Selective’s main office is located in Branchville, New Jersey, on a site owned by a subsidiary with approximately 114 acres and 315,000 square feet of operational space. Selective leases all of its other facilities. The principal office locations related to Selective’s three business segments are described in the “Field Strategy,” “Investments Segment,” and “Human Resource Administration Outsourcing” sections of Item 1. “Business.” Selective believes its facilities provide adequate space for its present needs and that additional space, if needed, would be available on reasonable terms.
Financial Highlights of Results for years ended December 31, 2007, 2006, and 2005;
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer, and the insurer’s payment of that loss. To recognize liabilities for unpaid losses and loss expenses, insurers establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported net losses and loss expenses. As of December 31, 2007, we had accrued $2.5 billion of gross loss and loss expense reserves compared to $2.3 billion at December 31, 2006.
In addition to case reserves, we maintain estimates of reserves for losses and loss expenses incurred but not yet reported (“IBNR”). Using generally accepted actuarial reserving techniques, we project our estimate of ultimate losses and loss expenses at each reporting date. The difference between: (i) projected ultimate loss and loss expense reserves and (ii) case loss reserves and loss expense reserves thereon are carried as the IBNR reserve. The actuarial techniques used are part of a comprehensive reserving process that includes two primary components. The first component is a detailed quarterly reserve analysis performed by our internal actuarial staff, which is managed independently from the operating units. In completing this analysis, the actuaries are required to make numerous assumptions, including, for example, the selection of loss development factors and the weight to be applied to each individual actuarial indication. These indications include paid and incurred versions for the following actuarial methodologies: loss development, Bornhuetter-Ferguson, Berquist-Sherman, and frequency/severity. Additionally, the actuaries must gather substantially similar data in sufficient volume to ensure the statistical credibility of the data. The second component of the analysis is the projection of the expected ultimate loss ratio for each line of business for the current accident year. This projection is part of our planning process wherein we review and update expected loss ratios each quarter. This review includes actual versus expected pricing changes, loss trend assumptions, and updated prior period loss ratios from the most recent quarterly reserve analysis.
The Insurance Subsidiaries are multi-state, multi-line property and casualty insurance companies and, as such, are subject to reserve uncertainty stemming from a variety of sources. These uncertainties are considered at each step in the process of establishing loss and loss expense reserves. However, as market conditions change, certain trends are identified that management believes create an additional amount of uncertainty. A discussion of recent trends, by line of business, that have been recognized by management follows:
With $832 million, or 36% of our total recorded reserves, net of reinsurance at December 31, 2007, workers compensation is our largest reserved line of business. In addition to the uncertainties associated with actuarial assumptions and methodologies described above, workers compensation is the line of business most susceptible to unexpected changes in medical services costs due to the length of time over which medical services are provided and the unpredictability of medical cost inflation. From 2005 through 2007, we experienced an unusual amount of volatility associated with our workers compensation medical costs. In 2005, we had sufficient evidence of greater than expected increases in our workers compensation medical costs and raised our reserves in this line of business by $42 million for accident years 2001 and prior. From 2006 to 2007, our workers compensation medical development returned to a more normal level and as a result our reserves for prior accident years were reduced by the relatively moderate amount of $4 million in 2006 and $4 million in 2007. Even though medical cost development returned to a more customary level in 2007, the unusual amount of volatility over the past few years does create additional uncertainty. If the higher than historical increases in medical costs in 2005 were a just an anomaly, then our historical patterns are an appropriate basis for our future reserve projections. If higher trends return and continue on a longer term, our historical patterns will be less meaningful in predicting future loss costs and could result in significant adverse reserve development.
At December 31, 2007, our general liability line of business had recorded reserves, net of reinsurance of $815 million, which represented 35% of our total net reserves. This line of business includes umbrella policies which provide additional limits above underlying automobile and general liability coverages. While favorable development in 2007 for prior years was minimal, two recent changes in our book of business relating to umbrella coverage could create additional volatility in our results: (i) we have grown the number of our commercial umbrella policies at a greater rate than the rest of our commercial lines of business; and (ii) we have raised the net retention of our reinsurance covering these policies. Both of these changes raise the average limits of losses that we retain on a net basis. While management has not identified any specific trends relating to additional reserve uncertainty, our increase in average net retention does create the potential for additional volatility in our reserves.
The following tables provide case and IBNR reserves for losses, reserves for loss expenses, and reinsurance recoverable on unpaid losses and loss expenses as of December 31, 2007 and 2006:
Sensitivity Analysis: Potential impact on reserve volatility due to changes in key assumptions
In addition to the normal amount of volatility, general liability loss development factors have greater uncertainty due to the complexity of the coverages and the possibly significant periods of time that can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer, and the insurer’s payment of that loss. In our judgment, it is possible that general liability loss development factors could be +/- 6% from those actually selected in our latest reserve analysis. If the loss development assumptions were changed by +/- 6%, that would increase/decrease our indicated general liability reserves by approximately $80 million for accident years 2006 and prior.
In addition to the normal amount of volatility, our commercial automobile line of business has experienced significant favorable development in recent years. This favorable development has been driven in large part by a reduction in our bodily injury large loss experience. The actual number of large claims has a high degree of volatility from year-to-year and, therefore, requires a longer period of time before we would respond to this type of information. Under these circumstances, the difference between a traditional loss development method and the expected ultimate loss ratio is larger than usually expected. For this reason, the weight to be applied to each individual actuarial indication in this situation is another key assumption. If the impact of changing the weights to be applied to each actuarial indication is combined with the impact of possible changes to selected loss development factors of +/- 6%, it is our judgment that the possible impact to overall reserves could range from approximately $65 million reduction to approximately $40 million increase for accident years 2006 and prior.
In light of the many uncertainties associated with establishing the estimates and making the assumptions necessary to establish reserve levels, we review our reserve estimates on a regular basis as described above and make adjustments in the period that the need for such adjustment is determined. These reviews could result in the identification of information and trends that would require us to increase some reserves and/or decrease other reserves for prior periods and could also lead to additional increases in loss and loss adjustment expense reserves, which could materially adversely affect our results of operations, equity, business, insurer financial strength, and debt ratings. In 2007, we experienced favorable loss development in accident years 2002 through 2006 of $61.7 million partially offset by unfavorable loss development in accident years 2001 and prior of $42.9 million, netting to total favorable prior year development of $18.8 million. In 2006, we experienced net favorable prior year development of $7.3 million, and in 2005, we experienced net adverse prior year development of $5.1 million. For further discussion on the prior year development in loss and loss expense reserves, see the discussion on “Net Loss and Loss Expense Reserves” in Item 1. “Business” and Note 8 of Item 8. “Financial Statements and Supplementary Data” in this Form 10-K.
Included in our loss and loss expense reserves are amounts for environmental claims, both asbestos and non-asbestos. Carried net loss and loss expense reserves for environmental claims were $51.4 million as of December 31, 2007 and $46.5 million as of December 31, 2006. Our exposure to environmental liability is primarily due to policies written prior to the introduction of the absolute pollution exclusion endorsement in the mid-1980’s and underground storage tank leaks, mostly from New Jersey homeowners policies in recent years. Our asbestos and non-asbestos environmental claims have arisen primarily from insured exposures in municipal government, small commercial risks, and homeowners policies. The emergence of these claims is slow and highly unpredictable. Over the past few years, we also experienced adverse development in its homeowners line of business as a result of unfavorable trends in claims for groundwater contamination caused by leakage of certain underground heating oil storage tanks in New Jersey. In addition, certain landfill sites are included on the National Priorities List (“NPL”) by the United States Environmental Protection Agency (“USEPA”). Once on the NPL the USEPA determines an appropriate remediation plan for these sites. A landfill can remain on the NPL for many years until final approval for the removal of the site is granted from the USEPA. The USEPA also has the authority to re-open previously closed sites and return them to the NPL. We currently have reserves for several claims related to sites on the NPL.
The table below summarizes the number of asbestos and non-asbestos claims outstanding at December 31, 2007, 2006, and 2005. For additional information about our environmental reserves, see Item 1. “Business,” and Item 8. “Financial Statements and Supplementary Data,” Note 8 to the Consolidated Financial Statements.
Policy acquisition costs, which include commissions, premium taxes, fees, and certain other costs of underwriting policies, are deferred and amortized over the same period in which the related premiums are earned. Deferred policy acquisition costs are limited to the estimated amounts recoverable after providing for losses and loss expenses that are expected to be incurred, based upon historical and current experience. Anticipated investment income is considered in determining whether a premium deficiency exists. The methods of making such estimates and establishing the deferred costs are continually reviewed, and any adjustments are made in the accounting period in which the adjustment arose. We measure the recoverability of deferred policy acquisition costs at the operating segment level. We had deferred policy acquisition costs of $226.4 million at December 31, 2007 compared to $218.1 million at December 31, 2006.
The discount rate enables us to state expected future cash flow as a present value on the measurement date. The guideline for setting this rate is a high-quality long-term corporate bond rate. A higher discount rate decreases the present value of benefit obligations and decreases pension expense. We increased our discount rate to 6.50% for 2007, from 5.90% for 2006 to reflect market interest rate conditions. To determine the expected long-term rate of return on the plan assets, we consider the current and expected asset allocation, as well as historical and expected returns on each plan asset class. A lower expected rate of return on pension plan assets would increase pension expense. Our long-term expected return on plan assets was 8.00% in 2007 and 2006. Changes in the related pension and postretirement benefit expense may occur in the future due to changes in these assumptions.
For additional information regarding our pension and postretirement benefit plan obligations, see Item 8. “Financial Statements and Supplementary Data,” Note 16(d) to the Consolidated Financial Statements.
Our evaluation for other-than-temporary impairment of a fixed maturity security, includes, but is not limited to, the evaluation of the following factors:
The degree to which an issuer is current or in arrears in making principal and interest payments on the fixed maturity security;
Our evaluation for other-than-temporary impairment of an equity security, other investment, or a short-term investment includes, but is not limited to, the evaluation of the following factors:
Goodwill results from business acquisitions where the cost of assets acquired exceeds the fair value of those assets. We test goodwill for impairment annually, or more frequently if events or changes in circumstances indicate that goodwill may be impaired. Goodwill is allocated to the reporting units for the purposes of the impairment test. We did not record any impairments during 2007, 2006 or 2005.
Financial Highlights of Results for Years Ended December 31, 2007, 2006, and 2005 1
Refer to the Glossary of Terms attached to this Form 10-K as Exhibit 99.1 for definitions of terms used in this financial review, which exhibit is incorporated by reference.
Revenues increased in 2007 compared to 2006 and 2005 primarily due to growth in net premiums earned (“NPE”) and net investment income earned.
Direct new business written, excluding flood, of $352.3 million in 2007 compared to $310.0 million in 2006 and $300.5 million in 2005.
The above items were partially offset by (i) a slight reduction in commercial lines retention in 2007 compared to 2006 and 2005; (ii) a $17.9 million reduction in audit and endorsement premium activity in 2007 compared to 2006 and a $7.6 million reduction in 2006 compared to 2005 as a result of economic changes, especially in the construction industry; and (iii) decreases in NPE on our New Jersey personal automobile book of business attributable to the loss of a portion of our book that was repriced at higher pricing levels through our MATRIX® pricing system and subsequently did not renew. Our New Jersey personal automobile book of business experienced an 8% reduction in the number of cars insured at December 31, 2007 compared to December 31, 2006 and a 12% reduction in the number of cars from December 31, 2006 compared to December 31, 2005. Overall personal lines NPE was down 5% to $203.3 million in 2007 compared to $213.8 million in 2006. These premiums increased 2% in 2006 from $209.3 million in 2005.
Net investment income earned increased 11% in 2007 compared to 2006 and contributed $17.3 million to the $38.4 million revenue growth in 2007. In 2006, net investment income earned increased 15% compared to 2005 and contributed $20.9 million to the $136.9 million revenue growth in 2006. These increases are primarily attributable to a higher invested asset base, coupled with higher interest rates and strong returns from our other investment portfolio. The increase in our invested asset base is the result of operating cash flows of $386.3 million in 2007 and $393.1 million in 2006, as well as net proceeds of $96.8 million from our $100.0 million junior subordinated notes offering in the third quarter of 2006. These increases were partially offset by: (i) stock repurchases under our authorized stock repurchase program of 5.7 million shares during 2007 at a total cost of $143.3 million and 4.1 million shares during 2006 at a total cost of $110.1 million; and (ii) net share settlements of principal for $37.5 million in 2007 on our Senior convertible notes.
Net income increased in 2006 compared to 2005 due to growth in NPE, net investment income earned, and net realized gains as discussed above, partially offset by the reduction in our underwriting profit, resulting from increased property losses, including catastrophe losses, and increased underwriting expenses.
Premium growth in 2006 compared to 2005 is attributable to increases in direct new business written, excluding flood, of 3% to $310.0 million for 2006 compared to 2005 coupled with Commercial Lines renewal pricing increases, including exposure, of 2.2% in 2006. Partially offsetting these items is a decline in NPW for our New Jersey personal automobile business of $14.6 million to $92.7 million for 2006 compared to 2005 as a result of the highly competitive marketplace.
NPE increased slightly in 2007 compared to 2006 and increased in 2006 compared to 2005 reflecting increases in NPW discussed above.
The 1.9 point increase in the GAAP loss and loss expense ratio in 2007 compared to 2006 was primarily attributable to lower pricing on our Commercial and Personal Lines business, as well as increases in property losses and overall higher loss costs in 2007 compared to 2006. The increases in property losses were driven by higher non-catastrophe losses for 2007 compared to 2006. These increases to the GAAP loss and loss expense ratio were partially offset by (i) improved profitability in our workers compensation line of business, and (ii) net favorable prior year loss and loss expense development within our casualty lines of business of approximately $19 million in 2007, compared to approximately $7 million in 2006. The GAAP loss and loss expense ratio in 2006 remained comparable with the 2005 ratio.
The increases in the GAAP underwriting expense ratio in 2007 compared to 2006 and 2005 was primarily attributable to increases in underwriting expenses that outpaced premium growth in the comparable periods. Increased labor expenses drove the increase in expense dollars for 2007 and 2006. For additional information regarding our initiatives in the management of the underwriting expense ratio, see the outlook section below and Note 22, “Subsequent Events” in Item 8. “Financial Statements and Supplementary Data” of this Form 10-K.
We believe that future profitability may be impacted by higher loss trends, which are characterized by changes in frequency, severity, and pricing deterioration. When renewal pure price increases are declining and loss costs trend higher, a market cycle shift occurs. General inflation and, notably, medical inflation, can drive up loss costs and lead to higher industry-wide statutory combined ratios. We believe it is critical to have a clearly defined plan to improve risk selection and mitigate higher frequency and severity trends during market cycles. Some of the tools we use to lower frequency and severity are knowledge management, predictive modeling, safety management, managed care, and enhanced claims review. Although it is uncertain at this time whether our initiatives will offset macro pricing and loss trends, we have outperformed the industry’s loss and loss adjustment expense ratio by 6.8 points, on average, over the past 10 years.
Even in this competitive market, we believe that the strategies we have implemented will allow us to continue to profitably grow our business based on strong agency relationships and our unique field-based model. To this end, we have developed market-planning tools that are allowing us to strategically appoint additional independent agencies as well as agency management specialists (“AMSs”) in under-penetrated territories, with classes of business that we know historically have been profitable. Through the end of 2007, the Insurance Subsidiaries’ total agency count increased to approximately 880, up from 770 at last year-end, serviced by approximately 100 field-based AMSs who make hands-on underwriting decisions in agents’ offices on a daily basis.
We back the “high touch” component of our business model with technology that allows agents and the Insurance Subsidiaries’ field teams to input business seamlessly into our systems, while also allowing them to select and price accounts at optimal levels through predictive modeling. Technology that allows for the seamless placement of business into our systems includes our One & Done® small business system and our xSELerate® straight-through processing system. Premiums of $250,000 per workday were processed through our One & Done® small business system in 2007, up 42% from 2006. We have set a multi-year small business growth target of $350,000 in One & Done® business per work day, and in 2008 our efforts will be centered on: (i) better managing price points and scale; (ii) implementing a more comprehensive marketing and branding strategy; and (iii) updating the distribution model to address multiple agent and customer needs.
We also continue to pursue our organic growth strategy. Effective July 1, 2007, we entered our 21st primary state, Massachusetts, for Commercial Lines only and wrote approximately $3.8 million of new business in 2007. In 2008, we have plans to expand our footprint to Tennessee. We also have expanded Personal Lines into Rhode Island, Minnesota, and Iowa, states that are already within our existing Commercial Lines footprint. In addition to our organic growth strategy, we are taking note of opportunities that marketplace competition may be creating and would not rule out making an opportunistic acquisition.
Premium growth in 2006 as compared to 2005 was attributable to increases in direct new business of $14.1 million to $276.9 million coupled with renewal price increases, including exposure, of 2.2% in 2006.
The increase in the GAAP underwriting expense ratio in 2007 compared to 2006 and 2005 was attributable to increases in underwriting expenses that outpaced premium growth. These underwriting expense increases were driven by higher labor costs. For additional information regarding our initiatives in the management of the underwriting expense ratio, see the outlook section below and Note 22, “Subsequent Events” in Item 8. “Financial Statements and Supplementary Data” of this Form 10-K.
The following is a discussion on our most significant commercial lines of business:
Our continued strong performance in this line is the result of underwriting and pricing improvements over the last several years. We have implemented targeted rate decreases on the best accounts to grow this profitable line of business. The policy count on this line of business increased 8% in 2007 compared to 2006 driven by new policy count increases of 18%. In 2006, as compared to 2005, policy counts increased 6% driven by new policy count increases of 4%. However, renewal prices, including exposure, decreased 2.9% in 2007 compared to a decrease of 1.1% in 2006 and an increase of 0.4% in 2005, which has put pressure on NPW and NPE. Lower severity trends have resulted in favorable prior year statutory loss and loss expense development of approximately $19 million in 2007 compared to $15 million in 2006 and $48 million in 2005.
Pricing pressure, coupled with higher loss costs, continues to put pressure on profitability in this line of business. However, we continue to concentrate on our long-term strategy to improve profitability, which focuses on: (i) contractor growth in business segments with lower completed operations exposures; and (ii) contractor and subcontractor underwriting guidelines to minimize losses.
Our multi-faceted workers compensation strategy, which incorporates our knowledge management and predictive modeling initiatives, has enabled us to retain and write more of the best accounts, leading to 2007 increases in total policy counts of 9% compared to 2006 and 6% in 2006 compared to 2005. Direct new voluntary policy premiums increased 28% for 2007 compared to 2006 and 30% for 2006 compared to 2005. At the same time, these initiatives have allowed us to target price increases for our worst performing business, which contributed to the decrease in our retention in 2007 to 79% from 80% in 2006 and 81% in 2005, thereby improving the profitability of our retained business.
The improvement in the statutory combined ratio of this line of 6.8 points in 2007 compared to 2006 and 15.7 points in 2006 compared to 2005 reflects not only the ongoing progress resulting from the execution of our workers compensation strategies, but also favorable prior year statutory development of $3 million attributable to these strategies, partially offset by an increase in the tail factor related to medical inflation and general development trends. Favorable prior year statutory development of approximately $2 million in 2006 was driven, in part, by savings realized from changing medical and pharmacy networks outside of New Jersey and re-contracting our medical bill review services. Adverse prior year statutory development of $40 million in 2005 was primarily the result of adverse loss trends, specifically in medical costs in the 2001 and prior accident years, which warranted an increase in management’s best estimates within the loss range.
Net premiums written for this line of business increased in 2007 compared to 2006 and 2005 due to increases in total policy counts of 11% in 2007 compared to 2006 and 9% in 2006 compared to 2005. Stable retention of approximately 81% over the past three years has also led to an increase in net premiums written. NPW growth was partially offset by renewal prices, including exposure, which decreased 0.4% in 2007 compared to increases of 2.1% in 2006 and 2.8% in 2005.
Although still profitable, the higher statutory combined ratio for commercial property reflects lower pricing and increased property losses especially in comparison to the unusually low experience in 2006. The increase in property losses appears to be part of the normal variability in this line and was primarily the result of an increase in the severity of losses, mainly attributable to flood events and electrical fires. For 2007, catastrophe losses decreased $2.5 million to $10.7 million compared to 2006, however, for 2006, catastrophe losses increased $10.4 million to $13.2 million compared to 2005.
NPW decreased in 2007 compared to 2006 after increasing in 2006 compared to 2005. Excluding the impact from the cancellation of the New Jersey Homeowners’ Quota Share Treaty (“Quota Share Treaty”), which increased 2006 NPW by $11.3 million, NPW decreased 1% in 2007 compared to 2006 and increased 2% in 2006 compared to 2005.
The remaining decrease in NPW in 2007 compared to 2006 was primarily driven by a decline in NPW for our New Jersey personal automobile business of $12.6 million to $80.1 million in 2007. This resulted from a reduction in the number of New Jersey personal automobiles that we insure, primarily driven by repricing at higher levels through our MATRIX® pricing system. Partially offsetting this decrease were increases in our personal automobile business outside of New Jersey of $5.4 million to $50.0 million coupled with increases in our homeowners business of $4.5 million to $65.4 million in 2007.
Excluding the impact of the one-time benefit received from the cancellation of the Quota Share Treaty, NPW increased 2% in 2006 compared to 2005. This increase reflects the retention of homeowners business that had previously been ceded under the treaty coupled with an increase in direct homeowners premiums written of 6% in 2006 compared to 2005, partially offset by a decrease in our personal automobile business of $16.6 million to $137.4 million. NPW on our personal automobile line of business decreased in 2006 as a result of the ongoing competition in the New Jersey personal automobile marketplace coupled with our rating plans that were not competitive through the first half of the year due to a historically restrictive rating environment.
Unfavorable prior year development in our casualty lines of $1 million in 2007 compared to favorable prior year development of $6 million in 2006. The unfavorable development in 2007 reflects (i) higher severity in accident year 2006 for our personal automobile line of business; (ii) adverse prior year development due to unfavorable trends in claims for groundwater contamination caused by the leakage of certain underground oil storage tanks in our homeowners line of business; and, (iii) several significant losses in our personal umbrella line of business, partially offset by lower than expected loss emergence for accident years prior to 2006. In 2006, the favorable prior year development primarily related to lower than expected frequency in personal automobile claims.
The improvement in the 2006 GAAP loss and loss expense ratio was driven by the reserving actions taken in 2005 in light of a New Jersey Supreme Court decision that eliminated the application of the serious life impact standard to personal automobile cases under the verbal tort threshold of New Jersey’s Automobile Insurance Cost Reduction Act (“AICRA”) and resulted in an increase to our reserves of $13.0 million in the second quarter of 2005. The implementation of AICRA, and our rating and tiering actions had enabled us to achieve profitability in the New Jersey personal automobile line of business over the two years prior to the ruling. However, factoring higher expected claim costs into our New Jersey personal automobile excess profits calculation eliminated $5.5 million of excess profits reserves in the second quarter of 2005.
We have also implemented a three-part profit improvement plan that will focus on returning Personal Lines to profitability by the end of 2009. To decrease costs associated with writing policies and servicing claims, we plan to: (i) utilize the full capability of our MATRIX® pricing system, along with widening the One & Done® pipeline to maximize the cost savings that are associated with these policies; (ii) roll out our knowledge management initiatives to the Personal Lines operation in May 2008; and, (iii) move additional claims to our centrally located claims department to cut down on costs incurred for claims handling.
We regularly reevaluate our overall reinsurance program and try to develop the most effective ways to manage our risk. Our analysis is based on a comprehensive process that includes periodic analysis of modeling results, aggregation of exposures, exposure growth, diversification of risks, limits written, projected reinsurance costs, financial strength of reinsurers and projected impact on earnings and statutory surplus. We strive to balance sometime opposing considerations of reinsurer credit quality, price, terms, and our appetite for retaining a certain level of risk.
In addition to treaty and facultative reinsurance, the Insurance Subsidiaries are partially protected by the Terrorism Risk Insurance Act of 2002, which was modified and extended through December 31, 2014 via the Terrorism Risk Insurance Program Reauthorization Act of 2007. For further information regarding this legislation, see Item 1A. “Risk Factors” of this Form 10-K.
The following table presents Risk Management Solutions, Inc.’s (“RMS”) v.7.0 modeled hurricane losses based on the Insurance Subsidiaries’ property book of business as of June 30, 2007:
RMS v.7.0 allows modeling based on the long term averages (historic view) and modeling based on a five year projection that includes an assumption of elevated hurricane activity in the Atlantic Basin in the short to medium term (stochastic view). Results of both models are provided above for select probabilities. Our current catastrophe program provides protection for a 1 in 209 year event, or an event with 0.5 % probability according to the RMS v.7.0 historic model, and for a 1 in 159 year event, or an event with 0.6% probability according to RMS v.7.0 stochastic model.
The retention and limit under our Property Excess of Loss treaty renewed July 1, 2007, remained the same at $23.0 million in excess of $2.0 million. Consistent with prior year contract, all nuclear, biological, chemical and radioactive reaction (“NBCR”) losses are excluded from the Property Excess of Loss treaty. Terrorism (excluding NBCR) and per occurrence aggregate limits remain at $46.5 million.
Additional layer to the Casualty Treaty covering all casualty business, including workers compensation, up to 75% of $40.0 million in excess of $50 million.
The total coverage for workers compensation claims continues to be $78.0 million per occurrence and $75.0 million per occurrence for casualty claims other than workers compensation, net of our co-participation in the $40.0 million in excess of $50.0 million layer.
The increase in net investment income, before tax, of $17.3 million for 2007 compared to 2006 was primarily the result of increased fixed maturity income due to higher invested assets and increased income of approximately $7.0 million from certain alternative investments within our “Other investments” category. Growth in net investment income, before tax, of $20.9 million for 2006 compared to 2005 was primarily attributable to the increase in our investment portfolio as well as increased income of $4.0 million in alternative investment income and $1.0 million in dividend income. Our investment portfolio totaled $3.7 billion at December 31, 2007, an increase of 4% compared to $3.6 billion at December 31, 2006. The increase in invested assets was due to substantial cash flows from operations of $386.3 million in 2007, $393.1 million in 2006 and $406.8 million in 2005. Cash flows from operations in 2007 were partially offset by cash outflows of: (i) $143.3 million related to treasury stock repurchases under our authorized program; (ii) $37.5 million related to principal payments on our senior convertible notes; and (iii) $18.3 million related to principal payments on our 8.87% and 8.63 senior notes. Debt offerings in September 2006 and November 2005 added approximately $96.8 million and $98.4 million in assets, respectively, in 2006 and 2005.
We continue to maintain a conservative, diversified investment portfolio, with fixed maturity investments representing 83% of invested assets. Sixty-nine percent (69%) of our fixed maturities portfolio is rated “AAA” while the portfolio has an average rating of “AA+,” S&P’s second highest credit quality rating. High credit quality continues to be a cornerstone of our investment strategy, as evidenced by the fact that almost 100% of the fixed maturities are investment grade. At December 31, 2007 and 2006, non-investment grade securities (below “BBB-“) represented less than 1%, or approximately $10 million, of our fixed maturity portfolio. Our mortgage backed securities portfolio totaled $697.9 million at December 31, 2007, with an average credit rating of “AA+.” Selective has no significant sub-prime mortgage exposure. Prior to investing in mortgage-backed securities, we analyze, among other credit factors, each transaction’s FICO credit score and loan to value ratio. For additional information regarding our fixed investment income portfolio, see Exhibit 99.1 of Form 8-K dated January 23, 2008 and Exhibit 99.2 of Form 8-K dated February 12, 2008. For additional information regarding market risk related to our investment portfolio, see
We have audited the accompanying consolidated balance sheets of Selective Insurance Group, Inc. and its subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2007. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules I to VI. These consolidated financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
As discussed in Note 2 to the Consolidated Financial Statements, in 2006 the Company changed its definition of cash equivalents for presentation in the statement of cash flows and, in 2005, changed its method of accounting for share-based payments.
Insurance Operations, which sells property and casualty insurance products and services primarily in 21 states in the Eastern and Midwestern United States;
Diversified Insurance Services, which provides human resource administration outsourcing products and services, and federal flood insurance administrative services.
The accompanying consolidated financial statements (“Financial Statements”), which include the accounts of Selective, have been prepared in conformity with: (i) U.S. generally accepted accounting principles (“GAAP”); and (ii) the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). All significant intercompany accounts and transactions are eliminated in consolidation.
Equity securities, which are classified as available for sale, are comprised of common stocks and non-redeemable preferred stocks and are carried at fair value. Dividend income on these securities is included in “Net investment income earned.” The associated unrealized gains and losses, net of tax are included in AOCI. The cost of equity securities is written down to fair value when a decline in value is considered to be other than temporary. See the discussion below on realized investment gains and losses for a description of the accounting for impairments.
Realized gains and losses on the sale of investments are determined on the basis of the cost of the specific investments sold and are credited or charged to income. Also included in realized gains and losses are write-downs for other than temporary impairment charges.
Evaluation for other-than-temporary impairment of equity securities, other investments, and short-term investments, includes, but is not limited to, the following factors:
(1) Investments: Fair values for fixed maturity and equity securities are based on market prices from independent pricing services. Short-term investments are carried at cost, which approximates fair value. Our investment in other miscellaneous securities are generally accounted for at fair value based on net asset value.
Effective January 1, 2005, Selective adopted Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards No. 123 (Revised 2004), “Share-Based Payment” (“FAS 123R”), which replaces FASB Statement No. 123 “Accounting for Stock Based Compensation” (“FAS 123”) and supersedes Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees” (“APB 25”). FAS 123R applies to all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share options, or other equity instruments. FAS 123R requires that the cost resulting from all share-based payment transactions be recognized in the financial statements, based on the fair value of such instruments at the grant date over the requisite service period. The requisite service period is typically the lesser of the vesting period or the period of time from the grant date to the date of retirement eligibility. The expense recognized for share-based awards, which, in some cases contain performance criteria, is based on the number of shares/units expected to be issued at the end of the performance period.
Policy acquisition costs directly related to the writing of insurance policies are deferred and amortized over the life of the policies. These costs include labor costs, commissions, premium taxes and assessments, boards, bureaus and dues, travel, and other underwriting expenses incurred in the acquisition of premium. The deferred policy acquisition costs are limited to the sum of unearned premiums and anticipated investment income less anticipated losses and loss expenses, policyholder dividends and other expenses for maintenance of policies in force. Selective regularly conducts reviews for potential premium deficiencies. There were no premium deficiencies for any of the reported years as the sum of the anticipated losses and loss expenses, policyholder dividends, and other expenses did not exceed the related unearned premium and anticipated investment income. The investment yields assumed in the premium deficiency assessment for each reporting period, which are based upon the Company’s actual average investment yield before-tax as of the calculation date on September 30, were 4.6% for 2007, 4.4% for 2006 and 2005. Deferred policy acquisition costs amortized to expense were $460.2 million for 2007, $443.3 million for 2006, and $400.6 million for 2005.
Goodwill results from business acquisitions where the cost of assets/liabilities acquired exceeds the fair value of those assets/liabilities. Goodwill is tested for impairment annually, or more frequently if events or changes in circumstances indicate that goodwill may be impaired. Goodwill is allocated to the reporting units for the purposes of the impairment test. Selective did not record any impairments during 2007, 2006 or 2005.
Reserves for losses and loss expenses are made up of both case reserves and reserves for claims incurred but not yet reported (“IBNR”). Case reserves result from claims that have been reported to the seven insurance subsidiaries (the “Insurance Subsidiaries”) and are estimated at the amount of ultimate payment. IBNR reserves are established based on generally accepted actuarial techniques. Such techniques assume that past experience, adjusted for the effects of current developments and anticipated trends, are an appropriate basis for predicting future events. In applying generally accepted actuarial techniques, Selective also considers a range of possible loss and loss adjustment expense reserves in establishing IBNR.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosure about fair value measurements. It applies to other pronouncements that require or permit fair value, however, it does not require any new fair value measurements. FAS 157 is effective for fiscal years beginning after November 15, 2007. Selective will apply FAS 157 to its invested assets portfolio beginning in the first quarter of 2008. This application will require the Company to classify the fair values of its investments into three different categories, each of which requires varying levels of disclosure in the financial statements beginning in the first quarter of 2008. The adoption of this statement is not expected to have a material impact on Selective’s results of operations or financial condition.
(a) Net unrealized gains on investments included in other comprehensive income by asset class at December 31, are as follows:
(b) The amortized cost, estimated fair values, and unrealized gains (losses) of held-to-maturity fixed maturity securities at December 31, 2007 and 2006, respectively, were as follows:
(c) The cost/amortized cost, estimated fair values, and unrealized gains (losses) of available-for-sale securities at December 31, 2007 and 2006, respectively, were as follows:
Although overall interest rates decreased in 2007, the unrealized losses for fixed maturity securities increased due primarily to the credit stress and dislocation in the capital markets, along with inflation worries and uncertainty about the U.S. economy in general caused fixed maturities credit spreads to widen. At December 31, 2007, there were 240 securities in an unrealized loss position. Broad changes in the overall market or interest rate environment generally do not lead to impairment charges. During 2007 Selective recorded an other than temporary impairment charge associated with two commercial real estate collateralized debt obligations (“CDO”) for $4.9 million. During the second half of 2007, the market for lower-rated commercial mortgage-backed securities (“CMBS”) saw severe contagion effects from the sub-prime mortgage crisis. CMBS spreads, particularly subordinated tranche CMBS, widened dramatically over the course of the second half of the year. As a result, CDOs in general have become extremely dislocated and difficult to value as the market spreads between bid and ask prices are very wide, even for CDOs that do not have any sub-prime asset backed exposure. At this time, there have been no credit defaults or rating downgrades on CDOs in our portfolio. However, given the severe lack of liquidity currently being experienced in the marketplace, it is difficult to value certain securities and, as a result, we recorded an other than temporary impairment charge on two commercial real estate CDOs in 2007. During 2006, Selective had not recognized any realized losses from other than temporary charges, whereas during 2005 Selective had recorded $1.2 million in realized losses related to other than temporary charges.
(e) The amortized cost and estimated fair value of fixed maturity securities at December 31, 2007, by contractual maturity are shown below. Mortgage-backed securities 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.
At December 31, 2007, Selective has contractual obligations that expire at various dates through 2022 to further invest up to $129.8 million in alternative investments. There is no certainty that any such additional investment will be required.
Proceeds from the sale of available-for-sale securities and other investments were $289.9 million during 2007, $414.4 million during 2006, and $235.8 million during 2005. There was $4.9 million in realized losses in 2007 associated with the two other than temporary impairment charges mentioned above. There were no realized losses from other than temporary impairment charges in 2006 and there were $1.2 million in realized losses from other than temporary impairment charges in 2005.
Selective’s carrying amounts shown in the table are included in the Consolidated Balance Sheets. The convertible subordinated debentures are included in “Other liabilities” on the Consolidated Balance Sheets. Alternative investments are not included in the table above as they are not financial instruments.
The Insurance Subsidiaries remain liable to policyholders to the extent that any reinsurer becomes unable to meet its contractual obligations. Selective evaluates and monitors the financial condition of its reinsurers under voluntary reinsurance arrangements to minimize its exposure to significant losses from reinsurer insolvencies. On an ongoing basis, Selective reviews amounts outstanding, length of collection period, changes in reinsurer credit ratings and other relevant factors to determine collectibility of reinsurance recoverables. The allowance for reinsurance recoverables on paid and unpaid losses and loss expenses was $2.8 million at December 31, 2007 and $3.2 million at December 31, 2006.
The net loss and loss expense reserves increased by $225.7 million in 2007, $223.2 million in 2006, and $249.4 million in 2005. The loss reserves include anticipated recoveries for salvage and subrogation claims, which amounted to $52.3 million for 2007, $49.6 million for 2006, and $46.5 million in 2005. The changes in the net loss and loss expense reserves were the result of growth in exposures, anticipated loss trends, changes in reinsurance retentions, as well as normal reserve development inherent in the uncertainty in establishing reserves for losses and loss expenses. As additional information is collected in the loss settlement process, reserves are adjusted accordingly. These adjustments are reflected in the consolidated statements of income in the period in which such adjustments are recognized. These changes could have a material impact on the results of operations of future periods when the adjustments are made.
Selective experienced favorable development in its loss and loss expense reserves totaling $7.3 million in 2006, which was primarily driven by favorable prior year development in its commercial automobile, workers compensation, and personal automobile lines of business partially offset by adverse development in its general liability line of business. The commercial automobile line of business experienced favorable prior year loss and loss expense reserve development of approximately $15 million, which was primarily driven by lower than expected severity in accident years 2004 and 2005. The workers compensation line of business experienced favorable prior year development of approximately $4 million, which was driven, in part, by savings realized from changing medical and pharmacy networks outside of New Jersey and re-contracting our medical bill review services. The personal automobile line of business experienced favorable prior year development of approximately $9 million, due to lower than expected frequency. The general liability line of business experienced adverse prior year loss and loss expense reserve development of approximately $15 million in 2006, which was largely driven by Selective’s contractor completed operations business and an increase in reserves for legal expenses. The remaining lines of business, which collectively contributed approximately $6 million of adverse development, do not individually reflect significant prior year development.
Selective experienced adverse development in its loss and loss expense reserves totaling $5.1 million in 2005. Through internal actuarial reviews, Selective analyzed certain negative trends in the workers compensation line of business and certain positive trends in the commercial automobile line of business. In the fourth quarter of 2005, Selective had sufficient evidence accumulated to move management’s best estimate of loss reserves for these lines. Accordingly, workers compensation reserves were increased by approximately $42 million to reflect rising medical cost trends that impacted accident years 2001 and prior. At the same time, commercial automobile reserves were decreased by approximately $48 million, primarily due to ongoing favorable severity trends in the 2002 through 2004 accident years. In addition, the general liability reserves adversely developed by approximately $14 million over the course of the year, which was driven mainly by our contractor completed operations business impacting accident years 2001 and prior, but partially offset by positive development in accident years 2002 through 2004. Also in 2005, Selective increased personal automobile reserves by approximately $10 million, of which $6.0 million was attributable to prior year development due to the adverse judicial ruling by the New Jersey Supreme Court in the second quarter of 2005 that eliminated the application of the serious life impact standard to personal automobile bodily injury liability cases under the verbal tort threshold of the New Jersey Automobile Insurance Cost Reduction Act (“AICRA”). The reserving action was based on an analysis of claim files and loss experience pre- and post-AICRA, which resulted in an increase to New Jersey personal automobile loss projections.
At December 31, 2007, Selective’s reserves for environmental claims amounted to $58.7 million on a gross basis (including case reserves of $26.1 million and IBNR reserves of $32.6 million) and $51.4 million on a net basis (including case reserves of $22.6 million and IBNR reserves of $28.8 million). There are a total of 2,448 environmental claims, including multiple claimants who are associated with the same site or incident. Of these, 2,177 are asbestos related, of which 1,150 are with seven insureds in the wholesale and/or retail of plumbing, electrical, and other building supplies with related case reserves of $3.1 million. During 2007, 210 asbestos claims were closed, which accounted for approximately $0.1 million of the total asbestos paid of $1.2 million. The total case reserves for asbestos related claims amounted to $6.8 million on a gross and net basis. About 69 of the total environmental claims involve six landfill sites. The landfill sites account for case reserves of $11.8 million on a gross and net basis, and include reserves for several sites that are currently listed on the National Priorities List. The remaining claims, which account for $7.5 million of case reserves on a gross and $4.0 million on a net basis, involve leaking underground heating oil storage tanks and other latent environmental exposures.
Based on its aggregate reserve for net losses and loss expenses at December 31, 2007, Selective does not expect that liabilities associated with environmental and non-environmental claims will have a materially adverse impact on its future liquidity, financial position and results of operations. However, given the complexity of coverage and other legal issues, and the significant assumptions used in estimating such exposures, actual results could significantly differ from Selective’s current estimates.
During 2006, $58.5 million of the principal balance was redeemed through an induced conversion that resulted in (i) the issuance of 3,996,306 shares of stock; (ii) additional expense of $2.1 million representing the incremental consideration in connection with the transactions; and (iii) a $1.5 million equity charge representing the related unamortized debt costs.
During the first ten months of 2007, $21.7 million of the principal balance was voluntarily presented for conversion, $11.2 million of which was settled through the issuance of 765,903 shares, with the remaining $10.5 million net-share settled resulting in the issuance of 235,220 shares.
During the last two months of 2007, the remaining $35.7 million of the Convertible Notes were called for redemption, of which $8.7 million settled in January 2008. The Company net-share settled the majority of these notes, which had been voluntarily presented for conversion prior to redemption, and as a result, issued 905,052 shares.
(1) On September 25, 2006, Selective issued $100 million aggregate principal amount of 7.5% Junior Subordinated Notes due 2066 (“Junior Notes”). The Junior Notes will pay interest, subject to Selective’s right to defer interest payments for up to 10 years, on March 15, June 15, September 15, and December 15 of each year, beginning December 15, 2006, and ending on September 27, 2066. At anytime on or after September 26, 2011, the Junior Notes may be called by Selective at any time, in whole or in part, at their aggregate principal amount, together with any accrued and unpaid interest. The net proceeds of $96.8 million from the issuance were used for general corporate purposes.
(3) On November 15, 2004, Selective issued $50 million of 7.25% Senior Notes due 2034. These notes were issued at a discount of $0.1 million, resulting in an effective yield of 7.27% and pay interest on May 15 and November 15 each year. The Parent contributed $25.0 million of the bond proceeds to the Insurance Subsidiaries as capital. The remainder of the proceeds were used for general corporate purposes.
(4) On May 4, 2000, Selective entered into a $30.0 million and a $61.5 million note purchase agreement with various private lenders covering the 8.63% and 8.87% Senior Notes, respectively. As of December 31, 2007, the principal amount of the 8.63% Senior Notes has been paid in full. Selective has paid $24.6 million in principal to date, in addition to accrued interest thereon, for the 8.87% Senior Notes. Principal payments of $12.3 million are required annually through May 4, 2010. The unpaid principal amount of these Senior Notes, which was $36.9 million at December 31, 2007 and $49.2 million at December 31, 2006, accrues interest and is payable semiannually on May 4 and November 4 of each year, until the principal is paid in full.
The Convertible Subordinated Debentures (the “Debentures”) were issued under an Indenture dated December 29, 1982, (the “1982 Indenture”) in the principal amount of $25.0 million, bearing interest at a rate of 8.75% per annum, which is payable on the unpaid principal semiannually on January 1 and July 1 in each year to holders of record at the close of business on the preceding December 15 and June 15, respectively. The Debentures are convertible into Common Stock at an effective conversion price of $3.54 per share. The 1982 Indenture requires Selective to retire, through the operation of a mandatory sinking fund, 5% of the original $25.0 million aggregate principal amount of the debentures on or before December 31 of each year from 1993 through 2006. Voluntary conversions have satisfied this obligation in its entirety.
The principal amount of the Debentures, which was $0.2 million at December 31, 2007 and $0.8 million at December 31, 2006, is included in “Other liabilities” on the Consolidated Balance Sheets. On January 2, 2008, the Debentures matured and were settled through the issuance of 45,763 shares of Selective’s Common Stock along with an insignificant cash payment.
On January 30, 2007, the Board of Directors of Selective Insurance Group, Inc. declared a two-for-one stock split of Selective’s Common Stock, par value $2.00 per share in the form of a share dividend of one additional share of Common Stock for each outstanding share of Common Stock issued by Selective (the “Share Dividend”). The Share Dividend was paid on February 20, 2007 to shareholders of record as of the close of business on February 13, 2007. The effect of the Share Dividend has been recognized retroactively in 2006 and 2005 share and per share data, as well as the capital stock account balances, in the accompanying Consolidated Financial Statements, Notes to Consolidated Financial Statements and supplemental financial data.
Selective’s ability to declare and pay dividends on its Common Stock is affected by the ability of its subsidiaries to declare and pay dividends to the parent holding company. The dividends from Selective HR are restricted by the operating cash flows of this entity, as well as professional employer organization licensing requirements to maintain a current ratio of at least 1:1. The dividends from the Insurance Subsidiaries are subject to the regulatory limitations of the states in which the Insurance Subsidiaries are domiciled: New Jersey, New York, North Carolina, South Carolina, or Maine. Based on the unaudited 2007 statutory financial statements, the maximum ordinary dividends that can be paid to Selective by the Insurance Subsidiaries in 2008 are:
If Selective is acquired in a merger, or 50% or more of its assets are sold (each a “Triggering Transaction”), each holder of a Right, other than an Acquiring Person, will have the right to receive, for an exercise price of $80, such number of shares of Common Stock of the Principal Party (as defined in the Rights Agreement) equal to $80 multiplied by the Rights Amount, divided by 50% of the current per-share market price of the Common Stock of the Principal Party on the consummation date of the Triggering Transaction.
Selective’s Board may, after a person or group becomes an Acquiring Person, but before an Acquiring Person acquires 50% or more of Selective’s outstanding Common Stock, exchange all or part of the outstanding Rights, other than the Rights of an Acquiring Person, for Selective’s Common Stock, at an exchange ratio of one (1) share of Common Stock per Right. The Rights expire at the earliest of: (i) the close of business on February 2, 2009; (ii) the time at which Selective’s Board of Directors redeems all of the outstanding Rights at a redemption price of $0.01 per Right before an announcement that a person or group has become an Acquiring Person; or (iii) the time at which the Rights are exchanged for shares of Selective’s Common Stock as described above.
During the fourth quarter of 2007, the remaining $46.6 million principal balance of Selective’s Senior Convertible Notes that were scheduled to mature on September 24, 2032 were either voluntarily converted or mandatorily redeemed, with the final $8.7 million settled in January 2008. These activities resulted in the issuance of approximately 1.2 million shares as well as the elimination of approximately 3.2 million common stock equivalents. The full impact on the weighted average shares for these transactions was not realized during 2007, because the transactions occurred during the fourth quarter of the year. For additional information regarding these transactions, see Note 9, “Indebtedness.”
Based on Selective’s federal tax loss carryback availability, expected levels of pre-tax financial statement income and federal taxable income, Selective believes it is more likely than not that the existing deductible temporary differences will reverse during periods in which Selective generates net federal taxable income or has adequate federal carryback availability. As a result, Selective has no valuation allowance recognized for federal deferred tax assets.
The Retirement Savings Plan allows employees to make voluntary contributions to a number of diversified investment options, as well as Selective’s Common Stock, on a before and/or after-tax basis. Shares of Selective’s Common Stock issued under this plan were 29,214 during 2007, 21,472 during 2006, and 29,572 during 2005. The number of shares of Selective’s Common Stock available to be purchased under the Retirement Savings Plan was 1,516,954 at December 31, 2007.
Selective also provides life insurance benefits (postretirement benefits) for retired employees. Substantially all of Selective’s employees may become eligible for these benefits if they reach retirement age while working for Selective and meet a minimum of 10 years of eligibility service. Those individuals who retired prior to January 1, 1991 receive life insurance coverage which decreases over ten years to a current ultimate value of up to approximately $70,000 per retiree. Those individuals who retired on or after January 1, 1991, through December 31, 2001, receive life insurance coverage in an amount equal to 50% of their annual salary amount in effect at the end of their active career to a maximum benefit of $100,000. Those individuals retiring on or after January 1, 2002, through December 31, 2004, receive life insurance coverage in an amount equal to 50% of their annual salary amount in effect at the end of their active career to a maximum benefit of $35,000. Those individuals retiring on or after January 1, 2005, through December 31, 2007, receive life insurance coverage in an amount equal to 50% of their active life insurance coverage in effect at the end of their active career to a maximum benefit of $35,000. Those individuals retiring on or after January 1, 2008 that have attained age 60 by December 31, 2007 will receive life insurance coverage in an amount equal to 50% of their active life insurance coverage in effect at the end of their active career to a maximum benefit of $35,000. All other individuals retiring on or after January 1, 2008 will receive life insurance coverage in an amount equal to $10,000. The estimated cost of these benefits is accrued over the working lives of those employees expected to qualify for such benefits.
The funded status was recognized in the consolidated balance sheet for 2007 and 2006.
Selective’s 2007 discount rate used to value the liability is 6.5% for both the Retirement Income Plan and Postretirement Plan. Selective determined the most appropriate discount rate in comparison to our expected pay-out patterns of the plans’ obligations.
Additionally, the portfolio may not contain more than 5% of the portfolio value invested in any one security or issuer, regardless of the number of differing issues, except for U.S. Treasury and agency obligations, as well as sovereign debt issues rated A through AAA. The use of leverage is prohibited and the fund managers are prohibited from investing in certain types of securities.
The following is a brief description of each of Selective’s share-based compensation plans:
The Selective Insurance Group, Inc. 2005 Omnibus Stock Plan (“Stock Plan”) was adopted and approved by the Board of Directors effective as of April 1, 2005, and approved by stockholders’ on April 27, 2005. With the Stock Plan’s approval, no further grants are available under the: (i) Selective Insurance Stock Option Plan III, as amended (“Stock Option Plan III”); (ii) Selective Insurance Group, Inc. Stock Option Plan for Directors, as amended (“Stock Option Plan for Directors”); or (iii) Selective Insurance Group, Inc. Stock Compensation Plan for Nonemployee Directors, as amended (“Stock Compensation Plan for Nonemployee Directors”), but awards outstanding under these plans and the Selective Insurance Group, Inc. Stock Option Plan II, as amended (“Stock Option Plan II”), under which future grants ceased being available on May 22, 2002, shall continue in effect according to the terms of those plans and any applicable award agreements.
Under the Stock Plan, the Board of Directors’ Salary and Employee Benefits Committee (“SEBC”) may grant stock options, stock appreciation rights, restricted stock, phantom stock, stock bonuses, and other awards in such amounts and with such terms and conditions as it shall determine, subject to the provisions of the Stock Plan. Each award granted under the Stock Plan (except unconditional stock bonuses and the cash component of Director compensation) shall be evidenced by an agreement containing such restrictions as the SEBC may, in its sole discretion, deem necessary or desirable and which are not in conflict with the terms of the Stock Plan. During 2007, Selective issued, net of forfeitures, 478,862 restricted shares, 309,218 restricted shares during 2006 and 8,750 during 2005. Selective also granted options to purchase 158,435 shares during 2007, 88,940, shares during 2006 and 2,500 shares during 2005. As of December 31, 2007, 2,691,599 shares of Selective’s Common Stock remain available for issuance pursuant to outstanding stock options and restricted stock awards granted under the Stock Plan.
The Selective Insurance Group, Inc. Cash Incentive Plan (“Cash Incentive Plan”) was adopted and approved by the Board of Directors effective March 1, 2006 and approved by stockholders on April 27, 2005. Under the Cash Incentive Plan, the Board of Directors’ SEBC may grant cash incentive units in such amounts and with such terms and conditions as it shall determine, subject to the provisions of the Cash Incentive Plan. The initial dollar value of these grants will be adjusted to reflect the percentage increase or decrease in the total shareholder return on the Common Stock of Selective over a specified performance period. In addition, for certain grants, the number of units granted will be adjusted to reflect Selective’s performance on specified indicators as compared to targeted peer companies. Each award granted under the Cash Incentive Plan shall be evidenced by an agreement containing such restrictions as the SEBC may, in its sole discretion, deem necessary or desirable and which are not in conflict with the terms of the Cash Incentive Plan. During 2007, Selective issued 38,681 cash units and 79,384 cash units, net of forfeitures.
During the vesting period, dividends are earned on the restricted shares and held in escrow subject to the same vesting period and conditions set forth in the award agreement. Effective September 3, 1996, dividends earned on the restricted shares were reinvested in Selective’s Common Stock at fair value. Selective issued, net of forfeitures, 539 restricted shares from the DRP reserves during 2007, 346 restricted shares during 2006, and 5,892 restricted shares during 2005.
Selective also granted 626,216 restricted shares during 2005, and experienced forfeitures of 25,128 shares during 2007, 61,446 shares during 2006 and 48,030 shares during 2005. During the vesting period, dividends earned on restricted shares are reinvested in Selective’s Common Stock at fair value. Selective issued, net of forfeitures, 11,694 restricted shares from the DRP reserves during 2007, 24,446 restricted shares during 2006, 27,042 restricted shares during 2005.
As of December 31, 2007, 420,000 shares of Selective’s Common Stock were available for issuance pursuant to outstanding stock option awards under the Stock Option Plan for Directors, under which future grants ceased being available with the approval of the Stock Plan. All non-employee directors participated in this plan and automatically received an annual nonqualified option to purchase 6,000 shares of Common Stock at not less than fair value on the date of grant, which was on March 1. Options under this plan vested on the first anniversary of the grant and must be exercised by the tenth anniversary of the grant. Under the Stock Option Plan for Directors, Selective granted 66,000 options during 2005.
The total intrinsic value of options exercised was $1.9 million at December 31, 2007, $6.1 million at December 31, 2006, and $7.4 million at December 31, 2005.
A summary of the restricted stock transactions under Selective’s share-based payment plans is as follows:
As of December 31, 2007, total unrecognized compensation cost related to nonvested restricted stock awards granted under Selective’s stock plans was $9.5 million. That cost is expected to be recognized over a weighted-average period of 1.6 years. The total fair value of restricted stock vested was $22.7 million for 2007, $11.7 million for 2006, and $10.9 million for 2005. In connection with the restricted stock vestings, the total fair value of the DRP shares that also vested was $1.1 million during 2007, $0.9 million during 2006, and $1.0 million during 2005.
The weighted-average fair value of options and stock granted per share for Selective’s stock plans, during 2007, 2006, and 2005 is as follows:
In August 1998, certain officers of Selective purchased stock on the open market with proceeds advanced by Selective. These officers gave Selective promissory notes totaling $1.8 million. The notes bear interest at 2.5% and are secured by the purchased shares of Selective’s Common Stock. The promissory notes are full recourse and subject to certain employment requirements. The principal amount outstanding, which is scheduled to be fully repaid in 2009, was $0.2 million at December 31, 2007 and December 31, 2006. The outstanding balances are reflected in “Other assets” on the Consolidated Balance Sheets.
William M. Rue, a Director of Selective Insurance Group, Inc., is President of, and owns more than 10% of the equity of, Chas. E. Rue & Sons, Inc. t/a Rue Insurance, a general independent insurance agency (“Rue Insurance”). Rue Insurance is an appointed independent agent of Selective’s Insurance Subsidiaries and Selective HR, on terms and conditions similar to those of other Selective agents. Rue Insurance also places insurance for Selective’s business operations. Selective’s relationship with Rue Insurance has existed since 1928.
Rue Insurance placed insurance policies with Selective’s Insurance Subsidiaries. Direct premiums written associated with these policies was $9.9 million in 2007, $9.5 million in 2006, and $10.2 million in 2005. In return, Selective’s Insurance Subsidiaries paid commissions to Rue Insurance of $1.7 million in 2007 and $1.9 million in 2006 and 2005.
Rue Insurance placed insurance coverage for Selective with non-Selective insurance companies for which Rue Insurance was paid commission pursuant to its agreements with those carriers. Selective paid premiums for such insurance coverage of $0.5 million in 2007, $0.5 million in 2006, and $0.6 million in 2005.
In 2005, a private foundation, The Selective Group Foundation (the “Foundation”), was established by Selective under Section 501(c)(3) of the Internal Revenue Code. The Board of Directors of the Foundation is comprised of certain Selective Insurance Group, Inc. officers. Selective made contributions to the Foundation in the amount of $0.4 million in 2007 and $0.5 million in 2005. No donations were made to the Foundation in 2006.
(a) Selective purchases annuities from life insurance companies to fulfill obligations under claim settlements which provide for periodic future payments to claimants. As of December 31, 2007, Selective had purchased such annuities in the amount of $10.3 million for settlement of claims on a structured basis for which Selective is contingently liable. To Selective’s knowledge, none of the issuers of such annuities have defaulted in their obligations thereunder.
(b) Selective has various operating leases for office space and equipment. Such lease agreements, which expire at various times, are generally renewed or replaced by similar leases. Rental expense under these leases amounted to $11.2 million in 2007, $9.6 million in 2006, and $10.0 million in 2005. See Note 2(p) for information on Selective’s accounting policy regarding leases.
(c) At December 31, 2007, Selective has contractual obligations that expire at various dates through 2022 to invest up to an additional $129.8 million in alternative investments. There is no certainty that any such additional investment will be required.
The Insurance Subsidiaries are also from time-to-time involved in other legal actions, some of which assert claims for substantial amounts. These actions include, among others, putative state class actions seeking certification of a state or national class. Such putative class actions have alleged, for example, improper reimbursement of medical providers paid under workers compensation and personal and commercial automobile insurance policies. The Insurance Subsidiaries are also from time-to-time involved in individual actions in which extra-contractual damages, punitive damages, or penalties are sought, such as claims alleging bad faith in the handling of insurance claims. Selective believes that it has valid defenses to these cases. Selective’s management expects that the ultimate liability, if any, with respect to such lawsuits, after consideration of provisions made for estimated losses, will not be material to Selective’s consolidated financial condition. Nonetheless, given the large or indeterminate amounts sought in certain of these actions, and the inherent unpredictability of litigation, an adverse outcome in certain matters could, from time-to-time, have a material adverse effect on Selective’s consolidated results of operations or cash flows in particular quarterly or annual periods.
Selective’s combined statutory capital and surplus of the Insurance Subsidiaries was $1,034.3 million (unaudited) in 2007, and $1,030.1 million in 2006. Selective’s combined statutory net income of the Insurance Subsidiaries was $167.6 million (unaudited) in 2007, $164.2 million in 2006, and $140.2 million in 2005.
The Insurance Subsidiaries are required to maintain certain minimum amounts of statutory surplus to satisfy their various state insurance departments of domicile. These risk-based capital (“RBC”) requirements for property and casualty insurance companies are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholders. Based upon the Insurance Subsidiaries 2007 unaudited statutory financial statements, their combined total adjusted capital exceeded the authorized control level RBC by 5.0:1, as defined by the NAIC.
In February 2008, Selective announced a reduction in its workforce of approximately 80 positions, including the immediate displacement of 60 employees and the elimination of 20 open positions. Selective anticipates these changes will have a related one-time pre-tax cost of approximately $4 million in the first quarter of 2008. In addition, Selective is implementing targeted changes to agency commissions that will maintain highly competitive awards for agents who produce the strongest results, while reducing commissions where historically higher payments have not generated an appropriate level of profitable growth. The changes will bring Selective’s program more in line with the competition; however, commissions on 87% of direct premiums written will not be affected, and the supplemental commission program that rewards the most profitable growth agencies does not change and is targeted for rollout in most states in July 2008.
These ranges of high and low prices of Selective’s Common Stock, as reported by the NASDAQ Global Select Market, represent actual transactions. All price quotations do not include retail markups, markdowns and commissions. The range of high and low prices for Common Stock for the period beginning January 2, 2008 and ending February 22, 2008 was $20.78 to $24.92.
All per share amounts in 2006 have been restated to give retroactive effect to the two-for-one stock split distributed on February 20, 2007 to shareholders of record as of February 13, 2007. See Note 10 to the consolidated financial statements for a discussion of the stock split.