor quality of business produced does not necessarily change the estimated useful life of the remaining agents representing the agent relationships intangible asset. Such evaluation is based on various analyses, including cash flow and profitability projections that incorporate, as applicable, the impact on existing company businesses. The analyses involve significant management judgments to evaluate the capacity of an acquired business to perform within projections. If future undiscounted cash flows are insufficient to recover the carrying amount of the asset, an impairment loss is recognized in income in the period in which the future cash flows are identified to be insufficient in comparison to the carrying amount of the asset. Due to the inherent uncertainties and judgments involved in developing assumptions for each agent, further reductions in the valuation of the agent relationships asset are likely to occur in the future.
The Company contributed $19.0 in the first quarter of 2006 and is currently evaluating whether any further contributions will be made in 2006. The source for the funding will be cash flow from operating activities.
In 2004, the Company announced changes to its defined benefit retirement plan and defined postretirement health care plans. The Company's traditional defined benefit retirement plan was amended to freeze accrued benefits effective June 30, 2004, and to incorporate a new benefit formula beginning July 2004. As a result of this change in the defined benefit retirement plan, the Company recognized a reduction in net periodic pension cost of $2.3 and $1.9 in 2005 and 2004, respectively, attributable to the amortization of unrecognized prior service cost and has a remaining unrecognized prior service cost of $27.5 at December 31, 2005 which will be ratably recognized over the next 12 years as a reduction of net periodic pension cost. Also effective in July 2004, eligibility for subsidized retiree medical and dental coverage was restricted to then current retirees and employees with 25 or more years of continuous service. Other employees are eligible for access to unsubsidized retiree medical and dental coverage. As a result of this change in the defined postretirement
The Group's largest liabilities are reserves for losses and LAE. Loss and LAE reserves (collectively "loss reserves") are established for all incurred claims without discounting for the time value of money. Before credit for reinsurance recoverables, these reserves amounted to $2.9 billion and $2.8 billion at December 31, 2005 and 2004, respectively. As of December 31, 2005, the loss reserves by operating segment were as follows: $1,814.6 Commercial Lines, $743.9 Specialty Lines and $388.3 Personal Lines. The Group purchases reinsurance to mitigate the impact of large losses and catastrophic events. Loss reserves ceded to reinsurers amounted to $684.6 and $570.3 at December 31, 2005 and 2004, respectively.
Most of our insurance policies are written on an occurrence basis which provides coverage if a loss occurs in the policy period, even if the insured reports the loss many years later. In addition, final settlement of certain claims can be delayed for years or decades due to litigation or other reasons. For example, some general liability claims are reported 10 years or more after the policy period, and the workers' compensation coverage provided by our policies pays unlimited medical benefits for the duration of the claimant's injury up to the lifetime of the claimant. Occurrence based forms of insurance require estimation of future costs, including the effect of judicial interpretations, societal litigation trends and medical cost inflation, among others. Reserve development can occur over time as conditions and circumstances change in the years following the policy issuance.
Product lines are generally classified as either long-tail or short-tail, based on the average length of time between the event triggering claims under a policy and the final resolution of those claims. Short-tail claims are reported and settled quickly, resulting in less estimation variability. The longer the time before final claim resolution, the greater the exposure to estimation risks and hence the greater the estimation uncertainty. Long-tail product lines
The process for estimating loss reserves begins by assessing risks and exposures. Data on individual reported claims, both current and historical, is collected including paid amounts and individual claim adjuster estimates, and this data is grouped by common characteristics and evaluated in the analyses of ultimate claim liabilities by product line. Such data is occasionally supplemented with external data such as industry development factors as available and when appropriate. The process of analyzing reserves is undertaken on a regular basis, generally quarterly, in light of continually updated information.
Multiple estimation methods are available for the analysis of ultimate claim liabilities. Each estimation method has its own advantages and disadvantages, with no single estimation method being better than the others in all situations. Generally more methods are used for long-tail product lines because of the difficulty in estimating reserves for these lines. Also, more methods are generally used for recent accident years compared to older accident years because the data available for recent accident years is less mature. The relative strengths and weaknesses of the particular estimation methods when applied to a particular group of claims can also change over time based on the available facts and circumstances. Therefore, the actual choice of estimation methods can change with each evaluation. The estimation methods chosen are those that are believed to produce the most reliable indication at that particular evaluation date for the claim liabilities being evaluated.
3. Expected loss ratio - loss ratios are determined for recent accident years based on historical accident year loss ratios, recent economic trends and changes in the book of business, including rate levels. The expected loss ratio for each accident year is then applied to the actual earned premiums to calculate ultimate losses.
4. Bornhuetter-Ferguson estimates - blends the expected loss ratio method with either the paid or incurred loss development method using weights based on the maturity of the accident year.
5. Claim count and severity estimates - ultimate claim counts and average claim severities are developed separately and then multiplied to derive an estimate of ultimate losses.
For short-tail lines, the paid loss and incurred loss development methods are generally relied on for all accident years, and the Bornhuetter-Ferguson method is also relied on for the most recent accident year. For long-tail lines, all of the above methods may be used for the most recent accident years, and as accident years mature, reliance is shifted to the paid and incurred loss development methods.
The merits of each method are evaluated given the facts at hand. An estimate of the ultimate losses is then made based upon the particular method or combination of methods that is deemed most appropriate. In some cases the methodologies produce a cluster of estimates with a tight band of indicated possible outcomes. In other cases, the methodologies produce conflicting results and wider bands of indicated possible outcomes. Management does not believe that such bands constitute a range of outcomes, nor does management determine a range of outcomes.
To illustrate the uncertainty by operating segment, the following table provides the before-tax amount of prior accident years' loss reserve development by operating segment on a net of reinsurance basis for the years ended December 31, 2005, 2004 and 2003, respectively:
Reserve estimates are also uncertain by accident period. To illustrate this, the following table provides the before-tax amount of prior accident years' loss and LAE reserve development by accident year on a net of reinsurance basis for all lines combined:
This table illustrates that recent accident periods have developed favorably while the older periods have developed adversely. More than half of the $78.5 of adverse development for accident years 2000 & prior in calendar period 2005 is attributed to our review of workers' compensation permanent cases which is discussed in more detail below. We do not believe that older accident years will always develop adversely while more recent years develop favorably. However, it should be understood that the "prior" accident years' category includes claims covering many decades, many of which are complex. Conversely, the recent accident years include a mix of claims of varying degrees of difficulty for which many are relatively straight-forward to establish loss reserves.
Workers' compensation represents the Group's largest product line as measured by the magnitude of loss reserves, representing approximately 30% of the total on a net of reinsurance basis. The coverage provided includes indemnity and medical benefits generally defined by state regulation. Indemnity benefits compensate the injured worker for wage replacement, while the medical benefits generally provide unlimited coverage for a work-related accident for the life of the claimant. Many workers' compensation claims are small and are settled within a year or two of the accident date. However, some of the claims are serious, resulting in costs that can extend for decades. For workers' compensation loss reserves net of reinsurance at year-end 2005, approximately 60% are related to claims over five years old, and approximately 35% are related to claims over ten years old.
The Group defines construction defect exposure as liability for allegations of defective work and completed operations losses from general, commercial multiple peril and umbrella liability policies involving multiple-units (condos/townhouses/apartments/tracts of single family homes), multiple defendants (e.g. developers, sub-contractors), usually with multiple defect issues, and often involving multiple insurance carriers. Loss reserves are difficult to estimate for this exposure because of the complexity of the claims and the late reporting which often occurs many years after the policy term. The Group excludes from this definition claims related to individual single family homes, apartments/townhomes or other residential properties if the defect issues are limited in scope and volume.
Paid losses for construction defect claims, net of reinsurance, were $19.2 in 2005, compared to $9.9 in 2004 and $16.5 in 2003. Paid claims legal related LAE, net of reinsurance, for construction defect claims were $6.1 in 2005, compared with $5.1 in 2004 and $4.3 in 2003. Loss and legal related LAE reserves were $56.4, $78.3 and $86.7 at year-end 2005, 2004 and 2003, respectively. These totals exclude construction defect losses from the state of California because the Group stopped writing in that state in 1993 and the remaining claims are minimal.
The Group writes commercial umbrella business with large policy limits. The period of time between the loss occurrence, the reporting of the claim to the insurer, and the settlement of the claim can extend over many years. The large policy limits, complexity of claims and the lengthy time period required to reach settlement increase the uncertainty of loss estimates. Reinsurance is purchased to mitigate the impact of these large losses. For 2005 and 2004, commercial umbrella loss reserves prior to reinsurance were $718.4 and $637.1, respectively, while loss reserves net of reinsurance were $272.3 and $236.1, respectively.
Some risk factors will affect more than one product line. Examples include changes in claim handling practices, changes in settlement patterns, regulatory and legislative actions, court actions, timeliness of claim reporting, state mix of claimants and degree of claimant fraud. The extent of the impact of a risk factor will also vary by components within a product line. Individual risk factors are also subject to interactions with other risk factors within product line components.
The evaluation of data is also subject to distortion from extreme events or structural shifts. While some changes in the claim environment are sudden in nature (such as a new court ruling affecting the interpretation of all contracts in that jurisdiction), others are more evolutionary. Evolutionary changes can occur when multiple factors affect final claim values, with the uncertainty surrounding each factor being resolved separately, in step-wise fashion. The final impact is not known until all steps have occurred.
The following section details reserving considerations and loss and LAE risk factors for the product lines representing most of our loss reserves. Each risk factor presented will have a different impact on required loss reserves. Also, risk factors can have offsetting or compounding effects on required loss reserves. For example, in workers' compensation, the use of expensive medical procedures that result in medical cost inflation may enable workers to return to work faster, thereby lowering indemnity costs. Thus, in almost all cases, it is impossible to discretely measure the effect of a single risk factor and construct a meaningful sensitivity expectation. The Group does not make explicit assumptions for the risk factors described below.
Workers' compensation is generally considered a long-tail coverage, as it takes a relatively long period of time to finalize claims from a given accident year. While certain payments such as initial medical treatment or temporary wage replacement for the injured worker are made quickly, some other payments are made over the course of several years, such as awards for permanent partial injuries. In addition, some payments can run as long as the injured worker's life, such as permanent disability benefits and on-going medical care. Despite the
possibility of long payment tail, the reporting lags are generally short, settlements are generally not complex, and most of the liability can be considered high frequency, moderate severity. The largest reserve risk generally comes from the low frequency, high severity claims providing lifetime coverage for medical expense arising from a worker's injury. Overall, the claim liabilities for this line create a somewhat greater than moderate estimation risk.
Examples of loss and LAE risk factors that can change and, thus, affect the required workers' compensation loss reserves include, but are not limited to, the following:
Frequency of claim re-openings on claims previously closed Mortality trends of injured workers with lifetime benefits and medical treatment Degree of cost shifting between workers' compensation and health insurance
General liability is considered a long-tail line, as it takes a relatively long period of time to finalize and settle claims from a given accident year. The speed of claim reporting and claim settlement is a function of the specific coverage provided, the jurisdiction and specific policy provisions. There are numerous components underlying the general liability product line. Some of these have relatively moderate payment patterns (with most of the claims for a given accident year closed within 5 to 7 years), while others can have extreme lags in both reporting and payment of claims. In addition, this line includes asbestos and environmental claims which are reviewed separately because of the unique character of the exposures.
Major contributors to loss reserve estimate uncertainty for general liability include the reporting lag (i.e. the length of time between the event triggering coverage and the actual reporting of the claim), the number of parties involved in the underlying tort action, whether the "event" triggering coverage is confined to only one time period or is spread over multiple time periods, the potential dollars involved (in the individual claim actions), whether such claims were reasonably foreseeable and intended to be covered at the time the contracts were written (i.e., coverage dispute potential) and the potential for mass claim actions. Claims with longer reporting lags result in greater inherent risk.
Examples of loss and LAE risk factors that can change and thus affect the required general liability loss reserves include, but are not limited to, the following:
Changes in claim handling procedures Changes in policy provisions or court interpretation of such provisions New theories of liability Trends in jury awards Changes in the propensity to sue, in general and with specificity to particular issues Changes in statutes of limitations Changes in the underlying court system Distortions from losses resulting from large single accounts or single issues Changes in tort law Shifts in law suit mix between federal and state courts Changes in claim office structure (causing distortions in the data) Changes in settlement patterns
Changes in policy provisions (e.g., deductibles, policy limits, endorsements) Changes in underwriting standards Product mix (e.g., size of account, industries insured, jurisdiction mix)
Commercial umbrella is considered a long-tail line as it takes a relatively long period of time to finalize and settle claims from a given accident year. This line has many of the same characteristics and risk factors as the general liability line described above. Additional risk factors for this line are the attachment point and limit provided. The attachment point is generally at least $1.0, and sometimes in excess of $25.0, resulting in a greater reporting lag (and thus more variability) than that of general liability. The limit provided by commercial umbrella varies from $1.0 up to $25.0. The higher limit policies create more variability in loss reserve estimates than general liability policies. Reinsurance is purchased to mitigate this additional uncertainty.
Commercial multi-peril provides a combination of property and liability coverage and therefore includes both short and long-tail coverages. For property coverage, it generally takes a relatively short period of time to close claims, while for the liability coverages it takes a longer period of time to close claims. The reserving risk for this line is dominated by the liability coverage portion of this product, and has risk factors similar to general liability described above.
Examples of loss and LAE risk factors that can change and, thus, affect the required commercial automobile loss reserves include, but are not limited to, the following:
Changes in policy provisions (e.g., deductibles, policy limits, endorsements, etc.) Changes in mix of insured vehicles Changes in underwriting standards
Investing activities used net cash of $267.5 in 2005, compared to $274.4 in 2004 and $175.6 in 2003. Cash used in investing activities during 2005 and 2004 were essentially flat year to year and consistent with the cash generated from operations. Cash used in investing activities increased $98.8 in 2004 when compared with 2003 due to the reinvestment of the cash generated from operations, which increased over $100.0 in 2004.
The Corporation is dependent on dividend payments from its insurance subsidiaries in order to meet operating expenses and debt obligations. Insurance regulatory authorities impose various restrictions and prior approval requirements on the payment of dividends by insurance companies. As of December 31, 2005, approximately $415.0 of statutory surplus was not subject to prior dividend approval requirements. Additional restrictions may result from the minimum risk-based capital requirements in the revolving credit agreement as disclosed in Item 15, Note 15, Debt, in the Notes to Consolidated Financial Statements, on pages 82 and 83 of this Annual Report on Form 10-K.
During 2005, the Consolidated Corporation finalized negotiations with the IRS regarding its examination of the Consolidated Corporation's tax years 1997 through 2001. On August 25, 2005, the IRS issued notification to the Consolidated Corporation that a settlement concerning its examination of these tax years was approved. This settlement resulted in a $2.7 net tax benefit related to realized capital gains and interest income, before tax, of $0.9. In conjunction with the IRS settlement, the Consolidated Corporation reversed $9.1 ($8.0 related to realized capital gains and $1.1 related to operations) of book tax reserves. Additionally, on September 28, 2005, the IRS advised the Consolidated Corporation that it accepted a protective claim for refund for the 1996 tax year related to adjustments resulting from the 2003 settlement of the IRS examination of the 1995 tax year. The acceptance of this protective refund claim resulted in a $3.4 net tax benefit related to operations and interest income, before tax, of $1.6. See Item 15, Note 3 - Income Taxes in the Notes to the Consolidated Financial Statements on page 72 of this Annual Report on Form 10-K.
As of December 31, 2005 and 2004, the Corporation did not have any off-balance sheet arrangements as defined by Financial Release - 67, "Disclosure in Management's Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations."
The following table presents the Consolidated Corporation's obligations to make future payments under contractual obligations as of December 31, 2005:
- --------------- * The amounts presented are estimates of the dollar amounts and time periods in which the Group expects to pay its gross loss and LAE reserves. These amounts are based upon historical payment patterns and do not represent actual contractual obligations. The actual payment amounts and the related timing of those payments could differ significantly from these estimates. See Item 15, Note 8, Loss and Loss Reserves, in the Notes to Consolidated Financial Statements, on page 79 of this Annual Report on Form 10-K and discussed separately above.
On February 16, 2006, the Corporation entered into a new revolving credit agreement with an expiration date of March 16, 2011. Under the terms of this new revolving credit agreement, the lenders agreed to make loans to the Corporation in an initial aggregate amount of up to $125.0 for general credit purposes.
For additional discussion regarding debt of the Consolidated Corporation, please refer to Item 15, Note 15, Debt, in the Notes to Consolidated Financial Statements, on pages 82 and 83 of this Annual Report on Form 10-K.
The ratio of net premiums written to statutory surplus is one of the measures used by insurance regulators to gauge the financial strength of an insurance company and indicates the ability of the Group to grow by writing additional business. At December 31, 2005, the Group's net premiums written to surplus ratio was 1.4 to 1 compared to 1.5 to 1 in 2004.
The Group's casualty exposures are reinsured through several contracts. The Casualty Excess of Loss contract retention is $2.0 with limits of $4.0 per occurrence. This contract covers liability exposures for Workers' Compensation, General Liability, Personal Umbrella and Commercial and Personal Automobile Liability. The 1st and 2nd Contingency Excess of Loss contracts cover all casualty lines with retention of $6.0 and limit of $18.0. Commercial Umbrella exposures are reinsured by the 1st and 2nd Cessions Excess of Loss contracts. These contracts provide retention of $2.0 and limit of $23.0 per occurrence. Workers' Compensation Catastrophe exposures are reinsured with the 1st and 2nd Workers' Compensation Catastrophe Excess of Loss contracts with retention of $12.0 and limits of $36.0 per occurrence.
Reinsurance contracts do not relieve the Group of their obligations to policyholders. The collectibility of reinsurance depends on the solvency of the reinsurers at the time any claims are presented. The Group monitors each reinsurer's financial health and claims settlement performance because reinsurance protection is an important component of the Consolidated Corporation's financial plan. Each year, the Group reviews financial statements and calculates various ratios used to identify reinsurers who no longer meet appropriate standards of financial strength. Reinsurers who fail to meet these tests are reviewed and those that are determined by the Group to have insufficient financial strength are removed from the program at renewal. Additionally, a large base of reinsurers is utilized to mitigate concentration of risk. The Group also records an estimated allowance for uncollectible reinsurance amounts as deemed necessary. At December 31, 2005 and 2004, no reinsurer accounted for more than 15 percent of the reinsurance recoverable amount. As a result of these measures, amounts of uncollectible reinsurance have not been significant. For more discussion on the reinsurance recoverable asset, see Item 15, Note 6, Reinsurance, in the Notes to Consolidated Financial Statements, on page 77 of this Annual Report on Form 10-K.
- ---------------- *Included in equity securities as of December 31, 2005 are common stock with a cost of $97.3 and carrying value of $327.9 and preferred stock with a cost of $46.9 and carrying value of $47.2. Included in equity securities as of December 31, 2004 are common stock with a cost of $91.6 and carrying value of $350.2 and preferred stock with a cost of $7.3 and carrying value of $7.2.
Following is a table displaying available-for-sale non-investment grade and non-rated securities in an unrealized loss position at December 31, 2005 and December 31, 2004, respectively:
The Consolidated Corporation uses assumptions and estimates when valuing certain investments and related income. These assumptions include estimations of cash flows and interest rates. Although the Consolidated Corporation believes the values of its investments represent fair value, certain estimates could change and lead to changes in fair values due to the inherent uncertainties and judgments involved with accounting measurements.
Ohio Casualty Corporation publishes forward-looking statements relating to such matters as anticipated financial performance, business prospects and plans, regulatory developments and similar matters. The statements contained in this MD&A that are not historical information, are forward-looking statements. The Private Securities Litigation Reform Act of 1995 provides a safe harbor under the Securities Act of 1933 and the Securities Exchange Act of 1934 for forward-looking statements. The operations, performance and development of the Consolidated Corporation's business are subject to risks and uncertainties, which may cause actual results to differ materially from those contained in or supported by the forward-looking statements in this report. The risks and uncertainties that may affect the operations, performance, development and results of the Consolidated Corporation's business include the following: changes in property and casualty reserves;
catastrophe losses; premium and investment growth; product pricing environment; availability of credit; changes in government regulation; performance of financial markets; fluctuations in interest rates; availability and pricing of reinsurance; litigation and administrative proceedings; rating agency actions; acts of war and terrorist activities; ability to appoint and/or retain agents; ability to achieve targeted expense savings; ability to achieve premium targets and profitability goals; and general economic and market conditions.