2 Operating income and operating return on average equity are non-GAAP measures. See the Glossary of Terms attached to this Form 10-K as Exhibit 99.1 for definitions of these items and see the “Financial Highlights” section in
Factors that could cause our actual results to differ materially from those we have projected, forecasted or estimated in forward-looking statements are discussed in further detail in Item 1A. “Risk Factors.” of this Form 10-K. These risk factors may not be exhaustive. We operate in a continually changing business environment, and new risk factors emerge from time-to-time. We can neither predict such new risk factors nor can we assess the impact, if any, of such new risk factors on our businesses or the extent to which any factor or combination of factors may cause actual results to differ materially from those expressed or implied in any forward-looking statements in this report. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report might not occur.
· Insurance Operations, which sells property and casualty insurance products and services; and
· The purchase of the renewal rights to an E&S book of business in August 2011. This renewal book had gross annual premiums of approximately $77 million in 2010.
In addition to case reserves, we maintain estimates of reserves for losses and loss expenses that have been incurred but not reported to us (referred to as “IBNR”). Using generally accepted actuarial reserving techniques, we project our estimate of ultimate losses and loss expenses at each reporting date. The difference between: (i) the projected ultimate loss and loss expense reserves; and (ii) the case loss reserves and the loss expenses reserved thereon is carried as the IBNR reserve. The actuarial techniques used are part of a comprehensive reserving process that includes two primary components. The first component is a detailed quarterly reserve analysis performed by our internal actuarial staff. In completing this analysis, the actuaries are required to make numerous assumptions including, for example, the selection of loss development factors and the weight to be applied to each individual actuarial indication. These indications include paid and incurred versions for the following actuarial methodologies: loss development, Bornhuetter-Ferguson, Berquist-Sherman, and frequency/severity modeling. Additionally, the actuaries must gather substantially similar data in sufficient volume to ensure the statistical credibility of the data. The second component of the analysis is the projection of the expected ultimate loss ratio for each line of business for the current accident year. This projection is part of our planning process wherein we review and update expected loss ratios each quarter. This review includes actual versus expected pricing changes, loss trend assumptions, and updated prior period loss ratios from the most recent quarterly reserve analysis.
Additionally, the economy could impact the frequency and severity of claims in ways unanticipated by management. In 2010, we experienced an unusually high amount of audit and endorsement activity, resulting in return premium of $20.5 million, while in 2011, audit and endorsement activity resulted in additional premiums of $11.2 million. Some volatility in premium activity may continue into the future and, since premiums earned are used as a basis for setting initial reserves on the current accident year, our reserves could be impacted. The result could be favorable development if the reduction in payroll resulting in return premium is truly a reduction in exposure. The result could be adverse development if the reduction in payroll resulting in return premium indicates that remaining workers are now overworked and more prone to accidents.
At December 31, 2011, our commercial automobile line of business had recorded reserves, net of reinsurance, of $346 million, which represented 13% of our total net reserves. This line of business experienced favorable prior year loss development from 2005 through 2011. In 2011 this development was driven by accident years 2007 through 2009, which represents a continued trend driven by lower frequencies in these years. While management has not identified any new specific emerging trends related to this line, the variability of frequencies creates additional uncertainty in our analysis for the more recent accident years.
Claims Initiative and Inflation Impact on Standard Market Workers Compensation, General Liability and Commercial Automobile Lines of Business
· The weight to be applied to each individual actuarial indication;
In addition to the normal amount of volatility, general liability loss development factors have greater uncertainty due to the complexity of the coverages and the possibly significant periods of time that can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer, and the insurer’s payment of that loss. In our judgment, it is possible that general liability loss development factors could be +/- 5% from those actually selected in our latest reserve analysis. If the loss development assumptions were changed by +/- 5%, that would increase/decrease our indicated general liability reserves by approximately $93 million for accident years 2010 and prior.
In addition to the normal amount of volatility, our commercial automobile line of business has realized significant favorable development in 2005 through 2011. In 2011, this development was driven by accident years 2007 through 2009, which represents a continued trend driven by lower frequencies in these years. The actual number of large claims has a high degree of volatility from year to year in terms of timing and ultimate final emergence. Even if large losses are ultimately consistent from year to year, if they are identified at different times than previous years, traditional loss development factors may overstate or understate actuarial indications. If the timing of large losses is significantly variable, it is our judgment that actual loss development factors could be +/- 5% different from those selected in our reserve review, which would increase/decrease our indicated commercial auto reserves by approximately $57 million for accident years 2010 and prior.
As discussed in the major trend section above, the claims initiatives and inflationary uncertainty could impact reserves for the workers compensation, general liability, and commercial automobile lines of business. In our judgment, it is possible that the selected reserves for these lines of business in our latest reserve review could increase by $128 million or decrease by $118 million due to the combination of case reserve volatility in accident years 2009 through 2011 due to claims initiatives and unexpected inflation or deflation. These potential impacts would likely manifest themselves as changes in development patterns and expected loss ratios as described within the discussions of the separate lines of business. Therefore, these impacts may be embedded within the line of business figures, in whole or in part.
In addition to a normal amount of volatility, the uncertainty of personal automobile loss development factors is greater than usual due to the change in our state mix for business written outside of New Jersey. In our judgment, it is possible that personal auto bodily injury loss development factors could be +/- 4% different from those selected in our reserve review. This would increase/decrease our indicated personal auto reserves by approximately $33 million for accident years 2010 and prior.
Included in our loss and loss expense reserves are amounts for environmental claims, both asbestos and non-asbestos. Carried net loss and loss expense reserves for environmental claims were $38.4 million as of December 31, 2011 and $39.4 million as of December 31, 2010. Our asbestos and non-asbestos environmental claims have arisen primarily from insured exposures in municipal government, small commercial risks, and homeowners policies. The emergence of these claims is slow and highly unpredictable. In past years, we also experienced adverse development in our homeowners line of business as a result of unfavorable trends in claims for groundwater contamination caused by leakage of certain underground heating oil storage tanks in New Jersey. In addition, certain landfill sites are included on the National Priorities List (“NPL”) by the United States Environmental Protection Agency (“USEPA”). Once on the NPL, the USEPA determines an appropriate remediation plan for these sites. A landfill can remain on the NPL for many years until final approval for the removal of the site is granted from the USEPA. The USEPA also has the authority to re-open previously closed sites and return them to the NPL. We currently have reserves for 13 insureds related to five sites on the NPL, one of which was reopened in 2009 related to a natural resources claim.
· We service our agency distribution channel through our field model, which includes AMSs, safety management specialists, CMSs, and our Underwriting and Claims Service Centers, all of which service the entire population of insurance contracts acquired through each agency.
We had deferred policy acquisition costs of $214.1 million at December 31, 2011 compared to $209.6 million at December 31, 2010. In October 2010, the Financial Accounting Standards Board issued accounting guidance regarding accounting for costs associated with acquiring or renewing insurance contracts effective January 1, 2012, which will result in a pre-tax impact on our deferred policy acquisition balance of $78.3 million. For further discussion regarding the impact of this new accounting guidance, see the “Pending Accounting Pronouncements” section below.
Our pension and post-retirement life benefit obligations and related costs are calculated using actuarial methods, within the framework of U.S. GAAP. Two key assumptions, the discount rate and the expected return on plan assets, are important elements of expense and/or liability measurement. We evaluate these key assumptions annually. Other assumptions involve demographic factors such as retirement age, mortality, turnover, and rate of compensation increases.
· The issuer’s current financial condition and ability to make future scheduled principal and interest payments on a timely basis;
If applicable, conditional default rate assumptions apply at the total collateral pool level held in the securitization trust. Generally, collateral conditional default rates will “ramp-up” over time as the collateral seasons, because the performance begins to weaken and losses begin to surface. As time passes, depending on the collateral type and vintage, losses will peak and performance will begin to improve as weaker borrowers are removed from the pool through delinquency resolutions. In the later years of a collateral pool’s life, performance is generally materially better as the resulting favorable selection of the portfolio improves the overall quality and performance.
· The financial condition and near-term prospects of the issuer, including any specific events that may influence the issuer’s operations, coupled with our intention to hold the securities in the near term;
· The dividend policy of the issuer at the date of acquisition and the date of evaluation;
· The length of time and the extent to which the fair value has been, or is expected to be, less than cost in the near term; and
· Emerging issues that may affect the success of the strategy; and
The variances in operating income are reflective of the results discussed above. Refer to Exhibit 99.1 of this Form 10-K for a definition of operating income.
Our Insurance Operations offers standard market insurance products and services through seven insurance subsidiaries and, in 2011, we began offering excess and surplus lines (“E&S”) insurance products as the result of the following acquisition activity:
· The purchase of Montpelier U.S. Insurance Company (“MUSIC”) in December 2011.
· NPW increased in compared to primarily driven by the following: (i) Commercial Lines renewal pure price increases of 2.8% coupled with a one-point increase in retention to 83%; (ii) new E&S premiums of $24.1 million in association with our renewal rights purchase in August 2011; and (iii) improvements in audit and endorsement premiums. Audit and endorsement activity was driven by economic conditions over the past three years as evidenced below:
NPE increases over the three-year period are consistent with the fluctuation in NPW.
· The increase in the GAAP loss and loss expense ratio of 5.4 points in compared to was primarily attributable to higher property losses of $81.7 million, which included increased catastrophe losses of $62.3 million, or 4.3 points, to $118.8 million in 2011. In addition, favorable prior year casualty development was $30 million, or 2.1 points, in compared to $39 million, or 2.8 points, in 2010. For more information on the favorable prior year development on our casualty lines of business, see the “Review of Underwriting Results by Lines of Business” below.
The increase in the GAAP loss and loss expense ratio of 1.4 points in 2010 compared to 2009 was primarily attributable to an increase in property losses of $50.3 million, which included increased catastrophe losses of $47.9 million, or 3.4 points, to $56.5 million in 2010. Partially offsetting this increase was: (i) favorable casualty prior year development of approximately $39 million, or 2.8 points, in 2010, compared to approximately $29 million, or 2.0 points, in 2009; and (ii) a reduction of loss costs due to a change in the mix of our casualty lines of business.
Several record breaking tornado outbreaks during the spring of 2011 marked the beginning of one the most costly catastrophe loss year for the property and casualty insurance industry since 2005 when three hurricanes made a direct landfall in the United States. Hurricane Irene was the first hurricane to hit the United States coastline since 2008 and the first to strike the New York City area since Hurricane Gloria in 1985. A.M. Best estimates that catastrophe losses in the United States were approximately $44 billion, more than double the amount in 2010. As a result, A.M. Best is projecting an industry combined ratio of 107.5% in 2011, which includes more than 10 points of catastrophe losses. Consistent with the trend noted by A.M. Best as a driver of industry-wide results, our Insurance Operations segment incurred the worst catastrophe year in the existence of our company with losses of $118.8 million, or 8.3 points on our combined ratio of 106.7%. As shown in the table below, catastrophe losses, by their nature, are volatile. In 2011 and 2010, we incurred elevated levels of catastrophe losses, and, conversely, 2009 was the period of lowest catastrophe losses during the last five years.
We are expecting to generate a 2012 full year statutory combined ratio of 101.5% and a GAAP combined ratio of 102.5%, which includes a catastrophe loss assumption of 2.5 points. Combined ratios do not include any assumptions for reserve development, favorable or unfavorable. In addition, we expect that investment income will be approximately flat with 2011 levels. Weighted average shares at year-end 2012 are expected to be approximately 55.6 million.
· NPW increased 7% in compared to 2010, which reflects the following:
o Renewal pure price increases of 2.8% coupled with strong retention with a one-point increase to 80%;
o $24.1 million in E&S premium in resulting from our renewal rights acquisition in August 2011; and
NPW decreased 5% in 2010 compared to 2009, which reflects the following:
Partially offsetting these decreases was direct new business of $210.8 million in 2010.
· The variances in the GAAP loss and loss expense ratio in both periods were reflective of increased catastrophe losses, coupled with the impact of favorable prior year casualty development, a summary of which follows:
The increase in the GAAP underwriting expense ratio of 1.1 points in 2011 compared to last year, was driven by expenses associated with our purchase of the E&S renewal book of business in 2011. The majority of these expenses, or $4.7 million, are directly related to the acquisition and will not impact the on-going results of this operation. However, as MUSIC unearned premiums as of the acquisition date were fully ceded, our underwriting expense ratio will be under pressure going forward until such time as premiums that we write subsequent to the purchase are earned to support the expenses of these operations.
In 2010, the economic weakness and competitive nature of the insurance marketplace negatively impacted NPW on this line compared to 2009 as evidenced by the following:
The impact of the prior year favorable development shown above was as follows:
NPW remained relatively flat in 2011 compared to last year while NPW decreased in 2010 compared to 2009. NPE decreased throughout the three-year period which was a reflection of the economic factors that put pressure on NPW as exposure levels declined in 2010.
The fluctuations in the statutory combined ratio were driven by favorable prior year casualty development as shown above was as follows:
o 2011: 4.6 points, in driven by the through accident years, representing a continued trend driven by lower frequencies in those years;
o 2010: 9.6 points, driven by lower than anticipated severity primarily in accident years through 2009; and
The fluctuations in the statutory combined ratio were primarily attributable to the impact of prior year casualty development on current year results as shown above was as follows:
· 2009: favorable by 3.9 points, primarily driven by accident years to 2007, partially offset by adverse severity in accident year 2008.
NPW and NPE were relatively flat over the three-year period. The decrease in the statutory combined ratio in 2011 compared to 2010 was largely due to lower estimates of current year loss costs, coupled with favorable prior year development. These items were partially offset by elevated catastrophe losses.
· The 11.4-point increase in the GAAP loss and loss expense ratio in compared to was primarily attributable to an increase in property losses of $42.4 million, or 12.7 points, which includes an increase in catastrophe losses of $25.7 million, or 9.1 points. The unprecedented level of catastrophe losses in we incurred included losses from Hurricane Irene of $17.9 million, or 6.8 points. Partially offsetting these losses were claims handling fees earned on our flood book of business that increased $4.4 million, or 1.6 points, from 2010. These claims handling fees reflect the significant flooding activity during the year throughout the Northeast and Mid-Atlantic states.
We have reinsurance contracts that cover both property and casualty insurance business. We use traditional forms of reinsurance and do not utilize finite risk reinsurance. Available reinsurance can be segregated into the following key categories:
· Property Reinsurance - includes our Property Excess of Loss treaties purchased for protection against large individual property losses and our Property Catastrophe treaty purchased to provide protection for the overall property portfolio against severe catastrophic events. Facultative reinsurance is also used for property risks that are in excess of our treaty capacity.
· Casualty Reinsurance - purchased to provide protection for both individual large casualty losses and catastrophic casualty losses involving multiple claimants or insureds. Facultative reinsurance is also used for casualty risks that are in excess of our treaty capacity.
· Terrorism Reinsurance - available as a federal backstop related to terrorism losses as provided under the TRIA. For further information regarding this legislation, see Item 1A. “Risk Factors.” of this Form 10-K.
· Flood Reinsurance - as a servicing carrier in the WYO Program, we receive a fee for writing flood business, for which the related premiums and losses are ceded to the federal government.
Information regarding the terms and related coverage associated with each of our categories of reinsurance above can be found in Item 1. “Business.” of this Form 10-K.
We use the results of the Risk Management Solutions (“RMS”) and AIR Worldwide (“AIR”) models in our review of exposure to hurricane risk. Each of these third party models provides two views of the modeled results. A long-term view closely relates modeled event frequency to historical hurricane activity, while a near-term view adjusts historical frequencies to reflect expectations of elevated hurricane activity in the North Atlantic Basin in the short to medium term. It is our view that modeled estimates provide a range of potential outcomes and multiple estimates should be reviewed for purposes of understanding catastrophic risk. The RMS v. 11.0 model substantially increased vulnerability of construction assumptions and increased wind hazards further inland for our book of business. Other changes included storm surge, demand surge, and hurricane frequency. Reinsurance brokers indicate that the RMS version change created significant increases in modeled losses across portfolios with different geographic and business mix attributes. The following table provides long-term and near-term views of blended RMS v.11.0 and AIR v.13.0 modeled hurricane results based on the Insurance Subsidiaries’ combined property book as of July 2011, adjusted to include our recent E&S acquisitions:
Our current catastrophe reinsurance program covers up to a 1 in 159 year return period, or events with 0.6% probability, based on a multi-model view of hurricane risk.
The Property Excess of Loss treaty (“Property Treaty”), which covers our standard market business, was renewed on July 1, 2011 and is effective through June 30, 2012, with the same terms as the expiring treaty. This treaty provides a per risk coverage of $28.0 million in excess of a $2.0 million retention.
· The first layer continues to have unlimited reinstatements. The annual aggregate limit for the second, $20.0 million in excess of $10.0 million, layer remains at $80.0 million.
The Casualty Excess of Loss treaty (“Casualty Treaty”), which covers our standard market business, was renewed on July 1, 2011 and is effective through June 30, 2012, with the same terms as the expiring treaty. The current program provides the following coverage:
· Annual aggregate terrorism limits, net of co-participation, increased to $201.0 million.
Our investment philosophy includes certain return and risk objectives for the fixed maturity, equity, and other investment portfolios. The primary fixed maturity portfolio return objective is to maximize after-tax investment yield and income while balancing risk. A secondary objective is to meet or exceed a weighted-average benchmark of public fixed income indices. Within the equity portfolio, the high dividend yield strategy, which we implemented in 2011, is designed to generate consistent dividend income while maintaining a minimal tracking error to the S&P 500 Index. Additional equity strategies are focused on meeting or exceeding strategy specific benchmarks of public equity indices. Although yield and income generation remain the key drivers to our investment strategy, our overall philosophy is to invest with a long-term horizon along with predominately a “buy-and-hold” approach. The return objective of the other investment portfolio, which includes alternative investments, is to meet or exceed the S&P 500 Index.
This increase in our investment portfolio was driven primarily by: (i) operating cash flows generated from Insurance Operations; (ii) proceeds from a borrowing with the Federal Home Loan Bank of Indiana (“FHLBI”); and (iii) valuation improvements on securities in our AFS portfolio. The cash generated from our Insurance Operations was used to invest in our high dividend yield equities strategy and to purchase AFS fixed maturity securities. We increased our outstanding borrowing with the FHLBI from $13.0 million to $58.0 million in the fourth quarter of 2011 to borrow funds at favorable interest rates in connection with our year-end acquisition of MUSIC. We acquired $40.5 million in short-term investments and $7.9 million in fixed maturity securities as part of the MUSIC acquisition.
We structure our portfolio conservatively with a focus on: (i) asset diversification; (ii) investment quality; (iii) liquidity, particularly to meet the cash obligations of our Insurance Operations segment; (iv) consideration of taxes; and (v) preservation of capital. We believe that we have a high quality and liquid investment portfolio. The breakdown of our investment portfolio is as follows:
The weighted average credit rating on our fixed maturity portfolio migrated to AA- at December 31, 2011, from AA at December 31, 2010. This slightly lower average rating is largely the result of: (i) the S&P downgrade of U.S. sovereign debt in August 2011; and (ii) our recent increased allocation to investment-grade corporate bonds. The following table presents the credit ratings of our fixed maturity securities portfolio:
We have audited the accompanying consolidated balance sheets of Selective Insurance Group, Inc. and its subsidiaries (the “Company”) as of December 31, 2011 and 2010, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2011. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules I to V. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Selective Insurance Group, Inc. and its subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
· Investments, which invests the premiums collected by our insurance operations.
Certain amounts in our prior years' consolidated financial statements and related notes have been reclassified to conform to the 2011 presentation. Such reclassifications had no effect on our net income, stockholders' equity, or cash flows.
Fixed maturity securities may include bonds, redeemable preferred stocks, and mortgage-backed securities (“MBS”) and asset-backed securities (“ABS”). Fixed maturity securities classified as available-for-sale (“AFS”) are reported at fair value. Those fixed maturity securities that we have the ability and positive intent to hold to maturity are classified as held-to-maturity (“HTM”) and are carried at either: (i) amortized cost; or (ii) market value at the date of transfer into the HTM category, adjusted for subsequent amortization. The amortized cost of fixed maturity securities is adjusted for amortization of premiums and accretion of discounts over the expected life of the security using the effective yield method. Premiums and discounts arising from the purchase of MBS are amortized over the expected life of the security based on future principal payments, and considering prepayments. These prepayments are estimated based upon historical and projected cash flows. Prepayment assumptions are reviewed quarterly and adjusted to reflect actual prepayments and changes in expectations. Future amortization of any premium and/or discount is also adjusted to reflect the revised assumptions. Interest income, as well as amortization and accretion, is included in "Net investment income earned" on our Consolidated Statements of Income. The carrying value of fixed maturity securities is written down to fair value when a decline in value is considered to be other than temporary. See the discussion below on realized investment gains and losses for a description of the accounting for impairments. Unrealized gains and losses on fixed maturity securities classified as AFS, net of tax, are included in accumulated other comprehensive income (loss) ("AOCI").
Other investments may include alternative investments and other miscellaneous securities. Alternative investments are accounted for using the equity method. Our share of distributed and undistributed net income from alternative investments is included in "Net investment income earned." Investments in other miscellaneous securities are either accounted for under the equity method or the effective yield method of accounting. Our share of distributed and undistributed net income is included in "Net investment income earned."
· Whether the decline appears to be issuer or industry specific;
· The degree to which the issuer is current or in arrears in making principal and interest payments on the fixed maturity security;
· Buy/hold/sell recommendations published by outside investment advisors and analysts; and
· Relevant rating history, analysis, and guidance provided by rating agencies and analysts.
· The independent auditors' report on the issuer's recent financial statements;
· Our expectation of when the cost of the security will be recovered.
· Changes made or future changes to be made to the investment strategy;
The techniques used to value our investment portfolio are as follows:
· For valuations of securities in our equity portfolio and U.S. Treasury notes held in our fixed maturity portfolio, we receive prices from an independent pricing service that are based on observable market transactions. We validate these prices against a second external pricing service and if established market value comparison thresholds are breached, in conjunction with our external investment managers, further analysis is performed to determine the price to be used. These securities are classified as Level 1 in the fair value hierarchy.
· The fair value of the 2.90% and 1.25% borrowings from the Federal Home Loan Bank of Indianapolis (“FHLBI”) are estimated using a DCF based on a current borrowing rate provided by the FHLBI consistent with the remaining term of the borrowing.
We regularly conduct reviews for potential premium deficiencies at a level consistent with that used for our segment reporting. We group our policies at the Insurance Operations level, considering the following:
· We service our agency distribution channel through our field model, which includes agency management specialists, safety management specialists, claim management specialists, and our Underwriting and Claims Service Centers, all of which service the entire population of insurance contracts acquired through each agency.
There were no premium deficiencies for any of the reported years, as the sum of the anticipated losses and loss expenses, policyholder dividends, and other expenses for our Insurance Operations segment did not exceed the related unearned premium and anticipated investment income. The investment yields assumed in the premium deficiency assessment for each reporting period, which are based on our actual average investment yield before tax as of the calculation date on September 30, were 4.0% for 2011, 3.6% for 2010, and 2.9% for 2009. Deferred policy acquisition costs amortized to expense were $430.8 million for 2011, $429.5 million for 2010, and $428.6 million for 2009.
Reserves for losses and loss expenses are comprised of both case reserves and reserves for claims incurred but not yet reported ("IBNR"). Case reserves result from claims that have been reported to our Insurance Subsidiaries and are estimated for the amount of ultimate payment. IBNR reserves are established based on generally accepted actuarial techniques. Such techniques assume that past experience, adjusted for the effects of current developments and anticipated trends, are an appropriate basis for predicting future events. In applying generally accepted actuarial techniques, we also consider a range of possible loss and loss adjustment expense reserves in establishing IBNR.
Overall reserves are reviewed for adequacy on a periodic basis. As part of the periodic review, we consider the range of possible loss and loss expense reserves, determined at the beginning of the year. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. However, there is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves because the eventual deficiency or redundancy is affected by many factors. Based upon such reviews, we believe that the estimated reserves for losses and loss expenses make a reasonable provision to cover the ultimate cost of claims. However, the ultimate actual liability may be higher or lower than the reserve established. The changes in these estimates, resulting from the continuous review process and the differences between estimates and ultimate payments, are reflected in the consolidated statements of income for the period in which such estimates are changed and may be material to the results of operations in future periods.
Our pension and post-retirement life benefit obligations and related costs are calculated using actuarial methods, within the framework of U.S. GAAP. Two key assumptions, the discount rate and the expected return on plan assets, are important elements of expense and/or liability measurement. We evaluate these key assumptions annually. Other assumptions involve demographic factors such as retirement age, mortality, turnover, and rate of compensation increases. The discount rate enables us to state expected future cash flows at their present value on the measurement date. The purpose of the discount rate is to determine the interest rates inherent in the price at which pension benefits could be effectively settled. Our discount rate selection is based on high-quality, long-term corporate bonds. To determine the expected long-term rate of return on the plan assets, we consider the current and expected asset allocation, as well as historical and expected returns on each plan asset class.
In January 2010, the FASB issued ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820 - Improving Disclosures about Fair Value Measurements (“ASU 2010-06”). This guidance requires: (i) separate disclosure of significant transfers between Level 1 and Level 2 of the fair value hierarchy and reasons for the transfers; (ii) disclosure, on a gross basis, of purchases, sales, issuances, and net settlements within Level 3 of the fair value hierarchy; (iii) disclosures by class of assets and liabilities; and (iv) a description of the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. ASU 2010-06 was effective for reporting periods beginning after December 15, 2009, except for the Level 3 disclosure requirements, which was effective for fiscal years beginning after December 15, 2010 and interim periods within those fiscal years. We have included the disclosures required by this guidance in our notes to the consolidated financial statements, where appropriate.
In December 2010, the FASB issued ASU 2010-28 Intangibles - Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts. This guidance modifies Step 1 of the goodwill impairment test, which assesses whether the carrying amount of a reporting unit exceeds its fair value, for reporting units with zero or negative carrying amounts. It requires that an entity perform Step 2 of the goodwill impairment test, which determines if goodwill has been impaired and measures the amount of impairment, if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider the qualitative factors within existing guidance that would require goodwill of a reporting unit to be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. This guidance was effective for interim and annual periods beginning after December 15, 2010 and did not impact our financial condition or results of operations.
In October 2010, the FASB issued ASU 2010-26, Financial Services-Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts (“ASU 2010-26”). ASU 2010-26 requires that only costs that are incremental or directly related to the successful acquisition of new or renewal insurance contracts are to be capitalized as a deferred acquisition cost. This would include, among other items, sales commissions paid to agents, premium taxes, and the portion of employee salaries and benefits directly related to time spent on acquired contracts. We have adopted this guidance, with retrospective application, on January 1, 2012. We anticipate an after-tax impact on stockholders’ equity of approximately $51 million. Restated financial statement information will be presented beginning with our first quarter 2012 Form 10-Q. The following tables provide select restated financial information as it is expected to appear:
In May 2011, the FASB issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (“ASU 2011-04”). This guidance changes the wording used to describe the requirements in U.S. GAAP for measuring fair value and disclosing information about fair value measurements to improve consistency in the application and description of fair value between GAAP and International Financial Reporting Standards. ASU 2011-04 clarifies that the concepts of highest and best use and valuation premise in a fair value measurement are relevant only when measuring the fair value of nonfinancial assets, and are not relevant when measuring the fair value of financial assets or liabilities. In addition, ASU 2011-04 expands the disclosures for unobservable inputs for Level 3 fair value measurements, requiring quantitative information to be disclosed related to: (i) the valuation processes used; (ii) the sensitivity of the fair value measurement to changes in unobservable inputs and the interrelationships between those unobservable inputs; and (iii) the use of a nonfinancial asset in a way that differs from the asset’s highest and best use. ASU 2011-04 is effective prospectively for interim and annual periods beginning after December 15, 2011. The adoption of this guidance is not expected to have a material impact on our financial condition, results of operations, or current disclosures.
In September 2011, the FASB issued ASU 2011-08, Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment, which simplifies the requirements to test goodwill for impairment. This guidance permits an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing events and circumstances, an entity determines that it is not more likely than not that the fair value of the reporting unit is less than the carrying amount, then performing the two-step impairment test is unnecessary. However, if the entity concludes otherwise, then it is required to perform the quantitative impairment test. This guidance is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, and early adoption is permitted. The adoption of this guidance is not expected to have a material impact on our financial condition, results of operations, or current disclosures.
(a) Net unrealized gains on investments included in OCI by asset class were as follows for the years ended December 31, 2011, 2010, and 2009:
2 RMBS includes government guaranteed agency securities with a carrying value $4.0 million at December 31, 2010.
2 CMBS includes government guaranteed agency securities with a fair value of $72.9 million at December 31, 2011 and $71.9 million at December 31, 2010.
3 U.S. government includes corporate securities fully guaranteed by the FDIC.
As evidenced by the table below, our unrealized/unrecognized loss positions improved by $10.9 million as of December 31, 2011 compared to last year as follows:
At December 31, 2011, we had 141 securities in an aggregate unrealized/unrecognized loss position of $10.6 million, $4.9 million of which have been in a loss position for more than 12 months. Non-credit OTTI impairments comprised $2.1 million of the $4.9 million balance, with the remainder related to securities that were on average 6% impaired compared to their amortized cost.
We do not have the intent to sell any securities in an unrealized/unrecognized loss position nor do we believe we will be required to sell these securities, and therefore we have concluded that they are temporarily impaired as of December 31, 2011. This conclusion reflects our current judgment as to the financial position and future prospects of the entity that issued the investment security and underlying collateral. If our judgment about an individual security changes in the future, we may ultimately record a credit loss after having originally concluded that one did not exist, which could have a material impact on our net income and financial position in future periods.
(e) Fixed-maturity securities at December 31, 2011, by contractual maturity are shown below. MBS are included in the maturity tables using the estimated average life of each security. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
Listed below are HTM fixed maturity securities at December 31, 2011:
Listed below are AFS fixed maturity securities at December 31, 2011:
The carrying value of our other investments decreased by $9.6 million as of year-end 2011 compared to year end 2010. The carrying value was primarily impacted by distributions of $45.8 million, partially offset by income of $20.5 million, and additional contributions of $16.1 million under our commitments.
The fund of funds component of our distressed debt strategy, which makes up approximately $9.6 million of our distressed debt strategy, encompasses a number of strategies that generally fall into one of the following broad categories:
Our seven alternative investment strategies employ low or moderate levels of leverage and generally use hedging only to reduce foreign exchange or interest rate volatility. At this time, our alternative investment strategies do not include hedge funds. We cannot redeem our investments with the general partners of these investments; however, occasionally these partnerships do trade on the secondary market. Once liquidation is triggered by clauses within the limited partnership agreements or at the funds’ stated end date, we will receive our final allocation of capital and any earned appreciation of the underlying investments, assuming we have not divested ourselves of our partnership interests prior to that time. We currently receive distributions from these alternative investments through the realization of the underlying investments in the limited partnerships. We anticipate that the general partners of these alternative investments will liquidate their underlying investment portfolios through 2022.
(g) At December 31, 2011, we had 26 fixed maturity securities, with a carrying value of $64.6 million, that were pledged as collateral for our outstanding borrowing with the FHLBI. We increased our outstanding borrowing with the FHLBI from $13.0 million to $58.0 million in the fourth quarter of 2011 to borrow funds at favorable interest rates in connection with our year-end acquisition of MUSIC. This outstanding borrowing is included in “Notes payable” on our Consolidated Balance Sheets. In accordance with the terms of our agreement with the FHLBI, we retain all rights regarding these securities, which are included in the “U.S. government and government agencies,” “RMBS,” and “CMBS” classifications of our AFS fixed maturity securities portfolio.
Income from our other investments, specifically our alternative investment portfolio, was the primary driver of the increase in investment income during 2010 when compared to 2009. This increase reflects the improved equity and credit markets in 2010 compared to the prior year. Partially offsetting these improved returns was a $10.9 million reduction in income on our fixed maturity securities portfolio reflecting the interest rate environment. As higher-yielding securities either matured or were sold, they were replaced with lower yielding securities that were available in the market. In 2010, bonds that matured or were sold, valued at $808.3 million, had average pre-tax yields of 3.8%, while new purchases of $1.0 billion had an average yield of 2.8%.
The following is a discussion surrounding the OTTI charges that were recognized in earnings during 2010:
· $8.3 million of RMBS credit OTTI charges were largely driven by impairments on two securities in the first quarter of that we intended to sell. We sold these securities in the second quarter of 2010. The remaining charges related to securities that experienced declines in the related cash flows of their underlying collateral. Based on our analysis, we did not believe it was probable that we would receive all contractual cash flows for these securities.
· $11.8 million of CMBS credit OTTI charges related to reductions in the cash flows of the underlying collateral of these securities. These securities, on average, showed signs of loss at conditional default rates between 2.5 to 3.0 and had declines in fair value of 77% as compared to their amortized cost. As a result, we did not believe it was probable that we would receive all contractual cash flows for these securities.
· The sale of certain equity securities in the first quarter of 2009, resulting in a net realized loss of approximately $0.6 million, comprised of $19.7 million in realized gains and $19.1 million in realized losses, in an effort to reduce overall portfolio risk. The decision to sell these equity positions was in response to an overall year-to-date market decline of approximately 24% by the end of the first week of March. In addition, the Parent's market capitalization at that time had decreased more than 50% since the latter part of January 2009, which we believed to be partially due to investment community views of our equity and equity-like investments. Our equity-like investments include alternative investments, many of which report results to us on a one quarter lag. Consequently, we believed the investment community would wait to evaluate our results based on the knowledge they had of the previous quarter's general market conditions. As a result, we determined it was prudent to mitigate a portion of our overall equity exposure. In determining which securities were to be sold, we contemplated, among other things, security-specific considerations with respect to downward earnings trends corroborated by recent analyst reports, primarily in the energy, commodity, and pharmaceutical sectors.
· The sale of certain equity securities in the second quarter of 2009. A.M. Best changed our ratings outlook from "Stable" to "Negative" due, in part, to concerns over the risk in our investment portfolio. To reduce this risk, we sold $31.1 million of equity securities for a net loss of $0.6 million, which included gross gains of $7.7 million and gross losses of $8.3 million.
Our ability to declare and pay dividends on the Parent's common stock is dependent on liquidity at the Parent coupled with the ability of the Insurance Subsidiaries to declare and pay dividends, if necessary, and/or the availability of other sources of liquidity to the Parent. Restrictions on the ability of the Insurance Subsidiaries to pay dividends, without alternative liquidity options, could materially affect our ability to pay dividends on common stock. The dividends from the Insurance Subsidiaries are subject to the regulatory limitations of the states in which the Insurance Subsidiaries are domiciled: New Jersey, New York, Indiana, or Maine. Based on the unaudited 2011 statutory financial statements, the maximum ordinary dividends that can be paid to the Parent by the Insurance Subsidiaries in 2012 are as follows:
The statutory capital and surplus of the Insurance Subsidiaries in excess of these ordinary dividend amounts must remain with the Insurance Subsidiaries in the absence of approval of an “extraordinary dividend” from the Insurance Subsidiaries’ states of domicile. In each such jurisdiction, domestic insurers are prohibited from paying extraordinary dividends without approval of the insurance commissioner of the respective state. Additionally, New Jersey, Indiana, and Maine require notice of the declaration of any ordinary or extraordinary dividend distribution. During the notice period, the relevant state regulatory authority may disallow all or part of the proposed dividend if it determines that the insurer's surplus, with regard to policyholders, is not reasonable in relation to the insurer's outstanding liabilities and adequate for its financial needs.
(b) The components of comprehensive income (loss), both gross and net of tax, for 2011, 2010, and 2009 were as follows:
The following table presents the carrying amounts and estimated fair values of our financial instruments as of December 31, 2011 and 2010:
For further discussion regarding the fair value valuation techniques for our financial instruments portfolio, refer to Note 2. “Summary of Significant Accounting Policies” in this Form 10-K.
Amounts are reported in “Other net unrealized gains on investment securities, net of deferred income tax” on the Consolidated Statements of Stockholders’ Equity.
The Insurance Subsidiaries remain liable to policyholders to the extent that any reinsurer becomes unable to meet our contractual obligations. We evaluate and monitor the financial condition of our reinsurers under voluntary reinsurance arrangements to minimize our exposure to significant losses from reinsurer insolvencies. On an ongoing basis, we review amounts outstanding, length of collection period, changes in reinsurer credit ratings, and other relevant factors to determine collectability of reinsurance recoverables. The allowance for reinsurance recoverables was $3.9 million at December 31, 2011 and $3.4 million at December 31, 2010.
In 2010, we experienced favorable loss development of approximately $44 million, which was primarily driven by favorable loss development in accident years 2004 through 2007, partially offset by unfavorable loss development in accident years 2008 to 2009 of approximately $24 million. The main driver of this development was favorable prior year development in our commercial automobile and general liability lines of business, partially offset by unfavorable development in our workers compensation line. Commercial automobile experienced favorable development of approximately $28 million driven by lower than anticipated severity emergence primarily in accident years 2004 to 2009. General liability experienced favorable development of approximately $26 million, driven by favorable loss emergence for accident years 2006 and prior, partially offset by adverse development in our products/completed operations business. Workers compensation experienced unfavorable prior year development of approximately $22 million, primarily driven by increases in accident years 2008 and 2009, which have experienced increases in average severity. Our remaining lines of business collectively experienced approximately $11 million of favorable development. While there were some offsetting impacts among these lines, homeowners contributed $6 million of favorable development towards the total development. This was due to lower than expected liability losses in accident years 2008 and 2009.
In 2009, we experienced favorable loss development of approximately $29 million, which was primarily driven by favorable loss development in accident years 2007 and prior, partially offset by unfavorable loss development in accident year 2008 of $29 million. The main driver of this development was favorable prior year development in our workers compensation, commercial automobile, and general liability lines of business. Workers compensation experienced favorable prior year development of approximately $11 million primarily driven by favorable development of $36 million in accident years 2005 to 2007, reflecting the on-going impact from a series of improvement strategies for this line in recent years, partially offset by adverse development of approximately $22 million due to higher than expected severity in accident year 2008. Commercial automobile experienced favorable development of approximately $10 million, driven by lower than anticipated severity emergence, primarily in accident year 2007. General liability experienced favorable development of approximately $8 million, driven by favorable loss emergence for accident years 2004 through 2007, partially offset by adverse development in our products/completed operations business.
(1) On November 15, 2004, we issued $50 million of 7.25% Senior Notes due 2034. These notes were issued at a discount of $0.1 million, resulting in an effective yield of 7.27% and pay interest on May 15 and November 15 each year. We contributed $25.0 million of the bond proceeds to the Insurance Subsidiaries as capital. The remainder of the proceeds were used for general corporate purposes. The agreements covering these notes contain a standard default cross-acceleration provision that provides the 7.25% Senior Notes will enter a state of default upon the failure to pay principal when due or upon any event or condition that results in an acceleration of principal of any other debt instrument in excess of $10 million that we have outstanding concurrently with the 7.25% Senior Notes. There are no attached financial debt covenants to which we are required to comply in regards to these notes.
(3) On September 25, 2006, we issued $100 million aggregate principal amount of 7.5% Junior Subordinated Notes due 2066 ("Junior Notes"). The Junior Notes will pay interest, subject to our right to defer interest payments for up to 10 years, on March 15, June 15, September 15, and December 15 of each year, beginning December 15, 2006, and ending on September 27, 2066. After September 26, 2011, the Junior Notes may be called at any time, in whole or in part, at their aggregate principal amount, together with any accrued and unpaid interest. The net proceeds of $96.8 million from the issuance were used for general corporate purposes. There are no attached financial debt covenants to which we are required to comply in regards to the Junior Notes.
Our Line of Credit was renewed effective June 13, 2011, with Wells Fargo Bank, National Association, as administrative agent, and Branch Banking and Trust Company (BB&T), with a borrowing capacity of $30 million. This amount can be increased to $50 million with the approval of both lending partners. The Line of Credit provides the Parent an additional source of short-term liquidity. The interest rate on our Line of Credit varies and is based on, among other factors, the Parent’s debt ratings. We continue to monitor current news regarding the banking industry, in general, and our lending partners, in particular, as, according to the line of credit agreement, the obligations of the lenders to make loans are several and not joint. The Line of Credit expires on June 13, 2014. There were no balances outstanding under this credit facility as of December 31, 2011 or at any time during 2011.
Our Insurance Operations segment has historically reflected the results of our standard market insurance products. In 2011, through our acquisition activities, we began writing E&S business. This business does not meet the quantitative thresholds for individual segment reporting as its revenue or income are not more than 10% of the related balances aggregated for all of our segments. As our E&S operations share various economic, regulatory, and production-related characteristics with our standard market insurance products, we have aggregated their results into our Insurance Operations segment.
Our standard market Insurance Operations are subject to certain geographic concentrations, particularly in the Northeast and Mid-Atlantic regions of the country. In 2011, approximately 25% of net premiums written were related to insurance policies written in New Jersey.
In 2009, we sold 100% of our interest in Selective HR, which had historically comprised the HR Outsourcing segment of our operations. We sold this interest for proceeds scheduled to be received over a 10-year period based on the ability of the purchaser to retain and generate new worksite lives through our independent agency distribution channel. We have concluded that these proceeds are indirect cash flows since we have no continuing involvement with the operations of Selective HR and have no continuing cash flows other than these proceeds. We recorded after-tax charges of $0.7 million in 2011 and $3.8 million in 2010, respectively, due to our revaluation of the contingent proceeds, including assumptions regarding worksite life generation and retention. As of December 31, 2011, our estimated sales price was approximately $5.9 million, of which $2.7 million has been received to date.
In 2009, we recorded goodwill impairment charges of $7.9 million, after-tax, which was the result of Selective HR’s estimated fair value not being sufficient to support its carrying value. In determining the impairment, we calculated the fair value of that reporting unit utilizing an income approach (i.e. expected present value of future cash flows).
To provide a nationally-licensed platform that allows us to write contract binding authority E&S business, on December 31, 2011, the Parent purchased MUSIC, a wholly-owned E&S lines subsidiary of Montpelier Re Holdings Ltd. (“Montpelier Re”). Under the terms of the agreement, the Parent acquired all of the issued and outstanding shares of MUSIC’s common stock as of December 31, 2011 for $51.5 million, net of cash acquired.
As part of the acquisition, we purchased intangible assets that amounted to approximately $7.3 million. The most significant of these items are licenses and customer lists. The $4.2 million indefinite intangible related to the licenses is reflective of the ability that these licenses provide us to write E&S business in 50 states and the District of Columbia. The $2.5 million finite life intangible asset related to customer lists reflects the access that we have obtained, through the acquisition, to MUSIC’s renewal book of business. Prior to our acquisition, in 2010, MUSIC wrote approximately $48 million of contract binding authority E&S business.
In addition to the assets acquired and liabilities assumed that are detailed in the table above, SICA also purchased intellectual property and information technology assets from Montpelier Re valued at $3.6 million as part of the transaction.
The following table provides a reconciliation of the numerators and denominators of basic and diluted earnings per share ("EPS") of net income:
After considering all evidence, both positive and negative, with respect to our federal tax loss carryback availability, expected levels of pre-tax financial statement income, and federal taxable income, we believe it is more likely than not that the existing deductible temporary differences will reverse during periods in which we generate net federal taxable income or have adequate federal carryback availability. As a result, we have no valuation allowance recognized for federal deferred tax assets at December 31, 2011 and 2010. The carry forward availability of our net operating loss will begin to expire in 2027 with the remainder expiring through 2031. Our alternative minimum tax credits, which are available to offset future regular taxable income, can be carried forward for an unlimited period of time.
Stockholders' equity reflects tax benefits related to compensation expense deductions for share-based compensation awards of $16.6 million at December 31, 2011, $16.7 million at December 31, 2010, and $17.4 million at December 31, 2009.
Selective Insurance Company of America ("SICA") offers a voluntary defined contribution 401(k) plan to employees who meet eligibility requirements. Participants can contribute 2% to 50% of their defined compensation to the Retirement Savings Plan not to exceed limits established by the IRS. Employees age 50 or older who are contributing the maximum may also make additional contributions not to exceed the additional amount permitted by the Internal Revenue Service (“IRS”). Effective October 1, 2011, SICA appointed T. Rowe Price Trust Company as trustee to the Retirement Savings Plan. Certain terms of the Retirement Savings Plan were amended effective January 1, 2011. The following table presents information regarding plan terms in effect as of December 31, 2010 and the related January 1, 2011 revisions:
(1) Effective January 1, 2006, the Retirement Savings Plan was amended to include additional enhanced matching contributions and non-elective contributions for otherwise eligible employees who, because of their date of hire after December 31, 2005, are not eligible to participate in the Retirement Income Plan for Selective Insurance Company of America (“Retirement Income Plan”).
The Retirement Savings Plan allows employees to make voluntary contributions to a number of diversified investment options on a before and/or after-tax basis. Until March 10, 2009, the Parent’s common stock fund had been an investment option, but on such date, this fund was closed to new contributions. Shares of the Parent's common stock issued under this plan were 13,983 during 2009.
In addition to the deferrals elected by the Participants, SICA may also choose to make matching contributions to the deferral accounts of some or all Participants to the extent a Participant did not receive the maximum matching contribution permissible under the Retirement Savings Plan due to limitations under the Internal Revenue Code or the Retirement Savings Plan. The Deferred Compensation Plan was amended effective January 1, 2010 to add a non-elective contribution of 4% of eligible compensation to the extent a participant could not receive the maximum non-elective contribution in the Retirement Savings Plan due to the limitations of the Retirement Savings Plan and the Internal Revenue Code. SICA may also choose at any time to make discretionary contributions to the deferral account of any Participant in our sole discretion. No discretionary contributions were made in 2011, 2010, or 2009. SICA contributed $0.1 million in 2011, $0.2 million in 2010, and $0.1 million in 2009 to the Deferred Compensation Plan.
The Retirement Income Plan is a noncontributory defined benefit plan covering all SICA employees who met eligibility requirements prior to January 1, 2006. As of such date, the plan was amended to eliminate eligibility for plan participation by employees first hired on or after January 1, 2006. If otherwise qualified, these employees will, however, be eligible for non-elective contributions from SICA under the Retirement Savings Plan as discussed above.
The funded status of the Retirement Income Plan and Retirement Life Plan was recognized on the Consolidated Balance Sheets for 2011 and 2010, the details of which are as follows:
The estimated net actuarial loss and prior service cost for the Retirement Income Plan that will be amortized from AOCI into net periodic benefit cost during the 2012 fiscal year are $5.5 million and $0.2 million, respectively.
Our 2011 discount rate used to value the liability was 5.16% for both the Retirement Income Plan and the Retirement Life Plan. When determining the most appropriate discount rate to be used in the valuation, we consider, among other factors, our expected pay out patterns of the plans' obligations as well as our investment strategy and we ultimately select the rate that we believe best represents our estimate of the inherent interest rate at which our pension benefits can be effectively settled.
Assets of the Retirement Income Plan are invested to ensure that principal is preserved and enhanced over time. In addition, the Retirement Income Plan is expected to perform above average relative to comparable funds without assuming undue risk, and to add value through active management. Our return objective is to exceed the returns of the plan's policy benchmark, which is the return the plan would have earned if the assets were invested according to the target asset class weightings and earned index returns. The Retirement Income Plan's exposure to a concentration of credit risk is limited by the diversification of investments across varied financial instruments, including common stocks, mutual funds, non-publicly traded stocks, investments in limited partnerships, fixed income securities, and short-term investments. Allocations to these instruments may vary from time to time. In 2012, we will continue to phase in adjustments to the asset allocation of the Retirement Income Plan to a more liability driven investment strategy.
· The deposit administration contract is carried at cost, which approximates fair value. Given the liquid nature of the underlying investments in overnight cash deposits and other short term duration products, we have determined that a correlation exists between the deposit administration contract and other short-term investments such as money market funds. As such, this investment is classified as Level 2 in the fair value hierarchy.
· For valuations of the investments in limited partnerships, fair value is based on the Retirement Income Plan’s ownership interest in the reported net asset values as a practical expedient. The majority of the net asset values are reported to us on a one quarter lag. We assess whether these reported net asset values are indicative of market activity that has occurred since the date of their valuation by the investees: (i) by reviewing the overall market fluctuation and whether a material impact to our investments' valuation could have occurred; and (ii) through routine conversations with the underlying funds' general partners/managers discussing, among other things, conditions or events having significant impacts to their portfolio assets that have occurred subsequent to the reported date, if any. The majority of the limited partnership investments cannot be redeemed with the investees as our partnership agreements require our commitment for the duration of the underlying funds’ lives. In the fourth quarter of 2010, we sold three of our limited partnership interests in the secondary market. As of December 31, 2011, there is no active plan to sell any of our remaining interests in the limited partnership investments; however, given the volatility in these investments over the recent past, we may continue to entertain potential opportunities to limit our exposure to these investments through the use of the secondary market. These limited partnerships have been fair valued using Level 3 inputs. The Retirement Income Plan has one limited partnership investment in a hedge fund that can be redeemed semi-annually subject to a 30 day notification of intent to redeem. Therefore, we are unable to redeem this investment at the net asset value reported to the plan at December 31, 2011 and 2010. However, we have determined that we have the ability to redeem this investment in the near term and the time between the redemption date and the valuation date is not significant enough to allow for a significant change in fair value. As a result of this determination, this fund has been fair valued using Level 2 inputs as of December 31, 2011 and 2010 using the net asset value of our ownership interest in partners' capital.
For a description of our private equity and real estate strategies, refer to Note 5. “Investments.” Our Equity long/short hedge strategy invests opportunistically in equities and equity-related instruments in companies generally in the financial services sector. Investments within this strategy are permitted to be sold short in order to: (i) prospectively benefit from a correction in overvalued equities; and (ii) partially hedge portfolio assets due to the strategy’s heavy weighting toward the financial sector.
The following is a brief description of each of our share-based compensation plans:
During the vesting period, dividend equivalent units ("DEUs") are earned on RSUs. The DEUs are reinvested in the Parent's common stock at fair value on each dividend payment date. We accrued 41,469 DEUs during 2011; 38,392 DEUs during 2010; and 32,088 DEUs in 2009. In addition, 33,532 DEUs were issued in 2011. The DEUs are subject to the same vesting period and conditions set forth in the award agreements for the RSUs.
The Parent's Cash Incentive Plan (“Cash Incentive Plan”) was approved effective April 1, 2005 by stockholders on April 27, 2005. Stockholders approved the amendment and restatement of the Cash Incentive Plan effective as of May 1, 2010 (the “Amended Cash Incentive Plan”) on April 28, 2010. Under the Amended Cash Incentive Plan, the SEBC may grant cash incentive units in such amounts and with such terms and conditions as it shall determine, subject to the provisions of the Amended Cash Incentive Plan. The initial dollar value of these grants will be adjusted to reflect the percentage increase or decrease in the total shareholder return on the Parent's common stock over a specified performance period. In addition, for certain grants, the number of units granted will be adjusted to reflect our performance on specified indicators as compared to targeted peer companies. Each award granted under the Amended Cash Incentive Plan shall be evidenced by an agreement containing such restrictions as the SEBC may, in its sole discretion, deem necessary or desirable and which are not in conflict with the terms of the Amended Cash Incentive Plan. We granted, net of forfeitures, 46,879 cash incentive units during 2011, 45,082 cash incentive units during 2010, and 46,349 cash incentive units during 2009.
As of December 31, 2011, 302,680 shares of the Parent's common stock remained available in the reserve for Stock Option Plan II, under which future grants ceased being available on May 22, 2002. Under Stock Option Plan II, employees were granted qualified and nonqualified stock options, with or without SARs, and restricted or unrestricted stock: (i) at not less than fair value on the date of grant; and (ii) subject to certain vesting periods as determined by the SEBC. Restricted stock awards also could be subject to the achievement of performance objectives as determined by the SEBC. The maximum exercise period for an option grant under this plan was ten years from the date of the grant.
As of December 31, 2011, 210,000 shares of the Parent's common stock remained in the reserve for the Stock Option Plan for Directors, under which future grants ceased being available with the approval of the Stock Plan. Non-employee directors participated in this plan and automatically received an annual nonqualified option to purchase 6,000 shares of the Parent's common stock at not less than fair value on the date of grant, which was on March 1. Options under this plan vested on the first anniversary of the grant and must be exercised by the tenth anniversary of the grant.
On April 29, 2009, the Parent’s stockholders approved the Parent’s Employee Stock Purchase Plan (2009) (“ESPP”). This plan replaced the previous employee stock purchase savings plan under which no further purchases could be made as of July 1, 2009. Under the ESPP, there were 1,122,962 shares of the Parent's common stock available for purchase as of December 31, 2011. The ESPP is available to all employees who meet the plan's eligibility requirements. The ESPP provides for the issuance of options to purchase shares of common stock. The purchase price is the lower of: (i) 85% of the closing market price at the time the option is granted; or (ii) 85% of the closing price at the time the option is exercised. Shares are generally issued on June 30 and December 31 of each year. Under the current plan, we issued 131,705 shares to employees during 2011, 149,258 shares during 2010, and 190,845 shares during 2009.
On July 27, 2010, the SEBC approved the Parent’s Amended and Restated Stock Purchase Plan for Independent Insurance Agencies ("Agent Plan") which made immaterial amendments to the plan approved by stockholders on April 26, 2006. Under the Agent Plan, there were 2,274,131 shares of the Parent’s common stock available for purchase as of December 31, 2011. The Agent Plan provides for quarterly offerings in which our independent insurance agencies, and certain eligible persons associated with the agencies, with contracts with the Insurance Subsidiaries can purchase the Parent's common stock at a 10% discount with a one year restricted period during which the shares purchased cannot be sold or transferred. Under the Agent Plan, we issued 111,427 shares in 2011, 109,343 shares in 2010, and 146,570 shares in 2009, and charged to expense $0.2 million in each year, with a corresponding income tax benefit of $0.1 million in each year.
The total intrinsic value of options exercised was $0.8 million during 2011 and 2010, and $0.4 million during 2009.
At December 31, 2011, the liability recorded in connection with our Cash Incentive Plan was $8.8 million. The fair value of the liability is re-measured at each reporting period through the settlement date of the awards, which is three years from the date of grant based on an amount expected to be paid. A Monte Carlo simulation is performed to approximate the projected fair value of the cash incentive units that, in accordance with the Cash Incentive Plan, are adjusted to reflect our performance on specified indicators as compared to targeted peer companies. The remaining cost associated with the cash incentive units is expected to be recognized over a weighted average period of 1.1 years. The cash incentive unit payments made were $3.0 million in 2011, $1.8 million in 2010 and $7.0 million in 2009.
The grant date fair value of RSUs is based on the market price of our common stock on the grant date, adjusted for the present value of the our expected dividend payments. The expense recognized for share-based awards is based on the number of shares or units expected to be issued at the end of the performance period and the grant date fair value, and is amortized over the requisite service period.
The decrease in the six month option value of our ESPP shares in 2011 and 2010, compared to their respective prior years, is driven primarily by a reduction in the volatility of the Parent’s common stock price. During 2009, as a result of the economic crisis and its impact on the global markets, particularly in the financial sector, the Parent’s common stock prices experienced unprecedented volatility, whereas the volatility in 2010 and 2011 returned to more normalized levels.
· Rue Insurance placed insurance policies with the Insurance Subsidiaries. Direct premiums written associated with these policies were $7.8 million in 2011, $7.2 million in 2010, and $7.6 million in 2009. In return, the Insurance Subsidiaries paid commissions to Rue Insurance of $1.2 million in 2011, $1.3 million in 2010, and $1.4 million in 2009.
· Rue Insurance placed insurance coverage for us with other insurance companies for which Rue Insurance was paid commission pursuant to its agreements with those carriers. We paid premiums for such insurance coverage of $0.2 million in 2011, $0.3 million in 2010, and $0.5 million in 2009.
(a) We purchase annuities from life insurance companies to fulfill obligations under claim settlements that provide for periodic future payments to claimants. As of December 31, 2011, we had purchased such annuities in the amount of $8.4 million for settlement of claims on a structured basis for which we are contingently liable. To our knowledge, none of the issuers of such annuities have defaulted in their obligations thereunder.
In addition, certain leases for rented premises and equipment are non-cancelable, and liability for payment will continue even though the space or equipment may no longer be in use. At December 31, 2011, the total future minimum rental commitments under non-cancelable leases were $25.4 million and such yearly amounts are as follows:
(c) At December 31, 2011, we have contractual obligations that expire at various dates through 2022 to invest up to an additional $56.9 million in alternative and other investments. There is no certainty that any such additional investment will be required. For additional information regarding these investments, see item (f) of Note 5. "Investments."
The combined statutory capital and surplus of the Insurance Subsidiaries was $1.1 billion (unaudited) in 2011 and in 2010. Excluding the recently-acquired MUSIC entity, the combined statutory net income of the Insurance Subsidiaries was $26.5 million (unaudited) in 2011, $86.9 million in 2010, and $69.8 million in 2009.
2 See Note 10. “Indebtedness” for a discussion of dividend restrictions.