Selective's main office is located in Branchville, New Jersey on a site owned by a subsidiary with approximately 114 acres and 315,000 square feet of operational space. Selective leases all of its other facilities. The principal office locations related to Selective's three business segments are described in the "Field Strategy" and "Human Resource Administration Outsourcing" sections of Item 1. "Business." Selective believes that its facilities provide space for its present needs and that additional space, if needed, would be available on reasonable terms.
See Item 8. "Financial Statements and Supplementary Data," Note 13 to the consolidated financial statements and
The purpose of the Management's Discussion and Analysis ("MD&A") is to provide an understanding of the consolidated results of operations and financial condition and known trends and uncertainties that may have a material impact in future periods. For convenience and reading ease, we have written the MD&A in the first person plural.
• Highlights of Results for years ended December 31, 2005, 2004, and 2003;
We have identified the policies and estimates described below as critical to our business operations and the understanding of the results of our operations. Our preparation of the consolidated financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurance that actual results will not differ from those estimates. We consider our most significant accounting policies and estimates to be those applied to establish reserves for loss and loss expenses, deferred acquisition costs, pension and post-retirement plan expenses, and other-than-temporary investment impairments.
Significant periods of time 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. To recognize liabilities for unpaid losses and loss expenses, insurers establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported net losses and loss expenses. As of December 31, 2005, the Company had accrued $2.1 billion of loss and loss expense reserves compared to $1.8 billion at December 31, 2004.
As of December 31, 2005, we established a range of reasonably possible reserves for net claims of approximately $1,764 million to $1,950 million and of $1,529 million to $1,695 million at December 31, 2004. A low and high reasonable reserve selection was derived primarily by considering the range of indications calculated using generally accepted actuarial techniques. Such techniques assume that past experience, adjusted for the effects of current developments and anticipated trends, are an appropriate basis for predicting future events. Although this range reflects the most likely scenarios, it is possible that the final outcomes may fall above or below these amounts. This range does not include a provision for potential increases or decreases associated with environmental reserves, as management believes it is not meaningful to calculate a range given the uncertainties associated with environmental claims. The Company does not discount to present value that portion of its loss reserves expected to be paid in future periods; however, the loss reserves include anticipated recoveries for salvage and subrogation claims.
The table below summarizes the number of asbestos and non-asbestos claims outstanding at December 31, 2005, 2004, and 2003. For additional information about our environmental reserves, see Item 1. "Business," Item 8. "Financial Statements and Supplementary Data," Note 6 to the consolidated financial statements.
The Company's pension benefit and postretirement life benefit obligations and related costs are calculated using actuarial concepts, within the framework of Statement of Financial Accounting Standards No. 87 Employers' Accounting for Pensions ("SFAS 87") and Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other than Pension ("SFAS 106"), respectively. 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 flow as a present value on the measurement date. The guideline for setting this rate is a high-quality long-term corporate bond rate. A lower discount rate increases the present value of benefit obligations and increases pension expense. We reduced our discount rate to 5.75% for 2005, from 6.25% in 2004, to reflect market interest rate conditions. To determine the expected long-term rate of return on the plan assets, we consider the current and expected asset allocation, as well as historical and expected returns on each plan asset class. A lower expected rate of return on pension plan assets would increase pension expense. Our long-term expected return on plan assets was 8.00% in 2005 and 8.25% in 2004. Changes in the related pension and postretirement benefit expense may occur in the future due to changes in these assumptions.
For additional information regarding the Company Pension and Postretirement Benefit Plan, see Item 8. "Financial Statements and Supplementary Data," Note 14(d) to the consolidated financial statements.
• The degree to which an issuer is current or in arrears in making principal and interest payments on the fixed maturity securities in question;
• The issuer's current financial condition and its ability to make future scheduled principal and interest payments on a timely basis;
• Relevant rating history, analysis and guidance provided by rating agencies and analysts; and
• The length of time and the extent to which the fair value has been less than carrying value.
Direct voluntary new business written of $289.2 million in 2005 compared to $264.9 million in 2004, and $268.7 million in 2003;
• Net income from continuing operations increased in 2005 compared to 2004 and 2003, primarily due to the following:
Lower weather-related catastrophe losses, which reduced net income by $3.0 million after tax in 2005 compared to $12.0 million after tax in 2004, and $19.7 million after tax in 2003;
Partially offset in 2005 by decreases in net realized gains of 41%, or $6.6 million compared to increases in 2004 of 91%, or $7.6 million. The decrease in net realized gains in 2005 compared to 2004, as well as the increase in net realized gains in 2004 compared to 2003, is primarily due to the sale of a single equity security in 2004, which resulted in a $9.7 million after-tax gain.
• Return on average equity improvements since 2003 are the result of the improvements to net income noted above coupled with our capital management techniques, which included repurchases of 335,000 shares of our common stock at a cost of $16.3 million in 2005 and 141,000 shares at a cost of $4.9 million in 2004 under the Company's authorized share repurchase programs. For further description of these programs, see Note 8 in Item 8. "Financial Statements and Supplementary Data" of this Form 10-K.
Our Insurance Operations segment writes our property and casualty insurance business in six insurance subsidiaries (the "Insurance Subsidiaries"). Our Insurance Operations segment sells property and casualty insurance products and services primarily in 20 states in the Eastern and Midwestern United States through approximately 750 independent insurance agencies, and we have at least one Insurance Subsidiary licensed to do business in each of the 50 states. Our Insurance Operations segment consists of two components: (i) commercial lines ("Commercial Lines"), which markets primarily to businesses, and represents approximately 86% of net premiums written ("NPW"), and (ii) personal lines ("Personal Lines"), which markets primarily to individuals and represents approximately 14% of NPW. The underwriting performance of these lines are generally measured by four different statutory ratios: (i) loss and loss expense ratio, (ii) underwriting expense ratio, (iii) dividend ratio, and (iv) combined ratio. For further details regarding these ratios see the discussion in the "Insurance Operations Results" section of Item 1. "Business" of this Form 10-K.
1 The statutory ratios include Selective's flood line of business, which is included in the Diversified Insurance Services Segment on a GAAP basis and
• Market Planning. Through business demographic and geographic analysis, this strategy: (i) identifies underserved markets in existing territories; (ii) identifies other areas for potential organic growth that may require additional agent appointments or field underwriter deployment; and (iii) enhances our ability to replicate success across different markets;
• Workers Compensation. This strategy includes six key initiatives that focus on predictive modeling, loss control, and maximizing our quality agency relationships.
Year-on-year renewal retention remaining level for 2005, 2004, and 2003; and
Lower weather-related catastrophe losses, which accounted for only 0.3 points of the GAAP loss and loss expense ratio for 2005, compared to 1.5 points for 2004, and 2.4 points for 2003; and
Due to the demands of the commercial marketplace, we include workers compensation as part of our overall product portfolio. Our overall commercial lines statutory combined ratio was a profitable 93.6% in 2005, 95.4% in 2004, and 100.9% in 2003. However, the workers compensation line continues to challenge us and has not been profitable in 2005, 2004 or 2003. In 2005, the lack of profitability was largely due to adverse statutory prior year loss and loss expense development of approximately $40 million. The adverse statutory prior year loss and loss expense development in 2004 was $4 million, and $1 million in 2003. As workers compensation is a long-tail line, it takes many years to develop. Over the course of 2005, we accumulated sufficient evidence of adverse loss trends, specifically in medical costs, in the 2001 and prior accident years to warrant an increase in management's best estimates within the loss range. Additionally, rating agency downgrades of certain reinsurers during 2004 caused us to reevaluate our ability to collect under certain reinsurance contracts, which resulted in an increase to our statutory loss reserves of $1.8 million to this line of business compared to prior periods.
The improvement in the statutory combined ratio in the Business Owners' Policy line of business is the result of pricing and underwriting actions that were taken over the past year, including ceasing to underwrite certain classes of business that have been consistently unprofitable and focusing growth on more profitable segments. The decrease in premiums in this line is due to the elimination of certain classes of business from our underwriting eligibility guidelines.
As was discussed in the "Insurance Operations Outlook" section above, the record catastrophe losses impacting the insurance industry in 2005 had minimal impact on our Commercial Lines business this year as our Commercial Property line of business experienced unusually low levels of weather-related catastrophe losses. Although we experienced minimal catastrophe losses this year, industry losses are expected to drive up reinsurance costs for all primary carriers. However, in spite of the overall marketplace challenges, the property and casualty industry saw an increase in surplus, or capital, which can create increased competition for a market that A.M. Best expects to grow by only 3%. The 2006 pricing environment will depend largely on the discipline of our competitors to focus on profitability. Although we are prepared for continued pricing pressure in 2006, we believe our 2005 market share of 1% in our 20 primary states, (based on our Commercial Lines NPW of $1.3 billion in 2005) combined with our strategic initiatives, provides us with substantial opportunities in 2006 for profitable growth in our current operating territories.
1 The statutory ratios include Selective's flood line of business, which is included in the Diversified Insurance Services Segment on a GAAP basis
and therefore excluded from the GAAP ratios. The total Statutory Combined Ratio excluding flood is 105.0 % for 2005, 101.8% for 2004, and
In 2005, Personal Lines NPW and NPE decreased compared to 2004 and 2003 primarily due to increased competition in New Jersey personal automobile, resulting in a cumulative decrease in rates of 5.2% along with a 10% reduction in the number of cars we insure during 2005 compared to 2004. Increases in 2004 compared to 2003 were primarily attributable to new business and renewal premium price increases. In 2004, there was an increase in rates of 6.3% along with an 8% reduction in the number of cars we insure compared to 2003.
The Personal Lines 2005 GAAP underwriting expense ratio reflected pressure from declining premiums, which were outpacing overall reductions in underwriting expenses, thereby negatively impacting the ratio compared to 2004. The reductions in the overall underwriting expenses in 2005 and 2004 are primarily attributable to increases in our ceded NJ Homeowners Quota share program and reductions in our New Jersey and New York limited assignment and distribution charges. Correspondingly, the decrease in the 2004 GAAP underwriting expense ratio compared to 2003 reflects the decreases in these expenses.
The increase in competition in the New Jersey automobile market reflects many new market entrants, including well-capitalized national carriers, and fewer regulatory constraints. Increased competition due to fewer regulatory constraints coupled with our older rating plans has led to overall pricing pressure in the Personal Automobile line of business. We are actively addressing this issue through the personal lines strategy discussed in the "Personal Lines Outlook" below.
Our overall year-over-year improved performance in 2005 and 2004 reflects lower catastrophe losses as well as premium growth. Weather-related catastrophe losses were only $0.6 million, or 1.7 points, during 2005 compared to $2.0 million, or 5.9 points, during 2004, and $7.2 million, or 23.0 points, during 2003. Offsetting further improvement in this line of business in 2004 compared to 2003 was the severity associated with unusual fire losses coupled with an approximately $2.0 million addition to our homeowners losses in 2004 resulting from unfavorable trends in claims related to groundwater contamination from leaking underground heating oil storage tanks in New Jersey that added 5.8 points to the statutory combined ratio in this line of business for 2004. Increased frequency of claims was triggered, in part, by New Jersey's robust real estate market that led to an increase in home tank inspections.
• Property Reinsurance - includes our Property Excess of Loss treaty 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 utilized for 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 utilized for risks that are in excess of our treaty capacity.
The Casualty Excess of Loss program, was restructured effective July 1, 2005 into the following two separate treaties to more efficiently transfer workers compensation risk, while retaining more of the predictable casualty lines. The two treaties are as follows:
(i) Workers Compensation only treaty ("WC Treaty"), covering up to $3.0 million in excess of $2.0 million per occurrence; and
On November 26, 2002 TRIA was signed into law. In 2005, TRIA was amended and extended through December 31, 2007. TRIA establishes a temporary federal program of shared public and private compensation for insured commercial property and casualty losses resulting from an "act of terrorism," as defined in TRIA ("Certified Loss"). Insurance companies with direct commercial insurance exposure in the United States are required to participate in the program. Selective offers its commercial policyholders the option to purchase terrorism coverage that will provide protection against a TRIA certified event. Some states require mandatory coverage of terrorism losses for certain lines of business and terrorism cannot be excluded under any workers compensation policy as a cause of loss. In 2005, approximately 90% of our commercial non-workers compensation policyholders purchased terrorism coverage. While the provisions of TRIA will serve to mitigate our exposure in the event of a large-scale terrorist attack, our deductible is substantial, approximating $160 million in 2006. In addition, it is uncertain whether TRIA will be extended past its current termination date in December 2007. As a result, we continue to monitor concentrations of risk and have purchased a separate terrorism treaty to supplement our protection to this highly unknown exposure.
Our Surety and Fidelity Excess of Loss treaty was renewed effective January 1, 2006 with essentially no changes in coverage and a reduction in premium rate. We realized a 10% reduction in the premium rate as compared to the 2005 treaty.
Our investment portfolio consists primarily (82%) of fixed maturity investments, but we also hold equity securities, short-term investments and alternative investments. Our investment philosophy includes certain return and risk objectives for our fixed maturity and equity portfolios. The primary return objective of the fixed maturity portfolio is to maximize after-tax investment yield and income while balancing certain risk objectives, with a secondary objective of meeting or exceeding a weighted-average benchmark of public fixed income indices. The return objective of the equity portfolio is to meet or exceed a weighted-average benchmark of public equity indices. The risk objectives for all portfolios are to ensure investments are being structured conservatively, focusing on (i) asset diversification, (ii) investment quality, (iii) liquidity particularly to meet the cash obligations of the insurance operations, (iv) consideration of taxes, and (v) preservation of capital.
The following table presents the Moody's and S&P's ratings of our fixed maturities portfolio:
At December 31, 2005, our investment portfolio included three non-investment grade securities (lower than a BBB- rating) with an amortized cost of $10.5 million and a fair value of $10.3 million, or 0.4% of the portfolio. At December 31, 2004, non-investment grade securities in our investment portfolio represented 0.2% of the portfolio, with an amortized cost of $5.0 million, and a fair value of $5.1 million. The fair value of these securities was determined by independent pricing services or bid prices provided by various broker dealers. We did not have a material investment in non-traded securities at December 31, 2005 or December 31, 2004.
The following table summarizes the Company's net realized gains by investment type:
Generally, the Insurance Subsidiaries have a duration mismatch between assets and liabilities. The duration of the fixed maturity portfolio is 4.3 years while the Insurance Subsidiaries liabilities have a duration of approximately 2.9 years. The current duration of our fixed maturities is within our historical range and is monitored and managed to maximize yield and limit interest rate risk. The duration mismatch is managed with a laddered maturity structure and an appropriate level of short term investments that avoids liquidation of available-for-sale fixed maturities in the ordinary course of business. Liquidity is always a consideration when buying or selling securities, but because of the high quality and active market for our investment portfolio, the securities sold have not diminished the overall liquidity of our portfolio. Our liquidity requirements in the past have been met by operating cash flow from our Insurance Operations and Diversified Insurance Services segments and the issuance of debt and equity securities. We expect our liquidity requirements in the future to be met by these sources of funds or, if necessary, borrowings from our credit facilities.
The following table summarizes the aggregate fair value and gross pre-tax unrealized loss recorded in our accumulated other comprehensive income, by asset class and by length of time, for all available-for-sale securities that have continuously been in an unrealized loss position at December 31, 2005 and December 31, 2004:
We believe that pre-tax investment income will continue to grow as a result of strong cash flow from Insurance Operations. As the Federal Reserve is not expected to finish its monetary tightening cycle until mid-2006, we expect continued volatility in the fixed income market during 2006. To manage our interest rate risk, we aim to keep portfolio duration stable and to maintain a well-laddered maturity structure for our bond portfolio. With regard to our equity portfolio, we are committed to pursuing opportunities in industries with favorable fundamentals and will continue to reduce exposure to those stocks or sectors with less favorable fundamentals and valuations. Additionally, our alternative investment portfolio has performed well over the past few years and as a result we are looking to modestly grow this investment class as a percentage of our overall portfolio, which should contribute to lowering our overall portfolio risk given that these investments have a low correlation to the S&P 500 index.
In December 2005, we divested ourselves of 100% ownership in CHN Solutions (Alta Services, LLC and Consumer Health Network Plus, LLC), which had historically been reported as part of the managed care component of the Diversified Insurance Services segment. These companies were sold for approximately $16 million in proceeds at an after tax net loss of approximately $2.6 million. For further information regarding this divestiture, see Note 13 in Item 8. "Financial Statements and Supplementary Data" of this Form 10-K.
The Diversified Insurance Services operations now include two core functions: human resource administration outsourcing (HR Outsourcing) and flood insurance. We believe these operations are within markets that continue to offer opportunity for growth. During 2005, these operations provided a contribution of $0.30 per diluted share compared to $0.24 per diluted share in 2004, and $0.15 per diluted share in 2003. These contributions continue to provide a level of mitigation to commercial lines pricing cycles and the adverse impact that catastrophe losses have on our Insurance Operations segment. We measure the performance of these operations based on several measures, including, but not limited to, results of operations in accordance with GAAP. The results for this segment's continuing operations are as follows:
• Profitability improvements in this business in 2005 compared to 2004, and in 2004 compared to 2003, are mainly due to: (i) operating expense reductions that have been implemented over the past few years; (ii) improved workers compensation margins; and (iii) higher average administration fees per worksite employee of $642 in 2005, compared to $596 in 2004, and $559 in 2003.
• As of December 31, 2005, our worksite lives were up 5% to 23,974, compared to 22,846 as of December 31, 2004, and 20,254 as of December 31, 2003.
• Flood premium in force was $93.7 million on approximately 222,000 policies at December 31, 2005, compared to premium in force of $78.0 million on approximately 188,000 policies at December 31, 2004, and $65.8 million in premium in force on approximately 162,000 policies at December 31, 2003.
• Pre-tax profit increased as a direct result of the higher revenues discussed above for 2005 compared to 2004 and 2003.
Capital resources and liquidity represent our overall financial strength and our ability to generate cash flows from business operations, borrow funds at competitive rates, and raise new capital to meet operating and growth needs.
Dividends on shares of our common stock are declared and paid at the discretion of our Board of Directors based on our operating results, financial condition, capital requirements, contractual restrictions, and other relevant factors. Our ability to declare dividends is restricted by covenants contained in the notes payable that we issued on May 4, 2000 ("2000 Senior Notes"). For further information regarding our notes payable, see Note 7 of the Notes to Consolidated Financial Statements, entitled, "Indebtedness", included in Item 8. "Financial Statements and Supplementary Data." All such covenants were met during 2005 and 2004. At December 31, 2005, the amount available for additional dividends to holders of our common stock under such restrictions was $333.0 million for the 2000 Senior Notes. As a result of our continued strong performance throughout 2005, the Board of Directors increased our quarterly cash dividend to stockholders by 16%, to $0.22 per share in the third quarter of 2005. Our ability to continue to pay dividends to our stockholders is also dependent in large part on the dividend paying ability of our Insurance Subsidiaries and the subsidiaries in our Diversified Insurance Services segment. Restrictions on the ability of those subsidiaries, particularly the Insurance Subsidiaries, to declare and pay dividends to us could materially affect our ability to pay principal and interest on indebtedness and dividends on common stock.
Our liquidity requirements in the past have been met by the operating cash flows from our subsidiaires and the issuance of debt and equity securities. We expect our liquidity requirements in the future to be met by these sources of funds or, if necessary, borrowings from our lines of credit.
Capital resources provide protection for policyholders, furnish the financial strength to support the business of underwriting insurance risks, and facilitate continued business growth. At December 31, 2005, we had stockholders' equity of $981.1 million and total debt of $339.4 million.
As active capital managers we continually monitor our cash requirements as well as the amount of capital resources that we maintain at the holding company and operating subsidiaries. As part of our long-term capital strategy, we strive to maintain a 25% debt-to-capital ratio and a sufficient premiums to surplus ratio to maintain an "A+ (Superior)" A.M. Best Rating. Based on our analysis and market conditions, we may take a variety of actions including, but not limited to contributing capital to subsidiaries in our Insurance Operations and Diversified Insurance Services segments, issuing additional debt and/or equity securities, repurchasing shares of our company stock, or increasing stockholders' dividends. The following are a few examples of capital management actions that were taken during 2005:
• In November 2005, the Parent successfully completed a $100 million bond offering. The security is a 30-year senior note with a 6.7% coupon. The Parent contributed approximately $50 million of the bond proceeds to an irrevocable trust to provide for certain payment obligations in respect to its outstanding debt. The market value of this trust is $48.8 million as of December 31, 2005. The remainder will be deployed for general corporate purposes, which may include opportunistic share repurchases or further capital contributions to the Insurance Operations, depending on the need for growth.
• On April 26, 2005 our Board of Directors adopted a share repurchase program authorizing us to repurchase up to 5.0 million shares of our common stock. During 2005, approximately 335,000 shares were repurchased at an average price per share of $48.65. The repurchase program is scheduled to expire on April 26, 2007.
At December 31, 2005 and 2004, the Company did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As such, the Company is not exposed to any financing, liquidity, market or credit risk that could arise if the Company had engaged in such relationships.
1 Selective has an irrevocable trust to provide for the repayment of certain debt obligations with a market value of $48.8 million as of December 31, 2005.
We currently have available revolving lines of credit amounting to $45.0 million, under which no balances are outstanding as of either December 31, 2005 or 2004. For more information regarding the Company's lines of credit, see Item 8. "Financial Statements and Supplementary Data," Note 7(d) to the consolidated financial statements. We have issued no material guarantees on behalf of others and have no trading activities involving non-exchange traded contracts accounted for at fair value. We have no material transactions with related parties other than those disclosed in Item 8. "Financial Statements and Supplementary Data," Note 17 to the consolidated financial statements.
Given that the loss and loss expense reserves are estimates as described above and in more detail under the "Critical Accounting Policies and Estimates" section of this Form 10-K, the payment of these estimates are generally not fixed as to amount or timing. Due to this uncertainty, financial accounting standards prohibit us from discounting these reserves to their present value. Additionally, estimated losses as of the financial statement date do not consider the impact of estimated losses from future business. Therefore, the projected settlement of the reserves for net loss and loss expenses will differ, perhaps significantly, from actual future payments.
Our future projected cash payments associated with our estimate of loss and loss expense reserves as of December 31, 2005 are summarized below:
Our total federal income tax expense increased $9.7 million in 2005 to $55.3 million, compared to $45.6 million in 2004 and $20.6 million in 2003. These amounts reflect an effective tax rate of 27.3% in 2005, compared to 26.4% for 2004, and 24.2% for 2003. Our effective rate differs from the federal corporate tax rate of 35% primarily as a result of tax-exempt investment income and the dividends received deduction. The increase in the effective tax rate in 2005, as compared to 2004 and 2003, is mainly attributable to significant improvements in underwriting results and increased capital gains on investment sales. In 2004, the improvement in the underwriting results were slightly offset by lower levels of taxable investment income, and a favorable resolution of an IRS appeals issue, which resulted in a benefit of $2.3 million. The benefit was in the form of a reduction to the Company's current federal income taxes payable that included a reserve specific to this issue. The IRS had attempted to disallow, on a consolidated basis, a deduction for interest expense incurred by the Parent while its Insurance Subsidiaries held municipal bonds. The Company established reserves over the course of the examination as follows: $0.9 million in 2003, and $1.4 million in prior years. A notice that the issue was resolved in the Company's favor was received on September 30, 2004, at which time the entire accrual was reversed.
The Company has a net deferred tax liability of $5.7 million at December 31, 2005 compared with $29.8 million at December 31, 2004. This change is mainly the result of the application of Alternative Minimum Tax credits against regular tax in the current year, increased unrealized gains on the available-for-sale investment portfolio, and increased deferred policy acquisition costs, offset by the increase in the discount on loss and loss expense reserves and increased unearned premium reserves. The following table presents the Company's taxable income, pre-tax financial statement income, and net deferred tax (liability) asset:
We have audited the accompanying consolidated balance sheets of Selective Insurance Group, Inc. and its subsidiaries as of December 31, 2005 and 2004, 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, 2005. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules I to VI. 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, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, 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.
As discussed in note 2 to the consolidated financial statements, in 2005 the Company changed its method of accounting for share-based payments.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Selective Insurance Group's internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 28, 2006 expressed an unqualified opinion on management's assessment of, and the effective operation of, internal control over financial reporting.
Increase in unearned premiums, net of prepaid reinsurance and advance premiums
Cash retained for tax deductibility of the increase in value of equity instruments
The accompanying consolidated financial statements, which include the accounts of Selective and its subsidiaries, have been prepared in conformity with (i) accounting principles generally accepted in the United States of America ("GAAP"); and (ii) the rules and regulations of the U.S. Securities and Exchange Commission ("SEC"). All significant intercompany accounts and transactions between Selective and its subsidiaries are eliminated in consolidation.
Certain amounts in Selective's prior years' consolidated financial statements and related footnotes have been reclassified to conform to the 2005 presentation. Such reclassifications had no effect on Selective's net income or stockholders' equity.
Realized gains and losses on the sale of investments are determined on the basis of the cost of the specific investments sold and are credited or charged to income. When the fair value of any investment is lower than its cost, an assessment is made to determine if the decline is other than temporary. If the decline is deemed to be other than temporary, the investment is written down to fair value and the amount of the write-down is charged to income as a realized loss. The fair value of the investment becomes its new cost basis.
Reserves for losses and loss expenses are made up of both case reserves and reserves for claims incurred but not yet reported ("IBNR"). Case reserves result from claims that have been reported to the Insurance Subsidiaries and are estimated at 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, Selective also considers a range of possible loss and loss adjustment expense reserves in establishing IBNR.
Reserves are reviewed for adequacy on a periodic basis. As part of the periodic review, Selective considers the range of possible loss and loss expense reserves, determined at the beginning of the year in evaluating reserve adequacy. When reviewing reserves, Selective analyzes historical data and estimates the impact of various factors such as: (i) per claim information; (ii) Selective and industry historical loss experience; (iii) legislative enactments, judicial decisions, legal developments in the imposition of damages, and changes in political attitudes; and (iv) trends in general economic conditions, including the effects of inflation. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method, however, 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, Selective believes that the estimated reserves for losses and loss expenses are adequate to cover the ultimate cost of claims. 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.
Net premiums written include direct writings plus reinsurance assumed and estimates of premiums earned but unbilled on the workers compensation and general liability lines of insurance, less reinsurance ceded. Premiums written are recognized as revenue over the period that coverage is provided using the semi-monthly pro rata method. Unearned premiums and prepaid reinsurance premiums represent that portion of premiums written that are applicable to the unexpired terms of policies in force.
Selective establishes reserves for dividends to policyholders on certain workers compensation policies. These dividends are based on the policyholders' loss experience. The dividend reserves are established based on past experience, adjusted for the effects of current developments and anticipated trends. The expense for these dividends is recognized over a period that begins at policy inception and ends with the payment of the dividend. The expense recognized for these dividends was $5.7 million for 2005; $4.3 million in 2004; and $5.1 million in 2003. Selective does not issue policies that entitle the policyholder to participate in the earnings or surplus of the Insurance Subsidiaries.
Selective uses the asset and liability method of accounting for income taxes. Deferred federal income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax basis of Selective's assets and liabilities. A valuation allowance is established when it is more likely than not that some portion of the deferred tax asset will not be realized. The effect of a change in tax rates is recognized in the period of enactment.
(a) The components of net investment income earned were as follows:
(b) Net unrealized gains on held-to-maturity fixed maturity securities were as follows:
(d) The amortized cost, estimated fair values and unrealized gains (losses) of held-to-maturity fixed maturity securities at December 31, 2005 and 2004, respectively, were as follows:
(e) The cost/amortized cost, estimated fair values and unrealized gains (losses) of available-for-sale securities at December 31, 2005 and 2004, respectively, were as follows:
At December 31, 2005, Selective held 333 fixed maturity securities, which had a fair value of $1,251.6 million in an unrealized loss position of $14.4 million. At December 31, 2005, Selective also held 10 equity securities in an unrealized loss position, which had a fair value of $9.4 million and an unrealized loss of $0.5 million. Of these 343 securities, 340 had fair values no less than 90% of their cost basis. The remaining 3 securities had fair values between 76% and 89% of their cost basis. Selective believes the decline in the fair value of all of these securities to be temporary. The assessment of whether a decline in value is temporary includes Selective's current judgment as to the financial position and future prospects of the entity that issued the investment security. Broad changes in the overall market or interest rate environment generally will not lead to a write-down. If Selective's judgment about an individual security changes in the future Selective may ultimately record a realized loss after having originally concluded that the decline in value was temporary, which could have a material impact on Selective's net income and financial position of future periods.
Selective's carrying amounts shown in the table are included in the consolidated balance sheets. The convertible subordinated debentures are included in "other liabilities" on the consolidated balance sheets. See Note 2(e) for the methods and assumptions used by Selective in estimating the fair values of its financial instruments.
Net reserves for losses and loss expenses, at beginning of year
Net reserves for losses and loss expenses, at end of year
Incurred loss and loss expense development related to prior years was $5.1 million in 2005, $4.9 million in 2004 and $15.0 million in 2003, while net loss and loss expense reserves increased by $249.4 million in 2005, $213.2 million in 2004, and $160.1 million in 2003. These changes were the result of normal reserve development inherent in the uncertainty in establishing reserves for losses and loss expenses, anticipated loss trends, growth in exposures, as well as increased reinsurance retentions. As additional information is collected in the loss settlement process, reserves are adjusted accordingly. These adjustments are reflected in the consolidated statements of income in the period in which such adjustments are recognized. These changes could have a material impact on the results of operations of future periods when the adjustment are made.
The Company experienced adverse development in its loss and loss expense reserves totaling $5.1 million in 2005. Through our internal actuarial reviews, we analyzed certain negative trends in the workers compensation line of business and certain positive trends in the commercial automobile line of business. In the fourth quarter of 2005, we had sufficient evidence accumulated to move management's best estimate of loss reserves for these lines. Accordingly, workers compensation reserves were increased by approximately $42 million to reflect rising medical cost trends that impacted accident years 2001 and prior. At the same time, commercial automobile reserves were decreased by approximately $48 million, primarily due to ongoing favorable severity trends in the 2002 through 2004 accident years. In addition, the general liability reserves adversely developed by approximately $14 million over the course of the year, which was driven mainly by our contractor completed operations business impacting accident years 2001 and prior, but partially offset by positive development in accident years 2002 through 2004. Also in 2005, we increased personal automobile reserves by approximately $10 million, of which $6.0 million was attributable to prior year development due to an adverse judicial ruling by the New Jersey Supreme Court, which eliminated the application of the serious life impact standard to personal automobile bodily injury liability cases under the verbal tort threshold of New Jersey's Automobile Insurance Cost Reduction Act ("AICRA"). The reserving action was based on an analysis of our claim files and loss experience pre- and post-AICRA, which resulted in an increase to our New Jersey personal automobile loss projections.
Reserves established for liability insurance, written primarily in the general liability line of business, continue to reflect exposure to environmental claims, both asbestos and non-asbestos. These claims have arisen primarily under older policies containing exclusions for environmental liability which certain courts, in interpreting such exclusions, have determined do not bar such claims. The emergence of these claims is slow and highly unpredictable. Since 1986, policies issued by the Insurance Subsidiaries have contained a more expansive exclusion for losses related to environmental claims. There are significant uncertainties in estimating Selective's exposure to environmental claims (for both case and IBNR reserves) resulting from lack of historical data, long reporting delays, uncertainty as to the number and identity of claimants and complex legal and coverage issues. Legal issues which arise in environmental cases include the following: federal or state venue, choice of law, causation, admissibility of evidence, allocation of damages and contribution among joint defendants, successor and predecessor liability, and whether direct action against insurers can be maintained. Coverage issues that arise in environmental cases include the interpretation and application of policy exclusions, the determination and calculation of policy limits, the determination of the ultimate amount of a loss, the extent to which a loss is covered by a policy, if at all, the obligation of an insurer to defend a claim and the extent to which a party can prove the existence of coverage. Courts have reached different and sometimes inconsistent conclusions on these legal and coverage issues. Selective does not discount to present value that portion of its loss reserves expected to be paid in future periods.
*Consists of leaking underground storage tanks, and other latent environmental exposures.
The Convertible Notes are redeemable by Selective in whole or in part, at any time on or after September 24, 2007, at a price equal to the sum of the issue price, plus the call premium, if any, plus accrued original issue discount and accrued and unpaid cash interest, if any, or such Convertible Notes to the applicable redemption date. The holders of the Convertible Notes may require Selective to purchase all or a portion of their Convertible Notes on either September 24, 2009, 2012, 2017, 2022, or 2027 at stated prices plus accrued cash interest, if any, to the purchase date. Selective may pay the purchase price in cash or shares of Selective's common stock or in a combination of cash and shares of Selective's common stock.
(2) On November 15, 2004, Selective 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. The Parent contributed $25.0 million of the bond proceeds to the Insurance Subsidiaries as capital. The remainder will be deployed for opportunistic share repurchases or further capital contributions to the Insurance Subsidiaries depending on the need for growth.
Selective has paid $18.0 million in principal to date, in addition to accrued interest thereon for the 8.63% Senior Notes. Principal payments of $6.0 million are required annually through May 4, 2007. The principal amount of these Senior Notes, $12.0 million at December 31, 2005 and $18.0 million at December 31, 2004, accrues interest and is payable semiannually on May 4 and November 4 of each year, until the principal is paid in full.
(4) On August 12, 1994, Selective entered into a $54.0 million note purchase agreement with various private lenders covering the 8.77% Senior Notes. During 2005, Selective made the final principal and interest payment on this note.
In all such jurisdictions, domestic insurers are prohibited from paying "extraordinary dividends" without approval of the insurance commissioner of the respective state. Additionally, New Jersey, North Carolina, and South Carolina 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.
Based on the unaudited 2005 statutory financial statements, the maximum ordinary dividends that can be paid to Selective by the Insurance Subsidiaries in 2006 are:
If Selective is acquired in a merger, or 50% or more of its assets are sold, each right, other than the rights of an Acquiring Person, will be exercisable to purchase shares of the acquiring company having twice the market value of the $80 exercise price.
In December 2005, Selective divested itself of its 100% ownership interest in CHN Solutions (Alta Services, LLC and Consumer Health Network Plus, LLC), which had historically been reported as part of the "Managed Care" component of the Diversified Insurance Services segment. Included in assets of discontinued operations on the consolidated balance sheet at December 31, 2004 is goodwill in the amount of $9.6 million related to CHN Solutions. For additional information regarding this divestiture, see Note 13, "Discontinued Operations." Selective's remaining goodwill balance by operating segment is as follows:
Selective and its subsidiaries also provide services to each other in the normal course of business. These transactions totaled $19.4 million in 2005, $28.5 million in 2004, and $27.1 million in 2003. These transactions were eliminated in all consolidated statements. In computing the results of each segment, Selective does not make adjustments for interest expense, net general corporate expenses, or federal income taxes. Selective does not maintain separate investment portfolios for the segments and therefore, does not allocate assets to the segments.
Included in the 2005 balance of "Other Assets" is a state deferred tax asset of $0.4 million with a corresponding state valuation allowance of $0.3 million. The asset is attributable to state net operating losses of our subsidiary, SHRS, which may be carried forward and applied in future years for tax. The valuation allowance was established mainly due to that company's lack of state carryback availability.
Operating results, as well as the loss on disposition, from discontinued operations are as follows:
The plan allows employees to make voluntary contributions to a number of diversified investment options, including Selective's common stock, on a before and/or after-tax basis. Shares of Selective's common stock issued under this plan were 14,786 during 2005, 11,730 during 2004 and 14,251 during 2003. The number of shares of Selective's common stock available to be purchased under the Retirement Savings Plan was 783,820 at December 31, 2005.
Two additional defined contribution plans are maintained by SHRS, a subsidiary of the Company's Diversified Insurance Services segment, which does not participate in Selective's defined contribution plan. During 2003, the plans allowed employees to contribute a maximum of 25% of defined compensation and up to 3% of contributions are matched 200% by the employer. Effective January 1, 2004, the maximum allowable employee contribution to the plans was increased from 25% to 75% of defined compensation.
Employer contributions for all the plans amounted to $4.0 million in 2005, $3.4 million in 2004, and $3.7 million in 2003.
Selective has a noncontributory defined benefit retirement income plan ("Retirement Income Plan") covering all employees who meet eligibility requirements. Selective's funding policy provides that payments to the pension trust shall be equal to the minimum funding requirements of the Employee Retirement Income Security Act, plus additional amounts that the Salary and Employee Benefits Committee of the Board of Directors may approve from time -to time. For entrants into the Retirement Income Plan on or after July 1, 2002, the monthly retirement benefits beginning at normal retirement were decreased to 1.2% from 2.0% of the average monthly compensation as defined. Also, for all plan participants, early retirement eligibility begins at age 55 or when participants age plus years of service sum to at least 70.
Selective also provides life insurance benefits (postretirement benefits) for retired employees. Substantially all of Selective's employees may become eligible for these benefits if they reach retirement age while working for Selective and meet a minimum of 10 years of eligibility service. Those individuals who retired prior to January 1, 1991 receive life insurance coverage which decreases over ten years to a current ultimate value of $5,000 per retiree. Those individuals retiring on or after January 1, 1991 receive life insurance coverage in an amount equal to 50% of their annual salary amount in effect at the end of their active career to a maximum benefit of $100,000. Those individuals retiring on or after January 1, 2002 receive life insurance coverage in an amount equal to 50% of their annual salary amount in effect at the end of their active career to a maximum benefit of $35,000. The estimated cost of these benefits is accrued over the working lives of those employees expected to qualify for such benefits.
Selective's investment objective is to maximize total return while preserving capital to meet plan obligations. To meet this objective, Selective's strategy is to utilize a long-term time horizon to design the portfolio in such a manner as for the plan assets to achieve an appropriate balance between equity and fixed maturity securities, alternative investments and cash. The asset allocation is a function of the relative attractiveness of each asset class and its risk/reward characteristics. Selective's investment policy limits its asset allocation in equity investments to a maximum of 60% of the total plan assets and alternative investments to a maximum of 20% of the total plan assets. A combination of equity investments and alternative investments is limited to 70% of the total market value of the plan assets. Each individual category of private equity, hedge funds, and real estate has a limit of 10% of total plan assets. Additionally, a limit of 10% of total plan assets is placed on non-U.S. equity investments, while no more than 10% of total plan assets may be invested in the stock of Selective Insurance Group, Inc., the plan sponsor. A limit of 10% of the plan's assets or 20% of fixed maturity securities may be invested in non-investment grade securities.
The Retirement Income Plan had no investments in the common stock of the Company at December 31, 2005 and 2004.
The Selective Insurance Group, Inc. 2005 Omnibus Stock Plan ("Stock Plan") was adopted and approved by the Board of Directors effective as of April 1, 2005, and approved by stockholders' on April 27, 2005. With the Stock Plan's approval, no further grants are available under the (i) Selective Insurance Stock Option Plan III ("Stock Option Plan III"); (ii) Selective Insurance Group, Inc. Stock Option Plan for Directors ("Stock Option Plan for Directors"); or (iii) Selective Insurance Group, Inc. Stock Compensation Plan for Nonemployee Directors, as Amended ("Stock Compensation Plan for Nonemployee Directors"), but awards outstanding under these plans and the Selective Insurance Group, Inc. Stock Option Plan II ("Stock Option Plan II"), under which future grants ceased being available on May 22, 2002, shall continue in effect according to the terms of those plans and any applicable award agreements.
As of December 31,2005, there were 268,285 shares of Selective's common stock available for issuance pursuant to outstanding stock options and restricted stock awards granted under Stock Option Plan III, under which future grants ceased being available with the approval of the Stock Plan. Under Stock Option Plan III, employees were granted qualified and nonqualified stock options, with or without SARs, and restricted or unrestricted stock (i) at not less than fair value on the date of grant and (ii) subject to certain vesting restrictions determined by the SEBC. Restricted stock awards also could be subject to achievement of performance objectives as determined by the SEBC. The maximum exercise period for an option grant under this plan is ten years from the date of the grant. Under this plan, Selective granted options to purchase 105,663 shares without SARS during 2005, options to purchase 104,600 shares without SARS during 2004, and options to purchase 146,250 shares without SARS during 2003.
Under the terms of the agents' stock purchase plan, there are 561,502 shares of common stock available for purchase as of December 31, 2005. This plan provides for quarterly offerings in which independent insurance agents can purchase Selective's common stock at a 10% discount with a one year restricted period during which the shares purchases cannot be sold or transferred. Selective issued shares to agents in the amount of 79,428 in 2005, 86,886 in 2004 and 73,467 in 2003 and charged to expense $0.4 million in 2005, $0.3 million in 2004, and $0.2 million in 2003.
A summary of the stock option transactions under Selective's share-based payment plans is as follows:
A summary of the restricted stock transactions under Selective's share-based payment plans is as follows:
As of December 31, 2005, total unrecognized compensation cost related to nonvested restricted stock awards granted under Selective's stock plans was $14.3 million. That cost is expected to be recognized over a weighted-average period of 2.5 years. The total fair value of restricted stock vested was $10.9 million for 2005, $5.1 million for 2004, and $3.6 million for 2003. In connection with the restricted stock vestings, the total fair value of the dividend reinvestment plan shares that also vested was $1.0 million during 2005, $0.6 million during 2004, and $0.4 million during 2003.
In determining expense to be recorded for stock options granted under Selective's share-based compensation plans, the fair value of each option award is estimated on the date of grant using the Black Scholes option valuation model ("Black Scholes"). The following are the significant assumptions utilized in applying Black Scholes: (i) risk-free interest rate, which is the implied yield currently available on U.S. Treasury zero-coupon issues with an equal remaining term; (ii) expected term, which is based on historical experience of similar awards; (iii) dividend yield, which is determined by dividing the expected per share dividend during the coming year by the grant date stock price; and (iv) expected volatility, which is based on the volatility of Selective's stock price over a historical period comparable to the expected term. In applying Black Scholes, Selective uses the weighted average assumptions illustrated in the following table:
The expense recorded for restricted stock awards and stock compensation for nonemployee directors is determined utilizing the number of awards granted and the grant date fair value.
The weighted-average fair value of options and stock granted per share for Selective's stock plans, during 2005, 2004, and 2003 is as follows:
In 1994, certain officers of Selective exercised stock options by signing promissory notes in payment for the stock, totaling $1.0 million. Selective's noninterest bearing promissory notes were secured by the common stock shares issued upon exercise and held by Selective as collateral. As of December 31, 2005 there were no outstanding balances relating to these notes, whereas the principal amount outstanding was $0.1 million at December 31, 2004.
William M. Rue, a Selective Director, is President of and owns more than 10% of the equity of Rue Insurance, a general independent insurance agency (the "Rue Agency"). The Rue Agency is an appointed independent agent of Selective's insurance subsidiaries and SHRS, Selective's human resources administration outsourcing subsidiary, on terms and conditions similar to those of other Selective agents. The Rue Agency also places insurance for Selective's business operations. Selective's relationship with the Rue Agency has existed since 1928. The following is a summary of transactions with the Rue Agency:
The Rue Agency placed human resource outsourcing contracts with SHRS of the Diversified Insurance Services segment resulting in revenues to SHRS of $64,000 in 2005, $57,000 in 2004, and $48,000 in 2003. In return, SHRS paid commissions to the Rue Agency of $15,000 in 2005, $13,000 in 2004, and $26,000 in 2003.
The Rue Agency placed insurance coverage for Selective with non-Selective insurance companies for which the Rue Agency was paid commission pursuant to its agreements with those carriers. Selective paid premiums for such insurance coverage of $0.6 million in 2005, $1.4 million in 2004, and $1.3 million in 2003.
(a) Selective purchases annuities from life insurance companies to fulfill obligations under claim settlements which provide for periodic future payments to claimants. As of December 31, 2005, Selective had purchased such annuities in the amount of $10.2 million for settlement of claims on a structured basis for which Selective is contingently liable. To Selective's knowledge, none of the issuers of such annuities have defaulted in their obligations thereunder.
At December 31, 2005, the total future minimum rental commitments under noncancelable leases was $21.9 million and such yearly amounts are as follows:
(c) At December 31, 2005, Selective has contractual obligations that expire at various dates through 2017 to invest up to an additional $64.5 million in alternative investments. There is no certainty that any such additional investment will be required.
In the ordinary course of conducting business, Selective and its subsidiaries are named as defendants in various legal proceedings. Some of these lawsuits attempt to establish liability under insurance contracts issued by our insurance subsidiaries. Plaintiffs in these lawsuits are seeking money damages that, in some cases, are extra-contractual in nature or they are seeking to have the court direct the activities of Selective's operations in certain ways. Although the ultimate outcome of these matters is not presently determinable, Selective does not believe that the total amounts that it will ultimately have to pay, if any, in all of these lawsuits in the aggregate will have a material adverse effect on its financial condition, results of operations, or liquidity.
Due to continuing growth of our overall property book outside of New Jersey, we have terminated our New Jersey Homeowners Property 75% Quota Share treaty effective January 1, 2006 and reallocated the cost of this treaty to the purchase of additional protection under our Property Catastrophe treaty, which covers our overall property book. Effective January 1, 2006, Property Catastrophe treaty retention increased to $20.0 million from the expiring $15.0 million and per occurrence coverage was increased to $220 million (with a 5% Company participation) from the expiring $150 million. The New Jersey Homeowners Property Quota Share treaty had provided up to $75.0 million per occurrence protection for the property portion of our New Jersey Homeowners book of business and was purchased primarily to protect the Company against a catastrophic event. The Company ceded $20.4 million in earned premium offset by $9.7 million in ceding commission and $8.3 million in losses under the 2005 New Jersey Homeowners Property Quota Share treaty.
1. Refer to the Glossary of Terms attached to this Form 10-K, 	as Exhibit 99.1.
3. See Note 2(g) to the consolidated financial statements for a discussion of the cumulative effect of change in accounting principle.
4. See Note 7(b) and Note 8 to the consolidated financial statements for a discussion of dividend restrictions.
5. These ranges of high and low prices of Selective's common stock, as reported by The NASDAQ National Market, represent actual transactions. All price quotations do