Our main office is located in Branchville, New Jersey, on a site owned by a subsidiary with approximately 114 acres and 315,000 square feet of operational space. We lease all of our other facilities. The principal office locations related to our three business segments are described in the “Field Strategy,” “Investments Segment,” and “HR Outsourcing” sections of Item 1. “Business.” We believe our facilities provide adequate space for our present needs and that additional space, if needed, would be available on reasonable terms.
See Item 8. “Financial Statements and Supplementary Data,” Note 12 to the consolidated financial statements for the components of of income. In 2002, we sold our ownership interest in PDA Software Services, Inc. and in 2005, we sold our ownership interest in CHN Solutions (Alta Services, LLC and Consumer Health Network Plus, LLC), both of which had historically been reported as components of the Diversified Insurance Services segment.
Changes in both the GAAP and statutory combined ratios are viewed by management and analysts as indicative of changes in the profitability of underwriting operations. A ratio over 100% is indicative of an underwriting loss, and a ratio below 100% is indicative of an underwriting profit.
Certain statements in this report, including information incorporated by reference, are “forward-looking statements” as that term is defined in the Private Securities Litigation Reform Act of 1995 (“PSLRA”). The PSLRA provides a safe harbor under the Securities Act of 1933 and the Exchange Act for forward-looking statements. These statements relate to our intentions, beliefs, projections, estimations or forecasts of future events or future financial performance and involve known and unknown risks, uncertainties and other factors that may cause us or the 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, forward-looking statements may be identified 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 are only predictions, and we can give no assurance that such expectations will prove to be correct. 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.
Factors that could cause our actual results to differ materially from those we have projected, forecasted or estimated in forward-looking statements are discussed in further detail in Item 1A. “Risk Factors.” 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 can neither 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.
We offer property and casualty insurance products and diversified insurance services through our various subsidiaries. We classify our businesses into three operating segments: (i) Insurance Operations; (ii) Investments; and (iii) Diversified Insurance Services.
In addition to case reserves, we maintain estimates of reserves for losses and loss expenses 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 our planning process wherein we review and update expected loss ratios 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.
The following tables provide case and IBNR reserves for losses, reserves for loss expenses, and reinsurance recoverable on unpaid losses and loss expenses as of December 31, 2008 and 2007:
We established a range of reasonably possible reserves for net claims of approximately $2,267 million to $2,545 million at December 31, 2008 and of $2,180 million to $2,414 million at December 31, 2007. A low and high reasonable reserve selection was derived primarily by considering the range of indications calculated using 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. Although this range reflects likely scenarios, it is possible that the final outcomes may fall above or below these amounts. Based on internal stochastic modeling, we feel that a reasonable estimate of the likelihood that the final outcome falls within the current range is approximately 75%. This range does not include a provision for potential increases or decreases associated with environmental reserves. Our best estimate is consistent with the actuarial best estimate. We do not discount to present value that portion of our loss reserves expected to be paid in future periods; however, the loss reserves take into account anticipated recoveries for salvage and subrogation claims.
In addition to the normal amount of volatility, medical loss development factors for workers compensation are particularly sensitive to assumptions relating to medical inflation. Actual medical loss development factors could be significantly different than those which are selected from historical loss experience if actual medical inflation is materially different than what was observed in the past. In addition, workers compensation has been the focus of a multi-faceted underwriting strategy designed to significantly reduce the loss ratio over time. The combination of the sensitivity of workers compensation results to medical inflation and changes in underwriting could lead to actual experience emerging differently than the assumptions used in the process to establish reserves. In our judgment, it is possible that actual medical loss development factors could range from 6% below to 8% above those selected in our latest reserve analysis and expected loss ratios could range from 5% below to 7% above those selected in our latest reserve analysis. The combination of reducing the assumptions for medical loss development by 6% and the expected loss ratio by 5% could decrease our indicated workers compensation reserves by approximately $58 million for accident years 2007 and prior. Alternatively, the combination of increasing the medical loss development factors by 8% and the expected loss ratio by 7% could increase our indicated workers compensation reserves by approximately $81 million for accident years 2007 and prior.
In addition to the normal amount of volatility, our commercial automobile line of business has realized significant favorable development in 2005 to 2007, which leveled off to a minimal amount in 2008. This favorable development was driven in large part by a reduction in our bodily injury large loss experience. The actual number of large claims has a high degree of volatility from year to year in terms of timing and ultimate final emergence. Even if ultimate large losses are ultimately consistent from year to year, if they are identified at different times than previous years, traditional loss development factors may overstate or understate actuarial indications. If the timing of large losses is significantly variable, it is our judgment that actual loss development factors could be +/- 6% different from those selected in our reserve review, which would increase/decrease our indicated commercial auto reserves by approximately $59 million for accident years 2007 and prior.
In addition to the line of business specific assumptions discussed above, a number of claims initiatives have increased average case reserves for both the general liability and commercial auto lines of business. This increase in case reserves causes larger differences between some indications than would normally be experienced. In our judgment, it is possible that the selections for these lines of business in our latest reserve review could increase by $57 million or decrease by $46 million depending on how various methodologies converge for these lines of business in accident years 2007 and 2008.
For the 2008 accident year, the expected ultimate loss ratio by line of business is a key assumption. This assumption is based upon a large number of inputs that are assessed periodically, such as historical loss ratios, projected future loss trend, and planned pricing amounts. In our judgment, it is possible that the actual ultimate loss ratio for the 2008 accident year could be +/-7% from the one selected in our latest reserve analysis for each of our four major long-tailed lines of business. The table below summarizes the possible impact on our reserves of varying our expected loss ratio assumption by +/-7% by line of business for the 2008 accident year.
Included in our loss and loss expense reserves are amounts for environmental claims, both asbestos and non-asbestos. Carried net loss and loss expense reserves for environmental claims were $44.1 million as of December 31, 2008 and $51.4 million as of December 31, 2007. Our asbestos and non-asbestos environmental claims have arisen primarily from insured exposures in municipal government, small commercial risks, and homeowners policies. The emergence of these claims is slow and highly unpredictable. Over the past few years, we also experienced adverse development in our homeowners line of business as a result of unfavorable trends in claims for groundwater contamination caused by leakage of certain underground heating oil storage tanks in New Jersey. In addition, certain landfill sites are included on the National Priorities List (“NPL”) by the United States Environmental Protection Agency (“USEPA”). Once on the NPL, the USEPA determines an appropriate remediation plan for these sites. A landfill can remain on the NPL for many years until final approval for the removal of the site is granted from the USEPA. The USEPA also has the authority to re-open previously closed sites and return them to the NPL. We currently have reserves for several claims related to sites on the NPL. During 2008, 43 of our past and present insureds filed formal consent decrees with the New Jersey Department of Environmental Protection, resolving our largest landfill claim, which resulted in our payment of approximately $4.7 million on behalf of these insureds.
The number of environmental claims includes all multiple claimants who are associated with the same site or incident.
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, and any adjustments are made in the accounting period in which the adjustment arose. We measure the recoverability of deferred policy acquisition costs at the operating segment level. We had deferred policy acquisition costs of $212.3 million at December 31, 2008 compared to $226.4 million at December 31, 2007.
The discount rate enables us to state expected future cash flow as a present value on the measurement date. The guideline for setting this rate is a high-quality long-term corporate bond rate. A lower discount rate increases the present value of benefit obligations and increases pension expense. We decreased our discount rate to 6.24% for 2008, from 6.50% for 2007 to reflect market interest rate conditions. To determine the expected long-term rate of return on the plan assets, we consider the current and expected asset allocation, as well as historical and expected returns on each plan asset class. A lower expected rate of return on pension plan assets would increase pension expense. Our long-term expected return on plan assets was 8.00% in 2008 and 2007. We had a pension and post-retirement benefit plan obligation of $188.0 million at December 31, 2008 compared to $161.2 million at December 31, 2007.
Our pension assets lost approximately 20% of their value in 2008 due to the volatility in the financial markets. As a result of this, coupled with the decrease in our pension discount rate, we recorded a charge to equity of approximately $38 million, after tax, as of December 31, 2008. In 2007, we recorded an equity increase of $5.7 million, after-tax, primarily due to an increase of our pension discount rate. In 2006, in relation to our adoption of Statement of Financial Accounting Standards No. 158, “Employers Accounting for Defined Benefit Pension and Other Post-retirement Plans - An amendment to FASB Statements No. 87, 88, 106, and 132(r),” we recorded a charge to equity of $13.7 million, after-tax, representing the recognition of the funded status of our plans. Changes in the related pension and post-retirement benefit expense may occur in the future due to changes in these assumptions.
For additional information regarding our pension and post-retirement benefit plan obligations, see Item 8. “Financial Statements and Supplementary Data,” Note 15(d) of this Form 10-K.
Our evaluation for OTTI of a fixed maturity security or a short-term investment includes, but is not limited to, the evaluation of the following factors:
The financial condition and near-term prospects of the issuer, including any specific events that may influence the issuer’s operations;
The length of time and the extent to which the fair value has been less than the carrying value.
Our evaluation for OTTI of an other investment (i.e., an alternative investment) includes, but is not limited to, conversations with the management of the alternative investment concerning the following:
In 2008, we recorded a pre-tax impairment charge of $53.1 million for investments that we concluded were impaired for other-than-temporary declines in fair value. This charge was comprised of $41.7 million related to our fixed maturity securities, $6.6 million related to our equity securities, and $4.8 million related to our alternative investments. We recorded a pre-tax impairment charge of $4.9 million in 2007 and had no impairment charges during 2006. For further information regarding the impairment charges, see the section entitled “Investments” in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” of this Form 10-K.
Goodwill results from business acquisitions where the cost of assets acquired exceeds the fair value of those assets. We test goodwill for impairment annually, or more frequently if events or changes in circumstances indicate that goodwill may be impaired. Goodwill is allocated to the reporting units for the purposes of the impairment test. In the fourth quarter of 2008, we recorded a pre-tax impairment charge of $4.0 million for Selective HR as our near-term financial projections for this subsidiary were not sufficient to support its carrying cost. We did not record any impairments during 2007 or 2006.
Net income decreased in 2008 compared to 2007 and 2006 primarily due to the following:
Net investment income earned of $131.0 million, pre-tax, in 2008 compared to $174.1 million in 2007 and $156.8 million in 2006. Reduced income levels in 2008 were primarily due to losses on our other investments portfolio, which includes alternative investments, as well as losses on our externally-managed equity trading portfolio. The lower returns on our alternative investments, compared to strong returns a year ago, resulted from the current volatility in the capital markets, the dislocation of the credit markets, and reduced values of financial assets globally. Although these assets resulted in a negative return for the year, they outperformed the S&P 500 by approximately 2,700 basis points in 2008. Our equity trading portfolio has experienced a reduction in fair value due to the continued sell off in the equity markets, as well as the collapse in commodity prices in the second half of 2008. For additional information on our other investment portfolio, which includes our alternative investments, as well as for information regarding our trading portfolio, refer to the “Investments” section below.
The increase in pre-tax net investment income earned in 2007 compared to 2006 is primarily attributable to a higher invested asset base, coupled with higher interest rates and strong returns from our other investment portfolio during the year.
A pre-tax goodwill impairment charge of $4.0 million related to Selective HR due to the fact that our near-term financial projections for this reporting unit were not sufficient to support its carrying value in light of current economic conditions. We did not record any goodwill impairments charges during 2007 or 2006.
NPW decreased in 2008 compared to 2007 as the result of the highly competitive insurance marketplace and the slowing economy. These factors were evidenced by: (i) our direct new business, which decreased $41.7 million to $310.6 million; (ii) a 3.1% decrease in Commercial Lines renewal pure pricing; and (iii) endorsement and audit activity which decreased $38.2 million.
Personal lines premiums grew 4% in 2008 compared to 2007 as we successfully received approval for rate increases during the year and have plans to implement additional rate increases in 2009. Partially offsetting our rate increases in this book of business was the disruption caused by the elimination of rate caps that had been in place while our MATRIXSM pricing system was implemented for our personal automobile business in New Jersey. This disruption was evidenced by car counts in New Jersey, which decreased by approximately 6,000 to approximately 65,000 at year-end 2008. As we further transition our entire Personal Lines book into MATRIXSM, we could see some modest downward pressure on retention which currently stands at a strong 81%.
The increase in the GAAP loss and loss expense ratio in 2008 compared to 2007 reflects higher catastrophe losses related to 2008 storm activity primarily in our Midwestern and Southern regions. Total catastrophe losses for the year added $31.7 million, or 2.1 points, to losses in 2008. For 2007, catastrophe losses added $14.9 million, or 1.0 point, to losses. In 2008, net favorable prior year loss and loss expense development, driven primarily by our workers compensation line of business, was flat at approximately $19 million, or 1.3 points, compared to approximately $19 million, or 1.2 points, in 2007 driven by our commercial automobile line of business.
Historically, the results of the property and casualty insurance industry have experienced significant fluctuations due to competition, economic conditions, interest rates, loss cost trends, and other factors. Since 2006, the industry has been experiencing a softening market under which both personal and commercial lines pricing are declining. In its report entitled, “U.S. Property/Casualty - Review & Preview”, A.M. Best increased its projection for the property and casualty industry-wide combined ratio for 2008 to 104.7% up from its initial projection of 98.6%, with commercial and personal lines projected to end the year at 106.5% and 103.3%, respectively. The initial projections for these lines were 97.5% and 99.5%, respectively.
During 2008, the Insurance Operations segment outperformed both A.M. Best’s projection of 104.7% and an industry-wide projection of 104.8% by Fitch Ratings (“Fitch”), provided in their report entitled “Review and Outlook for 2008 and 2009,” with a statutory combined ratio of 99.2% for the year. Our Commercial Lines business reported a statutory combined ratio of 98.5% and our Personal Lines business reported a statutory combined ratio of 103.7% for the year. In an effort to write profitable business in the current commercial and personal lines market conditions, we have implemented a clearly defined plan to improve risk selection and mitigate higher frequency and severity trends to complement our strong agency relationships and unique field-based model.
Claims management initiative with a focus on best practices in the areas of: (i) claims automation; (ii) enhancement of claims quality and control; (iii) litigation management; (iv) enhancement of compliance and bill review; (v) enhancement of workers compensation review; and (vi) enhancement of salvage and subrogation review.
Organic expansion including entering our 22nd state, Tennessee, in June 2008. In the first seven months of operations in this state, we wrote premium of $5.5 million. In addition, we wrote $14.6 million of premium in Massachusetts during 2008, our first full year of operations in this state.
Commercial lines pricing continued to soften in 2008, although there were early signs of rate stabilization as the year wore on. Our commercial lines pure renewal pricing decreased 3.1% for the year, which we consider an achievement when viewed in conjunction with our retention, which remained relatively stable at 77% compared to last year. In the current competitive marketplace, where many carriers are taking larger rate decreases in order to grow their revenues, our cycle management tools that we have in place performed as they were intended; they protected us from writing business that we believe will be unprofitable. As many of our competitors have more financial and operating resources than we do, they have greater scalability and more information regarding their risks which, coupled with the use of statistical and computer models, may give them a greater ability to make pricing and underwriting decisions. We believe that while the short-term downside of the use of our cycle management tools was a 5% decline in NPW for the year, over the longer run, by accepting this short-term decline, we will be in a better position to return to targeted return on equity levels.
NPW decreased in 2008 compared to 2007 and 2006 due to the highly competitive insurance marketplace and the slowing economy. These factors were evidenced by: (i) Commercial Lines direct new business that decreased $46.1 million to $267.2 million; (ii) a 3.1% decrease in renewal pure pricing; and (iii) endorsement and audit activity that decreased $37.7 million.
NPW for this line of business decreased in 2008 compared to 2007, primarily due to: (i) a decrease in direct voluntary new business premiums of $15.7 million, or 17%; (ii) a renewal pure price decrease of 2.0%; and (iii) a decrease in our audit and endorsement premiums of $17.7 million, to a return premium of $7.8 million. As of December 31, 2008, approximately 58% of our premium is subject to audit whereby actual exposure units (usually sales or payroll) are compared to estimates and a return premium or additional premium transaction occurs. In 2007, NPW increased compared to 2006, with a direct voluntary new business increase of 14%. In this line of business, we are experiencing the highest level of competition in our middle market and large account business. Despite this competition, overall policy counts increased 5% in 2008 compared to 2007 and 9% in 2007 compared to 2006, reflecting moderate growth in our small account business, which we define as policies with premiums less than $25,000. Retention on this line was 74% in 2008 compared to 75% in 2007 and 77% in 2006.
In 2007, NPW for this line increased from 2006, reflecting a 28% increase in direct new voluntary policy premiums. As in 2008, retention decreased one point in 2007 compared to 2006, while policy counts increased 9%.
NPW for this line of business decreased in 2008 compared to 2007, while it remained flat in 2007 compared to 2006. The 2008 decrease was primarily driven by: (i) lower direct voluntary new business premiums, which were $52.3 million in 2008, down $9.2 million, or 15% from 2007; and (ii) renewal pure price decreases of 5.0%. In managing our pure price decreases in 2008, we lost only one point in retention and ended the year at 79% compared to 80% in 2007. Pure price decreases on this line were 5.4% in 2007 and 4.1% in 2006 while retention was 80% and 81%, respectively. As with the general liability line of business, we are experiencing the highest level of competition in our middle market and large account business, while our small account business, which we define as policies with premiums less than $25,000, experienced moderate growth. Overall policy counts for this line increased 5% in 2008 compared to 2007. In 2007, as compared to 2006, policy counts increased 8%.
NPW for this line of business decreased in 2008 compared to 2007 driven by a new business premium decrease of $2.4 million, or 5%, coupled with a one point reduction in retention to 76%, and renewal pure pricing that decreased 4.1%. Partially offsetting these items is a 6% increase in policy counts in 2008 compared to 2007. NPW for this line of business increased in 2007 compared to 2006 due to increases in total policy counts of 11% in 2007 compared to 2006. Partially offsetting the 2007 increase were renewal pure price decreases of 5.9% during the year.
The statutory combined ratio remained relatively flat in 2008 as compared to 2007, despite increased catastrophe losses of $11.9 million, or 5.9 points, to $22.6 million related to storm activity in our Southern and Midwestern regions, including the effects of Hurricane Ike, which added $6.6 million, or 3.4 points, to the combined ratio for the year. These catastrophes were partially offset by a decrease in non-catastrophe property losses, reflecting normal volatility inherent in this line of business.
Although profitable, the increased statutory ratio in 2007 from 2006 reflects lower pricing and increased property losses especially compared to the unusually low experience in 2006. The increase in property losses in 2007 was primarily the result of an increase in the severity of losses, mainly attributable to flood events and electrical fires. As opposed to the increased catastrophe losses in 2008, catastrophes decreased $2.5 million in 2007 compared to 2006.
The statutory ratios include our flood line of business, which is included in the Diversified Insurance Services segment on a GAAP basis and therefore excluded from the GAAP ratios. The total statutory combined ratio excluding flood was 108.7% for 2008, 113.0% for 2007, and 102.9% for 2006.
The improvement in the GAAP loss and loss expense ratio in 2008 compared to 2007 is primarily driven by the 3% increase in NPE, coupled with favorable prior year development in our casualty lines of approximately $5 million, or 2.2 points, in 2008, compared to unfavorable prior year development of approximately $1 million, or 0.4 points, in 2007. The 2008 development reflected a better quality of business being written through our MATRIXSM pricing system, coupled with normal volatility, while the 2007 development included the impact of unfavorable trends in groundwater contamination caused by the leakage of certain underground oil storage tanks in our homeowners line of business. This improvement in the loss and loss expense ratio was partially offset by increases in: (i) catastrophe losses of $1.9 million, to $4.7, million in 2008; and (ii) non-catastrophe property losses of $4.5 million, to $56.5 million, in 2008.
An increase of $6.7 million in non-catastrophe property losses in 2007 compared to 2006.
Unfavorable prior year development in our casualty lines of $1 million in 2007 compared to favorable prior year development of $6 million in 2006. The unfavorable development in 2007 reflects: (i) higher severity in accident year 2006 for our personal automobile line of business; (ii) adverse prior year development due to unfavorable trends in claims for groundwater contamination caused by the leakage of certain underground oil storage tanks in our homeowners line of business; and (iii) several significant losses in our personal excess line of business, partially offset by lower than expected loss emergence for accident years prior to 2006. The favorable prior year development in 2006 primarily related to lower than expected frequency in personal automobile claims.
The GAAP underwriting expense ratio improved in 2008 compared to 2007 primarily due to costs associated with the reorganization of the Personal Lines department in May of 2007, which reduced the staffing level by 31 employees and, added 0.6 points to the underwriting expense ratio in 2007. The deterioration in the GAAP underwriting expense ratio in 2007 compared to 2006 was primarily attributable to overhead costs that have outpaced premiums earned.
In early 2009, we will be completing implementation of our MATRIXSM pricing system for our homeowners line of business. Through this system, we are able to better manage our coastal exposure by pricing risks at levels that we believe are more adequate.
We regularly reevaluate our overall reinsurance program and try to develop the most effective ways to manage our risk. Our analysis is based on a comprehensive process that includes periodic analysis of modeling results, aggregation of exposures, exposure growth, diversification of risks, limits written, projected reinsurance costs, financial strength of reinsurers and projected impact on earnings and statutory surplus. We strive to balance sometimes opposing considerations of reinsurer credit quality, price, terms, and our appetite for retaining a certain level of risk.
The Property Catastrophe treaty renewed effective January 1, 2009 with a 7.8% increase in premium. The current treaty structure remains the same providing per occurrence coverage for 95% of $310.0 million in excess of $40.0 million retention. The annual aggregate limit net of our co-participation is $589.0 million.
We continue to assess our property catastrophe exposure aggregations, modeled results and effects of growth on our property portfolio and strive to manage our exposure to individual large events balanced against the cost of reinsurance protection.
The Property Excess of Loss treaty was renewed on July 1, 2008 and is effective through June 30, 2009, with a $28.0 million limit in excess of a $2.0 million retention, compared to the prior treaty of $23.0 million limit in excess of a $2.0 million retention.
The Casualty Excess of Loss treaty (“Casualty Treaty”) was restructured effective July 1, 2008 into one treaty encompassing all casualty lines, including workers compensation. This treaty expires on June 30, 2009. As a result, the Workers Compensation Only treaty was not renewed at July 1, 2008. The current program provides the following coverage:
The first layer was expanded from a workers compensation only layer to now include all lines, which significantly reduces uncertainty surrounding losses in that layer. This layer provides coverage up to 65% of $3.0 million in excess of a $2.0 million retention.
The sixth layer provides coverage up to 75% of $40.0 million in excess of a $50.0 million retention.
Consistent with the prior year, the Casualty Treaty excludes nuclear, biological, chemical, and radiological terrorism losses. Annual aggregate terrorism limits, net of co-participation including a $40.0 million in excess of $50.0 million layer, is $175.8 million for all losses.
Effective January 1, 2009, we renewed the NWCRP treaty which covers our participation in the involuntary National Council on Compensation Insurance (NCCI) pool, a residual workers compensation market. The NWCRP treaty provides 100% Quota Share coverage, including terrorism coverage, for the 2009 and 2008 underwriting years, assumed business from the NCCI and has an aggregate combined ratio limit of approximately 152% and 142%, respectively for each of the underwriting years. The 2009 treaty is placed with three carriers with ratings of “A” or “A+” by A. M. Best. Due to our decision to participate in the New Jersey residual workers compensation market through the NCCI in 2009, the treaty now covers this state. We believe that the continued protection provided within this treaty for residual market business is especially beneficial given current market conditions and the expected deterioration in the experience of the NCCI pool.
During the second half of 2008, AIG entered into agreements with the U.S. Treasury Department and the Federal Reserve that include both ongoing financing facilities and one-time transactions designed to address AIG’s liquidity issues. As we maintain reinsurance relationships with the following AIG subsidiaries through three currently in-force treaties, we closely monitor developments regarding AIG’s liquidity concerns: (i) The Hartford Steam Boiler Inspection and Insurance Company (“HSB”), (ii) National Union Fire Insurance Company, and (iii) Transatlantic Reinsurance Company (collectively referred to as the “AIG Subsidiaries”). On December 22, 2008, AIG announced the sale of the HSB Group, Inc., HSB’s parent, to Munich Re Group.
Our investment philosophy includes certain return and risk objectives for the fixed maturity and equity portfolios. The primary fixed maturity portfolio return objective is to maximize after-tax investment yield and income while balancing risk. A secondary objective is to meet or exceed a weighted-average benchmark of public fixed income indices. The equity portfolio return objective is to meet or exceed a weighted-average benchmark of public equity indices. Although yield and income generation remain the key drivers to our investment strategy, our overall philosophy is to invest with a long-term horizon along with a “buy-and-hold” principle. Tactically, we also plan to further increase our portfolio allocation to government and agency holdings in the near-term in an effort to increase liquidity and capital preservation.
For additional information regarding market risk related to our investment portfolio, see
We have audited the accompanying consolidated balance sheets of Selective Insurance Group, Inc. and its subsidiaries as of December 31, 2008 and 2007, 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, 2008. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules I to V. 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.
Selective Insurance Group, Inc., through its subsidiaries, (collectively referred to as “we” or “our”) offers property and casualty insurance products and diversified insurance services and products. Selective Insurance Group, Inc. (referred to as the “Parent” or the “Parent Company”) was incorporated in New Jersey in 1977 and its main offices are located in Branchville, New Jersey. The Parent’s common stock is publicly traded on the NASDAQ Global Select Market under the symbol “SIGI.”
The accompanying consolidated financial statements (“Financial Statements”) include the accounts we have prepared in conformity with: (i) U.S. generally accepted accounting principles (“GAAP”); and (ii) the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). All significant intercompany accounts and transactions are eliminated in consolidation.
Certain amounts in our prior years’ consolidated financial statements and related footnotes have been reclassified to conform to the 2008 presentation. Such reclassifications had no effect on our net income or stockholders’ equity.
Fixed maturity securities may include bonds, redeemable preferred stocks, and mortgage and asset-backed securities. Fixed maturity securities classified as available-for-sale are reported at fair value. Those fixed maturity securities that we have the ability and positive intent to hold to maturity are classified as held-to-maturity and are carried at amortized cost. The amortized cost of fixed maturity securities is adjusted for amortization of premiums and accretion of discounts over the expected life of the security using the effective interest method. Premiums and discounts arising from the purchase of mortgage-backed securities are amortized over the expected life of the security based on future principal payments, and considering prepayments. These prepayments are estimated based upon historical and projected cash flows. Prepayment assumptions are reviewed annually and adjusted to reflect actual prepayments and changes in expectations. Future amortization of any premium and/or discount is also adjusted to reflect the revised assumptions. Interest income, as well as amortization and accretion, is included in “Net investment income earned” on our Consolidated Statements of Income. The amortized cost of fixed maturity securities is written down to fair value when a decline in value is considered to be other than temporary. See the discussion below on realized investment gains and losses for a description of the accounting for impairments. Unrealized gains and losses on fixed maturities classified as available-for-sale, net of tax are included in accumulated other comprehensive income (loss) (“AOCI”).
Equity securities which are classified as available-for-sale, may include common stocks and non-redeemable preferred stocks and are carried at fair value. Dividend income on these securities is included in “Net investment income earned.” The associated unrealized gains and losses, net of tax are included in AOCI. The cost of equity securities is written down to fair value when a decline in value is considered to be other than temporary. See the discussion below on realized investment gains and losses for a description of the accounting for impairments. Certain equity securities managed by an external portfolio manager are classified as trading securities and are carried at fair value. Trading securities are recorded at fair value with subsequent changes in fair value recognized in net investment income.
Short-term investments may include 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. These investments are carried at cost, which approximates fair value. The associated income is included in “Net investment income earned.”
Other investments may include alternative investments and other miscellaneous securities. Alternative investments are accounted for using the equity method. Our share of distributed and undistributed net income from alternative investments is included in “Net investment income earned.” Investments in other miscellaneous securities are generally carried at estimated fair value, because our interests are so minor that we exercise virtually no influence over operating and financial policies of the investees. Our distributed share of net income from other miscellaneous investments is included in “Net investment income earned.” Any changes in estimated fair value associated with these other miscellaneous investments are recorded as an unrealized gain or loss, of which these items, net of tax, are included in AOCI.
The issuer’s current financial condition and its ability to make future scheduled principal and interest payments on a timely basis;
Our ability and intent to hold a security to maturity given interest rate fluctuations.
We perform impairment assessments for the structured securities included in our fixed maturity portfolio (including, but not limited to, commercial-mortgage-backed securities (“CMBS”), residential-mortgage-backed securities (“RMBS”), asset-backed securities (“ABS”), and collateralized debt obligations (“CDOs”), comprising an evaluation of the underlying collateral of these structured securities. This assessment, although considering the length of time for which the security has been in an unrealized loss position, focuses on the performance of the underlying collateral under various economic and default scenarios which may involve subjective judgments and estimates determined by management. Considering various factors in our modeling of these structured securities, such as projected default rates, the nature and realizable value of the collateral, the ability of the security to make scheduled payments, historical performance, and other relevant economic and performance factors, we determine if an impairment is other than temporary in circumstances where our projection of losses extends into the tranche of the security in which we are invested.
On January 1, 2008, we adopted FASB Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“FAS 157”), which defines fair value, establishes a framework for measuring fair value, and expands disclosure about fair value measurements. The impact of the adoption of FAS 157 did not have a material impact on our results of operations or financial condition.
(1) Investments: The fair values of our investment portfolio are generated using various valuation techniques. For valuations of securities in our equity portfolio and U.S. Treasury notes held in our fixed maturity portfolio, we utilize a market approach, wherein we use quoted prices in an active market for identical assets. The source of these prices is an external pricing service, which we validate against other external pricing sources.
Short-term investments are carried at cost, which approximates fair value. Our investments in other miscellaneous securities are generally accounted for at fair value based on net asset value.
(2) Indebtedness: The fair values of the 1.6155% Senior Convertible Notes due September 24, 2032, the 7.25% Senior Notes due November 15, 2034, the 6.70% Senior Notes due November 1, 2035, and the 7.5% Junior Subordinated Notes due September 27, 2066, are based on quoted market prices. The fair value of the 8.87% Senior Notes due May 4, 2010 is estimated using a cash flow analysis based upon our current incremental borrowing rate for the remaining term of the loan.
We estimate an allowance for doubtful accounts on our premiums and other trade receivables. The allowance for premiums and other trade receivables is based on historical write-off percentages adjusted for the effects of current and anticipated trends.
Share-based compensation consists of all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share units, share options, or other equity instruments. The cost resulting from all share-based payment transactions are recognized in the consolidated financial statements, based on the fair value of such instruments at the grant date over the requisite service period. The requisite service period is typically the lesser of the vesting period or the period of time from the grant date to the date of retirement eligibility. The expense recognized for share-based awards, which, in some cases, contain performance criteria, is based on the number of shares/units expected to be issued at the end of the performance period.
Policy acquisition costs directly related to the writing of insurance policies are deferred and amortized over the life of the policies. These costs include labor costs, commissions, premium taxes and assessments, boards, bureaus and dues, travel, and other underwriting expenses incurred in the acquisition of premium. The deferred policy acquisition costs are limited to the sum of unearned premiums and anticipated investment income less anticipated losses and loss expenses, policyholder dividends and other expenses for maintenance of policies in force. We regularly conduct reviews for potential premium deficiencies. There were no premium deficiencies for any of the reported years as the sum of the anticipated losses and loss expenses, policyholder dividends, and other expenses did not exceed the related unearned premium and anticipated investment income. The investment yields assumed in the premium deficiency assessment for each reporting period, which are based upon our actual average investment yield before tax as of the calculation date on September 30, were 4.1% for 2008, 4.6% for 2007 and 4.4% for 2006. Deferred policy acquisition costs amortized to expense were $454.8 million for 2008, $460.2 million for 2007, and $443.3 million for 2006.
By using both individual estimates of reported claims and generally accepted actuarial reserving techniques, we estimate the ultimate net liability for losses and loss expenses. While the ultimate actual liability may be higher or lower than reserves established, we believe the reserves to be adequate. Any changes in the liability estimate may be material to the results of operations in future periods. We do not discount to present value that portion of our loss reserves expected to be paid in future periods; however, our loss reserves include anticipated recoveries for salvage and subrogation claims.
Selective HR Solutions (“Selective HR”), our human resource administration outsourcing operations, reports revenues on a net basis for the amount billed to clients for worksite employee salaries, wages and certain payroll-related taxes less amounts paid to worksite employees and taxing authorities for these salaries, wages and taxes. Fees that have the potential for a margin are included in revenue on a gross basis and amounts that pass through amounts collected from the client are presented on a net basis. Specifically, gross wages, Federal Insurance Contributions Act (“FICA”) tax and Federal Unemployment Tax (“FUTA”) are included on a net basis whereas administration fees, state unemployment taxes, health fees and workers compensation fees are included on a gross basis. Selective HR accounts for its revenues using the accrual method of accounting. Under the accrual method of accounting, Selective HR recognizes its revenues ratably over the payroll period as worksite employees perform their services at the clients’ worksites.
In June 2007, the Emerging Issues Task Force (“EITF”) of the Financial Accounting Standards Board (“FASB”) issued EITF Issue No. 06-11, Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards (“EITF 06-11”). EITF 06-11 requires that the tax benefit from dividends or dividend equivalents that are charged to retained earnings and are paid to employees for equity classified nonvested equity shares, nonvested equity share units, and outstanding equity share options be recognized as an increase to additional paid-in capital. EITF 06-11 was effective on a prospective basis beginning with dividends declared in fiscal years beginning after December 15, 2007, and we adopted it in the first quarter of 2008. The adoption of EITF 06-11 did not have a material impact on our results of operations or financial condition.
In May 2008, FASB issued Statement of Financial Accounting Standards No. 162, The Hierarchy of Generally Accepted Accounting Principles, (“FAS 162”) which identifies the sources of generally accepted accounting principles and provides a framework, or hierarchy, for selecting the principles to be used in preparing U.S. GAAP financial statements for non-governmental entities. FAS 162 makes the GAAP hierarchy explicitly and directly applicable to preparers of financial statements, a step that recognizes preparers’ responsibilities for selecting the accounting principles for their financial statements. The hierarchy of authoritative accounting guidance did not change current practice but has assisted in facilitating the FASB’s plan to designate as authoritative its forthcoming codification of accounting standards. FAS 162 was effective November 15, 2008 and did not have an impact on our existing accounting policies.
In May 2008, the FASB issued FSP No. APB 14-1, Accounting for Convertible Debt Instruments that may be Settled in Cash upon Conversion (Including Partial Cash Settlement) (“FSP 14-1”). FSP 14-1 applies to convertible debt instruments that, by their stated terms, may be completely or partially settled in cash (or other assets) upon conversion, unless the embedded conversion option is required to be separately accounted for as a derivative under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. FSP 14-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. We are currently evaluating the applicability of FSP 14-1 to our operations.
Fair-value measurements, and the fair-value techniques and inputs used to measure plan assets similar to the requirements set forth under FAS 157 (i.e.: Level 1, 2 & 3); and
The disclosure requirements are effective for years ending after December 15, 2009.
(b) The amortized cost, estimated fair values, and unrealized gains (losses) of held-to-maturity fixed maturity securities at December 31, 2008 and 2007, respectively, were as follows:
U.S. government includes corporate securities fully guaranteed by the Federal Deposit Insurance Corporation (“FDIC”).
In performing our OTTI analysis for corporate debt securities, we analyzed the general market condition of each industry, particularly the financial services sector, as well as the geographic area of the issuer given the current economic environment. In addition, we look for evidence of significant deterioration in the issuer’s credit worthiness. We have determined that the decline in fair value of $30.1 million of corporate securities in an unrealized loss position at December 31, 2008 to be attributed to the current volatile market conditions and not to the creditworthiness of any individual issuer. We have the ability and intent to hold these securities until a fair value recovery or until maturity and do not consider these securities to be other-than-temporarily-impaired.
Our alternative investment portfolio of $165.0 million in 2008 primarily utilizes six different strategies consisting of $56.9 million in private equity, $29.8 million in distressed debt, $24.1 million in secondary private equity, $23.4 million in real estate, $23.1 million in mezzanine financing, and $5.9 in venture capital. At December 31, 2008, we have contractual obligations that expire at various dates through 2023 to further invest up to $119.5 million in alternative investments. There is no certainty that any such additional investment will be required.
Due to the current market turmoil, there is uncertainty regarding reduced investment income in the future as a result of, among other things, falling interest rates, decreased dividend payment rates, or reduced returns on our other investments, including our portfolio of alternative investments, which are reported on a one-quarter lag.
(j) The components of net realized (losses) gains were as follows:
Increases in realized losses of our available for sale fixed maturity securities of $48.8 million was primarily due to non-cash OTTI charges of $41.7 million for 2008 which consisted of:
$15.1 million of RMBS and CMBS charges. These charges related to declines in the related cash flows of the collateral, based on our assumptions of the expected default rates and the value of the collateral, and accordingly, we do not believe it is probable that we will receive all contractual cash flows.
$10.2 million associated with corporate bond charges. These charges were due to issuer-specific events, primarily related to two Icelandic bank debt securities, on which the banks were placed in receivership.
The fixed maturity non-cash OTTI charge for 2007 consisted of $4.9 million associated with two commercial real estate CDOs. These charges were due to the severe contagion effects from the sub-prime mortgage crisis. CMBS spreads, particularly subordinated tranche CMBS, widened dramatically over the course of the second half of 2007. As a result, CDOs in general had become extremely dislocated and difficult to value as the market spreads between bid and ask prices became very wide, even for CDOs that did not have any sub-prime asset backed exposure. During 2006, we did not recognize any realized losses from OTTI charges.
Other investment realized losses increased $8.3 million primarily due to non-cash OTTI charges of $4.8 million on two alternative investments. These charges were directly related to a security held in their portfolio that had considerable unrealized losses because of the severe volatility in the current financial markets and the dramatic market sell off, specifically in commodity prices. Additionally, we sold one international investment fund which resulted in losses of $2.5 million.
On January 1, 2008, we adopted FASB Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115 (“FAS 159”). FAS 159 provides companies with an option to report selected financial assets and liabilities at fair value (“fair value option”). We elected to apply the fair value option to certain securities that were being managed by an external manager at the time of adoption. The securities for which we elected the fair value option were previously held as available-for-sale securities and are now classified as trading securities.
The following table provides information regarding the reclassification and corresponding cumulative-effect adjustment on retained earnings resulting from the initial application of FAS 159 for this portfolio:
The following table presents the carrying amounts and estimated fair values of our financial instruments as of December 31, 2008 and 2007:
See Note 2(e) for the methods and assumptions we used in estimating the fair values of our financial instruments. The following table provides quantitative disclosures regarding fair value measurements of our invested assets:
The Insurance Subsidiaries remain liable to policyholders to the extent that any reinsurer becomes unable to meet our contractual obligations. We evaluate and monitor the financial condition of our reinsurers under voluntary reinsurance arrangements to minimize our exposure to significant losses from reinsurer insolvencies. On an ongoing basis, we review amounts outstanding, length of collection period, changes in reinsurer credit ratings and other relevant factors to determine collectibility of reinsurance recoverables. The allowance for reinsurance recoverables on paid and unpaid losses and loss expenses was $2.5 million at December 31, 2008 and $2.8 million at December 31, 2007.
A trust fund in the amount of $32.5 million at December 31, 2008 and $31.6 million at December 31, 2007 securing a portion of the liabilities ceded to Munich Reinsurance America, Inc. is held for our benefit. Amounts ceded to Munich Reinsurance America, Inc., which is rated “A+” by A.M. Best, exceeding the available trust fund, represent 8% or $22.4 million as of December 31, 2008 and 13% or $36.0 million as of December 31, 2007 of our consolidated prepaid reinsurance premiums and loss recoverable balances not secured by trust funds, letters of credit or funds withheld (collateral). In addition, approximately 62% of our consolidated prepaid reinsurance premiums and net reinsurance recoverable balances not secured by collateral are ceded to two state or federally sponsored pools. We ceded $60.7 million as of December 31, 2008 and $64.5 million as of December 31, 2007 to New Jersey Unsatisfied Claims Judgment Fund. We also ceded $111.5 million as of December 31, 2008 and $88.0 million as of December 31, 2007 to the National Flood Insurance Program (“NFIP”).
Assumed premiums decreased in 2008 compared to 2007 and from 2007 compared to 2006 primarily due to reduction in mandatory and voluntary pool assumptions while assumed losses decreased primarily due to a reduction in mandatory pool assumptions. Ceded premiums increased in 2008 compared to 2007, primarily due to increases in flood premiums that are 100% ceded to the NFIP. Ceded premiums increased in 2007 compared to 2006 primarily due to increases in flood premiums and the termination of the New Jersey Homeowners Property 75% Quota Share Treaty that resulted in a return of premium of $11.3 million in the first quarter of 2006, previously ceded to this treaty and still unearned as of December 31, 2005. The increase in ceded loss and loss adjustment expenses incurred of $9.3 million in 2007 compared to 2006 is primarily a result of an increase in losses ceded to the NFIP, offset by a decrease in large loss activity from the excess of loss treaties. Ceded loss and loss adjustment expenses incurred increased $17.5 million in 2007 as compared to 2006 primarily as a result of an increase in large loss activity from the excess of loss treaties which was offset by decreases in losses ceded to the NFIP.
In 2008, we experienced favorable loss development of $19.3 million, which was primarily driven by favorable loss development in accident years 2002 through 2006 of $54.2 million partially offset by unfavorable loss development in accident year 2007 of $26.9 million as well as unfavorable development in accident years 2001 and prior of $8.0 million. The main driver of this development was favorable prior year development in our workers compensation line of business, partially offset by adverse prior year development in the general liability line of business. Workers compensation experienced favorable prior year development of $24 million primarily driven by favorable development in accident years 2004 to 2006 as a result of the implementation of improvement strategies for this line, partially offset by adverse prior year development in accident year 2007. Prior year development for the commercial automobile line of business was only minimally favorable reflecting the leveling off of improvements in severity trends. Partially offsetting the favorable loss development, the general liability line of business experienced adverse prior year development of approximately $3 million reflecting normal volatility in this line of business. The remaining lines of business, which collectively contributed approximately $2 million of adverse development, do not individually reflect any significant trends related to prior year development.
We experienced favorable development in our loss and loss expense reserves totaling $7.3 million in 2006, which was primarily driven by favorable prior year development in our commercial automobile, workers compensation, and personal automobile lines of business partially offset by adverse development in our general liability line of business. The commercial automobile line of business experienced favorable prior year loss and loss expense reserve development of approximately $15 million, which was primarily driven by lower than expected severity in accident years 2004 and 2005. The workers compensation line of business experienced favorable prior year development of approximately $4 million, which was driven, in part, by savings realized from changing medical and pharmacy networks outside of New Jersey and re-contracting our medical bill review services. The personal automobile line of business experienced favorable prior year development of approximately $9 million, due to lower than expected frequency. The general liability line of business experienced adverse prior year loss and loss expense reserve development of approximately $15 million in 2006, which was largely driven by our contractors completed operations business and an increase in reserves for legal expenses. The remaining lines of business, which collectively contributed approximately $6 million of adverse development, do not individually reflect significant prior year development.
(2) On November 3, 2005, we issued $100 million of 6.70% Senior Notes due 2035. These notes were issued at a discount of $0.7 million resulting in an effective yield of 6.754% and pay interest on May 1 and November 1 each year commencing on May 1, 2006. Net proceeds of approximately $50 million were used to fund an irrevocable trust to provide for certain payment obligations in respect of our outstanding debt. The remainder of the proceeds were used for general corporate purposes. The agreements covering these notes contain a standard default cross-acceleration provision that provides the 6.70% Senior Notes will enter a state of default upon the failure to pay principal when due or upon any event or condition that results in an acceleration of principal of any other debt instrument in excess of $10 million which we have outstanding concurrently with the 6.70% Senior Notes. There are no attached financial debt covenants to which we are required to comply in regards to these notes.
In order to have access to draw down on the line of credit, we are required, per the syndicated line of credit agreement, to comply with certain restrictive covenants. Some of the significant covenants are as follows:
Our consolidated net worth, as calculated per the syndicated line of credit agreement, must be equal to or greater than the required minimum consolidated net worth, as calculated per the syndicated line of credit agreement. In accordance with the calculations in the agreement, at December 31, 2008 our consolidated net worth was $890.5 million and the required minimum consolidated net worth was $882 million.
Our consolidated debt to total capitalization ratio, as calculated per the syndicated line of credit agreement, cannot exceed 30.0% at any point in time. At December 31, 2008 our consolidated debt to capitalization ratio was 23.6%.
The Insurance Subsidiaries must maintain a financial strength rating by A.M. Best of at least “A-” at all times. Throughout 2008, our A.M. Best financial strength rating was continuously “A+”.
In addition to the above requirements, the syndicated line of credit agreement contains a cross-default provision that provides that the line of credit will be in default if the Company fails to comply with any condition, covenant or agreement (including payment of principal and interest when due on any debt with an aggregate principal amount of at least $5.0 million), which causes, or permits, the acceleration of principal.
The maximum number of shares that may yet be purchased under our authorized stock repurchase program is 1.7 million. This program is scheduled to expire on July 26, 2009.
Our ability to declare and pay dividends on the Parent’s common stock is affected by the ability of the Insurance Subsidiaries to declare and pay dividends to the Parent. The dividends from Selective HR are restricted by the operating cash flows of this entity, as well as professional employer organization licensing requirements to maintain a current ratio of at least 1:1. The dividends from the Insurance Subsidiaries are subject to the regulatory limitations of the states in which the Insurance Subsidiaries are domiciled: New Jersey, New York, Indiana, or Maine. Based on the unaudited 2008 statutory financial statements, the maximum ordinary dividends that can be paid to our parent company by the Insurance Subsidiaries in 2009 are:
The statutory capital and surplus of the Insurance Subsidiaries in excess of these ordinary dividend amounts must remain with the Insurance Subsidiaries in the absence of the approval of a request for an extraordinary dividend. In each such jurisdiction, domestic insurers are prohibited from paying “extraordinary dividends” without approval of the insurance commissioner of the respective state. Additionally, New Jersey and Indiana require notice of the declaration of any ordinary or extraordinary dividend distribution. During the notice period, the relevant state regulatory authority may disallow all or part of the proposed dividend if it determines that the insurer’s surplus, with regard to policyholders, is not reasonable in relation to the insurer’s outstanding liabilities and adequate for our financial needs.
On February 2, 1999, the Board approved the Amended and Restated Rights Agreement (the “Rights Agreement”). This agreement expired on February 2, 2009. Under the previously existing Rights Agreement, the right to purchase one half of one two-hundredth (or one four-hundredth) of a share of the Parent’s Series A Junior Preferred Stock (each, a “Preferred Share”) at an exercise price of $80 (each, a “Right” and collectively, the “Rights”) was attached to each share of the Parent’s common stock. The Right was exercisable 10 days after an announcement that a person or group had acquired 15% or more of the Parent’s outstanding common stock (an “Acquiring Person”) or 10 business days after a person or group commenced or announced its intent to make a tender offer that would have resulted in such person or group becoming an Acquiring Person. If a person or group became an Acquiring Person, each Right would entitle the holder, other than an Acquiring Person, to purchase such number of one half of one two-hundredths of a Preferred Share, as set forth in the Rights certificate (the “Rights Amount”), at a price of $80 per one half of one two-hundredths of a Preferred Share.
Diversified Insurance Services (Flood and HR Outsourcing), which, because they are not dependent on insurance underwriting cycles, are evaluated based on several measures including, but not limited to, results of operations in accordance with GAAP, with a focus on return on revenues (net income divided by revenues).
We do not aggregate any of our operating segments. Our Insurance Operations and Diversified Insurance Services segments share a common marketing or distribution system and create new opportunities for independent insurance agents to bring value-added services and products to their customers. Our commercial and personal lines property and casualty insurance products, flood insurance, and human resource administration outsourcing products are sold through independent insurance agents.
We also provide services to each other in the normal course of business. These transactions totaled $13.8 million in 2008, $17.8 million in 2007, and $19.3 million in 2006. These transactions were eliminated in all consolidated statements. In computing the results of each segment, we do not make adjustments for interest expense, net general corporate expenses, or federal income taxes. We do not maintain separate investment portfolios for the segments and therefore, does not allocate assets to the segments.
The following table provides a reconciliation of the numerators and denominators of the basic and diluted earnings per share (“EPS”) computations of net income for the year ended:
Based on our federal tax loss carryback availability, expected levels of pre-tax financial statement income and federal taxable income, we believe it is more likely than not that the existing deductible temporary differences will reverse during periods in which we generate net federal taxable income or have adequate federal carryback availability. As a result, we have no valuation allowance recognized for federal deferred tax assets at December 31, 2008. In addition, at December 31, 2007, we had no similar valuation allowances recognized.
Stockholders’ equity reflects tax benefits related to compensation expense deductions for stock options exercised of $18.6 million at December 31, 2008, $17.0 million at December 31, 2007, and $13.5 million at December 31, 2006.
Selective Insurance Company of America (“SICA”) 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. We match 65% of participant contributions up to a maximum of 7% of defined compensation. Effective January 1, 2006, the 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, we match, dollar for dollar, up to 2% of the employee’s base pay contributions. In addition, we make 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.
Employer contributions for all the plans amounted to $6.4 million in 2008, $5.4 million in 2007, and $4.4 million in 2006.
In addition to the deferrals elected by the Participants, we may also choose to make matching contributions to the deferral accounts of some or all Participants to the extent a Participant did not receive the maximum matching contribution permissible under our Retirement Savings Plan due to limitations under the Internal Revenue Code or the Retirement Savings Plan. We may also choose at any time to make discretionary contributions to the deferral account of any Participant in our sole discretion. No discretionary contributions were made in 2008, 2007, or 2006.
We contributed $0.2 million in 2008 and $0.1 million in 2007 and 2006 to the Deferred Compensation Plan.
The Retirement Income Plan is a noncontributory defined benefit retirement income plan covering all SICA employees who meet eligibility requirements. The funding policy provides that payments to the pension trust shall be equal to the minimum funding requirements of the Employee Retirement Income Security Act, plus additional amounts that the Board of the plan sponsor, may approve from time to time.
The funded status of these plans was recognized in the Consolidated Balance Sheets for 2008 and 2007, the details of which are as follows:
Our measurement date was December 31, 2008 and our expected return on plan assets was 8.0%, which was based primarily on the Retirement Income Plan’s long-term historical returns. Our expected return approximates our actual 7.4% annualized return achieved since plan inception for all plan assets. In addition to the plan’s historical returns, we consider long-term historical rates of return on the respective asset classes. We presently anticipate contributing $8.0 million to the Retirement Income Plan in 2009, none of which represents minimum required contribution amounts, and have kept our expected return on plan assets at 8.0% after examining recent market conditions and trends.
Assets of the Retirement Income Plan shall be invested to ensure that principal is preserved and enhanced over time. In addition, the Retirement Income Plan is expected to perform above average relative to comparable funds without assuming undue risk, and to add value through active management. Our return objective is to meet or exceed the returns of the plan’s policy index, which is the return the plan would have earned if the assets were invested according to the target asset class weightings and earned index returns. The plan’s allocated target and ranges by investment categories are as follows:
The weighted average asset allocation by percentage of the Retirement Income Plan at December 31 is as follows:
The Retirement Income Plan had no investments in the Parent’s common stock as of December 31, 2008 and 2007.
The Parent’s 2005 Omnibus Stock Plan (“Stock Plan”) was adopted and approved by the Board effective as of April 1, 2005, and approved by stockholders on April 27, 2005. With the Stock Plan’s approval, no further grants are available under the: (i) Parent’s Stock Option Plan III, as amended (“Stock Option Plan III”); (ii) Parent’s Stock Option Plan for Directors, as amended (“Stock Option Plan for Directors”); or (iii) Parent’s Stock Compensation Plan for Nonemployee Directors, as amended (“Stock Compensation Plan for Nonemployee Directors”), but awards outstanding under these plans and the Stock Option Plan II, under which future grants ceased being available on May 22, 2002, shall continue in effect according to the terms of those plans and any applicable award agreements.
Under the Stock Plan, the Board’s Salary and Employee Benefits Committee (“SEBC”) may grant stock options, stock appreciation rights (“SARs”), restricted stock, restricted stock units (“RSUs”), phantom stock, stock bonuses, and other awards in such amounts and with such terms and conditions as it shall determine, subject to the provisions of the Stock Plan. Each award granted under the Stock Plan (except unconditional stock bonuses and the cash component of Director compensation) 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 Stock Plan. The maximum exercise period for an option grant under this plan is ten years from the date of the grant. During 2008, we granted, net of forfeitures, 382,521 RSUs, and experienced net restricted stock forfeitures of 45,240 shares. During 2007 and 2006 we granted, net of forfeitures, 478,862 and 309,218 shares of restricted stock, respectively. We also granted options to purchase 191,568 shares during 2008, 158,435 shares during 2007, and 88,940, shares during 2006. As of December 31, 2008, 2,724,227 shares of the Parent’s common stock remain available for issuance pursuant to outstanding stock options and restricted stock awards granted under the Stock Plan.
As of December 31, 2008, 416,242 shares of the Parent’s common stock remain available for issuance pursuant to outstanding stock options and restricted stock awards granted under Stock Option Plan II, under which future grants ceased being available on May 22, 2002. Under Stock Option Plan II, employees were granted qualified and nonqualified stock options, with or without SARs, and restricted or unrestricted stock: (i) at not less than fair value on the date of grant and (ii) subject to certain vesting periods as determined by the SEBC. Restricted stock awards also could be subject to the achievement of performance objectives as determined by the SEBC. The maximum exercise period for an option grant under this plan is ten years from the date of the grant. There were no forfeitures under this plan in 2008 and 2007, and forfeitures in 2006 amounted to 984 restricted shares.
During the vesting period, dividends are earned on the restricted shares and held in escrow subject to the same vesting period and conditions set forth in the award agreement. Effective September 3, 1996, dividends earned on the restricted shares were reinvested in the Parent’s common stock at fair value. We issued, net of forfeitures, 255 restricted shares from the Dividend Reinvestment Plan (“DRP”) reserves during 2008, 539 restricted shares during 2007, and 346 restricted shares during 2006.
As of December 31, 2008, there were 427,288 shares of the Parent’s common stock available for issuance pursuant to outstanding stock options and restricted stock awards granted under Stock Option Plan III, under which future grants ceased being available with the approval of the Stock Plan. Under Stock Option Plan III, employees were granted qualified and nonqualified stock options, with or without SARs, and restricted or unrestricted stock: (i) at not less than fair value on the date of grant and (ii) subject to certain vesting restrictions determined by the SEBC. Restricted stock awards also could be subject to achievement of performance objectives as determined by the SEBC. The maximum exercise period for an option grant under this plan is ten years from the date of the grant.
As of December 31, 2008, 372,000 shares of the Parent’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 the Parent’s 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.
In August 1998, certain officers of our company purchased stock on the open market with proceeds advanced by us. These officers gave our company promissory notes totaling $1.8 million. The promissory notes bear interest at 2.5% and are secured by the purchased shares of the Parent’s common stock. The promissory notes are full recourse and subject to certain employment requirements. The principal amount outstanding, which is scheduled to be fully repaid in 2009, was $0.1 million at December 31, 2008 and $0.2 million at December 31, 2007. The outstanding balances are reflected in “Other assets” on the Consolidated Balance Sheets.
William M. Rue, a Director of the Parent, is President of, and owns more than 10% of the equity of, Chas. E. Rue & Sons, Inc. t/a Rue Insurance, a general independent insurance agency (“Rue Insurance”). Rue Insurance is an appointed independent agent of the Insurance Subsidiaries and Selective HR, on terms and conditions similar to those of our other agents. Rue Insurance also places insurance for our business operations. Our relationship with Rue Insurance has existed since 1928.
Rue Insurance placed insurance policies with the Insurance Subsidiaries. Direct premiums written associated with these policies were $8.3 million in 2008, $9.9 million in 2007, and $9.5 million in 2006. In return, the Insurance Subsidiaries paid commissions to Rue Insurance of $1.7 million in 2008 and 2007 and $1.9 million in 2006.
(a) We purchase annuities from life insurance companies to fulfill obligations under claim settlements which provide for periodic future payments to claimants. As of December 31, 2008, we had purchased such annuities in the amount of $9.5 million for settlement of claims on a structured basis for which we are contingently liable. To our knowledge, none of the issuers of such annuities have defaulted in their obligations thereunder.
(b) We have various operating leases for office space and equipment. Such lease agreements, which expire at various times, are generally renewed or replaced by similar leases. Rental expense under these leases amounted to $11.9 million in 2008, $11.2 million in 2007, and $9.6 million in 2006. See Note 2(q) for information on our accounting policy regarding leases.
At December 31, 2008, the total future minimum rental commitments under non-cancelable leases were $25.9 million and such yearly amounts are as follows:
(c) At December 31, 2008, we have contractual obligations that expire at various dates through 2023 to invest up to an additional $119.5 million in alternative investments. There is no certainty that any such additional investment will be required. For additional information regarding these investments, see item (h) of Note 4, “Investments.”
In the ordinary course of conducting business, we are named as defendants in various legal proceedings. Most of these proceedings are claims litigation involving 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 us. We account for such activity through the establishment of unpaid loss and loss adjustment expense reserves. We expect 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 our consolidated financial condition, results of operations, or cash flows.
The combined statutory capital and surplus of the Insurance Subsidiaries was $884.4 million (unaudited) in 2008, and $1,034.3 million in 2007. The combined statutory net income of the Insurance Subsidiaries was $104.3 million (unaudited) in 2008, $167.6 million in 2007, and $164.2 million in 2006.