Selective Insurance Group 10-K 2007
Documents found in this filing:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
For the fiscal year ended December 31, 2006
For the transition period from to .
Commission file number 0-8641
SELECTIVE INSURANCE GROUP, INC.
(Exact name of registrant as specified in its charter)
7.5% Junior Subordinated Notes due September 27, 2066
(Title of class)
Common Stock, par value $2 per share
(Title of class)
Preferred Share Purchase Rights
(Title of class)
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
þ Yes o No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
o Yes þ No
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.
þ Yes o No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.
Large accelerated filer þ Accelerated filer o Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
o Yes þ No
The aggregate market value of the voting Common stock held by non-affiliates of the registrant, based on the closing price on the NASDAQ Global Select Market®, was $1,585,015,215 on June 30, 2006.
As of February 13, 2007, the registrant had outstanding 56,995,648 shares of Common Stock.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrants definitive Proxy Statement for the 2007 Annual Meeting of Stockholders to be held on April 24, 2007 are incorporated by reference into Part III of this report.
SELECTIVE INSURANCE GROUP, INC.
Table of Contents
Item 1. Business.
Selective Insurance Group, Inc. through its subsidiaries, (collectively known as Selective or the Company) offers property and casualty insurance products and diversified insurance products. Selective was incorporated in New Jersey in 1977. Its principal property and casualty insurance subsidiary was organized in New Jersey in 1926. Its main offices are located in Branchville, New Jersey.
Selective classifies its businesses into three operating segments:
Financial information about Selectives three operating segments is contained in this report in Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations, and Item 8. Financial Statements and Supplementary Data, Note 12 to the consolidated financial statements, Segment Information.
Description of Operating Segment Products and Markets
Insurance Operations Segment
Selectives Insurance Operations sell property and casualty insurance policies. Insurance policies are contracts to cover losses for specified risks in exchange for premiums. Property insurance generally covers the financial consequences of accidental loss to the insureds property. Property claims are generally reported and settled in a relatively short period of time. Casualty insurance generally covers the financial consequences of bodily injury and/or property damage to a third party as a result of the insureds negligent acts, omissions, or legal liabilities. Casualty claims often take years to be reported and settled.
Selectives Insurance Operations segment writes its property and casualty insurance products through seven insurance subsidiaries (Insurance Subsidiaries), which are listed on the following table together with their respective ratings by A.M. Best Company, Inc. (A.M. Best), and state of domicile by which each is primarily regulated:
In 2006, A.M. Best, in its list of Top Property/Casualty Writers, ranked Selective the 47th largest property and casualty group in the United States based on the 2005 combined net premiums written (NPW), or premiums for all policies sold, by the Insurance Subsidiaries.
Selectives Insurance Operations segment derives substantially all of its revenues from insurance policy premiums. The Insurance Subsidiaries predominantly write annual policies, of which the associated premiums are defined as net premiums written (NPW). NPW is recognized as revenue as net premiums earned (NPE) ratably over the life of the insurance policy. Expenses fall into three categories: (i) losses associated with claims and various loss expenses incurred for adjusting claims; (ii) expenses related to the issuance of insurance policies, such as agent commissions, premium taxes, and other underwriting expenses, including employee compensation and benefits; and (iii) policyholder dividends.
Selectives Insurance Subsidiaries are regulated by each of the states in which they do business. Each Insurance Subsidiary is required to file financial statements with such states, prepared in accordance with accounting principles prescribed by, or permitted by, such Insurance Subsidiarys state of domicile (Statutory Accounting Principles or SAP). SAP have been promulgated by the National Association of Insurance Commissioners (NAIC) and adopted by the various states. Selective evaluates the performance of our Insurance Subsidiaries in accordance with SAP. Incentive-based compensation to independent agents and employees is based on SAP results and our rating agencies use SAP information to evaluate our performance as well as for industry comparative purposes.
The underwriting performance of insurance companies is measured under SAP by four different ratios:
A statutory combined ratio under 100% generally indicates that an insurance company is generating an underwriting profit and a statutory combined ratio over 100% generally indicates that an insurance company is generating an underwriting loss. The statutory combined ratio does not reflect investment income, federal income taxes, or other non-operating income or expense.
SAP differs in many ways from generally accepted accounting principles in the United States of America (GAAP), under which Selective is required to report our financial results to the United States Securities and Exchange Commission (SEC). The most notable differences impacting our reported net income are as follows:
Selective primarily uses SAP information to monitor and manage its results of operations. Selective believes that providing SAP financial information for the Insurance Operations segment helps its investors, agents, and customers better evaluate the underwriting success of Selectives insurance business.
Selective believes that only providing a GAAP presentation of financial information for its Insurance Operations segment would make it more difficult for agents, customers, and investors to evaluate Selectives success or failure in its insurance business.
The following table shows the statutory results of the Insurance Operations segment for the last three completed fiscal years:
Selective has consistently produced a lower statutory combined ratio than the property and casualty insurance industry, generally outperforming the industry for the past 10 years by an average of 2.7 points. The table below sets forth a comparison of certain Company and industry statutory ratios:
Lines of Business and Products
Selectives Insurance Operations segment includes commercial lines (Commercial Lines), which markets primarily to businesses and represents approximately 86% of Selectives NPW; and personal lines (Personal Lines), which markets primarily to individuals and represents approximately 14% of NPW.
Commercial Lines underwrites general liability, commercial automobile, workers compensation, commercial property, business owners policy, and bond risks through traditional insurance and alternative risk management products.
Personal Lines underwrites and issues insurance policies for personal automobile, homeowners, and other various risks.
Regional Geographic Market Focus
Selectives Insurance Operations segment primarily focuses its marketing efforts and sells its products and services in the Eastern and Midwestern regions of the United States. This large geographic area diversifies Selectives exposure to catastrophic risk. The Insurance Operations segment does not conduct any business outside of the United States. The following table shows the principal states in which Selective writes insurance business and the percentage of Selectives total NPW that such state represents for the last three fiscal years.
Independent Insurance Agent Distribution Model
According to the Independent Insurance Agents and Brokers of America (IIABA), in 2004, independent insurance agents and brokers write approximately 80% of the commercial property and casualty insurance and approximately 35% of the personal lines insurance business in the United States. Independent agents are a significant force in overall insurance industry premium production, in large part because they represent more than one insurance company and, therefore, can provide insureds with a wider choice of commercial and personal property and casualty insurance products. As a result, Selective is committed to the independent agency distribution channel and focuses its primary strategy on building relationships with well-established, independent insurance agents while carefully monitoring each agents profitability, growth, financial stability, staff, and mix of business against plans that Selective develops annually with the agent. In developing annual plans with its independent insurance agents, Selectives field personnel and management spend considerable time meeting with agencies to: (i) advise them on Company developments; (ii) receive feedback on products and services; (iii) help agents increase market share; and (iv) consolidate more of their business utilizing Selectives technology advantages.
As of December 31, 2006, Selectives Insurance Subsidiaries had entered into agency agreements, pursuant to applicable state laws and regulations, with approximately 770 independent insurance agents having approximately 1,600 storefronts, to allow such agents to sell policies written by the Insurance Subsidiaries. Selective pays its independent agents commissions pursuant to calculations and specific percentages stated in the agency agreement. Under the agency agreement, other than as provided by law, agents are not permitted to receive compensation for the business they place with Selective from any insured or applicant for insurance other than Selective. The agency agreement provides for commissions to be paid based on a percentage of the premium written. Selective and its agents also negotiate other compensation arrangements, including supplemental commissions, based on the underwriting results of the business the agent writes with Selective.
Technology and Field Model Business Strategy
Selective uses the trademarks, High-Tech, High-Touch" and HT 2", to describe its business strategy for the Insurance Operations. High-Tech signifies the advanced technology that Selective uses to make it easy for: (i) independent insurance agents to transact and process business with Selective; and (ii) customers to access real-time information, manage their accounts and pay their bills through an on-line customer portal that was established in September 2006. High-Touch
signifies the close relationships that Selective has with its independent insurance agents and customers as a result of its business model that places underwriters, claims representatives, and safety management representatives in the field near its agents and customers.
Selective seeks to transact as much of its business as possible through the use of technology and, in recent years, has made significant investments in state-of-the-art information technology platforms, integrated systems, Internet-based applications, and predictive modeling initiatives to: (i) provide its independent agents and customers with access to accurate business information; (ii) provide independent agents the ability to process business transactions from their offices and systems; and (iii) provide underwriters with targeted pricing tools to enhance profitability while growing the business. In 2006, Applied Systems, Inc. presented Selective with the 2006 Interface Leadership and Innovation Award for promoting efficient communication between insurance carriers and independent agents. Applied Systems is the leading provider of automated solutions for the property and casualty insurance industry. The award was granted based on Selectives ability to advance agency-company interface through adoption, support and implementation of initiatives through its xSELerate® agency integration technology. Additionally, Selective received the 2006 E-Fusion Award from A.M. Best Co. for innovative, business-focused agency integration technology. This award was granted to Selective for increasing productivity for its independent insurance agents through its xSELerate® agency integration technology.
Selective manages its information technology projects through a project management office (PMO). The PMO is staffed by certified individuals who apply methodologies to: (i) communicate project management standards; (ii) provide project management training and tools; (iii) review project status and cost; and (iv) provide non-technology project management consulting services to the rest of Selective. The PMO meets monthly with Selectives senior management to review all major projects and report on the status of other projects. The PMO is a factor in the success of Selectives technology implementation and in ensuring that Selective has a competitive advantage with independent agents, while reducing overall company expenses and increasing overall employee productivity. Selectives technology operations are located in Branchville, New Jersey; Glastonbury, Connecticut; and Sarasota, Florida.
To support its independent agents, Selective employs a field underwriting model and a field claims model that are supported by the home office in Branchville, New Jersey, and five regional branch offices (Region), which were as follows as of December 31, 2006:
Selective also maintains an office in Hunt Valley, Maryland that supports our Selective Risk Managers (SRM) operations.
As of December 31, 2006, Selective had:
Selective seeks to price and underwrite a variety of insurance risks and focuses its efforts on four market segments:
Selectives underwriting process requires communication and interaction among:
A distinct advantage of Selectives field underwriting model is its ability to provide a wide range of front-line safety management services focused on improving the policyholders safety and risk management programs. Services that Selective offers include: (i) risk evaluation and improvement surveys intended to evaluate potential exposures and provide solutions for mitigation. Risk improvement efforts for existing customers are designed to improve loss experience and retention through valuable ongoing consultative service; (ii) web-based safety management educational resources, including a large library of coverage-specific safety materials, videos and on-line courses; such as defensive driving and employee educational safety courses; (iii) thermographic infrared surveys aimed at identifying electrical hazards; and (iv) OSHA construction and general industry certification training. Selectives Safety Management goal is to partner with policyholders to identify and eliminate potential loss exposures.
Selective also has an underwriting service center (USC) located in Richmond, Virginia. The USC assists Selectives agents by servicing small to mid size business customers. During 2006, the USC became available to personal lines business customers of our New Jersey agents with a rollout to Selectives remaining states during 2007. At the USC, Selective employees, who are licensed agents, respond to customer inquiries about insurance coverage, billing transactions, and other matters. The agent, as consideration for these services, receives a commission that is lower than the standard commission by approximately two points. Selective has found that the USC also provides additional opportunities to increase direct premiums written, as larger agencies seek insurance companies that have service center capabilities. Currently, the USC is servicing commercial lines net premiums written of $70 million and personal lines net premiums written of $26 million. The total $96 million serviced represents 6% of total net premiums written.
Selective analyzes its underwriting profitability by line of business, account, product, agency and other bases. Selectives goal is to continue to underwrite the risks that it understands well and that, in aggregate, are profitable.
Field Claims Management
Effective, fair, and timely claims management is one of the most important customer services that Selective provides and one of the critical factors in achieving underwriting profitability. Selectives claims policy emphasizes the maintenance of timely and adequate reserves for claims, and the cost-effective delivery of claims services by controlling losses and loss expenses. CMSs are primarily responsible for investigating and settling claims directly with policyholders and claimants. By promptly and personally investigating claims, CMSs are able to provide personal service and quickly resolve claims. CMSs also provide guidance on the handling of the claim until its final disposition. Selective also believes that by visiting the site of the claim, and meeting face-to-face with the insured or claimant, the settlement will be more accurate. In territories where there is insufficient claim volume to justify the placement of a CMS, or when a particular claim expertise is required, Selective uses independent adjusters to investigate and settle claims.
Selective has a centralized special investigative unit (SIU) that investigates potential insurance fraud and abuse, and supports efforts by regulatory bodies and trade associations to curtail the cost of fraud. The SIU adheres to uniform internal procedures to improve detection and takes action on potentially fraudulent claims. It is Selectives policy to notify the proper authorities of its findings. This policy sends a clear message that Selective will not tolerate fraudulent activity committed against the Company or its customers. The SIU also supervises anti-fraud training for CMSs and other employees, including AMSs.
Selective has a claims service center (CSC), co-located with the USC, in Richmond, Virginia. The CSC provides enhanced services to Selectives policyholders, including immediate claim review, 24 hours a day, seven days a week. The CSC is also designed to reduce the loss settlement time on first-party automobile claims and increase the usage of Selectives discounts at body shops, glass repair shops, and car rental agencies.
Net Loss and Loss Expense Reserves
Selective establishes loss and loss expense reserves that are estimates of amounts needed to pay claims and related expenses in the future for insured loss events that have already occurred. The process of estimating reserves involves a considerable degree of judgment by management and, as of any given date, is inherently uncertain. See Critical Accounting Policies and Estimates in Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations in this Form 10-K for a full discussion regarding Selectives loss reserving process.
The following information presents: (i) Selectives reserve development over the proceeding ten years; and (ii) a reconciliation of reserves in accordance with SAP to such reserves determined in accordance with GAAP, each as prescribed by Securities Act Industry Guide No. 6.
Section I of the ten-year table shows the estimated liability that was recorded at the end of each of the indicated years for all current and prior accident year unpaid loss and loss expenses. The liability represents the estimated amount of loss and loss expenses for claims that were unpaid at the balance sheet date, including incurred but not reported (IBNR) reserves. In accordance with GAAP, the liability for unpaid loss and loss expenses is recorded in the balance sheet gross of the effects of reinsurance with an estimate of reinsurance recoverables arising from reinsurance contracts reported separately as an asset. The net balance represents the estimated amount of unpaid loss and loss expenses outstanding as of the balance sheet date, reduced by estimates of amounts recoverable under reinsurance contracts.
Section II shows the re-estimated amount of the previously recorded net liability as of the end of each succeeding year. Estimates of the liability for unpaid loss and loss expenses are increased or decreased as payments are made and more information regarding individual claims and trends, such as overall frequency and severity patterns, becomes known. Section III shows the cumulative amount of net loss and loss expenses paid relating to recorded liabilities as of the end of each succeeding year. Section IV shows the re-estimated gross liability and re-estimated reinsurance recoverables through December 31, 2006. Section V shows the cumulative net (deficiency)/redundancy representing the aggregate change in the liability from the original balance sheet dates and the re-estimated liability through December 31, 2006.
This table does not present accident or policy year development data, which certain readers may be more accustomed to analyzing. Conditions and trends that have affected development of the reserves in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate redundancies or deficiencies based on this table.
Note: Some amounts may not foot due to rounding.
The Company experienced favorable development in its loss and loss expense reserves totaling $7.3 million in 2006, which was primarily driven by favorable prior year development in our commercial automobile, workers compensation, and personal automobile lines of business partially offset by adverse development in our general liability line of business. The commercial automobile line of business experienced favorable prior year loss and loss expense reserve development of approximately $15 million, which was primarily driven by lower than expected severity in accident years 2004 and 2005. The workers compensation line of business experienced favorable prior year development of approximately $4 million, which was driven, in part, by savings realized from changing medical and pharmacy networks outside the state of New Jersey and re-contracting our medical bill review services. The personal automobile line of business experienced favorable prior year development of approximately $9 million, due to lower than expected frequency. The general liability line of business experienced adverse prior year loss and loss expense reserve development of approximately $15 million in 2006, which was largely driven by our contractor completed operations business and an increase in reserves for legal expenses. The remaining
lines of business, which collectively contributed approximately $6 million of adverse development, do not individually reflect significant prior year development.
During the course of 2005, we had analyzed certain negative trends in the workers compensation line of business and certain positive trends in the commercial automobile line of business. In the fourth quarter of 2005, we had sufficient evidence accumulated to change managements best estimate of loss reserves for these lines. Accordingly, workers compensation reserves were increased by approximately $42 million to reflect rising medical cost trends that impacted accident years 2001 and prior. At the same time, commercial automobile reserves were decreased by approximately $48 million, primarily due to ongoing favorable severity trends in the 2002 through 2004 accident years. In addition, the general liability reserves adversely developed by approximately $14 million over the course of the year, which was driven mainly by our contractor completed operations business impacting accident years 2001 and prior, but partially offset by positive development in accident years 2002 through 2004.
In 2005 there was an adverse judicial ruling by the New Jersey Supreme Court, which is discussed in the Personal Automobile section of Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations. This adverse judicial ruling led to an increase in reserves of approximately $10 million, of which $6 million represents adverse development from prior years.
The cumulative net deficiencies seen in the years 1998 through 2003 are reflective of the soft market pricing in the industry during that time frame, which hit the lowest levels in 1999. The industry as a whole underestimated reserves and loss trends leading to intense pricing competition. Additionally, during 1999, Selective significantly increased gross and ceded reserves by $37.5 million for prior accident years related to unlimited medical claims ceded to the Unsatisfied Claim and Judgment Fund in the State of New Jersey. Approximately 24% of the cumulative gross deficiency for years 1998 and prior stems from this increase.
As discussed in the Insurance Operations section of Item 1. Business on this Annual Report on Form 10-K
(Form 10-K), there are differences between SAP and GAAP accounting. The following table reconciles losses and loss expense reserves under SAP and GAAP at December 31, as follows:
Reserves established for liability insurance include exposure to environmental claims, both asbestos and non-asbestos. Selectives exposure to environmental liability is primarily due to: i) policies written prior to the introduction of the absolute pollutions endorsement in the mid-1980s; and ii) the underground storage tank leaks, mostly from New Jersey homeowners policies in recent years. Selectives 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.
Asbestos claims are claims presented to us in which bodily injury is alleged to have occurred as a result of exposure to asbestos and/or asbestos-containing products. During the past two decades, the insurance industry has experienced the emergence and development of an increasing number of asbestos claims. At December 31, 2006, asbestos claims constituted 89% of our 2,568 environmental claims compared with 88% of our 2,382 outstanding environmental claims at December 31, 2005.
Non-asbestos claims are pollution and environmental claims alleging bodily injury or property damage presented, or expected to be presented to us, other than asbestos claims. These claims primarily include landfills and leaking underground storage tanks. In past years, landfill claims have accounted for a significant portion of Selectives environmental claim units litigation costs. Over the past few years, Selective has been experiencing adverse development in its 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.
Selective refers all environmental claims to its centralized environmental claim unit, which specializes in the claim management of these exposures. Environmental reserves are evaluated on a case-by-case basis. As cases progress, the ability to assess potential liability often improves. Reserves are then adjusted accordingly. In addition, each case is reviewed in light of other factors affecting liability, including judicial interpretation of coverage issues.
IBNR reserve estimation for environmental claims is difficult, because in addition to other factors, there are significant uncertainties associated with critical assumptions in the estimation process, such as average clean-up costs, third-party costs, potentially responsible party shares, allocation of damages, insurer litigation costs, insurer coverage defenses and potential changes to state and federal statutes. Moreover, normal historically-based actuarial approaches are difficult to apply because past environmental claims are not indicative of future potential environmental claims. In addition, while models can be applied, such models can produce significantly different results with small changes in assumptions. As a result, management does not calculate a specific environmental loss range, as it would not be meaningful. Historically, Selectives environmental claims have been significantly less volatile and uncertain than the commercial lines industry. In part, this is due to the fact that Selective is the primary insurance carrier on the majority of its environmental exposures, thus providing more certainty in its reserve position compared to the insurance marketplace.
In the ordinary course of their business, the Insurance Subsidiaries reinsure a portion of the risks that they underwrite in order to control exposure to losses and protect capital resources. Reinsurance also permits the Insurance Subsidiaries additional underwriting capacity by permitting them to accept larger risks and underwrite a greater number of risks without a corresponding increase in capital or surplus. For a premium paid by the Insurance Subsidiaries, reinsurers assume a portion of the losses ceded by the Insurance Subsidiaries. Selective uses traditional forms of reinsurance and does not use finite risk reinsurance. Amounts not reinsured are known as retention. The Insurance Subsidiaries use two types of reinsurance to control exposure to losses:
In addition to treaty and facultative reinsurance, the Insurance Subsidiaries are partially protected by the Terrorism Risk Insurance Act of 2002, which was modified and extended through December 31, 2007 via the Terrorism Risk Insurance Extension Act of 2005. For further information regarding this legislation, see Item 1A. Risk Factors of this Form 10-K.
Reinsurance does not legally discharge an insurer from its liability for the full-face amount of its policies, but it does make the reinsurer liable to the insurer to the extent of the reinsurance ceded. Reinsurance carries counterparty credit risk, which may be mitigated in certain cases by collateral such as letters of credit, trust funds, or funds withheld by the Insurance Subsidiaries. Selective attempts to mitigate the credit risk related to reinsurance by pursuing relationships with companies rated A- or higher in most circumstances and/or requiring collateral to secure reinsurance obligations. In addition, Selective employs procedures to continuously review the quality of reinsurance recoverables and reserve for uncollectible reinsurance. Selective also may take actions, such as commutations, in cases of potential reinsurer default. Some of the Insurance Subsidiaries reinsurance contracts include provisions that give Selective a contractual right to terminate and/or commute the reinsurers portion of the liabilities based on deterioration of the reinsurers rating or financial condition.
Reinsurance recoverable balances tend to fluctuate based on the underlying losses incurred by the Insurance Subsidiaries. If a severe catastrophic event occurs, reinsurance recoverable balances may increase significantly. The reinsurance recoverable balances on paid and unpaid claims were 19% of stockholders equity at December 31, 2006 compared to 23% at December 31, 2005. These balances net of available collateral were 15% of stockholders equity at December 31, 2006 compared to 19% at December 31, 2005. Approximately half of the uncollateralized recoverable on paid and unpaid balances at December 31, 2006 and at December 31, 2005 stem from federal or state sponsored pools, which we believe to have minimal default risk. The following are the five largest individual uncollateralized reinsurance recoverables on paid and unpaid balances based on December 31, 2006 amounts:
The table below summarizes the significant reinsurance treaties covering the Insurance Subsidiaries.
Reinsurance Pooling Agreement
The Insurance Subsidiaries are parties to an inter-company reinsurance pooling agreement (Pooling Agreement). The purpose of the Pooling Agreement is to:
Under the Pooling Agreement, all of the Insurance Subsidiaries mutually reinsure all insurance risks written by them pursuant to the respective percentage set forth opposite each Insurance Subsidiarys name on the table below:
Insurance companies are subject to supervision and regulation in the states in which they are domiciled and transact business. Such supervision and regulation relates to a variety of aspects of an insurance companys business and financial condition. The primary public purpose of such supervision and regulation is to protect the insurers policyholders; not the insurers shareholders. The extent of regulation varies, and generally is derived from state statutes that delegate regulatory, supervisory, and administrative authority to state insurance departments. Although the United States government does not directly regulate the insurance industry, federal initiatives from time to time can have an impact on the industry, such as the federal governments enactment and extension of TRIA.
The Financial Services Modernization Act of 1999, also known as the Gramm-Leach-Bliley Act (GLB), and related regulations govern, among other things, the privacy of consumer financial information. GLB limits disclosure by financial institutions of nonpublic personal information about individuals who obtain financial products or services for personal, family, or household purposes. GLB generally applies to disclosures to non-affiliated third parties, but not to disclosures to affiliates. Many states in which Selective operates have adopted laws that are at least as restrictive as GLB. Privacy of consumer financial information is an evolving area of regulation requiring continued monitoring to ensure continued compliance with GLB.
Selective cannot quantify the financial impact it would incur to satisfy revised or additional regulatory requirements that may be imposed in the future.
The regulatory authority of state insurance departments extends to such matters as insurer solvency standards, insurer and agent licensing, investment restrictions, payment of dividends and distributions, provisions for current losses and future liabilities, deposit of securities for the benefit of policyholders, restrictions on policy terminations, unfair trade practices, and approval of premium rates and policy forms. State insurance departments also conduct periodic examinations of the financial and business affairs of insurers and require insurers to file annual and other periodic reports relating to their financial condition. Regulatory agencies require that premium rates not be excessive, inadequate, or unfairly discriminatory. The Insurance Subsidiaries, consequently, must file all rates for commercial and personal insurance with the insurance department of each state in which they operate.
All states have enacted legislation that regulates insurance holding company systems. Each insurance company in a holding company system is required to register with certain insurance supervisory agencies and furnish information concerning the operations of companies within the holding company system that may materially affect the operations, management, or financial condition of the insurers. Pursuant to these laws, the respective departments may: (i) examine Selective and the Insurance Subsidiaries at any time; (ii) require disclosure or prior approval of material transactions of the Insurance Subsidiaries with any affiliate; and (iii) require prior approval or notice of certain transactions, such as dividends or distributions to Selective Insurance Group, Inc. (the Parent) from the Insurance Subsidiary domiciled in that state.
National Association of Insurance Commissioners (NAIC) Guidelines
The Insurance Subsidiaries are subject to statutory accounting principles and reporting formats established by the NAIC. The NAIC also promulgates model insurance laws and regulations relating to the financial and operational regulations of insurance companies, which includes the Insurance Regulatory Information System (IRIS). IRIS identifies 11 industry ratios and specifies usual values for each ratio. Departure from the usual values on four or more of the ratios can lead to inquiries from individual state insurance departments about certain aspects of the insurers business. The Insurance Subsidiaries have consistently met the majority of the IRIS ratio tests.
NAIC model laws and regulations are not usually applicable unless enacted into law or promulgated into regulation by the individual states. The adoption of certain NAIC model laws and regulations is a key aspect of the NAIC Financial Regulations Standards and Accreditation Program, which also sets forth minimum staffing and resource levels for all state insurance departments. All of the Insurance Subsidiaries states of domicile, except New York, are accredited by the NAIC. Examinations conducted by, or along with, accredited states can be accepted by other states. The NAIC intends to create nationwide regulatory network of accredited states.
The NAIC model laws and regulations are also intended to enhance the regulation of insurer solvency. These model laws and regulations contain certain risk-based capital requirements for property and casualty insurance companies designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholders. Risk-based capital is measured by the four major areas of risk to which property and casualty insurers are exposed: (i) asset risk; (ii) credit risk; (iii) underwriting risk; and (iv) off-balance sheet risk.
Insurers with total adjusted capital that is less than two times their Authorized Control Level, as calculated pursuant to the NAIC model laws and regulations, are subject to different levels of regulatory intervention and action. Based upon the unaudited 2006 statutory financial statements for the Insurance Subsidiaries, each Insurance Subsidiarys total adjusted capital substantially exceeded two times their Authorized Control Level.
Our investment philosophy includes certain return and risk objectives for our equity and fixed maturity portfolios. The return objective of the equity portfolio is to meet or exceed a weighted-average benchmark of public equity indices. The primary return objective of the fixed maturity portfolio is to maximize after-tax investment yield and income while balancing certain risk objectives, with a secondary objective of meeting or exceeding a weighted-average benchmark of public fixed income indices. The risk objectives for all portfolios are to ensure investments are being structured conservatively, focusing on: (i) asset diversification; (ii) investment quality; (iii) liquidity, particularly to meet the cash obligations of the insurance operations; (iv) consideration of taxes; and (v) preservation of capital. At December 31, 2006, Selectives investment portfolio consisted of $2,946.9 million (82%) of fixed maturity securities, $307.4 million (9%) of equity securities, $197.0 million (5%) of short-term investments, and $144.8 million (4%) of other investments.
Selectives fixed maturity portfolio is comprised primarily of highly rated securities with almost 100% rated investment grade. The average rating of its fixed maturity securities is AA by Standard & Poors (S&P), their second highest credit quality rating. Selective expects to continue to invest primarily in high quality, fixed maturity investments. For further information regarding Selectives interest rate sensitivity, see Item 7A. Quantitative and Qualitative Disclosures about Market Risk in this Form 10-K. The average duration of the fixed maturity portfolio, including short-term investments of $197.0 million at December 31, 2006 and $185.1 million at December 31, 2005, was 3.8 years at December 31, 2006 and 4.0 years at December 31, 2005.
Selectives Investments segment operations are primarily based in Parsippany, New Jersey, while certain segments of the portfolio are managed by external money managers. For additional information about investments, see the sections entitled, Investments, in Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations, and Item 8. Financial Statements and Supplementary Data, Note 4 to the consolidated financial statements.
Diversified Insurance Services Segment
Selectives Diversified Insurance Services segment provides fee-based revenues that contribute to earnings, increase operating cash flow, and help mitigate potential volatility in insurance operating results. The Diversified Insurance Services segment is complementary to Selectives business model by sharing a common marketing or distribution system and creating new opportunities for independent agents to bring value-added services and products to their customers. In December 2005, Selective divested itself of its 100% ownership interest in CHN Solutions (Alta Services, LLC and Consumer Health Network Plus, LLC), which had historically been reported as part of the Managed Care component of the Diversified Insurance Services segment. For more information concerning the results of the Diversified Insurance Services segment for the last three fiscal years ended December 31, refer to Note 15, Discontinued Operations in Item 8. Financial Statements and Supplementary Data on this Form 10-K. The Diversified Insurance Services operation currently has two major components: (i) human resource administration outsourcing; and (ii) flood insurance.
Human Resource Administration Outsourcing
Human resource administration outsourcing (HR Outsourcing) products and services are sold by Selective HR Solutions, Inc. and its subsidiaries (SHRS), which are headquartered in Sarasota, Florida. SHRSs customers are small business owners who generally have existing relationships with independent insurance agents. SHRS leverages these relationships by using independent insurance agents as its distribution channel for its products and services in the states where it operates. As a Professional Employer Organization (PEO), SHRS enters into agreements with clients that establish a three-party relationship under which SHRS and the client are co-employers of the employees who work at the clients location (worksite employees). As of December 31, 2006, SHRS had approximately 27,000 worksite employees.
Selective is a servicing carrier in the Write-Your-Own (WYO) Program of the United States governments National Flood Insurance Program (NFIP). The WYO Program operates within the context of the NFIP, and is subject to its rules and regulations. The NFIP is administered by the Federal Emergency Management Agency (FEMA), which is a component of the Department of Homeland Security. The WYO Program is a cooperative undertaking of the insurance industry and FEMA. The WYO Program allows participating property and casualty insurance companies to write and service the Standard Flood Insurance Policy in their own names, while ceding all of the premiums collected on these policies to the
federal government. The companies receive an expense allowance, or servicing fee, for policies written and claims processed under the program, while the federal government retains responsibility for all underwriting losses. Selective is servicing approximately 274,000 flood policies under the NFIP through over 6,100 independent agents in 50 states and the District of Columbia.
Diversified Insurance Services Regulation
The companies within the Diversified Insurance Services segment are subject to certain laws and regulations. In particular, as a co-employer for some of its clients, SHRS is subject to federal, state, and local laws and regulations relating to labor, tax, employment, employee benefits, and immigration matters. By contracting with its clients and creating a co-employer relationship with the worksite employees, SHRS may be assuming certain contractual and legal obligations and responsibilities of an employer and could incur liability for violations of such laws and regulations, even if it was not actually responsible for the conduct giving rise to such liability. Some states in which SHRS operates have already passed licensing or registration requirements for PEOs. These laws and regulations vary from state to state but generally provide for the monitoring of the fiscal responsibility of PEOs. Currently, many of these laws and regulations do not specifically address the obligations and responsibilities of co-employers. There can be no assurance that SHRS will be able to satisfy new or revised laws and regulations.
Flood insurance is offered through the federal governments NFIP program, which is managed by the Mitigation Division of FEMA under the U.S. Department of Homeland Security. In 2005, the destruction caused by the active hurricane season stressed the NFIP with unprecedented flood losses that have significantly increased the NFIPs deficit.
The NFIP currently covers flooding caused by storm surge, wherein water is pushed toward the shore by the force of the winds swirling around a storm. If this federal program is modified in an unfavorable manner, wherein flooding related to storm surge is no longer covered or is required to be covered by our Insurance Operations Homeowners policies, it could have a material adverse effect on Selectives financial condition, or results of operations, as it relates to Selectives Flood and/or Homeowners results.
Effective October 1, 2006, the fee paid to us by the NFIP decreased 0.6 points to 30.2% of premiums written. Future reductions in this rate could occur through legislative activity.
Selective faces significant competition in both the Insurance Operations and Diversified Insurance Services segments.
Property and casualty insurance is highly competitive on the basis of both price and service, and is extensively regulated by state insurance departments. In 2006, Selective was ranked as the 47th largest property and casualty group in the United States based on the 2005 NPW, by A.M. Best in its list, Top Property/Casualty Writers. The Insurance Operations compete with regional insurers, such as Cincinnati Financial, Ohio Casualty, and Harleysville, and national insurance companies, such as Travelers, The Hartford, and Zurich. Selective also competes against direct writers of insurance coverage, primarily in personal lines, such as GEICO and Progressive. Many of these competitors have greater financial, technical, and operating resources than Selective. Purchasers of property and casualty insurance products do not always differentiate between insurance carriers and differences in coverage. The more significant competitive factors for most of Selectives insurance products are financial ratings, safety management, price, coverage terms, claims service, and technology. In addition, Selective also faces competition within each insurance agency that sells its insurance products as most of the agencies represent more than one insurance company.
With regard to the Diversified Insurance Services segment, during 2006, SHRS was ranked as the 11th largest Professional Employer Organization in a Staffing Industry Report published by Staffing Industry Analysts, Inc., based on 2005 gross revenue. Based on 2005 information, Selectives Flood line of business is the 7th largest WYO carrier for the NFIP based on information obtained from Statutory Annual Statements.
Please refer to Item 1A. Risk Factors, for a discussion of the factors that could impact Selectives ability to compete.
Selectives insurance business experiences modest seasonality with regard to premiums written. Due to the general timing of commercial policy renewals, premiums written are usually highest in January and July and lowest during the fourth quarter of the year. Although the writing of insurance policies experiences modest seasonality, the premiums related to these policies are earned consistently over the period of coverage. Losses and loss expenses incurred tend to remain consistent throughout the year, unless a catastrophe occurs from man-made or weather-related events such as hail, tornadoes, windstorms, hurricanes, and noreasters.
No one customer or independent agency accounts for 10% or more of Selectives total revenue or the revenue of any one of its business segments.
At December 31, 2006, Selective had approximately 2,100 employees, of which 1,900 worked in the Insurance Operations and Investments segments and 200 worked in the Diversified Insurance Services segment.
Executive Officers of the Registrant
The following table sets forth biographical information about Selectives Chief Executive Officer, Executive Officers, and senior management, as of March 1, 2007:
Information regarding Selectives directors is included in the definitive Proxy Statement for the 2006 Annual Meeting of Stockholders to be held on April 24, 2007 in Information About Proposal 1, Election of Directors, and is also incorporated by reference into Part III of this
Selective files its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements, and other required information with the SEC. The public may read and copy any materials on file with the SEC at the SECs Public Reference Room at 100 F Street N.E., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet site, www.sec.gov, that contains reports, proxy and information statements, and other information regarding issuers, including Selective, that file electronically with the SEC.
Selective has a website, www.selective.com, through which its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (Exchange Act) are available free of charge as soon as reasonably practicable after they are electronically filed with, or furnished to the SEC.
Item 1A. Risk Factors
Certain risk factors exist that can have a significant impact on Selectives business, results of operations, and financial condition. The impact of these risk factors could also impact certain actions that Selective takes as part of its long-term capital strategy including, but not limited to, contributing capital to subsidiaries in its Insurance Operations and Diversified Insurance Services segments, issuing additional debt and/or equity securities, repurchasing shares of the Parents common stock (Common Stock), or increasing stockholders dividends. The following list of risk factors is not exhaustive and others may exist. Selective operates in a continually changing business environment, and new risk factors emerge from time to time. Consequently, Selective can neither predict such new risk factors nor assess the impact, if any, they might have on its business in the future.
The property and casualty insurance industry is cyclical.
Historically, the results of the property and casualty insurance industry have experienced significant fluctuations due to high levels of competition, economic conditions, interest rates, and other factors. We have experienced the following fluctuations in Commercial Lines premium pricing, excluding exposure, over the past several years:
The industrys profitability also is affected by unpredictable developments, including:
Results of property and casualty insurers are subject to weather and other conditions. While one year may be relatively free of major weather occurrences or other disasters, another year may have numerous such events, causing results to be materially worse than other years. Selectives Insurance Subsidiaries have experienced catastrophe losses and the Company expects them to experience such losses in the future.
Various natural and man-made events can cause catastrophes, including, but not limited to, hurricanes, tornadoes, windstorms, earthquakes, hail, terrorism, explosions, severe winter weather, and fires. The frequency and severity of these catastrophes are inherently unpredictable. The extent of losses from a catastrophe is determined by the severity of the event and the total amount of insured exposures in the area affected by the event. Although catastrophes can cause losses in a variety of property and casualty lines, most of the catastrophe-related claims of Selectives Insurance Subsidiaries historically have been related to commercial property and homeowners coverages. Selectives property and casualty insurance business is concentrated geographically in the Eastern and Midwestern regions of the United States. New Jersey accounts for 33% of the Companys total net premiums written.
Selectives Insurance Subsidiaries seek to reduce their exposure to catastrophe losses through the purchase of catastrophe reinsurance. Reinsurance, however, may prove inadequate if:
Acts of terrorism not covered by, or exceeding, reinsurance limits.
On November 26, 2002, the Terrorism Risk Insurance Act of 2002 legislation was signed into law. This legislation was amended in December 2005 to be in effect through December 31, 2007 through the Terrorism Risk Insurance Extension Act of 2005 (collectively, these two acts will be referred to as TRIA). TRIA requires sharing the risk of future losses from terrorism between private insurers and the federal government, and is applicable to almost all commercial lines of insurance. Insurance companies with direct commercial insurance exposure in the United States are required to participate in this program. TRIA rescinded all previously approved exclusions for terrorism. Policyholders for non-workers compensation policies have the option to accept or decline the terrorism coverage Selective offers in its policies, or negotiate other terms. In 2006, approximately 90% of Selectives commercial non-workers compensation policyholders purchased terrorism coverage. The terrorism coverage is mandatory for all workers compensation primary policies. In addition, 50%, or ten of the twenty primary states in which Selective writes commercial property coverage mandate the coverage of fire following an act of terrorism. These provisions apply to new policies written after enactment of TRIA. A terrorism act must be certified by the Secretary of Treasury in order to be covered by TRIA. TRIA limits the certified losses to international terrorism defined as an act committed on behalf of any foreign person or foreign interest in which the damage from the event is in excess of $100 million in 2007, and the event was not committed in the course of a war declared by the United States. Each participating insurance company will be responsible for paying out a certain amount in claims (a deductible) before federal assistance becomes available. This deductible, which is equal to approximately $200 million in 2007, is based on a percentage of commercial lines direct earned premiums for lines subject to TRIA from the prior calendar year. For losses above an insurers deductible, the federal government will cover 90%, while the insurer contributes 10%. Although the provisions of TRIA will serve to mitigate Selectives exposure in the event of a large-scale terrorist attack, the Companys deductible is substantial. In addition, it is uncertain whether TRIA will be extended past its current termination date of December 2007 and, therefore, it may not be a permanent solution. In January 2007, Selective began issuing policies whose effective dates will extend beyond the current expiration date of TRIA. Selective continues to monitor concentrations of risk and has secured additional per occurrence casualty coverage through its reinsurance program effective January 1, 2007 to enhance the Companys protection against this highly unknown exposure.
Selectives reserves may not be adequate to cover actual losses and expenses.
Selective is required to maintain loss reserves for its estimated liability for losses and loss expenses associated with reported and unreported insurance claims for each accounting period. From time to time, Selective adjusts reserves and, if the reserves are inadequate, the Company must increase its reserves. An increase in reserves: (i) reduces net income and stockholders equity for the period in which the deficiency in reserves is identified, and (ii) could have a material adverse effect on Selectives results of operations, liquidity, financial condition and financial strength, and debt ratings. Selectives estimates of reserve amounts are based on facts and circumstances of which it is aware, including its expectations of the ultimate settlement and claim administration expenses, predictions of future events, trends in claims severity and frequency, and other subjective factors. There is no method for precisely estimating the Companys ultimate liability for settlement of claims. Selective regularly reviews its reserving techniques and its overall amount of reserves. The Company also reviews:
Selective cannot be certain that the reserves it establishes are adequate or will be adequate in the future.
Selective is heavily regulated in the states in which it operates.
Selective is subject to extensive supervision and regulation in the states in which its Insurance Subsidiaries transact insurance business. The primary purpose of insurance regulation is to protect individual policyholders and not shareholders or other investors. Selectives business can be adversely affected by regulations affecting property and casualty insurance companies. For example, laws and regulations can lead to mandated reductions in rates to levels that Selective does not believe are adequate for the risks it insures. Other laws and regulations limit the Companys ability to cancel or refuse to renew certain policies and require Selective to offer coverage to all consumers. Changes in laws and regulations, or their interpretations, pertaining to insurance may also have an impact on Selectives business. Selectives concentration of business may expose the Company to increased risks of regulatory matters in the states in which the Insurance Subsidiaries write insurance that could be greater than the risks the Company could be exposed to by transacting business in a greater number of geographic markets.
Although the federal government does not directly regulate the insurance industry, federal initiatives, from time to time, can also impact the insurance industry. Proposals intended to control the cost and availability of healthcare services have been debated in the U.S. Congress and state legislatures. Although Selective neither writes health insurance nor assumes any
healthcare risk, rules affecting healthcare services can affect workers compensation, commercial and personal automobile, liability, and other insurance that the Company does write. Selective cannot determine whether, or in what form, healthcare reform legislation may be adopted by the U.S. Congress or any state legislature. Selective also cannot determine the nature and effect, if any, that the adoption of healthcare legislation or regulations, or changing interpretations, at the federal or state level would have on the Company.
Examples of insurance regulatory risks include:
Automobile Insurance Regulation
In 1998, New Jersey instituted an Urban Enterprise Zone (UEZ) Program, which requires New Jersey auto insurers to have a market share in certain urban territories that is in proportion to their statewide market share. Due to mandated urban rate caps, the premiums on these UEZ policies are typically insufficient to cover losses. Although the law that imposed these urban rate caps was repealed in 1998, the caps continue to be enforced by the New Jersey Department of Banking and Insurance (NJDOBI).
From time to time, legislative proposals are passed and judicial decisions are rendered related to automobile insurance regulation that could adversely affect Selectives results of operations. For example, in 2005 a New Jersey Supreme Court decision eliminated the application of the serious life impact standard to personal automobile bodily injury liability cases under the verbal tort threshold of New Jerseys Automobile Insurance Cost Reduction Act. This decision allows claimants to file lawsuits for non-economic damages without proving that the injuries sustained had a serious impact on their lives.
Workers Compensation Insurance Regulation
Because Selective voluntarily writes workers compensation insurance, it is required by state law to support the involuntary market. Insurance companies that underwrite voluntary workers compensation insurance can either directly write involuntary coverage, which is assigned by state regulatory authorities, or participate in a sharing arrangement, where the business is written by a servicing carrier and the profits or losses of that serviced business are shared among the participating insurers. Selective currently participates through a sharing arrangement in all states, except New Jersey, where it currently writes involuntary coverage directly. Historically, workers compensation business has been unprofitable whether written directly or handled through a sharing arrangement. Additionally, Selective is required to provide workers compensation benefits for losses arising from acts of terrorism under its workers compensation policies. The impact of any terrorist act is unpredictable, and the ultimate impact on Selective will depend upon the nature, extent, location, and timing of such an act. Any such impact on Selective could be material.
Homeowners Insurance Regulation
Selective is subject to regulatory provisions that are designed to address potential availability and/or affordability problems in the homeowners property insurance marketplace. Involuntary market mechanisms, such as the New Jersey Insurance Underwriting Association (New Jersey FAIR Plan), generally result in assessments to the Company. The New Jersey FAIR Plan writes fire and extended coverage on homeowners for those individuals unable to secure insurance elsewhere. Insurance companies who voluntarily write homeowners insurance in New Jersey are assessed a portion of any deficit from the New Jersey FAIR Plan based on their share of the voluntary market. Similar involuntary plans exist in most other states where Selective operates.
Certain coastal states have instituted, or are considering adopting, legislation or regulation to maintain or increase the availability of property insurance, particularly homeowners insurance, in those states. For example, in Florida, effective January 1, 2008, an insurer writing homeowners insurance in another state, but not in Florida, may not continue to write private passenger automobile insurance in Florida unless such insurer is affiliated with an insurer writing homeowners insurance in Florida. At this time, none of Selectives Insurance Subsidiaries write private passenger automobile insurance in Florida. Certain other coastal states, including certain states in which Selectives Insurance Subsidiaries transact homeowners insurance business, are considering legislation requiring that homeowners insurers that write homeowners insurance in any geographic area of a state must write homeowners insurance in all geographic areas of that state. We cannot predict whether any such legislation or regulation will be enacted, and the ultimate impact on Selective will depend upon the specifics of the legislation or regulation and the state or states that adopt any such legislation or regulation.
Flood Insurance Regulation
The federal governments NFIP program currently covers flooding caused by storm surge where water is pushed toward the shore by the force of the winds swirling around a storm. If this federal program is modified in an unfavorable manner, whereby flooding related to storm surge is no longer covered or is required to be covered by homeowners policies, such modification could have a material adverse effect on Selectives Flood and/or Homeowners results.
Regulation and Legislation of Agent Compensation
Selectives Insurance Subsidiaries sell insurance products and services primarily through appointed independent insurance agents. Accordingly, Selective seeks to compensate its agents consistent with market practices and pay commissions and other consideration for business agents place with Selectives Insurance Subsidiaries. Selective discloses its compensation practices in notices to all policyholders and on Selectives public website, while referring all specific questions about agent compensation to the agent that placed the business with Selective.
Because Selectives agents also generally represent several of Selectives competitors, Selectives primary marketing strategy is to:
At present, Selective believes its agent compensation practices and disclosures meet current legal and regulatory requirements. Over the last two years, however, certain state attorneys general have investigated, and continue to investigate, various alleged anticompetitive practices engaged in by several insurance brokers and national insurance companies that compete with Selective. Some of these investigations, mainly related to insureds that are much larger than Selectives target customer, have resulted in consent orders under which brokers and several of Selectives competitors have left uncontested the attorneys generals allegations that some of their compensation arrangements may have caused certain brokers to clandestinely steer clients to specific insurers without sufficient disclosure to the client. The consent orders also have, to one degree or another, banned the use of such compensation arrangements by the offending brokers and insurers in several, but not all, lines of business.
Given the regulatory scrutiny of compensation arrangements with brokers to date, it is possible that compensation arrangements between insurers and independent agents will come under further review and will be the subject of public policy debate and possible legislative reform. Selective monitors these developments but cannot determine the nature or effect, if any, that such a public policy debate or possible legislative reform will have on its agent compensation practices or business.
Risk of Regulatory Changes Adversely Affecting Our Ability to Appropriately Reinsure or Include Reinsurance Costs in Our Rates.
Florida, a state in which Selective does not write homeowners insurance, recently passed legislation (i) changing the funding and operation of the Florida state-sponsored insurer of last resort, Citizens Property Insurance Corporation, and the Florida Hurricane Catastrophe Fund (FHCF), which is the Florida state-sponsored reinsurance facility, and (ii) prohibiting residential property insurers from including in rate calculations the additional costs of private reinsurance or loss exposure that duplicates FHCF coverage. In the short-term, such legislative action may increase overall private property reinsurance availability and reduce its costs outside of Florida. Should other states in which Selective writes business enact similar legislation, it is possible that Selective may not be able to include the costs of reinsurance that it deems appropriate in its rates. In such an event, Selective may be forced, if permitted under applicable law, to exit certain markets. If not permitted to exit such markets, Selective may face unfair competitive situations, where state-sponsored insurers implement rate freezes or decreases.
Selective may be adversely impacted by a change in its ratings.
Insurance companies are subject to financial strength ratings produced by external rating agencies, based upon factors relevant to policyholders. Ratings are not recommendations to buy, hold, or sell any of Selectives securities. Higher ratings generally indicate financial stability and a strong ability to pay claims. A significant downgrade in ratings, from A.M. Best in particular, could: (i) affect our ability to write new business with customers, some of whom are required (under various third party agreements) to maintain insurance with a carrier that maintains a specified minimum rating; (ii) be an event of default under our line of credit; or (iii) make it more expensive for us to access capital markets.
Selective depends on independent insurance agents and other third party service providers.
Selective markets and sells its insurance products through independent, non-exclusive insurance agencies and brokers. Agencies and brokers are not obligated to promote Selectives insurance products, and they may also sell the insurance products of the Companys competitors. As a result, Selectives business depends in part on the marketing and sales efforts
of these agencies and brokers. As the Company diversifies and expands its business geographically, it may need to expand its network of agencies and brokers to successfully market its products. If these agencies and brokers fail to market Selectives products successfully, its business may be adversely impacted. Also, independent agents may decide to sell their businesses to banks, other insurance agencies, or other businesses. Agents with a Selective appointment may decide to buy other agents. Changes in ownership of agencies or expansion of agencies through acquisition could adversely affect an agencys ability to control growth and profitability, thereby adversely affecting Selectives business.
In addition to independent insurance agents, Selective also relies on third party service providers to conduct a portion of its premium audits, safety management services, and claims adjusting services. Selectives HR Outsourcing business relies on third party service providers for products such as health coverage, flexible spending accounts, and 401(k) savings plans. If these third-party service providers fail to perform their respective services and/or fail to provide their products successfully and/or accurately, Selectives business may be adversely impacted.
Selectives ability to reduce its exposure to risks depends on the availability and cost of reinsurance.
Selective transfers its risk exposure to other insurance and reinsurance companies through reinsurance arrangements. Through these arrangements, another insurer assumes a specified portion of the Companys losses and loss adjustment expenses in exchange for a specified portion of the insurance policy premiums. The availability, amount, and cost of reinsurance depend on market conditions, which may vary significantly. Any decrease in the amount of Selectives reinsurance will increase its risk of loss.
Selective also faces credit risk with respect to reinsurance. The inability of any of the Companys reinsurers to meet their financial obligations could materially and adversely affect Selectives operations, as the Company remains primarily liable to its customers under the policies that it has reinsured.
Selective faces significant competition from other regional and national insurance companies, agents, and self-insurance.
Selective competes with both regional and national property and casualty insurance companies, including those that do not use independent agents and write directly with insureds. Many of these competitors are larger than Selective and have greater financial, technical, and operating resources. Because Selective sells its coverages through independent insurance agents who also are agents of its competitors, the Company faces competition within each of its appointed independent insurance agencies.
The property and casualty insurance industry is highly competitive on the basis of both price and service. If Selectives competitors price their products more aggressively, the Companys ability to grow or renew its business as well as its profitability may be adversely impacted. There are many companies competing for the same insurance customers in the geographic areas in which Selective operates. The Internet has also emerged as a significant source of new competition, both from existing competitors and from new competitors. A new form of competition may enter the marketplace as reinsurers may attempt to diversify their insurance risk by writing business in the primary marketplace.
Selective also faces competition, primarily in the commercial insurance market, from entities that self-insure their own risks. Many of Selectives customers and potential customers are examining the benefits and risks of self-insuring as an alternative to traditional insurance.
A number of new, proposed, or potential legislative or industry developments could further increase competition in the property and casualty insurance industry. These developments include:
New competition from these developments could cause the supply or demand for insurance to change, which could adversely affect Selectives results of operations and financial condition.
Selective is a holding company, and its subsidiaries may have a limited ability to declare dividends, and thus may not have access to the cash that is needed to meet its cash needs.
Substantially all of Selectives operations are conducted through its subsidiaries. Restrictions on the ability of the Companys subsidiaries, particularly the Insurance Subsidiaries, to pay dividends or make other cash payments to the Parent may materially affect its ability to pay principal and interest on its indebtedness and dividends on its Common Stock.
Under the terms of Selectives debt agreements and financial solvency laws affecting insurers, the Companys subsidiaries are permitted to incur indebtedness up to certain levels that may restrict or prohibit the making of distributions, the payment of dividends, or the making of loans by the subsidiaries to the Parent. The Company cannot assure that the agreements governing the current and future indebtedness of its subsidiaries will permit such subsidiaries to provide the Parent with sufficient dividends, distributions, or loans to fund its cash needs. Sources of funds for the Insurance Subsidiaries primarily consist of premiums, investment income, and proceeds from sales and redemption of investments. Such funds are applied primarily to payment of claims, insurance operating expenses, income taxes and the purchase of investments, as well as dividends and other payments.
The Insurance Subsidiaries may declare and pay dividends to the Parent only if they are permitted to do so under the insurance regulations of their respective state of domicile. All of the states in which Selectives Insurance Subsidiaries are domiciled regulate the payment of dividends. Some states, including New Jersey, North Carolina, and South Carolina, require that Selective give notice to the relevant state insurance commissioner prior to its Insurance Subsidiary domiciled in that respective state declaring any dividends and distributions payable to the Parent. During the notice period, the state insurance commissioner may disallow all or part of the proposed dividend upon determination that: (i) the insurers surplus is not reasonable in relation to its liabilities and adequate to its financial needs and those of the policyholders, or (ii) in the case of New Jersey, the insurer is otherwise in a hazardous financial condition. In addition, insurance regulators may block dividends or other payments to affiliates that would otherwise be permitted without prior approval upon determination that, because of the financial condition of the insurance subsidiary or otherwise, payment of a dividend or any other payment to an affiliate would be detrimental to an insurance subsidiarys policyholders or creditors. Selectives SHRS subsidiary may also declare and pay dividends, which are restricted by the operating needs of this entity as well as a professional employer organization licensing requirement to maintain a current ratio of at least 1:1.
Class action litigation could affect Selectives business practices and financial results.
Selectives industries have been the target of class action litigation in areas including the following:
A change in Selectives market share in New Jersey could adversely impact the results of its private passenger automobile business.
New Jersey insurance regulations require New Jersey auto insurers to involuntarily write private passenger automobile insurance for individuals who are unable to obtain insurance in the voluntary market. These policies are priced according to a separate rating scheme that is established by the assigned risk plan and subject to approval by NJDOBI. The amount of involuntary insurance an insurer must write in New Jersey depends on the insurers statewide market share the greater the market share the more involuntary coverage the insurer is required to write. The underwriting of involuntary personal automobile insurance in New Jersey has been historically unprofitable.
Selective depends on key personnel.
To a large extent, the success of Selectives businesses is dependent on its ability to attract and retain key employees, in particular its senior officers, key management, sales, information systems, underwriting, claims, HR Outsourcing, and corporate personnel. Competition to attract and retain key personnel is intense. While Selective has employment agreements with a number of key managers, the Company generally does not have employment contracts with its employees and cannot ensure that it will be able to attract and retain key personnel.
Selectives investments support its operations and provide a significant portion of its revenues and earnings.
Like many other property and casualty insurance companies, Selective depends on income from its investment portfolio for a significant portion of its revenues and earnings. Any significant decline in the Companys investment income as a result of falling interest rates, decreased dividend payment rates, reduced returns in our other investment portfolio, or general market conditions would have an adverse effect on its results. Fluctuations in interest rates cause inverse fluctuations in the market value of the Companys debt portfolio. Any significant decline in the market value of its investments, excluding its held-to-maturity investments, would reduce the Companys stockholders equity and its policyholders surplus, which could impact the Companys ability to write additional premiums. In addition, Selectives notes payable are subject to certain debt-to-capitalization restrictions, which could also be impacted by a significant decline in investment values.
Selective faces risks as a servicing carrier in the Write-Your-Own (WYO) Program of the United States governments National Flood Insurance Program (NFIP).
Flood insurance is offered through the NFIP, which is managed by the Mitigation Division of FEMA under the U.S. Department of Homeland Security. 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 agencys funding authority and future limitations in this funding could occur.
Effective October 1, 2006, the fee paid to us by the NFIP decreased 0.6 points to 30.2% of premiums written. Future reductions in this rate could occur through legislative activity.
Selective employs anti-takeover measures that may discourage potential acquirers and could adversely affect the value of its Common Stock.
Selective owns all of the shares of stock of its 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 that controls a domestic insurance company. Any purchase of 10% or more of Selectives outstanding Common Stock would require prior action by all or some of the insurance commissioners of these states.
Other factors also may discourage, delay, or prevent a change of control of Selective, including, among others, provisions in the Companys certificate of incorporation (as amended), relating to:
The New Jersey Shareholders Protection Act provides that Selective, as a New Jersey corporation, may not engage in business combinations specified in the statute with a shareholder having indirect or direct beneficial ownership of 10% or more of the voting power of the Companys outstanding stock (an interested shareholder) for a period of five years following the date on which the shareholder became an interested shareholder, unless the business combination is approved by the board of directors of the corporation before the date the shareholder became an interested shareholder. In addition, Selective may not engage at any time in any business combination with any interested shareholder other than: (i) a business combination approved by Selectives board of directors prior to the shareholder becoming an interested shareholder; (ii) a business combination approved by two-thirds of the Companys shareholders (other than the interested shareholder); or (iii) a business combination that satisfies certain price criteria. These provisions also could have the effect of depriving Selective stockholders of an opportunity to receive a premium over the prevailing market price if a hostile takeover were attempted and may adversely affect the value of the Companys Common Stock.
Selective faces risks from technology-related failures.
Selectives businesses are increasingly dependent on computer and Internet-enabled technology. The Companys inability to anticipate or manage problems with technology associated with scalability, security, functionality, or reliability could adversely affect its ability to write business and service accounts, and could adversely impact its results of operations and financial condition.
Selective faces risks in the HR Outsourcing business.
The operations of SHRS are affected by numerous federal and state laws and regulations relating to employment matters, benefits plans, and taxes. In performing services for its clients, SHRS assumes some obligations of an employer under these laws and regulations. Regulation in the HR Outsourcing business is constantly evolving, which could result in the modification of laws and regulations from time to time. Selective is unable to predict what additional government initiatives, if any, affecting SHRSs business may be promulgated in the future. Consequently, the Company is also unable to predict whether SHRS will be able to adapt to new or modified regulatory requirements or obtain necessary licenses and government approvals.
Item 1B. Unresolved Staff Comments
Item 2. Properties.
Selectives main office is located in Branchville, New Jersey, on a site owned by a subsidiary with approximately 114 acres and 315,000 square feet of operational space. Selective leases all of its other facilities. The principal office locations related to Selectives three business segments are described in the Field Strategy, Investments Segment, and Human Resource Administration Outsourcing sections of Item 1. Business. Selective believes that its facilities provide adequate space for its present needs and that additional space, if needed, would be available on reasonable terms.
Item 3. Legal Proceedings.
In the ordinary course of conducting business, Selective and its subsidiaries are named as defendants in various legal proceedings. Some of these lawsuits attempt to establish liability under insurance contracts issued by Selectives 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 Selectives operations in certain ways.
Although the ultimate outcome of these matters is not presently determinable, Selective does not believe that the total amounts that it will ultimately have to pay, if any, in all of these lawsuits in the aggregate will have a material adverse effect on its financial condition, results of operations, or liquidity.
Item 4. Submission of Matters to a Vote of Security Holders.
No matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of 2006.
Item 5. Market For Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
(a) Market Information
Selectives Common Stock is traded on the NASDAQ Global Select Market under the symbol: SIGI. The following table sets forth the high and low sales prices, as reported on the NASDAQ Global Select Market, for Selectives Common Stock for each full quarterly period within the two most recent fiscal years:
On February 23, 2007, the closing price of Selective as reported on the NASDAQ Global Select Market was $24.89. All share and per share amounts have been restated to give retroactive effect to the two-for-one stock split distributed on February 20, 2007 to shareholders of record as of February 13, 2007. See Item 8. Financial Statements and Supplementary Data, Note 10 for discussion regarding the stock split.
As of February 13, 2006, there were approximately 2,744 holders of record of Selectives Common Stock, including beneficial holders whose securities were held in the name of the registered clearing agency or its nominee.
Dividends on shares of Selectives Common Stock are declared and paid at the discretion of the Board of Directors based on Selectives operating results, financial condition, capital requirements, contractual restrictions, and other relevant factors. The following table provides information on the dividends declared for each quarterly period within Selectives two most recent fiscal years:
The Parents ability to declare dividends is restricted by covenants contained in senior notes that it issued on May 4, 2000 (2000 Senior Notes). See Note 9 to the consolidated financial statements entitled, Indebtedness. All such covenants were met during 2006 and 2005. At December 31, 2006, the amount available for dividends to holders of Selectives common shares under such restrictions was $384.2 million for the 2000 Senior Notes.
Selectives ability to receive dividends, loans, or advances from its Insurance Subsidiaries is subject to the approval and/or review of the insurance regulators in the respective domiciliary states of the Insurance Subsidiaries. Such approval and review is made under the respective domiciliary states insurance holding company act, which generally requires that any transaction between related companies be fair and equitable to the insurance company and its policyholders. Selective does not believe that such restrictions materially limit the ability of the Insurance Subsidiaries to pay dividends to Selective now or in the foreseeable future. Selective currently expects to continue to pay quarterly cash dividends on shares of its Common Stock in the future and has increased the quarterly stock dividend by 9% to $0.12 per share in the first quarter of 2007.
(d) Securities Authorized for Issuance Under Equity Compensation Plans
The following table provides information about Selectives Common Stock authorized for issuance under equity compensation plans as of December 31, 2006:
(e) Performance Graph
The following chart, produced by Research Data Group, Inc., depicts Selectives performance for the period beginning December 31, 2001 and ending December 31, 2006, as measured by total stockholder return on the Companys Common Stock compared with the total return of the NASDAQ Composite Index and a select group of peer companies.
Notwithstanding anything to the contrary set forth in any of Selectives previous filings under the Securities Act of 1933 or the Exchange Act that might incorporate future filings made by Selective under those statutes, the preceding performance graph will not be incorporated by reference into any of those prior filings, nor will such graph be incorporated by reference into any future filings made by Selective under those statutes.
(f) Purchases of Equity Securities by the Issuer and Affiliated Purchasers
The following table provides information regarding Selectives purchase of its own Common Stock in the fourth quarter of 2006:
Item 6. Selected Financial Data.
Eleven-Year Financial Highlights1
Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations.
Certain statements in this report, including information incorporated by reference, are forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995 (PSLRA). The PSLRA provides a safe harbor under the Securities Act of 1933 and the Securities Exchange Act of 1934 for forward-looking statements. These statements relate to our intentions, beliefs, projections, estimations or forecasts of future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our or our industrys actual results, levels of activity, or performance to be materially different from those expressed or implied by the forward-looking statements. In some cases, you can identify forward-looking statements by use of words such as may, will, could, would, should, expect, plan, anticipate, target, project, intend, believe, estimate, predict, potential, pro forma, seek, likely or continue or other comparable terminology. These statements are only predictions, and we can give no assurance that such expectations will prove to be correct. We undertake no obligation, other than as may be required under the federal securities laws, to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
Factors that could cause our actual results to differ materially from those projected, forecasted or estimated by us in forward-looking statements are discussed in further detail in Item 1A. Risk Factors. These risk factors may not be exhaustive. We operate in a continually changing business environment, and new risk factors emerge from time-to-time. We can neither predict such new risk factors nor can we assess the impact, if any, of such new risk factors on our businesses or the extent to which any factor or combination of factors may cause actual results to differ materially from those expressed or implied in any forward-looking statements in this report. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report might not occur.
Selective Insurance Group, Inc., (Selective, the Company, we, or our) offers property and casualty insurance products and diversified insurance services through its various subsidiaries. Selective classifies its businesses into three operating segments: (i) Insurance Operations; (ii) Investments; and (iii) Diversified Insurance Services.
The purpose of the Managements 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.
In the MD&A, we will discuss and analyze the following:
Critical Accounting Policies and Estimates
We have identified the policies and estimates described below as critical to our business operations and the understanding of the results of our operations. Our preparation of the consolidated financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurance that actual results will not differ from those estimates. Those estimates that were most critical to the preparation of the financial statements involved the following: (i) reserve for losses and loss expenses; (ii) deferred policy acquisition costs; (iii) pension and postretirement benefit plan actuarial assumptions; and (iv) other-than-temporary investment impairments.
Reserves for Losses and Loss Expenses
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer, and the insurers payment of that loss. To recognize liabilities for unpaid losses and loss expenses, insurers establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported net losses and loss expenses. As of December 31, 2006, the Company had accrued $2.3 billion of gross loss and loss expense reserves compared to $2.1 billion at December 31, 2005.
How reserves are established
When a claim is reported to an insurance subsidiary, claims personnel establish a case reserve for the estimated amount of the ultimate payment. The amount of the reserve is primarily based upon a case-by-case evaluation of the type of claim involved, the circumstances surrounding each claim, and the policy provisions relating to the type of losses. The estimate reflects the informed judgment of such personnel based on general insurance reserving practices, as well as the experience and knowledge of the claims person. Until the claim is resolved, these estimates are revised as deemed necessary by the responsible claims personnel based on subsequent developments and periodic reviews of the case.
In addition to case reserves, we maintain estimates of reserves for losses and loss expenses incurred but not yet reported (IBNR). Using generally accepted actuarial reserving techniques, we project our estimate of ultimate losses and loss expenses at each reporting date. The difference between: (i) projected ultimate loss and loss expense reserves and (ii) case loss reserves and loss expense reserves thereon are carried as the IBNR reserve. The actuarial techniques used are part of a comprehensive reserving process that includes two primary components. The first component is a detailed quarterly reserve analysis performed by our internal actuarial staff, which is managed independently from the operating units. In completing this analysis, the actuaries are required to make numerous assumptions, including, for example, the selection of loss development factors and the weight to be applied to each individual actuarial indication. These indications include paid and incurred versions for the following actuarial methodologies: loss development, Bornhuetter-Ferguson, Berquist-Sherman, and frequency/severity. Additionally, the actuaries must gather substantially similar data in sufficient volume to ensure the statistical credibility of the data. The second component of the analysis is the projection of the expected ultimate loss ratio for each line of business for the current accident year. This projection is part of the Companys planning process wherein the expected loss ratios are reviewed and updated each quarter. This review includes actual versus expected pricing changes, loss trend assumptions, and updated prior period loss ratios from the most recent quarterly reserve analysis.
In addition to the most recent loss trends, a range of possible IBNR reserves is determined annually and continually considered, among other factors, in establishing IBNR for each reporting period. Loss trends include, but are not limited to, large loss activity, environmental claim activity, large case reserve additions or reductions for prior accident years, and reinsurance recoverable issues. The Company also considers factors such as: (i) per claim information; (ii) Company and industry 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. Based on the consideration of the range of possible IBNR reserves, recent loss trends, uncertainty associated with actuarial assumptions and other factors, IBNR is established and the ultimate net liability for losses and loss expenses is determined. Such an assessment requires considerable judgment given that it is frequently not possible to determine whether a change in the data is an anomaly until some time after the event. Even if a change is determined to be permanent, it is not always possible to reliably determine the extent of the change until some time later. 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. 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. Any changes in the liability estimate may be material to the results of operations in future periods.
Major trends by line of business creating additional loss and loss expense reserve uncertainty
The Insurance Subsidiaries are multi-state, multi-line property and casualty insurance companies and, as such, are subject to reserve uncertainty stemming from a variety of sources. These uncertainties are considered at each step in the process of establishing loss and loss expense reserves. However, as market conditions change, certain trends are identified that management believes create an additional amount of uncertainty. A discussion of recent trends, by line of business, that have been recognized by management follows.
With $763 million, or 37% of our total recorded reserves, net of reinsurance at December 31, 2006, workers compensation is our largest reserved line of business. In addition to the uncertainties associated with actuarial assumptions and methodologies described above, workers compensation is the line of business that is most susceptible to unexpected changes in the cost of medical services because of the length of time over which medical services are provided and the unpredictability of medical cost inflation. In 2005, we had sufficient evidence of greater than expected increases in our workers compensation medical costs and raised our reserves in this line of business by $42 million for
accident years 2001 and prior. In 2006, while medical cost trends were higher than historical amounts, they were lower than 2005 and were close to expected amounts in our reserve analysis. As a result, in 2006, reserves for prior accident years were reduced by the relatively moderate amount of $4 million. The higher than historical increase in medical costs in 2005 and 2006 could be a relatively short-term anomaly, in which case our historical patterns would be the best basis for future projections. If higher trends continue on a longer term, our historical patterns will be less meaningful in predicting future loss costs and could result in significant adverse reserve development.
At December 31, 2006, our general liability line of business had recorded reserves, net of reinsurance of $708 million, which represented 34% of our total net reserves. In recent years, this line of business has experienced adverse development mainly due to coverage for completed work under policies issued to contractors and higher than expected legal expenses. Contractors general liability business in the late 1990s was our fastest growing class of business, which brought with it more complex claims and created challenges in estimating the related reserves. By 2003, we had gained a better understanding of the underwriting complexities and were able to implement initiatives to improve the financial results for this line. Accordingly, our adverse development in 2006 of $15 million for this line of business was driven by reserve increases for accident years 2002 and prior, and was partially offset by favorable development in accident years 2004 and 2005 as we compiled additional experience to improve our actuarial projections of expected ultimate losses. At this time, management has not identified any recent trends that would create additional significant reserve uncertainty for this line of business.
At December 31, 2006, our commercial automobile line of business had recorded reserves, net of reinsurance, of $313 million, which represented 15% of our total net reserves. This line of business has experienced favorable loss development in recent years driven by a downward trend in large claims. The number of large claims has a high degree of volatility from year-to-year and, therefore, requires a longer period before true trends are recognized and can be acted upon. We have experienced lower than expected severity in accident years 2002 through 2005, which resulted in favorable development in 2005 and 2006 of $48 million and $15 million, respectively. This result is driven by trends that are positively affecting the commercial auto insurance market in general, as well as by Selective specific initiatives such as: (i) the increase in lower hazard auto business as a percentage of our overall commercial auto book of business; (ii) a re-underwriting of our newest operating region; and (iii) a more proactive approach to loss prevention. At this time, the lower trend in large claims has to some extent leveled off and management has not identified any other recent trends that would create significant reserve uncertainty for this line of business.
At December 31, 2006, our personal automobile line of business had recorded reserves, net of reinsurance, of $183 million, which represented 9% of our total net reserves. The majority of this business is written in the State of New Jersey, where the judicial and regulatory environment has been subject to significant changes over the past few decades. The most recent change occurred in June 2005, when the New Jersey Supreme Court ruled that the serious life impact standard does not apply to the Automobile Insurance Cost Reduction Acts limitation on lawsuit threshold. Consequently, we increased reserves for this line of business by $13 million in the second quarter of 2005. This recent judicial decision, however, also has increased the amount of uncertainty surrounding our personal automobile reserves, as much of the historical information used to make assumptions has been rendered less effective as a basis for projecting future results.
Other Lines of Business
At December 31, 2006, no other individual line of business had recorded reserves of more than $50 million, net of reinsurance. Management, at this time, has not identified any recent trends that would create additional significant reserve uncertainty for these other lines of business.
The following tables provide case and IBNR reserves for losses, reserves for loss expenses, and reinsurance recoverable on unpaid losses and loss expenses as of December 31, 2006 and 2005:
Range of reasonable reserves
The Company established a range of reasonably possible reserves for net claims of approximately $1,977 million to $2,174 million at December 31, 2006 and of $1,764 million to $1,950 million at December 31, 2005. A low and high reasonable reserve selection was derived primarily by considering the range of indications calculated using generally accepted actuarial techniques. Such techniques assume that past experience, adjusted for the effects of current developments and anticipated trends, are an appropriate basis for predicting future events. Although this range reflects the most likely scenarios, it is possible that the final outcomes may fall above or below these amounts. This range does not include a provision for potential increases or decreases associated with environmental reserves, as management believes it is not meaningful to calculate a range given the uncertainties associated with environmental claims. Managements best estimate is consistent with the actuarial best estimate. The Company does not discount to present value that portion of its loss reserves expected to be paid in future periods; however, the loss reserves take into account anticipated recoveries for salvage and subrogation claims.
Sensitivity Analysis: Potential impact on reserve volatility due to changes in key assumptions
Our process to establish reserves includes a variety of key assumptions. These assumptions include, but are not limited to, the following:
The importance of any single assumption depends on several considerations, such as the line of business and the accident year. If the actual experience emerges differently than the assumptions used in the process to establish reserves, changes in our reserve estimate are possible and may be material to the results of operations in future periods. Set forth below is a discussion of the potential impact of using certain key assumptions that differ from those used in our latest reserve analysis. It is important to note that the following discussion considers each assumption individually, without any consideration of correlation between lines of business and accident years, and therefore, does not constitute an actuarial range. While the following discussion represents possible volatility from variations in key assumptions as identified by management, there is no assurance that the future emergence of our loss experience will be consistent with either our current or alternative set of assumptions. By the very nature of the insurance business, loss development patterns have a certain amount of normal volatility.
In addition to the normal amount of volatility, medical loss development factors for workers compensation are particularly sensitive to assumptions relating to medical inflation. Actual medical loss development factors could be significantly different than those which are selected from historical loss experience if actual medical inflation is materially different than what was observed in the past. In our judgment, it is possible that actual medical loss development factors could range from 6% below those actually selected in our latest reserve analysis to 10% above those selected in our latest reserve analysis. If the medical loss development assumptions were reduced by 6%, that would decrease our indicated workers compensation reserves by approximately $50 million for accident years 2005 and prior. Alternatively, if the medical loss development factors were increased by 10%, that would increase our indicated workers compensation reserves by approximately $80 million.
In addition to the normal amount of volatility, general liability loss development factors have greater uncertainty due to the complexity of the coverages and the possibly significant periods of time that can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer, and the insurers payment of that loss. In our judgment, it is possible that general liability loss development factors could be +/- 6% from those actually selected in our latest reserve analysis. If the loss development assumptions were changed by +/- 6%, that would increase/decrease our indicated general liability reserves by approximately $70 million for accident years 2005 and prior.
In addition to the normal amount of volatility, the commercial automobile line of business of the Company has experienced significant favorable development in recent years. This favorable development has been driven in large part by a reduction in our bodily injury large loss experience. The actual number of large claims has a high degree of volatility from year-to-year, and therefore, requires a longer period of time before a company would respond to this type of information. Under these circumstances, the difference between a traditional loss development method and the expected ultimate loss ratio is larger than usually expected. For this reason the weight to be applied to each individual actuarial indication in this situation is another key assumption. If the impact of changing the weights to be applied to each actuarial indication is combined with the impact of possible changes to selected loss development factors of +/- 5%, it is our judgment that the possible impact to overall reserves could range from approximately $50 million reduction to approximately $30 million increase for accident years 2005 and prior.
In addition to the 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. In our judgment, it is possible that personal auto bodily injury loss development factors could range from 5% 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 5%, that would decrease our indicated personal automobile reserves by
approximately $40 million for accident years 2005 and prior. Alternatively, if the loss development factors were increased by 3%, that would increase our indicated personal automobile reserves by approximately $20 million.
Current Accident Year
For the 2006 accident year, the expected ultimate loss ratio by line of business is a key assumption. This assumption is based upon a large number of inputs that are assessed periodically, such as historical loss ratios, projected future loss trend, and planned pricing amounts. In our judgment, it is possible that the actual ultimate loss ratio for the 2006 accident year could be +/-7% from the one selected in our latest reserve analysis for each of our four major long tailed lines of business. The table below summarizes the possible impact on our reserves of varying our expected loss ratio assumption by +/-7% by line of business for the 2006 accident year.
Reserve Impact of Changing Current Year Expected Ultimate Loss Ratio Assumption
Prior year reserve development in 2006
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 could result in the Company identifying information and trends that would require the Company to increase some reserves and/or decrease other reserves for prior periods and could also lead to additional increases in loss and loss adjustment expense reserves, which could materially adversely affect the Companys results of operations, equity, business, insurer financial strength, and debt ratings. The Company experienced positive prior year development in its loss and loss expense reserves totaling $7.3 million in 2006, adverse prior year development of $5.1 million in 2005 and adverse prior year development of $4.9 million in 2004. For further discussion on the adverse development in loss and loss expense reserves, see the discussion on Net Loss and Loss Expense Reserves in Item 1. Business and Note 8 of Item 8. Financial Statements and Supplementary Data in this Form 10-K.
Asbestos and Environmental Reserves
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 $46.5 million as of December 31, 2006 and $41.8 million as of December 31, 2005. Selectives exposure to environmental liability is primarily due to policies written prior to the introduction of the absolute pollution exclusion endorsement in the mid-1980s and underground storage tank leaks, mostly from New Jersey homeowners policies in recent years. Selectives 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, Selective also experienced adverse development in its 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. Increased frequency has been triggered, in part, by the states robust real estate market, which has led to an increase in home tank inspections.
IBNR reserve estimation for environmental claims is often difficult because, in addition to other factors, there are significant uncertainties associated with critical assumptions in the estimation process, such as average clean-up costs, third-party costs, potentially responsible party shares, allocation of damages, insurer litigation costs, insurer coverage defenses, and potential changes to state and federal statutes. However, management is not aware of any emerging trends that could result in future reserve adjustments. Moreover, normal historically-based actuarial approaches are difficult to apply because relevant history is not available. While models can be applied, such models can produce significantly different results with small changes in assumptions. As a result, management does not calculate a specific environmental loss range, as it believes it would not be meaningful.
The table below summarizes the number of asbestos and non-asbestos claims outstanding at December 31, 2006, 2005, and 2004. For additional information about our environmental reserves, see Item 1. Business, Item 8. Financial Statements and Supplementary Data, Note 8 to the consolidated financial statements.
Deferred Policy Acquisition Costs
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. The Company had deferred policy acquisition costs of $218.1 million at December 31, 2006 compared to $204.8 million at December 31, 2005.
Pension and Postretirement Benefit Plan Actuarial Assumptions
The Companys pension benefit and postretirement life benefit obligations and related costs are calculated using actuarial concepts, within the framework of Statement of Financial Accounting Standards No. 87, Employers Accounting for Pensions (SFAS 87); and Statement of Financial Accounting Standards No. 106, Employers Accounting for Postretirement Benefits Other than Pension (SFAS 106), respectively. Two key assumptions, the discount rate and the expected return on plan assets, are important elements of expense and/or liability measurement. We evaluate these key assumptions annually. Other assumptions involve demographic factors such as retirement age, mortality, turnover, and rate of compensation increases.
The discount rate enables us to state expected future cash flow as a present value on the measurement date. The guideline for setting this rate is a high-quality long-term corporate bond rate. A lower discount rate increases the present value of benefit obligations and increases pension expense. We reduced our discount rate to 5.50% for 2006, from 5.75% for 2005 to reflect market interest rate conditions. To determine the expected long-term rate of return on the plan assets, we consider the current and expected asset allocation, as well as historical and expected returns on each plan asset class. A lower expected rate of return on pension plan assets would increase pension expense. Our long-term expected return on plan assets was 8.00% in 2006 and 2005. Changes in the related pension and postretirement benefit expense may occur in the future due to changes in these assumptions.
For additional information regarding the Companys pension and postretirement benefit plan obligations, see Item 8. Financial Statements and Supplementary Data, Note 16(d) to the consolidated financial statements.
Other-Than-Temporary Investment Impairments
An investment in a fixed maturity or equity security, which is available for sale or reported at fair value, is impaired if its fair value falls below its book value and the decline is considered to be other than temporary. We regularly review our entire investment portfolio for declines in value. If we believe that a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in accumulated other comprehensive income. If we believe the decline is other-than-temporary, we write down the carrying value of the investment and record a realized loss in our Consolidated Statements of Income. Managements assessment of a decline in value includes current judgment as to the financial position and future prospects of the entity that issued the investment security. Broad changes in the overall market or interest rate environment generally will not lead to a write-down provided that management has the ability and intent to hold such a security to maturity. In November 2005, the Financial Accounting Standards Board (FASB) issued two FASB Staff Positions (FSP), FAS115-1 and FAS124-1 titled The Meaning of Other-Than-Temporary Impairments and its Application to Certain Investments. These FSPs support existing requirements related to impairments with relatively few modifications.
Our evaluation for other-than-temporary impairment of fixed maturity securities, includes, but is not limited to, the evaluation of the following factors:
Our evaluation for other-than-temporary impairment of equity securities and alternative investments, includes, but is not limited to, the evaluation of the following factors:
There were no impairment charges during 2006. We recorded an impairment charge of $1.2 million in 2005 for one investment that we concluded was impaired for an other-than-temporary decline in value. There were no impairment charges recorded in 2004.
Financial Highlights of Results for years ended December 31, 2006, 2005, and 2004 1
The above items were partially offset by increased competition in the New Jersey personal automobile market. As of December 31, 2006, the number of cars we insured in New Jersey decreased 12% to 77,160 from 87,593 as of December 31, 2005. Net premiums earned for our New Jersey personal automobile business were $101.3 million for 2006 as compared to $118.1 million for 2005 and $136.7 million for 2004.
Results of Operations and Related Information by Segment
Our Insurance Operations segment writes property and casualty insurance business through seven insurance subsidiaries (the Insurance Subsidiaries). Our Insurance Operations segment sells property and casualty insurance products and services primarily in 20 states in the Eastern and Midwestern United States through approximately 770 independent insurance agencies. Selective has at least one Insurance Subsidiary licensed to do business in each of the 50 states. Our Insurance Operations segment consists of two components: (i) commercial lines (Commercial Lines), which markets primarily to businesses, and represents approximately 86% of net premiums written (NPW), and (ii) personal lines (Personal Lines), which markets primarily to individuals and represents approximately 14% of NPW. The underwriting performance of these lines are generally measured by four different statutory ratios: (i) loss and loss expense ratio; (ii) underwriting expense ratio; (iii) dividend ratio; and (iv) combined ratio. For further details regarding these ratios see the discussion in the Insurance Operations Results section of Item 1. Business of this Form 10-K.
Summary of Insurance Operations
These increases were partially offset by increased competition in the New Jersey personal automobile market. As of December 31, 2006, the number of cars we insured in New Jersey decreased 12% to 77,160 from 87,593 in 2005 and 97,685 in 2004. Net premiums written for our New Jersey personal automobile business were $92.7 million for 2006 as compared to $107.3 million for 2005 and $133.9 million for 2004.
Partially offsetting these increases was favorable prior year development in our loss and loss expense reserves of $7.3 million, resulting from normal reserve development inherent in the uncertainty in establishing reserves for losses and loss expenses, anticipated loss trends, growth in exposures, as well
as increased reinsurance retentions. For further discussion on the prior year development in loss and loss expense reserves, see the discussion on Net Loss and Loss Expense Reserves in Item 1. Business and Note 8 of Item 8. Financial Statements and Supplementary Data in this Form 10-K.
These improvements were partially offset by unprofitable results in our workers compensation line of business and reserve increases related to the New Jersey Supreme Court judicial ruling described below.
Insurance Operations Outlook
Historically, the results of the property and casualty insurance industry have experienced significant fluctuations from high levels of competition, economic conditions, interest rates, loss cost trends, and other factors. We expect the industry will continue to see increased pricing pressure in the primary insurance market in 2007, which will exert pressure on the future profitability of the Company's commercial lines business. The average forecast, according to the A.M. Best Review/Preview dated January 2007, calls for net premiums written to be relatively flat for 2007. This represents a slowdown from the projected estimate of 2.6% for 2006. The 2007 NPW forecast is ranked the second slowest rate of growth for property and casualty insurers since 1998. Loss trends, which are characterized by changes in severity and frequency, may also impact the future profitability of our business. As an example, taking a pure price decline of 1.4% and removing the expense that directly varies with premium volume yields an adverse combined ratio impact of approximately 1 point, in addition to a claims inflation increase of 3%, will cause the loss and loss adjustment expense ratio to increase approximately 2 points, all else remaining equal. The combination of claims inflation and price decreases could raise the combined ratio approximately 3 points in this example, absent any initiatives targeted to address these trends. These company initiatives would include Knowledge Management, Predictive Modeling and Safety Management and are discussed below.
When renewal pure price increases are declining and loss costs trend higher, a market cycle shift occurs. General inflation and, notably, medical inflation, can drive loss costs up, leading to higher industry-wide statutory combined ratios. We believe that this is the point in the market cycle when it is critical to have a clearly defined plan to improve risk selection and mitigate frequency and severity. Some of the tools we use to lower frequency and severity are safety management, managed care, knowledge management, predictive modeling, and enhanced claims review. Although it is uncertain at this time whether our initiatives will offset macro pricing and loss trends, we have outperformed the industrys loss and loss adjustment expense ratio by 7.1 points, on average, over the past 10 years.
As competition continues to intensify, managing growth and profitability will be a major focus for us in 2007. Driving profitable organic growth has always been Selectives strategy, and this will continue into 2007. Our growth drivers are:
Other strategic initiatives we are implementing to increase the effectiveness of our field strategy and improve risk selection include:
The demand for reinsurance coverage by the property and casualty insurance industry has continued to grow. Recent catastrophes, such as the huge losses incurred from Hurricane Katrina in 2005, have created capacity issues in the market. Catastrophe models in current use by the industry, such as RMS v.6.0, have projected significant increases in expected losses as a result of changing weather patterns, including increased hurricane activity in the Atlantic basin, and have resulted in increased demand for additional reinsurance coverage. Additionally, construction costs, both labor and raw materials, have increased in recent years in both the commercial and residential markets. These factors will continue to have a direct impact on the pricing and availability of reinsurance coverage. Each year, as we analyze our reinsurance program, we consider treaty attachment points, co-participation, alternative risk transfer mechanisms, and other changes in program structures that provide most effective protection in light of current market conditions.
Terrorism continues to remain an overall industry concern. In addition to treaty and facultative reinsurance, the Insurance Subsidiaries are partially protected by the Terrorism Risk Insurance Act of 2002, which was modified and extended through December 31, 2007 via the Terrorism Risk Insurance Extension Act of 2005. For further information regarding this legislation, see Item 1A. Risk Factors of this Form 10-K.
Competition in the New Jersey personal automobile market has been influenced by the recent introduction of new companies writing business in the state. Our new Personal Lines strategy allows us to better evaluate and price risks, which will help us to profitably compete for new business in an agents office. We are in the process of moving our existing renewal inventory into our new pricing and tiering structure in New Jersey, causing a one-time dislocation in this book of business. Annual increases or decreases are capped at 20% by NJDOBI. We continue to focus on increasing new business production through this advanced pricing methodology, as it will take several quarters for the improved renewal book profitability to materialize. We expect to see positive results more quickly outside of New Jersey, where the issues affecting the renewal inventory are less significant.
Technology also continues to play a critical role in our success. Our leading edge agency integration technology, xSELerate®, is creating new business opportunities by facilitating the automated movement of key underwriting data from an agents management system to our systems. In December 2006, we were awarded the A.M. Best eFusion award for xSELerate®, for innovative, business-focused agency integration technology. This technology allows for seamless quoting and rating capabilities, which is an example of why we are ranked so highly by our agents for ease of doing business.
On April 19, 2006, A.M. Best reaffirmed the A+ (Superior) financial strength rating for our Insurance Subsidiaries for the 45th consecutive year. In support of the rating, A.M. Best cited our solid capitalization, historically favorable operating performance and strong regional presence within the small commercial lines business segment. Only 9% of personal and commercial lines carriers attain an A+ rating or better, which provides us with a competitive advantage that reinforces our agents decision to make us their carrier of choice. On July 25, 2006, Standard and Poors Insurance Rating Services (S&P) raised our financial strength rating to A+ from A, citing our strong operating performance, strong operating company capitalization, and good financial flexibility. During the third quarter of 2006, Moodys Investor Services elevated their outlook regarding Selective to positive.
We recently formed a new Insurance Subsidiary, Selective Auto Insurance Company of New Jersey (SAICNJ), which is domiciled in the State of New Jersey. SAICNJ writes Selectives New Jersey personal automobile policies, effective July 1, 2006 for new business and August 15, 2006 for renewal business. SAICNJ, a member of the Pooling Agreement, received a financial strength rating of A+ from A.M. Best on August 14, 2006.
Review of Underwriting Results by Line of Business
Continued strong performance in this line is the result of underwriting and pricing improvements over the last several years. As we continue to write accounts, we have implemented granular rate decreases to grow this profitable line of business. The policy count on this line of business increased 6% in 2006 compared to 2005, and 5% in 2005 compared to 2004. The policy count benefited from a 4% increase in new policies in 2006 as compared to 2005 as well as a 4% increase in 2005 as compared to 2004. Pure price on our commercial automobile policies decreased 4.1% in 2006. The results for this line of business were also positively impacted by favorable prior year statutory loss and loss expense reserve development of approximately $15 million in 2006 compared to $48 million in 2005 and $20 million in 2004. This development was primarily driven by lower than expected severity in accident years 2002 and 2005.
Net premiums written for this line of business increased in 2006 compared to 2005 and 2004 due to the following: (i) increases in policy counts of 8% and direct new policy premium of 1% in 2006; (ii) renewal price increases, including exposure, of 1.5% in 2006; and (iii) stable retention of approximately 76% over the past two years.
The profitability in this line of business reflects our long-term improvement strategy of: (i) focusing our contractor growth on business segments with lower completed operations exposures; and (ii) improving contractor/subcontractor underwriting guidelines to minimize losses. Offsetting these improvements were pure renewal price decreases of 3.3% in 2006 and adverse prior year statutory loss and loss expense reserve development in this line of business of approximately $15 million in 2006 compared to $14 million in 2005 and $19 million in 2004. The adverse development in all years was largely driven by our contractor completed operations business and increases in reserves for legal expenses.
Statutory net premiums written for our workers compensation line of business increased by 5% in 2006 compared to 2005 and by 14% in 2005 compared to 2004 due to: (i) increases in policy counts of 5% in 2006; (ii) increases in direct new voluntary policy premium of 30% in 2006; and (iii) renewal price increases, including exposure, of 8% in 2006. Retention on this line of business decreased in 2006 to 80% from 82% in 2005, which was higher than 2004 retention of 80%.
We continue to execute on our multi-faceted workers compensation strategy aimed at reducing the statutory combined ratio by seven points by year-end 2007, barring other factors such as decreases in workers compensation rates or medical inflation beyond expectation. In 2006, this line was impacted by favorable prior year statutory development of approximately $2 million compared to adverse prior year statutory development of approximately $40 million in 2005 and approximately $4 million in 2004. The favorable prior year statutory development in 2006 was driven, in part, by savings realized from changing medical and pharmacy networks outside the State of New Jersey and re-contracting our medical bill review services. This redesign and re-contracting effort is expected to generate ongoing durable savings of about $3 million annually. The adverse development in 2005 was primarily the result of adverse loss trends, specifically in medical costs in the 2001 and prior accident years, which warranted an increase in managements best estimates within the loss range. The adverse development in 2004 was primarily the result of rating agency downgrades of certain reinsurers, which caused us to reevaluate our ability to collect under certain reinsurance contracts.
Over time, additional savings will be realized from other facets of our strategy, including our efforts to rank our operating states in tiers and target those which we believe will be the most profitable. Growth in our targeted states represents 76% of our 2006 new workers compensation voluntary business. Another facet of our workers compensation strategy is predictive modeling. The first predictive model for workers compensation was introduced in the second quarter of 2006. This model provides us with tools to identify unprofitable accounts and re-underwrite the workers compensation book more efficiently. We are pursuing strategies to grow the types of accounts that we have identified to be the most profitable. We are also looking at premiums written to ensure that they are reflective of the proper classes and payrolls for our workers compensation exposure. In the fourth quarter of 2006, we retained about 90% of our best business and non-renewed 33% of the worst business.
Net premiums written for this line of business increased in 2006 compared to 2005 and 2004 due to: (i) increases in direct new policy premium of 13% in 2006 to $45.1 million; (ii) stable retention of approximately 80% over the past two years; and (iii) renewal price increases, including exposure, were 1.3% in 2006.
The statutory combined ratio for commercial property increased in 2006 to a level more consistent with 2004 compared to 2005, primarily as a result of our catastrophe loss activity. Catastrophe losses were $13.2 million, or 7.2 points, in 2006 compared to $2.8 million, or 1.7 points, in 2005, and $13.3 million, or 8.7 points, in 2004. In addition, large property losses in 2005 were unusually low compared to the more normalized trend we are experiencing this year. Despite the increased losses this year, 2006 results continue to be strong as this line of business is benefiting from underwriting improvements over the past five years, including better insurance-to-value estimates across our book of business, a shift to risks of better construction quality and newer buildings, and an overall focus on low to medium hazard property exposures.
Business Owners Policy
The statutory net premiums written growth is the result of our completed Business Owners Policy (BOP) correction plan that included pricing and underwriting actions focused on the growth of more profitable segments and the elimination of certain classes of business from our underwriting eligibility guidelines. With our BOP correction plan completed and our BOP rewrite in place in all of our states, we are beginning to see our new business increase. Additionally, in November 2006, we rolled out the BOP predictive model and early indications demonstrate positive trends in our selection of profitable new business. Direct new business in 2006 was up 15% as compared to 2005 and 2% in 2005 compared to 2004. The policy count on this line of business increased 13% as of December 31, 2006 compared to December 31, 2005. The statutory combined ratio was negatively impacted by catastrophe losses of 4.0 points in 2006 compared to 1.5 points in 2005 and 3.9 points in 2004.
Growth and profitability in this line of business is driven by enhancements to the bond underwriting process, including the successful rollout of our automated bond system in late 2005.
The increase in NPW for Personal Lines business reflects the impact of the termination of the New Jersey Homeowners Quota Share Treaty on January 1, 2006. Excluding the impact of this treaty, NPW for Personal Lines would have decreased 7% in 2006 compared to 2005. This decrease is the result of ongoing competition in the New Jersey personal automobile market. As of December 31, 2006, the number of cars we insure in New Jersey decreased 12% to 77,160 from 87,593 as of December 31, 2005 and 97,685 as of December 31, 2004. Partially offsetting the impact of the increased competition was an increase in direct premiums written in our homeowners line of business of 6% to $65.1 million in 2006 compared to 2005 and an increase of 8% to $61.5 million in 2005 compared to 2004.
Net premiums written for this line of business decreased in 2006 as a result of the ongoing competition in the New Jersey personal automobile market coupled with our rating plans that were not competitive through the first half of the year due to a historically restrictive regulatory environment. As of December 31, 2006, the number of cars we insured decreased 12% compared to December 31, 2005 and decreased 10% as of December 31, 2005 as compared to December 31, 2004. During the second half of the year, we redesigned our Personal Lines pricing model, which we refer to as MATRIX. MATRIX is designed to provide increased pricing flexibility in an effort to improve our competitive position, and allows us to better match price to risk and helps us to profitably compete for new business. Annual increases or decreases are capped at 20% by NJDOBI.
The 2006 combined ratio improved slightly over 2005, however our non-New Jersey book of business is primarily driving the overall lack of profitability. Our New Jersey book of business posted a profitable combined ratio of 98.8% in 2006 compared to a 97.0% in 2005. The 1.8 point increase reflects the competitive pressures described above coupled with increased expenses resulting from the 2005 New Jersey Supreme Court decision discussed below. Our non-New Jersey book of business posted a combined ratio of 113.5% in 2006 compared to 130.8% in 2005.
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 Jerseys 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.
Statutory NPW for 2006 as compared to 2005 and 2004 increased as a result of the termination of the Quota Share Treaty on January 1, 2006. The termination resulted in a return of ceded premium in the first quarter of 2006 as well as the retention of homeowners business that had previously been ceded. An increase in direct premiums written of 6% in 2006 and 8% in 2005 compared to the prior years, also contributed to the increase in statutory net premiums written. Despite growth in premiums, the 2006 statutory combined ratio was negatively impacted by 7.6 points of catastrophe losses, while the 2005 ratio included only 1.7 points in catastrophe losses, and the 2004 ratio included 5.9 points in catastrophe losses.
We have reinsurance contracts that cover both property and casualty business. Selective uses traditional forms of reinsurance and does not utilize finite risk reinsurance. For purpose of this discussion, our contracts can be segregated into the following key categories:
While this discussion will provide you with an overview regarding the reasons for changing our reinsurance program over the past year, 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.
We continuously reevaluate our overall reinsurance program and the most effective ways to manage our risk. Our analysis is based on a comprehensive process that includes periodic analysis of modeling results, aggregation of exposures, exposure growth, diversification of portfolio, limits written, projected reinsurance costs, and projected impact on earnings and statutory surplus. We strive to balance often opposing considerations of reinsurer credit quality, price, terms, and our appetite for retaining a certain level of risk. This year the process led to two significant changes to our reinsurance program, which are effective January 1, 2007:
We made the decision not to renew our Terrorism Treaty for 2007. We determined that additional per occurrence casualty coverage would be a cost efficient way to enhance our protection against man-made catastrophic events. The cost of our Terrorism Treaty in 2006 was $4.3 million. The additional layer of casualty coverage cost $0.7 million.
In addition to treaty and facultative reinsurance, the Insurance Subsidiaries are partially protected by the Terrorism Risk Insurance Act of 2002, which was modified and extended through December 31, 2007 via the Terrorism Risk Insurance Extension Act of 2005. For further information regarding this legislation, see Item 1A. Risk Factors of this Form 10-K.
Although 2006 proved to be a year characterized by low incidence of significant catastrophic events, the reinsurance market continued to be influenced by retrocessional capacity constraints, rating agencies added emphasis on reinsurers capital adequacy, and recalibrated catastrophic models. In 2006, Risk Management Solutions Inc. (RMS), one of the leaders in catastrophe modeling, launched a new version of its U.S. Hurricane model. In addition to storm and demand surge options, RMS v.6.0 now provides results on both a stochastic five-year view and the traditional, longer-term historic view. RMS v.6.0 was influenced by RMSs analysis of the 2004 and 2005 hurricane seasons, as well as a prospective view that hurricane activity in the Atlantic Basin will be above historical averages in the short to medium-term (five years). As a result of these model changes, loss projections increased significantly. These external market forces, combined with the growth in our book of business, resulted in a $4.5 million, or 34%, increase in the cost of our property catastrophe program effective January 1, 2007 as compared with 2006. Based on a modeled portfolio and capital stress test analysis, we chose to increase our retention under the Catastrophe Excess of Loss treaty to $40.0 million from the expiring $20.0 million retention. In addition, we purchased $35.0 million of additional coverage in the upper limit with the treaty now covering 95% of $285.0 million in excess of $40.0 million per occurrence retention. This treaty provides for one full reinstatement of any portion of original limits exhausted by a loss.
The following table presents RMS v.6.0 modeled hurricane losses based on Selectives property portfolio as of June 30, 2006 under our 2007 catastrophe reinsurance treaty:
Our current catastrophe program provides protection for a 1 in 219 year event, or an event with 0.5 % probability according to the RMS v.6.0 historic model, and for a 1 in 168 year event, or an event with 0.6% probability according to RMS v.6.0 stochastic model.
The retention and limit under our Property Excess of Loss treaty, renewed July 1, 2006, remained the same at $23.0 million in excess of $2.0 million. Consistent with the prior year, all NBCR losses are excluded from the Property Excess of Loss treaty regardless of whether or not they are certified under TRIA. Terrorism (excluding NBCR) and per occurrence aggregate limits of $46.5 million reflect a moderate reduction in the upper layer aggregate limits from the expiring $54.0 million. The estimated ceded premium decreased by $0.4 million.
The Casualty Excess of Loss program renewed with an effective date of July 1, 2006. We purchased an additional layer of our casualty treaty on January 1, 2007. The new layer provides protection for 75% of $40.0 million in excess of $50.0 million per occurrence. It was purchased for an 18 month period and has an estimated annual cost of $0.7 million. The total program currently provides the following coverage:
In comparison, the prior year treaty provided per occurrence coverage of $48.0 million in excess of the Companys $2.0 million retention for workers compensation claims and $45.0 million in excess of the Companys $5 million retention for all other casualty claims. The total cost of the 2006 fiscal year casualty program is expected to be $1.0 million higher than the prior fiscal year.
Our Surety and Fidelity Excess of Loss treaty was renewed effective January 1, 2007 with essentially no changes in coverage and a 22% increase in estimated ceded premium influenced by projected subject premium increases and a modest increase to rate.
Our investment portfolio consists primarily (82%) of fixed maturity investments, but also contains equity securities, short-term investments, and other investments. Our investment philosophy includes certain return and risk objectives for our fixed maturity and equity portfolios. The primary return objective of our fixed maturity portfolio is to maximize after-tax investment yield and income while balancing certain risk objectives, with a secondary objective of meeting or exceeding a weighted-average benchmark of public fixed income indices. The return objective of the equity portfolio is to meet or exceed a weighted-average benchmark of public equity indices. The risk objectives for our entire portfolio is to ensure that our investments are structured conservatively, focusing on: (i) asset diversification; (ii) investment quality; (iii) liquidity, particularly to meet the cash obligations of the insurance operations; (iv) consideration of taxes; and (v) preservation of capital.
Growth in net investment income, before tax, of $20.9 million for 2006 compared to 2005 and $15.4 million for 2005 compared to 2004 was primarily attributable to the increase in our investment portfolio. The value of the investment portfolio reached $3.6 billion at December 31, 2006, an increase of 11% compared to $3.2 billion at December 31, 2005. The increase in invested assets was due to substantial cash flows from operations of $393.4 million in 2006 and $406.8 million in 2005. Debt offerings in September 2006 and November 2005 also added approximately $96.8 million and $98.4 million, respectively, in assets in 2006 and 2005. Also contributing to the growth in investment income were: (i) increased income of approximately $4.0 million from certain limited partnerships within our Other investments category for 2006 compared to 2005 and $1.8 million for 2005 compared to 2004; and (ii) dividend income increases of $1.0 million for 2006 compared to 2005 and $1.4 million for 2005 compared to 2004.
We continue to maintain a conservative, diversified investment portfolio, with fixed maturity investments representing 82% of invested assets. 73% of our fixed maturities portfolio is rated AAA while the portfolio has an average rating of AA, S&Ps second highest credit quality rating. High credit quality continues to be a cornerstone of our investment strategy, as evidenced by the fact that almost 100% of the fixed maturities are investment grade. At December 31, 2006 and 2005, non-investment grade securities (below BBB-) represented less than 1%, or approximately $10 million, of our fixed maturity portfolio.
The following table presents the Moodys and S&Ps ratings of our fixed maturities portfolio:
Our fixed maturity investment strategy is to make security purchases that are attractively priced in relation to perceived credit risks. We manage the interest rate risk associated with holding fixed maturity investments by monitoring and maintaining the average duration of the portfolio with a view toward achieving an adequate after-tax return without subjecting the portfolio to an unreasonable level of interest rate risk. We invest our fixed maturities portfolio primarily in intermediate-term securities to limit overall interest rate risk of fixed maturity investments. The average duration of the fixed maturity portfolio, including short-term investments, was 3.8 years at December 31, 2006 compared to 4.0 years at December 31, 2005. To provide liquidity, while maintaining consistent performance, fixed maturity investments are laddered so that some issues are always approaching maturity, thereby providing a source of predictable cash flow. Managing investment risk by adhering to these strategies is intended to protect the interests of our stockholders and the policyholders of our Insurance Subsidiaries, and enhance our financial strength and underwriting capacity.
Realized Gains and Losses
Realized gains and losses are determined on the basis of the cost of specific investments sold or written-down, and are credited or charged to income. Our Investments segment included net realized gains before tax of $35.5 million in 2006, compared to $14.5 million in 2005, and $24.6 million in 2004. The realized gains were principally from the sale of equity securities. Net realized gains in 2006 reflect the sale of several equity positions which resulted in re-weighting various sector exposures. Within the energy sector, we reduced our overweighted allocation by selling several positions that we felt had exceeded their fair value. During 2006 there were no impairment charges recorded. Net realized gains in 2005 also reflect the sale of certain long-term equity holdings, which were partially offset by an impairment charge from one write-down for other than temporary declines in fair value of $1.2 million. There were no impairment charges recorded in 2004. We maintain a high quality and liquid investment portfolio and the sale of the securities that resulted in realized gains did not change the overall liquidity of the investment portfolio. Our philosophy for sales of securities generally is to reduce our exposure to securities and sectors based upon economic evaluations or if the fundamentals for that security or sector have deteriorated and/or for tax planning purposes. We generally have a long investment time horizon and our turnover is low, which has resulted in many securities accumulating large unrealized gains. Every purchase or sale is made with the intent of improving future investment returns.
The following table summarizes the Companys net realized gains by investment type:
Generally, the Insurance Subsidiaries have a duration mismatch between assets and liabilities. The duration of the fixed maturity portfolio, including short-term investments, is 3.8 years while the Insurance Subsidiaries liabilities have a duration of approximately 3 years. The current duration of our fixed maturities is within our historical range and is monitored and managed to maximize yield and limit interest rate risk. The duration mismatch is managed with a laddered maturity structure and an appropriate level of short-term investments that avoids liquidation of available-for-sale fixed maturities in the ordinary course of business. Liquidity is always a consideration when buying or selling securities, but because of the high quality and active market for our investment portfolio, the securities sold have not diminished the overall liquidity of our portfolio. Our liquidity requirements in the past have been met by operating cash flow from our Insurance Operations and Diversified Insurance Services segments and the issuance of debt and equity securities. We expect our liquidity requirements in the future to be met by these sources of funds or, if necessary, borrowings from our credit facilities.
We realized gains and losses from the sale of available-for-sale debt and equity securities during 2006, 2005, and 2004. The following tables present the period of time that securities sold at a loss were continuously in an unrealized loss position prior to sale:
These securities were sold despite the fact that they were in a loss position. The decision to sell these securities was due to: (i) heightened credit risk of the individual security sold; (ii) the decision to reduce our exposure to certain issuers, industries or sectors in light of changing economic conditions; or (iii) tax purposes.
The following table summarizes the aggregate fair value and gross pre-tax unrealized loss recorded in our accumulated other comprehensive income, by asset class and by length of time, for all available-for-sale securities that have continuously been in an unrealized loss position at December 31, 2006 and December 31, 2005:
Broad changes in the overall market or interest rate environment generally do not lead to impairment charges. We believe the fluctuations in the fair value of fixed maturities and the increase in the associated gross unrealized loss since December 31, 2005 were primarily due to higher interest rates. As of December 31, 2006, there are 347 securities in an unrealized loss position.
The following table presents information regarding our available-for-sale fixed maturities that were in an unrealized loss position at December 31, 2006 by contractual maturity:
S&P earnings are expected to grow 9.5% in 2007, following an expected 16% increase in 2006 and 18% increase in 2005. The factors leading to this continued growth are lower energy prices, increased confidence in the economys job and income generating capacity, expectations of robust corporate capital expenditures, and continued healthy overseas demand for U.S. securities. However, given the uncertainty of the Federal Reserves monetary policy direction and international capital flows, we remain cautious on equity markets and we expect continued volatility in the fixed income market during 2007.
We believe that pre-tax investment income will continue to grow as a result of strong cash flow from our Insurance Operations. Given the current interest rate environment, which is marked by a very flat yield curve, we intend to maintain a fairly stable portfolio duration on our fixed income portfolio. We will also continue to make new investment decisions on our fixed income portfolio that are relatively duration neutral to the portfolio as a whole as we continue to dollar-cost average our reinvestment yields. With regard to our equity portfolio, we are committed to pursuing opportunities in industries with favorable fundamentals and will continue to reduce exposure to those stocks or sectors with less favorable fundamentals and valuations. Our Other investment portfolio has performed well over the past few years. As a result of favorable risk return characteristics for these investments, we are looking to modestly grow this investment class as a percentage of our overall portfolio, which should contribute to lowering our overall portfolio risk given that these investments have a low correlation to the S&P 500 Index.
Diversified Insurance Services Segment
The Diversified Insurance Services operations include two core functions: (i) human resource administration outsourcing (HR Outsourcing); and (ii) flood insurance. We believe these operations are within markets that continue to offer opportunity for growth. During 2006, these operations provided a contribution of $0.19 per diluted share, compared to $0.15 per diluted share in 2005. These operations continue to provide a level of mitigation to commercial lines pricing cycles. We measure the performance of these operations based on several measures, including, but not limited to, results of operations in accordance with GAAP. The results for this segments continuing operations are as follows:
Pre-tax profit increased as a result of the following:
These increases were partially offset by a decrease in the fee paid to us by the NFIP, which was effective for the NFIPs fiscal year beginning on October 1, 2006, to 30.2% from 30.8%.
In December 2005, we divested ourselves of our 100% ownership in CHN Solutions (Alta Services, LLC and Consumer Health Network Plus, LLC), which had historically been reported as part of the managed care component of the Diversified Insurance Services segment. These companies were sold for approximately $16 million in proceeds at an after-tax net loss of approximately $2.6 million. For further information regarding this divestiture, see Note 15 in Item 8. Financial Statements and Supplementary Data of this Form 10-K.
Diversified Insurance Services Outlook
Our HR Outsourcing products offer an additional potential agency revenue stream for our independent agents. New market entrants will continue to create increased competition for these products. We have repositioned the HR Outsourcing products as the EPP, which assists business owners in managing the risk of employee-related liabilities. Agent training regarding the EPP is ongoing and based on initial positive feedback, we expect to continue to recognize synergies created from this product in 2007.
The National Council on Compensation Insurance (NCCI) has passed an overall workers compensation rate level decrease of 15.7% for voluntary industrial classes in the State of Florida. The new rates were effective on January 1, 2007 for new and renewal business. Future reductions in this rate could adversely affect our results of operations for our HR Outsourcing business as workers compensation insurance is an important component of the EPP product.
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 agencys 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.
As described above, the fee paid to us by the NFIP decreased 0.6 points to 30.2% of premiums written effective October 1, 2006. Future reductions in this rate could occur through legislative activity.
Financial Condition, Liquidity and Capital Resources
Capital resources and liquidity represent our overall financial strength and our ability to generate cash flows from business operations, borrow funds at competitive rates, and raise new capital to meet operating and growth needs.
Liquidity is a measure of our ability to generate sufficient cash flows to meet the short and long-term cash requirements of our business operations. Our cash and short-term investments position at December 31, 2006 was $203.5 million compared to $188.1 million at December 31, 2005. Sources of cash consist of dividends from our subsidiaries, the issuance of debt and equity securities, as well as the sale of Common Stock under our employee and agent stock purchase plans. However, our ability to receive dividends from our subsidiaries is restricted. Dividends from our Insurance Subsidiaries to the parent company are subject to the approval and/or review of the insurance regulators in the respective domiciliary states of the Insurance Subsidiaries under insurance holding company acts, and are generally payable only from earned surplus as reported in the statutory annual statements of those subsidiaries as of the preceding December 31. Based on the 2006 unaudited statutory financial statements, the Insurance Subsidiaries are permitted to pay to us, in 2007, ordinary dividends in the aggregate amount of approximately $141.9 million. For additional information regarding dividend restrictions, refer to Note 9, Indebtedness and Note 10, Stockholders Equity of the Notes to Consolidated Financial Statements, included in Item 8. Financial Statements and Supplementary Data of this form 10-K.
Our Insurance Subsidiaries generate cash flows primarily from insurance float. Float is money that an insurance company holds for a limited time. In an insurance operation, float arises because premiums are collected before losses are paid. This interval can extend over many years. During that time, the insurer invests the money and generates investment income. The duration of the fixed maturity portfolio, including short-term investments, was 3.8 years as of December 31, 2006, while the liabilities of our Insurance Subsidiaries have a duration of approximately 3 years. To provide liquidity while maintaining consistent performance, we ladder our fixed maturity investments so that some issues are always approaching maturity and provide a source of predictable cash flow for claim payments in the ordinary course of business. In addition, the Insurance Subsidiaries purchase reinsurance coverage for protection against any significantly large claims or catastrophes that may occur during the year. Our consolidated investment portfolio was $3.6 billion as of December 31, 2006 and $3.2 billion as of December 31, 2005.
During 2006, Selective had revolving lines of credit with State Street Corporation of $20 million and Wachovia Bank of $25 million, under which no balances were outstanding during the year. In August 2006, these lines of credit were replaced with a syndicated line of credit agreement with Wachovia Bank, National Association as administrative agent. Under this new agreement, Selective has access to a $50 million credit facility, which can be increased to $75 million with the consent of all lending parties. Through December 31, 2006, no balances were outstanding under this credit facility.
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 companys 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.
Dividends on shares of our Common Stock are declared and paid at the discretion of our Board of Directors based on the Companys operating results, financial condition, capital requirements, contractual restrictions, and other relevant factors. Our ability to declare dividends is restricted by covenants contained in the notes payable that we issued on May 4, 2000 (the 2000 Senior Notes). All such covenants were met during 2006 and 2005. For further information regarding our notes payable, see Note 9 of the Notes to Consolidated Financial Statements, entitled, Indebtedness, included in Item 8. Financial Statements and Supplementary Data. At December 31, 2006, the amount available for dividends to holders of our Common Stock, in accordance with the restrictions of the 2000 Senior Notes, was $384.2 million. On March 1, 2007, for stockholders of record as of February 13, 2007, we have increased our dividend by 9% to $0.12 per share. Book value per share increased 8% to $18.81 in 2006 from $17.34 in 2005, and increased 19% compared to 2004, when it was $15.79. Our ability to continue to pay dividends to our stockholders is also dependent in large part on the dividend paying ability of our Insurance Subsidiaries and the subsidiaries in our Diversified Insurance Services segment to pay dividends to the parent company. Restrictions on the ability of our subsidiaries, particularly the Insurance Subsidiaries, to declare and pay dividends to the parent company could materially affect our ability to pay principal and interest on indebtedness and dividends on Common Stock.
Our liquidity requirements in the past have been met by dividends from our subsidiaries as well as the issuance of debt and equity securities. In the future, we expect our liquidity requirements to be met by these sources of funds. The Insurance Subsidiaries liquidity requirements have historically been met by cash receipts from operations, consisting of insurance premiums and investment income. These cash receipts have historically provided more than sufficient funds to pay losses, operating expenses, and dividends to the parent company.
Capital resources provide protection for policyholders, furnish the financial strength to support the business of underwriting insurance risks, and facilitate continued business growth. At December 31, 2006, we had stockholders equity of $1,077.2 million and total debt of $362.6 million. In addition, we have an irrevocable trust valued at $31.3 million to provide for the repayment of notes having maturities in 2007 and 2008.
As active capital managers, we continually monitor our cash requirements as well as the amount of capital resources that we maintain at the holding company and operating subsidiary levels. As part of our long-term capital strategy, we strive to maintain a 25% debt-to-capital ratio and a premiums to surplus ratio sufficient to maintain an A+ (Superior) financial strength A.M. Best rating for our Insurance Subsidiaries. Based on our analysis and market conditions, we may take a variety of actions including, but not limited to, contributing capital to the subsidiaries in our Insurance Operations and Diversified Insurance Services segments, issuing additional debt and/or equity securities, repurchasing shares of our Common Stock, or increasing stockholders dividends. The following are a few examples of capital management actions we have taken during 2006:
Our cash requirements include principal and interest payments on senior convertible notes, various notes payable and convertible subordinated debentures, dividends to stockholders, payment of claims, and other operating expenses, income taxes, the purchase of investments, and other expenses. Our operating obligations and cash outflows include: claim settlements, agents commissions, labor costs, premium taxes, general and administrative expenses, investment purchases, and capital expenditures. For further details regarding our cash requirements, refer to the section below titled Contractual Obligations and Contingent Liabilities and Commitments.
Off-Balance Sheet Arrangements
At December 31, 2006 and 2005, the Company did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As such, the Company is not exposed to any financing, liquidity, market or credit risk that could arise if the Company had engaged in such relationships.
Contractual Obligations and Contingent Liabilities and Commitments
We maintain case reserves and estimates of reserves for losses and loss expenses incurred but not yet reported (IBNR), in accordance with industry practice. Using generally accepted actuarial reserving techniques, we project our estimate of ultimate losses and loss expenses at each reporting date. Included within the estimate of ultimate losses and loss expenses are case reserves, which are analyzed on a case-by-case basis by the type of claim involved, the circumstances surrounding each claim, and the policy provisions relating to the type of losses. The difference between: (i) projected ultimate loss and loss expense reserves; and (ii) case loss reserves and loss expense reserves thereon are carried as the IBNR reserve. A range of possible reserves is determined annually and considered in addition to the most recent loss trends and other factors in establishing reserves for each reporting period. Based on the consideration of the range of possible reserves, recent loss trends and other factors, IBNR is established and the ultimate net liability for losses and loss expenses is determined. Such an assessment requires considerable judgment given that it is frequently not possible to determine whether a change in the data is an anomaly until sometime after the event. Even if a change is determined to be permanent, it is not always possible to reliably determine the extent of the change until sometime later. As a result, 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.
Given that the loss and loss expense reserves are estimates as described above and in more detail under the Critical Accounting Policies and Estimates section of Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations, of this Form 10-K, the payment of actual losses and loss expenses is generally not fixed as to amount or timing. Due to this uncertainty, financial accounting standards prohibit us from discounting these reserves to their present value. Additionally, estimated losses as of the financial statement date do not consider the impact of estimated losses from future business. Therefore, the projected settlement of the reserves for net loss and loss expenses will differ, perhaps significantly, from actual future payments.
The information in the Contractual Obligations table below relating to loss and loss expense payments is presented in accordance with reporting requirements of the SEC. These projected paid amounts by year are estimates based on past experience, adjusted for the effects of current developments and anticipated trends, and include considerable judgment. There is no precise method for evaluating the impact of any specific factor on the projected timing of when loss and loss expense reserves will be paid and as a result the timing and amounts of the actual payments will be affected by many factors. Care must be taken to avoid misinterpretation by those unfamiliar with this information or familiar with other data commonly reported by the insurance industry. As was noted above, for further information regarding the uncertainty associated with loss and loss expense reserves see the Critical Accounting Policies and Estimates section of Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations of this form 10-K.
Our future cash payments associated with contractual obligations pursuant to operating leases for office space and equipment, senior convertible notes, convertible subordinated debentures, notes payable, interest on debt obligations, and loss and loss expenses as of December 31, 2006 are summarized below:
See Liquidity section of Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations for a discussion of the Companys syndicated line of credit agreement.
At December 31, 2006, we had additional limited partnership investment commitments within Other investments of up to $110.5 million; but there is no certainty that any such additional investment will be required. We have issued no material guarantees on behalf of others and have no trading activities involving non-exchange traded contracts accounted for at fair value. We have no material transactions with related parties other than those disclosed in Note 19 of the Notes to Consolidated Financial Statements, included in Item 8. Financial Statements and Supplementary Data of this Form 10-K.
We are rated by major rating agencies, which provide opinions of our financial strength, operating performance, strategic position, and ability to meet policyholder obligations. The principal agencies that issue financial strength ratings for the property and casualty insurance industry are: A.M. Best, S&P, Moodys Investor Service (Moodys), and Fitch Ratings (Fitch). We believe that our ability to write insurance business is most influenced by our rating from A.M. Best. Currently, we are rated A+ (Superior) by A.M. Best, which is their second highest of fifteen ratings. Our insurance business has been rated A+ (Superior) by A.M. Best for 45 consecutive years. The financial strength reflected by our A.M. Best rating is a competitive advantage in the marketplace and influences where independent insurance agents place their business. A downgrade from A.M. Best, could: (i) affect our ability to write new business with customers, some of whom are required (under various third party agreements) to maintain insurance with a carrier that maintains a specified A.M. Best minimum rating; (ii) be an event of default under our line of credit; or (iii) make it more expensive for us to access capital markets. On July 25, 2006, S&Ps Insurance Rating Services raised our financial strength rating to A+ from A, citing our strong operating performance, strong operating company capitalization, and good financial flexibility. During the third quarter of 2006, Moodys elevated their outlook regarding Selective to positive. The financial strength of our insurance business has been rated, A2 by Moodys since 2001 and A+ by Fitch since 2004. Our Moodys and S&P financial strength ratings affect our ability to access capital markets and our interest rate under our line of credit varies based upon SIGIs debt ratings from Moodys and S&P. There can be no assurance that our ratings will continue for any given period of time or that they will not be changed. It is possible that positive or negative ratings actions by one or more of the rating agencies may occur in the future. We review our financial debt agreements for any potential rating triggers that could dictate a material change in terms if our credit ratings were to change.
Federal Income Taxes
The following table presents the Companys taxable income, pre-tax financial statement income, and net deferred tax (liability) asset:
The total federal income tax expense increased $1.6 million in 2006 to $56.9 million, compared to $55.3 million in 2005, and $45.6 million in 2004. These amounts reflect an effective tax rate of 25.8% in 2006 compared to 27.3% in 2005, and compared to 26.4% for 2004. The effective rate differs from the federal corporate tax rate of 35% primarily as a result of tax-exempt investment income and the dividends received deduction. The decrease in the effective tax rate in 2006, as compared to 2005 and 2004, is mainly attributable to: (i) an increase in the tax advantaged securities within our investment portfolio; (ii) a current income tax benefit recorded in 2006 as a result of the Company settling research and development credits with the Internal Revenue Service (IRS); and (iii) additional alternative minimum tax credits that became available. The increase in the 2005 effective tax rate, as compared to 2004, is mainly attributable to significant improvements in underwriting results and increased capital gains on investment sales.
The Company has a net deferred tax asset of $15.4 million at December 31, 2006 compared with a deferred tax liability of $5.7 million at December 31, 2005. This change is primarily due to temporary differences relating to pension, deferred compensation, the deferred impact of underwriting results, unrealized gains in the investment portfolio, and debt conversion.
Adoption of Accounting Pronouncements
For information concerning the adoption of accounting pronouncements and new accounting pronouncements that have been issued but not yet adopted, see Item 8. Financial Statements and Supplementary Data. Note 3 to the consolidated financial statements.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The fair value of Selectives assets and liabilities are subject to market risk, primarily interest rate, and equity price risk related to Selectives investment portfolio. Selectives investment portfolio is comprised of securities categorized as available for sale or held to maturity in accordance with the Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, issued by the Financial Accounting Standards Board (FAS 115), with no investment in securities categorized as trading. Selective does not hold derivative or commodity investments. Foreign investments are made on a limited basis, and all fixed maturity transactions are denominated in U.S. currency. Selective has minimal foreign currency fluctuation risk on certain equity securities.
Selectives investment philosophy includes certain return objectives relating to the equity and fixed maturity portfolios as well as risk objectives relating to the overall portfolio. The return objective of the equity portfolio is to meet or exceed a weighted-average benchmark of public equity indices. The primary return objective of the fixed maturity portfolio is to maximize after-tax investment yield and income while balancing certain risk objectives, with a secondary objective of meeting or exceeding a weighted-average benchmark of public fixed income indices. The risk objectives for all portfolios are to ensure investments are being structured conservatively, focusing on: (i) asset diversification; (ii) investment quality; (iii) liquidity, particularly to meet the cash obligations of the insurance operations; (iv) consideration of taxes; and (v) preservation of capital. As of December 31, 2006, the mix of Selectives investment portfolio was 82% fixed maturity securities, 9% equity securities, 5% short-term investments, and 4% other investments.
There were no significant changes in the primary market risk exposures for Selectives overall investment portfolio for the year ended December 31, 2006 compared to the prior year. Selective does not anticipate any significant changes in market risk in the foreseeable future or in how it will manage that risk.
Interest Rate Risk
In connection with the Insurance Subsidiaries, Selective invests in interest rate sensitive securities, mainly fixed maturity securities. Selectives fixed maturity portfolio is comprised of primarily investment grade (investments receiving a rating of 1 or 2 from the NAICs Securities Valuation Office) corporate securities, U.S. government and agency securities, municipal obligations, and mortgage-backed securities. Selectives strategy to manage interest rate risk is to purchase intermediate-term fixed maturity investments that are attractively priced in relation to perceived credit risks. Selectives fixed maturity securities include both available-for-sale and held-to-maturity securities in accordance with FAS 115. Fixed maturity securities that are not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders equity. Those fixed maturity securities that Selective has the ability and positive intent to hold to maturity are classified as held-to-maturity and carried at amortized cost.
Selective generally manages its interest rate risk associated with its portfolio of fixed maturity investments by monitoring the average duration of the portfolio, which allows Selective to achieve an adequate yield without subjecting the portfolio to an unreasonable level of interest rate risk. Increases and decreases in prevailing interest rates generally translate, respectively, into decreases and increases in fair values of fixed maturity investments. Fair values of interest rate sensitive instruments also may be affected by the credit worthiness of the issuer, prepayment options, relative values of other investments, the liquidity of the instrument, and other general market conditions. At December 31, 2006, 97% of Selectives fixed maturity portfolio (excluding short-term investments) had a maturity of less than ten years, and the average duration was 4.1 years. Based on its fixed maturity securities asset allocation and security selection process, Selective believes that its fixed maturity portfolio is not overly prone to prepayment or extension risk.
Selective uses interest rate sensitivity analysis to measure the potential loss or gain in future earnings, fair values, or cash flows of market sensitive fixed maturity securities and preferred stock. The sensitivity analysis hypothetically assumes a parallel 200 basis point shift in interest rates up and down in 100 basis point increments within one year from the date of the consolidated financial statements. Selective uses fair values to measure its potential loss.
This analysis is not intended to provide a precise forecast of the effect of changes in market interest rates and equity prices on Selectives income or stockholders equity. Further, the calculations do not take into account any actions Selective may take in response to market fluctuations.
The following table presents the sensitivity analysis of each component of market risk as of December 31, 2006:
Equity Price Risk
Selectives equity securities are classified as available for sale in accordance with FAS 115. The Companys portfolio of equity securities is exposed to equity price risk arising from potential volatility in equity market prices. Selective attempts to minimize the exposure to equity price risk by maintaining a diversified portfolio and limiting concentrations in any one company or industry. The sensitivity analysis hypothetically assumes a 20% change in equity prices up and down in 10% increments at December 31, 2006. In the analysis, we include investments in equity securities. The following table presents the hypothetical increases and decreases in market value of the equity portfolio as of December 31, 2006:
(a) Long-Term Debt. As of December 31, 2006, Selective had outstanding long-term debt of $362.6 million that mature as shown on the following table:
The weighted average effective interest rate for Selectives outstanding long-term debt is 6.94%. Selective is not exposed to material changes in interest rates because the interest rates are fixed on its long-term indebtedness.
(b) Short-Term Debt. During 2006, Selective had revolving lines of credit with State Street Corporation of $20 million and Wachovia Bank of $25 million, under which no balances were outstanding during the year. In August 2006, these lines of credit were replaced with a syndicated line of credit agreement with Wachovia Bank, National Association as administrative agent. Under this agreement, Selective has access to a $50 million credit facility, which can be increased to $75 million with the consent of all lending parties. Through December 31, 2006, no balances were outstanding under this credit facility.
There were no borrowings in 2006 and 2005 against any of the lines of credit.
Item 8. Financial Statements and Supplementary Data.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Selective Insurance Group, Inc.:
We have audited the accompanying consolidated balance sheets of Selective Insurance Group, Inc. and its subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders equity, and cash flows for each of the years in the three-year period ended December 31, 2006. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules I to VI. These consolidated financial statements and financial statement schedules are the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
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, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, 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.
As discussed in Note 2 to the consolidated financial statements, in 2006 the Company changed its definition of cash equivalents for presentation in the statement of cash flows and, in 2005, changed its method of accounting for share-based payments.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Selective Insurance Group, Inc.s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 28, 2007 expressed an unqualified opinion on managements assessment of, and the effective operation of, internal control over financial reporting.
/s/ KPMG LLP
New York, New York
February 28, 2007
Consolidated Balance Sheets
See accompanying notes to consolidated financial statements.
Consolidated Statements of Income
Years ended December 31,
See accompanying notes to consolidated financial statements.
Consolidated Statements of Stockholders Equity
Years ended December 31,