We offer property and casualty insurance products through our various subsidiaries. We classify our businesses into two operating segments: (i) Insurance Operations, which consists of commercial lines (“Commercial Lines”) and personal lines, including our flood line of business (“Personal Lines”) and (ii) Investments. These segments reflect a change from our historical segments of: Insurance Operations, Investments, and Diversified Insurance Services (which included federal flood insurance administrative services (“Flood”) and human resource administration outsourcing (“HR Outsourcing”)). In the process of periodically reviewing our operating segments, we reclassified our Flood operations in the first quarter of 2009 to be included within our Insurance Operations segment, which reflects the way we are now managing this business. We believe these reporting changes better enable investors to view us the way our management views our operations and provide more consistency with how our peers report their business. During the third quarter of 2009, we entered into a plan to dispose of our HR Outsourcing segment, which caused the elimination of this operating segment. The sale of this business was completed in Fourth Quarter 2009. Our revised segments are reflected throughout this report for all periods presented. See Note 13. “Discontinued Operations” in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K for additional information.
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer, and the insurer’s payment of that loss. To recognize liabilities for unpaid losses and loss expenses, insurers establish reserves as balance sheet liabilities representing an estimate of amounts needed to pay reported and unreported net losses and loss expense. As of December 31, 2009, we had accrued $2.7 billion of gross loss and loss expense reserves compared to $2.6 billion at December 31, 2008.
General Liability and Commercial Automobile (Impact of Claims Initiatives and Inflation)
In addition to a normal amount of volatility, the uncertainty of personal automobile loss development factors is greater than usual due to the number of judicial and regulatory changes in the New Jersey personal automobile market over the years as well as the change in our state mix for business written in states other than New Jersey. In our judgment, it is possible that personal auto bodily injury loss development factors could range from 4% below those actually selected in our latest reserve analysis to 3% above those selected in our latest reserve analysis. If the loss development assumptions were reduced by 4%, that would decrease our indicated personal automobile reserves by approximately $34 million for accident years 2008 and prior. Alternatively, if the loss development factors were increased by 3% that would increase our indicated personal automobile reserves by approximately $25 million for accident years 2008 and prior.
Reserve Impact of Changing Current year Expected Ultimate Loss Ratio Assumption
Included in our loss and loss expense reserves are amounts for environmental claims, both asbestos and non-asbestos. Carried net loss and loss expense reserves for environmental claims were $41.6 million as of December 31, 2009 and $44.1 million as of December 31, 2008. Our asbestos and non-asbestos environmental claims have arisen primarily from insured exposures in municipal government, small commercial risks, and homeowners policies. The emergence of these claims is slow and highly unpredictable. Over the past few years, we also experienced adverse development in our homeowners line of business as a result of unfavorable trends in claims for groundwater contamination caused by leakage of certain underground heating oil storage tanks in New Jersey. In addition, certain landfill sites are included on the National Priorities List (“NPL”) by the United States Environmental Protection Agency (“USEPA”). Once on the NPL, the USEPA determines an appropriate remediation plan for these sites. A landfill can remain on the NPL for many years until final approval for the removal of the site is granted from the USEPA. The USEPA also has the authority to re-open previously closed sites and return them to the NPL. We currently have reserves for several claims related to sites on the NPL, one of which has been reopened in 2009 relative to a natural resources claim.
Any shortfall in the expected present value of the future cash flows, based on the discounted cash flow analysis, from the amortized cost basis of a security is considered a “credit impairment,” with the remaining decline in fair value of a security considered as a “non-credit impairment.” Credit impairments are charged to earnings as a component of realized losses, while non-credit impairments are recorded to OCI as a component of unrealized losses.
We use a loan loss severity assumption in our discounted cash flow analysis that is applied at the loan level of the collateral pool. The loan loss severity assumptions represent the estimated percentage loss on the loan-to-value exposure for a particular security. If the current loan-to-value ratio of a security is not available, we assume a 50% loan loss severity. However, certain of the securities have lower current loan-to-value ratios, which in our opinion results in a severity assumption of 50% being overly conservative. Where we have current loan-to-value information and the loan-to-value ratio is lower than 80%, we adjust the severity assumption to reflect the fact that the loan-to-value ratio is lower.
Favorable prior year development of $29 million, or 2.1 points, in 2009 compared to favorable prior year development of $19 million, or 1.3 points, in 2008. Favorable development in 2007 was approximately $19 million, or 1.2 points. For more information on the favorable prior year development on our commercial lines of business, please refer to the “Review of Underwriting Results by Lines of Business” below; and
Approximately 28 rate increases that generated $6.7 million in annual premium, that went into effect across our Personal Lines footprint during 2009; and
The sixth layer provides coverage for 100% of up to $40.0 million in excess of a $50.0 million retention. The placement of this layer was increased from 75% in the expiring treaty.
Reduced our non-agency commercial mortgage-backed securities (“CMBS”) exposure from a carrying value of $154 million at December 31, 2008, or 4% of invested assets, to $74 million, or 2% of invested assets;
The degree to which the issuer is current or in arrears in making principal and interest payments on the fixed maturity security;
Changes made or future changes to be made to the investment strategy;
For valuations of securities in our equity portfolio and U.S. Treasury notes held in our fixed maturity portfolio, we utilize a market approach, wherein we use quoted prices in an active market for identical assets. The source of these prices is one primary external pricing service, which we validate against a second external pricing service. Significant variances between pricing from the two pricing services are challenged with the respective pricing service, the resolution of which determines the price utilized. These securities are classified as Level 1 in the fair value hierarchy.
In April 2009, the FASB issued guidance under ASC 320, Investments - Debt and Equity Securities, which was formerly referred to as FSP FAS 115-2 and FSP FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments. This guidance introduces the concept of credit and non-credit OTTI charges on fixed maturity securities. Under this guidance, when an OTTI of a fixed maturity security has occurred, the amount of the OTTI charge recognized in earnings depends on whether a company: (i) intends to sell the security; or (ii) will more likely than not will be required to sell the security before recovery of its amortized cost basis. If the debt security meets either of these two criteria, the OTTI recognized in earnings is equal to the entire difference between the security’s amortized cost basis and its fair value at the impairment measurement date. For impairments of fixed maturity securities that do not meet these two criteria, the net amount recognized in earnings is equal to the difference between the amortized cost of the debt security and its projected net present value of future cash flows (referred to as the “credit impairment”). Any difference between the fair value and the projected net present value of future cash flows at the impairment measurement date is recorded in OCI (referred to as the “non-credit impairment”). Prior to our adoption of this guidance on April 1, 2009, an OTTI recognized in earnings for fixed maturity securities was equal to the total difference between its amortized cost and fair value at the time of impairment. We were also required to analyze securities held as of the adoption date which have had past OTTI charges in order to quantify a cumulative effect adjustment to the opening balance of retained earnings with a corresponding adjustment to AOCI upon adoption. This cumulative effect adjustment amounted to $2.4 million, net of deferred tax, which decreased AOCI and increased retained earnings. Also upon adoption, we increased the amortized cost of these securities by $3.7 million, representing non-credit related impairments recognized in earnings prior to the adoption of this guidance. This guidance was effective for interim and annual reporting periods ending after June 15, 2009. See Note 5. “Investments” for information regarding our credit and non-credit OTTI charges. In addition, we have included the required disclosures in the notes to the consolidated financial statements where applicable.
We have reviewed the securities in the tables above in accordance with our OTTI policy, as described in Note 2. “Summary of Significant Accounting Policies” above. In determining the loss severity applied within the scenarios, we use a current, or estimated, loan-to-value ratio multiplied by an estimated 65% loss on that exposure. We typically use conditional default rates on our CMBS portfolio of 2.5, but these rates may exceed 2.5 based on our judgment regarding the facts surrounding the securities. Generally the range of the conditional default rate assumptions for our other structured securities is as follows:
HTM CMBS with an unrealized/unrecognized loss balance of $16.2 million; and
Unrealized losses on our AFS RMBS that have been in an unrealized loss position for more than 12 months amounted to $20.2 million at December 31, 2009. These losses can be categorized as follows:
(g) The components of net investment income earned were as follows:
The decrease in net investment income of $43.1 million for 2008 compared to 2007 was due to: (i) decrease returns of $31.9 million on the alternative investment portion of our other investments portfolio; and (ii) $8.1 million of reductions in the fair value of our equity trading portfolio due to the sell off in the equity markets, as well as the collapse in commodity prices in 2008.
The balances of and changes in each component of AOCI as of December 31, 2009 are as follows (net of taxes):
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 2,494,901 shares of common stock available for purchase as of December 31, 2009. 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. Under the Agent Plan, we issued to agents 146,570 shares in 2009, 137,264 shares in 2008 and 157,375 shares in 2007 and charged to expense $0.2 million in 2009, $0.3 million in 2008, and $0.4 million in 2007, with a corresponding income tax benefit of $0.1 million in each year.
The Insurance Subsidiaries are required to maintain certain minimum amounts of statutory surplus to satisfy their various state insurance departments of domicile. 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' 2009 unaudited statutory financial statements, their combined total adjusted capital exceeded the authorized control level RBC by 4.7:1, as defined by the NAIC.