This selected consolidated financial data comes from our Consolidated Financial Statements. It should be read in conjunction with the Consolidated Financial Statements and accompanying notes. On August 2, 2004, we completed the sale of our Life & Investments (L&I) businesses. Prior-year amounts have been restated to reflect L&I as a Discontinued Operation.
(2) Reflects the repurchase of 13,247,863 shares pursuant to an Accelerated Stock Buyback program in August 2004.
Our ability to appropriately price and reserve for changes in the mix of our book of business
Inflationary pressures on medical care costs, auto parts and repair, construction costs and other economic factors that increase the severity of claims
The availability and pricing of our reinsurance, including coverage for loss from terrorism and our ability to collect from our reinsurers
Our ability to price for or exclude the risk of loss from terrorism on our policies
Risks related to our Property & Casualty (P&C) insurance strategy, such as:
Our ability to run off businesses that we have exited, or intend to exit in the future, without incurring material unexpected charges
Our ability to successfully obtain regulatory approval of rates and underwriting guidelines, including price-tiered products and the use of insurance scores that include credit information as a component
The competitive pricing environment, initiatives by competitors and other changes in the competition
The occurrence of bankruptcies that result in losses on insurance products or investments
In 2004, we sold our Life & Investments operations. We rolled out Safeco Now, our unified, Web-based sales-and-service platform, and we reorganized our company around the way we operate. With these actions, we are a focused, more nimble P&C company.
Focusing on P&C Operations - During 2004, we completed the sale of our Life & Investments (L&I) businesses.
Increasing efficiency for our distribution partners - In 2004, we brought our major products together on Safeco Now, our automated sales-and-service platform. Safeco Now features a single point of entry for personal auto, homeowners, most small-commercial products and certain surety bonds. This allows our distributors to quote and issue these products in minutes. Products currently available on Safeco Now include: auto, homeowners, dwelling fire, business owner policies, commercial auto, workers compensation and commercial multi-peril. We also launched our policy change tool for handling certain simple but frequent personal auto policy endorsements.
Platform - We deliver our products over our automated platform called Safeco Now, which gives our distribution partners a single point of entry to quote and issue our major P&C products in a matter of minutes. Most of our pricing, underwriting and servicing processes are now presented through this user-friendly interface. In addition to technology, our platform encompasses the people and processes that make our company go - including the personalized support our service professionals provide to distributors and customers, the financial strength that gives us the capital we need to invest in our company, the physical infrastructure required to run the business, and the recruitment and development of the talented people of Safeco.
Focusing on P&C Operations - On September 29, 2003, we announced our decision to focus on our P&C operations and put our L&I businesses up for sale. This sale was subsequently completed in August 2004.
Partnering with Independent Distributors - Our strategy focuses on providing more products for our distributors to sell and providing ease-of-doing business tools that drive greater operating efficiencies in their offices. Our distributors can be more profitable selling our products through use of Safeco Now, and our commission programs are structured to incent profitable growth. In short, we offer our distribution partners more products to sell, make it easier for them to sell and service these products, and help our distributors make more money selling our products.
Selling Standardized Products - Our standardized auto, homeowners and small-business products have been designed to serve the insurance needs of the majority of the individuals and small-to medium-sized businesses in the U.S. marketplace.
Offering Multiple P&C Product Lines - We believe our ability to provide multiple P&C products gives us a “shelf space” advantage in our distributors’ offices. Our auto, homeowners and small-business insurance products represent the products our distribution partners sell most. These product lines generally represent more than 95% of the insurance revenues sold in our distributors’ offices.
Driving Execution Through Enhanced Metrics - We established financial metrics for the company and each business unit. We developed individual goals that aligned the performance of the workforce with the company and operating unit metrics. We also shifted to a monthly financial close to better understand and act on results.
Strengthening Our Financial Position - We took a number of actions, including replacing our short-term commercial paper borrowings with long-term senior notes and developing a plan to refinance $500.0 of long-term debt; issuing common stock and strengthening the capital base of our operations; and repositioning our investment portfolio, reducing risk and volatility.
Our vision is to be one of the top-performing property and casualty companies in the industry. We measure our success by tracking our performance against the following three long-term financial goals:
Return on Equity - performance that ranks us among the best in our industry
The following tables show the trends in these three key measures of our performance:
In addition to these segments, certain activities such as interest expense, debt repurchases and intercompany eliminations are reported in Corporate and are not allocated to individual segments.
We use three measures of our underwriting results to assess the profitability of our business segments. These measures are underwriting profit or loss, combined ratio and net earned premiums.
Combined ratio is our losses, LAE and underwriting expenses divided by our net earned premiums. We report combined ratio as a percentage. For example, a combined ratio of 95% means that for every dollar of premium received, 95 cents is spent on losses, LAE and underwriting expenses and 5 cents is underwriting profit. A lower combined ratio reflects better underwriting results than a higher combined ratio.
More information about our segment results can be found on page 46.
We measure our investment results in two parts - by the net investment income we earn on our invested assets, and the net realized investment gains or losses we recognize when we sell or impair investments.
More information about our investment results can be found on page 62.
We record two categories of loss and LAE reserves - case basis reserves and incurred but not reported (IBNR) reserves.
In addition, at the end of every reporting period, we establish IBNR reserves to estimate the amount we will have to pay for:
Losses that have been paid and closed but may reopen and require future payment
IBNR Reserves - To establish our IBNR reserves, we use different approaches for:
These approaches exclude exceptional loss activity associated with catastrophic weather losses, non- catastrophe weather losses and other large loss or salvage - the amount we recover from property that becomes ours after we pay for a total loss - and subrogation - our right to recover payments from third parties - activity. The methodologies used to establish IBNR reserves differ for the current accident year (the year in which a claim occurs) versus the prior accident years. The methodologies also differ for long-tailed lines of business versus short-tail lines of business. Generally speaking, short-tailed lines of business are those lines where the vast majority of claims from a particular accident year are both reported and settled within two years.
Prior Accident Years Losses - For long-tailed lines of business, the beginning IBNR for prior accident years is adjusted for paid and case-basis reserve activity in the current period. This yields ending IBNR, absent an explicit determination to adjust IBNR beyond this activity. For short-tailed lines of business, the beginning IBNR for prior accident years is adjusted for expected emerged losses to calculate IBNR, absent an explicit determination to adjust IBNR beyond this activity.
Estimating Loss and LAE Reserves - Estimating loss and LAE reserves is a complex process because the ultimate losses are uncertain. Some claims will be paid out over a number of years, and there may be a significant lag between the time a loss that is insured by us occurs and the time it is reported to us. We make significant judgments and assumptions about many internal variables and external factors. Examples of internal variables include:
Incurred Loss Development - historical case incurred patterns (paid losses plus case-basis reserves) for prior claims are used to estimate future case incurred patterns for current claims. These patterns are applied to current case incurred by accident year to yield expected ultimate losses.
Average Claim Value and Claim Count Development - loss payment and/or case incurred amounts are divided by the number of claims to generate average costs per claim. Using historical patterns, the expected ultimate average cost per claim by accident year is projected. Separately, the expected ultimate number of claims is projected by accident year. The product of the expected ultimate average cost per claim and the expected ultimate number of claims yields expected ultimate losses.
Our actuaries use many of the above methods to estimate reserves for each product line. The merits of each method are evaluated given the facts at hand. An estimate of the ultimate losses is then made based upon the particular method or combination of methods that is deemed most appropriate. For example, if a particular line has been subject to significant changes in claims handling practices that would impact the comparability of case-basis reserves between periods, the actuary would give little or no credibility to the Incurred Loss Development approach. The various assumptions, estimates and other factors that may have an impact on our ultimate losses are discussed with management to determine the company’s best estimate of the ultimate losses and LAE, and our estimate of IBNR is then recorded.
The emergence of internal variables or external factors that would alter management’s view
We review our reserves quarterly. This review includes either an actuarial analysis involving the application of standard actuarial techniques or the review of the paid and incurred activity in the quarter relative to the assumptions from previous actuarial analyses. In addition, special studies are undertaken periodically for certain lines of business or exposures. Using this information, considering assumptions, methods and internal variables or external factors results in management’s point of view.
Internal variables such as changes in claims handling practices and changes in our business mix, and external factors such as trends in loss costs, economic inflation or judicial or legislative changes are considered in determining an estimate.
Estimating our loss and LAE reserves is an ongoing process. Our loss and LAE reserves represent management’s best estimate of the ultimate future payments associated with losses and related expenses. We record any adjustments to these reserves in the periods in which we change the estimates. We report changes to these reserves in our Results of Operations.
We do not discount any of our reserves to present value.
We purchase reinsurance to limit our exposure to potential large losses. We report the amounts we expect to recover from reinsurers as reinsurance recoverable assets on our Consolidated Balance Sheets. For more discussion on reinsurance, see Reinsurance on page 42.
At year-end 2003 and 2004, our loss and ALAE reserves, excluding ULAE reserves, by reportable segment before reinsurance were:
Loss and LAE Reserve Variability - Loss and LAE reserves are subject to variability, particularly the IBNR component. For the lines of business that we write, variability in the frequency - the average number of claims filed - or severity - the average cost of a claim - is generally a function of one or more of the following factors:
Size of the reserve balance - slight variations in large reserve balances can generate significant financial volatility.
Policy limits - lines of business involving policies with high or unlimited policy limits are subject to greater variation.
Safeco Personal Insurance (SPI) - SPI loss and LAE reserves are estimated using standard actuarial methods combined with management judgment. These methods involve analyzing past claims experience for recent changes in business claim practices and the internal and external environments. Emphasis is placed on evaluating claims reporting and closing patterns as well as the size of loss payments and case-basis reserves. SPI losses and related expenses are analyzed by line of business, product, coverage and geographic area.
Our SBI and P&C Other segments have exposure to asbestos and environmental losses primarily from policies we no longer write. These segments also have exposure to construction defects losses and related expenses through the general liability, commercial multi-peril and umbrella coverages they provide. These exposures and the risks they present are discussed together as they are estimated by product and like exposure.
The table below provides the loss and ALAE reserves, excluding ULAE reserves, before reinsurance for our commercial products:
Workers Compensation - The following table shows our loss and ALAE reserves for voluntary and non-voluntary workers compensation and other relevant data. The data shown reflects workers compensation policies written in both SBI as well those workers compensation policies that are in runoff and included in the P&C Other segment. The table excludes ULAE reserves, which at year-end 2004 were $41.6:
Claim count history has been restated to reflect refinements in 2004 to our methods for counting claims.
Factors in Estimating Loss Reserves for Workers Compensation - Estimating reserves for workers compensation involves a significant degree of uncertainty and judgment. This is driven by:
Changes in life expectancy - changes in life expectancy increase both the length of future payments and the cost of treatment.
Changes in our business, including claims handling practices, changes in our writings of large versus small- to medium-sized accounts, and changes in state mix.
Long payout periods - many third-party liability claims are paid many years after the occurrence of the loss. As a result, the cumulative effect of inflation can be significant.
Changes in coverage interpretation - legislative and judicial interpretations can affect the cost of future payments.
These facts give rise to latent claim emergence and evolving coverage precedents for such claims as asbestos, environmental, construction defects and sexual misconduct allegations for religious institutions.
Asbestos - This table shows our loss and ALAE reserves for asbestos-related claims. The table excludes ULAE reserves, which at year-end 2004 were $14.2:
In this table, the three-year survival ratio represents the number of years that our current loss reserves would last if future payments are made at the same average annual rate experienced over the last three years. The three-year survival ratio is equal to our loss reserves, divided by our average annual payment over the last three years.
Our exposure through our runoff assumed reinsurance operations is primarily excess of loss reinsurance. Pools are groups of insurers that enter into agreements to share exposure related to specific insureds. Our loss reserve estimates for pools reflect the loss reserve estimates provided by the pools’ independent actuaries. The loss experience of our runoff assumed reinsurance operations follows the general industry trend. Our direct exposure is primarily due to smaller and more peripheral entities becoming defendants in asbestos claims.
Large Asbestos Accounts - our policyholders with cumulative loss payments exceeding $100,000 as of December 31, 2004.
Some asbestos-related claims are subject to non-product liability coverage rather than product liability coverage. Non-product liability coverage may not be subject to policy aggregate limits. This could result in higher asbestos claims payments and related expenses.
Environmental Claims - This table shows our loss and ALAE reserves for our liability coverages related to environmental claims. The table excludes ULAE reserves, which at year-end 2004 were $16.0:
In 2004, we refined the classification of our environmental reserves to include only claims involving gradual discharge or leakage of pollutants or contaminants into the environment. These claims generally involve multiple policy periods, and the exact date of the occurrence is generally not determinable. In general, these claims involve underground storage tanks, official United States EPA sites (Superfund), Clean Water Act allegations, and other exposures prior to the Insurance Services Office (ISO) pollution exclusion. The data in the table above has been restated to reflect this definition.
Estimating Loss Reserves for Environmental Claims - The volatility of actuarial estimates of liabilities for environmental claims is often greater than that of other exposures. That’s due to several factors including:
Due to the volatility and sparseness of data, we estimate loss reserves for environmental claims by combining standard actuarial techniques with our analysis of:
Construction Defects - This table shows our loss and ALAE reserves for construction defects claims. The table excludes ULAE reserves, which at year-end 2004 were $19.9:
Our Construction Defects Claims Exposure - Our exposure to construction defects claims comes from general liability and commercial multi-peril coverages we provide to contractors. Construction defects claims result from alleged defective work performed in the construction of large structures that include apartments, condominiums and large developments of single-family dwellings or other housing.
Construction defects claims often seek payment for damages resulting directly from the alleged defective construction work and diminished economic value of the structure - meaning that the structure has less market value because of the alleged defective construction work. Construction defects claims are complex, with an inherent difficulty in determining fault. Most of our claims are concentrated in a small number of states, including California.
At December 31, 2004, our IBNR was 78.6% of our loss reserves for construction defects claims.
We have taken a number of actions to mitigate our exposure to construction defects claims, enabling us to vigorously defend our coverage position. They include:
A separate claims handling function and internal legal counsel specializing in construction defects claims
Over the last three years, our number of open construction defects claims has decreased steadily - an average drop of 16.0% per year. Our loss reserve estimates assume that the number of open claims will continue to decrease, but at a slower rate.
In 2004, we reduced our estimates for prior years’ loss and LAE reserves by $39.0. This total decrease included loss and ALAE changes as follows:
$14.8 reduction in private passenger auto reserves, reflecting improved claims frequency in both our preferred and non-standard books of business
Of the $205.0 increase, $180.0 was related to loss and ALAE reserves. This increase included $130.0 in P&C Other, $48.0 in SBI Regular and $2.0 in SBI Special Accounts Facility. The largest amount of reserve development related to California, particularly the large-commercial business we began exiting in 2001. We also increased ULAE reserves by $25.0. This increase included $14.9 in P&C Other, $9.6 in SBI Regular and $0.5 in SBI Special Accounts Facility. This increase reflected our estimate of the ongoing expense of servicing workers compensation claims. As claims remain open for longer periods, our costs to handle these claims rise.
$33.3 for workers compensation losses, reflecting medical cost inflation at a rate that was higher than anticipated
Gross of Reinsurance - our total amount of loss and LAE reserves
As shown in Section A, our loss and LAE reserves net of reinsurance at year-end 1994 were $2,092.9.
As shown in Section A, our reserves net of reinsurance at year-end 1994 were $2,092.9.
Conditions and trends that affected our loss and LAE reserves in the past may not occur in the future. For example, substantial reduction in our large-commercial insurance and program business in 2001 will distort trends in these tables. As a result, our Analysis of Losses and LAE Reserve Development table is not a basis for estimating future redundancies or deficiencies.
The reinsurance we buy limits our losses on certain individual risks or reduces our exposure to catastrophic events. We buy reinsurance from several reinsurers and are not dependent upon any single reinsurer. Reinsurance recoverables are the amounts our reinsurers owe us related to the losses we have incurred. We reported $356.2 at December 31, 2004, and $372.0 at December 31, 2003, in reinsurance recoverables as assets on our Consolidated Balance Sheets.
Perform actuarial analyses of loss development above and below our retention levels - the amounts we absorb before the reinsurers reimburse us - specified under the reinsurance agreements
Based on our analysis, we make a judgment as to whether the decline is other-than-temporary. Sometimes, an investment decline that we consider temporary in one quarter can become other-than-temporary in a future quarter. If the decline is other-than-temporary, we report an impairment charge within Net Realized Investment Gains and Losses in our Consolidated Statements of Income in the period we make that determination.
$91.9 in fixed maturities and $30.9 in marketable equity securities on our Consolidated Balance Sheets as of December 31, 2004. These amounts represented 1.2% of our total investment portfolio.
Total revenues increased 13.7% in 2004 compared with 2003, and increased 4.3% in 2003 compared with 2002. The increases were driven by:
Net income increased 65.8% in 2004 compared with 2003, while net income in 2003 increased 12.7% over 2002, driven by:
compensation reserves, of $162.4 after tax ($249.9 pretax). In 2002, we had unfavorable prior-year reserve development of $81.8 ($125.8 pretax) in various lines. The improvement in underwriting results in 2003 over 2002 reflected price increases and segmented underwriting that better matched rate to risk.
Other underwriting and operating expenses: In 2004, we recorded an additional contribution to our employee Profit Sharing Retirement Plan of $15.8 as a result of our increased earnings. In addition, our expense reduction efforts that began in 2003 reduced our 2004 operating expenses by approximately $75, primarily by eliminating approximately 500 positions in our corporate departments. At the same time, our expenses reflected our business growth.
The following table assists in reconciling our GAAP results, specifically the “Income from Continuing Operations before Income Taxes” line from our Consolidated Statements of Income to our segment performance measures:
First, net earned premiums are the primary driver of our revenues, along with net investment income and net realized investment gains:
Finally, combined ratios show the relationship between underwriting profit or loss and net earned premiums. Using ratios helps us see our operating trends without the effect of changes in net earned premiums:
We’re achieving growth and improved underwriting profitability in our Auto business through these strategic initiatives, which we’ve been emphasizing since 2002:
Commitment to Ease of Doing Business - Our commitment to ease of doing business continues through our Safeco Now automated underwriting platform by lowering our distributors’ costs and providing an easy-to-use, Web-based sales-and-service platform. Our auto product is available on Safeco Now in all of the states where we write business. In 2004, we enhanced Safeco Now to streamline the service process for auto customers and distributors, allowing online processing of auto policy changes and endorsements, such as vehicle additions and deletions, vehicle replacements or updates, and coverage and deductible changes.
Offering a Segmented Auto Insurance Product - Our segmented auto insurance product, which was rolled out in phases throughout 2002 and 2003, offers up to 15 underwriting tiers. These underwriting tiers are determined using multi-variant models to assess the risk of loss based on many factors, and they provide a more accurate price for a wider range of risks. We’re better able to assign the right price to the
corresponding level of risk, producing greater precision and greater profitability. Also, this tiered approach has expanded the risks we can underwrite and price, so we have an auto product available for approximately 95% of all applications quoted by our distributors. Our segmented auto insurance product is available in 43 of the 44 states where we sell auto insurance. We continue to work with the California Department of Insurance to explore potential options to implement our tiered pricing methodology.
Improving the Claims Management Process - Changes in claims handling processes also contributed to our improved performance. We’ve made investments in training for our claims professionals, and we now have more efficient processes and better metrics to measure key performance drivers such as policyholder retention, customer satisfaction and quality and cost of service. Our claims processing combines the efficiency of centralized claims handling and customer service centers and the flexibility of field representatives. Using our paperless claims environment, our field representatives are not restricted to a specific office or physical location. This flexibility adds significant savings and efficiencies to the claims handling process and increases the quality of our customer service.
Growth of policies-in-force (PIF): PIF grew 8.8% in 2004 and 9.1% in 2003. This reflected stable retention of policies (80.4% in 2004, 79.9% in 2003 and 81.2% in 2002) and strong new-business growth. New policies sold increased 9.4% in 2004 compared with 2003, and 8.8% in 2003 compared with 2002. PIF growth contributed approximately $201 to the increase in net earned premiums in 2004 compared with 2003, and approximately $166 in 2003 compared with 2002. This growth was driven by the introduction of our Safeco Now Web-based platform early in 2004 and our segmented underwriting model in 2002.
Increases in filed rates: We file rate changes on a state-by-state basis. Overall, we received approval for average rate increases of 1.3% in 2004 and 5.6% in 2003. Rate changes are reflected on existing policies at renewal, resulting in an increase to 2004 net earned premiums of approximately $110 compared with 2003, and $88 in 2003 compared with 2002.
Expenses: The decrease in our expense ratio of 1.0 points in 2004 compared with 2003, and 0.7 points in 2003 compared with 2002 was the result of our wide-ranging expense improvement efforts, primarily as a result of the corporate restructuring initiatives. In 2004, this was partly offset by higher bonus commission and employee performance bonus expenses due to our growth and improved underwriting results.
Rates - In Auto, we are experiencing a more competitive marketplace as competitors increase advertising and sales incentives. We also have seen modest and selective rate decreases by competitors in some states. We remain committed to disciplined pricing using our segmented product. Actual rate changes obtained may vary, based on the rate needed in a given state combined with regulatory review and approval, as well as developments in loss cost trends. We anticipate that rate increases combined with premium trend will at least keep pace with loss cost growth.
Business Growth - As our business grows, we will write more policies in markets where we previously have not written significant business. We expect to write more standard and non-standard risks, which have, on average, higher frequencies than preferred risks. However, preferred auto business will still remain our largest book of business and continue to be our greatest area of opportunity. We are continuing to expand into eastern states where we have less geographic presence currently.
Continued Commitment to Ease of Doing Business - We will continue to deliver additional Web-based policy-change transactions capabilities in phases throughout 2005. During the first quarter of 2005, we will launch an updated automated underwriting model for our auto product. This will enhance our underwriting further, more closely matching rate for risk in our auto markets. We also are making billing system enhancements, enabling our distributors and customers to view on line billing information and auto changes.
Overall -In 2005, we anticipate our Auto revenue will grow at greater-than-industry rates, while achieving our target combined ratio of 96%.
We’re achieving improved profitability in our Property business through these strategic initiatives, which we’ve been emphasizing since 2002:
Offering a Segmented Homeowners Insurance Product - Our segmented homeowners product, which was rolled out in phases from 2002 to 2004, generally offers nine underwriting tiers. These underwriting tiers are determined using multi-variate models to assess the risk of loss based on many factors and provide a more accurate price for a wider range of risks. This increased segmentation means we are better able to align rate with risk, producing greater precision and greater profitability. It also means we can grow by offering coverage to more home owners. We sell our new product in 43 of the 44 states in which we are licensed to sell homeowners insurance. We continue to work with the California Department of Insurance to explore potential options to implement our tiered pricing methodology.
Improving the Claims Management Process - Changes in claims handling processes also contributed to our improved performance. We’ve made investments in training for our claims professionals, and we now have more efficient processes and better metrics to measure key performance drivers such as policyholder retention, customer satisfaction and quality and cost of service. Our claims processing combines the efficiency of centralized claims handling and customer service centers and the flexibility of field representatives. Using our paperless claims environment, our field representatives are not restricted to a specific office or physical location. This flexibility adds significant savings and efficiencies to the claims handling process and increases customer service. We established a National Catastrophe Team in 2002 that immediately mobilizes when a disaster strikes to assess the damage, write checks to cover temporary living expenses and emergency repairs, and provide comfort and support to customers. In most cases, we issue payments to customers on the spot following a disaster.
Net earned premiums were flat in 2004 compared with 2003, and increased less than 1% in 2003 compared with 2002. This reflects:
Decline in PIF: Our retention rates stabilized in 2004 at 83.7% compared with 83.1% in 2003 and 82.5% in 2002. However, the number of policies that did not renew with us in 2004 and 2003 exceeded the number of new policies written in each year. This led to a net reduction in PIF of 6.7%, or approximately $72 in net earned premiums in 2004 compared with 2003, and 8.9%, or approximately $78 in net earned premiums in 2003 compared with 2002.
New business: During 2004, we launched our homeowners and dwelling fire products on our automated Web-based sales platform, Safeco Now. As expected, this has contributed to an increase in new business. Our new business increased by 11.5% in 2004 over 2003, as our nine-tier homeowners product became available in 43 of the 44 states where we write business. New business decreased by 19.7% in 2003 compared with 2002 due to moratoriums in certain unprofitable states. We lifted these moratoriums throughout 2003 and into 2004, and currently have no statewide moratoriums.
Our underwriting results in Property improved $100.3 and our combined ratio improved 10.9 points in 2004 compared with 2003. Our underwriting results improved $132.1 and our combined ratio improved 14.3 points in 2003 compared with 2002. The improvements in underwriting results and combined ratios were primarily driven by:
Prior-year reserve development: Our underwriting results in 2004 included favorable reserve development of $47.5 related to prior accident years, primarily driven by changes in contract terms resulting in decreased frequency of claims beyond that previously expected. Results in 2003 included unfavorable reserve development of $16.0 relating to prior accident years. The favorable reserve development in 2004 improved the combined ratio by 6.9 points compared with 2003, while the increase in unfavorable reserve development in 2003 increased the combined ratio 1.5 points compared with 2002.
Catastrophe losses: We categorize catastrophes as events resulting in losses greater than $500,000 per state and involving multiple claims and policyholders. We cannot accurately predict when catastrophes may occur, and the number and type of catastrophes can vary widely. The losses they could cause might significantly exceed our prior experience. Catastrophes include hurricanes, windstorms, earthquakes, hailstorms, explosions, severe winter weather, fires and acts of terrorism. Our pretax catastrophe losses after reinsurance for the last three years were:
Expenses: The decreases in our expense ratio of 0.7 points in 2004 compared with 2003, and 1.0 points in 2003 compared with 2002 were the results of our wide-ranging expense improvement efforts, primarily as a result of corporate restructuring initiatives.
We anticipate the following factors will impact growth and profitability in our Property segment in the near future:
Commitment to Ease-of-Doing Business - Our commitment to ease of doing business continues through our Safeco Now automated underwriting platform by lowering our distributors’ costs and providing an easy-to-use Web-based sales-and-service platform. Our homeowners and dwelling fire products are available on Safeco Now in all of the states where we write business. As expected, this has contributed to the increase in new business. In late 2004, we began to introduce our new segmented dwelling fire product on Safeco Now. During 2005, we will integrate the majority of homeowners endorsements into Safeco Now.
Compensation -We have redesigned our SPI agent compensation plans for 2005. This allows distributors to select an SPI compensation structure best suited to their business model - whether their primary opportunity is new-business growth, retention of existing customers, cross-selling or overall profitability.
Overall -We expect our Property segment revenue to grow modestly while operating at or better than our target combined ratio of 92% in 2005. We do not, however, expect to experience the same favorable frequency trends. This will cause our margins to move closer to our target.
Net earned premiums increased 8.7% in 2004 compared with 2003, and 5.7% in 2003 compared with 2002. These increases were driven by an increase in new business. New-business policies sold increased 24.7% in 2004 compared with 2003, and 17.6% in 2003 compared with 2002. The growth in 2004 was driven by an increase in the sale of new boat owners, recreational vehicle and motorcycle policies. The growth in 2003 was driven by an increase in the sale of new umbrella and recreational vehicle policies. In addition, we began to offer motorcycle coverage in 2003.
Our underwriting results decreased $15.3 and our combined ratio increased 19.6 points in 2004 compared with 2003. Our underwriting results increased $10.8 and our combined ratio decreased 11.9 points in 2003 compared with 2002. Our underwriting results were affected by:
Catastrophe losses: Pretax catastrophe losses were $7.6 in 2004, primarily related to the hurricanes in Florida and surrounding states. This increased the combined ratio by 8.5 points in 2004 compared with 2003. There were no catastrophe losses in 2003 or 2002.
We anticipate stable results in 2005. We have not yet introduced our Specialty products on Safeco Now. We expect additional growth in this line when the products are available on Safeco Now during 2005.
We’re achieving growth and profitability in SBI Regular through these initiatives:
Commitment to Ease of Doing Business - Safeco Now is contributing to increased new business as it allows our distributors to quote and issue new business online in just minutes. We have experienced growth in BOP, commercial auto and workers compensation, all of which have been on Safeco Now for more than a year. Our commitment to ease of doing business continued as we began the launch of CMP on Safeco Now in December 2004. This will roll out on a state-by-state basis through 2005.
Field Specialization Model - We have created two separate underwriting units - one for our core small business and one for our mid-market business. We expect that this new approach, the “field specialization model,” will increase efficiency and underwriting accuracy and reduce underwriting expenses due to the automation of many of our underwriting processes and the use of multi-variate models. Implemented in 2004, this model has increased productivity while reducing underwriting staff expenses.
Net earned premiums increased 11.6% in 2004 compared with 2003, and 8.2% in 2003 compared with 2002. The increase in net earned premiums was driven by:
Growth in PIF: PIF grew slightly (0.2%) in 2004 compared with 2003, and decreased 3.7% in 2003 compared with 2002. This reflected increased retention rates of policies (79.9% in 2004, 75.9% in 2003 and 76.5% in 2002). New-business policies sold decreased 1.2% in 2004 compared with 2003, while new business increased 16.8% in 2003 compared with 2002. These sales did not fully offset the effect of policies that did not renew. New-business sales growth was driven by the introduction of our Safeco Now Web-based platform in 2003 and our automated underwriting models in 2002, which have allowed us to improve our accuracy in pricing risks. Safeco Now also provides an easy-to-use sales platform for our distributors.
Price increases: We file rate changes on a state-by-state basis. Our average written price increase, which includes rate changes and exposure growth, was 3% in 2004, 10% in 2003 and 15% in 2002. Price changes are reflected on existing policies at renewal, resulting in an increase to 2004 net earned premiums of approximately $39 compared with 2003, and $110 in 2003 compared with 2002. Premiums are affected by growth in the exposures we cover due to factors such as changes in compensation, the number of employees, sales receipts and building values for the businesses we insure. This increased net earned premiums by approximately $26 in 2004 compared with 2003, and $19 in 2003 compared with 2002.
Our underwriting results improved $75.8 and our combined ratio improved 6.4 points in 2004 compared with 2003. Our underwriting results improved $23.1 and our combined ratio improved 2.5 points in 2003 compared with 2002. Our underwriting results were affected by:
Prior-year reserve development: Our underwriting results in 2004 included unfavorable reserve development of $1.6 related to prior accident years, primarily related to reserve strengthening for asbestos, partly offset by favorable reserve development associated with Ohio commercial auto business and World Trade Center losses. Our underwriting results in 2003 included unfavorable reserve development of $41.8 related to prior accident years, primarily related to medical inflation in workers compensation reserves. Our underwriting results in 2002 included unfavorable reserve development of $49.4 related to prior accident years. The reserve development in 2004 reduced the combined ratio by 3.7 points compared with 2003, while the reserve development in 2003 reduced the combined ratio by 0.7 points compared with 2002.
Catastrophe losses: Pretax catastrophe losses were $113.9 in 2004, $19.0 in 2003 and $11.7 in 2002. The increased catastrophe losses in 2004 related to the hurricanes in Florida and surrounding states and impacted the combined ratio by 8.6 points compared with 2003. The catastrophes in 2003 impacted the combined ratio by 0.7 points compared with 2002.
Product Pricing and Segmentation - We will continue to appropriately match rate with risk through segmentation and disciplined underwriting. We will charge prices to earn acceptable profit margins and decline to write business when pricing or risk does not allow us to earn our target returns. We are reviewing our deductibles, pricing and coastal proximities as a result of the hurricanes in Florida and surrounding states to reduce our exposure to catastrophes. We are currently implementing our automated underwriting platform for CMP, which provides more accurate pricing and segmentation and makes it easier for distributors to write these policies with us. In 2005, we do not expect significant changes from our current pricing.
Net earned premiums increased 15.5% in 2004 compared with 2003, and 39.1% in 2003 compared with 2002. The increases in net earned premiums were driven by:
Price increases: Price changes include changes to manual rates, exposure growth and individual risk premium modifications. In 2004, our prices increased 4.8% for large-commercial accounts and 11.9% for specialty commercial insurance programs. In 2003, our prices increased 16.0% for large-commercial accounts and 23.1% for specialty commercial insurance programs. These price increases were the primary driver of the net earned premium increase in 2004 compared with 2003.
Consolidation of our business products: The increase in net earned premiums in 2003 compared with 2002 was due to the consolidation of our business insurance products. As each existing large-commercial policy was renewed a decision was made by SAF to renew or not. If it was renewed, it became part of SAF; otherwise the policy remained in P&C Other.
Improving underlying loss ratios: Price increases have outpaced loss cost changes.
Our goal is to continue to provide a limited large-commercial resource for those distributors who are also writing auto, property or small- to medium-sized commercial insurance with us, and to continue our existing specialty insurance programs. We do not expect to significantly expand these operations.
Net earned premiums increased 32.2% in 2004 compared with 2003, and 21.6% in 2003 compared with 2002. This was driven by increased new business from a reduction in competitors due to consolidation of other surety companies and the opening of new offices in Glendale, California; Syracuse, New York; and Richmond, Virginia. New business increased net earned premiums by approximately $43 in 2004 compared with 2003, and $24 in 2003 compared with 2002.
Our underwriting results improved $14.8 in 2004 compared with 2003, and $10.0 in 2003 compared with 2002, reflecting our disciplined underwriting, favorable loss experience and decreases in commission expense.
Overall -We expect the surety market to become more competitive and, as a result, we anticipate our growth rates will moderate in 2005.
London operations that we placed in runoff in the third quarter of 2002
Large-commercial business accounts in runoff and specialty programs that we exited. In 2002, those accounts that did not fit with our focus on SBI Regular or could not be effectively served within SAF were managed and reported in this segment.
We collect money from reinsurers for losses we have that are covered by reinsurance. We had $356.2 of reinsurance recoverables at December 31, 2004, net of an allowance of $15.4 that we have estimated as uncollectible. We had $372.0 of reinsurance recoverables at December 31, 2003, net of an allowance of $16.3 that we estimated as uncollectible.
78.3% of the remaining amounts due from our reinsurers outside the mandatory pools were due from reinsurers rated A or higher by A.M. Best
Our property catastrophe reinsurance is excess-of-loss reinsurance, which provides us with reinsurance coverage over an agreed-upon amount. The terms of our property catastrophe reinsurance in 2004 and 2005 are:
The first $100.0 of any property catastrophe loss is entirely ours. This is our retention - the amount of losses we absorb before the reinsurers reimburse us.
Workers Compensation Reinsurance - Our workers compensation reinsurance reduces the financial impact a single-event or catastrophe loss may have on our results. It is excess-of-loss coverage.
The terms of our workers compensation reinsurance in 2004 and 2005 are:
The terms of our commercial property reinsurance in 2004 and 2005 are:
Our reinsurer reimburses us for the rest of the loss up to $15.0 for each commercial property risk.
The terms of our commercial umbrella reinsurance in 2004 and 2005 are:
If two or more of these lines are affected by the same loss event:
Our reinsurer reimburses us for the rest of the loss up to $9.0.
TRIA does not apply to personal lines policyholders and will expire on December 31, 2005 unless Congress re-authorizes the law. We believe that re-authorization of TRIA would enable companies to continue to provide terrorism coverage at relatively stable prices. If TRIA is not re-authorized, we will continue to provide terrorism coverage at least for the current effective periods of commercial policies issued or renewed in 2004. We are closely following Congressional activity on this subject.
If the policyholder does reject our mandatory offer of terrorism coverage, we can then exclude coverage for losses due to foreign terrorism. The ISO has filed exclusions for acts of terrorism as defined by TRIA, and we have adopted those filings. However, some states limit the use of terrorism exclusions.
Investment returns are an important part of our overall profitability. Fluctuations in the fixed-income or equity markets could affect the timing and the amount of our net investment income. Defaults by third parties in the payment or performance of their obligations - primarily on our investments in corporate bonds - could reduce our net investment income or create net realized investment losses.
In 2004, the declines in our pretax investment yields in our portfolios reflected the low interest rate environment for new monies invested from our positive cash flows. In addition, rates on reinvestment on securities matured or called were lower than these investments had been earning, which resulted in lower yields compared with 2003. In 2003, the reinvestment of maturities or calls at yields that were lower than the yields on investments that matured or were called decreased our investment yields compared with 2002.
Pretax net realized investment gains and losses for 2004, 2003 and 2002 by portfolio were:
We closely monitor every investment that has declined in fair value to below our cost. If we determine that the decline is other-than-temporary, we write down the security to its fair value and report the charge as an impairment in Net Realized Investment Gains in the Consolidated Statements of Income in the period that we make this determination. More information about our process of estimating investment impairments can be found in the discussion of Critical Accounting Estimates on page 24.
In our impairment determination process, we consider our intent and ability to hold investments with declines in value long enough for them to recover in value. However, our intent to hold the investment could change due to:
Strategic decisions to reposition the duration, quality or asset allocation of our investment portfolio
These tables summarize our investment portfolio at December 31, 2004 and 2003:
As of December 31, 2004, our marketable equity securities, carried at $1,101.4, included:
As of December 31, 2003, our marketable equity securities, carried at $1,166.2, included:
No one industry contributed to more than 10% of the total gross unrealized losses.
We reviewed all our investments with unrealized losses at the end of 2004. Our evaluation determined that all their declines in fair value were temporary.
Unrealized losses on our fixed maturities that have been in a loss position for more than a year at December 31, 2004, were $2.6, down from $7.0 at December 31, 2003. There were no unrealized losses on our marketable equity securities that have been in a loss position for more than a year at December 31, 2004.
Below Investment Grade and Other Securities - A security is considered below investment grade if it has a rating below BBB. Our consolidated investment portfolio included below investment grade fixed maturities with a fair value of:
Our below investment grade securities had both a gross and net unrealized investment gain of $10.8 at year-end 2004.
Our investment portfolio also included $122.8 of non-publicly traded fixed maturities and marketable equity securities - representing 1.2% of our total portfolio at year-end 2004, and $99.9 of non-publicly traded fixed maturities and marketable equity securities - representing 1.1% of our total portfolio at year-end 2003. Our investment portfolio included $89.1 of not-rated fixed maturities - securities not rated by a national rating service - representing 0.9% of our total portfolio at year-end 2004 and $88.3 of not-rated fixed maturities- representing 0.9% of our total portfolio at year-end 2003.
This table summarizes our holdings of mortgage-backed securities at year-end 2004:
P&C insurance liabilities are somewhat unpredictable and largely short in duration. The payments we make to policyholders depend upon losses they suffer from accidents or other unpredictable events that are covered by insurance. While we estimate how much cash we’ll need and when we’ll need it based on prior experience and the mix of business we write, we cannot predict all future events, particularly catastrophes. So we generally invest in high-quality securities with greater liquidity - investments that can quickly be turned into cash - to support our projected or potential need for funds.
The cash flow from our operating activities for the past three years was:
We believe that cash flows from our operations, investment portfolio and bank credit facility are sufficient to meet our future liquidity needs.
Sale of L&I and Use of Proceeds- On August 2, 2004, we completed the sale of our L&I operations, resulting in $1,499.0 of total sales proceeds. We used $735.2 of these proceeds, including transaction costs, to repurchase $618.4 of debt, resulting in a $121.0 pretax ($78.7 after-tax) loss on debt repurchases. Including transaction costs, we used $625.0 to execute an Accelerated Stock Buyback (ASB) program of 13,247,863 shares of common stock, and we retained the balance to provide future flexibility and pay transaction-related expenses.
Accelerated Stock Buyback - On August 2, 2004, we repurchased 13,247,863 shares, or approximately 9.5% of our outstanding common stock under an ASB program. The shares were purchased from a dealer at a price of $46.80 per share, for a total of $625.0 including transaction costs. Through the ASB program, we returned excess capital from the L&I sale to shareholders and immediately reduced the number of our common shares outstanding. The dealer obtained the shares that we purchased by borrowing them in the open market, and then the dealer repurchases shares in the market over the following six to nine months to repay the borrowed shares. $200.0 of the ASB is subject to a collar, a contract that sets a minimum and maximum price for us for the shares repurchased under the collar. At the end of the program, we may receive, or be required to pay, a price adjustment based on volume weighted average price of our common stock during the period of the ASB repurchases. This adjustment will be recorded in shareholders’ equity.
$500.0 Long-Term Debt Refinancing - On January 27, 2003, we issued $500.0 of senior notes, including:
Our Bank Credit Facility - We maintain a bank credit facility with $300.0 available. This was reduced from $500.0 available following our sale of L&I. The terms of the bank credit facility - which runs through September 2005 - require us to:
We believe our financial position is sound. As we have continued to execute our plans to improve P&C operating results, our financial position has strengthened. Our debt service coverage has improved over the last two years, and we expect that to continue in 2005.
Various states’ Departments of Insurance and Attorneys General have responded to recent publicity surrounding broker compensation issues by issuing inquiries and subpoenas to insurance companies and
insurance producers domiciled or doing business in their states. To date, we have received inquiries or subpoenas from the California, Illinois, Missouri, Oregon, North Carolina, Texas and Washington Departments of Insurance and the California Attorney General. We have responded or are responding as these arrive. We have no reason to believe, and do not believe, that these events will materially or adversely impact our financial condition, operating results or liquidity.
At December 31, 2004, we had approximately $746.3 of gross deferred income tax assets. Gross deferred income tax assets are composed of temporary differences created as a result of amounts deductible for taxes in future periods. Our deferred income tax assets include capital loss carryforwards of $10.8 that expire in 2009 and alternative minimum tax carryforwards of $51.8 that carryforward indefinitely. Although realization of deferred income tax assets is not assured, we believe they will be realized through future earnings, including but not limited to the generation of future operating income, reversal of existing temporary differences and available tax planning strategies. Accordingly, we have not recorded a valuation allowance for these assets.
Amounts recorded for net periodic pension cost and the benefit obligation at the measurement date are affected by the changes in assumptions used to determine the weighted average discount rate and expected long-term rate of return on plan assets. To calculate our benefit obligation, as of December 31, 2004, we used a weighted average discount rate of 5.50% based on an evaluation of the nature and timing of the pension obligations. Specifically, we calculated an equivalent discount rate on a hypothetical portfolio of high-quality fixed maturities with future cash flows that match the timing and amount of our estimated future benefit payments. We used an expected long-term rate of return on our investments of 8.00%, by considering the mix of investments within the plan as well as actual investment experience during the lifetime of the plan.