Our home office is in Seattle, Washington, where we occupy 795,000 square feet of owned property.
In addition, we own a total of 1.6 million square feet in Redmond, Washington. As a result of the sale of our L&I businesses, we are leasing 278,000 square feet of this space to the buyer, and the lease expires in July 2005. We own 246,000 square feet in Pleasant Hill, California; Portland, Oregon; and Spokane, Washington. We also occupy 1.9 million square feet of leased space throughout the United States, 152,000 square feet of which we sublease to third parties. Our leased and owned space totals approximately 4.5 million square feet.
(1) Our 2001 loss includes a goodwill write-off of $916.9 after tax.
(3) Combined ratios are calculated on a GAAP basis. Expressed as a percentage, combined ratios equal losses and expenses divided by net earned premiums.
(Dollar amounts in millions except for ratios and per share data unless noted otherwise)
This discussion should be read with the Consolidated Financial Statements and Notes to the Consolidated Financial Statements included elsewhere in this report. Certain reclassifications have been made to prior-year financial information to conform with the current-year presentation.
Successful implementation of the new-business entry model for personal and commercial lines
Our ability to achieve premium targets and profitability, including realization of growth and business retention estimates
Weather conditions, including the severity and frequency of storms, hurricanes, hail, snowfall and winter conditions
The occurrence of significant man-made disasters, such as terrorist attacks or war
Our financial results for the last three years have been affected by the major strategic actions we have taken to turn our company around, reshape our business and become a more focused and successful competitor.
Four critical ideas led us to pursue the sale of L&I:
Our belief that relentless focus on what we do best drives the greatest benefits for Safeco and our shareholders
We used the $1,499.0 proceeds of the sale to return our debt-to-capital ratios to pre-sale levels and return excess capital to our shareholders. Specifically, we used $735.2, including transaction costs, to repurchase $618.4 of debt, resulting in a $121.0 pretax ($78.7 after-tax) loss on debt repurchases. Including transaction costs we used $625.0 to execute an Accelerated Stock Buyback (ASB) program of 13,247,863 shares and we retained the balance for future flexibility and to pay transaction-related expenses.
Meeting the needs of our customers at a fair price - We offer a competitively priced product through the sophistication of our automated underwriting models using Safeco Now, which enables us to appropriately match price to risk. We also focus on outstanding service by measuring ourselves against a “zero-defect” standard in our service transactions. These service transactions include our Gold Service program, which provides fee-based full-service customer support on behalf of our distribution partners through our regional service centers. We deploy a team of nearly 3,000 claims professionals across the country to deliver our most visible product - the personalized service and support we provide when customers experience a loss and file a claim. In addition, our expense reduction efforts that began in 2003 reduced our 2004 operating expenses by approximately $75, primarily by eliminating approximately 500 positions in our corporate departments. Our cost reductions and ongoing expense discipline help us provide competitively priced products.
Refining our business model further - Our market advantage is sustained by how we do business - offering standardized auto, homeowners and small-commercial insurance products over a unified sales-and-service platform through a common independent distribution network. To fully leverage this business model, in 2004, we realigned our organization around these three areas. Here’s a closer look at the key elements of our business model:
Product - We focus on the personal and commercial insurance products purchased by the vast majority of U.S. consumers. We call these “standardized” products because they don’t require significant customization, and they’re well suited to automated underwriting and sales-and-service support. Our claims operation, with its front-line experience and insight, is tightly aligned with our product development and underwriting teams. We continually work to refine our segmented pricing models and accurately match rate to risk.
Distribution - We sell our insurance products exclusively through a national network of 8,500 independent distributors that provides customers with choice and advice. We motivate our distributors by giving them more to sell (multiple lines of personal and commercial insurance), making it easier for them to sell (through technology and other ease-of-business tools), helping them make more money selling our products (through increased operational efficiencies) and providing competitive compensation programs.
Reducing Expenses - We identified expense reductions across the company to enable us to better compete in the property and casualty insurance markets. We announced that we would eliminate approximately 500 positions in our corporate departments, and we completed this in March 2004.
In 2002, we reshaped our P&C business to improve profitability and position our company for growth. Our major strategic actions included:
Improving Sales Growth through Independent Distributors - We began the rollout of our automated underwriting platform. This technology made it easier for distribution partners to sell all our primary product lines -auto, homeowners and small-business insurance.
Improving Service and Claims Handling - We launched a multi-year training effort to drive out errors from our processes involving customers. We initiated projects to eliminate mistakes that degrade service and waste money.
Investing in Our Employees - We implemented a total performance-management system that encompasses goal setting, employee development and compensation tied to individual and team performance. We also completed work on and began implementation of our diversity strategy, tied to our workforce, distributors, suppliers and customer base.
Revenue Growth - growth at or above the average of our peers, as long as it’s at acceptable profit margins
On January 1, 2004, we made minor revisions to our P&C segments to better reflect how these segments are currently managed. Our non-voluntary auto and property results, previously in P&C Other, are now included in SPI Auto and SPI Property. Certain products previously reported in Specialty, primarily earthquake, inland marine and dwelling fire, are now included in Property. Our commercial specialty programs and large-commercial accounts in runoff, previously SBI Runoff, are now included in P&C Other. Prior years have been restated to reflect this revised presentation.
Although investment activities are an important part of our business and comprise a significant part of our total revenues, we don’t include our investment portfolio results when measuring the profitability of our individual segments. That’s because we manage the investment portfolio separately from our underwriting activities. We invest the insurance premiums we receive in a diversified portfolio until they’re needed to pay claims. Our first priority is to protect our policyholders, so we invest in a diversified portfolio composed primarily of government securities and high-grade fixed maturities. This strategy generally provides protection for our policyholders and a steady income for our shareholders.
We have identified the accounting estimates listed below as critical to understanding our results of operations and financial condition. The application of these accounting estimates requires our management to use judgments involving assumptions and estimates about future results, trends or other developments that could significantly influence our results if actual experience differs from those assumptions and estimates. We review these judgments frequently. An understanding of them may help readers to better understand our Consolidated Financial Statements and Management’s Discussion and Analysis (MD&A). We consider our most critical accounting estimates to be:
Our loss and loss adjustment expense (LAE) reserves reflect management’s estimates of the ultimate amounts for losses from claims and related settlement expenses that we have not yet paid to settle both reported and unreported claims. We report these amounts in our Loss and LAE Reserves on our Consolidated Balance Sheets.
We use actuarial methods combined with management judgment to estimate IBNR reserves.
Allocated Loss Adjustment Expense (ALAE) - ALAE reserves represent an estimate of the claims settlement expenses that can be identified to a specific claim. ALAE reserve estimates are generally established as a function of losses. For some small lines, estimates of ultimate ALAE are established as a percentage of earned premiums. These ALAE factors are established based on historical ratios supplemented for changes in the internal and external environments. ALAE IBNR is determined by subtracting paid and case-basis activity from the ultimate ALAE estimate.
Unallocated Loss Adjustment Expense (ULAE) - ULAE reserves are booked in aggregate for current and prior accident years combined. In general, prior reserves are carried forward and supplemented with either a percentage of earned premiums or with a fixed dollar amount of additional reserves to account for growth in the line of business.
In addition, certain claims may be paid out over a number of years, and there may be a significant lag between the time a loss that is insured by us occurs and the time it is reported to us.
These variables and factors affect in a variety of ways the amounts we have to pay for losses and related expenses. As a result, it is not always possible to quantify their ultimate impact on our future payments. Our process for arriving at our best estimate of ultimate loss and LAE involves both management and actuaries. It involves reviewing actuarial assumptions, holding discussions with claims and underwriting management, and considering changes in the internal and external environment. Because estimating reserves requires us to use assumptions and judgment, our actual future losses will differ from our estimates.
Some actuarial techniques rely on our past loss and LAE experience to estimate our future payments. The changes we’ve made in our business in recent years, however, will affect our future payments. For instance, we have introduced new products, tightened our underwriting criteria and improved our claims handling practices. As a result, we also consider these changes when estimating future payments.
For most of our lines of business, we use multiple estimation methods that vary depending on the particular facts and circumstances of the claim liabilities being evaluated to establish our estimate of ultimate losses.
Our estimate of IBNR is the difference between our projection of ultimate losses and the payments and case-basis reserves for those losses. Our analyses are applied to historical claim activity and experience, supplemented with data about changes in our book of business, changes in the external environment in which we operate, changes in our pricing and underwriting, and changes in our claims handling practices. The standard actuarial methods we use include:
Paid Loss Development - historical payment patterns for prior claims are used to estimate future payment patterns for current claims. These patterns are applied to current payments by accident year to yield expected ultimate losses.
Expected Loss Ratio - loss ratios are developed for recent accident years based on historical accident year loss ratios adjusted to the current economic conditions and current rate levels. The expected loss ratio for each accident year is then applied to the actual earned premiums to calculate expected ultimate losses.
We use range analyses only to back test whether previously established estimates for reserves for our lines of business are reasonable, using subsequent information. We do not develop a range and then select a number from the range as our reserve estimate. Furthermore, the methods used and resulting end points of the ranges change over time as conditions affecting reserves change.
Changing Management’s Estimate - Management’s estimate of the ultimate loss and LAE reserves is subject to change as additional data emerge. This could occur as a result of:
Catastrophe and non- catastrophe weather losses are established by event by the claims department when the event occurs. These estimates are revised as the actual loss experience develops as the claims are reported and settled over time.
We may determine that certain loss or salvage/subrogation activity is beyond the scope of what was anticipated in the initial establishment of loss reserves. In this case, an explicit adjustment would be made to IBNR to reflect this activity directly as a change in IBNR.
Other Considerations - We reduce our reserves by the amounts we expect to recover from salvage and subrogation. We accrue salvage and subrogation recoveries on an individual case basis for large claims. We use actuarial techniques to estimate the amount for small claims.
Payout period - lines of business involving claims that stay open for long periods of time are subject to greater reserve variability. This is driven by the difficulty in estimating future economic, social and legal environments that will impact both the time that such claims remain open and their future costs.
Policy deductibles - lines of business involving policies with large deductibles or policies that provide coverage for claims that exceed the policy limit of an underlying policy (excess policies) are subject to greater variability. The existence of large policy deductibles considerably increases the lag between the occurrence of a claim and the time it is reported to the insurance carrier.
Bodily injury (BI) coverage represents the largest portion (60.5%) of our loss and ALAE reserves held for Auto. As of year-end 2004, our BI loss and ALAE reserves were $899.9. Small variations from our assumptions can yield significant financial volatility given the magnitude of the reserve balances.
Our changing mix of business - as our business grows, we write more policies in markets where we have not written significant business previously. We continue to write a higher proportion of standard and non-standard risks than we have historically. These risks have, on average, higher frequencies and lower severities than preferred risks.
To illustrate the sensitivity of our estimate, a one-point increase in our severity change assumption for Auto BI would yield an approximate $25 increase in the estimated reserve.
Safeco Business Insurance (SBI) and P&C Other - SBI primarily writes commercial multi-peril, property, workers compensation, automobile and general liability insurance for small- to medium-sized businesses. P&C Other is composed of large-commercial business and other businesses we have placed in runoff. As many of the commercial products and exposures are similar, we estimate reserves for these two segments in a combined fashion by product line.
Long payout periods - workers compensation claims can remain open 50 years or more, introducing variability in the ultimate length of the payout. The cumulative effect of inflation trends over time, particularly medical cost inflation, can be significant.
Changes in future benefit levels - legislative actions and judicial interpretations can affect the cost of future benefits.
Claim reporting lags - some claims are not made immediately; as a result, we remain exposed to workers compensation losses arising from policies written years ago.
Other Commercial Products - Excluding commercial liability products, which are discussed below, the payout periods for our other commercial products, primarily commercial auto and commercial property, are relatively short. As a result, our estimated loss reserves for these products are subject to less volatility than our workers compensation reserves. We use standard actuarial techniques combined with management judgment to estimate these loss reserves.
Claim reporting lags - some claims are not made immediately; as a result, we remain exposed to losses arising from policies written years ago.
66.4% relates to runoff assumed reinsurance operations and our exposure to syndicates and pools.
Accordingly, we’ve established two separate special claims handling functions, one that specializes in asbestos claims related to our runoff assumed reinsurance operations and one that specializes in asbestos claims related to our direct exposure.
Our exposure to the major high-profile asbestos defendants is limited for our direct business. This results from our historical business strategy to not write direct coverages for larger companies. In addition, we do not have direct exposure to businesses that are the subject of settlement agreements.
At December 31, 2004, our IBNR was 25.4% of our loss reserves for asbestos claims.
Small Asbestos Accounts - our policyholders with cumulative loss payments of less than $100,000 as of December 31, 2004.
Several factors make it difficult to predict future asbestos claim payments. They include:
* Number of claims and whole dollars, net of reinsurance. Claim count history has been restated to reflect refinements in 2004 to our methods for counting claims.
Our Environmental Claims Exposure - Our environmental claims result from our runoff assumed reinsurance operations and our commercial general liability line that we write on a direct basis. We generally have avoided writing coverages for large companies with substantial exposures to environmental claims. As a result, our average environmental claim tends to be small.
At year-end 2004, our IBNR was 75.6% of our loss reserves for environmental claims.
Unresolved legal issues, including existence of coverage, definition of ultimate damages and final allocation of damages due from the financially responsible parties
* Number of claims and whole dollars, net of reinsurance. Claim count history has been restated to reflect 2004 refinements to our methods for counting claims.
Estimating Loss Reserves for Construction Defects Claims - The main factors in estimating loss reserves for construction defects claims are:
Long periods of time between the actual construction work and the date the claim is reported
We use techniques developed specifically for estimating loss reserves for construction defects claims. With these techniques, we estimate the number of future claims and the average value of every claim and make adjustments for anticipated changes in coverage interpretations, regulations, judicial rulings, plaintiff attorney involvement and changes in our book of business.
In this section, we provide the actual reserve estimates for the last three years and discuss changes in those estimates.
This table shows the changes in our loss and LAE reserves for 2004, 2003 and 2002. We report changes in estimated reserves in our Consolidated Statements of Income the same year we make the change:
$20.7 increase in commercial multi-peril and other general liability reserves. This includes an $8.6 reduction in World Trade Center loss estimates, a $29.6 increase in asbestos reserves and a $14.3 increase in environmental reserves.
$30.6 in a number of lines at various times during the year due to emerging claim trends and related loss data, including ULAE.
In 2003, we increased our estimates for prior years’ loss and LAE reserves by $249.9. The total increase included:
$44.9 in a number of lines at various times during the year due to emerging claim trends and related loss data.
$37.0 for construction defects claims, reflecting legal costs that were higher than estimated. Efforts to mitigate the severity levels of construction defects losses led to higher legal costs.
$24.4 for asbestos claims, reflecting losses related to our participation in pools and syndicates that were higher than estimated
$31.1 for other loss reserves and ULAE reserves due primarily to higher-than-anticipated losses for our London operations that were placed in runoff. The losses were due to some high-layer excess coverages and the long reporting lag of these operations.
The Analysis of Losses and LAE Reserve Development table on page 41 shows the development of our loss and LAE reserves from 1994 through 2004. For 1997 to 2004, the table includes amounts for American States Financial Corporation, which we acquired in 1997.
Section A shows the unpaid loss and LAE reserves we recorded at December 31, 1994-2004. It breaks out these reserves as:
Net of Reinsurance - the amount of our loss and LAE reserves after reinsurance
Section C shows the annual reestimation of those reserves, and after 10 years our revised reserves were $1,849.2.
After one year those reserves developed a $59.7 redundancy, and after 10 years the redundancy grew to $243.7. This is the difference between the reserves shown in Section A net of reinsurance, and the reestimated amounts in Section C.
Benefits from establishing specialized claims units for construction defects, asbestos and environmental exposures and fraud investigations
Lower-than-expected number of claims in commercial auto, primarily related to Ohio auto
On page 10, we provided an overview of how we use reinsurance. Here, we focus on how we estimate reinsurance recoverables.
Reinsurance recoverables concentrated with a particular event or issue (for example, a large loss, a catastrophe or an emerging claim issue)
Our estimated allowance for uncollectible reinsurance was $15.4 at December 31, 2004, and $16.3 at December 31, 2003.
The fixed maturities we invest in include bonds, mortgage-backed securities and redeemable preferred stock. The marketable equity securities we invest in include common stock and non-redeemable preferred stock.
How We Determine Other-than-Temporary Declines in the Value of Our Investments - We regularly review the fair value of our investments. If the fair value of any of our investments falls below our cost basis in the investment, we analyze the decrease to determine whether it is an other-than-temporary decline in value. To make this determination for each security, we consider:
How long and by how much the fair value of the security has been below its cost
The financial condition and near-term prospects of the issuer of the security, including any specific events that may affect its operations or earnings potential
Determining the Fair Value of Our Investments - In most cases, we use public market price information to determine the fair value of our investments when such information is available. When third-party market information is not available, as is the case for securities that are not publicly traded, we use other valuation techniques. Such techniques include:
We used these other valuation techniques to estimate the fair value of:
$61.0 in fixed maturities and $38.9 in marketable equity securities on our Consolidated Balance Sheets as of December 31, 2003. These amounts represented 1.1% of our total investment portfolio.
The following table presents summary consolidated financial information for the years indicated. A detailed discussion of our results by segment can be found on page 46.
Underwriting profit: Our underwriting profit improved by $478.2 in 2004 compared with 2003, and by $233.7 in 2003 compared with 2002. After-tax catastrophe losses were $179.1 in 2004 ($275.6 pretax), compared with $99.9 ($153.7 pretax) in 2003 and $55.5 ($85.4 pretax) in 2002. Excluding catastrophes, our underwriting profit margins exceeded our targets in 2004, reflecting favorable loss trends, rate increases and expense reduction efforts. We had favorable prior-year reserve development of $25.4 after tax ($39.0 pretax) in 2004. This was driven primarily by favorable reserve development in our personal property, personal auto and commercial auto reserves. In 2003, we had unfavorable prior-year reserve development, primarily in workers
Loss on debt repurchases: We used $735.2 of the proceeds from the sale of L&I to repurchase $618.4 in principal amount of debt and capital securities. Including transaction costs, this resulted in a loss on debt repurchases of $78.7 after tax ($121.0 pretax) in 2004.
Net realized investment gains: After-tax net realized investment gains were $126.4 in 2004, $45.9 in 2003 and $146.6 in 2002. The changes in net realized investment gains are discussed above.
The primary measures of our P&C operating results include our net earned premiums, underwriting profit or loss and combined ratios. The next three tables report those key items - by our reportable segments - for the last three years. More information about the results - also by reportable segment - follows the tables.
Next, underwriting profit or loss is our measure of each segment’s performance. Underwriting profit or loss is our net earned premiums less our losses from claims, LAE and underwriting expenses:
Expense Management - In 2004 and 2003, we took actions to reduce our expenses through corporate restructuring, which reduced corporate department expenses allocated to Auto. We also continued to reduce costs through the refinement of our automated underwriting models.
Net earned premiums increased $387.1 or 17.3% in 2004 compared with 2003, and $320.2 or 16.7% in 2003 compared with 2002. The increases in net earned premiums were driven by:
Our underwriting results improved $128.5 and our combined ratio improved 4.6 points in 2004 compared with 2003. Our underwriting results improved $107.3 and our combined ratio improved 5.2 points in 2003 compared with 2002. The continued improvement in underwriting results reflects improved loss and LAE and expense ratios. In 2003, we achieved our first underwriting profit since 1998. Our underwriting results were affected by:
Rate increases: Our rate increases improved our combined ratio by 4.2 points in 2004 compared with 2003, and 3.9 points in 2003 compared with 2002.
Loss costs: In 2004, growth in our average premium more than offset the increase in loss costs. We experienced mid single-digit increases in severity - the average cost of a claim - in part due to the impact of medical inflation on bodily injury claims. The increases in severity were slightly
offset by a low single-digit decrease in frequency - the average number of claims filed. The impact of loss cost changes net of premium trend change increased our combined ratio by approximately 1.4 points. In 2003, our premium trend was higher than our loss cost change, which was slightly negative as a result of severity increases in the low single-digits offset by a slightly larger decrease in frequency. This improved our combined ratio by 3.2 points in 2003 compared with 2002.
Prior-year reserve development: Results in 2004 included favorable reserve development of $12.7 related to prior accident years primarily from lower claim frequencies than originally estimated. Results in 2003 and 2002 included unfavorable reserve development of $6.5 and $6.0 related to prior accident years. The favorable development in 2004 improved the combined ratio by 0.7 points compared with 2003.
Catastrophe losses: Pretax catastrophe losses were $18.9 in 2004 compared with $26.8 in 2003 and $9.1 in 2002. The lighter catastrophe losses in 2004 improved the combined ratio by 0.3 points compared with 2003. The increased catastrophes in 2003 increased the combined ratio by 0.8 points compared with 2002.
Competitive Environment - The auto insurance marketplace has become more competitive in recent months as more writers are experiencing strong underwriting results. While we expect this competition will slow our growth rate somewhat, we anticipate premium growth in the high single-digits. This growth will be driven by more distributor appointments, continuing to expand geographical coverage, ongoing refinement in our underwriting segmentation and our commitment to ease of doing business for our distributors.
Reunderwriting Our Homeowners Business in Selected States - During 2003, we reviewed and updated our policyholder information in several states to verify we had accurate information concerning their property. This helped us ensure we were charging the appropriate premium for the risk involved.
Tightening Policy Terms - In 2002, in 43 of the states in which we are licensed to sell homeowners insurance, we placed a cap on the maximum amount payable in a total loss of 125% of the home’s insured value. In some cases, we have taken steps to restrict coverage, primarily on mold damages. These restrictions generally cap mold damages at $10 thousand, including remediation costs.
Increases in filed rates: We file rate changes on a state-by-state basis. Overall we received approval for average rate changes in our homeowners business of 1.3% in 2004 and average rate changes of 8.3% in 2003. Rate changes are reflected on existing policies on renewal, resulting in an increase to 2004 net earned premiums of approximately $81 compared with 2003, and $99 in 2003 compared with 2002.
Loss costs: The trend over the past two years toward higher deductibles - with most home owners increasing their deductibles from $250 to $500 - as well as other policy changes that have tightened contract terms has significantly reduced the number of maintenance-type claims. In 2004, we have experienced reductions in frequency of claims in the mid-teens, offset by a mid-teen increase in severity, decreasing our combined ratio by approximately 2.2 points compared with 2003. We experienced a frequency decrease in the high 20% range in 2003 compared with 2002, which was offset slightly by a mid single-digit increase in severity. This improved our combined ratio by approximately 11.5 points in 2003 compared with 2002.
Catastrophe losses in 2004 decreased the combined ratio by 0.6 points in 2004 compared with 2003, and 4.2 points in 2003 compared with 2002. Catastrophe losses in 2004 included $66.3 from the four hurricanes in Florida and surrounding states. Catastrophe losses in 2003 included $11.8 from the wildfires in California. Catastrophes were unusually low in 2002 relative to historical trends.
Rates - In Property, we plan to file for rate increases to at least keep pace with the rate of underlying loss cost growth. Actual rate changes obtained may vary from this based on regulatory review and approval and development in loss cost trends. We anticipate that rate increases combined with premium trend will at least keep pace with overall loss cost changes.
Business Growth - As our business grows, we will write more policies in markets where we previously have not written significant business. We expect to write more standard risks which have, on average, higher frequencies than preferred risks, but will remain selective. We are continuing to expand into eastern states where we have less geographic presence currently, being selective on where we write business to manage our catastrophe exposure.
Our Specialty operation provides individuals with umbrella, recreational vehicle, motorcycle and boat owners insurance. These products serve to round out our personal lines offerings for our customers’ insurance needs.
Automated Underwriting Platform - Our automated underwriting platform uses multi-variate models to assess the risk of loss based on many factors and provides a more accurate matching of price to risk. This allows us to offer policies to a wider range of small businesses. This is a key competitive advantage, as we can better segment our business and provide the best rate to our best customers, while higher risks are charged higher rates. This also has allowed us to improve retention of our best customers.
Business Service Center - Our business service center offers fee-based Gold Service programs that provide full-service customer support on behalf of our distribution partners. This increases retention of business for us as distributors are able to shift their policy servicing activities to us. These services are provided through our regional service center and include customer billing, claims servicing, policy renewal and endorsements.
Expense Management - In 2004 and 2003, we took actions to reduce our expenses through corporate restructuring, which reduced corporate department expenses allocated to SBI Regular. We also continued to reduce costs through the refinement of our automated underwriting models.
Price increases: Our price increases improved our combined ratio by 9.2 points in 2004 compared with 2003, and 6.4 points in 2003 compared with 2002.
Loss costs: Loss costs increased over the past year, reflecting increased claims severity due in part to higher labor and material costs, partially offset by decreased claim frequency. This increased the combined ratio by 0.2 points in 2004 compared with 2003. Similarly, in 2003 loss costs increased the combined ratio by 2.0 points compared with 2002.
Non-catastrophe weather losses: Our pretax non-catastrophe weather losses were $20.7 in 2004, $60.7 in 2003 and $29.1 in 2002. The lower loss experience for non-catastrophe weather events in 2004 improved the combined ratio by 3.6 points compared with 2003 and increased the combined ratio 3.1 points in 2003 compared with 2002.
Expenses: The decrease in our expense ratio of 3.3 points in 2004 compared with 2003 was the result of our wide-ranging expense improvement efforts, primarily as a result of the 2003 restructuring, which reduced corporate department expenses allocated to SBI Regular and lowered underwriting costs. This was partially offset by higher bonus commission and employee performance bonus expenses related to our growth and improved underwriting results.
Growth - Given the increasing number of small businesses in the United States and the lack of a dominant market leader, we see growth potential in this segment, and it is our goal to be the leading insurance writer. As we continue to roll out our automated underwriting platform and Safeco Now technology, we will grow our business by focusing on small-business policies and making it easy for our distributors to sell and service business with us.
In the fourth quarter of 2004, we expanded our BOP product by adding 35 additional classes of business, and we expect to add 60 more classes in 2005. In July 2004, after reviewing reforms and closely monitoring the market, we lifted a new-business moratorium on the California workers compensation market, and we now write policies for existing small account customers in approximately 80 classes of low-hazard business for accounts where we already write BOP, commercial auto or CMP policies.
Competition - We are experiencing increased competition in our mid- market business (customers who pay annual written premiums from $25,000 to $200,000). Historically, this business is more price-competitive as industry profit margins expand. Some carriers are lowering rates to be more price-competitive, particularly in the commercial property line where rates appear to be adequate. However, inflation in building materials costs is increasing and will impact loss costs. We remain committed to disciplined pricing of our business based on loss cost trends and meeting our profit margin targets. We will further compete in this segment through our field specialization model, creating a focus on distributor relationships and increasing retention by providing superior customer service. We also will continue to emphasize “ease of doing business” through product and service expansion on Safeco Now.
Loss Costs - We anticipate that medical costs, auto repair and building material costs will continue to rise. We strive to effectively manage these costs through efficient claims handling to help offset increased loss costs. We expect claim frequency to continue at current levels in 2005.
Overall -We expect single-digit growth in PIF, despite competitive conditions in the marketplace, while maintaining our target combined ratio of 95% or better in 2005.
Our SBI Special Accounts Facility (SAF) segment provides insurance for large-commercial accounts (customers who pay annual written premiums of more than $200,000). While our main focus is the small- to medium-sized commercial market, we continue to serve some large-commercial accounts on behalf of key distributors who sell our core P&C products. Almost 60% of new small-commercial business comes from distributors who also sell to large-commercial accounts.
Our underwriting results improved $2.8 in 2004 compared with 2003, and $5.7 in 2003 compared with 2002, reflecting stable combined ratios. Our underwriting results were affected by:
Catastrophe losses: Pretax catastrophe losses were $28.0 in 2004, $7.1 in 2003 and $3.3 in 2002. Catastrophe losses decreased the combined ratio by 4.5 points in 2004 compared with 2003, and had minimal impact to the combined ratio in 2003 compared with 2002.
The growth in our 2004 and 2003 net earned premiums and underwriting profits resulted from:
Continued Disciplined Underwriting - We have benefited from disarray in the surety market because we are a stable, long-term provider of surety bonds. Some competitors in the industry have experienced significant underwriting losses in recent years. We will maintain our disciplined underwriting approach as a priority while we grow this business.
Automated Underwriting Platform - During 2004, Surety implemented Safeco Now for the automated underwriting of small, low-risk transactional bonds. While this currently represents less than 5% of our surety premiums, it has good long-term growth potential. Safeco Now allows our distributors to quote and issue transactional bonds quickly and easily from our common sales platform.
$22.5 unfavorable prior-year reserve development in 2004, primarily in asbestos and environmental
$26.3 in 2002 related to our decision to place the London operations into runoff
We analyze our reinsurance recoverables according to the credit ratings and types of reinsurers. At year-end 2004:
For earthquake events, we have an additional level of coverage. Our reinsurers reimburse us for 90% of $260.0 in excess of $500.0. The entire amount of any earthquake loss above $760.0 is ours.
Should we make a catastrophe claim to our reinsurers, we can reinstate this reinsurance coverage once with payment of an additional premium.
We can reinstate once with payment of an additional premium for reinsurance covering losses above $20.0.
Risks above $20.0 are reinsured individually for each individual risk (facultative reinsurance).
Our reinsurer reimburses us for the rest of the loss up to $16.0 for each commercial umbrella loss on each policy.
Commercial Basket Retention Reinsurance - In 2004 and 2005, we purchased a basket retention coverage that reduces our financial loss when two or more lines of business are involved in the same loss event. The lines of business that are covered by this reinsurance are workers compensation, commercial property and commercial umbrella.
The Terrorism Risk Insurance Act of 2002 (TRIA) requires insurance companies to offer terrorism coverage to all commercial policyholders. That includes workers compensation and surety policyholders.
U.S. GOVERNMENT FUNDING - Under TRIA, the U.S. Government will provide funding to the insurance industry if a terrorist attack is certified as such by the Secretary of the Treasury in concurrence with the Secretary of State and Attorney General of the United States. The criteria for certification include: the act is dangerous to human life, property or infrastructure; is committed by an individual or individuals on behalf of any foreign person or foreign interest; and the act results in aggregate losses of $5.0 or more. Funding from TRIA will be 90% of the certified terrorist losses in excess of individual insurance company deductibles, up to $100 billion. TRIA determines the deductibles for insurance companies as a percentage of their direct earned premiums. Our estimated deductible for 2005 is $274.2.
TERRORISM EXCLUSIONS - Prior to the enactment of TRIA, our policies excluded losses due to foreign terrorism in states that had approved the exclusions. With TRIA, we can no longer exclude losses due to foreign terrorism unless the policyholder rejects our mandatory offer of terrorism coverage. The Insurance Services Office (ISO) created coverage and pricing tools to help insurers respond to the TRIA requirements.
REINSURANCE OPTIONS - The availability of terrorism reinsurance is limited in the commercial reinsurance market. Our current reinsurance program provides limited terrorism coverage. All reinsurance treaties exclude certified terrorist acts and also non-certified terrorist acts involving nuclear, chemical, biological or radioactive materials. Treaties providing both certified and non-certified terrorist acts include - our workers compensation reinsurance program, our commercial umbrella reinsurance program and our commercial basket retention treaty. Our property catastrophe treaty provides non-certified terrorism coverage for 90% of $400.0 excess of $100.0.
OUR EXPOSURE IS MODEST - We believe our exposure to potential terrorism losses is relatively modest across all our product lines.
In 2004, we repurchased $473.4 in principal amount of 8.072% debentures for $562.7, and we repurchased $145.0 in principal amount of 7.250% senior notes for $170.9. Including transaction costs, we reported a pretax loss on debt repurchases of $121.0 ($78.7 after tax) in the Consolidated Statements of Income.
The $30.0 lower loss in our Corporate segment results in 2004 compared with 2003 principally reflects lower interest expense on debt resulting from the debt repurchases described above. The lower interest expense in 2003 compared with 2002 was due to debt refinancing at lower rates. Our interest expense on borrowings totaled:
Net realized investment gains on fixed maturities transactions decreased $22.4 in 2004 compared with 2003, and decreased $114.9 in 2003 compared with 2002. The 2003 gains resulted primarily from calls as well as fixed maturity sales initiated to manage our call risk and improve the yield of the underlying portfolio. These calls - issuers redeeming bonds in which we’ve invested before the final maturity date - are an expected part of our investment activity, particularly when interest rates are low. The high level of net realized investment gains on fixed maturities in 2002 resulted from the repositioning of our portfolio.
Net realized investment gains on equity securities transactions increased $120.7 in 2004 compared with 2003, and decreased $124.0 in 2003 compared with 2002. The 2004 increase included $76.3 from sales of equity securities during the second quarter to reduce our holdings in equity securities to our target of about 10% of the total investment portfolio. Similarly, the 2003 decrease was due to higher net realized investment gains in 2002 as a result of our investment portfolio repositioning.
Changes in the financial condition and near-term prospects of the issuer
The higher level of impairments in 2003 and 2002 primarily resulted from:
Credit problems of some of the companies in which we’ve invested
In 2004, the fair value of fixed maturities that we sold at a loss was $202.0. Our total net realized investment loss on these sales was $12.7. In 2003, the fair value of fixed maturities that we sold at a loss was $120.7. Our total net realized investment loss on these sales was $6.4.
In 2004, the fair value of equity securities that we sold at a loss was $166.5. Our total net realized investment loss on these sales was $12.1. In 2003, the fair value of equity securities that we sold at a loss was $62.0. Our total net realized investment loss on these sales was $22.6.
We sold investments for the reasons discussed above. Also, as discussed previously, we sold equity securities in 2004 to reduce our holdings to our target of about 10% of the total investment portfolio.
We wound down our Safeco Financial Products (SFP) operations and liquidated its derivative portfolio at December 31, 2003. SFP’s total net realized investment gains (losses), which consisted of credit default swaps that were marked-to-market and payments made for coverage of certain credit events, were:
$24.4 gain in 2003 - including a $3.4 gain related to liquidating the credit default swap portfolio
$28.3 loss in 2002 - including an $8.6 loss resulting from the WorldCom bankruptcy
Our other net realized investment losses in 2002 included a reclassification from Accumulated Other Comprehensive Income to Net Realized Investment Losses of $18.7 related to cash flow hedges that were discontinued in connection with the retirement of the underlying commercial paper borrowings.
As of December 31, 2004, our fixed maturities, carried at $9,294.3, included:
As of December 31, 2003, our fixed maturities, carried at $8,159.2, included:
This table shows by maturity, the total amount of gross unrealized losses on fixed maturities and marketable equity securities at December 31, 2004:
These unrealized losses were less than 1% of our total portfolio value at both December 31, 2004 and 2003.
At December 31, 2004, these securities represented 1.8% of our total fixed maturities at fair value. At December 31, 2003, these securities represented 3.1% of our total fixed maturities at fair value.
The related amortized cost of the below investment grade fixed maturities was $155.4 at year-end 2004 and $233.7 at year-end 2003.
Our below investment grade securities had a net unrealized investment gain of $19.1 at year-end 2003, composed of $21.6 of gross unrealized investment gains, partially offset by $2.5 of gross unrealized investment losses.
Here are the quality ratings of our mortgage-backed securities portfolio at year-end 2004:
We get cash from insurance premiums, dividends, interest, sales or maturity of investments and debt and equity offerings.
The increase was due to cash received from premium growth of $5.56 billion in 2004, $5.07 billion in 2003 and $4.54 billion in 2002, and lower insurance claims paid of $3.31 billion in 2004, $3.36 billion in 2003 and $3.41 billion in 2002, reflecting our improved underwriting results. Dividends and interest received on our investment portfolio of $512.5 in 2004, $464.5 in 2003 and $453.7 in 2002, also contributed to the increase in cash flow.
We use cash from insurance operations primarily to pay claims and claim adjustment expenses. We require insurance premiums to be paid in advance. As a result, cash flows into our business before or at the time premium revenues are recognized. Cash flows out of our business in subsequent months or years as claims are paid.
Repurchases of Debt - On August 13, 2004, we repurchased $473.4 in principal amount of 8.072% debentures for $562.7, and on September 1, 2004, we repurchased $145.0 in principal amount of 7.250% senior notes for $170.9. Including transaction costs, we reported a pretax loss on debt repurchases of $121.0 ($78.7 after tax) in the Consolidated Statements of Income.
The proceeds were used to support future growth in our core product lines and to strengthen the capital base of these operations.
At the same time, we entered into a $375.0 notional amount interest rate swap, of which we terminated $145.0 notional amount in 2004. This converted our 7.250% fixed rate into a LIBOR-based floating rate obligation. We marked-to-market the fair value of the interest rate swap on the Debt line of our Consolidated Balance Sheets.
The bank credit facility does not require us to maintain any deposits as compensating balances. At the end of 2004 and throughout 2004, we had no borrowings under the bank credit facility and we were in compliance with all its covenants.
Our off-balance sheet arrangements are described in Notes 1 and 12 to our Consolidated Financial Statements on pages 90 and 122.
There are no recently passed, or recommendations calling for, regulations that would materially affect our liquidity, capital resources or results of operations.
Dividend Payments From Our Subsidiaries - Our insurance subsidiaries pay dividends to Safeco Corporation. We then use those funds to pay dividends to our shareholders as well as to make principal and interest payments on our debt. Individual states limit the amount of dividends that our subsidiaries domiciled in those states can pay us. Exceeding such limits would require prior regulatory approval. In 2005, our insurance subsidiaries can pay up to $755.3 in dividends without obtaining prior regulatory approval. These amounts are according to the limits states had in place at the end of 2004.
Risk-Based Capital - The National Association of Insurance Commissioners (NAIC) and state regulators use risk-based capital (RBC) formulae to identify companies that are undercapitalized and that may merit further regulatory attention or action. Our insurance subsidiaries have more than sufficient capital to meet RBC requirements.
American Jobs Creation Act - This Act was signed into law on October 22, 2004 and largely focuses on provisions related to international and manufacturing operations, but it also imposes more rigorous tax disclosure and reporting rules and significant penalties for noncompliance and includes provisions that limit the traditional flexibility of executive deferred compensation plans. We are currently reviewing our nonqualified deferred compensation plans and assessing the new law’s impact on our operations, but we do not expect that it will have a material impact on our financial condition, operating results or liquidity.
Our pension obligations resulted from the defined benefit (pension) plan we sponsor covering substantially all employees. See Note 10 to the Consolidated Financial Statements for a discussion of the plan and its effect on the Consolidated Financial Statements.
See discussion of new accounting standards in Note 1 to our Consolidated Financial Statements.
The Consolidated Financial Statements and schedules listed in the Index to Financial Statements, Schedules and Exhibits on page 81 are filed as part of this report.