4 The impact of catastrophe losses on the 2012 statutory combined ratio including flood claims handling fees related to Superstorm Sandy was 5.8 points.
Excess and surplus line ("E&S") Lines - comprised of insurance products and services provided to customers who have not obtained coverage in the standard marketplace.
Our Standard Commercial Lines and Standard Personal Lines products and services are sold through nine subsidiaries that write commercial and personal insurance coverages, some of which write flood business through the National Flood Insurance Program's ("NFIP") Write Your Own ("WYO") Program. Our E&S Lines products and services are sold through one subsidiary, Mesa Underwriters Specialty Insurance Company ("MUSIC"), that provides a nationally-authorized non-admitted platform to write commercial and personal E&S business, of which we currently only write commercial coverages. Our ten insurance subsidiaries are collectively referred to as the "Insurance Subsidiaries."
Using generally accepted actuarial reserving techniques, we project our estimate of ultimate losses and loss expenses at each reporting date. Our IBNR reserve is the difference between the projected ultimate loss and loss expense incurred and the sum of: (i) case loss and loss expense reserves; and (ii) paid loss and loss expense reserves. The actuarial techniques used are part of a comprehensive reserving process that includes two primary components. The first component is a detailed quarterly reserve analysis performed by our internal actuarial staff. In completing this analysis, the actuaries must gather substantially similar data in sufficient volume to ensure statistical credibility of the data, while maintaining appropriate differentiation. This process defines the reserving segments, to which various actuarial projection methods are applied. When applying these methods, the actuaries are required to make numerous assumptions including, for example, the selection of loss and loss expense development factors and the weight to be applied to each individual projection method. These methods include paid and incurred versions for the following: loss and loss expense development, Bornhuetter-Ferguson, Berquist-Sherman, and frequency/severity modeling (chain-ladder approach). The second component of the analysis is the projection of the expected ultimate loss and loss expense ratio for each line of business for the current accident year. This projection is part of our planning process wherein we review and update expected loss and loss expense ratios each quarter. This review includes actual versus expected pricing changes, loss and loss expense trend assumptions, and updated prior period loss and loss expense ratios from the most recent quarterly reserve analysis.
This table does not present accident or policy year development data. Conditions and trends that have affected past reserve development may not necessarily occur in the future. As a result, extrapolating redundancies or deficiencies based on this table is inherently uncertain.
In 2015, we experienced overall favorable loss development of $69.0 million, compared to $59.3 million in 2014, and $25.5 million in 2013. The following table summarizes prior year development by line of business:
Unexpected changes in medical cost inflation - The industry is currently experiencing a period of lower claim cost inflation. Variability in our historical workers compensation medical costs, along with uncertainty regarding future medical inflation, creates the potential for additional volatility in our reserves;
In addition, changes in the economy could impact reserves in other ways. For example, in 2015, audit and endorsement activity resulted in additional premium of $22.5 million, and in 2014, audit and endorsement activity resulted in additional premium of $15.7 million. As premiums earned are used as a basis for setting initial reserves on the current accident year, our reserves could be impacted. While audit and endorsement premiums are modeled within our annual budgeting process, they remain uncertain, and therefore provide additional variability to the resulting loss and loss expense ratio estimates.
We experienced some modest unfavorable development in accident years 2013 and 2014, which we believe to be similar to more significant trends seen in the industry. We continue to analyze our portfolio to identify less profitable segments which require enhanced underwriting and pricing actions.
At December 31, 2015, our personal automobile line of business had recorded reserves, net of reinsurance, of $102 million, which represented 3.4% of our total net reserves. In 2015, this line experienced unfavorable development of $0.4 million. While this development is relatively neutral overall, it results from an increase in accident year 2014, largely offset by a decrease in accident year 2013. The overall development is a significant change compared to 2014, during which this line experienced favorable development of $10.8 million, which was driven by the liability coverages for accident years 2012 and prior. We continue to recalibrate our predictive models, as well as refine our underwriting and pricing approaches. While we believe these changes will ultimately lead to improved profitability and greater stability, they may impact paid and reported development patterns, thereby increasing the uncertainty in the reserves in the near-term.
At December 31, 2015, our E&S Lines had recorded reserves, net of reinsurance, of $219 million, which represented 7% of our total net reserves. In 2015, these lines experienced unfavorable development of $15.5 million, associated with accident years 2012 through 2014. In 2014, these lines experienced unfavorable development of $3.7 million, associated with accident years 2011 through 2013. As we have limited historical loss experience in this segment, our reserve estimates are partially based on development patterns of companies that have similar operations. Therefore, these estimates are subject to somewhat greater
During the second half of 2015, a review of all complex liability claims was performed by our corporate CCU.
Implemented actions to reduce the amount spent on outside adjusters and legal counsel, including increasing the use of the staff counsel that we use in standard lines claims defense.
Some of the specific actions implemented over the past several years, other than those regarding E&S as discussed above, are as follows:
The continued use of our Property Flex Unit and our Large Loss Unit. The Property Flex Unit handles claims between $25,000 to $100,000 and the Large Loss Unit handles claims above $100,000.
The weight to be applied to each individual actuarial projection method;
Expected ultimate loss and loss expense ratios for the current accident year.
The importance of any single assumption depends on several considerations, such as the line of business and the accident year. If the actual experience emerges differently than the assumptions used in the process to establish reserves, changes in our reserve estimate are possible and may be material to the results of operations in future periods. Set forth below are sensitivity tests which highlight potential impacts to loss and loss expense reserves under different scenarios, for the major casualty lines of business. These tests consider each assumption and line of business individually, without any consideration of correlation between lines of business and accident years. Therefore, the results in the tables below do not constitute an actuarial range. While the figures represent possible impacts from variations in key assumptions as identified by management, there is no assurance that the future emergence of our loss and loss expense experience will be consistent with either our current or alternative sets of assumptions.
The sensitivities of loss and loss expense reserves to these key assumptions are illustrated below for the major casualty lines. The first table shows the estimated impacts from changes in expected reported loss and loss expense development patterns. It shows reserve impacts by line of business if the actual calendar year incurred amounts are greater or less than current expectations by the selected percentages. The second table shows the estimated impacts from changes to the expected loss and loss expense ratios for the current accident year. It shows reserve impacts by line of business if the expected loss and loss expense ratios for the current accident year are greater or less than current expectations by the selected percentages. While the selected percentages by line are judgmentally based, they reflect the relative contribution of the specific line of business to the overall reserve range.
The total carried net losses and loss expense reserves for these claims were $23.2 million as of December 31, 2015 and $23.0 million at December 31, 2014. The emergence of these claims occurs over an extended period and is highly unpredictable. For example, within our Standard Commercial Lines book, certain landfill sites are included on the National Priorities List (“NPL”) by the United States Environmental Protection Agency (“USEPA”). Once on the NPL, the USEPA determines an appropriate remediation plan for these sites. A landfill can remain on the NPL for many years until final approval for the removal of the site is granted from the USEPA. The USEPA has the authority to re-open previously closed sites and return them to the NPL. We currently have reserves for nine customers related to six sites on the NPL.
The expected long-term rate of return on the plan assets is determined by considering the current and expected asset allocation, as well as historical and expected returns on each plan asset class. A lower expected rate of return on pension plan assets would increase pension expense. Our long-term expected return on the plan assets was increased 10 basis points to 6.37% in 2015 as compared to 6.27% in 2014, reflecting the current interest rate environment.
When the fair value of any investment is lower than its cost/amortized cost, an assessment is made to determine if the decline is other than temporary. We regularly review our entire investment portfolio for declines in fair value. If we believe that a decline in the value of an available-for-sale (“AFS”) security is temporary, we record the decline as an unrealized loss in Accumulated Other Comprehensive Income (“AOCI”). Temporary declines in the value of a held-to-maturity (“HTM”) security are not recognized in the Financial Statements. Our assessment of a decline in fair value includes judgment as to the financial position and future prospects of the entity that issued the investment security, as well as a review of the security’s underlying collateral for fixed income investments. Broad changes in the overall market or interest rate environment generally will not lead to a write-down.
Relevant rating history, analysis, and guidance provided by rating agencies and analysts.
In making our assessment, we perform a DCF to determine the present value of future cash flows to be generated by the underlying collateral of the security. Any shortfall in the expected present value of the future cash flows, based on the DCF, from the amortized cost basis of a security is considered a “credit impairment,” with the remaining decline in fair value of a
Emerging issues that may affect the success of the strategy; and
It is our goal to average an operating ROE that is at least three points higher than our weighted-average cost of capital. At December 31, 2015, our weighted-average cost of capital was 8.7%. Our operating ROE and contribution by component for the following years are as follows:
The key metric in understanding our insurance segments’ contribution to operating ROE is the GAAP combined ratio. The following table provides a quantitative foundation for analyzing this ratio:
Earned rate in excess of expected loss inflation. Renewal pure price increases on NPW of 3.4% in 2015, 5.6% in 2014, and 7.6% in 2013 provided earned rate of approximately 4% in 2015 and 6.5% in 2014, both of which were above our expected claim inflation. After taking into account the incremental expenses associated with the additional premium, the net benefit to the combined ratio was approximately 1 point in 2015 and 2.5 points in 2014.
Partially offsetting the improvements in the loss and loss expense ratios above were increases in the underwriting expense ratio of 1.5 points in 2015 that included the following:
declining interest rates last year that increased the ratio by 0.3 points; and
The March 2014 sale of the renewal rights to our $37 million Self Insured Group ("SIG") book of business that contributed $8 million to other income and reduced the combined ratio by 0.4 points. Although we did not solicit buyers, we decided to sell this small and specialized book of business when the opportunity presented itself because it had significant production outside of our standard lines footprint, and proved difficult to grow. We however, have retained our substantial individual risk public entity book of business and continue to look for opportunities to grow it.
In addition, A.M. Best also expects the industry’s investment income to decline in 2015 due to lower yields, partially offset by growth in invested assets. During 2015, we experienced positive impacts from strong cash flows and an increasing asset base; however, these positives were more than offset by: (i) the impact of lower reinvestment rates as fixed income securities that were purchased had an after-tax yield of 1.7% and fixed income securities that were disposed of had an after-tax yield of 2.5%; and (ii) lower than expected returns on our alternative investment portfolio due to energy sector performance.
As we turn to the future, we plan to leverage our competitive advantages by increasing our share of wallet with existing agents while adding agents in areas with strong new business opportunities. We celebrate our 90th year of business in 2016 and our pillars of success continue to be: (i) our unique field model combined with sophisticated underwriting and claims capabilities; (ii) true franchise value with our distribution partners; and (iii) delivering a superior customer experience with our “best in class” employees.
To that end, we remain focused on becoming a more customer-centric company in 2016. In 2015, we made key strategic investments in technology as part of our efforts to deliver a superior customer experience across all channels, commonly referred to as omni-channel. Over the last year we have rolled out self-servicing capabilities via our mobile application, mobile web, and on the desktop, and relaunched our public website with simplified navigation, richer content, and responsive capabilities. These investments have enabled us to provide our customers with 24/7 access to transactional capabilities and information. Customers expect this level of service and access from every company with which they conduct business. We view omni-channel as a key to future success in our industry and we will continue to focus our efforts in this area in 2016.
In 2015, we saw strong improvements in new business, which increased 26% over last year, whereas in 2014, new business was slightly down from 2013. In addition, renewal pure price increases and strong retention contributed to NPW growth in both periods. In 2014, our growth rate of 4% would have been 7% excluding the impact of the SIG renewal rights sale in the first quarter of 2014.
Earned rate above our expected claim inflation, which improved profitability by approximately 0.5 and 2.5 points for 2015 and 2014, respectively.
Partially offsetting the improvement in the loss and loss expense ratio in 2015 was an increase of 1.4 points in the GAAP underwriting expense ratio in 2015 compared to 2014. This increase is primarily attributable to: (i) higher supplemental commission expense to our distribution partners of 0.4 points; (ii) increases in annual incentive compensation expense to employees of 0.2 points; and (iii) pension expense increases of 0.3 points, which are discussed further in "Financial Highlights of Results for Years Ended December 31, 2015, 2014, and 2013" above. Additionally, the prior year underwriting ratio included $8.0 million, or 0.6 points, of non-recurring benefit related to the sale of the renewal rights to our SIG book of business in March 2014.
Growth in 2015 premium is primarily due to direct new business increases as outlined in the table above. Both reporting periods also reflect positive improvements in NPW and NPE from improving retention and renewal pure price increases. However, in 2014, the renewal pure price increases and strong retention outlined above were more than offset by a reduction in premiums that resulted from the sale of the SIG renewal rights. SIG NPW was approximately $17 million for the general liability line of business in 2013. Excluding the impact of this sale, NPW growth in 2014 compared to 2013 would have been 11%.
Prior year development can be volatile year to year, requiring a longer period of time before true trends are fully recognized. The impact of the prior year casualty reserve development on this line is as follows:
2015: favorable prior year development of 10.6 points attributable to accident years 2013 and prior. This was primarily driven by severities that continued to develop lower than expected, within both the premises and operations and products liability coverages. In addition, the reduction in frequencies exhibited in recent accident years continued into accident year 2015.
2014: favorable prior year development of 9.9 points driven by lower severities in the 2010 through 2012 accident years, within both the premises and operations and products liability coverages. In addition, accident years 2011 and 2012 continued to show lower claim counts, even as they matured.
In 2015, new business was up 23% over last year, while in 2014, new business was slightly down from 2013. In addition, renewal pure price increases and strong retention have contributed to NPW growth in both periods. NPE increases in 2015 and 2014 were consistent with the fluctuations in NPW for their respective twelve-month periods ended December 31.
The 5.7-point increase in the statutory combined ratio in 2015 compared to 2014 was driven by: (i) higher property losses of 1.2 points; (ii) higher current year loss costs of 3.2 points driven by a modest increase in loss severities; and (iii) prior year casualty reserve development that increased the combined ratio by 2.0 points compared to last year.
Centralizing all workers compensation claim handling in Charlotte, North Carolina providing us with: (i) focused management around workers compensation; (ii) units of scale and greater specialization; (iii) high levels of quality and consistency; (iv) better talent attraction and retention; (v) improved usage of nurse case managers; and (vi) increased network penetration;
Managing non-complex workers compensation claims within our footprint by leveraging the expertise of jurisdictionally-trained and aligned medical only and lost-time adjusters;
In addition, the industry has experienced a period of lower medical cost inflation, which has favorably impacted our estimate of ultimate losses on this line of business.
NPE decreases over the three-year period were consistent with the NPW fluctuations for their respective twelve-month periods ended December 31.
The GAAP loss and loss expense ratio decreased 3.7 points in 2014 compared to 2013 driven by: (i) earned rate in excess of our expected claims inflation, which improved profitability by approximately 2.6 points; and (ii) favorable prior year casualty reserve development that was higher than 2013 by 0.9 points.
The increase in the GAAP underwriting expense ratio in 2015 compared to 2014 was primarily due to the following factors:
Increases in annual incentive compensation expense to employees through our corporate-wide incentive plan;
Pension expense increases, which are discussed further in "Financial Highlights of Results for Years Ended December 2015, 2014, and 2013" above; and
Our E&S Lines segment, which represents 9% of our combined insurance segments' NPW, sells commercial lines insurance products and services in all 50 states and the District of Columbia through approximately 80 distribution partners. Insurance policies in this segment are sold to customers that typically have business risks with unique characteristics, such as the nature of the business or its claim history, that have not obtained coverage in the standard marketplace. E&S insurers have more flexibility in coverage terms and rates compared to standard market insurers, generally resulting in policies with higher rates and terms and conditions that are customized for specific risks.
The significant increase in the combined ratio in 2015 compared to 2014 was driven by: (i) unfavorable prior year casualty reserve development that was higher than last year by 5.2 points; (ii) a 2.9-point increase in the current year loss costs; and (iii) a 1.5-point increase in property losses.
The improvement that we saw in the combined ratio in 2014 compared to 2013 was driven by a change in the mix of business, coupled with lower catastrophe losses. Partially offsetting these items were non-catastrophe property losses and unfavorable prior year casualty reserve development.
Terrorism Reinsurance - in addition to protection built into our property and casualty reinsurance treaties, terrorism protection is available as a federal backstop related to terrorism losses as provided under the Terrorism Risk Insurance Program Reauthorization Act (“TRIPRA”). For further information regarding this legislation, see Item 1A. “Risk Factors.” of this Form 10-K.
Our current catastrophe reinsurance program exhausts at a 1 in 274 year return period, or events with 0.36% probability, based on a multi-model view of hurricane risk.
- 80% of losses in excess of $40 million up to
- 95% of losses in excess of $100 million up to
$58 million above $2 million retention covering 100% in three layers. Losses other than TRIPRA certified losses are subject to the following reinstatements and annual aggregate limits:
The casualty excess of loss treaty, which covers both our standard market and E&S business, was renewed on July 1, 2015 and is effective through June 30, 2016, with substantially the same terms as the expiring treaty. The details of the current year treaty are included in the table below.
We structure our portfolio conservatively with a focus on: (i) asset diversification; (ii) investment quality; (iii) liquidity, particularly to meet the cash obligations of our three insurance segments; (iv) consideration of taxes; and (v) preservation of capital. We believe that we have a high quality and liquid investment portfolio. The breakdown of our investment portfolio is as follows:
The average duration of the fixed income securities portfolio as of December 31, 2015 was 3.7 years, including short-term investments, compared to the Insurance Subsidiaries’ liability duration of approximately 4.3 years. The current duration of the fixed income securities portfolio is within our historical range, and is monitored and managed to maximize yield while managing interest rate risk at an acceptable level. We maintain a well-diversified portfolio across sectors, credit quality, and maturities that affords us ample liquidity. We typically have a long investment time horizon, and every purchase or sale is made with the intent of maximizing risk-adjusted investment returns in the current market environment while balancing capital preservation.
Our fixed income securities portfolio maintained a weighted average credit rating of AA- as of December 31, 2015. The following table presents the credit ratings of our fixed income securities portfolio:
Fixed income securities may include bonds, redeemable preferred stocks, mortgage-backed securities (“MBS”) and asset-backed securities (“ABS”). MBS and ABS are jointly referred to as structured securities. Fixed income securities classified as available-for-sale (“AFS”) are reported at fair value. Those fixed income securities that we have the ability and positive intent to hold to maturity are classified as held-to-maturity (“HTM”) and are carried at either: (i) amortized cost; or (ii) market value at the date of transfer into the HTM category, adjusted for subsequent amortization. The amortized cost of fixed income securities is adjusted for the amortization of premiums and the accretion of discounts over the expected life of the security using the effective yield method. Premiums and discounts arising from the purchase of structured securities are amortized over the expected life of the security based on future principal payments, and considering prepayments. These prepayments are estimated based on historical and projected cash flows. Prepayment assumptions are reviewed quarterly and adjusted to reflect actual prepayments and changes in expectations. Future amortization of any premium and/or discount is adjusted to reflect the revised assumptions. Interest income, as well as amortization and accretion, is included in "Net investment income earned" on our Consolidated Statements of Income. The amortized cost of fixed income securities is written down to fair value when a decline in value is considered to be other than temporary. See the discussion below on realized investment gains and losses for a description of the accounting for impairments. After-tax unrealized gains and losses on: (i) fixed income securities classified as AFS; and (ii) fixed income securities that were transferred into an HTM designation from an AFS designation, are included in accumulated other comprehensive income (loss) ("AOCI").
Equity securities, which are classified as AFS, may include common stocks and non-redeemable preferred stocks, and are carried at fair value. Dividend income on these securities is included in "Net investment income earned" on our Consolidated Statements of Income. The associated unrealized gains and losses, net of tax, are included in AOCI. The cost of equity securities is written down to fair value when a decline in value is considered to be other than temporary. See the discussion below on realized investment gains and losses for a description of the accounting for impairments.
Short-term investments may include certain money market instruments, savings accounts, commercial paper, and other debt issues purchased with a maturity of less than one year. These investments are carried at cost, which approximates fair value. The associated income is included in "Net investment income earned" on our Consolidated Statement of Income.
To determine if an impairment is other than temporary, we compare the present value of cash flows expected to be collected with the amortized cost of fixed income securities meeting certain criteria. In addition, this analysis is performed on all previously-impaired debt securities that continue to be held by us and all structured securities that were not of high-credit quality at the date of purchase. These impairment assessments may include, but are not limited to, discounted cash flow analyses ("DCFs").
Our evaluation for OTTI of an other investment (i.e., an alternative investment) may include, but is not limited to, conversations with the management of the alternative investment concerning the following:
The fair values of our investments are generated using various valuation techniques and are placed into the fair value hierarchy considering the following: (i) the highest priority is given to quoted prices in active markets for identical assets (Level 1); (ii) the next highest priority is given to quoted prices in markets that are not active or inputs that are observable either directly or indirectly, including quoted prices for similar assets in markets that are not active and other inputs that can be derived principally from, or corroborated by, observable market data for substantially the full term of the assets (Level 2); and (iii) the lowest priority is given to unobservable inputs supported by little or no market activity and that reflect our assumptions about the exit price, including assumptions that market participants would use in pricing the asset (Level 3). An asset’s classification within the fair value hierarchy is based on the lowest level of significant input to its valuation. Transfers between levels in the fair value hierarchy are recognized at the end of the reporting period.
The techniques used to value our financial assets are as follows:
Share-based compensation consists of all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share units, share options, or other equity instruments. The cost resulting from all share-based payment transactions are recognized in the Financial Statements based on the fair value of both equity and liability awards. The fair value is measured at grant date for equity awards, whereas the fair value for liability awards are remeasured at each reporting period. Both the fair value of equity and liability awards is recognized over the requisite service period. The requisite service period is typically the lesser of the vesting period or the period of time from the grant date to the date of retirement eligibility. The expense recognized for share-based awards, which, in some cases, contain performance criteria, is based on the number of shares or units expected to be issued at the end of the performance period. We repurchase the Parent’s stock from our employees in connections with, and as permitted under, our stock-based compensation plans. This activity is disclosed in our Consolidated Statements of Stockholders' Equity.
Reinsurance recoverables represent estimates of amounts that will be recovered from reinsurers under our various treaties. Generally, amounts recoverable from reinsurers are recognized as assets at the same time and in a manner consistent with the paid and unpaid losses associated with the reinsured policies. We require collateral to secure reinsurance recoverables primarily from our reinsurance carriers that are not authorized, otherwise approved, or certified to do business in our Insurance Subsidiaries’ domiciliary states. This collateral is typically in the form of a letter of credit or cash. An allowance for estimated uncollectible reinsurance is recorded based on an evaluation of balances due from reinsurers and other available information, such as each reinsurers' credit rating from A.M. Best Company ("A.M. Best") or Standard & Poor's Rating Services ("S&P"). We charge off reinsurance recoverables on paid losses when it becomes probable that we will not collect the balance.
We recorded depreciation expense of $16.4 million, $12.6 million, and $10.2 million for 2015, 2014 and 2013, respectively.
Accounting guidance requires a premium deficiency analysis to be performed at the level an entity acquires, services, and measures the profitability of its insurance contracts. We currently perform three premium deficiency analyses for our insurance segments, consistent with our reportable segments of Standard Commercial Lines, Standard Personal Lines, and E&S Lines. A combined ratio of over 100% does not necessarily indicate a premium deficiency, as any year's combined ratio includes a portion of underwriting expenses that are expensed at policy inception and therefore are not covered by the remaining unearned premium. In addition, investment income is not contemplated in the combined ratio calculation.
There were no premium deficiencies for any of the reported years, as the sum of the anticipated losses and loss expenses, unamortized acquisition costs, policyholder dividends, and other expenses for each segment did not exceed that segment’s related unearned premium and anticipated investment income. The investment yields assumed in the premium deficiency assessment for each reporting period, which are based on our actual average investment yield before tax as of the September 30 calculation date, were 2.5% for 2015 and 3.0% for both 2014 and 2013. Deferred policy acquisition costs amortized to expense were $399.4 million for 2015, $364.3 million for 2014, and $331.8 million for 2013.
Reserves for losses and loss expenses are comprised of both case reserves on individual claims, and reserves for claims incurred but not reported ("IBNR"). Case reserves result from claims that have been reported to one or more of our ten insurance subsidiaries, which are collectively referred to as the "Insurance Subsidiaries," and are estimated at the amount of the expected ultimate payment. IBNR reserves are established at more aggregated levels than case basis reserves, and in addition to reserves on claims that have been incurred but not reported, they include provisions for future emergence on known claims, and as well as reopened claims. IBNR reserves are established based on the results of the Insurance Subsidiaries’ internal reserve analysis, supplemented with other internal and external information.
Loss reserves are estimates, and as such, we also consider a range of possible loss and loss expense reserve estimates. This range is determined at the beginning of each year, and reflects the fact that there is no single precise method for estimating the required reserves, due to the many factors which may influence the amounts ultimately paid. Considering the reserve range along with all of the items described above, IBNR estimates are then established and recorded.
The combination of the IBNR estimates along with the case reserve estimates on individual claims results in our total reserves for losses and loss expenses. These reserves are expected to be sufficient for settling all loss and loss reserve liabilities on unpaid claims, reflecting changes in the volume of business written, claims frequency and severity, the mix of business, claims processing, and other items that management expects to affect our ultimate settlement of losses and loss expenses. However, the ultimate claim settlements may be higher or lower than reserves established. As our experience emerges and other information develops, we revise our reserve estimates accordingly. The changes in these estimates, resulting from the continuous review process and the differences between estimates and ultimate payments, are reflected in the consolidated statements of income for the period in which such estimates are changed. The associated impacts may be material to the results of operations in future periods.
We use the asset and liability method of accounting for income taxes. Current federal income taxes are recognized for the estimated taxes payable or refundable on tax returns for the current year. Deferred federal income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax basis of assets and liabilities. We consider all evidence, both positive and negative, with respect to our federal tax loss carryback availability, expected levels of pre-tax financial statement income, and federal taxable income, when evaluating whether the temporary differences will be realized. In projecting future taxable income, we begin with budgeted pre-tax income adjusted for estimated non-taxable items. The assumptions about future taxable income require significant judgment and are consistent with the plans and estimates we use to manage our businesses. A valuation allowance is established when it is more likely than not that some portion of the deferred tax asset will not be realized. A liability for uncertain tax positions is recorded when it is more likely than not that a tax position will not be sustained upon examination by taxing authorities. The effect of a change in tax rates is recognized in the period of enactment. If we were to be levied interest and penalties by the Internal Revenue Service (“IRS”) the interest would be recognized as “Interest expense” and the penalties would be recognized as “Other expense” on the Consolidated Statements of Income.
If either of these conditions exist, an entity should present an unrecognized tax benefit in the financial statements as a liability and should not net the unrecognized tax benefit with a deferred tax asset. ASU 2013-11 was effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. The adoption of this guidance did not impact our financial condition or results of operation.
In January 2014, the FASB issued ASU 2014-01, Accounting for Investments in Qualified Affordable Housing Projects (“ASU 2014-01”). ASU 2014-01 applies to all reporting entities that invest in flow-through limited liability entities that manage or invest in affordable housing projects that qualify for a low-income housing tax credit. ASU 2014-01 permits reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using a newly defined "proportional amortization method" if certain conditions are met. This policy election is required to be applied consistently to all qualifying investments, rather than a decision to be applied to individual investments. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received, and recognizes the net investment performance in the income statement as components of income tax expense (benefit). ASU 2014-01 is effective for public business entities for annual periods and interim periods within those annual periods, beginning after December 15, 2014, with early adoption being permitted. During the third quarter of 2014, we adopted this guidance and have made a policy election to use the proportional amortization method. The adoption of this guidance did not materially impact our financial condition or results of operation.
In February 2015, the FASB issued ASU 2015-02, Amendments to the Consolidation Analysis (“ASU 2015-02”). ASU 2015-02 affects the following areas: (i) limited partnerships and similar legal entities; (ii) the evaluation of fees paid to a decision maker or a service provider as a variable interest; (iii) the effect of fee arrangements on the primary beneficiary determination; (iv) the effect of related parties on the primary beneficiary determination; and (v) certain investment funds. ASU 2015-02 is effective for interim and annual reporting periods beginning after December 15, 2015. The amendments in ASU 2015-02 may be applied either retrospectively or by applying a modified retrospective approach, which would include recording a cumulative-effect adjustment to equity as of the beginning of the fiscal year of adoption. While we anticipate that our limited partnership and tax credit investments will be variable interest entities under the new guidance, we do not anticipate being the primary beneficiary of any of these investments. As such, we do not expect a material impact on our financial condition or results of operations from the adoption of this guidance.
In May 2015, the FASB issued ASU 2015-09, Disclosures about Short-Duration Contracts (“ASU 2015-09”). ASU 2015-09 requires companies that issue short duration contracts to disclose additional information, including: (i) incurred and paid claims development tables; (ii) frequency and severity of claims; and (iii) information about material changes in judgments made in calculating the liability for unpaid claim adjustment expenses, including reasons for the change and the effects on the financial statements. ASU 2015-09 is effective for annual periods beginning after December 15, 2015, and interim periods within annual periods beginning after December 15, 2016. The amendments in ASU 2015-09 should be applied retrospectively by providing comparative disclosures for each period presented, except for those requirements that apply only to the current period. As the requirements of this literature are disclosure only, the application of this guidance will not impact our financial condition or results of operations.
Supplemental cash flow information for the years ended December 31, 2015, 2014, and 2013 is as follows:
(a) Net unrealized gains on investments included in OCI by asset class were as follows for the years ended December 31, 2015, 2014, and 2013:
(b) The amortized cost, net unrealized gains and losses, carrying value, unrecognized holding gains and losses, and fair value of HTM fixed income securities were as follows:
2 RMBS includes government guaranteed agency securities with a fair value of $19.7 million at December 31, 2015 and $32.4 million at December 31, 2014.
The table below provides our net unrealized/unrecognized loss positions by impairment severity as of December 31, 2015 compared to the prior year:
We do not intend to sell any of the securities in the table above, nor do we believe we will be required to sell any of these securities. Additionally, we have reviewed these securities in accordance with our OTTI policy, as described in Note 2. “Summary of Significant Accounting Policies” of this Form 10-K and have concluded that they are temporarily impaired as of December 31, 2015. This conclusion reflects our current judgment as to the financial position and future prospects of the entity that issued the security and underlying collateral. If our judgment about an individual security changes in the future, we may ultimately record a credit loss after having originally concluded that one did not exist, which could have a material impact on our net income and financial position in future periods.
(e) Fixed income securities at December 31, 2015, by contractual maturity are shown below. MBS are included in the maturity tables using the estimated average life of each security. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
Listed below are HTM fixed income securities at December 31, 2015:
Listed below are AFS fixed income securities at December 31, 2015:
Mezzanine Financing: This strategy provides privately negotiated fixed income securities, generally with an equity component, to LBO firms and private and publicly traded large, mid and small-cap companies to finance LBOs, recapitalizations, and acquisitions.
(g) We did not have exposure to any credit concentration risk of a single issuer greater than 10% of our stockholder's equity, other than certain U.S. government agencies, as of December 31, 2015 or December 31, 2014.
The majority of the OTTI charges in 2015, 2014, and 2013 were comprised of charges on our equity portfolio. A significant portion of these charges relate to securities for which we had the intent to sell in relation to a change in our high dividend yield strategy and the remaining equity charges relate to securities that we did not believe would recover in the near term.
(b) The balances of, and changes in, each component of AOCI (net of taxes) as of December 31, 2015 and 2014 were as follows:
The following table presents the carrying amounts and estimated fair values of our financial instruments as of December 31, 2015 and 2014:
The following tables provide quantitative disclosures of our financial assets that were measured at fair value at December 31, 2015 and 2014:
The following tables provide quantitative information regarding our financial assets and liabilities that were disclosed at fair value at December 31, 2015 and 2014:
As a Standard Commercial Lines and E&S Lines writer, we are required to participate in Terrorism Risk Insurance Program Reauthorization Act ("TRIPRA"), which was extended by Congress to December 31, 2020. TRIPRA requires private insurers and the United States government to share the risk of loss on future acts of terrorism certified by the U.S. Secretary of the Treasury. Under TRIPRA, each participating insurer is responsible for paying a deductible of specified losses before federal assistance is available. This deductible is based on a percentage of the prior year’s applicable Standard Commercial Lines and E&S Lines premiums. In 2016, our deductible is approximately $280 million. For losses above the deductible, the federal government will pay 84% of losses to an industry limit of $100 billion, and the insurer retains 16%. The federal share of losses will be reduced by 1% each year to 80% by 2020.
The prior accident year development during 2015 was favorable by $69.0 million, which included $67.0 million of favorable casualty development and $2.0 million of favorable property development. The favorable casualty reserve development was largely driven by the general liability and workers compensation lines of business. For workers compensation, this was a significant change from 2014, during which period this line experienced no development. Our E&S Lines experienced unfavorable development of $15.5 million.
By accident year, the majority of the favorable development was attributable to accident years 2009 through 2013, driven by general liability and workers compensation. This favorable development was partially offset by unfavorable development in accident years 2012 through 2014, which was attributable to our E&S Lines.
The prior accident year development during 2014 was favorable by $59.3 million, which included $48.2 million of favorable casualty development and $11.1 million of favorable property development. The property development was primarily related to a prior year reinsurance recoverable. The favorable casualty reserve development was largely driven by the general liability and personal automobile lines of business. These lines both experienced increasingly favorable development in recent years. Conversely, businessowners' policies and our E&S Lines experienced unfavorable emergence in 2014, which was a reversal from 2013.
By accident year, the majority of the favorable development was attributable to accident years 2010 through 2012, although earlier accident years also developed favorably. General liability, commercial automobile, and personal automobile all contributed to this development, partially offset by businessowners’ liability. The general liability line of business was the primary driver of this favorable development, which was partially driven by lower severities in the 2010 through 2012 accident years, within both the premises and operations and products liability coverages. In addition, accident years 2011 and 2012 continue to show lower than expected claim counts. The overall favorable development for accident years 2012 and prior was partially offset by unfavorable development in accident year 2013, which was largely attributable to commercial automobile liability, and partially E&S casualty.
The prior accident year development during 2013 was favorable by $25.5 million, which included $14.5 million of favorable casualty development and $11.0 million of property development. The property development was primarily related to favorable non-catastrophe loss activity, mostly in the 2012 accident year.
In 2011, the Indiana Subsidiaries borrowed $45 million in the aggregate from the FHLBI. The unpaid principal amount accrues interest of 1.25%, which is paid on the 15th of every month. The principal amount is due on December 16, 2016. These funds were loaned to the Parent for use in the acquisition of Mesa Underwriters Specialty Insurance Company ("MUSIC") on December 31, 2011.
All borrowings from the FHLBI require security. For information on investments that are pledged as collateral for these borrowings, see Note 5. "Investments" above.
The Line of Credit agreement contains representations, warranties, and covenants that are customary for credit facilities of this type, including, without limitation, financial covenants under which we are obligated to maintain a minimum consolidated net worth, minimum combined statutory surplus, and maximum ratio of consolidated debt to total capitalization, and covenants limiting our ability to: (i) merge or liquidate; (ii) incur debt or liens; (iii) dispose of assets; (iv) make investments and acquisitions; and (v) engage in transactions with affiliates. The Line of Credit permits collateralized borrowings from the Federal Home Loan Banks by our Insurance Subsidiaries that are members of those banks so long as the aggregate amount borrowed does not exceed 10% of the respective member's admitted assets from the preceding calendar year.
Our combined insurance segments are subject to certain geographic concentrations, particularly in the Northeast and Mid-Atlantic regions of the country. In 2015, approximately 21% of NPW were related to insurance policies written in New Jersey.
The goodwill balance of $7.8 million at both December 31, 2015 and 2014 relates to our Standard Commercial Lines reporting unit.
The following table provides a reconciliation of the numerators and denominators of basic and diluted earnings per share ("EPS"):
After considering all evidence, both positive and negative, with respect to our federal tax loss carryback availability, expected levels of pre-tax financial statement income, and federal taxable income, we believe it is more likely than not that the existing deductible temporary differences will reverse during periods in which we generate net federal taxable income or have adequate federal carryback availability. As a result, we have no valuation allowance recognized for federal deferred tax assets at December 31, 2015 or 2014.
As of December 31, 2015, we had federal tax NOL carryforwards of $4.2 million. These NOLs, which are subject to an annual limitation of $1.9 million, will expire between 2029 and 2031 as follows:
Stockholders' equity reflects tax benefits related to compensation expense deductions for share-based compensation awards of $22.0 million at December 31, 2015, $20.2 million at December 31, 2014, and $19.2 million at December 31, 2013.
The estimated net actuarial loss for the Pension Plan that will be amortized from AOCI into net periodic benefit cost during the 2016 fiscal year is $5.9 million.
When determining the most appropriate discount rate to be used in the valuation, we consider, among other factors, our expected payout patterns of the plans' obligations as well as our investment strategy and we ultimately select the rate that we believe best represents our estimate of the inherent interest rate at which our pension and post-retirement life benefits can be effectively settled. Effective January 1, 2016, the approach used to calculate the service and interest components of net periodic benefit cost for benefit plans was changed to provide a more precise measurement of service and interest costs. Historically, we calculated these service and interest components utilizing a single weighted-average discount rate derived from the yield curve used to measure the benefit obligation at the beginning of the period. Going forward, we have elected to utilize an approach that discounts the individual expected cash flows using the applicable spot rates derived from the yield curve over the projected cash flow period. We will account for this change prospectively as a change in accounting estimate. The weighted average discount rates used to determine 2016 service and interest costs are 4.52% and 4.02%, respectively.
The fair value of the Pension Plan's investments is generated using various valuation techniques. We follow the methodology discussed in Note 2. “Summary of Significant Accounting Policies,” regarding pricing and valuation techniques, as well as the fair value hierarchy, for equity and fixed income securities and short-term investments held in the Pension Plan.
For valuations of the investments in limited partnerships, fair value is based on the Pension Plan’s ownership interest in the reported net asset values as a practical expedient. The majority of the net asset values are reported to us on a one quarter lag. We assess whether these reported net asset values are indicative of market activity that has occurred since the date of their valuation by the investees: (i) by reviewing the overall market fluctuation and whether a material impact to our investments' valuation could have occurred; and (ii) through routine conversations with the underlying funds' general partners/managers discussing, among other things, conditions or events having significant impacts to their portfolio assets that have occurred subsequent to the reported date, if any. Our limited partnership investments cannot be redeemed with the investees as our partnership agreements require our commitment for the duration of the underlying funds’ lives. There is no active plan to sell any of our remaining interests in the limited partnership investments; however, we may continue to entertain potential opportunities to limit our exposure to these investments through the use of the secondary market. These limited partnerships have been fair valued using Level 3 inputs.
The weighted-average fair value of options and stock per share, including RSUs granted for the Parent's stock plans, during 2015, 2014, and 2013 is as follows:
The following table provides share-based compensation expense in 2015, 2014, and 2013:
In 2005, we established a private foundation, now named The Selective Insurance Group Foundation (the "Foundation"), under Section 501(c)(3) of the Internal Revenue Code. The Board of Directors of the Foundation is comprised of some of the Parent's officers. We made contributions to the Foundation in the amount of $1.0 million in 2015, $0.8 million in 2014, and $0.4 million in 2013.
(a) We purchase annuities from life insurance companies to fulfill obligations under claim settlements that provide for periodic future payments to claimants. As of December 31, 2015, we had purchased such annuities with a present value of $15.8 million for settlement of claims on a structured basis for which we are contingently liable. To our knowledge, there are no material defaults from any of the issuers of such annuities.
(b) We have various operating leases for office space and equipment. Such lease agreements, which expire at various times, are generally renewed or replaced by similar leases. Rental expense under these leases amounted to $17.4 million in 2015, $15.6 million in 2014, and $13.2 million in 2013. We also lease computer hardware and software under capital lease agreements expiring at various dates through 2018. See Note 2(p) for information on our accounting policy regarding leases.
(c) At December 31, 2015, we have contractual obligations that expire at various dates through 2028 to invest up to an additional $74.4 million in alternative and other investments. There is no certainty that any such additional investment will be required. For additional information regarding these investments, see item (f) of Note 5. "Investments" in this Form 10-K.
In the ordinary course of conducting business, we are named as defendants in various legal proceedings. Most of these proceedings are claims litigation involving our Insurance Subsidiaries as either: (i) liability insurers defending or providing indemnity for third-party claims brought against our customers; or (ii) insurers defending first-party coverage claims brought against them. We account for such activity through the establishment of unpaid loss and loss expense reserves. We expect that the ultimate liability, if any, with respect to such ordinary course claims litigation, after consideration of provisions made for potential losses and costs of defense, will not be material to our consolidated financial condition, results of operations, or cash flows.
Our Insurance Subsidiaries are also from time to time involved in other legal actions, some of which assert claims for substantial amounts. These actions include, among others, putative class actions seeking certification of a state or national class. Such putative class actions have alleged, for example, improper reimbursement of medical providers paid under workers compensation and personal and commercial automobile insurance policies. Our Insurance Subsidiaries also are involved from time to time in individual actions in which extra-contractual damages, punitive damages, or penalties are sought, such as claims alleging bad faith in the handling of insurance claims. We believe that we have valid defenses to these cases. We expect that the ultimate liability, if any, with respect to such lawsuits, after consideration of provisions made for estimated losses, will not be material to our consolidated financial condition. Nonetheless, given the large or indeterminate amounts sought in certain of these actions, and the inherent unpredictability of litigation, an adverse outcome in certain matters could, from time to time, have a material adverse effect on our consolidated results of operations or cash flows in particular quarterly or annual periods.
As of December 31, 2015, we do not believe the Company was involved in any legal action that could have a material adverse effect on our consolidated financial condition, results of operations, or cash flows.
The Insurance Subsidiaries prepare their statutory financial statements in accordance with accounting principles prescribed or permitted by the various state insurance departments of domicile. Prescribed statutory accounting principles include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (“NAIC"). Permitted statutory accounting principles encompass all accounting principles that are not prescribed; such principles differ from state to state, may differ from company to company within a state and may change in the future. The Insurance Subsidiaries do not utilize any permitted statutory accounting principles that materially affect the determination of statutory surplus, statutory net income, or risk-based capital (“RBC”). As of December 31, 2015, the various state insurance departments of domicile have adopted the March 2015 version of the NAIC Accounting Practices and Procedures manual in its entirety, as a component of prescribed or permitted practices.
The Insurance Subsidiaries are required to maintain certain minimum amounts of statutory surplus to satisfy the requirements of their various state insurance departments of domicile. RBC requirements for property and casualty insurance companies are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholders. The Insurance Subsidiaries combined total adjusted capital exceeded the authorized control level RBC, as defined by the NAIC based on their 2015 statutory financial statements. In addition to statutory capital requirements, we are impacted by various rating agency requirements related to certain rating levels. These required capital levels may be more than statutory requirements.
Our ability to declare and pay dividends on the Parent's common stock is dependent on liquidity at the Parent coupled with the ability of the Insurance Subsidiaries to declare and pay dividends, if necessary, and/or the availability of other sources of liquidity to the Parent. As of December 31, 2015, the Parent had an aggregate of $91.6 million in investments and cash available to fund future dividends and interest payments. These amounts are not subject to any regulatory restrictions other than standard state insolvency restrictions, whereas our consolidated retained earnings of $1.4 billion is predominately restricted due to the regulation associated with our Insurance Subsidiaries. In 2016, the Insurance Subsidiaries have the ability to provide for $178.3 million in annual dividends to the Parent; however, as regulated entities, these dividends are subject to certain restrictions as is further discussed below. The Parent also has available to it other potential sources of liquidity, such as: (i) borrowings from our Indiana Subsidiaries; (ii) debt issuances; (iii) common stock issuances; and (iv) borrowings under our Line of Credit. Borrowings from our Indiana Subsidiaries are governed by approved intercompany lending agreements with the Parent that provide for additional capacity of $54.6 million as of December 31, 2015, after considering that borrowings under these lending agreements are restricted to 10% of the admitted assets of these respective subsidiaries. For additional information regarding the Parent's Line of Credit, refer to "Financial Condition, Liquidity, Short-Term Borrowings, and Capital Resources" in Item 7. "Management’s Discussion and Analysis of Financial Condition and Results of Operations.” of this Form 10-K. For additional restrictions on the Parent's debt, see Note 10. "Indebtedness" in this Form 10-K.
As noted above, the restriction on our net assets and retained earnings is predominantly driven by our Insurance Subsidiaries' ability to pay dividends to the Parent under applicable law and regulations. Under the insurance laws of the domiciliary states of the Insurance Subsidiaries, New Jersey, Indiana, and New York, an insurer can potentially make an ordinary dividend payment if its statutory surplus following such dividend is reasonable in relation to its outstanding liabilities, is adequate to its financial needs, and the dividend does not exceed the insurer's unassigned surplus. In general, New Jersey defines an ordinary dividend as a dividend whose fair market value, together with other dividends made within the preceding 12 months, is less than the greater of 10% of the insurer's statutory surplus as of the preceding December 31, or the insurer's net income (excluding capital gains) for the 12-month period ending on the preceding December 31. Indiana's ordinary dividend calculation is consistent with New Jersey's, except that it does not exclude capital gains from net income. In general, New York defines an ordinary dividend as a dividend whose fair market value, together with other dividends made within the preceding 12 months, is less than the lesser of 10% of the insurer's statutory surplus, or 100% of adjusted net investment income. New Jersey and Indiana require notice of the declaration of any ordinary dividend distribution. During the notice period, the
relevant state regulatory authority may disallow all or part of the proposed dividend if it determines that the dividend is not appropriate given the above considerations. New York does not require notice of ordinary dividends. Dividend payments exceeding ordinary dividends are referred to as extraordinary dividends and require review and approval by the applicable domiciliary insurance regulatory authority prior to payment.
Based on the 2015 statutory financial statements, the maximum ordinary dividends that can be paid to the Parent by the Insurance Subsidiaries in 2016 are as follows: