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Selective Insurance Group 10-K 2008 Documents found in this filing:
Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
FORM 10-K
(Mark one)
For the fiscal year ended December 31, 2007
OR
For the transition period from to .
Commission file number 0-8641
SELECTIVE INSURANCE GROUP, INC.
(Exact name of registrant as specified in its charter)
Registrant’s telephone number, including area code: (973) 948-3000
Securities registered pursuant to Section 12(b) of the Act:
Preferred Share Purchase Rights
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.
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or
Section 15(d) of the Act.
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.
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 registrant’s 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, a
non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated
filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
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
$1,393,617,821 on June 30, 2007.
As of February 15, 2008, the registrant had outstanding 53,869,967 shares of Common Stock.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s definitive Proxy Statement for the 2008 Annual Meeting of Stockholders
to be held on April 24, 2008 are incorporated by reference into Part III of this report.
SELECTIVE INSURANCE GROUP, INC.
Table of Contents
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PART I
Item 1. Business.
Overview
Selective Insurance Group, Inc., through its subsidiaries, (collectively known as “Selective” or
“the Company”) offers property and casualty insurance products and diversified insurance services
and products. Selective Insurance Group, Inc. was incorporated in New Jersey in 1977 and its main
offices are located in Branchville, New Jersey. Selective Insurance Group, Inc.’s Common Stock is
publicly traded on the NASDAQ Global Select Market under the symbol, “SIGI.”
Selective classifies its business into three operating segments:
Financial information about Selective’s three operating segments is contained in this report in
Item 7. “Management’s 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
Selective’s Insurance Operations sell property and casualty insurance policies, which are contracts
to cover losses for specified risks in exchange for premiums. Property insurance generally covers
the financial consequences of accidental loss to the insured’s 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 insured’s negligent acts, omissions, or legal liabilities. Casualty claims often take
years to be reported and settled.
Selective’s 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 pooled financial strength ratings by A.M. Best Company, Inc.
(“A.M. Best”), and state of domicile by which each is primarily regulated:
In 2007, A.M. Best, in its list of “Top Property/Casualty Writers,” ranked Selective the
46th largest property and casualty group in the United States based on the combined net
premiums written (“NPW”) for 2006.
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Insurance Operations
Selective’s 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 NPW. NPW is recognized as revenue as net premiums earned
(“NPE”) ratably over the term 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.
Selective’s 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 Subsidiary’s
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 and 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 an underwriting profit and a statutory
combined ratio over 100% generally indicates 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 several 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 Selective’s
insurance business.
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The following table shows the statutory results of the Insurance Operations segment for the last
three completed fiscal years:
Historically, Selective has produced a lower statutory combined ratio than the property and
casualty insurance industry, and outperformed the industry average for the past 10-year period by
2.3 points. The table below sets forth a comparison of certain Company and industry statutory
ratios:
Lines of Business and Products
Selective’s Insurance Operations segment includes commercial lines (“Commercial Lines”), which
markets primarily to businesses and represents approximately 87% of Selective’s NPW; and personal
lines (“Personal Lines”), which markets primarily to individuals and represents approximately 13%
of NPW.
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Commercial Lines
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
Personal Lines underwrites and issues insurance policies for personal automobile, homeowners, and
other various risks.
Regional Geographic Market Focus
Selective’s Insurance Operations segment primarily focuses its marketing efforts and sells its
products and services in the Eastern and Midwestern regions of the United States. Although still
concentrated in coastal eastern states, this geographic diversification lessens Selective’s
exposure to regulatory, competitive and 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 Selective’s total NPW
that such state represents for the last three fiscal years.
Independent Insurance Agent Distribution Model
According to a study done by the Independent Insurance Agents and Brokers of America, in 2005,
independent insurance agents and brokers wrote approximately 80% of commercial property and
casualty insurance and approximately 36% 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, including efforts to assist in the hiring and training of producers. In addition,
Selective carefully monitors each agent’s profitability, growth, financial stability, staff, and
mix of business against plans that are developed annually with the agent. In developing annual
plans with its independent insurance agents, Selective’s 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 Selective’s technology advantages.
As of December 31, 2007, Selective’s Insurance Subsidiaries had entered into agency agreements with
approximately 880 independent insurance agents having approximately 1,800 storefronts pursuant to
these agreements. The agents are authorized to sell policies written by the Insurance Subsidiaries
and are paid 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 volume and underwriting results of
the business the agent writes with Selective.
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Technology and Field Model Business Strategy
Selective uses the service mark “High Tech x High Touch = HT2®” 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, technical or technology staff, and safety management representatives in the field
near its agents and customers.
Technology
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 2007, Applied Systems Client Network presented Selective with the “2007
Commercial Lines Interface Carrier of the Year Award” for promoting efficient communication between
insurance carriers and independent agents. Applied Systems is a provider of automated solutions
for property and casualty insurance agents. The award was given in recognition of Selective’s
excellent work to implement download and real-time interface technology with independent agents
through its xSELerate® agency integration technology. Selective also received the 2007
Quantum Award from the AMS Users’ Group, another major provider of automated management solutions
for agents, for creating technology that enables independent agents to make a quantum leap in
productivity and profitability. This award was granted to Selective for increasing productivity
and efficiency for its independent insurance agents through its xSELerate® agency
integration technology. Additionally, Selective was recognized as a model carrier component by
Celent, an IT consulting group, for its effective use of its xSELerate® 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. Selective’s senior management meets monthly with the PMO to review all major
projects and report on the status of other projects. Selective believes that the PMO is a factor
in the success of its technology implementation and is a competitive advantage. Selective’s
technology operations are located in Branchville, New Jersey; Glastonbury, Connecticut; and
Sarasota, Florida.
Field Strategy
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 six regional branch
offices (“Region”), which as of December 31, 2007 were as follows:
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As of December 31, 2007, Selective’s field force included:
Underwriting
Selective seeks to underwrite a variety of insurance risks and divides its markets into three
segments:
Selective’s underwriting process requires communication and interaction among:
Selective also has an underwriting service center (“USC”) located in Richmond, Virginia. The USC
assists Selective’s agents by servicing small to mid-sized business customers. During 2006, the
USC became available to personal lines business customers of our New Jersey agents, with a rollout
to Selective’s 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 $33
million. The total $103 million serviced represents 7% of total net premiums written.
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Selective believes that a distinct advantage of its field underwriting model is its ability to
provide a wide range of front-line safety management services focused on improving the
policyholder’s safety and risk management programs, as expressed by its service mark “Safety
Management: Solutions for a safer workplaceSM”. Safety management services include: (i)
risk evaluation and improvement surveys intended to evaluate potential exposures and provide
solutions for mitigation; (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. Risk improvement efforts for existing customers are designed to improve loss experience
and policyholder retention through valuable ongoing consultative service. Selective’s safety
management goal is to partner with its policyholders to identify and eliminate potential loss
exposures.
Selective analyzes its underwriting profitability by line of business, account, product, agency and
other bases. Selective’s 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.
Selective’s claims practices emphasize the maintenance of timely and adequate claims reserves, 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 investigations 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 Selective’s practice to notify the proper
authorities of its findings. This practice sends a clear message that Selective will not tolerate
fraudulent activity committed against it 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 Selective’s 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 Selective’s 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. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this
Form 10-K for a full discussion regarding Selective’s loss reserving process.
Selective’s loss and loss expense reserve development over the proceeding 10 years is shown on the
following table.
Section I of the 10-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’s 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.
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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, 2007. 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, 2007.
This table does not present accident or policy year development data. 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.
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Selective experienced favorable prior year development in 2007 and 2006 of $18.8 million and $7.3 million, respectively. In 2005, prior year adverse development was $5.1 million. The following paragraphs provide information regarding
the development in each of these calender years.
Selective experienced overall favorable development in its loss and loss expense reserves totaling
$18.8 million in 2007, which was primarily driven as follows:
Selective’s 2006 overall favorable loss and loss expense reserve development was driven by the following:
During the course of 2005, Selective 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, Selective had accumulated sufficient evidence to change
management’s best estimate of loss reserves for these lines. Accordingly, Selective took the
following actions:
The adverse judicial ruling by the New Jersey Supreme Court in the second quarter of 2005 that
eliminated the application of the serious life impact standard to personal automobile bodily injury
liability cases under the verbal tort threshold of the New Jersey Automobile Insurance Cost
Reduction Act (“AICRA”) led to an increase in personal automobile reserves of approximately $10
million, of which $6 million represents adverse development from prior years.
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The cumulative loss and loss expense reserve net deficiencies seen in the years 1998 through 2003
are generally reflective of the soft market pricing in the industry during that time frame, which
hit the lowest levels in 1999. The property and casualty insurance 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 under personal injury protection provisions of
personal automobile policies ceded to the Unsatisfied Claim and Judgment Fund in the State of New
Jersey. Approximately 18% of the cumulative gross deficiency for years 1998 and prior stems from
this increase.
The following table reconciles losses and loss expense reserves under SAP and GAAP at December 31,
as follows:
Environmental Reserves
Reserves established for liability insurance include exposure to environmental claims, both
asbestos and non-asbestos. Selective’s exposure to environmental liability is primarily due to: (i)
policies written prior to the introduction of the absolute pollutions endorsement in the
mid-1980’s; and (ii) underground storage tank leaks, mostly from New Jersey homeowners policies in
recent years. Selective’s asbestos and non-asbestos environmental claims have arisen primarily
from insured exposures in municipal government, small non-manufacturing commercial risks, and
homeowners policies. The emergence of these claims is slow and highly unpredictable.
“Asbestos claims” are claims presented to Selective 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, 2007, asbestos claims constituted 89% of Selective’s
2,448 environmental claims compared with 88% of Selective’s 2,575 outstanding environmental claims
at December 31, 2006.
“Non-asbestos claims” are pollution and environmental claims alleging bodily injury or property
damage presented, or expected to be presented to Selective, 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 Selective’s environmental claim unit’s
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 and specialized environmental claim
unit. 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. Historically, Selective’s environmental claims have been significantly
less volatile and uncertain than other competitors in 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.
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Reinsurance
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, 2014 via the Terrorism Risk Insurance Program Reauthorization Act of 2007. 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
reinsurer’s 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
22% of stockholders equity at December 31, 2007 compared to 19% at December 31, 2006. These
balances, net of available collateral, were 18% of stockholders equity at December 31, 2007
compared to 15% at December 31, 2006. Federal or state sponsored pools, which Selective believes
to have minimal default risk, represented approximately 44% at December 31, 2007 and 50% at
December 31, 2006 of the uncollateralized reinsurance recoverable on paid and unpaid balance. The
following are the five largest individual uncollateralized reinsurance recoverables on paid and
unpaid balances:
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The table below summarizes the significant reinsurance treaties covering the Insurance
Subsidiaries.
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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
Subsidiary’s name on the table below:
Insurance Regulation
General
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 company’s business and financial condition. The primary public purpose of such
supervision and regulation is to protect the insurer’s policyholders, not the insurer’s
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 insurance industry is primarily regulated by individual states, federal initiatives
can have an impact on the industry, such as the federal government’s enactment and extension of
TRIA, the enforcement of economic and trade sanctions by the Office of Foreign Assets Control, and
the proposal for an optional federal charter that would allow companies to choose between state
regulation and national regulatory structure that would eliminate the need to comply with 51 sets
of different regulations.
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.
State Regulation
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.
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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 insurer’s
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 2007 statutory financial statements
for the Insurance Subsidiaries, each Insurance Subsidiary’s total adjusted capital substantially
exceeded two times their Authorized Control Level.
Investments Segment
Selective’s investment philosophy includes setting certain return and risk objectives for its
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. The risk objectives for all portfolios 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. At December 31, 2007, Selective’s investment portfolio consisted of
$3,079.3 million (83%) of fixed maturity securities, $274.7 million (7%) of equity securities,
$190.2 million (5%) of short-term investments, and $188.8 million (5%) of other investments.
Selective’s 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 & Poor’s (“S&P”), their second highest credit quality rating. Selective expects to
continue to invest primarily in high quality, fixed maturity investments in order to reduce
volatility of the portfolio and to maximize after-tax investment yield. For further information
regarding Selective’s interest rate sensitivity as well as other risks associated with its
portfolio, 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
$190.2 million at December 31, 2007 and $197.0 million at December 31, 2006, was 3.9 years at
December 31, 2007 and 3.8 years at December 31, 2006.
Selective’s Investments segment operations are based primarily 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. “Management’s
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.
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Diversified Insurance Services Segment
Selective’s Diversified Insurance Services segment provides fee-based revenues that are expected to
contribute to earnings, increase operating cash flow, and help mitigate potential volatility in
insurance operating results. The Diversified Insurance Services segment is complementary to
Selective’s 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 (“Selective HR”), which are headquartered in
Sarasota, Florida. Selective HR’s customers are small businesses who generally have existing
relationships with independent insurance agents. Selective HR 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”), Selective HR enters
into agreements with clients that establish a three-party relationship under which Selective HR and
the client are co-employers of the employees who work at the client’s location (“worksite
employees”). As of December 31, 2007, Selective HR had approximately 25,111 worksite employees,
39% of which are from the state of Florida.
Flood Insurance
Selective is a servicing carrier in the “Write-Your-Own” (“WYO”) Program of the United States
government’s 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 part 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 299,000 flood
policies under the NFIP through over 5,900 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, Selective HR 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, Selective HR 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 Selective HR 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 Selective HR will be able to satisfy new or revised
laws and regulations.
The viability of the NFIP’s reinsurance program under the WYO Program is an essential component of
Selective’s Diversified Insurance Services operations. In 2005, the destruction caused by the
active hurricane season stressed the NFIP with excessive levels of flood losses. Selective
continues to monitor developments with the NFIP regarding its ability to pay claims in the event of
another large-scale disaster. Congress controls the federal agency’s funding authority, which was
exceeded after Hurricane Katrina, and is again nearing maximum capacity. Bills are pending in the
House and Senate that could impact the NFIP. These bills contain substantial legislative changes
and revisions to the NFIP and WYO Program, some of which may be favorable and some of which may be
unfavorable for Selective. For additional information regarding regulation of flood insurance see
Item 1A. “Risk Factors” of this Form 10-K.
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Competition
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 2007, Selective was ranked as the
46th largest property and casualty group in the United States based on the 2006 NPW, by
A.M. Best in its list, “Top Property/Casualty Writers.” The Insurance Operations compete with
regional insurers, such as Cincinnati Financial and Harleysville, and national insurance companies,
such as Travelers, The Hartford, and Zurich. Selective also competes against direct writers of
insurance coverage, including insurance offered through competitors’ internet websites. These
writers offer coverage primarily in personal lines, such as GEICO and Progressive. Many of these
competitors have greater financial and operating resources than Selective. Many of them also have
more customers, which provide them with more information regarding their risks and, with the use of
statistical and computer models, may give them greater ability to make pricing and underwriting
decisions. 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 Selective’s 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, according to the most recent published
information, Selective HR 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 2006 information, Selective’s 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,” of this Form 10-K for a discussion of the factors that
could impact Selective’s ability to compete.
Seasonality
Selective’s 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 nor’easters.
Customers
No one customer or independent agency accounts for 10% or more of Selective’s total revenue or the
revenue of any one of its business segments.
Employees
At December 31, 2007, Selective had approximately 2,200 employees, of which 2,000 worked in the
Insurance Operations and Investments segments and 200 worked in the Diversified Insurance Services
segment.
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Executive Officers of the Registrant
The following table sets forth biographical information about Selective’s Chief Executive Officer,
Executive Officers, and senior management, as of February 28, 2008:
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Available
Information
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 SEC’s 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.
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Item 1A. Risk Factors
Certain risk factors exist that can have a significant impact on Selective’s 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 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.
Selective’s 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, 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
Selective’s results of operations, liquidity, financial condition and financial strength, and debt
ratings. Selective’s 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 ultimate liability for settlement of
claims. Selective regularly reviews its reserving techniques and its overall amount of reserves.
For more information regarding reserves, see the section entitled “Reserve for Losses and Loss
Expenses” in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of
Operations” of this Form 10-K. The Company also reviews:
Selective cannot be certain that the reserves it establishes are adequate or will be adequate in
the future.
Selective is subject to a variety of operational risks which could have a material adverse impact
on Selective’s business results.
Selective relies on complex financial models which have been developed internally and by third
parties to analyze historical loss costs and pricing, trends in claim severity and frequency, the occurrence of catastrophe losses, and investment performance. Flaws in these financial
models and/or faulty assumptions used by these financial models could lead to increased losses and
loss reserving. Examples of these various models are Risk Management Solutions, the ALGO risk
tool, and predictive modeling.
Catastrophic events.
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. Selective’s
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, some of which may be related to climate changes. 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 Selective’s Insurance Subsidiaries historically have been related
to commercial property and homeowners coverages. Selective’s property and casualty insurance
business is concentrated geographically in the Eastern and Midwestern regions of the United States.
New Jersey accounts for 30% of the Company’s total net premiums written.
Selective’s Insurance Subsidiaries seek to reduce their exposure to catastrophe losses through the
purchase of catastrophe reinsurance. Reinsurance, however, may prove inadequate if:
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The property and casualty insurance industry is cyclical.
Historically, the results of the property and casualty insurance industry have experienced
significant fluctuations due to economic conditions, interest rates, and other factors, such as,
competition. For example, the competitors pricing business below technical levels could force the
Company to reduce its profit margin in order to protect its best business. Selective has
experienced the following fluctuations in Commercial Lines premium pricing, excluding exposure
(“pure price”), over the past several years:
As an example of pricing and loss trends on the combined ratio, 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.
The industry’s profitability also is affected by unpredictable developments, including:
Selective competes with regional and national property and casualty insurance companies, including
public and mutual companies, some of which do not use independent agents and write directly with
insureds. Many of these competitors are larger than Selective and have greater financial and
operating resources, as well as greater information scale. The Internet has also emerged as a
significant place 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. 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.
Selective also faces competition, primarily in the commercial insurance market, from entities that
self-insure their own risks. Many of Selective’s customers and potential customers are examining
the benefits and risks of self-insuring as an alternative to traditional insurance.
New competition from these developments could cause the supply or demand for insurance to change,
which could adversely affect Selective’s results of operations and financial condition.
General economic conditions can adversely affect Selective’s business results and prospects.
Changes in general economic conditions can impact Selective’s business. For example, Selective’s
contractor business represents 45% of its insurance operations segment and is significantly
impacted by changes in general economic conditions, including the downturn in the U.S. housing
market. Other economic conditions impacting Selective’s business include, but, are not limited to,
recessions; increases in corporate, municipal and/or consumer bankruptcies; changes in interest
rate levels; a continued downturn in the U.S. housing market; changes in domestic and international
laws, including tax laws and bankruptcy laws; intervention by governments in financial markets,
including the imposition of limits on the ability of mortgagees to foreclose on defaulted mortgage
loans; wars; and terrorist acts could adversely affect the performance of the Company’s insured and
investment portfolios, possibly leading to increases in losses and loss reserves in the insured
portfolio and decreases in the value of the investment portfolio and, therefore, the Company’s
financial strength.
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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 and extended through December 31, 2007 through the
Terrorism Risk Insurance Extension Act of 2005 (collectively, these two acts will be referred to as
“TRIA”). On December 18, 2007, TRIA was extended for seven more years until December 31, 2014.
This revised legislation ends the distinction between foreign and domestic acts of terrorism
without increasing the level of damages necessary to trigger the program ($100 million). This seven
year period will provide the market with much-needed stability. 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 2007, approximately 90% of Selective’s commercial non-workers
compensation policyholders purchased terrorism coverage. The terrorism coverage is mandatory for
all workers compensation primary policies. In addition, 48%, or ten of the twenty-one 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. 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 2008, 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 insurer’s
deductible, the federal government will cover 85%, while the insurer contributes 15%. Although the
provisions of TRIA will serve to mitigate Selective’s exposure in the event of a large-scale
terrorist attack, the Company’s deductible is substantial.
Selective’s 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 Company’s investment income as a result of falling interest rates, decreased
dividend payment rates, reduced returns in the Company’s other investment portfolio, primarily from
alternative investments, 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 Company’s debt
portfolio. In addition, issuers of debt which the Company holds in its investment portfolio may
default in its financial obligations as a result of insolvency, lack of liquidity, operational
failure or other reasons. Any significant decline in the market value of its investments,
excluding its held-to-maturity investments, would reduce the Company’s stockholders’ equity. A
significant decline in the market value of its equity and other investments would also reduce its
policyholders’ surplus, which could impact the Company’s ability to write additional premiums. In
addition, Selective’s notes payable are subject to certain debt-to-capitalization restrictions,
which could also be impacted by a significant decline in investment values. For more information
see Item 7A. “Quantitative and Qualitative Disclosures About Market Risk” in this Form 10-K.
Changes in tax laws impacting marginal tax rates and/or the preferred tax treatment of municipal
obligations could adversely impact Selective’s business.
Tax legislation which imposes a “flat tax” or otherwise changes the tax preference of municipal
obligations under current law could adversely affect the market value of municipal obligations. Forty-one percent of the Company’s investment portfolio is invested in tax-exempt municipal obligations; as
such, the value of the investment portfolio could be adversely affected by any such legislation.
Additionally, any such changes in tax law could reduce the difference between tax-exempt interest
rates and taxable rates.
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 Selective’s 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 Selective’s 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 Selective’s line of credit; or (iii)
make it more expensive for Selective to access capital markets.
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 Selective’s operations are conducted through its subsidiaries. Restrictions
on the ability of the Company’s 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.
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Under the terms of Selective’s debt agreements and financial solvency laws affecting insurers, the
Company’s 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 the 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 insurer’s 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 subsidiary’s policyholders or creditors. Selective’s Selective HR
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 requirements to maintain a current
ratio of at least 1:1.
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. Agents and brokers are not obligated to promote Selective’s insurance
products, and they may also sell the insurance products of the Company’s competitors. As a result,
Selective’s business depends in part on the marketing and sales efforts of these agencies and
brokers. As Selective 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 Selective’s 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
agency’s ability to control growth and profitability, thereby adversely affecting Selective’s
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. Selective’s 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, Selective’s business may be adversely impacted.
Selective is heavily regulated in the states in which it operates.
Selective is subject to extensive supervision and regulation in the states in which the Insurance
Subsidiaries transact insurance business. The primary purpose of insurance regulation is to
protect individual policyholders and not shareholders or other investors. Selective’s 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
Company’s 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 Selective’s business. Selective’s 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.
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Although the insurance industry is primarily regulated by individual states, federal initiatives,
such as, the National Flood Insurance Program, the optional federal charter, and the Office of
Foreign Assets Control, 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 it 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 it.
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 Selective’s 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 Jersey’s Automobile Insurance Cost Reduction Act (“AICRA”). 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 against the Insurance Subsidiaries. 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.
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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 2002 Florida combined its two high-risk insurance pools, the
Windstorm and Joint Underwriting Association, to create Florida Citizens Property Insurance
Corporation (“CPIC”). CPIC is a state-regulated association and historically has provided property
insurance to policyholders unable to obtain coverage in the private insurance market. However,
CPIC has evolved from market of last resort to become the state’s largest property insurer. In May
2007, a new insurance law passed in Florida expanding the role of CPIC and making its rates more
competitive with the private market. Florida homeowners can now purchase coverage from CPIC if the
rates for a policy from a private insurer are more than 15% higher than from a similar CPIC policy.
CPIC can now also offer high-risk policyholders homeowners insurance as well as wind-only coverage
in other parts of the state, which is driving homeowners rates down in the private market. In
addition, 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 Selective’s Insurance Subsidiaries write private passenger automobile insurance in Florida.
Certain other coastal states, including certain states in which Selective’s Insurance Subsidiaries
transact homeowners insurance business, are considering legislation requiring that insurers that
write homeowners insurance in any geographic area of a state must write homeowners insurance in all
geographic areas of that state. Selective 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.
Credit Scoring Regulation
Selective uses certain aspects of credit scores when evaluating individual risks. In June 2007 the
United States Supreme Court interpreted the Fair Credit Reporting Act (“FCRA”) concerning the
meaning of the term “adverse action” as it relates to an insurance carrier’s use of credit scoring
when it quotes premium for a personal lines applicant or raises premium for an existing personal
lines insured. This interpretation requires insurance carriers to notify policyholders and
applicants when their credit reports are the basis for adverse action, such as a rate increase. An
adverse action notification, according to the interpretation, would be required if a quoted rate is
higher than it would have been in a credit neutral comparison, which compares the credit
score-based rate against a credit score neutral rate. The interpretation does not require an
insurance carrier to inform all policyholders that their credit reports have been reviewed in the
underwriting process or that the rate they have received is higher than the best possible rate of
the carrier.
In 2007, 31 states introduced 83 bills seeking to limit or completely restrict the use of credit
scores on individuals. In addition, the Federal Trade Commission produced a report in late 2007
stating the use of credit scores is an accurate predictor of risk and is not prejudicial to
minority groups. Congress is expected to continue investigating this issue and many state
legislatures and agencies will continue to monitor the impact credit scoring has on the insurance
marketplace.
Changes to regulation regarding the use of credit scores may impact the way in which the Company
prices business and/or notifies policyholders or applicants of adverse actions resulting from the
use of these score.
Flood Insurance Regulation
The federal government’s 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 Selective’s Flood and/or Homeowners results. Legislation exists that
may force policies to cover claims related to windstorm damage and could lower the fee paid by the
NFIP to the servicing carrier. The current repayment of claims by the NFIP could also be
restricted, with the current authorization expected to last only to 2009.
Regulation and Legislation of Agent Compensation
Selective’s 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
Selective’s Insurance Subsidiaries. Selective discloses its compensation practices in notices to
all policyholders and on Selective’s public website, while referring all specific questions about
agent compensation to the agent that placed the business with Selective.
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Because Selective’s agents also generally represent several of Selective’s competitors, Selective’s
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 Selective’s target
customers, have resulted in consent orders under which brokers and several of Selective’s
competitors have left uncontested the attorneys general’s 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.
Reinsurance Regulation
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’s 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 Company’s 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 Selective’s reinsurance
will increase its risk of loss.
Selective also faces credit risk with respect to reinsurance. In addition, reinsurers which the
Company has contracted with may default in their financial obligations as a result of insolvency,
lack of liquidity, operational failure or other reasons. The inability of any of the Company’s
reinsurers to meet their financial obligations could materially and adversely affect Selective’s
operations, as the Company remains primarily liable to its customers under the policies that it has
reinsured.
Class action litigation could affect Selective’s business practices and financial results.
Selective’s industries have been the target of class action litigation in areas including the
following:
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A change in Selective’s 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 insurer’s 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. In
addition to the assigned risk plan in New Jersey, there are ongoing attempts to address rate
disparities between different geographic regions in the state, as well as judicial attempts to
address limitations of lawsuits.
Selective depends on key personnel.
To a large extent, the success of Selective’s 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. In addition, Selective’s
workforce is older, with an average age of 47. Approximately 25% of Selective’s workforce is
retirement eligible under Selective’s retirement and benefit plans.
Selective faces risks from technology-related failures.
Selective’s businesses are increasingly dependent on computer and Internet-enabled technology. The
Company’s 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 as a servicing carrier in the “Write-Your-Own” (“WYO”) Program of the United
States government’s 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. Selective continues to monitor developments with the NFIP regarding its ability to
pay claims in the event of another large-scale disaster. Congress controls the federal agency’s
funding authority and future limitations in this funding could occur.
Effective October 1, 2006, the fee paid to Selective by the NFIP decreased 0.6 points to 30.2% of
premiums written. This fee structure is still in place as of December 31, 2007. However, during
2008, the NFIP is expected to further decrease the fee 0.5 points to 29.7%. Further reductions in
this rate could occur through legislative activity.
The current program is also being reevaluated to include a cap on claim fees paid by the NFIP.
While the final outcome of this legislation is unknown, this cap could impact the ultimate claim
fee the Company could receive in the event that there is a large catastrophe in an area in which
Selective is geographically concentrated.
Selective faces risks in the HR Outsourcing business.
Selective HR’s operations are affected by numerous federal and state laws and regulations relating
to employment matters, benefits plans, and taxes. In performing services for its clients,
Selective HR 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 cannot predict what additional government
initiatives, if any, affecting Selective HR’s business may be promulgated in the future.
Consequently, the Company also cannot predict whether Selective HR will be able to adapt to new or
modified regulatory requirements or obtain necessary licenses and government approvals.
Selective is subject to the compliance requirements of the federal securities laws.
Selective is subject to extensive regulation under the federal securities laws as a registrant
under the Securities Exchange Act of 1934, as amended. In the event Selective was unable to comply
with the federal securities laws, the Company would likely be unable to access the public capital
markets, which would make it more difficult to raise necessary capital and/or increase the cost of
capital. If Selective cannot obtain adequate capital on favorable terms or at all, the business,
operating results and financial condition would be adversely affected.
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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 Selective’s 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 Company’s 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 Selective’s 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 Selective’s board of directors
prior to the shareholder becoming an interested shareholder; (ii) a business combination approved
by two-thirds of Selective’s 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
Selective’s Common Stock.
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Item 1B. Unresolved Staff Comments
None.
Item 2. Properties.
Selective’s 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 Selective’s three business segments
are described in the “Field Strategy,” “Investments Segment,” and “Human Resource Administration
Outsourcing” sections of Item 1. “Business.” Selective believes 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. Most of these proceedings are claims litigation involving
the Insurance Subsidiaries as either: (a) liability insurers defending or providing indemnity for
third-party claims brought against insureds or (b) insurers defending first-party coverage claims
brought against them. Selective accounts for such activity through the establishment of unpaid
loss and loss adjustment expense reserves. Selective’s management expects that the ultimate
liability, if any, with respect to such ordinary-course claims litigation, after consideration of
provisions made for potential losses and costs of defense, will not be material to Selective’s
consolidated financial condition, results of operations, or cash flows.
From time-to-time, the Insurance Subsidiaries are also involved in other legal actions, some of
which assert claims for substantial amounts. These actions include, among others, putative state
class actions seeking certification of a state or national class. Such putative class actions have
alleged, for example, improper reimbursement of medical providers paid under workers compensation
and personal and commercial automobile insurance policies. The Insurance Subsidiaries are also
from time-to-time involved in individual actions in which extra-contractual damages, punitive
damages, or penalties are sought, such as claims alleging bad faith in the handling of insurance
claims. Selective believes that it has valid defenses to these cases. Selective’s management
expects that the ultimate liability, if any, with respect to such lawsuits, after consideration of
provisions made for estimated losses, will not be material to Selective’s consolidated financial
condition. Nonetheless, given the large or indeterminate amounts sought in certain of these
actions, and the inherent unpredictability of litigation, an adverse outcome in certain matters
could, from time-to-time, have a material adverse effect on Selective’s consolidated results of
operations or cash flows in particular quarterly or annual periods.
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 2007.
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PART II
Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of
Equity Securities.
(a) Market Information
Selective’s 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 Selective’s Common Stock for each full quarterly period within the two most recent
fiscal years:
On February 22, 2008, the closing price of Selective as reported on the NASDAQ Global Select Market
was $24.40.
(b) Holders
As of February 15, 2008, there were approximately 2,651 holders of record of Selective’s Common
Stock, including beneficial holders whose securities were held in the name of the registered
clearing agency or its nominee.
(c) Dividends
Dividends on shares of Selective’s Common Stock are declared and paid at the discretion of the
Board of Directors based on Selective’s 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 Selective’s two most recent
fiscal years:
Selective’s 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 2007 and 2006. At
December 31, 2007, the amount available for dividends to holders of Selective’s common shares under
such restrictions was $336.0 million for the 2000 Senior Notes.
Selective’s 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 acts, which generally require 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.
(d) Securities Authorized for Issuance Under Equity Compensation Plans
The following table provides information about Selective’s Common Stock authorized for issuance
under equity compensation plans as of December 31, 2007:
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(e) Performance Graph
The following chart, produced by Research Data Group, Inc., depicts Selective’s performance for the
period beginning December 31, 2002 and ending December 31, 2007, as measured by total stockholder
return on the Company’s Common Stock compared with the total return of the NASDAQ Composite Index
and a select group of peer companies.
COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among Selective Insurance Group Inc., The NASDAQ Composite Index And A Peer Group 
Notwithstanding anything to the contrary set forth in any of Selective’s 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 Selective’s purchase of its own Common Stock in
the fourth quarter of 2007:
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Item 6. Selected Financial Data.
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Forward-looking Statements
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
Selective’s intentions, beliefs, projections, estimations or forecasts of future events or future
financial performance and involve known and unknown risks, uncertainties and other factors that may
cause Selective’s or the industry’s actual results, levels of activity, or performance to be
materially different from those expressed or implied by the forward-looking statements. In some
cases, forward-looking statements may be identified 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 Selective can give no assurance that such
expectations will prove to be correct. Selective undertakes 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 Selective’s actual results to differ materially from those Selective has
projected, forecasted or estimated in forward-looking statements are discussed in further detail in
Item 1A. “Risk Factors.” These risk factors may not be exhaustive. Selective operates in a
continually changing business environment, and new risk factors emerge from time-to-time.
Selective can neither predict such new risk factors nor can Selective assess the impact, if any, of
such new risk factors on Selective’s 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.
Introduction
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 Management’s Discussion and Analysis (“MD&A”) is to provide an understanding of
the consolidated results of operations and financial condition and known trends and uncertainties
that may have a material impact in future periods. For convenience and reading ease, we have
written the remainder of 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.
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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 insurer’s 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, 2007, we had accrued $2.5 billion of gross loss and loss expense
reserves compared to $2.3 billion at December 31, 2006.
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 their knowledge, experience, and general insurance
reserving practices. Until the claim is resolved, these estimates are revised as deemed
appropriate 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 our planning process wherein we review and update expected loss ratios 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. We also consider 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:
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Workers Compensation
With $832 million, or 36% of our total recorded reserves, net of reinsurance at December 31, 2007,
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 most susceptible to unexpected changes in medical services costs due to the
length of time over which medical services are provided and the unpredictability of medical cost
inflation. From 2005 through 2007, we experienced an unusual amount of volatility associated with
our workers compensation medical costs. 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. From 2006 to 2007, our workers
compensation medical development returned to a more normal level and as a result our reserves for
prior accident years were reduced by the relatively moderate amount of $4 million in 2006 and $4
million in 2007. Even though medical cost development returned to a more customary level in 2007,
the unusual amount of volatility over the past few years does create additional uncertainty. If
the higher than historical increases in medical costs in 2005 were a just an anomaly, then our
historical patterns are an appropriate basis for our future reserve projections. If higher trends
return and 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.
General Liability
At December 31, 2007, our general liability line of business had recorded reserves, net of
reinsurance of $815 million, which represented 35% of our total net reserves. This line of
business includes umbrella policies which provide additional limits above underlying automobile and
general liability coverages. While favorable development in 2007 for prior years was minimal, two
recent changes in our book of business relating to umbrella coverage could create additional
volatility in our results: (i) we have grown the number of our commercial umbrella policies at a
greater rate than the rest of our commercial lines of business; and (ii) we have raised the net
retention of our reinsurance covering these policies. Both of these changes raise the average
limits of losses that we retain on a net basis. While management has not identified any specific
trends relating to additional reserve uncertainty, our increase in average net retention does
create the potential for additional volatility in our reserves.
Commercial Automobile
At December 31, 2007, our commercial automobile line of business had recorded reserves, net of
reinsurance, of $330 million, which represented 14% 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 2006, which resulted
in favorable development in 2006 and 2007 of $15 million and $19 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 leveled off and management has not
identified any other recent trends that would create significant reserve uncertainty for this line
of business.
Personal Automobile
At December 31, 2007, our personal automobile line of business had recorded reserves, net of
reinsurance, of $171 million, which represented 7% of our total net reserves. The majority of this
business is written in 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 Act (“AICRA”) limitation on lawsuit threshold. As a result of
this decision, we increased reserves for this line of business by a net amount of $10 million, the
majority of which was reflected in 2005 results. This recent judicial decision has increased the
uncertainty surrounding our personal automobile reserves, particularly for accident years 2006 and
2007, since 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, 2007, no other individual line of business had recorded reserves of more than $60
million, net of reinsurance. Management has not identified any recent trends that would create
additional significant reserve uncertainty for these other lines of business.
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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, 2007 and 2006:
As of December 31, 2007
As of December 31, 2006
Range of reasonable reserves
We established a range of reasonably possible reserves for net claims of approximately $2,180
million to $2,414 million at December 31, 2007 and of $1,977 million to $2,174 million at December
31, 2006. 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 likely
scenarios, it is possible that the final outcomes may fall above or below these amounts. Based on
internal stochastic modeling, management feels that a reasonable estimate of the likelihood that
the final outcome falls within the current range is approximately 70%. This range does not include
a provision for potential increases or decreases associated with environmental reserves. Management’s best estimate is consistent with the actuarial best
estimate. We do 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, including, but not limited
to, the following:
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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.
Workers Compensation
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 addition, workers compensation has been the focus of a multi-faceted
underwriting strategy designed to significantly reduce the loss ratio over time. The combination
of the sensitivity of workers compensation results to medical inflation and changes in underwriting
could lead to actual experience emerging differently than the assumptions used in the process to
establish reserves. In our judgment, it is possible that actual medical loss development factors
could range from 6% below to 8% above those selected in our latest reserve analysis and expected
loss ratios could range from 5% below to 3% above those selected in our latest reserve analysis.
The combination of reducing the assumptions for medical loss development by 6% and the expected
loss ratio by 5% could decrease our indicated workers compensation reserves by approximately $55
million for accident years 2006 and prior. Alternatively, the combination of increasing the
medical loss development factors by 8% and the expected loss ratio by 3% could increase our
indicated workers compensation reserves by approximately $70 million.
General Liability
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 insurer’s 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 $80 million for
accident years 2006 and prior.
Commercial Automobile
In addition to the normal amount of volatility, our commercial automobile line of business 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 we 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 +/- 6%, it is our judgment that the possible impact to
overall reserves could range from approximately $65 million reduction to approximately $40 million
increase for accident years 2006 and prior.
Personal Automobile
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 4% 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 $35 million for accident years 2006 and prior. Alternatively,
if the loss development factors were increased by 4%, that would increase our indicated personal
automobile reserves by approximately $30 million.
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Current Accident Year
For the 2007 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 2007 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 2007 accident year.
Reserve Impact of Changing Current Year Expected Ultimate Loss Ratio Assumption
Prior year reserve development
In light of the many uncertainties associated with establishing the estimates and making the
assumptions necessary to establish reserve levels, we review our reserve estimates on a regular
basis as described above and make adjustments in the period that the need for such adjustment is
determined. These reviews could result in the identification of information and trends that would
require us 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 our results of operations, equity, business, insurer financial
strength, and debt ratings. In 2007, we experienced favorable loss development in accident years
2002 through 2006 of $61.7 million partially offset by unfavorable loss development in accident
years 2001 and prior of $42.9 million, netting to total favorable prior year development of $18.8
million. In 2006, we experienced net favorable prior year development of $7.3 million, and in
2005, we experienced net adverse prior year development of $5.1 million. 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.
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 $51.4
million as of December 31, 2007 and $46.5 million as of December 31, 2006. Our exposure to
environmental liability is primarily due to policies written prior to the introduction of the
absolute pollution exclusion endorsement in the mid-1980’s and underground storage tank leaks,
mostly from New Jersey homeowners policies in recent years. Our asbestos and non-asbestos
environmental claims have arisen primarily from insured exposures in municipal government, small
commercial risks, and homeowners policies. The emergence of these claims is slow and highly
unpredictable. Over the past few years, we also experienced adverse development in 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. In addition, certain
landfill sites are included on the National Priorities List (“NPL”) by the United States
Environmental Protection Agency (“USEPA”). Once on the NPL the USEPA determines an appropriate
remediation plan for these sites. A landfill can remain on the NPL for many years until final
approval for the removal of the site is granted from the USEPA. The USEPA also has the authority
to re-open previously closed sites and return them to the NPL. We currently have reserves for
several claims related to sites on the NPL.
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.
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The table below summarizes the number of asbestos and non-asbestos claims outstanding at December
31, 2007, 2006, and 2005. For additional information about our environmental reserves, see Item 1.
“Business,” and Item 8. “Financial Statements and Supplementary Data,” Note 8 to the Consolidated
Financial Statements.
Environmental Claims Activity
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, and any adjustments are made in the accounting period in
which the adjustment arose. We measure the recoverability of deferred policy acquisition costs at
the operating segment level. We had deferred policy acquisition costs of $226.4 million at
December 31, 2007 compared to $218.1 million at December 31, 2006.
Pension and Postretirement Benefit Plan Actuarial Assumptions
Our 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 higher discount rate decreases the present value of benefit obligations and decreases
pension expense. We increased our discount rate to 6.50% for 2007, from 5.90% for 2006 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 2007 and 2006.
Changes in the related pension and postretirement benefit expense may occur in the future due to
changes in these assumptions.
For additional information regarding our pension and postretirement benefit plan obligations, see
Item 8. “Financial Statements and Supplementary Data,” Note 16(d) to the Consolidated Financial
Statements.
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Other-Than-Temporary Investment Impairments
An investment in a fixed maturity or equity security, that is available for sale and 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. Management’s 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.
Our evaluation for other-than-temporary impairment of a fixed maturity security, includes, but is
not limited to, the evaluation of the following factors:
Our evaluation for other-than-temporary impairment of an equity security, other investment, or a
short-term investment includes, but is not limited to, the evaluation of the following factors:
In 2007, we recorded an impairment charge of $4.9 million for two investments that we concluded
were impaired for other than temporary declines in fair value. We had 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. For further information
regarding the impairment charges, see the section entitled “Investments” in Item 7. “ Management’s
Discussion and Analysis of Financial Condition and Results of Operations.” of this Form 10-K.
Goodwill
Goodwill results from business acquisitions where the cost of assets acquired exceeds the fair
value of those assets. We test goodwill for impairment annually, or more frequently if events or
changes in circumstances indicate that goodwill may be impaired. Goodwill is allocated to the
reporting units for the purposes of the impairment test. We did not record any impairments during
2007, 2006 or 2005.
Reinsurance
Reinsurance recoverable on paid and unpaid losses and loss expenses represent estimates of the
portion of such liabilities that will be recovered from reinsurers. Each reinsurance contract is
analyzed to ensure that the transfer of risk exists to properly record the transactions in the
financial statements. Amounts recoverable from reinsurers are recognized as assets at the same
time and in a manner consistent with the paid and unpaid losses associated with the reinsurance
policies. An allowance for estimated uncollectible reinsurance is recorded based on an evaluation
of balances due from reinsurers and other available information. This allowance totaled $2.8
million at December 31, 2007.
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Financial Highlights of Results for Years Ended December 31, 2007, 2006, and 2005 1
Revenues
Revenues increased in 2007 compared to 2006 and 2005 primarily due to growth in net premiums earned
(“NPE”) and net investment income earned.
NPE growth contributed $17.6 million of the $38.4 million in revenue growth in 2007 compared to
2006 and $81.7 million to the $136.9 million in revenue growth in 2006 compared to 2005. The
following factors contributed to the growth of NPE:
The above items were partially offset by (i) a slight reduction in commercial lines retention in
2007 compared to 2006 and 2005; (ii) a $17.9 million reduction in audit and endorsement premium
activity in 2007 compared to 2006 and a $7.6 million reduction in 2006 compared to 2005 as a result
of economic changes, especially in the construction industry; and (iii) decreases in NPE on our New
Jersey personal automobile book of business attributable to the loss of a portion of our book that
was repriced at higher pricing levels through our MATRIX® pricing system and
subsequently did not renew. Our New Jersey personal automobile book of business experienced an 8%
reduction in the number of cars insured at December 31, 2007 compared to December 31, 2006 and a
12% reduction in the number of cars from December 31, 2006 compared to December 31, 2005. Overall
personal lines NPE was down 5% to $203.3 million in 2007 compared to $213.8 million in 2006. These
premiums increased 2% in 2006 from $209.3 million in 2005.
Net investment income earned increased 11% in 2007 compared to 2006 and contributed $17.3 million
to the $38.4 million revenue growth in 2007. In 2006, net investment income earned increased 15%
compared to 2005 and contributed $20.9 million to the $136.9 million revenue growth in 2006. These
increases are primarily attributable to a higher invested asset base, coupled with higher interest
rates and strong returns from our other investment portfolio. The increase in our invested asset
base is the result of operating cash flows of $386.3 million in 2007 and $393.1 million in 2006, as
well as net proceeds of $96.8 million from our $100.0 million junior subordinated notes offering in
the third quarter of 2006. These increases were partially offset by: (i) stock repurchases under
our authorized stock repurchase program of 5.7 million shares during 2007 at a total cost of $143.3
million and 4.1 million shares during 2006 at a total cost of $110.1 million; and (ii) net share
settlements of principal for $37.5 million in 2007 on our Senior convertible notes.
Net Income
Net income decreased in 2007 compared to 2006 due to increases in our GAAP combined ratio,
resulting from lower pricing and higher claim severity, particularly in property losses, partially
offset by profitability improvements in our workers compensation line of business and increases in
net favorable prior year loss and loss expense development within our casualty lines of business.
The reduction in our underwriting profit was partially offset by: (i) net investment income earned
increases in 2007 as noted above; and (ii) decreases in federal income tax expense in 2007 compared
to 2006, primarily attributable to lower underwriting income in our Insurance Operations segment,
as explained above.
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Net income increased in 2006 compared to 2005 due to growth in NPE, net investment income earned,
and net realized gains as discussed above, partially offset by the reduction in our underwriting
profit, resulting from increased property losses, including catastrophe losses, and increased
underwriting expenses.
Results of Operations and Related Information by Segment
Insurance Operations
Our Insurance Operations segment writes property and casualty insurance business in 21 states in
the Eastern and Midwestern United States through seven insurance subsidiaries (the “Insurance
Subsidiaries”). These Insurance Subsidiaries write business through approximately 880 independent
insurance agencies. Our Insurance Operations segment consists of two components: (i) commercial
lines (“Commercial Lines”), which markets primarily to businesses, and represents approximately 87%
of net premiums written (“NPW”), and (ii) personal lines (“Personal Lines”), which markets
primarily to individuals and represents approximately 13% of NPW.
Summary of Insurance Operations
All Lines
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Insurance Operations Outlook
Historically, the results of the property and casualty insurance industry have experienced
significant fluctuations due to high levels of competition, economic conditions, interest rates,
loss cost trends, and other factors. During 2007, the industry experienced low levels of
catastrophe losses and a softening market characterized by accelerated competition, leading to
pricing deterioration in the primary insurance market that was worse than originally anticipated.
We expect this trend to continue into 2008. The average forecast, according to the “U.S.
Property/Casualty — Review & Preview” from A.M. Best (the “Forecast”) dated January 28, 2008, calls
for negative growth in NPW of 0.6% in 2008. This is in addition to the estimated negative growth
in NPW of 1.2% for 2007 discussed in the Forecast and results from an across-the-board softening in
the personal and commercial lines pricing environments, a weakening economy, leakage of premium to
government operated reinsurers and strong interest in alternative forms of risk transfer, including
various forms of self insurance, captives, and catastrophe bonds. The 2008 NPW forecast, if
accurate, would represent the first decline in total industry annual premiums since 1943. As a
result, we may need to reduce our pricing, which could lead to a decrease in margins in order to
retain our best business. Accelerated competition in the marketplace, coupled with low premium
growth rates, has also led to an increased interest in merger and acquisition activity within the
industry. The Forecast also indicates an increase in the expected statutory combined ratio in 2008
compared to the 2007 expectation, indicating that underwriting performance in the industry,
although still profitable, is deteriorating.
We believe that future profitability may be impacted by higher loss trends, which are characterized
by changes in frequency, severity, and pricing deterioration. 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 up loss costs and lead to higher industry-wide statutory
combined ratios. We believe it is critical to have a clearly defined plan to improve risk
selection and mitigate higher frequency and severity trends during market cycles. Some of the
tools we use to lower frequency and severity are knowledge management, predictive modeling, safety
management, managed care, 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
industry’s loss and loss adjustment expense ratio by 6.8 points, on average, over the past 10
years.
Considering the current environment, in the upcoming year, we anticipate pricing discipline and
expense management to be key factors in the generation of strong underwriting results. As part of
our expense management initiative, in February 2008, we announced a reduction in our workforce of
approximately 80 positions, including the immediate displacement of 60 employees and the
elimination of 20 open positions. We anticipate these changes to have a related one-time pre-tax
cost of approximately $4 million in the first quarter of 2008 and annualized pre-tax savings of
approximately $8 million. In addition, we are implementing targeted changes to agency commissions
that will maintain highly competitive awards for agents who produce the strongest results for us,
while reducing commissions where our historically higher payments have not generated an appropriate
level of profitable growth. The changes will bring our program more in line with the competition;
however, commissions on 87% of our direct premiums written will not be affected, and the
supplemental commission program that rewards our most profitable growth agencies does not change.
We feel the changes will bring our program more in line with the competition. These commission
revisions are expected to generate annualized pre-tax savings of approximately $8.0 million, and
are targeted for rollout in most states in July 2008.
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Even in this competitive market, we believe that the strategies we have implemented will allow us
to continue to profitably grow our business based on strong agency relationships and our unique
field-based model. To this end, we have developed market-planning tools that are allowing us to
strategically appoint additional independent agencies as well as agency management specialists
(“AMSs”) in under-penetrated territories, with classes of business that we know historically have
been profitable. Through the end of 2007, the Insurance Subsidiaries’ total agency count increased
to approximately 880, up from 770 at last year-end, serviced by approximately 100 field-based AMSs
who make hands-on underwriting decisions in agents’ offices on a daily basis.
We back the “high touch” component of our business model with technology that allows agents and the
Insurance Subsidiaries’ field teams to input business seamlessly into our systems, while also
allowing them to select and price accounts at optimal levels through predictive modeling.
Technology that allows for the seamless placement of business into our systems includes our One &
Done® small business system and our xSELerate® straight-through processing
system. Premiums of $250,000 per workday were processed through our One & Done® small
business system in 2007, up 42% from 2006. We have set a multi-year small business growth target
of $350,000 in One & Done® business per work day, and in 2008 our efforts will be
centered on: (i) better managing price points and scale; (ii) implementing a more comprehensive
marketing and branding strategy; and (iii) updating the distribution model to address multiple
agent and customer needs.
We also continue to pursue our organic growth strategy. Effective July 1, 2007, we entered our
21st primary state, Massachusetts, for Commercial Lines only and wrote approximately
$3.8 million of new business in 2007. In 2008, we have plans to expand our footprint to Tennessee.
We also have expanded Personal Lines into Rhode Island, Minnesota, and Iowa, states that are
already within our existing Commercial Lines footprint. In addition to our organic growth
strategy, we are taking note of opportunities that marketplace competition may be creating and
would not rule out making an opportunistic acquisition.
Based on our expense management programs along with technology investments, ongoing underwriting
improvements, our assessment of current loss cost and pricing trends, and other areas of strategic
focus, we are providing 2008 earnings guidance in the range of $2.20 to $2.40 per diluted share.
Our guidance is based on the following assumptions: (i) a statutory combined ratio of 98% and a
GAAP combined ratio of 100%; (ii) after-tax catastrophe losses of $14.4 million; (iii) growth in
after-tax investment income of 3%, including a 10% pre-tax yield on alternative investments,
included in “Other investments” on the Consolidated Balance Sheets; (iv) Diversified Insurance
Services revenue growth of 5% with a return on revenue of 10%; and (v) diluted weighted average
shares of 52.5 million, which includes the expectation of repurchasing 3.5 million shares over the
course of the year.
Review of Underwriting Results by Line of Business
Commercial Lines
Commercial Lines
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The following is a discussion on our most significant commercial lines of business:
Commercial Automobile
Our continued strong performance in this line is the result of underwriting and pricing
improvements over the last several years. We have implemented targeted rate decreases on the best
accounts to grow this profitable line of business. The policy count on this line of business
increased 8% in 2007 compared to 2006 driven by new policy count increases of 18%. In 2006, as
compared to 2005, policy counts increased 6% driven by new policy count increases of 4%. However,
renewal prices, including exposure, decreased 2.9% in 2007 compared to a decrease of 1.1% in 2006
and an increase of 0.4% in 2005, which has put pressure on NPW and NPE. Lower severity trends have
resulted in favorable prior year statutory loss and loss expense development of approximately $19
million in 2007 compared to $15 million in 2006 and $48 million in 2005.
General Liability
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Total policy counts in this line of business increased 9% in 2007 compared to 2006 and 7% in 2006
compared to 2005. New business premiums in this line of business increased 14% for 2007 compared
to 2006 and 1% for 2006 compared to 2005. Evidence of the softening market is illustrated in our
renewal pricing for this line which, including exposure, decreased 1.1% in 2007 compared to
increases of 1.5% in 2006 and 3.0% in 2005. Continuing evidence of the softening market is
illustrated by retention that decreased slightly to 75% in 2007 compared to 77% in 2006 and 76% in
2005.
Pricing pressure, coupled with higher loss costs, continues to put pressure on profitability in
this line of business. However, we continue to concentrate on our long-term strategy to improve
profitability, which focuses on: (i) contractor growth in business segments with lower completed
operations exposures; and (ii) contractor and subcontractor underwriting guidelines to minimize
losses.
Workers Compensation
Our multi-faceted workers compensation strategy, which incorporates our knowledge management and
predictive modeling initiatives, has enabled us to retain and write more of the best accounts,
leading to 2007 increases in total policy counts of 9% compared to 2006 and 6% in 2006 compared to
2005. Direct new voluntary policy premiums increased 28% for 2007 compared to 2006 and 30% for
2006 compared to 2005. At the same time, these initiatives have allowed us to target price
increases for our worst performing business, which contributed to the decrease in our retention in
2007 to 79% from 80% in 2006 and 81% in 2005, thereby improving the profitability of our retained
business.
The improvement in the statutory combined ratio of this line of 6.8 points in 2007 compared to 2006
and 15.7 points in 2006 compared to 2005 reflects not only the ongoing progress resulting from the
execution of our workers compensation strategies, but also favorable prior year statutory
development of $3 million attributable to these strategies, partially offset by an increase in the
tail factor related to medical inflation and general development trends. Favorable prior year
statutory development of approximately $2 million in 2006 was driven, in part, by savings realized
from changing medical and pharmacy networks outside of New Jersey and re-contracting our medical
bill review services. Adverse prior year statutory development of $40 million 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 management’s best estimates within the loss range.
Commercial Property
Net premiums written for this line of business increased in 2007 compared to 2006 and 2005 due to
increases in total policy counts of 11% in 2007 compared to 2006 and 9% in 2006 compared to 2005.
Stable retention of approximately 81% over the past three years has also led to an increase in net
premiums written. NPW growth was partially offset by renewal prices, including exposure, which
decreased 0.4% in 2007 compared to increases of 2.1% in 2006 and 2.8% in 2005.
Although still profitable, the higher statutory combined ratio for commercial property reflects
lower pricing and increased property losses especially in comparison to the unusually low
experience in 2006. The increase in property losses appears to be part of the normal variability
in this line and was primarily the result of an increase in the severity of losses, mainly
attributable to flood events and electrical fires. For 2007, catastrophe losses decreased $2.5
million to $10.7 million compared to 2006, however, for 2006, catastrophe losses increased $10.4
million to $13.2 million compared to 2005.
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Personal Lines
Personal Lines
The remaining decrease in NPW in 2007 compared to 2006 was primarily driven by a decline in
NPW for our New Jersey personal automobile business of $12.6 million to $80.1 million in
2007. This resulted from a reduction in the number of New Jersey personal automobiles that
we insure, primarily driven by repricing at higher levels through our MATRIX®
pricing system. Partially offsetting this decrease were increases in our personal
automobile business outside of New Jersey of $5.4 million to $50.0 million coupled with
increases in our homeowners business of $4.5 million to $65.4 million in 2007.
The New Jersey personal automobile market has been impacted by the introduction of new
companies writing business in the state with rating plans that allow them to price accounts
competitively without the legacy issue of repricing existing accounts through filed rate
increases. Our new Personal Lines rating plan was approved by the New Jersey Department of
Banking and Insurance (“NJDOBI”) and was implemented in August 2006. Our new plan allows us
to better evaluate and price risks, which will help us to profitably compete for new
business in our agencies. We have moved our entire existing renewal inventory into our new
pricing and tiering structure in New Jersey, which has caused a dislocation in this book of
business due to the repricing of certain business at higher levels, some of which did not
renew. As annual increases or decreases are capped at 20% by the NJDOBI, we expect
improvements to materialize over a three-year period. We continue to focus on increasing
new business production within and outside of New Jersey through this advanced pricing
methodology. In our continuing efforts to improve our existing book of automobile business,
we have implemented average renewal rate increases of 13.1% in Pennsylvania effective August
1, 2007, and 8.5% in Maryland effective September 1, 2007. These changes applied to
business written prior to the implementation of our MATRIX® program. In 2008, we
are taking steps to continue to improve our automobile business by filing further rate
increases of 7% in New Jersey, which is targeted for May, 7% in Pennsylvania, targeted for
July, and 6% in Maryland, targeted for August. The New Jersey change applies to all
business, and the other changes apply to business originally written prior to the
implementation of our MATRIX® program. Such rate increases were necessary, as
these states have regulatory restrictions on moving the renewal book into our new pricing
methodology and the previous rates did not yield sufficient profitability.
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Excluding the impact of the one-time benefit received from the cancellation of the Quota
Share Treaty, NPW increased 2% in 2006 compared to 2005. This increase reflects the
retention of homeowners business that had previously been ceded under the treaty coupled
with an increase in direct homeowners premiums written of 6% in 2006 compared to 2005,
partially offset by a decrease in our personal automobile business of $16.6 million to
$137.4 million. NPW on our personal automobile line of business decreased in 2006 as a
result of the ongoing competition in the New Jersey personal automobile marketplace coupled
with our rating plans that were not competitive through the first half of the year due to a
historically restrictive rating environment.
This deterioration in the loss and loss expense ratio was partially offset by a reduction in
catastrophe losses of $2.2 million, to $2.9 million in 2007.
The improvement in the 2006 GAAP loss and loss expense ratio was driven by the reserving
actions taken in 2005 in light of a New Jersey Supreme Court decision that eliminated the
application of the serious life impact standard to personal automobile cases under the
verbal tort threshold of New Jersey’s Automobile Insurance Cost Reduction Act (“AICRA”) and
resulted in an increase to our reserves of $13.0 million in the second quarter of 2005. The
implementation of AICRA, and our rating and tiering actions had enabled us to achieve
profitability in the New Jersey personal automobile line of business over the two years
prior to the ruling. However, factoring higher expected claim costs into our New Jersey
personal automobile excess profits calculation eliminated $5.5 million of excess profits
reserves in the second quarter of 2005.
We have also implemented a three-part profit improvement plan that will focus on returning
Personal Lines to profitability by the end of 2009. To decrease costs associated with
writing policies and servicing claims, we plan to: (i) utilize the full capability of our
MATRIX® pricing system, along with widening the One & Done® pipeline
to maximize the cost savings that are associated with these policies; (ii) roll out our
knowledge management initiatives to the Personal Lines operation in May 2008; and, (iii)
move additional claims to our centrally located claims department to cut down on costs
incurred for claims handling.
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Reinsurance
We have reinsurance contracts that cover both property and casualty business. We use traditional
forms of reinsurance and do not utilize finite risk reinsurance. Our contracts can be segregated
into the following key categories:
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 regularly reevaluate our overall reinsurance program and try to develop 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 risks,
limits written, projected reinsurance costs, financial strength of reinsurers and projected impact
on earnings and statutory surplus. We strive to balance sometime opposing considerations of
reinsurer credit quality, price, terms, and our appetite for retaining a certain level of risk.
Terrorism Reinsurance
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, 2014 via the Terrorism Risk Insurance Program Reauthorization Act of 2007. For
further information regarding this legislation, see Item 1A. “Risk Factors” of this Form 10-K.
Property Reinsurance
The Property Catastrophe treaty renewed effective January 1, 2008 with a 15% reduction in premium.
The current treaty provides per occurrence coverage for 95% of $310.0 million in excess of $40.0
million retention compared to 95% of $335.0 million in excess of $40.0 million retention under the
expiring treaty. The annual aggregate limit net of our co-participation is $589.0 million compared
to $636.5 million for the expiring treaty. We continue to assess our property catastrophe exposure
aggregations, modeled results and effects of growth on our property portfolio and strive to manage
our exposure to individual large events balanced against the cost of reinsurance protection.
The following table presents Risk Management Solutions, Inc.’s (“RMS”) v.7.0 modeled hurricane
losses based on the Insurance Subsidiaries’ property book of business as of June 30, 2007:
RMS v.7.0 allows modeling based on the long term averages (historic view) and modeling based on a
five year projection that includes an assumption of elevated hurricane activity in the Atlantic
Basin in the short to medium term (stochastic view). Results of both models are provided above for
select probabilities. Our current catastrophe program provides protection for a 1 in 209 year
event, or an event with 0.5 % probability according to the RMS v.7.0 historic model, and for a 1 in
159 year event, or an event with 0.6% probability according to RMS v.7.0 stochastic model.
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The retention and limit under our Property Excess of Loss treaty renewed July 1, 2007, remained the
same at $23.0 million in excess of $2.0 million. Consistent with prior year contract, all nuclear,
biological, chemical and radioactive reaction (“NBCR”) losses are excluded from the Property Excess
of Loss treaty. Terrorism (excluding NBCR) and per occurrence aggregate limits remain at $46.5
million.
Casualty Reinsurance
The Casualty Excess of Loss program was renewed effective July 1, 2007, with no changes to the
expiring structure. The total program currently provides the following coverage:
The total coverage for workers compensation claims continues to be $78.0 million per occurrence and
$75.0 million per occurrence for casualty claims other than workers compensation, net of our
co-participation in the $40.0 million in excess of $50.0 million layer.
Other Reinsurance
Our Surety and Fidelity Excess of Loss treaty was renewed effective January 1, 2008, with
essentially no changes in coverage and a 2.5% increase in estimated ceded premium due to an
increase in projected subject premium offset by a decrease in the rate.
Effective January 1, 2008, we entered into a new treaty which covers our participation in the
involuntary National Council on Compensation Insurance (NCCI) pool, a residual workers compensation
market. The treaty provides 100% Quota Share coverage, including terrorism coverage, for the 2008
underwriting year business assumed from NCCI and has an aggregate combined ratio limit of
approximately 142%. The treaty is placed with two carriers both rated “A+” by A. M. Best and we
expect to cede $6.0 million in premium in 2008. We believe that the protection provided within
this treaty for residual market business will be especially beneficial given current market
conditions and the expected deterioration in the experience of the NCCI pool.
Investments
Our investment portfolio consists primarily of fixed maturity investments (83%), but also contains
equity securities (7%), short-term investments (5%), and other investments (5%). Our investment
philosophy includes setting 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. The return objective of the
equity portfolio is to meet or exceed a weighted-average benchmark of public equity indices. The
risk objective 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.
Our investment returns for the last three years are as follows:
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The increase in net investment income, before tax, of $17.3 million for 2007 compared to 2006 was
primarily the result of increased fixed maturity income due to higher invested assets and increased
income of approximately $7.0 million from certain alternative investments within our “Other
investments” category. Growth in net investment income, before tax, of $20.9 million for 2006
compared to 2005 was primarily attributable to the increase in our investment portfolio as well as
increased income of $4.0 million in alternative investment income and $1.0 million in dividend
income. Our investment portfolio totaled $3.7 billion at December 31, 2007, an increase of 4%
compared to $3.6 billion at December 31, 2006. The increase in invested assets was due to
substantial cash flows from operations of $386.3 million in 2007, $393.1 million in 2006 and $406.8
million in 2005. Cash flows from operations in 2007 were partially offset by cash outflows of: (i)
$143.3 million related to treasury stock repurchases under our authorized program; (ii) $37.5
million related to principal payments on our senior convertible notes; and (iii) $18.3 million
related to principal payments on our 8.87% and 8.63 senior notes. Debt offerings in September 2006
and November 2005 added approximately $96.8 million and $98.4 million in assets, respectively, in
2006 and 2005.
We continue to maintain a conservative, diversified investment portfolio, with fixed maturity
investments representing 83% of invested assets. Sixty-nine percent (69%) of our fixed maturities
portfolio is rated “AAA” while the portfolio has an average rating of “AA+,” S&P’s 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, 2007 and 2006, non-investment grade securities (below “BBB-“) represented less than
1%, or approximately $10 million, of our fixed maturity portfolio. Our mortgage backed securities
portfolio totaled $697.9 million at December 31, 2007, with an average credit rating of “AA+.”
Selective has no significant sub-prime mortgage exposure. Prior to investing in mortgage-backed
securities, we analyze, among other credit factors, each transaction’s FICO credit score and loan
to value ratio. For additional information regarding our fixed investment income portfolio, see
Exhibit 99.1 of Form 8-K dated January 23, 2008 and Exhibit 99.2 of Form 8-K dated February 12,
2008. For additional information regarding market risk related to our investment portfolio, see
Item 7A. “Quantitative and Qualitative Disclosures About Market Risk” of this Form 10-K.
The following table presents the Moody’s and S&P 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 the overall interest rate risk of fixed maturity investments.
Generally, the Insurance Subsidiaries have a duration mismatch between assets and liabilities.
The duration of the fixed maturity portfolio, including short-term investments, is 3.9 years while
the Insurance Subsidiaries’ liabilities have a duration of 3.4 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 the majority of
securities in our investment portfolio, the securities sold have not diminished the overall
liquidity of our portfolio. Our normal liquidity requirements have historically been met by
operating cash flow from our Insurance Operations and Diversified Insurance Services segments. We
expect our liquidity requirements in the future to be met by these sources of funds or, if
necessary, the issuance of debt and equity securities, as well as borrowings from our credit
facility. Managing investment risk by adhering to these strategies is intended to protect the
interests of our stockholders and the policyholders of our Insurance Subsidiaries, while enhancing
our financial strength and underwriting capacity.
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Realized Gains and Losses
Realized gains and losses are determined on the basis of the cost of specific investments sold, and
are credited or charged to income. Also included in realized gains and losses are write-downs for
other than temporary impairment charges. Our Investments segment included net realized gains
before tax of $33.4 million in 2007, compared to $35.5 million in 2006, and $14.5 million in 2005.
The realized gains were principally from the sale of equity securities. Net realized gains in 2007
and 2006 reflect the sale of several equity positions which resulted in re-weighting various sector
exposures. Realized gains were partially offset by realized losses, of which the most significant
losses are discussed below. 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. We typically 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 our net realized gains by investment type:
Realized losses within the available-for-sale fixed maturity securities increased in 2007 as
compared to 2006 and 2005. This is primarily the result of other than temporary impairment charge
associated with two commercial real estate collateralized debt obligations (“CDO”) for $4.9
million. During the second half of 2007, the market for lower-rated commercial mortgage-backed
securities (“CMBS”) saw severe contagion effects from the sub-prime mortgage crisis. CMBS spreads,
particularly subordinated tranche CMBS, widened dramatically over the course of the second half of
the year. As a result, CDOs in general have become extremely dislocated and difficult to value as
the market spreads between bid and ask prices are very wide, even for CDOs that do not have any
sub-prime asset backed exposure. At this time, there have been no credit defaults or rating
downgrades on CDOs in our portfolio. However, given the severe lack of liquidity currently being
experienced in the marketplace, it is difficult to value certain securities and, as a result, we
recorded an other than temporary impairment charge on two commercial real estate CDOs in 2007.
During 2006, Selective had not recognized any realized losses from other than temporary charges,
whereas during 2005 Selective had recorded $1.2 million in realized losses related to other than
temporary charges.
The dislocation in the sub-prime mortgage sector had also extended more broadly into both the
credit and equity markets in early August 2007. These events adversely affected quantitative
strategies that use factor-based models to identify incorrectly priced securities, and produced
widespread de-leveraging and unprecedented negative returns to all standard quantitative factors in
the U.S. during early August. With the increased uncertainty and risk of the equity markets at
that time, we had hedged our direct exposure to the S&P 500 by investing in an exchange-traded fund
(“ETF”). The fund was set up to perform inversely to the S&P 500 Index at a 2:1 ratio. Through this
action, we had protected $90 million of our equity capital base. While the investment limited the
upside of the equity portfolio, we believed that this strategy was appropriate during this period
of extreme market uncertainty. As a result of the aggressive actions by the Federal Reserve to
lower the federal funds rate later in the third quarter, improvements were seen in the equity
markets leading us to sell our interest in the ETF. This sale resulted in a $4.3 million realized
loss in the third quarter of 2007.
In light of the market conditions, we also decided to dispose of one of our other investments, a
global quantitative market-neutral equity hedge fund, primarily due to its undifferentiated model
and greater than anticipated volatility. This disposition resulted in a $1.7 million realized loss
and is reflected in the available-for-sale other investment category in the table above.
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The following tables present the period of time that securities sold at a loss were continuously in
an unrealized loss position prior to sale:
Unrealized Losses
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, 2007 and December 31, 2006:
Although overall interest rates decreased in 2007, the unrealized losses for fixed maturity
securities increased due primarily to the credit stress and dislocation in the capital markets,
along with inflation worries and uncertainty about the U.S. economy in general caused fixed
maturities credit spreads to widen. As of December 31, 2007, there are 240 securities in an
unrealized loss position. Broad changes in the overall market or interest rate environment
generally do not lead to impairment charges.
The following table presents information regarding our available-for-sale fixed maturities that
were in an unrealized loss position at December 31, 2007 by contractual maturity:
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Investment Outlook
As we look forward, we see a number of risks that could contribute to an extended period of
uncertainty and volatility in the financial markets. Recession fears abound and negative economic
predictions are increasingly more common. We foresee no stabilizing signs in the U.S. housing
market. Declining home prices are seemingly already affecting retail sales and other consumer
discretionary spending. A return to a more normally functioning housing market may not truly occur
until the securitization markets start to properly function again. We are encouraged by signs
pointing to a possible mortgage refinance wave that could occur in 2008 as interest rates and
mortgage rates have declined. However, we believe the post-credit bubble effects will continue to
keep volatility high in the financial markets for some time. Another concern is whether a
financial market malaise will result in a global recession. Given the surge in prices of oil and
other commodities, pricing inflation also remains a risk.
Our fixed income focus will be to seek high quality securities to reduce portfolio volatility and
to maximize after–tax investment yield. This will entail maintaining a fairly elevated level of
new purchase allocations to municipal securities, as they present attractive relative value on a
taxable equivalent yield basis. Volatility, downgrades, and a lack of market liquidity in ABS and
CMBS may also present some interesting opportunities in those sectors, as new issue volumes are
expected to be down by well over 25% or more by some estimates. The volatility in this sector is
not expected to end soon as leveraged positions in structured bonds are unwound. Nonetheless, we
expect that further Federal Reserve rate cuts may certainly aid the markets in 2008; although
additional cuts could further weaken the U.S. dollar, which could have a far-reaching negative
impact in the U.S. financial markets.
Considering all the volatility in the equity market, we are even more cautious now than we were in
late 2007. We will continue to manage through this period of uncertainty by investing in companies
with more defensive characteristics, such as solid free cash flow, exposure to secular growth
themes, strong balance sheets and reasonable valuations. Other considerations are favorable
long-term corporate performance and attractive relative historical valuations.
Our outlook for the alternative investment strategy continues to be positive over the longer-term.
In the near term, we expect the current credit crisis to slow the pace of merger and acquisitions,
as potential buyers no longer have access to large quantities of debt with favorable credit terms.
This will reduce the return that many private equity sponsors have been able to realize over the
past few years. Therefore, we expect a slowdown in deal activity and a reduction in distributions
to private equity investors.
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 in markets that continue to offer growth opportunities. During 2007, these
operations provided a contribution of $0.22 per diluted share, compared to $0.19 per diluted share
in 2006. Contributions from the Diversified Insurance Services segment, particularly the flood
business, continue to provide some mitigation of insurance pricing cycles and the adverse impact
that catastrophe losses have on our Insurance Operations segment. We evaluate the performance of
these operations based on several measures, including, but not limited to, results of operations in
accordance with GAAP, with a focus on our return on revenue (net income divided by revenues). The
results for this segment’s continuing operations are as follows:
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HR Outsourcing
Flood Insurance
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, primarily the EPP, offer an additional revenue stream for our independent agents. Since unveiling the EPP during the first quarter 2006, agents have gained a better understanding of the HR Outsourcing product. Despite this, consistent with trends in the professional employer industry that are pointing to flat to negative growth in worksite lives and the current economy, we expect our client sales to continue to be difficult. We also have two issues in Florida, where we derive 29% of our co-employer service fees. First, the economy is struggling and, second, workers compensation rates have been reduced by the regulators by 18.4% for 2008, after a 15.7% rate decrease that was effective January 1, 2007 for voluntary industrial classes. Consequently, we only expect marginal growth in the number of worksite lives during 2008. The viability of the NFIP’s reinsurance program under the “Write-Your-Own” (“WYO”) Program is an
essential component of our Diversified Insurance Services operations. In 2005, the destruction
caused by the active hurricane season stressed the NFIP with excessive levels of flood losses. We
continue to monitor developments with the NFIP regarding its ability to pay claims in the event of
another large-scale disaster. Congress controls the federal agency’s funding authority, which was
exceeded after Hurricane Katrina, and is again nearing maximum capacity. Bills are pending in the
House and Senate that could impact the NFIP. These bills contain substantial legislative changes
and revisions to the NFIP and WYO Program, some of which may be favorable and some of which may be
unfavorable for us. It is uncertain, at present, what the net impact to us may be if the
legislation is passed. During 2008, the NFIP also is expected to further decrease the fee paid to
us by 0.5 points to 29.7%, which could put some pressure on future margin levels. The current
program is also being reevaluated to include a cap on claim fees paid by the NFIP. While the final
outcome of this legislation is unknown, this cap could impact the ultimate claim fee that we
receive in the event that there is a large catastrophe in an area in which we are geographically
concentrated.
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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
Liquidity is a measure of our ability to generate sufficient cash flows to meet the short-term and
long-term cash requirements of our business operations. Our cash and short-term investments
position remained relatively flat at $198.6 million at December 31, 2007 compared to $203.5 million
at December 31, 2006. 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 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 2007 unaudited statutory financial statements, the Insurance Subsidiaries are permitted to pay
to Selective Insurance Group, Inc. ordinary dividends in the aggregate amount of approximately
$139.4 million in 2008. For additional information regarding dividend restrictions, refer to Note
9, “Indebtedness” and Note 10, “Stockholders’ Equity” in Item 8. “Financial Statements and
Supplementary Data” of this Form 10-K.
Our Insurance Subsidiaries generate cash flows primarily from insurance float, which is created by
collecting premiums and earning investment income before losses are paid. The period of the float
can extend over many years. To provide liquidity while maintaining consistent investment
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. The duration of the fixed maturity portfolio, including short-term investments, was 3.9
years as of December 31, 2007, while the liabilities of our Insurance Subsidiaries have a duration
of 3.4 years. In addition, the Insurance Subsidiaries purchase reinsurance coverage for protection
against any significantly large claims or catastrophes that may occur during the year.
We have a syndicated line of credit agreement with Wachovia Bank, National Association as
administrative agent. Under this agreement, we have access to a $50 million credit facility, which
can be increased to $75 million with the consent of all lending parties. At December 31, 2007, no
balances were outstanding under this credit facility.
Selective HR Solutions (“Selective HR”), our HR Outsourcing business, generates cash flows from its
operations. Dividends from Selective HR 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, which Selective HR generally maintains just above 1:1, provides an
indication of a company’s ability to meet its short-term obligations and is calculated by dividing
current assets by current liabilities. Selective HR provided dividends to Selective Insurance
Group, Inc. of $4.1 million in 2007 and $4.2 million in 2006.
Dividends on shares of our Common Stock are declared and paid at the discretion of our Board of
Directors based on our 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 we issued on May 4, 2000 (the “2000 Senior Notes”). All
such covenants were met during 2007 and 2006. For further information regarding our notes payable,
see Note 9, “Indebtedness,” included in Item 8. “Financial Statements and Supplementary Data” of
this Form 10-K. At December 31, 2007, the amount available for dividends to holders of our Common
Stock, in accordance with the restrictions of the 2000 Senior Notes, was $336.0 million. On
January 30, 2007, our Board of Directors declared a two-for-one stock split of our Common Stock, in
the form of a share dividend of one additional share of Common Stock for each outstanding share of
Common Stock (the “Share Dividend”). The Share Dividend was paid on February 20, 2007 to
stockholders of record as of the close of business on February 13, 2007. The effect of the Share
Dividend has been recognized retroactively in all share and per share data, as well as the capital
stock account balances, in the accompanying Consolidated Financial Statements, Notes to
Consolidated Financial Statements and supplemental financial data. Book value per share increased
to $19.81 as of December 31, 2007 compared to $18.81 as of December 31, 2006. Our ability to
continue to pay dividends to our stockholders is also dependent in large part on the ability of our
Insurance Subsidiaries and the subsidiaries in our Diversified Insurance Services segment to pay
dividends. Restrictions on the ability of our subsidiaries, particularly the Insurance
Subsidiaries, to declare and pay dividends, could materially affect our ability to pay principal
and interest on indebtedness and dividends on Common Stock.
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We have historically met our liquidity requirements through dividends from our subsidiaries and by
issuing debt and equity securities. We expect to meet our liquidity requirements by these sources
in the future. The Insurance Subsidiaries have historically met their liquidity requirements from
insurance premiums and investment income. These items have historically provided more than
sufficient funds to pay losses, operating expenses, and dividends.
Capital Resources
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, 2007, we had stockholders’ equity of $1,076.0 million and total debt of $295.1
million. In addition, we have an irrevocable trust valued at $13.2 million to provide for the
repayment of notes having maturities in 2008.
Our cash requirements include, but are not limited to, principal and interest payments on senior
convertible notes, various notes payable and convertible subordinated debentures, dividends to
stockholders, payment of claims, the purchase of investments and capital expenditures, as well as
other operating expenses, which include agents’ commissions, labor costs, premium taxes, general
and administrative expenses, and income taxes. For further details regarding our cash
requirements, refer to the section below titled “Contractual Obligations and Contingent Liabilities
and Commitments.”
As active capital managers, we continually monitor our cash requirements and 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 our 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 2007:
Off-Balance Sheet Arrangements
At December 31, 2007 and December 31, 2006, we 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, we
are not exposed to any financing, liquidity, market, or credit risk that could arise if we had
engaged in such relationships.
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Contractual Obligations and Contingent Liabilities and Commitments
As discussed in “Net Loss and Loss Expense Reserves” in Item 1. “Business.” of this Form 10-K, 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. “Management’s 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.
“Management’s 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, 2007 are
summarized below:
See “Liquidity” section of Item 7. “Management’s Discussion and Analysis of Financial Condition and
Results of Operations” for a discussion of our syndicated line of credit agreement.
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At December 31, 2007, we have contractual obligations that expire at various dates through 2022 to
invest up to an additional $129.8 million in alternative investments. 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 18, “Related Party Transactions” included in Item 8. “Financial Statements and Supplementary
Data” of this Form 10-K.
Ratings
We are rated by major rating agencies, which provide opinions of our financial strength, operating
performance, strategic position, and ability to meet policyholder obligations. We believe that our
ability to write insurance business is most influenced by our rating from A.M. Best, which
currently rates us “A+ (Superior),” their second highest of fifteen ratings, and has been our
rating for 46 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 and/or agents, 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. In the third quarter of 2007, S&P’s Insurance Rating Services (“S&P”) reaffirmed our
financial strength rating of “A+.” S&P’s reaffirmation cites our strong competitive position with
close ties to our agents, strong operating performance, very strong operating company
capitalization, and good financial flexibility. During the third quarter of 2006, Moody’s elevated
their outlook regarding Selective to “positive.” The financial strength of our insurance business
has been rated, “A2” by Moody’s since 2001 and “A+” by Fitch Ratings since 2004. Our Moody’s 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 Selective Insurance Group Inc.’s debt ratings from
Moody’s 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 our taxable income, pre-tax financial statement income, and net
deferred tax (liability) asset:
Total federal income tax expense was $46.3 million in 2007 compared to $56.9 million in 2006 and
$55.3 million in 2005. The effective tax rate for 2007 was 24.0% compared to 25.8% for 2006 and
27.3% for 2005. Our effective tax rate differs from the federal corporate rate of 35% primarily as
a result of tax-advantaged investment income. The decline in underwriting profits and the
resulting higher ratio of net investment income to total book income before tax contributed to the
1.8% decrease in the effective tax rate from 2006 to 2007. The 1.5% decrease in the effective tax
rate from 2005 to 2006 is mainly attributable to the increase in the tax advantaged securities
within our investment portfolio and the settlement of an IRS audit.
We have a net deferred tax asset of $22.4 million at December 31, 2007 compared with a deferred tax
asset of $15.4 million at December 31, 2006. This change is primarily due to temporary differences
relating to the conversion and redemption of the convertible debt, the deferred impact of
underwriting results and a reduction in unrealized gains in the investment portfolio offset by
pension and accelerated depreciation.
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.
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Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Market Risk
The fair value of Selective’s assets and liabilities are subject to market risk, primarily interest
rate, credit risk and equity price risk related to Selective’s investment portfolio. Selective’s
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.
Selective’s investment philosophy includes setting 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, 2007, the mix of Selective’s investment portfolio was
83% fixed maturity securities, 7% equity securities, 5% short-term investments, and 5% other
investments.
During 2007, portions of our investment portfolio were adversely affected by events and
developments in the capital markets, including decreased market liquidity for certain invested
assets, market perception of increased credit risk with respect to the types of securities held in
Selective’s portfolio, and the corresponding credit spread-widening with respect to our invested
assets.
Interest Rate Risk
In connection with the Insurance Subsidiaries, Selective invests in interest rate sensitive
securities, mainly fixed maturity securities. Selective’s fixed maturity portfolio is comprised of
primarily investment grade (investments receiving S&P or an equivalent rating of BBB- or above)
corporate securities, U.S. government and agency securities, municipal obligations, and
mortgage-backed securities. Selective’s strategy to manage interest rate risk is to purchase
intermediate-term fixed maturity investments that are attractively priced in relation to perceived
credit risks. Selective’s 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, 2007, 95% of Selective’s fixed maturity portfolio (excluding
short-term investments) had a maturity of 10 years or less, and the average duration was 4.2 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 Selective’s income or stockholders’ equity. Further, the
calculations do not take into account any actions Selective may take in response to market
fluctuations.
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The following table presents the sensitivity analysis of each component of market risk as of
December 31, 2007:
Credit Risk
Credit quality of the fixed maturity portfolio continues to remain high, with the weighted average
credit rating of the portfolio at “AA+.” Exposure to non-investment grade bonds remains at a low
absolute level, composing less than 1% of the total fixed maturity portfolio. Selective only has
three non-investment grade rated securities in the portfolio with a fair value of $10.1 million and
an unrealized loss of $0.3 million. As of December 31, 2007, no single fixed maturity security is
rated below “BB.”
However, Selective’s investment portfolio includes certain classes of assets, such as Residential
Asset Backed Securities (“RABS”) and Residential Mortgage Backed Securities (“RMBS”), which have
been affected by the current market conditions related to the sub-prime crisis. The RMBS and RABS
portfolio represents 14% of our total fixed maturity portfolio and consists entirely of investment
grade securities with 96% of the portfolio rated “AAA” and only 1% rated “A” or below. Agency
securities backed by various federal agencies represent approximately 50% of Selective’s RMBS and
RABS. Loan to Value (“LTV”) ratios and FICO score statistics are important in our initial as well
as ongoing analysis of this portfolio. 99% of the non-agency securities have current LTV ratios of
80% and below and 94% have FICO scores above 700 with only 1% where FICO scores are below 650. In
addition, we have no sub-prime reset risk in the RMBS or RABS portfolio. Despite the portfolio’s
high quality, current market conditions reduced the liquidity of the RMBS and RABS securities,
which in turn resulted in some volatility in their fair value. As of December 31, 2007,
Selective’s RMBS and RABS portfolio has a fair value of $440.6 million with unrealized losses of
$3.8 million. Selective continues to evaluate underlying credit quality within this portfolio and
believes that current fair value fluctuations are reflective of temporary market dislocation. As
long term, income-oriented investors, Selective remains comfortable with the credit risk in these
securities.
Residual effects of the current market conditions may also affect other parts of Selective’s
portfolio; such as bonds and equity investments in financial institutions and certain other
invested assets. For example, as of December 31, 2007, the market value of Selective’s Commercial
Mortgage Backed Securities (“CMBS”) portfolio is $284.4 million with unrealized losses of $4.6
million. The CMBS portfolio makes up 9% of our total fixed maturity portfolio and consists
primarily of highly rated securities with 92% of CMBS securities rated above “A” and only 2% rated
below investment grade as of December 31, 2007. In addition, agency securities backed by various
federal agencies represent approximately 17% of Selective’s CMBS portfolio.
During 2007, our RMBS, RABS, and CMBS portfolios experienced no ratings downgrades which is in part
a result of the high credit quality of the underlying collateral and stringent pre-purchase
analysis and due diligence. Based on Selective’s fixed maturity portfolio asset allocation and
security selection process, Selective believes that its fixed maturity portfolio is not overly
prone to significant credit risk and Selective does not believe that the fair value fluctuations
noted above will result in material changes to the value of our overall invested assets.
Equity Price Risk
Selective’s equity securities are classified as available for sale in accordance with FAS 115. The
Company’s equity securities portfolio 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, 2007. In the analysis, Selective includes investments in
equity securities. The following table presents the hypothetical increases and decreases in market
value of the equity portfolio as of December 31, 2007:
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Indebtedness
(a) Long-Term Debt. As of December 31, 2007, Selective had outstanding long-term debt of $295.1
million that mature as shown on the following table:
The weighted average effective interest rate for Selective’s outstanding long-term debt is 7.26%.
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 2007, Selective had 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. Selective accessed $6 million from the facility during 2007 at the London
Interbank Offered Rate. At December 31, 2007, there were no balances outstanding under the
facility.
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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, 2007 and 2006, 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, 2007. 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 Company’s 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, 2007 and 2006, and the results of their operations and their cash flows for each
of the years in the three-year period ended December 31, 2007, 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, 2007, based on criteria established in Internal
Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO), and our report dated February 27, 2008 expressed an unqualified opinion on the
effectiveness of the Company’s internal control over financial reporting.
/s/ KPMG LLP
New York, New York February 27, 2008
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Consolidated Balance Sheets
See accompanying notes to consolidated financial statements.
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Consolidated Statements of Income
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