Flood business is included in statutory underwriting results in accordance with prescribed statutory accounting practices. On a GAAP basis only, flood servicing revenue and expense has been reclassified from underwriting results to Diversified Insurance Services. 1997 - 2005 have been restated to reflect the exclusion of results from discontinued operations.
See Item 8. “Financial Statements and Supplementary Data,” Note 15 to the consolidated financial statements and
At December 31, 2006, our personal automobile line of business had recorded reserves, net of reinsurance, of $183 million, which represented 9% of our total net reserves. The majority of this business is written in the State of 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 Automobile Insurance Cost Reduction Act’s limitation on lawsuit threshold. Consequently, we increased reserves for this line of business by $13 million in the second quarter of 2005. This recent judicial decision, however, also has increased the amount of uncertainty surrounding our personal automobile reserves, as much of the historical information used to make assumptions has been rendered less effective as a basis for projecting future results.
The Company established a range of reasonably possible reserves for net claims of approximately $1,977 million to $2,174 million at December 31, 2006 and of $1,764 million to $1,950 million at December 31, 2005. A low and high reasonable reserve selection was derived primarily by considering the range of indications calculated using 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. Although this range reflects the most likely scenarios, it is possible that the final outcomes may fall above or below these amounts. This range does not include a provision for potential increases or decreases associated with environmental reserves, as management believes it is not meaningful to calculate a range given the uncertainties associated with environmental claims. Management’s best estimate is consistent with the actuarial best estimate. The Company does not discount to present value that portion of its loss reserves expected to be paid in future periods; however, the loss reserves take into account anticipated recoveries for salvage and subrogation claims.
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 $70 million for accident years 2005 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 5% 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 5%, that would decrease our indicated personal automobile reserves by
Reserve Impact of Changing Current Year Expected Ultimate Loss Ratio Assumption
IBNR reserve estimation for environmental claims is often difficult because, in addition to other factors, there are significant uncertainties associated with critical assumptions in the estimation process, such as average clean-up costs, third-party costs, potentially responsible party shares, allocation of damages, insurer litigation costs, insurer coverage defenses, and potential changes to state and federal statutes. However, management is not aware of any emerging trends that could result in future reserve adjustments. Moreover, normal historically-based actuarial approaches are difficult to apply because relevant history is not available. While models can be applied, such models can produce significantly different results with small changes in assumptions. As a result, management does not calculate a specific environmental loss range, as it believes it would not be meaningful.
The table below summarizes the number of asbestos and non-asbestos claims outstanding at December 31, 2006, 2005, and 2004. For additional information about our environmental reserves, see Item 1. “Business,” Item 8. “Financial Statements and Supplementary Data,” Note 8 to the consolidated financial statements.
Policy acquisition costs, which include commissions, premium taxes, fees, and certain other costs of underwriting policies, are deferred and amortized over the same period in which the related premiums are earned. Deferred policy acquisition costs are limited to the estimated amounts recoverable after providing for losses and loss expenses that are expected to be incurred, based upon historical and current experience. Anticipated investment income is considered in determining whether a premium deficiency exists. The methods of making such estimates and establishing the deferred costs are continually reviewed by the Company, and any adjustments are made in the accounting period in which the adjustment arose. The Company had deferred policy acquisition costs of $218.1 million at December 31, 2006 compared to $204.8 million at December 31, 2005.
The Company’s pension benefit and postretirement 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 Postretirement 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.
The discount rate enables us to state expected future cash flow as a present value on the measurement date. The guideline for setting this rate is a high-quality long-term corporate bond rate. A lower discount rate increases the present value of benefit obligations and increases pension expense. We reduced our discount rate to 5.50% for 2006, from 5.75% for 2005 to reflect market interest rate conditions. To determine the expected long-term rate of return on the plan assets, we consider 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 plan assets was 8.00% in 2006 and 2005. Changes in the related pension and postretirement benefit expense may occur in the future due to changes in these assumptions.
An investment in a fixed maturity or equity security, which is available for sale or reported at fair value, is impaired if its fair value falls below its book value and the decline is considered to be other than temporary. We regularly review our entire investment portfolio for declines in value. If we believe that a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in accumulated other comprehensive income. If we believe the decline is “other-than-temporary,” we write down the carrying value of the investment and record a realized loss in our Consolidated Statements of Income. Management’s assessment of a decline in value includes current judgment as to the financial position and future prospects of the entity that issued the investment security. Broad changes in the overall market or interest rate environment generally will not lead to a write-down provided that management has the ability and intent to hold such a security to maturity. In November 2005, the Financial Accounting Standards Board (“FASB”) issued two FASB Staff Positions (“FSP”), FAS115-1 and FAS124-1 titled “The Meaning of Other-Than-Temporary Impairments and its Application to Certain Investments.” These FSPs support existing requirements related to impairments with relatively few modifications.
Relevant rating history, analysis and guidance provided by rating agencies and analysts;
The length of time and the extent to which the fair value has been less than carrying value; and
Any buy/hold/sell recommendations or price projections published by outside investment advisors;
The above items were partially offset by increased competition in the New Jersey personal automobile market. As of December 31, 2006, the number of cars we insured in New Jersey decreased 12% to 77,160 from 87,593 as of December 31, 2005. Net premiums earned for our New Jersey personal automobile business were $101.3 million for 2006 as compared to $118.1 million for 2005 and $136.7 million for 2004.
Net realized gains before tax increased $21.0 million to $35.5 million in 2006 compared to 2005 and decreased $10.1 million to $14.5 million in 2005 compared to 2004; and
Diversified Insurance Services revenue increased $11.8 million, or 12%, in 2006 compared to 2005 and increased $12.2 million, or 14%, in 2005 compared to 2004.
Our Insurance Operations segment writes property and casualty insurance business through seven insurance subsidiaries (the “Insurance Subsidiaries”). Our Insurance Operations segment sells property and casualty insurance products and services primarily in 20 states in the Eastern and Midwestern United States through approximately 770 independent insurance agencies. Selective has at least one Insurance Subsidiary licensed to do business in each of the 50 states. Our Insurance Operations segment consists of two components: (i) commercial lines (“Commercial Lines”), which markets primarily to businesses, and represents approximately 86% of net premiums written (“NPW”), and (ii) personal lines (“Personal Lines”), which markets primarily to individuals and represents approximately 14% of NPW. The underwriting performance 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. For further details regarding these ratios see the discussion in the “Insurance Operations Results” section of Item 1. “Business” of this Form 10-K.
Commercial Lines renewal premium price increases, including exposure averaged 2.2% in 2006, 3.5% in 2005, and 8.8% in 2004. On a pure price basis, renewal pricing decreased 1.7% in 2006, decreased 0.4% in 2005, and increased 4.3% in 2004.
Underwriting income decreased in 2006 as compared to 2005 due to:
Underwriting income increased in 2005 as compared to 2004 due to:
Decreased catastrophe losses of $4.7 million in 2005 compared to $18.5 million in 2004; and
These improvements were partially offset by unprofitable results in our workers compensation line of business and reserve increases related to the New Jersey Supreme Court judicial ruling described below.
Enhancing and expanding use of our superior technology, such as xSELerate®;
Growing Personal Lines with the continued rollout of our MATRIX pricing model for auto; and
The demand for reinsurance coverage by the property and casualty insurance industry has continued to grow. Recent catastrophes, such as the huge losses incurred from Hurricane Katrina in 2005, have created capacity issues in the market. Catastrophe models in current use by the industry, such as RMS v.6.0, have projected significant increases in expected losses as a result of changing weather patterns, including increased hurricane activity in the Atlantic basin, and have resulted in increased demand for additional reinsurance coverage. Additionally, construction costs, both labor and raw materials, have increased in recent years in both the commercial and residential markets. These factors will continue to have a direct impact on the pricing and availability of reinsurance coverage. Each year, as we analyze our reinsurance program, we consider treaty attachment points, co-participation, alternative risk transfer mechanisms, and other changes in program structures that provide most effective protection in light of current market conditions.
Competition in the New Jersey personal automobile market has been influenced by the recent introduction of new companies writing business in the state. Our new Personal Lines strategy allows us to better evaluate and price risks, which will help us to profitably compete for new business in an agent’s office. We are in the process of moving our existing renewal inventory into our new pricing and tiering structure in New Jersey, causing a one-time dislocation in this book of business. Annual increases or decreases are capped at 20% by NJDOBI. We continue to focus on increasing new business production through this advanced pricing methodology, as it will take several quarters for the improved renewal book profitability to materialize. We expect to see positive results more quickly outside of New Jersey, where the issues affecting the renewal inventory are less significant.
Technology also continues to play a critical role in our success. Our leading edge agency integration technology, xSELerate®, is creating new business opportunities by facilitating the automated movement of key underwriting data from an agent’s management system to our systems. In December 2006, we were awarded the A.M. Best eFusion award for xSELerate®, for innovative, business-focused agency integration technology. This technology allows for seamless quoting and rating capabilities, which is an example of why we are ranked so highly by our agents for “ease of doing business.”
We recently formed a new Insurance Subsidiary, Selective Auto Insurance Company of New Jersey (“SAICNJ”), which is domiciled in the State of New Jersey. SAICNJ writes Selective’s New Jersey personal automobile policies, effective July 1, 2006 for new business and August 15, 2006 for renewal business. SAICNJ, a member of the Pooling Agreement, received a financial strength rating of “A+” from A.M. Best on August 14, 2006.
Direct voluntary new business written of $271.3 million for 2006, an 8% increase compared to $251.5 million in direct voluntary new business written in 2005, and $232.1 million in direct voluntary new business written in 2004;
Renewal premium price increases, including exposure averaged 2.2% for 2006, 3.5% for 2005, and 8.8% in 2004. On a pure price basis, renewal pricing decreased 1.7% in 2006, decreased 0.4% in 2005, and increased 4.3% in 2004.
The increase in the GAAP combined ratio is primarily attributable to the increase in loss and loss expense ratio discussed above for 2006 compared to 2005 and for 2005 compared to 2004.
Net premiums written for this line of business increased in 2006 compared to 2005 and 2004 due to the following: (i) increases in policy counts of 8% and direct new policy premium of 1% in 2006; (ii) renewal price increases, including exposure, of 1.5% in 2006; and (iii) stable retention of approximately 76% over the past two years.
The profitability in this line of business reflects our long-term improvement strategy of: (i) focusing our contractor growth on business segments with lower completed operations exposures; and (ii) improving contractor/subcontractor underwriting guidelines to minimize losses. Offsetting these improvements were pure renewal price decreases of 3.3% in 2006 and adverse prior year statutory loss and loss expense reserve development in this line of business of approximately $15 million in 2006 compared to $14 million in 2005 and $19 million in 2004. The adverse development in all years was largely driven by our contractor completed operations business and increases in reserves for legal expenses.
Statutory net premiums written for our workers compensation line of business increased by 5% in 2006 compared to 2005 and by 14% in 2005 compared to 2004 due to: (i) increases in policy counts of 5% in 2006; (ii) increases in direct new voluntary policy premium of 30% in 2006; and (iii) renewal price increases, including exposure, of 8% in 2006. Retention on this line of business decreased in 2006 to 80% from 82% in 2005, which was higher than 2004 retention of 80%.
We continue to execute on our multi-faceted workers compensation strategy aimed at reducing the statutory combined ratio by seven points by year-end 2007, barring other factors such as decreases in workers compensation rates or medical inflation beyond expectation. In 2006, this line was impacted by favorable prior year statutory development of approximately $2 million compared to adverse prior year statutory development of approximately $40 million in 2005 and approximately $4 million in 2004. The favorable prior year statutory development in 2006 was driven, in part, by savings realized from changing medical and pharmacy networks outside the State of New Jersey and re-contracting our medical bill review services. This redesign and re-contracting effort is expected to generate ongoing durable savings of about $3 million annually. The adverse development in 2005 was primarily the result of adverse loss trends, specifically in medical costs in the 2001 and prior accident years, which warranted an increase in management’s best estimates within the loss range. The adverse development in 2004 was primarily the result of rating agency downgrades of certain reinsurers, which caused us to reevaluate our ability to collect under certain reinsurance contracts.
The statutory combined ratio for commercial property increased in 2006 to a level more consistent with 2004 compared to 2005, primarily as a result of our catastrophe loss activity. Catastrophe losses were $13.2 million, or 7.2 points, in 2006 compared to $2.8 million, or 1.7 points, in 2005, and $13.3 million, or 8.7 points, in 2004. In addition, large property losses in 2005 were unusually low compared to the more normalized trend we are experiencing this year. Despite the increased losses this year, 2006 results continue to be strong as this line of business is benefiting from underwriting improvements over the past five years, including better insurance-to-value estimates across our book of business, a shift to risks of better construction quality and newer buildings, and an overall focus on low to medium hazard property exposures.
The statutory net premiums written growth is the result of our completed Business Owners’ Policy (“BOP”) correction plan that included pricing and underwriting actions focused on the growth of more profitable segments and the elimination of certain classes of business from our underwriting eligibility guidelines. With our BOP correction plan completed and our BOP rewrite in place in all of our states, we are beginning to see our new business increase. Additionally, in November 2006, we rolled out the BOP predictive model and early indications demonstrate positive trends in our selection of profitable new business. Direct new business in 2006 was up 15% as compared to 2005 and 2% in 2005 compared to 2004. The policy count on this line of business increased 13% as of December 31, 2006 compared to December 31, 2005. The statutory combined ratio was negatively impacted by catastrophe losses of 4.0 points in 2006 compared to 1.5 points in 2005 and 3.9 points in 2004.
Net premiums written for this line of business decreased in 2006 as a result of the ongoing competition in the New Jersey personal automobile market coupled with our rating plans that were not competitive through the first half of the year due to a historically restrictive regulatory environment. As of December 31, 2006, the number of cars we insured decreased 12% compared to December 31, 2005 and decreased 10% as of December 31, 2005 as compared to December 31, 2004. During the second half of the year, we redesigned our Personal Lines pricing model, which we refer to as “MATRIX.” MATRIX is designed to provide increased pricing flexibility in an effort to improve our competitive position, and allows us to better match price to risk and helps us to profitably compete for new business. Annual increases or decreases are capped at 20% by NJDOBI.
The 2006 combined ratio improved slightly over 2005, however our non-New Jersey book of business is primarily driving the overall lack of profitability. Our New Jersey book of business posted a profitable combined ratio of 98.8% in 2006 compared to a 97.0% in 2005. The 1.8 point increase reflects the competitive pressures described above coupled with increased expenses resulting from the 2005 New Jersey Supreme Court decision discussed below. Our non-New Jersey book of business posted a combined ratio of 113.5% in 2006 compared to 130.8% in 2005.
We have reinsurance contracts that cover both property and casualty business. Selective uses traditional forms of reinsurance and does not utilize finite risk reinsurance. For purpose of this discussion, our contracts can be segregated into the following key categories:
While this discussion will provide you with an overview regarding the reasons for changing our reinsurance program over the past year, additional information regarding the terms and related coverage associated with each of our categories of reinsurance can be found in Item 1. “Business” of this Form 10-K.
We increased both limit and retention under our catastrophe excess of loss treaty to 95% of $285.0 million in excess of $40.0 million per occurrence compared to 95% of $250.0 million in excess of $20.0 million per occurrence in the prior year.
We did not renew our Terrorism Treaty and purchased an additional 75% of $40.0 million in excess of $50.0 million layer in our Casualty Excess of Loss treaty.
We made the decision not to renew our Terrorism Treaty for 2007. We determined that additional per occurrence casualty coverage would be a cost efficient way to enhance our protection against man-made catastrophic events. The cost of our Terrorism Treaty in 2006 was $4.3 million. The additional layer of casualty coverage cost $0.7 million.
The following table presents RMS v.6.0 modeled hurricane losses based on Selective’s property portfolio as of June 30, 2006 under our 2007 catastrophe reinsurance treaty:
Our current catastrophe program provides protection for a 1 in 219 year event, or an event with 0.5 % probability according to the RMS v.6.0 historic model, and for a 1 in 168 year event, or an event with 0.6% probability according to RMS v.6.0 stochastic model.
Workers compensation only treaty, covering up to $3.0 million in excess of $2.0 million per occurrence;
Our investment portfolio consists primarily (82%) of fixed maturity investments, but also contains equity securities, short-term investments, and other investments. Our investment philosophy includes certain return and risk objectives for our fixed maturity and equity portfolios. The primary return objective of our fixed maturity portfolio is to maximize after-tax investment yield and income while balancing certain risk objectives, with a secondary objective of meeting or exceeding a weighted-average benchmark of public fixed income indices. The return objective of the equity portfolio is to meet or exceed a weighted-average benchmark of public equity indices. The risk objectives for our entire portfolio is to ensure that our investments are structured conservatively, focusing on: (i) asset diversification; (ii) investment quality; (iii) liquidity, particularly to meet the cash obligations of the insurance operations; (iv) consideration of taxes; and (v) preservation of capital.
The following table presents the Moody’s and S&P’s ratings of our fixed maturities portfolio:
Our fixed maturity investment strategy is to make security purchases that are attractively priced in relation to perceived credit risks. We manage the interest rate risk associated with holding fixed maturity investments by monitoring and maintaining the average duration of the portfolio with a view toward achieving an adequate after-tax return without subjecting the portfolio to an unreasonable level of interest rate risk. We invest our fixed maturities portfolio primarily in intermediate-term securities to limit overall interest rate risk of fixed maturity investments. The average duration of the fixed maturity portfolio, including short-term investments, was 3.8 years at December 31, 2006 compared to 4.0 years at December 31, 2005. To provide liquidity, while maintaining consistent performance, fixed maturity investments are “laddered” so that some issues are always approaching maturity, thereby providing a source of predictable cash flow. Managing investment risk by adhering to these strategies is intended to protect the interests of our stockholders and the policyholders of our Insurance Subsidiaries, and enhance our financial strength and underwriting capacity.
Generally, the Insurance Subsidiaries have a duration mismatch between assets and liabilities. The duration of the fixed maturity portfolio, including short-term investments, is 3.8 years while the Insurance Subsidiaries liabilities have a duration of approximately 3 years. The current duration of our fixed maturities is within our historical range and is monitored and managed to maximize yield and limit interest rate risk. The duration mismatch is managed with a laddered maturity structure and an appropriate level of short-term investments that avoids liquidation of available-for-sale fixed maturities in the ordinary course of business. Liquidity is always a consideration when buying or selling securities, but because of the high quality and active market for our investment portfolio, the securities sold have not diminished the overall liquidity of our portfolio. Our liquidity requirements in the past have been met by operating cash flow from our Insurance Operations and Diversified Insurance Services segments and the issuance of debt and equity securities. We expect our liquidity requirements in the future to be met by these sources of funds or, if necessary, borrowings from our credit facilities.
Broad changes in the overall market or interest rate environment generally do not lead to impairment charges. We believe the fluctuations in the fair value of fixed maturities and the increase in the associated gross unrealized loss since December 31, 2005 were primarily due to higher interest rates. As of December 31, 2006, there are 347 securities in an unrealized loss position.
S&P earnings are expected to grow 9.5% in 2007, following an expected 16% increase in 2006 and 18% increase in 2005. The factors leading to this continued growth are lower energy prices, increased confidence in the economy’s job and income generating capacity, expectations of robust corporate capital expenditures, and continued healthy overseas demand for U.S. securities. However, given the uncertainty of the Federal Reserve’s monetary policy direction and international capital flows, we remain cautious on equity markets and we expect continued volatility in the fixed income market during 2007.
We believe that pre-tax investment income will continue to grow as a result of strong cash flow from our Insurance Operations. Given the current interest rate environment, which is marked by a very flat yield curve, we intend to maintain a fairly stable portfolio duration on our fixed income portfolio. We will also continue to make new investment decisions on our fixed income portfolio that are relatively duration neutral to the portfolio as a whole as we continue to dollar-cost average our reinvestment yields. With regard to our equity portfolio, we are committed to pursuing opportunities in industries with favorable fundamentals and will continue to reduce exposure to those stocks or sectors with less favorable fundamentals and valuations. Our “Other investment” portfolio has performed well over the past few years. As a result of favorable risk return characteristics for these investments, we are looking to modestly grow this investment class as a percentage of our overall portfolio, which should contribute to lowering our overall portfolio risk given that these investments have a low correlation to the S&P 500 Index.
Profitability improvements in our HR Outsourcing business in 2006 compared to 2005 and 2004 are mainly due to: (i) increased average administration fee per worksite employee to $649 for 2006 compared to $642 for 2005 and $596 for 2004; (ii) higher margins, particularly on our workers compensation business; and (iii) an increase in our number of worksite lives, as described below.
An increase in flood premium in force of 28%. In-force premium was $119.2 million on 274,000 policies at December 31, 2006, compared to in-force premium of $93.5 million on 222,000 policies at December 31, 2005, and premium in force of $78.0 million on 188,000 policies at December 31, 2004; and
These increases were partially offset by a decrease in the fee paid to us by the NFIP, which was effective for the NFIP’s fiscal year beginning on October 1, 2006, to 30.2% from 30.8%.
Our HR Outsourcing products offer an additional potential agency revenue stream for our independent agents. New market entrants will continue to create increased competition for these products. We have repositioned the HR Outsourcing products as the EPP, which assists business owners in managing the risk of employee-related liabilities. Agent training regarding the EPP is ongoing and based on initial positive feedback, we expect to continue to recognize synergies created from this product in 2007.
The National Council on Compensation Insurance (“NCCI”) has passed an overall workers compensation rate level decrease of 15.7% for voluntary industrial classes in the State of Florida. The new rates were effective on January 1, 2007 for new and renewal business. Future reductions in this rate could adversely affect our results of operations for our HR Outsourcing business as workers compensation insurance is an important component of the EPP product.
Liquidity is a measure of our ability to generate sufficient cash flows to meet the short and long-term cash requirements of our business operations. Our cash and short-term investments position at December 31, 2006 was $203.5 million compared to $188.1 million at December 31, 2005. Sources of cash consist of dividends from our subsidiaries, the issuance of debt and equity securities, as well as the sale of Common Stock under our employee and agent stock purchase plans. However, our ability to receive dividends from our subsidiaries is restricted. Dividends from our Insurance Subsidiaries to the parent company are subject to the approval and/or review of the insurance regulators in the respective domiciliary states of the Insurance Subsidiaries under insurance holding company acts, and are generally payable only from earned surplus as reported in the statutory annual statements of those subsidiaries as of the preceding December 31. Based on the 2006 unaudited statutory financial statements, the Insurance Subsidiaries are permitted to pay to us, in 2007, ordinary dividends in the aggregate amount of approximately $141.9 million. For additional information regarding dividend restrictions, refer to Note 9, “Indebtedness” and Note 10, “Stockholders’ Equity” of the Notes to Consolidated Financial Statements, included in Item 8. “Financial Statements and Supplementary Data” of this form 10-K.
Dividends on shares of our Common Stock are declared and paid at the discretion of our Board of Directors based on the Company’s operating results, financial condition, capital requirements, contractual restrictions, and other relevant factors. Our ability to declare dividends is restricted by covenants contained in the notes payable that we issued on May 4, 2000 (the “2000 Senior Notes”). All such covenants were met during 2006 and 2005. For further information regarding our notes payable, see Note 9 of the Notes to Consolidated Financial Statements, entitled, “Indebtedness,” included in Item 8. “Financial Statements and Supplementary Data.” At December 31, 2006, the amount available for dividends to holders of our Common Stock, in accordance with the restrictions of the 2000 Senior Notes, was $384.2 million. On March 1, 2007, for stockholders of record as of February 13, 2007, we have increased our dividend by 9% to $0.12 per share. Book value per share increased 8% to $18.81 in 2006 from $17.34 in 2005, and increased 19% compared to 2004, when it was $15.79. Our ability to continue to pay dividends to our stockholders is also dependent in large part on the dividend paying ability of our Insurance Subsidiaries and the subsidiaries in our Diversified Insurance Services segment to pay dividends to the parent company. Restrictions on the ability of our subsidiaries, particularly the Insurance Subsidiaries, to declare and pay dividends to the parent company could materially affect our ability to pay principal and interest on indebtedness and dividends on Common Stock.
As active capital managers, we continually monitor our cash requirements as well as the amount of capital resources that we maintain at the holding company and operating subsidiary levels. As part of our long-term capital strategy, we strive to maintain a 25% debt-to-capital ratio and a premiums to surplus ratio sufficient to maintain an “A+” (Superior) financial strength A.M. Best rating for our Insurance Subsidiaries. Based on our analysis and market conditions, we may take a variety of actions including, but not limited to, contributing capital to the subsidiaries in our Insurance Operations and Diversified Insurance Services segments, issuing additional debt and/or equity securities, repurchasing shares of our Common Stock, or increasing stockholders’ dividends. The following are a few examples of capital management actions we have taken during 2006:
In 2006, we repurchased approximately 4.1 million shares of our Common Stock under our authorized share repurchase program at a cost of $110.1 million. As of December 31, 2006, there were 5.2 million shares remaining under the current repurchase authorization.
At December 31, 2006 and 2005, the Company did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As such, the Company is not exposed to any financing, liquidity, market or credit risk that could arise if the Company had engaged in such relationships.
We maintain case reserves and estimates of reserves for losses and loss expenses incurred but not yet reported (“IBNR”), in accordance with industry practice. Using generally accepted actuarial reserving techniques, we project our estimate of ultimate losses and loss expenses at each reporting date. Included within the estimate of ultimate losses and loss expenses are case reserves, which are analyzed on a case-by-case basis by the type of claim involved, the circumstances surrounding each claim, and the policy provisions relating to the type of losses. The difference between: (i) projected ultimate loss and loss expense reserves; and (ii) case loss reserves and loss expense reserves thereon are carried as the IBNR reserve. A range of possible reserves is determined annually and considered in addition to the most recent loss trends and other factors in establishing reserves for each reporting period. Based on the consideration of the range of possible reserves, recent loss trends and other factors, IBNR is established and the ultimate net liability for losses and loss expenses is determined. Such an assessment requires considerable judgment given that it is frequently not possible to determine whether a change in the data is an anomaly until sometime after the event. Even if a change is determined to be permanent, it is not always possible to reliably determine the extent of the change until sometime later. As a result, there is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves because the eventual deficiency or redundancy is affected by many factors.
Selective has an irrevocable trust to provide for the repayment of certain debt obligations with a market value of $31.3 million as of December 31, 2006.
See “Liquidity” section of Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a discussion of the Company’s syndicated line of credit agreement.
At December 31, 2006, we had additional limited partnership investment commitments within “Other investments” of up to $110.5 million; but there is no certainty that any such additional investment will be required. We have issued no material guarantees on behalf of others and have no trading activities involving non-exchange traded contracts accounted for at fair value. We have no material transactions with related parties other than those disclosed in Note 19 of the Notes to Consolidated Financial Statements, included in Item 8. “Financial Statements and Supplementary Data” of this Form 10-K.
We are rated by major rating agencies, which provide opinions of our financial strength, operating performance, strategic position, and ability to meet policyholder obligations. The principal agencies that issue financial strength ratings for the property and casualty insurance industry are: A.M. Best, S&P, Moody’s Investor Service (“Moody’s”), and Fitch Ratings (“Fitch”). We believe that our ability to write insurance business is most influenced by our rating from A.M. Best. Currently, we are rated “A+ (Superior)” by A.M. Best, which is their second highest of fifteen ratings. Our insurance business has been rated “A+ (Superior)” by A.M. Best for 45 consecutive years. The financial strength reflected by our A.M. Best rating is a competitive advantage in the marketplace and influences where independent insurance agents place their business. A downgrade from A.M. Best, could: (i) affect our ability to write new business with customers, some of whom are required (under various third party agreements) to maintain insurance with a carrier that maintains a specified A.M. Best minimum rating; (ii) be an event of default under our line of credit; or (iii) make it more expensive for us to access capital markets. On July 25, 2006, S&P’s Insurance Rating Services raised our financial strength rating to “A+” from “A”, citing our strong operating performance, strong operating company capitalization, and good financial flexibility. During the third quarter of 2006, Moody’s elevated their outlook regarding Selective to “positive.” The financial strength of our insurance business has been rated, “A2” by Moody’s since 2001 and “A+” by Fitch since 2004. Our Moody’s and S&P financial strength ratings affect our ability to access capital markets and our interest rate under our line of credit varies based upon SIGI’s debt ratings from Moody’s and S&P. There can be no assurance that our ratings will continue for any given period of time or that they will not be changed. It is possible that positive or negative ratings actions by one or more of the rating agencies may occur in the future. We review our financial debt agreements for any potential rating triggers that could dictate a material change in terms if our credit ratings were to change.
The following table presents the Company’s taxable income, pre-tax financial statement income, and net deferred tax (liability) asset:
The Company has a net deferred tax asset of $15.4 million at December 31, 2006 compared with a deferred tax liability of $5.7 million at December 31, 2005. This change is primarily due to temporary differences relating to pension, deferred compensation, the deferred impact of underwriting results, unrealized gains in the investment portfolio, and debt conversion.
The Company also has authorized, but not issued, 5,000,000 shares of preferred stock without par value of which 300,000 shares have been designated Series A junior preferred stock without par value.
Insurance Operations, which sells property and casualty insurance products and services primarily in 20 states in the Eastern and Midwestern United States, and has at least one company licensed to do business in each of the 50 states;
Equity securities, available for sale are comprised of common stocks and non-redeemable preferred stocks and are carried at fair value. Dividend income on these securities is included in “Net investment income earned.” The associated unrealized gains and losses, net of tax are included in accumulated other comprehensive income (loss). The cost of equity securities is written down to fair value when a decline in value is considered to be other than temporary. See the discussion below on realized investment gains and losses for a description of the accounting for impairments.
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. 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 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 other-than-temporary impairment of fixed maturity securities, includes, but is not limited to, the evaluation of the following factors:
(2) Indebtedness: The fair value of the convertible subordinated debentures, the 1.6155% Senior Convertible Notes due September 24, 2032, the 7.25% Senior Notes due November 15, 2034, the 6.70% Senior Notes due November 1, 2035, and the 7.5% Junior Subordinated Notes due September 27, 2066 are based on quoted market prices. The fair values of the 8.63% Senior Notes due May 4, 2007, and the 8.87% Senior Notes due May 4, 2010 were estimated using a cash flow analysis based upon Selective’s current incremental borrowing rate for the remaining term of the loan.
Effective January 1, 2005, Selective adopted the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards No. 123 (Revised 2004), “Share-Based Payment” (“FAS 123R”), which replaces FASB Statement No. 123 “Accounting for Stock Based Compensation” (“FAS 123”) and supercedes Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees” (“APB 25”). FAS 123R applies to all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share options, or other equity instruments. FAS 123R requires that the cost resulting from all share-based payment transactions be recognized in the financial statements, based on the fair value of such instruments at the grant date 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 a performance criteria, is based on the number of shares/units expected to be issued at the end of the performance period. Prior to the adoption of FAS 123R, Selective accounted for its share-based compensation in accordance with the intrinsic value method prescribed by APB 25 as was permitted by FAS 123, wherein compensation cost is recognized over the explicit service period. The explicit service period is typically the lesser of the vesting period or the period of time from the grant date to the date of actual retirement, which was the practice for awards granted prior to the adoption of FAS 123R. Share-based compensation granted prior to the adoption of FAS 123R continues to be recognized over the remaining explicit service period. The impact on Selective’s results of operations or financial condition for the change in the period over which expense is recognized is not material.
In adopting FAS 123R, Selective applied the modified prospective application method, which did not have a material effect on: (i) income before cumulative effect of change in accounting principle in 2005; or (ii) basic or diluted earnings per share before cumulative effect of change in accounting principle in 2005. At adoption, Selective recognized a cumulative effect of change in accounting principle resulting in a net income benefit of $0.5 million, which corresponded to the requirement of estimating forfeitures at the date of grant. FAS 123R also eliminated the presentation of the contra-equity account, “Unearned Stock Compensation” from the face of the Consolidated Balance Sheets, resulting in a reclassification of $14.7 million to “Additional Paid-in Capital.”
Goodwill results from business acquisitions where the cost of assets acquired exceeds the fair value of those assets. Goodwill is tested for impairment annually, or more frequently if events or changes in circumstances indicate that goodwill may be impaired. Goodwill is allocated to the reporting units for the purposes of the impairment test. Selective did not record any impairments during 2006, 2005, or 2004.
SHRS reports revenues on a net basis for the amount billed to clients for worksite employee salaries, wages and certain payroll-related taxes less amounts paid to worksite employees and taxing authorities for these salaries, wages and taxes. All fees that have the potential for a margin are included in revenue on a gross basis and all amounts that have no margin but are simply pass through amounts collected from the client and passed on to the employee or appropriate taxing authorities are presented on a net basis. Specifically, gross wages, Federal Insurance Contributions Act (FICA) tax and Federal Unemployment Tax (FUTA) are included on a net basis whereas administration fees, state unemployment taxes, health fees, and workers compensation fees are included on a gross basis. SHRS accounts for its revenues using the accrual method of accounting. Under the accrual method of accounting, SHRS recognizes its revenues ratably over the payroll period as worksite employees perform their service at the client worksite.
Cash and cash equivalents are comprised of cash and certain money market accounts that are used as part of the Company’s daily cash management. At December 31, 2006, the Company changed its definition of cash equivalents for presentation in the statement of cash flows. The Company previously defined short-term investments with original maturities of 90 days or less to be cash equivalents for statement of cash flow purposes. The Company changed its policy to exclude short-term investments from cash equivalents. The Company believes the revised policy is preferable because these short-term investments are in alignment with the way short-term investments are managed and are now included in investing activities in the statement of cash flows. Prior year balances in the statement of cash flows have been restated, which had the effect of increasing net cash used in investing activities by $77.8 million and $75.6 million for the years ended December 31, 2005 and 2004, respectively. The increase in cash used in investing activities for the year ended December 31, 2005, includes $68 million of Variable Rate Demand Notes incorrectly classified as cash equivalents.
In February 2006, the FASB issued FAS 155, Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140 (“FAS 155”), to clarify and/or amend previous accounting standards relating to certain derivatives embedded in other financial instruments (known as “hybrid” financial instruments). Under the guidance contained in FAS 155, companies are required to evaluate interests in securitized financial assets to identify whether such interests are freestanding derivatives or hybrid financial instruments that contain an embedded derivative. FAS 155 is effective for financial instruments acquired, issued, or subject to a remeasurement event occurring after December 31, 2006. During the fourth quarter of 2006, the FASB recommended a narrow scope exception for securitized interests if: (i) the securitized interest itself has no embedded derivative (including interest rate related derivatives) that would be required to be accounted for separately other than an embedded derivative that results solely from the embedded call options in the underlying financial assets; and (ii) the investor does not control the right to accelerate the settlement. Selective is currently evaluating the applicability of FAS 155 on its operations.
In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 calls for a two-step process in the evaluation of a tax position to be used in the recognition, derecognition, and measurement of benefits related to income taxes. The process begins with an initial assessment of whether a tax position, based on its technical merits and applicability to the facts and circumstances of the position, will “more-likely-than-not” be sustained upon examination, including related appeals or litigation. The “more-likely-than-not” threshold is defined as having greater than a 50% chance of being realized upon settlement. Tax positions that are “more-likely-than-not” sustainable are then measured to determine how much of the benefit should be recorded in the financial statements. This determination is made by considering the probabilities of the amounts that could be realized upon ultimate settlement. Each tax position is evaluated individually and must continue to meet the threshold in each subsequent reporting period or the benefit will be derecognized. A position that initially failed to meet the “more-likely-than-not” threshold should be recognized in a subsequent period if: (i) a change in facts and circumstances results in the position’s ability to meet the threshold, (ii) the issue is settled with the taxing authority, or (iii) the statute of limitations expires. FIN 48 is effective for years beginning after December 15, 2006 and its implementation is not expected to have a material impact on the results of operations or financial condition of the Company.
In September 2006, the FASB issued Statement No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment to FASB Statements No. 87, 88 ,106, and 132(R) (“FAS 158”), which requires employers to recognize on their balance sheets the funded status of pension and other postretirement benefit plans as of December 31, 2006 for calendar year public companies. FAS 158 will also require fiscal year-end measurements of plan assets and benefit obligations, eliminating the use of earlier measurement dates that are currently permissible. As Selective currently measures assets and benefit obligations as of each December 31, the measurement date change of FAS 158 will not have an impact on the Company. The requirement to recognize the funded status on the balance sheet has resulted in an after-tax charge of $13.7 million to accumulated other comprehensive income, which is a component of stockholders’ equity.
(b) The amortized cost, estimated fair values, and unrealized gains (losses) of held-to-maturity fixed maturity securities at December 31, 2006 and 2005, respectively, were as follows:
(c) The cost/amortized cost, estimated fair values, and unrealized gains (losses) of available-for-sale securities at December 31, 2006 and 2005, respectively, were as follows:
At December 31, 2006, Selective held (i) 339 fixed maturity securities, with a fair value of $1,190.0 million in an unrealized loss position of $12.5 million; (ii) seven equity securities in an unrealized loss position, with a fair value of $8.1 million and an unrealized loss of $0.4 million; and (iii) one security in other investments with an unrealized loss of $0.1 million and an estimated fair value of 6.9 million. Of these 347 securities, 345 had fair values no less than 95% of their cost basis. The remaining 2 securities had fair values between 70% and 87% of their cost basis. Selective believes the decline in the fair value of all of these securities to be temporary. The assessment of whether a decline in value is temporary includes Selective’s 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 Selective’s judgment about an individual security changes in the future, Selective may ultimately record a realized loss after having originally concluded that the decline in value was temporary, which could have a material impact on Selective’s net income and financial position of future periods.
(i) The components of net investment income earned were as follows:
Proceeds from the sale of available-for-sale securities were $422.0 million during 2006, $235.8 million during 2005, and $279.3 million during 2004. There were no realized losses from investment write-downs in 2006. There was $1.2 million in realized losses from investment write downs for 2005 and no investment write downs recorded in 2004.
The following table presents the carrying amounts and estimated fair values of Selective’s financial instruments as of December 31, 2006 and 2005:
Selective’s consolidated financial statements reflect the effects of assumed and ceded reinsurance transactions. Assumed reinsurance refers to the acceptance of certain insurance risks that other insurance entities have underwritten. Ceded reinsurance involves transferring certain insurance risks (along with the related written and earned premiums) that Selective has underwritten to other insurance companies that agree to share these risks. The primary purpose of ceded reinsurance is to protect Selective from potential losses in excess of the amount it is prepared to accept.
expenses was $2.7 million at December 31, 2006 and $3.5 million at December 31, 2005. The allowance for reinsurance recoverable on paid losses and loss expenses was $0.5 million at both December 31, 2006 and December 31, 2005.
A trust fund in the amount of $30.4 million at December 31, 2006 and $30.2 million at December 31, 2005 securing a portion of the liabilities ceded to Munich Reinsurance America, Inc. is held for the benefit of Selective. Amounts ceded to Munich Reinsurance America, Inc., exceeding the available trust fund, represent 13.5% or $32.1 million as of December 31, 2006 and 14% or $34.3 million as of December 31, 2005 of Selective’s consolidated prepaid reinsurance premiums and loss recoverable balances not secured by trust funds, letters of credit or funds withheld (collateral). In addition, approximately 61% of Selective’s consolidated prepaid reinsurance premiums and net reinsurance recoverable balances not secured by collateral are ceded to two state or federally sponsored pools. Selective ceded $65.6 million as of December 31, 2006 and December 31, 2005 to New Jersey Unsatisfied Claims Judgment Fund. Selective also ceded $78.9 million as of December 31, 2006 and $90.6 million as of December 31, 2005 to the National Flood Insurance Program.
The table below provides a roll-forward of reserves for losses and loss expenses for beginning and ending reserve balances:
The Company experienced adverse development in its loss and loss expense reserves totaling $5.1 million in 2005. Through our internal actuarial reviews, we analyzed certain negative trends in the workers compensation line of business and certain positive trends in the commercial automobile line of business. In the fourth quarter of 2005, we had sufficient evidence accumulated to move management’s best estimate of loss reserves for these lines. Accordingly, workers compensation reserves were increased by approximately $42 million to reflect rising medical cost trends that impacted accident years 2001 and prior. At the same time, commercial automobile reserves were decreased by approximately $48 million, primarily due to ongoing favorable severity trends in the 2002 through 2004 accident years. In addition, the general liability reserves adversely developed by approximately $14 million over the course of the year, which was driven mainly by our contractor completed operations business impacting accident years 2001 and prior, but partially offset by positive development in accident years 2002 through 2004. Also in 2005, we increased personal automobile reserves by approximately $10 million, of which $6.0 million was attributable to prior year development due to an adverse judicial ruling by the New Jersey Supreme Court, which eliminated the application of the serious life impact standard to personal automobile bodily injury liability cases under the verbal tort threshold of New Jersey’s Automobile Insurance Cost Reduction Act (“AICRA”). The reserving action was based on an analysis of our claim files and loss experience pre- and post-AICRA, which resulted in an increase to our New Jersey personal automobile loss projections.
At December 31, 2006, Selective’s reserves for environmental claims amounted to $50.7 million on a gross basis (including case reserves of $20.2 million and IBNR reserves of $30.5 million) and $46.5 million on a net basis (including case reserves of $19.7 million and IBNR reserves of $26.7 million). There are a total of 2,575 environmental claims, including multiple claimants who are associated with the same site or incident. Of these, 2,273 are asbestos related, of which 859 involve three insureds. The total case reserves associated with these three insureds amounted to $0.9 million on a gross and net basis. During 2006, 174 asbestos claims were closed, which accounted for approximately $0.2 million of the total asbestos paid of $1.0 million. The total case reserves for asbestos related claims amounted to $6.9 million on a gross and net basis. Sixty-six of the total environmental claims involve seven landfill sites. The landfill sites account for case reserves of $8.1 million on a gross and net basis. The remaining claims, which account for $5.1 million of case reserves on a gross and $4.7 million on a net basis, involve leaking underground storage tanks and other latent environmental exposures.
Consists of leaking underground storage tanks, and other latent environmental exposures.
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.
The Convertible Notes are redeemable by Selective 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. The holders of the Convertible Notes may require Selective to purchase all or a portion of their Convertible Notes on September 24, 2009, 2012, 2017, 2022, or 2027 at stated prices plus accrued cash interest, if any, to the purchase date. Selective may pay the purchase price in cash or shares of Selective’s Common Stock or in a combination of cash and shares of Selective’s Common Stock.
(1) On September 25, 2006, Selective issued $100 million aggregate principal amount of 7.5% Junior Subordinated Notes due 2066 (“Junior Notes”). The Junior Notes will pay interest, subject to Selective’s right to defer interest payments for up to ten years, on March 15, June 15, September 15, and December 15 of each year, beginning December 15, 2006, and ending on September 27, 2066. At anytime on or after September 26, 2011, the Junior Notes may be called by Selective 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 will be used for general corporate purposes.
(2) On November 3, 2005, Selective issued $100 million of 6.70% Senior Notes due 2035. These notes were issued at a discount of $0.7 million resulting in an effective yield of 6.754% and pay interest on May 1 and November 1 each year commencing on May 1, 2006. Net proceeds of approximately $50 million were used to fund an irrevocable trust to provide for certain payment obligations in respect of the Company’s outstanding debt. The remainder of the bond proceeds were used for general corporate purposes.
Selective has paid $24.0 million in principal to date, in addition to accrued interest thereon for the 8.63% Senior Notes. One remaining principal payment of $6.0 million is required on May 4, 2007. The principal amount of these senior notes, which was $6.0 million at December 31, 2006 and $12.0 million at December 31, 2005, accrues interest and is payable semiannually on May 4 and November 4 of each year, until the principal is paid in full.
Selective has paid $12.3 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 these senior notes, which was $49.2 million at December 31, 2006 and $61.5 million at December 31, 2005, accrues interest and is payable semiannually on May 4 and November 4 of each year, until the principal is paid in full.
The note purchase agreement covering the 8.63% and 8.87% Senior Notes contains restrictive business 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 2006 and 2005. At December 31, 2006, the amount available for dividends to stockholders under such restrictions was $384.2 million for the 2000 senior notes.
On January 30, 2007, the Board of Directors of Selective Insurance Group, Inc. declared a two-for-one stock split of the Company’s Common Stock, par value $2.00 per share in the form of a share dividend of one additional share of Common Stock for each outstanding share of Common Stock issued by Selective (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 all 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.
Effective April 26, 2005, the Board of Directors: (i) approved a new plan to repurchase up to 10.0 million shares of Selective Common Stock through April 26, 2007; and (ii) cancelled the then existing stock repurchase program, under which Selective was authorized to repurchase 4.8 million shares through November 30, 2005. Under the new plan, Selective has repurchased approximately 4.1 million shares at a cost of $110.1 million during 2006 and 670,000 shares at a cost of $16.3 million during 2005. In 2004, under the previous plan, Selective acquired 282,000 shares at a cost of $4.9 million.
In conjunction with restricted stock vestings and option exercises, Selective repurchased 229,000 shares at a cost of $6.2 million in 2006, 226,000 shares at a cost of $6.6 million in 2005, and 206,000 shares at a cost of $3.8 million in 2004.
Based on the unaudited 2006 statutory financial statements, the maximum ordinary dividends that can be paid to Selective by the Insurance Subsidiaries in 2007 are:
Investments, which are evaluated based on net investment income and net realized gains and losses; and
In December 2005, Selective divested itself of its 100% ownership interest in CHN Solutions (Alta Services, LLC and Consumer Health Network Plus, LLC), which had historically been reported as part of the “Managed Care” component of the Diversified Insurance Services segment. For additional information regarding this divestiture, see Note 15, “Discontinued Operations.” Selective’s remaining goodwill balance by operating segment is as follows:
co-employer service fees are related to business in Florida. Substantially all of Selective’s remaining revenues come from the states of Connecticut, Delaware, Georgia, Illinois, Indiana, Iowa, Kentucky, Maryland, Michigan, Minnesota, Missouri, New York, North Carolina, Ohio, Pennsylvania, Rhode Island, South Carolina, Virginia, and Wisconsin. Consequently, changes to economic or regulatory conditions in these states could adversely affect Selective.
Based on our federal tax loss carryback availability and expected levels of pre-tax financial statement income and federal taxable income, we believe that 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, Selective has no valuation allowance recognized for federal deferred tax assets.
Stockholders’ equity reflects tax benefits related to compensation expense deductions for stock options exercised in the amounts of $13.5 million at December 31, 2006, $9.6 million at December 31, 2005, and $5.9 million at December 31, 2004.
As part of the divestiture, Selective’s Insurance Subsidiaries entered into an agreement with the buyer, wherein Selective’s Insurance Subsidiaries have agreed to continue to use the managed care services of CHN Solutions in processing claims for its workers compensation and automobile policies issued by the Insurance Subsidiaries in the State of New Jersey. This agreement is effective until December 2010 and can be terminated by either party for the following reasons: (i) breach of contract; (ii) insolvency; or (iii) a change in control. In addition, Selective’s Insurance Subsidiaries can terminate the agreement if the buyer fails to meet the performance standards as outlined in the agreement.
The Retirement Savings Plan allows employees to make voluntary contributions to a number of diversified investment options, as well as Selective’s Common Stock, on a before and/or after-tax basis. Shares of Selective’s Common Stock issued under this plan were 21,472 during 2006, 29,572 during 2005, and 23,460 during 2004. The number of shares of Selective’s Common Stock available to be purchased under the Retirement Savings Plan was 1,546,168 at December 31, 2006.
Two additional defined contribution plans are maintained by SHRS, which does not participate in Selective’s defined contribution plan. The maximum allowable employee contribution to these plans is 75% of defined compensation.
Employer contributions for all the plans amounted to $4.4 million in 2006, $4.0 million in 2005, and $3.4 million in 2004.
The Company contributed $0.1 million in 2006, $0.4 million in 2005 and $0.3 million in 2004 to the Deferred Compensation Plan.
Selective’s Retirement Income Plan is a noncontributory defined benefit retirement income plan covering all employees who meet eligibility requirements. Selective’s funding policy provides that payments to the pension trust shall be equal to the minimum funding requirements of the Employee Retirement Income Security Act, plus additional amounts that the Board of Directors of Selective Insurance Company of America, the plan sponsor, may approve from time to time. For entrants into the Retirement Income Plan on or after July 1, 2002, the monthly retirement benefits beginning at normal retirement were decreased to 1.2% from 2.0% of the average monthly compensation as defined. Also, for all Retirement Income Plan participants, early retirement eligibility begins at age 55 with 10 years of service or when the sum of a participant’s age plus years of service equals at least 70.
Effective January 1, 2006, the Retirement Income Plan was amended to eliminate eligibility for plan participation by employees hired on or after January 1, 2006. If otherwise qualified, these employees will, however, be eligible for enhanced matching and non-elective Company contributions under the Retirement Savings Plan as discussed above.
The incremental effect of applying FAS 158 on individual line items in the Consolidated Balance Sheet is presented in the following table:
The funded status was recognized in the consolidated balance sheet for 2006, while the 2005 consolidated balance sheet reflects the amounts required to be recognized prior to the adoption of FAS 158.
Selective’s measurement date was December 31, 2006 and its expected return on plan assets was 8.0%, which was based primarily on the Retirement Income Plan’s long-term historical returns. Selective’s expected return is supported by its actual 7.8% annualized 10-year return and 9.2% annualized return achieved since plan inception for all plan assets. In addition to the plan’s historical returns, Selective considers long-term historical rates of return on the respective asset classes. Selective presently anticipates contributing $4.2 million to the Retirement Income Plan in 2007 and has kept its expected return on plan assets at 8.0% after examining recent market conditions and trends.
Assets of the Retirement Income Plan shall be invested to ensure that principal is preserved and enhanced over time. In addition, the Retirement Income Plan is expected to perform above average relative to comparable funds without assuming undue risk, and to add value through active
Selective has incentive compensation plans in which employees are eligible to participate based on corporate and individual performance goals. The total compensation costs charged to expense in connection with the plans were $26.5 million in 2006, $21.8 million in 2005, and $16.7 million in 2004.
Under the Stock Plan, the Board of Directors’ Salary and Employee Benefits Committee (“SEBC”) may grant stock options, stock appreciation rights, restricted stock, phantom stock, stock bonuses, and other awards in such amounts and with such terms and conditions as it shall determine, subject to the provisions of the Stock Plan. Each award granted under the Stock Plan (except unconditional stock bonuses and the cash component of Director compensation) shall be evidenced by an agreement containing such restrictions as the SEBC may, in its sole discretion, deem necessary or desirable and which are not in conflict with the terms of the Stock Plan. During 2006, Selective issued, net of forfeitures, 309,218 restricted shares and granted options to purchase 88,940 shares. As of December 31, 2006, 3,179,474 shares of Selective’s Common Stock remain available for issuance pursuant to outstanding stock options and restricted stock awards granted under the Stock Plan.
As of December 31, 2006, 625,808 shares of Selective’s Common Stock remain available for issuance pursuant to outstanding stock options and restricted stock awards granted under Stock Option Plan II, under which future grants ceased being available on May 22, 2002. Under Stock Option Plan II, employees were granted qualified and nonqualified stock options, with or without stock appreciation rights (“SARs”), and restricted or unrestricted stock: (i) at not less than fair value on the date of grant and (ii) subject to certain vesting periods as determined by the SEBC. Restricted stock awards also could be subject to the achievement of performance objectives as determined by the SEBC. The maximum exercise period for an option grant under this plan is ten years from the date of the grant. Selective experienced restricted forfeitures under Stock Option Plan II of 984 shares during 2006, 13,600 shares during 2005, and 29,076 shares during 2004.
As of December 31, 2006, there were 95,250 shares of the Common Stock available for issuance pursuant to outstanding stock option awards under the Stock Compensation Plan for Nonemployee Directors, under which future grants ceased being available with the approval of the Stock Plan. Under the Stock Compensation Plan for Nonemployee Directors, Directors could elect to receive a portion of their annual compensation in shares of Selective’s Common Stock. Selective issued 21,838 shares during 2005, and 27,548 shares during 2004 under this plan.
Under Selective’s Employee Stock Purchase Savings Plan (“ESPP”), there were 359,496 shares of Common Stock available for purchase as of December 31, 2006. 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, Selective issued 88,310 shares to employees during 2006, 88,758 shares during 2005, and 99,560 shares during 2004.
The total intrinsic value of options exercised was $6.1 million at December 31, 2006, $7.4 million at December 31, 2005, and $6.8 million at December 31, 2004.
As of December 31, 2006, total unrecognized compensation cost related to nonvested restricted stock awards granted under Selective’s stock plans was $12.0 million. That cost is expected to be recognized over a weighted-average period of 1.8 years. The total fair value of restricted stock vested was $11.7 million for 2006, $10.9 million for 2005, and $5.1 million for 2004. In connection with the restricted stock vestings, the total fair value of the DRP shares that also vested was $0.9 million during 2006, $1.0 million during 2005, and $0.6 million during 2004.
At December 31, 2006, the liability recorded in connection with Selective’s Cash Incentive Plan was $5.8 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. 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 Selective’s 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 1.8 years. During 2006, no cash incentive unit payments were made.
The expense recorded for restricted stock awards and stock compensation for non-employee directors is determined using the number of awards granted and the grant date fair value.
The weighted-average fair value of options and stock granted per share for Selective’s stock plans, during 2006, 2005, and 2004 is as follows:
Share-based compensation expense charged against net income before tax was $20.1 million at December 31, 2006 with a corresponding income tax benefit of $6.7 million. Share-based compensation expense that was charged against net income before cumulative effect of change in accounting principle before tax was $11.0 million at December 31, 2005 with a corresponding income tax benefit of $3.3 million. As part of the 2005 divestiture of CHN Solutions, unvested restricted stock awards were modified, resulting in a cash payment of $1.0 million in lieu of issuing shares. In addition, accelerated share based compensation of $0.4 million as of December 31, 2005 after tax, is included in “Loss on Disposal of Discontinued Operations, net of tax” on the consolidated statements of income. See Note 15, “Discontinued Operations,” for additional information regarding the divestiture. Share-based compensation expense that was charged against income before tax was $8.1 million for the year ended December 31, 2004 with a corresponding income tax benefit of $2.8 million.
In August 1998, certain officers of Selective purchased stock on the open market with proceeds advanced by Selective. These officers gave Selective promissory notes totaling $1.8 million. The notes bear interest at 2.5% and are secured by the purchased shares of Selective’s Common Stock. The promissory notes are full recourse and subject to certain employment requirements. The principal amount outstanding was $0.2 million at December 31, 2006 and $0.3 million at December 31, 2005. These outstanding balances are reflected in “other assets” on the Consolidated Balance Sheets.
William M. Rue, a Director of Selective Insurance Group, Inc., is President of, and owns more than 10% of the equity of, Chas. E. Rue & Sons, Inc. t/a Rue Insurance, a general independent insurance agency (“Rue Insurance”). Rue Insurance is an appointed independent agent of Selective’s Insurance Subsidiaries and SHRS, on terms and conditions similar to those of other Selective agents. Rue Insurance also places insurance for Selective’s business operations. Selective’s relationship with Rue Insurance has existed since 1928.
Selective paid reinsurance commissions of $0.2 million in 2006, 2005, and 2004 to PL, LLC. PL, LLC is an insurance fund administrator of which Rue Insurance owns 20% and which places reinsurance through a Selective Insurance Subsidiary.
(a) Selective purchases annuities from life insurance companies to fulfill obligations under claim settlements which provide for periodic future payments to claimants. As of December 31, 2006, Selective had purchased such annuities in the amount of $10.3 million for settlement of claims on a structured basis for which Selective is contingently liable. To Selective’s knowledge, none of the issuers of such annuities have defaulted in their obligations thereunder.
(c) At December 31, 2006, Selective has contractual obligations that expire at various dates through 2021 to invest up to an additional $110.5 million in limited partnerships. There is no certainty that any such additional investment will be required.
In the ordinary course of conducting business, Selective Insurance Group, Inc. and its subsidiaries are named as defendants in various legal proceedings. Some of these lawsuits attempt to establish liability under insurance contracts issued by our insurance subsidiaries. Plaintiffs in these lawsuits are seeking money damages that, in some cases, are extra-contractual in nature or they are seeking to have the court direct the activities of Selective’s operations in certain ways. Although the ultimate outcome of these matters is not presently determinable, Selective does not believe that the total amounts that it will ultimately have to pay, if any, in all of these lawsuits in the aggregate will have a material adverse effect on its financial condition, results of operations, or liquidity.
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 2006 unaudited statutory financial statements, their combined total adjusted capital exceeded the authorized control level RBC by 5.4:1, as defined by the NAIC.
See Note 15 to the consolidated financial statements for a discussion of discontinued operations.
See Note 2(g) to the consolidated financial statements for a discussion of the cumulative effect of change in accounting principle.
These ranges of high and low prices of Selective’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 3, 2007 and ending February 23, 2007 was $29.07 to $24.52.
All per share amounts have been restated to give retroactive effect to the two-for-one stock split distributed on February 20, 2007 to shareholders of record as of February 13, 2007. See Note 10 to the consolidated financial statements for a discussion of the stock split.