At December 31, 2008, no other individual line of business had recorded reserves of more than $67 million, net of reinsurance. We have not identified any recent trends that would create additional significant reserve uncertainty for these other lines of business.
Stress testing of projected cash flows under various economic and default scenarios.
We perform impairment assessments for the structured securities included in our fixed maturity portfolio (including, but not limited to, commercial mortgaged-backed securities (“CMBS”), residential mortgaged-backed securities (“RMBS”), asset-backed securities (“ABS”), and collateralized debt obligations (“CDOs”)), comprising an evaluation of the underlying collateral of these structured securities. This assessment, although considering the length of time for which the security has been in an unrealized loss position, focuses on the performance of the underlying collateral under various economic and default scenarios which may involve subjective judgments and estimates determined by management. Considering various factors in our modeling of these structured securities, such as projected default rates, the nature and realizable value of the collateral, the ability of the security to make scheduled payments, historical performance and other relevant economic and performance factors, we determine if an impairment is other than temporary in circumstances where our projection of losses extends into the tranche of the security in which we are invested.
The statutory ratios include our flood line of business, which is included in the Diversified Insurance Services Segment on a GAAP basis and therefore excluded from the GAAP ratios. The total statutory combined ratio excluding flood was 99.9% for 2008, 98.2% for 2007, and 96.1% for 2006.
As these initiatives are anticipated to accelerate the timing of reserve establishment, we ultimately expect lower loss costs to be realized through reduced legal and loss adjustment expenses. This acceleration inflates our severity statistics in the near term, but we expect the longer-term benefit to be a refined management of the claims process.
Additional information regarding the terms and related coverage associated with each of our categories of reinsurance can be found in Item 1. “Business” of this Form 10-K.
In 2008, we managed our hurricane exposures through the implementation of a Catastrophe (“CAT”) strategy initiative. It focused on policies with high Annual Average Loss (“AAL”) to premium ratios which were targeted for increases in deductibles and premium, and in certain cases non-renewals. The strategy led to the implementation of a variety of underwriting system tools that provide CAT management information to the underwriters for a more granular portfolio management of our property book of business. The July 2008 modeling results included a 4.4% reduction in gross AAL, while insured values increased 3.5% when compared to June 2007, clearly showing that the strategy has taken hold.
Consistent with the prior year contract, all NBCR losses are excluded from the Property Excess of Loss treaty. Terrorism (excluding NBCR) and per-occurrence aggregate limits were increased to $64.0 million from $46.5 million.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Selective Insurance Group, Inc. and its subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
Evaluation for OTTI of equity securities and other investments includes, but is not limited to, the following factors:
Reserves are reviewed for adequacy on a periodic basis. As part of the periodic review, we consider the range of possible loss and loss expense reserves, determined at the beginning of the year, in evaluating reserve adequacy. When reviewing reserves, we analyze historical data and estimate the impact of various factors such as: (i) per claim information; (ii) our and the industry’s historical loss experience; (iii) legislative enactments, judicial decisions, legal developments in the imposition of damages, and changes in political attitudes; and (iv) trends in general economic conditions, including the effects of inflation. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. However, there is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves because the eventual deficiency or redundancy is affected by many factors. Based upon such reviews, we believe that the estimated reserves for losses and loss expenses are adequate to cover the ultimate cost of claims. The changes in these estimates, resulting from the continuous review process and the differences between estimates and ultimate payments, are reflected in the consolidated statements of income for the period in which such estimates are changed.
We establish reserves for dividends to policyholders on certain policies, most significantly 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. We do not issue policies that entitle the policyholder to participate in the earnings or surplus of the Insurance Subsidiaries.
We have various operating leases for office space and equipment. Rental expense for such leases is recorded on a straight-line basis over the lease term. If a lease has a fixed and determinable escalation clause, or periods of rent holidays, the difference between rental expense and rent paid is included in “Other liabilities” as deferred rent in the Consolidated Balance Sheets.
In June 2008, the FASB issued FSP No. EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities (“FSP 03-6-1”). FSP 03-6-1 addresses the treatment of unvested share-based payment awards containing nonforfeitable rights to dividends or dividend equivalents in the calculation of earnings per share and is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years. We are currently evaluating the impact of FSP 03-6-1 on our calculation of earnings per share.
In performing our OTTI impairment analysis for asset-backed, agency mortgage-backed, and non-agency mortgage backed securities, which in total were in an unrealized loss position of $109.8 million at December 31, 2008, we estimated future cash flows for each security based upon our best estimate of future delinquencies, loss severity, and prepayments. The resulting cash flows were reviewed to determine whether we anticipate receiving all of the originally scheduled cash flows. Projected credit losses were compared to the current level of credit enhancement to determine whether the security is expected to experience losses during any future period and therefore become other-than-temporarily impaired. Based on this cash flow testing, we have determined that the decline in fair value of these structured securities presented in the table above is not attributable to credit quality, but to a significant widening of interest rate spreads across market sectors related to the continued illiquidity and uncertainty of the markets. As we have the ability and intent to hold these investments until a fair value recovery or until maturity, we do not consider these securities to be other-than-temporarily impaired as of December 31, 2008. It is possible that the underlying loan collateral of these securities will perform at a level worse than our expectations, which may lead to adverse changes in cash flows on these securities and potential future other-than-temporary impairment losses. Events that may trigger material declines in fair values for these securities include, but are not limited to, the deterioration of credit metrics, significantly higher levels of default and severity of losses on the underlying collateral, or further illiquidity.
The components of comprehensive (loss) income, both gross and net of tax, for 2008, 2007, and 2006 are as follows:
For the majority of our fixed maturity portfolio and several non-publicly traded equity securities, we also utilized a market approach, using primarily matrix pricing prepared by external pricing services. We validate these prices against other external pricing sources in order to determine the fair value of the positions, as well as to determine their placement within the fair value hierarchy (Level , Level 2, or Level 3) as defined in FAS 157.
During 2008, certain reinsurers with whom we do business have: (i) experienced liquidity concerns; or (ii) have been downgraded or placed on ratings review by one or more rating agencies. Some of the reinsurance arrangements that these reinsurers participate in involve upper layers of casualty business (known as “clash layers”) for which historical experience does not exist. Due to the uncertainty associated with casualty business, and specifically losses reaching those clash layers, current reinsurance recoverables from our reinsurers may change materially in the event of a significant loss event well in excess of our historical levels. The ability of our reinsurers to reimburse us for their portion of future losses may become uncertain in the event of significant financial deterioration of these reinsurers.
At December 31, 2008, our reserves for environmental claims amounted to $51.5 million on a gross basis (including case reserves of $20.3 million and IBNR reserves of $31.2 million) and $44.1 million on a net basis (including case reserves of $16.7 million and IBNR reserves of $27.4 million). There are a total of 2,362 environmental claims, including multiple claimants who are associated with the same site or incident. Of these, 2,037 are asbestos related, of which 1,321 are with seven insureds in the wholesale and/or retail of plumbing, electrical, and other building supplies with related case reserves of $4.9 million. During 2008, 264 asbestos claims were closed, which accounted for approximately $0.1 million of the total asbestos paid of $1.4 million. The total case reserves for asbestos related claims amounted to $6.4 million on a gross and net basis. About 70 of the total environmental claims involve six landfill sites. The landfill sites account for case reserves of $7.8 million on a gross and net basis, and include reserves for several sites that are currently listed on the National Priorities List. The remaining claims, which account for $6.1 million of case reserves on a gross and $2.5 million on a net basis, involve leaking underground heating oil storage tanks and other latent environmental exposures.
The following table provides a roll forward of gross and net environmental incurred losses and loss expenses and related reserves thereon:
In accordance with FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (“FIN 48”), we have analyzed our deferred tax positions in all open tax years, which as of December 31, 2008 were 2005, 2006, and 2007. Based on this analysis, we do not have unrecognized tax benefits as of December 31, 2008. We believe our tax positions will more likely than not be sustained upon examination, including related appeals or litigation. In the event we had a tax position that did not meet the more likely than not criteria, any tax, interest, and penalties incurred related to such a position would be reflected in “Federal income tax expense” on our Consolidated Income Statement.
The Parent’s Cash Incentive Plan was adopted and approved by the Board effective March 1, 2006 and approved by stockholders on April 27, 2005. Under the Cash Incentive Plan, the Board’s SEBC may grant cash incentive units in such amounts and with such terms and conditions as it shall determine, subject to the provisions of the Cash Incentive Plan. The initial dollar value of these grants will be adjusted to reflect the percentage increase or decrease in the total shareholder return on the Parent’s common stock over a specified performance period. In addition, for certain grants, the number of units granted will be adjusted to reflect our performance on specified indicators as compared to targeted peer companies. Each award granted under the Cash Incentive Plan shall be evidenced by an agreement containing such restrictions as the SEBC may, in its sole discretion, deem necessary or desirable and which are not in conflict with the terms of the Cash Incentive Plan. During 2008, we issued, net of forfeitures, 48,890 cash units, 38,681 cash units during 2007, and 79,384 cash units during 2006.
On April 26, 2006, our stockholders approved the Stock Purchase Plan for Independent Insurance Agencies (“Agent Plan”). This plan replaced the previous agent purchase plan under which no further purchases could be made as of July 1, 2006. Under the Agent Plan, there were 2,641,471 shares of common stock available for purchase as of December 31, 2008. The Agent Plan provides for quarterly offerings in which independent insurance agencies and certain eligible persons associated with the agencies with contracts with the Insurance Subsidiaries can purchase the Parent’s common stock at a 10% discount with a one year restricted period during which the shares purchased cannot be sold or transferred. Collectively, under the current and prior plans, we issued shares to agents in the amount of 137,264 in 2008, 157,375 in 2007 and 153,478 in 2006 and charged to expense $0.3 million in 2008, and $0.4 million in both 2007 and 2006, with a corresponding income tax benefit of $0.1 million in each year.