Our main office is located in Branchville, New Jersey on a site owned by a subsidiary with approximately 114 acres and 315,000 square feet of operational space. We lease all of our other facilities. The principal office locations related to our Insurance Operations segment is described in the “Field and Technology Strategies Supporting Independent Agent Distribution” section of Item 1. “Business.” of this Form 10-K. We believe our facilities provide adequate space for our present needs and that additional space, if needed, would be available on reasonable terms.
1 In 2009, we sold our Selective HR Solutions operations. See Note 12. “Discontinued Operations” in Item 8. “Financial Statements and
· The purchase of Montpelier U.S. Insurance Company (“MUSIC”) in December 2011. MUSIC had gross annual premiums of approximately $48 million in 2010.
For addition information regarding our recent acquisitions, refer to Note 13. “Business Combinations” in Item 8. “Financial Statements and Supplementary Data.” of the Form 10-K.
· Financial Highlights of Results for Years Ended December 31, 2011, 2010, and 2009;
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer, and the insurer’s payment of that loss. To recognize liabilities for unpaid losses and loss expenses, insurers establish reserves as balance sheet liabilities representing an estimate of amounts needed to pay reported and unreported net losses and loss expenses. As of December 31, 2011, we had accrued $3.1 billion of gross loss and loss expense reserves compared to $2.8 billion at December 31, 2010.
In addition to the most recent loss trends, a range of possible IBNR reserves is determined annually and continually considered, among other factors, in establishing IBNR for each reporting period. Loss trends include, but are not limited to, large loss activity, environmental claim activity, large case reserve additions or reductions for prior accident years, and reinsurance recoverable issues. We also consider factors such as: (i) per claim information; (ii) company and industry historical loss experience; (iii) legislative enactments, judicial decisions, legal developments in the imposition of damages, and changes in political attitudes; and (iv) trends in general economic conditions, including the effects of inflation. Based on the consideration of the range of possible IBNR reserves, recent loss trends, uncertainty associated with actuarial assumptions and other factors, IBNR is established and the ultimate net liability for losses and loss expenses is determined. Such an assessment requires considerable judgment given that it is frequently not possible to determine whether a change in the data is an anomaly until some time after the event. Even if a change is determined to be permanent, it is not always possible to reliably determine the extent of the change until some time later. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves because the eventual deficiency or redundancy is affected by many factors. The changes in these estimates, resulting from the continuous review process and the differences between estimates and ultimate payments, are reflected in the Consolidated Statements of Income for the period in which such estimates are changed. Any changes in the liability estimate may be material to the results of operations in future periods.
At December 31, 2011, our workers compensation line of business recorded reserves, net of reinsurance, of $898 million, or 35% of our total net reserves. In 2010 and 2011, this line experienced unfavorable loss development. In 2011 this was driven by increases in the 2010 accident year, partially offset by various earlier accident years. In addition to the uncertainties associated with actuarial assumptions and methodologies described above, the workers compensation line of business can be impacted by a variety of issues, such as unexpected changes in medical cost inflation, higher than anticipated claim severity, changes in overall economic conditions, and company specific initiatives. Variability in our historical workers compensation medical costs, along with uncertainty regarding future medical inflation, creates the potential for additional volatility in our reserves.
During the past several years, overall economic conditions were extremely unstable. High levels of unemployment could impact both the severity and frequency of our workers compensation claims. There is also potential for an increase in severity if the longevity of workers compensation claims increase. Injured workers could have less incentive to return to work when their company is in financial distress or injured workers could be laid off while on workers compensation. Conversely, there is potential for a decrease in frequency if workers are reluctant to file claims or have less work and less exposure to injury.
Finally, in the past few years, the company implemented a multi-faceted workers compensation strategy that incorporated knowledge management, predictive modeling, and a new claims handling model. While the expectation is that these initiatives will bring benefits, they are also a potential source of uncertainty in the future. If the ongoing impact of these strategies exceeds our expectations, the result could be favorable development in the future. If our internal strategies are less effective than anticipated, and we experience higher than expected claim severity, the result could be adverse development in the future.
In addition to the line of business specific issues mentioned above, these lines of business have been impacted by a number of initiatives undertaken by our claims department that have resulted in volatility in the average level of case reserves. This change in the average level of case reserves increases the uncertainty in the short run, but the longer-term benefit is a more refined management of the claims process. Additionally, although inflationary volatility is expected to be low in the near term, current United States’ monetary policy and global economic conditions bring additional uncertainty in the long-term given the long-tail nature of these lines of business. Uncertainty regarding future inflation or deflation creates the potential for additional volatility in our reserves for these lines of business.
At December 31, 2011, our personal automobile line of business had recorded reserves, net of reinsurance, of $134 million, which represented 5% of our total net reserves. The majority of the reserves are from business written in New Jersey. Over the past several years we have been decreasing the amount of business written in New Jersey while increasing the amount of business written in other states. We review the reserves for states other than New Jersey on a combined basis so that there is a sufficient volume of data to ensure statistical credibility. However, the state mix of business changes over time, which may increase the uncertainty surrounding our personal automobile reserves.
The following tables provide case and IBNR reserves for losses and loss expense, and reinsurance recoverable on unpaid losses and loss expenses as of December 31, 2011 and 2010:
We established a range of reasonably possible reserves for net claims of approximately $2,395 million to $2,716 million at December 31, 2011, and $2,356 million to $2,665 million at December 31, 2010. A low and high reasonable reserve selection was derived primarily by considering the range of indications calculated using generally accepted actuarial techniques. Such techniques assume that past experience, adjusted for the effects of current developments and anticipated trends, are an appropriate basis for predicting future events. Although this range reflects likely scenarios, it is possible that the final outcomes may fall above or below these amounts. Based on internal stochastic modeling, we believe that a reasonable estimate of the likelihood that the final outcome falls within the current range is approximately 75%. This range does not include a provision for potential increases or decreases associated with environmental reserves. Our best estimate is consistent with the actuarial central estimate. We do not discount to present value that portion of our loss reserves expected to be paid in future periods; however, the loss reserves take into account anticipated recoveries for salvage and subrogation claims.
In addition to the normal amount of volatility, the combination of the sensitivity of workers compensation results to medical inflation, economic conditions including unemployment, and changes in underwriting could lead to actual experience emerging differently than the assumptions used in the process to establish reserves. In our judgment, it is possible that actual medical loss development factors could range from 6% below to 9% above those selected in our latest reserve analysis and expected loss ratios could range from 5% below to 8% above those selected in our latest reserve analysis. The combination of reducing the assumptions for medical loss development by 6% and the expected loss ratio by 5% could decrease our indicated workers compensation reserves by approximately $73 million for accident years 2010 and prior. Alternatively, the combination of increasing the medical loss development factors by 9% and the expected loss ratio by 8% could increase our indicated workers compensation reserves by approximately $114 million for accident years 2010 and prior.
Claims Initiatives and Inflation Impact on Standard Market Workers Compensation, General Liability, and Commercial Automobile Lines of Business
For the 2011 accident year, the expected ultimate loss ratio by line of business is a key assumption. This assumption is based on a large number of inputs that are assessed periodically, such as historical loss ratios, projected future loss trend, and planned pricing amounts. In our judgment, it is possible that the actual ultimate loss ratio for the 2011 accident year could be +/-7 loss ratio points from the one selected in our latest reserve analysis for the combination of our four major long-tailed lines of business. The table below summarizes the possible impact on our reserves of varying our expected loss ratio assumption by +/-7 points by line of business for the 2011 accident year.
In light of the many uncertainties associated with establishing the estimates and making the assumptions necessary to establish reserve levels, we review our reserve estimates on a regular basis as described above and make adjustments in the period that the need for such adjustment is determined. These reviews could result in the identification of information and trends that would require us to increase some reserves and/or decrease other reserves for prior periods and could also lead to additional increases in loss and loss adjustment expense reserves, which could have a material adverse effect on our results of operations, equity, insurer financial strength, and debt ratings. In 2011, we experienced overall favorable loss development of approximately $39 million. This was driven by favorable loss development of $60 million in the 2006, 2008, and 2009 accident years, partially offset by unfavorable development in accident year 2010 of approximately $24 million.
In 2010, we experienced overall favorable loss development of approximately $44 million. This was driven by favorable emergence in accident years 2007 and prior of approximately $69 million, partially offset by unfavorable emergence in accident years 2008 and 2009 of approximately $24 million.
Moreover, normal historically-based actuarial approaches are difficult to apply because relevant history is not available. While models can be applied, such models can produce significantly different results with small changes in assumptions. As a result, we do not calculate a specific environmental loss range, as we believe it would not be meaningful.
· We measure the profitability of our business at the Insurance Operations level, which is evident in, among other items, the structure of our incentive compensation programs. We measure the profitability of our agents and calculate their compensation based on overall insurance results and all of our employees, including senior management, are incented based on overall insurance results.
We estimate the amount of premium that is anticipated to be either billed or returned on policies subsequent to expiration based on exposure levels (i.e., payroll or sales). This estimate of premiums that are earned but unbilled is based on historical trends adjusted for the uncertainty of future economic conditions. During 2011, 2010 and 2009, we had return audit premiums paid of $6.6 million, $31.1 million, and $27.7 million, respectively. Given the persistent uncertainty of the U.S. economy and the volatility in return premium over the last several years, we estimate our accrual for return audit premium on 2011 policies to be approximately $5 million. However, further economic instability could ultimately impact our estimates and assumptions, and consequently, changes in the liability estimate may be material to the results of operations in future periods.
The discount rate enables us to state expected future cash flows at their present value on the measurement date. The purpose of the discount rate is to determine the interest rates inherent in the price at which pension benefits could be effectively settled. Our discount rate selection is based on high-quality, long-term corporate bonds. A lower discount rate increases the present value of benefit obligations and increases pension expense. We decreased our discount rate to 5.16% for 2011, from 5.55% for 2010 reflecting ongoing pressure on market interest rates. To determine the expected long-term rate of return on the plan assets, we consider the current and expected asset allocation, as well as historical and expected returns on each plan asset class. A lower expected rate of return on pension plan assets would increase pension expense. Our long-term expected return on plan assets was lowered 25 basis points to 7.75% in 2011 as compared to 8.00% in 2010, reflecting the lower interest rate environment that is anticipated in the near term and our 2011 pension asset total return of 4%. We had a pension and post-retirement benefit plan obligation of $259.9 million at December 31, 2011 compared to $236.3 million at December 31, 2010.
As of December 31, 2011, our pension assets were $182.6 million, up from $173.3 million at the end of 2010. In 2011, we made $8.4 million in contributions to our plan assets to further improve the funded status of the pension plan. Volatility in the marketplace, coupled with changes in the discount rate assumption, could materially impact our pension valuation in the future.
For additional information regarding our pension and post-retirement benefit plan obligations, see Item 8. “Financial Statements and Supplementary Data,” Note 16(c) of this Form 10-K.
OTTI charges are recognized as a realized loss to the extent that they are credit related, unless we have the intent to sell the security or it is more-likely-than not that we will be required to sell the security. In those circumstances, the security is written down to fair value with the entire amount of the writedown charged to earnings as a component of realized losses. To determine if an impairment is other than temporary, discounted cash flow analyses (“DCFs”) are performed on all fixed maturity securities meeting certain criteria. In addition, DCFs are performed on all previously-impaired debt securities in an unrealized loss position that continue to be held by us and all structured securities that were not of high-credit quality at the date of purchase. These impairment assessments include, but are not limited to, the following security types: commercial mortgage-backed securities (“CMBS”); residential mortgage-backed securities (“RMBS”); asset-backed securities (“ABS”); collateralized debt obligations (“CDOs”); and corporate fixed maturity securities.
· The relationship of market prices per share to book value per share at the date of acquisition and date of evaluation;
· The independent auditors’ report on the issuer’s recent financial statements;
· The appropriateness of the valuation methodology used regarding the underlying investments.
Reinsurance recoverables on paid and unpaid losses and loss expenses represent estimates of the portion of such liabilities that will be recovered from reinsurers. Each reinsurance contract is analyzed to ensure that the transfer of risk exists to properly record the transactions in the financial statements. Amounts recovered from reinsurers are recognized as assets at the same time and in a manner consistent with the paid and unpaid losses associated with the reinsured policies. An allowance for estimated uncollectible reinsurance is recorded based on an evaluation of balances due from reinsurers and other available information. This allowance totaled $3.9 million at December 31, 2011 and $3.4 million at December 31, 2010. We continually monitor developments that may impact recoverability from our reinsurers and have available to us contractually provided remedies if necessary. For further information regarding reinsurance, see the “Reinsurance” section below and Note 8. “Reinsurance” in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
Our 2010 pre-tax net income increased $49.9 million compared to 2009, primarily due to an improvement in net realized losses. These losses were $7.1 million in 2010, a decrease of $38.9 million compared to 2009. Elevated losses in 2009 reflected non-cash OTTI charges of $55.4 million, compared to $17.7 million in 2010. For details regarding the OTTI charges, see Note 5, “Investments” in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K. Also included in the fluctuation from 2010 compared to 2009 is a $27.2 million increase in investment income driven by our alternative investment portfolio offset by a $24.6 million increase in underwriting losses driven by higher catastrophe losses partially offset by increased favorable prior year development.
The tax benefit from continuing operations was $12.5 million in 2011, compared to an expense of $12.6 million in 2010 and a benefit of $5.5 million in 2009. These fluctuations were primarily driven by the change in the components of pre-tax net income as discussed above.
· The purchase of the renewal rights to an E&S book of business in August 2011; and
· Our eight insurance subsidiaries are collectively referred to as the Insurance Subsidiaries.
Our standard market insurance products and services are sold primarily in 22 states in the Eastern and Midwestern U.S. through approximately 1,000 independent insurance agencies. Our recent E&S acquisitions provide us the opportunity to write contract binding authority E&S business in all 50 states and the District of Columbia through approximately 90 wholesale agents across the country.
Our Insurance Operations segment consists of two components: (i) Commercial Lines, which markets primarily to businesses and represents approximately 82% of NPW; and (ii) Personal Lines, which markets primarily to individuals and represents approximately 18% of NPW. The underwriting performance of these lines is generally measured by four different statutory ratios: (i) the loss and loss expense ratio; (ii) the underwriting expense ratio; (iii) the dividend ratio; and (iv) the combined ratio.
The decrease in NPW in 2010 compared to 2009 was driven by audit and endorsement activity as shown in the table above, coupled with a reduction in new business of $48.2 million, to $272.8 billion.
· The increase in the GAAP underwriting expense ratio of 0.3 points in compared to last year was driven by expenses associated with our purchase of the E&S renewal book of business in 2011. The majority of those expenses are directly related to the acquisition, and will not impact the on-going results of this operation. However, as MUSIC unearned premiums as of the acquisition date were fully ceded, our underwriting expense ratio will be under pressure going forward until such time premiums that we write subsequent to the purchase are earned to support the expenses of these operations.
The increase in the GAAP underwriting expense ratio of 0.4 points in 2010 was primarily due to declines in earned premium coupled with benefits recognized in 2009 related to the elimination of retiree life insurance benefits for current employees amounting to a total benefit of $4.2 million, pre-tax.
While industry pricing has just begun to improve, we are on our eleventh consecutive quarter of Commercial Lines renewal pure price increases, with 3.4% in the fourth quarter of 2011 and 2.8% for 2011. The price increases that we have obtained demonstrate the overall strength of the relationships that we have with our independent agents, even in difficult economic and competitive times. We believe that once the market as a whole becomes more successful at driving price, we will be able to further capitalize on our relationships with our agents to generate additional renewal price increases through the use of our granular pricing capabilities. The price increases we have been able to obtain, coupled with strong retention, have led to year-over-year NPW growth in our Commercial Lines for the first time since 2007 and an increase of 7% in 2011. We also expanded our underwriting appetite with new products in para-transit, technology, and communities of faith. Our recent acquisition of MUSIC broadens our E&S footprint to all 50 states and the District of Columbia, giving us a higher-margin product and the capability to drive NPW growth in the future. The MUSIC acquisition, coupled with our renewal rights purchase in August 2011, provides the potential for annual E&S premium volume of $120 million through 90 wholesale general agents as well as potential access to the $300 to $400 million of contract binding authority E&S business our independent retail agents currently write annually for our competitors. In 2011, we also invested in the consumer agent portal, along with the Independent Insurance Agents and Brokers of America and several other insurance companies, which will provide independent agents a more robust online presence on the Internet.
A.M. Best is maintaining a stable outlook for the personal lines industry, which implies their rating actions are expected to be widely affirmed with a fairly balanced distribution of negative and positive rating actions. The personal lines market has been more receptive to price increases, and our Personal Lines operations continue to experience NPW growth driven by ongoing rate increases that went into effect in 2010 and 2011. Rate increases that we were able to achieve in 2011 are expected to generate an additional $18.0 million in annual premium. In addition, we were able to generate Personal Lines renewal pure price increases of 6.2% in 2011, while retention increased one point to 86%. While underlying results show improvement in this line during the fourth quarter of 2011, they are still not where they need to be. The extreme volatility associated with the homeowners line due to continued weather related property losses led to $37.6 million, or 36.6 points, of catastrophe losses in 2011. We will continue to focus on driving rate and mix of business changes across our Personal Lines book to improve profitability.
o Net renewals of $1.0 billion in 2010, a $24.2 million reduction compared to 2009.
· The NPW decrease was offset by the NPW increase in leaving NPE largely unchanged over the period. However, the decrease in NPW from to resulted in a NPE decrease in 2010.
Catastrophe losses included losses from Hurricane Irene, which pierced the first layer of our catastrophe excess of loss treaty. Hurricane Irene’s impact to Commercial Lines was $21.7 million, net of reinsurance, or 1.8 points.
The GAAP underwriting expense ratio increased in 2010 compared to 2009, which was primarily due to declines in premiums earned coupled with the one-time benefit recognized in 2009 for the elimination of retiree life insurance benefits for current employees.
NPW increased in 2011 driven by improved economic conditions reflected in audit and endorsement premiums. During the three-year period, our premium subject to audit in this line was approximately 50%. At the end of the policy period, actual exposure units (usually sales or payroll) on policies with premium subject to audit are compared to beginning of period estimates and a return premium or additional premium transaction occurs. Audits and endorsements resulted in additional premium of $3.9 million in 2011 compared to return premium of $24.6 million in 2010. We also continued to see improvements in pricing in this line as our renewal pure price increase was 3.7% in 2011 coupled with increases of 4.2% and 1.6% in 2010 and 2009, respectively.
o New business was down 21%, or $14.8 million, to $56.7 million; and
o Continued pressure from audit and endorsement activity, which resulted in a return premium of $24.6 million in and $27.2 million in 2009.
The fluctuations in the statutory combined ratios were driven by favorable prior year development. Favorable prior year development in the general liability line of business is often volatile year to year and, therefore, requires a longer period of time before true trends are recognized and can be acted upon.
· 2011: 3.3 points, driven by favorable development on the premises and operations coverages for accident years and prior, largely offset by adverse development for the products coverage in and prior;
· 2010: 7.9 points, driven by and prior accident years; and
o 2009: 3.2 points, driven by lower than anticipated severity primarily in accident year 2007.
· 2011: unfavorable by 2.7 points, driven by the accident year, representing a continued trend related to increased severities in recent years, partially offset by various earlier accident years;
· 2010: unfavorable by 8.3 points, driven by increased severity in the and accident years; and
NPW and NPE were relatively flat over the three-year period. However, the increase in the statutory combined ratios over the three-year period were largely due to the increases in catastrophe losses as shown below:
o 2011: 15.5 points driven by favorable development on liability coverage for accident years through 2010; and
· The increase in NPW in compared to was primarily due to:
o Rate increases of 6.8%, or $17.9 million, that went into effect across our Personal Lines footprint during 2011; and
o New business direct premiums written of $50.2 million compared to $62.0 million in 2010.
The increase in NPW in 2010 compared to 2009 was primarily due to:
o Rate increases of 6.3%, or $14.8 million, that went into effect across our Personal Lines footprint during 2010;
o New business direct premium written of $62.0 million compared to $55.2 million in 2009.
· NPE over the three-year period was consistent with the NPW increases in compared to and as discussed above.
The 3.9-point increase in the GAAP loss and loss expense ratio in 2010 compared to 2009 was also driven by elevated property losses of $27.0 million, or 7.7 points, which included an increase in catastrophe losses of $15.1 million, or 6.1 points.
· The decrease in the GAAP underwriting expense ratio in and as compared to the respective prior years reflects the impact of premiums outpacing expenses, driven by the rate increases we have been able to obtain over the three-year period. On a statutory basis, the impact of this trend is recognized immediately in the expense ratio while on a GAAP basis, the impact is recognized over the course of one year, which is generally the term of our Personal Lines policies.
· Other Reinsurance - includes other treaties that we do not consider core to our reinsurance program, such as our Surety and Fidelity Excess of Loss, NWCRP and our Equipment Breakdown Coverage treaties, which do not fall within the categories above.
1 This amount represents reported and unreported gross losses estimated as of December 31, 2011.
· The per occurrence cap on the total program is $64.0 million.
· Six layers provide coverage for 100% of up to $88.0 million in excess of a $2.0 million retention.
· Consistent with the prior year, the Casualty Treaty excludes nuclear, biological, chemical, and radiological terrorism losses.
For further details on how we manage overall credit quality and the various risks to which our portfolio is subject, see
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Selective Insurance Group, Inc.'s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 24, 2012 expressed an unqualified opinion on the effectiveness of the Company's internal control over financial reporting.
In August 2011, we purchased the renewal rights to an E&S book of business and, effective as of December 31, 2011, we purchased Montpelier U.S. Insurance Company (“MUSIC”) which is now our eighth insurance subsidiary. Our eight insurance subsidiaries are collectively referred to as the “Insurance Subsidiaries”. MUSIC, an E&S carrier, is authorized to write business in all 50 states and the District of Columbia, and provides us with a nationally-licensed platform to write contract binding authority E&S business.
· Insurance Operations, which sells property and casualty insurance products and services in both the standard and E&S markets; and
Short-term investments may include certain money market instruments, savings accounts, commercial paper, and other debt issues purchased with a maturity of less than one year. These investments are carried at cost, which approximates fair value. The associated income is included in "Net investment income earned."
For structured securities, including CMBS, RMBS, ABS, and CDOs, we also consider variables such as expected default, severity, and prepayment assumptions based on security type and vintage, taking into consideration information from credit agencies, historical performance, and other relevant economic and performance factors.
· The price-earnings ratio at the time of acquisition and date of evaluation;
· The financial condition and near-term prospects of the issuer, including any specific events that may influence the issuer's operations, coupled with our intention to hold the securities in the near-term;
· Buy/hold/sell recommendations or price projections published by outside investment advisors;
· The length of time and the extent to which the fair value has been, or is expected to be, less than its cost in the near term; and
· For approximately 95% of our fixed maturity portfolio, we utilize a market approach, using primarily matrix pricing models prepared by external pricing services. Matrix pricing models use mathematical techniques to value debt securities by relying on the securities relationship to other benchmark quoted securities, and not relying exclusively on quoted prices for specific securities, as the specific securities are not always frequently traded. As a matter of policy, we consistently use one pricing service as our primary source and secondary pricing services if prices are not available from the primary pricing service. In conjunction with our external investment portfolio managers, fixed maturity portfolio pricing is reviewed for reasonableness in the following ways: (i) comparing positions traded directly by the external investment portfolio managers to prices received from the third-party pricing services; (ii) comparing the primary vendor pricing to other third-party pricing services as well as benchmark indexed pricing; (iii) comparing market value fluctuations between months for reasonableness; and (iv) reviewing stale prices. If further analysis is needed, a challenge is sent to the primary pricing service for review and confirmation of the price. In addition to the tests described above, management also selects a sample of prices for a comparison to a secondary price source. Historically, we have not experienced significant variances in prices, and therefore, we have consistently used our primary pricing service. These prices are typically Level 2 in the fair value hierarchy.
The fair value of the receivable for proceeds related to the sale of our Selective HR Solutions operations (“Selective HR”) is estimated using a DCF, which includes our judgment regarding future worksite life generation and retention assumptions. This receivable is classified as Level 3 in the fair value hierarchy.
The techniques used to value our notes payable are as follows:
· The fair values of the 7.25% Senior Notes due November 15, 2034, the 6.70% Senior Notes due November 1, 2035, and the 7.50% Junior Subordinated Notes due September 27, 2066, are based on quoted market prices.
Policy acquisition costs directly related to the writing of insurance policies are deferred and amortized over the life of the policies. These costs include labor costs; commissions; premium taxes and assessments; board, bureau and association fees; travel; and other underwriting expenses incurred in the acquisition of premium. Deferred policy acquisition costs are limited to the sum of unearned premiums and anticipated investment income less anticipated losses and loss expenses, policyholder dividends and other expenses for maintenance of policies in force. See the “Adoption of Accounting Pronouncements” note below for details regarding updated accounting literature on the accounting for deferred policy acquisition costs that we will implement in 2012.
· Our marketing efforts for all of our product lines within our Insurance Operations revolve around independent agencies and their touch points with our shared customers, the policyholders.
The Insurance Subsidiaries' net premiums written include direct insurance policy writings plus reinsurance assumed and estimates of premiums earned but unbilled on the workers compensation and general liability lines of insurance, less reinsurance ceded. The estimated premium on the workers compensation and general liability lines is referred to as audit premium. We estimate this premium, as it is anticipated to be either billed or returned on policies subsequent to expiration based on exposure levels (i.e. payroll or sales). Audit premium is based on historical trends adjusted for the uncertainty of future economic conditions. Further economic instability could ultimately impact our estimates and assumptions, and changes in our estimate may be material to the results of operations in future periods. Premiums written are recognized as revenue over the period that coverage is provided using the semi-monthly pro-rata method. Unearned premiums and prepaid reinsurance premiums represent that portion of premiums written that are applicable to the unexpired terms of policies in force.
In December 2010, the FASB issued ASU 2010-29 Business Combinations (Topic 805) Disclosure of Supplementary Pro Forma Information for Business Combinations (“ASU 2010-29”). This guidance relates to disclosure of pro forma information for business combinations that have occurred in the current reporting period. It requires that an entity presenting comparative financial statements include revenue and earnings of the combined entity as though the combination had occurred as of the beginning of the comparable prior annual period only. ASU 2010-29 was effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010, and we have included the disclosures applicable to us in this Form 10-K.
In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income (“ASU 2011-05”). ASU 2011-05 requires that all nonowner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. ASU 2011-05 originally required financial statement presentation of reclassification adjustments for items that are reclassified from OCI. This guidance, which only changes financial statement presentation, is effective, on a retrospective basis, for interim and annual periods beginning after December 15, 2011. In December 2011, the FASB postponed the required financial statement presentation of reclassification adjustments and, as a result, issued ASU 2011-12, Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05. This update defers the specific requirement to present items that are reclassified from accumulated other comprehensive income to net income separately with their respective components of net income and other comprehensive income.
1 CMBS includes government guaranteed agency securities with a carrying value $8.9 million at December 31, 2010.
Unrecognized holding gains/losses of HTM securities are not reflected in the consolidated financial statements, as they represent fair value fluctuations from the later of: (i) the date a security is designated as HTM; or (ii) the date that an OTTI charge is recognized on an HTM security, through the date of the balance sheet. Our HTM securities had an average duration of 2.9 years as of December 31, 2011.
During 2011, 105 securities with a carrying value of $323.1 million in a net unrecognized gain position of $18.7 million were reclassified from the HTM category to AFS due to credit rating downgrades that occurred by either Moody’s Investors Service (“Moody’s”), Standard and Poor’s Financial Services (“S&P”), or Fitch Ratings (“Fitch”). These unexpected rating downgrades raised significant concerns about the issuers’ credit worthiness, which changed our intention to hold these securities to maturity. In addition to the transfer activity, redemptions and maturities of HTM securities in 2011 amounted to $177.4 million.
1 U.S. government includes corporate securities fully guaranteed by the Federal Deposit Insurance Corporation (“FDIC”) with a fair value of $76.5 million at December 31, 2011 and $121.0 million at December 31, 2010.
3 RMBS includes government guaranteed agency securities with a fair value of $98.2 million at December 31, 2011 and $91.1 million at December 31, 2010.
At December 31, 2010, unrealized/unrecognized losses on securities that were in a loss position for more than 12 months amounted to $8.6 million, primarily driven by $5.8 million in our CMBS portfolio. This was comprised of: (i) $3.7 million of unrealized/unrecognized losses primarily driven by non-credit OTTI charges recognized in AOCI that were generated concurrently with credit-related charges; and (ii) $2.1 million on securities with an average decline in fair value of 17% of their amortized cost. The remaining $2.8 million of unrealized/unrecognized losses were comprised of 37 securities, 21 of which were municipal securities and 16 of which were either RMBS or ABS. Declines in the fair value of these municipal securities, RMBS, and ABS averaged 5% of their amortized cost.
This strategy invests opportunistically in real estate in North America, Europe, and Asia via direct property ownership, joint ventures, mortgages, and investments in equity and debt instruments.
These funds focus on buying and selling debt of distressed companies (“Distressed Debt”).
(h) The components of net investment income earned were as follows:
(i) The following tables summarize OTTI by asset type for the periods indicated:
OTTI losses in 2011 were primarily comprised of charges on our equity portfolio. Of these equity charges, $8.5 million related to securities that we do not believe will recover in the near term and $2.9 million related to securities for which we have the intent to sell.
· $37.8 million of RMBS credit OTTI charges related to securities that had experienced reductions in the cash flows of their underlying collateral. These securities, on average, showed signs of loss at conditional default rates of 0.33 and had declines in fair value of 65% as compared to their amortized cost. As a result, we did not believe it was probable that we would receive all contractual cash flows for these securities.
Realized gains and losses on the sale of investments are determined on the basis of the cost of the specific investments sold. Proceeds from the sale of AFS securities were $206.5 million in 2011, $288.5 million during 2010, and $676.0 million during 2009. Net realized gains in 2011, excluding OTTI charges, were driven by: (i) calls and maturities; (ii) the sale of AFS fixed maturity securities, primarily corporate, municipal, and government holdings; and (iii) the sale of AFS equity securities to facilitate the reallocation of the equity portfolio to a high-dividend yield strategy.
Realized gains in 2010 were driven by: (i) the sale of energy-focused AFS equity securities to mitigate portfolio risk and sector exposure; and (ii) the sale of AFS fixed maturity and equity securities associated with tax planning strategies. These gains were largely offset by realized losses on certain AFS fixed maturity securities that we sold in the second quarter of 2010 following an initial review of the portfolio by our newly hired external investment managers. The managers’ sale recommendations were due to ongoing credit concerns of the underlying investments coupled with strategically positioning the portfolio to generate maximum yield while balancing risk objectives. Realized losses in our other investment portfolio was due to the fourth quarter 2010 sale of certain limited partnerships in the secondary market, which reduced our exposure in the mezzanine financing, private equity, secondary private equity, and real estate sectors of our alternative investment portfolio.
Realized gains and losses in 2009 from AFS securities were attributable to the sale of: (i) securities on which we had previously taken OTTI charges, as we had the intent to sell such securities; and (ii) certain securities for financial and tax planning strategies. Additional sales of AFS fixed maturity securities that resulted in realized losses were also driven by further declines in the issuers’ credit worthiness and liquidity.
In addition to calls and maturities on HTM securities, we sold one HTM security with a carrying value of $6.0 million for a loss of $0.2 million during the second quarter of 2009. This security had experienced significant deterioration in the issuer’s credit worthiness. We sold equity securities during 2009 with realized gains of $33.4 million and realized losses of $28.1 million. This activity included the following:
As of December 31, 2011, we had 12.5 million shares reserved for various stock compensation and purchase plans, retirement plans and dividend reinvestment plans. As part of our ongoing capital management strategy, we repurchase the Parent’s stock from time-to-time, although we have not had an authorized stock repurchase program since July 26, 2009. The following table provides information regarding the purchase of the Parent’s common stock during the 2009 through 2011 reporting periods:
(c) The balances of, and changes in, each component of AOCI (net of taxes) as of December 31, 2011 and 2010 were as follows:
1 U.S. government includes corporate securities fully guaranteed by the FDIC.
The following table provides a summary of the changes in fair value of securities using level 3 inputs.
Amounts are reported in “Net realized gains (losses)” for realized gains and losses and “Net investment income earned” for amortization for the CMBS securities on the Consolidated Statements of Income.
Amounts are reported in either “Loss on disposal of discontinued operations, net of tax” or “Other income” for the receivable related to the sale of Selective HR on the Consolidated Statements of Income. Amounts in “Loss on disposal of discontinued operations, net of tax” relate to charges to reduce the fair value of our receivable and amounts in “Other income” related to interest accretion on the receivable.
The transfers of the government and corporate securities into level 3 classification at December 31, 2011 were primarily the result of broker-priced securities being transferred from an HTM to an AFS designation in 2011. The transfers in 2010 into the level 3 classification were driven by the availability and nature of the broker quotes used at the valuation dates.
Our consolidated financial statements reflect the effects of assumed and ceded reinsurance transactions. Assumed reinsurance refers to the acceptance of certain insurance risks that other insurance entities have underwritten. Ceded reinsurance involves transferring certain insurance risks (along with the related written and earned premiums) that we have underwritten to other insurance companies that agree to share these risks. The primary purpose of ceded reinsurance is to protect the Insurance Subsidiaries from potential losses in excess of the amount that we are prepared to accept.
Assumed premiums written increased by $26.3 million in 2011, as compared to 2010, primarily due to the August 2011 E&S renewal rights acquisition. Since this acquisition we have assumed $24.1 million in E&S premium.
The increases in direct and ceded losses and loss expenses incurred in 2011 primarily reflect the impact of our Flood operation, which experienced increased volume associated with the elevated levels of catastrophic weather events, the results of which are included in the table below:
The net loss and loss expense reserves increased by $79.1 million in 2011, $42.1 million in 2010, and $57.4 million in 2009. The loss reserves are net of anticipated recoveries for salvage and subrogation claims, which amounted to $67.6 million for 2011, $55.0 million for 2010, and $58.8 million for 2009. The changes in the net loss and loss expense reserves were the result of elevated catastrophe losses in 2011, growth in exposures, anticipated loss trends, changes in reinsurance retentions, as well as normal reserve development inherent in the uncertainty in establishing reserves for losses and loss expenses. As additional information is collected in the loss settlement process, reserves are adjusted accordingly. These adjustments are reflected in the consolidated statements of income in the period in which such adjustments are recognized. These changes could have a material impact on the results of operations of future periods when the adjustments are made.
In 2011, we experienced favorable loss development of approximately $39 million, which was primarily driven by favorable loss development of approximately $60 million in accident years 2006, 2008, and 2009, partially offset by unfavorable loss development in accident year 2010 of approximately $24 million. The main driver of this development was favorable prior year development in our commercial automobile, general liability, and business owners’ policy lines of business, partially offset by unfavorable development in our workers compensation line. Commercial automobile experienced favorable development of approximately $13 million, primarily in accident years 2007 through 2009. This represents a continued trend driven by lower frequencies in those years. General liability experienced favorable development of approximately $12 million. This was driven by favorable development on our premises and operations coverages for accident years 2009 and prior, largely offset by adverse development in our products business. Our business owners’ policy line had favorable development of approximately $11 million. This was driven by favorable development on liability coverage for accident years 2008 through 2010. Workers compensation experienced unfavorable prior year development of approximately $7 million, primarily driven by increases in the 2010 accident year, partially offset by various earlier accident years This increase represents a continued trend related to increased severity in recent years. Our remaining lines of business collectively experienced approximately $10 million of favorable development, largely driven by prior year catastrophe development.
(2) On November 3, 2005, we issued $100 million of 6.70% Senior Notes due 2035. These notes were issued at a discount of $0.7 million resulting in an effective yield of 6.754% and pay interest on May 1 and November 1 each year commencing on May 1, 2006. Net proceeds of approximately $50 million were used to fund an irrevocable trust to provide for certain payment obligations in respect of our outstanding debt. The remainder of the proceeds were used for general corporate purposes. The agreements covering these notes contain a standard default cross-acceleration provision that provides the 6.70% Senior Notes will enter a state of default upon the failure to pay principal when due or upon any event or condition that results in an acceleration of principal of any other debt instrument in excess of $10 million that we have outstanding concurrently with the 6.70% Senior Notes. There are no attached financial debt covenants to which we are required to comply in regards to these notes.
(4) In the first quarter of 2009, Selective Insurance Company of the Southeast and Selective Insurance Company of South Carolina (“Indiana Subsidiaries”) joined and invested in the FHLBI, which provides them with access to additional liquidity. The Indiana Subsidiaries’ aggregate investment was $2.9 million and $0.8 million at December 31, 2011 and 2010, respectively. Our investment provides us the ability to borrow up to 20 times the total amount of the FHLBI common stock purchased with additional collateral, at comparatively low borrowing rates. All borrowings from FHLBI are required to be secured by certain investments.
The following is a summary of the Indiana Subsidiaries’ borrowings from the FHLBI:
· In 2009, the Indiana Subsidiaries borrowed $13 million in the aggregate from the FHLBI. The unpaid principal amount accrues interest of 2.9% and is paid on the 15th of every month. The principal amount is due on December 15, 2014. These funds were loaned to the Parent to be used for general corporate purposes.
· In 2011, the Indiana Subsidiaries borrowed $45 million in the aggregate from the FHLBI. The unpaid principal amount accrues interest of 1.25% and is paid on the 15th of every month. The principal amount is due on December 16, 2016. These funds were loaned to the Parent for use in the acquisition of MUSIC on December 31, 2011.
· Insurance Operations, which is evaluated based on statutory underwriting results (net premiums earned, incurred losses and loss expenses, policyholders dividends, policy acquisition costs, and other underwriting expenses), and statutory combined ratios; and
· Investments, which is evaluated based on net investment income and net realized gains and losses.
Our goodwill balance for our operating segments was $7.8 million at December 31, 2011 and 2010 related to the standard market portion of our Insurance Operations segment.
Our segments may, from time-to-time, provide services to each other in the normal course of business. These service transactions included transactions with our discontinued operations, Selective HR, prior to its sale and totaled $9.0 million in 2009. These transactions were eliminated in the 2009 consolidated statements. In computing the results of each segment, we do not make adjustments for interest expense, net general corporate expenses, or federal income taxes. We do not maintain separate investment portfolios for the segments and therefore, do not allocate assets to the segments.
In August 2011, SICA purchased the renewal rights to the commercial E&S lines business written under contract binding authority by Alterra Excess & Surplus Insurance Company (“Alterra”). Prior to our acquisition, this business generated gross premiums written of approximately $77 million in 2010. If all of this business had been written by SICA in 2010, our NPW would have increased by approximately 6%. Considering the size of the book of business, we do not believe it would be meaningful to provide historical pro forma financial information regarding this transaction.
The following table provides the assets and liabilities purchased in the MUSIC transaction:
We have analyzed our tax positions in all open tax years, which as of December 31, 2011 were 2007 through 2010. The Internal Revenue Service (“IRS”) is currently conducting a limited scope examination of these open tax years. Based on our analysis, we do not have unrecognized tax expense or benefits as of December 31, 2011. In addition, we believe our tax positions will more likely than not be sustained upon examination, including related appeals or litigation. In the event we had a tax position that did not meet the more likely than not criteria, any tax, interest, and penalties incurred related to such a position would be reflected in "Total federal income tax expense (benefit)" on our Consolidated Statements of Income.
Employer contributions to the Retirement Savings Plan amounted to $7.0 million in 2011, $6.3 million in 2010, and $6.0 million in 2009.
The amortization of prior service cost related to the Retirement Income Plan and Retirement Life Plan is determined using a straight-line amortization of the cost over the average remaining service period of employees expected to receive benefits under the Plans.
Our measurement date was December 31, 2011 and our expected return on plan assets was 7.75%, which was based primarily on the Retirement Income Plan's long-term historical returns. In addition to the plan's historical returns, we consider long-term historical rates of return on the respective asset classes. Our expected return, after examining recent market conditions and trends, approximates our actual 8.0% annualized return achieved since plan inception for all plan assets.
The Retirement Income Plan had no investments in the Parent’s common stock as of December 31, 2011 and 2010.
The techniques used to determine the fair value the Retirement Income Plan’s remaining invested assets are as follows:
· For valuations of the mutual funds, we utilize a market approach wherein the quoted prices in the active market for identical assets are used. All of the mutual funds are traded in active markets at their net asset value per share. There are no restrictions as to the redemption of these investments nor do we have any contractual obligations to further invest in any of the individual mutual funds. These investments are classified as Level 1 in the fair value hierarchy.
At December 31, 2011, the Retirement Income Plan had contractual obligations that expire at various dates through 2022 to further invest up to $4.8 million in alternative investments. There is no certainty that any such additional investment will be required. The Retirement Income Plan currently receives distributions from these alternative investments through the realization of the underlying investments in the limited partnerships. We anticipate that the general partners of these alternative investments will liquidate their underlying investment portfolios through 2022.
We presently anticipate contributing $8.4 million to the Retirement Income Plan in 2012, none of which represents minimum required contribution amounts.
Stockholders approved the amendment and restatement of the Stock Plan effective as of May 1, 2010 (the “Amended Stock Plan”) on April 28, 2010. Under the Amended Stock Plan, the Board's Salary and Employee Benefits Committee ("SEBC") may grant stock options, stock appreciation rights ("SARs"), restricted stock, restricted stock units ("RSUs"), phantom stock, stock bonuses, and other awards in such amounts and with such terms and conditions as it shall determine, subject to the provisions of the Amended Stock Plan. Each award granted under the Amended Stock Plan (except unconditional stock bonuses and the cash component of Director compensation) shall be evidenced by an agreement containing such restrictions as the SEBC may, in its sole discretion, deem necessary or desirable and which are not in conflict with the terms of the Amended Stock Plan. The maximum exercise period for an option grant under this plan is ten years from the date of the grant. During 2011, we granted, net of forfeitures, 402,925 RSUs. During 2010, we granted, net of forfeitures, 374,153 RSUs, and experienced net restricted stock forfeitures of 820 shares. During 2009, we granted, net of forfeitures, 520,011 RSUs, and experienced net restricted stock forfeitures of 7,168 shares. We also granted options to purchase 238,790 shares during 2010, and 313,811 shares during 2009. No options were granted in 2011. As of December 31, 2011, 5,300,110 shares of the Parent's common stock remained available for issuance pursuant to outstanding stock options and restricted stock units granted under the Stock Plan and the Amended Stock Plan.
During the vesting period, dividends are earned on the restricted stock and held in escrow subject to the same vesting period and conditions set forth in the award agreements. Effective September 3, 1996, dividends earned on the restricted shares were reinvested in the Parent's common stock at fair value. In connection with restricted stock awards granted under Stock Option Plan II, we issued, net of forfeitures, 97 restricted shares from the Dividend Reinvestment Plan (“DRP”) reserves during 2010. We experienced net forfeitures of 679 restricted shares from DRP reserves during 2009.
As of December 31, 2011, there were 397,212 shares of the Parent's common stock in the reserve for Stock Option Plan III, under which future grants ceased being available with the approval of the Stock Plan. Under Stock Option Plan III, employees were granted qualified and nonqualified stock options, with or without SARs, and restricted or unrestricted stock: (i) at not less than fair value on the date of grant, and (ii) subject to certain vesting restrictions determined by the SEBC. Restricted stock awards also could be subject to achievement of performance objectives as determined by the SEBC. The maximum exercise period for an option grant under this plan was ten years from the date of the grant.
In connection with unvested restricted stock awards granted under Stock Option Plan III, we experienced restricted stock forfeitures of 1,924 shares during 2009. During the vesting period, dividends earned on restricted shares were reinvested in the Parent's common stock at fair value. We experienced net forfeitures of 23,285 restricted shares from the DRP reserve during 2009.
As of December 31, 2011 there were 94,290 shares of the Parent's common stock available for issuance pursuant to outstanding stock option awards under the Stock Compensation Plan for Non-employee Directors, under which future grants ceased being available with the approval of the Stock Plan. Under the Stock Compensation Plan for Non-employee Directors, Directors could elect to receive a portion of their annual compensation in shares of the Parent's common stock. There were no issuances under this plan in 2011 and 2010. We issued 960 shares under this plan during 2009.
As of December 31, 2011, total unrecognized compensation cost related to unvested RSU awards granted under our stock plans was $4.4 million. That cost is expected to be recognized over a weighted-average period of 1.8 years. The total intrinsic value of restricted stock and RSU vested was $6.6 million for 2011, $3.9 million for 2010, and $7.9 million for 2009.
Share-based compensation expense charged against net income before tax was $10.1 million for the year ended December 31, 2011 with a corresponding income tax benefit of $3.5 million. Share-based compensation expense that was charged against net income before tax was $12.2 million for the year ended December 31, 2010 and $10.8 million for the year ended December 31, 2009 with corresponding income tax benefits of $4.0 million and $3.4 million, respectively.
William M. Rue, a Director of the Parent, is President of, and owns more than 10% of the equity of, Chas. E. Rue & Son, Inc., t/a Rue Insurance, a general independent insurance agency ("Rue Insurance"). Rue Insurance is an appointed independent agent of the Insurance Subsidiaries and of the discontinued operations of Selective HR, on terms and conditions similar to those of our other agents. Rue Insurance also places insurance for our business operations. Our relationship with Rue Insurance has existed since 1928.
· Rue Insurance placed human resource outsourcing contracts with Selective HR resulting in revenues to Selective HR of approximately $77,000 in 2009. In return, Selective HR paid commissions to Rue Insurance of approximately $10,000 in 2009. These revenues are reflected in “Loss from discontinued operations, net of tax” in the Consolidated Statements of Income.
In 2005, we established a private foundation, The Selective Group Foundation (the "Foundation"), under Section 501(c)(3) of the Internal Revenue Code. The Board of Directors of the Foundation is comprised of some of the Parent's officers. We made contributions to the Foundation in the amount of $0.4 million in 2011, 2010, and 2009.
The Insurance Subsidiaries prepare their statutory financial statements in accordance with accounting principles prescribed or permitted by the various state insurance departments of domicile. Prescribed statutory accounting principles include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (“NAIC"). Permitted statutory accounting principles encompass all accounting principles that are not prescribed; such principles differ from state to state, may differ from company to company within a state and may change in the future. The Insurance Subsidiaries do not utilize any permitted statutory accounting principles that materially affect the determination of statutory surplus, statutory net income, or risk-based capital (“RBC”). As of December 31, 2011, the various state insurance departments of domicile have adopted the March 2011 version of the NAIC Accounting Practices and Procedures manual in its entirety, as a component of prescribed or permitted practices.
The Insurance Subsidiaries are required to maintain certain minimum amounts of statutory surplus to satisfy their various state insurance departments of domicile. RBC requirements for property and casualty insurance companies are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholders. Excluding MUSIC, the Insurance Subsidiaries combined total adjusted capital exceeded the authorized control level RBC, as defined by the NAIC, by 4.4:1 based on their 2011 unaudited statutory financial statements. MUSIC, based on its 2011 unaudited statutory financial statements, exceeded the authorized control level by 7.7:1.
1 See Note 12. “Discontinued Operations” for a discussion of discontinued operations.
3 These ranges of high and low prices of the Parent’s common stock, as reported by the NASDAQ Global Select Market, represent actual transactions. Price quotations do not include retail markups, markdowns, and commissions. The range of high and low prices for common stock for the period beginning January 3, 2012 and ending February 17, 2012 was $19.00 to $17.25.