Our current headquarters is in the University District of Seattle, Washington, where we occupy 510,000 square feet of leased space, which does not include 249,000 square feet of garage and surface parking space.
In 2006, we sold our office complexes in both Redmond, Washington and the University District of Seattle, Washington. We will re-establish our corporate headquarters in 486,000 square feet of leased space in downtown Seattle, Washington in 2007. We also completed the sale of our offices in Portland, Oregon; Pleasant Hill, California and Spokane, Washington.
We own a 66,000 square feet data center in Redmond, Washington and in Westminster, Colorado we own, within 30,000 square feet, our second data center. We also occupy 2.8 million square feet of leased space throughout the United States, of which we sublease 106,000 square feet to third parties.
(2) Our 2004 average diluted shares reflect the repurchase of 13.2 million shares pursuant to an accelerated share repurchase program.
(3) Our 2005 average diluted shares reflect the repurchase of 2.8 million shares pursuant to an accelerated share repurchase program and 1.7 million shares pursuant to a Rule 10b5-1 trading plan.
Marketing our products in ways that mirror the diversity of consumers and their buying preferences - We remain committed to selling our products primarily through independent agents, but we also recognize that to grow in this competitive environment, we need to market our products in ways that mirror the diversity of consumers and their buying preferences. We continue to explore opportunities to supplement our current distribution network and reach consumers who are not buying insurance through the independent agency channel. Our online sales increased in 2006, and we began rolling out our new Optimum Package with features that allow our customers to boost the value of their insurance, be rewarded for good driving and receive extra protection for emergencies and theft.
Making progress to become a low-cost carrier and enhancing our competitive position - As a part of our work to become a low-cost carrier, we launched a business process improvement (BPI) effort and implemented an organizational design initiative to examine 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, reducing levels of management and generally reducing the employee complement as warranted. We met our target savings of $75.0 in our expense run-rate in 2006. These savings will be used to increase new and renewal commissions to independent agents to improve our competitive position and to make investments in technology. Associated with these expense reduction steps and our real estate consolidation actions, we incurred $23.6 in pretax restructuring and asset impairment charges in 2006. We are targeting additional expense savings of $50.0 to $75.0 in 2007.
We recognized in 2006 that the growth trends in our business were unfavorable, and we made a commitment to reverse the slide in our policies-in-force. We re-engaged our independent agency force by meeting with agents across the country, listening to their feedback, which provided us with a foundation to improve our relationship with our agents. We developed action plans based on this feedback, including agent compensation structure changes, product enhancements and service improvements.
Managing our capital effectively - During 2006, we repurchased 20.7 million shares, or 16.7% of our then outstanding common stock, at a total cost of $1,165.2, primarily under stock buyback programs. We also repurchased $57.0 in principal amount of our debt for $61.5 including transaction costs. During 2005, we repurchased 4.5 million shares, or 3.6%, of our then outstanding common stock at a total cost of $255.9, primarily under stock buyback programs. We also repurchased $25.9 in principal amount of our debt for $29.8, including transaction costs. In 2004, we used the majority of the $1,499.0 proceeds from the sale of Life & Investments (L&I) to return our debt-to-capital ratios to pre-sale levels and return excess capital to our shareholders. Specifically, we used $735.2, including transaction costs, to repurchase $618.4 of debt, and we used $625.0 to execute an accelerated stock buyback program of 13.2 million shares. We retained the balance of the sale proceeds for future flexibility and to pay transaction-related expenses.
Our vision is to be the indispensable choice for customers and agents through excellence in the solutions we provide, the ease-of-doing business with us and the competitiveness of our products. We aim to achieve industry-leading profitable growth, build a sustainable competitive advantage, and create long-term shareholder value. We measure our success by tracking our operating and financial performance according to the following indicators:
Due to the sale of our L&I businesses in 2004, all results related to L&I are included in Discontinued Operations in our Consolidated Financial Statements.
More information about our segment results can be found in Our P&C Operating Results on page 49.
We measure our investment results in two parts: the after-tax net investment income we earn on our invested assets; and the net realized investment gains or losses we recognize when we sell or impair investments. It is our intent to hold a diversified portfolio so we will achieve consistent investment performance.
Losses that have been reported to us that may ultimately be paid out differently than expected in our case-basis reserves
Losses that have been paid and closed, but may reopen and require future payment
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 changes in the loss reserve estimate for the current year, which we report in current period earnings.
Our estimate of IBNR reserves is the difference between our projection of ultimate losses and the payments we have made and case-basis reserves we have established for those losses. Our analyses are applied to historical claim activity and experience, 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 policies, and changes in our claims-handling practices. The standard actuarial methods we use include:
We reduce our reserves by the amounts we expect to recover from salvage and subrogation. We accrue salvage and subrogation recoveries on an individual case basis for large claims. We use actuarial techniques to estimate the amount for small claims. We may determine that certain loss or salvage/subrogation activity is beyond the scope of what was anticipated in the initial establishment of loss reserves. In that case, we would adjust IBNR reserves to directly reflect this activity.
Other Considerations - We do not discount any of our reserves to present value.
Loss and LAE Reserves By Segment - At year-end 2006 and 2005, our loss and ALAE reserves, excluding ULAE reserves, by reportable segment before reinsurance were:
Policy limits - Lines of business involving policies with high or unlimited policy limits are subject to greater variation.
Bodily injury (BI) coverage represents the largest portion (62.2%) of our loss and ALAE reserves held for Auto. Small variations from our assumptions can yield significant financial volatility given the magnitude of these reserve balances.
Our Property and Specialty lines are predominantly short-tailed business, and most claims are reported and settled within 12 months. We use standard actuarial techniques and judgment to estimate reserves for those lines. Charges to our reserve estimates for Property and Specialty generally result from frequency or severity differences from historical patterns or development on catastrophe-related losses, which can be difficult to estimate due to the associated widespread damage.
Safeco Business Insurance (SBI) and P&C Other - SBI primarily writes commercial multi-peril, property, workers compensation, commercial auto and general liability insurance for small- to mid-sized businesses. P&C Other is composed of large-commercial business and other businesses we have placed in runoff.
Long payout periods - Workers compensation claims can remain open 50 years or more, introducing variability in the ultimate length of the payout. The cumulative effect of inflation trends over time, particularly medical cost inflation, can be significant.
Increases in life expectancy - Increases in life expectancy increase both the duration of future payments and the ultimate cost of treatment.
fault. Most of our claims are concentrated in a small number of states, particularly California.
Our IBNR reserves were 77.9% of our loss and ALAE reserves for construction defects claims at December 31, 2006 and 78.8% of our loss and ALAE reserves for construction defects claims at December 31, 2005.
Long periods between the actual construction work and the date the claim is reported
Asbestos - This table shows our loss and ALAE reserves for asbestos-related claims. The table excludes ULAE reserves, which were $15.1 at year-end 2006, $16.1 at year-end 2005 and $14.2 at year-end 2004:
Estimating loss reserves for asbestos claims requires more judgment than our other lines of business. That’s primarily because past claim experience may not be representative of future claims.
Changes in these factors could result in future asbestos claims payments that are significantly different from those currently predicted.
Environmental - This table shows our loss and ALAE reserves for our liability coverages related to environmental claims. The table excludes ULAE reserves, which were $13.8 at year-end 2006, $15.0 at year-end 2005 and $16.0 at year-end 2004:
Our environmental claims result from our assumed reinsurance operations that are in runoff status and from 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.
Our IBNR reserves were 64.4% of our loss and ALAE reserves for environmental claims at December 31, 2006 and 70.2% of our loss and ALAE reserves for environmental claims at December 31, 2005.
Our relatively limited environmental claims activity results in fluctuations in average values from period to period. The 2006 average paid closed environmental claim increased compared with 2005 due to a lag between our 2006 payments and ceded recoveries we expect to receive in 2007. The 2005 average paid closed environmental claim increased compared with 2004 due in part to a 2004 general liability settlement relating to contaminated land on a single private development project. Additionally, average payments were unusually low in 2004 due to the above-mentioned settlement reached on a large number of individual environmental claims related to coverage on general liability policies written for individual gasoline stations.
Our Surety loss and ALAE reserves, net of salvage and subrogation recoveries, were $47.5 at December 31, 2006 and $5.7 at December 31, 2005. 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.
$26.6 reduction in commercial umbrella reserves due to lower-than-expected number of claims
$12.2 increase in our assumed reinsurance runoff lines driven by large loss activity
$36.7 reduction in personal auto reserves, reflecting decreases in severity estimates for prior accident years in our liability lines
$26.3 reduction in construction defects reserves, reflecting claims frequency improvement in our runoff lines
In 2004, we reduced our estimates for prior years’ loss and LAE reserves by $39.0. This total decrease included:
$42.9 reduction in personal property reserves, reflecting lower claims frequency than our original estimates
Section A shows the unpaid loss and LAE reserves we recorded at December 31, 1996-2006. It breaks out these reserves as:
Gross of Reinsurance - Our total amount of loss and LAE reserves
Net of Reinsurance - The amount of our loss and LAE reserves after reinsurance
As shown in Section A, our loss and LAE reserves net of reinsurance at year-end 1996 were $1,955.7
Section C shows the annual reestimation of those reserves, and after 10 years our revised reserves were $1,975.7
After one year those reserves developed a $8.0 redundancy, and after 10 years these reserves developed a $20.0 deficiency. This is the difference between the reserves shown in Section A net of reinsurance, and the reestimated amounts in Section C.
Our Analysis of Losses and LAE Reserve Development table shows these trends:
Gross loss and LAE reserve development approximates the net loss and LAE reserve development disclosed above.
Determining reinsurance recoverables requires us to make estimates because we do not know the exact amount due from the reinsurer until all our underlying losses are settled. The amount of reinsurance recoverables varies depending on the size of individual losses and the aggregate amount of losses in particular lines of business.
Review reinsurance recoverable amounts for specific claims as well as for lines of business
Perform actuarial analyses of loss development above and below our retention levels - the amounts we absorb before the reinsurers reimburse us - specified under our reinsurance agreements
Our estimated allowance for uncollectible reinsurance was $12.9 at December 31, 2006 and $12.5 at December 31, 2005.
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 accumulated other comprehensive income on our Consolidated Balance Sheets and are not reflected in the operating results of any period until we sell the security or when declines in fair value are determined to be other-than-temporary. If the fair value of any of our investments falls below our cost or amortized cost basis in the investment, we analyze the decrease to determine whether it is an other-than-temporary decline in value. To make this determination for each security, we consider:
Any reduction or elimination of dividends or non-payment of scheduled interest payments
The following table presents summary consolidated financial information. A detailed discussion of our results by segment can be found beginning on page 49.
Net earned premiums - Our net earned premiums decreased 3.4% in 2006 compared with 2005, and increased 5.0% in 2005 compared with 2004. The decrease in net earned premiums in 2006 compared with 2005 reflects decreases in Auto and SBI partially offset by growth in Surety. Auto and SBI Regular premiums have decreased in the face of increased competitive pressures, as some of our competitors have increased advertising for auto insurance to attract customers, offered incentives to agents and lowered prices to attract new auto and commercial business. Despite increasing competitive pressures, we remain disciplined in our underwriting and continue to adhere to our long-term profitability targets. In addition, in 2006, net earned premiums decreased by $76.4 due to the second quarter sale of our lender-placed property insurance business. 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.
$29.2 on securities contributed to the Safeco Insurance Foundation. The decrease in 2005 compared with 2004 was due primarily to higher gains realized in 2004 related to the reduction of our equity holdings. Net realized investment gains included pretax impairments of $79.2 in 2006, $15.5 in 2005 and $9.0 in 2004.
Losses and Loss Adjustment Expenses - Losses and loss adjustment expenses decreased 9.8% in 2006 compared with 2005, and increased 4.0% in 2005 compared with 2004. In 2006, we reduced our estimates for prior years’ loss and LAE reserves by $146.2, reflecting favorable prior-year reserve development in our personal auto and SBI segments, compared with $45.9 of favorable prior-year reserve development in 2005 and $39.0 in 2004. The favorable prior-year reserve development in 2005 and 2004 was driven primarily by favorable reserve development in our personal property, personal auto and commercial auto reserves.
Interest expense - Interest expense was $91.4 in 2006, $88.6 in 2005 and $108.2 in 2004. The increase in 2006, compared with 2005 was due to increased interest rates on the portion of our debt that is swapped to floating rates partially offset by a decrease in interest expense as a result of our debt repurchases described below. The decrease in 2005 compared with 2004 was due to our debt repurchases.
Contribution to Safeco Insurance Foundation (the Foundation) - In 2006, we funded the Foundation with a non-recourse, non-refundable contribution of appreciated equity securities with a fair value of $30.0 and a book value of $0.8.
Net realized investment gains - After-tax net realized investment gains were $11.7 in 2006, $43.5 in 2005 and $126.4 in 2004. Results for 2006 included a tax-exempt gain of $29.2 on securities contributed to the Foundation.
+ Includes Amortization of Deferred Policy Acquisition Costs and Other Underwriting and Operating Expenses.
Our expenses for professional services increased in 2006 as we launched our business process improvement effort of our operations for potential cost savings.
The GAAP results are further described using our segment measures, which provide a helpful picture of how our company is doing. However, using them to measure profitability - while fairly common in our industry - is not consistent with GAAP.
* Not meaningful because this is a runoff business with declining premium.
Our Auto segment provides coverage for liability of our policyholders to others for both bodily injury and property damage, for injuries sustained by our policyholders and for physical damage to our customers’ vehicles from collision and other hazards.
Underwriting and Pricing Discipline - In 2006, we experienced continued competition within the auto segment as many insurers achieved strong underwriting results. Competitors increased marketing and advertising for new auto insurance customers. We also have seen rate decreases by competitors in some states, loosening of underwriting standards and use of unsupported new business discounting. We will maintain our underwriting discipline and not compete for business that we cannot obtain at our long-term target margins.
Ease-of-Doing Business - We are committed to enhancing the ease-of-doing business for our agents through further development of our Safeco Now automated underwriting platform, which lowers our agents’ costs and provides an easy-to-use, Web-based sales-and-service platform. We streamlined our enrollment and renewal processes further in 2006 by accessing information on prior insurance carriers and accessing motor vehicle reports automatically. We also enhanced our Safeco Now platform to streamline the service process by building functionality so auto policy changes and endorsements can be processed online. These endorsements include vehicle additions and deletions, vehicle replacements or updates, coverage and deductible charges. We increased our points of distribution by appointing approximately 1,200 new agents in 2006.
Net written premiums decreased $142.3, or 5.0%, in 2006 compared with 2005 and increased $114.4, or 4.2%, in 2005 compared with 2004. The changes in net written premiums were primarily driven by:
Policies-in-force (PIF) - PIF decreased 4.1% in 2006 compared with 2005 and increased 0.6% in 2005 compared with 2004. This reflected retention of policies of 79.5% in 2006, 79.5% in 2005 and 80.4% in 2004. Competitive pressures resulted in decreased new business in 2006 and 2005. New policies sold decreased 23.0% in 2006 compared with 2005, and 19.8% in 2005 compared with 2004.
Changes in average premiums - We file rate changes on a state-by-state basis. Rate changes are reflected on existing policies at renewal and are earned in our revenues over the six-month policy term. Overall, we received approval for average rate increases of 1.2% in 2006, decreases of 0.4% in 2005 and increases of 1.3% in 2004. Premium trend was negative in 2006, resulting from a change in our mix of business to lower average premium policies. This is primarily due to a reduced premium base of non-standard policies or drivers who represent relatively higher risks. Premiums also are affected by the increased pricing for those policies that insure newer and more expensive cars, as well as by changes in the risk profile of the book of business, which we refer to as premium trend.
Changes in average premiums - Changes in average premiums decreased net earned premiums by $41.1 in 2006 compared with 2005, and increased net earned premiums by $87.8 in 2005 compared with 2004.
Prior-year reserve development - Our underwriting results in 2006 included favorable prior-year reserve development of $98.2, reflecting lower-than-expected severity on bodily injury claims, primarily in accident years 2004 and 2005. Our underwriting results in 2005 included favorable prior-year reserve development of $34.7, reflecting a decrease in severity estimates for prior accident years across liability lines compared with our original estimates. Our underwriting results in 2004 included $12.7 of favorable prior-year reserve development. The favorable development in 2006 decreased our combined ratio by 2.4 points compared with 2005 and decreased our combined ratio by 0.8 points in 2005 compared with 2004.
Catastrophe losses - We categorize catastrophes as events resulting in losses greater than $0.5 per state and involving multiple claims and policyholders. We cannot accurately predict when catastrophes may occur, and the number and type of catastrophes can vary widely. The losses they cause may significantly exceed our prior experience. Pretax after reinsurance catastrophe losses were $30.8 in 2006 compared with $24.3 in 2005 and $18.9 in 2004. The higher catastrophe losses in 2006 increased the combined ratio by 0.3 points compared with 2005, and by 0.1 points in 2005 compared with 2004.
Overall - In 2007, we target to meet or beat our Auto long-term target combined ratio of 96% and generally maintaining our relative position in the market.
The Property segment provides homeowners, dwelling fire, earthquake and inland marine coverage for individuals. Our Property coverages protect homes, condominiums and rental property contents against losses from a wide variety of hazards.
Segmented Property Insurance Products - Our segmented homeowners product generally offers 9 to 13 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 are introducing new coverage choices through our Optimum Package that will enable our customers to better customize their coverage to their specific needs.
Ease-of-Doing Business - Our commitment to providing our agents improved ease-of-doing business continues through our Safeco Now automated underwriting platform, which lowers our agents’ costs and provides an easy-to-use, Web-based sales-and-service platform. Our homeowners products are available on Safeco Now where we write personal property business. Our dwelling fire products are available on Safeco Now in 40 of the 43 states where we write personal property business. We increased our points of distribution by appointing approximately 1,200 new agents in 2006.
Compensation Structure -We made compensation changes that included an incentive that gave agents an extra two points of commission for every homeowners policy written in the fourth quarter of 2006. In addition, on October 1, 2006, monoline homeowners commission was increased from 10% to 15% for new and renewal business.
Changes in PIF - PIF grew 1.9%, in 2006 compared with 2005, and new Property policies written increased 19.9% in 2006 compared with 2005. Our policy counts in 2006 benefited from the transfer of approximately 13,000 homeowners policies of a competitor that was placed under regulatory supervision. The number of policies that did not renew with us in 2005 and 2004 exceeded the number of new policies written in each year, resulting in a decrease in PIF of 0.5% in 2005 compared with 2004. During 2005, we launched our homeowners and dwelling fire products on our Safeco Now platform. This contributed to an increase in new Property policies written of 40.9% in 2005 compared with 2004. Our new business increased in 40 states in 2005, offset by a decline in new business in catastrophe-prone states. Our homeowners retention rates were 84.1% in 2006 compared with 85.2% in 2005 and 83.7% in 2004.
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 twelve-month policy term. Overall we received approval for average rate decreases in our homeowners business of 2.9% in 2006, 1.0% in 2005 and increases of 1.3% in 2004. Premiums also are affected by automatic increases in the amount of insurance coverage to adjust for inflation in building costs and by shifts in the mix of our business, which we refer to as premium trend.
Changes in average premiums - Changes in average premiums decreased net earned premiums by $9.2 in 2006 compared with 2005, primarily due to rate decreases in 2006, and increased net earned premiums by $25.1 in 2005 compared with 2004.
Changes in average premiums - Our homeowners rate changes, combined with premium trend, increased our Property combined ratio by 0.5 points in 2006 compared with 2005, and decreased our combined ratio by 2.1 points in 2005 compared with 2004.
involving multiple claims and policyholders. Pretax after reinsurance catastrophe losses were $106.2 in 2006 compared with $103.9 in 2005 and $107.2 in 2004. Current accident year catastrophe losses in 2006 decreased the combined ratio by 1.6 points in 2006 compared with 2005. Included in the 2006 pretax catastrophe losses was $22.5 related to the Pacific Northwest windstorm in December 2006. Catastrophe losses in 2005 decreased the combined ratio by 1.5 points in 2005 compared with 2004. Catastrophe losses in 2005 included $53.7 from Hurricanes Katrina, Rita and Wilma along the Gulf Coast. Catastrophe losses in 2004 included $66.3 from the four hurricanes in Florida and surrounding states.
Expenses - Our expense ratio increased by 0.9 points in 2006 compared with 2005, reflecting increased near-term investment in technology and costs related to the implementation of our process improvement efforts. Higher agent bonus commission expenses, driven by increased dwelling fire new business and better-than-anticipated underwriting results, increased our expense ratio by 0.2 points in 2005 compared with 2004.
Underwriting Segmentation - Our segmented personal property products offer up to 12 underwriting tiers, which we further refine 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. Going forward, we expect to continually 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. We have replaced our existing dwelling fire product with our new tiered product in 35 states as of December 31, 2006 and plan to substantially complete the rollout of the new program by the end of 2007.
Compensation Structure - Based on our review of the competitive environment, we redesigned our agent compensation package effective October 1, 2006 to include an increase on new monoline homeowners commission from 10% to 15%. This redesign also increases the renewal commission in monoline homeowners from 10% to 15%, applied to policies written between February 2002 and September 2006. Starting January 1, 2007, commission on new dwelling fire business decreased from 20% to 15%.
Overall - In 2007, we expect our Property segment revenue to grow modestly in non-catastrophe prone areas, while operating at a combined ratio that is slightly better than our long-term target of 92%.
Ease-of-Doing Business - Our commitment to providing ease-of-doing business for our agents continues through our Safeco Now automated underwriting platform, which lowers our agents’ costs and provides an easy-to-use, Web-based sales-and-service platform. We have automated the underwriting of our umbrella and motorcycle products through our Optimum Package that will enable our customer to choose their coverage to their specific needs. We recently completed the launch of our motorcycle product on Safeco Now. As a result, we wrote 18,600 new motorcycle policies in 2006, compared with 8,900 new motorcycle policies in 2005.
Catastrophe Management - We continue to actively manage our exposure to catastrophe risk through a combination of risk avoidance, risk mitigation and risk transfer strategies. Our underwriting strategy for Specialty insurance is to target customers whose risk of loss provides us with the opportunity for profitable growth. We have managed our catastrophe exposure by non-renewal of large boat policies. Due to our catastrophe management strategies, our catastrophe losses have been lower than our market share predicted.
Net earned premiums increased $7.3, or 7.4%, in 2006 compared with 2005 and $7.9, or 8.8%, in 2005 compared with 2004.
Loss costs - Lower umbrella losses decreased our combined ratio by 3.7 points in 2006 compared with 2005. Umbrella loss costs can be volatile from period to period. Higher umbrella losses, as a result of increased frequency, increased our combined ratio by 6.3 points in 2005 compared with 2004.
We anticipated the following factors will impact our growth and profitability in the near future:
Overall - We expect our Specialty product to grow modestly in non-catastrophe prone areas, particularly where we write boat owners policies, while operating at or better than our long-term target combined ratio of 92%.
Our SBI Regular segment provides insurance for small- to mid-sized businesses (customers who pay annual premiums of $200,000 or less). This is our core commercial lines business featuring these main products:
Ease-of-Doing Business - The introduction of CMP on Safeco Now and increased distribution points all contributed to new business growth in 2006. Safeco Now allows our agents to quote and issue new small-commercial business online in minutes. We have experienced growth in BOP, commercial auto and workers compensation, all of which are on Safeco Now. PIF for our automated products available on Safeco Now (BOP, commercial auto, CMP and workers compensation) increased 5.2% in 2006 compared with 2005, with most of our automated lines experiencing growth, while PIF for our non-automated products decreased 4.6% in 2006 compared with 2005. We increased our distribution points by appointing approximately 600 new commercial lines agents in 2006.
Our commitment to ease-of-doing business continued during 2006, as we further expanded our BOP product by adding more than 200 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 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 CMP product by introducing quote and issue capabilities on Safeco Now for our package policies up to $20,000 in annual premium. We also offered an incentive that gave agents an extra two points of commission for most commercial lines new business policies written in the fourth quarter of 2006.
Catastrophe Risk Management - Our underwriting strategy 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. Historically, when writing business in catastrophe-prone areas we have followed strict guidelines that include variables such as building age and condition, coastal proximity and standards for policy deductibles.
Changes in PIF - PIF increased 0.4% in 2006 compared with 2005, and decreased 0.6% in 2005 compared with 2004. This reflected retention rates of 79.0% in 2006, 80.0% in 2005 and 79.9% in 2004. Our new policies sold increased 16.7% in 2006 compared with 2005 and 7.3% in 2005 compared with 2004.
Mix of business - In addition to price changes, premiums are impacted by changes in average policy size and mix of policy lines.
Net earned premiums decreased $26.8, or 2.1%, in 2006 compared with 2005, and increased $47.5, or 3.9%, in 2005 compared with 2004. The changes in net earned premiums were driven by:
Price changes - Price changes decreased net earned premiums by $22.5 in 2006 compared with 2005, and increased net earned premiums by $8.6 in 2005 compared with 2004.
Mix of business - Mix of business increased net earned premiums by $0.7 in 2006 compared with 2005 and $40.9 in 2005 compared with 2004.
Loss costs - Loss costs decreased slightly over the past year, reflecting a mid-single-digit percentage decrease in claims frequency, offset by a low-single-digit percentage increase in claims severity. As a result, this decreased the combined ratio by 0.2 points in 2006 compared with 2005. Loss costs increased slightly in 2005 compared with 2004 due to increased claims severity as a result of higher labor and material costs, which were partly offset by a decrease in claims frequency. This increased the 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 $26.6 due to lower-than-expected claims frequency in CMP partially offset by an increase in auto liability claims severity. Our underwriting results in 2005 included favorable prior-year reserve development of $37.2, primarily related to decreases in auto and CMP business due to lower-than-anticipated claims frequency. These decreases were partially 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 favorable prior-year reserve development of $25.4, primarily related to favorable reserve development associated with Ohio commercial auto business and World Trade Center losses. The difference in prior-year reserve development increased the combined ratio by 0.8 points in 2006 compared with 2005, and decreased the combined ratio by 0.8 points in 2005 compared with 2004.
Expenses -The increase in our expense ratio of 0.8 points in 2006 compared with 2005 was the result of higher agent bonus commissions and employee performance bonus expenses related to our improved underwriting results. The expense ratio was relatively flat in 2005 compared with 2004.
Competition - We continue to see intense competition around both our small- and mid-sized businesses. Mid-market competition is characteristically more significant than what we are seeing in our small-business lines. We remain committed to disciplined pricing and underwriting based on loss-cost trends, and we intend to meet our profit margin targets. We will continue to compete in these conditions through enhancements to our Safeco Now sales-and-service platform, continued focus on agent relationships and our retention efforts through distinctive customer service.
Overall - In 2007, despite competitive conditions in the marketplace, we expect our SBI Regular segment revenue to grow while operating at our long-term target combined ratio of 95%.
Our SBI Special Accounts Facility segment includes 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 commercial products. Agents who have placed large-commercial accounts with us produced approximately 50% of our new business in SBI Regular in 2006.
Net written premiums decreased $7.6, or 2.8%, in 2006 compared with 2005, and $20.0, or 6.8%, in 2005 compared with 2004. Net written premiums decreased in 2006 compared with 2005 due to a slight decrease in average premiums, rate decreases and a slight decrease in policies-in-force. The decrease in 2005 compared with 2004 was primarily due to the reduction in written premiums in our non-profit social services programs as a result of an increasingly competitive market.
Our underwriting profit decreased $10.0, and our combined ratio increased 1.8 points in 2006 compared with 2005. Our underwriting profit increased $50.2, and our combined ratio decreased 18.0 points in 2005 compared with 2004. Our underwriting results and combined ratio primarily reflected:
Expenses - Our expense ratio increased in 2006 compared with 2005 by 4.8 points primarily due to an increase in bonus commissions related to our social services program. Our expense ratio was relatively flat in 2005 compared with 2004.
We plan to continue providing a limited large-commercial resource for those agents and brokers who are also writing auto, property or small- to mid-sized commercial insurance with us, and to continue writing specialty insurance programs to the extent market conditions provide reasonable margins.
Net earned premiums increased $36.6, or 14.0%, in 2006 compared with 2005 and $57.9, or 28.5%, in 2005 compared with 2004. New business increased net earned premiums by $32.2 in 2006 compared with 2005 and $45.4 in 2005 compared with 2004.
Our underwriting profit increased $43.4, and our combined ratio decreased 12.0 points in 2006 compared with 2005. Our underwriting profit increased $12.6, and our combined ratio decreased 0.2 points in 2005 compared with 2004. The results in both years reflected our disciplined underwriting, favorable loss experience and decreased commission expense.
Continued Disciplined Underwriting - Our disciplined underwriting approach has contributed to a favorable loss ratio. This underwriting approach focuses on stable contract and large commercial accounts. We have also benefited from new business and increased capacity utilization of our larger accounts. This is a result of increased construction project sizes due to increased material prices, particularly in our contract business. We intend to maintain our disciplined underwriting approach as a priority while we grow this business.
Overall - We expect the surety market to continue to be more competitive as industry results were stable in 2006. As a result, we anticipate our growth rates will moderate in 2007. We expect our loss experience in 2007 to be at more historical levels, versus the unusually low loss experience in 2006. Therefore, we expect our combined ratio to increase in 2007 compared with 2006.
Our underwriting results increased $49.5 in 2006 compared with 2005, and decreased $33.7 in 2005 compared with 2004. Our underwriting results include the results of SFIS through April 30, 2006. SFIS underwriting profit was $10.8 in 2006 compared with an underwriting loss of $46.1 in 2005 and an underwriting loss of $2.2 in 2004. Catastrophe losses for SFIS were $(0.4) in 2006, compared with $53.3 in 2005 and $20.2 in 2004. The higher catastrophe losses in 2005 were primarily
To help reduce the financial impact of losses in our business, our primary purchases of reinsurance cover:
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 2007 are:
For earthquake events, we have an additional level of coverage. Our reinsurers reimburse us for 90% of $500.0 in excess of the first $500.0 of the loss. The entire amount of any earthquake loss above $1,000.0 is ours.
Our reinsurers reimbursed us 90% for the next $350.0 of the loss. We absorbed the other 10%.
Workers Compensation Reinsurance - Our workers compensation reinsurance reduces the financial impact a single-event or catastrophe loss may have on our results. It is excess-of-loss reinsurance.
Our reinsurer reimburses us for the next $15.0 of the loss.
We can reinstate once with payment of an additional premium for reinsurance covering losses above $50.0.
The terms of our commercial property reinsurance in 2006 and 2007 are:
The first $5.0 of any loss for each commercial property risk is our retention.
Risks above $20.0 are reinsured individually for each risk (facultative reinsurance).
The first $4.0 of any commercial umbrella loss on each policy was our retention.
Our reinsurer reimbursed us for the next $16.0 for each commercial umbrella loss on each policy.
U.S. Government Funding - Under TRIEA, the U.S. Government will provide funding to the insurance industry if a terrorist attack is certified as such by the Secretary of the Treasury in concurrence with the Secretary of State and Attorney General of the United States. The criteria for certification include: the act is dangerous to human life, property or infrastructure; and is committed by an individual or individuals on behalf of any foreign person or foreign interest. The extension adds a program trigger. Under this new provision, insurers will not be compensated unless the aggregate industry insured losses from a certified act of terrorism, occurring in 2007, exceed $100.0. Subject to the program trigger, the U.S. Government’s share is 85% of the certified losses in excess of individual insurance company deductibles in Program Year 5 (2007). TRIEA determines the deductibles for insurance companies as a percentage of their direct earned premiums. Our estimated deductible for 2007 is $246.2.
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 $300.0 above the first $200.0 of loss.
With commercial insurance, our focus is on small- to mid-sized businesses - generally not viewed as likely potential terrorism targets.
Similarly, with workers compensation policies, the number of employees covered is a key consideration. We decline to provide coverage in cases where we believe the exposure to terrorism is potentially greater.
The increase in 2006 compared with 2005 was due to increased interest rates on the portion of our debt that is swapped to
floating rates partially offset by a decrease in interest expense as a result of our debt repurchases described previously. The decrease in 2005 compared with 2004 was due to our debt repurchases.
Our after-tax yields increased in 2006 compared with 2005 due to our increased investment in tax-exempt municipal bonds. Our after-tax yields decreased in 2005 compared with 2004 at a lesser rate than our pretax yield due to our increased investment in tax-exempt municipal bonds. In addition, we shifted our asset allocation mix to reduce the amount of marketable equity securities we hold.
Net gains on fixed maturities transactions increased $12.3 in 2006 compared with 2005, and decreased $37.2 in 2005 compared with 2004.
We closely monitor every investment that has declined in fair value to below our cost or amortized cost. If we determine that the decline is other-than-temporary, we write down the security to its fair value and report the charge as an impairment in Net Realized Investment Gains in the Consolidated Statements of Income in the period that we make this determination. More information about our process of estimating investment impairments can be found in the discussion of Application of Critical Accounting Estimates on page 28.
Recent changes in management resulted in a shift in our portfolio strategy to tax-exempt municipal bonds and a change to our real estate strategy. These changes resulted in a review of our investment portfolio and as a result, we changed our intent to hold certain securities long enough for them to recover to full value. In 2006, $74.9 of our investment impairments related to securities that we may not hold until they recover to full value.
As of December 31, 2006, our fixed maturities, carried at $9,119.0, included:
As of December 31, 2005, our fixed maturities, carried at $9,361.9, included:
As of December 31, 2006, these securities represented 0.9% of our total fixed maturities at fair value. As of December 31, 2005, these securities represented 1.1% of our total fixed maturities at fair value. The related amortized cost of the below investment grade fixed maturities was $79.1 at year-end 2006 and $99.5 at year-end 2005.
Our mortgage-backed securities consist mainly of commercial mortgage-backed securities (CMBSs), residential collateralized mortgage obligations (CMOs) and pass-throughs.
This table summarizes our holdings of mortgage-backed securities at year-end 2006:
The amount of dividends that our subsidiaries can pay us is subject to regulatory limits imposed by certain states where our subsidiaries are domiciled. Dividends in excess of those limits require prior regulatory approval. Based on state limits in place at the end of 2006, our insurance subsidiaries can pay us up to $884.8 in aggregate dividends without obtaining prior regulatory approval. We do not expect these regulatory restrictions to have any impact on our ability to meet our obligations.
The changes in cash from financing activities were a result of share and debt repurchases described below.
In 2006, we used $1.23 billion to repurchase stock and debt as described on page 77.
Repurchases of Debt - 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 loss on debt repurchases of $4.5 pretax ($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 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 summarize our share repurchase activity for 2004, 2005 and 2006 below:
On November 2, 2006, we declared a regular dividend of $0.30 per share on our common stock. The dividend was payable January 22, 2007 to shareholders on record on January 5, 2007.
Our Bank Credit Facility - On March 31, 2005, we executed a $300.0 five-year revolving credit facility, which may be used for working capital and general corporate purposes. The terms of the bank credit facility - which runs through March 2010 - require us to:
The bank credit facility does not require us to maintain any deposits as compensating balances. At the end of 2006 and throughout 2006, we had no borrowings under the bank credit facility and we were in compliance with all its covenants.
(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 significantly from our estimates.
On September 25, 2006, Fitch affirmed our ratings and revised its outlook to positive from stable. On May 18, 2006, A.M. Best affirmed our debt ratings and the financial strength ratings of our insurance subsidiaries, keeping its view of our ratings on positive outlook. On May 31, 2006, Standard & Poor’s affirmed our debt ratings and the financial strength ratings of our insurance subsidiaries, keeping its view of our ratings on positive outlook. In June 2005, Moody’s affirmed our ratings and revised its outlook to positive from stable.
We believe our financial position is sound. Our debt service coverage has improved over the last two years, and we expect to continue at our current level in 2007.
The Florida legislature, in a special session in January 2007, enacted wide-ranging legislation in an attempt to mandate lower prices for property insurance in the state. The actual impact of the new law on our business is still unknown, as there are unresolved regulatory and legal issues. For example, the following are issues still subject to regulatory action: determination of the mandatory rating factor intended to reflect a lower reinsurance cost related to expansion of the state-run Florida Hurricane Catastrophe Fund and the requirement that companies writing private passenger auto in Florida also write homeowners insurance there if they write it elsewhere in the United States. We write commercial insurance policies and personal auto policies in Florida. In 2005, we sought permission to discontinue our personal property business in the state, and we are complying with the regulator’s order dictating the terms of that run-off.
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. On January 1, 2007, we adopted Financial Accounting Standards Board (FASB) Interpretation Number (FIN) 48 with an immaterial impact to our Consolidated Financial Statements.
Our pension obligations (assets) resulting from the defined benefit (pension) plan we sponsor covering substantially all employees are recorded on our Consolidated Balance Sheets. More information can be found in Note 9 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, 2006, we used a discount rate assumption of 5.50% 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.
A discussion of new accounting standards can be found in Note 1 to our Consolidated Financial Statements.
The Consolidated Financial Statements and schedules listed in the Index to Financial Statements, Schedules and Exhibits on page are filed as part of this report.