- --------------- (1) Net premiums written are premiums for all policies sold during a specific accounting period less premiums returned.
(4) Underwriting expense ratio measures underwriting expenses as a percentage of net premiums earned.
(5) Combined ratio measures the percentage of premium dollars used to pay insurance losses, loss adjustment expenses and underwriting expenses.
Ohio Casualty Corporation (the Corporation) is the holding company of The Ohio Casualty Insurance Company (the Company), which is one of six property-casualty insurance companies that make up the Ohio Casualty Group (the Group), collectively the Consolidated Corporation. All dollar amounts in this Management's Discussion and Analysis (MD&A) are in millions unless otherwise noted.
The Consolidated Corporation earns revenue by providing businesses and consumers with competitive insurance products with high quality service and by income on funds invested. In 2005, the Consolidated Corporation continued to see improvement in financial performance as net income increased 66% to $212.7 in 2005 from $128.4 in 2004. Our capital structure continued to improve during the year as a result of the Corporation's elimination of the convertible notes through repurchase, redemption or conversion, with minimal dilution to earnings per share. During 2005, the Board of Directors reinstated the quarterly shareholder dividend and approved a share repurchase program of up to four million shares of the Corporation's common stock. As of December 31, 2005, we have repurchased 1,516,105 shares at an average price of $26.04 per share. In addition, the combined ratio was the best in decades.
In September 2003, the Consolidated Corporation announced its Corporate Strategic Plan for the 2004-2006 time frame. The plan brings together five broad objectives to help achieve the Consolidated Corporation's Vision to be a leading super regional Property and Casualty carrier providing a broad range of products/services through independent agents and brokers. The broad objectives include abilities to generate above market growth, produce competitive loss ratios, create a competitive expense structure, achieve a competitive return on equity and improve credit ratings and financial flexibility. Competitive advantages include strong agency relationships, especially with key agents, and technology platforms that provide operating flexibility. Technology is being leveraged to make it easier for agents to do business with the Group and to increase pricing and underwriting sophistication. The Consolidated Corporation continues to execute against this plan and the results in 2005 and 2004 are an indication that the plan and its execution are working.
The Consolidated Corporation reported net income of $212.7, or $3.19 per share, for 2005, compared with $128.4, or $1.89 per share, for the year 2004, and $75.8, or $1.18 per share, in 2003, which included after-tax realized investment gains of $41.6, ($0.62 per share), $14.9, ($0.20 per share) and $23.3, ($0.34 per share) for 2005, 2004 and 2003, respectively.
In the first quarter of 2003, management transferred a portion of its fixed income securities from the available-for-sale classification into the held-to-maturity classification. This transfer was made as the Consolidated Corporation has both the ability to hold the securities to maturity and the positive intent to do so. At December 31, 2005 and 2004 the amortized cost of the held-to-maturity portfolio was $264.4 and $301.4, respectively.
The assessment of whether a decline in fair value is considered temporary or other-than-temporary includes management's judgment as to the financial position and future prospects of the entity issuing the security. It is not possible to accurately predict when it may be determined that a specific security will become impaired.
exceeding 20%. This group represents $2.1, or 10% of the total unrealized loss position. Of this group, six securities representing approximately $1.1 in unrealized losses have been in an unrealized loss position for less than twelve months. Of the remaining five securities in an unrealized loss position for longer than twelve months totaling $1.0, management believes they will recover the cost basis of these securities, and has both the intent and ability to hold the securities until they mature or recover in value. All securities are monitored by portfolio managers who consider many factors such as an issuer's degree of financial flexibility, management competence and industry fundamentals in evaluating whether the decline in fair value is temporary. In addition, management considers whether it is probable that all contract terms of the security will be satisfied and whether the unrealized loss position is due to changes in the interest rate environment. Should management subsequently conclude the decline in fair value is other than temporary, the book value of the security is written down to the then fair value with the realized loss recognized in the consolidated statements of income.
The amortized cost and estimated fair value of fixed income securities classified as available-for-sale and held-to-maturity with an unrealized loss position at December 31, 2005, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
For additional discussion relative to the Consolidated Corporation's investment portfolio, see the "Investment Portfolio" section under "Liquidity and Capital Resources" on pages 55-57 of this MD&A.
For additional information relative to the internally developed software, see Note 1H - Summary of Significant Accounting Policies - Internally Developed Software in the Notes to the Consolidated Financial Statements on page 68 of this Annual Report on Form 10-K.
Insurance industry regulators require the Group to report its financial condition and results of operations, among other things, using statutory accounting principles. Management uses industry standard financial measures determined on a statutory basis, as well as those determined on a GAAP basis to analyze the Group's property and casualty operations. These insurance industry financial measures include loss and LAE ratios, underwriting expense ratio, combined ratio, net premiums written and net premiums earned. The combined ratio is a commonly used gauge of underwriting performance measuring the percentage of premium dollars used to pay insurance losses and related expenses. The combined ratio is the sum of the loss, LAE and underwriting expense ratios. All references to combined ratio or its components in this MD&A are calculated on a GAAP basis, unless otherwise indicated, and are calculated on a calendar year basis unless specified as calculated on an accident year basis. Insurance industry financial measures are included in the next several sections of this MD&A that discuss results of operations. A discussion of the differences between statutory accounting and generally accepted accounting principles in the United States is included in Item 15, Note 14, Statutory Accounting Information, in the Notes to Consolidated Financial Statements, on page 82 of this Annual Report on Form 10-K.
Gross premiums written differs from net premiums written by the amount of premiums ceded to reinsurers. Management analyzes premium revenues primarily by premiums written in the current period, which is a better indicator of current production levels. Net premiums written are recognized into revenue on a monthly pro rata basis over the coverage term of the policy which is reflected in the consolidated income statements as earned premium.
The Group's business is geographically concentrated in the Mid-West and Mid-Atlantic regions. The following table shows consolidated net premiums written for the Group's five largest states for each of the last three years:
Commercial Lines gross and net premiums written decreased in 2005, a result of an 18% decline in new business premium production partially offset by improved retention rates and average renewal price increases(1) in the low single digits. While average renewal price increases, including exposure changes, remained positive in 2005, the rate of increase has slowed as the Commercial Lines segment approaches price adequacy and competitive pricing pressures in the marketplace have increased. The 2005 average renewal price increase was 2.0% for Commercial Lines direct premiums written, compared with 5.0% and 11.4% average renewal price increases in 2004 and 2003, respectively. Commercial Lines gross and net premiums written increased in 2004 relative to 2003, a result of average renewal price increases as new business premium production remained relatively flat in 2004.
Specialty Lines gross premiums written decreased in 2005, a result of significantly lower new business premium production in the commercial umbrella product line partially offset by growth in the fidelity and surety product line. Net premiums written for this segment increased in 2005 as a result of a decline in ceded premiums primarily related to higher reinsurance retention limits and an increased accrual in 2004 for ceded premium of $6.1 on a commercial umbrella product line reinsurance treaty for the years 1999 through 2001, which reduced net premiums written in 2004. Without the effect of this additional ceded premium accrual in 2004, Specialty Lines net premiums written for 2005 would have increased by 6.2%. Gross and net premiums written declined in 2004 relative to 2003, a result of lower new business premium production, the $6.1 ceded premium accrual referenced above and higher reinsurance costs for the commercial umbrella product line. Renewal pricing in the commercial umbrella product line has increased during 2005, 2004 and 2003, but the rate of increase has slowed. Average renewal price increases for the commercial umbrella product line were 3.7%, compared to 8.0% in 2004 and 18.1% in 2003. Stricter underwriting guidelines for certain classes of business and market prices falling below what the Group believes are acceptable levels, contributed to the decline in new business production for the commercial umbrella product line.
Personal Lines gross and net premiums written declined during 2005 as a result of a 10% decline in new business premium production when compared with the prior year. Additionally, in the later part of 2005, the Group began taking rate reductions in a number of states for both the personal auto and homeowners product lines. All of these factors are either the result of or in response to increased competition, and as it relates to rate reduction, the achievement of significant levels of profitability in Personal Lines. Gross premiums written remained relatively flat during 2004 and net premiums written increased slightly. Both gross and net premiums written were negatively impacted in 2004 due to a $2.2 refund of escrowed premiums for North Carolina personal auto.
The 2004 All Lines combined ratio improved 7.8 points driven by a 7.4 point improvement in the loss and LAE ratios. The loss and LAE ratios were impacted by favorable prior year reserve development of $21.8 in 2004 compared to adverse reserve development of $34.1 in 2003, which reduced the 2004 loss and LAE ratio by 1.5 points and increased the 2003 loss and LAE ratio by 2.4 points. The remaining improvement of 3.5 points in the 2004 loss and LAE ratio over 2003 was due to improved price adequacy, more disciplined underwriting standards and improved claims efficiency. The underwriting expense ratio improved 0.4 points as a result of operational efficiencies implemented throughout 2003 and 2004, somewhat offset by $15.6, or 1.1 points of expense related to the Proformance surplus guarantee.
During 2005, the $20.1 before-tax favorable development from prior accident years' losses and LAE, which represented 0.7% of loss and LAE reserves at year-end 2004, was concentrated in the Specialty Lines (primarily the commercial umbrella product line) and Personal Lines (primarily the personal auto product line) operating segments. This net favorable development was partially offset by adverse development in the Commercial Lines operating segment due almost entirely to the review of all pension or permanent disability workers' compensation cases during the year.
Catastrophe losses in 2005, 2004 and 2003 were $25.8, $43.5 and $43.8, respectively. Hurricanes Katrina, Rita and Wilma made up $13.8 of the $25.8 of catastrophe losses in 2005. The Group was impacted by 23 separate catastrophes in 2005, compared with 22 catastrophes in 2004 and 21 in 2003. The largest catastrophe, as measured in terms of incurred loss, in each year was $11.2, $8.0 and $11.5, respectively. Additional catastrophes with over $1.0 in incurred losses numbered five, ten and nine in 2005, 2004 and 2003, respectively. The Group uses the serial number assigned by Property Claims Services, a unit of the Insurance Services Office, to define and track losses for specific catastrophes. Property Claims Services defines catastrophes as industry events that cause $25.0 or more in direct insured losses to property. The effects of future catastrophes on the Consolidated Corporation's results cannot be accurately predicted. As such, severe weather patterns, acts of war or terrorist activities could have a material adverse impact on the Consolidated Corporation's results, reinsurance pricing and availability of reinsurance.
(Proformance). The employee count continued to decline in 2005 with an approximate 20.4% reduction from 2003 as a result of the CSE initiative. The employee count was 2,125, 2,190 and 2,669 as of December 31, 2005, 2004 and 2003, respectively. Partially offsetting the decline in expenses related to the CSE initiative were increased incentive accruals due to improved profitability.
The 2005, 2004 and 2003 underwriting expenses also included $3.4, $3.1 and $2.6 of software amortization expense before tax, respectively, related to the rollout of P.A.R.I.S.(sm). On a GAAP accounting basis, the new application is being amortized over a ten-year period. The amortization expense is expected to be offset in part by reduced labor costs related to underwriting and policy processing.
In 2001, the Group introduced into operation, P.A.R.I.S.(sm) for Commercial Lines and substantially completed the rollout in 2002. At the end of 2004, P.A.R.I.S.(sm) was deployed for the Specialty Lines commercial umbrella excess capacity product line. Further implementation for other Specialty and Personal Lines products is expected during the balance of 2006 and 2007.
The P.A.R.I.S.(sm) system provides the policy administration environment used internally by the Group's associates. An extension of P.A.R.I.S.(sm) called P.A.R.I.S. Express(sm) leverages the P.A.R.I.S.(sm) system to provide underwriting, rating, inquiry and policy processing functionality to our agents. P.A.R.I.S. Express(sm) is a proprietary internet interface that uses the P.A.R.I.S.(sm) system to provide real-time functionality through a web browser to our agents. In addition, the Group is simultaneously introducing P.A.R.I.S. Connect(tm) which allows agents to transact with the Group directly from their agency management system without requiring re-entering of customer or agency information.
For selected Commercial Lines agents, P.A.R.I.S. Express(sm) and P.A.R.I.S. Connect(tm) provides on-line quoting capability. In February of 2005, P.A.R.I.S. Express(sm) was extended to support issuance and endorsement processing for selected pilot agents; nationwide rollout started in December 2005 and will extend through March 2006. Personal Lines currently offers on-line and real time quoting and issuance for new business and endorsements through existing (non- P.A.R.I.S.(sm)) systems.
Agents want a cost effective, timely and simple system for issuing and maintaining insurance policies. P.A.R.I.S. Express(sm) and P.A.R.I.S. Connect(tm) are the cornerstone in the Group's strategy of focusing on superior agent service. The continued success of the Group's strategic plan depends in part on the ability to provide agents with the technological advantages of these tools. If they do not work as expected, or fail to satisfy agents' needs, the Group may lose business to insurers with preferred technologies.
The following segment information is presented on a GAAP basis unless otherwise noted.
The 2005 Commercial Lines combined ratio increased 1.3 points when compared to 2004 results. The increase in loss and LAE ratios of 3.4 points is primarily related to $29.1 of adverse prior year reserve development compared to favorable development of $15.0 in 2004. The adverse development in 2005 was primarily related to the re-evaluation of lifetime case reserves in the workers' compensation product line, partially offset by favorable prior year reserve development in the commercial auto product line. The adverse reserve development was further offset by favorable claim frequency trends. The underwriting ratio decreased 2.1 points, primarily the result of staff reductions and operational efficiencies implemented in 2004 and 2005.
The workers' compensation product line combined ratio was 142.4% in 2005, an increase of 28.4 points compared to 114.0% in 2004 and 127.0% in 2003. The adverse development on the workers' compensation product line is related to the completion of a review of lifetime and other severe claims, which added 31.3 points to the workers' compensation combined ratio in 2005. Also impacting the loss and LAE ratios for these periods were assessments for the National Workers' Compensation Pool (NWCP), which added 0.4 points to the workers' compensation combined ratio in 2005 compared to 4.9 points and 4.0 points in 2004 and 2003, respectively. The Group continues to focus on improving profitability in the workers' compensation product line. The Group has restricted writings in states where the workers' compensation product line has historically been unprofitable and is focused on growing this product line in profitable states and classes. The concentration of the Group's business in a few states with limited pricing flexibility provides less opportunity to address issues specific to the workers' compensation product line in those states. These issues are offset by the Group's approach to writing workers' compensation as part of an overall Commercial Lines account, where underwriters seek to ensure that the pricing for the entire account is adequate.
The general liability product line combined ratio was 111.3% in 2005, an increase of 1.4 points compared to 109.9% in 2004 and 122.1% in 2003. This line is exposed to construction defect issues which are being addressed through strict underwriting standards for certain classes of business that are more prone to construction defect claims. In addition, the Group has introduced policy language changes to limit exposure to broadening court interpretations of additional insured and contractual general liability provisions within the policy. Also impacting the general liability product line combined ratio is an increase in asbestos and environmental loss and LAE reserves which added 9.6 points to the general liability loss and LAE ratio related to certain pre-1970 assumed reinsurance.
Specialty Lines combined ratio for 2005 improved 1.4 points. Given the volume and nature of the coverage, the Specialty Lines combined ratio is subject to more volatility than the other product lines. The 2005 combined ratio included $12.3, or 8.6 points, of favorable development on prior year loss and LAE reserves compared to $9.4, or 6.3 points, in 2004 and $21.3, or 13.1 points, in 2003.
The fidelity and surety combined ratio increased to 83.2% in 2005, compared with 81.5% in 2004 and 65.7% in 2003. The 2005 fidelity and surety combined ratio included $0.8 of favorable development on prior accident year loss and LAE reserves compared to $4.2 in 2004 and $5.5 in 2003.
All investment securities are classified upon acquisition as either held-to-maturity or available-for-sale. Fixed income securities classified as held-to-maturity are carried at amortized cost as management has the ability and positive intent to hold the securities until maturity. Available-for-sale securities are those securities that are not classified as either held-to-maturity or trading. Available-for-sale securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported as a component of other comprehensive income, net of deferred tax. Transfers of fixed income securities into the held-to-maturity category from the available-for-sale category are made at fair value at the date of transfer. The unrealized holding gain or loss at the date of transfer is retained in other comprehensive income and in the carrying value of the held-to-maturity securities. Such amounts are amortized over the remaining life of the security. Equity securities are carried at quoted market values and include non-redeemable preferred stocks and common stocks. The difference between cost and quoted market value, net of deferred taxes, is classified as other comprehensive income. The Consolidated Corporation closely monitors the fixed income and equity portfolios for declines in value that are deemed to be other than temporary. Investments are regularly evaluated based on current economic conditions, credit loss experience and other specific developments. If a decline in a security's fair value is considered to be other than temporary, the security is written down to the estimated fair value with a corresponding realized loss recognized in the then current consolidated statement of income.
Mortgage-backed securities are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations. Upon receipt of payments from such securities, the appropriate amount of the funds are allocated between a reduction of principal and interest income. In making this allocation decision, investment personnel consider such factors as the original estimated average life of the investment, the amount of funds received to date and the timing of future cash flows. Variations from prepayment assumptions will affect the life and yield of these securities. These securities are evaluated for impairment by computing the net-present-value of expected future cash flows and comparing this to the prior period estimate of expected future cash flows from the security. When the timing and/or amount of cash expected to be received from the security has changed materially and adversely from the previous valuation, the security is considered to be other than temporarily impaired and the amortized cost is written down to the estimated fair value with a realized loss recorded in the then current consolidated statement of income.
Reinsurance is a contract by which one insurer, called a reinsurer, agrees to cover, under certain defined circumstances, a portion of the losses incurred by a primary insurer in the event a claim is made under a policy issued by the primary insurer. The Group purchases reinsurance to diversify risk and reduce the loss that may arise from large or catastrophic losses or other events that cause unfavorable underwriting results. The Group records its ceded reinsurance transactions on a gross basis by recording an asset as reinsurance recoverable for estimates of paid and unpaid losses, including estimates for losses incurred but not reported. The collectibility of reinsurance depends on the solvency of the reinsurers at the time any claims are presented. The Group evaluates each reinsurer's financial health, claims settlement performance and monitors concentrations of
The Company sponsors a non-contributory defined benefit pension plan and a contributory postretirement healthcare plan. The pension and postretirement benefit obligations, related costs and contributions are calculated using actuarial methods in accordance with Statement of Financial Accounting Standards (SFAS) No. 87, "Employers' Accounting for Pensions" and SFAS 106, "Employers' Accounting for Postretirement Benefits Other than Pension." Several statistical and other factors, which attempt to anticipate future events, are used in calculating the expense and liability related to the plans. Key factors include assumptions about the expected rates of return on plan assets, discount rates, rate of compensation increases and health care cost trend rates, as determined by the Company, within certain guidelines. The Company considers market conditions, including changes in investment returns, interest rates and inflation in making these assumptions. Any adjustments to these assumptions are based on considerations of current and future market conditions, which can result in changes to the future related benefit obligations, related costs and contributions incurred by the Company. Management reviews the assumptions used in the valuations on an annual basis, or more frequently as deemed necessary.
The Company determines the expected long-term rate of return on plan assets based on the geometric method, which represents the average compound return of the plan assets. Plan assets are comprised primarily of investments in mutual funds, common stocks, corporate bonds, U.S. government securities, real estate investment trusts and other investments. The Company considers the current level of expected returns on risk free investments, primarily government bonds, the historical level of the risk premium associated with the other asset classes, current and expected asset allocation and the expectations for future returns of each asset class
when developing the expected long-term rate of return on assets assumption. The expected return for each asset class is weighted based on the target asset allocation to develop the expected long-term rate of return on assets assumption for the portfolio. This resulted in the selection of the 8.75% assumption for 2005, 2004 and 2003. The expected rate of return on plan assets is a long-term assumption. Holding all other assumptions constant, a one-percentage-point increase or decrease in the assumed rate of return on plan assets would decrease or increase, respectively, 2005 net periodic pension expense by approximately $3.1.
In determining the discount rate assumption, the Company utilizes current market information including analysis of the Moody's "Aa" Corporate Bond Index Rate, analysis provided by plan actuaries and independent survey data on similarly positioned companies. As regards to the analysis provided by plan actuaries, a discounted cash flow model of the plan's benefit obligations was developed using an interest rate yield curve to make judgments regarding the appropriate discount rate for both its pension and postretirement medical benefit obligations. The yield curve is comprised of the highest quartile yielding bonds with at least an "Aa" rating and with maturities primarily between zero and thirty years. This resulted in the selection of 5.50% for 2005, 5.95% for 2004 and 6.15% for 2003 for the pension plan and 5.35% for 2005, 5.75% for 2004 and 6.15% for 2003 for the postretirement medical plan.
Unrecognized losses of approximately $51.9, as of the measurement date (September 30, 2005), are being recognized over approximately a 13-year period, which represents the average future service period of active participants. Unrecognized gains and losses arise from several factors including experience and assumption changes in the obligations and from the difference between expected and actual returns on plan assets. These unrecognized losses will be systematically recognized as an increase in future net periodic pension expense in accordance with SFAS 87.
Key assumptions used in determining the amount of the obligation and expense recorded for postretirement benefits other than pensions (OPEB), under SFAS 106, including the assumed discount rate and the assumed rate of increases in future health care costs, are reviewed by management on an annual basis, or more frequently as deemed necessary. In estimating the health care cost trend rate, the Company considers its actual health care cost experience, future benefit structures, industry trends and advice from its third-party actuaries. The Company assumes that the relative increase in health care costs will generally trend downward over the next several years, reflecting assumed increases in efficiency in the health care system and industry-wide cost containment initiatives. At December 31, 2005, the expected rate of increase in future health care costs was 9% declining to 5% in 2013 and thereafter. Increasing the assumed health care cost trend by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 2005, by approximately $4.2 and increase the postretirement benefit cost for 2005 by $0.3. Likewise, decreasing the assumed health care cost trend by one percentage point in each year would decrease the accumulated postretirement benefit obligation as of December 31, 2005, by approximately $3.6 and decrease the postretirement benefit cost for 2005 by $0.2.
benefit plan, the Company recognized a reduction in net periodic postretirement cost of $6.1 and $5.0 in 2005 and 2004, respectively, attributable to the amortization of unrecognized prior service cost and has a remaining unrecognized prior service cost of $48.9 at December 31, 2005, which will be ratably recognized over the next eight years as a reduction of net periodic postretirement cost.
For more information on the Company's pension and other postretirement benefit plans, please refer to Item 15, Note 4, Employee Benefit Plans, in the Notes to Consolidated Financial Statements, on pages 72-75 of this Annual Report on Form 10-K.
The Group conducts a quarterly review of loss reserves using the methods described below, and records its best estimate each quarter based on that review. In the opinion of management, the reserves recorded at December 31, 2005 represent the Group's best estimate of its ultimate liability for losses and LAE. However, due to the inherent complexity of the estimation process and the potential variability of the assumptions used, final claim settlements may vary significantly from the amounts recorded. Furthermore, the timing, frequency and extent of adjustments to the estimated liabilities cannot be predicted with certainty since conditions and events which established historical loss reserve development and which serve as the basis for estimating ultimate claim costs may not occur in exactly the same manner, if at all.
Loss reserves are an estimate of ultimate unpaid costs of losses and LAE for claims that have been reported and claims that have been incurred but not yet reported. Loss reserves do not represent an exact calculation of liability, but instead represent estimates, generally utilizing actuarial expertise and reserving methods, at a given accounting date. These loss reserve estimates are expectations of what the ultimate settlement and administration of claims will cost upon final resolution in the future, based on the Group's assessment of facts and circumstances then known. In establishing reserves, the Group also takes into account estimated recoveries for reinsurance, salvage and subrogation.
The process of estimating loss reserves involves a high degree of judgment and is subject to a number of risk factors. These risk factors can be related to both internal and external events, such as changes in claims handling procedures, economic inflation, legal trends and legislative changes, among others. The impact of these items on ultimate costs for loss and LAE is difficult to estimate. Loss reserve estimation differs by product line due to differences in claim complexity, the volume of claims, the potential severity of individual claims, the determination of occurrence date for a claim and reporting lags (the time between the occurrence of the policyholder loss event and when it is actually reported to the insurer). Informed judgment is applied throughout the process. The Group continually refines its loss reserve estimates in a regular ongoing process as historical loss experience develops and additional claims are reported and settled. The Group considers all significant facts and circumstances known at the time loss reserves are established. Due to the inherent uncertainty underlying loss reserve estimates, final resolution of the estimated liability will be different from that anticipated at the reporting date. Therefore, actual paid losses in the future may yield a materially different amount than currently reserved--favorable or unfavorable. The Group reflects adjustments to reserves in the results of operations in the period the estimates are changed.
Loss and LAE Reserves as of December 31, 2005 and 2004:
include workers' compensation, commercial umbrella and general liability. Short-tail lines include homeowners, property and bonds. Product lines such as personal and commercial auto and commercial multi-peril include some long-tail coverages and some short-tail coverages.
A key assumption in most actuarial analyses is that past patterns demonstrated in the data will repeat themselves in the future, absent a material change in the associated risk factors discussed below. To the extent a material change affecting the ultimate claim liability is known, such change is quantified to the extent possible through an analysis of internal company data and, if available and when appropriate, external data. Such a measurement is specific to the facts and circumstances of the particular claim portfolio and the known change being evaluated.
1. Paid loss development - payment patterns of prior claims are used to estimate future payment patterns which are applied to current payments to derive an estimate of ultimate losses.
Loss reserve uncertainty is illustrated by the variability in reserve development presented in the Analysis of Development of Loss and LAE Liabilities schedule which appears on pages 11 and 12 under Item 1 of this Annual Report on Form 10-K. This schedule shows cumulative loss reserve development for each of the past ten years through December 31, 2005 on a gross and net of reinsurance basis. The development on a net of reinsurance basis as a percent of the original estimates ranges from adverse development of 17.2% of original estimates for loss reserves at year-end 2000 to favorable development of 0.9% of original estimates for loss reserves at year-end 2004. The oldest period shown, 1995, shows adverse development of 1.9% of original loss reserves ten years after the original estimates.
This table illustrates that favorable development can occur for one operating segment while adverse development occurs for another, and that development from year to year can be either favorable or adverse for an operating segment.
Within each operating segment, development can also be favorable or adverse by product line within the same period. For example, for the Commercial Lines operating segment in 2005, the workers' compensation product line had adverse development of $42.0 while the commercial auto product line had favorable development of $30.6.
The Group does not prepare loss reserve ranges, nor does it project future variability, when determining its best estimate, although the above examples of actual historical changes in loss reserve estimates provide a measure of the uncertainty underlying the current loss reserve estimates. The Loss Reserve process takes all risk factors, as previously disclosed, into account, but no one risk factor has been bifurcated to perform a sensitivity or variability analysis because the risk factors were considered in the aggregate. As a result, the Group is not in a position to quantify the impact of reasonably likely changes to significant assumptions at this time. Nevertheless, the Group plans to undertake an assessment to evaluate the sensitivity or variability of changes in significant assumptions related to the Group's estimate of loss reserves in the aggregate and/or by product line, to the extent material. Upon completion of such sensitivity or variability assessment, and to the extent that management believes the information to be reasonably accurate and credible and would be beneficial, in the opinion of management, to the understanding of the Group's financial statements, the Corporation will include the outcome of this sensitivity/variability analysis either in the aggregate or by product line, as appropriate, in the first practicable periodic filing of the Corporation that follows the completion of this assessment and continuing thereafter.
The Group has four categories of loss reserves that it considers highly uncertain, and therefore, could have a material impact on future financial results: workers' compensation, asbestos and environmental liability, construction defect exposures and commercial umbrella. These categories are described below with relevant historical data.
During 2005, in response to industry wide development, the Group's claims department reviewed permanent workers' compensation cases to re-assess life expectancy and medical costs. The review resulted in increases to loss reserves on approximately 25% of the inventory of approximately 1,200 permanent cases. These adjustments comprise a substantial part of the $42.0 adverse development for this product line in 2005. The Group will continue to monitor these types of claims in the future.
In recent years, asbestos and environmental liability claims have expanded greatly in the insurance industry. Historically, the Group has written small commercial accounts with a focus on contracting business. Within the manufacturing category, the Group has concentrated on light manufacturers, thus the Group's exposure to asbestos is related to installers and distributors as opposed to the large manufacturers. Consequently, the Group believes it has minimal exposure to the primary defendants involved in major asbestos litigation. The Group's exposure to environmental liability is due to policies written prior to the introduction of the absolute pollution endorsement in the mid-80's and to underground storage tanks, mostly from New Jersey homeowner's policies in recent years. The Group has limited exposures to the national priority list, a list of known or threatened releases of hazardous substances, pollutants, or contaminants throughout the United States. The Group also has limited asbestos and environmental exposures related to assumed reinsurance business written prior to 1980 with small policy limits.
In 2005 and 2004, respectively, the Group paid loss and LAE of $7.3 and $7.0 for asbestos and environmental claims on a net of reinsurance basis. At year-end 2005 and 2004, asbestos and environmental reserves net of reinsurance were $95.8 and $82.6, respectively.
The major causes of material uncertainty ("risk factors") generally will vary for each product line, as well as for each separately analyzed component of the product line. In some cases, such risk factors are explicit assumptions of the estimation method and in others, they are implicit. Actual results will likely vary from expectations for each of these assumptions, resulting in an ultimate claim liability that is different from that being estimated currently.
Time required to recover from the injury Degree of available transitional jobs Degree of legal involvement Changes in the interpretations and processes of the workers' compensation commissions' oversight of claims Future wage inflation for states that index benefits Changes in the administrative policies of second injury funds
Changes in the cost of medical treatments (including prescription drugs) and underlying fee schedules Frequency of visits to health providers Number of medical procedures given during visits to health providers Types of health providers used Type of medical treatments received Use of preferred provider networks and other medical cost containment practices Availability of new medical processes and equipment Changes in the use of pharmaceutical drugs Degree of patient responsiveness to treatment
The commercial automobile product line is a mix of property and liability coverages and, therefore, includes both short and long-tail coverages. The payments that are made quickly typically pertain to auto physical damage (property) claims and property damage (liability) claims. The payments that take longer to finalize and are more difficult to estimate relate to bodily injury claims. In general, claim reporting lags are minor, claim complexity is not a major issue and the line is viewed as high frequency, low to moderate severity. Overall, the claim liabilities for this line create a moderate estimation risk. Commercial automobile reserves are typically analyzed in three components; bodily injury liability, property damage liability and physical damage claims. These last two components have minimal loss reserve risk and fast payouts and, accordingly, separate risk factors are not presented.
Trends in jury awards Changes in the underlying court system Changes in case law Litigation trends Frequency of claims with payment capped by policy limits Change in average severity of accidents, or proportion of severe accidents Subrogation opportunities Changes in claim handling procedures Frequency of visits to health providers Number of medical procedures given during visits to health providers Types of health providers used Types of medical treatments received Changes in cost of medical treatments Degree of patient responsiveness to treatment
The personal automobile product line has risk factors comparable to the commercial automobile product line described above. In addition, this line is subject to risk related to the effectiveness of the no-fault laws that exist in some states.
For disclosure related to recently issued accounting standards, refer to Item 15, Note 19, Recently Issued Accounting Standards, in the Notes to Consolidated Financial Statements, on page 84 of this Annual Report on Form 10-K.
Total cash used in financing activities was $198.5 in 2005, compared to cash generated of $199.5 in 2004 and $1.6 in 2003. The primary uses of cash in financing activities in 2005 related to the repurchase or redemption of the Convertible Notes, reinstatement of the dividend to shareholders and the repurchase of the Corporation's common stock pursuant to the authorized share repurchase program. These uses were partially offset by cash received from the exercise of stock options. Cash provided by financing activities in 2004 resulted from net proceeds of approximately $198.0 from the issuance of 7.3% Senior Notes in June 2004, in addition to the exercise of stock options, partially offset by the repurchase of $12.5 of the Corporation's Convertible Notes.
Overall, total cash used in 2005 was $198.1, compared with cash generated of $195.7 in 2004 and net cash used of $5.3 in 2003. During 2005, the Corporation reinstated the shareholder dividend and the Board of Directors approved a share repurchase program. For additional information regarding the shareholder dividend and the share repurchase program see Part II, Item 5 - Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities on pages 26 and 27 of this Annual Report on Form 10-K.
**For additional disclosure, see Item 15, Note 15, Debt, in the Notes to Consolidated Financial Statements, on pages 82 and 83 of this Annual Report on Form 10-K.
***Excluded from other long-term liabilities are pension obligations which are described in Item 15, Note 4, Employee Benefit Plans, in the Notes to Consolidated Financial Statements, on pages 72-75 of this Annual Report on Form 10-K and disclosed separately above.
In December 2003, the SFAS issued a revised Interpretation No. 46, "Consolidation of Variable Interest Entities" (FIN 46), an interpretation of Accounting Research Bulletin No. 51. FIN 46 requires a variable interest entity (VIE) to be consolidated by the primary beneficiary of the entity if certain criteria are met. The Consolidated Corporation currently holds an equity investment, representing a 49% interest, in APM Spring Grove, Inc. (APM), which was deemed a variable interest entity in accordance with FIN 46. As a result, the entity was consolidated into the Consolidated Corporation's financial statements during the first quarter of 2004, which resulted in a $1.6 loss, net of tax, due to a cumulative effect of an accounting change. The Consolidated Corporation's maximum exposure to loss as a result of its involvement with APM is $2.6. See Item 15, Note 17, Variable Interest Entity, in the Notes to Consolidated Financial Statements, on page 84 of this Annual Report on Form 10-K for further discussion.
During 2005, the Corporation successfully completed the redemption or conversion of its Convertible Notes with minimal dilution to earnings or book value per share.
The Group maintains several programs that provide reinsurance coverage which is intended to mitigate the impact of larger losses and catastrophic events. The Group's 2005 property per risk program covers property losses in excess of $2.0 for each and every risk with a limit of $13.0.
Effective January 1, 2006, the Group renewed the vast majority of its reinsurance program, with no significant changes in terms and conditions or reinsurers and with a less than 2.0% increase in the total cost of the program.
The following table sets forth the distribution and other data of invested assets for the years ended December 31, 2005 and December 31, 2004.
The excess of market value over cost at December 31, 2005 was $305.1 compared with $427.0 at December 31, 2004. The decrease in unrealized gains for 2005 was attributable to declining market values of fixed income securities as a result of rising interest rates, and the sale of certain equity securities, which had appreciated in value, and had become a significant percentage of the Consolidated Corporation's total common stock portfolio.
During 2004, the Consolidated Corporation, as a result of improved profitability, revised its investment strategy to increase its investment into tax-exempt securities.
The consolidated fixed income portfolio, which for this purpose includes cash equivalents, has an intermediate duration and a laddered maturity structure. The duration of the fixed income portfolio was approximately 5.2 and 5.1 years as of December 31, 2005 and 2004, respectively. The Consolidated Corporation remains fully invested and does not time markets.
Fixed income securities are classified as investment grade or non-investment grade based upon the higher of the ratings provided by S&P and Moody's. When a security is not rated by either S&P or Moody's, the classification is based on other rating services, including the Securities Valuation Office of the NAIC. The market value of available-for-sale split-rated fixed income securities (i.e., those having an investment grade rating from one rating agency and a below investment grade rating from another rating agency) was $35.2 and $31.5 at December 31, 2005 and 2004, respectively.
See Item 15 for Index to Consolidated Financial Statements, including the Notes to Consolidated Financial Statements and the Report of Independent Registered Public Accounting Firm, and Schedules beginning on page 62 of this Annual Report on Form 10-K.