In 2009, we sold our Selective HR Solutions operations. See Note 12. “Discontinued Operations” in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K for additional information.
Operating income and operating return on average equity are non-GAAP measures. See the Glossary of Terms attached to this Form 10-K as Exhibit 99.1 for definitions of these items and see the “Financial Highlights” section in
Financial Highlights of Results for Years Ended December 31, 2010, 2009, and 2008;
We have identified the policies and estimates described below as critical to our business operations and the understanding of the results of our operations. Our preparation of the consolidated financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurance that actual results will not differ from those estimates. Those estimates that were most critical to the preparation of the consolidated financial statements involved the following: (i) reserve for losses and loss expenses; (ii) deferred policy acquisition costs; (iii) premium audit; (iv) pension and post-retirement benefit plan actuarial assumptions; (v) OTTI; and (vi) reinsurance.
At December 31, 2010, our general liability line of business had recorded reserves, net of reinsurance of $957 million, which represented 38% of our total net reserves. The broad nature of this coverage, and the longer tailed nature of the claims settlement process, makes this line more susceptible to changes in litigation and the tort environment. This line of business also includes excess policies that provide additional limits above underlying automobile and general liability coverages, which is subject to catastrophic losses, and therefore influenced by the factors noted above to a greater degree. While prior year development in recent years has been relatively minor, we have been growing the number of our commercial excess policies at a greater rate than the rest of our Commercial Lines of business, which could create additional volatility in our results. In 2010 and 2009, we have lowered the net retention of our reinsurance covering these policies, which should mitigate some of the potential volatility.
At December 31, 2010, our workers compensation line of business recorded reserves, net of reinsurance, of $865 million, or 34% of our total net reserves. In addition to the uncertainties associated with actuarial assumptions and methodologies described above, the workers compensation line of business can be impacted by a variety of issues such as unexpected changes in medical cost inflation, higher than anticipated claim severity, changes in overall economic conditions, and company specific initiatives. From 2005 through 2010, we experienced an unusual amount of volatility associated with our workers compensation medical costs. In addition, uncertainty regarding future medical inflation creates the potential for additional volatility in our reserves. In 2009, overall economic conditions were extremely unstable.
High levels of unemployment could impact both the severity and frequency of our workers compensation claims. There is also potential for an increase in severity if the longevity of workers compensation claims increase. Injured workers could have less incentive to return to work when their company is in financial distress or injured workers could be laid off while on workers compensation. Conversely, there is potential for a decrease in frequency if workers are reluctant to file claims or have less work and less exposure to injury. Additionally, the economy could impact the frequency and severity of claims in ways unanticipated by management. In 2010 and 2009, we have experienced an unusually high amount of audit activity, resulting in return premium of $17.2 million and $18.2 million, respectively, a trend which may continue into the future. Since premiums earned are used as a basis for setting initial reserves on the current accident year, our reserves could be impacted in ways not yet anticipated. The result could be favorable development if the reduction in payroll is truly a reduction in exposure. The result could be adverse development if the reduction in payroll indicates that remaining workers are now overworked and more prone to accidents. Finally, in the past few years, the company implemented a multi-faceted workers compensation strategy which incorporated knowledge management and predictive modeling initiatives. The ongoing impact of these initiatives is a potential source of uncertainty in the future. If the ongoing impact of these strategies exceeds our expectations, the result could be favorable development in the future. If our internal strategies are less effective than anticipated, and we experience higher than expected claim severity, the result could be adverse development in the future.
We established a range of reasonably possible reserves for net claims of approximately $2,356 million to $2,665 million at December 31, 2010 and $2,312 million to $2,608 million at December 31, 2009. A low and high reasonable reserve selection was derived primarily by considering the range of indications calculated using generally accepted actuarial techniques. Such techniques assume that past experience, adjusted for the effects of current developments and anticipated trends, are an appropriate basis for predicting future events. Although this range reflects likely scenarios, it is possible that the final outcomes may fall above or below these amounts. Based on internal stochastic modeling, we believe that a reasonable estimate of the likelihood that the final outcome falls within the current range is approximately 73%. This range does not include a provision for potential increases or decreases associated with environmental reserves. Our best estimate is consistent with the actuarial central estimate. We do not discount to present value that portion of our loss reserves expected to be paid in future periods; however, the loss reserves take into account anticipated recoveries for salvage and subrogation claims.
In addition to the normal amount of volatility, general liability loss development factors have greater uncertainty due to the complexity of the coverages and the possibly significant periods of time that can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer, and the insurer’s payment of that loss. In our judgment, it is possible that general liability loss development factors could be +/- 5% from those actually selected in our latest reserve analysis. If the loss development assumptions were changed by +/- 5%, that would increase/decrease our indicated general liability reserves by approximately $88 million for accident years 2009 and prior.
In addition to the normal amount of volatility, the combination of the sensitivity of workers compensation results to medical inflation, economic conditions including unemployment, and changes in underwriting could lead to actual experience emerging differently than the assumptions used in the process to establish reserves. In our judgment, it is possible that actual medical loss development factors could range from 6% below to 9% above those selected in our latest reserve analysis and expected loss ratios could range from 5% below to 8% above those selected in our latest reserve analysis. The combination of reducing the assumptions for medical loss development by 6% and the expected loss ratio by 5% could decrease our indicated workers compensation reserves by approximately $69 million for accident years 2009 and prior. Alternatively, the combination of increasing the medical loss development factors by 9% and the expected loss ratio by 8% could increase our indicated workers compensation reserves by approximately $110 million for accident years 2009 and prior.
Claims Initiatives Impact on Workers Compensation, General Liability, and Commercial Automobile
As discussed in the major trend section above, the claims initiatives and inflationary uncertainty could impact reserves for the workers compensation, general liability, and commercial automobile lines of business. In our judgment, it is possible that the selected reserves for these lines of business in our latest reserve review could increase by $147 million or decrease by $70 million due to the combination of case reserve volatility in accident years 2008 through 2010 and unexpected inflation or deflation. These potential impacts would likely manifest themselves as changes in development patterns and expected loss ratios as described within the discussions of the separate lines of business. Therefore, these impacts may be embedded within the line of business figures, in whole or in part.
In addition to a normal amount of volatility, the uncertainty of personal automobile loss development factors is greater than usual due to the change in our state mix for business written in states other than New Jersey. In our judgment, it is possible that personal auto bodily injury loss development factors could be +/- 4% different from those selected in our reserve review. This would increase/decrease our indicated personal auto reserves by approximately $34 million for accident years 2009 and prior.
In light of the many uncertainties associated with establishing the estimates and making the assumptions necessary to establish reserve levels, we review our reserve estimates on a regular basis as described above and make adjustments in the period that the need for such adjustment is determined. These reviews could result in the identification of information and trends that would require us to increase some reserves and/or decrease other reserves for prior periods and could also lead to additional increases in loss and loss adjustment expense reserves, which could have a material adverse effect on our results of operations, equity, business, insurer financial strength, and debt ratings. In 2010, we experienced overall favorable loss development of approximately $44 million. This was driven by favorable emergence in accident years 2007 and prior of approximately $69 million, partially offset by unfavorable emergence in accident years 2008 and 2009 of approximately $24 million. In 2009, we experienced favorable loss development of approximately $67 million in accident years 2004 through 2007 partially offset by unfavorable loss development in the 2008 accident year, as well as accident years prior to 2003, of approximately $38 million, netting to favorable prior year development of $29 million. In 2008, we experienced favorable loss development in accident years 2006 and prior of approximately $46 million partially offset by unfavorable loss development in accident year 2007 of approximately $27 million, netting to total favorable prior year development of approximately $19 million. For further discussion on the prior year development in loss and loss expense reserves, see the discussion on “Net Loss and Loss Expense Reserves” in Item 1. “Business” and Item 8. “Financial Statements and Supplementary Data,” Note 9 of this Form 10-K.
Included in our loss and loss expense reserves are amounts for environmental claims, both asbestos and non-asbestos. Carried net loss and loss expense reserves for environmental claims were $39.4 million as of December 31, 2010 and $41.6 million as of December 31, 2009. Our asbestos and non-asbestos environmental claims have arisen primarily from insured exposures in municipal government, small commercial risks, and homeowners policies. The emergence of these claims is slow and highly unpredictable. In past years, we also experienced adverse development in our homeowners line of business as a result of unfavorable trends in claims for groundwater contamination caused by leakage of certain underground heating oil storage tanks in New Jersey. In addition, certain landfill sites are included on the National Priorities List (“NPL”) by the United States Environmental Protection Agency (“USEPA”). Once on the NPL, the USEPA determines an appropriate remediation plan for these sites. A landfill can remain on the NPL for many years until final approval for the removal of the site is granted from the USEPA. The USEPA also has the authority to re-open previously closed sites and return them to the NPL. We currently have reserves for several claims related to sites on the NPL, one of which has been reopened in 2009 relative to a natural resources claim.
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.
Annually we perform a focused review on all of our asbestos claims with our defense counsel, confirming our participation in the claims and the number of claims that were open. During the 2009 review, coupled with a focused effort on resolving certain claims, a significant number of claim files were closed as compared to 2010 and 2008.
We service our agency distribution channel through our field model, which includes AMSs, safety management specialists, CMSs, and our Underwriting and Claims Service Centers, all of which service the entire population of insurance contracts acquired through each agency.
We estimate the amount of premium that is anticipated to be either billed or returned on policies subsequent to expiration based on exposure levels (i.e., payroll or sales). This estimate of premiums that are earned but unbilled is based on historical trends adjusted for the uncertainty of future economic conditions. During 2010, 2009, and 2008 we had return audit premium of $39.7 million, $39.0 million, and $9.3 million, respectively. However, unemployment has stabilized over the past year, and as a result, we expect exposure levels at policy inception to be more predictable. We believe this is supported by the trend of the last two quarters, within which we have seen significant decreases in audit return amounts. Considering these factors, we estimate our return audit premium on 2010 policies to be approximately $22 million. However, further economic instability could ultimately impact our estimates and assumptions, and consequently, changes in the liability estimate may be material to the results of operations in future periods.
The discount rate enables us to state expected future cash flows at their present value on the measurement date. The guideline for setting this rate is a high-quality long-term corporate bond rate. A lower discount rate increases the present value of benefit obligations and increases pension expense. We decreased our discount rate to 5.55% for 2010, from 5.93% for 2009 to reflect market interest rate conditions. To determine the expected long-term rate of return on the plan assets, we consider the current and expected asset allocation, as well as historical and expected returns on each plan asset class. A lower expected rate of return on pension plan assets would increase pension expense. Our long-term expected return on plan assets was 8.00% in 2010 and 2009. During 2010, our pension assets yielded a 12% return as the financial markets continued to recover. We had a pension and post-retirement benefit plan obligation of $236.3 million at December 31, 2010 compared to $205.5 million at December 31, 2009.
For additional information regarding our pension and post-retirement benefit plan obligations, see Item 8. “Financial Statements and Supplementary Data,” Note 15(c) of this Form 10-K.
When the fair value of any investment is lower than its cost/amortized cost, an assessment is made to determine if the decline is other than temporary. We regularly review our entire investment portfolio for declines in fair value. If we believe that a decline in the value of an AFS security is temporary, we record the decline as an unrealized loss in AOCI. Temporary declines in the value of an HTM security are not recognized in the financial statements. Our assessment of a decline in fair value includes judgment as to the financial position and future prospects of the entity that issued the investment security, as well as a review of the security’s underlying collateral for fixed maturity investments. Broad changes in the overall market or interest rate environment generally will not lead to a write-down.
To determine if an impairment is other than temporary, discounted cash flow analyses (“DCFs”) are performed on all fixed maturity securities meeting certain criteria. In addition, DCFs are performed on all previously-impaired debt securities in an unrealized loss position that continue to be held by us and all structured securities that were not of high-credit quality at the date of purchase. These impairment assessments include, but are not limited to, the following security types: commercial mortgage-backed securities (“CMBS”); residential mortgage-backed securities (“RMBS”); asset-backed securities (“ABS”); collateralized debt obligations (“CDOs”); and corporate fixed maturity securities.
Pre-tax net investment income increased $27.2 million, to $145.7 million in 2010, and decreased $12.6 million to $118.5 million in 2009. The increase in 2010 from 2009 was driven by income of $20.3 million on the alternative investment portion of our investment portfolio compared to a loss of $21.7 million in the prior year. This increase was partially offset by lower fixed maturity security and short-term investment income of $11.7 million resulting from lower reinvestment yields, coupled with increased investment expenses due to approximately $2.1 million of one-time costs in 2010 related to our decision to outsource our investment portfolio management operations.
The decrease in pre-tax net investment income of $12.6 million from 2008 to 2009 was due to: (i) an increase in losses of $9.1 million on our alternative investments; (ii) a decrease in interest income of approximately $7.7 million on our fixed maturity and short-term investment portfolios due to lower reinvestment yields; and (iii) lower dividend income of $3.3 million as we reduced our equity portfolio during the year. For additional information on our alternative investment portfolio and a discussion of the related strategies associated with this portfolio, see Note 5. “Investments” in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
Tax expense from continuing operations was $12.6 million in 2010 compared to a benefit of $5.5 million and $3.9 million in 2009 and 2008, respectively. These fluctuations were primarily driven by the change in the components of pre-tax net income as discussed above.
NPW decreased compared to 2009 due to a highly competitive commercial lines marketplace coupled with a slow economic recovery. We have experienced a decrease in exposure given the reduction in payroll and sales consistent with the soft economy and the fact that our contractors business, one of the most affected industries in the economic downturn, accounted for 35% of our Commercial Lines business in 2010 and 39% in 2009. These factors are evidenced by the following:
Reductions in new business premiums of $48.2 million, to $272.8 million; and
These items were partially offset by a Commercial Lines renewal pure price increase of 3.1% in 2010. We were one of the only insurance carriers to achieve Commercial Lines renewal rate increases in 2010.
Audit and endorsement return premium of $62.0 million in 2009 compared to $12.5 million in 2008; and
A reduction in net renewals of $20.3 million, to $1.2 billion.
The increase in the GAAP loss and loss expense ratio of 0.7 points in 2009 compared to 2008 was primarily attributable to casualty loss costs that had outpaced premiums in 2009’s current accident year, partially offset by favorable prior year casualty development of $29 million, or 2.0 points, in 2009 compared to $22 million, or 1.5 points, in 2008.
The decrease in the GAAP underwriting expense ratio of 0.9 points in 2009 was primarily attributable to several expense initiatives that we implemented in 2008 and during the first quarter of 2009, including workforce reductions in 2008 that resulted in a pre-tax charge of $4.5 million in 2008 and the benefit realized with the elimination of retiree life insurance benefits noted above. Partially offsetting these actions is the impact of the reduction in earned premium.
Reductions in net renewals of $24.2 million, to $1.0 billion, in 2010.
The increase in the GAAP loss and loss expense ratio in both periods was reflective of increased property losses partially offset by favorable prior year casualty development. In 2010 compared to 2009, property losses were driven by catastrophe losses, which were as follows for the past three years:
The GAAP underwriting expense ratio increased in 2010 compared to 2009, which was primarily attributable to declines in premiums earned coupled with the one-time benefit recognized in 2009 for the elimination of retiree life insurance benefits for current employees. Improvements in the GAAP underwriting expense ratio in 2009 compared to 2008 were primarily attributed to various expense initiatives that we have implemented over the last couple of years.
The following is a discussion of our most significant Commercial Lines of business:
We continued to see improvements in pricing in this line as our renewal pure price increase was 4.2% in 2010 compared to increases of 1.6% in 2009 and decreases of 2.0% in 2008. However, despite our ability to achieve price increases, the continued current economic weakness and the competitive nature of the insurance marketplace has impacted NPW on this line in recent years as evidenced by the following:
New business down 21%, or $14.8 million, to $56.7 million; and
New business down 5%, or $3.6 million, to $71.5 million; and
Endorsement and audit return premium of $29.2 million in 2009, compared to $3.7 million in 2008.
2009: favorable by $10 million, or 3.9 points, primarily driven by accident years 2005 to 2007, partially offset by adverse severity in accident year 2008; and
The 8.0-point decrease in the statutory combined ratio for 2010 compared to 2009 was driven primarily by the impact of prior year development, as follows:
In 2010, favorable casualty prior year development of approximately $28 million, or 9.6 points, driven by lower than anticipated severity primarily in accident years 2004 through 2009; and
The decrease in the statutory combined ratio in 2009 compared to 2008 was driven primarily by:
The 3.2 points of favorable casualty prior year development in 2009 mentioned above, compared to insignificant development in 2008; and
These items were partially offset by higher estimated loss cost in 2009.
New business that decreased $9.8 million, or 22%, to $35.5 million; and
Partially offset by an increase in net renewals of $3.7 million, or 2%, to $175.0 million, which included renewal pure price increases of 2.1%.
The increases in 2009 compared to 2008 were primarily due to:
The improvement in the statutory combined ratio in 2009 compared to 2008 was mainly due to decreases in catastrophe losses of $18.7 million, or 9.5 points, partially offset by an increase in non-catastrophe property losses of $3.0 million, or 1.0 points.
43 rate increases, 34 of which were 5% or more, that went into effect across our Personal Lines footprint during 2010;
Net renewal direct premium written increases of $21.6 million, or 12%, to $200.1 million for 2010, which includes an improvement in point of renewal retention of approximately two points, to 92% in 2010; and
NPE increases in 2010 compared to 2009 and 2008 are consistent with the NPW increases in 2010 compared to 2009 and 2008 as discussed above.
The decrease in the GAAP underwriting expense ratio in 2010 compared to 2009 was attributable to an increase in premiums that has outpaced increases in underwriting expense.
We continue to work to achieve the necessary rate increases across our footprint states to improve profitability. In addition, we are focused on reducing claim costs and improving underwriting efficiencies. We believe the various rate increases implemented over the last two years and forecasted for 2011 will help us achieve our goal of being profitable in this line of business. The following table illustrates the annual premium anticipated to be generated as a result of the rate increases:
In addition, our strategy on this line includes: (i) writing new policies in our expansion states and improving the mix of business as we write a greater distribution of low frequency, high retention business; (ii) continued diversification in our territory structure; and (iii) providing the excellent service that our policyholders and agents demand. During 2010, we introduced our homeowners business to the comparative raters system, joining our personal auto business. As a result, homeowners quote volume has significantly increased over 2009. Policy retention continues to be positive, despite increases to our rates over the past several years. We believe that this increase in policy retention reflects the hardening of the personal lines market as well as: (i) the ability of our pricing tools to comprehensively analyze where rate increases are appropriate; and (ii) our strategy to obtain high retention, low frequency accounts in our core book of business.
We continue to assess our property catastrophe exposure aggregations, modeled results, and effects of growth on our property portfolio and strive to manage our exposure to individual large events balanced against the cost of reinsurance protections.
RMS v. 9.0 allows modeling based on the long-term averages (historic view) and modeling based on a near-term view that includes an assumption of elevated hurricane activity in the North Atlantic Basin in the short to medium-term. Results of both models are provided above for select probabilities. Our current catastrophe program provides protection for a 1 in 240 year event, or an event with 0.4% probability according to the RMS v. 9.0 historic model, and for a 1 in 206 year event, or an event with 0.5% probability according to the RMS v. 9.0 near term model. RMS recently announced the upcoming release of its version 11 model that includes substantial changes to the hurricane model. The new version is expected to be released in early 2011. From the limited information released by RMS, we expect that the loss estimates will increase for our portfolio when modeled in the new release. However, the currently available information is not sufficient to quantify what impact the model change may have on our property catastrophe reinsurance program.
The per occurrence cap on the total program is $64.0 million.
The first layer continues to have unlimited reinstatements. The annual aggregate limit for the second, $20.0 million in excess of $10.0 million, layer remains at $80.0 million.
The next five layers provide coverage for 100% of up to $85.0 million in excess of $5.0 million.
Consistent with the prior year, the Casualty Treaty excludes nuclear, biological, chemical, and radiological terrorism losses. Annual aggregate terrorism limits, net of co-participation, remained the same at $198.8 million.
Our Surety and Fidelity Excess of Loss treaty was renewed effective January 1, 2011, with an additional third layer of coverage. The 2011 renewal had a 4% decrease in rate offset by an increase in projected subject premium when compared to 2010. The current program provides the following coverage:
The first layer provides coverage for 90% of up to $3.0 million in excess of a $1.0 million retention for both contract surety and fidelity, as well as commercial surety.
The third layer provides coverage of up to $3.0 million in excess of $9.0 million for contract surety only.
Our investment philosophy includes certain return and risk objectives for the fixed maturity, equity, and other investment portfolios. The primary fixed maturity portfolio return objective is to maximize after-tax investment yield and income while balancing risk. A secondary objective is to meet or exceed a weighted-average benchmark of public fixed income indices. The equity portfolio return objective is to meet or exceed a weighted-average benchmark of public equity indices. Although yield and income generation remain the key drivers to our investment strategy, our overall philosophy is to invest with a long-term horizon along with a “buy-and-hold” principle. The return objective of the other investment portfolio, which includes alternative investments, is to meet or exceed the S&P 500 Index.
Following the change to our execution model we performed several reviews of our portfolio which included detailed analyses of the municipal portion of our fixed maturity portfolio and our other investments, specifically our exposure to certain alternative investments. We reduced our allocation to state and municipal assets from 42% to 36% of the portfolio and we were able to take advantage of an opportunity in the secondary alternative investment market to reduce our exposure and reallocate risk to achieve better risk adjusted returns over the longer term. For further discussion regarding the alternative portfolio, see Note 5. “Investments” of Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K. During 2010, we also exited our master limited partnership investments, concentrated in the energy sector, to further diversify our equity exposure. Overall, we re-balanced the portfolio and maintained a high credit quality with an average S&P rating of “AA.” In addition, we are currently diversifying into investment-grade corporate bonds as part of our overall investment strategy due to the currently more attractive risk/return characteristics of this sector. During 2010, we increased our allocation to corporate fixed income securities from 13% to 27%.
Our investment portfolio totaled $3.9 billion at December 31, 2010, an increase of 4% compared to December 31, 2009. This increase was driven primarily by cash flows generated from Insurance Operations and valuation improvements within the fixed maturity securities portfolio, as mentioned above.
We structure our portfolio conservatively with a focus on: (i) asset diversification; (ii) investment quality; (iii) liquidity, particularly to meet the cash obligations of our Insurance Operations segment; (iv) consideration of taxes; and (v) preservation of capital. We believe that we have a high quality and liquid investment portfolio. The duration of the fixed maturity securities portfolio as of December 31, 2010, including short-term investments, was an average of 3.5 years compared to the Insurance Subsidiaries’ liability duration of approximately 3.8 years, which was relatively consistent with the prior year. The current duration of the fixed maturity securities portfolio is within our historical range, and is monitored and managed to maximize yield and limit interest rate risk. We are currently experiencing pressure on our yields within our fixed maturity securities portfolio as higher yielding bonds that are either maturing or have been sold are being replaced with the lower yielding bonds that are currently available in the marketplace. We manage liquidity with a laddered maturity structure and an appropriate level of short-term investments to avoid liquidation of AFS fixed maturities in the ordinary course of business. We typically have a long investment time horizon and every purchase or sale is made with the intent of improving future investment returns while balancing capital preservation.
As mentioned above, our fixed maturity securities portfolio carries a weighted average credit rating of “AA” despite some ratings migration over the past year due to general economic conditions and our recent heavier allocation to investment-grade corporate bonds. The following table presents the credit ratings of our fixed maturity securities portfolio:
We have audited the accompanying consolidated balance sheets of Selective Insurance Group, Inc. and its subsidiaries (the “Company”) as of December 31, 2010 and 2009, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2010. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules I to V. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 2 and Note 5 to the consolidated financial statements, the Company changed its method of evaluating other-than-temporary impairments of fixed maturity securities due to the adoption of new accounting requirements issued by the Financial Accounting Standards Board as of April 1, 2009.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Selective Insurance Group, Inc.'s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 25, 2011 expressed an unqualified opinion on the effectiveness of the Company's internal control over financial reporting.
During the fourth quarter of 2009 we disposed of Selective HR Solutions, Inc. (“Selective HR”), which comprised our HR Outsourcing segment, causing the elimination of this operating segment. See Note 12. “Discontinued Operations” for additional information.
Certain amounts in our prior years' consolidated financial statements and related notes have been reclassified to conform to the 2010 presentation. Such reclassifications had no effect on our net income, stockholders' equity, or cash flows.
Equity securities, which are classified as AFS, may include common stocks and non-redeemable preferred stocks and are carried at fair value. Dividend income on these securities is included in "Net investment income earned." The associated unrealized gains and losses, net of tax are included in AOCI. The cost of equity securities is written down to fair value when a decline in value is considered to be other than temporary. See the discussion below on realized investment gains and losses for a description of the accounting for impairments. Certain equity securities managed by an external portfolio manager that were disposed of in 2009 were classified as trading securities. Trading securities are recorded at fair value with subsequent changes in fair value recognized in net investment income.
Prior to April 1, 2009, when the decline in fair value below amortized cost of a fixed maturity security was deemed to be other than temporary, the investment was written down to fair value and the amount of the write-down was charged to income as a realized loss. A decline in fair value on a fixed maturity security was deemed to be other than temporary if we did not have the intent and ability to hold the security to its anticipated recovery. Effective April 1, 2009 with the adoption of revised OTTI accounting guidance, an other-than-temporary impairment charge is recognized as a realized loss to the extent that it is credit related, unless we have the intent to sell the security or it is more likely than not that we will be required to sell the security. In those circumstances, the security is written down to fair value with the entire amount of the writedown charged to earnings as a component of realized losses.
If applicable, conditional default rate assumptions apply at the total collateral pool level held in the securitization trust. Generally, collateral conditional default rates will “ramp-up” over time as the collateral seasons, the performance begins to weaken, and losses begin to surface. As time passes, depending on the collateral type and vintage, losses will peak and performance will begin to improve as weaker borrowers are removed from the pool through delinquency resolutions. In the later years of a collateral pool’s life, performance is generally materially better as the resulting favorable selection of the portfolio improves the overall quality and performance.
Evaluation for OTTI of an equity security may include, but is not limited to, the evaluation of the following factors:
The length of time and the extent to which the fair value has been less than its cost; and
If there is a decline in fair value on an other investment that we do not intend to hold, or if we determine the decline is other than temporary, we write down the cost of the investment and record the charge through earnings as a component of realized losses.
For valuations of securities in our equity portfolio and U.S. Treasury notes held in our fixed maturity portfolio, we receive prices from an independent pricing service that are based on observable market transactions. We validate these prices against a second external pricing service and significant variances between the prices are challenged to determine the price used. These securities are classified as Level 1 in the fair value hierarchy.
For the small portion of our fixed maturity portfolio that we cannot price using our primary or secondary services, we receive non-binding broker quotes. These prices, which we review for reasonableness, are generally classified as Level 3 in the fair value hierarchy as the inputs cannot be corroborated by observable market data.
The fair value of the receivable for proceeds related to the sale of Selective HR is estimated using a DCF, which includes our judgment regarding future worksite life generation and retention assumptions. This receivable is classified as Level 3 in the fair value hierarchy.
The fair values of the 7.25% Senior Notes due November 15, 2034, the 6.70% Senior Notes due November 1, 2035, and the 7.50% Junior Subordinated Notes due September 27, 2066, are based on quoted market prices.
The fair value of the 2.90% borrowings from the Federal Home Loan Bank of Indianapolis (“FHLBI”) is estimated using a DCF based on a current borrowing rate provided by the FHLBI consistent with the remaining term of the borrowing.
The 8.87% Senior Notes are not presented as of December 31, 2010 because they matured on May 4, 2010. The fair value of these notes as of December 31, 2009 was estimated to be its carrying value due to the close proximity of this note’s maturity date to the balance sheet date.
Policy acquisition costs directly related to the writing of insurance policies are deferred and amortized over the life of the policies. These costs include labor costs; commissions; premium taxes and assessments; board, bureau and association fees; travel; and other underwriting expenses incurred in the acquisition of premium. The deferred policy acquisition costs are limited to the sum of unearned premiums and anticipated investment income less anticipated losses and loss expenses, policyholder dividends and other expenses for maintenance of policies in force.
We service our agency distribution channel through our field model, which includes agency management specialists, safety management specialists, claim management specialists and our Underwriting and Claims Service Centers, all of which service the entire population of insurance contracts acquired through each agency.
There were no premium deficiencies for any of the reported years, as the sum of the anticipated losses and loss expenses, policyholder dividends, and other expenses for our Insurance Operations segment did not exceed the related unearned premium and anticipated investment income. The investment yields assumed in the premium deficiency assessment for each reporting period, which are based on our actual average investment yield before tax as of the calculation date on September 30, were 3.6% for 2010, 2.9% for 2009, and 4.1% for 2008. Deferred policy acquisition costs amortized to expense were $429.5 million for 2010, $428.6 million for 2009, and $454.8 million for 2008.
The Insurance Subsidiaries' net premiums written include direct insurance policy writings plus reinsurance assumed and estimates of premiums earned but unbilled on the workers compensation and general liability lines of insurance, less reinsurance ceded. The estimated premium on the workers compensation and general liability lines is referred to as audit premium. We estimate this premium as it is anticipated to be either billed or returned on policies subsequent to expiration based on exposure levels (i.e. payroll or sales). Audit premium is based on historical trends adjusted for the uncertainty of future economic conditions. Further economic instability could ultimately impact our estimates and assumptions, and changes in our estimate may be material to the results of operations in future periods. Premiums written are recognized as revenue over the period that coverage is provided using the semi-monthly pro-rata method. Unearned premiums and prepaid reinsurance premiums represent that portion of premiums written that are applicable to the unexpired terms of policies in force.
We establish reserves for dividends to policyholders on certain policies, most significantly 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. We do not issue policies that entitle the policyholder to participate in the earnings or surplus of the Insurance Subsidiaries.
Our pension and post-retirement life benefit obligations and related costs are calculated using actuarial methods, within the framework of U.S. GAAP. Two key assumptions, the discount rate and the expected return on plan assets, are important elements of expense and/or liability measurement. We evaluate these key assumptions annually. Other assumptions involve demographic factors such as retirement age, mortality, turnover, and rate of compensation increases. The discount rate enables us to state expected future cash flows at their present value on the measurement date. The guideline for setting this rate is a high-quality long-term corporate bond rate. To determine the expected long-term rate of return on the plan assets, we consider the current and expected asset allocation, as well as historical and expected returns on each plan asset class.
In December 2009, the FASB issued Accounting Standards Update (“ASU”) 2009-16, Transfers and Servicing (Topic 860) - Accounting for Transfers of Financial Assets. This guidance: (i) eliminates the concept of a qualifying “special-purpose entity”; (ii) alters the requirements for transferring assets off of the reporting company’s balance sheet; (iii) requires additional disclosure about a transferor’s involvement in transferred assets; and (iv) eliminates special treatment of guaranteed mortgage securitizations. The adoption of this guidance, which was effective for fiscal years beginning after November 15, 2009, did not impact our financial condition or results of operations.
In October 2010, the FASB issued ASU 2010-26, Financial Services-Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. This guidance requires that only costs that are incremental or directly related to the successful acquisition of new or renewal insurance contracts are to be capitalized as a deferred acquisition cost. This would include, among other items, sales commissions paid to agents, premium taxes, and the portion of employee salaries and benefits directly related to time spent on acquired contracts. This guidance is effective, either with a prospective or retrospective application, for interim and annual periods beginning after December 15, 2011, with early adoption permitted. Although we are currently evaluating the impact of this guidance, we anticipate that a significant portion of our deferred policy acquisition costs balance may be eliminated under the newly issued guidance, resulting in a reduction to GAAP equity. Deferred policy acquisition cost totaled $209.6 million as of December 31, 2010.
(b) The carrying value, unrecognized holding gains and losses, and fair values of HTM fixed maturity securities were as follows:
Unrecognized holding gains/losses of HTM securities are not reflected in the consolidated financial statements, as they represent fair value fluctuations from the later of: (i) the date a security is designated as HTM; or (ii) the date that an OTTI charge is recognized on an HTM security, through the date of the balance sheet. Our HTM securities had an average duration of 3.4 years as of December 31, 2010.
CMBS includes government guaranteed agency securities with a fair value of $71.9 million at December 31, 2010 and $94.6 million at December 31, 2009.
The month count for aging of unrealized losses was reset back to historical unrealized loss month counts for securities impacted by the adoption of OTTI guidance in the second quarter of 2009 and for securities that were transferred from an AFS to HTM category.
Unrealized/unrecognized losses decreased by $28.5 million compared to December 31, 2009 due to: (i) the general improvement in the overall marketplace for our fixed maturity securities portfolio; and (ii) the sale of certain fixed maturity securities that resulted in a decrease to unrealized/unrecognized losses of $14.3 million. As evidenced by the table below, our unrealized loss positions improved as of December 31, 2010 compared to last year:
We do not have the intent to sell any securities in an unrealized/unrecognized loss position nor do we believe we will be required to sell these securities, and therefore we have concluded that they are temporarily impaired as of December 31, 2010. This conclusion reflects our current judgment as to the financial position and future prospects of the entity that issued the investment security and underlying collateral. If our judgment about an individual security changes in the future, we may ultimately record a credit loss after having originally concluded that one did not exist, which could have a material impact on our net income and financial position in future periods.
(e) Fixed-maturity securities at December 31, 2010, by contractual maturity are shown below. Mortgage-backed securities are included in the maturity tables using the estimated average life of each security. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
Listed below are HTM fixed maturity securities at December 31, 2010:
Listed below are AFS fixed maturity securities at December 31, 2010:
(g) At December 31, 2010, we had one fixed maturity security, with a carrying value of $15.6 million that was pledged as collateral for our outstanding borrowing with the Federal Home Loan Bank of Indianapolis (“FHLBI”). This borrowing, which has an outstanding principal balance of $13.0 million, is included in “Notes payable” on our Consolidated Balance Sheets. In accordance with the terms of our agreement with the FHLBI, we retain all rights regarding this security, which is included in the “U.S. government and government agencies” classification of our AFS fixed maturity securities portfolio.
Net investment income, before tax, increased by $27.2 million, to $145.7 million, in 2010 from $118.5 million in 2009. This increase was due to higher income on our alternative investments of $42.0 million, primarily in the private equity, energy/power generation, and mezzanine financing sectors, driven by improved equity and credit markets compared to the prior year, with particularly strong results in the second half of 2010. In addition, results from the real estate sector showed signs of stabilizing in the second half of 2010 after nearly two years of losses incurred. The increase in investment income from our alternative investments was partially offset by: (i) a decrease in interest income of approximately $10.9 million on our fixed maturity portfolio as higher yielding securities are either maturing or have been sold and are being replaced with the lower market yields currently available; and (ii) increased investment expense of $2.5 million primarily related to severance payments and contract termination costs as a result of our decision to outsource the management of our investment portfolio in 2010.
$8.3 million of RMBS credit OTTI charges during 2010 largely driven by impairments on two securities in the first quarter of 2010 that we intended to sell. We sold these securities in the second quarter of 2010. The remaining charges related to securities that experienced declines in the related cash flows of their underlying collateral. Based on our analysis, we do not believe it is probable that we will receive all contractual cash flows for these securities.
$6.4 million of CMBS credit OTTI charges. These charges were due to reductions in the related cash flows of the underlying collateral of these securities. These charges were primarily associated with securities that had been previously impaired but, over time, have shown little, if any, improvement in valuations, poor net operating income performance of the underlying properties, and, in some cases, an increase in over 60-day delinquency rates. These securities had, on average, unrealized/unrecognized loss positions of more than 60% of their amortized cost. Based on our DCF analysis, we do not believe it is probable that we will receive all contractual cash flows for these securities.
The following is a discussion surrounding the credit-related OTTI charges taken during 2009 as outlined in the table above:
$37.8 million of RMBS credit OTTI charges during 2009. These charges taken during 2009 related to securities that experienced reductions in the cash flows of their underlying collateral. These securities, on average, showed signs of loss at conditional default rates of 0.33 and had declines in fair value of 65% as compared to their amortized cost. As a result, we did not believe it was probable that we would receive all contractual cash flows for these securities.
$2.1 million of equity charges during 2009 related to seven equity securities. These seven securities were comprised of two banks, one bank exchange traded fund, one energy company, a membership warehouse chain of stores, and two healthcare companies. We believed the share price weakness of these securities was more reflective of general overall financial market conditions, as we were not aware of any significant deterioration in the fundamentals of these six companies as well as the underyling portfolio investments of the exchange traded fund. However, the length of time these securities had been in an unrealized loss position, and the overall distressed trading levels of these stocks made a recovery to our cost basis unlikely in the near term.
$15.1 million of RMBS and CMBS charges. These charges related to declines in the related cash flows of the collateral, based on our assumptions of the expected default rates and the value of the collateral, and accordingly, we did not believe it was probable that we would receive all contractual cash flows.
The following tables sets forth, for the periods indicated, credit loss impairments on fixed maturity securities for which a portion of the OTTI charge was recognized in OCI, and the corresponding changes in such amounts:
(j) The components of net realized (losses) gains, excluding OTTI charges, were as follows:
Realized gains and losses in 2009 from AFS securities were attributable to: the sale of (i) securities on which we had previously taken OTTI charges, as we had the intent to sell such securities; and (ii) certain securities for financial and tax planning strategies. Additional sales of AFS fixed maturity securities that resulted in realized losses were also driven by further declines in the issuers’ credit worthiness and liquidity. In addition to calls and maturities on HTM securities, we sold one HTM security with a carrying value of $6.0 million for a loss of $0.2 million during the second quarter of 2009. This security had experienced significant deterioration in the issuer’s credit worthiness.
The sale of certain equity securities in the first quarter of 2009, resulting in a net realized loss of approximately $0.6 million, comprised of $19.7 million in realized gains and $19.1 million in realized losses, in an effort to reduce overall portfolio risk. The decision to sell these equity positions was in response to an overall year-to-date market decline of approximately 24% by the end of the first week of March. In addition, the Parent's market capitalization at that time had decreased more than 50% since the latter part of January 2009, which we believed to be partially due to investment community views of our equity and equity-like investments. Our equity-like investments include alternative investments, many of which report results to us on a one quarter lag. Consequently, we believed the investment community would wait to evaluate our results based on the knowledge they had of the previous quarter's general market conditions. As a result, we determined it was prudent to mitigate a portion of our overall equity exposure. In determining which securities were to be sold, we contemplated, among other things, security-specific considerations with respect to downward earnings trends corroborated by recent analyst reports, primarily in the energy, commodity, and pharmaceutical sectors.
Realized gains and losses in 2008 from the sale of AFS securities were related mainly to financial and tax planning strategies. Sales of AFS securities also included realized losses related to securities that had further declines in the issuer’s credit worthiness and liquidity. In addition, realized losses from other investments related primarily to the sale of one international investment fund.
As of December 31, 2010, we had 13.3 million shares reserved for various stock compensation and purchase plans, retirement plans and dividend reinvestment plans. As part of our ongoing capital management strategy, we repurchase the Parent's stock from time-to-time, although we had no authorized stock repurchase program in place as of December 31, 2010. Our previously authorized program expired on July 26, 2009. The following table provides information regarding the purchase of the Parent's common stock during the 2008-2010 reporting periods:
Our ability to declare and pay dividends on the Parent's common stock is dependent on liquidity at the Parent coupled with the ability of the Insurance Subsidiaries to declare and pay dividends, if necessary, and/or the availability of other sources of liquidity to the Parent. Restrictions on the ability of the Insurance Subsidiaries to pay dividends, without alternative liquidity options, could materially affect our ability to pay dividends on common stock. The dividends from the Insurance Subsidiaries are subject to the regulatory limitations of the states in which the Insurance Subsidiaries are domiciled: New Jersey, New York, Indiana, or Maine. Based on the unaudited 2010 statutory financial statements, the maximum ordinary dividends that can be paid to the Parent by the Insurance Subsidiaries in 2011 are as follows:
The statutory capital and surplus of the Insurance Subsidiaries in excess of these ordinary dividend amounts must remain with the Insurance Subsidiaries in the absence of approval of an “extraordinary dividend” from the Insurance Subsidiaries’ states of domicile. In each such jurisdiction, domestic insurers are prohibited from paying extraordinary dividends without approval of the insurance commissioner of the respective state. Additionally, New Jersey and Indiana require notice of the declaration of any ordinary or extraordinary dividend distribution. During the notice period, the relevant state regulatory authority may disallow all or part of the proposed dividend if it determines that the insurer's surplus, with regard to policyholders, is not reasonable in relation to the insurer's outstanding liabilities and adequate for its financial needs.
The following table presents the carrying amounts and estimated fair values of our financial instruments as of December 31, 2010 and 2009:
Our notes payable are subject to certain debt covenants that were met in their entirety in 2010 and 2009. For further discussion regarding the debt covenants, refer to Note 10, “Indebtedness” in this Form 10-K.
The following tables provide quantitative disclosures of our financial assets that were measured at fair value at December 31, 2010 and 2009:
The following table provides a summary of the changes in fair value of securities using Level 3 inputs. The transfers of the CMBS, AFS securities between levels in the fair value hierarchy were driven primarily by the availability and nature of the broker quotes used at the valuation dates:
Amounts are reported in “Net realized investment gains” for ABS, AFS and CMBS, AFS and in “Loss on disposal of discontinued operations, net of tax” for the receivable for proceeds related to sale of Selective HR on the Consolidated Statements of Income.
The Insurance Subsidiaries remain liable to policyholders to the extent that any reinsurer becomes unable to meet our contractual obligations. We evaluate and monitor the financial condition of our reinsurers under voluntary reinsurance arrangements to minimize our exposure to significant losses from reinsurer insolvencies. On an ongoing basis, we review amounts outstanding, length of collection period, changes in reinsurer credit ratings and other relevant factors to determine collectability of reinsurance recoverables. The allowance for reinsurance recoverables was $3.4 million at December 31, 2010 and $2.5 million at December 31, 2009.
The table below provides a roll forward of reserves for losses and loss expenses for beginning and ending reserve balances:
In 2008, we experienced favorable loss development of $19 million, which was primarily driven by favorable loss development in accident years 2002 through 2006 of $54 million, partially offset by unfavorable loss development in accident year 2007 of $27 million as well as unfavorable development in accident years 2001 and prior of $8 million. The main driver of this development was favorable prior year development in our workers compensation line of business, partially offset by adverse prior year development in the general liability line of business. Workers compensation experienced favorable prior year development of $24 million primarily driven by favorable development in accident years 2004 to 2006 as a result of the implementation of improvement strategies for this line, partially offset by adverse prior year development in accident year 2007. Prior year development for the commercial automobile line of business was only minimally favorable reflecting the leveling off of improvements in severity trends. Partially offsetting the favorable loss development, the general liability line of business experienced adverse prior year development of approximately $3 million reflecting normal volatility in this line of business. The remaining lines of business, which collectively contributed approximately $2 million of adverse development, do not individually reflect any significant trends related to prior year development.
Reserves established for liability insurance include exposure to environmental claims, both asbestos and non-asbestos. These claims have arisen primarily from insured exposures in municipal government, small non-manufacturing commercial risk, and homeowners policies. The emergence of these claims is slow and highly unpredictable. 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 that arise in environmental cases include federal or state venue, 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 that 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.
At December 31, 2010, our reserves for environmental claims amounted to $47.3 million on a gross basis (including case reserves of $15.7 million and IBNR reserves of $31.6 million) and $39.4 million on a net basis (including case reserves of $11.6 million and IBNR reserves of $27.8 million). There are a total of 1,329 environmental claims. Of these, 1,070 are asbestos related, of which 414 are with 43 insureds in the wholesale and/or retail of plumbing, electrical, and other building supplies with related case reserves of $3.1 million. In addition, 647 asbestos claims are with one insured, an asbestos gasket manufacturer with related case reserves of $0.9 million. These claims are associated with two policies each written with a $1.0 million policy aggregate limit. During 2010, 283 asbestos claims were closed. The total case reserves for asbestos related claims amounted to $4.2 million on a gross basis and $3.7 million on a net basis. About 66 of the total environmental claims involve nine landfill sites. The landfill sites account for case reserves of $6.6 million on a gross basis and $3.4 million on a net basis, and include reserves for several sites that are currently listed on the National Priorities List. The remaining claims, which account for $4.9 million of case reserves on a gross basis and $4.5 million on a net basis, involve leaking underground heating oil storage tanks and other latent environmental exposures.
IBNR reserve estimation 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. 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.
(3) On November 15, 2004, we issued $50 million of 7.25% Senior Notes due 2034. These notes were issued at a discount of $0.1 million, resulting in an effective yield of 7.27% and pay interest on May 15 and November 15 each year. We contributed $25.0 million of the bond proceeds to the Insurance Subsidiaries as capital. The remainder of the proceeds were used for general corporate purposes. The agreements covering these notes contain a standard default cross-acceleration provision that provides the 7.25% Senior Notes will enter a state of default upon the failure to pay principal when due or upon any event or condition that results in an acceleration of principal of any other debt instrument in excess of $10 million that we have outstanding concurrently with the 7.25% Senior Notes. There are no attached financial debt covenants to which we are required to comply in regards to these notes.
During the third quarter of 2009, the Parent terminated its previously existing line of credit and entered into a new syndicated line of credit agreement on August 25, 2009. This $30 million line of credit (“Line of Credit”) is syndicated between Wachovia Bank, National Association, a subsidiary of Wells Fargo & Company, as administrative agent and Branch Banking and Trust Company (BB&T) and allows us to increase our borrowings to $50 million with the approval of both lending parties. The interest rate on the Line of Credit varies and is based on, among other factors, the Parent’s debt ratings from S&P and Moody’s. The Line of Credit expires on August 11, 2011. We continue to monitor current news regarding the banking industry, in general, and our lending partners, in particular, as, according to the syndicated line of credit agreement, the obligations of the lenders to make loans and to make payments are several and not joint. There were no balances outstanding under this credit facility as of December 31, 2010 or at any point during the year.
In addition to the above requirements, the syndicated line of credit agreement contains a cross-default provision that provides that the Line of Credit will be in default if we fail to comply with any condition, covenant, or agreement (including payment of principal and interest when due on any debt with an aggregate principal amount of at least $10.0 million), which causes or permits the acceleration of principal.
Insurance Operations, which is evaluated based on statutory underwriting results (net premiums earned, incurred losses and loss expenses, policyholders dividends, policy acquisition costs, and other underwriting expenses), and statutory combined ratios; and
Our Insurance Operations are subject to certain geographic concentration. In 2010, approximately 26% of net premiums written were related to insurance policies written in New Jersey.
Our Commercial Lines and Personal Lines property and casualty insurance products are sold through independent insurance agents.
During the fourth quarter of 2009, we disposed of Selective HR, which comprised our HR Outsourcing segment. The results of Selective HR operations are included in “Loss from discontinued operations, net of tax” in our Consolidated Statements of Income. See Note 12. “Discontinued Operations” for additional information on the disposal.
Our segments may, from time-to-time, provide services to each other in the normal course of business. These service transactions included transactions with our discontinued operations, Selective HR, prior to its sale and totaled $9.0 million in 2009 and $13.8 million in 2008. These transactions were eliminated in all consolidated statements. In computing the results of each segment, we do not make adjustments for interest expense, net general corporate expenses, or federal income taxes. We do not maintain separate investment portfolios for the segments and therefore, do not allocate assets to the segments.
In 2009, we sold 100% of our interest in Selective HR, which had historically comprised the HR Outsourcing segment of our operations. We sold this interest for proceeds scheduled to be received over a 10-year period based on the ability of the purchaser to retain and generate new worksite lives through our independent agency distribution channel. We have concluded that these proceeds are indirect cash flows since we have no continuing involvement with the operations of Selective HR and have no continuing cash flows other than these proceeds. In 2010, we recorded after-tax charges of $3.8 million, primarily due to our revaluation of the contingent proceeds, including assumptions regarding worksite life generation and retention, bringing our estimated sales price to approximately $6.9 million, of which $1.9 million has been received as of December 31, 2010, as compared to $12.3 million at December 31, 2009.
After considering all evidence, both positive and negative with respect to our federal tax loss carryback availability, expected levels of pre-tax financial statement income and federal taxable income, we believe it is more likely than not that the existing deductible temporary differences will reverse during periods in which we generate net federal taxable income or have adequate federal carryback availability. As a result, we have no valuation allowance recognized for federal deferred tax assets at December 31, 2010 and 2009.
100% of participant contributions up to the first 3% of defined compensation and 50% up to the next 3%
100% match up to 2% of defined compensation and non-elective contributions equal to 2% of defined compensation
Vesting period of six years for SICA match and three years for SICA non-elective contribution
Employer contributions to the Retirement Savings Plan amounted to $6.3 million in 2010, $6.0 million in 2009, and $6.4 million in 2008.
The Retirement Savings Plan allows employees to make voluntary contributions to a number of diversified investment options on a before and/or after-tax basis. Until March 10, 2009, the Parent’s common stock fund had been an investment option, but on such date, this fund was closed to new contributions. Shares of the Parent's common stock issued under this plan were 13,983 during 2009 and 27,920 during 2008.
SICA offers a nonqualified deferred compensation plan ("Deferred Compensation Plan") to a group of management or highly compensated employees (the "Participants") as a method of recognizing and retaining such employees. The Deferred Compensation Plan provides the Participants the opportunity to elect to defer receipt of specified portions of compensation and to have such deferred amounts deemed to be invested in specified investment options. A Participant in the Deferred Compensation Plan may elect to defer compensation or awards to be received, including up to: (i) 50% of annual base salary; (ii) 100% of annual bonus; and/or (iii) a percentage of other compensation as otherwise designated by the administrator of the Deferred Compensation Plan.
The weighted average asset allocation by percentage of the Retirement Income Plan at December 31 was as follows:
For the valuation of the investment in the limited liability company (“LLC”), fair value is based on the Retirement Income Plan’s ownership interest in the reported net asset value, which is reported to us on a one quarter lag, as a practical expedient. The LLC did not have any imposed redemption restrictions nor did we have any contractual obligations to further invest in this investment. We determined that we had the ability to redeem this investment in the near term and the time between the redemption date and the valuation date is not significant enough to allow for a significant change in fair value. This investment is classified as Level 2 in the fair value hierarchy as of December 31, 2009; and
For a description of our private equity and real estate strategies, refer to Note 5. “Investments.” Our Equity Long/Short Hedge strategy invests opportunistically in equities and equity-related instruments in companies generally in the financial services sector. Investments within this strategy are permitted to be sold short in order to: (i) prospectively benefit from a correction in overvalued equities; and (ii) partially hedge portfolio assets due to the strategy’s heavy weighting toward the financial sector.
At December 31, 2010, the Retirement Income Plan had contractual obligations that expire at various dates through 2022 to further invest up to $5.7 million in alternative investments. There is no certainty that any such additional investment will be required. The Retirement Income Plan currently receives distributions from these alternative investments through the realization of the underlying investments in the limited partnerships. We anticipate that the general partners of these alternative investments will liquidate their underlying investment portfolios through 2022.
We presently anticipate contributing $8.4 million to the Retirement Income Plan in 2011, none of which represents minimum required contribution amounts.
The Parent's 2005 Omnibus Stock Plan ("Stock Plan") was approved effective as of April 1, 2005 by stockholders on April 27, 2005. With the Stock Plan's approval, no further grants were available under the: (i) Parent's Stock Option Plan III, as amended ("Stock Option Plan III"); (ii) Parent's Stock Option Plan for Directors, as amended ("Stock Option Plan for Directors"); or (iii) Parent's Stock Compensation Plan for Non-employee Directors, as amended ("Stock Compensation Plan for Non-employee Directors"), but awards outstanding under these plans and the Stock Option Plan II, under which future grants ceased being available on May 22, 2002, shall continue in effect according to the terms of those plans and any applicable award agreements.
The Parent's Cash Incentive Plan (“Cash Incentive Plan”) was approved effective April 1, 2005 by stockholders on April 27, 2005. Stockholders approved the amendment and restatement of the Cash Incentive Plan effective as of May 1, 2010 (the “Amended Cash Incentive Plan”) on April 28, 2010. Under the Amended Cash Incentive Plan, the Board's SEBC may grant cash incentive units in such amounts and with such terms and conditions as it shall determine, subject to the provisions of the Amended Cash Incentive Plan. The initial dollar value of these grants will be adjusted to reflect the percentage increase or decrease in the total shareholder return on the Parent's common stock over a specified performance period. In addition, for certain grants, the number of units granted will be adjusted to reflect our performance on specified indicators as compared to targeted peer companies. Each award granted under the Amended Cash Incentive Plan shall be evidenced by an agreement containing such restrictions as the SEBC may, in its sole discretion, deem necessary or desirable and which are not in conflict with the terms of the Amended Cash Incentive Plan. We issued, net of forfeitures, 45,082 cash units during 2010, 46,349 cash units during 2009, and 48,890 cash units during 2008.
As of December 31, 2010, 340,880 shares of the Parent's common stock remained available for issuance pursuant to outstanding stock options and restricted stock awards granted under Stock Option Plan II, under which future grants ceased being available on May 22, 2002. Under Stock Option Plan II, employees were granted qualified and nonqualified stock options, with or without SARs, and restricted or unrestricted stock: (i) at not less than fair value on the date of grant, and (ii) subject to certain vesting periods as determined by the SEBC. Restricted stock awards also could be subject to the achievement of performance objectives as determined by the SEBC. The maximum exercise period for an option grant under this plan was ten years from the date of the grant.
As of December 31, 2010 there were 94,290 shares of the Parent's common stock available for issuance pursuant to outstanding stock option awards under the Stock Compensation Plan for Nonemployee Directors, under which future grants ceased being available with the approval of the Stock Plan. Under the Stock Compensation Plan for Non-employee Directors, Directors could elect to receive a portion of their annual compensation in shares of the Parent's common stock. There were no issuances under this plan in 2010 and 2008. We issued 960 shares under this plan during 2009.
On July 27, 2010, the SEBC approved the Parent’s Amended and Restated Stock Purchase Plan for Independent Insurance Agencies ("Agent Plan") which made immaterial amendments to the plan approved by stockholders on April 26, 2006. Under the Agent Plan, there were 2,385,558 shares of common stock available for purchase as of December 31, 2010. The Agent Plan provides for quarterly offerings in which independent insurance agencies, and certain eligible persons associated with the agencies, with contracts with the Insurance Subsidiaries can purchase the Parent's common stock at a 10% discount with a one year restricted period during which the shares purchased cannot be sold or transferred. Under the Agent Plan, we issued 109,343 shares in 2010, 146,570 shares in 2009, and 137,264 shares in 2008, and charged to expense $0.2 million in 2010 and 2009, and $0.3 million in 2008, with a corresponding income tax benefit of $0.1 million in each year.
A summary of the restricted stock and RSU transactions under our share-based payment plans is as follows:
As of December 31, 2010, total unrecognized compensation cost related to unvested restricted stock and RSU awards granted under our stock plans was $4.1 million. That cost is expected to be recognized over a weighted-average period of 1.7 years. The total intrinsic value of restricted stock and RSU vested was $3.9 million for 2010, $7.9 million for 2009, and $14.2 million for 2008. In connection with the restricted stock vestings, the total fair value of the DRP shares that also vested was $0.6 million during 2008.
Share-based compensation expense charged against net income before tax was $12.2 million for the year ended December 31, 2010 with a corresponding income tax benefit of $4.0 million. Share-based compensation expense that was charged against net income before tax was $10.8 million for the year ended December 31, 2009 and $16.9 million for the year ended December 31, 2008 with corresponding income tax benefits of $3.4 million and $5.5 million, respectively.
Rue Insurance placed insurance policies with the Insurance Subsidiaries. Direct premiums written associated with these policies were $7.2 million in 2010, $7.6 million in 2009, and $8.3 million in 2008. In return, the Insurance Subsidiaries paid commissions to Rue Insurance of $1.3 million in 2010, $1.4 million in 2009, and $1.7 million in 2008.
We paid reinsurance commissions of $0.2 million in 2008 to PL, LLC. There were no reinsurance commissions paid to PL, LLC during 2010 or 2009. PL, LLC is an insurance fund administrator that places reinsurance through an Insurance Subsidiary. As of December 31, 2008, Rue Insurance owned 33.33% of PL, LLC.
(a) We purchase annuities from life insurance companies to fulfill obligations under claim settlements that provide for periodic future payments to claimants. As of December 31, 2010, we had purchased such annuities in the amount of $7.9 million for settlement of claims on a structured basis for which we are contingently liable. To our knowledge, none of the issuers of such annuities have defaulted in their obligations thereunder.
In the ordinary course of conducting business, we are named as defendants in various legal proceedings. Most of these proceedings are claims litigation involving the Insurance Subsidiaries as either: (a) liability insurers defending or providing indemnity for third-party claims brought against insureds; or (b) insurers defending first-party coverage claims brought against them. We account for such activity through the establishment of unpaid loss and loss adjustment expense reserves. We expect that the ultimate liability, if any, with respect to such ordinary course claims litigation, after consideration of provisions made for potential losses and costs of defense, will not be material to our consolidated financial condition, results of operations, or cash flows.
These ranges of high and low prices of the Parent’s common stock, as reported by the NASDAQ Global Select Market, represent actual transactions. 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 3, 2011 and ending February 18, 2011 was $18.97 to $17.35.