1 Data for 2010 through 2011 has been restated to reflect the implementation of ASU 2010-26, Financial Services-Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts, which was adopted on January 1, 2012.
3 The impact of catastrophe losses on the 2012 statutory combined ratio including flood claims handling fees related to Superstorm Sandy was 5.8 points.
4 Operating income and operating return on average equity are non-GAAP measures. See the Glossary of Terms attached to this Form 10-K as Exhibit 99.1 for definitions of these items and see the “Financial Highlights of Results for Years Ended December 31, 2014, 2013, and 2012” section in
This is a change from the segments that we have previously reported of Standard Insurance Operations, E&S Insurance Operations, and Investments. All prior year information contained in this Form 10-K has been restated to reflect our revised segments. For qualitative information behind the change, see Note 11. "Segment Information" in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K.
Financial Highlights of Results for Years Ended December 31, 2014, 2013, and 2012;
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 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 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 Financial Statements involved the following: (i) reserves for losses and loss expenses; (ii) pension and post-retirement benefit plan actuarial assumptions; (iii) other-than-temporary-impairment ("OTTI"); and (iv) reinsurance.
The following tables provide case and incurred but not reported ("IBNR") reserves for losses and loss expenses, and reinsurance recoverable on unpaid losses and loss expenses as of December 31, 2014 and 2013:
In addition to the quarterly reserve analysis, a range of possible IBNR reserves is estimated annually and continually considered, among other factors, in establishing IBNR for each reporting period. Loss and loss expense trends are also considered, which include, but are not limited to, large loss activity, asbestos and environmental claim activity, large case reserve additions or reductions for prior accident years, and reinsurance recoverable issues. We also consider factors such as: (i) per claim information; (ii) company and industry historical loss experience; (iii) legislative enactments, judicial decisions, legal developments in the imposition of damages, and changes in political attitudes; and (iv) trends in general economic conditions, including the effects of inflation. Based on the consideration of the range of possible IBNR reserves, recent loss and loss expense trends, uncertainty associated with actuarial assumptions and other factors, IBNR is established and the ultimate net liability for losses and loss expenses is determined. Such an assessment requires considerable judgment given that it is frequently not possible to determine whether a change in the data is an anomaly until sometime after the event. Even if a change is determined to be permanent, it is not always possible to reliably determine the extent of the change until sometime later. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves because the eventual deficiency or redundancy is affected by many factors. The changes in these estimates, resulting from the continuous review process and the differences between estimates and ultimate payments, are reflected in the Consolidated Statements of Income for the period in which such estimates are changed. Any changes in the liability estimate may be material to the results of operations in future periods. In addition to our internal review, statutory regulation requires us to have a Statement of Actuarial Opinion issued annually on our statutory reserve adequacy. We engage an independent actuary to issue this opinion based on their independent review.
For the past nine years, the Insurance Subsidiaries have experienced favorable prior accident year loss and loss expense development. Over the past three years, contributions to the favorable emergence have come from virtually all lines of business, with the exceptions of workers compensation and E&S Lines. The greater contributions have generally come from the longer tailed casualty lines, primarily due to their associated volume of reserves and the inherent uncertainty of the longer claims settlement process.
At December 31, 2014, our general liability line of business had recorded reserves, net of reinsurance, of $1.1 billion, which represented 37% of our total net reserves. In 2014, this line experienced favorable development of $43.9 million, which was partially driven by lower severities in the 2010 through 2012 accident years, within both the premises and operations and products liability coverages. In addition, accident years 2011 and 2012 continue to show lower than expected claim counts.
While we believe these changes are already contributing to our improved loss experience, there is always risk associated with change. Most notably, these changes in operations may inherently change paid and reported development patterns. While our reserve analyses incorporate methods that adjust for these changes, there nevertheless remains a greater risk in the estimated reserves.
At December 31, 2014, our commercial automobile line of business had recorded reserves, net of reinsurance, of $358 million, which represented 12% of our total net reserves. During the past three years, this line experienced favorable reserve development. In 2014, the favorable development was $4.1 million, driven by bodily injury liability for accident years 2012 and prior. For accident years 2011 and prior, this reflects a continued trend of better than expected reported emergence in these years. Accident year 2012 experienced favorable development due to a reduction in estimated severity, after experiencing unfavorable development during 2013 due to higher than expected claim frequency. The favorable development for accident years 2012 and prior was partially offset by unfavorable development in the 2013 accident year due to higher than expected claim frequency.
At December 31, 2014, our personal automobile line of business had recorded reserves, net of reinsurance, of $116 million, which represented 4% of our total net reserves. In 2014, this line experienced favorable development of $10.8 million, which was driven by the liability coverages for accident years 2012 and prior. Our mix of business continues to shift away from New Jersey towards other targeted states within our footprint. We continue to recalibrate our predictive models to improve the accuracy of our rating plans. While we believe these changes will ultimately lead to improved profitability and greater stability, they may impact paid and reported development patterns, thereby increasing the uncertainty in the reserves in the near-term.
Estimating IBNR reserves for asbestos and environmental claims is difficult because of the delayed and inconsistent reporting patterns associated with these claims. In addition, there are significant uncertainties associated with estimating critical assumptions, such as average clean-up costs, third-party costs, potentially responsible party shares, allocation of damages, litigation and coverage costs, and potential state and federal legislative changes. Normal historically-based actuarial approaches cannot be applied to asbestos and environmental claims because past loss history is not indicative of future potential loss emergence. In addition, while certain alternative models can be applied, such models can produce significantly different results with small changes in assumptions. As a result, we do not calculate an asbestos and environmental loss range. Historically, our asbestos and environmental claims have been significantly lower in volume, with less volatility and uncertainty than many of our competitors in the commercial lines industry. Prior to the introduction of the absolute pollution exclusion endorsement in the mid-1980's, we were primarily a personal lines carrier and therefore do not have broad exposure to asbestos and environmental claims. Additionally, we are the primary insurance carrier on the majority of these exposures, which provides more certainty in our reserve position compared to others in the insurance marketplace.
The discount rate enables us to state expected future cash flows at their present value on the measurement date. The purpose of the discount rate is to determine the interest rates inherent in the price at which pension benefits could be effectively settled. Our discount rate selection is based on high-quality, long-term corporate bonds. A higher discount rate reduces the present value of benefit obligations and reduces pension expense. Conversely, a lower discount rate increases the present value of benefit obligations and increases pension expense. We decreased our discount rate for the Retirement Income Plan for Selective Insurance Company of America and the Supplemental Excess Retirement Plan (jointly referred to as the "Retirement Income Plan" or the "Plan") to 4.29% for 2014, from 5.16% for 2013, reflecting lower market interest rates. We also decreased our discount rate for the life insurance benefit provided to eligible Selective Insurance Company of America ("SICA") employees (referred to as the "Retirement Life Plan") to 4.08% for 2014 from 4.85% for 2013.
The expected long-term rate of return on the plan assets is determined by considering the current and expected asset allocation, as well as historical and expected returns on each plan asset class. A lower expected rate of return on pension plan assets would increase pension expense. Our long-term expected return on the plan assets was lowered 65 basis points to 6.27% in 2014 as compared to 6.92% in 2013. This expected return is within a reasonable range considering the lower interest rate environment, as well as our actual 8.3% annualized return since the plan inception for all the plan assets.
At December 31, 2014, our pension and post-retirement benefit plan obligation was $337.4 million compared to $262.6 million at December 31, 2013. Volatility in the marketplace, changes in the discount rate assumption, and further changes in mortality assumptions could materially impact our pension and post-retirement life valuation in the future. For additional information regarding our pension and post-retirement benefit plan obligations, see Note 15. "Retirement Plans" in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
OTTI charges are recognized as a realized loss to the extent that they are credit related, unless we have the intent to sell the security or it is more likely than not that we will be required to sell the security. In those circumstances, the security is written down to fair value with the entire amount of the writedown charged to earnings as a component of realized losses.
For CMBS, we also consider the net operating income (“NOI”) generated by the underlying properties. Our assumptions of the properties’ ultimate cash flows take into consideration both an immediate reduction to the reported NOIs and decreases to projected NOIs.
Reinsurance recoverables on paid and unpaid losses and loss expenses represent estimates of the portion of such liabilities that will be recovered from reinsurers. Each reinsurance contract is analyzed to ensure that the transfer of risk exists to properly record the transactions in the Financial Statements. Amounts recovered 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. This allowance totaled $6.9 million at December 31, 2014 and $5.1 million at December 31, 2013. We continually monitor developments that may impact recoverability from our reinsurers and have available to us contractually provided remedies if necessary. For further information regarding reinsurance, see the “Reinsurance” section below and Note 8. “Reinsurance” in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
We are currently targeting an ROE that is three points higher than our cost of capital, or 12%, excluding the impact of realized gains and losses, which is referred to as operating return on equity. Our operating ROE and contribution by component for the following years are as follows:
Earned rate in excess of expected claims inflation in both 2014 and 2013. Renewal pure price increases of 5.6% in 2014, 7.6% in 2013, and 6.3% in 2012 have earned in at 6.6% in 2014 and 7.1% in 2013, both of which are above loss inflation trends of approximately 3%. After taking into account the incremental expenses associated with the additional premium, the net benefit to the combined ratio is approximately 2.5 points in both years.
1 Our estimated ultimate exposure decreased to $132 million in the third quarter of 2014.
While we expect the competitive market environment to continue, we believe that we have a strong foundation for further improvement in our underlying profitability considering:
Our reserve position that reflects the discipline we have always maintained in our reserving practices;
Our customer-centric approach to our business with a focus on our policyholders and the service we bring to them;
Our deep bench of talent in the organization and our continuous cultivation of that talent.
An ex-catastrophe combined ratio of 91%, which includes no prior year casualty reserve development;
On a longer-term basis, in order to achieve our goal of an operating ROE of 12%, we need to deliver a 90% ex-catastrophe combined ratio, which is our ongoing focus.
Our Standard Commercial Lines, which represents 76% of our combined insurance segments' NPW, sells commercial lines insurance products and services to businesses, non-profit organizations, and local government agencies located primarily in 22 states in the Eastern and Midwestern U.S. and the District of Columbia through approximately 1,100 distribution partners in the standard marketplace.
The GAAP loss and loss expense ratio improved by 1.6 points in 2014 compared to 2013 and by 6.5 points in 2013 compared to 2012. Both periods experienced earned renewal pure price increases of 6.5% to 7.0%, which outpaced our loss inflation trends, thus improving our results by approximately 2.5 points in each year. In 2014, prior year casualty reserve development of 3.2 points further contributed to the improved results, whereas 2013 and 2012 had comparable levels of prior year casualty reserve development at 0.8 and 0.9 points, respectively. For information on this development by line of business, see "Financial Highlights of Results for Years Ended December 31, 2014, 2013, and 2012" above.
NPW and NPE have seen increases over the three-year time period driven by renewal pure price increases and strong retention.
The combined ratio in this line of business has been very stable over the last three years. In all three years, the combined ratio has been impacted by renewal pure price increases that have exceeded loss inflation trends, higher property losses, and lower favorable prior year casualty reserve development, which are outlined below:
2013: 1.6 points driven by accident years 2006 through 2010 representing a continued trend of better than expected reported emergence, partially offset by increased severity in accident year 2012.
NPW decreased in 2014 compared to 2013 while it increased in 2013 compared to 2012. Excluding the impact of the sale of the SIG renewal rights, which included $4 million of premium in 2013, the decrease in NPW in 2014 would have been 1%. This decrease was due to reductions in new business and a focused effort to improve our hazard mix and reduce exposures on this line.
The 2013 NPW increase was due to: (i) renewal pure price increases of 7.5%; (ii) improvements in retention; and (iii) an increase in direct new business.
Prior year casualty reserve development on this line was as follows:
Our Standard Personal Lines segment, which includes our flood business, represents approximately 16% of our combined insurance segments' NPW, sells personal lines insurance products and services to individuals located primarily in 13 states through approximately 700 distribution partners. In addition, we have approximately 5,000 distribution partners selling our flood business.
The decrease in 2014 NPW was mainly due to lower retention. This was the result of our strategic nonrenewal of dwelling fire business of approximately $8.9 million and targeted nonrenewal actions on underperforming personal automobile and mono-line homeowners business. Excluding the impact of those targeted actions, retention remains strong at 84%, which is comparable to last year.
In addition, 2014 had favorable prior year casualty reserve development of 2.9 points, compared to favorable prior year casualty reserve development of 2.0 points in 2013. Quantitative details regarding this favorable prior year development is as follows:
The increase in the underwriting expense ratio in 2014 compared to 2013 was driven by higher supplemental commissions to our distribution partners.
The improvement in the underwriting expense ratio in 2013 compared to 2012 was driven by a higher underwriting expense allowance received from the NFIP as a result of: (i) an increase in the rate used in reimbursing WYO carriers for issuing and servicing flood policies; and (ii) an increase in flood premiums to which the reimbursement rate is applied.
Our E&S Lines segment, which represents 8% of our combined insurance segments' NPW, sells commercial lines insurance products and services in all 50 states and the District of Columbia through approximately 80 distribution partners. Insurance policies in this segment are sold to customers that typically have business risks with unique characteristics, such as the nature of the business or its claim history, that have not obtained coverage in the standard marketplace. E&S insurers have more flexibility in coverage terms and rates compared to standard market insurers, generally resulting in policies with higher rates and terms and conditions that are customized for specific risks.
By entering into reinsurance treaties and arrangements, we are able to increase underwriting capacity and accept larger risks and a larger number of risks without directly increasing capital or surplus. Our reinsurance consists of traditional reinsurance and we do not purchase finite reinsurance. Under our reinsurance treaties, the reinsurer generally assumes a portion of the losses we cede to them in exchange for a portion of the premium. Amounts not reinsured are known as retention. Reinsurance does not legally discharge us from liability under the terms and limits of our policies, but it does make our reinsurer liable to us for the amount of liability we cede to them. Accordingly, we have counterparty credit risk to our reinsurers. We attempt to mitigate this credit risk by: (i) pursuing relationships with reinsurers rated “A-” or higher; or (ii) obtaining collateral to secure reinsurance obligations. Some of our reinsurance contracts include provisions that permit us to terminate or commute the reinsurance treaty if the reinsurer's financial condition or rating deteriorates. We consistently monitor the financial condition of our reinsurers. We also continuously review the quality of reinsurance recoverables and reserves for uncollectible reinsurance. For additional information regarding our counterparty credit risk with our reinsurers, see Note 8. "Reinsurance" in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K.
Property Reinsurance - includes our property excess of loss treaties purchased for protection against large individual property losses and our Property Catastrophe treaty purchased to provide protection for the overall property portfolio against severe catastrophic events. Facultative reinsurance is used for property risks that are in excess of our treaty capacity.
The Property Catastrophe treaty, which covers both our standard market and E&S business, renewed effective January 1, 2015. The current treaty structure remains the same, providing total coverage of $685 million in excess of $40 million. The annual aggregate limit net of our co-participation is approximately $1.0 billion for 2015. As a result of our actions to further control our property aggregations, our modeled results showed decreases year on year, especially for higher severity, low-probability events. Due to this, we chose to decrease the percent of reinsurance placement in some of the catastrophe treaty layers. In addition, we placed a separate catastrophe treaty of $35 million in excess of $5 million to cover events outside of our standard lines footprint, in support of our growing E&S property book. We expect the overall catastrophe ceded premium for 2015 to be slightly lower than 2014. As our need for catastrophe reinsurance increases, we seek ways to minimize credit risk inherent in a reinsurance transaction by dealing with highly-rated reinsurance partners and purchasing collateralized reinsurance products, particularly for high severity, low-probability events. The current program includes $196 million in collateralized limit.
Our current catastrophe reinsurance program exhausts at a 1 in 273 year return period, or events with 0.37% probability, based on a multi-model view of hurricane risk.
The Property Excess of Loss treaty (“Property Treaty”), which covers our standard market business, was renewed on July 1, 2014 and is effective through June 30, 2015, the terms of which are consistent with the prior year treaty. The details of the current year treaty are included in the table below.
- 81% of losses in excess of $40 million up to
The Casualty Excess of Loss treaty (“Casualty Treaty”), which covers our standard market business, was renewed on July 1, 2014 and is effective through June 30, 2015, with substantially the same terms as the expiring treaty. The details of the current year treaty are included in the table below.
All NBCR losses are excluded. All other losses stemming from the acts of terrorism are subject to the following reinstatements and annual aggregate limits:
presents a challenge to us in generating after-tax return, as new purchase yields are below the average yield on bonds that are currently maturing.
Our fixed income securities portfolio maintained a weighted average credit rating of AA- as of December 31, 2014. The following table presents the credit ratings of our fixed income securities portfolio:
We have audited the accompanying consolidated balance sheets of Selective Insurance Group, Inc. and its subsidiaries (the “Company”) as of December 31, 2014 and 2013, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flow for each of the years in the three-year period ended December 31, 2014. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules I to V. These consolidated financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Selective Insurance Group, Inc. and its subsidiaries' internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 26, 2015, expressed an unqualified opinion of the Company’s internal controls over financial reporting.
Standard Commercial Lines - comprised of insurance products and services provided in the standard marketplace to our commercial customers, who are typically businesses, non-profit organizations, and local government agencies.
The accompanying consolidated financial statements ("Financial Statements") include the accounts of the Parent and its subsidiaries, and have been prepared in conformity with: (i) U.S. generally accepted accounting principles ("GAAP"); and (ii) the rules and regulations of the U.S. Securities and Exchange Commission. All significant intercompany accounts and transactions are eliminated in consolidation.
Other investments may include alternative investments and other securities. Alternative investments are accounted for using the equity method. Our share of distributed and undistributed net income from alternative investments is included in "Net investment income earned" on our Consolidated Statement of Income. Included in other securities are low income housing tax credits, which are accounted for under the proportional amortization method. The remainder of our other securities are accounted for using the equity method. Under the proportional amortization method, our share of the investment’s performance is recorded in our Consolidated Statement of Income as a component of “Federal income tax expense (benefit).” Under the equity method, our share of distributed and undistributed net income is included in "Net investment income earned" on our Consolidated Statement of Income.
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. Included in realized gains and losses are the other-than-temporary impairment ("OTTI") charges recognized in earnings, which are discussed below.
For structured securities, including commercial mortgage-backed securities ("CMBS"), residential mortgage-backed securities ("RMBS"), ABS, and collaterialized debt obligations ("CDOs"), we also consider variables such as expected default, severity, and prepayment assumptions based on security type and vintage, taking into consideration information from credit agencies, historical performance, and other relevant economic and performance factors.
For approximately 99% of our fixed income securities portfolio, we utilize a market approach, using primarily matrix pricing models prepared by external pricing services. Matrix pricing models use mathematical techniques to value debt securities by relying on the securities relationship to other benchmark quoted securities, and not relying exclusively on quoted prices for specific securities, as the specific securities are not always frequently traded. As a matter of policy, we consistently use one pricing service as our primary source and secondary pricing services if prices are not available from the primary pricing service. In conjunction with our external investment portfolio managers, fixed income securities portfolio pricing is reviewed for reasonableness in the following ways: (i) comparing our pricing to other third-party pricing services as well as benchmark indexed pricing; (ii) comparing positions traded directly by the external investment portfolio managers to prices received from the third-party pricing services; (iii) comparing market value fluctuations between months for reasonableness; and (iv) reviewing stale prices. If further analysis is needed, a challenge is sent to the pricing service for review and confirmation of the price. These prices are typically Level 2 in the fair value hierarchy.
For the small portion of our fixed income securities portfolio that we cannot price using our primary or secondary service, we typically use non-binding broker quotes. These prices are from various broker/dealers that use bid or ask prices, or benchmarks to indices, in measuring the fair value of a security. For the small portion of non-public equity securities that we hold, we typically receive prices from a third party pricing service or through statements provided by the security issuer. In conjunction with our external investment portfolio managers, these fair value measurements are reviewed for reasonableness. This review typically includes an analysis of price fluctuations between months with variances over established thresholds being analyzed further. These prices are generally classified as Level 3 in the fair value hierarchy, as the inputs cannot be corroborated by observable market data.
The fair value of the 1.25% and recently repaid 2.90% borrowings from the Federal Home Loan Bank of Indianapolis (“FHLBI”) are estimated using a DCF based on a current borrowing rate provided by the FHLBI consistent with the remaining term of the borrowing.
Share-based compensation consists of all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share units, share options, or other equity instruments. The cost resulting from all share-based payment transactions are recognized in the Financial Statements based on the fair value of both equity and liability awards. The fair value is measured at grant date for equity awards, whereas the fair value for liability awards are remeasured at each reporting period. Both the fair value of equity and liability awards is recognized over the requisite service period. The requisite service period is typically the lesser of the vesting period or the period of time from the grant date to the date of retirement eligibility. The expense recognized for share-based awards, which, in some cases, contain performance criteria, is based on the number of shares or units expected to be issued at the end of the performance period.
Reinsurance recoverables represent estimates of amounts that will be recovered from reinsurers under our various treaties. Generally, amounts recoverable from reinsurers are recognized as assets at the same time and in a manner consistent with the paid and unpaid losses associated with the reinsured policies. We require collateral to secure reinsurance recoverables primarily from our reinsurance carriers that are not authorized, otherwise approved, or certified to do business in our Insurance Subsidiaries’ domiciliary states. This collateral is typically in the form or a letter of credit or cash. An allowance for estimated uncollectible reinsurance is recorded based on an evaluation of balances due from reinsurers and other available information, such as each reinsurers' credit rating from A.M. Best and Company ("A.M. Best") or Standard & Poor's Rating Services ("S&P"). We charge off reinsurance recoverables on paid losses when it becomes probable that we will not collect the balance.
In October 2010, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2010-26, Financial Services-Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts (“ASU 2010-26”). ASU 2010-26 requires that only costs that are incremental or directly related to the successful acquisition of new or renewal insurance contracts are to be capitalized as a deferred acquisition cost. This includes, among other items, sales commissions paid to our distribution partners, premium taxes, and the portion of employee salaries and benefits directly related to time spent on acquired contracts. We adopted this guidance on January 1, 2012, with retrospective application.
In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income
continuous statement of comprehensive income or in two separate but consecutive statements. This standard eliminates the
option to report OCI and its components in the statement of stockholders’ equity. ASU 2011-05 was effective, on a retrospective basis, for interim and annual periods beginning after December 15, 2011. Based on an amendment issued in December 2011, companies were not required to present separate line items on the income statement for reclassification adjustments out of AOCI into net income, as would have been required under the initial ASU. This guidance, which is ASU 2011-12, Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05, was effective concurrently with ASU 2011-05. We have included a Consolidated Statement of Comprehensive Income as part of the Financial Statements to comply with the presentation required under this accounting guidance.
In August 2014, the FASB issued ASU 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (“ASU 2014-15”). ASU 2014-15 provides guidance about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. Currently U.S. auditing standards and federal securities law require that an auditor evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time not to exceed one year beyond the date of the financial statements being audited. Due to lack of guidance about management’s responsibility and the differing views about when there is substantial doubt about an entity’s ability to continue as a going concern, there is diversity in whether, when, and how an entity discloses the relevant conditions and events in its footnotes. In connection with preparing financial statements for each annual and interim reporting period, an entity's management should evaluate whether there are conditions or events, considered in the aggregate, that raise considerable doubt about the entity's ability to continue as a going concern within one year after the date that the financial statements are issued (or within one year after the date that the financial statements are to be issued when applicable). The amendments in ASU 2014-15 clarify the timing and content of footnote disclosures. ASU 2014-15 is effective for annual periods ending after December 15, 2016, and interim periods beginning in 2017. Early application is permitted. The adoption of this ASU is not expected to impact the Company.
Supplemental cash flow information for the years ended December 31, 2014, 2013, and 2012 is as follows:
Unrecognized holding gains and losses of HTM securities are not reflected in the Financial Statements, as they represent fair value fluctuations from the later of: (i) the date a security is designated as HTM; or (ii) the date that an OTTI charge is recognized on an HTM security, through the date of the balance sheet. Our HTM securities had an average duration of 1.7 years as of December 31, 2014.
Unrealized gains and losses of AFS securities represent fair value fluctuations from the later of: (i) the date a security is designated as AFS; or (ii) the date that an OTTI charge is recognized on an AFS security, through the date of the balance sheet. These unrealized gains and losses are recorded in AOCI on the Consolidated Balance Sheets.
(d) The following tables summarize, for all securities in a net unrealized/unrecognized loss position at December 31, 2014 and December 31, 2013, the fair value and pre-tax net unrealized/unrecognized loss by asset class and by length of time those securities have been in a net loss position:
The table below provides our net unrealized/unrecognized loss positions by impairment severity as of December 31, 2014 compared to the prior year:
(e) Fixed income securities at December 31, 2014, by contractual maturity are shown below. Mortgage-backed securities ("MBS") are included in the maturity tables using the estimated average life of each security. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
Listed below are AFS fixed income securities at December 31, 2014:
This strategy purchases seasoned private equity funds from investors desiring liquidity prior to normal fund termination. Investments are made across all sectors of the private equity market, including leveraged buyouts ("LBO"), venture capital, distressed securities, mezzanine financing, real estate, and infrastructure.
This strategy makes direct and indirect investments in debt and equity securities of companies that are experiencing financial and/or operational distress. Investments include buying indebtedness of bankrupt or financially troubled companies, small balance loan portfolios, special situations and capital structure arbitrage trades, commercial real estate mortgages and similar non-U.S. securities and debt obligations. This strategy includes a fund of funds component.
(g) We have pledged certain AFS fixed income securities as collateral related to: (i) our outstanding borrowing of $45 million with the Federal Home Loan Bank of Indianapolis ("FHLBI"); (ii) our reinsurance obligations related to our 2011 acquisition of our E&S book of business; and (iii) our compliance with insurance laws by placing certain securities on deposit with various state and regulatory agencies. We retain all rights regarding all securities pledged as collateral.
The following table sets forth, for the periods indicated, credit loss impairments on fixed income securities for which a portion of the OTTI charge was recognized in OCI, and the corresponding changes in such amounts:
(j) The components of net realized gains, excluding OTTI charges, were as follows:
(b) The components of comprehensive income, both gross and net of tax, for 2014, 2013, and 2012 were as follows:
The following table presents the carrying amounts and estimated fair values of our financial instruments as of December 31, 2014 and 2013:
The following tables provide quantitative disclosures of our financial assets that were measured at fair value at December 31, 2014 and 2013:
As discussed in Note 2. "Summary of Significant Accounting Policies," in this Form 10-K, the fair value of our Level 3 fixed income securities are typically obtained through non-binding broker quotes, which we review for reasonableness. At December 31, 2014 and December 31, 2013, there were no fixed income securities that were measured using Level 3 inputs. However, during 2013, securities with a fair value of $32.0 million were transferred out of Level 3 due to the availability of Level 2 pricing at December 31, 2013 that was not available previously.
Our 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 the Insurance Subsidiaries from potential losses in excess of the amount that we are prepared to accept. Our major treaties covering property, property catastrophe, and casualty business are excess of loss contracts. In addition, we have an intercompany quota share pooling arrangement and other minor quota share treaties.
As a Standard Commercial Lines and E&S Lines writer, we are required to participate in Terrorism Risk Insurance Program Reauthorization Act ("TRIPRA"), which was extended to December 31, 2020. TRIPRA requires private insurers and the United States government to share the risk of loss on future acts of terrorism certified by the U.S. Secretary of the Treasury. Under TRIPRA, each participating insurer is responsible for paying a deductible of specified losses before federal assistance is available. This deductible is based on a percentage of the prior year’s applicable Standard Commercial Lines and E&S Lines premiums. In 2015, our deductible is approximately $254 million. For losses above the deductible, the federal government will pay 85% of losses to an industry limit of $100 billion, and the insurer retains 15%. The federal share of losses will be reduced by 1% each year to 80% by 2020.
The Insurance Subsidiaries remain liable to policyholders to the extent that any reinsurer becomes unable to meet their contractual obligations. We evaluate and monitor the financial condition of our reinsurers under voluntary reinsurance arrangements to minimize our exposure to significant losses from reinsurer insolvencies. On an ongoing basis, we review amounts outstanding, length of collection period, changes in reinsurer credit ratings, and other relevant factors to determine collectability of reinsurance recoverables. The allowance for uncollectible reinsurance recoverables was $6.9 million at December 31, 2014 and $5.1 million at December 31, 2013.
Direct and ceded losses and loss expenses decreased significantly in 2013, primarily due to the impact of Superstorm Sandy, for which $1.1 billion in flood losses were ceded to the federal government in 2012.
The net losses and loss expense reserves increased by $97.0 million in 2014, $149.7 million in 2013, and $63.8 million in 2012. The losses and loss expense reserves are net of anticipated recoveries for salvage and subrogation claims, which amounted to $65.1 million for 2014, $61.0 million for 2013, and $62.2 million for 2012. The changes in the net losses and loss expense reserves were the result of growth in exposures, particularly associated with our E&S Lines of business, anticipated loss trends, changes in reinsurance retentions, and normal reserve changes 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.
The 2014 prior year favorable development of $59.3 million includes $48.2 million of favorable casualty development and $11.1 million of favorable property development. The property development was primarily related to a prior year reinsurance recoverable. The favorable casualty development was largely driven by the general liability and personal automobile lines of business. These lines have both experienced increasingly favorable development in recent years. Conversely, businessowners’ policies and our E&S Lines experienced unfavorable emergence in 2014, which was a reversal from 2013. Our workers compensation line had no development in 2014, after experiencing unfavorable development of $23.5 million last year.
The 2013 prior year favorable development of $25.5 million includes $14.5 million of favorable casualty development and $11.0 million of favorable property development. The property development was primarily related to favorable non-catastrophe loss activity, mostly in the 2012 accident year. The casualty lines were driven largely by favorable development in accident years 2006 through 2010, with lower than expected severities in general liability and commercial automobile. Partially offsetting this favorable development was: (i) unfavorable development in our workers compensation line driven by assisted living claims; and (ii) unfavorable development in accident year 2012 in our commercial automobile line of business driven by higher than expected severities.
The 2012 prior year favorable development of $25.5 million includes $18.0 million of casualty development and $7.5 million of property development. The property development was primarily related to the favorable non-catastrophe loss activity that occurred in the first quarter of 2012 mostly in the 2011 accident year. The casualty lines were driven by favorable development in the 2007 through 2009 accident years, partially offset by unfavorable development in accident year 2011. The favorable development was driven by lower than expected severities in all of the major casualty lines, which represents a consistent trend in recent years. The unfavorable development in accident year 2011 was driven by: (i) higher than expected severities in the workers compensation and general liability lines; and (ii) higher than expected frequencies in the commercial auto line. This was partially offset by continued favorable development in the homeowners' liability line, due to lower expected severity for this year.
(2) In the first quarter of 2009, Selective Insurance Company of the Southeast and Selective Insurance Company of South Carolina (“Indiana Subsidiaries”) joined and invested in the FHLBI, which provides them with access to additional liquidity. The Indiana Subsidiaries’ aggregate investment was $2.9 million at December 31, 2014 and December 31, 2013, respectively. Our investment provides us the ability to borrow approximately 20 times the total amount of the FHLBI common stock purchased with additional collateral, at comparatively low borrowing rates. All borrowings from FHLBI are required to be secured by certain investments.
Our Line of Credit was renewed effective September 26, 2013, with Wells Fargo Bank, National Association, as administrative agent, and Branch Banking and Trust Company, with a borrowing capacity of $30 million, which can be increased to $50 million with the approval of both lending partners. The Line of Credit provides the Parent with an additional source of short-term liquidity. The interest rate on our Line of Credit varies and is based on, among other factors, the Parent’s debt ratings. The Line of Credit expires on September 26, 2017. There have been no balances outstanding under this Line of Credit at December 31, 2014 or at any time during 2014.
Standard Personal Lines - comprised of insurance products and services, including flood insurance coverage, provided primarily to individuals acquiring coverage in the standard marketplace.
Investments - invests the premiums collected by our Standard Commercial Lines, Standard Personal Lines, and E&S Lines, as well as amounts generated through our capital management strategies, which may include the issuance of debt and equity securities.
The revised segments reflect the way we currently manage our business and allocate resources and therefore, our previously-reported segment of "Standard Insurance Operations" is now "Standard Commercial Lines" and "Standard Personal Lines." Historically, we focused our service model predominantly on our distribution partners. We now focus our customer service model on our policyholders, the servicing of which is shared by us and our distribution partners. This change in focus not only heightens awareness of our brand with our distribution partners, but it increases our brand recognition with our policyholders.
We are in the process of implementing organizational changes that realign executive leadership roles over Standard Personal Lines and Standard Commercial Lines.
All prior year information contained in this Form 10-K has been restated to reflect our revised segments.
Our combined insurance segments are subject to certain geographic concentrations, particularly in the Northeast and Mid-Atlantic regions of the country. In 2014, approximately 23% of net premiums written were related to insurance policies written in New Jersey.
The goodwill balance of $7.8 million at both December 31, 2014 and 2013 relates to our Standard Commercial Lines reporting unit.
After considering all evidence, both positive and negative, with respect to our federal tax loss carryback availability, expected levels of pre-tax financial statement income, and federal taxable income, we believe it is more likely than not that the existing deductible temporary differences will reverse during periods in which we generate net federal taxable income or have adequate federal carryback availability. As a result, we have no valuation allowance recognized for federal deferred tax assets at December 31, 2014 or 2013.
Our alternative minimum tax credits, which are available to offset future regular taxable income, can be carried forward for an unlimited period of time.
We have analyzed our tax positions in all open tax years, which as of December 31, 2014 were 2011 through 2013. The IRS recently completed a limited scope examination of the 2007 through 2010 tax years, which resulted in no material changes. We do not have unrecognized tax expense or benefit as of December 31, 2014.
SICA offers a voluntary defined contribution 401(k) plan to employees who meet eligibility requirements. Participants can contribute 2% to 50% of their defined compensation to the Retirement Savings Plan not to exceed limits established by the IRS. Employees age 50 or older who are contributing the maximum may make additional contributions not to exceed the additional amount permitted by the IRS. Subject to IRS limits, the following table presents information regarding plan terms:
Employer contributions to the Retirement Savings Plan amounted to $13.4 million in 2014, $12.2 million in 2013, and $8.2 million in 2012.
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, subject to certain limitations, elect to defer compensation or awards to be received, including up to: (i) 50% of annual base salary; (ii) 100% of annual bonus; and/or (iii) all or a percentage of such other compensation as otherwise designated by the administrator of the Deferred Compensation Plan.
1Discount rate for the Retirement Income Plan changed from 4.42% as of December 31, 2012 to 4.66% as of March 31, 2013 due to the remeasurement that was performed with the curtailment of the Plan.
Our 2014 discount rate used to value the liability was 4.29% for the Retirement Income Plan and 4.08% for the Retirement Life Plan. When determining the most appropriate discount rate to be used in the valuation, we consider, among other factors, our expected payout patterns of the plans' obligations as well as our investment strategy and we ultimately select the rate that we believe best represents our estimate of the inherent interest rate at which our pension and post-retirement life benefits can be effectively settled.
to steadily close the gap between the duration of the assets and the duration of the liabilities, provided certain improved funding targets are achieved.
The Retirement Income Plan’s equity investments may not contain investments in any one security greater than 8% of the portfolio value without notification to our management investment committee, nor have more than 5% of the outstanding shares of any one corporation or other entity. The use of derivative instruments is permitted under certain circumstances, but shall not be used for unrelated speculative hedging or to apply leverage to portfolio positions. Within the alternative investments portfolio, some leverage is permitted as defined and limited by the partnership agreements.
1 These asset classes do not have target ranges, as these exposures will be phased out over time as we opportunistically migrate to long duration fixed income security strategies.
For RSUs granted under the Stock Plan in 2014, dividend equivalent units ("DEUs") are earned during the vesting period. The DEUs are reinvested in the Parent's common stock at fair value on each dividend payment date. We accrued DEUs equivalent to 43 shares of the Parent's common stock in 2014. No shares were issued pursuant to vested DEUs in 2014. The DEUs are subject to the same vesting period and conditions set forth in the award agreements for the related RSUs.
The Parent's Cash Incentive Plan was approved effective April 1, 2005 by stockholders on April 27, 2005, and amended and restated effective as of May 1, 2010 and May 1, 2014 (the “Cash Incentive Plan”) pursuant to stockholder approvals on April 28, 2010 and April 23, 2014, respectively. Under the Cash Incentive Plan, the SEBC may grant cash incentive units in such amounts and with such terms and conditions as it shall determine, subject to the provisions of the Cash Incentive Plan. The initial dollar value of these grants will be adjusted to reflect the percentage increase or decrease in the total shareholder return on the Parent's common stock over a specified performance period. In addition, for certain grants, the number of cash incentive units granted will be increased or decreased to reflect our performance on specified indicators as compared to targeted peer companies. Each award granted under the Cash Incentive Plan shall be evidenced in such form as the SEBC may, in its sole discretion, deem necessary or desirable, subject to the terms of the Cash Incentive Plan. We granted, net of forfeitures, 60,305 cash incentive units during 2014, 55,365 cash incentive units during 2013, and 46,961 cash incentive units during 2012.
On July 27, 2010, the SEBC approved the Parent’s Amended and Restated Stock Purchase Plan for Independent Insurance Agencies ("Agent Plan") which made immaterial amendments to the plan approved by stockholders on April 26, 2006. Under the Agent Plan, there were 3,000,000 shares of the Parent’s common stock authorized and 2,019,296 shares available for purchase as of December 31, 2014. The Agent Plan provides for quarterly offerings in which our independent retail insurance agencies and wholesale general agencies, and certain eligible persons associated with the agencies, with contracts with the Insurance Subsidiaries can purchase the Parent's common stock at a 10% discount with a one year restricted period during which the shares purchased cannot be sold or transferred. Under the Agent Plan, we issued 78,724 shares in 2014, 86,388 shares in 2013, and 89,723 shares in 2012, and charged to expense $0.2 million in each year, with a corresponding income tax benefit of $0.1 million in each year.
The total intrinsic value of options exercised was $0.8 million during 2014, $1.3 million in 2013, and $0.8 million in 2012.
As of December 31, 2014, total unrecognized compensation expense related to unvested RSU awards granted under our stock plans was $4.7 million. That expense is expected to be recognized over a weighted-average period of 1.6 years. The total intrinsic value of RSUs vested was $8.5 million for 2014, $9.1 million for 2013, and $8.4 million for 2012. In connection with the vested RSUs, the total value of the DEU shares that vested was $0.7 million in 2014, and $0.9 million during both 2013 and 2012.
The weighted-average fair value of options and stock per share, including RSUs granted for the Parent's stock plans, during 2014, 2013, and 2012 is as follows:
Share-based compensation expense charged against net income before tax was $18.6 million for the year ended December 31, 2014 with a corresponding income tax benefit of $6.2 million. Share-based compensation expense that was charged against net income before tax was $19.9 million for the year ended December 31, 2013 and $13.8 million for the year ended December 31, 2012 with corresponding income tax benefits of $6.8 million and $4.8 million, respectively.
William M. Rue, a Director of the Parent, is Chairman of, and owns more than 10% of the equity of, Chas. E. Rue & Son, Inc., t/a Rue Insurance, a general independent retail insurance agency ("Rue Insurance"). Rue Insurance is an appointed distribution partner of the Insurance Subsidiaries on terms and conditions similar to those of our other distribution partners. Rue Insurance also places insurance for our business operations. Our relationship with Rue Insurance has existed since 1928.
In 2005, we established a private foundation, The Selective Group Foundation (the "Foundation"), under Section 501(c)(3) of the Internal Revenue Code. The Board of Directors of the Foundation is comprised of some of the Parent's officers. We made contributions to the Foundation in the amount of $0.8 million in 2014, and $0.4 million in both 2013 and 2012.
In addition, certain leases for rented premises and equipment are non-cancelable, and liability for payment will continue even though the space or equipment may no longer be in use. At December 31, 2014, the total future minimum rental commitments under non-cancelable leases were $44.9 million and such yearly amounts are as follows:
(c) At December 31, 2014, we have contractual obligations that expire at various dates through 2028 to invest up to an additional $68.4 million in alternative and other investments. There is no certainty that any such additional investment will be required. For additional information regarding these investments, see item (f) of Note 5. "Investments" in this Form 10-K.
Our Insurance Subsidiaries are from time to time involved in other legal actions, some of which assert claims for substantial amounts. These actions include, among others, putative class actions seeking certification of a state or national class. Such putative class actions have alleged, for example, improper reimbursement of medical providers paid under workers compensation and personal and commercial automobile insurance policies. Our Insurance Subsidiaries also are involved from time to time in individual actions in which extra-contractual damages, punitive damages, or penalties are sought, such as claims alleging bad faith in the handling of insurance claims. We believe that we have valid defenses to these cases. We expect that the ultimate liability, if any, with respect to such lawsuits, after consideration of provisions made for estimated losses, will not be material to our consolidated financial condition. Nonetheless, given the large or indeterminate amounts sought in certain of these actions, and the inherent unpredictability of litigation, an adverse outcome in certain matters could, from time to time, have a material adverse effect on our consolidated results of operations or cash flows in particular quarterly or annual periods.
The Insurance Subsidiaries prepare their statutory financial statements in accordance with accounting principles prescribed or permitted by the various state insurance departments of domicile. Prescribed statutory accounting principles include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (“NAIC"). Permitted statutory accounting principles encompass all accounting principles that are not prescribed; such principles differ from state to state, may differ from company to company within a state and may change in the future. The Insurance Subsidiaries do not utilize any permitted statutory accounting principles that materially affect the determination of statutory surplus, statutory net income, or risk-based capital (“RBC”). As of December 31, 2014, the various state insurance departments of domicile have adopted the March 2014 version of the NAIC Accounting Practices and Procedures manual in its entirety, as a component of prescribed or permitted practices.
The following table provides quantitative data regarding all Insurance Subsidiaries' dividends paid to the Parent in 2014 for debt service, shareholder dividends, and general operating purposes: