Our main office is located in Branchville, New Jersey, on a site owned by a subsidiary with approximately 114 acres and 315,000 square feet of operational space. We lease all of our other facilities. The principal office locations related to our two business segments are described in the “Field Strategy,” and “Investments Segment,” sections of Item 1. “Business.” We believe our facilities provide adequate space for our present needs and that additional space, if needed, would be available on reasonable terms.
of this Form 10-K for a reconciliation of operating income to net income.
In 2002, we sold our ownership interest in PDA Software Services, Inc., in 2005, we sold our ownership interest in CHN Solutions (Alta Services, LLC and Consumer Health Network Plus, LLC), and in 2009, we sold our ownership interest in Selective HR.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Factors that could cause our actual results to differ materially from those we have projected, forecasted or estimated in forward-looking statements are discussed in further detail in Item 1A. “Risk Factors.” These risk factors may not be exhaustive. We operate in a continually changing business environment, and new risk factors emerge from time-to-time. We can neither predict such new risk factors nor can we assess the impact, if any, of such new risk factors on our businesses or the extent to which any factor or combination of factors may cause actual results to differ materially from those expressed or implied in any forward-looking statements in this report. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report might not occur.
We have identified the policies and estimates described below as critical to our business operations and the understanding of the results of our operations. 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. Those estimates that were most critical to the preparation of the Consolidated Financial Statements involved the following: (i) reserve for losses and loss expenses; (ii) deferred policy acquisition costs; (iii) pension and post-retirement benefit plan actuarial assumptions; (iv) OTTI; and (v) reinsurance.
At December 31, 2009, our general liability line of business had recorded reserves, net of reinsurance of $948 million, which represented 38% of our total net reserves. This line of business includes excess policies which provide additional limits above underlying automobile and general liability coverages. While prior year development in recent years has been relatively minor, we have been growing the number of our commercial excess policies at a greater rate than the rest of our commercial lines of business which could create additional volatility in our results. In 2008 and 2009, we have lowered the net retention of our reinsurance covering these policies, which should mitigate some of the potential volatility.
At December 31, 2009, our personal automobile line of business had recorded reserves, net of reinsurance, of $138 million, which represented 6% of our total net reserves. The majority of the reserves are from business written in New Jersey, where the judicial and regulatory environment has been subject to significant changes over the past few decades. Over the past several years we have been decreasing the amount of business written in New Jersey while increasing the amount of business written in other states. We review the reserves for states other than New Jersey on a combined basis so that there is a sufficient volume of data to ensure statistical credibility. However, the state mix changes over time. Both the change in state mix and the change in the New Jersey judicial and regulatory environment increases the uncertainty surrounding our personal automobile reserves since much of the historical information used to make assumptions has been rendered less effective as a basis for projecting future results.
We established a range of reasonably possible reserves for net claims of approximately $2,312 million to $2,608 million at December 31, 2009 and $2,267 million to $2,545 million at December 31, 2008. A low and high reasonable reserve selection was derived primarily by considering the range of indications calculated using generally accepted actuarial techniques. Such techniques assume that past experience, adjusted for the effects of current developments and anticipated trends, are an appropriate basis for predicting future events. Although this range reflects likely scenarios, it is possible that the final outcomes may fall above or below these amounts. Based on internal stochastic modeling, we feel that a reasonable estimate of the likelihood that the final outcome falls within the current range is approximately 78%. This range does not include a provision for potential increases or decreases associated with environmental reserves. Our best estimate is consistent with the actuarial best estimate. We do not discount to present value that portion of our loss reserves expected to be paid in future periods; however, the loss reserves take into account anticipated recoveries for salvage and subrogation claims.
In addition to the normal amount of volatility, the combination of the sensitivity of workers compensation results to medical inflation, economic conditions including unemployment, and changes in underwriting could lead to actual experience emerging differently than the assumptions used in the process to establish reserves. In our judgment, it is possible that actual medical loss development factors could range from 6% below to 9% above those selected in our latest reserve analysis and expected loss ratios could range from 5% below to 8% above those selected in our latest reserve analysis. The combination of reducing the assumptions for medical loss development by 6% and the expected loss ratio by 5% could decrease our indicated workers compensation reserves by approximately $63 million for accident years 2008 and prior. Alternatively, the combination of increasing the medical loss development factors by 9% and the expected loss ratio by 8% could increase our indicated workers compensations reserves by approximately $101 million for accident years 2008 and prior.
3 The net survival ratio was calculated using a three-year average for the net losses and expenses paid.
Annually we perform a focused review on all of our asbestos claims with our defense counsel, confirming our participation in the claims and the number of claims that were open. During the 2009 review, coupled with a focused effort on resolving certain claims, a significant number of claim files were closed.
Policy acquisition costs, which include commissions, premium taxes, fees, and certain other costs of underwriting policies, are deferred and amortized over the same period in which the related premiums are earned. Deferred policy acquisition costs are limited to the estimated amounts recoverable after providing for losses and loss expenses that are expected to be incurred, based upon historical and current experience. Anticipated investment income is considered in determining whether a premium deficiency exists. The methods of making such estimates and establishing the deferred costs are continually reviewed, and any adjustments are made in the accounting period in which the adjustment arose.
Our pension and post-retirement life benefit obligations and related costs are calculated using actuarial methods, within the framework of U.S. generally accepted accounting principles. Two key assumptions, the discount rate and the expected return on plan assets, are important elements of expense and/or liability measurement. We evaluate these key assumptions annually. Other assumptions involve demographic factors such as retirement age, mortality, turnover, and rate of compensation increases.
In 2009, the financial markets experienced some degree of recovery which was reflected in the 19% increase in our pension assets, ending the year at $139.7 million up from $117.3 million at the end of 2008. Volatility in the marketplace, coupled with changes in the discount rate assumption could materially impact our pension valuation in the future.
Evaluation of projected cash flows under various economic and default scenarios;
In order to determine if an impairment is other than temporary, we perform additional impairment assessments for our fixed maturity portfolio including, but not limited to commercial mortgage-backed securities (“CMBS”), residential mortgage-backed securities (“RMBS”), asset-backed securities (“ABS”), collateralized debt obligations (“CDOs”), and corporate debt securities. This assessment takes into consideration the length of time for which the security has been in an unrealized loss position, but primarily focuses on evaluation of future cash flows, which involves subjective judgments and estimates determined by management including: performance of the underlying collateral under various economic and default scenarios, the nature and realizable value of such collateral, and the ability of the security to make scheduled payments.
The discount rate we use in this present value calculation is the effective interest rate implicit in the security at the date of acquisition for those structured securities 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.
We use a conditional default rate assumption in the present value calculation to estimate future defaults. The conditional default rate is the proportion of all loans outstanding in a security at the beginning of a time period that is expected to default during that period. Our assumption of this rate takes into consideration the uncertainty of future defaults as well as whether or not these securities have experienced significant cumulative losses or delinquencies to date. We use the conditional default rates used during our initial cash flow testing for each security as a reference point, but we may ultimately use rates at more elevated levels in the discounted cash flow analysis in order to determine our best estimate of the present value of future cash flows.
Conditional default rate assumptions apply at the total collateral pool level held in the securitization trust. Generally, collateral conditional default rates will “ramp-up” over time as the collateral seasons, the performance begins to weaken and losses begin to surface. As time passes, depending on the collateral type and vintage, losses will peak and performance will begin to improve as weaker borrowers are removed from the pool through delinquency resolutions. In the later years of a collateral pool’s life, performance is generally materially better as the resulting favorable selection of the portfolio improves the overall quality and performance. While “ramped up” assumptions are sometimes used in our discounted cash flow analysis of our CMBS portfolio, we typically apply a more conservative approach and do not apply a “ramp” of our conditional default rate assumptions in our initial evaluations. Instead, we assume the cash flows for the next period will experience defaults at the higher end of the range and then remain at that level for the life of the position, due to the current uncertainty surrounding the magnitude of potential future defaults on CMBS.
Applying an estimated loss on exposure percentage to the current loan-to-value ratio of a particular security; or
Evaluation for OTTI of an equity security, includes, but is not limited to, the evaluation of the following factors:
Reinsurance recoverables on paid and unpaid losses and loss expenses represent estimates of the portion of such liabilities that will be recovered from reinsurers. Each reinsurance contract is analyzed to ensure that the transfer of risk exists to properly record the transactions in the financial statements. Amounts recovered from reinsurers are recognized as assets at the same time and in a manner consistent with the paid and unpaid losses associated with the reinsurance policies. An allowance for estimated uncollectible reinsurance is recorded based on an evaluation of balances due from reinsurers and other available information. This allowance totaled $2.5 million at December 31, 2009 and December 31, 2008. We continually monitor developments that may impact recoverability from our reinsurers and have available to us contractually provided remedies if necessary. For further information regarding reinsurance, see Note 8. “Reinsurance” in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
Pre-tax net investment income earned decreased $12.6 million, to $118.5 million, in 2009 and $43.1 million, to $131.0 million, in 2008. The decrease from 2008 to 2009 was driven by: (i) an increase in losses of $9.1 million on our alternative investments; (ii) a decrease in interest income of approximately $7.7 million on our fixed maturity and short-term investment portfolios due to lower purchase yields; and (iii) lower dividend income of $3.3 million due to our reduced equity portfolio. Although our alternative investments began stabilizing in the second half of 2009, these losses, which amounted to $21.7 million on a pre-tax basis, were driven by the unprecedented volatility in the global capital markets that occurred during the second half of 2008 and continued through the first half of 2009. This volatility resulted in a decline in asset values, of which 57% was attributable to our real estate strategy and 30% was attributable to our private equity/private equity secondary market strategies. Our alternative investments, which are accounted for under the equity method, primarily consist of investments in limited partnerships that primarily report results to us on a one quarter lag. For additional information on our other investment portfolio and a discussion of the related strategies associated with this portfolio, refer to the “Investments” section below. This was partially offset by offset by the effect of the elimination of our trading portfolio in the first quarter of 2009. During 2008, unrealized losses of $8.1 million on the trading portfolio negatively impacted investment income.
Net realized losses, pre-tax, were $46.0 million in 2009 compared to a pre-tax loss of $49.5 million in 2008 and a pre-tax gain of $33.4 million in 2007. The level of net realized losses experienced in 2009 and 2008 were driven by pre-tax non-cash OTTI charges of $55.4 million and $53.1 million, respectively. For details regarding these charges see Note 5. “Investments” in Item. 8 “Financial Statements and Supplementary Data.” of this Form 10-K or “Investments” below.
Also included in net income are the results of the discontinuance of our Human Resources Outsourcing segment. We entered into a plan to dispose of Selective HR Solutions, Inc. in the third quarter of 2009, the sale of which was finalized with an after-tax loss on disposal of $1.2 million in the fourth quarter of 2009. The after-tax loss on the operating results of Selective HR Solutions, Inc. of $7.1 million for 2009 is primarily due to an after-tax goodwill impairment charge in the third quarter of 2009 of $7.9 million, resulting from our near-term projections for this segment not being sufficient to support its carrying value. A similar impairment charge of $2.6 million was recorded in 2008 for this segment. See Note 13 “Discontinued Operations” in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K for additional information.
On a pre-tax basis, operating income was $85.2 million in 2009, $89.6 million in 2008, and $155.4 million in 2007. The decrease in operating income is primarily attributable to the decrease in net investment income as discussed above. Refer to Exhibit 99.1 of this Form 10-K for a definition of operating income.
Despite 2009 being the first year since 2004 that we were able to achieve a Commercial Lines renewal pure price increase, which was 0.9%, NPW still decreased compared to 2008 primarily due to economic conditions. We have experienced the most significant NPW decreases in our workers compensation and general liability lines of businesses driven by reduced levels of exposure given the reduction in payroll and sales of our insureds, which is reflective of the current unemployment level resulting from the economic slowdown. These factors are evidenced by the following:
Reductions in net renewals of $19.4 million, to $1.2 billion including a reduction in Commercial Lines retention of one point to 76% in 2009.
The decrease in 2008 compared to 2007 was also largely attributable to economic factors of which were illustrated in our audit and endorsement return premium of $22.3 million in 2008 compared to additional audit and endorsement premiums of $15.8 million in 2007. Also contributing to the decline in 2008 was a decline in new business and Commercial Lines renewal pure pricing decrease of 3.1% as compared to 2009 wherein we experienced positive Commercial Lines renewal pure pricing of 0.9%. New business in 2009 was up 3% and was driven by growth in Personal Lines.
The increase in the GAAP loss and loss expense ratio in 2009 compared to 2008 was primarily attributable to casualty loss costs that have outpaced premiums in the current accident year, coupled with non-catastrophe property losses that were $205.4 million, or 14.4 points, compared to $192.2 million, or 12.8 points, in 2008. Partially offsetting these increases were:
Decreases in the GAAP underwriting expense ratio in 2009 were primarily attributable to several expense initiatives implemented in 2008 and during the first quarter of 2009. These initiatives included, but were not limited to:
The re-domestication of two of the Insurance Subsidiaries to Indiana in June 2008;
Partially offsetting these actions is the impact of reduced NPE and corresponding impact it has had on the expense ratio.
The GAAP underwriting expense ratio increased in 2008 compared to 2007 primarily as the result of the pre-tax workforce restructuring charge of $4.5 million discussed above. Absent this charge, the expense ratio remained relatively flat, reflecting a 1% decrease in NPE partially offset by lower overall underwriting expenses year over year. These reduced expenses were the result of lower than expected payments of profit-based incentives to our agents and employees, reflecting lower NPW and underwriting results during 2008, and benefits realized from our 2008 cost containment initiatives discussed above.
We continued to see a trend toward higher Commercial Lines and Personal Lines pricing in our Insurance Operations segment. The Commercial Lines Insurance Pricing Survey (“CLIPS”) third quarter 2009 report indicated that industry pricing remained flat during the quarter whereas we experienced a pure price increase over that period of 1.5%. Fitch has indicated that the industry is now solidly entrenched in the soft phase of the market cycle and that a material improvement in pricing does not appear imminent. In this light, the price increase of 2.7% we obtained during the fourth quarter of 2009, the largest quarterly price increase of 2009, and the overall 2009 pure price increase of 0.9%, both achieved while maintaining a delicate balance with retention, demonstrates the overall strength of the relationships that we have with our independent agents, even in difficult economic and competitive times. As for our Personal Lines operations, we have seen an increase in 2009 NPW driven by: (i) 28 rate increases that went into effect during 2009; (ii) new business premium increases of $11.8 million; and (iii) net renewal premium increases of $5.1 million.
Claims Strategic Program underway with a focus on enhancing areas of: (i) workers compensation best practices and targeted case management; (ii) litigation management; (iii) enhanced potential fraud and recovery recognition through use of advanced systems analytics; (iv) advanced claims automation; and (v) enhanced vendor management. We believe that these initiatives will allow us to maintain our reputation for superior claims service while enabling us to leverage our current resources to increase the effectiveness and efficiency of the claims area.
Expense management initiatives over the past year, which include the elimination of retiree life insurance benefits for current employees and ongoing controlled hiring practices, along with several initiatives taken in 2008, such as our workforce reduction initiatives, changes to agent commission programs, and the re-domestication of two of the Insurance Subsidiaries to Indiana. These expense management initiatives served to benefit our expense ratio this year, and the ongoing impact of these initiatives will continue to benefit expenses going forward.
Technology that allows agents and our field teams to input business seamlessly into our systems, including our One & Done® small business system and our xSELerate® straight-through processing system. Average premiums of approximately $294,000 per workday were processed through our One & Done® small business system during 2009, up 7% from 2008. These technology-based systems complement our existing underwriting group, giving them more time to focus on more technical underwriting accounts.
Strategically expanding our business in our footprint states, including Tennessee, where we began operations in June 2008. In the first full year of operations in this state, we wrote premium of approximately $14.6 million.
Fitch Ratings (“Fitch”) - In Fitch’s “Review and Outlook 2009-2010” December 2009 report, they are maintaining the negative outlook over the next 12 to 18 months, reflecting lingering economic and financial uncertainty. In addition, Fitch projects an industry-wide statutory combined ratio of 104.0% for 2010, reflecting their belief that underwriting results will not improve significantly as they project premiums will have insignificant growth. They anticipate that underwriting results will be impacted by higher expense ratios and less favorable reserve development, partially offset by a return to historical average catastrophe loss experience.
Standard & Poor’s (“S&P”) - S&P recently reiterated their negative outlook on the industry citing that the increase in cost of capital may not be able to be passed along to the insureds in its entirety, as well as the expectation that future investment returns will be relatively modest in the near term. S&P believes that rating downgrades will exceed upgrades for the industry over the next six months.
Despite 2009 being the first year since 2004 that we were able to achieve a Commercial Lines renewal pure price increase, which was 0.9%, NPW still decreased compared to 2008 primarily due to the economic recession. We have experienced the most significant decreases in our workers compensation and general liability lines of businesses due to reduced levels of exposure given the reduction in payroll and sales, which is reflective of the current unemployment level resulting from the economic slowdown. These factors are evidenced by the following:
Reductions in endorsement and audit activity of $49.5 million, to a net return premium of $72.6 million, in 2009;
The decrease in 2008 compared to 2007 was also largely due to economic factors of which were illustrated in our audit and endorsement return premium of $23.2 million in 2008 compared to additional audit and endorsement premiums of $14.5 million in 2007. Also contributing to the decline in 2008 was a decline in direct new business of $46.1 million compared to 2007 and a 3.1% decrease in renewal pure pricing.
NPE decreases in 2009 compared to 2008 and 2007 are consistent with the fluctuation in NPW discussed above. These decreases were primarily driven by a decrease in exposure coupled with premiums written in 2008, which experienced a decrease in renewal pure price of 3.1% in 2008 as mentioned above, earning in over the course of 2009.
Improvements in the GAAP underwriting expense ratio in 2009 compared to 2008 were primarily attributable to the expense initiatives that we implemented over the last couple of years as mentioned above.
In 2009, NPW on this line decreased compared to 2008, due primarily to: (i) a $26.4 million decrease in audit and endorsement activity, to a return premium of $39.9 million, reflecting the impact of the economic recession and reduced levels of exposure consistent with the current unemployment level; (ii) a $17.9 million, or 7%, decrease in net renewals; and (iii) a two point decrease in retention, to 76%, due to initiatives that have allowed us to target price increases for our worst performing business and competitive pressure from monoline carriers and competitors willing to write workers compensation policies mainly on the upper end of our middle market business and our large account business. These decreases were partially offset by a 0.6% increase in renewal pure price 2009 compared to a 2.1% decrease 2008. The decrease in NPW in 2008 compared to 2007 was driven by the aforementioned impacts on pricing and exposure due to the economic recession, which we began to experience in 2008, and the competitive marketplace.
The 1.5 point decrease in the statutory combined ratio for 2009, compared to 2008, was driven primarily by: (i) favorable casualty prior year development in 2009 of approximately $10 million, or 3.2 points, driven by lower than anticipated severity primarily in accident year 2007 compared to insignificant development in 2008; and (ii) physical damage losses that were $4.5 million, or approximately 1.2 points, lower in 2009 compared to 2008. These items were partially offset by higher estimated losses due to loss trends that have outpaced pricing.
NPW for this line of business increased in 2009 compared to 2008, while declining for 2008 compared to 2007. The increases in 2009 were primarily due to: (i) net renewal premium increases of 4%, to $171.3 million; (ii) total policy count increases of 3% in 2009; and (iii) renewal pure price increases of 0.3% in 2009 compared to decreases of 4.1% in 2008. The decrease in 2008 compared to 2007 was due to: (i) a reduction in new business premium of $2.4 million; (ii) the aforementioned renewal pure price decreases of 4.1%; and (iii) an one point reduction in retention to 76%.
The improvement in the GAAP loss and loss expense ratio in 2008 compared to 2007 is primarily driven by the 3% increase in NPE, coupled with favorable prior year development in our casualty lines of approximately $5 million, or 2.2 points, in 2008, compared to unfavorable prior year development of approximately $1 million, or 0.4 points, in 2007. The 2008 development reflected a better quality of business being written through our MATRIXSM pricing system, coupled with normal volatility, while the 2007 development included the impact of unfavorable trends in groundwater contamination caused by the leakage of certain underground oil storage tanks in our homeowners line of business. This improvement in the loss and loss expense ratio was partially offset by increases in: (i) catastrophe losses of $1.9 million to $4.7 million in 2008; and (ii) non-catastrophe property losses of $4.5 million to $56.5 million in 2008.
The higher GAAP underwriting expense ratio in 2009 compared to 2008 was primarily attributable to increased commissions resulting from the mix of premium. Additionally, although to a lesser degree, commissions on our Flood business reduced the expense ratio by 8.6 points in 2009 compared to 8.9 points in 2008. Partially offsetting these items were the expense initiatives that we implemented in 2008 and 2009, including a $0.5 million total benefit related to the elimination of retiree life insurance benefits recognized in the first quarter of 2009, combined with the $0.5 million restructuring charge in the first quarter of 2008.
We continue to assess our property catastrophe exposure aggregations, modeled results and effects of growth on our property portfolio and strive to manage our exposure to individual large events balanced against the cost of reinsurance protections.
The Property Excess of Loss treaty (“Property Treaty”) was renewed on July 1, 2009 and is effective through June 30, 2010, with the same terms as the expiring treaty. This treaty provides a per risk coverage of $28.0 million in excess of a $2.0 million retention.
The Casualty Excess of Loss treaty (“Casualty Treaty”) was renewed on July 1, 2009. The current program provides the following coverage:
The first layer provides coverage for 85% of up to $3.0 million in excess of a $2.0 million retention. The placement of this layer was increased from 65% in the expiring treaty.
Reduced our equity position from approximately $135 million at December 31, 2008 to approximately $80 million at December 31, 2009.
Reclassified approximately $1.9 billion of our fixed maturity portfolio from an AFS classification to a HTM classification. As a result of this transfer, coupled with activity during the year, our HTM portfolio has a carrying value of $1.7 billion as of December 31, 2009.
HTM fixed maturity securities are reported on the Consolidated Balance Sheets at carrying value, which represents either: (i) amortized cost reduced by unrealized non-credit OTTI amounts that are reflected in accumulated OCI; or (ii) for those securities that have been reclassified into an HTM designation, fair value at the time of transfer adjusted for subsequent accretion or amortization. AFS fixed maturity and equity securities, as well as our short-term investments are reported at fair value on the Consolidated Balance Sheets. These fair values are categorized into a three-level hierarchy, based on the priority of the inputs to the respective valuation technique. At December 31, 2009, all of our securities were priced using Level 1 or Level 2 inputs. For additional information see Note 2(e). “Summary of Significant Accounting Policies” and Note 7. “Fair Value Measurements” of Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
As mentioned above, our portfolio continues to have a weighted average credit rating of “AA+.” The following table presents the credit ratings of our fixed maturities portfolios:
We have audited the accompanying consolidated balance sheets of Selective Insurance Group, Inc. and its subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2009. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules I to V. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Selective Insurance Group, Inc.'s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 24, 2010 expressed an unqualified opinion on the effectiveness of the Company's internal control over financial reporting.
Insurance Operations, which sells property and casualty insurance products and services primarily in 22 states in the Eastern and Midwestern U.S.; and
These segments reflect a change from our historical segments of: Insurance Operations, Investments, and Diversified Insurance Services (which included federal flood insurance administrative services (“Flood”) and human resource administration outsourcing (“HR Outsourcing”)):
Certain amounts in our prior years' consolidated financial statements and related notes have been reclassified to conform to the 2009 presentation. Such reclassifications had no effect on our net income, stockholders' equity, or cash flows.
Fixed maturity securities may include bonds, redeemable preferred stocks, and mortgage and asset-backed securities. Fixed maturity securities classified as available-for-sale are reported at fair value. Those fixed maturity securities that we have the ability and positive intent to hold to maturity are classified as held-to-maturity (“HTM”) and are carried at either: (i) amortized cost; or (ii) market value at date of transfer into the HTM category, adjusted for subsequent amortization. The amortized cost of fixed maturity securities is adjusted for amortization of premiums and accretion of discounts over the expected life of the security using the effective interest method. Premiums and discounts arising from the purchase of mortgage-backed securities are amortized over the expected life of the security based on future principal payments, and considering prepayments. These prepayments are estimated based upon 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 also adjusted to reflect the revised assumptions. Interest income, as well as amortization and accretion, is included in "Net investment income earned" on our Consolidated Statements of Income. The carrying value of fixed maturity securities is written down to fair value when a decline in value is considered to be other than temporary. See the discussion below on realized investment gains and losses for a description of the accounting for impairments. Unrealized gains and losses on fixed maturities classified as available-for-sale, net of tax are included in accumulated other comprehensive income (loss) ("AOCI").
Short-term investments may include certain money market instruments, savings accounts, commercial paper, other debt issues purchased with a maturity of less than one year, and variable rate demand notes. These investments are carried at cost, which approximates fair value. The associated income is included in "Net investment income earned."
Other investments may include alternative investments and other miscellaneous securities. Alternative investments are accounted for using the equity method. Our share of distributed and undistributed net income from alternative investments is included in "Net investment income earned." Investments in other miscellaneous securities are generally carried at estimated fair value, because our interests are so minor that we exercise virtually no influence over operating and financial policies of the investees. Our distributed share of net income from other miscellaneous investments is included in "Net investment income earned." Any changes in estimated fair value associated with these other miscellaneous investments are recorded as an unrealized gain or loss, of which these items, net of tax, are included in AOCI.
When the fair value of any investment is lower than its cost/amortized cost, an assessment is made to determine if the decline is other than temporary. We regularly review our entire investment portfolio for declines in fair value. If we believe that a decline in the value of an available-for-sale (“AFS”) security is temporary, we record the decline as an unrealized loss in AOCI. Temporary declines in the value of a HTM security are not recognized in the financial statements. Our assessment of a decline in fair value includes judgment as to the financial position and future prospects of the entity that issued the investment security, as well as a review of the security’s underlying collateral. Broad changes in the overall market or interest rate environment generally will not lead to a write-down.
For purposes of our initial evaluations, the loan loss severity assumption is held constant and is derived in either one of two ways:
Our expectation of when the cost of the security will be recovered.
The fair values of our investment portfolio are generated using various valuation techniques and are placed into the fair value hierarchy considering the following: (i) the highest priority is given to quoted prices in active markets for identical assets (Level 1); (ii) the next highest priority is given to quoted prices in markets that are not active or inputs that are observable either directly or indirectly, including quoted prices for similar assets in markets that are not active and other inputs that can be derived principally from, or corroborated by, observable market data for substantially the full term of the assets (Level 2); and (iii) the lowest priority is given to unobservable inputs supported by little or no market activity and that reflect our assumptions about the exit price, including assumptions that market participants would use in pricing the asset (Level 3). An asset’s classification within the fair value hierarchy is based on the lowest level of significant input to its valuation.
Short-term investments are carried at cost, which approximates fair value. Given the liquid nature of our short-term investments, we generally validate their fair value by way of active trades within approximately a week of the financial statement close. These securities are Level 1 in the fair value hierarchy.
Our investments in other miscellaneous securities are generally accounted for at fair value based on net asset value and included in Level 2 in the fair value hierarchy. Investments in tax credits are carried under the effective interest method of accounting.
The fair values of the 1.6155% Senior Convertible Notes due September 24, 2032, the 7.25% Senior Notes due November 15, 2034, the 6.70% Senior Notes due November 1, 2035, and the 7.5% Junior Subordinated Notes due September 27, 2066, are based on quoted market prices.
The fair value of our borrowing from the Federal Home Loan Bank of Indianapolis (“FHLBI”) is estimated to be its carrying value due to the close proximity to December 31, 2009 when the borrowing took place.
Policy acquisition costs directly related to the writing of insurance policies are deferred and amortized over the life of the policies. These costs include labor costs, commissions, premium taxes and assessments, 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.
We regularly conduct reviews for potential premium deficiencies at a level consistent with that used for our segment reporting in that we group our policies at the Insurance Operations level, considering the following:
We measure the profitability of our business at the Insurance Operations level, which is evident in, among other items, the structure of our incentive compensation programs. We measure the profitability of our agents and calculate their compensation based on overall insurance results and all of our employees, including senior management, are incented based on overall insurance results.
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 for our Insurance Operations segment did not exceed the related unearned premium and anticipated investment income. The investment yields assumed in the premium deficiency assessment for each reporting period, which are based upon our actual average investment yield before tax as of the calculation date on September 30, were 2.9% for 2009, 4.1% for 2008, and 4.6% for 2007. Deferred policy acquisition costs amortized to expense were $428.6 million for 2009, $454.8 million for 2008, and $460.2 million for 2007.
In June 2007, the Financial Accounting Standards Board ("FASB") issued guidance under Accounting Standards Codification (“ASC”) 718, Compensation - Stock Compensation, which was formerly referred to as EITF Issue No. 06-11, Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards ("EITF 06-11"). This guidance requires that the tax benefit from dividends or dividend equivalents that are charged to retained earnings and are paid to employees for equity classified non-vested equity shares, non-vested equity share units, and outstanding equity share options be recognized as an increase to additional paid-in capital. This guidance was effective on a prospective basis beginning with dividends declared in fiscal years beginning after December 15, 2007, and we adopted it in the first quarter of 2008. The adoption of the guidance did not have a material impact on our results of operations or financial condition.
In June 2008, the FASB issued guidance under ASC 260, Earnings Per Share, which was formerly referred to as FSP No. EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities. This guidance addresses the treatment of unvested share-based payment awards containing non-forfeitable rights to dividends or dividend equivalents in the calculation of earnings per share and is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years. The adoption of this guidance did not have a material impact on our calculation of earnings per share for any period presented.
How investment allocation decisions are made (including investment policies and strategies, as well as the company’s strategy for funding the benefit obligations);
Fair-value measurements, and the fair-value techniques and inputs used to measure plan assets (i.e.: Level 1, 2 & 3); and
In June 2009, the FASB issued an update to ASC 855, Subsequent Events, which was formerly referred to as FASB Statement of Financial Accounting Standards No. 165, Subsequent Events. Under this guidance, we are required to disclose that we have analyzed subsequent events through February 24, 2010, the date on which these Financial Statements are issued. Requirements concerning the accounting and disclosure of subsequent events under this guidance are not significantly different from those contained in existing auditing standards and, as a result, our adoption of the guidance did not have a material impact on our financial condition or results of operations
In June 2009, the FASB issued guidance under ASC 105, Generally Accepted Accounting Principles, which was formerly referred to as FASB Statement of Financial Accounting Standards No. 168, FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles - A Replacement of FASB Statement No. 162. This guidance establishes the FASB Accounting Standards Codification (the “Codification”) as the source of authoritative GAAP for nongovernmental entities. The Codification supercedes all existing non-SEC accounting and reporting standards. Rules and interpretive releases of the SEC under authority of federal security laws remain authoritative GAAP for SEC registrants. This guidance and the Codification are effective for financial statements issued for interim and annual periods ending after September 15, 2009. As the Codification did not change existing GAAP, the adoption did not have an impact on our financial condition or results of operations.
In December 2009, the FASB issued ASC Update 2009-16, Transfers and Servicing (Topic 860) - Accounting for Transfers of Financial Assets. This guidance: (i) eliminates the concept of a qualifying “special-purpose entity” (“SPE”); (ii) alters the requirements for transferring assets off of the reporting company’s balance sheet; (iii) requires additional disclosure about a transferor’s involvement in transferred assets; and (iv) eliminates special treatment of guaranteed mortgage securitizations. This guidance is effective for fiscal years beginning after November 15, 2009. We do not expect that the adoption of this guidance will have a material impact on our financial condition or results of operations.
In December 2009, the FASB issued ASC Update 2009-17, Consolidations (Topic 810) - Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities. This guidance requires the reporting entity to perform a qualitative analysis that results in a variable interest entity (“VIE”) being consolidated if the reporting entity: (i) has the power to direct activities of the VIE that significantly impact the VIE’s financial performance; and (ii) has an obligation to absorb losses or receive benefits that may be significant to the VIE. This guidance further requires enhanced disclosures, including disclosure of significant judgments and assumptions as to whether a VIE must be consolidated, and how involvement with a VIE affects the company’s financial statements. This guidance is effective for fiscal years beginning after November 15, 2009. We do not expect that the adoption of this guidance will have a material impact on our financial condition or results of operations.
Cash paid or received during the year for interest and federal income taxes, as well as non-cash financing activities, was as follows for the years ended 2009, 2008, and 2007:
1 CMBS includes government guaranteed agency securities with a carrying value of $10.8 million.
2 RMBS includes government guaranteed agency securities with a carrying value of $3.9 million.
Unrecognized holding gains/losses of HTM securities are not reflected in the financial statements, as they represent market value fluctuations from the later of: (i) the date of security is designated as HTM; or (ii) the date that an OTTI charge is recognized on a HTM security, through the date of the balance sheet. Our HTM securities had an average duration of 3.5 years as of December 31, 2009.
1U.S. government includes corporate securities fully guaranteed by the FDIC with a fair value of $34.3 million.
Unrealized gains/losses represent market value fluctuations from the later of: (i) the date of security is designated as AFS; or (ii) the date that an OTTI charge is recognized on an AFS security, through the date of the balance sheet. These unrealized gains and losses are recorded in AOCI on the Consolidated Balance Sheets.
(d) The following tables summarize, for all securities in a net unrealized/unrecognized loss position at December 31, 2009 and December 31, 2008, the fair value and gross pre-tax net unrealized/unrecognized loss by asset class and by length of time those securities have been in a net loss position:
1 The month count for aging of unrealized losses was reset back to historical unrealized loss month counts for securities impacted by the adoption of OTTI guidance in the second quarter 2009 and for securities that were transferred from an AFS to HTM category.
1 2008 HTM securities are not presented in this table, as their fair value was approximately $1.2 million and therefore not material.
Given the range of conditional default rates assumptions for our Alt-A fixed structured and hybrid structured securities above, the following is a further outline of these assumptions by vintage year:
$3.8 million of non-credit OTTI charges that have been recognized in AOCI. These non-credit impairment charges were generated concurrently with related credit charges. Prior to impairment, these securities had a decline in fair value of 57%, or $4.4 million, as compared to their amortized cost.
Of the $16.4 million in traditional unrealized, $11.3 million, or approximately 70%, related to 10 securities, four of which were Alt-A securities with a related unrealized balance of $6.1 million. The weighted average life of these 10 securities was two years at December 31, 2009 and all principal and interest payments have been received to date. The evaluations performed utilized the following assumptions:
Loss severities that generally ranged from approximately 35% to 49% with a weighted average of 45%;
Conditional default rates that generally ranged from 1.0 to 1.3 for those securities that were not Alt-As; and
Conditional default rates that generally ranged from 3.0 to 7.0 for Alt-A securities, with a weighted average of 6.2.
$9.1 million in unrealized/unrecognized losses not related to OTTI charges (referred to as “traditional unrealized losses” in the discussion that follows). These securities had a decline in fair value of 35%, as compared to their amortized cost.
Loss severities that generally ranged from approximately 24% to 55% with a weighted average of 30%;
The remaining $7.9 million of unrealized/unrecognized losses was comprised of 66 securities with fair values that were, on average, 95% of their amortized costs. Given the number of securities and the close proximity of amortized cost and fair value, we have concluded that these securities are not other-than-temporarily impaired under our OTTI policy.
(e) Fixed-maturity securities at December 31, 2009, 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.
Listed below are HTM fixed maturity securities at December 31, 2009:
Listed below are AFS fixed maturity securities at December 31, 2009:
This strategy makes direct and indirect investments in debt and equity securities of companies that are experiencing financial and/or operational distress. Investments include buying indebtedness of bankrupt or financially-troubled companies, small balance loan portfolios, special situations and capital structure arbitrage trades, commercial real estate mortgages and similar non-U.S. securities and debt obligations. This strategy also includes a fund of funds component.
The following tables sets forth, as of the dates indicated, credit loss impairments on fixed maturity securities for which a portion of the OTTI charge was recognized in OCI, and the corresponding changes in such amounts:
$37.8 million of RMBS credit OTTI charges during 2009. These charges taken during the year related to securities that experienced reductions in the cash flows of their underlying collateral. These securities, on average, showed signs of loss at conditional default rates of 0.33 and had declines in fair value of 65% as compared to their amortized cost. As a result, we do not believe it is probable that we will receive all contractual cash flows for these securities.
Proceeds from the sale of AFS securities were $676.0 million during 2009, $255.0 million during 2008, and $289.9 million during 2007. Of the $13.9 million of realized losses incurred from sales of AFS fixed maturity securities during 2009, $5.8 million was attributable to five securities on which we had taken previous OTTI charges as we had the intention to sell these securities. Additionally sales of AFS fixed maturity securities that resulted in realized losses were driven by further declines in the issuers’ credit worthiness and liquidity.
In addition to calls and maturities on HTM securities, we sold one HTM security with a carrying value of $6.0 million for a loss of $0.2 million during the second quarter of 2009. This security had experienced significant deterioration in the issuer’s credit worthiness.
The sale of certain equity securities in the second quarter of 2009. A.M. Best changed our ratings outlook from "Stable" to "Negative" due, in part, to concerns over the risk in our investment portfolio. To reduce this risk, we sold $31.1 million of equity securities for a net loss of $0.6 million, which included gross gains of $7.7 million and gross losses of $8.3 million.
The components of comprehensive income (loss), both gross and net of tax, for 2009, 2008, and 2007 are as follows:
The following table presents the carrying amounts and estimated fair values of our financial instruments as of December 31, 2009 and 2008:
For further discussion regarding the fair value valuation techniques for our financial instruments portfolio, refer to Note 2. “Summary of Significant Accounting Policies” of this Form 10-K.
The fluctuation in ceded premium (written and earned) and ceded losses were primarily attributable charges in our Flood book of business, which is 100% ceded to the NFIP. The associated amounts are as follows:
The net loss and loss expense reserves increased by $57.4 million in 2009, $102.0 million in 2008, and $225.7 million in 2007. The loss reserves include anticipated recoveries for salvage and subrogation claims, which amounted to $58.8 million for 2009, $55.9 million for 2008, and $52.3 million in 2007. The changes in the net loss and loss expense reserves were the result of growth in exposures, anticipated loss trends, changes in reinsurance retentions, as well as normal reserve development inherent in the uncertainty in establishing reserves for losses and loss expenses. As additional information is collected in the loss settlement process, reserves are adjusted accordingly. These adjustments are reflected in the consolidated statements of income in the period in which such adjustments are recognized. These changes could have a material impact on the results of operations of future periods when the adjustments are made.
In 2007, we experienced favorable loss development in accident years 2002 through 2006 of $61.7 million partially offset by unfavorable loss development in accident years 2001 and prior of $42.9 million, netting to total favorable prior year development of $18.8 million. This development was primarily driven by favorable prior year development in our commercial automobile, personal automobile, and workers compensation lines of business partially offset by adverse development in our homeowners and personal excess lines of business. The commercial automobile line of business experienced favorable prior year loss and loss expense reserve development of approximately $19 million, which was primarily driven by lower than expected severity in accident years 2004 through 2006. The personal automobile line of business experienced favorable prior year development of approximately $10 million, due to lower than expected loss emergence for accident years 2005 and prior, partially offset by higher severity in accident year 2006. The workers compensation line of business experienced favorable prior year development of approximately $4 million reflecting the implementation of a series of improvement strategies for this line in recent accident years partially offset by an increase in the tail factor related to medical inflation and general development trends. The homeowners line of business experienced adverse prior year loss and loss expense reserve development of approximately $6 million driven by unfavorable trends in claims for groundwater contamination caused by the leakage of certain underground oil storage tanks. The personal excess line of business experienced adverse prior year loss and loss expense reserve development of approximately $4 million in 2007, which was due to the impact of several significant losses on this small line. The remaining lines of business, which collectively contributed approximately $4 million of adverse development, do not individually reflect any significant trends related to prior year development.
1 Consists of leaking underground storage tanks, and other latent environmental exposures.
As of December 31, 2009, we had 10.8 million shares reserved for various stock compensation and purchase plans, retirement plans and dividend reinvestment plans. As part of our ongoing capital management strategy, we repurchase the Parent's stock from time-to-time. The following table provides information regarding the purchase of the Parent's common stock during the 2007-2009 reporting periods:
On January 30, 2007, the Board of Directors (the "Board") of the Parent declared a two-for-one stock split of the Parent's common stock, par value $2.00 per share in the form of a share dividend of one additional share of the Parent's common stock for each outstanding share of the Parent's common stock issued by us (the "Share Dividend"). The Share Dividend was paid on February 20, 2007 to shareholders of record as of the close of business on February 13, 2007.
The statutory capital and surplus of the Insurance Subsidiaries in excess of these ordinary dividend amounts must remain with the Insurance Subsidiaries in the absence of the approval of a request for an extraordinary dividend. In each such jurisdiction, domestic insurers are prohibited from paying "extraordinary dividends" without approval of the insurance commissioner of the respective state. Additionally, New Jersey and Indiana require notice of the declaration of any ordinary or extraordinary dividend distribution. During the notice period, the relevant state regulatory authority may disallow all or part of the proposed dividend if it determines that the insurer's surplus, with regard to policyholders, is not reasonable in relation to the insurer's outstanding liabilities and adequate for our financial needs.
Our Insurance Operations are subject to certain geographic concentration. Approximately 27% of net premiums written are related to insurance policies written in New Jersey.
Our commercial and personal lines property and casualty insurance products are sold through independent insurance agents.
During the fourth quarter of 2009, we disposed of Selective HR, which comprised our HR Outsourcing segment. The results of Selective HR operations are included in “Loss from discontinued operations, net of tax” in our Consolidated Statements of Income. See Note 13. “Discontinued Operations” for additional information on the disposal.
We also provide services to each other in the normal course of business. These transactions, including transactions with our discontinued operations, Selective HR, totaled $9.0 million in 2009, $13.8 million in 2008, and $17.8 million in 2007. These transactions were eliminated in all consolidated statements. In computing the results of each segment, we do not make adjustments for interest expense, net general corporate expenses, or federal income taxes. We do not maintain separate investment portfolios for the segments and therefore, do not allocate assets to the segments.
We have reclassified prior period amounts on the consolidated financial statements to present the assets, liabilities, and operating results of Selective HR as a discontinued operation.
Stockholders' equity reflects tax benefits related to compensation expense deductions for stock options exercised of $17.4 million at December 31, 2009, $18.6 million at December 31, 2008, and $17.0 million at December 31, 2007.
We have analyzed our deferred tax positions in all open tax years, which as of December 31, 2009 were 2006, 2007 and 2008. Based on this analysis, we do not have unrecognized tax benefits as of December 31, 2009. We believe our tax positions will more likely than not be sustained upon examination, including related appeals or litigation. In the event we had a tax position that did not meet the more likely than not criteria, any tax, interest, and penalties incurred related to such a position would be reflected in "Federal income tax expense" on our Consolidated Statements of Income.
In addition to the deferrals elected by the Participants, we may also choose to make matching contributions to the deferral accounts of some or all Participants to the extent a Participant did not receive the maximum matching contribution permissible under our Retirement Savings Plan due to limitations under the Internal Revenue Code or the Retirement Savings Plan. We may also choose at any time to make discretionary contributions to the deferral account of any Participant in our sole discretion. No discretionary contributions were made in 2009, 2008, or 2007. We contributed $0.1 million in 2009, $0.2 million in 2008, and $0.1 million 2007 to the Deferred Compensation Plan.
The 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 the Board of the plan sponsor, may approve from time to time.
Prior to April 1, 2009, SICA provided a life insurance benefit (postretirement benefits) for employees who terminated employment and met the age and service requirements to otherwise be eligible for a benefit under the Retirement Income Plan (“Retirees”). Retirees who terminated employment with SICA prior to March 31, 2009 are eligible for a maximum life insurance benefit, depending upon the Retiree’s date of termination ranging from $10,000 to $100,000. On March 31, 2009, SICA eliminated the benefits under the Retirement Life Plan to active employees. This elimination resulted in a curtailment to the plan, the benefit of which was $4.2 million in the year and was composed of: (i) a $2.8 million reversal of the Retirement Life Plan liability; and (ii) a $1.4 million reversal of prior service credits and net actuarial losses included in Accumulated Other Comprehensive Loss.
In the second quarter of 2007, we restructured our personal lines department. As part of this restructuring, an early retirement enhancement option was offered to eligible employees. The present value of the enhancement to be made in conjunction with this early retirement option was equal to $0.9 million for the Retirement Income Plan and $0.1 million for the Post-retirement Plan.
The estimated net actuarial loss and prior service cost for the Retirement Income Plan that will be amortized from accumulated other comprehensive (loss) income into net periodic benefit cost during the 2010 fiscal year are $3.7 million and $0.2 million, respectively.
Our 2009 discount rate used to value the liability is 5.93% for both the Retirement Income Plan and the Post-retirement Plan. We determined the most appropriate discount rate in comparison to our expected pay out patterns of the plans' obligations.
Assets of the Retirement Income Plan shall be invested to ensure that principal is preserved and enhanced over time. In addition, the Retirement Income Plan is expected to perform above average relative to comparable funds without assuming undue risk, and to add value through active management. Our return objective is to meet or exceed the returns of the plan's policy index, 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. The Retirement Income Plan's exposure to a concentration of credit risk is limited by the diversification of investments across varied financial instruments, including common stocks, mutual funds, non-publicly traded stocks, investments in limited partnerships, fixed income securities, and short-term investments.
The plan's allocated target and ranges by investment categories are as follows:
The following tables provide quantitative disclosures of our pension plan assets that are measured at fair value on a recurring basis:
For a description of our private equity and real estate strategies, refer to Note 5. Investments. Our Equity Long/Short Hedge strategy invests opportunistically in equities and equity-related instruments in companies generally in the financial services sector. Investments within this strategy are permitted to be sold short in order to: (i) prospectively benefit from a correction in overvalued equities; and (ii) partially hedge portfolio assets due to the strategy’s heavy weighting toward the financial sector.
At this time, the Retirement Income Plan’s alternative investment portfolio includes one hedge fund. Redemption from this investment is permitted semi-annually on June 30th and December 31st subject to a 30-day notice of intent to redeem. Management currently does not intend to redeem its investment in this strategy in the near term. For the remainder of the alternative investments, we are currently committed for the full life of each fund and cannot redeem our investment with the general partner. 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. Management does not intend to sell these investments in the secondary market in the near term. At December 31, 2009, we have contractual obligations that expire at various dates through 2022 to further invest up to $9.0 million in alternative investments. There is no certainty that any such additional investment will be required. We currently receive distributions from these alternative investments through the realization of the underlying investments in the limited partnerships. We anticipate that the general partners of these alternative investments will liquidate their underlying investment portfolios up through 2022.
The Parent's 2005 Omnibus Stock Plan ("Stock Plan") was adopted and approved by the Board effective as of April 1, 2005, and approved by stockholders on April 27, 2005. With the Stock Plan's approval, no further grants are available under the: (i) Parent's Stock Option Plan III, as amended ("Stock Option Plan III"); (ii) Parent's Stock Option Plan for Directors, as amended ("Stock Option Plan for Directors"); or (iii) Parent's Stock Compensation Plan for Non-employee Directors, as amended ("Stock Compensation Plan for Non-employee Directors"), but awards outstanding under these plans and the Stock Option Plan II, under which future grants ceased being available on May 22, 2002, shall continue in effect according to the terms of those plans and any applicable award agreements.
Under the Stock Plan, the Board's Salary and Employee Benefits Committee ("SEBC") may grant stock options, stock appreciation rights ("SARs"), restricted stock, restricted stock units ("RSUs"), phantom stock, stock bonuses, and other awards in such amounts and with such terms and conditions as it shall determine, subject to the provisions of the Stock Plan. Each award granted under the Stock Plan (except unconditional stock bonuses and the cash component of Director compensation) shall be evidenced by an agreement containing such restrictions as the SEBC may, in its sole discretion, deem necessary or desirable and which are not in conflict with the terms of the Stock Plan. The maximum exercise period for an option grant under this plan is ten years from the date of the grant. During 2009, we granted, net of forfeitures, 520,011 RSUs, and experienced net restricted stock forfeitures of 7,168 shares. During 2008, we granted, net of forfeitures, 382,521 RSUs, and experienced net restricted stock forfeitures of 45,240. During 2007, we granted, net of forfeitures, 478,862 shares of restricted stock. We also granted options to purchase 313,811 shares during 2009, 191,568 shares during 2008, and 158,435 shares during 2007. As of December 31, 2009, 2,688,518 shares of the Parent's common stock remain available for issuance pursuant to outstanding stock options and restricted stock awards granted under the Stock Plan.
During the vesting period, dividend equivalent units ("DEUs") are earned on the RSUs. The DEUs are reinvested in the Parent's common stock at fair value on each dividend payment date. We accrued 32,088 and 8,667 DEUs in relation to the RSUs granted in 2009 and 2008, respectively. The DEUs are subject to the same vesting period and conditions set forth in the award agreement for the RSUs.
We experienced restricted stock forfeitures of 1,924 shares during 2009, 21,532 shares during 2008 and 25,128 shares during 2007. During the vesting period, dividends earned on restricted shares are reinvested in the Parent's common stock at fair value. We experienced net forfeitures of 23,285 restricted shares from the DRP reserve during 2009. We issued, net of forfeitures, 1,017 restricted shares during 2008, and 11,694 restricted shares during 2007 from the DRP reserve.
As of December 31, 2009, there were 94,290 shares of the Parent's common stock available for issuance pursuant to outstanding stock option awards under the Stock Compensation Plan for Non-employee Directors, under which future grants ceased being available with the approval of the Stock Plan. Under the Stock Compensation Plan for Non-employee Directors, Directors could elect to receive a portion of their annual compensation in shares of the Parent's common stock. We issued 960 shares during 2009. There were no issuances under this plan in 2008 and 2007.
In determining expense to be recorded for stock options granted under our share-based compensation plans, the fair value of each option award is estimated on the date of grant using the Black Scholes option valuation model ("Black Scholes"). The following are the significant assumptions used in applying Black Scholes: (i) risk-free interest rate, which is the implied yield currently available on U.S. Treasury zero-coupon issues with an equal remaining term; (ii) expected term, which is based on historical experience of similar awards; (iii) dividend yield, which is determined by dividing the expected per share dividend during the coming year by the grant date stock price; and (iv) expected volatility, which is based on the volatility of the Parent's stock price over a historical period comparable to the expected term. In applying Black Scholes, we use the weighted average assumptions illustrated in the following table:
The expense recorded for restricted stock awards and stock compensation for non-employee directors is determined using the number of awards granted and the grant date fair value and is amortized over the requisite service period.
Share-based compensation expense charged against net income before tax was $10.8 million for the year ended December 31, 2009 with a corresponding income tax benefit of $3.4 million. Share-based compensation expense that was charged against net income before tax was $16.9 million for the year ended December 31, 2008 and $20.6 million for the year ended December 31, 2007 with a corresponding income tax benefit of $5.5 million and $6.8 million, respectively.
Rue Insurance placed insurance policies with the Insurance Subsidiaries. Direct premiums written associated with these policies were $7.6 million in 2009, $8.3 million in 2008, and $9.9 million in 2007. In return, the Insurance Subsidiaries paid commissions to Rue Insurance of $1.4 million in 2009, $1.7 million in 2008 and 2007.
(a) We purchase annuities from life insurance companies to fulfill obligations under claim settlements which provide for periodic future payments to claimants. As of December 31, 2009, we had purchased such annuities in the amount of $10.4 million for settlement of claims on a structured basis for which we are contingently liable. To our knowledge, none of the issuers of such annuities have defaulted in their obligations thereunder.
(b) We have various operating leases for office space and equipment. Such lease agreements, which expire at various times, are generally renewed or replaced by similar leases. Rental expense under these leases amounted to $11.5 million in 2009, $11.9 million in 2008, and $11.2 million in 2007. See Note 2(p) for information on our accounting policy regarding leases.
In the ordinary course of conducting business, we are named as defendants in various legal proceedings. Most of these proceedings are claims litigation involving the Insurance Subsidiaries as either: (a) liability insurers defending or providing indemnity for third-party claims brought against insureds; or (b) insurers defending first-party coverage claims brought against us. We account for such activity through the establishment of unpaid loss and loss adjustment expense reserves. We expect that the ultimate liability, if any, with respect to such ordinary course claims litigation, after consideration of provisions made for potential losses and costs of defense, will not be material to our consolidated financial condition, results of operations, or cash flows.
The Insurance Subsidiaries are also from time to time involved in other legal actions, some of which assert claims for substantial amounts. These actions include, among others, putative state class actions seeking certification of a state or national class. Such putative class actions have alleged, for example, improper reimbursement of medical providers paid under workers compensation and personal and commercial automobile insurance policies. The Insurance Subsidiaries are also from time-to-time involved in individual actions in which extra-contractual damages, punitive damages, or penalties are sought, such as claims alleging bad faith in the handling of insurance claims. We believe that we have valid defenses to these cases. Our management expects that the ultimate liability, if any, with respect to such lawsuits, after consideration of provisions made for estimated losses, will not be material to our consolidated financial condition. Nonetheless, given the large or indeterminate amounts sought in certain of these actions, and the inherent unpredictability of litigation, an adverse outcome in certain matters could, from time-to-time, have a material adverse effect on our consolidated results of operations or cash flows in particular quarterly or annual periods.
The Insurance Subsidiaries prepare their statutory financial statements in accordance with accounting principles prescribed or permitted by the various state insurance departments of domicile. Prescribed statutory accounting principles include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (“NAIC"). Permitted statutory accounting principles encompass all accounting principles that are not prescribed; such principles differ from state to state, may differ from company to company within a state and may change in the future. The Insurance Subsidiaries do not utilize any permitted statutory accounting principles that materially affect the determination of statutory surplus, statutory net income, or risk-based capital ("RBC"). As of December 31, 2009, the various state insurance departments of domicile have adopted the March 2009 version of the NAIC Accounting Practices and Procedures manual in its entirety, as a component of prescribed or permitted practices.
The addition of all quarters may not agree to annual amounts on the consolidated financial statements due to rounding.
These ranges of high and low prices of the Parent’s common stock, as reported by the NASDAQ Global Select Market, represent actual transactions. All price quotations do not include retail markups, markdowns and commissions. The range of high and low prices for common stock for the period beginning January 4, 2010 and ending February 19, 2010 was $16.92 to $15.01.
See Note 13. to the consolidated financial statements for a discussion of discontinued operations.
See Note 10. and Note 11. to the consolidated financial statements for or a discussion of dividend restrictions.