The issuer's current financial condition and its ability to make future scheduled principal and interest payments on a timely basis;
In light of the many uncertainties associated with establishing the estimates and making the assumptions necessary to establish reserve levels, the Company reviews its reserve estimates on a regular basis as described above and makes adjustments in the period that the need for such adjustment is determined. These reviews, from time to time, result in the Company identifying information and trends that cause the Company to increase some reserves and decrease other reserves for prior periods and could lead to the identification of a need for additional increases in loss and loss adjustment expense reserves, which could materially adversely affect the Company's results of operations, equity, business, insurer financial strength and debt ratings. During 2004, the Company experienced adverse development in its loss and loss expense reserves totaling $4.9 million. This development was driven by an increase to our loss reserves in the general liability and workers compensation lines of business of $3.5 million, which was the result of rating agency downgrades of certain reinsurers during 2004, and reductions in expected bond subrogation recoveries in our bond line of business of $2.0 million. In addition, we had net favorable emergence of $0.6 million from our other lines of business, which was primarily the result of increases to our loss reserves for our general liability line of business of approximately $19 million, offset by decreases to our loss reserves for our commercial automobile line of business of approximately $20 million and minor development in other lines. The adverse development in the general liability line of business was mainly due to our contractor completed operations business. Prior to 2002, we had more exposure to faulty workmanship and materials for both the general contractors and subcontractors and inadequate limits on subcontractors. After 2002, we took extensive underwriting actions to limit our exposure. We adopted the Insurance Service Office (ISO) general liability insurance form, which excluded subcontractors for faulty workmanship. We also placed mold limitations or exclusions on most policies and required subcontractors to carry equal insurance limits to those carried by the general contractor as well as mandated that our insureds be named on any potential subcontractor's policy as an additional insured on a primary and noncontributory basis. The positive development in the commercial automobile line of business was driven by a reduction in claim frequency and severity. The most significant adverse development came from accident years 1999 and 2000, which was offset by favorable development from accident years 2002 and 2003. For the full year 2003, the Company experienced adverse development in its loss and loss expense reserves totaling $15.0 million. Similar to 2004, this development was driven by our general liability line of business, specifically our contractor completed operations business, which increased prior year loss estimates by approximately $18 million.
Policy acquisition costs, which include commissions, premium taxes, fees, and certain other costs of underwriting policies, are deferred and amortized over the same period in which the related premiums are earned. Deferred policy acquisition costs are limited to the estimated amounts recoverable after providing for losses and loss expenses that are expected to be incurred, based upon historical and current experience. Anticipated investment income is considered in determining whether a premium deficiency exists. The methods of making such estimates and establishing the deferred costs are continually reviewed by the Company, and any adjustments are made in the accounting period in which the adjustment arose. As of December 31, 2004 the Company had deferred policy acquisition costs of $186.9 million compared to $172.4 million as of December 31, 2003.
Results of property and casualty insurers are subject to weather and other conditions. While one year may be relatively free of major weather or other disasters, another year may have numerous such events causing results to be materially worse than other years.
Our subsidiary, CHN Solutions, builds medical provider networks and leases networks to insurers, medical management companies, third party administrators and other medical claim payors. The lessees receive medical fee discounts from network providers in exchange for potential patient volume commitments, where permitted under state law, from CHN Solutions' client and payor base. If medical providers, such as physicians, decided to unionize, that might impair CHN Solutions' ability to maintain and grow networks, negotiate fee discount arrangements and lease networks to their customers. These events would have an adverse impact not only on CHN Solutions, but also on Selective as a whole because we rely, in part, on provider networks and discounts to manage our claim medical expenses. Those events could also have an adverse effect on our results of operations and financial condition.
The Diversified Insurance Services subsidiaries may also declare and pay dividends. Potential dividends are restricted only by the operating needs of the subsidiaries, with the exception of our flood insurance operation, which is restricted by the same limitations of our Insurance Subsidiaries noted above. Sources of funds for the Diversified Insurance Services subsidiaries primarily consist of fees for services rendered. Such funds are applied primarily to payment of operating expenses as well as dividends and other payments.
Directly or indirectly, we own, all of the shares of stock of Insurance Subsidiaries domiciled in the states of New Jersey, New York, North Carolina, South Carolina, and Maine. State insurance laws require prior approval by state insurance departments of any acquisition or control of a domestic insurance company or of any company, which controls a domestic insurance company. Any purchase of 10% or more of our outstanding common stock would require prior action by all or some of the insurance commissioners of these states.
cash acquired of $4,890 in 2004; $0 in 2003; and $48 in 2002)
(2) Indebtedness: The fair value of the convertible subordinated debentures, the 1.6155% Senior Convertible Notes due September 24, 2032, and the 7.25% Senior Notes due November 15, 2034 are based on quoted market prices. The fair values of the 8.77% Senior Notes due August 1, 2005, the 8.63% Senior Notes due May 4, 2007, and the 8.87% Senior Notes due May 4, 2010 were estimated using a cash flow analysis based upon Selective's current incremental borrowing rate for the remaining term of the loan.
Selective establishes reserves for dividends to policyholders on certain workers' compensation policies. These dividends are based on the policyholders' loss experience. The dividend reserves are established based on past experience, adjusted for the effects of current developments and anticipated trends. The expense for these dividends is recognized over a period that begins at policy inception and ends with the payment of the dividend. The expense recognized for these dividends was $4.3 million for 2004; $5.1 million in 2003; and $5.8 million in 2002. Selective does not issue policies that entitle the policyholder to participate in the earnings or surplus of the Insurance Subsidiaries.
(j) Selective is not exposed to significant concentrations of credit risk within its investment portfolio. The largest investment in the securities of any one entity was $15.5 million at December 31, 2004 and $16.2 million at December 31, 2003.
A trust fund in the amount of $29.3 million as of December 31, 2004 and $38.7 million as of December 31, 2003, securing a portion of the liabilities ceded to American Re-Insurance Company, is held for the benefit of Selective. Amounts ceded to American Re-Insurance Company, exceeding the available trust fund, represent 13% or $32.9 million as of December 31, 2004 and 7% or $14.9 million as of December 31, 2003 of Selective's consolidated prepaid reinsurance premiums and loss recoverable balances not secured by trust funds, letters of credit or funds withheld (collateral). In addition, about 60% of Selective's consolidated prepaid reinsurance premiums and net reinsurance recoverable balances not secured by collateral are ceded to two state or federally sponsored pools. Selective ceded $69.2 million as of December 31, 2004 and $71.3 million as of December 31, 2003 to the New Jersey Unsatisfied Claims Judgment Fund. Selective also ceded $78.9 million as of December 31, 2004 and $52.2 million as of December 31, 2003 to the National Flood Insurance Program.
Under Selective's Stock Option Plan II, 583,772 shares of Selective's common stock are available for issuance at December 31, 2004. The plan permits the granting of qualified and nonqualified stock options to employees, which may or may not have SARs attached. Options and related SARs may be granted at not less than fair value on the date of the grant and may be subject to certain vesting periods as determined by the Salary and Employee Benefits Committee of the Board of Directors (SEBC). Each grant must be exercised within ten years from the date of the grant. No options were granted under this plan in 2004 and 2003, but the company did grant 146,750 options in 2002.
In the ordinary course of conducting business, Selective and its subsidiaries have been named as defendants in various legal proceedings. Some of these lawsuits attempt to establish liability under insurance contracts issued by our Insurance Subsidiaries. Plaintiffs in these lawsuits are seeking money damages that, in some cases, are extra-contractual in nature or they are seeking to have the court direct the activities of Selective's operations in certain ways.
Selective's combined statutory capital and surplus of the Insurance Subsidiaries was $807.9 million (unaudited) in 2004 and $666.2 million in 2003. Selective's combined statutory net income of the Insurance Subsidiaries was $135.0 million (unaudited) in 2004, $53.8 million in 2003 and $29.4 million in 2002.
The Insurance Subsidiaries are required to maintain certain minimum amounts of statutory surplus to satisfy its various state insurance departments of domicile. These risk-based capital (RBC) requirements for property and casualty insurance companies are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholders. Based upon the Insurance Subsidiaries 2004 unaudited statutory financial statements, their combined total adjusted capital exceeded the authorized control level RBC by 5.0:1, as defined by the NAIC.