Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Item 6. Selected Financial Data.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Item 8. Financial Statements and Supplementary Data.
Note 1. Organization
Note 2. Summary of Significant Accounting Policies
Note 3. Adoption of Accounting Pronouncements
Note 4. Statements of Cash Flows
Note 5. Investments
Note 6. Comprehensive Income
Note 7. Fair Value Measurements
Note 8. Reinsurance
Note 9. Reserve for Loss and Loss Expense
Note 10. Indebtedness
Note 11. Segment Information
Note 12. Earnings per Share
Note 13. Federal Income Taxes
Note 14. Retirement Plans
Note 15. Share-Based Payments
Note 16. Related Party Transactions
Note 17. Commitments and Contingencies
Note 18. Litigation
Note 19. Statutory Financial Information, Capital Requirements, and Restrictions on Dividends and Transfers of Funds
Note 20. Quarterly Financial Information
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
Item 9A. Controls and Procedures.
Item 9B. Other Information.
Item 10. Directors, Executive Officers and Corporate Governance.
Item 11. Executive Compensation.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
Item 14. Principal Accounting Fees and Services.
Item 15. Exhibits, Financial Statement Schedules.
Selective Insurance Group Earnings 2018-12-31
SIGI 10K Annual Report
10-K 1 sigi-12312018x10k.htm 10-K Document
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
ý ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended: December 31, 2018
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from_______________________to_______________________
Commission file number 001-33067
SELECTIVE INSURANCE GROUP, INC.
(Exact Name of Registrant as Specified in Its Charter)
(State or Other Jurisdiction of Incorporation or Organization)
(I.R.S. Employer Identification No.)
40 Wantage Avenue, Branchville, New Jersey
(Address of Principal Executive Offices)
Registrant’s telephone number, including area code:
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Name of each exchange on which registered
Common Stock, par value $2 per share
NASDAQ Global Select Market
5.875% Senior Notes due February 9, 2043
New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
ý Yes ¨ No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
¨ Yes ý No
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
ý Yes ¨ No
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).
ý Yes ¨ No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer x
Accelerated filer ¨
Non-accelerated filer ¨
Smaller reporting company ¨
Emerging growth company ¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
¨ Yes ý No
The aggregate market value of the voting company common stock held by non-affiliates of the registrant, based on the closing price on the NASDAQ Global Select Market, was $3,169,745,480 on June 30, 2018. As of February 7, 2019, the registrant had outstanding 58,966,940 shares of common stock.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s definitive Proxy Statement for the 2019 Annual Meeting of Stockholders to be held on May 1, 2019 are incorporated by reference into Part III of this report.
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:
Financial Strength Rating
Standard & Poor’s Global Ratings (“S&P”)
Moody’s Investors Services (“Moody’s”)
Fitch Ratings (“Fitch”)
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.
We classify our business into four reportable segments:
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.
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.
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.
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:
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.
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.
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.
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:
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.
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:
Types of Policies
Category of Insurance
Standard Commercial Lines
Standard Personal Lines
Commercial Property (including Inland Marine)
General Liability (including Excess Liability/Umbrella)
Bonds (Fidelity and Surety)
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"):
Percentage of Standard Commercial Lines
General contractors and trade contractors
Mercantile and Services
Focuses on retail, office, service businesses, restaurants, golf courses, and hotels
Community and Public Services
Focuses on public entities, social services, religious institutions, and schools
Manufacturing and Wholesale
Includes manufacturers, wholesalers, and distributors
Includes fidelity and surety
Total Standard Commercial Lines
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:
The average Standard Commercial Lines premium per customer is approximately $12,000.
The average Standard Personal Lines premium per customer is approximately $2,000.
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.
We sell in the following geographic markets:
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.
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.
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:
Hamilton, New Jersey
Branchville, New Jersey
Allentown, Pennsylvania and Hunt Valley, Maryland
Charlotte, North Carolina
In addition, our E&S Lines are supported by office locations in Horsham, Pennsylvania and Scottsdale, Arizona.
We sell our insurance products and services through the following types of distribution partners:
Standard Commercial Lines: independent retail agents;
Standard Personal Lines: independent retail agents; and
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.
Our primary marketing strategy is to:
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.
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.
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.
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
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:
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;
Our underwriters with targeted underwriting and pricing tools to enhance profitability while growing the business;
Our workers compensation claims adjusters with predictive tools to indicate when claims are likely to escalate to better serve our customers;
Our Special Investigations Unit ("SIU") investigators access to our business intelligence systems to better identify claims with potential fraudulent activities;
Our claims recovery and subrogation departments with the ability to expand and enhance their models through the use of our business intelligence systems; and
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.
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.
Our underwriting process requires communication and interaction among:
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;
Our corporate underwriting department, which develops our underwriting appetite, products, policy forms, pricing, and underwriting guidelines for our standard market business;
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;
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;
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;
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;
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;
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;
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;
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;
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;
Our field technical coordinators, who are responsible for technology assistance and training to aid our employees and standard market distribution partners;
Our Personal Lines Marketing Specialists (“PLMSs”), who have primary responsibility for identifying new opportunities to grow our Standard Personal Lines; and
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.
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:
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.
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.
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.
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.
The Large Loss Unit ("LLU") handles complex property claims, typically those in excess of $100,000.
All asbestos and environmental claims are referred to our specialized corporate Environmental Unit, which also handles other latent claims.
The Construction Defect Unit unit handles larger, complex construction defect claims.
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:
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.
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.
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:
Nautilus Insurance Group, a member of W. R. Berkley Company;
Colony Specialty, a member of the Argo Group International Holding Ltd;
Western World Insurance Group, a member of the American International Group;
Century Insurance Group, a member of the Meadowbrook Insurance Group;
The Burlington Insurance Company, a member of IFG Companies;
Scottsdale Insurance Company, an affiliate of Nationwide Mutual Insurance Company;
United States Liability Insurance Group, a member of Berkshire Hathaway, Inc.;
Cincinnati Financial Corporation; and
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.
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:
Pricing and underwriting practices;
Exiting geographic markets and/or canceling or non-renewing policies;
Assessments for guaranty funds and second-injury funds and other mandatory assigned risks and reinsurance;
The types, quality and concentration of investments we make;
Minimum capital requirements for the Insurance Subsidiaries;
Dividends from our Insurance Subsidiaries to the Parent; and
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. “Risk Factors.” of this Form 10-K.
Our various state insurance regulators are members of the National Association of Insurance Commissioners ("NAIC"). The NAIC has codified statutory accounting principles ("SAP") and other accounting reporting formats and drafts model insurance laws and regulations governing insurance companies. An NAIC model only becomes law when it is enacted in the various state legislatures or promulgated as a regulation by the state insurance department. The adoption of certain NAIC model laws and regulations, however, is a key aspect of the NAIC Financial Regulations Standards and Accreditation Program.
NAIC Monitoring Tools
Among the NAIC's various financial monitoring tools that are material to the regulators in states in which our Insurance Subsidiaries are organized are the following:
The Insurance Regulatory Information System ("IRIS"). IRIS identifies 13 industry financial ratios and specifies “usual values” for each ratio. Departure from the usual values on four or more of the financial ratios can lead to inquiries from individual state insurance departments about certain aspects of the insurer's business. Our Insurance Subsidiaries have consistently met the majority of the IRIS ratio tests.
Risk-Based Capital. Risk-based capital is measured by four major areas of risk to which property and casualty insurers are exposed: (i) asset risk; (ii) credit risk; (iii) underwriting risk; and (iv) off-balance sheet risk. Insurers face a steadily increasing amount of regulatory scrutiny and potential intervention as their total adjusted capital declines below three times their "Authorized Control Level." Based on our 2018 statutory financial statements, which have been prepared in accordance with SAP, the total adjusted capital for each of our Insurance Subsidiaries substantially exceeded three times their Authorized Control Level.
Annual Financial Reporting Regulation (referred to as the "Model Audit Rule"). The Model Audit Rule, which is modeled closely on the Sarbanes-Oxley Act of 2002, as amended ("Sarbanes-Oxley Act"), regulates: (i) auditor independence; (ii) corporate governance; and (iii) internal control over financial reporting. As permitted under the Model Audit Rule, the Audit Committee of the Board of Directors (the “Board”) of the Parent also serves as the audit committee of each of our Insurance Subsidiaries.
Own Risk and Solvency Assessment ("ORSA"). ORSA requires insurers to maintain a framework for identifying, assessing, monitoring, managing, and reporting on the “material and relevant risks” associated with the insurers' (or insurance groups') current and future business plans. ORSA, which has been adopted by the state insurance regulators of our Insurance Subsidiaries, requires companies to file an internal assessment of their solvency with insurance regulators annually. Although no specific capital adequacy standard is currently articulated in ORSA, it is possible that such standard will be developed over time and may increase insurers' minimum capital requirements, which could adversely impact our growth and return on equity.
In addition to the formal regulation above, we are subject to capital adequacy monitoring by rating agencies, for example, Best's Capital Adequacy Ratio ("BCAR") and S&P's capital model. BCAR, which was developed by A.M. Best, and S&P's capital model examine the strength of an insurer's balance sheet and compare available capital to estimated required capital at various probability or rating levels. The regulatory and rating agency models differ from each other in their design. Although the results of each model show similar direction as circumstances change, they react differently to changes in economic conditions, underwriting and investment portfolio mix, and capital, and are also subject to change as the rating agencies update and change their capital adequacy models and requirements over time. This model divergence, combined with updates and changes to the rating agency capital adequacy models over time, can complicate decisions around management of our capital, risk profile, and growth objectives.
Notable federal legislation and administrative policies that affect the insurance industry are:
Terrorism Risk Insurance Program Reauthorization Act ("TRIPRA");
Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”); and
Various privacy laws that apply to us because we have personal non-public information, including the:
Fair Credit Reporting Act;
Drivers Privacy Protection Act; and
Health Insurance Portability and Accountability Act.
Like all businesses, we are required to enforce the economic and trade sanctions of the Office of Foreign Assets Control (“OFAC”).
The Mitigation Division of the Federal Emergency Management Agency ("FEMA") oversees the NFIP's WYO, which was created by an act of Congress. Under the program, all losses are 100% reinsured by the Federal government and we receive an expense allowance for flood policies written and a servicing fee for flood claims administered . Congress sets the WYO's budgeting, rules, and rating parameters. The program has been extended several times since its 2018 expiration, and it currently expires on May 31, 2019. While short-term lapses impacting our ability to service NFIP policies may occur from time-to-time, we do not expect a long-term disruption to the program. We continue to participate in the public policy debate to achieve a long-term meaningful program extension.
In response to the financial markets crises in 2008 and 2009, the Dodd-Frank Act was enacted in 2010. This law provided for, among other things, the following:
The establishment of the Federal Insurance Office (“FIO”) under the United States Department of the Treasury;
Federal Reserve oversight of financial services firms designated as systemically important; and
Corporate governance reforms for publicly-traded companies.
The FIO, the Federal Reserve, state regulators, and other regulatory bodies have been developing models for capital standards, negotiated a covered agreement with the European Union that, among other things, impacted reinsurance collateral, and have been gathering data as required under the Dodd-Frank Act. We continue to monitor and be actively involved in the industry and public policy discussions around federal and international insurance regulatory developments to ensure that the state regulatory system established under the McCarran-Ferguson Act is maintained.
For additional information on the potential impact of the Dodd-Frank Act, refer to the risk factor related to this legislation within Item 1A. “Risk Factors.” of this Form 10-K.
We believe that development of global capital standards will influence the development of similar standards by domestic regulators. Notable international developments include the following:
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; and
The European Union enacted Solvency II, which sets out new requirements on capital adequacy and risk management for insurers operating in Europe, which was implemented in 2016.
For additional information on the potential impact of international regulation on our business, refer to the risk factor related to regulation within Item 1A. “Risk Factors.” of this Form 10-K.
Our Investments segment seeks to generate net investment income by investing the premiums we receive from our insurance operations and the amounts generated through our capital management strategies, which may include the issuance of debt and equity securities. Proceeds are used to satisfy obligations to our customers, our shareholders, and our debt holders, among others.
At December 31, 2018, our investment portfolio consisted of the following:
Category of Investment
($ in millions, except invested assets per dollar of stockholders' equity)
% of Investment
Fixed income securities
Other investments, including alternatives
Invested assets per dollar of stockholders' equity
Our investment philosophy includes certain net investment income, total return, and risk objectives for our fixed income, equity, and other investment portfolios. Our investment strategies are managed by our internal investment management team, and are executed by relationships with multiple external investment advisers.
During 2018, we were able to increase our after-tax pretax book yield on our core fixed income portfolio by 47 basis points as we tactically positioned the investment portfolio to take advantage of rising rates without increasing credit risk or extending the duration of the portfolio. As an example, approximately 16% of the fixed-income portfolio is in floating rate securities, which reset principally on 90-day LIBOR. The book yield on these securities has benefited from the 111 basis point increase in 90-day LIBOR in 2018. Also, we actively managed the investment portfolio with an emphasis on a portion of our portfolio that we refer to as risk assets. Our risk assets include public equity, high-yield fixed income securities, and alternative investments. Our active management included trimming our exposure to public equities and high yield fixed-income securities to 7.2% on December 31, 2018, from 7.9% on December 31, 2017. Overall, we have been gradually diversifying our portfolio, and will work towards modestly increasing our risk asset allocation over time, up to approximately 10% of our invested assets, depending on market conditions.
For further information regarding our risks associated with the overall investment portfolio, see Item 7A. “Quantitative and Qualitative Disclosures About Market Risk.” and Item 1A. “Risk Factors.” of this Form 10-K. For additional information about investments, see the section entitled, “Investments Segment,” in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” and Item 8. “Financial Statements and Supplementary Data.” Note 5. of this Form 10-K.
Enterprise Risk Management
As a property and casualty holding company, our Insurance Subsidiaries are in the business of assuming risk. We categorize our major risks into the following five broad categories:
Asset risk, which stems primarily from our investment portfolio and reinsurance recoverables and includes credit and market risk;
Underwriting risk, which is the risk that the insured losses are higher than our expectations, including:
Losses from inadequate loss reserves;
Larger than expected non-catastrophe current accident year losses; and
Catastrophe losses that exceed our expectations or our reinsurance treaty limits.
Liquidity risk, which is the risk we will be unable to meet contractual obligations as they become due because we are unable to liquidate assets or obtain adequate funding without incurring unacceptable losses;
Emerging risks, which are new and known but evolving risks that may have a significant impact on our financial strength, reputation, or long-term strategy, potentially including U.S. and global economic concerns; and
Other risks, including a broad range of operational risks that can be difficult to quantify, such as legal, regulatory, reputational, and strategic risks as well as the risk of fraud, human failure, and failure of controls and systems, including, for example a rapidly evolving cyber security risk.
Our internal control framework operates with the three lines of defense model. The first line of defense consists of individual functions that deliberately assume risks and own and manage that risk on a day-to-day and business operational basis. The second line of defense is responsible for risk oversight and also supports the first line to understand and manage risk. A dedicated risk team led by the Chief Risk Officer is responsible for this second line and reports to the Chief Financial Officer. The third line of defense is our Internal Audit team, which provides independent, objective assurance as to the assessment of the adequacy and effectiveness of our internal control environment. It also coordinates risk-based audits and compliance reviews and other specific initiatives to evaluate and address risk within targeted areas of our business.
We use Enterprise Risk Management (“ERM”) as part of our governance and control process to take an entity-wide view of our major risks and their impact. Our ERM framework is designed to identify, measure, report, and monitor our major risks and develop appropriate responses to support successful execution of our business strategy.
Our Board oversees our ERM process, while the Executive Risk Committee is responsible for the holistic evaluation, management, and supervision of our aggregated risk profile and determination of future risk management actions in support of overall risk appetite. In addition to the Board’s oversight of the ERM process, various committees of the Board oversee risks specific to their areas of supervision and report their activities and findings to the full Board. The Executive Risk Committee uses various management committees for detailed analysis and management of specific major risks. The Executive Risk Committee primarily consists of the Chief Executive Officer, the President and Chief Operating Officer, their direct reports and key operational leaders, each of whom is responsible for management of risk in his or her respective area, and the Chief Risk Officer.
In addition to the various committees and the governance process over the ERM process, we believe that high-quality and effective ERM is best achieved when it is a shared cultural value throughout the organization. We consider ERM to be a key process that is the responsibility of every employee. We have developed and use tools and processes that we believe support a culture of risk management and create a robust framework of ERM within our organization. In addition, our compensation policies and practices, as well as our governance framework, including our Board's leadership structure, are designed to support our overall risk appetite and strategy. Our ERM processes and practices help us to identify potential events that may affect us, quantify, evaluate and manage the risks to which we are exposed, and provide reasonable assurance regarding the achievement of our objectives.
We rely on quantitative and qualitative tools to identify, prioritize, and manage our major risks including proprietary and third-party computer modeling as well as various other analyses. The Executive Risk Committee meets at least quarterly and reviews and discusses various aspects and the interrelation of Selective’s major risks, including, but not limited to, capital modeling results, capital adequacy, risk metrics, emerging risks, and sensitivity analysis. Consistent with the requirements of state insurance regulators, our Insurance Subsidiaries annually file their ORSA report, which is an internal assessment of our Insurance Subsidiaries' solvency. The Chief Risk Officer develops the report in coordination with members of the Executive Risk Committee, and the report is provided to the Board. The Chief Risk Officer reports on the Executive Risk Committee's activities, analyses, and findings to the Board or the appropriate Board Committee, and provides a quarterly update on certain risk metrics.
We believe that our risk governance structure facilitates strong risk dialogue across all levels and disciplines of the organization and promotes robust risk management practices. All of our strategies and controls, however, 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. An investor should carefully consider the risks and all of the other information included in Item 1A. “Risk Factors.”, Item 7A. “Quantitative and Qualitative Disclosures About Market Risk.", and Item 8. “Financial Statements and Supplementary Data." of this Form 10-K.
Reports to Security Holders
We file with the SEC all required disclosures, including our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, Proxy Statements, and any amendments to these reports that we file or furnish pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (“Exchange Act”), which can be accessed on the SEC's website, www.SEC.gov. In addition, we provide access to these filed materials on our Internet website, www.Selective.com.
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:
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.
Certain life insurance companies if they fail to fulfill their obligations to those customers for whom we have purchased annuities under structured settlement agreements.
Some of our distribution partners, who collect premiums due us from our customers.
Some of our customers, who are responsible for payment of premiums and/or deductibles directly to us.
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:
Long Term Credit Outlook
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:
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.
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.
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:
Pricing and underwriting practices;
Exiting geographic markets and/or canceling or non-renewing policies;
Assessments for guaranty funds and second-injury funds and other mandatory assigned risks and reinsurance;
The types, quality, and concentration of investments we make;
Dividends from our Insurance Subsidiaries to the Parent; and
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:
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.
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.
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:
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;
Credit scoring and predictive modeling pricing;
Managed care practices;
Prompt and appropriate payment of personal injury protection claims;
Direct repair shop utilization practices;
The use of after-market replacement parts;
Flood insurance claim practices; and
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:
The highest priority is given to quoted prices in active markets for identical assets or liabilities (Level 1).
The next priority is to quoted prices in markets that are not active or inputs that are observable either directly or indirectly, including quoted prices for similar assets or liabilities or in markets that are not active and other inputs that can be derived principally from, or corroborated by, observable market data for substantially the full term of the assets or liabilities (Level 2).
The lowest priority in the fair value hierarchy is to unobservable inputs supported by little or no market activity and that reflect the reporting entity’s own assumptions about the exit price, including assumptions that market participants would use in pricing the asset or liability (Level 3).
An asset or liability’s classification within the fair value hierarchy is based on the lowest level of significant input to its valuation. We generally use an independent pricing service and broker quotes to price our investment securities. At December 31, 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:
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;
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. Unresolved Staff Comments.
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. 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.
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.”
We had 3,122 stockholders of record as of February 7, 2019 according to the records maintained by our transfer agent.
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:
Number of securities to be issued upon exercise of outstanding options, warrants and rights
Weighted-average exercise price of outstanding options, warrants and rights
Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
Equity compensation plans approved by security holders
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:
Total Number of Shares Purchased1
Average Price Paid Per Share
Total Number of Shares Purchased as Part of Publicly Announced Programs
Maximum Number of Shares that May Yet Be Purchased Under the Announced Programs
October 1 – 31, 2018
November 1 – 30, 2018
December 1 – 31, 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. Selected Financial Data.
Five-Year Financial Highlights
(All presentations are in accordance with GAAP unless noted otherwise, number of weighted average shares and dollars in thousands, except per share amounts)
Net premiums written
Net premiums earned
Net investment income earned
Net realized and unrealized (losses) gains1
Statutory premiums to surplus ratio
Impact of catastrophe losses on combined ratio
Invested assets per dollar of stockholders' equity
Yield on investments, after tax
Debt to capitalization ratio
Return on average equity
Per share data:
Dividends to stockholders
Price range of common stock:
Number of weighted average shares:
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. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Certain statements in this report, including information incorporated by reference, are “forward-looking statements” as that term is defined in the Private Securities Litigation Reform Act of 1995 (“PSLRA”). The PSLRA provides a safe harbor under the Securities Act of 1933, 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.
We classify our business into four reportable segments, which are as follows:
Standard Commercial Lines;
Standard Personal Lines;
E&S Lines; and
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:
Critical Accounting Policies and Estimates;
Financial Highlights of Results for Years Ended December 31, 2018, 2017, and 2016;
Results of Operations and Related Information by Segment;
Federal Income Taxes;
Financial Condition, Liquidity, and Capital Resources;
Off-Balance Sheet Arrangements;
Contractual Obligations, Contingent Liabilities, and Commitments; and
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 $3.2 billion, respectively. The Insurance Subsidiaries' liability duration was approximately 3.6 years at December 31, 2018, down from 3.8 years at December 31, 2017.
The following tables provide case and incurred but not reported (“IBNR”) reserves for loss and loss expenses, and reinsurance recoverable on unpaid loss and loss expense as of December 31, 2018 and 2017:
As of December 31, 2018
Loss and Loss Expense Reserves
($ in thousands)
Reinsurance Recoverable on Unpaid Loss and Loss Expense
Total Standard Commercial Lines
Total Standard Personal Lines
E&S casualty lines1
E&S property lines2
Total E&S Lines
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).
December 31, 2017
Loss and Loss Expense Reserves
($ in thousands)
Reinsurance Recoverable on Unpaid Loss and Loss Expense
Total Standard Commercial Lines
Total Standard Personal Lines
E&S casualty lines1
E&S property lines2
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 $65.8 million in 2016. The following table summarizes prior year development by line of business:
(Favorable)/Unfavorable Prior Year Loss and Loss Expense Development
($ in millions)
E&S casualty lines
E&S property lines
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:
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.
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.
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.
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:
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.
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.
We implemented the following expense improvement initiatives regarding outside adjusters and legal counsel:
Maximized use of staff counsel, increasing staff where necessary to support claims volume;
Utilized staff coverage attorney for coverage reviews;
Heightened focus on legal budgeting and expense management;
Required panel counsel firms to use our electronic legal billing and budgeting system to better manage budgets and expenses associated with litigation; and
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:
Increased focus on reducing workers compensation medical costs through more favorable Preferred Provider Organization ("PPO") contracts and greater PPO penetration.
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.
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.
The strategic realignment of our CMS model to handle property claims under $5,000.
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.
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:
The selection of loss and loss expense development factors;
The weight to be applied to each individual actuarial projection method;
Projected future loss trends; and
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.
Reserve Impacts of Changes to Expected Loss and Loss Expense Reporting Patterns
($ in millions)
(Decrease) to Future Calendar Year Reported
Increase to Future Calendar Year Reported
Commercial automobile liability
Personal automobile liability
E&S casualty lines
Reserve Impacts of Changes to Current Year Expected Ultimate Loss and Loss Expense Ratios
($ in millions)
(Decrease) to Current Accident Year Expected Loss and Loss Expense Ratio
Increase to Current Accident Year Expected Loss and Loss Expense Ratio
Commercial automobile liability
Personal automobile liability
E&S casualty lines
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
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.
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 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 $4.6 million at December 31, 2017. We continually monitor developments that may impact recoverability from our reinsurers and have available to us contractually provided remedies if necessary. For further information regarding reinsurance, see the “Reinsurance” section below and Note 8. “Reinsurance” in Item 8. “Financial Statements and Supplementary Data.” of this Form 10-K.
Financial Highlights of Results for Years Ended December 31, 2018, 2017, and 20161
($ in thousands, except per share amounts)
After-tax net investment income
After-tax underwriting income
Net income before federal income tax
Diluted net income per share
Diluted weighted-average outstanding shares
Invested assets per dollar of stockholders' equity
After-tax yield on investments
Return on equity ("ROE")
Non-GAAP operating income2
Diluted non-GAAP operating income per share2
Non-GAAP operating ROE2
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:
Reconciliation of net income to non-GAAP operating income