Combined ratio measures the percentage of premium dollars used to pay insurance losses, loss adjustment expenses and underwriting expenses.
The Corporation is the holding company of the Company, which is one of six property-casualty insurance companies that make up the Group, collectively the Consolidated Corporation. All dollar amounts in this Management’s Discussion and Analysis (MD&A) are in millions unless otherwise noted.
In November 2006, the Corporation announced its updated Corporate Strategic Plan for the 2007-2009 timeframe, “Building A Marketing Culture.” This growth plan includes three strategic initiatives to accelerate top line growth which include product development, distribution management and agent-centric or value added services. The Consolidated Corporation’s vision is to be the company that agencies trust with their best business, that policyholders trust for their protection and that associates respect based on performance and ethical conduct. The vision will be accomplished by collaborating strategically with growth-oriented agencies by offering differentiated products and comprehensive value-added services.
The key financial indicators management utilizes consist of GAAP combined ratios and component ratios on both a calendar year and accident year basis, gross and net written premium growth, impact of prior year reserve development, impact of catastrophes, renewal price increases and investment income growth.
The Consolidated Corporation reported net income of $218.3, or $3.44 per share, for 2006, compared with $212.7, or $3.19 per share, for the year 2005, and $128.4, or $1.89 per share, for the year 2004, which included after-tax realized investment gains of $28.3, ($0.44 per share), $41.6, ($0.62 per share) and $14.9, ($0.20 per share) for 2006, 2005 and 2004, respectively.
The Consolidated Corporation adopted the EITF Consensus 04-8, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share” in December 2004. See Item 15, Note 9 - Earnings Per Share in the Notes to the Consolidated Financial Statements on page 85 of this Annual Report on Form 10-K.
Financial results for 2006 continue to reflect our strong underwriting profitability with the combined ratio improving 0.5 points from 2005. The loss and LAE ratios increased as a result of increased catastrophe losses, an increase in large losses and loss cost trends increasing at a rate faster than premium rate increases, partially offset by favorable prior year reserve development in almost all product lines. The increase in these ratios was more than offset by improvement in the underwriting expense ratio primarily the result of recognition of state premium tax refunds related to prior years and lower incentive and contingent commissions accruals, partially offset by an increased legal settlement provision. Investment income grew during the year resulting from positive operating cash flows, reduced investment related expenses, an improvement in reinvestment yields and interest income related to the state premium tax refund.
The table below summarizes supplemental information which is useful to understand the Company’s premium trends:
Commercial Lines gross and net premiums written increased in 2006, a result of a 9.3% increase in new business premium production and improved policy retention ratios. This increase was partially offset by lower assumed premiums of $4.7 from mandatory workers’ compensation and commercial auto pools, our decision to reduce workers’ compensation writings in certain New Jersey classes of business as well as our efforts to improve the overall profitability of the workers’ compensation book of business. The average renewal price decreased 0.3% in 2006, as the Commercial Lines segment experienced increased price competition. Commercial Lines gross and net premiums written decreased in 2005 relative to 2004, a result of a 19% decline in new business production partially offset by improved policy retention ratios and average renewal price increases in the low single digits.
Specialty Lines gross and net premiums written decreased in 2006, a result of declines in the commercial umbrella product line as both in-force policies and new business premium production were lower than 2005. The decline is primarily in the unsupported lead umbrella product line, resulting from our efforts to improve the overall profitability of the commercial umbrella product line. This decline is partially offset by strong growth in our fidelity and surety bond product line during 2006 as we continue to leverage our market knowledge and strong producer base. Specialty lines gross premiums written declined in 2005 compared to 2004 resulting from significantly lower new business premium production in the commercial umbrella product line, partially offset by growth in the fidelity and surety product line. Net premium written for this segment increased in 2005 compared to 2004 resulting from a decline in ceded premiums primarily related to higher reinsurance retention limits and an increased accrual in 2004 for ceded premium of $6.1 on a commercial umbrella product line reinsurance treaty for years 1999 through 2001. Renewal pricing in the commercial umbrella product line has continued to be positive, however the rate of increase has slowed. Average renewal price increases for the commercial umbrella product line were 1.4% in 2006, compared to 3.7% in 2005 and 8.0% in 2004.
The 2006 All Lines combined ratio improved 0.5 points driven by a 0.8 point reduction in the underwriting expense ratio partially offset by a 0.3 point increase in the loss and LAE ratio. The improvement in the underwriting expense ratio is primarily the result of recognition of state premium tax refunds of $9.2 related to prior years’ and lower contingent commission and incentive compensation accruals during 2006, partially offset by a $6.0 increased legal provision related to an Ohio uninsured motorists class action legal proceeding. For additional information relating to the state premium tax refund see Item 15, Notes to the Consolidated Financial Statements, Note 7 - Other Contingencies and Commitments on pages 83 and 84 of this Annual Report on Form 10-K. The loss and LAE ratios increased as a result of increased catastrophe losses, an increase in large losses and loss cost trends increasing at a rate faster than premium rate increases, partially offset by increased favorable prior year reserve development.
During 2006, the Group reported $52.2 of favorable prior year reserve development, which represented 1.8% of loss and LAE reserves at year-end 2005, with all three operating segments experiencing favorable development. The net favorable development was concentrated in Commercial Lines (primarily in commercial auto and CMP product lines, partially offset by adverse development in the workers’ compensation product line), Specialty Lines (primarily the commercial umbrella product line) and Personal Lines (primarily the personal auto and homeowners product lines).
During 2005, the $20.1 of favorable prior years reserve development, which represented 0.7% of loss and LAE reserves at year-end 2004, was concentrated in the Specialty Lines (primarily the commercial umbrella product line) and Personal Lines (primarily the personal auto product line) operating segments. This net favorable development was partially offset by adverse development in the Commercial Lines operating segment due almost entirely to the review of pension or permanent disability workers’ compensation cases during the year.
Catastrophe losses in 2006, 2005 and 2004 were $32.8, $25.8 and $43.5, respectively. The Group was impacted by 32 separate catastrophes in 2006, compared with 23 catastrophes in 2005 and 22 in 2004. The largest catastrophe, as measured in terms of incurred loss, in each year was $5.1, $11.2 and $8.0, respectively. The Group uses the number assigned by Property Claims Services, a unit of the Insurance Services Office, to define and track losses for specific catastrophes. Property Claims Services defines catastrophes as industry events that cause $25.0 or more in direct insured losses to property. The effects of future catastrophes on the Consolidated Corporation’s results cannot be accurately predicted. As such, severe weather patterns, acts of war or terrorist activities could have a material adverse impact on the Consolidated Corporation’s results, reinsurance pricing and availability of reinsurance.
The seven-year historical catastrophe impact on the loss ratio compared to 2006 actual impact for all lines of business is as follows:
The underwriting expense ratio, which measures underwriting expenses as a percentage of net premiums earned, decreased by 0.8 points in 2006. The improvement in the underwriting expense ratio was primarily the result of lower contingent commission and incentive accruals, reduced assessments primarily related to second injury funds and state premium tax refunds related to prior years’. These improvements were partially offset by an increase in a legal settlement provision. The Group continues to focus on expense management, including implementation of additional process efficiencies that have continued to allow for reduced staffing levels. The employee count declined slightly in 2006 to 2,114 compared with 2,125 and 2,190 as of December 31, 2005 and 2004, respectively.
The 2005 underwriting expense ratio was favorably impacted by the Group’s focus on expense management, including implementation of additional process efficiencies that have continued to allow for reduced staffing levels and a $5.1 reduction in the surplus guarantee accrual related to the sale of the Group’s New Jersey private passenger auto business to Proformance Insurance Company.
The 2006, 2005 and 2004 underwriting expenses also included $3.9, $3.4 and $3.1 of software amortization expense, respectively, related to the rollout of P.A.R.I.S.sm. On a GAAP accounting basis, the new application is being amortized over a ten-year period. The amortization expense is expected to be offset in part by reduced labor costs related to underwriting and policy processing.
In 2001, the Group introduced into operation, P.A.R.I.S.sm for Commercial Lines and substantially completed the rollout in 2005. At the end of 2004, P.A.R.I.S.sm was deployed for the Specialty Lines commercial umbrella excess capacity product line. During the third quarter of 2006, the Group began the rollout of P.A.R.I.S.sm for the personal auto, personal umbrella and lead commercial umbrella product lines. The rollout of P.A.R.I.S.sm for the homeowners product line will begin in the second quarter of 2007. The Personal Lines rollout for all of the previously referenced product lines is anticipated to be completed by mid-year 2008. Further implementation for other Specialty Lines products are expected during the balance of 2007 and 2008.
For selected Commercial Lines agents, P.A.R.I.S. Expresssm and P.A.R.I.S. Connecttm inititially provided on-line quoting capability. In February of 2005, P.A.R.I.S. Expresssm was extended to support issuance and endorsement processing for selected pilot agents; nationwide rollout started in December 2005 and extended through March 2006. Personal Lines currently offers on-line and real time quoting and issuance for new business and endorsements through existing (non-P.A.R.I.S.sm ) systems. These non-P.A.R.I.S.sm Personal Lines systems will be replaced by P.A.R.I.S.sm as discussed above.
The Consolidated Corporation has three reportable segments: Commercial, Specialty and Personal Lines. These reportable segments represent the Consolidated Corporation’s operating segments. Within each operating segment are distinct insurance product lines that generate revenues by selling a variety of commercial, surety and personal insurance products. The Commercial Lines operating segment sells commercial multiple
peril, commercial auto, general liability and workers’ compensation insurance as its primary products. The Specialty Lines operating segment sells commercial umbrella, excess insurance and fidelity and surety insurance as its primary products. The Personal Lines operating segment sells personal automobile and homeowners insurance as its primary products. The Corporation also has an all other segment, which derives its revenue from investment income. For additional information relating to the Consolidated Corporation’s reportable segments see Item 15, Notes to the Consolidated Financial Statements, Note 12 - Segment Information on pages 86 and 87 of this Annual Report on Form 10-K.
The improvement in the 2006 underwriting expense ratio compared to 2005 is the result of lower contingent commission and incentive accruals, reduced assessments primarily related to second injury funds as well as the recognition of $5.2 of prior years’ state premium tax refunds related to the New Jersey premium tax litigation previously discussed.
The increase in the combined ratio from 2004 to 2005 is a result of adverse prior year reserve development in 2005 compared to favorable development in 2004. The adverse development in 2005 was primarily related to the re-evaluation of lifetime case reserves in the workers’ compensation product line, partially offset by favorable prior year reserve development in the commercial auto product line. The adverse reserve development was further offset by favorable claim frequency and lower current accident year large loss activity. The underwriting expense ratio improvement was primarily the result of staff reductions and operational efficiencies implemented throughout 2005 and 2004.
The following table shows the Commercial Lines segment by selected product lines:
The commercial auto product line combined ratio increased in 2006 due to an 8.2 point increase in the loss and LAE ratios driven by an increase in large losses and less favorable prior year reserve development in the current year compared to 2005. This increase was partially offset by a 1.2 point improvement in the underwriting expense ratio as discussed above for the Commercial Lines segment. The combined ratio improved from 2004 to 2005, due to improvement in the loss and LAE ratios driven by increased favorable prior year reserve development and a 1.6 point improvement in the underwriting expense ratio due to our expense management initiatives.
The fidelity and surety combined ratio improved in 2006 due to $2.8 of favorable development on prior accident year loss and LAE reserves, compared to $0.8 and $4.2 in 2005 and 2004, respectively.
The Personal Lines combined ratio decreased from 2004 to 2005, a result of a 14.0 point improvement in the loss and LAE ratios driven by lower catastrophe losses, favorable development on prior years’ reserves and favorable claim frequency trends. The underwriting expense ratio improved 4.1 points, which included a 1.1 point reduction related to the Proformance surplus guarantee, compared to a 3.2 point increase related to the guarantee in 2004.
Consolidated realized net investment gains amounted to $43.6, $47.4 and $23.0 for the years ended 2006, 2005 and 2004, respectively. Included in the 2006 and 2005 consolidated realized net investment gains were $29.4 and $40.9, respectively, of net gains on the sale of common stocks. These gains were the result of a portfolio reallocation strategy whereby management reduced equity holdings in certain common stocks that had appreciated in value over time and had become a significant percentage of the Consolidated Corporation’s common stock portfolio. In all periods presented there were no material losses on the disposal of any specific security or in any specific sector.
During 2003, management transferred a portion of its fixed income securities from the available-for-sale category into the held-to-maturity category. This transfer was made as the Consolidated Corporation had both the ability to hold the securities to maturity and the positive intent to do so. At December 31, 2006 and 2005 the amortized cost of the held-to-maturity portfolio was $235.8 and $264.4, respectively.
Future impairment charges could be material to the results of operations. The amount of the other-than-temporary impairment charge recorded was $13.4, $2.4 and $8.7 for the years ended 2006, 2005 and 2004, respectively. The increase in impairments from 2005 to 2006 is primarily interest rate related where our intent to hold to recovery changed. This impairment charge represents less than 0.5% of the market value of the investment portfolio at December 31, 2006, 2005 and 2004, respectively. The 2006 and 2005 impairment charges relate to various companies in various industries. Included in 2004 impairment charges were $5.1 related to fixed income securities issued by companies in the airline industry.
Management believes that it will recover the cost basis in the securities held with unrealized losses as it has both the positive intent and ability to hold the securities until they mature or recover in value.
The amortized cost and estimated fair value of fixed income securities classified as available-for-sale and held-to-maturity with an unrealized loss position at December 31, 2006, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Management of the Consolidated Corporation has identified the policies listed below as significant accounting policies that are critical to the Consolidated Corporation’s business operations and influence the consolidated results of operations and financial performance. The policies listed below were selected as they require a higher degree of complexity or use subjective judgments or assessments. Changes in these judgments, assessments or estimates could have a material adverse impact on the Consolidated Corporation’s financial statements. These policies follow U.S. GAAP. A summary of each critical accounting policy follows. Management discusses the development and selection of these accounting policies with the Audit Committee of the Board of Directors and the Audit Committee has reviewed the Consolidated Corporation’s MD&A. For a complete discussion on the application of these and other accounting policies, see Item 15, Note 1 - Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements, on pages 71-73 of this Annual Report on Form 10-K.
Premiums and discounts on fixed income securities are amortized or accreted using the interest method; mortgage and asset-backed securities are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations. Upon receipt of payments from such securities, the appropriate amount of the funds are allocated between a reduction of principal and interest income. In making this allocation decision, investment personnel consider such factors as the original estimated average life of the investment, the amount of funds received to date and the timing of future cash flows. Variations from prepayment assumptions will affect the life and yield of these securities. These securities are evaluated for impairment by computing the net present value of expected future cash flows and comparing this to the prior period estimate of expected future cash flows from the security. When the timing and/or amount of cash expected to be received from the security has changed materially and adversely from the previous valuation, the security is considered to be other than temporarily impaired and the amortized cost is written down to the estimated fair value with a realized loss recorded in the then current consolidated statement of income.
financial statements and calculates various ratios used to identify reinsurers who no longer meet appropriate standards of financial strength. Reinsurers who fail these tests are reviewed and those that are determined by the Group to have insufficient financial strength are removed from the program at renewal. Additionally, a large number of reinsurers are utilized to mitigate concentration of risk. To the extent that any reinsuring companies are unable to meet obligations under the ceded reinsurance agreements, the Group would remain liable to the policyholder. Amounts recoverable from reinsurers are calculated in a manner consistent with the reinsurance contract and are reported net of an estimated allowance for uncollectible reinsurance amounts, as deemed necessary. At December 31, 2006, one reinsurer accounted for 15.8% of the total reinsurance recoverable. At December 31, 2005, no reinsurer accounted for more than 15% of the reinsurance recoverable amount. As a result of these controls, amounts of uncollectible reinsurance have not been significant. There are several programs that provide reinsurance coverage and the programs in effect for 2006 are discussed in the “Reinsurance Programs” section of Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operation, on pages 59 and 60 of this Annual Report on Form 10-K. Additionally, reinsurance is further discussed in Item 15, Note 1K - Summary of Significant Accounting Policies on page 72 and Note 6 - Reinsurance, in the Notes to the Consolidated Financial Statements on pages 82 and 83 of this Annual Report on Form 10-K.
guidelines. The Company considers market conditions, including changes in investment returns, interest rates and inflation in making these assumptions. Any adjustments to these assumptions are based on considerations of current and future market conditions, which can result in changes to the future related benefit obligations and related costs incurred by the Company as well as its contributions. Management reviews the assumptions used in the valuations on an annual basis, or more frequently as deemed necessary.
Key assumptions used in determining the amount of the obligation and expense recorded for postretirement benefits other than pensions (OPEB), under SFAS 106, including the assumed discount rate and the assumed rate of increases in future health care costs, are reviewed by management on an annual basis, or more frequently as deemed necessary. In estimating the health care cost trend rate, the Company considers its actual health care cost experience, future benefit structures, industry trends and advice from its third-party actuaries.
The Company assumes that the relative increase in health care costs will generally trend downward over the next several years, reflecting assumed increases in efficiency in the health care system and industry-wide cost containment initiatives. At December 31, 2006, the expected rate of increase in future health care costs was 9.0% declining to 5.0% in 2014 and thereafter. Increasing the assumed health care cost trend by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 2006, by approximately $3.5 and increase the postretirement benefit cost for 2006 by $0.3. Likewise, decreasing the assumed health care cost trend by one percentage point in each year would decrease the accumulated postretirement benefit obligation as of December 31, 2006, by approximately $3.1 and decrease the postretirement benefit cost for 2006 by $0.2.
The actuarial assumptions used by the Company in determining its pension and OPEB retirement benefits may differ materially from actual results due to changing market and economic conditions, higher or lower turnover and retirement rates or longer or shorter life spans of participants. While the Company believes that the assumptions used are appropriate, differences in actual experience or changes in assumptions may materially affect the Company’s financial position or results of operations.
Upon adoption of SFAS 158, the Company recorded the funded status of the postretirement medical plan in its December 31, 2006 consolidated balance sheet, which included an increase to AOCI, net of deferred taxes of $26.4 ($27.7 related to prior service credits and ($1.3) for unrecognized actuarial losses). The unrecognized prior service credits were the result of the Company’s actions in July 2004 which effectively terminated the postretirement medical plan to new employees, restricting the benefits to then current retirees and employees with 25 or more years of continuous service. In accordance with the provisions of SFAS 106, the prior service credits will be amortized as a reduction of net periodic postretirement cost over approximately a 7-year period, and the unrecognized actuarial losses will be amortized as an increase in net periodic postretirement cost over approximately an 11-year period, which represents the average future service period of active participants. In subsequent years, as required by SFAS 158, as the unrecognized prior service credits and unrecognized actuarial losses are amortized into net periodic postretirement cost, there will be a corresponding adjustment to AOCI.
For more information on the Company’s pension and other postretirement benefit plans, please refer to Item 15, Note 4 - Employee Benefit Plans, in the Notes to Consolidated Financial Statements, on pages 76-80 of this Annual Report on Form 10-K.
Loss reserves are an estimate of ultimate unpaid costs of losses and LAE for claims that have been reported and claims that have been incurred but not yet reported. Loss reserves do not represent an exact calculation of liability, but instead represent estimates, generally utilizing actuarial expertise and reserving methods, at a given accounting date. These loss reserve estimates are expectations of what the ultimate settlement and administration of claims will cost upon final resolution in the future, based on the Group’s assessment of facts and circumstances then known. In establishing reserves, the Group also takes into account estimated recoveries for reinsurance, salvage and subrogation.
The following table displays case, IBNR and LAE reserves by product line both gross and net of reinsurance recoverables. Case reserves represent amounts determined for each claim based on the known facts regarding the claim and the parameters of the coverage that our policy provides. The IBNR reserves include provisions for incurred but not reported claims, provisions for losses in excess of the case reserves on previously reported claims, claims to be reopened and a provision for uncertainty in recognition of the variability and risk factors described below. The IBNR provision also includes an offset for anticipated salvage and subrogation recoveries. LAE reserves are an estimate of the expenses related to resolving and settling claims. Reserves ceded to reinsurers and reserves net of reinsurance are also shown.
Loss and LAE Reserves as of December 31, 2006 and 2005:
Product lines are generally classified as either long-tail or short-tail, based on the average length of time between the event triggering claims under a policy and the final resolution of those claims. Short-tail claims are reported and settled quickly, resulting in less estimation variability. The longer the time before final claim resolution, the greater the exposure to estimation risks and hence the greater the estimation uncertainty. Long-tail product lines include workers’ compensation, commercial umbrella and general liability. Short-tail lines include homeowners, property and bonds. Product lines such as personal and commercial auto and commercial multi-peril include some long-tail coverages and some short-tail coverages.
There is a great deal of uncertainty in the loss reserve estimates and unforeseen events can have unfavorable impacts on the loss reserve estimates. Reinsurance is purchased to mitigate the impact of large losses and catastrophic events. However, substantial variability exists on a net of reinsurance basis. The estimate of reinsurance recoverables is considered a critical accounting estimate and discussed on pages 45 and 46 of this Annual Report on Form 10-K.
Loss reserve uncertainty is illustrated by the variability in reserve development presented in the Analysis of Development of Loss and LAE Liabilities schedule which appears on pages 11 and 12 under Item 1 of this Annual Report on Form 10-K. This schedule shows cumulative loss reserve development for each of the past ten years through December 31, 2006 on a gross and net of reinsurance basis. The development on a net of reinsurance basis as a percent of the original estimates ranges from adverse development of 18.8% of original estimates for loss reserves at year-end 2000 to favorable development of 2.3% of original estimates for loss reserves at year-end 2004 and 2005. The oldest period shown, 1996, shows adverse development of 3.9% of original loss reserves ten years after the original estimates.
To illustrate the uncertainty by operating segment, the following table provides the (favorable)/adverse amount of prior accident years’ loss reserve development by operating segment on a net of reinsurance basis for the years ended December 31, 2006, 2005 and 2004, respectively:
Reserve estimates are also uncertain by accident period. To illustrate this, the following table provides the (favorable)/adverse amount of prior accident years’ loss and LAE reserve development by accident year on a net of reinsurance basis for all lines combined:
understood that the accident year 2001 & prior category includes only long-tail claims, some covering many decades, and many of which are complex. Conversely, the recent accident years include a mix of claims of varying degrees of difficulty many of which are short-tail and relatively straight-forward in establishing loss reserves.
An important assumption underlying reserve estimates is that the loss trends implicitly built into development patterns will continue into the future. However, an unexpected change in the underlying loss trends could impact future losses. This unexpected change could arise from a variety of sources such as a general increase in economic inflation, an increase in tort costs, increased utilization of medical procedures, increased life expectancy or many other factors. It is not possible to isolate and measure the potential impact of just one of these factors, and future loss trends could be partially impacted by several such factors concurrently. Nevertheless, it is meaningful to view the sensitivity of the reserves to potential changes in these variables by measuring the effect of a possible 1% change in future loss trends that may be caused by one or more of these factors. To demonstrate the sensitivity of loss reserves to changes in significant assumptions, the following example is presented. A 1% change has been selected as an example; actual variability could be greater or less than 1%. The estimated impact that a 1% change in loss trends would have on our net earnings is shown below for the six most significant product lines.
These changes apply in both directions, that is, when the unexpected change is both greater than or less than the underlying cost trends. They can also be extrapolated to unexpected changes greater than 1%.
Important risk factors affecting estimation of loss reserves for workers’ compensation include:
Medical cost inflation, including changes in medical technology and treatment procedures
Adverse loss development for workers’ compensation was $22.3, $42.0, $4.2, $9.6 and $8.8 for 2006, 2005, 2004, 2003 and 2002, respectively. The reason for the significant adverse development in 2006 and 2005 is described below.
During 2005, in response to industry wide development, the Group’s claims department reviewed permanent workers’ compensation cases to re-assess life expectancy and medical costs. The review resulted in increases to loss reserves on approximately 25% of the inventory of approximately 1,200 permanent cases. These adjustments comprise a substantial part of the $42.0 adverse development for this product line in 2005.
Our ongoing normal review of permanent cases continued in 2006. In addition, increasing medical costs including greater usage of prescription drugs led to further increased reserves. These two factors contributed to the adverse development of $22.3 in 2006.
Defense costs are also a part of the insured costs covered by liability policies and can be significant, sometimes greater than the cost of the actual paid indemnity amounts. Generally defense costs are outside of policy limits, meaning that amounts paid are in addition to the indemnity limits provided by the policy.
The reporting lag, that is, the length of time between the event triggering coverage and the actual reporting of the claim. Claims with longer reporting lags increase uncertainty
(Favorable)/adverse loss development for general liability was $3.7, $8.1, $(0.5), $6.9 and $46.4 for 2006, 2005, 2004, 2003 and 2002, respectively. The adverse development in 2002 is primarily attributed to construction defect losses as described below.
In 2002, the Group became aware of exposure to loss from construction defect exposure primarily related to business written in Arizona, Colorado and Washington in 1998 through 2002. As a result of a study by the Group’s actuaries, underwriters and claims staff, loss reserves were increased which contributed to the adverse development of $46.4 in 2002.
To mitigate future losses, the Group initiated numerous underwriting actions which included cancellation of certain policies, restrictions on writing certain types of policies, and the introduction of endorsements to business written with potential construction defect exposure. As a result, construction defect losses subsequent to 2002 have been limited.
(Favorable)/adverse loss development for commercial multi-peril was $(7.7), $9.8, $1.1, $24.1 and $1.8 for 2006, 2005, 2004, 2003 and 2002, respectively. The adverse development of $24.1 in 2003 is primarily related to increased asbestos and environmental reserves as a result of a reserve study completed that year. The adverse development of $9.8 in 2005 is primarily attributed to greater loss severity than expected including several large California claims from business written prior to 1993.
This line has many of the same characteristics and risk factors as the general liability line described above. Additional risk factors for this line are the attachment point and limit provided. The attachment point is generally at least $1.0, and sometimes in excess of $25.0, resulting in a greater reporting lag (and thus more variability) than that of general liability. The limit provided by commercial umbrella varies from $1.0 up to $25.0. The higher limit policies create more variability in loss reserve estimates than general liability policies.
Favorable loss development for commercial umbrella was $(29.0), $(11.5), $(5.1), $(15.3) and $(1.2) for 2006, 2005, 2004, 2003 and 2002, respectively. The favorable development is primarily attributed to fewer and less severe claims than expected on a net of reinsurance basis.
The commercial automobile product line is a mix of property and liability coverages and, therefore, includes both short and long-tail coverages. The payments that are made quickly typically pertain to auto physical damage (property) claims and property damage (liability) claims. The payments that take longer to finalize and are more difficult to estimate relate to bodily injury claims. In general, claim reporting lags are minor, claim complexity is not a major issue and the line is viewed as high frequency, low to moderate severity. Overall, the claim liabilities for this line create a moderate estimation risk. Commercial automobile reserves are typically analyzed in three components; bodily injury liability, property damage liability and physical damage claims. These last two components have minimal loss reserve risk.
Important risk factors affecting estimation of loss reserves for commercial automobile include:
Overall, total cash used in 2006 was $8.9, compared with $198.1 in 2005 and cash provided of $195.7 in 2004. During 2006, the Corporation increased the quarterly shareholder dividend from $0.06 to $0.09 per share and the Board of Directors approved another share repurchase program. For additional information regarding the shareholder dividend and the share repurchase program see Part II, Item 5 - Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities on pages 26-28 of this Annual Report on Form 10-K.
Over the long term, the Corporation is dependent on dividend payments from its insurance subsidiaries in order to meet operating expenses and debt obligations. Insurance regulatory authorities impose various restrictions and prior approval requirements on the payment of dividends by insurance companies. As of December 31, 2006, approximately $206.0 of statutory surplus was not subject to prior dividend approval requirements.
The following table presents the Consolidated Corporation’s obligations to make future payments under contractual obligations as of December 31, 2006:
The amounts presented are estimates of the dollar amounts and time periods in which the Group expects to pay its gross loss and LAE reserves. These amounts are based upon historical payment patterns and do not represent actual contractual obligations. The actual payment amounts and the related timing of those payments could differ significantly from these estimates. See Item 15, Note 8 - Loss and Loss Reserves, in the Notes to Consolidated Financial Statements, on pages 84 and 85 of this Annual Report on Form 10-K and discussed separately above.
For additional disclosure, see Item 15, Note 15 - Debt, in the Notes to Consolidated Financial Statements, on pages 87 and 88 of this Annual Report on Form
In December 2003, the FASB issued a revised Interpretation No. 46, “Consolidation of Variable Interest Entities” (FIN 46R), an interpretation of Accounting Research Bulletin No. 51. FIN 46 requires a variable interest entity (VIE) to be consolidated by the primary beneficiary of the entity if certain criteria are met. The Consolidated Corporation currently holds an equity investment, representing a 49% interest, in APM Spring Grove, Inc. (APM), which was deemed a variable interest entity in accordance with FIN 46. As a result, the entity was consolidated into the Consolidated Corporation’s financial statements during the first quarter of 2004, which resulted in a $1.6 (net of tax) charge for the cumulative effect of an accounting change. The Consolidated Corporation’s maximum exposure to loss as a result of its involvement with APM is $2.0. See Item 15, Note 17 - Variable Interest Entity, in the Notes to Consolidated Financial Statements, on page 89 of this Annual Report on Form 10-K for further discussion.
During 2005, the Corporation successfully completed the redemption or conversion of its Convertible Notes with minimal dilution to earnings or book value per share. For additional discussion regarding debt of the Consolidated Corporation, please refer to Item 15, Note 15 - Debt, in the Notes to Consolidated Financial Statements, on pages 87 and 88 of this Annual Report on Form 10-K.
During 2006, the Corporation and the Group received rating upgrades from Fitch and S&P, as well as receiving rating outlook upgrades from A.M. Best and Moody’s, all of which are reflected in the above table.
Statutory surplus, a traditional insurance industry measure of financial strength and underwriting capacity, was $1,082.7 at December 31, 2006, compared with $1,004.5 at December 31, 2005. Statutory surplus increased 7.8% from 2005 primarily from statutory net income of the Group, an increase in unrealized gains on equity securities and elimination of the additional minimum pension liability, partially offset by the payment of $195.0 of dividends to the Corporation.
The ratio of net premiums written to statutory surplus is one of the measures used by insurance regulators to gauge the financial strength of an insurance company and indicates the ability of the Group to grow by writing additional business. At December 31, 2006, the Group’s net premiums written to surplus ratio was 1.3 to 1 compared to 1.4 to 1 in 2005.
The Group’s casualty exposures are reinsured through several contracts. The Casualty Excess of Loss contract retention is $2.0 with limits of $4.0 per occurrence. This contract covers liability exposures for workers’ compensation, general liability, personal umbrella and commercial and personal automobile liability. The 1st and 2nd Contingency Excess of Loss contracts cover all casualty lines with retention of $6.0 and limit of $18.0. Commercial umbrella exposures are reinsured by the 1st and 2nd Cessions Excess of Loss contracts. These contracts provide retention of $2.0 and limit of $23.0 per occurrence. Workers’ compensation catastrophe exposures are reinsured with the 1st and 2nd Workers’ Compensation Catastrophe Excess of Loss contracts with retention of $12.0 and limits of $36.0 per occurrence.
GAI agreed to maintain reinsurance on the commercial lines business that the Group acquired from GAI and its affiliates in 1998 for loss dates prior to December 1, 1998. GAI is obligated to reimburse the Group if GAI’s reinsurers are unable to pay claims with respect to the acquired commercial lines business.
Included in the available-for-sale category of the mortgage and asset-backed securities allocation at December 31, 2006 are mortgage-backed securities with a cost of $397.3 and carrying value of $397.9. Included in the available-for-sale category of the mortgage and asset-backed securities allocation at December 31, 2005 are mortgage-backed securities with a cost of $415.5 and carrying value of $415.9. The remaining balance within this category for both 2006 and 2005 are asset-backed securities. All of the securities at both December 31, 2006 and 2005 within the held-to-maturity category of this security allocation are mortgage-backed securities.
Included in equity securities as of December 31, 2006 are common stock with a cost of $135.8 and carrying value of $360.4 and preferred stock with a cost of $96.3 and carrying value of $98.1. Included in equity securities as of December 31, 2005 are common stock with a cost of $97.3 and carrying value of $327.9 and preferred stock with a cost of $46.9 and carrying value of $47.2.
The excess of market value over cost at December 31, 2006 was $287.7 compared with $305.1 at December 31, 2005. The decrease in unrealized gains for 2006 was attributable to declining market values of fixed income securities as a result of rising interest rates, and the sale of certain equity securities, which had appreciated in value and had become a significant percentage of the Consolidated Corporation’s total common stock portfolio.
Fixed income securities are classified as investment grade or non-investment grade based upon the higher of the ratings provided by S&P and Moody’s. When a security is not rated by either S&P or Moody’s, the classification is based on other rating services, including the Securities Valuation Office of the NAIC. The market value of available-for-sale split-rated fixed income securities (i.e., those having an investment grade rating from one rating agency and a below investment grade rating from another rating agency) was $22.5 and $35.2 at December 31, 2006 and 2005, respectively.
The majority of mortgage-backed security holdings included in the fixed income portfolio are in sequential structures, planned amortization class and agency pass-through securities.
Equity securities are carried at fair market value on the consolidated balance sheets. As a result, shareholders’ equity and statutory surplus fluctuate with changes in the value of the equity portfolio. As of December 31, 2006, the equity portfolio consisted of stocks in a total of 83 separate entities covering all ten major S&P industry sectors. Of this total, 19.0% was invested in five companies and the largest single position was 4.9% of the equity portfolio. At December 31, 2005, the equity portfolio consisted of stocks in 60 separate entities covering all ten S&P industry sectors. Of this total, 24.2% was invested in five companies and the largest single position was 5.4% of the equity portfolio.
See Item 15 for Index to Consolidated Financial Statements, including the Notes to Consolidated Financial Statements and the Reports of Independent Registered Public Accounting Firm, and Schedules beginning on page 66 of this Annual Report on Form 10-K.