Item 1. Business.
Overview
Selective Insurance Group, Inc. (referred to as the “Parent”) is a New Jersey holding company 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 as admitted insurance carriers in what is referred to as the standard marketplace. The remaining subsidiary is authorized by various state insurance departments to write property and casualty insurance in the excess and surplus ("E&S") lines market as a non-admitted insurance carrier. 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 2018, we were ranked as the 35th largest property and casualty group in the United States based on 2017 net premiums written (“NPW”) in A.M. Best Company’s (“A.M. Best”) annual list of “Top 100 U.S. Property/Casualty Writers.”
The property and casualty insurance market is highly competitive, with fragmented market share and four main distribution methods: (i) sales through independent insurance agents; (ii) direct sales to personal and commercial customers; (iii) a combination of independent agent and direct sales; and (iv) sales through captive insurance agents that are contracted to work exclusively with one insurance company. In this highly competitive and regulated industry, we focus on sales exclusively through independent agents and have several strategic advantages as follows:
(i) The true franchise value we have built through our relationships with a small group of independent distribution partners that we refer to as our "ivy league" distribution partners, who collectively have significant market share in the states in which we operate and from whom we expect to gain increasing percentages of the business they write.
(ii) Our unique field model, in which our underwriting, claims, and safety management personnel are located in the same communities as our distribution partners and customers and benefit from sophisticated analytics, technology, and regional and home office support.
(iii) Our investment in technologies that help us enhance overall customer experience and position us to increase retention rates and new business hit ratios over time. Our digital platform allows customers to interact with us in a 24x7 environment in the manner of their choosing. Additionally, we have developed a 360-degree view of our customers, enhancing our ability to provide value-added services, such as proactive messaging in relation to product recalls, potential loss activity, or policy changes.
(iv) Our deployment of sophisticated underwriting and claims tools that enable our personnel to make better decisions faster, creating greater efficiencies and improving outcomes. Our underwriters receive real-time model driven underwriting and pricing guidance on every account, along with the tools to measure the impact of each decision on their overall portfolio.
Financial Strength Ratings play a significant role in insurance purchasing recommendations by our independent distribution partners and in decision-making by our customers. Distribution partners generally recommend higher rated carriers to limit their liability for error and omission claims, and customers often have minimum insurer rating requirements in loans, mortgages, and other agreements securing real and personal property. 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, which is comprised of insurance products and services provided in the standard marketplace to commercial enterprises; typically businesses, non-profit organizations, and local government agencies. This business represents 79% of our total insurance operations’ NPW and is sold in 27 states and the District of Columbia.
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Standard Personal Lines, which is comprised of insurance products and services provided primarily to individuals acquiring coverage in the standard marketplace. This business represents 12% of our total insurance operations’ NPW and is sold in 15 states. Standard Personal Lines includes flood insurance coverage. We are the fifth largest writer of this coverage through the National Flood Insurance Program (“NFIP”) and write flood business in all 50 states and the District of Columbia.
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E&S Lines, which is 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. This business represents 9% of our total insurance operations’ NPW and is sold in all 50 states and the District of Columbia.
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Investments, which invests the premiums collected by our insurance operations and amounts generated through our capital management strategies, which include the issuance of debt and equity securities.
We derive substantially all of our income in three ways:
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Underwriting income/loss from our insurance operations. Underwriting income/loss 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. NPW is equal to gross premiums less premium ceded to reinsurers. NPW is recognized as revenue ratably over a policy’s term as net premiums earned (“NPE”).
Expenses related to our insurance operations fall into three categories, which are depicted on our Consolidated Statements of Income: (i) "Loss and loss expense incurred," which includes losses associated with claims and all loss expenses incurred for adjusting claims; (ii) "Amortization of deferred policy acquisition costs," which includes expenses related to the successful acquisition of insurance policies, such as commissions to our distribution partners and premium taxes, and are recognized ratably over a policy's term; and (iii) "Other insurance expenses," which includes acquisition expenses not captured above, as well as expenses incurred in maintaining policies and 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: (i) interest earned on fixed income investments and preferred stocks; (ii) dividends earned on equity securities; and (iii) other income primarily generated from our alternative investment portfolio.
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Net realized and unrealized 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”). Due to a change in accounting literature that became effective January 1, 2018, changes in unrealized gains and losses on our equity portfolio are now recognized in income through "Net unrealized losses on equity securities" on our Consolidated Statements of Income.
Our income is partially offset by: (i) expenses of the Parent that include long-term incentive compensation to employees, interest on our debt obligations, and other general corporate expenses; and (ii) federal income taxes.
We use the combined ratio as the key measure in assessing the performance of our insurance operations. 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. A combined ratio under 100% indicates an underwriting profit and a combined ratio over 100% indicates an underwriting loss. The combined ratio does not reflect investment income, federal income taxes, or Parent company income or expense.
We use after-tax net investment income, and net realized and unrealized gains or losses as the key measures 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.
We also use non-generally accepted accounting principles operating return on equity ("non-GAAP operating ROE") as an important measure of our overall financial performance. We evaluate our segments, in part, based on their contribution to this company metric. Our non-GAAP operating ROE for 2018 was 12.5%, which exceeded our financial target of 12% for 2018. For 2019, we have established a non-GAAP operating ROE target of 12%, which is an appropriate return for our shareholders based on our current estimated weighted average cost of capital, the current interest rate environment, and property and casualty insurance market conditions. For further details regarding our 2018 performance as it relates to return on equity, refer to "Financial Highlights of Results for Years Ended December 31, 2018, 2017, and 2016" in Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations." of this Form 10-K.
Insurance Operations
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 expense.
To that end, we establish loss and loss expense reserves that are estimates of the ultimate amounts that we will need to pay in the future for claims and related expenses for insured losses that have already been incurred, but have not yet been settled. Estimating reserves as of any given date requires the application of estimation techniques, involves a considerable degree of judgment, and is an inherently uncertain process. We regularly review our reserving techniques and the overall adequacy of our reserves. For 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.
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 we underwrite. We use two main reinsurance vehicles: (i) a reinsurance pooling agreement among our Insurance Subsidiaries in which each company shares 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 Operations Products and Services
The types of insurance we sell in our insurance operations fall into two 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, and for some casualty claims even several decades, to be reported and settled.
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 Write Your Own Program ("WYO") of the NFIP. The results of our Standard Personal Lines and Standard Commercial Lines flood operations are reported solely within our Standard Personal Lines segment results.
Product Development and Pricing
Our insurance policies are contracts that specify the coverage provided to our insured, such as what we will pay to, or on behalf of, the insured upon a covered loss. We develop our coverages by: (i) adopting forms created or filed by statistical rating agencies or other third parties, notably Insurance Services Office, Inc. (“ISO”), American Association of Insurance Services, Inc. ("AAIS"), and the National Council on Compensation Insurance, Inc. ("NCCI"); (ii) independently creating our own coverage forms; or (iii) modifying third-party forms.
Since our policies provide coverage for future events, we do not know what our actual costs for a policy will be at the time we underwrite and issue it. Therefore, determining the prices to charge for our coverages involves consideration of many variables. In certain cases, we adopt rating structures and loss costs filed by statistical rating agencies, such as ISO and NCCI. We supplement this with detailed analyses of our own historical statistical data, factoring in loss trends and other expected impacts. We then load these expected loss costs for our own expenses and profit provision. In other cases, we develop rating structures and rates based upon a combination of our own experience and competitors information. Generally speaking, our approach is to rely upon our own experience to the full extent we deem it statistically credible.
To supplement our rating structures, we have developed predictive models for many of our Standard Commercial and Standard Personal Lines. Predictive models analyze historical statistical data regarding our customers and their loss experience to model additional risk characteristics that drive loss experience. These models rely upon more advanced statistical analysis and rigorous testing. We use the output of these models to group our policies, or potential policies, based upon their expected loss potential. In other cases, we use these models to develop factors in our rating plan. These models' predictive capabilities are limited by the amount and quality of the available statistical data, so they may be supplemented with competitive information or underwriting judgment.
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 SBU.
The following are general guidelines that can be used as indicators of the approximate size of our customers:
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The average Standard Commercial Lines premium per customer is approximately $12,000.
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The average Standard Personal Lines premium per customer is approximately $2,000.
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The average E&S Lines premium per policy is approximately $3,000.
No one customer accounts for 10% or more of our insurance operations in the aggregate.
Geographic Markets
We sell in the following geographic markets:
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Standard Commercial Lines products and services are sold in 27 states located in the Eastern, Midwestern, and Southwestern regions of the United States and the District of Columbia.
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Standard Personal Lines products and services are sold in 15 states located in the Eastern, Midwestern, and Southwestern 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 products and services are sold in all 50 states and the District of Columbia.
We support geographically diversified business 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 their office locations:
In addition, our E&S Lines are supported by office locations in Horsham, Pennsylvania and Scottsdale, Arizona.
Distribution Channel
We sell our insurance products and services through the following types of distribution partners:
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Standard Commercial Lines: independent retail agents;
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Standard Personal Lines: independent retail agents; and
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E&S Lines: wholesale general agents.
We pay our distribution partners commissions calculated as a percentage of DPW, and in some cases on profitability or other consideration for business placed with us. We seek to compensate them fairly and in a manner consistent with market practices. No one distribution partner is responsible for 10% or more of our combined insurance operations' premium. Our top 20 distribution partners generated approximately 30% of our NPW in 2018.
Our customers rely heavily on our distribution partners and some do not differentiate between their insurance agent and their insurance carrier, so developing brand recognition particularly with these types of customers can be difficult . We continue to evolve our service model, post policy-acquisition, with an increasing focus on the customer. Our goal is to provide our customers with 24/7 access to transactional capabilities and account information. Customers expect this level of access from us because of the technological and service improvements in retail and other consumer sectors. While many insurers offer such solutions in the personal lines space, we want to be a leader in digital and customer experience in all three segments of our insurance operations. As part of our digital strategy, we provide customers with a mobile application and a web-based portal that permit our customers on demand self-service access to basic account information, pay their bills electronically, and report claims. In addition, we are able to provide value-added services, such as proactive messaging in relation to product recalls, potential loss activity, or policy changes. These efforts will permit us to offer customers an improved shared experience with our independent distribution partners, and better position us to more directly demonstrate our value proposition to our customers and distribution partners.
Independent Retail Agents
According to a 2018 study by the Independent Insurance Agents & Brokers of America, independent retail insurance agents and brokers write approximately 84% of standard commercial lines insurance and 35% of standard personal lines insurance in the United States. We believe that independent retail insurance agents, which comprise the bulk of our independent distribution partners, will remain a significant force in overall insurance industry premium production because they represent more than one insurance carrier and provide a wider choice of commercial and personal lines insurance products and risk-based consultation to customers.
We currently have 1,320 distribution partners selling our Standard Commercial Lines business, and 720 of these distribution partners also sell our Standard Personal Lines business. These 1,320 distribution partners sell our products and services through approximately 2,200 office locations. We also have 6,000 retail agents selling our flood insurance products.
In our independently administered 2018 survey, we received an overall satisfaction score of 8.7 out of 10 from our standard market distribution partners. We believe this score highlights the satisfaction of our independent distribution partners with our products, the ease of reporting claims, and the professionalism and effectiveness of our employees.
Wholesale General Agents
Our distribution partners for our E&S Lines are 90 wholesale general agents with a combined 250 office locations. We have granted limited binding authority to the wholesale general agents for business that meets our prescribed underwriting and pricing guidelines. Our wholesale general agents submit brokerage business to us for risk acceptability, terms and conditions, and pricing.
Marketing
Our primary marketing strategy is to:
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Use an empowered field underwriting model to provide our Standard Commercial Lines retail distribution partners with resources within close geographic proximity to their businesses and our mutual 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, particularly their principals and producers by: (i) soliciting their feedback on products and services; (ii) advising them concerning our product developments; and (iii) providing education and development 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) new business and renewal retention expectations; (iii) customer service; (iv) pricing of their in-force book and changes in renewal prices; and (v) profitability of business placed with us.
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Develop brand recognition with our customers through our marketing efforts to be recognized as a proactive risk manager that provides the value-added services that customers seek, which include proactive communication, and providing exceptional products and services that help position us as a leader in the marketplace.
Technology and Field Model
Technology
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 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 workers compensation claims adjusters with predictive tools to indicate when claims are likely to escalate to better serve our customers;
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Our Special Investigations Unit ("SIU") investigators access to 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 24x7 access to transactional capabilities and information through a web-based customer portal and a customer mobile application.
We manage our information technology projects through an Enterprise Project Management Office (“EPMO”) governance model. The EPMO is supported by certified project managers who apply methodologies to: (i) communicate project management standards; (ii) provide project management training and tools; (iii) manage projects; (iv) review project status, the projected net present value of project benefits, if applicable, and external and internal costs; 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 50% of our skilled technology capacity and are principally based in the U.S., although we do contract with some service providers who are based, or utilize resources, outside the U.S. 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.
Field Model
To support our distribution partners, we employ a field model for both underwriting and claims, with various employees 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 customers. At December 31, 2018, we had approximately 2,290 employees, of which 590 worked in the field, 860 worked in one of our regional offices, and the remainder worked in our corporate office.
Underwriting Process
Our underwriting process requires communication and interaction among:
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Our Regions, which together with our corporate underwriting and actuarial departments, jointly establish and execute upon the following for our Standard Commercial Lines business: (i) annual premium and pricing goals; (ii) specific new business targets by distribution partner; and (iii) profit improvement plans as needed across our business segments, lines, states, and/or distribution partners;
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Our corporate underwriting department, which develops our underwriting appetite, products, policy forms, pricing, and underwriting guidelines for our standard market business;
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Our corporate actuaries who assist in the determination of rate and pricing levels, while monitoring pricing and profitability along with the Regions, corporate underwriting department, and business intelligence staff for our standard and E&S market business;
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Our distribution partners, which include independent retail agents for our standard market business and wholesale general agents for our E&S market business, that provide front-line underwriting within our prescribed guidelines;
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Our Agency Management Specialists (“AMSs”), who: (i) manage the growth and profitability of business that their assigned distribution partners write with us; and (ii) perform field underwriting for new Standard Commercial Lines business;
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Our field operations leadership, who have oversight of the AMS production team for Standard Commercial Lines, ensure that: (i) annual profit and growth plans are developed on a state by state basis; (ii) the achievement of these state plans are monitored at the state, AMS territory and account level; and (iii) individual agency plans are developed and monitored for achievement annually;
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Our Standard Commercial Lines small business teams that are responsible for handling: (i) new business in need of review that was submitted by our distribution partners through our automated underwriting platform, One & Done®; and (ii) other new small accounts and middle market accounts with low underwriting complexity;
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Our Safety Management Specialists (“SMSs”), who provide a wide range of front-line safety management services to our Standard Commercial Lines customers as discussed more fully below;
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Our regional underwriters, who manage our in-force policies for their assigned Standard Commercial Lines distribution partners, including, but not limited to, managing profitability and pricing levels within their portfolios by developing policy-specific pricing;
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Our managers and underwriters, who are responsible for new business, renewal underwriting and service needs for our large Standard Commercial Lines accounts, including those written with alternative risk transfer techniques for our distribution partners;
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Our premium auditors, who supplement the underwriting process by working with insureds to accurately audit exposures for certain Standard Commercial Lines policies that we write;
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Our field technical coordinators, who are responsible for technology assistance and training to aid our employees and standard market distribution partners;
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Our Personal Lines Marketing Specialists (“PLMSs”), who have primary responsibility for identifying new opportunities to grow our Standard Personal Lines; and
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Our E&S territory managers, who have primary responsibility for identifying new opportunities to grow our E&S Lines.
We have an underwriting service center (“USC”) located in Richmond, Virginia. The USC assists our distribution partners by servicing certain Standard Commercial and Personal 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, 2018, our USC was servicing Standard Commercial Lines NPW of $52.0 million and Standard Personal Lines NPW of $28.9 million. The $80.9 million total serviced by the USC represents 3% of our total NPW.
Our field model provides a wide range of front-line safety management services focused on improving a Standard Commercial Lines insured’s safety and risk management programs. During 2018, we introduced: (i) our Selective® Drive program to our commercial automobile policyholders. This product assists with logistics management and improved safety by tracking and scoring individual drivers based on driving attributes, including phone usage while the vehicle is in motion; and (ii) a web-based cybersecurity training program that is currently being piloted with our agents to help them better protect their agencies and better safeguard our data and systems. In addition, our service mark “Safety Management: Solutions for a safer workplace”SM includes: (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, mitigate, 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 expense; and (ii) maintenance of timely and adequate claims reserves. In connection with our Standard Commercial Lines and Standard Personal Lines, we achieve better claim outcomes through a field model that locates claim representatives in close proximity to our customers and distribution partners.
In 2018, we introduced the Swift Claims Handling process ("SWIFT") where parties can opt-in to having low-severity automobile or property claims handled entirely through email. This accelerates the claims handling process and improves the customer experience. Over 4,000 individuals have opted into having their claims managed through SWIFT, with payment issuance often occurring as soon as 24 hours from submission.
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 and manages routine automobile and property claims with no injuries. 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 and specified service levels; (iii) handle and settle small property claims; and (iv) investigate and negotiate auto liability claims. The CSC, as appropriate, will assign claims to the appropriate regional claims office or other specialized area within our claims organization.
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 severities. We also have Property Claims Specialists ("PCSs") to handle property claims with severities ranging from $10,000 to $100,000. They also form the basis of our catastrophe response team. Strategically located throughout our footprint, CMSs and PCSs are able to provide highly responsive customer and distribution partner service to quickly resolve claims within their authority.
Our E&S claims processing is consistent with our Standard Commercial Lines and Standard Personal Lines claims processing. E&S claims are handled in our standard lines regional offices, as well as in our Complex Claims and Litigation Unit ("CCU") discussed below, and are segregated by line of business (property and liability), litigation, and complexity.
Our Quality Assurance Unit conducts monthly file reviews on all of our operations to validate compliance with our quality claims handling standards. Complex and litigated claims oversight is handled by specialists within the CCU.
We have implemented specialized claims handling as follows:
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Liability claims with high severity or technically complex losses are handled by the CCU. The CCU specialists are primarily field-based employees, and handle losses based on injury type or with expected severities greater than $250,000 in our Standard Commercial Lines and Standard Personal Lines, and severities greater than $100,000 in our E&S Lines.
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Litigated matters not meeting the CCU criteria are handled within our litigation unit. Teams of litigation adjusters are aligned based upon jurisdictional knowledge and technical experience and are supervised by regional litigation managers. These claims are segregated from the CMSs to allow for focused management and application of specific technical expertise.
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Workers compensation claims 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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Low severity/high volume property claims are handled by the CSC. Certain complex claims that do not involve structural damage (i.e. employee dishonesty and equipment breakdown losses) are handled by a small group of specialists in the CSC.
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The Large Loss Unit ("LLU") handles complex property claims, typically those in excess of $100,000.
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All asbestos and environmental claims are referred to our specialized corporate Environmental Unit, which also handles other latent claims.
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The Construction Defect Unit unit handles larger, complex construction defect claims.
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All abuse and molestation claims have been centralized in one unit so as to apply the highest level of expertise possible to this emerging risk within the industry.
This structure allows us to provide experienced adjusting to each claim category.
The SIU, which investigates potential insurance fraud and abuse, and furthers efforts by regulatory bodies and trade associations to curtail the cost of fraud, supports all insurance operations. We have developed a proprietary SIU fraud detection model that identifies the potential fraud cases early on in the life of the claim. 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
We face substantial competition in the insurance marketplace, including from public, private, and mutual insurance companies, which in some cases may have lower cost of capital than we do. Many of our competitors, like us, rely on partners for the distribution of their products and services. Other insurance carriers either employ their own agents who only represent them or use a combination of distribution partners, captive agents, and direct marketing. The following provides information on the competition facing each of 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 primarily two types of companies, mostly on the basis of price, coverage terms, claims service, customer experience, safety management services, ease of technology usage, and financial ratings:
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Regional insurers, such as Acuity Insurance, American Family Insurance Group, Auto-Owners Insurance, Cincinnati Financial Corporation, Erie Indemnity Company, The Hanover Insurance Group, Inc., United Fire Group, Inc., and Westfield Insurance.
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National insurers, such as Chubb Limited, The Hartford Financial Services Group, Inc., Liberty Mutual Holding Company Inc., Nationwide Mutual Insurance Company, The Progressive Corporation, The Travelers Companies, Inc., and Zurich Insurance Group, Ltd.
Standard Personal Lines
Our Standard Personal Lines face competition primarily from the regional and national carriers noted above, as well as companies such as State Farm Mutual Automobile Insurance Company and Allstate Corporation. We also face competition from established direct-to-consumer insurers such as The Government Employees Insurance Company (GEICO) and The Progressive Corporation, which offer personal auto coverage.
E&S Lines
Our E&S Lines face competition from the E&S subsidiaries of the regional and national carriers named above, as well as the following companies:
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Nautilus Insurance Group, a member of W. R. Berkley Company;
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Colony Specialty, a member of the Argo Group International Holding Ltd;
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Western World Insurance Group, a member of the American International Group;
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Century Insurance Group, a member of the Meadowbrook Insurance Group;
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The Burlington Insurance Company, a member of IFG Companies;
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Scottsdale Insurance Company, an affiliate of Nationwide Mutual Insurance Company;
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United States Liability Insurance Group, a member of Berkshire Hathaway, Inc.;
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Cincinnati Financial Corporation; and
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Markel Corporation.
Other
Existing competitors and new entrants to the industry are developing new platforms that are leveraging digital technology to provide a lower cost "direct-to-the customer" and "pay-as-you-go" or "pay for use" models. These new platforms may offer the potential for enhanced customer experience, ease of understanding coverages, and streamlined claims processing. New competitors emerging under this digital platform include, but are not limited to, Lemonade, Next, and Metromile. Existing competitors leveraging new digital strategies to target small commercial customers directly include, Hiscox, The Progressive Corporation, Attune, a division of American International Group, and biBerk, a division of Berkshire Hathaway. Many of these new entrants have significant financial backing.
Insurance Regulation
Primary Oversight by the States in Which We Operate
Our insurance operations are heavily regulated. The primary public policy behind insurance regulation is the protection of policyholders and claimants against insurer insolvency and inappropriate business practices. Insurance regulation typically prioritizes policyholder and claimant protection 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 licensed. The types of activities that are regulated by the states include:
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Pricing and underwriting practices;
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Claims practices;
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Exiting geographic markets and/or canceling or non-renewing policies;
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Assessments for guaranty funds and second-injury funds and other mandatory assigned risks and reinsurance;
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The types, quality and concentration of investments we make;
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Minimum capital requirements for the Insurance Subsidiaries;
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Dividends from our Insurance Subsidiaries to the Parent; and
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Privacy and data security.
For additional 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: (i) significantly impact our business, liquidity, capital resources, results of operations, financial condition, and debt ratings; and (ii) cause our actual results to differ materially from historical or anticipated results. These non-exhaustive risk factors might affect, alter, or change our actions 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.
Risks Related to our Insurance Operations
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, including cyber-attacks, 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. In recent years, we have seen an escalation in global insured industry losses from catastrophes, with 2017 being the most costly year on record and 2018 being the third most costly year on record, as reported by various statistical reporting agencies. Whether this is a short-term phenomenon, or is part of a longer-term trend driven by climate change, other environmental factors, and development in areas more exposed to catastrophes, is subject to debate. 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 gasses 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 ISO's Property Claim Services unit. Most of the risks underwritten by our insurance operations are concentrated geographically in the Eastern and Midwestern regions of the country. Hurricanes continue to be our most significant catastrophic exposure, particularly in the Eastern states. However, tornadic activity in the Midwestern regions of the U.S. could also adversely impact our financial results. It also is possible that we could experience more than one severe catastrophic event in any given period.
Certain factors can impact our estimation of ultimate costs for catastrophes. Such factors can include inability to access portions of the impacted areas following a catastrophic event, scarcity of necessary labor and materials that delay repairs and increase our loss costs, regulatory uncertainties, including new interpretations of coverage, residual market assessment-related increases in our catastrophe losses, late claims reporting, and escalation of business interruption costs due to infrastructure disruption. The occurrence of a catastrophe close to the end of a reporting period also may limit the availability of information for estimating loss and loss expense reserves and it is possible that more detailed information about claims may be available later resulting in changes in reserves in subsequent periods.
Although catastrophes can cause losses in a variety of property and casualty insurance lines, most of our historical 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. Catastrophe 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 reinsurance 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.
Our loss and loss expense reserves may not be adequate to cover actual losses and expenses.
We must maintain loss and loss expense reserves for our estimated liability for loss and loss expense associated with reported and unreported insurance claims. Our estimates of reserve amounts are based on known facts and circumstances, including our expectations of the ultimate settlement and claim administration expenses, trends in claims severity and frequency, including the impact of inflationary trends on medical costs, predictions of future events, 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. Estimates of reserve amounts may be further impacted by unexpected increases in loss costs related to economic or social inflation, developments in tort law, and various state legislative initiatives, including expansion of statutes of limitations and
revisions to claims settlement practices standards. For example, several states in our principal operating areas are exploring expansion of the statute of limitations for previously time-barred civil suits alleging sexual abuse of a minor. This type of retroactive legislation may significantly increase insurance industry loss costs and require re-evaluation of previously established reserves. In addition, state initiatives such as legalization of marijuana may have significant impact on future loss development, as usage of this drug becomes more pervasive. Therefore, we cannot be certain that the reserves we establish are adequate or will be adequate in the future. From time-to-time, we increase reserves if they are inadequate or reduce them if they are redundant. 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 potentially 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 by Congress to December 31, 2020. TRIPRA rescinded all previously approved coverage exclusions for terrorism and requires private insurers and the U.S. 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 2019, our deductible is $339 million. For losses above the deductible, the federal government will pay 81% of losses to an industry limit of $100 billion, and the insurer retains 19%. The federal share of losses will be reduced by 1% to 80% in 2020. Although TRIPRA’s provisions 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. Additionally, if the U.S. Secretary of Treasury does not certify certain future terrorist events, it is possible we could be required to pay terrorism-related covered losses without TRIPRA's risk-sharing benefits. For example, the U.S. Secretary of Treasury did not certify either the 2013 Boston Marathon bombing or the 2015 San Bernardino, California shootings as terrorism events.
Under TRIPRA, terrorism coverage is mandatory for all primary workers compensation policies. Additionally, 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 2018, 89% of our Standard Commercial Lines non-workers compensation policyholders purchased terrorism coverage that included nuclear, biological, chemical, and radioactive ("NBCR") events.
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. Also, in addition to providing terrorism coverage for lines of business required and covered by TRIPRA, we sometimes choose to provide terrorism coverage for lines of business not included in TRIPRA, such as Commercial Automobile. 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.
If future legislation changes or eliminates TRIPRA, our exposure to terrorism losses could increase materially. If that happens, the measures we might take to mitigate our risk could impact our ability to write future business, or increase our reinsurance expense. We currently plan to continue providing coverage to our customers that includes protection from terrorism events, without the benefit of a conditional exclusion that would specifically exclude this coverage if TRIPRA was non-renewed. Therefore, in the event that TRIPRA is changed or eliminated, our exposure to losses from terrorism events will increase materially, which would have the potential to significantly negatively impact our results of operations and financial condition. Our current reinsurance programs generally provide coverage for conventional acts of foreign and domestic terrorism, but no coverage is afforded to NBCR events.
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 loss and loss expense is 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 fluctuate significantly, and do not necessarily correlate to our specific book of business experience. Most of our reinsurance contracts renew annually and may be impacted by the market conditions at the time of the renewal. Any decrease in the amount of our reinsurance will increase our risk of loss. Any increase in the cost of reinsurance that cannot be passed on to our policyholders will reduce our earnings. If we are unable to obtain reinsurance in amounts that we expected or on acceptable terms, our ability to write future business could be adversely affected, our reinsurance expenses could increase, or we might assume more risk for losses on aggregate or individual losses than we currently do.
We are exposed to credit risk.
We are exposed to credit risk in several areas of our insurance operations, including from:
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Our reinsurers, who are obligated to us under our reinsurance agreements. During periods of high catastrophe loss activity, amounts recoverable from our reinsurers and the correlated credit risk can increase quickly and significantly, fluctuating over time. Our reinsurers also often rely on their own reinsurance programs, or retrocessions, to manage their exposure to large losses. Any limitations on or the inability of our reinsurers to collect on their retrocession programs, or reinstate coverage after a large loss, particularly given the relatively small size of the global reinsurer community, may impair their ability to pay our reinsurance claims. Accordingly, we have direct and indirect counterparty credit risk from our reinsurers. We attempt to mitigate our direct and indirect counterparty credit risk from our reinsurers by: (i) pursuing relationships with reinsurers rated “A-” or higher by A.M. Best; and/or (ii) obtaining collateral to secure reinsurance obligations.
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Certain life insurance companies if they fail to fulfill their obligations to those customers for whom we have purchased annuities under structured settlement agreements.
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Some of our distribution partners, who collect premiums due us from our customers.
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Some of our customers, who are responsible for payment of premiums and/or deductibles directly to us.
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The invested assets in our defined benefit plan, which partially fund our liability associated with this plan. To the extent that credit risk adversely impacts the valuation and performance of the invested assets in our defined benefit plan, the funded status of the defined benefit plan could be adversely impacted and, if so, the expense of the plan and our obligations under it could increase.
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 U.S. and throughout the world and volatility in financial and insurance markets may materially affect our results of operations. Factors such as business and consumer confidence, unemployment levels, 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. During 2018, 32% of DPW in our Standard Commercial Lines business was based on payroll/sales of our underlying customers. An economic downturn in which our customers experience declines in revenue or employee count could 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. Adverse economic conditions 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.
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. For additional information on our current financial strength ratings, refer to "Overview" in Item 1. "Business." of this Form 10-K.
A significant financial strength 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 with a specified minimum rating. 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), so a downgrade could create a default leading to an acceleration of any outstanding principal. Such an event also could trigger default provisions under certain of our other debt instruments and negatively impact our ability to borrow in the future.
Nationally recognized statistical rating organizations ("NRSROs") also rate our long-term debt creditworthiness. Credit ratings indicate the ability of debt issuers to meet 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 the possible rating actions NRSROs might take that could adversely affect our business or our potential actions in response.
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, insured loss levels, and industry capital levels that may fluctuate in response to changing rates of return on insurance industry investments. Pricing also is influenced by the operating performance of insurers, who may increase pricing to meet return on equity objectives. Consequently, the insurance industry historically has had cycles characterized by periods of intense price competition from excess underwriting capacity and periods of favorable pricing driven by shortages of underwriting capacity and poor insurer operating performance. If competitors price business below technical levels, we might decide it is appropriate to reduce our profit margin to retain our best business.
We compete with regional, national, and direct-writer property and casualty insurance companies for customers, distribution partners, and employees. Some competitors are public stock companies, some are mutual companies, and some are reciprocal insurers. Many competitors are larger and may have lower operating costs, lower cost of capital, or the ability to absorb greater risk while maintaining their financial strength ratings. Other competitors, such as mutual or reciprocal companies, are cooperatively owned by insureds and do not have shareholders who evaluate return on equity performance. 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 limit our ability to maintain or increase our profitability. Because of its relatively low cost of entry, the Internet has emerged as a significant competitive new marketplace where existing and new competitors have platforms. Established insurance competitors, such as Chubb Limited and The Progressive Corporation, are beginning to explore broader offerings through this digital platform, while new insurance competitors continue to emerge, including, but are not limited to, Lemonade and Attune. Reinsurers also have entered certain primary property and casualty insurance markets to diversify their operations and compete with us. Because the Internet makes it easier to bundle products and services, it also is possible that companies doing business on the Internet could enter the insurance business in the future or form strategic alliances with insurers. Changes in competitors and competition, particularly on the Internet, 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.
Insurers rely on access to reliable data about their customers and loss experience to build complex analytics and predictive models that assess risk profitability, adverse claim development potential, recovery opportunities, fraudulent activities, and customer buying habits. We expect the use of data science and analytics will continue to increase and become more complex and accurate, particularly with the use of larger amounts of relevant data. Some of our competitors, particularly larger national carriers, have significantly larger volumes of data about the performance of the risks they have underwritten. It is possible that the loss experience from our insurance operations, particularly the more limited experience data we have related to our E&S business acquired in 2011, may not be sufficiently large or granular in all circumstances to analyze and project our future costs as accurately as our larger competitors. To supplement our data, we use industry loss experience data from ISO, AAIS, and NCCI. While relevant, industry data may not correlate specifically to the performance of risks we have underwritten and may not be as predictive as if we had more data on our book of business. Because we use and rely on the aggregated industry loss data assembled by ISO, AAIS, NCCI and other similar rating bureaus under the anti-trust exemptions of the McCarran-Ferguson Act, we likely would be at a competitive disadvantage to larger insurers with more loss experience data on their book of business if Congress repealed the McCarran-Ferguson Act.
We depend on distribution partners.
We market and sell our insurance products through independent distribution partners who are not our employees. We believe that these independent partners will remain a significant force in overall insurance industry premium production because they provide insurance and risk management expertise and advice to customers, particularly small businesses and individuals, who otherwise do not have it or cannot afford either the time or expense to acquire it. We also believe that some commercial customers, particularly smaller commercial businesses, will continue to use independent distribution partners for the potential customer and business referrals independent distribution partners may provide. Independent distribution partners also generally provide customers with a wider choice of insurance products than those who represent or are employed by only one insurer. Our reliance on independent distribution partners, however, present challenges and risks, including the following:
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The availability of products from multiple markets 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.
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Growth in our market share is dependent, in part, on growth in the market share controlled by our distribution partners. Independent retail insurance agencies control 84% of Standard Commercial Lines business but only 35% of Standard Personal Lines business in the U.S. Consequently, our Standard Personal Lines market opportunity could be more limited. Over the last several years, more competitors are focused on lower cost "direct to customer" distribution models based on technological developments and efficiencies. Continued advancements in "direct to customer" distribution models may impact the overall market share controlled by our distribution partners and make it more difficult for us to grow or require us to establish relationships with more distribution partners.
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There has been an increasing trend of consolidation among our independent distribution partners, particularly by private-equity-backed entities and publicly-traded insurance brokers ("aggregators"). As more of our independent distribution partners consolidate and become larger, their influence on our business and premium production can increase. For example, they could direct the business they produce to be consolidated with a smaller group of insurance carriers, which may or may not include us. With their increased size and control of meaningful amounts of business, they could also increase insurance carrier costs through requiring higher base and supplemental commissions to place business. Aggregators accounted for approximately 28% of our DPW at December 31, 2018. Currently, no one distribution partner is responsible for 10% or more of our combined insurance operations' premium.
Our financial condition and results of operations are tied to the successful marketing and sales efforts of our products by our independent distribution partners. In addition, under insurance laws and regulations and common law, we may have liability for the business practices of, or actions taken by, our independent distribution partners.
Expansion of our insurance offerings and geographic footprint may create additional risks
Part of our growth strategy includes measured geographic and product expansion. In 2017, we established a Southwest Region and began writing Standard Commercial Lines in Arizona. In 2018, we expanded our Standard Commercial Lines operations into Colorado, New Mexico, and Utah and, later in the year, began offering Standard Personal Lines products in Arizona and Utah. In our Northeast Region, we also expanded our Standard Commercial Lines business into New Hampshire in 2017. We expect to continue to diversify our book of business through geographic and product expansion. Although diversification of our business is beneficial to our competitive position and long-term results, it exposes us to increased and different risks, including catastrophic natural risks to which we previously only had limited exposure due to our narrower geographic footprint and risks related to insurance regulations in the expansion states. These new risks could have a material adverse effect on our results of operations, liquidity, financial condition, financial strength, and debt ratings.
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 insurance laws and regulations that can change on short notice. 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 primary public policy behind insurance regulation is the protection of policyholders and claimants against insurer insolvency and inappropriate business practices. Insurance regulation typically prioritizes policyholder and claimant protection over all other constituencies, including shareholders. 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. because most states have enacted variations of model laws and regulations that permit their insurance department to be accredited by the NAIC and have their regulatory examinations and other work be given full faith and credit by other state regulators. Despite their general similarity, state insurance laws and regulations do vary by jurisdiction. The types of insurance activities regulated by the states include:
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Pricing and underwriting practices;
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Claims practices;
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Exiting geographic markets and/or canceling or non-renewing policies;
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Assessments for guaranty funds and second-injury funds and other mandatory assigned risks and reinsurance;
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The types, quality, and concentration of investments we make;
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Dividends from our Insurance Subsidiaries to the Parent; and
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The acquisition of 10% or more of the stock of a company such as Selective, which is an insurance holding company that owns 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 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 our Insurance Subsidiaries or us 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 also are subject to federal legislation and administrative policies related our insurance business, including TRIPRA, OFAC, 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. By issuing workers compensation policies, we are subject to Mandatory Medicare Secondary Payer Reporting under the Medicare, Medicaid, and SCHIP Extension Act of 2007. As a publicly traded company, we also are subject to Federal securities laws, including the Sarbanes-Oxley Act and the Dodd-Frank Act. If Congress were to enact laws affecting the oversight of insurer solvency and state regulators remained responsible for rate approval, it is possible that we could be subject to a conflicting and inconsistent regulatory framework that could impact our profitability and capital adequacy.
The European Union enacted Solvency II, which was implemented in 2016 and sets out new requirements for capital adequacy and risk management for insurers operating in Europe. The strengthened regime is intended to reduce the possibility of consumer loss or market disruption in insurance. 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 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 requires companies to file an internal assessment of their solvency with insurance regulators annually. Although no specific capital adequacy standard currently is articulated in ORSA, it is possible that such a standard could be developed over time that might increase minimum capital requirements for insurers and 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. To some degree, these regulators can overlap each other and have different interpretations and/or regulations on the same legal issues. Consequently, we have the risk that one regulator’s position or interpretation may conflict with that of another regulator on the same issue and that they may 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.
Class action litigation could affect our business practices and financial results.
Class action litigation has been filed from time-to-time against our industry, related to the following issues:
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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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Prompt and appropriate payment of personal injury protection claims;
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Direct repair shop utilization practices;
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The use of after-market replacement parts;
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Flood insurance claim practices; and
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Shareholder class action suits.
If we were named as a defendant in class action litigation, we could suffer reputational harm with our customers, other purchasers of insurance, shareholders, and the general public. Expenses for the related litigation defense could have a materially adverse effect on our operations or results.
Risks Related to Our Investments Segment
We are exposed to interest rate 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. Recent economic data points to increased U.S. and global economic growth, continued low levels of unemployment, and signs of rising wages, which compounded with the potential for the pro-growth benefits of the Tax Cuts and Jobs Act of 2017 ("Tax Reform") and the potential for higher federal budget deficits, has recently led to rising U.S. 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 securities portfolio, which currently has an effective duration of 3.8 years, 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 or create a net unrealized loss. This would be 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. This may include investing in floating rate securities, which currently represent 16% of our fixed income portfolio, and other shorter duration securities that exhibit low effective duration and interest rate risk, but expose the portfolio to other risks, including the risk of a change in credit spreads, liquidity spreads, and other factors that may adversely impact the
value of the portfolio, including a decline in short-term interest rates, such as the 90-day London Interbank Offered Rate ("LIBOR"), which would result in lower yields and lower net investment income from our floating rate securities. 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.
Many of our floating rate securities are tied to the U.S. dollar-denominated LIBOR, which will be eliminated by the end of 2021. LIBOR is used to calculate interest rates for numerous types of debt obligations, including personal and commercial loans, interest rate swaps, and other derivative products, making it a primary metric in the global banking system. LIBOR is set every business day in numerous currencies and maturities, based on estimates submitted by major banks. In the wake of the financial crisis, several banks were discovered to have doctored estimates in order to manipulate LIBOR, promoting a push for submissions based on actual interbank loans. According to the U.K. Financial Conduct Authority ("FCA"), the interbank lending market slowed in recent years, resulting in a lack of data on which to base LIBOR estimates and therefore susceptible to further fraud. The FCA determined that, without an active market to support estimates, LIBOR should not be used as a benchmark rate. In anticipation of the elimination of LIBOR, the U.S. Federal Reserve established the Alternative Reference Rates Committee (ARRC) to select a replacement index for U.S. Dollar LIBOR. ARRC, comprised of a group of large domestic banks and regulators, voted to use a benchmark based on short-term loans backed by Treasury securities, known as repurchase agreements or "repo" trades. ARRC is expected to announce a transition plan for the new rate. We are unsure whether the elimination of LIBOR and the transition to a new rate will have any impact on the performance of our floating rate securities.
We are exposed to credit risk in our investment portfolio.
The value of our investment portfolio is subject to credit risk from the issuers and/or guarantors and insurers of the securities we hold and other counterparties in certain transactions. Defaults on any of our investments by any issuer, guarantor, insurer, or other counterparties 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 obligations. Changes in the financial market environment and general sentiment about the broad economy may impact the credit spreads demanded by fixed income investors and negatively impact the fair market value of our fixed income securities. At December 31, 2018, our fixed income securities portfolio represented approximately 89% of our total invested assets. Approximately 98% of these fixed income securities were investment grade and 2% were rated below investment grade, resulting in an average credit rating of AA- for our fixed income securities portfolio. Our fixed income portfolio spread duration, which reflects the portfolio's sensitivity to changes in credit spread, is currently 4.4 years. Over time, our exposure to below investment grade securities and other credit sensitive risk assets may fluctuate as we continue to diversify the portfolio and add or reduce risk commensurate with market conditions and our risk-taking capacity. Events adversely impacting issuers or guarantors of fixed income securities, such as a major economic downturn, acts of corporate malfeasance, widening credit spreads, budgetary deficits, and municipal bankruptcies spurred by, among other things, pension funding issues, 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.
Economic uncertainty could adversely affect the credit quality of fixed income issuers or guarantors, and a ratings downgrade in any of our holdings could cause the value of our fixed income securities portfolio and our net income to decrease. As our stockholders' equity is leveraged to our investment portfolio at 3.3:1, 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 our residential mortgage-backed securities ("RMBS"), commercial mortgage-backed securities ("CMBS"), collateralized loan obligations ("CLOs"), and other asset-backed securities ("ABS"), including structured note obligations, and our intent and ability to hold securities that have declined in value until recovery. If we reposition or realign portions of the portfolio and 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 related to interest rates, credit spreads, equity prices, and market value fluctuations in our alternative investment portfolio. We could experience a decline in both income and our investment portfolio asset values related to many different scenarios, including: (i) a decrease in market liquidity; (ii) fluctuations in interest rates; (iii) decreased dividend payment rates; (iv) negative market perception of credit risk with respect to types of securities in our portfolio; (v) a decline in the performance of the underlying collateral of our RMBS, CMBS, CLOs,
and other ABS; (vi) reduced returns on our alternative investment portfolio; or (vii) 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 3.2:1 ratio to our investment portfolio.
Economic uncertainty could adversely affect the credit quality and ratings of securities in our portfolio. If the NAIC were to apply a more adverse class code on a security than was originally assigned, our statutory surplus could be adversely affected because securities with NAIC class codes three through six are carried at fair market value and securities with NAIC class codes of one or two are carried at amortized cost under statutory accounting rules. For those securities carried at fair market value, see the risk factor immediately following regarding the risks around the methodologies used in determining these valuations.
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, 2018. As accounting rules require, we have categorized these securities into a three-level hierarchy based on the priority of the inputs to the respective valuation technique:
1.
The highest priority is given to quoted prices in active markets for identical assets or liabilities (Level 1).
2.
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).
3.
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, 2018, approximately 1% of our fixed income securities were priced with Level 1 inputs and 98% of our fixed income securities were priced with Level 2 inputs. However, prices provided by independent pricing services and brokers 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 when the evaluations are made. There can be no assurance that management has accurately assessed the level of impairments taken as reflected in our Financial Statements. Additional impairments may need to be taken in the future. It also is possible that interest rates, currently below historical averages, will increase. If they do, net unrealized gains may be reduced and net unrealized losses associated with declines in value strictly related to such interest rate movements may result. If that happens and we sell those impacted securities, we could experience realized losses or increased OTTI if we determine we do not have the ability and intent to hold those securities until they recover in value. Because our investment managers actively manage our fixed income securities portfolio, our OTTI also may fluctuate from period-to-period if the value of securities we may intend to sell despite being in an unrealized loss position increases. Historical impairment trends may not be indicative of future events. For further information about 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.
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 private equity, private credit, and real assets. Since the primary assets or liabilities underlying the investments in these limited partnerships generally do not have quoted prices in active markets for the same or similar assets, the valuation of our interests in these limited partnerships is subject to (i) a higher level of subjectivity and unobservable inputs than substantially all of our other investments and (ii) greater scrutiny and reconsideration from one reporting period to the next. Because these limited partnership investments are recorded under the equity method of accounting, any valuation decreases could negatively impact our results of operations. We currently expect to increase our allocation to these investments, which may result in additional variability in our net investment income.
Changes in tax law could adversely affect our investments results.
Changes in the tax laws and regulations of U.S. federal, state, and local governments may adversely impact us. Our investment portfolio benefits from tax exemptions and certain other tax law advantages, including those governing dividends received and tax-advantaged municipal bond interest. Future federal and/or state tax law changes could lessen or eliminate some or all of these favorable tax advantages, negatively impact the value of our investment portfolio, and materially and adversely impact our results of operations. It also is possible that the elimination of the state and local tax deduction (the "SALT deduction") for U.S. taxpayers filing Federal income tax returns could negatively impact the financial strength of issuers of state and local municipal securities in our portfolio, reduce the value of our investment portfolio, and materially and adversely impact our results of operations. The SALT deduction elimination and the reduction of mortgage interest deductibility to purchase money mortgages of $750,000 or less also could adversely impact the value or volatility of residential real estate markets, which would impact various classes of our investments, such as residential mortgage-backed securities and other asset classes backed by mortgages, or real estate. Ultimately, this could reduce the value of our investment portfolio, and materially and adversely impact our results of operations.
Uncertainty regarding domestic and international political developments and their impact on the economy could lead to investment losses, which may adversely affect our results of operations, financial condition, liquidity, and debt ratings.
As a property and casualty insurance holding company, 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. 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 RMBS, CMBS, CLOs, and other ABS. The current political climate has created more uncertainty about U.S. domestic and foreign policy that may elevate the volatility of the financial markets and adversely impact our investment portfolio.
Our notes payable and line of credit are subject to certain debt-to-capitalization restrictions and net worth covenants that a significant decline in investment value could impact. Significant future declines in investment value also could require further OTTI charges. Depending on future market conditions, such as an extreme prolonged market event like the global credit crisis, we could incur additional realized and unrealized losses in future periods that could adversely impact our results of operations, financial condition, debt and financial strength ratings, and our ability to access capital markets.
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.
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, 2018, the Parent had retained earnings of $1.9 billion. Of this amount, $1.7 billion was related to investments in our Insurance Subsidiaries. In 2019, the Insurance Subsidiaries have the ability to provide for $210 million in ordinary annual dividends to us in 2019 under applicable state regulation; but 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 19. “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.
In addition to regulatory restrictions on the availability of dividends that our Insurance Subsidiaries can pay to the Parent, the maximum amount of dividends the Parent can pay to our shareholders is limited by certain New Jersey corporate law provisions that limit dividends if either: (i) the Parent would be unable to pay its debts as they became due in the usual course of business; or (ii) the Parent’s total assets would be less than its total liabilities. The Parent’s ability to pay dividends to shareholders also are impacted by covenants in its Line of Credit agreement that obligate it, among other things, to maintain a minimum consolidated net worth, statutory surplus, and debt-to-capital ratio. For additional details about the Line of Credit’s financial covenants, see Note 10. “Indebtedness” 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:
•
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
•
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 Evolving Legislation and Public Policy Debates
We face risks regarding our flood business because of uncertainties regarding the NFIP.
We are the fifth largest insurance group in the WYO arrangement of the NFIP, which is managed by the Mitigation Division of FEMA in the U.S. Department of Homeland Security. Under the arrangement, we receive an expense allowance for policies written and a servicing fee for claims administered, and all losses are 100% reinsured by the Federal Government. The current expense allowance is 30.0% of DPW. The servicing fee is the combination of 0.9% of DPW and 1.5% of incurred losses.
As a WYO carrier, we are required to follow certain NFIP procedures in the administration of flood policies and claims. Some of these requirements may differ from our normal business practices and may present a reputational risk to our brand. While insurance companies are regulated by the states and the NFIP requires WYO carriers to be licensed in the states in which they operate, the NFIP is a federal program and WYO carriers are fiscal agents of the U.S. Government and must follow the NFIP's directives. Consequently, we have the risk that directives from the NFIP and a state regulator on the same issue may conflict.
The NFIP was authorized until May 31, 2019, as a short-term solution while Congress continues to debate a more comprehensive proposal. There continues to be significant public policy and political debate in Congress about an extension of the NFIP, appropriate compensation for the WYO carriers, and solutions for flood risk throughout the country. Effective October 2018, FEMA, on its own initiative, revised the arrangement by: (i) reducing the WYO’s expense allowance by 0.9 points, from 30.9% to 30.0%; and (ii) eliminating the provision allowing FEMA to increase a WYO’s expense allowance by one percentage point to cover additional incurred expenses.
Our flood business could be impacted by: (i) a lapse in program authorization; (ii) further changes to WYO carrier compensation; (iii) any mandate for primary insurance carriers to provide flood insurance; or (iv) private writers becoming more prevalent in the marketplace. The uncertainty created by the public policy debate and politics of flood insurance reform makes it difficult for us to predict the future of the NFIP and our continued participation in the program.
We are subject to risk that enacted legislation might significantly change insurance regulation and adversely impacts our business, financial condition, and/or the results of operations.
We cannot predict what federal and state rules or legislation will be proposed and 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.
In 2009, Congress passed the Dodd-Frank Act to address corporate governance and control issues identified in the financial crises in 2008 and 2009 and the non-insurance subsidiaries of American International Group, Inc. One of the key Dodd-Frank Act provisions created the FIO as part of the U.S. Department of Treasury to advise the federal government on insurance issues. Another Dodd-Frank Act provision requires the Federal Reserve, through the Financial Services Oversight Council (“FSOC”), to supervise financial service firms designated as systemically important financial institutions ("SIFI"). We are not and do not expect to be designated as a SIFI. Included among Dodd-Frank's corporate governance reforms for public companies were proxy access, say-on-pay, and other compensation and governance issues. A number of Dodd-Frank reform bills have been introduced, but it is uncertain whether any proposal will pass into law.
In general, the Trump Administration and the current Republican Senate majority favor less federal involvement in insurance. Legislative proposals, however, could involve the federal government directly in regulating the business of insurance. President Trump and the Republican Senate majority favor the repeal of the Affordable Care Act ("ACA"). Repeal of the ACA presents some legal and practical challenges. Some reform proposals include a provision to permit sales of insurance across state lines, which is not permitted under current federal law without approval of the respective state insurance regulators. Some ACA reforms call for the elimination of the anti-trust exemptions for health insurers under the McCarran-Ferguson Act ("MFA"). While we are not a health insurer, property and casualty insurers operate under anti-trust exemptions that permit the aggregation of claims and other data in numbers actuarially and statistically sufficient to price insurance. If the MFA were repealed for the property and casualty industry, we would have to seek a business practices exemption from the Department of Justice to share information with other insurers. In the election of November 2018, the Republicans lost their majority in the House of Representatives. Given the Democratic House Majority, we do not expect ACA repeal to be advanced for the foreseeable future. The Democratic House, however, may advance public policy positions or legislation focused on consumer issues and/or disclosures that may impact the manner in which we conduct our insurance operations. We cannot predict the impact that such a public policy debate or legislative event could have on our product and services supplier relationships, results of operations, liquidity, financial condition, financial strength, and debt ratings.
Legislative and regulatory proposals in various states sometimes seek to limit the ability of insurers to assess insurance risk, including limiting or prohibiting the use of certain factors or predictive measures in property and casualty underwriting such as insurance scores and marketplace considerations. There are also proposals from time-to-time to impose new or higher standards on claims settlement practices. These proposals, if enacted, could impact underwriting pricing, loss and loss expenses, and results of operations.
Legislative and regulatory proposals and public policy debates in various states and among legal experts also impact tort and insurance law, positively and negatively in relation to our business. For example, tort reform proposals may limit the amounts recoverable for certain torts or limit the statute of limitations on certain torts. Conversely, there are proposals to expand, in some cases retroactively, the statute of limitations for certain torts or misdeeds, such as sexual abuse and molestation. Further, legal expert groups like the American Law Institute ("ALI") traditionally have summarized and restated the common law in various areas. The ALI's Restatement of the Law, Liability, Insurance, expected to be published in 2019, differs from traditional restatements and offers concepts about insurance law that are not established in legal precedents. Depending on the proposal or initiative, if enacted or adopted, underwriting pricing, loss and loss expenses, and results of operations could be impacted positively or negatively.
Because some of our claims cannot be settled and are litigated, our loss and loss expenses may be impacted by our ability to promptly try cases. State court systems, in which many of our litigated claims cases reside, are subject to legislative funding, which is not always to the levels requested by the judicial branch. Consequently, some courts have overcrowded dockets, particularly with criminal, family, and small claims matters. According to the National Center for State Court's Court Statistic's Project, www.courtstatistics.org, tort cases, which represent the great majority of insurance claims cases, only represent between two and four percent of most state court dockets. Only one percent of those tort cases in which evidence is introduced - whether before a judge or a jury - wind up being tried to completion. Most cases settle and, with fewer cases being tried and
appealed, there are fewer reported judicial decisions that contribute to the common law. We are unsure as to the ultimate impact that crowded court dockets may have on our loss and loss expenses, and results of operations.
Risks Related to Our General Operations
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 the use of above average operational leverage, which can be measured as the ratio of NPW to our equity or policyholders surplus. We balance operational leverage risk with a number of risk management strategies within our insurance operations to achieve a balance of growth and profit and to reduce our exposure. These strategies include, but are not limited to, the following:
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Being disciplined in our underwriting practices;
•
Being prudent in our claims management practices, establishing adequate loss and loss expense reserves, and placing appropriate reliance on our claims analytics;
•
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;
•
Continuing to develop our customer experience platform as we grow in our understanding of customer segmentation;
•
Purchasing reinsurance and using catastrophe modeling;
•
Being disciplined in our monitoring of, and management over, our ERM framework; and
•
Being prudent in our financial planning process, which supports our underwriting strategies.
We also maintain a conservative approach to our investment portfolio management and employ risk management strategies that include, but are not limited to:
•
Being prudent in establishing our investment policy and appropriately diversifying our investments, which supports our liabilities and underwriting strategies;
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Using models to analyze historical investment performance and predict future investment performance under a variety of scenarios using asset concentration, asset volatility, asset correlation, and systematic risk; and
•
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.
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.
Our predictive models for underwriting, claims, and catastrophe losses, 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, particularly if we experience a privacy breach; 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.
Rapid development of new technologies may result in an unexpected impact on our business and the insurance industry overall.
Development of new technologies continues to impact all aspects of business and individuals’ lives at rapid speed. Often such developments are positive, gradually improving standards of living, the speed of communications, and fostering the development of more efficient processes. The rapid development of new technologies, however, also presents challenges and risks. Examples of such emerging risks include, but are not limited to:
•
Change in exposures and claims frequency and/or severity due to unanticipated consequences of new technologies and their use. For example, technologies have been developed and are being tested for autonomous self-driving
automobiles. It is unclear and we cannot predict the corresponding impact on automobile claims. It is possible that these technological developments will affect the profitability and demand for automobile insurance.
•
Changes in how insurance products are marketed and purchased due to the availability of new technologies and changes in customer expectations. For example, comparative rating technologies, which are widely used in personal lines insurance, facilitate the process of efficiently generating quotes from multiple insurance companies. This technology makes differentiation based upon factors other than pricing more difficult and has increased price comparisons, resulting in a higher level of quote activity with a lower percentage of quotes becoming new business written. These trends may continue to accelerate and may affect other lines of business, which could put pressure on our future profitability and growth.
•
New technologies may require the development of new insurance products without the support of sufficient historical claims data for us to continue to compete effectively for our distribution partners' business and customers.
We depend on key personnel.
To a large extent, our business' success depends on our ability to attract and retain key employees. Competition to attract and retain key personnel is intense. While we have employment agreements with certain key managers, all of our employees are at-will employees and we cannot ensure that we will be able to attract and retain key personnel. As of December 31, 2018, our workforce had an average age of approximately 47 and approximately 18% of our workforce was retirement eligible, which we define as including individuals who are 55 years of age and have 10 or more years of service.
We are subject to a variety of modeling risks, which could have a material adverse impact on our business results.
We rely on internally or third-party developed complex financial models, such as those that predict underwriting results on individual risks and our overall portfolio, claims fraud, impacts from catastrophes, enterprise risk management capital scenarios, and investment portfolio changes, 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 in the assumptions made in them could lead to increased losses. We believe that statistical models alone do not provide a reliable method for monitoring and controlling risk and are tools that do not substitute for the experience or judgment of senior management.
We are subject to attempted cyber-attacks and other cybersecurity risks.
Our business heavily relies on various information technology and application systems that are connected to, or may be accessed from, the Internet and may be impacted by a malicious cyber-attack. Our systems also contain proprietary and confidential information, including personally identifiable information, about our operations, our employees, our agents, our customers, and their employees and property. A malicious cyber-attack on our systems or those of our vendors may interrupt our ability to operate and impact our results of operations. We have and expect to continue to: (i) implement employee education programs and tabletop exercises; and (ii) develop and invest in a variety of controls to prevent, detect, and appropriately react to cyber-attacks, including frequently testing our systems' security and access controls.
Cyber-attacks 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 our systems or data security could damage our reputation and/or result in monetary damages that, 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 breach, it is possible that one might occur. We have insurance coverage for certain cybersecurity risks, including privacy breach incidents, that provides protection up to $20 million above a deductible of $1 million. In addition, within our Standard Commercial Lines segment, we offer cyber-related insurance products for which we have mitigated the majority of the related risk through protection under our reinsurance treaties.
Given the increased number of identity thefts from cyber-attacks, federal and state policymakers have, and will likely continue to propose increased regulation of the protection of personally identifiable information and appropriate protocols after a related cybersecurity breach. The New York Department of Financial Services recently adopted a cyber protection and reporting regulation for financial services companies with which we are complying. The NAIC also has adopted a model regulation based on the New York regulation, which several states adopted in 2018, and we expect other states will consider adopting in 2019. California passed a broad-reaching new Consumer Privacy Act in 2018 that layers additional obligations and penalties on companies that collect a variety of personal information. Compliance with these regulations and efforts to address continually developing cybersecurity risks may result in a material adverse effect on our results of operations, liquidity, financial condition, financial strength, and debt ratings.
Changes in tax law could adversely affect our results of operations and financial condition.
We are subject to the tax laws and regulations of U.S. federal, state, and local governments, and their amendment could adversely impact us. For example, the U.S. tax code was recently amended to reduce the federal corporate income tax rate from 35% to 21% effective for the 2018 tax year. As a result, our deferred tax assets were reduced and we were required to recognize a reduction of a previously-recognized federal tax benefit in the fourth quarter of 2017 when enacted. Potential future tax rule changes may increase or decrease our actual tax expense and could materially and adversely affect our results of operations.
If we experience difficulties with outsourcing relationships, our ability to conduct our business might be negatively impacted.
We currently outsource certain business and administrative functions to third parties for expediency, efficiency and economies of scale and this outsourcing may increase in the future. If we or our third-party partners falter in the development, implementation, or execution of our outsourcing strategies, we may experience operational difficulties, increased costs, and customer losses that may have a material adverse effect on our results of operations or financial condition. We have supplemental staffing service agreements with multiple consulting, information technology, and service providers that supply approximately 50% of our skilled technology capacity. These resources are principally based in the U.S., although some of the resources are foreign. The impact of the recently-enacted U.S. tax reform on the availability and cost of these services is still uncertain.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
Our headquarters are located in a 315,000 square foot structure on a 56 acre site zoned for office and professional use in Branchville, New Jersey. The site is owned by a subsidiary, which also owns abutting property in Frankford, New Jersey. We lease all of our other facilities. The principal office locations related to our insurance operations 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 any potential ultimate liability in such ordinary course claims litigation will not be material to our consolidated financial condition, results of operations, or cash flows after consideration of provisions made for potential losses and costs of defense.
From time to time, our Insurance Subsidiaries also are named as defendants 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. Similarly, our Insurance Subsidiaries are also named from time-to-time in individual actions seeking extra-contractual damages, punitive damages, or penalties, some of which allege bad faith in the handling of insurance claims. We believe that we have valid defenses to these cases. We expect that any potential ultimate liability in any such lawsuit will not be material to our consolidated financial condition, after consideration of provisions made for estimated losses. Nonetheless, given the inherent unpredictability of litigation and the large or indeterminate amounts sought in certain of these actions, an adverse outcome in certain matters could possibly have a material adverse effect on our consolidated results of operations or cash flows in particular quarterly or annual periods.
As of December 31, 2018, we do not believe the Company or any of the Insurance Subsidiaries was a defendant in any legal action that could have a material adverse effect on our consolidated financial condition, results of operations, or cash flows.
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.”
(b) Holders
We had 3,122 stockholders of record as of February 7, 2019 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. We currently expect to continue to pay quarterly cash dividends on shares of our common stock in the future.
On October 25, 2018, the Board of Directors approved an 11% increase in our dividend to $0.20 per share. In addition, on January 31, 2019, the Board of Directors declared a $0.20 per share quarterly cash dividend on common stock that is payable March 1, 2019, to stockholders of record as of February 15, 2019.
(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, 2018:
1Weighted average remaining contractual life of options is 0.8 years.
2Includes 429,181 shares available for issuance under our Employee Stock Purchase Plan (2009); 1,776,359 shares available for issuance under the Stock Purchase Plan for Independent Insurance Agencies; and 3,461,192 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, 2013 and ending December 31, 2018, 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 2018:
1These shares were purchased from employees in connection with the vesting of restricted stock units and option exercises. These repurchases were made to satisfy tax withholding obligations and/or option costs with respect to those employees.
Item 6.
Item 6. Selected Financial Data.
1Effective January 1, 2018, changes in unrealized gains and losses on our equity portfolio are recognized in income through "Net unrealized losses on equity securities" on our Consolidated Statements of Income, as a result of our adoption of the Financial Accounting Standards Board issued Accounting Standards Update 2016-01, Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities. See Note 3. "Adoption of Accounting Pronouncements" in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K for additional information.
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 business environment that changes constantly, and new risk factors may emerge at any time. We can neither predict these new risk factors nor assess their impact, if any, on our businesses or the extent to which any new factor or combination of factors may cause actual results to differ materially from any forward-looking statements. In light of these risks, uncertainties and assumptions, it is possible that the forward-looking events discussed in this report might not occur.
Introduction
We classify our business into four reportable segments, which are as follows:
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Standard Commercial Lines;
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Standard Personal Lines;
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E&S Lines; and
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Investments.
For further details regarding these segments, refer to Note 1. "Organization" and Note 11. "Segment Information" included in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
Our Standard Commercial and Standard Personal Lines products and services are written through our nine insurance subsidiaries, some of which write flood business through the NFIP's WYO. Our E&S Lines products and services are written through one subsidiary, Mesa Underwriters Specialty Insurance Company ("MUSIC"). This subsidiary provides us with a nationally-authorized non-admitted platform to offer insurance products and services to customers who generally cannot obtain coverage in the standard marketplace.
Our ten insurance subsidiaries are collectively referred to as the "Insurance Subsidiaries."
In Management's Discussion and Analysis ("MD&A"), we will discuss and analyze the consolidated results of operations and financial condition, as well as known trends and uncertainties that may have a material impact in future periods, including the following:
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Critical Accounting Policies and Estimates;
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Financial Highlights of Results for Years Ended December 31, 2018, 2017, and 2016;
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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, 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. We can offer no assurance that actual results will be the same as those estimates, and it is possible they will differ materially. Those estimates that were most critical to the preparation of the Financial Statements involved the following: (i) reserves for loss and loss expense; (ii) pension and post-retirement benefit plan actuarial assumptions; (iii) investment valuation and other-than-temporary-impairments (“OTTI”); and (iv) reinsurance.
Reserves for Loss and Loss Expense
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of the loss to us, and our payment of that loss. To recognize liabilities for unpaid loss and loss expense, insurers establish reserves as balance sheet liabilities representing an estimate of amounts needed to pay reported and unreported net loss and loss expense. We had accrued $3.9 billion of gross loss and loss expense reserves and $3.4 billion of net loss and loss expense reserves at December 31, 2018. At December 31, 2017, these gross and net reserves were $3.8 billion and $3.2 billion, respectively. The Insurance Subsidiaries' liability duration was approximately 3.6 years at December 31, 2018, down from 3.8 years at December 31, 2017.
The following tables provide case and incurred but not reported (“IBNR”) reserves for loss and loss expenses, and reinsurance recoverable on unpaid loss and loss expense as of December 31, 2018 and 2017:
1Includes general liability (95% of net reserves) and commercial auto liability coverages (5% of net reserves).
2Includes commercial property (88% of net reserves) and commercial auto property coverages (12% of net reserves).
1Includes general liability (95% of net reserves) and commercial auto liability coverages (5% of net reserves).
2Includes commercial property (90% of net reserves) and commercial auto property coverages (10% of net reserves).
How reserves are established
Each quarter, our actuaries prepare a comprehensive loss and loss expense reserve analysis. This analysis applies standard actuarial projection techniques to our own loss and loss expense experience, to produce updated ultimate loss and loss expense estimates. Our actuaries may also consider other non-standard approaches. The results of the reserve analysis results are then discussed with management to determine if any changes are required to the estimated ultimate loss and loss expense reserves. In addition to the actuarial loss and loss expense projections, management considers other information and factors, including internal impacts, such as changes to our underwriting and claims practices and external impacts, such as economic, legal, judicial, and social trends. Upon considering all of this information, management makes a decision about whether changes to the reserve estimates are appropriate.
The actuarial reserve analysis is the foundation of the quarterly reserve review process. Using generally accepted actuarial reserving techniques, we project our estimate of ultimate loss and loss expense 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. The actuarial techniques used in determining ultimate losses 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, such as the selection of loss and loss expense development factors and the weight to be applied to each individual projection method, among others. These methods include paid and incurred versions of the following methods: aggregate loss and loss expense development, Bornhuetter-Ferguson, Berquist-Sherman, and frequency/severity modeling (via a development 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 reserve 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. Actual claims counts and severities are also considered relative to initial expectations.
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, claims frequencies and severities, individual large loss activity, asbestos and environmental claim activity, and other latent and continuous trigger claims activities. We also consider factors such as: (i) industry loss experience; (ii) legislative enactments, judicial decisions, legal developments, and changes in political attitudes; and (iii) trends in general economic conditions, including the effects of inflation. Based upon our quarterly reserve analysis, our annual reserve range, and other relevant factors and considerations, IBNR is established and the ultimate net liability for loss and loss expense 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 external consulting 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 $3,003 million to $3,556 million at December 31, 2018, which compares to $2,899 million to $3,361 million at December 31, 2017. 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 reflect ranges of reasonable estimates, 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 certain other continuous exposure claims, as traditional actuarial techniques cannot be effectively applied to these exposures.
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.
Changes in Reserve Estimates (Loss Development)
Each quarter a reserve review produces updated reserve estimates for the current and prior accident years, which in turn leads to changes in the recorded reserves, favorably, or unfavorably. In 2018, we experienced overall net favorable prior year loss development of $29.9 million, compared to $39.2 million in 2017, and $65.8 million in 2016. The following table summarizes prior year development by line of business:
A detailed discussion of recent reserve developments, by line of business, follows.
Standard Market General Liability Line of Business
At December 31, 2018, our general liability line of business had recorded reserves, net of reinsurance, of $1.2 billion, which represented 36% of our total net reserves. In 2018, this line experienced favorable development of $9.5 million, attributable to lower than expected loss expenses in accident years 2013 through 2017. The favorable loss expense emergence was partially offset by higher than expected loss emergence in accident years 2016 and 2017.
During 2017, this line experienced favorable development of $48.3 million, attributable to lower than expected frequencies and severities, mainly in accident years 2016 and prior.
By its nature, this line presents a diverse set of exposures, and can be influenced by a variety of factors. In recent years, the line has been favorably impacted by decreasing frequencies partially offset by modest severity trends. Potential increases in either economic or social inflation could impact the loss trends for this line of business. Sources of social inflation could include: (i) state legislation that could extend the statute of limitation for lawsuits alleging abuse and/or re-open the window for lawsuits that were previously beyond the statute of limitations; and (ii) increased awareness of abuse and molestation liability. Our actuarial department actively monitors these trends within our reserve review data, and holds frequent discussions with claims, to identify any potential shifts in these trends.
Standard Market Workers Compensation Line of Business
At December 31, 2018, our workers compensation line of business recorded reserves, net of reinsurance, of $924.8 million, which represented 28% of our total net reserves. During 2018, this line experienced favorable development of $83.0 million driven by accident years 2017 and prior. During 2017, this line experienced favorable development of $52.3 million driven by accident years 2016 and prior. During 2018, this line again showed lower loss emergence than expected, due, in part, to: (i) lower medical inflation than originally anticipated; (ii) our proactive underwriting actions; and (iii) various significant claims initiatives that we have implemented. Because of the length of time that injured workers receive medical treatment, decreases in medical inflation can cause favorable loss development across an extended number of accident years.
While we believe the underwriting and claims operational changes are significant drivers of our improved loss experience, there is always risk associated with change. Most notably, changes in operations may inherently change paid and reported development patterns. While our reserve analyses incorporate methods that adjust for these changes, nevertheless there is a greater risk of fluctuation in the estimated reserves.
In addition to the uncertainties associated with our actuarial assumptions and methodologies, the workers compensation line of business can be impacted by a variety of issues, such as the following:
Unexpected changes in medical cost inflation - The industry is currently experiencing a period of lower claim cost inflation. Changes in our historical workers compensation medical costs, along with uncertainty regarding future medical inflation, creates the potential for additional variability 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, such as increased use of pharmaceuticals and more complex medical procedures, among others. Also, lower levels of unemployment may cause the hiring of less skilled workers who may experience higher loss frequencies.
Audit premium and endorsement premium may also introduce uncertainty into our reserves, as earned premiums are used as a basis to set initial reserves. Over recent years, this activity has been fairly consistent. Audit and endorsement activity resulted in additional DPW of $12.1 million in 2018 and $18.2 million in 2017.
Standard Market Commercial Automobile Line of Business
At December 31, 2018, our commercial automobile line of business had recorded reserves, net of reinsurance, of $545 million, which represented 16% of our total net reserves. In 2018, this line experienced unfavorable development of $36.7 million, which was mainly driven by higher than expected severities in accident years 2015 through 2017.
In 2017, this line experienced unfavorable development of $35.6 million, which was mainly driven by: (i) higher than expected frequencies and severities in accident years 2015 and 2016; and (ii) higher than expected severities in accident years 2012 through 2014.
For both us and the industry, the commercial automobile line has experienced unfavorable trends in recent years. Increased frequencies are likely due to increased miles driven as a result of lower unemployment and lower gasoline prices, as well as an increase in distracted driving. We have seen rising severities on both bodily injury and property damage claims. On bodily injury claims, we have seen an increase in the average value of our paid loss settlements, which may be related to higher awards driven by aggressive attorney representation. Increasing property damage severities may be the result of the increasing complexity of vehicles and the technology they incorporate, which results in increased repair costs.
We are currently taking actions to improve the profitability of this line of business, including:
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Taking meaningful rate and underwriting actions on our renewal portfolio. We will continue to leverage our predictive modeling and analytical capabilities to provide more granular insights as to where best to focus our actions.
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Aggressively managing new business pricing and hazard mix, co-underwriting selected higher hazard classes by the field and home office, providing better recognition of risk drivers, and improved pricing.
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Reducing premium leakage by improving the quality of our rating information. This includes validating application information using third-party data and obtaining more detailed driver information.
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Implementing new tools to score drivers to underwrite more effectively and align rate with exposure.
We also are investing in technologies that help us enhance the overall customer experience and improve our retention rates and hit ratios over time, such as our "Selective® Drive" program that was introduced to our commercial automobile policyholders in the fourth quarter of 2018. This product assists with logistics management and improved safety by tracking and scoring individual drivers based on driving attributes, including phone usage while the vehicle is in motion.
Standard Market Personal Automobile Line of Business
At December 31, 2018, our personal automobile line of business had recorded reserves, net of reinsurance, of $101 million, which represented 3% of our total net reserves. In 2018, this line experienced unfavorable development of $3.0 million, mainly attributable to an increase in accident years 2016 and 2017. In 2017, this line experienced unfavorable development of $6.7 million, mainly attributable to an increase in accident years 2011 through 2016.
Some of the sames issues affecting the commercial automobile line are also affecting this line. Increased usage and vehicle repair costs, coupled with social trends such as distracted driving, are likely causes of increased frequencies and rising severities. We continue to recalibrate our predictive models, as well as refine our underwriting and pricing approaches. 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 Casualty Lines of Business
At December 31, 2018, our E&S casualty lines of business had recorded reserves, net of reinsurance, of $350 million, which represented 10% of our total net reserves. In 2018, this line experienced unfavorable development of $12.0 million, mostly associated with accident years 2015 and 2016. In 2017, this line experienced unfavorable development of $10.0 million, mostly associated with accident years 2014 and 2015. While we continue to build historical loss experience in this segment, our experience base is still significantly shorter than we have in our Standard Commercial and Personal Lines segments. Therefore, our reserve estimates for this line are subject to somewhat greater uncertainty than the comparable Standard Commercial and Personal Line segments. In addition, by its nature, the composition of this book tends to undergo greater changes over time, which may impact development patterns.
Our E&S results have improved over recent years. In support of these improved results, we have taken the following actions related to E&S casualty claims:
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Over the course of late 2015 and early 2016, our E&S claims handling function was aligned with our standard operations claims function. E&S claims were migrated from the business unit in Scottsdale, Arizona, to the appropriate regional claims operation. Complex claims are referred to the corporate Complex Claims Unit ("CCU") for specialized handling.
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Claims have been segregated into “litigated” versus “non-litigated.” Separate claim handling teams have been created, with the required skill sets, to appropriately handle these two types of claims.
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We implemented the following expense improvement initiatives regarding outside adjusters and legal counsel:
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Maximized use of staff counsel, increasing staff where necessary to support claims volume;
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Utilized staff coverage attorney for coverage reviews;
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Heightened focus on legal budgeting and expense management;
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Required panel counsel firms to use our electronic legal billing and budgeting system to better manage budgets and expenses associated with litigation; and
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Implemented a panel counsel review process.
We believe that the actions above are leading to earlier identification of severe claims, as well as earlier claims resolutions with improved outcomes. However, changes in claims operations can result in changes to claims reserving and settlement patterns. Once claims initiatives are implemented, it takes time for patterns to stabilize, and in the near term, these operational changes increase the uncertainty in reserve estimates.
Other impacts creating additional loss and loss expense reserve uncertainty
Claims Initiative Impacts
Like all areas of our organization, our Claims Department is continually identifying areas for improvement and efficiency, increasing their value proposition to both our insureds and our organization. These improvements may lead to changes in claims practices that affect average case reserve levels and/or claims settlement rates, which directly impact the data used to project ultimate loss and loss expense. While these changes increase the uncertainty in our estimates in the short-term, we expect the longer-term benefit will be a more refined management of the claims process.
Some of the specific claims actions implemented over the past several years, in addition to those regarding E&S, as discussed above, are as follows:
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Increased focus on reducing workers compensation medical costs through more favorable Preferred Provider Organization ("PPO") contracts and greater PPO penetration.
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A more comprehensive approach for handling workers compensation claims, with an emphasis towards improving recovery times, allowing for earlier “return-to-work.” This involves elevated and proactive case management in the areas of medical, pharmaceutical, and physical therapy treatments.
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The continued use of our CCU, 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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The strategic realignment of our CMS model to handle property claims under $5,000.
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The continued use of our Property Claims Specialists ("PCS") and our Property Large Loss Unit ("LLU"). Our PCSs handle claims between $5,000 and $100,000, while the LLU handles claims above $100,000. Both groups form the core of our catastrophe response team. During 2016, we began increasing the number of property claims specialists to respond to property claims with higher severity and/or complexity. This provides us with more staff to respond to claim volume, including the fluctuations that result from catastrophes, while ensuring we have the highest level of property expertise available to apply to our more complex claims.
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Continued efforts in the areas of fraud investigation and salvage/subrogation recoveries. These efforts have been supported by predictive models that allow us to better focus our efforts.
Our internal reserve analyses incorporate certain 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
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 claim frequencies, severities, and 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 that 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. Therefore, the results in the tables below do 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 internal and external 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 through 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. While the selected percentages by line are judgmental, they are based on the reserve range analysis, as well as the actual historical reserve development for the line of business. 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.
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 loss and loss expense reserves for these claims were $22.8 million as of December 31, 2018 and $21.2 million as of December 31, 2017. The emergence of these claims occurs over an extended period and is 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 six customers related to three sites on the NPL.
“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.
“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, 2018, asbestos claims constituted 27% of our $22.8 million net asbestos and environmental reserves, compared to 30% of our $21.2 million net asbestos and environmental reserves at December 31, 2017.
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 Standard Commercial Lines industry. Prior to the introduction of the absolute pollution exclusion endorsement in the mid-1980's, we were primarily a Standard 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.
Other Latent Exposures
In addition to asbestos and environmental reserves, we also have exposure to other latent, or continuous trigger, exposures in our ongoing portfolio. Examples include construction defect claims and abuse and molestation coverage. We manage our exposure to these liabilities through our underwriting and claims practices. Similar to asbestos and environmental claims, these claims are handled by a dedicated claims unit. Nevertheless, these claims bring greater uncertainty to our estimates, and are particularly susceptible to changes in our legal, social, and judicial environments.
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 and mortality.
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. Conversely, a lower discount rate increases the present value of benefit obligations. Our discount rate increased 68 basis points, to 4.46%, as of December 31, 2018, compared to 3.78% as of December 31, 2017. For additional information regarding our discount rate selection, refer to Note 14. “Retirement Plans” in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
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 higher expected rate of return on pension plan assets would decrease pension expense. Our long-term expected return on plan assets increased 14 basis points, to 6.50%, as of December 31, 2018 compared to 6.36% as of December 31, 2017, reflecting a higher expected allocation to risk-seeking assets in the portfolio and a change to our investment funds.
At December 31, 2018, our pension and post-retirement benefit plan obligation was $350.0 million compared to $381.0 million at December 31, 2017. Plan assets were $331.7 million and $363.7 million at December 31, 2018 and December 31, 2017, respectively. Volatility in the marketplace, coupled with changes in the discount rate assumption, 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 14. “Retirement Plans” in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
Investment Valuation and OTTI
Investment Valuation
The fair value of our investment portfolio is defined under accounting guidance as the exit price or the amount that would be: (i) received to sell an asset; or (ii) paid to transfer a liability in an orderly transaction between market participants. When determining an exit price we must, when available, rely upon observable market data. The majority of securities in our equity portfolio have readily determinable fair values and, as such, are carried at fair value with changes in unrealized gains or losses being recognized through income. Additionally, our available-for-sale ("AFS") fixed income securities portfolio is carried at fair value and the related unrealized gains or losses are reflected in stockholders' equity, net of tax. For both our AFS and held-to-maturity ("HTM") fixed income securities portfolios, fair value is a key factor in the evaluation of a security for OTTI.
We have categorized our investment portfolio, based on the priority of the inputs to the valuation technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets and liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3).
The fair value of approximately 99% of our investment portfolio is classified as either Level 1 or Level 2 in the fair value hierarchy. Fair value measurements in Level 1 represent quoted prices in active markets for identical assets. Fair value measurements in Level 2 represent prices determined using observable data from similar securities that have traded in the marketplace, typically using matrix pricing. The fair value of our Level 2 securities are determined by external pricing services. We have evaluated the pricing methodology used for these Level 2 prices and have determined that the inputs used are observable. For additional information regarding the valuation techniques used, refer to item (e) of Note 2. "Summary of Significant Accounting Policies" within Item 8. "Financial Statements and Supplementary Data." of this Annual Report.
Less than 1% of our investment portfolio is classified as Level 3 in the fair value hierarchy. Fair value measurements in Level 3 are based on unobservable market inputs because the related securities are not traded on a public market. For additional information regarding the valuation techniques used for our Level 3 securities, refer to item (e) of Note 2. "Summary of Significant Accounting Policies" within Item 8. "Financial Statements and Supplementary Data." of this Annual Report.
OTTI
Our investment portfolio is subject to market declines below amortized cost that may be other than temporary and therefore may result in the recognition of OTTI losses. Factors considered in the determination of whether or not a decline is other than temporary require significant judgment and include, but are not limited to, the financial condition of the issuer, the expected near-term and long-term prospects of the issuer, and our evaluation of the projected cash flow stream from the security. We also consider whether or not we have the intent to sell securities that are in an unrealized loss position. For additional information regarding our OTTI process and OTTI charges recorded, see item (d) of Note 2. "Summary of Significant
Accounting Policies" and item (j) of Note 5. "Investments" within Item 8. "Financial Statements and Supplementary Data." of this Annual Report, respectively.
Reinsurance
Reinsurance recoverables on paid and unpaid loss and loss expense 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 $4.5 million at December 31, 2018 and $4.6 million at December 31, 2017. 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.
2Non-GAAP operating income is used as an important financial measure by us, analysts, and investors, because the realization of net investment gains and losses on sales of securities in any given period is largely discretionary as to timing. In addition, these net realized investment gains and losses, as well as OTTI that are charged to earnings, unrealized gains and losses on equity securities, and the deferred tax asset charge that was recognized in 2017 in relation to Tax Reform, could distort the analysis of trends.
For the year, our combined ratio was 95.0% and our non-GAAP operating ROE of 12.5% exceeded our financial target of 12% for 2018. Industry-wide commercial property results have been volatile and commercial auto has been a consistently poor performer, which when coupled with ongoing pricing pressures within the workers compensation line, have led to an expected 2018 combined ratio of 99.4% for the U.S. property and casualty insurance industry, or an ROE of 7.2%, as reported by Conning, Inc. in their fourth quarter 2018 Property-Casualty Forecast and Analysis Report.
Reconciliations of net income, net income per diluted share, and ROE to non-GAAP operating income, non-GAAP operating income per diluted share, and non-GAAP operating ROE, respectively, are provided in the tables below:
The components of our ROE are as follows:
2018 marks the fifth consecutive year that we reported double-digit non-GAAP operating ROEs, placing us among a select group of insurance companies that have achieved this level of performance. This is a particularly impressive track record in the context of: (i) meaningful catastrophe losses over the past two-year period; (ii) a highly competitive commercial lines pricing environment; and (iii) a continued low level of interest rates that negatively impacts net investment income from fixed income security portfolios.
Insurance Operations
Our insurance operations' ROE decreased 0.7 points, to 5.5%, in 2018 and 0.5 points, to 6.2%, in 2017 compared to the same prior year periods, reflecting increases in our combined ratio of 1.7 points and 0.4 points, respectively. These increases were principally driven by higher levels of both catastrophe and non-catastrophe property losses, lower levels of favorable prior year casualty reserve development, and a higher than expected booked accident year casualty loss and loss expense ratio for 2018, that were partially offset by improvements in our expense ratio.
The following table provides quantitative information for analyzing the combined ratio:
Our 2018 results continue to reflect our efforts to: (i) achieve meaningful overall renewal pure price increases at levels that are at or exceed expected claim cost inflation; (ii) generate new business; and (iii) improve the underlying profitability of our business through various underwriting and claims initiatives. Our NPW growth of 6% in 2018 and 2017 compared to the same prior year periods, was aided by the net appointment of about 110 retail agents in both 2018 and 2017, excluding agency consolidations. Included in these net appointments were 52 agents appointed in our new states of Arizona, New Hampshire, Colorado, New Mexico, and Utah, which contributed $25.7 million to our new business in 2018.
Loss and Loss Expenses
The loss and loss expense ratio increased 2.8 points in 2018 and 1.3 points in 2017 compared to the same prior year periods, driven by the following:
Details of the prior year casualty reserve development were as follows:
As illustrated in the table above, we have seen the most significant favorable prior year casualty reserve development in our
workers compensation and general liability lines of business and the most significant unfavorable prior year casualty reserve
development in our commercial automobile and E&S lines of business. The following provides some qualitative discussion
around the actions we have taken regarding these lines of business:
Workers Compensation
We continue to execute on various claims process enhancements and underwriting initiatives to improve our profitability on this line. During 2018, we experienced renewal pure price decreases of 0.2% in a market place that is demonstrating significant pricing pressure. Our workers compensation book of business, which represents approximately 16% of our Standard Commercial Lines business, continues to benefit from: (i) claims initiatives, such as reducing workers compensation medical costs through more favorable Preferred Provider Organization ("PPO") contracts and greater PPO penetration; and (ii) better outcomes driven by our workers compensation strategic case management unit, which handles claims with high exposure and/or significant escalation risk. In addition, this line has benefited in recent years from lower than anticipated medical inflation that has led to lower severity trends. Favorable prior year casualty reserve development in 2018 amounted to $83.0 million for the year, reflecting lower than expected severities in accident years 2017 and prior. For a full discussion of the claims initiatives we have deployed, refer to the “Reserves for Loss and Loss Expense” section within Critical Accounting Policies and Estimates in Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations."
Commercial Automobile
Our commercial automobile line of business has been unprofitable for the past three years and remains a significant area of focus for us. Loss severities and frequencies have remained elevated, resulting in upward adjustments for the prior and current accident year casualty reserves. We have been taking a number of steps to address profitability in this line, including renewal pure price increases that averaged 7.3% in 2018, 6.7% in 2017, and 4.9% in 2016. We also continue to take a more conservative underwriting and pricing stance on higher hazard classes, resulting in a shift of business mix towards lower and medium hazard accounts. Longer-term, we also expect the introduction of Selective® Drive to improve the performance of accounts in that program. Our commercial automobile combined ratio was 115.7% for 2018, compared to the full-year expectation of 112% reported by Conning, Inc. On-going industry-wide profitability issues should drive pricing higher for this line of business in 2019.
E&S
Our E&S segment continues to perform below our target level and remains an area of focus for us as we continued to experience unfavorable development on the 2015 and 2016 accident years. We have been taking active steps over the past two years to address profitability in this segment, including implementing meaningful targeted price increases, exiting challenged business segments, and improving claims handling processes. We have begun to see improvement in profitability from these actions and plan to maintain our focus on this front as we have started to see a return to reasonable growth rates. Renewal pure price increases in E&S averaged 4.7% in 2018, with substantially higher price increases in targeted classes. While the relatively small size of the book could lead to some volatility, improved underwriting, pricing and claim outcomes have us on track to achieve our risk-adjusted profitability target for this segment by the end of 2019.
For additional qualitative discussions regarding reserve development, please refer to the insurance segment sections below in
"Results of Operations and Related Information by Segment."
Underwriting Expenses
The increase in the loss and loss expense ratio in 2018 was partially offset by improvement in the underwriting expense ratio of of 1.2 points in 2018. The improvement was primarily driven by:
•
A 0.5-point decrease in employee-related expenses, reflecting reduced labor expenses associated with productivity gains from the growth of our business, coupled with lower pension and medical benefit costs; and
•
A 0.3-point decrease in profit-based compensation to our distribution partners, driven by the higher combined ratio, resulting in a reduced level of underwriting income.
The improvement in the underwriting expense ratio of 0.9 points in 2017 compared to 2016 was primarily due to:
•
A 0.7-point decrease in employee-related expenses, including 0.4 points from labor expenses and 0.3 points from pension expenses; and
•
A 0.5-point decrease in commissions to our distribution partners in 2017 due to lower supplemental commission
expense, as well as lower base commissions that were driven by targeted actions we took in late 2016 on our
homeowners book of business.
Investments Segment
Net investment income, after tax, contributed 9.2 percentage points to ROE in 2018 compared to 7.3 points in 2017 and 6.7 points in 2016.
The improvements in both periods were driven by: (i) a higher overall level of interest rates in 2018; (ii) active portfolio management; (iii) excellent operating cash flow that was 18% of NPW; (iv) improved alternative investment returns; and (v) in 2018 a lower Federal income tax rate. Our alternative investments generated $14 million in after-tax income in 2018, compared to $8 million in 2017. In addition, after-tax investment income benefited from higher reinvestment yields in 2018, including a 111 basis point increase in the 90-day London Interbank Offered Rate ("LIBOR"), which affected our floating rate securities that represented approximately 16% of our fixed income securities portfolio at year-end. The after-tax earned income yield on the portfolio averaged 2.8% during 2018, compared to 2.1% during 2017. After-tax new money yields averaged 2.9% in 2018, and the weighted average after-tax book yield on the fixed income securities portfolio was 3.0% at December 31, 2018. Invested assets per dollar of stockholders' equity was 3.33 at year-end, which was basically flat compared to 2017.
Net realized and unrealized gains and losses can fluctuate when comparing ROE contributions year over year as they contain realized gains and losses on disposals that are discretionary as to timing, as well as OTTI charges. Additionally, due to a change in accounting literature that became effective on January 1, 2018, fluctuations in the market value of our equity portfolio are included in this line item. In 2018, this change in literature resulted in after-tax market valuation fluctuations of $29.4 million, or a 1.7-point decrease to ROE. Additionally, in 2018, we had higher trading volume driven by opportunistic sales, with net losses primarily in our fixed income securities portfolio as we reacted to volatility in the marketplace to increase our risk-adjusted yield.
Other
Our interest and corporate expenses, which are primarily comprised of stock compensation expense at the holding company level, reduced ROE by 2.2 points in 2018, compared to 2.1 points in 2017 and 2.4 points in 2016. The lower corporate tax rate that was introduced with Tax Reform at the end of 2017 masked some of the improvement in the underlying pre-tax corporate expenses of $10.8 million. The decrease in the underlying corporate expenses were attributable to the following savings related to our long-term share based compensation program: (i) increases in our stock price that were of less magnitude than prior year increases; and (ii) structural changes we made to our long-term incentive program in early 2017.
Outlook
We ended 2018 with record levels of capital and liquidity, and we feel extremely positive about our financial position. For 2019, we have established a non-GAAP operating ROE target of 12%, which is an appropriate return for our shareholders based on our current estimated weighted average cost of capital, the current interest rate environment, and property and casualty insurance market conditions.
Looking into 2019, there remain a number of areas that require our continued focus to maintain our financial position:
•
Achieving written renewal pure price increases that match or exceed estimated loss inflation trends.
•
Delivering on our strategy for continued disciplined growth, which will be driven by the addition of new agents, greater share of wallet in our agents’ offices, and geographic expansion. Our longer-term Standard Commercial Lines target is to attain a 3% market share in the states in which we operate, by appointing partner relationships approximating 25% of their markets and seeking an average share of wallet of 12% across the relationships. This goal represents an additional premium opportunity in excess of $2.3 billion in our pre-expansion state footprint.
•
Continuing to enhance our customer experience strategy including value-added technologies and services such as our “Selective® Drive” program, which was introduced to our commercial automobile policyholders in the fourth quarter of 2018. This product assists with logistics management and improved safety by tracking and scoring individual drivers based on certain driving attributes, including phone usage while the vehicle is in motion.
•
Improving profitability in our commercial automobile line of business, personal automobile line of business and E&S Lines.
•
Actively managing the investment portfolio to enhance after-tax yields while managing credit, duration, and liquidity risk.
Overall, we remain extremely pleased with our financial and strategic position heading into 2019. We will maintain a steadfast focus on underwriting discipline as we execute on our various strategies to generate profitable growth. The investments we are making today in our franchise distribution model, sophisticated underwriting tools and technology, and overall customer experience in an omni-channel environment, will position us as a leader in the coming years.
Turning to 2019 expectations, Conning, Inc. is currently forecasting a property and casualty industry combined ratio of 97.8%, including 4 points of catastrophe losses, with a return on equity of 7.6%.
Our guidance for 2019 is based on our current view of the marketplace, and incorporates the following:
•
A GAAP combined ratio, excluding catastrophe losses, of 92.0%. This assumes no prior-year casualty reserve development;
•
Catastrophe losses of 3.5 points;
•
After-tax net investment income of $175 million, which includes $8 million after-tax net investment income from our alternative investments;
•
An overall effective tax rate of approximately 19%, which also includes an effective tax rate of 18% for net investment income, reflecting a tax rate of 5.25% for tax-advantaged municipal bonds, and a tax rate of 21% for all other items; and
•
Weighted average shares outstanding of 60 million on a diluted basis.
Results of Operations and Related Information by Segment
Standard Commercial Lines Segment
For the past three years, growth in this segment of our business has reflected: (i) renewal pure price increases; (ii) new business growth; and (iii) stable retention. Quantitative information on these drivers is as follows:
Increases in the loss and loss expense ratio over the three-year period were driven by: (i) higher weather and non-weather related property losses; and (ii) lower favorable prior year casualty reserve development, as displayed in the tables below. In addition, current year loss costs increased by 0.9 points in 2018 and 0.6 points in 2017, compared to the same prior year periods. For quantitative information on the prior year development by line of business, see "Financial Highlights of Results for Years Ended December 2018, 2017, and 2016" above and for qualitative information about the significant drivers of this development, see the line of business discussions below.
Our underwriting expense ratio decreased by 0.8 points in 2018 and 1.2 points in 2017 compared to the respective prior year periods. These expense improvements were primarily driven by the following:
•
Decreases in employee-related expenses of 0.4 points in 2018 and 0.7 points in 2017, mainly attributable to lower pension, medical benefit, and labor costs;
•
Decreases in profit-based compensation to our distribution partners of 0.2 points in 2018 and 0.3 points in 2017.
The following is a discussion of our most significant Standard Commercial Lines of business:
Growth in 2018 and 2017 premium was primarily due to direct new business as outlined in the table above, coupled with strong retention and renewal pure price increases.
The combined ratio increased in 2018 by 5.9 points, driven by lower favorable prior year casualty reserve development compared to 2017, which increased the combined ratio by 7.0 points. This was partially offset by a lower underwriting expense ratio of 1.0 point, primarily attributable to the aforementioned items discussed in the overall Commercial Lines segment above.
The combined ratio decreased in 2017 compared to 2016 by 2.3 points driven by: (i) a decrease in supplemental commission to our distribution partners of 0.4 points; (ii) a decrease in pension expense of 0.3 points; and (iii) a decrease in current year loss costs of approximately 0.4 points.
The favorable prior year casualty reserve development for each year is outlined in the table below.
The impact of the favorable prior year casualty reserve development on this line was as follows:
•
2018: 1.5 points attributable to lower than expected loss adjustment expenses in accident years 2013 through 2017, partially offset by higher than expected loss emergence in accident years 2016 and 2017.
•
2017: 8.5 points attributable to decreases in accident years 2016 and prior, driven by lower than expected frequencies and severities.
•
2016: 8.5 points attributable to accident years 2008 through 2013 and 2015. This was primarily driven by lower than anticipated claims severities.
For the past three years, growth in this line of business has reflected renewal pure price increases, new business growth, and strong retention.
The increases in the combined ratio of 1.0 points in 2018 compared to 2017, and 3.9 points in 2017 compared to 2016, were primarily driven by the items in the tables below, as well as increases in current year loss costs of 3.0 points in 2018 and 4.4 points in 2017 compared to the prior years. These items were partially offset by mix improvement of the underlying coverages within this line that reduced our loss estimates by 1.1 points in 2018 and 0.9 points in 2017, coupled with decreases in the underwriting expense ratio of 0.8 points in 2018 and 1.3 points in 2017, the drivers of which are consistent with those discussed in overall Standard Commercial Lines above.
Prior year casualty reserve development was as follows:
•
2018: Unfavorable development of 7.6 points, which was driven primarily by higher than expected severities in accident years 2015 through 2017.
•
2017: Unfavorable development of 8.1 points, which was driven primarily by: (i) higher than expected frequencies and severities in accident years 2015 and 2016; and (ii) higher than expected severities in accident years 2012 through 2014.
•
2016: Unfavorable development of 6.3 points, which was driven primarily by bodily injury liability for accident years 2014 and 2015. The unfavorable development in accident year 2014 was driven by higher than expected severity, whereas accident year 2015 was driven by higher than expected frequency and severity.
The 10.3 point improvement in the combined ratio in 2018 compared to 2017 was primarily attributable to higher favorable prior year development of 9.7 points. This favorable development was due to continued favorable medical severity trends impacting accident years 2017 and prior. Because of the length of time that injured workers receive medical treatment, decreases in medical inflation can cause favorable loss development across an extended number of accident years. In addition, the underwriting expense ratio improved by 0.7 points, consistent with the improvement in overall Standard Commercial Lines discussed above.
The 2017 combined ratio decrease compared to 2016 was attributable to the loss and loss expense ratio, which decreased 0.9 points in 2017, driven by lower current year loss costs, partially offset by lower favorable prior year development. Additionally, the expense ratio improved by 1.2 points, consistent with the improvement in overall Standard Commercial Lines discussed above.
The favorable prior year casualty reserve development for each year is outlined in the table below.
In 2018, favorable development resulted from an improvement in medical severity trends from accident years 2017 and prior.
The combined ratio increases in the table above were driven by property losses as shown below. The increased non-catastrophe property losses in 2018 were principally related to the January deep freeze in our footprint states coupled with the relatively large number of fire losses during the year and continued increases in non-catastrophe loss severities. Higher catastrophe losses in 2018 include the impact of two hurricanes, Hurricane Florence and Hurricane Michael, and severe winter storms including Grayson and Riley that impacted our footprint states.
Quantitative information regarding property losses is as follows:
Standard Personal Lines Segment
The increases in NPW reflected in the table above were driven by the following:
The loss and loss expense ratio increased 2.5 points in 2018 compared to 2017, and 2.1 points in 2017 compared to 2016, the primary drives of which were as follows:
The prior year development in all three years primarily related to our personal automobile book of business.
The underwriting expense ratio decreased 2.9 points in 2018 compared to 2017, reflecting: (i) a reduction in costs of 1.1 points associated with the internally developed software platform used in this segment of our business, which was fully amortized in the fourth quarter of 2017; (ii) a reduction in employee-related expenses of 0.9 points; (iii) a reduction in profit-based
commission of 0.3 points; and (iv) a reduction in the cost of insurance scoring and motor vehicle reports used in the underwriting process of 0.3 points.
The underwriting expense ratio decreased 1.5 points in 2017 compared to 2016 reflecting: (i) targeted actions taken on our homeowners book of business that drove a 0.7 point decrease in direct commissions for this segment; (ii) a decrease in supplemental commissions to our distribution partners of 0.2 points; and (iii) a reduction in pension expense of 0.3 points.
E&S Lines Segment
While this segment experienced increased growth in 2018, we continue to address profitability through targeted price increases, business mix shifts, and improved underwriting standards and claims handling processes. We have sacrificed growth during 2017 and the first half of 2018 as we addressed underwriting profitability and exited some unprofitable classes. We have begun to see improvement in profitability from these actions and plan to maintain our focus on this front as we have started to see a return to reasonable growth rates. Renewal pure price increases in E&S averaged 4.7% in 2018, with substantially higher price increases in targeted classes. While the relatively small size of the book could lead to some volatility, improved underwriting, pricing and claim outcomes have us on track to achieve our risk-adjusted profitability target for this segment by the end of 2019.
Quantitative information is as follows:
1The E&S casualty renewal price increases were 5.0%, 7.5%, and 9.1% in 2018, 2017, and 2016, respectively.
The loss and loss expense ratio improvement in 2018 compared to 2017 is primarily attributable to a decrease in catastrophe losses partially offset by increases in unfavorable prior year casualty reserve development and non-catastrophe property losses.
The loss and loss expense ratio improvement in 2017 compared to 2016 is primarily attributable to a decrease in current year loss costs reflecting our underwriting and claims improvement initiatives, including generating earned rate that is sufficient to outpace loss costs.
Quantitative information pertaining to our property losses and prior year development are as follows:
Unfavorable prior year casualty reserve development for 2018 was driven by frequencies and severities in accident years 2015 and 2016. Unfavorable prior year casualty reserve development for 2017 was driven by increases in claims severities in accident years 2014 and 2015.
The underwriting expense ratio improvement in 2018 compared to 2017 was primarily due to: (i) a decrease in labor-related expenses of 1.0 points; and (ii) a decrease in profit-based compensation to our distribution partners of 0.7 points. The increase in the underwriting expense ratio in 2017 compared to 2016 was primarily due to a 0.8-point increase in the allocation of corporate services to this segment in 2017.
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 through 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 Insurance Subsidiary as of December 31, 2018:
Reinsurance Treaties and Arrangements
By entering into reinsurance treaties and arrangements, we are able to increase our underwriting capacity and accept larger individual risks and a larger aggregation of risks without directly increasing our capital or surplus. Our reinsurance program principally consists of traditional 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 below an attachment point 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. In addition, our reinsurers often rely on their own reinsurance programs, or retrocession, as part of managing their exposure to large losses. Given the relatively small size of the
global reinsurance community, the inability of our reinsurers to collect on their retrocession program may impair their ability to pay us for the amounts we cede to them. Accordingly, we have direct and indirect counterparty credit risk from our reinsurers. We attempt to mitigate this credit risk by: (i) pursuing relationships with reinsurers rated “A-” or higher by A.M. Best; and/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 or otherwise require our reinsurers to post collateral. We monitor the financial condition of our reinsurers and we 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 treaties 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 - in addition to protection built into our property and casualty reinsurance treaties, terrorism protection is available as a federal backstop related to terrorism losses as provided under the Terrorism Risk Insurance Program Reauthorization Act (“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, 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, as part of the acquisition of MUSIC in December 2011, we entered into several reinsurance agreements with Montpelier Re Insurance Ltd., which subsequently merged into Endurance Specialty Insurance Ltd in December 2015. Together, these agreements 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 collateralized.
Property Reinsurance
The property catastrophe treaty, which covers both our standard market and E&S business, was renewed effective January 2019. We also renewed the separate catastrophe treaty of $35 million in excess of $5 million that covers events outside of our original 22-state footprint, in support of our growing E&S property book and geographic expansion into Arizona, New Hampshire, Colorado, Utah, and New Mexico. Both treaties were renewed with substantially the same terms as the expiring treaty. Overall catastrophe ceded premium for 2019 increased modestly primarily due to increases in reinsurer participation. On a risk-adjusted basis, however, the expiring layers saw a reduction in rate.
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 reinsurance program includes $242 million in collateralized limit, primarily in the top layer of the catastrophe program.
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:
1This amount represents reported and unreported gross losses estimated as of December 31, 2018.
2Net loss does not include reinstatement premiums, taxes, or flood claims handling fees.
We use the results of the Risk Management Solutions and AIR Worldwide 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 expectations of hurricane activity in the near future. We believe that modeled estimates provide a range of potential outcomes and we review multiple estimates for purposes of understanding our 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 2018:
1Include assumptions for certain un-modeled costs, such as the impact of loss expenses, residual market assessments, and automobile-related losses, which collectively increase our gross losses by an estimated 13%.
2Losses are after a 21% Federal income tax benefit and include applicable reinstatement premiums.
3Equity as of December 31, 2018.
Our current catastrophe reinsurance program exhausts at approximately 1 in 225 year return period, or events with 0.4% probability, based on a multi-model view of hurricane risk. Our actual gross and net losses incurred from U.S. landfalling hurricanes will vary, perhaps materially, from our estimated modeled losses.
The property excess of loss treaty, which covers both our standard market and E&S business, was renewed on July 1, 2018 with the top layer renewed on January 1, 2019. The major terms of these treaties are consistent with the prior year.
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 operations)
$735 million above $40 million retention treaty that responds on per occurrence basis in four layers:
All nuclear, biological, chemical, and radioactive ("NBCR") losses are excluded regardless of whether or not they are certified under TRIPRA. Non-NBCR losses are covered to the same extent as non-terrorism losses. Please see Item 1A. “Risk Factors.” of this Form 10-K for discussion regarding TRIPRA.
- 82% of losses in excess of $40 million up to
$100 million;
- 97% of losses in excess of $100 million up to
$225 million;
- 97% of losses in excess of $225 million up to
$475 million; and
- 90% of losses in excess of $475 million up
to $775 million.
- The treaty provides one reinstatement in each of the first three layers and no reinstatement in the fourth layer. The annual aggregate limit is $1.1 billion, net of the Insurance Subsidiaries' co-participation.
In addition, our $35 million above $5 million retention treaty that responds on per occurrence basis covers 85% of losses outside of our standard lines original 22-state footprint and has an annual aggregate limit of $30 million, net of the Insurance Subsidiaries' co-participation. This layer was purchased primarily to protect the growth of our E&S property book but also provides coverage for our Standard Lines expansion states.
Property Excess of Loss
(covers all insurance operations)
$58 million above $2 million retention covering 100% in three 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 and for the third layer approximately $35 million in annual aggregate limits. Non-foreign terrorism losses (other than NBCR) are covered to the same extent as non-terrorism losses.
- $8 million in excess of $2 million layer
provides unlimited reinstatements;
- $30 million in excess of $10 million layer
provides three reinstatements, $120 million in
aggregate limits; and
- $20 million in excess of $40 million layer
provides approximately $75 million in aggregate limits.
Flood
100% reinsurance by the federal government’s WYO.
None
Casualty Reinsurance
The casualty excess of loss treaty, which covers both our standard market and E&S business, was renewed on July 1, 2018 and is effective through June 30, 2019, with substantially the same terms as the expiring treaty.
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 all insurance operations)
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
with $78 million annual aggregate limit;
- $3 million in excess of $2 million layer with
$15 million net annual terrorism aggregate limit;
- $7 million in excess of $5 million layer
with $35 million annual aggregate limit;
- $7 million in excess of $5 million layer with
$28 million net annual terrorism aggregate limit;
- $9 million in excess of $12 million layer
with $27 million annual aggregate limit;
- $9 million in excess of $12 million layer with
$27 million net annual terrorism aggregate limit;
- $9 million in excess of $21 million layer
with $18 million annual aggregate limit;
- $9 million in excess of $21 million layer with
$18 million net annual terrorism aggregate limit;
- $20 million in excess of $30 million layer
with $40 million annual aggregate limit; and
- $20 million in excess of $30 million layer with
$40 million net annual terrorism aggregate limit; and
- $40 million in excess of $50 million layer
with $80 million annual aggregate limit.
- $40 million in excess of $50 million layer with
$80 million net annual terrorism aggregate limit.
Endurance Specialty 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. Montpelier Re was acquired by Endurance Specialty on December 29, 2015. On March 28, 2017, Endurance Specialty was acquired by SOMPO Holdings, Inc.
Provides full terrorism coverage including NBCR.
We have other reinsurance treaties that we do not consider core to our reinsurance program, such as our Surety and Fidelity Excess of Loss Reinsurance Treaty, National Workers Compensation Reinsurance Pool Quota Share, which covers business assumed from the involuntary workers compensation pool, our Equipment Breakdown Coverage Reinsurance Treaty, and our Data Compromise Reinsurance Treaty.
We regularly reevaluate our overall reinsurance program and try to develop effective ways to manage the 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 Segment
The primary objective of the investment portfolio is to maximize after-tax net investment income and the overall total return of the portfolio, while maintaining a high credit quality core fixed income securities portfolio and managing our duration risk profile. The effective duration of the fixed income securities portfolio as of December 31, 2018 was 3.8 years, compared to the Insurance Subsidiaries’ liability duration of approximately 3.6 years. The effective duration of the fixed income securities portfolio is monitored and managed to maximize yield while managing interest rate risk at an acceptable level. We maintain a well-diversified portfolio across sectors, credit quality, and maturities that affords us ample liquidity. Purchases and sales are made with the intent of maximizing investment returns in the current market environment while balancing capital preservation. Over time, we may seek to increase or decrease the duration and overall credit quality of the portfolio based on market conditions.
Our investment philosophy includes certain return and risk objectives for the fixed income, equity, and other investment portfolios. After-tax yield and income generation are key drivers to our investment strategy, which we believe will be obtained through active management of the portfolio.
Total Invested Assets
1Includes unrealized gain on fixed income securities and equity securities.
The increase in invested assets at December 31, 2018 compared to December 31, 2017 was driven by operating cash flow of $455 million, of which approximately $60 million was used to fund shareholder dividends and capital expenditures in the aggregate. The remaining operating cash flow was partially offset by a reduction in unrealized gains on our investment portfolio, primarily driven by the impact of rising interest rates on our fixed income securities portfolio during 2018.
Our fixed income securities and short-term investment portfolio, in the aggregate, represented 95% of our total invested assets at December 31, 2018, consistent with last year. In the aggregate, these portfolios maintained a weighted average credit rating of "AA-" as of both December 31, 2018 and 2017, with 98% and 97% of the securities within the portfolio being investment grade quality, respectively.
For further details on the composition, 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, equity price risk, and liquidity risk related to our investment portfolio as well as fluctuations in the value of our alternative investment portfolio. The allocation of our portfolio was 89% fixed income securities, 2% equity securities, 6% short-term investments, and 3% other investments as of December 31, 2018. We do not directly 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. For a discussion of our investment objective and philosophy, see the "Investments Segment" section of Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations." of this Form 10-K.
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, CLO and other ABS, 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 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.
We seek to mitigate our interest rate risk associated with holding fixed income investments by monitoring and managing the effective duration of our portfolio to maximize yield while managing interest rate risk at an acceptable level. The effective duration of the fixed income securities portfolio at both December 31, 2018 and December 31, 2017 was 3.8 years, which is within our historical range. The Insurance Subsidiaries’ liability duration is approximately 3.6 years.
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: (i) any actions we may take in response to market fluctuations; and (ii) changes to credit spreads, liquidity spreads, and other risk factors that may also impact the value of the fixed income securities portfolio.
The following table presents the sensitivity analysis of interest rate risk as of December 31, 2018:
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 liability measurement. Changes in the discount rate assumption could materially impact our pension and post-retirement life valuation in the future. For additional information regarding our discount rate selection, refer to Note 14. "Retirement Plans" in Item 8.
Item 8. Financial Statements and Supplementary Data.
Report of Independent Registered Public Accounting Firm
To the Stockholders and Board of Directors
Selective Insurance Group, Inc.:
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Selective Insurance Group, Inc. and subsidiaries (the Company) as of December 31, 2018 and 2017, the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2018, and the related notes and financial statement schedules I to V (collectively, the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2018, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 15, 2019, expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.
/s/ KPMG LLP
We have served as the Company's auditor since 1964.
New York, New York
February 15, 2019
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
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 ("E&S") lines property and casualty insurance products. Selective Insurance Group, Inc. (referred to as the “Parent”) was incorporated in New Jersey in 1977 and its corporate headquarters is 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, which are as follows:
•
Standard Commercial Lines - comprised of insurance products and services provided in the standard marketplace to commercial enterprises, which 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 insurance operations, as well as amounts generated through our capital management strategies, which may include the issuance of debt and equity securities.
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 (“SEC”). 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
2018 presentation. Specifically, we reclassified restricted cash balances related to our participation in the National Flood Insurance Program ("NFIP") from other assets in our consolidated balance sheet into a separate line item on the face of that statement. Additionally, refer to Note 3. "Adoption of Accounting Pronouncements" below for a discussion of the retroactive restatements that are included in these financial statements in relation to the adoption of new accounting pronouncements for the treatment of restricted cash and distributions from equity method investments on the Consolidated Statements of Cash Flows.
(d) Investments
Portfolio Composition and Presentation in the Consolidated Balance Sheets
Our investment portfolio is primarily comprised of fixed income securities, which represent approximately 89% of our invested assets. We also hold equity securities, short-term investments, and other investments. A description of our portfolio holdings, and the related presentation in our Consolidated Balance Sheets, is provided below.
Fixed Income Portfolio
We hold the following types of securities in our fixed income securities portfolio:
•
U.S. government and government agencies;
•
Foreign government obligations;
•
State and municipal obligations, including special revenue and general obligation bonds;
•
Corporate securities, which may include investment grade and below investment grade bonds, bank loan investments, redeemable preferred stock, and non-redeemable preferred stock with certain debt-like characteristics;
•
Collateralized loan obligations ("CLOs") and other asset-backed securities ("ABS");
•
Residential mortgage-backed securities ("RMBS"); and
•
Commercial mortgage-backed securities ("CMBS").
We have designated approximately 99% of our fixed income securities portfolio as available-for-sale ("AFS"), with the remaining 1% being designated as held-to-maturity ("HTM"), as we have the ability and positive intent to hold these securities to maturity. Our AFS securities are reported at fair value in our consolidated balance sheets, with unrealized gains or losses recognized in accumulated other comprehensive income (loss) ("AOCI"), net of tax. HTM securities are carried at either: (i) amortized cost; or (ii) market value at the date of transfer into the HTM category, adjusted for subsequent amortization. After-tax unrealized gains and losses on securities that were transferred into an HTM designation from an AFS designation, are also included in AOCI.
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. Callable debt securities held at a premium are amortized to the earliest call date. Premiums and discounts arising from the purchase of RMBS, CMBS, CLOs and other ABS are amortized over the expected life of the security based on future principal payments, giving additional consideration to 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.
Other Portfolio Holdings
Equity securities may include common and non-redeemable preferred stocks. Equity securities with readily determinable fair values are carried at fair value. Certain equity securities without readily determinable fair values are carried at net asset value ("NAV") as a practical expedient.
Short-term investments may include certain money market instruments, savings accounts, commercial paper, and debt issues purchased with a maturity of less than one year. We also enter into reverse repurchase agreements that are included in short-term investments. These loans are fully collateralized with high quality, readily marketable instruments at a minimum of 102% of the loan principal. At maturity, we receive principal and interest income on these agreements. All short-term investments are carried at cost, which approximates fair value.
Other investments may include alternative investments and other securities. Alternative investments are accounted for using the equity method, with income typically recognized on a one-quarter lag. Other securities are primarily comprised of tax credit investments and equity securities without readily determinable fair values that are not carried at NAV as a practical expedient. These equity securities are carried at cost. Accounting for our tax credit investments is dependent on the type of credit we have purchased, as follows:
•
Federal low income housing tax credits are accounted for under the proportional amortization method; and
•
All other tax credits in our investment portfolio are accounted for using the equity method.
For federal tax credits accounted for under the equity method, we use the deferral method for recognizing the benefit of the tax credit with the related deferred revenue being recognized in our Consolidated Income Statement as a component of "Federal income tax expense" proportionately over the life of the investment.
We evaluate the alternative investments and tax credit investments included in our other investments portfolio to determine whether those investments are variable interest entities ("VIEs") and if so, whether consolidation is required. A VIE is an entity that either has equity investors that lack certain essential characteristics of a controlling financial interest or lack sufficient funds to finance its own activities without financial support provided by other entities. We consider several significant factors in determining if our investments are VIEs and if we are the primary beneficiary, including whether we have: (i) the power to direct activities of the VIE; (ii) the ability to remove the decision maker of the VIE; (iii) the ability to participate in making decisions that are significant to the VIE; and (iv) the obligation to absorb losses and the right to receive benefits that could potentially be significant to the VIE. We have reviewed our alternative and tax credit investments and have concluded that they are VIEs, but that we are not the primary beneficiary and therefore, consolidation is not required.
Presentation in the Consolidated Statements of Income
Net investment income earned on our Consolidated Statements of Income include the following:
•
Interest income, as well as amortization and accretion, on fixed income securities;
•
Dividend income on equity securities;
•
Interest income on our short-term investments; and
•
Income recognized on our alternative and other investments accounted for under the equity method of accounting, except for federal tax credits, as discussed below.
Income related to federal tax credits (either low income housing tax credits or other federal credits) is recorded in our Consolidated Statements of Income as a component of “Federal income tax expense” proportionately over the life of the investment.
Net realized and unrealized gains and losses on our Consolidated Statements of Income include the following:
•
Realized gain and losses on the disposal of investment securities, which are determined on the basis of the cost of the specific investments sold;
•
Other-than-temporary impairment ("OTTI") charges that are credit related or related to our intent to sell; and
•
Changes in unrealized gains or losses on our equity securities that are carried at fair value.
On a quarterly basis, we review our investment portfolio for impairments that are other than temporary. The following provides information on this analysis for our fixed income securities and short-term investments, and our other investments.
OTTI Charges on Fixed Income Securities and Short-Term Investments
We review our fixed income securities and short-term investments that are in an unrealized loss position to determine: (i) if we have the intent to sell the security; (ii) if it is more likely than not that we will be required to sell the security before its anticipated recovery; (iii) if the decline is other than interest-rate related; and (iv) if the decline is other than temporary. Broad changes in the overall market or interest rate environment generally will not lead to a write down. If we determine that we have either the intent or requirement to sell the security, we write down its amortized cost to its fair value through an OTTI charge to earnings. If we do not have either the intent or requirement to sell the security, our evaluation for OTTI may include, but is not limited to, evaluation of the following factors:
•
Whether the decline appears to be issuer or industry specific;
•
The degree to which the issuer is current or in arrears in making principal and interest payments on the fixed income security;
•
The issuer’s current financial condition and ability to make future scheduled principal and interest payments on a timely basis;
•
Evaluation of projected cash flows;
•
Buy/hold/sell recommendations published by outside investment advisors and analysts; and
•
Relevant rating history, analysis, and guidance provided by rating agencies and analysts.
To determine if an impairment is other than temporary, we perform assessments that may include, but are not limited to, a discounted cash flow analysis ("DCF") to determine the security's present value of future cash flows. This analysis is also performed on all previously-impaired debt securities that continue to be held by us and all RMBS, CMBS, CLOs and ABS that were not of high credit quality at the date of purchase. 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 a “non-credit impairment.” 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.
The discount rate we use in a DCF is the effective interest rate implicit in the security at the date of acquisition for those RMBS, CMBS, CLOs and other ABS 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. DCFs may include, but are not necessarily limited to: (i) generating cash flows for each tranche considering tranche-specific data, market data, and other pertinent information, such as the historical performance of the underlying collateral, including net operating income generated by underlying properties, conditional default rate assumptions, loan loss severity assumptions, consensus projections, prepayment projections, and actual pool and collateral information; (ii) identifying applicable benchmark yields; and (iii) applying market-based tranche specific spreads to determine an appropriate yield by incorporating collateral performance, tranche-level attributes, trades, bids, and offers.
Non-redeemable preferred stocks that are classified as fixed income securities are evaluated using the OTTI method described above unless the security is below investment grade. In this situation, we would determine: (i) if we do not intend to hold the security to its forecasted recovery; or (ii) if the decline is other than temporary, which includes declines driven by market volatility for which we cannot assert recovery in the near term. If we determine either that we do not intend to hold the security, or the decline is other than temporary, we write down the security's cost to its fair value through an OTTI charge to earnings.
OTTI Charges on Other Investments
Our evaluation for OTTI of an alternative investment may include, but is not limited to, conversations with the management of the alternative investment concerning the following:
•
The current investment strategy;
•
Changes made or future changes to be made to the investment strategy;
•
Emerging issues that may affect the success of the strategy; and
•
The appropriateness of the valuation methodology used regarding the underlying investments.
Our evaluation for OTTI of our other investments (tax credits and equity securities without a readily determinable fair value for which NAV is not used as a practical expedient) include a qualitative assessment of impairment indicators, which include, but are not limited to, the following:
•
A significant deterioration in the earnings performance, credit ratings, asset quality, or business prospects of the investee;
•
A significant adverse change in the regulatory, economic, or technological environment of the investee;
•
A significant adverse change in the general market condition of either the geographical area or the industry in which the investee operates;
•
A bona fide offer to purchase, or an offer by the investee to sell, or a completed auction process for the same or similar investment for an amount less than the carrying amount of that investment; and
•
Factors that raise significant concerns about the investee's ability to continue as a going concern, such as negative cash flows from operations, working capital deficiencies, or noncompliance with statutory capital requirements or debt covenants.
If there is a decline in the fair value of an alternative or other investment that we do not intend to hold, or if we determine the decline is other than temporary, we write down the carry value of the investment through an OTTI charge to earnings.
(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:
Level 1 Pricing
Level 2 Pricing
We utilize a market approach for our Level 2 securities, 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. 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 fair value fluctuations between months for reasonableness; and (iii)
reviewing stale prices. If further analysis is needed, a challenge is sent to the pricing service for review and confirmation of the price.
Further information on our Level 2 asset pricing is included in the following table:
Level 3 Pricing
Less than 1% of our portfolio cannot be priced using our primary or secondary pricing service. At times, we may use valuations performed by the issuer or non-binding broker quotes to determine the fair value of these securities. We internally review these fair value measurements for reasonableness. This review typically includes an analysis of price fluctuations between months with variances over established thresholds being analyzed further.
Liabilities
The techniques used to value our notes payable are as follows:
Level 1 Pricing
Level 2 Pricing
(f) Allowance for Uncollectible Accounts
We estimate an allowance for uncollectible 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 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. The fair value of both 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. We repurchase the Parent’s stock from our employees in connection with tax withholding obligations, as permitted under our stock-based compensation plans. This activity is disclosed in our Consolidated Statements of Stockholders' Equity.
(h) Reinsurance
Reinsurance recoverable represents 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 one or more of our ten insurance subsidiaries' domiciliary states. Our ten insurance subsidiaries are collectively referred to as the "Insurance Subsidiaries." This collateral is typically in the form of 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 reinsurer's credit rating from A.M. Best 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 $19.5 million, $17.8 million, and $17.4 million for 2018, 2017, and 2016, 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 operations, consistent with our reportable segments of Standard Commercial Lines, Standard Personal Lines, and E&S Lines. A combined ratio of over 100% does not necessarily indicate a premium deficiency, as any year's combined ratio includes a portion of underwriting expenses that are expensed at policy inception and therefore are not covered by the remaining unearned premium. In addition, investment income is not contemplated in the combined ratio calculation.
There were no premium deficiencies for any of the reported years, as the sum of the anticipated loss and loss expense, unamortized acquisition costs, policyholder dividends, and other expenses for each segment did not exceed that segment’s related unearned premium and anticipated investment income. The investment yields assumed in the premium deficiency assessment for each reporting period, which were based on our actual average investment yield before tax as of the September 30 calculation date, were 3.3% for 2018, 2.9% for 2017, and 2.4% for 2016.
(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 our 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. Based on our analysis at December 31, 2018, goodwill was not impaired.
(l) Reserve for Loss and Loss Expense
Reserves for loss and loss expense are comprised of both case reserves on individual claims and reserves for claims incurred but not reported ("IBNR"). Case reserves result from claims that have been reported to one or more of our Insurance Subsidiaries, and are estimated at the amount of the expected ultimate payment. IBNR reserves are established at more aggregated levels than case basis reserves, and include: (i) reserves on IBNR claims; and (ii) provisions for future emergence on known or reopened claims. IBNR reserves are established based on the results of the Insurance Subsidiaries’ internal reserve analysis, supplemented with other internal and external information.
The internal reserve analysis is performed quarterly, and relies upon 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. Our analyses rely upon historical paid and case loss and loss expense experience organized by line of business, accident year, and maturity (i.e., “triangles”). Standard actuarial projection methods are applied to this history, producing a set of estimated ultimate loss and loss expenses. Ultimate loss and loss expenses are selected from the various methods, considering the strengths and weaknesses of the methods as they apply to the specific line and accident year.
Certain types of exposures do not lend themselves to standard actuarial methods. Examples of these are:
•
Certain property catastrophe events may be low in frequency and high in severity. These events may affect many insureds simultaneously. Due to the unique nature of these events, ultimate liabilities are estimated for each event, based on surveys of our portfolio of exposures, in conjunction with individual claims estimates. While generally short-tailed, the liabilities associated with these events are subject to a higher degree of uncertainty. We maintain significant reinsurance protection that greatly limits the impact that these extreme events have on net loss and loss expenses.
•
Some insured events may span multiple years and trigger multiple policies, as in the case of asbestos and environmental claims, where the injury is deemed to occur over an extended period of time. These types of losses often do not lend themselves to traditional actuarial methods. Where we deem appropriate, our experience may be analyzed without differentiating by accident year, using alternative methods and metrics. In these cases, the associated selected ultimate loss and loss expenses are then allocated to the applicable accident years for reporting.
•
Another example of non-standard methods relate to loss expenses that cannot be attributed to a specific claim (referred to as “unallocated loss expenses”). These expenses are first allocated to line of business, and alternative projection methods are then applied to estimate expenses by calendar year, which are then allocated back to the applicable accident years for reporting.
The selected ultimate loss and loss expenses are translated into indicated IBNR reserves, which are then compared to the recorded IBNR reserves. Management's judgment is applied in determining any required adjustments to IBNR and the resulting adjustments are then recorded and assigned or allocated to accident year using the results of the actuarial analysis.
While the reserve analysis is the primary basis for determining the recorded IBNR reserves, other internal and external factors are considered. Internal factors include: (i) supplemental data regarding claims reporting and settlement trends; (ii) exposure estimates for reported claims, along with recent development on those estimates with respect to individual large claims and the aggregate of all claims; (iii) the rate at which new large or complex claims are being reported; and (iv) additional trends observed by claims personnel or reported to them by defense counsel. External factors considered include: (i) legislative enactments; (ii) judicial decisions; (iii) legal developments in the determination of liability and the imposition of damages; (iv) social inflation and heightened awareness of sources of liability; and (v) trends in general economic conditions, including the effects of inflation.
Loss reserves are estimates, and as such, we also consider a range of possible loss and loss expense reserve estimates. This range is determined at the beginning of each year, using prior year-end data, and reflects the fact that there is no single precise method for estimating the required reserves, due to the many factors that may influence the amounts ultimately paid. Considering the reserve range along with all of the items described above, as well as current market conditions, IBNR estimates are then established and recorded.
The combination of the IBNR estimates along with the case reserve estimates on individual claims results in our total reserves for loss and loss expense. These reserves are expected to be sufficient for settling loss and loss expense obligations under our policies on unpaid claims, including 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 ultimate settlement of loss and loss expense. However, the ultimate claim settlements may be higher or lower than reserves established. As our experience emerges and
other information develops, we revise our reserve estimates accordingly. 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. The associated impacts may be material to the results of operations in future periods.
We do not discount to present value that portion of our loss and loss expense reserves expected to be paid in future periods.
Our loss and loss expense reserves implicitly include anticipated recoveries for salvage and subrogation claims.
Claims are counted at the occurrence, line of business, and policy level. For example, if a single occurrence (e.g. an auto accident) leads to a claim under an auto and an associated umbrella policy, they are each counted separately. Conversely, multiple claimants under the same occurrence/line/policy would contribute only a single count. The claim counts provided are on a reported basis. A claim is considered reported when a reserve is established or a payment is made. Therefore, claims closed without payment are included in the count as long as there was an associated case reserve at some point in its life cycle.
We also write a small amount of assumed reinsurance. Currently, this business is limited to our share of certain involuntary pools. As the associated claims are not processed by us, they are not captured within our claims system. Therefore, the claim counts reported exclude this business.
(m) Revenue Recognition
The Insurance Subsidiaries' net premiums written (“NPW”) include direct insurance policy writings, plus reinsurance assumed and estimates of premiums earned but unbilled on the workers compensation and general liability lines of business, 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. 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 report these dividends within "Other insurance expenses" on the Consolidated Statements of Income. 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 either “Other insurance expenses” or "Corporate expenses" on the Consolidated Statements of Income depending on the nature of what caused the occurrence of such an item.
(p) Leases
We have various operating leases for office space, equipment, and fleet vehicles. 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" 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 with a corresponding 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, based on the average life expectancy of the employee. Our funding policy provides that payments to our pension trust shall be equal to the minimum funding requirements of the Employee Retirement Income Security Act of 1974 ("ERISA"), plus additional amounts that the Board of Directors of Selective Insurance Company of America (“SICA”) may approve from time to time.
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 and mortality.
Note 3. Adoption of Accounting Pronouncements
In January 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2016-01,
Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU
2016-01”). ASU 2016-01 provides guidance to improve certain aspects of recognition, measurement, presentation, and
disclosure of financial instruments. Specifically the guidance: (i) requires equity securities held in our investment portfolio to
be measured at fair value with changes in fair value recognized in earnings; (ii) simplifies the impairment assessment of equity
investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; (iii)
eliminates the requirement to disclose the methods and significant assumptions used to estimate the fair value that is required to
be disclosed for financial instruments measured at amortized cost; (iv) requires the use of the exit price notion when measuring
the fair value of financial instruments for disclosure purposes; and (v) clarifies that the need for a valuation allowance on a
deferred tax asset related to an available-for-sale ("AFS") security should be evaluated with other deferred tax assets.
We adopted ASU 2016-01 in the first quarter of 2018 and recognized a $30.7 million cumulative-effect adjustment to the
opening balances of accumulated other comprehensive income ("AOCI") and retained earnings, which represents the after-tax
net unrealized gain on our equity portfolio as of December 31, 2017. Additionally, beginning in the first quarter of 2018,
changes in unrealized gains or losses on this portfolio are no longer recorded to AOCI, but are instead recognized in income
through "Net unrealized losses on equity securities" on our Consolidated Statements of Income. See Note 5. "Investments" below for information regarding unrealized equity losses recognized in income for 2018.
There were two accounting updates that we adopted with a retrospective transition in the first quarter of 2018 that related to our
statements of cash flows. These accounting updates impacted our categorization of distributions from equity method investees
(ASU 2016-15, Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments ("ASU 2016-15")) and
the presentation of restricted cash (ASU 2016-18, Statement of Cash Flows: Restricted Cash ("ASU 2016-18")). These ASUs
are discussed below and the discussions are followed with a table presenting the impact of the prior period restatements.
In August 2016, the FASB issued ASU 2016-15. As mentioned above, this ASU adds guidance on the categorization of
distributions from equity method investees within the statement of cash flows. In accordance with this guidance, we made an
accounting policy election to classify these distributions using the cumulative earnings approach. This election resulted in a
restatement to operating and investing cash flows as outlined in the table below. ASU 2016-15 also added or clarified guidance
on the cash flow classification of certain cash receipts and payments, including, but not limited to: (i) debt prepayment or debt
extinguishment costs; (ii) proceeds from the settlement of corporate-owned life insurance policies, including bank-owned life
insurance policies; and (iii) separately identifiable cash flows and application of the predominance principle. The updated
guidance for these topics did not result in any restatements to our statement of cash flows.
In November 2016, the FASB issued ASU 2016-18. ASU 2016-18 requires restricted cash and restricted cash equivalents to be
included with cash and cash equivalents in the reconciliation of beginning and ending cash on the statements of cash flows.
This update also requires a reconciliation of the statement of the cash flows to the balance sheet if the balance sheet includes
more than one line item containing cash, cash equivalents, and restricted cash. We have restricted cash related to our
participation in the NFIP, which we had previously reported as part of "Other assets" on the Consolidated Balance Sheets.
Beginning in the first quarter of 2018, we are reporting restricted cash in its own line item on the Consolidated Balance Sheets
to aid in the reconciliation of the amounts presented on the Consolidated Statements of Cash Flows. We have also restated
prior year balances on the Consolidated Balance Sheets to conform to the current year presentation.
The adoption of this guidance resulted in a restatement of operating cash flows in 2017 and 2016 to remove the impact of
the change in restricted cash from operating activities and include the restricted cash balance in the reconciliation of beginning
and ending cash balances on the Statements of Cash Flows. In addition, we have included the required reconciliation in Note 4.
"Statements of Cash Flows" below.
ASU 2016-15 and ASU 2016-18 resulted in the following line item restatements within operating and investing cash flows on
the Statements of Cash Flows:
In January 2017, the FASB issued ASU 2017-04, Intangibles-Goodwill and Other: Simplifying the Test for Goodwill
Impairment (“ASU 2017-04”). ASU 2017-04 eliminates the second step of the two part goodwill impairment test, which
required entities to determine the fair value of individual assets and liabilities of a reporting unit to measure the goodwill
impairment. Under the new guidance, a goodwill impairment is calculated as the amount by which a reporting unit’s carrying
value exceeds its fair value, not to exceed the carrying amount of goodwill. An entity still has the option to perform the
qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. The amendments in this
update are to be applied on a prospective basis for annual or interim goodwill impairment tests in fiscal years beginning after
December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates
after January 1, 2017. We adopted ASU 2017-04 in the first quarter of 2018 and it had no impact on us.
In March 2017, the FASB issued ASU 2017-07, Compensation-Retirement Benefits: Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost ("ASU 2017-07"). ASU 2017-07 requires that an employer report a pension plan's service cost in the same line item or line items as other compensation costs arising from services rendered by pertinent employees during the period. ASU 2017-07 also requires that other components of net benefit cost be presented in the income statement separately from the service cost component. If a separate line item or items are not used, the line item or items used in the income statement to present the other components of net benefit cost must be disclosed. ASU 2017-07 was effective for annual periods beginning after December 15, 2017, including interim periods within those annual periods, with early adoption permitted at the beginning of an annual period. We adopted ASU 2017-07 in the first quarter of 2018, but it had no impact on us as our pension plan was frozen as of March 2016 and we have therefore ceased accruing additional service fee costs since that time.
In February 2018, the FASB issued ASU 2018-02, Income Statement - Reporting Comprehensive Income ("ASU 2018-02").
ASU 2018-02 allows a one-time reclassification from AOCI to retained earnings for the stranded tax assets that were created in
AOCI from the enactment of the Tax Cuts and Jobs Act of 2017 ("Tax Reform"). We adopted ASU 2018-02 in the first quarter
of 2018 and recognized a $5.7 million cumulative-effect adjustment for the deferred tax charge to income in the fourth quarter
of 2017 that was associated with net unrealized gains on our investment portfolio and pension plan resulting from the
enactment of Tax Reform.
Pronouncements to be effective in the future
The FASB has issued new leasing guidance through ASU 2016-02, Leases, which was issued in February 2016, as well as
additional implementation guidance that was issued in 2018 (collectively referred to as "ASU 2016-02"). ASU 2016-02
requires all lessees to recognize assets and liabilities on their balance sheets for the rights and obligations created by leases with
terms longer than 12 months. For leases with a term of 12 months or less, an accounting policy election is allowed to recognize
lease expense on a straight-line basis over the lease term. Under the new lease guidance, we expect an increase in assets and
liabilities as we will recognize operating leases for office space, fleet vehicles, and equipment on our Consolidated Balance Sheets for the first time. ASU 2016-02 allows for certain practical expedients, accounting policy elections, and a transition method election. We currently plan to adopt practical expedients related to reassessing: (i) whether our existing contracts are,
or contain, leases; (ii) lease classification for existing leases; and (iii) initial direct costs for existing leases. Additionally, we plan to adopt accounting policy elections to: (i) aggregate lease and non-lease components of a contract into a single lease component; and (ii) expense short-term leases on a straight-line basis over the lease term. We will be adopting ASU 2016-02 effective January 1, 2019 with a cumulative-effect adjustment to the opening balance of retained earnings as of that date. We do not anticipate the impact of this guidance to be material to our financial condition or results of operations, as operating lease right-of-use assets are expected to be approximately $21 million at transition with related lease liabilities of approximately $20 million. The differential of $1 million will be recognized, on an after-tax basis, as a cumulative-effect adjustment to the opening balance of 2019 retained earnings. Financing lease right-of-use assets and the related lease liabilities are expected to be approximately $1 million as of January 1, 2019.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (“ASU 2016-13”). ASU 2016-13 will change the way entities recognize impairment of financial assets by requiring immediate recognition of estimated credit losses expected to occur over the remaining life of many financial assets, including, among others, HTM debt securities, trade receivables, and reinsurance recoverables. This ASU will not impact the impairment accounting model for AFS debt securities. ASU 2016-13 requires a valuation allowance to be calculated on these financial assets and that they be presented on the financial statements net of the valuation allowance. The valuation allowance is a measurement of expected losses that is based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This methodology is referred to as the current expected credit loss model. ASU 2016-13 is effective for fiscal years beginning after December 15, 2019, including interim periods within those annual periods. Early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2018. We are currently evaluating the impact of this guidance on our financial condition and results of operations.
In June 2018, the FASB issued ASU 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to
Nonemployee Share-Based Payment Accounting ("ASU 2018-07"). The amendments in ASU 2018-07 expand the scope of
Topic 718 to include share-based payment transactions for acquiring goods and services from non-employees. ASU 2018-07 is
effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is
permitted. The adoption of this guidance will not have a material impact on our financial condition or results of operations.
In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement: Disclosure Framework - Changes to the Disclosure
Requirements for Fair Value Measurement (“ASU 2018-13”). ASU 2018-13 modifies the disclosure requirements for fair value
measurements. The modifications removed the following disclosure requirements: (i) the amount of, and reasons for, transfers
between Level 1 and Level 2 of the fair value hierarchy; (ii) the policy for timing of transfers between levels; and (iii) the
valuation processes for Level 3 fair value measurements. This ASU added the following disclosure requirements: (i) the
changes in unrealized gains and losses for the period included in other comprehensive income ("OCI") for recurring Level 3
fair value measurements held at the end of the reporting period; and (ii) the range and weighted average of significant
observable inputs used to develop Level 3 fair value measurements. This update is effective for annual and interim periods
beginning after December 15, 2019, with early adoption permitted. As the requirements of this literature are disclosure only,
ASU 2018-13 will not impact our financial condition or results of operations.
In August 2018, the FASB issued ASU 2018-14, Compensation - Retirement Benefits - Defined Benefit Plans - General:
Disclosure Framework - Changes to the Disclosure Requirements for Defined Benefit Plans (“ASU 2018-14”). ASU 2018-14
modifies the disclosure requirements for employers that sponsor defined benefit pension or other postretirement plans. These
modifications include: (i) removing the requirement to disclose the amount in AOCI expected to be recognized as components
of net periodic benefit cost over the next fiscal year; and (ii) adding the requirement to disclose an explanation of the reasons
for significant gains or losses related to changes in the benefit obligation for the period. This update is effective for fiscal years
ending after December 15, 2020, with early adoption permitted. As the requirements of this literature are disclosure only, ASU
2018-14 will not impact our financial condition or results of operations.
In August 2018, the FASB issued ASU 2018-15, Intangibles - Goodwill and Other - Internal-Use Software: Customer’s
Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract (“ASU
2018-15”). ASU 2018-15 aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that
is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use
software. This update is effective for annual and interim periods beginning after December 15, 2019, with early adoption
permitted. We are currently evaluating the impact of this guidance on our financial condition or results of operations.
Note 4. Statements of Cash Flows
Supplemental cash flow information for the years ended December 31, 2018, 2017, and 2016 is as follows:
1Examples of corporate actions include exchanges, non-cash acquisitions, and stock-splits.
The following table provides a reconciliation of cash and restricted cash reported within the Consolidated Balance Sheets that equate to the amount reported in the Consolidated Statements of Cash Flows:
Amounts included in restricted cash represent cash received from the NFIP, which is restricted to pay flood claims under the Write Your Own 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, 2018, 2017, and 2016:
1Upon adoption of ASU 2016-01, we recognized a $30.7 million cumulative-effect adjustment to the opening balance of AOCI, which represents the after-tax net unrealized gain on our equity portfolio as of December 31, 2017. Additionally, upon adoption of ASU 2018-02, we recognized a one-time reclassification from AOCI to retained earnings for $17.9 million representing the stranded tax assets related to our investment portfolio that were created in AOCI from the enactment of Tax Reform. See Note 3. "Adoption of Accounting Pronouncements" above for additional information.
(b) Information regarding our HTM fixed income securities as of December 31, 2018 and December 31, 2017 was 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 date a security is designated as HTM through the date of the balance sheet.
(c) Information regarding our AFS securities as of December 31, 2018 and December 31, 2017 were as follows:
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. As of the first quarter of 2018, equity securities are no longer required to be included in the table above under new accounting guidance that provides that unrealized gains and losses on equity securities should no longer be recognized in AOCI, but instead recognized though income. Refer to Note 3. "Adoption of Accounting Pronouncements" for additional information regarding the adoption of ASU 2016-01.
(d) The severity of impairment on the securities in an unrealized/unrecognized loss position averaged approximately 2% of amortized cost at December 31, 2018 and approximately 1% at December 31, 2017. Quantitative information regarding unrealized losses on our AFS portfolio is provided below. Our HTM portfolio had $0.2 million in unrealized/unrecognized losses at December 31, 2018 and $0.1 million in unrealized/unrecognized losses at December 31, 2017.
The increase in the less than 12 months unrealized loss position was due to higher interest rates, with a 60-basis point increase in the 2-year U.S. Treasury Note yields and a 28-point basis increase in the 10-year U.S. Treasury Note yields during 2018. We do not currently intend to sell any of the securities in the tables above, nor will we be required to sell any of these securities. Considering these factors and our review of these securities under our OTTI policy as described in Note 2,“Summary of Significant Accounting Policies” of this Form 10-K, we have concluded that they are temporarily impaired as we believe: (i) they will mature at par value; (ii) they have not incurred a credit impairment; and (iii) future values of these securities will fluctuate with changes in interest rates. 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.
(e) Fixed income securities at December 31, 2018, by contractual maturity are shown below. Mortgage-backed securities 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 the contractual maturities of fixed income securities at December 31, 2018:
(f) The following table summarizes our other investment portfolio by strategy:
1The maximum exposure to loss includes both the carrying value of these investments and the related unfunded commitments. In addition, tax credits that have been previously recognized in Other securities are subject to the risk of recapture, which we do not consider significant.
2Other securities primarily consists of tax credit investments.
We have reviewed various investments included in the table above and have concluded that they are VIEs, but that we are not the primary beneficiary and therefore, consolidation is not required. We do not have a future obligation to fund losses or debts on behalf of these investments; however, we are contractually committed to make additional investments up to the remaining commitment outlined above. We have not provided any non-contractual financial support at any time during 2018 or 2017.
The following is a description of our alternative investment strategies:
Our private equity strategy includes the following:
•
Primary Private Equity: This strategy makes private equity investments, primarily in established large and middle market companies across diverse industries globally.
•
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.
•
Venture Capital: In general, these investments are 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 private credit strategy includes the following:
•
Middle Market Lending: This strategy provides privately negotiated loans to U.S. middle market companies. Typically, these are floating rate, senior secured loans diversified across industries. Loans can be made to private equity sponsor-backed companies or non-sponsored companies to finance LBOs, recapitalizations, and acquisitions.
•
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.
•
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.
Our real assets strategy includes the following:
•
Energy & Power Generation: This strategy makes energy and power generation investments in cash flow generating infrastructure assets. Energy investments are made in a variety of industries including oil, natural gas, and coal. These investments are diversified across the energy supply chain and include assets in the exploration and production, pipeline, and refining sectors. Power generation includes investments in: (i) conventional power, such as natural gas and oil; (ii) renewable power, such as wind and solar; and (iii) electric transmission and distribution.
•
Real Estate: This strategy invests in real estate in North America, Europe, and Asia via direct property ownership, joint ventures, mortgages, and investments in equity and debt instruments.
Our alternative investment strategies generally employ low or moderate levels of leverage and may use hedging to reduce foreign exchange or interest rate volatility. At this time, our alternative investment strategies do not include hedge funds. We typically 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 or income generated in the limited partnerships.
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 did not have exposure to any credit concentration risk of a single issuer greater than 10% of our stockholders' equity, other than certain U.S. government agencies, as of December 31, 2018 or December 31, 2017.
(h) We have pledged certain AFS fixed income securities as collateral related to our relationships with the Federal Home Loan Bank of Indianapolis ("FHLBI") and the Federal Home Loan Bank of New York ("FHLBNY"). In addition, certain securities were on deposit with various state and regulatory agencies at December 31, 2018 to comply with insurance laws. We retain all rights regarding all securities pledged as collateral.
The following table summarizes the market value of these securities at December 31, 2018:
(i) The components of pre-tax net investment income earned were as follows:
(j) The following tables summarize OTTI by asset type for the periods indicated:
(k) Net realized and unrealized gains and losses included the following:
1Includes unrealized holding gains (losses) of: (i) $(3.1) million on equity securities remaining in our portfolio as of December 31, 2018; and (ii) $(26.3) million on equity securities sold in 2018.
The components of net realized (losses) gains on disposals 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 fixed income securities were $2,030.7 million, $1,197.9 million, and $926.5 million in 2018, 2017, and 2016, respectively. Proceeds from sale of equity securities were $113.3 million, $38.0 million, and $119.6 million in 2018, 2017, and 2016, respectively.
Net realized (losses) gains in the table above were driven by the following:
•
2018: Higher trading volume driven by opportunistic sales in both our fixed income securities and equity portfolios.
•
2017: Higher trading volume in our fixed income securities portfolio related to a more active external investment management approach and opportunistic sales in our equity portfolio.
2016: A repositioning of our equity portfolio, partially offset by net losses in our AFS fixed income portfolio related to the change in our strategy to more actively manage this portfolio.
Note 6. Comprehensive Income
(a) The components of comprehensive income, both gross and net of tax, for 2018, 2017, and 2016 were as follows:
(b) The balances of, and changes in, each component of AOCI (net of taxes) as of December 31, 2018 and 2017 were as follows:
1 Upon adoption of ASU 2016-01 and ASU 2018-02 in the first quarter of 2018, we recognized a $25.0 million cumulative-effect adjustment to the opening balance of AOCI, which represents the after-tax net unrealized gain on our equity portfolio as of December 31, 2017 and the one-time reclassification from AOCI to retained earnings for the stranded tax assets that were created in AOCI from the enactment of Tax Reform. See Note 3. "Adoption of Accounting Pronouncements" above for additional information.
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, 2018 and 2017:
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 and recorded at fair value at December 31, 2018 and 2017:
1There were no transfers of securities between Level 1 and Level 2.
2In accordance with ASU 2015-07, investments amounting to $37.3 million and $23.7 million at December 31, 2018 and December 31, 2017, respectively, were measured at fair value using the net asset value per share (or its practical expedient) and have not been classified in the fair value hierarchy. The fair value amounts presented in this table are intended to permit reconciliation of the fair value hierarchy to total assets measured at fair value.
The following table provides a summary of the changes in the fair value of securities measured using Level 3 inputs and related quantitative information during 2018:
The following tables provide quantitative information regarding our financial assets and liabilities that were not measured, but were disclosed at fair value at December 31, 2018 and 2017:
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 reinsurance treaties.
As a Standard Commercial Lines and E&S Lines writer, we are subject to the Terrorism Risk Insurance Program Reauthorization Act ("TRIPRA"), which was extended by Congress 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 2019, our deductible is approximately $339 million. For losses above the deductible, the federal government will pay 81% of losses to an industry limit of $100 billion, and the insurer retains 19%. The federal share of losses will be reduced to 80% in 2020.
The Insurance Subsidiaries remain liable to policyholders to the extent that any reinsurer becomes unable to meet their contractual obligations. In addition to this direct counterparty credit risk, we have indirect counterparty credit risk as our reinsurers often enter into their own reinsurance programs, or retrocessions, as part of managing their exposure to large losses. 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 $4.5 million at December 31, 2018 and $4.6 million at December 31, 2017.
The following table represents our total reinsurance balances segregated by reinsurer to illustrate our concentration of risk throughout our reinsurance portfolio:
1Considered to have minimal risk of default.
2Includes letters of credit, trust funds, and funds held against reinsurance recoverables.
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 loss and loss expense incurred:
The ceded premiums and losses related to our participation in the NFIP, under which 100% of our flood premiums, and loss and loss expense are ceded to the NFIP, are as follows:
Note 9. Reserve for Loss and Loss Expense
(a) The table below provides a roll forward of reserves for loss and loss expense for beginning and ending reserve balances:
Our net loss and loss expense reserves increased by $171.1 million in 2018, $104.9 million in 2017, and $113.8 million in 2016. The loss and loss expense reserves are net of anticipated recoveries for salvage and subrogation claims, which amounted to $67.7 million for 2018, $64.8 million for 2017, and $64.9 million for 2016. The increase in net loss and loss expense reserves in 2018 was primarily driven by increases in: (i) current year loss costs on our commercial automobile line of business; and (ii) exposure due to premium growth. This increase was partially offset by favorable prior year loss development, largely driven by the workers compensation and general liability lines of business.
In 2018, we experienced overall net favorable prior year loss development of $29.9 million, compared to $39.2 million in 2017 and $65.8 million in 2016. The following table summarizes the prior year development by line of business:
The Insurance Subsidiaries had $29.9 million of favorable prior accident year development during 2018, which included $41.5 million of net favorable casualty development and $11.6 million of unfavorable property development. The net favorable casualty reserve development was largely driven by the workers compensation and general liability lines of business. Partially offsetting this net favorable development was $37.5 million of unfavorable casualty development in the commercial auto line of business. In addition, our E&S casualty lines experienced unfavorable development of $12.0 million in 2018.
The majority of the 2018 net favorable development was attributable to our workers compensation line of business, which was impacted by continued favorable medical trends in accident years 2017 and prior. Partially offsetting this was adverse development in the commercial automobile line of business, driven by increases in severities in accident years 2015 through 2017.
The Insurance Subsidiaries had $39.2 million of favorable prior accident year development during 2017, which included $48.6 million of net favorable casualty development and $9.4 million of unfavorable property development. The net favorable casualty reserve development was largely driven by the workers compensation and general liability lines of business, including products liability and excess liability. Partially offsetting this net favorable development was $36.0 million of unfavorable casualty development in the commercial auto line of business, which was primarily driven by: (i) higher than expected frequencies and severities in accident years 2015 and 2016, and (ii) higher than expected severities in accident years 2012 through 2014. In addition, our E&S casualty lines experienced unfavorable development of $10.0 million in 2017.
The majority of the 2017 net favorable development was attributable to accident years 2014 and prior, driven by the general liability and workers compensation lines of business. This net favorable development was partially offset by unfavorable development in accident years 2015 and 2016 attributable to our commercial auto and E&S casualty lines of business. The unfavorable development in our commercial auto line of business was driven primarily by bodily injury liability for accident years 2012 through 2016, driven by higher than expected frequency and severity.
The Insurance Subsidiaries had $65.8 million of favorable prior accident year development during 2016, which included $69.0 million of net favorable casualty development and $3.2 million of unfavorable property development. The net favorable casualty reserve development was largely driven by the workers compensation and general liability lines of business, including products liability and excess liability. Partially offsetting this net favorable development was $25 million of unfavorable casualty development in the commercial automobile line of business. In addition, our E&S casualty lines experienced unfavorable development of $6.0 million in 2016.
The majority of the 2016 net favorable development was attributable to accident years 2013 and prior, driven by the workers compensation and general liability lines of business. This net favorable development was partially offset by unfavorable development in accident years 2014 and 2015 attributable to our commercial auto and E&S casualty lines of business. The unfavorable development in our commercial auto line of business was driven primarily by bodily injury liability for accident years 2014 and 2015. The unfavorable development in accident year 2014 was driven by higher than expected severity, whereas accident year 2015 was driven by higher than expected frequency and severity.
(b) 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 loss and loss expense reserves expected to be paid in future periods.
The following table details our loss and loss expense reserves for various asbestos and environmental claims:
Reserves for asbestos and environmental claims are highly uncertain. 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. Estimating IBNR is challenging because of the delayed and inconsistent reporting patterns associated with these claims. Traditional actuarial approaches cannot be applied because past loss history is not necessarily indicative of future behavior. While certain alternative projection models can be applied, such models can produce significantly different results with small changes in assumptions. As a result, reserves for asbestos and environmental require a high degree of judgment. Because of the significant uncertainty in the estimate, we do not calculate an asbestos and environmental loss range.
Historically, our asbestos and environmental claims have been significantly lower in volume than many other standard commercial lines carriers since, prior to the introduction of the absolute pollution exclusion endorsement in the mid-1980’s, we were primarily a Standard Personal Lines carrier and therefore do not have broad exposure to asbestos and environmental claims.
The following table provides a roll forward of gross and net asbestos and environmental incurred loss and loss expense and related reserves thereon:
(c) The following is information about incurred and paid claims development as of December 31, 2018, net of reinsurance, as well as cumulative claim frequency and the total of IBNR liabilities. During the experience period, we implemented a series of claims-related initiatives and claims management changes. These initiatives focused on claims handling and reserving, medical claims costs, and loss expenses. As a result of these initiatives, several historical patterns have changed and may no longer be appropriate to use as the sole basis for projections.
In 2011, the Parent purchased Mesa Underwriters Specialty Insurance Company ("MUSIC"), a wholly-owned E&S Lines subsidiary of Montpelier Re Holdings, Ltd. Under the terms of the purchase agreement, the Parent acquired net loss and loss reserves amounting to approximately $15 million. All development on this acquired business was fully reinsured as of the acquisition date.
(d) The reconciliation of the net incurred and paid claims development tables to the liability for loss and loss expenses in the consolidated statement of financial position is as follows:
(e) The table below reflects the historical average annual percentage payout of incurred claims by age. For example, the general liability line of business averages payout of 6.5% of its ultimate losses in the first year, 12.2% in the second year, and so forth. The following is supplementary information about average historical claims duration as of December 31, 2018:
Note 10. Indebtedness
The table below provides a summary of our outstanding debt at December 31, 2018 and 2017:
1 Beginning on January 1, 2019, finance lease obligations will also be included in our outstanding debt balance upon the adoption of the new lease accounting standard. For further information, refer to Note 3. "Adoption of Accounting Pronouncements, above.
Short-term Debt
SICA borrowed: (i) $75 million in short-term funds from the FHLBNY on February 27, 2018 at an interest rate of 1.75%, which was repaid on March 20, 2018; and (ii) $55 million in short-term funds from the FHLBNY on March 28, 2018 at an interest rate of 1.98%, which was repaid on April 18, 2018.
The Parent's line of credit with Wells Fargo Bank, National Association, as administrative agent, and Branch Banking and Trust Company (BB&T) (referred to as our "Line of Credit"), was renewed effective December 1, 2015, with a borrowing capacity of $30 million, which can be increased to $50 million with the approval of both lending partners. Our Line of Credit expires on December 1, 2020, and has an interest rate, which varies and is based on, among other factors, the Parent’s debt ratings. There were no balances outstanding under our Line of Credit at December 31, 2018 or at any time during 2018.
Our 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, 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 table below outlines information regarding certain of the covenants in the Line of Credit:
1Calculated in accordance with the 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. Additionally, the Line of Credit limits borrowings from the FHLBI and the FHLBNY to 10% of the respective member company's admitted assets for the previous year.
Long-term Debt
(1) In the first quarter of 2009, Selective Insurance Company of South Carolina ("SICSC") and Selective Insurance Company of the Southeast ("SICSE"), which are collectively referred to as the "Indiana Subsidiaries" as they are domiciled in Indiana, joined, and invested in, the FHLBI, which provides them with access to additional liquidity. The Indiana Subsidiaries’ aggregate investment in the FHLBI was $2.8 million at December 31, 2018 and December 31, 2017. 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. The proceeds from the FHLBI borrowing on December 16, 2016 of $60 million were used to repay a $45 million borrowing from the FHLBI that was outstanding at the time, with the remaining $15 million used for general corporate purposes. All borrowings from the FHLBI require security. For information on investments that are pledged as collateral for these borrowings, see Note 5. "Investments" above.
(2) In the fourth quarter of 2015, SICA and Selective Insurance Company of New York ("SICNY") joined, and invested in, the FHLBNY, which provides them with access to additional liquidity. The aggregate investment for both subsidiaries was $2.7 million at December 31, 2018 and $2.6 million at December 31, 2017. Our investment provides us the ability to borrow approximately 20 times the total amount of the FHLBNY common stock purchased with additional collateral, at comparatively low borrowing rates. In 2016, SICA borrowed the following amounts from the FHLBNY: (i) $25 million in August 2016 at an interest rate of 1.56%, which is due on August 16, 2021; and (ii) $25 million from the FHLBNY at an interest rate of 1.61%, which is due on July 21, 2021.
All borrowings from the FHLBNY require security. For information on investments that are pledged as collateral for these borrowings, see Note 5. "Investments" above.
(3) In February 2013, we issued $185 million of 5.875% Senior Notes due 2043. The notes became callable by us on 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 that were outstanding at the time. 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.
(4) In November 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%. Net proceeds of approximately $50 million were used to fund an irrevocable trust that subsequently funded 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.
(5) In November 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%. 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.
Note 11. Segment Information
The disaggregated results of our four reportable segments are used by senior management to manage our operations. These reportable segments are evaluated as follows:
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Our Standard Commercial Lines, Standard Personal Lines, and E&S Lines are evaluated based on before and after-tax underwriting results (net premiums earned, incurred loss and loss expense, policyholders dividends, policy acquisition costs, and other underwriting expenses), return on equity ("ROE") contribution, and combined ratios.
•
Our Investments segment is evaluated based on after-tax net investment income and its ROE contribution, as well as after-tax net realized and unrealized gains and losses.
In computing the results of each segment, we do not make adjustments for interest expense or corporate expenses. We do not maintain separate investment portfolios for the segments and therefore, do not allocate assets to the segments.
Our combined insurance operations are subject to certain geographic concentrations, particularly in the Northeast and Mid-Atlantic regions of the country. In 2018, approximately 19% of NPW were related to insurance policies written in New Jersey.
We had a goodwill balance of $7.8 million at both December 31, 2018 and 2017 on our Consolidated Balance Sheet that relates to our Standard Commercial Lines reporting unit.
The following summaries present revenues (net investment income and net realized gains on investments in the case of the Investments segment) and pre-tax income for the individual segments:
Note 12. Earnings per Share
The following table provides a reconciliation of the numerators and denominators of basic and diluted earnings per share ("EPS"):
Note 13. Federal Income Taxes
(a) On December 22, 2017, the Tax Cuts and Jobs Act of 2017 ("Tax Reform") was signed into law, which among other implications, reduced our statutory corporate tax rate from 35% to 21% beginning with our 2018 tax year. We revalued our deferred tax inventory at December 31, 2017 to reflect this reduction, which resulted in a $20.2 million charge to income as illustrated in the rate table below.
As of December 31, 2017, our accounting for the impact of Tax Reform on our deferred tax assets and liabilities was complete with the exception of amounts related to loss reserve discounting. Prior to Tax Reform, we had elected to use our own loss reserve payment patterns for determining the factors to be used for calculating our discounted loss reserves for federal income tax purposes. Under Tax Reform, this election was eliminated and we are now required to utilize discount factors based on industry experience and a corporate bond yield curve, which the IRS had not finalized as of December 31, 2017. Considering this, at December 31, 2017, we calculated a pre-tax decrease to our discounted loss reserves of $35 million by utilizing the industry experience approach under the tax law that existed prior to Tax Reform. This increased the deferred tax asset related to loss reserves by $7.5 million. A Tax Reform transition rule allows this change in accounting method to be amortized into expense over an eight-year period beginning in 2018. As a result, we established an offsetting deferred tax liability of $7.5 million as of December 31, 2017.
In the fourth quarter of 2018, the IRS published the loss reserve discount factors to be used for calculating the beginning and ending 2018 discounted loss reserves under the industry experience approach. Based on these factors, we calculated a pre-tax decrease to our discounted loss reserves of $125 million, which resulted in a deferred tax asset of $26.3 million, an increase from the $7.5 million estimate described above. The $26.3 million adjustment is being taken into income over eight years, beginning with 2018, at approximately $3.3 million per year.
(b) A reconciliation of federal income tax on income at the corporate rate to the effective tax rate is as follows:
12018 includes approximately $3.8 million of capital loss carry back items to prior tax years at the previous 35% statutory tax rate.
In addition to the impact of Tax Reform discussed above, our statutory tax rate reconciliation for 2018 and 2017 benefited from accounting literature implemented in 2017 that requires the tax effects of share-based compensation to be recognized in the income tax provision. Prior to 2017, these amounts were recorded in additional paid-in capital.
(c) The tax effects of the significant temporary differences that gave rise to deferred tax assets and liabilities were as follows:
Net deferred income tax assets increased by $21.6 million in 2018, driven by an $18.6 million decrease in gross deferred tax liabilities as rising interest rates have reduced unrealized gains on our fixed income securities portfolio.
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 had no valuation allowance recognized for federal deferred tax assets at December 31, 2018 or 2017.
We have analyzed our tax positions in all open tax years, which as of December 31, 2018 were 2015 through 2017, and 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" on our Consolidated Statements of Income. We are not currently under a federal income tax audit for any tax year.
Note 14. Retirement Plans
(a) Selective Insurance Retirement Savings Plan (“Retirement Savings Plan”)
SICA offers a voluntary defined contribution 401(k) plan that is available to most of our employees and is a tax-qualified retirement plan subject to ERISA. Expense recorded for this plan was $15.8 million in both 2018 and 2017, and $15.0 million in 2016.
(b) Deferred Compensation Plan
SICA offers a non-qualified deferred compensation plan, the Selective Insurance Company of America Deferred Compensation Plan ("Deferred Compensation Plan") to a group of management or highly compensated employees as a method of recognizing and retaining such employees. The Deferred Compensation Plan provides these employees 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. In addition to the employee deferrals, SICA may choose to make matching contributions to some or all of the participants in this plan to the extent the 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. Expense recorded for these contributions was $0.4 million in 2018, $0.2 million in 2017, and $0.3 million in 2016.
(c) Retirement Income Plan and Retirement Life Plan
SICA maintains a defined benefit pension plan, the Retirement Income Plan for Selective Insurance Company of America (the "Pension Plan"). This qualified, noncontributory plan is closed to new entrants and existing participants ceased accruing benefits after March 31, 2016.
In addition to the Pension Plan, SICA also sponsors the Supplemental Excess Retirement Plan (the "Excess Plan") and a life insurance benefit plan (the "Retirement Life Plan"). Both of these plans are closed to new entrants and participants in the Excess Plan ceased accruing benefits after March 31, 2016. The Retirement Life Plan does not accrue benefits and this plan applies only to retirees who terminated employment with SICA on or before March 31, 2009. These are both unfunded plans with benefit obligations as of December 31, 2018 and December 31, 2017 of $9.5 million and $10.1 million, respectively, for the Excess Plan and $5.8 million and $6.4 million, respectively, for the Retirement Life Plan. Expense recorded for the Excess Plan was $0.4 million in both 2018 and 2017, and $0.5 million in 2016. Expense recorded for the Retirement Life Plan was $0.3 million in each of 2018, 2017, and 2016.
The following tables provide details on the Pension Plan for 2018 and 2017:
The estimated net actuarial loss for the Pension Plan that will be amortized from AOCI into net periodic benefit cost during the 2019 fiscal year is $2.6 million.
1This assumption was 4.00% through March 31, 2016, the date after which benefits ceased accruing for all participants of the Pension Plan.
Our latest measurement date was December 31, 2018, at which time we increased our expected return on plan assets to 6.50%, reflecting a higher expected allocation to risk-seeking assets in the portfolio.
When determining the most appropriate discount rate to be used in the valuation, we consider, among other factors, our expected payout patterns of the Pension Plan's 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. The approach we utilize discounts the individual expected cash flows using the applicable spot rates derived from the yield curve over the projected cash flow period. The weighted average discount rate used to determine 2019 interest cost is 4.12%.
Pension Plan Assets
Assets of the Pension Plan are invested to adequately support the liability associated with the Pension Plan's defined benefit obligation. 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 shown below. In 2019, we will continue to phase in adjustments to the asset allocation to steadily close the gap between the duration of the assets and the duration of the liabilities, provided certain improved funding targets are achieved. Over time, the target and actual asset allocations may change based on the funded status of the Pension Plan and market return expectations.
The Pension Plan’s target ranges, as well as the actual weighted average asset allocation by strategy, at December 31 were as follows:
1Includes limited partnerships.
2Target percent allocations may change over time based on the funded status of the plan and market return expectations.
3The actual percentage of assets allocated to short-term investments is higher than our target as of December 31, 2018 due to portfolio rebalancing initiatives that are expected to be completed during 2019. As part of this rebalancing initiative, $49 million, or 15%, of plan assets were redeployed into risk seeking assets in January 2019. Excluding the impact of this redeployment, our short-term investments represented 5% of plan assets at December 31, 2018.
The use of derivative instruments is permitted under certain circumstances for the Pension Plan portfolio, but may not be used for unrelated speculative purposes or to create exposures that are not permitted in the Pension Plan's investment guidelines. Within the liability hedging assets, derivatives may be used to mitigate interest rate risk and reduce the interest duration mismatch between assets and liabilities of the Pension Plan to help insulate the funded status of the plan. We currently invest in a U.S. Treasury overlay derivative strategy, within the funds in our liability hedging assets, to manage the interest rate duration mismatch between the assets and liabilities of the Pension Plan. Considering the impact of this derivative overlay, the liability hedging assets provide for an approximate 50% hedge against the projected benefit obligation.
The Pension Plan had no investments in the Parent’s common stock as of December 31, 2018 or 2017. For information regarding investments in funds of our related parties, refer to Note 16. "Related Party Transactions" below.
The techniques used to determine the fair value of the Pension Plan's invested assets that appear on the following page are as follows:
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The investments in the global equity and liability hedging funds are collective investment funds that utilize a market approach wherein the published prices in the active market for identical assets are used. These investments are traded at their net asset value per share. There are no restrictions as to the redemption of these investments nor do we have any contractual obligations for further investment. These investments are classified as Level 1 in the fair value hierarchy.
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The investments in private limited partnerships and other private equity securities are valued utilizing net asset value as a practical expedient for fair value. These investments are not classified in the fair value hierarchy.
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Short-term investments are carried at cost, which approximates fair value. Given that these investments are listed on active exchanges, coupled with their liquid nature, these investments are classified as Level 1 in 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.
For discussion regarding the levels within the fair value hierarchy, see Note 2. "Summary of Significant Accounting Policies."
In addition, refer to Note 5. "Investments" for discussion regarding the limited partnership investment strategies, excluding the middle market lending strategy, as these investments are not part of the Pension Plan.
The Pension Plan invests in hedge funds, as part of its overall private asset strategy, with diversified exposure to a number of underlying systematic strategies that include arbitrage, macro-oriented, and equity-related strategies. These positions are expected to improve the risk-adjusted return of the portfolio given their lower volatility profile than public equities, with returns that are generally uncorrelated to traditional asset classes over a complete market cycle.
The following tables provide quantitative disclosures of the Pension Plan’s invested assets that are measured at fair value on a recurring basis:
1In accordance with ASU 2015-07, certain investments that are measured at fair value using the net asset value per share (or its practical expedient) have not been classified in the fair value hierarchy. The fair value amounts presented in this table are intended to permit reconciliation of the fair value hierarchy to total Pension Plan invested assets.
Contributions
We presently do not anticipate contributing to the Pension Plan in 2019, as we have no minimum required contribution amounts.
Benefit Payments
Note 15. Share-Based Payments
Active Plans
As of December 31, 2018, the following four plans were available for the issuance of share-based payment awards:
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The 2014 Omnibus Stock Plan, As Amended and Restated Effective as of May 2, 2018 (the "Stock Plan");
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The Cash Incentive Plan, As Amended and Restated as of May 1, 2014 (the "Cash Plan");
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The Employee Stock Purchase Plan (2009) ("ESPP"); and
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The Amended and Restated Stock Purchase Plan for Independent Insurance Agencies (2010), Amended and Restated as of February 1, 2017 (the "Agent Plan").
The following table provides information regarding the approval of these plans:
The types of awards that can be issued under each of these plans are as follows:
Shares authorized and available for issuance as of December 31, 2018 are as follows:
Retired Plans
The following plans are closed for the issuance of new awards, although awards outstanding continue in effect according to the terms of the applicable award agreements:
1Awards outstanding under the 2005 Stock Plan consisted of 47,268 shares deferred by our non-employee directors and 126,735 stock options.
RSU Transactions
A summary of the RSU transactions under our share-based payment plans is as follows:
As of December 31, 2018, total unrecognized compensation expense related to unvested RSU awards granted under our Stock Plan was $11.0 million. That expense is expected to be recognized over a weighted-average period of 1.7 years. The total intrinsic value of RSUs vested was $18.0 million for 2018, $16.0 million for 2017, and $12.6 million for 2016. In connection with vested RSUs, the total value of the DEUs that vested was $0.8 million in 2018, $0.9 million in 2017, and $0.7 million in 2016.
Option Transactions
A summary of the stock option transactions under our 2005 Stock Plan is as follows:
The total intrinsic value of options exercised was $4.5 million in 2018, $4.0 million in 2017, and $2.3 million in 2016.
CIU Transactions
The liability recorded in connection with our Cash Plan was $21.6 million at December 31, 2018 and $37.0 million at December 31, 2017. The remaining cost associated with the CIUs is expected to be recognized over a weighted average period of 0.8 years. The CIU payments made were $20.2 million in 2018, $14.2 million in 2017, and $14.3 million in 2016.
ESPP and Agent Plan Transactions
A summary of ESPP and Agent Plan share issuances is as follows:
Fair Value Measurements
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.
The grant date fair value of each option award is estimated 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 weighted-average fair value of options and stock per share, including RSUs granted for the Parent's stock plans, during 2018, 2017, and 2016 was as follows:
The fair value of the CIU liability is remeasured 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 CIUs that, in accordance with the CIU agreements established under the Cash Plan, is adjusted to reflect our performance on specified indicators as compared to targeted peer companies.
Expense Recognition
The following table provides share-based compensation expense in 2018, 2017, and 2016:
Note 16. 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, which includes the right to participate in the Agent Plan. Mr. Rue’s son is President, and an employee, of Rue Insurance, and owns more than 10% of the equity of Rue Insurance. Mr. Rue’s daughter is an employee of Rue Insurance. Our relationship with Rue Insurance has existed since 1928.
Rue Insurance placed insurance policies with the Insurance Subsidiaries for its customers and itself. Direct premiums written associated with these policies were $10.1 million in 2018, $11.1 million in 2017, and $10.4 million in 2016. In return, the Insurance Subsidiaries paid standard market commissions, including supplemental commissions, to Rue Insurance of $2.1 million in 2018, $2.3 million in 2017, and $2.1 million in 2016. Amounts due to Rue Insurance at December 31, 2018 and December 31, 2017 were $0.4 million and $0.6 million, respectively. All contracts and transactions with Rue Insurance were consummated in the ordinary course of business on an arm's-length basis.
In 2005, we established a private foundation, now named The Selective Insurance 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 $0.5 million of contributions to the Foundation in 2018. We made no contributions to the Foundation in 2017 and 2016, respectively.
BlackRock, Inc., a leading publicly traded investment management firm (“BlackRock”), has purchased our common shares in the ordinary course of its investment business and has previously filed Schedules 13G/A with the SEC. On January 31, 2019, BlackRock filed a Schedule 13G/A reporting beneficial ownership as of December 31, 2018, of 14.2% of our common stock. In connection with purchasing our common shares, BlackRock filed the necessary filings with insurance regulatory authorities. On the basis of those filings, BlackRock is deemed not to be a controlling person for the purposes of applicable insurance law.
We are required to disclose related party information for our transactions with BlackRock. BlackRock is highly regulated, serves its clients as a fiduciary, and has a diverse platform of active (alpha) and index (beta) investment strategies across asset classes that enables it to tailor investment outcomes and asset allocation solutions for clients. BlackRock also offers the BlackRock Solutions® investment and risk management technology platform, Aladdin®, risk analytics, advisory, and technology services and solutions to a broad base of institutional and wealth management investors. We incurred expenses related to BlackRock for services rendered of $2.0 million in both 2018 and 2017, and $0.4 million in 2016. Amounts payable for such services at December 31, 2018 and December 31, 2017, were $1.0 million and $0.5 million, respectively.
As part of our overall investment diversification, we invest in various BlackRock funds from time to time. The market value of these investments were $0.8 million at December 31, 2018, and $0.5 million at both December 31, 2017 and December 31, 2016. There were no material transactions related to these holdings in 2018 and 2017. During 2016, we sold $77.6 million of these investments, which resulted in a $1.1 million gain on our investment portfolio. In addition, we recorded $2.3 million of investment income on these funds in 2016. There were no amounts payable on the settlement of these investment transactions at December 31, 2018 or December 31, 2017.
Our Pension Plan contained investments in BlackRock funds of $131.9 million at December 31, 2018 and $134.3 million at December 31, 2017. We recorded a net investment loss on these funds of $9.3 million in 2018, net investment income of $25.2 million in 2017, and net investment income of $8.5 million in 2016. In addition, our Deferred Compensation Plan and Retirement Savings Plan may offer our employees the option to invest in various BlackRock funds. All contracts and transactions with BlackRock were consummated in the ordinary course of business on an arm's-length basis.
The Vanguard Group ("Vanguard"), one of the world's largest investment management companies, offers low cost mutual funds and exchange-trade funds ("ETFs"), as well as other investment related services. On January 10, 2019, Vanguard filed a Schedule 13G/A reporting beneficial ownership as of December 31, 2018, of 10.1% of our common stock. In connection with purchasing our common shares, Vanguard filed the necessary filings with insurance regulatory authorities. On the basis of those filings, we do not expect Vanguard to be deemed a controlling person for the purposes of applicable insurance law.
We are required to disclose related party information for our transactions with Vanguard. As part of our overall investment diversification, we may invest in various Vanguard funds from time to time. During 2018, we purchased $11.5 million in a Vanguard ETF and recorded dividend income of $0.4 million, with no amounts payable on the settlement of this transaction at December 31, 2018. The market value of this fund in our investment portfolio at December 31, 2018 was $10.5 million. There were no transactions with Vanguard in 2017 and 2016.
Our Pension Plan contained investments in Vanguard funds of $86.3 million at December 31, 2017, but no investment in these funds existed at December 31, 2018. We recorded a net investment loss on these funds of $5.5 million in 2018, net investment income of $9.1 million in 2017, and net investment income of $5.4 million in 2016. In addition, our Deferred Compensation Plan and Retirement Savings Plan may offer our employees the option to invest in various Vanguard funds. All transactions with Vanguard are consummated in the ordinary course of business on an arm's-length basis.
Note 17. 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, 2018, we had purchased such annuities with a present value of $21.0 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, equipment, and fleet vehicles. Such lease agreements, which expire at various times, are generally renewed or replaced by similar leases. Rental expense under these leases amounted to $10.4 million in 2018, $10.8 million in 2017, and $12.3 million in 2016. We also lease computer hardware and software under capital lease agreements expiring at various dates through 2022. See item (p) of Note 2. "Summary of Significant Accounting Policies" in this Form 10-K for information on our accounting policy regarding leases.
In addition, certain of these leases are non-cancelable, and liability for payment will continue even though the leased asset may no longer be in use. At December 31, 2018, the total future minimum rental commitments under non-cancelable leases were as follows:
(c) As of December 31, 2018, we had contractual obligations that expire at various dates through 2036 to invest up to an additional $202.3 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. In addition, as of December 31, 2018, we had the following contractual obligations: (i) $17.8 million to further invest in non-publicly traded common stock within our equity portfolio that expire in 2023; and (ii) $40.4 million to further invest in non-publicly traded CLOs in our fixed income securities portfolio that expire through 2030. We expect to have the capacity to repay and/or refinance these obligations as they become due.
Note 18. 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 any potential ultimate liability in such ordinary course claims litigation will not be material to our consolidated financial condition, results of operations, or cash flows after consideration of provisions made for potential losses and costs of defense.
From time to time, our Insurance Subsidiaries also are named as defendants 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. Similarly, our Insurance Subsidiaries are also named from time-to-time in individual actions seeking extra-contractual damages, punitive damages, or penalties, some of which allege bad faith in the handling of insurance claims. We believe that we have valid defenses to these cases. We expect that any potential ultimate liability in any such lawsuit will not be material to our consolidated financial condition, after consideration of provisions made for estimated losses. Nonetheless, given the inherent unpredictability of litigation and the large or indeterminate amounts sought in certain of these actions, an adverse outcome in certain matters could possibly have a material adverse effect on our consolidated results of operations or cash flows in particular quarterly or annual periods.
As of December 31, 2018, we do not believe the Company was involved in any legal action that could have a material adverse effect on our consolidated financial condition, results of operations, or cash flows.
Note 19. 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 affect the determination of statutory surplus, statutory net income, or risk-based capital (“RBC”). As of December 31, 2018, the various state insurance departments of domicile have adopted the March 2018 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 based on their 2018 statutory financial statements. 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
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.
In addition to regulatory restrictions on the availability of dividends that our Insurance Subsidiaries can pay to the Parent, the maximum amount of dividends the Parent can pay our shareholders is limited by certain New Jersey corporate law provisions that limit dividends if either: (i) the Parent would be unable to pay its debts as they became due in the usual course of business; or (ii) the Parent’s total assets would be less than its total liabilities. The Parent’s ability to pay dividends to shareholders also are impacted by covenants in its Line of Credit agreement that obligate it, among other things, to maintain a minimum consolidated net worth, statutory surplus, and debt-to-capital ratio.
As of December 31, 2018, the Parent had an aggregate of $146.0 million in investments and cash available to fund future dividends and interest payments. These amounts are not subject to any regulatory restrictions other than the standard state insolvency restrictions noted above, whereas our consolidated retained earnings of $1.9 billion is predominately restricted due
to the regulation associated with our Insurance Subsidiaries. In 2019, the Insurance Subsidiaries have the ability to provide for $210.0 million in annual dividends to the Parent; however, as regulated entities, these dividends are subject to certain restrictions, which are further discussed below. The Parent also has available to it other potential sources of liquidity, such as: (i) borrowings from our Indiana Subsidiaries; (ii) debt issuances; (iii) common stock issuances; and (iv) borrowings under our Line of Credit. Borrowings from our Indiana Subsidiaries are governed by approved intercompany lending agreements with the Parent that provide for additional capacity of $70.5 million as of December 31, 2018, based on restrictions in these agreements that limit borrowings to 10% of the admitted assets of the Indiana 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 laws 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 table below provides the following information: (i) quantitative data regarding all Insurance Subsidiaries' dividends paid to the Parent in 2018 for debt service, shareholder dividends, and general operating purposes; and (ii) the maximum ordinary dividends that can be paid to the Parent by the Insurance Subsidiaries in 2019, based on the 2018 statutory financial statements.
Note 20. Quarterly Financial Information
1Results for the fourth quarter of 2017 include the impact of the $20.2 million write off of deferred tax assets required with the implementation of Tax Reform. See Note 13. "Federal Income Taxes" above for additional information.
2Effective January 1, 2018, changes in unrealized gains and losses on our equity portfolio are recognized in income through "Net unrealized losses on equity securities" on our Consolidated Statements of Income, as a result of our adoption of ASU 2016-01. See Note 3. "Adoption of Accounting Pronouncements" above.
The addition of all quarters may not agree to annual amounts on the Financial Statements due to rounding.
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 this 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, 2018. 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.
Based on this assessment, our management believes that, as of December 31, 2018, 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 2018 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
To the Stockholders and Board of Directors
Selective Insurance Group, Inc.:
Opinion on Internal Control Over Financial Reporting
We have audited Selective Insurance Group, Inc. and subsidiaries’ (the "Company") internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States)
("PCAOB"), the consolidated balance sheets of the Company as of December 31, 2018 and 2017, the related consolidated
statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the years in the three-year
period ended December 31, 2018, and the related notes and financial statement schedules I to V (collectively, the "consolidated
financial statements"), and our report dated February 15, 2019 expressed an unqualified opinion on those consolidated
financial statements.
Basis for Opinion
The Company’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 are a public accounting firm registered with the PCAOB and are
required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. 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 of internal control over financial reporting 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.
Definition and Limitations of Internal Control Over Financial Reporting
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.
/s/ KPMG LLP
New York, New York
February 15, 2019
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 2018 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, 2018, 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 "Information About Proposal 1 - 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 "Information About Proposal 4 - Ratification of Appointment of Independent Registered Public Accounting Firm" section of the Proxy Statement and is hereby incorporated by reference.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules.
(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.
SCHEDULE I
SELECTIVE INSURANCE GROUP, INC. AND CONSOLIDATED SUBSIDIARIES
SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES
December 31, 2018
See accompanying Report of Independent Registered Public Accounting Firm in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K.
SCHEDULE II
SELECTIVE INSURANCE GROUP, INC.
(Parent Corporation)
Balance Sheets
See accompanying Report of Independent Registered Public Accounting Firm. Information should be read in conjunction with the Notes to Consolidated Financial Statements of Selective Insurance Group, Inc. and its subsidiaries. Both items are 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
See accompanying Report of Independent Registered Public Accounting Firm. Information should be read in conjunction with the Notes to Consolidated Financial Statements of Selective Insurance Group, Inc. and its subsidiaries. Both items are 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
See accompanying Report of Independent Registered Public Accounting Firm. Information should be read in conjunction with the Notes to Consolidated Financial Statements of Selective Insurance Group, Inc. and its subsidiaries. Both items are 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, 2018
1Includes “Net investment income earned” and “Total net realized and unrealized (losses) gains” on the Consolidated Statements of Income.
2“Other operating expenses” of $321,880 reconciles to the Consolidated Statements of Income as follows:
See accompanying Report of Independent Registered Public Accounting Firm in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K.
Year ended December 31, 2017
1Includes “Net investment income earned” and “Total net realized and unrealized (losses) gains” on the Consolidated Statements of Income.
2“Other operating expenses” of $322,381 reconciles to the Consolidated Statements of Income as follows:
See accompanying Report of Independent Registered Public Accounting Firm in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K.
SCHEDULE III (continued)
SELECTIVE INSURANCE GROUP, INC. AND CONSOLIDATED SUBSIDIARIES
SUPPLEMENTARY INSURANCE INFORMATION
Year ended December 31, 2016
1Includes “Net investment income earned” and “Total net realized and unrealized (losses) gains” on the Consolidated Statements of Income.
2“Other operating expenses” of $312,514 reconciles to the Consolidated Statements of Income as follows:
See accompanying Report of Independent Registered Public Accounting Firm in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K.
SCHEDULE IV
SELECTIVE INSURANCE GROUP, INC. AND CONSOLIDATED SUBSIDIARIES
REINSURANCE
Years ended December 31, 2018, 2017, and 2016
See accompanying Report of Independent Registered Public Accounting Firm in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K.
SCHEDULE V
SELECTIVE INSURANCE GROUP, INC. AND CONSOLIDATED SUBSIDIARIES
ALLOWANCE FOR UNCOLLECTIBLE PREMIUMS AND OTHER RECEIVABLES
Years ended December 31, 2018, 2017, and 2016
See accompanying Report of Independent Registered Public Accounting Firm in Item 8. "Financial Statements and Supplementary Data." of this Form 10-K.
EXHIBIT INDEX
* Filed herewith.
** Furnished and not filed herewith.
+ Management compensation plan or arrangement.
(P) Paper filed.
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 15, 2019
Gregory E. Murphy
Chairman of the Board and Chief Executive Officer
(principal executive officer)
By: /s/ Mark A. Wilcox
February 15, 2019
Mark A. Wilcox
Executive Vice President and Chief Financial Officer
(principal financial officer)
By: /s/ Anthony D. Harnett
February 15, 2019
Anthony D. Harnett
Senior Vice President and Chief Accounting Officer
(principal accounting 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.