flood servicing revenue and expense has been reclassified from underwriting results to Diversified Insurance Services. 1997 - 2005 have been
When a claim is reported to an insurance subsidiary, its claims personnel establish a "case reserve" for the estimated amount of the ultimate payment. The amount of the reserve is primarily based upon a case-by-case evaluation of the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the type of losses. The estimate reflects the informed judgment of such personnel based on general insurance reserving practices, as well as the experience and knowledge of the claims person. Until the claim is resolved, these estimates are revised as deemed necessary by the responsible claims personnel based on subsequent developments and periodic reviews of the case.
In accordance with industry practice, we maintain, in addition to case reserves, estimates of reserves for losses and loss expenses incurred but not yet reported ("IBNR"). Using generally accepted actuarial reserving techniques, we project our estimate of ultimate losses and loss expenses at each reporting date. The difference between: (i) projected ultimate loss and loss expense reserves and (ii) case loss reserves and loss expense reserves thereon are carried as the IBNR reserve. 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 are required to make numerous assumptions, including for example, the selection of loss development factors and the weight to be applied to each individual actuarial indication. These indications include paid and incurred versions for the following methodologies: loss development, Bornhuetter-Ferguson, Berquist-Sherman, and frequency/severity. Additionally, the actuaries must gather substantially similar data in sufficient volume to ensure the statistical credibility of the data. The second component of the analysis is the projection of the expected ultimate loss ratio for each line of business for the current accident year. This projection is part of the Company's planning process wherein the expected loss ratios are reviewed and updated each quarter. This review includes actual versus expected pricing changes, loss trend assumptions, and updated prior period loss ratios from the most recent quarterly reserve analysis.
In addition to the most recent loss trends, a range of possible IBNR reserves is determined annually and continually considered, amongst other factors, in establishing IBNR for each reporting period. Loss trends include, but are not limited to large loss activity, environmental claim activity, large case reserve additions or reductions for prior accident years, and reinsurance recoverable issues. The Company also considers factors such as: (i) per claim information; (ii) Company and industry historical loss experience; (iii) legislative enactments, judicial decisions, legal developments in the imposition of damages, and changes in political attitudes; and (iv) trends in general economic conditions, including the effects of inflation. Based on the consideration of the range of possible IBNR reserves, recent loss trends and other factors, IBNR is established and the ultimate net liability for losses and loss expenses is determined. Such an assessment requires considerable judgment given that it is frequently not possible to determine whether a change in the data is an anomaly until some time after the event. Even if a change is determined to be permanent, it is not always possible to reliably determine the extent of the change until some time later. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves because the eventual deficiency or redundancy is affected by many factors. 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. Any changes in the liability estimate may be material to the results of operations in future periods.
The following tables provide case and IBNR reserves for losses, reserves for loss expenses, and reinsurance recoverable on unpaid losses and loss expenses as of December 31, 2005 and 2004:
In light of the many uncertainties associated with establishing the estimates and making the assumptions necessary to establish reserve levels, the Company reviews its reserve estimates on a regular basis as described above and makes adjustments in the period that the need for such adjustment is determined. These reviews, from time to time, result in the Company identifying information and trends that cause the Company to increase some reserves and decrease other reserves for prior periods and could lead to the identification of a need for additional increases in loss and loss adjustment expense reserves, which could materially adversely affect the Company's results of operations, equity, business, insurer financial strength and debt ratings. The Company experienced adverse development in its loss and loss expense reserves totaling $5.1 million in 2005, $4.9 million in 2004 and $15.0 million in 2003. For further discussion on the adverse development in loss and loss expense reserves, see the discussion on "Net Loss and Loss Expense Reserves" in Item 1. "Business" and Note 6 of Item 8. "Financial Statements and Supplementary Data" in this Form 10-K.
Included in our loss and loss expense reserves are amounts for environmental claims, both asbestos and non-asbestos. Carried net loss and loss expense reserves for environmental claims was $41.8 million as of December 31, 2005 and $38.5 million as of December 31, 2004. Selective's exposure to environmental liability is primarily due to policies written prior to the introduction of the absolute pollutions endorsement in the mid-80's and the underground storage tank leaks mostly from New Jersey homeowners policies in recent years. Selective's asbestos and non-asbestos environmental claims have arisen primarily from insured exposures in municipal government, small commercial risks, and homeowners policies. The emergence of these claims is slow and highly unpredictable. During 2004, Selective also experienced adverse development in its homeowners line of business as a result of unfavorable trends in claims for groundwater contamination caused by leakage of certain underground heating oil storage tanks in New Jersey. Increased frequency was triggered, in part, by the state's robust real estate market, which led to an increase in home tank inspections.
IBNR reserve estimation for environmental claims is often difficult because, in addition to other factors, there are significant uncertainties associated with critical assumptions in the estimation process such as average clean-up costs, third-party costs, potentially responsible party shares, allocation of damages, insurer litigation costs, insurer coverage defenses, and potential changes to state and federal statutes. However, management is not aware of any emerging trends that could result in future reserve adjustments. Moreover, normal historically-based actuarial approaches are difficult to apply because relevant history is not available. In addition, while models can be applied, such models can produce significantly different results with small changes in assumptions. As a result, management does not calculate a specific environmental loss range, as it believes it would not be meaningful.
Policy acquisition costs, which include commissions, premium taxes, fees, and certain other costs of underwriting policies, are deferred and amortized over the same period in which the related premiums are earned. Deferred policy acquisition costs are limited to the estimated amounts recoverable after providing for losses and loss expenses that are expected to be incurred, based upon historical and current experience. Anticipated investment income is considered in determining whether a premium deficiency exists. The methods of making such estimates and establishing the deferred costs are continually reviewed by the Company, and any adjustments are made in the accounting period in which the adjustment arose. As of December 31, 2005 the Company had deferred policy acquisition costs of $204.8 million compared to $186.9 million as of December 31, 2004.
An investment in a fixed maturity or equity security, which is available for sale or reported at fair value is impaired if its fair value falls below its book value and the decline is considered to be other-than-temporary. We regularly review our entire investment portfolio for declines in value. If we believe that a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in accumulated other comprehensive income. If we believe the decline is "other-than-temporary," we write down the carrying value of the investment and record a realized loss in our Consolidated Statements of Income. Management's assessment of a decline in value includes current judgment as to the financial position and future prospects of the entity that issued the investment security. Broad changes in the overall market or interest rate environment generally will not lead to a write-down. In November 2005, the Financial Accounting Standards Board ("FASB") issued two FASB Staff Positions ("FSP"), FAS115-1 and FAS124-1 titled "The Meaning of Other-Than-Temporary Impairments and its Application to Certain Investments". These staff positions essentially endorse existing requirements related to impairments with relatively few modifications. We believe this solidified our approach in evaluating our portfolio for other-than-temporary impairment.
Our evaluation for other-than-temporary impairment of fixed maturity securities, includes, but is not limited to, the evaluation of the following factors:
• Whether the decline appears to be issuer or industry specific;
• The price-earnings ratio at the time of acquisition and date of evaluation;
• The financial condition and near-term prospects of the issuer, including any specific events that may influence the issuer's operations;
• The independent auditors' report on the issuer's recent financial statements;
• The dividend policy of the issuer at the date of acquisition and the date of evaluation;
• Any buy/hold/sell recommendations or price projections published by outside investment advisors;
Highlights of years ended December 31, 2005, 2004, and 2003 Results
• Total revenues increased in 2005 compared to 2004, and 2003, primarily due to net premiums earned ("NPE") growth of 8% in 2005 as compared to 2004 and growth of 16% in 2004 as compared to 2003. Increases in NPE are attributed to the following:
Commercial Lines renewal retention, which remained level in 2005 compared to 2004 and 2003;
Commercial Lines renewal premium price increases, including exposure, that averaged 4% in 2005 compared to 9% in 2004, and 13% in 2003;
Increased competition in the New Jersey personal automobile market partially offset the items above, and resulted in a decrease in rates of 5.2% along with a 10% reduction in the number of cars we insured during 2005 compared to 2004. In 2004, there was an increase in rates of 6.3% along with an 8% reduction in the number of cars we insured compared to 2003.
After-tax investment income, which increased $14.2 million, or 16%, in 2005 compared to $6.6 million, or 8%, in 2004 compared to 2003. These increases were the result of increased invested assets due to strong operating cash flows of $406.8 million in 2005, $367.1 million in 2004, and $281.9 million in 2003. Increases in operating cash flows resulted in an increase in invested assets of 14% to $3.2 billion at December 31, 2005, and an increase of 17% to $2.8 billion at December 31, 2004;
therefore excluded from the GAAP ratios. The total Statutory Combined Ratio excluding flood is 95.3% for 2005, 96.5% for 2004, and 102.0% for 2003.
Commercial Lines renewal premium price increases that averaged 4% in 2005 compared to 9% in 2004, and 13% in 2003; and
The improvement in 2005 GAAP loss and loss expense ratio when compared to 2004 and 2003 was primarily attributable to: (i) a decrease in weather-related catastrophe losses, which accounted for $4.7 million in incurred losses or 0.3 points of the GAAP loss and loss expense ratio for 2005 compared to $18.5 million or 1.4 points for 2004, and $30.3 million in incurred losses or 2.7 points of the GAAP loss and loss expense ratio for 2003; and (ii) underwriting improvements mainly in our Commercial Lines business. These improvements were partially offset by the following: (i) unprofitable results in our workers compensation line of business, and (ii) reserve increases related to the New Jersey Supreme Court judicial ruling described below. For further discussion regarding these items, see our "Commercial Lines" and "Personal Lines" discussions below.
During 2005, the Property and Casualty industry faced several large-scale disasters including Hurricanes Katrina and Rita. As the year unfolded, industry speculation was that these events may result in the stabilization of market prices after the increasing pricing pressures that the industry was experiencing prior to these disasters. Currently, we do not anticipate pure price increases in 2006 within our 20-state footprint. The effect of the hurricanes sustained by the reinsurance sector during 2005 was evidenced by the January 1, 2006 renewal of our property catastrophe program. Although we have not sustained significant catastrophic losses for well over a decade, the growth in our book of business along with the hardening of the market and reinsurers' perception of catastrophic risk have led to higher property catastrophe costs in 2006 compared to 2005. Additionally, terrorism remains a key concern, despite the two-year extension of the Terrorism Risk Insurance Act of 2002 ("TRIA") signed into law on December 22, 2005. While the provisions of TRIA will serve to mitigate our significant exposure in the event of a large-scale terrorist attack, our deductible is substantial, approximating $160 million in 2006. In addition, it is uncertain whether TRIA will be extended past its current termination date. We continue to monitor concentrations of risk and have purchased a separate terrorism treaty to supplement our protection to this highly unknown exposure.
Despite these marketplace challenges and barring excess catastrophe losses, we are anticipating achieving an underwriting profit for a third consecutive year in 2006. We believe that our profitability will continue to be driven by our field strategy, a key competitive advantage that will allow us to grow our new business with both our existing agency plant and the strategic appointment of new agencies. The strategies that we are implementing will continue to increase the effectiveness of our field strategy, thus driving our profitable growth. These key strategies are as follows:
Direct voluntary new business written of $251.5 million for 2005, an 8% increase compared to $232.1 million in direct voluntary new business written in 2004, and $230.9 million in direct voluntary new business written in 2003;
Renewal premium price increases, including exposure, that averaged 4% for 2005 compared to 9% in 2004, and 13% for 2003.
Loss trends for Commercial Lines that were flat in 2005 compared to 2004, versus an average earned premium increase of 3% in 2005. Partially offsetting this, workers compensation 12-month loss trends were up 24% in 2005 compared to 2004, versus an average earned premium increase of 10% in 2005 compared to 2004.
These results reflect the cumulative effect of price increases over the last five years, underwriting improvements, including the removal of certain classes of business determined to be unprofitable, and favorable prior-year statutory loss and loss expense development in 2005 of approximately $48 million compared to approximately $20 million in 2004 and approximately $3 million in 2003. In 2005, the favorable reserve development in our commercial automobile line of business, which is a line wherein loss trends develop at a much faster pace, was primarily attributable to ongoing severity trends in the 2002 through 2004 accident years. The favorable development in 2004 and 2003 was also primarily attributable to reductions in claim frequency.
Our favorable performance trend in this line reflects our long-term improvement strategy that incorporated higher pricing, heightened loss control efforts and continued underwriting enhancements. Partially offsetting the favorable performance in this line of business were increases in the statutory loss and loss expense reserves for prior year development of approximately $14 million in 2005, $19 million in 2004, and $22 million in 2003. The adverse development in all years was created mainly by our contractor completed operations business. Since 2002, we have taken extensive underwriting actions to limit our exposure. For example, we adopted the Insurance Service Office general liability insurance form, which excluded coverage for faulty workmanship of subcontractors. We also placed mold limitations or exclusions on most policies and required subcontractors to carry equal insurance limits to those carried by the general contractor as well as mandated that our insureds be named on any potential subcontractor's policy as an additional insured on a primary and noncontributory basis. Also included in the increases to the 2004 statutory loss and loss expense reserves was $1.7 million that was the result of rating agency downgrades of certain reinsurers, which caused us to reevaluate our ability to collect under certain reinsurance contracts.
To restore profitability in this line of business, we have implemented a comprehensive workers compensation strategy that combines underwriting execution and incorporates our Knowledge Management strategy, both of which are discussed in the "Insurance Operations Outlook" section above.
The improvement in the statutory combined ratio for Commercial Property is primarily attributable to higher prices and underwriting improvements that have been made over the past five years, including better insurance-to-value estimates across our book of business; a shift to risks of better construction quality and newer buildings; and an overall focus on low-to-medium hazard property exposures. This line also benefited from low weather-related catastrophe losses during 2005 of $2.8 million, or 1.7 points, compared to $13.3 million, or 8.7 points, during 2004 and $18.4 million, or 14.1 points, during 2003.
Although the bond operation represents only 1% of our Commercial Lines business, we continue to make strides to grow this line of business given its value to our agents in rounding out the commercial account for their clients. Improvements in our bond line of business during 2005, compared to the last two years, reflect enhancements to the bond underwriting process, including the successful rollout of our automated bond system and the elimination of bond-only agents. The 2004 results included a charge of approximately $2.0 million, or 15.3 points, which related to salvage and subrogation recoverables for prior accident years.
The Personal Lines GAAP loss and loss expense ratio slightly increased in 2005 compared to 2004, which was primarily driven by reserve increases related to the New Jersey Supreme Court judicial ruling described below, partially offset by lower weather-related catastrophe losses. The improvement in the 2004 GAAP loss and loss expense ratio compared to the 2003 GAAP loss and loss expense ratio was primarily driven by lower weather-related catastrophe losses. Weather-related catastrophe losses were only 0.4 points in 2005, compared to 1.1 points in 2004, and 3.9 points in 2003.
The 2005 statutory combined ratios, compared to 2004 and 2003, were negatively impacted by: (i) decreases in statutory NPW driven by increased competition in the New Jersey automobile market resulting in decreases in rate and the number of cars we insure as noted above, and (ii) increases in New Jersey personal automobile reserves.
Personal Lines comprise nearly half of all U.S. property and casualty premiums. In our 20-state footprint, independent agents control more than $37 billion in personal automobile and homeowners premium. Based on our belief that independent agents will continue to control a meaningful market share, our strategy is designed to differentiate Selective from the other companies that compete in the agency channel through market consistency, breadth of appetite, and ease of doing business. To improve our competitive position in the overall personal lines markets in each of our primary operating states, we have taken the following strategic steps: (i) a realignment of the management team in Personal Lines; (ii) rate and tier filings based on a multivariate model in key states in 2006; (iii) enhanced use of SelectPlus™, our personal lines automated underwriting system; and (iv) the opening of a Personal Lines service center in 2006.
• Terrorism Reinsurance - includes coverage provided under TRIA in excess of our deductible as well as our Terrorism Aggregate Excess of Loss treaty purchased to protect the Company against any type of terrorism events, including events within the TRIA deductible.
• Other Reinsurance - includes smaller treaties, such as our Surety and Fidelity Excess of Loss treaty, that do not fall within the categories above.
While this discussion will provide you with an overview regarding the reasons for changing our reinsurance program over the past year, additional information regarding the terms and related coverage associated with each of our categories of reinsurance can be found in Item 1. "Business" of this Form 10-K.
The effect of the hurricanes on the insurance industry as a whole during 2005 was evident in the January 1, 2006 renewal of our property catastrophe program. Although we have not sustained significant catastrophic losses for well over a decade, the growth in our book of business, along with the hardening of the market and reinsurers' perception of catastrophic risk, led to an estimated $2.4 million, or 26%, increase in the total cost of our property catastrophe program for 2006 as compared to 2005.
Due to continuing growth of our overall property book outside of New Jersey, we have terminated our New Jersey Homeowners Property 75% Quota Share treaty effective January 1, 2006 and reallocated the cost of this treaty to the purchase of additional protection under our Property Catastrophe treaty, which covers our overall property book. Effective January 1, 2006, Property Catastrophe treaty retention increased to $20.0 million from the expiring $15.0 million and per occurrence coverage was increased to $220 million (with a 5% Company participation) from the expiring $150 million. The New Jersey Homeowners Property Quota Share treaty had provided up to $75.0 million per occurrence protection for the property portion of our New Jersey Homeowners book of business and was purchased primarily to protect the Company against a catastrophic event. The Company ceded $20.4 million in earned premium offset by $9.7 million in ceding commission and $8.3 million in losses under the New Jersey Homeowners Property Quota Share treaty in 2005.
The retention under Property Excess of Loss treaty remained stable at $2.0 million, however, the limit was increased effective July 1, 2005 to $23.0 million in excess of the retention compared to expiring limit of $18 million. The increase in our Property Excess of Loss treaty's limit will reduce our need to purchase facultative reinsurance. Consistent with the prior year, all NBCR losses are excluded from the Property Excess of Loss treaty regardless of whether or not they are certified under TRIA, however, our Terrorism Excess of Loss treaty, discussed below, does cover these exposures up to an annual aggregate of $45.0 million once our $15.0 million annual aggregate deductible is met. The Property Excess of Loss treaty rate was reduced by 15% due to favorable experience despite the increase in our limit.
(ii) All Casualty Lines Excess of Loss treaty ("Casualty Treaty") covering all casualty business, including Workers Compensation, up to $45.0 million in excess of $5.0 million per occurrence.
Growth in net investment income, before tax, of $15.4 million for 2005 compared to 2004 and $5.8 million for 2004 compared to 2003 was primarily attributable to: (i) increased invested assets; (ii) increased income of approximately $1.8 million from investments in various alternative investments for 2005 compared to 2004 and $1.9 million for 2004 compared to 2003; and (iii) higher dividend income of $1.6 million for 2005 compared to 2004 and $1.8 million for 2004 compared to 2003. The value of the investment portfolio reached $3.2 billion at December 31, 2005, an increase of 14% compared to $2.8 billion at December 31, 2004. The increase in invested assets was due to substantial cash flows from operations of $406.8 million in 2005 and $367.1 million in 2004. Debt offerings in November 2004 and November 2005 added approximately $50 million in assets in 2004 and $100 million in assets in 2005. However, growth in net investment income in 2004 was reduced by lower available reinvestment rates on fixed maturities that matured over the past two years. Although short-term interest rates have risen, investment yields on new money are still lower than the overall portfolio yield, which continues to put pressure on overall investment yields.
Our fixed maturity investment strategy is to make security purchases that are attractively priced in relation to perceived credit risks. We manage the interest rate risk associated with holding fixed maturity investments by monitoring and maintaining the average duration of the portfolio with a view toward achieving an adequate after-tax return without subjecting the portfolio to an unreasonable level of interest rate risk. We invest our fixed maturities portfolio primarily in intermediate-term securities to limit overall interest rate risk of fixed maturity investments. The average duration of the fixed maturity portfolio, excluding short-term investments, was 4.3 years at December 31, 2005 unchanged from December 31, 2004. To provide liquidity, while maintaining consistent performance, fixed maturity investments are "laddered" so that some issues are always approaching maturity, thereby providing a source of predictable cash flow. Managing investment risk by adhering to these strategies is intended to protect the interests of our stockholders and the policyholders of our Insurance Subsidiaries, and enhance our financial strength and underwriting capacity.
Realized gains and losses are determined on the basis of the cost of specific investments sold or written-down, and are credited or charged to income. Our Investments segment included net realized gains before tax of $14.5 million in 2005, compared to $24.6 million in 2004, and $12.8 million in 2003. The realized gains were principally from the sale of equity securities. Net realized gains in 2005 reflect the sale of certain long-term equity holdings, which were partially offset by an impairment charge from one write-down for other than temporary declines in fair value of $1.2 million. There were no impairment charges recorded in 2004 and $1.2 million for 2003. The decrease in net realized gains in 2005 compared to 2004, as well as the increase in net realized gains in 2004 compared to 2003, is primarily due to the sale of a single equity security in 2004, which resulted in a $14.9 million pre-tax gain. We maintain a high quality and liquid investment portfolio and the sale of the securities that resulted in realized gains did not change the overall liquidity of the investment portfolio. Our philosophy for sales of securities generally is to reduce our exposure to securities and sectors based upon economic evaluations or the fundamentals for that security or sector have deteriorated and/or for tax planning purposes. We generally have a long investment time horizon and our turnover is low, which has resulted in many securities accumulating large unrealized gains. Every purchase or sale is made with the intent of improving future investment returns.
We realized gains and losses from the sale of available-for-sale debt and equity securities during 2005, 2004, and 2003. The following tables present the period of time that securities sold at a loss were continuously in an unrealized loss position prior to sale:
Broad changes in the overall market or interest rate environment generally do not lead to impairment charges. We believe the fluctuations in the fair value of fixed maturities and the increase in the associated gross unrealized loss since December 31, 2004 were primarily due to higher interest rates. As of December 31, 2005, there are 343 securities in an unrealized loss position.
The following table presents information regarding our available-for-sale fixed maturities that were in an unrealized loss position at December 31, 2005 by contractual maturity:
• Revenue increases were mainly attributable to: (i) an increase in claims servicing fees of $3.6 million in 2005 compared to $2.6 million in 2004, and $1.4 million in 2003, which were primarily attributable to active hurricane seasons in those respective years; and (ii) expanded marketing efforts and the competitive advantage provided by our on-line flood system. This growth was partially tempered by a decrease in the fee paid to us by the National Flood Insurance Program ("NFIP") of 0.6 points to 31.2% from 31.8%, which was effective for the fiscal year beginning on October 1, 2004 and a further reduction of the fee of 0.4 points to 30.8% from 31.2%, which was effective for the fiscal year beginning on October 1, 2005.
Our HR Outsourcing products offer an additional potential agency revenue stream for our independent agents. However, this product is outside of the traditional insurance arena and as a result has been met with some reluctance by our agency distribution force. This reluctance, coupled with the softening of the insurance market, has led to slower than anticipated growth through our agency distribution sales channel and, consequently, in our overall worksite lives. To gain more traction with our independent agents, we are currently working on repositioning the product as an employer protection program that we expect to roll out in early 2006.
Our ability to provide flood insurance is a significant component of our Diversified Insurance Services strategy. During 2005, the destruction caused by the active hurricane season stressed the NFIP with flood losses estimated to be in excess of $20 billion. We anticipate that given such losses, the future of the NFIP will be critically evaluated with a focus on easing the costs of the program. While we continue to monitor this situation, we are seeking to aggressively grow our flood business. During 2005, we completed our licensing for all 50 states, increased our sales force in several key locations, and appointed over 400 flood-only agents. These strategic steps have us well-positioned for continued growth in 2006.
Liquidity is a measure of our ability to generate sufficient cash flows to meet the short and long-term cash requirements of our business operations. Our consolidated sources of cash consist of premium collections by our Insurance Subsidiaries, income from our investment portfolio, and fee income from our Diversified Insurance Services segment. We also generate cash from the sale of our common stock under our stock plans.
Our Insurance Subsidiaries provide liquidity from premiums that are generally received months or even years before we are obligated to pay losses. Consequently, we can invest with a longer time horizon than our liability duration and generate greater stockholder returns. We also generate cash from Diversified Insurance Services segment's fee income and the sale of our common stock under our stock plans. Historically, cash receipts from operations, consisting of insurance premiums, investment income, and fee income, have provided more than sufficient funds to pay losses, operating expenses, and subsidiary dividends. After satisfying our cash requirements, excess cash flows are used to build the investment portfolio and increase future investment income. As of December 31, 2005, we had $3.2 billion in investments compared to $2.8 billion at December 31, 2004. We also have available revolving lines of credit totaling $45.0 million, under which no balances were outstanding as of either December 31, 2005 or December 31, 2004. These lines of credit are scheduled to expire in June 2006, although we currently expect to renew them with similar terms.
Our cash and short-term investments ("cash equivalent(s)") position at December 31, 2005 was $179.5 million compared to $98.7 million at December 31, 2004. The increase in our cash equivalent position was primarily attributable to our $100 million bond offering in November 2005.
Generally, payments from our Insurance Subsidiaries to the holding company are subject to the approval and/or review of the insurance regulators in the respective domiciliary states of the Insurance Subsidiaries under insurance holding company acts, which generally require any transaction between related companies be fair and equitable to the insurance company and its policyholders. All of the states in which our Insurance Subsidiaries are domiciled regulate the payment of dividends. Some states, including New Jersey, North Carolina, and South Carolina, require advance notice to the state insurance commissioner prior to the Insurance Subsidiaries declaring any dividends and distributions payable to us. During the notice period, the state insurance commissioner may disallow all or part of the proposed ordinary dividend upon determination that: (i) the insurer's surplus is not reasonable in relation to its liabilities and adequate to its financial needs and those of the policyholders; or (ii) in the case of New Jersey, the insurer is otherwise in a hazardous financial condition. In addition, our Insurance Subsidiaries are not permitted to pay extraordinary dividends without the prior approval of the insurance commissions of their domiciliary state. Insurance regulators may block dividends or other payments to affiliates that would otherwise be permitted without prior approval upon determination that, because of the financial condition of the Insurance Subsidiary or otherwise, payment of a dividend or any other payment to an affiliate would be detrimental to an Insurance Subsidiary's policyholders or creditors. At present, we do not believe that any of these restrictions should limit the ability of the Insurance Subsidiaries to pay dividends to us now or in the foreseeable future. Dividends are generally payable only from earned surplus as reported in the statutory annual statements of our Insurance Subsidiaries as of the preceding December 31. Based on the 2005 unaudited statutory financial statements, the Insurance Subsidiaries are permitted to pay to us in 2006 ordinary dividends in the aggregate amount of approximately $120.6 million.
SHRS may also declare and pay dividends. Potential dividends are restricted only by the operating needs of this entity. In 2005, SHRS provided dividends to us of $4.0 million. No dividends were provided for either 2004 or 2003.
• In the third quarter of 2005, the Board of Directors increased our quarterly cash dividend to stockholders by 16%, to $0.22 per share.
Our future cash payments associated with contractual obligations pursuant to operating leases for office space and equipment, senior convertible notes, convertible subordinated debentures, and notes payable as of December 31, 2005 are summarized below:
At December 31, 2005, Selective had contractual obligations that expire at various dates through 2017 to invest up to an additional $65 million in alternative investments. There is no certainty that any such additional investment will be required.
In addition to our contractual obligations, we maintain case reserves and estimates of reserves for losses and loss expenses incurred but not yet reported ("IBNR"), in accordance with industry practice. Using generally accepted actuarial reserving techniques, we project our estimate of ultimate losses and loss expenses at each reporting date. Included within the estimate of ultimate losses and loss expenses are case reserves, which are analyzed on a case-by-case basis by the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the type of losses. The difference between: (i) projected ultimate loss and loss expense reserves; and (ii) case loss reserves and loss expense reserves thereon are carried as the IBNR reserve. A range of possible reserves is determined annually and considered in addition to the most recent loss trends and other factors in establishing reserves for each reporting period. Based on the consideration of the range of possible reserves, recent loss trends and other factors, IBNR is established and the ultimate net liability for losses and loss expenses is determined. Such an assessment requires considerable judgment given that it is frequently not possible to determine whether a change in the data is an anomaly until sometime after the event. Even if a change is determined to be permanent, it is not always possible to reliably determine the extent of the change until sometime later. As a result, there is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves because the eventual deficiency or redundancy is affected by many factors.
The information in the "Loss and Loss Expense Reserves" table above is presented in accordance with reporting requirements of the SEC. These projected paid amounts by year are estimates based on past experience, adjusted for the effects of current developments and anticipated trends, and include considerable judgment. There is no precise method for evaluating the impact of any specific factor on the projected timing of when loss and loss expense reserves will be paid and as a result the timing and amounts of the actual payments will be affected by many factors. Care must be taken to avoid misinterpretation by those unfamiliar with this information or familiar with other data commonly reported by the insurance industry. As was noted above, for further information regarding the uncertainty associated with loss and loss expense reserves see the "Critical Accounting Policies and Estimates" section of this form 10-K.
We are rated by major rating agencies, which provide opinions of our financial strength, operating performance, strategic position, and ability to meet policyholder obligations. The principal agencies that issue financial strength ratings for the property and casualty insurance industry are: A.M. Best, S&P, Moody's Investor Service ("Moody's"), and Fitch Ratings ("Fitch"). We believe that our ability to write insurance business is most influenced by our rating from A.M. Best. Currently, we are rated "A+ (Superior)" by A.M. Best, which is their second highest of fifteen ratings. Our insurance business has been rated "A+ (Superior)" by A.M. Best for 44 consecutive years. The financial strength reflected by our A.M. Best rating is a competitive advantage in the marketplace and influences where independent insurance agents place their business. A significant downgrade from A.M. Best, could: (i) affect our ability to write new business with customers, some of whom are required (under various third party agreements) to maintain insurance with a carrier that maintains a specified minimum rating; (ii) be an event of default or increase the interest rate charged under our current lines of credit; or (iii) make it more expensive for us to access capital markets. The financial strength of our insurance business has been rated "A" by S&P since 2001, "A2" by Moody's since 2001 and "A+" by Fitch since 2004. A rating downgrade to below "A-" in the A.M. Best or S&P rating would be considered an event of default under the terms of our line of credit agreements. Ratings are an important factor in establishing our competitive position in the insurance markets. There can be no assurance that our ratings will continue for any given period of time or that they will not be changed. It is possible that positive or negative ratings actions by one or more of the rating agencies may occur in the future. We review our financial debt agreements for any potential rating triggers that could dictate a material change in terms if our credit ratings were to suddenly and drastically change.
In June 2005, the NAIC Property and Casualty Reinsurance Study Group ("Study Group") approved enhanced disclosure requirements for insurers that utilized reinsurance with limited risk transfer features, also know as finite reinsurance. These enhanced disclosure requirements have had no impact on Selective as Selective only uses traditional forms of reinsurance and does not use finite risk reinsurance. The Study Group also approved a standard reinsurance attestation supplement to be signed by an insurer's CEO and CFO attesting that there are no side agreements and that risk transfer has occurred as it applies for all contracts entered into, renewed, or amended on or after January 1, 1994. Selective will be filing these attestations for the first time on March 1, 2006 for its 2005 annual statutory filings.
Also in 2004, the FASB ratified EITF Issue No. 04-8, "The Effect of Contingently Convertible Instruments on Diluted Earnings per Share" ("EITF 04-8"). This EITF requires that instruments convertible into common stock upon the achievement of a specified price of the issuer's shares be included in diluted earnings per share computations under the if-converted method regardless of whether the triggering market conditions have been met. This EITF, which is effective for reporting periods ending after December 15, 2004, was applied by restating previously reported diluted earnings per share amounts. As a result, the Company has restated its 2003 and 2002 diluted earnings per share amounts for the inclusion of approximately 3.9 million shares related to the September 2002 issuance of Senior Convertible Notes. This restatement reduced 2003 diluted earnings per share from $2.40 to $2.20 and reduced 2002 diluted earnings per share from $1.56 to $1.53. This restatement had no effect on reported net income and there was no impact on the 2004 diluted earnings per share as these shares have been included in the diluted computation for the entire year.
investments and cash acquired of $4,890 in 2004; and $0 in 2003)
Selective Insurance Group, Inc. and its subsidiaries, ("Selective" or the "Company") offers property and casualty insurance products and diversified insurance services and products through its various subsidiaries. Selective was incorporated in New Jersey in 1977 and its main offices are located in Branchville, New Jersey. Selective's common stock is publicly traded on the NASDAQ National MarketÒ under the symbol, "SIGI."
Insurance Operations, which sells property and casualty insurance products and services primarily in 20 states in the Eastern and Midwestern United States, and has at least one company licensed to do business in each of the 50 states ;
During 2004, Selective purchased a property and casualty insurance company, domiciled in Maine, with approximately $5.0 million in surplus that was not currently writing any business, for $5.3 million. Separate pro forma information of this acquisition has not been presented, as management has determined that this acquisition is not material.
Equity securities include common stocks, while alternative investments consist primarily of limited partnerships and private equity securities. Equities securities are carried at fair value as of the balance sheet date, and alternative investments are carried using the equity method, which approximates fair value. Equity securities are classified as available-for-sale.
(2) Indebtedness: The fair value of the convertible subordinated debentures, the 1.6155% Senior Convertible Notes due September 24, 2032, the 7.25% Senior Notes due November 15, 2034, and the 6.70% Senior Notes due November 1, 2035 are based on quoted market prices. The fair values of the 8.63% Senior Notes due May 4, 2007, and the 8.87% Senior Notes due May 4, 2010 were estimated using a cash flow analysis based upon Selective's current incremental borrowing rate for the remaining term of the loan.
In adopting FAS 123R, Selective applied the modified prospective application method, which did not have a material effect on (i) income before cumulative effect of change in accounting principle and (ii) basic or diluted earnings per share before cumulative effect of change in accounting principle in 2005. At adoption, Selective recognized a cumulative effect of change in accounting principle resulting in a net income benefit of $0.5 million, which corresponded to the requirement of estimating forfeitures at the date of grant. FAS 123R also eliminated the presentation of the contra-equity account, "Unearned Stock Compensation" from the face of the Consolidated Balance Sheets, resulting in a reclassification of $14.7 million to "Additional Paid-in Capital."
The following table shows a pro forma reconciliation of net income reported under APB 25 to pro forma net income and earnings per share under FAS 123 for the years ended December 31, 2004 and December 31, 2003:
Reinsurance recoverable on paid and unpaid losses and loss expenses represent estimates of the portion of such liabilities that will be recovered from reinsurers. 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. An allowance for estimated uncollectible reinsurance is recorded based on an evaluation of balances due from reinsurers and other available information.
Policy acquisition costs directly related to the writing of insurance policies are deferred and amortized over the life of the policies. These costs include labor costs, commissions, premium taxes and assessments, boards, bureaus and dues, travel, and other underwriting expenses incurred in the acquisition of premium. The deferred policy acquisition costs are limited to the sum of unearned premiums and anticipated investment income less anticipated losses and loss expenses, policyholder dividends and other expenses for maintenance of policies in force. Selective regularly conducts reviews for potential premium deficiencies. There were no premium deficiencies for any of the reported years as the sum of the anticipated losses and loss expenses, policyholder dividends, and other expenses did not exceed the related unearned premium and anticipated investment income. The investment yields assumed in the premium deficiency assessment for each reporting period, which are based upon the Company's actual average investment yield before-tax as of the calculation date on September 30, were 4.4% for 2005, 4.6% for 2004, and 5.0% for 2003. Deferred policy acquisition costs amortized to expense were $400.6 million for 2005; $372.2 million for 2004; and $324.6 million for 2003.
Goodwill results from business acquisitions where the cost of assets acquired exceeds the fair value of those assets. Goodwill is tested for impairment annually, or more frequently if events or changes in circumstances indicate that goodwill may be impaired. Goodwill is allocated to the reporting units for the purposes of the impairment test. Selective did not record any impairments during 2005, 2004, or 2003.
The internal assumptions considered by Selective in the estimation of the IBNR amounts for both environmental and non-environmental reserves at Selective's reporting dates are based on: (i) an analysis of both paid and incurred loss and loss expense development trends; (ii) an analysis of both paid and incurred claim count development trends; (iii) the exposure estimates for reported claims; (iv) recent development on exposure estimates with respect to individual large claims and the aggregate of all claims; (v) the rate at which new environmental claims are being reported; and (vi) patterns of events observed by claims personnel or reported to them by defense counsel. External factors identified by Selective in the estimation of IBNR for both environmental and non-environmental IBNR reserves include: legislative enactments, judicial decisions, legal developments in the determination of liability and the imposition of damages, and trends in general economic conditions, including the effects of inflation. Adjustments to IBNR are made periodically to take into account changes in the volume of business written, claims frequency and severity, the mix of business, claims processing, and other items as described that are expected by management to affect Selective's reserves for losses and loss expenses over time.
By using both individual estimates of reported claims and generally accepted actuarial reserving techniques, Selective estimates the ultimate net liability for losses and loss expenses. While the ultimate actual liability may be higher or lower than reserves established, Selective believes the reserves to be adequate. Any changes in the liability estimate may be material to the results of operations in future periods. Selective does not discount to present value that portion of its loss reserves expected to be paid in future periods; however, the loss reserves include anticipated recoveries for salvage and subrogation claims. Such salvage and subrogation amounted to $46.5 million for 2005 and $48.1 million for 2004.
Short-term investments, comprised of highly liquid investments, are readily convertible into known amounts of cash and have maturities of 90 days or less from the date of purchase.
(Decrease) increase in net unrealized gains, net of deferred income tax expense
(f) The following table summarizes, for all securities in an unrealized loss position at December 31, 2005, the aggregate fair value and gross pre-tax unrealized loss recorded in Selective's accumulated other comprehensive income, by asset class and by length of time those securities have been in an unrealized loss position:
Proceeds from the sale of available-for-sale securities were $235.8 million during 2005, $279.3 million during 2004, and $245.4 million during 2003. Realized losses from investment write-downs were $1.2 million for both 2005 and 2003. There were no impairment charges recorded in 2004.
(h) The amortized cost and estimated fair value of fixed maturity securities at December 31, 2005, by contractual maturity are shown below. Mortgage-backed securities 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.
(i) Certain investments were on deposit with various state regulatory agencies to comply with insurance laws and had carrying values of $28.2 million as of December 31, 2005 and $32.2 million as of December 31, 2004.
(j) Selective is not exposed to significant concentrations of credit risk within its investment portfolio. The largest investment in the securities of any one issuer was $23.2 million at December 31, 2005 and $23.8 million at December 31, 2004.
(k) Included in alternative investments is $63.0 million in 2005 and $44.1 million in 2004 in limited partnership investments. These investments are carried using the equity method, which approximates fair value. Any change in fair value of these investments is recognized in net investment income earned in the period of change. At December 31, 2005 Selective has contractual obligations that expire at various dates through 2017 to further invest up to $64.5 million in these alternative investments. There is no certainty that any such additional investment will be required.
The following table presents the carrying amounts and estimated fair values of Selective's financial instruments as of December 31, 2005 and 2004:
Selective's consolidated financial statements reflect the effects of assumed and ceded reinsurance transactions. Assumed reinsurance refers to the acceptance of certain insurance risks that other insurance entities have underwritten. Ceded reinsurance involves transferring certain insurance risks (along with the related written and earned premiums) that Selective has underwritten to other insurance companies that agree to share these risks. The primary purpose of ceded reinsurance is to protect Selective from potential losses in excess of the amount it is prepared to accept.
A trust fund in the amount of $30.2 million as of December 31, 2005 and $29.3 million as of December 31, 2004 securing a portion of the liabilities ceded to American Re-Insurance Company is held for the benefit of Selective. Amounts ceded to American Re-Insurance Company, exceeding the available trust fund, represent 14% or $34.3 million as of December 31, 2005 and 13% or $32.9 million as of December 31, 2004 of Selective's consolidated prepaid reinsurance premiums and loss recoverable balances not secured by trust funds, letters of credit or funds withheld (collateral). In addition, about 62% of Selective's consolidated prepaid reinsurance premiums and net reinsurance recoverable balances not secured by collateral are ceded to two state or federally sponsored pools. Selective ceded $65.6 million as of December 31, 2005, and $69.2 million as of December 31, 2004 to New Jersey Unsatisfied Claims Judgment Fund. Selective also ceded $90.6 million as of December 31, 2005 and $78.9 million as of December 31, 2004 to the National Flood Insurance Program.
The insurance subsidiaries are contingently liable to the extent that any reinsurer becomes unable to meet its contractual obligations. Selective evaluates and monitors the financial condition of its reinsurers under voluntary reinsurance arrangements to minimize its exposure to significant losses from reinsurer insolvencies. On an ongoing basis, Selective reviews amounts outstanding, length of collection period, changes in reinsurance credit standing and other relevant factors to determine collectibility of reinsurance recoverables. On July 1, 2005, we entered into, and settled, a commutation agreement with one of our reinsurers that had no impact on 2005 results. The allowance for reinsurance recoverable on unpaid losses and loss expenses was $3.5 million at December 31, 2005 and $4.3 million at December 31, 2004. The allowance for reinsurance recoverable on paid losses and loss expenses was $0.5 million at December 31, 2005, with no allowance at December 31, 2004.
Under Selective's reinsurance arrangements, which are all prospective in nature, reinsurance premiums ceded are recorded as prepaid reinsurance and amortized over the remaining contract period in proportion to the reinsurance protection provided, or recorded periodically, as per terms of the contract, in a direct relationship to the gross premium recording. Reinsurance recoveries are recognized as gross losses are incurred.
Gross reserves for losses and loss expenses, at beginning of year
Gross reserves for losses and loss expenses at end of year
In 2004, the Company experienced adverse development in its loss and loss expense reserves totaling $4.9 million. This development was driven by an increase to our loss reserves in the general liability and workers compensation lines of business of $3.5 million, which was the result of rating agency downgrades of certain reinsurers during 2004, and reductions in expected bond subrogation recoveries in our bond line of business of $2.0 million. In addition, we had net favorable emergence of $0.6 million from our other lines of business, which was primarily the result of increases to our loss reserves for our general liability line of business of approximately $19 million, offset by decreases to our loss reserves for our commercial automobile line of business of approximately $20 million and minor development in other lines. The adverse development in the general liability line of business was mainly due to our contractor completed operations business. Prior to 2002, we had more exposure to faulty workmanship and materials for both the general contractors and subcontractors and inadequate limits on subcontractors. After 2002, we took extensive underwriting actions to limit our exposure. The positive development in the commercial automobile line of business was driven by a reduction in claim frequency and severity. The most significant adverse development came from accident years 1999 and 2000, which was offset by favorable development from accident years 2002 and 2003.
In 2003, adverse development of $15.0 million was driven by our general liability line of business, specifically our contractor completed operations business, which increased prior year loss estimates by approximately $18 million. Partially offsetting this development was positive development in our commercial automobile line of business of $3.0 million driven by a reduction in claim frequency and severity. The most significant adverse development came from accident years 1998 through 2000, which was offset by favorable development from accident years 2000 and 2001.
At December 31, 2005, Selective's reserves for environmental claims amounted to $45.6 million on a gross basis (including case reserves of $25.0 million and IBNR reserves of $20.6 million) and $41.8 million on a net basis (including case reserves of $25.0 million and IBNR reserves of $16.8 million). There are a total of 2,382 environmental claims, including multiple claimants who are associated with the same site or incident. Of these, 2,089 are asbestos related, of which 748 involve three insureds. The total case reserves associated with these three insureds amounted to $4.7 million on a gross and net basis. During 2005, 1,212 asbestos claims were closed, which accounted for approximately $0.9 million of the total asbestos paid of $1.2 million. The total case reserves for asbestos related claims amounted to $8.5 million on a gross and net basis. About 65 of the total environmental claims involve eight landfill sites. The landfill sites account for case reserves of $9.2 million on a gross and net basis. The remaining claims, which account for $7.4 million of case reserves on a gross and net basis, involve leaking underground storage tanks and other latent environmental exposures.
The following table provides a roll-forward of gross and net environmental incurred losses and loss expenses and related reserves thereon:
Reserves for losses and loss expenses at the beginning of year
Reserves for losses and loss expenses at the end of year
Based on its aggregate reserve for net losses and loss expenses at December 31, 2005, Selective does not expect that liabilities associated with environmental and non-environmental claims will have a materially adverse impact on its future liquidity, financial position and results of operations. However, given the complexity of coverage and other legal issues, and the significant assumptions used in estimating such exposures, actual results could significantly differ from its current estimates. The increase in paid losses in 2004 for non-asbestos environmental claims includes final payment for two large outstanding claims which were included in its 2003 case reserves.
In 2002, Selective issued $305 million aggregate principal amount of 1.6155% senior convertible notes ("Convertible Notes"), due September 24, 2032, at a discount of 61.988% resulting in an effective yield of 4.25%. Selective recorded gross proceeds of $116.0 million along with $3.2 million of deferred charges, which are amortized over the life of the note, in connection with debt issuance costs. Approximately $72.0 million of the net proceeds were used to fund an irrevocable trust, which provided for certain payment obligations in respect of Selective's outstanding debt obligations through 2005. Selective also paid a $40.0 million capital contribution to its Insurance Subsidiaries with the remainder of the net proceeds.
Interest on the Convertible Notes is payable semi-annually at a rate of 1.6155% beginning March 24, 2003 until September 24, 2009, to holders of record at the close of business on the preceding March 9 or September 9, respectively. After that date, cash interest will not be paid on the Convertible Notes prior to maturity unless contingent cash interest becomes payable. Contingent cash interest becomes payable if the average market price of a Convertible Note for the applicable five trading day period equals 120% or more of the sum of the Convertible Note's issue price, accrued original issue discount and accrued cash interest, if any, for a Convertible Note to the day immediately preceding the relevant six-month period. The contingent cash interest payable per Convertible Note in respect of any quarterly period within any six-month period will equal the greater of: (a) any regular cash dividends per share paid by Selective on its common stock during that quarterly period multiplied by the then applicable conversion rate or (b) $0.15 multiplied by 12.9783.
On October 26, 2004, in accordance with the provisions of the Indenture, Selective's Board of Directors voted to permanently waive the stock price contingency provision, which was satisfied for the quarters ended March 31, 2004 and June 30, 2004, when the price of Selective's common stock maintained a 20% premium to the conversion price of $29.29, or $35.15, for 20 of 30 consecutive trading days ending on the last day of each of these respective quarters. If all of the Convertible Notes were converted, Selective would be required to issue 3.9 million shares of common stock. No such conversions occurred during 2005 or 2004.
Selective has various covenants under the Indenture dated September 24, 2002, which include, but are not limited to, timely payment of securities, timely filing of SEC and other reports, and compliance with securities laws upon purchase of securities.
(3) On May 4, 2000, Selective entered into a $30.0 million and a $61.5 million note purchase agreement with various private lenders covering the 8.63% and 8.87% Senior Notes, respectively.
The Convertible Subordinated Debentures were issued under an Indenture dated December 29, 1982, (the "1982 Indenture") in the principal amount of $25.0 million, bearing interest at a rate of 8.75% per annum, which is payable on the unpaid principal semiannually on January 1 and July 1 in each year to holders of record at the close of business on the preceding December 15 and June 15, respectively. The Debentures are convertible into common stock at an effective conversion price of $7.08 per share. The principal amount of the Debentures, $0.8 million at 2005 and $1.0 million at 2004, including any accrued interest, is due on January 1, 2008 and is included in other liabilities on the consolidated balance sheets.
The 1982 Indenture requires Selective to retire, through the operation of a mandatory sinking fund, 5% of the original $25.0 million aggregate principal amount of the debentures on or before December 31 of each of the years from 1993, to and including, 2006. Voluntary conversions have satisfied this obligation in its entirety.
Selective has revolving lines of credit with State Street Corporation of $20.0 million, and Wachovia Bank of $25.0 million, totaling $45.0 million at both December 31, 2005 and December 31, 2004. At December 31, 2005 and 2004, there were no balances outstanding on either line of credit. Interest is determined on a LIBOR, prime rate or money market rate basis at Selective's option. There were no borrowings in 2005 against the lines of credit. The weighted average interest rate on borrowings was 1.74% in 2004.
Effective April 26, 2005, the Board of Directors: (i) approved a new plan to repurchase up to 5.0 million shares of Selective common stock through April 26, 2007; and (ii) cancelled the existing stock repurchase program, under which Selective was authorized to repurchase 2.4 million shares through November 30, 2005. Under the new plan, Selective repurchased approximately 335,000 shares at a cost of $16.3 million during 2005. In 2004, under the canceled plan, Selective acquired 141,000 shares at a cost of $4.9 million. No shares were repurchased in 2003.
Shares repurchased in conjunction with restricted stock vestings and option exercises were approximately 113,000 shares at a cost of $6.6 million in 2005, 103,000 shares at a cost of $3.8 million in 2004, and 100,000 shares at a cost of $2.5 million in 2003.
Selective's ability to declare and pay dividends on its common stock is affected by the ability of its subsidiaries to declare and pay dividends to the parent holding company. The dividends from Selective's SHRS subsidiary are restricted only by the operating cash flows of such subsidiary. The dividends from Insurance Subsidiaries are under the regulatory limitations of the state in which the particular Insurance Subsidiary are domiciled: New Jersey, New York, North Carolina, South Carolina, or Maine.
On February 2, 1999, Selective's Board of Directors approved an amended and restated stockholder rights plan. The rights to purchase one two-hundredth of a share of Selective Series A Junior Preferred Stock at an exercise price of $80 are attached to all shares of Selective common stock and are exercisable ten days after an announcement that a person or group has acquired 15% or more of the common stock ("Acquiring Person") or ten business days after a person commences or announces its intent to make a tender offer which would result in their becoming an Acquiring Person. If a person or group becomes an Acquiring Person, each right will entitle the holder, other than the Acquiring Person, to purchase the number of Selective common shares having a market value of two times the exercise price of $80.
Before an Acquiring Person acquires 50% or more of the common shares, Selective's Board of Directors may exchange rights, other than the rights of an Acquiring Person, at an exchange ratio of one share of common stock per right. The rights expire February 2, 2009 unless Selective's Board of Directors redeem them at $0.01 per right before the plan is triggered, or unless Selective's Board of Directors exchanges them for common stock.
Selective has classified its operations into three segments, the disaggregated results of which are reported to and used by senior management to manage Selective's operations:
• Insurance Operations (commercial lines and personal lines), which are evaluated based on statutory underwriting results (net premiums earned, incurred losses and loss expenses, policyholders dividends, policy acquisition costs, and other underwriting expenses) and statutory combined ratios;
• Diversified Insurance Services (flood insurance and human resource administration outsourcing), which, because they are not dependent on insurance underwriting cycles, are evaluated based on several measures including, but not limited to, results of operations in accordance with GAAP.
Selective does not aggregate any of its operating segments. The Insurance Operations and Diversified Insurance Services segments share a common marketing or distribution system and create new opportunities for independent agents to bring value-added services and products to their customers. Selective's commercial and personal lines property and casualty insurance products, flood insurance, and human resource administration outsourcing products are principally sold through appointed independent insurance agents.
Selective's Insurance Operations and Diversified Insurance Services segments are subject to geographic concentration. Approximately 34% of net premiums written are related to insurance policies written in New Jersey and 39% of SHRS' co-employer service fees are related to business in Florida. Substantially all of Selective's remaining revenues come from the states of Connecticut, Delaware, Georgia, Illinois, Indiana, Iowa, Kentucky, Maryland, Michigan, Minnesota, Missouri, New York, North Carolina, Ohio, Pennsylvania, Rhode Island, South Carolina, Virginia, and Wisconsin. Consequently, changes to economic or regulatory conditions in these states could adversely affect Selective.
The "other" benefit in 2004 was primarily due to a reduction to the Company's current federal income taxes payable as a result of a favorable resolution of an IRS appeals issue. The IRS had attempted to disallow, on a consolidated basis, a deduction for interest expense incurred by the Parent while its Insurance Subsidiaries held municipal bonds. The Company established reserves over the course of the examination as follows: $0.9 million in 2003, $1.2 million in 2002, and $0.2 million in prior years. A notice that the issue was resolved in the Company's favor was received on September 30, 2004, at which time the entire accrual was reversed.
Stockholders' equity reflects tax benefits related to compensation expense deductions for stock options exercised of $9.6 million at December 31, 2005, $5.9 million at December 31, 2004, and $3.4 million at December 31, 2003.
In December 2005, Selective divested itself of its 100% ownership interest in CHN Solutions (Alta Services, LLC and Consumer Health Network Plus, LLC), which had historically been reported as part of the "Managed Care" component of the Diversified Insurance Services segment. Selective sold its interest in CHN Solutions for proceeds of $16.4 million, which produced an after tax loss of $2.6 million. This loss, which is net of a tax benefit of $1.4 million, is included in discontinued operations on the consolidated statements of income. Also included in discontinued operations on the consolidated statements of income are after tax profits of $3.2 million in 2005, $1.5 million in 2004, and $2.0 million in 2003 from the operations CHN prior to divestiture. Taxes on these operating profits amounted to $1.7 million in 2005, $0.8 million in 2004, and $1.0 million in 2003.
As part of the divestiture, Selective entered into an agreement with the buyer, wherein Selective has agreed to continue to utilize the managed care services of CHN Solutions in processing claims for its workers compensation and automobile policies issued by Selective in the State of New Jersey. This agreement is effective until December 2010 and can be terminated by either party for the following reasons: (i) breach of contract; (ii) insolvency or a change in control; or (iii) performance standards as outlined in the agreement.
Selective has reclassified prior period amounts on the consolidated financial statements to present the assets, liabilities, and operating results of CHN as a discontinued operation.
Selective terminated, effective December 31, 1997, a nonqualified defined benefit retirement income plan for nonemployee Directors. The estimated accrued costs for this plan were not material. As part of the termination, the present value of each Director's future benefits, as of that date, was converted into units based on the fair value of Selective common stock. The original termination called for the cash value of these units based upon the fair value of Selective common stock on retirement date to be distributed to each Director, or at each Director's election, over a period of fifteen years after such retirement. On May 8, 2002, the stockholders approved the conversion of the units issued under the termination plan into shares of Selective stock. All of the shares issued under this conversion have been deferred by the participants for receipt upon retirement, or at each Director's election, over a period of no more than five years after such retirement. These deferred shares, which are currently being held in accounts on behalf of each Director, are credited with cash dividends along with interest on those dividends. The adoption of FAS 123R resulted in a reclassification of $1.3 million to "Additional Paid-in Capital" on the consolidated balance sheet for these deferred shares. At December 31, 2005, Additional Paid-in Capital for these deferred shares was $1.1 million. The prior years' accrued liability of these deferred shares of stock accounted for under APB 25 and the related dividend and interest earnings was $1.4 million at December 31, 2004 and $1.5 million at December 31, 2003.
Selective offers a voluntary defined contribution 401(k) retirement savings plan to employees who meet eligibility requirements. Participants, other than highly compensated employees as defined by the IRS, can contribute 50% of their defined compensation to the Retirement Savings Plan. Highly compensated employees are limited to 8% of their defined compensation. Contributions by participants are matched 65% by the Company up to a maximum of 7% of defined compensation. Effective January 1, 2006, Selective's Retirement Savings Plan was amended to include additional enhanced matching contributions and non-elective contributions for otherwise eligible employees who, because of a date of hire after December 31, 2005, are not eligible for the Retirement Income Plan. For those employees, following one year of service, the Company will also match, dollar for dollar, up to 2% of the employee's base pay contributions. In addition, the Company will make non-elective contributions to the Retirement Savings Plan equal to 2% of the employee's base pay effective with the first pay following one year of service.
In all plans, employees age 50 or older who are contributing the maximum may also make additional contributions not to exceed the additional amount permitted by the IRS.
Selective offers a nonqualifed deferred compensation plan ("Deferred Compensation Plan") to a group of management or highly compensated employees (the "Participants"). The Deferred Compensation Plan provides the Participants the opportunity to elect to defer receipt of specified portions of compensation and to have such deferred amounts treated as if invested in specified investment options as a method of rewarding and retaining such employees. A Participant in the Deferred Compensation Plan may elect to defer compensation or awards to be received from Selective or an affiliated entity, including up to: (i) 50% annual base salary; (ii) 100% of incentive compensation; and/or (iii) a percentage of other compensation as otherwise designated by the Administrator of the Deferred Compensation Plan.
In addition to the deferrals elected by the Participants, Selective may choose at any time to make discretionary contributions on a consistent basis to the deferral accounts of all Participants in its sole discretion. No discretionary contributions were made in 2005, 2004, or 2003. Selective may also choose to make matching contributions to the deferral accounts of some or all Participants to the extent a Participant did not receive the maximum matching contribution permissible under Selective's Retirement Savings Plan due to limitations under the Internal Revenue Code or the Retirement Savings Plan.
The Company contributed $0.4 million in 2005 and $0.3 million in 2004 and 2003 to the Deferred Compensation Plan.
Effective January 1, 2006, the Retirement Income Plan was amended to eliminate eligibility for plan participation by employees hired on or after January 1, 2006. If otherwise qualified, these employees will, however, be eligible for enhanced matching and non-elective Company contributions under the Retirement Savings plan.
Selective has incentive compensation plans in which employees are eligible to participate based on corporate and individual performance goals. The total compensation costs charged to expense in connection with the plans were $21.8 million in 2005, $16.7 million in 2004, and $13.0 million in 2003.
The following is a brief description of each of Selective's share-based compensation plans:
As of December 31, 2005, 412,589 shares of Selective's common stock remain available for issuance pursuant to outstanding stock options and restricted stock awards granted under Stock Option Plan II, under which future grants ceased being available on May 22, 2002. Under Stock Option Plan II, employees were granted qualified and nonqualified stock options, with or without stock appreciation rights ("SARs"), and restricted or unrestricted stock at (i) not less than fair value on the date of grant and (ii) subject to certain vesting periods as determined by the SEBC. Restricted stock awards also could be subject to the achievement of performance objectives as determined by the SEBC. The maximum exercise period for an option grant under this plan is ten years from the date of the grant. Selective experienced restricted forfeitures under the plan of 6,800 shares during 2005, 14,538 shares during 2004, and 31,348 shares during 2003.
Selective also granted 313,108 restricted shares during 2005, 328,684 restricted shares during 2004, and 264,069 restricted shares during 2003 and experienced forfeitures of 24,015 shares during 2005, 27,434 shares during 2004, and 10,667 shares during 2003. During the vesting period, dividends earned on restricted shares are reinvested in Selective's common stock at fair value. Selective issued, net of forfeitures, 13,521 restricted shares from the dividend reinvestment plan reserves during 2005, 10,005 restricted shares during 2004, and 5,882 restricted shares during 2003.
As of December 31, 2005, 276,000 shares of Selective's common stock were available for issuance pursuant to outstanding stock option awards under the Stock Option Plan for Directors, under which future grants ceased being available with the approval of the Stock Plan. All non-employee directors participated in this plan and automatically received an annual nonqualified option to purchase 3,000 shares of common stock at not less than fair value on the date of grant, which is on March 1. Options under this plan vest on the first anniversary of the grant and must be exercised by the tenth anniversary of the grant. Under the Stock Option Plan for Directors, Selective granted 33,000 options during 2005, and 30,000 options during 2004 and 2003.
As of December 31, 2005, there were 47,625 shares of the common stock available for issuance pursuant to outstanding stock option awards under the Stock Compensation Plan for Nonemployee Directors, under which future grants ceased being available with the approval of the Stock Plan. Under the stock Compensation Plan for Nonemployee Directors, Directors could elect to receive a portion of their annual compensation in shares of Selective's common stock. Selective issued 10,919 shares during 2005, 13,774 shares during 2004, and 9,085 shares during 2003 under this plan.
Under Selective's Employee Stock Purchase Plan ("ESPP"), there are 223,903 shares of common stock available for purchase as of December 31, 2005. The ESPP is available to all employees who meet its eligibility requirements. The ESPP provides for the issuance of options to purchase shares of common stock. The purchase price is the lower of: (i) 85% of the closing market price at the time the option is granted or (ii) 85% of the closing price at the time the option is exercised. Shares are generally issued on June 30 and December 31 of each year. Under the ESPP, Selective issued 44,379 shares to employees during 2005, 49,780 shares during 2004, and 66,463 shares during 2003.
The total intrinsic value of options exercised was $7.4 million at December 31, 2005, $6.8 million at December 31, 2004, and $3.3 million at December 31, 2003.
Share-based compensation expense charged against net income before cumulative effect of change in accounting principle before tax was $11.0 million at December 31, 2005 with a corresponding income tax benefit of $3.3 million. As part of the 2005 divestiture of CHN Solutions, unvested restricted stock awards were modified, resulting in a cash payment of $1.0 million in lieu of issuing shares. In addition, accelerated share based compensation of $0.4 million after tax, is included in "Loss on Disposal of Discontinued Operations, net of tax" on the 2005 Consolidated Statements of Income. See Note 13, "Discontinued Operations," for additional information regarding the divestiture. Share-based compensation expense that was charged against income before tax was $8.1 million for the year ended December 31, 2004 and $5.4 million for the year ended December 31, 2003 with a corresponding income tax benefit of $2.8 million for the year ended December 31, 2004 and $1.9 million for the year ended December 31, 2003.
In August 1998, certain officers of Selective purchased stock on the open market with proceeds advanced by Selective. These officers gave Selective promissory notes totaling $1.8 million. The notes bear interest at 2.5% and are secured by the purchased shares of Selective's common stock. The promissory notes are full recourse and subject to certain employment requirements. The principal amount outstanding was $0.3 million at December 31, 2005 and $0.4 million at December 31, 2004. These outstanding balances are reflected in "other assets" on the Consolidated Balance Sheets.
The Rue Agency placed insurance policies with Selective's insurance subsidiaries. Direct premiums written associated with these policies was $10.2 million in 2005, $9.9 million in 2004, and $9.2 million in 2003. In return, Selective's insurance subsidiaries paid commissions to the Rue Agency $1.9 million in 2005, $1.8 million in 2004, and $1.6 million in 2003.
(b) Selective has 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 $10.0 million in 2005, $9.7 million in 2004 and $9.3 million in 2003.
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. As of December 31, 2005 the various state insurance departments of domicile have adopted the NAIC Accounting Practices and Procedures manual, version as of March 2005, in its entirety, as a component of prescribed or permitted practices.
Selective's combined statutory capital and surplus of the Insurance Subsidiaries was $930.6 million (unaudited) in 2005 and $807.9 million in 2004. Selective's combined statutory net income of the Insurance Subsidiaries was $139.3 million (unaudited) in 2005, $135.0 million in 2004, and $53.8 million in 2003.
The Insurance Subsidiaries are required to maintain certain minimum amounts of statutory surplus to satisfy its various state insurance departments of domicile. These risk-based capital ("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. Based upon the Insurance Subsidiaries 2005 unaudited statutory financial statements, their combined total adjusted capital exceeded the authorized control level RBC by 5.4:1, as defined by the NAIC.
2. See Note 13 to the consolidated financial statements for a discussion of discontinued operations.
not include retail markups, markdowns and commissions. The range of high and low prices for common stock for the period beginning January 1, 2006 and ending February 28, 2006 was $52.90 to $58.36 and the last sale price on February 28, 2006 was $54.22.