The Consolidated Corporation owns and leases office space in various parts of the country. The principal office buildings consist of facilities owned in Fairfield and Hamilton, Ohio. These office buildings service all of the Consolidated Corporation’s segments. The Fairfield, Ohio office building is subject to a mortgage with an outstanding balance of $2.0 million as of December 31, 2006.
Net premiums written are premiums for all policies sold during a specific accounting period less premiums returned.
Loss ratio measures net losses incurred as a percentage of net premiums earned.
Loss adjustment expense ratio measures loss adjustment expenses as a percentage of net premiums earned.
Statutory policyholders’ surplus is equal to an insurance company’s admitted assets minus liabilities.
The Consolidated Corporation earns revenue by providing businesses and consumers with competitive insurance products with high quality service and by earning income on invested assets. In 2006, the Consolidated Corporation’s net income increased 2.6% to $218.3 from $212.7 in 2005 and 70.0% when compared with 2004 net income of $128.4. During the year, the Corporation completed the share repurchase program authorized by the Corporation’s Board of Directors in 2005. In September 2006, the Board of Directors approved another share repurchase program with authorization to repurchase up to $100.0 of the Corporation’s common stock. Through December 31, 2006, the Corporation has repurchased 979,501 shares under the newly authorized share repurchase program at an average cost of $28.57. For the full year 2006, the Corporation repurchased a total of 3,463,396 shares under the combined repurchase programs or 5.5% of the total outstanding shares at December 31, 2005. The Board of Directors also increased the quarterly dividend during the year from $0.06 to $0.09 signifying our strong liquidity position.
From a profitability perspective, the 2006 All Lines GAAP combined ratio was 93.7% compared to 94.2% in 2005 and 99.6% in 2004. All three operating segments achieved combined ratios below 100% in 2006 despite an overall decline in earned premium, higher catastrophe losses and loss cost trends increasing at a faster rate than premium rates, all when compared with prior year. The Group has experienced favorable prior year reserve development in each of the last three years. From a premium perspective, both gross and net premiums declined from prior year as a result of rate reductions taken in late 2005 and early 2006 in the Personal Lines segment and a decline in in-force policy counts in the Personal Lines segment and commercial umbrella product line. Partially offsetting the impact of these items was an increase in new business premium production in Commercial and Personal Lines. The Group has begun several initiatives to reverse the trend in the decline in premiums including leveraging the advantage of our P.A.R.I.S.sm technology, restructuring our marketing approach, and investing in new product opportunities.
The improved financial results for 2005 compared to 2004 were driven by improvements in both loss and LAE ratios as a result of favorable claim frequency, adequate pricing, favorable prior year reserve development and lower catastrophe losses. Catastrophe losses decreased $17.7 in 2005, even though the industry experienced its worst ever year for natural catastrophes. Underwriting expenses decreased during the year as expense savings resulting from the Cost Structure Efficiency (CSE) initiative came to fruition. The increase in financial results also can be attributed to a favorable Internal Revenue Service (IRS) settlement adjustment and an accrual reversal for the exit of the New Jersey private passenger auto business. Offsetting some of the favorable items mentioned above was a $9.0 loss on retirement of the convertible debt incurred in connection with the call/redemption of the Convertible Notes. For additional information regarding these transactions, see Item 15, Note 3 - Income taxes on page 76, Note 7 - Other Contingencies and Commitments on pages 83 and 84 and Note 15 - Debt, in the Notes to the Consolidated Financial Statements on pages 87 and 88 of this Annual Report on Form 10-K.
Insurance industry regulators require the Group to report its financial condition and results of operations, among other things, using statutory accounting principles. Management uses industry standard financial measures determined on a statutory basis, as well as those determined on a GAAP basis to analyze the Group’s property and casualty operations. These insurance industry financial measures include loss and LAE ratios, underwriting expense ratio, combined ratio, net premiums written and net premiums earned. The 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 this MD&A are calculated on a GAAP basis, unless otherwise indicated, and are calculated on a calendar year basis unless specified as calculated on an accident year basis. Insurance industry financial measures are included in the next several sections of this MD&A that discuss results of operations. A discussion of the differences between statutory accounting and generally accepted accounting principles in the United States is included in Item 15, Note 14 - Statutory Accounting Information, in the Notes to Consolidated Financial Statements, on page 87 of this Annual Report on Form 10-K. Statutory surplus, a financial measure that is required by insurance regulators and used to monitor financial strength, is discussed in the “Statutory Surplus” section of the “Liquidity and Capital Resources” section on pages 58 and 59 of this MD&A.
The table below summarizes property and casualty insurance premiums on a gross and net basis for the year ended December 31, 2006 compared with the same period of 2005 and 2004, respectively:
All Lines gross and net premiums written declined in 2006 when compared with the prior year due primarily to lower in-force policy counts, rate reductions taken in late 2005 and 2006 in the Personal Lines segment, lower Commercial Lines assumed premiums from mandatory workers’ compensation and commercial auto pools, as well as other actions we are taking in the workers’ compensation product line, as discussed later in this MD&A. This decline is partially offset by an increase in new business premium production for Commercial and Personal Lines and improving retention ratios for these two segments as well as the commercial umbrella product line. All Lines gross and net premiums written declined in 2005 over 2004 due primarily to Commercial and Personal Lines and the commercial umbrella product line experiencing declines in new business premium production as a result of an increase in price competition and declining retention ratios in the Personal Lines segment and commercial umbrella product line, partially offset by slightly better retention rates in the Commercial Lines segment. The decline in gross premiums written in 2005 over 2004 due to the reasons noted above was partially offset on a net basis by lower ceded premiums resulting from higher retention limits, especially for the commercial umbrella product line, in our 2005 reinsurance program when compared with the 2004 program.
When used in this Annual Report on Form 10-K, renewal price increase / decrease means the average increase in premium for policies renewed by the Group. The Group revised its methodology for calculating the average renewal price change for the Commercial Lines segment in 2006. Previously the Company calculated this amount by comparing the total expiring premium for the policy with the total renewal premium for the same policy, including endorsement and audit premium on those policies subsequent to the renewal date. The revised methodology is calculated by comparing the total expiring premium for the policy with the total renewal premium for the same policy at the renewal date. Endorsements and audit premium subsequent to the renewal date are excluded from the calculation. The amounts presented in the table above have been restated for all periods to present the percentage using the revised methodology. Renewal price increases include, among other things, the effects of rate increases and changes in the underlying insured exposures of the policy. Only policies issued by the Group in the previous policy term with the same policy identification codes are included. Therefore, renewal price increases do not include changes in premiums for newly issued policies and business assumed through reinsurance agreements. Renewal price increases also do not reflect the cost of any reinsurance purchased on the policies issued.
When used in this Annual Report on Form 10-K, policy retention ratio is calculated by dividing policies in force as of December 31 of the current year that were also in force as of December 31 of the prior year by policies in force as of December 31 of the prior year.
The 2005 All Lines combined ratio improved 5.4 points resulting from continued improvement in all three component ratios. The 2.3 point improvement in the loss and LAE ratios is the result of the Group’s continued focus on disciplined underwriting quality, lower claim frequency, favorable prior year reserve development of $20.1 and lower catastrophe losses. The favorable prior year reserve development reduced the loss and LAE ratio by 1.4 points. The 3.1 point improvement in the underwriting expense ratio is primarily a result of the Group’s continued focus on expense management and the result of expense savings from the CSE initiative announced in 2004, including over a 20% reduction in headcount from year-end 2003.
We monitor incurred losses by operating segment, product line, risk classification, geographic region and agency addressing loss ratio issues or trends as part of our ongoing business operations. We also track current accident year large losses (losses greater than $250 thousand, excluding catastrophe losses), to monitor severity trends.
The following table provides a reconciliation of significant changes to the All Lines loss and LAE ratio for 2006, 2005 and 2004, respectively.
Large loss activity can be volatile from year to year as indicated by the Group’s experience over the last five years. The increase in large loss activity in 2006 does not appear to be indicative of a new trend. The current accident year large loss impact on the loss ratio in each of these years, evaluated at December 31 for each of the respective years, is as follows:
The loss and LAE ratio components of the accident year combined ratio measure 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. The table below summarizes the impact of changes in provision for all prior accident year losses and LAE for each of the last three years:
In 2004, the impact of the prior years favorable reserve development was concentrated in the Commercial and Specialty Lines operating segments. The Specialty Lines segment experienced significant favorable development for prior years’ losses and LAE, primarily due to a reduction in estimated future costs for claims adjuster related expenses. The total provision reduction for prior years’ losses and LAE of $21.8 represents 0.8% of loss and LAE reserves as of year-end 2003.
Additional information relating to loss and LAE reserves is discussed in the “Reserves for Losses and Loss Adjustment Expenses” sub-section in the “Critical Accounting Policies” section of Item 7, on pages 48-56 of this Annual Report on Form 10-K.
The 2004 underwriting expense ratio was favorably impacted by a reduction in employee related costs, a non-recurring reduction in assessments, fees and premium taxes and by other operating efficiencies. These improvements were partially offset by 1.1 points of expense related to the Proformance surplus guarantee.
The P.A.R.I.S.sm system provides the policy administration environment used internally by the Group’s associates. An extension of P.A.R.I.S.sm called P.A.R.I.S. Expresssm leverages the P.A.R.I.S.sm system to provide underwriting, rating, inquiry and policy processing functionality to our agents. P.A.R.I.S. Expresssm is a proprietary internet interface that uses the P.A.R.I.S.sm system to provide real-time functionality through a web browser to our agents. In addition, the Group is simultaneously introducing P.A.R.I.S. Connecttm which allows agents to transact with the Group directly from their agency management system without requiring re-entering of customer or agency information.
The 2006 Commercial Lines combined ratio improved when compared to 2005 as a result of a significant decline in catastrophe losses and an increase in favorable prior year reserve development as well as improvement in the underwriting expense ratio. The favorable reserve development was concentrated in the commercial auto and commercial multiple peril (CMP) product lines, partially offset by continued adverse development in the workers’ compensation product line. These improvements were partially offset by increased current accident year large loss activity, as presented in the table below, along with margin compression related to loss cost trends exceeding premium rate increases. Loss cost trends are increasing in the mid single digit range with severity increasing in the high single digit range offset by decreases in frequency in the low single digit range.
We monitor incurred losses by product line, risk classification, geographic region and agency addressing loss ratio issues or trends as part of our ongoing business operations. We also track current accident year large losses, as defined, to monitor severity trends.
The following table provides a reconciliation of significant changes to the Commercial Lines loss and LAE ratio for each of the last three years.
As indicated in the All Lines section, current accident year large loss activity can be volatile from year to year. The increase in current accident year large losses from 2005 to 2006 does not appear to be indicative of a new trend. The current accident year large loss impact on the Commercial Lines loss ratio, evaluated at December 31 for each of the respective years, has been as follows:
The workers’ compensation product line combined ratio improved in 2006 when compared with the prior year, however this product line continued to experience adverse prior year reserve development, a result of increasing medical costs (including greater usage of prescription drugs) and continued review of lifetime cases. The continued adverse development in this product line is consistent with the trends of peer companies who write this product in similar states as the Group. During 2005, the workers’ compensation product line experienced significant adverse prior year reserve development related to the review of lifetime and other severe claims, which added 31.3 points to the workers’ compensation combined ratio. Also impacting the loss and LAE ratios for the period were assessments for the National Workers’ Compensation Pool (NWCP), which decreased the workers’ compensation combined ratio in 2006 by (1.2) points compared to increasing the workers’ compensation combined ratio by 0.9 points and 5.1 points in 2005 and 2004, respectively. The 2006 underwriting expense ratio benefited from lower assessments, primarily related to second injury funds. The Group continues to focus on improving profitability in the workers’ compensation product line. Through the use of predictive modeling the Group is better able to identify the attractive classes of business and increase its writing within these classes, while reducing its writings in the lesser attractive classes. Additionally, the Group has restricted writings in states where the workers’ compensation product line has historically been unprofitable and is focused on growing this product line in profitable states and classes. The concentration of the Group’s business in a few states with limited pricing flexibility provides less opportunity to address issues specific to the workers’ compensation product line in those states. These issues are offset by the Group’s approach to writing workers’ compensation as part of an overall Commercial Lines account, where underwriters seek to ensure that the pricing for the entire account is adequate.
The general liability product line combined ratio improvement in 2006 is primarily due to a 4.1 point improvement in the loss ratio. We believe this loss ratio improvement is driven by our efforts in the last few years to limit exposure to broadening court interpretations of additional insured and contractual general liability provisions by adding policy language changes. This line is exposed to construction defect issues which are being addressed through strict underwriting standards for certain classes of business that are more prone to construction defect claims. The 2005 general liability product line combined ratio was impacted by an increase in asbestos and environmental loss and LAE reserves which added 9.6 points to the general liability loss and LAE ratio in 2005 related to certain pre-1970 assumed reinsurance contracts.
The CMP, fire and inland marine combined ratio improved when compared to 2005 due primarily to a 4.6 point improvement in the loss and LAE ratios driven by favorable prior year reserve development in 2006 compared with adverse prior year reserve development in 2005, partially offset by an increase in catastrophe losses. The combined ratio was also impacted by a 1.7 point improvement in the underwriting expense ratio. The combined ratio improved from 2004 to 2005 primarily due to a 3.1 point improvement in the underwriting expense ratio due to our expense management initiatives.
The Specialty Lines combined ratio for 2006 improved due to favorable prior year reserve development of $31.8 (21.6 points) primarily concentrated in the commercial umbrella product line, partially offset by an increase in large losses. For the same period in 2005 and 2004, favorable development was $12.3 (8.6 points) and $9.4 (6.3 points), respectively. Given the volume and nature of the coverage, the Specialty Lines combined ratio is subject to more volatility than the other operating segments. Underwriting expenses were favorably impacted by lower incentive accruals and recognition of $1.3 of prior years’ New Jersey premium tax refunds as discussed in the All Lines section.
The following table shows the Specialty Lines segment by selected product lines:
The 2006 commercial umbrella/other combined ratio improvement was primarily related to $29.0 (31.3 points) of favorable development on prior year loss and LAE reserves compared to $11.5 (12.4 points) and $5.1 (4.9 points) in 2005 and 2004, respectively. The favorable prior year reserve development over the last two years is primarily related to fewer and less severe claims than previously expected on a net of reinsurance basis. Also impacting the comparison of 2005 to 2004 is a $6.1 premium reinstatement accrual in 2004, which reduced net premium written and earned, and put upward pressure on the combined and component ratios.
The Personal Lines combined ratio for 2006 increased 11.0 points over the same period last year. The increase in the loss and LAE ratios is a result of higher catastrophe losses and less favorable prior year reserve development when compared to 2005. The decline in favorable prior year reserve development was primarily related to a $5.5 legal settlement provision related to our uninsured/underinsured motorist coverage claims handling practices and reduced favorable development on New Jersey automobile claims. Also impacting the increase in the loss and LAE ratios is margin compression related to loss cost increases compared to premium rate declines which is reflected in the increase in the “all other loss and LAE ratio” in the table below. Loss cost trends are increasing at a low single digit rate with severity increasing at a mid single digit rate offset by a low single digit decrease in frequency. As discussed above, we have correspondingly been experiencing premium rate reductions due to rate changes taken in the last half of 2005 and 2006.
The underwriting expense ratio increased 1.5 points primarily due to a $6.0 increase in legal settlement provision related to an Ohio uninsured motorists class action proceeding and the 2005 underwriting expense ratio included a 1.1 point reduction related to the Proformance surplus guarantee that was not present in 2006. These increases were partially offset by lower incentive and contingent commission accruals in 2006 as well as recognition of $2.7 for the New Jersey prior years’ premium tax refunds as discussed in the All Lines section.
We monitor incurred losses by product line, risk classification, geographic region and agency addressing loss ratio issues or trends as part of our ongoing business operations. We also track current accident year large losses, as defined, to monitor severity trends. The following table provides a reconciliation of significant changes to the Personal Lines loss and LAE ratio for each of the last three years.
As indicated in the All Lines section, current accident year large loss activity can be volatile from year to year. The current accident year large loss impact on the Personal Lines loss ratio, evaluated at December 31 for each of the respective years, has been as follows:
The following table shows the Personal Lines segment by selected product lines:
Consolidated net investment income for the three years ended December 31, 2006, 2005 and 2004 was $208.7 ($155.1 after tax), $201.4 ($146.8 after tax) and $201.2 ($137.0 after tax), respectively. The effective tax rate on investment income for the three years ended December 31, 2006, 2005 and 2004 was 25.7%, 27.1% and 31.9%, respectively.
Investment income for 2006 was higher than the same period of 2005, a result of lower investment related expenses, growth in the investment portfolio resulting from positive operating cash flows and an improvement in reinvestment yields resulting from the upward movement in interest rates when compared with the prior year. Additionally, included in 2006 investment income is $3.2 of interest income related to the New Jersey premium tax refunds. See Item 15, Notes to Consolidated Financial Statements, Note 7 - Other Contingencies and Commitments on pages 83 and 84 of this Annual Report on Form 10-K for additional information related to the state premium tax refund. Investment income for 2005 included $2.5 of interest income received from the IRS as a result of a favorable tax settlement which was somewhat offset by a reduction in investment income as a result of the reduction in cash equivalent holdings which were used during 2005 to fund the call/redemption of the Corporation’s 5.0% Convertible Notes. As a result of the strategy to invest more heavily into tax-exempt securities, the effective tax rate on investment income has declined over the last few years thereby generating an increase in after-tax investment income. At December 31, 2006, our allocation to tax-exempt securities as a percentage of the fixed income portfolio was 37.6%, compared with 33.7% at December 31, 2005.
Invested assets comprise a majority of the consolidated assets. Consequently, accounting policies related to investments are critical. See further discussion of important investment accounting policies in the “Critical Accounting Policies” section of this MD&A and in Item 15, Notes to Consolidated Financial Statements, Note 1C - Investments, on page 71 of this Annual Report on Form 10-K.
The Consolidated Corporation regularly evaluates all investments based upon current economic conditions (including the interest rate environment), credit loss experience and other specific developments. The Consolidated Corporation monitors the difference between cost (or amortized cost) and estimated fair value to determine whether a decline in value is temporary or other-than-temporary. The assessment of whether a decline in fair value is considered temporary or other-than-temporary includes management’s judgment as to the financial position and future prospects of the entity issuing the security. It is not possible to accurately predict when it may be determined that a specific security will become impaired. If a decline in fair value is determined to be other-than-temporary, the cost basis of the security is reduced to its then estimated fair value in the period of determination.
As part of its evaluation of the aggregate $16.6 unrealized loss on securities in the investment portfolio at December 31, 2006, management performed a more intensive review of securities with a higher unrealized loss percentage when compared with their cost or amortized cost. Based on this review of each security, management believes that unrealized losses on these securities were temporary declines in value at December 31, 2006. In the table above, there are approximately 308 securities represented. Of this total, 19 securities have unrealized loss positions greater than 5% of their market values at December 31, 2006, with none exceeding 20%. This group represents $3.0, or 18% of the total unrealized loss position. Of this group, ten securities representing approximately $1.9 in unrealized losses have been in an unrealized loss position for less than twelve months. Of the remaining nine securities in an unrealized loss position for longer than twelve months totaling $1.1, management believes they will recover the cost basis of these securities, and has both the intent and ability to hold the securities until they mature or recover in value. All securities are monitored by portfolio managers who consider many factors such as an issuer’s degree of financial flexibility, management competence and industry fundamentals in evaluating whether the decline in fair value is temporary. In addition, management considers whether it is probable that all contract terms of the security will be satisfied and whether the unrealized loss position is due to changes in the interest rate environment. Should management subsequently conclude the decline in fair value is other than temporary, the book value of the security is written down to the then fair value with the realized loss recognized in the consolidated statements of income.
For additional discussion relative to the Consolidated Corporation’s investment portfolio, see the “Investment Portfolio” section under “Liquidity and Capital Resources” on pages 60-62 of this MD&A.
Fixed income securities are categorized upon acquisition as either held-to-maturity, available-for-sale or trading. Fixed income securities categorized 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 are not categorized as either held-to-maturity or trading. Available-for-sale securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported as a component of accumulated other comprehensive income, net of deferred tax. Equity securities are categorized as available-for-sale and 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 Consolidated Corporation closely monitors the fixed income and equity portfolios for declines in value that are deemed to be other than temporary. Investments are regularly evaluated based on current economic conditions (including the interest rate environment), 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 then current consolidated statement of income.
Reinsurance is a contract by which one insurer, called a reinsurer, agrees to cover, under certain defined circumstances, a portion of the losses incurred by a primary insurer in the event a claim is made under a policy issued by the primary insurer. The Group purchases reinsurance to diversify risk and reduce the loss that may arise from large or catastrophic losses or other events that cause unfavorable underwriting results. The Group records its ceded reinsurance transactions on a gross basis by recording an asset as reinsurance recoverable for estimates of paid and unpaid losses, including estimates for losses incurred but not reported. The collectibility of reinsurance depends on the solvency of the reinsurers at the time any claims are presented. The Group evaluates each reinsurer’s financial health, claims settlement performance and monitors concentrations of credit risk to minimize exposure to significant losses from reinsurer insolvencies. Each year, the Group reviews
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 the consolidated statement of 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 judgments 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 Company sponsors a non-contributory defined benefit pension plan and a contributory postretirement healthcare plan. The pension and postretirement benefit obligations, related costs and contributions are calculated using actuarial methods in accordance with Statement of Financial Accounting Standards (SFAS) No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans an amendment of FASB statements No. 87, 88, 106 and 132(R),” SFAS 87, “Employers’ Accounting for Pensions” and SFAS 106, “Employers’ Accounting for Postretirement Benefits Other than Pension.” 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 rate of return on plan assets, discount rate, rate of compensation increases and health care cost trend rates, as determined by the Company, within certain
The Company determines the expected long-term rate of return on plan assets based on the geometric method, which estimates 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 2006, 2005 and 2004. The expected rate of return on plan assets is a long-term assumption. 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, 2006 net periodic pension expense by approximately $3.5.
In determining the discount rate assumption, the Company utilizes current market information including analysis of the Moody’s “Aa” Corporate Bond Index Rate, analysis provided by plan actuaries and independent survey data on similarly positioned companies. As regards to the analysis provided by plan actuaries, a discounted cash flow model of the plan’s benefit obligations was developed using an interest rate yield curve to make judgments regarding the appropriate discount rate for both its pension and postretirement medical benefit obligations. The yield curve is comprised of the highest quartile yielding bonds with at least a “Aa” rating and with maturities primarily between zero and thirty years. This resulted in the selection of 5.90% for 2006, 5.50% for 2005 and 5.95% for 2004 for the pension plan and 5.75% for 2006, 5.35% for 2005 and 5.75% for 2004 for the postretirement medical plan.
In August 2006, the Pension Protection Act of 2006 (PPA) was signed into law. This pension legislation fundamentally changes the funding rules for single employer defined benefit plans and makes extensive changes to other rules pertaining to multiemployer pension plans, hybrid pension plans and defined contribution retirement plans.
The PPA is effective for the Company beginning on July 1, 2008, and the effect that the PPA will have on Company contributions, if any, is currently being evaluated and can fluctuate based on market performance of plan assets, actuarial assumption changes and additional legislation. The Company is currently evaluating whether any contributions to the defined benefit plan will be made during the 2007 calendar year.
The Group conducts a quarterly review of loss reserves using the methods described below and records its best estimate each quarter based on that review. In the opinion of management, the reserves recorded at December 31, 2006 represent the Group’s best estimate of its ultimate liability for losses and LAE. However, due to the inherent complexity of the estimation process and the potential variability of the assumptions used, final claim settlements may vary significantly from the amounts recorded. Furthermore, the timing, frequency and extent of adjustments to the estimated liabilities cannot be predicted with certainty since conditions and events which established historical loss reserve development and which serve as the basis for estimating ultimate claim costs may not occur in exactly the same manner, if at all.
Most of the Group’s insurance policies are written on an occurrence basis which provides coverage if a loss occurs in the policy period, even if the insured reports the loss many years later. In addition, final settlement of certain claims can be delayed for years or decades due to litigation or other reasons. For example, some general liability claims are reported 10 years or more after the policy period, and the workers’ compensation coverage provided by our policies pays unlimited medical benefits for the duration of the claimant’s injury up to the lifetime of the claimant. Occurrence based forms of insurance require estimation of future costs, including the effect of judicial interpretations, societal litigation trends and medical cost inflation, among others. Reserve development can occur over time as conditions and circumstances change in the years following the policy issuance.
One of the key assumptions in most actuarial analyses is that past patterns demonstrated in the data will repeat themselves in the future, absent a material change in the associated risk factors discussed below. To the extent a material change affecting the ultimate claim liability is known, such change is quantified to the extent possible through an analysis of internal company data and, if available and when appropriate, external data. Such a measurement is specific to the facts and circumstances of the particular claim portfolio and the known change being evaluated.
Multiple estimation methods are available for the analysis of ultimate claim liabilities. Each estimation method has its own advantages and disadvantages, with no single estimation method being better than the others in all situations. Generally more methods are used for long-tail product lines because of the difficulty in estimating reserves for these lines. Also, more methods are generally used for recent accident years compared to older accident years because the data available for recent accident years is less mature. The relative strengths and
weaknesses of the particular estimation methods when applied to a particular group of claims can also change over time based on the available facts and circumstances. Therefore, the actual choice of estimation methods can change with each evaluation. The estimation methods chosen are those that are believed to produce the most reliable indication at that particular evaluation date for the claim liabilities being evaluated.
The principal actuarial reserving methods utilized by the Group to establish loss reserves include, but are not limited to:
Paid loss development methods: These methods use historical loss payments over discrete periods of time to estimate future losses. Paid loss development methods assume that the ratio of losses paid in one period to losses paid in an earlier period will remain constant. These methods necessarily assume that factors that have affected paid losses in the past, such as inflation or the effects of litigation, will remain constant in the future. Because paid loss development methods do not use case reserves to estimate ultimate losses, they can be more reliable than the other methods discussed below that look to case reserves (such as actuarial methods that use incurred losses) in situations where there are significant changes in how case reserves are established by a company’s claims adjusters. However, paid loss development methods are more leveraged (meaning that small changes in payments have a larger impact on estimates of ultimate losses) than actuarial methods that use incurred losses because cumulative loss payments take much longer to equal the expected ultimate losses than cumulative incurred amounts. In addition, and for similar reasons, paid loss development methods are often slow to react to situations when new or different factors arise than those that have affected paid losses in the past.
Incurred loss development methods: These methods, like paid loss development methods, assume that the ratio of losses in one period to losses in an earlier period will remain constant in the future. However, instead of using paid losses, these methods use incurred losses (i.e., the sum of cumulative historical loss payments plus outstanding case reserves) over discrete periods of time to estimate future losses. Incurred loss development methods can be preferable to paid loss development methods because they explicitly take into account open cases and the claims adjusters’ evaluations of the cost to settle all known claims. However, incurred loss development methods necessarily assume that case reserving practices are consistently applied over time. Therefore, when there have been significant changes in how case reserves are established, using incurred loss data to project ultimate losses can be less reliable than other methods.
Expected loss ratio methods: These methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected loss ratios are typically developed based upon the information used in pricing, and are multiplied by premiums earned to calculate ultimate losses. Expected loss ratio methods are useful for estimating ultimate losses in the early years of long-tail lines of business, when little or no paid or incurred loss information is available.
Claim count and severity methods: In these methods, claim counts are estimated similar to the paid and incurred loss development methods described above. The estimated claim counts are then multiplied by an average cost per claim (severity) to determine ultimate losses. They are useful when claim counts are available and severity is reasonably predictable.
Reserves for losses and allocated LAE for asbestos and environmental exposures are especially difficult to determine because of the high amount of legal costs and the extended period of time required to settle these claims. Methods used by the Group to estimate these loss reserves include survival ratio estimates, curve fitting applied to both paid and case incurred losses and allocated LAE, and frequency and severity estimates.
Within each operating segment, development can also be favorable or adverse by product line within the same period. For example, for the Commercial Lines operating segment in 2006, the workers’ compensation product line had adverse development of $22.3 while the commercial auto product line had favorable development of $23.5.
This table illustrates that recent accident periods have developed favorably while the older periods have developed adversely. More than half of the $27.2 of adverse development for accident years 2001 & prior in calendar year 2006 is attributed to the workers’ compensation product line. We do not believe that older accident years will always develop adversely while more recent years develop favorably. However, it should be
The Group does not prepare loss reserve ranges, nor does it project future variability, when determining its best estimate, although the above examples of actual historical changes in loss reserve estimates provide a measure of the uncertainty underlying the current loss reserve estimates. The loss reserve process takes all risk factors into account, but no one risk factor has been bifurcated to perform a sensitivity or variability analysis because management considers the risk factors in the aggregate. Explicit assumptions for individual risk factors are not made. The potential for reasonably possible variability in management’s reserve estimates may be viewed by applying recent historical average calendar year development to current loss reserve estimates. The following table shows what the effect on the Group’s earnings would be if the December 31, 2006 reserves developed at the same rate as the average (favorable)/adverse calendar year development of the most recent five years, net of reinsurance, for the six most significant product lines which represent 96% of total loss reserves at December 31, 2006.
The following discussion describes certain critical risk factors that affect the estimation of loss reserves of the more significant lines of business and provides an explanation for significant changes to reserve estimates in the preceding three year period.
This line of business consists of coverages protecting the insured against legal liability resulting from negligence, carelessness, or a failure to act causing property damage or personal injury to others. General liability is considered a long-tail line, as it takes a relatively long period of time to finalize and settle claims from a given accident year. The speed of claim reporting and claim settlement is a function of the specific coverage provided, the jurisdiction and specific policy provisions. There are numerous components underlying the general liability product line. Some of these have relatively moderate payment patterns (with most of the claims for a given accident year closed within 5 to 7 years), while others can have extreme lags in both reporting and payment of claims. In addition, this line includes asbestos and environmental exposures which are discussed in detail on the following page.
Important risk factors affecting estimation of loss reserves for general liability include:
Whether the event triggering coverage is confined to only one time period or is spread over multiple time periods
The Group defines construction defect exposure as liability for allegations of defective work and completed operations losses from general liability policies involving multiple-units (for example, condos, townhouses, apartments, or tracts of single family homes), multiple defendants (for example, developers, general contractors, and/or sub-contractors), usually with multiple defect issues, and often involving multiple insurance carriers. Loss reserves are difficult to estimate for this exposure because of the complexity of the claims and the late reporting which often occurs many years after the policy term.
The Group writes commercial umbrella business with large policy limits. The period of time between the loss occurrence, the reporting of the claim to the insurer, and the settlement of the claim can extend over many years. The large policy limits, complexity of claims and the lengthy time period required to reach settlement increase the uncertainty of loss estimates. Reinsurance is purchased to mitigate the impact of these large losses.
(Favorable)/adverse loss development for personal automobile was $(7.1), $(25.9), $0.5, $12.4 and $10.3 for 2006, 2005, 2004, 2003 and 2002, respectively. The favorable development in 2005 and 2006 is primarily attributed to less loss severity than expected on bodily injury claims. The adverse development in 2002 and 2003 is due to a re-assessment of automobile case reserves during the exit from the New Jersey personal automobile market beginning in 2002.
In recent years, asbestos and environmental liability claims have expanded greatly in the insurance industry. Historically, the Group has written small commercial accounts with a focus on contracting business thus the Group’s exposure to asbestos is related to installers and distributors as opposed to manufacturers. Consequently, the Group believes it has minimal exposure to the primary defendants involved in major asbestos litigation. The Group’s exposure to environmental liability is due to policies written prior to the introduction of the absolute pollution endorsement in the mid-1980’s and to underground storage tanks, mostly from New Jersey homeowners’ policies in recent years. The Group has limited exposure to the national priority list, a list of known or threatened releases of hazardous substances, pollutants, or contaminants throughout the United States. The Group also has limited asbestos and environmental exposures related to assumed reinsurance business written prior to 1980 with small policy limits.
In 2006, 2005 and 2004, respectively, the Group paid loss and LAE of $6.1, $7.3 and $7.0 for asbestos and environmental claims on a net of reinsurance basis. At year-end 2006 and 2005, asbestos and environmental reserves net of reinsurance were $94.4 and $95.8, respectively. The Group’s thirty-six month (2004 - 2006) survival ratios, on a net of reinsurance basis, are 14.5 years for asbestos and 13.4 years for environmental liability.
Investing activities used net cash of $41.6 in 2006, compared to $267.5 in 2005 and $274.4 in 2004. The reduction of the net cash used in investing of $225.9 primarily relates to a reduction in the cash provided by operations as discussed above and increased share repurchase activity and shareholder dividends as reflected in financing activities. Cash used in investing activities during 2005 and 2004 were essentially flat year to year and consistent with the cash generated from operations.
Total cash used in financing activities was $114.5 in 2006, compared to $198.5 in 2005 and cash provided of $199.5 in 2004. The increase in the quarterly shareholder dividend and increased repurchase activity of the Corporation’s common stock over prior year contributed to the cash used in financing during 2006. The primary uses of cash in financing activities in 2005 related to the repurchase or redemption of the Convertible Notes, reinstatement of the dividend to shareholders and the repurchase of the Corporation’s common stock pursuant to the authorized share repurchase program. These uses were partially offset by cash received from the exercise of stock options. The cash provided in 2004 was primarily the result of the June 2004 Senior Notes offering that raised approximately $199.0.
As of December 31, 2006 and 2005, the Consolidated Corporation did not have any off-balance sheet arrangements as defined by Financial Release - 67, “Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations.”
The Group maintains several programs that provide reinsurance coverage which is intended to mitigate the impact of larger losses and catastrophic events. The Group’s 2006 property per risk program covers property losses in excess of $2.0 for each and every risk with a limit of $13.0.
The property catastrophe reinsurance program protects the Group against an accumulation of losses arising from a catastrophe. The 2006 program provides $100.0 of coverage in excess of the Group’s $25.0 retention. 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 were purchased to cover exposure to catastrophic events having the probability of occurring approximately every 250 years. During 2006, industry catastrophe models were recalibrated in response to the 2004 and 2005 hurricane seasons. As a result, the reinsurance limits coverage was reduced to a probability of occurrence in the 150 - 200 year range.
The Group purchases reinsurance for its fidelity and surety product lines as well. This program runs from April 1, 2006 to March 31, 2007. The Group’s coverage under this reinsurance program is $10.0 in excess of $5.0 per occurrence.
Reinsurance contracts do not relieve the Group of their obligations to policyholders. The collectibility of reinsurance depends on the solvency of the reinsurers at the time any claims are presented. The Group monitors each reinsurer’s financial health and claims settlement performance because reinsurance protection is an important component of the Consolidated Corporation’s financial plan. Each year, the Group reviews financial statements and calculates various ratios used to identify reinsurers who no longer meet appropriate standards of financial strength. Reinsurers who fail to meet these tests are reviewed and those that are determined by the Group to have insufficient financial strength are removed from the program at renewal. Additionally, a large base of reinsurers is utilized to mitigate concentration of risk. The Group also records an estimated allowance for uncollectible reinsurance amounts as deemed necessary. At December 31, 2006, one reinsurer accounted for 15.8% of the total reinsurance recoverable. At December 31, 2005, no reinsurer accounted for more than 15% of the reinsurance recoverable amount. As a result of these measures, amounts of uncollectible reinsurance have not been significant. For more discussion on the reinsurance recoverable asset, see Item 15, Note 6 - Reinsurance, in the Notes to Consolidated Financial Statements, on pages 82 and 83 of this Annual Report on Form 10-K.
Effective January 1, 2007, the Group renewed the vast majority of its reinsurance program, with no significant changes in terms and conditions or reinsurers and with a less than 3.0% increase in the total cost of the program.
The following table sets forth the distribution and other data of invested assets for the years ended December 31, 2006 and December 31, 2005.
The fixed income portfolio is allocated between available-for-sale and held-to-maturity as follows:
The consolidated fixed income portfolio, which for this purpose includes cash equivalents, has an intermediate duration and a laddered maturity structure. The duration of the fixed income portfolio was approximately 4.8 and 5.2 years as of December 31, 2006 and 2005, respectively. The Consolidated Corporation remains fully invested and does not time markets.
Following is a table displaying available-for-sale non-investment grade and non-rated securities in an unrealized loss position at December 31, 2006 and December 31, 2005, respectively:
The investment portfolio also includes non-publicly traded securities such as private placements, non-exchange traded equities and limited partnerships which are carried at fair value. Fair values are based on valuations from pricing services, brokers and other methods as determined by management to provide the most accurate price. The carrying value of this portfolio at December 31, 2006 was $229.3 compared to $320.3 at December 31, 2005.
The Corporation publishes forward-looking statements relating to such matters as anticipated financial performance, business prospects and plans, regulatory developments and similar matters. The statements contained in this MD&A that are not historical information, are forward-looking statements. The Private Securities Litigation Reform Act of 1995 provides a safe harbor under the Securities Act of 1933 and the Securities Exchange Act of 1934 for forward-looking statements. The operations, performance and development of the Consolidated Corporation’s business are subject to risks and uncertainties, which may cause actual results to differ materially from those contained in or supported by the forward-looking statements in this report. The risks and uncertainties that may affect the operations, performance, development and results of the Consolidated Corporation’s business include the following: changes in property and casualty reserves; catastrophe losses; premium and investment growth; product pricing environment; availability of credit; changes in government regulation; performance of financial markets; fluctuations in interest rates; availability and pricing of reinsurance; litigation and administrative proceedings; rating agency actions; acts of war and terrorist activities; ability to appoint and/or retain agents; ability to achieve targeted expense savings; ability to achieve premium targets and profitability goals; and general economic and market conditions.