(1) Discontinued Operations include our Life & Investments (L&I) businesses that were sold in 2004.
: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward-looking information contained in this report is subject to risk and uncertainty.
Changes in general economic and business conditions and in the insurance industry
Other factors discussed under “Risk Factors” and elsewhere in this Form 10-K
We are a property and casualty (P&C) insurance company with headquarters in Seattle, Washington. We sell insurance to drivers, home owners, renters and owners and operators of small- and mid-sized businesses. Our business helps people protect what they value and deal with the unexpected. Our revenues come from the premiums we earn on the insurance policies we write and the income we earn from our investment of these premium dollars.
Marketing our products in ways that mirror the diversity of consumers and their buying preferences
Making progress to become a low-cost carrier and enhancing our competitive position
Investing to modernize and standardize our technology - In 2006, we evaluated our technology infrastructure and developed a five-year roadmap to replace obsolete technology. We improved our critical systems availability to almost 100%, in support of our automated underwriting. We also completed our major developments on our Safeco Now® platform, including umbrella and our next generation of auto and small-business products. We have piloted a virtual worker program for claims and underwriting to be implemented in 2007.
In 2006, we made revisions to our segments, which are intended to be more reflective of how these segments are managed. Our asbestos and environmental results, previously included in SBI Regular and SBI Special Accounts Facility, are in P&C Other. In addition, due to the 2006 sale of Safeco Financial Institution Solutions (SFIS), our lender-placed property insurance business, these results previously included in SBI Special Accounts Facility are in P&C Other. Prior periods have been restated to reflect the revised presentation.
In addition to the activities of these reportable segments, we report certain transactions, such as the interest expense we pay on our debt, debt repurchases, miscellaneous corporate investment income, intercompany eliminations, real-estate holdings, contributions to Safeco Insurance Foundation (the Foundation) and other corporate activities in our Corporate segment and do not allocate these to individual reportable segments.
More information about our investment results can be found in Our Investment Results on page 68.
Our loss reserves reflect our estimates of the ultimate amounts to be paid for losses arising from both reported and unreported claims and our loss adjustment expense (LAE) reserves reflect our estimates for claim settlement expenses related to those losses including legal expenses and other costs that we have not yet paid to settle both reported and unreported claims. We report these amounts in our Loss and LAE Reserves on our Consolidated Balance Sheets.
We record two categories of loss and LAE reserves - case-basis reserves and incurred but not reported (IBNR) reserves.
Losses that have occurred, but have not yet been reported to us
Paid Loss Development - Historical payment patterns for prior claims are used to estimate future payment patterns for current claims. These patterns are applied to current payments by accident year to yield expected ultimate losses.
Incurred Loss Development - Historical case incurred patterns (paid losses plus case-basis reserves) for past 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.
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 the Reinsurance section on page 64.
Size of the reserve balance - Slight variations in large reserve balances can generate significant financial volatility.
Our changing mix of business - We write more policies in standard and non-standard markets where we have not written significant business previously. These risks have, on average, higher frequencies and lower severities than preferred risks.
To illustrate the sensitivity of our estimate, a one-point increase in our severity assumption for Auto BI would yield an increase of approximately $31 in the estimated reserve.
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 SBI, as well as those workers compensation policies that are in runoff and included in the P&C Other segment. The table excludes ULAE reserves, which were $59.9 at year-end 2006, $62.1 at year-end 2005 and $41.6 at year-end 2004:
Estimating reserves for workers compensation involves a significant degree of uncertainty and judgment. This is driven by:
Unlimited liability nature of workers compensation policies - Many claims can pay out for the lifetime of the claimant with no limit on the total payment amount.
Claim reporting lags - Some claims are not made immediately; as a result, we remain exposed to workers compensation losses arising from policies written in prior years.
In determining our best estimate for workers compensation reserves, long-term medical cost inflation trends over the average claim payout period represent our most significant assumption. We have assumed that double-digit medical cost inflation will continue in the near-term, moderating over time to historical levels. Our best estimate of workers compensation reserves presents risk of unfavorable reserve development should medical inflation trends not abate. A one-point increase in our estimate of the average medical cost severity trend would yield an increase of approximately $75 in our estimated reserves.
Estimating reserves for third-party liability involves a significant degree of uncertainty and judgment. This is driven by:
Long payout periods - Many third-party liability claims are paid years after the occurrence of the loss. As a result, the cumulative effect of inflation can be significant.
Changes in coverage interpretation - Legislative actions and judicial interpretations can affect the cost of future payments.
Construction Defects - This table shows our loss and ALAE reserves for construction defects claims. The table excludes ULAE reserves, which were $22.2 at year-end 2006, $28.5 at year-end 2005 and $19.9 at year-end 2004:
Construction defects claimants 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
The main factors driving the uncertainty and judgment in estimating loss reserves for construction defects claims are:
Over the last three years, the number of open construction defects claims has decreased steadily - an average drop of 20.3% per year. Our loss reserve estimates assume that the number of open claims will continue to decrease, but at a slower rate.
Due to volatility and the sparseness of data, estimating loss reserves for asbestos claims requires more than standard actuarial techniques. As a result, we analyze and consider claims statistics and trends, directional trends in survival ratios, and applicable law and coverage litigation.
Our Asbestos Liability Exposure - Here’s the breakout of our asbestos loss reserves, net of reinsurance:
Accordingly, we have two separate special claims-handling functions, one that specializes in asbestos claims related to our runoff assumed reinsurance operations, and one that specializes in asbestos claims related to our direct exposure.
Our direct exposure is primarily due to smaller and more peripheral entities becoming defendants in asbestos claims. Our exposure to the major high-profile asbestos defendants is limited for our direct business. This stems from our historical business strategy to not write direct coverages for larger companies. In addition, we do not have direct exposure to businesses that are the subject of settlement agreements.
Efforts by insureds to seek coverage interpretation not subject to aggregate limits
Changes in the number and types of defendants involved with these claims
Loss and LAE Reserves - Three-Year Review - In this section, we provide the actual reserve estimates for the last three years and discuss changes in those estimates. This table shows the changes in our loss and LAE reserves for 2006, 2005 and 2004.
In 2006, we reduced our estimates for prior years’ loss and LAE reserves by $146.2. This total decrease included:
$98.2 reduction in personal auto reserves, reflecting decreases in severity estimates primarily for accident years 2004 and 2005 in our liability lines
$23.2 increase in our general liability reserves in our runoff lines primarily due to religious institution allegations
$16.1 increase in commercial auto reserves, reflecting increases in severity estimates for prior accident years in our liability lines
$12.9 reduction in workers compensation reserves due to reforms in California and Texas
$12.5 reduction in personal specialty lines, reflecting decreases in personal umbrella severity estimates for prior accident years
In 2005, we reduced our estimates for prior years’ loss and LAE reserves by $45.9. This total decrease included:
$14.8 reduction in personal auto reserves, reflecting improved claims frequency in both our preferred and non-standard books of business
Analysis of Losses and LAE Reserve Development - 10-Year Review - The Analysis of Losses and LAE Reserve Development table on page 43 shows the development of our loss and LAE reserves from 1996 through 2006. For 1997 to 2006, the table includes amounts for American States Financial Corporation, which we acquired in 1997.
As shown in Section A, our reserves net of reinsurance at year-end 1996 were $1,955.7
The unfavorable trend from 1996 through 2002 was primarily due to:
Higher-than-expected number of construction defects, religious institution allegations, asbestos and environmental losses
On page 11, we provided an overview of how we use reinsurance. Here, we focus on how we estimate reinsurance recoverables.
The reinsurance we buy limits our losses on certain individual risks and reduces our exposure to catastrophic events. We purchase 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 $429.9 at December 31, 2006 and $447.0 at December 31, 2005 in reinsurance recoverables as assets on our Consolidated Balance Sheets. The decrease in our reinsurance recoverables in 2006 is a result of recoverables from Hurricane Katrina losses in 2005 and estimated reinsurance recoveries related to workers compensation.
Reinsurance recoverables associated with individual reinsurers, including large exposures and those with lower-rated reinsurers
Based on our analysis, we make a judgment as to whether the decline is other-than-temporary. Sometimes, an investment decline 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 in our Consolidated Statements of Income in the period we make that determination. We reported impairment charges of $79.2 in 2006 compared with $15.5 in 2005 and $9.0 in 2004.
Determining the Fair Value of Our Investments - For the majority of our investments, we use available public market price information to determine the fair value. When such information is not available, as is the case for securities that are not publicly traded, we use other valuation techniques. These techniques include:
More about our investments can be found in the Our Investment Results section on page 68.
Total revenues decreased 1.0% in 2006 compared with 2005, and increased 2.5% in 2005 compared with 2004. The changes were driven by:
Gains on sales of real estate - In connection with our revision in our real estate strategy, we sold various real estate properties in 2006 for a total proceeds of $372.1 and a pretax gain of $168.7.
Net realized investment gains - Net realized investment gains decreased $56.6 in 2006 compared with 2005, and $140.4 in 2005 compared with 2004. The decrease in 2006 compared with 2005 was due to losses on securities sold and increased impairments caused primarily by changes in fair value (driven by interest rates) on securities that we may not hold until they recover in value. The 2006 net realized investment gains included a tax-exempt gain of
Net income increased 27.3% in 2006 compared with 2005, while net income in 2005 increased 22.9% compared with 2004, driven by:
Catastrophe Losses - The decrease in 2006 losses and LAE reflected lower catastrophe losses. We categorize catastrophes as events resulting in losses greater than $0.5 per event and involving multiple claims and policyholders. Catastrophes can be caused by natural events, such as hurricanes, tornadoes, wildfires, earthquakes and hailstorms, or other factors such as terrorism, riots, hazardous materials releases or utility outages. Pretax catastrophe losses, net of reinsurance, were $155.3 in 2006, compared with $267.4 in 2005 and $275.6 in 2004. Catastrophe losses in 2005 were primarily from hurricanes Katrina and Rita along the Gulf Coast. Catastrophe losses in 2004 were primarily from four hurricanes in Florida and surrounding states.
Gains on sales of real estate - After-tax gains on the sales of real estate were $109.6 in 2006. There were no such gains in 2005 or 2004.
Discontinued Operations - In 2004, Results from Discontinued Operations included the after-tax loss on the sale of our L&I operations of $131.0. This was partially offset by $73.2 in Income from Discontinued Operations.
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 operating results:
The primary measures of our operating results include our premiums, underwriting profit or loss and combined ratios. The following tables report those key items - by our reportable segments - for the last three years. More information about the results - also by reportable segment - follows the tables.
Premiums are the primary driver of our revenues, along with net investment income and net realized investment gains. Net written premiums are a non-GAAP measure representing the amount of premium charged for policies issued with effective dates during the period. Premiums are reflected as revenue in the Consolidated Statements of Income as they are earned over the underlying policy period. Net written premiums applicable to the unexpired term of a policy are recorded as unearned premiums on our Consolidated Balance Sheets.
Segmented Auto Insurance Product - Our segmented auto insurance product offers up to 15 underwriting tiers. These underwriting tiers are further refined using multivariate models to assess the risk of loss based on many factors and provide a more accurate price for a wider range of risks. Our new personal auto policy, now available in 35 of the 44 states where we write business, is designed to give our customers a more personalized product. We plan to reach additional customers with the new Safeco Optimum Package, which policyholders can purchase as an endorsement to their personal auto policy. With the package, customers can boost the value of their insurance, be rewarded for good driving and receive extra protection for emergencies and theft.
Compensation Structure - We carefully monitor our rates and offer our agents choices in the area of compensation so they can match compensation to their business model. We made compensation changes including an incentive that gave agents an extra two points of commission for every new auto policy written in the fourth quarter of 2006.
Net earned premiums decreased $107.2, or 3.8%, in 2006 compared with 2005, and increased $191.8, or 7.3%, in 2005 compared with 2004. The changes in net earned premiums were primarily driven by:
Policies-in-force (PIF) - PIF decline decreased net earned premiums by $66.1 in 2006 compared with 2005, and PIF growth increased net earned premiums by $118.7 in 2005 compared with 2004.
Our underwriting results increased $104.5, and our combined ratio decreased 4.1 points in 2006 compared with 2005. Our underwriting results decreased $36.6, and our combined ratio increased 1.8 points in 2005 compared with 2004. Our underwriting results and combined ratio were primarily driven by:
Changes in average premiums - Our earned rate changes, combined with premium trend, increased our Auto combined ratio by 1.4 points in 2006 compared with 2005, and decreased our Auto combined ratio by 3.0 points in 2005 compared with 2004.
Loss costs - Our loss costs decreased in 2006 compared with 2005. This was driven by a mid-single-digit percentage decrease in frequency (the average number of claims filed) partially offset by a low-single-digit percentage increase in severity (the average cost of a claim). This was in part due to fewer-than-expected bodily injury and uninsured motorist claims. These factors, net of reinsurance, decreased our combined ratio by 1.8 points in 2006 compared with 2005. Our loss costs increased in 2005 compared with 2004. This was partly due to the effect of our increased average deductible, which has eliminated some low-severity losses that are not reported because they are less than the now higher deductible amounts. The impact of loss-cost changes in 2005 increased our combined ratio by 3.5 points compared with 2004.
Expenses - The increase in our expense ratio of 0.3 points in 2006 compared with 2005 was driven by our near-term increased investment in technology and costs related to the implementation of our process improvement efforts. In 2005, the increase in our expense ratio of 0.7 points compared with 2004 was driven by increased investment in technology and bad debt expense related primarily to non-standard policies, partially offset by decreased agent commissions resulting from slower growth and earned premium increases due to average premium changes.
Competitive Environment - We expect the competition within the auto segment to continue through the use of mass-market advertising, agent and broker compensation and promotional pricing. We will maintain our underwriting discipline and not compete for business that we do not believe will meet our long-term target margins. While adhering to our discipline, we will seek ways to grow profitably during this competitive cycle. We carefully monitor our rates and our compensation, and make changes to each when actuarially supported by our total business and justified by our economics. We also are committed to reducing our expenses, which will allow us flexibility to enhance our competitive position while still achieving our target margins.
Underwriting Segmentation - Our segmented auto product offers up to 15 underwriting tiers using multivariate models to assess the risk of loss based on many factors, providing a more accurate price for a wider range of risks. Going forward, we expect to refine our underwriting and pricing models to increase precision in matching rate for each risk and to enable us to quote a broader range of risks within the states where we do business. In 2007, we will introduce a liability component to our Optimum Package, providing further enhancements and choices.
Business Growth - As we seek to grow our business, we will continue to write the entire spectrum of Auto risks, from preferred through non-standard, though our strength in the near-term is preferred risks with its longer-tenured customers. We will continually strive to make our rates more competitive by driving cost and inefficiency out of the product. We also will focus on the changing nature of the independent distribution channel through new agency appointments and customized business approaches. We will continue to study the purchasing behaviors of insurance consumers to design products that reflect changing demographics.
Compensation - Based on our review of our competitive environment, we redesigned our agent compensation package for 2007 to include a bonus plan to reward our agents who have more than 350 personal auto PIF with us and provide those agents with additional options for their compensation arrangements.
Continued Catastrophe Management - We actively manage our exposure to catastrophe risk through a combination of risk avoidance, risk mitigation and risk transfer strategies. Our underwriting strategy for property insurance is to target customers whose risk of loss provides us with the opportunity for profitable growth. We do this by managing exposure on policies in catastrophe-prone areas. Because of our catastrophe management strategies, our catastrophe losses have been lower than our market share predicted. In 2005, we announced our withdrawal from the personal property business in Florida. Beginning in 2006, we no longer renewed policies of existing personal property policyholders in Florida as those policies came up for renewal. In 2006, we non-renewed more than 94% of our Property policies in Florida. At the end of 2006, we had approximately 1,700 personal property policies remaining in Florida, and by January 11, 2007 all policies were in non-renewal status.
Net written premiums increased $16.0, or 1.8%, in 2006 compared with 2005, and decreased $10.1, or 1.1%, in 2005 compared with 2004. This reflected:
Changes in PIF - The change in PIF increased net earned premiums by $4.9 in 2006 compared with 2005, and the decline in PIF decreased net earned premiums by $33.8 in 2005 compared with 2004.
Our underwriting profit in Property decreased $34.5, and our combined ratio increased 3.7 points in 2006 compared with 2005. Our underwriting profit decreased $11.0, and our combined ratio increased 1.0 point in 2005 compared with 2004. Our underwriting results and combined ratios were primarily driven by:
Loss costs - Our Property loss costs experienced a mid-single-digit percentage increase in 2006 compared with 2005, due primarily to increases in severity from the increased cost of building materials. These factors, net of reinsurance, increased our Property combined ratio by 1.7 points in 2006 compared with 2005. Our homeowners loss costs were relatively flat in 2005 compared with 2004. Loss costs for other property lines were down, resulting in a net decrease in loss costs for the Property segment in 2005. This change decreased our combined ratio by 0.6 points in 2005 compared with 2004.
Prior-year reserve development - Our underwriting results in 2006 included favorable prior-year reserve development of $15.7 due to lower-than-expected severity. Our underwriting results in 2005 included favorable prior-year reserve development of $11.0, including unfavorable prior-year reserve development of $10.5 in our estimates of the 2004 hurricanes in Florida and surrounding states. The favorable prior-year reserve development in 2005 reflected better-than-expected experience in our estimates of loss costs, primarily for accident years 2003 and 2004. Our underwriting results in 2004 included favorable prior-year reserve development of $47.5, primarily driven by changes in contract terms resulting in lower-than-expected frequency. The change in reserve development in 2006 decreased the combined ratio by 0.5 points compared with 2005. The change in reserve development in 2005 increased the combined ratio by 4.0 points compared with 2004.
Catastrophe losses - We categorize catastrophes as events resulting in losses greater than $0.5 per state and
Our Specialty operation provides individuals with umbrella, motorcycle, recreational vehicle, and boat owners insurance.
Net written premiums increased $9.3, or 9.2%, in 2006 compared with 2005, and $7.9, or 8.5%, in 2005 compared with 2004. New-business policies sold increased 18.8% in 2006 compared with 2005, and decreased 2.7% in 2005 compared with 2004. The increased premiums in 2006 were due to an increase in new motorcycle policies and in the numbers of motorcycle policies that renewed with us, resulting in an increase in PIF. The increased premiums in 2005 were driven by an increase in the number of policies that renewed with us, resulting in an increase in PIF, primarily in our motorcycle, umbrella and recreational vehicle policies.
Our underwriting profit increased $22.1, and our combined ratio decreased 20.5 points in 2006 compared with 2005. Our underwriting profit decreased $5.0, and our combined ratio increased 6.2 points in 2005 compared with 2004. Our underwriting results and combined ratio were primarily driven by:
Prior-year reserve development - Our underwriting results in 2006 included favorable prior-year reserve development of $12.5, primarily related to reduced estimates of catastrophe losses from Hurricane Wilma as well as better-than-expected frequency for 2005 umbrella claims compared with favorable prior-year development of
Catastrophe losses - Pretax after reinsurance catastrophe losses were $(3.2) in 2006 compared with $9.3 in 2005 and $7.6 in 2004. The negative catastrophe loss amount in 2006 was due to reduced estimates of catastrophe losses from Hurricane Wilma. The 2005 catastrophe losses were primarily due to Hurricanes Katrina, Rita and Wilma in the Gulf States and in 2004 resulted from four hurricanes in Florida and surrounding states. Excluding prior-year development on catastrophes, lower catastrophe losses decreased our combined ratio by 9.6 points in 2006 compared with 2005. Higher catastrophe losses increased the combined ratio by 0.9 points in 2005 compared with 2004.
Expenses - Our expense ratio increased 1.6 points in 2006 compared with 2005, primarily reflecting our increased near-term investment in technology and costs related to the implementation of our strategic goals as well as higher commission expense due to change in mix of business. Our 2005 expense ratio increased 3.3 points compared with 2004 as a result of increased investment in technology.
Expense Management - We have launched a business process improvement effort that is examining all aspects of our operations for potential cost savings. The goal is to achieve greater efficiency by streamlining or eliminating processes, outsourcing processes where appropriate, and building our infrastructure and technological capability.
Segmented Insurance Products - Our automated underwriting platform uses multivariate models to assess the risk of loss based on many factors and provides a more accurate price for a wider range of risks. This allows us to offer policies to a wider range of small businesses. We believe this capability is a key competitive advantage. It allows us to better segment our business with higher risks charged higher rates and lower risk charged with lower rates. We validate the underwriting factors we use by reviewing them every month for unusual patterns in quotes, close rates and other factors by state, Zip code and agency. In commercial auto, we consider additional variables in rating risks that are not independently considered.
Net written premiums were flat in 2006 compared with 2005, and increased $4.5, or 0.4%, in 2005 compared with 2004. The changes in net written premiums were driven by:
Price changes - We file rate changes on a state-by-state basis. Our average prices, which include filed rate changes and exposure growth, were down 1.2% in 2006, after decreasing slightly in 2005 and increasing 3.0% in 2004. Premiums are affected by growth in the exposures we cover due to factors such as changes in payroll, the number of employees, sales receipts and property building values for the businesses we insure. Price changes are reflected on existing policies at renewal.
Price changes - Our price changes increased our combined ratio by 1.2 points in 2006 compared with 2005, and decreased our combined ratio by 0.5 points in 2005 compared with 2004.
Catastrophe losses - Our pretax after reinsurance catastrophe losses were $21.9 in 2006, $59.1 in 2005 and $113.9 in 2004. The lower catastrophe losses decreased our combined ratio by 2.4 points in 2006 compared with 2005, and by 4.4 points in 2005 compared with 2004.
Business Growth - Given the increasing number of small businesses in the United States and the lack of a dominant market leader, we continue to see growth potential in this segment. Our goal is to be the leading small-business insurance writer in the independent agency channel. We will continue to appropriately match rate with risk through segmentation and disciplined underwriting. We will charge prices that will allow us to achieve our target profit margins, and we will decline to write business when pricing or risk factors do not allow us to earn our target returns. We will expand our appetite for business by expanding limits and removing others.
Compensation Structure - Based on our review of the competitive environment, we redesigned our agent compensation package for 2007 to include a minor increase to our commercial lines commission structure.
Net earned premiums decreased $19.0, or 6.7%, in 2006 compared with 2005, and $7.9, or 2.7%, in 2005 compared with 2004.
Prior-year reserve development - Our underwriting results in 2006 included favorable prior-year reserve development of $38.2, compared with favorable prior-year reserve development of $42.4 in 2005, and $0.4 in 2004 and for all three years the reserves were primarily related to general liability coverages. The difference in prior-year reserve development increased our combined ratio by 0.5 points in 2006 compared with 2005 and decreased our combined ratio by 14.9 points in 2005 compared with 2004.
Our pretax after reinsurance catastrophe losses were $0.1 in 2006, $17.5 in 2005 and $28.0 in 2004. The lower catastrophe losses decreased our combined ratio by 3.2 points in 2006 compared with 2005 and by 3.4 points in 2005 compared with 2004.
We’ve achieved growth and underwriting profitability in our Surety business through:
Net written premiums increased $47.9, or 17.2%, in 2006 compared with 2005 and $47.0, or 20.3%, in 2005 compared with 2004. The increases in net written premiums over the past two years were driven by increased large contract new business. The favorable market conditions for construction and economic expansion fueled the growth in large contract business in 2006 and 2005.
Large-commercial business accounts in runoff and specialty programs that we have exited, including asbestos and environmental results
Safeco Financial Institution Solutions (SFIS), our lender-placed property insurance business, which we sold on April 30, 2006
Net written premiums decreased $83.4, or 53.4%, in 2006 compared with 2005 and $13.9, or 8.2%, in 2005 compared with 2004. Net earned premiums decreased $83.7, or 53.2%, in 2006 compared with 2005 and $13.6, or 8.0%, in 2005 compared with 2004. The decrease in 2006 compared with 2005 was primarily due to the sale of SFIS. Net written premiums related to this business were $71.9 in 2006 through the sale date of April 30, 2006, compared with $148.6 in 2005 and net earned premiums were $72.3 in 2006 and $148.7 in 2005. The decrease in 2005 compared with 2004 was primarily due to the non-renewal of a large account in SFIS.
due to Hurricanes Katrina, Rita and Wilma in the Gulf states.
Our underwriting results also included $50.3 of unfavorable prior-year reserve development in 2006, primarily related to asbestos claims and sexual misconduct allegations for religious institutions. In 2005, $48.2 of unfavorable prior-year reserve development was primarily driven by reserve increases in assumed reinsurance and asbestos and environmental, partially offset by favorable construction defects reserve development. In 2004, $51.6 of unfavorable prior-year reserve development was primarily driven by asbestos and environmental reserves.
We collect money from reinsurers for losses we have that are covered by reinsurance. We had $429.9 of reinsurance recoverables at December 31, 2006, net of an allowance of $12.9 that we estimated as uncollectible. We had $447.0 of reinsurance recoverables at December 31, 2005, net of an allowance of $12.5 that we estimated as uncollectible.
27.6% of our reinsurance recoverables were due from state and mandatory reinsurance pools
86.8% of the remaining amounts due from our reinsurers outside the mandatory pools were due from reinsurers rated A- or higher by A.M. Best
Property Catastrophe Reinsurance - Our property catastrophe reinsurance reduces the financial impact a catastrophe could have on our personal and commercial property insurance lines. Catastrophes involve multiple claims and policyholders. We cannot accurately predict catastrophes, and the number and type of catastrophes can vary widely. The resulting losses could significantly exceed our prior experience.
Our reinsurers reimburse us 90% for the next $300.0 of the loss. We absorb the other 10%.
For events other than earthquake, the entire amount above $500.0 is ours.
The first $150.0 of any property catastrophe loss was our retention.
For events other than earthquake, the entire amount above $500.0 was ours.
The terms of our workers compensation reinsurance in 2006 and 2007 are:
The first $5.0 of any workers compensation loss is our retention.
Our reinsurer reimburses us for the next $15.0 of the loss for each commercial property risk.
The first $4.0 of any commercial umbrella loss on each policy is our retention.
Our reinsurers reimbursed us 90% of the next $80.0 of the loss under each of the three layers of coverage.
The Terrorism Risk Insurance Extension Act of 2005 (TRIEA) extends the requirement of insurance companies to offer terrorism coverage to certain commercial policyholders, including workers compensation policyholders. Under the extension, TRIEA now excludes automobile, burglary and theft, surety, professional liability and farm owners’ multi-peril insurance. Although TRIEA excludes professional liability insurance from the commercial policies required to offer terrorism coverage, it explicitly retains directors’ and officers’ liability insurance.
Terrorism Exclusions - Prior to the enactment of TRIEA, our policies excluded losses due to foreign terrorism in states that had approved the exclusions. For TRIEA-covered policies, we do not exclude losses due to foreign terrorism unless the policyholder rejects our mandatory offer of terrorism coverage. The Insurance Services Office (ISO) created coverage and pricing tools to help insurers respond to the TRIEA requirements.
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 TRIEA, and we have adopted those filings. However, some states limit the use of terrorism exclusions.
Our corporate segment results for the year ended December 31, 2006 include a non-recourse, non-refundable marketable equity securities contribution of $30.0 to the Safeco Insurance Foundation (the Foundation), a separate 501(c)(3) endowment fund. Since the Foundation’s inception, we have provided at no charge certain resources to the Foundation such as accounting, legal and investment management services and office space. See Note 16 to our Notes to Consolidated Financial Statements.
In 2006, we repurchased $54.3 in principal amount of 8.072% Debentures for $58.8 and $2.7 in principal amount of 6.875% senior notes for $2.7. Including transaction costs, we reported a pretax loss on debt repurchases of $4.5 ($2.9 after tax) in the Consolidated Statements of Income. In 2005, we repurchased $25.9 in principal amount of 7.25% senior notes for $29.8. Including transaction costs, we reported a pretax loss on debt repurchase of $4.0 ($2.6 after tax) in the Consolidated Statements of Income. In 2004, we repurchased $473.4 in principal amount of 8.072% Debentures for $562.7, and we repurchased $145.0 in principal amount of 7.25% senior notes for $170.9. Including transaction costs, we reported a pretax loss on debt repurchases of $121.0 ($78.7 after tax) in the Consolidated Statements of Income.
Investment returns are an important part of our overall profitability. Investment returns are subject to various risks such as interest rate, market and credit risks. 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.
The increase in net investment income in 2006 compared with 2005 was due to higher interest rates on new purchases of fixed income investments. The increase in net investment income in 2005 compared with 2004 was due to an increase in average invested assets, as a result of positive operating cash flows partially offset by lower yields on new investments, compared with yields on matured or called investments.
Net gains on marketable equity securities transactions decreased $11.6 in 2006 compared with 2005, and $81.9 in 2005 compared with 2004.
In 2006, the fair value of fixed maturities that we sold at a loss was $815.8. Our total net realized investment loss on these sales was $11.5. In 2005, the fair value of fixed maturities that we sold at a loss was $809.4. Our total net realized investment loss on these sales was $13.0. In 2006, the fair value of marketable equity securities that we sold at a loss was $100.2. Our total net realized investment loss on these sales was $9.2. In 2005, the fair value of marketable equity securities that we sold at a loss was $42.9. Our total net realized investment loss on these sales was $7.3. Our net realized investment losses on transactions in 2006 were primarily related to additional impairments of securities initially impaired in prior periods, securities that became impaired during the year ended December 31, 2006, and sales of securities that had substantially recovered in value. The securities sold at a loss during 2006 and 2005 were due to sales of fixed maturities to fund our accelerated share repurchase program and the sale of lower-yielding taxable bonds to purchase tax-exempt securities to grow our municipal bond portfolio.
In our impairment determination process, we consider our intent and ability to hold to maturity investments with declines in value. However, our intent to hold the investment could change due to changes in the financial condition and near-term prospects of the issuer or significant changes in our cash needs as a result of a major catastrophe.
These tables summarize our investment portfolio at December 31, 2006 and 2005:
Investments in secured finance mortgage-backed securities accounted for 17.6% of our total gross unrealized losses at December 31, 2006 and 11.4% of our total gross unrealized losses at December 31, 2005. Investments in the banking industry accounted for 12.4% of our total gross unrealized losses at December 31, 2005.
We reviewed all our investments with unrealized losses at the end of 2006. For all investments other than those for which we recognized an impairment charge, our evaluation determined that all their declines in fair value were temporary, and we had the intent and ability to hold these securities until they had recovered in value.
Unrealized losses on our fixed maturities that have been in a loss position for more than a year at December 31, 2006 were $32.3, compared with $44.5 at December 31, 2005, reflecting changes in interest rates. There were no unrealized losses on our marketable equity securities that were in a loss position for more than a year at December 31, 2006. Unrealized losses on our marketable equity securities that were in a loss position for more than a year at December 31, 2005 were $1.2. These unrealized losses were less than 1% of our total portfolio value at both December 31, 2006 and 2005.
We continue to monitor these securities as part of our overall portfolio evaluation. If we determine an unrealized loss to be other-than-temporary, we report an impairment loss in the period that we make the determination.
Our investment portfolio is well diversified by issuer and industry type with no single issuer, except the U.S. Government fixed maturities, exceeding 1% of the fair value of our consolidated investment portfolio.
These tables show our investment types and industries of our fixed maturities and marketable equity securities that exceed 3% of our portfolio at year-end 2006 or 2005:
As of December 31, 2006, our below investment grade securities included gross unrealized investment gains of $4.1 and gross unrealized losses of $0.2. As of December 31, 2005, our below investment grade securities included gross unrealized investment gains of $4.5 and gross unrealized losses of $0.9.
Here are the quality ratings of our mortgage-backed securities portfolio at year-end 2006:
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. Although 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 invest most of our money in high-quality liquid securities - investments that can quickly be turned into cash - to support our projected or potential need for liquidity.
We believe that cash flows from our operations, investment portfolio and bank credit facility are sufficient to meet our future liquidity needs. For more information about our financial abilities, see the Financial Strength Ratings section on page 78.
The decrease in cash provided by operating activities each year was primarily the result of the cash received from insurance premiums of $5.64 billion in 2006, $5.82 billion in 2005 and $5.58 billion in 2004, offset by the insurance claims paid of $3.44 billion in 2006, $3.55 billion in 2005 and $3.37 billion in 2004. Dividends and interest received on our investment portfolio were $554.0 in 2006, $532.8 in 2005 and $512.5 in 2004.
The increase in cash provided by investing activities in 2006 compared with 2005 was a result of increased sales of fixed maturities, marketable equity securities, and related to our securities lending program, as well as our real estate sales. The decrease in cash used in investing activities in 2005 compared with 2004 was a result of the sale of our discontinued operations in 2004.
Capital resources protect our policyholders, provide us with financial strength and facilitate continued business growth. Our capital structure consists of debt and equity and was as follows:
Share Repurchases - On November 2, 2006, our board of directors increased the number of shares available for purchase under our share repurchase program to 15 million shares. We repurchase shares under Rule 10b5-1 trading plans, open market purchases and accelerated share repurchase programs. A 10b5-1 trading plan allows us to repurchase our shares during periods when we would normally not be active in the market because of our own internal trading windows. Through accelerated share repurchase programs, we return excess capital to shareholders and immediately reduce the number of our common shares outstanding. The dealer obtains the shares that we repurchase by borrowing them on the open market and then purchases shares in the market over time to repay the borrowed shares.
Factors That Determine Financial Strength Ratings - In determining financial strength ratings, the rating agencies focus on:
Dividend Payments From Our Subsidiaries - Our insurance subsidiaries pay dividends to Safeco Corporation. We then use that money to pay dividends to our shareholders as well as to make principal and interest payments on our debt. Individual states limit the amount of dividends that our subsidiaries domiciled in those states can pay Safeco Corporation. Exceeding such limits would require prior regulatory approval. In total in 2007, our insurance subsidiaries can pay up to $884.8 in dividends without obtaining prior regulatory approval. These amounts are according to the limits states had in place at the end of 2006.
At December 31, 2006, we had $568.1 of gross deferred income tax assets. Gross deferred income tax assets are composed of temporary differences created as a result of amounts deductible for taxes in future periods. Such temporary differences relate primarily to unrealized gains on investments and differences in the recognition of loss and loss adjustment expense reserves, deferred policy acquisition costs, goodwill and unearned premiums. 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
To calculate pension cost for the year ended December 31, 2006, we used a discount rate assumption of 5.50%, an expected long-term rate of return on plan assets assumption of 8.00% and a compensation increase of 5.00% compounded annually. We determined the expected long-term rate of return on plan assets assumption by considering the mix of investments within the plan, the expected future investment performance of those asset sectors, actual investment experience during the lifetime of our plan and other relevant factors. A decrease of 100 basis points in the discount rate would result in an increase of $1.4 in pension cost in 2006. A decrease of 100 basis points in the expected long-term rate of return on plan assets assumption would result in an increase of $1.6 in pension cost in 2006.