Selective's 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. Selective leases all of its other facilities. The principal office locations related to Selective's three business segments are described in Item 1. "Business." Selective believes that its facilities provide space for its present needs and that additional space, if needed, would be available on reasonable terms.
See Item 8. "Financial Statements and Supplementary Data," Note 14 to the consolidated financial statements and
Selective generates earnings from its three segments: (i) Insurance Operations (ii) Diversified Insurance Services, and (iii) Investments. The most important measures on which Selective's management focuses in evaluating financial condition and operating performance include combined ratio, growth in revenue, and return on equity. To this end, Selective must balance returns from the three sources under current market conditions to maximize the overall return to shareholders. Selective is disciplined in its risk selection and expense control. Selective patiently builds relationships in markets where it sees long-term profitable growth opportunities. Growth for Selective has predominately been generated organically with the objective of fulfilling strategic goals and providing a risk appropriate return to shareholders.
Selective had a record year in 2004 as it achieved the highest earnings in its history. The summary table below provides highlights regarding overall financial performance for 2004, 2003 and 2002:
From continuing operations, refer to Item 8. "Financial Statements and Supplementary Data," Note 14 to the consolidated financial statements and this section for further discussion.
The "Statutory Combined Ratio" includes the flood line of business, which is included in the Diversified Insurance Services Segment on a GAAP basis and therefore excluded from the GAAP combined ratio. The total Statutory Combined Ratio excluding flood is 96.5% in 2004, 102.0% in 2003, and 103.6% in 2002.
For 2004, net premiums written were $1.4 billion, an increase of 12% over 2003 net premiums written of $1.2 billion, which were 16% higher than 2002 net premiums written of $1.1 billion. Net premiums earned were $1.3 billion, an increase of 16% over 2003 net premiums earned of $1.1 billion, which were 15% higher than 2002 net premiums earned of just under $1.0 billion. These increases were largely attributable to Commercial Lines renewal premium written price increases, including exposure, that averaged 9% for 2004, 13% for 2003, and 19% for 2002. As expected, these price increases have decelerated during 2004; however, commercial lines earned price increases have outpaced loss trends for the year. Combined ratios, and ultimately earnings, would be unfavorably impacted if earned premium price increases cease to outpace loss costs trends in the future. However, underwriting improvements resulting in lower loss ratios could partially offset the unfavorable result of loss trends. Additional factors contributing to the growth in net premiums written were: (i) net new business written of $265.9 million for 2004 compared with $264.9 million for 2003 and $224.8 million for 2002; and (ii) commercial lines year-on-year retention improvement of two points during 2004 to 82%, compared with 80% for 2003 and 78% for 2002.
The commercial lines underwriting expense ratio was 31.7% in 2004, which was comparable to both 2003 and 2002. Underlying improvements in the expense ratio are being offset by higher profit-based incentive compensation as was noted in the overall Insurance Operations discussion above. In 2005, we are expanding several expense initiatives to enhance our ability to increase performance without increasing price. This includes eliminating low-value work from the organization, and streamlining operations, such as what we have done with the automation of commercial policy endorsements.
For 2004, our commercial lines combined ratio was 96.1% down from 101.5% in 2003 and 102.7% in 2002. This steady trend of improving performance is based on almost five years of double-digit commercial renewal price increases; ongoing underwriting enhancements; heightened loss control efforts; and the value of the Selective agency relationships.
Property statutory net premiums written were $159.8 million or 14% of total Commercial Lines net premium written for 2004, compared to $143.2 million in 2003 and $121.0 million in 2002. The property line of business posted a statutory combined ratio of 80.9% compared to 98.3% in 2003, and 91.0% in 2002. Improvements in 2004 were largely due to substantially lower frequency and severity of claims when compared to the same period a year ago. Weather-related catastrophe losses were 8.7 points in 2004 compared to 14.1 points in 2003 and 6.2 points in 2002. Additionally, we continue to implement ongoing pricing and underwriting actions to improve results in this line of business, which include: better insurance to value estimates across our book of business; a shift to risks of better construction quality and newer buildings; and an overall focus on low-to-medium hazard property exposures.
Bonds statutory net premiums written were $14.6 million for 2004, compared to $11.8 million in 2003 and $12.5 million in 2002. The Bond line of business posted a statutory combined ratio of 112.8% compared to 113.7% in 2003, and 121.4% in 2002. Although the bond operation represents only 1% of our Commercial Lines business, we continue to make strides to grow this line of business given its value to our agents in rounding out the commercial account for their clients. As a result of reduced availability in the market in 2002, reinsurance costs escalated by almost $2.0 million adding approximately 13.0 points to the 2002 combined ratio. The Company's reinsurance costs are represented by the difference between direct combined ratios and net combined ratios. Since 2002 underwriting improvements and changes to our reinsurance program have reduced our bond reinsurance costs. We expect this decline in reinsurance costs to continue in 2005. Improvements in our Bond line of business during 2004 reflect enhancements to the Bond underwriting process, as well as the successful rollout of two phases of our automated bond system. The third and final phase is expected to be rolled out during 2005. Our improved results in this line of business were largely offset by a one-time charge for $2.0 million, which related to salvage and subrogation recoverables for prior accident years.
The Personal Lines underwriting expense ratio decreased to 26.9% in 2004 from 29.7% in 2003 and 28.8% in 2002. Personal lines expenses decreased $2.4 million to $60.9 million in 2004 from $63.2 million in 2003. This is primarily the result of a $1.2 million decrease in New Jersey and New York limited assignment and distributions (LAD) charges due to a reduction in LAD pricing in these states and a $0.8 million increase in New Jersey homeowners' quota share ceded commissions, a contra expense, due to decreased losses for treaty year 2004. In 2005, we expect our new automated personal lines system to drive profitable growth, as it becomes even easier to do business with us. This leads to greater scale, which reduces underwriting expenses over time as agents directly process more of the transactions directly into our system. All of these enhancements should lead to a more profitable book of Personal Lines business.
Our homeowners line of business accounted for $35.7 million or 16% of total personal lines statutory net premiums written in 2004, compared to $33.2 million in 2003 and $28.5 million in 2002. The statutory combined ratio was 113.6% in 2004, compared to 125.3% in 2003 and 104.3% in 2002. Weather-related catastrophe losses impacted the combined ratio by 5.9 points compared to 23.0 points in 2003 and 8.6 points in 2002. Offsetting further improvement in this line of business in 2004 compared to 2003 was the severity associated with unusual fire losses coupled with approximately $2.0 million addition to our homeowners' losses in 2004. The addition to our homeowners' losses resulted from unfavorable trends in claims for groundwater contamination caused by leakage of certain underground heating oil storage tanks in New Jersey. Increased frequency was triggered, in part, by the state's robust real estate market, leading to an increase in home tank inspections. To address this issue, we began restricting writings of policies with coverage for underground heating oil storage tanks, company-wide, just about two years ago, and are reviewing possible coverage changes for existing business. We are seeing steady improvement in homeowner accident year frequencies, while tier and underwriting changes, as well as increased rates are beginning to favorably impact this business.
The Insurance Subsidiaries follow the customary practice of ceding a portion of their risks and paying to reinsurers a portion of the premiums received under the policies. This permits greater diversification of business and the ability to offer increased coverage while limiting maximum net losses. Reinsurance does not legally discharge an insurer from its liability for the full face amount of its policies, but does make the reinsurer liable to the insurer to the extent of the reinsurance ceded. We have reinsurance contracts that cover both property and casualty business. Selective uses traditional forms of reinsurance and does not utilize finite risk reinsurance.
Our Property Excess of Loss treaty, renewed effective July 1, 2004, covers each property risk in excess of a $2.0 million retention up to $20.0 million in three layers. Under the 2004 treaty, the Company cedes 100% of $18.0 million per risk in excess of the $2.0 million retention. This is a change from the 2003 treaty, where the Company retained 25% of the $5.0 million in excess of $5.0 million in the second layer for a total coverage of $16.7 million per risk in excess of the $2.0 million retention. The property treaty distinguishes between certified TRIA events and non-certified terrorism losses. The treaty provides annual aggregate certified terrorism limits for all risks (other than NBC) of $9.0 million for the first layer, $15.0 million for the second layer and $20.0 million for the third layer. Claims arising from non-certified terrorist acts are subject to the normal limits under the treaty: i) $3 million in excess of $2 million layer does not have an annual aggregate (unlimited annual recoveries); ii) $5 million in excess of $5 million layer provides seven reinstatements, $40 million in annual aggregate; iii) $10 million in excess of $10 million layer provides two reinstatements, $30 million annual aggregate limit. The provision in the July 1, 2003 treaty that provided only coverage for TRIA losses for all risks up to $75.0 million in total insured value per location was eliminated with the July 1, 2004 renewal. Consistent with the 2003 contract: all NBC losses are excluded from the Property Excess of Loss treaty regardless of whether or not they are certified under TRIA, however, our Terrorism Excess of Loss treaty, discussed earlier in this section, does cover these exposures up to an annual aggregate of $45.0 million once our $15.0 million annual aggregate deductible is met. There is no exclusion for mold or cyber risks in this contract.
Our New Jersey Homeowners Property 75% Quota Share treaty renewed January 1, 2005 at the 2004 expiring $75.0 million per occurrence limit with form following coverage. Under this treaty, the reinsurers follow our original policies including any loss from a terrorism event. The renewed treaty has a reduction in net cost of an estimated $0.3 million. Terms and conditions remained relatively the same. Premiums ceded under this treaty in 2004 increased by 1% to $19.4 million compared to $19.2 million in 2003.
Our Surety Excess of Loss treaty was renewed effective January 1, 2005 with essentially no changes in coverage and a significant reduction in premium rate. We realized a 22% reduction in the premium rate as compared to the 2004 treaty. The treaty provides per loss/per principal coverage up to $7.2 million in excess of $1.0 million retention and $0.8 million co-participation. The treaty provides the following reinstatements and annual aggregate limits: i) $3 million in excess of $1 million layer provides two reinstatements, $8.1 million annual aggregate limit, net of our co-participation; and ii) $5 million in excess of $4 million layer provides one reinstatement, $9 million annual aggregate limit, net of our co-participation.
In compliance with New Jersey regulation, the Insurance Subsidiaries ceded premium and no-fault claims for medical benefits in excess of $75,000 to the New Jersey Unsatisfied Claim and Judgment Fund (UCJF). Due to a change in New Jersey regulations, the cessions to UCJF were discontinued for policies with effective dates of January 1, 2004 or later. Claims covered under policies issued or renewed prior to January 1, 2004 will continue to be paid by the UCJF.
Although lower interest rates have put pressure on investment returns, we still generated an increase in pre-tax investment income to $120.5 million for the year, compared to $114.7 million for 2003 and $103.1 million in 2002. The increase reflects a 32% increase in dividend income, a 43% increase in limited partnership income and a 2% increase in fixed maturity income. Our investment portfolio reached $2.8 billion in value at December 31, 2004, an increase of 17%, compared to $2.4 billion in 2003 and $2.1 billion in 2002. This increase was due to strong operating cash flows of $367.1 million in 2004, compared with $281.9 million in 2003 and $180.1 million in 2002. Additionally, our debt offering in November 2004 added approximately $50 million in assets and our convertible debt offering in 2002 added approximately $116 million in assets. Our before-tax annualized portfolio yield was 4.7% in 2004 compared to 5.1% in 2003 and 5.4% in 2002.
The following table presents the Moody's and Standard & Poor's ratings of our fixed maturities portfolio:
At December 31, 2004, our investment portfolio included one non-investment grade security with an amortized cost of $5.0 million, or 0.2% of the portfolio, and a fair value of $5.1 million. At December 31, 2003, non-investment grade securities in our investment portfolio represented 1%, with an amortized cost of $25.2 million and a fair value of $27.2 million. The fair value of these securities was determined by independent pricing services or bid prices provided by various broker dealers. The Company did not have a material investment in non-traded securities in 2004 or 2003.
In evaluating for other than temporary impairment of fixed maturity securities, we evaluate certain factors, including but not limited to the following:
In evaluating for other than temporary impairment of equity securities, we evaluate certain factors, including but not limited to the following:
The dividend policy of the issuer at the date of acquisition and the date of evaluation;
Any buy/hold/sell recommendations or price projections published by outside investment advisors; and
Realized gains and losses are determined on the basis of the cost of specific investments sold or written-down, and are credited or charged to income. Our Investments segment included net realized gains before tax of $24.6 million in 2004 compared to $12.8 million in 2003 and $3.3 million in 2002. The realized gains were principally from the sale of equity securities. The primary reason for the significant increase in net realized gains in 2004 was the sale of a single equity security, which resulted in a $14.9 million pre-tax gain when compared to 2003. We maintain a high quality and liquid investment portfolio and the sale of the securities that resulted in realized gains did not change the overall liquidity of the investment portfolio. The Company's philosophy for sales of securities generally is to reduce our exposure to securities and sectors based upon economic evaluations or the fundamentals for that security or sector have deteriorated. The Company generally has a long investment time horizon and our turnover is low, which has resulted in many securities accumulating large unrealized gains. Every purchase or sale is made with the intent of improving future investment returns. Realized losses also include impairment charges from investment write-downs for other than temporary declines. There were no impairment charges recorded in 2004 compared to $1.2 million for 2003 and $7.1 million for 2002. The impairment charges in 2002 were the primary reason for the significantly decreased level of net realized gains as compared to 2003. These securities were written down due to heightened credit risk that was security specific and would not impact other securities held. The following table summarizes the Company's net realized gains by investment type:
Generally, the Insurance Subsidiaries have a duration mismatch between assets and liabilities. The duration of the fixed maturity portfolio of 4.3 years is longer than that of the Insurance Subsidiaries liabilities by approximately 1.7 years. The current duration of our fixed maturities is within the Company's historical range, and is monitored and managed to maximize yield yet limit interest rate risk. A high level of liquidity is maintained to mitigate the duration mismatch by utilizing a laddered maturity structure so that liquidation of available-for-sale fixed maturities should not be necessary in the ordinary course of business. Liquidity is always a consideration when buying or selling securities, but because of the high quality and active market for our investment portfolio, the securities sold have not diminished the overall liquidity of our portfolio.
The Company realized gains and losses from the sale of available-for-sale debt and equity securities during 2004, 2003 and 2002. The following table presents the period of time that securities, sold at a loss during these years, were continuously in an unrealized loss position prior to sale:
These securities were sold despite the fact that they were in a loss position. The decision to sell these securities was due to: (i) heightened credit risk of the individual security sold; (ii) the decision to reduce our exposure to certain issuers, industries or sectors in light of changing economic conditions; or (iii) tax efficiency purposes.
Selective is a servicing carrier for the federal government's National Flood Insurance Program (NFIP). Through this program, Selective is able to provide a market for flood insurance to approximately 6,300 agents across the country. As a servicing carrier, Selective bears no risk of policyholder loss since the program is fully reinsured by the federal government. Currently, Selective is servicing more than 188,000 flood policies under this program, compared to 162,000 policies in 2003 and 135,000 policies in 2002. Total Flood premium serviced is $78.0 million in 2004, compared to $65.8 million in 2003 and $53.3 million in 2002. Premium growth produced service revenue of $26.6 million and when combined with $2.6 million in claim administrative fees from the active hurricane season it resulted in an overall increase in revenues in 2004 of 23% to $29.2 million, compared to $23.6 million, which included $22.2 million in service revenue and $1.4 million in claim administrative fees, for 2003, and $18.3 million, which included $18.2 million in service revenue and $0.1 million in claim administrative fees, for 2002. The increase in pre-tax profit to $8.5 million in 2004, compared to $6.1 million in 2003 and $3.9 million in 2002 is driven by the increase in claim administrative fees, which is higher margin business compared to the servicing revenue generated on writing premium. The higher margin on claim administrative fees is also evident in the increased after-tax return on revenue to 19.0% compared to 16.8% in 2003 and 13.7% in 2002. In October 2004, the NFIP reduced the service fee rate by 0.6 points from 31.8% to 31.2% of flood premium serviced, which will impact our revenue and after-tax return on revenue.
In December 2001, the Company's management adopted a plan to divest itself of its 100% ownership interest in PDA Software Services, Inc. (PDA), which had historically been reported as part of the Diversified Insurance Services segment. This divestiture plan was completed in May 2002 when the Company sold all of the issued and outstanding shares of capital stock of PDA as well as certain software applications developed by PDA at a net gain of $0.5 million. In addition, the Company recovered $5.0 million of capitalized software development costs. For further information on discontinued operations, see Item 8. "Financial Statements and Supplementary Data," Note 14 to the consolidated financial statements.
The payment of dividends from the Diversified Insurance Services subsidiaries are restricted only by the available operating cash flows of those subsidiaries, with the exception of our flood insurance operation, which is restricted by the same limitations of our Insurance Subsidiaries noted above. Cash flows from operations in the Diversified Insurance Services segment of $14.2 million in 2004, $14.4 million in 2003, and $18.6 million in 2002 resulted in dividends to the Parent of $9.4 million in 2004 compared to $8.9 million in 2003. No dividends were paid in 2002.
The Parent's cash requirements were $64.6 million in 2004 and included principal and interest payments on the Senior Convertible Notes, various notes payable, dividends to stockholders and general operating expenses. As indicated in the table on page 50, the Company has contractual obligations pursuant to various notes payable of $24.0 million in 2005 of which the entire balance has been set aside in an irrevocable trust as noted above. The 2002 convertible note issuance has a contingent conversion feature that permitted the holders of the notes to convert the notes when the price of the Company's common stock has maintained a 20% premium to the conversion price of $29.29, or $35.15, for 20 of 30 consecutive trading days ending on the last trading day of the previous calendar quarter. On October 26, 2004, in accordance with the applicable provisions of the notes, the Company's Board of Directors voted to permanently waive the stock price contingency provision. As a result, the Senior Convertible Notes will continue to be convertible at the option of the note holder into shares of common stock until their maturity, although no such conversions had occurred as of the end of 2004. As a result of the notes being convertible, 3.9 million shares of common stock were added to our diluted earnings per share calculation in 2004. Also, due to new accounting guidance issued in 2004, the 3.9 million shares related to the Senior Convertible Notes have been added to our diluted earnings per share calculation since the date of the issuance of the notes. This resulted in a revision to our diluted earnings per share calculation for 2003 and 2002. This had no effect on reported net income. See Item 8. "Financial Statements and Supplementary Data," Note 8(a) to the consolidated financial statements for additional information concerning these Senior Convertible Notes and Note 3 to the consolidated financial statements for additional information concerning the new accounting guidance and the resulting restatements.
The Company reviews its financial debt agreements for any potential rating triggers that could dictate a significant change in terms of the agreements if the Company's credit rating were to suddenly and drastically change. The principal agencies that issue financial strength ratings for the property and casualty industry are: A.M. Best Company (A.M. Best), Standard & Poor's Rating Services (S&P), Moody's Investor Service (Moody's) and Fitch Ratings Service (Fitch). We believe our ability to write business is most influenced by our rating from A.M. Best. We are currently rated "A+" (Superior) by A.M. Best, which is their second highest of fifteen ratings. A significant downgrade from A.M. Best, could materially adversely affect the business we write. We believe that ratings from S&P, Moody's and Fitch, although important, have less of an impact on our business. A rating downgrade to below "A-" in its A.M. Best or S&P rating would be considered an event of default under the terms of the Company's line of credit agreements.
In addition to the cash requirements of the Parent, our operating obligations and cash outflows include: claim settlements; agents commissions; labor costs; premium taxes; general and administrative expenses; investment purchases; and capital expenditures. Generally, the Insurance Subsidiaries do not match securities held to liabilities as part of ongoing asset/liability duration management. The duration of the asset portfolio of 4.3 years is longer than its liabilities of approximately 1.7 years. The current duration of our fixed maturities, which is within the Company's historical range and a component of our investment philosophy, utilizes a laddered maturity structure so that liquidation of available-for-sale fixed maturities should not be necessary in the ordinary course of business. Liquidity is always a consideration when buying or selling securities, but because of the high quality of our investment portfolio, the securities sold have not diminished the overall liquidity of our portfolio. Since cash inflow from premiums is received in advance of cash outflow required to settle claims, we accumulate funds that we invest. At December 31, 2004, we had $2.8 billion in investments compared with $2.4 billion at December 31, 2003. Additionally, the Insurance Subsidiaries have additional investment commitments for their limited partnership investments of up to $45.3 million; however, there is no certainty that any additional investment will be required.
Total assets increased by 14%, or $490.6 million, at December 31, 2004 compared to December 31, 2003. Invested assets increased by $403.9 million due to: (i) net investment purchases in the amount of $394.4 million primarily funded by operating cash flows, which totaled $367.1 million, $49.9 million in debt issuance proceeds, cash generated from realized investment gains of $24.6 million, as well as an increase in net securities payable of $2.7 million; and (ii) an increase in unrealized gains of $9.4 million. Increased premiums written drove increases in premium receivables of $22.8 million and deferred policy acquisition costs of $14.5 million. Reinsurance recoverables on unpaid losses and loss expenses increased $34.2 million primarily due to an $18.3 million increase in Flood losses, which are ceded to the Federal Government's National Flood Insurance Program, and a $20.1 million increase in casualty losses. The increase in other assets of $10.4 million is primarily due to a funding of the pension, which resulted in a prepaid asset of $10.2 million. For further information regarding our pension plan and its related funding see the discussion, "Pension and Postretirement Benefit Plan Actuarial Assumptions," on page 49 of this Form 10-K.
Total liabilities increased 13%, or $358.4 million, at December 31, 2004 compared to December 31, 2003. Loss and loss expense reserves increased $247.4 million as a result of increased exposure on new and existing policies as well as normal loss trends, which include inflation and rising medical costs. Increased premium writings are primarily responsible for the increase in unearned premium reserves of $52.2 million. Notes payable increased $25.9 million due the issuance of notes payable in the amount of $49.9 million during November 2004, partially offset by scheduled payments totaling $24.0 million on other notes payable that were made in May and August 2004. Deferred federal income tax liability increased $17.1 million from $12.7 million at December 31, 2003 to $29.8 million at December 31, 2004 primarily due to: (i) a $20 million pension contribution in December 2004; (ii) increased unrealized gains in our investment portfolio; and (iii) the deferred impact of improved underwriting results from the insurance operations. Commissions payable increased to $66.9 million at December 31, 2004 compared with $53.7 million at December 31, 2003 due to improved underwriting profitability, which generated $37.5 million in supplemental agents' commissions compared with $24.8 million last year, as well as increased premium-based commission amounts due to higher premium levels. Other liabilities increased $14.3 million compared to December 31, 2003 primarily due to a $12.0 million increase in the Company's bank accounts that allow checks to be paid upon presentation prior to the funding of the account, as well as an increase in securities payable of $2.7 million for investment trades that had not yet been settled in cash as of December 31, 2004.
Total stockholders' equity increased 18%, or $132.2 million at December 31, 2004 compared to December 31, 2003. Additional paid in capital increased $29.0 million primarily due to activity involving various stock award and purchase plans. Retained earnings increased $109.3 million due to net income of $128.6 million, partially offset by stockholder dividends of $19.4 million. After-tax unrealized gains on our investment portfolio increased as of December 31, 2004, compared to December 31, 2003 accounting for the $6.1 million increase in accumulated other comprehensive income. As a partial offset to stockholders' equity, unearned stock compensation and notes receivable from stock sales increased $5.2 million, or 55%, compared to December 31, 2003, due to the issuance of 2004 restricted stock grants. Treasury stock increased $8.7 million due to the repurchase of approximately 141,000 shares for $4.9 million under the Company's common stock repurchase program and the repurchase of 103,000 shares for $3.8 million in relation to various stock plan awards.
As of December 31, 2004, we established a range of reasonably possible reserves for net claims of approximately $1,529 million to $1,695 million and of approximately $1,331 million to $1,488 million at December 31, 2003. 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 the most likely scenarios, it is possible that the final outcomes may fall above or below these amounts. This range does not include a provision for potential increases or decreases associated with environmental reserves, as management believes it is not meaningful to calculate a range given the uncertainties associated with environmental claims. As of December 31, 2004, the Company had accrued $1,616.4 million of net loss and loss expense reserves compared to $1,403.2 million as of December 31, 2003. The Company does not discount to present value that portion of its loss reserves expected to be paid in future periods; however, the loss reserves include anticipated recoveries for salvage and subrogation claims.
The number of environmental claims presented in the tables includes all multiple claimants who are associated with the same site or incident.
The net survival ratio was calculated utilizing a three-year average for net losses and expenses paid.
In 2003, the Financial Accounting Standards Board (FASB) issued revised FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" (FIN 46R), which is a revised interpretation of Accounting Research Bulletin No. 51, "Consolidated Financial Statements." FIN 46R is required to be applied starting with fiscal years beginning after December 15, 2003. FIN 46R requires the consolidation of a variable interest entity (VIE) by an enterprise if that enterprise either absorbs a majority of the VIE's expected losses or receives a majority of the VIE's expected residual returns as a result of ownership, contractual or other financial interests in the VIE. Prior to FIN 46R, entities were generally consolidated by an enterprise that had a controlling financial interest through ownership of a majority voting interest in the entity. FIN 46R defines a VIE as an entity in which equity investors do not have the characteristics of a controlling financial interest nor do they have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support. The Company has no interests in VIEs or potential VIEs commonly referred to as special-purpose entities and as such, the adoption of this revised interpretation on January 1, 2004 has had no effect on the Company's results of operations or financial condition.
In 2004, the FASB issued Statement No. 123 (revised 2004), "Share-Based Payment" (FAS 123R), which requires all companies to measure compensation expense on the income statement for all share-based payments (including employee stock options) at grant date fair value of the equity instruments. The effective date of this statement for public companies is as of the beginning of the first interim or annual reporting period that begins after June 15, 2005, however early adoption is encouraged. The Company expects to adopt the modified prospective application provisions of FAS 123R as of January 1, 2005. The pro forma results presented in Note 2(n) are in accordance with the required disclosures under Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" (FAS 148), and should provide for a reasonable approximation of the impact the implementation of this statement will have on the Company.
Also in 2004, the FASB ratified EITF Issue No. 04-8, "The Effect of Contingently Convertible Instruments on Diluted Earnings per Share" (EITF 04-8). This EITF requires that instruments convertible into common stock upon the achievement of a specified price of the issuer's shares be included in diluted earnings per share computations under the if-converted method regardless of whether the triggering market conditions have been met. This EITF, which is effective for reporting periods ending after December 15, 2004, was applied by restating previously reported diluted earnings per share amounts. As a result, the Company has restated its 2003 and 2002 diluted earnings per share amounts for the inclusion of approximately 3.9 million shares related to the September 2002 issuance of Senior Convertible Notes. This restatement reduced 2003 diluted earnings per share from $2.40 to $2.20 and reduced 2002 diluted earnings per share from $1.56 to $1.53. This restatement had no effect on reported net income and there was no impact on the 2004 diluted earnings per share as these shares have been included in the diluted computation for the entire year.
We currently have available revolving lines of credit amounting to $45.0 million, under which no balances are outstanding as of either December 31, 2004 or 2003. For more information regarding the Company's lines of credit, see Item 8. "Financial Statements and Supplementary Data," Note 8(d) to the consolidated financial statements for more information. We have issued no guarantees on behalf of others and have no trading activities involving non-exchange traded contracts accounted for at fair value. We have no material transactions with related parties other than those disclosed in Item 8. "Financial Statements and Supplementary Data," Note 18 to the consolidated financial statements.
In addition to our contractual obligations, we maintain case reserves and estimates of reserves for losses and loss expenses incurred but not yet reported (IBNR), which is in accordance with industry practice. Using generally accepted actuarial reserving techniques we project our estimate of ultimate losses and loss expenses at each reporting date. Included within the estimate of ultimate losses and loss expenses are case reserves, which are analyzed on a case-by-case basis by the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the type of losses. 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. A range of possible reserves is determined annually and considered in addition to the most recent loss trends and other factors in establishing reserves for each reporting period. Based on the consideration of the range of possible reserves, recent loss trends and other factors, IBNR is established and the ultimate net liability for losses and loss expenses is determined. Such an assessment requires considerable judgment given that it is frequently not possible to determine whether a change in the data is an anomaly until sometime after the event. Even if a change is determined to be permanent, it is not always possible to reliably determine the extent of the change until sometime later. As a result, there is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves because the eventual deficiency or redundancy is affected by many factors.
Fluctuations in interest rates and other changes in the investment environment that affect investment returns;
Catastrophic events can have a significant impact on our financial and operational condition.
Various natural and man-made events can cause catastrophes, including, but not limited to hurricanes, tornadoes, windstorms, earthquakes, hail, terrorism, explosions, severe winter weather and fires. The frequency and severity of these catastrophes are inherently unpredictable. The extent of losses from a catastrophe is determined by the severity of the event and the total amount of insured exposures in the area affected by the event. Although catastrophes can cause losses in a variety of property and casualty lines, most of the catastrophe-related claims of our Insurance Subsidiaries historically have been related to commercial property and homeowners' coverages.
Our Insurance Subsidiaries seek to reduce their exposure to catastrophe losses through the purchase of catastrophe reinsurance. Reinsurance, however, may prove inadequate if:
On November 26, 2002, TRIA legislation was signed into law and will be in effect through December 31, 2005. TRIA requires sharing the risk of future losses from terrorism between private insurers and the federal government, and is applicable to almost all commercial lines of insurance. Insurance companies with direct commercial insurance exposure in the United States are required to participate in this program. TRIA rescinded all previously approved exclusions for terrorism. Policyholders for non- workers compensation policies have the option to accept or decline the terrorism coverage Selective offers in its policies, or negotiate other terms. In 2004, approximately 90% of our commercial non-workers compensation policyholders purchased terrorism coverage. The terrorism coverage is mandatory for all workers compensation primary policies. In addition, ten of the twenty primary states Selective writes commercial property coverage in mandate the coverage of fire following an act of terrorism. These provisions apply to new policies written after enactment of TRIA. A terrorism act has to be certified by the Secretary of Treasury in order to be covered by TRIA. TRIA limits the certified losses to "international terrorism" defined as an act committed on behalf of any foreign person or foreign interest where the damage from the event is in excess of $5 million and the event was not committed in the course of a war declared by the United States. Terrorism acts related to the use of nuclear, biological or chemical (NBC) weapons are covered by TRIA provided that the Secretary of the Treasury certifies the loss. Each participating insurance company will be responsible for paying out a certain amount in claims (a deductible) before federal assistance becomes available. This deductible is based on a percentage of commercial lines direct earned premiums from the prior calendar year. For losses above an insurer's deductible, the federal government will cover 90%, while the insurer contributes 10%. Although the provisions of TRIA will serve to mitigate our exposure in the event of a large-scale terrorist attack, Selective's deductible is substantial. In addition, it is uncertain whether TRIA will be extended past its current termination date. Selective continues to monitor concentrations of risk and has purchased a separate terrorism treaty to supplement its protection to this highly unknown exposure.
Our geographic concentration ties our performance to the economic and regulatory conditions and weather-related events in the Eastern region of the United States.
Our property and casualty insurance business is concentrated geographically in Eastern region of the United States. New Jersey accounts for thirty-seven (37%) percent of our total net premiums written. Substantially all of our remaining business is written in other Eastern region jurisdictions (Connecticut, Delaware, District of Columbia, Georgia, Illinois, Indiana, Iowa, Kentucky, Maryland, Michigan, Minnesota, Missouri, New York, North Carolina, Ohio, Pennsylvania, Rhode Island, South Carolina, Virginia and Wisconsin). Unusually severe storms or other natural or man-made disasters that destroy property in these states could adversely affect our operations. Our revenues and profitability are also subject to prevailing economic and regulatory conditions in the states in which we write insurance. Because our business is concentrated in a limited number of geographic markets, we may be exposed to risks of adverse developments that are greater than the risks of having business in a greater number of geographic markets.
Proposals intended to control the cost and availability of healthcare services have been debated in the U.S. Congress and state legislatures. Although we neither write health insurance in our managed care business nor assume any healthcare risk, rules affecting healthcare services can affect workers' compensation, commercial and personal automobile, liability, and other insurance that we do write. We cannot determine whether, or in what form, healthcare reform legislation may be adopted by the U.S. Congress or any state legislature. We also cannot determine the nature and effect, if any, that the adoption of healthcare legislation or regulations, or changing interpretations, at the federal or state level would have on us. Examples of insurance regulatory risks include:
We are also potentially subject to unfair competition based on uneven application of regulatory requirements by state regulators. For example, in 2004 a new market entrant in the New Jersey automobile insurance market was permitted to use insurance credit scoring to price personal automobile insurance policies while all other insurers were precluded from so doing. New Jersey subsequently has allowed other personal automobile insurers to use credit scoring, but our ability to competitively price our New Jersey personal automobile business was restricted for a period of time.
Because Selective voluntarily writes workers' compensation insurance, it is required by state law to support the involuntary market. Insurance companies that underwrite voluntary workers' compensation insurance can either directly write involuntary coverage, which is assigned by state regulatory authorities, or participate in a sharing arrangement, where the business is written by a servicing carrier and the profits or losses of that serviced business are shared among the participating insurers. Selective currently participates through a sharing arrangement in all states, except New Jersey, where it currently writes involuntary coverage directly. Historically, this business has been unprofitable whether written directly or handled through a sharing arrangement. Additionally, Selective is required to provide workers' compensation benefits for losses arising from acts of terrorism under its workers' compensation policies. The impact of any terrorist act is unpredictable, and the ultimate impact on Selective will depend upon the nature, extent, location and timing of such an act. Any such impact on Selective could be material.
We are subject to regulatory provisions that are designed to address potential availability and/or affordability problems in the homeowners property insurance marketplace. Involuntary market mechanisms, such as the New Jersey Insurance Underwriting Association (FAIR Plan), generally result in assessments to us. The New Jersey FAIR Plan writes fire and extended coverage on homeowners for those individuals unable to secure insurance elsewhere. Insurance companies who voluntarily write homeowners insurance in New Jersey are assessed a portion of any deficit from the New Jersey FAIR Plan based on their share of the voluntary market. Similar involuntary plans exist in most other states where we operate.
A change in our market share in New Jersey could adversely impact the results in our private passenger automobile business.
We compete with both regional and national property and casualty insurance companies, including those that do not use independent agents and write directly with insureds. Many of these competitors are larger than Selective and have greater financial, technical, and operating resources. Because we sell our coverages through independent insurance agents who also are agents of our competitors, we face competition within each of our appointed independent insurance agencies.
The property and casualty insurance industry is highly competitive on the basis of both price and service. If our competitors price their products more aggressively, our ability to grow or renew our business as well as our profitability may be adversely impacted. There are many companies competing for the same insurance customers in the geographic areas in which we operate. The Internet may also emerge as a significant source of new competition, both from existing competitors and from new competitors.
We also face competition, primarily in the commercial insurance market, from entities that self-insure their own risks. Many of our customers and potential customers are examining the benefits and risks of self-insuring as an alternative to traditional insurance.
A number of new, proposed, or potential legislative or industry developments could further increase competition in the property and casualty insurance industry. These developments include:
The Gramm-Leach-Bliley Act, which could result in increased competition from new entrants to the insurance market, including banks and other financial service companies;
Programs in which state-sponsored entities provide property insurance in catastrophe-prone areas or other alternative market types of coverage; and
Our reserves may not be adequate to cover actual losses and expenses.
We cannot be certain that the reserves we establish are adequate or will be adequate in the future.
We market and sell our insurance products through independent, non-exclusive insurance agencies and brokers. Agencies and brokers are not obligated to promote our insurance products, and they may also sell our competitors' insurance products. As a result, our business depends in part on the marketing and sales efforts of these agencies and brokers. As we diversify and expand our business geographically, we may need to expand our network of agencies and brokers to successfully market our products. If these agencies and brokers fail to market our products successfully, our business may be adversely impacted. Also, independent agents may decide to sell their businesses to banks, other insurance agencies, or other businesses. Agents with a Selective appointment may decide to buy other agents. Changes in ownership of agencies or expansion of agencies through acquisition could adversely affect an agency's ability to control growth and profitability, thereby adversely affecting our business.
Our investments support our operations and provide a significant portion of our revenues and earnings.
When providing co-employment services, SHRS assumes the obligations to pay the salaries, wages, and related benefit costs and payroll taxes of its clients' worksite employees. Clients are required to fund these obligations for us. If clients fail to fund these obligations, and if these obligations are significant, it could have a material adverse effect on our results of operations or financial condition.
SHRS establishes, by contract, a division of responsibility with its clients for various personnel management matters, including compliance with and liability under various governmental regulations. Because of this relationship, SHRS may be subject to liability for its clients' violations of laws and regulations. Although the agreements with clients generally obligate them to indemnify SHRS for any liability attributable to the conduct of the clients, SHRS may not be able to collect on the contractual indemnification claim. In addition, worksite employees may be deemed to be agents of SHRS, subjecting SHRS to liability for the actions of those worksite employees that could have a material adverse effect on our results of operations or financial condition. SHRS maintains professional liability insurance and such other coverages that it believes are reasonable in light of its experiences to date. There can be no assurance, however, that such insurance will be sufficient or available in the future at reasonable cost to protect SHRS from liability which might adversely affect its business, financial condition, or results of operations.
Some states in which CHN Solutions transacts business have licensing and other statutory or regulatory requirements, particularly for medical review services. Some of these requirements apply to medical review of care covered by workers' compensation. Typically, these laws establish minimum standards for qualifications of personnel, confidentiality, internal quality control, and dispute resolution procedures. In addition, some states regulate the operation of managed care provider networks. If additional statutory or regulatory requirements are imposed, CHN Solutions might encounter increased costs of operations.
Healthcare providers have become more active in their efforts to minimize the use of certain cost containment techniques and are litigating to prevent application of certain cost containment practices. Their success in these efforts could limit the scope of certain cost containment services that we provide and revenue, accordingly, could decline. Although CHN Solutions does not grant or deny claims for payment of benefits and does not engage in the practice of medicine or deliver medical services, it does make recommendations concerning the appropriateness of providers' medical treatment plans of patients. Consequently, there can be no assurance that CHN Solutions will not be subject to claims for adverse medical consequences, including being joined in suits brought against its customers. Such litigation might adversely affect its business, financial condition, or results of operations. CHN Solutions maintains professional liability insurance and such other coverages that it believes are reasonable in light of its experiences to date. There can be no assurance, however, that such insurance will be sufficient or available in the future at reasonable cost to protect CHN Solutions from liability which might adversely affect its business, financial condition, or results of operations.
We are a holding company, and we may have a limited ability to declare dividends, and thus may not have access to the cash that is needed to meet our cash needs.
Substantially all of our operations are conducted through our subsidiaries. Restrictions on the ability of our subsidiaries, particularly the Insurance Subsidiaries, to pay dividends or make other cash payments to us may materially affect our ability to pay principal and interest on our indebtedness and dividends on our common stock.
The ability of our board of directors to issue "blank check" preferred stock.
To a large extent, the success of our businesses is dependent on our ability to attract and retain key employees, in particular our senior officers, key management, sales, information systems, underwriting, claims, managed care, HR outsourcing and corporate personnel. Competition to attract and retain key personnel is intense. While we have employment agreements with a number of key managers, we generally do not have employment contracts with our employees and cannot ensure that we will be able to attract and retain key personnel.
Our businesses are increasingly dependent on computer and Internet-enabled technology. Our inability to anticipate or manage problems with technology associated with scalability, security, functionality or reliability could adversely affect our ability to write business and service accounts, and could adversely impact our results of operations and financial conditions.
Our industries have been the target of class action litigation in areas including the following:
It is possible that future class action litigation could adversely affect results of our insurance and diversified insurance services businesses and our financial condition.
Purchase and adjustments of subsidiaries acquired (net of short-term investments and
Selective Insurance Group, Inc., (Selective) offers property and casualty insurance products and diversified insurance services and products through its various subsidiaries. Selective was incorporated in New Jersey in 1977 and its main offices are located in Branchville, New Jersey. Its common stock is publicly traded on the NASDAQ National MarketÒ under the symbol, "SIGI." Selective classifies its business into three operating segments:
Insurance Operations, which write commercial lines and personal lines property and casualty insurance through independent insurance agents, mainly in 20 states in the Eastern region of the United States;
Diversified Insurance Services, which provide managed care services, human resource administration outsourcing products and services, and federal flood insurance administrative services.
Certain amounts in Selectives's prior years' consolidated financial statements and related footnotes have been reclassified to conform to the 2004 presentation. Such reclassification had no effect on Selective's net income or stockholders' equity.
Realized gains and losses on the sale of investments are determined on the basis of the cost of the specific investments sold and are credited or charged to income. When the fair value of any investment is lower than its cost, an assessment is made to determine if the decline is other than temporary. If the decline is deemed to be other than temporary, the investment is written down to fair value and the amount of the writedown is charged to income as a realized loss. The fair value of the investment becomes its new cost basis. There were no impairment charges recorded in 2004. Realized losses from investment write-downs were $1.2 million for 2003 and $7.1 million for 2002.
The following methods and assumptions were used by Selective in estimating its fair value disclosures for financial instruments:
See Note 5 for a summary table of the fair value and related carrying amounts of financial instruments.
If a client does not pay its related payroll and service fees prior to the applicable payroll date, SHRS has the right to cancel the co-employer contract or, at its option, require letters of credit or other collateral. SHRS generally has not required such collateral. As of December 31, 2004, the maximum exposure SHRS had to any one account for earned payroll was approximately $0.6 million. If the financial condition of a client were to deteriorate rapidly, resulting in nonpayment, SHRS's accounts receivable balances could grow and SHRS could be required to provide for allowances, which would decrease net income in the period that such determination was made.
Policy acquisition costs are directly related to the writing of an insurance policy and are deferred and amortized over the life of the policies in order to facilitate a matching of revenues and expenses. 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. Selective regularly conducts 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 decrease in goodwill in our Diversified Insurance Services segment of $0.7 million in 2004 is due to a purchase price adjustment relating to our acquisition of Consumer Health Network Plus, LLC (CHN). The increase in goodwill for the Insurance Operations' segment of $0.3 million is due to the acquisition of Selective Insurance Company of New England in January of 2004. See Note 2(r) for additional information regarding acquisitions.
By using both individual estimates of reported claims and generally accepted actuarial reserving techniques, Selective estimates the ultimate net liability for losses and loss expenses. While the ultimate actual liability may be higher or lower than reserves established, Selective believes the reserves to be adequate. Any changes in the liability estimate may be material to the results of operations in future periods. Selective does not discount to present value that portion of its loss reserves expected to be paid in future periods; however, the loss reserves include anticipated recoveries for salvage and subrogation claims. Such salvage and subrogation amounted to $48.1 million for 2004 and $43.6 million for 2003.
Net premiums written include direct writings plus reinsurance assumed and estimates of premiums earned but unbilled on the workers' compensation and general liability lines of insurance, less reinsurance ceded. Premiums written are recognized as revenue over the period that coverage is provided using the semi-monthly pro rata method. Unearned premiums and prepaid reinsurance premiums represent that portion of premiums written that are applicable to the unexpired terms of policies in force.
Selective uses the asset and liability method of accounting for income taxes. Deferred federal income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax basis of Selective's assets and liabilities, as well as tax on net unrealized gains or losses on available-for-sale securities. A valuation allowance is established when it is more likely than not that some portion of the deferred tax asset will not be realized. The effect of a change in tax rates is recognized in the period of enactment.
Short-term investments are comprised of highly liquid investments that are readily convertible into known amounts of cash. Such investments have maturities of 90 days or less from the date of purchase.
Selective's cash paid during the year for interest and federal income taxes and non-cash financing activities were as follows:
Also in 2004, the FASB ratified Emerging Issues Task Force Issue No. 04-8, "The Effect of Contingently Convertible Instruments on Diluted Earnings per Share" (EITF 04-8). This EITF requires that instruments convertible into common stock upon the achievement of a specified price of the issuer's shares be included in diluted earnings per share computations under the if-converted method regardless of whether the triggering market conditions have been met. This EITF, which is effective for reporting periods ending after December 15, 2004, was applied by restating previously reported diluted earnings per share amounts. Consequently, Selective has restated its 2003 and 2002 diluted earnings per share amounts for the inclusion of approximately 3.9 million shares related to the September 2002 issuance of Senior Convertible Notes. This restatement reduced 2003 diluted earnings per share from $2.40 to $2.20 and reduced 2002 diluted earnings per share from $1.56 to $1.53. There was no impact on the 2004 diluted earnings per share as these shares have been included in the diluted computation for the entire year.
(b) Net unrealized gains on held-to-maturity fixed maturity securities are as follows:
Increase in net unrealized gains, net of deferred income tax expense
(d) The amortized cost, estimated fair values and unrealized gains (losses) of held-to-maturity fixed maturity securities at December 31, 2004 and 2003, respectively, are as follows:
(e) The cost/amortized cost, estimated fair values and unrealized gains (losses) of available-for-sale securities at December 31, 2004 and 2003, respectively, are as follows:
(f) The following table summarizes, for all securities in an unrealized loss position at December 31, 2004, the aggregate fair value and gross pre-tax unrealized loss recorded in Selective's accumulated other comprehensive income, by asset class and by length of time those securities have been in an unrealized loss position:
At December 31, 2004, Selective held 123 fixed maturity securities, which had a fair value of $415.5 million in an unrealized loss of $3.3 million. At December 31, 2004, Selective also held three equity securities, which had a fair value of $5.1 million in an unrealized loss of $0.3 million. All of these securities had fair values no less than 91% of their cost basis. Selective believes the decline in the fair value of these securities to be temporary. The assessment of whether a decline in value is temporary includes Selective's current judgment as to the financial position and future prospects of the entity that issued the investment security. Broad changes in the overall market or interest rate environment generally will not lead to a write-down. If Selective's judgment about an individual security changes in the future Selective may ultimately record a realized loss after having originally concluded that the decline in value was temporary, which could have a material impact on Selective's net income and financial position of future periods.
Proceeds from the sale of available-for-sale securities were $279.3 million during 2004; $245.4 million during 2003; and $234.4 million during 2002.
(h) The amortized cost and estimated fair value of fixed maturity securities at December 31, 2004, by contractual maturity are shown below. Mortgage-backed securities are included in the maturity tables using the estimated average life of each security.
Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
(i) Certain investments were on deposit with various state regulatory agencies to comply with insurance laws and had carrying values of $32.2 million as of December 31, 2004 and $29.5 million as of December 31, 2003.
(k) Included in other investments is $44.1 million of investments in limited partnerships in 2004 and $35.6 million in 2003. These investments are carried using the equity method, which approximates fair value. Any change in fair value of these investments is recognized in net investment income earned in the period of change. At December 31, 2004 Selective had additional investment commitments of up to $45.3 million related to these limited partnerships. There is no certainty that any additional investment will be required.
The following table presents the carrying amounts and estimated fair values of Selective's financial instruments as of December 31, 2004 and 2003:
Selective's consolidated financial statements reflect the effects of assumed and ceded reinsurance transactions. Assumed reinsurance refers to the acceptance of certain insurance risks that other insurance entities have underwritten. Ceded reinsurance involves transferring certain insurance risks (along with the related written and earned premiums) Selective has underwritten to other insurance companies who agree to share these risks. The primary purpose of ceded reinsurance is to protect the Company from potential losses in excess of the amount it is prepared to accept.
Flood business which Selective cedes 100% to the federal government's National Flood Insurance Program, is included in the above amounts as follows:
Less: reinsurance recoverable on unpaid loss and loss expenses, at beginning of year
At December 31, 2004, Selective's reserves for environmental claims amounted to $42.3 million on a gross basis (including case reserves of $22.9 million and IBNR reserves of $19.4 million) and $38.5 million on a net basis (including case reserves of $22.9 million and IBNR reserves of $15.6 million). There are a total of 3,310 environmental claims, including multiple claimants who are associated with the same site or incident. Of these, 3,025 are asbestos related, of which 1,729 involve four insureds. The total case reserves associated with these four insureds amounted to $4.0 million on a gross and net basis. The total case reserves for asbestos related claims amounted to $7.6 million on a gross and net basis. About 60 of the total environmental claims involve nine landfill sites. The landfill sites account for case reserves of $8.7 million on a gross and net basis. The remaining claims, which account for $6.6 million of case reserves on a gross and net basis, involve leaking underground storage tanks and other latent environmental exposures.
In 2002, Selective issued $305 million aggregate principal amount of 1.6155% senior convertible notes (Convertible Notes), due September 24, 2032, at a discount of 61.988% resulting in an effective yield of 4.25%. Selective recorded gross proceeds of $116.0 million along with $3.2 million of deferred charges, which are amortized over the life of the note, in connection with debt issuance costs. Net proceeds of approximately $72.0 million were used to fund an irrevocable trust to provide for certain payment obligations in respect of Selective's outstanding debt obligations of which $24.1 million was still available as of December 31, 2004. Selective paid as a capital contribution $40.0 million to Selective's insurance operating subsidiaries.
(2) On May 4, 2000, Selective entered into a $30.0 million and a $61.5 million note purchase agreement with various private lenders covering the 8.63% and 8.87% Senior Notes, respectively.
Selective has paid $12.0 million in principal, together with accrued interest thereon for the 8.63% Senior Notes. Principal payments of $6.0 million are required annually through May 4, 2007. The principal amount of these Senior Notes, $18.0 million at December 31, 2004 and $24.0 million at December 31, 2003, accrues interest and is payable semiannually on May 4 and November 4 of each year, until the principal is paid in full.
For the 8.87% Senior Notes, Selective is required to pay $12.3 million principal amount in each year commencing on May 4, 2006 and ending on May 4, 2010, inclusive, together with accrued interest thereon. The unpaid principal amount of these Senior Notes accrues interest and is payable semiannually on May 4 and November 4 of each year, until the principal is paid in full.
(3) On August 12, 1994, Selective entered into a $54.0 million note purchase agreement with various private lenders covering the 8.77% Senior Notes. Selective has paid $36.0 million in principal, together with accrued interest thereon for the 8.77% Senior Notes. There is one remaining $18.0 million principal payment that is required on August 1, 2005. The principal amount of $18.0 million on the 8.77% Senior Notes accrues interest and is payable semiannually on February 1 and August 1 of each year, until the principal is paid in full.
Each note purchase agreement contains restrictive business covenants that are reviewed quarterly. They include, but are not limited to, a limitation on indebtedness, restricted ability to declare dividends and net worth maintenance. All of the covenants were met during 2004 and 2003. At December 31, 2004, the amount available for dividends to stockholders under said restrictions was $325.6 million for the 1994 Senior Notes and $287.9 million for the 2000 Senior Notes.
The Debentures were issued under an Indenture dated December 29, 1982, (Indenture) in the principal amount of $25.0 million, bearing interest at a rate of 8.75% per annum, which is payable on the unpaid principal semiannually on January 1 and July 1 in each year to holders of record at the close of business on the preceding December 15 and June 15, respectively. The Debentures are convertible into common stock at an effective conversion price of $7.08 per share. The principal amount of the Debentures, $1.0 million at 2004 and $1.2 million at 2003, including any accrued interest, is due on January 1, 2008 and is included in other liabilities on the consolidated balance sheets.
The Indenture requires Selective to retire, through the operation of a mandatory sinking fund, 5% of the original $25.0 million aggregate principal amount of the debentures on, or before December 31 of each of the years from 1993, to and including, 2006. Voluntary conversions have satisfied this obligation in its entirety.
Selective has revolving lines of credit with State Street Corporation, $20.0 million, and Wachovia Bank, $25.0 million, totaling $45.0 million at December 31, 2004 and December 31, 2003. At December 31, 2004 and 2003, there were no balances outstanding. Interest is determined on a LIBOR, prime rate or money market rate basis at Selective's option. The weighted average interest rates on these borrowings were 1.74% in 2004 and 1.67% in 2003.
On November 4, 2003, the Board of Directors authorized a 2.5 million share common stock repurchase program scheduled to expire on November 30, 2005. This program replaced Selective's previous common stock repurchase program that expired on May 31, 2003 and allowed Selective to repurchase up to 8.0 million shares. In 2004, Selective acquired 141,000 shares at a cost of $4.9 million. No shares were repurchased in 2003 under either plan. During 2002, 11,000 shares were purchased at a cost of $0.2 million, bringing the total number of shares repurchased under the expired plan to 7.3 million at a total cost of $140.5 million.
Shares repurchased in conjunction with restricted stock vestings and option exercises were 103,000 shares at a cost of $3.8 million in 2004, 100,000 shares at a cost of $2.5 million in 2003 and 117,000 shares at a cost of $2.8 million in 2002.
Based on the unaudited 2004 statutory financial statements, the maximum ordinary dividends that can be paid to Selective in 2005 are:
On February 2, 1999, Selective's Board of Directors approved an amended and restated stockholder rights plan. The rights to purchase one two-hundredth of a share of Selective Series A Junior Preferred Stock at an exercise price of $80 are attached to all shares of Selective common stock and are exercisable ten days after an announcement that a person or group has acquired 15% or more of the common stock (Acquiring Person) or ten business days after a person commences or announces its intent to make a tender offer which would result in their becoming an Acquiring Person. If a person or group becomes an Acquiring Person, each right will entitle the holder, other than the Acquiring Person, to purchase the number of Selective common shares having a market value of two times the exercise price of $80.
Before an Acquiring Person acquires 50% or more of the common shares, Selective's Board of Directors may exchange rights, other than the rights of an Acquiring Person, at an exchange ratio of one share of common stock per right. The rights expire February 2, 2009, unless Selective's Board of Directors redeem them at $0.01 per right before the plan is triggered, or unless Selective's Board of Directors exchanges them for common stock.
Selective has classified its operations into three segments, the disaggregated results of which are reported to and used by Selective's senior management to manage Selective:
Insurance Operations (commercial lines and personal lines), which are evaluated based on GAAP underwriting results (net premiums earned, incurred losses and loss expenses, policyholders dividends, policy acquisition costs and other underwriting expenses) and statutory combined ratios;
Investments, which are evaluated based on after-tax net investment income and net realized gains and losses; and
Selective and its subsidiaries provide services to each other in the normal course of business. These transactions totaled $28.5 million in 2004, $27.1million in 2003 and $32.1 million in 2002. These transactions were eliminated in all consolidated statements.
Stockholders' equity reflects tax benefits related to compensation expense deductions for stock options exercised of $5.9 million at December 31, 2004, $3.4 million at December 31, 2003 and $2.4 million at December 31, 2002.
In December 2001, Selective adopted a plan to divest itself of its 100% ownership interest in PDA Software Services, Inc. (PDA). During May 2002, Selective sold all of the issued and outstanding shares of PDA's capital stock and certain software applications developed by PDA for proceeds of $16.3 million, which produced a net gain of $0.5 million. This gain is included in discontinued operations on the consolidated statements of income. The tax benefit included in the loss from discontinued operations was $0.4 million for 2002. The amount of tax expense in 2002 for the gain on disposition of discontinued operations was $0.3 million. As a result of the sale, $5.0 million of capitalized software development costs were recovered. Selective has reclassified prior period amounts to present the operating results of PDA as a discontinued operation.
Selective terminated, effective December 31, 1997, a nonqualified defined benefit retirement income plan for nonemployee Directors. The estimated accrued costs for this plan were not material. As part of the termination, the present value of each Director's future benefits, as of that date, was converted into units based on the fair value of Selective common stock. The original termination called for the cash value of these units based upon the fair value of Selective common stock on retirement date to be distributed to each Director, or at each Director's election, over a period of fifteen years after such retirement. On May 8, 2002, the stockholders approved the conversion of the units issued under the termination plan into shares of Selective stock. All of the shares issued under this conversion have been deferred by the participants for receipt upon retirement, or at each Director's election, over a period of no more than five years after such retirement. These deferred shares, which are currently being held in accounts on behalf of each Director, are credited with cash dividends along with interest on those dividends. The accrued liability of these deferred shares of stock and the related dividend and interest earnings was $1.4 million at December 31, 2004 and $1.5 million at December 31, 2003 and December 31, 2002.
In both plans, employees age 50 or older who are contributing the maximum may also make additional contributions not to exceed the additional amount permitted by the IRS.
Effective July 1, 2002, Selective began offering a nonqualifed deferred compensation plan (deferred compensation plan) to a group of management or highly compensated employees (the Participants). The plan provides the Participants the opportunity to elect to defer receipt of specified portions of compensation and to have such deferred amounts treated as if invested in specified investment options as a method of rewarding and retaining such employees. A Participant in the plan may elect to defer compensation or awards to be received from Selective or an affiliated entity, including up to: (i) 50% annual base salary; (ii) 100% of incentive compensation; and/or (iii) a percentage of other compensation as otherwise designated by the Administrator of the plan.
The Company contributed $0.3 million in 2004 and 2003 to the deferred compensation plan.
Selective has a noncontributory defined benefit retirement income plan covering all employees who meet eligibility requirements. Selective's 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 Salary and Employee Benefits Committee of the Board of Directors may approve from time-to-time. Effective July 1, 2002, two new amendments to the plan were adopted. For new entrants into the plan the monthly retirement benefits beginning at normal retirement were decreased to 1.2% from 2.0% of the average monthly compensation as defined. Also, for all plan participants the early retirement age was changed to include a formula, whereby age plus years of service must sum to at least 70.
Information for Pension Plans with an Accumulated Benefit Obligation in Excess of Plan Assets as of December 31:
All amounts in the reconciliations of funded status were recognized in the consolidated balance sheets for 2004 and 2003. There were no amounts to be included in accumulated other comprehensive income for the periods shown resulting from an additional minimum pension liability. Selective's measurement date was December 31, 2004 and its expected return on plan assets was 8.25%, which was based primarily on the plan's long-term historical returns. Selective's expected return is supported by its actual 9.8% annualized 10 year return and 9.3% annualized return achieved since plan inception for all plan assets. In addition to the plan's historical returns, Selective considers long-term historical rates of return on the respective asset classes. Selective presently anticipates contributing $8.0 million to the retirement income plan in 2005 and has lowered its expected return on plan assets to 8.0% given recent market conditions and trends.
Selective has adopted the pro forma footnote disclosure-only provisions of FAS 123. See Note 2(n) for the pro forma effect on net income and earnings per share if Selective had adopted FAS 123. See Note 3, "Adoption of New Accounting Pronouncements" for further details regarding Selective's adoption of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment" (FAS 123R) on January 1, 2005. Under the pro forma footnote disclosure-only provisions of FAS 123 the fair value of each option grant is estimated on the date of grant using the Black Scholes option-pricing model with the following weighted average assumptions for 2004, 2003 and 2002:
The weighted-average fair value of options and stocks granted per share, during the year for 2004, 2003 and 2002 is as follows:
Under Selective's Stock Option Plan II, the SEBC, in its sole discretion, may grant restricted or unrestricted shares of Selective's common stock, or grant rights to receive common stock, to employees in addition to or in substitution for options and/or SARs granted. Each such grant must be expressly subject to the attainment of one or more performance-related objectives for certain executive officers, and may be subject to the attainment of one or more performance-related objectives for other employees, as determined by the SEBC and set forth in an award agreement. Each such grant also is subject to a vesting period or other terms, conditions, restrictions and limitations as determined by the SEBC at its discretion and set forth in an award agreement. Selective did not grant restricted shares under Stock Plan II in 2004 and 2003, but did grant 208,588 in 2002, and forfeited shares of 14,538 in 2004, 31,348 in 2003 and 39,415 in 2002.
Unearned stock compensation is recognized for the fair value of the restricted shares when granted and is accounted for as a reduction of stockholders' equity. This balance is amortized into compensation expense over the four year length of the restriction along with the adjustment for the increases or decreases in the fair value of Selective's common stock for share awards subject to performance-related objectives. Unearned stock compensation of $1.5 million in 2004, $4.0 million in 2003 and $7.2 million in 2002, was recorded as a reduction of stockholders' equity and the amounts amortized to compensation expense were $3.2 million in 2004, $3.6 million in 2003 and $3.8 million in 2002. This plan expired on September 1, 2002 and was replaced with Selective's Stock Option Plan III.
Under Selective's stock option plan for directors, 643,000 shares of Selective's common stock are available for issuance. Each director who is not a full-time employee of Selective participates in the plan and automatically receives a nonqualified option to purchase 3,000 shares of common stock at not less than fair value on March 1 of each year. Each option becomes exercisable one year after the option was granted and expires no more than ten years from the date the option is granted. Under this plan, Selective granted 30,000 options in 2004 and 2003, and 33,000 in 2002.
Under the terms of the agents' stock purchase plan, the number of shares of common stock available to be purchased is 640,930. This plan provides for quarterly offerings in which independent insurance agents can purchase Selective's common stock at a 10% discount with a one year restricted period during which the shares purchased cannot be sold or transferred. Selective issued shares to agents in the amount of 86,886 in 2004, 73,467 in 2003, and 69,341 in 2002, and charged to expense $0.3 million in 2004, and $0.2 million in 2003 and 2002.
In 1994, certain officers of Selective exercised stock options by signing promissory notes in payment for the stock, totaling $1.0 million. Selective's noninterest bearing promissory notes are secured by the common stock shares issued upon exercise, which are held by Selective as collateral. The promissory notes are full recourse and subject to certain employment requirements. The outstanding principal amount was $0.1 million at December 31, 2004 and $0.1 million at December 31, 2003. These outstanding balance are reflected in stockholders' equity on the Consolidated Balance Sheets in the line "unearned stock compensation and notes receivable from stock sales."
In August 1998, certain officers of Selective purchased stock on the open market with proceeds advanced by Selective. These officers gave Selective promissory notes totaling $1.8 million. The notes bear interest at 2.5% and are secured by the purchased shares of Selective's common stock. The promissory notes are full recourse and subject to certain employment requirements. The principal amount outstanding was $0.4 million at December 31, 2004 and $0.6 million at December 31, 2003. These outstanding balance are reflected in "other assets" on the Consolidated Balance Sheets.
Selective has utilized the services of Chas. E. Rue & Sons, Inc., a general insurance agency, of which William M. Rue, a director of Selective Insurance Group, Inc., is the President and owner of more than a 5% equity interest. Selective's Insurance Subsidiaries purchased insurance coverages from Chas. E. Rue & Sons, Inc. with premiums of $1.4 million in 2004, $1.3 million in 2003 and $1.1 million in 2002. As an independent agent for Selective, Chas. E. Rue & Sons, Inc. received $1.8 million in commissions for insurance policies placed with the Selective's Insurance Subsidiaries in 2004, $1.6 million in 2003 and $1.3 million in 2002. Chas. E. Rue & Sons, Inc. also received $13,000 in commissions in 2004 for business placed with Selective's human resources administration subsidiary. Additionally, Chas. E. Rue & Sons, Inc., owns 20% of PL, LLC, which is an insurance fund administrator that places reinsurance through Selective. PL, LLC received reinsurance commissions of $0.2 million in 2004, $0.1 million in 2003 and $0.4 million in 2002. Selective believes that the related party transactions with Chas. E. Rue & Sons, Inc. and PL, LLC were on terms as fair to Selective as could have been obtained from unaffiliated third parties.
(a) Selective purchases annuities from life insurance companies to fulfill obligations under claim settlements which provide for periodic future payments to claimants. As of December 31, 2004, Selective had purchased such annuities in the amount of $10.2 million for settlement of claims on a structured basis for which Selective is contingently liable. To Selective's knowledge, none of the issuers of such annuities have defaulted in their obligations thereunder.
(b) Selective has 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 $9.7 million in 2004, $9.3 million in 2003 and $8.2 million in 2002.
At December 31, 2004, the total future minimum rental commitments under noncancelable leases was $21.7 million and such yearly amounts are as follows:
(c) As of December 31, 2004, Selective has additional investment commitments for its limited partnership investments of up to $45.3 million. There is no certainty that any additional investment will be required in these limited partnerships. See Note 4(k) for additional discussion of our investments in limited partnerships.
Although the ultimate outcome of these matters is not presently determinable, Selective does not believe that the total amounts that it will ultimately have to pay in all of these lawsuits in the aggregate will have a material adverse effect on its financial condition, results of operations, or liquidity.
3. See Note 8(b) and Note 9 to the consolidated financial statements and Financial Review for a discussion of dividend restrictions.