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 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 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. Those estimates that were most critical to the preparation of the Financial Statements involved the following: (i) reserves for loss and loss expense; (ii) pension and post-retirement benefit plan actuarial assumptions; (iii) investment valuation and other-than-temporary-impairments (“OTTI”); and (iv) reinsurance.
The following tables provide case and incurred but not reported (“IBNR”) reserves for loss and loss expenses, and reinsurance recoverable on unpaid loss and loss expense as of December 31, 2017 and 2016:
1Includes general liability (97% of net reserves) and commercial auto liability coverages (3% of net reserves).
2Includes commercial property (93% of net reserves) and commercial auto property coverages (7% of net reserves).
The actuarial reserve analysis is the foundation of the quarterly reserve review process. Using generally accepted actuarial reserving techniques, we project our estimate of ultimate loss and loss expense at each reporting date. Our IBNR reserve is the difference between the projected ultimate loss and loss expense incurred and the sum of: (i) case loss and loss expense reserves; and (ii) paid loss and loss expense. The actuarial techniques used in determining ultimate losses are part of a comprehensive reserving process that includes two primary components. The first component is a detailed quarterly reserve analysis performed by our internal actuarial staff. In completing this analysis, the actuaries must gather substantially similar data in sufficient volume to ensure statistical credibility of the data, while maintaining appropriate differentiation. This process defines the reserving segments, to which various actuarial projection methods are applied. When applying these methods, the actuaries are required to make numerous assumptions including, for example, the selection of loss and loss expense development factors and the weight to be applied to each individual projection method. These methods include paid and incurred versions of the following methods: aggregate loss and loss expense development, Bornhuetter-Ferguson, Berquist-Sherman, and frequency/severity modeling (via a development approach). The second component of the analysis is the projection of the expected ultimate loss and loss expense ratio for each line of business for the current accident year. This projection is part of our planning process wherein we review and update expected loss and loss expense ratios each quarter. This review includes actual versus expected pricing changes, loss and loss expense trend assumptions, and updated prior period loss and loss expense ratios from the most recent quarterly reserve analysis. Actual claims counts and severities are also considered relative to initial expectations.
In addition to the quarterly reserve analysis, a range of possible IBNR reserves is estimated annually and continually considered, among other factors, in establishing IBNR for each reporting period. Loss and loss expense trends are also considered, which include, but are not limited to, large loss activity, asbestos and environmental claim activity, large case reserve additions or reductions for prior accident years, and reinsurance recoverable issues. We also consider factors such as: (i) per claim information; (ii) company and industry historical loss experience; (iii) legislative enactments, judicial decisions, legal developments, and changes in political attitudes; and (iv) trends in general economic conditions, including the effects of inflation. Based upon our quarterly reserve analysis, our annual reserve range, and other relevant factors and considerations, IBNR is established and the ultimate net liability for loss and loss expense is determined. Such an assessment requires considerable judgment given that it is frequently not possible to determine whether a change in the data is an anomaly until sometime after the event. Even if a change is determined to be permanent, it is not always possible to reliably determine the extent of the change until sometime later. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves because the eventual deficiency or redundancy is affected by many factors. 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. Any changes in the liability estimate may be material to the results of operations in future periods. In addition to our internal review, statutory regulation requires us to have a Statement of Actuarial Opinion issued annually on our statutory reserve adequacy. We engage an external consulting actuary to issue this opinion based on their independent review.
We have estimated a range of reasonably possible reserves for net loss and loss expense claims to be $2,899 million to $3,361 million at December 31, 2017, which compares to $2,780 million to $3,237 million at December 31, 2016. These ranges reflect low and high reasonable reserve estimates, which were selected 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 these reflect ranges of reasonable estimates, it is possible that the final outcomes may fall above or below these amounts. The ranges do not include a provision for potential increases or decreases associated with asbestos, environmental, and certain other continuous exposure claims, as traditional actuarial techniques cannot be effectively applied to these exposures.
Each quarter a reserve review produces updated reserve estimates for the current and prior accident years, which in turn leads to changes in the booked reserves, favorably, or unfavorably. In 2017, we experienced overall net favorable loss development of $39.2 million, compared to $65.8 million in 2016, and $69.0 million in 2015. The following table summarizes prior year development by line of business:
At December 31, 2017, our workers compensation line of business recorded reserves, net of reinsurance, of $966.5 million, which represented 30% of our total net reserves. During 2017, this line experienced favorable development of $52.3 million driven by accident years 2016 and prior. During 2016, this line experienced favorable development of $56.0 million driven by accident years 2014 and prior. During 2017, this line again showed lower loss emergence than expected, due, in part, to: (i) lower medical inflation than originally anticipated; (ii) our proactive underwriting actions in recent years; and (iii) various significant claims initiatives that we have implemented.
Unexpected changes in medical cost inflation - The industry is currently experiencing a period of lower claim cost inflation. Changes in our historical workers compensation medical costs, along with uncertainty regarding future medical inflation, creates the potential for additional variability in our reserves;
Changes in utilization of the workers compensation system - These changes may be driven by economic, legislative, or other changes. For example, this includes increased use of pharmaceuticals and more complex medical procedures.
Audit premium and endorsement premium may also introduce uncertainty into our reserves, since earned premiums are used as a basis to set initial reserves. Over recent years, this activity has been fairly consistent. In 2017, audit and endorsement activity resulted in additional premium of $18.2 million, and in 2016 it resulted in additional premium of $22.6 million.
unemployment and lower gasoline prices, as well as an increase in distracted driving. Rising severities may be the result of the increasing complexity of vehicles and the technology they incorporate, which results in increased repair costs.
We are currently taking actions to improve the profitability of this line of business, including:
At December 31, 2017, our E&S casualty lines of business had recorded reserves, net of reinsurance, of $306 million, which represented 10% of our total net reserves. In 2017, this line experienced unfavorable development of $10.0 million, mostly associated with accident years 2014 and 2015. In 2016, this line experienced unfavorable development of $6.0 million, mostly associated with accident year 2014. Since we have limited historical loss experience in this segment, our reserve estimates are subject to somewhat greater uncertainty than the comparable Standard Commercial and Personal Line segments. In addition, by its nature, the composition of this book changes over time, which may impact development patterns.
Over the course of late 2015 and early 2016, our E&S claims handling function was aligned with our standard operations claims function. E&S claims were migrated from the business unit in Scottsdale, Arizona, to the appropriate regional claims operation. Complex claims are referred to the corporate Complex Claims Unit ("CCU") for specialized handling.
Increased focus on reducing workers compensation medical costs through more favorable Preferred Provider Organization ("PPO") contracts and greater PPO penetration.
Continued efforts in the areas of fraud investigation and salvage/subrogation recoveries. These efforts have been supported by the introduction of predictive models that allow us to better focus our efforts.
Our internal reserve analyses incorporate certain actuarial projection methods, which make adjustments for changes in case reserve adequacy and claims settlement rates. These methods adjust our historical loss experience to the current level of case adequacy or settlement rate, which provides a more consistent basis for projecting future development patterns. These methods have their own assumptions and judgments associated with them, so as with any projection method, they are not definitive in and of themselves. Furthermore, given that the expected benefits from our claims initiatives take time to fully manifest, we do not take full credit for the anticipated benefit in establishing our loss and loss expense reserves. These initiatives may prove more or less beneficial than currently reflected, which will affect development in future years. Our various projection methods provide an indication of these potential future impacts. These impacts would be greatest within our larger reserve lines of workers compensation, general liability, and commercial automobile liability, within the more recent accident years.
The sensitivities of loss and loss expense reserves to these key assumptions are illustrated below for the major casualty lines. The first table shows the estimated impacts from changes in expected reported loss and loss expense development patterns. It shows reserve impacts by line of business if the actual calendar year incurred amounts are greater or less than current expectations by the selected percentages. While the selected percentages by line are judgmental, they are based upon the reserve range analysis, as well as the actual historical reserve development for the line of business. The second table shows the estimated impacts from changes to the expected loss and loss expense ratios for the current accident year. It shows reserve impacts by line of business if the expected loss and loss expense ratios for the current accident year are greater or less than current expectations by the selected percentages.
The total carried net losses and loss expense reserves for these claims were $21.2 million as of December 31, 2017 and $22.7 million as of December 31, 2016. The emergence of these claims occurs over an extended period and is highly unpredictable. For example, within our Standard Commercial Lines book, certain landfill sites are included on the National Priorities List (“NPL”) by the United States Environmental Protection Agency (“USEPA”). Once on the NPL, the USEPA determines an appropriate remediation plan for these sites. A landfill can remain on the NPL for many years until final approval for the removal of the site is granted from the USEPA. The USEPA has the authority to re-open previously closed sites and return them to the NPL. We currently have reserves for seven customers related to four sites on the NPL.
The discount rate enables us to state expected future cash flows at their present value on the measurement date. The purpose of the discount rate is to determine the interest rates inherent in the price at which pension benefits could be effectively settled. Our discount rate selection is based on high-quality, long-term corporate bonds. A higher discount rate reduces the present value of benefit obligations. Conversely, a lower discount rate increases the present value of benefit obligations. Our discount rate decreased 63 basis points, to 3.78%, as of December 31, 2017 compared to 4.41% as of December 31, 2016. For additional information regarding our discount rate selection, refer to Note 14. “Retirement Plans” in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
The fair value of our investment portfolio is defined under accounting guidance as the exit price or the amount that would be: (i) received to sell an asset; or (ii) paid to transfer a liability in an orderly transaction between market participants. When determining an exit price we must, when available, rely upon observable market data. Our available-for-sale ("AFS") portfolio is carried at fair value and the related unrealized gains or losses are reflected in stockholders' equity, net of tax. For both our AFS and held-to-maturity ("HTM") portfolios, fair value is a key factor in the evaluation of a security for OTTI.
Reinsurance recoverables on paid and unpaid loss and loss expense represent estimates of the portion of such liabilities that will be recovered from reinsurers. Each reinsurance contract is analyzed to ensure that the transfer of risk exists to properly record the transactions in the Financial Statements. Amounts recovered from reinsurers are recognized as assets at the same time and in a manner consistent with the paid and unpaid losses associated with the reinsured policies. An allowance for estimated uncollectible reinsurance is recorded based on an evaluation of balances due from reinsurers and other available information. This allowance totaled $4.6 million at December 31, 2017 and $5.5 million at December 31, 2016. We continually monitor developments that may impact recoverability from our reinsurers and have available to us contractually provided remedies if necessary. For further information regarding reinsurance, see the “Reinsurance” section below and Note 8. “Reinsurance” in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
Reconciliations of net income, net income per share, and ROE to non-GAAP operating income, non-GAAP operating income per share, and non-GAAP operating ROE, respectively, are provided in the tables below:
Our commercial and personal automobile lines of business have been unprofitable in recent years and remain areas of focus as we are taking steps to improve profitability in these lines of business. In 2017, we recorded unfavorable prior year casualty reserve development and increases to our current year loss costs for these lines. We will continue to seek to actively implement renewal pure price increases in these lines, which have averaged 6.7% in 2017 for commercial auto and 4.1% for personal auto, to improve the level of profitability of these lines of business, which have not met our risk adjusted return expectations in recent years. We have also been managing our commercial auto in-force book of business in targeted industry segments and we have been reducing exposures to higher hazard commercial auto classes to improve the underlying profitability of this business.
Our E&S segment also remains a focus area, with a combined ratio of 103.0% for 2017. We face a competitive environment in this segment, and our pricing and underwriting initiatives aimed at improving profitability have resulted in a decline in new business volume. Our focus in E&S is on improving profitability, rather than premium volume or growth, and we expect continued volatility in net premiums written in this segment until the E&S segment meets our risk adjusted return expectations.
The deterioration in the loss and loss expense ratio in 2017 was partially offset by improvement in the underwriting expense ratio of 0.9 points in 2017. This improvement was driven by:
A 0.5-point decrease in commissions to our distribution partners in 2017 due to lower supplemental commission expense, as well as lower base commissions that were driven by targeted actions we took in late 2016 on our homeowners book of business;
Partially offsetting these improvements was an increase of 0.3 points of other expense items.
The ROE contribution from investment income has increased in 2017 compared to 2016 reflecting higher yields on our core fixed income portfolio, coupled with a higher asset base driven by cash flows from operations that were 16% of NPW for the year. In addition, our alternative investment portfolio generated $8.3 million in after-tax income in 2017 compared to $2.0 million in 2016.
Our long-term growth plans include: (i) increasing the Standard Commercial Lines market share held by our "ivy league" distribution partners to at least 25%; (ii) increasing our share of the business within these distribution partners, which we refer to as our "share of wallet," to 12%; and (iii) geographic expansion. To date, we write Standard Commercial Lines business in 25 states and the District of Columbia, which at a 3% market share, would create a corporate Standard Commercial Lines profile in excess of $4 billion of net premiums written.
Effective July 1, 2017, we opened Arizona and New Hampshire for Standard Commercial Lines business. We have appointed a total of 26 agents in these states, with appointments in each state controlling in excess of 20% of that state's available Standard Commercial Lines premium. During 2017, we generated $9.1 million of premium volume in these new markets. On January 1, 2018 we opened Standard Commercial Lines business in Colorado, and we expect to open New Mexico and Utah by the end of 2018. We also expect to open Arizona and Utah for Standard Personal Lines business in the future.
As an organization, we are making significant investments that are focused on enhancing the overall customer experience in an omni-channel environment. To that end, we have recently deployed a new customer experience desktop to our contact center employees and we are also working closely with our distribution partners to ensure we present our customers with a seamless experience. We recognize that our customers' expectations on how they engage with us are rapidly evolving and we continue to strive towards providing best-in-class customer service in a 24-hour, 365-day environment. Our goals in this area are centered around leveraging technology to improve customer retention rates, which should, over time, enhance the quality of our business.
Our investment portfolio generated after-tax net investment income of $119 million in 2017, which was a 20% increase over 2016. We have generated strong investment returns despite low interest rates, while maintaining a similar level of credit quality and duration risk on the portfolio. Risk assets, which principally include high-yield fixed income securities, equities, and our alternative investment portfolio, are up modestly to 8% from 7% last year end. We have been gradually diversifying our portfolio, and will likely continue to modestly increase our risk asset allocation over time up to approximately 10% of our invested assets, depending on market conditions.
Our achievements in 2017, coupled with the impact of Tax Reform, will help drive our future financial performance in 2018 and beyond.
A GAAP combined ratio, excluding catastrophe losses, of approximately 91.0%. This assumes no prior year casualty reserve development;
Our weighted average cost of capital has increased from 8.5% in 2017 to 9.0% in 2018, driven principally by a higher estimated cost of equity, and as such our long-term financial target of generating a non-GAAP operating ROE of 300 basis points above our weighted average cost of capital, has increased our financial target to 12.0% for 2018.
Increases in the loss and loss expense ratio over the three-year period were driven by lower favorable prior year casualty reserve development coupled with higher property losses, as displayed in the tables below. For quantitative information on the prior year development by line of business, see "Financial Highlights of Results for Years Ended December 2017, 2016, and 2015" above and for qualitative information about the significant drivers of this development, see the line of business discussions below.
A 0.4-point decrease in labor expenses reflecting productivity gains from the growth of our business, including our geographic expansion efforts; and
The combined ratio decreased in 2017 by 2.3 points driven by: (i) a decrease in supplemental commission to our distribution partners of 0.4 points; (ii) a decrease in pension expense of 0.3 points; and (iii) a decrease in current year loss costs of approximately 0.4 points. Favorable prior year development was consistent with 2016 at 8.5 points.
The combined ratio increased in 2016 compared to 2015 by 2.8 points driven by a reduction in favorable prior year development. The impact of the prior year casualty reserve development on this line was as follows:
The 3.9-point increase in the combined ratio in 2017 compared to 2016 was primarily driven by a 5.4-point increase in the loss and loss expense ratio, which was attributable to the following: (i) an increase in the current year loss reserve estimate of 4.6 points reflecting higher casualty claim frequency; and (ii) unfavorable prior year casualty reserve development that increased the combined ratio by 1.8 points compared to last year. The increase in the loss and loss expense ratio was partially offset by a 1.3-point decrease in the underwriting expense ratio.
2016: Unfavorable development of 6.3 points, which was driven primarily by bodily injury liability for accident years 2014 and 2015. The unfavorable development in accident year 2014 was driven by higher than expected severity, whereas accident year 2015 was driven by higher than expected frequency and severity.
2015: Unfavorable development of 0.8 points, which was driven by bodily injury liability for accident years 2013 and 2014. This was partially offset by favorable development in accident years 2010 and 2011. The unfavorable development in accident years 2013 and 2014 was driven by severities that were greater than expected.
The improvement in the combined ratio was attributable to the loss and loss expense ratio, which decreased 0.9 points in 2017 driven by lower current year loss costs, which was partially offset by lower favorable prior year development. Additionally, the expense ratio improved by 1.2-points, consistent with the improvement in overall Standard Commercial Lines discussed above.
NPW in this segment increased 5% in 2017 compared to 2016 as shown in the table above. As illustrated in the table below, the increase in 2017 was primarily due to increases in new business and improving retention. In 2016, NPW decreased compared to 2015 reflecting the highly competitive market.
The loss and loss expense ratio increased 2.1 points in 2017 compared to 2016, primarily driven by unfavorable prior year casualty reserve development. Despite the unfavorable prior year casualty reserve development in 2016 as compared to 2015, the overall combined ratio improved almost 4 points primarily as a result of improved property results. The details of the prior year casualty reserve development, catastrophe losses and non-catastrophe property losses for all of the years presented were as follows:
Flood Reinsurance - as a servicing carrier in the WYO Program, we receive a fee for writing flood business, for which the related premiums and losses are 100% ceded to the federal government.
As our need for catastrophe reinsurance increases, we seek ways to minimize credit risk inherent in a reinsurance transaction by dealing with highly-rated reinsurance partners and purchasing collateralized reinsurance products, particularly for high severity, low-probability events. The current reinsurance program includes $224 million in collateralized limit, primarily in the top layers of the catastrophe program.
The property excess of loss treaty, which covers both our standard market and E&S business, was renewed on July 1, 2017 with the top layer renewed on January 1, 2018. The major terms of these treaties are consistent with the prior year.
The following is a summary of our property reinsurance treaties and arrangements covering our Insurance Subsidiaries:
The following is a summary of our casualty reinsurance treaties and arrangements covering our Insurance Subsidiaries:
As part of the acquisition of MUSIC we entered into several reinsurance agreements that together provide protection for losses on policies written prior to the acquisition and any development on reserves established by MUSIC as of the date of acquisition. The reinsurance recoverables under these treaties are 100% collateralized. Montpelier Re was acquired by Endurance Specialty on December 29, 2015. On March 28, 2017, Endurance Specialty was acquired by SOMPO Holdings, Inc.
In 2017, we reclassified certain line items within our Consolidated Statements of Income to enhance the ability to analyze our expenses. Specifically, we reclassified our insurance underwriting expenses into amortization of deferred policy acquisition costs and other insurance expenses. These expenses were previously included in policy acquisition costs and other expenses. In addition, all expenses of the Parent, which were previously included in other expenses, are now separately identifiable as corporate expenses on the Consolidated Statements of Income. All prior periods presented in this Form 10-K have been reclassified to reflect this change.
Fixed income securities may include investment grade and below investment grade rated bonds, redeemable preferred stocks, non-redeemable preferred stocks with certain debt-like characteristics, mortgage-backed securities (“MBS”), collateralized loan obligations ("CLO"), and other asset-backed securities (“ABS”). MBS, CLO, and other ABS are jointly referred to as structured securities. Fixed income securities classified as available-for-sale (“AFS”) are reported at fair value. Those fixed income securities that we have the ability and positive intent to hold to maturity are classified as held-to-maturity (“HTM”) and are carried at either: (i) amortized cost; or (ii) market value at the date of transfer into the HTM category, adjusted for subsequent amortization. The amortized cost of fixed income securities is adjusted for the amortization of premiums and the accretion of discounts over the expected life of the security using the effective yield method. Premiums and discounts arising from the purchase of structured securities are amortized over the expected life of the security based on future principal payments, giving additional consideration to prepayments. These prepayments are estimated based on historical and projected cash flows. Prepayment assumptions are reviewed quarterly and adjusted to reflect actual prepayments and changes in expectations. Future amortization of any premium and/or discount is adjusted to reflect the revised assumptions. Interest income, as well as amortization and accretion, is included in "Net investment income earned" on our Consolidated Statements of Income. The amortized cost of a fixed income security is written down to fair value when a decline in value is considered to
Other investments may include alternative investments and other securities. Alternative investments are accounted for using the equity method. Our share of distributed and undistributed net income from alternative investments is included in "Net investment income earned" on our Consolidated Statements of Income. Other securities are primarily comprised of tax credit investments. Low income housing tax credits are accounted for under the proportional amortization method and all other tax credits are accounted for using the equity method. Under the proportional amortization method, our share of the investment’s performance is recorded in our Consolidated Statements of Income as a component of “Federal income tax expense.” Under the equity method, our share of distributed and undistributed net income is included in "Net investment income earned" on our Consolidated Statements of Income. For federal income tax credits accounted for under the equity method, we use the deferral method for recognizing the benefit of the tax credit with the related deferred revenue being recognized in our Consolidated Statements of Income as a component of "Federal income tax expense" proportionately over the life of the investment.
We evaluate the alternative investments and tax credit investments included in our other investments portfolio to determine whether those investments are variable interest entities ("VIEs") and if so, whether consolidation is required. A VIE is an entity that either has equity investors that lack certain essential characteristics of a controlling financial interest or lack sufficient funds to finance its own activities without financial support provided by other entities. We consider several significant factors in determining if our investments are VIEs and if we are the primary beneficiary, including whether we have: (i) the power to direct activities of the VIE; (ii) the ability to remove the decision maker of the VIE; (iii) the ability to participate in making decisions that are significant to the VIE; and (iv) the obligation to absorb losses and the right to receive benefits that could potentially be significant to the VIE. We have reviewed our alternative and tax credit investments and have concluded that they are VIEs, but that we are not the primary beneficiary and therefore, consolidation is not required.
Non-redeemable preferred stocks that are classified as fixed income securities are evaluated under this OTTI method unless the security is below investment grade, at which time it is evaluated under the equity securities OTTI model discussed below.
We estimate an allowance for doubtful accounts on our premiums receivable. This allowance is based on historical write-off percentages adjusted for the effects of current and anticipated trends. An account is charged off when we believe it is probable that we will not collect a receivable. In making this determination, we consider information obtained from our efforts to collect amounts due directly or through collection agencies.
Reinsurance recoverables represent estimates of amounts that will be recovered from reinsurers under our various treaties. Generally, amounts recoverable from reinsurers are recognized as assets at the same time and in a manner consistent with the paid and unpaid losses associated with the reinsured policies. We require collateral to secure reinsurance recoverables primarily from our reinsurance carriers that are not authorized, otherwise approved, or certified to do business in one or more of our ten insurance subsidiaries' domiciliary states. Our ten insurance subsidiaries are collectively referred to as the
We recorded depreciation expense of $17.8 million, $17.4 million, and $16.4 million for 2017, 2016, and 2015, respectively.
Goodwill results from business acquisitions where the cost of assets and liabilities acquired exceeds the fair value of those assets and liabilities. A quantitative goodwill impairment analysis is performed if our quarterly qualitative analysis indicates that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Goodwill is allocated to the reporting units for purposes of these analyses. Based on our analysis at December 31, 2017, goodwill was not impaired.
producing a set of estimated ultimate loss and loss expenses. Ultimate loss and loss expenses are selected from the various methods, considering the strengths and weaknesses of the methods as they apply to the specific line and accident year.
Another example of non-standard methods relate to loss expenses that cannot be attributed to a specific claim (referred to as “unallocated loss expenses”). These expenses are first allocated to line of business, and alternative projection methods are then applied to estimate expenses by calendar year, which are then allocated back to the applicable accident years for reporting.
The combination of the IBNR estimates along with the case reserve estimates on individual claims results in our total reserves for loss and loss expense. These reserves are expected to be sufficient for settling losses and loss reserve obligations under our policies on unpaid claims, including changes in the volume of business written, claims frequency and severity, the mix of business, claims processing, and other items that management expects to affect our ultimate settlement of loss and loss expense. However, the ultimate claim settlements may be higher or lower than reserves established. As our experience emerges and other information develops, we revise our reserve estimates accordingly. 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. The associated impacts may be material to the results of operations in future periods.
We use the asset and liability method of accounting for income taxes. Current federal income taxes are recognized for the estimated taxes payable or refundable on tax returns for the current year. Deferred federal income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax basis of assets and liabilities. We consider all evidence, both positive and negative, with respect to our federal tax loss carryback availability, expected levels of pre-tax financial statement income, and federal taxable income, when evaluating whether the temporary differences will be realized. In projecting future taxable income, we begin with budgeted pre-tax income adjusted for estimated non-taxable items. The assumptions about future taxable income require significant judgment and are consistent with the plans and estimates we use to manage our businesses. A valuation allowance is established when it is more likely than not that some portion of the deferred tax asset will not be realized. A liability for uncertain tax positions is recorded when it is more likely than not that a tax position will not be sustained upon examination by taxing authorities. The effect of a change in tax rates is recognized in the period of enactment. If we were to be levied interest and penalties by the Internal Revenue Service (“IRS”), the interest would be recognized as “Interest expense” and the penalties would be recognized as either “Other insurance expenses” or "Corporate expenses" on the Consolidated Statements of Income depending on the nature of what caused the occurrence of such an item.
For information regarding the impact of the the recent tax reform, refer to Note 13. "Federal Income Taxes" of this Form 10-K.
In addition, we have various capital leases for computer hardware and software. These leases are accounted for as an acquisition of an asset with a corresponding obligation. Depreciation is calculated using the straight-line method over the shorter of the estimated useful life of the asset or the lease term.
Our pension and post-retirement life benefit obligations and related costs are calculated using actuarial methods, within the framework of GAAP. Our pension benefit obligation is determined as the actuarial present value of the vested benefits to which the employee is currently entitled, based on the average life expectancy of the employee. Our funding policy provides that payments to our pension trust shall be equal to the minimum funding requirements of the Employee Retirement Income Security Act, plus additional amounts that the Board of Directors of Selective Insurance Company of America (“SICA”) may approve from time to time.
ASU 2016-09 also requires that employee taxes paid when an employer withholds shares for tax-withholding purposes be reported as financing activities in the consolidated statement of cash flows. This requirement has no impact to us as we have historically reported these cash flows as part of financing activities.
In October 2016, the FASB issued ASU 2016-17, Consolidation: Interests Held through Related Parties That Are under Common Control ("ASU 2016-17"). ASU 2016-17 changes how a decision maker considers indirect interests in a VIE held under common control in making the primary beneficiary determination. We adopted ASU 2016-17 in the first quarter of 2017. This adoption did not impact us, as we are not the decision maker in any of the VIEs in which we invest.
In May 2017, the FASB issued ASU 2017-09, Compensation - Stock Compensation: Scope of Modification Accounting ("ASU 2017-09"). ASU 2017-09 provides clarification about which changes to the terms or conditions of a share-based payment award would require the application of modification accounting. ASU 2017-09 is effective for annual and interim periods beginning after December 15, 2017, with early adoption permitted. We adopted this guidance in the fourth quarter of 2017 and the adoption did not impact us, as we currently record modifications in accordance with this ASU.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (“ASU 2016-13”). ASU 2016-13 will change the way entities recognize impairment of financial assets by requiring immediate recognition of estimated credit losses expected to occur over the remaining life of many financial assets, including, among others, held-to-maturity debt securities, trade receivables, and reinsurance recoverables. ASU 2016-13 requires a valuation allowance to be calculated on these financial assets and that they be presented on the financial statements net of the valuation allowance. The valuation allowance is a measurement of expected losses that is based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This methodology is referred to as the current expected credit loss model. ASU 2016-13 is effective for fiscal years beginning after December 15, 2019, including interim periods within those annual periods. Early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2018. We are currently evaluating the impact of this guidance on our financial condition and results of operations.
In March 2017, the FASB issued ASU 2017-07, Compensation-Retirement Benefits: Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost ("ASU 2017-07"). ASU 2017-07 requires that an employer report a pension plan's service cost in the same line item or line items as other compensation costs arising from services rendered by pertinent employees during the period. ASU 2017-07 also requires that other components of net benefit cost be presented in the income statement separately from the service cost component. If a separate line item or items are not used, the line item or items used in the income statement to present the other components of net benefit cost must be disclosed. ASU 2017-07 is effective for annual periods beginning after December 15, 2017, including interim periods within those annual periods, with early adoption permitted at the beginning of an annual period. As our pension plan was frozen as of March 2016, we have ceased accruing additional service fee costs since that time. Therefore, the application of this guidance is not anticipated to impact our financial condition, results of operations, or disclosures.
Supplemental cash flow information for the years ended December 31, 2017, 2016, and 2015 is as follows:
Included in "Other assets" on the Consolidated Balance Sheet was $44.2 million at December 31, 2017 and $36.9 million at December 31, 2016 of cash received from the NFIP, which is restricted to pay flood claims under the Write Your Own Program.
(a) Net unrealized gains on investments included in OCI by asset class were as follows for the years ended December 31, 2017, 2016, and 2015:
Unrecognized holding gains and losses of HTM securities are not reflected in the Financial Statements, as they represent fair value fluctuations from the later of: (i) the date a security is designated as HTM either through purchase or transfer from AFS; or (ii) the date that an OTTI charge is recognized on an HTM security, through the date of the balance sheet.
(c) The cost/amortized cost, unrealized gains and losses, and fair value of AFS securities were as follows:
(e) Fixed income securities at December 31, 2017, by contractual maturity are shown below. MBS are included in the maturity tables using the estimated average life of each security. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
Middle Market Lending: This strategy provides privately negotiated loans to U.S. middle market companies. Typically, these are floating rate, senior secured loans diversified across industries. Loans can be made to private equity sponsor-backed companies or non-sponsored companies to finance LBOs, recapitalizations, and acquisitions.
Distressed Debt: This strategy makes direct and indirect investments in debt and equity securities of companies that are experiencing financial and/or operational distress. Investments include buying indebtedness of bankrupt or financially troubled companies, small balance loan portfolios, special situations and capital structure arbitrage trades,
Our alternative investment strategies generally employ low or moderate levels of leverage and use hedging only to reduce foreign exchange or interest rate volatility. At this time, our alternative investment strategies do not include hedge funds. We cannot redeem our investments with the general partners of these investments; however, occasionally these partnerships can be traded on the secondary market. Once liquidation is triggered by clauses within the limited partnership agreements or at the funds’ stated end date, we will receive our final allocation of capital and any earned appreciation of the underlying investments, assuming we have not divested ourselves of our partnership interests prior to that time. We currently receive distributions from these alternative investments through the realization of the underlying investments in the limited partnerships. We anticipate that the general partners of these alternative investments will liquidate their underlying investment portfolios through 2032.
(h) We have pledged certain AFS fixed income securities as collateral related to our relationships with the Federal Home Loan Bank of Indianapolis ("FHLBI") and the Federal Home Loan Bank of New York ("FHLBNY"). In addition, certain securities were on deposit with various state and regulatory agencies at December 31, 2017 to comply with insurance laws. We retain all rights regarding securities pledged as collateral.
Realized gains and losses on the sale of investments are determined on the basis of the cost of the specific investments sold. Proceeds from the sale of AFS securities were $1,235.9 million in 2017, $1,046.1 million in 2016, and $234.1 million in 2015.
2017: A higher trading volume in our fixed income securities portfolio related to a more active external investment management approach and opportunistic sales in our equity portfolio.
(b) The balances of, and changes in, each component of AOCI (net of taxes) as of December 31, 2017 and 2016 were as follows:
The following table presents the carrying amounts and estimated fair values of our financial instruments as of December 31, 2017 and 2016:
2 In accordance with ASU 2015-07, investments amounting to $23.7 million at December 31, 2017, respectively, were measured at fair value using the net asset value per share (or its practical expedient) and have not been classified in the fair value hierarchy. The fair value amounts presented in this table are intended to permit reconciliation of the fair value hierarchy to total assets measured at fair value.
The following table provides a summary of the changes in the fair value of securities measured using Level 3 inputs and related quantitative information during 2017:
The Insurance Subsidiaries remain liable to policyholders to the extent that any reinsurer becomes unable to meet their contractual obligations. In addition to this direct counterparty credit risk, we have indirect counterparty credit risk as our reinsurers often enter into their own reinsurance programs, or retrocessions, as part of managing their exposure to large losses. We evaluate and monitor the financial condition of our reinsurers under voluntary reinsurance arrangements to minimize our exposure to significant losses from reinsurer insolvencies. On an ongoing basis, we review amounts outstanding, length of collection period, changes in reinsurer credit ratings, and other relevant factors to determine collectability of reinsurance recoverables. The allowance for uncollectible reinsurance recoverables was $4.6 million at December 31, 2017 and $5.5 million at December 31, 2016.
The majority of the 2015 net favorable development was attributable to accident years 2009 through 2013, driven by the workers compensation and general liability lines of business. This net favorable development was partially offset by unfavorable development in accident years 2012 through 2014 attributable to our E&S casualty lines of business.
The following table details our loss and loss expense reserves for various asbestos and environmental claims:
can be applied, such models can produce significantly different results with small changes in assumptions. As a result, reserves for asbestos and environmental require a high degree of judgment. Because of the significant uncertainty in the estimate, we do not calculate an asbestos and environmental loss range.
Historically, our asbestos and environmental claims have been significantly lower in volume than many other standard commercial lines carriers since, prior to the introduction of the absolute pollution exclusion endorsement in the mid-1980’s, we were primarily a Standard Personal Lines carrier and therefore do not have broad exposure to asbestos and environmental claims. Additionally, we are the primary insurance carrier on the majority of these exposures, which provides more certainty in our reserve position compared to other insurance carriers.
In 2011, the Parent purchased Mesa Underwriters Specialty Insurance Company ("MUSIC"), a wholly-owned E&S Lines subsidiary of Montpelier Re Holdings, Ltd. Under the terms of the purchase agreement, the Parent acquired net loss and loss adjustment reserves amounting to approximately $15 million. All development on this acquired business was fully reinsured as of the acquisition date.
(e) The table below reflects the historical average annual percentage payout of incurred claims by age. For example, the general liability line of business averages payout of 6.6% of its ultimate losses in the first year, 12.5% in the second year, and so forth. The following is supplementary information about average historical claims duration as of December 31, 2017:
(1) In the first quarter of 2009, Selective Insurance Company of South Carolina ("SICSC") and Selective Insurance Company of the Southeast ("SICSE"), which are collectively referred to as the "Indiana Subsidiaries" as they are domiciled in Indiana, joined, and invested in, the FHLBI, which provides them with access to additional liquidity. The Indiana Subsidiaries’ aggregate investment in the FHLBI was $2.8 million at December 31, 2017 and December 31, 2016. Our investment provides us the ability to borrow approximately 20 times the total amount of the FHLBI common stock purchased with additional collateral, at comparatively low borrowing rates. The proceeds from the FHLBI borrowing on December 16, 2016 of $60 million were used to repay a $45 million borrowing from the FHLBI that was outstanding at the time, with the remaining $15 million used for general corporate purposes. All borrowings from the FHLBI require security. For information on investments that are pledged as collateral for these borrowings, see Note 5. "Investments" above.
All borrowings from the FHLBNY require security. For information on investments that are pledged as collateral for these borrowings, see Note 5. "Investments" above.
(3) In February 2013, we issued $185 million of 5.875% Senior Notes due 2043. The notes became callable by us on February 8, 2018, at a price equal to 100% of their principal outstanding amount, plus accrued and unpaid interest to, but excluding, the date of redemption. A portion of the proceeds from this debt issuance was used to fully redeem the $100 million aggregate principal amount of our 7.5% Junior Subordinated Notes due 2066. Of the remaining net proceeds, $57.1 million was used to make capital contributions to the Insurance Subsidiaries, while the balance was used for general corporate purposes. There are no financial debt covenants to which we are required to comply in regards to these Senior Notes.
Our Standard Commercial Lines, Standard Personal Lines, and E&S Lines are evaluated based on before and after-tax underwriting results (net premiums earned, incurred loss and loss expense, policyholders dividends, policy acquisition costs, and other underwriting expenses), and combined ratios.
The goodwill balance of $7.8 million at both December 31, 2017 and 2016 relates to our Standard Commercial Lines reporting unit.
(a) On December 22, 2017, the Tax Cuts and Jobs Act of 2017 ("Tax Reform") was signed into law, which among other implications, will reduce our statutory corporate tax rate from 35% to 21% beginning with our 2018 tax year. We revalued our deferred tax inventory as of December 31, 2017 in anticipation of this reduction, which resulted in a $20.2 million charge to income as illustrated in the rate reconciliation table below. This charge included a $5.7 million benefit related to net unrealized gains on our investment portfolio and pension plan, which were originally recorded through AOCI.
Our accounting for the impact of Tax Reform on our deferred tax assets and liabilities is complete with the exception of amounts related to loss reserve discounting. Prior to Tax Reform, we had elected to use our own loss reserve payment patterns in determining the factors that we use in our discounting calculation. Under Tax Reform, this election has been eliminated and we are required to use an industry experience approach that includes a discount rate based on a corporate bond yield curve for which the IRS has not yet issued any guidance. Considering this, we have recorded a $7.5 million provisional increase to our deferred tax asset that is based on the industry experience approach under the tax law that existed prior to Tax Reform. We believe this is a reasonable estimate for the elimination of the company experience method election. We have not estimated a provisional amount based on the revised Tax Reform industry experience approach. Based on a Tax Reform transition rule that allows for this type of change in accounting method to be amortized into expense over an eight-year period beginning in 2018, we have established an offsetting deferred tax liability of $7.5 million as of December 31, 2017. During 2018, we will obtain, prepare, and analyze the necessary information to complete the accounting for loss reserve discounting.
In addition to the impact of Tax Reform discussed above, our rate reconciliation for 2017 was also impacted by the $4.3 million impact of new accounting literature requiring that the tax effects of share-based compensation be recognized in the income tax provision. Previously, these amounts were recorded in additional paid-in capital. See Note 3. "Adoption of Accounting Pronouncements" for additional information regarding this literature change.
In addition to the Pension Plan, SICA also sponsors the Supplemental Excess Retirement Plan (the "Excess Plan") and a life insurance benefit plan (the "Retirement Life Plan"). Both of these plans are closed to new entrants and participants in the Excess Plan ceased accruing benefits after March 31, 2016. The Retirement Life Plan does not accrue benefits and this plan applies only to retirees who terminated employment with SICA on or before March 31, 2009. These are both unfunded plans with benefit obligations as of December 31, 2017 and December 31, 2016 of $10.1 million and $9.1 million, respectively, for the Excess Plan and $6.4 million and $6.3 million, respectively, for the Retirement Life Plan. Expense recorded for the Excess Plan was $0.4 million in 2017, $0.5 million in 2016, and $0.8 million in 2015. Expense recorded for the Retirement Life Plan was $0.3 million in 2017, 2016, and 2015.
The following tables provide details on the Pension Plan for 2017 and 2016:
The estimated net actuarial loss for the Pension Plan that will be amortized from AOCI into net periodic benefit cost during the 2018 fiscal year is $2.0 million.
Our latest measurement date was December 31, 2017, at which time we increased our expected return on plan assets to 6.36%, reflecting a higher allocation to equity securities in the portfolio.
When determining the most appropriate discount rate to be used in the valuation, we consider, among other factors, our expected payout patterns of the Pension Plan's obligations as well as our investment strategy and we ultimately select the rate that we believe best represents our estimate of the inherent interest rate at which our pension and post-retirement life benefits can be effectively settled. Effective January 1, 2016, the approach used to calculate the service and interest components of net periodic benefit cost for benefit plans was changed to provide a more precise measurement of service and interest costs. Prior to 2016, we calculated these service and interest components utilizing a single weighted-average discount rate derived from the yield curve used to measure the benefit obligation at the beginning of the period. Beginning in 2016, we elected to utilize an approach that discounts the individual expected cash flows using the applicable spot rates derived from the yield curve over the projected cash flow period. We have accounted for this change prospectively as a change in accounting estimate. The weighted average discount rate used to determine 2018 interest cost is 3.46%.
The plan’s target ranges, as well as the actual weighted average asset allocation by strategy, at December 31 were as follows:
2Target percent allocations may change over time based on the funded status of the plan and market return expectations.
The long-duration fixed income mutual funds utilize a market approach wherein the quoted prices in the active market for identical assets are used. All of the mutual funds are traded in active markets at their net asset value per share. These investments are classified as Level 1 in the fair value hierarchy.
The investments in global equity collective investment funds utilize a market approach wherein the published prices in the active market for identical assets are used. These investments are traded at their net asset value per share. There are no restrictions as to the redemption of these investments nor do we have any contractual obligations for further investment. These investments are classified as Level 1 in the fair value hierarchy.
Short-term investments are carried at cost, which approximates fair value. Given that these investments are listed on active exchanges, coupled with their liquid nature, these investments are classified as Level 1 in the fair value hierarchy.
1 Awards outstanding under the 2005 Stock Plan consisted of 47,268 RSUs and 229,864 stock options.
The total intrinsic value of options exercised was $4.0 million in 2017, $2.3 million in 2016, and $2.2 million in 2015.
The weighted-average fair value of options and stock per share, including RSUs granted for the Parent's stock plans, during 2017, 2016, and 2015 was as follows:
The fair value of the CIU liability is remeasured at each reporting period through the settlement date of the awards, which is three years from the date of grant based on an amount expected to be paid. A Monte Carlo simulation is performed to approximate the projected fair value of the CIUs that, in accordance with the Cash Plan, is adjusted to reflect our performance on specified indicators as compared to targeted peer companies.
The following table provides share-based compensation expense in 2017, 2016, and 2015:
In 2005, we established a private foundation, now named The Selective Insurance Group Foundation (the "Foundation"), under Section 501(c)(3) of the Internal Revenue Code. The Board of Directors of the Foundation is comprised of some of the Parent's officers. We made less than $0.1 million of contributions and no contributions to the Foundation in 2017 and 2016, respectively. We made contributions to the Foundation in the amount of $1.0 million in 2015.
(b) We have various operating leases for office space, equipment, and fleet vehicles. Such lease agreements, which expire at various times, are generally renewed or replaced by similar leases. Rental expense under these leases amounted to $10.8 million in 2017, $12.3 million in 2016, and $11.7 million in 2015. We also lease computer hardware and software under capital lease agreements expiring at various dates through 2019. See item (p) of Note 2. "Summary of Significant Accounting Policies" in this Form 10-K for information on our accounting policy regarding leases.
Note 19. Statutory Financial Information, Capital Requirements, and Restrictions on Dividends and Transfers of Funds
The Insurance Subsidiaries prepare their statutory financial statements in accordance with accounting principles prescribed or permitted by the various state insurance departments of domicile. Prescribed statutory accounting principles include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (“NAIC"). Permitted statutory accounting principles encompass all accounting principles that are not prescribed; such principles differ from state to state, may differ from company to company within a state and may change in the future. The Insurance Subsidiaries do not utilize any permitted statutory accounting principles that materially affect the determination of statutory surplus, statutory net income, or risk-based capital (“RBC”). As of December 31, 2017, the various state insurance departments of domicile have adopted the March 2017 version of the NAIC Accounting Practices and Procedures manual in its entirety, as a component of prescribed or permitted practices.
Our ability to declare and pay dividends on the Parent's common stock is dependent on liquidity at the Parent coupled with the ability of the Insurance Subsidiaries to declare and pay dividends, if necessary, and/or the availability of other sources of liquidity to the Parent. As of December 31, 2017, the Parent had an aggregate of $114.5 million in investments and cash available to fund future dividends and interest payments. These amounts are not subject to any regulatory restrictions other than standard state insolvency restrictions, whereas our consolidated retained earnings of $1.7 billion is predominately restricted due to the regulation associated with our Insurance Subsidiaries. In 2018, the Insurance Subsidiaries have the ability to provide for $211.0 million in annual dividends to the Parent; however, as regulated entities, these dividends are subject to certain restrictions, which are further discussed below. The Parent also has available to it other potential sources of liquidity, such as: (i) borrowings from our Indiana Subsidiaries; (ii) debt issuances; (iii) common stock issuances; and (iv) borrowings under our Line of Credit. Borrowings from our Indiana Subsidiaries are governed by approved intercompany lending agreements with the Parent that provide for additional capacity of $70.5 million as of December 31, 2017, based on restrictions in these agreements that limit borrowings to 10% of the admitted assets of the Indiana Subsidiaries. For additional restrictions on the Parent's debt, see Note 10. "Indebtedness" in this Form 10-K.
New Jersey and Indiana require notice of the declaration of any ordinary 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 dividend is not appropriate given the above considerations. New York does not require notice of ordinary dividends. Dividend payments
The following table provides quantitative data regarding all Insurance Subsidiaries' dividends paid to the Parent in 2017 for debt service, shareholder dividends, and general operating purposes:
Subsequent to year-end and through the end of January 2018, our insurance operations experienced significant insured property losses, principally due to the deep freeze that impacted our footprint states during the month, the Property Claims Services ("PCS") named winter storm that occurred between January 3 and January 6, and a relatively large number of severe fire losses. For January 2018, non-catastrophe property losses amounted to $47 million and catastrophe losses, which we define as only those losses specifically attributable to a named PCS catastrophe, totaled $16 million. In total, the $63 million of insured property losses were approximately $30 million in excess of our property loss expectations for the month of January.