GAAP Combined Ratio. A key measure of an insurance company's performance is its combined ratio. The following table shows the components of TIG's consolidated combined ratio for its active operating segments on a consolidated GAAP basis:
Premium. TIG's reinsurance operations are conducted through TIG Re, which is based in Stamford, Connecticut. TIG Re's products and distribution system are described at Item 1.2 - Reinsurance. The table below shows premium production for TIG Re by business unit:
Commercial Specialty's underwriting results deteriorated $47 million in 1998 compared to 1997. The deterioration is primarily due to 1998 reserve strengthening of $54 million, primarily for workers' compensation and primary casualty lines. This strengthening was reduced by $35 million for corporate aggregate stop loss reinsurance benefits, which were triggered as a result of the strengthening. Additionally, 1997 results include favorable prior year loss reserve development in Workers' Compensation (see Item 1.6 - Reserves for a further discussion of the 1998 and 1997 reserve developments), contributing to the comparative deterioration. The 1998 underwriting results include benefits realized as a result of changes in the Managed Compensation unit's reinsurance strategy. As described in Item 7.6 - Exposure Management, the Managed Compensation unit reduced its net retention to $100 thousand from $1 million effective April 1, 1998 and effective January 1, 1998 the unit purchased finite reinsurance that allows the unit to stay competitive with other insurers whose states of domicile allow discounting of workers' compensation loss reserves. These changes improved Commercial Specialty's underwriting results by approximately $37 million in 1998 compared to 1997. Excluding the reserve development in each period and the benefits derived from reinsurance strategies, Commercial Specialty's underwriting results deteriorated approximately $49 million. This deterioration is primarily due to pricing pressures in most business units due to soft market conditions and increased underwriting expenses to support new business initiatives and the development of new business processes.
The GAAP commission expense ratio declined 1.8 points in 1998 and increased 0.6 points in 1997 as compared to the corresponding prior year. The 1998 decrease is primarily due to a change in the classification of payments to a large producer within Managed Compensation to more accurately reflect services performed from commission expense to unallocated loss adjustment expense. The 1997 increase is primarily attributable to increased corporate aggregate stop loss cessions which do not carry a ceding commission.
Derivatives/Hedges. In the normal course of business, TIG may choose to hedge some of its interest rate risk with futures contracts and/or interest rate swaps. Alternatively, derivative financial instruments may also be utilized to enhance prospective returns. TIG's interest rate swap arrangements generally provide that one party pays interest at a floating rate in relation to movements in an underlying index, and the other party pays interest at a fixed rate. While TIG is exposed to credit risk in the event of nonperformance by the other party, nonperformance is not anticipated due to the credit rating of the counterparties. No futures contract positions were open at December 31, 1998, or December 31, 1997. However, positions were opened and closed during 1998, 1997 and prior years. The deferral method has been used to account for these closed futures contracts. Under the deferral method, gains and losses from derivatives are deferred on the balance sheet and recognized in earnings in conjunction with the earnings recognition of the designated items. There were no interest rate swaps at December 31, 1998, and $14 million notional face amount of interest rate swaps at December 31, 1997. All TIG derivative financial instruments were with financial institutions rated "A" or better by one or more of the major credit rating agencies.
Capacity. A key measure of both strength and growth capacity for property/casualty insurers is the ratio of net premium written to statutory policyholders' surplus. At December 31, 1998, TIG's net premium-to-surplus ratio was 1.5, higher than the industry average of 1.0, but within an acceptable range. Insurance regulators generally accept a ceiling for this ratio of 3.0; therefore, at its current ratio, TIG has the capacity to grow by writing new business in its targeted markets.
Catastrophe: An event that is designated to be a "catastrophe" by the Property Claims Service Division of American Services Group, an industry body. It generally defines events which are estimated to cause more than $25 million in insured property damage and which affect a significant number of insureds and insurers.
Commercial Specialty. Commercial Specialty coverages provide protection against property loss and legal liability for injuries to other persons or damage to their property arising from the policyholder's business operations. Commercial Specialty primarily develops and markets insurance programs where the nature of the risk does not lend itself to traditional commercial insurance. Significant programs include Sports and Leisure, with products for professional and amateur sports events; Workers' Compensation, which provides liability coverage to employers for payment of employee benefits associated with employment related accidents as mandated by state laws; Primary Casualty, which focuses on commercial auto, professional liability, construction and marine programs; Excess Casualty which offers lead umbrella and excess umbrella policies; and participation in three Lloyd's of London syndicates writing marine, UK property and aviation business. Commercial Specialty products are principally marketed through large general agents, with which TIG sometimes has exclusive marketing contracts. Net premium written for the Commercial Specialty operating segment comprised 53%, 41% and 29% of consolidated net premium written for the years ended December 31, 1998, 1997 and 1996, respectively.
Basis of Presentation. The consolidated financial statements are prepared in accordance with generally accepted accounting principles ("GAAP") and include the accounts of TIG Holdings, Inc. and its subsidiaries. Intercompany transactions are eliminated in consolidation. Certain reclassifications of prior years' amounts have been made to conform with the 1998 presentation.
Loss and loss adjustment expense reserves. The liability for loss and loss adjustment expenses ("LAE") is based on an evaluation of reported losses and on estimates of incurred but not reported ("IBNR") losses. The reserve liabilities are determined using estimates of losses for individual claims (case basis reserves) and statistical projections of reserves for IBNR. Management considers many factors when setting reserves including: (i) current legal interpretations of coverage and liability; (ii) economic conditions; and (iii) internal methodologies which analyze TIG's experience with similar cases, with information from ceding companies, and with historical trends such as reserving patterns, loss payments, pending levels of unpaid claims, and product mix. Based on these considerations, management believes that adequate provision has been made for TIG's loss and LAE reserves. Actual losses and LAE paid may deviate, perhaps substantially, from such reserves. Adjustments to the reserves resulting from subsequent developments or revisions to the estimate are reflected in results of operations in the period in which such adjustments become known. The liability is reported net of estimated salvage and subrogation recoverables of $26 million and $31 million at December 31, 1998 and 1997, respectively. Certain liabilities for unpaid losses related to long-term workers' compensation coverage are discounted to present value. The workers' compensation indemnity reserves subject to discounting and the related discount are as follows:
During 1998, in response to favorable market conditions for obtaining reinsurance coverage and to mitigate the inherent financial volatility of a changing book of business, TIG increased the utilization of aggregate stop loss and other finite reinsurance coverages by entering into several new contracts with reinsurance providers. In addition to the loss portfolio reinsurance agreement mentioned above, the Company also purchased finite reinsurance for workers' compensation programs that allows TIG to stay competitive with other insurers whose state of domicile allow discounting of workers' compensation loss reserves. The Company also purchased finite reinsurance to provide aggregate stop loss coverage for all lines. The pre-tax net benefit provided by these contracts, including additional interest costs on withheld funds, was $36 million for 1998.
In 1998, the NAIC adopted codified statutory accounting principles ("Codification"). Codification will likely change, to some extent, prescribed statutory accounting practices and may result in changes to the accounting practices that TIG uses to prepare its statutory-basis financial statements. Codification will require adoption by the various states before it becomes the prescribed statutory basis of accounting for insurance companies domesticated within those states. Accordingly, before Codification becomes effective for TIG, the insurance regulatory bodies of states in which TIG writes business must adopt Codification as the prescribed basis of accounting on which domestic insurers must report their statutory-basis results to the Insurance Department. At this time it is anticipated that the State of California, which is the state of domicile for TIG Insurance Company, the primary insurer for TIG, will adopt Codification. Management has not yet determined the impact of Codification on TIG's statutory-basis financial statements.