Safeco’s home offices are located in Seattle and Redmond, Washington. The Corporate and Property & Casualty operations predominantly occupy 825,000 square feet of owned property in Seattle, and the Life & Investments operations are headquartered in 218,000 square feet of owned property in Redmond.
Safeco owns and occupies an additional 1,340,000 square feet of space in Redmond, Washington, as well as an aggregate of 453,000 square feet in Fountain Valley and Pleasant Hill, California; Cincinnati, Ohio; Portland, Oregon; and Spokane, Washington. Safeco also occupies 2.4 million square feet of additional leased space throughout the United States. Leased and owned space totals approximately 5.2 million square feet.
The following selected consolidated financial data of Safeco was derived from our consolidated financial statements. The following financial data should be read in conjunction with the consolidated financial statements and accompanying notes.
Management’s Discussion and Analysis (MD&A) reviews our consolidated and segment financial condition as of December 31, 2002 and 2001, our consolidated and segment results of operations for the years ended December 31, 2002, 2001 and 2000 and, where appropriate, factors that may affect our future financial performance. This discussion should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this report.
success in implementing a new business entry model for personal and commercial lines;
the occurrence of bankruptcies that result in losses under surety bonds, investment losses or lower investment income;
the ability to price for, exclude and reinsure the risk of loss from terrorism;
the effect of current insurance and credit ratings levels on business production and the effect of negative changes to our ratings;
inflationary pressures on medical care costs, auto parts and repair, construction costs and other economic sectors that increase the severity of claims;
the profitability of the use of derivative securities by Safeco Financial Products, Inc. (SFP);
Throughout this report, Safeco Corporation and its subsidiaries are referred to as “Safeco,” “we” and “our.” The property and casualty insurance related businesses, including surety, are referred to as “Property & Casualty.” The life insurance and asset management businesses are referred to as “Life & Investments.” All other activities, primarily involving financing, are collectively referred to as “Corporate.” Our Property & Casualty operations generated 75% of our consolidated revenues in 2002.
The process of estimating loss and LAE reserves involves significant judgment and is complex and imprecise due to the number of variables and assumptions inherent in the estimation process. These variables include the effects on ultimate loss payments of internal factors such as changes in claims handling practices and changes in business mix, as well as external factors such as trends in loss costs, economic inflation, judicial trends and legislative changes. In addition, certain claims may be paid out over many years, for example, workers compensation medical costs for severe injuries, and there may be significant lags between the occurrence of an insured event and the time it is actually reported to us, contributing to the variability in estimating ultimate loss payments. Variables such as these affect the reserving process in a variety of ways and the impacts of many of these variables cannot be directly quantified, particularly on a prospective basis.
As a result of the inherent variability in estimating reserves, we use a number of actuarial techniques to estimate loss and LAE reserves. Standard actuarial techniques rely on the premise that historic loss experience can be used to estimate future loss experience. However, Safeco has undergone substantial transformation since 2000, including new product launches, changes in underwriting criteria and improvements in claim handling practices. These actions serve to improve business performance but also affect loss trends and actuarial data. As a result, Safeco has employed a more sophisticated set of actuarial techniques to assess the variables affecting loss experience in certain lines of business and applied multiple actuarial techniques to lines with the greatest volatility. In some cases, these actuarial techniques produce a cluster of estimates, giving management confidence that the reserve estimate is within a relatively tight band of possible outcomes. In other cases, however, additional techniques produce conflicting results. Management reviews reserve indications and the assumptions underlying them in applying the judgments necessary to determine its best estimate for Safeco’s carried reserves.
Our loss and LAE reserves before reinsurance by operating segment as of December 31, 2002 are summarized below:
SPI reserves of $1,664.8 at December 31, 2002 are comprised of personal auto reserves of $1,256.9 and homeowners and specialty lines reserves of $407.9.
Personal automobile policies provide coverage for bodily injury and property damage. While loss frequencies have been decreasing in 2002, we have assumed flattening of this trend in our reserve estimates. Variability in personal auto reserve estimates is primarily driven by bodily injury claim severity trends (average claim costs), which reflect inflationary trends for medical costs.
Homeowners and specialty personal lines coverages are short tailed in nature with most claims generally reported and settled within 12 months. Reserve estimates are based on standard loss development techniques, which produced consistent reserve estimates based on our overall experience.
SBI has exposure to construction defect, asbestos, environmental and other toxic tort losses through the general liability and commercial multiperil coverages it provides. These exposures and the risks they present to Safeco are discussed in the P&C Other segment below, where the majority of the exposure resides. The remainder of the SBI reserve discussion excludes these exposures.
Declining premium volumes in 2001 and 2002 are consistent with Safeco’s strategy to limit its workers compensation writings in states where rate levels fall below Safeco’s return targets. In particular, Safeco significantly restricted writing new workers compensation business in California beginning in the third quarter of 2002. This decline in business volume has led to lower claim activity, which has served to reduce reserves. This is partially offset by rising loss costs.
Workers compensation claims are largely comprised of medical costs and salary/wage payments while claimants are out of work. The payout period for these claims can be 50 years or more. Safeco’s average payout period is generally shorter than the industry as a whole due to our historical focus on low-hazard risks.
Workers compensation reserves may also be impacted by our claim practices. Since late 2001, we have placed greater emphasis on full exposure recognition in case reserving and on settlement of long-term claims. While management has assumed that these actions will modestly improve our ultimate loss trends, these activities impact our claim trend data and actuarial analysis and, as a result, increase the variability in our reserve estimates.
In determining management’s best estimate for workers compensation reserves, long-term medical cost inflation trends over the average claim payout period represent our most significant assumption. We have assumed that double digit medical cost inflation will continue in the near-term, moderating over time to historic levels, resulting in a 5-6% medical loss severity trend over the life of the reserves. Our best estimate of workers compensation reserves presents some risk of unfavorable reserve development should medical trends not abate.
Surety loss and LAE reserves totaled $60.2 at December 31, 2002. By their nature, Surety contracts produce lower loss frequency and higher loss severity than much of Safeco’s Property & Casualty business. In addition, Surety
claims provide substantial opportunity for subrogation and salvage the nature of which tends to vary from case to case. As a result of the underlying nature of surety losses and the limited historical data available for analyses, management relies on large claim analysis and individual insured exposure analysis of loss as well as subrogation and salvage potential to determine carried reserves. Actual subrogation and salvage recoveries in the future or changes in loss trends due to changes in the economy may affect management’s estimate of Surety reserves.
P&C Other reserves totaled $655.3 at December 31, 2002 and are comprised of construction defect reserves of $236.3, asbestos and environmental reserves of $161.5, reserves for our London operations that are in runoff of $52.1 and other reserves of $205.4.
In the discussion that follows we have combined the SBI and P&C Other operating segment reserves for construction defects, asbestos, environmental and other toxic tort claims. Accordingly, the tables below include statistics for both segments.
Safeco has exposure to construction defect losses through general liability and commercial multiperil coverages it provides to contractors. Construction defect claims arise from alleged defective work performed in the construction of large habitation structures, such as apartments, condominiums and large developments of single-family dwellings or other housing. In addition to damages arising directly from the alleged defective work, construction defect claims often also allege that the economic value of the structure has been diminished. The majority of Safeco’s losses have been concentrated in a limited number of states, including California, and Safeco has taken a number of underwriting actions to mitigate this exposure. Prior to the acquisition of American States, we avoided writing the construction class of business in California and ceased writing these coverages in 1989. American States was a major writer of California contractor business until 1994 when it implemented significant restrictions in this line.
Because of the underlying nature of the claims and the difficulty inherent in determining fault in alleged construction defect claims, Safeco has established a separate claims handling and adjudication function to address these claims. As a part of this claims handling and adjudication function, Safeco has developed expertise in internal counsel, and has established relationships, particularly in California, with external legal counsel specializing in construction defect claims allowing us to vigorously defend our coverage position.
inventory will continue to decrease, but at a slower rate, because management anticipates the continued expansion of construction defect claims outside of California and because of the erosion of statutes of limitations for loss reporting in certain jurisdictions. Management’s estimate also contemplates a modest ability for Safeco’s claims handling and adjudication function to reduce construction defect loss severity, consistent with recent experience.
The three year survival ratio is calculated by dividing reserves at end of year by average annual payments for the three years then ended.
The majority of Safeco’s asbestos liability exposure (approximately 70% of asbestos reserves) relates to the discontinued assumed reinsurance operations of American States. This exposure relates primarily to reinsurance of excess coverage. Safeco also has exposure to syndicates and pools due to its historical writings, which resulted in increased paid activity during 2002 and may result in additional development in future periods. Our reserves for pools reflect the reserve estimates provided by the pool’s independent actuaries. The loss experience of our assumed reinsurance operations follows the general industry trend.
Policyholders that have active asbestos claims are identified below in two separate groups based on their perceived level of exposure. Policyholders are defined as Large Asbestos Accounts if their cumulative loss payments as of December 31, 2002 exceeded $100,000. The remaining policyholders are defined as Small Asbestos Accounts.
Based on the unique nature of asbestos claims, Safeco has established separate claims handling functions to address asbestos claims, separately for direct claims and assumed reinsurance claims. Our estimated asbestos reserves are based on consideration of the current state of the applicable law and coverage litigation.
Actuarial estimates include ground up analysis based on a sampling of claims. While Safeco’s level of asbestos payments has remained steady over the last two years (excluding pools and syndicates), management’s estimate assumes emerging unfavorable industry trends will begin to impact Safeco’s discontinued assumed reinsurance operations within the next two years and subsequently produce industry-like loss patterns. Our analysis also assumes that future claims will have severities similar to past Safeco experience.
Safeco’s environmental claims arise from the discontinued assumed reinsurance operations of American States and from the commercial general liability line written on a direct basis. Safeco generally avoided writing coverages for larger companies with substantial exposures in these areas. As a consequence, Safeco’s environmental claims tend to be of small relative average size.
Unassigned IBNR represents $128.2 of the $183.2 of reserves, or 70.0% of reserves as of December 31, 2002.
Safeco’s estimated environmental and other toxic tort reserves are based on consideration of the current state of the applicable law and coverage litigation. Actuarial estimates of these ultimate liabilities are subject to greater than normal variability. Reasons for this include, but are not limited to, a general lack of sufficiently detailed data, expansion of the population being held responsible for these exposures, and significant unresolved legal issues
To estimate reinsurance recoverables, we examine individual estimates of large losses subject to reinsurance treaties or facultative arrangements. Using the reinsurance contracts in place we estimate reinsurance recoverable amounts for specific claims as well as for lines of business. This analysis includes the examination of past reinsurance recoverables, the examination of actuarial data with and without reinsurance recoverables, as well as actuarial analysis of loss development above and below relevant retention levels. We also examine historical collection experience, recoverables associated with individual reinsurers (including our largest exposures as well as our lower rated reinsurers), and recoverables concentrated around any particular issue (for example; a large loss, a catastrophe, or an emerging claim issue) to assure our recoverables are collectible. Our estimated allowance for uncollectible reinsurance at December 31, 2002 was $12.5.
SFP activities are not designated as hedging activities for purposes of SFAS 133. Changes in the fair values of these instruments and any net realized investment gain or loss are recognized as net realized investment gains (losses) in the Consolidated Statements of Income (Loss).
To assure the success of our recovery plan for our core lines, we refocused our core strengths in personal auto, small-to-medium commercial insurance, and life insurance and asset management. Several actions were taken with respect to Property & Casualty operations including: increasing rates and re-underwriting across all lines of business; terminating relationships with underperforming agents; and exiting lines of business not core to our strategy and expertise. In a rigorous company-wide effort to reduce expenses, we implemented a plan to consolidate regional offices and reduce employment in our Property & Casualty operations and corporate headquarters. To strengthen our financial position, in 2001 we reduced our quarterly dividend by 50% and sold Safeco Credit, reinvesting the proceeds in our Property & Casualty business. In the third quarter of 2001, we strengthened property and casualty reserves by $240.0 on a pretax basis, reflecting developments in prior year losses primarily from workers compensation, construction defect, asbestos and environmental claims. We recognized goodwill write-downs of $1,214.1 pretax. We invested in our employees primarily by introducing a performance-based compensation system based on the achievement of specific goals linked directly to our business plans and by developing a diversity program to prepare us to increase workforce effectiveness and to better compete in today’s business world.
During 2002, we took additional actions that continue in 2003 to reshape our business into a more profitable enterprise positioned for growth. These actions include: (1) improving sales growth through independent agents; (2) improving service and claims handling by reducing errors and improving our processes; (3) driving execution through enhanced metrics and measurement practices; and (4) continuing investment in our employees. Our 2002 results improved significantly as a result of these and prior actions discussed above, as well as favorable industry conditions and mild weather in 2002.
Consolidated net income was $301.1 in 2002, compared to a net loss of $989.2 in 2001 and net income of $114.6 in 2000. The increase in consolidated net income in 2002 over our loss in 2001 was driven primarily by improved underwriting results within the Property & Casualty operations, increased earnings in Life & Investments and certain significant charges in 2001. These 2001 charges consisted principally of a goodwill write-off of $925.5 ($1,214.1 pretax), third quarter 2001 property and casualty reserve strengthening of $156.0 ($240.0 pretax) and restructuring charges of $28.8 ($44.3 pretax). These charges were also the primary contributors to the $989.2 net loss incurred in 2001 compared to net income of $114.6 in 2000.
Combined ratios are GAAP basis and are calculated on losses and expenses expressed as a percentage of earned premiums.
Net earned premiums increased $179.7 or 10.2% in 2002 to $1,947.1, compared to net earned premiums of $1,767.4 in 2001, which was an increase of 2.5% over 2000. The growth in premiums in 2002 reflects actions taken in 2002 and 2001 to increase rates, as well as growth in overall auto policies in force (PIF) in 2002. Average personal auto rates increased 7%, 9% and 6% in 2002, 2001 and 2000, respectively, and we plan to implement mid single-digit rate increases in 2003. PIF increased 8% at December 31, 2002 compared to a year ago as a result of significant new business production and stable retentions.
The increased premiums in 2001 resulted from the rate increases described above, which were partially offset by a PIF decrease in 2001. The decrease in PIF reflected decreasing retentions during 2001 driven by the tightening of underwriting standards and the cancellation of contracts with agencies producing unprofitable business.
Net earned premiums increased $16.8 or 2.3% in 2002 to $757.4, compared to net earned premiums of $740.6 in 2001, which was an increase of 1.5% over 2000. The increase in net earned premiums in 2002 reflects the efforts in 2002 and 2001 to significantly increase average renewal premiums in order to reduce losses in this product line. Average homeowners rates increased 14%, 12% and 6% in 2002, 2001 and 2000, respectively, and we expect comparable increases for 2003. The impact of increasing rates was largely offset by a decrease of 8% in PIF at December 31, 2002 in comparison to a year ago due to tightening of underwriting standards. The tightening of underwriting standards and higher rates decreased 2002 new business production, although we experienced stable retention rates in comparison to the prior year. Net earned premiums increased slightly during 2001 as rate increases began to take hold. Homeowners PIF remained stable in 2001 compared to 2000.
In the first quarter of 2002, we launched a new tiered pricing structure for homeowners that more accurately prices business based on risk characteristics. This approach, which matches rates more closely to risks, is currently in place in 22 states, and we expect to have it in place across the country by the end of 2003.
Our 2002 underwriting loss of $51.7 improved $111.5 over our underwriting loss of $163.2 in 2001, which compared to an underwriting loss of $110.6 in 2000. Similarly, the combined ratio improved to 105.1% in 2002, compared to 115.8% in 2001 and 109.4% in 2000. The improvement in underwriting loss and combined ratio during 2002 was due to the underwriting actions described above and the impact of reserve strengthening of $65.0 in the third quarter of 2001, as well as lower claim costs from catastrophe and weather losses. Catastrophe losses decreased $20.0 in 2002, to $11.7 from $31.7 in 2001, and weather-related losses decreased $26.7 in 2002, to $14.2 in comparison to $40.9 in 2001. Our 2001 underwriting loss of $163.2 increased $52.6 in comparison to 2000 due primarily to the impact of the reserve strengthening previously described. The impact of the reserve strengthening in 2001 was partially offset by the underwriting actions and rate increases that began in 2001.
Our 2002 underwriting profit of $17.8 improved $13.9 over our 2001 underwriting profit of $3.9, which decreased slightly from the underwriting profit of $5.7 in 2000. SBI - Special Accounts Facility took aggressive actions in 2001 to re-underwrite existing business, apply stricter underwriting standards and increase rates. These actions drove the underwriting improvements in the 2002 underwriting profit and the combined ratio, which were also impacted by increased profits from the acquired lender-placed property business.
Surety net earned premiums increased $30.7 or 32.1% in 2002 to $126.3, compared to net earned premiums of $95.6 in 2001, which was an increase from $61.6 in 2000. The increase in net earned premiums in 2002
partially reflects the impact of new business production and rate increases, which we expect to continue into 2003. In addition, a change in Surety’s reinsurance treaty in February 2001, to an excess of loss cover from a 50% quota share, lowered ceded premiums and increased net earned premiums in 2002 and 2001. The excess of loss treaty provides reinsurance coverage for 88% of $85.0 in excess of $15.0 retention for each loss, and includes one reinstatement premium should a second loss exceed our retention.
Surety underwriting profit of $17.6 improved $15.2 over our 2001 underwriting profit of $2.4, which decreased from $11.7 in 2000. The increase in the underwriting profit in 2002 over 2001 reflects the impact of the $18.0 loss recognized in the fourth quarter of 2001 related to the bankruptcy of Enron, a large energy company. Surety issued advance pay and payment guaranty bonds for Enron totaling $193.5. The initial estimated loss recorded in 2001 was $59.5 gross of reinsurance and $18.0 net of reinsurance. On January 2, 2003, we entered into a settlement with JP Morgan to end the litigation involving these bonds. The terms of the settlement did not result in a material change to our net recorded loss, and we do not anticipate incurring any further charges related to this loss. The 2001 underwriting profit was impacted by the Enron loss and the underwriting profit in 2002 was impacted by higher contract and commercial bond losses in the second half of the year, due in part to the slowing national economy.
P&C Other includes our discontinued assumed reinsurance business, our involuntary-assigned risk and other state-mandated personal lines business, our Lloyds of London operations which are in runoff and certain discontinued product lines.
Our 2002 underwriting loss of $63.1 improved $55.7 over our 2001 underwriting loss of $118.8, which compared to an underwriting loss of $44.9 in 2000. In the third quarter of 2002 Safeco decided to put its London operations into runoff, resulting in a charge of $26.3 pretax in the quarter. This charge primarily reflects reserve strengthening to provide for emerging losses as the business is run off.
We have estimated our pretax losses net of reinsurance resulting from the September 11, 2001 terrorist attacks at $52.0, of which $30.0 is attributable to reinsurance written through R.F. Bailey, a wholly-owned foreign subsidiary that participated in the Lloyds of London underwriting market, $21.0 to our business insurance accounts, and $1.0 to Life & Investments. Effective January 1, 2002, our reinsurers stopped providing terrorism coverage in our commercial property and casualty reinsurance treaties. The loss of reinsurance coverage for terrorism was immediate with respect to new business and has affected renewal business as the policies come up for renewal. Consequently, terrorism coverage in our reinsurance protection is limited to certain commercial property risks that have obtained facultative reinsurance which includes coverage for terrorism, personal lines losses covered under our property catastrophe treaty or high value home treaty, and coverage for certain terrorism acts under our Surety excess of loss treaty.
For its direct writings in 2002 up until November 26, 2002, Safeco adopted the commercial property and casualty terrorism exclusion developed and filed for approval by the Insurance Services Office (ISO). This exclusion was absolute with respect to losses from terrorism arising from biological, chemical or nuclear hazards. With respect to non-biological, non-chemical and non-nuclear losses from terrorism, the exclusions only applied if the total losses
TRIA also requires that insurance companies notify in force commercial policyholders by February 24, 2003 that coverage is now provided and the cost for that coverage. Safeco sent out required notices by that due date.
In 2002, estimates for Property & Casualty prior years’ loss and LAE reserves were increased by $125.8. These increases occurred over the course of 2002 as emerging claim trends and related loss data were evaluated each
quarter. The increase of $125.8 included $33.3 related to estimates of workers compensation losses. We reevaluate our estimates of workers compensation loss severity quarterly, with particular focus on the expected future rate of medical inflation. Over the course of the year, actual medical inflation proved to be higher than anticipated and we adjusted our estimated reserves accordingly. While loss severities for construction defect claims appear to be mitigating, the legal costs associated with achieving reduced loss costs were higher than estimated, resulting in a reserve increase of $37.0. Asbestos claims related to our participation in pools and syndicates were higher than estimated, resulting in a reserve increase of $24.4. The $31.1 increase in other reserves related primarily to Safeco’s London operations. Safeco placed its London operations in runoff in the third quarter of 2002. Due to the high layer excess nature of some of the coverages provided by this operation, and the long reporting lag, management strengthened reserves to provide for higher-than-anticipated losses as the business is run off.
During the third quarter of 2001, Safeco completed a review of its Property & Casualty loss reserve adequacy. As a result of this review, which included an independent actuarial study, we increased reserves by $240.0. This $240.0 reserve addition related to Property & Casualty operating segments as follows: $155.0 for SBI and $85.0 for P&C Other. The P&C Other segment includes the discontinued reinsurance operation that Safeco acquired when it purchased American States in 1997. The $240.0 reserve addition related to recent developments in prior year losses as follows: $80.0 for workers compensation, $90.0 for construction defect and $70.0 for other coverages, primarily asbestos and environmental.
The estimation of liabilities related to construction defect and asbestos and environmental claims is subject to greater subjectivity than for other claims. Construction defect reserves were $322.6 at December 31, 2000. In early 2000, Safeco’s construction defect claims appeared to have peaked and were trending down through the rest of 2000. Such claims were predominantly in California. However, in the first two quarters of 2001, newly reported claims increased significantly, owing largely to increased attorney involvement in California and increased claim activity into additional states. As a result of these considerations, management concluded that ultimate losses for construction defect will likely be higher than previously estimated, leading to our assessment in the third quarter of 2001 to increase reserves by $90.0.
In 2000, estimates for Property & Casualty prior year loss and LAE reserves were increased by $148.3, of which $44.4 related to construction defect claims as Safeco saw reported claim volumes that, while trending down in the
latter part of 2000, exceeded expectations. Workers compensation estimates were increased $50.9 and commercial automobile estimates were increased $23.5, both in reaction to claim severities. Safeco regularly monitors loss frequency and loss severity relative to expectations. When emerging frequency or severity differs materially from expectations, projections for future frequency and severity are re-evaluated and estimates are increased, or decreased, accordingly. The remaining $29.5 change in estimate in 2000 came from a combination of lines of business including commercial automobile, commercial multiperil, general liability and homeowners. Each change was a reaction to emerging loss frequency or severity relative to expected loss frequency or severity. The change for any one line represented a small percentage of the line’s reserves.
Our Property & Casualty nationwide catastrophe property reinsurance program for 2003 covers 90% of $400.0 of single-event losses in excess of $100.0 retention and is unchanged from 2002. In a large catastrophe, Property & Casualty retains the first $100.0 of losses, 10% of the next $400.0 and all losses in excess of $500.0. Catastrophe property reinsurance contracts for 2003 include provisions for one reinstatement for a second catastrophe event in 2003 at current rates.
Effective February 1, 2001, Surety modified its reinsurance coverage from a 50% quota share treaty to an excess of loss treaty. The excess of loss treaty provides reinsurance coverage for 88% of $85.0 in excess of $15.0 retention for each loss, and includes one reinstatement premium should a second loss exceed our retention.
For workers compensation, we purchase reinsurance protection that provides reimbursement of up to $44.0 for single event losses in excess of $3.0. A reinstatement premium is required for workers compensation reinsurance layers covering losses that are in excess of $20.0.
We purchase commercial property reinsurance that limits our exposure to a net loss of $2.5. This is accomplished through the purchase of a property per risk treaty that provides reinsurance coverage up to $7.5 for losses in excess of a $2.5 retention. Commercial property risks with limits above $10.0 are ceded through facultative reinsurance.
For the personal umbrella line of business we purchase a 10% quota share for the first $2.0 event and 100% quota share for the next $8.0. For commercial umbrella we retain the first $1.0 of each event and cede up to $19.0 in excess of this retention.
The primary products in this business line are fixed deferred and variable annuities (both qualified and non-qualified), and guaranteed investment contracts (GIC). In 2002, sales of our fixed deferred annuity products were strong. The Safeco Select fixed deferred annuity product, launched in June 2001, had deposits of $832.3 in 2002
Revenues remained relatively flat at $529.2 in 2002 compared to revenues of $530.0 in 2001, which were up $33.0 from $497.0 in 2000. Revenues grew in 2002 due to favorable prepayment adjustments on mortgage-backed securities included in net investment income, but were offset by declining portfolio yields and lack of growth in assets under management, causing 2002 revenues to remain at 2001 levels. Revenues in 2001 were higher than in 2000 primarily due to a full year of interest earnings on 2000 deposits and increased mortgage- backed securities prepayment adjustments. The mortgage-backed securities prepayment adjustment increased revenues $13.9 in 2002, $8.0 in 2001 and decreased revenues $4.8 in 2000.
Income Annuities produced pretax operating earnings of $41.5 in 2002, a decrease of $6.3 from 2001 pretax operating earnings of $47.8, which grew $21.4 over 2000. The 2002 decrease in pretax operating earnings of $6.3 was driven primarily by the lack of growth in assets under management and investment income which contributed to lower interest margins. The 2001 increase in pretax operating earnings of $21.4 over 2000 resulted from higher interest margins driven by the increase in average assets under management in 2001 compared to 2000, the favorable impact of mortgage-backed securities prepayment adjustments and favorable mortality experience.
Individual products include term, universal and variable universal life and BOLI. BOLI is universal life insurance sold to banks and is extremely sensitive to financial strength ratings.
In 2002, Individual launched updated term and universal life insurance products. These updated products and a new internet sales tool (Safeco Now) contributed to increased sales in 2002.
Pretax operating earnings of $21.6 in 2002 were down slightly from 2001 pretax operating earnings of $22.8, also down from 2000 pretax operating earnings of $24.6. The decrease in 2002 and 2001 pretax operating earnings was due primarily to less favorable mortality experience.
The availability and cost of reinsurance are subject to prevailing market conditions, both in terms of price and available capacity. Although the reinsurer is liable to Safeco to the extent of the reinsurance ceded, we remain primarily liable to the policyholders as the direct insurer on all risks insured. To Safeco’s knowledge, none of our major reinsurers is currently experiencing material financial difficulties.
Of the total Life & Investments amounts due from reinsurers balance at December 31, 2002, 98% was with reinsurers rated A- or higher by A.M. Best.
The Corporate segment includes operating results for Safeco Corporation, our parent company, SFP, Safeco Properties and intercompany eliminations. Our parent company’s primary expense is interest expense on borrowings totaling $64.7, $79.0 and $89.0 in 2002, 2001 and 2000, respectively. These amounts do not include the expense for the distributions on Safeco’s Capital Securities that is presented net of tax on the Consolidated Statements of Income (Loss).
SFP was organized in 2000 to write S&P 500 index options to mitigate the risk associated with the EIA product (see Life & Investments section for further discussion on EIA). SFP also engages in limited activity for its own account by selling single name credit default swaps (credit swaps), writing and hedging S&P 500 index options and investing in and hedging convertible bonds. Changes in the fair values of these instruments and any realized gain or loss are recognized in current income. Net investment income includes the premium income on the credit swaps and the earnings and fair value adjustments for the S&P 500 index options and the convertible bonds. Realized gain or loss includes the fair value adjustments and net realized investment gains or losses from the single credit default swaps. Pretax income (loss) before net realized investment gain (loss) for SFP was $3.6, $6.7 and $2.3 in 2002, 2001 and 2000, respectively.
The fair value of SFP’s written S&P 500 index options liability was $29.6 and $45.4 at December 31, 2002 and 2001, respectively. SFP’s investment portfolio included investment grade convertible bonds with market values totaling $47.7 and $38.4 at December 31, 2002 and 2001, respectively.
In 1999, Safeco sold most of the assets of its real estate investment operation, Safeco Properties, Inc. The remaining investment properties ($7.2 at December 31, 2002) are included in Other Invested Assets on the Consolidated Balance Sheets. These are being marketed for sale.
Safeco uses funds to support operations, service and pay down debt, pay dividends to Safeco shareholders and grow the investment portfolio. Cash from insurance operations is used primarily to pay claims and claim adjustment expenses. Most insurance premiums are received before or at the time premium revenues are recognized, while related claims are incurred and paid in subsequent months or years. Catastrophe claims, the timing and amount of which are inherently unpredictable, may create increased liquidity requirements.
The higher level of proceeds from the sale of fixed maturities and equities and the higher level of purchases of fixed maturities in 2002 compared to 2001 were due to the portfolio repositioning discussed above. In addition, the relatively high level of proceeds from the maturity of fixed maturities in all three years reflects the high number of calls of fixed maturities and prepayments of mortgage-backed securities. These calls and prepayments were due to the lower interest rate environment during the past three years and issuer-driven actions. The high level of purchase and sale activity related to fixed maturities available-for-sale in 2000 was also due in part to shifting a portion of Property & Casualty’s bond holdings from tax-exempt to taxable bonds. The reason for this shift was to maximize the portfolio’s after tax return in view of the higher level of underwriting losses in 2000 and the resulting alternative minimum tax. The high level of proceeds from equity securities in 2000 is mainly due to approximately $300.0 of planned equity securities sales out of Property & Casualty’s investment portfolio. The proceeds from these equity securities sales were reinvested in taxable fixed-income securities. These sales resulted in increased net realized investment gains from equity securities in 2000.
Safeco renewed its bank credit facility in September 2002 with $500.0 available through September 2005. This replaced the $800.0 facility that expired in September 2002. The reduction in this bank credit facility is consistent with the elimination of Safeco’s commercial paper program in August 2002. Safeco pays a fee to have the facility available and does not maintain deposits as compensating balances. Similar to its previous facility, the new facility carries certain covenants that require Safeco to maintain a specified minimum level of shareholders’ equity and a maximum debt-to-capitalization ratio. There were no borrowings under either facility as of December 31, 2002 and 2001 and Safeco was in compliance with all covenants.
On November 20, 2002, Safeco completed the sale of 10,465,000 shares of common stock at $33.00 per share. Safeco received proceeds net of related expenses of $328.7 from the sale of these shares. The net proceeds were used to contribute capital of $150.0 to our Property & Casualty operations and $100.0 to our Life & Investments operations in December 2002 to support future growth in our core product lines and strengthen the capital base of these operations. Remaining proceeds will be used for general corporate purposes and may include the repayment or repurchase of outstanding indebtedness.
Due primarily to our poor Property & Casualty underwriting results in 2000 and 2001, our financial strength and corporate credit ratings were lowered in the first half of 2001. The lower operating results in 2000 and 2001, combined with increased operating leverage in Property & Casualty, contributed to lower debt service coverage for Safeco. In addition, the interest rates on short-term borrowings increased due to the ratings downgrades.
Currently, all rating agencies maintain a stable outlook on their ratings of Safeco. On August 13, 2002, Standard & Poor’s (S&P) affirmed its ratings on Safeco Corporation and our Property & Casualty subsidiaries. At the same time, S&P lowered its ratings on our life insurance subsidiaries because of a change in S&P group methodology criteria, which modified the rating provided to subsidiaries. The new criteria generally limits the rating given to a subsidiary that S&P deems “strategically important” to the parent to within one notch of the rating on the parent’s core group. On December 4, 2002, A.M. Best reaffirmed Safeco’s ratings and revised its outlook for our Corporate and Property & Casualty ratings from negative to stable.
2003 in amounts sufficient to fund our shareholder dividends and service debt. Based on the statutory limits as of December 31, 2002, Safeco is able to receive approximately $490.6 in dividends from its insurance subsidiaries in 2003 without obtaining prior regulatory approval.
Effective January 1, 2001, our insurance subsidiaries adopted the NAIC’s revised Accounting Practices and Procedures Manual and the domiciliary states of our insurance subsidiaries have adopted the provisions of the revised manual. The revised manual has changed, to some extent, prescribed statutory accounting practices and resulted in changes to the accounting practices that our insurance subsidiaries use to prepare their statutory-basis financial statements. Our Property & Casualty insurance companies’ statutory surplus increased by $207.4 and the Life & Investments insurance companies by $45.3 upon the January 1, 2001 adoption. Nearly all of these increases in statutory surplus related to the recording of deferred tax assets that was not recorded in the statutory basis financial statements under the prior statutory accounting guidance.
Consolidated pretax net realized investment gains totaled $82.5, $93.0 and $139.5 in 2002, 2001 and 2000, respectively. The net realized investment gains in 2000 were mainly due to gains on approximately $300.0 of planned equity securities sales from the Property & Casualty’s investment portfolio. The proceeds from these equity securities sales were reinvested in taxable fixed-income securities. Consolidated net realized investment gains from investments are recorded net of losses on the sale or impairment of investments. The amounts of investment impairments were $258.5, $126.8 and $35.7 in 2002, 2001 and 2000, respectively. Each investment that has declined in fair value below cost is monitored closely and if the decline is judged to be other than temporary, the security is written down to fair value.
Safeco’s portfolio of investment securities at December 31, 2002 consisted of $24,278.0 fixed-maturity securities and $1,082.5 equity securities. Included in the fixed-maturity securities carrying amount were gross unrealized losses of $337.6 and gross unrealized gains of $1,969.5. Included in the equity securities carrying amount were gross unrealized losses of $66.5 and gross unrealized gains of $371.8. Industries that contributed more than 10% of the total gross unrealized loss were electric utilities (17%) and airlines (11%).
The impairments of $258.5 in 2002 were comprised of $220.1 for fixed maturity securities and $38.4 for equity securities. The increases in impairments in 2002 and 2001 were due to credit deterioration and corporate failures of several issuers, particularly in the retail, airline and telecommunications sectors. Additional impairments are possible in 2003 due to the continued weak economy, however, the timing and amount of any further impairments are not currently estimable.
Consolidated net realized investment gains also include pretax losses on credit default swaps that totaled $28.3 ($18.4 after tax) for 2002 and $18.2 ($11.8 after tax) for 2001. These amounts reflect mark-to-market adjustments and realized default losses. Also included was a reclassification from accumulated other comprehensive income to realized loss of $18.7 ($12.1 after tax) related to the termination of an interest rate swap in 2002.
The table below summarizes Safeco’s consolidated securities investment portfolio at December 31, 2002.
Safeco’s consolidated fixed maturities portfolio included $465.2 and $594.4 of not-rated securities representing 1.9% and 2.8% of total fixed maturity investments at December 31, 2002 and 2001, respectively.
Safeco’s consolidated investment holdings in mortgage-backed securities of $5.5 billion at fair value at December 31, 2002, consists mainly of residential collateralized mortgage obligations (CMOs), pass-throughs and commercial loan-backed mortgage obligations (CMBSs). Life & Investments portfolio holds 77.5% and Property & Casualty portfolio holds 22.5% of these securities. 90.0% of the mortgage-backed securities are government/agency-backed or AAA rated at December 31, 2002. Safeco has intentionally limited its investment in riskier, more volatile CMOs and CMBSs (e.g., principal only, interest only, etc.) to $24.4 or 0.4% of total mortgage-backed securities at December 31, 2002.
The table below summarizes Safeco’s consolidated holdings of mortgage-backed securities at December 31, 2002:
The quality rating of Safeco’s mortgage-backed securities portfolio is shown in the following table:
Safeco’s consolidated investment portfolio also included $925.9 of mortgage loan investments at December 31, 2002, representing 3% of total investments. Our policy is that no loan when originated shall exceed 75% of its appraised value. These loans are held by Life & Investments and are secured by first mortgage liens on completed, income-producing commercial real estate, primarily in the retail, industrial and office building sectors. The majority of the properties are located in the western United States, with 66% of the total in the states of Washington (29%), Oregon (11%) and California (26%). Individual loans generally do not exceed $10.0. Historically the mortgage portfolio has performed well and the loan charge-off rate has been low on this portfolio over the past three years. Less than 1% of the loans were non-performing at both December 31, 2002 and 2001. The allowance for mortgage loan losses at December 31, 2002 remained unchanged from 2001 at $10.5.
See discussion of new accounting standards in Note 1 of the Notes to Consolidated Financial Statements.
Safeco has paid cash dividends continuously since 1933. Common stock dividends paid to shareholders were $0.74 per share in 2002 compared with $0.93 in 2001 and $1.48 in 2000. Dividends are funded with dividends to the parent company from operating subsidiaries. We expect to continue paying dividends in the foreseeable future. However, payment of future dividends is subject to the discretion of our board of directors and will depend upon many factors, including our financial condition, earnings, capital requirements of our operating subsidiaries, legal requirements, regulatory constraints and other such factors as our board of directors deems relevant. Due to underlying business conditions in 2001 and 2000, in February 2001 our board of directors reduced the quarterly dividend from $0.37 to $0.185 per share.