Item 1. Business.
Overview
Selective Insurance Group, Inc. (referred to as the “Parent”) is a New Jersey holding company that was incorporated in 1977. Our main office is located in Branchville, New Jersey and the Parent’s common stock is publicly traded on the NASDAQ Global Select Market under the symbol “SIGI.” The Parent has ten insurance subsidiaries, nine of which are licensed by various state departments of insurance to write specific lines of property and casualty insurance business in the standard market. The remaining subsidiary is authorized by various state insurance departments to write property and casualty insurance in the excess and surplus lines ("E&S") market. Our ten insurance subsidiaries are collectively referred to as the “Insurance Subsidiaries.” The Parent and its subsidiaries are collectively referred to as "we," “us,” or “our” in this document.
In 2014, we were ranked as the 44th largest property and casualty group in the United States based on 2013 net premium written (“NPW”) in A.M. Best and Company’s (“A.M. Best”) annual list of “Top 200 U.S. Property/Casualty Writers.”
Our Insurance Subsidiaries’ ratings by major rating agency are as follows:
For further discussion on our ratings, please see the “Ratings” section of Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” of this Form 10-K.
We have provided a glossary of terms as Exhibit 99.1 to this Form 10-K, which defines certain industry-specific and other terms that are used in this Form 10-K.
Segments
We classify our business into four reportable segments:
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Standard Commercial Lines - comprised of insurance products and services provided in the standard marketplace to our commercial customers, who are typically businesses, non-profit organizations, and local government agencies. This business represents about 76% of our total insurance segments’ net premiums written.
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Standard Personal Lines - comprised of insurance products and services, including flood insurance coverage that we write through the National Flood Insurance Program (“NFIP”), provided primarily to individuals acquiring coverage in the standard marketplace. This business represents about 16% of our total insurance segments’ net premiums written.
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E&S Lines - comprised of insurance products and services provided to customers who have not obtained coverage in the standard marketplace. We currently only write commercial lines E&S coverages and this business represents about 8% of our total insurance segments’ net premiums written.
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Investments - invests the premiums collected by our insurance segments, as well as amounts generated through our capital management strategies, which may include the issuance of debt and equity securities.
These segments are different from the segments that we have previously reported, which were Standard Insurance Operations, E&S Insurance Operations, and Investments. All prior year information contained in this Form 10-K has been restated to reflect our revised segments. For qualitative information behind the change, as well as quantitative information regarding these segments, such as revenue contributions and profitability measures, see Note 11. "Segment Information" in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K.
We derive substantially all of our income in three ways:
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Underwriting income from our three insurance segments. Underwriting income is comprised of revenues, which are the premiums earned on our insurance products and services, less expenses. Gross premiums are direct premium written (“DPW”) plus premiums assumed from other insurers. Gross premiums less premium ceded to reinsurers, is net premiums written (“NPW”). NPW is recognized as revenue ratably over a policy’s term as net premiums earned (“NPE”). Expenses related to our insurance segments fall into three main categories: (i) losses associated with claims and various loss expenses incurred for adjusting claims (referred to as “loss and loss expenses”); (ii) expenses related to insurance policy issuance, such as commissions to our distribution partners, premium taxes, and other expenses incurred in issuing and maintaining policies, including employee compensation and benefits (referred to as “underwriting expenses”); and (iii) policyholder dividends.
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Net investment income from the investment segment. We generate income from investing insurance premiums and amounts generated through our capital management strategies. Net investment income consists primarily of interest earned on fixed income investments, dividends earned on equity securities, and other income primarily generated from our alternative investment portfolio.
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Net realized gains and losses on investment securities from the investments segment. Realized gains and losses from the investment portfolios of the Insurance Subsidiaries and the Parent are typically the result of sales, calls, and redemptions. They also include write downs from other-than-temporary impairments (“OTTI”).
Our income is partially offset by general corporate expenses, including interest on our debt obligations, and tax payments.
We use the combined ratio as the key measure in assessing the performance of our insurance segments. Under U.S. generally accepted accounting principles (“GAAP”), the combined ratio is calculated by adding: (i) the loss and loss expense ratio, which is the ratio of incurred loss and loss expense to NPE; (ii) the expense ratio, which is the ratio of underwriting expenses to NPE; and (iii) the dividend ratio, which is the ratio of policyholder dividends to NPE. Statutory accounting principles ("SAP") provides a calculation of the combined ratio that differs from GAAP in that the statutory expense ratio is the ratio of underwriting expenses to NPW, not NPE. A combined ratio under 100% generally indicates an underwriting profit and a combined ratio over 100% generally indicates an underwriting loss. The combined ratio does not reflect investment income, federal income taxes, or other non-insurance related income or expense.
We use after-tax investment income and net realized gains or losses as the key measure in assessing the performance of our investments segment. Our investment philosophy includes setting certain risk and return objectives for the fixed income, equity, and other investment portfolios. We generally review our performance by comparing our returns for each of these components of our portfolio to a weighted-average benchmark of comparable indices.
Our operations are heavily regulated by the state insurance regulators in the states in which our Insurance Subsidiaries are organized and licensed or authorized to do business. In these states, the Insurance Subsidiaries are required to file financial statements prepared in accordance with SAP, which are promulgated by the National Association of Insurance Commissioners (“NAIC”) and adopted by the various states. Because of these state insurance regulatory requirements, we use SAP to manage our insurance operations. The purpose of these state insurance regulations is to protect policyholders, so SAP focuses on solvency and liquidation value unlike GAAP, which focuses on shareholder returns as a going concern. Consequently, significant differences exist between SAP and GAAP as discussed below:
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With regard to the underwriting expense ratio: As noted above, NPE is the denominator for GAAP; whereas NPW is the denominator for SAP.
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With regard to certain income:
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Underwriting expenses that are incremental and directly related to the successful acquisition of insurance policies are deferred and amortized to expense over the life of an insurance policy under GAAP; whereas they are recognized when incurred under SAP.
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Deferred taxes are recognized in our Consolidated Statements of Income as either a deferred tax expense or a deferred tax benefit under GAAP; whereas they are recorded directly to surplus under SAP.
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Changes in the value of our alternative investments, which are part of our other investment portfolio on our Consolidated Balance Sheets, are recognized in income under GAAP; whereas they are recorded directly to surplus under SAP and only recognized in income when cash is received.
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With regard to loss and loss expense reserves:
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Under GAAP, reinsurance recoverables, net of a provision for uncollectible reinsurance, are presented as an asset on the Consolidated Balance Sheet, whereas under SAP, this amount is netted within the liability for loss and loss expense reserves.
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Under GAAP, for those structured settlements for which we did not obtain a release, a deposit asset and the related loss reserve are included on the Consolidated Balance Sheet, whereas under SAP, the structured settlement transaction is recorded as a paid loss.
The following table reconciles losses and loss expense reserves under SAP and GAAP at December 31 as follows:
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With regard to equity under GAAP and statutory surplus under SAP:
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The timing difference in income due to the GAAP/SAP differences in expense recognition creates a difference between GAAP equity and SAP statutory surplus.
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Regarding unrealized gains and losses on fixed income securities:
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Under GAAP, unrealized gains and losses on available-for-sale (“AFS”) fixed income securities are recognized in equity; but they are not recognized in equity on purchased held-to-maturity (“HTM”) securities. Unrealized gains and losses on HTM securities transferred from an AFS designation are amortized from equity as a yield adjustment.
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Under SAP, unrealized gains and losses on fixed income securities assigned certain NAIC Security Valuation Office ratings (specifically designations of one or two, which generally equate to investment grade bonds) are not recognized in statutory surplus. However, unrealized losses on fixed income securities that have a designation of three or higher are recognized as an adjustment to statutory surplus.
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Certain assets are designated under insurance regulations as “non-admitted,” including, but not limited to, certain deferred tax assets, overdue premium receivables, furniture and equipment, and prepaid expenses. These assets are excluded from statutory surplus under SAP, but are recorded in the Consolidated Balance Sheets net of applicable allowances under GAAP.
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Regarding the recognition of the liability for our defined benefit plans, under both GAAP and SAP, the liability is recognized in an amount equal to the excess of the projected benefit obligation over the fair value of the plan assets. However, changes in this balance not otherwise recognized in income are recognized in equity as a component of other comprehensive income (“OCI”) under GAAP and in statutory surplus under SAP.
Our combined insurance segments' GAAP results for the last three completed fiscal years are shown on the following table:
For revenue and profitability measures for each of our three insurance segments, see Note 11. "Segment Information" in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K. We do not allocate assets to individual segments. In addition, for analysis of our insurance segments' results, see "Results of Operations and Related Information by Segment" in Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations." of this Form 10-K.
Insurance Segments
Overview
We derive all of our insurance operations revenue from selling insurance products and services to businesses and individuals for premium. The majority of our sales are annual insurance policies. Our most significant cost associated with the sale of insurance policies is our loss and loss expenses.
To that end, we establish loss and loss expense reserves that are estimates of the amounts that we will need to pay in the future for claims and related expenses for insured losses that have already occurred. Estimating reserves as of any given date involves a considerable degree of judgment and is inherently uncertain. We regularly review our reserving techniques and our overall amount of reserves. For disclosures concerning our unpaid loss and loss expenses, as well as a full discussion regarding our loss reserving process, see "Critical Accounting Policies and Estimates" in Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations." of this Form 10-K. Additionally, for an analysis of changes in our loss reserves over the most recent three-year period, see Note 9. "Reserves for Losses and Loss Expenses" in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K.
As part of our risk management efforts associated with the sale of our products and services, we use reinsurance to protect our capital resources and insure us against losses on the risks that we underwrite. We use two main reinsurance vehicles: (i) a reinsurance pooling agreement among our Insurance Subsidiaries in which each company agrees to share in premiums and losses based on certain specified percentages; and (ii) reinsurance contracts and arrangements with third parties that cover various policies that we issue to our customers. For information regarding reinsurance treaties and agreements, see "Reinsurance" in Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations." of this Form 10-K.
Insurance Segments Products and Services
The types of insurance we sell in our insurance segments fall into three broad categories:
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Property insurance, which generally covers the financial consequences of accidental loss of an insured’s real and/or personal property. Property claims are generally reported and settled in a relatively short period of time.
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Casualty insurance, which generally covers the financial consequences of employee injuries in the course of employment and bodily injury and/or property damage to a third party as a result of an insured’s negligent acts, omissions, or legal liabilities. Casualty claims may take several years to be reported and settled.
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Flood insurance, which generally covers property losses under the Federal Government's Write Your Own ("WYO") program of the NFIP. Flood insurance premiums and losses are 100% ceded to the NFIP.
We underwrite our business primarily through traditional insurance. The following table shows the principal types of policies we write:
1Flood insurance premiums and losses are 100% ceded to the federal government’s WYO program. Certain other policies contain minimal flood or flood related coverages.
Product Development and Pricing
Our insurance policies are contracts that specify our coverages - what we will pay to or for an insured upon a specified loss. We develop our coverages internally and by adopting and modifying forms and statistical data licensed from third party aggregators, notably Insurance Services Office, Inc. (“ISO”), American Association of Insurance Services, Inc. ("AAIS"), and the National Council on Compensation Insurance, Inc. ("NCCI"). Determining the price to charge for our coverages involves consideration of many variables. At the time we underwrite and issue a policy, we do not know what our actual costs for the policy will be in the future. To calculate and project future costs, we examine and analyze historical statistical data and factor in expected changes in loss trends. Additionally, we have developed predictive models for certain of our Standard Commercial and Standard Personal Lines. Predictive models analyze historical statistical data regarding our customers and their loss experience, rank our policies, or potential policies, based on this analysis, and apply this risk data to current and future customers to predict the likely profitability of an account. A model’s predictive capabilities are limited by the amount and quality of the statistical data available. As a regional insurance group, our loss experience is not always statistically large enough to analyze and project future costs. Consequently, we use ISO, AAIS, and NCCI data to supplement our proprietary data.
Customers and Customer Markets
We categorize our Standard Commercial Lines customers into the following strategic business units ("SBUs"):
We do not categorize our Standard Personal Line customers or our E&S Line customers by class.
The following are general guidelines that can be used as indicators of the size of our customers:
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The average Standard Commercial Lines account size is approximately $10,000.
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The average Standard Personal Lines account size is approximately $1,500.
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The average E&S Lines policy is approximately $3,100.
No one customer accounts for 10% or more of our insurance segments in the aggregate.
Geographic Markets
We principally sell in the following geographic markets:
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Standard Commercial Lines products and services are primarily sold in 22 states and the District of Columbia in the Eastern and Midwestern regions of the United States.
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Standard Personal Lines products and services are primarily sold in 13 states in the Eastern and Midwestern regions of the United States, except for the flood portion of this segment, which is sold in all 50 states and the District of Columbia.
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E&S Lines are sold in all 50 states and the District of Columbia.
We believe this geographic diversification lessens our exposure to regulatory, competitive, and catastrophic risk. The following table lists the principal states in which we write business and the percentage of total NPW each represents for the last three fiscal years:
We support these geographic locations from our corporate headquarters in Branchville, New Jersey, and our six regional branches (referred to as our “Regions”). The table below lists our Regions and where they have office locations:
Distribution and Marketing
We sell and distribute our Standard Commercial and Standard Personal Lines products and services through our distribution partners, who in the case of our standard market business are independent retail insurance agents. Independent retail insurance agents and brokers write approximately 80% of Standard Commercial Lines insurance in the United States according to a study released in 2014 by the Independent Insurance Agents & Brokers of America. Approximately 35% of Standard Personal Lines insurance is sold through independent retail insurance agents, according to the same survey. We believe that independent retail insurance agents will remain a significant force in overall insurance industry premium production because they represent more than one insurance carrier and therefore are able to provide a wider choice of commercial lines and personal lines insurance products and risk-based consultation to customers. We have agreements with approximately 1,100 distribution partners in the commercial lines standard market as of December 31, 2014. Of these distribution partners, 700 of them also sell personal lines, excluding flood. The distribution partners have approximately 2,000 office locations that sell our products to our standard market customers. In addition, we have approximately 5,000 distribution partners selling our flood insurance products.
E&S Lines are written almost exclusively through approximately 80 wholesale general agents, who are our distribution partners in the E&S market. We have granted contract binding authority to these partners for business that meets our prescribed underwriting and pricing guidelines.
We pay our distribution partners commissions and other consideration for business placed with us. We seek to compensate our distribution partners fairly and consistent with market practices. No one distribution partner is responsible for 10% or more of our combined insurance segments' premium.
In our most recent survey of our retail distribution partners, which was conducted in 2014, we received an overall satisfaction score of 8.6 out of 10, which, we believe, highlighted our distribution partners’ satisfaction with our Standard Commercial Lines and Standard Personal Lines products, the ease of reporting claims, and the professionalism and effectiveness of our employees.
As our customers rely heavily on our distribution partners, it is sometimes difficult to develop brand recognition with our customers, who cannot always differentiate between their insurance agents and their insurance carriers. We continue to evolve our service model, post-acquisition, with an increasing focus on the customer. While we currently offer customers a shared experience with our distribution partners, we are moving towards a model that positions us to more directly demonstrate our value proposition to our customers.
Our primary marketing strategy is to:
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Use an empowered field model to provide our retail distribution partners with resources within close geographic proximity to their businesses and our customers. For further discussion on this, see the “Field Model and Technology” section below.
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Develop close relationships with each distribution partner, as well as their principals and producers: (i) by soliciting their feedback on products and services; (ii) by advising them concerning product developments; and (iii) through interaction with them focusing on producer recruitment, sales training, enhancing customer experience, online marketing, and distribution operations.
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Develop with each distribution partner, and then carefully monitor, annual goals regarding: (i) types and mix of risks placed with us; (ii) amount of premium or number of policies placed with us; (iii) customer service and retention levels; and (iv) profitability of business placed with us.
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Develop brand recognition with our customers through our marketing efforts, which include radio and television advertising, as well as advertising at certain national and local sporting events.
Field Model and Technology
We use the service mark “High-tech x High-touch = HT2 SM” to describe our business strategy. “High-tech” refers to our technology that we use to make it easy for our distribution partners and customers to do business with us. “High-touch” refers to the close relationships that we have with our distribution partners and customers through our field business model.
High Tech
We leverage the use of technology in our business. We have made significant investments in information technology platforms, integrated systems, internet-based applications, and predictive modeling initiatives. We do this to provide:
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Our distribution partners and our customers with access to accurate business information and the ability to process certain transactions from their locations, seamlessly integrating those transactions into our systems;
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Our underwriters with targeted underwriting and pricing tools to enhance profitability while growing the business;
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Our Special Investigations Unit ("SIU") investigators access our business intelligence systems to better identify claims with potential fraudulent activities;
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Our claims recovery and subrogation departments with the ability to expand and enhance their models through the use of our business intelligence systems; and
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Our customers with 24/7 access to transactional capabilities and information through a web-based customer portal and a customer mobile app.
In 2014, we received the Interface Partner Award from Applied Systems, an automated solutions provider to independent retail insurance agents, for the seventh consecutive year. The award recognizes our leadership and innovation in our interface advancements in download and real-time rating.
We manage our information technology projects through an Enterprise Project Management Office (“EPMO”) governance model. The EPMO is supported by certified individuals who apply methodologies to: (i) communicate project management standards; (ii) provide project management training and tools; (iii) manage projects; (iv) review project status and cost; and (v) provide non-technology project management consulting services to the rest of the organization. The EPMO, which includes senior management representatives from all major business areas, corporate functions, and information technology, meets regularly to review all major initiatives and receives reports on the status of other projects. We believe the EPMO is an important factor in the success of our technology implementation.
Our primary technology operations are located in Branchville, New Jersey and Glastonbury, Connecticut. We have agreements with multiple consulting, information technology, and service providers for supplemental staffing services. Collectively, these providers supply approximately 36% of our skilled technology capacity. We retain management oversight of all projects and ongoing information technology production operations. We believe we would be able to manage an efficient transition to new vendors without significant impact to our operations if we terminated an existing vendor.
High Touch
To support our distribution partners, we employ a field model for both underwriting and claims, with various employees in the field, usually working from home offices near our distribution partners. We believe that we build better and stronger relationships with our distribution partners because of the close proximity of our field employees, and the resulting direct interaction with our distribution partners and our customers. At December 31, 2014, we had approximately 2,200 employees, about 320 of which worked in the field, and another 850 that worked in one of our regional offices noted above.
Underwriting Process
Our underwriting process requires communication and interaction among:
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Our distribution partners, who provide front-line underwriting, our Agency Management Specialists (“AMSs”) and Safety Management Specialists (“SMSs”), our Standard Personal Lines marketing representatives, and our corporate and regional underwriters. Our AMSs continue to be a central focus of the field model, with responsibility for: (i) managing the growth and profitability of their distribution partners with us; and (ii) performing field underwriting for new Standard Commercial Lines business. In the fourth quarter of 2014, a strategic decision was made to eliminate our field marketing specialist role, which had been a multi-purpose role focused on Standard Personal Lines, small Standard Commercial Lines business, and technology training. This role was replaced with dedicated Standard Personal Lines marketing representatives with the primary responsibility of growing Standard Personal Lines, dedicated field technical coordinators responsible solely for technology assistance and training and over a dozen additional AMSs. In addition, we broadened the scope of, and enhanced the talent in, our small business teams. These teams were previously responsible for handling business in need of review that was submitted through our automated underwriting platform, One & Done®. They now also handle small accounts with low underwriting complexity, which enables our AMSs to spend more time underwriting middle market accounts.
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Our 5,000 flood distribution partners for our Standard Personal Lines business under the NFIP's WYO program.
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Our corporate underwriting department, which develops our products, policy forms, pricing, and underwriting guidelines in conjunction with the Regions.
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Our Regions, which establish: (i) annual premium and pricing goals in consultation with the corporate underwriting department; (ii) new business targets for our distribution partners; and (iii) profit improvement plans for our distribution partners.
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Our Actuarial Department, located primarily in our corporate headquarters, which assists in the determination of rate and pricing levels, while monitoring pricing and profitability.
We have an underwriting service center (“USC”) located in Richmond, Virginia. The USC assists our distribution partners by servicing certain Standard Personal Lines and smaller Standard Commercial Lines accounts. At the USC, many of our employees are licensed agents who respond to customer inquiries about insurance coverage, billing transactions, and other matters. For the convenience of using the USC and our handling of certain transactions, our distribution partners agree to receive a slightly lower than standard commission for the premium associated with the USC. As of December 31, 2014, our USC was servicing Standard Commercial Lines NPW of $49.6 million and Standard Personal Lines NPW of $26.3 million. The $75.9 million total serviced by the USC represents 4% of our total NPW.
We believe that our field model has a distinct advantage in its ability to provide a wide range of front-line safety management services focused on improving a Standard Commercial Lines insured’s safety and risk management programs and we have obtained the service mark “Safety Management: Solutions for a safer workplace.”SM Safety management services include: (i) risk evaluation and improvement surveys intended to evaluate potential exposures and provide solutions for mitigation; (ii) internet-based safety management educational resources, including a large library of coverage-specific safety materials, videos and online courses, such as defensive driving and employee educational safety courses; (iii) thermographic infrared surveys aimed at identifying electrical hazards; and (iv) Occupational Safety and Health Administration 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. Our safety management goal is to work with our customers to identify and eliminate potential loss exposures.
Claims Management
Effective, fair, and timely claims management is one of the most important services that we provide to our customers and distribution partners. It is also one of the critical factors in achieving underwriting profitability. We have structured our claims organization to emphasize: (i) cost-effective delivery of claims services and control of loss and loss expenses; and (ii) maintenance of timely and adequate claims reserves. In connection with our Standard Commercial Lines and Standard Personal Lines, we believe that we can achieve lower claims expenses through our field model by locating claims representatives in close proximity to our customers and distribution partners. For our E&S Line, we use external adjusters who are situated close to claimants and work with our corporate E&S claims adjusters to manage individual claims for this segment.
We have a claims service center (“CSC”), co-located with the USC, in Richmond, Virginia. The CSC receives first notices of loss from our customers and claimants related to our Standard Commercial Lines and Standard Personal Lines. The CSC is designed to help: (i) reduce the claims settlement time on first- and third-party automobile property damage claims; (ii) increase the use of body shops, glass repair shops, and car rental agencies that have contracted with us at discounted rates; (iii) handle and settle small property claims; and (iv) investigate and negotiate auto liability claims. Upon receipt of a claim, the CSC, as appropriate, will assign the matter to the appropriate Region or specialized area at our corporate headquarters.
Claims management specialists (“CMSs”) are responsible for investigating and resolving the majority of our standard marketplace commercial automobile bodily injury, general liability, and property losses with low to moderate severities. Strategically located throughout our footprint, CMSs are able to provide highly responsive customer and distribution partner service to quickly resolve claims within their authority. We have implemented specialized claims handling as follows:
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Workers compensation claim handling is centralized in Charlotte, North Carolina. Jurisdictionally trained and aligned medical only and lost-time adjusters manage non-complex workers compensation claims within our footprint. Claims with high exposure and/or significant escalation risk are referred to the workers compensation strategic case management unit.
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Property claims with high severity or technically complex losses are handled by either the Property Flex Unit or the Large Loss Unit. Both of these groups specifically handle only higher exposure property claims. The Large Loss Unit, which is comprised of seasoned general adjusters, handles claims above $100,000. During 2014, we established the Property Flex Unit to: (i) handle claims between $25,000 to $100,000; and (ii) form the core of a catastrophe team.
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Liability claims with high severity or technically complex losses are handled by the Complex Claims Unit ("CCU"). The CCU specialists are primarily field based and handle losses based on injury type or with severities greater than $250,000. Litigated matters not meeting the CCU criteria are handled within our regional offices by our litigation teams. These teams are aligned based upon jurisdictional knowledge and technical experience.
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All asbestos and environmental claims are referred to our specialized corporate Environmental Unit, which also handles latent claims.
This structure allows us to provide experienced adjusting to each claim category.
For all of our insurance segments, we have an 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 take action on potentially fraudulent claims. It is our practice to notify the proper authorities of SIU findings, which we believe sends a clear message that we will not tolerate fraud against us or our customers. The SIU supervises anti-fraud training for all claims adjusters and AMSs.
Insurance Operations Competition
Our insurance segments face competition from both public companies and mutual companies, which may have lower operating costs or cost of capital than we do. Some, like us, rely on partners for the distribution of their products and services and have competition within their distribution channel, making growth in market share difficult. Others either employ their own agents who only represent one insurance carrier or use a combination of distribution partners, captive agents, and direct marketing. The following provides information on the competition facing our insurance segments:
Standard Commercial Lines
The Standard Commercial Lines property and casualty insurance market is highly competitive and market share is fragmented among many companies. We compete with two types of companies, primarily on the basis of price, coverage terms, claims service, customer experience, safety management services, ease of technology, and financial ratings:
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Regional insurers, such as Cincinnati Financial Corporation, Erie Indemnity Company, The Hanover Insurance Group, Inc., and United Fire Group, Inc.; and
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National insurers, such as Liberty Mutual Holding Company Inc., The Travelers Companies, Inc., The Hartford Financial Services Group, Inc., Nationwide Mutual Insurance Company, and Zurich Insurance Group, Ltd.
Standard Personal Lines
While we face competition in Standard Personal Lines, carriers have been more successful at obtaining rate increases. Our Standard Personal Lines face competition primarily from the regional and national carriers noted above, as well as companies such as State Farm and Allstate Corporation. In addition, we face competition from direct insurers such as GEICO and The Progressive Corporation, which primarily offer personal auto coverage and market through a direct-to-consumer model.
E&S Lines
Our E&S Lines face competition from insurers such as Scottsdale Insurance Company, Nautilus Insurance Group, Colony Specialty, a member of the Argo Group International Holding Ltd, Markel Corporation, Western World Insurance Group, Century Insurance Group, a member of the Meadowbrook Insurance Group, Burlington Insurance Company, and Cincinnati Financial Corporation. In addition, we face competition from E&S insurers who work directly with retail agencies such as United States Liability Insurance Group.
Industry Comparison
A comparison of certain statutory ratios for our combined insurance segments and our industry are shown in the following table:
Note: Some amounts may not foot due to rounding.
1The ratios and percentages are based on SAP prescribed or permitted by state insurance departments in the states in which the Insurance Subsidiaries are domiciled.
2Source: A.M. Best. The industry ratios for 2014 have been estimated by A.M. Best.
Insurance Regulation
Primary Oversight by the States in Which We Operate
Our insurance segments are heavily regulated. The primary public policy behind insurance regulation is the protection of policyholders and claimants over all other constituencies, including shareholders. By virtue of the McCarran-Ferguson Act, Congress has largely delegated insurance regulation to the various states. The primary market conduct and financial regulators of our Insurance Subsidiaries are the departments of insurance in the states in which they are organized and are licensed. For a discussion of the broad regulatory, administrative, and supervisory powers of the various departments of insurance, refer to the risk factor that discusses regulation in Item 1A.
Item 1A. Risk Factors.
Any of the following risk factors could cause our actual results to differ materially from historical or anticipated results. They could have a significant impact on our business, liquidity, capital resources, results of operations, financial condition, and debt ratings. These risk factors might affect, alter, or change actions that we might take in executing our long-term capital strategy, including but not limited to, contributing capital to any or all of the Insurance Subsidiaries, issuing additional debt and/or equity securities, repurchasing our equity securities, redeeming our fixed income securities, or increasing or decreasing stockholders’ dividends. The following list of risk factors is not exhaustive, and others may exist.
Risks Related to Insurance Segments
The failure of our risk management strategies could have a material adverse effect on our financial condition or results of operations.
As an insurance provider, it is our business to take on risk from our customers. Our long term strategy includes use of above average operational leverage, which can be measured as the NPW to our equity or policyholders surplus. We balance operational leverage risk with a number of risk management strategies to achieve a balance of growth and profit and to reduce our exposure that include, but are not limited to, the following:
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Being disciplined in our underwriting practices;
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Being prudent in our claims management practices, establishing adequate loss and loss expense reserves, and placing appropriate reliance on our claims analytics;
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Continuing to develop and implement various underwriting tools and automated analytics to examine historical statistical data regarding our customers and their loss experience to: (i) classify such policies based on that information; (ii) apply that information to current and prospective accounts; and (iii) better predict account profitability;
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Continuing to develop our customer experience platform as we grow in our understanding of customer segmentation;
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Purchasing reinsurance and using catastrophe modeling;
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Being prudent in managing our investment portfolio, which supports our liabilities and underwriting strategies; and
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Being prudent in our financial planning process,which supports our underwriting strategies.
All of these strategies have inherent limitations. We cannot be certain that an unanticipated event or series of unanticipated events will not occur and result in losses greater than we expect and have a material adverse effect on our results of operations, liquidity, financial condition, financial strength, and debt ratings.
Our loss and loss expense reserves may not be adequate to cover actual losses and expenses.
We are required to maintain loss and loss expense reserves for our estimated liability for losses and loss expenses associated with reported and unreported insurance claims. Our estimates of reserve amounts are based on facts and circumstances that we know, including our expectations of the ultimate settlement and claim administration expenses, including inflationary trends particularly regarding medical costs, predictions of future events, trends in claims severity and frequency, and other subjective factors relating to our insurance policies in force. There is no method for precisely estimating the ultimate liability for settlement of claims. From time-to-time, we increase reserves if they are inadequate or reduce them if they are redundant. We cannot be certain that the reserves we establish are adequate or will be adequate in the future. An increase in reserves: (i) reduces net income and stockholders’ equity for the period in which the reserves are increased; and (ii) could have a material adverse effect on our results of operations, liquidity, financial condition, financial strength, and debt ratings.
We are subject to losses from catastrophic events.
Our results are subject to losses from natural and man-made catastrophes, including but not limited to: hurricanes, tornadoes, windstorms, earthquakes, hail, terrorism, explosions, severe winter weather, floods and fires, some of which may be related to climate changes. The frequency and severity of these catastrophes are inherently unpredictable. One year may be relatively free of such events while another may have multiple events. For further discussion regarding man-made catastrophes that relate to terrorism, see the risk factor directly below regarding the potential for significant losses from acts of terrorism.
There is widespread interest among scientists, legislators, regulators, and the public regarding the effect that greenhouse gas emissions may have on our environment, including climate change. If greenhouse gases continue to impact our climate, it is possible that more devastating catastrophic events could occur.
The magnitude of catastrophe losses is determined by the severity of the event and the total amount of insured exposures in the area affected by the event as determined by Property Claim Services®. Most of the risks underwritten by our insurance segments are concentrated geographically in the Eastern and Midwestern regions of the United States, particularly in New Jersey, which represented approximately 23% of our total NPW during the year ended December 31, 2014. Catastrophes in the Eastern and Midwestern regions of the United States could adversely impact our financial results, as was the case in 2010, 2011, and 2012.
Although catastrophes can cause losses in a variety of property and casualty insurance lines, most of our historic catastrophe-related claims have been from commercial property and homeowners coverages. In an effort to limit our exposure to catastrophe losses, we purchase catastrophe reinsurance. Reinsurance could prove inadequate if: (i) the various modeling software programs that we use to analyze the Insurance Subsidiaries’ risk result in an inadequate purchase of reinsurance by us; (ii) a major catastrophe loss exceeds the reinsurance limit or the reinsurers’ financial capacity; or (iii) the frequency of catastrophe losses results in our Insurance Subsidiaries exceeding the aggregate limits provided by the catastrophe treaty. Even after considering our reinsurance protection, our exposure to catastrophe risks could have a material adverse effect on our results of operations, liquidity, financial condition, financial strength, and debt ratings.
We are subject to potential significant losses from acts of terrorism.
As a Standard Commercial Lines and E&S Lines writer, we are required to participate in TRIPRA, which was extended to December 31, 2020. TRIPRA requires private insurers and the United States government to share the risk of loss on future acts of terrorism certified by the U.S. Secretary of the Treasury. A risk exists that certain future terrorist events would not be certified by the U.S. Secretary of Treasury and TRIPRA would not cover them and we would be required to pay in the event of a covered loss. For example, the 2013 Boston Marathon bombing was not a certified event. Under TRIPRA, insureds with non-workers compensation commercial policies have the option to accept or decline our terrorism coverage or negotiate with us for other terms. In 2014, 87% of our Standard Commercial Lines non-workers compensation policyholders purchased terrorism coverage that included nuclear, biological, chemical, and radioactive ("NBCR") events. In addition, terrorism coverage is mandatory for all primary workers compensation policies. The TRIPRA back-stop applies to these coverages when they are written.
Under TRIPRA, each participating insurer is responsible for paying a deductible of specified losses before federal assistance is available. This deductible is based on a percentage of the prior year’s applicable Standard Commercial Lines and E&S Lines premiums. In 2015, our deductible is approximately $254 million. For losses above the deductible, the federal government will pay 85% of losses to an industry limit of $100 billion, and the insurer retains 15%. The federal share of losses will be reduced by 1% each year to 80% by 2020. Although TRIPRA’s provisions will mitigate our loss exposure to a large-scale terrorist attack, our deductible is substantial and could have a material adverse effect on our results of operations, liquidity, financial condition, financial strength, and debt ratings.
TRIPRA rescinded all previously approved coverage exclusions for terrorism. Many of the states in which we write commercial property insurance mandate that we cover fire following an act of terrorism regardless of whether the insured specifically purchased terrorism coverage. Likewise, terrorism coverage cannot be excluded from workers compensation policies in any state in which we write.
Personal lines of business have never been covered under TRIPRA. Homeowners policies within our Standard Personal Lines exclude nuclear losses, but do not exclude biological or chemical losses.
Our ability to reduce our risk exposure depends on the availability and cost of reinsurance.
We transfer a portion of our underwriting risk exposure to reinsurance companies. Through our reinsurance arrangements, a specified portion of our losses and loss expenses are assumed by the reinsurer in exchange for a specified portion of premiums. The availability, amount, and cost of reinsurance depend on market conditions, which may vary significantly. Most of our reinsurance contracts renew annually and may be impacted by the market conditions at the time of the renewal that are unrelated to our specific book of business or experience. Any decrease in the amount of our reinsurance will increase our risk of loss. Any increase in the cost of reinsurance that cannot be included in renewal price increases will reduce our earnings. Accordingly, we may be forced to incur additional expenses for reinsurance or may not be able to obtain sufficient reinsurance on acceptable terms. Either could adversely affect our ability to write future business or result in the assumption of more risk with respect to those policies we issue.
We are exposed to credit risk.
We are exposed to credit risk in several areas of our insurance segments, including from:
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Our reinsurers, who are obligated to us under our reinsurance agreements. The relatively small size of the reinsurance market and our objective to maintain an average weighted rating of “A” by A.M. Best on our current reinsurance programs constrains our ability to diversify this credit risk. However, some of our reinsurance credit risk is collateralized.
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Certain life insurance companies that are obligated to our customers, as we have purchased annuities from them under structured settlement agreements.
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Some of our distribution partners, who collect premiums from our customers and are required to remit the collected premium to us.
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Some of our customers, who are responsible for payment of deductibles and/or premiums directly to us.
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The invested assets in our defined benefit plan, which partially serve to fund the insurance segments liability associated with this plan. To the extent that credit risk adversely impacts the valuation and performance of the invested assets within our defined benefit plan, the funded status of the defined benefit plan could be adversely impacted and, as result, could increase the cost of the plan to us.
Our exposure to credit risk could have a material adverse effect on our results of operations, liquidity, financial condition, financial strength, and debt ratings.
Difficult conditions in global capital markets and the economy may adversely affect our revenue and profitability and harm our business, and these conditions may not improve in the near future.
General economic conditions in the United States and throughout the world and volatility in financial and insurance markets may materially affect our results of operations. Concerns over such issues as the availability and cost of credit, the stability of the United States mortgage market, weak real estate markets, high unemployment, volatile energy and commodity prices, and geopolitical issues, may lead to declines in business and consumer confidence. Declines in business and consumer confidence limit economic growth, which decreases insurance purchases and limits our ability to achieve price increases.
Factors such as consumer spending, business investment, government spending, the volatility and strength of the capital markets, and inflation all affect the business and economic environment and, indirectly, the amount and profitability of our business. Elevated unemployment, lower family income, lower corporate earnings, lower business investment, and lower consumer spending adversely affect the demand for insurance products. In addition, we are impacted by the slow improvement in commercial and new home construction and home ownership because 34% of DPW in our Standard Commercial Lines business during 2014 were generated through insurance policies written to cover contractors. In addition, 35% of DPW in our Standard Commercial Lines business during 2014 were based on payroll/sales of our underlying customers. An economic downturn in which our customers decline in revenue or employee count can adversely affect our audit and endorsement premium in our Standard Commercial Lines. Unfavorable economic developments could adversely affect our earnings if our customers have less need for insurance coverage, cancel existing insurance policies, modify coverage, or choose not to renew with us. Challenging economic conditions may impair the ability of our customers to pay premiums as they come due. Although economic conditions have consistently improved over the last two years, many fundamental concerns still exist, which may have a material effect on our results of operations, liquidity, financial condition, financial strength, and debt ratings.
A downgrade or a potential downgrade in our financial strength or credit ratings could result in a loss of business and could have a material adverse effect on our financial condition and results of operations.
Our financial strength ratings, as issued by the following Nationally Recognized Statistical Rating Organizations ("NRSROs"), are as follows:
A significant rating downgrade, particularly from A.M. Best, would affect our ability to write new or renewal 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. In addition, our $30 million line of credit ("Line of Credit") requires our Insurance Subsidiaries to maintain an A.M. Best rating of at least “A-” (one level below our current rating) and a default could lead to acceleration of any outstanding principal. Such an event could trigger default provisions under certain of our other debt instruments and negatively impact our ability to borrow in the future. As a result, any significant downgrade in our financial strength ratings could have a material adverse effect on our results of operations, liquidity, financial condition, financial strength, and debt ratings.
NRSROs also rate our long-term debt creditworthiness. Credit ratings indicate the ability of debt issuers to meet debt obligations in a timely manner and are important factors in our overall funding profile and ability to access certain types of liquidity. Our current senior credit ratings are as follows:
Downgrades in our credit ratings could have a material adverse effect on our financial condition and results of operations in many ways, including making it more expensive for us to access capital markets. We cannot predict possible actions NRSROs may take regarding our ratings that could adversely affect our business or the possible actions we may take in response to any such actions.
We have many competitors and potential competitors.
Demand for insurance is influenced by prevailing general economic conditions. The supply of insurance is related to prevailing prices, the levels of insured losses and the levels of industry capital which, in turn, may fluctuate in response to changes in rates of return on investments being earned in the insurance industry. In addition, pricing is influenced by the operating performance of insurers as increased pricing may be necessary to meet return on equity objectives. As a result, the insurance industry historically has been through cycles characterized by periods of intense price competition due to excessive underwriting capacity and periods when shortages of capacity and poor operating performance by insurers drives favorable premium levels. If competitors price business below technical levels, we might reduce our profit margin in order to retain our best business.
Pricing and loss trends impact our profitability. For example, assuming retention and all other factors remain constant:
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A pure price decline of approximately 1% would increase our statutory combined ratio by approximately 0.77 points;
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A 3% increase in our expected claim costs for the year would cause our loss and loss expense ratio to increase by approximately two points; and
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A combination of the two could raise the combined ratio by approximately three points.
We compete with regional, national, and direct-writer property and casualty insurance companies for customers, distribution partners, and employees. Some competitors are public companies and some are mutual companies. Many competitors are larger and may have lower operating costs or costs of capital. They may have the ability to absorb greater risk while maintaining their financial strength ratings. Consequently, some competitors may be able to price their products more competitively. These competitive pressures could result in increased pricing pressures on a number of our products and services, particularly as competitors seek to win market share, and may impair our ability to maintain or increase our profitability. Because of its relatively low cost of entry, the internet has emerged as a significant place of new competition, both from existing competitors and new competitors. It is possible that reinsurers, who have significant knowledge of the primary property and casualty insurance business because they reinsure it, could enter the market to diversify their operations. New competition could cause changes in the supply or demand for insurance and adversely affect our business.
We have less loss experience data than our larger competitors.
We believe that insurance companies are competing and will continue to compete on their ability to use reliable data about their customers and loss experience in complex analytics and predictive models to assess profitability of the risk, as well as the potential for adverse claim development, recovery opportunities, fraudulent activities, and customer buying habits. With the consistent expansion of computing power and the decline in its cost, we believe that data and analytics use will continue to increase and become more complex and accurate. As a regional insurance group, the loss experience from our insurance operations is not large enough in all circumstances to analyze and project our future costs. In addition, we have limited data regarding our E&S business, which we assumed in 2011 and began writing directly in 2012. We use data from ISO, NCCI, and AASI to obtain sufficient industry loss experience data. While statistically relevant, that data is not specific to the performance of risks we have underwritten. Larger competitors, particularly national carriers, have significantly more data regarding the performance of risks that they have underwritten. The analytics of their loss experience data may be more predictive of profitability of their risks than our analysis using, in part, general industry loss experience. For the same reason, should Congress repeal the McCarran-Ferguson Act, which provides an anti-trust exemption for the aggregation of loss data, and we are unable to access data from ISO, NCCI, and AASI, we will be at a competitive disadvantage to larger insurers who have more sufficient loss experience data on their own customers.
We depend on distribution partners.
We market and sell our insurance products through distribution partners who are not our employees. We believe that these partners will remain a significant force in overall insurance industry premium production because they can provide customers with a wider choice of insurance products than if they represented only one insurer. That, however, creates competition in our distribution channel and we must market our products and services to our distribution partners before they sell them to our mutual customers. Additionally, there has been a trend towards increased levels of consolidation of these distribution partners in the marketplace, which increases competition among fewer distributors. Our Standard Personal Lines production is further limited by the fact that independent retail insurance agencies only write approximately 35% of this business in the United States. Our financial condition and results of operations are tied to the successful marketing and sales efforts of our products by our distribution partners. In addition, under insurance laws and regulations and common law, we potentially can be held liable for business practices or actions taken by our distribution partners.
We face risks regarding our flood business because of uncertainties regarding the NFIP.
We are the fifth largest insurance group participating in the WYO arrangement of the NFIP, which is managed by the Mitigation Division of Federal Emergency Management Agency (“FEMA”) in the U.S. Department of Homeland Security. For WYO participation, we receive an expense allowance for policies written and a servicing fee for claims administered. Under the program, all losses are 100% reinsured by the Federal Government. Currently, the expense allowance is 30.8% of direct premiums written. The servicing fee is the combination of 0.9% of DPW and 1.5% of incurred losses.
The NFIP is funded by Congress and in 2012, Congress passed, and the President signed, the Biggert-Waters Flood Insurance Reform Act of 2012 (“Biggert-Waters Act”). The Biggert-Waters Act: (i) extended NFIP funding to September 30, 2017; and (ii) moved the program to more market based rates for certain flood policyholders. FEMA implemented these rates throughout 2013, which created significant public discontent and Congressional concern over the impact of the new rates on NFIP customers.
Consequently, Congress passed and, on March 21, 2014, the President signed into law, the Homeowner Flood Insurance Affordability Act of 2014 (“Flood Affordability Act”). The Flood Affordability Act substantially modifies certain provisions of the Biggert-Waters Act, including the reversal of certain rate increases resulting in premium refunds for many NFIP policyholders that began after October 1, 2014. Additional changes are expected to occur in April 2015, such as an increase in the Reserve Fund Assessment, implementation of an annual surcharge on all new and renewal policies, an additional deductible option, and increases in the federal policy fee and basic rates.
As a WYO carrier, we are required to follow certain NFIP procedures when administering flood policies and claims. Some of these requirements may differ from our normal business practices and may present a reputational risk to our brand. Insurance companies are regulated by states; however, the NFIP is a federal program. Consequently, we have the risk that regulatory positions taken by the NFIP and a state regulator on the same issue may conflict.
Despite the passage of the Flood Affordability Act, the role of the NFIP program remains under scrutiny by policymakers. The uncertainty behind the public policy debate and politics of flood insurance reform make it difficult for us to predict the future of the NFIP and our continued participation in the program.
We are heavily regulated and changes in regulation may reduce our profitability, increase our capital requirements, and/or limit our growth.
Our Insurance Subsidiaries are heavily regulated by extensive laws and regulations that may change on short notice. The primary public policy behind insurance regulation is the protection of policyholders and claimants over all other constituencies, including shareholders. Historically, and by virtue of the McCarran-Ferguson Act, our Insurance Subsidiaries are primarily regulated by the states in which they are domiciled and licensed. State insurance regulation is generally uniform throughout the U.S. by virtue of similar laws and regulations required by the NAIC to accredit state insurance departments so their examinations can be given full faith and credit by other state regulators. Despite their general similarity, various provisions of these laws and regulations vary from state to state. At any given time, there may be various legislative and regulatory proposals in each of the 50 states and District of Columbia that, if enacted, may affect our Insurance Subsidiaries.
The broad regulatory, administrative, and supervisory powers of the various state departments of insurance include the following:
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Related to our financial condition, review and approval of such matters as minimum capital and surplus requirements, standards of solvency, security deposits, methods of accounting, form and content of statutory financial statements, reserves for unpaid loss and loss adjustment expenses, reinsurance, payment of dividends and other distributions to shareholders, periodic financial examinations, and annual and other report filings.
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Related to our general business, review and approval of such matters as certificates of authority and other insurance company licenses, licensing and compensation of distribution partners, premium rates (which may not be excessive, inadequate, or unfairly discriminatory), policy forms, policy terminations, reporting of statistical information regarding our premiums and losses, periodic market conduct examinations, unfair trade practices, participation in mandatory shared market mechanisms, such as assigned risk pools and reinsurance pools, participation in mandatory state guaranty funds, and mandated continuing workers compensation coverage post-termination of employment.
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Related to our ownership of the Insurance Subsidiaries, we are required to register as an insurance holding company system in each state where an insurance subsidiary is domiciled and report information concerning all of our operations that may materially affect the operations, management, or financial condition of the insurers. As an insurance holding company, the appropriate state regulatory authority may: (i) examine us or our Insurance Subsidiaries at any time; (ii) require disclosure or prior approval of material transactions of any of the Insurance Subsidiaries with its affiliates; and (iii) require prior approval or notice of certain transactions, such as payment of dividends or distributions to us.
Although Congress has largely delegated insurance regulation to the various states by virtue of the McCarran-Ferguson Act, we are also subject to federal legislation and administrative policies, such as disclosure under the securities laws, including the Sarbanes-Oxley Act and the Dodd-Frank Act, TRIPRA, OFAC, and various privacy laws, including the Gramm-Leach-Bliley Act, the Fair Credit Reporting Act, the Drivers Privacy Protection Act, the Health Insurance Portability and Accountability Act, and the policies of the Federal Trade Commission. As a result of issuing workers compensation policies, we are subject to Mandatory Medicare Secondary Payer Reporting under the Medicare, Medicaid, and SCHIP Extension Act of 2007.
The European Union has enacted Solvency II, which sets out new requirements on capital adequacy and risk management for insurers, which is expected to be implemented in 2016. The strengthened regime is intended to reduce the possibility of consumer loss or market disruption in insurance. In addition, in 2014, the International Association of Insurance Supervisors proposed Basic Capital Standards for Global Systemically Important Insurers as well as a uniform capital framework for internationally active insurers. Although Solvency II does not govern domestic American insurers and we do not have international operations, we believe that development of global capital standards will influence the development of similar standards by domestic regulators. The NAIC has recently adopted the ORSA Model Law, which requires insurers to maintain a framework for identifying, assessing, monitoring, managing and reporting on the “material and relevant risks” associated with the insurer's (or insurance group's) current and future business plans. ORSA, which has been adopted by the state insurance regulators of our Insurance Subsidiaries, requires companies to file an internal assessment of their solvency with insurance regulators annually beginning in 2015. Although no specific capital adequacy standard is currently articulated in ORSA, it is possible that such standard will be developed over time and may increase insurers' minimum capital requirements, which could adversely impact our growth and return on equity.
We are subject to non-governmental regulators, such as the NASDAQ Stock Market and the New York Stock Exchange where we list our securities. Many of these regulators, to some degree, overlap with each other on various matters. They have different regulations on the same legal issues that are subject to their individual interpretative discretion. Consequently, we have the risk that one regulator’s position may conflict with another regulator’s position on the same issue. As compliance is generally reviewed in hindsight, we are subject to the risk that interpretations will change over time.
We believe we are in compliance with all laws and regulations that have a material effect on our results of operations, but the cost of complying with various, potentially conflicting laws and regulations, and changes in those laws and regulations could have a material adverse effect on our results of operations, liquidity, financial condition, financial strength, and debt ratings.
We are subject to the risk that legislation will be passed that significantly changes insurance regulation and adversely impacts our business, financial condition, and/or the results of operations.
In 2009, the Dodd-Frank Act was enacted to address the financial markets crises in 2008 and 2009 and the issues regarding the American International Group, Inc. scandal. The Dodd-Frank Act created the FIO as part of the U.S. Department of Treasury to advise the federal government regarding insurance issues. The Dodd-Frank Act also requires the Federal Reserve through the Financial Services Oversight Council (“FSOC”) to supervise financial services firms designated as systemically important financial institutions ("SIFI"). The FSOC has not designated Selective as a SIFI. The Dodd-Frank Act also included a number of corporate governance reforms for publicly traded companies, including proxy access, say-on-pay, and other compensation and governance issues. We anticipate that there will continue to be legislative proposals in Congress that could result in the federal government becoming directly involved in the regulation of insurance. There are also legislative and regulatory proposals in the various states that seek to limit the ability of carriers to properly assess insurance risk.
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Repeal of the McCarran-Ferguson Act. While recent proposals for McCarran-Ferguson Act repeal have been directed primarily at health insurers, if enacted and applicable to property and casualty insurers, such repeal would significantly reduce our ability to compete and materially affect our results of operations because we rely on the anti-trust exemptions the law provides to obtain loss data from third party aggregators, such as ISO and NCCI, to predict future losses. Our inability to access data from ISO and NCCI would put us at a competitive disadvantage compared to larger insurers who have more sufficient loss experience data with their own customers.
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Healthcare reform. The enactment of the Patient Protection and Affordable Care Act of 2010 (the “Healthcare Act”) may have an impact on various aspects of our business, including our insurance segments. The Healthcare Act reduces the reimbursement to healthcare providers, which may result in healthcare providers charging more to insurers not covered under the Healthcare Act. This could increase our cost to provide workers compensation, automobile Personal Injury Protection ("PIP") and general liability coverages, among others. In addition, we will continue to be impacted as a business enterprise by potential tax issues and changes in employee benefits. The Healthcare Act has been adopted, its implementation is ongoing, and we continue to monitor and assess its impact.
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Changes in rules for Department of Housing and Urban Development ("HUD"). In 2013, HUD finalized a new "Disparate Impact" regulation that may adversely impact insurers' ability to differentiate pricing for homeowners policies using traditional risk selection analysis. Three insurance industry trade associations are challenging the regulation in two separate Federal lawsuits, one by the American Insurance Association (“AIA”) and the National Association of Mutual Insurance Companies (“NAMIC”) in the District of Columbia and the other by Property Casualty Insurers Association of America (“PCI”) in Chicago. In the PCI case, the court ruled that HUD acted arbitrarily in considering comments regarding the application of the McCarran-Ferguson Act and has remanded the regulation back to HUD for review and reconsideration. Subsequently, the court in the AIA and NAMIC case vacated the regulation on summary judgment. HUD has filed an appeal of this ruling. It is uncertain to what extent the application of this regulation will impact the property and casualty industry and underwriting practices, but it could increase litigation costs, force changes in underwriting practices, and impair our ability to write homeowners business profitably. The outcome of the litigations and potential rulemaking cannot be predicted at this time.
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State Regulatory and Legislative Limits to Underwriting. From time-to-time, there are proposals in various states seeking to limit the ability of insurers to use certain factors or predictive measures in the underwriting of property and casualty risks. Among the proposed legislation and regulation have been limits on the use of insurance scores and marketplace considerations. These proposals, if enacted, could impact underwriting pricing and results.
We expect the debate about the role of the federal government in regulating insurance to continue.
We cannot predict whether any of the above discussed proposed rules or legislation will be adopted, or what impact, if any, such proposals or the cost of compliance with such proposals, could have on our results of operations, liquidity, financial condition, financial strength, and debt ratings if enacted.
Class action litigation could affect our business practices and financial results.
Our industry has been the target of class action litigation, including the following areas:
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After-market parts;
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Urban homeowner insurance underwriting practices, including those related to architectural or structural features and attempts by federal regulators to expand the Federal Housing Administration's guidelines to determine unfair discrimination;
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Credit scoring and predictive modeling pricing;
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Cybersecurity breaches;
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Investment disclosure;
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Managed care practices;
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Timing and discounting of personal injury protection claims payments;
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Direct repair shop utilization practices;
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Flood insurance claim practices; and
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Shareholder class action suits.
If we were to be named in such class action litigation, we could suffer reputational harm with purchasers of insurance and have increased litigation expenses that could have a materially adverse effect on our operations or results.
Risks Related to Our Investment Segment
The failure of our risk management strategies could have a material adverse effect on our financial condition or results of operations.
Our long-term strategy includes the use of above average operational leverage, which results in above average investment leverage, or higher invested assets as a percent of our equity or policyholder surplus. Therefore, we maintain a conservative approach to our investment portfolio management and employ a number of risk management strategies to reduce our exposure to risk that include, but are not limited to, the following:
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Being prudent in establishing our investment policy and appropriately diversifying our investments;
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Using complex financial and investment models to analyze historic investment performance and predict future investment performance under a variety of scenarios using asset concentration, asset volatility, asset correlation, and systematic risk; and
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Closely monitoring investment performance, general economic and financial conditions, and other relevant factors.
All of these strategies have inherent limitations. We cannot be certain that an event or series of unanticipated events will not occur and result in losses greater than we expect and have a material adverse effect on our results of operations, liquidity, financial condition, financial strength, and debt ratings.
We are exposed to interest rate and credit risk in our investment portfolio.
We are exposed to interest rate risk primarily related to the market price, and cash flow variability, associated with changes in interest rates. A rise in interest rates may decrease the fair value of our existing fixed income investments and declines in interest rates may result in an increase in the fair value of our existing fixed income investments. Our fixed income investment portfolio, which currently has a duration of 3.8 years excluding short term investments, contains interest rate sensitive instruments that may be adversely affected by changes in interest rates resulting from governmental monetary policies, domestic and international economic and political conditions, and other factors beyond our control. A rise in interest rates would decrease the net unrealized gain position of the investment portfolio, partially offset by our ability to earn higher rates of return on funds reinvested in new investments. Conversely, a decline in interest rates would increase the net unrealized gain position of the investment portfolio, partially offset by lower rates of return on new and reinvested cash in the portfolio. Changes in interest rates have an effect on the calculated duration of certain securities in the portfolio. We seek to mitigate our interest rate risk associated with holding fixed income investments by monitoring and maintaining the average duration of our portfolio with a view toward achieving an adequate after-tax return without subjecting the portfolio to an unreasonable level of interest rate risk. Although we take measures to manage the economic risks of investing in a changing interest rate environment, we may not be able to mitigate the interest rate risk of our assets relative to our liabilities, particularly our loss reserves. In addition, our pension and post-retirement benefit obligations include a discount rate assumption, which is an important element of expense and/or liability measurement. Changes in the discount rate assumption could materially impact our pension and post-retirement life valuation.
The value of our investment portfolio is subject to credit risk from the issuers and/or guarantors of the securities in the portfolio, other counterparties in certain transactions and, for certain securities, insurers that guarantee specific issuer’s obligations. Defaults by the issuer or an issuer’s guarantor, insurer, or other counterparties regarding any of our investments, could reduce our net investment income and net realized investment gains or result in investment losses. We are subject to the risk that the issuers, or guarantors, of fixed income securities we own may default on principal and interest payments due under the terms of the securities. At December 31, 2014, our fixed income securities portfolio represented approximately
91% of our total invested assets. The occurrence of a major economic downturn, acts of corporate malfeasance, widening credit spreads, budgetary deficits, municipal bankruptcies spurred by, among other things, pension funding issues, or other events that adversely affect the issuers or guarantors of these securities could cause the value of our fixed income securities portfolio and our net income to decline and the default rate of our fixed income securities portfolio to increase.
With economic uncertainty, credit quality of issuers or guarantors could be adversely affected and a ratings downgrade of the issuers or guarantors of the securities in our portfolio could cause the value of our fixed income securities portfolio and our net income to decrease. As our stockholders' equity is leveraged at 3.77:1 to our investment portfolio, a reduction in the value of our investment portfolio could have a material adverse effect on our business, results of operations, financial condition, and debt ratings. Levels of write downs are impacted by our assessment of the impairment, including a review of the underlying collateral of structured securities, and our intent and ability to hold securities that have declined in value until recovery. If we reposition or realign portions of the portfolio so that we determine not to hold certain securities in an unrealized loss position to recovery, we will incur an OTTI charge. For further information regarding credit and interest rate risk, see Item 7A. “Quantitative and Qualitative Disclosures About Market Risk.” of this Form 10-K.
Our statutory surplus may be materially affected by rating downgrades on investments held in our portfolio.
We are exposed to significant financial and capital markets risks, primarily relating to interest rates, credit spreads, equity prices, and the change in market value of our alternative investment portfolio. A decline in both income and our investment portfolio asset values could occur as a result of, among other things, a decrease in market liquidity, fluctuations in interest rates, decreased dividend payment rates, negative market perception of credit risk with respect to types of securities in our portfolio, a decline in the performance of the underlying collateral of our structured securities, reduced returns on our alternative investment portfolio, or general market conditions. A global decline in asset values will be more amplified in our financial condition, as our statutory surplus is leveraged at a 3.6:1 ratio to our investment portfolio.
With economic uncertainty, the credit quality and ratings of securities in our portfolio could be adversely affected. The NAIC could potentially apply a more adverse class code on a security than was originally assigned, which could adversely affect statutory surplus because securities with NAIC class codes three through six require securities to be marked-to-market for statutory accounting purposes, as compared to securities with NAIC class codes of one or two that are carried at amortized cost.
Deterioration in the public debt and equity markets, the private investment marketplace, and the economy could lead to investment losses, which may adversely affect our results of operations, financial condition, liquidity, and debt ratings.
Like many other property and casualty insurance companies, we depend on income from our investment portfolio for a significant portion of our revenue and earnings. Our investment portfolio is exposed to significant financial and capital market risks, both in the U.S. and abroad, and volatile changes in general market or economic conditions could lead to a decline in the market value of our portfolio as well as the performance of the underlying collateral of our structured securities. Concerns over weak economic growth globally, elevated unemployment, volatile energy and commodity prices, and geopolitical issues, among other factors, contribute to increased volatility in the financial markets, increased potential for credit downgrades, and decreased liquidity in certain investment segments.
Our notes payable and Line of Credit are subject to certain debt-to-capitalization restrictions and net worth covenants, which could be impacted by a significant decline in investment value. Further OTTI charges could be necessary if there is a future significant decline in investment values. Depending on market conditions going forward, and in the event of extreme prolonged market events, such as the global credit crisis, we could incur additional realized and unrealized losses in future periods, which could have an adverse impact on our results of operations, financial condition, debt and financial strength ratings, and our ability to access capital markets as a result of realized losses, impairments, and changes in unrealized positions.
For more information regarding market interest rate, credit, and equity price risk, see Item 7A. “Quantitative and Qualitative Disclosures About Market Risk.” of this Form 10-K.
There can be no assurance that the actions of the U.S. Government, Federal Reserve, and other governmental and regulatory bodies will achieve their intended effect.
Over the past several years, the Federal Reserve has taken a number of actions related to interest rates and purchasing of financial instruments intended to spur economic recovery. The Federal Reserve has recently signaled that it will be "patient in beginning to normalize the stance of monetary policy," but continued low interest rates have an adverse effect on our investment income as higher yielding securities mature and we reinvest the proceeds at lower yields. At the same time, increased pressure on the price of our fixed income and equity portfolios may occur if these economic stimulus actions by the Federal Reserve are not as effective as originally intended. These results could materially and adversely affect our results of operations, financial condition, liquidity, and the trading price of our common stock. In the event of future material deterioration in business conditions, we may need to raise additional capital or consider other transactions to manage our capital position and liquidity.
In addition, our investment activities are subject to extensive laws and regulations that are administered and enforced by a number of different governmental authorities and non-governmental self-regulatory agencies. In light of the current economic conditions, some of these authorities have implemented, or may in the future implement, new or enhanced regulatory requirements, such as those included in the Dodd-Frank Act, intended to restore confidence in financial institutions and reduce the likelihood of similar economic events in the future. These authorities may seek to exercise their supervisory and enforcement authority in new or more robust ways. Such events could affect the way we conduct our business and manage our capital, and may require us to satisfy increased capital requirements. These developments, if they occurred, could have a material adverse effect on our results of operations, liquidity, financial condition, financial strength, and debt ratings.
We are subject to the types of risks inherent in investing in private limited partnerships.
Our other investments include investments in private limited partnerships that invest in various strategies, such as secondary private equity, private equity, energy, mezzanine debt, real estate, and distressed debt. Since these partnerships’ underlying investments consist primarily of assets or liabilities for which there are no quoted prices in active markets for the same or similar assets, the valuation of interests in these partnerships is subject to a higher level of subjectivity and unobservable inputs than substantially all of our other investments and as such, is subject to greater scrutiny and reconsideration from one reporting period to the next. As these investments are recorded under the equity method of accounting, any decreases in the valuation of these investments would negatively impact our results of operations.
We value our investments using methodologies, estimations, and assumptions that are subject to differing interpretations. Changes in these interpretations could result in fluctuations in the valuations of our investments that may adversely affect our results of operations or financial condition.
Fixed income, equity, and short-term investments, which are reported at fair value on our Consolidated Balance Sheet, represented the majority of our total cash and invested assets as of December 31, 2014. As required under accounting rules, we have categorized these securities into a three-level hierarchy, based on the priority of the inputs to the respective valuation technique. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1). The next priority is to quoted prices in markets that are not active or inputs that are observable either directly or indirectly, including quoted prices for similar assets or liabilities or in markets that are not active and other inputs that can be derived principally from, or corroborated by, observable market data for substantially the full term of the assets or liabilities (Level 2). The lowest priority in the fair value hierarchy is to unobservable inputs supported by little or no market activity and that reflect the reporting entity’s own assumptions about the exit price, including assumptions that market participants would use in pricing the asset or liability (Level 3).
An asset or liability’s classification within the fair value hierarchy is based on the lowest level of significant input to its valuation. We generally use an independent pricing service and broker quotes to price our investment securities. At December 31, 2014, approximately 8% and 92% of these securities represented Level 1 and Level 2, respectively. However, prices provided by an independent pricing service and independent broker quotes can vary widely even for the same security. Rapidly changing and unprecedented credit and equity market conditions could materially impact the valuation of securities as reported within our consolidated financial statements (“Financial Statements”) and the period-to-period changes in value could vary significantly. Decreases in value may result in an increase in non-cash OTTI charges, which could have a material adverse effect on our results of operations, liquidity, financial condition, financial strength, and debt ratings.
The determination of the amount of impairments taken on our investments is highly subjective and could materially impact our results of operations or our financial position.
The determination of the amount of impairments taken on our investments is based on our periodic evaluation and assessment of our investments and known and inherent risks associated with the various asset classes. Such evaluations and assessments are revised as conditions change and new information becomes available. Management updates its evaluations regularly and reflects changes in impairments as such evaluations are revised. There can be no assurance that management has accurately assessed the level of impairments taken as reflected in our Financial Statements. Furthermore, additional impairments may need to be taken in the future. Historical trends may not be indicative of future impairments. For further information regarding our evaluation and considerations for determining whether a security is other-than-temporarily impaired, please refer to “Critical Accounting Policies and Estimates” in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” of this Form 10-K.
Risks Related to Our Corporate Structure and Governance
We are a holding company and our ability to declare dividends to our shareholders, pay indebtedness, and enter into affiliate transactions may be limited because our Insurance Subsidiaries are regulated.
Restrictions on the ability of the Insurance Subsidiaries to pay dividends, make loans or advances to us, or enter into transactions with affiliates may materially affect our ability to pay dividends on our common stock or repay our indebtedness.
As of December 31, 2014, the Parent had stand-alone retained earnings of $1.3 billion. Of this amount, $1.2 billion is related to investments in our Insurance Subsidiaries and debt. The Insurance Subsidiaries have the ability to provide for $162 million in annual dividends to us; however, as they are regulated entities, their ability to pay dividends or make loans or advances to us is subject to the approval or review of the insurance regulators in the states where they are domiciled. The standards for review of such transactions are whether: (i) the terms and charges are fair and reasonable; and (ii) after the transaction, the Insurance Subsidiary's surplus for policyholders is reasonable in relation to its outstanding liabilities and financial needs. Although dividends and loans to us from our Insurance Subsidiaries historically have been approved, we can make no assurance that future dividends and loans will be approved. For additional details regarding dividend restrictions, see Note 20. “Statutory Financial Information, Capital Requirements, and Restrictions on Dividends and Transfers of Funds” in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K.
Because we are an insurance holding company and a New Jersey corporation, we may be less attractive to potential acquirers and the value of our common stock could be adversely affected.
Because we are an insurance holding company that owns insurance subsidiaries, anyone who seeks to acquire 10% or more of our stock must seek prior approval from the insurance regulators in the states in which the subsidiaries are organized and file extensive information regarding their business operations and finances.
Provisions in our Amended and Restated Certificate of Incorporation may discourage, delay, or prevent us from being acquired, including:
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Supermajority shareholder voting requirements to approve certain business combinations with interested shareholders (as defined in the Amended and Restated Certificate of Incorporation) unless certain other conditions are satisfied; and
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Supermajority shareholder voting requirements to amend the foregoing provisions in our Amended and Restated Certificate of Incorporation.
In addition to the requirements in our Amended and Restated Certificate of Incorporation, the New Jersey Shareholders’ Protection Act also prohibits us from engaging in certain business combinations with interested stockholders (as defined in the statute), in certain instances for a five year period, and in other instances indefinitely, unless certain conditions are satisfied. These conditions may relate to, among other things, the interested stockholder’s acquisition of stock, the approval of the business combination by disinterested members of our Board of Directors and disinterested stockholders, and the price and payment of the consideration proposed in the business combination. Such conditions are in addition to those requirements set forth in our Amended and Restated Certificate of Incorporation.
These provisions of our Amended and Restated Certificate of Incorporation and New Jersey law could have the effect of depriving our stockholders of an opportunity to receive a premium over our common stock’s prevailing market price in the event of a hostile takeover and may adversely affect the value of our common stock.
Risks Related to Our General Operations
Operational risks, including human or systems failures, are inherent in our business.
Operational risks and losses can result from, among other things, fraud, errors, failure to document transactions properly or to obtain proper internal authorization, failure to comply with regulatory requirements, information technology failures, or external events.
We believe that our underwriting, claims, predictive, and catastrophe modeling, as well as our business analytics and our information technology and application systems are critical to our business. We expect our information technology and application systems to remain an important part of our underwriting process and our ability to compete successfully. A major defect or failure in our internal controls or information technology and application systems could: (i) result in management distraction; (ii) harm our reputation; or (iii) increase our expenses. We believe appropriate controls and mitigation procedures are in place to prevent significant risk of a defect in our internal controls around our information technology and application systems, but internal controls provide only a reasonable, not absolute, assurance as to the absence of errors or irregularities and any ineffectiveness of such controls and procedures could have a significant and negative effect on our business.
We are subject to attempted cyber-attacks and other cybersecurity risks.
The nature of our business requires that we store and use significant amounts of personally identifiable information in electronic format that may be targeted in an attempted cybersecurity breach. In addition, our business is heavily reliant on various information technology and application systems that may be impacted by a malicious cyber-attack. These cyber incidents may cause lost revenues or increased expenses stemming from reputational damage and fines related to the breach of personally identifiable information, inability to use certain systems for a period of time, loss of financial assets, remediation and litigation costs, and increased cybersecurity protection costs. We have developed and continue to invest in a variety of controls to prevent, detect and appropriately react to such cyber-attacks, including frequently testing our systems' security and access controls. However, cybersecurity risks continue to become more complex and broad ranging and our internal controls provide only a reasonable, not absolute, assurance that we will be able to protect ourselves from significant cyber-attack incidents. By outsourcing certain business and administrative functions to third parties, we may be exposed to enhanced risk of data security breaches. Any breach of data security could damage our reputation and/or result in monetary damages, which, in turn, could have a material adverse effect on our results of operations, liquidity, financial condition, financial strength, and debt ratings. Although we have not experienced a material cyber-attack, we purchase insurance coverage to specifically address cybersecurity risks. The coverage provides protection up to $20 million above a deductible of $250,000 for various cybersecurity risks, including privacy breach related incidents.
If we experience difficulties with outsourcing relationships, our ability to conduct our business might be negatively impacted.
We outsource certain business and administrative functions to third parties for efficiencies and cost savings, and may do so increasingly in the future. If we fail to develop and implement our outsourcing strategies or our third-party providers fail to perform as anticipated, we may experience operational difficulties, increased costs, and a loss of business that may have a material adverse effect on our results of operations or financial condition.
We are subject to a variety of modeling risks, which could have a material adverse impact on our business results.
We rely on complex financial models, such as predictive modeling, a claims fraud model, third party catastrophe models, an enterprise risk management capital model, and modeling tools used by our investment managers, which have been developed internally or by third parties to analyze historical loss costs and pricing, trends in claims severity and frequency, the occurrence of catastrophe losses, investment performance, and portfolio risk. Flaws in these financial models, or faulty assumptions used by these financial models, could lead to increased losses. We believe that statistical models alone do not provide a reliable method of monitoring and controlling risk. Therefore, such models are tools and do not substitute for the experience or judgment of senior management.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
Our 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. We lease all of our other facilities. The principal office locations related to our insurance segments are described in the “Geographic Markets” section of Item 1. “Business.” of this Form 10-K. We believe our facilities provide adequate space for our present needs and that additional space, if needed, would be available on reasonable terms.
Item 3.
Item 3. Legal Proceedings.
In the ordinary course of conducting business, we are named as defendants in various legal proceedings. Most of these proceedings are claims litigation involving our Insurance Subsidiaries as either: (i) liability insurers defending or providing indemnity for third-party claims brought against our customers; or (ii) insurers defending first-party coverage claims brought against them. We account for such activity through the establishment of unpaid loss and loss expense reserves. We expect 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 our consolidated financial condition, results of operations, or cash flows.
Our Insurance Subsidiaries are also from time-to-time involved in other legal actions, some of which assert claims for substantial amounts. These actions include, among others, putative 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. Our Insurance Subsidiaries are also involved from time-to-time 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. We believe that we have valid defenses to these cases. We expect that the ultimate liability, if any, with respect to such lawsuits, after consideration of provisions made for estimated losses, will not be material to our 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 our consolidated results of operations or cash flows in particular quarterly or annual periods.
PART II
Item 5.
Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
(a) Market Information
Our 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 our common stock for each full quarterly period within the two most recent fiscal years:
On February 13, 2015, the closing price of our common stock as reported on the NASDAQ Global Select Market was $27.36.
(b) Holders
We had 3,612 stockholders of record as of February 13, 2015 according to the records maintained by our transfer agent.
(c) Dividends
Dividends on shares of our common stock are declared and paid at the discretion of the Board based on our results of operations, financial condition, capital requirements, contractual restrictions, and other relevant factors. Considering our improving profitability, in the fourth quarter of 2014, our Board of Directors approved an 8% increase in our dividend to $0.14 per share. The following table provides information on the dividends declared for each quarterly period within our two most recent fiscal years:
Our ability to receive dividends, loans, or advances from our Insurance Subsidiaries is subject to the approval or review of the insurance regulators in the respective domiciliary states of our 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. Although our dividends have historically been met with regulatory approval, there is no assurance that future dividends will be approved given current market conditions. We currently expect to continue to pay quarterly cash dividends on shares of our common stock in the future. For additional information, see Note 20. "Statutory Financial Information, Capital Requirements, and Restrictions on Dividends and Transfers of Funds" in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K.
(d) Securities Authorized for Issuance under Equity Compensation Plans
The following table provides information about our common stock authorized for issuance under equity compensation plans as of December 31, 2014:
1 Weighted average remaining contractual life of options is 3.42 years.
2 Includes 764,098 shares available for issuance under the Employee Stock Purchase Plan; 2,019,296 shares available for issuance under the Stock Purchase Plan for Independent Insurance Agencies; and 3,491,894 shares for issuance under the Selective Insurance Group, Inc. 2014 Omnibus Stock Plan ("Stock Plan"). Future grants under the Stock Plan can be made, among other things, as stock options, restricted stock units, or restricted stock.
(e) Performance Graph
The following chart, produced by Research Data Group, Inc., depicts our performance for the period beginning December 31, 2009 and ending December 31, 2014, as measured by total stockholder return on our common stock compared with the total return of the NASDAQ Composite Index and a select group of peer companies comprised of NASDAQ-listed companies in SIC Code 6330-6339, Fire, Marine, and Casualty Insurance.
This performance graph is not incorporated into any other filing we have made with the U.S. Securities and Exchange Commission ("SEC") and will not be incorporated into any future filing we may make with the SEC unless we so specifically incorporate it by reference. This performance graph shall not be deemed to be “soliciting material” or to be “filed” with the SEC unless we specifically request so or specifically incorporate it by reference in any filing we make with the SEC.
(f) Purchases of Equity Securities by the Issuer and Affiliated Purchasers
The following table provides information regarding our purchases of our common stock in the fourth quarter of 2014:
1During the fourth quarter of 2014, 1,605 shares were purchased from employees in connection with the vesting of restricted stock units and 22,381 shares were purchased from employees in connection with stock option exercises. These repurchases were made to satisfy tax withholding obligations and/or option costs with respect to those employees. These shares were not purchased as part of any publicly announced program. The shares that were purchased in connection with the vesting of restricted stock units were purchased at fair market value as defined in the Selective Insurance Group, Inc. 2005 Omnibus Stock Plan as Amended and Restated Effective as of May 1, 2010. The shares purchased in connection with the option exercises were purchased at the current market prices of our common stock on the dates the options were exercised.
Item 6.
Item 6. Selected Financial Data.
1 Data for 2010 through 2011 has been restated to reflect the implementation of ASU 2010-26, Financial Services-Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts, which was adopted on January 1, 2012.
2 In 2009, we sold our Selective HR Solutions operations. See Note 7. "Fair Value Measurements" and Note 12. "Discontinued Operations" in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K for additional information.
3 The impact of catastrophe losses on the 2012 statutory combined ratio including flood claims handling fees related to Superstorm Sandy was 5.8 points.
4 Operating income and operating return on average equity are non-GAAP measures. See the Glossary of Terms attached to this Form 10-K as Exhibit 99.1 for definitions of these items and see the “Financial Highlights of Results for Years Ended December 31, 2014, 2013, and 2012” section in Item 7.
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, as amended, and the Exchange Act for forward-looking statements. These statements relate to our 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 us 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 the words such as “may,” “will,” “could,” “would,” “should,” “expect,” “plan,” “anticipate,” “target,” “project,” “intend,” “believe,” “estimate,” “predict,” “potential,” “pro forma,” “seek,” “likely,” or “continue” or other comparable terminology. These statements are only predictions, and we can give no assurance that such expectations will prove to be correct. We undertake no obligation, other than as may be required under the federal securities laws, to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.
Factors that could cause our actual results to differ materially from those we have projected, forecasted or estimated in forward-looking statements are discussed in further detail in Item 1A. “Risk Factors.” of this Form 10-K. These risk factors may not be exhaustive. We operate in a continually changing business environment, and new risk factors emerge from time-to-time. We can neither predict such new risk factors nor can we assess the impact, if any, of such new risk factors on our businesses or the extent to which any factor or combination of factors may cause actual results to differ materially from those expressed or implied in any forward-looking statements in this report. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report might not occur.
Introduction
We classify our business into four reportable segments:
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Standard Commercial Lines - comprised of insurance products and services provided in the standard marketplace to our commercial customers, who are typically businesses, non-profit organizations, and local government agencies.
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Standard Personal Lines - comprised of insurance products and services, including flood insurance coverage, provided primarily to individuals acquiring coverage in the standard marketplace.
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E&S Lines - comprised of insurance products and services provided to customers who have not obtained coverage in the standard marketplace.
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Investments - invests the premiums collected by our Standard Commercial Lines, Standard Personal Lines, and E&S Lines, as well as amounts generated through our capital management strategies, which may include the issuance of debt and equity securities.
This is a change from the segments that we have previously reported of Standard Insurance Operations, E&S Insurance Operations, and Investments. All prior year information contained in this Form 10-K has been restated to reflect our revised segments. For qualitative information behind the change, see Note 11. "Segment Information" in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K.
Our Standard Commercial Lines and Standard Personal Lines products and services are sold through nine subsidiaries that write commercial and personal insurance coverages, some of which write flood business through the National Flood Insurance Program's ("NFIP") Write Your Own ("WYO") program. Our E&S Lines products and services are sold through one subsidiary, Mesa Underwriters Specialty Insurance Company ("MUSIC"), that provides a nationally-authorized non-admitted platform to write commercial and personal E&S business, of which we currently only write commercial coverages. Our ten insurance subsidiaries are collectively referred to as the "Insurance Subsidiaries".
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.
In the MD&A, we will discuss and analyze the following:
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Critical Accounting Policies and Estimates;
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Financial Highlights of Results for Years Ended December 31, 2014, 2013, and 2012;
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Results of Operations and Related Information by Segment;
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Federal Income Taxes;
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Financial Condition, Liquidity, Short-term Borrowings, and Capital Resources;
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Off-Balance Sheet Arrangements;
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Contractual Obligations, Contingent Liabilities, and Commitments; and
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Ratings.
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 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 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) reserves for losses and loss expenses; (ii) pension and post-retirement benefit plan actuarial assumptions; (iii) other-than-temporary-impairment ("OTTI"); and (iv) reinsurance.
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 an estimate of amounts needed to pay reported and unreported net losses and loss expenses. As of December 31, 2014, we had accrued $3.5 billion of gross loss and loss expense reserves compared to $3.3 billion at December 31, 2013.
The following tables provide case and incurred but not reported ("IBNR") reserves for losses and loss expenses, and reinsurance recoverable on unpaid losses and loss expenses as of December 31, 2014 and 2013:
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 on 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.
Using generally accepted actuarial reserving techniques, we project our estimate of ultimate losses and loss expenses at each reporting date. Our IBNR reserve is the difference between the projected ultimate loss and loss expense incurred and the sum of: (i) case loss and loss expense reserves; and (ii) paid loss and loss expense reserves. 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. In completing this analysis, the actuaries must gather substantially similar data in sufficient volume to ensure statistical credibility of the data, while maintaining appropriate differentiation. This process defines the reserving segments, to which various actuarial projection methods are applied. When applying these methods, the actuaries are required to make numerous assumptions including, for example, the selection of loss and loss expense development factors and the weight to be applied to each individual projection method. These methods include paid and incurred versions for the following: loss and loss expense development, Bornhuetter-Ferguson, Berquist-Sherman, and frequency/severity modeling (chain-ladder approach). The second component of the analysis is the projection of the expected ultimate loss and loss expense 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 and loss expense ratios each quarter. This review includes actual versus expected pricing changes, loss and loss expense trend assumptions, and updated prior period loss and loss expense ratios from the most recent quarterly reserve analysis.
In addition to the quarterly reserve analysis, a range of possible IBNR reserves is estimated annually and continually considered, among other factors, in establishing IBNR for each reporting period. Loss and loss expense trends are also considered, which include, but are not limited to, large loss activity, asbestos and 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 and loss expense 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 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. 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. In addition to our internal review, statutory regulation requires us to have a Statement of Actuarial Opinion issued annually on our statutory reserve adequacy. We engage an independent actuary to issue this opinion based on their independent review.
Range of reasonable reserves
We have estimated a range of reasonably possible reserves for net loss and loss expense claims to be $2,645 million to $3,061 million at December 31, 2014, which compares to $2,574 million to $2,966 million at December 31, 2013. These ranges reflect low and high reasonable reserve estimates, which were selected 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 these ranges reflect likely scenarios, it is possible that the final outcomes may fall above or below these amounts. The ranges do not include a provision for potential increases or decreases associated with asbestos, environmental, and other continuous exposure claims, as traditional actuarial techniques cannot be effectively applied to these exposures.
Our loss and loss expense reserve development over the preceding 10 years is shown on the following table, which has five parts:
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Section I shows the estimated liability recorded at the end of each indicated year 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 unpaid claims, including IBNR reserves. In accordance with GAAP, the liability for unpaid loss and loss expenses is recorded gross of the effects of reinsurance. An estimate of reinsurance recoverables is reported separately as an asset. The net balance represents the estimated amount of unpaid loss and loss expenses outstanding 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 of 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.
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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.
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Section IV shows the re-estimated gross liability and re-estimated reinsurance recoverables through December 31, 2014.
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Section V shows the cumulative gross and net (deficiency)/redundancy representing the aggregate change in the liability from the original balance sheet dates and the re-estimated liability through December 31, 2014.
This table does not present accident or policy year development data. Conditions and trends that have affected past reserve development may not necessarily occur in the future. As a result, extrapolating redundancies or deficiencies based on this table is inherently uncertain.
Note: Some amounts may not foot due to rounding.
In 2014, we experienced overall favorable loss development of approximately $59.3 million, compared to $25.5 million in both 2013 and 2012. The following table summarizes prior year development by line of business:
Major developments related to loss and loss expense reserve estimates and 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. As market conditions change, certain developments may occur that increase or decrease the amount of uncertainty. These developments include impacts within our own paid and reported loss and loss expense experience, as well as other internal and external factors that have not yet manifested within our data, but may do so in the future. All of these developments are considered when establishing loss and loss expense reserves, and in estimating the range of reasonable reserves.
For the past nine years, the Insurance Subsidiaries have experienced favorable prior accident year loss and loss expense development. Over the past three years, contributions to the favorable emergence have come from virtually all lines of business, with the exceptions of workers compensation and E&S Lines. The greater contributions have generally come from the longer tailed casualty lines, primarily due to their associated volume of reserves and the inherent uncertainty of the longer claims settlement process.
A more detailed discussion of recent developments, by line of business, follows.
Standard Market General Liability Line of Business
At December 31, 2014, our general liability line of business had recorded reserves, net of reinsurance, of $1.1 billion, which represented 37% of our total net reserves. In 2014, this line experienced favorable development of $43.9 million, which was partially driven by lower severities in the 2010 through 2012 accident years, within both the premises and operations and products liability coverages. In addition, accident years 2011 and 2012 continue to show lower than expected claim counts.
During 2013, this line experienced favorable development due to lower severities in accident years 2010 and prior. This was partially offset by unfavorable development in accident years 2011 and 2012, which showed higher average severities in the premises and operations coverage. During 2012, this line of business showed modestly unfavorable development due to increased severities in the 2010 and 2011 accident years. The broad nature of this line of business, and the longer average time for the claims settlement process, makes it more susceptible to changes in litigation and the tort environment. This line of business includes excess policies that provide additional limits above underlying automobile and general liability coverages, which is subject to catastrophic losses, and therefore influenced by the factors noted above to a greater degree.
Standard Market Workers Compensation Line of Business
At December 31, 2014, our workers compensation line of business recorded reserves, net of reinsurance, of $1.0 billion, which represented 35% of our total net reserves. During 2014, this line experienced no development on prior accident years. This represents a significant change compared to 2013, during which this line experienced unfavorable development of approximately $23.5 million driven mainly by assisted living facility claims. Unfavorable development in 2012 was approximately $2.5 million. During 2014, this line showed a significant reduction in reported claim counts and associated paid and reported amounts. We believe this to be reflective of both our proactive underwriting actions in recent years, as well as various claims initiatives that we implemented, including the centralization of our workers compensation claim handling in Charlotte, North Carolina. Jurisdictionally trained and aligned medical only and lost-time adjusters manage non-complex workers compensation claims within our footprint. Claims with high exposure and/or significant escalation risk are referred to the workers compensation strategic case management unit.
While we believe these changes are already contributing to our improved loss experience, there is always risk associated with change. Most notably, these changes in operations may inherently change paid and reported development patterns. While our reserve analyses incorporate methods that adjust for these changes, there nevertheless remains a greater risk in the estimated reserves.
In addition to the uncertainties associated with actuarial assumptions and methodologies described above, the workers compensation line of business can be impacted by a variety of issues, such as the following:
Unexpected changes in medical cost inflation - Variability in our historical workers compensation medical costs, along with uncertainty regarding future medical inflation, creates the potential for additional volatility in our reserves;
Changes in statutory workers compensation benefits - Benefit changes may be enacted that affect all outstanding claims, regardless of having occurred in the past. Depending upon the social and political climate, these changes may either increase or decrease associated claim costs;
Changes in utilization of the workers compensation system - These changes may be driven by economic, legislative, or other changes. For example, higher levels of unemployment could ultimately impact both the severity and frequency of workers compensation claims. In particular, during more difficult economic times, workers may be more likely to use the system, and less likely to return to work. Another example is the potential impact of federal healthcare reform, for which there are opposing views regarding the impact on workers compensation costs.
In addition, changes in the economy could impact reserves in other ways. For example, in 2014, audit and endorsement activity resulted in additional premium of $15.7 million, and in 2013, audit and endorsement activity resulted in additional premium of $7.4 million. As premiums earned are used as a basis for setting initial reserves on the current accident year, our reserves could be impacted. While audit and endorsement premiums are modeled within our annual budgeting process, they remain uncertain, and therefore provide additional variability to the resulting loss and loss expense ratio estimates.
Standard Market Commercial Automobile Line of Business
At December 31, 2014, our commercial automobile line of business had recorded reserves, net of reinsurance, of $358 million, which represented 12% of our total net reserves. During the past three years, this line experienced favorable reserve development. In 2014, the favorable development was $4.1 million, driven by bodily injury liability for accident years 2012 and prior. For accident years 2011 and prior, this reflects a continued trend of better than expected reported emergence in these years. Accident year 2012 experienced favorable development due to a reduction in estimated severity, after experiencing unfavorable development during 2013 due to higher than expected claim frequency. The favorable development for accident years 2012 and prior was partially offset by unfavorable development in the 2013 accident year due to higher than expected claim frequency.
Standard Market Personal Automobile Line of Business
At December 31, 2014, our personal automobile line of business had recorded reserves, net of reinsurance, of $116 million, which represented 4% of our total net reserves. In 2014, this line experienced favorable development of $10.8 million, which was driven by the liability coverages for accident years 2012 and prior. Our mix of business continues to shift away from New Jersey towards other targeted states within our footprint. We continue to recalibrate our predictive models to improve the accuracy of our rating plans. While we believe these changes will ultimately lead to improved profitability and greater stability, they may impact paid and reported development patterns, thereby increasing the uncertainty in the reserves in the near-term.
E&S Lines
At December 31, 2014, our E&S Lines had recorded reserves, net of reinsurance, of $160 million, which represented 6% of our total net reserves. In 2014, these lines experienced unfavorable development of $3.7 million, associated with accident years 2011 through 2013. As we have limited historical loss experience in this segment, our reserve estimates are partially based on development patterns of companies that have similar operations. Therefore, these estimates are subject to somewhat greater uncertainty than the comparable traditional lines of business. As our own experience matures, we will continue to place greater weight upon it, and less weight upon the surrogate patterns.
Other Lines of Business
At December 31, 2014, no other individual line of business had recorded reserves of more than $87 million, net of reinsurance. We have not identified any recent trends that would create additional significant reserve uncertainty for these other lines of business.
Other impacts creating additional loss and loss expense reserve uncertainty
Claims Initiative Impacts
In addition to the line of business specific issues mentioned above, our lines of business have been impacted by a number of initiatives undertaken by our claims department that have resulted in variability, or shifts, in the average level of case reserves. Some of these initiatives have also impacted claims settlement rates. These changes affect the data upon which the ultimate loss and loss expense projections are made. While these changes in case reserve levels and settlement rates increase the uncertainty in the short run, we expect the longer-term benefit will be a more refined management of the claims process.
Some of the specific actions implemented over the past several years are as follows:
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Increased focus on reducing workers compensation medical costs through more favorable Preferred Provider Organizations ("PPO") contracts and greater PPO penetration.
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The introduction of a Complex Claims Unit to which all significant and complex liability claims are assigned. This unit has been staffed with personnel that have significant experience in handling and settling these types of claims.
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Increased activity in the areas of fraud investigation and salvage/subrogation recoveries. These efforts have been supported by the introduction of predictive models that allow us to better focus our efforts.
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The centralization of workers compensation claims handling discussed above.
Our internal reserve analyses incorporate actuarial projection methods, which make adjustments for changes in case reserve adequacy and claims settlement rates. These methods adjust our historical loss experience to the current level of case adequacy or settlement rate, which provides a more consistent basis for projecting future development patterns. These methods have their own assumptions and judgments associated with them, so as with any projection method, they are not definitive in and of themselves. Furthermore, given that the expected benefits from our claims initiatives take time to fully manifest, we do not take full credit for the anticipated benefit in establishing our loss and loss expense reserves. These initiatives may prove more or less beneficial than currently reflected, which will affect development in future years. Our various projection methods provide an indication of these potential future impacts. These impacts would be greatest within our larger reserve lines of workers compensation, general liability, and commercial automobile liability, within the more recent accident years.
Economic Inflationary Impacts
Although inflationary volatility is expected to be low in the near term, current United States monetary policy and global economic conditions bring additional uncertainty in the long-term given the length of time required for claim settlement and the impact of medical cost trends relating to longer-tail liability and workers compensation claims. Uncertainty regarding future inflation or deflation creates the potential for additional volatility in our reserves for these lines of business.
Sensitivity analysis: Potential impact on reserve uncertainty 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 selection of loss and loss expense development factors;
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The weight to be applied to each individual actuarial projection method;
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Projected future loss trends; and
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Expected ultimate loss and loss expense ratios for the current accident year.
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 are sensitivity tests which highlight potential impacts to loss and loss expense reserves under different scenarios, for the major casualty lines of business. These tests consider each assumption and line of business individually, without any consideration of correlation between lines of business and accident years, and therefore, does not constitute an actuarial range. While the figures represent possible impacts from variations in key assumptions as identified by management, there is no assurance that the future emergence of our loss and loss expense experience will be consistent with either our current or alternative sets of assumptions.
While the sources of variability discussed above are generated by different underlying trends and operational changes, they ultimately manifest themselves as changes in the expected loss and loss expense development patterns. These patterns are a key assumption in the reserving process. In addition to the expected development patterns, the expected loss and loss expense ratios are another key assumption in the reserving process. These expected ratios are developed via a rigorous process of projecting recent accident years' experience to an ultimate settlement basis, and then adjusting it to the current accident year's pricing and loss cost levels. Impact from changes in the underwriting portfolio and changes in claims handling practices are also quantified and reflected, where appropriate. As is the case with all estimates, the ultimate loss and loss expense ratios may differ from those currently estimated.
The sensitivities of loss and loss expense reserves to these key assumptions are illustrated below for the major casualty lines. The first table shows the estimated impacts from changes in expected reported loss and loss expense development patterns. It shows reserve impacts by line of business if the actual calendar year incurred amounts are greater or less than current expectations by the selected percentages. The second table shows the estimated impacts from changes to the expected loss and loss expense ratios for the current accident year. It shows reserve impacts by line of business if the expected loss and loss expense ratios for the current accident year are greater or less than current expectations by the selected percentages. While the selected percentages by line are judgmentally based, they reflect the relative contribution of the specific line of business to the overall reserve range. Therefore, the smaller reserve lines reflect greater percentages due to their greater relative variability.
Note that there is some overlap between the impacts in the two tables. For example, increases in the calendar year development would ultimately impact our view of the current accident year's loss and loss expense ratios. Nevertheless, these tables provide perspective into the sensitivity of each of these key assumptions.
Asbestos and Environmental Reserves
Our general liability, excess liability, and homeowners reserves include exposure to asbestos and environmental claims. Our exposure to environmental liability is primarily due to: (i) landfill exposures from policies written prior to the absolute pollution endorsement in the mid 1980s; and (ii) underground storage tank leaks mainly from New Jersey homeowners policies. These environmental claims stem primarily from insured exposures in municipal government, small non-manufacturing commercial risks, and homeowners policies.
The total carried net losses and loss expense reserves for these claims was $23.0 million as of December 31, 2014 and $25.2 million as of December 31, 2013. The emergence of these claims is slow and highly unpredictable. For example, within our Standard Commercial Lines book, 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 has the authority to re-open previously closed sites and return them to the NPL. We currently have reserves for eight customers related to four sites on the NPL.
“Asbestos claims” are claims for bodily injury alleged to have occurred from exposure to asbestos-containing products. Our primary exposure arises from insuring various distributors of asbestos-containing products, such as electrical and plumbing materials. At December 31, 2014, asbestos claims constituted 32% of our $23.0 million net asbestos and environmental reserves, compared to 30% of our $25.2 million net asbestos and environmental reserves at December 31, 2013.
“Environmental claims” are claims alleging bodily injury or property damage from pollution or other environmental contaminants other than asbestos. These claims include landfills and leaking underground storage tanks. Our landfill exposure lies largely in policies written for municipal governments, in their operation or maintenance of certain public lands. In addition to landfill exposures, in recent years, we have experienced a relatively consistent level of reported losses in the homeowners line of business related to claims for groundwater contamination from leaking underground heating oil storage tanks in New Jersey. In 2007, we instituted a fuel oil system exclusion on our New Jersey homeowners policies that limits our exposure to leaking underground storage tanks for certain customers. At that time, existing customers were offered a one-time opportunity to buy back oil tank liability coverage. The exclusion applies to all new homeowners policies in New Jersey. These customers are eligible for the buy-back option only if the tank meets specific eligibility criteria.
Our asbestos and environmental claims are handled in our centralized and specialized asbestos and environmental claim unit. Case reserves for these exposures are evaluated on a claim-by-claim basis. The ability to assess potential exposure often improves as a claim develops, including judicial determinations of coverage issues. As a result, reserves are adjusted accordingly.
Estimating IBNR reserves for asbestos and environmental claims is difficult because of the delayed and inconsistent reporting patterns associated with these claims. In addition, there are significant uncertainties associated with estimating critical assumptions, such as average clean-up costs, third-party costs, potentially responsible party shares, allocation of damages, litigation and coverage costs, and potential state and federal legislative changes. Normal historically-based actuarial approaches cannot be applied to asbestos and environmental claims because past loss history is not indicative of future potential loss emergence. In addition, while certain alternative models can be applied, such models can produce significantly different results with small changes in assumptions. As a result, we do not calculate an asbestos and environmental loss range. Historically, our asbestos and environmental claims have been significantly lower in volume, with less volatility and uncertainty than many of our competitors in the commercial lines industry. Prior to the introduction of the absolute pollution exclusion endorsement in the mid-1980's, we were primarily a personal lines carrier and therefore do not have broad exposure to asbestos and environmental claims. Additionally, we are the primary insurance carrier on the majority of these exposures, which provides more certainty in our reserve position compared to others in the insurance marketplace.
Pension and Post-retirement Benefit Plan Actuarial Assumptions
Our pension and post-retirement benefit obligations and related costs are calculated using actuarial methods, within the framework of U.S. GAAP. 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. In the fourth quarter of 2014, the Society of Actuaries issued their updated mortality table (RP-2014), which reflects increasing life expectancies in the United States. We adopted these mortality tables in the fourth quarter of 2014.
The discount rate enables us to state expected future cash flows at their present value on the measurement date. The purpose of the discount rate is to determine the interest rates inherent in the price at which pension benefits could be effectively settled. Our discount rate selection is based on high-quality, long-term corporate bonds. A higher discount rate reduces the present value of benefit obligations and reduces pension expense. Conversely, a lower discount rate increases the present value of benefit obligations and increases pension expense. We decreased our discount rate for the Retirement Income Plan for Selective Insurance Company of America and the Supplemental Excess Retirement Plan (jointly referred to as the "Retirement Income Plan" or the "Plan") to 4.29% for 2014, from 5.16% for 2013, reflecting lower market interest rates. We also decreased our discount rate for the life insurance benefit provided to eligible Selective Insurance Company of America ("SICA") employees (referred to as the "Retirement Life Plan") to 4.08% for 2014 from 4.85% for 2013.
The expected long-term rate of return on the plan assets is determined by considering 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 the plan assets was lowered 65 basis points to 6.27% in 2014 as compared to 6.92% in 2013. This expected return is within a reasonable range considering the lower interest rate environment, as well as our actual 8.3% annualized return since the plan inception for all the plan assets.
At December 31, 2014, our pension and post-retirement benefit plan obligation was $337.4 million compared to $262.6 million at December 31, 2013. Volatility in the marketplace, changes in the discount rate assumption, and further changes in mortality assumptions could materially impact our pension and post-retirement life valuation in the future. For additional information regarding our pension and post-retirement benefit plan obligations, see Note 15. "Retirement Plans" in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
Other-Than-Temporary Investment Impairments
When the fair value of any investment is lower than its cost/amortized cost, an assessment is made to determine if the decline is other than temporary. We regularly review our entire investment portfolio for declines in fair value. If we believe that a decline in the value of an available-for-sale ("AFS") security is temporary, we record the decline as an unrealized loss in Accumulated Other Comprehensive Income ("AOCI"). Temporary declines in the value of a held-to-maturity ("HTM") security are not recognized in the Financial Statements. Our assessment of a decline in fair value includes judgment as to the financial position and future prospects of the entity that issued the investment security, as well as a review of the security’s underlying collateral for fixed income investments. Broad changes in the overall market or interest rate environment generally will not lead to a write-down.
Fixed Income Securities and Short-Term Investments
Our evaluation for OTTI of a fixed income security or a short-term investment may include, but is not limited to, the evaluation of the following factors:
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Whether the decline appears to be issuer or industry specific;
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The degree to which the issuer is current or in arrears in making principal and interest payments on the fixed income security;
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The issuer’s current financial condition and ability to make future scheduled principal and interest payments on a timely basis;
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Evaluation of projected cash flows;
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Buy/hold/sell recommendations published by outside investment advisors and analysts; and
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Relevant rating history, analysis, and guidance provided by rating agencies and analysts.
OTTI charges are recognized as a realized loss to the extent that they are credit related, unless we have the intent to sell the security or it is more likely than not that we will be required to sell the security. In those circumstances, the security is written down to fair value with the entire amount of the writedown charged to earnings as a component of realized losses.
To determine if an impairment is other than temporary, we compare the present value of cash flows expected to be collected with the amortized cost of fixed income securities meeting certain criteria. In addition, this analysis is performed on all previously-impaired debt securities that continue to be held by us and all structured securities that were not of high-credit quality at the date of purchase. These impairment assessments may include, but are not limited to, discounted cash flow analyses ("DCFs").
For structured securities, including CMBS, RMBS, ABS, and CDOs, we also consider variables such as expected default, severity, and prepayment assumptions based on security type and vintage, taking into consideration information from credit agencies, historical performance, and other relevant economic and performance factors.
In making our assessment, we perform a DCF to determine the present value of future cash flows to be generated by the underlying collateral of the security. Any shortfall in the expected present value of the future cash flows, based on the DCF, from the amortized cost basis of a security is considered a “credit impairment,” with the remaining decline in fair value of a security considered as a “non-credit impairment.” As mentioned above, credit impairments are charged to earnings as a component of realized losses, while non-credit impairments are recorded to Other Comprehensive Income ("OCI") as a component of unrealized losses.
Discounted Cash Flow Assumptions
The discount rate we use in a DCF is the effective interest rate implicit in the security at the date of acquisition for those structured securities that were not of high-credit quality at acquisition. For all other securities, we use a discount rate that equals the current yield, excluding the impact of previous OTTI charges, used to accrete the beneficial interest.
If applicable, we use a conditional default rate assumption in the DCF to estimate future defaults. The conditional default rate is the proportion of all loans outstanding in a security at the beginning of a time period that are expected to default during that period. Our assumption of this rate takes into consideration the uncertainty of future defaults as well as whether or not these securities have experienced significant cumulative losses or delinquencies to date.
If applicable, conditional default rate assumptions apply at the total collateral pool level held in the securitization trust. Generally, collateral conditional default rates will “ramp-up” over time as the collateral seasons, because the performance begins to weaken and losses begin to surface. As time passes, depending on the collateral type and vintage, losses will peak and performance will begin to improve as weaker borrowers are removed from the pool through delinquency resolutions. In the later years of a collateral pool’s life, performance is generally materially better as the resulting favorable selection of the portfolio improves the overall quality and performance.
For CMBS, we also consider the net operating income (“NOI”) generated by the underlying properties. Our assumptions of the properties’ ultimate cash flows take into consideration both an immediate reduction to the reported NOIs and decreases to projected NOIs.
If applicable, we use a loan loss severity assumption in our DCF that is applied at the loan level of the collateral pool. The loan loss severity assumptions represent the estimated percentage loss on the loan-to-value exposure for a particular security. For CMBS, the loan loss severities applied are based on property type. Losses generated from the evaluations are then applied to the entire underlying deal structure in accordance with the original service agreements.
Equity Securities
Evaluation for OTTI of an equity security may include, but is not limited to, an evaluation of the following factors:
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Whether the decline appears to be issuer or industry specific;
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The relationship of market prices per share to book value per share at the date of acquisition and date of evaluation;
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The price-earnings ratio at the time of acquisition and date of evaluation;
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The financial condition and near-term prospects of the issuer, including any specific events that may influence the issuer’s operations, coupled with our intention to hold the securities in the near term;
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The recent income or loss of the issuer;
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The independent auditors’ report on the issuer’s recent financial statements;
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The dividend policy of the issuer at the date of acquisition and the date of evaluation;
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Buy/hold/sell recommendations or price projections published by outside investment advisors;
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Rating agency announcements;
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The length of time and the extent to which the fair value has been, or is expected to be, less than cost in the near term; and
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Our expectation of when the cost of the security will be recovered.
If there is a decline in the fair value on an equity security that we do not intend to hold, or if we determine the decline is other-than-temporary, including declines driven by market volatility for which we cannot assert will recover in the near term, we will write down the carrying value of the investment and record the charge through earnings as a component of realized losses.
Other Investments
Our evaluation for OTTI of an other investment (i.e., an alternative investment) may include, but is not limited to, conversations with the management of the alternative investment concerning the following:
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The current investment strategy;
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Changes made or future changes to be made to the investment strategy;
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Emerging issues that may affect the success of the strategy; and
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The appropriateness of the valuation methodology used regarding the underlying investments.
If there is a decline in the equity method value of an other investment that we do not intend to hold, or if we determine the decline is other than temporary, we write down the cost of the investment and record the charge through earnings as a component of realized losses.
Reinsurance
Reinsurance recoverables 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 recovered from reinsurers are recognized as assets at the same time and in a manner consistent with the paid and unpaid losses associated with the reinsured 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 $6.9 million at December 31, 2014 and $5.1 million at December 31, 2013. We continually monitor developments that may impact recoverability from our reinsurers and have available to us contractually provided remedies if necessary. For further information regarding reinsurance, see the “Reinsurance” section below and Note 8. “Reinsurance” in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
1Refer to the Glossary of Terms attached to this Form 10-K as Exhibit 99.1 for definitions of terms used in this financial review.
The following table reconciles operating income and net income for the periods presented above:
We are currently targeting an ROE that is three points higher than our cost of capital, or 12%, excluding the impact of realized gains and losses, which is referred to as operating return on equity. Our operating ROE and contribution by component for the following years are as follows:
Insurance Segments
The key metric in understanding our insurance segments’ contribution to operating ROE is the GAAP combined ratio. The following table provides a quantitative foundation for analyzing this ratio:
Fluctuations in our GAAP combined ratio were driven by the following:
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Earned rate in excess of expected claims inflation in both 2014 and 2013. Renewal pure price increases of 5.6% in 2014, 7.6% in 2013, and 6.3% in 2012 have earned in at 6.6% in 2014 and 7.1% in 2013, both of which are above loss inflation trends of approximately 3%. After taking into account the incremental expenses associated with the additional premium, the net benefit to the combined ratio is approximately 2.5 points in both years.
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Favorable prior year casualty reserve development, the details of which are below:
For a qualitative discussion of this reserve development, please see the related insurance segment discussions below.
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The March 2014 sale of the renewal rights to our $37 million SIG book of business contributed $8 million to other income and reduced the combined ratio by 0.4 points. Although we did not solicit buyers, we decided to sell this small and specialized book of business when the opportunity presented itself because it had significant production outside of our standard lines footprint, and proved difficult to grow. We however, have retained our substantial individual risk public entity book of business and continue to look for opportunities to grow it.
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Catastrophe losses, the details of which are below:
The significant improvement in 2013 was driven by the fact that 2012 included the impact of Superstorm Sandy, which was the single largest catastrophic event in our history. The net impact of this storm on 2012 results was as follows:
1 Our estimated ultimate exposure decreased to $132 million in the third quarter of 2014.
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Non-catastrophe property losses, the details of which are below:
Investments Segment
The investment segment's operating ROE has been negatively impacted by the declining interest rate environment over the last three years. While on a numerical basis, the impact of decreasing interest rates has been more than offset by a higher asset base within our fixed income portfolio in 2014 and by higher alternative investment income in 2013, this segment's contribution to ROE has been deteriorating over the past three years as the rate of investment income growth has been outpaced by the growth in equity.
Outlook
In its Review & Preview report issued in February 2015, A.M. Best noted that the U.S. property and casualty industry is expected to record its second consecutive year of underwriting profitability in 2014, although at a lower level than last year. Their expectation is for an industry statutory combined ratio of 97.2% for the year, 0.8 points higher than last year’s 96.4%. This expectation includes catastrophe losses of 4.4 points and overall favorable prior year reserve development of 1.9 points. This compares with our statutory combined ratio for 2014 of 95.7%, which included 3.2 points of catastrophe losses and 2.6 points of favorable prior year casualty reserve development. In addition, A.M. Best projects a decline in investment yields, continuing a trend that has persisted over the past five years, with yields on new investments remaining significantly lower than those on investments that mature or are called. This is consistent with our experience, which has continued into 2014 with bonds that we purchased having a yield of 2.0% and bonds that were called, matured, or otherwise disposed of yielding 2.3%.
A.M. Best expects the industry combined ratio to deteriorate almost 200 basis points in 2015 to 99.1%, reflecting: (i) a reduction in rate increases; (ii) a modest catastrophe loss increase to 4.9 points, a level that is more in line with recent averages; and (iii) reductions in the level of favorable prior year development to one point on the statutory combined ratio. They believe the main challenges facing the industry include: (i) low returns on fixed-income investments; (ii) reserve shortfalls due to current accident year underestimations and prior accident year unfavorable development; (iii) developing, attracting, and maintaining underwriting talent; (iv) continuing the evolution of data analytics; and (v) addressing the uncertainties surrounding emerging risks such as terrorism, cyber risk, and infectious diseases. Considering these, among other factors, A.M. Best has a negative outlook on the commercial lines market and a stable outlook on the personal lines market. Additionally, after declining in each of the past two years, A.M. Best expects investment income to increase modestly in 2015, driven by growth in invested assets from positive cash flow as yields will continue to be challenged.
While we expect the competitive market environment to continue, we believe that we have a strong foundation for further improvement in our underlying profitability considering:
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The size of our company and our field model that provides us with the ability to be agile and responsive to our customer needs;
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Our reserve position that reflects the discipline we have always maintained in our reserving practices;
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Our customer-centric approach to our business with a focus on our policyholders and the service we bring to them;
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The utilization of our capabilities regarding data analytics;
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Our demonstrated ability to execute on our strategic cost reduction strategies; and
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Our deep bench of talent in the organization and our continuous cultivation of that talent.
For 2015, we expect the following:
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An ex-catastrophe combined ratio of 91%, which includes no prior year casualty reserve development;
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Four points of catastrophe losses for the year;
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After-tax investment income of approximately $105 million; and
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Weighted average shares of approximately 58 million.
On a longer-term basis, in order to achieve our goal of an operating ROE of 12%, we need to deliver a 90% ex-catastrophe combined ratio, which is our ongoing focus.
Results of Operations and Related Information by Segment
Standard Commercial Lines
Our Standard Commercial Lines, which represents 76% of our combined insurance segments' NPW, sells commercial lines insurance products and services to businesses, non-profit organizations, and local government agencies located primarily in 22 states in the Eastern and Midwestern U.S. and the District of Columbia through approximately 1,100 distribution partners in the standard marketplace.
The growth in NPW and NPE from 2012 through 2014 is primarily the result of the following:
Renewal pure price increases and strong retention have contributed to NPW growth over the past three years. In 2014, our growth rate of 4% would have been 7% excluding the impact of the SIG renewal rights sale in the first quarter of 2014. In addition to the items above, premium in 2012 was reduced by a reinstatement premium on our catastrophe excess of loss treaty of $4.6 million due to the impact of Superstorm Sandy. Our 2013 NPW growth would have remained at 9% excluding this reinstatement premium.
The GAAP loss and loss expense ratio improved by 1.6 points in 2014 compared to 2013 and by 6.5 points in 2013 compared to 2012. Both periods experienced earned renewal pure price increases of 6.5% to 7.0%, which outpaced our loss inflation trends, thus improving our results by approximately 2.5 points in each year. In 2014, prior year casualty reserve development of 3.2 points further contributed to the improved results, whereas 2013 and 2012 had comparable levels of prior year casualty reserve development at 0.8 and 0.9 points, respectively. For information on this development by line of business, see "Financial Highlights of Results for Years Ended December 31, 2014, 2013, and 2012" above.
Additionally, lower non-catastrophe property losses and catastrophe losses contributed to the favorable results in 2013 compared to 2012. However, in 2014, we saw a deterioration in these losses compared to 2013. The following table provides the details by year for the property losses:
The following is a discussion of our most significant Standard Commercial Lines of business:
The growth in NPW and NPE for our general liability business in 2014 and 2013 reflects renewal pure price increases and strong retention. In 2014, renewal pure price increases and strong retention more than offset a reduction in premiums that resulted from the sale of the SIG renewal rights. SIG NPW was approximately $17 million for the general liability line of business in 2013. Excluding the impact of this sale, NPW growth in 2014 compared to 2013 would have been 11%.
The fluctuations in the statutory combined ratios reflect: (i) earned renewal pure price increases of 7.9% in 2014 and 2013, exceeding our projected loss inflation trends and improving profitability by approximately 3 points in both years; and (ii) changes in prior year development.
Prior year development can be volatile year to year and, therefore, requires a longer period of time before true trends are fully recognized. The impact of the prior year casualty reserve development on this line was as follows:
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2014: favorable prior year development of 9.9 points driven by lower severities in the 2010 through 2012 accident years, within both the premises and operations and products liability coverages. In addition, accident years 2011 and 2012 continued to show lower claim counts, even as they matured.
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2013: favorable prior year development of 4.9 points driven by lower severities in 2010 and prior accident years, partially offset by unfavorable development in accident years 2011 and 2012, which showed higher average severities in premises and operations coverage.
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2012: unfavorable by 0.8 points, driven by increased severities in the 2010 and 2011 accident years. This unfavorable development was largely offset by continued favorable development in the premises and products coverages in accident years 2007 and 2009, which showed lower frequencies of large losses, particularly in the umbrella coverage.
NPW and NPE have seen increases over the three-year time period driven by renewal pure price increases and strong retention.
The combined ratio in this line of business has been very stable over the last three years. In all three years, the combined ratio has been impacted by renewal pure price increases that have exceeded loss inflation trends, higher property losses, and lower favorable prior year casualty reserve development, which are outlined below:
Favorable prior year casualty reserve development was as follows:
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2014: 1.2 points driven by bodily injury liability for accident years 2012 and prior, partially offset by accident year 2013 due to higher frequency of claims.
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2013: 1.6 points driven by accident years 2006 through 2010 representing a continued trend of better than expected reported emergence, partially offset by increased severity in accident year 2012.
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2012: 2.6 points driven by the 2009 accident year, representing a continued trend driven by better than expected reported emergence. This was partially offset by unfavorable development in the 2011 accident year, due to higher frequency of claims.
NPW decreased in 2014 compared to 2013 while it increased in 2013 compared to 2012. Excluding the impact of the sale of the SIG renewal rights, which included $4 million of premium in 2013, the decrease in NPW in 2014 would have been 1%. This decrease was due to reductions in new business and a focused effort to improve our hazard mix and reduce exposures on this line.
The 2013 NPW increase was due to: (i) renewal pure price increases of 7.5%; (ii) improvements in retention; and (iii) an increase in direct new business.
NPE increases in 2014 and 2013 were consistent with the fluctuations in NPW for their respective twelve-month periods ended December 31st.
While we continue to view workers compensation in the context of an overall account, we remain very focused on improving this competitive line of business through both underwriting and claims initiatives. We achieved earned renewal pure price increases of 6.1% in 2014 and 8.0% in 2013, exceeding projected loss inflation trends and improving profitability by approximately 2.5 points and 4.0 points, respectively. Additionally, we have seen improvements in claims outcomes as all workers compensation claim handling has been centralized in Charlotte, North Carolina. Jurisdictionally trained and aligned medical only and lost-time adjusters manage non-complex workers compensation claims within our footprint. Claims with high exposure and/or significant escalation risk are referred to the workers compensation strategic case management unit. While there is still more work to do, the improvement in our workers compensation combined ratio and the fact that there was no prior year casualty reserve development in 2014 are evidence of the progress being achieved.
Prior year casualty reserve development on this line was as follows:
•2014: no prior year development.
•
2013: unfavorable prior year development of 8.6 points driven by 2008 and prior accident years reflecting increases in severities for medical costs. These increases largely related to case reserve adjustments to assisted living facility claims, and our review of medical cost development over many years.
•
2012: unfavorable by 1.1 points driven by the 2011 accident year, due to an increase in the ultimate severity, partially offset by accident years 2007 and 2008, due to a decrease in expected severity for those years.
NPW and NPE increased in 2014 compared to 2013, as well as in 2013 compared to 2012, primarily due to: (i) renewal pure price increases; (ii) strong retention; and (iii) growth in new business.
The fluctuations in the statutory combined ratios over the three-year period are best understood by reviewing the fluctuations in non-catastrophe property losses and catastrophe losses. The significant increases in these losses in 2014 compared to 2013 was primarily driven by extreme cold caused by the polar vortex that impacted our entire 22 state footprint and Midwest storms in the first and second quarters of 2014, respectively. The significant improvement in total property losses in 2013 compared to 2012 reflects the impact of Superstorm Sandy in 2012. Quantitative information regarding these items is as follows:
Standard Personal Lines
Our Standard Personal Lines segment, which includes our flood business, represents approximately 16% of our combined insurance segments' NPW, sells personal lines insurance products and services to individuals located primarily in 13 states through approximately 700 distribution partners. In addition, we have approximately 5,000 distribution partners selling our flood business.
NPW fluctuations over the three-year periods were driven by the following:
The decrease in 2014 NPW was mainly due to lower retention. This was the result of our strategic nonrenewal of dwelling fire business of approximately $8.9 million and targeted nonrenewal actions on underperforming personal automobile and mono-line homeowners business. Excluding the impact of those targeted actions, retention remains strong at 84%, which is comparable to last year.
In addition to the items above, premium in 2012 was reduced by a reinstatement premium on our catastrophe excess of loss treaty of $3.9 million due to the impact of Superstorm Sandy.
NPE increases in 2014 and 2013 were consistent with the fluctuations in NPW for their respective twelve-month periods ended December 31st.
The improvement in the loss and loss expense ratio in the three-year period is primarily driven by: (i) earned renewal pure price increases of 6.8% in 2014 and 7.6% in 2013, exceeding our projected loss inflation trends and improving profitability by approximately 2.6 points and 3.3 points, respectively; and (ii) decreased catastrophe losses. This was partially offset by the impact of non-catastrophe property losses and lower flood claims handling fees earned from our participation in the NFIP. These amounts are quantified in the tables below:
1 Represents amounts received from the NFIP to reimburse us for claims expenses, which are recorded as a reduction to loss and loss expenses incurred.
In addition, 2014 had favorable prior year casualty reserve development of 2.9 points, compared to favorable prior year casualty reserve development of 2.0 points in 2013. Quantitative details regarding this favorable prior year development is as follows:
The increase in the underwriting expense ratio in 2014 compared to 2013 was driven by higher supplemental commissions to our distribution partners.
The improvement in the underwriting expense ratio in 2013 compared to 2012 was driven by a higher underwriting expense allowance received from the NFIP as a result of: (i) an increase in the rate used in reimbursing WYO carriers for issuing and servicing flood policies; and (ii) an increase in flood premiums to which the reimbursement rate is applied.
E&S Lines
Our E&S Lines segment, which represents 8% of our combined insurance segments' NPW, sells commercial lines insurance products and services in all 50 states and the District of Columbia through approximately 80 distribution partners. Insurance policies in this segment are sold to customers that typically have business risks with unique characteristics, such as the nature of the business or its claim history, that have not obtained coverage in the standard marketplace. E&S insurers have more flexibility in coverage terms and rates compared to standard market insurers, generally resulting in policies with higher rates and terms and conditions that are customized for specific risks.
NPW increases in 2014 and 2013 reflect the following:
The increase in NPE in 2014 is consistent with the NPW increase, while the increase in NPE in 2013 compared to 2012 is significantly higher because 2012 did not have a full year of earned premium due to the timing of the acquisition of the E&S business.
The improvement in the combined ratio in 2014 was driven by a change in the mix of business, coupled with catastrophe losses that decreased by 1.7 points. Partially offsetting these items were non-catastrophe property losses that increased by 2.5 points and unfavorable prior year casualty reserve development. This development was $5.8 million, or 4.1 points, in 2014 compared to $2.5 million, or 1.9 points, in 2013. The 2014 development related to updated actuarial assumptions as the book matures and we gather more of our own experience.
The significant combined ratio improvement in 2013 compared to 2012 was driven by a change in the mix of business, a reduction in acquisition and integration costs, and significant underwriting actions to improve profitability.
Reinsurance
We use reinsurance to protect our capital resources and insure us against losses on property and casualty risks that we underwrite. We use two main reinsurance vehicles: (i) a reinsurance pooling agreement among our Insurance Subsidiaries in which each company agrees to share in premiums and losses based on certain specified percentages; and (ii) reinsurance contracts and arrangements with third parties that cover various policies that we issue to our customers.
Reinsurance Pooling Agreement
The primary purposes of the reinsurance pooling agreement among our Insurance Subsidiaries are the following:
•
Pool or share proportionately the underwriting profit and loss results of property and casualty insurance underwriting operations through reinsurance;
•
Prevent any of our Insurance Subsidiaries from suffering undue loss;
•
Reduce administration expenses; and
•
Permit all of the Insurance Subsidiaries to obtain a uniform rating from A.M. Best.
The following illustrates the pooling percentages by company as of December 31, 2014:
Reinsurance Treaties and Arrangements
By entering into reinsurance treaties and arrangements, we are able to increase underwriting capacity and accept larger risks and a larger number of risks without directly increasing capital or surplus. Our reinsurance consists of traditional reinsurance and we do not purchase finite reinsurance. Under our reinsurance treaties, the reinsurer generally assumes a portion of the losses we cede to them in exchange for a portion of the premium. Amounts not reinsured are known as retention. Reinsurance does not legally discharge us from liability under the terms and limits of our policies, but it does make our reinsurer liable to us for the amount of liability we cede to them. Accordingly, we have counterparty credit risk to our reinsurers. We attempt to mitigate this credit risk by: (i) pursuing relationships with reinsurers rated “A-” or higher; or (ii) obtaining collateral to secure reinsurance obligations. Some of our reinsurance contracts include provisions that permit us to terminate or commute the reinsurance treaty if the reinsurer's financial condition or rating deteriorates. We consistently monitor the financial condition of our reinsurers. We also continuously review the quality of reinsurance recoverables and reserves for uncollectible reinsurance. For additional information regarding our counterparty credit risk with our reinsurers, see Note 8. "Reinsurance" in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K.
We have reinsurance contracts that separately cover our property and casualty insurance business. Available reinsurance can be segregated into the following key categories:
•
Property Reinsurance - includes our property excess of loss treaties purchased for protection against large individual property losses and our Property Catastrophe treaty purchased to provide protection for the overall property portfolio against severe catastrophic events. Facultative reinsurance is used for property risks that are in excess of our treaty capacity.
•
Casualty Reinsurance - purchased to provide protection for both individual large casualty losses and catastrophic casualty losses involving multiple claimants or customers. Facultative reinsurance is also used for casualty risks that are in excess of our treaty capacity.
•
Terrorism Reinsurance - available as a federal backstop related to terrorism losses as provided under the TRIPRA. For further information regarding this legislation, see Item 1A. “Risk Factors.” of this Form 10-K.
•
Flood Reinsurance - as a servicing carrier in the WYO program, we receive a fee for writing flood business, for which the related premiums and losses are 100% ceded to the federal government.
In addition to the above categories, we have entered into several reinsurance agreements with Montpelier Re Insurance Ltd. as part of the acquisition of MUSIC. Together, these agreements provide protection for losses on policies written prior to the December 2011 acquisition and any development on reserves established by MUSIC as of the date of acquisition. The reinsurance recoverables under these treaties are 100% collateralized.
Property Reinsurance
The Property Catastrophe treaty, which covers both our standard market and E&S business, renewed effective January 1, 2015. The current treaty structure remains the same, providing total coverage of $685 million in excess of $40 million. The annual aggregate limit net of our co-participation is approximately $1.0 billion for 2015. As a result of our actions to further control our property aggregations, our modeled results showed decreases year on year, especially for higher severity, low-probability events. Due to this, we chose to decrease the percent of reinsurance placement in some of the catastrophe treaty layers. In addition, we placed a separate catastrophe treaty of $35 million in excess of $5 million to cover events outside of our standard lines footprint, in support of our growing E&S property book. We expect the overall catastrophe ceded premium for 2015 to be slightly lower than 2014. As our need for catastrophe reinsurance increases, we seek ways to minimize credit risk inherent in a reinsurance transaction by dealing with highly-rated reinsurance partners and purchasing collateralized reinsurance products, particularly for high severity, low-probability events. The current program includes $196 million in collateralized limit.
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 protections.
Although we model various catastrophic perils, due to our geographic spread, the risk of hurricane continues to be the most significant natural catastrophe peril to which our portfolio is exposed. Below is a summary of the largest five actual hurricane losses that we experienced in the past 25 years:
1 This amount represents reported and unreported gross losses estimated as of December 31, 2014.
We use the results of the Risk Management Solutions (“RMS”) and AIR Worldwide (“AIR”) models in our review of exposure to hurricane risk. Each of these third party vendors provide two views of the modeled results as follows: (i) a long-term view that closely relates modeled event frequency to historical hurricane activity; and (ii) a medium-term view that adjusts historical frequencies to reflect higher expectations of hurricane activity in the North Atlantic Basin. We believe that modeled estimates provide a range of potential outcomes and we review multiple estimates for purposes of understanding catastrophic risk. The following table provides modeled hurricane results based on a blended view of the four models for the Insurance Subsidiaries' combined property book as of July 2014:
1 Losses are after tax and include applicable reinstatement premium.
2 Equity as of December 31, 2014.
Our current catastrophe reinsurance program exhausts at a 1 in 273 year return period, or events with 0.37% probability, based on a multi-model view of hurricane risk.
The Property Excess of Loss treaty (“Property Treaty”), which covers our standard market business, was renewed on July 1, 2014 and is effective through June 30, 2015, the terms of which are consistent with the prior year treaty. The details of the current year treaty are included in the table below.
The following is a summary of our property reinsurance treaties and arrangements covering our Insurance Subsidiaries:
PROPERTY REINSURANCE ON INSURANCE PRODUCTS
Treaty Name
Reinsurance Coverage
Terrorism Coverage
Property Catastrophe Excess of Loss
(covers all insurance segments)
$685 million above $40 million retention in four layers:
All NBCR losses are excluded regardless of whether or not they are certified under TRIPRA. Non-NBCR losses are covered with certain limitations. Please see Item 1A. “Risk Factors.” of this Form 10-K for discussion regarding changes in TRIPRA.
- 81% of losses in excess of $40 million up to
$100 million;
- 95% of losses in excess of $100 million up to
$225 million;
- 95% of losses in excess of $225 million up to
$475 million; and
- 85% of losses in excess of $475 million up
to $725 million.
- The treaty provides one reinstatement per layer
for the first three layers and no reinstatements
on the fourth layer. The annual aggregate limit
is $1.02 billion, net of the Insurance
Subsidiaries' co-participation.
Property Excess of Loss
(covers Standard Commercial and Personal Lines)
$38 million above $2 million retention covering 100% in two layers. Losses other than TRIPRA certified losses are subject to the following reinstatements and annual aggregate limits:
All NBCR losses are excluded regardless of whether or not they are certified under TRIPRA. For non-NBCR losses, the treaty distinguishes between acts committed on behalf of foreign persons or foreign interests ("Foreign Terrorism") and those that are not. The treaty provides annual aggregate limits for Foreign Terrorism (other than NBCR) acts of $24 million for the first layer and $60 million for the second layer. Non-certified terrorism losses (other than NBCR) are subject to the normal limits under the treaty.
- $8 million in excess of $2 million layer
provides unlimited reinstatements; and
- $30 million in excess of $10 million layer
provides three reinstatements, $120 million in
aggregate limits.
Flood
100% reinsurance by the federal government’s WYO program.
None
Casualty Reinsurance
The Casualty Excess of Loss treaty (“Casualty Treaty”), which covers our standard market business, was renewed on July 1, 2014 and is effective through June 30, 2015, with substantially the same terms as the expiring treaty. The details of the current year treaty are included in the table below.
The following is a summary of our casualty reinsurance treaties and arrangements covering our Insurance Subsidiaries:
CASUALTY REINSURANCE ON INSURANCE PRODUCTS
Treaty Name
Reinsurance Coverage
Terrorism Coverage
Casualty Excess of Loss
(covers Standard Commercial and Personal Lines)
There are six layers covering 100% of $88 million in excess of $2 million. Losses other than terrorism losses are subject to the following reinstatements and annual aggregate limits:
All NBCR losses are excluded. All other losses stemming from the acts of terrorism are subject to the following reinstatements and annual aggregate limits:
- $3 million in excess of $2 million layer
provides 23 reinstatements, $72 million net
annual aggregate limit;
- $3 million in excess of $2 million layer provides
four reinstatements for terrorism losses, $15 million
net annual aggregate limit;
- $7 million in excess of $5 million layer
provides four reinstatements, $35 million
annual aggregate limit;
- $7 million in excess of $5 million layer provides
three reinstatements for terrorism losses, $28 million
annual aggregate limit;
- $9 million in excess of $12 million layer provides
two reinstatements, $27 million annual aggregate limit;
- $9 million in excess of $12 million layer provides
two reinstatements for terrorism losses, $27 million
annual aggregate limit;
- $9 million in excess of $21 million layer provides
one reinstatement, $18 million annual aggregate limit;
- $9 million in excess of $21 million layer provides
one reinstatement for terrorism losses, $18 million
annual aggregate limit;
- $20 million in excess of $30 million layer provides
one reinstatement, $40 million annual aggregate
limit; and
- $20 million in excess of $30 million layer provides
one reinstatement for terrorism losses, $40 million
annual aggregate limit; and
- $40 million in excess of $50 million layer provides
one reinstatement, $80 million in net annual
aggregate limit.
- $40 million in excess of $50 million layer provides
one reinstatement for terrorism losses, $80 million in net
annual aggregate limit.
Montpelier Re Quota Share and Loss Development Cover
(covers E&S Lines)
As part of the acquisition of MUSIC we entered into several reinsurance agreements that together provide protection for losses on policies written prior to the acquisition and any development on reserves established by MUSIC as of the date of acquisition. The reinsurance recoverables under these treaties are 100% collateralized.
Provides full terrorism coverage including NBCR.
We have other reinsurance treaties that we do not consider core to our reinsurance program for our Standard Commercial Lines, such as our Surety and Fidelity Excess of Loss Reinsurance Treaty, National Workers Compensation Reinsurance Pool, which covers business assumed from the involuntary workers compensation pool, and our Equipment Breakdown Coverage Reinsurance Treaty. In addition, we have Property and Casualty Excess of Loss Reinsurance Treaties and a Property Catastrophe Excess of Loss Reinsurance Treaty providing coverage for our E&S Lines.
We regularly reevaluate our overall reinsurance program and try to develop effective ways to manage transfer of 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, equity, and statutory surplus. We strive to balance sometimes opposing considerations of reinsurer credit quality, price, terms, and our appetite for retaining a certain level of risk.
Investments
Our investment philosophy includes certain return and risk objectives for the fixed income, equity, and other investment portfolios. Although yield and income generation remain the key drivers to our investment strategy, our overall philosophy is to invest with a long-term horizon with predominantly a "buy-and-hold" approach. The primary fixed income portfolio return objective is to maximize after-tax investment yield and income while balancing risk. A secondary objective is to meet or exceed a weighted-average benchmark of public fixed income indices. The equity portfolio strategy is designed to generate consistent dividend income and long term capital appreciation benchmarked to the S&P 500 Index. The return objective of the other investment portfolio, which includes alternative investments, is to meet or exceed the S&P 500 Index.
Total Invested Assets
The increase in our investment portfolio in 2014 was driven primarily by: (i) cash flows provided by operating activities of $232.8 million, which resulted in investable cash flows of $185.7 million; and (ii) an increase in pre-tax unrealized gains of $44.4 million. These gains were driven by increases in the market value of our fixed income securities portfolio as interest rates decreased during 2014.
During 2014, interest rates on the 10-year U.S. Treasury Note fell by 86 basis points. The low interest rate environment
presents a challenge to us in generating after-tax return, as new purchase yields are below the average yield on bonds that are currently maturing.
We structure our portfolio conservatively with a focus on: (i) asset diversification; (ii) investment quality; (iii) liquidity, particularly to meet the cash obligations of our three insurance segments; (iv) consideration of taxes; and (v) preservation of capital. We believe that we have a high quality and liquid investment portfolio. The breakdown of our investment portfolio is as follows:
Fixed Income Securities
We typically have a long investment time horizon, and every purchase or sale is made with the intent of maximizing risk adjusted investment returns in the current market environment while balancing capital preservation.
Our fixed income securities portfolio maintained a weighted average credit rating of AA- as of December 31, 2014. The following table presents the credit ratings of our fixed income securities portfolio:
For further details on how we manage overall credit quality and the various risks to which our portfolio is subject, see Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Market Risk
The fair value of our assets and liabilities are subject to market risk, primarily interest rate, credit risk, and equity price risk related to our investment portfolio as well as fluctuations in the value of our alternative investment portfolio. Our investment portfolio is currently comprised of securities categorized as AFS and HTM. We do not hold derivative or commodity investments. Foreign investments are made on a limited basis, and all fixed income transactions are denominated in U.S. currency. We have minimal foreign currency fluctuation risk on certain equity securities.
Our investment philosophy includes certain return and risk objectives for the fixed income, equity, and other investment portfolios. Although yield and income generation remain the key drivers to our investment strategy, our overall philosophy is to invest with a long-term horizon along with predominantly a “buy-and-hold” approach. The primary fixed income portfolio return objective is to maximize after-tax investment yield and income while balancing risk. A secondary objective is to meet or exceed a weighted-average benchmark of public fixed income indices. The equity portfolio strategy is designed to generate consistent dividend income and long term capital appreciation benchmarked to the S&P 500 Index. The return objective of the other investment portfolio, which includes alternative investments, is to meet or exceed the S&P 500 Index. The allocation of our portfolio was 91% fixed income securities, 4% equity securities, 3% short-term investments, and 2% other investments as of December 31, 2014.
We manage our investment portfolio to mitigate risks associated with various financial market scenarios. We will, however, take prudent risk to enhance our overall long-term results while managing a conservative, well-diversified investment portfolio to support our underwriting activities.
Interest Rate Risk
Investment Portfolio
We invest in interest rate-sensitive securities, mainly fixed income securities. Our fixed income securities 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 MBS. Our strategy to manage interest rate risk is to purchase intermediate-term fixed income investments that are attractively priced in relation to perceived credit risks. Our fixed income securities include both AFS and HTM securities. Fixed income securities that are not classified as either HTM securities or trading securities are classified as AFS securities and reported at fair value, with unrealized gains and losses excluded from current earnings and reported as a separate component of comprehensive income. Those fixed income securities that we have the ability and positive intent to hold to maturity are classified as HTM and carried at either: (i) amortized cost; or (ii) market value at the date the security was transferred into the HTM category, adjusted for subsequent amortization.
Our exposure to interest rate risk relates primarily to the market price and cash flow variability associated with changes in interest rates. As our fixed income securities portfolio contains interest rate-sensitive instruments, it may be adversely affected by changes in interest rates resulting from governmental monetary policies, domestic and international economic and political conditions, and other factors beyond our control. A rise in interest rates will decrease the fair value of our existing fixed income investments and a decline in interest rates will result in an increase in the fair value of our existing fixed income investments. However, new and reinvested money used to purchase fixed income securities would benefit from rising interest rates and would be negatively impacted by falling interest rates.
During 2014, interest rates on the 10-year U.S. Treasury Note fell by 86 basis points. This decline in interest rates
contributed to the increase in the unrealized gain position on our fixed income securities portfolio. The low interest rate environment presents a challenge to us in generating after-tax return, as new purchase yields are below the average yield on bonds that are currently maturing.
In 2014, bonds that matured, were sold or otherwise redeemed, valued at $607.2 million, had yields that averaged 2.3%, after-tax, while new purchases of $860.4 million had an average after-tax yield of 2.0%. We seek to mitigate our interest rate risk associated with holding fixed income investments by monitoring and maintaining the average duration of our portfolio with a view toward achieving an adequate after-tax return without subjecting the portfolio to an unreasonable level of interest rate risk.
The fixed income securities portfolio duration at December 31, 2014 increased from 3.6 to 3.8 years, excluding short-term investments, compared to a year ago. The current duration is within our historical range, and is monitored and managed to maximize yield while managing interest rate risk at an acceptable level. During 2014, we increased our purchases of highly-rated municipal bonds, investment grade corporate bonds, and structured securities due to attractive risk adjusted return opportunities in those sectors. Despite the relative attractiveness, the prevailing low interest rate environment resulted in the fixed income securities portfolio after-tax return of 2.2% for 2014.
The Insurance Subsidiaries’ liability duration is approximately 4.2 years. We manage our asset liquidity with a laddered maturity structure and an appropriate level of short-term investments to avoid liquidation of AFS fixed income securities in the ordinary course of business.
We use an interest rate sensitivity analysis to measure the potential loss or gain in future earnings, fair values, or cash flows of market sensitive fixed income securities. The sensitivity analysis hypothetically assumes an instant parallel 200 basis point shift in interest rates up and down in 100 basis point increments from the date of the Financial Statements. We use fair values to measure the 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 our income or stockholders’ equity. Further, the calculations do not take into account any actions we may take in response to market fluctuations.
The following table presents the sensitivity analysis of interest rate risk as of December 31, 2014:
1 Given the low interest rate environment, an interest rate decline of 200 basis points is deemed unreasonable for certain securities in our portfolio, as the decline would generate a zero or negative yield, therefore this interest rate decline for purposes of the sensitivity analysis is not meaningful ("n/m").
Pension and Post-Retirement Benefit Plan Obligation
Our pension and post-retirement benefit obligations and related costs are calculated using actuarial methods within the framework of U.S. GAAP. The discount rate assumption is an important element of expense and/or liability measurement. Changes in the discount rate assumption could materially impact our pension and post-retirement life valuation in the future.
The discount rate enables us to state expected future cash flows at their present value on the measurement date. The purpose of the discount rate is to determine the interest rates inherent in the price at which pension benefits could be effectively settled. Our discount rate selection is based on high-quality, long-term corporate bonds. A higher discount rate reduces the present value of benefit obligations and reduces pension expense. Conversely, a lower discount rate increases the present value of benefit obligations and increases pension expense. We decreased our discount rate for the Retirement Income Plan for Selective Insurance Company of America and the Supplemental Excess Retirement Plan (jointly referred to as the "Retirement Income Plan" or the "Plan") to 4.29% for 2014, from 5.16% for 2013, reflecting lower market interest rates. We also decreased our discount rate for the Retirement Life Plan to 4.08% for 2014 from 4.85% for 2013.
For additional information regarding our pension and post-retirement benefit plan obligations, see Note 15. "Retirement Plans" in Item 8.
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 (the “Company”) as of December 31, 2014 and 2013, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flow for each of the years in the three-year period ended December 31, 2014. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules I to V. 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, 2014 and 2013, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2014, 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.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Selective Insurance Group, Inc. and its subsidiaries' internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 26, 2015, expressed an unqualified opinion of the Company’s internal controls over financial reporting.
/s/ KPMG LLP
New York, New York
February 26, 2015
See accompanying Notes to Consolidated Financial Statements.
See accompanying Notes to Consolidated Financial Statements.
See accompanying Notes to Consolidated Financial Statements.
Selective Insurance Group, Inc. also has authorized, but not issued, 5,000,000 shares of preferred stock, without par value, of which 300,000 shares have been designated Series A junior preferred stock, without par value.
See accompanying Notes to Consolidated Financial Statements.
See accompanying Notes to Consolidated Financial Statements.
Notes to Consolidated Financial Statements
December 31, 2014, 2013, and 2012
Note 1. Organization
Selective Insurance Group, Inc., through its subsidiaries, (collectively referred to as “we,” “us,” or “our”) offers standard commercial, standard personal, and excess and surplus lines (“E&S”) property and casualty insurance products. Selective Insurance Group, Inc. (referred to as the “Parent”) was incorporated in New Jersey in 1977 and its main offices are located in Branchville, New Jersey. The Parent’s common stock is publicly traded on the NASDAQ Global Select Market under the symbol “SIGI.” We have provided a glossary of terms as Exhibit 99.1 to this Form 10-K, which defines certain industry-specific and other terms that are used in this Form 10-K.
We classify our business into four reportable segments:
•
Standard Commercial Lines - comprised of insurance products and services provided in the standard marketplace to our commercial customers, who are typically businesses, non-profit organizations, and local government agencies.
•
Standard Personal Lines - comprised of insurance products and services, including flood insurance coverage, provided primarily to individuals acquiring coverage in the standard marketplace.
•
E&S Lines - comprised of insurance products and services provided to customers who have not obtained coverage in the standard marketplace.
•
Investments - invests the premiums collected by our Standard Commercial Lines, Standard Personal Lines, and E&S Lines, as well as amounts generated through our capital management strategies, which may include the issuance of debt and equity securities.
This is a change from the segments that we have previously reported of Standard Insurance Operations, E&S Insurance Operations, and Investments. All prior year information contained in this Form 10-K has been restated to reflect our revised segments. For qualitative information behind the change, see Note 11. "Segment Information" below.
Note 2. Summary of Significant Accounting Policies
(a) Principles of Consolidation
The accompanying consolidated financial statements ("Financial Statements") include the accounts of the Parent and its subsidiaries, and have been prepared in conformity with: (i) U.S. generally accepted accounting principles ("GAAP"); and (ii) the rules and regulations of the U.S. Securities and Exchange Commission. All significant intercompany accounts and transactions are eliminated in consolidation.
(b) Use of Estimates
The preparation of our Financial Statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported financial statement balances, as well as the disclosure of contingent assets and liabilities. Actual results could differ from those estimates.
(c) Reclassifications
Certain amounts in our prior years' Financial Statements and related notes have been reclassified to conform to the 2014 presentation. Such reclassifications had no effect on our net income, stockholders' equity, or cash flows.
(d) Investments
Fixed income securities may include bonds, redeemable preferred stocks, mortgage-backed securities (“MBS”) and asset-backed securities (“ABS”). Fixed income securities classified as available-for-sale (“AFS”) are reported at fair value. Those fixed income securities that we have the ability and positive intent to hold to maturity are classified as held-to-maturity (“HTM”) and are carried at either: (i) amortized cost; or (ii) market value at the date of transfer into the HTM category, adjusted for subsequent amortization. The amortized cost of fixed income securities is adjusted for the amortization of premiums and the accretion of discounts over the expected life of the security using the effective yield method. Premiums and discounts arising from the purchase of MBS are amortized over the expected life of the security based on future principal payments, and considering prepayments. These prepayments are estimated based on historical and projected cash flows. Prepayment assumptions are reviewed quarterly and adjusted to reflect actual prepayments and changes in expectations. Future amortization of any premium and/or discount is adjusted to reflect the revised assumptions. Interest income, as well as amortization and accretion, is included in "Net investment income earned" on our Consolidated Statements of Income. The amortized cost of fixed income securities is written down to fair value when a decline in value is considered to be other than temporary. See the discussion below on realized investment gains and losses for a description of the accounting for impairments. Unrealized gains and losses on fixed income securities classified as AFS, net of tax, are included in accumulated other comprehensive income (loss) ("AOCI").
Equity securities, which are classified as AFS, may include common stocks and non-redeemable preferred stocks, and are carried at fair value. Dividend income on these securities is included in "Net investment income earned" on our Consolidated Statements of Income. The associated unrealized gains and losses, net of tax, are included in AOCI. The cost of equity securities is written down to fair value when a decline in value is considered to be other than temporary. See the discussion below on realized investment gains and losses for a description of the accounting for impairments.
Short-term investments may include certain money market instruments, savings accounts, commercial paper, and other debt issues purchased with a maturity of less than one year. These investments are carried at cost, which approximates fair value. The associated income is included in "Net investment income earned" on our Consolidated Statement of Income.
Other investments may include alternative investments and other securities. Alternative investments are accounted for using the equity method. Our share of distributed and undistributed net income from alternative investments is included in "Net investment income earned" on our Consolidated Statement of Income. Included in other securities are low income housing tax credits, which are accounted for under the proportional amortization method. The remainder of our other securities are accounted for using the equity method. Under the proportional amortization method, our share of the investment’s performance is recorded in our Consolidated Statement of Income as a component of “Federal income tax expense (benefit).” Under the equity method, our share of distributed and undistributed net income is included in "Net investment income earned" on our Consolidated Statement of Income.
Realized gains and losses on the sale of investments are determined on the basis of the cost of the specific investments sold and are credited or charged to income. Included in realized gains and losses are the other-than-temporary impairment ("OTTI") charges recognized in earnings, which are discussed below.
When the fair value of any investment is lower than its cost/amortized cost, an assessment is made to determine if the decline is other than temporary. We regularly review our entire investment portfolio for declines in fair value. If we believe that a decline in the value of an AFS security is temporary, we record the decline as an unrealized loss in AOCI. Temporary declines in the value of an HTM security are not recognized in the Financial Statements. Our assessment of a decline in fair value includes judgment as to the financial position and future prospects of the entity that issued the investment security, as well as a review of the security’s underlying collateral for fixed income investments. Broad changes in the overall market or interest rate environment generally will not lead to a write-down.
Fixed Income Securities and Short-Term Investments
Our evaluation for OTTI of a fixed income security or a short-term investment may include, but is not limited to, the evaluation of the following factors:
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Whether the decline appears to be issuer or industry specific;
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The degree to which the issuer is current or in arrears in making principal and interest payments on the fixed income security;
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The issuer’s current financial condition and ability to make future scheduled principal and interest payments on a timely basis;
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Evaluation of projected cash flows;
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Buy/hold/sell recommendations published by outside investment advisors and analysts; and
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Relevant rating history, analysis, and guidance provided by rating agencies and analysts.
OTTI charges are recognized as a realized loss to the extent that they are credit related, unless we have the intent to sell the security or it is more-likely-than not that we will be required to sell the security. In those circumstances, the security is written down to fair value with the entire amount of the writedown charged to earnings as a component of realized losses.
To determine if an impairment is other than temporary, we compare the present value of cash flows expected to be collected with the amortized cost of fixed income securities meeting certain criteria. In addition, this analysis is performed on all previously-impaired debt securities that continue to be held by us and all structured securities that were not of high-credit quality at the date of purchase. These impairment assessments may include, but are not limited to, discounted cash flow analyses ("DCFs").
For structured securities, including commercial mortgage-backed securities ("CMBS"), residential mortgage-backed securities ("RMBS"), ABS, and collaterialized debt obligations ("CDOs"), we also consider variables such as expected default, severity, and prepayment assumptions based on security type and vintage, taking into consideration information from credit agencies, historical performance, and other relevant economic and performance factors.
In making our assessment, we perform a DCF to determine the present value of future cash flows to be generated by the underlying collateral of the security. Any shortfall in the expected present value of the future cash flows, based on the DCF, from the amortized cost basis of a security is considered a “credit impairment,” with the remaining decline in fair value of a security considered as a “non-credit impairment.” As mentioned above, credit impairments are charged to earnings as a component of realized losses, while non-credit impairments are recorded to Other Comprehensive Income ("OCI") as a component of unrealized losses.
Discounted Cash Flow Assumptions
The discount rate we use in a DCF is the effective interest rate implicit in the security at the date of acquisition for those structured securities that were not of high-credit quality at acquisition. For all other securities, we use a discount rate that equals the current yield, excluding the impact of previous OTTI charges, used to accrete the beneficial interest.
If applicable, we use a conditional default rate assumption in the DCF to estimate future defaults. The conditional default rate is the proportion of all loans outstanding in a security at the beginning of a time period that are expected to default during that period. Our assumption of this rate takes into consideration the uncertainty of future defaults as well as whether or not these securities have experienced significant cumulative losses or delinquencies to date.
If applicable, conditional default rate assumptions apply at the total collateral pool level held in the securitization trust. Generally, collateral conditional default rates will “ramp-up” over time as the collateral seasons, because the performance begins to weaken and losses begin to surface. As time passes, depending on the collateral type and vintage, losses will peak and performance will begin to improve as weaker borrowers are removed from the pool through delinquency resolutions. In the later years of a collateral pool’s life, performance is generally materially better as the resulting favorable selection of the portfolio improves the overall quality and performance.
For CMBS, we also consider the net operating income (“NOI”) generated by the underlying properties. Our assumptions of the properties’ ultimate cash flows take into consideration both an immediate reduction to the reported NOIs and decreases to projected NOIs.
If applicable, we use a loan loss severity assumption in our DCF that is applied at the loan level of the collateral pool. The loan loss severity assumptions represent the estimated percentage loss on the loan-to-value exposure for a particular security. For CMBS, the loan loss severities applied are based on property type. Losses generated from the evaluations are then applied to the entire underlying deal structure in accordance with the original service agreements.
Equity Securities
Evaluation for OTTI of an equity security may include, but is not limited to, an evaluation of the following factors:
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Whether the decline appears to be issuer or industry specific;
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The relationship of market prices per share to book value per share at the date of acquisition and date of evaluation;
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The price-earnings ratio at the time of acquisition and date of evaluation;
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The financial condition and near-term prospects of the issuer, including any specific events that may influence the issuer's operations, coupled with our intention to hold the securities in the near-term;
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The recent income or loss of the issuer;
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The independent auditors' report on the issuer's recent financial statements;
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The dividend policy of the issuer at the date of acquisition and the date of evaluation;
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Buy/hold/sell recommendations or price projections published by outside investment advisors;
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Rating agency announcements;
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The length of time and the extent to which the fair value has been, or is expected to be, less than its cost in the near term; and
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Our expectation of when the cost of the security will be recovered.
If there is a decline in the fair value on an equity security that we do not intend to hold, or if we determine the decline is other-than-temporary, including declines driven by market volatility for which we cannot assert will recover in the near term, we will write down the carrying value of the investment and record the charge through earnings as a component of realized losses.
Other Investments
Our evaluation for OTTI of an other investment (i.e., an alternative investment) may include, but is not limited to, conversations with the management of the alternative investment concerning the following:
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The current investment strategy;
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Changes made or future changes to be made to the investment strategy;
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Emerging issues that may affect the success of the strategy; and
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The appropriateness of the valuation methodology used regarding the underlying investments.
If there is a decline in the equity method value of an other investment that we do not intend to hold, or if we determine the decline is other than temporary, we write down the cost of the investment and record the charge through earnings as a component of realized losses.
(e) Fair Values of Financial Instruments
Assets
The fair values of our investments are generated using various valuation techniques and are placed into the fair value hierarchy considering the following: (i) the highest priority is given to quoted prices in active markets for identical assets (Level 1); (ii) the next highest priority is given to quoted prices in markets that are not active or inputs that are observable either directly or indirectly, including quoted prices for similar assets in markets that are not active and other inputs that can be derived principally from, or corroborated by, observable market data for substantially the full term of the assets (Level 2); and (iii) the lowest priority is given to unobservable inputs supported by little or no market activity and that reflect our assumptions about the exit price, including assumptions that market participants would use in pricing the asset (Level 3). An asset’s classification within the fair value hierarchy is based on the lowest level of significant input to its valuation. Transfers between levels in the fair value hierarchy are recognized at the end of the reporting period.
The techniques used to value our financial assets are as follows:
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For valuations of a large portion of our equity securities portfolio, as well as U.S. Treasury Notes held in our fixed income securities portfolio, we receive prices from an independent pricing service that are based on observable market transactions. We validate these prices against a second external pricing service, and if established market value comparison thresholds are breached, further analysis is performed, in conjunction with our external investment managers, to determine the price to be used. These securities are classified as Level 1 in the fair value hierarchy.
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For approximately 99% of our fixed income securities portfolio, we utilize a market approach, using primarily matrix pricing models prepared by external pricing services. Matrix pricing models use mathematical techniques to value debt securities by relying on the securities relationship to other benchmark quoted securities, and not relying exclusively on quoted prices for specific securities, as the specific securities are not always frequently traded. As a matter of policy, we consistently use one pricing service as our primary source and secondary pricing services if prices are not available from the primary pricing service. In conjunction with our external investment portfolio managers, fixed income securities portfolio pricing is reviewed for reasonableness in the following ways: (i) comparing our pricing to other third-party pricing services as well as benchmark indexed pricing; (ii) comparing positions traded directly by the external investment portfolio managers to prices received from the third-party pricing services; (iii) comparing market value fluctuations between months for reasonableness; and (iv) reviewing stale prices. If further analysis is needed, a challenge is sent to the pricing service for review and confirmation of the price. These prices are typically Level 2 in the fair value hierarchy.
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For the small portion of our fixed income securities portfolio that we cannot price using our primary or secondary service, we typically use non-binding broker quotes. These prices are from various broker/dealers that use bid or ask prices, or benchmarks to indices, in measuring the fair value of a security. For the small portion of non-public equity securities that we hold, we typically receive prices from a third party pricing service or through statements provided by the security issuer. In conjunction with our external investment portfolio managers, these fair value measurements are reviewed for reasonableness. This review typically includes an analysis of price fluctuations between months with variances over established thresholds being analyzed further. These prices are generally classified as Level 3 in the fair value hierarchy, as the inputs cannot be corroborated by observable market data.
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Short-term investments are carried at cost, which approximates fair value. Given the liquid nature of our short-term investments, we generally validate their fair value by way of active trades within approximately one week of the financial statement close. These securities are classified as Level 1 in the fair value hierarchy.
Liabilities
The techniques used to value our notes payable are as follows:
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The fair value of the 5.875% Senior Notes due February 9, 2043 is based on quoted market prices.
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The fair values of the 7.25% Senior Notes due November 15, 2034 and the 6.70% Senior Notes due November 1, 2035 are based on matrix pricing models prepared by external pricing services.
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The fair value of the 1.25% and recently repaid 2.90% borrowings from the Federal Home Loan Bank of Indianapolis (“FHLBI”) are estimated using a DCF based on a current borrowing rate provided by the FHLBI consistent with the remaining term of the borrowing.
See Note 7. “Fair Value Measurements” for a summary table of the fair value and related carrying amounts of financial instruments.
(f) Allowance for Doubtful Accounts
We estimate an allowance for doubtful accounts on our premiums receivable. This allowance is based on historical write-off percentages adjusted for the effects of current and anticipated trends. An account is charged off when we believe it is probable that we will not collect a receivable. In making this determination, we consider information obtained from our efforts to collect amounts due directly and/or through collection agencies.
(g) Share-Based Compensation
Share-based compensation consists of all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share units, share options, or other equity instruments. The cost resulting from all share-based payment transactions are recognized in the Financial Statements based on the fair value of both equity and liability awards. The fair value is measured at grant date for equity awards, whereas the fair value for liability awards are remeasured at each reporting period. Both the fair value of equity and liability awards is recognized over the requisite service period. The requisite service period is typically the lesser of the vesting period or the period of time from the grant date to the date of retirement eligibility. The expense recognized for share-based awards, which, in some cases, contain performance criteria, is based on the number of shares or units expected to be issued at the end of the performance period.
(h) Reinsurance
Reinsurance recoverables represent estimates of amounts that will be recovered from reinsurers under our various treaties. Generally, 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 reinsured policies. We require collateral to secure reinsurance recoverables primarily from our reinsurance carriers that are not authorized, otherwise approved, or certified to do business in our Insurance Subsidiaries’ domiciliary states. This collateral is typically in the form or a letter of credit or cash. An allowance for estimated uncollectible reinsurance is recorded based on an evaluation of balances due from reinsurers and other available information, such as each reinsurers' credit rating from A.M. Best and Company ("A.M. Best") or Standard & Poor's Rating Services ("S&P"). We charge off reinsurance recoverables on paid losses when it becomes probable that we will not collect the balance.
(i) Property and Equipment
Property and equipment used in operations, including certain costs incurred to develop or obtain computer software for internal use, are capitalized and carried at cost less accumulated depreciation. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets. The following estimated useful lives can be considered as general guidelines:
We recorded depreciation expense of $12.6 million, $10.2 million, and $9.2 million for 2014, 2013, and 2012, respectively.
(j) Deferred Policy Acquisition Costs
Deferred policy acquisition costs are limited to costs directly related to the successful acquisition of insurance contracts. Costs meeting this definition typically include, among other things, sales commissions paid to our distribution partners, premium taxes, and the portion of employee salaries and benefits directly related to time spent on acquired contracts. These costs are deferred and amortized over the life of the contracts.
Accounting guidance requires a premium deficiency analysis to be performed at the level an entity acquires, services, and measures the profitability of its insurance contracts. We currently perform three premium deficiency analyses for our insurance segments, consistent with our segments of Standard Commercial Lines, Standard Personal Lines, and E&S Lines. This is a change from the insurance segments that we have previously reported. For qualitative information behind the change, see Note 11. "Segment Information" below.
There were no premium deficiencies for any of the reported years, as the sum of the anticipated losses and loss expenses, unamortized acquisition costs, policyholder dividends, and other expenses for Standard Commercial Lines, Standard Personal Lines, and E&S Lines did not exceed the related unearned premium and anticipated investment income. The investment yields assumed in the premium deficiency assessment for each reporting period, which are based on our actual average investment yield before tax as of the September 30 calculation date were 3.0% for both 2014 and 2013, and 3.1% for 2012. Deferred policy acquisition costs amortized to expense were $364.3 million for 2014, $331.8 million for 2013, and $298.5 million for 2012.
(k) Goodwill
Goodwill results from business acquisitions where the cost of assets and liabilities acquired exceeds the fair value of those assets and liabilities. A quantitative goodwill impairment analysis is performed if a quarterly qualitative analysis indicates that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Goodwill is allocated to the reporting units for purposes of these analyses.
(l) Reserves for Losses and Loss Expenses
Reserves for losses and loss expenses are comprised of both case reserves and reserves for claims incurred but not yet reported ("IBNR"). Case reserves result from claims that have been reported to one or more of our ten insurance subsidiaries, which are collectively referred to as the "Insurance Subsidiaries," and are estimated for the amount of ultimate payment. IBNR reserves are established based on 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. In applying generally accepted actuarial techniques, we consider a range of possible loss and loss expense reserves in establishing IBNR.
The internal assumptions we consider in the estimation of the IBNR amounts for both asbestos and environmental and non-environmental reserves at our reporting dates are based on: (i) an analysis of both paid and incurred loss and loss expense development trends; (ii) an analysis of both paid and incurred claim count development trends; (iii) the exposure estimates for reported claims; (iv) recent development on exposure estimates with respect to individual large claims and the aggregate of all claims; (v) the rate at which new asbestos and environmental claims are being reported; and (vi) patterns of events observed by claims personnel or reported to them by defense counsel. External factors we monitor for the estimation of IBNR for both asbestos and environmental and non-environmental IBNR reserves include: (i) legislative enactments; (ii) judicial decisions; (iii) legal developments in the determination of liability and the imposition of damages; and (iv) trends in general economic conditions, including the effects of inflation. Adjustments to IBNR are made periodically to take into account changes in the volume of business written, claims frequency and severity, the mix of business, claims processing, and other items that management expects to affect our reserves for losses and loss expenses over time.
By using both individual estimates of reported claims and generally accepted actuarial reserving techniques, we estimate the ultimate net liability for losses and loss expenses. While the ultimate actual liability may be higher or lower than reserves established, we believe the reserves make a reasonable provision, in the aggregate, for all unpaid losses and loss expenses incurred. Any changes in the liability estimate may be material to the results of operations in future periods. We do not discount to present value that portion of our losses and loss expense reserves expected to be paid in future periods; however, our loss and loss expense reserves include anticipated recoveries for salvage and subrogation claims.
Overall reserves are reviewed for adequacy on a periodic basis. As part of the periodic review, we consider the range of possible loss and loss expense reserves, determined at the beginning of the year. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. However, 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. Based upon such reviews, we believe that the estimated reserves for losses and loss expenses make a reasonable provision to cover the ultimate cost of claims. However, the ultimate actual liability may be higher or lower than the reserve established. 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 and may be material to the results of operations in future periods.
(m) Revenue Recognition
The Insurance Subsidiaries' net premiums written include direct insurance policy writings, plus reinsurance assumed and estimates of premiums earned but unbilled on the workers compensation and general liability lines of insurance, less reinsurance ceded. The estimated premium on the workers compensation and general liability lines is referred to as audit premium. We estimate this premium, as it is anticipated to be either billed or returned on policies subsequent to expiration based on exposure levels (i.e. payroll or sales). Audit premium is based on historical trends adjusted for the uncertainty of future economic conditions. Economic instability could ultimately impact our estimates and assumptions, and changes in our estimate may be material to the results of operations in future periods. Premiums written are recognized as revenue over the period that coverage is provided using the semi-monthly pro-rata method. Unearned premiums and prepaid reinsurance premiums represent that portion of premiums written that are applicable to the unexpired terms of policies in force.
(n) Dividends to Policyholders
We establish reserves for dividends to policyholders on certain policies, most significantly workers compensation policies. These dividends are based on the policyholders' loss experience. The dividend reserves are established based on past experience, adjusted for the effects of current developments and anticipated trends. The expense for these dividends is recognized over a period that begins at policy inception and ends with the payment of the dividend. We do not issue policies that entitle the policyholder to participate in the earnings or surplus of our Insurance Subsidiaries.
(o) Federal Income Tax
We use the asset and liability method of accounting for income taxes. Current federal income taxes are recognized for the estimated taxes payable or refundable on tax returns for the current year. Deferred federal income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax basis of assets and liabilities. We consider all evidence, both positive and negative, with respect to our federal tax loss carryback availability, expected levels of pre-tax financial statement income, and federal taxable income, when evaluating whether the temporary differences will be realized. In projecting future taxable income, we begin with budgeted pre-tax income adjusted for estimated non-taxable items. The assumptions about future taxable income require significant judgment and are consistent with the plans and estimates we use to manage our businesses. A valuation allowance is established when it is more likely than not that some portion of the deferred tax asset will not be realized. A liability for uncertain tax positions is recorded when it is more likely than not that a tax position will not be sustained upon examination by taxing authorities. The effect of a change in tax rates is recognized in the period of enactment. If we were to be levied interest and penalties by the Internal Revenue Service (“IRS”) the interest would be recognized as “Interest expense” and the penalties would be recognized as “Other expense” on the Consolidated Statements of Income.
(p) Leases
We have various operating leases for office space and equipment. Rental expense for such leases is recorded on a straight-line basis over the lease term. If a lease has a fixed and determinable escalation clause, or periods of rent holidays, the difference between rental expense and rent paid is included in "Other liabilities" as deferred rent in the Consolidated Balance Sheets.
In addition, we have various capital leases for computer hardware and software. These leases are accounted for as an acquisition of an asset and an incurrence of an obligation. Depreciation is calculated using the straight-line method over the shorter of the estimated useful life of the asset or the lease term.
(q) Pension
Our pension and post-retirement life benefit obligations and related costs are calculated using actuarial methods, within the framework of GAAP. Our pension benefit obligation is determined as the actuarial present value of the vested benefits to which the employee is currently entitled, but based on the employee's expected date of separation or retirement. 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 unless facts indicate that a more frequent review is required. The discount rate enables us to state expected future cash flows at their present value on the measurement date. The purpose of the discount rate is to determine the interest rates inherent in the price at which pension benefits could be effectively settled. Our discount rate selection is based on high-quality, long-term corporate bonds. 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. Other assumptions involve demographic factors such as retirement age, mortality, turnover, and rate of compensation increases. In the fourth quarter of 2014, we updated our mortality assumption to reflect RP-2014, which is the table that was most recently adopted by the U.S. Society of Actuaries.
Note 3. Adoption of Accounting Pronouncements
In October 2010, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2010-26, Financial Services-Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts (“ASU 2010-26”). ASU 2010-26 requires that only costs that are incremental or directly related to the successful acquisition of new or renewal insurance contracts are to be capitalized as a deferred acquisition cost. This includes, among other items, sales commissions paid to our distribution partners, premium taxes, and the portion of employee salaries and benefits directly related to time spent on acquired contracts. We adopted this guidance on January 1, 2012, with retrospective application.
In May 2011, the FASB issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS (“ASU 2011-04”). This guidance changes the wording used to describe the requirements in U.S. GAAP for measuring fair value and disclosing information about fair value measurements to improve consistency in the application and description of fair value between GAAP and International Financial Reporting Standards. ASU 2011-04 clarifies that the concepts of highest and best use and valuation premise in a fair value measurement are relevant only when measuring the fair value of nonfinancial assets, and are not relevant when measuring the fair value of financial assets or liabilities. In addition, ASU 2011-04 expands the disclosures for unobservable inputs for Level 3 fair value measurements, requiring quantitative and qualitative information to be disclosed related to: (i) the valuation processes used; (ii) the sensitivity of the fair value measurement to changes in unobservable inputs and the interrelationships between those unobservable inputs; and (iii) the use of a nonfinancial asset in a way that differs from the asset’s highest and best use. ASU 2011-04 was effective prospectively for interim and annual periods beginning after December 15, 2011. We have included the disclosures required by this guidance in our notes to the Financial Statements, where appropriate.
In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income
(“ASU 2011-05”). ASU 2011-05 requires that all non-owner changes in stockholders’ equity be presented either in a single
continuous statement of comprehensive income or in two separate but consecutive statements. This standard eliminates the
option to report OCI and its components in the statement of stockholders’ equity. ASU 2011-05 was effective, on a retrospective basis, for interim and annual periods beginning after December 15, 2011. Based on an amendment issued in December 2011, companies were not required to present separate line items on the income statement for reclassification adjustments out of AOCI into net income, as would have been required under the initial ASU. This guidance, which is ASU 2011-12, Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05, was effective concurrently with ASU 2011-05. We have included a Consolidated Statement of Comprehensive Income as part of the Financial Statements to comply with the presentation required under this accounting guidance.
In September 2011, the FASB issued ASU 2011-08, Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment ("ASU 2011-08"), which simplifies the requirements to test goodwill for impairment. ASU 2011-08 permits an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing events and circumstances, an entity determines that it is not more likely than not that the fair value of the reporting unit is less than the carrying amount, then performing the two-step impairment test is unnecessary. However, if the entity concludes otherwise, then it is required to perform the quantitative impairment test. ASU 2011-08 was effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, and early adoption was permitted. The adoption of this guidance did not impact our financial condition or results of operation.
In July 2012, the FASB issued ASU 2012-02, Intangibles-Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment ("ASU 2012-02"), which reduces the cost and complexity of performing an impairment test for indefinite-lived intangible assets. This guidance permits an entity to first assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform a quantitative impairment test. ASU 2012-02 was effective for annual and interim intangible impairment tests performed for fiscal years beginning on, or after, September 15, 2012, and early adoption was permitted. The adoption of this guidance did not impact our financial condition or results of operation.
In February 2013, the FASB issued ASU 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income ("ASU 2013-02"), which adds new disclosure requirements for items reclassified out of Accumulated Other Comprehensive Income ("AOCI"). ASU 2013-02 requires entities to disclose additional information about reclassification adjustments, including: (i) changes in AOCI balances by component; and (ii) significant items reclassified out of AOCI. Prospective application of ASU 2013-02 was effective for fiscal years, and interim periods within those years, beginning after December 15, 2012. We have included the disclosures required by ASU 2013-02 in the notes to our Financial Statements, as appropriate.
In July 2013, the FASB issued ASU No. 2013-11, Income Taxes, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists (a consensus of the FASB Emerging Issues Task Force) ("ASU 2013-11"). ASU 2013-11 applies to all entities with unrecognized tax benefits that also have tax loss or tax credit carryforwards in the same tax jurisdiction as of the reporting date. An unrecognized tax benefit is the difference between a tax position taken or expected to be taken in a tax return and the benefit that is more likely than not sustainable under examination. Under ASU 2013-11, an entity must net an unrecognized tax benefit, or a portion of an unrecognized tax benefit, against deferred tax assets for a net operating loss ("NOL") carryforward, a similar tax loss, or a tax credit carryforward except when:
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An NOL carryforward, a similar tax loss, or a tax credit carryfoward is not available as of the reporting date under the governing tax law to settle taxes that would result from the disallowance of the tax position; or
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The entity does not intend to use the deferred tax asset for this purpose.
If either of these conditions exist, an entity should present an unrecognized tax benefit in the financial statements as a liability and should not net the unrecognized tax benefit with a deferred tax asset. ASU 2013-11 was effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. The adoption of this guidance did not impact our financial condition or results of operation.
In January 2014, the FASB issued ASU 2014-01, Accounting for Investments in Qualified Affordable Housing Projects ("ASU 2014-01"). ASU 2014-01 applies to all reporting entities that invest in flow-through limited liability entities that manage or invest in affordable housing projects that qualify for a low-income housing tax credit. ASU 2014-01 permits reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using a newly defined "proportional amortization method" if certain conditions are met. This policy election is required to be applied consistently to all qualifying investments, rather than a decision to be applied to individual investments. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received, and recognizes the net investment performance in the income statement as components of income tax expense (benefit). When a company does not make a policy election to account for investments in qualified affordable housing projects using the proportional amortization method, these investments are required to be accounted for as an equity method investment or a cost method investment. ASU 2014-01 is effective for public business entities for annual periods and interim periods within those annual periods, beginning after December 15, 2014, with early adoption being permitted. During the third quarter of 2014, we adopted this guidance and have made a policy election to use the proportional amortization method. The adoption of this guidance did not materially impact our financial condition or results of operation.
Pronouncements to be effective in the future
In June 2014, the FASB issued ASU 2014-12, Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period (“ASU 2014-12”). ASU 2014-12 applies to all reporting entities that grant their employees share-based payments in which the terms of the award provide that a performance target that affects vesting could be achieved after the requisite service period. That is the case when an employee is eligible to retire or otherwise terminate employment before the end of the period in which a performance target could be achieved and still be eligible to vest in the award if and when the performance target is achieved. ASU 2014-12 is intended to resolve the diverse accounting treatment of these types of awards in practice. Many reporting entities were accounting for these types of performance targets as non-vesting conditions that affect the grant-date fair value of the award while other entities treated these performance targets as performance conditions that do not affect the grant-date fair value of the award. ASU 2014-12 clarifies that these types of performance targets should be treated as performance conditions that do not impact the grant-date fair value of the award. This guidance is effective for annual periods and interim periods within those annual periods, beginning after December 15, 2015. The implementation of ASU 2014-12 will not affect us, as we are currently recording expense consistent with the requirements of this accounting update.
In August 2014, the FASB issued ASU 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (“ASU 2014-15”). ASU 2014-15 provides guidance about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. Currently U.S. auditing standards and federal securities law require that an auditor evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time not to exceed one year beyond the date of the financial statements being audited. Due to lack of guidance about management’s responsibility and the differing views about when there is substantial doubt about an entity’s ability to continue as a going concern, there is diversity in whether, when, and how an entity discloses the relevant conditions and events in its footnotes. In connection with preparing financial statements for each annual and interim reporting period, an entity's management should evaluate whether there are conditions or events, considered in the aggregate, that raise considerable doubt about the entity's ability to continue as a going concern within one year after the date that the financial statements are issued (or within one year after the date that the financial statements are to be issued when applicable). The amendments in ASU 2014-15 clarify the timing and content of footnote disclosures. ASU 2014-15 is effective for annual periods ending after December 15, 2016, and interim periods beginning in 2017. Early application is permitted. The adoption of this ASU is not expected to impact the Company.
Note 4. Statements of Cash Flow
Supplemental cash flow information for the years ended December 31, 2014, 2013, and 2012 is as follows:
Included in "Other assets" on the Consolidated Balance Sheet was $6.0 million at December 31, 2014 and $7.3 million at December 31, 2013 of cash received from the National Flood Insurance Program ("NFIP") which is restricted to pay flood claims under the Write Your Own ("WYO") program.
Note 5. Investments
(a) Net unrealized gains on investments included in OCI by asset class were as follows for the years ended December 31, 2014, 2013, and 2012:
(b) The amortized cost, net unrealized gains and losses, carrying value, unrecognized holding gains and losses, and fair value of HTM fixed income securities were as follows:
Unrecognized holding gains and losses of HTM securities are not reflected in the Financial Statements, as they represent fair value fluctuations from the later of: (i) the date a security is designated as HTM; or (ii) the date that an OTTI charge is recognized on an HTM security, through the date of the balance sheet. Our HTM securities had an average duration of 1.7 years as of December 31, 2014.
(c) The cost/amortized cost, unrealized gains and losses, and fair value of AFS securities were as follows:
1 CMBS includes government guaranteed agency securities with a fair value of $13.2 million at December 31, 2014 and $30.0 million at December 31, 2013.
2 RMBS includes government guaranteed agency securities with a fair value of $32.4 million at December 31, 2014 and $55.2 million at December 31, 2013.
Unrealized gains and losses of AFS securities represent fair value fluctuations from the later of: (i) the date a security is designated as AFS; or (ii) the date that an OTTI charge is recognized on an AFS security, through the date of the balance sheet. These unrealized gains and losses are recorded in AOCI on the Consolidated Balance Sheets.
(d) The following tables summarize, for all securities in a net unrealized/unrecognized loss position at December 31, 2014 and December 31, 2013, the fair value and pre-tax net unrealized/unrecognized loss by asset class and by length of time those securities have been in a net loss position:
1 Gross unrealized losses include non-OTTI unrealized amounts and OTTI losses recognized in AOCI. In addition, this column includes remaining unrealized gain or loss amounts on securities that were transferred to an HTM designation in the first quarter of 2009 for those securities that are in a net unrealized/unrecognized loss position.
2 Unrecognized holding gains represent fair value fluctuations from the later of: (i) the date a security is designated as HTM; or (ii) the date that an OTTI charge is recognized on an HTM security.
The table below provides our net unrealized/unrecognized loss positions by impairment severity as of December 31, 2014 compared to the prior year:
At December 31, 2014, we had 350 securities in an aggregate unrealized/unrecognized loss position of $10.6 million, compared to 557 securities in an aggregate unrealized/unrecognized loss position of $52.0 million at December 31, 2013. This improvement was mainly driven by a lower interest rate environment. Fixed income security pricing in the marketplace has improved reflecting the 86 basis point decrease in the 10-year U.S. Treasury Note during 2014. At December 31, 2014, $8.2 million of the aggregate unrealized/unrecognized losses related to securities that have been in a loss position for more than 12 months, while at December 31, 2013, these losses amounted to $2.9 million. Included in the $8.2 million was one security that experienced a rating downgrade during 2014. The impairment severity on this security deteriorated from 9% at December 31, 2013 to 13%, or $1.1 million, at December 31, 2014. Given the close proximity of amortized cost and market value, we have concluded that this security is not other-than-temporarily impaired. Excluding this one security, the nature of the unrealized/unrecognized losses over 12 months is interest-rate related as opposed to credit-related concerns, as evidenced by the fact that the severity of impairment on these securities improved from an average of 6% of amortized cost at December 31, 2013 to an average of 2% of amortized cost at December 31, 2014.
For a discussion regarding the sensitivity of interest rate movements and the related impacts on the fixed income securities portfolio, refer to Item 7A. "Quantitative and Qualitative Disclosures About Market Risk" of this Form 10-K.
We have reviewed the securities in the tables above in accordance with our OTTI policy, as described in Note 2. “Summary of Significant Accounting Policies” of this Form 10-K. In addition, we do not intend to sell any securities in an unrealized/unrecognized loss position nor do we believe we will be required to sell these securities, and therefore we have concluded that they are temporarily impaired as of December 31, 2014. This conclusion reflects our current judgment as to the financial position and future prospects of the entity that issued the investment security and underlying collateral. If our judgment about an individual security changes in the future, we may ultimately record a credit loss after having originally concluded that one did not exist, which could have a material impact on our net income and financial position in future periods.
(e) Fixed income securities at December 31, 2014, by contractual maturity are shown below. Mortgage-backed securities ("MBS") are included in the maturity tables using the estimated average life of each security. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
Listed below are HTM fixed income securities at December 31, 2014:
Listed below are AFS fixed income securities at December 31, 2014:
(f) The following table summarizes our other investment portfolio by strategy and the remaining commitment amount associated with each strategy:
The following is a description of our alternative investment strategies:
Secondary Private Equity
This strategy purchases seasoned private equity funds from investors desiring liquidity prior to normal fund termination. Investments are made across all sectors of the private equity market, including leveraged buyouts ("LBO"), venture capital, distressed securities, mezzanine financing, real estate, and infrastructure.
Private Equity
This strategy makes private equity investments, primarily in established large and middle market companies across diverse industries globally.
Energy/Power Generation
This strategy invests primarily in cash flow generating assets in the coal, natural gas, power generation, and electric and gas transmission and distribution industries.
Mezzanine Financing
This strategy provides privately negotiated fixed income securities, generally with an equity component, to LBO firms and private and publicly traded large, mid and small-cap companies to finance LBOs, recapitalizations, and acquisitions.
Real Estate
This strategy invests opportunistically in real estate in North America, Europe, and Asia via direct property ownership, joint ventures, mortgages, and investments in equity and debt instruments.
Distressed Debt
This strategy makes direct and indirect investments in debt and equity securities of companies that are experiencing financial and/or operational distress. Investments include buying indebtedness of bankrupt or financially troubled companies, small balance loan portfolios, special situations and capital structure arbitrage trades, commercial real estate mortgages and similar non-U.S. securities and debt obligations. This strategy includes a fund of funds component.
Venture Capital
In general, these investments are venture capital investments made principally by investing in equity securities of privately held corporations, for long-term capital appreciation. This strategy makes private equity investments in growth equity and buyout partnerships.
Our seven alternative investment strategies employ low or moderate levels of leverage and generally use hedging only to reduce foreign exchange or interest rate volatility. At this time, our alternative investment strategies do not include hedge funds. We cannot redeem our investments with the general partners of these investments; however, occasionally these partnerships can be traded on the secondary market. Once liquidation is triggered by clauses within the limited partnership agreements or at the funds’ stated end date, we will receive our final allocation of capital and any earned appreciation of the underlying investments, assuming we have not divested ourselves of our partnership interests prior to that time. We currently receive distributions from these alternative investments through the realization of the underlying investments in the limited partnerships. We anticipate that the general partners of these alternative investments will liquidate their underlying investment portfolios through 2028.
The following tables set forth summarized financial information for our other investments portfolio, including the portion not owned by us. The investments are carried under the equity method of accounting. The last line in the income statement information table below reflects our share of the aggregate income, which is the portion included in our Financial Statements. As the majority of these investments report results to us on a one quarter lag, the summarized financial statement information is as of, and for the 12-month period ended, September 30:
(g) We have pledged certain AFS fixed income securities as collateral related to: (i) our outstanding borrowing of $45 million with the Federal Home Loan Bank of Indianapolis ("FHLBI"); (ii) our reinsurance obligations related to our 2011 acquisition of our E&S book of business; and (iii) our compliance with insurance laws by placing certain securities on deposit with various state and regulatory agencies. We retain all rights regarding all securities pledged as collateral.
The following table summarizes the market value of these securities at December 31, 2014:
(h) The components of pre-tax net investment income earned were as follows:
(i) The following tables summarize OTTI by asset type for the periods indicated:
The majority of the OTTI charges in 2014, 2013, and 2012 were comprised of charges on our equity portfolio. In 2014, $9.0 million related to securities for which we had the intent to sell in relation to a change in our high-dividend yield strategy. In 2013, $2.0 million related to securities that we did not believe would recover in the near term and $1.7 million related to securities for which we had the intent to sell. Contributing to the OTTI charges in 2013 were $1.8 million of charges that relate to an investment in a limited liability company within our other investments portfolio that has sustained significant losses for which we do not anticipate recovery. In 2012, $1.0 million related to securities that we did not believe would recover in the near term and $2.2 million related to securities for which we had the intent to sell.
The following table sets forth, for the periods indicated, credit loss impairments on fixed income securities for which a portion of the OTTI charge was recognized in OCI, and the corresponding changes in such amounts:
(j) The components of net realized gains, excluding OTTI charges, were as follows:
Realized gains and losses on the sale of investments are determined on the basis of the cost of the specific investments sold. Proceeds from the sale of AFS securities were $259.0 million in 2014, $135.9 million in 2013, and $205.3 million in 2012. Net realized gains in 2014, 2013, and 2012, excluding OTTI charges, were driven by the sale of AFS equity securities due to the rebalancing of our high-dividend yield strategy holdings within our equity portfolio. In addition, $9.2 million of the 2014 gains on our equity portfolio related to a change in our strategy for this portfolio.
Note 6. Stockholders’ Equity and Comprehensive Income
(a)
Stockholders’ Equity
As of December 31, 2014, we had 13.3 million shares reserved for various stock compensation and purchase plans, retirement plans, and dividend reinvestment plans. As a convenience to our employees and directors, we repurchase the Parent’s stock from time-to-time as permitted under our stock-based compensation plans. The Parent has not had an authorized stock repurchase program since 2009. The following table provides information regarding the purchase of the Parent’s common stock during the 2012 through 2014 reporting periods:
Our ability to declare and pay dividends on the Parent's common stock is dependent on liquidity at the Parent coupled with the ability of the Insurance Subsidiaries to declare and pay dividends, if necessary, and/or the availability of other sources of liquidity to the Parent. See Note 20. “Statutory Financial Information, Capital Requirements, and Restrictions on Dividends and Transfers of Funds” for information regarding these dividend restrictions.
(b) The components of comprehensive income, both gross and net of tax, for 2014, 2013, and 2012 were as follows:
(c) The balances of, and changes in, each component of AOCI (net of taxes) as of December 31, 2014 and 2013 were as follows:
The reclassifications out of AOCI are as follows:
Note 7. Fair Value Measurements
The following table presents the carrying amounts and estimated fair values of our financial instruments as of December 31, 2014 and 2013:
For discussion regarding the fair value techniques of our financial instruments, refer to Note 2. "Summary of Significant Accounting Policies" in this Form 10-K.
The following tables provide quantitative disclosures of our financial assets that were measured at fair value at December 31, 2014 and 2013:
1 There were no transfers of securities between Level 1 and Level 2.
There were no changes in the fair value of securities measured using Level 3 prices during 2014. The following
table provides a summary of these changes during 2013:
1 Amounts are reported in “Unrealized holding gains (losses) arising during period” on the Consolidated Statements of Comprehensive Income.
2 Amounts are reported in “Net realized gains” for realized gains and losses and “Net investment income earned” for amortization of securities on the Consolidated Statements of Income.
3For the receivable related to the sale of Selective HR, amounts in “Loss on disposal of discontinued operations, net of tax” relate to an impairment charge and
amounts in “Other income” relate to interest accretion on the Consolidated Statements of Income.
As discussed in Note 2. "Summary of Significant Accounting Policies," in this Form 10-K, the fair value of our Level 3 fixed income securities are typically obtained through non-binding broker quotes, which we review for reasonableness. At December 31, 2014 and December 31, 2013, there were no fixed income securities that were measured using Level 3 inputs. However, during 2013, securities with a fair value of $32.0 million were transferred out of Level 3 due to the availability of Level 2 pricing at December 31, 2013 that was not available previously.
Equity securities with a fair value of $2.9 million were measured using Level 3 inputs at December 31, 2014 and at
December 31, 2013. An equity security with a fair value of $4.6 million was transferred out of Level 3 during 2013 due to the availability of Level 2 pricing at the date of transfer. This security was subsequently sold for an amount that approximated the value at the transfer date. In addition, the receivable related to the sale of Selective HR was settled during 2013 and as a result was transferred out of Level 3.
The following tables provide quantitative information regarding our financial assets and liabilities that were disclosed at fair value at December 31, 2014 and 2013:
Note 8. Reinsurance
Our Financial Statements reflect the effects of assumed and ceded reinsurance transactions. Assumed reinsurance refers to the acceptance of certain insurance risks that other insurance entities have underwritten. Ceded reinsurance involves transferring certain insurance risks (along with the related written and earned premiums) that we have underwritten to other insurance companies that agree to share these risks. The primary purpose of ceded reinsurance is to protect the Insurance Subsidiaries from potential losses in excess of the amount that we are prepared to accept. Our major treaties covering property, property catastrophe, and casualty business are excess of loss contracts. In addition, we have an intercompany quota share pooling arrangement and other minor quota share treaties.
As a Standard Commercial Lines and E&S Lines writer, we are required to participate in Terrorism Risk Insurance Program Reauthorization Act ("TRIPRA"), which was extended to December 31, 2020. TRIPRA requires private insurers and the United States government to share the risk of loss on future acts of terrorism certified by the U.S. Secretary of the Treasury. Under TRIPRA, each participating insurer is responsible for paying a deductible of specified losses before federal assistance is available. This deductible is based on a percentage of the prior year’s applicable Standard Commercial Lines and E&S Lines premiums. In 2015, our deductible is approximately $254 million. For losses above the deductible, the federal government will pay 85% of losses to an industry limit of $100 billion, and the insurer retains 15%. The federal share of losses will be reduced by 1% each year to 80% by 2020.
The Insurance Subsidiaries remain liable to policyholders to the extent that any reinsurer becomes unable to meet their contractual obligations. We evaluate and monitor the financial condition of our reinsurers under voluntary reinsurance arrangements to minimize our exposure to significant losses from reinsurer insolvencies. On an ongoing basis, we review amounts outstanding, length of collection period, changes in reinsurer credit ratings, and other relevant factors to determine collectability of reinsurance recoverables. The allowance for uncollectible reinsurance recoverables was $6.9 million at December 31, 2014 and $5.1 million at December 31, 2013.
The following table represents our total reinsurance balances segregated by reinsurer to depict our concentration of risk throughout our reinsurance portfolio:
1 Includes letters of credit, trust funds, and funds withheld.
2 Considered to have minimal risk of default.
Note: Some amounts may not foot due to rounding.
Under our reinsurance arrangements, which are prospective in nature, reinsurance premiums ceded are recorded as prepaid reinsurance and amortized over the remaining contract period in proportion to the reinsurance protection provided, or recorded periodically, as per the terms of the contract, in a direct relationship to the gross premium recording. Reinsurance recoveries are recognized as gross losses are incurred.
The following table contains a listing of direct, assumed, and ceded reinsurance amounts for premiums written, premiums earned, and losses and loss expenses incurred:
Direct and ceded losses and loss expenses decreased significantly in 2013, primarily due to the impact of Superstorm Sandy, for which $1.1 billion in flood losses were ceded to the federal government in 2012.
The ceded premiums and losses related to our participation in the NFIP, under which 100% of our flood premiums, losses and loss expenses are ceded to the NFIP, are as follows:
Note 9. Reserves for Losses and Loss Expenses
The table below provides a roll forward of reserves for losses and loss expenses for beginning and ending reserve balances:
The net losses and loss expense reserves increased by $97.0 million in 2014, $149.7 million in 2013, and $63.8 million in 2012. The losses and loss expense reserves are net of anticipated recoveries for salvage and subrogation claims, which amounted to $65.1 million for 2014, $61.0 million for 2013, and $62.2 million for 2012. The changes in the net losses and loss expense reserves were the result of growth in exposures, particularly associated with our E&S Lines of business, anticipated loss trends, changes in reinsurance retentions, and normal reserve changes inherent in the uncertainty in establishing reserves for losses and loss expenses. As additional information is collected in the loss settlement process, reserves are adjusted accordingly. These adjustments are reflected in the Consolidated Statements of Income in the period in which such adjustments are recognized. These changes could have a material impact on the results of operations of future periods when the adjustments are made.
In 2014, we experienced overall favorable loss development of approximately $59.3 million, compared to $25.5 million in both 2013 and 2012. The following table summarizes the prior year development by line of business:
The 2014 prior year favorable development of $59.3 million includes $48.2 million of favorable casualty development and $11.1 million of favorable property development. The property development was primarily related to a prior year reinsurance recoverable. The favorable casualty development was largely driven by the general liability and personal automobile lines of business. These lines have both experienced increasingly favorable development in recent years. Conversely, businessowners’ policies and our E&S Lines experienced unfavorable emergence in 2014, which was a reversal from 2013. Our workers compensation line had no development in 2014, after experiencing unfavorable development of $23.5 million last year.
By accident year, the majority of the favorable development was attributable to accident years 2010 through 2012, although earlier accident years also developed favorably. General liability, commercial automobile, and personal automobile all contributed to this development, partially offset by businessowners’ liability. The general liability line of business was the primary driver of this favorable development, which was partially driven by lower severities in the 2010 through 2012 accident years, within both the premises and operations and products liability coverages. In addition, accident years 2011 and 2012 continue to show lower than expected claim counts. The overall favorable development for accident years 2012 and prior was partially offset by unfavorable development in accident year 2013, which was largely attributable to commercial automobile liability, and partially E&S casualty.
The 2013 prior year favorable development of $25.5 million includes $14.5 million of favorable casualty development and $11.0 million of favorable property development. The property development was primarily related to favorable non-catastrophe loss activity, mostly in the 2012 accident year. The casualty lines were driven largely by favorable development in accident years 2006 through 2010, with lower than expected severities in general liability and commercial automobile. Partially offsetting this favorable development was: (i) unfavorable development in our workers compensation line driven by assisted living claims; and (ii) unfavorable development in accident year 2012 in our commercial automobile line of business driven by higher than expected severities.
The 2012 prior year favorable development of $25.5 million includes $18.0 million of casualty development and $7.5 million of property development. The property development was primarily related to the favorable non-catastrophe loss activity that occurred in the first quarter of 2012 mostly in the 2011 accident year. The casualty lines were driven by favorable development in the 2007 through 2009 accident years, partially offset by unfavorable development in accident year 2011. The favorable development was driven by lower than expected severities in all of the major casualty lines, which represents a consistent trend in recent years. The unfavorable development in accident year 2011 was driven by: (i) higher than expected severities in the workers compensation and general liability lines; and (ii) higher than expected frequencies in the commercial auto line. This was partially offset by continued favorable development in the homeowners' liability line, due to lower expected severity for this year.
Reserves established for liability insurance include exposure to asbestos and environmental claims. These claims have arisen primarily from insured exposures in municipal government, small non-manufacturing commercial risk, and homeowners policies. The emergence of these claims is slow and highly unpredictable. There are significant uncertainties in estimating our exposure to asbestos and environmental claims (for both case and IBNR reserves) resulting from lack of relevant historical data, the delayed and inconsistent reporting patterns associated with these claims, and uncertainty as to the number and identity of claimants and complex legal and coverage issues. Legal issues that arise in asbestos and environmental cases include federal or state venue, choice of law, causation, admissibility of evidence, allocation of damages and contribution among joint defendants, successor and predecessor liability, and whether direct action against insurers can be maintained. Coverage issues that arise in asbestos and environmental cases include the interpretation and application of policy exclusions, the determination and calculation of policy limits, the determination of the ultimate amount of a loss, the extent to which a loss is covered by a policy, if at all, the obligation of an insurer to defend a claim, and the extent to which a party can prove the existence of coverage. Courts have reached different and sometimes inconsistent conclusions on these legal and coverage issues. We do not discount to present value that portion of our losses and loss expense reserves expected to be paid in future periods.
The following table details our losses and loss expense reserves for various asbestos and environmental claims:
Estimating IBNR reserves for asbestos and environmental claims is difficult because of the delayed and inconsistent reporting patterns associated with these claims. In addition, there are significant uncertainties associated with estimating critical assumptions, such as average clean-up costs, third-party costs, potentially responsible party shares, allocation of damages, litigation and coverage costs, and potential state and federal legislative changes. Normal historically based actuarial approaches cannot be applied to asbestos and environmental claims because past loss history is not indicative of future potential asbestos and environmental losses. In addition, while certain alternative models can be applied, such models can produce significantly different results with small changes in assumptions.
The following table provides a roll forward of gross and net asbestos and environmental incurred losses and loss expenses and related reserves thereon:
Note 10. Indebtedness
(a) Notes Payable
(1) In the first quarter of 2013, we issued $185 million of 5.875% Senior Notes due 2043. These notes pay interest on February 15, May 15, August 15, and November 15 of each year, beginning on May 15, 2013, and at maturity. The notes are callable by us on or after February 8, 2018, at a price equal to 100% of their principal outstanding amount, plus accrued and unpaid interest to, but excluding, the date of redemption. A portion of the proceeds from this debt issuance was used to fully redeem the $100 million aggregate principal amount of our 7.5% Junior Subordinated Notes due 2066, which had an associated $3.3 million pre-tax write-off for the remaining capitalized debt issuance costs on these notes. Of the remaining net proceeds, $57.1 million was used to make capital contributions to the Insurance Subsidiaries, while the balance was used for general corporate purposes. There are no financial debt covenants to which we are required to comply in regards to these Senior Notes.
(2) In the first quarter of 2009, Selective Insurance Company of the Southeast and Selective Insurance Company of South Carolina (“Indiana Subsidiaries”) joined and invested in the FHLBI, which provides them with access to additional liquidity. The Indiana Subsidiaries’ aggregate investment was $2.9 million at December 31, 2014 and December 31, 2013, respectively. Our investment provides us the ability to borrow approximately 20 times the total amount of the FHLBI common stock purchased with additional collateral, at comparatively low borrowing rates. All borrowings from FHLBI are required to be secured by certain investments.
The following is a summary of the Indiana Subsidiaries’ borrowings from the FHLBI:
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In 2011, the Indiana Subsidiaries borrowed $45 million in the aggregate from the FHLBI. The unpaid principal amount accrues interest of 1.25%, which is paid on the 15th of every month. The principal amount is due on December 16, 2016. These funds were loaned to the Parent for use in the acquisition of Mesa Underwriters Specialty Insurance Company ("MUSIC") on December 31, 2011.
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In 2009, the Indiana Subsidiaries borrowed $13 million in the aggregate from the FHLBI. The unpaid principal amount accrues interest of 2.9%, which was paid on the 15th of every month. These funds were loaned to the Parent to be used for general corporate purposes. The principal amount was paid in full on December 15, 2014.
•
In January 2015, the Indiana Subsidiaries borrowed $15 million in the aggregate from the FHLBI for general corporate purposes. The unpaid principal amount accrues interest of 0.63%, which is paid on the 15th of every month. The principal amount is due on July 22, 2016.
(3) In the fourth quarter of 2005, we issued $100 million of 6.70% Senior Notes due 2035. These notes were issued at a discount of $0.7 million resulting in an effective yield of 6.754% and pay interest on May 1 and November 1 each year commencing on May 1, 2006. Net proceeds of approximately $50 million were used to fund an irrevocable trust to provide for certain payment obligations in respect of our outstanding debt. The remainder of the proceeds was used for general corporate purposes. The agreements covering these notes contain a standard default cross-acceleration provision that provides the 6.70% Senior Notes will enter a state of default upon the failure to pay principal when due or upon any event or condition that results in an acceleration of principal of any other debt instrument in excess of $10 million that we have outstanding concurrently with the 6.70% Senior Notes. There are no financial debt covenants to which we are required to comply in regards to these notes.
(4) In the fourth quarter of 2004, we issued $50 million of 7.25% Senior Notes due 2034. These notes were issued at a discount of $0.1 million, resulting in an effective yield of 7.27% and pay interest on May 15 and November 15 each year. We contributed $25 million of the bond proceeds to the Insurance Subsidiaries as capital. The remainder of the proceeds was used for general corporate purposes. The agreements covering these notes contain a standard default cross-acceleration provision that provides the 7.25% Senior Notes will enter a state of default upon the failure to pay principal when due or upon any event or condition that results in an acceleration of principal of any other debt instrument in excess of $10 million that we have outstanding concurrently with the 7.25% Senior Notes. There are no financial debt covenants to which we are required to comply in regards to these notes.
(b) Short-Term Debt
Our Line of Credit was renewed effective September 26, 2013, with Wells Fargo Bank, National Association, as administrative agent, and Branch Banking and Trust Company, with a borrowing capacity of $30 million, which can be increased to $50 million with the approval of both lending partners. The Line of Credit provides the Parent with an additional source of short-term liquidity. The interest rate on our Line of Credit varies and is based on, among other factors, the Parent’s debt ratings. The Line of Credit expires on September 26, 2017. There have been no balances outstanding under this Line of Credit at December 31, 2014 or at any time during 2014.
The Line of Credit agreement contains representations, warranties, and covenants that are customary for credit facilities of this type, including, without limitation, financial covenants under which we are obligated to maintain a minimum consolidated net worth, minimum combined statutory surplus, and maximum ratio of consolidated debt to total capitalization, and covenants limiting our ability to: (i) merge or liquidate; (ii) incur debt or liens; (iii) dispose of assets; (iv) make investments and acquisitions; and (v) engage in transactions with affiliates. The Line of Credit permits collateralized borrowings by the Indiana Subsidiaries from the FHLBI so long as the aggregate amount borrowed does not exceed 10% of the respective Indiana Subsidiary’s admitted assets from the preceding calendar year.
The table below outlines information regarding certain of the covenants in the Line of Credit:
1 Calculated in accordance with Line of Credit agreement.
In addition to the above requirements, the Line of Credit agreement contains a cross-default provision that provides that the Line of Credit will be in default if we fail to comply with any condition, covenant, or agreement (including payment of principal and interest when due on any debt with an aggregate principal amount of at least $20 million), which causes or permits the acceleration of principal.
Note 11. Segment Information
We classify our business into four reportable segments:
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Standard Commercial Lines - comprised of insurance products and services provided in the standard marketplace to our commercial customers, who are typically businesses, non-profit organizations, and local government agencies.
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Standard Personal Lines - comprised of insurance products and services, including flood insurance coverage, provided primarily to individuals acquiring coverage in the standard marketplace.
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E&S Lines - comprised of insurance products and services provided to customers who have not obtained coverage in the standard marketplace.
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Investments - invests the premiums collected by our Standard Commercial Lines, Standard Personal Lines, and E&S Lines, as well as amounts generated through our capital management strategies, which may include the issuance of debt and equity securities.
We revised our reporting segments to the above in 2014 because:
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The revised segments reflect the way we currently manage our business and allocate resources and therefore, our previously-reported segment of "Standard Insurance Operations" is now "Standard Commercial Lines" and "Standard Personal Lines." Historically, we focused our service model predominantly on our distribution partners. We now focus our customer service model on our policyholders, the servicing of which is shared by us and our distribution partners. This change in focus not only heightens awareness of our brand with our distribution partners, but it increases our brand recognition with our policyholders.
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We implemented changes related to our field model as we realigned the responsibilities of certain management positions and their related field employees. This realignment included redeploying certain field employees to focus solely on Standard Personal Lines marketing, instead of sharing responsibilities between both Standard Personal Lines and Standard Commercial Lines business. Our Agency Management Specialists continue to be a central focus of our field model, with responsibility for managing the growth and profitability of their territories and underwriting new Standard Commercial Lines accounts.
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We are in the process of implementing organizational changes that realign executive leadership roles over Standard Personal Lines and Standard Commercial Lines.
We remain an account underwriter within Standard Commercial Lines and Standard Personal Lines, as evidenced by the fact that we do not actively market certain mono-line business, such as workers compensation and homeowners coverages.
Our E&S Lines remain a separate segment as their customers and distribution channel have different characteristics than that of our Standard Commercial Lines and Standard Personal Lines. In addition, our Investment segment continues to be managed separately and distinctly from our insurance segments, therefore it continues to meet the definition of a segment for us.
All prior year information contained in this Form 10-K has been restated to reflect our revised segments.
The disaggregated results of our four segments are used by senior management to manage our operations. These segments are evaluated as follows:
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Standard Commercial Lines, Standard Personal Lines, and our E&S Lines are evaluated based on statutory underwriting results (net premiums earned, incurred losses and loss expenses, policyholders dividends, policy acquisition costs, and other underwriting expenses), and statutory combined ratios; and
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Our Investments segment is evaluated based on after-tax net investment income and net realized gains and losses.
Our combined insurance segments are subject to certain geographic concentrations, particularly in the Northeast and Mid-Atlantic regions of the country. In 2014, approximately 23% of net premiums written were related to insurance policies written in New Jersey.
The goodwill balance of $7.8 million at both December 31, 2014 and 2013 relates to our Standard Commercial Lines reporting unit.
In computing the results of each segment, we do not make adjustments for interest expense or net general corporate expenses. While we do not fully allocate taxes to all segments, we do allocate taxes to our investments segment as we manage that segment on after-tax results. We do not maintain separate investment portfolios for the segments and therefore, do not allocate assets to the segments.
The following summaries present revenues from continuing operations (net investment income and net realized gains on investments in the case of the Investments segment) and pre-tax income from continuing operations for the individual segments:
Note 12. Discontinued Operations
In the fourth quarter of 2009, we sold 100% of our interest in Selective HR for proceeds to be received over a 10-year period. These proceeds were based on the ability of the purchaser to retain and generate new worksite lives though the independent agents who distribute the products. In 2013, we settled the remaining receivable for an aggregate of $1.0 million, which was received in two installments during the second quarter of 2013, in full and final settlement of the contingent purchase price. An impairment of $1.5 million, pre tax, was recorded in the first quarter of 2013 and is included in "Loss on disposal of discontinued operations, net of tax" in the Consolidated Statements of Income.
Note 13. Earnings per Share
The following table provides a reconciliation of the numerators and denominators of basic and diluted earnings per share ("EPS"):
Note 14. Federal Income Taxes
(a) A reconciliation of federal income tax on income at the corporate rate to the effective tax rate is as follows:
(b) The tax effects of the significant temporary differences that give rise to deferred tax assets and liabilities are as follows:
After considering all evidence, both positive and negative, with respect to our federal tax loss carryback availability, expected levels of pre-tax financial statement income, and federal taxable income, we believe it is more likely than not that the existing deductible temporary differences will reverse during periods in which we generate net federal taxable income or have adequate federal carryback availability. As a result, we have no valuation allowance recognized for federal deferred tax assets at December 31, 2014 or 2013.
As of December 31, 2014, we had federal tax net operating loss carryforwards (“NOL”) of $6.1 million. These NOLs, which are subject to an annual limitation of $1.9 million, will expire between 2029 and 2031 as follows:
Our alternative minimum tax credits, which are available to offset future regular taxable income, can be carried forward for an unlimited period of time.
Stockholders' equity reflects tax benefits related to compensation expense deductions for share-based compensation awards of $20.2 million at December 31, 2014, $19.2 million at December 31, 2013, and $17.7 million at December 31, 2012.
We have analyzed our tax positions in all open tax years, which as of December 31, 2014 were 2011 through 2013. The IRS recently completed a limited scope examination of the 2007 through 2010 tax years, which resulted in no material changes. We do not have unrecognized tax expense or benefit as of December 31, 2014.
In addition, we believe our tax positions will more likely than not be sustained upon examination, including related appeals or litigation. In the event we had a tax position that did not meet the more likely than not criteria, any tax, interest, and penalties incurred related to such a position would be reflected in "Total federal income tax expense (benefit)" on our Consolidated Statements of Income.
Note 15. Retirement Plans
(a) Selective Insurance Retirement Savings Plan (“Retirement Savings Plan”)
SICA offers a voluntary defined contribution 401(k) plan to employees who meet eligibility requirements. Participants can contribute 2% to 50% of their defined compensation to the Retirement Savings Plan not to exceed limits established by the IRS. Employees age 50 or older who are contributing the maximum may make additional contributions not to exceed the additional amount permitted by the IRS. Subject to IRS limits, the following table presents information regarding plan terms:
Employer contributions to the Retirement Savings Plan amounted to $13.4 million in 2014, $12.2 million in 2013, and $8.2 million in 2012.
(b) Deferred Compensation Plan
SICA offers a nonqualified deferred compensation plan ("Deferred Compensation Plan") to a group of management or highly compensated employees (the "Participants") as a method of recognizing and retaining such employees. The Deferred Compensation Plan provides the Participants the opportunity to elect to defer receipt of specified portions of compensation and to have such deferred amounts deemed to be invested in specified investment options. A Participant in the Deferred Compensation Plan may, subject to certain limitations, elect to defer compensation or awards to be received, including up to: (i) 50% of annual base salary; (ii) 100% of annual bonus; and/or (iii) all or a percentage of such other compensation as otherwise designated by the administrator of the Deferred Compensation Plan.
In addition to the deferrals elected by the Participants, SICA may choose to make matching contributions to the deferral accounts of some or all Participants to the extent a Participant did not receive the maximum matching or non-elective contributions permissible under the Retirement Savings Plan due to limitations under the Internal Revenue Code or the Retirement Savings Plan. SICA may also choose at any time to make discretionary contributions to the deferral account of any Participant in our sole discretion. No discretionary contributions were made in 2014, 2013, or 2012. SICA contributed $0.2 million in both 2014 and 2013, and a nominal amount in 2012 to the Deferred Compensation Plan.
(c) Retirement Income Plan and Retirement Life Plan
The Retirement Income Plan for Selective Insurance Company of America and the Supplemental Excess Retirement Plan (jointly referred to as the "Retirement Income Plan" or the "Plan") is a noncontributory defined benefit plan covering SICA employees who met each Plan's eligibility requirements prior to January 1, 2006. As of such date, the Plan was amended to eliminate eligibility for participation by employees first hired on or after January 1, 2006. In addition, the Plan was further amended in the first quarter of 2013 to curtail the accrual of additional benefits for all eligible employees after March 31, 2016. This curtailment resulted in a net actuarial gain recognized in OCI of $44.0 million on a pre-tax basis as of March 31, 2013.
The Retirement Income Plan was previously amended as of July 1, 2002 to provide for different calculations based on service with SICA as of that date. Monthly benefits payable under the Retirement Income Plan at normal retirement age are computed under the terms of those calculations. The earliest retirement age is age 55 with 10 years of service or the attainment of 70 points (age plus years of service). If a participant chooses to begin receiving benefits before their 65th birthday, the amount of the participant's monthly benefit would be reduced in accordance with the provisions of the plan. At retirement, participants receive monthly pension payments and may choose among five payment options, including joint and survivor options.
The funding policy provides that payments to the pension trust shall be equal to the minimum funding requirements of the Employee Retirement Income Security Act, plus additional amounts that the Board of Directors of SICA may approve from time to time.
The funded status of the Retirement Income Plan and Retirement Life Plan was recognized in the Consolidated Balance Sheets for 2014 and 2013, the details of which are as follows:
The amortization of prior service cost related to the Retirement Income Plan and Retirement Life Plan is determined using a straight-line amortization of the cost over the average remaining service period of employees expected to receive benefits under the Plans.
The estimated net actuarial loss for the Retirement Income Plan and Retirement Life Plan that will be amortized from AOCI into net periodic benefit cost during the 2015 fiscal year are $6.8 million and $0.1 million, respectively.
1Discount rate for the Retirement Income Plan changed from 4.42% as of December 31, 2012 to 4.66% as of March 31, 2013 due to the remeasurement that was performed with the curtailment of the Plan.
Our latest measurement date was December 31, 2014 and we lowered our expected return on plan assets to 6.27%, reflecting the lower interest rate environment, coupled with our investment strategy to closer match the duration of the assets and liabilities of the Retirement Income Plan. Our expected return is within a reasonable range considering the lower interest rate environment, as well as our actual 8.3% annualized return achieved since plan inception for all plan assets.
Our 2014 discount rate used to value the liability was 4.29% for the Retirement Income Plan and 4.08% for the Retirement Life Plan. When determining the most appropriate discount rate to be used in the valuation, we consider, among other factors, our expected payout patterns of the plans' obligations as well as our investment strategy and we ultimately select the rate that we believe best represents our estimate of the inherent interest rate at which our pension and post-retirement life benefits can be effectively settled.
Our 2014 mortality assumption used to value the liability was based on RP-2014, which is the mortality table that was approved by the Society of Actuaries in the fourth quarter of 2014.
Plan Assets
Assets of the Retirement Income Plan are invested to ensure that principal is preserved and enhanced over time. In addition, the Retirement Income Plan is expected to perform above average relative to comparable funds without assuming undue risk, and to add value through active management. Our return objective is to exceed the returns of the plan's policy benchmark, which is the return the plan would have earned if the assets were invested according to the target asset class weightings and earned index returns. The Retirement Income Plan's exposure to a concentration of credit risk is limited by the diversification of investments across varied financial instruments, including common stocks, mutual funds, non-publicly traded stocks, investments in limited partnerships, fixed income securities, and short-term investments. Allocations to these instruments may vary from time to time. In 2015, we will continue to phase in adjustments to the asset allocation of the Retirement Income Plan
to steadily close the gap between the duration of the assets and the duration of the liabilities, provided certain improved funding targets are achieved.
The Retirement Income Plan’s equity investments may not contain investments in any one security greater than 8% of the portfolio value without notification to our management investment committee, nor have more than 5% of the outstanding shares of any one corporation or other entity. The use of derivative instruments is permitted under certain circumstances, but shall not be used for unrelated speculative hedging or to apply leverage to portfolio positions. Within the alternative investments portfolio, some leverage is permitted as defined and limited by the partnership agreements.
The plan’s target ranges, as well as the actual weighted average asset allocation by asset class, at December 31 were as follows:
1 These asset classes do not have target ranges, as these exposures will be phased out over time as we opportunistically migrate to long duration fixed income security strategies.
2 Includes limited partnerships.
The Retirement Income Plan had no investments in the Parent’s common stock as of December 31, 2014 or 2013.
The fair value of our Retirement Income Plan investments is generated using various valuation techniques. We follow the methodology discussed in Note 2. “Summary of Significant Accounting Policies,” regarding pricing and valuation techniques, as well as the fair value hierarchy, for equity and fixed income securities and short-term investments held in the Retirement Income Plan.
The techniques used to determine the fair value of the Retirement Income Plan’s remaining invested assets are as follows:
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Valuations for the majority of the investment funds utilize the market approach wherein the quoted prices in the active market for identical assets are used. These investment funds are traded in active markets at their net asset value per share. There are no restrictions on the redemption of these investments and we do not have any contractual obligations to further invest in any of the individual mutual funds. These investments are classified as Level 1 in the fair value hierarchy. Valuations of non-publicly traded investment funds are based upon the observable and verifiable market values of the underlying publicly traded securities and therefore are classified as Level 2 within the fair value hierarchy.
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The deposit administration contract is carried at cost, which approximates fair value. Given the liquid nature of the underlying investments in overnight cash deposits and other short term duration products, we have determined that a correlation exists between the deposit administration contract and other short-term investments such as money market funds. As such, this investment is classified as Level 2 in the fair value hierarchy.
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For valuations of the investments in limited partnerships, fair value is based on the Retirement Income Plan’s ownership interest in the reported net asset values as a practical expedient. The majority of the net asset values are reported to us on a one quarter lag. We assess whether these reported net asset values are indicative of market activity that has occurred since the date of their valuation by the investees: (i) by reviewing the overall market fluctuation and whether a material impact to our investments' valuation could have occurred; and (ii) through routine conversations with the underlying funds' general partners/managers discussing, among other things, conditions or events having significant impacts to their portfolio assets that have occurred subsequent to the reported date, if any. Our limited partnership investments cannot be redeemed with the investees as our partnership agreements require our commitment for the duration of the underlying funds’ lives. There is no active plan to sell any of our remaining interests in the limited partnership investments; however, we may continue to entertain potential opportunities to limit our exposure to these investments through the use of the secondary market. These limited partnerships have been fair valued using Level 3 inputs.
The following tables provide quantitative disclosures of the Retirement Income Plan’s invested assets that are measured at fair value on a recurring basis:
The following tables provide a summary of the changes in fair value of securities using significant unobservable inputs (Level 3):
The following table outlines a summary of our alternative investment portfolio by strategy and the remaining commitment amount associated with each strategy:
For a description of our private equity and real estate strategies, refer to Note 5. “Investments.” Our equity long/short hedge strategy invests opportunistically in equities and equity-related instruments in companies generally in the financial services sector. Investments within this strategy are permitted to be sold short in order to: (i) prospectively benefit from a correction in overvalued equities; and (ii) partially hedge portfolio assets due to the strategy’s heavy weighting toward the financial sector.
At December 31, 2014, the Retirement Income Plan had contractual obligations that expire at various dates through 2022 to further invest up to $3.6 million in alternative investments. There is no certainty that any such additional investment will be required. The Retirement Income Plan currently receives distributions from these alternative investments through the realization of the underlying investments in the limited partnerships. We anticipate that the general partners of these alternative investments will liquidate their underlying investment portfolios through 2022.
Contributions
We presently anticipate contributing $11.9 million to the Retirement Income Plan in 2015, none of which represents minimum required contribution amounts.
Benefit Payments
Note 16. Share-Based Payments
The following is a brief description of each of our share-based compensation plans:
2014 Omnibus Stock Plan
The Parent's 2014 Omnibus Stock Plan ("Stock Plan") was approved effective as of May 1, 2014 by stockholders on April 23, 2014. Under the Stock Plan, the Parent's Board of Directors' Salary and Employee Benefits Committee ("SEBC") may grant qualified and nonqualified stock options, stock appreciation rights ("SARs"), restricted stock, restricted stock units ("RSUs"), stock grants, and other awards valued in whole or in part by reference to the Parent's common stock, in such amounts and with such terms and conditions as it shall determine, subject to the provisions of the Stock Plan. Each award granted under the Stock Plan (except unconditional stock grants and stock grants issued under the Parent's Non-Employee Directors' Compensation and Deferral Plan, as amended and restated effective as of May 1, 2014) shall be evidenced by an agreement containing such restrictions as the SEBC may, in its sole discretion, deem necessary or desirable and which are not in conflict with the terms of the Stock Plan. The maximum exercise period for an option grant under this plan is 10 years from the date of the grant. During 2014, we granted 4,023 RSUs and had no forfeitures under the Stock Plan. No options to purchase common stock were granted in 2014 under the Stock Plan. As of December 31, 2014, 3,500,000 shares of the Parent's common stock were authorized under the Stock Plan and 3,491,894 shares remained available for issuance under the Stock Plan.
For RSUs granted under the Stock Plan in 2014, dividend equivalent units ("DEUs") are earned during the vesting period. The DEUs are reinvested in the Parent's common stock at fair value on each dividend payment date. We accrued DEUs equivalent to 43 shares of the Parent's common stock in 2014. No shares were issued pursuant to vested DEUs in 2014. The DEUs are subject to the same vesting period and conditions set forth in the award agreements for the related RSUs.
2005 Omnibus Stock Plan
The Parent's 2005 Omnibus Stock Plan was approved effective as of April 1, 2005 by stockholders on April 27, 2005, and was amended and restated effective as of May 1, 2010 on April 28, 2010 ("2005 Stock Plan"). With the approval of the 2014 Stock Plan, no further grants are available under the 2005 Stock Plan, although awards outstanding under the 2005 Stock Plan continue in effect according to the terms thereof and any applicable award agreements. In addition, with the 2005 Stock Plan's approval, no further grants were available under the: (i) Parent's Stock Option Plan III, as amended ("Stock Option Plan III"); (ii) Parent's Stock Option Plan for Directors, as amended ("Stock Option Plan for Directors"); or (iii) Parent's Stock Compensation Plan for Non-employee Directors, as amended ("Stock Compensation Plan for Non-employee Directors"), but awards outstanding under these plans continue in effect according to the terms of those plans and any applicable award agreements.
Under the 2005 Stock Plan, the SEBC could grant stock options, SARs, restricted stock, RSUs, phantom stock, stock bonuses, and other awards in such amounts and with such terms and conditions as it determined, subject to the provisions of the 2005 Stock Plan. Each award granted under the 2005 Stock Plan (except unconditional stock grants and the cash component of Director compensation) was evidenced by an agreement containing such restrictions as the SEBC, in its sole discretion, deemed necessary or desirable and which were not in conflict with the terms of the 2005 Stock Plan. The maximum exercise period for an option granted under this plan was 10 years from the date of the grant.
We granted, net of forfeitures, 354,357 RSUs in 2014, 376,163 RSUs in 2013, and 326,213 RSUs in 2012 under the 2005 Stock Plan. No options to purchase common stock were granted in 2014, 2013, or 2012. As of December 31, 2014, 3,035,652 shares of the Parent's common stock were in the reserve for the 2005 Stock Plan.
During the vesting period, DEUs are earned on RSUs. The DEUs are reinvested in the Parent's common stock at fair value on each dividend payment date. We accrued DEUs equivalent to 24,010 shares of the Parent's common stock in 2014, 23,505 shares in 2013, and 32,558 shares in 2012. In addition, 30,991 shares of the Parent's common stock were issued pursuant to vested DEUs in 2014, 39,296 shares were issued pursuant to vested DEUs in 2013, and 48,224 shares were issued pursuant to vested DEUs in 2012. The DEUs are subject to the same vesting period and conditions set forth in the award agreements for the related RSUs.
Cash Incentive Plan
The Parent's Cash Incentive Plan was approved effective April 1, 2005 by stockholders on April 27, 2005, and amended and restated effective as of May 1, 2010 and May 1, 2014 (the “Cash Incentive Plan”) pursuant to stockholder approvals on April 28, 2010 and April 23, 2014, respectively. Under the Cash Incentive Plan, the SEBC may grant cash incentive units in such amounts and with such terms and conditions as it shall determine, subject to the provisions of the Cash Incentive Plan. The initial dollar value of these grants will be adjusted to reflect the percentage increase or decrease in the total shareholder return on the Parent's common stock over a specified performance period. In addition, for certain grants, the number of cash incentive units granted will be increased or decreased to reflect our performance on specified indicators as compared to targeted peer companies. Each award granted under the Cash Incentive Plan shall be evidenced in such form as the SEBC may, in its sole discretion, deem necessary or desirable, subject to the terms of the Cash Incentive Plan. We granted, net of forfeitures, 60,305 cash incentive units during 2014, 55,365 cash incentive units during 2013, and 46,961 cash incentive units during 2012.
Stock Option Plan III
As of December 31, 2014, there were 223,440 shares of the Parent's common stock in the reserve for Stock Option Plan III, under which future grants ceased being available with the approval of the 2005 Stock Plan. Under Stock Option Plan III, employees were granted qualified and nonqualified stock options, with or without SARs, and restricted or unrestricted stock: (i) at not less than fair value on the date of grant, and (ii) subject to certain vesting restrictions determined by the SEBC. Restricted stock awards could be subject to achievement of performance objectives as determined by the SEBC. The maximum exercise period for an option grant under this plan was 10 years from the date of the grant.
Stock Option Plan for Directors
As of December 31, 2014, 36,000 shares of the Parent's common stock remained in the reserve for the Stock Option Plan for Directors, under which future grants ceased being available with the approval of the 2005 Stock Plan. Non-employee directors participated in this plan and automatically received an annual nonqualified option to purchase 6,000 shares of the Parent's common stock at not less than fair value on the date of grant, which is typically on March 1. Options under this plan vested on the first anniversary of the grant and must be exercised by the tenth anniversary of the grant.
Stock Compensation Plan for Non-employee Directors
As of December 31, 2014, there were 94,290 shares of the Parent's common stock available for issuance pursuant to outstanding stock option awards under the Stock Compensation Plan for Non-employee Directors, under which future grants ceased being available with the approval of the 2005 Stock Plan. Under the Stock Compensation Plan for Non-employee Directors, directors could elect to receive a portion of their annual compensation in shares of the Parent's common stock. There were no issuances under this plan in 2014, 2013, and 2012.
Employee Stock Purchase Plan
On April 29, 2009, the Parent’s stockholders approved the Parent’s Employee Stock Purchase Plan (2009) (“ESPP”). This plan replaced the previous employee stock purchase savings plan under which no further purchases could be made as of July 1, 2009. Under the ESPP, there were 1,500,000 shares of the Parent's common stock authorized and 764,098 shares available for purchase as of December 31, 2014. The ESPP is available to all employees who meet the plan's eligibility requirements. The ESPP provides for the issuance of options to purchase shares of common stock. The purchase price is the lower of: (i) 85% of the closing market price at the time the option is granted; or (ii) 85% of the closing price at the time the option is exercised. Shares are generally issued on June 30 and December 31 of each year. Under the ESPP, we issued 106,832 shares to employees during 2014, 122,951 shares during 2013, and 129,081 shares during 2012.
Agent Stock Purchase Plan
On July 27, 2010, the SEBC approved the Parent’s Amended and Restated Stock Purchase Plan for Independent Insurance Agencies ("Agent Plan") which made immaterial amendments to the plan approved by stockholders on April 26, 2006. Under the Agent Plan, there were 3,000,000 shares of the Parent’s common stock authorized and 2,019,296 shares available for purchase as of December 31, 2014. The Agent Plan provides for quarterly offerings in which our independent retail insurance agencies and wholesale general agencies, and certain eligible persons associated with the agencies, with contracts with the Insurance Subsidiaries can purchase the Parent's common stock at a 10% discount with a one year restricted period during which the shares purchased cannot be sold or transferred. Under the Agent Plan, we issued 78,724 shares in 2014, 86,388 shares in 2013, and 89,723 shares in 2012, and charged to expense $0.2 million in each year, with a corresponding income tax benefit of $0.1 million in each year.
A summary of the stock option transactions under our share-based payment plans is as follows:
The total intrinsic value of options exercised was $0.8 million during 2014, $1.3 million in 2013, and $0.8 million in 2012.
A summary of the RSU transactions under our share-based payment plans is as follows:
As of December 31, 2014, total unrecognized compensation expense related to unvested RSU awards granted under our stock plans was $4.7 million. That expense is expected to be recognized over a weighted-average period of 1.6 years. The total intrinsic value of RSUs vested was $8.5 million for 2014, $9.1 million for 2013, and $8.4 million for 2012. In connection with the vested RSUs, the total value of the DEU shares that vested was $0.7 million in 2014, and $0.9 million during both 2013 and 2012.
At December 31, 2014, the liability recorded in connection with our Cash Incentive Plan was $21.9 million. The fair value of the liability is re-measured at each reporting period through the settlement date of the awards, which is three years from the date of grant based on an amount expected to be paid. A Monte Carlo simulation is performed to approximate the projected fair value of the cash incentive units that, in accordance with the Cash Incentive Plan, is adjusted to reflect our performance on specified indicators as compared to targeted peer companies. The remaining cost associated with the cash incentive units is expected to be recognized over a weighted average period of 1.1 years. The cash incentive unit payments made were $9.0 million in 2014, $4.7 million in 2013, and $3.0 million in 2012.
In determining expense to be recorded for stock options granted under our share-based compensation plans, the fair value of each option award is estimated on the date of grant using the Black Scholes option valuation model ("Black Scholes"). The following are the significant assumptions used in applying Black Scholes: (i) the risk-free interest rate, which is the implied yield currently available on U.S. Treasury zero-coupon issues with an equal remaining term; (ii) the expected term, which is based on historical experience of similar awards; (iii) the dividend yield, which is determined by dividing the expected per share dividend during the coming year by the grant date stock price; and (iv) the expected volatility, which is based on the volatility of the Parent's stock price over a historical period comparable to the expected term. In applying Black Scholes, we use the weighted average assumptions illustrated in the following table:
The grant date fair value of RSUs is based on the market price of our common stock on the grant date, adjusted for the present value of our expected dividend payments. The expense recognized for share-based awards is based on the number of shares or units expected to be issued at the end of the performance period and the grant date fair value, and is amortized over the requisite service period.
The weighted-average fair value of options and stock per share, including RSUs granted for the Parent's stock plans, during 2014, 2013, and 2012 is as follows:
Share-based compensation expense charged against net income before tax was $18.6 million for the year ended December 31, 2014 with a corresponding income tax benefit of $6.2 million. Share-based compensation expense that was charged against net income before tax was $19.9 million for the year ended December 31, 2013 and $13.8 million for the year ended December 31, 2012 with corresponding income tax benefits of $6.8 million and $4.8 million, respectively.
Note 17. Related Party Transactions
William M. Rue, a Director of the Parent, is Chairman of, and owns more than 10% of the equity of, Chas. E. Rue & Son, Inc., t/a Rue Insurance, a general independent retail insurance agency ("Rue Insurance"). Rue Insurance is an appointed distribution partner of the Insurance Subsidiaries on terms and conditions similar to those of our other distribution partners. Rue Insurance also places insurance for our business operations. Our relationship with Rue Insurance has existed since 1928.
The following is a summary of transactions with Rue Insurance:
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Rue Insurance placed insurance policies with the Insurance Subsidiaries. DPW associated with these policies were $9.0 million in 2014, $8.2 million in 2013, and $7.7 million in 2012. In return, the Insurance Subsidiaries paid standard market commissions to Rue Insurance of $1.6 million in 2014, $1.3 million in 2013, and $1.3 million in 2012 including supplemental commissions.
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Rue Insurance has placed insurance coverage for us with other insurance companies for which Rue Insurance was paid commission pursuant to its agreements with those carriers in 2012. We paid premiums for such insurance coverage of $0.2 million in 2012.
In 2005, we established a private foundation, The Selective Group Foundation (the "Foundation"), under Section 501(c)(3) of the Internal Revenue Code. The Board of Directors of the Foundation is comprised of some of the Parent's officers. We made contributions to the Foundation in the amount of $0.8 million in 2014, and $0.4 million in both 2013 and 2012.
Note 18. Commitments and Contingencies
(a) We purchase annuities from life insurance companies to fulfill obligations under claim settlements that provide for periodic future payments to claimants. As of December 31, 2014, we had purchased such annuities with a present value of $15.0 million for settlement of claims on a structured basis for which we are contingently liable. To our knowledge, there are no material defaults from any of the issuers of such annuities.
(b) We have various operating leases for office space and equipment. Such lease agreements, which expire at various times, are generally renewed or replaced by similar leases. Rental expense under these leases amounted to $15.6 million in 2014, $13.2 million in 2013, and $13.1 million in 2012. We also lease computer hardware and software under capital lease agreements expiring at various dates through 2019. See Note 2(p) for information on our accounting policy regarding leases.
In addition, certain leases for rented premises and equipment are non-cancelable, and liability for payment will continue even though the space or equipment may no longer be in use. At December 31, 2014, the total future minimum rental commitments under non-cancelable leases were $44.9 million and such yearly amounts are as follows:
(c) At December 31, 2014, we have contractual obligations that expire at various dates through 2028 to invest up to an additional $68.4 million in alternative and other investments. There is no certainty that any such additional investment will be required. For additional information regarding these investments, see item (f) of Note 5. "Investments" in this Form 10-K.
Note 19. Litigation
In the ordinary course of conducting business, we are named as defendants in various legal proceedings. Most of these proceedings are claims litigation involving our Insurance Subsidiaries as either: (i) liability insurers defending or providing indemnity for third-party claims brought against our customers; or (ii) insurers defending first-party coverage claims brought against them. We account for such activity through the establishment of unpaid loss and loss expense reserves. We expect 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 our consolidated financial condition, results of operations, or cash flows.
Our Insurance Subsidiaries are from time to time involved in other legal actions, some of which assert claims for substantial amounts. These actions include, among others, putative 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. Our Insurance Subsidiaries also are involved from time to time 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. We believe that we have valid defenses to these cases. We expect that the ultimate liability, if any, with respect to such lawsuits, after consideration of provisions made for estimated losses, will not be material to our 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 our consolidated results of operations or cash flows in particular quarterly or annual periods.
Note 20. Statutory Financial Information, Capital Requirements, and Restrictions on Dividends and Transfers of Funds
(a) Statutory Financial Information
The Insurance Subsidiaries prepare their statutory financial statements in accordance with accounting principles prescribed or permitted by the various state insurance departments of domicile. Prescribed statutory accounting principles include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (“NAIC"). Permitted statutory accounting principles encompass all accounting principles that are not prescribed; such principles differ from state to state, may differ from company to company within a state and may change in the future. The Insurance Subsidiaries do not utilize any permitted statutory accounting principles that materially affect the determination of statutory surplus, statutory net income, or risk-based capital (“RBC”). As of December 31, 2014, the various state insurance departments of domicile have adopted the March 2014 version of the NAIC Accounting Practices and Procedures manual in its entirety, as a component of prescribed or permitted practices.
The following table provides statutory data for each of our Insurance Subsidiaries:
(b) Capital Requirements
The Insurance Subsidiaries are required to maintain certain minimum amounts of statutory surplus to satisfy the requirements of their various state insurance departments of domicile. RBC requirements for property and casualty insurance companies are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholders. The Insurance Subsidiaries combined total adjusted capital exceeded the authorized control level RBC, as defined by the NAIC, by 4.5:1 based on their 2014 statutory financial statements. The negative unassigned surplus balance for MUSIC existed prior to our acquisition of this company in 2011. This company has not generated sufficient net income since our purchase to offset the existing negative surplus. In addition to statutory capital requirements, we are impacted by various rating agency requirements related to certain rating levels. These required capital levels may be more than statutory requirements.
(c) Restrictions on Dividends and Transfers of Funds
The Parent pays dividends to stockholders from funds available at the holding company level. As of December 31, 2014, the Parent had an aggregate of $83.0 million in investments and cash available to fund future dividends and interest payments. These amounts are not subject to any regulatory restrictions other than standard state insolvency restrictions, whereas our consolidated retained earnings of $1.3 billion is predominately restricted due to the regulation associated with our Insurance Subsidiaries. In 2015, the Insurance Subsidiaries have the ability to provide for $162.0 million in annual dividends to the Parent; however, as regulated entities, these dividends are subject to certain restrictions as is further discussed below. The Parent also has available to it other potential sources of liquidity, such as: (i) borrowings from our Indiana-domiciled Insurance Subsidiaries; (ii) debt issuances; (iii) common stock issuances; and (iv) borrowings under our Line of Credit. Borrowings from SICSE and SICSC are governed by approved intercompany lending agreements with the Parent that provide for additional capacity of $46.4 million as of December 31, 2014, after considering that borrowings under these lending agreements are restricted to 10% of the admitted assets of these respective subsidiaries. For additional restrictions on the Parent's debt, see Note 10. "Indebtedness" in this Form 10-K.
Insurance Subsidiaries Dividend Restrictions
As noted above, the restriction on our net assets and retained earnings is predominantly driven by our Insurance Subsidiaries' ability to pay dividends to the Parent under applicable law and regulations. Under the insurance laws of the domiciliary states of the Insurance Subsidiaries, New Jersey, Indiana, and New York, an insurer can potentially make an ordinary dividend payment if its statutory surplus following such dividend is reasonable in relation to its outstanding liabilities, is adequate to its financial needs, and the dividend does not exceed the insurer's unassigned surplus. In general, New Jersey defines an ordinary dividend as a dividend whose fair market value, together with other dividends made within the preceding 12 months, is less than the greater of 10% of the insurer's statutory surplus as of the preceding December 31, or the insurer's net income (excluding capital gains) for the 12-month period ending on the preceding December 31. Indiana's ordinary dividend calculation is consistent with New Jersey's, except that it does not exclude capital gains from net income. In general, New York defines an ordinary dividend as a dividend whose fair market value, together with other dividends made within the preceding 12 months, is less than the lesser of 10% of the insurer's statutory surplus, or 100% of adjusted net investment income. New Jersey and Indiana require notice of the declaration of any ordinary dividend distribution. During the notice period, the relevant state regulatory authority may disallow all or part of the proposed dividend if it determines that the dividend is not appropriate given the above considerations. New York does not require notice of ordinary dividends. Dividend payments exceeding ordinary dividends are referred to as extraordinary dividends and require review and approval by the applicable domiciliary insurance regulatory authority prior to payment.
The following table provides quantitative data regarding all Insurance Subsidiaries' dividends paid to the Parent in 2014 for debt service, shareholder dividends, and general operating purposes:
Based on the 2014 statutory financial statements, the maximum ordinary dividends that can be paid to the Parent by the Insurance Subsidiaries in 2015 are as follows:
Note 21. Quarterly Financial Information
The addition of all quarters may not agree to annual amounts on the Financial Statements due to rounding.
1 See Note 20. “Statutory Financial Information, Capital Requirements, and Restrictions on Dividends and Transfers of Funds” for a discussion of dividend restrictions.
2 These ranges of high and low prices of the Parent’s common stock, as reported by the NASDAQ Global Select Market, represent actual transactions. Price quotations do not include retail markups, markdowns, and commissions. The range of high and low prices for common stock for the period beginning January 2, 2015 and ending February 13, 2015 was $25.49 to $28.08.
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A. Controls and Procedures.
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d- 15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are: (i) effective in recording, processing, summarizing, and reporting information on a timely basis that we are required to disclose in the reports that we file or submit under the Exchange Act; and (ii) effective in ensuring that information that we are required to disclose in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Management's Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) is a process designed by, or under the supervision of, a company's principal executive and principal financial officers and effected by the Board, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:
•
Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the company;
•
Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and
•
Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2014. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework ("COSO Framework") in 2013, transitioning from the 1992 COSO Framework in the third quarter of 2014.
Based on its assessment, our management believes that, as of December 31, 2014, our internal control over financial reporting is effective.
No changes in our internal control over financial reporting (as such term is defined in Rule 13a-15(f) of the Exchange Act) occurred during the fourth quarter of 2014 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Attestation Report of the Independent Registered Public Accounting Firm
Our independent registered public accounting firm, KPMG, LLP has issued their attestation report on our internal control over financial reporting which is set forth below.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Selective Insurance Group, Inc.:
We have audited Selective Insurance Group, Inc. and its subsidiaries’ (the “Company”) internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Selective Insurance Group, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Selective Insurance Group, Inc. and its subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Selective Insurance Group, Inc. and subsidiaries as of December 31, 2014 and December 31, 2013, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flow for each of the years in the three-year period ended December 31, 2014, and our report dated February 26, 2015 expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
New York, New York
February 26, 2015
Item 9B.
Item 9B. Other Information.
There is no other information that was required to be disclosed in a report on Form 8-K during the fourth quarter of 2014 that we did not report.
PART III
Because we will file a Proxy Statement within 120 days after the end of the fiscal year ending December 31, 2014, this Annual Report on Form 10-K omits certain information required by Part III and incorporates by reference certain information included in the Proxy Statement.
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
Information about our executive officers, Directors, and all other matters required to be disclosed in Item 10. "Directors, Executive Officers and Corporate Governance." appears under the "Executive Officers" and "Information About Proposal 1- Election of Directors" sections of the Proxy Statement. These portions of the Proxy Statement are hereby incorporated by reference.
Section 16(a) Beneficial Ownership Reporting Compliance
Information about compliance with Section 16(a) of the Exchange Act appears under "Section 16(a) Beneficial Ownership Reporting Compliance" in the "Information About Proposal 1, Election of Directors" section of the Proxy Statement and is hereby incorporated by reference.
Item 11.
Item 11. Executive Compensation.
Information about compensation of our named executive officers appears under "Executive Compensation" in the "Election of Directors" section of the Proxy Statement and is hereby incorporated by reference. Information about compensation of the Board appears under "Director Compensation" in the "Information About Proposal 1 - Election of Directors" section of the Proxy Statement and is hereby incorporated by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
Information about security ownership of certain beneficial owners and management appears under "Security Ownership of Management and Certain Beneficial Owners" in the "Information About Proposal 1- Election of Directors" section of the Proxy Statement and is hereby incorporated by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
Information about certain relationships and related transactions, and director independence appears under “Transactions with Related Persons” in the "Information About Proposal 1- Election of Directors" section of the Proxy Statement and is hereby incorporated by reference.
Item 14.
Item 14. Principal Accounting Fees and Services.
Information about the fees and services of our principal accountants appears under "Audit Committee Report" and "Fees of Independent Registered Public Accounting Firm" in the "Ratification of Appointment of Independent Registered Public Accounting Firm" section of the Proxy Statement and is hereby incorporated by reference.
PART IV
(a) The following documents are filed as part of this report:
(1) Financial Statements:
The Financial Statements listed below are included in Item 8. "Financial Statements and Supplementary Data."
(2) Financial Statement Schedules:
The financial statement schedules, with Independent Auditors' Report thereon, required to be filed are listed below by page number as filed in this report. All other schedules are omitted as the information required is inapplicable, immaterial, or the information is presented in the Financial Statements or related notes.
(3) Exhibits:
The exhibits required by Item 601 of Regulation S-K are listed in the Exhibit Index, which is incorporated by reference and immediately precedes the exhibits filed with or incorporated by reference in this Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
SELECTIVE INSURANCE GROUP, INC.
By: /s/ Gregory E. Murphy
February 26, 2015
Gregory E. Murphy
Chairman of the Board and Chief Executive Officer
By: /s/ Dale A. Thatcher
February 26, 2015
Dale A. Thatcher
Executive Vice President and Chief Financial Officer
(principal accounting officer and principal financial officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
SCHEDULE I
SELECTIVE INSURANCE GROUP, INC. AND CONSOLIDATED SUBSIDIARIES
SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES
December 31, 2014
SCHEDULE II
SELECTIVE INSURANCE GROUP, INC.
(Parent Corporation)
Balance Sheets
Information should be read in conjunction with the Notes to Consolidated Financial Statements of Selective Insurance Group, Inc. and its subsidiaries in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
SCHEDULE II (continued)
SELECTIVE INSURANCE GROUP, INC.
(Parent Corporation)
Statements of Income
Information should be read in conjunction with the Notes to Consolidated Financial Statements of Selective Insurance Group, Inc. and its subsidiaries in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
SCHEDULE II (continued)
SELECTIVE INSURANCE GROUP, INC.
(Parent Corporation)
Statements of Cash Flows
Information should be read in conjunction with the Notes to Consolidated Financial Statements of Selective Insurance Group, Inc. and its subsidiaries in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
SCHEDULE III
SELECTIVE INSURANCE GROUP, INC. AND CONSOLIDATED SUBSIDIARIES
SUPPLEMENTARY INSURANCE INFORMATION
Year ended December 31, 2014
1Includes “Net investment income earned” and “Net realized investment gains” on the Consolidated Statements of Income.
2The total of “Amortization of deferred policy acquisition costs” of $364,295 and “Other operating expenses” of $252,670 reconciles to the Consolidated Statements of Income as follows:
3 In addition to amounts related to the Standard Commercial Lines, Standard Personal Lines, and E&S Lines, “Other income” and “Other expenses” on the Consolidated Statements of Income includes holding company income and expense amounts of $347 and $24,580, respectively.
Year ended December 31, 2013
1Includes “Net investment income earned” and “Net realized investment gains” on the Consolidated Statements of Income.
2 The total of “Amortization of deferred policy acquisition costs” of $331,828 and “Other operating expenses” of $243,740 reconciles to the Consolidated Statements of Income as follows:
3 In addition to amounts related to the Standard Commercial Lines, Standard Personal Lines, and E&S Lines, “Other income” and “Other expenses” on the Consolidated Statements of Income includes holding company income and expense amounts of $93 and $27,894, respectively.
SCHEDULE III (continued)
SELECTIVE INSURANCE GROUP, INC. AND CONSOLIDATED SUBSIDIARIES
SUPPLEMENTARY INSURANCE INFORMATION
Year ended December 31, 2012
1 Includes “Net investment income earned” and “Net realized investment gains” on the Consolidated Statements of Income.
2 The total of “Amortization of deferred policy acquisition costs” of $298,547 and “Other operating expenses” of $228,589 reconciles to the Consolidated Statements of Income as follows:
3 In addition to amounts related to the Standard Commercial Lines, Standard Personal Lines, and E&S Lines, “Other income” and “Other expenses” on the Consolidated Statements of Income includes holding company income and expense amounts of $291 and $20,642, respectively.
SCHEDULE IV
SELECTIVE INSURANCE GROUP, INC. AND CONSOLIDATED SUBSIDIARIES
REINSURANCE
Years ended December 31, 2014, 2013, and 2012
SCHEDULE V
SELECTIVE INSURANCE GROUP, INC. AND CONSOLIDATED SUBSIDIARIES
ALLOWANCE FOR UNCOLLECTIBLE PREMIUMS AND OTHER RECEIVABLES
Years ended December 31, 2014, 2013, and 2012
EXHIBIT INDEX
* Filed herewith.
** Furnished and not filed herewith.
+ Management compensation plan or arrangement.