Regulatory and rating agencies use the statutory premiums to surplus ratio as a measure of solvency, viewing an increase in the ratio as a possible increase in solvency risk. Management and analysts also view this ratio as a measure of the effective use of capital because, as the ratio increases, revenue per dollar of capital increases, indicating the possibility of increased returns or increased losses due to the effects of leverage.
See Item 8. “Financial Statements and Supplementary Data,” Note 9 to the consolidated financial statements for a discussion of notes payable and debentures.
Financial Highlights of Results for years ended December 31, 2008, 2007, and 2006;
We have identified the policies and estimates described below as critical to our business operations and the understanding of the results of our operations. Our preparation of the Consolidated Financial Statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our Consolidated Financial Statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurance that actual results will not differ from those estimates. Those estimates that were most critical to the preparation of the Consolidated Financial Statements involved the following: (i) reserve for losses and loss expenses; (ii) deferred policy acquisition costs; (iii) pension and post-retirement benefit plan actuarial assumptions; (iv) OTTI; (v) goodwill; and (vi) reinsurance.
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer, and the insurer’s payment of that loss. To recognize liabilities for unpaid losses and loss expenses, insurers establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported net losses and loss expenses. As of December 31, 2008, we had accrued $2.6 billion of gross loss and loss expense reserves compared to $2.5 billion at December 31, 2007.
At December 31, 2008, our workers compensation line of business recorded reserves, net of reinsurance, of $850 million, or 35% of our total recorded reserves. In addition to the uncertainties associated with actuarial assumptions and methodologies described above, the workers compensation line of business can be impacted by a variety of issues such as unexpected changes in medical cost inflation, changes in overall economic conditions and company specific initiatives. From 2005 through 2008, we experienced an unusual amount of volatility associated with our workers compensation medical costs. In 2008 overall economic conditions were extremely unstable. Finally, in the past few years the company implemented a multi-faceted workers compensation strategy which incorporated knowledge management and predictive modeling initiatives. From 2005 through 2008, we experienced an unusual amount of volatility in our prior year reserve development ranging from $42 million of adverse development in 2005 to $24 million of favorable development in 2008. Even though medical cost development returned to a more customary level in 2007 and 2008, the unusual amount of volatility over the previous few years does create additional uncertainty. In addition, potential impacts from changing economic conditions and unforeseen expected results from our company-specific strategies are potential sources of additional uncertainty in the future. If the higher than historical increases in medical costs in 2005 do not return and/or external economic conditions improve and/or our workers compensation strategies exceed our expectations, the result could be favorable development in the future. However, if higher medical trends return and/or economic conditions remain poor and/or our internal strategies are less effective than anticipated, the result could be adverse reserve development in the future.
At December 31, 2008, our general liability line of business had recorded reserves, net of reinsurance of $891 million, which represented 37% of our total net reserves. This line of business includes excess policies which provide additional limits above underlying automobile and general liability coverages. While prior year development in recent years has been relatively minor, two recent changes in our book of business relating to excess coverage could create additional volatility in our results: (i) we have grown the number of our commercial excess policies at a greater rate than the rest of our commercial lines of business; and (ii) we have raised the net retention of our reinsurance covering these policies over the past several accident years. Both of these changes raise the average limits of losses that we retain on a net basis. While management has not identified any specific trends relating to additional reserve uncertainty, our increase in average net retention does create the potential for additional volatility in our reserves.
At December 31, 2008, our commercial automobile line of business had recorded reserves, net of reinsurance, of $346 million, which represented 14% of our total net reserves. This line of business experienced only $0.4 million of favorable development in 2008 which is significantly less than the $19 million and $15 million it experienced in 2007 and 2006, respectively. The significant favorable prior year loss development from 2005 to 2007 was driven by a downward trend in large claims. The number of large claims has a high degree of volatility from year to year and, therefore, requires a longer period before true trends are recognized and can be acted upon. We experienced lower than expected severity in accident years 2002 through 2005 which has not continued in the most recent three accident years. While management has not identified any specific trends related to this line, the volatility of large claims does create additional uncertainty in our analysis for our most recent accident years.
In addition to the line of business specific issues mentioned above, both of these lines of business have been impacted by a number of initiatives undertaken by our claims department which have resulted in the quicker development of case reserves. This change in the average level of case reserves increases the uncertainty in both the positive and negative directions in the short run, but the longer term benefit is a more refined management of the claims process.
At December 31, 2008, our personal automobile line of business had recorded reserves, net of reinsurance, of $159 million, which represented 7% of our total net reserves. The majority of this business is written in New Jersey, where the judicial and regulatory environment has been subject to significant changes over the past few decades. The most recent change occurred in June 2005, when the New Jersey Supreme Court ruled that the serious life impact standard does not apply to the AICRA limitation on lawsuit threshold. As a result of this decision, we increased reserves for this line of business by a net amount of $10 million, the majority of which was reflected in 2005 results. This recent judicial decision has increased the uncertainty surrounding our personal automobile reserves, particularly for accident years 2006 through 2008, since much of the historical information used to make assumptions has been rendered less effective as a basis for projecting future results.
Our process to establish reserves includes a variety of key assumptions, including, but not limited to, the following:
In addition to the normal amount of volatility, general liability loss development factors have greater uncertainty due to the complexity of the coverages and the possibly significant periods of time that can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer, and the insurer’s payment of that loss. In our judgment, it is possible that general liability loss development factors could be +/- 6% from those actually selected in our latest reserve analysis. If the loss development assumptions were changed by +/- 6%, that would increase/decrease our indicated general liability reserves by approximately $92 million for accident years 2007 and prior.
In addition to the normal amount of volatility, the uncertainty of personal automobile loss development factors is greater than usual due to the number of judicial and regulatory changes in the New Jersey personal automobile market over the years. In our judgment, it is possible that personal auto bodily injury loss development factors could range from 4% below those actually selected in our latest reserve analysis to 3% above those selected in our latest reserve analysis. If the loss development assumptions were reduced by 4%, that would decrease our indicated personal automobile reserves by approximately $28 million for accident years 2007 and prior. Alternatively, if the loss development factors were increased by 3%, that would increase our indicated personal automobile reserves by approximately $21 million for accident years 2007 and prior.
In light of the many uncertainties associated with establishing the estimates and making the assumptions necessary to establish reserve levels, we review our reserve estimates on a regular basis as described above and make adjustments in the period that the need for such adjustment is determined. These reviews could result in the identification of information and trends that would require us to increase some reserves and/or decrease other reserves for prior periods and could also lead to additional increases in loss and loss adjustment expense reserves, which could have a material adverse effect our results of operations, equity, business, insurer financial strength, and debt ratings. In 2008, we experienced favorable loss development in accident years 2006 and prior of $46.2 million partially offset by unfavorable loss development in accident year 2007 of $26.9 million, netting to total favorable prior year development of $19.3 million. In 2007, we experienced net favorable prior year development of $18.8 million, and in 2006, we experienced net favorable prior year development of $7.3 million. For further discussion on the prior year development in loss and loss expense reserves, see the discussion on “Net Loss and Loss Expense Reserves” in Item 1. “Business” and Note 8 of Item 8. “Financial Statements and Supplementary Data” of this Form 10-K.
However, we are not aware of any emerging trends that could result in future reserve adjustments. Moreover, normal historically based actuarial approaches are difficult to apply because relevant history is not available. While models can be applied, such models can produce significantly different results with small changes in assumptions. As a result, we do not calculate a specific environmental loss range, as we believe it would not be meaningful.
Our pension benefit and post-retirement life benefit obligations and related costs are calculated using actuarial concepts, within the framework of Statement of Financial Accounting Standards No. 87, “Employers’ Accounting for Pensions” (“SFAS 87”); and Statement of Financial Accounting Standards No. 106, “Employers’ Accounting for Post-retirement Benefits Other than Pension” (“SFAS 106”), respectively. Two key assumptions, the discount rate and the expected return on plan assets, are important elements of expense and/or liability measurement. We evaluate these key assumptions annually. Other assumptions involve demographic factors such as retirement age, mortality, turnover, and rate of compensation increases.
An investment in a fixed maturity, equity security or an other investment (i.e., an alternative investment), is impaired if its fair value falls below its book value and the decline is considered to be other than temporary. We regularly review our entire investment portfolio for declines in fair value. If we believe that a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in accumulated other comprehensive income. If we believe the decline is other than temporary, we write down the carrying value of the investment and record a realized loss in our Consolidated Statements of Income. Our assessment of a decline in fair value includes judgment as to the financial position and future prospects of the entity that issued the investment security. Broad changes in the overall market or interest rate environment generally will not lead to a write-down provided that we have the ability and intent to hold such a security to maturity.
Relevant rating history, analysis and guidance provided by rating agencies and analysts; and
Our evaluation for OTTI of an equity security, includes, but is not limited to, the evaluation of the following factors:
Financial Highlights of Results for Years Ended December 31, 2008, 2007, and 2006 1
Net realized gains in 2007 and 2006 reflect the sale of several equity positions which resulted in re-weighting various sector exposures. Partially offsetting the 2007 realized gains were pre-tax OTTI charges of $4.9 million. There were no OTTI charges in 2006.
Underwriting losses of $15.2 million, pre-tax, in 2008 compared to underwriting gains of $16.0 million in 2007 and $58.0 million in 2006. The underwriting loss in 2008 reflects higher catastrophe losses and reduced NPE. Catastrophe losses increased by $16.8 million, to $31.7 million in 2008 driven by storm activity in the Southern and Midwestern states. NPE decreased by $21.8 million, or 1%, to $1.5 billion in 2008 reflecting pricing pressure stemming from a highly competitive insurance marketplace and the slowing economy. The following factors also contributed to the decline in NPE:
Direct new business written, excluding flood, decreased $41.7 million to $310.6 million in 2008 compared to $352.3 million in 2007.
Audit and endorsement activity decreased $38.2 million to a net premium return to policyholders of $22.3 million in 2008.
As a result of the various expense savings initiatives we implemented in 2008, net underwriting expenses incurred in 2008 were slightly lower than 2007. We acted early in 2008 to manage expenses with a workforce reduction initiative, changes to our agent commission programs, and the re-domestication of two of the Insurance Subsidiaries to Indiana. In addition to helping to manage expenses in 2008, these initiatives will continue to benefit expenses going forward.
The aforementioned pre-tax items resulted in a reduction in tax expense of $50.6 million in 2008 compared to 2007, resulting in a 2008 total tax benefit of $4.4 million compared to expenses of $46.3 million in 2007 and $56.9 million in 2006.
Our Insurance Operations segment writes property and casualty insurance business through the Insurance Subsidiaries primarily in 22 states in the Eastern and Midwestern U.S. through approximately 940 independent insurance agencies. Our Insurance Operations segment consists of two components: (i) Commercial Lines, which markets primarily to businesses, and represents approximately 86% of NPW, and (ii) Personal Lines, which markets primarily to individuals, and represents approximately 14% of NPW. The underwriting performances of these lines are generally measured by four different statutory ratios: (i) loss and loss expense ratio; (ii) underwriting expense ratio; (iii) dividend ratio; and (iv) combined ratio.
As mentioned above, Commercial Lines renewal pure pricing in 2008 decreased 3.1% on renewal premiums, which we consider an achievement in the current competitive marketplace where many carriers are taking much larger rate decreases. Several commercial lines pricing studies indicate that, over the past 15 quarters, we have outperformed the industry, by as much as 6.5 points in the case of one survey. In addition, our Commercial Lines retention has remained relatively stable at 77% in 2008 compared to 78% in 2007 and 2006. In response to the highly competitive marketplace, our agents are actively managing our books of business by renewing accounts as much as 60 days in advance of the policy expiration date.
NPW increased in 2007 compared to 2006, driven by increases in direct new business of 14%, to $352.3 million partially offset by: (i) Commercial Lines renewal pure price decrease of 3.9% in 2007; (ii) a slight reduction in Commercial Lines retention; (iii) a $17.9 million reduction in audit and endorsement premium activity; and (iv) a decline in NPW for our New Jersey personal automobile business of $12.6 million, to $80.1 million, driven by a reduction in the number of New Jersey personal automobiles that we insure, primarily as a result of repricing at higher levels through our MATRIXSM pricing system.
The GAAP underwriting expense ratio increased in 2008 compared to 2007 primarily as the result of the pre-tax restructuring charge of $5.0 million, or 0.3 points, related to reductions in our workforce during 2008. Absent this charge, the expense ratio remained relatively flat, reflecting a 1% decrease in NPE partially offset by lower overall underwriting expenses year over year. These reduced expenses are the result of lower expected payments of profit-based incentives to our agents and employees, reflecting lower NPW and underwriting results during 2008, and benefits realized from our cost containment initiatives including: (i) targeted changes to our agency commission program implemented in July 2008 and expected to generate annual savings of $7 million, pre-tax; (ii) our workforce reductions during 2007 and 2008, expected to generate annual savings of $7 million, pre-tax; and (iii) the re-domestication of two of the Insurance Subsidiaries effective June 30, 2008, to achieve operational efficiencies with an anticipated pre-tax savings of $2 million annually.
Efforts to manage expenses with a workforce reduction initiative, changes to our agent commission programs, and the re-domestication of two of the Insurance Subsidiaries to Indiana. In addition to helping to manage our expense ratios this year, the ongoing impact of these initiatives will continue to benefit expenses going forward. While the cost-savings generated by these efforts are recognized immediately on a statutory basis, they are recognized on a GAAP basis over a 12-month period, thereby somewhat delaying their impact.
Sales management efforts including our market planning tools and leads program. Our market planning tools allow us to identify and strategically appoint additional independent agencies in and hire AMSs for underpenetrated territories. During 2008, the Insurance Subsidiaries independent agency count grew by approximately 60, bringing our total agency count to approximately 940. These independent insurance agencies are serviced by approximately 100 field-based AMSs who make hands-on underwriting decisions on a daily basis.
Technology that allows agents and our field teams to input business seamlessly into our systems, including our One & Done® small business system and our xSELerate® straight-through processing system. Premiums of approximately $273,000 per workday were processed through our One & Done® small business system during 2008, up 9% from the same period in 2007.
Looking forward into 2009, Fitch is projecting an industry-wide statutory combined ratio of 104.0% for the year, reflecting their belief that underwriting results will not improve significantly as premiums are projected to grow by less than 1% due to premium rate declines. In addition, Fitch anticipates that underwriting results will be adversely impacted by higher expense ratios and less favorable reserve development, offset by a return to historical average catastrophe loss experience.
Considering the ongoing impact of the 3.1% decrease in commercial lines pure renewal pricing in 2008, coupled with anticipated normal loss cost trends, we have provided guidance for 2009 that includes a GAAP combined ratio below 103.5% and a statutory combined ratio below 102.5%, both of which reflect catastrophe losses of 1.4 points.
As mentioned above, Commercial Lines renewal pure pricing in 2008 decreased 3.1% on renewal premiums, which we consider an achievement in the current competitive marketplace, especially when viewed in conjunction with our retention, which remained relatively flat at 77% during the year. In response to the highly competitive marketplace, our agents are actively managing our books of business by renewing accounts as much as 60 days in advance of the policy expiration date.
NPW increased in 2007 compared to 2006, driven by increases in direct new business of $36.4 million, to $313.3 million, partially offset by: (i) renewal pure price decreases of 3.9%; (ii) a slight reduction in retention; and (iii) decreases in audit and endorsement premium activity of $11.5 million and $6.3 million, respectively.
As the result of decreased NPW over the last 12 months, NPE declined in 2008 compared to 2007. There was a slight increase in NPE in 2007 compared to 2006 reflecting the 2007 increases in NPW discussed above.
The increase in the GAAP loss and loss expense ratio in 2008 compared to 2007 reflects higher catastrophe losses related to 2008 storm activity primarily in our Midwestern and Southern regions and a reduction in favorable prior year loss and loss expense development of approximately $6 million, from approximately $20 million, or 1.5 points in 2007 to approximately $14 million, or 1.1 points in 2008. Total catastrophe losses for the year added $27.0 million, or 2.1 points, to losses in 2008. For 2007, catastrophe losses added $12.0 million, or 0.9 points, to losses. The favorable prior year development in 2008 was driven by improvement in our workers compensation line of business, while the prior year development in 2007 was driven by lower than expected severity on our commercial automobile line of business.
The increase in the GAAP loss and loss expense ratio in 2007 compared to 2006 is primarily attributable to lower pricing on our commercial book of business as well as increases in property losses. Included in property losses were catastrophe losses that decreased $3.6 million, or 0.3 points, to $12.0 million in 2007 compared to $15.6 million in 2006. These increases were partially offset by net favorable prior year loss and loss expense development, primarily in our commercial automobile line of business, that amounted to approximately $20 million, or 1.5 points in 2007, compared to approximately $2 million, or 0.1 points, of net favorable prior year loss and loss expense development in 2006.
NPW for this line of business decreased in 2008 compared to 2007, primarily as the result of: (i) competitive pressure from monoline carriers willing to write workers compensation policies, mainly on the upper end of our middle market business and our large account business that led to a direct voluntary new business premium decrease of $17.0 million, or 21%; (ii) a decrease in audit and endorsement premium of $15.5 million; and (iii) renewal pure price decreases of 2.1% in 2008. Retention decreased one point to 78% partially due to initiatives that have allowed us to target price increases for our worst performing business, thereby improving the quality of our retained business. Policy counts increased by 5% in 2008 compared to 2007 as we are writing more, smaller premium policies.
The improvement in the statutory combined ratio of 5.5 points in 2008 compared to 2007 and 6.8 points in 2007 compared to 2006 reflects: (i) favorable prior year development of approximately $23 million, or 7.6 points, in 2008 compared to $3 million, or 0.8 points, in 2007 and $2 million, or 0.7 points in 2006; and (ii) the ongoing progress resulting from our improvement initiative including the use of our business analytics tools enabling us to price and retain our best accounts, coupled with the impact of medical trends that have returned to a more normalized level, and the redesign and recontracting of our managed care process. The prior year development in 2008 reflects favorable development in accident years 2004 to 2006, as a result of our improvement initiatives on this line as mentioned above, partially offset by adverse development in the 2007 accident year driven by higher than expected severity.
The increase in the statutory combined ratio in 2008 compared to 2007 for the commercial automobile line is primarily due to: (i) favorable prior year statutory development in 2007 of approximately $19 million due to improved severity trends; (ii) physical damage losses that were $6.2 million, or 2.3 points, higher in 2008; and (iii) pure price decreases as discussed above.
Our rate increases were partially offset by a decline in retention of approximately one point, to 81%, on our overall Personal Lines book. In addition, the number of automobiles that we insure in New Jersey decreased by approximately 6,000, to 65,000 cars, at December 31, 2008.
NPW decreased in 2007 compared to 2006. Excluding the impact from the cancellation of the New Jersey Homeowners’ Quota Share Treaty, which increased 2006 NPW by $11.3 million, NPW decreased 1% in 2007 compared to 2006. This modest 1% decrease was driven by the implementation of our MATRIXSM pricing system, which caused a dislocation in our New Jersey personal automobile line of business as renewal policies were repriced at higher levels. Partially offsetting this decrease were increases in our personal automobile business outside of New Jersey of $5.4 million, to $50.0 million, coupled with increases in our homeowners business of $4.5 million, to $65.4 million, in 2007.
The deterioration in the 2007 loss and loss expense ratio was partially offset by a reduction in catastrophe losses of $2.2 million, to $2.9 million, in 2007.
We continue to focus on improving our Personal Lines results and continue to diligently take steps in that regard. The significant rate increases that we achieved in 2008 will generate an additional $15 million in annual premium. In addition, we have more rate increases planned in 2009 that are expected to generate approximately $9 million in additional premium, including 21 anticipated rate increases of 3% or more. In December of 2008, we implemented territory rate changes for our New Jersey personal automobile business. The number of territories in the state was increased from 40 to 60 and, as we move into these new territories for our renewal book of business, price increases or decreases in any given year are capped at 10%. We anticipate having the majority of the price adjustments reflected in our renewal book by year-end 2010, and we believe the new territory rates will provide more adequate pricing in territories that have historically not been profitable for us.
Other Reinsurance - includes smaller treaties, such as our Surety and Fidelity Excess of Loss and our Equipment Breakdown Coverage treaties, which do not fall within the categories above.
The following table presents Risk Management Solutions, Inc.’s (“RMS”) v.8.0 modeled hurricane losses based on the Insurance Subsidiaries’ property book of business as of July 1, 2008:
RMS v.8.0 allows modeling based on the long-term averages (historic view) and modeling based on a near-term view that includes an assumption of elevated hurricane activity in the North Atlantic Basin in the short to medium-term. Results of both models are provided above for select probabilities. Our current catastrophe program provides protection for a 1 in 225 year event, or an event with 0.4% probability according to the RMS v8.0 historic model, and for a 1 in 171 year event, or an event with 0.6% probability according to RMS v.8.0 near term model.
The per-occurrence cap on the first layer of this treaty was $24.0 million in both the current and expiring treaty and the per occurrence cap on the second layer was increased to $40.0 million from $22.5 million, bringing the total per-occurrence limit for the program to $64.0 million compared to the $46.5 million limit in the expiring treaty.
The annual aggregate limit for the second $20.0 million in excess of $10.0 million layer was also increased, by an additional reinstatement, to $80.0 million. The first layer continues to have unlimited reinstatements.
The next four layers provide coverage up to 100% of $45.0 million in excess of a $5.0 million retention.
The cost of the second through sixth layers of this treaty have decreased 2% to $10 million. On a fiscal year basis, the ceded premium for the entire casualty program will be approximately $10 million above the expiring premium due to the significant extension in coverage. The overall impact of the restructured program will be to improve insurance operations by about $2.0 million with lower investment income being offset due to higher ceded premium. In addition, we expect reduced volatility in our results as the first layer of this treaty was expanded to cover all lines of business, including our excess lines.
Our Surety and Fidelity Excess of Loss treaty was renewed effective January 1, 2009, with essentially no changes in coverage and an 11.4% decrease in estimated ceded premium due to a decrease in projected subject premium and an increase in the rate.
The AIG Subsidiaries are rated “A” by A.M. Best and National Union Fire Insurance Company and Transatlantic Reinsurance Company have S&P credit ratings of “A+” as of December 31, 2008. Uncollateralized reinsurance recoverables on paid and unpaid loss and loss adjustment expenses, including IBNR losses, amounted to $2.3 million at year-end 2008, representing 1.3%, of our total uncollateralized reinsurance recoverables and less than one percent of our stockholders’ equity. Some of the reinsurance arrangements that the AIG Subsidiaries participate in involve upper layers of casualty business (known as “clash layers”) for which historical experience does not exist. Due to the uncertainty associated with casualty business, and specifically losses reaching those clash layers, current reinsurance recoverables from AIG Subsidiaries may change materially in the event of a significant loss event well in excess of our historical levels. As we continually monitor developments that may impact our prospects for recovery from the AIG Subsidiaries, we are prepared to avail ourselves of certain contractually provided remedies available to us if we determine it to be appropriate.
In early 2009, the “A+” financial strength rating of Swiss Reinsurance Company and its similarly rated subsidiaries (collectively referred to as “Swiss Re”), was placed under review by A.M. Best with negative implications. Swiss Re is currently one of our top five reinsurance groups. A.M. Best placed Swiss Re’s ratings under review due to the announcement of planned actions to initiate several asset de-risking and capital strengthening initiatives, including an anticipated capital infusion agreement with Berkshire Hathaway, Inc. of approximately $2.6 billion. This comes after Swiss Re’s announcement of an expected net loss for fiscal year 2008 and a fourth quarter decline of its capital balance of approximately $4 to $5 billion as of December 31, 2008. A.M. Best had previously assigned a negative outlook to Swiss Re’s ratings due to concerns that the continuing turmoil in the financial markets could further erode their capital position and negatively impact earnings in 2009. As of December 31, 2008, Swiss Re’s uncollateralized reinsurance recoverables on paid and unpaid loss and loss adjustment expenses, including IBNR losses, amounted to $17.6 million, representing 20%, of our total uncollateralized reinsurance recoverables and approximately 2% of our stockholders’ equity.
Our investment results have been significantly affected by conditions in the global capital markets and the overall economy, in both the U.S. and abroad. As widely reported, financial markets in the U.S., Europe, and Asia have been experiencing extreme disruption since the second half of 2007. Concerns over the availability and cost of credit, the U.S. mortgage market, a declining global real estate market, increased unemployment, volatile energy and commodity prices and geopolitical issues, among other factors, have contributed to increased volatility and diminished expectations for the economy and the financial markets going forward. These concerns have led to declines in business and consumer confidence, which have precipitated an economic slowdown and fears of a sustained recession. These factors have had, and could continue to have, an adverse effect on our investment portfolio.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Selective Insurance Group, Inc.’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 27, 2009 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Insurance Operations, which sells property and casualty insurance products and services primarily in 22 states in the Eastern and Midwestern U.S.;
Diversified Insurance Services, which provides human resource administration outsourcing (“HR Outsourcing”) products and services, and federal flood insurance administrative services (“Flood”).
Realized gains and losses on the sale of investments are determined on the basis of the cost of the specific investments sold and are credited or charged to income. Also included in realized gains and losses are write-downs for other-than-temporary impairment (“OTTI”) charges.
When the fair value of any investment is lower than its cost, an assessment is made to determine if the decline is other than temporary. If the decline is deemed to be other than temporary, the investment is written down to fair value, which approximates the price at which a market participant would be willing to transact at (i.e., the exit price), and the amount of the write-down is charged to income as a realized loss. The fair value of the investment becomes its new cost basis. Our assessment for OTTI of fixed maturity securities and short-term investments, includes, but is not limited to, the evaluation of the following factors:
Stress testing of projected cash flows under various economic and default scenarios;
The length of time and the extent to which the fair value has been less than carrying value.
For the majority of our fixed maturity portfolio and several non-publicly traded equity securities, we also utilize a market approach, using primarily matrix pricing models prepared by external pricing services. We validate these prices against other external pricing sources in order to determine the fair market value of the positions, as well as to determine their placement within the fair value hierarchy (Level 1, Level 2, or Level 3) as defined in FAS 157. For disclosures required by FAS 157, refer to Note 6, “Fair Values of Financial Instruments.”
See Note 6 for a summary table of the fair value and related carrying amounts of financial instruments.
Reinsurance recoverable on paid and unpaid losses and loss expenses represent estimates of the portion of such liabilities that will be recovered from reinsurers. Generally, amounts recoverable from reinsurers are recognized as assets at the same time and in a manner consistent with the paid and unpaid losses associated with the reinsured policies. An allowance for estimated uncollectible reinsurance is recorded based on an evaluation of balances due from reinsurers and other available information.
Goodwill results from business acquisitions where the cost of assets/liabilities acquired exceeds the fair value of those assets/liabilities. Goodwill is tested for impairment annually or more frequently if events or changes in circumstances indicate that goodwill may be impaired. Goodwill is allocated to the reporting units for the purposes of the impairment test.
Reserves for losses and loss expenses are made up of both case reserves and reserves for claims incurred but not yet reported (“IBNR”). Case reserves result from claims that have been reported to our seven insurance subsidiaries (the “Insurance Subsidiaries”) and are estimated at the amount of ultimate payment. IBNR reserves are established based on generally accepted actuarial techniques. Such techniques assume that past experience, adjusted for the effects of current developments and anticipated trends, are an appropriate basis for predicting future events. In applying generally accepted actuarial techniques, we also consider a range of possible loss and loss adjustment expense reserves in establishing IBNR.
The Insurance Subsidiaries’ net premiums written include direct insurance policy writings plus reinsurance assumed and estimates of premiums earned but unbilled on the workers compensation and general liability lines of insurance, less reinsurance ceded. Premiums written are recognized as revenue over the period that coverage is provided using the semi-monthly pro-rata method. Unearned premiums and prepaid reinsurance premiums represent that portion of premiums written that are applicable to the unexpired terms of policies in force.
We use the asset and liability method of accounting for income taxes. Deferred federal income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax basis of assets and liabilities. A valuation allowance is established when it is more likely than not that some portion of the deferred tax asset will not be realized. The effect of a change in tax rates is recognized in the period of enactment.
Cash and cash equivalents are comprised of cash and certain money market accounts that are used as part of our daily cash management.
In May 2008, the FASB issued Statement of Financial Accounting Standards No. 163, Accounting for Financial Guarantee Insurance Contracts - an interpretation of FASB Statement No. 60 (“FAS 163”). FAS 163 applies to financial guarantee insurance and reinsurance contracts that are: (i) issued by enterprises that are included within the scope of FASB Statement of Financial Accounting Standards No. 60, Accounting and Reporting by Insurance Enterprises (“FAS 60”); and (ii) not accounted for as derivative instruments. FAS 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. The adoption of FAS 163 is not expected to have an impact on our results of operations or financial condition.
In December 2008, the FASB issued FSP FAS 132(R)-1 (“FSP FAS 132(R)-1”) which amends FASB Statement No. 132 (revised 2003), Employers’ Disclosures about Pensions and Other Post-retirement Benefits, to provide guidance on an employer’s disclosures about plan assets of a defined benefit pension or other postretirement plan. The FSP requires employers of public and nonpublic entities to disclose more information about the following:
The major categories of plan assets, including cash and cash equivalents; equity securities (segregated by industry type, company size, or investment objective); debt securities (segregated by those issued by national, state, and local governments); corporate debt securities; asset-backed securities; structured debt; derivatives (segregated by the type of underlying risk in the contract); investment funds (segregated by type of fund); and real estate;
In January 2009, FASB issued FASB Staff Position (“FSP”) EITF 99-20-1 (“FSP 99-20-1”) which amends the other-than-temporary impairment guidance in EITF Issue No. 99-20, Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets, (“EITF 99-20”) to be consistent with that contained in Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (“FAS 115”). Under the previously existing guidance in EITF 99-20, a company was required to use market participant assumptions about future cash flows. This requirement could not be overcome by management’s judgment as to the probability of collecting all projected cash flows. On the contrary, FAS 115 does not require exclusive reliance on market participant assumptions about future cash flows and instead management is permitted to use reasonable judgment when considering the probability of collection of all future cash flows due in determining whether an OTTI charge exists. FSP 99-20-1, which was effective for reporting periods ending after December 15, 2008, did not have a material impact on our operations.
(c) The cost/amortized cost, estimated fair values, and unrealized gains (losses) of available-for-sale securities at December 31, 2008 and 2007, respectively, were as follows:
(d) The following tables summarize, for all securities in an unrealized loss position at December 31, 2008 and December 31, 2007, the aggregate fair value and gross pre-tax unrealized loss recorded in our AOCI by asset class and by length of time those securities have been in an unrealized loss position:
Unrealized losses for fixed maturity securities, equities, and other investments increased in 2008 as compared to 2007, primarily due to the volatile nature of the securities marketplace driven by the credit stress and resulting widening credit spreads, the dislocation in the capital markets, and inflation concerns. An atmosphere of economic uncertainty was created by declines in residential home values, the sharp sell off in the equity markets, reduced consumer spending, and increased unemployment rates. Our investment portfolio was adversely affected by these events, which included decreased market liquidity for certain invested assets, increased credit risk with respect to the type of securities held in our portfolio, and the corresponding widening of credit spreads with respect to our invested assets. These effects were evidenced by an increase in unrealized losses of $153.6 million as compared to the prior year. At December 31, 2008, we held 355 fixed maturity securities, 45 equity securities, and one other investment security in an unrealized loss position. At December 31, 2007, we held 231 fixed maturity securities and nine equity securities in unrealized loss positions.
We have reviewed the securities in the table above in accordance with our OTTI policy, which is discussed in Note 2, “Summary of Significant Accounting Policies,” above. The overall S&P credit quality rating of our fixed maturity securities is “AA+” and these securities are performing according to their contractual terms. The assessment of whether a decline in value is temporary includes our current judgment as to the financial position and future prospects of the entity that issued the investment security. Broad changes in the overall market or interest rate environment generally will not lead to a write-down, provided that management has the ability and intent to hold a security to maturity. If our judgment about an individual security changes in the future, we may ultimately record a realized loss after having originally concluded that the decline in value was temporary, which could have a material impact on our net income and financial position in future periods. Currently, we have the ability and intent to hold all securities in an unrealized loss position until their anticipated recovery.
The following table presents information regarding securities in our portfolio with the five largest unrealized balances as of December 31, 2008:
(e) The amortized cost and estimated fair value of fixed maturity securities at December 31, 2008, by contractual maturity are shown below. Mortgage-backed securities are included in the maturity tables using the estimated average life of each security. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
(f) Certain investments were on deposit with various state regulatory agencies to comply with insurance laws and had fair values of $26.8 million as of December 31, 2008 and $26.0 million as of December 31, 2007.
(g) We are not exposed to significant concentrations of credit risk within our investment portfolio. The largest investment in the securities of any one issuer was $26.0 million at December 31, 2008 and $16.0 million at December 31, 2007. In addition, the sector exposure of our available-for-sale fixed maturity securities breaks down as follows: (i) 58% in state and municipal obligations; (ii) 12% in corporate securities, 28% of which are in the financial services industry sector; (iii) 12% in residential-mortgage-backed securities RMBS; (iv) 8% in U.S. government obligations; (v) 8% in commercial-mortgage-backed securities CMBS; and (vi) 2% in asset-backed securities ABS.
The decrease of other investments of $16.8 million for 2008 compared to 2007 was primarily due to the decrease of $25.2 million in other securities resulting from the sale of one international investment fund for $11.5 million and another large capital growth fund for $5.0 million. We sold these securities to reduce our equity exposure in the current volatile market. Additionally, the decrease in the fair value of our other securities led to a reduction in the carrying value of these securities.
The decrease in net investment income, before tax, of $43.1 million for 2008 compared to 2007 was due to: (i) decreased returns of $31.9 million on the alternative investment portion of our other investments portfolio; and (ii) $8.1 million of reductions in the fair value of our equity trading portfolio due to the sell off in the equity markets, as well as the collapse in commodity prices in 2008.
The general volatility in the capital markets, the dislocation of the credit markets, and reduced asset values globally has resulted in a negative return for our alternative investments, which primarily consist of investments in limited partnerships, during 2008. In addition, the majority of these limited partnerships adopted FAS 157 during 2008; the result of which we believe has led to increased volatility in the period to period changes in the fair values associated with the underlying assets of these partnerships as fair values are now based on current exit values. As we account for these investments under the equity method of accounting, any changes in the valuation of these limited partnerships are reflected in net investment income as opposed to other comprehensive income.
Proceeds from the sale of available for sale securities were $255.0 million during 2008, $289.9 million during 2007, and $414.4 million during 2006. The shift from realized gains of $33.4 million in 2007 to realized losses of $49.5 million in 2008 is due primarily to OTTI. An investment in a fixed maturity or equity security, that is available for sale and reported at fair value, is impaired if its fair value falls below its book value and the decline is considered to be other than temporary. In addition, during 2008, we sold certain fixed maturity securities that were in an unrealized loss position immediately prior to their sale. These sales resulted from our financial and tax planning strategies. Furthermore, in the early portion of 2008 we also took steps to limit our overall portfolio volatility by reducing our equity position by approximately $50 million.
$16.4 million of ABS charges. These charges related to issuer-specific credit events that revolved around the performance of the underlying collateral, which had materially deteriorated; however, none of which were bankruptcy related. In general, these securities were experiencing increased conditional default rates and expected loss severities, and as a result, our stress test scenarios were indicating less of a margin to absorb losses going forward. Although some of these securities were insured or guaranteed by monoline bond guarantors, downgrades have reduced our confidence in their ability to perform in the event of default. In addition, credit support for these securities has also begun to erode, thereby further increasing the potential for eventual loss.
The increase in realized losses on available for sale equity securities of $11.9 million is primarily due to non-cash OTTI charges of $6.6 million from six equity securities, including $1.5 million related to an externally managed trading portfolio. These securities were written down due to the fact that we lack the intent to hold these securities through their anticipated recovery period as we do not control day-to-day trading decisions for this portfolio. These charges related to the sharp sell off in the global equity markets stemming from the mortgage and credit crisis, which led to concerns that both U.S. and global economic growth would slow in the near future.
Our notes payable are subject to certain debt covenants which were met in their entirety in 2008 and 2007. For further discussion regarding the debt covenants, refer to Note 9, “Indebtedness.”
Investment income associated with the above invested assets is included in net investment income in the Consolidated Income Statement, including unrealized gains and losses on our trading securities. In 2008, net investment income included $8.1 million of reductions in fair value, respectively, representing the change in market value on our trading securities. The portion of trading losses for the period that relates to the trading securities still held at December 31, 2008 is $2.0 million.
Fair values in the above table were generated using various valuation techniques. For valuations of securities in our equity portfolio and U.S. Treasury notes held in our fixed maturity portfolio, we utilized a market approach, wherein we used quoted prices in an active market for identical assets (i.e., Level 1 prices). The source of our Level 1 prices for these securities was an external pricing service, which we validated against other external pricing sources.
Our consolidated financial statements reflect the effects of assumed and ceded reinsurance transactions. Assumed reinsurance refers to the acceptance of certain insurance risks that other insurance entities have underwritten. Ceded reinsurance involves transferring certain insurance risks (along with the related written and earned premiums) that we have underwritten to other insurance companies that agree to share these risks. The primary purpose of ceded reinsurance is to protect our company from potential losses in excess of the amount it is prepared to accept.
The net loss and loss expense reserves increased by $102.0 million in 2008, $225.7 million in 2007, and $223.2 million in 2006. The loss reserves include anticipated recoveries for salvage and subrogation claims, which amounted to $55.9 million for 2008, $52.3 million for 2007, and $49.6 million in 2006. The changes in the net loss and loss expense reserves were the result of growth in exposures, anticipated loss trends, changes in reinsurance retentions, as well as normal reserve development inherent in the uncertainty in establishing reserves for losses and loss expenses. As additional information is collected in the loss settlement process, reserves are adjusted accordingly. These adjustments are reflected in the consolidated statements of income in the period in which such adjustments are recognized. These changes could have a material impact on the results of operations of future periods when the adjustments are made.
IBNR reserve estimation is often difficult because, in addition to other factors, there are significant uncertainties associated with critical assumptions in the estimation process such as average clean-up costs, third-party costs, potentially responsible party shares, allocation of damages, insurer litigation costs, insurer coverage defenses and potential changes to state and federal statutes. Moreover, normal historically based actuarial approaches are difficult to apply because relevant history is not available. In addition, while models can be applied, such models can produce significantly different results with small changes in assumptions.
During 2008, 43 of our past and present insureds filed formal consent decrees with the New Jersey Department of Environmental Protection, resolving our largest landfill claim, which resulted in our payment of approximately $4.7 million on behalf of these insureds.
(1) On September 25, 2006, we issued $100 million aggregate principal amount of 7.5% Junior Subordinated Notes due 2066 (“Junior Notes”). The Junior Notes will pay interest, subject to our right to defer interest payments for up to 10 years, on March 15, June 15, September 15, and December 15 of each year, beginning December 15, 2006, and ending on September 27, 2066. On or after September 26, 2011, the Junior Notes may be called at any time, in whole or in part, at their aggregate principal amount, together with any accrued and unpaid interest. The net proceeds of $96.8 million from the issuance were used for general corporate purposes. There are no attached financial debt covenants to which we are required to comply in regards to the Junior Notes.
(4) On May 4, 2000, we entered into a $30.0 million and a $61.5 million note purchase agreement with various private lenders covering the 8.63% and 8.87% Senior Notes, respectively. During 2007, the principal amount of the 8.63% Senior Notes was paid in full. We have paid $36.9 million in principal to date, in addition to accrued interest thereon, for the 8.87% Senior Notes. Principal payments of $12.3 million are required annually through May 4, 2010. The unpaid principal amount of the 8.87% Senior Notes, which was $24.6 million at December 31, 2008 and $36.9 million at December 31, 2007, accrues interest and is payable semiannually on May 4 and November 4 of each year, until the principal is paid in full. The agreements covering these notes contain a standard default cross-acceleration provision that provides the 8.87% Senior Notes will enter a state of default upon the failure to pay principal when due or upon any event or condition that results in an acceleration of principal, the election of directors to the Board, or a mandatory repurchase of any other debt instrument in excess of $1 million which we have outstanding concurrently with the 8.87% Senior Notes. In addition to the above cross-acceleration provision covenants, the note purchase agreement covering the 8.87% Senior Notes also contains financial debt covenants that are reviewed quarterly. They include, but are not limited to, a limitation on indebtedness, restricted ability to declare dividends, and net worth maintenance. All of the covenants were met during 2008 and 2007. At December 31, 2008, the amount available for dividends to stockholders under such restrictions was $302.6 million for the 8.87% Senior Notes.
On August 11, 2006, the Parent entered into a syndicated line of credit agreement, which is contingent upon the satisfaction of certain agreed upon debt covenants, as outlined below, and is syndicated among the following five banks: (i) Wachovia Bank N.A., a subsidiary of Wells Fargo & Company, as administrative agent; (ii) JP Morgan Chase Bank, N.A.; (iii) State Street Bank and Trust Company; (iv) Branch Banking and Trust Company; and (v) TD Bank, National Association (formerly known as Commerce Bank, N.A.). This line can be increased to $75 million with the consent of all lending parties. According to the syndicated line of credit agreement, the lenders are not joint and severally liable with regards to the total commitment under the agreement. The Parent did not access the facility during 2008 and there were no balances outstanding under the line of credit as of December 31, 2008 or December 31, 2007.
In 2002, we issued $305 million aggregate principal amount of 1.6155% senior convertible notes (“Convertible Notes”), due September 24, 2032, at a discount of 61.988% resulting in an effective yield of 4.25%.
The Convertible Notes were redeemable by the Parent in whole or in part, at any time on or after September 24, 2007, at a price equal to the sum of the issue price, plus the call premium, if any, plus accrued original issue discount and accrued and unpaid cash interest, if any, on such Convertible Notes to the applicable redemption date.
During 2006, $58.5 million of the principal balance was redeemed through an induced conversion that resulted in the issuance of 3,996,306 shares of stock and the recognition of $2.1 million in expense representing the incremental consideration in connection with the transactions. During 2007, the remaining principal balance was settled as follows: (i) $21.7 million was voluntarily presented for conversion, $11.2 million of which was settled through the issuance of 765,903 shares, with the remaining $10.5 million net-share settled resulting in the issuance of 235,220 shares; and (ii) $35.7 million was called for redemption, with the final $8.7 million settling in January 2008. The majority of these redemptions were net-share settled resulting in the issuance of 905,052 shares.
The Convertible Subordinated Debentures (the “Debentures”) were issued under an Indenture dated December 29, 1982, (the “1982 Indenture”) in the principal amount of $25.0 million, bearing interest at a rate of 8.75% per annum, which was payable on the unpaid principal semiannually on January 1 and July 1 in each year to holders of record at the close of business on the preceding December 15 and June 15, respectively. The Debentures were convertible into common stock at an effective conversion price of $3.54 per share. The 1982 Indenture required us to retire, through the operation of a mandatory sinking fund, 5% of the original $25.0 million aggregate principal amount of the debentures on or before December 31 of each year from 1993 through 2006. Voluntary conversions have satisfied this obligation in its entirety.
On January 2, 2008, the Debentures matured and were settled through the issuance of 45,759 shares of the Parent’s common stock along with an insignificant cash payment. The principal amount of the Debentures, which was $0.2 million at December 31, 2007, is included in “Other liabilities” on the Consolidated Balance Sheets.
As of December 31, 2008, we had 9.9 million shares reserved for various stock compensation and purchase plans, retirement plans, dividend reinvestment plans and convertible debt offerings. As part of our ongoing capital management strategy, we repurchase the Parent’s stock from time to time. The following table provides information regarding the purchase of the Parent’s common stock during the 2006-2008 reporting periods:
On January 30, 2007, the Board of Directors (the “Board”) of the Parent declared a two-for-one stock split of the Parent’s common stock, par value $2.00 per share in the form of a share dividend of one additional share of the Parent’s common stock for each outstanding share of the Parent’s common stock issued by us (the “Share Dividend”). The Share Dividend was paid on February 20, 2007 to shareholders of record as of the close of business on February 13, 2007. The effect of the Share Dividend has been recognized retroactively in 2006 share and per share data, as well as the capital stock account balances, in the accompanying Consolidated Financial Statements, Notes to Consolidated Financial Statements and supplemental financial data.
If we were acquired in a merger, or 50% or more of our assets were sold (each a “Triggering Transaction”), each holder of a Right, other than an Acquiring Person, would have had the right to receive, for an exercise price of $80, such number of shares of common stock of the Principal Party (as defined in the Rights Agreement) equal to $80 multiplied by the Rights Amount, divided by 50% of the current per-share market price of the common stock of the Principal Party on the consummation date of the Triggering Transaction.
The Board could have, after a person or group became an Acquiring Person, but before an Acquiring Person acquired 50% or more of the Parent’s outstanding common stock, exchanged all or part of the outstanding Rights, other than the Rights of an Acquiring Person, for the Parent’s common stock, at an exchange ratio of one (1) share of the Parent’s common stock per Right. Under the previously existing Rights Agreement, the Rights were scheduled to expire at the earliest of: (i) the close of business on February 2, 2009; (ii) the time at which the Board redeemed all of the outstanding Rights at a redemption price of $0.01 per Right before an announcement that a person or group had become an Acquiring Person; or (iii) the time at which the Rights were exchanged for shares of the Parent’s common stock as described above.
We have classified our operations into three segments, the disaggregated results of which are reported to and used by senior management to manage our operations:
Due to the economic deterioration that occurred during 2008 in the U.S., our near-term financial projections for our HR Outsourcing reporting unit were not sufficient to support its carrying value. As a result, in the fourth quarter of 2008, a pre-tax goodwill impairment loss of $4.0 million was recognized for this reporting unit. We calculated the fair value of that reporting unit utilizing an income approach as defined under FAS 157 (i.e. expected present value of future cash flows). We did not record any goodwill impairment charges during 2007 or 2006.
Our Insurance Operations and Diversified Insurance Services segments are subject to certain geographic concentration. Approximately 29% of net premiums written are related to insurance policies written in New Jersey and 25% of Selective HR’s co-employer service fees are related to business in Florida. For additional information regarding the states that generate our remaining revenues, see the section entitled “Regional Geographic Market Focus” in Item 1. “Business,” from this Form 10-K.
We terminated, effective December 31, 1997, a nonqualified defined benefit retirement income plan for non-employee Directors. The estimated accrued costs for this plan were not material. As part of the termination, the present value of each Director’s future benefits, as of that date, was converted into units based on the fair value of the Parent’s common stock. The original termination called for the cash value of these units based upon the fair value of the Parent’s common stock on retirement date to be distributed to each Director, or at each Director’s election, over a period of fifteen years after such retirement. On May 8, 2002, the stockholders approved the conversion of the units issued under the termination plan into shares of the Parent’s common stock. All of the shares issued under this conversion have been deferred by the participants for receipt upon retirement, or at each Director’s election, over a period of no more than five years after such retirement. These deferred shares, which are currently being held in accounts on behalf of each Director, are credited with cash dividends along with interest on those dividends. The adoption of FASB Statement No. 123 (revised 2004) on January 1, 2005 resulted in a reclassification of $1.3 million to “Additional paid-in capital” on the Consolidated Balance Sheet for these deferred shares. The amount reflected in “Additional paid-in capital” for these deferred shares was $1.0 million at December 31, 2008 and $1.0 million at December 31, 2007.
The Retirement Savings Plan allows employees to make voluntary contributions to a number of diversified investment options, as well as the Parent’s common stock, on a before and/or after-tax basis. Shares of the Parent’s common stock issued under this plan were 27,920 during 2008, 29,214 during 2007, and 21,472 during 2006. The number of shares of the Parent’s common stock available to be purchased under the Retirement Savings Plan was 1,489,034 at December 31, 2008.
Three additional defined contribution plans were maintained by Selective HR in 2008, which does not participate in SICA’s defined contribution plan. The maximum allowable employee contribution to these plans is 75% of defined compensation. The contributions of highly compensated employees may be further restricted in accordance with the plan terms. At year end, Selective HR maintains only one defined contribution plan.
SICA offers a nonqualified deferred compensation plan (“Deferred Compensation Plan”) to a group of management or highly compensated employees (the “Participants”) as a method of recognizing and retaining such employees. The Deferred Compensation Plan provides the Participants the opportunity to elect to defer receipt of specified portions of compensation and to have such deferred amounts deemed to be invested in specified investment options. A Participant in the Deferred Compensation Plan may elect to defer compensation or awards to be received from our company, including up to: (i) 50% of annual base salary; (ii) 100% of annual bonus; and/or (iii) a percentage of other compensation as otherwise designated by the Administrator of the Deferred Compensation Plan.
The Retirement Income Plan was amended as of July 1, 2002, to provide for different calculations based on service with the company as of that date. Monthly benefits payable under the Retirement Income Plan and Supplemental Excess Retirement Plan at normal retirement age are computed by adding two calculations: (i) 2% of “average monthly base salary” (based on the monthly average of the participant’s compensation for the 60 months out of the most recent 120 months of employment preceding the participant’s termination of employment for which the employee’s base salary is the highest) less 1 3/7% of a social security benefit multiplied by the number of years of benefit service through June 30, 2002 (up to a maximum of 35 years); and, (ii) 1.2% of average monthly base salary (as described above) multiplied by the number of years of benefit service after June 30, 2002. The earliest retirement age is age 55 with 10 years of service or the attainment of 70 points (age plus years of service). For a participant who retires at the earliest retirement age, the Retirement Income Plan’s early reduction factors are 6 2/3% per year for the first five years and 3 1/3% for the next five years and the reduction is actuarially equivalent for the years earlier than age 55. At retirement, participants receive monthly pension payments and may choose among four joint and survivor payment options.
Effective January 1, 2006, the Retirement Income Plan was amended to eliminate eligibility for plan participation by employees first hired on or after January 1, 2006. If otherwise qualified, these employees will, however, be eligible for enhanced matching and non-elective contributions from SICA under the Retirement Savings Plan as discussed above.
SICA also provides life insurance benefits (post-retirement benefits) for employees who terminate employment and meet the age and service requirements to otherwise be eligible for a benefit under the Retirement Income Plan (referred to as “Retirees”). Retirees who terminated employment with SICA on or after January 1, 2008 who have attained age 60 by December 31, 2007 will receive life insurance coverage in an amount equal to 50% of their active life insurance coverage in effect on the date the Retiree terminates employment with SICA to a maximum benefit of $35,000. All other Retirees who terminated employment with SICA on or after January 1, 2008 will receive life insurance coverage in an amount equal to $10,000. Retirees who terminated employment with SICA prior to January 1, 2008 are eligible for a maximum life insurance benefit, depending upon the Retiree’s date of termination ranging from $35,000 to $100,000. The estimated cost of these benefits is accrued over the working lives of those employees expected to qualify for such benefits.
The amortization of prior service cost related to the Retirement Income Plan and Post-retirement Plan is determined using a straight-line amortization of the cost over the average remaining service period of employees expected to receive benefits under the Plans.
Our 2008 discount rate used to value the liability is 6.24% for both the Retirement Income Plan and the Post-retirement Plan. We determined the most appropriate discount rate in comparison to our expected pay out patterns of the plans’ obligations.
During the vesting period, dividend equivalent units (“DEUs”) are earned on the RSUs. The DEUs are reinvested in the Parent’s common stock at fair value on each dividend payment date. During 2008, 8,667 DEUs were accrued in relation to the RSUs granted. The DEUs are subject to the same vesting period and conditions set forth in the award agreement for the RSUs.
We experienced restricted stock forfeitures of 21,532 shares during 2008, 25,128 shares during 2007 and 61,446 shares during 2006. During the vesting period, dividends earned on restricted shares are reinvested in the Parent’s common stock at fair value. We issued, net of forfeitures, 1,017 restricted shares from the DRP reserves during 2008, 11,694 restricted shares during 2007, and 24,446 restricted shares during 2006.
As of December 31, 2008, there were 95,250 shares of the Parent’s common stock available for issuance pursuant to outstanding stock option awards under the Stock Compensation Plan for Non-employee Directors, under which future grants ceased being available with the approval of the Stock Plan. Under the Stock Compensation Plan for Non-employee Directors, Directors could elect to receive a portion of their annual compensation in shares of the Parent’s common stock.
Under our Employee Stock Purchase Savings Plan (“ESPP”), there were 116,873 shares of the Parent’s common stock available for purchase as of December 31, 2008. The ESPP is available to all employees who meet the plan’s eligibility requirements. The ESPP provides for the issuance of options to purchase shares of common stock. The purchase price is the lower of: (i) 85% of the closing market price at the time the option is granted or (ii) 85% of the closing price at the time the option is exercised. Shares are generally issued on June 30 and December 31 of each year. Under the ESPP, we issued 134,561 shares to employees during 2008, 108,062 shares during 2007, and 88,310 shares during 2006.
The total intrinsic value of options exercised was $2.8 million at December 31, 2008, $1.9 million at December 31, 2007, and $6.1 million at December 31, 2006.
As of December 31, 2008, total unrecognized compensation cost related to non-vested restricted stock and RSU awards granted under our stock plans was $6.6 million. That cost is expected to be recognized over a weighted-average period of 1.5 years. The total fair value of restricted stock and RSU vested was $14.2 million for 2008, $22.7 million for 2007, and $11.7 million for 2006. In connection with the restricted stock vestings, the total fair value of the DRP shares that also vested was $0.6 million during 2008, $1.1 million during 2007, and $0.9 million during 2006.
At December 31, 2008, the liability recorded in connection with our Cash Incentive Plan was $13.2 million. The fair value of the liability is re-measured at each reporting period through the settlement date of the awards, which is three years from the date of grant based on an amount expected to be paid. A Monte Carlo simulation is performed to determine the fair value of the cash incentive units that, in accordance with the Cash Incentive Plan, are adjusted to reflect our performance on specified indicators as compared to targeted peer companies. The remaining cost associated with the cash incentive units is expected to be recognized over a weighted average period of 1.6 years. During 2008, 2007, and 2006, no cash incentive unit payments were made.
In determining expense to be recorded for stock options granted under our share-based compensation plans, the fair value of each option award is estimated on the date of grant using the Black Scholes option valuation model (“Black Scholes”). The following are the significant assumptions used in applying Black Scholes: (i) risk-free interest rate, which is the implied yield currently available on U.S. Treasury zero-coupon issues with an equal remaining term; (ii) expected term, which is based on historical experience of similar awards; (iii) dividend yield, which is determined by dividing the expected per share dividend during the coming year by the grant date stock price; and (iv) expected volatility, which is based on the volatility of the Parent’s stock price over a historical period comparable to the expected term. In applying Black Scholes, we use the weighted average assumptions illustrated in the following table:
The weighted-average fair value of options and stock, including restricted stock and RSUs granted per share for the Parent’s stock plans, during 2008, 2007, and 2006 is as follows:
Share-based compensation expense charged against net income before tax was $16.9 million for the year ended December 31, 2008 with a corresponding income tax benefit of $5.5 million. Share-based compensation expense that was charged against net income before tax was $20.6 million for the year ended December 31, 2007 and $20.1 million for the year ended December 31, 2006 with a corresponding income tax benefit of $6.8 million and $6.7 million, respectively.
Rue Insurance placed human resource outsourcing contracts with Selective HR resulting in revenues to Selective HR of approximately $79,000 in 2008, $69,000 in 2007, and $62,000 in 2006. In return, Selective HR paid commissions to Rue Insurance of $12,000 in 2008, $15,000 in 2007, and $14,000 in 2006.
Rue Insurance placed insurance coverage for us with other insurance companies for which Rue Insurance was paid commission pursuant to its agreements with those carriers. We paid premiums for such insurance coverage of $0.5 million in 2008, 2007, and 2006.
We paid reinsurance commissions of $0.2 million in 2008, 2007 and 2006 to PL, LLC. PL, LLC is an insurance fund administrator of which Rue Insurance owns 33.33% and which places reinsurance through an Insurance Subsidiary.
In 2005, a private foundation, The Selective Group Foundation (the “Foundation”), was established by us under Section 501(c)(3) of the Internal Revenue Code. The Board of Directors of the Foundation is comprised of some of the Parent’s officers. We made contributions to the Foundation in the amount of $0.5 million in 2008, $0.4 million in 2007 and no donations were made to the Foundation in 2006.
The Insurance Subsidiaries are also from time to time involved in other legal actions, some of which assert claims for substantial amounts. These actions include, among others, putative state class actions seeking certification of a state or national class. Such putative class actions have alleged, for example, improper reimbursement of medical providers paid under workers compensation and personal and commercial automobile insurance policies. The Insurance Subsidiaries are also from time to time involved in individual actions in which extra-contractual damages, punitive damages, or penalties are sought, such as claims alleging bad faith in the handling of insurance claims. We believe that we have valid defenses to these cases. Our management expects that the ultimate liability, if any, with respect to such lawsuits, after consideration of provisions made for estimated losses, will not be material to our consolidated financial condition. Nonetheless, given the large or indeterminate amounts sought in certain of these actions, and the inherent unpredictability of litigation, an adverse outcome in certain matters could, from time to time, have a material adverse effect on our consolidated results of operations or cash flows in particular quarterly or annual periods.
The Insurance Subsidiaries prepare their statutory financial statements in accordance with accounting principles prescribed or permitted by the various state insurance departments of domicile. Prescribed statutory accounting principles include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (“NAIC”). Permitted statutory accounting principles encompass all accounting principles that are not prescribed; such principles differ from state to state, may differ from company to company within a state and may change in the future. The Insurance Subsidiaries do not utilize any permitted statutory accounting principles that materially affect the determination of statutory surplus, statutory net income, or risk-based capital. As of December 31, 2008 the various state insurance departments of domicile have adopted the NAIC Accounting Practices and Procedures manual, version as of March 2008, in its entirety, as a component of prescribed or permitted practices.
The Insurance Subsidiaries are required to maintain certain minimum amounts of statutory surplus to satisfy their various state insurance departments of domicile. These risk-based capital (“RBC”) requirements for property and casualty insurance companies are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholders. Based upon the Insurance Subsidiaries’ 2008 unaudited statutory financial statements, their combined total adjusted capital exceeded the authorized control level RBC by 4.4:1, as defined by the NAIC.
In February 2009, we transferred $1.6 billion of our AFS securities to a held-to-maturity designation. In accordance with FAS 115, we are required at each balance sheet date to reassess the classification designation of each security we hold. The reclassification of these securities is permitted as we have appropriately determined that we have the ability and the intent to hold these securities as an investment until maturity or call. When a security is transferred from AFS to held-to-maturity, the difference between its par value and fair value at the date of transfer is amortized as a yield adjustment in accordance with FASB Statement No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases. The fair value at the date of transfer, adjusted for subsequent amortization, becomes the security’s amortized cost basis as required by FAS 115. The unrealized holding gain or loss at the date of transfer is retained in other comprehensive income and in the carrying value of the held-to maturity securities. Of the $1.6 billion in AFS securities transferred, $1.3 billion consist of state and political subdivision obligations and $0.3 billion in U.S. government, government agency obligations, and corporate, mortgage-backed and asset-backed securities. In total, the securities transferred had a net unrealized gain of approximately $8 million.
Refer to the Glossary of Terms attached to this Form 10-K as Exhibit 99.1.
These ranges of high and low prices of the Parent’s common stock, as reported by the NASDAQ Global Select Market, represent actual transactions. All price quotations do not include retail markups, markdowns and commissions. The range of high and low prices for common stock for the period beginning January 2, 2009 and ending February 20, 2009 was $23.28 to $12.33.