1. Flood business is included in statutory underwriting results in accordance with prescribed statutory accounting practices. On a GAAP basis only, flood servicing revenue and expense has been reclassified from underwriting results to Diversified Insurance Services. Prior years have been restated to reflect the exclusion of results from discontinued operations.
2. See the Glossary of Terms on Exhibit 13 on Form 10-K.
(2)- From continuing operations, refer to Item 8. "Financial Statements and Supplementary Data," Note 13 to the consolidated financial statements and this section for further discussion.
2003 was a successful year in which Selective's distinctive competitive advantage and growth strategies enabled us to increase net premiums written to $1.2 billion, a 16% increase over 2002's $1.1 billion. Driven by continued improvements across our entire operation, net income was $66.3 million, or $2.40 per diluted share on 27,645,000 weighted average shares compared with $42.0 million, or $1.56 per diluted share on 26,922,000 weighted average shares in 2002 and $25.7 million or $0.98 per diluted share in 2001 on 26,424,000 weighted average shares. The 58% increase in net income for 2003 compared with 2002 was mainly attributable to our core commercial lines operation, where we have achieved double digit renewal price increases for 15 straight quarters. These increases averaged 13% for 2003, compared with 19% in 2002 and 16% in 2001. However, we anticipate commercial lines renewal price increases will decelerate in 2004, but expect them to continue to outpace loss trends.
We manage our business in three segments: Insurance Operations (commercial lines underwriting and personal lines underwriting), Investments, and Diversified Insurance Services. The summaries below provide further information about these segments.
Commercial lines net premiums written were $999.5 million for 2003, or approximately 82% of total net premiums written, $849.2 million for 2002 and $723.8 million for 2001. Growth in our core commercial lines operation was led by a 13% increase in renewal pricing for the year, compared with 19% for 2002 and 16% for 2001. We anticipate these increases will decelerate in 2004. Commercial lines policies in force were 325,100 at December 31, 2003 compared with 302,672 in 2002 and 295,860 in 2001. Retention was 81% for 2003, compared with 78% in 2002 and 75% in 2001. Included in the net premiums written totals are new business of $228.1 million in 2003, compared with $193.2 million in 2002 and $163.3 million in 2001. We believe the increase in new business was primarily attributable to our field strategy, which puts underwriting and claims specialists in direct contact with our agencies. This new business growth also reflects continued agency integration of our small business and technology initiatives through systems such as One & Done, our Internet-based policy system that allows agents to issue small business policies, those with premiums under $10,000, from their offices. In 2003, agents generated $25.3 million of new small commercial business through One & Done, compared with $18.8 million in 2002 and $7.0 million in 2001. Agents entered 14,700 policies or 33% of new commercial policies through One & Done, 52% more than 2002.
The Company's commercial lines combined ratio for the year was 101.5%, compared with 102.7% in 2002 and 104.9% in 2001. Price increases, combined with underwriting improvements, are driving these profitability improvements. Our commercial lines statutory combined ratios showed similar improvements, as 2003 finished at 100.9% compared with 102.2% in 2002 and 104.5% in 2001.
Our commercial lines loss and loss expense ratio was 69.3% in 2003, including 2.4 points from weather-related catastrophe losses, compared with 70.4% in 2002, including 1.1 points from catastrophe losses, and 70.9% in 2001, including 0.4 points from catastrophe losses. The 1.1 point decrease in the ratio in 2003 from 2002 was attributable to the renewal price increases, discussed above, which had a favorable effect of 7.5 points on the loss and loss expense ratio. This was partially offset by 4.6 points attributable to loss trends, 1.3 points of additional catastrophe losses and 0.5 points of other costs, including adverse development and reinsurance costs. The 0.5 point decrease in the ratio in 2002 from 2001 was attributable to the renewal price increases which had an effect of 7.4 points on the loss and loss expense ratio. This was partially offset by 4.7 points of loss trends, 1.0 point of additional catastrophes losses and 1.2 points of other costs, including adverse development and reinsurance costs. Loss trends include the effects of such items as general, legal and regulatory, jury verdict and medical inflation.
Our general liability line of business, which accounted for $281.1 million or 28% of total commercial lines net premiums written in 2003, compared with $235.6 million in 2002 and $191.9 million in 2001, saw its loss and loss expense ratio decline to 66.8% in 2003 from 68.6% in 2002 and 65.0% in 2001. The improved profitability is the result of price increases and tightened underwriting guidelines such as restricting the amount of work a contractor is able to sub-contract and setting minimum limits of liability coverage. However, during 2003, our Products/Completed Operations business demonstrated significant prior year development. Estimates for prior year losses increased by $17.9 million, with $14.0 million in accident years 2000 and prior. This deficiency was created mainly by our contractor completed operations business. Prior to 2002, we had more exposure to faulty workmanship and materials for both the general contractor and subcontractors and inadequate limits on subcontractors. After 2002, we took extensive underwriting actions to limit our exposure. We adopted the Insurance Service Office (ISO) general liability insurance form which excluded subcontractors for faulty workmanship. We also placed mold limitations or exclusions on most policies and required subcontractors to carry equal insurance limits to those carried by the general contractor as well as mandated that our insureds be named on any potential subcontractor's policy as an additional insured on a primary and noncontributory basis. This business is inherently volatile which makes it more difficult to reserve.
Our commercial property line of business, which had net premiums written of $106.3 million or 11% of total commercial lines net premiums written, had a loss and loss expense ratio of 68.6% including 18.6 points from weather-related catastrophe losses in 2003, compared with 60.7%, including 8.5 points from catastrophe losses in 2002 and 67.9%, including 2.4 points from catastrophe losses in 2001. In addition to price increases, the progress we have made in our commercial property line can be attributed to: better insurance-to-value estimates across our book of business; a shift of risks to better construction quality and newer buildings; and an overall focus on low-to-medium hazard property exposures.
The personal lines combined ratio for the year was 105.5%, including 3.9 points from weather-related catastrophe losses, compared with 108.8% in 2002, which included 1.4 points from catastrophe losses and 113.5% in 2001, which included 0.5 points from catastrophe losses. The personal lines loss and loss expense ratio was 75.8% in 2003, down from 80.0% in 2002 and 85.4% in 2001. The 2003 improvement in both the combined ratio and the loss and loss expense ratio was primarily the result of an improving New Jersey personal automobile loss and loss expense ratio discussed below. The improvement in the personal lines combined ratio in 2002 from 2001 reflects an $8.0 million pre-tax reserve charge taken during 2001 due to less favorable savings for the Company's New Jersey private passenger automobile liability coverage from New Jersey's Automobile Insurance Cost Reduction Act (AICRA). The charge added 4.0 points to the overall personal lines and 6.3 points to the New Jersey personal automobile combined ratio for 2001.
The personal lines underwriting expense ratio increased to 29.7% in 2003 from 28.8% in 2002 and 28.1% in 2001. Excluding the impact of incentive-based agent and employee profit sharing expenses, which are discussed in the commercial lines results section, the personal lines underwriting expense ratio increased 0.1 point in 2003 compared to 2002. These expenses amounted to $6.9 million in 2003, $4.9 million in 2002, and $4.1 million in 2001.
face amount of its policies, but does make the reinsurer liable to the insurer to the extent of the reinsurance ceded. We have reinsurance contracts that cover both property and casualty business.
Our New Jersey Homeowners 75% Quota Share treaty renewed January 1, 2004 at the 2003 expiring $75.0 million per occurrence limit with form following coverage. Under this treaty, the reinsurers follow our original policies including any loss from a terrorism event. Premiums ceded under this treaty in 2003 remained flat compared with 2002 at approximately $19.2 million. Terms and conditions remained relatively the same.
Our Property Catastrophe treaty renewed at existing limits of $150.0 million and retention of $15.0 million. The structure for the property catastrophe reinsurance program was unchanged from 2003 for the January 1, 2004 renewal, remaining in five layers and covering: (i) 95% of losses in excess of $15.0 million up to $25.0 million; (ii) 95% of losses in excess of $25.0 million up to $50.0 million; (iii) 95% of losses in excess of $50.0 million up to $85.0 million; (iv) 83.5% of losses in excess of $85.0 million up to $120.0 million; (v) 83.5% of losses in excess of $120.0 million up to $165.0 million. Total coverage under the program is $133.3 million. Terrorism coverage is excluded as per definition of TRIA, as well as nuclear, biological and chemical losses. However, these losses are covered under a separate Terrorism Excess of Loss treaty, which is discussed later in the Casualty Reinsurance section. The overall program cost for this treaty in 2003 is $6.9 million, compared with $7.1 million in 2002. The $15.0 million retention could be reduced to a minimum retention of $1.0 million for a New Jersey region catastrophe, due to a provision under the treaty that provides Selective up to $14.0 million of benefit from the New Jersey Homeowners 75% Quota Share treaty.
We continue to maintain a conservative, diversified investment portfolio, with debt security holdings representing 85% of invested assets. 62% of our debt securities portfolio is rated "AAA" while the portfolio has an average rating of "AA," Standard & Poor's second highest credit quality rating. High credit quality continues to be a cornerstone of our investment strategy, as evidenced by the fact that 99% of the debt securities are investment grade.
We emphasize liquidity requirements in response to an unpredictable underwriting environment and the need to minimize the exposure to catastrophic events. To provide liquidity while maintaining consistent performance, debt security maturities are "laddered" so that some issues are always approaching maturity, thereby providing a source of predictable cash flow. To reduce sensitivity to interest rate fluctuations, we invest our debt securities portfolio primarily in intermediate-term securities. The average maturity of the portfolio at December 31, 2003 was 5.5 years compared with 5.3 years at December 31, 2002.
At December 31, 2003, our investment portfolio included non-investment grade securities with an amortized cost of $25.2 million, or 1% of the portfolio, and a fair value of $27.2 million. At December 31, 2002, non-investment grade securities in
The Company regularly reviews the diversification of the investment portfolio compared with an investment grade corporate index. At December 31, 2003, 18% of the market value of our corporate bond and preferred stock portfolios were represented by investments in banks, some of which were in an unrealized loss position, compared with 11% in the benchmark corporate index. The average Moody's rating for the banking portfolio is "A1" with the lowest rated security at "Baa1" and the average Standard and Poor's rating is "A," with the lowest rated security at "BBB."
The Company regularly reviews its investment portfolio for declines in value, focusing attention on securities whose market value is less than 85% of their cost/amortized cost at the time of review. If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in accumulated other comprehensive income. If we believe the decline is "other than temporary," we write down the carrying value of the investment and record a realized loss in our consolidated statements of income. Our assessment of a decline in value includes our current judgment as to the financial position and future prospects of the entity that issued the investment security. Broad changes in the overall market or interest rate environment generally will not lead to a write-down. If our judgment about an individual security changes in the future, we may ultimately record a realized loss after having originally concluded that the decline in value was temporary, which could have a material impact on our net income and financial position of future periods. Factors considered, but not limited to, in evaluating potential impairment of debt securities include the following:
- Whether the decline appears to be issuer or industry specific;
- The independent auditors' report on the issuer's recent financial statements;
Realized gains and losses are determined on the basis of the cost of specific investments sold or written-down, and are credited or charged to income. Realized losses include impairment charges from investment write-downs for other than temporary declines of $1.2 million for 2003, $7.1 million for 2002 and $1.4 million for 2001. These securities were written down due to heightened credit risk that was security specific and would not impact other securities held.
These securities were sold despite the fact that they were in a loss position. The decision to sell these securities was due to: (i) heightened credit risk of the individual security sold, (ii) the decision to reduce our exposure to certain issuers, industries or sectors in light of changing economic conditions, or (iii) tax management purposes.
The Diversified Insurance Services businesses create a fee-based source of revenue that is not dependent on insurance underwriting cycles. These businesses are not capital intensive and allow us to develop alternate revenue streams in growing markets. Our Diversified Insurance Services strategy focuses on businesses that provide synergy with our insurance agency force and create new opportunities for agents to bring value added services and products to their customers. The Diversified Insurance Services operations include three core functions: human resource administration outsourcing (HR outsourcing), managed care and flood insurance. These businesses fit into our business model in one of two ways: complementary (they share a common marketing or distribution system) or vertically (one company uses the other's products or services in its own product or supply output). The flood and HR outsourcing products are sold through our independent agent distribution channel, while our managed care businesses provide a service used by our claims operation, as well as by other insurance carriers. We measure the performance of these companies based on several measures, including, but not limited to, results of operations in accordance with GAAP.
The continuing operations of Diversified Insurance Services generated $91.8 million of net revenue and $6.2 million of net income for 2003, compared with $80.8 million of net revenue and $4.1 million of net income for 2002 and $69.6 million of net revenue and $0.2 million of net loss for 2001. The segment's return on net revenue increased to 6.7% for 2003, compared with 5.0% for 2002 and (0.3)% for 2001. Operating cash flow from the segment was $10.5 million in 2003, $16.3 million in 2002 and $3.6 million in 2001.
Selective is a servicing carrier for the federal government's National Flood Insurance Program. Through this program, Selective is able to provide a market for flood insurance to over 5,700 agents across the country. As a servicing carrier, Selective bears no risk of policyholder loss since the program is fully reinsured by the federal government. Currently, Selective is servicing more than 162,000 flood policies under this program, compared with 135,000 in 2002 and 115,000 in 2001. Premium growth combined with claim administrative servicing fees related to Hurricane Isabel claims resulted in an overall increase in net revenues in 2003 of 29% to $23.6 million, compared with $18.3 million for 2002 and $14.6 million for 2001. This increase in net revenues resulted in a corresponding increase in net income to $4.0 million for 2003, compared with $2.5 million for 2002 and $1.4 million for 2001.
In December 2001, the Company's management adopted a plan to divest itself of its 100% ownership interest in PDA Software Services, Inc. (PDA), which had historically been reported as part of the Diversified Insurance Services segment. This divestiture plan was completed in May 2002 when the Company sold all of the issued and outstanding shares of capital stock of PDA as well as certain software applications developed by PDA at a net gain of $0.5 million. In addition, the Company recovered $5.0 million of capitalized software development costs, see Item 8. "Financial Statements and Supplementary Data," Note 13 to the consolidated financial statements.
The Company has a net deferred tax liability of $12.7 million at December 31, 2003, compared with a net deferred tax asset of $8.7 million at December 31, 2002. The application of Alternative Minimum Tax (AMT) credits against regular tax in the current year, as well as increases in unrealized gains on the available-for-sale investment portfolio, deferred policy acquisition costs, and accelerated depreciation partially offset by the increase in the discount on loss and LAE reserves and increased unearned premium reserves led to this change. The following table presents the Company's taxable income (loss), pre-tax financial statement income, and net deferred tax (liability) asset:
When a claim is reported to an insurance subsidiary, its claims personnel establish a "case reserve" for the estimated amount of the ultimate payment. The amount of the reserve is primarily based upon a case-by-case evaluation of the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the type of losses. The estimate reflects the informed judgment of such personnel based on general insurance reserving practices, as well as the experience and knowledge of the claims person. Until the claim is resolved, these estimates are revised as deemed necessary by the responsible claims personnel based on subsequent developments and periodic reviews of the cases.
In accordance with industry practice, we maintain, in addition to case reserves, estimates of reserves for losses and loss expenses incurred but not yet reported (IBNR). 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 is carried as the IBNR reserve. By using both estimates of reported claims and IBNR determined using generally accepted actuarial reserving techniques, we estimate the ultimate net liability for losses and loss expenses. We have established a range of reasonably possible IBNR losses for non-environmental net claims of approximately $661.5 million to $818.4 million at December 31, 2003 and of approximately $531.7 million to $674.6 million at December 31, 2002. A low and high reasonable IBNR selection was derived primarily by considering the range of indications calculated using generally accepted actuarial techniques. Such techniques assume that past experience, adjusted for the effects of current developments and anticipated trends, are an appropriate basis for predicting future events. Our net carried IBNR reserves for non-environmental claims, including loss expense reserves, were $733.7 million at December 31, 2003 and $588.5 million at December 31, 2002. The ultimate actual liability may be higher or lower than reserves established. We do not discount to present value that portion of our loss and loss expense reserves expected to be paid in future periods. However, the loss reserves include anticipated recoveries from salvage and subrogation.
Included in our reserves are amounts for environmental claims, both asbestos and non-asbestos. These claims have arisen primarily under older policies containing exclusions for environmental liability which certain courts, in interpreting such exclusions, have determined do not bar such claims. The emergence of these claims is slow and highly unpredictable. Since 1986, policies issued by our Insurance Subsidiaries have contained a more expansive exclusion for losses related to environmental claims. Our asbestos and non-asbestos environmental claims have arisen primarily from exposures in municipal government, small commercial risks and homeowners policies.
(1) The number of environmental claims presented in the tables includes all multiple claimants who are associated with the same site or incident.
(3) The net survival ratio was calculated utilizing a three-year average for net losses and expenses paid.
premiums written have a coverage period of twelve months. This means we record 1/12 of the net premiums written as earned premium each month, until the full amount is recognized. When premium rates increase, the effect of those increases do not immediately affect earned premium. Rather, those increases are recognized ratably over the period of coverage. Unearned premiums and prepaid reinsurance premiums, which are recorded on the consolidated balance sheets, represent that portion of premiums written that are applicable to the unexpired terms of policies in force.
In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 ("the Interpretation"). The Interpretation was originally effective for public companies at the beginning of fiscal periods beginning after June 15, 2003. In October 2003, the FASB agreed to defer the effective date of the Interpretation to the end of fiscal periods ending after December 15, 2003. In December 2003, the FASB further deferred the effective date of the Interpretation to the end of fiscal periods ending after March 15, 2004, for potential variable interest entities other than those commonly referred to as special-purpose entities. Since the Company has no entities commonly referred to as special-purpose entities, we will adopt the Interpretation as of March 31, 2004. The Company does not believe the adoption of the Interpretation will have a material impact on its results of operations or financial condition.
The discount rate enables us to state expected future cash flow as a present value on the measurement date. The guideline for setting this rate is a high-quality long-term corporate bond rate. A lower discount rate increases the present value of benefit obligations and increases pension expense. We reduced our discount rate to 6.75% in 2003 from 7.25% in 2002 to reflect market interest rate conditions. We have further reduced our discount rate to 6.25% for 2004.
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 will increase pension expense. Our long-term expected return on plan assets was 8.25% in 2003 and 8.50% in 2002.
The payment of dividends from Diversified Insurance Services subsidiaries are restricted only by the available operating cash flows of those subsidiaries. Growth in the Diversified Insurance Services segment has augmented consolidated cash flows from operations by generating $10.5 million in 2003, compared with $16.3 million in 2002 and $3.6 million in 2001. The
The Company also continually reviews its financial debt agreements for any potential rating triggers that could dictate a significant change in terms of the agreements if the Company's credit rating were to suddenly and drastically change. The principal agencies that issue financial strength ratings for the property and casualty industry are: A.M. Best Company (A.M. Best), Standard & Poor's Rating Services (S&P), Moody's Investor Service (Moody's) and Fitch Ratings Service (Fitch). We believe our ability to write business is most influenced by our rating from A.M. Best. We are currently rated "A+" (Superior) by A.M. Best, which is their second highest of fifteen ratings. A significant downgrade from A.M. Best, could materially adversely affect the business we write. We believe that ratings from S&P, Moody's or Fitch, although important, have less of an impact on our business. A rating downgrade to below "A-" in its A.M. Best or S&P rating would be considered an event of default under the terms of the Company's line of credit agreements. The Company had no outstanding borrowings on these lines at December 31, 2003 or 2002.
Dividends to stockholders are declared and paid at the discretion of the Board of Directors based upon the Company's operating results, financial condition, capital requirements, contractual restrictions and other relevant factors. The Parent has paid regular quarterly cash dividends to its stockholders for 75 consecutive years, including a $0.02 increase per share in the fourth quarter of 2003, to $0.17 per share, and currently plans to continue to pay quarterly cash dividends. For information regarding restrictions on the Parent's ability to pay dividends to its stockholders, see Item 8. "Financial Statements and Supplementary Data," Note 7(b) to the consolidated financial statements.
On November 4, 2003, the Board of Directors authorized a 2.5 million share stock repurchase program scheduled to expire on November 30, 2005. This program replaces the previous program that expired on May 31, 2003. No shares were repurchased under the current program and 7.3 million shares at an aggregate cost of $140.5 million were repurchased under the expired program.
The Insurance Subsidiaries and HR outsourcing operation are also subject to geographic concentration. Approximately 39% of our net premiums written are for insurance policies written in New Jersey, while 39% of our HR outsourcing co-employer client payroll is within the state of Florida. Other east coast states, including Connecticut, Delaware, Georgia, Maryland, New York, North Carolina, Pennsylvania, Rhode Island, South Carolina, Virginia and several midwestern states, including Illinois, Indiana, Iowa, Kentucky, Michigan, Minnesota, Missouri, Ohio and Wisconsin, account for substantially all of our other business. Consequently, changes to economic or regulatory conditions in these states could adversely affect the Company.
Since cash inflow from premiums is received in advance of cash outflow required to settle claims, we accumulate funds that we invest. At December 31, 2003, we had $2.4 billion in investments compared with $2.1 billion in 2002, as a result of the aforementioned increased operating cash flow. Our investment program is structured with staggered maturities so that liquidation of available-for-sale debt securities should not be necessary in the ordinary course of business.
Total assets increased 13%, or $408.9 million, to $3.4 billion at December 31, 2003 from December 31, 2002. Invested assets increased $311.1 million primarily due to net purchases of $259.3 million funded by $281.9 million of operating cash flow and a $50.8 million increase in net unrealized gains on the portfolio. Increased premium volume drove increases in premiums receivable of $53.7 million and deferred policy acquisition costs of $24.2 million. Reinsurance recoverable on unpaid losses and loss expenses increased $24.2 million due to: (i) $11.1 million of flood reserves from Hurricane Isabel, which we 100% cede to the federal government's National Flood Insurance Program, (ii) a $5.9 million increase in ceded claims with the New Jersey Unsatisfied Claim and Judgment Fund and (iii) growth in policy count and exposures.
At December 31, 2003 and 2002, the Company did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As such, the Company is not exposed to any financing, liquidity, market or credit risk that could arise if the Company had engaged in such relationships.
The senior convertible notes have a contingent conversion feature that allows conversion of the notes when the stock price has maintained a 20% premium to the conversion price of $29.29, or $35.15, for 20 of 30 consecutive trading days ending on
We currently have available revolving lines of credit amounting to $45.0 million, under which no balances are outstanding as of either December 31, 2003 or 2002. See Item 8. "Financial Statements and Supplementary Data," Note 7(d) to the consolidated financial statements for more information. We have issued no guarantees on behalf of others and have no trading activities involving non-exchange traded contracts accounted for at fair value. We have no material transactions with related parties other than those disclosed in Item 8. "Financial Statements and Supplementary Data," Note 17 to the consolidated financial statements.
The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported financial statement balances, as well as the disclosure of contingent assets and liabilities. Actual results could differ from those estimates.
Realized gains and losses are determined on the basis of the cost of specific investments sold and are credited or charged to income. In the event that a decline in fair value of an investment is considered to be other than temporary, such investments are written down to their fair value at the date the impairment was determined and the amount of the write-down is included in realized losses. Realized losses from investment write-downs were $1.2 million for 2003, $7.1 million for 2002, and $1.4 million for 2001.
(2) Indebtedness: The fair value of the convertible subordinated debentures and the 1.6155% Senior Convertible Notes due September 24, 2032, are based on quoted market prices. The fair values of the 8.77% Senior Notes due August 1, 2005, the
The Property and Casualty Insurance and HR outsourcing businesses are also subject to geographic concentration. Approximately 39% of our net premiums written are for insurance policies written in New Jersey while 39% of our HR outsourcing co-employer client payroll is within the state of Florida. Other east coast states, including Connecticut, Delaware, Georgia, Maryland, New York, North Carolina, Pennsylvania, Rhode Island, South Carolina, Virginia and several midwestern states, including Illinois, Indiana, Iowa, Kentucky, Michigan, Minnesota, Missouri, Ohio and Wisconsin, account for substantially all of our other business. Consequently, changes to economic or regulatory conditions in these states could adversely affect the Company.
Policy acquisition costs are directly related to the writing of an insurance policy and are deferred and amortized over the life of the policies in order to facilitate a matching of revenues and expenses. 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
Deferred policy acquisition costs amortized to expense were $324.6 million for 2003, $280.6 million for 2002, and $257.2 million for 2001. The investment yields assumed for each reporting period, which are based upon the Company's actual average investment yield before-tax, as of the date of the calculation, were 5.0% for 2003, 5.2% for 2002, and 5.4% for 2001.
The increase in goodwill in our Diversified Insurance Services segment of $0.8 million is due to contingent purchase price adjustments relating to our acquisition of Northeast Health Direct, LLC (NHD) in 2002. See Note 2(r) for additional information regarding acquisitions.
As of January 1, 2002 the Company adopted the FASB Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" (FAS 142). FAS 142 addresses the initial recognition and measurement of goodwill and other intangible assets. FAS 142 changed the accounting for goodwill and intangible assets that have indefinite useful lives from an amortization approach to an impairment-only approach that requires those assets to be tested at least annually for impairment. The statement is applied to all goodwill and other intangible assets recognized in an entity's financial statements at that date. No such impairments were recorded during 2003 or 2002. Goodwill amortization expense, which is included in other expenses on the consolidated statements of income and mainly in the Diversified Insurance Services segment, was $3.3 million for 2001. This 2001 expense amount was calculated using the straight-line method amortized over the estimated useful lives of the assets acquired, which ranged between nine and twenty years.
The following table shows net income and earnings per share as if FAS 142 had been adopted during the period presented:
The FASB Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (FAS 123) establishes financial accounting and reporting standards for stock-based compensation plans. As permitted by FAS 123, the Company uses the accounting method prescribed by Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees" (APB 25) to account for its stock-based compensation plans. Companies using APB 25 are required to make pro forma footnote disclosures of net income and earnings per share as if the fair value method of accounting, as defined in FAS 123, had been applied. See Note 16 for more information.
The Company uses the asset and liability method of accounting for income taxes. Deferred federal income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax basis of the Company's assets and liabilities, as well as tax on net unrealized gains or losses on available-for-sale securities. A valuation allowance is established when it is more likely than not that some portion of the deferred tax asset will not be realized. The effect of a change in tax rates is recognized in the period of enactment.
an indefinite life and will be reviewed annually for potential impairment. The client contracts are being amortized over their useful lives, 3 years, with $0.2 million amortized to expense in both 2003 and in 2002. These amounts are included in other assets on the consolidated balance sheets.
(b) Net unrealized gains on held-to-maturity debt securities are as follows:
(d) The amortized cost, estimated fair values and unrealized gains (losses) of held-to-maturity debt securities at December 31, 2003 and 2002, respectively, are as follows:
(e) The cost/amortized cost, estimated fair values and unrealized gains (losses) of available-for-sale securities at December 31, 2003 and 2002, respectively, are as follows:
At December 31, 2003, the Company had 49 debt securities, with a fair value of $206.0 million in an unrealized loss position of $3.7 million. The decline in 47 of these securities is attributable to changes in the interest rate environment. These securities have a fair value of $199.2 million and unrealized losses of $3.5 million. Issuer specific concerns account for declines in the remaining two debt securities, with a fair value of $6.8 million and unrealized losses of $0.2 million. The Company believes these declines to be temporary.
(h) The amortized cost and estimated fair value of debt securities at December 31, 2003, by contractual maturity are shown below. Mortgage-backed securities are included in the maturity tables using the estimated average life of each security.
(k) Included in other investments is $35.6 million of investments in limited partnerships in 2003 and $23.5 million in 2002. These investments are purchased and sold through an investment advisor and are carried at the equity method, which approximates fair value. Any change in fair value of these investments is recognized in net investment income earned in the period of change. At December 31, 2003 the Company has additional investment commitments of up to $32.4 million. There is no certainty that any additional investment will be required.
The following table presents the carrying amounts and estimated fair values of the Company's financial instruments as of December 31, 2003 and 2002:
In the ordinary course of business, the Insurance Subsidiaries assume and cede premiums with other reinsurance and insurance companies and various pools and associations of which they are members. A large portion of the reinsurance is effected under reinsurance contracts known as treaties and, in some instances, by negotiation on each individual risk. The Insurance Subsidiaries have in place excess of loss and catastrophe reinsurance treaties that protect against losses over
Under the Company's reinsurance arrangements, which are all prospective in nature, reinsurance premiums ceded are recorded as prepaid reinsurance and amortized over the remaining contract period in proportion to the reinsurance protection provided, or recorded periodically, as per terms of the contract, in a direct relationship to the direct premium recording. Reinsurance recoveries are recognized as direct losses are incurred.
Flood business which we cede 100% to the federal government's National Flood Insurance Program, is included in the above amounts as follows:
Assumed written and earned premium increased primarily due to an increase in mandatory pool assumptions.
Ceded losses and loss expenses incurred from our flood business increased in 2003 compared with 2002 due to $34.8 million of losses incurred from Hurricane Isabel. In addition to the increase in flood business, ceded losses and loss expenses incurred increased in 2003 compared with 2002 primarily due to: i) an increase in losses ceded to a state insurance fund of $13.2 million; ii) an increase in casualty losses of $6.7 million; and iii) an increase in New Jersey homeowners property losses of $3.7 million.
Incurred loss and loss expense development related to prior years was $15.0 million in 2003, $19.8 million in 2002 and $13.7 million in 2001, while net loss and loss expense reserves increased by $160.1 million in 2003 and $111.2 million in 2002. These changes were the result of normal reserve development inherent in the uncertainty in establishing reserves for losses and loss expenses, anticipated loss trends, growth in business, as well as increased reinsurance retentions.
During 2003, our General Liability line of business, specifically Products/Completed Operations business, demonstrated significant prior year development. The estimates for prior year losses increased by $17.9 million, with $14.0 million in accident years 2000 and prior. The General Liability line of business is inherently volatile which makes it more difficult to reserve.
In addition, changes in our claims operation including senior management changes and the development of a field claims model over the past five years have impacted claim settlement patterns and average case reserves. During 2003 and 2002, these changes were minimal relative to the previous three years. This, combined with higher than expected loss emergence in 2003 for past accident years, has led us to recognize and increase in our estimates for these older periods.
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.
conversion rate or (b) $0.15 multiplied by 12.9783. The Convertible Notes will be convertible at the option of the holders, if the conditions for conversion are satisfied, into shares of the Company's common stock at a conversion price of $29.29. These notes have a contingent conversion feature that allows conversion of the notes when the stock price has maintained a 20% premium to the conversion price of $29.29, or $35.15, for 20 of 30 consecutive trading days ending on the last trading day of a calendar quarter. Then, on any business day in the following calendar quarter, the holders may surrender notes for conversion into shares of common stock, or cash at the Company's option. If all the Convertible Notes were converted, the Company would be required to issue 3.9 million shares of common stock. The 20% premium trigger is in effect until and including September 30, 2009 and declines approximately 0.11% per calendar quarter thereafter to 10% on the last day of the quarter ending June 30, 2032. Holders may also surrender Convertible Notes for conversion only during any period in which the credit rating assigned to the Convertible Notes is Ba2 or lower by Moody's Investors Service, Inc. (Moody's) or BB+ or lower by Standard and Poor's Credit Market Services (S&P), the Convertible Notes are no longer rated by either Moody's or S&P, or the credit rating assigned to the Convertible Notes has been suspended or withdrawn by either Moody's or S&P. The Convertible Notes will cease to be convertible pursuant to this credit rating criteria during any period or periods in which all of the credit ratings are increased above such levels. The Convertible Notes are redeemable by the Company in whole or in part, at any time on or after September 24, 2007, at a price equal to the sum of the issue price, plus the call premium, if any, plus accrued original issue discount and accrued and unpaid cash interest, if any, or such Convertible Notes to the applicable redemption date. The holders of the Convertible Notes may require the Company to purchase all or a portion of their Convertible Notes on either September 24, 2009, 2012, 2017, 2022, or 2027 at stated prices plus accrued cash interest, if any, to the purchase date. The Company may pay the purchase price in cash or shares of Company common stock or in a combination of cash and shares of Company common stock.
Commencing on May 4, 2003, the Company paid $6.0 million in principal, together with accrued interest thereon for the 8.63% Senior Notes. This $6.0 million principal payment is required annually through May 4, 2007. The unpaid principal amount of these Senior Notes accrues interest and is payable semiannually on May 4 and November 4 of each year, until the principal is paid in full.
The Debentures were issued under an Indenture dated December 29, 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 $7.08 per share. The principal amount of the Debentures, $1.2 million at 2003 and $1.3 million at 2002, including any accrued interest, is due on January 1, 2008 and is included in other liabilities on the consolidated balance sheets.
Shares repurchased in conjunction with restricted stock vestings and option exercises were 100,000 shares at a cost of $2.5 million in 2003, 117,000 shares at a cost of $2.8 million in 2002 and 133,000 shares at a cost of $3.2 million in 2001.
In all such jurisdictions, domestic insurers are prohibited from paying "extraordinary dividends" without approval of the insurance commissioner of the respective state. Additionally, New Jersey and South Carolina require notice of the declaration of any ordinary or extraordinary dividend distribution. During the notice period, the relevant state regulatory authority may disallow all or part of the proposed dividend if it determines that the insurer's surplus, with regard to policyholders, is not reasonable in relation to the insurer's outstanding liabilities and adequate for its financial needs.
Based on the unaudited 2003 statutory financial statements, the maximum ordinary dividends that can be paid to Selective in 2004 are:
The Company is primarily engaged in writing property and casualty insurance. The Company has classified its business into three segments, which is at the same level of disaggregation as that reviewed by senior management: Insurance Operations (commercial lines underwriting, personal lines underwriting), Investments, and Diversified Insurance Services. Insurance Operations are evaluated based on GAAP underwriting results, Investments are evaluated based on after-tax investment returns, and the Diversified Insurance Services are evaluated based on several measures including, but not limited to, results of operations in accordance with GAAP. The Company does not aggregate any of its operating segments.
The GAAP underwriting results of the Insurance Operations segment are determined taking into account net premiums earned, incurred losses and loss expenses, policyholders dividends, policy acquisition costs and other underwriting expenses. Management of the Investments segment is separate from the Insurance Operations segment and, therefore, has been classified as a separate segment. The operating results of the Investments segment takes into account net investment income and net realized gains and losses on investments. The Diversified Insurance Services segment is managed independently from the other segments and, therefore, has been classified separately. The Diversified Insurance Services segment consists of managed care, flood operations and human resource administration outsourcing (HR outsourcing). The segment results are determined taking into account the net revenues generated in each of the businesses, less the costs of operations. Prior years have been restated to exclude software development and administration, which are accounted for as discontinued operations in 2002 and 2001.
upon retirement, or at each Director's election, over a period of no more than 5 years after such retirement. These deferred shares, which are currently being held in accounts on behalf of each Director, are credited with cash dividends along with interest on those dividends. The accrued liability of these deferred shares of stock and the related dividend and interest earnings at December 31, 2003 and December 31, 2002 was $1.5 million compared with the accrued liability for the units outstanding at December 31, 2001 of $1.4 million.
The number of shares of the Company's common stock available to be purchased under the plan was 810,336 at December 31, 2003. During the first six months of 2002 and all of 2001, employees could contribute up to a maximum of 12% of their defined compensation and these contributions were matched 50% by the Company up to a maximum of 6%. Effective July 1, 2002 employees can contribute 50% of their defined compensation and these contributions are matched 65% by the Company up to a maximum of 7%.
An additional defined contribution plan is maintained by Selective HR Solutions, a subsidiary of the Diversified Insurance Services segment, which does not participate in the Company's defined contribution plan. Effective January 1, 2002, the plan allows employees to contribute a maximum of 25% of defined compensation and up to 3% of contributions are matched 200% by the employer. Prior to 2002, the maximum contribution was 15% of defined compensation.
Employer contributions for all the plans amounted to $3.7 million in 2003, $3.1 million in 2002, and $2.6 million in 2001.
The Company contributed $0.3 million in 2003 and $0.1 million in 2002 to the deferred compensation plan.
The Company has a noncontributory defined benefit retirement income plan covering all employees who meet eligibility requirements. The Company's funding policy provides that payments to the pension trust shall be equal to the minimum funding requirements of the Employee Retirement Income Security Act, plus additional amounts that may be approved by the Company from time to time. Effective July 1, 2002, two new amendments to the plan were adopted. For new entrants into the plan the monthly retirement benefits beginning at normal retirement were decreased to 1.2% from 2.0% of the average monthly compensation as defined. Also, for all plan participants the early retirement age was changed to include a formula, whereby age plus years of service must sum to at least 70.
The estimated cost of these benefits is accrued over the working lives of those employees expected to qualify for such benefits as a level percentage of their payroll costs.
The weighted average asset allocation by percentage of the retirement income plan at December 31 is as follows:
The retirement income plan holds investments in the common stock of the Company. These investments amounted to $1.3 million at December 31, 2003 and $1.0 million at December 31, 2002.
The Company has incentive compensation plans in which employees are eligible to participate based on corporate and individual performance goals. The total compensation costs charged to expense in connection with the plans were $13.0 million in 2003, $6.9 million in 2002 and $4.5 million in 2001.
During the vesting period, dividends are earned and held in escrow on the restricted shares subject to the same vesting period and conditions as set forth in the award agreement. Effective September 3, 1996, dividends earned on the restricted shares are reinvested in the Company's common stock at fair value. The Company issued through the dividend reinvestment feature (net of forfeitures), restricted shares of 12,004 in 2003, 16,817 in 2002, and 16,929 in 2001, from the dividend reinvestment plan reserves.
In May 2002, the shareholders approved the Company's Stock Option Plan III, which has 1,723,098 shares of the Company's common stock available for issuance at December 31, 2003. The plan permits the granting of qualified and nonqualified stock options to employees, which may or may not have stock appreciation rights (SARs) attached. Options and related SARs may be granted at not less than fair value on the date of the grant and may be subject to certain vesting periods as determined by the Company's Salary and Employee Benefits Committee (Committee). Each grant must be exercised within ten years from the date of the grant. Under this plan, the Company granted options for 146,250 shares in 2003 and 5,000 shares in 2002.
Unearned stock compensation is recognized for the fair value of the restricted shares when granted and is accounted for as a reduction of stockholders' equity. This balance is amortized into compensation expense over the 4 year length of the restriction along with the adjustment for the increases or decreases in the fair value of the Company's common stock for share awards subject to the performance related objectives. Unearned stock compensation of $5.3 million in 2003, and $0.2 million in 2002 was recorded as a reduction of stockholders' equity and the amounts amortized to compensation expense were $1.5 million in 2003 and $14,000 in 2002.
In May 1996, the shareholders approved the stock compensation plan for nonemployee directors, effective January 1, 1997. The purpose of this plan is to provide for the payment of the annual compensation for the directors' services in shares of the Company's common stock. The amount of common shares available for issuance under the plan is 339,063. The Company issued 7,672 shares during 2003, 6,479 shares during 2002, and 6,120 shares during 2001 and charged to expense $0.5 million in 2003, and $0.4 million in 2002 and 2001. The plan was amended, effective January 1, 2001, to permit the directors to elect to receive up to 50% of their compensation under the plan in cash for each calendar year. Each non-employee director must elect on or before December 20th of each year how compensation for the following year will be paid.
In August 1998, certain officers of Selective purchased stock on the open market with proceeds advanced by the Company. 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 was $0.6 million at December 31, 2003 and $0.7 million at December 31, 2002.
The Company has utilized the services of Chas. E. Rue & Sons, Inc., a general insurance agency, of which William M. Rue, a director of Selective Insurance Group, Inc., is the President and owner of more than a 5% equity interest. The Company's Insurance Subsidiaries purchased insurance coverages from Chas. E. Rue & Sons, Inc. with premiums of $1.3 million in 2003, $1.1 million in 2002, and $1.0 million in 2001. As an independent agent for Selective, Chas. E. Rue & Sons, Inc. received $1.6 million in commissions for insurance policies placed with the Company's Insurance Subsidiaries in 2003, $1.3 million in 2002 and $1.2 million in 2001. Additionally, Chas E. Rue & Son, Inc., owns 20% of PL, LLC, which is an insurance fund administrator that places reinsurance through the Company. PL, LLC received reinsurance commissions of $0.1 million in 2003, $0.4 million in 2002 and $0.1 million in 2001. The Company believes that the related party transactions with Chas. E. Rue & Sons, Inc. and PL, LLC were on terms as fair to the Company as could have been obtained from unaffiliated third parties.
Based on our aggregate reserve for net losses and loss expenses at December 31, 2003, we do not expect that liabilities associated with environmental and non-environmental claims will have a materially adverse impact on our 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 our current estimates.
(c) The Company 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 $9.3 million in 2003, $8.2 million in 2002, and $9.1 million in 2001.
On October 15, 2003 and October 27, 2003, two related purported class action lawsuits were brought by the same plaintiff in the Third Judicial Circuit Court of Illinois against SICA. The first lawsuit alleges a class that covers all states in which SICA does business and that it breached its insurance policies, the Illinois Consumer Fraud and Deceptive Business Practice Act and similar laws of other states and was unjustly enriched. The plaintiff also filed a Motion for Class Certification. We are vigorously defending the lawsuit and have filed a Motion to Dismiss. The second lawsuit also alleges a class that covers all states in which SICA does business and also alleges that it breached its insurance policies, the Illinois Consumer Fraud and Deceptive Business Practice Act and similar laws of other states and was unjustly enriched. We are vigorously defending the suit and have filed Motions to Dismiss.
On January 1, 2004, the Parent purchased a property and casualty insurance company, domiciled in Maine, with $5.0 million in surplus that currently does not write any business, for $5.3 million.