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 Standard and E&S Insurance Operations segments are described in the “Field and Technology Strategies Supporting Independent Retail Agent Distribution” section of Item 1. “Business.” of this Form 10-K. We believe our facilities provide adequate space for our present needs and that additional space, if needed, would be available on reasonable terms.
3 The impact of catastrophe losses on the 2012 statutory combined ratio including flood claims handling fees related to Hurricane Sandy was 5.8 points.
4Operating income and operating return on average equity are non-GAAP measures. See the Glossary of Terms attached to this Form 10-K as Exhibit 99.1 for definitions of these items and see the “Financial Highlights” section in
Standard Insurance Operations - comprised of both commercial lines ("Commercial Lines") and personal lines ("Personal Lines") insurance products and services that are sold in the standard marketplace;
Our E&S Insurance Operations products and services are sold through a subsidiary that was acquired in December 2011. This subsidiary, Mesa Underwriters Specialty Insurance Company ("MUSIC"), provides a nationally-authorized non-admitted platform to write commercial and personal E&S lines business.
Financial Highlights of Results for Years Ended December 31, 2013, 2012, and 2011;
The following tables provide case and incurred but not reported ("IBNR") reserves for losses and loss expenses, and reinsurance recoverable on unpaid losses and loss expenses as of December 31, 2013 and 2012:
At December 31, 2013, our general liability line of business had recorded reserves, net of reinsurance, of $1.1 billion, which represented 38% of our total net reserves. In calendar year 2013, this line experienced favorable development of $20.0 million, which was driven by lower severities in the 2010 and prior accident years. This favorable development was partially offset by unfavorable development in accident years 2011 and 2012, which showed higher average severities in the premises and operations coverage. During the 2012 calendar year, this line of business showed modestly unfavorable development due to increased severities in the 2010 and 2011 accident years. During the 2011 calendar year, this line of business experienced overall favorable reserve development that was largely attributable to accident years 2006 through 2009, which showed generally lower frequencies. The broad nature of this line of business, and the longer average time for the claims settlement process, makes it more susceptible to changes in litigation and the tort environment. This line of business also includes excess policies that provide additional limits above underlying automobile and general liability coverages, which is subject to catastrophic losses, and therefore influenced by the factors noted above to a greater degree.
Changes in overall economic conditions - Higher levels of unemployment could ultimately impact both the severity and frequency of workers compensation claims. There is also potential for an increase in severity if the longevity of workers compensation claims increases. Injured workers could have less incentive to return to work when their company is in financial distress or injured workers could be laid off while on workers compensation. Conversely, there is potential for a decrease in frequency if workers are reluctant to file claims or have less work and less exposure to injury.
At December 31, 2013, our personal automobile line of business had recorded reserves, net of reinsurance, of $133 million, which represented 5% of our total net reserves. In calendar year 2013, this line experienced favorable development of $3.0 million, which was driven by accident years 2010 and 2011 in states other than New Jersey. Over the past several years, the New Jersey personal automobile marketplace has continued to be extremely competitive, while at the same time we have been growing our market share in our other personal lines footprint states, the result of which has been a gradually changing overall mix of business. We review the reserves for states other than New Jersey on a combined basis so that there is a sufficient volume of data to ensure statistical credibility. However, the state mix of business changes over time may increase the uncertainty surrounding our personal automobile reserves.
Increased focus on reducing workers compensation medical costs through more favorable Preferred Provider Organizations ("PPO") contracts and greater PPO penetration.
Our internal reserve analyses incorporate actuarial projection methods which make adjustments for changes in case reserve adequacy and claims settlement rates. These methods adjust our historical loss experience to the current level of case adequacy or settlement rate, which provides a more consistent basis for projecting future development patterns. These methods have their own assumptions and judgments associated with them, so as with any projection method, they are not definitive in and of themselves. Furthermore, given that the expected benefits from our claims initiatives take time to fully manifest, we do not take full credit for the anticipated benefit in establishing our loss and loss expense reserves. Therefore, these initiatives may prove more or less beneficial than currently reflected, which will affect development in future years. Our various projection methods provide an indication of these potential future impacts. These impacts would be greatest within our larger reserve lines of workers compensation, general liability, and commercial automobile liability, within the more recent accident years.
Although inflationary volatility is expected to be low in the near term, current United States monetary policy and global economic conditions bring additional uncertainty in the long-term given the length of time required for claim settlement in these lines of business. Uncertainty regarding future inflation or deflation creates the potential for additional volatility in our reserves for these lines of business.
Estimating IBNR reserves for asbestos and environmental claims is difficult because of the delayed and inconsistent reporting patterns associated with these claims. In addition, 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. Normal historically based actuarial approaches cannot be applied to asbestos and environmental claims because past loss history is not indicative of future potential asbestos and environmental losses. In addition, while certain alternative models can be applied, such models can produce significantly different results with small changes in assumptions. As a result, we do not calculate an asbestos and environmental loss range.
Our pension and post-retirement benefit obligations and related costs are calculated using actuarial methods, within the framework of U.S. GAAP. 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.
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 and reduces pension expense. Conversely, a lower discount rate increases the present value of benefit obligations and increases pension expense. We increased our discount rate for the Retirement Income Plan for Selective Insurance Company of America and the Supplemental Excess Retirement Plan (jointly referred to as the "Retirement Income Plan" or the "Plan") to 5.16% for 2013, from 4.42% for 2012, reflecting higher market interest rates. We also increased our discount rate for the life insurance benefit provided to eligible SICA employees (referred to as the "Retirement Life Plan") to 4.85% for 2013 from 4.42% for 2012.
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 lower expected rate of return on pension plan assets would increase pension expense. Our long-term expected return on plan assets was lowered 48 basis points to 6.92% in 2013 as compared to 7.40% in 2012, reflecting the lower interest rate environment, coupled with our liability driven investment strategy, that is anticipated in the near term despite our 2013 total return of 8.75% .
1Refer to the Glossary of Terms attached to this Form 10-K as Exhibit 99.1 for definitions of terms used in this financial review.
We are currently targeting a return on average equity that is three points higher than our cost of capital, or 12%, excluding the impact of realized gains and losses, which is referred to as operating return on equity. Improvement in our operating return on average equity between 2013 and 2012 reflects underwriting profitability of $38.8 million in 2013 compared to an underwriting loss of $64.0 million in 2012. The 161% improvement between years is driven primarily by: (i) higher underwriting profitability in our Standard Insurance Operations of $87 million as a result of significantly lower catastrophe losses and renewal pure price increases that exceeded loss costs trends; and (ii) improvement in our E&S Insurance Operations of $15.8 million. E&S operations were primarily affected by: (i) earned premiums that now reflect the full operations of this business following its acquisition in 2011; (ii) renewal pure price increases; and (iii) a decrease in initial start up expenditures.
Operating ROE in both 2012 and 2011 reflect reduced levels of pre-tax operating income due to significant catastrophe losses in each of those years.
The growth in NPW and NPE for our Insurance Subsidiaries in 2013 and 2012 reflects the following in our Standard Insurance Operations: (i) renewal pure price increases; (ii) strong retention; and (iii) new business. In addition, incremental premiums were generated over these years from our E&S business, which was acquired in 2011.
The combined ratios improved when comparing all three years. The main driver of this improvement is the impact of catastrophe losses on our results. In 2011 and 2012, these losses were the highest that they have been in our history. Historical catastrophe losses in the 10 years prior to 2011 include a high of 4.0 points, a low of 0.3 points, and a median of 1.5 points. See the tables below for quantitative data regarding catastrophe losses over the past three years. In addition, the combined ratio improvement was driven by renewal pure price increases that are exceeding loss trends in our Standard Insurance Operations and the following in our E&S Insurance Operations: (i) earned premiums that now reflect the full operations of this business; (ii) underwriting improvements, including renewal pure price increases; and (iii) a decrease in initial start-up expenditures and acquisition costs.
1 The impact of catastrophe losses on the 2012 statutory combined ratio including flood claims handling fees related to Hurricane Sandy was 5.8 points.
In line with A.M. Best's expectation of a 97.6% industry combined ratio for 2013, we achieved a statutory combined ratio of 97.5%. However, as catastrophe losses are inherently unpredictable, we believe it is best to examine progress towards targeted combined ratio goals that exclude these losses. Our 2013 combined ratio excluding catastrophes was 94.8%. In 2012, we established a three-year targeted statutory combined ratio excluding catastrophes of 92%, which we expect to meet in 2014. This expectation excludes our assumption for catastrophe losses of approximately 4 points and any prior year development, favorable or unfavorable. This expectation is based, in part, on a three-year rate plan laid out in early 2012 to achieve overall annual renewal pure price increases of 5% to 8%. We have achieved overall renewal pure price increases of 6.3% in 2012 and 7.6% in 2013 and we expect to achieve overall renewal pure price increases between 6% to 7% in 2014. Our 2014 renewal pure price expectation for Commercial Lines is 6% to 7%, down from the 7.6% that we achieved in 2013. In addition, we expect to achieve renewal pure price of 6.25% for Personal Lines and 8.5% for E&S Lines in 2014. We expect our E&S Insurance Operations segment to produce consistent profitability in line with our standard Commercial Lines business and we anticipate after-tax investment income of approximately $100 million and weighted-average shares at year-end 2014 of approximately 57.4 million.
Although interest rates on the 10-year U.S. Treasury rose by 127 basis points in 2013, they are still low by historical standards. The continued low interest rate environment has several significant impacts on our business, some of which are beneficial and some of which present a challenge to us. The benefits include lower inflation rates that suppress loss trends, as well as reduce our cost of capital. However, the interest rate environment presents a significant challenge in generating after-tax return on our investment portfolio as fixed income securities mature and money is re-invested at lower rates. Because maturing and called bonds generally carry a higher book yield than is available in the current market, we expect the yield on the overall investment portfolio to continue to decline, albeit at a less significant pace than we have been experiencing.
Our Standard Insurance Operations segment, which represents 93% of our combined insurance operations NPW, sells insurance products and services primarily in 22 states in the Eastern and Midwestern U.S. and the District of Columbia, through approximately 1,100 independent retail insurance agencies. This segment consists of two components: (i) Commercial Lines, which markets primarily to businesses and represents approximately 82% of the segment's NPW; and (ii) Personal Lines, including our flood business, which markets primarily to individuals and represents approximately 18% of the segment's NPW.
The GAAP loss and loss expense ratio improved in each of the three years depicted in the table above. These fluctuations are driven by the volatile nature of property losses as illustrated in the tables below. In addition, the improvement in the ratios reflect the earning of Standard Insurance Operations renewal pure price increases that averaged 7.6% in 2013, which exceeds our projected loss trend of approximately 3%.
Prior year development also impacted the GAAP loss and loss expense ratio as follows:
1 2013 includes 0.1 points in the loss and loss expense ratio, 0.3 points in the underwriting expense ratio, and 0.4 points in the combined ratio related to the Retirement Income Plan amendments recorded in the first quarter of 2013 that curtail the accrual of additional benefits for all eligible employees participating in the plans after March 31, 2016.
The GAAP loss and loss expense ratio improved by 6.5 points in 2013 compared to 2012, and 1.5 points in 2012 compared to 2011. Both fluctuations were impacted by catastrophe losses, which are outlined in the table below. The ratios also reflect the earning of standard Commercial Lines renewal pure price increases that averaged 7.6% in 2013, which exceeds our projected loss trend of approximately 3%. In addition, the improvement in 2013 was impacted by non-catastrophe property losses, which were 1.6 points lower than 2012.
The following is a discussion of our most significant standard Commercial Lines of business:
The growth in NPW and NPE for our general liability business in 2013 and 2012 reflect: (i) renewal pure price increases; (ii) stronger retention; and (iii) higher new business.
2012: unfavorable by 0.8 points, driven by increased severities in the 2010 and 2011 accident years. This unfavorable development was largely offset by continued favorable development in the premises and products coverages in accident years 2007 and 2009, which showed lower frequencies of large losses, particularly in the umbrella coverage.
2012: 2.6 points driven by the 2009 accident year, representing a continued trend driven by better than expected reported emergence. This was partially offset by unfavorable development in the 2011 accident year, due to higher frequency of claims.
NPW increased in 2013 compared to 2012 while it remained relatively flat in 2012 compared to 2011. The 2013 NPW growth was primarily attributable to: (i) renewal pure price increases of 7.5%; (ii) improvements in retention; and (iii) new business. The workers compensation book of business represents 20% of our total statutory standard Commercial Lines NPW for 2013. We continue to carefully manage growth in this line with 2013 premiums up only 5% compared to 9% in our standard Commercial Lines book.
The fluctuations in the statutory combined ratio were primarily attributable to the impact of prior year casualty reserve development as follows:
2012: unfavorable by 1.1 points, driven by the 2011 accident year, due to an increase in the ultimate severity, partially offset by accident years 2007 and 2008, due to a decrease in expected severity for those years.
The improvement in the underwriting expense ratio in 2013 compared to 2012, was driven by: (i) higher direct premiums written in our flood business; and (ii) an increase in the flood expense allowance for issuing and servicing policies.
In addition to the above categories, we have entered into several reinsurance agreements with Montpelier Re Insurance Ltd. as part of the acquisition of MUSIC. Together, these agreements provide protection for losses on policies written prior to the December 2011 acquisition and any development on reserves established by MUSIC as of the date of acquisition. The reinsurance recoverables under these treaties are 100% collateralized.
1 This amount represents reported and unreported gross losses estimated as of December 31, 2013.
We use the results of the Risk Management Solutions (“RMS”) and AIR Worldwide (“AIR”) 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 higher expectations of hurricane activity in the North Atlantic Basin. We believe that modeled estimates provide a range of potential outcomes and multiple estimates, as well as changes in estimates from year-to-year. These should all be reviewed for purposes of understanding 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 2013:
Our current catastrophe reinsurance program exhausts at 1 in 250 year return period, or events with 0.40% probability, based on a multi-model view of hurricane risk.
Per risk coverage of $38.0 million in excess of a $2.0 million retention; consistent with the prior year treaty;
Per occurrence cap on the total program of $84.0 million, consistent with the prior year treaty;
The first layer continues to have unlimited reinstatements. The annual aggregate limit for the second $30.0 million in excess of $10.0 million layer is consistent with the prior year treaty at $120.0 million; and
The Casualty Excess of Loss treaty (“Casualty Treaty”), which covers our standard market business, was renewed on July 1, 2013 and is effective through June 30, 2014, with substantially the same terms as the expiring treaty providing the following per occurrence coverage:
Consistent with the prior year treaty, the Casualty Treaty excludes nuclear, biological, chemical, and radiological terrorism losses; and
The increase in our investment portfolio compared to 2012 was driven primarily by: (i) strong operating cash flows of $336.1 million; and (ii) net proceeds from our debt issuance of $78.4 million in February 2013. These increases were partially offset by a $109.0 million pre-tax decrease in unrealized gains, primarily from a decrease in the market value of our fixed maturity securities portfolio, driven by the rise in interest rates during 2013. During 2013, interest rates, other than short-term, generally rose. For example, the yield on the 10-year U.S. Treasury Note rose by 127 basis points. These interest rate movements have negatively impacted our fixed maturity securities portfolio's valuation, thus increasing the number of securities in a loss position and reducing the portfolio's overall unrealized gain. The cash generated from our insurance operations segments, as well as net amounts generated from our capital management strategies executed in the first quarter of 2013, were used to invest primarily in corporate bonds, structured securities, and municipal bonds within our fixed maturity securities portfolio.
Our fixed maturity securities portfolio had a weighted average credit rating of AA- as of December 31, 2013. The following table presents the credit ratings of our fixed maturity securities portfolio:
Our Investments segment, which invests the premiums collected by our Standard and E&S Insurance Operations and amounts generated through our capital management strategies, which may include the issuance of debt and equity securities.
Fixed maturity securities may include bonds, redeemable preferred stocks, mortgage-backed securities (“MBS”) and asset-backed securities (“ABS”). Fixed maturity securities classified as available-for-sale (“AFS”) 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 the date of transfer into the HTM category, adjusted for subsequent amortization. The amortized cost of fixed maturity 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. Premiums and discounts arising from the purchase of MBS are amortized over the expected life of the security based on future principal payments, and considering 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 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 amortized cost 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 maturity securities classified as AFS, net of tax, are included in accumulated other comprehensive income (loss) ("AOCI").
Equity securities, which are classified as AFS, may include common stocks and non-redeemable preferred stocks, and are carried at fair value. Dividend income on these securities is included in "Net investment income earned" on our Consolidated Statement of Income. The associated unrealized gains and losses, net of tax, are included in AOCI. The cost of equity 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.
To determine if an impairment is other than temporary, we compare the present value of cash flows expected to be collected with the amortized cost of fixed maturity securities meeting certain criteria. In addition, this analysis is performed on all previously-impaired debt securities that continue to be held by us and all structured securities that were not of high-credit quality at the date of purchase. These impairment assessments may include, but are not limited to, discounted cash flow analyses ("DCFs").
For valuations of a large portion of our equity securities portfolio as well as U.S. Treasury Notes held in our fixed maturity securities portfolio, we receive prices from an independent pricing service that are based on observable market transactions. We validate these prices against a second external pricing service, and if established market value comparison thresholds are breached, further analysis is performed, in conjunction with our external investment managers, to determine the price to be used. These securities are classified as Level 1 in the fair value hierarchy.
For the small portion of our fixed maturity securities portfolio that we cannot price using our primary or secondary service, we typically use non-binding broker quotes. These prices are from various broker/dealers that use bid or ask prices, or benchmarks to indices, in measuring the fair value of a security. For the small portion of non-public equity securities that we hold, we typically receive prices from a third party pricing service or through statements provided by the security issuer. In conjunction with our external investment portfolio managers, these fair value measurements are reviewed for reasonableness. This review typically includes an analysis of price fluctuations between months with variances over established thresholds being analyzed further. These prices are generally classified as Level 3 in the fair value hierarchy, as the inputs cannot be corroborated by observable market data.
The fair value of the 5.875% Senior Notes due February 9, 2043, and the 7.50% Junior Subordinated Notes that were originally due on September 27, 2066 but have been redeemed, are based on quoted market prices.
The fair value of the 2.90% and 1.25% borrowings from the Federal Home Loan Bank of Indianapolis (“FHLBI”) are estimated using a DCF based on a current borrowing rate provided by the FHLBI consistent with the remaining term of the borrowing.
Reinsurance recoverables represent estimates of amounts that will be recovered from reinsurers under our various treaties. Generally, amounts recoverable from reinsurers are recognized as assets at the same time and in a manner consistent with the paid and unpaid losses associated with the reinsured policies. An allowance for estimated uncollectible reinsurance is recorded based on an evaluation of balances due from reinsurers and other available information. We charge off reinsurance recoverables on paid losses when it becomes probable that we will not collect the balance.
Deferred policy acquisition costs are limited to costs directly related to the successful acquisition of insurance contracts. Costs meeting this definition typically include, among other things, sales commissions paid to agents, premium taxes, and the portion of employee salaries and benefits directly related to time spent on acquired contracts. These costs are deferred and amortized over the life of the contracts.
We service our Standard Insurance Operations' agency distribution channel through our field model, which includes agency management specialists ("AMSs"), safety management specialists, claims management specialists ("CMSs"), and our Underwriting and Claims Service Centers, all of which service the entire population of insurance contracts acquired through each agency. For our E&S Insurance Operations, we use external adjusters to service claims on behalf of our customers.
There were no premium deficiencies for any of the reported years, as the sum of the anticipated losses and loss expenses, unamortized acquisition costs, policyholder dividends, and other expenses for our Standard Insurance Operations and E&S Insurance Operations segments 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 on our actual average investment yield before tax as of the September 30 calculation date were 3.0% for 2013, 3.1% for 2012, and 4.0% for 2011. Deferred policy acquisition costs amortized to expense were $331.8 million for 2013, $298.5 million for 2012, and $266.1 million for 2011.
We use the asset and liability method of accounting for income taxes. Current federal income taxes are recognized for the estimated taxes payable or refundable on tax returns for the current year. Deferred federal income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax basis of assets and liabilities. A valuation allowance is established when it is more likely than not that some portion of the deferred tax asset will not be realized. A liability for uncertain tax positions is recorded when it is more likely than not that a tax position will not be sustained upon examination by taxing authorities. The effect of a change in tax rates is recognized in the period of enactment.
Our pension and post-retirement life benefit obligations and related costs are calculated using actuarial methods, within the framework of GAAP. 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 unless facts indicate that a more frequent review is required. Other assumptions involve demographic factors such as retirement age, mortality, turnover, and rate of compensation increases. 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. To determine the expected long-term rate of return on the plan assets, we consider the current and expected asset allocation, as well as historical and expected returns on each plan asset class.
In October 2010, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2010-26, Financial Services-Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts (“ASU 2010-26”). ASU 2010-26 requires that only costs that are incremental or directly related to the successful acquisition of new or renewal insurance contracts are to be capitalized as a deferred acquisition cost. This includes, among other items, sales commissions paid to agents, premium taxes, and the portion of employee salaries and benefits directly related to time spent on acquired contracts. We adopted this guidance on January 1, 2012, with retrospective application and, as such, all historical data in this Form 10-K has been restated to reflect the revised guidance.
In May 2011, the FASB issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS (“ASU 2011-04”). This guidance changes the wording used to describe the requirements in U.S. GAAP for measuring fair value and disclosing information about fair value measurements to improve consistency in the application and description of fair value between GAAP and International Financial Reporting Standards. ASU 2011-04 clarifies that the concepts of highest and best use and valuation premise in a fair value measurement are relevant only when measuring the fair value of nonfinancial assets, and are not relevant when measuring the fair value of financial assets or liabilities. In addition, ASU 2011-04 expands the disclosures for unobservable inputs for Level 3 fair value measurements, requiring quantitative and qualitative information to be disclosed related to: (i) the valuation processes used; (ii) the sensitivity of the fair value measurement to changes in unobservable inputs and the interrelationships between those unobservable inputs; and (iii) the use of a nonfinancial asset in a way that differs from the asset’s highest and best use. ASU 2011-04 was effective prospectively for interim and annual periods beginning after December 15, 2011. We have included the disclosures required by this guidance in our notes to the Financial Statements, where appropriate.
The entity does not intend to use the deferred tax asset for this purpose.
ASU 2014-01 is effective for public business entities for annual periods and interim periods within those annual periods, beginning after December 15, 2014. The adoption of this guidance will not have a material impact on our financial condition or results of operations.
Supplemental cash flow information for the years ended December 31, 2013, 2012, and 2011 is as follows:
At December 31, 2013, included in "Other assets" on the Consolidated Balance Sheet was $7.3 million of cash received from the NFIP which is restricted to pay flood claims under the WYO program.
(a) Net unrealized gains on investments included in OCI by asset class were as follows for the years ended December 31, 2013, 2012, and 2011:
Unrecognized holding gains/losses of HTM securities are not reflected in the Financial Statements, as they represent fair value fluctuations from the later of: (i) the date a security is designated as HTM; or (ii) the date that an OTTI charge is recognized on an HTM security, through the date of the balance sheet. Our HTM securities had an average duration of 2.2 years as of December 31, 2013.
1 CMBS includes government guaranteed agency securities with a fair value of $30.0 million at December 31, 2013 and $48.9 million at December 31, 2012.
(d) The following tables summarize, for all securities in a net unrealized/unrecognized loss position at December 31, 2013 and December 31, 2012, 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:
As evidenced by the table below, our net unrealized/unrecognized loss positions increased by $49.1 million as of December 31, 2013 compared to the prior year as follows:
At December 31, 2013, we had 557 securities in an aggregate unrealized/unrecognized loss position of $52.0 million, $2.9 million of which have been in a loss position for more than 12 months. At December 31, 2012, we had 101 securities in an aggregate unrealized/unrecognized loss position of $2.9 million, $1.7 million of which have been in a loss position for more than 12 months. During 2013, interest rates, other than short-term, generally rose. For example, the yield on the 10-year U.S. Treasury Note rose by 127 basis points. This interest rate movement has negatively impacted our fixed maturity securities portfolio's valuation, thus increasing the number of securities in a loss position and the corresponding dollar amount of unrealized losses. The increase in the unrealized losses does not correspond to any issuer specific credit concerns; however, it does reflect an expected reduction in market value due to higher market interest rates. If interest rates rise further, it is reasonable to expect downward pressure on the fair market values within our fixed maturity securities portfolio, potentially resulting in an increased number of securities in a loss position for an extended period of time, and a corresponding increase in the dollar amount of unrealized losses. For a discussion regarding the sensitivity of interest rate movements and the related impacts on the fixed maturity securities portfolio, refer to Item 7A. "Quantitative and Qualitative Disclosures About Market Risk" of this Form 10-K.
We do not intend to sell any securities in an unrealized/unrecognized loss position nor do we believe we will be required to sell these securities, and therefore we have concluded that they are temporarily impaired as of December 31, 2013. This conclusion reflects our current judgment as to the financial position and future prospects of the entity that issued the investment security and underlying collateral. If our judgment about an individual security changes in the future, we may ultimately record a credit loss after having originally concluded that one did not exist, which could have a material impact on our net income and financial position in future periods.
The fund of funds component of our distressed debt strategy, which makes up approximately $7.9 million of our distressed debt strategy, encompasses a number of strategies that generally fall into one of the following broad categories:
Our seven alternative investment strategies employ low or moderate levels of leverage and generally use hedging only to reduce foreign exchange or interest rate volatility. At this time, our alternative investment strategies do not include hedge funds. We 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 in the limited partnerships. We anticipate that the general partners of these alternative investments will liquidate their underlying investment portfolios through 2026.
(g) At December 31, 2013, we had fixed maturity securities, with a carrying value of $62.3 million, that were pledged as collateral for our outstanding borrowing of $58 million with the FHLBI. This outstanding borrowing is included in “Notes payable” on our Consolidated Balance Sheets. In accordance with the terms of our agreement with the FHLBI, we retain all rights regarding these securities, which are included in the “U.S. government and government agencies,” “RMBS,” and “CMBS” classifications of our AFS fixed maturity securities portfolio.
In addition, certain bonds with a carrying value of $26.5 million were on deposit with various state and regulatory agencies to comply with insurance laws. We retain all rights regarding these securities, which are primarily included in the "U.S. government and government agencies" classification of our AFS fixed maturity securities portfolio.
The following table sets forth, for the periods 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:
(j) The components of net realized gains (losses), excluding OTTI charges, were as follows:
As of December 31, 2013, we had 10.6 million shares reserved for various stock compensation and purchase plans, retirement plans and dividend reinvestment plans. As a convenience to our employees and directors, we repurchase the Parent’s stock from time-to-time as permitted under our stock-based compensation plans. The Parent has not had an authorized stock repurchase program since 2009. The following table provides information regarding the purchase of the Parent’s common stock during the 2011 through 2013 reporting periods:
(b) The components of comprehensive income, both gross and net of tax, for 2013, 2012, and 2011 were as follows:
The following table presents the carrying amounts and estimated fair values of our financial instruments as of December 31, 2013 and 2012:
The following table provides a summary of the changes in the fair value of securities measured using Level 3 inputs and related quantitative information for the years ended December 31, 2013 and 2012:
1 Amounts are reported in “Unrealized holding (losses) gains arising during period” on the Consolidated Statements of Comprehensive Income.
3For the receivable related to the sale of Selective HR, amounts in “Loss on disposal of discontinued operations, net of tax” relate to an impairment charge and
In 2012, fixed maturity securities with a fair value of $9.0 million were transferred into Level 3 during the year. These
value, for which available pricing at December 31, 2012 used Level 3 inputs. Fixed maturity securities with a fair value of $8.5 million were transferred out of Level 3 due to the availability of Level 2 pricing at December 31, 2012 that was not available previously.
and 2012, respectively. During 2012, two non-publicly traded equity securities were transferred into Level 3 due
to the nature of the quotes used at the valuation date. One of these securities was transferred out of Level 3 and into Level 2 at
At December 31, 2012, the receivable related to the sale of Selective HR was contingent on the purchaser's ability to retain
business subsequent to the sale. At that time, the fair value of this receivable was measured using unobservable inputs, the
a result, the receivable was transferred out of Level 3. See Note 12. "Discontinued Operations" of this Form 10-K for a
discussion of the impairment charge that was recorded on this receivable in the first quarter of 2013.
The following tables provide quantitative information regarding our financial assets and liabilities that were disclosed at fair value at December 31, 2013 and 2012:
Our Financial Statements reflect the effects of assumed and ceded reinsurance transactions. Assumed reinsurance refers to the acceptance of certain insurance risks that other insurance entities have underwritten. Ceded reinsurance involves transferring certain insurance risks (along with the related written and earned premiums) that we have underwritten to other insurance companies that agree to share these risks. The primary purpose of ceded reinsurance is to protect the Insurance Subsidiaries from potential losses in excess of the amount that we are prepared to accept.
The Insurance Subsidiaries remain liable to policyholders to the extent that any reinsurer becomes unable to meet their contractual obligations. We evaluate and monitor the financial condition of our reinsurers under voluntary reinsurance arrangements to minimize our exposure to significant losses from reinsurer insolvencies. On an ongoing basis, we review amounts outstanding, length of collection period, changes in reinsurer credit ratings, and other relevant factors to determine collectability of reinsurance recoverables. The allowance for uncollectible reinsurance recoverables was $5.1 million at December 31, 2013 and $4.8 million at December 31, 2012.
Direct losses and loss expenses decreased significantly in 2013, primarily due to the impact of Hurricane Sandy in 2012 which included the following: (i) $136.0 million in gross losses, of which $89.4 million were covered under our catastrophe excess of loss treaty, resulting in a net impact of $46.6 million; and (ii) $1 billion in gross flood losses that are 100% ceded to the federal government, resulting in no net loss to us. Partially offsetting these direct losses were flood claims handling fees of $18.3 million in 2012.
1 Includes $44.0 million related to the acquisition of MUSIC at December 31, 2011.
The net losses and loss expense reserves increased by $149.7 million in 2013, $63.8 million in 2012, and $79.1 million in 2011. The losses and loss expense reserves are net of anticipated recoveries for salvage and subrogation claims, which amounted to $61.0 million for 2013, $62.2 million for 2012, and $67.6 million for 2011. The changes in the net losses and loss expense reserves were the result of growth in exposures, particularly associated with our E&S line of business, anticipated loss trends, changes in reinsurance retentions, and normal reserve changes 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 2013, we experienced overall favorable loss development of approximately $25.5 million, compared to $25.5 million in 2012 and $38.5 million in 2011. The following table summarizes the prior year development by line of business:
The 2013 prior year favorable development of $25.5 million includes $14.5 million of favorable casualty development and $11.0 million of favorable property development. The property development was primarily related to favorable non-catastrophe loss activity, mostly in the 2012 accident year. The casualty lines were driven largely by favorable development in accident years 2006 through 2010, partially offset by unfavorable development in accident year 2012. The favorable development was driven primarily by lower than expected severities in general liability and commercial automobile, which represents a continued trend in these lines of business. The unfavorable development in accident year 2012 was driven by higher than expected severities in the general liability, commercial automobile, and workers compensation lines of business.
The 2012 prior year favorable development of $25.5 million includes $18.0 million of casualty development and $7.5 million of property development. The property development was primarily related to the favorable non-catastrophe loss activity that occurred in the first quarter of 2012 mostly in the 2011 accident year. The casualty lines were driven by favorable development in the 2007 through 2009 accident years partially offset by unfavorable development in accident year 2011. The favorable development was driven by lower than expected severities in all of the major casualty lines, which represents a consistent trend in recent years. The unfavorable development in accident year 2011 was driven by: (i) higher than expected severities in the workers compensation and general liability lines; and (ii) higher than expected frequencies in the commercial auto line. This was partially offset by continued favorable development in the homeowners liability line, due to lower expected severity for this year.
In 2009, the Indiana Subsidiaries borrowed $13 million in the aggregate from the FHLBI. The unpaid principal amount accrues interest of 2.9% and is paid on the 15th of every month. The principal amount is due on December 15, 2014. These funds were loaned to the Parent to be used for general corporate purposes.
(3) In the fourth quarter of 2005, we issued $100 million of 6.70% Senior Notes due 2035. These notes were issued at a discount of $0.7 million resulting in an effective yield of 6.754% and pay interest on May 1 and November 1 each year commencing on May 1, 2006. Net proceeds of approximately $50 million were used to fund an irrevocable trust to provide for certain payment obligations in respect of our outstanding debt. The remainder of the proceeds 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.
(4) In the fourth quarter of 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% and pay interest on May 15 and November 15 each year. 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.
The table below outlines information regarding certain of the covenants in the Line of Credit:
Stockholders' equity reflects tax benefits related to compensation expense deductions for share-based compensation awards of $19.2 million at December 31, 2013, $17.7 million at December 31, 2012, and $16.6 million at December 31, 2011.
We have analyzed our tax positions in all open tax years, which as of December 31, 2013 were 2007 through 2012. The Internal Revenue Service (“IRS”) recently completed a limited scope examination of the 2007 through 2010 tax years, which resulted in no material changes. We do not have unrecognized tax expense or benefit as of December 31, 2013.
In addition, we believe our tax positions will more likely than not be sustained upon examination, including related appeals or litigation. In the event we had a tax position that did not meet the more likely than not criteria, any tax, interest, and penalties incurred related to such a position would be reflected in "Total federal income tax expense (benefit)" on our Consolidated Statements of Income.
SICA offers a voluntary defined contribution 401(k) plan to employees who meet eligibility requirements. Participants can contribute 2% to 50% of their defined compensation to the Retirement Savings Plan not to exceed limits established by the IRS. Employees age 50 or older who are contributing the maximum may also make additional contributions not to exceed the additional amount permitted by the IRS. Subject to IRS limits, the following table presents information regarding plan terms:
Non-elective contributions of 4% of defined compensation for employees not eligible to participate in the Retirement Income Plan due to a date of hire after December 31, 2005
Non-elective contributions of 4% of defined compensation expanded to include employees impacted by the curtailment of the Retirement Income Plan
In addition to the deferrals elected by the Participants, SICA 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 or non-elective contributions permissible under the Retirement Savings Plan due to limitations under the Internal Revenue Code or the Retirement Savings Plan. SICA 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 2013, 2012, or 2011. SICA contributed $0.2 million in 2013, a nominal amount in 2012, and $0.1 million in 2011 to the Deferred Compensation Plan.
The Retirement Income Plan for Selective Insurance Company of America and the Supplemental Excess Retirement Plan (jointly referred to as the "Retirement Income Plan" or the "Plan") is a noncontributory defined benefit plan covering SICA employees who met each Plan's eligibility requirements prior to January 1, 2006. As of such date, the Plan was amended to eliminate eligibility for participation by employees first hired on or after January 1, 2006. In addition, the Plan was further amended in the first quarter of 2013 to curtail the accrual of additional benefits for all eligible employees after March 31, 2016. This curtailment resulted in a net actuarial gain recognized in OCI of $44.0 million on a pre-tax basis as of March 31, 2013.
The Retirement Income Plan was amended as of July 1, 2002 to provide for different calculations based on service with SICA as of that date. Monthly benefits payable under the Retirement Income Plan at normal retirement age are computed under the terms of those calculations. The earliest retirement age is age 55 with 10 years of service or the attainment of 70 points (age plus years of service). If a participant chooses to begin receiving benefits before their 65th birthday, the amount of the participant's monthly benefit would be reduced in accordance with the provisions of the plan. At retirement, participants receive monthly pension payments and may choose among five payment options, including joint and survivor options.
The funded status of the Retirement Income Plan and Retirement Life Plan was recognized in the Consolidated Balance Sheets for 2013 and 2012, the details of which are as follows:
1 Discount rate for the Retirement Income Plan changed from 4.42% as of December 31, 2012 to 4.66% as of March 31, 2013 due to the remeasurement that was performed with the curtailment of the Plan.
1The Retirement Income Plan currently has fixed maturity security exposures that do not have target and range percentages since these exposures will be phased out over time as we opportunistically migrate from intermediate to long duration fixed maturity security strategies.
The deposit administration contract is carried at cost, which approximates fair value. Given the liquid nature of the underlying investments in overnight cash deposits and other short term duration products, we have determined that a correlation exists between the deposit administration contract and other short-term investments such as money market funds. As such, this investment is classified as Level 2 in the fair value hierarchy.
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 December 31, 2013, the Retirement Income Plan had contractual obligations that expire at various dates through 2022 to further invest up to $3.9 million in alternative investments. There is no certainty that any such additional investment will be required. The Retirement Income Plan currently receives distributions from these alternative investments through the realization of the underlying investments in the limited partnerships. We anticipate that the general partners of these alternative investments will liquidate their underlying investment portfolios through 2022.
The Parent's 2005 Omnibus Stock Plan ("Stock Plan") was approved effective as of April 1, 2005 by stockholders on April 27, 2005. With the Stock Plan's approval, no further grants were 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 Parent's Stock Option Plan II, as amended ("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.
During the vesting period, dividend equivalent units ("DEUs") are earned on RSUs. The DEUs are reinvested in the Parent's common stock at fair value on each dividend payment date. We accrued 23,505 DEUs in 2013; 32,558 DEUs in 2012; and 41,469 DEUs in 2011. In addition, 39,296 DEUs were vested in 2013, 48,224 DEUs were vested in 2012, and 33,532 were vested in 2011. The DEUs are subject to the same vesting period and conditions set forth in the award agreements for the related RSUs.
As of December 31, 2013, 298,680 shares of the Parent's common stock remained available in the reserve for Stock Option Plan II, under which future grants ceased being available on May 22, 2002. Under Stock Option Plan II, employees were granted qualified and nonqualified stock options, with or without SARs, and restricted or unrestricted stock: (i) at not less than fair value on the date of grant; and (ii) subject to certain vesting periods as determined by the SEBC. Restricted stock awards also could be subject to the achievement of performance objectives as determined by the SEBC. The maximum exercise period for an option grant under this plan was 10 years from the date of the grant.
The total intrinsic value of options exercised was $1.3 million during 2013, and $0.8 million in 2012 and 2011.
At December 31, 2013, the liability recorded in connection with our Cash Incentive Plan was $20.8 million. The fair value of the liability is re-measured at each reporting period through the settlement date of the awards, which is three years from the date of grant based on an amount expected to be paid. A Monte Carlo simulation is performed to approximate the projected fair value of the cash incentive units that, in accordance with the Cash Incentive Plan, is adjusted to reflect our performance on specified indicators as compared to targeted peer companies. The remaining cost associated with the cash incentive units is expected to be recognized over a weighted average period of 1.2 years. The cash incentive unit payments made were $4.7 million in 2013, and $3.0 million in 2012 and 2011.
Share-based compensation expense charged against net income before tax was $19.9 million for the year ended December 31, 2013 with a corresponding income tax benefit of $6.8 million. Share-based compensation expense that was charged against net income before tax was $13.8 million for the year ended December 31, 2012 and $10.1 million for the year ended December 31, 2011 with corresponding income tax benefits of $4.8 million and $3.5 million, respectively.
William M. Rue, a Director of the Parent, is Chairman of, and owns more than 10% of the equity of, Chas. E. Rue & Son, Inc., t/a Rue Insurance, a general independent retail insurance agency ("Rue Insurance"). Rue Insurance is an appointed independent retail agent of the Insurance Subsidiaries on terms and conditions similar to those of our other agents. Rue Insurance also places insurance for our business operations. Our relationship with Rue Insurance has existed since 1928.
Note 20. Statutory Financial Information, Capital Requirements, and Restrictions on Dividends and Transfers of Funds
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, 2013, the various state insurance departments of domicile have adopted the March 2013 version of the NAIC Accounting Practices and Procedures manual in its entirety, as a component of prescribed or permitted practices.
The Insurance Subsidiaries are required to maintain certain minimum amounts of statutory surplus to satisfy the requirements of their various state insurance departments of domicile. RBC requirements for property and casualty insurance companies are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholders. The Insurance Subsidiaries combined total adjusted capital exceeded the authorized control level RBC, as defined by the NAIC, by 4.5:1 based on their 2013 statutory financial statements. The negative unassigned surplus balance for MUSIC existed prior to our acquisition of this company in 2011. This company has not generated sufficient net income as of yet to offset negative surplus items, such as non-admitted assets. In addition to statutory capital requirements, we are impacted by various rating agency requirements related to certain rating levels. These required capital levels may be more than statutory requirements.
The extraordinary dividends paid in 2013 were part of the capitalization plan for the formation of SFCIC and SCIC.
Based on the 2013 statutory financial statements, the maximum ordinary dividends that can be paid to the Parent by the Insurance Subsidiaries in 2014 are as follows:
1 See Note 20. “Statutory Financial Information, Capital Requirements, and Restrictions on Dividends and Transfers of Funds” for a discussion of dividend restrictions.
2 These ranges of high and low prices of the Parent’s common stock, as reported by the NASDAQ Global Select Market, represent actual transactions. Price quotations do not include retail markups, markdowns, and commissions. The range of high and low prices for common stock for the period beginning January 2, 2014 and ending February 14, 2014 was $21.38 to $26.99.