We lease our current headquarters of 305,000 square feet in Seattle, Washington. We own data centers of 97,000 square feet in Washington and Colorado and lease an additional 1.8 million square feet of space throughout the United States.
(1) Discontinued Operations reflect our Life & Investments (L&I) businesses that were sold in 2004.
(4) Our 2006 average diluted shares reflect the repurchase of 10.2 million shares pursuant to an accelerated share repurchase program and 10.0 million shares pursuant to Rule 10b5-1 trading plans.
We have made statements under the captions “Our Business,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere in this Form 10-K that are forward-looking statements. We have tried, whenever possible, to identify such statements by using words such as “will,” “anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,” “believe,” “target,” “forecast,” and other words and terms of similar meaning in connection with any discussion of future operating or financial performance or business plans and prospects.
In 2007, we focused on achieving a balance between growth and profitability. We:
Improved our pricing models in our Homeowners and Auto lines using Safeco True Pricing
Managed our capital actively for the benefit of our shareholders, as we increased our dividend rate by 33%, repurchased $1.0 billion of our common stock and repaid of $545.9 of our higher cost debt
Our Auto combined ratio increased to 98.8% in 2007 and exceeded 100% for the 4th quarter, as loss costs, principally related to bodily injury, increased faster than our ability to increase rates. We plan to maintain our underwriting discipline and not compete for business that we do not believe will meet our long-term target margins. In 2008, we will focus on lowering our combined ratio to our target of 96.0% in Auto, rather than pursuing growth opportunities. Our ability to achieve this will depend in part on the effectiveness of current efforts to reduce loss costs through improved training and logistics management and our ability to obtain rate increases necessary to properly match rate to risk. As our loss costs have risen, we have taken steps to offset with rate increases. In 2007, we increased our Auto premium rates an average of 4%, most of which will be earned into premium in 2008. Rates are subject to regulatory approval on a state-by state basis and increases may take time to implement.
In our commercial surety business, we continued to focus on Fortune 1000 and other large companies with high credit quality to drive that business at a solid pace and we increased capacity on our highest rated accounts. We have grown our Surety business in 2007 by focusing on our highest credit quality accounts and new account growth. We achieved record underwriting profits in our Surety segment in 2007. We do not expect to be able to maintain that level of profitability in 2008 as we do not expect historically low loss levels to recur.
In 2008, we must realize benefits from our business process improvement effort that is examining all aspects of our operations for potential cost savings. The goal is to achieve greater efficiency by streamlining or eliminating processes, outsourcing processes where appropriate, and building our infrastructure and technological capability. We met our targeted annualized expense savings in 2007 offset in part by increased spending associated with strategic technology and claims initiatives and increased advertising. In 2008, we expect to achieve $25 to $50 million in expense savings. Some of these savings will benefit the bottom line directly, and we may choose to reinvest a portion in various strategic initiatives. We expect the savings will be derived from a number of projects, including for example, further outsourcing of administrative functions to lower-cost markets and continued review of in-house operations to create efficiencies using Lean Six Sigma methodologies.
We are committed to further reducing our expenses, which will allow us flexibility to enhance our competitive position while still achieving our target margins. We plan to continue to retain customers and maintain opportunities to quote new business through enhancements to our Safeco Now Sales-and-Service platform, our focus on agency relationships, customer retention efforts and distinctive customer service.
We measure our success by tracking our operating and financial performance according to the following indicators:
In addition, we track our operating performance with various productivity and efficiency measures; we report periodically on a subset of productivity measures, such as policies-in-force per full-time equivalent employee (PIF per FTE) and expense per policies-in-force (expense per PIF).
(2) Expense represents annual (12 month trailing) G&A expense and paid ULAE (loss handling expenses). It excludes commissions, legal defense costs, premium taxes and certain other expenses.
In addition to the activities of these segments, we report certain transactions in our corporate segment, such as the interest expense we pay on our debt, debt repurchases, miscellaneous corporate investment income, intercompany eliminations, real-estate holdings, contributions to Safeco Insurance Foundation (the Foundation) and other corporate activities and do not allocate these to individual reportable segments.
We look at these measures to assess the results of our business segments:
Combined ratio is our losses, LAE and underwriting expenses divided by our net earned premiums. We report combined ratio as a percentage. For example, a combined ratio of 95% means that for every dollar of premium earned, 95 cents is spent on losses, LAE and underwriting expenses, and 5 cents is underwriting profit. The lower the combined ratio, the better the results.
More information about our segment results can be found in Our P&C Operating Results section of Item 7: MD&A.
The following table presents our consolidated financial information. A detailed discussion of our results by segment follows.
Total revenues decreased 1.3% in 2007 compared with 2006, and decreased 1.0% in 2006 compared with 2005. The changes were driven by:
Net investment income - Our net investment income decreased 4.4% in 2007 compared with 2006, and increased 4.9% in 2006 compared with 2005. The decrease in 2007 compared with 2006 was the result of the shift in our portfolio strategy throughout 2006 to tax-exempt municipal bonds, and an overall lower invested asset base due primarily to the sale of securities to fund the maturity and redemption of our debt and the special dividend paid by our operating subsidiaries to Safeco Corporation that has not been reinvested. The increase in 2006 compared with 2005 was due to slightly higher interest rates in 2006.
Net realized investment gains - Net realized investment gains increased $142.3 in 2007 compared with 2006, and decreased $56.6 in 2006 compared with 2005. The increase in 2007 compared with 2006 was due primarily to a $28.7 tax-exempt increase in the gain from the contributions of highly appreciated marketable equity securities to Safeco Insurance Foundation (the Foundation), the sale of securities to fund the special dividend paid by our insurance subsidiaries to Safeco Corporation and the sale of securities to increase our cash position for future share repurchases. The decrease in 2006 compared with 2005 was due to losses on securities sold and increased impairments caused primarily by changes in fair value (driven by interest rates) on securities that we may not hold until they recover in value. The 2006 net realized investment gains included a tax-exempt gain of $29.2 on securities contributed to the Foundation. Net realized investment gains included pretax impairments of $56.0 in 2007, $79.2 in 2006 and $15.5 in 2005.
Net income decreased 19.6% in 2007 compared with 2006, while net income increased 27.3% in 2006 compared with 2005, driven by:
Catastrophe Losses - In 2007 and prior years, we categorize catastrophes as events resulting in losses greater than $0.5 per event and involving multiple claims and policyholders. Beginning in 2008, catastrophes are events resulting in losses greater than $1.0 involving multiple claims and policyholders. Pretax catastrophe losses, net of reinsurance, were $104.3 in 2007 compared with $155.3 in 2006 and $267.4 in 2005. Catastrophe losses in 2005 were primarily from hurricanes Katrina and Rita along the Gulf Coast.
Interest expense - Interest expense decreased $22.7 in 2007 compared with 2006 as a result of our redemption and the maturity of debt in July 2007. The increase of $2.8 in 2006 compared with 2005 was due to increased interest rates on the portion of our debt that is swapped to floating rates, partially offset by a decrease in interest expense as a result of our debt repurchases described below.
Net realized investment gains - After-tax net realized investment gains were $115.3 in 2007, compared with $11.7 in 2006 and $43.5 in 2005. Results for 2007 included a tax-exempt gain of $57.9 on securities contributed to the Foundation, compared with a $29.2 of tax-exempt gain on our contribution of securities to the Foundation in 2006. The increase in 2007 when compared with 2006 was also attributable to the sale of securities to fund the special dividend paid by our insurance operating subsidiaries to the parent company and the sale of securities to increase our cash position for future share repurchases.
Provision for income taxes - Our effective tax rate was 25.7% in 2007, 29.0% in 2006 and 29.9% in 2005. The decrease in our effective tax rate in 2007 primarily reflected increased investments in tax-exempt fixed maturities and the tax-exempt contribution of highly appreciated marketable equity securities to the Foundation. The decrease in our effective tax rate in 2006 reflected increased investments in tax-exempt fixed maturities, the tax-exempt contribution to the Foundation and interest received on a tax refund. Included in our 2005 results was a $10.6 tax benefit stemming primarily from the favorable resolution of state tax-related issues.
The following table details the categories of our other underwriting and operating expenses:
* Includes service fee income, policyholder dividends, brokerage expenses and other miscellaneous corporate expenses.
The decrease in our other underwriting and operating expenses in 2006 compared with 2005 primarily reflects a reduction in costs related to business process improvement efforts, reductions in rent and other expenses due to consolidation of regional offices and the sale of our life insurance group, and lower loss based assessment surcharges and state taxes. The overall decrease was offset primarily by increases in our deferred policy acquisition costs due to premium growth, and increases in professional services due to business process improvement efforts.
In addition to financial measures presented in the consolidated financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP), we also use certain non-GAAP financial measures to analyze and report our financial results. Management believes that these non-GAAP measures, when used in conjunction with the consolidated financial statements, can aid in understanding our financial condition and results of operations. These non-GAAP measures are not a substitute for GAAP measures, and where these measures are described we provide tables that reconcile the non-GAAP measures to the GAAP measures reported in our consolidated financial statements.
Premiums are the primary driver of our revenues, along with net investment income and net realized investment gains or losses. Net written premiums are a non-GAAP measure representing the amount of premium charged for policies issued with effective dates during the period. Premiums are included as revenue in the Consolidated Statements of Income as they are earned over the underlying policy period. Net written premiums applicable to the unexpired term of a policy are recorded as unearned premiums on our Consolidated Balance Sheets.
Net written premiums decreased $96.0, or 3.6%, in 2007 compared with 2006 and decreased $142.3, or 5.0%, in 2006 compared with 2005. The changes in net written premiums were primarily driven by:
Policies-in-force (PIF) - PIF decreased 3.4% in 2007 compared with 2006 and decreased 4.1% in 2006 compared with 2005. This decrease reflected increased competition that resulted in decreased new business in 2007, 2006 and 2005. New policies sold decreased 1.8% in 2007 compared with 2006, and 23.0% in 2006 compared with 2005. Retention of policies was 80.2% in 2007 and 79.5% in both 2006 and 2005.
Changes in average premiums - We file rate changes on a state-by-state basis. Rate changes are reflected on existing policies at renewal and are earned in our revenues over the six-month policy term. Overall, we received approval for average rate increases of 4.2% in 2007, increases of 1.2% in 2006 and decreases of 0.4% in 2005. Premiums also are affected by the increased pricing for those policies that cover newer and more expensive cars, as well as by changes in the risk profile of the book of business, which we refer to as premium trend. Premium trend was negative in 2007 and 2006, resulting from a change in our mix of business to lower average premium policies. This is primarily due to a reduced premium base of non-standard policies, or drivers who represent relatively higher risks.
Net earned premiums decreased $108.4, or 4.0%, in 2007 compared with 2006, and decreased $107.2, or 3.8%, in 2006 compared with 2005. The decreases in net earned premiums were primarily driven by:
Changes in average premiums - Changes in average premiums decreased net earned premiums by $19.7 in 2007 compared with 2006, and decreased net earned premiums by $41.1 in 2006 compared with 2005.
Our underwriting results decreased $212.3, and our combined ratio increased 7.8 points in 2007 compared with 2006. Our underwriting results increased $104.5, and our combined ratio decreased 4.1 points in 2006 compared with 2005. The changes in our underwriting results and combined ratio were primarily driven by:
Prior-year reserve development - The favorable prior-year reserve development in 2007 and in 2006 reflected lower-than-expected severity on bodily injury claims, primarily in accident years 2004 and 2005. The favorable prior-year reserve development in 2005 reflected a decrease in severity estimates for prior accident years across liability lines compared with our original estimates. The change in prior-year reserve development increased our combined ratio by 2.8 points in 2007 compared with 2006, and the change in prior-year reserve development decreased our combined ratio by 2.4 points in 2006 compared with 2005.
Expenses - The increase in our expense ratio of 0.6 points in 2007 compared with 2006 was driven by additional agent commission resulting from our restructured 2007 agent compensation program, partly offset by our ongoing process improvement efforts and expense reduction initiatives. The increase in our expense ratio of 0.3 points in 2006 compared with 2005 was driven by our increased investment in technology and costs related to the implementation of our process improvement efforts.
Net earned premiums increased $33.3, or 3.7%, in 2007 compared with 2006, and decreased $4.3, or 0.5%, in 2006 compared with 2005. This reflected:
Changes in PIF - The change in PIF increased net earned premiums by $46.9 in 2007 compared with 2006, and the change in PIF increased net earned premiums by $4.9 in 2006 compared with 2005.
Our underwriting profit in Property decreased $37.6, and our combined ratio increased 4.6 points in 2007 compared with 2006. Our underwriting profit decreased $34.5, and our combined ratio increased 3.7 points in 2006 compared with 2005. The changes in our underwriting results and combined ratios were primarily driven by:
Catastrophe losses - Pretax catastrophe losses in 2007 included $20.0 related to the California wildfires. Excluding the impact of prior-year reserve development, catastrophe losses decreased the combined ratio by 3.3 points in 2007 compared with 2006. Pretax catastrophe losses in 2006 included $22.5 related to the Pacific Northwest windstorm in December 2006. Pretax catastrophe losses in 2006 decreased the combined ratio by 1.6 points in 2006 compared with 2005. Pretax catastrophe losses in 2005 included $53.7 from Hurricanes Katrina, Rita and Wilma along the Gulf Coast.
Net written premiums increased $9.6, or 8.7%, in 2007 compared with 2006, and $9.3, or 9.2%, in 2006 compared with 2005. New-business policies sold increased 17.4% in 2007 compared with 2006, and 18.8% in 2006 compared with 2005. Net written premium growth in 2007 was primarily driven by an increase in new business in our umbrella and motorcycle products. New business growth in 2007 was primarily driven by improvements in automation, rating and increased customer awareness of our products. The increased premiums in 2006 were due to an increase in new motorcycle policies and in the numbers of motorcycle policies that renewed with us, resulting in an increase in PIF.
Outlook - We expect to continue to grow our specialty product modestly in non-catastrophe prone areas, while operating at or below our long-term target combined ratio of 92.0% in 2008.
Our SBI Regular segment provides insurance for small- to mid-sized businesses (customers who typically pay annual premiums of $250,000 or less). This is our core commercial lines business featuring these main products:
Net written premiums increased $61.2, or 4.8% in 2007 compared with 2006, and were flat in 2006 compared with 2005. The changes in net written premiums were driven by:
Price changes - We file rate changes on a state-by-state basis. Our average prices, which include filed rate changes and exposure growth, increased 0.5% in 2007, after decreasing 1.4% in 2006 compared with 2005. Premiums are affected by growth in the exposures we cover due to factors such as changes in payroll, the number of employees, sales receipts and property building values for the businesses we insure. Price changes are reflected on existing policies at renewal.
Price changes - Price changes decreased net earned premiums by $6.3 in 2007 compared with 2006, and decreased net earned premiums by $22.5 in 2006 compared with 2005.
Mix of business - Mix of business increased net earned premiums by $27.9 in 2007 compared with 2006 and $0.7 in 2006 compared with 2005.
Price changes - Our price changes increased our combined ratio by 0.4 points in 2007 compared with 2006, and increased our combined ratio by 1.2 points in 2006 compared with 2005.
Prior-year reserve development - The favorable prior-year reserve development in 2007 was due to better-than-expected loss experience on long-term workers’ compensation medical claims and favorable claim frequency for umbrella and construction defects claims, partially offset by increased claim severity in auto liability. The favorable prior-year reserve development in 2006 was due to lower-than-expected claims frequency in CMP partially offset by an increase in auto liability claims severity. The change in prior-year reserve development decreased the combined ratio by 0.8 points in 2007 compared with 2006 and increased the combined ratio by 0.8 points in 2006 compared with 2005.
Catastrophe losses - The lower catastrophe losses decreased our combined ratio by 0.4 points in 2007 compared with 2006 and 2.4 points in 2006 compared with 2005.
Outlook - We anticipate a challenging market for premium growth in our SBI Regular segment in 2008, in a continuing soft market in which loss cost increases may outpace earned price increases. Our long-term target combined ratio is 95.0%.
Our SBI Special Accounts Facility segment includes insurance for large-commercial accounts (those with annual premiums of more than $250,000). While our main focus is the small- to mid-sized market, we continue to serve some large-commercial accounts on behalf of key agents and brokers who sell our core commercial products.
Property, auto and professional and general liability insurance for non-profit social service organizations
Our underwriting profit decreased $10.2, and our combined ratio increased 3.6 points in 2007 compared with 2006. Our underwriting profit decreased $10.0, and our combined ratio increased 1.8 points in 2006 compared with 2005. The changes in our underwriting results and combined ratio primarily reflected:
Prior-year reserve development - The favorable prior-year reserve development in 2007, 2006 and 2005 was primarily related to general liability coverages. The change in prior-year reserve development increased our combined ratio by 4.5 points in 2007 compared with 2006, and the change in prior-year reserve development increased our combined ratio by 0.5 points in 2006 compared with 2005.
Catastrophe losses - The higher catastrophe losses increased our combined ratio by 1.6 points in 2007 compared with 2006. The lower catastrophe losses decreased our combined ratio by 3.2 points in 2006 compared with 2005.
Net earned premiums increased $55.4, or 18.6%, in 2007 compared with 2006 and $36.6, or 14.0%, in 2006 compared with 2005. New business increased net earned premiums by $45.0 in 2007 compared with 2006 and $32.2 in 2006 compared with 2005.
Our underwriting profit increased $49.6, and our combined ratio decreased 8.8 points in 2007 compared with 2006. Our underwriting profit increased $43.4, and our combined ratio decreased 12.0 points in 2006 compared with 2005. The increases were driven by premium growth combined with historically low levels of loss experience, loss cost containment, and expense management.
Results of business related to Safeco Financial Institution Solutions (SFIS), our lender-placed property insurance business, which we sold on April 30, 2006
Our underwriting results increased $20.3 in 2007 compared with 2006 and increased $49.5 in 2006 compared with 2005. Our underwriting results and combined ratio primarily reflected:
Prior-year reserve development - Our 2007 underwriting results included $12.9 of unfavorable prior-year reserve development in 2007, primarily related to reserve increases for asbestos exposure claims and for allegations against religious institutions, partially offset by reduced estimates for construction defects. In 2006, $50.3 of unfavorable prior-year reserve development was primarily related to asbestos claims and allegations against religious institutions. In 2005, $48.2 of unfavorable prior-year reserve development was primarily driven by reserve increases in assumed reinsurance and asbestos and environmental claims, partially offset by favorable construction defects reserve development.
We analyze our reinsurance recoverables according to the credit ratings and types of reinsurers. At year-end 2007:
Our property catastrophe reinsurance is excess-of-loss reinsurance, which provides us with reinsurance coverage over an agreed-upon amount. The terms of our property catastrophe reinsurance in 2008 are:
Our reinsurers reimburse us 90% for the next $400.0 of the loss. We absorb the other 10%.
For earthquake events, we have an additional level of coverage. Our reinsurers reimburse us for 90% of $500.0 in excess of the first $600.0 of the loss. The entire amount of any earthquake loss above $1,100.0 is ours.
Our reinsurers reimbursed us 90% for the next $300.0 of the loss. We absorbed the other 10%.
Under our catastrophe treaty, our reinsurers reimburse us 90% of the next $30.0.
Should we make a workers’ compensation catastrophe claim to our reinsurers, we can reinstate this reinsurance coverage with payment of an additional premium.
Our reinsurers reimburse us 80% of the next $110.0 of the loss under each of the three layers of coverage.
Reinsurance Options - The availability of terrorism reinsurance is limited in the commercial reinsurance market. Our current reinsurance program provides limited terrorism coverage. All reinsurance treaties exclude acts involving nuclear, chemical, biological or radioactive materials. Treaties providing coverage for both certified and non-certified terrorist acts include our workers’ compensation reinsurance program and our commercial umbrella reinsurance program. Additionally, our commercial property treaty provides coverage for non-certified terrorist acts. Our property catastrophe treaty provides coverage for non-certified terrorist acts for 90% of $400.0 above the first $200.0 of loss.
Our Exposure is Modest - We have strict underwriting guidelines, and believe our exposure to potential terrorism losses is relatively modest across all our product lines. With commercial insurance, our focus is on small- to mid-sized businesses - generally not viewed as likely potential terrorism targets. Similarly, with workers’ compensation policies, the number of employees covered is a key consideration. Our internal guidelines decline coverage in cases where we believe the exposure to terrorism has the greatest potential. With regard to our personal lines of insurance, we believe that losses due to terrorism would be relatively modest.
Miscellaneous corporate investment and other activities, including real estate holdings, transactions and losses on debt repurchases and contributions to the Foundation
Gains on sales of real estate - In connection with our revision in our real estate strategy, we sold various real estate in 2006, detailed in the table below:
In 2007, we redeemed the remaining balance of $322.3 of our 8.072% Debentures for $335.3. The Debentures were redeemed at a price of 104% of principal. We reported a pretax loss of $16.6 ($10.8 after tax), including the write-off of deferred debt costs in the Consolidated Statements of Income. We also retired $26.3 of related Capital Trust equity securities. In addition, we repaid $197.3 of our 6.875% senior notes, which matured in 2007.
In 2006, we repurchased $54.3 in principal amount of 8.072% Debentures for $58.8 and $2.7 in principal amount of 6.875% senior notes for $2.7. Including transaction costs, we reported a pretax loss on debt repurchases of $4.5 ($2.9 after tax) in the Consolidated Statements of Income. In 2005, we repurchased $25.9 in principal amount of 7.25% senior notes for $29.8. Including transaction costs, we reported a pretax loss on debt repurchase of $4.0 ($2.6 after tax) in the Consolidated Statements of Income.
We have identified the accounting estimates for loss and loss adjustment expense reserves, reinsurance recoverables, and valuation of investments as critical to understanding our results of operations and financial condition. The application of these accounting estimates requires us to use judgments involving assumptions and estimates about future results, trends or other developments that could significantly influence our results if actual experience differs from those assumptions and estimates. We review these judgments frequently. An understanding of them may help readers to better understand our Consolidated Financial Statements and Management’s Discussion and Analysis (MD&A).
Case-Basis Reserve - For reported losses, we establish a reserve estimate for each claim based on the known facts regarding the claim and the parameters of the coverage that our policy provides. Case-basis reserves are adjusted as additional facts become available to us. Case-basis reserves are reduced as we make payments for our reported claims.
For short-tailed lines of business, beginning IBNR reserves for prior accident years may be adjusted for expected paid and case activity, as well as explicit adjustments beyond this activity. For long-tailed lines of business, the beginning IBNR reserves for prior accident years may be adjusted for actual paid and case activity, as well as explicit adjustments beyond this activity.
ULAE reserves represent an estimate of the claims settlement expenses that cannot be identified to a specific claim. ULAE reserves are booked in aggregate for current and prior accident years combined. In general, prior reserves are carried forward and supplemented with either a percentage of earned premiums or with a fixed dollar amount of additional reserves to account for growth in the line of business.
Estimating Loss and LAE Reserves - Estimating loss and LAE reserves is a complex process because the ultimate losses are uncertain. Some claims will be paid out over a number of years, and there may be a significant lag between the time a loss occurs and the time it is reported to us. We make significant judgments and assumptions about many internal variables and external factors. Examples of internal variables include:
Average Claim Value and Claim Count Development - Loss payment and/or case incurred amounts are divided by the number of claims to generate average costs per claim. Using historical patterns, the expected ultimate average cost per claim by accident year is projected. Separately, the expected ultimate number of claims is projected by accident year. The product of the expected ultimate average cost per claim and the expected ultimate number of claims yields expected ultimate losses.
Bornhuetter/Ferguson - This approach blends the expected loss ratio method with either the paid or incurred loss development method. Both methods are used with weights applied to each of them based on the maturity of the accident year. As an example, if the current accident year for personal automobile bodily injury is estimated to be 10% paid, then the paid loss development method would receive a weight of 10%, and the expected loss ratio method would receive a 90% weight.
We segregate the activities of estimating losses for product pricing purposes from those of determining reserves to be reported in our financial statements. Management has the ultimate responsibility for the determination of appropriate reserves, based on recommendations from the appointed actuary.
Estimating our loss and LAE reserves is an ongoing process. Our loss and LAE reserves represent our best estimate of the ultimate future payments associated with losses and related expenses net of salvage (the amount we recover from property that becomes ours after we pay for a total loss) and subrogation (our right to recover payments from third parties), giving consideration to the uncertainties inherent in the estimates. We record any adjustments to these reserves in the periods in which we change the estimates. We report changes to these reserves in our Consolidated Statements of Income.
Catastrophe loss reserves are established by event by the claims department when the event occurs. These estimates are revised as the actual loss experience develops and claims are reported and settled over time.
Loss and LAE Reserve Variability - Loss and LAE reserves are subject to variability, particularly the IBNR component. For the lines of business we write, variability in the frequency (the average number of claims filed), or severity (the average cost of a claim) is generally a function of one or more of the following factors:
Safeco Personal Insurance (SPI) - SPI loss and LAE reserves generally are estimated using standard actuarial methods and judgment. These methods involve analyzing past claims experience for recent changes in business claims practices and the internal and external environments. Emphasis is placed on evaluating claims reporting and closing patterns, as well as the size of loss payments and case-basis reserves. SPI losses and related expenses are analyzed by line of business, product, coverage and geographic area.
Our changing mix of business - We have migrated to writing more preferred and standard risks than we wrote in past periods. These risks have on average lower frequencies and higher severities than non-standard risks.
Bodily injury (BI) coverage represents the largest portion (61.0%) of our loss and ALAE reserves held for Auto. Small variations from our assumptions can yield significant financial volatility given the magnitude of these reserve balances.
Our Property and Specialty lines are predominantly short-tailed business, and most claims are reported and settled within 12 months. We use standard actuarial techniques and judgment to estimate reserves for those lines. Changes to our reserve estimates for Property and Specialty generally result from frequency or severity differences from historical patterns or development on catastrophe-related losses, which can be difficult to estimate due to the associated widespread damage.
Long payout periods - Workers’ compensation claims can remain open 50 years or more, introducing variability in the ultimate length of the payout. The cumulative effect of inflation trends over time, particularly medical cost inflation, can be significant.
Unlimited liability nature of workers’ compensation policies - Many claims can pay out for the lifetime of the claimant with no limit on the total payment amount.
Claim reporting lags - Some claims are not made immediately; as a result, we remain exposed to workers’ compensation losses arising from policies written in prior years.
Other Commercial Products - Excluding commercial liability products, which are discussed below, the payout periods for our other commercial products, primarily commercial auto and commercial property, are relatively short. As a result, our estimated loss reserves for these products are subject to less volatility than our workers’ compensation reserves. We use standard actuarial techniques combined with judgment to estimate these loss reserves.
The uncertainty created by these factors requires more judgment in estimating loss reserves for construction defects claims than for most of our other lines of business.
Over the last four years, the number of open construction defects claims has decreased steadily - an average drop exceeding 20% per year. Our loss reserve estimates assume that the number of open claims will continue to decrease, but at a slower rate, and that severity will increase due to inflationary pressure.
In this table, the three-year survival ratio represents the number of years our current loss reserves would last if future payments were made at the same average annual rate experienced over the last three years. The three-year survival ratio is equal to our loss reserves, divided by our average annual payment over the last three years.
58.0% relates to our run-off assumed reinsurance operations and our exposure to syndicates and pools.
Our IBNR reserves were 32.6% of our loss and ALAE reserves for asbestos claims at December 31, 2007 and 19.8% of our loss and ALAE reserves from asbestos claims at December 31, 2006.
Our IBNR reserves were 69.6% of our loss and ALAE reserves for environmental claims at December 31, 2007 and 64.4% of our loss and ALAE reserves for environmental claims at December 31, 2006.
Our relatively limited environmental claims activity results in fluctuations in average values from period to period. The 2006 average paid closed environmental claim increased compared with 2005 due to numerous settlements of large exposures.
Our Surety loss and ALAE reserves, net of salvage and subrogation recoveries, were $101.4 at December 31, 2007 and $47.5 at December 31, 2006. Surety reserves fluctuate from period to period due to the lag between the time payments are made on a claim and the time we receive salvage and subrogation amounts.
Loss and LAE Reserves - Three-Year Review - In this section, we provide the actual reserve estimates for the last three years and discuss changes in those estimates. This table shows the changes in our loss and LAE reserves for 2007, 2006 and 2005.
$98.2 reduction in personal auto reserves, reflecting decreases in severity estimates primarily for prior accident years 2004 and 2005 in our liability lines
$23.2 increase in our general liability reserves in our run-off lines primarily due to religious institution allegations
$12.9 reduction in workers’ compensation reserves due to reforms in California and Texas
$11.2 reduction in SFIS prior accident year reserves driven by a reduction of hurricane assessments
$11.0 reduction in personal property reserves, reflecting improvement in severity relative to our original estimates
$30.5 increase in our Surety reserves related to large loss activity in our contract lines
$47.0 increase in workers’ compensation reserves to reflect increased provisions for long-term medical claim inflation and associated claims adjustment expenses
Section C shows our revised loss and LAE reserve estimates through the years. For example:
Section C shows the annual reestimation of those reserves, and after 10 years our revised reserves were $4,506.5
The unfavorable trend from 1997 through 2003 was primarily due to:
Conditions and trends that affected our loss and LAE reserves in the past may not occur in the future. For example, substantial reduction in our large-commercial insurance and program business in 2001 will disproportionately affect trends in these tables for several years. As a result, our Analysis of Losses and LAE Reserve Development table is not a basis for estimating future redundancies or deficiencies.
Our estimated allowance for uncollectible reinsurance was $35.9 at December 31, 2007 and $12.9 at December 31, 2006. The increase in our allowance was primarily due to an increase in the provision for losses of $22.2 from historical casualty business in run-off.
Our investments include fixed maturities and marketable equity securities, which we report at fair value as Available-for-Sale Securities on our Consolidated Balance Sheets. Our investments also include other invested assets, which we report at cost, which approximates fair value.
How long and by how much the fair value of the security has been below its cost or amortized cost
Our investment portfolios are primarily divided between Corporate and P&C. They are managed by BlackRock Financial Management, Inc. The primary investment objective for the Corporate portfolio is to maximize economic value while generating after-tax income to meet policyholder and corporate obligations. The Corporate investment strategy is developed based on a variety of factors including business needs, regulatory requirements and tax considerations. The primary investment objective for the Property & Casualty portfolio is to ensure the full and timely payment of all liabilities.
These tables summarize our investment portfolio at December 31, 2007 and 2006:
As of December 31, 2007, our marketable equity securities, carried at $1,402.6, included:
As of December 31, 2006, our marketable equity securities, carried at $1,529.7, included:
At December 31, 2007, there were no investments in any one industry that accounted for more than 10% of our total gross unrealized losses. At December 31, 2006, investments in secured finance mortgage-backed securities accounted for 17.6% of our total gross unrealized losses.
Unrealized losses on our fixed maturities that have been in a loss position for more than a year at December 31, 2007 were $6.1, compared with $32.3 at December 31, 2006, reflecting higher interest rates. There were no unrealized losses on our marketable equity securities that were in a loss position for more than a year at December 31, 2007 or 2006. Total unrealized losses were less than 1% of our total portfolio value at both December 31, 2007 and December 31, 2006.
Our investment portfolio is diversified by issuer and industry type with no single issuer, except the U.S. Government fixed maturities, exceeding 1% of the fair value of our consolidated investment portfolio. We do not rely on the presence of bond insurance in the selection of securities for our portfolio. We evaluate the underlying creditworthiness of the entity in our selection process.
These tables show our investment types and industries of our fixed maturities and marketable equity securities that exceed 3% of our portfolio at year-end 2007 or 2006:
The decrease in net investment income in 2007 compared with 2006 was a result of the shift in our portfolio strategy throughout 2006 to tax-exempt municipal bonds, and an overall lower invested asset base due primarily to the sale of securities to fund our debt maturity and redemption and the special dividend paid by our insurance subsidiaries to Safeco Corporation that have not been invested. The increase in net investment income in 2006 compared with 2005 was due to higher interest rates on new purchases of fixed income investments.
Our portfolio duration is an important part of our investment returns. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. The bigger the duration number, the greater the interest-rate risk or reward for bond prices. Our effective duration was 4.82 at December 31, 2007, compared with 4.66 at December 31, 2006 and 4.75 at December 31, 2005.
Net gains on marketable equity securities transactions increased $121.6 in 2007 compared with 2006, and decreased $11.6 in 2006 compared with 2005.
In 2007, the fair value of fixed maturities that we sold at a loss was $1,011.7. Our total net realized investment loss on these sales was $19.3. In 2006, the fair value of fixed maturities that we sold at a loss was $815.8. Our total net realized investment loss on these sales was $11.5. In 2007, the fair value of marketable equity securities that we sold at a loss was $92.2. Our total net realized investment loss on these sales was $13.4. In 2006, the fair value of marketable equity securities that we sold at a loss was $100.2. Our total net realized investment loss on these sales was $9.2. The securities sold at a loss during 2007 primarily related to non-performing securities sold to purchase tax-exempt bonds and securities with credit-related losses in connection with market volatility that emerged during 2007. Our net realized investment losses on transactions in 2006 were primarily related to additional impairments of securities initially impaired in prior periods, securities that became impaired during the year ended December 31, 2006, and sales of securities that had substantially recovered in value. The securities sold at a loss during 2006 and 2005 were due to sales of fixed maturities to fund our accelerated share repurchase program and the sale of lower-yielding taxable bonds to purchase tax-exempt securities to grow our municipal bond portfolio.
Impairments in 2007 were primarily due to credit-related events caused by recent market volatility. Impairments in 2006 were primarily due to changes in management which resulted in a shift in our portfolio strategy to tax-exempt municipal bonds and a change to our real estate strategy. These changes resulted in a review of our investment portfolio and as a result, we changed our intent to hold certain securities long enough for them to recover to full value.
We continually monitor our investment portfolio and markets for opportunities to:
We receive cash from insurance premiums, dividends from our subsidiaries, interest income, sales or maturity of investments and debt and equity offerings.
Cash provided by operating activities increased in 2007 compared with 2006 primarily due to lower income tax payments and administrative expenses, offset in part by higher loss expenses paid and lower dividends and interest received. Cash provided by operating activities decreased in 2006 compared with 2005 primarily as a result of the cash lower insurance premiums received, higher income taxes, underwriting and operating expenses, partially offset by lower loss expenses and higher dividends and interest income received.
The changes in cash from financing activities were the result of share and debt repurchases described below.
We use funds to support our operations, make interest and principal payments on debt, pay dividends to our shareholders, grow our investment portfolio, and repurchase shares of common stock. We use cash from insurance operations primarily to pay claims, underwriting expenses and claim adjustment expenses. We require insurance premiums to be paid in advance. As a result, cash flows into our business before or at the time premium revenues are recognized. Cash flows out of our business in subsequent months or years as claims are paid and expenses incurred.
In 2007, we used $1.56 billion to repurchase stock and debt, compared with $1.23 billion in 2006.
In 2006, we repurchased $54.3 in principal amount of 8.072% Debentures for $58.8 and $2.7 in principal amount of 6.875% senior notes for $2.7. Including transaction costs, we reported a loss on debt repurchases of $4.5 pretax ($2.9 after tax) in the Consolidated Statements of Income. In 2005, we repurchased $25.9 in principal amount of 7.25% senior notes for $29.8. Including transaction costs, we reported a loss on debt repurchase of $4.0 pretax ($2.6 after tax) in the Consolidated Statements of Income.
We summarize our share repurchase activity for 2005, 2006 and 2007 below:
* Transaction costs and price adjustments are excluded from the average price per share amount.
Our Bank Credit Facility - We maintain a $300.0 revolving credit facility, which may be used for working capital and general corporate purposes. The terms of the bank credit facility - which runs through March 2010 - require us to:
Maintain a minimum level of $2,700.0 shareholders’ equity plus 50% of accumulated net income
At December 31, 2007, we had $524.6 and at December 31, 2006, we had $568.1 of gross deferred income tax assets. Gross deferred income tax assets are composed of temporary differences created as a result of amounts deductible for taxes in future periods. Although realization of deferred income tax assets is not assured, we believe they will be realized through future earnings, including but not limited to the generation of future operating income, reversal of existing temporary differences and available tax planning strategies. Accordingly, we have not recorded a valuation allowance for these assets. More information on income taxes can be found in Note 7 to our Consolidated Financial Statements.
At the end of 2007, we had a $3.8 of gross unrecognized tax benefits, of which $3.4 would affect our effective tax rate if recognized. The difference between the gross unrecognized tax benefits and the amount that would affect our effective tax rate is attributable to the federal tax benefit of state income tax.
It is expected that the amount of unrecognized tax benefits will change in the next 12 months. However, we do not expect the change to have a significant impact on our results of operations or financial position. We recognize interest accrued related to unrecognized tax benefits in the Provision for Income Taxes and penalties in Other Underwriting and Operating Expenses in our Consolidated Statements of Income. We had $7.3 accrued for interest and no liability for penalties as of December 31, 2007.