Our home office is in Seattle, Washington, where we occupy 760,000 square feet of owned property and 130,000 square feet of leased space.
We also own 1.6 million square feet in Redmond, Washington. On January 13, 2006, we entered into an agreement to sell our Redmond office campus, subject to contingencies. The sale does not include the 66,000 square-foot parcel containing our data center. We expect the sale to close in the latter part of 2006 when all contingencies are resolved. Following the close of the sale, we expect to enter into a lease for 550,000 square feet of office space and 70,000 square feet of warehouse space for a period of up to three years.
This selected consolidated financial data comes from our Consolidated Financial Statements. It should be read in conjunction with the Consolidated Financial Statements and accompanying notes:
(5) Combined ratios are calculated on a GAAP basis. Expressed as a percentage, combined ratios equal losses and expenses divided by net earned premiums.
(Dollar amounts in millions except for ratios and per-share data, unless noted otherwise)
We have made statements under the captions “Our Business,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere in this Form 10-K that are forward-looking statements.
We are a property and casualty (P&C) insurance company with headquarters in Seattle, Washington. We sell insurance to drivers, home owners and owners of small- and mid-sized businesses through a national network of independent agents and brokers. 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.
Our financial results have been affected by the major strategic actions we have taken to reshape our business and become a more focused and successful competitor.
We focus on the personal and commercial insurance products purchased by the vast majority of U.S. consumers. We call these “standardized” products because they don’t require significant customization, and they’re well suited to automated underwriting and sales-and-service support. Our claims operation, with its front-line experience and insight, is tightly aligned with our product development and underwriting teams. We continually refine our segmented pricing models and accurately match rate to risk.
We deliver the majority of our products to our agents and brokers over our Safeco Now automated Web-based sales-and-service platform, which gives our distributors a single point of entry to sell our major P&C products in a matter of minutes. Most of our pricing, underwriting and servicing processes are presented through this user-friendly tool. We sell our insurance products principally through independent agents and brokers who provide customers with choice and advice. We motivate our distributors by giving them more to sell (multiple lines of personal and commercial insurance), making it easier for them to sell (through technology and other ease-of-business tools), helping them make more money selling our products (through increased operational efficiencies) and providing competitive compensation programs.
Meeting the needs of our customers at a fair price - We offer competitively priced products using sophisticated multivariate underwriting models, which enable us to appropriately match price to risk. We look at many variables to help predict future loss. For example, in our homeowners product, we may consider the number of stories of a home, the number of mortgages, the credit score or how long the policyholder has been a homeowner, as well as other variables. Each of these factors, in combination with others, applies to pricing points, allowing for multiple pricing tiers and segmentation. We analyze each of the characteristics in relation to one another - multivariate segmentation - which we believe allows us to match rate with risk at a finer level.
We focus on providing outstanding service by measuring ourselves against a “zero-defect” standard in our service transactions. We also have a team of more than 3,000 claims professionals across the country who deliver our most visible product - the quality service and support we provide when customers experience a loss and file a claim. Our cost reductions in recent years and ongoing expense discipline help us provide competitively priced products.
Along with the sale of our L&I businesses, all results related to L&I are included in Discontinued Operations in our Consolidated Financial Statements.
We look at three measures to assess the results of our business segments:
More information about our investment results can be found in the Our Investment Results section on page 73.
We have identified the accounting estimates listed below as critical to understanding our results of operations and financial condition. The application of these accounting estimates requires us to use judgments involving assumptions and estimates about future results, trends or other developments that could significantly influence our results if actual experience differs from those assumptions and estimates. We review these judgments frequently. An understanding of them may help readers to better understand our Consolidated Financial Statements and Management’s Discussion and Analysis (MD&A).
Our loss and loss adjustment expense (LAE) reserves reflect our estimates of the ultimate amounts for losses from claims and related settlement expenses 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 estimate case-basis reserves as the amount we will have to pay for losses that have already been reported to us but are not yet fully paid. These amounts include related legal expenses and other costs associated with resolving and settling a particular claim.
We establish IBNR reserves at the end of every reporting period to estimate the amount we will have to pay for:
Process and Methodology for Establishing Loss and LAE Reserves - The process for establishing loss and LAE reserves differs for case-basis versus IBNR reserves.
Expected loss ratios and IBNR-to-earned premiums percentages are developed based on our analysis of prior accident years supplemented with data about changes in our book of business, changes in the external environment in which we operate, changes in our pricing and underwriting, and changes in our claims-handling practices. We review these ratios throughout the year, and we revise the expected loss ratio and IBNR percentage periodically based on these analyses. Changes in the selection of the expected loss ratio or IBNR percentage result in a change in the loss reserve estimate for the current year, which we report in current period earnings.
For short-tailed lines of business, the beginning IBNR reserves for prior accident years is adjusted for expected emerged losses to calculate IBNR reserves, absent an explicit determination to adjust IBNR reserves beyond this activity. For long-tailed lines of business, the beginning IBNR reserves for prior accident years is adjusted for paid and case-basis reserve activity in the current period. This yields ending IBNR reserves, absent an explicit determination to adjust IBNR reserves beyond this activity.
We use many of the above methods to estimate reserves for each product line. The merits of each method are evaluated given the facts at hand. An estimate of the ultimate losses is then made based on the particular method or combination of methods deemed most appropriate. For example, if a particular line has been subject to significant changes in claims-handling practices that would impact the comparability of case-basis reserves between periods, we would give little or no credibility to the incurred loss development approach.
There is uncertainty in our estimates of ultimate losses. This uncertainty can stem from such factors as irregular claim reporting and payment patterns and changes in our mix of business. We consider this uncertainty by looking at historical claim patterns by line of business and by examining our historic reserve accuracy. For each line, we consider expected volatility when estimating and recording reserves.
The various assumptions, estimates and other factors that may have an impact on our ultimate losses are discussed with management to determine our best estimate of ultimate losses and LAE, and our estimate of IBNR reserves is then recorded.
We use range analyses only as a retrospective view to test whether previously established estimates for reserves for our lines of business are reasonable, using subsequent information.
Our estimate of our ultimate loss and LAE reserves is subject to change as additional data emerge. This could occur as a result of:
Estimating our loss and LAE reserves is an ongoing process. Our loss and LAE reserves represent our best estimate of the ultimate future payments associated with losses and related expenses, giving consideration to the uncertainties inherent in the estimates. We record any adjustments to these reserves in the periods in which we change the estimates. We report changes to these reserves in our Consolidated Statements of Income.
Loss and LAE Reserves By Segment - At year-end 2005 and 2004, our loss and ALAE reserves, excluding ULAE reserves, by reportable segment before reinsurance were:
Safeco Personal Insurance (SPI) - SPI loss and LAE reserves are estimated using standard actuarial methods and judgment. These methods involve analyzing past claims experience for recent changes in business claims practices and the internal and external environments. Emphasis is placed on evaluating claims reporting and closing patterns, as well as the size of loss payments and case-basis reserves. SPI losses and related expenses are analyzed by line of business, product, coverage and geographic area.
Our changing mix of business - As our business grows, we write more policies in markets where we have not written significant business previously. We continue to write a higher proportion of standard and non-standard risks than we have historically. These risks have, on average, higher frequencies and lower severities than preferred risks.
Our increase in new business - New business generally has higher claim frequencies than business that has been on the books for longer than one year
To illustrate the sensitivity of our estimate, a one-point increase in our severity assumption for Auto BI would yield an increase of approximately $33 in the estimated reserve.
Unlimited liability nature of workers compensation policies - Many claims can payout for the lifetime of the claimant with no limit on the total payment amount.
Increases in life expectancy - Increases in life expectancy increase both the length of future payments and the cost of treatment.
Changes in our business - Changes in our claims-handling practices, changes in our writings of large versus small- to mid-sized accounts, and changes in the mix of states where these policies are written can affect our ability to predict ultimate payout based on historical data.
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 $70 in our estimated reserves.
Other Commercial Products - Excluding commercial liability products, which are discussed below, the payout periods for our other commercial products, primarily commercial auto and commercial property, are relatively short. As a result, our estimated loss reserves for these products are subject to less volatility than our workers compensation reserves. We use standard actuarial techniques combined with judgment to estimate these loss reserves.
Commercial Liability Products - Our commercial multi-peril policies, business owners policies, general liability and commercial umbrella policies provide third-party liability coverage to our policyholders.
Claim reporting lags - Some claims are not made immediately; as a result, we remain exposed to losses arising from policies written years ago.
Asbestos - This table shows our loss and ALAE reserves for asbestos-related claims. The table excludes ULAE reserves, which were $16.1 at year-end 2005, $14.2 at year-end 2004 and $4.0 at year-end 2003:
In this table, the three-year survival ratio represents the number of years our current loss reserves would last if future payments are made at the same average annual rate experienced over the last three years. The three-year survival ratio is equal to our loss reserves, divided by our average annual payment over the last three years.
55.6% relates to our runoff assumed reinsurance operations and our exposure to syndicates and pools.
Our exposure through our runoff assumed reinsurance operations is primarily excess-of-loss reinsurance. Pools are groups of insurers that enter into agreements to share exposure related to specific insureds. Our loss reserve estimates for pools reflect the loss reserve estimates provided by the pools’ independent actuaries. The loss experience of our runoff assumed reinsurance operations follows the general industry trend.
Our IBNR reserves were 24.4% of our loss and ALAE reserves for asbestos claims at December 31, 2005 and 25.4% at December 31, 2004.
We categorize our policyholders with active asbestos claims in two groups according to their exposure:
Large asbestos accounts - Our policyholders with cumulative loss payments exceeding $100,000 as of December 31, 2005.
These tables provide details about our policyholders and losses paid related to asbestos loss reserves:
Environmental - This table shows our loss and ALAE reserves for our liability coverages related to environmental claims. The table excludes ULAE reserves, which were $15.0 at year-end 2005, $16.0 at year-end 2004 and $9.8 at year-end 2003:
Our environmental claims result from our runoff assumed reinsurance operations and our commercial general liability line that we write on a direct basis. We generally have avoided writing coverages for large companies with substantial exposures to environmental claims. As a result, our average environmental claim tends to be small.
Construction Defects - This table shows our loss and ALAE reserves for construction defects claims. The table excludes ULAE reserves, which were $28.5 at year-end 2005, $19.9 at year-end 2004 and $8.2 at year-end 2003:
Surety - Our surety bonds insure construction performance, as well as legal matters that include appeals, probate cases and bankruptcies. By their nature, surety claims result in lower loss frequency and higher loss severity than most of our P&C products. In addition, surety claims provide us with substantial opportunity for salvage and subrogation, the nature and extent of which vary from case to case.
Our Surety loss and ALAE reserves, net of salvage and subrogation recoveries, were $5.7 at December 31, 2005 and $12.2 at December 31, 2004. Surety reserves fluctuate from period to period due to the lag between the time payments are made on a claim and the time we receive salvage and subrogation amounts.
2005 - In 2005, we reduced our estimates for prior years’ loss and LAE reserves by $45.9. This total decrease included:
$7.9 reduction in a number of lines due to emerging claim trends and related loss data, including ULAE
$32.6 reduction in commercial auto reserves, primarily due to a favorable ruling related to Ohio uninsured motorists coverage
$30.6 increase in a number of lines due to emerging claim trends and related loss data, including ULAE
2003 - In 2003, we increased our estimates for prior years’ loss and LAE reserves by $249.9. The total increase included:
$205.0 increase as a result of higher medical cost trends for workers compensation than previously expected
$44.9 increase in a number of lines due to emerging claim trends and related loss data
Of the $205.0 increase, $180.0 was related to loss and ALAE reserves. This increase included $130.0 in P&C Other, $48.0 in SBI Regular and $2.0 in SBI Special Accounts Facility. The largest amount of reserve development related to California, particularly in the large-commercial business we began exiting in 2001. We also increased ULAE reserves by $25.0. This increase included $14.9 in P&C Other, $9.6 in SBI Regular and $0.5 in SBI Special Accounts Facility. This increase reflected our estimate of the ongoing expense of servicing workers compensation claims. As claims remain open for longer periods, our costs to handle those claims rise.
As shown in Section A, our loss and LAE reserves net of reinsurance at year-end 1995 were $2,070.1.
As shown in Section A, our reserves net of reinsurance at year-end 1995 were $2,070.1.
The favorable trend from 1995 through 1996 was primarily due to:
Benefits from establishing specialized claims-handling units for construction defects, asbestos and environmental exposures, and fraud investigations
Our estimated allowance for uncollectible reinsurance was $12.5 at December 31, 2005 and $15.4 at December 31, 2004.
How We Determine Other-than-Temporary Declines in the Value of Our Investments - We regularly review the fair value of our investments. Invested assets are subject to various risks, such as interest rate, market and credit risks. Periodic changes in fair values of our investments are reported as a component of
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 $15.5 in 2005, $9.0 in 2004 and $47.8 in 2003.
The following table presents summary consolidated financial information. A detailed discussion of our results by segment can be found on page 54.
Net earned premiums - Our net earned premiums grew 5.0% in 2005 compared with 2004, and 12.8% in 2004 compared with 2003. These increases reflect growth in policies-in-force (PIF) as well as price increases primarily in our Auto segment. 2004 also included PIF growth and price increases in SBI Regular and Surety. In 2005, our growth slowed in the face of increased competitive pressures as some of our competitors increased advertising for auto insurance and lowered prices to attract new auto and commercial business.
Net investment income - 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 income increased 22.9% in 2005 compared with 2004, while net income in 2004 increased 65.8% compared with 2003, driven by:
Loss on debt repurchases - In 2005, we repurchased $25.9 in principal amount of debt. Including transaction costs, this resulted in a loss on debt repurchases of $4.0. In 2004, we used $735.2 of the proceeds from the sale of L&I to repurchase $618.4 in principal amount of debt and capital securities. Including transaction costs, this resulted in a loss on debt repurchases of $121.0.
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. Income from Discontinued Operations was $53.7 in 2003.
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.
We view net written premiums as a measure of business production for the period under review and a leading indicator of net earned premiums. The following table reconciles net written premiums to net earned premiums, the most directly comparable GAAP measure on our Consolidated Statements of Income:
We’ve achieved growth and underwriting profitability in our Auto business through our:
Net earned premiums increased $191.8, or 7.3%, in 2005 compared with 2004, and $387.1, or 17.3%, in 2004 compared with 2003. The increases in net earned premiums were primarily driven by:
Our underwriting results decreased $36.6, and our combined ratio increased 1.8 points in 2005 compared with 2004. Our underwriting results increased $128.5, and our combined ratio decreased 4.6 points in 2004 compared with 2003. Our underwriting results and combined ratio were primarily driven by:
Prior-year reserve development - Our underwriting results in 2005 included favorable prior-year reserve development of $34.7 and in 2004 included favorable prior-year reserve development of $12.7, reflecting decreases in severity estimates for prior accident years across liability lines compared with our original estimates. Results in 2003 included unfavorable reserve development of $6.5 related to prior accident years. The favorable development in 2005 decreased the combined ratio by 0.8 points compared with 2004. The favorable development in 2004 decreased the combined ratio by 0.9 points compared with 2003.
Catastrophe losses - We categorize catastrophes as events resulting in losses greater than $0.5 per event and involving multiple claims and policyholders. We cannot accurately predict when catastrophes may occur, and the number and type of catastrophes can vary widely. The losses they cause may significantly exceed our prior experience. Catastrophes can be caused by natural events, such as hurricanes, tornadoes, wildfires, earthquakes and hailstorms or other factors such as terrorism, riots, hazardous material releases or utility outages. Pretax after reinsurance catastrophe losses were $24.3 in 2005 compared with $18.9 in 2004 and $26.8 in 2003. The higher catastrophe losses increased the combined ratio by 0.1 points in 2005 compared with 2004. The lighter catastrophe losses in 2004 decreased the combined ratio by 0.3 points compared with 2003.
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 further refine our underwriting and pricing models. This continuous process will provide increasing precision in matching rate for each risk.
Ease-of-Doing Business - We believe that the combination of our ongoing product development through underwriting segmentation and continued improvements in our ease-of-doing business through Safeco Now will allow us to continue to build profitable growth in the face of increasing competition. We believe that having more verifiable data available at the point of sale, such as motor vehicle reports, police reports and credit reports will make our application process smoother. We anticipate the change in average premium will be in the low-single digits in 2006, with rate increases targeted to specific segments of our business.
Overall - In 2006, we anticipate our Auto revenue will continue to grow, while achieving our long-term target combined ratio of 96%.
Segmented Property Insurance Products - Our segmented homeowners product generally offers nine 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. This increased segmentation means we are better able to align rate with risk, producing greater pricing precision. It also means we can grow by offering coverage to more home owners. We sell our segmented products in 43 of the 44 states where we write homeowners insurance. In 2005, we began to launch our new segmented dwelling fire product, a landlord protection policy that insures residential rental property. This is currently rolled out in 14 states, and we plan to complete the rollout of the new program by year-end 2006.
Net written premiums decreased $10.1, or 1.1%, in 2005 compared with 2004, and $5.5, or 0.6%, in 2004 compared with 2003. This reflected:
Changes in average premiums - We file rate changes on a state-by-state basis. Rate changes are reflected on existing policies on renewal and are earned in our revenues over the 12 month policy term. Overall we received approval for average rate decreases in our homeowners business of 1.0% in 2005, and increases of 1.3% in 2004 and 8.3% in 2003. Premiums also are impacted by automatic increases in the amount of insurance coverage to adjust for inflation in building costs, which we refer to as premium trend. They also are impacted by shifts in the mix of our business.
Decline in PIF - The decline in PIF reduced net earned premiums by $33.8 in 2005 compared with 2004, and $72.4 in 2004 compared with 2003.
Changes in average premiums - Changes in average premiums increased net earned premiums by $25.1 in 2005 compared with 2004, and $72.8 in 2004 compared with 2003.
Our underwriting profit in Property decreased $11.0, and our combined ratio increased 1.0 points in 2005 compared with 2004. Our underwriting profit increased $100.3, and our combined ratio decreased 10.9 points in 2004 compared with 2003. Our underwriting results and combined ratios were primarily driven by:
Net earned premiums increased $7.9, or 8.8%, in 2005 compared with 2004, and $7.2, or 8.7%, in 2004 compared with 2003.
Our commitment to ease-of-doing business continued during 2005, as we further expanded our BOP product by adding more than 150 additional classes of business, increasing eligibility limits and expanding coverages in additional states. The expanded product is available in all states where we write commercial business. We also expanded our commercial auto automated underwriting model on the Safeco Now platform to include auto fleets of 15 vehicles, up from nine, and we enhanced our commercial multi-peril product by introducing quote and issue capabilities on Safeco Now for our package policies up to $20,000 in annual premium.
Net written premiums increased $4.5, or 0.4%, in 2005 compared with 2004, and $101.6, or 8.8%, in 2004 compared with 2003. The increase in net written premiums was 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 slightly in 2005, after increasing 3% in 2004 and 10% in 2003. 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.
Net earned premiums increased $47.5, or 3.9%, in 2005 compared with 2004, and $127.2, or 11.6%, in 2004 compared with 2003. The increases in net earned premiums were driven by:
Price changes - Price changes increased net earned premiums by $8.6 in 2005 compared with 2004, and $64.7 in 2004 compared with 2003.
Mix of business - Mix of business increased net earned premiums by $40.9 in 2005 compared with 2004 and $50.4 in 2004 compared with 2003.
Our underwriting profit in SBI Regular increased $70.7, and our combined ratio decreased 5.5 points in 2005 compared with 2004. Our underwriting profit increased $75.8, and our combined ratio decreased 6.4 points in 2004 compared with 2003. Our underwriting results and combined ratio primarily reflected:
Price changes - Our price changes decreased our combined ratio by 0.5 points in 2005 compared with 2004, and 9.2 points in 2004 compared with 2003.
Loss costs - Loss costs increased slightly over the past year, reflecting increased claims severity in the mid-single digits due in part to higher labor and material costs, which was nearly offset by decreased claims frequency. This increased the combined ratio by 0.6 points in 2005 compared with 2004. In 2004, loss costs increased the combined ratio by 0.2 points compared with 2003.
Prior-year reserve development - Our underwriting results in 2005 included favorable prior-year reserve development of $10.5, primarily related to decreases in auto and commercial multi-peril business due to lower-than-anticipated claim frequency. This was mostly offset by increases in workers compensation due to increased provisions for long-term medical claim inflation and associated claims adjustment expenses. Our underwriting results in 2004 included unfavorable prior-year reserve development of $1.6, primarily related to reserve strengthening for asbestos,
partly offset by favorable reserve development associated with Ohio commercial auto business and World Trade Center losses. Our underwriting results in 2003 included unfavorable prior-year reserve development of $41.8, primarily related to medical inflation in workers compensation reserves. The difference in prior-year reserve development decreased the combined ratio by 1.0 points in 2005 compared with 2004, and 3.7 points in 2004 compared with 2003.
Expenses - The expense ratio was relatively flat in 2005 compared with 2004. The decrease in our expense ratio of 3.3 points in 2004 compared with 2003 was the result of our expense improvement efforts. This was partially offset by higher employee performance bonus expenses related to our growth and improved underwriting results.
Competition - We are experiencing increased competition in both our small- and mid-sized business with more intensity in mid-market. Historically, this business is more price-competitive as industry profit margins expand. We remain committed to disciplined pricing and underwriting based on loss cost trends, and we intend to meet our profit margin targets. We will further compete in this segment through our field specialization model, continued focus on agent relationships and our retention efforts through distinctive customer service. We also will continue to emphasize ease-of-doing business through product and service expansion on Safeco Now.
Expense Management - We expect to further reduce our expense ratio as we make productivity enhancements by providing more capabilities on our Safeco Now platform, including self-serve policy-change transactions as well as other overall improvements in efficiency.
Overall - Despite competitive conditions in the marketplace, we expect our 2006 SBI Regular segment revenue to grow slightly. We expect to maintain our long-term target combined ratio of 95% or better in 2006.
Our SBI Special Accounts Facility (SAF) segment provides insurance for large-commercial accounts (customers who pay annual premiums of more than $200,000). While our main focus is the small- to mid-sized market, we continue to serve some large-commercial accounts on behalf of key agents and brokers who sell our core products. Agents who have placed large-commercial accounts with us produce almost 60% of our new business in SBI Regular.
Our underwriting results also were driven by higher loss experience in 2005 in our lender-placed property program and our mini-storage and warehouse properties program, primarily due to Hurricanes Katrina, Rita and Wilma. Pretax after reinsurance catastrophe losses were $70.8 in 2005, $28.0 in 2004 and $7.1 in 2003. The higher catastrophe losses increased the combined ratio by 9.9 points in 2005 compared with 2004, and 4.5 points in 2004 compared with 2003.
Net earned premiums increased $57.9, or 28.5%, in 2005 compared with 2004, and $49.4, or 32.2%, in 2004 compared with 2003. New business increased net earned premiums by $45.4 in 2005 compared with 2004, and $42.6 in 2004 compared with 2003.
Large-commercial business accounts in runoff and specialty programs that we have exited
$17.1 unfavorable prior-year reserve development in 2005, primarily driven by reserve increases in assumed reinsurance and asbestos and environmental, partially offset by favorable construction defects reserve development
$22.5 unfavorable prior-year reserve development in 2004, primarily in asbestos and environmental reserves
$183.4 unfavorable prior-year reserve development in 2003, including $144.9 of workers compensation reserve strengthening
We collect money from reinsurers for losses we have that are covered by reinsurance. We had $447.0 of reinsurance recoverables at December 31, 2005, net of an allowance of $12.5 that we estimated as uncollectible. We had $355.4 of reinsurance recoverables at December 31, 2004, net of an allowance of $15.4 that we estimated as uncollectible.
We analyze our reinsurance recoverables according to the credit ratings and types of reinsurers. At year-end 2005:
23.5% of our reinsurance recoverables were due from state and mandatory reinsurance pools
81.9% 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. Catastrophes include hurricanes, windstorms, earthquakes, hailstorms, explosions, severe winter weather, fires and acts of terrorism.
Our property catastrophe reinsurance is excess-of-loss reinsurance, which provides us with reinsurance coverage over an agreed-upon amount. The terms of our property catastrophe reinsurance in 2006 are:
The first $100.0 of any property catastrophe loss was our retention.
For earthquake events, we had an additional level of coverage. Our reinsurers would reimburse us for 90% of $260.0 in excess of $500.0. The entire amount of any earthquake loss above $760.0 would be ours.
The terms of our commercial property reinsurance in 2005 and 2006 are:
The terms of our commercial umbrella reinsurance in 2005 and 2006 are:
The Terrorism Risk Insurance Extension Act of 2005 (TRIA) extends the requirement of insurance companies to offer terrorism coverage to certain commercial policyholders, including workers compensation policyholders. Under the extension, TRIA now excludes automobile, burglary and theft, surety, professional liability and farm owners’ multi-peril insurance. Although TRIA 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 TRIA, our policies excluded losses due to foreign terrorism in states that had approved the exclusions. For TRIA-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 TRIA requirements.
Reinsurance Options - The availability of terrorism reinsurance is limited in the commercial reinsurance market. Our current reinsurance program provides limited terrorism coverage. All reinsurance treaties exclude certified terrorist acts and also non-certified terrorist acts involving nuclear, chemical, biological or radioactive materials. Treaties providing both certified and non-certified terrorist acts include our workers compensation reinsurance program and our commercial umbrella reinsurance program. Our property catastrophe treaty provides non-certified terrorism coverage for 90% of $350.0 above the first $150.0 of loss.
Our after-tax yields decreased in 2005 compared with 2004, however, at a lesser rate than our pretax yield due to our increased investment in tax-exempt municipal bonds. Our after-tax yields decreased in 2004 compared with 2003 due to our shift to shorter-term taxable bonds and the impact of declining interest rates. In addition, we shifted our asset allocation mix to reduce the amount of marketable equity securities we hold to a target of approximately 10% of the P&C investment portfolio.
Net gains on fixed maturities transactions decreased $37.2 in 2005 compared with 2004, and $22.4 in 2004 compared with 2003. The 2004 and 2003 gains resulted primarily from calls - issuers redeeming bonds in which we’ve invested before the final maturity date - as well as fixed maturity sales initiated to manage our call risk and improve the yield of the underlying portfolio. These calls are an expected part of our investment activity, particularly when interest rates are low. We experienced less call activity in 2005.
We sold investments for the reasons discussed above. Also, as discussed previously, we sold marketable equity securities in 2004 to reduce our holdings to our target of about 10% of the total investment portfolio.
We reviewed all our investments with unrealized losses at the end of 2005. 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.
Here are the quality ratings of our mortgage-backed securities portfolio at year-end 2005:
We use cash from insurance operations primarily to pay claims, underwriting expenses and claim adjustment expenses. We require insurance premiums to be paid in advance. As a result, cash flows into our business before or at the time premium revenues are recognized. Cash flows out of our business in subsequent months or years as claims are paid.
Repurchases of Debt - In 2005, we repurchased $25.9 in principal amount of 7.25% senior notes for $29.8. Including transaction costs, we reported a loss on debt repurchase of $4.0 pretax ($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 loss on debt repurchases of $121.0 pretax ($78.7 after tax) in the Consolidated Statements of Income.
We executed a Rule 10b5-1 trading plan to purchase up to an additional $100.0 of our outstanding common stock. This plan allowed us to repurchase our shares during periods when we would normally not be active in the market because of our own internal trading windows. Under this program, we repurchased a total of 1,756,278 shares at an average price of $53.13 per share for a total cost of $93.3.
In 2004, we repurchased 13,247,863 shares, or approximately 9.5% of our then outstanding common stock, under an accelerated stock buyback program. We purchased the shares from a dealer at a price of $46.80 per share, for a total cost of $625.0, including transaction costs. The effect of the repurchase program was to return excess capital resulting from the L&I sale to our shareholders, and it immediately reduced the number of our common shares outstanding. The dealer obtained the shares that we repurchased by borrowing them in the open market, and then purchased shares in the market over a nine-month period to repay the borrowed shares. The program included $200.0 that was subject to a collar, a contract that set a minimum and maximum price for us for the shares repurchased under the collar. We completed the
On December 1, 2005, our board of directors increased our share repurchase authorization to 10 million shares, including shares that remain available for repurchase under previously approved programs.
On February 6, 2006, we announced the execution of a Rule 10b5-1 trading plan to purchase up to $250.0 of our outstanding common stock. If the 10b5-1 program is fully executed, approximately 5 million shares will remain available for repurchase under board-approved repurchase programs.
(1) Loss and LAE reserves represent our best estimate of losses from claims and related settlement costs. Because of the nature of insurance policies, there is typically no minimum contractual commitment associated with covered claims. Both the amounts and timing of such payments are estimates, and the inherent variability of resolving claims as well as changes in market conditions make the timing of cash outflows uncertain. Therefore, the ultimate amount and timing of Loss and LAE payments could differ from our estimates.
In 2005, A.M. Best, Standard & Poor’s and Moody’s affirmed our ratings and revised their outlooks to positive from stable. Also in 2005, Fitch affirmed our ratings and maintained its stable outlook.
At December 31, 2005, we had $646.0 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 have not recorded a valuation allowance for these assets. More information on income taxes can be found in Note 7 to our Consolidated Financial Statements.
Our pension obligations resulted from the defined benefit (pension) plan we sponsor covering substantially all employees. More information can be found in Note 10 to our Consolidated Financial Statements.
Amounts recorded for our pension obligation and pension cost are affected by assumptions used to calculate them, including the discount rate and expected long-term rate of return on plan assets. To calculate our benefit obligation, as of December 31, 2005, we used a discount rate assumption of 5.5% based on consideration of the general interest rate environment, the calculation of an equivalent discount rate based on a hypothetical portfolio of high-quality fixed maturities with future cash flows that are similar to the timing and amount of our estimated future pension benefit payments and other relevant factors.
To calculate pension cost for the year ended December 31, 2005, we used a discount rate assumption of 5.5% and an expected long-term rate of return on plan assets assumption of 8.0%. 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 2005. A decrease of 100 basis points in the expected long-term rate of return on plan assets assumption would result in an increase of $1.4 in pension cost in 2005.