General America Corporation (a wholly-owned subsidiary of SAFECO Corporation) leases office space to both Property & Casualty and Life & Investments. Property & Casualty’s and Corporate’s home office facility (567,000 gross square feet) is located in Seattle, Washington. A 700-car parking garage is connected to this facility. Life & Investments’ headquarters facility (220,000 gross square feet) is located in Redmond, Washington.
Income (Loss) Before Realized Gain is a standard industry measurement used by management to analyze income from core operations and is presented to supplement net income as a measure of profitability.
Net income (loss) per share amounts are after distributions on capital securities.
Operating ratios are GAAP basis and are based on expenses expressed as a percentage of earned premiums. Ratios exclude goodwill write-off, goodwill amortization, restructuring charges and nonrecurring acquisition charges.
Includes Loss Reserve Strengthening of $240.0 in 2001. Excluding this adjustment the Combined Ratio was 113.4%; the Loss Ratio was 70.7% and the Adjustment Expense Ratio was 12.6%.
SAFECO exited lines of business not core to its strategy. For example, 15 of 19 Select Markets programs were cancelled.
For further discussion of these and other actions see the Property & Casualty - Operations section of this MD&A.
A rigorous company-wide effort to reduce expenses was commenced and continues. In July 2001, SAFECO announced that it would eliminate approximately 1,200 jobs by the end of 2003 with half of the reductions expected to be completed in 2001. SAFECO’s total employment declined by approximately 900 in 2001, excluding the reduction due to the sale of SAFECO Credit. Positions being eliminated are in the corporate headquarters and regional Property & Casualty operations. When fully implemented, these actions are expected to reduce SAFECO’s annual operating expenses by approximately $100.
Restructuring charges and period costs associated with these changes are expected to total approximately $65 through 2002. This includes pretax charges incurred in 2001 of $44 and $21 to be incurred throughout 2002 as the restructuring actions occur. Additional information can be found in Note 12 in the Notes to Consolidated Financial Statements.
Effective March 31, 2001, SAFECO wrote off $1.2 billion of goodwill associated with the 1997 American States Insurance acquisition (Property & Casualty $1,152.1, Life & Investments $48.9). See Note 1 in the Notes to Consolidated Financial Statements for additional information.
Increased emphasis on employee training to strengthen the tools and capabilities of the workforce.
A performance-based compensation system based on the achievement of specific goals linked directly to SAFECO’s business plan was developed and is being implemented in early 2002. The new compensation system applies to all SAFECO employees, including the senior leadership team, and is designed to motivate and reward superior performance. In addition employee communication was increased to help all employees better understand SAFECO’s business plans and their role in helping achieve them.
SAFECO added several strong leaders and completed the formation of a new senior leadership team:
In July 2001 Michael LaRocco was appointed President and Chief Operating Officer of SAFECO Personal Insurance. Mr. LaRocco most recently headed the $1.2 billion northeastern operations for GEICO;
In September 2001 Yomtov Senegor was named Chief Information Officer bringing extensive information systems experience from Accenture (formerly Andersen Consulting);
In January 2002 Christine Mead was named Senior Vice President and Chief Financial Officer. Ms. Mead most recently was the Chief Financial Officer for Travelers Insurance Group’s property and casualty business bringing extensive experience in financial management and strategy from that company as well as prior public accounting experience with Deloitte & Touche and PricewaterhouseCoopers; and
Introduced a corporate-wide program on diversity to prepare SAFECO to compete in a more diverse America and to increase workforce effectiveness.
SAFECO’s leaders have identified four focus areas for the coming year. They are:
Consolidated commercial lines and recognized restructuring charges of $44.3 before tax ($28.8 after tax).
Recognized investment write-downs of $126.8 before tax ($82.4 after tax) due to credit deterioration and corporate failures of certain investment holdings.
Approximately 17% of Property & Casualty premiums are written in the state of California, and approximately 35% of premiums are written in the three West Coast states of California, Washington and Oregon. SAFECO purchased American States Financial Corporation (American States) in October 1997. This purchase broadened the product mix available to the combined companies and geographically diversified SAFECO’s revenue and risk exposure. The purchase also increased Property & Casualty’s risk exposure to the types of commercial business written by American States as well as to weather-related losses in the midwest.
Personal Insurance, Business Insurance, Commercial Insurance and Surety comprised approximately 61%, 22%, 14% and 3%, respectively, of the 2001 gross written premiums of $4.6 billion. Gross written premiums decreased $138.9 (2.9%) in 2001 due to re-underwriting efforts which included non-renewing underpriced risks and reducing underperforming and unprofitable lines. In addition, relationships with approximately 1,000 underperforming agents were terminated in 2001. These actions resulted in an overall net decrease in premiums, more than offsetting the impact of premium rate increases.
Underwriting profit or loss is a standard industry measurement used by management to analyze core Property & Casualty operations. This measurement represents the net amount of earned premiums less underwriting losses and expenses; it does not include realized investment gains and losses, goodwill amortization, goodwill write-down, restructuring charges, net investment income and taxes. This measurement does not replace net income as a measure of profitability, but is presented to supplement the other financial measurements provided.
Includes Loss Reserve Strengthening of $240.0 in 2001 (see discussion in the next section for more information). Excluding this adjustment the underwriting loss was $(597.5).
Includes Loss Reserve Strengthening of $240.0 in 2001. Excluding this adjustment the Combined Ratio was 113.4%; the Loss Ratio was 70.7% and the Loss Adjustment Expense Ratio was 12.6%.
Catastrophe losses for all lines, net of reinsurance, totaled $268.0, $136.0 and $103.0 in 2001, 2000 and 1999, respectively. Catastrophes are defined as events resulting in losses greater than $0.5, involving multiple claims and policyholders.
During the third quarter 2001, SAFECO completed a review of Property & Casualty’s loss reserve adequacy. As a result of this review, which included an independent actuarial study, Property & Casualty increased reserves by $240.0, pretax. The $240.0 reserve addition related to Property & Casualty segments as follows: $65.0 for Business Insurance, $90.0 for Commercial Insurance, and $85.0 in the Other lines of business. The Other lines include the discontinued reinsurance operation SAFECO acquired when it purchased American States in 1997. The $240.0 reserve addition relates to recent developments in prior year claims as follows:
The $90.0 increase in construction defect reserves is due to continued adverse development on prior year claims and the expansion of the number of claims in states outside California. Recent state courts’ rulings have expanded the number of potential claims beyond those contemplated by SAFECO’s original estimate.
To mitigate the capital impact of the reserve strengthening, the Corporation contributed $250.0 of capital to Property & Casualty on September 28, 2001. The source of the capital contribution was the proceeds from the sale of SAFECO Credit. See additional information in the Discontinued Operations - SAFECO Credit section of this MD&A.
Additional information about loss reserves can be found in the Property & Casualty - Loss Reserves section of this MD&A.
Rate increases, agency cancellations and tighter underwriting have helped to reduce the combined ratio from 107.1 in 2000 to 104.6 in 2001. The losses from underwriting of $80.5 in 2001, $123.0 in 2000 and $63.3 in 1999 were primarily the result of rate decreases in 1999 and 1998 which were taken to retain American States business and to respond to competition. Average auto rates increased 9% and 6% in 2001 and 2000, respectively, and decreased 2% in 1999. SAFECO plans to increase personal auto rates on average 7% (including inflation adjustments) in 2002. Actions taken in 2001 to re-underwrite all personal lines business and these rate increases are contributing to the improvements in personal auto results. These actions have resulted in the decline in the number of personal auto policies inforce by 4% offset by an increase in written premiums by 4% in 2001. SAFECO expects further rate increases to depress the growth in the number of policies and to contribute to improved underwriting results.
In 2000 Property & Casualty expanded the use of “insurance-scoring” (utilizing multiple variants to classify risk) which is in use by several competitors. As expected the use of insurance-scoring along with tighter underwriting standards has resulted in a better match of rate and risk. In August 2001 SAFECO began to launch a new automated underwriting initiative with point of sale technology that allows its agent partners to more efficiently quote and sell policies. This technology also includes the updated version of the automated multi-variant underwriting model. This automated approach is expected eventually to handle the majority of new business. The automation initiative, rate increases and tighter underwriting actions are expected to help improve the overall quality of this line of business going forward. The use of insurance-scoring is the subject of both legislative and regulatory review in several states where Property & Casualty has a concentration of business, including Washington state. Property & Casualty will comply with any limitation imposed by regulation or legislation on the use of insurance-scoring, including modification of its underwriting model as may be necessary.
The homeowners line operated at a combined ratio of 127.8, 116.0 and 106.8 and the underwriting losses by year were $205.6, $116.7 and $48.2 in 2001, 2000 and 1999, respectively. The acquisition of American States in 1997 increased SAFECO’s exposure to large, single weather-related events due to geographic concentration of homeowners risk particularly in the midwest. Losses due to large, single events (nearly all weather-related) were $145.0, $86.0 and $52.0 for 2001, 2000 and 1999, respectively. In 2001 the increase includes $60.0 for a single catastrophic storm in St. Louis. Non-weather losses, particularly from fire and water damage, increased by $26.5 in 2001 over similar losses in 2000. Non-weather losses in 2000 increased $44.4 over similar losses in 1999.
Property & Casualty is executing an aggressive profit restoration plan for homeowners. Elements of the plan include pricing the product to generate an appropriate return based on risk characteristics, adding new pricing tiers, restricting policy terms, insurance to value efforts (involves updating policyholders coverage levels) and a willingness to exit geographic markets that do not respond to pricing actions. This action plan is expected to take up to two years to restore acceptable underwriting results. Average homeowners rates (including inflation adjustments) increased approximately 12%, 6% and 1% in 2001, 2000 and 1999, respectively. These actions have resulted in a reduction in new business production of 41% in 2001, and total homeowners policies inforce decreased 8% in 2001 and were flat in 2000, compared with an increase of 4% in 1999. Under the new agent compensation plan, commissions for new monoline homeowners business have been reduced. In addition, a moratorium on writing homeowners business in Texas was established in September 2001 in response to concern about the rising number of mold claims.
Business Insurance focuses on small-to-medium-sized businesses. It produced underwriting losses of $163.2, $155.3 and $183.4 and operated at combined ratios of 115.8, 113.3 and 118.0 in 2001, 2000 and 1999, respectively. Written premiums decreased 14% in 2001 and increased 2% in 2000. The 2001 underwriting loss includes a $65.0 reserve charge described earlier relating to unfavorable prior year development on construction defect and workers’ compensation claims. In addition, following the acquisition of American States in 1997, Property & Casualty sought both to underwrite and to price this business to ensure retention of inforce business, resulting in higher underwriting losses. In recent years, the overall competitive marketplace (particularly in workers’ compensation) led to further price reductions. Property & Casualty took aggressive action in 2001 and 2000 to reverse the underwriting losses in this line by re-underwriting existing business, strengthening underwriting criteria and discipline, terminating relationships with agents who produced poor quality business, and obtaining rate increases, particularly in workers’ compensation and commercial auto. Workers’ compensation remains an unprofitable line as medical loss costs are expected to continue to rise. As a result new business production has been substantially curtailed. Workers’ compensation net written premiums were down 32% in 2001 from 2000 despite rate increases of approximately 14%.
Re-underwriting this book of business and agency cancellations resulted in the reduction of $90.0 of unprofitable business in 2001. In 2002 the focus is to improve profitability by achieving rate adequacy with a goal of increasing rates on average 20% on the small-to-medium-sized businesses, and 30% on the medium-to-larger-sized businesses. In 2002 the focus on the agents will be to secure profitable growth. A redesigned
As discussed above Property & Casualty has now completed the process of consolidating its commercial lines operations and will focus on small-to-medium business product lines going forward. Starting in May 2001, Property & Casualty discontinued its pursuit of large single account business as it was significantly unprofitable. Accounts above one hundred thousand dollars in premiums are now underwritten by a special facility within SBI.
The surety line produced pretax underwriting profits of $2.4, $11.7 and $15.2 in 2001, 2000 and 1999, respectively. Fourth quarter 2001 results were adversely affected by an $18.0 loss, after reinsurance, from the bankruptcy of Enron, a large energy company. Surety issued advance pay and payment guaranty bonds for Enron totaling $193.5. The estimated gross loss related to these bonds is $59.5. Excluding the loss related to Enron, Surety profits in 2001 were $20.4. Due to the complex nature of the Enron bankruptcy, additional losses may occur as further information develops. Additional losses, if any, cannot be estimated at this time and any such losses would impact current operating results.
As a result of extraordinary loss experience in the industry in all major lines of surety in 2001, prices of surety bonds have increased and industry capacity has been reduced. Continued availability of adequate reinsurance is integral to SAFECO’s ability to profitably grow the surety line in the future.
As a result of the September 11, 2001 terrorist attacks, SAFECO estimated its losses net of reinsurance at $52.0, of which $21.0 is attributable to SBI accounts, $30.0 to reinsurance written through R.F. Bailey and $1.0 to Life & Investments. Effective January 1, 2002, SAFECO’s reinsurers stopped providing terrorism coverage in SAFECO’s commercial property and casualty reinsurance treaties. The impact is immediate with respect to new business and affects renewal business as the policies come up for renewal throughout the year. Consequently, except with respect to certain property risks with policy limits in excess of $10.0 for which there may be limited reinsurance for terrorism, SAFECO does not have reinsurance coverage for terrorism losses on its commercial property and casualty policies. Terrorism was similarly excluded from the workers’ compensation reinsurance treaties but is not excluded on the surety treaties. The existing reinsurance treaty for homeowners does not have a terrorism exclusion although SAFECO has received notice that its personal lines treaties may be modified. SAFECO’s catastrophe treaty also excludes terrorism except for personal lines losses other than from biological, chemical or nuclear contamination.
For its direct writings in 2002, SAFECO has adopted the commercial property and casualty terrorism exclusion developed and filed for approval by the Insurance Services Office (ISO). This exclusion is absolute with respect to losses from terrorism arising from biological, chemical or nuclear hazards. With respect to non-biological, non-chemical and non-nuclear losses from terrorism, the exclusions only apply if the total losses from a terrorist event exceed $25.0. In addition, for casualty policies, the exclusion will apply if the terrorist event involves the deaths or serious injury to 50 or more persons. The property exclusion does not apply to losses arising from fire following a terrorist event in the 29 states that follow the standard fire policy form.
With regard to commercial lines policies, SAFECO’s focus is on the small-to-medium account business. Few of its customers are viewed as potential terrorism targets. In states where exclusions for terrorism are approved, they are being added to policies for certain classes of business, in geographic areas where the potential for attack may be greater and where SAFECO insures a high concentration of values. For workers’ compensation the number of employees covered is monitored and coverage is declined in cases where the exposure is severe. SAFECO’s exposure to personal lines losses currently is relatively modest due to small individual exposure and wide spread of risk. Therefore, SAFECO believes its terrorism exposure is relatively modest across all product lines.
SAFECO’s objective is to set reserves that are adequate; that is, the amounts originally recorded as reserves should equal the amounts ultimately required to settle losses. SAFECO’s reserves reflect its aggregate best estimate of the total ultimate cost of claims that have been incurred but have not yet been paid. SAFECO believes its reserves are adequate as of December 31, 2001. The estimates are based on past claims experience and consider current claim trends as well as social, legal and economic conditions, including inflation. The reserves are not discounted.
The process of estimating claim reserves is complex and imprecise due to a number of variables. These variables are affected by both internal and external events such as changes in claims handling procedures, trends in loss costs, inflation, judicial trends and legislative changes. Many of these items are difficult to quantify, particularly on a prospective basis. Additionally, there may be significant lags between the occurrence of the insured event and the time it is actually reported to the insurer. SAFECO continually refines reserve estimates in a regular ongoing process as experience develops and further claims are reported and settled. SAFECO records adjustments to reserves in the results of operations in the periods in which the estimates are changed. In establishing reserves, SAFECO takes into account estimated recoveries for reinsurance, salvage and subrogation.
Property & Casualty operations in 2001 were charged $345.1 from increases in estimated loss and LAE for claims occurring in prior years. These increases included $142.6 in workers’ compensation, $132.8 in general liability, as well as $21.6 in homeowners, $23.1 in commercial auto and $25.0 in all other lines. This adverse development includes the $240.0 of loss reserve strengthening discussed earlier. Operations were charged $148.3 in 2000 from increases in estimated loss and LAE for claims occurring in prior years. These increases were due to adverse development within commercial operations in workers’ compensation ($50.9), general liability ($44.4) primarily related to construction defect, commercial auto ($23.5), and in other ($29.5) lines of business as the costs of settling claims increased. Property & Casualty operations were charged $78.8 in 1999 due to increased losses including construction defect, asbestos and environmental, and workers’ compensation.
IBNR reserves comprise 69% of total environmental and asbestos reserves at December 31, 2001. The incurred losses and LAE amount of $51.7 in the table above includes $50.0 of loss reserve strengthening. Continued emergence of these claims has resulted in higher ultimate expected losses than previously estimated. While Property & Casualty has generally avoided writing coverages for larger companies with substantial exposure in these areas, recent industry experience with asbestos claims has shown an expansion of defendants to include smaller and more peripheral firms. The exposure of the assumed reinsurance operations also follows the general industry trend. This has resulted in higher estimates of ultimate losses. Developing industry trends will continue to be monitored and used in conjunction with other quantitative loss reserving techniques to evaluate reserves on an ongoing basis.
The significant uncertainties involved in the reserving for these claims include future court resolution, judicial interpretations, regulatory actions, industry experience as well as company experience. Changes in these factors could result in future claims significantly different from those currently predicted. The impact upon reserves of changes in these factors would be reflected in future operating results.
Construction defect claims are a subset of claims that arise from coverage provided by general property damage liability insurance. Construction defect claims arise from the alleged defective work performed in the construction of large habitation structures, such as apartments, condominiums and large developments of single-family dwellings or other housing. In addition to damages arising directly from the alleged defective work, construction defect claims often also allege that the economic value of the structure has been diminished. The vast majority of Property & Casualty’s construction defect claims arise from past contractor business written in the state of California. Commercial Insurance, which does not include SBI, has avoided writing the construction class of business in California since 1989 and has limited exposure to these types of claims. However, American States, prior to its acquisition by SAFECO, was a major writer of California contractor business until 1994 when it implemented significant restrictions in this line. Continued loss development in California as well as emerging claims in other states resulted in additions to reserves of $90.0 as part of the loss reserve strengthening in September 2001.
The following table presents the loss and LAE reserve activity for liability coverages related to construction defect claims, before reinsurance:
The significant uncertainties involved in the reserving for these claims include future court resolution, judicial interpretations, regulatory actions, and industry experience as well as company experience. Changes in these factors could result in future claims significantly different from those currently predicted. The impact upon reserves of changes in these factors would be reflected in future operating results.
See discussion on Impact of Terrorism and its impact on reinsurance.
Approximately 42% of the total reinsurance recoverables balance at December 31, 2001 was with the following four reinsurers: American Re-Insurance, Employers Reinsurance Corporation, Swiss Reinsurance America Corporation and General Reinsurance Corporation all of whom are rated A++ by A.M. Best. The reinsurance recoverables balance categorized by reinsurer rating (by A.M. Best Company on a scale ranging from A++ to F) at December 31, 2001 is presented below:
Property & Casualty’s nationwide catastrophe property reinsurance program for 2002, covering 90% of $400.0 of single-event losses in excess of $100.0 retention, is unchanged from 2001. In a large catastrophe, Property & Casualty retains the first $100.0 of losses, 10% of the next $400.0 and all losses in excess of $500.0. In 2001, in addition to this nationwide coverage, for all states other than California, SAFECO had a supplemental earthquake-only reinsurance contract that covered 90% of $250.0 of single-event earthquake losses in excess of $500.0. Given Property & Casualty’s successful efforts to reduce West Coast earthquake exposure, it was no longer considered necessary to continue this excess contract in 2002. Catastrophe property reinsurance contracts for 2002 include provisions for one reinstatement for a second catastrophe event in 2002 at current rates.
Property & Casualty does not enter into retrospective reinsurance contracts and does not participate in any unusual or nonrecurring reinsurance transactions such as “swaps” of reserves or loss portfolio transfers. Property & Casualty does not use funding covers and does not participate in any surplus relief transactions. Additional information on reinsurance can be found in Note 5 of the Notes to Consolidated Financial Statements.
Life & Investments offers individual and group insurance products, retirement services, annuity products, mutual funds and investment advisory services. The most significant product lines in terms of premium and deposit volume include single premium immediate and deferred annuities, business owned life insurance, variable annuities, tax-sheltered annuities, corporate retirement plans, excess loss group medical insurance and individual life insurance.
Earnings before investment losses and income taxes (pretax income) for all lines combined were $148.6 ($197.5 before goodwill write-down), $168.5 and $195.1 in 2001, 2000 and 1999, respectively. The main reason for the increase in income in 2001 (before goodwill write-down) versus 2000 was due to improved results in Income Annuities and Group.
SAFECO’s ratings downgrades in early 2001 have impacted Life & Investments’ ability to sell some of its products. The impact of the ratings downgrades and other information about the lines of business are explained further below.
The following table summarizes the pretax income (loss) for Life & Investments major product lines:
Effective December 31, 2001, SAFECO’s asset management companies and Talbot Financial Corporation are reported as part of the Life & Investments operating results. Prior period information has been reclassified to reflect this change.
SAFECO’s retirement services operations produced pretax income of $15.6, $30.0 and $52.6 in 2001, 2000 and 1999, respectively. Retirement services products are primarily tax-sheltered annuities (marketed primarily to teachers and not-for-profit organizations), fixed and variable deferred annuities (both qualified and non-qualified), guaranteed investment contracts (GIC) and corporate retirement funds. This line has protection against early withdrawals of most of these products in the form of surrender charges during the initial years of each policy or the option to defer payouts over five years. Pretax income declined by $14.4 in 2001 due to the decline in assets under management during the first two quarters of 2001, a reduction in variable product fee revenue due to unfavorable market conditions and an increase in operating costs. Pretax income declined $22.6 in 2000 compared to 1999 mainly due to losses from the Equity Index Annuity (EIA) product and a decline in assets under management.
Losses on the EIA product were $14.4, $15.3 and $2.9 in 2001, 2000 and 1999, respectively. In 2001 and 2000, offers were extended to EIA policyholders to surrender their policies and receive their account values with no surrender charge. This resulted in a charge to income totaling $5.8 and $12.0 in 2001 and 2000, respectively. At December 31, 2001, $161.0 remained on deposit for the EIA product compared to $305.0 and $596.0 at December 31, 2000 and 1999, respectively. Life & Investments stopped marketing this product in 1999.
SAFECO’s individual life operations produced pretax income of $22.8, $24.6 and $30.1 in 2001, 2000 and 1999, respectively. Individual products include term, universal and variable universal life and business owned life insurance (BOLI). BOLI is universal life insurance sold to banks and is extremely sensitive to financial strength ratings. Pretax income declined $1.8 in 2001 due to increased claims experience which was partially offset by increased earnings on BOLI, permanent and term life products. New BOLI deposits were $120.0, $710.0 and $705.0 in 2001, 2000 and 1999, respectively. The decline in the BOLI deposits in 2001 is due to the ratings downgrade that is discussed further in the Ratings section of this MD&A.
The Corporation has made loans to certain officers and other members of management related to stock option exercises and home purchases related to relocations upon initial hiring. At December 31, 2001 these related-party loans totaled less than $10.0. Corresponding interest income on the related party loans is included in the Corporate segment.
The Corporation’s wholly-owned subsidiary, SAFECO Financial Products (SFP) was organized in 2000, to write S&P 500 index options to mitigate the risk associated with the EIA (see Life & Investments section for further discussion on EIA). Due to the success of this activity, SFP also engaged in limited activity for its own account in 2001 by writing S&P 500 index options, selling single credit default swaps and investing in convertible bonds. These activities are not designed as hedging activities. Consequently, both changes in the fair values of these instruments and any realized gain or loss are recognized in current income. Net investment income includes the premium income on the single credit default swaps and the earnings and fair value adjustments for the S&P 500 index options and the convertible bonds. Realized gain or loss includes the fair value adjustments and realized gains or losses from the single credit default swaps. Pretax income before realized loss was $6.7 and $2.3 for 2001 and 2000, respectively. Realized loss was $18.2 in 2001 including a $7.8 loss from an Enron single credit default swap. There were no realized gains or losses in 2000.
The table below summarizes the quality of the single credit default swap portfolio:
consolidated investments. Because the assets and operations are not material to the consolidated financial statements, they have not been reclassified as discontinued operations. In the Consolidated Statements of Income (Loss), revenues for SAFECO Properties are included in Other Revenues and related expenses are included in Other Expenses. For 2001, 2000 and 1999, these revenues totaled $10.4, $20.5 and $39.3 and expenses totaled $9.9, $16.7 and $32.1, respectively. SAFECO Properties’ income before realized gains and income taxes is included in the Corporate segment and totaled $0.5, $3.8 and $7.2, for 2001, 2000 and 1999, respectively.
SAFECO Credit generated after tax profits for the seven months ended July 31, 2001 of $4.2 and years ended December 31, 2000 and 1999 of $12.7 and $14.5, respectively.
SAFECO’s operations have liquidity requirements that vary among the segments and their principal product lines. Life insurance, retirement services and annuity product reserves are primarily longer-term liabilities that are typically predictable in nature and are supported by investments that are generally longer-term. Property & Casualty liabilities are both short-term and long-term. These liabilities are less predictable in nature and generally require greater liquidity in the investment portfolio.
The Corporation’s liquidity needs are met by dividends from its subsidiary operations, the sale and maturity of invested assets, bank borrowings and issuances of commercial paper and debt. The subsidiaries’ primary sources of cash from operations are insurance premiums, funds received under deposit contracts, dividends, interest and asset management fees. SAFECO has not engaged in the sale by securitization of any investments or other assets.
Given the number of changes underway, SAFECO’s ability to achieve the goals of improving the profitability of Property & Casualty and maintaining the profitability of its entire operations involves uncertainty. SAFECO’s liquidity needs are currently being met and the successful achievement of its goals will enhance its liquidity position; conversely, further deterioration of profitability may adversely affect its capital resources and liquidity position.
Short-term investments and cash at December 31, 2001 were significantly higher than at December 31, 2000 due primarily to proceeds received from the sale of SAFECO Credit in August 2001. The cash received was invested in primarily short-term commercial paper and will be re-invested long term as the commercial paper matures during the first half of 2002.
Funds received under deposit contracts relate primarily to annuity, retirement services and individual products of Life & Investments. Of the total $14.6 billion in deposit contracts at December 31, 2001, approximately 43% are structured settlement immediate annuity products. These annuities have an average expected maturity of over 25 years at issuance and cannot be surrendered by policyholders. Equity indexed annuities (EIA), comprising approximately 1% of total deposit contracts, have remaining expected maturities of approximately 4 years and associated surrender charges ranging from 8% in year one to zero after year six. During 2000 and 2001, Life & Investments offered to waive surrender charges on several different occasions in order to induce EIA policyholders to surrender their contracts. These offers were successful and resulted in a reduction of the EIA policy account balance of $144.0 and $291.0 in 2001 and 2000, respectively. Since the EIA book of business had been generating ongoing losses, reducing the size of the book will reduce the amount of future losses. These surrenders accounted for the majority of the increase in the return of funds held under deposit contracts in 2000 compared with 1999 (see Consolidated Statements of Cash Flows for more information). Other annuity and retirement services products comprise approximately 31% of total deposit contracts. These products generally have expected maturities of 5 to 20 years at issuance and associated surrender charges ranging from 10% to 5% in year one reduced to zero within 5 to 10 years. Life & Investments retains the option to defer payouts over 5 years on approximately 20% of these contracts. Universal life products comprise approximately 22% of total deposit contracts. Of the total universal life product deposit contracts, 80% are business owned life insurance (BOLI) policies which have expected maturities of 20 to 25 years at issuance with surrender charges varying according to policy type. As a result of the downgrade in SAFECO’s ratings, Life & Investments new BOLI deposits declined to $120.0 in 2001 compared to $710.0 and $705.0 in 2000 and 1999, respectively. The guaranteed investment contracts within the retirement services area comprise the remaining 3% of total deposit contracts.
The high level of proceeds from the maturity of fixed maturities in all three years was due primarily to the high number of calls of fixed maturities and prepayments of mortgage-backed securities. These calls and prepayments were primarily due to the lower interest rate environment during the past three years and issuer-driven actions. The high level of purchase and sale activity related to fixed maturities available-for-sale in 2000 and 1999 was due in part to shifting a portion of Property & Casualty’s bond holdings from tax-exempt to taxable bonds. The reason for this shift was to maximize the portfolio’s after-tax return in view of the higher level of underwriting losses in 2000 and 1999 and the resulting alternative minimum tax. The high level of proceeds from equity securities in 2000 is mainly due to approximately $300.0 of planned equity securities sales out of Property & Casualty’s investment portfolio in the third quarter. The proceeds from these equity securities sales were reinvested in taxable fixed-income securities. These sales resulted in increased realized gains from equity securities in 2000 compared with 1999. Additional information on realized gains can be found in Note 2 of the Notes to Consolidated Financial Statements.
In order to reduce refinancing risk, on March 16, 2000, the Corporation issued $300.0 of medium-term notes at 7.875% which mature on March 15, 2003. In conjunction with this debt issue, the Corporation entered into interest rate swap agreements. The swaps are for notional amounts totaling $300.0 and replace the fixed rates of the medium-term notes with variable rates at 65.03 basis points over the 90-day LIBOR rate. The swaps mature in March 2003. The $300.0 of medium-term notes issued is part of a shelf offering of $800.0 made earlier in 2000. The Corporation has available $500.0 under the existing shelf registration.
The claims-paying abilities of insurers are rated to provide both insurance consumers and industry participants with comparative information on specific insurance companies. Claims-paying ratings are important for the marketing of certain insurance products, e.g., structured settlement annuities, business owned life insurance. Higher ratings generally indicate greater financial strength and a stronger ability to pay claims. Ratings focus on factors such as results of operations, capital resources, debt-to-capital ratio, demonstrated management expertise in the insurance business, marketing, investment operations, minimum policyholders’ surplus requirements and capital sufficiency to meet projected growth, as well as access to such traditional capital as may be necessary to continue to meet standards for capital adequacy.
Due primarily to Property & Casualty ‘s continued poor underwriting results, SAFECO’s claims-paying and corporate credit ratings have been lowered in recent years, most recently in the first half of 2001. As of December 31, 2001, A.M. Best maintains a negative outlook on Property & Casualty’s financial strength rating and the Corporation’s debt rating. All other rating agency ratings are stable. Lower operating results combined with increased operating leverage in Property & Casualty contributed to lower debt service coverage for the Corporation. Although overall interest expense for the Corporation has decreased due to the general market decline in short term borrowing rates in 2001, SAFECO’s relative interest rates on short term borrowing are higher due to the ratings downgrades. SAFECO believes its financial position is sound and has action plans in place to improve Property & Casualty results. It is, however, possible that further negative ratings actions may occur. Lower ratings have significantly affected Life & Investments ability to sell income annuities and business owned life insurance products. If ratings are further lowered, SAFECO may incur higher borrowing costs, may have more limited means to access capital, and may have additional difficulties marketing certain of its insurance products that are dependent upon ratings being at or above a particular level of risk.
Those states in which SAFECO’s insurance subsidiaries are domiciled or deemed to be commercially domiciled limit the amount of dividend payments that can be made by those subsidiaries without prior regulatory approval. These limitations are not anticipated to keep the insurance subsidiaries from paying dividends to the Corporation in 2002 in amounts sufficient to fund its shareholder dividends and service debt. Based on the statutory limits as of December 31, 2001, the Corporation is able to receive approximately $470.0 in dividends from its subsidiaries in 2002 without obtaining prior regulatory approval.
SAFECO’s consolidated pretax investment income increased to $1,649.3 during 2001 from $1,633.5 and $1,588.3 in 2000 and 1999, respectively. Substantially all of this investment income is produced by the investment portfolios of Property & Casualty and Life & Investments. The net investment income (loss) detail is presented below:
Consolidated pretax realized gains from security investments totaled $93.0, $139.5, and $82.6 in 2001, 2000 and 1999, respectively. The increase in realized gains in 2000 is mainly due to realized gains on approximately $300.0 of planned equity securities sales out of Property & Casualty’s investment portfolio during the third quarter 2000. The proceeds from these equity securities sales were reinvested in taxable fixed-income securities. Additional information on realized gains can be found in Note 2 of the Notes to Consolidated Financial Statements.
Property & Casualty’s investment portfolio totaled $8.5 billion at estimated fair value at December 31, 2001, compared with $8.3 billion at December 31, 2000. The investment philosophy for Property & Casualty’s portfolio is to emphasize investment yield without sacrificing investment quality, and to provide for liquidity and diversification. Fixed maturities securities comprised 77% of this portfolio while equity securities comprised 18%.
The quality of Property & Casualty’s fixed maturities portfolio is detailed in the following table:
The quality of Life & Investments’ fixed maturities portfolio is detailed in the following table:
This portfolio contains $643.1 at fair value of securities rated below investment-grade quality. These securities represent approximately 4% of the total $16.3 billion Life & Investments portfolio at fair value at December 31, 2001. On a consolidated basis, below investment-grade securities with a fair value of $790.8 were held at December 31, 2001. (The related amortized cost amount is $858.9 or 109% of the fair value.) These securities represented approximately 4% of total consolidated securities investments at fair value at December 31, 2001. As discussed above, investment write-downs impacting income have and may continue to occur on these below investment grade securities.
SAFECO’s investment portfolio includes approximately $297.0 and $403.8 of fixed maturities at December 31, 2001 and 2000, respectively that are not publicly traded. This represents less than 2% of total fixed maturity investments. Fair values for these securities have been estimated using quoted market prices of comparable instruments and/or internally prepared valuations using third party modeling tools.
The quality rating of SAFECO’s mortgage-backed security portfolio is shown in the following table:
SAFECO’s consolidated investment portfolio also included $924.2 of mortgage loan investments at December 31, 2001, representing approximately 4% of total investments. The collateral value of the mortgage portfolio was approximately $1.6 billion at December 31, 2001 making the loan-to-value on the mortgage portfolio less than 60%. Historically the mortgage portfolio has performed well and the loan charge-off rate has been very low on this portfolio over the past three years (see additional information about the allowance for mortgage loans in Note 2 of the Notes to Consolidated Financial Statements). The majority of these loans are held by Life & Investments and are secured by first mortgage liens on completed, income-producing commercial real estate, primarily in the retail, industrial and office building sectors. The majority of the properties are located in the western United States, with approximately 69% of the total in the states of Washington (32%), Oregon (11%) and California (26%). Individual loans generally do not exceed $10. Less than 1% of the loans were non-performing at both December 31, 2001 and 2000. The allowance for mortgage loan losses was $10.5 and $10.8 at December 31, 2001 and 2000, respectively.
Statements made in this report that relate to anticipated financial performance, business prospects and plans, regulatory developments and similar matters are “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995. Statements in this report that are not historical information are forward-looking. The operations, performance and development of SAFECO’s business are subject to certain risks and uncertainties which may cause actual results to differ materially from those contained in or suggested by the forward-looking statements in this report. The risks and uncertainties include:
The ability to obtain rate increases and non-renew underpriced insurance accounts;
Success in obtaining regulatory approval of price tiered products and the use of insurance scores;
The ability to manage exposure to the Lloyd’s of London underwriting market;
The ability to exclude and to reinsure the risk of loss from terrorism;
Changes in tax laws and regulations that affect the favorable taxation of certain life insurance products or that decrease the usefulness of life insurance products for estate planning purposes;
The effect of current insurance and credit ratings levels on business production;
The financial statements and schedules listed in the Index to Financial Statements, Schedules and Exhibits on page FS-1 are filed as part of this report.