(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 this reclassification as well as the exclusion of results from discontinued operations.
(3) See Note 12 to the consolidated financial statements and the section entitled Results of Operations for a discussion of discontinued operations and Note 9 for components of income (loss), which are incorporated by reference herein.
(4) Net income for 1992 increased by $26 million due to the adoption of two accounting policies, Financial Accounting Standards No. 109, "Accounting for Income Taxes" (FASB 109), and a change in the method of deferring policy acquisition costs. FASB 109 increased net income by $20 million ($0.76 per basic share and $0.70 per diluted share) and the change in deferred policy acquisition costs increased net income by $6 million ($0.23 per basic share and $0.21 per diluted share).
(6) Changes in both the GAAP and statutory combined ratios are viewed by management and analysts as indicative of changes in the profitability of underwriting operations. A ratio over 100% is indicative of an underwriting loss, and a ratio below 100% is indicative of an underwriting profit.
(7) See Note 6 to the consolidated financial statements for a discussion of senior convertible notes issued during 2002, which discussion is incorporated by reference herein.
(1) - Refer to the Glossary of Terms on page 20 of the 2002 Annual Report to Shareholders for definitions of terms used in this financial review, incorporated by reference herein.
(2) - From continuing operations, refer to Note 12 to the consolidated financial statements and this section for further discussion.
2002 was a year characterized by serious challenges for the entire property and casualty insurance industry and the U.S. economy. However, our competitive positioning and growth strategies enabled us to reach the goals we set for 2002 and reinforce our capacity for continued improvement. We surpassed our 2001 record revenue of $1 billion and net premiums written of $925 million with revenue from continuing operations of $1.2 billion and net premiums written over the billion-dollar threshold to $1.1 billion.
These results increased 2002 net income to $42.0 million, or $1.56 per diluted share on 26,922,000 weighted average shares, compared with $25.7 million or $0.98 per diluted share in 2001 on 26,424,000 weighted average shares and $26.5 million or $1.01 per diluted share in 2000 on 26,572,000 weighted average shares. The 63% increase for 2002 compared with 2001 was attributable to our core commercial lines operation, where we achieved our 11th straight quarter of double digit price increases. These increases averaged 19% for 2002, compared with 16% in 2001 and 13% in 2000.
Net investment income earned for the year was $103.1 million compared with $96.8 million in 2001 and $99.5 million in 2000. The Company generated operating cash flows of $180.1 million in 2002, compared with $52.7 million in 2001 and $64.3 million in 2000. The 2002 operating cash flows coupled with the $112.8 million net proceeds from the senior convertible notes, increased our overall investment portfolio to $2.1 billion. This higher asset base drove our increased investment income, even though interest rates continue to trend downward. The decrease in 2001 compared with 2000 was due to: (i) lower interest rates, (ii) lower return on our investments in limited partnerships that are subject to market fluctuations (see Note 2 (j) to the consolidated financial statements for additional discussion), and (iii) lower year-end distributions from mutual funds. Net pre-tax realized gains for 2002 decreased to $3.3 million from $6.8 million in 2001 and $4.2 million in 2000. Realized investment gains and losses fluctuate based on investment decisions regarding individual securities as well as tax planning strategies.
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 insight into these segments.
Historically in the insurance industry, the ratio of statutory premiums to surplus has been used as a measure of solvency. An increase in the ratio can indicate a possible increase in solvency risk. Management and certain analysts also view this ratio as a measure of the effective use of capital since, as the ratio increases, revenue per dollar of invested capital increases, indicating the possible opportunity for an increased return. Our statutory premiums to surplus ratio has increased to 1.9x in 2002 from 1.8x in 2001, but this increase is mainly due to the effect of price increases and not to increased exposure.
Commercial lines net premiums written were $849.2 million for 2002, or approximately 81% of our total net premiums written, $723.8 million for 2001 and $639.0 million for 2000. Growth in our core commercial lines operation was led by a 19% increase in renewal price increases for the year, compared with 16% for 2001 and 13% for 2000. Commercial lines policies in force were 302,672 at December 31, 2002 compared with 295,860 in 2001 and 296,986 in 2000. Even with these price increases, retention at point of renewal was 83% for 2002, versus 81% in 2001. Included in the net premiums written totals are new business of $196.7 million in 2002, compared with $163.6 million in 2001 and $133.6 million in 2000. We believe that 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 business system that allows agents to issue small business policies from their offices. In 2002, our agents processed $18.8 million of new small commercial business through One & Done, compared with $7.0 million in 2001, the initial year this system was in use. Policies entered through One & Done accounted for more than 30% of our new commercial policies in 2002.
The Company's commercial lines combined ratio finished the year at 102.7%, compared with 104.9% in 2001 and 107.4% in 2000. Price increases, combined with underwriting improvements, are driving these profitability improvements. Our commercial lines statutory combined ratios showed similar improvements, as 2002 finished at 102.2% compared with 104.5% in 2001 and 108.2% in 2000.
We yielded solid improvements in underwriting results across most commercial lines segments. The statutory combined ratio for commercial property dropped to 90.2%, compared with 101.4% in 2001 and 113.5% in 2000.
The liability line of business is inherently volatile, which makes it more difficult to reserve. To bring our statutory combined ratio back to levels seen in prior years we have tightened underwriting guidelines. As a result, we are restricting the amount of work a contractor is able to subcontract, requiring written contracts with Hold Harmless and Indemnification agreements in place and setting minimum limits of liability coverage. In addition, we have revised underwriting guidelines in our restaurant business, to allow less liquor sales, disallow playground or recreational activities, and require more stringent life safety measures in each restaurant.
Personal lines net premiums written were $204.3 million in 2002, $201.6 million in 2001, and $204.6 million in 2000. The increase in net premiums written is attributable to renewal price increases reaching an average of 9.0% in 2002, compared with 2.1% in 2001 and a decrease of 2.9% in 2000 due to the rate roll-back imposed by New Jersey's Automobile Insurance Cost Reduction Act (AICRA).
In our nine other personal lines states, net premiums written were up 6% for the year to $65.4 million, compared with $61.9 million in 2001 and $62.0 million in 2000, reflecting the ongoing implementation of price increases, tier changes and other underwriting actions to improve results. We also continue efforts to control our exposure in New York due to the high cost of required participation in the involuntary automobile insurance market. In 2002, we decreased the number of vehicles written in New York by more than 17%, to under 11,000 compared with 12,900 in 2001 and 11,900 in 2000.
Price and tier changes for these nine states, totaling more than 22% for automobile and about 12% for homeowners over the last two years, continue to favorably impact net premiums earned. We are aggressively pursuing additional double-digit rate increases and tier changes in 2003, as personal lines prices continue to push upward industry-wide.
Our New Jersey Homeowners' 75% Quota Share treaty renewed at the expiring $75.0 million per occurrence limit with form following coverage. Premiums ceded under this treaty remained flat compared with the prior year at approximately $19.7 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. Terrorism coverage is excluded as per definition of the Terrorism Risk Insurance Act (TRIA) as well as nuclear, biological and chemical losses. The overall program cost for this treaty was $7.8 million, an increase of 4.0% over last year's $7.5 million. The $15.0 million retention would 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.
Our bond treaty included a slight increase in retention, to $800,000 in 2003 from $750,000 in 2002 and a small co-participation feature, but the rate remained stable at 11.3% of subject premium.
The property excess of loss structure remained unchanged with coverage of up to $13.0 million per risk in excess of the Company's retention of $2.0 million. This treaty includes terrorism coverage for all risks that are under $50.0 million in total insured value, with annual aggregate limits of $9.0 million for the first layer, $15.0 million for the second layer and $10.0 million for the third layer. Nuclear, biological and chemical losses are excluded, but there is no exclusion for mold losses or cyber risks. The underlying policies exclude nuclear losses, however, biological and chemical losses are covered to some extent on most policies.
Although lower interest rates have put pressure on investment returns, we still generated an increase in before-tax investment income to $103.1 million for the year, compared with $96.8 million for 2001 and $99.5 million in 2000. The increase reflects an increased asset base as our overall investment portfolio reached $2.1 billion. This was due to strong operating cash flows of $180.1 million in 2002, compared with $52.7 million in 2001 and $64.3 in 2000 coupled with the net proceeds of $112.8 million from the senior convertible notes offered in September. Our before-tax portfolio yield was 5.4% in 2002 consistent with 2001 but lower than the 5.8% in 2000.
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, 2002 was 5.3 years compared with 4.9 years at December 31, 2001.
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:
- The degree to which an issuer is current or in arrears in making principal and interest payments on the debt securities in question;
- The issuer's current financial condition and its ability to make future scheduled principal and interest payments on a timely basis;
- The dividend policy of the issuer at the date of acquisition and the date of evaluation;
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 $7.1 million for 2002, $1.4 million for 2001 and $1.0 million for 2000. These securities were written down due to heightened credit risk that was security specific and would not impact other securities held.
At December 31, 2002 our investment portfolio included non-investment grade securities with an amortized cost of $14.7 million, or 0.6% of the portfolio, and a fair value of $13.3 million. At December 31, 2001, non-investment grade securities in our investment portfolio represented 0.8%, with an amortized cost of $16.2 million and a fair value of $14.8 million. The unrealized loss on these securities represented 9.8% of our total unrealized loss at December 31, 2002, and 11.3% at December 31, 2001. The fair value of these securities was determined by independent pricing services or bid prices provided by various broker dealers. The Company does not have a material investment in non-traded securities in 2002 or 2001.
The Company regularly reviews the diversification of the investment portfolio compared with an investment grade corporate index. At December 31, 2002, 19.8% 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 11.2% in the benchmark corporate index. The average Moody's rating for the banking portfolio is "A1" with the lowest rated security at "Baa2" and the average Standard and Poor's rating is "A+", with the lowest rated security at "BB"-.
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 strengthen our ability to develop new revenue streams in fast-growing markets. During 2002, our Diversified Insurance Services strategy further evolved, which led to a more refined focus on businesses that provide synergy with our agency force and create new opportunities for agents to bring added value services and products to their customers. This focus has led us to consolidate our Diversified Insurance Services operations into three core functions: Human Resource Administration Outsourcing (HR outsourcing), managed care and flood insurance. The 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 an integral service used by our claims operation, as well as by other insurance carriers. We measure the performance of these companies in terms of revenue growth, results of operations, and returns on revenue.
locations in 2001. This expansion was primarily the result of the acquisition of NHD, a 16,000-location network that operates in Connecticut and certain regions within the states of Massachusetts, Vermont, and New Hampshire. CHN acquired NHD for $3.2 million including certain acquisition and financial performance related costs during 2002. CHN may be further required to pay additional consideration of approximately $1 million over the next two years based on certain criteria related to future financial performance. Managed care revenues increased 18% to $22.5 million for 2002, compared with $19.1 million for 2001 and $15.0 million for 2000. Net income decreased to $2.0 million in 2002, compared with $2.4 million for 2001 and $2.3 million for 2000. The increase in revenue during 2002 was attributable to network growth and expansion, but was more than offset by increased legal expenses and benefit costs. In an effort to reduce operating expenses, initiatives are currently underway to consolidate offices and reduce staff counts as duplicate functions are eliminated. Increases in both revenues and net income during 2001 were the result of network and client expansion.
Selective is a servicing carrier for the 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 135,000 flood policies under this program, compared with 115,000 in 2001 and 85,000 in 2000. This growth resulted in an increase in servicing fees in 2002 of 26% to $18.3 million, compared with $14.6 million for 2001 and $12.0 million for 2000. This increase in servicing revenues resulted in a corresponding increase in net income to $2.5 million for 2002, compared with $1.4 million for 2001 and $1.1 million for 2000.
Our total federal income tax expense increased $13.4 million in 2002 to an expense of $10.8 million, compared with a benefit of $2.6 million in 2001 and $1.9 million in 2000. These amounts reflect an effective tax rate of 20.4% for 2002, compared with (11.1)% in 2001 and (7.5)% in 2000. The expense in 2002 reflects improved underwriting results as well as an increase in net investment income, which was comprised of a higher percentage of taxable securities as compared with prior years. The benefit in 2001 and 2000 reflects lower taxable income for those years due mainly to increased underwriting losses. Our effective tax rate differs from the federal corporate rate of 35% primarily as a result of tax-exempt investment income and the dividends received deduction.
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer and the insurer's payment of that loss. To recognize liabilities for unpaid losses and loss expenses, insurers establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported net losses and loss
expenses. As of December 31, 2002, the Company had accrued $1.4 billion of loss and loss expense reserves compared with $1.3 billion at December 31, 2001.
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 $523.5 million to $666.5 million at December 31, 2002 and of approximately $460.4 million to $573.9 million at December 31, 2001. A low and high reasonable IBNR selection was derived primarily by considering the range of indications calculated using standard 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 $588.5 million at December 31, 2002 and $496.2 million at December 31, 2001. 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.
Reserves are reviewed by both internal and independent actuaries for adequacy on a periodic basis. When reviewing reserves, we analyze historical data and estimate the impact of various 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. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method, however, 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.
IBNR reserve estimation for environmental claims is often difficult because, in addition to other factors, there are significant uncertainties associated with critical assumptions in the estimation process such as average clean-up costs, third-party costs, potentially responsible party shares, allocation of damages, insurer litigation costs, insurer coverage defenses and potential changes to state and federal statutes. However, management is not aware of any emerging trends that could result in future reserve adjustments. Moreover, normal historically-based actuarial approaches are difficult to apply because relevant history is not available. In addition, while models can be applied, such models can produce significantly different results with small changes in assumptions. As a result, management does not calculate a specific environmental loss range, as it believes it would not be meaningful.
Of the 2,346 asbestos related claims, 1,296 involve only three insureds. The case reserves associated with these three insureds amounted to $3.0 million on a net and gross basis. About 90 of the total environmental claims involve approximately 20 landfill sites. The landfill sites account for case reserves of $17.9 million on a gross basis and $17.7 million on a net basis. The remaining claims, which account for $5.7 million of case reserves on a gross basis and $4.9 million on a net basis, involve leaking underground storage tanks and other latent environmental exposures.
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, 2002 we had $2.1 billion in investments compared with $1.8 billion in 2001 as a result of increased operating cash flow combined with the net proceeds from the issuance of senior convertible notes. 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.
available-for-sale investment portfolio, as well as additional purchases of available-for-sale debt securities from cash received from increased net premiums written; (ii) a 10% increase in premium receivables of $33.2 million and a 13% increase in deferred policy acquisition costs of $16.5 million, both corresponding with the net premiums written growth for the year.
We fully expect to have the capacity to repay and/or refinance these obligations as they come due.
Certain amounts in the Company's prior years' consolidated financial statements and related footnotes have been reclassified to conform with the 2002 presentation. Such reclassification had no effect on the Company's net income or stockholders' equity.
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 $7.1 million for 2002, $1.4 million for 2001 and $1.0 million for 2000.
(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 8.63% Senior Notes due May 4, 2007, and the 8.87% Senior Notes due May 4, 2010 were estimated using a cash flow analysis based upon the Company's current incremental borrowing rate for the remaining term of the loan.
Financial instruments that could potentially subject the Company to concentration of credit risk include accounts receivable associated with our human resource administration outsourcing subsidiary, which acts as a co-employer with certain clients. As a co-employer, we contractually assume substantial employer rights, responsibilities and risks of our clients' employees,
Deferred policy acquisition costs amortized to expense were $280.6 million for 2002, $257.2 million for 2001 and $235.4 million for 2000. The investment yields assumed for each reporting period, which are based upon the Company's actual average investment yield, before-tax, were 5.4% for 2002, 5.4% for 2001 and 5.8% for 2000.
Goodwill results from business acquisitions where the cost of assets acquired exceeds the fair value of those assets. The Company's goodwill balance by operating segment is as follows:
By using both individual estimates of reported claims and generally accepted actuarial reserving techniques, the Company estimates the ultimate net liability for losses and loss expenses. While the ultimate actual liability may be higher or lower than reserves established, the Company believes the reserves to be adequate. Any changes in the liability estimate may be material to the results of operations in future periods. The Company 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 $40.5 million for 2002 and $37.6 million for 2001.
Reserves are reviewed for adequacy on a periodic basis. When reviewing reserves, the Company analyzes historical data and estimates the impact of various 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
The Company 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 $5.8 million in 2002, $8.3 million in 2001, and $7.7 million in 2000. The Company issues no policies that entitle the policyholder to participate in the earnings or surplus of the Insurance Subsidiaries.
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
(c) Net unrealized gains (losses) on available-for-sale securities are as follows:
(g) The amortized cost and estimated fair value of debt securities at December 31, 2002, by contractual maturity are shown below. Mortgage-backed securities are included in the maturity tables using the estimated average life of each security.
(k) The components of comprehensive income, both gross and net of tax, for 2002, 2001 and 2000 are as follows:
The following table presents the carrying amounts and estimated fair values of the Company's financial instruments as of December 31, 2002 and 2001:
The Insurance Subsidiaries are contingently liable to the extent that any reinsurer becomes unable to meet its contractual obligations. The Company reviews the financial condition of its existing reinsurers for any potential write-offs of uncollectible amounts as well as suitability to remain on the reinsurance program. The Company had prepaid reinsurance premiums and net reinsurance recoverables with American Re-Insurance Company (American Re) (rated "A+ Superior" by A.M. Best Company, Inc.) that amounted to $62.0 million at December 31, 2002 and $71.0 million at December 31, 2001, and a state insurance fund for $64.9 million in 2002 and $76.5 million in 2001. The Company has a $39.6 million trust fund agreement with American Re that secures a portion of their recoverable amounts.
Flood business, which we cede 100% to the National Flood Insurance Program, is included in the above amounts as follows:
In addition to our flood business, ceded premiums written increased approximately $13.0 million in 2002 compared with 2001, due to increased direct premiums written and reinsurance rates.
Ceded losses and loss expenses incurred decreased in 2002 compared with 2001, beyond our flood business included in the above table, due to: i) a decrease in losses ceded to a state insurance fund of $ 9.1 million, ii) a decrease in casualty losses of $7.8 million and iii) a decrease in property losses of $11.2 million.
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 adjustments could have a material impact on the results of operations of future periods when the adjustments are made.
(3) On November 24, 1992, the Company entered into a $50.0 million note purchase agreement with various lenders covering the 7.84% Senior Notes. The Company made its final required principal payment of $7.1 million on November 15, 2002 together with accrued interest thereon.
The Company maintains a dividend reinvestment plan, under which 60,598 shares of common stock are available for issuance. Shares purchased under this plan are issued at fair value. As of December 31, 2002, the Company had an additional 6.4 million shares reserved for various stock compensation plans, retirement plans and debt offerings.
Shares repurchased in conjunction with restricted stock vestings and option exercises were 117,000 shares at a cost of $2.8 million in 2002, 133,000 shares at a cost of $3.2 million in 2001 and 69,000 shares at a cost of $1.1 million in 2000.
Selective's ability to declare and pay dividends on common stock is affected by the ability of its subsidiaries to declare and pay dividends to the holding company. The dividends from Diversified Insurance Services subsidiaries are restricted only by the operating needs of those subsidiaries. The dividends from Insurance Subsidiaries are under the regulatory limitations of the states in which the Insurance Subsidiaries are domiciled: New Jersey, New York, North Carolina and South Carolina.
Selective and its subsidiaries provide services to each other in the normal course of business. These transactions totaled $12.4 million in 2002, $14.1 million in 2001 and $14.5 million in 2000. These transactions were eliminated in all consolidated financial statements.
Stockholders' equity reflects tax benefits related to compensation expense deductions for stock options exercised of $2.4 million at December 31, 2002, and $1.3 million at December 31, 2001. There was no tax benefit recognized in 2000.
In December 2001, the Company's management adopted a plan to divest itself of its 100% ownership interest in PDA. During May 2002, the Company sold all of the issued and outstanding shares of capital stock and certain software applications developed by PDA for proceeds of $16.3 million at a net gain of $0.5 million. This gain is included in discontinued operations, on the consolidated statements of income. The tax benefit included in the loss from discontinued operations was $0.4 million for 2002, $0.2 million for 2001 and $0.1 million for 2000. The amount of tax expense in 2002 for the gain on disposition of discontinued operations is $0.3 million. As a result of the sale, $5.0 million of capitalized software development cost were recovered. We have reclassified all prior period amounts to present the operating results of PDA as a discontinued operation.
The Company offers a voluntary defined contribution 401(k) retirement savings plan to employees who meet eligibility requirements. The plan allows employees to make voluntary contributions to a number of diversified investment options including the Company's common stock, on a before and/or after-tax basis. Shares of the Company's common stock issued under this plan were 23,496 during 2002 and 23,095 during 2001.
The number of shares of the Company's common stock available to be purchased under the plan was 824,587 at December 31, 2002. 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, up to a maximum of 6%, were matched 50% by the Company. Effective July 1, 2002 employees can contribute 50% of their defined compensation and these contributions, up to a maximum of 7%, are matched 65% by the Company.
During 2002, the Company contributed $0.1 million to the deferred compensation plan.
The plan's assets are generally invested in debt and equity securities. The debt securities are invested 100% in investment grade quality securities.
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 $6.9 million in 2002, $4.5 million in 2001, and $1.3 million in 2000.
Options exercisable and their weighted average exercise price at year end are 1,287,204 and $19.22 for 2002, 1,562,244 and $18.38 for 2001 and 1,773,915 and $17.02 for 2000.
Under the Company's Stock Option Plan II, 1,069,921 shares of the Company's common stock are available for issuance at December 31, 2002. The plan permits the granting of qualified and nonqualified stock options to employees, which may or may not have 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 of 146,750 for 2002, 161,350 for 2001 and 130,950 for 2000.
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 16,817 in 2002, 16,929 in 2001 and 9,908 in 2000, from the dividend reinvestment plan reserves.
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 along with the adjustment for the increases or decreases in the fair value of the Company's common stock for share awards subject to performance-related objectives. Unearned stock compensation of $7.2 million in 2002, $6.8 million in 2001 and $5.9 million in 2000 was recorded as a reduction of stockholders' equity and the amounts amortized to compensation expense were $3.8 million in 2002, $3.0 million in 2001 and $3.5 million in 2000. This plan expired on September 1, 2002 and was replaced with the Company's Stock Option Plan III.
Under the Company's Stock Option Plan III, the Committee may, at its discretion, make restricted or unrestricted grants of common stock, or grant rights to receive common stock, to employees in addition to or in substitution for options and/or SARs granted. The Company granted total restricted shares of 11,000 for 2002 with no related forfeitures. Each such grant must be expressly subject to the attainment of one or more performance-related objectives for certain executive officers, and may be subject to the attainment of one or more performance-related objectives for other employees, as determined by the Committee and set forth in an award agreement. Each such grant also is subject to a vesting period or other terms, conditions, restrictions and limitations as determined by the Committee at its discretion as set forth in an award agreement. 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), 75 restricted shares in 2002.
Unearned stock compensation of $0.2 million was recorded in 2002 as a reduction of stockholders' equity and the amount amortized to compensation expense was $14,000.
Under the terms of the employee stock purchase plan, the number of shares of common stock available to be purchased is 384,525. This plan is available to all employees who meet the eligibility requirements and provides for the issuance of options to purchase shares of common stock. The purchase price is the lower of: (i) 85% of the closing market price at the time the option is granted or (ii) 85% of the closing price at the time the option is exercised. The Company issued shares to employees in the amount of 64,869 in 2002, 72,460 in 2001 and 92,886 in 2000.
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 346,735. The Company issued 6,479 shares during 2002, 6,120 shares during 2001 and 11,435 shares during 2000, and charged to expense $0.4 million in 2002, 2001 and 2000. 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 20 of each year how compensation for the following year will be paid.
Under the terms of the agents' stock purchase plan, the number of shares of common stock available to be purchased is 801,283. This plan provides for quarterly offerings in which independent insurance agents can purchase the Company's common stock at a 10% discount with a one year restricted period during which the shares purchased cannot be sold or transferred. Purchases made prior to the December 1, 2001 quarterly offering were discounted at 5% with no holding restrictions applied. The Company issued shares to agents in the amount of 69,341 in 2002, 40,883 in 2001 and 33,082 in 2000.
In 1994, certain officers of Selective exercised stock options by signing promissory notes in payment for the stock, totaling $1.0 million. The Company's noninterest bearing promissory notes are secured by the common stock shares issued upon exercise, which are held by the Company as collateral. The promissory notes are full recourse and subject to certain employment requirements. The outstanding principal amount was $0.2 million at December 31, 2002 and $0.3 million at December 31, 2001.
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 $0.7 million at December 31, 2002 and $1.0 million at December 31, 2001.
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 $1.1 million in 2002, $1.0 million in 2001, and $0.9 million in 2000. As an independent agent for Selective, Chas. E. Rue & Sons, Inc. received $1.3 million in commissions for insurance policies placed with the Company's Insurance Subsidiaries in 2002 and $1.2 million in both 2001 and 2000. 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 $0.4 million in 2002, $0.1 million in 2001 and $0.3 million in 2000. 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.
(a) Reserves established for liability insurance, written primarily in the general liability line of business, continue to reflect exposure to 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 the Insurance Subsidiaries have contained a more expansive exclusion for losses related to environmental claims. There are significant uncertainties in estimating our exposure to environmental claims (for both case and IBNR reserves) resulting from lack of historical data, long reporting delays, uncertainty as to the number and identity of claimants and complex legal and coverage issues. Legal issues which arise in environmental cases include the determination of whether a case is one for a federal or state forum, choice of law, causation, admissibility of evidence, allocation of damages and contribution among joint defendants, successor and predecessor liability and whether direct action against insurers can be maintained. Coverage issues which arise in environmental cases include the interpretation and application of policy exclusions, the determination and calculation of policy limits, the determination of the ultimate amount of a loss, the extent to which a loss is covered by a policy, if at all, the obligation of an insurer to defend a claim and the extent to which a party can prove the existence of coverage. Courts have reached different and sometimes inconsistent conclusions on these legal and coverage issues. We do not discount to present value that portion of our loss reserves expected to be paid in future periods.
(b) The Company purchases annuities from life insurance companies to fulfill obligations under claim settlements which provide for periodic future payments to claimants. As of December 31, 2002, the Company had purchased such annuities in the amount of $10.7 million for settlement of claims on a structured basis for which the Company is contingently liable. To the Company's knowledge, none of the issuers of such annuities have defaulted in their obligations thereunder.
(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 $8.2 million in 2002, $9.1 million in 2001, and $8.4 million in 2000.
The Insurance Subsidiaries prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by the various state insurance departments of domicile. Prescribed statutory accounting practices 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 practices encompass all accounting practices that are not prescribed; such practices 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 practices that materially affect the determination of statutory surplus, statutory net income or risk-based capital. As of December 31, 2002 the various state insurance departments of domicile have adopted the NAIC Accounting Practices and Procedures manual, version effective January 1, 2001, (NAIC SAP) in its entirety, as a component of prescribed or permitted practices.
The Company's combined statutory capital and surplus was $549.4 million (unaudited) in 2002 and $525.9 million in 2001. The Company's combined statutory net income was $29.4 million (unaudited) in 2002, $21.4 million in 2001 and $26.4 million in 2000.
The Company is required to maintain certain minimum amounts of statutory surplus to satisfy their various state insurance departments of domicile. These risk-based capital (RBC) requirements for property and casualty insurance companies are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholders. Based upon the Insurance Subsidiaries 2002 unaudited statutory financial statements, their combined total adjusted capital exceeded the authorized control level RBC by 4.7:1, as defined by the NAIC.
(2) See Note 12 to the consolidated financial statements and Financial Review for a discussion of discontinued operations.
(5) These ranges of high and low prices of the Company's common stock, as reported by The Nasdaq National Market, represent actual transactions. All price quotations do not include retail markups, markdowns and commissions. The range of high and low prices for common stock for the period beginning January 1, 2003 and ending January 31, 2003 was $26.48 to $22.93 and the last sale price on January 31, 2003 was $23.44