Management's Discussion and Analysis (MD&A) of financial condition and results of operations addresses the financial condition of the Corporation and the Group as of December 31, 2003, compared with December 31, 2002 and December 31, 2001 and the Corporation's and the Group's results of operations for each of the three years. The supplementary financial information should be read in conjunction with the consolidated financial statements and related notes, all of which are integral parts of the following analysis of the results of operations and financial position.
Deferred Policy Acquisition Costs The Group establishes a deferred asset for costs that vary with and are primarily related to acquiring property and casualty business. The acquisition costs deferred consist of commissions, brokerage fees, salaries and benefits and other underwriting expenses to include allocations for inspections, taxes, rent and other expenses that vary directly with the acquisition of insurance contracts. These costs are amortized over the life of the underlying policies. Quarterly, an analysis of the asset is performed in relation to the expected recognition of revenues including investment income to determine if any deficiency exists. No deficiencies have been indicated for the periods presented.
Agent Relationships The Corporation and the Group have recorded an asset, which it refers to as agent relationships, for the excess of cost over the fair value of net assets acquired in connection with the 1998 Great American Insurance Company (GAI) commercial lines acquisition. The Corporation and the Group followed the practice of allocating purchase price to specifically identifiable intangible assets based on their estimated values as determined by appropriate valuation models. The agent relationships asset is amortized on a straight-line basis over an estimated useful life of twenty-five years. The estimated useful life was based on the Group's actual experience for agency appointment terms for similar agents, which averaged approximately twenty-five years in length. The Corporation and the Group evaluate the estimated useful life on an annual basis or as events or circumstances arise that may impact the useful life of the asset. The asset is evaluated quarterly as events or circumstances, such as cancellation of agents, indicate a possible inability to recover the carrying amount. Cancellation of certain agents for reasons such as lack of revenue production or poor quality of business produced does not necessarily change the estimated useful life of the remaining agents representing the agent relationships intangible asset. Such evaluation is based on various analyses, including cash flow and profitability projections that incorporate, as applicable, the impact on existing company businesses. The analyses involve significant management judgments to evaluate the capacity of an acquired business to perform within projections. If future undiscounted cash flows are insufficient to recover the
Executive-Level Overview The Corporation earns revenue by providing businesses and consumers with competitive insurance products with high quality service and by income on funds invested. This year the Corporation achieved meaningful improvement in financial performance. Net income increased in 2003 compared to 2002 as a result of a better priced book of business through realization of double- digit price increases in certain lines and an improved risk profile as a result of tighter underwriting standards. The statutory expense ratio continued to improve as a result of expense management initiatives. The year ended with a strong capital position and the highest level of statutory policyholders' surplus since 1999.
The 2003 All Lines statutory combined ratio improved to 106.1% compared to 112.8% in 2002 as a result of lower underwriting expenses and lower LAE. These results for 2003 were slightly higher than the expected range due primarily to an increase in reserves for environmental claims in the fourth quarter of 2003, higher than expected catastrophe losses and large non- catastrophe property losses.
Besides improving the Group's risk profile in 2003, the Group also focused on reducing expenses through a Cost Structure Efficiency program. Some of the specific areas that were addressed include more effective management of claims litigation efforts; improved procurement practices, including a reduction in telecommunications expenses; the use of emerging technologies to streamline, simplify and speed up processes and management of staff levels, including a steady reduction in employee count and a focus on increased skills training to improve products and services. In the fourth quarter of 2003 a new phase of the Cost Structure Efficiency program was initiated. This new phase focuses on process improvements, increased productivity and appropriate staffing to deliver high levels of service to agents and policyholders. As a result of company-wide process reengineering initiatives, the Corporation announced on February 11, 2004 an immediate 260 staff and managerial position reduction with an additional reduction of 150- 250 positions expected to be announced by the end of
the second quarter of 2004. The reduction of 260 positions will result in net savings of approximately $5.5 million before tax in 2004 and annual savings of $14.9 million before tax beginning in 2005. The Corporation will record in the first quarter of 2004 approximately $4.6 million before tax for severance and other related expenses for the 260 positions reduced.
As part of its strategic planning process, the Corporation evaluated insurance industry trends over the past couple of years. These trends show some insurance companies performing at combined ratios in the 90% to 100% range with lower investment income due to lower market yields. In addition, the industry took less aggressive price increases in 2003 in most insurance product lines and an increased focus on the quality of reinsurers. Recognizing that improved industry results may mean increased price competition, the Corporation has taken steps in 2003 to achieve improved profitability through expense reduction initiatives while maintaining quality underwriting and pricing.
In September 2003, the Corporation announced its Corporate Strategic Plan for the 2004-2006 time frame. The plan brings together five broad objectives to help achieve the Corporation's Vision to be a leading super regional Property and Casualty carrier providing a broad range of products/services through independent agents and brokers. The broad objectives include abilities to generate above market real growth, produce competitive loss ratios, create a competitive expense structure, achieve a competitive return on equity and improve credit ratings and financial flexibility. Competitive advantages include strong agency relationships, especially with key agents, and technology platforms that provide operating flexibility. Technology is being leveraged to make it easier for agents to do business with the Group and to increase pricing and underwriting sophistication.
Net Income The Corporation reported net income of $75.8 million, or $1.24 per share, compared with a net loss of $.9 million, or $.01 per share, for the year 2002, and net income of $98.6 million, or $1.64 per share, in 2001.
Net income for 2001 was negatively impacted by prior accident year adverse development in the Group's workers' compensation product line and asbestos related claims as well as the impact of an early retirement plan. During the fourth quarter of 2001, a member of the Group, Ohio Casualty of New Jersey, Inc. (OCNJ), entered into an agreement to transfer its obligations to renew private
passenger auto business in New Jersey to Proformance Insurance Company (Proformance). In recent years, the market in New Jersey private passenger auto had become unstable due to the inability to control both the volume of writings and the profitability. The Group decided to eliminate future uncertainty and risks related to the New Jersey private passenger automobile market in order to achieve its long-term strategic objectives. Management determined that it was uncertain whether profitability would return to the New Jersey private passenger auto business, as there were indications that some insurance companies were receiving premium rate increase approval from regulators while others were not. The Group's inability to determine the future impact of insurance reform legislation created additional uncertainty. Both premium rate increases and insurance reform legislation might have returned OCNJ's private passenger auto business to profitability, but it was uncertain as to if and when that would occur. As a result, the Group concluded that it was prudent to pay a fee to transfer the obligation to renew OCNJ's New Jersey private passenger auto policies in order to eliminate the future uncertainty associated with that business.
The transaction allowed the Group to stop writing private passenger auto business in New Jersey beginning in March of 2002. Under the terms of the transaction, OCNJ agreed to pay $40.6 million to Proformance to transfer its renewal obligations. The before-tax amount of $40.6 million was charged to income in the fourth quarter of 2001, reducing net income by $26.8 million on an after-tax basis. The contract stipulates that a premiums-to-surplus ratio of 2.5 to 1.0 must be maintained on the transferred business during the three year period beginning March 2002. The final measurement date is December 31, 2004 and will include use of the statutory insurance expense exhibit which is due April 1, 2005. If this criteria is not met, OCNJ will have to pay up to $15.6 million to Proformance to maintain this premiums-to-surplus ratio. At December 31, 2003, the Group evaluated the contingency based upon financial data provided by Proformance and concluded that a payment is not probable, and has not recognized a liability in the financial statements. The Group will continue to monitor the contingency for possible future liability recognition.
Consolidated before-tax realized net investment gains amounted to $35.9 million in 2003, $45.2 million in 2002 and $182.9 million in 2001. Throughout 2002 and 2001 equity securities were sold, many of which had substantially appreciated in value in earlier periods. These sales were part of a program to reduce exposure to the market volatility of equity securities.
Invested assets comprise a majority of the consolidated assets. Consequently, accounting policies related to investments are critical. See further discussion of important investment accounting policies in the "Critical Accounting Policies" section and in Footnote 1C on page 62 of this Form 10-K. The Corporation and the Group continually evaluate all of their investments based on current economic conditions, credit loss experience and other developments. The difference between the cost and estimated fair value of investments is continually evaluated to determine whether a decline in value is temporary or other than temporary in nature. This determination involves a degree of uncertainty. If a decline in the fair value of a security is determined to be temporary, the decline is recorded as an unrealized loss in shareholders' equity. If there is a decline in a security's fair value that is considered to be other than temporary, the security is written down to the estimated fair value with a corresponding realized loss recognized in the consolidated statements of income.
The assessment of whether a decline in fair value is considered temporary or other-than-temporary includes management's judgement as to the financial position and future prospects of the entity issuing the security. It is not possible to accurately predict when it may be determined that a specific security will become impaired. Future impairment charges could be material to the results of operations. The amount of impairment charge before tax was $10.5 million in 2003, compared to $10.9 million and $12.0 million in 2002 and 2001, respectively. The impairment charge represents .3% of the market value at December 31, 2003, 2002 and 2001, respectively of the investment portfolio. During 2003, certain AMR Corporation and Delta Air Lines, Inc. fixed maturity investments were written down by $3.9 million and $2.0 million, respectively. The write-down amounts were determined by the difference between fair value and cost of the securities at the time of the write-down. Management determined that these securities have an other-than- temporary impairment of value based on its review, which is described above.
The following tables summarize for all available-for-sale securities and held-to-maturity securities, the total gross unrealized losses, excluding gross unrealized gains, by investment category and length of time the securities have continuously been in an unrealized loss position as of December 31, 2003:
subsequently conclude the decline in fair value is other than temporary, the book value of the security is written down to fair value with the realized loss recognized in the consolidated statements of income.
Reinsurance Programs The Group renewed all of its reinsurance programs for 2003 with only moderate changes in the program structure. Although the terrorist events of September 11, 2001 had a significant impact on the reinsurance market, the Group's reinsurance contracts continue to include coverage for acts of terrorism. Instead of being unlimited as in the past, terrorism coverage in the 2003 contracts was modified to exclude or limit coverage for certain upper layers of reinsurance. The Group believes that the terrorism coverage in its reinsurance programs is adequate to protect its financial health. The Group has renewed its reinsurance programs for 2004 except for the bond reinsurance treaty that is expected to be renewed at the April 1, 2004 expiration date. The 2004 program maintains a $1.0 million loss retention level for most risks, but the property per risk treaty has a $1.5 million loss retention level. In addition, beginning in 2004, the Group retains 7 percent of all umbrella losses applicable to the $20.0 million excess of $5.0 million layer. The top layer of the property catastrophe treaty was reduced from $50 million excess of $75 million to $30 million excess of $75 million, reflecting reduced exposure for personal lines of business. Pricing for the 2004 program reflected flat pricing for the property treaties on average and double digit increases for the casualty treaties on average.
for the final state. The rollout period can exceed one year for an individual major product line. The Group capitalizes costs incurred during the application development stage, primarily relating to payroll and payroll-related costs for employees, along with costs incurred for external consultants who are directly associated with the internal-use software project. The cost associated with this application is amortized on a straight-line basis over the estimated useful life of ten years from the date placed into service with before tax amortization expense of $2.6 million, $1.3 million and $.2 million for 2003, 2002 and 2001, respectively. Upon full implementation of all major product lines, the new application should impact results by approximately $4.0 million to $6.0 million before tax per year in amortization expense until 2015. Capitalized internally developed software costs (including P.A.R.I.S.sm and other internally developed software) and accumulated amortization are summarized in the table below:
All Lines Discussion Statutory net premiums written decreased $7.0 million in 2003 to $1,441.6 million. The decline in statutory net premiums written over 2002 reflects the Group's efforts to restructure its risk profile as Personal Lines withdrew from select markets and Commercial Lines implemented stricter underwriting guidelines, including the non-renewal of certain construction defect related risks. In addition, the decline in net premiums written from last year also reflects the impact of higher reinsurance costs. Net premiums written totaled $1,448.6 million in 2002 and $1,472.2 million in 2001. The slight decline of net premiums written in 2002 when compared to 2001 is primarily attributable to the reduction in premiums related to the non- renewal of the Group's New Jersey private passenger auto business which began to be non-renewed in March of 2002.
The All Lines combined ratio improved 6.7 points to 106.1% in 2003, compared with 112.8% in 2002 and 115.3% in 2001. An improved underwriting expense ratio and lower losses and LAE contributed to the All Lines combined ratio improvement in 2003. The combined ratio benefited from a reduction in personnel and sales related expenses. These two items, somewhat offset by increased expenses for technology including amortization of internally developed software, contributed to the .8 point reduction in the underwriting expense ratio from 34.9% in 2002 to 34.1% in 2003. The loss and LAE ratio decreased 5.8 points from 77.9% in 2002 to 72.1% in 2003. The loss and LAE ratio was impacted by $34.1 million and $84.4 million of before tax prior accident year reserve development in 2003 and 2002, respectively, which added 2.4 points and 5.8 points to the 2003 and 2002 All Lines combined ratio, respectively. The remaining improvement of 2.4 points in the 2003 loss and LAE ratio over 2002 was due to significant improvement in the Personal Lines loss ratio primarily related to the withdrawal from New Jersey personal auto and a decrease in non-catastrophe experience for the personal property product lines.
The table below summarizes the impact of changes in provision for all prior accident year losses and LAE:
In 2003, the impact of this adverse development for prior accident years' losses and LAE was concentrated in the commercial multi-peril product line of the Commercial Lines operating segment and in the personal auto product line of the Personal Lines operating segment. The commercial umbrella product line experienced significant favorable development for prior years' losses and LAE, primarily due to a reduction in estimated future costs for claims adjuster related expenses. The total provision for prior years' losses and LAE of $34.1 million before tax represents 1.6% of loss and LAE reserves as of year-end 2002.
The comparable amount for provisions for prior years' losses and LAE recognized during the year 2001 was $58.5 million before tax. This represents 3.1% of loss and LAE reserves as of year-end 2000. This was concentrated primarily in the workers' compensation and general liability product lines.
The seven-year historical catastrophe impact on the loss ratio compared to 2003 actual for all lines of business were:
The underwriting expense ratio, which measures underwriting expenses as a percentage of net premiums written, decreased by .8 points in 2003 to 34.1% compared with 34.9% in 2002 and 35.4% in 2001. The 2003 underwriting expense ratio was favorably impacted by a reduction in employee related costs and lower sales related expenses as a percentage of premiums, and was partially offset by higher expenses related to investments in technology. Sales related expenses for 2003 included the resumption of a ceding commission for certain layers of commercial umbrella reinsurance and also agent bonus commission levels more similar to years prior to 2002. The employee count continued to decline in 2003 with an 11.2% decline over 2002, resulting in part from claim staff reorganization and underwriting facility consolidations. The employee count was 2,669, 3,004 and 3,365 as of December 31, 2003, 2002 and 2001, respectively.
Commercial Lines Segment The Commercial Lines combined ratio for the year 2003 decreased 2.8 points to 112.3% from 115.1% in 2002. The improvement in the combined ratio occurred in spite of 5.3 points of adverse development on loss and LAE reserves primarily in the workers' compensation and commercial multiple peril product lines. The combined ratio improved from 2001 to 2002 by 1.1 points. This improvement was less than expected due to $73.9 million of adverse development in loss and LAE reserves from prior years adding 10.2 points to the 2002 combined ratio. Of this amount, approximately $51.6 million related to construction defect issues which added 7.1 points to the combined ratio for 2002. Renewal price increases had a positive impact during 2003, 2002 and 2001. The 2003 average renewal price increase was 11.4% for Commercial Lines direct premiums written, compared with 16.3% and 15.2% average renewal price increases(1) in 2002 and 2001, respectively. The 2003 average renewal price increase is lower than in prior years due to a broad trend indicating that Commercial Lines policies are approaching price adequacy and competitive pricing pressures in the marketplace are increasing.
Commercial Lines results for 2003 included higher than expected catastrophe losses and large non-catastrophe losses compared to 2002. Catastrophe losses added 2.6 points in 2003 to the Commercial Lines combined ratio, compared to 0.5 points in 2002 and 1.0 point in 2001. Large non-catastrophe losses related to current accident year losses measured as of December 31 added 7.2 points, 4.6 points and 5.5 points to the combined ratio for 2003, 2002 and 2001, respectively.
The commercial auto product line net premiums written increased $14.9 million or 7.0% to $228.3 million in 2003. During 2002, net premiums written for this line increased $26.7 million, or 14.3% to $213.4 million, compared with $186.7 million in 2001. The 2003, 2002 and 2001 increases were driven by renewal price increases, averaging 11.0%, 15.2% and 15.5%, respectively.
Net premiums written for the monoline general liability product line decreased slightly to $83.4 million compared to $84.5 million in 2002 and $79.0 million in 2001. The small decrease in 2003 is a result of actions taken on classes of business potentially subject to construction defect losses. The increase from 2001 to 2002 is due to higher new and renewal pricing levels.
Personal Lines Segment The Personal Lines combined ratio for 2003 decreased 8.5 points to 105.6% compared to 114.1% in 2002 and 119.2% in 2001. Every product line in the Personal Lines operating segment registered an improved combined ratio in 2003 compared to 2002. The improvement is driven by the withdrawal from New Jersey private passenger auto market which began in 2002, premium rate increases, a significant improvement in the non-catastrophe experience for homeowners and a decline in the underwriting expense ratio. The 5.1 point improvement in 2002 is attributable to the implementation of price increases, insurance scoring, enhanced claims management procedures, withdrawal from states that have proven unprofitable and lower than average losses from catastrophes. The Group continued to narrow its geographic focus in Personal Lines during 2003. The Group has received all necessary approvals from regulators to withdraw its Personal Lines business from Florida, Georgia and Texas. These three states contributed approximately $3.0 million to net premiums written in 2003. Personal lines excluding New Jersey private passenger auto results and the effects of the withdrawal states and cancelled agents would have grown by approximately 9.0% in 2003. The Group does not write any lines of business in California.
Given the unfavorable regulatory environment and uncertainty over the future profitability for private passenger auto in New Jersey, the Group announced in the fourth quarter of 2001 the transaction to allow the Group in early 2002 to stop writing private passenger auto business in New Jersey. The transaction, described in the "Results of Operations - Net Income" section, has allowed the Group to complete its exit from the New Jersey personal lines auto market in early 2003. New Jersey's private passenger auto net premiums written represented approximately 7.5% of the Group's total private passenger auto book of business in 2002, compared to 27.0% in 2001. New Jersey regulation mandates private passenger automobile insurers in the state to provide insurance to all eligible consumers with limited exceptions. This "take-all-comers" regulation eliminated the Group's ability to control the volume and selection of writings in the state. Poor underwriting results in New Jersey contributed to the poor performance in 2002 and 2001. The New Jersey private passenger auto results added 6.2 and 7.1 points to the 2002 and 2001 Personal Lines loss ratio, respectively.
The 2003 homeowners combined ratio decreased 3.4 points to 106.9% compared to a 10.2 point decrease in 2002 to 110.3%. This compares with a combined ratio of 120.5% in 2001. The improvement in 2003 is attributable to improved underwriting discipline and aggressive pricing. Combined ratios are heavily impacted by catastrophe losses which added 11.8 points to the combined ratio in 2003, 8.7 points in 2002 and 12.3 points in 2001.
Investing activities used net cash of $175.6 million in 2003, compared with net cash used of $173.7 million in 2002 and $57.4 million in 2001. The Corporation and the Group purchased fewer fixed maturity securities in 2003 as prepayments on mortgage backed securities were reduced in 2003 compared to 2002, leaving less cash flow to reinvest. Proceeds from the sale of equity and fixed maturity securities also continues to decline as the Corporation and the Group are maintaining the current portfolio which contains primarily investment grade corporate and mortgage backed securities. Cash inflows from the sale of property and equipment increased over 2002 as the Group sold a building located in Lexington, Kentucky including the related office equipment and land for sales proceeds of $4.6 million.
The Corporation is dependent on dividend payments from its insurance subsidiaries in order to meet operating expenses and debt obligations. Insurance regulatory authorities impose various restrictions and prior approval requirements on the payment of dividends by insurance companies. As of December 31, 2003, approximately $86.8 million of statutory surplus was not subject to prior dividend approval requirements. Additional restrictions may result from the minimum net worth and surplus requirements in the credit agreement as disclosed in Footnote 16 on pages 74 and 75 of this Form 10-K.
Off-Balance Sheet Arrangements and Contractual Obligations As of December 31, 2003, 2002 and 2001, the Corporation did not have any off- balance sheet arrangements as defined by Financial Release - 67, "Disclosure in Management's Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations."
**Excluded from other long-term liabilities are pension obligations which are described in Footnote 5 on pages 67 through 69 of this Form 10-K and disclosed separately below. Also excluded are loss and LAE reserves as the timing of payout is uncertain. For further discussion on loss and LAE reserves, refer to the loss and LAE discussion below.
In December 2003, the FASB issued a revised Interpretation No. 46 - Consolidation of Variable Interest Entities (FIN 46), an interpretation of Accounting Research Bulletin No. 51. FIN 46 requires a variable interest entity (VIE) to be consolidated by the primary beneficiary of the entity if certain criteria are met. Some provisions of FIN 46 require certain Special Purpose Entity's (SPE) to be consolidated as of December 31, 2003. The Corporation does not have any investments that qualify as SPE's under these provisions. FIN 46 also requires consolidation of all variable interests held no later than the end of the first reporting period that ends after March 15, 2004 (as of March 31, 2004 for the Corporation). The Corporation currently holds one equity investment, which represents a 49% interest in the entity, which will require consolidation in accordance with FIN 46. The expected loss upon adoption will be immaterial to the Corporation's consolidated financial statements. See Footnote 18 on page 75 of this Form 10-K for further discussion.
March 23, 2005, the Corporation has the option to redeem all or a portion of the notes that have not been previously converted at the following redemption prices (expressed as a percentage of principal amount):
The holders of the notes have the option to require the Corporation to purchase all or a portion of their notes on March 19 of 2007, 2012 and 2017 at 100% of the principal amount of the notes. In addition, upon a change in control of the Corporation occurring anytime prior to maturity, holders may require the Corporation to purchase for cash all or a portion of their notes at 100% of the principal amount plus accrued interest.
(September 30) and is subject to change each year. For example, holding all other assumptions constant, a one-percentage-point increase or decrease in the assumed rate of return on plan assets would decrease or increase, respectively, 2004 net periodic pension expense by approximately $2.4 million.
Unrecognized losses of approximately $37.8 million are being recognized over approximately a 14-year period, which represents the average future service period of active participants. Unrecognized gains and losses arise from several factors including experience and assumption changes in the obligations and from the difference between expected returns and actual returns on plan assets. These unrecognized losses will be systematically recognized as an increase in future net periodic pension expense in accordance with FASB Statement No. 87, "Employers' Accounting for Pensions."
In March 2004, the Company announced changes to its defined benefit, defined contribution and health insurance plans. The Company's traditional defined benefit plan will be amended to freeze accrued benefits effective June 30, 2004 and to incorporate a new pension equity plan benefit formula beginning July 2004. Also effective in July 2004, eligibility for subsidized retiree medical and dental coverage will be restricted to then current retirees and employees with 25 or more years of continuous service. Other employees will be eligible for access to unsubsidized retiree medical and dental coverage. These changes will result in a decrease in expenses of approximately $7.9 million before tax in 2004 and $5.6 million before tax in 2005 when compared to the 2003 expense.
On March 11, 2002, Standard & Poor's Rating Services (S&P) removed its negative outlook and placed a stable outlook on the Group's "BBB" financial strength rating. S&P also announced that it assigned its "BB" senior debt rating to the Corporation's convertible notes. Following the Corporation's announcement of third quarter 2002 results, S&P revised its outlook to negative from stable and indicated that the Group's financial strength rating would be reviewed for possible downgrade. On April 30, 2003, S&P affirmed its "BBB" financial strength rating for the Group and maintained its negative outlook. On May 13, 2003 S&P assigned prospective ratings to Ohio Casualty's universal shelf. The prospective ratings for senior unsecured debt, subordinated debt and preferred stock were "BB", "B+" and "B", respectively. On February 13, 2004 S&P revised its outlook to stable and affirmed its financial strength and credit ratings on the Group and the Corporation.
Generally, credit ratings affect the cost and availability of debt financing. Often, borrowers with investment grade credit ratings can borrow at lower rates than those available to similarly situated companies with ratings that are below investment grade, and the availability of certain debt products may be greater for borrowers with investment grade credit ratings. Currently, the Corporation is a "split-rated" borrower, having investment grade ratings from A.M. Best, Fitch and Moody's and below investment grade credit rating from S&P. While influenced by conditions in the credit markets, it is reasonable to anticipate that the Corporation's split rating will result in a higher cost of borrowing as compared to borrowers with only investment grade credit ratings. The recent improvement in the rating outlook by S&P is a positive development in the Corporation's rating profile.
Statutory Surplus Statutory surplus, a traditional insurance industry measure of financial strength and underwriting capacity, was $867.6 million at December 31, 2003, compared with $725.7 million at December 31, 2002 and $767.5 million at December 31, 2001. Statutory surplus increased 19.6% from 2002 resulting principally from statutory net income and an increase in the market value of equity investments. These positive factors were partially offset by $21.2 million and $4.8 million after-tax charge in 2003 and 2002, respectively for an increase in the additional minimum liability for the pension plan. The decline in statutory surplus during 2002 was due primarily to a decrease in the market value of the equity investment portfolio. Statutory surplus benefited in 2001 from the sale of a minority interest in the stock of a subsidiary, which caused a tax benefit of $16.1 million.
The ratio of net premiums written to statutory surplus is one of the measures used by insurance regulators to gauge the financial strength of an insurance company and indicates the ability of the Group to grow by writing additional business. At December 31, 2003, the Group's net premiums written to surplus ratio was 1.7 to 1, compared to 2.0 to 1 in 2002 and 1.9 to 1 in 2001. The 2003 result is the strongest ratio for premiums to surplus since 1998.
Reinsurance Reinsurance is a contract by which one insurer, called a reinsurer, agrees to cover, under certain defined circumstances, a portion of the losses incurred by a primary insurer in the event a claim is made under a policy issued by the primary insurer. The Group purchases reinsurance to protect against large or catastrophic losses. There are several programs that provide reinsurance coverage and the programs in effect for 2003 are summarized below.
The Group's property per risk program covers property losses in excess of $1.0 million for a single insured, for a single event. This property per risk program covers up to $14.0 million in losses in excess of the $1.0 million retention level for a single event. The Group's casualty per occurrence program covers liability losses. Workers' compensation, umbrella and other casualty reinsurance cover losses up to $59.0 million, $24.0 million and $23.0 million, respectively, in excess of the $1.0 million retention level for a single insured event. The retention on the property per risk excess of loss treaty increased from $1.0 million in 2003 to $1.5 million in 2004. The casualty reinsurance treaty includes a layer of coverage of $5.0 million in excess of $1.0 million that consists of a fund managed by the Group, and the Group has title to the assets. Ceded premiums are paid by the Group into the fund and reinsured losses are paid to the Group under the terms of the reinsurance agreement with various reinsurers. The reinsurers bear the risk of losses in excess of the fund. The Group's ability to manage the investments of the fund reduces credit risk related to reinsurers. The balance of the fund as of December 31, 2003 was approximately $150.5 million.
The property catastrophe reinsurance program protects the Group against an accumulation of losses arising from one defined catastrophic occurrence or series of events. This program provides $100.0 million of coverage in excess of the Group's $25.0 million retention level. The catastrophe excess of loss treaty changed from $100.0 million in excess of $25.0 million in 2003 to $80.0 million in excess of $25.0 million in 2004. The treaty was written on a multiple year basis for years 2001 - 2003 with only a portion of the reinsurance layers expiring in a single year. This provides continuity, maintains rates and preserves each reinsurer's share of the overall program. Over the last 20 years, two events triggered coverage under the catastrophe reinsurance program. Losses and LAE from the fires in Oakland, California in 1991 totaled $35.6 million and losses and LAE from Hurricane Andrew in 1992 totaled $29.8 million. Both of these losses exceeded the prior retention amount of $13.0 million, resulting in significant recoveries from reinsurers. Reinsurance limits are purchased to cover exposure to catastrophic events having the probability of occurring every 100-250 years.
Reinsurance contracts do not relieve the Group of their obligations to policyholders. The collectibility of reinsurance depends on the solvency of the reinsurers at the time any claims are presented. The Group monitors each reinsurer's financial health and claims settlement performance because reinsurance protection is an important component of the Corporation's financial plan. Each year, the Group reviews financial statements and calculates various ratios used to identify reinsurers who no longer meet appropriate standards of financial strength. Reinsurers who fail these tests are removed from the program at renewal. Additionally, a large base of reinsurers is utilized to mitigate concentration of risk. The Group also records an estimated allowance for uncollectible reinsurance amounts as deemed necessary. During the last three fiscal years, no reinsurer accounted for more than 15% of total ceded premiums, excluding the Security Trust Fund. As a result of these controls, amounts of uncollectible reinsurance have not been significant. For more discussion on the reinsurance recoverable asset, see Footnote 7 on page 70 of this Form 10-K.
In recent years, asbestos and environmental liability claims have expanded greatly in the insurance industry. Historically, the Group has written small commercial accounts and has not sold policies with significant manufacturing liability coverages. Within the manufacturing category, the Group has concentrated on the light manufacturers, which further limits exposure to environmental claims. Consequently, the Group believes it does not have exposure to the primary defendants involved in major asbestos litigation. The Group's exposure to asbestos is related to installers and distributors as opposed to the large manufacturers. In 2001, the Group increased asbestos reserves because of the expansion of litigation to these types of business. The Group's exposure to environmental liability is due to policies written prior to the introduction of the absolute pollution endorsement in the mid- 80's, and to the underground storage tank leaks mostly from New Jersey homeowners policies in recent
The Group defines construction defect exposure as liability for allegations of defective work and completed operations losses from general liability, commercial multiple peril liability and umbrella liability policies involving multiple-units (condos/townhouses/apartments/tracts of single family homes), multiple defendants (e.g. developers, sub-contractors), usually with multiple defect issues, and often involving multiple insurance carriers. The Group excludes from the definition claims related to individual single family homes, apartments/townhomes or other residential properties if the defect issues are limited in scope and volume.
The number of construction defect claims reported in 2003, 2002 and 2001, respectively, were 271, 224 and 157. The paid losses, net of reinsurance, in 2003 were $16.5 million, compared to $11.4 million in 2002 and $6.7 million in 2001. The paid claims legal related LAE, net of reinsurance, for construction defect claims were $4.3 million in 2003, compared with $4.1 million in 2002 and $1.9 million in 2001. These totals exclude construction defect losses from the state of California. Although the Group has construction defect losses from California exposure, it excludes California from this data because the Group stopped writing in the state in 1993 and the remaining claims are minimal and of a different nature than its exposure in the rest of the country. This data also includes claims assumed from the GAI acquisition beginning in November 2001, slightly distorting the 2001 numbers.
In 2002 the Group also experienced greater than expected loss activity from older accident years for the commercial automobile product line. This was due to greater than expected severity on bodily injury claims. As a result, the estimate of ultimate loss and LAE was increased by $17.0 million.
Because of the inherent uncertainties in estimating ultimate costs of claims, actual loss and LAE may deviate substantially from the amounts recorded. Furthermore, the timing, frequency and extent of adjustments to the estimated liabilities cannot be predicted since conditions and events which established historical loss and LAE reserve development and which serve as the basis for estimating ultimate claim cost may not occur in exactly the same manner, if at all.
Investment Portfolio At year-end 2003, total consolidated investments had a carrying value of $3.7 billion. The excess of market value over cost was $422.1 million, compared with $392.2 million at year-end 2002 and $420.9 million at year-end 2001. The increase in 2003 was attributable to the increase in the market value of certain equity securities. The decrease in 2002 was largely due to the recognition of realized gains in connection with the sale of appreciated equity securities and declines in the market value of certain equity securities. The reduction in unrealized gains related to equity securities in 2002 was somewhat offset by an increase in unrealized gains in the fixed maturity portfolio of $130.0 million.
At December 31, 2003, the available-for-sale fixed maturity portfolio had a market value of $3.0 billion, which consisted of 96.7% investment grade securities. The held-to-maturity fixed maturity portfolio is accounted for at amortized cost, which was $356.1 million at December 31, 2003 and consists entirely of investment grade securities.
The consolidated fixed maturity portfolio has an intermediate duration and a laddered maturity structure. The duration of the fixed maturity portfolio is approximately 4.6 years as of December 31, 2003. The Corporation and the Group remain fully invested and do not time markets. The Corporation and the Group also have no off-balance sheet investments or arrangements as defined by section 401(a) of the Sarbanes-Oxley Act of 2002.
As of December 31, 2003, the Corporation and the Group held a total of $1,002.9 million in mortgage-backed securities, compared with $1,154.3 million and $1,107.9 million at December 31, 2002 and 2001, respectively. As of December 31, 2003, $188.4 million of these mortgage-backed securities are held at amortized cost in the held-to-maturity portfolio. In the first quarter of 2003, management decided to transfer a portion of its fixed maturity securities from available-for-sale to held-to-maturity classification. This transfer was made, as management believes the Corporation and the Group have both the ability to hold securities to maturity and the intent to do so. The majority of mortgage-backed security holdings are in sequential structures, planned amortization class and agency pass-through securities. Of this portfolio, $6.2 million, $7.8 million and $10.0 million were invested in more volatile bond classes (e.g. interest-only securities which do not return principal at maturity, super-floater securities which pay interest at a formula rate that is a function of LIBOR and inverse-floater securities which pay interest per a formula that adjusts inversely to changes in LIBOR rates) at December 31, 2003, 2002 and 2001, respectively.
Securities are classified as investment grade or non-investment grade based upon the higher of the ratings provided by S&P and Moody's. When a security is not rated by either S&P or Moody's, the classification is based on other rating services, including the Securities Valuation Office of the National Association of Insurance Commissioners. The market value of available-for- sale split-rated fixed maturity securities (i.e., those having an investment grade rating from one rating agency and a below investment grade rating from another rating agency) was $24.0 million at December 31, 2003 compared to $45.8 million and $27.8 million at December 31, 2002 and 2001, respectively.
At December 31, 2003, the fixed maturity portfolio included non-investment grade securities and non-rated securities that had a fair value of $98.7 million and comprised 3.3% of the available-for-sale fixed maturity investment portfolio and 2.9% of the total fixed maturity investment portfolio. This compares to a fair value of $105.3 million and $94.3 million at December 31, 2002 and 2001, respectively. These securities comprised 3.0% and 2.8% of the available-for-sale investment portfolio at December 31, 2002 and 2001, respectively. The held-to-maturity securities are all investment grade. Following is a table displaying available-for-sale non-investment grade and non-rated securities in an unrealized loss position at December 31:
The investment portfolio includes non-publicly traded securities such as private placements, non-exchange traded equities and limited partnerships which are carried at fair value. Fair values are based on valuations from pricing services, brokers and other methods as determined by management to provide the most accurate price. The carrying value of this portfolio at December 31, 2003 was $318.8 million compared to $319.4 million at December 31, 2002 and $326.1 million at December 31, 2001.
The Corporation and the Group use assumptions and estimates when valuing certain investments and related income. These assumptions include estimations of cash flows and interest rates. Although the Corporation and the Group believe the values of its investments represent fair value, certain estimates could change and lead to changes in fair values due to the inherent uncertainties and judgements involved with accounting measurements.
See Item 15 for Index to Consolidated Financial Statements, including the Notes to Consolidated Financial Statements and the Report of Independent Accountants, and Schedules on page 57 of this Form 10-K.