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.
Certain statements in this report, including information incorporated by reference, are “forward-looking statements” as that term is defined in the Private Securities Litigation Reform Act of 1995 (“PSLRA”). The PSLRA provides a safe harbor under the Securities Act of 1933 and the Securities Exchange Act of 1934 for forward-looking statements. These statements relate to Selective’s intentions, beliefs, projections, estimations or forecasts of future events or future financial performance and involve known and unknown risks, uncertainties and other factors that may cause Selective’s or the industry’s actual results, levels of activity, or performance to be materially different from those expressed or implied by the forward-looking statements. In some cases, forward-looking statements may be identified by use of words such as “may,” “will,” “could,” “would,” “should,” “expect,” “plan,” “anticipate,” “target,” “project,” “intend,” “believe,” “estimate,” “predict,” “potential,” “pro forma,” “seek,” “likely” or “continue” or other comparable terminology. These statements are only predictions, and Selective can give no assurance that such expectations will prove to be correct. Selective undertakes no obligation, other than as may be required under the federal securities laws, to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
Factors that could cause Selective’s actual results to differ materially from those Selective has projected, forecasted or estimated in forward-looking statements are discussed in further detail in Item 1A. “Risk Factors.” These risk factors may not be exhaustive. Selective operates in a continually changing business environment, and new risk factors emerge from time-to-time. Selective can neither predict such new risk factors nor can Selective assess the impact, if any, of such new risk factors on Selective’s businesses or the extent to which any factor or combination of factors may cause actual results to differ materially from those expressed or implied in any forward-looking statements in this report. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report might not occur.
The purpose of the Management’s Discussion and Analysis (“MD&A”) is to provide an understanding of the consolidated results of operations and financial condition and known trends and uncertainties that may have a material impact in future periods. For convenience and reading ease, we have written the remainder of the MD&A in the first person plural.
We have identified the policies and estimates described below as critical to our business operations and the understanding of the results of our operations. Our preparation of the Consolidated Financial Statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our Consolidated Financial Statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurance that actual results will not differ from those estimates. Those estimates that were most critical to the preparation of the financial statements involved the following: (i) reserve for losses and loss expenses; (ii) deferred policy acquisition costs; (iii) pension and postretirement benefit plan actuarial assumptions; and (iv) other-than-temporary investment impairments.
At December 31, 2007, our commercial automobile line of business had recorded reserves, net of reinsurance, of $330 million, which represented 14% of our total net reserves. This line of business has experienced favorable loss development in recent years driven by a downward trend in large claims. The number of large claims has a high degree of volatility from year-to-year and, therefore, requires a longer period before true trends are recognized and can be acted upon. We have experienced lower than expected severity in accident years 2002 through 2006, which resulted in favorable development in 2006 and 2007 of $15 million and $19 million, respectively. This result is driven by trends that are positively affecting the commercial auto insurance market in general, as well as by Selective specific initiatives such as: (i) the increase in lower hazard auto business as a percentage of our overall commercial auto book of business; (ii) a re-underwriting of our newest operating region; and (iii) a more proactive approach to loss prevention. At this time, the lower trend in large claims has leveled off and management has not identified any other recent trends that would create significant reserve uncertainty for this line of business.
At December 31, 2007, our personal automobile line of business had recorded reserves, net of reinsurance, of $171 million, which represented 7% of our total net reserves. The majority of this business is written in New Jersey, where the judicial and regulatory environment has been subject to significant changes over the past few decades. The most recent change occurred in June 2005, when the New Jersey Supreme Court ruled that the serious life impact standard does not apply to the Automobile Insurance Cost Reduction Act (“AICRA”) limitation on lawsuit threshold. As a result of this decision, we increased reserves for this line of business by a net amount of $10 million, the majority of which was reflected in 2005 results. This recent judicial decision has increased the uncertainty surrounding our personal automobile reserves, particularly for accident years 2006 and 2007, since much of the historical information used to make assumptions has been rendered less effective as a basis for projecting future results.
At December 31, 2007, no other individual line of business had recorded reserves of more than $60 million, net of reinsurance. Management has not identified any recent trends that would create additional significant reserve uncertainty for these other lines of business.
We established a range of reasonably possible reserves for net claims of approximately $2,180 million to $2,414 million at December 31, 2007 and of $1,977 million to $2,174 million at December 31, 2006. 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 likely scenarios, it is possible that the final outcomes may fall above or below these amounts. Based on internal stochastic modeling, management feels that a reasonable estimate of the likelihood that the final outcome falls within the current range is approximately 70%. This range does not include a provision for potential increases or decreases associated with environmental reserves. Management’s best estimate is consistent with the actuarial best estimate. We do 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, medical loss development factors for workers compensation are particularly sensitive to assumptions relating to medical inflation. Actual medical loss development factors could be significantly different than those which are selected from historical loss experience if actual medical inflation is materially different than what was observed in the past. In addition, workers compensation has been the focus of a multi-faceted underwriting strategy designed to significantly reduce the loss ratio over time. The combination of the sensitivity of workers compensation results to medical inflation and changes in underwriting could lead to actual experience emerging differently than the assumptions used in the process to establish reserves. In our judgment, it is possible that actual medical loss development factors could range from 6% below to 8% above those selected in our latest reserve analysis and expected loss ratios could range from 5% below to 3% above those selected in our latest reserve analysis. The combination of reducing the assumptions for medical loss development by 6% and the expected loss ratio by 5% could decrease our indicated workers compensation reserves by approximately $55 million for accident years 2006 and prior. Alternatively, the combination of increasing the medical loss development factors by 8% and the expected loss ratio by 3% could increase our indicated workers compensation reserves by approximately $70 million.
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 4% 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 approximately $35 million for accident years 2006 and prior. Alternatively, if the loss development factors were increased by 4%, that would increase our indicated personal automobile reserves by approximately $30 million.
For the 2007 accident year, the expected ultimate loss ratio by line of business is a key assumption. This assumption is based upon a large number of inputs that are assessed periodically, such as historical loss ratios, projected future loss trend, and planned pricing amounts. In our judgment, it is possible that the actual ultimate loss ratio for the 2007 accident year could be +/-7% from the one selected in our latest reserve analysis for each of our four major long tailed lines of business. The table below summarizes the possible impact on our reserves of varying our expected loss ratio assumption by +/-7% by line of business for the 2007 accident year.
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.
Our 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.
An investment in a fixed maturity or equity security, that is available for sale and reported at fair value, is impaired if its fair value falls below its book value and the decline is considered to be other than temporary. 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 2007, we recorded an impairment charge of $4.9 million for two investments that we concluded were impaired for other than temporary declines in fair value. We had no impairment charges during 2006. We recorded an impairment charge of $1.2 million in 2005 for one investment that we concluded was impaired for an other-than-temporary decline in value. For further information regarding the impairment charges, see the section entitled “Investments” in Item 7. “ Management’s Discussion and Analysis of Financial Condition and Results of Operations.” of this Form 10-K.
Reinsurance recoverable 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 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 reinsurance 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 $2.8 million at December 31, 2007.
NPE growth contributed $17.6 million of the $38.4 million in revenue growth in 2007 compared to 2006 and $81.7 million to the $136.9 million in revenue growth in 2006 compared to 2005. The following factors contributed to the growth of NPE:
Commercial lines renewal prices, including exposure, which decreased by 0.3% in 2007 and increased in 2006 and 2005 by 2.2% and 3.5%, respectively.
Net income decreased in 2007 compared to 2006 due to increases in our GAAP combined ratio, resulting from lower pricing and higher claim severity, particularly in property losses, partially offset by profitability improvements in our workers compensation line of business and increases in net favorable prior year loss and loss expense development within our casualty lines of business. The reduction in our underwriting profit was partially offset by: (i) net investment income earned increases in 2007 as noted above; and (ii) decreases in federal income tax expense in 2007 compared to 2006, primarily attributable to lower underwriting income in our Insurance Operations segment, as explained above.
Our Insurance Operations segment writes property and casualty insurance business in 21 states in the Eastern and Midwestern United States through seven insurance subsidiaries (the “Insurance Subsidiaries”). These Insurance Subsidiaries write business through approximately 880 independent insurance agencies. Our Insurance Operations segment consists of two components: (i) commercial lines (“Commercial Lines”), which markets primarily to businesses, and represents approximately 87% of net premiums written (“NPW”), and (ii) personal lines (“Personal Lines”), which markets primarily to individuals and represents approximately 13% of NPW.
The statutory ratios include Selective’s flood line of business, which is included in the Diversified Insurance Services Segment on a GAAP basis and therefore excluded from the GAAP ratios. The total Statutory Combined ratio excluding flood was 98.2% for 2007, 96.1% for 2006, and 95.3% for 2005.
Considering the current environment, in the upcoming year, we anticipate pricing discipline and expense management to be key factors in the generation of strong underwriting results. As part of our expense management initiative, in February 2008, we announced a reduction in our workforce of approximately 80 positions, including the immediate displacement of 60 employees and the elimination of 20 open positions. We anticipate these changes to have a related one-time pre-tax cost of approximately $4 million in the first quarter of 2008 and annualized pre-tax savings of approximately $8 million. In addition, we are implementing targeted changes to agency commissions that will maintain highly competitive awards for agents who produce the strongest results for us, while reducing commissions where our historically higher payments have not generated an appropriate level of profitable growth. The changes will bring our program more in line with the competition; however, commissions on 87% of our direct premiums written will not be affected, and the supplemental commission program that rewards our most profitable growth agencies does not change. We feel the changes will bring our program more in line with the competition. These commission revisions are expected to generate annualized pre-tax savings of approximately $8.0 million, and are targeted for rollout in most states in July 2008.
Based on our expense management programs along with technology investments, ongoing underwriting improvements, our assessment of current loss cost and pricing trends, and other areas of strategic focus, we are providing 2008 earnings guidance in the range of $2.20 to $2.40 per diluted share. Our guidance is based on the following assumptions: (i) a statutory combined ratio of 98% and a GAAP combined ratio of 100%; (ii) after-tax catastrophe losses of $14.4 million; (iii) growth in after-tax investment income of 3%, including a 10% pre-tax yield on alternative investments, included in “Other investments” on the Consolidated Balance Sheets; (iv) Diversified Insurance Services revenue growth of 5% with a return on revenue of 10%; and (v) diluted weighted average shares of 52.5 million, which includes the expectation of repurchasing 3.5 million shares over the course of the year.
NPW increased in 2007 compared to 2006 and 2005. Premium growth in 2007 was attributable to increases in direct new business written of $36.4 million to $313.3 million for 2007 compared to 2006 partially offset by: (i) a slight reduction in retention for 2007 compared to 2006 and 2005; (ii) decreases in audit and endorsement premium activity of $11.5 million and $6.3 million, respectively; and, (iii) renewal price decreases, including exposure of 0.3% in 2007 reflecting the competitive pressure on our renewal book of business.
For 2007, net favorable prior year loss and loss expense development within our casualty lines of business amounted to approximately $20 million, or 1.5 points, compared to approximately $2 million in 2006, or 0.1 points, and minimal prior year loss and loss expense development in 2005.
Total policy counts in this line of business increased 9% in 2007 compared to 2006 and 7% in 2006 compared to 2005. New business premiums in this line of business increased 14% for 2007 compared to 2006 and 1% for 2006 compared to 2005. Evidence of the softening market is illustrated in our renewal pricing for this line which, including exposure, decreased 1.1% in 2007 compared to increases of 1.5% in 2006 and 3.0% in 2005. Continuing evidence of the softening market is illustrated by retention that decreased slightly to 75% in 2007 compared to 77% in 2006 and 76% in 2005.
The statutory ratios include Selective’s flood line of business, which is included in the Diversified Insurance Services Segment on a GAAP basis and therefore excluded from the GAAP ratios. The total Statutory Combined ratio excluding flood was 113.0% for 2007, 102.9% for 2006, and 105.0 % for 2005.
The New Jersey personal automobile market has been impacted by the introduction of new companies writing business in the state with rating plans that allow them to price accounts competitively without the legacy issue of repricing existing accounts through filed rate increases. Our new Personal Lines rating plan was approved by the New Jersey Department of Banking and Insurance (“NJDOBI”) and was implemented in August 2006. Our new plan allows us to better evaluate and price risks, which will help us to profitably compete for new business in our agencies. We have moved our entire existing renewal inventory into our new pricing and tiering structure in New Jersey, which has caused a dislocation in this book of business due to the repricing of certain business at higher levels, some of which did not renew. As annual increases or decreases are capped at 20% by the NJDOBI, we expect improvements to materialize over a three-year period. We continue to focus on increasing new business production within and outside of New Jersey through this advanced pricing methodology. In our continuing efforts to improve our existing book of automobile business, we have implemented average renewal rate increases of 13.1% in Pennsylvania effective August 1, 2007, and 8.5% in Maryland effective September 1, 2007. These changes applied to business written prior to the implementation of our MATRIX® program. In 2008, we are taking steps to continue to improve our automobile business by filing further rate increases of 7% in New Jersey, which is targeted for May, 7% in Pennsylvania, targeted for July, and 6% in Maryland, targeted for August. The New Jersey change applies to all business, and the other changes apply to business originally written prior to the implementation of our MATRIX® program. Such rate increases were necessary, as these states have regulatory restrictions on moving the renewal book into our new pricing methodology and the previous rates did not yield sufficient profitability.
The fluctuations in NPE reflect the fluctuations in NPW as discussed above.
The deterioration in the GAAP underwriting expense ratio in 2007 compared to 2006 and 2005 was primarily attributable to overhead costs that have outpaced premiums earned. In addition, costs associated with the reorganization of the Personal Lines department in May of 2007, which reduced the staffing level by 31 employees, added 0.6 points to the underwriting expense ratio in 2007.
We have reinsurance contracts that cover both property and casualty business. We use traditional forms of reinsurance and do not utilize finite risk reinsurance. Our contracts can be segregated into the following key categories:
Other Reinsurance - includes smaller treaties, such as our Surety and Fidelity Excess of Loss treaties, which do not fall within the categories above.
The Property Catastrophe treaty renewed effective January 1, 2008 with a 15% reduction in premium. The current treaty provides per occurrence coverage for 95% of $310.0 million in excess of $40.0 million retention compared to 95% of $335.0 million in excess of $40.0 million retention under the expiring treaty. The annual aggregate limit net of our co-participation is $589.0 million compared to $636.5 million for the expiring treaty. We continue to assess our property catastrophe exposure aggregations, modeled results and effects of growth on our property portfolio and strive to manage our exposure to individual large events balanced against the cost of reinsurance protection.
Our Surety and Fidelity Excess of Loss treaty was renewed effective January 1, 2008, with essentially no changes in coverage and a 2.5% increase in estimated ceded premium due to an increase in projected subject premium offset by a decrease in the rate.
Our investment portfolio consists primarily of fixed maturity investments (83%), but also contains equity securities (7%), short-term investments (5%), and other investments (5%). Our investment philosophy includes setting 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. The return objective of the equity portfolio is to meet or exceed a weighted-average benchmark of public equity indices. The risk objective 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.
Our investment returns for the last three years are as follows:
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Selective Insurance Group, Inc. and its subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
Selective Insurance Group, Inc., through its subsidiaries, (collectively known as “Selective”) offers property and casualty insurance products and diversified insurance services and products. Selective Insurance Group, Inc. was incorporated in New Jersey in 1977 and its main offices are located in Branchville, New Jersey. Selective Insurance Group, Inc.’s Common Stock is publicly traded on the NASDAQ Global Select Market under the symbol “SIGI.”
The preparation of the Financial Statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported financial statement balances, as well as the disclosure of contingent assets and liabilities. Actual results could differ from those estimates.
Fixed maturity securities are comprised of bonds, redeemable preferred stocks, and mortgage-backed securities. Fixed maturity securities classified as available for sale are reported at fair value. Those fixed maturity securities that Selective has the ability and positive intent to hold to maturity are classified as held-to-maturity and carried at amortized cost. The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts over the expected life of the security using the effective interest method. Premiums expected and discounts arising from the purchase of mortgage-backed securities are amortized over the expected life of the security based on future principal payments, and considering prepayments. These prepayments are estimated based upon historical and projected cash flows. Prepayment assumptions are reviewed annually and adjusted to reflect actual prepayments and changes in expectations. Future amortization of any premium and/or discount is also adjusted to reflect the revised assumptions. Interest income, as well as amortization and accretion, is included in “Net investment income earned.” The amortized cost of fixed maturity 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. Unrealized gains and losses on fixed maturities classified as available-for-sale, net of tax are included in accumulated other comprehensive income (loss) (“AOCI”).
Short-term investments are comprised of certain money market instruments, savings accounts, commercial paper, other debt issues purchased with a maturity of less than one year, and variable rate demand notes. These investments are carried at cost, which approximates fair value. The associated income is included in “Net investment income earned.”
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. Selective’s assessment for other-than-temporary impairment of fixed maturity securities, includes, but is not limited to, the evaluation of the following factors:
The following methods and assumptions are used in estimating the fair value of financial instruments:
(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 value of the 8.63% Senior Notes due May 4, 2007 and 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 loans.
The internal assumptions considered by Selective in the estimation of the IBNR amounts for both environmental and non-environmental reserves at Selective’s reporting dates are based on: (i) an analysis of both paid and incurred loss and loss expense development trends; (ii) an analysis of both paid and incurred claim count development trends; (iii) the exposure estimates for reported claims; (iv) recent development on exposure estimates with respect to individual large claims and the aggregate of all claims; (v) the rate at which new environmental claims are being reported; and (vi) patterns of events observed by claims personnel or reported to them by defense counsel. External factors identified by Selective in the estimation of IBNR for both environmental and non-environmental IBNR reserves include: (i) legislative enactments; (ii) judicial decisions; (iii) legal developments in the determination of liability and the imposition of damages; and (iv) trends in general economic conditions, including the effects of inflation. Adjustments to IBNR are made periodically to take into account changes in the volume of business written, claims frequency and severity, the mix of business, claims processing, and other items that are expected by management to affect Selective’s reserves for losses and loss expenses over time.
By using both individual estimates of reported claims and generally accepted actuarial reserving techniques, Selective estimates the ultimate net liability for losses and loss expenses. While the ultimate actual liability may be higher or lower than reserves established, Selective believes the reserves to be adequate. Any changes in the liability estimate may be material to the results of operations in future periods. Selective does not discount to present value that portion of its loss reserves expected to be paid in future periods; however, the loss reserves include anticipated recoveries for salvage and subrogation claims.
Selective’s seven insurance subsidiaries’ net premiums written include direct insurance policy writings plus reinsurance assumed and estimates of premiums earned but unbilled on the workers compensation and general liability lines of insurance, less reinsurance ceded. Premiums written are recognized as revenue over the period that coverage is provided using the semi-monthly pro-rata method. Unearned premiums and prepaid reinsurance premiums represent that portion of premiums written that are applicable to the unexpired terms of policies in force.
Selective HR Solutions (“Selective HR”), our human resource administration outsourcing operation, 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. Selective HR accounts for its revenues using the accrual method of accounting. Under the accrual method of accounting, Selective HR recognizes its revenues ratably over the payroll period as worksite employees perform their services at the clients’ worksites.
Selective establishes reserves for dividends to policyholders on certain policies, most significantly workers compensation policies. These dividends are based on the policyholders’ loss experience. The dividend reserves are established based on past experience, adjusted for the effects of current developments and anticipated trends. The expense for these dividends is recognized over a period that begins at policy inception and ends with the payment of the dividend. Selective does not issue policies that entitle the policyholder to participate in the earnings or surplus of the Insurance Subsidiaries.
Selective uses the asset and liability method of accounting for income taxes. Deferred federal income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax basis of Selective’s assets and liabilities. A valuation allowance is established when it is more likely than not that some portion of the deferred tax asset will not be realized. The effect of a change in tax rates is recognized in the period of enactment.
Cash and cash equivalents are comprised of cash and certain money market accounts that are used as part of the Company’s daily cash management.
Selective has various operating leases for office space and equipment. Rental expense for such leases is recorded on a straight-line basis over the lease term. If a lease has a fixed and determinable escalation clause, or periods of rent holidays, the difference between rental expense and rent paid is included in “Other liabilities” as deferred rent in the Consolidated Balance Sheets.
On January 1, 2007, Selective adopted the provisions of 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 to evaluate tax positions based on 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, 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 effective 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. Selective has analyzed its tax positions in all federal and state jurisdictions in which it is required to file income tax returns for all open tax years. The open tax years for the federal returns are 2003 though 2006. The Internal Revenue Service completed a limited scope examination of tax year 2003 and 2004 that resulted in a favorable adjustment of $1.1 million. Selective did not have any unrecognized tax benefits as of January 1, 2007. Selective believes its tax positions will be sustained on audit and does not anticipate any adjustments that will result in a material change to its financial position. As a result, there was no material change in Selective’s liability for unrecognized tax benefits.
In February 2007, the FASB issued Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115 (“FAS 159”), which provides companies with an option to report selected financial assets and liabilities at fair value (“fair value option”). FAS 159 requires companies to provide additional information that will help investors and other users of financial statements to more easily understand the effect of a company’s choice to use fair value on its earnings. FAS 159 also requires companies to display the fair value of those assets and liabilities for which a company has chosen to use fair value on the face of the balance sheet. Selective adopted FAS 159 on January 1, 2008 and has made the fair value option election as it relates to a portfolio of equity securities currently being managed by one outside manager. The impact of making this election is not expected to be material to the Consolidated Financial Statements.
In June 2007, the Emerging Issues Task Force (“EITF”) of the FASB issued EITF Issue No. 06-11 Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards (“EITF 06-11”). EITF 06-11 requires that the tax benefit from dividends or dividend equivalents that are charged to retained earnings and are paid to employees for equity classified nonvested equity shares, nonvested equity share units, and outstanding equity share options be recognized as an increase to additional paid-in capital. This EITF is effective on a prospective basis beginning with dividends declared in fiscal years beginning after December 15, 2007. The adoption of this EITF is not expected to have a material impact on Selective’s results of operations or financial condition.
(d) The following tables summarize, for all securities in an unrealized loss position at December 31, 2007 and December 31, 2006, the aggregate fair value and gross pre-tax unrealized loss recorded in Selective’s accumulated other comprehensive income, by asset class and by length of time those securities have been in an unrealized loss position:
At December 31, 2007, Selective held (i) 231 fixed maturity securities, with a fair value of $748.3 million in an unrealized loss position of $25.3 million; (ii) 9 equity securities in an unrealized loss position, with a fair value of $26.8 million and an unrealized loss of $1.4 million. Of these 240 securities, 10 had fair values less than 85% of their cost basis. The remaining 230 securities had fair values between 86% and 99% 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 in future periods. Currently, except for securities for which an impairment loss has been recognized, Selective has the ability and intent to hold all securities in an unrealized loss position until their anticipated recovery.
(f) Certain investments were on deposit with various state regulatory agencies to comply with insurance laws and had carrying values of $26.0 million as of December 31, 2007 and $25.3 million as of December 31, 2006.
(g) Selective is not exposed to significant concentrations of credit risk within its investment portfolio. The largest investment in the securities of any one issuer was $16.0 million at December 31, 2007 and $19.3 million at December 31, 2006.
The following table presents the carrying amounts and estimated fair values of Selective’s financial instruments as of December 31, 2007 and 2006:
See Note 2(d) for the methods and assumptions used by Selective in estimating the fair values of its financial instruments.
A trust fund in the amount of $31.6 million at December 31, 2007 and $30.4 million at December 31, 2006 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., which is rated “A+” by A.M. Best, exceeding the available trust fund, represent 13% or $36.0 million as of December 31, 2007 and 14% or $32.1 million as of December 31, 2006 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 55% 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 $64.5 million as of December 31, 2007 and $65.6 million as of December 31, 2006 to New Jersey Unsatisfied Claims Judgment Fund. Selective also ceded $88.0 million as of December 31, 2007 and $78.9 million as of December 31, 2006 to the National Flood Insurance Program (“NFIP”).
Under Selective’s reinsurance arrangements, which are prospective in nature, reinsurance premiums ceded are recorded as prepaid reinsurance and amortized over the remaining contract period in proportion to the reinsurance protection provided, or recorded periodically, as per the terms of the contract, in a direct relationship to the gross premium recording. Reinsurance recoveries are recognized as gross losses are incurred.
Assumed premiums and losses decreased in 2007 compared to 2006 primarily due to reduction in mandatory pool assumptions. Ceded written premiums increased in 2007 compared to 2006, primarily due to increases in flood premiums that are 100% ceded to the NFIP and the termination of New Jersey Homeowners Property 75% Quota Share Treaty that resulted in a return of premium of $11.3 million in the first quarter of 2006, previously ceded to this treaty and still unearned as of December 31, 2005. Increase in ceded loss and loss adjustment expenses incurred of $17.5 million is primarily a result of increase in large loss activity, which was offset by decreases in losses ceded to the NFIP. The flood ceded premiums and losses are as follows:
In 2007, Selective experienced favorable loss development in accident years 2002 through 2006 of $61.7 million partially offset by unfavorable loss development in accident years 2001 and prior of $42.9 million, netting to total favorable prior year development of $18.8 million. This development was primarily driven by favorable prior year development in Selective’s commercial automobile, personal automobile, and workers compensation lines of business partially offset by adverse development in its homeowners and personal umbrella lines of business. The commercial automobile line of business experienced favorable prior year loss and loss expense reserve development of approximately $19 million, which was primarily driven by lower than expected severity in accident years 2004 through 2006. The personal automobile line of business experienced favorable prior year development of approximately $10 million, due to lower than expected loss emergence for accident years 2005 and prior, partially offset by higher severity in accident year 2006. The workers compensation line of business experienced favorable prior year development of approximately $4 million reflecting the implementation of a series of improvement strategies for this line in recent accident years partially offset by an increase in the tail factor related to medical inflation and general development trends. The homeowners line of business experienced adverse prior year loss and loss expense reserve development of approximately $6 million driven by unfavorable trends in claims for groundwater contamination caused by the leakage of certain underground oil storage tanks. The personal umbrella line of business experienced adverse prior year loss and loss expense reserve development of approximately $4 million in 2007, which was due to the impact of several significant losses on this small line. The remaining lines of business, which collectively contributed approximately $4 million of adverse development, do not individually reflect any significant trends related to prior year development.
In 2002, Selective issued $305 million aggregate principal amount of 1.6155% senior convertible notes (“Convertible Notes”), due September 24, 2032, at a discount of 61.988% resulting in an effective yield of 4.25%. Selective recorded gross proceeds of $116.0 million along with $3.2 million of deferred charges, which were amortized over the life of the Convertible Notes, in connection with debt issuance costs. Approximately $72.0 million of the net proceeds were used to fund an irrevocable trust, which provided for certain payment obligations in respect of Selective’s outstanding debt obligations through 2005. Selective also paid a $40.0 million capital contribution to its Insurance Subsidiaries with the remainder of the net proceeds.
The Convertible Notes were 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.
(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 Selective’s outstanding debt. The remainder of the bond proceeds were used for general corporate purposes.
The note purchase agreement covering the 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 2007 and 2006. At December 31, 2007, the amount available for dividends to stockholders under such restrictions was $336.0 million for the 2000 senior notes.
On August 11, 2006, Selective entered into a syndicated line of credit agreement with Wachovia Bank, National Association, as administrative agent. Under this agreement, Selective has access to a $50.0 million revolving credit facility, which can be increased to $75.0 million with the consent of all lending parties. The agreement will expire on August 11, 2011. Interest rates on borrowings under the credit facility are based on either London Interbank Offered Rate or the higher of the prime rate and adjusted federal funds rate. Selective accessed $6.0 million from the facility during 2007 at the London Interbank Offered Rate. At December 31, 2007, there were no balances outstanding under the line of credit. Prior to this time, Selective had revolving lines of credit with State Street Corporation of $20.0 million and Wachovia Bank, National Association, of $25.0 million which expired during the third quarter of 2006.
As of December 31, 2007, Selective had an additional 12.5 million shares reserved for various stock compensation and purchase plans, retirement plans, dividend reinvestment plans and convertible debt offerings. As part of its ongoing capital management strategy, Selective repurchases its own stock. The following table provides information regarding Selective’s purchase of its own Common Stock during the 2005-2007 reporting periods:
The statutory capital and surplus of the Insurance Subsidiaries in excess of these ordinary dividend amounts must remain with the Insurance Subsidiaries in the absence of the approval of a request for an extraordinary dividend. In each such jurisdiction, domestic insurers are prohibited from paying “extraordinary dividends” without approval of the insurance commissioner of the respective state. Additionally, New Jersey, North Carolina, and South Carolina require notice of the declaration of any ordinary or extraordinary dividend distribution. During the notice period, the relevant state regulatory authority may disallow all or part of the proposed dividend if it determines that the insurer’s surplus, with regard to policyholders, is not reasonable in relation to the insurer’s outstanding liabilities and adequate for its financial needs.
On February 2, 1999, Selective’s Board of Directors (the “Board”) approved the Amended and Restated Rights Agreement (the “Rights Agreement”). Under the Rights Agreement, the right to purchase one-half of one two-hundredth (or one four-hundredth) of a share of Selective’s Series A Junior Preferred Stock (each, a “Preferred Share”) at an exercise price of $80 (each, a “Right” and collectively, the “Rights”) is attached to each share of Selective’s Common Stock. The Right is exercisable 10 days after an announcement that a person or group has acquired 15% or more of Selective’s outstanding Common Stock (an “Acquiring Person”) or 10 business days after a person or group commences or announces its intent to make a tender offer that would result in such person or group becoming an Acquiring Person. If a person or group becomes an Acquiring Person, each Right will entitle the holder, other than an Acquiring Person, to purchase such number of one-half of one two-hundredths of a Preferred Share, as set forth in the Rights certificate (the “Rights Amount”), at a price of $80 per one-half of one two-hundreds of a Preferred Share.
Selective has classified its operations into three segments, the disaggregated results of which are reported to and used by senior management to manage Selective’s operations:
Diversified Insurance Services (federal flood insurance administrative services and human resource administration outsourcing products and servicing), which, because they are not dependent on insurance underwriting cycles, are evaluated based on several measures including, but not limited to, results of operations in accordance with GAAP, with a focus on return on revenues (net income divided by revenues).
Selective’s Insurance Operations and Diversified Insurance Services segments are subject to geographic concentration. Approximately 30% of net premiums written are related to insurance policies written in New Jersey and 29% of Selective HR’s co-employer service fees are related to business in Florida. For additional information regarding the states that the Company’s remaining revenues are generated from, see the section entitled “Regional Geographic Market Focus” in Item 1. “Business,” from this Form 10-K.
Selective and its subsidiaries also provide services to each other in the normal course of business. These transactions totaled $17.8 million in 2007, $19.3 million in 2006, and $19.4 million in 2005. These transactions were eliminated in all consolidated statements. In computing the results of each segment, Selective does not make adjustments for interest expense, net general corporate expenses, or federal income taxes. Selective does not maintain separate investment portfolios for the segments and therefore, does not allocate assets to the segments.
Stockholders’ equity reflects tax benefits related to compensation expense deductions for stock options exercised of $17.0 million at December 31, 2007, $13.5 million at December 31, 2006, and $9.6 million at December 31, 2005.
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. Selective sold its interest in CHN Solutions for proceeds of $16.4 million, which produced an after tax loss of $2.6 million. This loss, which is net of a tax benefit of $1.4 million, is included in discontinued operations on the Consolidated Statements of Income. Also included in discontinued operations on the Consolidated Statements of Income are after tax profits of $3.2 million in 2005 from the operations of CHN Solutions prior to divestiture. Taxes on these operating profits amounted to $1.7 million in 2005.
Selective has reclassified prior period amounts on the consolidated statements of income to present the operating results of CHN Solutions as a discontinued operation.
Selective terminated, effective December 31, 1997, a nonqualified defined benefit retirement income plan for non-employee Directors. The estimated accrued costs for this plan were not material. As part of the termination, the present value of each Director’s future benefits, as of that date, was converted into units based on the fair value of Selective Common Stock. The original termination called for the cash value of these units based upon the fair value of Selective Common Stock on retirement date to be distributed to each Director, or at each Director’s election, over a period of fifteen years after such retirement. On May 8, 2002, the stockholders approved the conversion of the units issued under the termination plan into shares of Selective Common Stock. All of the shares issued under this conversion have been deferred by the participants for receipt upon retirement, or at each Director’s election, over a period of no more than five years after such retirement. These deferred shares, which are currently being held in accounts on behalf of each Director, are credited with cash dividends along with interest on those dividends. The adoption of FAS 123R on January 1, 2005 resulted in a reclassification of $1.3 million to “Additional paid-in capital” on the Consolidated Balance Sheet for these deferred shares. The amount reflected in “Additional paid-in capital” for these deferred shares was $1.0 million at December 31, 2007 and $1.1 million at December 31, 2006.
Selective offers a voluntary defined contribution 401(k) retirement savings plan to employees who meet eligibility requirements. Participants, other than highly compensated employees as defined by the IRS, can contribute up to 50% of their defined compensation to the Retirement Savings Plan. Highly compensated employees are limited to 8% of their defined compensation. Contributions by participants are matched 65% by Selective up to a maximum of 7% of defined compensation. Effective January 1, 2006, Selective Insurance Retirement Savings Plan (“Retirement Savings Plan”) was amended to include additional enhanced matching contributions and non-elective contributions for otherwise eligible employees who, because of a date of hire after December 31, 2005, are not eligible for the Retirement Income Plan for Selective Insurance Company of America (“Retirement Income Plan”). For those employees, following one year of service, Selective matches, dollar for dollar, up to 2% of the employee’s base pay contributions. In addition, Selective makes non-elective contributions to the Retirement Savings Plan equal to 2% of the employee’s base pay effective with the first pay following one year of service.
Two additional defined contribution plans are maintained by Selective HR, which does not participate in Selective’s defined contribution plan. The maximum allowable employee contribution to these plans is 75% of defined compensation. The contributions of highly compensated employees may be further restricted in accordance with the plan terms.
Selective 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 treated as if invested in specified investment options. A Participant in the Deferred Compensation Plan may elect to defer compensation or awards to be received from Selective, including up to: (i) 50% of annual base salary; (ii) 100% of incentive compensation; and/or (iii) a percentage of other compensation as otherwise designated by the Administrator of the Deferred Compensation Plan.
In addition to the deferrals elected by the Participants, Selective may choose at any time to make discretionary contributions on a consistent basis to the deferral accounts of all Participants in its sole discretion. No discretionary contributions were made in 2007, 2006, or 2005. Selective may also choose to make matching contributions to the deferral accounts of some or all Participants to the extent a Participant did not receive the maximum matching contribution permissible under Selective’s Retirement Savings Plan due to limitations under the Internal Revenue Code or the Retirement Savings Plan.
Selective contributed $0.1 million in 2007 and 2006 and $0.4 million in 2005 to the Deferred Compensation Plan.
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 Selective contributions under the Retirement Savings Plan as discussed above.
The amortization of prior service cost related to the Retirement Income Plan and Postretirement Plan is determined using a straight-line amortization of the cost over the average remaining service period of employees expected to receive benefits under the Plans.
The estimated net actuarial loss and prior service cost for the Retirement Income Plan that will be amortized from accumulated other comprehensive income into net periodic benefit cost during the 2008 fiscal year are $0.1 million and $0.2 million respectively. The estimated net actuarial loss and prior service cost for the Postretirement Plan that will be amortized from accumulated other comprehensive income into net periodic benefit cost during the 2008 fiscal year are $0 and $(32,000) respectively.
Selective’s measurement date was December 31, 2007 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 9.0% 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 2008 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 management. Selective’s return objective is to meet or exceed the returns of the plan’s policy index, which is the return the plan would have earned if the assets were invested according to the target asset class weightings and earned index returns. The plan’s allocated target and ranges by investment categories are as follows:
The Retirement Income Plan had no investments in the Common Stock of the Company at December 31, 2007 and 2006.
As of December 31, 2007, 548,682 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. There were no forfeitures under this plan in 2007 and forfeitures in 2006 and 2005 amounted to 984 restricted shares and 13,600 restricted shares respectively.
As of December 31, 2007, there were 458,930 shares of Selective’s Common Stock available for issuance pursuant to outstanding stock options and restricted stock awards granted under Stock Option Plan III, under which future grants ceased being available with the approval of the Stock Plan. Under Stock Option Plan III, employees were granted qualified and nonqualified stock options, with or without SARs, and restricted or unrestricted stock: (i) at not less than fair value on the date of grant and (ii) subject to certain vesting restrictions determined by the SEBC. Restricted stock awards also could be subject to 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. Under Stock Option Plan III, Selective granted options to purchase 211,326 shares without SARs during 2005.
Under Selective’s Employee Stock Purchase Savings Plan (“ESPP”), there were 251,434 shares of Common Stock available for purchase as of December 31, 2007. 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 108,062 shares to employees during 2007, 88,310 shares during 2006, 88,758 shares during 2005.
At December 31, 2007, the liability recorded in connection with Selective’s Cash Incentive Plan was $9.4 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 1.2 years. During 2007 and 2006, no cash incentive unit payments were made.
Share-based compensation expense charged against net income before tax was $20.6 million at December 31, 2007 with a corresponding income tax benefit of $6.8 million. Share-based compensation expense that was charged against net income before tax was $20.1 million at December 31, 2006 with a corresponding income tax benefit of $6.7 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.
Selective paid reinsurance commissions of $0.2 million in 2007, 2006, and 2005 to PL, LLC. PL, LLC is an insurance fund administrator of which Rue Insurance owns 26.67% and which places reinsurance through a Selective Insurance Subsidiary.
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, 2007, the total future minimum rental commitments under non-cancelable leases were $25.3 million and such yearly amounts are as follows:
The Insurance Subsidiaries prepare their statutory financial statements in accordance with accounting principles prescribed or permitted by the various state insurance departments of domicile. Prescribed statutory accounting principles include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (“NAIC”). Permitted statutory accounting principles encompass all accounting principles that are not prescribed; such principles differ from state to state, may differ from company to company within a state and may change in the future. The Insurance Subsidiaries do not utilize any permitted statutory accounting principles that materially affect the determination of statutory surplus, statutory net income, or risk-based capital. As of December 31, 2005 the various state insurance departments of domicile have adopted the NAIC Accounting Practices and Procedures manual, version as of March 2007, in its entirety, as a component of prescribed or permitted practices.