The purpose of the Management’s Discussion and Analysis (“MD&A”) is to provide an understanding of the consolidated results of operations and financial condition and known trends and uncertainties that may have a material impact in future periods. For convenience and reading ease, we have written the MD&A in the first person plural.
After-tax net realized gains, which increased $13.7 million for 2006 as compared to 2005 resulting from the sale of certain long-term equity investments.
The 2005 results compared to 2004 were significantly impacted by our reserving actions taken in light of a New Jersey Supreme Court decision in 2005. This decision eliminated the application of the serious life impact standard to personal automobile cases under the verbal tort threshold of New Jersey’s Automobile Insurance Cost Reduction Act (“AICRA”) and resulted in an increase to our reserves of $13.0 million in the second quarter of 2005. The implementation of AICRA, combined with our rating and tiering actions, had enabled us to achieve profitability in the New Jersey personal automobile line of business over the two years previous to the Supreme Court ruling. However, factoring higher expected claim costs
into our New Jersey personal automobile excess profits calculation resulted in the elimination of an excess profits reserve of $5.5 million in the second quarter of 2005.
Our ability to provide flood insurance is a significant component of our Diversified Insurance Services operations. Information provided by the Federal Emergency Management Agency (“FEMA”) in 2004 indicated that total flood insurance premium written was approximately $2 billion. In 2005, the destruction caused by the active hurricane season stressed the NFIP with flood losses currently estimated by FEMA to be in excess of $20 billion. We continue to monitor developments with the NFIP regarding its ability to pay claims in the event of another large-scale disaster. Congress controls the federal agency’s funding authority, which topped out after Hurricane Katrina, and is again nearing maximum capacity. At this point, it is uncertain what impact, if any, this will have on our flood operations.
Selective HR Solutions (“SHRS”), our HR Outsourcing business, generates cash flows from their operations. Dividends from SHRS to the parent company are restricted by the operating needs of this entity as well as professional employer organization licensing requirements to maintain a current ratio of at least 1:1. The current ratio provides an indication of a company’s ability to meet its short-term obligations and is calculated by dividing current assets by current liabilities. SHRS provided dividends to the parent company of $4.2 million in 2006 and $4.0 million in 2005.
(d) The following tables summarize, for all securities in an unrealized loss position at December 31, 2006 and December 31, 2005, the aggregate fair value and gross pre-tax unrealized loss recorded in Selective’s accumulated other comprehensive income, by asset class and by length of time those securities have been in an unrealized loss position:
Reserves established for liability insurance, written primarily in the general liability line of business, continue to reflect exposure to environmental claims, both asbestos and non-asbestos. These claims have arisen primarily under older policies containing exclusions for environmental liability which certain courts, in interpreting such exclusions, have determined do not bar such claims. The emergence of these claims is slow and highly unpredictable. Since 1986, policies issued by the Insurance Subsidiaries have contained a more expansive exclusion for losses related to environmental claims. There are significant uncertainties in estimating Selective’s exposure to environmental claims (for both case and IBNR reserves) resulting from lack of historical data, long reporting delays, uncertainty as to the number and identity of claimants and complex legal and coverage issues. Legal issues that arise in environmental cases include federal or state venue, choice of law, causation, admissibility of evidence, allocation of damages and contribution among joint defendants, successor and predecessor liability, and whether direct action against insurers can be maintained. Coverage issues that arise in environmental cases include the interpretation and application of policy exclusions, the determination and calculation of policy limits, the determination of the ultimate amount of a loss, the extent to which a loss is covered by a policy, if at all, the obligation of an insurer to defend a claim and the extent to which a party can prove the existence of coverage. Courts have reached different and sometimes inconsistent conclusions on these legal and coverage issues. Selective does not discount to present value that portion of its loss reserves expected to be paid in future periods.
Based on its aggregate reserve for net losses and loss expenses at December 31, 2006, Selective does not expect that liabilities associated with environmental and non-environmental claims will have a materially adverse impact on its future liquidity, financial position and results of operations. However, given the complexity of coverage and other legal issues, and the significant assumptions used in estimating such exposures, actual results could significantly differ from Selective’s current estimates. The increase in paid losses in 2004 for non-asbestos environmental claims includes final payment for two large outstanding claims that were included in Selective’s 2003 case reserves.
The Convertible Subordinated Debentures (the “Debentures”) were issued under an Indenture dated December 29, 1982, (the “1982 Indenture”) in the principal amount of $25.0 million, bearing interest at a rate of 8.75% per annum, which is payable on the unpaid principal semiannually on January 1 and July 1 in each year to holders of record at the close of business on the preceding December 15 and June 15, respectively. The Debentures are convertible into Common Stock at an effective conversion price of $3.54 per share. The principal amount of the Debentures, which was $0.8 million at 2006 and 2005, including any accrued interest thereon, is due on January 1, 2008 and is included in other liabilities on the consolidated balance sheets.
The “other” benefit in 2004 was primarily due to a reduction to the Company’s current federal income taxes payable as a result of a favorable resolution of an IRS appeals issue. The IRS had attempted to disallow, on a consolidated basis, a deduction for interest expense incurred by the Parent while its Insurance Subsidiaries held municipal bonds. A notice that the issue was resolved in the Company’s favor was received on September 30, 2004, at which time the benefit was recognized.
Selective’s 2006 discount rate used to value the liability is 5.9% for both the Retirement Income Plan and postretirement plan. Selective determined the most appropriate discount rate in comparison to our expected pay-out patterns of the plans’ obligations.