Operating ratios are GAAP basis and are calculated on losses and expenses expressed as a percentage of earned premiums.
Forward-looking information contained in this report is subject to risk and uncertainty
Statements, analysis and other information contained in this report that relate to anticipated financial performance, business prospects and plans, regulatory developments and similar matters are “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995. Statements in this report that are not historical information are forward-looking. The operations, performance and development of our business are subject to certain risks and uncertainties that may cause actual results to differ materially from those contained in or suggested by the forward-looking statements in this report. The risks and uncertainties include, but are not limited to:
the ability to obtain rate increases and decline or non-renew underpriced insurance accounts;
success in obtaining regulatory approval of price-tiered products and the use of insurance scores, including credit scores as a component;
the competitive pricing environment, initiatives by competitors and other changes in competition;
weather conditions, including the severity and frequency of storms, hurricanes, snowfalls, hail and winter conditions;
the occurrence of significant man-made disasters, such as the attack on September 11, 2001 or war;
the adequacy of loss and benefit reserves for the Property & Casualty and Life & Investments businesses;
the ability to run off the Lloyds of London business without incurring material unexpected charges;
interpretation of insurance policy provisions by courts, court decisions regarding coverage and theories of liability, trends in litigation and changes in claims settlement practices;
legislative and regulatory developments affecting the actions of insurers, including requirements regarding rates and availability of coverage;
changes in tax laws and regulations that affect the favorable taxation of certain life insurance products or that decrease the usefulness of life insurance products for estate-planning purposes;
Because insurance rates in some jurisdictions are subject to regulatory review and approval, our achievement of rate increases may occur in amounts and on a time schedule different than planned, which may affect efforts to continue to restore profitability in our Property & Casualty lines.
Safeco Corporation is a Washington corporation that has been in the insurance business since 1923. We operate subsidiaries on a nationwide basis in segments of the insurance industry and other financial services-related businesses. Our two principal businesses are (1) property and casualty insurance, including surety, and (2) life insurance and asset management. These activities generated nearly all of our revenues in 2002.
We have identified the accounting policies below as critical to understanding our results of operations and financial condition. The application of these accounting policies requires management to use judgments involving assumptions and estimates concerning future results, trends or other developments that could significantly influence our results should actual experience differ from those assumptions and estimates. These judgments are reviewed frequently by senior management, and an understanding of them may enhance the reader’s understanding of our consolidated financial statements and MD&A.
Safeco’s consolidated financial statements include estimated reserves for unpaid losses and related claim settlement or loss adjustment expenses (LAE) of our Property & Casualty businesses. We record loss and LAE reserves at each balance sheet date at management’s best estimate of the ultimate payments that will be made to settle all losses incurred at that date and to pay related expenses.
Due to the assumptions and judgments inherent in the estimation of loss and LAE reserves, actual experience may differ from these estimates. We refine reserve estimates in an ongoing quarterly process as experience develops. We record adjustments to reserves in our results of operations in the periods in which we change the estimate.
Automobile bodily injury paid loss severity on claims that closed in 2002 increased 4.4% over 2001. The incurred severity on claims reported in 2002 increased 7.1% over 2001. Management believes that incurred severity increases include the effects of claim department activities since 2001. These activities include focused settlement efforts and improved case reserve measurement processes, which will serve to reduce loss severity over time. However, until the benefits of such actions are evidenced in our loss development experience, and in view of the uncertainties inherent in estimating the effects of medical inflation, management’s estimate of reserves for this coverage has assumed an aggregate loss severity trend of 7%.
SBI reserves totaled $2,618.2 at December 31, 2002, comprised of workers compensation reserves of $830.5, commercial multiperil reserves of $516.6, commercial auto reserves of $384.2, asbestos and environmental reserves of $196.5, construction defect reserves of $158.0, business owners policy reserves of $140.3 and all other reserves of $392.1.
For SBI, workers compensation reserves are subject to the greatest uncertainty and subjectivity in their estimation. The key assumptions and the inherent variability in reserving for these losses are described below.
The following table presents the loss and allocated LAE reserves before reinsurance related to voluntary and non-voluntary workers compensation. The table excludes unallocated LAE reserves which were $21.1 as of December 31, 2002:
Workers compensation reserves are subject to a greater degree of uncertainty than most reserves due to the late-reporting nature of certain of the claims, the long-term payout period of many claims and the resulting impact of inflationary trends over time, particularly for medical costs, and the impact of legislative actions and judicial interpretations in establishing prescribed benefits. Currently, medical inflation trends are resulting in significant increases to paid losses, particularly in the state of California. The rate of change in medical inflation and payment trends may impact our estimates in future periods due to the difficulty of precisely estimating the pattern of such trends over the claim payout period.
Other SBI reserves comprise loss and LAE reserves for commercial multiperil policies, monoline property, monoline general liability (other than construction defects, asbestos, environmental and other toxic tort claims, which are discussed separately below), commercial automobile and commercial umbrella. These reserves are analyzed quarterly using standard actuarial methodologies. The duration of payout for these products is relatively short, and the loss cost trends for the shorter tailed lines have been stable to improving. These factors result in more predictive experience for reserving than is the case for workers compensation.
The process of estimating reserves for these claims involves subjectivity different than our other lines due to the changing legal and regulatory environment, including statutes of limitations in filing these claims and the impact of diminished value claims. In addition, estimates are more subjective due to the involvement of multiple plaintiffs, defendants and insurers and the potentially long period of time between the accident date and the date the claim is reported.
Safeco estimates its ultimate liability for construction defects using techniques developed specifically for this purpose. This includes estimation of future claim reporting and the average value of each claim and includes adjustments for changes in coverage interpretations, changes in regulation and judicial rulings, and changes in plaintiff attorney involvement. As the table above indicates, claim inventories for construction defect have decreased steadily over the last two years, annualized at -14% per year. Management’s reserve estimate assumes that the
The following table presents the loss and allocated LAE reserves before reinsurance for liability coverages related to asbestos claims. The table excludes unallocated LAE reserves which were $8.8 as of December 31, 2002 for asbestos and environmental combined.
Safeco’s direct exposure (approximately 30% of asbestos reserves) to asbestos liabilities primarily relates to the expansion of defendants to include smaller and more peripheral entities. Safeco’s exposure to the major high profile asbestos defendants is limited as a result of our historic business strategy, which generally avoided writing direct coverages for larger companies. Safeco has no direct exposure to businesses or claims that are the subject of settlement agreements.
The process of estimating reserves for asbestos claims involves greater subjectivity than other claims. Past claim experience may not be representative of future claim experience due to a general lack of sufficiently detailed data, the risk inherent in major litigation, diverging legal interpretations, regulatory actions, the recent proliferation of bankruptcy proceedings, the extent to which non-impaired claimants can be precluded from making claims, the efforts by insureds to obtain coverage not subject to aggregate limits, and other factors. Changes in these factors, particularly in the overall legal environment and the proliferation of these claims to peripheral defendants, could result in future claims significantly different from those currently predicted. Also, some asbestos-related claims are subject to non-product liability coverage rather than product liability coverage, and the non-product liability coverage may not be subject to policy aggregate limits.
Unassigned IBNR represents 52.9% of Safeco’s net asbestos reserves as of December 31, 2002.
The following table presents the loss and allocated LAE reserves before reinsurance for liability coverages related to environmental and other toxic tort claims. The table excludes unallocated LAE reserves which were $8.8 as of year end 2002 for asbestos and environmental combined:
including such issues as the existence of coverage, the definition of ultimate damages, and the final allocation of such damages to financially responsible parties.
Since Safeco’s environmental claims are relatively small in size, this exposure does not lend itself to ground up analysis. The data is too volatile and too sparse to place sole reliance on standard actuarial techniques. As a consequence, management relies upon analysis of claim statistics and trends, together with directional trends in survival ratios, to estimate the carried reserves.
We use treaty and facultative reinsurance in managing our exposure to potential losses for Property & Casualty. Reinsurance recoverables related to unpaid losses resulting from these operations were $411.6 at December 31, 2002. Because the amount of the reinsurance recoverable can vary depending on the loss activity before reinsurance is applied, the exact amount of the reinsurance recoverables is not known until all losses are settled.
We currently classify all of our fixed maturity and equity securities as available-for-sale and, accordingly, carry them at fair value. Fixed maturity securities include bonds, mortgage-backed securities and redeemable preferred stock. Equity securities include common stock and non-redeemable preferred stock.
Fair value amounts for financial instruments are determined using available third-party market information. When such information is not available, the fair value amounts are determined using appropriate valuation methodologies including discounted cash flows and market prices of comparable instruments. Our investment portfolio includes $314.8 of fixed maturities that are not publicly traded. When third-party market information is not available, fair values for these securities have been estimated using quoted market prices of comparable instruments based on industry sector, credit quality and maturity and/or internally prepared valuations using third-party modeling tools, which also typically use comparable-instrument pricing techniques based on industry sector, credit quality and maturity. Judgment is required in developing certain of these estimates of fair value and the estimates may not represent amounts at December 31, 2002 that would be realized in a current market exchange.
Consolidated revenues increased 3% to $7,065.1 during 2002 compared to consolidated revenues of $6,862.5 in 2001 and $6,975.1 in 2000. The growth in 2002 reflects overall increases in Property & Casualty earned premiums, Life & Investments premiums and other revenues and net investment income. The slight increase in Property & Casualty earned premiums was driven by targeted growth in selected markets and premium rate increases across all lines of business. Life & Investments premiums and other revenues increased 22% in 2002 primarily due to the acquisition of Swiss Re’s stop-loss medical business. The increase in net investment income was primarily due to improved cash flows in Property & Casualty operations, repositioning of the Property & Casualty investment portfolio, and a higher invested asset base in Life & Investments, offset in part by lower yields due to declining interest rates. Consolidated revenues in 2001 decreased 1.6% in comparison to the $6,975.1 of revenues in 2000, primarily from a decline in Property & Casualty earned premiums of 2% as a result of our re-underwriting efforts, which included non-renewing under-priced risks and reducing under-performing and unprofitable lines. This decrease was partially offset by growth in Life & Investments’ revenues driven by premium rate increases and an increase in investment income.
In the following sections of MD&A, we discuss the results from operations of each of our reportable segments. Safeco’s management measures segment profit or loss for its Property & Casualty businesses primarily based upon
underwriting results. Underwriting results (profit or loss) represent the net amount of earned premium less underwriting losses and expenses on a pretax basis. Management views underwriting results as a critical measure to assess the effectiveness of the underwriting of the Property & Casualty operations and to evaluate the results of these business units. The related investment portfolio is managed separately from these underwriting businesses and, accordingly, net investment income and net realized investment gains and losses are discussed separately.
Life & Investments results are evaluated based on pretax operating earnings, which excludes net realized investment gains and losses and unusual or non-recurring events or transactions. Management believes the presentation of segment pretax operating earnings enhances the understanding of our results of operations by highlighting earnings attributable to the normal, recurring operations of the business.
Underwriting results and segment pretax operating earnings are not a substitute for net income determined in accordance with accounting principles generally accepted in the United States (GAAP).
We have provided the following table to facilitate the reconciliation of our segment measures to our GAAP results, specifically the line caption “Income (Loss) from Continuing Operations before Income Taxes, Distributions on Capital Securities and Change in Accounting Principle” of our GAAP Consolidated Statements of Income (Loss).
Safeco’s Property & Casualty operations are organized around our four operating segments, Safeco Personal Insurance (SPI), Safeco Business Insurance (SBI), Surety and Property & Casualty Other (P&C Other). Within SPI there are three reportable segments, Auto, Homeowners and Specialty. Within SBI the three reportable segments are Regular, Special Accounts Facility and Runoff.
The growth in PIF and premiums in 2002 was impacted by three strategic initiatives: the introduction of our new auto insurance product, the new business entry model using point-of-sale technology (POS) and increased commissions on new business effective January 1, 2002.
In early 2002, we also implemented improved POS technology in our agents’ offices, making it easier for them to write business with Safeco. This technology allows agents to quote policies more quickly and makes it easier for our agents to sell Safeco products.
Our new commission structure increased commissions on new auto policies significantly for the first six-month policy period and revised the bonus commission structure to align our bonus incentives to agents with both our growth and profitability goals.
Our 2002 underwriting loss of $44.4 improved $36.1 over our 2001 underwriting loss of $80.5, which improved $42.5 over our underwriting loss of $123.0 in 2000. Our improved underwriting results in both 2002 and 2001 reflect the growth in premium rates and our expanded use of automated underwriting techniques which, along with stricter underwriting standards, resulted in better matching of rates with risk.
The underwriting loss for Homeowners of $37.2 improved by $168.4 over our 2001 underwriting loss of $205.6, which grew by $88.9 over our 2000 underwriting loss. The combined ratio improved to 104.9% in 2002 compared to 127.8% in 2001. Improvements in 2002 were due to significantly lower catastrophe losses and milder-than-anticipated weather conditions during 2002 compared to 2001 and the impact of continued rate increases. Homeowners catastrophe losses were $54.3 in 2002 compared to $145.0 in 2001. The underwriting loss in 2001 increased $88.9 over 2000, and the combined ratio increased correspondingly to 127.8% in 2001 from 116.0% in 2000. The increased underwriting loss in 2001 resulted from the significant catastrophe losses of $145.0 in 2001, which included $60.0 for a single catastrophe storm in St. Louis, in comparison to catastrophe losses of $86.0 in 2000.
Specialty lines include earthquake, dwelling fire, inland marine and boat insurance for individuals.
Net earned premiums increased $1.5 or 0.7% in 2002 to $203.1, compared to net earned premiums of $201.6 in 2001 and $186.7 in 2000. Net earned premiums increased slightly during 2002 due to average rate increases of 6%, offset by a slight reduction to PIF. The PIF reduction in 2002 reflected a decrease in new business production and stable retention rates. Net earned premiums increased 8.0% in 2001 due to increased rates and the impact of a change to the personal umbrella reinsurance treaty. We purchase a 10% quota share for the first $2.0 of each event and 100% quota share for the next $8.0. With the previous treaty, we ceded 10% of the first $1.0 of each event and 100% of the next $9.0. This change resulted in an increase in net earned premiums of $11.9 in 2001.
Our 2002 underwriting profit of $28.9 improved $25.0, compared to the 2001 underwriting profit of $3.9, which compares to the 2000 underwriting profit of $18.2. The combined ratio improved to 85.8% in 2002, compared to 98.0% in 2001 and 90.3% in 2000. The improved underwriting profit and combined ratio in 2002 in comparison to 2001 related to the rate increases described above and $2.3 of losses from the Seattle earthquake that occurred in February 2001. Results in 2002 also benefited from a reduction in personal umbrella loss costs.
The 2001 underwriting profit decreased $14.3 in comparison to 2000 due to the Seattle earthquake losses, and several large losses.
SBI - Regular is our core commercial segment writing commercial lines insurance for small-to-medium sized businesses.
Net earned premiums decreased $18.9 or 1.8% in 2002 to $1,014.1, compared to net earned premiums of $1,033.0 in 2001, which was a decrease of $138.7 compared to 2000. The decreases reflect the aggressive actions taken in 2001 to re-underwrite existing business, apply stricter underwriting standards and increase rates. SBI - Regular’s average insurance prices increased 15% in 2002 and 12% in 2001, and we expect comparable increases in 2003. The impact of rate increases in 2002 and 2001 were offset by a decrease in PIF of 8.9% in 2002 compared to 2001 and 15% in 2001 compared to 2000. The decrease in PIF in 2002 reflects the re-underwriting of existing business, offset in part by an increase in new business production. New business production was up approximately 14% for 2002 while retentions improved marginally during the year. During 2001, retentions decreased slightly and new business production was limited due to the underwriting actions previously described.
SBI - Regular is introducing a redesigned business model to support sales growth, deliver pricing more accurately matched to risk characteristics and improve customer service. The suite of services being introduced includes an automated underwriting platform, a business service center and a new business agency interface system. The underwriting platform and service center were launched during the first and second quarters of 2002 and the new business agency interface module was launched in the fourth quarter of 2002. The new underwriting approach provides an increased number of pricing tiers and better matching of rate to risk. SBI - Regular also continues to restrict writing new workers compensation policies, particularly in the state of California.
SBI - Special Accounts Facility writes larger commercial accounts for our key Safeco agents and our four continuing specialty commercial programs (lender-placed property insurance, agents’ errors and omissions insurance written predominantly for Safeco agents, mini storage and warehouse property coverages, and coverages for non-profit social service organizations).
Net earned premiums increased $147.9 or 115.5% in 2002 to $276.0, compared to net earned premiums of $128.1 in 2001, which was an increase of $16.5 over 2000. Net earned premiums were impacted in 2002 by the consolidation of the results for all of our business insurance products. As each existing Safeco large account
commercial policy comes up for renewal (reported in SBI - Runoff), a decision is made by SBI - Special Accounts Facility to renew or not. If it is renewed it becomes part of SBI - Special Accounts Facility, otherwise underwriting results associated with the discontinued account remain in SBI - Runoff. This transfer of business from SBI -Runoff to SBI - Special Accounts Facility resulted in an increase of $71.0 to net earned premiums in 2002 as certain policies reported in SBI - Runoff in 2001 were renewed into SBI - Special Accounts Facility. Net earned premiums in 2002 and 2001 also increased due to the acquisition of a lender placed property business from ACE, Limited (ACE) in September 2001. This acquisition drove additional earned premiums of $57.7 in 2002 and $5.6 in 2001. Increases to net earned premiums in 2002 and 2001 were impacted by rate increases in 2002 and 2001 as well.
Net earned premiums decreased $311.4 or 64.6% in 2002 to $170.9, compared to net earned premiums of $482.3 in 2001, which was a decrease of 13.2% from 2000. The decrease in net earned premiums in 2002 compared to 2001 and in 2001 compared to 2000 reflect the actions taken to exit this unprofitable business. In particular, the workers compensation line continues to be unprofitable. As previously described, the runoff business that we are not exiting is reflected in the results for SBI - Special Accounts Facility from the time that the policies are renewed.
Our 2002 underwriting loss of $107.5 improved $172.1 over our 2001 underwriting loss of $279.6, which increased from an underwriting loss of $162.3 in 2000. The decrease in the underwriting loss in 2002 reflects the reduction of business volume as insurance policies are not renewed, as reflected by the decrease in net earned premiums previously described. The 2001 underwriting loss includes the impact of third quarter loss reserves strengthening of $90.0.
The combined ratio increased to 162.9% in 2002 from 158.0% in 2001, which compares to 129.3% in 2000. The combined ratios for SBI - Runoff increased in 2002 and 2001 due to the impact of the significant decrease in earned premiums in those years. The decreasing earned premiums makes the analysis of combined ratio less meaningful for this line as the business is run off.
We expect earned premiums to decrease dramatically in 2003 with minimal earned premiums after the third quarter of 2003.
The 2001 underwriting loss includes third quarter reserve strengthening of $85.0 described earlier related to construction defect and asbestos and environmental loss development, as well as $30.0 in losses from the September 11, 2001 attacks, net of reinsurance, which primarily related to losses in the Lloyds of London operations.
from a terrorist event exceeded $25.0. In addition, for casualty policies, the exclusion applied if the terrorist event involved the deaths or serious injury to 50 or more persons. The property exclusion did not apply to losses arising from fire following a terrorist event in the 29 states that follow the standard fire policy form. This exclusion applied to both domestic and foreign terrorist events.
As a consequence of TRIA and Safeco’s response, Safeco’s reinsurers are providing limited options to purchase reinsurance for terrorism events. Safeco is considering these options. In the meantime, due to the current unavailability of the ISO exclusion for Safeco’s commercial Property & Casualty policies in a few states, Safeco will continue to be exposed to commercial losses that arise from terrorism without reinsurance for such losses. We also have no reinsurance for terrorism related losses in our workers compensation line.
The following table analyzes the changes in Property & Casualty loss and LAE reserves for 2002, 2001 and 2000. Changes in estimated reserves are reflected in the income statement in the year the change is made.
In 2001, Safeco increased its estimates for loss and LAE related to prior years by $345.1.
Workers compensation reserves were $802.8 at December 31, 2000. The reserve strengthening in the third quarter of 2001 of $80.0 was due to unexpected development of prior year losses and continued increases in medical costs that manifested in 2001 beyond levels previously anticipated in estimating workers compensation reserves. Throughout 2000, average workers compensation case reserves carried by Safeco were stable, but increased 14% in the first quarter of 2001 compared to the first quarter of 2000 and increased 23% in the second quarter of 2001 compared to the second quarter of 2000. These increases reflected the impact of rising medical costs and administrative rulings that had been more favorable to plaintiffs’ claims for compensation, particularly in California and Florida. In general, workers compensation claims are largely comprised of medical costs and salary/wage payments while claimants are out of work. The payout period for these claims can be up to 50 years or more. Accordingly, the estimation of long-term medical costs requires considerable judgment and involves inherent uncertainty, having a significant impact on our estimate of workers compensation reserves. In light of these emerging trends of rising medical costs and recent administrative rulings, we strengthened reserves by $80.0.
Asbestos and environmental reserves were $315.5 at December 31, 2000; $103.1 for asbestos and $212.4 for environmental. The $70.0 increase in reserves in the P&C Other segment relates to the anticipated increase in asbestos claims relating primarily to the discontinued reinsurance operations acquired in the American States purchase. In 2001, the insurance industry was experiencing a trend of expansion of asbestos defendants to include smaller and more peripheral firms such as installers, in addition to asbestos manufacturers and producers and Safeco was receiving more claims in the first half of 2001 than in prior years. Because these trends were expected to ultimately impact the losses assumed by Safeco, and because Safeco expected a lag in its asbestos activity due to its assumed reinsurance exposure, reserves were strengthened by $70.0.
We use treaty and facultative reinsurance in managing our exposure to potential losses for Property & Casualty operations. As noted previously, the liability for unpaid losses and LAE is reported gross of reinsurance recoverables of $411.6 at December 31, 2002 and $415.9 at December 31, 2001 before allowance for uncollectible reinsurance. Because the amount of the ultimate reinsurance recoverables depends on the amounts of individual losses or, in some cases, the aggregate amount of all losses by year in a particular line of business, the exact amount of the reinsurance recoverables is not known until losses are settled. Therefore, we estimate the amount of reinsurance recoverables we anticipate receiving based on the terms of the underlying reinsurance contracts, historical reinsurance recovery experience and our estimates of related loss and LAE reserves.
The availability and cost of reinsurance is subject to prevailing market conditions, both in terms of price and available capacity. Although the reinsurer is liable to Safeco to the extent of the reinsurance ceded, we remain primarily liable to the policyholders as the direct insurer on all risks insured. The magnitude of losses in the reinsurance industry resulting from the September 11, 2001 terrorist attacks has impacted the financial strength of certain reinsurers which may result in collectibility or recoverability issues. However, to Safeco’s knowledge, none of our major reinsurers is currently experiencing material financial difficulties. At December 31, 2002, the estimated allowance for uncollectible reinsurance was $12.5. Safeco’s business is not substantially dependent upon any single reinsurance account.
Of the total Property & Casualty reinsurance recoverables balance at December 31, 2002, 23% was with mandatory reinsurance pools and foreign reinsurers. Approximately 88% of the remaining amounts due are from reinsurers rated A- or higher by A.M Best; including 49% with the following four reinsurers: American Re-Insurance Corporation, Employers Reinsurance Corporation, Swiss Reinsurance America Corporation and General/Cologne Reinsurance Corporation, all of which are rated A+ or higher by A.M. Best.
Life & Investments operations are managed separately as six reportable segments: Retirement Services, Income Annuities, Group, Individual, Asset Management and Life & Investments Other (L&I Other). The following table summarizes comparative operating results for Life & Investments:
Life & Investments revenues are comprised of premiums, net investment income and other fees. The following tables summarize revenues (excluding net realized investment gains and losses) and pretax operating earnings by reportable segment.
Pretax operating earnings were $21.6 in 2002, an increase of $6.0 or 38% compared to 2001 pretax operating earnings of $15.6, which were down 48% from 2000. The increase in 2002 pretax operating earnings was due to the growth in our general account assets under management, which contributed additional interest income, and lower losses from our EIA products.
These favorable results were somewhat offset by reduced fees from our separate account products. Pretax operating earnings decreased $14.4 in 2001 compared to 2000. Our results in 2001 were significantly impacted by the decline in the equity markets, our EIA surrender program and lower interest rates. These factors contributed to lower fees, a reduction in spreads and less interest margin when compared to 2000.
General account assets under management grew in 2001 and 2002 primarily due to the strong sales of fixed deferred annuities, partially offset by maturing GIC policies and indexed annuity withdrawals. The decrease in separate account assets under management in 2002 and 2001 was primarily due to declines in the equity markets.
Group’s principal product is stop-loss medical insurance sold to employers with self-insured medical plans. Also offered in this line are group life, accidental death and dismemberment, and disability products.
Revenues were $477.4 in 2002, an increase of $141.2 or 42.0% over 2001 revenues of $336.2, which were up 6.5% from 2000. The increase in 2002 revenues is primarily due to overall rate increases and the acquisition of Swiss Re’s stop-loss medical business in July, which generated $116.0 in premiums. Rate increases in the stop-loss medical business also contributed to higher revenues in 2001 over 2000.
Pretax operating earnings increased $42.6 to $69.2 in 2002 compared to $26.6 in 2001 which increased $22.3 over 2000. In 2002, the growth in premiums, primarily from the Swiss Re acquisition, coupled with rate increases and an improved loss ratio of 60% compared to a loss ratio of 64% in 2001, contributed to the increase in pretax operating earnings of $42.6. Premium growth of 6.3% in 2001, and an improved loss ratio of 64% compared to a loss ratio of 69% in 2000 contributed to the 2001 growth in pretax operating earnings of $22.3. The improving trend in the loss ratios can be attributed to rate increases. We expect that the 2002 level of profit will be difficult to sustain in 2003 due to increased competition from existing and new entrants into the business.
Revenues were $379.7 in 2002, an increase of 3.2% over 2001 revenues, which were up 7.9% from 2000. The increase in total revenues in 2002 and 2001 reflect growth in the investment portfolio supporting our life products and premiums from increased sales.
Our L&I Other segment is comprised mainly of investment income on capital and accumulated earnings of the other reportable segments, as well as earnings from Talbot, our insurance agency, which distributes property and casualty and life insurance products. Revenues were $189.2 in 2002, a 5.0% increase from 2001 revenues of $180.3, which were up 3.5% from 2000. The increase in revenues in 2002 and 2001 was due to increased net investment income and increases in Talbot revenues from commissions. Pretax operating earnings were $77.9, $76.7 and $70.2 in 2002, 2001 and 2000, respectively.
We use treaty reinsurance in managing our exposure to potential losses for our Life & Investments operations. Amounts due from reinsurers were $158.9 at December 31, 2002 and $90.1 at December 31, 2001.
Safeco’s operations have liquidity requirements that vary among our segments and principal product lines. Life insurance, retirement services and annuity product reserves are primarily longer-duration liabilities that are typically predictable in nature and are supported by investments that are generally longer duration. Property & Casualty liabilities vary in duration according to the product and coverages provided. These liabilities are less predictable in nature and generally require greater liquidity in the investment portfolio.
Total cash provided by operating activities for 2002, 2001 and 2000 was $853.9, $528.8 and $619.3, respectively (see Consolidated Statements of Cash Flows for additional information). The main reasons for the improved operating cash flow in 2002 compared to 2001 were lower Property & Casualty claims payments, due to lower catastrophe and weather losses, as well as the effect of our re-underwriting efforts and rate increases that began in 2001. After tax investment income declined in 2002 and is expected to be modestly lower in 2003 due to lower interest rates available for investment of new cash flows and maturing investments, as well as changes in Safeco’s investment strategy as discussed above.
Funds received under deposit contracts relate primarily to annuity, retirement services and individual products of Life & Investments. Of the total $15.7 billion in deposit contracts at December 31, 2002, approximately 40.3% are structured settlement immediate annuity products. These annuities have an average expected maturity of over 25 years at issuance and cannot be surrendered by policyholders. Equity indexed annuities (EIA), comprising $162.5 or approximately 1% of total deposit contracts at December 31, 2002, have associated surrender charges ranging from 8% in year one to 0% after year six. During 2002, 2001 and 2000, Life & Investments has offered to waive surrender charges on several different occasions in order to induce EIA policyholders to surrender their contracts. These offers resulted in a reduction of the EIA principal policy account balance of $36.5, $144.0 and $291.0 in 2002, 2001 and 2000, respectively. These surrenders contributed to the return of funds held under deposit contracts in 2002, 2001 and 2000 (see Consolidated Statements of Cash Flows for more information). Other annuity and retirement services products comprise 35.7% of total deposit contracts. These products generally have expected maturities of 3 to 20 years at issuance and associated surrender charges ranging from 10% to 3% in year one reduced to 0% within 3 to 10 years. Life & Investments retains the option to defer payouts over 5 years on approximately 16% of these contracts. Universal life products comprise 21.7% of total deposit contracts. Of the total universal life product deposit contracts, 84% are BOLI policies which have expected maturities of 20 to 25 years at issuance with surrender charges varying according to policy type. As a result of the downgrade in Safeco’s
ratings in 2001, Life & Investments received no new direct BOLI deposits in 2002, compared to $120.0 and $710.0 in 2001 and 2000, respectively. The GICs within the retirement services area comprise the remaining 1.3% of total deposit contracts.
On August 23, 2002, we issued $375.0 of senior notes with a coupon of 7.250% that mature in 2012. The majority of the proceeds of the notes were used for the repayment of $299.0 of commercial paper borrowings, $18.7 for the termination of related interest rate swaps and $28.4 for repayment of medium-term notes. The remaining balance has been used for general corporate purposes. Safeco simultaneously entered into a $375.0 notional interest rate swap to effectively convert the fixed rate senior note obligation into a LIBOR-based floating rate obligation. The fair value of the interest rate swap is marked-to-market on the balance sheet and included in Other Invested Assets with the corresponding offsetting asset or liability included in the face value of the debt.
On January 27, 2003, Safeco issued $200.0 of senior notes with a coupon of 4.200% that mature in 2008 and $300.0 of senior notes with a coupon of 4.875% that mature in 2010. The notes are unsecured and rank equally with all our other unsecured senior indebtedness. The proceeds from the notes will be used to repay $300.0 principal amount of 7.875% notes due March 15, 2003 and to call up to $200.0 principal amount of 7.875% notes maturing in 2005 with a call date at par of April 1, 2003.
Material terms of contractual obligations are described in Notes 8 and 12 to the consolidated financial statements.
The financial strength of insurers is rated to provide both insurance consumers and industry participants with comparative information on specific insurance companies. Financial strength ratings are important for the marketing of our products and some lines are especially sensitive to ratings such as structured settlement
annuities, BOLI products and GICs. Higher ratings generally indicate greater financial strength and a stronger ability to pay claims. Lower ratings for us could, among other things, significantly affect our ability to sell certain life insurance and investment products, materially increase the number of policy surrenders and withdrawals by policyholders of cash value from their policies, adversely affect relationships with broker-dealers, banks, agents and other distributors of our products and services, adversely affect new sales, significantly affect borrowing costs or limit our access to capital, and adversely affect our ability to compete. Any of these factors could have a material adverse effect on our business, consolidated results of operations and financial condition.
We believe our financial position is sound and continue to execute our action plans to improve Property & Casualty’s operating results. The effect of our operating action plans has been reflected in improved operating results and this has improved Safeco’s debt service coverage during 2002. It is, however, possible that further negative ratings actions may occur. Lower ratings have significantly affected Life & Investments ability to sell structured settlement immediate annuities and BOLI products. If ratings are further lowered, Safeco may incur higher borrowing costs, may have more limited means to access capital, and may have additional difficulties marketing certain of its insurance products that are dependent upon ratings being at or above a particular level.
Safeco is not aware of any recently passed or current recommendations by regulatory authorities which have or would have, if passed, a material effect on its liquidity, capital resources or results of operations.
Those states in which Safeco’s insurance subsidiaries are domiciled or deemed to be commercially domiciled, limit the amount of dividend payments that can be made by those subsidiaries without prior regulatory approval. These limitations are not anticipated to limit our insurance subsidiaries from paying dividends to Safeco Corporation in
The National Association of Insurance Commissioners (NAIC) uses risk-based capital (RBC) formulas for both life insurers and property and casualty insurers. These serve as an early warning tool by the NAIC and state regulators to identify companies that are undercapitalized and merit further regulatory attention or the initiation of regulatory action. Safeco’s life and property and casualty companies have more than sufficient capital to meet the RBC requirements.
Under Washington State’s insurance code, investments in foreign securities are not considered admitted assets for statutory accounting purposes. However, statutory accounting practices prescribed by the NAIC allow insurance companies to account for foreign investments as admitted assets. The Washington State Insurance Commissioner has the express statutory authority to permit an insurer to make investments not otherwise eligible under the state’s insurance code and has exercised this authority by permitting Safeco to account for its foreign investments as admitted assets. The Property & Casualty insurance subsidiaries hold investments in foreign corporations and municipalities of $114.9 and $105.9 at December 31, 2002 and 2001, respectively, and the Life & Investments insurance subsidiaries hold investments in foreign corporations and municipalities of $162.9 and $326.4 at December 31, 2002 and 2001, respectively. These amounts increase the surplus of our insurance subsidiaries accordingly.
As of December 31, 2002, Safeco had approximately $1,127.2 of gross deferred tax assets, including net operating loss carryforwards of $110.0 that expire in 2020 and 2021. Although realization of deferred tax assets is not assured, we believe it is more likely than not that the deferred assets will be realized through future earnings, including but not limited to the generation of future operating income and reversal of existing temporary differences and available tax planning strategies. Accordingly, no valuation allowance has been recorded. In preparing estimates of future taxable income, we have used the assumptions and projections utilized in our internal financial projections. These projections of future profitable results are subject to uncertainties primarily related to the variability of Property & Casualty underwriting results. Should results not be as profitable as we have forecasted the establishment of a valuation allowance may be required. Any such allowance would impact current operating results.
Investment activities are an integral part of our business and investment income is a significant component of our total revenues. Our investment philosophy is to emphasize investment yield balanced with investment quality, and to provide for liquidity, diversification and a reasonable matching of expected asset and liability durations. We are subject to the risk that our investments may decline in value and bond defaults may occur.
Safeco’s consolidated pretax net investment income increased to $1,672.3 during 2002 from $1,649.3 in 2001 and $1,633.5 in 2000. The investment portfolios of Property & Casualty and Life & Investments produced substantially all of this investment income. Our consolidated pretax net investment income increased slightly in 2002 over 2001, primarily due to improved cash flows in Property & Casualty, a repositioning of the Property & Casualty investment portfolio as discussed below, and a higher invested asset base in Life & Investments, offset in
part by lower pretax yields on fixed maturity investments due to lower interest rates. Net investment income in 2001 increased slightly over 2000. Lower investment yields, the low interest rate environment, bond call activity and an overall decline in the equity markets dampened the growth of investment income in both the Property & Casualty and Life & Investment portfolios.
In order to better match invested asset duration to the duration of related liabilities, during 2002 we repositioned our Property & Casualty investment portfolio to reduce the bond investment portfolio duration from approximately 7 to approximately 5. As of December 31, 2002, the bond investment portfolio’s duration was 5.3 compared to 7.1 at December 31, 2001 and 7.4 at December 31, 2000. The Property & Casualty asset allocation mix was also adjusted to reduce volatility, by lowering the exposure to equity securities. Equity securities comprised approximately 11% of this investment portfolio at December 31, 2002 compared to approximately 18% at December 31, 2001. As a result of executing this strategy, this portfolio’s allocation to taxable bonds has increased relative to its tax-exempt holdings. As a result, pretax investment income for the Property & Casualty investment portfolio increased 0.5% in 2002 compared to 2001 while after tax investment income declined 3.5% in 2002 compared to 2001.
Life & Investments pretax net investment income was $1,206.6, $1,180.3 and $1,181.5 in 2002, 2001 and 2000, respectively. The growth in investment income in 2002 compared to 2001 was due primarily to the higher invested assets related to the growth of total funds held under deposit contracts, partially offset by lower pretax yields on new investments and loss of interest income due to bond defaults. Life & Investments paid dividends to the parent company totaling $50.0, $112.0 and $49.0 for 2002, 2001 and 2000, respectively.
We analyze all investments with a fair value below cost as of each quarterly reporting date to determine if an other than temporary decline in value has occurred. The determination of whether a decline is other than temporary is made based on the relevant facts and circumstances related to the security. These considerations include: (1) the length of time and the extent to which the fair value has been less than cost; (2) the financial condition and near-term prospects of the issuer, including any specific events that influence the operations of the issuer or that affect its future earnings potential; (3) our intent and ability to retain the investment for a period of time sufficient to allow for a recovery in value; (4) a review of any downgrades of the security by a rating agency; and (5) any reduction or elimination of dividends or non-payment of scheduled interest payments. Determining what constitutes an other than temporary decline involves judgment. Declines in fair value below cost not considered other than temporary in the current period could be considered other than temporary in a future period and reduce earnings to the extent of the impairment.
As of December 31, 2002, unrealized losses on securities that were in an unrealized loss position for longer than a year amounted to $20.4 for equity securities and $207.5 for fixed maturity securities. These unrealized losses represent less than 1% of total portfolio value and are attributed to a prolonged period of distressed credit markets experienced in both 2001 and 2002. We continue to monitor these securities as part of our overall portfolio evaluation and if an unrealized loss is determined to be other than temporary, the impairment loss would be recognized in the current period when that determination is made.
The total amount of gross unrealized losses on fixed-maturity and equity securities at December 31, 2002 was $404.1 and is detailed by maturity in the following table:
While we have the ability to hold fixed income securities to maturity, we continually monitor the portfolio and markets for opportunities to improve credit quality, reduce exposure to troubled credits or sectors and minimize call risk. In 2002, we repositioned a portion of our fixed income portfolio in order to reduce duration and adjust our asset allocation mix to reduce our exposure to equity securities. These activities resulted in both realized gains and losses. The total sales proceeds at fair value from fixed maturities and equities sold at a loss in 2002 were $707.9. The related total net realized investment loss on these sales was $246.3. In accordance with our investment impairment process described above, we consider our intent and ability to retain investments for a period of time sufficient to allow for a market value recovery. However, our intent to hold is reassessed frequently in light of financial market fluctuations and the financial condition and near term prospects of the issuer. Safeco’s sales activity reflects ongoing investment management decisions and modifications in our intent due to actual or expected deterioration in the issuer’s credit, our decisions to lessen exposure to a particular issuer or industry and our actions to reposition our portfolio duration and asset allocation.
Property & Casualty’s fixed maturities portfolio, which totaled $7.5 billion at fair value at December 31, 2002, is comprised of 28% tax-exempt and 72% taxable investments at December 31, 2002 compared with 42% tax- exempt and 58% taxable investments at December 31, 2001. The effective tax rate on investment income was 25%, 22% and 21% in 2002, 2001 and 2000, respectively, reflecting the shift to a higher level of taxable bond holdings.
On a consolidated basis, below investment-grade securities with a fair value of $1.1 billion were held at December 31, 2002 compared to $790.8 at December 31, 2001. The related amortized cost at December 31, 2002 was $1.2 billion and $858.9 at December 31, 2001. The increase reflects rating decreases of portfolio investments rather than purchases of below investment grade securities. The net unrealized investment loss of $119.1 at December 31, 2002 is comprised of gross unrealized investment losses of $150.6 and gross unrealized investment gains of $31.5. These securities represented 4.5% of total fixed maturities at fair value at December 31, 2002.
Safeco’s consolidated investment portfolio included $335.9 and $391.4 of non-publicly traded fixed maturities and equity securities, representing 1.3% and 1.6% of the portfolio at December 31, 2002 and 2001, respectively.
The consolidated financial statements and schedules listed in the Index to Financial Statements, Schedules and Exhibits on page FS-1 are filed as part of this report.