We own 276,000 square feet in Pleasant Hill, California; Westminster, Colorado; Portland, Oregon; and Spokane, Washington. We also occupy 1.8 million square feet of leased space throughout the United States, of which we sublease 138,000 square feet to third parties.
(1) Our 2001 loss included a $916.9 after-tax goodwill write-off and a $2.1 after-tax charge related to the Change in Accounting Principle for derivatives.
(2) Discontinued Operations include our Life & Investments businesses that were sold in 2004.
(3) Our 2004 average diluted shares reflect the repurchase of 13.2 million shares pursuant to an accelerated stock buyback program.
(4) Our 2005 average diluted shares reflect the repurchase of 2.8 million shares pursuant to an accelerated share repurchase program and 1.7 million shares pursuant to a Rule 10b5-1 trading plan.
Refining our business model - During 2005, market conditions became more competitive. Through refinements to our business model, we continued to gain efficiencies that enabled us to grow profitably. Our market advantage is sustained by how we do business - offering standardized auto, homeowners and small- and mid-sized commercial insurance products over a unified sales-and-service platform to meet the needs of our distributors and insurance consumers.
Increasing efficiencies for our independent agents and brokers - During 2004 and 2005, we brought our major products together on Safeco Now, our automated Web-based sales-and-service platform. Safeco Now features a single point of entry for personal auto, homeowners, most small-commercial products and certain surety bonds. Products currently available on Safeco Now include: auto, homeowners, dwelling fire, motorcycle, business owner policies, commercial auto, workers compensation and commercial multi-peril. We also launched our policy change tool for handling most personal lines endorsements online. Ninety-eight percent of our personal lines policies are quoted and issued on Safeco Now, and 80% of our personal lines policy endorsements are made online. Eighty percent of our commercial lines policies also are quoted and issued on Safeco Now.
Focusing on P&C operations - During 2004, we completed the sale of our Life & Investments (L&I) businesses. Four critical ideas led us to sell L&I:
The low interest rate environment, limited investment returns and weakened L&I earnings relative to our P&C lines
Competing in multiple insurance sectors increased the complexity of our business, which in turn increased our costs
Our vision is to be one of the top-performing insurance companies in the P&C industry. We measure the success of our strategy by tracking our performance against the following three financial indicators:
The following table shows the trends in these three key measures:
In addition to the activities of these reportable segments, we report certain transactions, such as the interest expense we pay on our debt, debt repurchases, intercompany eliminations and miscellaneous corporate investment and other activities in our Corporate segment and do not allocate these to individual reportable segments.
Written premiums are premiums charged for policies issued. We view net written premiums as a measure of business production for the period under review and a leading indicator of net earned premiums. We include insurance premiums in revenues as they are earned over the terms of the policies.
Combined ratio is our losses, LAE and underwriting expenses divided by our net earned premiums. We report combined ratio as a percentage. For example, a combined ratio of 95% means that for every dollar of premium received, 95 cents is spent on losses, LAE and underwriting expenses, and 5 cents is underwriting profit. A lower combined ratio reflects better underwriting results than a higher combined ratio.
More information about our segment results can be found in the Our P&C Operating Results section on page 54.
We record two categories of loss and LAE reserves - case-basis reserves, and incurred but not reported (IBNR) reserves.
Losses that have been reported to us that may ultimately be paid out differently than expected by our case-basis reserves
Expected Loss Ratio - Loss ratios are developed for recent accident years based on historical accident year loss ratios adjusted to reflect current economic conditions and current rate levels. The expected loss ratio for each accident year is then applied to the actual earned premiums to calculate expected ultimate losses.
In general, we review our reserves quarterly. This review includes either an actuarial analysis involving the application of standard actuarial techniques or the review of the paid and incurred activity in the quarter relative to the assumptions from our previous actuarial analyses. In addition, special studies are undertaken periodically for certain lines of business or exposures. We segregate the activities of estimating losses for product pricing purposes from those of determining reserves to be reported in our financial statements. The Chief Risk Officer has the ultimate responsibility for the independent determination of appropriate reserves.
We purchase reinsurance to limit our exposure to potential large losses. We report the amounts we expect to recover from reinsurers as reinsurance recoverable assets on our Consolidated Balance Sheets. For more discussion on reinsurance, see the Reinsurance section on page 69.
Loss and LAE Reserve Variability - Loss and LAE reserves are subject to variability, particularly the IBNR component. For the lines of business we write, variability in the frequency - the average number of claims filed, or severity - the average cost of a claim - is generally a function of one or more of the following factors:
Payout period - Lines of business involving claims that stay open for long periods are subject to greater reserve variability. This is driven by the difficulty in estimating future economic, social and legal trends that impact both the time that such claims remain open and their future costs.
Policy deductibles - Lines of business involving excess policies with large deductibles, or policies that provide coverage for claims that exceed the policy limit of an underlying policy, are subject to greater variability. The existence of large policy deductibles considerably increases the lag between the occurrence of a claim and the time it is reported to us.
Bodily injury (BI) coverage represents the largest portion (62.7%) of our loss and ALAE reserves held for Auto. Small variations from our assumptions can yield significant financial volatility given the magnitude of these reserve balances.
Our Property and Specialty lines are predominantly short-tailed business, and most claims are reported and settled within 12 months. We use standard actuarial techniques and judgment to estimate reserves for those lines.
Our SBI and P&C Other segments have exposure to asbestos and environmental losses primarily from policies we no longer write. These segments also have exposure to construction defects losses and related expenses through the general liability, commercial multi-peril and umbrella coverages they provide. These exposures and the risks they present are discussed in aggregate for SBI and P&C Other as they are estimated by product and like exposure.
Workers Compensation - The following table shows our loss and ALAE reserves for voluntary and non-voluntary workers compensation and other relevant data. The data shown reflects workers compensation policies written in SBI as well as those workers compensation policies that are in runoff and included in the P&C Other segment. The table excludes ULAE reserves, which were $62.1 at year-end 2005, $41.6 at year-end 2004 and $43.8 at year-end 2003:
Changes in future benefit levels - Legislative actions and judicial interpretations can affect the cost of future benefits.
Claim reporting lags - Some claims are not made immediately; as a result, we remain exposed to workers compensation losses arising from policies written years ago.
These factors give rise to latent claim emergence and evolving coverage precedents for claims regarding such things as asbestos, environmental and construction defects. We discuss each of these claim types in further detail below.
Small asbestos accounts - Our policyholders with cumulative loss payments of less than $100,000 as of December 31, 2005.
Some asbestos-related claims are subject to non-product liability coverage rather than product liability coverage. Non-product liability coverage may not be subject to policy aggregate limits, resulting in higher asbestos claims payments and related expenses.
Our IBNR reserves were 70.2% of our loss and ALAE reserves for environmental claims at December 31, 2005 and 75.6% at December 31, 2004.
In 2003, we reached a settlement on a large number of environmental claims related to coverage on general liability policies written for individual gasoline stations. Under these policies, there was a petrochemical company named as an “additional insured.” We have settled all claims with the additional insured. This $11.0 global settlement and future indemnification agreement is included in our 2003 payment activity. We have no other reported claims of this nature. Other payments in 2003 reflect year-to-year volatility in claim and payment activity. In 2004, our loss payments returned to levels more in line with our historical experience.
Our relatively limited environmental claims activity results in fluctuations in average values from period to period. The 2005 average paid closed environmental claim increased compared with 2004 due in part to a general liability settlement relating to contaminated land on a single private development project. Additionally, average payments were unusually low in 2003 and 2004 due to the above-mentioned settlement reached on a large number of individual environmental claims related to coverage on general liability policies written for individual gasoline stations.
The volatility of actuarial estimates of liabilities for environmental claims is often greater than that of other exposures. This is due to several factors including:
Our exposure to construction defects claims comes from general liability and commercial multi-peril coverages we provide to contractors. Construction defects claims result from alleged defective work performed in the construction of large structures that include apartments, condominiums and large developments of single-family dwellings or other housing.
Our IBNR reserves were 78.8% of our loss and ALAE reserves for construction defects claims at December 31, 2005 and 78.6% at December 31, 2004.
The main factors in estimating loss reserves for construction defects claims are:
The uncertainty created by these factors requires more judgment in estimating loss reserves for construction defects claims than for our other lines of business.
Over the last three years, our number of open construction defects claims has decreased steadily - an average drop of 16.8% per year. Our loss reserve estimates assume that the number of open claims will continue to decrease, but at a slower rate.
Loss and LAE Reserves - Three-Year Review - In this section, we provide the actual reserve estimates for the last three years and discuss changes in those estimates. We report changes in estimated reserves in our Consolidated Statements of Income the same year we make the change. This table shows the changes in our loss and LAE reserves for 2005, 2004 and 2003:
2004 - In 2004, we reduced our estimates for prior years’ loss and LAE reserves by $39.0. This total decrease included:
$20.7 increase in commercial multi-peril and other general liability reserves. This included an $8.6 reduction in World Trade Center loss estimates, a $29.6 increase in asbestos reserves and a $14.3 increase in environmental reserves
Analysis of Losses and LAE Reserve Development - 10-Year Review - The Analysis of Losses and LAE Reserve Development table on page 50 shows the development of our loss and LAE reserves from 1995 through 2005. For 1997 to 2005, the table includes amounts for American States Financial Corporation, which we acquired in 1997.
Section A shows the unpaid loss and LAE reserves we recorded at December 31, 1995-2005. It breaks out these reserves as:
Section C shows the annual reestimation of those reserves, and after 10 years our revised reserves were $1,911.1.
After one year those reserves developed a $77.7 redundancy, and after 10 years the redundancy grew to $159.0. This is the difference between the reserves shown in Section A net of reinsurance, and the reestimated amounts in Section C.
The favorable development from 2004 and 2005 was primarily due to:
On page 12, we provided an overview of how we use reinsurance. Here, we focus on how we estimate reinsurance recoverables.
The reinsurance we buy limits our losses on certain individual risks and reduces our exposure to catastrophic events. We purchase reinsurance from several reinsurers and are not dependent upon any single reinsurer. Reinsurance recoverables are the amounts our reinsurers owe us related to the losses we have incurred. We reported $447.0 at December 31, 2005 and $355.4 at December 31, 2004 in reinsurance recoverables as assets on our Consolidated Balance Sheets. The increase in our reinsurance recoverables in 2005 is a result of estimated reinsurance recoveries related to workers compensation and Hurricane Katrina losses.
Our investments include fixed maturities and marketable equity securities, which we report at fair value as Available-for-Sale Securities on our Consolidated Balance Sheets.
accumulated other comprehensive income on our Consolidated Balance Sheets and are not reflected in the operating results of any period until we sell the security or when declines in fair value are determined to be other-than-temporary. If the fair value of any of our investments falls below our cost or amortized cost basis in the investment, we analyze the decrease to determine whether it is an other-than-temporary decline in value. To make this determination for each security, we consider:
The current financial condition and future prospects of the issuer of the security, including any specific events that may affect its operations or earnings potential
Total revenues increased 2.5% in 2005 compared with 2004, and increased 13.7% in 2004 compared with 2003. The increases were driven by:
Net realized investment gains - Net realized investment gains decreased $140.4 in 2005 compared with 2004 and increased $130.7 in 2004 compared with 2003. These changes were due primarily to higher gains realized in 2004 related to the reduction of our equity holdings to our target level of approximately 10% of our investment portfolio. Net realized investment gains included pretax impairments of $15.5 in 2005, $9.0 in 2004 and $47.8 in 2003.
Underwriting profit - Our underwriting profit increased by $46.9 in 2005 compared with 2004 due to improved results in SBI Regular. Our underwriting profit increased by $478.2 in 2004 compared with the underwriting loss in 2003, primarily due to improved results in Auto, Property and SBI Regular. Pretax net of reinsurance catastrophe losses were $267.4 in 2005, compared with
$275.6 in 2004 and $153.7 in 2003. We had favorable prior-year reserve development of $44.0 in 2005 and $39.0 in 2004. This was driven primarily by favorable reserve development in our personal property, personal auto and commercial auto reserves. In 2003, we had unfavorable prior-year reserve development, primarily in workers compensation reserves, of $249.9.
Other underwriting and operating expenses - Our expense reduction efforts that began in 2003 reduced our 2004 operating expenses by approximately $75, primarily by eliminating approximately 500 positions in our corporate departments. At the same time, our expenses reflected our business growth.
Provision for income taxes - Our effective tax rate was 29.9% in 2005, 30.5% in 2004 and 24.9% in 2003. The increase in the effective tax rate in 2004 compared with 2003 was due to the change to an underwriting profit of $472.3 from an underwriting loss of $5.9. When the profit or loss approaches zero, our permanent differences - differences resulting from income that is not included in taxable income and will never be taxable, such as tax-exempt interest income - have a more significant impact on the effective tax rate.
First, premiums are the primary driver of our revenues, along with net investment income and net realized investment gains.
Net written premiums are a non-GAAP measure representing the amount of premium charged for policies issued with effective dates during the period. Premiums are reflected as revenue in the Consolidated Statements of Income as they are earned over the underlying policy period. Net written premiums
applicable to the unexpired term of a policy are recorded as unearned premiums on our Consolidated Balance Sheets.
Our Auto segment provides coverage for liability of our policyholders to others for both bodily injury and property damage, for injuries sustained by our policyholders, and for physical damage to our customers’ vehicles from collision and other hazards.
Segmented Auto Insurance Product - Our segmented auto insurance product offers up to 15 underwriting tiers. These underwriting tiers are further refined using multivariate models to assess the risk of loss based on many factors, and provide a more accurate price for a wider range of risks. During 2005, we launched an updated underwriting and pricing model for our Auto product. The primary change involves using our own vehicle groupings (known as rating symbols) based on our experience and data rather than industry vehicle rating symbols, allowing us to vary some of our deductibles. This updated model, now in place in 31 of the 44 states where we write auto business, further increases our sophistication and accuracy in our underwriting and pricing, giving us greater precision in matching rate for each risk.
Underwriting and Pricing Discipline - In 2005, we experienced a more competitive marketplace as many insurers achieved strong underwriting results. Competitors increased marketing and advertising for new auto insurance customers. We also have seen rate decreases by competitors in some states and loosening of underwriting standards. We continue to adhere to our disciplined underwriting standards and pricing in this environment.
Ease-of-Doing Business - Our commitment to ease-of-doing business continued through further development of our Safeco Now automated underwriting platform, which lowers our agents’ costs and provides an easy-to-use, Web-based sales-and-service platform. Our auto product is available on Safeco Now in all of the states where we write auto business. In 2004 and 2005, we enhanced our Safeco Now platform to streamline the service process for distributors and auto customers so that our agents and brokers can efficiently handle most auto policy changes and endorsements online.
Growth of PIF - PIF increased 0.6% in 2005, 8.9% in 2004 and 9.0% in 2003. This reflected stable retention of policies of 79.5% in 2005, 80.4% in 2004 and 79.9% in 2003. Competitive pressures dampened new business growth in 2005. New policies sold decreased 19.8% in 2005 compared with 2004, and increased 8.8% in 2004 compared with 2003. The 2004 growth was primarily driven by the introduction of our Safeco Now Web-based sales-and-service platform early in 2004.
Changes in average premiums - We file rate changes on a state-by-state basis. Overall, we received approval for average rate decreases of 0.4% in 2005 and increases of 1.3% in 2004 and 5.6% in 2003. Rate changes are reflected on existing policies at renewal and are earned in our revenues over the six-month policy term. Premiums also are affected by the increased pricing for those policies that insure newer and more expensive cars, which we refer to as premium trend. They also are impacted by shifts in the mix of our business.
Growth of PIF - PIF growth increased net earned premiums by $118.7 in 2005 compared with 2004, and $201.0 in 2004 compared with 2003.
Changes in average premiums - Changes in average premiums increased net earned premiums by $87.8 in 2005 compared with 2004, and $188.7 in 2004 compared with 2003.
Changes in average premiums - Our earned rate changes, combined with premium trend, decreased our Auto combined ratio by 3.0 points in 2005 compared with 2004, and 7.9 points in 2004 compared with 2003.
Loss costs - In 2005, we experienced a mid-single-digit increase in severity - the average cost of a claim. This was in part due to the impact of medical costs inflation on bodily injury claims and a slight shift in business mix to states with higher bodily injury severity claims over the past 18 months. This also was partly due to the effect of our increased average deductible, which has eliminated some low-severity losses that are not reported because they are less than the now higher deductible amounts. The impact of the increase in severity was partially offset by the effect of a low-single-digit decrease in frequency - the average number of claims filed. These factors, net of reinsurance, increased our combined ratio by 3.5 points in 2005 compared with 2004. In 2004, the impact of loss-cost changes increased our combined ratio by 4.3 points compared with 2003.
Expenses - The increase in our expense ratio of 0.7 points in 2005 compared with 2004 was driven by increased investment in technology and bad debt expense related primarily to non-standard policies, partially offset by decreased agent commissions resulting from slower growth and earned premium increases due to average premium changes. In 2004, the decrease in our expense ratio by 1.0 points compared with 2003 was the result of our expense improvement efforts, primarily as a result of the corporate restructuring initiatives. This was partly offset by higher bonus commission and employee performance bonus expenses due to our growth and improved underwriting results.
Competitive Environment - We believe competition in the auto segment will continue through mass market advertising, higher agency compensation and lower prices. We will maintain our underwriting discipline and will not compete for business for which we cannot obtain our long-term target margins. While maintaining our discipline, we will be relentless in seeking ways to profitably grow our business during this competitive cycle. We carefully monitor our rates and offer our distributors choices in the area of compensation so they can match compensation to their business model. We also are committed to managing our expenses, as we recognize that our competitors are doing the same.
Business Growth - As our business grows, we may write more policies with standard and non-standard risks, which have, on average, higher frequencies than preferred risks. However, preferred auto business will still remain our largest book of business and continue to be our greatest area of opportunity. We will continue to grow into eastern states where we currently have less geographic presence. We also will focus on the changing nature of the independent distribution channel through new agency appointments and customized business approaches. Finally, we will continue to study the purchasing behaviors of insurance consumers to be certain we are meeting their needs.
Ease-of-Doing Business - Our commitment to ease-of-doing business for our agents continues through our Safeco Now automated underwriting platform, which lowers our agents’ costs and provides an easy-to-use, Web-based sales-and-service platform. Our homeowners and dwelling fire products are available on Safeco Now in 43 of the 44 states where we write property business. As expected, this has contributed to an increase in new business.
Continued Catastrophe Management - We continue to actively manage our exposure to catastrophe risk through a combination of risk avoidance, risk mitigation and risk transfer strategies. Because of our catastrophe management strategies, our losses from the major hurricanes in 2005 and 2004 were less than our market share would indicate. In addition, our catastrophe losses due to tornadoes and hailstorms have dropped significantly over the past three years.
Decline in PIF - The number of policies that did not renew with us in 2005, 2004 and 2003 exceeded the number of new policies written in each year, resulting in a decrease in PIF of 0.5% in 2005 compared with 2004, and 6.7% in 2004 compared with 2003. During 2004 and 2005, we launched our homeowners and dwelling fire products on our Safeco Now platform. This contributed to an increase in new Property policies written of 40.9% in 2005 compared with 2004. Our new business increased in 40 states in 2005, offset by a decline in new business in catastrophe-prone states. Our homeowners retention rates increased in 2005 to 85.2% compared with 83.7% in 2004 and 83.1% in 2003.
Changes in average premiums - Our homeowners rate changes combined with premium trend decreased our Property combined ratio by 2.1 points in 2005 compared with 2004, and 6.4 points in 2004 compared with 2003.
Prior-year reserve development - Our underwriting results in 2005 included favorable prior-year reserve development of $11.0, including unfavorable prior-year reserve development of $10.5 in our estimates of the 2004 hurricanes in Florida and surrounding states. The favorable development reflected better-than-expected experience in our estimates of loss costs, primarily for accident years 2003 and 2004. Our underwriting results in 2004 included favorable prior-year reserve development of $47.5, primarily driven by changes in contract terms resulting in decreased frequency of claims beyond that previously expected. Results in 2003 included unfavorable prior-year reserve development of $16.0. The change in favorable reserve development in 2005 increased the combined ratio by 4.0 points compared with 2004. The change in reserve development in 2004 decreased the combined ratio by 6.9 points compared with 2003.
Catastrophe losses - We categorize catastrophes as events resulting in losses greater than $0.5 per event and involving multiple claims and policyholders. We cannot accurately predict when catastrophes may occur, and the number and type of catastrophes can vary widely. The losses they cause may significantly exceed our prior experience. Catastrophes can be caused by natural events, such as hurricanes, tornadoes, wildfires, earthquakes and hailstorms or other factors such as terrorism, riots, hazardous material releases or utility outages. Pretax after reinsurance catastrophe losses were $103.9 in 2005 (including the increase in reserves for the 2004 hurricanes described above) compared with $107.2 in 2004 and $101.9 in 2003. Catastrophe losses in 2005 (excluding the reserve increase for the 2004 hurricanes) decreased the combined ratio by 1.5 points in 2005 compared with 2004. The increase in 2004 catastrophe losses increased the combined ratio by 0.6 points in 2004 compared with 2003. Catastrophe losses in 2005 included $53.7 from hurricanes Katrina, Rita and Wilma in the Gulf States. Catastrophe losses in 2004 included $66.3 from the four hurricanes in Florida and surrounding states. Catastrophe losses in 2003 included $11.8 from the wildfires in California.
Expenses - Higher agent bonus commission expenses, driven by increased dwelling fire new business and better-than-anticipated underwriting results, increased our expense ratio by 0.2 points in 2005 compared with 2004. Our expense improvement efforts, primarily from corporate restructuring initiatives, decreased our expense ratio by 0.7 points in 2004 compared with 2003.
Underwriting Segmentation - We have replaced our existing dwelling fire product with our new tiered product in 14 states and plan to complete the rollout of the new program by year-end 2006.
Catastrophe Risk Management - Our underwriting strategy for property insurance is to target customers whose risk of loss provides us with the opportunity for profitable growth. We do this by managing exposure on policies in catastrophe-prone areas. In July 2005, we announced our withdrawal from the personal property business in Florida. We will stop renewing policies of existing personal property policyholders beginning in early 2006 as policies come up for renewal. In 2005, net earned premiums for personal property policies in Florida were $24.1.
Overall - We expect our Property segment revenue to grow modestly while operating at or better than our long-term target combined ratio of 92% in 2006. We do not, however, expect to experience favorable frequency trends. This will cause our margins to move closer to our target.
Our Specialty operation provides individuals with umbrella, recreational vehicle, motorcycle and boat owners insurance.
Net written premiums increased $7.9, or 8.5%, in 2005 compared with 2004, and $7.7, or 9.0%, in 2004 compared with 2003. New-business policies sold decreased 2.7% in 2005 compared with 2004, and increased 24.7% in 2004 compared with 2003. The increased premiums in 2005 were driven by an increase in the number of policies that renewed with us, resulting in an increase in PIF, primarily in our umbrella, recreational vehicle and motorcycle policies. The growth in 2004 was driven by an increase in the sale of new boat owner, recreational vehicle and motorcycle policies.
Catastrophe losses - Pretax after reinsurance catastrophe losses were $9.3 in 2005 and $7.6 in 2004. The catastrophe losses were primarily due to hurricanes Katrina, Rita and Wilma in the Gulf States in 2005 and the four hurricanes in Florida and surrounding states in 2004. There were no catastrophe losses in 2003. Higher catastrophe losses increased the combined ratio by 0.9 points in 2005 compared with 2004, and 8.5 points in 2004 compared with 2003.
Loss costs - We experienced increased losses in our umbrella business in 2005 and 2004 as a result of an increased number of claims reported. Higher umbrella losses increased our combined ratio by 6.3 points in 2005 compared with 2004, and 8.1 points in 2004 compared with 2003. In 2003, our claim experience for our umbrella business was unusually low, resulting in a lower combined ratio and higher underwriting profit. Umbrella loss costs can be volatile from period to period.
We anticipate improved underwriting results in 2006, while achieving our long-term targets for each specialty line. In 2005, we began to launch our motorcycle product on Safeco Now. In 2006, we will launch our umbrella product on Safeco Now, enabling cross-sell opportunities with Auto.
Ease-of-Doing Business - Safeco Now contributed to increased new business as it allows our agents to quote and issue new small-commercial business online in just minutes. We have experienced growth in BOP, commercial auto and workers compensation, all of which have been on Safeco Now for more than a year. PIF for our automated products available on Safeco Now (BOP, commercial auto and workers compensation) increased 4.1% in 2005 compared with 2004, while PIF for our non-automated products decreased 5.1% in 2005 compared with 2004.
Field Specialization Model - We have two separate underwriting units - one for our core small-business accounts (customers who pay annual premiums up to approximately $25,000) and one for our mid-market business (customers who pay annual premiums of approximately $25,000 to $200,000). This “field specialization model” has increased efficiency and underwriting accuracy and reduced underwriting expenses with the automation of many of our underwriting processes and the use of multivariate models. Implemented in 2004, this model has increased productivity while reducing underwriting staff expenses.
Catastrophe Risk Management - Our underwriting strategy is to target customers whose risk of loss provides us with the opportunity for profitable growth. We do this by managing exposure on policies in catastrophe-prone areas. Historically, for writing business in catastrophe-prone areas we have followed strict guidelines that include variables, such as building age and condition, coastal proximity and standards for policy deductibles. In the aftermath of the unprecedented hurricane season in 2004, we reviewed the performance of our underwriting standards. With the exception of some tightening in key areas, our guidelines have remained consistent. We continually monitor these guidelines.
Changes in PIF - PIF decreased 0.6% in 2005 compared with 2004, and increased 0.2% in 2004 compared with 2003. This reflected retention rates of 80.0% in 2005, 79.9% in 2004 and 75.9% in 2003. Our new policies sold decreased 7.3% in 2005 compared with 2004, and 1.2% in 2004 compared with 2003.
Mix of business - In addition to price changes, premiums are impacted by changes in average policy size.
Catastrophe losses - Our pretax after reinsurance catastrophe losses were $59.1 in 2005, $113.9 in 2004 and $19.0 in 2003. The lower catastrophe losses decreased our combined ratio by 4.4 points in 2005 compared with 2004, while higher catastrophe losses increased our combined ratio by 8.6 points in 2004 compared with 2003.
We anticipate the following factors will impact our growth and profitability in the near future:
Service Capabilities - In 2006, we will provide our agents and brokers with self-service capabilities for as much as 60% of their business, up from 25% today. Agents will be able to initiate policy change requests electronically on Safeco Now, with real-time quoting and processing for a majority of these transactions. The billing and payment processes will be accessible through a Web-based tool, where both agents and customers will have quick access to billing information and a variety of electronic bill payment options. Agents will also be able to turn off receipt of paper output and access policies and forms electronically and have the ability to route policies and other policy related output from us directly to customers.
Business Growth - Given the increasing number of small businesses in the United States and the lack of a dominant market leader, we see growth potential in this segment. Our goal is to be the leading small-business insurance writer in the independent agency channel. We will continue to appropriately match rate with risk through segmentation and disciplined underwriting. We will charge prices that will allow us to achieve our target profit margins, and we will decline to write business when pricing or risk factors do not allow us to earn our target returns. We also will focus on increasing our points of distribution with the appointment of new agents in 2006.
Net written premiums decreased $23.7, or 5.3%, in 2005 compared with 2004, and increased $41.6, or 10.3%, in 2004 compared with 2003. The decrease in 2005 compared with 2004 was primarily due to the non-renewal of a large account in our lender-placed property program and reduction in written premiums in our non-profit social services programs due to an increasingly competitive market. The increase in 2004 compared with 2003 was primarily due to rate increases.
Net earned premiums decreased $11.4, or 2.6%, in 2005 compared with 2004, and increased $59.5, or 15.5%, in 2004 compared with 2003.
We plan to continue providing a limited large-commercial resource for those agents and brokers who also are writing auto, property or small- to mid-sized commercial insurance with us, and to continue writing specialty insurance programs to the extent this continuation fits our strategic objectives.
Continued Disciplined Underwriting - We have benefited from disarray in the surety market because we are a stable, long-term provider of surety bonds. Some competitors in the industry have experienced significant underwriting losses in recent years. We intend to maintain our disciplined underwriting approach as a priority while we grow this business.
Compensation - We will revise the commission structure of our large brokers in 2006, which will cause our expense ratio to increase slightly.
Overall - We expect the surety market to become more competitive as industry results have stabilized in 2005. As a result, we anticipate our growth rates will moderate in 2006. We do not expect significant changes in our underwriting results.
The first $150.0 of any property catastrophe loss is entirely ours. This is our retention - the amount of losses we absorb before the reinsurers reimburse us.
Our reinsurers reimburse us 90% for the next $350.0 of the loss. We absorb the other 10%.
For earthquake events, we have an additional level of coverage. Our reinsurers reimburse us for 90% of $500.0 in excess of $500.0. The entire amount of any earthquake loss above $1,000.0 is ours.
Our reinsurers would reimburse us 90% for the next $400.0 of the loss. We would absorb the other 10%.
The terms of our workers compensation reinsurance in 2005 and 2006 are:
Commercial Property Reinsurance - Our commercial property reinsurance reduces the financial impact that any single loss can have on us. It is excess-of-loss reinsurance.
Our reinsurers reimburse us 90% of the next $80.0 of the loss under each of the three layers of coverage.
U.S. Government Funding - Under TRIA, the U.S. Government will provide funding to the insurance industry if a terrorist attack is certified as such by the Secretary of the Treasury in concurrence with the Secretary of State and Attorney General of the United States. The criteria for certification include: the act is
dangerous to human life, property or infrastructure; and is committed by an individual or individuals on behalf of any foreign person or foreign interest. The extension adds a program trigger. Under this new provision, insurers will not be compensated unless the aggregate industry insured losses from a certified act of terrorism, occurring after March 31, 2006, exceed $50.0 in 2006 and $100.0 in 2007. Subject to the program trigger, the U.S. Government’s share is 90% of the certified losses in excess of individual insurance company deductibles in Program Year 4 (2006) and decreases to 85% in year 5 (2007). TRIA determines the deductibles for insurance companies as a percentage of their direct earned premiums. Our estimated deductible for 2006 is $209.4.
Our Exposure is Modest - We believe our exposure to potential terrorism losses is relatively modest across all our product lines.
Similarly, with workers compensation policies, the number of employees covered is a key consideration. We decline to provide coverage in cases where we believe the exposure is potentially severe to terrorism.
With our personal lines of insurance, we believe that losses due to terrorism would be relatively modest. We believe that exposure and risk to individuals are small.
The lower loss in our Corporate segment results in 2005 compared with 2004, and in 2004 compared with 2003 reflects lower interest expense as a result of the debt repurchases described above. Our interest expense was:
Investment returns are an important part of our overall profitability. Investment returns are subject to various risks, such as interest rate, market and credit risks. Fluctuations in the fixed-income or equity markets could affect the timing and the amount of our net investment income. Defaults by third parties in the payment or performance of their obligations - primarily on our investments in corporate bonds - could reduce our net investment income or create net realized investment losses.
The increase in net investment income in 2005 compared with 2004 was due to an increase in average invested assets, as a result of positive operating cash flows partially offset by lower yields on new investments, compared with yields on matured or called investments. Similarly, in 2004, rates on reinvestment on securities matured or called were lower than these investments had been earning, which resulted in lower yields compared with 2003.
Pretax net realized investment gains and losses by component for the last three years were:
Net gains on marketable equity securities transactions decreased $81.9 in 2005 compared with 2004, and increased $120.7 in 2004 compared with 2003. The gains in 2004 included $76.3 from sales of marketable equity securities to reduce our holdings in marketable equity securities to our target of about 10% of the total investment portfolio.
We closely monitor every investment that has declined in fair value to below our amortized cost. If we determine that the decline is other-than-temporary, we write down the security to its fair value and report the charge as an impairment in Net Realized Investment Gains in the Consolidated Statements of Income in the period that we make this determination. More information about our process of estimating investment impairments can be found in the discussion of Critical Accounting Estimates on page 31.
In our impairment determination process, we consider our intent and ability to hold to maturity investments with declines in value. However, our intent to hold the investment could change due to changes in the financial condition and near-term prospects of the issuer.
In 2005, the fair value of fixed maturities that we sold at a loss was $809.4. Our total net realized investment loss on these sales was $13.0. In 2004, the fair value of fixed maturities that we sold at a loss was $202.0. Our total net realized investment loss on these sales was $12.7.
In 2005, the fair value of marketable equity securities that we sold at a loss was $42.9. Our total net realized investment loss on these sales was $7.3. In 2004, the fair value of marketable equity securities that we sold at a loss was $166.5. Our total net realized investment loss on these sales was $12.1.
These tables summarize our investment portfolio at December 31, 2005 and 2004:
Investments in the banking industry accounted for 12.4% of our total gross unrealized losses at December 31, 2005 and 14.7% of our total gross unrealized losses at December 31, 2004. Investments in secured finance mortgage-backed securities accounted for 11.4% of our total gross unrealized losses at December 31, 2005 and 3.8% of our total gross unrealized losses at December 31, 2004.
This table shows by maturity, the total amount of gross unrealized losses on fixed maturities and marketable equity securities at December 31, 2005:
Unrealized losses on our fixed maturities that have been in a loss position for more than a year at December 31, 2005 were $44.5, compared with $2.6 at December 31, 2004 reflecting changes in interest rates. Unrealized losses on our marketable equity securities that were in a loss position for more than a year at December 31, 2005 were $1.2. There were no unrealized losses on our marketable equity securities that were in a loss position for more than a year at December 31, 2004. These unrealized losses were less than 1% of our total portfolio value at both December 31, 2005 and 2004.
We continue to monitor these securities as part of our overall portfolio evaluation. If we determine an unrealized loss to be other-than-temporary, we report an impairment loss. We report impairment losses in the same period that we make the determination.
Our investment portfolio is well diversified by issuer and industry type with no single issuer, except U.S. Government fixed maturities, exceeding 1% of the fair value of our consolidated investment portfolio.
These tables show our investment types and industries of our fixed maturities and marketable equity securities that exceed 3% of our portfolio at year-end 2005 and 2004:
As of December 31, 2005, these securities represented 1.1% of our total fixed maturities at fair value. As of December 31, 2004, these securities represented 1.8% of our total fixed maturities at fair value. The related amortized cost of the below investment grade fixed maturities was $99.5 at year-end 2005 and $155.4 at year-end 2004.
As of December 31, 2005, our below investment grade securities included gross unrealized investment gains of $4.5 and gross unrealized losses of $0.9. As of December 31, 2004, our below investment grade securities had both a gross and net unrealized investment gain of $10.8.
This table summarizes our holdings of mortgage-backed securities at year-end 2005:
Liquidity is a measure of our ability to generate sufficient cash flows to meet the short- and long-term cash requirements of our insurance operations.
Our cash flow from continuing operations for the past three years was:
The increase in cash provided by operating activities from continuing operations was primarily due to cash received from insurance premiums of $5.82 billion in 2005, $5.58 billion in 2004, and $5.08 billion in 2003, and lower insurance claims paid of $3.55 billion in 2005, $3.37 billion in 2004 and $3.37 billion in 2003, reflecting our improved underwriting results. Dividends and interest received on our investment portfolio of $532.8 in 2005, $512.5 in 2004 and $464.5 in 2003, also contributed to the increase in operating cash flows.
The increase in cash provided by investing activities from continuing operations in 2004 compared with cash used in financing activities in 2003 was due to proceeds received from the sale of our discontinued L&I operations.
Our cash flows from discontinued operations prior to the completion of the sale of L&I on August 2, 2004 and for the full year 2003 were:
We use funds to support our operations, make interest and principal payments on debt, pay dividends to our shareholders and grow our investment portfolio.
In 2005, we used $269.0 to repurchase stock and debt as described on page 82. On August 2, 2004, we completed the sale of our L&I operations, resulting in $1,499.0 of total sales proceeds. We used $1,360.2 of these proceeds to repurchase stock and debt as described on page 82.
Stock Repurchases - In 2005, we repurchased 4,508,578 shares or 3.6% of our outstanding common stock, at a total cost of $239.2 under the stock buyback programs described below.
We repurchased 2,752,300 shares, or 2.2% of our outstanding common stock, through an accelerated share repurchase program. We purchased the shares from a dealer at a price of $54.50 per share, for a total cost of $150.3, including transaction costs. Through the repurchase program we returned excess capital to shareholders and immediately reduced the number of our common shares outstanding. The dealer obtained the shares that we repurchased by borrowing them in the open market, and then purchased shares in the market over time to repay the borrowed shares. We completed the repurchase program in November 2005, receiving a price adjustment of $4.4 based on the average price of shares purchased. We reported the price adjustment as an increase to Shareholders’ Equity on our Consolidated Balance Sheet as of December 31, 2005.
program in April 2005, paying a price adjustment of $16.1 to the dealer based on the volume weighted average price of our common stock during the period of the repurchases. We reported this price adjustment as a reduction to Shareholders’ Equity on our Consolidated Balance Sheet as of December 31, 2005.
$200.0 of senior notes at an interest rate of 4.200% that mature in 2008
$300.0 of senior notes at an interest rate of 4.875% that mature in 2010
$200.0 to pay off notes that had a 7.875% interest rate and were due in 2005, but had a call date at par of April 1, 2003
Our Bank Credit Facility - On March 31, 2005, we executed a $300.0 five-year revolving credit facility, which may be used for working capital and general corporate purposes. This facility replaced our $300.0 three-year facility, which expired in September 2005. The terms of the bank credit facility - which runs through March 2010 - require us to:
The bank credit facility does not require us to maintain any deposits as compensating balances. At the end of 2005 and throughout 2005, we had no borrowings under the bank credit facility and we were in compliance with all its covenants.
We believe our financial position is sound. As we have continued to execute plans to improve P&C operating results, our financial position has strengthened. Our debt service coverage has improved over the last two years, and we expect to continue at our current level in 2006.
A number of state legislatures and insurance regulatory agencies have enacted laws and regulations that limit the use of credit information in the underwriting process. Additional states are considering doing so. Our P&C businesses use insurance scoring, which is partially based on credit information in making risk selection and pricing decisions. Limitations or prohibitions on the use of credit information could negatively affect our P&C business plans.
Dividend Payments From Our Subsidiaries - Our insurance subsidiaries pay dividends to Safeco Corporation. We then use that money to pay dividends to our shareholders as well as to make principal and interest payments on our debt. Individual states limit the amount of dividends that our subsidiaries domiciled in those states can pay Safeco Corporation. Exceeding such limits would require prior regulatory approval. In the aggregate in 2006, our insurance subsidiaries can pay up to $769.2 in dividends without obtaining prior regulatory approval. These amounts are according to the limits states had in place at the end of 2005.
The Consolidated Financial Statements and schedules listed in the Index to Financial Statements, Schedules and Exhibits on page 92 are filed as part of this report.