(1) Net premiums written are premiums for all policies sold during a specific accounting period less premiums returned.
(4) Statutory underwriting expense ratio measures underwriting expenses as a percentage of net premiums written based upon statutory accounting principals.
(5) Statutory combined ratio measures the percentage of premium dollars used to pay insurance losses, loss adjustment expenses and underwriting expenses based upon statutory accounting principals.
(6) Statutory policyholders' surplus is equal to an insurance company's admitted assets minus liabilities based upon statutory accounting principals.
* Adjusted for effect of EITF Issue No. 04-8 in 2004, 2003 and 2002, see Footnote 10, Earnings Per Share.
The following discussion of financial condition and results of operation highlights significant factors influencing the consolidated results and financial position of the Corporation. This discussion should be read in conjunction with the consolidated financial statements and related notes, all of which are integral parts of the following analysis of the results of operations and financial position.
The Corporation reported net income of $128.4, or $1.89 per share, for 2004, compared with $75.8, or $1.18 per share, for the year 2003, and a net loss of $0.9, or $0.01 per share, in 2002. The Corporation reported operating income of $115.1, or $1.71 per share, for 2004, compared with $52.5, or $0.84 per share, for the year 2003 and an operating loss of $30.3, or $0.50 per share, for 2002.
The Corporation adopted the Emerging Issues Task Force ("EITF") Consensus 04-8 "The Effect of Contingently Convertible Debt on Diluted Earnings per Share" in December 2004 and as required by the EITF restated the average diluted shares outstanding and diluted net income per share for each of the three years presented in this MD&A using the "if-converted" method. The impact of the adoption of the EITF was a reduction to diluted net income per share of $0.16 and $0.06 for the years ended December 31, 2004 and 2003, respectively. The impact of this EITF on operating income per share was a reduction of $0.13 and $0.02 for the years ended December 31, 2004 and 2003, respectively. The year ended December 31, 2002 was not restated for either net income or operating income per share as the Corporation incurred a net loss during that year, which resulted in the calculation being anti-dilutive.
Decreases in personnel and sales related expenses led to the improved results for 2003 compared with 2002. Staff reductions of 11.2% in 2003 compared to 2002 were the result of the claim department reorganization and the Lexington and Indianapolis underwriting offices being consolidated into other locations. The loss ratio improved in 2003 due to tighter underwriting standards and an improved risk profile. In addition, development on prior accident years' losses and LAE decreased $50.3 before tax from 2002 to $34.1 before tax in 2003. These improved results were offset by increased catastrophe losses during 2003. Catastrophe losses before tax more than doubled to $43.8 in 2003 from $20.8 in 2002 resulting from storms that swept through the Midwest
Consolidated before-tax net investment income was $201.2 in 2004, compared with $208.7 in 2003 and $207.1 in 2002. The decrease in 2004 consolidated before-tax net investment income of $7.5 is attributable to reinvestment yields being below average portfolio yields, the strategic decision to invest, or reinvest, more of the portfolio into tax exempt fixed maturities, increased investment expenses attributable to outside management fees and the allocation of interest income pertaining to investments held in the reinsurance treaty fund as part of the Group's reinsurance program. This decrease is partially offset by larger average portfolio holdings during 2004 than in 2003 and a favorable amortization adjustment on certain fixed income securities, with a portion of this adjustment representing a reclassification from realized gains. The change in investment strategy to invest more into tax exempt securities is the result of improved profitability. This change in investment strategy will result in the Corporation's and the Group's before-tax investment income declining when compared to prior periods when the strategy was to invest in taxable securities. As a result of this strategy, the Corporation's and the Group's effective tax rate on investment income will be lower when compared to these prior periods.
The increase in 2003 consolidated before-tax net investment income of $1.6 is attributable to an increase in investment assets held, partially offset by increased investment expenses attributable to the implementation of a new investment accounting system, lower average yields on its fixed income portfolio, and increased investment management fees from expanded use of outside investment managers. As part of a conversion to a new investment accounting system in 2003, before tax investment income was reduced by $5.9 as a result of a change in accounting estimate relating to amortization of interest only mortgage-backed and asset-backed securities. Offsetting most of this charge was a $5.3 credit for interest received on a federal income tax settlement.
Consolidated before-tax realized net investment gains amounted to $23.0, $35.9 and $45.2 for the years ended 2004, 2003 and 2002, respectively. During 2004, 2003 and 2002, there were no significant realized losses on sales of securities.
Future impairment charges could be material to the results of operations. The amount of the before-tax other-than-temporary impairment charge recorded was $8.7, $10.5 and $10.9 for the years ended 2004, 2003 and 2002, respectively. This impairment charge represents less than 0.5% of the market value of the investment portfolio at December 31, 2004, 2003 and 2002, respectively. Included in both the 2004 and 2003 impairment charges were $5.1 and $5.9, respectively, related to fixed maturity securities issued by companies in the airline industry, Delta Air Lines, Inc. and AMR Corporation specifically.
The following tables summarize for all available-for-sale and held-to-maturity securities, the total gross unrealized losses, excluding gross unrealized gains, by investment category and length of time the securities have continuously been in an unrealized loss position as of December 31, 2004 and December 31, 2003:
Management believes that it will recover the cost basis in the securities held with unrealized losses as it has both the intent and ability to hold the securities until they mature or recover in value. Securities are sold to achieve management's investment goals, which include the diversification of credit risk, the maintenance of adequate portfolio liquidity, a competitive investment yield and the management of interest rate risk. In order to achieve these goals, sales of investments are based upon current market conditions, liquidity needs and estimates of the future market value of the individual securities.
The amortized cost and estimated fair value of fixed maturity securities classified as available-for-sale and held-to-maturity with an unrealized loss position at December 31, 2004, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
For additional discussion relative to the Corporation's investment portfolio, see the "Investment Portfolio" section under "Liquidity and Capital Resources" on pages 43 and 44 of this MD&A.
The Corporation maintains an identifiable intangible asset referred to as "Agent Relationships." See the "Critical Accounting Policies" section of this MD&A on page 32 for additional information. In 2004, the before-tax amortization and impairment costs related to this asset were $20.6 compared with $18.7 in 2003 and $79.7 in 2002. At December 31, 2004, the largest individual agent asset carrying value was $5.6, which represents the maximum future impairment charge for an individual agent, compared to $5.9 at December 31, 2003. Based upon historical performance of this agent, it is unlikely the agent will become impaired or cancelled in the near term. For the approximately 250 individual agents remaining that represent the total agent relationships intangible asset, the average asset carrying value as of December 31, 2004, was $0.5 which compares to approximately 300 agents with an average asset carrying value of $0.5 at December 31, 2003. The larger than usual impairment charge in 2002 was due primarily to the recognition that certain agents experienced sustained premium revenue trends that were significantly different from prior estimates, resulting in changes in estimated future cash flows for those agents.
The Group has introduced into production, for certain lines of business, an internally developed software application for issuing and maintaining insurance policies named P.A.R.I.S.(sm), a policy administration, rating and issuance system. During 2004 and 2003, the Group capitalized application development costs associated with the Personal Lines segment, which is expected to begin rollout in 2006. In addition, in December 2004, the Group began rollout for the Specialty Lines segment. The Specialty Lines segment rollout is expected to continue throughout 2005. During 2002, the Group substantially completed the rollout for the Commercial Lines operating segment. A rollout begins when the application has been placed into service for one or more states for an individual major product line and ends when the application is placed into service for the final state. The rollout period can exceed one year for an individual major product line. The Group capitalizes costs incurred during the application development stage, primarily relating to payroll and payroll-related costs for employees,
along with costs incurred for external consultants who are directly associated with the internal-use software project. The cost associated with this application is amortized on a straight-line basis over the estimated useful life of ten years from the date placed into service with before-tax amortization expense of $3.1, $2.6 and $1.3 for 2004, 2003 and 2002, respectively. Capitalized internally developed software costs (including P.A.R.I.S.(sm) and other internally developed software) and accumulated amortization are summarized in the table below:
For additional information relative to the internally developed software, see the "Critical Accounting Policies" section of this MD&A on page 32.
Management uses statutory financial data to analyze the Group's property and casualty results and insurance industry regulators require the Group to report statutory financial measures. Management analyzes statutory results of operations through the use of insurance industry financial measures including statutory loss and LAE ratios, statutory underwriting expense ratio, statutory combined ratio, net premiums written and net premiums earned. The statutory combined ratio is a commonly used gauge of underwriting performance measuring the percentage of premium dollars used to pay insurance losses and related expenses. The combined ratio is the sum of the loss, LAE and underwriting expense ratios. All references to combined ratio or its components in the MD&A are calculated on a statutory accounting basis and are calculated on a calendar year basis unless specified as calculated on an accident year basis. A discussion of the differences between statutory accounting and generally accepted accounting principles in the United States is included in Item 15, Notes to Consolidated Financial Statements, Footnote 15 on page 69 of this Annual Report on Form 10-K.
Premium revenue reflects premiums earned by the Group. The Group's premiums are earned principally on a monthly pro rata basis over the term of the policy. Management analyzes premium revenues primarily by premiums written in the current period. Net premiums written differ from gross premiums written by premiums ceded to reinsurers.
The table below summarizes property and casualty premiums on a gross and net basis compared with the same period of the prior year for 2004, 2003 and 2002, respectively:
Statutory net premiums written increased $12.3 in 2004 to $1,453.9. The increase in statutory net premiums written over 2003 reflects the Group's improved retention ratios and price increases. Net premiums written for 2004 include negative impacts for higher reinsurance costs and lower new business production. Net premiums written totaled $1,441.6 in 2003 and $1,448.6 in 2002. The slight decline of net premiums written in 2003 when compared to 2002 is primarily attributable to the Group's withdrawal from select markets and implementation of stricter underwriting guidelines, including the non-renewal of certain construction defect related risks. In addition, the decline in net premiums written from 2002 to 2003 reflects the impact of higher reinsurance costs.
Commercial Lines gross and net premiums written increased in 2004 and 2003, a result of policy renewal rate increases as new business gross written premium has remained relatively flat. Renewal pricing increased during 2004, 2003 and 2002, but the rate of increase slowed as the Commercial Lines segment approached price adequacy and competitive pricing pressures in the marketplace have increased. The 2004 average renewal price increase 1 was 5.0% for Commercial Lines direct premiums written, compared with 11.4% and 16.3% average renewal price increases in 2003 and 2002, respectively.
Specialty Lines gross and net premiums written decreased in 2004, a result of lower new business production and higher reinsurance costs in the commercial umbrella product line partially offset by growth in the fidelity and surety product line. Net premiums written for the commercial umbrella product line decreased $33.8 or 28.0% in 2004 to $87.1, compared with $120.9 in 2003 and $132.7 in 2002. Fidelity and surety net premiums written increased 10.2% to $48.4 million, compared to $43.9 million and $45.6 million in 2003 and 2002, respectively. Stricter underwriting guidelines for certain classes of business and market prices falling below what the Group believes are acceptable levels, contributed to the decline in new business production for the commercial umbrella product line. The net premiums written decline from 2002 to 2003 was impacted by higher reinsurance costs, including the addition of a ceding commission and increased reinsurance rates per dollar of premium. The addition of ceding commissions on the 2003 and 2004 reinsurance contracts causes a corresponding increase to ceded premiums. Average renewal price increases for the commercial umbrella product line were 8.0%, compared to 18.1% in 2003 and 37.6% in 2002.
During 2003, the Group reported adverse development of $34.1 for prior years' losses and LAE, representing 1.6% of loss and LAE reserves as of year-end 2002. This adverse development was concentrated in the Commercial and Personal Lines operating segments.
The 2002 combined ratio includes a reallocation of LAE reserve estimates related to claims adjuster salaries, benefits and similar costs from the Commercial and Specialty Lines segments, to the Personal Lines segment. This increased the 2002 Personal Lines segment combined ratio by 1.5 points and decreased the Commercial and Specialty Lines segments combined ratios by 0.6 and 2.4 points, respectively.
Catastrophe losses in 2004, 2003 and 2002 were $43.5, $43.8 and $20.8, respectively. The Group was impacted by 22 separate catastrophes in 2004, compared with 21 catastrophes in 2003 and 25 in 2002. The Group uses the serial number assigned by Property Claims Services, a unit of the Insurance Services Office, to define and track losses for specific catastrophes. Property Claims Services defines catastrophes as industry events that cause $25.0 or more in direct insured losses to property. The effects of future catastrophes on the Corporation's results cannot be accurately predicted. As such, severe weather patterns, acts of war or terrorist activities could have a material adverse impact on the Corporation's results, reinsurance pricing and availability of reinsurance.
The seven-year historical catastrophe impact on the loss ratio compared to 2004 actual for all lines of business was:
The year 2002 underwriting expense ratio experienced upward pressure due to two factors with a total impact of approximately 1.6 points. These two factors were the non-renewal of the New Jersey private passenger auto business, which had lower commission rates and lower variable processing costs than most other business and the elimination of ceding commissions on umbrella premiums ceded to reinsurers, which had reduced expenses in previous years. The 2002 commission expense ratio, a component of the underwriting expense ratio, was at a relatively high level due to higher than expected umbrella net premiums written, which had a relatively high commission rate on a net of reinsurance basis and to higher than expected accruals for agent bonus commissions.
(a) The loss and LAE ratio component of the accident year combined ratio measures losses and LAE arising from insured events that occurred in the respective accident year. The current accident year excludes losses and LAE for insured events that occurred in prior accident years. Accident year 2004 as of December 31, 2004 measures insured events for the twelve months of 2004. Accident year 2003 as of December 31, 2004 measures insured events for the twelve months of 2003 with remaining related liabilities estimated as of December 31, 2004. Accident year 2002 as of December 31, 2004 measures insured events for the twelve months of 2002 with remaining related liabilities estimated as of December 31, 2004. Accident periods may not be comparable due to seasonality, claim reporting and development patterns, claim settlement rates and other factors.
The Commercial Lines combined ratio for the year 2004 decreased 13.0 points due to a significantly lower loss ratio as a result of improved pricing and underwriting quality in addition to favorable development on prior year reserves. Favorable claim frequency trends, driven in part by underwriting actions, and improved pricing helped to offset the Commercial Lines claim severity trend. The 2004 combined ratio included 1.9 points of favorable development on loss and LAE reserves from prior years, compared to adverse development of 5.3 points in 2003 on loss and LAE reserves from prior years. The decline in the combined ratio also included a 2.1 point improvement in the underwriting expense ratio primarily as a result of staff reductions and employee benefit changes.
The combined ratio improved from 2002 to 2003 by 2.8 points, in spite of $41.0 or 5.3 points of adverse development on loss and LAE reserves. The 2002 combined ratio was impacted by $73.9 or 10.2 points of adverse prior year development of loss and LAE reserves. Of this amount, approximately $51.6 related to construction defect issues, which added 7.1 points to the combined ratio for 2002.
Commercial Lines results for 2004 included higher than expected catastrophe losses which added 2.4 points to the Commercial Lines combined ratio in 2004, compared to 2.6 points and 0.5 points in 2003 and 2002, respectively.
Specialty Lines combined ratio for 2004 increased 20.0 points. Given the volume and nature of the coverage, the Specialty Lines combined ratio is subject to more volatility than the other product lines. The 2004 combined ratio included $9.3, or 6.2 points, of favorable development on prior year loss and LAE reserves compared to $21.3, or 13.1 points, in 2003 and $2.2, or 1.4 points, in 2002.
Management of the Corporation has identified the policies listed below as significant accounting policies that are critical to the Corporation's business operations and influence the consolidated results of operations and financial performance. The policies listed below were selected as they require a higher degree of complexity or use subjective judgements or assessments. Changes in these judgements, assessments or estimates could have a material adverse impact on the Corporation's consolidated financial statements. These policies follow accounting principles generally accepted in the United States. A brief summary of each critical accounting policy follows. Management discusses the development and selection of these accounting policies with the Audit Committee of the Board of Directors and the Audit Committee has reviewed the Corporation's MD&A. For a complete discussion on the application of these and other accounting policies, see Item 15, Notes to Consolidated Financial Statements, Footnote 1 on pages 54-56 of this Annual Report on Form 10-K.
All investment securities are classified upon acquisition as either held-to-maturity or available-for-sale. Fixed maturity securities classified as held-to-maturity are carried at amortized cost as management has the ability and positive intent to hold the securities until maturity. Available-for-sale securities are those securities that would be available to be sold in the future in response to liquidity needs, changes in market interest rates and asset-liability management strategies, among others. Available-for-sale securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported as a component of other comprehensive income, net of deferred tax. Transfers of fixed maturity securities into the held-to-maturity category from the available-for-sale category are made at fair value at the date of transfer. The unrealized holding gain or loss at the date of transfer is retained in other comprehensive income and in the carrying value of the held-to-maturity securities. Such amounts are amortized over the remaining life of the security. Equity securities are carried at quoted market values and include non-redeemable preferred stocks and common stocks. The difference between cost and quoted market value, net of deferred taxes, is classified as other comprehensive income. The Corporation and the Group closely monitor the fixed maturity and equity portfolios for declines in value that are deemed to be other than temporary. Investments are regularly evaluated based on current economic conditions, credit loss experience and other specific developments. If a decline in a security's fair value is considered to be other than temporary, the security is written down to the estimated fair value with a corresponding realized loss recognized in the current consolidated statement of income.
funds are allocated between a reduction of principal and interest income. In making this allocation decision, investment personnel consider such factors as the original estimated average life of the investment, the amount of funds received to date and the timing of future cash flows. Variations from prepayment assumptions will affect the life and yield of these securities. These securities are evaluated for impairment by computing the net-present-value of expected future cash flows and comparing this to the prior period estimate of expected future cash flows from the security. When the timing and/or amount of cash expected to be received from the security has changed materially and adversely from the previous valuation, the security is considered to be other than temporarily impaired and the amortized cost is written down to the estimated fair value with a realized loss recorded in the current consolidated statement of income.
The Group establishes a deferred asset for costs that vary with and are primarily related to acquiring property and casualty insurance business. The acquisition costs deferred consist principally of commissions, brokerage fees, salaries and benefits and other underwriting expenses to include allocations for inspections, taxes, rent and other expenses that vary directly with the acquisition of insurance contracts. These costs are amortized over the life of the underlying policies. Quarterly, an analysis of the asset is performed in relation to the expected recognition of revenues including investment income to determine if any deficiency exists. No deficiencies have been indicated for the periods presented.
The agent relationships asset is an identifiable intangible asset representing the excess of cost over the fair value of net assets acquired in connection with the 1998 GAI commercial lines acquisition. This purchase price was allocated to specifically identifiable intangible assets based on their estimated values as determined by appropriate valuation models. The agent relationships asset is amortized on a straight-line basis over an estimated useful life of twenty-five years. The estimated useful life was based on the Group's actual experience for agency appointment terms for similar agents, which averaged approximately twenty-five years in length. The estimated useful life is evaluated on an annual basis or as events or circumstances arise that may impact the useful life of the asset. The asset is evaluated quarterly as events or circumstances, such as cancellation of agents, indicate a possible inability to recover the carrying amount. Cancellation of certain agents for reasons such as lack of revenue production or poor quality of business produced does not necessarily change the estimated useful life of the remaining agents representing the agent relationships intangible asset. Such evaluation is based on various analyses, including cash flow and profitability projections that incorporate, as applicable, the impact on existing company businesses. The analyses involve significant management judgments to evaluate the capacity of an acquired business to perform within projections. If future undiscounted cash flows are insufficient to recover the carrying amount of the asset, an impairment loss is recognized in income in the period in which the future cash flows are identified to be insufficient in comparison to the carrying amount of the asset. Due to the inherent uncertainties and judgements involved in developing assumptions for each agent, further reductions in the valuation of the agent relationships asset are likely to occur in the future.
The Corporation is dependent on dividend payments from its insurance subsidiaries in order to meet operating expenses and debt obligations. Insurance regulatory authorities impose various restrictions and prior approval requirements on the payment of dividends by insurance companies. As of December 31, 2004, approximately $138.3 of statutory surplus was not subject to prior dividend approval requirements. Additional restrictions may result from the minimum net worth and surplus requirements in the credit agreement as disclosed in Item 15, Notes to Consolidated Financial Statements, Footnote 16 on pages 69 and 70 of this Annual Report on Form 10-K.
The following table presents the Corporation's obligations to make future payments under contractual obligations as of December 31, 2004:
***Excluded from other long-term liabilities are pension obligations which are described in Item 15, Notes to Consolidated Financial Statements, Footnote 5 on pages 59-62 of this Annual Report on Form 10-K and disclosed separately below.
In December 2003, the FASB issued a revised Interpretation No. 46 "Consolidation of Variable Interest Entities" (FIN 46), an interpretation of Accounting Research Bulletin No. 51. FIN 46 requires a variable interest entity (VIE) to be consolidated by the primary beneficiary of the entity if certain criteria are met. The Corporation currently holds an equity investment, representing a 49% interest, in APM Spring Grove, Inc. (APM), which was deemed a variable interest entity in accordance with FIN 46. As a result, the entity was consolidated into the Corporation's financial statements during the first quarter of 2004, which resulted in a $1.6 loss, net of tax, due to a cumulative effect of an accounting change. The Corporation's maximum exposure to loss as a result of its involvement with APM is $3.3. See Item 15, Notes to Consolidated Financial Statements, Footnote 18 on page 71 of this Annual Report on Form 10-K for further discussion.
On June 29, 2004, the Corporation issued $200.0 of 7.3% Senior Notes due June 15, 2014 (Senior Notes). The net proceeds from the issuance after related fees and discount were $198.0. In the fourth quarter 2004, the Corporation used part of the net proceeds to repurchase $12.5 of the $201.3 aggregate principal amount of its 5.00% Convertible Notes due March 19, 2022, (Convertible Notes) and intends to use the remainder of the net proceeds to redeem the remainder of its Convertible Notes. The Corporation may also use the net proceeds to repurchase shares of its common stock in an amount up to the equivalent number of shares issued if holders convert their Convertible Notes into shares of the Corporation's common stock. The repayment of the Convertible Notes will reduce the potential for significant future share and earnings dilution. Until the funds are needed for such purposes, the Corporation has invested the net proceeds from the Senior Notes in short-term marketable securities. Interest is payable on the Convertible Notes on March 19 and September 19 and payable on the Senior Notes on June 15 and December 15.
The Convertible and Senior Notes are reported on the consolidated balance sheets net of unamortized issuance-related costs and discount of $8.7 ($6.3 related to the Convertible Notes and $2.4 related to the Senior Notes) and $6.9 (all related to the Convertible Notes) at December 31, 2004 and 2003, respectively. The Corporation uses the effective interest rate method to record interest expense, amortization of issuance-related costs and amortization of the discount.
Holders of the Convertible Notes have the option to require the Corporation to purchase all or a portion of the Convertible Notes on March 19 of 2007, 2012 and 2017 at 100% of the principal amount. Further, if a change in control, as defined in the indenture, of the Corporation occurs anytime prior to maturity, holders may require the Corporation to purchase for cash all or a portion of the Convertible Notes at 100% of the principal amount.
Under certain conditions, at the option of the holders, the Convertible Notes may be converted into shares of the Corporation's common stock at the rate of 44.2112 shares per $1,000 principal amount, subject to adjustment in certain circumstances. If the closing sale price of the Corporation's common stock for at least twenty of the thirty consecutive trading days ending on the last trading day of a calendar quarter is more than $24.88, then the Convertible Notes may be converted during the immediately following calendar quarter. Additionally, the Convertible Notes may be converted when the credit rating of the Convertible Notes is below a specified level or withdrawn, or when certain corporate transactions occur. At December 31, 2004, if all the outstanding Convertible Notes were converted, total outstanding common shares would increase by 8.3 million shares compared to 8.9 million shares at December 31, 2003.
The impact of the Convertible Notes on diluted earnings per share is based upon the "if-converted" method. In accordance with EITF 04-8, all diluted earnings per share amounts have been restated since the issuance of the Convertible Notes in March 2002. See Item 15, Notes to Consolidated Financial Statements, Footnote 10 on pages 66 and 67 of this Annual Report on Form 10-K for further discussion.
to establishing the line of credit and amortizes the fees over the term of the agreement with a remaining unamortized balance at December 31, 2004, of less than $0.1 compared to $0.2 at December 31, 2003. In addition, the Corporation is obligated to pay agency fees and facility fees of up to $0.2 annually. These fees are expensed when incurred by the Corporation. The revolving credit agreement requires the Corporation to maintain minimum net worth of $800.0. The credit agreement also includes a minimum statutory surplus for the Company of $650.0. Additionally, other financial covenants and other customary provisions, as defined in the agreement, exist. At December 31, 2004, the Corporation was in compliance with all financial covenants and other provisions of this agreement. There were no amounts outstanding under this revolving credit agreement at either December 31, 2004 or 2003. In February 2005, the revolving credit agreement was renewed, under substantially the same terms and conditions, for one year and will expire on March 15, 2006.
On September 6, 2002, A.M. Best Company (A.M. Best) affirmed the Group's financial strength rating of "A-" and assigned a positive outlook. In addition, A.M. Best assigned an initial rating of "bbb" to the Corporation's Convertible Notes. On August 22, 2003, A.M. Best revised its debt rating criteria and assigned a "bbb-" to the Corporation's Convertible Notes. On December 8, 2003, A.M. Best affirmed the Group's "A-" financial strength rating and the Corporation's "bbb-" senior unsecured debt rating and assigned stable outlooks on the ratings. On June 23, 2004, A.M. Best assigned a "bbb-" rating and a stable outlook to the Corporation's 7.3% Senior Notes.
On March 14, 2002, Fitch, Inc. (Fitch) assigned its "BBB-" rating to the Corporation's Convertible Notes and placed a stable outlook on its rating. On November 5, 2002, Fitch affirmed its "BBB-" rating and stable outlook on the Corporation's Convertible Notes. On January 21, 2004, Fitch assigned a financial strength rating of "A-" to the Group and also affirmed its "BBB-" senior debt and long term issuer ratings. On June 24, 2004, Fitch assigned a "BBB-" rating to the Corporation's 7.3% Senior Notes. On December 21, 2004, Fitch affirmed its financial strength rating of "A-" and re-affirmed its "BBB-" senior debt and long term issuer ratings. The rating outlook remains at stable.
On March 13, 2002, Moody's Investor Services (Moody's) assigned its "Baa2" rating to the Corporation's Convertible Notes. On November 27, 2002, Moody's downgraded the Group's "A2" financial strength rating to "A3" and placed a stable outlook on the Group's rating. Moody's also announced that it placed a "Baa3" rating on the Corporation's Convertible Notes. On June 16, 2003, Moody's affirmed its "Baa3" rating on the Convertible Notes and affirmed the "A3" insurance financial strength ratings on the Group's intercompany pool. Moody's also placed a stable outlook on its ratings. In addition, Moody's also assigned prospective ratings to the $500 universal shelf registration filed on May 8, 2003. The prospective ratings for senior unsecured debt, subordinated debt and preferred stock were "Baa3", "Ba1" and "Ba2", respectively. On June 29, 2004, Moody's assigned a "Baa3" rating to the Corporation's 7.3% Senior Notes.
On March 11, 2002, Standard & Poor's Rating Services (S&P) removed its negative outlook and placed a stable outlook on the Group's "BBB" financial strength rating. S&P also announced that it assigned its "BB" senior debt rating to the Corporation's Convertible Notes. Following the Corporation's announcement of third quarter 2002 results, S&P revised its outlook to negative from stable and indicated that the Group's financial strength rating would be reviewed for possible downgrade. On April 30, 2003, S&P affirmed its "BBB" financial strength rating for the Group and maintained its negative outlook. On May 13, 2003, S&P assigned prospective ratings to the Corporation's universal shelf. The prospective ratings for senior unsecured debt, subordinated debt and preferred stock were "BB", "B+" and "B", respectively. On February 13, 2004, S&P revised its outlook to stable and affirmed its financial strength and debt ratings on the Group and the Corporation. On June 28, 2004, S&P assigned a "BB" rating to the Corporation's 7.3% Senior Notes. On December 29, 2004, S&P revised its outlook to positive from stable, affirmed its "BBB" financial strength rating on the Group's intercompany pool, and affirmed its "BB" senior unsecured debt rating on the Corporation.
The National Association of Insurance Commissioners (NAIC) has developed a "Risk-Based Capital" formula for property and casualty and life insurers. The formula is intended to measure the adequacy of an insurer's capital given the asset and liability structure and product mix of the company. As of December 31, 2004 and 2003, all insurance companies in the Group exceeded the necessary capital requirements.
The Company sponsors a non-contributory defined benefit pension plan and a contributory postretirement healthcare plan. Several statistical and other factors, which attempt to anticipate future events, are used in calculating the expense and liability related to the plans. Key factors include assumptions about the expected rates of return on plan assets, discount rates, rate of compensation increases and health care cost trend rates, as determined by the Company, within certain guidelines. Management reviews the assumptions used in the valuations on an annual basis, or more frequently as needed. The Company considers market conditions, including changes in investment returns, interest rates and inflation in making these assumptions.
The Company determines the expected long-term rate of return on plan assets based on the geometric method, which represents the average compound return of the plan assets. Plan assets are comprised primarily of investments in mutual funds, common stocks, corporate bonds, U.S. government securities, real estate investment trusts and other investments. The Company considers the current level of expected returns on risk free investments, primarily government bonds, the historical level of the risk premium associated with the other asset classes, current and expected asset allocation and the expectations for future returns of each asset class when developing the expected long-term rate of return on assets assumption. The expected return for each asset class is weighted based on the target asset allocation to develop the expected long-term rate of return on assets assumption for the portfolio. This resulted in the selection of the 8.75% assumption for 2004 and 2003. The expected rate of return on plan assets is a long-term assumption and generally does not change annually. Holding all other assumptions constant, a one-percentage-point increase or decrease in the assumed rate of return on plan assets would decrease or increase, respectively, 2005 net periodic pension expense by approximately $2.5.
The Company expects to contribute approximately $8.0 to fund the pension plan during 2005. The source for the funding will be cash flow from operating activities.
In 2004, the Company announced changes to its defined benefit retirement plan and defined postretirement health care plans. The Company's traditional defined benefit retirement plan was amended to freeze accrued benefits effective June 30, 2004, and to incorporate a new benefit formula beginning July 2004. As a result of this change in the defined benefit retirement plan, the Company recognized a reduction in net periodic pension cost of $1.9 in 2004 attributable to the amortization of unrecognized prior service cost and has a remaining unrecognized prior service cost of $28.9 at December 31, 2004, which will be ratably recognized over the next 13 years as a reduction of net periodic pension cost. Also effective in July 2004, eligibility for subsidized retiree medical and dental coverage was restricted to then current retirees and employees with 25 or more years of continuous service. Other employees are eligible for access to unsubsidized retiree medical and dental coverage. As a result of this change in the defined postretirement benefit plan, the Company recognized a reduction in net periodic postretirement cost of $5.0 in 2004 attributable to the amortization of unrecognized prior service cost and has a remaining unrecognized prior service cost of $54.3 at December 31, 2004, which will be ratably recognized over the next 9 years as a reduction of net periodic postretirement cost.
For more information on the Company's pension and other postretirement benefit plans, please refer to Item 15, Notes to Consolidated Financial Statements, Footnote 5 on pages 59-62 of this Annual Report on Form 10-K.
The Group's actuaries conduct a reserve study using generally accepted actuarial methods each quarter from which point estimates of ultimate losses and LAE by product line or coverage within product line are selected. In selecting the point estimates, thousands of data points are reviewed and the judgment of the actuaries is applied broadly. Each quarter management records its best estimate of the liability for loss and LAE reserves by considering the actuaries' point estimates. Management's best estimate recognizes that there is uncertainty underlying the actuarial point estimates.
The following example is presented to illustrate the sensitivity of loss estimates to a change in the stable loss inflation assumption. The impact of an unexpected increase in loss inflation was determined by deriving expected payment patterns for each major product line and applying these patterns to the December 31, 2004, loss and LAE reserves to generate estimated annual payments for each subsequent calendar year. Then, an explicit annual incremental inflationary trend of one percent was applied to the annual payments, and revised loss and LAE payments were calculated. The estimated cumulative impact that this additional unexpected one percent increase in the inflationary trend would have on our results over the lifetime of the underlying claims is shown below.
In 2004 and 2003, respectively, the Group increased loss and LAE reserves by $12.3 and $12.0 for environmental claims. In 2002, the Group re-classified approximately $5.0 of homeowners reserves related to underground storage tanks as environmental reserves. For 2004 and 2003, respectively, the asbestos and environmental reserves, prior to the impact of reinsurance, were $90.8 and $78.0. Asbestos reserves were $38.0 and $37.6, and environmental reserves were $52.8 and $40.4 for 2004 and 2003, respectively.
The Group defines construction defect exposure as liability for allegations of defective work and completed operations losses from general liability, commercial multiple peril liability and umbrella liability policies involving multiple-units (condos/townhouses/apartments/tracts of single family homes), multiple defendants (e.g. developers, sub-contractors), usually with multiple defect issues, and often involving multiple insurance carriers. The Group excludes from the definition, claims related to individual single family homes, apartments/townhomes or other residential properties if the defect issues are limited in scope and volume.
The number of construction defect claims reported in 2004, 2003 and 2002 were 332, 271 and 224, respectively. Paid losses, net of reinsurance, in 2004 were $9.9, compared to $16.5 in 2003 and $11.4 in 2002. Paid claims legal related LAE, net of reinsurance, for construction defect claims were $5.1 in 2004, compared with $4.3 in 2003 and $4.1 in 2002. These totals exclude construction defect losses from the state of California. Although the Group has construction defect losses from California exposure, it excludes California from this data because the Group stopped writing in the state in 1993 and the remaining claims are minimal.
Results for the year 2004 were favorably impacted by losses and LAE incurred for prior accident years totaling $21.8 before tax on an All Lines basis. This amount and those stated below are net of reinsurance, including change in the allowance for uncollectible reinsurance recoverables. Losses and LAE incurred for prior accident years were recognized during the year 2004 due to new information that caused a revision to prior estimates for loss and LAE reserves.
The following table provides the before-tax amount of prior accident year loss and LAE reserve development by reportable segment:
For the Personal Lines operating segment, the adverse loss and LAE development for prior accident years recorded during 2004, 2003 and 2002 was concentrated in the personal automobile including personal umbrella product line.
The amount of statutory loss and LAE reserves by accident year at the beginning of 2004 was $602.8 for accident year 2003, $401.8 for accident year 2002 and $1,124.3 for accident year 2001 and prior.
The Group maintains several programs that provide reinsurance coverage. The programs in effect for 2004 and key changes in these programs for 2005 are summarized below.
The Group's 2004 property per risk program covers property losses in excess of $1.5 for a single insured, for a single event. This property per risk program covers up to $13.5 in losses in excess of the $1.5 retention level for a single event. The retention on the property per risk excess of loss treaty increased to $2.0 in 2005. The Group's casualty per occurrence program covers liability losses. For 2004, workers' compensation, umbrella and other casualty reinsurance cover losses up to $58.8, $22.4 and $22.8, respectively, in excess of the $1.0 retention level for a single insured event. The 2004 casualty reinsurance treaty includes a layer of coverage of $5.0 in excess of $1.0 that consists of a reinsurance treaty fund managed by the Group, and the Group has title to the assets held in this fund. Ceded premiums are paid by the Group into the reinsurance treaty fund and reinsured losses are paid to the Group under the terms of the reinsurance agreement with various reinsurers. The reinsurers bear the risk of losses in excess of the assets held in the reinsurance treaty fund. The Group's ability to manage the investments of the fund reduces credit risk related to reinsurers. The balance of the reinsurance treaty fund as of December 31, 2004, was approximately $195.0. For 2005, the casualty $5.0 layer excess of $1.0 retention was replaced by two treaties. For casualty other than commercial umbrella, a $4.0 layer excess of $2.0 retention was purchased; the Group retains 15% of the $4.0 layer. For commercial umbrella, a $3.0 layer excess of $2.0 retention was purchased; the Group retains 25% and 50% of the $3.0 layer for supported and unsupported policies, respectively.
The property catastrophe reinsurance program protects the Group against an accumulation of losses arising from one defined catastrophic occurrence or series of events. The 2004 program provided $80.0 of coverage in excess of the Group's $25.0 retention level. The catastrophe excess of loss treaty changed to $100.0 in excess of $25.0 for 2005. Over the last 20 years, only two events triggered coverage under the catastrophe reinsurance program. Both of these losses exceeded the prior retention amount of $13.0, resulting in significant recoveries from reinsurers. Reinsurance limits are purchased to cover exposure to catastrophic events having the probability of occurring approximately every 250 years.
The fixed maturity portfolio is allocated between investment grade and below investment grade as follows:
The excess of market value over cost was $427.0 compared with $422.1 at year-end 2003. The increase in 2004 was attributable to the increase in the market value of certain equity securities.
Equity securities are carried at fair market value on the consolidated balance sheets. As a result, shareholders' equity and statutory surplus fluctuate with changes in the value of the equity portfolio. As of December 31, 2004, the equity portfolio consisted of stocks in a total of 50 separate entities in 38 different industries. Of this total, 31.2% was invested in five companies and the largest single position was 7.3% of the equity portfolio. At December 31, 2003, the equity portfolio consisted of stocks in 44 separate entities in 35 different industries. Of this total, 32.3% was invested in five companies and the largest single position was 8.1% of the equity portfolio.