Our headquarters are located in a 315,000 square foot structure on a 56 acre site zoned for office and professional use in Branchville, New Jersey. The site is owned by a subsidiary, which also owns abutting property in Frankford, New Jersey. We lease all of our other facilities. The principal office locations related to our insurance operations are described in the “Geographic Markets” 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.
Our Standard Commercial and Standard Personal Lines products and services are written through our nine insurance subsidiaries, some of which write flood business through the NFIP's WYO. Our E&S Lines products and services are written through one subsidiary, Mesa Underwriters Specialty Insurance Company ("MUSIC"). This subsidiary provides us with a nationally-authorized non-admitted platform to offer insurance products and services to customers who generally cannot obtain coverage in the standard marketplace.
In Management's Discussion and Analysis ("MD&A"), we will discuss and analyze the consolidated results of operations and financial condition, as well as known trends and uncertainties that may have a material impact in future periods, including the following:
Each quarter, our actuaries prepare a comprehensive loss and loss expense reserve analysis. This analysis applies standard actuarial projection techniques to our own loss and loss expense experience, to produce updated ultimate loss and loss expense estimates. Our actuaries may also consider other non-standard approaches. The results of the reserve analysis results are then discussed with management to determine if any changes are required to the estimated ultimate loss and loss expense reserves. In addition to the actuarial loss and loss expense projections, management considers other information and factors, including internal impacts, such as changes to our underwriting and claims practices and external impacts, such as economic, legal, judicial, and social trends. Upon considering all of this information, management makes a decision about whether changes to the reserve estimates are appropriate.
We have estimated a range of reasonably possible reserves for net loss and loss expense claims to be $3,003 million to $3,556 million at December 31, 2018, which compares to $2,899 million to $3,361 million at December 31, 2017. These ranges reflect low and high reasonable reserve estimates, which were selected 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 these reflect ranges of reasonable estimates, it is possible that the final outcomes may fall above or below these amounts. The ranges do not include a provision for potential increases or decreases associated with asbestos, environmental, and certain other continuous exposure claims, as traditional actuarial techniques cannot be effectively applied to these exposures.
By its nature, this line presents a diverse set of exposures, and can be influenced by a variety of factors. In recent years, the line has been favorably impacted by decreasing frequencies partially offset by modest severity trends. Potential increases in either economic or social inflation could impact the loss trends for this line of business. Sources of social inflation could include: (i) state legislation that could extend the statute of limitation for lawsuits alleging abuse and/or re-open the window for lawsuits that were previously beyond the statute of limitations; and (ii) increased awareness of abuse and molestation liability. Our actuarial department actively monitors these trends within our reserve review data, and holds frequent discussions with claims, to identify any potential shifts in these trends.
Changes in utilization of the workers compensation system - These changes may be driven by economic, legislative, or other changes, such as increased use of pharmaceuticals and more complex medical procedures, among others. Also, lower levels of unemployment may cause the hiring of less skilled workers who may experience higher loss frequencies.
Aggressively managing new business pricing and hazard mix, co-underwriting selected higher hazard classes by the field and home office, providing better recognition of risk drivers, and improved pricing.
At December 31, 2018, our personal automobile line of business had recorded reserves, net of reinsurance, of $101 million, which represented 3% of our total net reserves. In 2018, this line experienced unfavorable development of $3.0 million, mainly attributable to an increase in accident years 2016 and 2017. In 2017, this line experienced unfavorable development of $6.7 million, mainly attributable to an increase in accident years 2011 through 2016.
Like all areas of our organization, our Claims Department is continually identifying areas for improvement and efficiency, increasing their value proposition to both our insureds and our organization. These improvements may lead to changes in claims practices that affect average case reserve levels and/or claims settlement rates, which directly impact the data used to project ultimate loss and loss expense. While these changes increase the uncertainty in our estimates in the short-term, we expect the longer-term benefit will be a more refined management of the claims process.
Some of the specific claims actions implemented over the past several years, in addition to those regarding E&S, as discussed above, are as follows:
The continued use of our CCU, to which all significant and complex liability claims are assigned. This unit has been staffed with personnel that have significant experience in handling and settling these types of claims.
The total carried net loss and loss expense reserves for these claims were $22.8 million as of December 31, 2018 and $21.2 million as of December 31, 2017. The emergence of these claims occurs over an extended period and is highly unpredictable. For example, within our Standard Commercial Lines book, certain landfill sites are included on the National Priorities List (“NPL”) by the United States Environmental Protection Agency (“USEPA”). Once on the NPL, the USEPA determines an appropriate remediation plan for these sites. A landfill can remain on the NPL for many years until final approval for the removal of the site is granted from the USEPA. The USEPA has the authority to re-open previously closed sites and return them to the NPL. We currently have reserves for six customers related to three sites on the NPL.
“Asbestos claims” are claims for bodily injury alleged to have occurred from exposure to asbestos-containing products. Our primary exposure arises from insuring various distributors of asbestos-containing products, such as electrical and plumbing materials. At December 31, 2018, asbestos claims constituted 27% of our $22.8 million net asbestos and environmental reserves, compared to 30% of our $21.2 million net asbestos and environmental reserves at December 31, 2017.
In addition to asbestos and environmental reserves, we also have exposure to other latent, or continuous trigger, exposures in our ongoing portfolio. Examples include construction defect claims and abuse and molestation coverage. We manage our exposure to these liabilities through our underwriting and claims practices. Similar to asbestos and environmental claims, these claims are handled by a dedicated claims unit. Nevertheless, these claims bring greater uncertainty to our estimates, and are particularly susceptible to changes in our legal, social, and judicial environments.
elements of expense and/or liability measurement. We evaluate these key assumptions annually. Other assumptions involve demographic factors, such as retirement age and mortality.
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 higher discount rate reduces the present value of benefit obligations. Conversely, a lower discount rate increases the present value of benefit obligations. Our discount rate increased 68 basis points, to 4.46%, as of December 31, 2018, compared to 3.78% as of December 31, 2017. For additional information regarding our discount rate selection, refer to Note 14. “Retirement Plans” in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
The expected long-term rate of return on the plan assets is determined by considering the current and expected asset allocation, as well as historical and expected returns on each plan asset class. A higher expected rate of return on pension plan assets would decrease pension expense. Our long-term expected return on plan assets increased 14 basis points, to 6.50%, as of December 31, 2018 compared to 6.36% as of December 31, 2017, reflecting a higher expected allocation to risk-seeking assets in the portfolio and a change to our investment funds.
At December 31, 2018, our pension and post-retirement benefit plan obligation was $350.0 million compared to $381.0 million at December 31, 2017. Plan assets were $331.7 million and $363.7 million at December 31, 2018 and December 31, 2017, respectively. Volatility in the marketplace, coupled with changes in the discount rate assumption, could materially impact our pension and post-retirement life valuation in the future. For additional information regarding our pension and post-retirement benefit plan obligations, see Note 14. “Retirement Plans” in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
2Non-GAAP operating income is used as an important financial measure by us, analysts, and investors, because the realization of net investment gains and losses on sales of securities in any given period is largely discretionary as to timing. In addition, these net realized investment gains and losses, as well as OTTI that are charged to earnings, unrealized gains and losses on equity securities, and the deferred tax asset charge that was recognized in 2017 in relation to Tax Reform, could distort the analysis of trends.
The loss and loss expense ratio increased 2.8 points in 2018 and 1.3 points in 2017 compared to the same prior year periods, driven by the following:
We continue to execute on various claims process enhancements and underwriting initiatives to improve our profitability on this line. During 2018, we experienced renewal pure price decreases of 0.2% in a market place that is demonstrating significant pricing pressure. Our workers compensation book of business, which represents approximately 16% of our Standard Commercial Lines business, continues to benefit from: (i) claims initiatives, such as reducing workers compensation medical costs through more favorable Preferred Provider Organization ("PPO") contracts and greater PPO penetration; and (ii) better outcomes driven by our workers compensation strategic case management unit, which handles claims with high exposure and/or significant escalation risk. In addition, this line has benefited in recent years from lower than anticipated medical inflation that has led to lower severity trends. Favorable prior year casualty reserve development in 2018 amounted to $83.0 million for the year, reflecting lower than expected severities in accident years 2017 and prior. For a full discussion of the claims initiatives we have deployed, refer to the “Reserves for Loss and Loss Expense” section within Critical Accounting Policies and Estimates in Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations."
The increase in the loss and loss expense ratio in 2018 was partially offset by improvement in the underwriting expense ratio of of 1.2 points in 2018. The improvement was primarily driven by:
A 0.3-point decrease in profit-based compensation to our distribution partners, driven by the higher combined ratio, resulting in a reduced level of underwriting income.
A 0.7-point decrease in employee-related expenses, including 0.4 points from labor expenses and 0.3 points from pension expenses; and
A 0.5-point decrease in commissions to our distribution partners in 2017 due to lower supplemental commission
expense, as well as lower base commissions that were driven by targeted actions we took in late 2016 on our
We ended 2018 with record levels of capital and liquidity, and we feel extremely positive about our financial position. For 2019, we have established a non-GAAP operating ROE target of 12%, which is an appropriate return for our shareholders based on our current estimated weighted average cost of capital, the current interest rate environment, and property and casualty insurance market conditions.
Looking into 2019, there remain a number of areas that require our continued focus to maintain our financial position:
Delivering on our strategy for continued disciplined growth, which will be driven by the addition of new agents, greater share of wallet in our agents’ offices, and geographic expansion. Our longer-term Standard Commercial Lines target is to attain a 3% market share in the states in which we operate, by appointing partner relationships approximating 25% of their markets and seeking an average share of wallet of 12% across the relationships. This goal represents an additional premium opportunity in excess of $2.3 billion in our pre-expansion state footprint.
Actively managing the investment portfolio to enhance after-tax yields while managing credit, duration, and liquidity risk.
Overall, we remain extremely pleased with our financial and strategic position heading into 2019. We will maintain a steadfast focus on underwriting discipline as we execute on our various strategies to generate profitable growth. The investments we are making today in our franchise distribution model, sophisticated underwriting tools and technology, and overall customer experience in an omni-channel environment, will position us as a leader in the coming years.
Our guidance for 2019 is based on our current view of the marketplace, and incorporates the following:
Weighted average shares outstanding of 60 million on a diluted basis.
For the past three years, growth in this segment of our business has reflected: (i) renewal pure price increases; (ii) new business growth; and (iii) stable retention. Quantitative information on these drivers is as follows:
Decreases in profit-based compensation to our distribution partners of 0.2 points in 2018 and 0.3 points in 2017.
The following is a discussion of our most significant Standard Commercial Lines of business:
Growth in 2018 and 2017 premium was primarily due to direct new business as outlined in the table above, coupled with strong retention and renewal pure price increases.
The combined ratio increased in 2018 by 5.9 points, driven by lower favorable prior year casualty reserve development compared to 2017, which increased the combined ratio by 7.0 points. This was partially offset by a lower underwriting expense ratio of 1.0 point, primarily attributable to the aforementioned items discussed in the overall Commercial Lines segment above.
The favorable prior year casualty reserve development for each year is outlined in the table below.
2018: 1.5 points attributable to lower than expected loss adjustment expenses in accident years 2013 through 2017, partially offset by higher than expected loss emergence in accident years 2016 and 2017.
For the past three years, growth in this line of business has reflected renewal pure price increases, new business growth, and strong retention.
2018: Unfavorable development of 7.6 points, which was driven primarily by higher than expected severities in accident years 2015 through 2017.
The 10.3 point improvement in the combined ratio in 2018 compared to 2017 was primarily attributable to higher favorable prior year development of 9.7 points. This favorable development was due to continued favorable medical severity trends impacting accident years 2017 and prior. Because of the length of time that injured workers receive medical treatment, decreases in medical inflation can cause favorable loss development across an extended number of accident years. In addition, the underwriting expense ratio improved by 0.7 points, consistent with the improvement in overall Standard Commercial Lines discussed above.
In 2018, favorable development resulted from an improvement in medical severity trends from accident years 2017 and prior.
The increases in NPW reflected in the table above were driven by the following:
The prior year development in all three years primarily related to our personal automobile book of business.
commission of 0.3 points; and (iv) a reduction in the cost of insurance scoring and motor vehicle reports used in the underwriting process of 0.3 points.
Quantitative information pertaining to our property losses and prior year development are as follows:
Unfavorable prior year casualty reserve development for 2018 was driven by frequencies and severities in accident years 2015 and 2016. Unfavorable prior year casualty reserve development for 2017 was driven by increases in claims severities in accident years 2014 and 2015.
Permit all of the Insurance Subsidiaries to obtain a uniform rating from A.M. Best.
global reinsurance community, the inability of our reinsurers to collect on their retrocession program may impair their ability to pay us for the amounts we cede to them. Accordingly, we have direct and indirect counterparty credit risk from our reinsurers. We attempt to mitigate this credit risk by: (i) pursuing relationships with reinsurers rated “A-” or higher by A.M. Best; and/or (ii) obtaining collateral to secure reinsurance obligations. Some of our reinsurance contracts include provisions that permit us to terminate or commute the reinsurance treaty if the reinsurer's financial condition or rating deteriorates or otherwise require our reinsurers to post collateral. We monitor the financial condition of our reinsurers and we review the quality of reinsurance recoverables and reserves for uncollectible reinsurance. For additional information regarding our counterparty credit risk with our reinsurers, see Note 8. "Reinsurance" in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K.
We use the results of the Risk Management Solutions and AIR Worldwide models in our review of exposure to hurricane risk. Each of these third party vendors provide two views of the modeled results as follows: (i) a long-term view that closely relates modeled event frequency to historical hurricane activity; and (ii) a medium-term view that adjusts historical frequencies to reflect expectations of hurricane activity in the near future. We believe that modeled estimates provide a range of potential outcomes and we review multiple estimates for purposes of understanding our catastrophic risk. The following table provides modeled hurricane results based on a blended view of the four models for the Insurance Subsidiaries' combined property book as of July 2018:
1Include assumptions for certain un-modeled costs, such as the impact of loss expenses, residual market assessments, and automobile-related losses, which collectively increase our gross losses by an estimated 13%.
The property excess of loss treaty, which covers both our standard market and E&S business, was renewed on July 1, 2018 with the top layer renewed on January 1, 2019. The major terms of these treaties are consistent with the prior year.
$735 million above $40 million retention treaty that responds on per occurrence basis in four layers:
All nuclear, biological, chemical, and radioactive ("NBCR") losses are excluded regardless of whether or not they are certified under TRIPRA. Non-NBCR losses are covered to the same extent as non-terrorism losses. Please see Item 1A. “Risk Factors.” of this Form 10-K for discussion regarding TRIPRA.
All NBCR losses are excluded regardless of whether or not they are certified under TRIPRA. For non-NBCR losses, the treaty distinguishes between acts committed on behalf of foreign persons or foreign interests ("Foreign Terrorism") and those that are not. The treaty provides annual aggregate limits for Foreign Terrorism (other than NBCR) acts of $24 million for the first layer and $60 million for the second layer and for the third layer approximately $35 million in annual aggregate limits. Non-foreign terrorism losses (other than NBCR) are covered to the same extent as non-terrorism losses.
The primary objective of the investment portfolio is to maximize after-tax net investment income and the overall total return of the portfolio, while maintaining a high credit quality core fixed income securities portfolio and managing our duration risk profile. The effective duration of the fixed income securities portfolio as of December 31, 2018 was 3.8 years, compared to the Insurance Subsidiaries’ liability duration of approximately 3.6 years. The effective duration of the fixed income securities portfolio is monitored and managed to maximize yield while managing interest rate risk at an acceptable level. We maintain a well-diversified portfolio across sectors, credit quality, and maturities that affords us ample liquidity. Purchases and sales are made with the intent of maximizing investment returns in the current market environment while balancing capital preservation. Over time, we may seek to increase or decrease the duration and overall credit quality of the portfolio based on market conditions.
Our fixed income securities and short-term investment portfolio, in the aggregate, represented 95% of our total invested assets at December 31, 2018, consistent with last year. In the aggregate, these portfolios maintained a weighted average credit rating of "AA-" as of both December 31, 2018 and 2017, with 98% and 97% of the securities within the portfolio being investment grade quality, respectively.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.
The accompanying consolidated financial statements (“Financial Statements”) include the accounts of the Parent and its subsidiaries, and have been prepared in conformity with: (i) U.S. generally accepted accounting principles ("GAAP"); and (ii) the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). All significant intercompany accounts and transactions are eliminated in consolidation.
We have designated approximately 99% of our fixed income securities portfolio as available-for-sale ("AFS"), with the remaining 1% being designated as held-to-maturity ("HTM"), as we have the ability and positive intent to hold these securities to maturity. Our AFS securities are reported at fair value in our consolidated balance sheets, with unrealized gains or losses recognized in accumulated other comprehensive income (loss) ("AOCI"), net of tax. HTM securities are carried at either: (i) amortized cost; or (ii) market value at the date of transfer into the HTM category, adjusted for subsequent amortization. After-tax unrealized gains and losses on securities that were transferred into an HTM designation from an AFS designation, are also included in AOCI.
The amortized cost of fixed income securities is adjusted for the amortization of premiums and the accretion of discounts over the expected life of the security using the effective yield method. Callable debt securities held at a premium are amortized to the earliest call date. Premiums and discounts arising from the purchase of RMBS, CMBS, CLOs and other ABS are amortized over the expected life of the security based on future principal payments, giving additional consideration to prepayments. These prepayments are estimated based on historical and projected cash flows. Prepayment assumptions are reviewed quarterly and adjusted to reflect actual prepayments and changes in expectations. Future amortization of any premium and/or discount is adjusted to reflect the revised assumptions.
Short-term investments may include certain money market instruments, savings accounts, commercial paper, and debt issues purchased with a maturity of less than one year. We also enter into reverse repurchase agreements that are included in short-term investments. These loans are fully collateralized with high quality, readily marketable instruments at a minimum of 102% of the loan principal. At maturity, we receive principal and interest income on these agreements. All short-term investments are carried at cost, which approximates fair value.
Other investments may include alternative investments and other securities. Alternative investments are accounted for using the equity method, with income typically recognized on a one-quarter lag. Other securities are primarily comprised of tax credit investments and equity securities without readily determinable fair values that are not carried at NAV as a practical expedient. These equity securities are carried at cost. Accounting for our tax credit investments is dependent on the type of credit we have purchased, as follows:
For federal tax credits accounted for under the equity method, we use the deferral method for recognizing the benefit of the tax credit with the related deferred revenue being recognized in our Consolidated Income Statement as a component of "Federal income tax expense" proportionately over the life of the investment.
Net investment income earned on our Consolidated Statements of Income include the following:
Changes in unrealized gains or losses on our equity securities that are carried at fair value.
On a quarterly basis, we review our investment portfolio for impairments that are other than temporary. The following provides information on this analysis for our fixed income securities and short-term investments, and our other investments.
The discount rate we use in a DCF is the effective interest rate implicit in the security at the date of acquisition for those RMBS, CMBS, CLOs and other ABS that were not of high credit quality at acquisition. For all other securities, we use a discount rate that equals the current yield, excluding the impact of previous OTTI charges, used to accrete the beneficial interest. DCFs may include, but are not necessarily limited to: (i) generating cash flows for each tranche considering tranche-specific data, market data, and other pertinent information, such as the historical performance of the underlying collateral, including net operating income generated by underlying properties, conditional default rate assumptions, loan loss severity assumptions, consensus projections, prepayment projections, and actual pool and collateral information; (ii) identifying applicable benchmark yields; and (iii) applying market-based tranche specific spreads to determine an appropriate yield by incorporating collateral performance, tranche-level attributes, trades, bids, and offers.
Our evaluation for OTTI of our other investments (tax credits and equity securities without a readily determinable fair value for which NAV is not used as a practical expedient) include a qualitative assessment of impairment indicators, which include, but are not limited to, the following:
Factors that raise significant concerns about the investee's ability to continue as a going concern, such as negative cash flows from operations, working capital deficiencies, or noncompliance with statutory capital requirements or debt covenants.
If there is a decline in the fair value of an alternative or other investment that we do not intend to hold, or if we determine the decline is other than temporary, we write down the carry value of the investment through an OTTI charge to earnings.
Less than 1% of our portfolio cannot be priced using our primary or secondary pricing service. At times, we may use valuations performed by the issuer or non-binding broker quotes to determine the fair value of these securities. We internally review these fair value measurements for reasonableness. This review typically includes an analysis of price fluctuations between months with variances over established thresholds being analyzed further.
Goodwill results from business acquisitions where the cost of assets and liabilities acquired exceeds the fair value of those assets and liabilities. A quantitative goodwill impairment analysis is performed if our quarterly qualitative analysis indicates that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Goodwill is allocated to the reporting units for purposes of these analyses. Based on our analysis at December 31, 2018, goodwill was not impaired.
Some insured events may span multiple years and trigger multiple policies, as in the case of asbestos and environmental claims, where the injury is deemed to occur over an extended period of time. These types of losses often do not lend themselves to traditional actuarial methods. Where we deem appropriate, our experience may be analyzed without differentiating by accident year, using alternative methods and metrics. In these cases, the associated selected ultimate loss and loss expenses are then allocated to the applicable accident years for reporting.
The selected ultimate loss and loss expenses are translated into indicated IBNR reserves, which are then compared to the recorded IBNR reserves. Management's judgment is applied in determining any required adjustments to IBNR and the resulting adjustments are then recorded and assigned or allocated to accident year using the results of the actuarial analysis.
Loss reserves are estimates, and as such, we also consider a range of possible loss and loss expense reserve estimates. This range is determined at the beginning of each year, using prior year-end data, and reflects the fact that there is no single precise method for estimating the required reserves, due to the many factors that may influence the amounts ultimately paid. Considering the reserve range along with all of the items described above, as well as current market conditions, IBNR estimates are then established and recorded.
The combination of the IBNR estimates along with the case reserve estimates on individual claims results in our total reserves for loss and loss expense. These reserves are expected to be sufficient for settling loss and loss expense obligations under our policies on unpaid claims, including changes in the volume of business written, claims frequency and severity, the mix of business, claims processing, and other items that management expects to affect our ultimate settlement of loss and loss expense. However, the ultimate claim settlements may be higher or lower than reserves established. As our experience emerges and
other information develops, we revise our reserve estimates accordingly. 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 associated impacts may be material to the results of operations in future periods.
We do not discount to present value that portion of our loss and loss expense reserves expected to be paid in future periods.
We establish reserves for dividends to policyholders on certain policies, most significantly workers compensation policies. These dividends are based on the policyholders' loss experience. Dividend reserves are established based on past experience, adjusted for the effects of current developments and anticipated trends. The expense for these dividends is recognized over a period that begins at policy inception and ends with the payment of the dividend. We report these dividends within "Other insurance expenses" on the Consolidated Statements of Income. We do not issue policies that entitle the policyholder to participate in the earnings or surplus of our Insurance Subsidiaries.
Our pension and post-retirement life benefit obligations and related costs are calculated using actuarial methods, within the framework of GAAP. Our pension benefit obligation is determined as the actuarial present value of the vested benefits to which the employee is currently entitled, based on the average life expectancy of the employee. Our funding policy provides that payments to our pension trust shall be equal to the minimum funding requirements of the Employee Retirement Income Security Act of 1974 ("ERISA"), plus additional amounts that the Board of Directors of Selective Insurance Company of America (“SICA”) may approve from time to time.
Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU
be measured at fair value with changes in fair value recognized in earnings; (ii) simplifies the impairment assessment of equity
investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; (iii)
deferred tax asset related to an available-for-sale ("AFS") security should be evaluated with other deferred tax assets.
net unrealized gain on our equity portfolio as of December 31, 2017. Additionally, beginning in the first quarter of 2018,
changes in unrealized gains or losses on this portfolio are no longer recorded to AOCI, but are instead recognized in income
In August 2016, the FASB issued ASU 2016-15. As mentioned above, this ASU adds guidance on the categorization of
on the cash flow classification of certain cash receipts and payments, including, but not limited to: (i) debt prepayment or debt
insurance policies; and (iii) separately identifiable cash flows and application of the predominance principle. The updated
In November 2016, the FASB issued ASU 2016-18. ASU 2016-18 requires restricted cash and restricted cash equivalents to be
included with cash and cash equivalents in the reconciliation of beginning and ending cash on the statements of cash flows.
This update also requires a reconciliation of the statement of the cash flows to the balance sheet if the balance sheet includes
more than one line item containing cash, cash equivalents, and restricted cash. We have restricted cash related to our
the change in restricted cash from operating activities and include the restricted cash balance in the reconciliation of beginning
Impairment (“ASU 2017-04”). ASU 2017-04 eliminates the second step of the two part goodwill impairment test, which
required entities to determine the fair value of individual assets and liabilities of a reporting unit to measure the goodwill
value exceeds its fair value, not to exceed the carrying amount of goodwill. An entity still has the option to perform the
December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates
after January 1, 2017. We adopted ASU 2017-04 in the first quarter of 2018 and it had no impact on us.
In March 2017, the FASB issued ASU 2017-07, Compensation-Retirement Benefits: Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost ("ASU 2017-07"). ASU 2017-07 requires that an employer report a pension plan's service cost in the same line item or line items as other compensation costs arising from services rendered by pertinent employees during the period. ASU 2017-07 also requires that other components of net benefit cost be presented in the income statement separately from the service cost component. If a separate line item or items are not used, the line item or items used in the income statement to present the other components of net benefit cost must be disclosed. ASU 2017-07 was effective for annual periods beginning after December 15, 2017, including interim periods within those annual periods, with early adoption permitted at the beginning of an annual period. We adopted ASU 2017-07 in the first quarter of 2018, but it had no impact on us as our pension plan was frozen as of March 2016 and we have therefore ceased accruing additional service fee costs since that time.
ASU 2018-02 allows a one-time reclassification from AOCI to retained earnings for the stranded tax assets that were created in
AOCI from the enactment of the Tax Cuts and Jobs Act of 2017 ("Tax Reform"). We adopted ASU 2018-02 in the first quarter
The FASB has issued new leasing guidance through ASU 2016-02, Leases, which was issued in February 2016, as well as
additional implementation guidance that was issued in 2018 (collectively referred to as "ASU 2016-02"). ASU 2016-02
requires all lessees to recognize assets and liabilities on their balance sheets for the rights and obligations created by leases with
or contain, leases; (ii) lease classification for existing leases; and (iii) initial direct costs for existing leases. Additionally, we plan to adopt accounting policy elections to: (i) aggregate lease and non-lease components of a contract into a single lease component; and (ii) expense short-term leases on a straight-line basis over the lease term. We will be adopting ASU 2016-02 effective January 1, 2019 with a cumulative-effect adjustment to the opening balance of retained earnings as of that date. We do not anticipate the impact of this guidance to be material to our financial condition or results of operations, as operating lease right-of-use assets are expected to be approximately $21 million at transition with related lease liabilities of approximately $20 million. The differential of $1 million will be recognized, on an after-tax basis, as a cumulative-effect adjustment to the opening balance of 2019 retained earnings. Financing lease right-of-use assets and the related lease liabilities are expected to be approximately $1 million as of January 1, 2019.
In June 2018, the FASB issued ASU 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to
Nonemployee Share-Based Payment Accounting ("ASU 2018-07"). The amendments in ASU 2018-07 expand the scope of
effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is
measurements. The modifications removed the following disclosure requirements: (i) the amount of, and reasons for, transfers
between Level 1 and Level 2 of the fair value hierarchy; (ii) the policy for timing of transfers between levels; and (iii) the
In August 2018, the FASB issued ASU 2018-14, Compensation - Retirement Benefits - Defined Benefit Plans - General:
modifies the disclosure requirements for employers that sponsor defined benefit pension or other postretirement plans. These
for significant gains or losses related to changes in the benefit obligation for the period. This update is effective for fiscal years
Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract (“ASU
2018-15”). ASU 2018-15 aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that
is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use
Supplemental cash flow information for the years ended December 31, 2018, 2017, and 2016 is as follows:
Amounts included in restricted cash represent cash received from the NFIP, which is restricted to pay flood claims under the Write Your Own Program.
(e) Fixed income securities at December 31, 2018, by contractual maturity are shown below. Mortgage-backed securities are included in the maturity tables using the estimated average life of each security. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
We have reviewed various investments included in the table above and have concluded that they are VIEs, but that we are not the primary beneficiary and therefore, consolidation is not required. We do not have a future obligation to fund losses or debts on behalf of these investments; however, we are contractually committed to make additional investments up to the remaining commitment outlined above. We have not provided any non-contractual financial support at any time during 2018 or 2017.
Our alternative investment strategies generally employ low or moderate levels of leverage and may use hedging to reduce foreign exchange or interest rate volatility. At this time, our alternative investment strategies do not include hedge funds. We typically cannot redeem our investments with the general partners of these investments; however, occasionally these partnerships can be traded on the secondary market. Once liquidation is triggered by clauses within the limited partnership agreements or at the funds’ stated end date, we will receive our final allocation of capital and any earned appreciation of the underlying investments, assuming we have not divested ourselves of our partnership interests prior to that time. We currently receive distributions from these alternative investments through the realization of the underlying investments or income generated in the limited partnerships.
The following tables set forth summarized financial information for our other investments portfolio, including the portion not owned by us. The investments are carried under the equity method of accounting. The last line in the income statement information table below reflects our share of the aggregate income, which is the portion included in our Financial Statements. As the majority of these investments report results to us on a one quarter lag, the summarized financial statement information is as of, and for the 12-month period ended, September 30:
(h) We have pledged certain AFS fixed income securities as collateral related to our relationships with the Federal Home Loan Bank of Indianapolis ("FHLBI") and the Federal Home Loan Bank of New York ("FHLBNY"). In addition, certain securities were on deposit with various state and regulatory agencies at December 31, 2018 to comply with insurance laws. We retain all rights regarding all securities pledged as collateral.
The components of net realized (losses) gains on disposals were as follows:
2017: Higher trading volume in our fixed income securities portfolio related to a more active external investment management approach and opportunistic sales in our equity portfolio.
(b) The balances of, and changes in, each component of AOCI (net of taxes) as of December 31, 2018 and 2017 were as follows:
1 Upon adoption of ASU 2016-01 and ASU 2018-02 in the first quarter of 2018, we recognized a $25.0 million cumulative-effect adjustment to the opening balance of AOCI, which represents the after-tax net unrealized gain on our equity portfolio as of December 31, 2017 and the one-time reclassification from AOCI to retained earnings for the stranded tax assets that were created in AOCI from the enactment of Tax Reform. See Note 3. "Adoption of Accounting Pronouncements" above for additional information.
1There were no transfers of securities between Level 1 and Level 2.
The following table provides a summary of the changes in the fair value of securities measured using Level 3 inputs and related quantitative information during 2018:
The following table represents our total reinsurance balances segregated by reinsurer to illustrate our concentration of risk throughout our reinsurance portfolio:
(a) The table below provides a roll forward of reserves for loss and loss expense for beginning and ending reserve balances:
Our net loss and loss expense reserves increased by $171.1 million in 2018, $104.9 million in 2017, and $113.8 million in 2016. The loss and loss expense reserves are net of anticipated recoveries for salvage and subrogation claims, which amounted to $67.7 million for 2018, $64.8 million for 2017, and $64.9 million for 2016. The increase in net loss and loss expense reserves in 2018 was primarily driven by increases in: (i) current year loss costs on our commercial automobile line of business; and (ii) exposure due to premium growth. This increase was partially offset by favorable prior year loss development, largely driven by the workers compensation and general liability lines of business.
The Insurance Subsidiaries had $29.9 million of favorable prior accident year development during 2018, which included $41.5 million of net favorable casualty development and $11.6 million of unfavorable property development. The net favorable casualty reserve development was largely driven by the workers compensation and general liability lines of business. Partially offsetting this net favorable development was $37.5 million of unfavorable casualty development in the commercial auto line of business. In addition, our E&S casualty lines experienced unfavorable development of $12.0 million in 2018.
The majority of the 2017 net favorable development was attributable to accident years 2014 and prior, driven by the general liability and workers compensation lines of business. This net favorable development was partially offset by unfavorable development in accident years 2015 and 2016 attributable to our commercial auto and E&S casualty lines of business. The unfavorable development in our commercial auto line of business was driven primarily by bodily injury liability for accident years 2012 through 2016, driven by higher than expected frequency and severity.
(b) Reserves established for liability insurance include exposure to asbestos and environmental claims. These claims have arisen primarily from insured exposures in municipal government, small non-manufacturing commercial risk, and homeowners policies.
The emergence of these claims is slow and highly unpredictable. There are significant uncertainties in estimating our exposure to asbestos and environmental claims (for both case and IBNR reserves) resulting from lack of relevant historical data, the delayed and inconsistent reporting patterns associated with these claims, and uncertainty as to the number and identity of claimants and complex legal and coverage issues. Legal issues that arise in asbestos and environmental cases include federal or state venue, choice of law, causation, admissibility of evidence, allocation of damages and contribution among joint defendants, successor and predecessor liability, and whether direct action against insurers can be maintained. Coverage issues that arise in asbestos and environmental cases include the interpretation and application of policy exclusions, the determination and calculation of policy limits, the determination of the ultimate amount of a loss, the extent to which a loss is covered by a policy, if at all, the obligation of an insurer to defend a claim, and the extent to which a party can prove the existence of coverage. Courts have reached different and sometimes inconsistent conclusions on these legal and coverage issues. We do not discount to present value that portion of our loss and loss expense reserves expected to be paid in future periods.
Reserves for asbestos and environmental claims are highly uncertain. There are significant uncertainties associated with estimating critical assumptions, such as average clean-up costs, third-party costs, potentially responsible party shares, allocation of damages, litigation and coverage costs, and potential state and federal legislative changes. Estimating IBNR is challenging because of the delayed and inconsistent reporting patterns associated with these claims. Traditional actuarial approaches cannot be applied because past loss history is not necessarily indicative of future behavior. While certain alternative projection models can be applied, such models can produce significantly different results with small changes in assumptions. As a result, reserves for asbestos and environmental require a high degree of judgment. Because of the significant uncertainty in the estimate, we do not calculate an asbestos and environmental loss range.
Historically, our asbestos and environmental claims have been significantly lower in volume than many other standard commercial lines carriers since, prior to the introduction of the absolute pollution exclusion endorsement in the mid-1980’s, we were primarily a Standard Personal Lines carrier and therefore do not have broad exposure to asbestos and environmental claims.
The following table provides a roll forward of gross and net asbestos and environmental incurred loss and loss expense and related reserves thereon:
(c) The following is information about incurred and paid claims development as of December 31, 2018, net of reinsurance, as well as cumulative claim frequency and the total of IBNR liabilities. During the experience period, we implemented a series of claims-related initiatives and claims management changes. These initiatives focused on claims handling and reserving, medical claims costs, and loss expenses. As a result of these initiatives, several historical patterns have changed and may no longer be appropriate to use as the sole basis for projections.
In 2011, the Parent purchased Mesa Underwriters Specialty Insurance Company ("MUSIC"), a wholly-owned E&S Lines subsidiary of Montpelier Re Holdings, Ltd. Under the terms of the purchase agreement, the Parent acquired net loss and loss reserves amounting to approximately $15 million. All development on this acquired business was fully reinsured as of the acquisition date.
(e) The table below reflects the historical average annual percentage payout of incurred claims by age. For example, the general liability line of business averages payout of 6.5% of its ultimate losses in the first year, 12.2% in the second year, and so forth. The following is supplementary information about average historical claims duration as of December 31, 2018:
1 Beginning on January 1, 2019, finance lease obligations will also be included in our outstanding debt balance upon the adoption of the new lease accounting standard. For further information, refer to Note 3. "Adoption of Accounting Pronouncements, above.
(1) In the first quarter of 2009, Selective Insurance Company of South Carolina ("SICSC") and Selective Insurance Company of the Southeast ("SICSE"), which are collectively referred to as the "Indiana Subsidiaries" as they are domiciled in Indiana, joined, and invested in, the FHLBI, which provides them with access to additional liquidity. The Indiana Subsidiaries’ aggregate investment in the FHLBI was $2.8 million at December 31, 2018 and December 31, 2017. Our investment provides us the ability to borrow approximately 20 times the total amount of the FHLBI common stock purchased with additional collateral, at comparatively low borrowing rates. The proceeds from the FHLBI borrowing on December 16, 2016 of $60 million were used to repay a $45 million borrowing from the FHLBI that was outstanding at the time, with the remaining $15 million used for general corporate purposes. All borrowings from the FHLBI require security. For information on investments that are pledged as collateral for these borrowings, see Note 5. "Investments" above.
(4) In November 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%. Net proceeds of approximately $50 million were used to fund an irrevocable trust that subsequently funded certain payment obligations in respect of our outstanding debt. The remainder of the proceeds was 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 financial debt covenants to which we are required to comply in regards to these notes.
(5) In November 2004, we issued $50 million of 7.25% Senior Notes due 2034. These notes were issued at a discount of $0.1 million, resulting in an effective yield of 7.27%. We contributed $25 million of the bond proceeds to the Insurance Subsidiaries as capital. The remainder of the proceeds was used for general corporate purposes. The agreements covering these notes contain a standard default cross-acceleration provision that provides the 7.25% 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 7.25% Senior Notes. There are no financial debt covenants to which we are required to comply in regards to these notes.
(a) On December 22, 2017, the Tax Cuts and Jobs Act of 2017 ("Tax Reform") was signed into law, which among other implications, reduced our statutory corporate tax rate from 35% to 21% beginning with our 2018 tax year. We revalued our deferred tax inventory at December 31, 2017 to reflect this reduction, which resulted in a $20.2 million charge to income as illustrated in the rate table below.
In the fourth quarter of 2018, the IRS published the loss reserve discount factors to be used for calculating the beginning and ending 2018 discounted loss reserves under the industry experience approach. Based on these factors, we calculated a pre-tax decrease to our discounted loss reserves of $125 million, which resulted in a deferred tax asset of $26.3 million, an increase from the $7.5 million estimate described above. The $26.3 million adjustment is being taken into income over eight years, beginning with 2018, at approximately $3.3 million per year.
(b) A reconciliation of federal income tax on income at the corporate rate to the effective tax rate is as follows:
SICA offers a non-qualified deferred compensation plan, the Selective Insurance Company of America Deferred Compensation Plan ("Deferred Compensation Plan") to a group of management or highly compensated employees as a method of recognizing and retaining such employees. The Deferred Compensation Plan provides these employees the opportunity to elect to defer receipt of specified portions of compensation and to have such deferred amounts deemed to be invested in specified investment options. In addition to the employee deferrals, SICA may choose to make matching contributions to some or all of the participants in this plan to the extent the participant did not receive the maximum matching or non-elective contributions permissible under the Retirement Savings Plan due to limitations under the Internal Revenue Code or the Retirement Savings Plan. Expense recorded for these contributions was $0.4 million in 2018, $0.2 million in 2017, and $0.3 million in 2016.
Our latest measurement date was December 31, 2018, at which time we increased our expected return on plan assets to 6.50%, reflecting a higher expected allocation to risk-seeking assets in the portfolio.
Assets of the Pension Plan are invested to adequately support the liability associated with the Pension Plan's defined benefit obligation. Our return objective is to exceed the returns of the plan's policy benchmark, which is the return the plan would have earned if the assets were invested according to the target asset class weightings and earned index returns shown below. In 2019, we will continue to phase in adjustments to the asset allocation to steadily close the gap between the duration of the assets and the duration of the liabilities, provided certain improved funding targets are achieved. Over time, the target and actual asset allocations may change based on the funded status of the Pension Plan and market return expectations.
3The actual percentage of assets allocated to short-term investments is higher than our target as of December 31, 2018 due to portfolio rebalancing initiatives that are expected to be completed during 2019. As part of this rebalancing initiative, $49 million, or 15%, of plan assets were redeployed into risk seeking assets in January 2019. Excluding the impact of this redeployment, our short-term investments represented 5% of plan assets at December 31, 2018.
The use of derivative instruments is permitted under certain circumstances for the Pension Plan portfolio, but may not be used for unrelated speculative purposes or to create exposures that are not permitted in the Pension Plan's investment guidelines. Within the liability hedging assets, derivatives may be used to mitigate interest rate risk and reduce the interest duration mismatch between assets and liabilities of the Pension Plan to help insulate the funded status of the plan. We currently invest in a U.S. Treasury overlay derivative strategy, within the funds in our liability hedging assets, to manage the interest rate duration mismatch between the assets and liabilities of the Pension Plan. Considering the impact of this derivative overlay, the liability hedging assets provide for an approximate 50% hedge against the projected benefit obligation.
The techniques used to determine the fair value of the Pension Plan's invested assets that appear on the following page are as follows:
The Pension Plan invests in hedge funds, as part of its overall private asset strategy, with diversified exposure to a number of underlying systematic strategies that include arbitrage, macro-oriented, and equity-related strategies. These positions are expected to improve the risk-adjusted return of the portfolio given their lower volatility profile than public equities, with returns that are generally uncorrelated to traditional asset classes over a complete market cycle.
As of December 31, 2018, the following four plans were available for the issuance of share-based payment awards:
The Cash Incentive Plan, As Amended and Restated as of May 1, 2014 (the "Cash Plan");
Shares authorized and available for issuance as of December 31, 2018 are as follows:
1Awards outstanding under the 2005 Stock Plan consisted of 47,268 shares deferred by our non-employee directors and 126,735 stock options.
As of December 31, 2018, total unrecognized compensation expense related to unvested RSU awards granted under our Stock Plan was $11.0 million. That expense is expected to be recognized over a weighted-average period of 1.7 years. The total intrinsic value of RSUs vested was $18.0 million for 2018, $16.0 million for 2017, and $12.6 million for 2016. In connection with vested RSUs, the total value of the DEUs that vested was $0.8 million in 2018, $0.9 million in 2017, and $0.7 million in 2016.
The liability recorded in connection with our Cash Plan was $21.6 million at December 31, 2018 and $37.0 million at December 31, 2017. The remaining cost associated with the CIUs is expected to be recognized over a weighted average period of 0.8 years. The CIU payments made were $20.2 million in 2018, $14.2 million in 2017, and $14.3 million in 2016.
The weighted-average fair value of options and stock per share, including RSUs granted for the Parent's stock plans, during 2018, 2017, and 2016 was as follows:
Rue Insurance placed insurance policies with the Insurance Subsidiaries for its customers and itself. Direct premiums written associated with these policies were $10.1 million in 2018, $11.1 million in 2017, and $10.4 million in 2016. In return, the Insurance Subsidiaries paid standard market commissions, including supplemental commissions, to Rue Insurance of $2.1 million in 2018, $2.3 million in 2017, and $2.1 million in 2016. Amounts due to Rue Insurance at December 31, 2018 and December 31, 2017 were $0.4 million and $0.6 million, respectively. All contracts and transactions with Rue Insurance were consummated in the ordinary course of business on an arm's-length basis.
As part of our overall investment diversification, we invest in various BlackRock funds from time to time. The market value of these investments were $0.8 million at December 31, 2018, and $0.5 million at both December 31, 2017 and December 31, 2016. There were no material transactions related to these holdings in 2018 and 2017. During 2016, we sold $77.6 million of these investments, which resulted in a $1.1 million gain on our investment portfolio. In addition, we recorded $2.3 million of investment income on these funds in 2016. There were no amounts payable on the settlement of these investment transactions at December 31, 2018 or December 31, 2017.
We are required to disclose related party information for our transactions with Vanguard. As part of our overall investment diversification, we may invest in various Vanguard funds from time to time. During 2018, we purchased $11.5 million in a Vanguard ETF and recorded dividend income of $0.4 million, with no amounts payable on the settlement of this transaction at December 31, 2018. The market value of this fund in our investment portfolio at December 31, 2018 was $10.5 million. There were no transactions with Vanguard in 2017 and 2016.
In addition, certain of these leases are non-cancelable, and liability for payment will continue even though the leased asset may no longer be in use. At December 31, 2018, the total future minimum rental commitments under non-cancelable leases were as follows:
In the ordinary course of conducting business, we are named as defendants in various legal proceedings. Most of these proceedings are claims litigation involving our Insurance Subsidiaries as either: (i) liability insurers defending or providing indemnity for third-party claims brought against our customers; or (ii) insurers defending first-party coverage claims brought against them. We account for such activity through the establishment of unpaid loss and loss expense reserves. We expect that any potential ultimate liability in such ordinary course claims litigation will not be material to our consolidated financial condition, results of operations, or cash flows after consideration of provisions made for potential losses and costs of defense.
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 affect the determination of statutory surplus, statutory net income, or risk-based capital (“RBC”). As of December 31, 2018, the various state insurance departments of domicile have adopted the March 2018 version of the NAIC Accounting Practices and Procedures manual in its entirety, as a component of prescribed or permitted practices.
In addition to regulatory restrictions on the availability of dividends that our Insurance Subsidiaries can pay to the Parent, the maximum amount of dividends the Parent can pay our shareholders is limited by certain New Jersey corporate law provisions that limit dividends if either: (i) the Parent would be unable to pay its debts as they became due in the usual course of business; or (ii) the Parent’s total assets would be less than its total liabilities. The Parent’s ability to pay dividends to shareholders also are impacted by covenants in its Line of Credit agreement that obligate it, among other things, to maintain a minimum consolidated net worth, statutory surplus, and debt-to-capital ratio.
The table below provides the following information: (i) quantitative data regarding all Insurance Subsidiaries' dividends paid to the Parent in 2018 for debt service, shareholder dividends, and general operating purposes; and (ii) the maximum ordinary dividends that can be paid to the Parent by the Insurance Subsidiaries in 2019, based on the 2018 statutory financial statements.
1Results for the fourth quarter of 2017 include the impact of the $20.2 million write off of deferred tax assets required with the implementation of Tax Reform. See Note 13. "Federal Income Taxes" above for additional information.