Our home offices are in Seattle and Redmond, Washington. Our Corporate and P&C operations occupy 803,000 square feet of owned property in Seattle and 1,240,000 square feet of owned property in Redmond. Our L&I operations occupy 312,000 square feet of owned property in Redmond.
We also own and occupy a total of 246,000 square feet in Pleasant Hill, California; Portland, Oregon; and Spokane, Washington. We also occupy 2.4 million square feet of leased space throughout the United States. Our leased and owned space totals approximately 5.0 million square feet.
This discussion should be read with the Consolidated Financial Statements and related footnotes included elsewhere in this report. Certain reclassifications have been made to prior-year amounts to conform to the current-year presentation.
• Risks related to the pricing and underwriting of our products, and the subsequent establishment of reserves, such as:
• Ability to appropriately price and reserve for changes in the mix of our book of business
• Inflationary pressures on medical care costs, auto parts and repair, construction costs and other economic factors that increase the severity of claims
• Our ability to run off our London business and other businesses that we have exited, or intend to exit in the future, without incurring material unexpected charges
• Our ability to freely enter and exit lines of business
• Interpretation of insurance policy provisions by courts or tax authorities, court decisions regarding coverage and theories of liability, trends in litigation and changes in claims settlement practices
• Legislative and regulatory developments affecting the actions of insurers, including requirements regarding rates, taxes and availability of coverage
Our Form 10-K was written this year to be as reader-friendly as possible. The following section builds upon earlier discussion and provides more information about our company and our financial performance.
• Policy fees and charges on life insurance and investment-type contracts
• Property & Casualty (P&C) - provides auto and homeowners insurance to individuals, commercial insurance for small- and medium-sized businesses and surety bonds.
In our ongoing effort to position our company for future profitability and growth, we announced a strategic decision in September 2003 to focus more fully on our P&C businesses and pursue the sale of our L&I operations. More information about our decision can be found on pages 16 to 17 in Part I, Item 1.
Our financial results for the last three years have been impacted by the major strategic actions we have taken to turn our company around, reshape our P&C business and become a more focused and successful competitor.
Focusing on P&C- On September 29, 2003, we announced our decision to focus on P&C operations and put our L&I businesses up for sale. We intend to use a portion of the proceeds to reduce our debt to a level appropriate for our new size following the sale and then assess whether to retain any amount to support our business growth. We will return the balance of the proceeds to shareholders in the form of a special dividend, a stock repurchase, or a combination of both.
Partnering with Distributors - Our strategy focuses on providing more products for our distributors to sell that more accurately match price to customer risk characteristics. In addition, we are focusing on making it easier for distributors to use our new point-of-sale technology, providing greater operating efficiencies in their offices. Our distributors can be more profitable selling our products through use of this technology, and our commission programs are structured to incent profitable growth. In short, we offer our distribution partners more products to sell, make it easier for them to sell and service these products, helping our distributors make more money selling our products.
Marketing Standardized Products - Our standardized personal auto, homeowners and small-business products have been designed to serve the insurance needs of the majority of the individuals and small to medium-sized businesses in the U.S. marketplace. These products are delivered over a common sales-and-service platform using point-of-sale technology that can process and service transactions quickly and easily.
Providing Multiple Product Lines - We believe that our ability to provide multiple property and casualty product lines gives us a “shelf space” advantage in our distributors’ offices. Our auto, homeowners and small-commercial insurance products represent the products our distribution partners sell most, and generally represent more than 95% of the insurance revenues sold from an agent’s office.
Driving Execution Through Enhanced Metrics - We established financial metrics for the company and each business unit. We developed individual goals that aligned the performance of the workforce with the company and business unit metrics. We also shifted to a monthly financial close to better understand and act on results.
Strengthening Our Financial Position - We took a number of actions including replacing our short-term commercial paper borrowings with long-term senior notes and developing a plan to refinance $500.0 of long-term debt; issuing common stock and strengthening the capital base of our P&C and L&I operations; and repositioning our investment portfolio, reducing risk and volatility.
In 2001, we focused on turning around our company, which had poor profitability, particularly in our P&C businesses. Our major strategic actions included:
• Executing a successful recovery plan to return our P&C operations to profitability
Reducing Expenses - We restructured our P&C and Corporate operations and consolidated regional offices.
We view our results on an overall basis by three primary measures of performance:
To understand the difference between business and reportable segments, see also Note 20 in our Notes to the Consolidated Financial Statements on page 140.
We manage our P&C businesses in four business and eight reportable segments:
In addition to these segments, certain activities such as interest expense and intercompany eliminations are reported in Corporate and not allocated to individual segments.
Property & Casualty - We use two measures of our underwriting results to assess the profitability of our P&C businesses. These measures are underwriting profit or loss and combined ratio.
We don’t include our investment portfolio results when measuring the profitability of our P&C businesses. That’s because we manage the investment portfolio separately from our underwriting activities.
• Match the duration of the invested asset portfolio with the expected policyholder liability durations
We measure our investment results in two parts - the net investment income that we earn on our invested assets and the net realized investment gains and losses we recognize when we sell or impair investments.
Estimating our loss and LAE reserves requires us to make significant judgments and use many assumptions.
At year-end 2003 and 2002, our loss and LAE reserves by business segment before reinsurance were:
Safeco Personal Insurance (SPI) - SPI loss and LAE reserves are estimated using standard actuarial methods. These methods involve analyzing past claims experience for recent changes in business claim practices and the environment. Emphasis is placed on evaluating claims reporting and closing patterns as well as the size of loss payments and case basis reserves. SPI losses and related expenses are analyzed by line of business, product, coverage and geographic area.
Bodily injury (BI) coverage represents the largest portion (59%) of our loss and LAE reserves held for Personal Auto. We estimate the growth in BI loss costs will be moderate, with the frequency of losses increasing and the severity of claims declining.
Our Homeowners and Specialty lines are generally short-tailed, which means most claims are reported and settled within 12 months. We use standard actuarial techniques to estimate reserves for those lines. Reserve estimates for the Homeowners line continue to be favorably impacted by double-digit declines in frequency of claims.
• Some claims are not made immediately; as a result, we remain exposed to workers compensation losses arising from policies written years ago.
The following table shows our loss and allocated LAE reserves for voluntary and non-voluntary workers compensation and other relevant data.
• Changes in state workers compensation statutes that are applied retroactively
Payout periods for workers compensation claims can be 50 years or more. However, because we focus on low-hazard risks, our average payout period is generally shorter than the industry average.
• Focusing on the settlement of long term claims, increasing the number that we settle
Generally, the payout periods for our other SBI products are relatively short. As a result, our estimated loss reserves for these products are subject to less variability than our workers compensation reserves. We use standard actuarial techniques to estimate these loss reserves.
P&C Other - This section combines the loss reserves information from our SBI and P&C Other business segments for:
Asbestos - This table shows our loss and allocated LAE reserves for asbestos-related claims.
Due to volatility and sparseness of data, estimating loss reserves for asbestos claims requires more than standard actuarial techniques. As a result, we analyze and consider claims statistics and trends, directional trends in survival ratios, and applicable law and coverage litigation.
• 70% relates to the runoff assumed reinsurance operations of American States, which we acquired in 1997, and our exposure to syndicates and pools.
• Large Asbestos Accounts - our policyholders with cumulative loss payments exceeding $100,000 as of December 31, 2003
• Small Asbestos Accounts - our policyholders with cumulative loss payments of less than $100,000 as of December 31, 2003
• Perform actuarial analysis for smaller accounts using industry information and Safeco information
Our loss reserve estimates assume that emerging unfavorable industry trends will increase our level of asbestos payments in our runoff assumed reinsurance operations within the next two years.
• The small number of accounts generating the 2003 payments. Ten accounts represent $6.7 or two-thirds of the 2003 payments.
• The limited number of accounts we wrote of the nature that generated the 2003 payments.
Environmental and Other Toxic Tort Claims - This table shows our loss and allocated LAE reserves for our liability coverages related to environmental and other toxic tort claims.
The table excludes unallocated LAE reserves. At year-end 2003, our unallocated LAE reserves were $9.8.
Estimating Loss Reserves for Environmental and Other Toxic Tort Claims - The volatility of actuarial estimates of liabilities for environmental and other toxic tort claims is often greater than that of other exposures. That’s due to factors including:
Construction defect claims often seek payment for damages resulting directly from the alleged defective construction work and diminished economic value of the structure - meaning that the structure has less market value because of the alleged defective construction work. Construction defect claims are complex, with an inherent difficulty in determining fault. Most of our claims are concentrated in a small number of states, including California.
We have taken a number of actions to mitigate our exposure to construction defect claims and enable us to vigorously defend our coverage position. They include:
Estimating Loss Reserves for Construction Defect Claims - The main factors in estimating loss reserves for construction defect claims are:
• Statutes of limitations and statutes of repose in filing these claims
Surety - Our Surety contracts insure construction performance, as well as legal matters that include probate and bankruptcies. By their nature, Surety claims result in lower loss frequency and higher loss severity than most of our P&C businesses. In addition, Surety claims provide us with substantial opportunity for subrogation and salvage, the nature and extent of which vary from case to case.
The reinsurance we buy limits our losses on certain individual risks or reduces our exposure to catastrophic events. We buy it from several reinsurers and are not dependent upon any single reinsurer. Reinsurance recoverables are the amounts our reinsurers owe us related to the losses we have incurred. We reported $372.0 at December 31, 2003 and $419.9 at December 31, 2002 in P&C reinsurance recoverables as assets on our Consolidated Balance Sheets.
• Perform actuarial analyses of loss development above and below our retention levels - the amounts we absorb before the reinsurers reimburse us - specified under the reinsurance agreements
Our estimated allowance for uncollectible reinsurance was $16.3 at December 31, 2003 and $12.5 at December 31, 2002. The increase in 2003 reflects the impact on our recoverables of the industry-wide decline in creditworthiness of reinsurers since 2001.
• The financial condition and near-term prospects of the issuer of the security, including any specific events that may affect its operations or earnings potential
• Any reduction or elimination of dividends or non-payment of scheduled interest payments
• Identifying comparable securities with quoted market prices based on industry sector, credit quality and maturity
• $314.8 in fixed maturities and $21.1 in equity securities on our Consolidated Balance Sheets as of December 31, 2002. These amounts represented 1.3% of our total investment portfolio.
The increase in consolidated net income in 2002 over our loss in 2001 was driven by improved results in the P&C operations and increased L&I earnings. Our results in 2001 included a goodwill write-off of $925.5 ($1,214.1 pretax), as a result of a change in accounting policy for assessing goodwill from undiscounted cash flows to a market value method and a gain from the sale of our Credit Operations of $54.0.
Our net realized investment losses in 2003 primarily resulted from our impairment losses. The losses reflect $292.3 of impairments, including $146.5 related to our intent to sell L&I. Specific industries that contributed to impairments in 2003 included airline and air transportation.
Net investment income increased slightly in 2003 due to improved P&C cash flows from better underwriting results, partially offset by lower interest rates on our investments.
Losses, LAE and Policy Benefits - The increase in 2003 losses and LAE resulted from a $205.0 increase to our workers compensation reserves for prior year losses, and an increase in catastrophe losses of $68.3 in 2003 over 2002.
The improving ratios resulted from price increases, segmented underwriting that better matched rate and risk and favorable loss experience, particularly from lower claims frequency in Homeowners.
The increase in 2002 was due to higher commissions we paid on new auto policies, higher training costs for our claims handlers and costs related to the rollout of our automated underwriting platform.
The 2002 and 2001 restructuring charges relate to the elimination of approximately 1,200 positions to reorganize our P&C and Corporate operations and consolidate regional offices.
* Not meaningful because this is a runoff business with minimal premium.
Net earned premiums increased by 16.5% in 2003 and 10.2% in 2002. The increases in net earned premiums were driven by:
• Premium trend: Premiums are impacted by the increases in the portion of our policies that insure
In 2003, we achieved an underwriting profit - our first since 1998. Our loss ratio has steadily improved to 60.4% in 2003 from 65.9% in 2002 and 68.8% in 2001. These lower loss ratios were primarily driven by:
• Improved rate adequacy: As discussed above, rates increased in 2003 and 2002, while loss costs, adjusted for the growth in standard and non-standard business, increased only slightly during that period.
Offering a New Auto Insurance Product - Our new auto insurance product offers up to 15 underwriting tiers. These additional tiers provide a more accurate price for a wider range of risks. We’re better able to assign the right price to the corresponding level of risk, producing greater precision and greater profitability. Also, tiers expand the risks that we can underwrite and price, so that we have an auto product available for about 95% of all applicants quoted by our agents. Our new auto insurance product is now available in 43 of the 44 states where we sell auto insurance.
Improving the Claims Management Process - Better claims handling processes also contributed to our improved performance. We’ve made investments in training for our claims handlers and we now have more efficient processes and better metrics to measure key performance drivers. Our claims processing combines the efficiency of centralized claims handling, customer service centers and the flexibility of field representatives. Using our paperless claims environment, our field representatives are not restricted to a specific office or physical location. This flexibility adds significant savings and efficiencies to the claims handling process and increases customer service.
We anticipate the following factors will impact growth and profitability in the near future:
Rates - We plan to file for rate increases to at least keep pace with the rate of underlying loss cost growth. We anticipate loss cost growth to be in the 3%-5% range in 2004. Actual rate changes obtained may vary, based on the rate needed in a given state combined with regulatory review and approval, and developments in loss cost trends.
Expenses - We expect to continue the improvement in our expense ratio for Personal Auto, as a result of the savings from our corporate restructuring.
Net earned premiums increased by 1.4% in 2003 and 2.3% in 2002. The increases in net earned premiums were impacted by:
• Increases in filed rates: We file rate changes on a state-by-state basis. Overall we received approval for average rate changes in the high single-digits in 2003 and the low-to-mid teens in 2002. Additionally, premiums are impacted by automatic increases in the amount of insurance coverage to adjust for inflation in building costs. This was in the low single-digits in 2003 and 2002.
In 2003, we achieved an underwriting profit in our Homeowners line, our first underwriting profit in more than a decade. Our loss ratio steadily improved to 51.7% in 2003 from 66.5% in 2002 and 89.4% in 2001. These lower loss ratios were primarily driven by:
The reductions in loss costs were the primary contributor to the improvements in our combined ratios which were:
Catastrophes include hurricanes, windstorms, earthquakes, hailstorms, explosions, severe winter weather, fires and acts of terrorism.
Improving the Claims Management Process - Better claims handling processes also contributed to our improved performance. We’ve made investments in training for our claims handlers and we now have more efficient processes, and better metrics to measure key performance drivers. Our claims processing combines the efficiency of centralized claims handling, customer service centers and the flexibility of field representatives. Using our paperless claims environment, our field representatives are not restricted to a specific office or physical location. This flexibility adds significant savings and efficiencies to the claims handling process and increases customer service.
Rates - We plan to file for rate increases to at least keep pace with the rate of underlying loss cost growth. We anticipate this loss cost growth to be in the 2%-4% range in 2004. Actual rate changes obtained may vary from this based on regulatory review and approval and development in loss cost trends.
Business Growth - As our business grows, we will write more policies in markets where we have not written significant business previously. We expect to write more standard risks which have, on average, higher frequencies than preferred risks.
Our Specialty operation provides individuals with umbrella, earthquake, dwelling fire, inland marine, motorcycle and boat insurance. These products serve to round out our personal lines offerings.
The combined ratio improved to 77.9% in 2003, compared with 85.8% in 2002 and 98.0% in 2001. The increases in underwriting profit and decreases in combined ratio reflect lower claims experience in these lines.
Our SBI Regular segment provides insurance for small- to medium-sized businesses (those with annual written premiums of $100,000 or less). This is our core commercial lines business. Its main products include:
The fluctuations in net earned premiums are a result of the efforts we began in 2001 to restore profitability to this segment. This included:
The price increases and stricter underwriting practices caused decreases in our retention rate and new business. With the continued rollout of our redesigned business model in 2003, however, we recently have seen the trend of declining PIF reverse as our retention stabilized and our new business growth strengthened. Over the last six months of 2003, our PIF increased slightly. Year over year, our PIF decreased 3.7% in 2003 and 8.9% in 2002.
Underwriting results in 2003 improved $23.1 over 2002, and 2002 improved $111.5 over 2001, reflecting our effort to restore profitability to this segment. This effort included price increases, reunderwriting business and implementing our automated underwriting platform. Our automated underwriting platform provides a better matching of price to risk.
Our underwriting results include the changes in our workers compensation reserves. The estimation of workers compensation reserves involves a high degree of judgment and uncertainty. We have reacted to increasing medical cost inflation trends, elongating payout periods and delayed claims reporting and have increased our reserves in the period such information becomes available and trends are known. Workers compensation reserves in SBI Regular were increased:
Our effort to restore growth and profitability to this segment centers on our redesigned business model. Our redesigned business model includes:
We are seeing improvement in matching price to risk using our automated underwriting model. This is a key competitive advantage as we can better segment our business and provide the best rate to our best customers, while higher risks are charged higher rates. This has also allowed us to improve retention of our best customers.
Business Service Center - We provide agents with an option to have us service the policies of their customers for a fee. This allows the agent to focus on profitably growing their business and shifts the policy servicing activities to us. Early indications show that this service increases the retention of policyholders, benefiting both us and the agent.
In 2004, we will launch our online sales-and-service platform called Safeco Now. While we have automated many of our major P&C product lines over the last two years, Safeco Now will bring them all together on a unified platform featuring a single entry point and seamless cross-sell capabilities.
The centerpiece of Safeco Now is a new-business hub where distributors can quote and bind personal auto, homeowners and most small-business products in just minutes. Additional P&C products will go online over the next two years.
Product Pricing and Segmentation - We will continue to appropriately match rate with risk through segmentation and disciplined underwriting. We will charge prices at acceptable profit levels and decline business when pricing or risk does not allow us to earn acceptable returns.
Expenses - We expect improvement in our expense ratio for SBI Regular, as the savings from our corporate restructuring and the leveraging of our existing infrastructure with our automated underwriting platform and new-business interface will impact 2004 financial results.
SAF also provides insurance for the following specialty commercial insurance programs:
The increase in net earned premiums for SAF in 2003 and 2002 was due to the consolidation of our business insurance products in 2002. As each existing large commercial policy was renewed (reported in SBI Runoff) a decision was made by SAF to renew or not. If it was renewed, it became part of SAF; otherwise the policy remained in SBI Runoff. Net earned premiums increased in 2002 due to the acquisition of a lender-placed property business from ACE Limited in September 2001. This acquisition increased net earned premiums by $57.7 in 2002.
Our combined ratio was 93.9% in 2003, compared with 93.5% in 2002 and 96.9% in 2001. The improvement in the combined ratios is a result of improved underwriting results in our large-commercial business.
We also took aggressive actions in 2001 to reunderwrite existing SAF business, applying stricter underwriting standards and increasing rates. These actions improved our underwriting results in 2003 and 2002.
Our goal is to provide a limited large-commercial resource for those distributors who are also writing auto, homeowners or small- to medium-sized commercial insurance with us.
Net earned premiums were minimal in 2003 as we completed the runoff and included return premiums on retrospectively rated policies. We determine ultimate premiums for retrospectively rated policies based on actual loss experience for the policy term. This sometimes results in a return of premium to the policyholder at the end of the policy term. Net earned premiums in 2002 decreased by 64.6% from 2001, due to actions taken to exit this unprofitable business and renew certain policies into SAF.
Our net earned premiums increased 21.6% in 2003 and 32.1% in 2002 as a result of average rate increases of 10% to 15% beginning in 2002 and new business. In 2003, the increased new business was primarily driven by the opening of new offices in Glendale, California and Syracuse, New York.
• $5.6 increase to reserves for our London operations in 2003 and $26.3 in 2002 in charges related to our decision to put the London operations into runoff
• $85.0 to strengthen our reserves for construction defect and asbestos and environmental losses in 2001
• $30.0 in losses after reinsurance from the September 11, 2001 terrorist attacks
TRIA does not apply to life insurance or personal lines policyholders.
Under TRIA, the U.S. government will provide funding to the insurance industry if a terrorist attack on behalf of a foreign interest causes losses of $5 billion or more. The funding will be provided on an aggregate basis of 90% of covered losses in excess of individual insurance company deductibles of up to $100 billion. TRIA determines the deductibles for insurance companies as a percentage of their direct earned premiums. Our estimated deductible for 2004 is $153.1.
If the policyholder does reject our mandatory offer of terrorism coverage, we can then exclude coverage for losses due to foreign terrorism. The ISO has filed exclusions for acts of terrorism as defined by TRIA, and we have adopted those filings.
TRIA required insurance companies to send notices to commercial policyholders by February 24, 2003. The notices had to include the offer of terrorism coverage and the cost for that coverage. We sent out the required notices by that date.
The availability of terrorism reinsurance is limited in the commercial market. Our current reinsurance program provides limited terrorism coverage. All reinsurance treaties exclude certified terrorist acts and also non-certified terrorist acts involving nuclear, chemical, biological or radioactive materials. The following treaties provide non-certified terrorism coverage - property catastrophe reinsurance covering 90% of $400.0 in excess of $100.0 layer, workers compensation reinsurance covering $15.0 in excess of $5.0 layer, and our commercial and personal umbrella reinsurance.
With commercial insurance, our focus is on small- to medium-sized businesses - generally not viewed as likely potential terrorism targets.
With workers compensation policies, the number of employees covered is a key consideration. We decline to provide coverage in cases where we believe the exposure is potentially severe.
We estimated our pretax losses net of reinsurance resulting from the September 11, 2001 terrorist attacks at $51.7, of which $30.0 was reinsurance written through our London operation, $20.7 for our business insurance accounts and $1.0 for L&I.
On pages 10 and 34 we described the Critical Accounting Estimates involved in determining these reserves. In this section, we provide the actual reserve estimates for the last three years and discuss changes in those estimates.
While we expect these business changes to reduce our ultimate losses, they have decreased the predictive value of our past data in estimating future loss reserves. With this in mind, in the second quarter of 2003, we began performing additional actuarial analysis primarily focused on medical inflation trends and changes in Safeco claim practices and mix of business. This produced divergent indications. As a consequence, in the third quarter of 2003, we took additional steps to evaluate medical inflation trends, reviewing:
• Construction defect claims - legal costs were higher than estimated. Efforts to mitigate the severity levels of construction defect losses led to higher legal costs.
• Workers compensation losses - the rate of medical cost inflation was higher than anticipated.
In 2001, we increased our estimates for prior years’ loss and LAE reserves by $345.1. We made that increase in two ways:
• $240.0 during the third quarter as a result of a review of our P&C loss reserve adequacy
The P&C Other segment includes the runoff assumed reinsurance business that we acquired when we purchased American States in 1997.
Next, pretax operating earnings are our measure of each segment’s profitability:
Group’s principal product is stop-loss medical insurance sold to employers with self-insured medical plans.
Our revenue increases in 2003 and 2002 were primarily due to our acquisition of Swiss Re’s stop-loss medical business in July 2002 and overall rate increases we implemented over the last two years.
Our loss ratio improved to 57% in 2003, compared with 60% in 2002 and 64% in 2001. Our rate increases were the primary drivers of the improved trend in our loss ratios. A $10.5 benefit from favorable loss reserve development related to policies obtained in the Swiss Re acquisition also contributed to our improved loss ratio in 2003.
We continue to price for profitability and to grow our revenues only when we can do so profitably. Our loss experience has been unusually favorable in 2003 and 2002 due to both rate increases and lower claim experience. The acquisition of Swiss Re’s stop-loss medical business contributed to both revenue and earnings growth in 2003 and 2002.
Income Annuities’ main product is structured settlement annuities, sold to fund third-party personal injury settlements and long-term claim settlements of our P&C affiliates. This product is extremely sensitive to financial strength ratings and our ratings downgrades in 2001 decreased our ability to sell this product. Income Annuities also sells non-structured fixed annuities, which provide an immediate payment stream.
• Lower market interest rates on our new and reinvested assets
Retirement Services’ principal products are fixed deferred annuities and variable annuities.
We earn revenues relative to the amount of assets under management and the rate of return on these investments during the year. The increase in revenues in 2003 was primarily due to higher investment income on our general account liabilities. Higher fee income on separate account liabilities, due to the improved performance of the equity markets in 2003, also contributed to our increase in revenues. These increases were partially offset by the impact of lower average interest rates on new and reinvested assets.
General account liabilities are amounts we owe to contract holders for products where we bear the investment risk, and include fixed deferred annuities and guaranteed investment contracts.
That growth resulted principally from the launch of Safeco Secure fixed deferred annuity in 2002 and Safeco Select fixed deferred annuity in 2001.
Our pretax operating earnings increased in 2002 compared with 2001 due to growth in general account assets under management and lower losses from our Equity Indexed Annuity product.
The profitability of our fixed and variable annuities depends on pricing our products at a margin over the cost of providing benefits and the expense of acquiring customers. Specifically:
Profitability for these products also depends on our persistency experience (how long this business stays with us). This affects our ability to recover the costs of acquiring new business over the lives of the contracts. Accordingly, if a contract owner withdraws funds during the early years of the contract - usually during the first seven or eight years - we keep a certain percentage of the withdrawal as a surrender charge, to recoup our acquisition costs. Some contracts allow us to pay the requested withdrawal out over five years.
In 2003, we refiled fixed annuity products with our regulators in all 50 states and obtained approval to lower our crediting rates in response to a decline in investment yields in all but three states. At various times, we suspended sales of our products pending approval of these changes.
The decrease in pretax operating earnings in 2003 was primarily due to higher claims resulting from unfavorable mortality experience and lower margins on our BOLI products.
2002 pretax operating earnings were down slightly compared with 2001 due primarily to less favorable mortality experience and decreased BOLI deposits. There were no new BOLI deposits in 2003, down from $50.0 in 2002 and $120.0 in 2001.
The decreases in revenues in both 2003 and 2002 were due to lower investment advisory fee revenue on lower average assets under management during both years.
Earnings were higher in 2003 due to income on the retained capital of the other L&I segments and $100.0 contributed to L&I in December 2002 from the proceeds of our common stock offering. Earnings in 2003 were reduced by $9.2 for expenses associated with the planned sale of the L&I operations.
Earnings increased in 2002 compared with 2001 due to an increase in retained capital from other L&I segments.
The decreases in interest expense reflected our refinancing of debt in 2003 and 2002 at lower rates.
Because of our strategic decision to focus on P&C products, we wound down SFP’s operations as of December 31, 2003. We set up SFP in 2000 mainly to write S&P 500 index options that reduce the risk associated with our Equity Indexed Annuity product. Other SFP activities - done for its own account - included selling single-name credit default swaps, writing and hedging S&P 500 index options and investing in and hedging convertible bonds.
SFP’s net investment income included fee income on our credit default swaps and earnings from our S&P 500 index options and convertible bonds.
SFP’s investment and derivative portfolio, including credit default swaps, was completely liquidated at December 31, 2003. SFP had credit default swaps with a notional amount outstanding of $835.0 at December 31, 2002.
The declines in our pretax investment yields in our portfolios reflected the low interest rate environment in 2003 and 2002.
During 2002, we repositioned our P&C investment portfolio to better match expected asset and liability durations and to reduce risk and volatility. In doing this, we reduced the average duration of the bonds we hold, primarily by shifting from long-term tax exempt bonds to shorter-term taxable bonds. In addition, we shifted our asset allocation mix to reduce the amount of equity securities we hold.
At year-end 2003, our P&C fixed maturities portfolio’s duration was 4.5, down from 5.3 at year-end 2002 and 7.1 at year-end 2001. Equity securities were approximately 12% of our investment portfolio at year-end 2003 and 11% at year-end 2002, down from 18% at year-end 2001. Our goal is to keep equity securities at or near 10% of our total P&C investment portfolio.
Our after-tax yields for our P&C portfolio have decreased due to our shift to shorter-term taxable bonds and declining interest rates. The yields were:
Pretax net realized investment gains and losses for 2003, 2002 and 2001 by portfolio were:
Net gains on securities transactions in 2003 resulted primarily from calls as well as fixed maturity sales initiated to manage our call risk and improve the yield of the underlying portfolio. These calls - issuers redeeming bonds in which we’ve invested before the final maturity date - are an expected part of our investment activity, particularly when interest rates are low.
Pretax investment impairments for 2003, 2002 and 2001 by portfolio were:
The increase in impairments in 2003 and 2002 primarily resulted from:
• Credit problems of some of the companies in which we’ve invested
SFP’s total net realized investment gains (losses), which consisted of credit default swaps that were marked-to-market and payments made for coverage of certain credit events were:
• $24.3 gain in 2003 - including a $3.4 gain related to liquidating the credit default swap portfolio
• $18.2 loss in 2001 - including a $7.8 loss resulting from the Enron bankruptcy
Also included in other items in 2002 was a reclassification from accumulated other comprehensive income to net realized investment loss of $18.7 related to cash flow hedges that were discontinued in connection with the retirement of the underlying commercial paper borrowings.
Unrealized gains and losses are recorded as realized when the securities are sold or impairments are recognized.
We reviewed all our investments with unrealized losses at the end of 2003. Our evaluation determined that all other declines in fair value were temporary. We have impaired all securities held by L&I with unrealized losses at December 31, 2003 because we do not expect them to recover in value before the sale of our L&I businesses.
This table shows by maturity the total amount of gross unrealized losses on fixed maturities and equity securities at December 31, 2003:
Unrealized losses on our investments that have been in a loss position for more than a year at December 31, 2003 were:
• $0.6 on equity securities, down from $20.4 at December 31, 2002
• $16.4 on fixed maturities, down from $207.5 at December 31, 2002
These unrealized losses were less than 1% of our total portfolio value.
We continue to monitor these securities as part of our overall portfolio evaluation. If we determine an unrealized loss to be other-than-temporary, we record an impairment loss. We record impairment losses in the same period that we make the determination.
Below Investment Grade and Other Securities - A security is considered below investment grade if it has a rating below BBB. Our consolidated investment portfolio includes below investment grade securities with a fair value of:
At December 31, 2003, these securities represented 5.0% of our total fixed maturities at fair value. At December 31, 2002, these securities represented 4.5% of our total fixed maturities at fair value.
Our below investment grade securities had a net unrealized investment gain of $127.8 at year-end 2003. That gain comprised:
Our below investment grade securities had a net unrealized investment loss of $119.1 at year-end 2002. The loss comprised:
• $517.0 of not-rated securities - securities not rated by a national rating service - representing 1.8% of our total portfolio
• $335.9 of non-publicly traded fixed maturities and equity securities - representing 1.3% of our total portfolio
• $465.2 of not-rated securities - representing 1.7% of our total portfolio
We held $936.1 of mortgage loans at December 31, 2003. That represents 3% of our investment portfolio. Substantially all of the mortgage loans are held by our L&I business as of December 31, 2003.
We hold mortgages in no other state that represents greater than 10% of the mortgage loan balance.
This table summarizes our consolidated holdings of mortgage-backed securities at year-end 2003:
Quality of Our Mortgage-Backed Securities - At year-end 2003, 93% of our mortgage-backed securities were either government/agency-backed or AAA rated. We’ve limited our investment in riskier, more volatile CMOs and CMBSs to $29.6. That amount represents 0.5% of our total mortgage-backed securities.
Here are the quality ratings of our mortgage-backed securities portfolio at year-end 2003:
The main reason for the increase in 2003 operating cash flows was improved underwriting results in Personal Auto, Homeowners and SBI Regular. The main reasons for the improved operating cash flow in 2002 compared with 2001 were lower P&C claims payments, resulting from lower catastrophe and weather losses, as well as the effect of our reunderwriting efforts and rate increases that began in 2001.
We believe that cash flow from our operations, investment portfolio and bank credit facility are sufficient to meet our future liquidity needs.
• $200.0 of senior notes at an interest rate of 4.200% that mature in 2008
• $300.0 of senior notes at an interest rate of 4.875% that mature in 2010
In our business operations, the proceeds were used to support future growth in our core product lines and to strengthen the capital base of these operations.
At the same time, we entered into a $375.0 notional interest rate swap. This converted our 7.250% fixed rate into a LIBOR-based floating rate obligation. We marked-to-market the fair value of the interest rate swap and we included the fair value of the interest rate swap on the Other Invested Assets line of our Consolidated Balance Sheets.
Our Bank Credit Facility - We maintain a bank credit facility with $500.0 available. The terms of the bank credit facility - which runs through September 2005 - require us to:
After the sale of L&I, we may lower the bank credit facility and we would seek a reset of the requirement to maintain minimum shareholders’ equity. We would continue to keep our debt-to-capitalization ratio below the maximum requirement using proceeds from the sale of L&I to reduce debt to a level consistent with our ratios prior to the sale.
We excluded Loss and LAE Reserves and Funds Held Under Deposit Contracts from the above table. The Loss and LAE Reserves amounted to $5,044.6 and the Funds Held Under Deposit Contracts amounted to $16,575.4 on our Consolidated Balance Sheet at December 31, 2003. The timing of actual claims and benefit payments related to these reserves varies based on catastrophes, mortality and morbidity rates, surrender and lapse rates, as well as market conditions. The ultimate amount of claims and benefit payments could also differ from our estimated reserves.
We believe our financial position is sound. As we have continued to execute our plans to improve P&C operating results, our financial position has strengthened. Our debt service coverage has improved over the last two years, and we expect that to continue.
• Inhibit our distributors’ willingness and ability to sell our products, particularly L&I products
On September 29, 2003, we announced our intent to sell our L&I businesses. Until a buyer is announced, the rating agencies cannot fully evaluate the effect - if any - on the factors they will consider in determining financial strength ratings.
• Moody’s downgraded the financial strength rating of Safeco Life Insurance Company with direction uncertain.
There are no recently passed or recommendations calling for regulations that would materially affect liquidity, capital resources or results of operations.
Risk-Based Capital - The National Association of Insurance Commissioners (NAIC) uses risk-based capital (RBC) formulas for both property and casualty insurers and life insurers. The RBC formulas are used by the NAIC and state regulators to identify companies that are undercapitalized and that may merit further regulatory attention or action. Our insurance subsidiaries have more than sufficient capital to meet RBC requirements.
We used the same assumptions and projections as in our internal financial projections to estimate our future taxable income. These projections are subject to uncertainties primarily related to the variability of our P&C underwriting results.
If our results are not as profitable as expected, we may have to record a valuation allowance for our gross deferred income tax assets. Doing that would reduce our earnings.