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 that its facilities provide adequate space for its present needs and that additional space, if needed, would be available on reasonable terms.
Certain statements in this report, including information incorporated by reference, are “forward-looking statements” as that term is defined in the Private Securities Litigation Reform Act of 1995 (“PSLRA”). The PSLRA provides a safe harbor under the Securities Act of 1933 and the Securities Exchange Act of 1934 for forward-looking statements. These statements relate to our intentions, beliefs, projections, estimations or forecasts of future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, or performance to be materially different from those expressed or implied by the forward-looking statements. In some cases, you can identify forward-looking statements by use of words such as “may,” “will,” “could,” “would,” “should,” “expect,” “plan,” “anticipate,” “target,” “project,” “intend,” “believe,” “estimate,” “predict,” “potential,” “pro forma,” “seek,” “likely” or “continue” or other comparable terminology. These statements are only predictions, and we can give no assurance that such expectations will prove to be correct. We undertake no obligation, other than as may be required under the federal securities laws, to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
Factors that could cause our actual results to differ materially from those projected, forecasted or estimated by us in forward-looking statements are discussed in further detail in Item 1A. “Risk Factors.” These risk factors may not be exhaustive. We operate in a continually changing business environment, and new risk factors emerge from time-to-time. We can neither predict such new risk factors nor can we assess the impact, if any, of such new risk factors on our businesses or the extent to which any factor or combination of factors may cause actual results to differ materially from those expressed or implied in any forward-looking statements in this report. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report might not occur.
Selective Insurance Group, Inc., (“Selective,” the “Company,” “we,” or “our”) offers property and casualty insurance products and diversified insurance services through its various subsidiaries. Selective classifies its businesses into three operating segments: (i) Insurance Operations; (ii) Investments; and (iii) Diversified Insurance Services.
Financial Highlights of Results for years ended December 31, 2006, 2005, and 2004;
We have identified the policies and estimates described below as critical to our business operations and the understanding of the results of our operations. Our preparation of the consolidated financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurance that actual results will not differ from those estimates. Those estimates that were most critical to the preparation of the financial statements involved the following: (i) reserve for losses and loss expenses; (ii) deferred policy acquisition costs; (iii) pension and postretirement benefit plan actuarial assumptions; and (iv) other-than-temporary investment impairments.
When a claim is reported to an insurance subsidiary, 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 case.
In addition to the most recent loss trends, a range of possible IBNR reserves is determined annually and continually considered, among other factors, in establishing IBNR for each reporting period. Loss trends include, but are not limited to, large loss activity, environmental claim activity, large case reserve additions or reductions for prior accident years, and reinsurance recoverable issues. The Company also considers factors such as: (i) per claim information; (ii) Company and industry historical loss experience; (iii) legislative enactments, judicial decisions, legal developments in the imposition of damages, and changes in political attitudes; and (iv) trends in general economic conditions, including the effects of inflation. Based on the consideration of the range of possible IBNR reserves, recent loss trends, uncertainty associated with actuarial assumptions and other factors, IBNR is established and the ultimate net liability for losses and loss expenses is determined. Such an assessment requires considerable judgment given that it is frequently not possible to determine whether a change in the data is an anomaly until some time after the event. Even if a change is determined to be permanent, it is not always possible to reliably determine the extent of the change until some time later. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves because the eventual deficiency or redundancy is affected by many factors. The changes in these estimates, resulting from the continuous review process and the differences between estimates and ultimate payments, are reflected in the consolidated statements of income for the period in which such estimates are changed. Any changes in the liability estimate may be material to the results of operations in future periods.
With $763 million, or 37% of our total recorded reserves, net of reinsurance at December 31, 2006, 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 that is most susceptible to unexpected changes in the cost of medical services because of the length of time over which medical services are provided and the unpredictability of medical cost inflation. 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. In 2006, while medical cost trends were higher than historical amounts, they were lower than 2005 and were close to expected amounts in our reserve analysis. As a result, in 2006, reserves for prior accident years were reduced by the relatively moderate amount of $4 million. The higher than historical increase in medical costs in 2005 and 2006 could be a relatively short-term anomaly, in which case our historical patterns would be the best basis for future projections. If higher trends 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, 2006, our general liability line of business had recorded reserves, net of reinsurance of $708 million, which represented 34% of our total net reserves. In recent years, this line of business has experienced adverse development mainly due to coverage for completed work under policies issued to contractors and higher than expected legal expenses. Contractors general liability business in the late 1990’s was our fastest growing class of business, which brought with it more complex claims and created challenges in estimating the related reserves. By 2003, we had gained a better understanding of the underwriting complexities and were able to implement initiatives to improve the financial results for this line. Accordingly, our adverse development in 2006 of $15 million for this line of business was driven by reserve increases for accident years 2002 and prior, and was partially offset by favorable development in accident years 2004 and 2005 as we compiled additional experience to improve our actuarial projections of expected ultimate losses. At this time, management has not identified any recent trends that would create additional significant reserve uncertainty for this line of business.
At December 31, 2006, our commercial automobile line of business had recorded reserves, net of reinsurance, of $313 million, which represented 15% of our total net reserves. This line of business has experienced favorable loss development in recent years driven by a downward trend in large claims. The number of large claims has a high degree of volatility from year-to-year and, therefore, requires a longer period before true trends are recognized and can be acted upon. We have experienced lower than expected severity in accident years 2002 through 2005, which resulted in favorable development in 2005 and 2006 of $48 million and $15 million, respectively. This result is driven by trends that are positively affecting the commercial auto insurance market in general, as well as by Selective specific initiatives such as: (i) the increase in lower hazard auto business as a percentage of our overall commercial auto book of business; (ii) a re-underwriting of our newest operating region; and (iii) a more proactive approach to loss prevention. At this time, the lower trend in large claims has to some extent leveled off and management has not identified any other recent trends that would create significant reserve uncertainty for this line of business.
At December 31, 2006, no other individual line of business had recorded reserves of more than $50 million, net of reinsurance. Management, at this time, has not identified any recent trends that would create additional significant reserve uncertainty for these other lines of business.
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, 2006 and 2005:
Our process to establish reserves includes a variety of key assumptions. These assumptions include, but are not limited to, the following:
In addition to the normal amount of volatility, medical loss development factors for workers compensation are particularly sensitive to assumptions relating to medical inflation. Actual medical loss development factors could be significantly different than those which are selected from historical loss experience if actual medical inflation is materially different than what was observed in the past. In our judgment, it is possible that actual medical loss development factors could range from 6% below those actually selected in our latest reserve analysis to 10% above those selected in our latest reserve analysis. If the medical loss development assumptions were reduced by 6%, that would decrease our indicated workers compensation reserves by approximately $50 million for accident years 2005 and prior. Alternatively, if the medical loss development factors were increased by 10%, that would increase our indicated workers compensation reserves by approximately $80 million.
In addition to the normal amount of volatility, the commercial automobile line of business of the Company 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 a company 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 +/- 5%, it is our judgment that the possible impact to overall reserves could range from approximately $50 million reduction to approximately $30 million increase for accident years 2005 and prior.
approximately $40 million for accident years 2005 and prior. Alternatively, if the loss development factors were increased by 3%, that would increase our indicated personal automobile reserves by approximately $20 million.
For the 2006 accident year, the expected ultimate loss ratio by line of business is a key assumption. This assumption is based upon a large number of inputs that are assessed periodically, such as historical loss ratios, projected future loss trend, and planned pricing amounts. In our judgment, it is possible that the actual ultimate loss ratio for the 2006 accident year could be +/-7% from the one selected in our latest reserve analysis for each of our four major long tailed lines of business. The table below summarizes the possible impact on our reserves of varying our expected loss ratio assumption by +/-7% by line of business for the 2006 accident year.
In light of the many uncertainties associated with establishing the estimates and making the assumptions necessary to establish reserve levels, the Company reviews its reserve estimates on a regular basis as described above and makes adjustments in the period that the need for such adjustment is determined. These reviews could result in the Company identifying information and trends that would require the Company 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 the Company’s results of operations, equity, business, insurer financial strength, and debt ratings. The Company experienced positive prior year development in its loss and loss expense reserves totaling $7.3 million in 2006, adverse prior year development of $5.1 million in 2005 and adverse prior year development of $4.9 million in 2004. For further discussion on the adverse 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 $46.5 million as of December 31, 2006 and $41.8 million as of December 31, 2005. Selective’s 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. Selective’s 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, Selective 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. Increased frequency has been triggered, in part, by the state’s robust real estate market, which has led to an increase in home tank inspections.
The net survival ratio was calculated using a three-year average for net losses and expenses paid.
For additional information regarding the Company’s 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 equity securities and alternative investments, includes, but is not limited to, the evaluation of the following factors:
The price-earnings ratio at the time of acquisition and date of evaluation;
There were no impairment charges during 2006. We recorded an impairment charge of $1.2 million in 2005 for one investment that we concluded was impaired for an other-than-temporary decline in value. There were no impairment charges recorded in 2004.
Revenues increased in 2006 compared to 2005 and 2004, primarily due to net premiums earned (“NPE”) growth of 6% in 2006 compared to 2005 and growth of 8% in 2005 as compared to 2004. Increases in NPE are attributed to the following:
Direct voluntary new business written of $304.3 million in 2006 compared to $289.2 million in 2005 and $264.9 million in 2004;
Net investment income earned increased $20.9 million or 15% in 2006 compared to 2005 and increased $15.4 million or 13% in 2005 compared to 2004. These increases are primarily attributable to higher interest rates coupled with a higher invested asset base, and strong returns from our other investment portfolio, including limited partnerships. The increase in the invested asset base resulted from strong net investable cash flows of $326.9 million in 2006 and $460.4 million in 2005, which included net proceeds from our $100.0 million debt offerings in both the third quarter of 2006 and the fourth quarter of 2005 of $96.8 million and $98.1 million, respectively. These increases were partially offset by treasury stock purchases of approximately 4.1 million shares at a total cost of $110.1 million during 2006 and 0.7 million shares at a total cost of $16.3 million during 2005;
Net income increased 10% in 2006 compared to 2005 and 15% in 2005 compared to 2004 primarily due to:
Commercial Lines underwriting and pricing improvements over the last few years and strong new business growth offset by increases in after-tax catastrophe losses in 2006 of $10.4 million to $13.5 million compared to catastrophe losses of $3.0 million in 2005 and $12.0 million in 2004;
After-tax investment income, which increased $16.6 million, or 16%, in 2006 as compared to 2005 and increased $14.2 million, or 16%, in 2005 compared to 2004 resulting from the higher invested asset base, higher interest rates, and strong other investment returns; and
The statutory ratios include Selective’s flood line of business, which is included in the Diversified Insurance Services Segment on a GAAP basis and therefore excluded from the GAAP ratios. The total Statutory Combined Ratio excluding flood was 96.1% for 2006, 95.3% for 2005, and 96.5% for 2004.
Direct voluntary new business written of $304.3 million in 2006 compared to $289.2 million in 2005 and $264.9 million in 2004; and
These increases were partially offset by increased competition in the New Jersey personal automobile market. As of December 31, 2006, the number of cars we insured in New Jersey decreased 12% to 77,160 from 87,593 in 2005 and 97,685 in 2004. Net premiums written for our New Jersey personal automobile business were $92.7 million for 2006 as compared to $107.3 million for 2005 and $133.9 million for 2004.
Catastrophe losses increased to $20.7 million in 2006 as compared to $4.7 million in 2005 and $18.5 million in 2004; and
Increased underwriting expenses resulting from: (i) increased commissions related to the termination of the New Jersey Homeowners’ Quota Share Treaty (“Quota Share Treaty”) of 9.7 million in 2006 as compared to 2005; and (ii) an increase in profit-based compensation for employees of $3.3 million in 2006 as compared to 2005.
Partially offsetting these increases was favorable prior year development in our loss and loss expense reserves of $7.3 million, resulting from normal reserve development inherent in the uncertainty in establishing reserves for losses and loss expenses, anticipated loss trends, growth in exposures, as well
The GAAP underwriting expense ratio increased by 0.9 points in 2006 as compared to 2005 and decreased 0.1 points in 2005 as compared to 2004, driven by the items discussed above.
Historically, the results of the property and casualty insurance industry have experienced significant fluctuations from high levels of competition, economic conditions, interest rates, loss cost trends, and other factors. We expect the industry will continue to see increased pricing pressure in the primary insurance market in 2007, which will exert pressure on the future profitability of the Company's commercial lines business. The average forecast, according to the “A.M. Best Review/Preview” dated January 2007, calls for net premiums written to be relatively flat for 2007. This represents a slowdown from the projected estimate of 2.6% for 2006. The 2007 NPW forecast is ranked the second slowest rate of growth for property and casualty insurers since 1998. Loss trends, which are characterized by changes in severity and frequency, may also impact the future profitability of our business. As an example, taking a pure price decline of 1.4% and removing the expense that directly varies with premium volume yields an adverse combined ratio impact of approximately 1 point, in addition to a claims inflation increase of 3%, will cause the loss and loss adjustment expense ratio to increase approximately 2 points, all else remaining equal. The combination of claims inflation and price decreases could raise the combined ratio approximately 3 points in this example, absent any initiatives targeted to address these trends. These company initiatives would include Knowledge Management, Predictive Modeling and Safety Management and are discussed below.
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 loss costs up, leading to higher industry-wide statutory combined ratios. We believe that this is the point in the market cycle when it is critical to have a clearly defined plan to improve risk selection and mitigate frequency and severity. Some of the tools we use to lower frequency and severity are safety management, managed care, knowledge management, predictive modeling, 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 7.1 points, on average, over the past 10 years.
As competition continues to intensify, managing growth and profitability will be a major focus for us in 2007. Driving profitable organic growth has always been Selective’s strategy, and this will continue into 2007. Our growth drivers are:
Expanding our appetite for existing products and creating new products to target pockets of opportunity as identified through market planning;
Expanding the pipeline for our One-and-Done® system to include other successful programs such as auto services, manufacturing, and golf courses;
Adding 100 new agents throughout our footprint based on market planning analytics;
Other strategic initiatives we are implementing to increase the effectiveness of our field strategy and improve risk selection include:
Knowledge Management. We are accumulating and organizing existing underwriting data to enhance underwriting and pricing decisions, and have begun to implement predictive modeling to further support the underwriting process.
Workers Compensation. This strategy includes six key underwriting initiatives that focus on predictive modeling, premium leakage, premium audit procedures, and other operational improvements. In addition, multiple claims initiatives include medical bill review services, medical and pharmacy networks, case management, and first notice of loss services.
Terrorism continues to remain an overall industry concern. 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, 2007 via the Terrorism Risk Insurance Extension Act of 2005. For further information regarding this legislation, see Item 1A. “Risk Factors” of this Form 10-K.
On April 19, 2006, A.M. Best reaffirmed the “A+” (Superior) financial strength rating for our Insurance Subsidiaries for the 45th consecutive year. In support of the rating, A.M. Best cited our “solid capitalization, historically favorable operating performance and strong regional presence within the small commercial lines business segment.” Only 9% of personal and commercial lines carriers attain an “A+” rating or better, which provides us with a competitive advantage that reinforces our agents’ decision to make us their carrier of choice. On July 25, 2006, Standard and Poor’s Insurance Rating Services (“S&P”) raised our financial strength rating to “A+” from “A”, citing our strong operating performance, strong operating company capitalization, and good financial flexibility. During the third quarter of 2006, Moody’s Investor Services elevated their outlook regarding Selective to “positive.”
Year-on-year renewal retention remained level in 2006, 2005, and 2004; and
The increase in the loss and loss expense ratio for 2006 is primarily the result of catastrophe losses of $15.6 million or 1.2 points, which was an increase of $11.8 million, or 0.9 points, compared to catastrophe losses of $3.8 million, or 0.3 points, in 2005. In 2005, catastrophe losses had decreased $12.2 million, or 1.2 points, compared to 2004.
Continued strong performance in this line is the result of underwriting and pricing improvements over the last several years. As we continue to write accounts, we have implemented granular rate decreases to grow this profitable line of business. The policy count on this line of business increased 6% in 2006 compared to 2005, and 5% in 2005 compared to 2004. The policy count benefited from a 4% increase in new policies in 2006 as compared to 2005 as well as a 4% increase in 2005 as compared to 2004. Pure price on our commercial automobile policies decreased 4.1% in 2006. The results for this line of business were also positively impacted by favorable prior year statutory loss and loss expense reserve development of approximately $15 million in 2006 compared to $48 million in 2005 and $20 million in 2004. This development was primarily driven by lower than expected severity in accident years 2002 and 2005.
Over time, additional savings will be realized from other facets of our strategy, including our efforts to rank our operating states in tiers and target those which we believe will be the most profitable. Growth in our targeted states represents 76% of our 2006 new workers compensation voluntary business. Another facet of our workers compensation strategy is predictive modeling. The first predictive model for workers compensation was introduced in the second quarter of 2006. This model provides us with tools to identify unprofitable accounts and re-underwrite the workers compensation book more efficiently. We are pursuing strategies to grow the types of accounts that we have identified to be the most profitable. We are also looking at premiums written to ensure that they are reflective of the proper classes and payrolls for our workers compensation exposure. In the fourth quarter of 2006, we retained about 90% of our best business and non-renewed 33% of the worst business.
Net premiums written for this line of business increased in 2006 compared to 2005 and 2004 due to: (i) increases in direct new policy premium of 13% in 2006 to $45.1 million; (ii) stable retention of approximately 80% over the past two years; and (iii) renewal price increases, including exposure, were 1.3% in 2006.
The statutory ratios include Selective’s flood line of business, which is included in the Diversified Insurance Services Segment on a GAAP basis and therefore excluded from the GAAP ratios. The total Statutory Combined Ratio excluding flood was 102.9% for 2006, 105.0 % for 2005, and 101.8% for 2004.
The increase in NPW for Personal Lines business reflects the impact of the termination of the New Jersey Homeowners Quota Share Treaty on January 1, 2006. Excluding the impact of this treaty, NPW for Personal Lines would have decreased 7% in 2006 compared to 2005. This decrease is the result of ongoing competition in the New Jersey personal automobile market. As of December 31, 2006, the number of cars we insure in New Jersey decreased 12% to 77,160 from 87,593 as of December 31, 2005 and 97,685 as of December 31, 2004. Partially offsetting the impact of the increased competition was an increase in direct premiums written in our homeowners’ line of business of 6% to $65.1 million in 2006 compared to 2005 and an increase of 8% to $61.5 million in 2005 compared to 2004.
Statutory NPW for 2006 as compared to 2005 and 2004 increased as a result of the termination of the Quota Share Treaty on January 1, 2006. The termination resulted in a return of ceded premium in the first quarter of 2006 as well as the retention of homeowners business that had previously been ceded. An increase in direct premiums written of 6% in 2006 and 8% in 2005 compared to the prior years, also contributed to the increase in statutory net premiums written. Despite growth in premiums, the 2006 statutory combined ratio was negatively impacted by 7.6 points of catastrophe losses, while the 2005 ratio included only 1.7 points in catastrophe losses, and the 2004 ratio included 5.9 points in catastrophe losses.
We continuously reevaluate our overall reinsurance program and 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 portfolio, limits written, projected reinsurance costs, and projected impact on earnings and statutory surplus. We strive to balance often opposing considerations of reinsurer credit quality, price, terms, and our appetite for retaining a certain level of risk. This year the process led to two significant changes to our reinsurance program, which are effective January 1, 2007:
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, 2007 via the Terrorism Risk Insurance Extension Act of 2005. For further information regarding this legislation, see Item 1A. “Risk Factors” of this Form 10-K.
Although 2006 proved to be a year characterized by low incidence of significant catastrophic events, the reinsurance market continued to be influenced by retrocessional capacity constraints, rating agencies’ added emphasis on reinsurers’ capital adequacy, and recalibrated catastrophic models. In 2006, Risk Management Solutions Inc. (“RMS”), one of the leaders in catastrophe modeling, launched a new version of its U.S. Hurricane model. In addition to storm and demand surge options, RMS v.6.0 now provides results on both a “stochastic” five-year view and the traditional, longer-term “historic” view. RMS v.6.0 was influenced by RMS’s analysis of the 2004 and 2005 hurricane seasons, as well as a prospective view that hurricane activity in the Atlantic Basin will be above historical averages in the short to medium-term (five years). As a result of these model changes, loss projections increased significantly. These external market forces, combined with the growth in our book of business, resulted in a $4.5 million, or 34%, increase in the cost of our property catastrophe program effective January 1, 2007 as compared with 2006. Based on a modeled portfolio and capital stress test analysis, we chose to increase our retention under the Catastrophe Excess of Loss treaty to $40.0 million from the expiring $20.0 million retention. In addition, we purchased $35.0 million of additional coverage in the upper limit with the treaty now covering 95% of $285.0 million in excess of $40.0 million per occurrence retention. This treaty provides for one full reinstatement of any portion of original limits exhausted by a loss.
The retention and limit under our Property Excess of Loss treaty, renewed July 1, 2006, remained the same at $23.0 million in excess of $2.0 million. Consistent with the prior year, all NBCR losses are excluded from the Property Excess of Loss treaty regardless of whether or not they are certified under TRIA. Terrorism (excluding NBCR) and per occurrence aggregate limits of $46.5 million reflect a moderate reduction in the upper layer aggregate limits from the expiring $54.0 million. The estimated ceded premium decreased by $0.4 million.
The Casualty Excess of Loss program renewed with an effective date of July 1, 2006. We purchased an additional layer of our casualty treaty on January 1, 2007. The new layer provides protection for 75% of $40.0 million in excess of $50.0 million per occurrence. It was purchased for an 18 month period and has an estimated annual cost of $0.7 million. The total program currently provides the following coverage:
All Casualty Lines Excess of Loss treaty (“Casualty Treaty”) covering all casualty business, including workers compensation, up to $45.0 million, in excess of $5.0 million per occurrence; and
In comparison, the prior year treaty provided per occurrence coverage of $48.0 million in excess of the Company’s $2.0 million retention for workers compensation claims and $45.0 million in excess of the Company’s $5 million retention for all other casualty claims. The total cost of the 2006 fiscal year casualty program is expected to be $1.0 million higher than the prior fiscal year.
Our Surety and Fidelity Excess of Loss treaty was renewed effective January 1, 2007 with essentially no changes in coverage and a 22% increase in estimated ceded premium influenced by projected subject premium increases and a modest increase to rate.
Growth in net investment income, before tax, of $20.9 million for 2006 compared to 2005 and $15.4 million for 2005 compared to 2004 was primarily attributable to the increase in our investment portfolio. The value of the investment portfolio reached $3.6 billion at December 31, 2006, an increase of 11% compared to $3.2 billion at December 31, 2005. The increase in invested assets was due to substantial cash flows from operations of $393.4 million in 2006 and $406.8 million in 2005. Debt offerings in September 2006 and November 2005 also added approximately $96.8 million and $98.4 million, respectively, in assets in 2006 and 2005. Also contributing to the growth in investment income were: (i) increased income of approximately $4.0 million from certain limited partnerships within our “Other investments” category for 2006 compared to 2005 and $1.8 million for 2005 compared to 2004; and (ii) dividend income increases of $1.0 million for 2006 compared to 2005 and $1.4 million for 2005 compared to 2004.
We continue to maintain a conservative, diversified investment portfolio, with fixed maturity investments representing 82% of invested assets. 73% 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, 2006 and 2005, non-investment grade securities (below BBB-) represented less than 1%, or approximately $10 million, of our fixed maturity portfolio.
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. Our Investments segment included net realized gains before tax of $35.5 million in 2006, compared to $14.5 million in 2005, and $24.6 million in 2004. The realized gains were principally from the sale of equity securities. Net realized gains in 2006 reflect the sale of several equity positions which resulted in re-weighting various sector exposures. Within the energy sector, we reduced our overweighted allocation by selling several positions that we felt had exceeded their fair value. During 2006 there were no impairment charges recorded. Net realized gains in 2005 also reflect the sale of certain long-term equity holdings, which were partially offset by an impairment charge from one write-down for other than temporary declines in fair value of $1.2 million. There were no impairment charges recorded in 2004. We maintain a high quality and liquid investment portfolio and the sale of the securities that resulted in realized gains did not change the overall liquidity of the investment portfolio. Our philosophy for sales of securities generally is to reduce our exposure to securities and sectors based upon economic evaluations or if the fundamentals for that security or sector have deteriorated and/or for tax planning purposes. We generally have a long investment time horizon and our turnover is low, which has resulted in many securities accumulating large unrealized gains. Every purchase or sale is made with the intent of improving future investment returns.
The following table summarizes the Company’s net realized gains by investment type:
We realized gains and losses from the sale of available-for-sale debt and equity securities during 2006, 2005, and 2004. The following tables present the period of time that securities sold at a loss were continuously in an unrealized loss position prior to sale:
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 purposes.
The following table summarizes the aggregate fair value and gross pre-tax unrealized loss recorded in our accumulated other comprehensive income, by asset class and by length of time, for all available-for-sale securities that have continuously been in an unrealized loss position at December 31, 2006 and December 31, 2005:
The Diversified Insurance Services operations include two core functions: (i) human resource administration outsourcing (“HR Outsourcing”); and (ii) flood insurance. We believe these operations are within markets that continue to offer opportunity for growth. During 2006, these operations provided a contribution of $0.19 per diluted share, compared to $0.15 per diluted share in 2005. These operations continue to provide a level of mitigation to commercial lines pricing cycles. We measure the performance of these operations based on several measures, including, but not limited to, results of operations in accordance with GAAP. The results for this segment’s continuing operations are as follows:
As of December 31, 2006, our worksite lives were up 12% to 26,952 compared to 23,974 as of December 31, 2005 and 22,846 as of December 31, 2004. To improve sales, during the first quarter of 2006 we unveiled a new marketing strategy and a new agent commission structure for our human resources outsourcing product, which we refer to as our employer protection program (“EPP”). The EPP is designed to assist business owners in managing the risk of employer-related liabilities.
As described above, the fee paid to us by the NFIP decreased 0.6 points to 30.2% of premiums written effective October 1, 2006. Future reductions in this rate could occur through legislative activity.
Our Insurance Subsidiaries generate cash flows primarily from insurance float. Float is money that an insurance company holds for a limited time. In an insurance operation, float arises because premiums are collected before losses are paid. This interval can extend over many years. During that time, the insurer invests the money and generates investment income. The duration of the fixed maturity portfolio, including short-term investments, was 3.8 years as of December 31, 2006, while the liabilities of our Insurance Subsidiaries’ have a duration of approximately 3 years. To provide liquidity while maintaining consistent performance, we ladder our fixed maturity investments so that some issues are always approaching maturity and provide a source of predictable cash flow for claim payments in the ordinary course of business. In addition, the Insurance Subsidiaries purchase reinsurance coverage for protection against any significantly large claims or catastrophes that may occur during the year. Our consolidated investment portfolio was $3.6 billion as of December 31, 2006 and $3.2 billion as of December 31, 2005.
During 2006, Selective had revolving lines of credit with State Street Corporation of $20 million and Wachovia Bank of $25 million, under which no balances were outstanding during the year. In August 2006, these lines of credit were replaced with a syndicated line of credit agreement with Wachovia Bank, National Association as administrative agent. Under this new agreement, Selective has access to a $50 million credit facility, which can be increased to $75 million with the consent of all lending parties. Through December 31, 2006, no balances were outstanding under this credit facility.
Our liquidity requirements in the past have been met by dividends from our subsidiaries as well as the issuance of debt and equity securities. In the future, we expect our liquidity requirements to be met by these sources of funds. The Insurance Subsidiaries’ liquidity requirements have historically been met by cash receipts from operations, consisting of insurance premiums and investment income. These cash receipts have historically provided more than sufficient funds to pay losses, operating expenses, and dividends to the parent company.
Capital resources provide protection for policyholders, furnish the financial strength to support the business of underwriting insurance risks, and facilitate continued business growth. At December 31, 2006, we had stockholders’ equity of $1,077.2 million and total debt of $362.6 million. In addition, we have an irrevocable trust valued at $31.3 million to provide for the repayment of notes having maturities in 2007 and 2008.
On September 25, 2006, we successfully completed a $100 million offering of 60-year junior subordinated notes with a 7.5% coupon. At any time on or after September 26, 2011, we can call these notes, in whole or in part, at their aggregate principal amount, together with any accrued and unpaid interest. The proceeds from this offering will be used for general corporate purposes.
Our cash requirements include principal and interest payments on senior convertible notes, various notes payable and convertible subordinated debentures, dividends to stockholders, payment of claims, and other operating expenses, income taxes, the purchase of investments, and other expenses. Our operating obligations and cash outflows include: claim settlements, agents’ commissions, labor costs, premium taxes, general and administrative expenses, investment purchases, and capital expenditures. For further details regarding our cash requirements, refer to the section below titled “Contractual Obligations and Contingent Liabilities and Commitments.”
Given that the loss and loss expense reserves are estimates as described above and in more detail under the “Critical Accounting Policies and Estimates” section of Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” of this Form 10-K, the payment of actual losses and loss expenses is generally not fixed as to amount or timing. Due to this uncertainty, financial accounting standards prohibit us from discounting these reserves to their present value. Additionally, estimated losses as of the financial statement date do not consider the impact of estimated losses from future business. Therefore, the projected settlement of the reserves for net loss and loss expenses will differ, perhaps significantly, from actual future payments.
The information in the “Contractual Obligations” table below relating to loss and loss expense payments is presented in accordance with reporting requirements of the SEC. These projected paid amounts by year are estimates based on past experience, adjusted for the effects of current developments and anticipated trends, and include considerable judgment. There is no precise method for evaluating the impact of any specific factor on the projected timing of when loss and loss expense reserves will be paid and as a result the timing and amounts of the actual payments will be affected by many factors. Care must be taken to avoid misinterpretation by those unfamiliar with this information or familiar with other data commonly reported by the insurance industry. As was noted above, for further information regarding the uncertainty associated with loss and loss expense reserves see the “Critical Accounting Policies and Estimates” section of Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this form 10-K.
Our future cash payments associated with contractual obligations pursuant to operating leases for office space and equipment, senior convertible notes, convertible subordinated debentures, notes payable, interest on debt obligations, and loss and loss expenses as of December 31, 2006 are summarized below:
The total federal income tax expense increased $1.6 million in 2006 to $56.9 million, compared to $55.3 million in 2005, and $45.6 million in 2004. These amounts reflect an effective tax rate of 25.8% in 2006 compared to 27.3% in 2005, and compared to 26.4% for 2004. The effective rate differs from the federal corporate tax rate of 35% primarily as a result of tax-exempt investment income and the dividends received deduction. The decrease in the effective tax rate in 2006, as compared to 2005 and 2004, is mainly attributable to: (i) an increase in the tax advantaged securities within our investment portfolio; (ii) a current income tax benefit recorded in 2006 as a result of the Company settling research and development credits with the Internal Revenue Service (“IRS”); and (iii) additional alternative minimum tax credits that became available. The increase in the 2005 effective tax rate, as compared to 2004, is mainly attributable to significant improvements in underwriting results and increased capital gains on investment sales.
For information concerning the adoption of accounting pronouncements and new accounting pronouncements that have been issued but not yet adopted, see Item 8. “Financial Statements and Supplementary Data.” Note 3 to the consolidated financial statements.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Selective Insurance Group, Inc. and its subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Selective Insurance Group, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 28, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
Selective Insurance Group, Inc. through its subsidiaries, (collectively known as “Selective” or the “Company”) offers property and casualty insurance products and diversified insurance services and products. Selective Insurance Group, Inc. (the “Parent”) was incorporated in New Jersey in 1977 and its main offices are located in Branchville, New Jersey. The Parent’s Common Stock is publicly traded on the NASDAQ Global Select MarketÒ under the symbol, “SIGI.”
During 2004, Selective purchased a property and casualty insurance company, domiciled in Maine, with approximately $5.0 million in surplus that was not writing any business at the time of acquisition, for $5.3 million. Separate pro forma information of this acquisition has not been presented, as management has determined that this acquisition is not material.
The accompanying consolidated financial statements (“Financial Statements”), which include the accounts of Selective, have been prepared in conformity with: (i) accounting principles generally accepted in the United States of America (“GAAP”); and (ii) the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). All significant intercompany accounts and transactions are eliminated in consolidation.
Fixed maturity securities are comprised of bonds, redeemable preferred stocks, and mortgage-backed securities. Fixed maturity securities classified as available for sale are reported at fair value. Those fixed maturity securities that Selective has the ability and positive intent to hold to maturity are classified as held-to-maturity and carried at amortized cost. The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts to maturity. Premiums expected and discounts arising from the purchase of mortgage-backed securities are amortized to the expected maturity based on future principal payments, and considering prepayments. These prepayments are estimated based upon historical and projected cash flows. Prepayment assumptions are reviewed annually and adjusted to reflect actual prepayments and changes in expectations. Future amortization of any premium and/or discount is also adjusted to reflect the revised assumptions. Interest income, as well as amortization and accretion, is included in “Net investment income earned.” The amortized cost of fixed maturity 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. Unrealized gains and losses on fixed maturities classified as “available for sale,” net of tax are included in accumulated other comprehensive income (loss) (“AOCI”).
Other investments are comprised of limited partnerships and other miscellaneous securities, including limited liability companies. Our limited partnership investments are carried using the equity method. The Company’s share of distributed and undistributed net income from limited partnerships is included in “Net investment income earned.” Our investment in other miscellaneous securities are generally accounted for using the estimated fair value, because the Company’s interests are so minor that it exercises virtually no influence over operating and financial policies. The Company’s distributed share of net income from other miscellaneous investments is included in “Net investment income earned.” Any changes in estimated fair value associated with these investments is recorded as an unrealized gain or loss, of which these items net of tax are included in accumulated other comprehensive income (loss).
(1) Investments: Fair values for fixed maturity and equity securities are based on quoted market prices where available, or from independent pricing services. Other investments are comprised of limited partnerships and other miscellaneous securities, including limited liability companies and equity securities. Our limited partnership investments are carried using the equity method. Our investment in other miscellaneous securities are generally accounted for at estimated fair value with changes in estimated fair value associated with these investments recorded as an unrealized gain or loss, in AOCI.
Selective estimates an allowance for doubtful accounts on its premiums and other trade receivables. The allowance for premiums and other trade receivables is based on historical write-off percentages adjusted for the effects of current and anticipated trends.
The following table shows a pro forma reconciliation of net income reported under APB 25 to pro forma net income and earnings per share under FAS 123 for the year ended December 31, 2004:
Property and equipment used in operations, including certain costs incurred to develop or obtain computer software for internal use, are capitalized and carried at cost less accumulated depreciation. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets, which range up to 40 years.
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 4.4% for 2006 and 2005, and 4.6% for 2004. Deferred policy acquisition costs amortized to expense were $443.3 million for 2006, $400.6 million for 2005, and $372.2 million for 2004.
By using both individual estimates of reported claims and generally accepted actuarial reserving techniques, Selective estimates the ultimate net liability for losses and loss expenses. While the ultimate actual liability may be higher or lower than reserves established, Selective believes the reserves to be adequate. Any changes in the liability estimate may be material to the results of operations in future periods. Selective does not discount to present value that portion of its loss reserves expected to be paid in future periods; however, the loss reserves include anticipated recoveries for salvage and subrogation claims. Such salvage and subrogation amounted to $49.6 million for 2006 and $46.5 million for 2005.
Our Insurance Subsidiaries record net premiums written, which include direct writings plus reinsurance assumed and estimates of premiums earned but unbilled on the workers compensation and general liability lines of insurance, less reinsurance ceded. Premiums written are recognized as revenue over the period that coverage is provided using the semi-monthly pro rata method. Unearned premiums and prepaid reinsurance premiums represent that portion of premiums written that are applicable to the unexpired terms of policies in force.
Selective establishes reserves for dividends to policyholders on certain workers compensation policies. These dividends are based on the policyholders’ loss experience. The dividend reserves are established based on past experience, adjusted for the effects of current developments and anticipated trends. The expense for these dividends is recognized over a period that begins at policy inception and ends with the payment of the dividend. The expense recognized for these dividends was $5.9 million for 2006, $5.7 million for 2005, and $4.3 million in 2004. Selective does not issue policies that entitle the policyholder to participate in the earnings or surplus of the Insurance Subsidiaries.
Certain amounts in Selective’s prior years’ Financial Statements and related footnotes have been reclassified. The December 31, 2005 amounts reflected on the consolidated balance sheets include the following reclassifications: (i) $11.7 million of other investments that have been reclassified from equity securities; (ii) $8.6 million of short-term investments that have been reclassified from available for sale fixed maturity securities; and (iii) $18.0 million of premiums receivable that have been reclassified from commissions payable. Such reclassifications had no effect on Selective’s net income, stockholders’ equity, or cash flows.
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards 123 (revised 2004), Share-Based Payment (“FAS 123R”), which requires that compensation expense be measured on the income statement for all share-based payments (including employee stock options) at grant date fair value of the equity instruments. Selective’s January 1, 2005 adoption of this accounting pronouncement resulted in an after-tax cumulative effect of change in accounting principle benefit of $0.5 million due to the requirement to estimate the impact of expected forfeitures at the grant date in the first quarter of 2005.
In September 2006, the SEC issued staff accounting bulletin No. 108, Considering the effects of prior year misstatements when quantifying misstatements in current year financial statements (“SAB 108”), to address diversity in practice in quantifying financial statement misstatements and the potential under current practice for the build-up of improper amounts on the balance sheet. SAB 108 concludes that an adjustment would be required to a registrant’s financial statements when either the iron curtain or rollover approach results in quantifying a misstatement that is material, after considering all relevant quantitative and qualitative factors. Selective has applied the guidance of SAB 108 with respect to the December 2006 financial statements and will continue to do so prospectively. An adjustment to the current financial statements was not required as a result of applying this guidance.
(a) Net unrealized gains (losses) on investments included in other comprehensive income by asset class at December 31, are as follows:
(e) The amortized cost and estimated fair value of fixed maturity securities at December 31, 2006, 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.
(f) Certain investments were on deposit with various state regulatory agencies to comply with insurance laws and had carrying values of $25.3 million as of December 31, 2006 and $28.2 million as of December 31, 2005.
At December 31, 2006, Selective has contractual obligations that expire at various dates through 2021 to further invest up to $110.5 million in limited partnerships. There is no certainty that any such additional investment will be required.
(j) The components of net realized gains (losses) were as follows:
The components of comprehensive income, both gross and net of tax, for 2006, 2005, and 2004 are as follows:
Selective’s carrying amounts shown in the table are included in the consolidated balance sheets. The convertible subordinated debentures are included in “other liabilities” on the consolidated balance sheets. See Note 2(e) for the methods and assumptions used by Selective in estimating the fair values of its financial instruments.
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 reinsurance credit standing and other relevant factors to determine collectibility of reinsurance recoverables. The allowance for reinsurance recoverable on unpaid losses and loss
Under Selective’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 the terms of the contract, in a direct relationship to the gross premium recording. Reinsurance recoveries are recognized as gross losses are incurred.
The net loss and loss expense reserves increased by $223.2 million in 2006, $249.4 million in 2005, and $213.2 million in 2004. These changes 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.
The Company 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 our commercial automobile, workers compensation, and personal automobile lines of business partially offset by adverse development in our 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 the State 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 our 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.
In 2004, the Company experienced adverse development in its loss and loss expense reserves totaling $4.9 million. This development was driven by an increase to our loss reserves in the general liability and workers compensation lines of business of $3.5 million, which was the result of rating agency downgrades of certain reinsurers during 2004, and reductions in expected bond subrogation recoveries in our bond line of business of $2.0 million. In addition, we had net favorable
emergence of $0.6 million from our other lines of business, which was primarily the result of increases to our loss reserves for our general liability line of business of approximately $19 million, offset by decreases to our loss reserves for our commercial automobile line of business of approximately $20 million and minor development in other lines. The adverse development in the general liability line of business was mainly due to our contractor completed operations business. Prior to 2002, we had more exposure to faulty workmanship and materials for both the general contractors and subcontractors and inadequate limits on subcontractors. After 2002, we took extensive underwriting actions to limit our exposure. The positive development in the commercial automobile line of business was driven by a reduction in claim frequency and severity. The most significant adverse development came from accident years 1999 and 2000, which was offset by favorable development from accident years 2002 and 2003.
In 2002, Selective issued $305 million aggregate principal amount of 1.6155% senior convertible notes (“Convertible Notes”), due September 24, 2032, at a discount of 61.988% resulting in an effective yield of 4.25%. Selective recorded gross proceeds of $116.0 million along with $3.2 million of deferred charges, which are amortized over the life of the Convertible Notes, in connection with debt issuance costs. Approximately $72.0 million of the net proceeds were used to fund an irrevocable trust, which provided for certain payment obligations in respect of Selective’s outstanding debt obligations through 2005. Selective also paid a $40.0 million capital contribution to its Insurance Subsidiaries with the remainder of the net proceeds.
Interest on the Convertible Notes is payable semi-annually at a rate of 1.6155% beginning March 24, 2003 until September 24, 2009, to holders of record at the close of business on the preceding March 9 or September 9, respectively. After that date, cash interest will not be paid on the Convertible Notes prior to maturity unless contingent cash interest becomes payable. Contingent cash interest becomes payable if the average market price of a Convertible Note for the applicable five trading day period equals 120% or more of the sum of the Convertible Note’s issue price, accrued original issue discount and accrued cash interest, if any, for a Convertible Note to the day immediately preceding the relevant six-month period. The contingent cash interest payable per Convertible Note in respect of any quarterly period within any six-month period will equal the greater of: (a) any regular cash dividends per share paid by Selective on its Common Stock during that quarterly period multiplied by the then applicable conversion rate and (b) $0.08 multiplied by 25.9566.
On October 26, 2004, in accordance with the provisions of the Indenture dated September 24, 2002 covering the Convertible Notes (the “Convertible Notes Indenture”), Selective’s Board of Directors voted to permanently waive the stock price contingency provision, which was satisfied for the quarters ended March 31, 2004 and June 30, 2004, when the price of Selective’s Common Stock maintained a 20% premium to the conversion price of $14.65, or $17.58, for 20 of 30 consecutive trading days ending on the last day of each of these respective quarters.
Selective has various covenants under the Convertible Notes Indenture dated September 24, 2002, which include, but are not limited to, timely payment of securities, timely filing of SEC and other reports, and compliance with securities laws upon purchase of securities.
(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 deployed 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.
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.
At December 31, 2005, Selective had revolving lines of credit with State Street Corporation of $20.0 million and Wachovia Bank of $25.0 million which expired during the third quarter of 2006. On August 11, 2006, Selective entered into a syndicated line of credit agreement with Wachovia Bank, National Association as administrative agent. Under this agreement, Selective has access to a $50.0 million revolving credit facility, which can be increased to $75.0 million with the consent of all lending parties. The agreement will expire on August 11, 2011. Interest rates on borrowings under the credit facility are based on either London Interbank Offered Rate or the higher of the prime rate and adjusted federal funds rate. There have been no borrowings under this credit agreement through December 31, 2006.
Selective maintains a dividend reinvestment plan (the “DRP”). On November 18, 2003, Selective registered with the SEC 2,025,746 shares of Selective’s Common Shares with the SEC for the DRP, of which 25,746 were previously registered unissued shares. At December 31, 2006, 1,705,638 shares of Selective’s Common Stock were available for issuance under the DRP. Shares purchased under the DRP are issued at fair value. As of December 31, 2006, Selective had an additional 13.9 million shares reserved for various stock compensation and purchase plans, retirement plans, and convertible debt offerings.
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 SHRS 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.
In each such jurisdictions, domestic insurers are prohibited from paying “extraordinary dividends” without approval of the insurance commissioner of the respective state. Additionally, New Jersey, North Carolina, and South Carolina require notice of the declaration of any ordinary or extraordinary dividend distribution. During the notice period, the relevant state regulatory authority may disallow all or part of the proposed dividend if it determines that the insurer’s surplus, with regard to policyholders, is not reasonable in relation to the insurer’s outstanding liabilities and adequate for its financial needs.
On February 2, 1999, Selective’s Board of Directors (the “Board”) approved the Amended and Restated Rights Agreement (the “Rights Agreement”). Under the Rights Agreement, the right to purchase one-half of one two-hundredth (or one four-hundredth) of a share of Selective’s Series A Junior Preferred Stock (each, a “Preferred Share”) at an exercise price of $80 (each, a “Right” and collectively, the “Rights”) is attached to each share of Selective’s Common Stock. The Right is exercisable ten (10) days after an announcement that a person or group has acquired 15% or more of Selective’s outstanding Common Stock (an “Acquiring Person”) or ten (10) business days after a person or group commences or announces its intent to make a tender offer that would result in such person or group becoming an Acquiring Person. If a person or group becomes an Acquiring Person, each Right will entitle the holder, other than an Acquiring Person, to purchase such number of one-half of one two-hundredths of a Preferred Share, as set forth in the Rights certificate (the “Rights Amount”), at a price of $80 per one-half of one two-hundreds of a Preferred Share.
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 and 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.
Insurance Operations, which are evaluated based on statutory underwriting results (net premiums earned, incurred losses and loss expenses, policyholders dividends, policy acquisition costs, and other underwriting expenses), and statutory combined ratios;
Diversified Insurance Services (federal flood insurance administrative services and human resource administration outsourcing), which, because they are not dependent on insurance underwriting cycles, are evaluated based on several measures including, but not limited to, results of operations in accordance with GAAP, with a focus on return on revenues (net income divided by revenues).
Selective does not aggregate any of its operating segments. The Insurance Operations and Diversified Insurance Services segments share a common marketing or distribution system and create new opportunities for independent insurance agents to bring value-added services and products to their customers. Selective’s commercial and personal lines property and casualty insurance products, flood insurance, and human resource administration outsourcing products are sold through independent insurance agents.
Selective’s Insurance Operations and Diversified Insurance Services segments are subject to geographic concentration. Approximately 33% of net premiums written are related to insurance policies written in New Jersey and 38% of SHRS’s
Selective and its subsidiaries also provide services to each other in the normal course of business. These transactions totaled $19.3 million in 2006, $19.4 million in 2005, and $28.5 million in 2004. These transactions were eliminated in all consolidated statements. In computing the results of each segment, Selective does not make adjustments for interest expense, net general corporate expenses, or federal income taxes. Selective does not maintain separate investment portfolios for the segments and therefore, does not allocate assets to the segments.
In December 2005, Selective divested itself of its 100% ownership interest in CHN Solutions (Alta Services, LLC and Consumer Health Network Plus, LLC), which had historically been reported as part of the “Managed Care” component of the Diversified Insurance Services segment. Selective sold its interest in CHN Solutions for proceeds of $16.4 million, which produced an after tax loss of $2.6 million. This loss, which is net of a tax benefit of $1.4 million, is included in discontinued operations on the consolidated statements of income. Also included in discontinued operations on the consolidated statements of income are after tax profits of $3.2 million in 2005 and $1.5 million in 2004 from the operations of CHN Solutions prior to divestiture. Taxes on these operating profits amounted to $1.7 million in 2005 and $0.8 million in 2004.
Selective terminated, effective December 31, 1997, a nonqualified defined benefit retirement income plan for nonemployee Directors. The estimated accrued costs for this plan were not material. As part of the termination, the present value of each Director’s future benefits, as of that date, was converted into units based on the fair value of Selective Common Stock. The original termination called for the cash value of these units based upon the fair value of Selective Common Stock on retirement date to be distributed to each Director, or at each Director’s election, over a period of fifteen years after such retirement. On May 8, 2002, the stockholders approved the conversion of the units issued under the termination plan into shares of Selective Common Stock. All of the shares issued under this conversion have been deferred by the participants for receipt upon retirement, or at each Director’s election, over a period of no more than five 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 adoption of FAS 123R resulted in a reclassification of $1.3 million to “Additional Paid-in Capital” on the consolidated balance sheet for these deferred shares. At December 31, 2006 and December 31, 2005, Additional Paid-in Capital for these deferred shares was $1.1 million.
Selective offers a nonqualifed deferred compensation plan (“Deferred Compensation Plan”) to a group of management or highly compensated employees (the “Participants”) as a method of recognizing and retaining such employees. The Deferred Compensation Plan provides the Participants the opportunity to elect to defer receipt of specified portions of compensation and to have such deferred amounts treated as if invested in specified investment options. A Participant in the Deferred Compensation Plan may elect to defer compensation or awards to be received from Selective, including up to: (i) 50% annual base salary; (ii) 100% of incentive compensation; and/or (iii) a percentage of other compensation as otherwise designated by the Administrator of the Deferred Compensation Plan.
In addition to the deferrals elected by the Participants, Selective may choose at any time to make discretionary contributions on a consistent basis to the deferral accounts of all Participants in its sole discretion. No discretionary contributions were made in 2006, 2005, or 2004. Selective may also choose to make matching contributions to the deferral accounts of some or all Participants to the extent a Participant did not receive the maximum matching contribution permissible under Selective’s Retirement Savings Plan due to limitations under the Internal Revenue Code or the Retirement Savings Plan.
Selective also provides life insurance benefits (postretirement benefits) for retired employees. Substantially all of Selective’s employees may become eligible for these benefits if they reach retirement age while working for Selective and meet a minimum of 10 years of eligibility service. Those individuals who retired prior to January 1, 1991 receive life insurance coverage which decreases over ten years to a current ultimate value of $5,000 per retiree. Those individuals retiring on or after January 1, 1991, 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 receive life insurance coverage in an amount equal to 50% of their annual salary amount in effect at the end of their active career to a maximum benefit of $35,000. The estimated cost of these benefits is accrued over the working lives of those employees expected to qualify for such benefits.
The effects of adopting FAS 158 are applied prospectively, while prior year information remains unchanged.
The estimated net actuarial loss, prior service cost, and transition obligation for the defined benefit pension plan that will be amortized from accumulated other comprehensive income into net periodic benefit cost during the 2007 fiscal year are $0.5 million, $0.2 million, and $0, respectively. The estimated net actuarial loss, prior service cost, and transition obligation for the postretirement life insurance plan that will be amortized from accumulated other comprehensive income into net periodic benefit cost during the 2007 fiscal year are $0, $(32,000), and $0, respectively.
management. Selective’s return objective is to meet or exceed the returns of the plan’s policy index, which is the return the plan would have earned if the assets were invested according to the target asset class weightings and earned index returns. The plan’s allocated target and ranges by investment categories are as follows:
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 Retirement Income Plan had no investments in the Common Stock of the Company at December 31, 2006 and 2005.
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, 346 restricted shares from the DRP reserves during 2006, 5,892 restricted shares during 2005, and 13,828 restricted shares during 2004.
As of December 31, 2006, there were 473,730 shares of Selective’s Common Stock available for issuance pursuant to outstanding stock options and restricted stock awards granted under Stock Option Plan III, under which future grants ceased being available with the approval of the Stock Plan. Under Stock Option Plan III, employees were granted qualified and nonqualified stock options, with or without SARs, and restricted or unrestricted stock: (i) at not less than fair value on the date of grant and (ii) subject to certain vesting restrictions determined by the SEBC. Restricted stock awards also could be subject to achievement of performance objectives as determined by the SEBC. The maximum exercise period for an option grant under this plan is ten years from the date of the grant. Under Stock Option Plan III, Selective granted options to purchase 211,326 shares without SARs during 2005, and options to purchase 209,200 shares without SARs during 2004.
Selective also granted 626,216 restricted shares during 2005, and 657,368 restricted shares during 2004, and experienced forfeitures of 61,446 shares during 2006, 48,030 shares during 2005, and 54,868 shares during 2004. During the vesting period, dividends earned on restricted shares are reinvested in Selective’s Common Stock at fair value. Selective issued, net of forfeitures, 24,446 restricted shares from the DRP reserves during 2006, 27,042 restricted shares during 2005, and 20,010 restricted shares during 2004.
On April 26, 2006, Selective’s stockholders approved the Selective Insurance Group, Inc. Stock Purchase Plan for Independent Insurance Agencies (“Agent Plan”). This plan replaced the previous agent purchase plan under which no further purchases could be made as of July 1, 2006. Under the Agent Plan, there were 2,936,110 shares of Common Stock available for purchase as of December 31, 2006. The Agent Plan provides for quarterly offerings in which independent insurance agencies and certain eligible persons associated with the agencies with contracts with the Insurance Subsidiaries can purchase Selective’s Common Stock at a 10% discount with a one year restricted period during which the shares purchased cannot be sold or transferred. Collectively, under the current and prior plans, Selective issued shares to agents in the amount of 153,478 in 2006, 158,856 in 2005, and 173,772 in 2004 and charged to expense $0.4 million in 2006, $0.4 million in 2005, and $0.3 million in 2004.
In determining expense to be recorded for stock options granted under Selective’s share-based compensation plans, the fair value of each option award is estimated on the date of grant using the Black Scholes option valuation model (“Black Scholes”). The following are the significant assumptions used in applying Black Scholes: (i) risk-free interest rate, which is the implied yield currently available on U.S. Treasury zero-coupon issues with an equal remaining term; (ii) expected term, which is based on historical experience of similar awards; (iii) dividend yield, which is determined by dividing the expected per share dividend during the coming year by the grant date stock price; and (iv) expected volatility, which is based on the volatility of Selective’s stock price over a historical period comparable to the expected term. In applying Black Scholes, Selective uses the weighted average assumptions illustrated in the following table:
Rue Insurance placed insurance policies with Selective’s Insurance Subsidiaries. Direct premiums written associated with these policies was $9.5 million in 2006, $10.2 million in 2005, and $9.9 million in 2004. In return, Selective’s Insurance Subsidiaries paid commissions to Rue Insurance of $1.9 million in 2006, $1.9 million in 2005, and $1.8 million in 2004.
Rue Insurance placed human resource outsourcing contracts with SHRS resulting in revenues to SHRS of $62,000 in 2006, $64,000 in 2005, and $57,000 in 2004. In return, SHRS paid commissions to Rue Insurance of $14,000 in 2006, $15,000 in 2005, and $13,000 in 2004.
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 2006, $0.6 million in 2005, and $1.4 million in 2004.
(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 $9.6 million in 2006, $10.0 million in 2005, and $9.7 million in 2004.
At December 31, 2006, the total future minimum rental commitments under noncancelable leases was $24.8 million and such yearly amounts are as follows:
The Insurance Subsidiaries prepare their statutory financial statements in accordance with accounting principles prescribed or permitted by the various state insurance departments of domicile. Prescribed statutory accounting principles include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (“NAIC”). Permitted statutory accounting principles encompass all accounting principles that are not prescribed; such principles differ from state to state, may differ from company to company within a state and may change in the future. The Insurance Subsidiaries do not utilize any permitted statutory accounting principles that materially affect the determination of statutory surplus, statutory net income, or risk-based capital. As of December 31, 2005 the various state
insurance departments of domicile have adopted the NAIC Accounting Practices and Procedures manual, version as of March 2006, in its entirety, as a component of prescribed or permitted practices.
Selective’s combined statutory capital and surplus of the Insurance Subsidiaries was $1,030.1 million (unaudited) in 2006 and $930.6 million in 2005. Selective’s combined statutory net income of the Insurance Subsidiaries was $164.2 million (unaudited) in 2006, $140.2 million in 2005, and $135.0 million in 2004.
See Note 9(b) and Note 10 to the consolidated financial statements for a discussion of dividend restrictions.