This selected consolidated financial data comes from our Consolidated Financial Statements. It should be read in conjunction with the Consolidated Financial Statements and accompanying notes.
Information contained in this report that relates to anticipated financial performance, business prospects and plans, regulatory developments and similar matters are “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995. Statements in this report that are not historical information are forward-looking. Our business is subject to certain risks and uncertainties that may cause actual results to differ materially from those suggested by the forward-looking statements in this report. The risks and uncertainties include, but are not limited to:
• Successful implementation of a new-business entry model for personal and commercial lines
• Ability to establish pricing for any changes in driving patterns
• The availability and pricing of our reinsurance, including coverage for loss from terrorism and our ability to collect from our reinsurers
• The ability to price for or exclude the risk of loss from terrorism on our policies
• Our ability to achieve premium targets and profitability, including realization of growth and business retention estimates
• Our ability to successfully obtain regulatory approval of rates and underwriting guidelines, including price-tiered products and the use of insurance scores that include credit information as a component
• The competitive pricing environment, initiatives by competitors and changes in the competition
• Weather conditions, including the severity and frequency of storms, hurricanes, hail, snowfall and winter conditions
• The occurrence of significant man-made disasters, such as the terrorist attacks on September 11, 2001, or war
• Damage to our infrastructure resulting in a disruption of our operations
We are an insurance and investment company with headquarters in Seattle, Washington. We sell insurance and investment products through a national network of independent agents, brokers and financial advisors. Our business helps people protect what they value and deal with the unexpected. We started our business in 1923. We earn revenue from:
• Life & Investments (L&I) - provides individual life and group medical insurance, retirement services, annuities, mutual funds and investment advisory services.
Continuing to Invest in Our Employees - We implemented a total performance-management system that encompasses goal setting, employee development, and compensation tied to individual and team performance. We also completed work and began implementation of our diversity strategy, tied to our workforce, distributors, suppliers and customer base.
Executing a Successful Recovery Plan - We refocused on our core strengths in personal auto, small- to medium-sized commercial insurance, and life insurance and asset management. Our recovery plan focused on pricing each of our insurance products to achieve an appropriate profit level. We increased rates across all lines of our business. We began reunderwriting across all lines of business. In addition, we terminated relationships with underperforming agents who were writing unprofitable business with us. We also exited lines of business that were not core to our strategy and expertise.
Investing in our Employees - We introduced a new performance-based compensation system, linking employee pay directly to achievement of specific goals that support our business plans. In addition, we started developing a diversity strategy to accelerate our ability to compete in today’s business world.
The following tables show the trends in these three primary measures of performance:
Combined ratio is our losses, LAE and underwriting expenses divided by our net earned premiums. We report combined ratio as a percentage. For example, a combined ratio of 95% means that our losses, LAE and underwriting expenses equal 95% of our net earned premiums and result in a 5% underwriting profit. A lower combined ratio reflects better underwriting results than a higher combined ratio.
Life & Investments - We measure our L&I results using pretax operating earnings. This measure excludes from earnings net realized investment gains and losses. We believe that looking at pretax operating earnings enhances the understanding of our L&I results of operations. Net realized investment gains and losses can fluctuate significantly and distort the comparison of our results.
Investment activities are an important part of our business. We invest insurance premiums received in a diversified portfolio until they’re needed to pay claims. Income from our investments is a significant part of our total revenues.
We have identified the accounting estimates listed below as critical to understanding our results of operations and financial condition. The application of these accounting estimates requires our management to use judgments involving assumptions and estimates about future results, trends or other developments that could significantly influence our results if actual experience differs from those assumptions and estimates. We review these judgments frequently. An understanding of them may help readers understand our Consolidated Financial Statements and MD&A. We consider our most critical accounting estimates to be:
Personal Auto policies provide coverage for bodily injury, uninsured motorists, personal injury protection, medical payments, property damage, comprehensive and collision losses.
• Our changing mix of business - As our business grows, we write more policies in markets where we have not written significant business previously. We expect to write more standard and non-standard risks which have, on average, higher frequencies than preferred risks.
• Our increase in new business, which generally has higher claim frequencies than business that has been on the books for longer than one year
Safeco Business Insurance (SBI) - SBI primarily writes commercial multi-peril, property, workers compensation, automobile and general liability insurance for small- to medium-sized businesses. SBI has exposure to asbestos, environmental and other toxic tort and construction defect losses and related expenses through the general liability, commercial multi-peril and umbrella coverages it provides. These exposures and the risks they present to us are discussed in the P&C Other segment below, where the majority of the reserves reside. The remainder of the SBI reserve discussion excludes these exposures.
Workers Compensation -Estimating reserves for workers compensation involves a high degree of uncertainty and judgment. That’s because:
• Many claims have long-term payout periods that increase the impact of inflation trends over time, particularly medical cost inflation.
The table excludes unallocated LAE reserves - reserves not assigned to specific claims. At year-end 2003, our unallocated LAE reserves were $43.8.
The decreases in premiums since 2001 result primarily from our strategy to limit our workers compensation writings in states where rate levels fall below our profitability targets. In particular, we significantly restricted writing new workers compensation business in California beginning in the third quarter of 2002.
Factors in Estimating Loss Reserves for Workers Compensation - Workers compensation claims are mostly composed of medical costs and salary/wage payments while claimants are out of work (indemnity payments). The main factors in estimating loss and LAE reserves for workers compensation are:
While we expect these business practice changes to reduce our ultimate losses, they have decreased the
Based on our analysis, we increased our loss and LAE reserves for workers compensation losses occurring in prior years by $205.0 pretax during the third quarter of 2003. Of this increase, $180.0 was related to loss and allocated LAE reserves. This increase included $130.0 in SBI Runoff, $48.0 in SBI Regular and $2.0 in SBI Special Accounts Facility. The largest amount of reserve development relates to California, particularly the large account business that we began exiting in 2001. We also increased unallocated LAE reserves by $25.0 pretax. This increase included $14.9 in SBI Runoff, $9.6 in SBI Regular and $0.5 in SBI Special Accounts Facility. This increase reflects our estimate of the ongoing expense of servicing workers compensation claims. As claims remain open for longer periods of time, our costs to handle those claims rise.
In determining management’s best estimate for workers compensation reserves, long-term medical cost inflation trends over the average claim payout period represent our most significant assumption. We have assumed that double-digit medical cost inflation will continue in the near-term, moderating over time to historic levels, resulting in a 5%-6% medical loss severity trend over the life of the reserves. Our best estimate of workers compensation reserves presents risk of unfavorable reserve development should medical trends not abate.
Other SBI - We also maintain loss and LAE reserves for our other SBI products. These include (other than asbestos, environmental, other toxic tort and construction defects claims, which are discussed separately below):
The table excludes unallocated LAE reserves. At year-end 2003, our unallocated LAE reserves for asbestos were $4.0.
Our Asbestos Liability Exposure - Here’s the breakout of our asbestos loss reserves:
• 30% relates to our direct exposure, included in SBI Regular.
Accordingly, we’ve established two separate, special claims handling functions, one that specializes in asbestos claims related to our runoff assumed reinsurance operations and one that specializes in asbestos claims related to our direct exposure.
Our exposure through our runoff assumed reinsurance operations is primarily reinsurance of excess coverage. This business also exposes us to syndicates and pools, which resulted in increased asbestos payments in 2002. Pools are groups of insurers that enter into agreements to share exposure related to specific insureds. Our loss reserve estimates for pools reflect the loss reserve estimates provided by the pools’ independent actuaries. The loss experience of our runoff assumed reinsurance operations follows the general industry trend. Our direct exposure is primarily due to smaller and more peripheral entities becoming defendants in asbestos claims.
Our exposure to the major high-profile asbestos defendants is limited. That’s because our business strategy resulted in us not writing direct coverages for larger companies. In addition, we do not have direct exposure to businesses or claims that are the subject of settlement agreements.
At year-end 2003, our unassigned IBNR was 38.6% of our loss reserves for asbestos claims.
We categorize our policyholders with active asbestos claims in two groups according to their exposure, consisting of:
This table provides details about our policyholders and losses paid related to asbestos loss reserves for 2003:
• Efforts by insureds to obtain coverage not subject to aggregate limits
Some asbestos-related claims are subject to non-product liability coverage rather than product liability coverage. Non-product liability coverage might not be subject to policy aggregate limits. That could result in higher asbestos claims payments and related expenses.
Our loss reserve estimates assume that the payments for our direct asbestos exposure in 2003 will return to 2002 and prior levels in the future. This assumption is based on:
Our loss reserve estimates also assume that the severities of future claims will remain relatively unchanged.
Our Environmental and Other Toxic Tort Claims Exposure - Our environmental and other toxic tort
claims result from our runoff assumed reinsurance operations and our commercial general liability line that we write on a direct basis. We generally have avoided writing coverages for large companies with substantial exposures to environmental and other toxic tort claims. As a result, our average environmental claim tends to be small. At year-end 2003, our unassigned IBNR was 71.0% of our loss reserves for environmental and other toxic tort claims.
In 2003, we reached a settlement related to a large number of environmental claims related to coverage on general liability policies written for individual gasoline stations. Under these policies, there was a petrochemical company named as an “additional insured”. We have settled all claims with the additional insured. This $11.0 global settlement and future indemnification agreement is included in our 2003 payment activity. We have no other reported claims of this nature. Other payments in 2003 reflect year-to-year volatility in claim and payment activity.
• Changes in the number and types of defendants involved with these claims
Due to the volatility and sparseness of data, estimating loss reserves for environmental and other toxic tort claims requires more than standard actuarial techniques. As a result, we analyze and consider:
Construction Defects - This table shows our loss and allocated LAE reserves for construction defect claims. The table excludes unallocated LAE reserves. At year-end 2003, our unallocated LAE reserves were $8.2.
Note: Certain reclassifications have been made to the prior-year amounts to conform to the current-year presentation.
Our Construction Defect Claims Exposure - Our exposure to construction defect claims comes from general liability and commercial multi-peril coverages we have provided to contractors. Construction defect claims result from alleged defective work performed in the construction of large habitation structures that include apartments, condominiums and large developments of single-family dwellings or other housing.
• Relationships with external legal counsel specializing in construction defect claims
• Long periods of time between the actual construction work and the date the claim is reported
The uncertainty created by these factors requires more judgment in estimating loss reserves for construction defect claims than for our other lines of business.
We use techniques developed specifically for estimating loss reserves for construction defect claims. With these techniques, we estimate the number of future claims and the average value of every claim and make adjustments for anticipated changes in coverage interpretations, regulations, judicial rulings, plaintiff attorney involvement and changes in our book of business.
Over the last three years, our number of open construction defect claims has decreased steadily - an average drop of 13% per year. Our loss reserve estimates assume that the number of open claims will continue to decrease, but at a slower rate. The slowing will come from increases in construction defect claims outside of California and extended or exempted statutes of limitations for loss reporting in certain jurisdictions. Our loss reserve estimates also assume that our claims handling function modestly reduces loss severity.
Our expected salvage and subrogation recoveries exceeded our loss reserves by $12.2 at December 31, 2003. Surety reserves fluctuate from period to period due to the lag between the time when payments are made on a claim and the time when we receive salvage and subrogation amounts.
• Review estimates of large losses that are covered under reinsurance agreements
• Review reinsurance recoverable amounts for specific claims as well as for lines of business
• Reinsurance recoverables associated with individual reinsurers, including large exposures and those with lower rated reinsurers
• Reinsurance recoverables concentrated with a particular event or issue (for example, a large loss, a catastrophe or an emerging claim issue)
Our investments include fixed maturities and equity securities, which we report at fair value as Available-for-Sale Securities on our Consolidated Balance Sheets.
The fixed maturities we invest in include bonds, mortgage-backed securities and redeemable preferred stock. The equity securities we invest in include common stock and non-redeemable preferred stock.
• How long and by how much the fair value of the security has been below its cost
• Our intent and ability to keep the security long enough for it to recover its value
Based on our analysis, we make a judgment as to whether the loss is other-than-temporary. Sometimes, an investment loss that we consider temporary in one quarter can become other-than-temporary in a future quarter. If the loss is other-than-temporary, we record an impairment charge within Net Realized Investment Gains (Losses) in our Consolidated Statements of Income (Loss) in the period we make that determination.
We recorded $292.3 of these impairment charges in 2003 and $258.5 in 2002. The impairment charges in 2003 included $146.5 that was incurred because of our intent to sell our L&I businesses, together with their investment portfolio. This charge related to all L&I securities with unrealized losses at September 30, 2003 and at December 31, 2003 and our expectation that these securities will not recover in value before the completion of a sale.
• Using internally prepared valuations based on certain modeling and pricing methods
Net Income (Loss) - Consolidated net income increased in 2003, driven primarily by growth and improved results within the P&C operations, offset by a decrease in net realized investment gains (losses).
Consolidated Revenues - The increases in 2003 and in 2002 consolidated revenues reflected overall growth in P&C earned premiums and L&I premiums and other revenues. Declines in our net realized investment gains (losses) offset some of that increase.
Increases in our P&C earned premiums resulted from growth in policies-in-force in our personal auto segment and premium rate increases across all our lines of business.
Increases in our L&I revenues resulted primarily from our acquisition of the Swiss Re Life & Health America Holding Company (Swiss Re) stop-loss medical business in July 2002.
The net realized investment gains included impairments of $258.5 in 2002 and $126.8 in 2001, reflecting the impact of credit deterioration and corporate failures particularly in airline and telecommunication sectors. In 2002, these impairments were offset by gains realized on repositioning our P&C investment portfolio.
Also contributing to the decrease in our losses and LAE in 2002 compared with 2001 were lower catastrophe losses of $85.4 in 2002 compared with catastrophe losses of $268.1 in 2001, and a third quarter 2001 reserve strengthening of $240.0.
Restructuring Charges - The restructuring charges in 2003 include the elimination of approximately 500 positions related to corporate expense reductions. We expect this initiative to reduce our 2004 operating expenses by approximately $75.
The following table assists in reconciling our GAAP results, specifically the “Income (Loss) from Continuing Operations before Income Taxes and Change in Accounting Principle” line from our Consolidated Statements of Income (Loss) to our segment performance measures:
These GAAP results are further detailed into segment underwriting results and pretax operating earnings. Underwriting results and pretax operating earnings provide a helpful picture of how our company is doing. However, using them to measure profitability - while fairly common in our industry - is not consistent with GAAP.
The primary measures of our operating results include our underwriting profits or losses, net earned premiums and combined ratios. The next three tables report those key items - by our reportable segments - for the last three years. More information about the results - also by reportable segment - follows the tables.
First, underwriting profits (losses) are our measure of each segment’s performance:
Finally, combined ratios show the relationship between underwriting profit (loss) and net earned premiums. Using ratios helps us see our operating trends without the effect of changes in net earned premiums:
+ Combined ratios are GAAP basis. Expressed as a percentage, they are equal to losses and expenses divided by net earned premiums.
• Increases in filed rates: We file rate changes on a state-by-state basis. Overall, we received approval for average rate increases in the mid-single digits in 2003 and 2002.
• Growth of policies-in-force (PIF): PIF grew by 9% in 2003 and by 8% in 2002, reflecting the introduction of our new business entry model using point-of-sale (POS) underwriting technology and stable retention rates. Our new auto policies grew 9.7% in 2003 over 2002, and 5.3% in 2002 over 2001.
• Disciplined underwriting through our automated underwriting platform that provides more segmentation and better matching of rates to risk characteristics.
Introducing Our New-Business Entry Model - In early 2002, we introduced our new-business entry model using POS underwriting technology. This model makes it easier for our distributors to sell our new auto insurance product. Accessing the system from their offices, our distributors follow a series of easy-to-use screens to complete the sale. This helps our agents to be more efficient in processing auto business.
Paying Commissions to Incent Profitable Growth - In early 2002, we introduced some changes to our commission structure that have contributed to higher sales during 2002 and 2003. We increased commissions from 10% to 17% on new auto policies. The increase applies to the first six-month policy period. In addition, we revised the bonus commission structure for our agents in 2002. The new structure aligns their incentives with our growth and profitability goals.
Business Growth - As our business grows, we will write more policies in markets where we have not written significant business previously. We expect to write more standard and non-standard risks which have, on average, higher frequencies than preferred risks.
Product Pricing and Segmentation - We will continue to refine our pricing structure to more precisely match rate to risk.
Overall - Barring extraordinary catastrophes and other unusual events, we expect our Personal Auto segment to grow, while operating at our target combined ratio of 96%, in 2004.
• Decline in PIF: The number of policies that did not renew in 2003 and 2002 exceeded the number of new policies written in each year, leading to a net reduction in PIF of 9.1% in 2003 and 8.2% in 2002. Lower new business due to moratoriums in certain unprofitable states also resulted in our PIF declining during 2003. Currently, we have moratoriums in only two states, down from 10 states at December 31, 2002.
• Improved rate adequacy: As discussed above, rates increased in 2002 and 2003, while loss costs declined during that period.
• Loss frequency: The decrease in loss costs was driven by double-digit decreases in claims frequency - the average number of claims filed that are not catastrophe-related. This was only partially offset by increases in claims severity - the average cost per claim.
Loss frequency in 2003 was lower in all areas - fire, theft and other perils. Our frequency fell by 28% in 2003 and 19% in 2002.
Catastrophe Losses - Catastrophes involve multiple claims and policyholders. We cannot accurately predict catastrophes, and the number and type of catastrophes can vary widely. The losses they could cause might significantly exceed our prior experience.
Our catastrophe losses returned to historical averages in 2003. Catastrophe losses were unusually low in 2002 and unusually high in 2001. Our pretax catastrophe losses after reinsurance for the last three years were:
Catastrophe losses for 2003 included $11.8 pretax for the wildfires in California. The catastrophes in 2001 included $60.0 pretax for a single wind and hailstorm in St. Louis.
Offering a New Homeowners Insurance Product - Our new homeowners product generally offers nine underwriting tiers. This increased segmentation means we are better able to align rate with risk, and to offer coverage to more homeowners. We have obtained approval to sell our new product in 43 of the 44 states in which we are licensed to sell business.
Introducing Our New-Business Entry Model - In early 2002, we introduced our new-business entry model using point-of-sale (POS) underwriting technology. This model makes it easier for our distributors to sell our new homeowners insurance product.
Reunderwriting our Homeowners Business in Selected States - During 2003, we reviewed and updated our data for current policyholders in several states to make sure we had accurate information concerning their property. This helped us ensure that we are charging the appropriate premium for the risk insured.
Changing Policy Language - We placed a cap on the maximum amount payable in a total loss of 125% of the home’s insured value. In some cases, we have taken steps to restrict coverage, primarily on mold damages. These restrictions generally cap mold damages at $10 thousand, including remediation costs.
We anticipate the following factors will impact growth and profitability in our Homeowners segment in the near future:
Product Pricing and Segmentation - We will continue to refine our pricing structure and matching of rate to risk.
PIF - We expect to see further reduction in PIF in 2004, but at a slower rate of decline than the past two years, and in the second half of 2004 we expect PIF levels to stabilize.
Overall - We do not expect to experience the same favorable frequency trends. This will cause our margins in this business to move closer to our target 92% combined ratio than the extraordinary results we experienced in the last half of 2003.
We experienced a small net decrease in PIF in 2003 and 2002, which was largely offset by our rate increases.
We anticipate stable results in 2004. We have not yet introduced our point-of-sale (POS) technology in Specialty. We expect growth in this line when those advancements in technology are introduced in 2005.
• $57.6 in 2003 as part of the $205.0 reserve strengthening in the third quarter
• $65.0 in 2001 as part of the $240.0 reserve strengthening in the third quarter
More information about our workers compensation reserves is in the P&C Loss and LAE Reserves section on page 35.
Catastrophe losses increased in 2003. Our catastrophe losses before tax and after reinsurance were $19.0 in 2003, $11.7 in 2002 and $31.7 in 2001.
Automated Underwriting Platform - Our automated underwriting platform provides improved matching of price to risk that allows us to offer policies to a wider range of small businesses.
Introducing our Point-Of-Sale Technology - The point-of-sale technology is an easy-to-use, web-based interface that helps agents provide real-time quotes to their customers quickly and efficiently.
Growth - Given the increasing number of small businesses in the United States and the lack of a dominant market leader, we see growth potential in this segment and aim to become the top insurance writer. As we continue to roll out our automated underwriting platform and point-of-sale technology, we will grow our business by focusing on small business policies.
We believe that Safeco Now will be a powerful tool to drive growth and greater efficiencies for our distributors and for us.
Loss Costs - We anticipate that medical costs, auto repair and building material costs will continue to rise. We strive to effectively manage these costs through efficient claims handling to help offset this loss cost inflation.
Overall - We expect good growth in PIF and continued ability to maintain our target margins (95% combined ratio).
Our SBI Special Accounts Facility (SAF) segment provides insurance for large commercial accounts (customers who pay annual written premiums of more than $100,000).
While our main focus is the small- to medium-sized commercial market, we continue to serve some large commercial accounts on behalf of key agents and brokers who sell our core property and casualty products. Sixty percent of new small-commercial business comes from distributors who also sell to large commercial accounts.
The changes in our net earned premiums, underwriting results and combined ratios over the last two years mainly resulted from the consolidation of our business insurance products. As discussed above, this consolidation reflects the decisions we made as the large account policies came up for renewal. We renewed only those that we could underwrite profitably within our redesigned business model.
Our SBI Runoff segment consists of large commercial business accounts and specialty programs that we have exited.
Those accounts that do not fit with our focus on SBI Regular or that cannot be effectively served within SAF continue to be managed and reported in this segment.
The 2003 and 2001 underwriting losses include $144.9 and $90.0 of prior-year workers compensation reserve strengthening. More information about our workers compensation reserves is in the P&C Loss and LAE Reserves section on page 35.
We analyze our results in SBI Runoff using underwriting profit (loss). That’s due to the decreasing earned premiums associated with accounts in runoff which means combined ratio is less meaningful in assessing underwriting performance.
The growth in our 2003 and 2002 premiums and underwriting profits resulted from:
We are benefiting from the disarray in the surety market because we are a stable, long-term provider of surety bonds. Some providers in the industry have experienced significant underwriting losses in recent years. While 2003 was favorable for us in terms of obtaining increased rates, we expect 2004 to bring more modest rate increases. We will maintain our disciplined underwriting approach as a priority while we grow this business.
• Runoff assumed reinsurance business acquired as part of the American States acquisition
• London operations that have been in runoff since the third quarter of 2002
The Terrorism Risk Insurance Act of 2002 (TRIA), enacted by the federal government on November 26, 2002, requires insurance companies to offer terrorism coverage to all commercial policyholders. That includes workers compensation and surety policyholders.
Prior to the enactment of TRIA, our policies excluded losses due to foreign terrorism in states that had approved the exclusions. With TRIA, we can no longer exclude losses due to foreign terrorism unless the policyholder rejects our mandatory offer of terrorism coverage. The Insurance Services Office (ISO) created coverage and pricing tools to help insurers respond to the TRIA requirements.
We believe our exposure to potential terrorism losses is relatively modest across all our product lines.
With our personal lines of insurance, we believe that losses due to terrorism would likely be relatively modest. We believe that exposure and risk to individuals are small.
This table shows the changes in our P&C loss and LAE reserves for 2003, 2002 and 2001. We record changes in estimated reserves in our Consolidated Statements of Income (Loss) the same year we make the change.
• $205.0 during the third quarter as a result of higher medical cost trends for workers compensation than previously expected.
• $44.9 in a number of lines at various times during the year due to emerging claim trends and related loss data.
• Improving our claims handling practices, putting greater emphasis on early recognition of exposure potential in case reserves
• Focusing on the settlement of long-term claims, increasing the number that we settle
• Limiting our workers compensation writings in states where rate levels fall below our profitability targets
Based on our analysis, we increased our loss and LAE reserves for workers compensation losses occurring in prior years by $205.0 pretax during the third quarter of 2003. Of this increase, $180.0 was related to loss and allocated LAE reserves. This increase included $130.0 in SBI Runoff, $48.0 in SBI Regular and $2.0 in SBI Special Accounts Facility. The largest amount of reserve development relates to California, particularly the large account business that we began exiting in 2001. We also increased unallocated LAE reserves by $25.0 pretax. This increase included $14.9 in SBI Runoff, $9.6 in SBI Regular and $0.5 in SBI Special Accounts Facility. This increase reflects our estimate of the ongoing expense of servicing workers compensation claims. As claims remain open for longer periods of time, our costs to handle these claims rise.
In 2002, we increased our estimates for P&C prior years’ loss and LAE reserves by $125.8. We made increases throughout the year as part of our quarterly evaluations, based on emerging claim trends and related loss data.
• Asbestos claims - losses related to our participation in pools and syndicates were higher than estimated.
• Other reserves - primarily higher than anticipated losses for our London operations that were put in runoff. The losses are due to some high layer excess coverages and the long reporting lag of these operations.
• $105.1 at various times during the year due primarily to continued rising medical costs that affected our workers compensation losses
The review of our P&C loss reserve adequacy included an independent actuarial study. The $240.0 loss reserve increase by operating segment included:
• Workers compensation losses - unexpected prior year loss development and increases in medical costs at levels higher than previously anticipated
• Asbestos claims - in 2001, the insurance industry was experiencing an expansion of asbestos claims to include smaller and more peripheral firms as defendants. In the first half of 2001, we experienced more claims than in prior years. This led us to expect a larger number of asbestos claims affecting our runoff assumed reinsurance operations.
The primary measures of our L&I operating results include revenues and pretax operating earnings. The next two tables summarize revenues and pretax operating earnings by our reportable L&I segments for the last three years. More information about the results - also by reportable segment - follows the tables.
First, revenues include premiums, net investment income and fees. Revenues do not include our net realized investment gains and losses:
The increases in our pretax operating earnings were primarily due to growth in revenues and earnings that resulted from the acquisition of Swiss Re’s stop-loss medical business and improved loss ratios.
The decrease in 2003 revenues resulted mainly from the impact of lower favorable prepayment adjustments on our mortgage-backed securities investment portfolio. These prepayment adjustments totaled $5.4 in 2003 compared with $13.9 in 2002. Favorable prepayment adjustments on these securities occur when interest rates decline and the underlying mortgage prepayments happen sooner than we estimated. These prepayments, however, could also be unfavorable in the future if actual prepayments occur at a slower rate than anticipated.
Despite ratings downgrades in 2001, revenues remained flat in 2002 as a result of growth in our sales of non-structured annuity products and the income from prepayment adjustments.
High financial strength ratings are critical to our ability to market structured settlement annuities. Accordingly, our ratings downgrades in 2001 significantly limited our ability to sell them. The majority of annuities are long term, 25 years or longer, and are priced based upon investment return projections at the time of sale. While we invest in longer-term fixed maturities to match the duration of the annuities, when these investments are prepaid or are called the proceeds are generally reinvested at the then prevailing rate.
Separate account liabilities are amounts we owe to contract holders for products where the contract holder bears the investment risk and has the right to allocate funds among various sub-accounts. They principally include variable annuities for which we hold matching separate account assets. Our separate account liabilities have fluctuated in a manner consistent with equity markets increases in 2003 and declines in 2002. They were:
Our pretax operating earnings declined slightly in 2003 despite our increased assets under management, due principally to an increase in certain operating expenses.
• Variable annuity profits depend on the amount of our assets under management and changes in their fair value, which affect the amount of fees we receive.
Individual’s products include term, universal and variable universal life and bank-owned life insurance (BOLI). Our ratings downgrades in 2001 have significantly curtailed BOLI sales.
The increases in revenues in 2003 and 2002 were due to our new web-based sales tool and our updated term and universal life insurance products.
We price our products based on mortality risk assumptions. When our mortality experience differs from those assumptions, the claims experience affects our profitability. For our BOLI products, financial strength ratings impact our ability to sell the product. Also, we can only change the interest credited on the policy anniversary date and are therefore susceptible to market fluctuations, which impact the margins on our BOLI products.
Asset Management serves as an investment advisor for Safeco Mutual Funds, variable insurance portfolios and institutional and trust accounts.
Average assets under management have declined over the past two years reflecting the overall decline in equity markets until the second half of 2003.
Results are highly dependent on the overall performance of equity markets.
L&I Other is composed mainly of investment income on capital and accumulated earnings of other L&I segments and Talbot Financial Services (Talbot) - our insurance agency that distributes property and casualty, life insurance and investment products.
The increases in revenues for 2003 and 2002 were due to increases in net investment income, reflecting higher retained capital and increases in commission revenues at Talbot.
Our Corporate segment’s primary expense is interest we pay on our debt. Our interest expense on borrowings totaled:
SFP pretax income (loss) included in the Corporate results was $(0.5) in 2003, $3.6 in 2002 and $6.7 in 2001.
Note: Certain reclassifications have been made to the prior year amounts to conform to current year presentation.
This table summarizes our pretax investment yields for the last three years:
Net gains on securities transactions in 2002 resulted primarily from the repositioning of our portfolio.
We closely monitor every investment that has declined in fair value to below our cost. If we determine that the decline is other-than-temporary, we write down the security to its fair value and record the charge as an impairment in Net Realized Investment Gains (Losses) in the Consolidated Statements of Income (Loss) in the period that we make this determination. More information about our process of estimating investment impairments can be found in the Critical Accounting Estimates section on page 43.
• Reduce our exposure to companies and industries with credit problems
In our impairment determination process, we consider our intent and ability to hold investments long enough for them to recover in value. However, our intent to hold the investment can change due to:
• Changes in the financial condition and near-term prospects of the issuer
• Strategic decisions to reposition our investment portfolio’s duration or asset allocation
Our Corporate segment recorded $119.6 in the third quarter of 2003 and $26.9 in the fourth quarter of 2003 in impairment charges for securities held by L&I which are not expected to recover in value before the sale of our L&I businesses. These impairments were not recorded in L&I since the ability and intent to hold securities at the L&I operating level has not changed as a result of our intent to sell the L&I businesses. Additional impairments are possible in 2004, depending on the fair value of these investments.
In 2003, the fair value of fixed maturities and equity securities that we sold at a loss was $348.5. Our total net realized investment loss on these sales was $44.6. In 2002, the fair value of fixed maturities and equity securities that we sold at a loss was $707.9. Our total net realized investment loss on these sales was $246.3. We sold investments in 2002 and 2003 for the reasons discussed above.
As discussed earlier on page 67, we have wound down our SFP operations and have liquidated its derivative portfolio at December 31, 2003. The derivative portfolio consisted mainly of credit default swaps which had notional amounts outstanding of $835.0 at December 31, 2002.
• $28.3 loss in 2002 - including an $8.6 loss resulting from the WorldCom bankruptcy
Credit swap mark-to-market gains in 2003 resulted from the tightening of credit spreads. The losses in 2002 resulted from credit spreads widening.
Our other items for 2003 included $15.2 in gains related to fair value hedges, representing hedges on forecasted transactions that are no longer considered probable of occurring.
Here is a summary of our investments showing investment types and industries of our fixed maturities and equity securities that exceed 3% of our portfolio at year-end 2003:
The related amortized cost of the below investment grade securities at year-end 2003 was $1,172.3 and $1,218.5 at year-end 2002.
• $315.2 of non-publicly traded fixed maturities and equity securities - representing 1.1% of our total portfolio
Our mortgage loans are on completed, income-producing commercial real estate, primarily in the retail, industrial and office building sectors.
The majority of the properties on which we hold mortgages are in three states:
• No loan when issued shall exceed 75% of the property’s appraised value
Less than 1% of our mortgage loans were non-performing - those loans in default of principal or interest or both - at the end of each of the last two years. As a result, our allowance for mortgage loan losses has remained relatively unchanged at $10.2 at December 31, 2003, compared with $10.5 at December 31, 2002.
Our mortgage-backed securities consist mainly of residential collateralized mortgage obligations (CMOs), pass-throughs and commercial mortgage-backed securities (CMBSs).
Our L&I portfolio holds 79% of our mortgage-backed securities. Our P&C investment portfolio holds the remaining 21%.
We use funds to support operations, make interest and principal payments on debt, pay dividends to our shareholders and grow our investment portfolio.
• $200.0 to pay off notes that had a 7.875% interest rate and were due in 2005, but had a call date at par of April 1, 2003
$328.7 Common Stock Offering - On November 20, 2002, we raised $328.7 by selling 10,465,000 shares of our common stock at $33.00 per share.
$375.0 Long-Term Debt Issuance - On August 23, 2002, we issued $375.0 of senior notes at an interest rate of 7.250%. The notes mature in 2012.
The bank credit facility does not require us to maintain any deposits as compensating balances. At the end of 2003 and throughout 2003, we had no borrowings under the bank credit facility and we were in compliance with all its covenants.
More information about our contractual obligations is in Notes 8 and 12 to our Consolidated Financial Statements on pages 125 and 133.
In April 2003, Safeco Corporation issued a letter of credit to Citibank on behalf of Safeco UK, Ltd. (Safeco UK), our wholly owned subsidiary. Safeco UK conducted our London operations that were put into runoff in the third quarter of 2002. The letter of credit guarantees payment of Safeco UK’s share of potential losses up to $19.6 arising from prior participation in a London reinsurance syndicate. Prior to April 2003, this guarantee was provided by Safeco Insurance Company of America (SICA), a wholly owned subsidiary of Safeco Corporation.
In June 2000, Safeco Life Insurance Company (Safeco Life), our wholly owned subsidiary, issued a guarantee to General America Corporation (GAC), our wholly owned subsidiary. Under the guarantee, Safeco Life guarantees repayment of a loan made by GAC to Investar Holdings, an insurance agency. The loan was made in June 2000 and matures in June 2017. The principal balance of $15.9 is included with Other Notes and Accounts Receivable on the Consolidated Balance Sheets.
Financial strength ratings provide a benchmark for comparing insurers. Higher ratings generally indicate greater financial strength and a stronger ability to pay claims. Claims paying ratings are important for the marketing of insurance products, particularly structured settlement annuities and BOLI products in our L&I operations.
Due to our poor P&C results in 2000 and 2001, our financial strength and corporate credit ratings were lowered in the first half of 2001. The lower results in 2000 and 2001, combined with increased operating leverage in P&C, contributed to lowering our debt service coverage. In addition, the interest rate on our short-term borrowings increased due to the ratings downgrades.
On August 13, 2002, Standard & Poor’s (S&P) affirmed its ratings on Safeco Corporation and our P&C subsidiaries. At the same time, S&P lowered its ratings on our life insurance subsidiaries because of a change in S&P group methodology criteria, which modified the rating available to subsidiaries. The new criteria generally limit the rating given to a subsidiary that S&P deems “strategically important” to the parent to within one notch of the rating on the parent’s core group. On December 4, 2002, A.M. Best reaffirmed our ratings and revised its outlook for our Corporate and P&C ratings from negative to stable.
As a result, the rating agencies took these actions concerning our L&I businesses:
• A.M. Best and Fitch placed the financial strength ratings of our life insurance subsidiaries under review with developing implications.
• S&P’s lowered its ratings on our life insurance subsidiaries with developing implications.
A.M. Best and Fitch commented that our debt ratings, as well as the financial strength ratings of our P&C subsidiaries, are unaffected. S&P’s and Moody’s affirmed their ratings of Safeco Corporation and our P&C subsidiaries, with a stable outlook.
A number of state legislatures and insurance regulatory agencies have enacted laws and regulations that limit the use of credit information in the underwriting process. Additional states are considering doing so. Our P&C businesses use insurance scoring which is partially based on credit information in making risk selection and pricing decisions. Limitations or prohibitions on the use of credit information could negatively affect our P&C business plans.
Dividend Payments from Our Subsidiaries - Our insurance subsidiaries pay dividends to Safeco Corporation. We then use those funds to pay dividends to our shareholders, as well as to make principal and interest payments on our debt. Individual states limit the amount of dividends that our subsidiaries domiciled in those states can pay us. Exceeding such limits would require prior regulatory approval. In 2004, our P&C insurance subsidiaries can pay up to $314.6 in dividends and our L&I insurance subsidiaries can pay up to $166.6 in dividends without obtaining prior regulatory approval. These amounts are according to the limits states had in place at the end of 2003.
At December 31, 2003, we had approximately $1,091.0 of gross deferred income tax assets. Gross deferred income tax assets are composed of temporary differences created as a result of amounts deductible for taxes in future periods. These deferred income tax assets included net operating loss carryforwards of $23.5 that will expire in 2020 and 2021. A net operating loss carryforward is a tax loss that may be carried forward into future years. It reduces taxable income, and as a result, tax liability.
The Consolidated Financial Statements and schedules listed in the Index to Financial Statements, Schedules and Exhibits on page 88 are filed as part of this report.