Situated on approximately 125 acres in Branchville, New Jersey, is our 315,000 square foot facility owned by Wantage Avenue Holding Company, Inc., a subsidiary of Selective. This office complex and the information technology office below are used by all segments of the business. All regional, field underwriting, information technology office, service centers, and subsidiary office locations, as indicated below, are leased. The regional offices are used by the Insurance Operations segment. The subsidiary offices are used by the Diversified Insurance Services segment. Our facilities are substantially fully utilized and are adequate for the conduct of our business.
(2) See the Glossary of Terms on page 20 of the 2002 Annual Report to Shareholders for definitions of terms and specific measures, which glossary is incorporated by reference herein.
(5) Regulatory and rating agencies use the statutory premiums to surplus ratio as a measure of solvency, viewing an increase in the ratio as a possible increase in solvency risk. Management and analysts also view this ratio as a measure of the effective use of capital since, as the ratio increases, revenue per dollar of invested capital increases, indicating the possible opportunity for an increased return.
For 2002, net premiums written were $1.1 billion, an increase of 14%, over 2001 net premiums written of $925.4 million which were 10% higher than 2000 net premiums written of $843.6 million. The 2002 increase included approximately
Our commercial lines loss and loss expense ratio was 70.4% in 2002, compared with 70.9% in 2001 and 72.5% in 2000. The 0.5% decrease in the ratio in 2002 from 2001 was attributable to the 19% renewal price increase which had an effect of 7.4 points on the loss and loss expense ratio. This was offset by 4.7 points of loss trends, 1.0 point of catastrophes losses and 1.2 points of reinsurance costs. The 1.6% decrease in the ratio in 2001 from 2000 was attributable to the 16% renewal price increase which had an effect of 5.7 points on the loss and loss expense ratio and 0.9 points of favorable catastrophe losses. This was offset by 4.0 points of loss trends and 1.0 point of reinsurance costs.
The commercial automobile statutory combined ratio improved to 99.2%, for the year, compared with 108.0% in 2001 and 113.8% in 2000, while the business owners policy statutory combined ratio improved to 108.3%, compared with 120.0% in 2001 and 116.8% in 2000. Improvements in these lines reflect higher pricing, as well as continued underwriting improvement and heightened loss control efforts, all of which lead to a better overall mix of business.
Our workers' compensation line requires further improvement, however, as the statutory combined ratio increased to 110.9%, compared with 106.6% in 2001 and 110.5% in 2000. We saw an increase in claim severity during 2002, primarily from contracting and manufacturing risks. These risks accounted for 65% of our losses greater than $100,000. In response to this, we are writing less business in certain contracting classes, along with eliminating new business policies written for one to three person operations. To increase earned premium we have reduced our average schedule credit, to an average of 3.1% in 2002 compared with 5.5% in 2001 and 8.2% in 2000. Since these credits reduce net premiums written, by reducing the credits we are increasing our net premiums written. Where obtainable, we are also seeking aggressive pricing, which includes an 11.5% average increase effective January 1, 2003 in New Jersey, one of our larger workers' compensation markets. It is also important to keep in mind our use of account-based underwriting. In New Jersey, for example, our workers' compensation statutory combined ratio was 120.7% for 2002 compared with 100.2% in 2001 and 112.3% in 2000. However, the state's overall commercial lines statutory combined ratio came in at 93.7% for 2002 compared with 97.0% in 2001 and 100.4% in 2000, demonstrating our ability to manage the workers' compensation product as just one component of the overall commercial account.
We experienced higher than expected loss emergence in 2002 for past accident years in our Other Liability line of business. This led to a statutory combined ratio of 101.0% in 2002, compared with 99.1% in 2001 and 95.2% in 2000.
The commercial lines underwriting expense ratio decreased to 31.6% in 2002 down from 32.7% in 2001 and 33.6% in 2000. These improvements reflect the higher prices as well as the "high-tech, high-touch" approach that makes it easy and cost-effective for our agents to do business with us. One & Done is part of our small business strategy: to eliminate redundancies in the independent agency distribution model by delivering easy and efficient systems. This system allows us to write business at a marginal underwriting expense ratio of about 23%. This will have a positive impact on our underwriting expense ratio as we use One & Done to process more business. We have begun to roll out our web-based commercial lines system that delivers real-time rating to our agencies, while enabling them to seamlessly exchange information with the Company. Having our agents perform tasks that in the past would have been performed by a Selective employee has allowed us to reduce staff, which has also contributed to the reduced underwriting expense ratio. Overall, Selective agencies utilized these systems to enter more than 65% of commercial policies directly from their offices.
In addition, two years ago we established our Underwriting Service Center. The Underwriting Service Center services smaller accounts for a 2% reduction in commission, so agents can focus their attention on larger, more complex accounts. The Underwriting Service Center was servicing more than $25 million of premiums as of the end of 2002. Agents are beginning to realize that it is not efficient to handle small business, and that our Underwriting Service Center is a better option.
The personal lines combined ratio for the year was 108.8%, compared with 113.5% last year and 109.5% in 2000. This decrease was caused primarily by a decrease in the New Jersey personal automobile loss and loss expense ratio for the year to 79.7% from 90.8% in 2001 and 81.4% in 2000. This decrease reflects an $8.0 million pre-tax reserve charge taken during 2001 due to the shortfall in estimated savings for the Company's New Jersey private passenger automobile liability coverage from AICRA. The charge added 4.0 points to the overall and 6.3 points to the New Jersey personal automobile combined ratio for 2001.
The personal lines ratio of losses and loss expenses incurred decreased 5.4 points, to 80.1% in 2002, compared with 85.5%, in 2001 and 81.4% in 2000 due to two years of favorable pricing and tier changes and the reserve charge taken during 2001. This book of business, however, remains unprofitable.
As we continue to earn higher premiums from price and tier changes, we expect ongoing improvements in our New Jersey personal automobile results. In 2002, we continued to see reductions in new business submissions for New Jersey personal automobile, with our market share now down to approximately 2.3% compared with 2.5% in 2001 and 2.7% in 2000. New Jersey insured vehicles declined to 111,000 over the course of 2002 from approximately 121,000 in 2001. New Jersey personal automobile net premiums written now represents about 12% of our overall net premiums written down from 13% in 2001 and 15% in 2000. In addition, we were recently granted a 2.8% increase, effective in March 2003 that will continue the upward trend of higher premiums per vehicle. Our average premium per vehicle in New Jersey increased 9.3% for 2002, compared with an increase of 4.6% in 2001; while it remained flat in 2000. During 2002, we also realized commission savings of $3.5 million over 2001, as we reduced our commission schedule to be more in line with competitors.
Our personal lines statutory combined ratio for these nine states was 120.5%, compared with 115.4% in 2001 and 119.6% in 2000, reflecting the negative impact of charges relating to the New York assigned risk automobile business. Excluding New York, the full year ratio was 116.1%, compared with 113.4% in 2001 and 119.1% in 2000, and in line with our full year 2002 revised estimate of 118.0%. Obviously, these results are not acceptable, and we have extensive plans, by state, to establish an appropriate level of profitability.
We recently completed the renewals for our 2003 calendar reinsurance treaties. All three treaties remained substantially unchanged from 2002.
Our property and casualty excess of loss treaties were renewed effective July 1, 2002. Under our casualty treaty, the Company retains the first $2.0 million of any casualty loss as well as 25% of the next $3.0 million in losses in excess of the $2.0 million retention. For contract year 2001, the Company retained 15% of this layer. The casualty program provides coverage of $48.0 million in excess of the Company's $2.0 million retention in six layers, except commercial umbrella, which is reinsured up to $10.0 million. The casualty contract includes one annual aggregate limit by coverage layer for a terrorism loss. Nuclear, biological and chemical losses are excluded, but there is no exclusion for mold losses or cyber risks. The underlying Selective policies exclude nuclear losses, however, biological and chemical losses are covered to some extent on most policies.
The estimated reinsurance cost for the property and casualty excess of loss treaties is projected to be approximately $27.6 million for the contract year ending June 2003, compared with $18.5 million for contract year ending June 2002 and $11.5 million for contract year ending June 2001. Reinsurance costs over the past three years have trended upward reflecting poor industry-wide reinsurance results, including the September 11th terrorist attacks, as well as concerns about industry-wide asbestos and other environmental claims. Our costs reflect these factors despite our relatively good results and significantly lower exposure to these industry-wide issues.
We continue to maintain a conservative, diversified investment portfolio, with our debt security holdings representing 89% of invested assets. 59% of our debt securities portfolio is rated "AAA" while the portfolio has an average rating of "AA", Standard & Poor's second highest credit quality rating. High credit quality continues to be a cornerstone of our investment strategy, as evidenced by the fact that 99% of the debt securities are investment grade.
We will continue to follow our investment philosophy that has historically proven successful. The strategy is to continue to purchase debt securities in sectors that represent the most attractive relative value and maintain a moderate equity exposure. Managing investment risk by adhering to these strategies is intended to protect the interests of our stockholders as well as those of our policyholders and, at the same time, enhance our financial strength and underwriting capacity.
- The financial condition and near-term prospects of the issuer, including any specific events that may influence the issuer's operations;
The Company realized gains and losses from the sale of available-for-sale debt and equity securities during 2002, 2001 and 2000. The following table presents the period of time that securities, sold at a loss during these years, were continuously in an unrealized loss position prior to sale:
These securities were sold despite the fact that they were in a loss position due to heightened credit risk of the individual security sold, or the need to reduce our exposure to certain issuers, industries or sectors in light of changing economic conditions.
The following table summarizes, for all available-for-sale securities in an unrealized loss position at December 31, 2002 and 2001, the aggregate fair value and gross pre-tax unrealized loss recorded in our accumulated other comprehensive income, by asset class and by length of time those securities have continuously been in an unrealized loss position:
The continuing operations of Diversified Insurance Services generated $80.8 million of revenue and $4.1 million of net income for 2002, compared with $69.6 million of revenue and $0.2 million of net loss for 2001 and $57.5 million of revenue and $3.6 million of net income for 2000. The segment's return on net revenue increased to 5.0% for 2002, compared with (0.3)% for 2001 and 6.3% for 2000.
Our managed care companies [Alta Services LLC (Alta), SelecTech, LLC (Selectech), Consumer Health Network Plus, LLC (CHN) and Northeast Health Direct, LLC (NHD)] provide workers' compensation and automobile medical claim services, third party administrative services and discounted access to the number one membership based medical provider network in New Jersey while bearing no underwriting risks. Network expansion has been, and will continue to be a major initiative for our managed care program. During 2002 our medical provider network expanded to just over 83,000 locations from 60,000
We have identified the policies described below as critical to our business operations and the understanding of our results of operations. For a detailed discussion on the application of these and other accounting policies, see Note 1 to the consolidated financial statements. Note that our preparation of the consolidated financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurance that actual results will not differ from those estimates.
Included in the reserves above are amounts for environmental claims, both asbestos and non-asbestos. These claims have arisen primarily under older policies containing exclusions for environmental liability which certain courts, in interpreting such exclusions, have determined do not bar such claims. The emergence of these claims is slow and highly unpredictable. Since 1986, policies issued by the Insurance Subsidiaries have contained a more expansive exclusion for losses related to environmental claims. Our asbestos and non-asbestos environmental claims have arisen primarily from exposures in municipal government, small commercial risks and homeowners policies.
The table below summarizes the number of asbestos and non-asbestos claims outstanding at December 31, 2002, 2001 and 2000. For additional information about our environmental reserves, see page 11 and Note 17(a) to the consolidated financial statements.
After taking into account all relevant factors, we believe that the reserve for net losses and loss expenses at December 31, 2002, is adequate to provide for the ultimate net costs of claims incurred as of that date. Establishment of appropriate reserves is an inherently uncertain process and there can be no certainty that currently established reserves will prove adequate in light of subsequent actual experience.
Net premiums written equal direct premiums written, plus assumed premiums less ceded premiums. All three components of net premiums written are recognized in revenue over the period that coverage is provided. The vast majority of our net premiums written have a coverage period of twelve months. This means we record 1/12 of the net premiums written as earned premium each month, until the full amount is recognized. It should be noted that when premium rates increase, the effect of those increases will not immediately affect earned premium. Rather, those increases will be recognized ratably over the period of coverage. Unearned premiums and prepaid reinsurance premiums, which are recorded on the consolidated balance sheets, represent that portion of premiums written that are applicable to the unexpired terms of policies in force.
Selective Insurance Group, Inc. (Parent) is an insurance holding company whose principal assets are its investments in its insurance and Diversified Insurance Services subsidiaries. The Parent's primary means of meeting its liquidity requirements is through dividends from these subsidiaries. The payment of dividends from the Insurance Subsidiaries is governed by state regulatory requirements, and these dividends are generally payable only from earned surplus as reported in our statutory Annual Statements as of the preceding December 31. See Note 7 to the consolidated financial statements for additional
discussion. Dividends from Diversified Insurance Services subsidiaries are restricted only by the operating needs of those subsidiaries. The Parent's cash requirements include principal and interest payments on the senior convertible notes, various notes payable and convertible subordinated debentures, dividends to stockholders and general operating expenses.
The Parent generates cash from the sale of its common stock under various stock plans, the dividend reinvestment program, and from investment income, all of which approximated $9.9 million and reduced the Parent's annual cash requirements from $36.5 million to $26.6 million. As indicated in the table on the next page, the Company has contractual obligations pursuant to convertible subordinated debentures and various notes payable of $24.0 million in 2003. As part of our senior convertible note issuance, the Company has established an irrevocable trust in the amount of $72.0 million, to provide funds for the notes payable maturities scheduled in the next three years.
Based upon the 2002 unaudited statutory financial statements, the Insurance Subsidiaries are permitted to pay the Parent in 2003 ordinary dividends in the aggregate amount of approximately $51 million. There can be no assurance that the Insurance Subsidiaries will be able to pay dividends to the Parent in the future in an amount sufficient to enable the Parent to meet its liquidity requirements. For additional information regarding regulatory limitations on the payment of dividends by the Insurance Subsidiaries to the Parent and amounts available for the payment of such dividends, see Note 7 to the consolidated financial statements. Growth in the Diversified Insurance Services segment has augmented consolidated cash flows from operations by generating $16.3 million in 2002, compared with $3.6 million in 2001 and $10.3 million in 2000. Dividends to stockholders are declared and paid at the discretion of the Board based upon the Company's operating results, financial condition, capital requirements, contractual restrictions and other relevant factors. The Parent has paid regular quarterly cash dividends to its stockholders for 74 consecutive years and currently plans to continue to pay quarterly cash dividends. For information regarding restrictions on the Parent's ability to pay dividends to its stockholders, see Note 6(b) to the consolidated financial statements.
In addition to the cash requirements of the Parent, our operating obligations and cash outflow include: claim settlements; commissions; labor costs; premium taxes; general and administrative expenses; investment purchases; and capital expenditures. The Insurance Subsidiaries satisfy their obligations and cash outflow through premium collections, interest and dividend income and maturities of investments.
On May 7, 2002, the Board of Directors extended the expiration date of the stock repurchase program to May 31, 2003. There are approximately 700,000 shares remaining under the current repurchase authorization of 8 million shares. The Company also has additional investment commitments for its limited partnership investments of up to $16.4 million, however there is no certainty that any additional investment will be required.
Financial instruments that could potentially subject the Company to concentration of credit risk include accounts receivable associated with our HR Outsourcing subsidiary, which acts as a co-employer with certain clients. As a co-employer, we contractually assume substantial employer rights, responsibilities and risks of its clients' employees, who are considered co-employees. Co-employer payroll and related service fees that were earned, but unpaid, were $12.2 million as of December 31, 2002 and $15.4 million as of December 31, 2001. Certain states in which we conduct this business, limit a co-employer's liability for earned payroll to minimum wage. This would reduce the Company's potential liability for accrued co-employer payroll. In the event that a client does not pay their related payroll and service fees prior to the applicable payroll date, the Company has the right to cancel the co-employer contract or at its option, require letters of credit or other collateral. As of December 31, 2002 the maximum exposure to any one account for earned payroll is approximately $1.1 million. HR outsourcing is also subject to geographic concentration. Approximately 32% of co-employer client payroll is within the state of Florida. Other east coast states, including Georgia, Maryland, New Jersey, Virginia, North Carolina, South Carolina, Pennsylvania, New York, and Delaware account for substantially all of our other business. Consequently, changes to economic or regulatory conditions in these states could adversely affect the HR outsourcing operations.
Cash provided by operating activities amounted to $180.1 million in 2002, $52.7 million in 2001, and $64.3 million in 2000. This increase in 2002 is a result of: i) a 13.8% increase in net premiums written and improved underwriting profitability, driven by rate increases in renewal premiums; ii) increased investment income from a larger investment portfolio; and iii) approximately $13.0 million more operating cash generated by our Diversified Insurance Services companies due to 16% revenue growth and a $4.3 million increase in their net income.
Total assets increased 13%, or $345.5 million, from December 31, 2001 to December 31, 2002. This increase was primarily due to: (i) an increase in total investments of $313.2 million resulting from the $180.1 million operating cash flow, $112.8 million net proceeds from our senior convertible notes and an increase of $26.8 million in pre-tax unrealized gains in the
The rise in total liabilities of $284.6 million, or 14%, from December 31, 2001 to December 31, 2002, was attributable to: (i) the senior convertible notes offering of $115.9 million; (ii) an increase in unearned premium reserve of 15%, or $71.4 million, due to growth in net premiums written over the year 2001, and our loss and loss expense reserves of 8%, or $105.1 million, due to normal reserve development and growth in net premiums written over the year 2001.
We are subject to financial strength ratings produced by external rating agencies. The principal agencies that cover the property and casualty industry are: A.M. Best Company (A.M. Best), Standard & Poor's Rating Services (S&P), Moody's Investor Service (Moody's) and Fitch Ratings Service (Fitch). We believe our ability to write business is most influenced by our rating from A.M. Best. We are currently rated "A+" (Superior) by A.M. Best, which is their second highest of fifteen ratings. A rating below "A" from A.M. Best, could materially adversely affect the business we write. We believe that ratings from S&P, Moody's or Fitch, although important, have less of an impact on our business. The Company continually reviews its financial agreements for any potential rating triggers that could dictate a significant change in terms of the agreements if the Company's credit rating were to suddenly and drastically change. A rating downgrade to below "A-" in its A.M. Best or S&P rating would be considered an event of default under the terms of the Company's line of credit agreements. The Company had no outstanding borrowings on these lines at December 31, 2002 or 2001. Holders of the senior convertible notes due 2032 may surrender their note for conversion during any period in which the credit rating assigned to the notes is "Ba2" or lower by Moody's or "BB" or lower by S&P. While these triggers would not materially affect our results of operations or financial condition, they may impact certain financial ratios.
At December 31, 2002 and 2001, the Company did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As such, the Company is not exposed to any financing, liquidity, market or credit risk that could arise if the Company had engaged in such relationships.
We currently have available revolving lines of credit amounting to $50.0 million, under which no balances are outstanding as of either December 31, 2002 or 2001. See Note 6(d) to the consolidated financial statements for more information. We have issued no guarantees on behalf of others and have no trading activities involving non-exchange traded contracts accounted for at fair value. We have no material transactions with related parties other than those disclosed in Note 16 to the consolidated financial statements.
In accordance with Section 10A(i)(2) of the Securities Exchange Act of 1934, as amended, as added by Section 202 of the Sarbanes-Oxley Act of 2002, we are required to disclose non-audit services approved by our Audit Committee to be performed by KPMG, LLP, our independent auditors. Non-audit services are services other than those provided in connection with an audit or a review of our financial statements and the financial statements of our subsidiaries. During 2002, KPMG, LLP did not provide any non-audit services to us.
The Company estimates an allowance for doubtful accounts on its premiums, other trade receivables, and reinsurance recoverables. This allowance is based on historical write-off percentages adjusted for the effects of current and anticipated trends. The allowance for premium receivables was $2.8 million at December 31, 2002 and $3.6 million at December 31, 2001. The allowance for trade receivables was $0.9 million at December 31, 2002 and $0.7 million at December 31, 2001. The allowance for reinsurance recoverables was $1.5 million at December 31, 2002 and $0.7 million at December 31, 2001.
who are considered co-employees. These accounts receivable, which are included in other trade receivables on the consolidated balance sheets, consist of service fees to be paid by our clients. Under the accrual method, earned but unpaid wages at the end of each period related to the Company's worksite employees are recognized as an accrued payroll liability as well as an account receivable during the period in which wages are earned by the worksite employee. Subsequent to the end of each period, such wages are paid and the related co-employer service fees are billed. Accrued co-employer payroll and related service fees were $12.2 million as of December 31, 2002 and $15.4 million as of December 31, 2001. Certain states limit a co-employer's liability for earned payroll to minimum wage. This would reduce the Company's potential liability for accrued co-employer payroll. In the event that a client does not pay their related payroll and service fees prior to the applicable payroll date, the Company has the right to cancel the co-employer contract or at its option, require letters of credit or other collateral. The Company has generally not required such collateral. As of December 31, 2002 the maximum exposure to any one account for earned payroll is approximately $1.1 million. If the financial condition of a client were to deteriorate rapidly, resulting in nonpayment, the Company's accounts receivable balances could grow and the Company could be required to provide for allowances, which would decrease net income in the period that such determination was made.
The Company records its ceded reinsurance transactions on a gross basis which results in reinsurance recoverables on losses and loss expenses and ceded unearned premiums (prepaid reinsurance premiums). The Company also discloses reinsurance amounts for ceded premiums written and earned and ceded losses and loss expenses incurred. See Note 4 for more information on reinsurance.
Policy acquisition costs are directly related to the writing of an insurance policy and are deferred and amortized over the life of the policies in order to facilitate a matching of revenues and expenses. These costs include labor costs, commissions, premium taxes and assessments, boards, bureaus and dues, travel, and other underwriting expenses incurred in the acquisition of premium. The 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. The Company regularly conducts reviews for potential premium deficiencies. There were no premium deficiencies for any of the reported years as the sum of the anticipated losses and loss expenses, policyholder dividends and other expenses did not exceed the related unearned premium and anticipated investment income.
The decrease in goodwill in our Diversified Insurance Services segment is the net effect of the sale of PDA Software Services, Inc. (PDA), $4.2 million, offset by the acquisition of Northeast Health Direct, LLC (NHD), $0.5 million. See Notes 12 and 1(r) for additional information regarding discontinued operations and acquisitions, respectively.
As of January 1, 2002 the Company adopted the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" (FAS 142). FAS 142 addresses the initial recognition and measurement of goodwill and other intangible assets. FAS 142 changes the accounting for goodwill and intangible assets that have indefinite useful lives from an amortization approach to an impairment-only approach that requires those assets to be tested at least annually for impairment. The statement is applied to all goodwill and other intangible assets recognized in an entity's financial statements at that date. Impairment losses that arise due to the initial application of FAS 142 (resulting from an impairment test) are to be reported as a change in accounting principle. No such impairments were recorded during 2002. Goodwill amortization expense, which is included in other expenses on the consolidated statements of income and mainly in the Diversified Insurance Services segment, was $3.3 million for 2001 and $3.1 million for 2000.
The following table shows net income and earnings per share as if FAS 142 had been adopted during those periods presented:
In accordance with industry practice, the Company maintains reserves for losses and loss expenses. These reserves are made up of both case reserves and reserves for claims incurred but not yet reported (IBNR). Case reserves result from a claim that has been reported to an insurance subsidiary and are estimated at the amount of ultimate payment. Additional IBNR reserves are established based on 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.
The internal assumptions considered by the Company in the estimation of the IBNR amounts for both environmental and non-environmental reserves at the Company's reporting dates are based on: (i) an analysis of both paid and incurred loss and loss expense development trends; (ii) an analysis of both paid and incurred claim count development trends; (iii) the exposure estimates for reported claims; (iv) recent development on exposure estimates with respect to individual large claims and the aggregate of all claims; (v) the rate at which new environmental claims are being reported; and (vi) patterns of events observed by claims personnel or reported to them by defense counsel. External factors identified by the Company in the estimation of IBNR for both environmental and non-environmental IBNR reserves include: legislative enactments, judicial decisions, legal developments in the determination of liability and the imposition of damages, and trends in general economic conditions, including the effects of inflation. Adjustments to IBNR are made periodically to take into account changes in the volume of business written, claims frequency and severity, the mix of business, claims processing and other items as described that are expected by management to affect the Company's reserves for losses and loss expenses over time.
attitudes; and (iv) trends in general economic conditions, including the effects of inflation. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method, however, 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. Based upon such reviews, the Company believes that the estimated reserves for losses and loss expenses are adequate to cover the ultimate cost of claims. 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.
The FASB Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (FAS 123) establishes financial accounting and reporting standards for stock-based compensation plans. As permitted by FAS 123, the Company uses the accounting method prescribed by Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees" (APB 25) to account for its stock-based compensation plans. Companies using APB 25 are required to make pro forma footnote disclosures of net income and earnings per share as if the fair value method of accounting, as defined in FAS 123, had been applied. See Note 15 for more information.
The Company has adopted the pro forma footnote disclosure-only provisions of FAS 123. Based on the fair value method consistent with the provisions of FAS 123, the Company's net income and earnings per share would have been reduced to the following pro forma amounts indicated below:
established when it is more likely than not that some portion of the deferred tax asset will not be realized. The effect of a change in tax rates is recognized in the period of enactment.
The Company's cash paid during the year for interest and federal income taxes and non-cash financing activities were as follows:
Separate pro forma information of this acquisition has not been presented, as management has determined that such information is not material.
(d) The amortized cost, estimated fair values and unrealized gains (losses) of held-to-maturity debt securities at December 31, 2002 and 2001, respectively, are as follows:
(e) The cost/amortized cost, estimated fair values and unrealized gains (losses) of available-for-sale securities at December 31, 2002 and 2001, respectively, are as follows:
Proceeds from sale of available-for-sale securities were $240.3 million during 2002, $101.6 million during 2001, and $64.1 million during 2000.
(i) The Company is not exposed to significant concentrations of credit risk within its investment portfolio.
(j) Included in other investments is $23.5 million of investments in limited partnerships in 2002 and $14.7 million in 2001. These investments are purchased and sold through an investment advisor and are carried at the equity method, which approximates fair value. Any change in fair value of these investments is recognized in net investment income earned in the period of change. At December 31, 2002 the Company has additional investment commitments of up to $16.4 million. There is no certainty that any additional investment will be required.
The Company's carrying amounts shown in the table are included in the consolidated balance sheets. The convertible subordinated debentures are included in "other liabilities" on the consolidated balance sheets. See Note 1 (e) for the methods and assumptions used by the Company in estimating the fair values of its financial instruments.
Incurred loss and loss expense development related to prior years was $19.8 million in 2002, $13.7 million in 2001 and ($1.0) million in 2000, while net loss and loss expense reserves increased by $111.2 million in 2002 and by $20.0 million in 2001. These changes were the result of normal reserve development inherent in the uncertainty in establishing reserves for losses and loss expenses, anticipated loss trends, growth in business, as well as increased reinsurance retentions.
During 2002, the only line of business that demonstrated significant prior year development was the Other Liability line of business. In this line, estimates for prior year losses increased by $21.1 million, primarily in accident years 1998 and 1999. The Other Liability line of business is inherently volatile which makes it more difficult to reserve.
In addition, changes in our claims operation including senior management changes and the development of a field claims model over the past four years have impacted claim settlement patterns and average case reserves. During 2002, these changes were minimal relative to the previous three years. This, combined with higher than expected loss emergence in 2002 for past accident years, has led us to recognize an increase in our estimates for these older periods.
In 2002 the Company issued $305 million aggregate principal amount of 1.6155% senior convertible notes (Convertible Notes), due September 24, 2032, at a discount of 61.988% resulting in an effective yield of 4.25%. The Company recorded gross proceeds of $116.0 million along with $3.2 million of deferred charges, which are amortized over the life of the note, in connection with debt issuance costs. $72.0 million of the net proceeds have been used to fund an irrevocable trust to provide for certain payment obligations in respect of the Company's outstanding debt obligations. The Company paid as a capital contribution $40.0 million to the Company's insurance operating subsidiaries. Interest on the Convertible Notes is payable semi-annually at a rate of 1.6155% beginning March 24, 2003 until September 24, 2009, to holders of record at the close of business on the preceding March 9 or September 9, respectively. After that date, cash interest will not be paid on the Convertible Notes prior to maturity unless contingent cash interest becomes payable. Contingent cash interest becomes payable if the average market price of a Convertible Note for the applicable five trading day period equals 120% or more of the sum of the Convertible Note's issue price, accrued original issue discount and accrued cash interest, if any, for a Convertible Note to the day immediately preceding the relevant six-month period. The contingent cash interest payable per Convertible Note in respect of any quarterly period within any six-month period will equal the greater of (a) any regular cash dividends per share paid by the Company on our common stock during that quarterly period multiplied by the then applicable conversion rate or (b) $0.15 multiplied by 12.9783. The Convertible Notes will be convertible at the option of the holders, if the conditions for conversion are satisfied, into shares of the Company's common stock at a conversion price of $29.29. Holders may also surrender Convertible Notes for conversion only during any period in which the credit rating assigned to the Convertible Notes is Ba2 or lower by Moody's Investors Service, Inc. (Moody's) or BB+ or lower by Standard and Poor's Credit Market Services (S&P), the Convertible Notes are no longer rated by either Moody's or S&P, or the credit rating assigned to the Convertible Notes has been suspended or withdrawn by either Moody's or S&P. The Convertible Notes will cease to be convertible pursuant to this credit rating criteria during any period or periods in which all of the credit ratings are increased above such levels. The Convertible Notes are redeemable by the Company in whole or in part, at any time on or after September 24, 2007, at a price equal to the sum of the issue price, plus the call premium, if any, plus accrued original issue discount and accrued and unpaid cash interest, if any, or such Convertible Notes to the applicable redemption date. The holders of the Convertible Notes may require the Company to purchase all or a portion of their Convertible Notes on either September 24, 2009, 2012, 2017, 2022, or 2027 at stated prices plus accrued cash interest, if any, to the purchase date. The Company may pay the purchase price in cash or shares of Company common stock or in a combination of cash and shares of Company common stock.
For the 8.63% Senior Notes, the Company is required to pay $6.0 million principal amount in each year commencing on May 4, 2003 and ending on May 4, 2007, inclusive, together with accrued interest thereon. The unpaid principal amount of these Senior Notes accrues interest and is payable semiannually on May 4 and November 4 of each year, until the principal is paid in full.
(2) On August 12, 1994, the Company entered into a $54.0 million note purchase agreement with various lenders covering the 8.77% Senior Notes. The Company is required to pay $18.0 million principal amount in each year commencing on August 1, 2003 and ending on August 1, 2005, inclusive, together with accrued interest thereon. The unpaid principal amount of the 8.77% Senior Notes accrues interest and is payable semiannually on February 1 and August 1 of each year, until the principal is paid in full.
Each note purchase agreement contains restrictive business covenants that are reviewed quarterly. They include, but are not limited to, a limitation on indebtedness, restricted ability to declare dividends and net worth maintenance. At December 31, 2002 the amount available for dividends to stockholders under said restrictions was $176.4 million for the 1994 Senior Notes and $138.6 million for the 2000 Senior Notes.
The Debentures were issued under an Indenture dated December 29, 1982, ("Indenture") in the principal amount of $25.0 million, bearing interest at a rate of 8.75% per annum, which is payable on the unpaid principal semiannually on January 1 and July 1 in each year to holders of record at the close of business on the preceding December 15 and June 15, respectively. The Debentures are convertible into common stock at an effective conversion price of $7.08 per share. The principal amount of the Debentures, $1.3 million at 2002 and $3.8 million at 2001, including any accrued interest, is due on January 1, 2008 and is included in other liabilities on the consolidated balance sheets.
The Indenture requires the Company to retire, through the operation of a mandatory sinking fund, 5% of the original $25.0 million aggregate principal amount of the debentures on, or before December 31 of each of the years from 1993, to and including, 2006. Voluntary conversions have satisfied this obligation in its entirety.
(d) Short-Term Debt The Company has revolving lines of credit with State Street Corporation, $25.0 million, and Wachovia Bank (formerly First Union National Bank), $25.0 million, totaling $50.0 million at December 31, 2002 and 2001. At December 31, 2002 and 2001, there were no balances outstanding. Interest is determined on a LIBOR, prime rate or money market rate basis at the Company's option. The weighted average interest rate on these borrowings was 5.3% in 2001. No borrowings were made during 2002.
Based on the unaudited 2002 statutory financial statements, the maximum ordinary dividends that can be paid to Selective in 2003 are:
Before an Acquiring Person acquires 50% or more of the common shares, Selective's Board may exchange rights, other than the rights of an Acquiring Person, at an exchange ratio of one share of common stock per right. The rights expire February 2, 2009, unless Selective's Board redeems them at $0.01 per right before a person or group triggers the plan or unless Selective's Board exchanges them for common stock.
The GAAP underwriting results of the Insurance Operations segment are determined taking into account net premiums earned, incurred losses and loss expenses, policyholders dividends, policy acquisition costs and other underwriting expenses. Management of the Investments segment is separate from the Insurance Operations segment and, therefore, has been classified as a separate segment. The operating results of the Investments segment takes into account net investment income and net realized gains and losses. The Diversified Insurance Services segment is managed independently from the other segments and, therefore, has been classified separately. The Diversified Insurance Services segment consists of managed care, flood operations and human resource administration outsourcing (HR Outsourcing). The segment results are determined taking into account the net revenues generated in each of the businesses, less the costs of operations. Prior years have been restated to exclude software development and administration, which are accounted for as discontinued operations in 2002 and 2001.
The following summaries present revenues (net investment income and net realized gains or losses in the case of the Investments segment) and pre-tax income for the individual segments:
Based on our tax loss carryback availability, and the historic levels of current taxable income and pretax financial statement income, we believe that more likely than not, the existing deductible temporary differences will reverse during periods in which we will generate net taxable income or have adequate carryback availability. As a result, the Company has taken down the valuation allowance recognized for deferred tax assets.
The Company terminated, effective December 31, 1997, a nonqualified defined benefit retirement income plan for nonemployee Directors. The estimated accrued costs for this plan were not material. As part of the termination, the present value of each Director's future benefits, as of that date, was converted into units based on the fair value of Selective common stock. The original termination called for the cash value of these units based upon the fair value of Selective common stock on retirement date to be distributed to each Director, or at each Director's election, over a period of fifteen years after such retirement. On May 8, 2002, the shareholders approved the conversion of the units issued under the termination plan into shares of Selective stock. All of the shares issued under this conversion have been deferred by the participants for receipt upon retirement, or at each Director's election, over a period of no more than 5 years after such retirement. These deferred shares, which are currently being held in accounts on behalf of each Director, are credited with cash dividends along with interest on those dividends. The accrued liability of these deferred shares of stock and the related dividend and interest earnings at December 31, 2002 was $1.5 million compared with the accrued liability for the units outstanding at December 31, 2001 of $1.4 million.
An additional defined contribution plan is maintained by Selective HR Solutions, a subsidiary of the Diversified Insurance Services segment, which does not participate in the Company's defined contribution plan. The plan allows employees to contribute a maximum of 15% of defined compensation and up to 3% of contributions are matched 200% by the employer.
Employer contributions for all the plans amounted to $3.1 million in 2002, $2.6 million in 2001 and $2.2 million in 2000.
The Company has a noncontributory defined benefit retirement income plan covering substantially all employees who meet eligibility requirements. The Company's funding policy provides that payments to the pension trust shall be equal to the minimum funding requirements of the Employee Retirement Income Security Act, plus additional amounts that may be approved by the Company from time to time. Effective July 1, 2002, two new amendments to the plan were adopted. For new entrants into the plan the monthly retirement benefits beginning at normal retirement were decreased to 1.2% from 2.0% of the average monthly compensation as defined. Also, for all plan participants the early retirement age was changed to include a formula, whereby age plus years of service must sum to at least 70.
All amounts in the reconciliations of funded status were recognized in the consolidated balance sheets for 2002 and 2001. There were no amounts to be included in other comprehensive income for the periods shown resulting from a change in the minimum pension liability.
The weighted-average fair value of options and stocks granted per share, during the year for 2002, 2001 and 2000, is as follows:
The following table summarizes information about stock options outstanding and exercisable under the stock option plans at December 31, 2002:
Under the Company's Stock Option Plan II, the Committee may, at its discretion, make restricted or unrestricted grants of common stock, or grant rights to receive common stock, to employees in addition to or in substitution for options and/or SARs granted. The Company granted total restricted shares of 208,588 for 2002, 235,342 for 2001 and 211,309 for 2000, and forfeited shares of 39,415 in 2002, 52,969 in 2001 and 69,718 in 2000. Each such grant must be expressly subject to the attainment of one or more performance-related objectives for certain executive officers, and may be subject to the attainment of one or more performance-related objectives for other employees, as determined by the Committee and set forth in an award agreement. Each such grant also is subject to a vesting period or other terms, conditions, restrictions and limitations as determined by the Committee at its discretion and set forth in an award agreement.
In May 2002, the shareholders approved the Company's Stock Option Plan III, which has 1,989,000 shares of the Company's common stock available for issuance at December 31, 2002. The plan permits the granting of qualified and nonqualified stock options to employees, which may or may not have stock appreciation rights (SARs) attached. Options and related SARs may be granted at not less than fair value on the date of the grant and may be subject to certain vesting periods as determined by the Company's Salary and Employee Benefits Committee (Committee). Each grant must be exercised within ten years from the date of the grant. Under this plan, the Company granted options for 5,000 shares in 2002.
Beginning in 1998, certain officers of the Company were granted phantom stock units in lieu of grants of restricted stock. There were no phantom stock units awarded in 2002, 2001 and 2000. The value of all outstanding phantom stock units was paid in cash during 2002. The value of the phantom stock units was charged to compensation expense over the employment period.
At December 31, 2002, our reserves for environmental claims amounted to $40.1 million on a gross basis (including case reserves of $29.5 million and IBNR reserves of $10.6 million) and $34.3 million on a net basis (including case reserves of $27.5 million and IBNR reserves of $6.8 million). There are a total of 2,593 environmental claims, including multiple claimants who are associated with the same site or incident. Of these 2,346 are asbestos related, of which 1,296 involve only three insureds. The total case reserves associated with these three insureds amounted to $3.0 million on a net and gross basis. The total case reserves for asbestos related claims amounted to $5.9 million on a gross basis and $4.9 million on a net basis. About 90 of the total environmental claims involve approximately 20 landfill sites. The landfill sites account for case reserves of $17.9 million on a gross basis and $17.7 million on a net basis. The remaining claims, which account for $5.7 million of case reserves on a gross basis and $4.9 million on a net basis, involve leaking underground storage tanks and other latent environmental exposures.
Based on our aggregate reserve for net losses and loss expenses at December 31, 2002, we do not expect that liabilities associated with environmental and non-environmental claims will have a materially adverse impact on our future liquidity, financial position and results of operations. However, given the complexity of coverage and other legal issues, and the significant assumptions used in estimating such exposures, actual results could significantly differ from our current estimates.
At December 31, 2002, the total future minimum rental commitments under noncancelable leases was $24.2 million and such yearly amounts are as follows:
(d) The Company has additional investment commitments for its limited partnership investments of up to $16.4 million. There is no certainty that any additional investment will be required. See Note 2(j) for additional discussion of our investments in limited partnerships.
(3) Income from continuing operations and net income for the third quarter of 2001 were reduced by $8 million, after taxes, due to increases in reserves of $8 million pre-tax for Insurance Operations and $4 million pre-tax for Diversified Insurance Services. See Financial Review for a discussion of the reserve increases.