*Adjusted for 2 for 1 stock dividend effective July 22, 1999
Ohio Casualty Corporation (the Corporation) is the holding company of The Ohio Casualty Insurance Company (the Company), which is one of six property- casualty companies that make up the Ohio Casualty Group (the Group).
Critical Accounting Policies Management of the Corporation has identified the policies listed below as significant accounting policies that are critical to the Corporation's business operations and influence the consolidated results of operations and financial performance. The policies listed below were selected as they require a higher degree of complexity or use subjective judgements or assessments. These policies follow accounting principles generally accepted in the United States. A brief summary of each critical accounting policy follows. For a complete discussion on the application of these and other accounting policies, see Footnote 1 on pages 62 through 64 of this Form 10-K.
Reserves for Losses and Loss Adjustment Expenses The Group establishes reserves for losses and loss adjustment expenses (LAE) equal to the estimated amount to settle both reported (case reserves) and unreported claims (incurred but not yet reported, "IBNR"). For reported losses, a case reserve is established within the parameters of coverage provided in the insurance policy. For IBNR losses, reserves are estimated using established actuarial methods. An estimate of the loss and LAE for each claim is developed using the facts in each case, the Group's experience with similar cases, the effects of current developments and anticipated trends. The methods and assumptions of making such estimates are continually reviewed and updated when considered appropriate. Any resulting adjustments are reflected in the consolidated statements of income for the period in which such estimates are changed. Reserves established in prior years are adjusted as loss experience develops and new information becomes available. Adjustments to previously estimated reserves, both positive and negative, are reflected in the consolidated financial statements in the periods in which they are made and are referred to as prior period development. Because of the high degree of uncertainty involved in estimating loss and LAE reserves, revisions to estimated reserves could have a material impact on the results of operations of the Group.
Investments All investment securities are classified upon acquisition as held-to-maturity or available-for-sale. Fixed maturity securities classified as held-to- maturity are carried at amortized cost because management has the ability and positive intent to hold the securities until maturity. Available-for-sale securities are those securities that would be available to be sold in the future in response to liquidity needs, changes in market interest rates and asset-liability management strategies, among others. Available-for-sale securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported as a component of comprehensive income, net of deferred tax. Transfers of fixed maturity securities into the held-to maturity category from the available-for-sale category are made at fair value at the date of transfer. The unrealized holding gain or loss at the date of transfer is retained in other comprehensive income and in the carrying value of the held-to-maturity securities. Such amounts are amortized over the remaining life of the security. Equity securities are carried at quoted market values
Mortgage-backed securities are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations. Upon receipt of payments from such securities, the Corporation and the Group determine the appropriate amount of the funds to be allocated as a reduction of principal and interest income. In making this allocation decision, investment personnel consider such factors as the original estimated average life of the investment, the amount of funds received to date and the timing of future cash flows. Variations from prepayment assumptions will affect the life and yield of these securities. These securities are evaluated for impairment by computing the net-present- value of expected future cash flows and comparing this to the prior period estimate of expected future cash flows from the security. When the timing and/or amount of cash expected to be received from the security has changed materially and adversely from the previous valuation, the security is considered to be other than temporarily impaired and the amortized cost is written down to the estimated fair value with a realized loss recorded in the consolidated statement of income.
Item 7. Continued carrying amount of the asset, an impairment loss is recognized in income in the period in which the future cash flows are identified to be insufficient in comparison to the carrying amount of the asset. The Corporation and the Group anticipate that based on future events or circumstances additional write-downs for impairment will be made in future periods.
Internally Developed Software In accordance with SOP 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" the Group capitalizes costs incurred during the application development stage for the development of internal-use software. These costs primarily relate to payroll and payroll-related costs for employees along with costs incurred for external consultants who are directly associated with the internal-use software project. Costs such as maintenance, training, data conversion, overhead and general and administrative are expensed as incurred. Management believes the expected future cash flows of the asset exceed the carrying value. The expected future cash flows are determined using various assumptions and estimates. Changes in these assumptions could result in an immediate impairment to the asset and a corresponding charge to net income. The costs associated with the software are amortized on a straight-line basis over the estimated useful life of ten years commencing when the software is substantially complete and ready for its intended use.
Although full year premiums are below last year's levels, the Group's risk profile has improved. The decline in net premiums written for the full year reflects Personal Lines withdrawal from selected markets, stricter underwriting guidelines for Commercial Lines, including the non-renewal of certain construction-defect related risks, stricter underwriting of workers' compensation risks in several states and higher reinsurance costs, primarily for the commercial umbrella product line.
The key financial indicators management utilizes consist of statutory combined ratios and component ratios on both a calendar year and accident year basis, gross and net written premium growth, impact of catastrophes, renewal price increases and investment income growth.
The improved financial results for 2003 are the result of expense reductions and an improved loss ratio. Decreases in personnel and sales related expenses led to the improved results for 2003 compared with 2002. Staff reductions of 11.2% in 2003 compared to 2002 were the result of the claim department reorganization and the Lexington and Indianapolis underwriting offices being consolidated into other locations. Additional savings are anticipated to occur in 2004 as additional workflow re-engineering will occur in the first half of 2004. The loss ratio improvement in 2003 is due to tighter underwriting standards and an improved risk profile. In addition, development on prior accident years' losses and LAE decreased $50.3 million before tax from 2002 to $34.1 million before tax in 2003. During 2002, the increase in provision for prior accident years' losses and LAE totaled $84.4 million before tax and was concentrated in the general liability, commercial auto and personal auto product lines. These improved results were offset by increased catastrophe losses during 2003. The catastrophe losses before tax more than doubled to $43.8 million in 2003 from $20.8 million in 2002 resulting from storms that swept through the midwest and the effects of Hurricane Isabel.
In 2002, results were negatively impacted by the losses and LAE for prior accident years as described above. The majority of the charge, $62.2 million before tax, occurred in the third quarter and was primarily related to construction defect claims for residential developers and contractors. The Group continues to address this specific type of business for non-renewal. For further discussion, refer to the "Loss and Loss Adjustment Expenses" section under "Liquidity and Financial Strength."
During 2001, loss and LAE reserves for prior accident years were strengthened by $29.6 million before tax for the workers' compensation product line and $17.6 million before tax for asbestos related claims development in other product lines. Also in 2001, the Corporation adopted an early retirement plan that impacted 147 employees and resulted in a one-time after-tax charge of $4.0 million.
Investment Results Consolidated before-tax net investment income was $208.7 million in 2003, compared with $207.1 million in 2002 and $212.4 million in 2001. The 2003 increase in consolidated before-tax net investment income of $1.6 million is attributable to an increase in investment assets held, partially offset by increased investment expenses attributable to the implementation of a new investment accounting system, lower average yields on its fixed income portfolio, and increased investment management fees from expanded use of outside investment managers. As part of a conversion to a new investment accounting system in 2003, $5.9 million before tax expense was recorded for a change in accounting estimate relating to amortization of interest only mortgage-backed securities and asset-backed securities. Offsetting most of this charge was a $5.3 million credit for interest received on a federal income tax settlement.
The decrease in investment income of $5.3 million before tax in 2002 was attributable to the significant decline in reinvestment rates on fixed maturity investments. This decline in rates in 2002 was partially offset by increased investment in fixed maturities following the reallocation of the equity portfolio in 2002 and 2001. The reallocation in the investment portfolio reduced holdings of equity securities and increased holdings of investment grade fixed maturity securities. After-tax investment income totaled $138.4 million in 2003 compared with $136.9 million in 2002 and $141.3 million in 2001.
During 2003 and 2002, there were no significant realized losses on sales of securities. In 2001, a loss of approximately $6.8 million before tax was realized on the sale of fixed maturity securities issued by Enron Corporation. These securities had been purchased in prior periods and were sold both prior and subsequent to Enron Corporation's filing for bankruptcy in December 2001. Prior to 2001, these securities were not in an unrealized loss position.
In the first quarter of 2003, management decided to transfer a portion of its fixed maturity securities from the available-for-sale classification into the held-to-maturity classification. This transfer was made as the Corporation and the Group have both the ability to hold the securities to maturity and the positive intent to do so. At December 31, 2003, the amortized cost of the held-to-maturity portfolio was $356.1 million.
As part of the evaluation of the entire $21.2 million aggregate unrealized loss on the investment portfolio, management performed a more intensive review of securities with a relatively higher degree of unrealized loss. Based on a review of each security, management believes that unrealized losses on these securities were temporary declines in value at December 31, 2003. In the table above, there are approximately 190 securities represented. Of this total, 31 securities have unrealized loss positions greater than 5% of their market values at December 31, 2003 with none exceeding 20%. This group represents $10.0 million, or 47% of the total unrealized loss position. Of this group, 22 securities representing approximately $7.1 million in unrealized losses have been in an unrealized loss position for less than twelve months. Of the remaining nine securities in an unrealized loss position for longer than twelve months totaling $2.9 million, management believes that they will recover the cost basis of these securities, and have both the intent and ability to hold the securities until they mature or recover in value. All securities are monitored by portfolio managers who consider many factors such as an issuer's degree of financial flexibility, management competence and industry fundamentals in evaluating whether the decline in fair value is temporary. In addition, management considers whether it is probable that all contract terms of the security will be satisfied and whether the unrealized loss position is due to changes in the interest rate environment. Should management
The amortized cost and estimated fair value of available-for-sale and held- to-maturity fixed maturity securities in an unrealized loss position at December 31, 2003, by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Internally Developed Software In 2001, the Group introduced into limited production an internally developed software application for issuing and maintaining insurance policies named P.A.R.I.S.sm, a policy administration, rating and issuance system. During 2003, the Group began capitalizing application development costs associated with the Personal Lines segment, which are expected to begin roll out in 2005 and continued capitalization for the Specialty Lines segment which are expected to be rolled out beginning in 2005. During 2002, the Group substantially completed the rollout for the Commercial Lines operating segment. A rollout begins when the application has been placed into service for one or more states for an individual major product line and ends when the application is placed into service
Statutory Results Management uses statutory financial criteria to analyze the Group's property and casualty results and insurance industry regulators require the Group to report statutory financial measures. Management analyzes statutory results through the use of insurance industry financial measures including statutory loss and LAE ratios, statutory underwriting expense ratio, statutory combined ratio, net premiums written and net premiums earned. The statutory combined ratio is a commonly used gauge of underwriting performance measuring the percentages of premium dollars used to pay insurance losses and related expenses. The combined ratio is the sum of the loss ratio, the loss adjustment expense ratio and the underwriting expense ratio. All references to combined ratio or its components in the MD&A are calculated on a statutory accounting basis and are calculated on a calendar year basis unless specified as calculated on an accident year basis. A discussion of the differences between statutory accounting and generally accepted accounting principles in the United States is included in Footnote 15 on pages 73 and 74 of this Form 10-K.
Insurance industry financial measures are included in the next several sections of this MD&A that discuss results of operations. Statutory surplus, a financial measure that is required by insurance regulators and used to monitor financial strength, is discussed in the "Statutory Surplus" section of the "Liquidity and Financial Strength" portion of this MD&A.
New Jersey is the Group's largest state with 11.1% of the total net premiums written during 2003. In recent years, New Jersey's legislative and regulatory environments for private passenger automobile insurance have become less favorable to the insurance industry. The state requires insurance companies to accept all risks that meet underwriting guidelines for private passenger automobile while rigidly controlling the rates charged. In the fourth quarter of 2001, OCNJ entered into an agreement to transfer its New Jersey private passenger auto renewal obligations to Proformance. This transaction allowed the Group to stop writing business in the New Jersey private passenger auto and personal umbrella markets in early 2002.
The All Lines combined ratio improved 2.5 points in 2002 compared to 2001 due primarily to improvement in the Personal Lines and Commercial Lines loss and LAE ratio. The positive improvements resulted from tighter underwriting standards, lower catastrophe losses and large losses offset by increases in loss and LAE reserves due to adverse prior years development, primarily related to construction defect losses.
The loss and LAE ratios were impacted negatively in 2003, 2002 and 2001 by adjustments to estimated losses related to prior years' business. The loss and LAE ratio components of the accident year combined ratio measures losses and LAE arising from insured events that occurred in the respective accident year. The current accident year excludes losses and LAE for insured events that occurred in prior accident years.
In 2003, the All Lines accident year combined ratio was 103.7%, which is 2.4 points better than the All Lines calendar year combined ratio of 106.1%. The All Lines combined ratio for accident years 2002 and 2001, measured as of December 31, 2003, were 104.2% and 110.9%, respectively.
The comparable amount of provision for prior years' losses and LAE recognized during the year 2002 was $84.4 million before tax representing 4.3% of loss and LAE reserves as of year-end 2001. This was concentrated in the commercial auto and general liability product lines of the Commercial Lines operating segment.
Catastrophe losses in 2003 totaled $43.8 million, compared with $20.8 million in 2002 and $34.6 million in 2001. The Group was impacted by 21 separate catastrophes in 2003, compared with 25 catastrophes in 2002 and 19 in 2001. Catastrophe losses added 3.1 points to the combined ratio in 2003, compared with 1.4 points in 2002 and 2.3 points in 2001. The effects of catastrophes on the Corporation's results cannot be accurately predicted. As such, severe weather patterns, acts of war or terrorist activities could have a material adverse impact on the Corporation's results, reinsurance pricing and availability of reinsurance.
The underwriting expense ratio for the year 2002 decreased compared to 2001 due primarily to the 2001 impact of 2.7 points related to the $40.6 million New Jersey transfer fee. The year 2002 underwriting expense ratio experienced upward pressure due to two factors with a total impact of approximately 1.6 points. These two factors were the non-renewal of the New Jersey private passenger auto business, which had lower commission rates and lower variable processing costs than most other business and the elimination of ceding commissions received in previous years on umbrella premiums ceded to reinsurers. The 2002 commission expense ratio, a component of the underwriting expense ratio, was at a relatively high level due to higher than expected umbrella net premiums written, which had a relatively high commission rate on a net of reinsurance basis and to higher than expected accruals for agent bonus commissions.
The 2003, 2002 and 2001 statutory underwriting expenses also included $5.2 million, $2.6 million and $.5 million of software amortization expense before tax, respectively, related to the rollout of P.A.R.I.S.sm, a new internally developed software application. On a statutory accounting basis, the new application is being amortized over a five-year period (compared to ten-year period under GAAP) in accordance with statutory accounting principles. During 2002, the Group substantially completed the rollout of the new application for the Commercial Lines segment. During 2003, the Group began capitalizing application development costs associated with the Personal Lines segment which are expected to begin rollout in 2005. The Specialty Lines segment is on target for rollout in the beginning of 2005. Upon full implementation, the impact on statutory expenses is expected to be approximately $8.0 million to $12.0 million in annual amortization expense before tax through 2010. The additional cost is expected to be offset in part by reduced labor costs related to underwriting and policy processing.
Segment Discussion In June of 2001, the Corporation introduced an organizational structure around three business units: Commercial Lines, Specialty Lines, and Personal Lines. These business units represent the Corporation's operating segments as well as its reportable segments. Within each operating segment are distinct insurance product lines that generate revenues by selling a variety of personal, commercial, and surety insurance products. The Commercial Lines operating segment sells commercial multiple peril, commercial auto, general liability and workers' compensation insurance as its primary products. The Specialty Lines operating segment sells commercial umbrella, excess
(1)When used in this report, renewal price increase means the average increase in premium for policies renewed by the Group. The average increase in premiums for each renewed policy is calculated by comparing the total expiring premium for the policy with the total renewal premium for the same policy. Renewal price increases include, among other things, the effects of rate increases and changes in the underlying insured exposures of the policy. Only policies issued by the Group in the previous policy term with the same policy identification codes are included. Therefore, renewal price increases do not include changes in premiums for newly issued policies and business assumed through reinsurance agreements, including Great American business not yet issued in the Group's systems. Renewal price increases also do not reflect the cost of any reinsurance purchased on the policies issued.
The workers' compensation product line combined ratio decreased 6.2 points in 2003 to 123.0%, despite 7.1 points of adverse prior years loss and LAE reserve development, 3.8 points of which was due to increased reserves on two lifetime workers' compensation claims. Although this line continues to experience adverse development on prior accident years', the combined ratio has decreased for the third year in a row. In 2002, the combined ratio decreased 9.4 points to 129.2%, compared to 138.6% in 2001. The loss ratio was the main component driving the high combined ratios in all three years. The 2003 workers' compensation loss ratio was 78.3% compared to 80.6% in 2002 and 95.8% in 2001. Adverse development of prior year losses due to an increase in claims severity contributed to the poor results for all three years. The 2003 accident year loss ratio of 69.0% was 9.3 points lower than the 2003 calendar year loss ratio. The 2002 and 2001 accident year loss ratios were 72.5% and 73.3%, respectively, which were 8.1 points and 22.5 points lower than the respective calendar year loss ratios.
Although the Group has taken actions to improve workers' compensation results, including a more conservative underwriting appetite in states where there is rate inadequacy despite the attainment of double-digit renewal increases for the year, the product line continues to be negatively impacted by assessments for the National Workers' Compensation residual market pool. The impact of the National Workers' Compensation residual market pool added 4.5 points to the workers' compensation combined ratio in 2003, compared to 1.5 points in 2002 and decreased the ratio 1.9 points in 2001.
The Group continued to achieve average renewal price increases for workers' compensation of 14.7% for 2003, compared with increases of 20.1% and 16.6% for 2002 and 2001, respectively. Net premiums written for 2003, 2002 and 2001 totaled $132.4 million, $143.9 million, and $148.6 million, respectively. The continued decrease in net premiums written for workers' compensation is the result of the Group's initiative to responsibly price and underwrite this product line in order to make the line more profitable.
The 2003 commercial auto combined ratio improved 4.7 points to 105.5% compared to 110.2% in 2002. This improvement is largely due to improved underwriting, the effect of renewal price increases and less adverse loss and LAE reserve development from prior years. The 2002 commercial auto combined ratio increased to 110.2%, from 107.6% in 2001. The increase in the combined ratio from 2001 is due to greater than expected average settlement amounts (loss severity) from prior years. The accident year combined ratios for this line were 104.6% in 2003, 99.0% in 2002 and 105.2% in 2001. The increase in the accident year combined ratio from 2002 is due to an increase in the number of large losses as measured by higher average paid losses and case reserves.
Net premiums written for the commercial multiple peril, fire and inland marine product lines increased 8.7% to $348.4 million in 2003. These product lines also experienced an increase in 2002 of 16.4% to $320.4 million, compared with $275.2 million in 2001. The combined ratio increased in 2003 to 109.7% as a result of higher than expected catastrophe losses, large property losses and adverse
prior years loss development. Catastrophe losses added 6.3 points to the combined ratio in 2003, compared to 1.5 and 2.9 points in 2002 and 2001, respectively. Large property losses were $22.5 million in 2003, which added 6.7 points to the combined ratio compared with $16.2 million in 2002, adding 5.4 points to the 2002 combined ratio. Adverse development in 2003 added 7.1 points to the 2003 combined ratio compared to .6 points in 2002. In 2002, the combined ratio decreased to 95.8% from 106.4% in 2001. The improvement from 2001 to 2002 resulted from strong new and renewal pricing and more selective and focused underwriting.
(a) The loss and LAE ratio component of the accident year combined ratio measures losses and LAE arising from insured events that occurred in the respective accident year. The current accident year excludes losses and LAE for insured events that occurred in prior accident years. Accident year 2003 as of December 31, 2003 measures insured events for the twelve months of 2003. Accident year 2002 as of December 31, 2003 measures insured events for the twelve months of 2002 with remaining related liabilities estimated as of December 31, 2003. Accident year 2001 as of December 31, 2003 measures insured events for the twelve months of 2001 with remaining related liabilities estimated as of December 31, 2003. Accident periods may not be comparable due to seasonality, claim reporting and development patterns, claim settlement rates and other factors. (b) The Group exited the New Jersey private passenger automobile market in March 2002 which was completed in March 2003. The combined ratio in 2003 for New Jersey personal auto is larger than normal due to prior year loss development in relation to significantly reduced premium levels from this business.
Specialty Lines Segment Specialty Lines combined ratio for 2003 improved 16.8 points to 77.2% compared to 94.0% and 90.8% for 2002 and 2001, respectively. The improvement in the 2003 combined ratio is due primarily to overall favorable development on prior accident year loss and LAE reserves of $21.3 million compared to favorable development in 2002 of $2.2 million and adverse development of $4.1 million in 2001.
The fidelity and surety product lines in the Specialty Lines segment contributed to the favorable results for this segment. Fidelity and surety net premiums written decreased slightly to $43.9 million, compared to $45.6 million and $38.7 million in 2002 and 2001, respectively. Despite lower net premiums written in 2003, the combined ratio improved to 68.1% in 2003, compared with 81.7% in 2002 and 76.8% in 2001. The improvement in the 2003 fidelity and surety combined ratio was the result of favorable development on prior accident year loss and LAE reserves of $5.5 million and overall lower losses for this product line. During the fourth quarter of 2002, there was a return of ceded premium of $5.3 million before tax for the fidelity and surety business in the Specialty Lines operating segment. This return of ceded premium was due to the exercise of a contractual option on the bond reinsurance treaty based on highly favorable bond combined ratios over the past fourteen years.
Net premiums written for the commercial umbrella product line decreased $11.8 million, or 8.9% in 2003 to $120.9 million, compared with $132.7 million in 2002 and $92.2 million in 2001. Higher reinsurance costs in 2003, driven by the addition of a ceding commission and by increased reinsurance rates per dollar of premium, had a negative impact on net premiums written. The addition of ceding commissions on the current reinsurance contract causes a corresponding increase to ceded premiums. Average renewal price increases were 18.1%, compared to 37.6% in 2002 and 20.3% in 2001. The 2003 combined ratio was 80.5% compared to 97.7% and 93.6% in 2002 and 2001, respectively. The improved combined ratio in 2003 was largely attributable to favorable development on prior accident year loss and LAE reserves due largely to a reduction in estimated future costs for commercial umbrella claims adjuster related expenses that favorably impacted the Specialty Lines combined ratio by 6.8 points.
Net premiums written for private passenger auto decreased in 2003 by $28.6 million to $292.7 million compared to $321.3 million in 2002 and $451.2 million in 2001. This product line has decreased, as expected, due to the Group's strategy to withdraw from certain states. Agency cancellations also contributed to the decline in premiums in 2003, 2002 and 2001. The combined ratio for private
passenger auto improved during 2003 by 8.6 points to 107.7% compared to 116.3% in 2002 and 118.9% in 2001. The Group is implementing price increases and claims management procedures to further improve results.
Homeowners product line net premiums written increased 2.3% in 2003 to $157.2 million compared to $153.7 million in 2002 and $162.0 million in 2001. The Group has placed emphasis on price increases, coverage restrictions, insurance scoring and agency management. Average implemented rate increases were 22.0%, 10.1% and 2.8% in 2003, 2002 and 2001, respectively.
Total cash generated in financing activities was $1.6 million in 2003, compared to cash used of $4.6 million and $10.5 million in 2002 and 2001, respectively. Cash generated by financing in 2003 resulted from the exercise of stock options partially offset by principal payments on the low interest rate loan from the State of Ohio. This compares to cash used for financing activities in 2002, which included the repayment of the Corporation's $205.0 million credit facility and issuance of new convertible debt with net proceeds of $194.0 million.
Overall, total cash used in 2003 was $5.3 million, compared to $30.1 million in 2002 and cash generated of $2.3 million in 2001. To further strengthen its financial position, the Corporation did not pay any shareholder dividends for the years presented. On a regular basis management analyzes the profitability and capital position of the Group and the liquidity of the Corporation, including the Corporation's evaluation of whether to reinstitute a dividend to shareholders of the Corporation or a share repurchase program.
*Excluded from long-term debt obligations are the convertible notes with outstanding principal of $201.3 million which is due on March 19, 2022 and semi-annual interest payments of $5.0 million. The notes may be converted into common stock under certain conditions described in Footnote 16 on pages 74 and 75 of this Form 10-K and disclosed separately below.
Debt As of December 31, 2003, the Corporation had $205.2 million of principal outstanding on debt that includes a $3.9 million low interest loan with the state of Ohio. During the year 2002, the Corporation completed an offering of 5.00% convertible notes, in an aggregate principal amount of $201.3 million, due March 19, 2022 and generated net proceeds of $194.0 million. The issuance related costs are being amortized over the life of the notes and are being recorded as related fees. The liability for debt is reported on the balance sheet net of the unamortized fees. The Corporation uses the effective interest rate method to record the interest and related fee amortization. Interest is payable on March 19 and September 19 of each year. The notes may be converted into shares of the Corporation's common stock under certain conditions, including: if the price per share of the Corporation's common stock reaches specific thresholds; if the credit rating of the notes is below a specified level or withdrawn, or if the notes have no credit rating during any period; or if specified corporate transactions have occurred. The conversion rate is 44.2112 shares per each $1,000 principal amount of notes, subject to adjustment in certain circumstances. If all outstanding notes are converted, the total outstanding common shares would increase by 8.9 million shares. The convertible debt impact on earnings per share is based on the "if-converted" method. The impact on diluted earnings per share is contingent on whether or not certain criteria have been met for conversion. As of December 31, 2003, the common share price criterion had not been met and, therefore, no adjustment to the number of diluted shares on the earnings per share calculation was made for the convertible debt. On or after
During the twelve Redemption months commencing Price - ----------------- ---------- March 23, 2005 102% March 19, 2006 101% March 19, 2007 until maturity of the notes 100%
Additionally, on July 31, 2002, the Corporation entered into a revolving credit agreement. Under the terms of the credit agreement, the lenders agreed to make loans to the Corporation in an aggregate amount up to $80.0 million for general corporate purposes. The agreement requires the Corporation to maintain minimum net worth of $800.0 million. The credit agreement also includes a minimum statutory surplus requirement for The Ohio Casualty Insurance Company of $650.0 million. Additionally, other covenants and customary provisions are included in the agreement. The Corporation has not been in violation of the covenants contained in the agreement and does not foresee any difficulties in meeting the covenant requirements in the near future. The Corporation has not drawn on the revolver as of December 31, 2003. The credit agreement expires on March 15, 2005 and the Corporation plans to either renew or replace the revolving credit facility. Prior to the expiration of the current revolver, the Corporation will determine if the principal amount of the facility should be adjusted.
Pension and Other Postretirement Benefits The Company sponsors a defined benefit pension plan and other postretirement benefit plans that cover substantially all employees. Several statistical and other factors, which attempt to anticipate future events, are used in calculating the expense and liability related to the plans. Key factors include assumptions about the expected rates of return on plan assets, discount rates, rate of compensation increases and health care cost trend rates, as determined by the Company, within certain guidelines. The Company considers market conditions, including changes in investment returns, interest rates and inflation in making these assumptions.
The Company determines the expected long-term rate of return on plan assets based on the geometric method, which represents the average compound return of the plan assets. Plan assets are comprised primarily of investments in mutual funds, common stocks, corporate bonds, U.S. government securities, real estate investment trusts and other investments. The Company considers the current level of expected returns on risk free investments, primarily government bonds, the historical level of the risk premium associated with the other asset classes and the expectations for future returns of each asset class when developing the expected long-term rate of return on assets assumption. The expected return for each asset class is weighted based on the target asset allocation to develop the expected long-term rate of return on assets assumption for the portfolio. This resulted in the selection of the 8.75% assumption for 2003. The expected rate of return on plan assets is a long-term assumption and generally does not change annually. The discount rate reflects the market rate for high-quality fixed income debt instruments on the plan's annual measurement date
The Company expects to contribute approximately $7.6 million to fund the pension plan during 2004. The source for the funding will be cash flow from operating activities.
Key assumptions used in determining the amount of the obligation and expense recorded for postretirement benefits other than pensions (OPEB), under FASB Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", include the assumed discount rate and the assumed rate of increases in future health care costs. The discount rate used to determine the obligation for these benefits has matched the discount rate used in determining our pension obligations in each year presented. In estimating the health care cost trend rate, the Company considers its actual health care cost experience, future benefit structures, industry trends and advice from its third-party actuaries. The Company assumes that the relative increase in health care costs will generally trend downward over the next several years, reflecting assumed increases in efficiency in the health care system and industry-wide cost containment initiatives. At December 31, 2003, the expected rate of increase in future health care costs was 10 percent for 2004, declining to 5 percent in 2013 and thereafter. Increasing the assumed health care cost trend by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 2003 by approximately $18.9 million and increase the postretirement benefit cost for 2003 by $1.7 million. Likewise, decreasing the assumed health care cost trend by one percentage point in each year would decrease the accumulated postretirement benefit obligation as of December 31, 2003 by approximately $16.4 million and decrease the postretirement benefit cost for 2003 by $1.5 million.
In January 2004, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) FAS 106-1, regarding the accounting for the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (MMA). The FSP allows companies an opportunity to either assess the effect of MMA on their retirement-related benefit costs and obligations or to defer accounting for the effects of MMA until authoritative guidance is issued. The Corporation has elected to defer accounting for the effects of MMA, in accordance with the FSP. The Corporation does not expect the adoption of the FSP to have a material impact on the financial statements.
For more information on the Company's pension and other postretirement benefit plans, please refer to Footnote 5 on pages 67 through 69 of this Form 10-K.
Rating Agencies Regularly the Group's financial strength is reviewed by independent rating agencies. These agencies may upgrade, downgrade, or affirm their previous ratings of the Group. These agencies may also place an outlook on the Group's rating.
On March 14, 2002, Fitch, Inc. (Fitch) assigned its "BBB-" rating to the Corporation's convertible notes and placed a stable outlook on its rating. On November 5, 2002, Fitch affirmed its "BBB-" rating on the Corporation's convertible notes and placed a stable outlook on its rating. On January 21, 2004, Fitch assigned a financial strength rating of "A-" to the Group and also affirmed its "BBB-" senior debt and long term issuer ratings.
The Group's actuaries conduct a reserve study using generally accepted actuarial methods each quarter from which point estimates of ultimate losses and LAE by product line or coverage within product line are selected. In selecting the point estimates, thousands of data points are reviewed and the judgment of the actuaries is applied broadly. Each quarter management records its best estimate of the liability for loss and LAE reserves by considering the actuaries' point estimates. Management's best estimate recognizes that there is uncertainty underlying the actuarial point estimates. Reasonable range estimates around the point estimates are used by management to validate its best estimate of the liability.
There are several key assumptions supporting the point estimate including those summarized below. The fundamental assumption is that actuarial reserving methods, using historical loss experience organized by line of business, or coverage within line, and accident year at successive evaluation points, applied by experienced reserving actuaries, produces reasonable estimates of future loss development on prior insured events. Supporting assumptions internal to company operations are as follows: recording of premium and loss statistics in the appropriate detail has been accurate and consistent; claims handling, including the recording of claims, payment and closure rates, and case reserving has been consistent; the quality of business written and the mix of business (e.g. states, limits, coverages, and deductibles) have been consistent; rate changes and changes in policy provisions have been measured accurately; reinsurance coverage has been consistent and reinsured losses are collectible. To the extent any of the above factors have changed over time, attempts must be made to quantify and adjust for the changes. Supporting assumptions related to the external environment are as follows: tort law and the legal environment have been consistent; coverage interpretation by the courts has been consistent; regulations regarding coverage provisions have been consistent; and loss inflation has been relatively steady. To the extent any of the above factors have changed over time, attempts must be made to quantify and adjust for the changes. The more the inconsistency, the greater the uncertainty of the loss reserve estimates.
The Group has three categories of loss and LAE reserves that it considers highly uncertain, and therefore, could have a material impact on future financial results and financial position: asbestos and environmental liability exposures, construction defect exposures, and excess capacity liability exposures. These categories are described below with relevant historical data.
years. The Group has limited exposures to the national priority list, a list of known or threatened releases of hazardous substances, pollutants, or contaminants throughout the United States. In 2003, the Group increased losses and LAE by $16.0 million for environmental claims from prior accident years. In 2002, the Group re-classified approximately $5.0 million of homeowners reserves related to underground storage tanks as environmental reserves. For 2003, 2002 and 2001, respectively, the asbestos and environmental reserves, excluding the impact of reinsurance, were $78.0 million, $64.3 million and $53.5 million. Asbestos reserves were $37.6 million, $35.9 million and $31.8 million and environmental reserves were $40.4 million, $28.4 million and $21.7 million for those respective years.
The Group writes excess capacity liability business with large policy limits that are heavily reinsured. There have been very few losses to date on this business, but the large policy limits increase the uncertainty of future losses before the application of reinsurance. There is a relatively small amount of loss data available for this business. The Group's coverage for approximately 80% of this business written during 2003 begins when losses or LAE on an individual claim reach $10.0 million or more. The Group's limit of coverage on an individual claim for approximately two-thirds of this business written during 2003 is $25.0 million. For losses occurring in 2003, reinsurance purchased by the Group limits its retention of losses to $1.0 million and 3.5% of $4.0 million excess of $1.0 million. During 2003, the Group wrote approximately 1,900 of these excess capacity liability policies, representing an annual growth of approximately 15% since 2001.
Results for the year 2003 were negatively impacted by losses and LAE reserves for prior accident years totaling $34.1 million before tax on an All Lines basis. Losses and LAE reserves for prior accident years were recognized during the year 2003 due to new information that caused a revision to prior estimates for loss and LAE reserves as described above. The following table provides the before-tax expense of prior accident year loss and LAE reserve development by reportable segment:
For the Commercial Lines operating segment, the losses and LAE for prior accident years recorded during 2003 were concentrated in the commercial multi-peril, workers' compensation and general liability product lines. In 2002, the development was concentrated in the general liability, commercial automobile and worker's compensation product lines. In 2001, the development was concentrated in the workers' compensation and general liability product lines.
For the Specialty Lines operating segment, the losses and LAE for prior accident years recorded during 2003 was concentrated in the commercial umbrella product line. Roughly half of this amount, or $11.1 million, was a reduction in estimated future costs for commercial umbrella claims adjuster related expenses. In 2002 and 2001, the development was concentrated in the commercial umbrella product line.
The reserve study in third quarter 2002 revealed that average severity (loss per claim) and the amount of legal expense for certain types of construction defect claims were much greater than previously seen or anticipated. The study also indicated that more of these severe claims had been reported and were expected to be reported in the future than previously anticipated, despite a decrease in frequency of other types of general liability claims. It was concluded that these construction defect claims impacted the general liability, commercial multiple peril and commercial umbrella product lines. As a result of this third quarter 2002 review, the estimate of ultimate loss and LAE for this exposure was increased. For these three product lines combined, the impact of construction defect in 2002 was $62.2 million before tax. The loss estimates for these claims are based on currently available information. However, given the expansion of coverage and liability by the courts and legislatures, there is substantial uncertainty as to the ultimate liability.
The following table provides prior year development for loss and LAE by accident year:
The amount of loss and LAE reserves by accident year at the beginning of 2003 was $621.2 million for accident year 2002, $394.2 million for accident year 2001 and $1,063.3 million for accident year 2000 and prior.
Investments in below investment grade securities have greater risks than investments in investment grade securities. The risk of default by borrowers that issue below investment grade securities is significantly greater because these borrowers are often highly leveraged and more sensitive to adverse economic conditions, including a recession or a sharp increase in interest rates. Additionally, investments in below investment grade securities are generally unsecured and subordinate to other debt. Investment grade securities are also subject to significant risks, including additional leveraging, changes in control of the issuer or worse than previously expected operating results. In most instances, investors are unprotected with respect to these risks, the negative effects of which can be substantial.
At December 31, 2003, the Group's equity portfolio was $329.0 million, or 8.8% of the total investment portfolio. Equity investments have decreased, as a percentage of market value of the consolidated portfolio, from 14.7% at year-end 2001 to 8.8% at year-end 2003. This decrease is primarily attributable to the Corporation's and the Group's 2002 and 2001 actions which reduced assets invested in equities. Equity securities are marked to fair value on the balance sheet. As a result, shareholders' equity and statutory surplus fluctuate with changes in the value of the equity portfolio. As of December 31, 2003, the equity portfolio consisted of stocks in 44 separate entities in 35 different industries. As of December 31, 2003, 32.3% of the Group's equity portfolio was invested in five companies and the largest single position was 8.1% of the equity portfolio.
FORWARD-LOOKING STATEMENTS Ohio Casualty Corporation publishes forward-looking statements relating to such matters as anticipated financial performance, business prospects and plans, regulatory developments and similar matters. The statements contained in this MD&A that are not historical information, are forward-looking statements. The Private Securities Litigation Reform Act of 1995 provides a safe harbor under the Securities Act of 1933 and the Securities Exchange Act of 1934 for forward-looking statements. The operations, performance and development of the Corporation's business are subject to risks and uncertainties, which may cause actual results to differ materially from those contained in or supported by the forward-looking statements in this release. The risks and uncertainties that may affect the operations, performance, development and results of the Corporation's business include the following: changes in property and casualty reserves; catastrophe losses; premium and investment growth; product pricing environment; availability of credit; changes in government regulation; performance of financial markets; fluctuations in interest rates; availability and pricing of reinsurance; litigation and administrative proceedings; rating agency actions; acts of war and terrorist activities; ability to appoint and/or retain agents; ability to achieve targeted expense savings; ability to achieve premium targets and profitability goals; and general economic and market conditions.