(5) Our 2007 average diluted shares reflect the repurchase of 13.6 million shares pursuant to a Rule 10b5-1 trading plan and 3.4 million shares as a result of open market purchases. 2007 also includes (0.9) million shares issued to settle an accelerated share repurchase settlement.
(6) Combined ratios are calculated on a GAAP basis. Expressed as a percentage, combined ratios equal losses and expenses divided by net earned premiums.
(Dollar amounts in millions except for ratios, per-claim data and per-share data, unless noted otherwise)
We believe it is important to communicate our expectations to investors. However, there may be events in the future that we are not able to predict accurately or that we do not fully control, which could cause actual results to differ materially from those expressed or implied by our forward-looking statements, including changes in general economic and business conditions, changes in the insurance industry and changes in our business strategies. Investors should bear this in mind as they consider forward-looking statements. Additional information on factors that may impact our forward-looking statements are included under “Risk Factors” and elsewhere in this Form 10-K.
We have been in business serving the insurance needs of our customers since 1923. Safeco Corporation is an insurance holding company. We are licensed to provide property and casualty insurance along with related services to individuals and small to mid-size businesses in all 50 states through our insurance subsidiaries. We also sell surety bonds to contractors and businesses. Our revenues come primarily from the premiums we earn on the insurance policies we write and the income we earn from our investment of premium dollars.
We sell our insurance products principally through independent agents and deliver the majority of our products over our Safeco Now® automated platform. Safeco Now gives our agents a single point of entry to sell our core property and casualty products and select transactional surety bonds in a matter of minutes. Most of our pricing, underwriting and servicing processes are presented through this platform. Consumers can also purchase certain policies online at www.Safeco.com. Today, over 95% of our personal lines and small commercial business lines are automated and priced based on predictive models.
We manage our business through four segments, Safeco Personal Insurance, Safeco Business Insurance, Surety and P&C Other.
Exercised careful stewardship of our invested assets, generating net investment income of $486.7, with no subprime exposure; and
Our long-term focus remains to pursue growth only where we see opportunities to maintain overall underwriting profitability. Net written premiums overall remained essentially flat in 2007 compared with the prior year as growth in Property, SBI Regular and Surety were offset by a decline in Auto. This reflects a combination of softness in rates and our unwillingness to write risks at prices we believe to be uneconomic. We expect the rate environment for each of our business segments in 2008 to be similar to that of 2007, with some opportunity for selective rate increases. As a result, we do not expect overall significant net written premium growth in 2008 compared with 2007.
The premium growth in our SBI Regular segment was due in part to automating several products on the Safeco Now platform as well as the mix of the coverages our customers chose and the nature of the risk. We do not intend to write business when pricing or risk factors indicate we will be putting our target returns at risk, which could limit our growth opportunities.
We manage our businesses in four business and seven reportable segments:
Investment activities are an important part of our business. We don’t include our investment portfolio results when measuring the profitability of our individual segments because we manage them separately. Our first priority is to meet our promise to our policyholders that we will maintain resources to pay their claims. We invest the insurance premiums we receive in a diversified portfolio of primarily high-grade fixed maturities in the event they are needed to pay claims. This strategy is designed to provide protection for our policyholders and a steady income for our shareholders.
We measure our investment results in two parts: the after-tax net investment income we earn on our invested assets; and the net realized investment gains or losses we recognize when we sell or impair investments. It is our intent to hold a conservatively invested but diversified portfolio so we will achieve consistent investment performance.
More information about our investment results can be found in Our Investment Results section of Item 7: MD&A.
Net earned premiums - Our net earned premiums decreased 0.6% in 2007 compared with 2006, and decreased 3.4% in 2006 compared with 2005. The decrease in net earned premiums in 2007 compared with 2006 reflects decreases in Auto partially offset by growth in Property, SBI Regular and Surety. In 2007 and 2006, Auto premiums decreased in the face of increased competitive pressures, as some of our competitors have increased advertising for auto insurance to attract customers, offered incentives to agents and lowered prices to attract new auto business. Despite increasing competitive pressures, we remain disciplined in our underwriting and continue to strive toward our long-term profitability targets. In 2006, SBI Regular growth also slowed in the face of increased competitive pressures. In addition, net earned premiums decreased by $76.4 due to the sale of our lender-placed property insurance business in 2006.
Gains on sales of real estate - In connection with our real estate strategy, we sold various real estate properties in 2006 for total proceeds of $372.1 and a pretax gain of $168.7.
Losses and Loss Adjustment Expenses - Losses and loss adjustment expenses increased 7.3% in 2007 compared with 2006 due primarily to increased bodily injury costs in Auto, and decreased 9.8% in 2006 compared with 2005 primarily due to fewer-than-expected bodily injury and uninsured motorist claims. In 2007, we reduced our estimates for prior years’ loss and LAE reserves by $123.6, primarily due to favorable prior-year reserve development in our personal auto, construction defects, workers’ compensation and surety lines. In 2006, we reduced our estimates for prior years’ loss and LAE reserves by $146.2, reflecting favorable prior-year reserve development in our personal auto and SBI segments, compared with $45.9 of favorable prior-year reserve development in 2005. The favorable prior-year reserve development in 2005 was related to our personal property, personal auto and commercial auto reserves. In addition, LAE were impacted by catastrophe losses described below.
Other Underwriting and Operating Expenses - Other Underwriting and Operating Expenses decreased 8.3% in 2007 compared with 2006 due primarily to a decrease in payroll and employee benefit related expenses. The increase of 4.4% in 2006 compared with 2005 was primarily related to increased spending in technology and business process improvements partially offset by a decrease in payroll and employee benefit related expenses.
Contributions to the Foundation - We made contributions to the Foundation with a non-revocable, non-refundable contribution of appreciated marketable equity securities with a fair value of $60.0 and a cost of $2.1 in 2007, compared with a fair value of $30.0 and a cost of $0.8 in 2006. No such contribution was made in 2005.
Losses on debt repurchases -We repurchased $545.9 in principal amount of debt in 2007, $57.0 in 2006 and $25.9 in 2005. Including transaction costs, these debt repurchases resulted in pretax losses of $16.6 in 2007, $4.5 in 2006 and $4.0 in 2005.
Restructuring and asset impairment charges - During 2007, we completed our organizational design initiative and our real estate consolidation strategy. Our pretax restructuring and asset impairment charges were $3.1 in 2007 compared with $25.7 in 2006 and $2.7 in 2005.
Gains on sales of real estate - After-tax net gains on sales of real estate were $109.6 in 2006. There were no such gains in 2007 or 2005.
The decrease in our other underwriting and operating expenses in 2007 compared with 2006 primarily reflects the implementation of our organizational design and business process improvement initiatives, which have decreased our headcount and related costs, increased productivity, and reduced our dependence upon outside legal counsel. The overall decrease was offset primarily by increased agent commissions, increased advertising in targeted markets and additional professional services attributable to our business process improvement initiatives.
The following table assists in reconciling our GAAP results, specifically the “Income before Income Taxes” line from our Consolidated Statements of Income to our operating results:
We view net written premiums as a measure of business production for the period under review and a leading indicator of net earned premiums. The following table reconciles net written premiums to net earned premiums by reportable segment, the most directly comparable GAAP measure on our Consolidated Statements of Income:
Underwriting profit or loss is our measure of each segment’s performance. Underwriting profit or loss is our net earned premiums less our losses from claims, LAE and underwriting expenses:
Combined ratios show the relationship between underwriting profit or loss and net earned premiums. Using ratios helps us see our operating trends without the effect of changes in the volume of net earned premiums:
* Not meaningful because this is a run-off business with declining premium.
Changes in average premiums - Our earned rate changes, combined with premium trend, increased our Auto combined ratio by 0.7 points in 2007 compared with 2006, and increased our Auto combined ratio by 1.4 points in 2006 compared with 2005.
Loss costs - We experienced percentage increases in the mid-single digits in our loss costs in 2007 compared with 2006. This was driven by a mid-single-digit percentage increase in severity (the average cost of a claim) while frequency (the average number of claims filed) remained flat. This was due primarily to higher costs for bodily injury and personal injury protection claims. These factors, net of reinsurance, increased our combined ratio by 5.0 points in 2007 compared with 2006. Our loss costs decreased our combined ratio by 1.8 points in 2006 compared with 2005. This was in part due to fewer-than-expected bodily injury and uninsured motorist claims.
Catastrophe losses - The lower catastrophe losses decreased the combined ratio by 0.8 points in 2007 compared with 2006, and the higher catastrophe losses increased the combined ratio by 0.3 points in 2006 compared with 2005.
Net written premiums increased $48.2, or 5.2%, in 2007 compared with 2006, and increased $16.0, or 1.8%, in 2006 compared with 2005. This reflected:
Changes in average premiums - We file rate changes on a state-by-state basis. Rate changes are reflected on existing policies on renewal and are earned in our revenues over the twelve-month policy term. Overall we received approval for average rate decreases in our homeowners business of 3.8% in 2007, 2.9% in 2006 and average rate increases of 1.0% in 2005. Average premiums also are affected by automatic increases in the amount of insurance coverage to adjust for inflation in building costs and by shifts in the mix of our business, which we refer to as premium trend. For example, a shift in our mix of business between homeowners’ and renters’ coverage could impact our premium trend because renters’ coverage yields a much lower average premium. Premium trend resulted in an increase to net written premiums in 2007 compared with 2006, due in part to inflation guard increases and new business from higher average premium states.
Changes in average premiums - Changes in average premiums decreased net earned premiums by $13.6 in 2007 compared with 2006 and decreased net earned premiums by $9.2 in 2006 compared with 2005.
Changes in average premiums - Our homeowners rate changes, combined with premium trend, increased our Property combined ratio by 0.6 points in 2007 compared with 2006, and increased our combined ratio by 0.5 points in 2006 compared with 2005.
Loss costs - Our Property loss costs in 2007 compared with 2006 experienced percentage increases in the mid teens due to mid-single digit percentage increases in frequency, resulting from an increased number of non-catastrophe weather claims during the year, and percentage increases in the low teens in severity due to a number of non-catastrophe large fire losses. These factors, net of reinsurance, increased our Property combined ratio by 7.1 points in 2007 compared with 2006. Net of reinsurance, loss costs increased our Property combined ratio by 1.7 points in 2006 compared with 2005, due to increases in severity from the increased cost of building materials.
Prior-year reserve development - The favorable prior-year reserve development in 2007 and in 2006 was due to lower-than-expected severity for homeowners claims. The favorable prior-year reserve development in 2005 (including unfavorable prior-year reserve development of $10.5 in our estimates of the 2004 hurricanes in Florida and surrounding states), reflected better-than-expected experience in our estimates of loss costs, primarily for accident years 2003 and 2004. The change in prior-year reserve development increased the combined ratio by 0.6 points in 2007 compared with 2006 and by 0.5 points in 2006 compared with 2005.
Expenses - Our expense ratio decreased by 0.2 points in 2007 compared with 2006, due to the results of ongoing process improvement efforts and expense reduction initiatives, partially offset by increased agent compensation in our homeowners product line. Increased investment in technology and costs related to the implementation of our process improvement efforts increased our expense ratio by 0.9 points in 2006 compared with 2005.
Outlook - We remain focused on our business process improvement efforts and goal of streamlining processes while building our infrastructure and technological capabilities. Our use of our multi-variate predictive underwriting model and our adherence to our catastrophe management guidelines set the course for us to continue to operate at or below our long-term target combined ratio of 92.0% in 2008.
Net earned premiums increased $10.5, or 10.0%, in 2007 compared with 2006 and $7.3, or 7.4%, in 2006 compared with 2005.
Our underwriting profit decreased $11.3, and our combined ratio increased 12.2 points in 2007 compared with 2006. Our underwriting profit increased $22.1, and our combined ratio decreased 20.5 points in 2006 compared with 2005. The changes in our underwriting results and combined ratio were primarily driven by:
Prior-year reserve development - The unfavorable prior-year reserve development in 2007 was primarily related to umbrella policies and specialty vehicles. The favorable prior-year reserve development in 2006 was related to reduced estimates of catastrophe losses from Hurricane Wilma as well as better-than-expected frequency for 2005 umbrella claims. These changes in prior-year reserve development increased our combined ratio by 14.7 points in 2007 compared with 2006 and decreased our combined ratio by 9.5 points in 2006 compared with 2005.
Catastrophe losses - The negative catastrophe losses in 2006 and 2007 were due to reduced estimates of pretax catastrophe losses from Hurricane Wilma. The 2005 catastrophe losses were primarily due to Hurricanes Katrina, Rita and Wilma in the Gulf States. Excluding prior-year reserve development, higher catastrophe losses increased the combined ratio by 0.2 points in 2007 compared with 2006. Lower catastrophe losses in 2006 decreased the combined ratio by 9.6 points compared with 2005.
Expenses - The decrease in our expense ratio of 1.9 points in 2007 compared with 2006 was due to our ongoing process improvement efforts and expense reduction initiatives. The increase in our expense ratio was 1.6 points in 2006 compared with 2005 and primarily reflected our increased investment in technology and costs related to the implementation of our strategic goals as well as higher commission expense due to change in mix of business.
Changes in PIF - PIF increased 2.5% in 2007 compared with 2006, and decreased 1.1% in 2006 compared with 2005. This reflected retention rates of 81.8% in 2007, 79.5% in 2006 and 80.0% in 2005. Our new policies sold increased 6.7% in 2007 compared with 2006 and 3.0% in 2006 compared with 2005.
Mix of business - In addition to price changes, premiums are impacted by changes in average policy size and mix of coverages our customers choose as well as the nature of the risk.
Net earned premiums increased $52.4, or 4.2%, in 2007 compared with 2006, and decreased $26.8, or 2.1%, in 2006 compared with 2005. The changes in net earned premiums were driven by:
Our underwriting profit in SBI Regular decreased $30.4, and our combined ratio increased 2.8 points in 2007 compared with 2006. Our underwriting profit increased $17.5, and our combined ratio decreased 1.6 points in 2006 compared with 2005. The changes in our underwriting results and combined ratio primarily reflected:
Loss costs - We booked a provision for increased severity for all lines in 2007 which added 4.7 points to the combined ratio compared with 2006. Large property losses in our BOP product and auto liability claims were key drivers of this increase. In contrast, loss cost increases in accident year 2006 added 1.2 points to its combined ratio compared with 2005.
Special Accounts Facility also provides insurance for the following commercial programs:
Net written premiums decreased $17.9, or 6.7% in 2007 compared with 2006 and $7.6, or 2.8%, in 2006 compared with 2005. Net written premiums decreased in 2007 due to competitive market conditions which continue to exert downward pressure in this segment. Net written premiums decreased in 2006 compared with 2005 due to a slight decrease in average premiums, rate decreases and a slight decrease in policies-in-force.
Expenses - Our expense ratio decreased 1.7 points in 2007 compared with 2006 due to a reduction in agent bonus commissions. Our expense ratio increased by 4.8 points in 2006 compared with 2005 primarily due to an increase in bonus commissions related to our social services program.
Net written premiums increased $61.8, or 18.9%, in 2007 compared with 2006, and $47.9, or 17.2%, in 2006 compared with 2005. The increases in net written premiums over the past two years were driven by growth in large contract new business and focus on our highest credit quality accounts. Favorable market conditions for construction and economic expansion fueled the growth in large contract business in both years.
Outlook - Industry results were again stable in 2007. As a result, we expect the surety market to remain healthy in 2008. We expect that infrastructure improvement needs will drive demand. However, current economic uncertainty may alter our risk assessments and temper future growth. Overall, we expect our growth rates to moderate and we anticipate some shift from the historically low level of loss experience in 2007 back to more typical losses in 2008.
Large-commercial business accounts in run-off and specialty programs that we have exited
Net written premiums decreased $69.0, or 94.9%, in 2007 compared with 2006 and $83.4, or 53.4%, in 2006 compared with 2005. Net earned premiums decreased $72.6, or 98.6%, in 2007 compared with 2006 and $83.7, or 53.2%, in 2006 compared with 2005. The decreases in 2007 compared with 2006 were due to the sale of SFIS. Net written premiums related to this business were $71.9 in 2006 through the sale date of April 30, 2006, compared with $148.6 in 2005. Net earned premiums were $72.3 in 2006 compared with $148.7 in 2005.
SFIS - Our 2006 underwriting results included the results of SFIS through April 30, 2006. SFIS underwriting profit was $10.8 in 2006 compared with an underwriting loss of $46.1 in 2005. Catastrophe losses for SFIS were $(0.4) in 2006 compared with losses of $53.3 in 2005. The higher catastrophe losses in 2005 were primarily due to Hurricanes Katrina, Rita and Wilma in the Gulf States.
25.6% of our reinsurance recoverables were due from state and mandatory reinsurance pools
88.6% of the remaining amounts due from our reinsurers outside the mandatory pools were due from reinsurers rated A- or higher by A.M. Best
Property Catastrophe Reinsurance - Our property catastrophe reinsurance reduces the financial impact a catastrophe could have on our personal and commercial property insurance lines. Catastrophes involve multiple claims and policyholders. We cannot accurately predict catastrophes, and the number and type of catastrophes can vary widely. The resulting losses could significantly impact our results.
For events other than earthquake, the entire amount above $600.0 is ours.
The first $200.0 of any property catastrophe loss was entirely ours. This is our retention - the amount of losses we absorb before the reinsurers reimburse us.
Workers’ Compensation Reinsurance - Our workers’ compensation reinsurance reduces the financial impact a catastrophe loss or a single event may have on our results. Our catastrophe treaty protects us against losses that involve multiple claims and policyholders. Additionally, we purchase reinsurance specifically for the working layer (layers where we expect to have losses). Both treaties are excess-of-loss reinsurance.
The first $5.0 of any workers’ compensation loss is our retention.
Commercial Property Reinsurance - We purchase reinsurance specifically for the working layer (layers in which we expect to have losses) on our commercial property. Our commercial property reinsurance reduces the financial impact that any single loss can have on us. It is excess-of-loss reinsurance.
The terms of our commercial property reinsurance in 2007 and 2008 are:
The treaty is structured in three $5.0 layers. We are granted free reinstatements at each layer as follows: three for layer 1; two for layer 2 and one for layer 3.
Commercial Umbrella Reinsurance - Our commercial umbrella reinsurance reduces the financial impact of losses in this line of our business. We provide our customers with umbrella insurance to cover losses that exceed the amounts covered by other insurance policies they own. For our commercial umbrella business, we have excess-of-loss reinsurance.
Our reinsurer reimburses us for 80% of the next $16.0 for each commercial umbrella loss on each policy.
Surety Reinsurance - For our surety business, we have excess-of-loss reinsurance.
Our reinsurers reimbursed us 80% of the next $80.0 of the loss under each of the three layers of coverage.
On December 26, 2007, President Bush signed into law the Terrorism Risk Insurance Program Reauthorization Act of 2007 (“TRIPRA”). TRIPRA keeps in place the basic framework of the Terrorism Risk Insurance Act (“TRIA”) enacted in 2002 and extended in 2005 by the Terrorism Risk Insurance Extension Act (“TRIEA”), while amending the law in certain key ways to clarify the program and enhance its scope. TRIPRA reauthorizes the federal terrorism risk insurance program for an additional seven years, until December 31, 2014. In order to trigger inclusion within the federal program, an act of terrorism must result in aggregate industry insured losses of at least $100 million. TRIPRA retains the current $100 million trigger throughout the seven-year duration.
U.S. Government Funding - Under TRIPRA, the U.S. Government will provide funding to the insurance industry if a terrorist attack is certified as such by the Secretary of the Treasury in concurrence with the Secretary of State and Attorney General of the United States. Each property-casualty insurer that has insured losses is required to retain and pay insured losses from an act (or acts) of terrorism during a program year equal to 20% of its prior calendar year direct earned premium for covered commercial property-casualty lines. Above that individual deductible, or “retention,” each insurer must pay 15 cents on each dollar of its insured losses up to the annual program cap of $100 billion in aggregate insured losses, with the federal government responsible for paying the other 85 cents on the dollar. The program is capped at $100 billion in annual aggregate insured losses, with Treasury prohibited from making payment for any portion of losses exceeding that amount, and insurers that have met their deductibles having no liability for the payment of any portion of such excess losses. TRIPRA adds language clarifying that an insurer’s financial responsibility is limited to its applicable deductible and co-share only up to the annual program cap. Additional amendments also clarify that the $100 billion in annual aggregate losses is a hard cap.
Terrorism Exclusions -The definition of “act of terrorism” has been altered to remove the requirement that an act be committed “on behalf of any foreign person or foreign interest.” Effectively, this means that domestic acts of terrorism can now be certified as “acts of terrorism” within the federal program, subject to those acts meeting the other definitional requirements of TRIPRA. TRIPRA does not change the lines of insurance that were covered by TRIEA. As a result, the federal program covers all commercial property-casualty lines except crop, private mortgage insurance (PMI), title, financial guaranty, medical malpractice, flood, reinsurance, commercial auto, burglary/theft, surety, professional liability, and farmowners’ multi-peril insurance. Life/health insurance is not included within the scope of the program.
Like the “mandatory availability” provisions in TRIA and TRIEA, under TRIPRA, insurers are required to make available coverage for “acts of terrorism” on the same material terms and conditions as other covered types of loss (i.e., insurers can use general exclusions where permitted by state law, but not terrorism-specific exclusions unless allowed by state law and the make available provision has been satisfied). If the policyholder does reject our mandatory offer of terrorism coverage, we can then exclude coverage for losses due to foreign terrorism. The ISO has filed exclusions for acts of terrorism as defined by TRIEA, and we have adopted those filings. However, some states limit the use of terrorism exclusions.
TRIPRA maintains the original TRIA disclosure provisions, requiring clear and conspicuous indication of the terrorism premium charge and the federal share of compensation. TRIPRA does add a new policyholder disclosure requirement with respect to the $100 billion program cap, but the program cap disclosure does not need to be included in an insurer’s policy form.
Our corporate segment results for the year ended December 31, 2007 include a non-recourse, non-refundable marketable equity securities contribution of $60.0 to the Foundation, a separate 501(c)(3) endowment fund and $30.0 for the year ended December 31, 2006. Since the Foundation’s inception, we have provided at no charge certain resources to the Foundation such as accounting, legal and investment management services and office space.
The decrease in 2007 compared with 2006 reflects a reduction in outstanding debt due to maturities and the redemption of Debentures in 2006 and 2007. The increase in 2006 compared with 2005 was due to increased interest rates on the portion of our debt that was swapped to floating rates partially offset by a decrease in interest expense as a result of our debt repurchases described previously.
We use actuarial methods combined with judgment to estimate IBNR reserves.
The process for establishing loss and LAE reserves differs for case-basis versus IBNR reserves.
These approaches exclude exceptional loss activity associated with catastrophic weather losses, non-catastrophe weather losses and other large loss or salvage - the amount we recover from property that becomes ours after we pay for a total loss, and subrogation - our right to recover payments from third parties. The methodologies used to establish IBNR reserves differ for the current accident year (the year in which a claim occurs) versus prior accident years. The methodologies also differ for long-tailed lines of business versus short-tailed lines of business. Generally speaking, short-tailed lines of business are those lines where the vast majority of claims from a particular accident year are both reported and settled within two years.
For short-tailed lines of business, we use a ratio of IBNR reserves to earned premiums. Under this approach, an IBNR percentage is applied to current period earned premiums resulting in current period IBNR reserves. For long-tailed lines of business, we use an annual expected loss ratio approach. Under this approach, an expected loss ratio is applied to current period earned premiums resulting in an estimate of ultimate losses. The resulting estimate of ultimate losses is reduced by the current period paid and case-basis reserve activity, resulting in the current period IBNR reserves.
Expected loss ratios and IBNR-to-earned premiums percentages are developed based on our analysis of prior accident years supplemented with data about changes in our book of business, changes in the external environment in which we operate, changes in our pricing and underwriting, and changes in our claims-handling practices. We review these ratios throughout the year, and we revise the expected loss ratio and IBNR percentage periodically based on these analyses. Changes in the selection of the expected loss ratio or IBNR percentage result in changes in the loss reserve estimate for the current year, which we report in current period earnings.
ALAE reserves represent an estimate of the claims settlement expenses that can be identified to a specific claim. ALAE reserve estimates are generally established as a function of losses. For some small lines, estimates of ultimate ALAE are established as a percentage of earned premiums. These ALAE factors are established based on historical ratios supplemented for changes in our internal and external environments. ALAE IBNR reserves are determined by subtracting paid and case-basis activity from the ultimate ALAE estimate.
Expected Loss Ratio - Loss ratios are developed for recent accident years based on historical accident year loss ratios, adjusted to reflect current economic conditions and current rate levels. The expected loss ratio for each accident year is then applied to the actual earned premiums to calculate expected ultimate losses.
The emergence of internal variables or external factors that would alter our view
In general, we review our reserves quarterly. This review includes either an actuarial analysis involving the application of standard actuarial techniques or the review of the paid and incurred activity in the quarter relative to the assumptions from our previous actuarial analyses. In addition, special studies are undertaken periodically for certain lines of business or exposures.
We purchase reinsurance to limit our exposure to potential large losses. We report the amounts we expect to recover from reinsurers as reinsurance recoverable assets on our Consolidated Balance Sheets. For more discussion on reinsurance, see the Reinsurance section of Item 7: MD&A.
Loss and LAE Reserves By Segment - At year-end 2007 and 2006, our loss and ALAE reserves, excluding ULAE reserves, by reportable segment before reinsurance were:
Our change in new business - New business generally has higher claim frequencies than business that has been on the books for longer than one year.
To illustrate the sensitivity of our estimate, a one-point increase in our severity assumption for Auto BI would yield an increase of approximately $28.0 in the estimated reserve.
Safeco Business Insurance (SBI) and P&C Other - SBI primarily writes commercial multi-peril, property, workers’ compensation, commercial auto and general liability insurance for small- to mid-sized businesses. P&C Other is composed of large-commercial business and other businesses we have placed in run-off.
Our P&C Other segment has exposure to asbestos and environmental losses primarily from policies we no longer write. Our SBI segment has exposure to construction defect losses and related expenses through the general liability, commercial multi-peril and umbrella coverages it provides. These exposures and the risks they present are discussed in aggregate for SBI and P&C Other as they are estimated by product and like exposure.
Workers’ Compensation - The following table shows our loss and ALAE reserves for voluntary and non-voluntary workers’ compensation and other relevant data. The data shown reflects workers’ compensation policies written in SBI, as well as those workers’ compensation policies that are in run-off and included in the P&C Other segment. The table excludes ULAE reserves, which were $58.2 at year-end 2007, $59.9 at year-end 2006 and $62.1 at year-end 2005:
Estimating reserves for workers’ compensation involves a significant degree of uncertainty and judgment. This is driven by:
In determining our best estimate for workers’ compensation reserves, long-term medical cost inflation trends over the average claim payout period represent our most significant assumption. We have assumed that double-digit medical cost inflation will continue in the near-term, moderating over time to historical levels. Our best estimate of workers’ compensation reserves presents risk of unfavorable reserve development should medical inflation trends not abate. A one-point increase in our estimate of the average medical cost severity trend would yield an increase of approximately $68.0 in the estimated reserve.
Construction Defects - This table shows our loss and ALAE reserves for construction defects claims. The table excludes ULAE reserves, which were $20.1 at year-end 2007, $22.2 at year-end 2006 and $28.5 at year-end 2005:
Our exposure to construction defects claims comes from general liability and commercial multi-peril coverages we provide to contractors. Construction defects claims result from alleged defective work performed in the construction of large structures that include apartments, condominiums and large developments of single-family dwellings or other housing. We no longer write new business with large contractors, but periodically have claims arise from prior periods.
Construction defects claimants often seek payment for damages resulting directly from the alleged defective construction work and diminished economic value of the structure - meaning that the structure has less market value because of the alleged defective construction work. Construction defects claims are complex, with an inherent difficulty in determining fault. Most of our claims are concentrated in a small number of states, particularly California.
Statutes of limitations and statutes of repose in filing these claims
Our Asbestos Liability Exposure - Here is the breakout of our asbestos loss reserves, net of reinsurance:
Accordingly, we have two separate special claims-handling functions, one that specializes in asbestos claims related to our run-off assumed reinsurance operations, and one that specializes in asbestos claims related to our direct exposure.
Our exposure through our run-off assumed reinsurance operations is primarily excess-of-loss reinsurance. Pools are groups of insurers that enter into agreements to share exposure related to specific insureds. Our loss reserve estimates for pools reflect the loss reserve estimates provided by the pools’ independent actuaries. The loss experience of our run-off assumed reinsurance operations follows the general industry trend.
This table provides details about our policyholders and losses paid related to asbestos loss reserves:
Estimating loss reserves for asbestos claims requires more judgment than most of our other lines of business. This is primarily because past claim experience may not be representative of future claims.
Environmental - This table shows our loss and ALAE reserves for our liability coverages related to environmental claims. The table excludes ULAE reserves, which were $12.2 at year-end 2007, $13.8 at year-end 2006 and $15.0 at year-end 2005:
Our environmental claims result from our assumed reinsurance operations that are in run-off status and from our commercial general liability line that we write on a direct basis. We have attempted to avoid writing coverages for large companies with substantial exposures to environmental claims. As a result, our average environmental claim tends to be small.
In light of these factors, we estimate loss reserves for environmental claims including consideration of:
$11.4 reduction in commercial multi-peril reserves excluding catastrophes and other than asbestos, environmental and construction defects due to lower-than-expected number of claims
$35.8 increase in asbestos reserves primarily due to liabilities assumed from others
$39.5 reduction in commercial multi-peril reserves and general liability reserves other than asbestos, environmental and construction defects due to lower-than-expected number of claims
$25.9 increase in our asbestos reserves related to large loss activity
$12.2 increase in our assumed reinsurance run-off lines driven by large loss activity
$7.0 reduction in a number of lines due to emerging claim trends and related loss data, including ULAE
$77.3 reduction in commercial multi-peril reserves and general liability reserves other than asbestos, environmental and construction defects due to lower-than-expected number of claims
$26.3 reduction in construction defects reserves, reflecting claims frequency improvement in our run-off lines
Analysis of Losses and LAE Reserve Development - 10-Year Review - The Analysis of Losses and LAE Reserve Development table which follows shows the development of our loss and LAE reserves from 1997 through 2007.
Section A shows the unpaid loss and LAE reserves we recorded at December 31, 1997-2007. It breaks out these reserves as:
As shown in Section A, our loss and LAE reserves net of reinsurance at year-end 1997 were $4,081.9
After one year those reserves developed a $100.0 redundancy, and after 10 years these reserves developed a $424.6 deficiency. This is the difference between the reserves shown in Section A net of reinsurance, and the reestimated amounts in Section C.
The favorable development from 2004 through 2005 was primarily due to:
The favorable development from 2006 through 2007 was primarily due to:
The reinsurance we buy limits our losses on certain individual risks and reduces our exposure to catastrophic events. We purchase reinsurance from several reinsurers and are not dependent upon any single reinsurer. Reinsurance recoverables are the amounts our reinsurers owe us related to the losses we have incurred. We reported $461.9 at December 31, 2007 and $429.9 at December 31, 2006 in reinsurance recoverables as assets on our Consolidated Balance Sheets. The increase in our reinsurance recoverables in 2007 is a result of an increase in recoverables on losses from historical casualty business in run-off partially offset by an increase in the related allowance for uncollectible reinsurance.
Review estimates of large losses that are covered under reinsurance agreements
Estimating an Allowance for Uncollectible Reinsurance Recoverables - We regularly review our reinsurance recoverables to determine the collectibility of what is owed to us. In doing that, we review:
How We Determine Other-than-Temporary Declines in the Value of Our Investments - We regularly review the fair value of our investments. Invested assets are subject to various risks, such as interest rate, market and credit risks. Periodic changes in fair values of our investments are reported as a component of accumulated other comprehensive income on our Consolidated Balance Sheets and are not reflected in the operating results of any period until we sell the security or when declines in fair value are determined to be other-than-temporary. If the fair value of any of our investments falls below our cost or amortized cost basis in the investment, we analyze the decrease to determine whether it is an other-than-temporary decline in value.
Based on our analysis, we make a judgment as to whether the decline is other-than-temporary. Sometimes, an investment decline we consider temporary in one quarter can become other-than-temporary in a future quarter. If the decline is other-than-temporary, we report an impairment charge within Net Realized Investment Gains in our Consolidated Statements of Income in the period we make that determination. We reported impairment charges of $56.0 in 2007 compared with $79.2 in 2006 and $15.5 in 2005.
Determining the Fair Value of Our Investments - For the majority of our investments, we use quoted market prices or available public market price information to determine the fair value. When such information is not available, as is the case for securities that are not publicly traded, we use other valuation techniques. These techniques include:
Identifying comparable securities with quoted market prices based on industry sector, credit quality and maturity
Using internally prepared valuations based on certain modeling and pricing methods
As of December 31, 2007, our fixed maturities, carried at $7,763.9, included:
We reviewed all our investments with unrealized losses at the end of 2007. For all investments other than those for which we recognized an impairment charge, our evaluation determined that all their declines in fair value were temporary, and we have the intent and ability to hold these securities until they recover in value.
This table shows by maturity, the total amount of gross unrealized losses on fixed maturities and marketable equity securities at December 31, 2007:
As of December 31, 2007, these securities represented 2.9% of our total fixed maturities at fair value. As of December 31, 2006, these securities represented 0.9% of our total fixed maturities at fair value. The related amortized cost of the below investment grade fixed maturities was $229.1 at year-end 2007 and $79.1 at year-end 2006.
As of December 31, 2007, our below investment grade securities included gross unrealized investment gains of $2.9 and gross unrealized losses of $3.8. As of December 31, 2006, our below investment grade securities included gross unrealized investment gains of $4.1 and gross unrealized losses of $0.2.
Our investment portfolio also included $149.8 of non-publicly traded fixed maturities and marketable equity securities - representing 1.6% of our total portfolio at year-end 2007, and $127.5 of not-rated fixed maturities - securities not rated by a national rating service - representing 1.4% of our total portfolio at year-end 2007. At year-end 2006, our portfolio included $144.2 of non-publicly traded fixed maturities and marketable equity securities - representing 1.4% of our total portfolio and $87.4 of not-rated fixed maturities- representing 0.8% of our total portfolio.
Our mortgage-backed securities consist mainly of commercial mortgage-backed securities (CMBSs), residential collateralized mortgage obligations (CMOs) and residential mortgage-bonded pass-throughs. We have no collateralized debt obligations (CDOs), home equity lines of credit (HELOCs) or similar securities in our portfolio.
This table summarizes our holdings of mortgage-backed securities at year-end 2007:
We measure our investment returns by net investment income and net realized investment gains and losses. Our net investment income is measured by after-tax yields and portfolio duration. These measurements may be impacted by impairments we report due to investment declines we determine to be other-than-temporary.
Our after-tax yields increased in 2007 and 2006 due to our increased investment in tax-exempt municipal bonds.
Our net realized investment gains in 2007 were due primarily to the gain of $57.9 from the contribution of highly appreciated marketable equity securities to the Foundation, and the sale of securities to fund the special dividend paid by our insurance subsidiaries to Safeco Corporation and to increase our cash position for future share repurchases. Net realized investment gains decreased in 2006 compared with 2005 primarily due to higher impairments in 2006.
We closely monitor every investment that has declined in fair value to below our cost or amortized cost. If we determine that the decline is other-than-temporary, we write down the security to its fair value and report the charge as an impairment in Net Realized Investment Gains in the Consolidated Statements of Income in the period that we make this determination. More information about our process of estimating investment impairments can be found in the discussion of Application of Critical Accounting Estimates in Item 7: MD&A.
In our impairment determination process, we consider our intent and ability to hold to recovery those investments with declines in value. Our intent to hold the investment could change due to changes in the financial condition and near-term prospects of the issuer or significant changes in our cash needs as a result of a major catastrophe.
P&C insurance liabilities are somewhat unpredictable and largely short in duration. Our payments to policyholders depend upon losses they suffer from accidents or other unpredictable events that are covered by insurance. Although we estimate how much cash we will need and when we will need it based on prior experience and the mix of business we write, we cannot predict all future events, particularly catastrophes. As a result, we invest most of our money in high-quality liquid securities - investments that can quickly be turned into cash - to support our projected or potential need for liquidity.
The amount of dividends that our subsidiaries can pay us is subject to regulatory limits imposed by certain states where our subsidiaries are domiciled. Dividends in excess of those limits require prior regulatory approval. Based on state limits in place at the end of 2007, our insurance subsidiaries can pay us up to $584.4 in aggregate dividends without obtaining prior regulatory approval. We do not expect these regulatory restrictions to have any impact on our ability to meet our obligations.
The increase in cash provided by investing activities in 2007 compared with 2006 was a result of increased sales of fixed maturities and marketable equity securities. The increase in cash provided by investing activities in 2006 compared with 2005 was a result of increased sales of fixed maturities, marketable equity securities, and activities related to our securities lending program, as well as our real estate sales.
Repurchases of Debt - In July 2007, we called and redeemed the remaining balance of $322.3 of our 8.072% Debentures for $335.3. The Debentures were redeemed at a price of 104% of principal. We reported a pretax loss on our debt repurchase of $16.6 ($10.8 after tax), including the write-off of deferred debt costs in the Consolidated Statements of Income. We also retired our $26.3 Capital Trust equity investment. In addition, we repaid $197.3 of our 6.875% senior notes, which matured on July 15, 2007.
Share Repurchases - We repurchase shares under Rule 10b5-1 trading plans, open market purchases and accelerated share repurchase programs. A Rule 10b5-1 trading plan allows us to repurchase our shares during periods when we would normally not be active in the market because of our own internal trading windows. Through accelerated share repurchase programs, we return excess capital to shareholders and immediately reduce the number of our common shares outstanding. The dealer obtains the shares that we repurchase by borrowing them on the open market and then purchases shares in the market over time to repay the borrowed shares.
The bank credit facility does not require us to maintain any deposits as compensating balances. As of December 31, 2007 we had no borrowings under the bank credit facility and we were in compliance with all its covenants.
Financial strength ratings provide a benchmark for comparing insurers. Higher ratings generally indicate greater financial strength and a stronger ability to pay claims.
We believe our financial position is sound. Our debt service coverage has improved over the last two years, and we expect at least to maintain ratings at the current levels.
We adopted the provisions of FASB Interpretation No. (FIN) 48 “Accounting for Uncertainty in Income Taxes,” on January 1, 2007. As a result of the implementation of FIN 48, we recognized a $0.7 increase in the liability for unrecognized tax benefits, which was accounted for as a reduction to Retained Earnings in our Consolidated Balance Sheets at January 1, 2007.
We are currently under a routine audit by the Internal Revenue Service (IRS) for calendar years 2004 and 2005. Calendar years 2006 and 2007 remain subject to IRS examination and the IRS examinations for calendar years 2003 and prior have been completed.
Amounts recorded for our pension obligation and pension cost are affected by assumptions used to calculate them, including the discount rate and expected long-term rate of return on plan assets. To calculate our benefit obligation, as of December 31, 2007, we used a discount rate assumption of 4.75% based on consideration of the general interest rate environment, the calculation of an equivalent discount rate based on a hypothetical portfolio of high-quality fixed maturities with future cash flows that are similar to the timing and amount of our estimated future pension benefit payments and other relevant factors.
To calculate pension cost for the year ended December 31, 2007, we used a discount rate assumption of 5.50%, an expected long-term rate of return on plan assets assumption of 7.00% and a compensation increase of 5.00% compounded annually. We determined the expected long-term rate of return on plan assets assumption by considering the mix of investments within the plan, the expected future investment performance of those asset sectors, actual investment experience during the lifetime of our plan and other relevant factors. A decrease of 100 basis points in the discount rate would result in an increase of $2.5 in pension cost in 2007. A decrease of 100 basis points in the expected long-term rate of return on plan assets assumption would result in an increase of $1.9 in pension cost in 2007.
The Consolidated Financial Statements and schedules listed in the Index to Financial Statements, Schedules and Exhibits in Part IV are filed as part of this report.