The Corporation owns and leases office space in various parts of the country. The principal office buildings consist of facilities owned in Fairfield and Hamilton, Ohio. These office buildings service all of the Corporation's segments. The Fairfield, Ohio office building is subject to a mortgage with an outstanding balance of $3.2 million as of December 31, 2004. For additional information related to the mortgage, refer to Footnote 16 in Item 15 on pages 69 and 70 of this Annual Report on Form 10-K.
(2) Statutory loss ratio measures net losses incurred as a percentage of net premiums earned based upon statutory accounting principals.
(3) Statutory loss adjustment expense ratio measures loss adjustment expenses as a percentage of net premiums earned based upon statutory accounting principals.
Ohio Casualty Corporation (the Corporation) is the holding company of The Ohio Casualty Insurance Company (the Company), which is one of six property-casualty companies that make up the Ohio Casualty Group (the Group). All dollar amounts in this Management Discussion and Analysis (MD&A) are in millions unless otherwise noted.
The Corporation earns revenue by providing businesses and consumers with competitive insurance products with high quality service and by income on funds invested. In 2004, the Corporation achieved meaningful improvement in financial performance. Net income increased in 2004 compared to 2003 as a result of a better priced book of business through realization of price increases in certain lines and an improved risk profile as a result of more disciplined underwriting. The statutory expense ratio continued to improve as a result of expense management initiatives. The statutory combined ratio was the best since 1980.
The 2004 All Lines statutory combined ratio improved to 98.4% compared to 106.1% in 2003 as a result of significantly improved loss experience, including lower loss adjustment expenses (LAE) because of our cost reduction programs, which are continuing into 2005. The improved loss experience is the result of disciplined underwriting and enhanced pricing methodologies the Corporation continues to develop and implement. In addition, the Corporation experienced favorable prior years reserve development for the first year since 1998. While full year 2004 premiums increased only slightly when compared to the prior year, the Group's risk profile has improved as the focus was on disciplined underwriting, improving pricing methodologies and driving operational efficiencies and expense reductions throughout the organization. The results of this focus and effort are discussed throughout the following sections.
In September 2003, the Corporation announced its Corporate Strategic Plan for the 2004-2006 time frame. The plan brings together five broad objectives to help achieve the Corporation's Vision to be a leading super regional Property and Casualty carrier providing a broad range of products/services through independent agents and brokers. The broad objectives include abilities to generate above market growth, produce competitive loss ratios, create a competitive expense structure, achieve a competitive return on equity and improve credit ratings and financial flexibility. Competitive advantages include strong agency relationships, especially with key agents, and technology platforms that provide operating flexibility. Technology is being leveraged to make it easier for agents to do business with the Group and to increase pricing and underwriting sophistication. The Corporation continues to execute against this plan and the Corporation's results in 2004 are an indication that the plan and its execution are working.
Management of the Corporation believes the significant volatility of realized investment gains and losses limits the usefulness of net income (loss) as a measure of current operating performance. Accordingly, management uses the non-GAAP financial measure of operating income (loss) to further evaluate current operating performance. Operating income (loss), both in dollar amount and per share amount, is reconciled to net income (loss) in the table below:
The improved financial results for 2004 were driven by significantly improved loss experience, including lower LAE, a result of cost reduction programs that have been implemented. The improved loss and LAE ratios are the result of disciplined underwriting and improved pricing methodologies, reduced claim frequency, a decline in large losses (losses greater than $250,000 per loss) and favorable prior years reserve development. Catastrophe losses decreased $0.3 in 2004 to $43.5. During 2004, underwriting and loss adjustment expenses were impacted by increased severance and other related costs, primarily associated with the Cost Structure Efficiency (CSE) initiative and expenses related to the Proformance transaction. As previously discussed, in 2001 OCNJ entered into a transaction which effectively exited the Group from the New Jersey private passenger auto market. Based upon data through December 31, 2003 as provided by Proformance in the first quarter of 2004, the Group estimated and accrued $9.0 (of which $6.8 was paid in July 2004) related to this obligation. During the second half of 2004, the Group accrued an additional $6.6. At December 31, 2004, the Group has $8.8 accrued in the consolidated financial statements for any possible additional liability that may be incurred based upon the final liability calculation using Proformance's 2004 results. This amount, which is management's best estimate of the liability, reflects the maximum additional amount that could be required to be paid to Proformance. The Group expects to resolve the final settlement to be paid to Proformance relative to the surplus guarantee in the first half of 2005. For additional information on this transaction, see Item 15, Notes to Consolidated Financial Statements, Footnote 8 on pages 64 and 65 of this Annual Report on Form 10-K.
and the effects of Hurricane Isabel. During 2002, the increase in provision for prior accident years' losses and LAE totaled $84.4 before tax and was concentrated in the general liability, commercial auto and personal auto product lines. The majority of the charge, $62.2 before tax, occurred in the third quarter and was primarily related to construction defect claims for residential developers and contractors. The Group continues to address this specific type of business for non-renewal. For further discussion, refer to the "Loss and Loss Adjustment Expenses" section under "Liquidity and Capital Resources" on pages 39-41 of this MD&A.
In the first quarter of 2003, management decided to transfer a portion of its fixed maturity securities from the available-for-sale classification into the held-to-maturity classification. This transfer was made as the Corporation and the Group have both the ability to hold the securities to maturity and the positive intent to do so. At December 31, 2004, the amortized cost of the held-to-maturity portfolio was $301.4.
Invested assets comprise a majority of the consolidated assets. Consequently, accounting policies related to investments are critical. See further discussion of important investment accounting policies in the "Critical Accounting Policies" section of this MD&A and in Item 15, Notes to Consolidated Financial Statements, Footnote 1C on page 54 of this Annual Report on Form 10-K. The Corporation and the Group continually evaluate all of their investments based on current economic conditions, credit loss experience and other developments. The difference between the cost and estimated fair value of investments is continually evaluated to determine whether a decline in value is temporary or other than temporary in nature. This determination involves a degree of uncertainty. If a decline in the fair value of a security is determined to be temporary, the decline is recorded as an unrealized loss, net of tax, in shareholders' equity. If there is a decline in a security's fair value that is considered to be other than temporary, the security is written down to the estimated fair value with a corresponding realized loss recognized in the consolidated statements of income.
the unrealized loss position is due to changes in the interest rate environment. Should management subsequently conclude the decline in fair value is other than temporary, the book value of the security is written down to fair value with the realized loss recognized in the consolidated statements of income.
Insurance industry financial measures are included in the next several sections of this MD&A that discuss results of operations. Statutory surplus, a financial measure that is required by insurance regulators and used to monitor financial strength, is discussed in the "Statutory Surplus" section of the "Liquidity and Capital Resources" section on page 37 of this MD&A.
New Jersey remains the Group's largest state, with 11.5% of the total net premiums written during 2004, even after the Group ceased writing in the New Jersey private passenger auto and personal umbrella markets in early 2002. The Group continues to underwrite other product lines in the New Jersey market.
(1) When used in this report, renewal price increase means the average increase in premium for policies renewed by the Group. The average increase in premiums for each renewed policy is calculated by comparing the total expiring premium for the policy with the total renewal premium for the same policy. Renewal price increases include, among other things, the effects of rate increases and changes in the underlying insured exposures of the policy. Only policies issued by the Group in the previous policy term with the same policy identification codes are included. Therefore, renewal price increases do not include changes in premiums for newly issued policies and business assumed through reinsurance agreements, including Great American business not yet issued in the Group's systems in 2002. Renewal price increases also do not reflect the cost of any reinsurance purchased on the policies issued.
Personal Lines gross premiums written remained relatively flat during 2004 and net premiums written increased $6.1. Both gross and net premiums written were reduced in 2004 due to a refund of escrowed premiums for North Carolina personal auto of $2.2. The personal auto including personal umbrella product line net premiums written decreased $2.7 to $294.1 in 2004 compared to $296.8 and $324.6 in 2003 and 2002, respectively. The decrease in Personal Lines gross and net premiums written from 2002 to 2003 is driven by the withdrawal from New Jersey private passenger auto, which began in 2002, and the Group's continued effort to narrow the geographic focus for Personal Lines products.
The following table provides key financial measures for All Lines for each of the last three years:
The All Lines combined ratio improved 7.7 points driven by a 7.5 point improvement in the loss and LAE ratios. The loss and LAE ratio was impacted by favorable prior year reserve development of $21.7 in 2004 compared to adverse reserve development of $34.1 in 2003, which reduced the 2004 loss and LAE ratio by 1.4 points and increased the 2003 loss and LAE ratio by 2.4 points. The remaining improvement of 3.7 points in the 2004 loss and LAE ratio over 2003 was due to improved price adequacy, more disciplined underwriting standards and improved claims efficiency. The underwriting expense ratio improved 0.2 points as a result of operational efficiencies implemented throughout 2003 and 2004, somewhat offset by $15.6, or 1.1 points of expense related to the Proformance surplus guarantee.
The All Lines combined ratio improved 6.7 points in 2003 compared to 2002 with an improved underwriting expense ratio as well as lower loss and LAE ratios each contributing to the improvement. The All Lines combined ratio was impacted by $34.1 of adverse prior year reserve development, a $50.3 reduction from 2002. The 2003 combined ratio benefited from a reduction in personnel and sales related expenses, somewhat offset by increased expenses for technology including amortization of internally developed software.
The loss and LAE ratio components of the accident year combined ratio measure losses and LAE arising from insured events that occurred in the respective accident year. The current accident year excludes losses and LAE for insured events that occurred in prior accident years.
The table below summarizes the impact of changes in provision for all prior accident year losses and LAE for each of the last three years:
In 2004, the impact of the favorable development for prior accident years' losses and LAE was concentrated in the Commercial and Specialty Lines operating segments. In 2004, the Specialty Lines segment experienced significant favorable development for prior years' losses and LAE, primarily due to a reduction in estimated future costs for claims adjuster related expenses. The total provision reduction for prior years' losses and LAE of $21.7 before-tax represents 1.0% of loss and LAE reserves as of year-end 2003.
The comparable amount of adverse development for prior years' losses and LAE recognized during 2002 was $84.4 before tax. This represents 4.3% of loss and LAE reserves as of year-end 2001. The adverse development was concentrated in the Commercial Lines operating segment.
The underwriting expense ratio, which measures underwriting expenses as a percentage of net premiums written, decreased by 0.2 points in 2004. The 2004 underwriting expense ratio was favorably impacted by a reduction in employee related costs, a non-recurring reduction in assessments, fees and premium taxes and by other operating efficiencies. These improvements were partially offset by 1.1 points of expense related to the Proformance surplus guarantee, previously discussed. The employee count continued to decline in 2004 with an approximate 18.0% reduction from 2003 as a result of the CSE initiative. The employee count was 2,190, 2,669 and 3,004 as of December 31, 2004, 2003 and 2002, respectively.
The 2004, 2003 and 2002 statutory underwriting expenses also included $6.3, $5.2 and $2.6 of software amortization expense before tax, respectively, related to the rollout of P.A.R.I.S.(sm). On a statutory accounting basis, the new application is being amortized over a five-year period (compared to ten-year period under GAAP) in accordance with statutory accounting principles. The additional amortization expense is expected to be offset in part by reduced labor costs related to underwriting and policy processing.
In 2001, the Group introduced into operation, after more than three years of development, the Policy Administration Rating and Issuance System (P.A.R.I.S.(sm)) for Commercial Lines. At the end of 2004, P.A.R.I.S.(sm) was deployed for the Specialty Lines commercial umbrella excess capacity product line. Further implementation for other Specialty and Personal Lines products is expected during 2005 and 2006.
The P.A.R.I.S.(sm) system provides the policy administration environment used internally by the Group's associates. An extension of P.A.R.I.S.(sm) called P.A.R.I.S. Express(sm) leverages the P.A.R.I.S.(sm) system to provide functionality to our agents. P.A.R.I.S. Express(sm) is a proprietary internet interface that uses the P.A.R.I.S.(sm) system to provide real-time functionality through a web browser to our agents. In addition, the Group is simultaneously introducing P.A.R.I.S. Connect(sm) which allows agents to transact with the Group directly from their agency management system.
For Commercial Lines, P.A.R.I.S. Express(sm) and P.A.R.I.S. Connect(sm) currently provide agents with on-line quoting capability. In February of 2005 P.A.R.I.S. Express(sm) was extended to support issuance and endorsement processing for selected pilot agents; nationwide roll-out is expected during 2005. Personal Lines currently offers on-line and real time quoting and issuance for new business and endorsements through existing (non- P.A.R.I.S.(sm)) systems.
Agents want a cost effective, timely and simple system for issuing and maintaining insurance policies. P.A.R.I.S. Express(sm) and P.A.R.I.S. Connect(sm) are the cornerstone in the Group's strategy of focusing on superior agent service. The success of this strategic plan depends in part on the ability to provide agents with the technological advantages of these tools. If they do not work as expected, or fail to satisfy agents' needs, the Group may lose business to insurers with preferred technologies.
The Corporation is organized around three business units: Commercial, Specialty and Personal Lines. These business units represent the Corporation's operating segments as well as its reportable segments. Within each operating segment are distinct insurance product lines that generate revenues by selling a variety of commercial, surety and personal insurance products. The Commercial Lines operating segment sells commercial multiple peril, commercial auto, general liability and workers' compensation insurance as its primary products. The Specialty Lines operating segment sells commercial umbrella, excess insurance and fidelity and surety insurance as its primary products. The Personal Lines operating segment sells personal automobile and homeowners insurance as its primary products. The Corporation also has an all other segment, which derives its revenue from investment income. The following table provides key financial measures for each of the property and casualty reportable segments and product lines:
The workers' compensation product line combined ratio was 115.4% in 2004 a decline of 7.6 points compared to 123.0% in 2003 and 129.2% in 2002. Although the Group has taken actions to improve workers' compensation results with higher pricing and a conservative underwriting posture, this product line continues to perform at an
The general liability product line combined ratio was 105.0% in 2004 a decline of 17.6 points compared to 122.6% in 2003 and 171.3% in 2002. This line is exposed to construction defect issues which are being addressed through strict underwriting standards for certain classes of business that are more prone to construction defect claims. In addition, the Group has introduced policy language changes to limit exposure to broadening court interpretations of additional insured and contractual general liability provisions within the policy.
The fidelity and surety product lines contributed to the favorable results for this segment. The fidelity and surety combined ratio increased to 78.9% in 2004, compared with 68.1% in 2003 and 81.7% in 2002. The 2004 fidelity and surety combined ratio included $4.2 of favorable development on prior accident year loss and LAE reserves compared to $5.5 in 2003 and $1.2 in 2002. The 2003 fidelity and surety combined ratio also benefited from lower overall losses (in both frequency and severity) for this product line. In 2002, there was a return of ceded premium of $5.3 million before tax for the fidelity and surety business, which lowered the combined ratio by 10.8 points. This return of ceded premium was due to the exercise of a contractual option on the bond reinsurance treaty based on highly favorable bond combined ratios over the past fourteen years.
The 2004 commercial umbrella combined ratio was 103.8% compared to 80.5% and 97.7% in 2003 and 2002, respectively. The 2004 combined ratio included 4.8 points of favorable development on prior year loss and LAE reserves compared to 12.7 points and 1.1 points in 2003 and 2002, respectively. The increase in the commercial umbrella combined ratio over 2003 is also the result of a $6.1 reinstatement accrual, which increased the 2004 combined ratio by 6.2 points and a reduction in net premiums written of 28.0%, putting upward pressure on the combined and component ratios for this product line.
The Personal Lines combined ratio for 2004 decreased 8.0 points. The 2004 improvement was partially driven by increased pricing and improved underwriting such as increased deductibles on homeowner's policies. In addition, adverse prior years reserve development was 0.5 points in 2004 compared to 3.0 points in 2003 and 2.2 points in 2002. Offsetting these improvements was the addition of 3.2 points of expense for the Proformance guarantee, as discussed previously. In 2004, the Group completed its withdrawal of Personal Lines business from Florida, Georgia and Texas.
The Group establishes reserves for losses and LAE equal to the estimated amount required to settle both reported and incurred but not yet reported (IBNR) claims. For each reported claim, a case reserve is established within the parameters of coverage provided in the specific insurance policy. For IBNR claims, additional loss amounts needed for reported claims and LAE, reserves are estimated using generally accepted actuarial methods. Estimates for loss and LAE reserves are developed using the facts in each case, the Group's experience with similar cases, the effects of current developments and anticipated trends. The methods and assumptions used in making such estimates are continually reviewed and updated when considered appropriate. Reserves established in prior years are adjusted as loss experience develops and new information becomes available. Adjustments to previously estimated reserves, both positive and negative, are reflected in the consolidated financial statements in the periods in which they are made and are referred to as prior period development. Because of the high degree of uncertainty involved in estimating loss and LAE reserves, revisions to estimated reserves could have a material impact on the results of operations of the Group.
Mortgage-backed securities are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations. Upon receipt of payments from such securities, the appropriate amount of the
In accordance with Statement of Position (SOP) 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" the Group capitalizes costs incurred during the application development stage for the development of internal-use software. These costs primarily relate to payroll and payroll-related costs for employees along with costs incurred for external consultants who are directly associated with the internal-use software project. Costs such as maintenance, training, data conversion, overhead and general and administrative are expensed as incurred. Management believes the expected future value of the asset exceeds the carrying value. Management evaluates the asset on an annual basis for impairment. The costs associated with the software are amortized on a straight-line basis over the estimated useful life of ten years commencing when the software is substantially complete and ready for its intended use.
adjustments to these assumptions are based on considerations of current and future market conditions, which can result in changes to the future related benefit obligations, related costs and contributions incurred by the Company. For additional discussion relative to pension and postretirement benefit plan assumptions, see the section entitled "Pension and Other Postretirement Benefits" of this MD&A on pages 37-39 and Item 15, Notes to Consolidated Financial Statements, Footnote 5, pages 59-62 of this Annual Report on Form 10-K.
Net cash generated from operations was $270.0 compared with $168.7 and $148.2 in 2003 and 2002, respectively. The increase in net cash for the years 2004 and 2003 compared to 2002 is due primarily to a reduction in paid losses and LAE of $98.0 in 2004 and $57.2 in 2003, a result of the improved loss experience discussed above. During 2003, the increase in cash was partially offset by an increase in payments to reinsurers for premium cessions, contingent commission bonus payments to agents and the final payments of the replacement carrier fee for New Jersey private passenger auto business. The increase in the reinsurance recoverable asset did not significantly impact cash flow in 2004 and 2003 since there was a corresponding increase in liabilities for most of the increase in this asset. The reinsurance recoverable asset at December 31 2004 and 2003, increased $73.8 and $172.8 with $73.6 and $144.1 due to increases in loss and LAE reserves for future loss payments expected to be paid by reinsurers along with other components as shown in Item 15, Notes to Consolidated Financial Statements, Footnote 7 on page 64 of this Annual Report on Form 10-K.
Investing activities used net cash of $274.4 in 2004, compared to $175.6 in 2003 and $173.7 in 2002. Cash used in investing activities increased $98.8 in 2004 due to the net proceeds received from the issuance of the Senior Notes in June 2004 and reinvestment of the cash generated from operations. Cash used in investing activities remained relatively flat in 2003 compared to 2002 as fewer fixed maturity securities were purchased as prepayments on mortgage backed securities were reduced in 2003, leaving less cash inflow to reinvest. Cash inflows from the sale of property and equipment increased over 2002 as the Group sold a building located in Lexington, Kentucky including the related office equipment and land for sales proceeds of $4.6.
Total cash generated from financing activities was $200.1 in 2004, compared to $1.6 in 2003 and cash used of $4.6 in 2002. Cash provided by financing activities in 2004 resulted from net proceeds of approximately $198.0 from the issuance of 7.3% Senior Notes in June 2004, in addition to the exercise of stock options, partially offset by the repurchase of $12.5 of the Corporation's Convertible Notes and normal principal payments on the State of Ohio loan. Cash provided by financing activities in 2003 resulted from the exercise of stock options partially offset by principal payments on the State of Ohio loan. This compares to cash used for financing activities in 2002, which included the repayment of the Corporation's $205.0 credit facility and issuance of the Convertible Notes with net proceeds of $194.0.
Overall, total cash generated in 2004 was $195.7, compared with net cash used in 2003 and 2002 of $5.3 and $30.1, respectively. The Corporation did not pay any shareholder dividends for the years presented. On a regular basis management analyzes the profitability and capital position of the Group and the liquidity of the Corporation, including the Corporation's evaluation of whether to reinstitute a dividend to shareholders of the Corporation or a share repurchase program.
The Corporation has been examined by the Internal Revenue Service for the tax years 1997 through 2001 and is currently in the process of finalizing a settlement. The Corporation believes that the ultimate settlement of these years will not have a material adverse impact on its financial position or results of operations and has provided adequate book reserves for any matters that may not be resolved as part of the settlement.
As of December 31, 2004 and 2003, the Corporation did not have any off-balance sheet arrangements as defined by Financial Release - 67, "Disclosure in Management's Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations."
* The amounts presented are estimates of the dollar amounts and time periods in which the Group expects to pay its gross loss and LAE reserves. These amounts are based upon historical payment patterns and do not represent actual contractual obligations. The actual payment amounts and the related timing of those payments could differ significantly from these estimates. See Item 15, Notes to Consolidated Financial Statements, Footnote 9 on page 66 of this Annual Report on Form 10-K and discussed separately below.
**Excluded from long-term debt obligations are the Convertible Notes with outstanding principal of $188.8 and semi-annual interest payments of $4.7. For additional disclosure, see Item 15, Notes to Consolidated Financial Statements, Footnote 16 on pages 69 and 70 of this Annual Report on Form 10-K and the Debt section below.
After March 22, 2005, the Corporation has the option to redeem all or a portion of the outstanding Convertible Notes at the following redemption prices, expressed as percentages of the principal amount of the Notes:
On February 22, 2005, the Corporation announced that it has commenced an exchange offer under which the Corporation is offering to exchange up to $184.3 of new 5.00% Convertible Notes due 2022 for an equal principal amount of its currently outstanding Convertible Notes. The exchange offer is being made pursuant to Section 3(a)(9) of the Securities Act of 1933, as amended. The new notes will have substantially similar terms to the old notes, except that the new notes will include a net share settlement feature and a cash exchange fee payable to the holder of the old notes in an amount equal to 0.35% of the principal amount of the old notes exchanged. The net share settlement feature will require the Corporation upon conversion to pay cash up to the principal amount of the new notes and pay any conversion consideration in excess of the principal amount in common shares. The exchange offer will expire at 12:00 midnight EST on March 21, 2005, unless extended or terminated by the Corporation. The Corporation plans to redeem all or a portion of the new notes and the old notes, to the extent any remain outstanding, shortly after the completion of this exchange offer. The Corporation intends to use the proceeds of the Senior Note offering discussed above to accomplish this redemption. In 2005, prior to the commencement of this exchange offer, the Corporation repurchased $4.5 of the Convertible Notes in unsolicited negotiated transactions.
On July 31, 2002, the Corporation entered into a revolving credit agreement expiring on March 15, 2005. Under the terms of the revolving credit agreement, the lenders agreed to make loans to the Corporation in an aggregate amount up to $80.0 for general corporate purposes. Interest is payable in arrears, and the interest rate on borrowings under the revolving credit agreement is based on a margin over LIBOR or the LaSalle Bank Prime Rate, at the option of the Corporation. The Corporation has capitalized approximately $0.4 in fees related
In addition to the debt described above, the Corporation has a $6.5 loan with the State of Ohio that is secured by a mortgage on the Corporation's home office property. As of December 31, 2004, the loan bears a fixed interest rate of 3%, compared to an interest rate of 2% at December 31, 2003. The loan requires annual principal payments of approximately $0.6 and expires in November 2009. The remaining balance at December 31, 2004, was $3.2 compared to $3.9 at December 31, 2003.
Interest expense incurred for the period ending December 31, 2004, 2003 and 2002 was $17.5, $10.1 and $9.5, respectively. The increase in interest expense incurred during 2004 is related to the issuance of the Senior Notes.
Following is a summary of the Corporation's current ratings and rating outlooks as of December 31, 2004:
Statutory surplus, a traditional insurance industry measure of financial strength and underwriting capacity, was $972.0 at December 31, 2004, compared with $867.6 at December 31, 2003. Statutory surplus increased 12.0% from 2003 resulting primarily from statutory net income.
The ratio of net premiums written to statutory surplus is one of the measures used by insurance regulators to gauge the financial strength of an insurance company and indicates the ability of the Group to grow by writing additional business. At December 31, 2004, the Group's net premiums written to surplus ratio was 1.5 to 1 compared to 1.7 to 1 in 2003.
Unrecognized losses of approximately $49.7 are being recognized over approximately a 13-year period, which represents the average future service period of active participants. Unrecognized gains and losses arise from several factors including experience and assumption changes in the obligations and from the difference between expected and actual returns on plan assets. These unrecognized losses will be systematically recognized as an increase in future net periodic pension expense in accordance with FASB Statement No. 87, "Employers' Accounting for Pensions."
Key assumptions used in determining the amount of the obligation and expense recorded for postretirement benefits other than pensions (OPEB), under FASB Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," including the assumed discount rate and the assumed rate of increases in future health care costs, are reviewed by management on an annual basis, or more frequently as needed. In estimating the health care cost trend rate, the Company considers its actual health care cost experience, future benefit structures, industry trends and advice from its third-party actuaries. The Company assumes that the relative increase in health care costs will generally trend downward over the next several years, reflecting assumed increases in efficiency in the health care system and industry-wide cost containment initiatives. At December 31, 2004, the expected rate of increase in future health care costs was 10% for 2005, declining to 5% in 2014 and thereafter. Increasing the assumed health care cost trend by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 2004, by approximately $5.1 and increase the postretirement benefit cost for 2004 by $0.9. Likewise, decreasing the assumed health care cost trend by one percentage point in each year would decrease the accumulated postretirement benefit obligation as of December 31, 2004, by approximately $4.6 and decrease the postretirement benefit cost for 2004 by $0.7.
The Group's largest liabilities are reserves for losses and LAE. Loss and LAE reserves are established for all incurred claims without discounting for the time value of money and before credit for reinsurance recoverable. Actual losses and LAE are adjusted upward or downward as new information is received. These reserves amounted to $2.8 billion and $2.6 billion at December 31, 2004 and 2003, respectively. As of December 31, 2004, the reserves by operating segment were as follows: $1.7 billion Commercial Lines, $0.7 billion Specialty Lines and $0.4 billion Personal Lines.
Estimating the ultimate cost of claims is a complex process. This estimation process is based largely on the assumption that actuarial reserving methods, using historical loss experience and applied by experienced reserving actuaries, produces reasonable estimates of future losses on prior insured events. Reserve estimates can change over time because of unexpected changes in the internal and/or external environment. Assumptions internal to company operations include: recording of premium and loss statistics in the appropriate detail is accurate and consistent; claims handling, including the recording of claims, payment and closure rates, and case reserving is consistent; the quality of business written and the mix of business (e.g. states, limits, coverages and deductibles) have been consistent; rate changes and changes in policy provisions have been measured accurately; reinsurance coverage has been consistent and reinsured losses are collectible. Assumptions related to the external environment include: tort law and the legal environment have been and remain consistent; coverage interpretation by the courts has been and remains consistent; regulations regarding coverage provisions have been consistent; and loss inflation is relatively stable. To the extent any of the above factors have changed over time, attempts are made to adjust for the changes.
This additional unexpected claims inflation trend could arise from a variety of sources such as a general increase in economic inflation, an increase in tort costs, the introduction of higher cost medical technologies and procedures, changes in the utilization of medical procedures, or increased life expectancy. Unexpected changes to other internal and external assumptions could also generate changes to the expected loss and LAE payments.
The Group has three categories of loss and LAE reserves that it considers highly uncertain, and therefore, could have a material impact on future financial results: asbestos and environmental liability, construction defect and commercial umbrella exposures. These categories are described below with relevant historical data.
In recent years, asbestos and environmental liability claims have expanded greatly in the insurance industry. Historically, the Group has written small commercial accounts with a focus on contracting business. Within the manufacturing category, the Group has concentrated on light manufacturers. Thus the Group's exposure to asbestos is related to installers and distributors as opposed to the large manufacturers. Consequently, the Group believes it does not have exposure to the primary defendants involved in major asbestos litigation. The Group's exposure to environmental liability is due to policies written prior to the introduction of the absolute pollution endorsement in the mid-80's, and to underground storage tanks mostly from New Jersey homeowners policies in recent years. The Group has limited exposures to the national priority list, a list of known or threatened releases of hazardous substances, pollutants, or contaminants throughout the United States.
The Group writes commercial umbrella business with large policy limits that are heavily reinsured. The period of time between the loss occurrence, the reporting of the claim to the insurer, and the settlement of the claim can be substantial. The large policy limits coupled with this lengthy time period increase the uncertainty of loss estimates before the application of reinsurance. For 2004 and 2003 loss and LAE reserves prior to reinsurance were $637.1 and $496.0, respectively. For losses occurring in 2004, reinsurance purchased by the Group limits
its retention of losses to 100% of the first $1.0, 3.5% of $4.0 excess of $1.0 and 7% of $20 excess of $5.0. The reinsurance purchased in 2003 and 2002 was comparable to that purchased in 2004. For 2004 and 2003 loss and LAE reserves net of reinsurance were $236.1 and $198.5, respectively.
For the Commercial Lines operating segment, the favorable loss and LAE development for prior accident years recorded during 2004 was concentrated in the commercial automobile product line. In 2003, the adverse development was concentrated in the general liability, commercial multi-peril and workers' compensation product lines. In 2002, the adverse development was concentrated in the general liability product line, and was heavily impacted by construction defect losses. Commercial automobile and workers' compensation also contributed to the 2002 adverse development.
In the opinion of management, the reserves recorded at December 31, 2004, represent the Group's best estimate of its ultimate liability for losses and LAE. However, due to the inherent complexity of the estimation process and the potential variability of the assumptions used, final claim settlements may vary significantly from the amounts recorded. Furthermore, the timing, frequency and extent of adjustments to the estimated liabilities cannot be predicted since conditions and events which established historical loss and LAE reserve development and which serve as the basis for estimating ultimate claim costs may not occur in exactly the same manner, if at all.
The following table sets forth the distribution and other data of invested assets for the years ended December 31, 2004 and December 31, 2003.
The fixed maturity portfolio is allocated between available-for-sale and held-to-maturity as follows:
During 2004, the Corporation and Group, as a result of improved profitability, changed its investment strategy to increase its investment into tax exempt securities.
The consolidated fixed maturity portfolio, including short-term securities, has an intermediate duration and a laddered maturity structure. The duration of the fixed maturity portfolio was approximately 5.1 and 4.6 years as of December 31, 2004 and 2003, respectively. The Corporation and the Group remain fully invested and do not time markets.
Fixed maturity securities are classified as investment grade or non-investment grade based upon the higher of the ratings provided by S&P and Moody's. When a security is not rated by either S&P or Moody's, the classification is based on other rating services, including the Securities Valuation Office of the National Association of Insurance Commissioners. The market value of available-for-sale split-rated fixed maturity securities (i.e., those having an investment grade rating from one rating agency and a below investment grade rating from another rating agency) was $31.5 and $24.0 at December 31, 2004 and 2003, respectively.
Following is a table displaying available-for-sale non-investment grade and non-rated securities in an unrealized loss position at December 31, 2004 and December 31, 2003:
The majority of mortgage-backed security holdings within the fixed maturity portfolio are in sequential structures, planned amortization class and agency pass-through securities. Of this portfolio, $0.2, and $6.2 were invested in more volatile bond classes (e.g. interest-only securities which do not return principal at maturity, super-floater securities which pay interest at a formula rate that is a function of LIBOR and inverse-floater securities which pay interest per a formula that adjusts inversely to changes in LIBOR rates) at December 31, 2004 and 2003, respectively.
In June 2004, the Corporation invested the proceeds of the June 2004 Senior Note offering in short-term instruments. Short-term investments are carried at fair market value on the consolidated balance sheets and produce a lower yield.
The investment portfolio also includes non-publicly traded securities such as private placements, non-exchange traded equities and limited partnerships which are carried at fair value. Fair values are based on valuations from pricing services, brokers and other methods as determined by management to provide the most accurate price. The carrying value of this portfolio at December 31, 2004, was $310.8 compared to $318.8 at December 31, 2003.
The Corporation and Group use assumptions and estimates when valuing certain investments and related income. These assumptions include estimations of cash flows and interest rates. Although the Corporation and Group believe the values of its investments represent fair value, certain estimates could change and lead to changes in fair values due to the inherent uncertainties and judgements involved with accounting measurements.
See Item 15 for Index to Consolidated Financial Statements, including the Notes to Consolidated Financial Statements and the Report of Independent Registered Public Accounting Firm, and Schedules on page 49 of this Annual Report on Form 10-K.