See the Glossary of Terms attached to this Form 10-K as Exhibit 99.1
Operating income (loss) is a non-GAAP measure. Operating return on average equity is a profitability measure calculated by dividing operating income (loss) by average equity. See the “Financial Highlights” section in
Operating income (loss) is a non-GAAP measure. Operating return on average equity is a profitability measure calculated by dividing operating income (loss) by average equity. See the “Financial Highlights” section in Item 7. of this Form 10-K for a reconciliation of operating income to net income.
Financial Highlights of Results for Years Ended December 31, 2009, 2008, and 2007;
When a claim is reported to an insurance subsidiary, claims personnel establish a “case reserve” for the estimated amount of the ultimate payment. The amount of the reserve is primarily based upon a case by case evaluation of the type of claim involved, the circumstances surrounding each claim, and the policy provisions relating to the type of losses. The estimate reflects the informed judgment of such personnel based on their knowledge, experience, and general insurance reserving practices. Until the claim is resolved, these estimates are revised as deemed appropriate by the responsible claims personnel based on subsequent developments and periodic reviews of the case.
In addition to case reserves, we maintain estimates of reserves for losses and loss expenses that have been incurred but not reported to us (referred to as “IBNR”). Using generally accepted actuarial reserving techniques, we project our estimate of ultimate losses and loss expenses at each reporting date. The difference between: (i) the projected ultimate loss and loss expense reserves; and (ii) the case loss reserves and the loss expenses reserved thereon is carried as the IBNR reserve. The actuarial techniques used are part of a comprehensive reserving process that included two primary components. The first component is a detailed quarterly reserve analysis performed by our internal actuarial staff. In completing this analysis, the actuaries are required to make numerous assumptions including, for example, the selection of loss development factors and the weight to be applied to each individual actuarial indication. These indications include paid and incurred versions for the following actuarial methodologies: loss development, Bornhuetter-Ferguson, Berquist-Sherman, and frequency/severity modeling. Additionally, the actuaries must gather substantially similar data in sufficient volume to ensure the statistical credibility of the data. The second component of the analysis is the projection of the expected ultimate loss ratio for each line of business for the current accident year. This projection is part of our planning process wherein we review and update expected loss ratios each quarter. This review includes actual versus expected pricing changes, loss trend assumptions, and updated prior period loss ratios from the most recent quarterly reserve analysis.
At December 31, 2009, our workers compensation line of business recorded reserves, net of reinsurance, of $843 million, or 34% of our total net reserves. In addition to the uncertainties associated with actuarial assumptions and methodologies described above, the workers compensation line of business can be impacted by a variety of issues such as unexpected changes in medical cost inflation, higher than anticipated claim severity, changes in overall economic conditions, and Company specific initiatives. From 2005 through 2009, we experienced an unusual amount of volatility associated with our workers compensation medical costs. In addition, uncertainty regarding future medical inflation creates the potential for additional volatility in our reserves. In 2009, overall economic conditions were extremely unstable. High levels of unemployment could impact both the severity and frequency of our workers compensation claims. There is potential for an increase in severity if the longevity of workers compensation claims increase. Injured workers could have less incentive to return to work when their company is in financial distress or injured workers could be laid off while on workers compensation. There is potential for a decrease in frequency if workers are reluctant to file claims or have less work and less exposure to injury. Additionally, the economy could impact the frequency and severity of claims in ways unanticipated by management. In 2009 and 2008, we have experienced an unusually high amount of audit activity in which we have return premium of $29.0 million and $10.7 million, respectively, a trend which may continue into the future. This could impact our reserves in ways not yet determined. The result could be favorable development if the reduction in payroll is truly a reduction in exposure. The result could be adverse development if the reduction in payroll indicates that remaining workers are now overworked and more prone to accidents. Finally, in the past few years, the company implemented a multi-faceted workers compensation strategy which incorporated knowledge management and predictive modeling initiatives. The ongoing impact of these initiatives is a potential source of uncertainty in the future. If the ongoing impact of these strategies exceed our expectations, the result could be favorable development in the future. If our internal strategies are less effective than anticipated and we experience higher than expected claim severity, the result could be adverse development in the future.
At December 31, 2009, our commercial automobile line of business had recorded reserves, net of reinsurance, of $370 million, which represented 15% of our total net reserves. This line of business experienced favorable prior year loss development from 2005 to 2009 which was driven by a downward trend in frequency of large claims. The number of large claims has a high degree of volatility from year to year and, therefore, requires a longer period before true trends are recognized and can be acted upon. We experienced lower than expected severity in accident years 2002 through 2006 which did not continue into the 2007 and 2008 accident years. At this early stage, accident year 2009 is showing positive signs of having lower than expected severity. While management has not identified any specific trends related to this line, the volatility of large claims does create additional uncertainty in our analysis for our most recent accident years.
In addition to the line of business specific issues mentioned above, both of these lines of business have been impacted by a number of initiatives undertaken by our claims department which have resulted in volatility in the average case reserves. This change in the average level of case reserves increases the uncertainty in the short run, but the longer term benefit is a more refined management of the claims process. Additionally, inflationary pressures are perceived to be more likely in the current economic environment. Uncertainty regarding future inflation or deflation creates the potential for additional volatility in our reserves for both of these lines of business.
At December 31, 2009, no other individual line of business had recorded reserves of more than $79 million, net of reinsurance. We have not identified any recent trends that would create additional significant reserve uncertainty for these other lines of business.
The following tables provide case and IBNR reserves for losses, reserves for loss expenses, and reinsurance recoverable on unpaid losses and loss expenses as of December 31, 2009 and 2008:
The importance of any single assumption depends on several considerations, such as the line of business and the accident year. If the actual experience emerges differently than the assumptions used in the process to establish reserves, changes in our reserve estimate are possible and may be material to the results of operations in future periods. Set forth below is a discussion of the potential impact of using certain key assumptions that differ from those used in our latest reserve analysis. It is important to note that the following discussion considers each assumption individually, without any consideration of correlation between lines of business and accident years, and therefore, does not constitute an actuarial range. While the following discussion represents possible volatility from variations in key assumptions as identified by management, there is no assurance that the future emergence of our loss experience will be consistent with either our current or alternative set of assumptions. By the very nature of the insurance business, loss development patterns have a certain amount of normal volatility.
In addition to the normal amount of volatility, our commercial automobile line of business has realized significant favorable development in 2005 to 2009. This favorable development was driven in large part by a reduction in our bodily injury large loss experience. The actual number of large claims has a high degree of volatility from year to year in terms of timing and ultimate final emergence. Even if ultimate large losses are ultimately consistent from year to year, if they are identified at different times than previous years, traditional loss development factors may overstate or understate actuarial indications. If the timing of large losses is significantly variable, it is our judgment that actual loss development factors could be +/- 5% different from those selected in our reserve review, which would increase/decrease our indicated commercial auto reserves by approximately $52 million for accident years 2008 and prior.
As discussed in the major trend section above, the claims initiatives and inflationary uncertainty could impact reserves for the general liability and commercial automobile lines of business. In our judgment, it is possible that the selected reserves for these lines of business in our latest reserve review could increase by $72 million or decrease by $51 million due to the combination of case reserve volatility in accident years 2008 and 2009 and unexpected inflation or deflation.
For the 2009 accident year, the expected ultimate loss ratio by line of business is a key assumption. This assumption is based upon a large number of inputs that are assessed periodically, such as historical loss ratios, projected future loss trend, and planned pricing amounts. In our judgment, it is possible that the actual ultimate loss ratio for the 2009 accident year could be +/-7% from the one selected in our latest reserve analysis for each of our four major long-tailed lines of business. The table below summarizes the possible impact on our reserves of varying our expected loss ratio assumption by +/-7% by line of business for the 2009 accident year.
In light of the many uncertainties associated with establishing the estimates and making the assumptions necessary to establish reserve levels, we review our reserve estimates on a regular basis as described above and make adjustments in the period that the need for such adjustment is determined. These reviews could result in the identification of information and trends that would require us to increase some reserves and/or decrease other reserves for prior periods and could also lead to additional increases in loss and loss adjustment expense reserves, which could have a material adverse effect on our results of operations, equity, business, insurer financial strength, and debt ratings. In 2009, we experienced favorable loss development of approximately $67 million in accident years 2004 through 2007 partially offset by unfavorable loss development in the 2008 accident year, as well as accident years prior to 2003, of approximately $38 million, netting to favorable prior year development of $29 million. In 2008, we experienced favorable loss development in accident years 2006 and prior of $46.2 million partially offset by unfavorable loss development in accident year 2007 of $26.9 million, netting to total favorable prior year development of $19.3 million and in 2007, we experienced net favorable prior year development of $18.8 million. For further discussion on the prior year development in loss and loss expense reserves, see the discussion on “Net Loss and Loss Expense Reserves” in Item 1. “Business” and Note 9 of Item 8. “Financial Statements and Supplementary Data” of this Form 10-K.
The table below summarizes the number of asbestos and non-asbestos claims outstanding at December 31, 2009, 2008, and 2007. For additional information about our environmental reserves, see Item 1. “Business,” and Item 8. “Financial Statements and Supplementary Data,” Note 9. to the Consolidated Financial Statements.
We had deferred policy acquisition costs of $218.6 million at December 31, 2009 compared to $212.3 million at December 31, 2008. Currently, the Financial Accounting Standards Board is reviewing proposed changes to existing accounting guidance regarding accounting for costs associated with acquiring or renewing insurance contracts. Depending on the outcome of their review, changes in this guidance could materially impact our results of operations.
The discount rate enables us to state expected future cash flows at their present value on the measurement date. The guideline for setting this rate is a high-quality long-term corporate bond rate. A lower discount rate increases the present value of benefit obligations and increases pension expense. We decreased our discount rate to 5.93% for 2009, from 6.24% for 2008 to reflect market interest rate conditions. To determine the expected long-term rate of return on the plan assets, we consider the current and expected asset allocation, as well as historical and expected returns on each plan asset class. A lower expected rate of return on pension plan assets would increase pension expense. Our long-term expected return on plan assets was 8.00% in 2009 and 2008. We had a pension and post-retirement benefit plan obligation of $205.5 million at December 31, 2009 compared to $188.0 million at December 31, 2008.
When the fair value of any investment is lower than its cost/amortized cost, an assessment is made to determine if the decline is other than temporary. We regularly review our entire investment portfolio for declines in fair value. If we believe that a decline in the value of an available-for-sale (“AFS”) security is temporary, we record the decline as an unrealized loss in other comprehensive income (“OCI”). Temporary declines in the value of a held-to-maturity (“HTM”) security are not recognized in the financial statements. Our assessment of a decline in fair value includes judgment as to the financial positions and future prospects of the entity that issued the investment security, as well as a review of the security’s underlying collateral. Broad changes in the overall market or interest rate environment generally will not lead to a write-down.
Prior to April 1, 2009, when the decline in fair value below amortized cost of a fixed maturity security was deemed to be other than temporary, the investment was written down to fair value and the amount of the write-down was charged to income as a realized loss. A decline in fair value on a fixed maturity security was deemed to be other than temporary if we did not have the intent and ability to hold the security to its anticipated recovery. Effective April 1, 2009 with the adoption of revised OTTI accounting guidance, unless we have the intent to sell, or it is more likely than not that we may be required to sell, a fixed maturity security, an other than temporary impairment is only recognized as a realized loss to the extent it is credit related. If there is a decline in fair value to below amortized cost of a fixed maturity security that we intend to sell or, more-likely-than-not, may be required to sell, the impairment is considered other than temporary and the security is written down to fair value with the amount of the write-down charged to earnings as a component of realized losses.
Based on these projections, we determine expected recovery values to be generated by the collateral for each security. Prior to April 1, 2009, if these projections indicated an other-than-temporary impairment, the shortfall between the amortized cost of the security and the fair value was charged to earnings as a component of realized losses. Subsequent to April 1, 2009, if these projections indicate an impairment, we perform a discounted cash flow analysis to determine the present value of future cash flows to be generated by the underlying collateral of the security. Additionally, we perform a discounted cash flow analysis on all previously other-than-temporarily impaired securities and all structured securities that are not of high-credit quality at the date of purchase.
The length of time and the extent to which the fair value has been less than cost; and
If there is a decline in the fair value on an equity security that we do not intend to hold, or if we determine the decline is other-than-temporary, we will write down the carrying value of the investment and record the charge through earnings as a component of realized losses.
Financial Highlights of Results for Years Ended December 31, 2009, 2008, and 20071
1 Refer to the Glossary of Terms attached to this Form 10-K as Exhibit 99.1 for definitions of terms used in this financial review.
Operating income is used as an important financial measure by us, analysts, and investors, because the realization of investment gains and losses on sales in any given period is largely discretionary as to timing. In addition, these realized investment gains and losses, as well as OTTI charges that are charged to earnings, and the results of discontinued operations, could distort the analysis of trends. See below for a reconciliation of operating income to net income in accordance with generally accepted accounting principles.
Pre-tax net income decreased in 2009 compared to 2008 and 2007 as seen in the table above. On a pre-tax basis, net income decreased by $13.1 million in 2009 and $153.4 million in 2008 compared to the respective prior years. These fluctuations were driven by the following:
The decrease in net investment income, before tax, of $43.1 million for 2008 compared to 2007 was due to: (i) decreased returns of $31.9 million on the alternative investment portion of our other investments portfolio; and (ii) $8.1 million of reductions in the fair value of our equity trading portfolio due to the sell off in the equity markets, as well as the collapse in commodity prices in the second half of 2008.
Underwriting profits were $2.4 million in 2009 compared to $0.1 million in 2008 and $31.0 million in 2007. The decrease in 2008 is primarily attributable to higher catastrophe losses and reduced NPE. Catastrophe losses increased to $31.7 million in 2008 compared to $14.9 million in 2007 driven by storm activity in the southern and mid-western states. Also in 2008, NPE decreased 1% reflecting pricing pressure stemming from a highly competitive insurance marketplace and the slowing economy.
Taxes from continuing operations were a benefit of $5.5 million in 2009 compared to a benefit of $3.9 million in 2008 and an expense of $45.1 million in 2007. These decreases are primarily driven by the decreases in pre-tax investment income discussed above.
Our Insurance Operations segment writes property and casualty insurance business through seven insurance subsidiaries (the “Insurance Subsidiaries”). Our Insurance Operations segment sells property and casualty insurance products and services primarily in 22 states in the Eastern and Midwestern U.S. through approximately 960 independent insurance agencies. Our Insurance Operations segment consists of two components: (i) Commercial Lines, which markets primarily to businesses and represents approximately 84% of net premium written (“NPW”); and (ii) Personal Lines, including Flood, which markets primarily to individuals and represents approximately 16% of NPW. The underwriting performance of these lines is generally measured by four different statutory ratios: (i) loss and loss expense ratio; (ii) underwriting expense ratio; (iii) dividend ratio; and (iv) combined ratio.
Reductions in endorsement and audit activity of $50.4 million, to a net return premium of $72.7 million; and
NPE decreases in 2009 compared to 2008 and 2007 are consistent with the fluctuation in NPW. These decreases were primarily driven by a decrease in exposure coupled with premiums written in 2008, which experienced a decrease in pure price of 3.1% in 2008, earning in over the course of 2009.
Catastrophe losses that were 0.6 points, or $8.5 million, compared to 2.1 points, or $31.7 million, in 2008.
Workforce reductions in 2008 that resulted in a pre-tax charge of $4.5 million in 2008;
Targeted changes to agency commissions that were implemented in most states in July 2008;
The consolidation of our purchasing power with fewer vendors and their desire to lock up longer-term contracts; and
Historically, the results of the property and casualty insurance industry have experienced significant fluctuations due to competition, economic conditions, interest rates, loss cost trends, and other factors. During 2009, the Insurance Operations segment outperformed both A.M. Best and Fitch Ratings (“Fitch”) industry wide projections of 100.6% and 101%, respectively, with a statutory combined ratio of 100.5%. Our Commercial Lines business reported a statutory combined ratio of 99.8% and our Personal Lines business reported a statutory combined ratio of 104.4% for the year.
Deploying second generation Commercial Lines predictive modeling tools that give our underwriters superior information, enabling them to make better decisions regarding individual account underwriting. It also ensures that we price our business with precision, giving our agents the ability to compete for the most attractive accounts, furthering our focus on maintaining insurance operations profitability. Going forward, we believe that the use of this tool will enable us to maintain our competitive pricing for the best accounts while driving a meaningful improvement in the loss ratio.
Putting into effect the Personal Lines rate increases mentioned above, which we believe will generate $6.7 million in additional premium. We accomplished this while losing only one point of retention and increasing new policy counts by 51% in 2009.
Sales management efforts, including our market planning tools and leads program. Our market planning tools allow us to identify and strategically appoint additional independent agencies and hire or redeploy agency management specialists (“AMS”) in under-penetrated territories. We have continued to expand our independent agency count, which now stands at approximately 960 agencies across our footprint. These independent insurance agencies are serviced by approximately 94 field-based AMSs who make hands-on underwriting decisions on a daily basis. In addition, we use our predictive modeling and business analytics to build tools that help agents identify potential new customers.
The overall outlook on the industry for 2010 from key rating agencies is as follows:
A.M. Best - A.M. Best is maintaining a stable outlook on the industry looking forward as they project that balance sheet strength and liquidity will remain adequate in 2010. They expect that although commercial line’s underwriting results and loss reserve adequacy will continue to deteriorate, this line of business is in a reasonably solid position to confront these challenges. They cite that with economic uncertainty expected to continue, commercial line managers should remain prudent in pricing, reserving, and deployment of capital. For 2010, A.M. Best expects a small decline in NPW driven by an anticipated sluggish economic recovery, coupled with an increase in catastrophe-related losses, will lead to a combined ratio of 101.7%.
We will continue to manage our book of business in 2010 by: (i) balancing anticipated Commercial Lines pure price increases with retention; and (ii) as discussed above, we expect the 2010 rate changes, will generate an additional $14.1 million in premium over the course of the next year in Personal Lines. We continue to believe that the cycle management tools we have in place are performing as we intended in the current market conditions. These tools protect us from writing business that we believe will ultimately be unprofitable and, over the long run as pricing and exposures improve, will better position us to return to targeted return on equity levels.
Reductions in direct new business of $1.5 million, to $265.7 million, in 2009.
The increase in the GAAP loss and loss expense ratio in 2009 compared to 2008 was primarily attributable to an increase in casualty loss costs that have outpaced premium in the current accident year coupled with non-catastrophe property losses that increased $4.2 million, or 1.0 points. Partially offsetting these increases were:
Increase in favorable prior year development of approximately $13 million. This development of $28 million, or 2.3 points in 2009 was primarily driven by our workers compensation, commercial auto, and general liability lines of business while favorable prior year development of $15 million, or 1.1 points in 2008 was primarily driven by our workers compensation line of business. Favorable development in 2007 was approximately $20 million, or 1.5 points, driven by our commercial automobile line of business; and
Catastrophe losses that were 0.5 points, or $5.8 million, compared to 2.1, points or $27.0 million, in 2008.
NPW for this line of business decreased in 2009 compared to 2008, and in 2008 compared to 2007. The decrease in 2009, compared to 2008 was driven by: (i) a $19.5 million decrease in audit and endorsement activity, to a return premium of $27.2 million; (ii) a $14.9 million, or 4%, decrease in net renewals; and (iii) a $3.6 million, or 5%, decrease in new business for 2009. The decrease in 2008, compared to 2007 was driven by: (i) a $17.7 million decrease in audit and endorsement activity, to a return premium of $7.8 million; and (ii) a decrease in direct voluntary new business premiums of $15.7 million, or 17%. The decreases in both 2009 and 2008 were primarily driven by the effects of the economic recession that has been ongoing since the middle of 2008. Approximately 56% of our premium as of December 31, 2009 and 58% as of December 31, 2008 is subject to audit, wherein actual exposure units (usually sales or payroll) are compared to estimates and a return premium or additional premium transaction occurs.
Our renewal pure price increase was 1.6% in 2009 compared to decreases of 2.0% in 2008 and 4.5% in 2007. We achieved these increases while increasing policy counts 1% and losing only one point in retention in 2009 compared to 2008. We continue to concentrate on our long-term strategies of improving profitability by focusing on diversifying our mix of business by writing more non-contractor classes of business. In 2009, non-contractor new business comprised 51% of our total new business, up from 46% in 2008. This business typically experiences lower volatility during economic cycles.
The increase in the statutory combined ratio for 2009 compared to 2008 and 2008 compared to 2007 was driven by: (i) increased loss and loss expense costs in the current accident years that have outpaced premiums, leading to a higher combined ratio; and (ii) an increase in the expense ratio caused by premium declines, particularly in audit and endorsements, that have outpaced expense reductions resulting from our various expense initiatives. The 2009 increase was partially offset by favorable prior year development of approximately $8 million, or 2.3 points, in 2009 compared to adverse prior year development of approximately $4 million, or 0.9 points, in 2008. Favorable development in the general liability line of business is often times volatile year-to-year and, therefore, requires a longer period of time before true trends are recognized and can be acted upon. The favorable development in 2009 was driven by favorable loss emergence for accident years 2004 to 2007. The increase in the statutory combined ratio for 2008 compared to 2007 reflected higher estimated losses due to loss trends that have outpaced pricing.
The increase in the statutory combined ratio on this line for 2009 compared to 2008 was primarily attributable to higher loss costs in the current accident year coupled with the following: (i) higher audit return premium in 2009 that added 11.1 points to the combined ratio compared to audit return premium in 2008 that added 3.3 points; and (ii) prior year favorable development in 2009 of approximately $10 million, or 3.9 points, primarily driven by accident years 2005 to 2007 reflecting the on-going impact from a series of improvement strategies for this line in recent years, partially offset by adverse severity in accident year 2008. In 2008, favorable prior year development was approximately $23 million, or 7.6 points, related to accident years 2004 to 2006, as a result of our improvement initiatives on this line, partially offset by adverse development in the 2007 accident year driven by higher than expected severity. The improvement in the statutory combined ratio in 2008 compared to 2007 reflects the aforementioned favorable prior year development in 2008 compared to $3 million, or 0.8 points, in 2007, partially offset by higher estimated losses due to loss trends that have outpaced pricing.
NPW for this line of business decreased in 2009 compared to 2008, and in 2008 compared to 2007, due to the ongoing effects of the economic recession. The decrease in 2009 was primarily attributable to: (i) net renewal premiums down $4.8 million; or 2%; and (ii) a two-point decrease in retention, to 77%. This was partially offset by new business that increased 4%, to $54.2 million in 2009 compared to 2008 and renewal pure price increases of 1.1% in 2009 compared to decreases of 5.0% in 2008. The decrease in premium for 2008 compared to 2007 was driven by direct voluntary new business premiums, which were down $9.2 million, or 15%, from 2007 and the aforementioned renewal pure price decreases.
The increase in the statutory combined ratio in 2008 compared to 2007 is primarily due to: (i) insignificant prior year development in 2008 compared to favorable prior year statutory development in 2007 of approximately $19 million due to improved severity trends; (ii) physical damage losses that were $6.2 million, or 2.3 points, higher in 2008; and (iii) pure price decreases in 2008 as discussed above.
The increase in NPW in 2009 compared to 2008 is primarily due to:
New business premium increases of $11.8 million to $55.2 million in 2009.
Our rate increases were partially offset by a decline in retention of approximately one point, to 80%, on our overall Personal Lines book. In addition, the number of automobiles that we insure in New Jersey decreased by approximately 9,000 to 56,000 cars, at December 31, 2009.
The increase in NPW in 2008 compared to 2007 is primarily due to the impact of rate actions that became effective during the year. These rate actions resulted in an overall rate increase of 7.7% in Personal Lines, comprised of 11.1% in our personal automobile line of business and 1.1% in our homeowners line of business. Specific to our New Jersey personal automobile business, we have received rate increases of 6.8% effective in May 2008 and 6.5% effective in October 2008.
NPE increases in 2009 compared to 2008 and 2007 are consistent with the fluctuation in NPW increase in 2009 compared to 2008 and 2007 as discussed below.
The improvement in the GAAP loss and loss expense ratio for 2009 compared to 2008 was driven by: (i) increased rate on this book of business that is favorably impacting NPE and outpacing loss costs; and (ii) a decrease in catastrophe losses of $2.0 million, or 1.0 points. Partially offsetting these items was increased non-catastrophe property losses of $8.9 million, or 3.4 points.
The increases in new business and net premiums written are attributable, among other things, to our ability to continue to increase quote volume through the following: (i) improved marketing and communication strategies; (ii) strong representation across our footprint; and (iii) providing the excellent service that our policyholders and agents demand. We are now participating in several programs that allow our agents to compare our personal auto rates to those of other insurance companies through a system known as “comparative raters,” which has increased our quote volume by 66% during 2009 compared to 2008. Starting in first quarter 2010, we will be adding our homeowners line of business to the comparative raters system, with New Jersey as the first state in production. In addition, New Jersey automobile new business is now written under our 60-territory structure, which provides more adequate pricing in territories that historically have not been profitable for us. Price increases for renewal business are capped at 10% as we reclassify these policies into the new territory definitions.
The Property Catastrophe treaty renewed effective January 1, 2010 with an 8% decrease in premium. The current treaty structure remains the same providing per occurrence coverage for 95% of $310.0 million in excess of $40.0 million retention. The annual aggregate limit net of our co-participation is $589.0 million.
In 2008, we managed our hurricane exposures through the implementation of a Catastrophe (“CAT”) strategy initiative. It focused on policies with high Annual Average Loss (“AAL”) to premium ratios which were targeted for increases in deductibles and premium, and in certain cases non-renewals. The strategy led to the implementation of a variety of underwriting system tools that provide CAT management information to the underwriters for a more granular portfolio management of our property book of business. The July 2009 modeling results included a 9.5% reduction in gross AAL, while insured values increased 7.6% when compared to June 2008, clearly showing that the strategy has taken hold.
The following table presents Risk Management Solutions, Inc.’s (“RMS”) v. 9.0 modeled hurricane losses based on the Insurance Subsidiaries’ property book of business as of July 2009:
RMS v.9.0 allows modeling based on the long-term averages (historic view) and modeling based on a near-term view that includes an assumption of elevated hurricane activity in the North Atlantic Basin in the short to medium-term. Results of both models are provided above for select probabilities. Our current catastrophe program provides protection for a 1 in 209 year event, or an event with 0.5% probability according to the RMS v.9.0 historic model, and for a 1 in 179 year event, or an event with 0.6% probability according to RMS v.9.0 near term model.
Consistent with the prior year treaty, the Property Treaty excludes nuclear, biological, chemical, and radiological terrorism losses.
The next four layers provide coverage for 100% of up to $45.0 million in excess of a $5.0 million retention.
Consistent with the prior year, the Casualty Treaty excludes nuclear, biological, chemical and radiological terrorism losses. Annual aggregate terrorism limits, net of co-participation, increased to $198.8 million due to increased placement percentages for the fifth and sixth layers.
Our Surety and Fidelity Excess of Loss treaty was renewed effective January 1, 2010, with essentially no changes in coverage and a 0.9% decrease in the rate partially offset by an increase in projected subject premium.
Effective January 1, 2010, we renewed the NWCRP treaty which covers our participation in the involuntary National Council of Compensation Insurance (“NCCI”) pool, a residual workers compensation market, and essentially keeps the same coverage as the expiring treaty. The NWCRP treaty provides 100% Quota Share coverage, including terrorism coverage, assumed business from the NCCI and has an aggregate combined ratio limit of approximately 141% for the 2010 underwriting year. The 2010 treaty is placed with three carriers with ratings of “A” by A.M. Best. We believe that the continued protection provided within this treaty for residual market business is especially beneficial given current market conditions and the expected deterioration in the experience of the NCCI pool.
During the first half of 2009, the economy continued to be impacted by the dislocation of the credit markets brought on by the financial crisis that began in the latter part of 2008. However, during the second half of 2009, credit spreads rallied, outperforming the “safe haven” government and agency bond markets as capital flowed back to risk sectors. Virtually all sectors of the credit markets saw a return to more normal functioning and stability, accompanied by much reduced credit spread levels. Improved market confidence and positive sentiments continue to feed a recovery in valuations of fixed maturity securities. Consistent with these conditions, we saw our overall investment portfolio go from a unrealized loss position at December 31, 2008 to an overall unrealized gain position at December 31, 2009, reflecting a $133.2 million improvement in valuations. Credit quality of our fixed maturity portfolio continues to remain high, with an average S&P rating of “AA+.” This is primarily due to the large allocation of the fixed income portfolio to high quality municipal bonds, agency RMBS, and government and agency obligations. Exposure to non-investment grade bonds remains low, composing approximately 1% of the total fixed maturity portfolio. We have 20 non-investment grade rated securities in the portfolio with a fair value of $34.9 million and an unrealized loss of $17.9 million.
Our investment philosophy includes certain return and risk objectives for the fixed maturity and equity portfolios. The primary fixed maturity portfolio return objective is to maximize after-tax investment yield and income while balancing risk. A secondary objective is to meet or exceed a weighted-average benchmark of public fixed income indices. The equity portfolio return objective is to meet or exceed a weighted-average benchmark of public equity indices. Although yield and income generation remain the key drivers to our investment strategy, our overall philosophy is to invest with a long-term horizon along with a “buy-and-hold” principle.
Our portfolio totaled $3.8 billion at December 31, 2009, an increase of 7% compared to $3.5 billion at December 31, 2008. The increase in invested assets was primarily due to pre-tax unrealized gains of $133.2 million during 2009 as discussed above. Our investment portfolio as of December 31, 2009 was comprised of 88% fixed maturity securities, 2% equities, 6% short term investment and 4% other investments.
Reduced our non-agency RMBS, Home Equity ABS and Alternative-A securities (“Alt-A”) exposure from a carrying value of $127 million at December 31, 2008, or 4% of invested assets, to $63 million, or 2%, of invested assets;
Increased our position in U.S. government obligations by $368.2 million, raising our allocation from 7% to 16% as a percentage of invested assets; and
To manage and mitigate exposure, we perform our analysis on mortgage-backed securities both at the time of the purchase and as part of the ongoing portfolio evaluation. This analysis may include loan level reviews of average FICO® scores, loan-to-value ratios, geographic spread of the assets securing the bond, delinquencies in payments for the underlying mortgages, gains/losses on sales, evaluations of projected cash flows under various economic and default scenarios, as well as other information that aids in determination of the health of the underlying assets. We also consider overall credit environment, economic conditions, total projected return on the investment, and overall asset allocation of the portfolio in our decisions to purchase or sell structured securities. For additional information regarding credit risk associated with our portfolio see
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Selective Insurance Group, Inc. and its subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
The Company also has authorized, but not issued, 5,000,000 shares of preferred stock, without par value, of which 300,000 shares have been designated Series A junior preferred stock, without par value.
Selective Insurance Group, Inc., through its subsidiaries, (collectively referred to as “we,” “us,” or “our”) offers property and casualty insurance products. Selective Insurance Group, Inc. (referred to as the “Parent”) was incorporated in New Jersey in 1977 and its main offices are located in Branchville, New Jersey. The Parent’s common stock is publicly traded on the NASDAQ Global Select Market under the symbol “SIGI.”
During the fourth quarter of 2009 we disposed of Selective HR Solutions, Inc. (“Selective HR”), which comprised our HR Outsourcing segment, causing the elimination of this operating segment. See Note 13. “Discontinued Operations” for additional information.
Our revised segments are reflected throughout this report for all periods presented.
Equity securities, which are classified as available-for-sale, may include common stocks and non-redeemable preferred stocks and are carried at fair value. Dividend income on these securities is included in "Net investment income earned." The associated unrealized gains and losses, net of tax are included in AOCI. The cost of equity securities is written down to fair value when a decline in value is considered to be other than temporary. See the discussion below on realized investment gains and losses for a description of the accounting for impairments. Certain equity securities managed by an external portfolio manager that were disposed of in 2009, were classified as trading securities. Trading securities are recorded at fair value with subsequent changes in fair value recognized in net investment income.
Evaluations of projected cash flows under various economic and default scenarios;
In order to determine if an impairment is other than temporary, we perform impairment assessments for our fixed maturity portfolio including, but not limited to commercial mortgage-backed securities (“CMBS”), residential mortgage-backed securities (“RMBS”), asset-backed securities (“ABS”), collateralized debt obligations (“CDOs”), and corporate debt securities. This assessment takes into consideration the length of time for which the security has been in an unrealized loss position, but primarily focuses on an evaluation of future cash flows, which involve subjective judgments and estimates determined by management including: performance of the underlying collateral under various economic and default scenarios, the nature and realizable value of such collateral, and the ability of the security to make scheduled payments.
Using an assumed 50% in those instances where current loan-to-value ratios were not available at the time of our assessment.
Evaluation for OTTI of an equity security includes, but is not limited to, the evaluation of the following factors:
If there is a decline in fair value on an equity security that we do not intend to hold, or if we determine the decline is other than temporary, we write down the cost of the investment to its fair value and record the charge through earnings as a component of realized losses.
For the majority of our fixed maturity portfolio, approximately 98%, we also utilize a market approach, using primarily matrix pricing models prepared by external pricing services. Matrix pricing models use mathematical techniques to value debt securities by relying on the securities relationship to other benchmark quoted securities, and not relying exclusively on quoted prices for specific securities, as the specific securities are not always frequently traded. We utilize up to two pricing services in order to obtain prices on our fixed maturity portfolio. As a matter of policy, we consistently use one of the pricing services as our primary source and we use the second pricing service in certain circumstances where prices were not available from the primary pricing service. We validate the prices utilized for reasonableness in one of two ways: (i) randomly sampling the population and verifying the price to a separate third party source; or (ii) analytically validating the entire portfolio against a third pricing service. Historically, we have not experienced significant variances in prices and therefore we have consistently used either our primary or secondary pricing service. These prices are typically Level 2 in the fair value hierarchy.
For approximately 1% of our fixed maturity portfolio, we are unable to obtain a price from either our primary or secondary pricing service; therefore, we obtain non-binding broker quotes for such securities. These quotes are reviewed for reasonableness by internal investment professionals and are generally classified as Level 2 in the fair value hierarchy as the brokers are generally using market information to determine the quotes.
The fair value of the 8.87% Senior Notes due May 4, 2010 is estimated to be its carrying value due to its maturity being approximately 120 days from the balance sheet date.
Share-based compensation consists of all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share units, share options, or other equity instruments. The cost resulting from all share-based payment transactions are recognized in the consolidated financial statements, based on the fair value of both equity and liability awards. The fair value is measured at grant date for equity awards, whereas the fair value for liability awards are remeasured at each reporting period. Both the fair value of equity and liability awards is recognized over the requisite service period. The requisite service period is typically the lesser of the vesting period or the period of time from the grant date to the date of retirement eligibility. The expense recognized for share-based awards, which, in some cases, contain performance criteria, is based on the number of shares/units expected to be issued at the end of the performance period.
We service our agency distribution channel through our field model, which includes agency management specialists, loss control representatives, claim management specialists and our Underwriting and Claims Service Centers, all of which service the entire population of insurance contracts acquired through each agency.
Goodwill results from business acquisitions where the cost of assets and liabilities acquired exceeds the fair value of those assets and liabilities. Goodwill is tested for impairment annually or more frequently if events or changes in circumstances indicate that goodwill may be impaired. Goodwill is allocated to the reporting units for the purposes of the impairment test.
Reserves for losses and loss expenses are made up of both case reserves and reserves for claims incurred but not yet reported ("IBNR"). Case reserves result from claims that have been reported to our seven insurance subsidiaries (the "Insurance Subsidiaries") and are estimated at the amount of ultimate payment. IBNR reserves are established based on generally accepted actuarial techniques. Such techniques assume that past experience, adjusted for the effects of current developments and anticipated trends, are an appropriate basis for predicting future events. In applying generally accepted actuarial techniques, we also consider a range of possible loss and loss adjustment expense reserves in establishing IBNR.
The internal assumptions considered by us in the estimation of the IBNR amounts for both environmental and non-environmental reserves at our reporting dates are based on: (i) an analysis of both paid and incurred loss and loss expense development trends; (ii) an analysis of both paid and incurred claim count development trends; (iii) the exposure estimates for reported claims; (iv) recent development on exposure estimates with respect to individual large claims and the aggregate of all claims; (v) the rate at which new environmental claims are being reported; and (vi) patterns of events observed by claims personnel or reported to them by defense counsel. External factors identified by us in the estimation of IBNR for both environmental and non-environmental IBNR reserves include: (i) legislative enactments; (ii) judicial decisions; (iii) legal developments in the determination of liability and the imposition of damages; and (iv) trends in general economic conditions, including the effects of inflation. Adjustments to IBNR are made periodically to take into account changes in the volume of business written, claims frequency and severity, the mix of business, claims processing, and other items that are expected by management to affect our reserves for losses and loss expenses over time.
Reserves are reviewed for adequacy on a periodic basis. As part of the periodic review, we consider the range of possible loss and loss expense reserves, determined at the beginning of the year, in evaluating reserve adequacy. When reviewing reserves, we analyze historical data and estimate the impact of various factors such as: (i) per claim information; (ii) our and the industry's historical loss experience; (iii) legislative enactments, judicial decisions, legal developments in the imposition of damages, and changes in political attitudes; and (iv) trends in general economic conditions, including the effects of inflation. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. However, there is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves because the eventual deficiency or redundancy is affected by many factors. Based upon such reviews, we believe that the estimated reserves for losses and loss expenses are adequate to cover the ultimate cost of claims. The changes in these estimates, resulting from the continuous review process and the differences between estimates and ultimate payments, are reflected in the consolidated statements of income for the period in which such estimates are changed.
The Insurance Subsidiaries' net premiums written include direct insurance policy writings plus reinsurance assumed and estimates of premiums earned but unbilled on the workers compensation and general liability lines of insurance, less reinsurance ceded. Premiums written are recognized as revenue over the period that coverage is provided using the semi-monthly pro-rata method. Unearned premiums and prepaid reinsurance premiums represent that portion of premiums written that are applicable to the unexpired terms of policies in force.
Our pension and post-retirement life benefit obligations and related costs are calculated using actuarial methods, within the framework of U.S. generally accepted accounting principles. Two key assumptions, the discount rate and the expected return on plan assets, are important elements of expense and/or liability measurement. We evaluate these key assumptions annually. Other assumptions involve demographic factors such as retirement age, mortality, turnover, and rate of compensation increases. The discount rate enables us to state expected future cash flows at their present value on the measurement date. The guideline for setting this rate is a high-quality long-term corporate bond rate. To determine the expected long-term rate of return on the plan assets, we consider the current and expected asset allocation, as well as historical and expected returns on each plan asset class.
In February 2008, the FASB issued guidance under ASC 820, Fair Value Measurements and Disclosures (“ASC 820”), which was formerly referred to as FASB Staff Position (“FSP”) FAS 157-2, Effective Date of FASB Statement No. 157. This guidance delayed the previously issued fair value guidance until January 1, 2009 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the consolidated financial statements on a recurring basis. The adoption of this guidance did not have an impact on our results of operations or financial condition.
In May 2008, the FASB issued guidance under ASC 944, Financial Services - Insurance (“ASC 944”), which was formerly referred to as FASB Statement of Financial Accounting Standards No. 163, Accounting for Financial Guarantee Insurance Contracts - an interpretation of FASB Statement No. 60. This guidance applies to financial guarantee insurance and reinsurance contracts that are: (i) issued by enterprises that are included within the scope of ASC 944; and (ii) not accounted for as derivative instruments. This guidance is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. The adoption of this guidance did not have an impact on our results of operations or financial condition.
In December 2008, the FASB issued guidance under ASC 715, Compensation - Retirement Benefits, which was formerly referred to as FSP FAS 132(R)-1, an amendment to FASB Statement No. 132 (revised 2003), Employers' Disclosures about Pensions and Other Post-retirement Benefits, to provide guidance on an employer's disclosures about plan assets of a defined benefit pension or other postretirement plan. This guidance requires employers of public and nonpublic entities to disclose more information about the following:
The disclosure requirements are effective for years ending after December 15, 2009. We have included the required disclosures in Note 16. “Retirement Plans” of this Form 10-K.
In January 2009, FASB issued OTTI guidance under ASC 325 Investments, pertaining to structured securities that were not of high-credit quality at the date of purchase. Under the previously existing guidance for these securities, a company was required to use market participant assumptions about future cash flows. This requirement could not be overcome by management's judgment as to the probability of collecting all projected cash flows. This guidance amends this requirement in that companies are not required to place exclusive reliance on market participant assumptions about future cash flows and instead management is permitted to use reasonable judgment when considering the probability of collection of all future cash flows due in determining whether an OTTI charge exists. This guidance, which was effective for reporting periods ending after December 15, 2008, did not have a material impact on our operations.
In April 2009, the FASB issued guidance under ASC 820, which was formerly referred to as FSP FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly. This guidance addresses the factors that determine whether there has been a significant decrease in the volume and level of activity for an asset or liability when compared to the normal market activity. Under this guidance, if the reporting entity has determined that the volume and level of activity has significantly decreased and transactions are not orderly, further analysis is required and significant adjustments to the quoted prices or transactions may be needed. This guidance was effective for interim and annual reporting periods ending after June 15, 2009 and our adoption on April 1, 2009 did not have a material impact on our financial condition or results of operations. We have included the required disclosures in the following notes to the consolidated financial statements where applicable.
In April 2009, the FASB issued guidance under ASC 825, Financial Instruments, which was formerly referred to as FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments to provide guidance on additional disclosures surrounding fair value of financial instruments required when a publicly traded company issues financial information for interim reporting periods. The disclosure requirements are effective for interim reporting periods ending after June 15, 2009. We have included the required disclosures of this guidance for interim reporting purposes.
In August 2009, the FASB issued ASC Update 2009-05, Fair Value Measurements and Disclosures (Topic 820) - Measuring Liabilities at Fair Value, which provides guidance on the fair value measurement of liabilities that are traded as assets in the marketplace (i.e. debt obligations). In circumstances in which the quoted price in an active market is not available for an identical liability, a company should measure fair value using one or more of the following valuation techniques: (i) quoted price of the identical liability when traded as an asset; (ii) quoted prices for similar liabilities when traded as an asset; or (iii) a valuation technique that is based on the amount that the company would pay or receive to transfer an identical liability. This guidance was effective for the first reporting period beginning after August 26, 2009. The adoption did not have a material impact on our financial condition or results of operations.
In September 2009, the FASB issued ASC Update 2009-12, Fair Value Measurements and Disclosures (Topic 820) - Investment in Certain Entities that Calculate Net Asset Value per Share (or Its Equivalent). This update provides guidance in estimating the fair value of a company’s investments in investment companies when the investment does not have a readily determinable fair value. It permits the use of the investment’s net asset value as a practical expedient to determine fair value. This guidance also required additional disclosure of the attributes of these investments such as: (i) the nature of any restrictions on the reporting entity’s ability to redeem its investment; (ii) unfunded commitments; and (iii) investment strategies of the investees. This guidance is effective for periods ending after December 15, 2009. The adoption did not have a material impact on our financial condition or results of operations.
(a) Net unrealized gains (losses) on investments included in other comprehensive income (loss) by asset class are as follows:
The increase in our HTM securities in 2009 was primarily attributable to a $1.9 billion transfer of previously designated AFS securities to a HTM designation in the first quarter of 2009. We reassess the classification designation of each security we hold at each balance sheet date. The reclassification of these securities was permitted because we determined that we have the ability and the intent to hold these securities as an investment until maturity or call. We transferred these previously designated AFS securities to a HTM designation to preserve capital. Upon transfer from AFS to HTM, the difference between par value and fair value at the date of transfer is reflected as an unrealized gain or loss that is amortized as a yield adjustment over the expected life of the security. These unrealized gains or losses are reflected in AOCI on the Consolidated Balance Sheet, net of subsequent amortization.
3 RMBS includes government guaranteed agency securities with a fair value of $105.2 million.
2 Gross unrealized gains/(losses) include non-OTTI unrealized amounts and OTTI losses recognized in AOCI at December 31, 2009. In addition, this column includes remaining unrealized gain or loss amounts on securities that were transferred to a HTM designation in the first quarter of 2009 for those securities that are in a net unrealized/unrecognized loss position at December 31, 2009.
Unrecognized holding gains/(losses) represent market value fluctuations from the later of: (i) the date of a security is designated as HTM; or (ii) the date that an OTTI charge is recognized on a HTM security.
4 U.S. government includes corporate securities fully guaranteed by the FDIC.
Unrealized losses decreased compared to December 31, 2008, primarily because of the general improvement in the overall marketplace for our fixed maturity portfolio and the reduction in our equity portfolio as discussed below. As of December 31, 2009, 173 fixed maturity securities and six equity securities were in an unrealized loss position. At December 31, 2008, 355 fixed maturity securities, 45 equity securities, and one other investment security were in an unrealized loss position. As of December 31, 2009, the overall Standard and Poor’s credit quality rating of our fixed maturity securities was “AA+” and these securities are performing according to their contractual terms.
All other fixed maturity securities with an unrealized/unrecognized loss balance of $7.9 million.
$16.4 million in unrealized losses not related to OTTI charges (referred to as “traditional unrealized losses” in the discussion that follows). These securities had a decline in fair value of 24%, or $16.4 million, as compared to their amortized cost.
Loan-to-value ratios that generally ranged from 54% to 75%, with a weighted average of 70%;
Unrealized losses on our HTM CMBS that have been in a loss position for more than 12 months amounted to $16.2 million at December 31, 2009. These losses can be categorized as follows:
$7.1 million of non-credit OTTI charges that have been recognized in AOCI. These non-credit impairment charges were generated concurrently with related credit charges. Prior to impairment, these securities had a decline in fair value of 78%, or $19.1 million, as compared to their amortized cost.
Of the $9.1 million in traditional unrealized losses, $6.8 million, or 75%, related to three securities. The weighted average remaining contractual life of these securities was approximately two years as of December 31, 2009, and all scheduled principal and interest payments have been received to date. The evaluations performed used the following assumptions:
As a comparison, recent industry publications indicated a weighted average historical conditional default rate of 0.9 for CMBS, which is based on vintage years dating back to the mid-1990’s.
Under all scenarios performed, the underlying cash flows did not indicate that the impairment is other than temporary.
Based on the above, coupled with the fact that we do not have the intent to sell any of the securities discussed above, nor do we believe we will be required to sell these securities, we have concluded that they are not other-than-temporarily impaired as of December 31, 2009. This conclusion reflects our current judgment as to the financial position and future prospects of the entity that issued the investment security and underlying collateral. If our judgment about an individual security changes in the future, we may ultimately record a credit loss after having originally concluded that one did not exist, which could have a material impact on our net income and financial position in future periods.
The decrease in other investments of $31.4 million for 2009 compared to 2008 was primarily due to the $21.7 million decrease in the value of our alternative investments, combined with $5.7 million in distributions net of additional investments. The distributions include the sale of one of our limited partnerships for $12.1 million. The decrease in value was driven by general volatility in the capital markets and the slowdown of merger and acquisition activity that began in 2008. As 2009 progressed, the improvements in the credit markets and increasing stability in the financial markets were reflected in our returns on this portfolio, which improved from a $29.4 million loss in the first half of the year to a $7.7 million gain in the second half of the year.
This strategy makes private equity investments primarily in established large and middle market companies across diverse industries in North America, Europe and Asia.
This strategy purchases seasoned private equity funds from investors desiring liquidity prior to normal fund termination. Investments are made across all sectors of the private equity market, including leveraged buyouts, venture capital, distressed securities, mezzanine financing, real estate, and infrastructure.
The fund of funds component of our distressed debt strategy, which makes up approximately $7.4 million of our distressed debt strategy, encompasses a number of strategies that generally fall into one of the following broad categories:
Our seven alternative investment strategies employ low or moderate levels of leverage and generally use hedging only to reduce foreign exchange or interest rate volatility. At this time, our alternative investment strategies do not include hedge funds. We are committed for the full life of each fund and cannot redeem our investment with the general partner. Once liquidation is triggered by clauses within the limited partnership agreements or at the funds’ stated end date, we will receive our final allocation of capital and any earned appreciation of the underlying investments. Management does not intend to sell these investments in the secondary market in the near-term. We currently receive distributions from these alternative investments through the realization of the underlying investments in the limited partnerships. We anticipate that the general partners of these alternative investments will liquidate their underlying investment portfolios up through 2023. At December 31, 2009, we have contractual obligations that expire at various dates through 2023 to further invest up to $102.9 million in alternative investments. There is no certainty that any such additional investment will be required.
Net investment income, before tax, decreased to $118.5 million in 2009 from $131.0 million in 2008 due to: (i) an increase in losses on our alternative investments of $9.1 million; (ii) a decrease in interest income of approximately $7.7 million on our fixed maturity and short-term investment portfolios resulting from lower purchase yields; and (iii) lower dividend income of $3.3 million due to our reduced equity portfolio. Alternative investment losses, which amounted to $21.7 million on a pre-tax basis, were driven by the unprecedented volatility in the global capital markets that occurred during the second half of 2008 and continued through the first half of 2009. This volatility resulted in a decline in asset values, of which 57% was attributable to our real estate strategy and 30% was attributable to our private equity/private equity secondary market strategies. Alternative investment income made a sound recovery in the latter half of 2009 as equity markets rebounded and credit markets eased, in turn allowing the merger and acquisition environment to improve. These decreases were partially offset by the effect of the elimination of our trading portfolio in the first quarter of 2009. During 2008, unrealized losses of $8.1 million on the trading portfolio negatively impacted investment income.
(h) The following tables summarize OTTI by asset type for the periods indicated:
$2.5 million of ABS credit OTTI charges during 2009. These charges related primarily to two bonds from the same issuer, who is currently in technical default, that were previously written down.
$2.1 million of equity charges during 2009 related to seven equity securities. These seven securities were comprised of two banks, one bank exchange traded fund, one energy company, a membership warehouse chain of stores, and two healthcare companies. We believe the share price weakness of these securities is more reflective of general overall financial market conditions, as we are not aware of any significant deterioration in the fundamentals of these four companies. However, the length of time these securities have been in an unrealized loss position, and the overall distressed trading levels of these stocks make a recovery to our cost basis unlikely in the near term.
(i) The components of net realized (losses) gains, excluding OTTI charges, were as follows:
We sold equity securities during 2009 with realized gains of $33.4 million and realized losses of $28.1 million. This activity included the following:
The sale of certain equity securities in the first quarter of 2009, resulting in a net realized loss of approximately $0.2 million, comprised of $19.7 million in realized gains and $19.0 million in realized losses, in an effort to reduce overall portfolio risk. The decision to sell these equity positions was in response to an overall year-to-date market decline of approximately 24% by the end of the first week of March. In addition, the Parent's market capitalization at that time had decreased more than 50% since the latter part of January 2009, which we believe to be due partially to investment community views of our equity and equity-like investments. Our equity-like investments include alternative investments, many of which report results to us on a one quarter lag. Consequently, we believed the investment community would wait to evaluate our results based on the knowledge they had of the previous quarter's general market conditions. As a result, we determined it was prudent to mitigate a portion of our overall equity exposure. In determining which securities were to be sold, we contemplated, among other things, security-specific considerations with respect to downward earnings trends corroborated by recent analyst reports, primarily in the energy, commodity, and pharmaceutical sectors.
1 Our notes payable are subject to certain debt covenants that were met in their entirety in 2009 and 2008. For further discussion regarding the debt covenants, refer to Note 10, “Indebtedness” in this Form 10-K.
The following tables provide quantitative disclosures of our financial assets that were measured at fair value at December 31, 2009 and 2008:
Certain assets are measured at fair value on a nonrecurring basis. Due to the economic deterioration that occurred during 2008 and 2009 in the U.S., our near-term financial projections for our HR Outsourcing reporting unit were not sufficient to support its carrying value during the fourth quarter of 2008. As a result, a pre-tax goodwill impairment loss of $4.0 million was recognized for this reporting unit, which is included in “Loss from discontinued operations, net of tax” in our Consolidated Statements of Income. Fair value was determined using various inputs including, but not limited to expected present value of future cash flows, comparison to similar companies, and market multiples.
On January 1, 2008, we adopted the Fair Value Option of ASC Topic 825. This topic provides companies with an option to report selected financial assets and liabilities at fair value (“fair value option”). We elected to apply the fair value option to certain securities that were being managed by an external manager at the time of adoption. The securities for which we elected the fair value option were previously held as AFS securities and were classified as trading securities as of December 31, 2008. As of December 31, 2009, we no longer hold equities classified as trading securities.
The following table provides information regarding the reclassification and corresponding cumulative-effect adjustment on retained earnings resulting from the initial application of this topic for this portfolio:
The Insurance Subsidiaries remain liable to policyholders to the extent that any reinsurer becomes unable to meet our contractual obligations. We evaluate and monitor the financial condition of our reinsurers under voluntary reinsurance arrangements to minimize our exposure to significant losses from reinsurer insolvencies. On an ongoing basis, we review amounts outstanding, length of collection period, changes in reinsurer credit ratings and other relevant factors to determine collectability of reinsurance recoverables. The allowance for reinsurance recoverables on paid and unpaid losses and loss expenses was $2.5 million at both December 31, 2009 and December 31, 2008.
Assumed premiums written remained flat in 2009 compared to 2008 and decreased in 2008 compared to 2007 primarily due to reduction in mandatory and voluntary pool assumptions. Assumed premiums earned decreased in 2009 compared to 2008 and in 2008 compared to 2007, reflecting the assumed premiums written changes mentioned above. Assumed losses decreased in each period primarily due to a reduction in mandatory pool assumptions.
At December 31, 2009, our reserves for environmental claims amounted to $50.5 million on a gross basis (including case reserves of $16.5 million and IBNR reserves of $34.0 million) and $41.6 million on a net basis (including case reserves of $11.4 million and IBNR reserves of $30.2 million). There are a total of 1,366 environmental claims. Of these, 1,136 are asbestos related, of which 440 are with 27 insureds in the wholesale and/or retail of plumbing, electrical, and other building supplies with related case reserves of $1.1 million. In addition, 647 asbestos claims are with one insured, an asbestos gasket manufacturer with related case reserves of $0.9 million. During 2009, 1,030 asbestos claims were closed, which accounted for approximately $0.1 million of the total asbestos paid of $0.8 million. The total case reserves for asbestos related claims amounted to $2.9 million on a gross basis and $2.3 million on a net basis. About 51 of the total environmental claims involve nine landfill sites. The landfill sites account for case reserves of $8.1 million on a gross and $4.0 million on a net basis, and include reserves for several sites that are currently listed on the National Priorities List. The remaining claims, which account for $5.5 million of case reserves on a gross and $5.0 million on a net basis, involve leaking underground heating oil storage tanks and other latent environmental exposures.
(1) On September 25, 2006, we issued $100 million aggregate principal amount of 7.5% Junior Subordinated Notes due 2066 ("Junior Notes"). The Junior Notes will pay interest, subject to our right to defer interest payments for up to 10 years, on March 15, June 15, September 15, and December 15 of each year, beginning December 15, 2006, and ending on September 27, 2066. On or after September 26, 2011, the Junior Notes may be called at any time, in whole or in part, at their aggregate principal amount, together with any accrued and unpaid interest. The net proceeds of $96.8 million from the issuance were used for general corporate purposes. There are no attached financial debt covenants to which we are required to comply in regards to the Junior Notes.
(4) On May 4, 2000, we entered into a $61.5 million note purchase agreement with various private lenders covering the 8.87% Senior Notes. We have paid $49.2 million in principal to date, in addition to accrued interest thereon, for these notes. The final principal payment of $12.3 million is due on May 4, 2010. The unpaid principal amount of the 8.87% Senior Notes, which was $12.3 million at December 31, 2009 and $24.6 million at December 31, 2008, accrues interest and is payable semiannually on May 4 and November 4 of each year, until the principal is paid in full. The agreements covering these notes contain a standard default cross-acceleration provision that provides the 8.87% Senior Notes will enter a state of default upon the failure to pay principal when due or upon any event or condition that results in an acceleration of principal, the election of directors to the Board, or a mandatory repurchase of any other debt instrument in excess of $1 million which we have outstanding concurrently with the 8.87% Senior Notes. In addition to the above cross-acceleration provision covenants, the note purchase agreement covering the 8.87% Senior Notes also contains financial debt covenants that are reviewed quarterly. They include, but are not limited to, a limitation on indebtedness, restricted ability to declare dividends, and net worth maintenance. All of the covenants were met during 2009 and 2008. At December 31, 2009, the amount available for dividends to stockholders under such restrictions was $303.6 million.
The funds borrowed by the Indiana Subsidiaries have been loaned to the Parent as of December 31, 2009 and are being used for general corporate purposes.
During the third quarter of 2009, the Parent terminated its previously existing line of credit and entered into a new syndicated line of credit agreement on August 25, 2009. This new $30 million line of credit is syndicated between Wachovia Bank N.A., a subsidiary of Wells Fargo & Company, as administrative agent and Branch Banking and Trust Company (“Line of Credit”) and allows us to increase our borrowings to $50 million with the approval of both lending parties. We continue to monitor current news regarding the banking industry, in general, and our lending partners, in particular, as, according to the syndicated line of credit agreement, the obligations of the lenders to make loans and to make payments are several and not joint. There were no balances outstanding under this credit facility as of December 31, 2009.
In addition to the above requirements, the syndicated line of credit agreement contains a cross-default provision that provides that the line of credit will be in default if we fail to comply with any condition, covenant or agreement (including payment of principal and interest when due on any debt with an aggregate principal amount of at least $10.0 million), which causes, or permits, the acceleration of principal.
Our ability to declare and pay dividends on the Parent's common stock is dependent on liquidity at the Parent coupled with the ability of the Insurance Subsidiaries to declare and pay dividends, if necessary, and/or the availability of other sources of liquidity to the Parent. Restrictions on the ability of the Insurance Subsidiaries to pay dividends, without alternative liquidity options, could materially affect our ability to pay dividends on common stock. The dividends from the Insurance Subsidiaries are subject to the regulatory limitations of the states in which the Insurance Subsidiaries are domiciled: New Jersey, New York, Indiana, or Maine. Based on the unaudited 2009 statutory financial statements, the maximum ordinary dividends that can be paid to the Parent by the Insurance Subsidiaries in 2010 are as follows:
We do not aggregate any of our operating segments. All historical data presented has been restated to reflect our current operating segments. Our goodwill balance for our operating segments was $7.8 million at December 31, 2009 and December 31, 2008 related to our Insurance Operations segment. The goodwill balance for our discontinued operation was $21.8 million at December 31, 2008 and is reflected in “Assets from discontinued operations” on the Consolidated Balance Sheets. See Note 13. “Discontinued Operations” for information regarding the goodwill impairment charge recognized in 2009.
In the fourth quarter of 2009, we sold 100% of our interest in Selective HR, which had historically comprised the HR Outsourcing segment of our operations. We sold our interest in Selective HR for proceeds to be received over a 10-year period in the amount of $12.3 million, based on the ability of the purchaser to retain and generate new worksite lives though the independent agents who currently distribute the HR Outsourcing products. The sale resulted in an after-tax loss of $1.2 million, which is included in discontinued operations on the Consolidated Statements of Income. Also included in discontinued operations on the Consolidated Statements of Income are $7.1 million and $0.3 million of after-tax losses in 2009 and 2008, respectively and $2.9 million of after-tax profit in 2007, reflecting the results of Selective HR’s operations prior to divestiture. Included in the 2009 after-tax loss, is the impact of a goodwill impairment charge of $7.9 million, after-tax, recognized in the third quarter of 2009 which was the result of Selective HR’s estimated fair value being not sufficient enough to support its carrying value.
The following table provides a reconciliation of the numerators and denominators of the basic and diluted earnings per share
Based on our federal tax loss carryback availability, expected levels of pre-tax financial statement income and federal taxable income, we believe it is more likely than not that the existing deductible temporary differences will reverse during periods in which we generate net federal taxable income or have adequate federal carryback availability. As a result, we have no valuation allowance recognized for federal deferred tax assets at December 31, 2009 and 2008.
Selective Insurance Company of America ("SICA") offers a voluntary defined contribution 401(k) retirement savings plan to employees who meet eligibility requirements. Participants, other than highly compensated employees (“HCEs”) as defined by the IRS can contribute up to 50% of their defined compensation to the Retirement Savings Plan. SICA limits the contributions of HCEs. We match 65% of participant contributions up to a maximum of 7% of defined compensation. Effective January 1, 2006, the Selective Insurance Retirement Savings Plan ("Retirement Savings Plan") was amended to include additional enhanced matching contributions and non-elective contributions for otherwise eligible employees who, because of a date of hire after December 31, 2005, are not eligible for the Retirement Income Plan for Selective Insurance Company of America ("Retirement Income Plan"). For those employees, following one year of service, we match, dollar for dollar, up to 2% of the employee's defined compensation. In addition, we make non-elective contributions to the Retirement Savings Plan equal to 2% of the employee's defined compensation. Employees age 50 or older who are contributing the maximum may also make additional contributions not to exceed the additional amount permitted by the IRS. Employer contributions plan amounted to $6.0 million in 2009, $6.4 million in 2008, and $5.4 million in 2007.
The Retirement Savings Plan allows employees to make voluntary contributions to a number of diversified investment options on a before and/or after-tax basis. The Parent’s common stock fund had been an investment option but as of March 10, the Parent common stock fund was closed to new contributions. Shares of the Parent's common stock issued under this plan were 13,983 during 2009, 27,920 during 2008, and 29,214 during 2007.
The Retirement Income Plan is a noncontributory defined benefit retirement income plan covering all SICA employees who meet eligibility requirements prior to January 1, 2006. At such date, the plan was amended to eliminate eligibility for plan participation by employees first hired on or after January 1, 2006. If otherwise qualified, these employees will, however, be eligible for enhanced matching and non-elective contributions from SICA under the Retirement Savings Plan as discussed above.
The Retirement Income Plan was amended as of July 1, 2002 to provide for different calculations based on service with the company as of that date. Monthly benefits payable under the Retirement Income Plan and Supplemental Excess Retirement Plan at normal retirement age are computed under the terms of those agreements. The earliest retirement age is age 55 with 10 years of service or the attainment of 70 points (age plus years of service). If a participant chooses to begin receiving benefits before their 65th birthday, the amount of their monthly benefit would be reduced in accordance with the provisions of the plan. At retirement, participants receive monthly pension payments and may choose among four joint and survivor payment options.
The funded status of these plans was recognized on the Consolidated Balance Sheets for 2009 and 2008, the details of which are as follows:
The fair value of our Retirement Income Plan investments is generated using various valuation techniques. We follow the methodology discussed in Note 2. “Summary of Significant Accounting Policies,” regarding pricing and valuation techniques, as well as the fair value hierarchy of equity and fixed maturity securities held in the Retirement Income Plan. The remaining assets, which primarily consist of investments in limited liability companies and limited partnerships, are carried at fair value based on net asset value. The majority of the net asset values are reported to us on a one quarter lag. We assess whether these reported net asset values are indicative of market activity that has occurred since the date of their valuation by the investees by: (i) reviewing the overall market fluctuation and whether a material impact to our investments' valuation could have occurred; and (ii) routine conversations had with the underlying funds' general partners/managers discussing, among other things, conditions or events having significant impacts to their portfolio assets that have occurred subsequent to the reported date, if any. The majority of these investments cannot be redeemed with the investee as we are required to hold the investments for the duration of the underlying funds' lives. As such, these funds have been fair valued using Level 3 inputs as of December 31, 2009 using the net asset value of our ownership interest in partners' capital. The Retirement Income Plan has one investment in a hedge fund which can be redeemed semi-annually provided a 30 day notification of intent to redeem. The net asset value is reported to us on a one quarter lag, thus we are unable to redeem these investments at the net asset value reported to us on December 31, 2009. However, management has determined the time between reporting periods is not significant enough to allow for a drastic change in fair value indications. As such these funds have been fair valued using Level 2 inputs as of December 31, 2009 using the net asset value of our ownership interest in partners' capital.
The following table provides a summary of the changes in fair value of securities using significant unobservable inputs (Level 3):
The following table outlines a summary of our alternative investment portfolio by strategy and the remaining commitment amount associated with each strategy:
Additionally, the portfolio may not contain investments in any one security or issuer greater than 5% of the portfolio value, regardless of the number of differing issues, except for U.S. Treasury and agency obligations, as well as sovereign debt issues rated A through AAA. The use of leverage is prohibited and the fund managers are prohibited from investing in certain types of securities.
The Retirement Income Plan had no investments in the Parent’s common stock as of December 31, 2009 and 2008.
We presently anticipate contributing $8.0 million to the Retirement Income Plan in 2010, none of which represents minimum required contribution amounts.
The Parent's Cash Incentive Plan was adopted and approved by the Board effective April 1, 2005 and approved by stockholders on April 27, 2005. Under the Cash Incentive Plan, the Board's SEBC may grant cash incentive units in such amounts and with such terms and conditions as it shall determine, subject to the provisions of the Cash Incentive Plan. The initial dollar value of these grants will be adjusted to reflect the percentage increase or decrease in the total shareholder return on the Parent's common stock over a specified performance period. In addition, for certain grants, the number of units granted will be adjusted to reflect our performance on specified indicators as compared to targeted peer companies. Each award granted under the Cash Incentive Plan shall be evidenced by an agreement containing such restrictions as the SEBC may, in its sole discretion, deem necessary or desirable and which are not in conflict with the terms of the Cash Incentive Plan. During 2009, we issued, net of forfeitures, 46,349 cash units, 48,890 cash units during 2008, and 38,681 cash units during 2007.
As of December 31, 2009, 400,742 shares of the Parent's common stock remain available for issuance pursuant to outstanding stock options and restricted stock awards granted under Stock Option Plan II, under which future grants ceased being available on May 22, 2002. Under Stock Option Plan II, employees were granted qualified and nonqualified stock options, with or without SARs, and restricted or unrestricted stock: (i) at not less than fair value on the date of grant and (ii) subject to certain vesting periods as determined by the SEBC. Restricted stock awards also could be subject to the achievement of performance objectives as determined by the SEBC. The maximum exercise period for an option grant under this plan is ten years from the date of the grant.
During the vesting period, dividends are earned on the restricted shares and held in escrow subject to the same vesting period and conditions set forth in the award agreement. Effective September 3, 1996, dividends earned on the restricted shares were reinvested in the Parent's common stock at fair value. We experienced net forfeitures of 679 restricted shares from Dividend Reinvestment Plan (“DRP”) reserves during 2009. We issued, net of forfeitures, 255 restricted shares from the DRP reserves during 2008 and 539 restricted shares from the DRP reserves during 2007.
As of December 31, 2009, there were 426,212 shares of the Parent's common stock available for issuance pursuant to outstanding stock options and restricted stock awards granted under Stock Option Plan III, under which future grants ceased being available with the approval of the Stock Plan. Under Stock Option Plan III, employees were granted qualified and nonqualified stock options, with or without SARs, and restricted or unrestricted stock: (i) at not less than fair value on the date of grant and (ii) subject to certain vesting restrictions determined by the SEBC. Restricted stock awards also could be subject to achievement of performance objectives as determined by the SEBC. The maximum exercise period for an option grant under this plan is 10 years from the date of the grant.
As of December 31, 2009, 336,000 shares of the Parent's common stock were available for issuance pursuant to outstanding stock option awards under the Stock Option Plan for Directors, under which future grants ceased being available with the approval of the Stock Plan. All non-employee directors participated in this plan and automatically received an annual nonqualified option to purchase 6,000 shares of the Parent's common stock at not less than fair value on the date of grant, which was on March 1. Options under this plan vested on the first anniversary of the grant and must be exercised by the tenth anniversary of the grant.
On April 29, 2009, our stockholders’ approved the Employee Stock Purchase plan (2009) (“ESPP”). This plan replaced the previous employee stock purchase savings plan under which no further purchases could be made as of July 1, 2009. Under ESPP, there were 1,404,195 shares of the Parent's common stock available for purchase as of December 31, 2009. The ESPP is available to all employees who meet the plan's eligibility requirements. The ESPP provides for the issuance of options to purchase shares of common stock. The purchase price is the lower of: (i) 85% of the closing market price at the time the option is granted or (ii) 85% of the closing price at the time the option is exercised. Shares are generally issued on June 30 and December 31 of each year. Collectively, under the current and prior plans, we issued 190,845 shares to employees during 2009, 134,561 shares during 2008, and 108,062 shares during 2007.
The total intrinsic value of options exercised was $0.4 million during December 31, 2009, $2.8 million during December 31, 2008, and $1.9 million during December 31, 2007.
As of December 31, 2009, total unrecognized compensation cost related to non-vested restricted stock and RSU awards granted under our stock plans was $4.7 million. That cost is expected to be recognized over a weighted-average period of 1.7 years. The total fair value of restricted stock and RSU vested was $7.9 million for 2009, $14.2 million for 2008, and $22.7 million for 2007. In connection with the restricted stock vestings, the total fair value of the DRP shares that also vested was $0.6 million during 2008 and $1.1 million during 2007.
William M. Rue, a Director of the Parent, is President of, and owns more than 10% of the equity of, Chas. E. Rue & Sons, Inc. t/a Rue Insurance, a general independent insurance agency ("Rue Insurance"). Rue Insurance is an appointed independent agent of the Insurance Subsidiaries and of the recently discontinued operations of Selective HR, on terms and conditions similar to those of our other agents. Rue Insurance also places insurance for our business operations. Our relationship with Rue Insurance has existed since 1928.
Rue Insurance placed human resource outsourcing contracts with Selective HR resulting in revenues to Selective HR of approximately $77,000 in 2009, $79,000 in 2008, and $69,000 in 2007. In return, Selective HR paid commissions to Rue Insurance of approximately $10,000 in 2009, $12,000 in 2008, and $15,000 in 2007. These revenues are reflected in “(Loss) income from discontinued operations, net of tax” in the Consolidated Statements of Income.
Rue Insurance placed insurance coverage for us with other insurance companies for which Rue Insurance was paid commission pursuant to its agreements with those carriers. We paid premiums for such insurance coverage of $0.5 million in 2009, 2008, and 2007.
In 2005, a private foundation, The Selective Group Foundation (the "Foundation"), was established by us under Section 501(c)(3) of the Internal Revenue Code. The Board of Directors of the Foundation is comprised of some of the Parent's officers. We made contributions to the Foundation in the amount of $0.4 million in 2009, $0.5 million in 2008, and $0.4 million in 2007.
In addition, certain leases for rented premises and equipment are non-cancelable, and liability for payment will continue even though the space or equipment may no longer be in use. At December 31, 2009, the total future minimum rental commitments under non-cancelable leases were $24.1 million and such yearly amounts are as follows:
(c) At December 31, 2009, we have contractual obligations that expire at various dates through 2023 to invest up to an additional $102.9 million in alternative investments. There is no certainty that any such additional investment will be required. For additional information regarding these investments, see item (f) of Note 5. "Investments."
The combined statutory capital and surplus of the Insurance Subsidiaries was $981.9 million (unaudited) in 2009 and $884.4 million in 2008. The combined statutory net income of the Insurance Subsidiaries was $69.8 million (unaudited) in 2009, $104.3 million in 2008, and $167.6 million in 2007.